Using the Monetary Base as a Recessionary Indicator

"The reason why there is inflation is because the money supply is increasing"

I've heard that argument so many times over the years I decided to look at the data. So I began keying in the increase in money supply using the AMBNS data series at the St Louis Fed when I saw this problem:

Yep, the monetary base seems to have gone into overdrive since the Global Financial Crisis hit. The problem was, though, that in a credit crisis banks and financial institutions tend to sit on their money. I then discovered the EXCRESNS data series at the St Louis Fed, which measures excess reserves:

Yes well that graph is certainly frightening and pretty much confirms that the financial crisis we are experiencing is the worst since the great depression. Yet despite the fact that the Fed has been madly pumping money into the economy and increasing the monetary base (M0), "depository institutions" (ie banks, mainly) have sat on a lot of that money. In other words, a lot of the increase in money supply has been countered by a resistance to lend. Yet there is obviously a way to more accurately measure the net amount of money in the monetary base by removing the excess reserves from the monetary base figure. So to come up with the "Net Monetary Base", we get the M0 figure ("AMBNS") and take away the excess reserve figure ("EXCRESNS"). So I punched up the data into my spreadsheet and this is what I have come up with for the past 20 years:

Well there we have it. A line going up. Woo hoo OSO you've done some great work there.

But it's not the actual amount of money we're interested in so much as the annual increase. So here's the year on year increase in Net M0, with recession bars thrown in:

Now THAT looks more interesting doesn't it? In fact the most obvious question I had when I first made this graph was "What is that spike in the money supply in the middle of the graph?" According to the Federal Reserve Bank of New York:

A variety of factors continue to complicate the relationship between money supply growth and U.S. macroeconomic performance. For example, the amount of currency in circulation rose rapidly in late 1999, as fears of Y2K-related problems led people to build up their holdings of the most liquid form of money...

Interesting stuff. Yet there also seems to be another factor at play here, namely the fact that recessions seem to be associated with monetary bases that are only growing slowly. Let's look at the same graph for 1970-1990:

Oh well so much for that theory I suppose. Look those four recessions in the 1970s and early 1980s - obviously the money supply was increasing before and after these recessions. If we connect the above graph with the 1990-2010 one we'll even see that while the increase in the money supply drops in the late 1980s, it is still increasing when the early 1990s recession hits. So it appears as though the experience of a contracting money supply causing a recession is only applicable to the last two recessions. Or is it?

We need to remember that inflation is something which needs to be factored in here. While inflation can be caused by an increase in the monetary base, it can also result from an increase in money velocity as well as supply constraints. In theory, if the money supply is increasing (or decreasing) at a faster rate than inflation (or deflation), then it means that goods and services are getting "cheaper" in relation to the total money supply; conversely, if the money supply is increasing (or decreasing) at a slower rate than inflation (or deflation), then it means that goods and services are getting more "expensive" in relation to the total money supply.

So let's put that in some graphs - the spread between annual growth in the net money supply and annual inflation, for 1960-1970, 1970-1990 and 1990-2010:

Bingo! Suddenly it all makes sense. Recessions occur whenever the spread between the Net Monetary Base and Inflation is negative. A negative result implies that inflation is greater than the increase in the money supply, which means that a real deterioration in purchasing power occurs. It is thus a reliable recessionary indicator going back to at least 1960.

Of course one of the characteristics of this indicator is that while negative results imply a recession, the actual recession may or may not be directly associated with that period:

• The 1973-74 recession starts almost immediately the spread goes negative (it was the direct result of the 1973 oil crisis, which was a supply shock).
• By contrast, the 1980 and 1982 recessions start after a long negative spread period.
  
• The early 90s recession is also different in that it started after the spread returns to positive.
  
• The GFC recession started after multiple dips into negative territory and continued for some time even when the positive spread exceeded 1000 basis points.
  

Obviously if we keep a close eye on this spread, we can determine whether the economy is in danger of recession. At the present time (using data from November 2010), the spread is 426.61, which is healthily in positive territory. In fact, here's a graph of the last 36 months:

This shows that it was touch and go in the first half of 2010 as the spread neared zero but remained positive, but that things have improved somewhat since then.

