The circular flow of income fallacy

At the Tory Party Conference, the Prime Minister said:

The only way out of a debt crisis is to pay off your debts. That’s why households are paying down their credit card bills and store card bills. It means banks getting their books in order. And it means governments all over the world  – cutting spending and living within their means.

This contrasts with a recent Globe and Mail editorial by Martin Wolf:

What Mr. Cameron recommends is even nigh on impossible. Why is that? Is it not common sense that if one has borrowed too much, one must pay it back? Alas, what makes sense for individuals does not make sense for an economy, because one person’s spending is another person’s income. Consider a closed economy. Income and spending must match. If the private sector decided to spend less than its income, to pay down debt and if the government also decided to stop borrowing, aggregate incomes would fall until they could no longer achieve what they wanted. All they would obtain, by following Mr. Cameron’s advice, is a race to the economic bottom.

This is the gigantic cul-de-sac of the “Circular Flow of Income” that every 1st year economics undergraduate is taught in their opening macro class. Whilst it is true that one man’s spending is another man’s income, this truism says nothing about how that money is spent or whether it is conducive to prosperity. The aggregation makes the circular flow nothing more than a tautological statement.  I previously explored some of the negative routes that economists have embarked upon in this blog post from September 2009.

Wolf is one of the FT’s most mainstream high-profile writers. Before Keynes he would have been considered a consumptionist crank of the sort that used to come to fore every few decades or so to be thoroughly discredited by any non-muddleheaded economist of the day. Now he and his type are in the majority.

If your household had outgoings of £2,000 per month and income of £1,800, you have to either consume your saved capital, or borrow some else’s to the tune of £200 per month.  If there is no one to borrow from, or the amount you have borrowed is making it very burdensome for you to make any repayments (or even to cover the interest costs), then you need to cut back on your outgoings.

Now if you cut back on your outgoings so you now spend £1,700 per month on a £1,800 per month income, it is happy days for you as you are accumulating £100 of capital per month. You are profitable.

In this example, substitute you for a company and you can see how a company reliant upon debt can become a profitable contributor to society.

Now with a sovereign government, the same logical of living within your means must also apply.

Restoration of profitability is the only sure-fire way of establishing long-term recovery in the economy.  The aggregate expenditures of all being the aggregate income of all is in fact a red herring. What matters is the degree of profitability within the aggregate measures in all aspects of the economy, from the Sovereign State, through the corporations, to the humble household.

This implies a deflating down of the credit-induced bubble. This is liquidation. This will mean creditors who have lent money unwisely to walking dead businesses, zombie governments and bozo corporations will not get all their money back. This means there will be some pain.

The alternative proposed by Wolf and much of the economics profession is to inflate the debt away. This means that all the prudent and wise people who have saved to provide for themselves will see their savings eroded, and will be forced to live on less. Meanwhile, those who unwisely lent to households, corporations and governments who could never fulfill their promises will in nominal terms be spared any default on their debt.

Morally, I prefer liquidation, just as I prefer a restoration of profitability to the current approach of maintaining the aggregate incomes and expenditures of all at unsustainable levels without regard to profit. Creating and perpetuating illusions is not for any sane politician or economist, only muddle-heads like Wolf.

17 Comments

  • Toby Baxendale says:

    Since I wrote this, I notice Sir Samuel Brittan , in the FT wrote about the “fallacy of composition” being when you apply what is right for a certain class to that of a whole class. He has thus, like Wolf , joined the ranks of the consumptionist cranks. This is a sad time for economics indeed.

  • I feel the ‘sadness for economics’ will only be a short term problem as even the most economically illiterate realise every economic article presented to the population in the press and on TV is pure propaganda and spin to allow the kleptocracy to confiscate even more wealth for themselves at the expense of the entire country. Viva the revolution

  • corrigan says:

    Have you also noticed, Toby, that Keynesians are happy to dismiss our Austrian idea of a ‘structure of production’ (of which the hallowed GDP components are only one, subjectively-selected subset) yet, when they start to espouse their tautologous ‘circular flow of money’ argument, much less their insupportable ‘multiplier effect’, they are suddenly happy to rely upon the actual existence of a larger, ‘subsurface’, Hayekian component to the lesser, above-water, final sales part of the iceberg of spending and making upon which they are so fixated?

    Moreover, even if we accept the lack of a deeper appreciation of the role of time and capital which categorises these economic Neanderthals, this childish simplification of only considering the various ‘sectors’ as if such a statistically-compliant aggregation had any real world validity is really an insupportable reduction to the absurd of the workings of a vastly complex, ever-changing, economic network.

