A “quasi-movie trailer” re government debt and associated inflation
The system of monetary circulations
The importance of the Diagram of Rates of Flow
Unbalanced budgets are dangerous for both government and individuals.
Appendix 1: Understanding the economic process
Appendix 2: Possible disruptions of equilibrium
References to Related Topics
This treatment should be read in conjunction with the reading of The Road Up Is The Road Down; The Mechanism Of rising and Falling Prices, keeping in mind Lonergan’s three assumptions about whether and how to add money to the economic process.
A “quasi-movie trailer” re government debt and associated inflation
A vicious circle of ever more demands for a larger money supply with no increase in real income is inflationary.
… this type of surplus (personal income stemming from government profligacy) is not confined to warlike concerns. Once the possibility of an unbalanced budget is established, the precedent can be invoked to persuade politicians to carry on other wars: wars on illiteracy, on poverty, on ill health, on unemployment, on insecurity. Where the profit motive does not prove efficacious, the state must intervene. … the increasing volume of transactions requires a larger money supply, and the central bank can be persuaded to meet the demand. … it appears to be less evident that a vicious circle of ever more demands for a larger money supply with no increase in real income is inflationary … In any case there has emerged in fact if not in name the welfare state. … now the long overdue basic expansion is doled out to one’s fellow countrymen under the haughty name of welfare. [CWL 15, 85-86]
… , positive or negative transfers (from the Redistributive Function) to basic demand (D’-s’I’) and consequent similar transfers (from the Redistributive Function) to surplus demand (D”-s”I”) belong to the theory of booms and slumps. … (CWL 15, 64)
The channels of circulation replace the overall dominance claimed for general equilibrium theory, … More positively, the channels account for booms and slumps, for inflation and deflation, for changed rates of profit, …. CWL15, 17
It is now necessary to state the necessary and sufficient condition of constancy or variation in the exchange value of the dummy (money). To this end we compare two flows of the circulation: the real flow of property, goods, and services, and the dummy flow being given and taken in exchange for the real flow….Accordingly, the necessary and sufficient condition of constant value in the dummy lies in its concomitant variation with the real flow. (CWL 21, 38-39)
real analysis (is) identifying money with what money buys. If you want to treat payments as though they are not strictly correlated with the movements of goods and services, you will have a degenerate monetary theory, (such as Modern Monetary Theory,) which disconnects flows of products from flows of money and will, systematically, sooner or later, cause stresses, torture the flows, and wreak social havoc. Modern Monetary Proponents have no understanding of the underlying laws of the process of production and sale. [See CWL 21, xxviii]
(Ideally,) … the dummy must be constant in exchange value, so that equal quantities continue to exchange, in the general case, for equal quantities of goods and services. The alternative to constant value in the dummy is the alternative of inflation and deflation. Of these famous twins, inflation swindles those with cash to enrich those with property or debts, while deflation swindles those with property or debts to enrich those with cash; in addition to the swindle each of these twins has his own way of torturing the dynamic flows; deflation gives producers a steady stream of losses; inflation yields a steady stream of gains to give production a drug-like stimulus. [CWL 21, 37-38]
G = c”O” – i’O’ = 0 is the condition of equilibrium [CWL 15, 54]
… Traditional theory looked to shifting interest rates to provide suitable adjustment (of the rate of saving to the requirements of the phase of the pure expansion). In the main we shall be concerned with factors that are prior to changing interest rates and more effective. [CWL 15, 133]
Now every unit of enterprise involves a turnover magnitude and a turnover frequency. … it involves a correlation between the quantities and velocities of rates of payment and the quantities and velocities of goods and services. (CWL 15, 57)
The existence of this correlation may be seen readily enough. … the quantity alternative in the rates of payment is conjoined with the quantity alternative in the rate of production, and the frequency alternative in the rate of payment is conjoined with the frequency alternative in the rate of production. The two cases of quantity-velocity are not only parallel but also correlated. [CWL 15, 57]
Having the proper supply of money in the process is important. Modern Monetary Theory, espoused by the advisor to B. Sanders, is a prescription for inflationary swindles, financial disaster, and social chaos. The magnitudes and frequencies of payments must be correlated and coordinated with the magnitudes and frequencies of productive turnovers. The system must have the proper money supply in order to achieve the proper circulation of monies within and between the operative, productive circuits and, thus, avoid the swindles called inflation and deflation.
… we shall be concerned with factors that are prior to changing interest rates and more effective. … The simplest manner of attaining a fairly adequate concept of basic income is to divide the economic community into an extremely large number of groups of practically equal income. … In any group i let there be at any given time ni members; let each member receive an aggregate (basic and surplus) income yi per interval, so that the whole group receives niyi; finally, let us say that the group directs the fraction wi of its total income to the basic demand function, so that basic income per interval is given by the equation
I’ = Σwiniyi (CWL 15, 133-134)
… and so one obtains for the increment per interval of basic income the simpler equation
δI’ = Σ (wiδni + niδwi)yi (CWL 15, 133-134)ftnt. 189
where ni includes the adjustment due to migration.
