The savings glut or the death of Schumpeterian growth

In general, I read Michael Pettis, Brad Setser and Matthew Klein and am amazed by what I learn. They are experts in the best sense of the word: inquisitive, open to argument and very effective at presenting complex ideas. Based on recent posts (Klein, Setser) and an old post (Pettis), I see a gap in the analytic approach being used. (NB: I was unable to watch the Geoeconomics plenary yesterday, so this post is not informed by that discussion. Nor have I read Trade Wars are Class Wars – but only because my ‘must read’ list is too long.)

Both Pettis and Klein are explicit that in the context of endogenous money their analytic framework is based on drawing a distinction between an economy with slack and an economy without slack (or at full employment). And it is because of this distinction that “One country’s trade deficit is another’s excess production (or under-consumption/under-investment). There is no financial system capable of removing this real resource constraint.”

What I think is missing from this analytic picture is Schumpeterian growth. (Which BTW was also missing from Keynes and as a result Business Cycles was Schumpeter’s response the General Theory IIRC.) The theory of Schumpeterian growth starts from bank credit. Creative destruction can take place because the elastic flow of bank credit very fluidly and continuously redirects the flow of the economy’s resources into innovative activity that is thus enabled by the system of financing to challenge and then ‘destroy’ incumbent firms. It is essential to this theory that this finance be a monetary, bank-based activity because that is what allows a fluid, unobserved shift in the price system away from dying firms and towards innovative firms. It is bank finance that ensures that we do not notice how easy it is for consumers to choose the better product simply because its there. In Schumpeter’s world that product is there, because some banker made a decision to finance it – and to facilitate the destruction of its competitors.

The problem with the slack/no-slack framework for understanding the economy is that it misses the whole point of the modern economy, which is not full employment but creative destruction and the continuous creation of economic slack due to the continuous changing of what it means to be at full employment. From a Schumpeterian point of view ‘full employment’ is a static and somewhat bewildering concept, because in fact if the economy is doing what it should be doing, then the ‘full employment’ boundary is always dynamically changing.

Thus, a competing explanation for the savings glut is the death of Schumpeterian growth. Our financial system has been so dramatically reformed that it no longer is very effective at financing creative destruction, but instead is geared towards financing incumbent firms. In this environment there is no impetus for firms to invest; the goal instead is for firms to entrench the ‘moats’ around their market power. Thus, the ‘corporate savings glut’ – which is also necessarily a corporate investment famine – accompanied the ‘global savings glut.’ It is this fact that makes ‘savings’ as a causal driver of the contemporary world’s dynamics open to significant question.

An alternate narrative to explain the same facts is that financial reform has had the effect of promoting financialization and discouraging productive investment. What we are experiencing is in fact an investment famine due to the fundamental dysfunction of our financial system. The focus on the savings glut as a causal factor is therefore misleading – because in fact the savings glut exists, because we have broken our financial system.

In practice, most likely there is some truth to both causal narratives. But no one should be surprised when a causal narrative that appears to have convincing evidence is challenged by an alternate causal narrative. This duality exists at the very heart of economic analysis (cf Vincent Grossman-Wirth).

Taxonomy of liquidity III: modeling liquidity

The fundamental problem that economics should seek to solve is what I will call the primary liquidity problem:

  • An individual, S, has a good that she wants to sell
  • There exists a buyer, XH, with the highest valuation, H, for the good
  • However, because finding XH is difficult, S may end up selling the good at a low valuation, L

The first task of economics is to organize trade in the economy so that every individual, S, can realize the high valuation, H, of that individual’s assets. Fundamentally the primary liquidity problem is a problem of trading across time and space. Note that the economic model of competitive equilibrium does not address this problem at all, but assumes it away, substituting for the primary liquidity problem the trope of the centralized market.

The primary liquidity problem can be addressed by borrowing. If S can borrow H, the value of the asset to XH until such time as S can find and trade with XH, then S will not sell at valuation L. Thus, there is a secondary liquidity problem, which only exists if there is a primary liquidity problem. This is the problem of borrowing the value of the asset until it can be sold.

Historically, banking developed to address the secondary liquidity problem. Banking in its 17th to 19th century origins developed to monetize the value of trade bills, where trade bills represent what in modern terms are called Accounts Receivable: a transaction has taken place, delivery has been made, and all that remains is for the buyer in the transaction to make the final payment. By standing ready to encash claims for payment held by sellers, the banking system provided traders with the time and space to locate their highest value counterparties.

Indeed, given the timing of the development of the competitive model in economics over the course of the late 18th and 19th centuries – in an environment where advances in banking had solved the secondary liquidity problem – there is every reason to believe that the competitive model could be conceived only after banking had developed and successfully addressed the primary liquidity problem. That is, the capacity to abstract from the primary liquidity problem was developed, because people were living in a world where bank credit made the primary liquidity problem irrelevant.

Note that there is a related, but in fact very different problem, which is the financing problem. Unlike the liquidity problem, which is a matter of realizing the highest value of a good that already exists, the financing problem is one of funding the development and production of a future good. While the ability to borrow against future income has implications for economic activity, this problem is of second-order importance to the primary problem of realizing the value of the goods that already exist. If the primary problem cannot be solved, then future incomes will be affected and have higher variability than when the primary problem can be solved. Thus, the financing problem is a tertiary problem, to be addressed only after the liquidity problem has been addressed.

Observe that in a post-banking world, the liquidity problem is often framed as a payments problem. A payments-type liquidity problem occurs when someone with an obligation to pay does not have the means to pay it. Note that payments-type liquidity problem can reflect either a primary liquidity problem, where the debtor is having difficulty realizing the value of the debtor’s assets, or a solvency problem, where the debtor does not have enough assets to pay the debt even when the assets are valued at their highest value. The concept of a solvency problem goes beyond the scope of this post, because instead of focusing on how to realize the value of individual assets, the solvency problem is evaluated at the level of the borrowing entity and requires a comprehensive examination of that entity’s assets and liabilities.

Bottom line: the competitive markets model should not be viewed as a model of the efficient allocation of resources, instead it should be viewed as a model that shows what happens when institutional factors exogenous to the model allocate resources efficiently (i.e. to their highest value use).

Last paragraph added 8-8-20