The Role of Money in the Economy - I

In this series of posts, I would like to cover the role of money in today's economy and I hope that by the end of the series that I am able to convey the reasons why I have been avoiding bringing money into my discussions. Let's start off by understanding why money is important in the functioning of modern economies.

To begin with, one can imagine a primitive village economy with very few people that is able to work solely on barter/exchange because:

1. Each villager produces something of value that every other villager needs
2. Each villager produces just enough over the year to meet the entire village's need for that product and for that year
3. All villagers bring their produce to the market place once every year and leave with their respective share
4. Villagers are able to engage in one-on-one barter/exchange in the market place because of the assumption in point 1 above. 

One can see that this setting works well and it does not need money to continue functioning.

However, we know that things are not that simple. One can easily imagine a scenario where there are so many villagers participating in the economy such that:

1. One-on-one barter/exchange is no longer possible because now the village is replete with mismatched pairs where one person desires what the other person produces but is unable to offer something in return. However, we assume (very important) that every villager produces something that some other villager wants even though the two might not be able to form a one-on-one barter/exchange pair. Therefore, for villagers to obtain something from another villager (whom they can not pair with) they:
1. have to set up a complex sequence of barters/exchanges with multiple other villagers till they are able to obtain something that the target villager actually wants,
2. have to group enough people people together so that when they pool a portion of their produce everybody is able to find what they want from that pool and walks away happy
3. or most simply write an I Owe U (IOU) to the other villager who in turn can use it to barter with other villagers till it reaches somebody who can actually cash that IOU in. Note, again, the assumption that there is necessarily such a villager present otherwise the IOU has no value.
2. There is uncertainty in whether some villagers are able to produce consistently ever year although they are able to on average in the long run. In such cases, these villagers would have to write IOUs for their share of produce till they can come good on their IOUs.
3. Some villagers can not bring their produce into the market place at the same time as other villagers and hence will have to write IOUs that the other villagers can cash in whenever the requisite produce is ready.
4. Villagers can barter one kind of IOUs with other kinds and the exchange ratio between IOUs can be determined by the market place. E.g.
1. An IOU for one bag of cashew nuts is worth three IOUs for one bag of rice each. 
2. An IOU for a house is worth three hundred IOUs for one bag of rice each.
3. As a result an IOU for a house is worth one hundred IOUs for one bag of cashew nuts each.
4. etc.
5. Villagers are able to barter IOUs because they know they can eventually cash their IOUs in by going to the issuer of a particular IOU whenever the time is ripe.

One can immediately see the potential for abuse with IOUs. Some villagers might simply use the concept of IOUs to mooch off others. We can see that although IOUs are the most convenient way to make the complex barter/exchange system work one would need a central authority (the government), rules and laws that together can first endorse the villagers issuing the IOUs and then enforce the honoring of those IOUs.

Now, we the see faint outline of what money is. Basically, money is a form of IOU backed by government decree and oversight that allows smooth functioning of a complex economic ecosystem where simple barter/exchange is no longer possible. In the subsequent posts, we will explore further what a government backed IOU means and what the complications are in an IOU based economy.

The Economy of the Future - II

We saw in the previous post what the economy of the future looks like if Martin Ford's prediction comes true and a small fraction of the society ends up producing all the goods that meet the demands of the society. If we do not let the government intervene and let the market evolve on its own, under free-market principles, most of the people will be shut out from the economy and be forced into poverty. The GDP of the society will shrink with the economy just large enough to cater to only the productive members. If we do not want the majority of the society to be mired in poverty then the government has to step in and employ most of the people to provide them with some means of sustenance.

We saw in http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html that the government can do this in either of two forms:

1. Raise taxes on all the productive members to pay for the government programs that support the non-productive members of the society. This essentially means that the government is forcing the productive members to produce for others without expecting anything in return.
2. Hand GOUs to all productive members in return for supporting the non-productive members. This results in a continuously rising debt (However, this may not be an issue as outlined in "is public debt really that terrible?") parts of which the productive members can redeem if and when they find something appealing in the market place.

The second approach is what will appeal to the human psyche because it allows the productive members to gain something in return for selling their goods in the market. What they gain are GOUs that they can redeem for whatever they find of value in the future. We will have to get used to mounting debt and not view it as a bad thing. This is similar to accruing paid time off (PTO) in your company but with no accrual limits and unlimited roll-over from year to year. However, just like you would avail yourself of your PTO savings only when the need arises the "rich" would only be able to avail themselves of their savings only when there are services available. Looked at in a different way, the second approach is simply providing the productive members with access to more services than others and first dibs at those services in the society. Once everybody understands how the new economy works we will continue to have a thriving market economy.

The Economy of the Future

This post has been inspired by the book "The lights in the Tunnel" by Martin Ford. It's a short, interesting and thought provoking book on how the economy needs to adapt to the possibility of automation taking over most of the mundane and routine tasks. The book discusses the danger posed by the possibility of some members of society unable to compete with machines and unable to find any form of employment. In addition to the book's thesis, the fact that it is a set-your-own-price book and can even be downloaded for free from "The Lights in the Tunnel" makes it especially attractive. I urge the readers to check it out and the one hour that is spent reading the book might be well worth it (and if the reader feels it has been helpful then maybe he/she can retroactively pay for the book).

Some of the highlights of the book are:

1. Concise representation of what the future will look like if the market, without any government intervention, is allowed to evolve naturally with machines becoming more and more capable of not only taking over blue collar jobs but also white collar jobs.
2. The steps and remedies in terms of tax reforms and government incentives outlined under the current framework to address the issue raised in the point above.

However, I have some criticisms (hopefully constructive) to make on the book:

1. I feel the analogy of the lights in the tunnel, which ironically is the title of book, adds nothing of value to the reader. The analogy does not give any special insight into what the author is trying to convey. The rest of the book is lucid, however, and is sufficient to get the main thrust of author's thought process.
2. The author uses the concept of wages, earning, taxes and consumer spending to explain how an economy based on free market principles can work in the future. However, there is a danger that the reader might miss the forest for the trees. It is important for such discussions to take money completely out of the picture to get a true sense of what is really driving the economy in the futuristic scenario painted by Martin Ford. 
3. The picture painted by Martin Ford, I think, is too dire. Humans will always find new needs and desires where none existed before and we will find employment for everybody in the society but there will be periods where the government would have to step in to ensure that every member of the society continues to be a participating member of the economy.

