Wednesday, January 29, 2014

The National Income Balance

In this post, Dissecting Money will build the equation used to calculate a nation's GDP. 

 GDP is the simple sum of all measured components of all participants in the economy.

GDP can be calculated from two perspectives, spending and income.  These two perspectives can be considered as evaluating two economic participants, or,  as establishing the income and expenditures of a single participant as might be found on a financial balance sheet. 

The balanced version of the equation is

(0)   C + I + G + (X – M) = C + S + T

Where C represents Consumption, I is Investment, G is Government expenditures, X is eXports,  M is iMports, S is Savings and T is Taxes (government revenue).  These terms will be used consistently throughout this post.

Equation 0 is known as the National Income Identity or sometimes as the National Income Balance.  The idea here is that the left side of the equation is expenditures and the right side is how the expenditures are redeployed by recipients.  The two sides are equal but each side describes a different mix of distribution.

We would like to build Equation 0 from the ground up.  We can begin by assuming that spending upon consumption is received by the consumption supplier who immediately redeploys the money  As a receiver of money, the supplier will consume and probably save some of the money.   We could write the resulting equation as

(1)      C = CS + S

where CS is secondary consumer spending..  Equation 1 has the defined assumption that the left hand spender is NOT the right hand spender.  

We may wish to consider only ONE participant.  If we consider that all spenders must first receive income, then we can reduce the number of participants from two to one.  We can consider the participant as an accounting unit with income and expenses carefully recorded.  Equation 1 would still apply to the one participant situation.

After studying Equation 1 for a while, we might consider that savings would be spent at some time.  In fact, the spending of the left side of Equation 1 could all come from previous savings.  More importantly, consumers are not considered as having the ability to create money.  As a result, all consumer spending MUST come from previous savings unless earned and then re-spent within the measurement period.  

With this limitation on money creation in mind, we would abandon Equation 1 and substitute

(2)    C + I = C + S

where consumption is identical on both sides of the equation.  Equation 2 makes clear that Investment is equal to Savings.  Unfortunately, the building of Equation 2 highlights a strange problem.

Consumers can not create money so all money spent upon savings must first be saved!  The simple logic of savings as the result of deferred consumption found in Equation 1 has been replaced in Equation 2 with the logic that all savings must first exist and will always be equal to investment!  Where might the money identified as Savings (and Investment) come from?

There is a second logical difference between Equations 1 and 2.  Equation 1 is a flow equation and Equation 2 is an accounting equation.  We would evaluate the terms in Equation 2 by simply counting each savings and consumption event within a measurement period.  Equation 2 has no information as to the source of money used in the transactions.

Bank loans as a money source can be considered at this point in the discussion.  Bank loans result in bank deposits held by third parties.  As a result, every loan can be considered as an Investment by the bank and Savings by the current third party holder of the dynamic deposit. Bank loans will result in both sides of Equation 2 increasing equally.

After studying equation 2 for a while, we might want to split consumption between private and government.  We could then add government spending (G) on the left side and government receipts (T) on the right side to get

(3)    C + I + G = C + S + T

We can re-arrange and simplify equation 3 to read

(4)    S = I + G - T

Notice that G - T is the government deficit.  We therefore see that S = I + government deficit.

We can also re-arrange equation 3 to read

(5)    I = S + T - G = S - (G - T)

Equation 5 is confusing because a deficit is shown as a negative investment.  The confusion is mitigated with the observation that S is increased by the amount of the deficit. A government deficit is considered as if it was an Investment.

From Equation 4, we see that a government deficit has increased Savings which is the identical effect we previously attributed to bank loans.  Economist usually consider increases in Savings as an increase in money supply.  The exact definition of money supply remains a controversial subject.

After studying Equation 3 for a while, we might want to add the export sector.  We can do this by writing

(6)   C + I + G + (X - M) = C + S + T

which is the beginning Equation 0.

Sunday, January 19, 2014

Supply Constrained versus Demand Constrained Products, versus Money Supply

A change-in-money-supply is a tool used in economic theory to accomplish the goals of economist. A criticism of this tool is that the effects of money supply change are not as predictable as theory would suggest.  In this post we will look at the interaction between products and money supply to gain a better understanding of possible interactions.

We will begin by considering the limits of product availability and then consider money supply variation.

Supply Limited Products
Suppose that we have a potato shortage.  The price of potatoes increases. Suppose next that pity is shown on one person who can not afford to buy potatoes at the increased price and this person receives a money gift.  The lucky person now purchases potatoes BUT now another person is discovered who can not buy potatoes!  The gift of money has only shifted the identity of the persons unable to buy potatoes!  More money does not create more potatoes!

The potato shortage story is a description of a supply limited product.

Demand Limited Products
Products are limited by demand when supply is unlimited.  Cordless power drills in modern America are available in at least 10 different brands. They are differentiated by color, strength, durability, etc, and PRICE.  It is hard to imagine that everyone would rush to buy a cordless power drill if the price fell to zero but clearly, price is a differentiation criteria.

We next suppose that we observe a person unable to buy even the lowest price cordless power drill, decide to take pity on him, and give him a gift of money.  He now can buy a cordless power drill and would take the next step of selection which would be to choose between the lowest priced drill and second lowest priced drill.  Presumably the second lowest priced drill would not be a single choice but a choice between color, strength, durability, etc, in a multivariate supply.  One person buying a drill certainly would NOT set up conditions that would prevent another from buying a cordless power drill. It is logical to assume that the purchase of one drill would create the need (opportunity) to build a replacement drill.

The cordless-power-drill story is a description of a demand limited product.

These two examples of products at opposite-ends-of-the-supply-curve can be used to predict what might happen in a generous economy that decides to give money to people.