To create this graph yourself you can download the following data from the St Louis Fed and use it in a spreadsheet:

• AMBNS (The Monetary Base)
• EXCRESNS (Excess Reserves)
• CPIAUCSL (Inflation Index)
• NBER recession cycles
  

The equation is simple:

1. AMBNS minus EXCRESNS = Net Monetary Base
2. Place the results of the Net Monetary Base and CPIAUCSL side by side in the spreadsheet
3. Use the spreadsheet to determine the year on year percentage growth of both the Net Monetary Base and CPIAUCSL
4. Take the year on year result for the Net Monetary Base and minus the year on year inflation result to discover the spread
5. Add recession bars from NBER data
   

Here is how the page in my spreadsheet looks with this data.

Update: 2011-01-08
Graphs showing each decade can be found here.

Iceland vs Ireland: Which is worse?

Much has been said recently about the contrasting fortunes of Ireland and Iceland. In 2008, both nations were seriously affected by the global financial crisis with both economies declining substantially. Recent commentators, most notably Paul Krugman, have argued that Iceland's response to the crisis has had a better outcome than Ireland's. Iceland, with its own currency, allowed the Krona to depreciate substantially - a process which caused an inflationary bout. Ireland, on the other hand, is part of the Eurozone and while capital flight has been felt in the Irish bond market, the Irish economy has not undergone a currency depreciation - a process which has caused a bout of deflation.

So in order to discover which nation has had a worse economic experience, I have mined some data at official sites. For Irish GDP data, I downloaded the latest Quarterly National Accounts; for Icelandic GDP, I looked up data at Statistics Iceland. In order to ensure harmony between the two datasets (and thus ensure apples are being compared to apples) I cross checked the data with the latest Eurostat GDP release. Then, via a spreadsheet, I have created an Index comparing the economies of the two nations. Here is that index:

As you can see the current situation is hardly good for either nation. According to this index, Ireland's economy has shrunk by 13.4% since 2007 Q4, while Iceland's has shrunk by 11.7%. The advantage that Iceland has over Ireland in terms of GDP is quite small. Moreover, Ireland's economy has been in trouble longer than Iceland's - it wasn't until 2008 Q4 that Iceland's troubles really began while Ireland's had begun 12 months previously.

Nevertheless, one important indicator shows a huge difference between the two: unemployment. The latest figures from The Economist show that Ireland's unemployment is currently 13.6%, while Iceland's unemployment is 7.5%. Another important indicator is the budget balance. The Economist tells us that Ireland's budget balance is -37% of GDP, while Iceland's is only -7.7%. While both nations have serious problems, these figures seem to show that Ireland's is far worse.

Of course one of the reasons why Iceland and Ireland are so different in their experience of the economic crisis is the one that Krugman likes to champion: devaluation. Iceland has allowed the Krona to devalue while the Irish are "stuck" with the Euro. Yet this argument assumes that exchange rate variations don't really matter - at least over the medium to long term. It is obvious, though, that Iceland's GDP has reduced in value in comparison to the Eurozone simply because of the Krona's devaluation. When we factor in the devaluation of the Krona when comparing the two nations, the difference is much starker:

The data for the Krona's performance against the Euro can be found here. I averaged out the monthly mid-range figures for each quarter. For example the Euro-Krona exchange rate for 2007 Q4 was 88.7466926667 while for 2008 Q1 it was 101.325026. I then assigned an index of 100 for the 2007 Q4 and used the math in the spreadsheet to multiply each quarter's decline in currency to the GDP figures.

According to this graph, Iceland's GDP, as measured in Euro, has declined by a whopping 52.1% since 2007 Q4, which is due to a combination of economic decline and currency devaluation. While Iceland's unemployment rate may be lower than Ireland's, holders of the Krona (ie the citizens, businesses and government of Iceland) have had their wealth taken away... not by taxes, not by spending cuts, not by austerity measures, but by the foreign exchange market.

Ireland has a number of choices, none of them good. One choice is to default on debt. Another choice is to take money away from households and businesses in the form of spending cuts and/or tax increases. Iceland, by contrast, has had these choices forced upon them by the currency devaluation. If Ireland had the choice of default, Iceland has already done this as international creditors have lost out on their investment. If Ireland has the choice to take money away from households and businesses, Iceland has already had this done as the purchasing power of the Krona has been essentially halved.

