Saturday, July 2, 2016

Money Series: Origins of inequality

Who drives economic growth in the world?

Answer: the United Stated of America, by far.

In this post, I am going to explain why the importing countries ARE the drivers of economy in the world, and the deep causes of raising inequality in the western world.
There are many important concepts in this post, and, as far as I have read on internet, nobody has put so many different slides in one single post in an amateur blog to explain the origins of inequality from such a large number of different angles.

When newspapers say that Germany is the locomotive of Europe, they are dead wrong. It is the net importers in Europe that are the locomotive of Europe.

Here's why.

First of all, every country has imports and exports. When there was a gold standard, the trade balance had to...well, balance! if a country exported more than what it imported (the country was in trade surplus), there were compensating mechanisms that made its exports more expensive. As a consequence, after some time, the exports became more expensive and the exporting country became less competitive. Imports would rise, and a new balance was reached.

NOTE: we will examine the compensating mechanism in the gold standard in another post. Today I want to draw your attention to the trade imparities in a fiat money system, like the one we are living in today.

Today, this compensating mechanism no longer exists.
A country can increase indefinitely its trade deficit or surplus, for many many years in a row.

First, let's have a look at this graph:

NOTE: This graph is taken from here. The data are referring to 2014.

We can see that there are countries which are net exporters (that is in trade surplus, bars on the right) and countries that are net importers (that is in trade deficit, bars on the left, negative numbers). The USA, last line, are by far the most important net importer in the world (800 billion dollars in 2014 means that they could buy all the excess production from China and Germany combined!).
This means that if the USA should end up in crisis, and stop buying German vehicles and Chinese computers (and broadcasting equipment, telephones, integrated circuits etc), then for China and Germany the situation would be really bad.

In other terms, if the two most important net importers like UK (ops, did I mention Brexit??) and USA would stop printing dollars and pounds to buy stuff  (ie goods and services) from Germany and China, the world economy would collapse.

It is the net importers that drive the economy. If net importers, like USA and UK, stop creating money out of thin air and buy products and services from the rest of the world, there would be nobody to sell stuff to.
But, is it possible to buy stuff simply printing money?? It sounds like a free lunch, and we are told that that there are not free lunches in life.
The answer is..yes. With several "buts".

To understand how this is possible, let's have a look at the US trade balance historical chart. US are the big champion of trade deficit, and we are very intrigued to see if they have been in trade deficit only sporadically, or on a systematic basis.

Since the mid Seventies the US has been always in deficit! they have always imported more than what they have exported. We can see that the peak in the deficit was reached just before the big crash in 2008.

Now I would like to show you another graph...the stagnation of US wages

NOTE: folks, wages in Europe have been following the same downward trend.

The graph is taken from here.

The dark blue line shows the productivity in US, that is how much product you create during your working time. You can think of it in this terms: if technology evolves, to build a car you do not need one month, but one week, with the same number of workers. In other terms, the productivity for a worker has increased four times.
You would expect that if you build a car four times faster, you are paid four times more. This graph shows that  this was not the case. The light blue line shows the increase of compensation, that is how much you are paid.
You can see that, starting from mid seventies (again the mid seventies!), there is a gap becoming larger and larger between productivity and salaries. Now, you may question: if cars are sold, and I am paid the same, who gets the  profit from the extra cars that have been sold?

Ehm....the answer is the corporations. And the guys of the Banks and Wall Street that work to give corporations enough credit to build new factories and enterprises.

How's that possible? Well, if I am right, then banks should have seen their balance, that is their assets literally explode from the mid seventies. The commercial banks should have created other money to let people buy all those imported stuff and, since wages were suffering, to give families extra credit to buy theirs homes with 10, 20 and then 30 year mortgages!
There is a metric that lets us understand if there is more money around. This metric is called M2 Money Supply. Just think of it as the sum of all the money in your bank account.

NOTE: The exact definition of M2 can be found here

WOOOWW! (again)

The money created by banks has literally exploded since the mid seventies. After mid Nineties it has become almost parabolic.

