Solution to the Credit Crunch : NEFS – Net Export Financial Simulation.
There are 5 Main Financial Flow Patterns :
1) Fixed Assets
2) Consumer Debt
3) Mortgage Debt
4) Net Imports
5) Net Exports
In this article I’m going to look at the first one – Fixed Assets.
So what do I mean by the phrase a “Financial Flow Pattern” ? – Sounds little bit intellectually ponsy “Financial Flow Pattern” I know but it’s quite simple : It’s the flow of a) Where money comes from b) What it does after it has been created and c) How it gets destroyed
Imagine there is a Desert Island with :
1 Business man and
The economy is starting from scratch with nothing.
So the Business man goes to the Banker and says “Please lend me $110 (the $ is the Island currency they just made up) so I can pay some workers to make some stuff and get on with business”. The banker says “Yes” and makes the following accountancy entry in his books :
Dr $110 – Loan owed by Business to Bank – Asset of Bank
Cr $110 – Current Account of Business – Liability of Bank
Already, just understanding just this one accountancy entry, makes you more of an expert on how the banking system really works than a bar full of finance ministers at a G8 Summit.
The three things to note are :
a) What ‘Money’ actually is, is the Credit entry – the : “Cr $110 – Current Account of Business” part. This ‘money’ was created at the same time the Loan – the Debit entry – was created. Some people – Finance Ministers and Professors of Economics included – have the idea that the numbers you see in your current account represent something else – some real thing called ‘money’ that is somewhere else… “but it’s actually all very complicated to understand. It’s a good job those banking fellows are jolly clever; they sort out all those complicated, behind the scenes, things out for us”. Whereas in fact it’s quite simple – all money is is Current Accounts at the bank – its bank debt that you own. In long-hand, the definition of money is merely : “Universally Transferable Bank Debt”. Many people have the idea that if you look at the balance sheet of a bank you will see it’s assets are things like buildings and ATM machines and it’s liabilities will be things like taxes due and shareholdings. “Money” is frequently thought of as being some real thing that banks look after for people in some sort of complicated “money accounts”. A quick Goolge for ‘Financial statements Lloyds bank’ or some other bank (try : Lloyds_2006) will show that money sits in the liabilities section of a bank’s balance sheet under the heading “Customer accounts”, loans sit in the assets section under the heading “Loans and advances to customers”. These form an integral part – indeed the largest part – of a bank’s balance sheet. To Create a loan, a bank does not go to some “money account” to see if there is any spare money to loan out, instead it makes the accountancy entry:
Debit £100 “Loans and advances to customers”
Credit £100 “Customer accounts”
This credit of £100 shows up on your bank statement in your favour – it’s money. When you repay the loan, the entries are reversed and the money is destroyed – the money does not go back into a “money pot” or a “money account” in the bank.
b) “Oh Look at the situation ! There is $110 of Savings in the economy (The $110 current account of the business) and $110 of Borrowings (The $110 loan of the business). Aren’t economists clever ! They say that S=I (Savings = Investment) and once again S($110)= I($110) and once again economists are proved right and further this proves the other thing that economists say : That ‘Borrowers borrow from Savers – with the Bankers merely acting as a middle-man – a broker’ ” – Wrong – As you have just seen yourself from the accountancy entry above, bankers do not need Savers to ‘Loan their Savings to Borrowers’, in the example given, the Bank started with nothing – there was nothing in the whole economy. What bankers do when they ‘Issue a Loan’ is they create both a Loan Account and a Current Account (money) at the same time – they create both New Savings and New Investment in the same instance. So instead of “We need Savers so that Bankers can lend those savings to Borrowers” we have something more like : “When a bank issues a loan it creates money that is then saved” or perhaps “When a bank issues a loan it creates both New Investment and New Savings that are the same amount” – no wonder S=I !
c) The banker is not a market middleman, a broker forced by Adam Smith’s “Invisible Hand” to find the crossing point of the combined will, abilities and resources of all the participants in the economy and follow the orders he finds left there in a sealed envelope written by this “Invisible Hand” on pain of loss of occupation. He is the de-facto King : if he issues the Loan to Businessman A then the workers will obey Businessman A or starve, if he issues the Loan to Businessman B then the workers will obey Businessman B or starve. This sounds like a lot of power to Businessman A or Businessman B. But given it is the banker who chooses who is to receive this power it is the banker who is King.
