As you listen to economic news on television the next time, do pay more attention to the things that are said and the forecasts that were made. Are some of these statements facts or just myths?
1. GDP growth is seen as an indicator of the health of the economy. Deficit spending is necessary to overcome recessions.
GDP itself is an aggregation of spending. Spending itself is not a sign of health, in particular deficit spending. Do you look at your ballooning credit card bill monthly and say, “Honey, we are doing better this month than last month?” There is a serious calculation problem with aggregation. Destructive activities such as war, natural disasters, demolitions and man made disasters, including the oil spill from British Petroleum are all contributing to the GDP. Cost of cleaning up the shores and the ligation costs by the parties involved are not creating any economic value. Transactional costs that attempt to protect your assets from governments are also included into GDP, e.g. tax planning to reduce tax burden and investment advisory to protect against inflation.
Politicians who determine their salaries based on GDP growth/figures is akin to a student setting his own exam paper and grading it himself because government spending is a contributor to the GDP in the form of Y = C + I + G + nX. The common misguided thinking is that government spending(G) is the solution to the slack that private sector has created with their reduced investing(I)/spending(C). These folks fail to realize government spending has to be financed, either through tax collections or additional Treasury sales. If the Federal Reserve buys these treasuries, it has to increase the money supply to buy them. Rising prices is an effect of the dilution of purchasing power caused by the increase of money supply. Taxpayers are poorer as a result of taxation but everyone else, except the government, is poorer as a result of inflation. The health of an economy should be reflected by rising standards of everyone in terms of both improvements in life or/and purchasing power and not a politically manipulated GDP figure.
2. Is demand of money infinite? Due to this infinite demand, we cannot use gold as money as there is not enough gold in this world for everyone to use as money.
Common misguided economic thinking will portray demand as infinite because of the argument that everyone seeks more money for himself. Central banks use this as an excuse to conjure up new money by saying money is being hoarded by savers. The most important distinction one has to make is between wealth and money. The collective demand for wealth is infinite, which suggests everyone try to improve his/her wealth consistently over time with every action. However, money is just one form of wealth. There are other substitutes for wealth, inclusive of property, cars, assets and antiques etc.
There is always enough gold. Price of gold adjusts according to supply and demand of gold versus others goods. Gold “circulates” just like our paper money changes hands. It can be used repeatedly with less wear and tear than paper money. If people start storing gold in a bank or hoard it under their pillows, it reduces the gold supply in the market and increases the value of the gold in circulation. Money is a commodity that is being used as an exchange for another good/service. The supply and demand determines the value of the commodity, just like another other good/service. Lowering prices in terms of weight of gold is not deflation. It is a sign of rising standards of living.
Another possible situation is the bimetallism standard where silver and gold could both be used as money concurrently, just like in ancient china where teals of gold and silver were used. There will then be prices in terms of gold and silver, with silver floating freely against gold in a ratio determined by market.
The infinite demand for money is only a psychological effect caused by rising prices. As prices consistent rise over time, the demand for more money to cope with rising costs of living increases. We do not need more money if prices are declining over time, a reflection of higher productivity and larger economies of scale. In order to earn more money we have to sacrifice our time for other things in our lives, leisure, family and friends. Would it not be better if there were declining prices and you have more time for everything else you enjoy other than work?
3. Quantity Theory of Money (MV = PQ) suggests that monetarists can target a specific inflation rate of 2-3% by keeping money supply within a acceptable bandwidth. For the near term, most monetarists agree that an increase in money supply can offer a stimulus in kicking start a staggering economy.
This theory has a list of assumptions that will only hold in this perfect state of economy in Irving Fisher’s mind. The most heavily criticized assumption has to be velocity(V) is assumed to be constant. Robert Gabriel Mugabe probably read Irving Fisher’s theory before he printed trillions of Zimbabwean dollars, creating millions of billionaires in his country. This is probably the only time u will see inflation being announced with percentages in “sextillion”, which represents 10,000,000,000,000,000,000,000. Velocity is neither constant nor stable. Velocity should be a function of price volatility and confidence in the sovereignty of the currency as it reacts to central banks’ policies and prices movements. The more the central bank devalues the currency, the quicker the citizens will spend the currency.
Further assumptions like full employment and economy in equilibrium are also made. This seems to be a perfect world that exists only in monetarists’ theories. The world we know today is never in equilibrium. The economy is made up of billions of people seeking what is best for himself/herself. The economy is constantly evolving and adapting to new changes, regulations, competition and innovation. Change is a constant and not a variable; the only thing that varies is the degree of change.
Economic Myths to be continued…