Friday, February 27, 2009

The Economic Crisis - The Underlying Cause

There is a widespread belief that what we are currently witnessing is an economic crisis resultant from a financial/banking crisis. It may come as a complete surprise to many to find out that what we are witnessing is an economic crisis that has led to a financial crisis. The current problems in the world economy have a different underlying cause to that which is widely discussed.

I have previously discussed the underlying causes of the current economic crisis, but thought it might be time to update the analysis, and also consider the actions of governments in light of the real underlying reason for the crisis. The focus of the post will be on UK and US, as most readers of the blog come from these countries, but there are many points that might be applied to other countries. As an introduction to the underlying cause of the crisis, I will quote from a post from last year.

The first element to consider is that of the entry of the emerging markets into the world economy. I have dealt with this in the posts 'Why Do Economists Get it so Wrong?' and 'The Root of the Problem'. The argument, at its most basic, is that there has been a massive input of new labour into the world. The labour was always there, but the key difference is that the emergence of these economies has seen capital and technology, and access to markets, become available to this previously underutilised workforce.

The result of this change has seen the available labour force available in the world roughly double in the last 10-20 years. This is nothing short of a revolution in the world economy, but few economists have understood what it really means. This is best expressed in simple terms of an example (using made up figures but referencing the real events) to make the point clear.

If we imagine that (to pick an arbitrary date) in 1990 there were 100 units of labour and 100 units of commodity utilised by that labour, and an available 120 units of commodity capacity (not all utilised), we can see a benign situation. It is a situation in which the commodity supply exceeds demands. We can see this, for example, in the long period in which oil prices were so low for so long. Now, if we jump to 2008, we see the oil prices spiking. This is because, whilst the supply of commodities such as oil has been increasing, they have not been increasing at the same rate as the available supply of labour. Let's call the supply of units of commodity in 2008 a total of 140, to pluck a number out of the air. At the same time we now have 200 units of available labour. At this point, it is apparent that there is a mismatch.

The question arises as to why it is that the problem did not hit at the point where labour first exceeded the supply of commodity. This is because the labour entering the market was not as efficient at utilising the resource as the original labour. It is the catching up, the increase in both the efficiency of the new labour, and the increase in the use of the output of their own labour that has tipped the world into the current situation. (note: I have split the original post into more paragraphs to aid readability)

I think it may be helpful to expand on this post, and give some real examples for illustration. The best example of the problem can be found in oil, as it is still so central to economic activity. In 1997 output was around 75 million bpd, and output had only climbed to about 85 million bpd in 2007 (a chart here shows the output - not a good source but the chart is usefully clear and conforms to charts from better sources). Copper has seen higher growth in output from around 11 million tons to 16 million tons over the same period, but this would still suggest that the growth is still probably not matching growth in labour.

However, not all of the commodities have seen a similar pattern to these examples, with iron ore output nearly doubling over the same period. Whilst this might suggest that there is no problem, it is necessary to remember that countries such as China have been growing infrastructure at an astounding rate, such that their demand for steel will be exceptionally high in comparison with a 'developed' economy (take a look the pictures of Pudong in Shanghai, or Chongqing and you will get a visual sense of one source of demand).

At its most basic, we have a situation in which there are more units of labour, but less units of commodity available to service each unit of labour. In this situation we have a situation of competition for the finite amount of resources, and competition means winners and losers. What we have is a zero sum game in which the utilisation of resource in one place means that it is not available in another place. In such a situation resource will distribute away from the losers towards the winners. However, it is not a winner takes all situation, but rather a competition to see what proportion of the resource is allocated where.

At this point, you may be asking a very reasonable question. You might be asking how, if there is such competition for these resources, the prices of these resources has sunk along with demand for the resources. The answer to this question goes to the very heart of the economic crisis, and why we are witnessing the current economic collapse.

Once again, I will try to summarise a summary of what has happened, before expanding on the ideas. I strongly recommend that you read the original posts (e.g. here), but hope that this summary will serve as an introduction.

The summary of the situation is that the emerging economies lent their new found wealth from their increasingly large workforce into the West, and in doing so allowed the emergence of the so called 'service economy', or 'post-industrial economy'. The lending was built on an unfounded belief that, because the West had been economically dominant for so long, it would always be in a position to pay back the lending. The problem with the lending was that there were no productive wealth creating opportunities to soak up the money, (e.g. investment in manufacturing was being directed towards the emerging economies themselves) such that the money pouring into countries like the UK and US was directed into asset price inflation (real estate), consumption and consumer credit, and excessive government borrowing.

In addition to the emerging economies, we need to add in the flood of money from Japan through the carry trade (I explain this and how the Japanese central bank was responsible for this here). On top of this, the rising demand for oil sent oil prices ever higher, and some of those profits were also recycled into the economies of the UK and US. All of this represents a 'wall of money' pouring into the UK and US that fed the credit and housing bubbles.

All of this lending has had a dramatic and powerful influence on the shape of the world economy. In particular the world economy has been shaped around a perception of growth in wealth in countries like the UK and US, whilst the real growth in wealth has been taking place elsewhere. This takes a little explanation, and starts with the idea of the multiplier effect.

The multiplier effect is where consumption of one 'thing' drives further activity throughout the economy. If we imagine that I spend money in a restaurant, that spending will help do many things, such as pay for the produce, the rent of the building, investment in equipment and pay for staff salaries. If we just look at the payment of salaries, that payment will then be used to pay for other things, and that in turn will pay for the salaries of other staff, who will then use that money to pay for other things and so on....In other words, that single transaction of paying for a meal will result in lots of activity through the economy.

This is all very well, but the problem arises that GDP is widely used as a measure of the success of an economy. The problem is that GDP measures activity in an economy, and this has led to a false perception of growth in the wealth of the US and UK. The reason for this is that activity based upon an increase in borrowing shows up as activity in the same way as any other activity. There is no distinction between sources of the activity. However, borrowing does not represent wealth, but represents the foregoing of future wealth. It is the consumption now of future added value from labour.

A good illustration of how flawed GDP is as a measure of wealth is the example of Hurricane Katrina. This disaster saw the destruction of large amounts of infrastructure, and that destruction necessitated the replacement of infrastructure. That replacement would appear in GDP figures as a growth in activity, and you have a situation in which destruction appears as economic growth. In summary, the huge amount of borrowing in the US and UK appeared as economic growth. There is a perception of growth in wealth in these countries, but the reality is that much of the activity taking place was at the expense of future wealth.

This perception, or I should say illusion, of wealth was to have some dramatic effects on the shape of the world economy. This is best illustrated with some examples.

The first example comes from a conversation with a friend about 2-3 years ago. We were sitting in a restaurant, and I pointed out the large numbers of expensive cars in the car park. There were several BMWs and Mercedes, and other luxury brands, and I asked how it was we could see so many expensive cars. Even ten years before, such cars were relatively rare.

It was actually a rhetorical question, as I was well aware at the time, the reason why they were there was as a direct or indirect result of the credit bubble. If we think of the multiplier effect lifting activity across the economy, we can see that some of the money that paid for the cars was resultant from all of the activity created by borrowed money. As such, when we looked at those cars, they were at least in part the result of borrowed money.

If we then think of the impact of this on the wider world economy, we can see that this will have had a broad effect. For example, this means that there would be investment in additional dealerships to service the demand, and the increase in sales would see additional investment in the manufacturing of companies like Mercedes, and this in turn would encourage investment in the Mercedes suppliers and so forth.

A more mundane example would be the additional money in the pockets of each individual as a result of the borrowed money flowing through the economy. Some of that money for one individual might have been used for home improvement, such as the purchase of new lighting for their house. This lighting that was purchased would likely have been manufactured in the Chinese city of Zhongshan, where there are hundreds of lighting factories. This individual purchase would be one of many that cumulatively saw the investment in ever more factories in Zhongshan to service the overall consumer demand in the UK and US. Each of these factories in turn would have its own suppliers of goods and services, and those suppliers would have their own suppliers and so forth.

Furthermore, the cumulative purchases of lighting would contribute to growth in retail that services home improvements and decoration in the UK and US. This in turn would increase employment in these sectors, which would then have those individuals spending money on other purchases, further raising the activity in the economy.

Such examples illustrate that, as borrowed money flows through the UK and US economy, it shapes the wider world economy to service this credit fuelled activity. The world shapes itself around the consumption. As such, the world economy has been shaped by an illusory perception of growth in wealth.

It is here that we come to the first problem, which is what happens when the illusion vanishes, and when the lending stops. Huge swathes of the world economy are suddenly seen to be pointing in the wrong direction.

