Obama Puts the Economic Cart before the Horse

In 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.

Similarly, 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.

The 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 followed.

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.

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11 Responses to "Obama Puts the Economic Cart before the Horse"

  1. AB   March 1, 2009 at 10:25 am

    Yep Gold, Gold, Gold!!!

  2. Guest   March 1, 2009 at 12:28 pm

    Its time to stop the speeches and get on with real work.Someone should tell Obama that he has already won the presidency and all the blah blah blah that goes with the history making of the first black president.Get on with it man!

  3. Guest   March 1, 2009 at 12:36 pm

    Glad to see Peter Schiff here. I value RGE Monitor’s all-encompassing broad base. Schiff’s article is good, basic Econ 101.

    • Guest   March 1, 2009 at 1:06 pm

      Should we have elected someone who had experience of making real things, not laws, speeches, or half-baked economic “Theories”. It is time to get some engineers, doctors, into high offices, in other words technocrats who know the real world.

  4. Guest   March 1, 2009 at 1:00 pm

    A point of contention to Mr. Schiff’s theories. Should the candle maker borrow the bread and steak only to sit on his butt (sustenance), our free-market economy may well reward that candle maker with a new entrepreneur/competitor in his field (to fill the production void of the candle maker). This possibility increases significantly by access to available credit. Therefore, Obamanomics provides a platform/opprotunity for increasing production.

    • Anonymous   March 2, 2009 at 8:39 am

      I have yet to see one thing that encourages more production, more entrepreneurship, or makes it easier for the small businessman to survive. These are the drivers of our economy. Obama doesn’t really get it yet. The spending wherein we add $50 a month to someone’s paycheck is not going to get this economy rolling. Peter Schiff has nailed it.

  5. Guest   March 1, 2009 at 5:14 pm

    Hyper inflation might be the desired end result of Obamanomics. Pay back with worthless or devalued currency. Obamanomics is not using borrowed money now, just printed or e- money. Slight deflation from the popping of the bubbles, flowed by hyper inflation. Hyer inflation will kick in after the money is in circulation and the ecomony picks up. There will be a very low chance of long-term deflation. Ben Franklin had paying back in inflated currency 250 years ago. It’s not a new idea.The risk is the final bill of 4 to 5 trillion dollars will be eventially financed by borrowing. For a average family, the medium federal debt per person will have federal debt equal to medium household income. Thus a drag on the ecomony.

    • Guest   March 1, 2009 at 9:39 pm

      everyone is worried about inflation when the economy picks up. has any one ever thought about the senario that the econmomy never picks up, and we end up like Japan in stagnation. with the credit destroyed by bank and the waste resources in bailouts, we may be as likely to be in delation as in inflation.

  6. Shalom Freedman   March 1, 2009 at 10:28 pm

    Does Roubini agree with this analysis? Is he as negative as Schiff? He has spoken of the government being able to ‘do all the right things’ to get the Economy slowly on track. As Roubini carries so much weight of authority today it would be interesting to know whether he agrees with this criticism of the President.

  7. Anonymous   March 1, 2009 at 11:17 pm

    Economists are continually taking about the huge amount of idle capacity resulting from the downturn (We can still produce 17 million cars annually, we just can’t sell them). What does Schiff make of that?

  8. Dr. Fred in PA   March 7, 2009 at 9:07 pm

    Mr. Schiff, as new customer of EuroPacific, I ask you to consider running for President. U.S. Senator from CT is just not good enough.