By the principle of concomitance, Outlays are concomitant with Expenditures; i.e. Expenditures are concomitant with Outlays. So, we have:
- P’Q’ = p’a’Q’ + p”a”Q”, (CWL 15, 156-62)
- thus, P’/p’ = a’ + a”(p”Q”)/(p’Q’)(the pure surplus income ratio)
- thus, J = a’ + a’R(the pure surplus income ratio)
- and, dJ = da’ + a”dR + Rda” (CWL 15, 156-62)
… When then prices begin to fall to effect the continual reduction of the price spread, there follows sooner or later the real and final crash. Speculative embarrassment makes both da’ and da” negative, to augment the rate of contraction of the price spread and intensify the embarrassment. Assets are frozen and then liquidated in a great drop of prices. Worse, there is no recovery; for the remainder of the cycle should be a basic expansion which our ill-adapted economies transform into a depression. (CWL 15, 161)
Modern Monetary Theory – the quicksand of socialism’s grand canyon of ignorance – disposes the system to disaster. In its unchecked extreme of printing and distributing money unconstrained by relation of the flow of dummy money to the real flow of goods, and services, it would bring about rampant inflation, menace the financial system, and, ultimately, bring about a) the destruction of the financial system, and b) social chaos. The longer unconstrained printing and irresponsible borrowing would last, the greater would be the intractability of ultimate problems.
… “until the position of the strong is undermined by the general and prolonged contracting, the requirement for the rate of losses continues, and with it the depression. … On the other hand, increasing contraction and liquidation tends to reduce the requirement for a rate of losses: with the surplus stage already operating at a minimum, any further reduction of the basic stage means that a zero dQ”/Q” is greater than a negative dQ’/Q’; this postulates an increasing rate of savings, and under the circumstances, this increase of required savings (since actual savings already are too great) is a reduction of losses. Thus the greater the contraction, the less the rate of losses required; again, the greater the contraction, the weaker the position of the initially invulnerable; in the limit the rate of losses will disappear, and a distorted equilibrium give place to a true equilibrium. Meanwhile, obsolescence will have mounted, and so as orders for replacements begin to increase they will be accompanied by surplus purchases that are new fixed investment; v begins to increase, and the proportionate expansion of the revival is underway. (CWL 15, p.155-56)
Our framework is the Macroeconomic Field Theory represented by the two operative circuits connected by “crossovers” shown in the Diagram of Rates of Flow. (See CWL 15, 55) Important theoretical components of the analysis are a) the abstract explanatory formulation based on the concomitance of basic Expenditures with the basic Outlays, and b) the correlation and normative concomitant variation of the magnitudes and frequencies of flows of products with the magnitudes and frequencies of payments.
P’Q’ = p’a’Q’ + p”a”Q” (CWL 15, 156-62)
Recently it has been reported that:
- Nominal Gross Domestic Product is running at about
- The national debt is about
- In1980 federal debt was under 25% of gross domestic produc t. Now it is over 100%. Cochrane, 6/28/2022
- Since February 2020, publicly held U.S. Treasury debt has exploded, growing from about $17 trillion to $24 trillion. Almost half of the increase has wound up at the Fed, whose Treasury holdings have ballooned from $2.5 trillion in February, 2020 to $5.8 trillion
- M2 has risen by $6.3 trillion since the start of 2020, of which $4.8 trillion has come directly from the Fed and a net $1.5 trillion from the banks. M2 has increased an incredible 41% in only 2 ½ years – an average annual growth rate of 16.3%. Greenwood and Hanke
- The Executive action on student debt could cost as mauch as $1 trillion. Jay Starkman; 9/29/2022
- A possible net interest expense … (a rate of) $756 billion a year. That’s a lot of money in the context of a $6 trillion federal budget and a $25 trillion economy. Red Jahncke
- It’s highly likely that gross interest expense will rise well above $1 trilion a year and surpass Social Security as the largest item in the federal budget. Red Jahncke
The system of monetary circulations
- The monetary flows represented in the Diagram of Rates of Flow are pretio-quantital flows – price times quantity.
- Flows are so much or so many every so often, and, thus, they are specified mathematically as rates or velocities.
- The same monetary flow can be achieved by different combinations of price times quantity: P’ x Q’ for final Expenditures, E’, and , c’O’ = p’a’Q’ and c”O” = p”a”Q” for the initial “macroeconomic costs”, which limit “macroeconomic profits.”
