Saturday, February 21, 2009


This two-part article is the second in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity. The first article in the series was “Falling Prices Are Not Deflation but the Antidote to Deflation.”

Part I: Capital, Saving, and Our Economic Crisis

Imagine an individual who is lethargic and lacks the energy to function at his normal level because of too little sleep. There are drugs that can make him feel fully refreshed, even after a night without any sleep whatever, and apparently capable of functioning the next day with full efficiency.

Nevertheless taking such drugs is definitely not a good idea. This is because the individual’s underlying problem of insufficient sleep is not only not addressed by his being stimulated but is actually worsened. For the stimulus further depletes his body’s already diminished energy reserves and takes him down the path of utter exhaustion.

This description applies to the current slowdown in our economic system and to the efforts to overcome it through the use of “fiscal policy” and its “stimulus packages.” The meaning of these terms is more government spending and lower taxes specifically designed to promote consumption. This includes giving income-tax refunds to people who paid no income tax and who, because of their low incomes, can presumably be most counted on to rush out and consume more as soon as additional funds are put in their hands.

The main difference between such economic “stimulants” and pharmaceutical stimulants is that the economic stimulants will not succeed even in temporarily restoring the economic system to anything approaching its normal level of activity.

An economic system entering into a major recession or depression is in a situation very similar to that of our imaginary, sleep-deprived individual. All that one need do is substitute for the loss of the sleep required for the body’s proper functioning the loss of something required for the proper functioning of the economic system.


In the case of the economic system, that something is capital. The economic system is not functioning properly because it has lost capital. Capital is the accumulated wealth that is owned by business enterprises or individuals and that is used for the purpose of earning profit or interest.

Capital embraces all of the farms, factories, mines, machinery and all other equipment, means of transportation and communication, warehouses, shops, office buildings, rental housing, and inventories of materials, components, supplies, semi-manufactures, and finished goods that are owned by business firms.

Capital also embraces the money that is owned by business firms, though money is in a special category. In addition, it embraces funds that have been lent to consumers at interest, for the purpose of buying consumers’ goods such as houses, automobiles, appliances, and anything else that is too expensive to be paid for out of the income earned in one pay period and for which the purchaser himself does not have sufficient savings.

The amount of capital in an economic system determines its ability to produce goods and services and to employ labor, and also to purchase consumers’ goods on credit. The greater the capital, the greater the ability to do all of these things; the less the capital, the less the ability to do any of these things.


Capital is accumulated on a foundation of saving. Saving is the act of abstaining from consuming funds that have been earned in the sale of goods or services.

Saving does not mean not spending. It does not mean hoarding. It means not spending for purposes of consumption. Abstaining from spending for consumption makes possible equivalent spending for production. Whoever saves is in a position to that extent to buy capital goods and pay wages to workers, to lend funds for the purchase of expensive consumers’ goods, or to lend funds to others who will use them for any of these purposes.

It is necessary to stress these facts because of the prevailing state of utter ignorance on the subject. Such ignorance is typified by a casual statement made in a recent New York Times news article. The statement was offered in the conviction that its truth was so well established as to be non-controversial. It claimed that “A dollar saved does not circulate through the economy and higher savings rates translate into fewer sales and lower revenue for struggling businesses.” (Jack Healy, “Consumers Are Saving More and Spending Less,” February 3, 2009, p. B3.)

The writer of the article apparently believes that houses and other expensive consumers’ goods are purchased out of the earnings of a single week or month, which is the normal range of time between paychecks. If that were the case, no savings would be necessary in order to purchase them. In fact, of course, the purchase of a house typically requires a sum equal to the purchaser’s entire income of three years or more; that of an automobile, the income of several months; and that of countless other goods, too large a fraction of the income of just one pay period to be affordable out of such limited funds.

In all such cases, a process of saving is essential for the purchase of consumers’ goods. The savings accumulated may be those of the purchaser himself, or they may be borrowed, or be partly the purchaser’s own and partly borrowed. But, in every case, savings are essential for the purchase of expensive consumers’ goods.

The Times reporter, and all of his colleagues, and the professors who supposedly educated him and his colleagues, all of whom spout such nonsense about saving, also do not know other, even more important facts abut saving. They do not know that saving is the precondition of retailers being able to buy goods from wholesalers, of wholesalers being able to buy goods from manufacturers, of manufacturers, and all other producers, being able to buy goods from their suppliers, and so on and on. It is also the precondition of sellers at any and all stages being able to pay wages.

