Sunday, April 26, 2009

Lesson V – How Our Economy Works

The Basic Pattern:
Like any other piece of complicated machinery, at first sight our economic system appears like a great jumble of interacting forces, and it is difficult to see what is cause and what is effect: what it is that sets things moving, and what are the things that are being moved.

By now, however, we have been able to clear some of the ground, and isolate some of the basic parts of the economic mechanism.

If we compare our economic system to a piece of machinery, such as an automobile, we can see that its basic drive comes from the wants of Consumers – in the case of the automobile, the driver's need for an efficient, speedy and safe means of transportation. The governing mechanism which limits how far those wants will be satisfied, is the willingness of Consumers to work to satisfy those wants. That includes the price they are willing to pay for the car and the gasoline, insurance and other supplies needed to make it operational. That will dictate the quality of the vehicle, and the size of its engine in particular. Just like our economy, the engine makes use of natural resources, in this case, gasoline, to provide energy. The driving wheels transmit that energy to the road, to move the car forward. Between the two comes the transmission, which takes the energy provided by the engine, and converts it through gears to put it in a useful form to move those wheels. If Production is the engine, and Consumption is the movement, then it is the Money System is the Transmission that stands between the two and is essential to make movement possible.

In a primitive society, the system of production is not well developed, and so is inefficient. Effective tools and skills are not easily available. Exchange is difficult, therefore production is not specialized, and as a result, consumer wants have to be very acute indeed before production can be assigned to satisfying them. Driven by the need to satisfy simple needs such as food to stay alive, long hours are worked, and heavy labour performed, for a low standard of living.

Developing the economic machine so that production is possible with less and less human effort is like the process of eliminating friction. On the one hand, less urgent demands of consumers can be satisfied: people can enjoy luxuries as well as necessities. On the other hand, because these wants are less urgent, people are less willing to work long hours for little reward. If the difference between working an eight hour day and a sixteen hour day is the difference between life and death, as it may well be in a primitive country, or one where working people on minimum wage are forced to work overtime to cover expenses such as taxes, rents and debt charges, most people will be willing to work the sixteen hour day. But if the difference is only that of having a second car or a bigger house to live in, many will prefer to work fewer hours, and take additional time for vacations and to enjoy their possessions. So over time the working week has steadily shortened, while people have enjoyed a rising standard of living. This is a direct result of greater and greater efficiency in the process of production – its ability to satisfy a particular degree of human want with a smaller and smaller quantity of human energy.

The “A Plus B” Phenomenon
When Capital development of new projects takes place, we can therefore see that a problem arises in balancing the flow of money to Consumers who want to buy, with the actual flow of Consumer goods for sale.

If there were no money creation by banks for the purpose of financing capital development, the problem would be less acute. People who wanted to finance new projects would have to dip into their pockets or those of their friends, perhaps borrowing from the funds of those saving for retirement and similar sources. This would take off the market money demand for a certain quantity of consumer goods, replacing this by demand for materials and labour needed in putting together the new project.

However, it is rare for new businesses to go ahead without the help of new credit created by the Banking system against their indebtedness. In fact, the financing of new investments or the takeover of existing companies can be carried out with very little investment by the borrower of his own money. Sometimes he borrows “on margin” - that is, investing in purchase of a company, real estate, shares on the stock exchange, the commodities or foreign exchange markets by obtaining an enormous loan secured by a small amount of cash and the value of the asset acquired by the bank financing, on the understanding that if the market falls, the assets will be sold and the loan paid back out of the proceeds. The speculator's hope is that his acquisition will drive up the price of the asset through his increased money demand, giving him the chance to “flip” the asset to another buyer at a higher price, repay the Bank with interest, and still receive an enormous return on the small amount of money he has laid out. It does happen, though, that the market may fall rather than rise, in which case, he loses everything. Speculation of this kind by an unauthorized employee of long established Baring's Bank, who in 1995 gambled on a rise in the Japanese stock market when it actually fell, led to the bankruptcy and complete collapse of that bank, which now no longer exists. In the same way, many who had expected capital gains on the housing or stock markets in the year 2008, were desolated to find their investments lost value, as credit became less and less easy to obtain, and foreclosures of houses and halving of the value of pension funds became a social disaster.