In this post, I will attempt to summarize the message from the book in layconomic terms. First, we need to establish some assumptions that we take for granted implicitly. 

1. Money has no intrinsic value. It only has value if it can be exchanged for goods either now or in the future. The main driver for an economy running on free market principles is barter or the exchange of goods. Money acts as a conduit for complex barter exchanges and acts as GOU (Government owes U) if the producers of goods putting their goods into the market place can NOT pull something else out that they find of value. Instead, they can pull GOUs out in exchange for putting their goods into the market place which they can redeem whenever they find something of value in the same market place in the future.  
2. In an economy operating on free market principles, nobody likes to trade what they produce for nothing. People produce goods for others only if they get something in return either today or in the future. People will not produce, even if they have the capability, if the feel that they will get nothing in return for their efforts.
3. I have already pointed out earlier that in modern day societies a subset of the population can produce enough to meet all the consumption requirements of the entire society (http://layconomics.blogspot.com/2012/11/austrian-vs-keynesian-economics-deficit.html).  

In the scenario painted by Martin Ford the assumption in point 2 above is taken to the extreme where a very small fraction of the population is able to produce everything that the society needs. In which case, there are four categories of people:

1. People who are not at all productive (because the machines can do a much better job than them)
2. People who are productive (because the machines may not be able to do as good a job as them or they are required to program and maintain the machines)
3. Owners of the productive factories that cater to the needs and desires of other productive members - namely people in categories 2, 3 and 4 (they may also cater to the needs of people in category 1)
4. Owners of the productive factories that cater to the needs and desires of people only in category 1.

If there is no government intervention, eventually people in category 4 will also end up in category 1, because neither people in category 2 nor people in category 3 will want to engage in barter exchanges with them. Obviously, they do not find anything that people in category 4 produce appealing. Eventually, we will end up with only three categories of people:

1. People who are not at all productive (because the machines can do a much better job than them)
2. People who are productive (because the machines may not be able to do as good a job as them or they are required to program and maintain the machines)
3. Owners of the productive factories that cater to the needs and desires of other productive members - namely people in categories 2 and 3 (they may also cater to the needs of people in category 1 but will not trade with them because they will get nothing in return).

People in categories 2 and 3 will just trade among themselves shutting people in category 1 out and will produce just enough to meet the needs of people that constitute categories 2 and 3. This reduces production and the GDP of the society falls. 

However, government can step in and maintain the four categories of people via the use of GOUs. This way:

1. People in category 1 can obtain goods and services from people in categories 2, 3 and 4 by handing them GOUs that they got from the government either via welfare or via working for the government.
2. People in categories 2 and 3 can exchange goods and services with each other.
3. People in category 4 can obtain their goods and services from people in categories 2 and 3 by handing them for GOUs that they got from people in category 1 as payment.

This way the people in categories 2, 3 and 4 can build up their savings via GOUs. Note the important point that the more GOUs are in circulation the greater the debt that the society carries. So ultimately, what this boils down to is the same scenario that was painted in http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html where some of the people will have to be supported by the government in form of either welfare or stimulus package for them in the hope that they will find something useful in the future (i.e. there will have to be a lot more government funded research programs like NASA, NSF and NIH).

In summary, if what Martin Ford is saying comes true then a lot more people will be in the employment of the government with the rich people in the society either bearing a higher tax burden and/or their assets will be in the form of continuously rising debt owed to them by the government. 

Gross Domestic Product (GDP): Nominal vs PPP

Wikipedia entry for Gross Domestic Product (http://en.wikipedia.org/wiki/Gross_domestic_product) says: Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.

GDP is a measure of how productive and hence how prosperous the people of a country are. Also, there are two ways GDP of a country is described - in Nominal and Purchasing Power Parity terms.

What does the GDP and the other terms really mean? 


In this post, we will understand them using the language of layconomics where we prefer to describe things without using the concept of money. Please read Real growth, prosperity and the standard of living and Why Layconomics? for some background.


To use the language of layconomics, we have to create two villages, A and B, as usual. Let's say, there are three people in each village. In village A, the first person produces three bags of grain every year, the second person builds three huts (that last a year each) and the third person sows outfits from dead animals' leather for clothing. However, it so happens that the clothing produced is enough to cover nine people instead of just three. The three people use barter to exchange goods and services. The exchange is as follows:

1. The first person exchanges one bag of grain for one hut with the second person
2. The first person exchanges one bag of grain for one outfit from the third person
3. Finally, the second person exchanges one hut for one outfit with the third person 

Hence, the third person has a saving of six outfits every year that can build up year over year (he is the rich designer of the village!). The village subsists itself via mutual exchange of goods.

Now, we can say that the Gross Domestic Product of village A is fifteen bags of grain. Why? Because:

1. The first person produces three bags of grain every year
2. The second person produces three huts every year where each is worth one bag of grain (as determined by the market value that one hut commanded)
3. The third person produces nine outfits every year where each is worth one bag of grain (as determined by the market value that one outfit commanded)

Next, let's visit village B. Let's imagine that village B is exactly the same as village A producing its own version of grain, huts and outfits. Therefore, similar to village A, village B also has a Gross Domestic Product of fifteen bags of grain. Therefore, we can say that GDP of both villages is fifteen bags of grain.

Let's also imagine that village A and B establish trade relations and exchange their excess outfits with each other. However, the exchange turns out to be favorable for village B, because village B's outfits are more desirable. Village A has to cough up two outfits for one outfit of village B.