There are two ways this power is exercised : One is visible and the other, the really powerful one, is invisible and can only be seen by the imagination.
The visible way : If you run your business on an overdraft, the bank is legally entitled to treat your overdraft in the same way that you treat your current account – At a moments notice you can withdraw your money from the bank – At a moments notice – though practically a short notice period of a few days is given – the bank can demand repayment of your entire overdraft. If you can’t repay then the bank will close you down. You will be bankrupt and lose everything. The banks have done this to many business’s – perfectly viable businesses – and that was before the credit crunch – (so as a practical hint re-arrange your overdraft into a loan or put some decent repayment notice period in the terms and conditions of your overdraft facility).
The invisible way :
a) The Virtual Millionaire
Where will the Island be 10 years down the line ? Imagine on the Island there was a millionaire who had brought his millions with him – due to his wealth and hence his power it would not be surprising to find that the Island in 10 years time will have the imprint of his ‘will’ all over it. If he wants pubs then there will be pubs, if he wants theatres then there shall be theatres if he wants people to live in small houses then small houses will be built… there will be a definitive imprint of his will. A different millionaire will make a different imprint. What’s the real wealth of the Island ? The real wealth is the good manners and abilities of the people, the state and potential of the industrial capacity and the natural resources of the land. You might at this stage be thinking “These guys could do with a mini-revolution to get some democratic power in charge here, why should some bloke, just because he has some money, be able to control the whole direction of the future of the Island ? ” The only defence to that question is to say “Well he has the money”. Now take the millionaire away and go back to the situation we started with : A Businessman with nothing and a Banker with nothing. The businessman goes to the Banker and asks for some money for a project in the same way that a businessman might ask the millionaire for some money. The power the millionaire has to shape the Island with his “Yes’s and No’s” to the various business proposals put before him is the same power the banker has. Then the question should be asked “Why should some bloke, who doesn’t even have any money, be able to control the whole direction of the future of the Island just because he has a job as a banker ? – The Banker is more powerful that the millionaire – the banker is not limited to 1 million – he can create as much money as he wants – and there is no “Oh he has the money” justification for allowing this situation.
b) Heaven on Earth/ Hell on Earth :
Take both the Millionaire and the Banker away for a moment and assume that the Island has some ‘X’ method of finance whereby the Islanders can effectively express their will as to how the natural resources, the industrial potential and their own time and abilities are directed – so they have the power possessed by the millionaire and the Banker to imprint their will on the future state of the Island – not by just using their hand to mouth wages but more importantly, by their conscious power to say who the loans are given to and for what purpose : Given the Island economy can produce stuff to consume – Consumables, and it can produce stuff to produce other stuff automatically – ‘Fixed Assets’ – then after 10 years the Islanders will have the choice to go in two directions : As they now have lots of Capital equipment to produce consumables – they will have the ability to have the same standard of living as when they arrived (by this I mean the same level of consumer goods) but with hardly any work – or they could continue working hard producing even more capital goods and increase their standard of living – have more consumable goods. At any point after this, say another 10 years, with machines producing other machines which produce other machines… which produce consumer goods they can say “Stop ! let’s take the standard of living we have now in terms of consumable goods, which is very high, and lets enjoy it in a Garden of Eden like situation – very little human work producing lots of consumer goods as the machines do most of the work – then spend the thing a machine cannot make – time – living instead of working. Now look at the present world – we live in a world of push button or even screen click production and yet there is not the option for society as a whole to say ‘Let’s stop making more stuff. Let’s just maintain what we have at present and spend some time living. Why ? Well it is the will of the bankers that we follow rather than our own will. The will of the Banker is “Full Employment or Poverty”. Though most people look quite well off driving their cars and reading oversized newspapers over posh coffees at a weekend – 2 months without income and they’d be in a food queue with their car having been driven off by the Repo man. Such people – that’s most of us – have no power to impose our will over very much at all. This is where the real power of the Bankers lies. They control the policy and future direction of the human race, civilisation, the planet with no legitimacy to do so.
OK back to the ‘Fixed Assets’ Financial Flow Pattern :
The businessman asks the Banker for a loan of $110. Of this, $100 is to be paid to the workers to produce goods for consumption, $10 is to be paid to the workers to produce a machine – a Fixed Asset. At the end of the cycle, the business has a debt to the bank of $110, $100 of Stock and $10 of Fixed assets – Investment $110. The Workers have $110 of cash so Savings (S) equals Investment (I). The Businessman wants to make a profit so he sells the Stock of consumables for $110. When he gets the $110 in sales he gives it to the bank to pay off the loan.
