The circle of economic life or flaming wheels of commerce (Irving Fischer, Brad De Long)

The economist Irving Fischer (1867-1947) and internet-pioneer public intellectual economist Brad De Long (1960-) provide some wonderful intuitive toy examples to help visualize and better understand:

1. The circular flow of economic activity (See diagram above)
2. The nature of a credit economy (debt is natural, loans abound, financially sober and punctual good citizens with good credit ratings) 

Credit and the circular flow of economic life grinds to a halt and the economy fails to function properly under the extreme case of debt deflation and depression, also the name of Irving Fischer's 1933 paper describing the forces at work as the US slid into the Great Depression (Read paper).

The velocity of money falls precipitously but later, during the subsequent recovery, shoots up again. Fischer brings to life a world where velocity of money is falling. De Long brings to life the rising velocity of money of an economic revival. 

First, the quantity theory of money: which emphasizes the positive relationship of overall prices (P) to the quantity of money (M) most noticeable under hyperinflation when a government prints money (M) like a madman and the general price level (P) shoots through the roof. (See ten trillion dollar Zimbabwe banknote below currently in use and Bronte Capital's suggestion that Zimbabwean central bankers should be appoint to run the US central bank to make US monetary policy seem more reckless).



Here's the simple but powerful equation:

M.V = Q.P

M = money supply
V = velocity of money
Q = the quantity of output (real value of final expenditures)
P = the general price level in the economy

When the economy is humming along at a snappy pace the velocity of money is a constant.

With extreme levels of leverage and debt, one day you will inevitably hit a gigantic pothole in the cart path. 
 

...once extreme over-indebtedness occurs, fiscal and monetary policy become impotent in spurring economic growth because money velocity will decline — something that is currently happening [now]. Individuals and businesses struggle to repay debt with harder dollars, and saving begins to rise as caution prevails." (See The Great Experiment and WSJ Real Time Economics and Seeking Alpha)

Fischer weaves an old-fashioned story of economic causality, vicious cycle of deflation, deflationary spiral, life-threatening drunk at the wheel swerving erratically into the oncoming traffic (Stiglitzian analogy for current Fed monetary policy):

1. A state of over-indebtedness leads to liquidation through the alarm either of debtors or creditors or both.
2. Debt liquidation leads to distress selling
3. Bank loans are paid off. 
4. This leads to a contraction in bank deposits and a slowing down of the velocity of bank deposits, i.e. the velocity of circulation (V).  
5. This contraction in deposits and velocity leads to a fall in the general level of prices in the economy (deflation).
6. This deflation leads to a fall in the net worths of business which precipitates bankruptcies.
7. Deflation also causes a fall in profits
8. With a fall in profits comes business losses and a reduction in output, in trade, and employment of labour.
9. Business losses, bankruptcies, and unemployment leads to pessimism and the loss of business confidence.
10. Loss of business confidence leads to hoarding.
11. Hoarding further slows down the velocity of circulation
12. The nominal rate of interest falls and the real rate of interest rises

Economic life rises again out of the primeval mud or Alice, Beverly, Carol, and Deborah rediscover the credit economy

At the depths of depression and deflation, the flower of life still throbs in the heart of the jungle. Fisher’s solution to this deflation mess is reflation. Hopefully not as economist Joseph Stiglitz describes it:

The Federal Reserve is swerving all over the place...In some ways, the Fed resembles a drunk driver who, suddenly realising that he is heading off the road starts careening from side to side. The response to the lack of liquidity is ever more liquidity. When the economy starts recovering, and banks start lending, will they be able to drain the liquidity smoothly out of the system? Will America face a bout of inflation? Or, more likely, in another moment of excess, will the Fed over-react, nipping the recovery in the bud? Given the unsteady hand exhibited so far, we cannot have much confidence in what awaits us. (Source: Guardian)

But rather a more orderly and civilized reflation as Brad De Long describes: 

Suppose that we have four agents: Alice, Beverly, Carol, and Deborah.

Suppose that Beverly has $500 in cash that she owes Carol, due in two months. Suppose that Alice and Carol are both unemployed and idle.

In one scenario in two months Beverly goes to Carol and pays her the $500. End of story.

In a second scenario Beverly says to Alice: "I have a house. Why don't you build a deck--I will pay you $500 after the work is done. Here is the contract." Alice takes the contract and goes to Carol. She shows the contract to Carol and says: "See. I will be good for the debt. Cook me meals so I will have the strength to build the deck--here's another contract in which I promise to pay you $500 within 90 days if you cook for me." Carol agrees.

Two months pass. Carol cooks and feeds Alice. Alice goes and builds the deck.

Alice then asks Beverly for payment. Beverly says: "Wait a minute." She goes to Carol and says: "Here is the the $500 cash I owe you." Beverly pays the money to Carol. Beverly then says: "But now could I borrow the cash back by offering you a long-term mortgage at an attractive interest rate secured with an interest in my newly more-valuable house?" Carol says: "Sure." Beverly files an amended deed showing Carol's mortgage lien with the town office. Carol gives Beverly back the $500. Beverly then goes to Alice and pays her the $500. Alice then goes to Carol and pays her the $500.

The net result? (a) Alice who would otherwise have been idle has been employed--has traded her labor for meals. (b) Carol who would otherwise have been idle has been employed--has traded her labor for a secured lien on Beverly's house. (c) Beverly has taken out a mortgage on her house and in exchange has gotten a deck built. (d) Carol has the $500 cash that Beverly owed her in the first place.

Alice has more income and consumption expenditure than if she hadn't taken Beverly's job offer. Carol has more income and saving than if she hadn't cooked for Alice and then invested her earnings with Beverly. Beverly has an extra capital asset (the deck) and an extra financial liability (the mortgage) than if she had never offered to hire Alice.

A deck has gotten built. Meals have been cooked and eaten. Two women have been employed. And all this has happened without printing any extra money.

John Cochrane would say that this is impossible. John Cochrane would say:

[I]f money is not going to be printed, it has to come from somewhere. If Beverly borrows a dollar from Carol, that is a dollar that Carol does not spend, or does not lend to Deborah to spend on new investment. Every dollar of increased Beverly spending must correspond to one less dollar of Carol or Deborah spending.  Alice's job created by Beverly spending is offset by a job lost from the decline in Carol or Deborah spending. We can build decks instead of fountains, but Beverly stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out”...

John Cochrane is wrong.

You sometimes see this mistake in freshmen students in Economics 1, students who do not fully understand either the circular flow of economic activity or what a credit economy is. They think--like Cochrane--that the flow of spending must be constant unless somebody "prints money" because, you see, you need "money" in order to buy things.

The premise is true--you do need "money" to buy things--but the conclusion is false: the flow of spending is not necessarily constant. In the world in which Beverly does not hire Alice but instead pays the $500 directly to Carol, that $500 turns over only once--its velocity of circulation is equal to one. In the world in which Beverly does hire Alice, the velocity of circulation of the $500 is four--it goes from Beverly to Carol, from Carol to Beverly, from Beverly to Alice, and from Alice to Carol.

Cochrane's mistake--an elementary, freshman mistake--is because he has not thought enough about how a credit economy works to recognize that the velocity of circulation can be an economic variable and is not necessarily a technological constant. And as the velocity of circulation varies, the amount of the flow of spending varies as well: it is now longer the case that if Beverly borrows a dollar from Carol that is a dollar that Carol does not spend.