The correlation between GDP, taxes, and debt.

This will be a lesson based on the Khan Academy economics course to explain how government tries to affect the economy. I say “try to,” because evidently government cannot fully control the economy as it might wish. This makes sense, when we want to compare government policies between, say Democrat vs. Republican leadership. There is no clearly defined border between the two. There is always a delay, number one, and number two: depending on the conditions (economic and otherwise) the implemented policies may or may not result in its intended purpose to the desired degree.

There are basically two kinds of policies: Monetary and Fiscal policy. Monetary policy deals with how much money to print by the “Central Bank”. In the USA that is a quasi independent institution. It is run by the government, but also gets input from private industry, such as banks. It is given the right to print money, but it is mostly electronic money. It buys “debt”. An interesting way of “lending money”. When someone buys bonds, he/she directly lends money to the government. This increases the amount of money.

Screen Shot 2015-02-24 at 6.17.40 PM

When the supply curve moves to the right, interest rate will drop, as seen in the graph by the little yellow line on the demand curve, while the supply of money increases as seen on the yellow line on the horizontal supply axis. This is like micro economics. When more money is available because of the shift in money demand, that shifts the aggregate demand on the macro economical side to the right, stimulating the economy, thus increasing GDP as can be seen in the graph below:

Screen Shot 2015-02-24 at 6.18.14 PM

This graph compares Price on the vertical axis to GDP on the horizontal axis. So, GDP can increase because more money is available.

Another way that aggregate supply can increase is through fiscal policy. Fiscal policy is the government directly demanding goods and services from the economy. It uses two sources to finance those demands: taxes and / or debt in the form of treasury bonds and other means. Say, the government issues more bonds, thus increasing the debt, but taxes remain the same. This will increase spending, having the same effect as the increase in money supply in the previous example.

This brings up an interesting difference between the Democrats and Republicans. Typically, but not always, the Republicans want to hold the line on taxes and at the same time not increase the debt. Democrats tend to want to increase social programs meaning increased taxes. The way I see it, is that the Republicans, for the most part, want to increase or stimulate the economy, at the appropriate time through printing more money (micro economics), while the Democrats want to stimulate more directly through tax increases (macro economics). Both parties want to promise the moon, so need more money to fulfill their promises, but since neither can get the full amount they want in their own way, debt on the fiscal side goes up, unchecked. I say “unchecked”, because debt keeps rising no matter which party is in the majority. That is just my simplistic opinion, looking at how our economy functions.

GDP and Luca Pacioli

In my last blog, I wrote that GDP ignored the difference between credits and debits, or assets vs. expenses. It only records “transactions”. In a prior blog I also referred to National Debt as a humongous concept and was wondering what we as “peons” can do about it. I think we can do something about it! We have to speak up against the “Enrons” of the world, who misrepresent the accounting principles. They should be forced to explain their accounting processes. Also banks often use very “loose” accounting practices to make their status look good; better than it really is. Paclioli addressed not only double entry accounting, but also the ethics of accounting. Alas, the ethics today are going by the wayside.

Thomas G Rooney: “Paclioli was a Catholic monk who observed local Italian parissoners often in need of a hand out, not able to keep track of their activites, so he came up with a kind of community outreach plan in the form of a work book to help people 500 years ago keep track of their transactions by type. Debitiere is what one was to do with where something was put, and creditiere was what one was to do in recording where something came from. But in the “Nobody is going to tell me what to do” society, people often do not want to be told to keep track of messy things like that, and just enjoy the fact that transactions are occurring.  Paclioli’s system spread far and wide, now used by just about every entity that exists to keep track of things…. banks, trust companies, realtors, insurers, the professions, businesses, many churches, etc. But for some reason, governments only like half the system, emphasizing trnasaction volume, happy with inflows, whether the source is income or debt….. happy with outflows whether the object is an asset or an expense … as long as there is movement, you got that right Bert.”

“Since Pacioli was a Franciscan friar, he might be referred to simply as Friar Luca. While Friar Luca is often called the “Father of Accounting,” he did not invent the system. Instead, he simply described a method used by merchants in Venice during the Italian Renaissance period. His system included most of the accounting cycle as we know it today. For example, he described the use journals and ledgers, and he warned that a person should not go to sleep at night until the debits equalled the credits! His ledger included assets (including receivables and inventories), liabilities, capital, income, and expense accounts. Friar Luca demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. Also, his treatise alludes to a wide range of topics from accounting ethics to cost accounting

Pacioli was about 49 years old in 1494 – just two years after Columbus discovered America – when he returned to Venice for the publication of his fifth book, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion). It was written as a digest and guide to existing mathematical knowledge, and bookkeeping was only one of five topics covered. The Summa’s 36 short chapters on bookkeeping, entitled De Computis et Scripturis (Of Reckonings and Writings) were added “in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business,” and to “give the trader without delay information as to his assets and liabilities” (All quotes from the translation by J.B. Geijsbeek, Ancient Double Entry Bookkeeping: Lucas Pacioli’s Treatise, 1914).”