The funny thing about this is that nobody has a penny left ! – The workers have had all their money taken off them in prices and the businessman has used the money he received to pay off the loan. Superficially though this seems like a nice cycle and in a few cycles there will be lots of fixed assets and machines producing consumable goods automatically. Surely everybody will be better off ? – Wrong. Just look at the basic maths : Assume the Depreciation charge on a $10 Machine is $1 per cycle. Then instead of the situation being this :
End of Cycle 1: Dr $10 Accumulated Fixed Assets/Capital Goods – Cr $10 Accumulated Profit
End of Cycle 2: Dr $20 Accumulated Fixed Assets/Capital Goods – Cr $20 Accumulated Profit
End of Cycle 3: Dr $30 Accumulated Fixed Assets/Capital Goods – Cr $30 Accumulated Profit … etc
you have this :
End of Cycle 1: Dr $10 – Dep on Zero Assets $ 0 = $10 Accumulated Fixed Assets/Capital Goods – Cr $10 Accumulated Profit
End of Cycle 2: Dr $20 – Dep on One Asset $ 1 = $19 Accumulated Fixed Assets/Capital Goods Cr – $19 Accumulated Profit
End of Cycle 3: Dr $30 – Dep on Two Assets $ 2 = $28 Accumulated Fixed Assets/Capital Goods – Cr $28 Accumulated Profit
End of Cycle 4: Dr $40 – Dep on Three Assets $ 3 = $37 Accumulated Fixed Assets/Capital Goods – Cr $37 Accumulated Profit
End of Cycle 5: Dr $50 – Dep on Four Assets $ 4 = $46 Accumulated Fixed Assets/Capital Goods – Cr $46 Accumulated Profit
End of Cycle 6: Dr $60 – Dep on Five Assets $ 5 = $55 Accumulated Fixed Assets/Capital Goods – Cr $55 Accumulated Profit
End of Cycle 7: Dr $70 – Dep on Six Assets $ 6 = $64 Accumulated Fixed Assets/Capital Goods – Cr $64 Accumulated Profit
End of Cycle 8: Dr $80 – Dep on Seven Assets $ 7 = $73 Accumulated Fixed Assets/Capital Goods – Cr $73 Accumulated Profit
End of Cycle 9: Dr $90 – Dep on Eight Assets $ 8 = $82 Accumulated Fixed Assets/Capital Goods – Cr $82 Accumulated Profit
End of Cycle 10: Dr $100 – Dep on Nine Assets $ 9 = $91 Accumulated Fixed Assets/Capital Goods – Cr $91 Accumulated Profit
End of Cycle 11: Dr $110 – Dep on Ten Assets $ 10 = $100 Accumulated Fixed Assets/Capital Goods – Cr $100 Accumulated Profit
End of Cycle 12: Dr $110 – Dep on Ten Assets $ 10 = $100 Accumulated Fixed Assets/Capital Goods – Cr $100 Accumulated Profit
End of Cycle 13: Dr $110 – Dep on Ten Assets $ 10 = $100 Accumulated Fixed Assets/Capital Goods – Cr $100 Accumulated Profit ..etc
The reason the figures ‘Flat Line’ after Cycle 11 is that once the first machine has depreciated to zero (after 10 depreciation charges of $1) there is no more depreciation to charge on this asset. Likewise, the machine built in period 2 has no more depreciation charges after period 11 etc.
Let’s look at this again, but this time, instead of looking at the Accumulated Profits, we look at the Profit per Period :
Cycle 1: Profit $10 – Dep on Zero Assets $ 0 = $10
Cycle 2: Profit $10 – Dep on One Asset $ 1 = $9
Cycle 3: Profit $10 – Dep on Two Assets $ 2 = $8
Cycle 4: Profit $10 – Dep on Three Assets $ 3 = $7
Cycle 5: Profit $10 – Dep on Four Assets $ 4 = $6
Cycle 6: Profit $10 – Dep on Five Assets $ 5 = $5
Cycle 7: Profit $10 – Dep on Six Assets $ 6 = $4
Cycle 8: Profit $10 – Dep on Seven Assets $ 7 = $3
Cycle 9: Profit $10 – Dep on Eight Assets $ 8 = $2
Cycle 10: Profit $10 – Dep on Nine Assets $ 9 = $1
Cycle 11: Profit $10 – Dep on Ten Assets $ 10 = $0
Cycle 12: Profit $10 – Dep on Ten Assets $ 10 = $0
Cycle 13: Profit $10 – Dep on Ten Assets $ 10= $0
Again the reason the profit figure ‘Flat Lines’ at zero after Cycle 11 is that once the first machine has depreciated to zero (after 10 depreciation charges of $1) there is no more depreciation to charge. Likewise, the machine built in period 2 has no more depreciation charges after period 11 etc.
