P H Lee

Economic discussions have been coming up a lot recently, which is why I am writing this. Note: I'm an "advanced beginner" at best. If you have actual economics training, feel free to correct.

(Note: I am interested in corrections and discussion. I am not interested in conversing with know-nothings and ignoramuses. I will gladly summarily delete such posts so keep a saved copy.)

Exchanges create value
Money generally isn't valuable in and of itself. An economy which produces only money (by printing bills, by loan shell games, etc), no goods or services or labor, is not useful. In a real sense, the basis of modern economy is about people making trades of things that they have in abundance (their time, their expertise, their insufficiently fancy hats) for things that they do want (food, healthcare, fancy hats.) The act of exchange creates value, because (putatively) both parties gain something more valuable in the exchange.

The simplest example of this I have is that Betty has a coffee, and Jack has a hot chocolate, and they trade 50% of each, and now they both have a mocha, which they both enjoy more than their original drink. If Betty likes coffee 10, and Jack likes chocolate 8, and both like mochas 15, we have gone from a system with 18 points of enjoyment to 30, a gain for everyone.

(Note that things don't quite work like this in the real world, for several reasons. The biggest being what 18th century economists called "the lash of hunger:" people who are forced to trade for survival goods in order to, well, survive. This desperation is the reason that, even in a system which is putatively free trades, exploitation can still thrive. The lash of hunger is, in effect, a form of violent coercion.)

(also note I'm trying to avoid any idea of "primitive barter." Most early societies, it looks like, did not barter. Rather, they have gift and status economies, which are totally different. This is the basis of how our modern economy works, not any sort of primal form of anything.)

Money as a medium of exchange
You can see that there are a lot of advantages to not directly trading, but instead having a mutually agreed upon medium of exchange: it lets Betty buy a hot chocolate from Joe even if Joe has nothing he wants from her. In its earliest form, money is exactly this: leftover clay tablets in Sumer putatively exchangeable at the central bank for grain. In conditions of social collapse, money as a system fails, so the medium of exchange must be inherently valuable and, ideally, easy to transport, from which we get metallic currency (although still in the shape of the clay chits of Sumer.) In this case, you don't really have any money at all, just an advanced form of barter.

The downside of having a real good (gold, grain, anything else) as the medium of exchange is that the value of your currency is subject to price shocks in that particular commodity. This regularly crashes your economy as your money becomes way too valuable (no one wants to spend money), or not valuable enough (no one wants to accept money). It encourages hoarding behavior of both goods and cash, which is bad. This pretty much happens regularly to every society which fixes currency to a real good, which is why no one does that anymore (even societies with fixed currencies, such as China, fix them to other stable currencies, rather than to commodities.)

But why is hoarding bad? Well, money is useful because it facilitates economic trades. Up to a point, the more money floating around in a system, the more and higher value trades can be performed. Since all trades have a marginal benefit, this process creates more value. We measure the total value-output of society as the Gross Domestic Product (or Gross Regional Product or Gross World Product or whatever.) Money that is in the system, being traded, represents swaps of increasing value. Money or espcially goods that are hoarded don't participate in this process, which means that they are not helping anyone do anything.

The goal, in a modern economy, is to increase value for everyone, mostly by means of trades. Any sort of hoarding behavior stops this dead in its tracks.

Money, in a modern system, has no inherent value in and of itself (if you burn a billion dollars in cash there's no loss to the system: the feds can just print a billion more next time), but it's like engine oil: it makes all the parts of an economy move more smoothly. This is why we see "liquidity" and other fluid metaphors for money. You want there to be sufficient money to make all economic activity work, which means a growing money supply since, in a free trade system, the amount of economic activity generally increases

If you have too little money in a system, economic deals that could happen (starting a company, buying a house) won't happen because the parties involve lack the liquid cash to make it happen. This reduces exchange, which reduces produced value. If GDP is still growing with insufficient money supply (or if you've pegged your money to a commodity that has a price spike), that creates deflation, which means that it is advantageous to sit on cash rather than spend it. Not only is there an opportunity cost to cash not in the system (i.e. it could be used for economic activity, but it isn't) it introduces inherent instability.

If you have too much money in the system, relative to the amount of economic activity, you have inflation. Inflation means that money becomes worth less and less over time, because there it is more common and, just like everything else, works along the lines of supply and demand: if there's more of it, its worth less. Large amounts of inflation can be devastating to an economy because the instabilities in your money mean that it can't function as a medium of exchange: if I don't know how much a dollar is worth today, I can't sell you coffee beans or chocolate, because you might be just ripping me off.

