Economics … Monetary System and GDP explained

To understand economic issues, we need some understanding of GDP and the monetary system. I have constructed a few simple tables based on a primitive economy that should help to show what GDP actually is, and demonstrate how the monetary system works … you might even be able to conclude that “there is no money!”

A basic primitive economic model:

Business A has a rock which has lots of shiny bits in it … sells it to Business B for two shells

Business B throws Rock in a fire and extracts a lump of metal … sells it to Business C for 4 shells

Business C fashions a sharp point out of metal … sells it to Business D for 6 shells

Business D attaches point to a long bamboo cane … sells it to Business E for 10 shells

Business E sells it to Citizen F for 20 shells

Throws it at a deer … the bamboo breaks and the deer runs off with metal point embedded.

A few observations … The community started with 20 shells plus a rock with shiny bits and finished with only 20 shells. Our natural reaction would be to say that the community has lost a stone with shiny bits.

The Economist is not so much concerned with the profit or loss, rather with the sum of the activities of the business community, sold to the population.The sum of Outputs – Inputs. In our little table the column GVA represents Gross Value Added, or more simply Outputs – Inputs.

The Column I represents investment and in this case the investment in stock that has not been replaced. The Column C represents the purchases from business by the citizens, or their consumption. M represents Money as we perceive it. SP represents the Gross Selling Price or total output of the business.

Table 1.

If we look at the table we see that

GVA = C+I (Sum of Values Added = Consumption + Investment)

This figure is known as GDP. (GVA = C+I = GDP)

We have come to look on GDP as the size of the economy. Activity would have been better description than size.

If we do a few experiments changing the price at which E sells to F we see that this will either increase or decrease our figure, without increasing the quantity of goods being produced. From this we should be able to see that GVA or GDP (to use our common term) can rise or fall without an increase or decrease in the physical outputs. This makes it clear that GDP is not a sound measure of the actual size of outputs by an economy!

To decide whether there has been growth in an economy we compare this figure with a previous years figures and apply an adjustment for inflation (changes in pricing relative to the previous year). As we are not actually measuring outputs (difficult in a diverse economy) the accuracy of this adjustment is imperative, if we are to believe claims of growth.

We should also have noticed that the actual quantity of money within our little model did not change as a result of the transactions, it only changed hands and is therefore available for more transactions. The important thing is that it must flow back into the hands of the consumers, and this generally happens by the businesses paying wages and or distributing its profits to the shareholders.

Adding imports and exports to our model.

At the simplest level we will say that A used his two shells out of the sale to purchase another rock with shiny bits, from the neighbouring tribe, to replenish his stock.

Instead of showing a negative investment (dwindling of stock) it now shows no movement in investment (he started with 2 and he is back to 2).

We need to adjust the economists formula to cater for external trade.

Therefore:

GDP = GVA = C+I-Imp+Exp

Obviously the value added does not change as the import is simply an input to the business while an export is simply an output albeit not a sale to one of our citizens.

Table 2

We do see however that the quantity of money within our community has dropped as a result of the import. Even if the businesses paid out all the money by way of wages or profit distributions our citizenry would not be able to afford to purchase a spear from E were the original sequence of transactions to be repeated.

To repeat the transactions someone is going to have to incur debt.

Banking gets added to our equation and for a time it will suffice to allow the transactions to continue flowing, but, the debt burden on the people will continue growing,as long as imports exceed exports, slowly consuming our stock of shells.

At this stage we have been looking at a model with a scarce commodity as it’s currency let us call it a “gold standard”. My own beliefs, as they have evolved, are that there should be some solid standard at the heart of any monetary system. I am not too concerned whether this is a physical asset … gold or some other commodity … or whether it is a system that limits the ability to consume more than is produced.

It should be obvious, to most, that if we consistently consume more than is produced there will come a time when there is nothing left to consume. It may not be on the immediate horizon, however, it is a point in the future no matter how distant it may appear.

In essence we need to export at least as much as we import to be able to sustain our economy, otherwise our foreign debt level will continue growing to the point where foreign companies eventually control all our industry.

Let us revise the model to take into account banking, which many believe solves the problems created by a “gold standard”, where unless one is producing as much as one consumes one eventually runs out of money.

