The development of physical productive forces is not cyclical, but we have a macroeconomic system that follows boom-and-bust cycles. If the development of physical productive power behaves in a boom-and-bust cyclical pattern, we have to tolerate the boom-and-bust cycle of macroeconomic output and the system as a whole. But if the progress of the physical productive power or the potential of the increment of physical productive power is progressive, it is not necessary to tolerate the cyclical behavior of the macroeconomic system. This does not mean that the business cycles of microeconomic system (which correspond to the performance of individual enterprises) should not be tolerated; instead, such cyclical behavior is necessary to ensure business efficiency that is based on consumer preferences. Businesses should be allowed to fail and new businesses should be allowed to emerge based on efficiency and consumer preferences. But macroeconomic system failures are not due to consumer preferences—but to the general illiquidity of consumers arising from a cyclical bad debt crisis as explained by the System Gap Theory. The illiquidity of consumers is not a physical phenomenon but a monetary phenomenon; and money that is not “real” is an abstract quantity, which we can control. That is why I strongly argue that we could have prevented the collapse of macroeconomic systems in the US and Europe in late 2007—and the continuing crisis can be resolved rather quickly if we change the monetary equation. To do it what was—and is—needed is a new macroeconomic policy tool and wisdom beyond the Federal Reserve.

Occupy The Solution not Wall Street

Managing Systemic Bad Debt with System Gap TheoryBy Hema Senanayake

AuthorHouse

Copyright © 2012 Hema Senanayake
All right reserved.
ISBN: 978-1-4772-5698-5

Contents

Acknowledgments..........................................................................................................xiIntroduction.............................................................................................................1Chapter 1: Understanding the Functioning of Macroeconomic System Through the Great Recession of 2008.....................19Chapter 2: Fractional Reserve Banking System and Full Reserve (or 100 Percent Reserve) Banking...........................37Chapter 3: System Gap Theory.............................................................................................51Chapter 4: The Two-Tier Production System................................................................................61Chapter 5: Market Mechanism and Monetary Mechanism.......................................................................71Chapter 6: Achieving Economic Equilibriums or Filling the System Gap.....................................................81Chapter 7: Resolving Some Economic Policy Issues.........................................................................93Chapter 8: The Solution..................................................................................................105Chapter 9: The Question of Pension Planning..............................................................................119Chapter 10: Conclusive Remarks...........................................................................................125Paradigm Shift and Kalama Sutta..........................................................................................129References...............................................................................................................131

Chapter One

Understanding the Functioning of Macroeconomic System through the Great Recession of 2008

The economic system has to be fixed; this notion is now unanimous around the world after the Great Recession of 2008. You can't fix a system if you do not understand it or if you do not understand how it works as a whole.

Sometimes events and occurrences reveal how a system really works. Likewise, the Great Recession of 2008 (which is sometimes referred to as the great crash of 2008) reveals the inner workings of the modern "complex" economic system.

In 2008, the world's wealthiest nation, the United States, suddenly revealed to the world that the US economic system and the society had accumulated enormous debt and other monetary obligations that could not be paid back or honored. The incumbent president, Barack Obama, said "I think it is important to understand that some of that wealth was illusionary in the first place." ("After the Great Recession" interview with President Obama, New York Times Magazine, April 28, 2009)

Without the occurrence of the Great Crash of 2008, such contradiction of wealth and bad debt would not have surfaced. What is important is that such contradictions would continue—and the same occurrences will take place if we do not fix the system. Understanding this systemic contradiction is the first step in fixing the problem.

Therefore, I will use the systemic crash of 2008 to explain the inner workings of the contemporary economic system. Yet, my primary objective in this chapter is not to explain the events of 2008; instead, I want to introduce three economic concepts to the reader that will facilitate understanding how the modern macroeconomic system works. This knowledge will lead to understanding the systemic contradiction that we have to deal with.

