Economical Equilibrium

by Ilya Kuntsevich

  One of Albert Einstein’s quotes: “The hardest thing in the world to understand is income taxes” has a lot of merit. Net profit (income) is not possible in a closed-end system, unless money is printed, on the one hand, or people start working harder and compete with each other for profits, on the other. While the former premise makes sense in expansionary economics (taxes are effectively “paid” by the growing demand), the latter doesn’t, because a government only wins from a rat race by its citizens. Who would want such a government or such a system?

  It is easier to understand income taxes in terms of a circulation volume, not difference between revenue and costs (accounting profit or income). The same Dollar can be taxed multiple times, depending on how quickly that Dollar is circulated within the economic system. Effectively income taxes are charged not on income, but on volume of business activity (i.e. GDP). Back to our village example, if $100 is circulating (changing hands) at a rate of 5 times during a year, and the government imposes 10% income tax, government would collect and spend $50 during that year. Accordingly, if GDP slows down (consumption decreases), a government collects less taxes in absolute terms, and vice versa.

  If a government doesn’t have enough cash to perform its duties, it has three choices: reduce government spending, increase taxes or borrow money. While the first two choices are intuitive, the third choice, given the modern state of the global economy, requires an explanation.

  Let’s see a big picture using the U.S. as an example. Due to the pressure on corporate profits, companies outsource jobs overseas for cheap labor and resources. Such business practice not only causes a significant burden on local unemployment levels, but also results in net capital outflow. Increased profit tax (due to increased margins) more or less compensates social security benefits to those who lost their jobs, but how does the Government handle net capital outflow?

  The only way to issue international debt is by selling it for U.S. Dollars. Due to the U.S. international outsourcing model of low labor and goods manufacturing, U.S. Dollars, which would have stayed in the U.S. otherwise, flow to other countries. Other countries can’t spend Dollars locally; hence they buy U.S. debt, thus importing money back to the U.S. This way the Federal Reserve doesn’t need to print money to compensate for the net capital outflow, but there is one big problem - government starts spending money it doesn’t have, artificially boosting GDP with debt money.

  In order to maintain a healthy economy, money (local currency) should stay within the economic system. Otherwise there is less local economic activity and tax revenue no longer covers government needs. When imports exceed exports (main reason of net capital outflow), merchandise, which otherwise would have been produced locally, is assembled overseas. In this case corporate profits should be taxed at higher rates in order to remove the cheap labor incentive and instigate local contribution instead, thus adding to the local GDP.

  Currency Purchasing Power

  An economy, represented by its own local currency, can grow only if there are more goods and services produced and /or sold (exchanged) in that local currency.

  The more goods and services are exchanged in one currency, the stronger that currency becomes:

  - Increased demand for a currency means a country can borrow against its increased value;

  - It doesn’t matter where a commodity / merchandise is located as long as it is traded in a given currency;

  - Confidence in a given currency increases as more goods and services are measured and exchanged in it; and

  - Increased demand for a given currency makes it a commodity and a value preservation asset.

  Value of money is derived from what one can buy with the money, that’s why it is an asset and a commodity at the same time. As the economy grows, money circulation increases, on the one hand, and more money is printed, on the other, in order to sustain the economic growth. One should never forget that money is still an ether, allowing economic transactions to take place. Its value may fluctuate like any other commodity or intangible asset – depending on the ultimate demand and supply.

  The mechanism of international trade with foreign economies and foreign currencies (FC) works as follows. Before buying FC denominated goods, one first buys FC at an exchange rate that approximates how much the goods would cost in a local currency. The FC bank has a right to sell you FC in exchange for your local currency. This is usually done by means of giving you a loan in FC (or a letter of credit), which can be spent to buy FC goods. This way a bank finances sale of the goods in the first place. In order to repay the loan, one needs to buy back FC.

  A foreign currency is an attractive buy only if there are valuable goods and services in that foreign country, thus backing FC value. Exchange rate is something that represents a comparable value of FC in local currency. Otherwise there would be no exchange rate. Therefore, currencies represent access to valuable goods and services, nominated in those currencies.

  Demand for FC means that a willing buyer will sell his local currency (and as such, open an opportunity to buy goods and services, denominated in the local currency) to get FC, so that he could buy goods in that foreign currency. Accordingly, if one country just buys FC and doesn’t spend it on the goods and services, it removes the purchasing power of the local currency, because then there is less money in its economic system. If the other country decides to sell its FC currency as well, there will also be less money in its economic system.