- Flows of payments made and received in Supply and Demand are effected by human beings – whether as individual employees or entrepreneurs or in aggregates such as a unit of enterprise or a government entity. Human beings are the efficient cause, while the immanent intelligibility of the interdependencies of the flows is the formal cause. Materials, such as steel or cocoa, do not have bank accounts; and all initial, transitional, and final payments in a supply chain are payments to and from people acting as workers, entrepreneurs, etc. Neither carrots nor clothing write checks.
- By the principles of concomitance and implicit definition in the normative theory, basic final Expenditures, E’, should normatively equal basic initial Costs: P’Q’ = p’a’Q’ + p”a”Q”. CWL 15, 156-62)
- Our “An Einsteinian Relativistic Context: Space and Time Become Space-Time; Price and Quantity become Price-Quantity; An Abstract Set of Invariant Explanatory Relations’ treats what we have loosely dubbed the “contest” of quantities vs. prices in honoring the equals sign in P’Q’ = p’a’Q’ + p”a”Q”.
- The quantities and prices are co-operative and relative to one another; so to speak, entrepreneurs decide how quantities and prices will trade off with one another inside the three major implicit price-quantity flows in P’Q’ = p’a’Q’ + p”a”Q”.
- The addition of money to the operative circuits, represented in the Diagram, is normatively to the supply function through (S’ – s’O’) and (S” – s”O”) to finance the supply of goods and services. It is production which “justifies” new money.
- On the other hand, the injection of free, unearned, money into the demand function of the operative circuits through (D’ – s’I’) and (D” – s”I”), belongs to the theory of booms and slumps.
- Any amount of money added to the economic process should be an amount to be properly correlated in the magnitude and frequency of its use with the magnitudes and frequencies of productive turnovers so that prices remain stable.
- Much of the recent infusion was added straight into monetary demand through the (D’ – s’I’) and (D” – s”I”) channels. The infusion provided much free money having no initial connection to productivity or production, and it was thus intrinsically inflationary and causative of an artificial boom– whether the timing of the inflation be immediate or lagged.
- If, purely for a simplified example – assuming a balance of crossovers and constant rates of production – a quantity of money, whose use for payments at frequencies were perfectly correlated with the magnitudes and frequencies of productive turnovers, and if that quantity of money were to circulate in the operative circuits on average, say, three times per year, then, a Gross Domestic Product of, say, $21 trillion would require a money supply of $7 trillion.
- And, assuming stable quantities and unchanging velocity of monetary circulation, if, say, an additional $9 trillion were added through (D’ – s’I’) and (D” – s”I”) into the operative circuits, there would eventually be adjustments in P’ x ‘Q, and its concomitant p’ x a’Q’ and p”a”Q” to effect an inflation of prices of (9 + 7)/7 or 129%. Not considering possible price reduction ensuing from improved productivity, $229 would then be required to purchase what used to cost $100. In our simplified example, the purchasing power of a union or non-union senior’s past cash savings would have declined by 56%. That person would be 65% poorer. (In Burley’s von Neumann model, this would be represented by a 129% in crease in the monetary scale factor.)
- Alternatively, in our simplified example, if the entire $9 trillion were not spent in the operative circuits, but were instead tucked away in cash or liquid securities in the secondary bond and stock markets, and, thus, remained latent in the Redistributive Function, it would eventually inflate stock and bond prices in those secondary markets. And, assuming zero secondary-market price changes based on speculative optimism or pessimism (See CWL 15,162) affecting secondary financial assets, the $9 trillion would work its swindle, dollar for dollar, in the secondary markets.
- The effect of the new money winding up in an indeterminate mix of operative vs unproductive activities would, of course, be determined by the mix.
- In any inflation there are winners and losers in both the operative circuits and the secondary markets of the Redistributive Function. The ultimate effect of the $9 trillion addition would work its way through the tiers of income strata I’ = winiyi, . (CWL 15, 134) and through the change-of-incomes equation dI’ = Σ(widni + nidwi)yi (CWL 15, 134) with the different propensities to consume or save to effect some “migrations” among the income strata and determine the winners and losers in what we might call the “The Big Swindle.”
Again, the framework of this treatment is the Macroeconomic Field Theory represented by the 5-circled, two crossover-connected circuits shown in the Diagram of Rates of Flow. (See CWL 15, 55) Again, P’Q’ = p’a’Q’ + p”a”Q”. Important expressions and equations are
- G = c”O” –I’O’ = 0 (The condition of equilibrium) (CWL 15, 54)
- dI’= Σ(widni+ nidwi+dnidwi)yi [CWL 15, 134]
- w = I”/(I’ + I”) (CWL 15, 131-32)ΔΔΔ
- df = vdw + wdv [CWL 15, 148-49]
- d(P’/p’) = dJ = da’ + a”dR + Rda” [CWL 15, 158]
- DZ = PQ[(dP/P + dQ/Q + dPdQ/PQ) cos (A + dA) – 2 sin(dA/2) sin(A + dA/2)] [CWL 15, 108-9]
- (S’-s’O’) = ΔT’ + (O’-R”) +ΔR’ (CWL 15, 67), and
- (S”-s”O”) = ΔT” + (O”-R”) +ΔR” (CWL 15, 67)
The importance of the Diagram of Rates of Flow
What the analysis reveals is a mechanism (that) determines the channels within which the price mechanism works. It is not separable from the price mechanism, for a channel is irrelevant when nothing flows through it. (CWL 15, 17)
Walras’ general equilibrium is superseded by the dynamic equilibrium of Macroeconomic Field Theory.