The Iceland/Ireland battle is an interesting one because it lines up different views of economics: Iceland is favoured by Krugman and those who believe in using inflation as a means to reduce real debt; Ireland is favoured by Europhiles and those who believe that currency devaluations and inflation damage economies; Iceland is favoured by those who are not too concerned about sovereign debt default; Ireland is favoured by those who believe that debt should be paid back, especially sovereign debt; Iceland is favoured by those who believe that the Eurozone and its "one size fits all" monetary policy is doomed to failure; Ireland is favoured by those who see inherent advantages in having a common currency and monetary policy which ensures that the currency retains its value; Iceland is favoured by those who believe that monetary policy should be used by central banks to help grow the economy when needed; Ireland is favoured by those who believe that price stability should be a central bank's sole concern, and that fiscal policy should be used by governments to grow the economy when needed.

My bet, of course, is with Ireland - the Eurozone recovery, led by Germany, will create a demand for Irish goods and services, grow the Irish economy and reduce Irish unemployment. Nevertheless it will be fascinating to see how these two nations perform as years go by.

Random thoughts on the basics of economics

At its basic level, economic growth involves an increase in the production of goods and services. Real growth - that is, economic growth adjusted by population - is thus a function of efficiency: an increase in the production of goods and services per head of population. This implies an increasing efficiency in production. In a market system, efficiency is measured by profits and price. In any system (market or otherwise), efficiency is measured by total cost.

Profit: When goods and services are cheaper to produce, private companies make higher amounts of profit.
Price: When goods and services are cheaper to produce, consumers pay less.
Total Cost: When goods and services are cheaper to produce, the total cost of production and consumption to the economy is lowered.

The economy suffers when:

• The total cost of purchasing these goods and services goes up - total cost being price plus total cost of ownership plus total cost of production. Cost involves more than price.
• The measurement of price and cost becomes opaque due to changes in the value of money, which acts as a unit of measurement. (Money is simply the means by which society orders the economy around. Money acts as a unit of exchange, a unit of measurement and an asset that is subject to the laws of supply and demand.)
• Investment bubbles occur within a market system. A bubble is inherently unproductive.
• An economy produces and consumes goods and services that it does not need (eg, most Western nations can survive on half the food they consume without any real negative effects to the economy)

If there is no increase in the efficiency of production, the economy moves into a steady state, neither growing nor declining (the model proposed by Robert Solow).

An increase in the efficiency of production usually results from technological change (also pointed out by Solow)

While the market system is the most widely used economic system, government forays into an economy have proven to sometimes work and sometimes not. The only pragmatic reason for a government to inject itself into an economy (ie by producing goods and services itself) is if it is able to be more efficient than the market in the area being affected (there are other reasons than being pragmatic though).

With Sovereign Bankruptcy must come a change in Sovereignty

It appears as though Ireland will accept a bailout from the IMF. Without this, and without help from its European partners, the Irish government is likely to default on its debts. While Ireland's sovereign debt level is not as bad as some, a budget deficit of 38.5% of GDP has passed the point of ridiculousness. Even though the economy is improving, it has not improved enough to make an impact on the nation's finances.

Ireland, like Iceland and Greece, has been the creator of its own problems. In normal times, political and economic stupidity and profligacy can be forgiven and eventually papered over. Not this time. The Global Financial Crisis has led to social and economic misery around the globe. Like a cyclone or hurricane it caused major damages to whichever country it hits, but especially upon those who were unprepared and whose financial and economic systems were already dangerously unbalanced.

Ireland's biggest advantage is that it is part of the European Union and that it is part of the Eurozone. This means that it was not tempted to destroy its people's wealth through a currency devaluation - the error that Iceland has made and one which the United States is likely to make. Whatever can be said about architects of Ireland's demise, at least those who saved responsibly have retained their savings and their purchasing power. This will help in Ireland's recovery.

But just as bankruptcy leads to the closure of a business, so should a sovereign default result in a change of sovereignty. This is not to say that Ireland should cease to exist as a political entity - far from it. What needs to change is the nation's constitution and its political system. And this is not code for a new election and some constitutional amendments - rather it is the creation of a completely new nation with a new constitution and a newer way of doing things.

The modern Republic of Ireland came into being during the 20th century. Independence from the United Kingdom resulted from a bloody but thankfully short-lived war. The nation was proclaimed a republic in 1949, completely seceding from the commonwealth of nations and setting up an Irish presidency to replace the British crown as the nation's executive.

Of course none of these political achievements of sovereignty need to be repealed. Nor should the efforts of individuals in gaining such sovereignty be ignored or forgotten. Yet the Republic of Ireland has had its day. A new nation needs to be created from the ashes of the old.