Those three economic concepts are (1) Mechanics of Recessions (2) Fractional Reserve Banking System, and (3) System Gap Theory. These three concepts explain the fundamental and integral parts of the macroeconomic system. Without knowing these concepts accurately, no one could understand the economic system as a whole or understand the true reasons behind the crash of 2008. They also couldn't figure out the true solutions rather than increasing the deficit financing of the government on public projects and programs as done in the US or suggesting austerity measures as done in Europe.

The important thing is that you do not need to be an economist to understand these concepts. Any curious reader will understand them without any difficulty in this chapter since I took great care to simplify them. Let me explain them with a small background story through which you may find how I achieved the goal of simplification of theories/concepts.

I was invited to deliver a public lecture on February 10, 2012, on the topic of the "Global Economic Crisis of 2008—Reasons and Solutions." This crisis was something I wrote articles about and I duly claim that I predicted it. The challenge was that I had to do it in thirty minutes. The organizers had allocated thirty minutes for the initial monologue presentation and two hours or more to discuss questions. The logic behind their time allocation was simple. They were of the opinion that the attention of most participants in public lectures is good for the first thirty minutes. If I could arouse their attention and establish my main points in first thirty minutes of my presentation, the rest of the time would be used effectively in answering questions. Their rationale was sensible, and I agreed to do the seminar. I had a fear about the time limit because it was a subject discussed in volumes and volumes of books.

As you may know, the Global Economic Crisis of 2008 became very serious and complex. The European Commission at one point totally rejected the existing macroeconomic theories as incapable of predicting crises and also was incapable of giving any insight to resolve the crises. Many economic scholars have been disappointed by the way things have turned around. Yet many economic scholars, Central Bankers, and policymakers submitted their own theories and views, which did not find consensus as of today. Arguments among Keynesians, monetarists, economists of Chicago School, and economists of Austrian School seem to never end. Apart from that, presidents and prime ministers of troubled countries, IMF, the World Bank, and the International Bank of Settlements (IBS) had their own "pragmatic" explanations. On the other side of the spectrum, there are Marxist scholars who revived Marx's thesis of "falling rate of profit" to explain the crisis, which could not be simply ignored.

But my goal was not to present any existing idea or another controversial view. My goal was to achieve a consensus. Yet in an environment of diverse opinions and views, how a person can explain the crisis of 2008 in thirty minutes with an objective to achieve a consensus of a crisis that is still continuing after nearly four years. However, in this environment, if somebody could achieve a consensus, then he must be presenting a provable truth.

In November 2008, I published a new macro-economic theory called "The Theory of Economic System Gap" in Indispensable Bad Debt to explain the world economic crisis. I knew I had some strong arguments on the subject. Most of those who did read that book never rejected the theory or main arguments presented there. Along with that theory and two other fundamental economic and financial concepts—Mechanics of Recessions and Fractional Reserve Banking—I knew I could present a good case. I was confident that I would achieve my goal but allocated time for the initial presentation was still a challenge.

The economic system itself is a complex one—at least it seems so for many people. It is not a simple production economy anymore, but it has enormously large financial market too. In order to provide a reasonable insight, it is highly required to provide a reasonable understanding of the macroeconomic system. Moreover, the core banking system, through which the modern economy is powered, is itself a complex one called Fractional Reserve Banking. Again System Gap Theory requires a good amount of time to understand it properly. I knew I would not achieve my goal of obtaining a consensus from the audience if I did not explain or touch these aspects properly. How it could be done in thirty minutes?

Then I realized that simplification was the only solution. Without simplifying these economic concepts, I would not be able to achieve my goal.

This was a situation where anybody could be influenced by the words of Werner Heisenberg, the great physicist. Werner Heisenberg contributed to the subject of quantum theory immensely. Once he said that if you can't explain quantum mechanics to a barmaid (a lady who sells beer in pubs/restaurants), then you yourself do not know about it. The message of his idea is that "simplification" is what is most important in profound subjects. But simplification would not devalue the profoundness of the subjects that need to be discussed.

