An Economic Model?

In the discussions, so far, an attempt has been made to outline some of the evolving ideas and institutions, which have come to underpin today’s global economy. This section of discussions will now try to add some further detail in the form of a very basic model of an economy in the hope that it might help illustrate some of the key functions and interactions. In the diagram below, as detailed in the right block, we see the basic working parts of a nation’s economy, which then interface with the economies of other nations, as represented by the smaller blocks on the left. In the background, we see planet Earth, which represents all of the global resources available at any given time, which have a tangible value based on ‘supply and demand’ criteria. It is highlighted that some of these resources have to be classed as non-renewable, i.e. finite, which may ultimately come to place a limit on economic growth. However, based  on current wisdom, it appears that all economies ‘must’ continue to strive for growth, such that the nation’s economy is expected to increase in size year-on-year by some suitable percentage.

Within this simplified model, we only have 4 internal components supporting the economic infrastructure. While this is clearly a gross simplification, the main focus of the discussion is primarily orientated towards the role of the banking system, especially the potential effects originating from the issuance of loans and the accrual of interest. However, it may be worth introducing each component as follows:

  • Government:
    This includes both the legislative and judiciary arms of government, inclusive of its need to collect taxes to pay for public services and its social welfare system. Public services are also an employer of people and, by necessity, these services can also borrow from the banks and buy products from industry.

  • Industry:
    In the current context, industry accounts for all goods and services, inclusive of agricultural products, i.e. essentially anything that is manufactured or sold for profit. As such, industry sells products, pays taxes on profits, employs people and applies for bank loans and the payment of interest.

  • People:
    While people are representative of the population, as a whole, there is a smaller section of people who have jobs and therefore earn wages and pay taxes. There is another, and sometimes overlapping, section of the population, which receive public services and benefits. However, generally all sections buy products and can apply for bank loans in many forms with varying rates of interest.

  • Banks:
    For the purposes of this discussion, the banking system includes both the central and private banks. Private banks issue loans and receive interest payments, pay taxes on profits and employ people. While banks contribute to the Gross Domestic Product (GDP) of a nation, as per industry defined above, it will be discussed as a special case.

As indicated in the opening paragraph above, the current generally accepted wisdom appears to require an economy to grow, year-on-year, otherwise it will be described as ‘stagnating’ or ‘in recession’. Therefore, the question that needs to be considered is:

How and why does an economy grow?

In practice, any of the components of the model described above can contribute to growth, but it may be necessary to distinguish between what may be real growth, in terms of production and people, and artificial growth associated with monetary inflationary spirals. Therefore, it might be useful to initially highlight some of these distinctions for each component of the model:

  • Government:
    If a nation is growing for the right reasons, a government may receive more revenue in taxation, which allows it to spend more on its public services and benefits, including the national infrastructure and the number of people employed. Recent history suggests that many governments have attempted to simply simulate growth in their economies by borrowing billions from the banking system; often as a knee-jerk political reaction to maintain public services or combat unemployment by funding large construction projects. Of course, any borrowing from the banks requires not only the principle sum to be repaid, but additional interest charges. While government borrowing may effectively contribute to the profits of the banking system, it also adds to the national debt that ultimately has to be repaid using tax revenue collected from the working population.

  • Industry:
    As defined, industry is any business that sells products for a profit, excluding the banking system. While some will produce physical goods, others may be more service-orientated. Of course, if this industry is operating within an expanding sector, it may well expect an increase in its turnover and profits, which then provides more taxation revenue for the government, more jobs for people and more confidence to borrow from the banks for future investment. Within this mix, technology developments are also continuingly opening up new market opportunities, i.e. growth potential. However, on the flip-side, many industries are now competing for global resources that are finite in supply, which is driving up prices, i.e. there is an inflationary pressure being caused by supply and demand. It might also be necessary to consider whether any industry that imports more than it exports is only contributing growth of another economy, not the local one.

