Hurricane Sandy and Good Ole MV=PQ. Have We Broken Enough Windows to End the Recession?

Over at the Mises forums, one Austen laid out the Keynesian case very nicely. It’s a long long post of his, and this humble article will talk about the beginning of it, upon which the rest depends.

OK, Austen, you have the floor. You get the fancy italics, I get the normal font.

Total Spending in an economy is equal to total income

In an economy, based on simple arthimetic and common sense, one can see that all spending is equal to income, assuming that the money supply is not increasing. One man’s consumption is another man’s income. If I buy a fruit at the store, then the store has income, which they would not have If I did not spend my money. If for example, everyone saved their money and nobody spent any money, nobody would have income. 

Total spending = Total income

Therefore, the more spending that occurs in an economy, the higher one’s income is.

Another way to think of this is the velocity of money:

M*V = Q*P
This is the quantity theory of money. It states that the velocity of money (how fast money is ciruclating) times money, is equal to the quanity of goods and services, times the price of these goods and serves.

M = money, V = velocity of money, Q = quantity of goods and services, P = price of goods and services.

So as one can see If the velocity of money increases, then so do the quantity of goods and services, so long as prices do not not increase at the same rate.

Prices have been observed to be “sticky” or resistent to change in the short-run and during recessions. Therefore an increase in the velocity of money corresponses to an increase in goods and services.

You see where Austen is going here. M and P are assumed the same. So all we need do is increase V, and by the laws of mathematics, Q will go up, too. Recession over.

How lucky we are, we conclude from Austen’s argument, that Hurricane Sandy destroyed all that it did! Because thanks to Sandy, the recession will end. And I quote:

A broken window causes spending to increase 

So let’s say someone’s window is broken. This means that someone is needed to fix the window. This corresponds to an increase in income for the glassman and the glassman can use his income to buy other goods and services, and so forth causing a multiplier effect.

Hey, if one broken window does all that, surely damage in hurricane proportions will make us all rich and fat. No wonder they call Florida the Sunshine State.

There has to be a flaw here somewhere. right? How can death and destruction on a massive scale improve things? To quote Chico Marx, “She make-a no sense”. And yet, Austen has “simple arthimetic and common sense” on his side. Or does he?

Fortunately, Smiling Dave has refuted Austen’s post over at the forum, and he allows us to quote it in full over here. Lights, camera, action:

Austen,

I like several things about your post. First and most important, that you summarize your opponent’s position before you refute it. Second, that you provide links to justify your factual claims. Third, that the whole post has structure, a logical chain of reasoning, as opposed to rambling along. Fourth, that there is no appeal to emotion.

Thus, it deserves a response. The thing is, you have a lot to learn, and even more to unlearn. The ole fingers will wear out addressing your whole post, so let’s just look at the very first part, from which all the rest follows. If that is shown flawed, the rest, like a house whose first floor has been demolished by Hurricane Sandy, will fall apart of itself.

So let’s examine the Total Spending = Total Income equation, and the conclusions you draw from it.

Yes, the equation is correct. Total Spending does equal Total Income. But Total Income is not a measure of Total Wealth, obviously. For example, if I make $30,000 a year selling all I own, my Total Income is 30 thou, but I am not any better off. So we are barking up the wrong tree from the very start if we are looking to increase Total Income, or its buddy, Total Spending.

So what is the right thing to look at, if not at Total Spending or Total Income? We can find a clue if we examine the following homely scenario. Say the Govt taxed rich people at 50%, and poor people at zero, and then gave the tax money to the poor. The rich had no intention of spending that money. The poor go out and spend it all, buying all the wine and cocaine the rich had stashed away for future use. Total Spending went up. Total Income went up. But that did not improve the economy at all; the only thing that happened was that wealth changed hands. After the poor wake up from their hangover, what do we have? The rich are poorer, having less wine and coke. The poor are in the exact same boat, poor again. And if the govt repeats this little process again and again, Total Spending and Total Income will keep on chugging away, but all that is happening is that the poor are consuming [=using up, destroying] the wealth of the nation. At some point there will be nothing left, if this is all that’s happening in the economy. And yet, according to the numbers, everything is fine. What is wrong with this picture?

The answer, of course, is that “Total Spending = Total Income” is ignoring the variable that really counts, Total Production. You can increase Spending and Income all you want, but if Production is non existent, the economy has not improved in the least. In fact, it has gotten worse, because the stock of goods has been reduced by all that Spending, and is not going to be replenished, since there is no Production.

Notice that the same flaw inheres in the other equation you quote, MV=PQ. If the MV is spent on previously produced stuff, but nothing new has been produced, an increase in MV just means exactly the same thing as in the above analysis, that the economic situation has gotten worse, not better.

The only way to improve the economy is to make good and sure that the quantity of goods produced goes up. If it stays the same or goes down, the economy is not better off, because we do not have more goodies than before.

The equation MV=PQ does not discuss production at all. Q is the amount of goods bought, not the amount produced. So that increases in Q do nothing to improve the economy

Before Keynes muddied the waters, this was universally understood. Increased Production is what counts. As J. B. Say put it, [BTW, he gets the italics for the rest of this article, not Austen. Sorry, Austen]:

…in every community the more numerous are the producers, and the more various their productions, the more prompt, numerous, and extensive are the markets for those productions; and, by a natural consequence, the more profitable are they to the producers… But this advantage is to be derived from real production alone, and not from a forced circulation of products; for a value once created is not augmented in its passage from one hand to another, nor by being seized and expended by the government, instead of by an individual. The man, that lives upon the productions of other people, originates no demand for those productions; he merely puts himself in the place of the producer, to the great injury of production…

…the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone, furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption…

…Indeed, if the nation be in a thriving condition, the gross national re-production exceeds the gross consumption. The consumed products have fulfilled their office, as it is natural and fitting they should; the consumption, however, has opened no new market, but just the reverse.

Thank you, J. B. Say, for putting so eloquently exactly what we have said above in our own humble way.

[Edited 11/7/2012]