I have recently discussed the benefits of deflation, and the effect of this on economic development. However, in the case of the misdirection of resource, there is the potential for a less pleasant (but necessary) form of deflation. This is not deflation resultant from efficiency gains (higher output from each unit of labour), but rather deflation resultant of collapsing markets. As the economy shifts into its new shape, there will be significant overcapacity in industries with a now insufficiently large market.

This overcapacity will lead to fierce price competition before the bankruptcy follows. As such, price deflation should be relatively brief and painful as industries realign to a more sustainable size. In the US and UK, this is being seen in the collapse of the service economy, along with a knock on effect of the suppliers of goods and services into the service economy. If we take the example of retail, they are having to increasingly fight on price, as they chase a diminishing pool of money available for consumption. Some will survive the price competition, others will not. When those that do not survive disappear, there will be a shrinkage in other sectors. A simple example is that demand for shop fitters will fall, such that they will then have to compete on price. These effects will ripple through the wider economy. If we look at our Chinese lighting manufacturers, we will see the same effects.

In all of these cases, what is taking place is destruction of large swathes of economies. This destruction represents the investment of capital, which is in turn the investment of surplus of value of labour. Put another way, this is the destruction of savings. In order to understand this, we only have to think of an empty lighting factory in Zhongshan, with machines standing idle. The idle factory represents the destruction of the accumulated surplus of value of labour. The shops we see with peeling 'closing down sale' posters represent the same phenomenon.

This massive contraction across so many sectors of so many economies is at the heart of the economic crisis. Quite simply, the structure of the world economy was pointing in the wrong direction, and it is now paying the price for that misdirection, which is a massive destruction of capital, which is the destruction of savings.

'What if' the massive wall of lending into the Western economies had never taken place?

I ask this question because it illustrates the severity and depth of the problems that are now becoming apparent. If we think of what would have happened had we not seen the massive lending into the UK and US, and many other credit fuelled economies, we can start to see the shape of the world economy that might emerge.

I will use China as an example of the 'what if' for the big creditors and exporters. In the case that China had not diverted the massive savings into the West, and had used that money internally, then the situation would be very different. The first thing is that the RMB would have risen against the $US, as the ongoing purchase of US debt was one of the reasons for the ongoing strength of the $US. With such a shift, the exports to the US would not have been so large, meaning that the export growth model would have disappeared, and the growth in China would have needed to be more balanced towards internal growth. This is not to say that Chinese exports would not have grown, but the scale of exports would have been smaller.

Alongside this, China would still have steadily accumulated savings which would then have been available for investment within China, which could have seen accelerated growth within the Chinese economy. In all cases, there would have been more money available for consumption within China, and money would have represented a real increase in the living standards of Chinese people. Their savings would have been invested in a sustainable way, and they might have used more of the surplus of value they produced for other things such as health care.

in the 'What if' scenario, what we have is a picture of more balanced and sustainable growth. It would be a model in which China would still have made a major impact on the world economy. It is not possible to drop so much labour into the world market, without a corresponding increase in resource, and for no effects to be felt. Without the amount of resource increasing fast enough, whatever happened, China was going to take a share of the utilisation of resource from the OECD. The big difference would have been that the effect of the shift in resource utilisation would have become visible as it occurred.

What that visibility would have represented for the UK and US would have been a long and painful recession. As manufacturing shifted to China, there would have been rising unemployment, and pressure on real wages to compete with China. This would have been enacted through adjustment of the currency between China and the US and UK. Instead of this process, as fast as the manufacturing jobs were disappearing, they were replaced with the jobs created in the shift to the 'post-industrial' or service economy, paid for out of borrowing. This hid the reality in the shift of real wealth. It allowed the massive misdirection of the world economy into servicing Western consumption.

The reality would have been that Western real wages (in terms of what they could purchase) would have fallen, whilst Chinese real wages would have risen. It would have been a situation where the wages in the two countries would have moved closer together. This is not to say that they would have met in the middle, as the West still had the capacity in industries that could add more value per unit of labour than China, and this would take a long time to change.

This moving together of salary levels would be representative of a more even distribution of wealth, and that distribution of wealth would have had a wider impact on the world economy. At a time when individuals were purchasing SUVs they should have been purchasing small cars. At a time when they were going on expensive overseas holidays, they should have been spending that money at home on domestic holidays. These are generalisations, and discount the variable distribution of wealth, but illustrate a central point. If we take the SUV example, the US car industry expanded production in this area, when the underlying economic drivers were suggesting they should have been investing in small cars. However, this reality was still not visible. They responded to the immediate market signals which were based upon credit driven growth, and are now left with capacity that will never be utilised.

As it is, the what if scenario did not happen, and the result is that the world economy is indeed pointing in the wrong direction, and going through a painful correction as a result. As such it is worth examining what the situation actually is.

The first point is one that I have already explained. Even as I am writing there is a massive ongoing process of destruction. The legacy of that destruction is that there will need to be fresh accumulation of capital, which means savings, in order to transition from the collapsed economic model to a model that better reflects the real distribution of wealth in the world.

In a simplistic example, it might mean that the world market has shifted towards demand for Tata Nano cars, rather than Toyota Corollas. It might mean a smaller market for luxury brands, such as Gucci. It might mean many changes. However, I can not say what those changes might be, as they will be determined both by the redistribution of wealth between countries and within countries. For example, if the Chinese model were to continue as it is, there would be both a relatively large market for luxury cars, a very large market for the Nano, and a medium market for the Corolla. The only certainty is that the shape of markets is changing.

Another certainty is that this move, this transition to the new shape of the world economy, will require significant amounts of capital. This will be needed to rebuild and transition companies to meet the new market demands. The only source of this capital is from savings, and the key to the future is therefore reliant on the accumulation of savings being invested in new productive output to meet the new market demands.

If we look at the big exporting countries like China and Japan, we see that they already have amassed significant capital, and look to be in a position to make the transition rapidly. However, all is not as it seems. In some respects, the growth in wealth in places like China is as illusory as the growth in the wealth of the UK and US was. The way in which countries were accumulating wealth was through lending to countries like the UK and US, and it is here that the illusory nature of their accumulated wealth becomes apparent.

The problem that creditor nations like China and Japan have is that, having exchanged their goods for overseas paper (debt), it is not entirely clear what they can do with such paper. If they sell the paper, they will quite literally destroy the value of the paper, as there is now more and more paper being issued - more than demand can ever soak up. When supply outstrips demand, prices fall, and the addition of sales of any of the existing paper into a market of increasing supply and diminishing demand will simply cause the value to plummet. As such, the paper has little real value, as it can not be exchanged for anything. It is not wealth, but the appearance of wealth.

When the big creditor countries were lending into the UK and US, they were making assumptions that these countries were able to service the debt. The reality that has been exposed in the financial crisis is that there is simply not enough output in these countries to service the debt. It returns to the problem that everybody looked at the GDP growth in the UK and US and thought that this represented growth in wealth.

What we have in reality seen is the consumption within the UK and US of the capital accumulation of overseas countries, with a commensurate rise in GDP as a result. When countries like China and Japan lent money, it was utilised for consumption, and consumption represents the destruction of capital. It is quite literally consumed. The best way to illustrate the consequence of this consumption of the capital of others is through an analogy.

Imagine lending money to a businessman, and later finding that he was spending all of the money on 'parties' and other forms of consumption. You will eventually realise that, without his investing the money in some kind of productive activity, there will come a point where he will be unable to pay it back - he is spending your capital. The US and UK have been having the equivalent of a 'party' using the money borrowed from places like China. As a result, much of the paper held by China has rapidly lost its value. With the borrowed money being utilised for consumption, there has been little investment in output that might repay the lending in value added goods and services.

At its most basic, when a person buys a plasma television made in China using borrowed money, at some point in the future they must repay that purchase with a value of labour with an equivalent value to the plasma television (+the value of the interest). However, instead of investing the money in a way that might help create that value, there has been a move away from development of such investment into investment that utilises labour to service the 'party' (shopping malls, personal trainers, restaurants, entertainment etc.). The shape of the UK and US economies has adapted to facilitate debt fuelled consumption, rather than new wealth creation.

The party is now over, and both sides are looking with regret at this massive consumption of capital. In the case of the creditors to the UK and US, they have seen how their previous lending was spent on the 'party' and are now wary of lending any more to such irresponsible and profligate countries. They no longer want to pay for the 'party'.

More worryingly, in the US and UK, not only has there been a massive consumption of the value of labour of overseas savers, but both economies have also seen a massive contraction in their own savings rates in favour of consumption. As such, both economies are left with a massive hangover of debt, which commits future added value from labour into servicing the debts, meaning that there will be less for accumulation of capital. Both economies have little capital base and the situation exists where both countries must produce enough surplus value to both service debt, and build a new base of capital.

