Wednesday, July 20, 2016

The Economy

The economy, amiright? But can anyone give me an assuring answer whether the economy is an actually controlled, sustainable thing, or just everyone sort of scrawling to keep things away from chaos? I mean, how is printing money a thing and who runs the computer program that says, this country has this much of its money, so one unit equals this? Stock market, country debt and I tried googling but couldn't find an infographic.
This was a question posed on a section of one of my current favorite blogs, Wait but Why. It was a part of this discussion. Being someone with a Commerce degree who thinks that how the economy works is a big part of how our current world works, I've come to a fairly detailed understanding of how a lot of the economy works, over the years. So I had answers to most of this guy's questions, and when nobody answered, I felt like I should. Here is a slightly modified version of my answer.

Those are questions with long answers! :P I'll try to keep it short but also correct but also something that increases understanding, but it will probably be long.

Is the economy controlled? No. Not really. But kinda. More on this later.

Is the economy sustainable? Depends what you mean by sustainable. Short answer: maybe it can possibly be one day, but some changes in how things are done have to happen first. Currently we're doing things that will leave future generations screwed.

How is printing money a thing? Long one, I'll get to this later. Short version: Because money is primarily an idea or concept rather than a physical object, and ideas are flexible, so governments can pretty much do what they want with it as long as people will go along.

Who runs the computer program that says how much money is worth? Nobody. How much money is worth is decided by people buying and selling money. In the same way that people who have chickens will accept a certain number of dollars for a chicken, people who have pounds or euros or whatever will accept a certain number of dollars for a pound or a euro - and there are people whose job it is to buy pounds, euros and dollars, and then sell them to people at a profit, like with chickens. And the same way that at certain times of the year people eat more chicken so the price goes up, same deal with currencies - sometimes people want more of one currency or another, so the price of a currency (the amount of another currency that you have to pay to get it) goes up or down.

Stock market: A lot could be said about the stock market, but let's see... if there was one thing I wish more people knew, it would be this: You know how you buy more chicken when it goes on sale, and buy less when the price goes up? And you know how people think it's terrible when the stock market crashes? Reframe that last sentence. Think "stocks are going on sale!". Which sucks if you want to sell, but it's great if you want to buy.

Why do we buy more chicken when it goes on sale, but not treat stocks the same? I think it's because people understand what a chicken is and why it's worth money, whereas with stocks they often don't, so they think maybe a stock is like fiat money, it's worth whatever people are willing to pay for it, and if suddenly its price goes to $0, it's worthless, or if it goes to $1 million a share, it's worth that. A chicken is still a chicken, even if if yesterday it cost twice as much - so when the price goes down, people go "I can get this valuable thing for less money now!" and they're happy. And the thing is, a stock is still a stock, too. It still gives you ownership in the same business today as it did yesterday, even if the price today is a lot different.

If you buy stock, what that is is, you're a business owner. Maybe you only get to own 0.00005% of a large business, but technically you can actually go to meetings where they decide things about the business, and you get a vote in proportion to how much of the company's stock you own. And say Apple earns $100 billion (a number I picked out of the air) this year and over the years Apple has sold 100 billion shares. Then the "earnings per share" is $1. This affects how much sane people are willing to pay for that stock. $1 is a good price, because really, Apple makes that much every year. $100 is a bad price, because in order for $100 of value to be generated from your stock at Apple's current rate of earning money, you'd have to wait a hundred years, and maybe something bad happens to Apple over the next century and it stops making $1 per share. Stocks typically sell at a "price to earnings" ratio of between 15 and 25. So... that should help you figure out whether a particular chicken is really on sale or not :).

Most of the money from the $1 of earnings per share is reinvested back into the business each year (they call it "retained earnings"), so you don't get that much of a payout, particularly in young and growing businesses, but more established businesses will pay out some of their earnings to shareholders. That's what a "dividend" is. High dividend stocks are businesses like banks where they're well established and making more money than they know what to do with, which from an investor's perspective is pretty OK really.

Country debt: You know how you can buy GICs and things at a bank, if you want your savings to earn interest? Well, those are loans to someone, which they pay back with interest. Same deal with country debt, except you're loaning money to the government, to finance their deficit - so basically, they use the money you give them to build roads and schools and things, and hopefully that helps the economy to grow which increases their tax base which allows them to pay off the debt they've accumulated, the same way a person might take out a loan to finance a business opportunity or get an education. Not sure which country you're from, but I do know you can almost certainly go to your local bank and buy some of your country's debt, and your government will pay you back sometime later with some amount of interest. Or people in other countries can buy your county's debt. For example, in the US government debt is financed by "treasury bills", and the Chinese government has bought a gazillion of them and would now be very unhappy if the US economy did poorly and the government couldn't pay back its debts. Countries even have credit ratings based on how likely they are to pay back their debt, same as a person has a credit score. I'm not sure if that answers your questions regarding country debt, but I feel like I've talked about it enough for now.

Infographic: here. I'll see you in half an hour :)

Now back to the longer questions...