So, we can say that we have seen things from quite different angles. And we have some clues. From all these charts, we can say that something happend in mid Seventies that changed the rules, ie:

  1. The US became net importers (financing Japan and China boom in different decades) 
  2. wages started decreasing
  3. banks started having bigger balance sheets
It is no mistery that the guys of finance have become richer and richer, since they were managing more and more money. But do we have another metric to verify that inequality has become wider in US in the last 40 years, since the mid-seventies?
Indeed, such a metric does exist, it is called the Gini index: the higer it is, the bigger the gap between the richest and the poorest in a country. In other terms, the Gini index is a measure of inequality.

NOTE: the exact definition of the Gini index can be found here.

This graph was taken from here.

Indeed, we find a confirmation of our findings: the inequality has become larger and larger since the mid Seventies. Before that, inequality had been decreasng since the beginning of WWII.
At this point, we have all the evidences we need to understand that something in mid seventies happened. This let the US to run huge trade deficits: this has caused raising debts for families, increasing inequality, huge profits for people working in the finance sector.

Now you start grasping the surface of why we are so deep in debt.
Since the Seventies, wages have not risen at all, while profits for multinationals and the guys of Wall Street have skyrocketed. This has led a family father of the Seventies to apply for a 15 years mortgage to buy his house and a family father of the 2000's to apply for a 30 years mortgage.
Money has been vastly created, but much part of this money have gone to the richest.

The main event that led all of this happen, since the very beginning, was the abolition of the Gold Standard in 1971 by the USA. 

By abolishing the Gold Standard, trade balance had not to balance any longer: USA could print dollars and buy all the stuff they needed. In this way, they fell heavily into debt: normal workers had to survive, the guys who managed the money thrived.

Thanks to the invention of fax, of tele typewriter, by the beginning of 1970's it was possible for the guys in the finance to move capital from one place to another over the planet. So, it was possible to buy stuff on a large extent from overseas. These huge amount of freshly printed money let Japan first, and China later, to boom.

Unfortunately, if other countries are producing, the countries that buy the imported goods and services get deindustrialised. If are so eager of a Green economy, then you hae to accept the fact that your unemployment will raise, if you want to be competitive: becauses factories will move abroad.
This topic is very intereseting and a MAJOR impact on our lives.

But the key point I would like you to remember from this post is that it was the break up of the gold standard that triggered booms in Asia, deindustrialised Western Countries and make wages stagnate.


  1. There is a point that you should take into consideration. You observe that imbalances occurred since the gold standard was abandoned.
    Well, that is correct but at the same time it is not correct.
    What do I mean? That both gold standard and fiat money could work, provided that people know how to make them work.
    You are an engineer, I am too. So, I believe, you have studied Building Science (scienza delle Costruzioni). You will likely remember that to solve hyperstatic systems there are two ways, the flexibility method (metodo delle forze) and the displacement method (metodo degli spostamenti). The flexibility method is much more intuitive, i.e. it is the gold standard, but it has a limit; it is very difficult to use it when the number of variable is high. I am about 15 years older than you, when I was studying computer era was still at the beginning, so we were studying both methods. Likely you have studied the flexibility method just as a historical curiosity; nowadays, using an Excel spreadsheet and the displacement method, you may solve an hyperstatic system with 100 unknowns in a matter of minutes (I still needed hours at the time of my studies).
    So what? Most of the people that today, or till few years ago, are on the top levels of governments, companies, banks and so on, have studied in an environment that was based on the gold standard, at least mentally. They are (were) simply not ready to develop solutions under the new system.
    Gold standard, as well as the flexibility method, was good in a "small" world. In a global context it was becoming too complex to be managed. But we still need the "Excel spreadsheet" to manage quickly the new system

  2. I am not an expert in building science. Actually, I am an electronics engineer, but I see your point.

    I partly share your opinion, in that if you use the wrong models to foresee the consequences of your decisions, you end up with completely wrong outcomes.

    I think that the the abandonement of the "gold standard" under the Bretton Woods system (and it was not a real Gold Standard, it was a Dollar Standard backed by gold) was driven by two main forces in USA:
    1. The expensive welfare policy
    2. The super expensive Vietnam war

    In such a contest, they had to exit the parity of dollar with gold. The consequence of this choice was the hyperinflation of the early Seventies.
    Later, the USA discovered that they could print how much money they wanted. The Dollar Standard was born.

    Each systems has strenghts and weaknesses: of course the world we are living in was shaped by the fiat money. And western central banks have largely abused of the flexibility granted by running large deficits for decades.

    I will cover this topic in one of my next posts.