Now, to GDP (Nominal) and GDP (PPP). To compare the GDP of both villages, we want to describe the GDP of both villages using a common denomination, maybe in terms of bags of grain from village A. We can do it in two ways. In the first method of comparison (Nominal GDP), we do this by taking the exchange ratio determined by trade into account. We can, immediately, see that the GDP of village B is twice that of village A. Why? Because every bag of grain of village B is worth two bags of village A grain. To see this, we note that the trade established between the two villages determined that every village B outfit was worth two village A outfits. And since the internal exchange ratio of village A determined that one village A outfit is worth one bag of village A grain and the same with village B, we can conclude that one bag of grain from village B is worth two bags of grain from village A. Therefore, we are forced to conclude that the GDP (nominal) in terms of bags of village A grain is fifteen bags for village A and thirty bags for village B.

Now, to the second method of comparing a bag of grain from village A to a bag of grain from village B. This method is used for describing the GDP of both villages in purchasing power parity (PPP) terms. In this method, we want the true value (not the one obtained from the exchange ratio determined by trade) of a bag of grain of village B in terms of a bag of village A grain. This is called the basic basket of goods required for sustenance. Going by the eating habits of both villages and the nutritional value of each grain, one bag of village A is determined to be worth exactly one bag of village B. Therefore, in terms of purchasing power parity the GDP of both villages is fifteen bags of grain of village A.

In summary, in this post, we saw that the relative prosperity of two countries can be artificially distorted by trade relations between the two countries and is solely determined by the goods actually traded. Also, we got a glimpse that a country's prosperity is better described by GDP (PPP) than by GDP (nominal). Here is a nice picture from Wikipedia to go along with this conclusion (http://en.wikipedia.org/wiki/File:Gdp_nominal_and_ppp_2005_world_map_single_colour.png).

Austrian vs Keynesian Economics - Investment from Savings vs Debt

This is the second in a series of posts where this particular layconomist tries to understand the major differences between the Austrian and Keynesian approaches towards future investments. Austrians claim that all investments have to come necessarily from society's savings whereas Keynesians are okay with taking on debt to make that investment.

In this post, we will describe some examples that illustrate the thought process behind the two approaches.

Austrian Village: Imagine a village that sustains itself through agriculture. The entire village is required to till the fields, sow the seeds, water the crops and finally harvest the grains. The harvested grains can sustain the village for a year. The villagers sustain themselves on the previous year's harvest while they prepare the ground for next year.  This cycle repeats every year. Note that the villagers' investments for the future (preparing the ground for the next cycle) have to come necessarily from their savings (i.e. the villagers have to sustain themselves from the previous year's harvest).

Austrian Village 2: Imagine another village that sustains itself through agriculture. Only half the village is required to till the fields, sow the seeds, water the crops and finally harvest the grains. The second half is required to scour the forest for arable land and lay the ground work for next year. The harvested grains can sustain the entire village for a year but the grains belong to only the first half of the village (that is responsible for growing the crops). However, the new lands found belong to the second half. While the scouting party goes looking out for new land it sustains itself by borrowing the grain from the first half which it repays by giving away the right to farm the new lands. This way the villagers sustain themselves on the previous year's harvest while they prepare the ground for next year.  This cycle repeats every year. Here, note that even though the second half builds up a debt which it repays at the end of the year, the overall debt for the society is still zero. Why? Because the debt built up by the second half is offset by the first half's savings. This way, again, the villagers' investments for the future (scouting and preparing the ground for the next cycle) come necessarily from village's savings (even though the savings actually belong to the first half).

Keynesian Village: Imagine another village that sustains itself through hunting. Here again, only half the village is required to go hunting but they have to go hunting everyday to bring enough meat for the entire village. The villagers do not have the ability to hunt enough meat and store the meat even for a day to have any "savings". Their investment for the future is to be able to identify new hunting grounds in time for sustainable hunting. The other half of the village is engaged in this task while the first half is off hunting. Here, there are no "savings" that future investments can arise from. The investments are actually coming from building up "debt" which is repaid as soon as the search party finds new hunting grounds. Till new hunting grounds are found, the searchers have to sustain themselves by borrowing from the hunters (with blessings from the village) with a promise of future repayment. This debt built up by the second half is not offset by any savings by the first half. So, over the course of the year the village as a whole builds up debt that it owes to the first half of the village. The village's debt is repaid as soon as the second half is able to identify new hunting grounds that allows the first half to engage in a fresh season of hunting.

As can be seen, both approaches are appropriate for their respective scenarios painted here. More importantly, the Austrian approach would have been completely inappropriate for the Keynesian village.

Since, modern societies are a complex mix of both scenarios and multiple others, investments for the future have to come from a mix of savings and debt. Here again, it is appropriate to highlight that in modern economies a fraction of population can sustain the whole society in terms of basic necessities - 1) food 2) clothes 3) shelter and 4) health.

Why Layconomics? Part II

For an effective democracy, informed populace is an essential ingredient. The direction the country takes and the policies that a government adopts are to a large extent dictated by the popular viewpoint held by the citizens. Hence, basic understanding of economics is essential to ensure proper policy enactment (and oh yes, to make the right call on long-term individual investment decisions). Just like people have a basic understanding of Physics, Biology and Mathematics, so should they of Economics. We believe people should be able to answer the following questions themselves without relying on experts.

1. Why is Gold valuable?
2. Why was there a real-estate bubble?
3. Is it austerity or deficit spending that is the reason for Europe's troubles?
4. Is the US dollar going to crash? Should the US dollar go back to a gold standard?
5. Is China in a bubble or in continued economic ascendancy?
6. How should the US tackle the fiscal cliff?
7. Should we adopt top-down or middle-out economic policies?
8. Is money creation good for the economy?
9. And many many more.

We have multiple vocal players debating each other on the questions listed above and calling each other out. Are we competent enough to understand the validity of a viewpoint or do we rely on other experts to tell us? Here are some of the multiple battles taking place in the media.

1. Robert Murphy vs Paul Krugman
2. Mike Shedlock vs Paul Krugman
3. Paul Krugman vs Ben Bernanke
4. Mike Shedlock vs Peter Schiff
5. Paul Krugman vs Peter Schiff
6. Austrian economists vs Keynesian economists
7. Keynesians vs Monetarists

Most of the debates use econo jargon which makes it very difficult for the lay person to understand what the experts are really talking about. Just look at some of the terms that are bandied about by experts to make their point.

