## Tuesday, August 10, 2010

### What is the economy?

I bet if you asked most people what the economy was they wouldn’t be able to really define it. They’d say it’s “business” or the work we do or making money. It’s certainly all those things, but it’s really more.

Very simply, the economy can be defined as the sum total of everything that we produce here in America. That’s what we call GDP or, “Gross Domestic Product.”

There are four components to GDP. They are:

1. Personal consumption (C): That’s everything that individuals spend money on. It’s also the biggest component, comprising about 70% of GDP or, \$10.3 trillion.

3. Net Exports (NE): That’s the sum of exports minus imports. This number is pretty much always negative because we pretty much always run a trade deficit (imports being larger than exports). At the current time net exports subtract about \$520 billion from GDP or -4%.

4. Government (G): This is everything the government spends money on. That comprises about 21% of GDP or, \$3 trillion.

Now that you know the four components or “ingredients,” you should understand that the economy can be expressed as a simple arithmetic equation that looks like this

GDP = C + I + G –NE

Where C equals consumption, I equals business investment, G equals government, and NE equals net exports (which is almost always negative as I said).

Once you see how simple this is, you can see how you can manipulate the equation to come up with any desired outcome.

Here’s an example.

Suppose C=3, I=2, G=1, NE=-1

Plugging those variables into the equation we get:

GDP = 3 +2 + 1 -1

Therefore, GDP = 5.

Changing any one of the variables or all of the variables changes the outcome.

So if government spending goes up, rather than get all excited and worried about it, just plug the new number into the equation and see what happens.

If government spending (G) goes from +1 to +2 and the rest of the equation stays the same, we get:

GDP = 3 + 2 +2 -1

Therefore, GDP = 6.

In other words, GDP has grown, it’s gotten bigger. That’s good for stocks!

Why is this important?

Because in the present environment government spending is the easiest variable to change. The others are lot tougher. (How do you expect people to consume more when they don’t have jobs, for example?) On the other hand the government really has no constraint to how much it can spend because it spends in its own money (the U.S. dollar and the gov’t is the monopoly issuer of its own currency) and spending is done by merely electronically crediting bank accounts.

Is there a risk to doing this? Yes. The risk is that spending without constraint will use up all the available capital (both physical and human capital) of the nation. Think of it like pushing your car past the “red line” on the tachometer. However, we are nowhere near that at the present time. We have millions of people (human capital) out of work and industry operating at only 70% of its capacity. In other words, we have a lot of capital not being used.

Hopefully, when you explain this to your friends and colleagues it will take some of the fear or misunderstanding out of the whole thing and it will help them see that there are opportunities when others may look at this as risk. It should also show that the way out of our mess is quite easy.

Tom Hickey said...

Nice post, Mike. I would add that philosophically the economy is the material life-support system of society. That is to say, a society's economy has a purpose that is determined exogenously by society, not endogenously by the economy. The end-in-view is the survival and progress of society as a whole, not the benefit of any particular part.

Macroeconomics is the study of action and consequence from an economic perspective. The conclusions inform about policy options. The political process is the choice among these options and their implementation.

Presently, this is being ignored in favor of partisan struggles for power, influence, and wealth. The questions that should be asked relate to macro-based models that are based on operational reality and fact, not on ideological assumptions lacking empirical warrant and contradicting operational reality.

When the accounting identities relating to sectoral balances are considered and data is plugged into stock-flow consistent macro models based on operational reality, it becomes clear that the existing problem is twofold, too much private debt and too little demand. The private sector needs space to repair balance sheets after a long debt binge. If debt-deflation, massive liquidation, and depression are to be avoided, then government must step in to prop up effective demand to spur consumption without adding private debt.

This means that government needs to expand its balance sheet, which is can always "afford" because a monetarily sovereign government that is the sole provider of a nonconvertible floating rate currency funds itself directly though currency issuance. The US government does not face a fiscal crisis now, nor will it in the future under the present monetary system.

The political choice is not whether, but how. This involves examining the options, like cutting taxes and increasing disbursements, figuring the multipliers, and locating targets. That is not yet happening, and if it doesn't happen soon, disinflation is going to turn into deflation.

The cost of not acting is foregone opportunity from lost GDP, as well as degradation of resources, especially human resources. A cost cannot be computed for the later, since human life is priceless.

Tom Hickey said...

Nice post, Mike. I would add that philosophically the economy is the material life-support system of society. That is to say, a society's economy has a purpose that is determined exogenously by society, not endogenously by the economy. The end-in-view is the survival and progress of society as a whole, not the benefit of any particular part.

Macroeconomics is the study of action and consequence from an economic perspective. The conclusions inform about policy options. The political process is the choice among these options and their implementation.

Presently, this is being ignored in favor of partisan struggles for power, influence, and wealth. The questions that should be asked relate to macro-based models that are based on operational reality and fact, not on ideological assumptions lacking empirical warrant and contradicting operational reality.

When the accounting identities relating to sectoral balances are considered and data is plugged into stock-flow consistent macro models based on operational reality, it becomes clear that the existing problem is twofold, too much private debt and too little demand. The private sector needs space to repair balance sheets after a long debt binge. If debt-deflation, massive liquidation, and depression are to be avoided, then government must step in to prop up effective demand to spur consumption without increasing private debt. [Continued]

Tom Hickey said...

This means that government needs to expand its balance sheet, which is can always "afford" because a monetarily sovereign government that is the sole provider of a nonconvertible floating rate currency funds itself directly though currency issuance. The US government does not face a fiscal crisis now, nor will it in the future under the present monetary system.

[Continuation]
The political choice is not whether, but how. This involves examining the options, like cutting taxes and increasing disbursements, figuring the multipliers, and locating targets. That is not yet happening, and if it doesn't happen soon, disinflation is going to turn into deflation.

The cost of not acting is foregone opportunity from lost GDP, as well as degradation of resources, especially human resources. A cost cannot be computed for the later, since human life is priceless.

Tom Hickey said...

Oops. Sorry for the duplication. I got a warning that the post was too long, and I didn't realize it had actually been posted anyway.