The above usually hits people (including economists and finance ministers) a little like the “Grain of wheat doubled on every square of a chessboard” puzzle – It doesn’t seem like much of a problem at the beginning. But later… So what will be the financial flow pattern in cycle 27 or 127 :
Well the Businessman goes to the Banker and says “Please lend me $110 so I can pay some workers to make some stuff and get on with business”. The banker says “Yes” and makes the following accountancy entry in his books :
Dr $110 – Loan owed by Business to Bank – Asset of Bank
Cr $110 – Current Account of Business – Liability of Bank
The Businessman who, despite the best workforce the World has ever seen, and customers willing to buy the produce, pays $100 to workers to make some consumables, $10 to make a new machine and sells the produce for $110. The businessman then pays off the loan of $110 and makes $10 profit before depreciation – but has no money (he never had any money) but now he has a $10 depreciation charge ($1 from the 10 machines built in the last 10 cycles) and so has zero money and zero profit.
Let’s have a look again at the first line :
Cycle 1: Profit $10 – Depreciation on Zero Assets $ 0 = $10
To repeat this pattern for the next cycles, what is it that we really need to repeat ? Businesses work on percentages of this and that. To take a fundamental one : Profit /Sales – the Profit is $10 and the Sales is $110 so on this example the Profit / Sales is 10/110 % = 9.09%. This is the same as a Costs/Sales Ration of 100/110 = 90.91 %
To maintain this ratio in the next period we have :
Costs : Salary to make consumable goods $100 + Depreciation of $1 = $101 so Sales must be 101/90.91% = $111.10. As a check : 101/111.10 = 9.09%. As the workers who make the consumables get paid £100, then the people who make the fixed assets must get paid, not $10 like last time, but $111.10 – $100 = $11.10 in order for there to be $111.10 in the community to buy the goods. Ok Big deal – So What ? Well the “Ok Big deal – So What ?” turns out, once again, to be a similar “Ok Big deal – So What ?” of the Persian King who promised to pay the inventor of chess one grain of wheat on one square of a chess board, double that for the second square … double that for the 3rd square…, things start off not to bad but the 64th square leaves the King in debt to the inventor for 9, with eighteen zeros after it, grains of wheat.
Something similar, but not quite so exponential happens here :
In Cycle 6, using these numbers, Business must make $16.85 worth of assets to cover the increasing depreciation charges and have enough money in the community to buy all the gods on sale – now at a total prices of $116.85 so that it continues to make a profit % of 9.09%. $116.85 Sales – $100 wages paid to produce consumables – depreciation charge on assets built in last five periods $6.23 = Profit $10.63. And so Profit /Sales = 10.62/16.85 = 9.09% – See fixed_percentage_profit_schedule.xls for Full Schedule and calculations… In cycle 88 we need $394.30 of assets to be built. While an economy is growing and all these fixed assets are needed then things look fine. But should the day of happiness arrive where people have enough machines producing enough stuff and no more expansion is required – By expansion I am not even go so far as to say lets stop building $10 of new assets per cycle, I am just saying when we get to the point of saying lets stop increasing the number of new Fixed assets built per cycle – then what should finally be Heaven on Earth (cheap machine slaves producing what we need and want) suddenly turns to Hell. Stock will not be sold as there will not be enough wages paid out to cover and maintain the profit margins, Businesses will close – factories will be shut, people will lose their homes … for no other reason that when we reached industrial point where we could go home and live, the Financial system said “Oh no you don’t – If you don’t work (and continually increase) then we will ruin you. This seems to me to be a rather dumb situation. This has nothing to do with any “allocation of scarce real resources”, it’s about the artificial allocation of scarce numbers in a bank’s ledgers while there is an abundance of real goods and production ability.
So What’s wrong with Keynesianism, What’s wrong with Monetarism ?