Let us examine more closely what happens when investment takes place, either through direct bank borrowing, or private investment where the investor has borrowed to finance the shares he buys. The money supply is increased, but the supply of Consumer goods does not just stay the same – it is reduced by the increased demand for labour and materials needed to assemble the project. If this involves, say, an oil sands plant costing ten billion dollars, and taking ten years to assemble before it goes into production, we indeed gain “full employment”, with a shortage of labour causing rising costs including wages, as has been seen in Alberta – but the cost of this has not been borne by the investors, but by the public at large. The value of their dollars has been reduced as the buying power of the dollar has been taken away by the increase in the money supply. Until the work is completed, the community is actually poorer in terms of the real wealth it can enjoy.

The time comes when such a plant is completed and goes into production. If five thousand people were employed in construction while the plant is being built, then likely only five hundred will be needed to run it when the installation is complete. So 4,500 workers are laid off, and will no longer be receiving wages from this source. Assuming a twenty year term for paying off the bank loan and writing down the value of the plant, we can see a yearly cash flow statement for the plant once it has been completed that looks something like the following:

“A” costs:
500 employees at $80,000.00 = $40,000,000.00
Materials, royalties, taxes. $40,000,000.00
Interest on Bank Loan and/or dividends to shareholders $500,000,000.00
TOTAL: $580,000,000.00
“B” costs
Repayment of Bank advance $500,000,000.00
Total costs incurred to be charged into prices $1,080,000,000.00
LESS: Total of cash paid out to Consumers $ 580,000,000.00
DEFICIENCY $ 500,000,000.00

The sums taken from the public through inflation now are paid back to the bank and canceled, and deflation sets in, prices fall, unemployment mounts and just when more product than ever before becomes available, the money that would have made it possible for people to buy it disappears. Recession and Depression replace the previous boom. What looked like a promising venture now is the cause of surplus production that cannot be sold. So our plant may well be mothballed or go into bankruptcy. What should have been a source of more wealth to the community now becomes a wasted asset.

It is worth noting that, even in cases where Bank financing is no longer used, and if all the cost of the plant has been assembled through actual money savings, the fact that when the plant is complete, there will be more product on the market for consumers to buy. That means that there will be a need for the public to have additional dollars to spend if this new product is to be sold without a change in the price level. To quote a phrase of Major Douglas, there will be a need for “New Credit for New Production” to be placed in the hands of the consuming public.

The Trade Cycle:
One cannot look at the whole of industry, of course, as a single and simple business concern. At any moment, among the thousands of enterprises in any country, some will be in the process of organization and capital expansion, where the tendency is to pay more out in incomes than is balanced by goods reaching the market. Others will be in that later stage, when they are seeking to recoup these previous expenses, by obtaining a cash flow from their sales greater than the payments they make for labour and raw materials. What would be, if there were only one giant business concern in the country, a gigantic expansion and depression, is evened out through adding together the actions of a large number of concerns in the business sector, and summing them up in economic “trends” that differ at different times, known generally as the “upswing” and “downswing” of the Trade (or Business) Cycle.

Generally, “trade cycles” are of two basic patterns. The first and less serious is the “two year cycle”, associated with ebbs and flows in the building up and liquidation of stocks of commodities by business. If firms in general become overstocked, they may cut production for a short while, causing a rise in unemployment, until these inventories shrink to a more normal figure. Production then resumes, and employment picks up once again.

The second is the “long term” or “cyclical” depression. In theory, it comes around about every twenty years, but in fact, it cannot be predicted with such regularity. Others have counted such depressions as occurring every eleven years, and blamed them on the natural cycle of sunspot activity. However, the causes can likely be found much nearer earth. A dozen such depressions were recorded in the United States during the nineteenth century, and another four before the Great Depression of the 1930's. Public Works, rearmament and war financing kept recession away for several years thereafter, but recessions could be observed once again in 1981, 1991, and a most serious one commencing in the year 2008.

