I am sorry that I am caught between the urge to understand and to respond as I go through the motions of reflecting on what I gather as one of the least cultivated subjects of our time, while being the most visible one in the blogosphere.

I have this nagging doubt that sometimes tilts towards a disbelief of the fractional reserve system and its purpose as it stands today; or for that matter money itself, as it mistakenly replaces capital, and in its over-abundance we find the scarcity of ideas in building a meaningful foundation of an economy that does not falter from one day to the other following cues, or simply an information over-drive that masquerades the true underlying facts.

Money must move between savers and borrowers and the exchange must have a purpose that satisfies an economic need; the fractional reserve system, together with the Central bank engineering initiatives cannot replace the basic structure of lending that leaves one section completely dis-incentivized at the cost of the other. Is it possible to have only borrowers (going by the incentives for the same) and no incentives for savers in an economy? Could we therefore sufficiently posit for making people to spend and consume?

The paradox revisited

Keynes raised the issue for the first time in his famous ‘Paradox of thrift’, where he posited that individual’s desire to save more and consume less makes the societal outcome severe in a recession in particular as aggregate demand is impacted by the lack of aggregate spending. Here we must be cautious to examine what exactly Keynes meant by ‘savings’ in this example; he meant money that is taken out of circulation, or negative change in the circulating capital. This is a very significant observation as distinct from the assumption that savings could mean investment in fixed income assets as we generally connote, which could be less yielding and in riskless ventures, otherwise it is naïve to imagine that savings would be stashed under the carpet for rainy days, such an assumption could actually alter the nature of the debate.

If we assume that savers are forced into saving for the want of adequate future income or present, they could actually take money out of circulation, in the same way as Keynes argued and that naturally would mean that spending would be impacted by it and which is also the other man’s income, in absence of which less goods and services would be eventually produced and consumed as a cascade effect for the economy. This cascade effect would cause output gap that would prolong the recession.

F.A. Hayek on the other hand in his famous essay of “Paradox of Saving”, examined the illustrious work of Foster & Catchings in their essay, “Dilemma of Thrift”, and their books, “Business without a Buyer” and “Profits”. He proved that the dilemma or the paradox could be actually solved by making savings move from its stupor of idleness and transform its unproductive stasis to move through a locomotion of investment where others in want of capital and who had means of using it productively would be able to make better use of it by ‘producing’ which could be ‘consumed’, through a market clearing mechanism.

This was the first ideation of the usefulness of savings, something contrary to the long arduous treatment that Economists had meted out to this subject and was indeed quite uncharacteristic and somewhat at variance to the general acceptance of the alternate hypothesis that savings takes out spending in an economy and is at the root of recessionary posturing.

Circulating Capital and what happens when it does not move into goods and services

Here we are forced to make a distinction between circulating capital and capital (which is investable surplus as we define it) and monetary supply through the fractional reserve system, which could be progressively denominated as M0, M1 or M2, which is also denoted as the monetary base.

Quantity Theory of Money suggests in the equation of exchange that


content_pt is the price level associated with transactions for the economy during the period

content_t is an index of the real value of aggregate transactions.

A simpler form of the equation would be



content_v is the velocity of money in final expenditures.

content_q is an index of the real value of final expenditures.

As an example, content_m_l might represent currency plus deposits in checking and savings accounts held by the public, Q real output (which equals real expenditure in macroeconomic equilibrium) with P the corresponding price level, and P.Q the nominal (money) value of output. In one empirical formulation, velocity was taken to be “the ratio of net national product in current prices to the money stock. Money could be replaced by circulating capital here in this example.

Here we must go to the concept of circulating capital as first proposed by Marx and later explained by Keynes, as the engine through which capital is created, that in its circulating form makes transactions possible and by its transacting repeatability (combined with inter-changeability from hand to hand) enhances the prospects of making any surplus. To put it in lay terms, the monetary release moves through money in circulation and deposits to make meaningful exchange in goods and services possible that makes the engine of the economy move from a state of inaction to a state of surplus creation. If the creation of surplus in any form takes out money in circulation, which is negatively impacting the circulating capital, we have situation of stasis once again returning, with a deleterious impact on the creation of further surplus.