The channels of circulation replace the overall dominance claimed for general equilibrium theory, (CWL 15, 17)
More positively, the channels account for booms and slumps, for inflation and deflation, for changed rates of profit, for the attraction found in a favorable balance of trade, the relief given by deficit spending, and the variant provided by multinational corporations and their opposition to the welfare state. [CWL 15, 17]
Referring to the Diagram: Assuming constant aggregate production, Q’ = 1Σqi , let c’O’ = p’a’Q’ and c”O”’ = p”a”Q”. Basic Expenditures are identified with basic Costs to units of enterprise and associated Incomes to employees and owners. The equals sign signifies the normative theoretical correlated togetherness and, thus, concomitance of Basic Outlays and basic Expenditures:
P’Q’ = p’a’Q’ + p”a”Q”, (basic Expenditures = basic Costs) (CWL 15, 156-62)
And the change in the Aggregate Basic Price Spread Ratio, dJ is derived: (CWL 15, 156-62)
- P’Q’ = p’a’Q’ + p”a”Q”,
- thus, P’/p’ = a’ + a”(p”Q”)/(p’Q’) (the pure surplus income ratio)
- thus, J = a’ + a’R (the pure surplus income ratio)
- and, dJ = da’ + a”dR + Rda”
There is a sense in which one may speak of the fraction of basic outlay that moves to basic income as the “costs” of basic production. … the greater the fraction that basic income is of total income (or total outlay), the less the remainder which constitutes the aggregate possibility of profit. But what limits profit may be termed costs. Hence we propose ….to speak of c’O’ and c”O” as costs of production, having warned the reader that the costs in question are aggregate and functional costs…. [CWL 15 156-57]
And in the case of We-The-People acting in the capacity of governing ourselves but torturing the flows by misallocating new money, or flooding the basic demand function, P’Q’, with free, previously-unproductive, purely inflationary money from the Redistributive Function through (D’ – s’I’) and (D” – s”I”),
P’Q’ = p’a’Q’ + p”a”Q” + (D’ – s’I’), or
P’Q’ – (D’ – s’I’) = p’a’Q’ + p”a”Q”
… , positive or negative transfers (from the Redistributive Function) to basic demand (D’-s’I’) and consequent similar transfers (from the Redistributive Function) to surplus demand (D”-s”I”) belong to the theory of booms and slumps. They involve changes in (aggregate basic or aggregate surplus) demand, with entrepreneurs receiving back more (or less) than they paid out in outlay (which includes profits of all kinds). The immediate effect is on the price levels at the final markets, and to these changes (in price), enterprise as a whole responds to release an upward (or downward) movement of the whole economy. But the initial increased transfers to demand [that is, (D’-s’I’) and (D”-s”I”) are not zero] are not simply to be supposed. For that would be postulating without explaining the boom or slump. (CWL 15, 64)
Lonergan’s channels of pretio-quantital circulations represent a Macroeconomic Field Theory. “the lack of ultimacy that Lonergan ascribes to prices and price theory can scarcely be overemphasized.” Thus, while academic economists and politicians are floundering in price theory, Lonergan presents the principles and fundamental laws which explain both the equilibria and the disequilibria of the dynamic pretio-quantital process. He discovers and formulates the normative macroeconomic theory of production, exchange, and finance which can provide systematic guidance to all, but which academics and all politicians ignore.