    To say that ‘if the household sector doesn’t borrow, then government must’ is to roll the very different tastes, circumstances, and capabilities of – let’s take the case of the US – 300-odd million individuals, living in 100-odd million households, into one, indistinguishable blob of clay and then to throw it into the scales against the only true monolith in existence – Leviathan. Likewise, they do this when they talk about the ‘company sector’ as if the innumerably rich range of business enterprises, all eagerly beavering away to try to generate their various interested parties an income, is nothing but a mass of mindless automatons, marching monotonically to the same beat, as if they were part of a birthday parade for Kim Jong-Il.

    Additionally, they make a similar – but possibly even greater – error when they say that ‘if no-one at home will borrow, then someone abroad must do so’ and then fret that if that uncountable, planet-girdling, to-them-utterly-homogenous, offshore sector does not wish to run the trade deficit which is that net borrowing’s usual counterpart (the crude mercantile implication being, of course, that ‘it’ will not wish to do so), then we’re all doomed. This is now to lump the 6 1/2 BILLION people outside our current exemplar of the US into a single, unthinking ant hill of identical preferences and possibilities!!!!

    An extension of this approach is the constant appeal to the shibboleth that ‘we can’t ALL export our way out of difficulties’ – in direct contradiction of the truth that this is exactly what we each attempt to do, every single day of our working lives!

    I try to export my skills to you and those like you endeavour to do the same – sometimes to me, but often to a group which does not (and, moreover, NEED not) actually include me. As we each expand our ability to produce those goods and services of economic value which we constantly seek to ‘export’ across our interpersonal boundaries, so as to profit from our comparative advantage of talents – and irrespective of whether these boundaries coincide with the artificial divisions which the ‘territorial monopoly of violence’ lay down (i.e., of whether they synch with political borders) – the chances are that we will all become richer in the process, even if there will inevitably be the odd, residual imbalance between A and B – and even the less common one between C and everyone else from D through Z – when we take the misleading if regular, single-instant snapshot upon which we depend for accounting and tax-related purposes of the inconceivably extended, thrummingly dynamic matrix of global interchange in which we cannot help but be participants.

    Truly, there is no hope for the world while we allow our self-serving political elite to derive post hoc, self-justification for its members’ depredations from dilettantes such as Wolf – ‘second-hand dealers in ideas’ all – who are irredeemably prey to the many logical fallacies and faults of truncated reasoning which allow them to persist in propagating such errant nonsense with such unshakable conviction.

  • Clare Krishan says:

    FYI more goofishness at the NYTimes infographic “Its all connected” (see layer of chart on ‘risk of contagion’) erroneously states
    “…the lack of central banks in each country – those went away in 1999 with the arrival of the euro – make the euro zone “the ultimate contagion machine” says Kenneth Rogoff, a Harvard economist.”

    http://www.nytimes.com/interactive/2011/10/23/sunday-review/an-overview-of-the-euro-crisis.html

    It’s a case of “Who stole the cookies from the cookies in the jar?” aka “declining” reserve banking…where the socialized losses of FIAT currency moral hazard have emptied out any privatized gains… irony of ironies until one considers the wisdom of Haggai
    “When one came to a heap of twenty measures, there were but ten. When one came to the wine vat to draw fifty measures, there were but twenty” (H/T http://speakingofscripture.wordpress.com/2011/10/22/what-is-our-lord-saying-to-american-catholics/)

  • Dan Mosley says:

    Toby,

    You talk of restoration of profitability. But how is this possible if everyone (including government) is paying down debt at the same time? This means a deflationary spiral and a huge drop in demand; surely not the way to restore profitability, and a sure-fire way to make the situation much worse. 

  • corrigan says:

    Dan,

    Profit is the difference between income and outgo (less such legal deductibles as depreciation, etc).

    Even if most prices were to fall for the reasons you suggest, there is nothing to say that my unit costs may not go down faster than my selling prices, thus leaving me with a profit.

    Moreoever, even if the monetary count of whatever profit that left me with was lower than before, there is nothing to say that this will not now allow me to buy just as many – and possibly more – goods and services as before since, as you first postulated, prices have meanwhile fallen!

  • Toby Baxendale says:

    Dan, the article addresses the points you raise , I wonder did you read the article ?

    Corrigan has answered well.

    I pose some hypothetical questions as I detect that you must be an employee and not an employer.

    Think about this phrase: Sales is vanity and Profit is sanity. There is much truth in it. Aggregationist economists have long forgotten this.

