Wednesday, 2 March 2016

The Economy Simply Explained

Sometimes my friends tell me that they try to read them, but my posts are too complicated. I am using jargon that they don't understand and probably they are too long and confusingly written. To remedy this, I have decided to try to write a simplified version of this piece I wrote about how the economy works.

How can one picture the economy? The economy should be viewed as a flow of money. This may seem straightforward, but mainstream economic models do not include money at all. And yet, a lot of the workings of the economy can be understood by looking at who receives money and how much of it they spend.

 If everyone is working and producing goods and services, then people need to buy these goods and services. In order for people to buy these products they need to have enough money.

Money received by people for producing things is then spent by these people on more things. This cycle repeats itself and makes the economy run.

What if people don't have enough money? They can't buy the goods and services. In a perfect world, the price of everything would go down so that all of what is produced can be bought. Unfortunately, in reality this is not the case.

Why can't prices go down very easily? The reason that prices can't adjust very easily to not enough money is that people's wages tend not to go down. This is called 'stickiness of wages'. Because people generally don't like having pay cuts, producers can't reduce prices or they will be making goods at a loss.

If they can't reduce prices, what do they do? Instead they cut production and make people unemployed. This then, in turn, reduces the amount of money that people have to buy things. Leading to further job losses.

Eventually what would happen? Without any government intervention, in the end prices and wages would fall enough so that everyone could have a job again. But it is a long and painful process. It is much better to ensure that the correct amount of money is running therough the system.

How much money is the correct amount? A generally accepted nominal GDP growth target is 5% per year. This means that in total 5% more value in goods and services are produced each year. Some of this increase is due to inflation - one pays more for the same number of goods. And some of this is growth - more goods are produced.

If too much money is spent then we get more inflation. That is to say that the growth in production of goods can't keep up with the rise in amount of money spent. Consequently prices go up.

But if 5% more £ worth of goods and services are produced, doesn't that mean that people need to spend 5% more money each year than the year before? Exactly. Every year, for the economy to be healthy, 5% more money needs to be spent than the year before.

Where does this extra money come from? This is a very good question. And it is one that seems to be ignored by most economists.

The problem we have with the economy today is that actually it is being drained of money. If £1m of goods are produced and sold, then in the next year only approximately £970,000 will be spent. People are saving the other £30,000.

To be more exact, the gap between the amount people are saving and the amount of people's savings from previous years that they are spending comes to 3%, maybe even 4%, of GDP.

Why is this gap so large? There are a number of reasons but it mainly has to do with the difference in spending of the people who receive the money. Working people on low and medium incomes tend to spend most of the money they receive. But savers receiving interest and dividends spend less of it in the economy.

Private sector debt in the economy has increased hugely over the past 40 years, meaning more money goes to interest payments. And corporate profits as a percentage of GDP are at record highs. Meaning that workers receive less of the money from their work than they used to. And because of this, less money is spent.

On top of this, widening inequality means more income goes to richer people, who tend to have a higher saving rate than poorer people.

In the UK and US there is also a trade deficit - meaning that more money spent by people in the UK and US goes to other countries.

Currently, the average annual saving rate in the UK is probably 3-4%. The exact figure each year depends on how confident people are in the economy. 20 years ago, the average saving rate was probably only around 2-3%, and 40 years ago it would have been closer to 1-2%. These are approximate guesses but it shows the problem caused by the financialised economy we live in today.

So that means we need to send a lot more money through the economy every year? That's right. If we have a 3% saving rate, and we are looking to achieve a 5% nominal increase in GDP each year, we need people to spend an extra 8% of GDP worth of money each year.

So, again, where does this money come from? Historically it has come from two places.

First, governments normally run deficits of on average 4-5% per year. The multiplier of this on GDP (ie. how much of this gets spent on GDP additive goods and services) is approximately 1. So around two thirds of the historical gap comes from government deficits.

Second, private sector debt has increased year on year.This consists of, for example, money borrowed by individuals for mortgages or credit cards, and by companies for investment or to buy back shares. This has grown by 10% of GDP per year since the 1970s. Effectively 10% of GDP more money has been printed by banks and corporations every year.

However the private sector debt is not as efficient at getting people to actually spend the money. Much less of it is spent on GDP. So the increase in private sector debt, despite being twice as large,  makes up about a third of the new money spent every year.

Why is the economy struggling at the moment? Because private sector debt has hit such high levels. This means that interest rates are low, and that makes house prices very high. Because many people can not buy homes any more they do not take out more mortgages. Because the economy is not growing so much, companies want to borrow less. So we do not have the new money coming in from new private sector debt.