How is printing money a thing, revisited:

Step 1 to answering "how is printing money a thing?" is understanding the answer to the question "how is money a thing?". And money is a thing because people are willing to take it in exchange for stuff. Think of it kind of the same way as, "laws" are a thing because we agree it would be cool if everyone followed the same rules. We made up a system, and we all have decided that's how things will be, and on we go. We did that with laws because having everyone follow the same rules is incredibly helpful when you want to get stuff done that involves large groups of people. Same deal with money - it has value because we all (or almost all) agree it has value, and we made it up because it was useful to do so. It has value to the extent that if I give you a certain amount of money, you will give me a certain amount of stuff. And it's useful because finding someone who both has what I want and wants what I have is hard. If I want a chicken, maybe someone who has one wants a laptop, but I don't have a spare laptop, so we're stuck. It's much easier if we use money as a medium of exchange, because then I use money to buy the chicken plus also some carrots and a notepad, from the same store, and the person who now has my money can use it to buy anything they want. Another thought regarding the value of money: We don't all have to agree how much a dollar should be worth, for it to be worth something. In fact, to different people, money has different value. Some people are happy to pay $800 for a puppy, others would find that an insane thing to do. Some people are incredibly unwilling to pay money for things, other people have a lot of money and will give up eye-watering amounts of it for the privilege of wearing shoes with a special picture on them. This is a partial answer to "who runs the computer program that says how much one country's money should be worth compared to another?" There is no computer program. There's just a bunch of people who are willing to give up certain amounts of money for a given amount of stuff. And say you've got two currencies, currency A and currency B. If I've got a chicken I don't want any more, and everyone around me is using currency A, I will want people to pay me for the chicken in currency A. If someone has some currency B, maybe I'll take it, but I might want more of currency B than the person is used to paying for a chicken back home, because to me, currency B is pretty worthless because nobody will take it for stuff. So if I wanted to go to that person's home country, I'd want to buy things in currency B - and before s/he came here, that person ought to have bought some currency A to pay for the chicken with, from someone who wants currency B more than I do. And so, seeing an opportunity to make a profit, someone starts buying currency A and currency B, and then selling those currencies to other people at a slight markup when they want to travel places. And how much currency B costs depends on how much there is of it, and how many people want it, as compared to how much there is of my currency A, and how many people want that. And the supply of money can be affected when governments print more or less of it than the amount that wears out each year, or when the economy changes in size but the amount of currency doesn't change by the same amount (more stuff, same number of dollars --> number of dollars per thing (price, in dollars) goes down, "deflation", for example) or by a couple of other things they can do, one of which is change the interest rate, which I'll get into shortly.

Anyway, the deal with printing money is, it's just a thing that countries (or rather, governments) have decided they can do, and like with the value of money itself, we've all agreed that those are OK rules to play by. I think they were like "y'know what would be cool? If all our people used the same money, and also if when our debt got too high we could print more money and so the price of each local-dollar in terms of other currency goes down and our debt is less sucky to pay back (assuming the debt is expressed in a local currency the government controls - smaller economies often have to accept debt in foreign currencies). So like, we should set up a central bank and a mint." In concentration camps and prisons and other places where there was no country saying "we'll print the money for you", people used cigarettes and shells and whatnot as currency, and that works just as well as paper with pictures on it, in terms of being able to buy chickens without a laptop. Actually there was a time in US history where banks could print their own money, and it didn't have to be done by the government. And as long as you figured the bank wasn't going to go bankrupt, that worked fine.

There's a whole complicated field of economics around how much money countries should print to keep their prices stable-ish (governments like to have a little bit of inflation but not too much because money that goes down a little bit in value each year encourages people to put their spare money in banks where it can be loaned out to others rather keeping it in their socks). Most advanced economies aim for inflation of around 2% per year. The different factors that affect inflation, unemployment, wages, interest rates, etc., is probably another post, but the bottom line is, when labour market conditions are tight (low unemployment) firms compete for workers by offering higher wages. But, if those higher wages aren't matched by increased worker productivity, then that flows through into prices, which means inflation. So if the economy is growing, there's a danger of inflation, and governments will increase interest rates to slow things down a bit. If the economy is not doing really well, governments will lower interest rates to give it a boost, which will also increase the money supply and move inflation towards the 2% target.

Is the economy controlled, revisited:

