One Way to Run an Economy

There is more than one way to run an economy. Today, let's explore a single way.

In our imagination, we have an isolated island with it's own currency. With sunny days and pristine beaches, they wish to join the wider world's economy.

They collectively decide to advertise their island, offering a one week stay for XX.XX in their currency or YY.YY in a number of other currencies. It seems to me that they are setting their own foreign exchange rate. They would need to decide among themselves how the divide the cost of providing that one week experience.

OK. With a plan in place, they begin the experiment. After one year, they find that they have a booming business. They have more people arriving than they can handle. What do they do? Change the exchange rate? Put people on a waiting list? Send guest home dissatisfied?

Whoa. We have too many possible answers! We need to more accurately examine how this island's business is economically arranged. Let's assume that government has been issuing local currency in exchange for foreign currency. This local currency has been obtained from a stable system of taxation that results in an agreeable balance within the island's economy.

Returning to the problem of excessive success, the island government decides to decrease the exchange rate, which results in a decrease in the amount of local currency for each unit of foreign currency. In other words, the price of a week on the island has increased in terms of foreign currency. This action stabilizes the tourist industry but leaves it running at a high and nationally profitable level.

Let's continue this story for 50 years. Our island has a stable, successful tourist industry. Government routinely spends part of the foreign currency and saves part in the form of bank deposits and safe investments in the currency of foreign origin. After 50 years, large sums of reserves are held in some nations.

Could this really happen? Think China? Think Japan? "Whoa!" someone shouts! "Those are both exporting nations. Just the opposite of this story." Hold that thought until later in the article.

Now we add a new twist to the story. An enterprising journalist (who is also an amateur economist) notices the large sums held by a single nation. He also notices the large number of tourist on vacation. He writes a story. The story is read by a politician. We have a political moment.

The story expresses concern about the large overhang of potential spending by this single island economy. There is concern that people are off vacationing rather than working, which just continues the trend long in place. Something must be wrong, but an exact problem and suggested solutions are not part of the article.

Eager politicians begin blaming this island nation for causing unemployment in other nations by failing to spend all of it's earnings (Like the critics were doing?).  Politicians begin expanding the argument by complained that vacations spent on the island could have been provided in-nation to reduce the unemployment numbers and improve the balance of payments. Obviously, according to some politicians, the island nation was doing some things wrong. Maybe the exchange rate was not correct.

This seems to be a good place for ending the story. The political story has developed into something that we can learn from. A single government is controlling the exchange rate. The method of money exchange allows the controlling government to claim a repeated annual share from the labor and resources provided by the entire economy. The situation has gone on long enough to attract the attention of media and political elements.

Except for the critics, everyone seems happy with the stable economy described. Is there REALLY a need for change?

I would suggest that need for change is in the eye of the beholders. The island described is neither China nor Japan, but the effects on reserves and unemployment can be made to sound the same. Every national economy has the ability to arrange a division of resources within it's borders. Whatever arrangement is made has potential interactions with other national economies, which will be developed if mutual benefits for each side can be found.

The economies and economic interactions we have in today's world are the result of political and individual decisions on thousands, maybe even billions, of levels. The illustration provided in this article is just one way to run an economy.

How does EX/IM money circulate?

Our evidence is persistent import surpluses accompanied by increasing foreign ownership of domestic debt. Can we justify speculation that unbalanced imports move capital from the ownership of (probably) eager buyers into the ownership of postponing buyers? 

President Trump is concerned about foreign imports reducing the number of available domestic jobs. It is easy to see that foreign made products can have that effect by replacing domestic made products but what is the effect on the internal domestic flows of financial capital? We will find a plausible answer using logic and a mathematical relationship.

The Five Sector Rhythm Production Equation

The rhythm equation describes the productive evolution from initial labor to final product consumption in terms of capital and ownership. The five sectors are household \(c,\) government \(g,\) [both consumers] labor \(n,\) private firm \(k_p,\) and capital (money) \(k_k.\)The precedes-equals symbol \(\preceq \) replaces the familiar equality symbol \(=\) to remind us that production precedes consumption. The term \(f_w \) relates labor hours to the unique currency of the domestic economy. \[(1+k_k) n f_w  \preceq c + g \pm k_p. \] The left side of the equation describes sectors that produce product for sale. The right side describes consumer sectors and the owning firm's profit. Product and time moves to the right with capital returned to owners at sale completion. 

Figure 1. may help the reader understand the worker-to-consumer evolution.

Figure 1. The equation's left side represents worker's time, conversion of time to capital, and the production of product. The right side represents consumption and a return of capital to the productive firm.

The 'Catastrophic Transfer Dilemma'

A quick glance at this equation might leave the reader thinking that all of the capital in the economy could end up in the ownership of the left side of the equation. Well, that won't happen if the owners and producers (who are mostly workers) are actually consumers (shown in Figure 1). If we assume that people receiving money also spend money, there will never be a 'catastrophic transfer dilemma'.

What about foreign trade, particularly unbalanced trade, where external economies acquire considerable ownership of domestic capital? As of February18, 2018, offshore investors have invested $6291.6B in United States Government debt, or about 31.5% of current GDP.  China ($1176.7B) and Japan ($1059.5B) have accumulated combined debt valued at about 11.2% of current GDP ($19965B). Do we have a slow moving catastrophe here?

We can model foreign production with a generalized production equation. This is easily done by denoting net imports \( k_\text{ni} \) and writing \[(1+k_k) n f_w + k_\text{ni}\preceq c + g \pm k_p. \]Now the equation shows foreign imports with a share of the domestic production marketplace. Foreign production will be purchased with domestic currency. While in the case of domestic production, we assumed that 'money earned will be money spent', that condition is glaringly absent in the case of unbalanced imports. Therefore, alarmingly, the equation gives us cause to predict that a catastrophic transfer dilemma is possible should importers continue to delay spending the monetary resource.

Any value received from sale of imports (which were initially produced using a foreign currency) is pure profit in terms of the domestic currency. The implication from this knowledge is that imports should be modeled exactly like the finished domestic product, which is what we have done. Both domestic production and imports are forms of 'capital' at this point of entry into the equation.

Imports Counter Stimulus Efforts

Imports are recognized as a transfer of capital between two currency systems. This type of transfer will leave a capital hole in the exporting economy and (after sale) create a newly filled deposit account in the importing economy. A natural (and probably safe) place to invest this new deposit is into the debt of the importing nation's national government (which seems to have happened in the United States).

To the extent that domestic workers buy imported goods, the pool of consumer money eagerly awaiting spending is reduced. To the extent of the reduction, the demand for government bonds is increased. Hence, government stimulus activity is directly countered by import purchases when not balanced by exports (Figure 2.).

Figure 2. Net Federal Government Saving less Net Exports of Goods and Services. The remaining stimulation to the economy has varied widely over the last 20 years.

Conclusion

We have a coherent model that supports speculation of capital migration from eager spenders into a postponing ownership.  Perhaps we should be gratified that actual data confirms that possibility as an actual event, albeit as a slow moving evolution.

Domestic money flowing into unbalanced import accounts can be cycled through the lending process while awaiting permanent decisions. A loan to government is one of several possible money absorbing possibilities.


(c) Roger Sparks 2018