  • People:
    Initially, it might appear logical to assume that any associated growth in the population would correspond to a growth in the economy. Of course, this assumption must be predicated on an additional assumption that all these extra people are productively employed, i.e. have jobs primarily linked to industry. Therefore, in the harsh reality of economic numbers, it may also be necessary to consider whether a person’s job, and wages, makes any net contribution to ‘productive growth’, which is not offset by demands on public services and benefits. However, many of the wider issues associated with global population growth will be deferred to the discussion entitled Limits to Growth’.

  • Banks:
    The banking and financial service sector have long been seen as a ‘profitable industry’ . Later, in the discussion, ‘Banks, Money and Loans’, an attempt will been made to show how the banking system can effectively ‘create’ money every time a loan is requested. However, by way of an initial example, when a loan is authorized for a car purchase, the buyer signs a legally binding contract that is equivalent to the asset value of the loan. In the simplest case, the seller of the car may also have an account at the same bank as the buyer, so that the money paid for the car ends up as simply being an update of the private bank (PB) balance sheet, e.g.

  • PB Balance Sheet
    Asset Liability
    Buyer’s loan: £10,000 Buyer’s account: £0
    Seller’s account: £10,000

    So, in this example, no physical money is actually moved, but the bank is now earning interest on a loan, which it effectively created out of nothing. In another discussion ‘The History of Usury’, it will be shown how the original condemnation of usury was transposed into the idea of ‘interest’ as meaning for avoiding loss followed by an analogous story in which a goldsmith stumbles on the idea of using gold reserves that he does not own and which eventually do not even exist to underwrite loans and the issuance of ‘paper money.

So, based on the outline above, there may be many interpretation of growth, which possibly needs to be aggregated into some composite measure, e.g. an increase in the capacity of an economy to produce goods and services, when compared to some other period of time. However, this form of economic growth might also need to be adjusted for population growth and monetary inflation.

Note: Gross Domestic Output (GDP) is an estimate of the total value of goods and services produced in a given economic zone, e.g. nation-state. However, in isolation, GDP may not accurately reflect the overall economic state of a nation or the individuals within that state.

Traditionally, the idea of the Gross Domestic Output (GDP) has long been used as a measure of economic growth, which might also be refined in terms of GDP per capita to account for population change. Of course, today, we might all be more aware that the state of the public finances, i.e. the ‘deficit’ and ‘total debt’, may be masking problems in the GDP per capita measure, if not taken into account.

Note: Basically, the ‘deficit’ is the difference between what the government takes in by way of taxes, and other revenues, and the amount of money it spends. In contrast, the ‘total debt’ is the accumulation of the national deficits year-on-year.

In practice, there is no one accepted monetary measure of the state of a nation’s economy, which quantifies wealth in terms of human happiness and physical assets. As such, economists invariably limit their definition to various permutations of GDP, which is primarily a measure of income rather than assets, let alone human happiness or the state of environment. This said, some have attempted to put a dollar ($) value on three kinds of assets:

  • Manufactured Capital: roads, buildings, machinery etc.
  • Human Capital: people’s skills and health etc.
  • Natural Capital: forests and fossil fuels etc.

Of course, it is possible to seen the limitation of such an approach, even without understanding all the details, if everything is reduced to a ‘capital’ measure. For ultimately, ‘economic growth’ will always require an increase in the production and consumption of goods and services, which in-turn imply an increased use of natural resources. However, while any economy must operate within the ecosystems that supports it, i.e. planet Earth, this fact is often ignored or reduced to the idea that the ecosystem simply exists as a resource of the economy. For the production of goods and services requires natural resources be converted into ‘natural capital’ and ‘manufactured capital’, which possibly reflects the fundamental conflict between economic growth and conservation of natural resources. However, this line of argument will again be deferred to the discussion entitled ‘Limits to Growth’.

Can the economic model above be anchored in real data?