Such expenditures must generally be made and paid for prior to the purchaser’s receipt of money from the sale of his own goods that will ultimately result. For example, automobile and steel companies cannot pay their workers and suppliers out of the receipts from the sale of the automobiles that will eventually come in as the result of using the labor and capital goods purchased. And even in the cases in which the payments to suppliers are made out of receipts from the sale of the resulting goods, the seller must abstain from consuming those funds, i.e., he must save them and use them to pay for the capital goods and labor he previously purchased.

In contrast, the Keynesian reporters and professors believe that sellers do nothing but consume or hoard cash. They are too dull to realize that if that were really the case, there would be no demand for anything but consumers’ goods. This becomes clear simply by following the pattern of the Keynesian textbooks in allegedly describing the process of spending.

Thus a consumer buys, say, $100 dollars worth of shirts in a department store; the owner of the department store, following his Keynesian “marginal propensity to consume” of .75, then buys $75 worth of food in a restaurant, and allegedly hoards the other $25 of his income; the owner of the restaurant then buys $56.25 (.75 x $75) worth of books, while allegedly hoarding the remaining $18.75 of his income; and so on and on. Now, unknown to the Keynesians, if such a sequence of spending actually took place, all that would exist is a sum of consumption expenditures and nothing else.

The fact is that most spending in the economic system rests on a foundation of saving. The seller of the shirts will likely save and productively expend $95 or more in buying replacement shirts and in paying his employees and making other purchases necessary for the conduct of his business, and perhaps only $5 on consumption. And so it will be for those who sell to him, or to the suppliers of his suppliers, or to the suppliers of those suppliers, and so on.

Any business income statement can provide a simple confirmation of such facts. The ratio of costs to sales revenues that can be derived from it, is an indicator of the ratio of the use of savings to make expenditures for labor and capital goods relative to sales revenues. For the costs it shows are a reflection of expenditures for labor and capital goods made in the past. The saving and productive expenditure out of current sales revenues will show up as costs in the future. The higher is the ratio of costs to sales, the higher is the degree of saving and productive expenditure relative to sales revenues. A firm with costs of $95 and sales revenues of $100 is a firm that can be understood as saving and productively expending $95 out of its $100 of sales revenues. This relationship applies throughout the economic system.

Hoarding Versus Saving

To the extent that “hoarding” or, more accurately, an increase in the demand for money for cash holding takes place, it is not because people have decided to save. What is actually going on is that business firms and investors have decided that they need to change the composition of their already accumulated savings in favor of holding more cash and less of other assets.

For example, an individual may decide that instead of being 90 percent invested in stocks and other securities and having only 10 percent of his savings in cash in his checking account, he needs to increase his cash holding to 20 or 25 percent of his savings.

Similarly, a corporation may decide that it needs to increase its cash holding relative to its other assets in order to be better able to meet its bills coming due. Indeed, this is happening right now as more and more firms find that they can no longer count on being able to borrow money for such purposes.

Furthermore, the increases in cash holdings that take place in such circumstances are not only not an addition to savings but occur in the midst of a sharp decline in the overall amount of accumulated savings. For example, the increases in cash holdings that are taking place today are in response to a major plunge in the real estate and stock markets, of numerous and sizable corporate bankruptcies, and of huge losses on the part of banks and other financial institutions.

All of this represents a reduction in asset values, i.e., in the value of accumulated savings. People are turning to cash in order to avoid further such losses of their accumulated savings. Of course, widespread attempts to convert assets other than cash into cash, entail further declines in the value of accumulated savings, since the unloading of those assets reduces their value.

Accumulated savings in the economic system have fallen by several trillion dollars, and nothing could be more incredible than that, in the midst of this, many people, including the great majority of professional economists, fear saving and think that it is necessary to stimulate consumption at the expense of saving. Such is the complete and utter lack of economic understanding that prevails.

One might expect that a group of people such as most of today’s economists, who pride themselves on their empiricism, would once and a while look at the actual facts of the world in which they live, and, in the midst of the loss of trillions of dollars of accumulated savings, begin to suspect that there might actually be a need to replace savings that have been lost rather than do everything possible to prevent their replacement.

Depressions and Credit Expansion

The loss of accumulated savings is at the core of the problem of economic depressions. Recessions and depressions and the losses that accompany them are the result of the attempt to create capital on a foundation of credit expansion rather than saving. Credit expansion is the lending out of new and additional money that is created out of thin air by the banking system, which acts with the encouragement and support of the government. The money so created and lent has the appearance of being new and additional capital, but it is not.