To say the least, it is a very, very painful situation. At the very time when the US and UK need to make huge adaptations in their economic structures, they have nothing with which to undertake the process, and large amounts of what they might produce will go to servicing overseas debt. The US and UK are both entering a more competitive world with nothing left in their armouries. Returning to the 'what if' scenario, this is one of the major differences. If the US and UK had not binged on borrowing, they could have utilised their capital to adjust their economies as the new competitive threat emerged. As it is now, both countries are in no shape to meet the competition.

It is at this point that we come to the actions of both governments, and at this point we should be feeling knots in our stomachs.

The problem confronting the UK and US are the same. In both cases, their economies are transitioning to their real level of wealth. In both cases they are massively in debt, and have very little capital with which to rebuild there economies into the correct shape. Despite this gloomy picture, there is a bright side. Both economies still have large numbers of companies that create significant value, and that value has the potential to start to replace the capital base for each country. Such a process of rebuilding capital would be tough, and would see some very hard years ahead, but would eventually provide a route out of the current crisis.

However, what we see from the government is action which will actively prevent any further formation of new capital, and will see a growing future outflow of money that might have contributed to rebuilding the capital base.

The first problem is that the government is pouring ever more money into insolvent banks in an attempt to move time backwards. I often read that the intention is to save the banking system. However, it is not to save the banking system, but an attempt to save a banking system. In doing so, they are borrowing and foregoing huge amounts of future capital accumulation in order to save an insolvent banking system.

The next problem is that, in borrowing so much money, they are denying the availability of that capital to businesses that might start the process of transition of the economy to the new economic situation. The amount of savings, both domestic and international, available is finite. This means that every $US that is put to use for government borrowing is not available for business. At a time of a massive shortage of capital, governments are taking ever greater slices of what is available.

If we then look at what the governments are using this money for, we can see that (over and above the bank bailouts) they are using it for various 'stimulus' measures that amount to spending. Nobody is hiding that the aim is just to get individuals into employment, any employment, with a view to encouraging them to resume consumption. In all of the government policy, the aim is a resumption of consumption.

If we then think of the underlying problems, we see that this is the worst of all possible outcomes. It is not consumption that is needed but savings, such that there is the capital available for economic restructuring.

If we think back to the idea of the 'party', the governments are trying to tell overseas lenders that when they borrow to encourage the resumption of consumption, it is different to consumers borrowing directly for consumption. They are borrowing to try to make up for the shortfall in consumer borrowing, and trying to restart the party. A perfect example can be found here from the Bank of England:

So it is too early yet for us to assess how far this relaxation in monetary policy is providing support for consumer spending and other elements of private sector demand. (p16)
However, whoever is doing the borrowing, it still adds up to yet more consumption, which is the very thing which led to the incredible severity of this crisis.

All the while governments are trying to borrow more to keep the party going, they are also actively discouraging saving. It is well illustrated in the Telegraph, which recently reported on the problems for savers in the UK, with large withdrawals taking place:

As the Bank of England has reduced interest rates to a 300-year low, many savers have seen the return on their money fall to almost nothing. The figures were the latest evidence that savers, who outnumber borrowers by six-to-one, had been cut adrift by the Bank of England, which cut interest rates from 5 per cent in the middle of last year to just 1 per cent in an attempt to stimulate the economy.
The “cash drain”, as the BBA described it, was also a worrying symptom of rising unemployment. People who had lost their jobs were being forced to dip into their savings to pay for everyday expenses.

At the very time that they should be encouraging saving, they are discouraging saving. On top of this, both governments are toying with quantitative easing, otherwise known as printing money. In doing this, they are imagining that they can create new capital. However, all they do is provide a tax on every single unit of currency, as all that happens is that part of the value of the old currency is transferred to the new. This new currency then ends up in the hands of government, who then spend it. Part of that transfer of value will come from savings, further diminishing the availability of capital for investments, and transferring that into government consumption.

At the heart of all the government activity is the failure to recognise the underlying causes for this crisis. All it would take is to direct some of their clever PhD qualified economists to examine the relationship between labour supply and commodities, and the underlying reality of the world would emerge. They would see the reality that we are in a zero sum game, and that reality would translate into an acceptance that wealth has moved away from us. They would then see that the only way that we could return to wealth will be to restructure our economies to meet the new challenges.They would, or surely must see, that this needs capital, and the only source of capital is savings.

Instead, they are continuing on a delusional path, as if nothing has changed in the world. That delusion is driving their every action, and the longer the delusion lasts, the more long and painful the adjustment will be. Their borrowing and money printing adds nothing to the wealth of the countries, but just consumes more capital, and more future capital.

The one certainty in all of this is that the governments can not magic new capital into existence. They can not support the entire economic structure through borrowing, will power and optimism. There is a real world out there, and the only solution is to face up to it.....

Note 1: Regarding the ongoing saga from the Bank of England regarding my questions on the detail of the policy of quantitative easing (QE-Printing money), I have had an email from the BoE requesting a 'chat'. I have asked if they can give me a number to call, and will see what the chat is about.

In the meantime, it seems Edmund Conway has been given further details on the policy of QE, though he does not give his actual source. These are two key passages from his article:

The Bank's governor, Mervyn King, will be granted approval by the Treasury within days to create up to £150bn in new money in the coming months to buy up verything from corporate bonds to government debt. It will pave the way for the Bank's Monetary Policy Committee effectively to "start the presses" at its interest rate setting meeting this Thursday.


But, more significantly, the Bank will indicate in an exchange of letters with the Treasury that it intends to pump a significant amount of cash into the markets, by buying commercial paper and corporate bonds alongside gilts. The amount it is likely to spend on these purchases will probably be around £5bn-£10bn a month.
If you read the article, you will notice that none of it is attributed to any source in the BoE, and it is all therefore unofficial. I am very suspiscious of Edmund Conway who has said the following:
Those of us who have signed up to the idea that the Bank of England should start printing money have done so on the proviso that that money is pulped as soon as any hints of inflation start to surface.
I did not think it was the purpose of commentators and journalists to 'sign up' for policy, but to investigate, analyse and explain policy. What exactly is meant by 'signed up'????

I am genuinely puzzled that these commentators have 'signed up' to this policy. Can they not see the only solution - which is to stop borrowing, cut back on expenditure, and return the UK government to levels of expenditure that can be sustained.

This QE policy will destroy the UK economy, and is no different to what has happened in Zimbabwe. However many clever economists line up in support, the BoE is printing money to pay government expenses, and that is exactly what happened in Zimbabwe. Once started, there is no turning back, and no return to normal policy as suggested by Conway in his articles.

When money is created, it is done through the purchase of an asset. This is done by the BoE simply placing a credit for x amount of money in the account of a broker. In this way money is created. In order to do remove this money, the asset must then be sold, and the credit into the BoE 'disappears' along with the created money.

In the current economic climate, there are very few potentitial buyers of UK bonds out there. We then have to ask who exactly will be buying when the BoE wants to sell the bonds. Their action is to dilute the value of the £GB, and this is more likely to make UK government bonds even less attractive.

Furthermore, look at the ever expanding government borrowing requirements. Who is going to be lending all of this money. The amount of borrowing is growing ever faster...the only way the government will be able to keep up its commitments will be through money printing from the BoE to purchase ever more bonds....are the politicians going to ask for the policy to stop?? And with an election around the corner....

MADNESS. This is sheer madness and the press have 'signed up' for it.

I will keep you updated on progress, and will wait to see if anything official whatsoever comes out of the BoE. However, in the meantime, everything remains very, very opaque despite the article cited above. It all just confirms my belief that the UK government is bankrupt, and is using money printing to attempt to avoid default, and avoid failing to pay for its operations. Very worrying indeed....

Note 2:

I hope the above post makes sense. It is quite long, and I hope that I have not made any silly errors and without an editor, this is always quite possible. If you see an error/problem, feel free to point it out. I will not necessarily change the error, as I follow a principle of never changing a post without a note once it is published (though occasionally cheat on this if I see an error immediately after publication). However, it will help flag this for other readers.

Note 3: As you will notice, this is a long post, so I do not have time to respond to comments on this occasion. Apologies for this.

Thursday, February 26, 2009

Obama's Budget - From where will the money come?

The news at the moment might be described as worrying. Today, we have the story of the 'Obama' budget, which is simply quite staggering. The link I have provided will take you to the Times version with plenty of detail, but I rather like this from the Telegraph, which illustrates the scale of the spending:
If the $3.552 billion budget is divided between all 138,893,908 American taxpayers – the 2007 US Internal Revenue System figure, the latest available – then it will each one $25, 573.48.
The Republicans are up in arms (despite their own prior fiscal incontinence), with their concerns ranging across many areas. However, their focus appears to be on taxation, rather than the idea of deficit spending (Ron Paul is a notable exception).

Inevitably - the promised return to shrinking deficits is apparently going to happen at some point in the future. In order to achieve this, there is very little detail:
Mr. Obama’s first budget was light on proposals to cut spending, despite his statement at the White House on Thursday that the government would be “cutting what we don’t need to pay for what we do.” (NY Times)
Of particular interest as illustration of the lack of clarity is that one of the ways proposed for balancing the budget is to increase taxation on higher earners. This raises a question of how many higher earners there will be, and how much they will be earning, as the economic shake-out progresses. The news reports do not give the details of how calculations have been made, but I would guess that such 'details' have not been considered. For example, this is from the NY Times:
He says he would shrink annual deficits, now at levels not seen in six decades, mostly through higher revenue from rich individuals and polluting industries, by reducing war costs and by assuming a rate of economic growth by 2010 that private forecasters and even some White House advisers consider overly rosy. [italics added]
In other words, the return to fiscal continence looks rather improbable. Perhaps the most worrying part in all of it is the proposals to tax business and increase business costs:
He would remake the energy sector to reduce reliance on foreign oil and address global warming, by requiring industries to buy permits to emit the heat-trapping gases that contribute to global warming. The revenue would pay to develop alternative energy sources and to provide tax relief for Americans facing higher prices from utilities and industries passing on their permit costs. (NY Times)
At a time when the US is on its metaphorical economic knees, this is a proposal to increase the costs of businesses that provide employment. Whatever your views on man made global warming, such action will have an impact on those industries, and will see their competitive position erode, and the businesses that rely on such industries erode in many cases (e.g. if US energy costs increase, so will the cost of steel produced in the US).

Above all else, on top of all the other borrowing and activity that has been undertaken, there is an assumption that the money will be available for borrowing. The US has managed to continue to fund its borrowing due to the 'flight to safety' towards the $US, but Hilary Clinton's visit to China with a begging bowl clutched in her hands illustrates the fragility of the situation.

Regular readers will know that my belief is that a situation of the world (and in particular China) continuing to fund US deficits looks ever more improbable. What we now have is the US attempting to raise $US trillions to finance government, the same in the UK, the same across Europe, the same in many places in the world. Governments across the OECD are going on a binge of borrowing and spending. If we then think of the creditor countries, the countries that potentially have the savings to fund such borrowing, we see that their priorities are to deal with their own troubles.

China and Japan are both in a situation in which the rapid contraction in exports are hitting them hard, and they need to rapidly act to restructure/transition their own economies away from exports. As an article in the Economist points out, there is severe pain in the Chinese industrial heartlands, and a Chinese government fearing social disorder. This is a government that must use their own resources for their own needs, not use the resource for further lending into collapsing world economies. At this point I will digress slightly, as I have seen a contrary view from an individual whose views I respect. Niall Ferguson has the following to say:
The line is very clear from China. They've consistently made their position clear. They want the status quo. They do not want this thing to break down. They were kind of appalled when Geithner said the ‘m' word. And they took full advantage of Hillary Clinton's visit to smooth ruffled feathers and restate their commitment. It's a very good bilateral relation. That bilateral will is important here. The Chinese believe in Chimerica maybe even more than Americans do.
As for my views on the situation, Niall Ferguson believes that China and the US are locked in a perverse economic embrace. However, we differ in the belief that the embrace can be maintained. My reason for disagreement is that, even if China pours more money into the US, an insufficient amount of that lending will be returned to the US through consumer purchasing of Chinese goods, as the wallets of US consumers are snapping shut. In addition the US is printing money, and the possibility of repaying debt in anything other than more useless paper looks increasingly improbable. In such a situation, China is giving large amounts of output for free, and that will in any case be unsustainable.

With regards to Japan, I find the country quite a puzzle to understand. Whilst familiar with Asian culture, and Japanese business, I find the country as a whole a genuinely difficult one to understand. I promised an article on Japan long ago, but never managed to have enough confidence to plunge into the muddy waters of this subject. Some things we do know, which is that the Japanese export machine is grinding to a rapid halt, the economy is falling off a very big cliff, and the only salvation for Japan is in the huge savings of the Japanese individuals. I have read somewhere (sorry no reference) that the Japanese have started to eat into those savings to fund their day-to-day expenses. Again, in such a situation, it is hard to imagine that Japan will ride to the rescue of the West.

The big oil producers are returning to the hard realities of life in an environment of cheap oil. Even in December 2008, there were reports of problems in the finances of Saudi Arabia (although their problems might be considered slight when viewed against the problems of the West), and reports of diversification of petro money away from US treasuries in November of 2008. I believe that I have also given some further examples of an increasing cynicism towards Western investment in the last few months in several articles. As a source of finance, the petro economies look unlikely to be willing to dip into their deep pockets.

For Germany, it has its own problems due to falling exports, and is faced with the potential for disaster in the Eastern and Central European countries turning into massive losses across Europe, as well as the troubles in the evocatively named PIIGS countries (Portugal, Ireland, Italy, Greece, Spain). As a result, the future of the Euro is starting to look threatened (something I discussed as a possibility long ago), and Germany will be focusing resources into their own troubles as a priority, and the Euro area troubles as a second priority.

The essential problem is this. All around the world, economies are in free fall, and resources directed to problems at home will be the absolute priority of each country. In such circumstances, the possibility of countries being able to finance their deficits through overseas borrowing looks to be so unlikely that it remains close to impossibility. In the case of the US and China, the Ferguson thesis looks to be the best explanation for how lending might occur, but the insanity and unsustainable nature of the imbalance must be apparent to China. I just do not believe that they will continue to finance US profligacy in return for increasingly worthless pieces of paper. However, I can offer no clear evidence for this, though I have previously posted articles in which China has been hinting at their unwillingness to do so.

Regular readers will have noted my continuing campaign for clarity on the Bank of England's policy on quantitative easing (QE, printing money), and my suspicion that the Bank will be using this to directly fund government operations. I have not, as yet, looked as closely at the situation in the US, and will look at this in the future. However, bearing in mind that there just does not appear to be the money 'out there' to borrow, my suspicions that the US government is doing a 'Zimbabwe' is very strong indeed. Further discussion to follow....

Note 1: I had a comment from 'Red' pointing out that I am putting flies in the ointment in my requests for clarity on the BoE policy on QE. As one anonymous poster put it, better to get the truth out sooner than later, before the real damage is done. Another commentator suggested that I am fear mongering. To this I would respond by saying that, rather than fear mongering with no justification, I have sought to gain a clear understanding of what the BoE is up to. As such, I am giving them the opportunity to assuage my fears, and hopefully the fears of those who share my concerns. Their evasion to date suggests that they have something to hide. I have today sent an email asking them to acknowledge my email, and am still awaiting any replies to my questions. We will see...

Note 2: ChasH has sent a letter to his local Conservative MP, and received a reply. The reply really says very little at all, and as ChasH points out, it looks remarkably like a 'form' letter. The letter can be found at the bottom of this post in the comments section, and I would be interested to hear if others have had similar replies. It is a little worrying that the reply appears to be so complacent and could be summarised as 'wait and see'. As I have stressed, this may be the most radical economic policy every undertaken, and we have no idea about any details of the policy....

Note 3: I have had some interesting comments on my article on deflation, and can not reply to them all. However, I would like to some points.

A few people have suggested that division of a unit of currency into smaller units is expanding the money supply. This is a very different process, as you are not changing the number of units of the actual currency. If we were to imagine that we followed the idea of a fixed money supply, and imagined that we froze it at £1000 units of currency (for the sake of illustration), we could have the following:

We start with £1 units of currency with a total of £1000 units as £notes. As deflation occurs, we subdivide the currency into each £1 = 100 pence. In practical terms, if we imagine that £1 at the start buys 1 litre of milk, and as deflation occurs it is not possible to use that £1, because the price of milk is now £0.5. We have a problem. How can we exchange the currency for the milk, if we only want 1 litre? We can now only exchange the £1 for 2 litres.

To overcome the problem, we are not diluting the value of the £1, we are merely allowing it to be chopped up into smaller units, for example coins. If you hold a £1, the £1 will still buy 2 litres at £0.5 each. Alternatively, if you decide to exchange your £1 for 100 pence in coins, the £1 will be replaced by 100 pence. Any holder of £1 is not losing anything, as this has absolutely no effect on the £1 that they hold. The important part is that, as the new units are called upon, each 100 pence issued sees the removal of a £1 note. The money supply remains the same, and is always equal to £1000. At any time in the future, although it would become an increasingly impractical unit, you could return to a bank, and exchange the 100 pence back into a £1 note.

However, if you want to really increase the overall supply of money, you would print £1 notes. In this case, every holder of £1 sees the £1 erode in value, because there are now more than 1000 £1 notes. When the new £1 notes are printed, some of the value of those notes is transferred to the new £1 notes. In this situation, if we start with our £1 litre of milk, and more £1 notes are printed, there are more £1 notes chasing the milk, and the price of milk goes up, thereby reducing the value of each £1 in exchange.

The example I give uses physical notes and coins for ease. However, if we think of this in terms of electronic currency, in terms of accounting, large numbers of pence will still be accounted for as £s. All sub-units of currency are measured against the fixed number of £1000 that were there at the start. That number never changes. Whatever happens the number of 1000 x £1 never changes.

I hope this answers the question? Let me know if not.

On a related issue, I have had comments on the fact that this is another fiat currency. The answer is both yes and no.

It is not fixed against an individual commodity, but is fixed against the total output of an economy. Fiat currencies make this claim, but the ability to increase the units means that they can, and actively do, produce more units of currency than the growth in the value of output. In fixing the units of currency, you fix the value of the currency against actual output of value. If output increases, then the value of the currency increases, and if output decreases the value of the currency decreases.

As such, in the example I have given, each £1 = 1000th of the total output of the economy. In normal fiat systems, each £1 = 1000th of output but we would have to add that it would need the proviso that the value would be a feature of time, such that the value is determined not as fixed, but as measured against time (inflation). In other words, the value will become £1 = 2000th of the value of output at some stage in the future. In the fixed money system, whatever happens, £1 = 1000th of the total value of output.

I hope this is clear...

With regards to commodity currencies, they also have inflationary potential (e.g. new gold source found) but are better than ordinary fiat systems, as they create some kind of constraint on the expansion of money. Moreover, they offer a default value as a contract, such that whatever happens you can exchange this money for x amount of gold. A standard fiat currency simply implies that at some point in the future, it may be exchanged for 'something', including another unit of the same currency. However, as we may be about to find out, it may be useless to exchange for 'things', because the value is destroyed by oversupply of units of money. In the case of the fixed money supply, there is a contractual commitment that (staying with the 1000 unit example) you will be able to exchange the £1 for 1000th of total value of output. That is a strong contractual commitment.

Tuesday, February 24, 2009

The Bank of England and Printing Money: Still no public explanation of the policy

For regular readers, they may be aware that I requested some very specific questions from the Bank of England (BoE) regarding their policy of quantitative easing (QE). I am very concerned that what we are starting to see is a process where the BoE is creating (printing) money to directly pay for the operations of the UK government. I have written many posts on the subject of QE, the most recent of which can be found here and here.

Having looked carefully at the documentation of the BoE that discusses the policy of QE, I have been somewhat suprised to find that there is absolutely detail whatsoever on the policy. To give a flavour of the degree of lack of information, there is absolutely no discussion of how much money will actually be created (printed), which would seem to be an absolute minimum of information that might be expected.

As such, I sent some detailed questions to the BoE (see note 1) which were essentially asking them to explain exactly what they are doing. The full reply from the BoE is included in Note 2 at the end of this post. The reply completely fails to answer any of the questions that were asked. There is, however, a suggestion that there will be some kind of further policy disclosure in the future:
The Bank has not published any information on quantitative easing since the latest Minutes. An exchange of letters between the Bank's Governor and the Chancellor of the Exchequer containing further information on the subject is due to be published this week.
At this stage, we have no idea what such a letter might include, but I suspect that the letters will not include answers to questions of the detail of the policy. Such details are not normally found in letters of this kind, but rather in policy documentation. It may be that the 'letters' mentioned in the BoE reply will include the answers to my questions, but I very much doubt it.

The central question remains as to why it is that the BoE is not publishing a full policy document that details exactly what it is about to undertake. It is perfectly normal practice for policy documents to be provided to explain and detail major shifts in policy. An equal concern is that the method of reporting the activities proposed by the BoE is to report through the minutes of the BoE MPC. This is not what the minutes are there for, and is an inadequate method of reporting such a radical policy with such potential for profound effects on the economy.

In one sense, I believe that we have made a small amount of progress in gaining this reply. It appears to confirm that the two documents that are referred to in the BoE reply (see notes) are the only explanation of the policy that the BoE is actually about to undertake. This is really quite extraordinary.

Overall, this is a profoundly disturbing situation. This is perhaps the most radical economic policy that has ever been undertaken in the UK, and there is absolutely no detail on the policy whatsoever available to either the public or the media. I might summarise the situation as being that the only people who know the economic policy of the the government and Bank of England's are the Bank of England and the government. I do not believe that this is in any way an acceptable situation, as this means that the current economic policy is not being subjected to any external oversight whatsoever.

In light of this, I have sent another letter to the BoE requesting that they answer the questions that were actually asked. The new letter can be found in note 4. As before, I will inform you of any answer that may be returned. I considered waiting for the publication of the letters between the Bank's Governor and the Chancellor of the Exchequer, but I do not want to delay on this when the BoE is so close to enacting the policy.

In a previous post I suggested that individuals might wish to write to their local MPs. I will repeat that suggestion, and a proposed letter and how to find your MP's contact details can be found in note 3. It might also be possible that some of the previous letters written to MPs have helped put pressure on the government and BoE to publish the letters (at least one MP responded by saying they would start to ask questions), and I suspect that is why my letter resulted in a reply from the BoE. As such, I hope that further pressure might help to bring some brighter light to bear on the subject.

Note 1: The questions I asked in my letter to the BoE:
  1. What quantity of money will the Bank of England be adding to base money in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
  2. In what form are you planning to add the money? This is the question of which assets the Bank of England will buy as part of the QE operations? Can you give a projected split / proportion of which type of assets will be purchased in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
  3. Can you give a clear description of how the split/proportion of assets to be purchased under QE has been determined?
  4. If you are unable to answer questions 1,2, & 3 can you confirm that this is because you have no firm plans for what you will be undertaking in relation to quantitative easing? If there are no plans, can you give a clear description of your criteria for the decision making that you will use in determining how much you will purchase of which kind of asset, under what circumstances?
  5. Can you give a clear description of the method you will use to purchase each asset class? In particular will you undertake any action to purchase gilts, or an other form of UK government bonds, directly through the UK Government Debt Office auction process or any other direct means?
  6. In a recent press conference Mervyn King suggested that the reporting of QE would be undertaken in the minutes of the MPC. Can you confirm in detail exactly what information will be provided in the minutes?
  7. The MPC minutes are not (I believe) intended as a reporting tool for activity such as QE. As such, why is the policy and action of QE not being reported in a formal publication dedicated to this policy? In particular, QE is widely seen as a radical policy, which Mervyn King describes as 'unconventional'. Under such circumstances, with significant implications for the operations of markets and the broader economy, why is no formal and transparent method of reporting being implemented?
Note 2: The full BoE reply

You recently contacted the Bank of England with regard to a number of questions concerning quantitative easing based around the degree to which the monetary base might be expanded under such a policy, and the types of assets that might be purchased. You also asked whether reporting of any use of quantitative easing in the United Kingdom would be recorded in the Minutes of the Monetary Policy Committee (MPC).

The most recent set of MPC Minutes, published 18 February and covering the meeting of 4 & 5 February, paragraphs 35 to 39, deal explicitly with the Committee’s most recent discussion of the potential use of quantitative easing. These paragraphs are set out below, but concluded with a unanimous request by the MPC "that the Governor should write on its behalf to the Chancellor to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money using the APF."

Monetary Policy Committee Meeting - 4 & 5 February 2009
35 To the extent that further cuts in Bank Rate could not inject sufficient stimulus, the Committee would need to use alternative policy instruments. The MPC’s ability to influence the value of nominal spending and inflation in the economy ultimately came from the Bank of England’s role as the monopoly supplier of sterling central bank money: banknotes and reserves held by the banking system at the Bank. The MPC had up until now influenced the economy by changing the interest rate – currently Bank Rate – at which those reserves were remunerated. The Bank had supplied the amount of central bank money demanded at that level of Bank Rate, mostly by purchasing and selling government securities.

36 But the MPC could also influence the economy by controlling the quantity of that central bank money directly. Increasing the supply of central bank money in the economy through additional purchases of government securities should raise private sector spending, both directly (through the increase in money holdings of private sector asset sellers) and indirectly (through an expansion by banks of the supply of credit).

37 In the present environment, where particular credit markets were not functioning normally, it was appropriate to consider increasing the supply of central bank money by more unconventional types of asset purchases. Buying private sector assets in such markets, including commercial paper and corporate bonds, would help to stimulate the economy further by improving liquidity in the markets for these securities. In turn, that would encourage the flow of credit to companies.

38 The Bank, rather than the MPC, had already been given the authority by the Chancellor to conduct such purchases, via the Asset Purchase Facility (APF), although in this case financed by the issuance of Treasury Bills. The APF was a specially created fund, indemnified by the Treasury. Those purchases were aimed at improving conditions in the specific credit markets rather than achieving the inflation target. Nevertheless, these measures might help to change banks’ behaviour and boost the broad supply of money, which could provide a material stimulus to nominal spending.