1. Liquidity trap
2. Velocity of money
3. M1/M2 money supply
4. Capital theory
5. Surplus account
6. Current account
7. Debt-neutrality
8. Supply-side economics

Do we really need to familiarize ourselves with these terms to make some sense out of media "noise"? We believe that the current debate in the media between "experts" on economic concepts should not be esoteric and should be made understandable to people with exposure only to high school level economics. (By the way, here is a primer which starts people off in the right direction -http://www.econlib.org/library/Topics/HighSchool/HighSchoolTopics.html)

The goal of this blog is to simplify the prominent debates to layman terms and to hopefully provide the necessary information for readers to extrapolate the discussion to questions that they themselves find interesting. We would like to end this post with what we believe are appropriate definitions in the context of this blog.

Economics - Economics is the study of:

1. how a society organizes itself via co-operation and specialization of individual members' roles in production to be more effective in meeting the needs and desires of its members and,
2. the influence of various environmental, technological, political and pyschological factors on above mentioned effectiveness via any changes in the structure, specialization and co-operation within the society.

Layconomics - Layconomics is Economics as defined above with the added restriction of keeping econoSpeak to a minimum while explaining economic trends and without losing sight of the forest for trees.

Austrian vs Keynesian Economics, Deficit hawks vs Deficit Doves

In the last couple of posts, we had concluded that it is okay to not address the debt problem being faced by the US/Europe right away in the middle of a recession. The prescription we had in mind was to focus more on creating jobs rather than tackling the rising debt because the debt is not coming due any time soon. This is similar to the stand taken by Keynesian economists (most prominent of them being the nobel laureate - Paul Krugman) but completely contrary to that of Austrian economists (economists from the Austrian school of thought, the most prominent believer of them being Congressman Ron Paul who was bested by Mitt Romney in the Republican primaries).

Debate has been raging on between the two schools for a long time showing that economics is more of an art than science. Check out the highly popular debate between the two Pauls (http://www.youtube.com/watch?v=WEoGKpnutyA&feature=related ) on YouTube. If you don't make head or tail out of this highly anticipated debate - fret not! Here's the lay economist to the rescue.

Actually, we were concerned that the conclusions made in the last two posts went against traditional wisdom dished out to individuals - a) live within ones means; b) do not live off of potential future earnings. After considerable head scratching, we believe we are able to understand the assumptions made by the Austrian economists (as applied to our village) and we are still standing firm behind our earlier prescription.

Let's visit our village to get an idea of what Austrian and Keynesian principles are (Please read: http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html for some background). There we had seen that when recession hit the village, Wesley had three options.

1. Tax-cuts and easing of regulations
2. Active government stimulus
3. Quantitative Easing

If Wesley is of Austrian school of thought then he should choose option 1 and simply step out of the way, cut taxes and regulations and let the markets take their own free course. If Wesley is of Keynesian school of thought then he should follow the other options 2 and 3, namely quantitative easing  and active government stimulus (Again, please see: http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html).

The Austrian economists believe the following (among many others):

1. The boom and bust cycles are due to the power of issuing GOUs bestowed upon governments.
2. Governments are capable of abusing their power of issuing GOUs to distort the markets and fund unpopular programs that the governments believe are necessary.
3. If the government issues unlimited GOUs (like we had discussed in http://layconomics.blogspot.com/2012/11/is-public-debt-really-that-terrible.html) then it will cause inflation by lowering the value of GOUs. Why? Simply because there are too many GOUs floating around in the economy (this is not true - as we will see later).
1. Actually, the scenario the economists paint is even more dire where they predict the collapse of the entire currency market (e.g. the US dollar) - where the GOUs have no value and people holding tons of GOUs will be left holding the bag unable to exchange the GOUs for any goods of value.
4. The government should completely step out of the way and let the markets decide how to revive the economy.
5. The capital for investment should come from savings and not from debt (GOUs).

In our opinion, (Very Important - we keep raising this over and over) given that:

1. all the basic needs of the modern society can be satisfied by a segment of the society,
2. humans are capable of producing more goods if sufficiently motivated (elastic capacity) and,
3. the same humans are capable of finding new needs and wants (where none existed before),

the Austrian school of thought is a little anachronistic. 

Please consider the following arguments:

1. Somebody should have the power to issue GOUs or non government equivalents (IOUs) - Without IOUs, in a society where some of the goods have a shelf life (e.g. fresh food), future investments/savings and the GDP are necessarily lower. Let's see why. Without IOUs, productive members of goods (destined for immediate consumption) will only barter with other productive members, leaving non-productive members out of the loop even if they can be productive in the future. This will also mean that those productive members will only produce as much as required for their own needs and for the purposes of barter. They will not produce for the non-productive members, even if they are capable, because they will get nothing in return (remember! IOUs don't count) and any extra produce, if not immediately consumed, is wasted. This means that IOUs are important and GOUs which are IOUs with governmental backing carry even more weight.
1. In the US, the power to issue GOUs lies with the Federal Reserve (printing of money) and the power to issue IOUs lies with the banks (via fractional reserve lending).
2. More GOUs/IOUs does not necessarily cause inflation - GOUs/IOUs issued for goods are necessarily for consumption by currently non-productive members of the society (unless people misuse them for hoarding goods and speculation - even then production can rise to meet this imaginary demand). Note that the productive members have the capacity to expand production to meet the demand from the non-productive members given life via said GOUs/IOUs.
3. Power to issue GOUs need not be unlimited - In a democracy, no government has the power to issue GOUs endlessly to fund unpopular programs.
4. Issuing GOUs/IOUs increases real GDP - GOUs/IOUs issued to productive members increases production of goods of actual value (since they are for the consumption by non-productive members).
5. GOUs are definitely more popular than taxes - After all, who wants to keep producing something for nothing.
6. Booms and busts are related to investments regardless of whether they are from GOUs/IOUs or savings - Austrian school of thought claims that GOUs/IOUs allow for massive mis-investments causing huge busts when the investments don't pan out in unison. However, the potential to mis-invest does not lie with the government alone. Even private businessmen have the potential to mis-invest enmasse based on the latest hot investment idea (the housing and internet bubbles come to mind).