The fact of its appearing to be new and additional capital creates an exaggerated, false understanding of the amount of capital that is available to support economic activity. Like an individual who believes he has grown rich in the course of a financial bubble, and who is led to adopt a level of living that is beyond his actual means, business firms are led to undertake ventures that are beyond their actual means.

For an individual consumer, the purchase of an expensive home or automobile in the delusion that he is rich later on turns out to be a major loss in the light of the fact that he cannot actually afford these things and would have been better off had he not bought them. In the same way, business construction projects, stepped up store openings, acquisitions of other firms, and the like, carried out in the delusion of a sudden abundance of available capital, turn out to be sources of major losses when the delusion of additional capital evaporates.

Credit expansion also fosters an artificial reduction in the demand for money for cash holding, which sets the stage for a later rise in the demand for money for cash holding, such as was described a few paragraphs ago. The reduction in the demand for money for cash holding occurs because so long as credit expansion continues, it is possible for business firms to borrow easily and profitably and thus to come to believe that they can substitute their ability to borrow for the holding of actual cash. The rising sales revenues created by the expenditure of the new and additional money that is lent out also encourages the holding of additional inventories as a substitute for the holding of cash, in the conviction that the inventories can be liquidated easily and profitably.

Recessions and depressions are the result of the loss of capital in the malinvestments and overconsumption that credit expansion causes. The losses are then compounded by the rise in the demand for money for cash holding that subsequently follows. They can be further compounded by reductions in the quantity of money as well, such as would occur if the losses suffered by banks resulted in losses to the banks’ checking depositors. (Checking deposits are part of the money supply, indeed, the far greater part. In such cases, they would lose the status of money and assume that of a security in default, which would render them useless for making purchases or paying bills.)

The Housing Bubble

Our housing bubble is an excellent illustration of the malinvestment and overconsumption caused by credit expansion. Perhaps as much as $2 trillion or more of capital has been lost in the construction and financing of houses for people who, it turned out, could not afford to pay for them. The housing bubble was financed by the creation of $1.5 trillion of new and additional money in the form of checking deposits created for the benefit of home buyers.

The creation of these deposits rested on the readiness of the Federal Reserve System to create whatever new and additional supporting funds were required in the form of bank reserves. In the three years 2001-2004, the Federal Reserve created enough such funds to drive the interest rate paid on them, i.e., the Federal Funds Rate, below 2 percent. And from July of 2003 to June of 2004, it created enough such funds to hold this rate down to just 1 percent. The end result was a substantial reduction in mortgage interest rates and thus in monthly mortgage payments, which served greatly to increase the demand for houses.

Government also greatly contributed specifically to loans being made to homebuyers who were not credit worthy. It did this through its various loan-guarantee programs, carried out by Fannie Mae, Freddie Mac, and the Department of Housing and Urban Development; and by means even of outright extortion, though the Community Reinvestment Act, which required banks to make sufficient such loans as would satisfy local “community groups.”

In physical terms, the result of credit expansion was the passage of literally millions of houses that represented capital to the firms that built them, and to the banks and others that financed them, into the hands of consumers who not only had not contributed anything remotely comparable to the wealth and capital of the economic system but also had no realistic prospect of ever being able to do so. The further result has been that many of the builders of these houses are now ruined as are many of the banks and other investors that financed the construction and sale of those houses. And because so many lenders have lost so much, the business firms that depend on them for loans can no longer obtain those loans, and so they must close their doors and fire their workers.

The growing problem of unemployment that we are experiencing and the accompanying reduction in consumer spending on the part both of the unemployed and of those who fear becoming unemployed is the result of this loss of capital, not of any sudden, capricious refusal of consumers to spend or of banks to lend. Indeed, the kind of consumer spending that so many people want to revive and encourage, by means of “stimulus packages,” played a major role in the loss of capital that has taken place and now results in unemployment and impoverishment.

During the housing boom, millions of owners of existing houses thought that they were growing rich as the result of the rise in the prices of their homes and that they could actually live to a substantial degree off the accompanying increase in the equity in their homes. They borrowed against the increased equity and spent the proceeds. This consumption was at the expense of capital investment in the economic system, which was rendered correspondingly poorer by it. And when housing prices collapsed, and fell below the enlarged mortgage debts that had been taken on, the effect was to add to the losses suffered by lenders. This was the case to the extent such equity-consuming homeowners then walked away from their homes, leaving their creditors to lose by the decline in the price of their homes.

Keynesian Ignorance and Blindness

The immense majority of people, including, of course, most professional economists, are ignorant of the actual nature and cause of our financial crisis. This is because they are ignorant of the role of capital in the economic system. They are all Keynesians. (Even Milton Friedman, the alleged arch-defender of capitalism is reported to have said, “We are all Keynesians now.”)