France is in its Fifth Republic. The current political entity of France came into being in 1958. Of course France existed long before 1958, even longer than the four republics and other institutions that governed since 1789. Yet despite the idea that France is an "older" country than Ireland, the current iteration of France is actually nine years younger. Countries have dissolved themselves in the past and reformed themselves into newer entities.

What is needed is an Irish Second Republic.

Some time in the near future (1-2 years), the people of Ireland need to vote in a new constitution. Specifics of the electoral system will be voted on. Moreover, the political parties currently involved in the government will be dissolved - their assets stripped and sold off and the money given to the treasury of the new government. No politician who served in the first republic will be eligible to serve in the second republic. The new political parties will have to go back to the drawing board in garnering popular support. Once the constitution has been approved by the people, the second Republic will be "born" and a new country will result.

Naturally you might ask the question why? Why should sovereign bankruptcy lead to a change in sovereignty?

Part of my reasoning on this is that nations, like individuals, need to suffer the consequences of their actions. Since Ireland as a nation is responsible for its current plight, then Ireland as a nation should cease to exist and be replaced by a new entity. Just as a bankrupt business needs to close permanently, so should a country shut itself down permanently. Yet a nation is not like a business in that it consists of people, and people exist no matter what happens to a business - so the only reasonable solution is that when the nation is "shut down" it undergoes a new birth into a new national identity. So should the current Irish republic shut down and a new one replace it.

Moreover there is the idea that Ireland's plight is not just due to the stupid decisions made by those in power, but by the political system that brought such people into power into the first place. As a result, the political system itself needs to change. From a business perspective, it isn't just sacking the board and electing a new one that will solve the problem - it is the entire system of how the board was voted in, and how the business runs itself, that needs to be changed.

Some may find my business/nation analogies here to be simplistic or offensive. They're not meant to be. Yet just as a company board acts on behalf of shareholders, so too do elected officials act on behalf of the people who make up the nation. Since Ireland's current political system led the nation into bankruptcy, it only stands to reason that a new political system be set up. Wipe the slate clean. Start again as a new country.

Of course, one alternative solution would be for the Irish to simply take the money and keeps things running the same way. Not only does this not punish those who failed, but it leaves in place a clearly defective political system that may just fail again in the future.

Another solution might be to subsume Ireland into the territory of another nation. A nearby friendly nation could, in theory, offer to pay off all of Ireland's debts if Ireland become part of their... kingdom. Naturally such a suggestion is ridiculous.

For Firefly Fans

When banks refuse to lend, the government should create banks that do

One of the more distasteful occurrences over the past few years has been the sight of banks and financial institutions wallowing in the mess they created. Yet this has not been as distasteful as the sight of these same banks and financial institutions being propped up by the US Federal Government, either in the form of bailouts or in increasingly radical monetary policy.

On the one hand I heartily approve of the "creative destruction" that oftentimes besets capitalism, namely that companies and corporations should suffer the consequence of their actions. To watch a stupid company wallow in the mess that it has created is a sober reminder of the perils of too much risky behaviour, especially if such behaviour is endemic. Schadenfreude aside, one of the major advantages of this "creative destruction" occurs when new entrepreneurs with different ideas begin to take control. Recessions and economic downturns are excellent ways of restructuring and improving the system that failed.

But on the other hand, banks and financial institutions are not just like any other company or corporation. Lending money for the purposes of profit is one of the most important practices of a market economy. The collapse of financial institutions can be far more damaging to an economy because, without them, it becomes harder for investors to invest, and harder for borrowers to borrow. This is called a Credit Crisis, and it is what caused both the Great Depression of the 1930s and the Global Financical Crisis that we are experiencing today.

Many economists have pointed out since 2008 that the United States economy is not in a liquidity crisis, but a solvency crisis. This doesn't just mean that it is harder and harder to borrow and lend (as per a liquidity crisis), but that the very financial institutions themselves have become insolvent and close to bankruptcy. This means that money "pumped into" the economy through monetary policy is unlikely to have much effect, since it takes time for bad debts to disappear from the books of these financial institutions (a process that could take years). This in turn leads to "Zombie Banks", whereby the net worth of these institutions is less than zero.

So what we have now is a series of zombie banks and other financial institutions. We're trying to resuscitate them in the hope that they will come alive again, and the process by which we are resuscitating them involves conventional monetary policy (raising and lowering interest rates) and unconventional monetary policy (quantitative easing).

Yet I think that there is an alternative to the current situation. If banks and other financial institutions have encountered a solvency crisis and have been "zombified", then perhaps it would be better to simply put them out of their misery, while simultaneously creating "new life" - creating new banks and financial institutions that do not have the same limitations of the undead ones.

