Basics of real world economics

Not a game post.

Many people believe that economics is a highly complicated science which is hard to understand. But in reality economics is like any other science: It has some very easy to understand basics, which were discovered hundreds of years ago, and are now taken for granted by the scientists. And then there are the modern bells and whistles, going into minute details, and obscuring the layman's view on the basics. In consequence today most people believe that the current financial crisis was an unforeseen consequence of complicated financial wizardry, and that it is unclear what lies ahead. But that is not correct: What was unforeseen then, and is unknown now, is just details. Nobody knew when exactly the financial crisis would strike, which banks would go under, and nobody knows how long the current recession will last, and what other companies will go bankrupt until it ends. But just looking at the fundamentals it was clear years ago that some sort of crash was coming, and it is clear now how the long-term future will look.

Economics get extremely easy to understand if you just forget about money. Then it becomes very clear that on the one side of the economy there is consumption, people consuming goods like TVs, and services like haircuts. And on the other side of the economy there is production, workers producing TVs, and barbers providing haircuts. And the fundamental truth is that consumption can not be higher than production. You can't get more TVs or haircuts than there are TVs produced and haircuts provided. In the case of services, haircuts in our example, it also is clear that there can't be more haircuts provided than consumed. In the case of goods there can be more TVs produced than consumed, but not for long, because soon you'd have warehouses full of TVs nobody wants. So overall consumption is always equal to, or slightly lower than, production. Worldwide.

Money is just a tool which allows people to exchange work. The barber sells hundred haircuts for $10 each, then buys one TV for $1,000 with the money. If there was no money, the barber would have to persuade the hundred people involved in building a TV to each receive one haircut in barter exchange for them producing a TV for him. That only works in extremely simple economies. So people basically agreed that money was a token of work provided. You agree to accept money for your work instead of payment in goods, because everybody agrees that money has a worth, and will accept money in exchange for their goods and services. Money in itself has no worth, it is only that agreement to accept it for goods and services that makes money have value.

Money not only eases exchange of goods and services, it also allows you to store wealth by saving, or to temporarily consume more than you produce by borrowing. Taking on debt is a simple promise that while you consume more than you produce now, you will consume less than you produce in the future, and with the excess pay back the debt plus some interest. But whatever complicated form this debt takes, sub-prime mortgages, collateralized debt obligations, or what else, this doesn't change the fundamentals of economics: Consumption can not be higher than production.

What happened over the last decades was that the people in some countries, most notably the US, continuously consumed more than they produced. And other countries, like China, produced more than they consumed. Everybody either knew that, or could at least have known it, as it was printed in many a newspaper, magazine, or all over the internet. And many people with knowledge of basic economics repeatedly pointed out that this was unsustainable. At some point you have to stop consuming more than you produce, and reduce your consumption to below the value of what you produce, to pay back your debt. Many people also pointed out that cheap debt not only lead to people consuming more than they produced, it also lead to them borrowing money to invest into assets, on the mistaken belief that the value of these assets would continuously go up, so the debt would repay itself. Again everybody knew, or could have known, that this was not sustainable.

The actual surprise of the current financial and economic crisis is not that it happened, but that it happened so late. Many people had assumed the system to crash a lot earlier, which actually might have been better than letting instabilities build up further. And of course nobody could foresee the actual exact sequence of events, which is why even people aware of the problem lost money.

Looking at the fundamentals, the course of action to take is extremely simple: Americans need to consume less or produce more, Chinese need to produce less or consume more. Unfortunately it isn't obvious how the US could suddenly produce much more in goods and services, so a reduction in consumption seems inevitable. Nobody likes to reduce his consumption. It has repeatedly been shown that happiness is not a consequence of the wealth that you actually have, but a consequence of you feeling that you get wealthier, consuming more. Consuming less also means consuming different things, because you'll not cut your consumption evenly when you have to. Luxury stuff like massage chairs go first, while you'd cut food consumption only in the gravest circumstances. But that means that an abrupt change in consumption behavior means the workers previously busy producing massage chairs are unemployed, earn leass, thus can consume even less, and the whole economy spirals into a recession.

Thus to fight the recession, governments all over the world are now doing exactly that what got their economies into trouble in the first place: Taking on debt, and making money available cheaply by lowering interest rates. Again everybody knows that this is unsustainable, but it is meant as a temporary measure to smooth out the economic cycle, so that the economy is not dropping of a cliff with painful consequences. The inevitable point at which overall consumption has to be reduced to be less than production is postponed, debt builds up further. The national debt clock of the US shows an overall national debt of over 11 trillion dollars, or $38,000 per US citizen, and is growing every day.

Now sooner or later the Chinese, and other creditor countries, will want their money back. Many people lament how this will take forever, and the current generation will leave a huge load of debt to the next generation, if not generations. But this assumes a constant value of money, and a willingness in the future of people to consume less and work more. It is not certain that this will happen, because it would be extremely painful. There is another way to pay back the debt, which is basically cheating the creditors, and thus a lot less painful to the debtors: Inflation.

While everyone pretends they are against inflation, inflation is actually not universally bad for everybody. Inflation is good for people with debt, because the value of their debt decreases without them having to do anything. Inflation is neutral to people who work and spend their earnings, because wages go up roughly in step with price increases. Inflation is extremely bad for people who have money, because it decreases their wealth.

Inflation happens if the government prints more money than there is value produced by their economy. Imagine the US government starts their printing presses and prints 11 trillion dollars, using them to pay back all the national debt. This is possible, because the debt is in dollars, not a foreign currency. So suddenly all the debt is gone, but there is a lot more money around. And as explained earlier, money hasn't got inherent value, it is only a token for real wealth and work. With more dollars around, but the amount of stuff that can be bought being unchanged, the value of the dollar falls, and everything just gets more expensive. Legally the creditors have been paid back, but the dollars they received now are worth less than the dollars they originally lended out.

Of course this won't happen as obviously as I described. The US will not print 11 trillion dollars at once, load it into a container ship, and send it to China. But it is extremely likely that this is a process that will happen slowly, and gradually. A bit of simple math shows you that just 7% of inflation means your debt or your wealth halves in value in 10 years. Inflation is a hidden form of redistribution, from creditors to debtors. If you have a fixed rate mortgage, inflation is higher than the mortgage rate, and your earnings raise in line with inflation, your mortgage is basically paying itself, while whoever lended you that money is losing out.

Of course inflation has its negative sides too. The next time you want to buy something from another country, for example oil, you'll find that it will be a lot more expensive, as the value of your currency has diminished. And the next time you want to borrow money, you'll find the creditor wants a higher interest rate, or insists you borrow the money in a stable currency you can't print yourself. But overall, printing money and having some inflation is going to be a lot less painful for the US than the alternative of reducing consumption a lot. Which is why it is quite likely that inflation will happen. It is just basic economic fundamentals. Again, nobody knows when and at what rate this will happen, and the exact details. But just as people knew or could have known the basics of how we got into the economic crisis, the most likely way out is also known. Just don't believe the people who in a couple of years will tell you they have no idea why suddenly inflation like in the 70's is back, when it appeared to have been conquered in the 90's.
- posted by Tobold @ 9:26 AM Permanent Link