Finance versus Economics

There is a lot of confusion, it seems to me, over what the economy really is. A good working definition is the production and distribution of goods and services. Prosperity occurs when there is a high level of production and distribution of goods and services that people want. In a free market, the price system sends a clear signal as to what people want. When governments interfere, by quotas, or by subsidies, or even by point of sale taxes, prices can get distorted and send the wrong signal. I well remember my introduction to shopping behind the Iron Curtain many years ago. It was at a department store in Bratislava. There was a skimpy selection of basics, but an abundance of fur coats. Rows and rows of them. Without a free market pricing system to send out the signals, manufacturers had no reliable measure of the market. They didn’t know what to make.

A similar confusion appears in government response to the current economic downturn. In Canada, our governments are flooding the country with cash. Our problem is a sharp decrease in the production of goods and services; the distribution systems are still working more or less. Throwing cash at the problem isn’t going to resolve it. Although more energetic, this is the same tactic used about 11 years ago in response to the then collapsing financial and manufacturing industries. But back then, the problem was a balance sheet problem. It was liquidity. Part of it was rising current liabilities versus current assets. In other words, depleted and negative working capital. Another problem was that many assets had lost significant value: loans that had been made to debtors who became insolvent, real estate that had lost much of its value, and financial derivatives that had evaporated into money heaven. In short, equity had disappeared. Pumping cash into impaired balance sheets helped.

Today, the problem is primarily an income statement problem, not a balance sheet one.  Revenues are down because people aren’t working to produce and people aren’t buying. Giving those businesses money helps them stay in business a little longer, but is just an exercise in kicking the can down the road. People are not inclined to spend the money if they don’t have to. I think we will look back to 2020 and see that government largesse rapidly inflated the M1 money supply, but did not stem the declining velocity of money. And it is the velocity that is more important. I think we are seeing a financial fix being applied to an economic problem, and it will not work.