Loads of books on Economics have some blurb about using simple theoretical models to model the economy and how this is legitimate. They then present a model of the economy that is so simple it’s just plain wrong. This model is the basis for both Monetarism and Keynesianism. In this model there is no Retained Profit so none of the complications explained above occur. Monetarism and Keyensism are then later explained as different solutions to the same problem in this wrong model. Let me explain :
In both the Monetarist and Keynesian model, Business pays $100 to workers to produce $100 of Goods. These $100 of goods are sold for $100 and the Business then uses the $100 to pay workers to make another $100 of goods and so it goes on for ever : Income = Expenditure (I = E) is what they say without understanding what they are really talking about “Sometimes though, there is a shock – a terrorist act or something and consumers loose confidence then a recession can occur” (this really is the sort of thing they say). What they say is that $100 is paid to workers to produce some stock but the workers don’t spend it all, they save too much – “their marginal propensity to save increases” is the pseudo-scientific talk they use. Business is then left with unsold stock and is short of money to pay the next cycle’s wages and so there is a recession. At this point the Keynesian bods and Monetarist bods divide. Keynes says the government should issue bonds at this point, then the savers will buy these bonds with the money they are not using to buy goods with, and the government can use the money it has received from the sale of these bonds (government debt) to buy the stock itself and so Business can keep going and can keep paying wages. When the shock is over and ‘confidence’ is restored then business can return to normal – people will get paid $100 as usual, the taxman will take some of this from everyone in taxes and use it to repay the bond holders so there is : $100 in the community being spent when a) Things were normal, b) When there was a crisis (“Crisis ! What Crisis ?” – Jim Callahagn – you see, according to people trained by economists, it’s all about keeping ‘Confidence’ high as “The cure to a recession is ‘Confidence’ ” – Lucy Kellaway from the FT on the BBC World Service 31 March 2009. You see ‘Confidence’ gets all those shy, frightened, irrational over-savers to go to the shops and get the ‘economy back in balance’) – and c) Afterwards as well – they call it smoothing. Monetarists on the other hand take the view that if people get paid $100 to make say 100 things and then people start saving too much and only spend $70 in the shops then business should say “well if you only want to spend $70 then this will be the new price of the 100 things that you made that are in the shops but – but we will now drop the wages to $70 to make the same 100 things”. So that’s the “genius” of both Keynes and Friedman in a few lines – they offer a solution to a theoretical problem that has nothing to do with reality.
Let’s quickly crash an economy using the Fixed Assets financial flow pattern and then apply Keynenists and Monetarist solutions to it.
Assume Business wants to make a 9.09 % return each period and it has been expanding its fixed asset based to finance this for 5 years so we have :
|Cycle||Wages||Wages||Depreciation||Total Sales||Net Profit|
|To Create||To Create||%|
After 5 cycles Business has no need to continue the increase in the fixed asset building programme as all production as we know it now has been automated. So in period 6 business lays off the fixed asset building people and we would have the following situation :
|Cycle||Wages||Wages||Depreciation||Total Sales||Net Profit|
|To Create||To Create||%|
But these numbers do not add up – there is $116.85 on sale in the shops but only $100 in wages paid out. Clever Economists, both Keynesians and Monetarists, as well as G8 finance ministers who sleep with their economic text books tucked under their pillows at night, ‘know’ that this recession in cycle 6 was caused by “too much savings” (consumers are spending only $100, and, as there is $116.85 of prices in the shops, somebody secretly somewhere must be saving $16.85 !) Of course it has nothing to do with a medieval finance system that has not yet learnt to cope with fixed assets and the machine age, never mind the computer age. The Keynesians will solve this problem by issuing government bonds. These bonds will actually get bought by the banks rather than by ‘savers’ as you can see from the figures there are in fact no “Secret Savers” holding onto $16.85. Banks can buy the bonds because they can make up money at will. So with a quick accountancy entry of :
Debit Government issued Bonds $16.85
Cr Current Account of Government $16.85
The bonds are ‘sold’ and the bank earns an income stream of whatever interest these bonds pay for free – paid for by future taxes. Nice work if you can get it ! (No you haven’t been drinking and neither have I – this is how banks do things – mind you they have been getting a free income stream from the loans they made up to business as well). So as the $16.85 of fixed assets that should have been built weren’t, then there is only $100 of salary in the community and despite the current production capacity being able to meet everyone’s needs, the Keynesian government needs to go into debt and borrow $16.85 to buy the stock itself – or more usually to pay the unemployed fixed asset workers $16.85 to build bridges, roads, hospitals, sewers – large public Keynesian works – then the workers can buy the unsold goods in the shops. If they do this the business gets a debt holiday – they get to receive $116.85 in sales but only borrow $100 and not only were they able to pay off their loan of $100, they get to keep $16.85 in cash. This might give them the impression that they are doing something right and might deserve a bonus “Oh Keynes how clever you are !” The economy has been “Stimulated” and back in business !”. Meanwhile back at the ranch… well in the next cycle anyway…
a) If the government decides to pay off the bonds in the next cycle and the Business fixed asset building programme has not restarted, then the workers making consumables will be paid $100 and then will be taxed $16.85 to leave them with $83.15 in their pockets, With a depreciation charge of $6.23, wages of $100 and a profit margin of 9.09% to maintain in period 7, Business will need to sell its goods at $116.85 but with only $83.15 in people’s pockets, just after people thought the government had fixed the problem by throwing money at the problem there will be an almighty depression – You might want to make note of that last sentence given the current ‘solution’ to the Credit Crunch.