Given these arguments, it is clear to us that GOUs are not the monsters they are made out to be. Does this mean that we can let the debt build on itself forever as long as we can guarantee that people are able to use their GOUs to obtain goods and services as and when they want it? In an ideal situation, yes. However, the health of the economy is heavily dependent on the sentiment of the members. If the society suddenly loses confidence in the GOUs (because they get spooked out by the number of GOUs floating around) then the newer members of the society might stop accepting GOUs in exchange for their products. All the members in possession of GOUs thinking they have a certain amount of wealth will end up with nothing. This should give us a good idea why the Austrian school of thought appeals to the rich. After all, this guarantees there is no chance, however remote, of their wealth suddenly transforming to nothing.

Is it imperative to immediately tackle growing external debt?

We saw, in the previous post, how tackling internal debt is not really of immediate paramount importance for the following reasons:

1. It is a debt that people owe to themselves.
2. (Very important) As long as a subset of the population is able to satisfy all needs of the entire population, the debt can be transferred to the future (i.e. it will NOT be required to be settled immediately) and to top it off, new debt can be created because:
1. ALL immediate current needs of the productive section of society can be satisfied via exchange within the section itself - producers can exchange their goods for goods from other productive members of the society.
2. ALL future needs of all producers in the society can be satisfied via generation of new public debt. Producers can not expect their "needs" to be satisfied if those needs are not currently being produced by somebody else.
3. The productive members will be willing to produce for the non-productive members of the society as long as there is a promise of future pay off (new debt - similar to point 2 above).
4. People holding public debt can use that debt to obtain goods from productive members either in the form of higher taxes (in which case the debt is reduced) or in the form of debt transfer.
3. If required, the government has the power and authority to default, impose taxes and force productivity increase to address the debt. This step will only have to be taken if the part of the population holding the debt becomes adamant in using their credit to obtain goods rather than working and using their productivity to pay for their needs and wants.

However, does the same apply to external debt? External debt is different from internal debt because now the government does not have the authority to impose taxes and force productivity increase on creditors. Default is always an option but we are leaving that off the table for now. Will the creditors demand settlement, thus forcing the society to shed its assets and/or work harder to satisfy that demand?

We will see how in the case of external debt that it will not come due any time soon either. For that we have to understand how external debt is created and how at this moment the society of external creditors works.

We already know that external debt is created when a country (or society) obtains goods from another country with the promise of future pay-off. What is remaining is - understanding how the economy of the creditor country works.

We will limit our discussion to the situation currently involving the US, Europe and China. As luck would have it, China also satisfies the condition of a subset of its population being able to produce for the entire country. Keep in mind though that the goods that are "required" in China are much smaller in number than in the West (China has not graduated to a consumption based economy yet - please see http://layconomics.blogspot.com/2012/11/the-us-european-and-chinese-economies.html). Therefore, in China, there is a whole segment of low-skilled population that is not producing what Chinese citizens want. China has the following options:

1. Let that segment starve. This is definitely not desirable.
2. Put that entire segment on welfare by forcing the productive members to produce for the entire society. These are what we refer to as high taxes on productive members. This situation is not desirable either.
3. Put that segment on welfare by paying the productive members using GOUs (Government-owes-U) for their goods. This is better than option 1 and 2 but not the most optimal because it raises debt without any accompanying benefits. 
4. Put that segment to work in some manner or the other to make them earn their "wages". These take two forms:
1. Investment in the form of making them work on something that might possibly be useful in the future. This raises debt but also gives government investments that might pay-off in the future. BTW, the massive infrastructure projects being undertaken in China fall under this category.
2. Produce goods for the West hoping to get something in return. However, at the moment there are very few things the Chinese want from Western countries as is evident from the huge trade deficit. All China is getting are promises of future pay off. This is still better than options 1, 2 and 3 listed above.

(Very important) What the above means is that China will neither demand settlement nor stop buying more US/Europe debt because:

1. There are no goods that the US or Europe produce that the Chinese consider desirable (demand in China is still low for any goods manufactured in the West).
2. There are no goods that the non-productive population of China can currently produce that the Chinese consider diserable (demand in China is still low for any consumer goods produced by Chinese labor for Western markets).
3. As long as both points above are true, China has no choice but to employ its population in producing goods for the West and to continue accepting the US and Europe GOUs in return.

This picture will change, if:

1. The Chinese society gets transformed into a consumption based society where the goods currently being produced for the West become desirable within China. In that case, China might stop producing goods for the West in exchange for a simple promise of future pay-off and/or the price of the goods from China will go up. This is acceptable because this does not mean that the debt will have to be settled immediately. However, the citizens of the US and Europe will have to give up their expectation of low priced goods from China.
2. The US and Europe start producing goods that the Chinese consider desirable. In this case, China will demand settlement and the US and Europe will be obliged to work harder to settle that demand. This is highly desirable because it brings down the external debt while at the same time creating jobs in the West.

As you can see, there is nothing that shows that the external debt is disastrous and needs to be confronted immediately. However, it would be desirable to keep the debt from growing by reducing consumption of Chinese manufactured goods. Tackling external debt can be deferred to the future and this gives us a chance to focus on more immediate task of creating jobs instead of worrying ourselves sick about crushing debt.

Is public debt really that terrible?

 

Recently, every tom, dick and harry (and not to forget their brother) has been clamoring about the fiscal cliff looming in front of us. The cliff is in place to ensure that federal deficit and public debt do not spiral out of control. However, the following questions can be asked. Is such a drastic step of following through with the fiscal cliff really necessary? Is it really imperative for us to solve the debt crisis immediately in the middle of a recession? Finally, is public debt really this monster that it is made out to be? Let's explore using our village as the backdrop.

We have established in a previous post (http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html) that Government-Owes-U is what really constitutes public debt. We have understood that generation of GOUs only happens in those situations where people barter the goods they are producing not for other goods but for the promise of future pay-off from the government. The government instead of simply taking the goods away as "taxes", and creating an unhappy populace,  does the next best thing of giving them the promise of future pay-off for their goods (or services).

