It’s now been 16 weeks of posting every Friday, and I’ve reached the end of a series of posts setting out some fundamental concepts. I thought it would be useful to pause and summarise what’s been said so far. (This is a slightly longer post than usual, but it’s quicker than going back through the previous 15,000 words!)
The first 3 posts introduced the theme of the whole blog – asking how we could, as one human race on one planet, create an economy that provides enough for everyone to have a decent, basic standard of living. At the heart of this question is the productivity of our economy – can we actually produce enough. But what we produce also needs to be distributed to everyone, and all people need to be able to earn the income to purchase what they need. And in addition, we need to be able to do this in an environmentally sustainable way.
On the key question of productivity, I pointed out in the third week that businesses cannot simply focus all their resources on producing the maximum amount possible now, they also need to invest for the future. So a key question is how our savings (such as our pension funds) are used to fund investment – what kind of economy are those investments (funded with our money) creating?
Having set the scene, I then set about introducing some key economic concepts. I used the analogy of a car engine – the economy is a lot like an engine in that it’s an intricate system that functions according to a logic that is, in its own way, quite beautiful. And it’s also like an engine in that you know the names of some of the main parts, you like to think you basically know what they do, but faced with all its complicated messiness you don’t really have a clue. What I tried to do over 13 posts (all gathered under the category “Models” in the menu bar above) is strip the “engine” of the economy and then put it back together piece by piece.
I started by imagining a very simple economy in which everyone is happy with what they have – the economy produces exactly the same goods each year, people consume the same and therefore spend the same amount, and prices remain the same. And importantly, all money is cash – there are no banks, electronic money or financial assets. This is how I intellectually “stripped the engine”. I then examined logically the impact on this very simple economy if one person started to save (or equally, you could imagine that saving becomes a trend and lots of people start saving). By holding all the other aspects of the economy constant, we could observe in isolation the dynamics of saving – and so plug the saving component back into the engine. From there I built the engine back up through a series of models, and here is a summary of some of the key points.
Increasing productivity requires investment (I explain the economic definition of this term in the relevant post). But investment requires credit – you need to have funds up front to purchase investment goods that will then pay for themselves as they are used over the following years. And in fact, the relevant post points out that credit is ubiquitous and essential to business.
But increasing productivity will cause prices to fall unless you also increase the money supply (read the relevant posts if you can’t see why), and deflation is a bad thing because consumers will start holding off purchases in the hope prices will fall further, causing the economy to choke. So an economy with increasing productivity needs an increasing money supply. This new money has to enter the economy somehow, and providing credit to businesses is way one to achieve this – government simply spending the money into the economy would be another.
The importance of credit in funding the functioning and development of business means that the allocation of credit is a critical issue in determining the direction of the economy. The analysis of this concept led to a foundational concept of this blog, that I have returned to several times since:
Decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the path the economy takes in the future.
The next series of posts on the blog will pick up this theme, and explain how money is created in the modern economy through the allocation of bank credit.
In the subsequent weeks I added a simple version of banking (still imagining a cash-only world, with no electronic banking, debit cards or even cheques). In fact, I described “fractional reserve banking”, which is the model given in economics textbooks even though this is not how banking operates in the real world. Then I added chequebooks and the bank clearing system, and then financial assets.
And with all these models I considered the impact of saving on the economy. In a simple, cash-only model, saving causes the economy to slow-down. Because those who are saving aren’t spending, businesses lose out on the income, and then they have less to spend and so there is a knock-on effect to other businesses. This is called the paradox of thrift, a concept explained in my first post on saving and then revisited in Saving parts 2, 3 and 4.
You might think that one person or business saving contributes to the saving of the nation as a whole (national saving) – it’s an easy mistake to make, and one often made by economists and journalists. But the value of the impact of that saving depends on how it is put to use. If it is simply hoarded away (e.g. as cash in a safe) it will cause the economy to slow down, and the saving of wealth by some will simply be balanced by the reduction in wealth for others. One person’s saving can be another person’s dissaving. If the saving is allowed to flow back into the economy through intermediation (explained below), it’s impact depends on which parts of the economy it flows to.
