Marx, Keynes and the Last Economic Mile

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There is a mathematical problem running through the mainstream of economic thought, one that has been expressed in various forms since the time of Adam Smith. There is apparently a shortcoming to capitalism that springs forth from the very basic, elemental idea of profits. If businesses can make a profit on their endeavors, necessarily paying only a portion of their revenue to labor, then who will buy all the products they produce?

If we view the customer base of business in general to be the very workers that allow the means of production to occur, then the mathematical fact that those same businesses pay their labor force less than the full value of what they produce (the leftover part is the capitalist profit) has to leave a desperate shortfall in the economy. If labor is receiving less than full value, it cannot, on its own, finance the purchase of everything that is produced. Something else must step in to fill the gap between labor's earned income and the receipt of total revenue for production, maintaining the level of production and profit.

This problem of "underconsumption" forms the basis of modern economic thought in certain vital areas, and underscores the political motivations of the economic hierarchy. While the first big debates about underconsumption took place between Thomas Malthus and David Ricardo in the early 19th century (Malthus arguing for it, Ricardo against), the idea has been passed down in many strands of political thought from that point.

Even Karl Marx's critique of the capitalist system (since it is apparently fashionable now to acknowledge the apparent prescience of Marx) contains a strand of what might be thought of as underconsumption in certain situations (though he rejected the idea of capitalism's troubles residing on the demand side, he saw this as a problem of production, so the semantic term underconsumption might not be the best way to phrase this). For Marx, capitalism has an inherent flaw where the long run rate of profitability tends to decline over time (a long topic for another day). In response to this central problem, capitalists, at times, try to squeeze as much profit as possible out of their workforce. In doing so they reduce the overall proportion of revenue paid to the labor force at the cost of essentially shorting their paying customers. This was the basis for the fuss Nouriel Roubini caused when he said that Marx was right about capitalism destroying itself - it seems to accurately describe our current predicament.

It was really the 1920's that got the idea of underconsumption into the mainstream consciousness, particularly in the political arena. It influenced Herbert Hoover and Franklin Roosevelt's similar responses to the growing Great Depression (as well as Marriner Eccles, Chairman of the Federal Reserve from 1934 through 1948, and a very influential economist of demand-side thinking). It also formed an essential basis for John Maynard Keynes.

The point of this brief and intentionally oversimplified review of economic history is to demonstrate that the political ends of the economic policymaking process have been dealing with what they see as a vital economic shortfall inherent to the system. What Keynes did (as Marx before him allowed for) was correctly interpret that the wage shortfall against production could be overcome by using the larger pool of existing savings, even commandeering it during a crisis. He turned the historic problem of underconsumption into the modern idea of aggregate demand.

The larger pool of societal savings, largely through borrowing and lending, can produce additional economic activity on top of the wage-based portion, thereby erasing the underconsumption shortfall. In times of recession, it follows from this line of thinking that governments should appropriate a larger share of the pool of savings to create economic activity, thus filling in the hole in aggregate demand where businesses and households (especially if they are under wage pressure) are reluctant to expand.

In many ways this idea of underconsumption within aggregate demand and the wider use of the pool of savings reminds me of the problem the telecommunications industry ran into in the 1990's and early 2000's. The industry spent tens of billions of dollars on high-tech, high-speed networks (the very models of efficient uses of resources and energy) to connect major metropolitan areas. But, once these metro markets were connected there was no easy or apparent way to finish the "last mile". Spaces within metro areas had been built up and wired over the previous decades by all sorts of different technologies, and owing to the complications of trying to build in densely populated areas, these high speed networks were essentially at the mercy of how the efficient trunk lines eventually connected to your house. They would feature state of the art fiber optics and switching equipment, but at some point data would have to transit from the trunk to century old copper wires or first generation cable systems to complete the circuit.

In economic terms, the most efficient transmission of money through the economy is through wage income to labor, paralleling the high-speed trunk line. How society's pool of savings is used to fill in the rest is essentially the economic "last mile" problem. As the telecomm industry found out, often the hard way, there were massive variations in the success of each individual solution to the last mile. Each had its own set of efficiencies and cost effectiveness, meaning that the selection of a method of resolution greatly impacted the ultimate success of the entire network.

That is the economy that we see today. How the economic system uses its pool of savings in transmitting economic flow as the "last mile" is important in determining the ultimate success of the economy ( I should note here that I am not advocating or accepting the idea of aggregate demand, I am merely attempting to demonstrate, albeit simplistically, why certain actions have been taken).

