Wednesday, 16 December 2009

Balance of payments lie

It has commonly come to be believed that the fallacy known as the “balance of trade” exists and is a real effect. Although propagated, this myth is one that needs to be relegated to the dustbin of history or at the least assigned to the flat earth society.

To explain this misunderstood concept cleanly, it is best to simplify it and not confound the issue with the added miasma of obscure relationships that create a society or nation. To do this, I would start with a household balance of trade. This is the income and expenses for a household. If we take a common family group of two working adults and two children under the working age, we see two sources of income and four direct expense sources (which we can think of as the states).

Each adult has an income from an employer and possibly some smaller amount from a hobby or side occupation. Let's assume that partner A works at a department store and has hobby income C and partner B as an engineer. In this instance, there are three sources of favorable trade balances. These are partner A’s employer, partner B’s employer and any person who purchases from partner A’s hobby side business.

Each of these is what is commonly deemed a “favorable balance of trade” in the commonly misapplied term. Partner A and Partner B each have a positive balance with their respective employers. However, partner A’s hobby income breaks even. This means that it is a balanced trade source.

Partner A in our scenario has the responsibility (they are not pooling their income) for food and school fees. Partner B has the responsibility the rent and entertainment. Each partner supplies their children with a small sum each month. We will assume for simplicity that our family is rather ascetic and wants for little. We will also assume that 50% of the expenses for food go to the same store that partner A works at and that the other 50% goes to the grocer.

In this scenario, we have a favourable balance of trade with the department store. Here we see the following equation:

  • (Partner A’s income) – 0.5(Food Expenses) = positive trade balance with department store
We see this positive balance of trade as Partner A is unable to spend the entirety of income (by the fact that this is split to several parties) to the department store where partner A is employed. Partner A receives the amount of (Partner A’s income) from the department store, but spends 0.5(Food Expenses) at that same store.

We next see a negative balance of trade for partner A’s dealing with the grocer and partner B’s dealings with the land lord. In each instance, we can represent this mathematically as the following:
  • 0.5(Food Expenses) = negative balance of trade with grocer
  • Rent expenses = negative balance of trade with landlord

In each example, we have a negative balance of trade. Let us presume that partner B earns 150% as an engineer of what she could earn as an estate agent working for the landlord. Partner B could sacrifice some of her time employed as an engineer and work for the real estate agent (the landlord). Let us assume that partner B works 40 hours a week and that 40% of her income is assigned to rent.

In this instance, we see that 16 hours of partner B’s time is associated with working to pay the rent. This is 40% times 40 hours. An option exists where partner B (we presume she is talented and can be either an estate agent or an engineer as she wishes) can work for her landlord part time by sacrificing some of the time spend working as an engineer.

Working for the landlord, she earns 66.67% of her earnings as an engineer (the reverse of 150% as noted previously). This means that she must by needs work a longer time to create the same income. This is, in order to earn and hence pay the same value of rent, she must work longer hours. As the income from the landlord is only 66.67% of her earnings as an engineer, she must work 1.5 times as long for the landlord. This is:
  • (work for landlord) = 1.5 x (work as engineer)
As partner B works 16 hours directly for the payment of rent, we can express the previous equation as follows:
  • (work for landlord) = 1.5 x (work as engineer) = 1.5 x 16 = 24 hours
In this case, partner B is still working 24 hours (40-16) as an engineer, but also needs to work an additional 8 hours (this is 24 hours at the landlord – the 16 hours she was working).

So we have two scenarios already, partner B can engage in the most efficient source of trade (this is working as an engineer for her) or she can seek to minimize “balance of trade” deficiencies. BY working in her optimal trade position and creating several “unfavorable trade balances”, partner B is better off. She needs to work only 40 hours to have the same standard of living as she would have required if she was working 48 hours with a “more favorable trade balance”.

This scenario is the same if you substitute companies, states or nations for the partners. We could also argue in our example that the children are an unfavourable trade balance that could be removed by removing the children. This is the nature of the anti-trade and protectionist argument.

This of course begs the question, why do governments perpetrate this lie?

The answer lies in inflation. Most people have little understanding of the economy and few people seem to want to spend any time explaining it in simple terms.

Inflation, the hidden tax.
What is inflation and why does it occur? This is far simpler than many would like to state. There are many complex reasons that can be used to explain inflation, but simply and completely, inflation is the result of an expansion in the money supply. There is only ever one cause for an expansion of the money supply, this is more money.

The creation of money is a monopoly of the government. In modern western nations, the reserve banking system (such as the US Federal Reserve or the Australian Reserve Bank) is government institutions. This is the case even (as in the US) where the reserve banking function is “nominally” a private concern. In all instances, policy is either set or at the least influenced by the government.

Even in the event that government was independent of policy (which occurs in no existing context), the additional money manufactured through inflation goes to the government. This is in effect an indirect and hidden tax.

If the inflation rate is set at 5% for a year and the total money supply for the economy is $1,000,000 (low I know) at the end of the year, the total money supply is now $1,050,000. This is, the government has printed an additional $50,000 that did not previously exist. As the gold standard does not exist any longer and as it is no more expensive to print a $10 note than a $100 note, there is no cost to the government in doing this.

So at the end of the day, we have an economy with 1.05 times the supply of money, but no additional productivity. Productivity is a function of companies and individuals. In contravention to what governments (right or left or centre) would have you believe, they do nothing to aid productivity other than not hindering it. That is, they can stay out of the way. This is a reduction of a negative effect at best and never a positive effect.

So what does this extra money supply mean?
Without an increase in productivity, additional money has a negative effect. There are the same amount of goods and services in society, just there is more money competing for the same goods and services.

To demonstrate this, imaging that the government uses the $50,000 they have created to pay its people. To now purchase the same amount of goods, there is more money available. As such, if you want to have the same goods, you can pay more for them (as can others). This increase in demand (added money) causes prices to rise. Hence the effect of inflation is an increase in prices. Price rises are the effect of inflation and not as if stated the cause. This is lie perpetrated to keep people in the dark about one of the most insidious taxes.

As there are no new sources of productivity, the overall market will shift to consume the entirety of the new volume of money. This is, a product that formerly cost $1 will now cost $1.05. The salary of $50,000 will now increase to $50,250. The end result may seem to have no change in values, or is there?

The reality and what is frequently ignored, is that there is an addition of money in a fixed location. This is the created money goes to the government. The created $50,000 is not distributed to all members of the nation; it is assigned to a single party.

The effect of this is that price rises will occur, but value will be impacted to the individual. There will be a lag in pay rises and other effects (that the government can later use to justify the next round of inflation).

So what is the result?
The sole result is a hidden tax. In effect, the item that costs $100 prior to the injection of more money by the government now costs $105. As such, each $100 a person earns can now buy a pre-inflationary amount of $95.24. This is, $4.76 has been lost (or at least reallocated to the government). As the government has the newly printed money to distribute, this is a hidden means to taking money, in effect a tax.

What this all comes to is that a 5% inflation is in reality a 4.74% hidden tax.


Andrew said...

What are your thoughts on repealing legal tender laws and floating more than one currency to create competition?

Craig S Wright said...

Money should be available as both fixed and credit varieties. I believe that a gold based float should be a common fixed currency, but that other forms of credit should also be allowed. The fluctuations of these credit based currencies would make them less stable without substantive backing, but this would be a matter for individual negotiation and choice.

As long as there is a means to trade currency and set exchange rates, this is hence a matter of choice. For standard trades, a gold backed currency system would provide the backbone. This would then be exchangeable to other standards under the existing exchange standards (minus many regulations).

Market based solutions have proven more successful than group think based answers in all existing contexts.