39 It seemed likely that the Committee would want to consider a range of asset purchases in due course. That would strengthen the Committee’s ability to meet the inflation target. Therefore the Committee unanimously agreed that the Governor should write on its behalf to the Chancellor to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money using the APF. It would be crucial for the Chancellor to ensure that the Government’s debt management policy would be consistent with the monetary policy actions of the MPC. The Committee recognised that the impact of such operations was both uncertain and subject to time lags. In communicating the MPC’s actions, it would be important to stress that such measures were being considered in order to meet the inflation target. The publication of the February Inflation Report would provide an opportunity to emphasise this.
The Governor of the Bank also answered questions on the subject at February's Inflation Report press conference a week earlier - a transcript is available on the Bank's website:

The Bank has not published any information on quantitative easing since the latest Minutes. An exchange of letters between the Bank's Governor and the Chancellor of the Exchequer containing further information on the subject is due to be published this week.

Note 3:
Thanks to those who have already sent letters, and here is a suggested letter format for those who have not already done so. You can find the email address for your local MP here (click on the map for your constituency).

This is is my suggested letter which you can copy and paste, or alternatively write your own version:

I am writing as I have very increasing concerns over the recent Bank of England policy to implement quantitative easing. In particular, I am worried about the following:
  1. There is no policy document that clearly outlines how this policy will operate, what quantity of money will be created, what assets the money will be used to purchase, and what method will be used for the purchases.
  2. In addition to this Mervyn King has suggested that the method of reporting for Quantitative Easing will be through the MPC minutes. This is not the purpose of the MPC minutes, and there is no requirement for full disclosure of activity in such a method of reporting.
This is all very opaque.

I am very concerned at such opacity in consideration of the fact that the Bank of England will be using money creation to purchase gilts. In this situation the Bank of England will therefore be creating ('printing') money to purchase government debt. This might be seen as government operations being funded by printing money.

Under such circumstances, it would be reasonable to expect the Bank of England to offer a transparent and detailed discussion of the policy as a formal policy document, as well as a formal, full and transparent procedure for reporting their activity.

I would therefore be most grateful if you could, on my behalf, seek to clarify why this process is being undertaken in such an opaque manner, and clarify exactly what the policy will be. I would also be grateful if you could press for a proper method of reporting on the policy of quantitative easing.

Note 4:

Thank you for your reply of 24 February 2009.

Unfortunately, it appears that you have sent me information without having read the questions contained in my last letter. Instead of answering my questions you have pointed me to sources of information that I have already seen, and which do not offer answers to any of my questions. I have written to you because there are no answers to my questions available in your existing documentation.

As such, I will repeat the questions and you will therefore have a second opportunity to answer them. They are as follows (QE = Quantitative Easing):

  1. What quantity of money will the Bank of England be adding to base money in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
  2. In what form are you planning to add the money? This is the question of which assets the Bank of England will buy as part of the QE operations? Can you give a projected split / proportion of which type of assets will be purchased in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
  3. Can you give a clear description of how the split/proportion of assets to be purchased under QE has been determined?
  4. If you are unable to answer questions 1,2, & 3 can you confirm that this is because you have no firm plans for what you will be undertaking in relation to quantitative easing? If there are no plans, can you give a clear description of your criteria for the decision making that you will use in determining how much you will purchase of which kind of asset, under what circumstances?
  5. Can you give a clear description of the method you will use to purchase each asset class? In particular will you undertake any action to purchase gilts, or an other form of UK government bonds, directly through the UK Government Debt Office auction process or any other direct means?
  6. In a recent press conference Mervyn King suggested that the reporting of QE would be undertaken in the minutes of the MPC. Can you confirm in detail exactly what information will be provided in the minutes?
  7. The MPC minutes are not (I believe) intended as a reporting tool for activity such as QE. As such, why is the policy and action of QE not being reported in a formal publication dedicated to this policy? In particular, QE is widely seen as a radical policy, which Mervyn King describes as 'unconventional'. Under such circumstances, with significant implications for the operations of markets and the broader economy, why is no formal and transparent method of reporting being implemented?

I believe that my questions are quite clear, and quite specific. In my previous letter I asked 'In any reply, please do not refer me to documents that do not answer the specific questions that are being asked.' This is exactly what you have done - you have referred me to documents that do not answer the specific questions.

It may be that you do not have sufficient knowledge to answer the questions that I have asked, but I would think that within your organisation there will be many people who are in a position to answer the questions. I would therefore be grateful if you could forward my questions to such a person who is able to give specific answers to my specific questions. I assume that all of the information to answer my questions will be readily available, as I would expect that a policy as radical as QE will have been fully documented and a clear policy will have been outlined. As such, you just need to direct my questions to a person who has been part of that policy formulation process, and I would expect that they will have all of the answers to hand.

I look forward to the receipt of a full reply, and would like to thank you in advance for your help in gaining answers to each of my specific questions.

Note 5:

Many thanks for all of your kind responses to my last post, which are very encouraging. I was also planning to respond to some of the very interesting comments on deflation, but found the BoE letter in my inbox, so will delay my replies for a little while.

Saturday, February 21, 2009

Dinner Table Economics and Deflation

I recently mentioned that I would post an article on deflation, as I have become concerned by the way that this is being used as an excuse to engage in printing money. The idea that deflation is bad seems to be widespread amongst economists, but I am not at all convinced of this. In order to understand why, I will need to take a slightly circuitous route, which is to discuss what wealth is and how it is created. After all, economics should be primarily about how we create (and distribute) wealth.

Happily for the purpose of writing this post, I had a couple of friends come to dinner recently, and our discussion turned to economics and wealth creation. I say 'happily', as one of the friends is very knowledgeable about economics, meaning that he knows the arguments of many mainstream economists. As we conducted our discussion, it struck me that there is a fundamental problem in such arguments. It is not something that they ever say directly, but an assumption that sits underneath many of their theories and thinking. They actually think that wealth has arisen as a result of macroeconomic tinkering by governments.

As such, I thought I would start this post with a key part of understanding deflation, which is to consider what wealth actually is and how it is created. I will use some rather odd illustrations that I used during the dinner so that, as I explain, at several points it might be useful to imagine you are at the dining table with us.

One of the points which was central to the discussion, is so obvious that it should not need to be said. However, it is a point which is often lost in all of the complexity of economic discussion. The point was this:

If an economy has a total output of 100 units, it does not matter what the number of money units there are in circulation, as this will have absolutely no bearing on the level of wealth in that economy. The economy could have one hundred units of money in circulation, a thousand units, or a million units. It will make not one jot of difference to the wealth of that economy. The output will still be 100, and that output represents wealth.

To explain the point I was making, I took two wine glasses on the table and said that yesterday I, as a unit of labour, produced two such wine glasses every day. These two glasses of output were sufficient for me to live a day to day subsistence lifestyle. I then added a wine glass, and explained that due to various improvements in my ability to make glasses, I was today making three glasses instead of the two yesterday. As such, I have an additional glass which means that I have increased my wealth creation such that I can use that one glass of output for discretionary spending.

Having added the additional wine glass to my output, I suddenly have some choices. I looked around the dinner table, and decided that I would utilise that additional wine glass as a means of exchange for one portion of dessert. I designated one of my friends at the table as a dessert manufacturer. I moved my additional wine glass over the table, and exchanged it for a portion of dessert. I am now one portion of dessert richer, and the dessert manufacturer has one wine glass.

The interesting part of our transaction, however, is not immediately visible in this example. When we increase the output of a good, more of that good is available in the market. Assuming that demand is not increasing through factors such as significant population growth, then the additional supply of glasses has some interesting effects.

Before my output of wine glasses increased, the cost of wine glasses was higher reflecting the greater input of my labour in each wine glass, and the dessert maker would therefore have to pay me one and a half portions of dessert in exchange for a wine glass. Under these circumstances, the dessert maker could not afford to buy the wine glass, and was forced to use a cheap pottery mug to drink his wine. As it is now, the number of wine glasses has increased in relation to demand, my input of labour per glass is lower, such that I am now willing to exchange my additional wine glass for just one portion of dessert. The result of this change in my wine glass output is therefore as follows:

I am one portion of dessert wealthier, and the person who makes the dessert is wealthier because he can now keep a half portion of dessert that he would previously need to have given me. We have both become wealthier. Even as the exchange value of the glasses has decreased, we have both become wealthier.

The curious point in this is that, if the wine glass production had not increased, then the dessert manufacturer would not have wanted to make the exchange at all. He felt that one and a half portions of dessert was too much of a price to pay for a wine glass. My increase in output not only allowed me to increase my wealth by one dessert, but also expanded the market for my output. This is why everyone is wealthier...