In 1965, the Federal Reserve did not operate as it does today. The Fed was ultimately subservient to the Treasury Dept., at the very least monetary policy played second fiddle (a distant second) to fiscal policy. The various economic problems of the time were to be decided by fiscal factors - the last mile problem was left as a political consideration. That year marked both the escalation of the Vietnam War and the passage of programs that would form the Great Society. That meant a large escalation in the amount of debt issued by the federal government.

Since the Fed's primary monetary policy job in 1965 was to ensure the smooth auctions of US treasury securities, it would release reserves into the banking system in anticipation of debt issuing auctions. After the auction, the Fed would re-absorb those reserves to maintain a relatively constant money supply over time. As the pace of debt expanded in 1965 and especially 1966, the Fed found itself constantly expanding reserves without the ability to re-absorb them. As inflation rose due to this semi-permanent expansion in the money supply, the Fed sat on the sidelines as the "fix" to inflation was debated in 1967 and 1968 as some kind of tax increase.

Politically, the government was building a permanent method of bridging the "last mile" through transfer payments, on terms that were more social than economic. It brought the Fed and its money supply control along for the ride. According to the theory, if the government could tax the wealthy (who contribute disproportionately to the larger pool of savings) and transfer that money to the "poor", it would be connecting the last mile of potential savings to those who would spend. It was thought that this was an economically as well as socially beneficial arrangement (not much has changed).

Of course inflation raged out of control for more than 15 years after that inflection in last mile thinking. Finally in 1979 and 1980, the Federal Reserve under Paul Volcker instituted another inflection where monetary policy would assume relative economic dominance. The Fed decided that interest rates needed to float to very high levels (to defend the dollar, ironically in light of today's policies) to finally put an end to the inflationary spiral. Conventional wisdom has always held that the Fed was successful in its efforts, and it was in the narrow space of consumer price inflation. What came out of the early 1980's, however, was nothing more than a different form of inflation: asset inflation (the junk bond bubble, the mini real estate boom that brought down the S&L's, the stock market's wild ride - rising nearly 40% in 1987 before crashing that October).

But discounting asset inflation as it did (and still does), the Fed believed it had found the Holy Grail of economics. It had "solved" the last mile problem through the management and control over the credit system. The answer to aggregate demand or underconsumption or the last mile is always and everywhere, for the Fed, debt.

It can even act as a solution to perceived supply side troubles, since credit to businesses to expand production satisfies the conditions loosely based on the understanding of Say's Law (the opposite of aggregate demand in the political spectrum). Fed-inspired credit management is a bridge across the political divide, morphing into a solution to whatever factor is perceived by the current political authorities to be the prime malfunction. It is a perfectly ambiguous system that sees the growth of the financial system as a wholly positive development for every political administration or brand.

After the largest asset bubbles in human history (on top of the relatively minor episodes from the 1980's), however, the universal solution of credit control may no longer be so universal. This is where the analogy of the last mile is most apt, in my opinion. There really is a tremendous difference in HOW you bridge that last mile. Each different path toward resolution presents challenges and potentially fatal problems as well as successes.

How money circulates, the actual pathways and channels it takes, through the larger pool of savings to end up as economic activity and flow is as important as how much money circulates.

The housing bubble really does offer the starkest and most obvious example of why debt will never be a perfect substitute for wages. Since most debt is accumulated based on considerations of net worth, such a debt-centric system is really based on the much riskier price appreciation dynamic that is inherently unstable and finite. But monetary policy accepts these risks, especially in the early and mid-2000's, because it believes the debt-based activity it fosters through accommodative monetary policy is a near perfect short-term substitute for wage-based activity. More importantly, the Fed believes that debt-based activity directly leads to an increase in wage-based activity over time - solving the last mile.

Both the dot-com and housing bubbles showed rather conclusively the opposite. Debt-based activity leads to more debt-based activity, especially as it is cycled higher by asset inflation. Since the natural condition of debt accumulation is based primarily on perceptions of net worth, the Fed actually has to overcome two hurdles to get to its last mile economic bridge. Monetary policy has to create credible expectations for future growth in net worth first, mostly through price manipulations that feedback onto themselves, in order to create conditions where debt accumulation can begin.

But the human impulse to follow the crowd, especially when "easy" money is being made, ends up taking money in a different direction than intended. Instead of generating solid, wage-based activity, the price-assisted debt-based activity feeds on itself by drawing more and more money into the vortex of asset inflation. The corrupting influence of asset inflation is that it actually leaves an economy in worse shape, and not just saddled with debt that is no longer supported by prices (which always reverse). During the build up in prices and credit, productive endeavors are neglected or left on the drawing boards (during the housing bubble there was far more corporate money flowing into stock prices through repurchase programs than actual capital expenditures or, in far too many cases, even R&D - money chases more money).