    1. Would you rather your salesman come and say I have made millions in sales today and not mention profitability – remember any fool can give away product for less prices than your competitors. Or would you rather he says , I have sold what you have required, plus a little bit more , at the price that delivers us the net margin we require to thus deliver us up the profit we require?

    2. Would you rather any turnover recorded by GDP for the nation, or turnover of goods and services that produced the net margins required for most economic agents to be profitable? If you prefer the former to the latter, then anything that boosts GDP is good. Thus making bombs and slinging them at tents in Libya , would be a good act despite the fact that a series of taxpayers need to have this wealth extracted from them, then we must use this extracted wealth to destroy other governments taxpayers wealth. But hey, for sure GDP will go up. Aggregate demand will go up.

    3. Would you rather a government who lives well beyond its means , brought its outlays into line with the extractions from its taxpayers that they could afford? More expenditure than the taxpayers can afford suck the life out of them.

    If the state is solvent , it can continue with its programs. If it is not, no amount of boosting aggregate demand of any type will sort this out.

    In my old business , post Lehman with 15% off my top line and my bottom line only being 7%, we engineered a turn around in 9 months so instead of misery and surely us going bust, we LOWERED marginal TURNOVER (lowering aggregate demand etc) and restored profitability as we took less marginal work off our book and concentrated on the most profitable work with less resources deployed . Soon with less TURNOVER we had higher profits. Happy days. Many private sector businesses have already made this adjustment – only the State does not. How immoral.

    In short, the government needs to do this. The more we delay, the longer and more painful will be the correction.

    • Dan Mosley says:

      Toby, Corrigan,

      Maybe I wasn’t very clear in my last post. Just to expand on what I’m trying to say: 

      In a normally functioning economy, households spend most of their income, and save a proportion of it which is then lent out to businesses and invested. Thus total income is equal to total spending. But if, for example, businesses all begin to pay down debt at once, there is no one to borrow the funds that households have saved. 

      Say a household has £2000 in income and saves 10 percent of this, or £200. If all companies are paying down debt, there is no one to borrow and spend this £200, which therefore stays in the banking system. So only £1800 of the £2000 can become income for someone else. Assuming the next household also saves 10 percent, they will spend £1620 of the £1800 and save £180. In this way, the initial £2000 keeps reducing, and money piles up in the banks, which depresses the economy. 

      So in this scenario, aggregate demand decreases by the sum of net household savings plus net debt repayment by firms. The money supply will also plunge as debt is repaid and not lent out. This is clearly a fallacy of composition – a course of action which makes sense for an individual firm, but not for all collectively. 

      This decrease in aggregate demand would be bad news for profits of many businesses – households are getting poorer and poorer and will have less money to spend than they did – many small businesses (e.g. Restaurants) would be unable to adjust to this sudden drop in demand and will have to go bust. So Toby, this is what I was referring to when I said that this fallacy of composition could lead to many businesses going bust, and would hardly assist in restoring profitability.

      Where we would disagree is that in my view there is something that can be done about this fallacy of composition, i.e government stepping in. In the example I gave, the government could step in to borrow and spend the funds saved by households, ensuring that there are £2000 in expenditures for £2000 of income and preventing a crash in GDP. 

      To answer your points Toby:
      1. Yes, of course profitability should be what drives business. 
      2. I don’t have an issue with the GDP measure. In a normally functioning economy, making bombs and slinging them at tents in Libya would add to GDP. but GDP would be greater if the government reduced taxes and let the private sector decide what to do with the funds.
      3. I agree that governments need to live within their means; as soon as the economy returns to normal, the deficit needs to be eliminated. 

      • Dan, it is a fact of human action that at all times we are faced with choices (we have to act). At all time we seek to re move uneasiness that faces us and replace with satisfying outcome. When people save, they are putting money away for future consumption. It is from this that investment is made to produce the goods and services for the future consumption . Again, this is a logical facet of action.

        In extremis you posit a situation in which there is no borrowing at all as banks won’t lend. They will go bust (as this is what they do for a living) and others will eventually replace them as all the savers will be looking to spend their savings on future consumption , for which there needs to be goods and services. This is an inescapable fact of the condition of being human. Your situation is one that is as unreal as it will lead to no consumption and no removal of uneasiness i.e., not a society we know or one that will ever exist. I would not get yourself bogged down in thinking of these impossible situations.