The process would be rather simple. A bank is brought into existence by way of congressional legislation and capitalised with quite a few billion dollars of tax payer's money. A board of directors is set up, also by congressional fiat. This board should consist not of industry insiders but experienced businessmen and women who are not just cognizant of the circumstances that led to the recent financial collapse but also willing to avoid the mistakes that were made by the industry leading up to it. The bank will thus become a profit making government enterprise, governed by the congressionally appointed board, and will begin setting up offices throughout the United States to begin operations. As time goes by - say a few years - the bank will be privatized and an IPO will be made on the share market. The money raised in the sale will then be deducted against the tax-payer's money invested in the first place, with the debt remaining becoming a corporate bond owed to the government that will eventually be repaid over time. Moreover, laws would exist to prevent the bank from being merged or acquired by single entities wich would keep the bank owned by a plurality of shareholders for at least the first 10 years of its privatised life (or however many years congress decides upon).

If all goes well, the new bank will generate enough income and profit from its activities to not just pay back money owed to taxpayers, but paid back with interest. This would not just be revenue neutral but revenue positive, allowing a net reduction of government debt over the lifetime of the operation (from creation and capitalisation to IPO and then debt retirement).

And what happens to the Zombie banks while this new bank is created? Hopefully as the new bank grows and develops, so will the zombie banks shrink and eventually disappear.

It needs to be pointed out that the best solution would not be the creation of a single bank, but of multiple ones. Instead of one bank being created and capitalised with tax payer's money, a whole number of banks can be created. This whole process of bank creation could also span many years, with multiple banks being created annually. The process would only stop once congress decides that enough is enough and that the market no longer needs any direct government support.

The creation of multiple banks will help prevent any unsavoury relationships between the banks and the government that created them - once privatized, the government will treat the bank the same as any other, without fear nor favour. Moreover, the creation of multiple banks is essential for a more competitive banking environment.

The advantage that these new banks will have is that they will be solvent, which means that they will be able to respond more effectively to conventional or unconventional monetary policy without being burdened by debts. These banks will also be governed and run by wiser individuals than those who created the crisis, leading to a change of thinking within the credit market hierarchy - a process that is less likely to occur if zombie banks with their flawed management keep being propped up. It also allows "creative destruction" by allowing failing banks to (eventually) go under without compromising the credit market as a whole.

Of course Minarchists would point out that the creation of such financial entities would result in the government intruding into an important part of the marketplace and should not be undertaken, considering, you know, that the government will abuse its position and yada yada yada Nazi tyranny founding fathers blah blah blah. But for those who take stock of what the Founding Fathers of the United States said and did should not be too concerned since congress often created public companies by legislation. In fact the First Bank of the United States was created by the 1st congress which, despite functioning as a proto-central bank, was also partially privatized for the purposes of open market, profit making operations. In short, the government creating a bank by legislation to function in the open market is not just something the Founding Fathers would approve of, but is something they actually did.

Moreover, the creation of new, solvent banks is a better alternative than trying to resuscitate the zombies through increased inflationary policy. Increasing inflation deliberately (which appears to be Krugman's solution) would naturally reduce the debt burden of the zombies and may even result in a more solvent environment. Nevertheless, this would be at the cost of debasing the currency, which may create a pre-2008 environment of negative real interest rates and another bubble economy developing. Additionally, this would ensure that the same financial hierarchy who created the crisis in the first place would retain their power without suffering the consequences of their actions.

The current crop of banks and financial institutions killed the credit industry and helped create the current economic crisis - it stands to reason that they deserve to die and suffer the consequences of their actions. Instead, we have chosen to keep them on life support, feeding them money via bailouts and loose monetary policy in the hope that they will live again, and in the hope that they won't make the same mistakes again. We should abandon this strategy. Instead, we should create new banks capitalised with tax payers money - new banks who will eventually take over the market and allow the zombie banks to die off peacefully.

US Dollar history since 1980 - and how it affects GDP

The USDX is the indice that measures the relative worth of the US Dollar to the rest of the world. Here is a graph showing how the US Dollar has performed since 1980:

As you can see, there was a huge increase in the mid 1980s. The Plaza Accord wiped out the value in the second half of the 80s, while the late 90s saw a resurgence in the US dollar, partly as a result of panic induced by the Asian Economic Crisis, and partly by the Dot-Com Bubble. The large swing upwards in 2008 was due to panic induced by the 2008 Credit Crisis, when investors dumped shares and fled to the safety of treasuries, which naturally drove the US dollar up.