So what has the government done? Central banks have tried to do what they can to make more money be spent. They have enacted a policy called Quantitative Easing which prints new money and uses it to buy bonds. This pushes down long term interest rates and pushes up the prices of assets (like shares and houses). This makes (generally) richer people even richer and encourages them to spend more.

Our elected government has been working against this though, cutting money from poorer people who spend more, and trying to get the government deficit to zero.

Can the government cut the deficit to zero? No. Or they can, but if they did they would shrink the economy so much that the debt to GDP ratio of the government would rise hugely. This is because, as mentioned above, there is not enough other new money flowing through the economy.

In fact, austerity, if anything increases the government debt to GDP ratio as a) GDP does not rise as much as it could and b) private debt rises instead making financial crises more likely.

What is the effect of their attempts so far? Economic growth since 2008 has slowed hugely. As I discuss here, government policies to push the unemployed into low paying work has reduced the number unemployed, but the economy is not healthy. The graph below (taken from here) shows what has happened to productivity per hour worked in the UK. Historically this has grown by 2-3% per year, but since 2008 it has not grown at all. The low wage austerity economy has meant that increases in employment are in more menial rather than more productive labour. This is not to mention the human cost of austerity.

Also, by using lower interest rates instead of government debt to get the economy going, the government has pushed house prices up even further out of the reach of most of the population.

So the money to grow the economy must come from the government? YES.

The government must run larger deficits. As shown in my last post,by spending more money we get three beneficial impacts:
  1. The economy grows much faster, meaning more and higher paid, better jobs. Productivity (which has stagnated in the UK's low wage austerity economy) will increase and the country will produce a lot more.
  2. Interest rates will be able to rise, meaning private sector debt levels will fall. This makes economic crises far less likely.
  3. Government debt to GDP actually will probably end up being lower - as although debt rises, GDP rises by just as much, and we don't get debt crises.  

But if the government spends too much money won't it go bankrupt? No. At least not in countries where the government has control of its own currency and borrows in that currency. In the UK, the Bank of England could print money to buy government bonds if there were ever the need. The Eurozone is a different story. For this reason, the Eurozone will suffer from permanently low growth (probably ending with a disastrous crisis).

But if we print money we'll end up like Zimbabwe won't we? No again. Inflation is created when money is spent. If we are going to have inflation it will be at the time the debt is taken out. If the central bank swaps newly printed money for government bonds at a later date, then all that happens is that people in the future will have their savings in cash rather than government bonds.

Doesn't the government borrowing more money now steal from our children? No. It does affect how future prosperity is distributed. But if you think about it, the way to give a prosperous future to our children is to invest in our productive capacity now so that the economy they inherit is blooming. The only way we steal from them is by penny pinching now and not investing. And of course destroying the environment, but I'll leave that lesson to Leonardo DiCaprio.

I understand it all now, thank you Ari. You're welcome, my imaginary friend.


  1. The G in GDP is gross. It is not net income. So all kinds of distruction add to GDP.

    And many good things do not add to it.

  2. "So the money to grow the economy must come from the government? YES."?

    ". In this paper, I will show how MMT designs a reserve centric or state centric view of the money system when the reality is that we have an almost purely endogenous or private bank controlled money system."

    1. I don't really want to get bogged down in a critical appraisal of the finer points of MMT. I share some views with them, but my point is far simpler.

      a) there isn't enough money going round and b) we need to stop using private sector debt to fund growth.

      Simple solutions within the existing framework are available. The government can run bigger deficits. And the government debt held by the BOE could be written off, in the case that politically having too much debt is difficult.

      I am just trying to raise awareness of the serious problem we have here, when we rely on monetary policy for economic growth.

    2. "b) we need to stop using private sector debt to fund growth."

      It depends upon the type of 'private sector debt'?

      Prof. R. A. Werner believes that the 'man-made problem' was the issuing of the 'wrong' type of credit. There is 'productive' and 'unproductive' credit.

      “Importantly for our disaggregated quantity equation, credit creation can be disaggregated, as we can obtain and analyse information about who obtains loans and what use they are put to. Sectoral loan data provide us with information about the direction of purchasing power - something deposit aggregates cannot tell us. By institutional analysis and the use of such disaggregated credit data it can be determined, at least approximately, what share of purchasing power is primarily spent on ‘real’ transactions that are part of GDP and which part is primarily used for financial transactions. Further, transactions contributing to GDP can be divided into ‘productive’ ones that have a lower risk, as they generate income streams to service them (they can thus be referred to as sustainable or productive), and those that do not increase productivity or the stock of goods and services. Data availability is dependent on central bank publication of such data. The identification of transactions that are part of GDP and those that are not is more straight-forward, simply following the NIA rules.”