Similar thoughts struck in my mind—and then I began to write my presentation. I wanted to do it as a PowerPoint presentation. I started to prepare slides too. Initially, the number of slides came to twenty-two. My wife laughed at me, saying that I could not use twenty-two slides for a thirty-minute presentation. Then I gave my notes for the speech to her and asked her to prepare the slides. She made a lot of changes, but the number of slides remained the same.

But that exercise did help me a lot. She is a laywoman when comes to economics. By profession, she is a computer systems analyst. From the slides she prepared, I understood the way that any lay intellectual or any curious listener would understand this difficult subject. I used her slides to redraft my speech. Thanks to her effort, the necessary simplification I had been looking for was achieved. Then I realized I did not need any slides to deliver the lecture.

I gave up the idea of making a PowerPoint presentation. I did the presentation on the scheduled date within the allocated time for a small but diverse crowd. Immediately after the lecture, I realized to a greater extent that I was going to achieve a consensus for my explanation on what we identify now as the Great Recession of 2008. The question-and-answer session went almost two and a half hours. The audience was satisfied.

I strongly felt that I achieved my goal of achieving consensus and so did the organizers because they achieved their goal of organizing a good public lecture.

I submit below extracts of the lecture notes I used in that seminar. It is a good start to dig into this controversial subject.

(1) Mechanics of Recession

Let us assume that a producer produces a consumable item. He expects consumers to buy what he offered to the market. If consumers did not buy, the producer cuts back his volume of production, which leads to a recession because reduction of output is defined as a recession.

Economic system produces two kinds of commodities.

1) Commodities for consumption.

2) Commodities for the use of production i.e. capital goods.

Total output consists of these two kinds of commodities.

Capital goods are in demand only to produce consumables. If the production of commodities for consumption is reduced, the demand for capital goods will be reduced. As a result, total output will be reduced. If total output is reduced for two consecutive quarters, it is officially defined as a recession by economists.

Recessions cannot occur in contemporary economic systems outside the above mechanisms if we ignore the reduction of output due to natural disasters. Hence the above explains the mechanics of recessions.

(2) Fractional Reserve Banking System

This is the second concept we need to understand accurately. If I give you $100 and ask you to lend it, how much can you lend? According to common sense, you cannot lend more than $100 because that is the sum of money you have.

But under the Fractional Reserve System, you can lend $900 or so out of a deposit of $100. This is the core banking practice in the contemporary economic system. You have to understand the concept of Fractional Reserve Banking System accurately because most explanations—even in many scholarly books and on the Internet—are not accurate.

It is believed that this practice was started in middle centuries by goldsmiths. People used to keep their extra gold/silver with the goldsmiths for safekeeping. He issued a note from his notebook for each deposit. Sometimes people also came to goldsmith to borrow gold deposited by others.

Let us assume that people deposited 100 gold coins. He issued one note for each gold coin. So, depositors had 100 notes. The goldsmith returned anybody's gold upon the submission of notes. The goldsmith observed that only 10 percent of notes were submitted to withdraw their gold at any particular time. Subsequently what was withdrawn was usually deposited back. Firstly, the goldsmith thought he could lend ninety gold coins out of a deposit of 100 coins because only 10 percent is withdrawn at any given time. So, he lent only ninety coins out of the 100.

Secondly, the goldsmith thought he would issue a note to any borrower instead of real gold. People liked it because they believed that goldsmith would pay back actual gold upon submission of notes. Now assume that the goldsmith has 100 coins in deposits. He issues 100 notes to depositors. Also he decides to issue 900 notes to borrowers; each note has a value of one gold coin.

Now, there are 1,000 notes in circulation: 100 notes with depositors and 900 notes with borrowers. His past experience says that 10 percent of notes would be submitted to him at any given time to withdraw actual gold coins.

