The economy is essentially a system of flows. Someone spends, another person earns this income, this person invests, the recipient spends and the cycle goes on. When the cycle of spending dies the economy essentially dies. Income’s decline, profits dry up, output goes unsold, workers get fired, etc. It’s very similar to the way the human body works. The human body is largely based on a system of flows. As long as the blood flows the body receives the nutrients necessary for survival and every day operation. But the flow is not necessarily enough on its own to sustain the system. The system must be properly nourished and taken care of. A human being who sits on his/her couch every day eating pizza is likely to experience an interruption in this flow at some point as the system deteriorates in health over time. And when the flow stops (for whatever reason) the system dies.
In the economy, the “health” of the system is based largely on how this flow results in an improvement in living standards over time. Are the economic agents using this flow to create goods and services that improve the overall standards of living for the system as a whole? The “sitting on the couch eating pizza” equivalent for the economic system is a system in which the economic agents are unable to find productive uses for this flow. In this scenario living standards stagnate, the flow stagnates and the system deteriorates.
One of the more important developments over time has been the understanding that humans have powerful tools that can sustain the flow. That is, we understand (well, some of us at least) that the human body does not merely fix itself. Sometimes it requires external aid in the form of modern medicine. The economy is no different. It does not merely fix itself at all times. And we have developed powerful tools that can, at times, help (and, like modern medicine, can even be abused or misused). I’ve often spoken of government deficits as one tool that can help. Using this analogy of a system of flows, we can see that there are times when the flow slows or even stops (as it did in 2008). When the flow stops the system is at risk of collapse. A bit of modern medicine can help. How can this be? Isn’t government something exogenous and evil? Well, it certainly can be if it is abused or misused. But it can also be a very powerful tool created by us and for us. In the recent crisis, for instance, when the flow stopped (i.e., incomes declined, revenues declined, output went unsold, workers got fired) there was only one entity that could step in and turn on the flow. The government, in this regard, operates like an artificial heart. It can ALWAYS procure funds from you in the process of taxing or selling bonds and essentially redistribute funds through the system. In other words, it can increase the flow at critical times when the flow slows or stops.
But don’t get me wrong here. The flow does not equal an increase in living standards per se. That is primarily up to the economic agents who utilize this flow in certain ways. Will they sit on their couches eating pizza or will they create goods and services that create a virtuous cycle whereby the flow sustains itself and the need for the artificial heart is reduced? We are living in a period of great economic turmoil where we have powerful tools that can help. Tools we have built over decades of debate and even death. And we’re afraid to utilize these tools because we have fallen into the trap of believing economists who essentially pass their “modern” models off as the medicinal form of “if he dies, he dies”. The human body, and the economy, does not always fix itself. There are times when we can use the powerful tools we have created to help steer the body back towards full health.
Currently, the flow remains abnormally slow. The body has partially recovered from its near-death experience, but we remain paralyzed by fear of becoming something we are not (Greece, a currency user). We can increase the flow in various ways depending on your political preference (lower taxes or higher spending). But the simple fact is this – we still need the artificial heart to sustain this flow as the private sector continues to de-leverage, spends below historical average and output goes unsold as a result. The biggest risk we still face is turning off the spigot at a time when the private sector has not yet returned to full health. And if the system dies or becomes sick again as a result we have no one to blame but our “modern” doctors who continue to push the idea that the human body is a self sustaining system that never requires external aid.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.