In our village setting, we saw that Wesley used the GOUs in the following manner (during the recession):

1. To support Debbie's and Billy's welfare.
2. To invest in Billy and employ him in building a bridge for the village and kickstart the economy.
3. To enable tax-breaks for Fannie, Henry and Taylor so that they can kickstart the economy by employing Billy.

 

However, Wesley can still use the GOUs even when there's no recession to:

1. Enable tax-breaks for Fannie, Henry, Debbie, Billy and Taylor so that they can invest outside the village and expand the economy further
2. Have the government invest in somebody outside of the village:
1. to prepare for the future
2. to expand the economy

 

In each case, Wesley's hope is that fulfilling the obligations for GOUs in the future will be easier because:

1. The economy has grown and the public's investment (via the government) has paid off. The government can easily share the returns of the investment back with the people.
2. The economy has grown and the public does not mind paying "taxes" in the future rather than in the present

As an aside, note that, in a perverse sense, it is the same villagers owning the GOUs who might be "taxed" to fulfil the obligations (this is actually true for internal debt) so fulfilling the obligations will involve paying oneself. Of course, people owning the GOUs will try their hardest to avoid being the ones who have to fulfil the obligations.  

To determine whether the debt problem should be tackled immediately by Wesley, it is imperative to note that GOU obligations will have to fulfilled immediately only if all three of the following conditions are true at the same time:

1. There is an immediate need for products that somebody is already producing that the GOU owners "need".
2. The GOU owner does not have anything he can use to barter for his "need"  (this is similar to Debbie and Billy's situation during the recession when they had nothing to barter for things that they needed).
3. (very important) The "in-demand" producer is unwilling to compromise on future pay-off for his product.

 

Since, all three conditions listed can not be true as long as a percentage of the population can fully support the entire village's needs, Wesley can rest easy that the "debt crisis" is not really an immediate crisis and he can tackle it at a better time in the future.

However, if the events conspire to demand action from Wesley then there are multiple ways for him to deal with the situation:

1. He can void the GOUs (default on the debt) and simply say that people should have actually paid taxes in the past instead of getting a pass like they did.
2. He can "tax" the villagers by allowing people to use their GOUs to demand from their neighbor a product that they "need". Exercising this option is what is called the "fiscal cliff".
3. He can sell the rights to public assets to fulfil the obligations (e.g. the bridge) - which works only if the in-demand producer thinks that he "needs" the bridge. This is what is called privatization to raise capital.

 

Otherwise,

1. He can wait for a time when people do not mind giving up something for nothing (when the economy is humming along) and reduce some of the obligations at that time. This would be equivalent to raising "taxes" during good times.
2. He can allow the GOUs to be transferred by letting in-demand producers to retain the GOUs and using them for a future pay-off (which is the best thing for him to do during a recession).
1. "But this is just delaying the problem" could be the refrain. If transferring the debt goes on ad infinitum there will come a time when there are people who are left holding the bag when there is nothing for them to redeem using their GOUs. However, this is an implausible Mad Max scenario and God forbid we ever get there because debt crisis will not be the worst crisis we will be facing at that point.

The US, European and Chinese economies demystified

In this post, we try to describe how some major economies of the world currently function by revisiting our village and understanding how it would look if it followed the model of each of those economies. We do this again without using the concept of money (only partly true because we use the concept of Government-Owes-U and money is nothing but a special form of GOU).

Note that what we are trying to describe certainly does not capture each and every nuanced detail of the economies. Note also that another layconomist might differ from us on the salient aspects of each economy that should be highlighted.

The US economy

If the village followed the current US economic model it might look like the following:

1. Wesley would be employed in the government and use his services to barter for produce, meat, shelter, clothes and GOUs. He might use IOUs to barter for toys. He would also be responsible for using GOUs to barter for produce, meat, shelter and clothes within the village on Debbie's behalf. Finally, He would be responsible for using GOUs to barter for toys with China on the village's behalf.
2. Fannie would be employed as a farmer and use her produce to barter for meat, shelter, clothes and GOUs. She might use IOUs to barter for toys. She would be paying "taxes" in the form of bartering her produce for Wesley's services.
3. Henry would be employed as a hunter and use his meat to barter for produce, shelter, clothes and GOUs. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his meat for Wesley's services.
4. Billy would be employed as a builder and use his shelter to barter for produce, meat, clothes and GOUs. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services.
5. Taylor would be employed as a tailor and use his clothes to barter for produce, meat, shelter and GOUs. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services.
6. Debbie is currently unemployed and using IOUs to barter for shelter, clothes and toys while getting produce and meat for free from the government (welfare). She might be training herself to produce something of value in the future that she can use to not only fulfil her IOUs but also to use for bartering in the future.
7. Main points:
1. The internal debt is in the form of GOUs to Fannie, Henry, Billy and Taylor that can be repaid whenever Debbie fulfils her IOUs. The external debt is in the form of GOUs to China that is balanced out by the IOUs that the villagers have to repay. The GOUs to China can be repaid in the future by having everybody work a little harder (if China is interested in what the village produces) which incidentally also allows the villagers to fulfil their IOU obligations.
2. The IOUs that people are using to barter for toys is what we would call consumer/credit card debt.
3. The GOUs that were used to barter for toys is essentially the $1.1 trillion that the US currently owes to China.
4. The $11.1 trillion public debt owed to Americans is essentially the internal debt in the form of GOUs to Fannie, Henry, Billy and Taylor.