 

4060EB0B-D6A8-40C8-B41F-C7BCE5B3AE3B

 

Luca Pacioli: The Father of Accounting

Weaknesses of Fractional Reserve Lending

There are some negative features in this system.

  1. It is not stable. The banks say your money is safe and it is your money, so is available to you, but that is not fully true. Banks lend out a sizable amount, so do not have all of your money available to you. The government does not have direct control over the money they issue, but can implement some rules to somewhat manage the money.                                  Say one of the banks makes a bad investment, or worse, some money is embezzled, so now they cannot pay out the money you ask for.  You do not have faith in the bank anymore, you read about it in the newspaper and other people start to demand their money, too. Even though the other banks are solid, people start to question those and start taking out money from there as well. That is where the FDIC comes in. It is a government agency which steps in and provides insurance to banks. The money a bank client asks for, will ultimately be provided through this insurance policy.
  2. Bad incentives. Because the bank is insured by this FDIC policy, the customer is not too concerned with how the bank invests its money, so there is no accountability necessary toward the customer, as to whether the bank is making good loans or bad loans.             Banks can issue sub-prime loans to people who cannot really afford that house. It is not just the sub-prime loans that cause financial problems, but more so the ease with which the banks “offer” all kinds of incentives so people will buy whether it is wise or not.
  3. Lending money. The banking system has a lot of control over the money. When the economy is doing well the banks will distribute more money into the lending supply. The opposite is true as well: when the economy is weak it can turn into a recession. Businesses will ask for less money in the form of loans, etc. But in a recession the economy really needs more money so people will buy more again. The Federal government will print more money. However, that is only half of the equation, when in fact, the banks provide less lending, being scared because of the recession. In reality, when you want to get more money into circulation the opposite is happening. When there is a boom and you want to slow down the economy, the opposite is also happening. Because of the boom, more money is entering the market place. To temper an overheated economy, the government can sell more securities and take the money it receives for them, out of circulation.

This is not some law of economics. It is a system, but not the only system, although the most common in many countries.

Sal really explains this very well with a diagram in The Monetary System class of the Khan Academy:

weaknesses-reserve-banking

My challenge to you:    Take time to study this diagram, and see if you can explain it to a friend!

Fractional Reserve Banking

How does our banking system work, and why bring that up? The most common banking system used by most countries is the Fractional Reserve System. This is explained very well in the Khan Academy class of the monetary system. It is not a perfect system but needs to be explained for understanding because national debt is related to it. Here is a diagram again from the Khan Academy:

overview-reserve-banking

How does the money, that the Central Bank prints, get circulated? For simplicity, say the Central Bank prints three dollars, or three units, if you will. We have a system whereby the government sells securities, often in the form of bonds. Whoever has those securities can sell them and deposit that money in a bank. The money can also physically or electronically be transferred to a bank. Say, someone owns securities (the 3 yellow rectangles on the borrow left), sells those and deposits the money in a bank, or the bank obtains dollars from the Central Bank. I will skip the details of that process for now. The bank, let’s say receives $3 (the green rectangles in the diagram) from someone who sells securities. So now the individual can access his / her money from the bank (the “bank” with the 3 dollar bills). But the bank does not keep all $3, because it assumes the individual will not access all $3 at once, so it reinvests most of that money, even though it will tell the depositor that his money is safe and will be accessible. In reality a bank only has to keep about 10% available to its customers. This % fluctuates.

Whoever buys those securities may not use all of it, or buy a car and the dealership deposits that money in a bank. This is shown as the second “bank” with two dollar bills. That bank reinvests, say, $1 and the same thing happens all over again. So, the three dollars, or units, printed by the Central Bank now have multiplied to six dollars (fractional).

The bank issues checks. Say I want to buy an apple which costs $1. I can write a check for $1 (Yellow rectangle left of the apple) and give that to the vendor, who in turn deposits that back in the bank into his account. Only a paper transaction has taken place: my account has been reduced by $1 and the apple vendor’s account, increased by $1. So the original $1 printed by the Central Bank does not even come into play!

The point of this exercise, is to show that the government has limited control over the money it prints. To reduce the $$ in circulation, the government can sell the securities, and keep the money they receive out of circulation to reduce the money supply, thus reducing the amount of lending by the banks. The government can also buy securities and take that money and put it into circulation, so the banks can increase their lending portfolio.

There are also some drawbacks about the system, but that will be for another blog.