Instead of shells we will call our money, units of government debt. Within an economy that operates on a “fiat” monetary system (without any physical asset backing), The primary money within the system is government debt. The reason it is the primary money is simply because government debt implies that the population as a whole are guaranteeing the payment of that debt. Whenever the government runs at a deficit we the people are going to have to pay that deficit at some point in the future through our taxes.

In the UK we have granted our banks the right to create money, virtually without limitation. In many other countries there is a strict relationship between government debt and the amount of credit banks are allowed to advance. Bank money or Bank credit is simply IOUs between the Bank and its customers or depositors.

Using Table 1 and adding required columns.

I have added a column M1 which represents government debt and assumed that all the government debt is owed to the Bank. The column M now represents deposits by the population in Banks. You will note that I have reflected the total of column M (now Bank Money) as zero. As government debt is actually a debt of the population (which they hope they never have to repay) I have shown it as a negative in the column M.

Table 3

The perceived money in the economy is the total in column M1 which exists only to the extent that we believe the promise of the population to guarantee that they will ultimately pay the government debt

If we repeat the first set of transactions, this time using bank money and assume that A went out and dug out another rock with shiny bits the result would be as follows:

Table 4

After the second round of transactions we see that the value added column has grown to 38 and our economist sum still results in the same number.

Consumption + Investment = Gross Value Added = GDP

The total quantity of money circulating within the economy is still zero. However in our example A, B, C, D and E all believe that the banks are looking after their money.

Therefore within a closed economy with the Banks given the right to create infinite money (The UK model) we should be able to see that the economy will support an infinite value of transactions, provided all people with balances in the banks believe the banks will be able to repay them.

Whether this can perpetuate is open to doubt. Sooner or later some people will start wondering about the wisdom of the bank that keeps on lending money to someone who:

always breaks the spear

instead of

bringing back the deer!

Now if it were A and E who started doubting and approached their banks to withdraw their deposits, the banks would not be able to meet their requests and the banking system would start collapsing.

A run on Northern Rock commenced as a result of their lending 125% of the purchase price to the purchasers. Someone doubted the wisdom of the bank, and suddenly everyone else wanted their money before it ran out!

If we consider the models above carefully we should come to the conclusion that adding banking to our primitive economy, where money was based on an asset, has done little apart from making transactions easier in the face of a limited supply of the asset which was used as money. The economy has however become dependent on the wisdom of the banks in limiting their risks, while maintaining reasonable access to money for the population.

In our primitive economy we saw that, by adding external trade, the actual supply of money would fall if we had a surplus of imports over exports. It must be understandable, to most, that a trade deficit (imports exceed exports) must weaken the economy. This situation continued to exist when we added banking to the system.

The difference is that, the foreign country is not forced to accept our bank money and may well ask for hard currency (assets) instead!

This may seem remote, but if we look at the UK, we see evidence of this happening. We see an increasing trend for ownership of our businesses to be moving abroad. Primary examples being in the utilities sector.

Analysing our National Accounts shows that over the past two decades we have moved from a position where we had a net income from our Investments abroad exceeding our trade deficit, to a position where the dividends flowing out of the country more than counterbalance that income.

We are told that it is not important where the ownership lies. We are told that this is an indication of how good our economy is, that this is inward Investment into the UK. In a way, this is true but not entirely so, it can also be an indication that foreign countries are less inclined to holding our promissory notes (currency) and are starting to convert their sterling holdings into assets.

While ownership does not impact on GDP directly, it does in another way. We can only show growth (increase in business activity) if the resources flow back into the hands of the consumer by way of wages and profits. The profits from business activity flow back to the consumer, or should I say shareholders, by way of dividends.

We may not see this, with most of the shares in the stock exchange being held by institutions, but even those dividends going to pension funds are ultimately ending in the hands of the pensioner or the consumer. If we are reducing the amount of dividends flowing back to UK residents, we are reducing the growth of the incomes of UK residents.

Economic growth that is dependent on increased borrowings by the consumer can never be sustainable. If ownership of our businesses is increasingly non resident, growth will be stunted as the profits from those businesses will not supplement the incomes of the population. Economic growth can only come from growth in peoples’ incomes!