The whole structure is purely relational. A macroeconomic functioning is not a compilation or aggregation of particular income statement categories, such as wages or interest expense. A macroeconomic functioning is implicitly defined by its functional relation to other functionings. The whole structure is purely relational. “Lonergan’s analysis is concrete but heuristic. It focuses on functional relations intrinsic to the productive process to reach eventually a general theory of dynamic equilibria and disequilibria.” [McShane 1980, 117]
Lonergan’s intention was ‘to formulate the laws of an economic mechanism more remote and, in a sense, more fundamental than the pricing system…laws which men themselves administrate in the personal conduct of their lives. In 1978 he began to refer to Nicholas Kaldor in support of his judgment that the significance traditionally accorded to price theory by conventional economics since Adam Smith’s Wealth of Nations (1776) amounted to a virtual derailment of economic theory… … …. Lonergan’s interest in Kaldor’s sweeping statement was to emphasize that prices and their changes are not explanatory but accountants’ entities. For a first approximation of what Lonergan means here, let us draw an analogy to empirical scientific inquiry. The physicists antecedent job of measuring and plotting measurements on graphs in physical science might be compared to tracing movements of prices as the exchange economy ebbs and flows. What Lonergan has called ‘grasping in the scattered points the possibility of a smooth curve,’ or determining an indeterminate function in physics, would then be comparable to working out an economic theory that specifies the channels through which money circulates. Lonergan insists that the mechanism of the pricing system does not furnish economists with distinctions among significant variables of aggregate surplus (or producer-goods) and basic (or consumer-goods) supply and demand with their determinate yet flexible velocities and accelerations, any more than Galileo Galilei’s discrete measurements of distances and times at the Tower of Pisa of themselves provided the law of the acceleration of falling bodies… …. the lack of ultimacy that Lonergan ascribes to prices and price theory can scarcely be overemphasized. CWL 15, Editors’ Introduction, xlvi-xlvi
So, how is an injection of, say, $9 trillion of unearned, “unpaid for” money to be absorbed by or corrected in the economic system? Remote possibilities are that, a) the dangerous unlikely case that the Fed’s past open-market operations are reversed and much of the money is quickly withdrawn, or b) productivity and new investment quickly swell the rates of production so as to counter inflation by absorbing the new money in greater quantities, or c) the early beneficiaries of the flood keep the money in idleness in swollen cash accounts and marketable securities. But the more likely case is that the new free money will be absorbed, sooner or later in some combinations of higher prices, P’ = Σpi , and quantities, Q’ = Σqi . The pretio-quantital corrective action may be in any of: a) the basic circuit, b) the surplus circuit, or c) the Redistributive Function’s secondary stock and bond markets. How much will be in operative P’ and how much will be in operative Q’ will be determined by a) present and future productive-capacity limits and in what phase of the pure cycle the process happens to be, b) entrepreneurs’ decisions re production quantities and prices, and c) Executive and Legislative fiscal and monetary decisions.
Investors are sitting on some $5 trillion of idle cash, originating from the Executive and Legislative branches and accommodated by the the U.S. Treasury and the Federal Reserve Bank. It sits on personal and corporate balance sheets as cash and short-term liquid investments. As interest rates are raised, intending to damp the inflated prices by increasing the costs of borrowing, the higher interest costs will delay or eliminate long-term projects and induce contractions, liquidations, bankruptcies, and layoffs by units of enterprise seeking to survive. Forecasts of GAAP earnings will be pessimistic. The owners of the larger stashes of cash and short-term investments will await an opportunity to scoop up the deflated valuations in the secondary markets. If these investors use this money to purchase secondary-market, previously-issued stocks and bonds, it will tend to artificially support stock and bond prices once again in these markets. For sure, unless the money is withdrawn from the system by the Fed’s open-market operations, the money will always remain in someone’s hands. One problem is that conspicuous withdrawal will tend to reduce the artificially inflated values of stocks and bonds, mistakenly perceived by most investors as having been legitimately earned. A second problem is that reversals through open-market operations are not equitable; lucky investors who bought low and sold high for cash in the game would walk away with inflated proceeds, while unlucky investors who bought high and would sell low would be clobbered. Again, unless the money is withdrawn from the system by the Fed’s open-market operations, the money will always remain in someone’s hands.
Unbalanced budgets are dangerous for both government and individuals.