Note that printing more money doesn't necessarily cause inflation: inflation only occurs if there is more money than is necessary for the economic exchange. Given that we do have a real GDP growth rate, we need a larger money supply year after year in order to keep deflation from occurring. So you shouldn't think that printing more money (via bonds or cash) will necessarily cause inflation. Rather, the ratio between the supply of money and the total real value of the economy needs to be kept constant.

Well, constant or a little bit increasingly. As it turns out that small amounts of inflation is a good thing.

Inflation as a driver of economic activity
The general consensus amongst economists is that a small amount of inflation is generally a good thing. The reasoning goes like this: you want to encourage people to spend and invest and trade with their money, rather than stuff it in a mattress or whatever. There's a hierarchy here: spending money is better than investing it which is better than banking it which is better than keeping it in cash. Inflation is a handy tool for this: if money is slowly getting less valuable, you want to make sure you don't have too much of it sitting around. It's a light coercion to get your money into the system rather than sitting on it.

(Note that the same logic applies to giving money to poor people: they tend to spend, rather than invest or bank. This is why food stamps are so amazingly stimulative.)

Of course, there are dangers. Too much inflation and your money no longer works as a medium of exchange. Furthermore, inflation over time makes accounting more and more of a hassle as numbers go up and up. And friction regarding money issues means you can end up with pennies and nickels which cost more to produce than they represent, which isn't a huge deal but is pretty silly.

Most people seem to agree that somewhere between 2-4% annual is ideal for inflation, all other things being equal.

The government and money
The role of the state -- by which I mean "the entity the produces money and collects taxes --" is thus not exactly about "balancing the books." The state creates money in several different ways: printing cash, issuing bonds, etc. These have subtle differences but they are basically all means of putting more money into the economic system. Likewise, we have taxes, which is a means of destroying money currently in the system.

So here's the thing. The idea that the government works like a household or individual: that it has a big bank account that it puts its paycheck (taxes) into and pays rent and utilities (expenditures) out of is simply wrong. The state is not balancing a checkbook, both because the state has a printing press but also because the state does not function in any way shape or form like an individual.

Rather, the state is managing the flow of money through society. In order to allow for increased economic activity, it issues more money, preventing dangerous liquidity problems and reaching an ideal inflation rate. In order to prevent dangerous hoarding behavior, it destroys money in the system via taxes, particularly from places it regularly pools (like the bank accounts of the very wealthy.) This is more akin to managing a water park (making sure that the water is always flowing) than it is the running a bank account.

(it's important to note that there are political concerns to all of this: it's not as neatly technocratic as I describe. A lot of very effective expenditures -- food stamps, for example -- are unpopular. And a lot of pretty ineffective expenditures -- more highways! more wars! -- are popular. But I think a huge part of this is the ignorance that people have about how state money really works.)

Sovereign debt
Debt issue is one means that the state has of introducing money into the economic system. A bond is essentially a form of currency that auto-deflates: it exchanges liquidity (you can't spend a bond at the supermarket) for keeping up with inflation. The government issues these when it wants to pay people for services without increasing unduly causing inflation. Because the money auto-deflates, paying the interest on it has to be part of the government's expenditures.

You don't want too much debt, because the interest (which generally goes to pension funds, bond traders, and foreign governments) doesn't really go to ideal places in your economy, and you want more control over your expenditures. But debt issue has such an upside in increased economic activity that it is pretty worthwhile to do most of the time, which is why almost every civilized country runs a national debt.

For the US, foreign countries are a not-insignificant holder of our debt. This is because the dollar is an incredibly stable currency and other countries who have decided to peg their currency (an agreement to not print however much money they want, basically) generally peg their currency to the dollar (or to a "basket of currencies" which is heavily weighted towards the dollar.) This is a great way for a small or growing economy to introduce currency stability, but it requires the government of that country to hold a huge reserve of dollars (much in the way that, when we were on the gold standard, we needed a huge reserve of gold.) This is good for us, because it means we have a huge number of countries devoted to our stability, who will buy huge swathes of our debt, allowing us a lot of the benefits of debt issue without many of the drawbacks.

Note that debt is not voting shares. No matter how much of our debt China, Japan, or Belize hold they will never be able to "take over the country." The best that they could do is threaten a murder-suicide, where they undersell their US bonds to crash our bond prices at the same time that they destroy their currency and reserves.

That's the basics
There's a lot of other things, including what fractional reserve banking is and how it creates currency as well, but that is probably plenty for now. My main goal is for people to be informed about what people are actually talking about when they talk about tax rates, liquidity traps, etc. I think that there's a lot of misinformation around (particularly the "balancing a checkbook" myth of state finance) and I want to try to at least penetrate a bit of that fog.