This is another dynamic examined in all the models. It’s very important not to assume that all acts of saving are adding to national saving – what turned out to be true in all the models is that national saving is only possible through investment in actual physical things (fixed capital or increases in investment). Increasing the money stock of the nation does not, in itself, represent any increase in wealth – if there are not more goods to purchase it will simply cause inflation. In the real world we see this in housing and asset price bubbles. An increasing demand for financial assets (i.e. increased saving) can cause such bubbles rather than leading to new investment and therefore greater wealth for the nation as a whole.
Saving is actually defined as the difference between disposable income and expenditure on consumption – investment in fixed capital, increases in inventory and purchase of financial assets are forms of saving, as these goods are not consumed (for example, by definition if you increase inventory you haven’t consumed that inventory, that’s why it has increased). Financial assets are particularly significant – a person saves by purchasing financial assets, but whoever sold that asset now has the proceeds to spend back into the real economy. In this way, financial assets as a form of saving can avoid the paradox of thrift and channel saving towards investment that increases productivity. This process is called intermediation – financial markets intermediate betwen savers and borrowers, channelling people’s savings to those who need credit, thereby keeping the money flowing in the economy. (Textbooks claim that banks also intermediate when they make loans – they don’t, and how bank loans work in the real world is something we will look at in the next series of posts.)
But just because financial assets can intermediate in an economically useful way, doesn’t mean that financial markets do always achieve this. The seller of an asset may simply use the funds to purchase another asset, and if asset markets are growing they could actually be diverting money from the real economy (the paradox of thrift again). An increase in demand for financial assets will cause asset prices to rise above their “fundamental value” (i.e. an asset price bubble), making these markets significantly less efficient at channelling funds towards investment.
In fact, the role financial markets play in channelling savings towards investment (and other areas of expenditure) is so important that we will need to look at this in detail in a future series of posts. But traditional economic theories overlook financial markets, so much so that they were caught out by the financial crash and subsequently labelled sections of these markets “shadow banking”. But it’s not that these markets were hidden in the shadows – it’s just that economists and those they mislead (such as politicians) were not paying attention to them because their inadequate economic theories were telling them they didn’t need to, that everything could just be left to the unregulated free market.
Obviously, we won’t be making the same mistake, we will come back and examine these markets in detail in due course. And because tracking this flow of wealth is so important, it leads us to another foundational concept of the blog:
The distribution of wealth is critical to the future path of the economy, because what influences the direction of that path is how those who have the wealth choose to spend or save it.
In other words, we need to follow the money. What is Apple doing with it’s $250bn of offshore undistributed profits? How are our pension funds being utilised? Are they in the best possible investments to ensure a strong economy when we retire?
And this is what the blog is going to do – we are going to examine how the economy actually functions in the real world in areas such as banking, money creation and credit allocation; central banking and monetary policy (including quantitative easing); “shadow banking” and asset markets. All of these areas matter because they determine how the wealth of society gets channelled towards activities that increase our productivity and distribute our wealth – or more to the point, fail to enhance our productivity and concentrate our wealth in the hands of a few, such that the economy is not producing and distributing enough for everyone.
It may sound a bit dry, it may sound challenging, but we cannot begin to start trying to create an economy that works for everyone until we understand how this system operates, in all its intricate detail and beauty.
The opening series of posts has set out a theoretical, conceptual framework. As we now get into the detail of the real world, I will be using these concepts to understand what we are looking at and what is actually going on. That’s why I started by laying this foundation, but with hindsight maybe I should have jumped straight into the empirical, real-world stuff. From the feedback I’ve had, I think some readers have found these opening posts increasingly hard to follow. For my own part, I’ve found that having to try and write this as clearly, briefly and accurately as possible has really honed my thinking – often I realised that what I was writing lacked precision, and would do more research to refine my point. As a result, I had to write more posts in this series than I originally intended, and towards the end wrote longer posts rather than spreading this over even more weeks.
I’m hoping now to get back to shorter, pithier posts each week, closer to my goal of 500 words every Friday, starting next week with the question of where money comes from. If you haven’t read all the posts up till now, this summary should be sufficient to enable you to pick it up from here. The older posts are always there for future reference!