b) If the fixed asset programme does not resume, then the government will have to borrow another $16.85 and get some more Keynsian holes in the road dug.
c) If the Business fixed asset programme resumes, and Business picks up where it left off at making $16.85 worth of assets, then, if the government tax workers $16.85 to pay off the bond then all the stock will not be sold and all the government did was delay the day of doom by one cycle. What generally happens is the Government never pays off the loan to stop this sort of thing happening – they just role it over and over for years. Assuming this does happen, and the interest rate is zero to make things simpler, business will still be in the same situation – they will have to increase the amount they spend on fixed assets cycle after cycle. After the Keynesian emergency help, we are not back at normal equilibrium “Business pays $100 to workers who buy $100 of goods” as this never happens in the first place anyway.
(If you tax the whole nation say $100 to get the money to pay back a bond that was bought from a few savers, then all that happens is that $100 is transferred from one set of people to another. If it was a bank that ‘bought’ the bond, then, when you repay it, the money is destroyed; the accountancy entries are :
Cr Government Issued Bonds $100
Dr Government Current Account $100
… and as ‘money’ is Cr’s in the current account of a bank, having this Dr’d by $100 reduces it – $100 is destroyed)
Wages should drop from $116.85 to $100 and then prices can drop to $100 and everyone will be happy. As total wages have already dropped to $100, this just doesn’t make any sense at all, but assuming we get past the first bit, if Business drops it’s prices to $100, as it has a depreciation charge of $6.23 it’ll make a loss of $6.23 which is a little shy of it’s profit target of 9.09% ! Add to that practical things like some of the workers will have mortgages and fixed rents and consumer debts they took out when they earned an average of $X; if the average wage dropped without all other business and private debts being magically reduced by the same proportion then paying off those debts would be that much more difficult and a wave of bankruptcies along with the wave of suicides that usually accompanies it would be expected to ensue.
What, you might ask does the National Accounts – the Blue Book have to say about this ? – Well, despite every company being required to file it’s annual figures they say : “However, because of the difficulties in obtaining reliable estimates of the consumption of fixed capital (depreciation)”… we don’t use it : “Gross domestic product: the concept of net and gross The term gross refers to the fact that when measuring domestic production we have not allowed for an important phenomenon: capital consumption or depreciation. Capital goods are different from the materials and fuels used up in the production process because they are not used up in the period of account but are instrumental in allowing that process to take place. However over time, capital goods wear out or become obsolete and in this sense gross domestic product does not give a true picture of value added in the economy. In otherwords, in calculating value added as the difference between output and costs we should include as a current cost that part of the capital goods used up in the production process; that is, the depreciation of the capital assets. Net concepts are net of this capital depreciation, for example: Gross domestic product minus consumption of fixed capital equals Net domestic product However, because of the difficulties in obtaining reliable estimates of the consumption of fixed capital (depreciation), gross domestic product remains the most widely used measure of economic activity.” – Blue Book 2010 Pg 9.
This leaves the National Accounts looking like we live in a “World According to Keynes” or a “World According to Monetarists” but as the National Accounts say themselves : this “does not give a true picture”.
What’s wrong with GDP (Gross Domestic Product) ?