For illustrative purposes, the state of the UK economy might be used as an example. Today, in 2014, the UK has a national debt in the order of £1.3 trillion, which corresponds to ~77% of its real GDP. This debt incurs interest payment of £53 billion, which might be seen in the context of the UK government’s balance sheet:

Income in Billions Outgoings in Billions
National Insurance £110 15.0% Defence £38 5.2%
Business Rates £27 3.7% Education £98 13.4%
Value Added Tax £111 15.2% Transport £23 3.1%
Corporation Tax £41 5.6% Public Order £32 4.4%
Income Tax £167 22.8% Health £140 19.1%
Excise Duty £47 6.4% Industry £17 2.3%
Council Tax £27 3.7% Housing £25 3.4%
Others £118 16.1% Social Services £31 4.2%
      Welfare System £222 30.3%
      Other £53 7.2%
Total £648 88.5% Total £679 92.8%
Deflicit/Borrowing £84 11.5% Debt Interest £53 7.2%
Balanced Total £732 100.0% Balance Total £732 100.0%

So, based on the approximated figures above, the UK government income from its various taxation sources is $648 billion, while its basic outgoings are £679 billion. As such, we might recognise that the UK government has overspent its income by £31 billion, which we might define as an ‘annual deficit’. However, as indicated above, the UK government also has to service the total national debt of £1.3 trillion, which is effectively the year-on-year accumulation of its annual deficit, i.e. it has to pay £53 billion in interest charges on its debt, such that the ‘total deficit’ becomes £84 billion, i.e. £31+£53 billion. Therefore, it might be realised that before the UK can reduced its overall debt of £1.3 trillion, it must first reduced its ‘total deficit’. However, reducing this deficit will require the government, of any political persuasion, to reduce its expenditure on one or more of the ‘outgoings’ listed above, which is invariably unpopular with some section of the electorate. In the UK, both major political parties have promised to protect the ‘health budget’. If so, then £84 billion of savings must come from the remaining £679-£140=£539 billion of government outgoings, i.e. a net reduction of 15.5%, or more likely a targeted reduction on the ‘welfare system’. Based on current political policy, the present government is ‘promising’ the following reduction in the deficit and return to a surplus; whether this will be achieved is another matter entirely.

Of course, even if the chart above does turn out to be a reasonable prediction, the actual debt must continue to increase until 2019 and will then only be slowly reduce if the £20 billion surplus can be maintain for the next 70 years! On this optimistic note, let us turn the turn our attention on the historic accumulation of the UK debt as illustrated in the next chart:

If we initially focus on the UK debt as a % of real GDP, as explained below, we see that the situation was at its worse just after the end of World War II for fairly understandable reasons, i.e. peaking at nearly 240% of real GDP. By 1992, the figure had fallen to under 30%, which equated to a total UK debt of ~£300 billion and while debt as a ‘% of GDP’ has never return to that immediately after WWII, the increasing debt problem can only be perceived when viewed in terms of ‘real money’, i.e. growing towards today’s 2014 figure of £1.3 trillion.

Can the UK government simply not increase income via further taxation?

Working in ballpark round numbers, the total population of the UK is 64 million with 30 million estimated to be in some form of employment. Assuming an average wage of £25,000, we might crudely estimate the total wage income of the UK to be £750 billion. If we extract the 3 largest taxation sources within the UK government budget to which most people in work contribute, the total of £388 billion represents over 50% of the £750 billion estimated in wages, i.e. 50% of people’s wages already goes in tax!

Income in Billions
National Insurance £110 15.0%
Value Added Tax £111 15.2%
Income Tax £167 22.8%
Totals £388 53.0%

Of course, while this is a very crude estimate, it might suggest that the UK electorate will not accept any further increases in taxation, even if they could afford it. While the left of centre political parties might wish to levy more taxes on the rich, the economic results of this approach may not dramatically change the debt situation, as outlined above.

So how might the state of the UK economy be assessed?

We might start to address this question by presenting some historic data from the UK economy, where GDP has now recovered from the 2008 financial crisis to be in the region of £1,700 billion. The definition of ‘real’ and ‘nominal’ can sometimes appear somewhat misleading as the real GDP reflects the nominal GDP adjusted for inflation, such that it might be more meaningful to suggest that the nominal figures were ‘real’ at a given point in time, while the real figures are normalized to account for inflation in today’s terms. However, the historic trend of these figures can best be seen in the following graphs, although the accuracy and resolution of the data is only intended to reflect the general trends.