European economy

If the village followed the current European economic model it might look like the following:

1. Wesley would be employed in the government and use his services to barter for produce, meat, shelter, and clothes. He might be using IOUs to barter for toys. He would also be responsible for collecting produce, meat, shelter and clothes from within the village in the form of extra "taxes" on Debbie's behalf. He would also be responsible for using GOUs to barter for toys with China on the village's behalf.
2. Fannie would be employed as a farmer and use her produce to barter for meat, shelter and clothes. She might use IOUs to barter for toys. She would be paying "taxes" in the form of bartering her produce for Wesley's services and simply covering Debbie's welfare.
3. Henry would be employed as a hunter and use his meat to barter for produce, shelter and clothes. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his meat for Wesley's services and simply covering Debbie's welfare.
4. Billy would be employed as a builder and use his shelter to barter for produce, meat and clothes. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services and simply covering Debbie's welfare.
5. Taylor would be employed as a tailor and use his clothes to barter for produce, meat and shelter. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services and simply covering Debbie's welfare.
6. Debbie is currently unemployed and using IOUs to barter for toys while getting shelter, clothes, produce and meat for free from the government (welfare). She might be training herself to produce something of value in the future that she can use to not only fulfil her IOUs but also to use for bartering in the future.
7. Main points:
1. In this particular scenario, there is no internal debt in the form of GOUs to Fannie, Henry, Billy and Taylor because Wesley instead of using GOUs to obtain the extra products simply got them by levying extra "taxes". The external debt is in the form of GOUs to China that is balanced out by the IOUs that the villagers have to repay. The GOUs to China can be repaid in the future by having everybody work a little harder (if China is interested in what the village produces) which incidentally also allows the villagers to fulfil their IOU obligations.
2. Alternatively, under the European model Wesley could have used GOUs instead of higher taxes to pay for Debbie's welfare just like in the US model described earlier. This would result in higher internal debt than in the US model because there are fewer Debbie's IOUs to balance out the higher number of GOUs issued.
3. The point to be highlighted is that welfare support in the European model is broader than in the US model. Broader welfare is supported either through higher taxes or by increasing debt or a combination of both.

Chinese Economy

If the village followed the Chinese economic model it would look like the following:

1. Wesley would be employed in the government and use his services to barter for produce and shelter. He would be responsible for using toys produced by Taylor to barter for the US and European GOUs. He would also be responsible for collecting produce from Fannie and Henry for Debbie. Finally, he would be responsible for using GOUs to barter for shelter and produce on Taylor's behalf.
2. Fannie and Henry would both be employed as farmers and use their produce to barter for GOUs and shelter that they will share together. They would be paying "taxes" in the form of bartering their produce for Wesley's services and Debbie's welfare.
3. Billy would be employed as a builder and use his shelter to barter for produce and Wesley's services. Wesley as part of the government also employs Billy to build more than required by other villagers in the hope that the shelter he is building will be in demand in the future. Billy uses the extra shelter he builds to barter for GOUs. He would be paying "taxes" in the form of bartering his shelter for Wesley's services and Debbie's welfare.
4. Taylor would NOT be employed as a tailor but as a toy maker using the know-how from the US and Europe. He would use his toys to barter with Wesley (who is acting as Taylor's proxy to barter with Fannie, Henry and Billy) for produce and shelter which he shares with Debbie. He would be paying "taxes" in the form of bartering his toys for Wesley's services and Debbie's welfare.
5. Debbie is currently unemployed while getting produce for free from the government (welfare) while sharing the shelter with Taylor. She might be training herself to produce something of value in the future to use for bartering in the future.
6. Main points:
1. There is some government debt in the form of GOUs to Fannie, Henry and Billy. There is no external debt and to put some icing on the cake there is external credit in the form of European and the US GOUs to China. China can use the GOUs to get something from Europe and the US if it is interested at some point in what those villages produce.
2. The productivity of Chinese farmers is lower than that of those in Europe and US because a greater fraction of the villagers are required to produce enough food for the entire village. This cuts down the amount of food avaiiable to each villager in China.
3. The villagers do not see any need to use their hard work to barter for clothes which they feel is a luxury.
4. The villagers do not see any need to own individual shelters when they can share it with somebody else. They would rather save (in the form of GOUs) than use their hardwork to barter for things they don't feel is a necessity.
5. Basically, the point to be highlighted is that the villagers are not making/producing something that other villagers would want. That is, China has not transitioned to a consumption based economy where people feel the need to satisfy their many desires. However, they are producing something that will satisfy the desires of inhabitants of other villages. For this they are getting Chinese GOUs in exchange. The Chinese villagers are holding on to their GOUs hoping to exchange it for something they might want in the future.
6. It's quite possible to exchange US GOUs for European GOUs and Chinese GOUs and vice-versa at some exchange rate that we will explore at a later stage.

Stimulus, tax-cuts, debts, deficits and Quantitative Easing

With impending presidential elections, there are divergent economic viewpoints (I would not call them ideologies because they are not all that different from each other) on how to best create jobs and lower unemployment. One viewpoint (republican) emphasizes cutting taxes and easing regulations while another (democratic) emphasizes raising taxes and government stimulus to create jobs. There is yet another approach (the Federal reserve) that involves printing money and providing easy credit to businesses and individuals to spur demand and hence employment.

Let's try to understand the three approaches with the simple village scenario in mind and we will do this again without involving the concept of money. Our village, if we have not already seen it, is operating on free-market principles with government oversight and government provided services.

The village has been humming along with Wesley the wise, Henry the hunter, Taylor the tailor, Fannie the farmer, Billy the builder and Debbie the designer. Here, we have to understand that Henry, Taylor, Fannie, Billy and Debbie are all paying "taxes" in the form of paying Wesley with grain, clothes, shelter, meat and footwear in exchange for his administrative services (policing, resolution of disputes, enactment and enforcement of laws and regulations etc. etc.). Also, the economy has matured in the sense that food supply is guaranteed. I.e. The village does not and will not experience recession with lack of food as the underlying reason. Does this mean that the village can never experience a recession? Not really, as we will see.

Before moving on, we will take a look at some of the regulations/law that Wesley had laid out for the village. The regulations are the original "ten commandments" along with an eleventh arbitrary one:

   11. Thou shalt not cross the river.

Now, we come to the recession bit. As luck would have it, the weather's improved considerably over the years and Billy's shelters and Debbie's footwear are lasting much longer than expected. People no longer feel the need to have Billy rebuild their shelter and Debbie replace their footwear on a regular basis. I.e. the demand for Billy and Debbie's products has gone down. Henry, Fannie and Taylor would rather save their grains, meat and clothes for later rather than barter them for shelter and footwear now. Billy and Debbie find themselves underemployed and with little means to pay for food and clothes. They will have to rely on their fellow villagers' charity.

