Tuesday, December 20, 2011

Spending and Income

Spending and income intuitively sound like opposites. This is because, from the perspective of an individual person, they are -- income is how you get money, spending is how you go broke. We intuitively understand that money must come from somewhere and that it is a finite resource that we will run out of if we’re not careful. But problems arise when we try to apply our intuitions about money to the economy as a whole, because money doesn’t go anywhere. Income and spending are not opposites; in fact they are exactly the same thing, just viewed from different perspectives. Every penny you earn was the result of someone else choosing to spend that penny, and every penny you spend becomes someone else’s income. An economy where everyone is thrifty and does not spend more than they absolutely have to is an economy without much opportunity to make money.

And the economy cannot run out of money due to overspending or be constrained by past overspending. Oil can run out, trees can be cut down more quickly than they regrow, but money is the perfect renewable resource, creating additional income exactly as quickly as it is spent. So if we can never run out of money, the economy cannot possibly be constrained by it, right?

Not so fast. Let’s look at one possible economic scenario that is a lot like running out of money. To keep it simple, we’ll ignore the effects of banking and governments for now.

The Pardox of Thrift

For simplicity, we’ll consider a society with more-or-less evenly distributed wealth. (This scenario can happen with unequal wealth too.) Let’s say, that on average people in this society have $5,000 at any given time -- note that without a change in the money supply, this average cannot ever change. On average, people make $50,000 a year, and on average they spend $50,000 a year -- note that these can change, but these averages must necessarily be equal at all times.

Over time, the people in this society have come to expect to typically have about $5,000 on hand, so when they notice they have less than this they get uncomfortable and start cutting back on unnecessary spending and when they have more than this they loosen up and spend more, and so average spending (and income) remain reasonably steady for a while. So far so good. But, while $5,000 may be the only level of cash on hand that everyone possibly can target given the money supply, the only reason that people are actually targeting that level of cash is simply that it is the amount they are used to having on hand -- hardly anyone is aware of the size of the money supply as a whole. (Are you?)

So one day this economy is hit by some mildly bad economic news -- let’s say one business somewhere is doing layoffs, but not that many people are affected, and nothing big is fundamentally wrong with the economy. Now if a few people see their cash supply fall below $5,000 because they lost their job, they’ll cut back on spending, but the fact that their cash supply has fallen means someone else’s is higher and is splurging, right? But what if you lost your job and had $7,000 on hand? Without a job, you might not feel comfortable spending it even if you would feel comfortable spending it if you did have a job. And what if you knew the people who got laid off, perhaps because you worked at the same company? You might think, “If I lost my job, $5,000 would only last me about a month, maybe I shouldn’t be spending unless I have more than that on hand.” Now not everyone will react by trying to be more thrifty, but no one will react in the opposite way. So some people who could spend are cutting spending, and this means income must also be falling -- some one else loses a job, a wage is cut or a raise doesn’t come. Now a feedback loop has started; others might get the sense that the economy isn’t doing well and they ought to have more money on hand, so spending will fall further, income drops with it, leading to more economic concerns resulting in more cutbacks in spending, and so on.

What’s going on here is essentially a butterfly effect, and if you’ve spent any time studying chaotic systems you’ve probably run across quite simple systems that nonetheless exhibit surprisingly complicated behavior. The real economy is quite a lot more complicated than what is described here, but even without supply shocks, political turmoil, meddling governments or banks, it is already capable of chaotic, unpredictable behavior. And this really does happen; the baby-sitters co-op is a classic real world example of this. Even though there is no change in the availability of money, people’s perceptions of how much money they ought to have can vary unpredictably, so that even though the economy doesn’t run out of money the economy can be brought to a halt by people’s perception that they are short on money.

What have we learned?

An economy with its own money supply cannot run out of money, so it cannot be constrained by a general lack of money. However, an economy can be constrained by an inability or general unwillingness to spend the money it has.

This example also presents two potential roles for government intervention in this sort of downturn. One possible response is, when people try to save more money, expand the money supply. Make it possible for people to have the amount of cash on hand that they want so they can continue spending normally. Of course you will need to be able to contract the money supply as well once people become more comfortable with the state of the economy. The second possible response is, when people spend less, have the government spend more so there is still income to be earned. The tricky part here is financing the spending without further reducing spending; this is best done by borrowing or by taxing money that wasn’t as likely to be quickly spent.

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