  Natural resources or something else of value – art, machinery, equipment, etc. represent value to the FC holders. An interesting chain of events occurred post-2008, when the Swiss franc was designated a “safe haven” currency, and the Swiss government had to peg its currency exchange rate to the Euro in order to stay competitively priced for exports. When one country just buys other country’s FC, it increases its exchange rate artificially, because there are no goods or services sold for this purchase back to the country that buys FC. Accordingly, maintenance of a healthy equilibrium of sales (buys) of currencies and respective exports (imports) is one of the main responsibilities of any central bank.

  Pegged currency means that a currency’s exchange rate is fixed at a certain rate regardless of supply and demand. Such measures allow some countries to keep the exchange rate of their local currency low in order to stimulate local production (if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services instead). This measure will generate more jobs and stimulate the local economy’s GDP. Such a policy will also allow accumulation of excess FC reserves, which can be later used to buy foreign assets. China is one of the most effective users of such FC policy, keeping its exchange rate low for years in a row, in order to stimulate its local economy and accumulate FC reserves to buy foreign currency denominated assets.

  PART II: GLOBAL ECONOMY

  Economic Growth

  The global value of economics and wealth increase as the standard of living increases, i.e. both contribution and demand increase at the expense of once abundant natural resources. Human labor and technology helps convert natural resources into devices, homes, cars, etc., which are valued by the society and associated with so called civilization, progress and overall standard of living. Recent technological advances allow more people to enjoy lifestyles they could only dream about 20–30 years ago. The monetary base and its velocity increase in order to support increased consumption, because more goods and services are exchanged.

  In order for you to sell something, someone else has to have money to buy it. The economy grows organically as people invent new things and make technological progress, although it causes wealth inequality, as discussed in Part I. Nevertheless people tend to try new items and thus exchange these items if they find them of value.

  In the past people used to trade and accumulate gold and silver as the only means of exchange. Today people trade to accumulate paper and electronic money, because everything can be exchanged for it,
including gold and silver. Lending money in the form of debt became an option after profits started to accumulate on the banks’ balance sheets, because money would have been continuously circulated otherwise and banks would have no discretion over its use.

  Spent debt (e.g. credit cards, HELOCs, student loans, etc.) has no immediate cash value, because a person who received debt money and spent it didn’t contribute anything that can be immediately monetized. On the other hand, this debt money, spent on goods and services, increases GDP. Therefore, real GDP growth (not debt financed) occurs only when there is an equivalent contribution by labor or technological conversion of natural resources.

  How much money does an economic system need? As much as it takes to exchange goods and services multiple times during a given period. Excess money, accumulated from profits, stays within the financial system, waiting for allocation in order to grow the economy further. When economic growth stops or slows down, excess money sits idle, unless it is introduced to other economies in a form of debt, which then stimulates the local economy.

  As a consequence of the 2008 crisis, money was printed post-2008 by the Federal Reserve in order to deleverage banks and bring liquidity into the financial system. Such policy will eventually cause CPI inflation that will be absorbed by all participants involved in the economic process, because there is still no real contribution justifying printing more money. The only measure that “saves” the U.S. from high CPI inflation today is the “export” of inflation in the form of international debt increase.

  Profit recognition effectively reflects more work required in order to justify monetary inflation and economic growth. Part II covers this and other matters pertaining to the current state of the modern global economy.

  International Reserves

  Let’s create an example. Germany sells a car to the U.S. The buyer pays $50,000 (a promise to deliver value in the future in exchange for $50,000 worth of value). A German bank shows $50,000 in cash (assets) and current account of a German manufacturer (bank deposit). The buyer agrees to deliver something of $50,000 in value to the seller at a later time, signifying indebtedness with money – delayed value.

  The German bank buys $50,000 worth of the U.S. treasuries and wires the money back to a U.S. bank. $50,000 returns back to the U.S., but the German bank has $50,000 due to the German manufacturer. Cash to the value of $50,000 returned to the U.S. and is now back in the pockets of the U.S. buyer to spend.

  In the aftermath, the German manufacturer has produced and delivered a car for a promise to be paid and / or receive similar value of goods and services in the future. This promise was later converted into the U.S. treasuries, which allowed the U.S. to have both a car and $50,000 of liquid assets (cash) to spend on other items. Accordingly, Germany’s (or any other country’s) reserves, placed into the U.S. treasuries, are effectively money spent by the U.S. on goods and services, imported by the U.S.

  The U.S. debt is secured by the United States’ capability to produce and sell goods and services (or anything else Germany finds of value), which Germany may be in need of in the future, because the only way for Germany to redeem the U.S. debt is by spending U.S. Dollars. Such confidence comes from a number of things, including U.S. manufacturing, intellectual property and U.S. Dollars’ denominated natural resources.

  The more Germany produces and the U.S. consumes, the better it is for the German economy, but unless Germany needs something in return for their excess of contribution over demand, the U.S. will never have to pay its debt back.

