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.