Wesley the wise, however, decides to tackle it differently. The options available to him are:

1. Raise taxes on Henry, Fannie and Taylor by making them give up the extra grain, meat and clothes and put Debbie and Billy on "welfare" by giving them the food and clothes needed to survive.
2. Raise taxes on Henry, Fannie and Taylor and put Debbie and Billy to work on specific projects that he thinks will help the village and grow the economy in the future. This is what we would call "stimulus".
3. Put Billy and Debbie on "welfare" after handing Henry, Fannie and Taylor GOUs (Government Owes You) for their grain, meat and clothes, that they can use to exchange in the future for some goods of value. The GOUs are what we would call "government debt". Creation of "government debt" was Wesley's way to tackle the "deficit" problem where he needed to spend more (on Billy's and Debbie's "welfare") than he was getting in "taxes". Of course, paying off the GOUs will require increased tax revenues in the future but that's for later.
4. "Stimulate" the economy by employing Billy and Debbie and creating a "deficit". Tackle the "deficit" by printing and handing Henry, Fannie and Taylor GOUs and raising "government debt" instead of raising taxes.
5. "Stimulate" the economy by printing and handing Debbie and Billy GOUs (provided that they can pay it back in the future with interest - i.e. Wesley exchanges GOUs for Debbie and Billy's IOUs) that they can use to "buy" food and clothes for themselves. This is what we would call "Quantitative Easing".
6. "Stimulate" the economy by cutting regulations, not raising taxes and making it easier for Fannie, Taylor and Henry to employ Billy and Debbie.
7. "Stimulate" the economy by cutting both regulations and taxes and thus creating incentives for Fannie, Taylor and Henry to use the extra money to employ Billy and Debbie. How does Wesley "cut taxes"? Instead of simply providing Fannie, Taylor and Henry with administrative services in exchange for food and cloth he gives them additional "GOUs" for their goods. Effectively, Fannie, Taylor and Henry would have paid no taxes since they have the "GOUs" that they can essentially use in the future to retrieve their goods back.

Obviously, nobody wants options 1 and 3 to continue forever because nobody wants "moochers" in the society. Therefore, the viable options open to Wesley are:

1. Government stimulus via raising taxes (option 2 above)
2. Government stimulus via raising government debt (option 4 above)
3. Stimulus via Quantitative Easing (option 5 above)
4. Stimulus via cutting regulations (option 6 above)
5. Combination of one or more of the above

In the specific scenario mentioned here, Wesley can:

1. Remove the regulation of "Thou shalt not cross the river" and employ Billy to build a bridge across the river ("stimulus") while keeping Debbie on "welfare". In this case, the village will own the bridge.
2. Remove the regulation and provide a loan to Billy, while keeping Debbie on "welfare", hoping that Billy will have the wisdom to build a bridge himself ("QE"). In this case, Billy will own the bridge while paying the government off from revenues he might generate from operating the bridge.
3. Remove the regulation and hope that Fannie/Henry/Taylor will employ Billy to build that bridge ("tax-cuts") while keeping Debbie on "welfare". In this case, Fannie/Henry/Taylor will own the bridge and profit from their investment into Billy.

What would this do? Building the bridge will open access to precious and scenic land on the other side of the river and who knows, maybe, Billy will get the idea of building and operating a gated community of beautiful villas on the other side of the river that people will want to own. This will give Debbie the chance to change her vocation and gain employment by becoming a property manager in the gated community. Maybe, Fannie will find more nutrient rich land to raise silk worms or better quality of cotton to generate even more luxuriant cloth for Taylor thus raising the standard of living for everyone.

However, on the flip side, it's quite possible that the arbitrary regulation was not so arbitrary after all. Crossing the river might open the village to attacks from the neighboring village and endanger the current way of life. Blind cutting of regulations might not be the universal answer to economic recession.

As you can see, even in such a small village, there is no single approach that one can point to that is guaranteed to work while the others fail. If we extend the argument to an entire country employing millions of people in "services" what is to say which approach will work and which will not.

The important takeaways from this post are:

1. In the current economy, most of the people are employed via exchanging "services" with each other.
2. In a services based economy with guaranteed supply of basic amenities, recession is only possible when demand for certain kinds of services dries up. Economy can pick up again if out-of-demand services can be replaced by new services that catch people's fancy and generate new demand for those services. I.e. a new want can be created where none existed before.
3. The government can create new demand by loosening corporate credit that will allow companies to invest in new R&D or by loosening consumer credit that will allow consumers to borrow and spend, thus creating a new wave of demand. However, if loosening credit does not spur the economy the government might have to step in and create employment to restore consumer confidence and create fresh demand.
4. In the current economy, it is quite possible to have half the society on welfare while the other half works to provide all the basic necessities for the entire society. However, this is not acceptable to anybody believing in "free market".
5. There is no single recipe for stimulating the economy. Republicans touting small government, tax-cuts and easing regulations as the universal recipe do not possess that magic bullet. Nor do democrats when they are touting government stimulus, tax-hikes and more regulations as their answer to the current economic recession. What will work and what will not will depend on specificity of the situation. If you look carefully, both democratic and republican approaches raise "debt" and create "deficits". The differences between democratic and republican approaches are in:
1. Who makes the investment decisions? The government or private individuals? It all depends on who the wiser people are at the moment. If Wesley was not wise, then it makes more sense to let Fannie, Taylor and Henry make the call on making the right investment. After all, they are the only ones doing well in the bad economy.
2. Who benefits from the approaches? In the current economy, both approaches have the potential to increase GDP and raise the standard of living. However, with the republican approach the wealth gets concentrated in the hands of the already-haves.
6. Most probably, what will work is a mix of all three approaches ("stimulus", "tax-cuts" and "QE") because in such a large society as ours there are bound to be people who will be able to make use of "QE" to start new businesses, people who will require the government to provide them with employment that makes use of their current skills, people who will have to go on welfare and finally, people who will start new businesses if restrictive regulations are lifted.