Money Supply Generosity
A generous economy may look to see that many people are unable to purchase as much as most and then attempt to correct the imbalance with government action. An easily prescribed method is to give money to the people in need.  This action would increase the buying power of the needy but would also raise the question of where the money came from.  We will first examine how more money in the hands of the needy would affect the product mix of the economy.

Assume that more money from some source is placed in the hands of needy persons. For products in limited supply, the inability to purchase would shift from the needy to the new-needy.  The formerly needy persons would now have enough money to buy but that shift would force formerly not-needy persons into the needy category.

For demand limited products,  additional money in the hands of the needy should increase demand and create the opportunity of producing replacement product. The additional demand should increase employment.

Where Could Money-for-generosity Come From?
Additional money for government generosity could come from three sources:
1. Taxes
2. Borrowing from private money holders.
3. Never-to-be-repaid government borrowing from government agencies

Taxes would be a forced, permanent shift of buying power from people-who-have-money to those-who-do-not-have-money.

Borrowing from private money holders requires that the private money holders first have money.  Borrowing from them would would delay their spending on personal consumption and would not diminish their wealth.  A case can be made that borrowing from private money holders could perpetuate the system that enabled initial accumulation of wealth, and could result in an increase in lender's wealth.

Never-to-be-repaid government borrowing from government agencies would be an increase in the permanent money supply of the economy.  The persons first receiving the newly created money would have increased buying power, allowing them to purchase on terms identically available to those people already holding money. The final holders of the newly created money would be capital accumulators expected to hold the funds for investment for long periods of time.

The Long Term Effect of Generosity
The reader should notice that government generosity to one person has an effect on others in every description.  Need may be shifted, the opportunity for employment increased, wealth transferred, or wealth increased. Government generosity is never neutral; some people will gain much more than others.

Government generosity is not limited to needy people.  Government generosity can be extended to paradigms where government pays employees generous wages, undertakes generous projects, extends generous foreign aid, and generously contributes to cultural interest such as art and science.

When some people or supply chains gain more than others from government action, political divisions arise.  The politics of taxes are much easier to predict and understand than are the politics of money supply change.  Money supply change by private-sourced-borrowing is easier to understand than money supply change by borrowing-from-government-agencies.  This post will not attempt to analyze either source of money supply expansion.

Wednesday, January 8, 2014

Positive Taxation as a Method of Measuring Monetary Stimulus

Taxation is (almost) universally looked upon as a negative economic force.  I think every tax payer must have looked at his tax bill and thought how nice it would be if I was not required to pay tax!

It is easy to see how much tax the nation pays the Federal Government.  Simply look at Federal Receipts. Then, we can relate receipts to the GDP and find that Federal Receipts are a very large part of GDP.  This can not be good!

But then we can look at Federal Expenditures and see that, for the last 60 years or more, Federal Expenditures are MORE than Federal Receipts.    Whoa, the Federal Government is spending more than it receives; the Federal Government must be actually practicing a POSITIVE TAX policy!  Yes, the Federal Government is actually a stimulation to the economy, not a drag as would occur if the Federal Government was actually collecting taxes ON THE AVERAGE.

From a mechanical economic standpoint, it seems logical that economist would utilize the positive tax as a measure of monetary stimulation received by an economy.  After all, an increased money supply is widely assumed to be stimulative to the economy, whether the result of increased loans from banks or increased spending by government.  Rather than speculate on why economist do not make wide use of positive taxation as a stimulus measure, this post will show the resulting chart and add two traces that show stimulus added by bank loans.

Positive taxation calculated in three ways.
The bottom heavy blue line is Federal Expenses less Federal Receipts expressed as a ratio to GDP.  Simply stated, this is the positive tax rate contributed by the Federal Government to the economy each year.  The reader can see that in about 2008 and 2009, the stimulation from positive taxation reached nearly 9 percent of GDP.  

Economist certainly do not agree on what constitutes money supply but here at Dissecting Money, a favorite description of money supply is the Government Provided Money Supply.  If we assume that only government and banks can create money supply, we can make an estimate of how much stimulation comes from bank loan activity.  Loan activity acts the same as positive taxation toward increasing money supply.

Due to the complexity of bank activities, in this post we will estimate money creation by lending activity in two ways: (1) Directly use the Federal Reserve data series TOTLL and (2) as a check, assume that loans create deposits, which can be hidden with further lending.

The chart red line highlighted with diamond point is the stimulus obtained by adding the change in loan levels to annual Federal expenses.  The reader can see that the sum of Federal and Loan stimulus was greater than about 6% annually going into the 2007-8 recession.

The light green line is the check line.  To create this line, assume that loans create bank deposits.  This is true whether the loan is to government or to non-government entities.  Bank deposits from loans need not remain in the bank; deposits are often exchanged for government bonds (or corporate bonds) and thus are recycled into the dynamic money supply where deposits generate GDP activity before again becoming static.  To account for these 'hidden' deposits, we add Federal Reserve data series FDHBPIN which is Federal Debt Held By Private Investors, using only the annual change.  The annual change in bank deposits is tracked with Federal Reserve data series DPSACBW027BOG.  To these two series is added Federal Receipts which are all re-spent.

While lines two and three track well together, they are not a perfect fit which indicates that additional factors, not considered here, are in play. 

One additional factor included in the check line (but not in the loan line) is changes in depositor spending habits.  For example, during the last 40 years, deposits sourced from loans have become an ever larger portion of bank assets as depositors drew down bank savings accounts.

The technique of calculating a rate of positive taxation results in a chart showing high monetary stimulation for much of the last 40 years.  This chart and the line slopes, as related to recession periods, will be the subject of future posts.  The relative stimulation from loan activity and government activity will also be discussed in future posts.