Actual production that did occur was moved overseas, owing in large part to the intentional dollar devaluation that accompanies monetary "easing". So, in terms of marginal production and consumption, the last mile conundrum flowed through trade dollars. These trade dollars were largely recycled into foreign central bank holdings of US government debt, especially GSE issues. So in the end, even marginal productive activity got recycled back to consumers through the creation of more housing debt. Instead of solving or alleviating the last mile problem, this artificial system made it worse as the gap between total consumption activities and wages widened dramatically, actively fulfilling Marx's "prophecy".

I have long argued that this artificial system is not really capitalism since there is a little noticed but distinct and important difference in the methodology of circulation. During the housing bubble, few realized that the purported prosperity of the age was an illusion. It only became widely accepted after the collapse. The illusion was accepted as real because money was freely flowing through the economy.

Money flowing through the economy is not the same as the creation, expansion and maintenance of true wealth. In the basic, most efficient system of economic flow, from business to consumer back to business, there is a mutually beneficial exchange that results in the creation of something tangible (or, in the case of services, the completion of a task). Businesses pay wages because labor is engaged in the productive process that results in a real good (in the case of services, an enhancement to productivity).

Money flowing through debt or even government transfers is lacking this mutual exchange. There is no tangible creation in the transfer of money from bondholder to homeowner via debt and credit. In fact, that indirect flow of money through debt or government elongates the pathway that money takes to actually get to a transaction that does create tangible wealth. In other words, these artificial pathways of asset price-fueled credit decrease the efficiency of money, just as archaic electronic systems of old telephone wires in the last mile of telecom networks reduced the overall efficiency of those networks.

We accept indirect flow as a consequence of certain parameters of social existence. For example, as much as some political figures have made the hiring of first responders an economic growth issue, it is largely an issue of economic cost. It is absolutely true that police officers and firefighters "on the job" end up spending money in the economy, but they do not create anything tangible for their service. We need them as a society, they do perform a vital role, but they are a net cost to the economy since the money that flows to them must be taxed or borrowed in the first place (moving money out of the basic, most efficient chain of wealth creation). So the issue of preserving or adding to their rolls is not one of economic growth, but how much cost do we as a society (a political calculation) want to bear for the benefits we engender by having them.

Think about economic efficiency in this way: if police officers stimulate the economy, then why can't we just hire millions of them to get out of this economic rut? As much as we cannot increase the real economy by hiring police officers or firefighters, we cannot create a sustainable real economy through debt and the wealth effect. Both are economically inefficient means of simply moving money around. In terms of true wealth, neither really advances the cause of the real economy in a manner that is sustainable over the long term because neither method efficiently contributes to the productive activities that form a real economy. Inefficiency of money is essentially a tax on the real economy to be collected at some point, usually when the economy is least able to pay it.

The Federal Reserve's policy of credit as the universal answer to the economic last mile is like finishing off a high-tech network with old copper telephone wires. Unfortunately, the copper wire lobby holds a lot of sway over the political considerations that often end up affecting the outcome (see Community Reinvestment Act).

The real question of the last mile problem is how the economic system utilizes its pool of savings. If the incentive structure is economically and politically skewed toward asset prices and debt, the long run efficiency of the entire system is jeopardized. As such, the illusion of prosperity they bring entices the widespread belief in the success of "free market" capitalism. After the inevitable collapse, it entices the widespread belief in the failure of capitalism.

The Federal Reserve has done more to discredit capitalism than Karl Marx himself could have done. Yet it has never really represented a true capitalist system (especially in the decades after 1965) since it places no distinction on how it moves money throughout the system. Instead, the modern central banking system blindly creates money from nothing and then spends valuable time and effort trying to force it to circulate in any and all ways, just as long as it circulates. A "clean" capitalist system, rather, does make the conscious distinction of money from productive enterprise, valuing productive capabilities as the true standard of wealth. All the rest is just paper.

Keynes argued for a societal aggregate demand that can be managed by any number of perfect or near perfect substitutes. Marx saw the awesome productive capacity of a capitalist system, but also saw irreconcilable political and social contradictions that would eventually bring the system to chaos. Neither of them recognized a determined effort toward efficiency (of money and the last mile) would spawn all manner of innovation and productivity that would create the conditions where the illusion of prosperity could actually be achieved, resulting in an environment where it is conventional wisdom to criticize the best way to finish off that last mile in favor of the very means that formed the illusion of prosperity in the first place. Efficiency counts in all things, including money.



Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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