        It is a fact bank lending is lower than before the Great Recession. This should be considered a normal outcome of a prior massive un precedented credit expansion of fiduciary media for which there is not actually the real savings to sustain the future purchases that will need to be made to keep the newly minted credit in circulation making goods and services . Until and only until this realignment of savings with investment happens , we will continue to be in a difficult hard correction. Savings , and in fact more of them, and not credit will be the well spring of the recovery for the reasons stated above.

        If Govt steps in, it has to extract the wealth of the people to give to its favoured groups to keep spending going at its old rate. To keep this inflated amount at the level you desire, it will need to create more fiduciary media to keep the old pre Great Recession Levels in circulation. These are the levels that caused the problem in the first place. THus we get no where . Only an alignment of the needs of consumers with savers and investors will give you sustainable growth.

        • Dan Mosley says:

          Toby,

          I don’t think that the situation I mentioned is impossible. This relates to the ‘balance sheet recession’ theory developed by Richard Koo, which I think goes some way to explaining the mess we are in at the moment, as well as past crises. 

          Koo provides some strong evidence to support the theory that this situation is exactly what happened in Japan’s lost decade. It is put forward that the problem was not that banks wouldn’t lend, it was that businesses did not want to borrow, even at 0% interest, as they were focused on repairing their balance sheets, paying down the gigantic levels of debt they had accumulated before the asset bubble burst. 

          The reason given as to why companies were so focused on debt repayment is that asset prices had crashed and, due to borrowing, many companies were pushed into negative equity. But as they still had healthy cash flow, they prioritised debt repayment and did not invest, leading to a fallacy of composition. This situation continued until companies had repaired their balance sheets; it was only then (around 2006) that they started investing again and the economy could return to normal. 

          The fact that QE had no effect on prices is also explained; the central bank pushed trillions of Yen into the banking system, but no one wanted to borrow the extra cash, so it just piled up in bank vaults. 

          I’m still not sure how much this relates to the situation in the UK, but I think it could be at least part of the explanation. Our crisis is similar in many ways to Japan’s, including an asset bubble and high debt levels. 

          Sorry to keep banging on about Japan, but in my view there are some important lessons to be learned from their experience. By the way, I would recommend Koo’s book ‘The Holy Grail of Macroeconomics’ – though you would disagree with much of the analysis, it is a very good study on what happened in Japan’s lost decade. 

          • Dan, what you are describing is the correction itself . This is something that is unavoidable . Until saving is in line with investment , then there will be this deleveraging. This is “good” and should be let happen as quick as possible. Not investing for future consumption is an impossibility, like suggesting man will not act . This is all about degrees . Letting the govt step in with a magic dose of QE, Tax , Funny Money A,B or C will never stop this adjustment happening , all it can do is delay until another day. When that day was for Japan was nearly 20 years and to some extent still counting ……

            • Dan Mosley says:

              Toby, 

              The example shows I think that the fallacy of composition  can be a real concern in certain situations and is not just a tautological statement.

              You say that “it is a fact of human action that at all times we are faced with choices (we have to act)”.  But you also say that the correction is unavoidable, ie that governments should stand by whilst GDP plunges by 10, 20, 30 percent and unemployment rises  by 10, 20, 30 percent. 

              But it is human nature to act in a crisis, and governments will surely act if faced with an economic crisis. If their chosen course of action doesn’t work, they will try something else until something is found that does work. 

              • Dan, and create more problems……..the positive policy of inaction is needed by the State , so action by entrepreneurs can get moving once more.

  • Rob Thorpe says:

    What Toby presents here is a criticism of savings-investment Keynesian, it’s a criticism of the “Samuelson Cross”. Though I disagree with Toby about the price level, I largely agree with him here.

    The problem is that Keynesians are so fascinated by perversities of composition and group action that they forget the common cases.

    In a thread over at thinkmarkets I wrote:

    You are always assuming that it’s worthwhile for input goods to be made into output goods. Marx made the same assumption and there is a term for it though I can’t remember it right now.

    We have the situation where the reason investment spending is low is because holders of assets don’t believe that transforming them from one form into another is worthwhile. Surely it is possible that they are *right* about this. Why must they be assumed to be wrong?

    Greg replied:

    I don’t think that any individual asset holder is necessarily wrong in believing that investment at the moment would be unprofitable. However, I do believe that low levels of investment can be the result of a coordination failure.

    Imagine a two-firm economy in which the factor incomes paid out by firm X are spent on the output of firm Y, and vice versa. If X believes Y will be hiring additional labor, then X will expand its output, and if Y believes the same about X, Y will expand, and the result will be a high-output equilibrium. If both X and Y expect the other to reduce output, then you’ve got a low-output equilibrium.