Now this type of surplus (personal income stemming from government profligacy) is not confined to warlike concerns. Once the possibility of an unbalanced budget is established, the precedent can be invoked to persuade politicians to carry on other wars: wars on illiteracy, on poverty, on ill health, on unemployment, on insecurity. Where the profit motive does not prove efficacious, the state must intervene. … the increasing volume of transactions requires a larger money supply, and the central bank can be persuaded to meet the demand. … it appears to be less evident that a vicious circle of ever more demands for a larger money supply with no increase in real income is inflationary … In any case there has emerged in fact if not in name the welfare state. … Its mechanism is rather strikingly similar to that of the favorable balance of foreign trade. The debt once owed by colonies to richer countries now is replaced by the national debt. … now the long overdue basic expansion is doled out to one’s fellow countrymen under the haughty name of welfare. [CWL 15, 85-86]
Appendix: Understanding the economic process
In order to understand how the economic process would absorb an excessive injection of excessive money, the economic scientist must have a scientific, dynamic heuristic and analytic toolkit of mental skills and research methods, which yield a normative theory which explains the process and provides systematic guidance to econometricians and the general public. The analytic toolkit would include
- The mastery of first-order and second-order differentiation to deal with velocities and accelerations of flows
- The understanding of the difference between scientific explanation and narrative description
- The guiding principle of concomitance
- The technique of implicit definition and the principle of mutual conditioning
- Expertise in abstract correlations
- The ability to achieve the enriching abstraction of explanatory terms and relations
- The appreciation of mathematical operators and collocations to specify an isomorphic structure
- The appreciation of the significance of the equals sign, or the sign of identity, or the sign of definition, or the sign of congruence
- The laws of probability and the divergence or convergence of a series of conditions,
- The principle of isomorphism or similar structure between a mathematical formulation and the correlations in a pattern of behavior
- The skill of evaluating and choosing a theory, modeling, selecting data for measurements, testing, andverification of the theory
- A complementary, suggestive understanding of the theories of hydrodynamic systems, electric circuits, electromagnetic waves, potential and kinetic energy, work and power
… if the real flows of goods and services move, as it were, in straight lines from the potentialities of universal nature, on the other hand, the dummy flows of money and monetary substitutes, of cash and credit, move in circles. The same currency is used over and over; the same accumulation sustains indefinitely a given volume of credit. One must not be misled by the name ‘circulation’ into thinking of dummies as moving with an angular velocity. They lie very quietly in the reserves of individuals, firms, banks. Only at the instant of exchange or loan do they move and then their movement is instantaneous. The meaning of the term ‘circulation’ is that these instantaneous movements in various directions have to balance with opposite movements. There has to be equilibrium. … funds, like rivers, can be permanent principles of flow only on condition that they permanently are fed by tributary streams. (CWL 21, 57-58)
Also see “The Road Up is The Road Down; The Mechanism of Rising and Falling Prices”
Appendix 2: Possible disruptions of equilibrium
While reading this section, please refer frequently to the Diagram of Rates of Flow (above), in order to understand that the swapping of past-issued stocks and bonds in the secondary market – situated in the Redistributive Function of the diagram – is outside the operative circuits of the current, purely-dynamic, productive process. A change of ownership does not in and of itself constitute or cause production. The swap of a million shares of General Motors – vital as swaps may be for retirement funds, insurance reserves, or college endowments – does not produce a single automobile.
For a simple demonstration of the macroeconomic principles relevant to stock and bond prices, let us isolate stocks and bonds from the influence of uncertainty and international transactions by supposing a closed economy and perfect foresight in a theoretical static phase. Population growth is zero, so widening of capital is unnecessary. This economy is merely reproducing itself period after period; no innovations are being implemented to improve the standard of living; the pure surplus income associated with expansion does not exist; ordinary surplus income is being devoted properly to the repair and maintenance of existing capital equipment; all other income is basic income, which is being spent on consumption rather than invested in superfluous capital equipment; price indices are stable; monetary circulating capital is just enough to bridge the gap between payments made and payments received by individuals and units of enterprise, who, each period, are using money to complete their particular contributions to the overall process; the short- and long-term interest rates tend towards zero because, by our oversimplifying assumptions, a) there are no returns available from expansionary investment and, b)perfect foresight reduces risk to zero. However, they hover enough above zero to pay lenders for their operative administrative services. In sum, there is dynamic equilibrium because participants have applied rates of flow of money properly to the rates of flow of goods and services of this static phase.
The entire system relies upon the fiat issue extended in the past by the central and commercial banking system. At bottom, the commercial and investment banking system has loaned the proper amount of money needed to finance the transactions among individuals and units of enterprise in the productive process. On the lending bank’s books, reserves and loans receivable are offset by deposit obligations. On the borrowing entrepreneurs’ books, the gap between payments made and payments received is financed by working-capital or equipment loans payable. Thus, net through all the books, there is an ultimate balance between needs and obligations, and loans receivable are balanced by obligations payable.
Past exchanges within the redistributive function have recognized past combinations of estimated risk and reward, so that “ownership” forms now include loans, preferred stocks and common equity. Within the entire system there may be a profusion of outstanding offsetting loans (and equity investments) as, over time, A has loaned to B, B has loaned the same amount to C, and so on. But overall, debits equal credits, receivables equal payables, with the grand totals equaling the gap between payments made and payments to be received.
Capital equipment is fully installed and has entered the status of static wealth. It is ever being repaired and maintained so as to remain productive at a constant rate, but it is not being made obsolete by newer and more efficient equipment.
In this static closed economy, the values of the instruments representing ownership of static-wealth, such as past-issued bonds and stocks, are properly calibrated in accord with the technical coefficients of their productive possibilities. Expectations do not change and the individual values of all individual stocks is constant; thus, the total value of all stocks and bonds is constant.
Since, for simplicity, the economy is asssumed closed, exports and imports do not exist. The foreign exchange rate for the domestic currency is frozen at a level to obviate arbitrage and so that speculative changes in the foreign exchange rate will not cause any windfall profits or losses.