If we return to the earlier point about an economy having 100 units of output, in this case I have just increased the output by one. We have 101 units of output. The economy is more wealthy, and it has nothing to do with the number of units of currency in circulation.

Returning to my increase in output of glasses, there is no necessity for me to use this addition of one glass of output to consume a portion of dessert. I can use it for many purposes. Let's imagine that I am supporting a family, and I have ambitions for my children. I want them to go to university. In order for my children to go to university, I will need to save some money to pay for the fees. As such, I forgo the portion of dessert, and decide I will save the additional daily output of wineglasses. According to many economists today, this foregoing of consumption of dessert is a bad thing....the more we consume, the wealthier everyone becomes.

However, (wisely) ignoring these economists, I go ahead and decide that I will save the one wine glass of additional output to pay for my children to go to university. I look around, and conveniently decide that the other person at the dinner table happens to be a bank. I cancelled my deal with the dessert maker, returned his portion of dessert, and passed the wine glass to my friend who is now acting as a bank. Instead of the dessert manufacturer holding the glass, the bank now holds the glass.

Why did I not just keep hold of the additional glass? After all, over the years, I could store up lots of glasses and give them to the children when they reach university age, and they can then use those glasses to exchange for all the things they need. Why did I give it to the bank?

I gave it to the bank because the bank will invest it. In this case, the bank uses the value of the glass as a means to give another producer the ability to do something new, such as increase the sales of wine. At the time I am giving the glass to the bank, one glass of wine can be exchanged for one wine glass (obviously that is the quantity of wine - as you do not keep the wine glass). In order for me to give the glass to the wine seller (a wine bar owner), I ask that the wine seller gives me a tenth of a glass of wine every day for every glass that I provide. The wine seller gets more glasses in which to serve the wine, and I get wine in return. Meanwhile, as a price for putting me and the wine seller together, the bank charges a fee of one twentieth of a glass of wine per day, per wine glass invested. We all get wealthier.

In the case of the wine seller, with more wine glasses available, he can now serve more units of wine to more people and increase output, I am wealthier as I am getting lots of wine, and the banker is wealthier because they used their knowledge to put me and the wine seller together, and they get some wine too. Just as before, the economy has become wealthier. It has nothing to do with the number of units of currency. It has to do with my increased output of wine glasses.

Now at one point, my economically knowledgeable friend suggested that we needed inflation to make people invest money, and that it was necessary to increase the money supply as the economy grows. That was why I gave the example of why I would (without any inflation) still invest my money in the bank. I also explained inflation this way:

I went back to my original choice of using my original wine glass as an exchange for a dessert; exchanging a portion of dessert in exchange for a wine glass. Instead of consuming the dessert myself, however, imagine that I am going to give it as a birthday present. The birthday is not for 6 months, so I take the dessert home and put it in my freezer. Having put it in the freezer, I am rather surprised to find that, every day, a stranger comes into my house, opens the freezer, and takes a small piece of the dessert away with them. As such, every day the dessert gets a little smaller. This is inflation. The stored value of my labour, represented by the dessert, is reducing every day that goes by.

This is one of the keys to understanding the supply of money. Every time there is an increase in the money supply, it is the equivalent of taking a little part of the value of everything from people. Where does that value go. Who is the person who is coming in and taking away a small piece of my dessert every day?

In the case of money, this is the person who makes more units of the money. Whenever they do this, they take a little part of the value of money from the existing money. In the case of the dessert, it represents the stored value of my additional wine glass of production, which is equivalent to saving x units of money. I made an exchange for one unit of dessert, and wanted to give the person having the birthday the equivalent of one wine glass of my labour. However, in a situation of inflation, the same thing happens to money as happens to my portion of dessert. Someone comes and takes a bit of it away every day. Whilst we would not accept a person coming in to our house and taking a piece of our stored value from the dessert, we readily accept them doing the same thing with our money in the bank, or money in our wallets.

In this example there is an illustration of something about wealth and money. Wealth is based upon output, and the structure of the money supply has nothing to do with making wealth, but has something to do with the distribution of wealth. Inflation distributes wealth away from you to the printer of the money. The only way to become wealthier is to produce more 'stuff' and this can be achieved without any manipulation of the money supply. This then raises the question of why there is so much manipulation of the supply of money. Macroeconomics is full of lots of complex models of the supply of money.

For the answer to this, we will leave the dinner table economics behind and turn to Adam Smith, who (as ever) got the picture absolutely right. This is what he has to say about money:
'For in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal [gold or silver], which had been originally contained in their coins [...] By means of those operations the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and fulfil their engagements with a smaller quantity of silver than would otherwise been requisite.'
The cost of this he illustrates with an examination of landed estates, some of which which were awarded rent in money, and some which were awarded rents in corn. The estates with rent fixed in units of corn continued to be wealthy, but the estates with rent fixed in money became poor.

What Smith is explaining is that debasement of money serves only to help the state. Inflation of the money supply today is exactly the same in principle to what Smith was describing, and the same as someone coming in an taking a piece of my dessert.

In modern macroeconomics it appears that many economists are entirely confused about money. They seem to think that money has some mysterious purpose. If we go back to the dinner table economics, we did not need money to get wealthier, we just needed me to increase my daily output. Money has absolutely nothing to do with wealth. Money is, or should be, a unit of exchange that makes transactions more simple, and an abstraction of stored value that everybody accepts. It is the equivalent of the portion of dessert, or the wine glass - it is representation of these objects and the input of labour that created them.

The velocity of money, the number of units in circulation has nothing do with output whatsoever, it has to do with the way the wealth of output is distributed. I can not put this any more clearly than this:

Wealth is created by units of labour A, B and C producing and output of X, Y and Z.

The only difference that money makes in this equation is whether the money system offers incentives or disincentives to those units of labour to produce more or less output, and how the wealth is distributed. That is largely a factor of how much and in what way the value of their labour is expropriated through the scheming of 'princes and sovereign states'.

My knowledgeable friend was suggesting, and has argued that it is that monetary system that has allowed the growth in wealth in the Western world. My point is very clear; it is the increase in total output of labour that is the sole reason for the increase in wealth. All of the fiat money systems, and all of the rest of the apparatus of modern macroeconomics has done is play a part in how that wealth is distributed. From the dinner table economics, we can see that there is no need to create any incentives for people to get on with the useful business of increasing output and investing their increasing wealth to create even more output. The logic of these actions determines that this is what would, in any case, be what would happen.

Now if we return to the economy that has an output of 100 units, and imagine that today we have 100 units of money for that output, we can see where inflation fits in. If we then increase the money supply to 110 units, then we have inflation. The increase in the money supply has no bearing on the output, but simply means that there are more units of money relative to the output. The ten new units of money have been produced, and the value of the new units means that the producer of the new units of money have taken a portion of the value in exchange of the existing money. If you hold one of those units of money, you have just given something to the producer of the new money.

Lets imagine that the units of output also increases to 110, at the same time as the money supply increases to 110 units. Surely this is okay, as we can still buy the same number of units of output with our 1 unit of currency? This might seem reasonable, right up to the point where we start to think about where the increase in output has come from. If we think of the dinner table, it is me that has increased my output of wine glasses, so I have created the wealth. The printer of the new money has not increased output of anything, but they still have ten units more of money. This still means that my unit of money is worth less than it should be. If the additional units of money had not been created I would have been wealthier, but that additional wealth has been transferred to the producer of the new money.

But the producer of the new money has created no output....I have, and it is me that increased the output....but I see no benefits from it.

As an alternative, we can take another scenario, which is that output increases from 100 units to 11o units, but the units of money remain at 100. In this case, as my output increases, I become wealthier. My increase in output directly benefits me. I gain the full benefit of my output (the reality is however, that this is collective, not individual - everyone benefits). This is what many economists fear - deflation.

Economists say that deflation is a terrible thing. They say that it wrecks economies. If you have deflation, then people stop consuming, and stop investing.....

Let's start with the case of consumers stopping consuming. In this case, we have a good example of deflation to illustrate that deflation does not stop people buying things that they want. The example is computers which, as every year has gone by, have become ever cheaper in relation to their performance and sophistication. We all know that if we wait until next year, we will get a much better computer for our money. This is real deflation, but during a period of real deflation, the sales of computers has expanded, and expanded, and expanded.

If we think of a more mundane example, we might come up with something like a bottle of shampoo. Let's imagine that every year there are ongoing productivity gains in manufacturing shampoo such that the price falls by 3% per year. Does this mean that we will defer our buying of shampoo? Does that mean that, in order to benefit from the price reduction of shampoo, we will walk around with greasy hair.