An Important aside on “Economist’s Formulae”:
Economists, both Keynesians, Monetarists and sundry others will attempt to dignify their field with mathematical sounding pseudo-equations. Most of theses are merely linguistic tricks. Let’s look at some of them within the context of the Fixed Asset Financial Flow pattern I’ve been discussing :
Business borrows $110 to make $100 worth of consumables and $10 of fixed assets, sells the $100 worth of stock for $110, makes a profit of $10 and pays the $110 loan off with the $110 receipts.
Equation 1) GDP = Y= C + I (Gross Domestic Product = National Income Y = Consumption C + Investment I)
In this case GDP = Y = $110 + $10 = $120 which doesn’t make much sense as the workers were paid $110 in total, the business owners earned a profit of $10 from this $110 when the goods were sold but at no time did anyone have $120 of income. So if a foreign country had made something that was priced at $120 they might look at the GDP equation and say “you had an ‘income’ of $120 last cycle so you could afford to buy this” but they could not look at everyone’s bank accounts and ever see the total money in them adding up to $120, the most it got to was $110. As well as the other well known problems GDP has – it also “double counts”.
Economists have there own language : they use archaic words like “Demand” instead of money and “GDP” instead of – well what ? – if you had a “One Island, One Business” situation, in normal human terms you could ask the business what the sales are ?, what the profit is ? – but you ever ask what is your GDP ? – what, in normal language is GDP ? – at this point trained economists start trotting out their catechistic definitions they memorised for their exams which are of little use and essentially are merely the different ways of calculating GDP. At base, essentially GDP is just Sales – Final Consumption Sales. There are some extra bits but pretty much, ball park figure it’s sales. In 2009 in the UK sales for Final Consumption was £1.2 Trillion and GDP was £1.4 Trillion the rest was Fixed asset Building £0.2 Trillion less Net Imports £0.03 Trillion. So now we’ve got that, we can now look at the value of the supposed solution to our economic woes – Increased GDP – “Growth”- which now equates to increases Sales. If you go to the “One Island, One Business” place for a moment, if they had economic problems would your solution be “You need more Sales” ? – To make a profit business needs to sell stuff for more money than it paid out. So more sales – at a profit – means more debt for the consumers or more debt for the Government (a fixed asset building programme would mean more debt for companies and an export drive would mean more debt for foreigners). Saying you “need more sales” makes you look a bit silly, but if you say the same thing using Economists jargon “You need more GDP”, then despite it being equally as silly, it has so much more gravitas and makes you sound like you know what you are talking about.
Equation 2) Income (Y) = Expenditure (E) : Someone’s Expenditure = Someone else’s Income.
Economists look at the retained profit made of $10 of a company say this is “Income” of the Owners. Because they use the word ‘Income’ and are, institutionally speaking, a bit dim – (Clever kids go to study Engineering, Maths Physics and Medicine. Economics is for C students who can’t do maths) they forget that there is Real Income – $Dosh in the bank available to spend and Definitional Income. Retained Profits is Definitional Income. If you own shares in a company that makes $10 Profit and they give you $2 in a dividend then you can’t go to the shops and buy food with the other $8 of profit still held in the company. I know you can sell the shares for $8 but look at it from the perspective of the whole economy : If there is $100 of goods in the shops and people have only say $50 in cash and the other $50 in shares then people can swap the $50 of shares for the $50 of cash amongst themselves; but in total they will still be short in total of the $100 needed to keep the economy going round. Economists don’t get the idea of there being a shortage of money because they trot out Income = Expenditure. An Economists “Income” is no income Average Joe would recognise – it’s not even Income the Taxman would recognise – it’s definitional.
Equation 3) What’s wrong with MV = PT ?- see MV = PT That is the Question ?
The Solution to the Credit Crunch.
There are two ways to solve the Credit Crunch and bring World Peace etc one is to stop reading this article at the end of this paragraph and to take what you now know at this point, see the real wealth we still have, that is about to be destroyed on bankers orders – which are a lot more destructive than the orders of most military commanders – no Military force could close down the USA but a handful of bailiffs could turn the USA into an industrial desert in months – destroying real wealth in order to make it match with the numbers in a set of dodgy books. You could take what you know now and work out a better way of counting the numbers – especially that bit about what happens when machines can do everything – will we all be rich because everything is free or will we all be poor because no one has a job.
The second way is to read the link below – which is my idea on how to fix it – but it may not be the best one and reading it might stifle your imagination or it may stimulate it to a better idea. It’s only a bunch of numbers – how difficult can it be ?
A Solution to the Credit Crunch :