All federal, state and local budgets are balanced. The Central Bank has nothing to do and is doing nothing with respect to interest rates and the size of the money supply. The commercial banks are merely rolling over loans as they mature.
Static wealth is the ownership, and the right to govern the use of, what is owned as evidenced by previously-issued bonds and stocks. Static wealth itself is not income. Static wealth is the properly-calculated, intrinsic value of the assets owned and controlled. Static wealth is to be distinguished from income. Income in the entire process is the actual receipt by human persons of wages, salaries, interest, rents, royalties or dividends. A person may have zero wealth but receive a high income, which he spends in full on his standard of living; and, in theory (though not practically because of interest and dividends and the need for food, shelter, and clothing), a person may have great wealth yet receive zero income to spend on a standard of living.
Owners of static wealth are, of course, free to buy and sell their stocks and bonds. In a first simple case, investors A and B, who are owners of stocks and bonds respectively, may swap their titles consistent with their proper value. No money changes hands. In a second arrangement, A may sell a stock for cash to B who has pledged his bond as collateral to the bank in return for the cash. A may then purchase B’s bond from the bank at its proper value. In both cases a) A has migrated from stocks to bonds, b) B has migrated from bonds to stocks, c) the stocks and bonds are continuously owned, d) the negotiated rate of exchange remains in accord with technical values and perfect estimates of zero risk, and therefore, the total quantity of instruments and the total value of all instruments remains unchanged. In the aggregate, the swap or sale nets to a mere change of ownership of no economic affect.
In the aggregate, migrations of individuals or groups between financial instruments are somewhat illusory in that the instruments in the secondary market are always owned by somebody. A sale is also a purchase. Individuals may migrate out of and into different sectors, but there is always somebody in each stock or bond. Thus overall, there is no migration; there are only changes of titles of ownership.
So far, for purposes of illustration we have described and are beginning with the theoretical perfect static phase. Now, what identifiable disruptions might upset the values of stocks and bonds?
- The first disruption occurs totally within the Redistribution Function. The Central Bank, in an attempt to stimulate the economy with more money and lower interest coats (think QE1, QE2, QE#), may disrupt what had been a perfectly calibrated money supply and normative intrinsic-value pricing in the secondary markets by “printing” superfluous money for open-market purchase of existing securities. Thus, by this act the Central Bank increases monetary demand for securities while simultaneously pulling the purchased securities out of the market and, thus, reducing the supply of securities. Market prices would rise and interest rates would fall, but with no attractive investment prospects, the money would stay in the Redistributive Function and just slosh around among secondary stocks and bonds.
Conversely, it may sell bonds from its portfolio, thus increasing the bond supply while reducing money in the system. The injection of superfluous money into the secondary markets upsets previous normative valuations within those markets, and tends to inflate the total values of these assets. The removal of money, on the other hand, would have a deflationary effect.
- In a second disruption, the government (of, by, for, and identical with we-the-people) may decide to run a deficit, i.e. spend directly or through transfer payments more than it takes in from producers’ production, by issuing bonds (borrowing).  This increases the debt payable by we-the-people. This deficit spending, with no ultimate source in real production of assets to be owned or consumed, will raise prices for products and generate pure surplus income to the recipients of higher prices, so that they can directly or indirectly purchase these same bonds. It results in higher prices in the operative circuits, pure surplus income not normatively associated with legitimate capital expansion, and greater static wealth, absent real production. The economy receives no stimulus from a “wealth effect”, but the wealthy become wealthier on paper as the total values of stocks and bonds increases. Conversely the government may run a surplus …
- In a third disruption, within the redistribution function gamblers in the secondary market may borrow money from willing banks to purchase secondary instruments on margins. By our assumptions, the banks would extract useful money from the operative circuits, depress activity in those operative circuits to that extent, lend the money to gamblers, and, thereby, inflate the stock and bond markets while depressing productive activities; this would cause an illusory increase in the secondary-market values while decreasing the activities that would otherwise tend to support intrinsic market values.
- In a fourth disruption, income recipients may disturb the equilibrium among circular and crossover flows in the operative circuits by draining money required for continuity of adequate demand in one circuit across to the other operative circuit. (For one example, money would travel from I’ in the basic circuit through s’I’’, into and along D” for use as I” in the surplus circuit.). Initially, this activity reduces demand for basic output while temporarily and artificially inflating activity in the surplus circuit. But, sooner or later, some of the formerly fully productive assets of static wealth, now rendered superfluous or less than fully productive, suffer a deflation in value.
In the worst case, entrepreneurs would direct money out of the basic circuit and into the Redistributive Function where it would inflate prices; the real economy would shrink in activity and suffer a reduction in its overall normative value. In the aggregate this would be self-destructive behavior by income recipients in the aggregate attended by layoffs and by contractions and liquidations of machines into the scrap metal market.