These recessions are part of a regular process. The cycle is started by some event which causes a marked increase in the money supply – it may be a war, some other program involving extensive Government borrowing, a gold rush, or even some consumer installment buying boom. This leads to an increase in “effective” consumer demand – that is, demand matched with the dollars to pay for what is demanded. This in turn makes capital development appear profitable, and the fact that resources are therefore turned to capital purposes drives consumer goods prices higher. But a time comes when the growth in the money supply that triggered the boom can no longer be continued (the war is over, the gold runs out, the government or the consumer are too deeply in debt to go further: business is over extended and has no need to increase capacity, or banks may be at the limit of their lending resources) and business conditions get worse. If Bank failures occur, or in some other way the money supply is suddenly reduced, the depression may turn into a Crash. Otherwise, it may simply become a slow drift into stagnation, only to be ended by some new event that increases consumer buying power, and so touches off a “boom” once again. In the mean time, everyone lives at a far lower standard of living that could physically be possible.

SUMMARY: The basic driving force of an economic system is the desire of consumers for the things that will satisfy their wants. This desire, when accompanied by money of an acceptable kind, constitutes the “effective demand” for wealth in differing forms.

This effective (money) demand in its turn sets consumers to work in all of the different ways that Society requires to satisfy its needs and wants. The money that consumers receive for the services they so render again gives them an effective demand in the form of money with which they can satisfy their own wants.

The use of tools (capital) to make production more efficient leads to more satisfaction for less work. In an age of automation, such “tools” are so complex and perfect, that much of the labour required to make any article goes into making the “tool”, and comparatively little into the item by item production of the product – think of the automation that produces in quantity the modern automobile. As a consequence, production of useful goods and services generally takes place long after most of the physical labour required has been performed, and the wages paid out for doing this have already been paid out and spent.

When the finance spent on creating the capital tools has originated in newly created Bank credit, the consequence is a “trade cycle” in which consumers receive incomes and spend them, before new wealth comes on the market, leading to a time of inflationary boom. The boom period tends to be followed by a period of deflation, unemployment, and cutthroat price competition, as bank credit is repaid and canceled, and the money supply ceases to expand. Even when new production is financed from savings rather than bank credit, the fact that the new plant is able to place more physical production on the market will still tend to drive down prices, unless some new event occurs that makes consumer purchasing power available in order to buy the increased production. In general, a vast increase in Consumer and Government debt since the 1930's has made it possible to expand the economy (at the price of continuous inflation of prices) and avoid recession. However, current economic signs are that the limits of Consumer and Government borrowing have now been reached.

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1. What is the basic force which sets the whole economic system in motion?
2. State three factors which have the effect of placing a limit on the degree to which consumers are able to satisfy their wants.
3. What is the result of increased efficiency in the process of production? Are unemployment, or shorter working hours, a sign of greater or less efficiency?
4. A hydro-electric project takes five years to assemble at a cost of $100 millions, and has a projected life of 30 years. Its costs of operation once in service will be $1 million per year, plus loan repayment blended payments of principal and interest at 6% per annum of $7.2 millions. Describe the effect on the economy (1) during the construction phase, and (2) after electricity generation commences, (a) if funds come from Bank loans, and (b) from private investment. Assume that money paid to the lender for interest will pass back to the public in wages and dividends, but that repayment of principal to a bank will be cancelled.
5. Why is it that a war can cause economic prosperity?
6. The year 2008 saw remarkable and world wide financial turmoil, with the collapse of several financial institutions, and mass layoffs in many industries. Give as many reasons as you can for this phenomenon taking place.
7. How far is full employment a necessity for economic prosperity?

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C.H.Douglas: “Social Credit” (Revised 1933 edition), Part II, pages 78 sqq.
J.M.Keynes: “General Theory of Employment, Interest and Money”
Statistics Canada: “National Accounts: Income and Expenditure” 1926-1956 and continuation volumes.
John W. Hughes: “Major Douglas – The Policy of a Philosophy” Chapter 5.

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