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Now if we add Real GDP to the mix, we can see just how well the United States as an economy has performed against the rest of the world. The idea here is that we look at Q1 1980 as the baseline (100), and then adjust each quarter's GDP performance by the 12 month USDX average. I chose to average out the USDX over twelve months rather than three months because otherwise the graph would look a bit too shaky. Here it is:

What is notable here is that the US economy grew rapidly in the early 80s and then busted as a result of the Plaza Accord. this meant the US GDP relative to the rest of the world did not recover until the 90s. The indicie on my spreadsheet shows that GDP per capita peaked at 193.86 in Q3 1985, reached a trough of 133.49 in Q1 1991, and then reached 195.29 in Q2 1998. In other words, it took 13 years for the 1985 peak to be reached again.

GDP then peaked at 259.93 in Q1 2002, which is interesting since this was after the early 2000s recession had peaked. Obviously the drop in GDP was more than made up for in the rise of the US Dollar. Since 2002, the US has been in a protracted fall in real GDP measured against the value of the US Dollar, the trough being 192.54 in Q3 2008 (just when the credit crisis was hitting the most). Since then there has been a small rise, but not by much. The Q3 2010 indice was 207.38 (awaiting GDP revisions), which means that the US economy has barely doubled in size since 1980.

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Now we look at Real GDP per capita. This is an important measurement because it examines economic performance per head of population rather than just output. Measuring Real GDP per capita is probably the broadest way to measure whether an economy is growing or is in recession. If we adjust it according to the USDX, we get this:

This, of course, looks worse than Real GDP. In fact the latest indice on my spreadsheet for Q3 2010 is 151.48, which means that economic growth per person is only 50% better than what it was in 1980. Peaks and troughs are pretty much the same as Real GDP.

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The last thing I want to look at is the performance of public companies in the US. The Russell 3000 Index measures market capitalisation and has been running as an indice since September 1987. If we adjust the indice by the USDX (monthly values for both) we get the following graph:

Again you can see here the massive impact of the Dot-Com bubble in the late 1990s. The index peaked at 532.12 in August 2000, with a trough of 266.82 in February 2003, a smaller peak of 417.43 in May 2007, a deep trough of 209.98 in February 2009 (a few months after the credit crisis started), and a recent peak of 326.03 in April 2010. The October 2010 indice is 309.75.

In many ways you can see just how damaging the Dot-Com bubble was - each successive peak appears to be lower than the previous one. And remember that this takes into account the relative value of the US Dollar, which means that while Market Caps (and the Russell 3000) might be increasing, the US Dollar might be lowering in value - so what we're seeing is US Market Capitalisation in the context of the entire global economy.

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NOTE: The use of Real GDP figures as opposed to current dollar GDP figures here may be problematic. When I measure public debt I only ever use current dollar GDP. If there are any problems with this then let me know, since re-doing these graphs according to current dollar GDP will be fairly easy (the numbers are already in my spreadsheet).

If anyone wants the raw data on my spreadsheet, contact me and I'll send a copy to you. Having my data and conclusions verified by others is a pleasure (even if it means that I have been proved wrong).

Random Thoughts on Government as Business

One way to look at the place of government in an economy is to view it is as just another business. This is because:

1. It produces goods and services
2. It has customers
3. It has shareholders
   

Of course there is a limit to which government can be identified as a business:

1. It cannot go bankrupt (debt can be defaulted)
2. Monopoly: It has little to no competition in an economy
3. If it is a national government, It can declare war against foreign national governments
4. It writes and enforces law to govern both society and itself
5. It has the means of creating money and enforcing its use
   

The way I always look at government is that it is a mutualized monopoly - while it has no competitors (and is thus a monopoly), its customers are its shareholders. At least in a Democratic country, the government's customers are the people, who are equal shareholders in the national government.

Tax, therefore, should be seen as the price the customers pay for the goods and services that the government provides. The fact that a "user pays" system is not set up does not mean that the system is flawed, since "user pays" itself can be a flawed way of pricing, depending upon the goods or services produced (selling food over the counter is a good user pays system, having toll booths every few kilometres to pay for road building and maintenance is not a good user pays system).

World trade needs to be rebalanced - here's my suggestion

International trade has been around for centuries and has been the creator of both good and bad world economic conditions. What has evolved now, though, is a trade and capital imbalance that is one of the causes of the current economic crisis. If a new economic order is to be created out of this mess, world trade and capital flows need to change.

