Wednesday, July 08, 2015

Economics as a Weapon

Within a modern economy there are two important economic policy tools: the money supply and the level of taxation.

The money supply is the money the central bank makes available to individuals and firms which operate within an economy. There is a market for money, just like for any good, which determines the level of prices. If the money demand is stable and the money supply increases, then we see a rise in the level of prices, known as "inflation"; if the money supply decreases, then we see a fall in the level of prices, known as "deflation".

Deflation has a number of interesting effects on an economy:

1. In order for an economy to adjust to a lower money supply, all prices should decrease, such that the economic activity could continue with a lower amount of money. A shop owner, for example, will see that his clients lack the cash required to buy his goods as before and he has to lower prices. This means that his employees' salaries, prices for his acquired goods, utilities and rent should also decrease. The employees' utilities and rents also should decrease and so on, until all prices adjust. As a result, the economy could function like it did before the money supply decreased, but with lower prices. However, THIS DOES NOT HAPPEN. Some prices are "sticky". The building owner usually is rich enough to keep the rent high, even if this means that the building will stay empty and he will actually lose the rent over a long period of time. The utilities suppliers usually are large enough to function as monopolies and they even continue to rise prices in the middle of the recession. This squeezes the shop owner into bankruptcy. The unemployment increases, the production of goods decreases. We have recession.

2. Potential investors see that their money are more valuable every day. They are no longer motivated to invest the money, unless the business opportunities offer profits above the deflation rate and at a very low risk. Keeping paper money is safer than starting a business, especially during a recession, and now they get a profit by keeping paper money. This decreases investment, and further decreases the money supply, since more money are effectively withdrawn from the economy. As a result, unemployment increases and production decreases further. The circle of disinvestment and recession can continue for a long while.

3. Inflation acts like a tax: an increasing level of prices devalues any cash in the economy, while allowing the government to spend the newly printed money just like any other public money. Unlike a regular tax, inflation taxes undeclared money, money kept in a suitcase under a bed, as well. Deflation has the opposite effect, it rewards black money. In a country with a poor tax collection rate, like Greece, this effect alone can blow up the economy, because the government can no longer tax income as efficiently as before.

4. There is a psychological effect of low money supply. When you see money entering your pocket, and you expect more money to come tomorrow, you plan to spend or invest it. When you see that money supply is tight, you save even more than it would be rational to do. This goes beyond the rational planning in point 2. This strengthens economic booms and recessions, making them worse.

5. A government needs to face unexpected adverse shocks, like bad weather or financial attacks from global speculators. If that government can not print money then its ability to answer to such adversities decreases. When financial global speculators know that a government is unable to answer, the attack becomes certain, because its success is almost certain.

6. When a government prints money in the right amount and at the right time, and spends it the right way (which basically means helping the poor within the society), the economy will grow. As a result, the money demand will increase, and the price level may not even increase at all. This is what happened in the USA, which printed large amounts of dollars, as opposed to EU, which applied tight money supply policies. Today, the dollar grows stronger against the euro.

Taxation also has an optimum level which in Greece has been exceeded by far. In Greece, lower tax rates would increase tax revenues, because the economic activity would increase.

These simple statements are the conclusion of any economics college first grade Macroeconomics textbook.

I remind you that money supply is only paper, printed paper. So why are we having this problem of lower money supply in Greece at all?

Greece is less efficient and more corrupt than Germany. As a result, there is a level of euro money supply which would bankrupt Greece and allow Germany to function. Now ECB knows precisely what that level is. After five years of austerity in Southern Europe the German economy also bordered deflation. ECB reacted on the spot: (risk of deflation in Germany) (reaction).