So, 10 percent of 1,000 is 100; this means the goldsmith is supposed to have 100 actual gold coins in reserve to honor any possible withdrawal if he puts 1,000 notes into circulation.

He has 100 coins in reserve because he did not issue gold coins to any borrower. Therefore, the goldsmith did not face any problem—even if he lent 900 out of an incoming deposit of 100 gold coins. This is a mechanism to create more credit out of a relatively lesser amount of incoming deposit.

In this system, the goldsmith issued 1,000 notes. He is liable to issue one gold coin for each note. So, his total liability is 1,000. He kept only 100 gold coins in reserve. This means the system has a fraction of actual cash reserves to total liability. That is why it is called Fractional Reserve Banking.

Fractional Reserve System is the modern banking practice done through commercial banks with the full backing of the Federal Reserve or the Central Bank.

But this Fractional Reserve System is inherently bankrupt. If 20 percent of notes (i.e. 200) were submitted to withdraw actual gold (cash) the goldsmith can't pay. He is virtually bankrupt because he had only 100 coins. In that event, the goldsmith can temporarily borrow from another goldsmith—it is a situation of a lender borrowing from another lender. In modern days, this practice is in use and is called interbank borrowing. This means in order to sustain the banking system, bank-to-bank lending is crucially important.

If all goldsmiths face the same problem, then the system needs an "ultimate lender." In modern days, the ultimate lender is the Central Bank. In 2008, American Central Bank (Federal Reserve) saved all major banks. It was like a situation when 20 percent of notes came to the goldsmith. The best example is the collapse of IndyMac in July 2008. However big or good the banking system appears to be, it is an inherently fragile system under the Fractional Reserve System. Why do we need this fragile system? Keep this question in mind, but let us go to the final concept called "System Gap Theory."

(3) System Gap Theory

In the present economic system, a producer sells his product to a consumer, another entrepreneur, or both parties. This system is called an un-integrated economic system. Instead of this system, let us take a simple production economy to understand the System Gap Theory. You may find later that this theory equally applies to any un-integrated system with or without large financial markets.

In our simple economy, a producer does not sell to another entrepreneur. He should sell only to consumers. Also in this simple system, the producer does not invest money to buy from another producer because there is no buying and selling among producers. So, he should invest only on labor. In economics, this system is called a "Fully Integrated Economic System."

Now let us consider that a producer invests $500 to produce something. As he does not buy anything from another producer, that $500 must be spent on labor. What is paid for labor is the income of consumers. So consumer income is $500 in this system; this obviously includes the remuneration earned by the entrepreneur for his consumption.

Thinking that it is required to have a capital reserve to expand the business, the entrepreneur values his product at $590. That is the sum of money that the entrepreneur expects from consumers. Now the value of consumables offered is $590, and the consumer income is $500. So, there is a gap between the value of consumables offered and the consumer income (which is a lesser amount). This gap is the System Gap when the values represent the sum of total sales proceeds and the sum of total consumer income.

So, the System Gap Theory explains that the economic system can never pay consumers an aggregate income that equals or exceeds the value of consumables offered by the system. The contemporary economic system is not a simple production economy, but it has a large financial market. We will bring it up later in this discussion. (Please note that the existence of the System Gap for the modern economic system has been proved—and that document was distributed during the lecture. The same with a little more detail is presented in the Chapter 3 of this book).

Yet, if the consumer did not buy what is offered, then the producer cut back production. That is how a recession starts. We learned about it above from the Mechanics of Recessions.

So, the consumer must spend $590 to put the economic system into equilibrium or, in other words, to have demand-and-supply equilibrium. How do the consumers spend $590 while having an income of $500? This is how it happens.

Some consumers save a little bit of money. Let us assume they save $100 collectively. This money can be loaned to another consumer. So, now consumers spend $400—plus a loan of $100. Still the total is $500 and $90 is short, and the system is not in equilibrium. This means if we have a banking system that creates loans subjected to the limits of savings, the system will be in disequilibrium.

(Continues...)

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