    3. OK, I agree with this. If we could direct private sector loans to productive investment, it would be great. It is not how the world has gone for the past 30 years though.

    4. Proscribe the type of loans allowed by commercial banks, and in return offer commercial banks an unlimited uncollateralised direct overdraft at the central bank.

      All this liability side jiggery pokery is all down to trying to maintain the illusion of 'markets' in the provision of debt. It's time to admit it doesn't work like that.

      Regulate bank assets.

  3. Stephen Ferguson4 March 2016 at 15:56

    Nice post Ari.

    Absolutely agree on keeping the model simple. Adding in negatives e.g. "Why can't...", "What if..." makes it not only simple but complete.

    Just a question on ever-rising GDP. What do you make of 'steady state' economics? Is that an impossibility?

    1. Thanks Stephen. I don't know much about this subject, but I have three rather simple points to make.

      First, although we are constrained by limited resources, this does not mean that technology can not improve how we use these resources. Unfortunately traditional GDP measures do penalise improvements in technology that lead to less consumption for the same output. But that is still growth.

      Second, I think we will always need inflation. It is what enables the economy to reallocate wages efficiently and run more smoothly. It effectively enables small real pay cuts in industries that are losing ground rather than destructive unemployment.

      Third, I think that the whole idea of a steady state economy relies on a far higher level of equality in pay than we currently have. It feels at the moment like we need economic growth just for those at the lower end of the pay scale to keep up the same standard of living. As more and more goes to the richest in society, if we don't hae economic growth then we will end up with real problems in society.

  4. I'm assuming by government deficits we're also including all the wonderful things that are created by corrupt governments run by sociopaths. Like the ability to "afford" perpetual war? The ability to "afford" creating a police state. The ability to "afford" giving loot to cronies is the guise of "infrastructure".

    Yeah, in a society where morals don't matter, allowing political sociopaths to perpetuate their existence using deficits will surely lead to good things (for the sociopaths). Too bad about the society's democracy tho. Oh well, as a famous economists once said: Economics isn't a morality play. (He didn't say what economics was tho).

    1. All the problems you state are political, and require political and social solutions, not economic.

      Imposing artificial scarcity on the population by avoiding to use fiat is not going to make them any better, a quick look at history will show this. Jingoism and war are usually the product of scarcity and misguided desperate populations, sane democracies were people is enjoying "the good life" don't want anything to do with war.

      Corrupt elites need the population support for their stupid greedy and violent adventures, artificial scarcity is what creates conflict and space for corruption (both at internal-national and external-international level)

  5. Why is it that economists cannot distinguish between wealth - free and clear ownership, and the "wealth effect", ownership in the moment enabled by credit money/debt?

    Long term credit purchases like autos, homes, tools, capital investment - have a good probability of enabling repayment of credit and interest, in order that they be truly owned. Of the things owned, most do not appreciate in value, but their ownership can be more cost effective than rental.

    All these owned items have maintenance costs and many will need to be replaced. Some also have tax liabilities, but again, that cost is better paid directly than through a rental fee, as the landlord pays taxes on the property.

    Credit money/debt - by pulling consumption forward from the future, getting what one can not own in consumer terms, just for the moment of consumption, leaves unpaid debt, which in our recent society has grown rapidly. The credit card companies operated on the notion that the more credit you have, the more you can get. They were competing for our debt, and of course competition is always good.

    At one time I had eight credit cards with a $25,000 limit. I could have spent $200,000 in a single day, but could I have done so to get something of long term value? No - but, as the extension of credit is an implied extension of trust that one can repay, people have "wealth effected" themselves into debt and fee slavery.

    The bubbles that economists can't see are "wealth effect" situations where individuals are taking on debt beyond which their incomes can repay. U.S. household incomes grew since the 1980s, not because of real higher wages, but because of dual income families and multiple job-holding. Work more, get less.

  6. Wonderfully enlightening simple summary of economic factors. Still economics, which describes phenomena, begs the question: why? Economics describes phenomena which are totally optional, political constructs. Economics thereby obscures, and acts as apologist for, the social relations responsible for needless scarcity. Time for a total redesign of social relations!

  7. Further national debt is not the answer and we have to increase GDP to pay the ever increasing interest. This gets worse if rates rise. The answer to increasing home prices is automated building. The answer to increasing the standard of living is tough population control.

  8. "Further national debt is not the answer and we have to increase GDP to pay the ever increasing interest. This gets worse if rates rise."

    None of that is correct despite it being a widely held belief.


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