  Therefore, global international reserves (debt) represent the excess of the previously recognized contribution of some countries over the previously fulfilled demand of other countries. Value of the international reserves is backed by a confidence that someday it will be paid back in the form of goods, services or anything else of future value, but in fact it doesn’t have to in order to keep the global economy going as is. The only loser in this equation is Mother Nature, because economic activity increases only at the expense of natural resources to satisfy the ever-growing demand of the human population.

  Pension Funds and Social Security

  Pension funds and any other form of social security were invented to ensure trouble-free retirement for people of a certain age and people with disabilities, who cannot contribute equally to their demands. Every country is different in the way that they determine the respective designations and requirements for retirement or other social benefits.

  Retirement age hovers around 60 years old across the globe. While the economic model in place when such plans were introduced was one of expansionary growth and, as such, earlier retirees could benefit from it, nowadays such an economic model is no longer viable and sustainable due to market saturation, increased competition and technological advancements.

  Most likely, the initial pension models were not well thought through in light of the fundamentals of economics discussed in Part I. It is sad to observe the reaction of some countries to the fact that pension and social security models are broken. Instead of changing the substance of their economic models, i.e. try to figure out a non-expansionary economic model, governments leave the core of the model the same, but increase retirement age, make strict qualification requirements and increase overall taxes in order to stay current on their pension obligations. Such measures represent “active inertia” and an attempt to cover incompetence of economists, who advise on such measures.

  If the initial premise was that a given economy would always grow and increase productivity indefinitely (in perpetuity), the pyramid of the pension funds would have worked just fine. Given the fact that constant perpetual economic growth is impossible due to market saturation, competition and technological advancements, pension funds and any form of social security cannot possibly pay back more than was contributed.

  Some money could be preserved in line with inflation had the pension money been invested into value preservation assets, but not stocks and bonds, which currently represent 70–90% of all pension funds’ investments in the U.S. Stock market. Bonds are non-cash, i.e. they cannot be sold instantaneously without losing the majority of their value.

  What is the best storage of value for pensioners and social security? If money continues to be printed and borrowed to sustain increased demand, but no actual contribution is made to compensate, where should money be invested? Historically, houses, gold and oil represent the best storage of value over time and offer the strongest resistance to (monetary) inflation. According to the Flow of Funds Accounts of the Federal Reserve Board, the value of residential real estate doubled between 1999 and 2006, rising from $10 trillion to $20 trillion.[8] The spot gold price increased from under $400 per ounce in 2002 to over $1,600 per ounce in 2012.[9] Crude oil (WTI) increased from low $20s in 2000 to low $90s per barrel.[10] How much residential real estate value was kept post 2006 is a different question, because there surely was a decline, but my point is that land is more secure than stocks or bonds, and tends to appreciate in line with monetary inflation because people need land to live and produce. The same is valid for gold and oil – these are essential commodities both from perception and for living.

  Living either on rent from the hard assets (houses) or selling them makes more sense than investing in stocks and bonds. I understand there may be a lot of counterarguments to this conservative position; why not invest pension and social security money in the instruments that historically show better protection against inflation, shortage of liquidity and distress in the financial markets?

  People and Jobs

  When people give up their free time to labor in order to get food and shelter, they contribute to economic growth. Working for a paycheck and paying taxes works to the benefit of GDP and government, thus the entire society wins.

  Progress, on the one hand, allows more free time, but due to increased consumption, on the other hand, we tend to sacrifice this freedom by working more, in order to get more stuff. Such dependency on technology is most
likely because we want to keep up with others who do the same – must be the ancient “herd” instinct.

  Activity of people, involved in the process of creating something of value for sale, is measured with money. When technology progress reduces labor input (thus reducing the cost of manufacturing), increased profits accumulate and cause economic distortion (more on this topic in Wealth Distribution chapter).

  This is a sensitive subject given where the global economy is now – significant unemployment levels both in developed, but even more in developing countries. On the one hand, the more people are busy at work, the more taxes they pay to the government through individual income taxes. On the other hand, reliance on employees as a key source of income tax revenue in developed countries appears to be a shortsighted approach due to a shift in wealth distribution, ultimately resulting in less tax revenues for governments.

  An economic growth model that is based on high employment works in countries like China, but it no longer works in countries like the U.S., where either technology has replaced hard labor, or low paid jobs were outsourced to the developing world. On the one hand, China uses cheap human labor in labor-intensive industries to maximize profits of the worldwide corporations (most of which are U.S. based), but on the other hand, accumulation of wealth by these corporations is done at the expense of U.S. demand, which, in turn, puts excess pressure on the U.S. Government, as was discussed in the Government and Taxes chapter in Part I.

  Therefore, the U.S. tax model has to change to match changing wealth distribution with the needs of society, at which expense such wealth is created in the first place.