But as von Mises so aptly put it, “The essence of Keynesianism is its complete failure to conceive the role that saving and capital accumulation play in the improvement of economic conditions.” (Planning for Freedom, 4th ed., p. 207. Italics in original.) In the eyes of Keynes and his countless followers, economic activity begins and ends with consumption.

So deeply do people hold the view that consumption is everything, that it blinds them to obvious facts. Thus, the present crisis has been well underway at least since the late spring of 2007, when the sudden collapse of two large Bear Stearns hedge funds occurred. This was followed by a continuing string of bankruptcies between June of 2007 and August of 2008 of significant-sized and fairly well-known firms, such as Aloha Airlines, Levitz Furniture, Wickes Furniture, Mervyns Department Stores, Linens N’ Things, IndyMac Bank, and Bear Stearns itself. The list includes an actual run on a major bank—Northern Rock in Great Britain—in September of 2007, probably the first such run since the 1930s.

Financial failures reached a crisis point in September of 2008, with the collapse of such major firms as American International Group (AIG), Lehman Brothers, and the Halifax Bank of Scotland. These were followed by the bankruptcy of Fannie Mae and Freddie Mac, the two giant government-sponsored mortgage lenders that had led the way in guaranteeing sub-prime mortgages to borrowers who could not repay them.

Yet as late as September of 2008, the unemployment rate in the United States was no more than 6.2 percent and at mid-month the Dow Jones Industrial Average was still well above 11,000.

All this confirms that the crisis did not originate in any sudden refusal of consumers to consume or in any surge in unemployment. To the extent that unemployment is growing and consumption is declining, they are both the consequence of the economy’s loss of capital. The loss of capital is what precipitated a reduction in the availability of credit and a widening wave of bankruptcies, which in turn has resulted in growing unemployment and a decline in the ability and willingness of people to consume. The collapse in home prices and the more recent collapse in the stock market have also contributed to the decline in consumption, and probably to an even greater extent, at least up to now. Both of these events are also an aspect of the loss of capital and accumulated savings.

What Economic Recovery Requires

What all of the preceding discussion implies is that economic recovery requires that the economic system rebuild its stock of capital and that to be able to do so, it needs to engage in greater saving relative to consumption. This is what will help to restore the supply of credit and thus help put an end to financial failures based on a lack of credit.

Recovery also requires the freedom of wage rates and prices to fall, so that the presently reduced supply of capital and credit becomes capable of supporting a larger volume of employment and production, as I explained in
“Falling Prices Are Not Deflation but the Antidote to Deflation,” which was my first article in this series. Recovery will be achieved by the combination of more saving, capital, and credit along with lower wage rates, costs, and prices.

In addition, recovery requires the rapid liquidation of unsound investments. If borrowers are unable to meet their contractual obligation to pay principal and interest, the assets involved need to be sold off and the proceeds turned over to the lenders as quickly as possible, in order to put an end to further losses and thus salvage as much capital from the debacle as possible.

In the present situation of widespread financial paralysis, firms and individuals can be driven into bankruptcy because they are unable to collect the sums due them from their debtors. Thus, for example, the failure of mortgage lenders would be alleviated, if not perhaps altogether avoided in some cases, if the mortgage borrowers who were in default on their properties lost their houses quickly, with the proceeds quickly being turned over to the lenders.

In that way, the lenders would at least have those funds available to meet their obligations and thus might avoid their own default; in either event, their creditors would be better off. In helping to restore the capital of lenders, or what will become the capital of the creditors of the lenders, quick foreclosures would serve to restore the ability to originate new loans.

Recovery requires the end of financial pretense. There are banks that do not want to see the liquidation of various types of assets that they own, notably, “collateralized debt obligations” (CDOs). These are securities issued against collections of other securities, which in turn were issued against collections of mortgages, an undetermined number of which are in default or likely to go into default. The presumably low prices that such securities would bring in the market would likely serve to reveal the presence of so little capital on the part of many banks that they would be plunged into immediate bankruptcy. To avoid that, the banks want to prevent the discovery of the actual value of those securities. At the same time, they want creditors to trust them. Yet before trust can be established, the actual, market value of the banks’ assets must be established, even if it serves to bankrupt many of them. The safety of their deposits can be secured without the banks’ present owners continuing in that role.

When these various requirements have been met and the process of financial contraction comes to an end, the profitability of business investment will be restored and recovery will be at hand.

Next: Part II: Stimulus Packages

*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of
Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is and his blog is A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.

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