This is the first in a series of posts I’ve planned for the next few weeks. The series will end with a conclusion about deficits and debt that will probably startle many people. No, wait: not just probably; I’ll stick my neck out and guarantee it.
Developing the topic properly would be too much for a single article, so I chopped it into several subtopics—because the two most important things I’ve learned about publishing on the web are (1) keep the prose concise, and (2) use images when possible. A single, lengthy article would have violated rule number 1.
That’s a lengthy introduction that really means, “If you think this post is too elementary, bear with me. There’s more to come, and this is important groundwork. You will not be disappointed.”
Money is lube
Our economy is not 13 trillion dollars in size; instead, its size is $13 trillion worth of goods and services. Big distinction there: it’s the goods and services that make our lives better, not the money. (In a dark alley at night, would you rather have a twenty dollar bill, or a twenty dollar flashlight?) The dollars are just a time-shifting mechanism to bridge the gap between the value of stuff you produced for others, versus the value of the stuff produced by others that you might buy someday.
To illustrate the purpose and use of money in an economy, let's take a look at several different economies—using a few simple images I've been keeping in my head. The most primitive economy is a barter economy. No money at all. Economists are universal on at least this one point: barter economies are highly primitive and inefficient—and highly unlikely to enable the participants to escape from poverty. Because every exchange (transaction) requires a "double-coincidence of wants," there aren’t many exchanges because there aren't many double-coincidences. Result: One small, anemic pile of goods and services is all the economy can produce and consume, as shown in Economy 1a, below.
But in Economy 1b, an economy utilizing money as a medium of exchange, the double-coincidence is no longer required for a transaction to take place. Money provides liquidity; it lubricates the economy. Pouring a sufficient amount of money into a barter economy is like pouring water onto that small pile of goods and services. It forms a nice, viscous little slurry, allowing things to move more freely.
Money enables the economy to increase its production and consumption of goods and services; i.e., to escape from poverty. That’s economic growth.
But what if goods and services growth is not matched by a sufficient amount of money growth? We end up with Economy 2a, below: an economy with insufficient liquidity. Growth slows, or stops altogether. That’s economic stagnation. The lack of liquidity could even result in economic contraction.
Economy 2b, on the other hand, has just the right amount of money growth. Whoever is controlling the money supply is doing a good job of creating new money at the same rate that new goods and services are being created. [This, by the way, is my favorite kind of economy: high growth, while inflation is low, predictable, and well under control.]
Economy 2c is an inflationary economy. Money growth is outpacing real goods and services growth. Result: too much liquidity. I haven’t found too many people, including economists, who like this scenario more than the previous one.
I frequently hear politicians and journalists (of all political persuasions, by the way) talking as if increasing the number of dollars flying around in our economy is automatically inflationary. That’s just not true, but the fear of creating “too much money” (Economy 2c) has stifled economic growth in the past, and resulted, ironically, in saddling us with Economy 2a. Believe it or not, many intelligent people believe that real growth actually causes inflation. (I wonder if that philosophy was prevailing at the Fed Board of Governors in early 2000; I’ve speculated on that before.)
In any case, money enables growth; too much money causes inflation; too little money causes stagnation or contraction. We need just the right amount of money growth to enable the real economy to grow without inflating the currency.
[Although that may sound elementary to some, it is an absolutely necessary foundation for the subsequent articles I have planned on the topic of deficits and debt. Stay tuned.]
UPDATE: Here are links to all six articles in this series: