Saturday, December 1, 2012

Real Markets and Money Markets

Last year, well before the US presidential election, I was in a bar having a heated conversation with some guy who had been listening to too much Tea Party rhetoric, although he wasn't aware of its origins at the time.  From points 20, 21, 31, 32 cited in that link, part of the issues the Tea Party have is with the size of debt - there's too much of it, its all owned by the banks, and its growth is unsustainable.

Where this guy was coming from was that banks take yours and my money, then lend it out 5, 10, 15 whatever times, and every single time they're charging somebody interest on that debt!  So mine or his deposited $100 gets lent out 5, 10, 15 whatever times and balloons out to $1500 worth of debt!  And on that $1500, if it all gets paid back in a year, and the banks were able to charge 9%, then that's $135 worth of new debt that collectively the country owes purely because of how banks abuse yours and my deposits!  Which means someone has to work harder, or work longer, or suffer under growing debt to pay $135 more debt than what existed 1 year ago!

He was getting quite heated about this - this was an outrage!  Abusive bank practices perpetuate the proliferation of debt and were the road to madness.  Then he went on to talk about how the US banking system is privately owned by US Central Banks - and this all added to the conspiracy of shadowy figures somewhere who's deep dark plan was to royally root America for some nefarious purpose, of which he could only speculate.  But maybe Zionists were involved in there somewhere....  His thinking was American centric, obviously because he read something from someone over there.

In economics, we like to think of the world in models, our favour being market models.  In these models, economic activity occurs in separate and discrete markets which are all, however, deeply inter-related.  Stylised models of the economy talk about the:
  • Labour Market:  where workers sell their labour efforts to producers and receive a wage which they use to consume or invest.
  • Goods Market:  where producers use financial capital (paying interest) to employ workers (paying wages) to produce goods and services which are sold for profit (receiving prices) to either domestic or overseas consumers.
  • Money Market:  where financial capital is supplied by lenders and financially intermediated to borrowers in return for interest.
  • The Rest of the World: where quantities of goods and money comes from or goes to.  Changes in the rest of the world demand for New Zealand goods or financial assets effects New Zealand's exchange rate.
There's a little more to it than this, but this is a very basic stylised model of the economy.

Within this picture all the markets quantities are deeply integrated, with changes in one market effecting others all other markets.  There's disagreement about the pace of change, and whether changes propagate simultaneously or with lag.  But just assume for the moment, that changes ultimately occur.  Each individual market have both quantity and price dimensions, where changes in quantities demanded and supplied affect the market's prices.  And its normally the prices generated within each market which connect the different markets together (a bit of a simplification, but run with this for a bit). 

Decreases in the quantity of labour for hire in the Labour Market increases wage prices, and adds to the cost of producing goods and services in the Goods Market.  Increased wage prices also increase the financial capital needed for production in the Goods Market, increasing the demand for money in the Money Market, putting pressure in interest rates.  Increased costs of production leads to increased costs of New Zealand goods and services, which relative to the Rest of the Work, decreases the overseas demand for our goods and services.  Decreases in demand lead business to reduce the amount of goods and services they produce, decreasing thier demand for labour.  Decreasing in the demand for labour puts downward pressure on wages back in the Labour market, and the initial "shock" to the system which started in the Labour Market is returns back to the Labour Market through the interaction the shock has had throughout the system. 

That's only one potential "channel" for the transmission of shocks and responses around the model.  Potentially, the increase in interest rates can attract overseas capital as one response, and that itself has implications within the system.

But the important point is that everything is connected, everything is inter-related, and no market is an "island" where changes can occur in isolation.  Economists create careers perturbing models like this and getting a sense about how changes oscillate through and around "the system".

Getting back to the this bar-fly's point:  bank's can't make money and debt in isolation - the demand for finance is tied to the demand for goods and services, which is itself tied to production.  They match dollar-for-dollar. Increase in debt is match by a corresponding increases in amounts spent on goods and services, which matches dollar for dollar to an increase in the returns to the incomes of the factor's for production.  Interest payments are achievable because production processes generate "value added" - an excess of income over the costs of production.  In fact, that's the engine of economic growth and why the Gross Domestic Production of economies normally increases over time :)

Thinking about markets and models of the economy is how economists avoid fuzzy thinking, especially from unbalanced political rhetoric.

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