Like I said, kinda, but not really. "The economy" in one sense, is just a bunch of people doing stuff. Like "society" isn't really this one thing, it's just groups of people and ultimately individuals. And to the extent that it is possible to understand what people will get up to, and what makes them do different things, a certain amount of control can be exerted over the economy. For example, we know if interest rates are high, people who have money will want to lend it to other people, and people who might get a loan will think pretty hard about whether they can pay it back at that interest rate. Whereas if interest rates are low, more people will want to get a loan and fewer people will be interested in keeping their money in the bank. In general, more loans get made at a lower interest rate, and fewer loans get made at a higher interest rate. Same way more chickens get sold at a lower price, than when the price goes up - except if the price is below cost, in which case chicken-makers go out of business and the number of chickens sold goes down eventually. Since the cost of printing money is pretty near 0, the demand side (whether people can pay back at a given interest rate) mostly determines how many loans get made. In one sense, the interest rate is the price of money (the price of a currency in terms of itself, rather than in terms of another currency as we discussed above.) The interest rate is how much you have to pay someone to give you their money for a while. When the price (interest rate) goes up, those who have money are more willing to give it to others (a loan), and those who want money become less willing to take it. And when the price of money goes down, the return you have to make (say if you have a business and you're going to use a loan to invest in the business) in order to pay off a loan goes down too. So with ridiculously low interest rates come asset bubbles like the subprime crisis, whereas with higher interest rates, the only people who will take loans are people who are going "see, the thing is, I think if I had $1,000 today I could do something that gave me $1,500 by the time I had to pay back that loan, so 10% interest is OK". The deal is, when the fundamentals of the economy (stuff like how productive workers are and how many workers there are) are not doing well, the government decides it would be better if there were more loans getting made. Because loans are magical for the economy, until people have taken on too much debt and then everything sucks for a while. This is known as "the business cycle", and governments try to set interest rates to make it so that the business cycle isn't bumpy and awful, as I touched on in the paragraph above. Here's why loans are magical: because when someone gets a loan, they spend that money on something, which gives someone else more money which they put in the bank which means more money available for loans which means someone else gets a loan which means more money in the economy which means more money in the bank which means more loans. This is called the "multiplier effect", and the effect of giving a loan is similar to the effect of printing money - more money moving around the economy. So that's one reason why when the central bank lowers the interest rate, the value of the local currency goes down the same as it would have done if they'd printed more money.

So: the economy is a bit controlled when governments use their central banks to mess with interest rates, or print more money than is taken out of circulation. That's called "monetary policy", because it controls the amount of money in the economy. Governments can also exert control by "fiscal policy" - basically, spending more money without increasing taxes, and issuing bonds (IOUs, known as treasury bills for the US government, Canada Savings Bonds in Canada, and other similar things in other countries) to cover the cost. Basically if lowering interest rates didn't make enough people want to get a loan, the government can go "I'll have a loan then, at these nice low interest rates, and build a thing, and that'll give people jobs for a bit".

But the thing is, the economy is just people doing things. And people are complicated. If you raise the price of a chicken, you can't really tell whether people are going to buy less chicken and more pork, or less chicken and more rice, or less chicken and more Canada Savings Bonds. So although there are some "policy levers" that governments can pull to affect things in broad terms, unless they get really micro-manage-y about prices (which is a bad idea, because prices carry a lot of information and the government isn't good at deciding what the right price for things should be - there's actually an argument that they shouldn't be deciding what the right price for money should be, and their efforts to control the interest rate are counter-productive in the long run) then the government isn't really in control. Things are always changing - new technologies are coming into existence, old sources of resources are running out, cultural factors mean people want different stuff than they used to, thousands of things are changing all the time and feeding back into each other. It's like an ecosystem. Maybe, and I mean only maybe we can make improvements to an ecosystem by carefully managing some things, but doing so is complicated and there are lots of unintended side effects, and maybe the best thing to do is study similar ecosystems in a less disrupted state, ask what we changed that screwed things up so that now there are only jellyfish, and then un-change it and let the ecosystem do its thing unmolested. The same argument applies to the economy. The economy is 7+ billion people thinking about what different things are worth to them and doing the best they can to produce stuff that other people want for as low of a cost to themselves as possible. The amount of information processing that happens when you take 7 billion people thinking for any amount of time is beyond what any computer or centralized government could match. So the best we could do is only a "kinda, but sometimes things go off the rails" sort of control.

There are some key differences between the economy and an ecosystem, though. One is, in an ecosystem, there are natural checks and balances. Even a top predator doesn't get to eat everything, because there are physical limits to how big and strong and fast a predator can become (and if you want to live by eating small bugs, being big is a disadvantage - there's a natural push to specialization). But because corporations are make-believe, they aren't subject to as many physical limits. And the bigger a corporation gets, the more power it gets, which means it makes it easier for it to grow bigger later, and harder for new entrants to compete. Bad news, and justification for some government interventions. What kind of government interventions make sense is a different post, but the thing is, the "leave things alone or you're likely to screw them up, markets are really powerful decision making mechanisms" argument is valid, but so is the "if you leave things alone they're likely to screw themselves up in defined ways without your help, so you should probably intervene a bit" argument. Ecosystems reach a natural balance with diverse life forms competing and all of them filling specialized niches. Markets reach a natural balance called "monopoly", which is not fun for consumers. Also, corporations' social license to exist comes from the idea that we're all better off if that is allowed to happen. Unlike natural physically embodied life-forms, they don't have any intrinsic right to exist, and the rules they have to play by are the rules people decide would be for the best, not the natural physical laws we all have to live by as life-forms. So... long policy posts could happen later, but I want to end this one by reassuring readers that while I understand the rationale for laissez faire economics, I also understand the rationales for government intervention. When we should step in and start messing with markets is a tricky, tricky problem indeed. 0 is not the right answer, but "as little as possible to achieve desired effects" is.

There is much more I could talk about, but I think that answers the question that was asked (possibly more thoroughly than the asker anticipated :) ).