In the bad old days, mercantilism ruled the waves and nations would compete against each other to gain the best export advantages. This was a self destructive process, since it resulted in trade tariffs and quotas. Mercantilism was part of a broader scheme called "economic nationalism" which saw international trade as a win/lose battle against other nations. Instead of fighting against another nation with armies, countries would fight each other economically. Fortunately economists appeared whose arguments proved beyond reasonable doubt that international trade was actually a win/win - though with a number of caveats.

Sadly, mercantilism is still around. It is practised most notably by China and Japan, with a number of smaller nations (eg Singapore) jumping in. When one nation has a mercantilist trade policy in world trade, the result is a large trade surplus. This trade surplus generates large amounts of foreign currency, which the countries then use to reinvest back into their trade partners. So in Japan and China's case, their trade surplus with the United States leads to large US dollar profits which, rather than being converted into Yen, are reinvested back into the United States. It is a circular process which creates a "virtuous cycle" - US demand for Japanese & Chinese goods leads to US Dollar profits for Japan & China, which leads to reinvestment of these profits back into the United States, which results increased domestic US demand, which results in increased demand for Japanese & Chinese goods. The problem is that this "virtuous cycle" has been exposed as just another bubble that is in the process of bursting.

Theoretically, mercantilism has been abolished. The Word Trade Organisation and its members take a very dim view of member countries setting up trade barriers or quotas. Japan and China get around it however, thanks to the actions of their Central banks. Instead of creating trade barriers, the Central banks of Japan and China sell their own currency and purchase US government bonds (treasuries). This keeps the Yen and the Yuan/Renmimbi cheaper while simultaneously making the US dollar more expensive. With cheap domestic currencies and a customer country with an expensive currency, Japan and China naturally end up having a trade surplus with the United States. Having a cheap currency allows the development of cheap labour thus undercutting any competition from US based companies.

This situation is reflected in a fairly basic economic indicator called the Current account. Nations which have a Current account surplus are nations who receive large amounts of foreign currency for goods and services they sell, as well as from investments that they have in foreign nations. Nations which have a current account deficit are nations who borrow lots of money from nations with current account surpluses.

It is best to look at the current account as an accounting measurement. If our world economy consists of two countries, and country one has a $1 billion current account surplus, then the other country will have a $1 billion current account deficit. You can't have these two nations in this model both running current account deficits or both running current account surpluses. When we take this model to the wider world we realise that one nation's current account deficit is another nation's current account surplus.

So which is better? It might sound better to have a current account surplus, but this is actually mercantilist thinking. In reality they are just as good or just as bad as each other. If we think that the US current account deficit is bad, then we must conclude that the Japanese current account surplus is bad too.

The problem with running large, long term current account imbalances is that, over time, the economy becomes "geared". In the case of the United States, the economy has been "geared" towards the importation of goods and services, it has become "geared" towards borrowing money from overseas - in short, it is an economy that is geared towards consumption and borrowing. By contrast, China and Japan have been "geared" to complement the United States - they are geared towards producing goods and services, and they are geared towards saving. In short, Japan and China are geared towards production and saving.

The figures for these three countries are stark. The United States is running a current account deficit of 3.3% of GDP; Japan is running a current account surplus of 3.3% of GDP; China is running a current account surplus of 4.9% of GDP. Smaller economies have even more notable imbalances (eg Singapore with a current account surplus of 18.4% of GDP, Turkey with a current account deficit of 5.4% of GDP)

Now of course China and Japan DO purchase goods and services from the United States, and people in China and Japan DO borrow money from the United States, and the United States DOES manufacture goods that it exports to China and Japan, and the United States DOES save money. But what we're talking about here is the net result. Just because the United States gets most of its manufactured goods from China and Japan doesn't mean that the United States doesn't manufacture anything. What I'm trying to point out here is that in the back and forth of buying and selling and borrowing and investing that makes up international trade, that current accounts reflect an overall, net position. This means that various industries within these countries stand to gain from any changes in the exchange rate, whichever way it goes.

