Obama Puts the Economic Cart Before the Horse

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his first televised speech before Congress, President Obama asserted
that prosperity will return once the government restores the flow
of credit in the economy. It may come as a surprise to him, but
an economy cannot run on consumer loans. Furthermore, credit stopped
flowing in the U.S. for a very good reason: there was no more savings
left to loan. Government efforts to simply make credit available,
without rebuilding productive capacity or increasing savings, are
doomed to destroy what’s left of our economy.

The central
tenets of Obamanomics appear to be that access to credit will enable
people to borrow money to buy stuff, the spending will spur production
and employment, and thus the economy will grow. It’s a neat
and simple picture, but it has nothing whatsoever to do with how
an economy works. The President does not understand that consumption
is made possible by production and that credit is made possible
by savings. The size and complexity of modern economies has obscured
these simple concepts, but reducing the picture to a small scale
can help clear away the fog.

Suppose there
is a very small barter-based economy consisting of only three individuals,
a butcher, a baker, and a candlestick maker. If the candlestick
maker wants bread or steak, he makes candles and trades. The candlestick
maker always wants food, but his demand can only be satisfied if
he makes candles, without which he goes hungry. The mere fact that
he desires bread and steak is meaningless.

Enter the magic
wand of credit, which many now assume can take the place of production.
Suppose the butcher has managed to produce an excess amount of steak
and has more than he needs on a daily basis. Knowing this, the candlestick
maker asks to borrow a steak from the butcher to trade to the baker
for bread. For this transaction to take place the butcher must first
have produced steaks which he did not consume (savings). He then
loans his savings to the candlestick maker, who issues the butcher
a note promising to repay his debt in candlesticks.

In this instance,
it was the butcher’s production of steak that enabled the candlestick
maker to buy bread, which also had to be produced. The fact that
the candlestick maker had access to credit did not increase demand
or bolster the economy. In fact, by using credit to buy instead
of candles, the economy now has fewer candles, and the butcher now
has fewer steaks with which to buy bread himself. What has happened
is that through savings, the butcher has loaned his purchasing power,
created by his production, to the candlestick maker, who used it
to buy bread.

the candlestick maker could have offered “IOU candlesticks”
directly to the baker. Again, the transaction could only be successful
if the baker actually baked bread that he did not consume himself
and was therefore able to loan his savings to the candlestick maker.
Since he loaned his bread to the candlestick maker, he no longer
has that bread himself to trade for steak.

existence of credit in no way increases aggregate consumption within
this community, it merely temporarily alters the way consumption
is distributed. The only way for aggregate consumption to increase
is for the production of candlesticks, steak, and bread to increase.

One way credit
could be used to grow this economy would be for the candlestick
maker to borrow bread and steak for sustenance while he improves
the productive capacity of his candlestick-making equipment. If
successful, he could repay his loans with interest out of his increased
production, and all would benefit from greater productivity. In
this case the under-consumption of the butcher and baker led to
the accumulation of savings, which were then loaned to the candlestick
maker to finance capital investments. Had the butcher and baker
consumed all their production, no savings would have been accumulated,
and no credit would have been available to the candlestick maker,
depriving society of the increased productivity that would have

On the other
hand, had the candlestick maker merely borrowed bread and steak
to sustain himself while taking a vacation from candlestick making,
society would gain nothing, and there would be a good chance the
candlestick maker would default on the loan. In this case, the extension
of consumer credit squanders savings which are now no longer available
to finance other capital investments.

What would
happen if a natural disaster destroyed all the equipment used to
make candlesticks, bread and steak? Confronted with dangerous shortages
of food and lighting, Barack Obama would offer to stimulate the
economy by handing out pieces of paper called money and guaranteeing
loans to whomever wants to consume. What good would the money do?
Would these pieces of paper or loans make goods magically appear?

The mere introduction
of paper money into this economy only increases the ability of the
butcher, baker, and candlestick maker to bid up prices (measured
in money, not trade goods) once goods are actually produced again.
The only way to restore actual prosperity is to repair the destroyed
equipment and start producing again.

The sad truth
is that the productive capacity of the American economy is now largely
in tatters. Our industrial economy has been replaced by a reliance
on health care, financial services and government spending. Introducing
freer-flowing credit and more printed money into such a system will
do nothing except spark inflation. We need to get back to the basics
of production. It won’t be easy, but it will work.

President Obama
would have us believe that we can all spend the day relaxing in
a tub while his printing press does all the work for us. The problem
comes when you get out of the tub to go to dinner and the only thing
on your plate is an IOU for steak.

28, 2009

Schiff is president of Euro Pacific Capital and author of The
Little Book of Bull Moves in Bear Markets
and Crash
Proof: How to Profit from the Coming Economic Collapse

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