Here again we see that circulating capital (whether from Central bank advances or from any other) has the sole purpose of creation of goods and services that would move through a market clearing mechanism to be exchanged and the whole quantity theory of money is based on the assumption that the velocity of money (the speed with which goods and services would be exchanged or changing hands) induces the effect of higher output. The point to be noted is that circulating capital, if it does not move into goods and services but moves as a medium through which assets like equities or other paper assets are bought and sold, its impact on total output may not be the equivalent to the alternate mode where in it is used to buy or sell goods (which effectively means that some direct income streams are created); this partial response to output when circulating capital is used for transactions in speculative activity, not in production, has been a big remiss of our times and has been the least mentioned subject in the recent debates.

So when monetary base is increased (assuming M2) and the big delta is used to buy equities, or in any other speculative ventures, there is only partial response to output; in the recent example the rise in the Central Bank Balance sheets almost coincided with the rise of the liabilities as well as the commercial bank excess reserves soared, which is another indication that there was very little change in the circulating capital that moved into real goods and services. This perfectly makes sense to the hypothesis that a portion of the circulating capital which was earlier used for production of goods have been taken out systemically during the recession and now with ‘easy money’ situation it has further moved out to non-good or non-service areas (equities or other speculative assets) which has only partial impact on the economic output revival.

What does it leave for the savers ?

In an environment where output gap exists, and circulating capital is taken out of goods and services to promote speculative ventures, there is all the good reason why savers (corporate one included) would need to think twice before they would lock their hard earned savings into investments which are based on activities that relate to production or building infrastructure.

This is simply because there is so much excess stock of savings already (corporate world is a harbinger of savings) and which means avenues of investments have long been tasted beyond that threshold where no further stock of investment makes sense (unless someone wants to create over-capacity over the current stock).

Corporate savings cannot therefore move any further into those investment channels for creating capacity; with interest rates at record low fixed income streams of investments make no sense, bond markets are even more turbulent with yield curves moving upwards, as positions unwind, the odds of seeking an alpha is moving towards stiff uncertainties.

Individual small savers have no incentives for taking out consumption expenditure and putting that in assets that are either risky, or giving fixed income streams that would have no value in the event of inflation surge; parking in safe havens and even in un-invested ‘carry’, makes sense.

Banks are already in “carry” trades as never before, it makes a perfect sense for them. But carry works with an upward-sloping yield curve, but it loses money if the curve becomes inverted. Many investment banks have failed because they borrowed cheap short-term money to fund higher interest bearing long-term positions. When the long-term positions default, or the short-term interest rate rises too high (or there are simply no lenders), the bank cannot meet its short-term liabilities and goes under.

The current carry investment was working wonders with constant bouts of money dozing, which kept the yield curve upward sloping; with the slightest hint of rewind the lenders are seeking long-term debt contracts more aggressively than short-term debt contracts, the yield curve “inverts,” with interest rates (yields) being lower for the longer periods of repayment so that lenders can attract long-term borrowing.

Dollar carry and yen carry could be rewinding fast as there are new hints in the air. In the current climate predictability has reached a nadir, where small savers have no incentives to save while borrowers must be those lucky few who could make the most from volatility, not from any solidity of trading positions.

Going back to Hayek and on his usefulness of savings, we have a new normal where the limits of investments in fixed assets due to the stock of capacity already existing and with no new innovation in products or services, we are straddled with a situation that savings cannot be channelized into gainful use by those who could convert them into productive use. The rise of capital share of income and the lowering of labor share is one more reason that goes against the cause of savings as the net purchasing power has not moved in tandem to augur well in the drive for increased consumption, something that remains as the most potent missing element towards bringing parity between the savers and borrowers.

For the engine to work smoothly the circulating capital must produce goods that are cleared by the market, for which consumption holds the key through the potency of purchasing power.

We are back to the basics.

Procyon Mukherjee 24th June 2013.

Gyrations In Circulating Capital: The Special Case Of Savers Revisited
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