The Capacity-Output Cross, Part II

by Melanie Friedrichs

Saving-money-tips-stacks-of-dollars-cashThe Icarus Factor: Interpreting Financial Crisis through the Capacity-Output Cross

In finance, the “Icarus factor” describes the dangerous over-excitement that leads company managers to take on projects too risky or too ambitious for the company to handle. But can the story of Icarus apply to a bigger picture? Perhaps the economy is like a company; it can only handle so much real estate speculation, so many collateralized debt obligations, so much easy credit before it begins to get uncomfortably hot.

A Short Summary of The Capacity-Output Cross

Two weeks ago I introduced the “capacity-output cross,” a new way to conceptualize the causal role of money and finance that came from thinking about how classical theorists—Adam Smith, David Hume, John Maynard Keynes, F.A. Hayek, Milton Friedman—differ in their interpretations of the equation of exchange, MV = PQ. I renamed Q real output proposed a new term: capacity for exchange, roughly equal to M times potential V determined by the state of financial innovation and the strength of institutions. Neither quantity is measurable, but real output can be imagined as utility value of all goods and services produced during a given period of time, and capacity for exchange can be imagined as the amount of money available to be spent during a given period of time, recognizing that within that in any given period some dollars will be spent more than once.

I sketched economic history with the two lines. Capacity crosses Real Output, because it is usually easier to mine or print money or to improve institutions than it is to increase the efficiency of production and make more real value. The lines cross at different times in different markets and in different places, but as an example I suggested that the economy of northern Europe “crossed” during the expansion of coinage and banking during the 18th century, sometime around the time of Hume and Smith.

Actual Output (Spending)

But the capacity-output cross is still incomplete; it fails to specify the path by which growth actually proceeds. The economy does not always function at capacity. People hold money and credit for long periods of time and do nothing with it, as seen today in the cash holdings of major companies and banks. Nor does it seem grow at the rate of real output. Instead, it passes through periods of increasing output and high prices and periods of stagnant or decreasing output and low prices. This recognition suggests a new line that fluctuates between capacity and real output.

We define booms and slumps by measuring spending, the total amount of money spent on immediate consumption or invested in a given period of time. In a boom, spending, prices, and output are high, and in a slump, spending, prices, and output are low. In the equation of exchange, spending is P times Q, and in the US national income and product accounts, spending is nominal GDP. When Adam Smith laid out the bare bones of supply and demand in The Wealth of Nations, he called the money spent on a good at market the actual price (as opposed to its real value or natural price), so I have chosen to use the term Actual Output to represent spending in the capacity-output cross.

Unlike capacity for exchange, measured in potential dollars, or real output, measured in theoretical dollars of real value, actual output is measurable. Its level depends on real output, on the institutionally derived capacity for exchange and on the psychological factors that govern spending: Keynes’ propensity to consume.

Spending, The Real Business Cycle, and the Trouble with the CPI Actual spending, not potential capacity to spend, directly affects real output. Those condos built in the US housing boom are real not because low-interest mortgages made real estate speculation possible, but because buyers and builders alike took advantage of easy credit to make real estate speculation actual. Money is not causal unless it is spent, either to purchase goods and indirectly promote investment or to directly invest in new production. Therefore, real output grows faster when actual output is at the top of a credit cycle than when it is at the bottom. If actual output falls below real output, real output will decrease. In this regard Keynes was right: the propensity to consume does affect the level of output.

Actual output/real output, like nominal GDP/real GDP, determines the price level, P. When the gap between actual output and real output is large, P is high and actual prices greatly exceed real values. When the gap is small, P is low and actual prices closely approximate real values. In this sense Hayek and the Austrian economists were also right; increases in output due to expansions in credit or the money supply are artificial (although with real consequences). However, unlike the Austrians, I argue that because actual output positively pulls on real output, credit booms can create lasting benefits— more condos, more real value. Nominal fluctuations in actual output translate to a real business cycle.

The constantly changing gap between real and actual output on the capacity-output cross implies frequent deflations in P, a pattern that seems to contradict the past half-century of inflation data. Inflation is usually measured by comparing a basket of established goods whose consumption is relatively constant over time. But the overvaluation that occurs

during booms is almost never in milk or mittens; it is in trendy goods or new companies not in the basket. Thus current measures of inflation fail to capture much of the business cycle. The long-term rise in the price of mittens reflects a long-term increase the gap between capacity and real output.

Hoarding, Risk, and Icarus’s Ascent to Financial Crisis The gap between capacity and actual output represents money available but not spent. People may spend as much as the money supply, the strength of institutions, and the state of financial innovation allow, but they may also choose to spend less than capacity, as little or less than real output. Saving without investment, or hoarding, to use Marx’s term, is a natural and normal part of exchange—it is money left under the mattress, lines of credit left untapped, or the positive difference between assets and liabilities on a corporate balance sheet.

Hoarding is security. The price of gold, the safest form of hoarding, rises when uncertainty is high, and liquid money reserves allow firms and people to weather shocks in relative comfort. The closer spending gets to capacity, or the closer Icarus flies to the sun, the smaller hoarding gets and the more risk there is in the system. Recessions happen when Icarus looks down and takes fright, hoarding more to decrease his risk. Financial crises occur when Icarus in excitement continues flying up and soars briefly above the capacity that the current state of institutions and societal trust can support. Then his wings melt—a bank fails, a currency rapidly depreciates, or a government defaults.

Icarus can't fly above capacity for long without falling. You tend to stop spending when your bank rolls out from under you. Often, Icarus and actual output dive much further than necessary return to a level comfortably below capacity. Expectations stay pessimistic; the memory of the burn lasts much longer than the burn itself.

Back to the Equation of Exchange Rewrite all of the above in terms of MV = PQ, and you get:

(Capacity) (Actual / Capacity) = (Actual / Real) (Real)

The redefinition of MV = PQ is not revolutionary, but is perhaps a more helpful way of conceptualizing the role of money, especially at the current moment, when the idea of long run monetary neutrality flies in the face of nearly every policy proposition to restart the American economy or resolve the crisis in the Eurozone. The question of causality still remains, but instead of asking if money is causal, the model asks how much capacity, actual output, and real output push and pull on each other as causal phenomena.

Melanie Friedrichs is an undergraduate studying economics, among other subjects, at Brown University. When she graduates in May she will participate in a two-year fellowship in entrepreneurship as part of the first class of Venture for America fellows.

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