Mo' Money, Mo' Problems

The Big Picture on the Economy, and How It Affects You

Joey deVilla – Shopify Tech Evangelist @AccordionGuy

Ryan Murphy – BU Law, Class of 2011@NouveauSouth

What In The Bojangles Are They Talking About?

The Fed? Quantitative Easing (QE)? The Debt Ceiling? Default? Inflation/Deflation?

This dog is also confused

Answer: No One Really Knows

There are too many variables to isolate to perfectly understand what is happening in the economy.

There are economists who spend their entire careers studying concepts presented on only one slide here. This presentation is necessarily a gloss and avoids a number of important, but very complicated, concepts.

Any statement about a certain action leading to a certain outcome should be viewed with skepticism (this presentation included). You can probably find an economist that would say the opposite.

ex. Some economists say raising taxes on the wealthy would hurt the economy, others say it would help.

To-Do List To understand what is going on with the

economy and why the political responses aren't helping, it is essential to answer these questions: How is the money supply regulated? What are the effects of recent monetary policy? Why does government debt matter? What can we do about the debt?

Once you understand where we are economically, we get to a humble solution to our current state.

Its the (Real) Economy, Stupid

The “real” economy creates the goods and services that people want, like iPads, t-bone steaks, and Beanie Babies. This is wealth.

The financial system doesn't create wealth. It should allocate stored wealth to its most productive use in the real economy.

Money is a way to store wealth created and not immediately consumed, and is a medium of exchange for goods and services.

The financial system and money exist to enhance the functions of the real economy.

The Big Players In The Financial/Monetary System

There are three institutions that influence the money supply in the United States: The Federal Reserve (The Fed) The Big Banks The Treasury

The Fed

The Federal Reserve is charged by Congress to control the money supply by adding or removing money from circulation.

Only the Fed has the power to print (read: create more) money.

It is independent from Congress in an effort to prevent politics from encouraging the excessive creation of money.

The Fed's objectives are to maintain price stability and full employment.

How Does The Fed Work? The Fed has 2 primary

ways to control the money supply: 1) change the interest

rate it provides the Big Banks on its deposits, or

2) change the interest rate it charges big banks on its loans.

Deposits

The Fed accepts deposits from the Big Banks. When the Fed wants the Big Banks to put more

money into the economy, it lowers the interest rate it pays on the deposits.

The Big Banks have greater incentive to lend to businesses rather than leave money sitting at the Fed. This expands the amount of money in circulation.

Interest Rates

The Fed also provides loans to the Big Banks. When the Fed wants the Big Banks to put more

money into the economy, it lowers the interest rate it charges on the loans.

The Big Banks have greater incentive to borrow from the Fed and lend to businesses. This also expands the amount of money in circulation in the economy.

Quantitative Easing

During the financial crisis, institutions stopped lending. Banks and other businesses needed loans to operate.

The Fed dropped its interest rates on loans and deposits to 0% to encourage lending, and still, no loans for businesses that needed money.

Rather than let the financial system and many businesses collapse, the Fed expanded the money supply by buying US Treasury Bonds from the Big Banks with freshly printed money, a practice called Quantitative Easing.

How Quantitative Easing Expands the Money Supply: Step 1

The Treasury issues a bond to the Big Banks. A bond is just another word for a loan with interest.

How Quantitative Easing Expands the Money Supply: Step 2

The Treasury spends the money in the economy on things like defense, social security, and medicare.

The Fed buys the bond from the Big Banks with freshly printed money.

How Quantitative Easing Expands the Money Supply: Step 3

The Banks were supposed to lend the money to the economy, increasing the money supply in the real economy.

Unintended Consequences of QE

The Big Banks invested in stocks and commodities instead of the economy.

Big Business did not want as much debt shortly after the crisis because they did not want to be dependent on the financial markets for funding their operations.

Loans to Small Businesses are too risky and expensive for the Big Banks.

Individuals either couldn't pay their debts or wanted to lower their debt.

Effects of QE Stock prices went up.

The Fed said this is good because it would make individuals feel more wealthy and stimulates consumption. However, only 10% of Americans own 90% of all financial assets like stocks.

Commodity prices went up. Commodities are things people

use, like food and oil. Rising prices on these essentials decreases the amount of money individuals have to spend on other things. This is inflation, and it is generally not good.

This young man is angry when he considers how his life has changed.

The Results of QE The economy has not improved with the extent

of QE used thus far. The economy only grew by just over 1% last

quarter. The federal government is running a deficit equal to

10% of all total economic activity in one year. If the government was not sustaining the economy with debt, the economy would contract at a rate of 9+%.

Once QE stopped in May, the stock market has tumbled. Along with numerous global events, lack of QE has been a factor in this decline. Monday (8/8/11) was the 6th largest single day drop in history and followed a week of falling stock prices.

What Else Can The Government Do To Help?

Not much Why? Because it has taken on too much debt. Why does that matter? I'm glad you asked. We will get to that shortly.

The Other Side of the Equation: Government Debt

Total government debt is approaching 100% GDP. That means the debt is worth a years worth of all goods and services produced in the entire country.

The debt is increasing at a rate of 10% of GDP per year.

