Economic Model Dynamics

Note: In the last round of QE, food prices rose by 60% in some regions around the world, which triggered a humanitarian crisis for the 2 billion people living on less than $2/day. As a general a rule of thumb it is assumed that when food prices consume more that 40% of income, societies starts to destabilise. Therefore, it is far from clear that the present economic global strategy is sustainable unless the rich 1% can live without the 99% and defend itself from them.

Let us initially anchor this discussion to an earlier simplified model, which  shows just 4 internal components of the  economic infrastructure of a nation-state, i.e. government, industry, people and banking. While this model maybe generally representative of some of the basic interface exchanges within a nation-state economy, it does not really reflect the dynamics that takes place within this system, especially when considering some of the issues discussed under the heading: Historic Background. This said, it is possibly worthy of a brief outline before expanding some further details.

In this somewhat static model, the government collects taxes to pay for public services including its military. As such, the government is a major employer of people that also buys products from industry and, when necessary, borrows from banks to cover any deficit in its expenditure. Industry then accounts for all goods and services sold for profit on which it must pay taxes to the government, while employing people who also pay taxes on their wages and repaying any bank loans with interest.

Note: In the context of the model above, we can define the economy as the sum of all transactions that take place within some geographical region within some measured timeframe, which might be quantified in terms of the Gross Domestic Product (GDP) or Gross National Product (GNP). While GDP and GNP are both measures of economic activity, the scope is different. GDP is a measure, or estimate, of the domestic level of production, whereas GNP is a measure, or estimate, of the overall production of any person or corporation associated with a nation-state. As such, the US GNP is a measure the production of any US owned entity, irrespective of where this production takes place. So while GNP may be less commonly used, it possibly better reflects the measure of national output although GNP can be either higher or lower than GDP. For example, China's GDP is greater than its GNP, because a large number of foreign companies manufacture in China, while in contrast, the US GNP is greater than its GDP, because a large amount of its production takes place outside of the US national or domestic borders.

While people in the model above are representative of the population as a whole, only a smaller section of this population may have jobs and earn wages that contribute taxes to the government. There is also another overlapping section of the population that will receive public services and benefits, while generally all sections buy products and can apply for bank loans that can have varying rates of interest. Finally, there is a banking system, normally comprised of a central bank and many private banks, where the latter is generally responsible for issuing loans, again, with a broad range of interest rates. However, as indicated, this simplified model does not really explain the scope of the dynamics that can now affect most modern economies. At one level, the dynamics of the economic system is driven by a multitude of different types of financial and commodity transactions taking place, which are normally conducted as electronic transfers based on credit or fiat currency exchanges, rather than money based on gold or silver. As such, many of these transactions have no intrinsic monetary value, i.e. they are essentially based on promissory notes, i.e. an IOU, by the buyer to the seller for some asset, i.e. goods, services or commodity.

Note: The reason for highlighting the IOU nature of a promissory fiat currency, or credit, is to also highlight a degree of fragility in the dynamics of the economic system, as a whole, should any of the ‘players’ within this myriad of transactions start to default on their debts, which might then lead to a loss of confidence in the market and possibly wholesale panic. In such cases, the value of a promissory fiat currency, or credit loan, can quickly fall towards zero.

At this point, we should also highlight another ‘dynamics’ introduced into the economic system by the charging of interest on loans, especially when viewed from the perspective of the sum total of national and private debt. The basics of this system has been previously outlined – see Banks, Money & Loans plus Central Bank Reserves and Private Bank Money, although it might be worth highlighting a story by way of some further historical background.

Note : At some point in history, it is said that traders started to deposit their gold and silver coins with local goldsmiths, because they own the strongest safes. In return, the goldsmiths issued them with a paper receipt, which in-turn started to be used as a form of fiat currency that began to be traded in preference to gold coins.  However, it did not take long for this class of ‘goldsmith’ to noticed that only about 10-20% of their receipts were ever redeemed at any given time. As a consequence, they started to ‘lend’ against not only the gold reserves they held on behalf of others, but actually exceeded this value, as they only required the 10-20% figure to meet the demand for gold to be redeemed.

 

 Today, we might realise that the goldsmiths were  acting as bankers, who were effectively creating a form of fiat currency that exceeded the actual gold reserve held by a factor of 5 in the example cited. However, should we assume a compound interest rate of 5% on loans issued, this interest would double the amount of currency in circulation every 14 years. While this might only be regarded as an anecdotal story, figures released by the US Federal Reserve suggest that the currency supply in the US has doubled every 14 years since 1959, while the graph illustrates an effective devaluing of the purchasing power of the US dollar since 1913. As such, we need to consider whether this graph is reflecting the dynamic implications of interest charges in the economy, if it also creates new currency, which in the case of the US far exceeded its gold reserves by the 1960’s and led to the Bretton Woods Agreement being abandoned. The subsequent adoption of a floating exchange rates between fiat currencies means that market confidence simply rest on an assessment on a given economy to pay its debts, especially the US. Of course, today, many mainstream economists are quick to point out that responsible governments no longer simply print currency, although the mechanism called ‘quantitative easing’ has been challenged by other economists as simply a convoluted means of injecting more currency into the economy, in excess of its gold reserves, such that it still amounts to the creation of new debt that is not and cannot be addressed. Therefore, the next discussion will attempt to model some of the dynamics within this mechanism.