Clearly, to gain some insight to the GDP trends described as ‘nominal’ and ‘real’. It would be useful to see the effects of inflation, both as a ‘yearly % increase’ and an ‘accumulating year-on-year ’ effect. In the chart below, the ‘% inflation’ changes year-by-year and while now normally controlled below 5%, historic data shows it reaching a peak of 24.2% in 1975. The accumulating year-on-year inflation factor effectively show the devaluation of the purchasing power of money over time due to inflation. This factor is used to create the ‘real’ or ‘normalised’ GDP graph above from the actual or nominal GDP figures. However, while this is a somewhat ad-hoc definition, it is possibly more easily understood as a general explanation of the trends being presented.

We might also convert the idea of the ‘real GDP’ to a ‘per capita’ figure by simply dividing by the UK population at each point in time. In many ways, it might be argued that the ‘real GDP per capita’, which accounts for any changes in the ‘population’, is the most representative of the actual growth in the economy.

So, in the chart below, we see the growth in ‘real GDP’ shown in blue, while the growth in ‘real GDP per capita’ in shown in brown. The growth in population, as shown above, tends to lower the GDP per capita such that we might now see the real growth that has taken place in the UK economy over the last 60 years or so.

So, while there is often much concern raised over population growth, it would appear that population growth is not a major factor in the growth of industrial output, as measured in terms of GDP. However, this does not mean that there are not major concerns to be taken into consideration when it comes to global resource depletion, but we shall defer this issue to the ‘Limits to Growthdiscussion.

So what factors are driving the growth in the economy as measured by real GDP?

We might start by trying to simply quantify the concept of GDP as a mathematical expression, although it does not really describe the complexity:

GDP = consumption + investment + spending + (exports − imports)

In practice, the factors affecting GDP in every nation-state can differ, although it is often claimed that the increase in ‘industrial’ productivity is the major factor responsible for the ‘per capita’ growth driven by technology developments and innovations. Certainly, increases in productivity have historically been an important source of real per capita growth, which has led to lower cost of goods, which then helps to simulate an increase in demand. Of course, by the 20th century, most national economies were becoming increasingly dependent on global trading conditions, such that events in one region might have serious knock-on effects on economic growth in another region. However, we might still try to summarise some possible growth factors:

  • Technological progress and innovation available to the economy
  • Growth in size and quality of the labour force within the economy.
  • Growth in capital stock, reflecting the equity of businesses within an economy.
  • The stability of social and political environment in which the economy operates.
  • The demand for goods and services, both local and global.

As such, real GDP growth can be affected by a number of factors, although consumer spending can also be a significant driver within any economy, which history suggests has been manipulated through the extension of monetary credit to both individuals and governments. Of course, international trade also affects a nation's economic stability in terms of its balance of trade, i.e. imports versus exports. Therefore, when international trade demand is increasing, any weaknesses in the local economy may not be obvious in the real GDP figures. Governments can also affect the GDP figures by injecting money into the economy, e.g. infrastructure development and military programs. However, the ability of governments to spend more than they can really afford, i.e. via borrowing, can lead to many problems that may ultimately affect the real GDP growth in an adverse way. However, there is one other factor that we may also need to take into consideration, which is linked to the cause of inflation and anchored in the banking system of loans with interest.

Based on the chart above, we may estimate that the amount of money in the global economy has increased by a factor of ~20 in the last 40 years or so, which is in the same ballpark as the inflationary increase in the cost of living, i.e. the price of goods and services. While this is not entirely surprising as the amount of money in circulation will cause prices to increase, it does not necessarily explain why the amount of money in circulation is increasing.

So why and how is this increase in the money supply taking place?

If we return to the basic building blocks of the model economy, but now extend it to represent the global economy as a whole, rather than just a national economy, we might realise that ‘industry’ and ‘people’ cannot really create new money as being suggested by the chart above.

While individual ‘governments’ may simply print more ‘fiat money, this would only lead to a devaluation of its local currency via the global exchange rate markets rather than producing any real increase in purchasing power. If so, we possibly need to take a closer look at the ‘banking system and the ability to earn interest on loans may actually be able to ‘create’ the new money in circulation year-on-year. However, before this discussion takes place, it might be useful to reflect on the concept of 'interest' as described within the 'history of usury'.