    As I understand it you’re making the same argument as Greg.

    I wrote a long reply to this which I’ll reproduce here because this the subject of this thread is the same:

    I think your “two-firm economy” is useful.

    But we must be very clear about what we’re talking about.

    I your example you talk about both firms hiring additional labour. That means you’re assuming that we have unemployment of people. Specifically, you’re assuming that there is unemployment above the level caused by frictions such as search costs and skill mismatches. If there wasn’t then firm X could only expand output by hiring employees away from firm Y.

    You’re assuming that a reserve of consumer goods or capital goods exists, or that an income stream can take their place. There are two possibilities here… Firstly, a stock of consumer goods may exist to pay newly hired workers. Then while consuming those goods the workers can create capital goods from raw inputs. So, at some point in the future firm X and firm Y can expand output, but not straight away. In fact, to assume that surplus workers will continue to survive between one period and the next we must assume that they have a reserve of some sort, or that they have an income (e.g. from savings or government welfare). But an additional reserve of existing goods or a promise of future returns would be needed incentivise workers to work rather than relying on their reserve.

    Alternatively, there could be unemployed capital goods in firm X and firm Y. In that case if those firms can find workers with the right skills then they can easily expand. If these criteria aren’t met than expansion can’t occur. If both businesses are using all their capital goods and they can’t obtain a reserve to pay workers with while they make more capital goods then expansion isn’t possible. This is why Keynes says that in some situations the special-case of what he calls “Classical Economics” holds, just as Newton’s laws hold as a special case of Einstein’s.

    (This brings us to the impact of expected productivity on interest. Firms bid down the price of bonds because they believe expansion will be profitable. But there’s no need to go into that here.)

    I agree that the situations I describe above can occur. The issue you’re describing is only really relevant for recessions. Your argument is that the problem in a recession is assets (including money) that have being placed on the side-lines by capitalists, rather than being invested in creating output. I agree that this happens and that it decreases GDP in the short-run. I’m not convinced that the government should do anything about that though.

    You argue that coordination failure occurs because there is no way to communicate the plans involved. As John Papola points out, that’s always the case to some extent. In a real economy experimentation, expectations and forward planning help to deal with this issue. To think about this we have to move away from the two firm model. Rather than their being a single firm in the position of firm X there are many, some will experiment with expanding production, and some with keeping it the same or reducing it. The set of firms in the position of firm Y in the two-firm model will respond to this and do it themselves. It could be argued that this process of discovery can be bypassed, as I understand it that’s what you’re arguing.

    One problem with this is that it assumes that the fall in output is a composition problem. That is, you’re assuming that it would be rational for society as a whole to expand production. You’re only considering the case that it’s irrational for particular agents, but rational for society as a whole. But it could also be both rational for particular agents and for society as a whole.

    It may be that for a particular project, business, or industry the conversion of inputs into outputs isn’t profitable in the new economic conditions and wouldn’t be profitable even after recovery has occurred. In that case it’s wise for anyone for capital to be directed into that project. Keynesian stimulus depends on businesses taking increase demand as a signal to increase output. That means that when and where that signal is misplaced waste will occur. When the government spend money on investment we must hope that the outputs of that investment are worth more than the inputs. If they are worth less then we may hope that the extra investment spurs extra output elsewhere and that output is worthwhile. It’s similar for the stimulus spending that is spent on consumption. Directly that leads to greater satisfaction for the consumers at the cost of consumption of resources. Again, we are hoping that as a spin-off of that income will be spent elsewhere and will aide recovery.

    Notice I’m not just saying that the multiplier is low. I’m saying that that multiplier must be high enough to compensate for the waste involved in stimulus. Modern Keynesians have latched onto the idea that the PIH is wrong as though it proves their case. All it proves is that stimulus may expand GDP. It doesn’t prove how much of that GDP expansion represents additional wealth society has.

    This is without considering the negative effect stimulus may have on expectaions. If investors believe stimulus won’t be effective that may decrease investment and offset the effect of stimulus.

    • mrg says:

      Good response, Rob. Am I right in thinking that there’s a ‘not’ missing from this sentence:

      In that case it’s wise for anyone for capital to be directed into that project

      (that project being the one for which “the conversion of inputs into outputs isn’t profitable in the new economic conditions and wouldn’t be profitable even after recovery has occurred.”)

      • Rob Thorpe says:

        That’s right, I meant to say “In that case it isn’t wise for anyone for capital to be directed into that project.”

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