43% of all government expenditures are financed with debt.

Why Does Debt Matter? Debt represents past or current consumption at the

expense of greater future consumption. When you buy something on credit, you get it now, but

you pay more for it over time then you would have by paying up front.

If the government is not using debt to invest in endeavors that will increase economic productivity, government debt is also more costly than beneficial long-term.

When debt gets to be over 90% of GDP, it becomes a drag on the economy.

The amount of money necessary to make interest payments on a debt of that size diverts resources from the real economy to interest payments.

The Debt Ceiling The potential crisis created by the debt ceiling

was completely political in nature, not economic.

However, the debt is a very serious economic problem and will have to be addressed in 1 of 4 ways: 1) Cutting Spending 2) Raising Taxes 3) Default 4) Inflation (devaluing the debt)

Cutting Spending

Cutting spending, while reducing the deficit, would make the economy worse short-term. Less money would be available for employment,

and therefore, consumer spending, investment, and income tax.

Raising Taxes

While raising taxes would reduce the deficit, taxes seem to be politically untouchable. Additionally, raising taxes may harm the economy

by decreasing the amount of money available for employment and/or consumption. (I don't fully buy this, but that is an issue for another time.)

Default

Default is not paying back the debt issued by the Treasury.

Since US Treasury Bonds are the savings of most world governments, default would have unpredictable worldwide economic implications. This is the option to choose if you'd ever wanted to

live in a post-apocalyptic movie.

Default is Necessarily a Political Decision

There is no economic possibility of default. Because the US government has the ability to

print money, it can always pay its debts with new money.

However, its ability to pay debts with new money is limited by the effects of inflation that would be caused by adding to the money supply.

The only way we can default is through the political process, like failing to raise the debt ceiling or simply deciding not to repay bonds.

Inflation Inflation is the least undesirable,

most palatable response. Inflation devalues the debt by

increasing the money supply while debt remains constant.

The government creates more money to pay the debt, so the debt becomes less burdensome to pay.

Because the amount of goods and services does not increase as fast as the money supply, each unit of money buys fewer goods and services. It is devalued.

Look at this chart. Those lines definitely prove something.

How Would Inflation Creation Work?

The US pays its creditors with new money through Quantitative Easing. So the answer is to do more of the same.

Note: Paying our creditors with devalued currency will not make them happy.

See how simple it is?

The Benefits of Inflation All levels of the US economy are deeply indebted and would

benefit from inflation. Total debt owed by individuals, businesses, and governments

(federal, state, and local) is around 350% of GDP. The nominal values of all debt would remain constant while their

real values would decrease.

This benefit could be offset by the increased cost of necessities, leaving less discretionary income for paying debt. Individuals who have the least discretionary income (read: poor people) would likely be hurt by inflation.

Not actively pursuing inflation would likely lead to deflation. This would make money more valuable and debts more onerous.

By artificially increasing demand for US debt, QE can keep interest payments lower than otherwise. This keeps the debt from compounding at a faster rate and interest payments lower.

The Costs of Inflationary Monetary Policy

It hurts savers and those on fixed incomes. There is an ethical uneasiness with this effect. The

costs are borne by the prudent, and the benefits are bestowed on the profligate.

It may create “moral hazard” in risk taking with debt. Those who take on debt are not subject to the full

economic implications of their actions. Not making those who took bad debts face the

consequences of their actions may encourage more risky behavior in the future.

The Big Risks of Inflation

Social unrest from imposing decreased standards of living on those already marginalized.

The worst-case scenario is extremely dire. Read the Wikipedia entries for inflation in

Zimbabwe, Argentina, Hungary, and the Wiemar Republic.

What Does All This Mean For You?

All of the options available to solve this debt problem likely involve lower standards of living.

The macroeconomic environment will continue to create problems for most people and businesses. Do not expect top-down solutions. They are not

available, and the political process seems too dysfunctional to enact good policy options even if they were available.

Do expect inflation. Find ways to hedge against inflation risks.

Your Answer To The Problems

Take things into your own hands. Start a business. My Shopify colleague would stay to start that business

using the fine services of Shopify.com. At the very least, support a local start-up.

These people are starting a business together. They don't even have faces. What's your excuse?

Small Business Small businesses make communities more

prosperous. Small businesses address the macroeconomic

issues that are plaguing the country: lack of growth, unemployment, and debt. They: Account for the majority of economic growth. Are responsible for the majority of hiring.

More employment and growth increases tax revenue and makes debt less burdensome for individuals and governments.

Create new goods and services or distribute them to markets where they do not currently exist.

Putting It All Together

There is a lot of debt in the system. This is bad. Monetary policy can only put a band-aid on the

problems. It can't make the economy better, but it could make

debts less bad. The solution is for you to create prosperity for

yourself and those around you. Politicians cannot do much to help us, even if

they decide to start trying. But if enough of us work at it, we can help ourselves.

That's All, Folks

Mo' Money, Mo' ProblemsThe Big Picture on the Economy, and How It Affects You

Joey deVilla – Shopify Tech Evangelist @AccordionGuy

Ryan Murphy – BU Law, Class of 2011@NouveauSouth