But the problem with gearing is that any changes in the exchange rate will impact both consumer-friendly nations and producer-friendly nations. Just as investment bubbles will inflate, burst and destroy wealth in the form of stock market busts or property busts, so too can it happen on an international scale. The US, for example, has been running as a consumer-friendly nation for a long time and, as a result, the bubble is about to burst. The United States is naturally the world's financial capital, yet debt has ballooned out of control over the years. The GFC is the beginning of the end of the consumer-friendly United States. Steps need to be taken to gear the United States into a more producer-friendly economy. This doesn't mean becoming mercantilist and running a current account surplus, but it does mean policies to ensure a balanced current account.

The current accounts of Japan and China should therefore no longer be running at a surplus, but should become balanced (ie neither surplus nor deficit) over the long term. This means that the current account of the United States should no longer be running at a deficit, but should become balanced as well. Put simply, the United States needs to produce more and consume less, and save more and borrow less. On the other side of the coin, this means that China and Japan needs to consume more and produce less, and borrow more and save less.

Retooling the United States to become a more producer friendly economy will be painful and it will take time (ie years) to bear fruit. Similarly, retooling Japan and China to become more consumer friendly will be painful too, and will take a similar amount of time to bear fruit.

One solution to the problem of international trade and current account imbalances is to have a common currency. That is what Europe has done with the creation of the Euro. Within the Eurozone, current account differences do occur: Germany has a current account surplus, Spain has a current account deficit. But that doesn't really matter since comparative advantages are very real in international trade, while internal current account issues within the Eurozone will be dealt with by the market without having problems caused by differing currencies. What does matter is the Eurozone's current account overall (presently a current account deficit of 0.4%, which is close to being balanced)

But since the chances of Japan, China or the United States joining the Eurozone (and all that such a joining would entail) is virtually none, another solution must be found.

The solution I have is for the creation of a new international trading agreement that ensures all member nations have balanced current accounts. This would involve the creation of national currency boards in each member nation whose role will be the maintenance of a balanced current account (as opposed to the traditional role of a currency board to maintain a fixed exchange rate). If a nation has a current account deficit, as the United States does, then the currency board (acting with various government bodies like the central bank and/or treasury) will sell off its local currency and purchase foreign currencies on the foreign exchange market, most obviously the currencies of nations who run current account surpluses. Of course these currency boards will have a reciprocal arrangement with the currency boards of the nations they are dealing with. So in the case of the United States and Japan, the US currency board would sell off US dollars and purchase Yen, while the Japanese currency board would sell off US dollar and purchase Yen as well - with the eventual aim of ensuring a balanced current account between the US and Japan.

This system still allows floating currencies but the forex market will be initially dominated by the actions of national currency boards buying and selling currencies in order to create balanced current accounts throughout. This would be better than instituting fixed exchange rates or returning to a gold standard. Since the currency boards will be operating with their respective central banks, money creation by fiat followed by the selling of this currency will be one way to devalue a currency. These currency boards would then only act to ensure a balanced current account. So long as a balanced current account is maintained for their nation or currency zone, they will stay out of the forex markets. Long term current account maintenance will, however, result in regular forays into the forex market - but each foray being only as large as it needs to be to maintain a balanced current account.

Moreover, the more nations which join this agreement, the more natural comparative advantages between nations can be maintained. Rather than ensuring that each nation has a balanced current account with every other nation, the agreement will simply ensure that member nations have a balanced current account overall. For example, in an international economy of three nations, nation A might have a $500 billion current account deficit with country B, country B might have a $500 billion current account deficit with country C, while country C has a $500 billion current account deficit with country A. In this situation, each nation has an unbalanced current account with individual nations, but the overall result is a balanced current account for each of the three nations.

Once this situation is imposed, international trade and capital flows will be easier for the market to handle, since the market will act in the knowledge that currency values will only move within a certain band - and that band will be determined by the currency board and only acted upon according to the status of the current account. There will be less market speculation and more real trade being achieved. This should also result in more predictable, more sustainable economic growth for all nations involved. The win/lose attitude of mercantilism should be replaced by the win/win of balanced international trade.


Addendum

Of course the theory I am working with here is that balance ensures better economic conditions for all. Ensuring that nations (or more correctly, currency zones) run balanced current accounts is one "pillar" of the new economic order that I see should emerge over the next few decades. These three pillars are:

• Each currency zone has a balanced current account - neither current account surplus nor current account deficit over the long term.
• Each currency zone has governments that run balanced budgets over the long term - neither budget surplus nor budget deficit over the long term
• Each currency zone maintains absolute price stability - neither inflation nor deflation over the long term.
  

I believe that if these three pillars are set up and maintained, the chances of devastating economic downturns (eg great depression / GFC) will be minimised.