- In a fifth disruption of a static, properly equilibrated economy there could be an overall equilibrium, but it would be a distorted equilibrium. Less vulnerable workers (protected by contracts, fees, election, or indispensability) may demand and win higher incomes at the expense of the more vulnerable. If these winners do not spend this income but, instead, misdirect this income out of the productive circuits into the Redistributive Function, rather than spend all that the losers would have spent, this activity reduces what had been effective real demand and shrinks real wealth, while temporarily and misleadingly tending to inflate or at least sustain the values of static wealth.
This disequilibrium would continue
“until the position of the strong is undermined by the general and prolonged contracting, the requirement for the rate of losses continues, and with it the depression. … On the other hand, increasing contraction and liquidation tends to reduce the requirement for a rate of losses: with the surplus stage already operating at a minimum, any further reduction of the basic stage means that a zero dQ”/Q” is greater than a negative dQ’/Q’; this postulates an increasing rate of savings, and under the circumstances, this increase of required savings (since actual savings already are too great) is a reduction of losses. Thus the greater the contraction, the less the rate of losses required; again, the greater the contraction, the weaker the position of the initially invulnerable; in the limit the rate of losses will disappear, and a distorted equilibrium give place to a true equilibrium. Meanwhile, obsolescence will have mounted, and so as orders for replacements begin to increase they will be accompanied by surplus purchases that are new fixed investment; v begins to increase, and the proportionate expansion of the revival is underway. CWL 15, p.155-56
In our static economy, these five disruptions represent real disruptions to the normative flows of money within and among the operative circuits. And, the money flowing into, and remaining in the secondary markets, changes the total secondary stock and bond values – dollar for dollar.
Barring disruptive flows of money into or out of the previously-equilibrated, smoothly-functioning circuits, what non-flow occurrences may change stock and bond prices? The answer – simple speculative optimism or pessimism. Let us return to the equilibrium static phase but remove perfect foresight and allow speculators to speculate about future prospects and negotiate the rates of exchange of secondary instruments in an attempt to outwit one another. Again, we assume that ,overall, there is no migration to higher or lower incomes. The same quantity of financial instruments are continuously owned by someone. Though expectations may change and optimism or pessimism may take hold, someone will always be holding the bag when a price declines or enjoying the benefit when the price increases. Even though in this static phase the economy is neither accelerating nor decelerating, and even apart from disruptive or restorative money flows, prices may fluctuate wildly purely due to these fluctuations in speculative optimism and pessimism.
On the last trade of the day, week, month, or year, owners of stocks and bonds may optimistically trade at higher prices. A single trade of 100 shares at, say $11.00 per share up from $10.00 per share – an $1,100 trade – may convince a collective of owners holding a billion shares of that same stock that their wealth has increased collectively by $1 billion. Conversely, an end-of-day trade of 100 shares at $9.00 down from $10.00 may convince a collective of shareholders that their wealth has decreased collectively by $1 billion
When those folks bought the stock at ($11.00), they artificially inflated the net worth of all the shareholders…….That’s because brokerage statements indicate that everyone’s stock is worth the last share price multiplied by the number of shares they own….This huge collective amount … is the non-existent money that people believe they have lost when a stock tanks
But what if they had all sold the stock at its peak? Nope. That was never possible. Marilyn Vos Savant, Parade Magazine, 4/5/09
There is a related issue, relevant especially to the later stages of a long-term expansion, when the basic price spread, P/p, is not being swollen by pure surplus income passing through the basic circuit and should instead be contracting. Higher stock prices caused by speculative optimism may induce more basic spending and preventing the normative contraction of the basic price spread.
A speculative boom in the stock market which encourages basic spending………with its basis in redistributional optimism will offset any tendency towards a contraction of the price spread and will reinforce any tendency of the price spread to expand. On the other hand, the subsequent stock market break intensifies the crisis of the circuits, removing the props that had hitherto swollen expansive tendencies, and leaving the system with a greater height from which to fall. CWL 15, 162
Speculative pessimism may have the opposite effect and discourage basic spending when it should be increasing.
Other than in the quote above, Lonergan never says much about the secondary markets, and for good reason. Redistributive activities such as exchanges of ownership, whose only basis is redistributional optimism or pessimism, are not part of the current, purely-dynamic, productive process. They take part outside of the productive process and are of little interest in a general specification of how the economy actually works.
References to Related Topics
The Road Up is the Road Down; The Mechanism of Rising or Falling Prices
The Correlation of the Need for Money With the Magnitudes and Frequencies of Turnovers
Facing Facts: The Ideal Of Constant Value Of The Currency vs. The Fact Of Inflation
Postulating vs. Explaining in Macroeconomics
Criticism Requires an Normative theory