Alternatively, we can take the case of a discretionary spend on something like a holiday. As some people will be aware, the low cost airlines have seen huge reductions in the cost of overseas travel, and the costs continued to go down over a period of years. Did this mean that people stopped overseas travel while they waited for the flight prices to drop even lower? What we actually saw in places like the UK was a massive expansion in overseas travel, as it became ever more affordable. However, this occurred despite deflating prices. This is like the example of the wine glasses....

The idea that people will not spend money during deflation is simply not true. However, if we knew that there was an unusual deflation about to take place, such that we expected the price of something to drop dramatically at some future point, we might defer our spending. For example, if the newspapers were to announce that in April of this year that there will be a new type of computer which will cost half the price of a computer today, then we would likely wait until April before buying a new computer. Moreover, when the new computers were released in April, then the sales of computers would increase as more people could afford them, and we would all potentially be richer by a factor of half a computer (if that makes sense).

However, such events would always be exceptions, and we readily buy computers despite the steady price deflation.

In short, steady deflation does not stop people from consuming.

This still leaves investment. In the case of investment, an argument might be put forward that, in the event of deflation, you could keep money under your mattress and still see it increase in value. As such, you have a disincentive to invest.

However, if we imagine that we have a situation of deflation, what has changed compared with inflation. In a period of inflation we have to invest our money just to stand still. However, we have many choices. We can put our money into a building society account and get a steady interest rate which will see a small return on our investment. Alternatively, we can put our money in a higher risk investment but risk our investment overall. In all cases we measure our return bearing in mind the rate of inflation. If we see inflation is at 3%, then we will want at least a 3% return, but most of us will want a return greater than inflation.

If we then imagine a deflation rate of 3%, that means that we will gain a 3% return on our money under the mattress. However, if someone offers us an additional 2% return over and above that 3%, we are very likely to be tempted into this. Just as in the case of the investment of the wine glass in the dinner table example, we will see that this can be a very smart thing to do with our savings. The only difference here is that it is not necessary to invest in order to keep your money, and this therefore becomes an issue of morality.

This is the morality argument; if we return to the dinner table economy, I have through my own ingenuity and efforts, ensured that I have achieved enough output to have an additional wine glass every day. This is the value of my own labour, not the labour of anyone else. The question here is, do I own the value of my own labour? What I do with the value of my labour should, as far as possible, be my own. If I choose to risk that value of labour by investing it should be my own decision. Whilst there are good arguments in favour of me making that investment, does that mean I should be compelled to invest it in order to preserve its value? If we think of the person coming into my house and taking away a piece of my dessert every day, such that I will not want to store the value of my labour in such a way, is that morally justified?

I will let you decide on the morality argument. However, what is certain is that there is no reason why deflation should lead to people not wanting to invest their money.

The final argument is that it makes the burden of debt greater. This one is a real puzzle to me. If you have a situation of inflation of 2 % and you want a 5% return, you will charge 7% to achieve this return. If you have deflation of 2%, then you will charge interest of 3%. In both cases the cost to the borrower remains the same. If you move from inflation into deflation, as would be the case now, then you have a problem in that the debt burden would increase. However, if you went from an inflation rate of 10% down to an inflation rate of 2% then the debt burden would also increase. In other words, the burden of debt is nothing to do with inflation of deflation, except for when there is a change.

What if there were a rate of deflation of 10%? The cost of borrowing would then have to go up dramatically for our example, with a 15% rate! However, if we had no increase in the money supply and the output of wealth from the economy was increasing by 10% causing 10% price deflation, I think that nobody would be complaining....everyone would be much, much wealthier...the deflation would later ease back as the supply of credit would reduce, reducing investments which might increase output...the system would balance back towards steady deflation. In other words, deflationary growth in wealth is self-regulatory and will provide a more steady model of growth in wealth.

Quite simply, I just do not believe that ongoing and steady deflation is a bad thing. If anything it is far better than ongoing inflation. Regular readers will know that I have advocated a system of money based upon a fixed specie of commodity (such as a gold standard). However, the more I have thought about this, the less I like the idea as the supply of gold also increases, such that the supply of money increases.

There is a better way, which is to absolutely fix the supply of money, such that it can never be expanded. Instead of inflating the money supply, as an economy expands, the units of currency at the start simply increase in value.

This does pose some practical difficulties, such as a unit of currency increasing in value so much that it becomes difficult to exchange for anything but ever larger items. To illustrate with an extreme example, if there were one thousand units of currency in the year 1066, then each unit of currency today hold nearly enough value to buy a city. The way around this is not to increase the units of currency, but to sub-divide the currency into smaller units. Just as today there are pounds and pence, as the value of a currency increases, it would need to be divided into pounds, pence and 'x'. At no time are any more pounds created, such that the pound is never watered down. Dividing a pound into pence does not devalue the pound, it is the increase in supply of pounds that devalues the pound.

There are many more points that could be made for such a fixed supply of currency (such as international implications), but this post has already gone way beyond my original intent. As such, I will leave it there, and leave you pondering on dinner table economics.

Note 1:

I am still getting more comments on my posts on fractional reserve banking. A brief answer to some of the comments. Yes, I agree that £1 GB is actually an IOU, and that banks also are creating IOUs. As such they are comparable. As you may have noted - throughout the blog I am casting doubts on whether the IOU that underpins the £GB and $US have any greater value as money than the IOUs of banks. In this sense, they are even more comparable than is widely believed.

However, my point about what is money always rests on a single principle, and I have explained this in several examples. Money is what people collectively believe it to be. I think I gave an example that illustrates this. A person who is starving to death will see a bowl of rice as more valuable than an ingot of gold, if he can not exchange the gold for rice. In a situation of starvation (where no food can be purchased from outside with the gold) rice would become a currency. People would exchange houses, land, or anything for the rice. It would become the currency that everybody believed in.

In the example in this post, even the value of the currency that I am proposing would be superseded by a food currency in the starvation situation.

When people were waiting in long lines outside of Northern Rock, they wanted to have their money denominated in £GB, not in bank IOUs. When they did this, they were clearly expressing their view of what money was, and that was not a bank IOU. It was a government IOU. Sadly, their belief in the government IOU is probably about to be tested as well....

The point in all of this is that when policy makers make policy, it seems a wise idea that, when they model the economic world, they have an understanding of money that conforms to the idea of money held by all of the economic actors - a reality which is expressed in the people waiting in line outside Northern Rock.

Note 2: At the dinner (on Saturday), I was explaining to a Chinese friend that her country was now the most powerful in the world, that power had shifted entirely towards China. As if on cue, Hilary Clinton is seen with the begging bowl out in China. Regular readers will know that I have been pointing to the reliance of the US on China for a long time.....

Note 3: Regular readers will also know that I have long been suggesting that the economic crisis has the potential to see the end of the Euro, and this is now the subject of speculation in the press..

Note 4:

A regular commentator 'Lord Sidcup' points out that mainstream commentators are starting to arrive at the same conclusions as my own (a couple of examples above). He asks where I can take the blog as they finally catch up.

It is a good point. I am wondering this myself, as my purpose was always to try to get a message 'out there' to as many people as possible. The blog has moved to the point where many readers (measured in many 1000s) now read each of my posts. As such I have a sense of obligation to offer something useful and that will only be the case if I can offer what I believe to be a better description of 'reality' than others. My philosophical foundation is critical scientific realism, which has helped me in this task so far.

However, if others offer the same analysis as the blog, then it might be time to call it a day. As such, I suspect that this blog may not have much life left in it. In particular, the scene is now set, and I very much doubt that anything will turn back the inevitable course of events. Whilst the exact timing of the denouement is still a matter of some uncertainty, the contradictions I have been discussing for so long must be resolved. A commentary on the detail of events will not offer anything that I have not already covered. Wealth will be still be wealth, and ongoing economic delusions that are the subject of this blog will remain delusions.

The populists, the something must be done politicians, will flail around for solutions, all the while doing more harm. The general populace will still think that everything might be 'fixed', without accepting the reality of what is actually broken. The fundamental problem is that the reality of the underlying problem is something that is hard to accept. This is the idea that we are no longer wealthy enough to live as we have before....unless we accept reform, and very tough reform.

At this stage, I am less and less sure of what I can add, and have had this thought occur to me several times recently. I will give this subject some thought. Comments welcomed.

P.S. Lord Sidcup, I am glad to hear that you read Marx and Adam Smith. Smith, is quite astonishing, and I have long suspected that one of the problems with economics is that all economists are comparing themselves to his ghost.

Note 5: I had a considerable amount of traffic on my posts on QE, and hope that many letters were sent to MPs. My thanks to those who took the trouble. I find it very disturbing that a significant (historic proportions?l) policy might take place under such conditions of opacity. Let's hope somebody pays attention.....