Academic Weasel Words, Translated (source unknown).

Hat tip: macroexposure

It is unquestionably true that without entrepreneurs and investors, you can’t have a dynamic and growing capitalist economy. But it’s equally true that without consumers, you can’t have entrepreneurs and investors. And the more we have happy customers with lots of disposable income, the better our businesses will do.

That’s why our current policies are so upside down. When the American middle class defends a tax system in which the lion’s share of benefits accrues to the richest, all in the name of job creation, all that happens is that the rich get richer.

Source: Raise Taxes on Rich to Reward True Job Creators: Nick Hanauer.

If the private sector is seeking to run down its debts, it is hard for the government to do so, too, because everybody cannot spend less than their income. That is the “paradox of thrift”. No, it is not a novel idea. (Link)

In other words:

The sectoral financial flows of an economy always add up to zero. (Click to enlarge.)

You can find a simple explanation of this accounting identity here.

Two sets of charts neatly summarize Sufi and Mian’s findings.

The first set of charts shows that, across the country, the consumption expenditure of counties with the highest household leverage (i.e., highest debt-to-income ratio) lags far behind that of counties with the lowest household leverage (click to enlarge):

Household debt is holding back consumption (click to enlarge). (Source: Amir Sufi and Atif Mian.)

The second set of charts, shown further below, requires a bit more explanation. Sufi and Mian wanted to understand how the dramatic decrease in spending by high-leverage households translates into job losses, but this question is difficult to answer because many things are often produced far from where people buy them. (For example, when a county sharply reduces its spending on automobiles, there will be job losses not just at local car dealers but also in other places where automobiles and their parts are manufactured.)

Sufi and Mian overcame this challenge by classifying jobs into those that depend on the local economy (e.g., retail clerks, waiters, barbers) and those that depend on the national or global economy (e.g., manufacturing jobs). They labeled the local category “non-tradable” and the national or global category “tradable.”

What they found is that non-tradable employment, excluding construction, has declined most in counties with the highest household leverage, whereas tradable employment has not experienced a comparable decline (click to enlarge):

Household debt is holding back employment (click to enlarge). (Source: Amir Sufi and Atif Mian.)

The areas of the country that have high household leverage are not just spending a lot less; they also have much worse unemployment. As the researchers’ presentation explains, the decline in consumption due to high household leverage explains “65% of job losses from 2007 to 2009.”

Any sane person who looks at this data and still somehow concludes that “lack of confidence” or “government spending” are holding back the U.S. economy is, to put it mildly, full of baloney (whether they realize it or not).

High levels of household debt, by limiting consumer spending, are holding back the U.S. economy. Period.

Prior to the switch, we had been accessing our emails via IMAP using various applications in our desktop computers, laptops, tablet, and mobile devices. We had also been archiving copies of old emails in local files in our desktop computers – close to 120,000 old emails in total – which we hoped to store in the cloud for easy searching anywhere, anytime.

Surely, I thought, it wouldn’t be that hard to upload these email archives to Google, right?

Wrong

After more than a day (and night) of non-stop uploading, fewer than a third of the emails in the archive had made it through our “high-speed” (ha-ha) Internet connection. At that rate, I realized, the upload would take three to four days.

It would have been three times faster to save the email archives on a USB drive and ship them overnight via FedEx.  All emails would have arrived intact the next morning. Too bad Google doesn’t offer a FedEx option for uploading personal emails.

Anyway, curious to see how the upload was going, I logged into Google Apps… and discovered that all email timestamps had been messed up. The Inbox was showing all messages as if they had been received (or sent) at the date and time of upload, as opposed to the date and time of actual receipt (or sending). What gives?

Surely, I thought, there must be an easy way to fix this, right?

Wrong Again

After searching the Google support forums, I learned that this has been a known issue with Gmail IMAP uploads since at least 2009, and that the only known way to solve it (other than spending time, money, and/or effort to develop a custom application for importing emails) requires installing a popular desktop email application, Thunderbird, and following these instructions:

So, somehow I would have to get the email archives imported into Thunderbird, and then upload them from there to Google. In the meantime, I would have to delete any emails already uploaded to Google.

Wikipedia lists several dozen desktop email applications; why must this be done with Thunderbird? According to the forums, it is the only such application that has proven reliable at uploading old emails to Google with the correct dates via the “standard” (ha-ha) IMAP protocol.

Surely, I thought, it shouldn’t be that difficult to import the email archives into Thunderbird and then into Google, right?

More Hiccups

After searching for help online, I learned that importing the emails from our old email application into Thunderbird would require the installation of an add-on called “ImportExportTools.”  I downloaded and installed this add-on and started the import – at this point, with my fingers crossed.

It took nearly half a day, but Thunderbird successfully imported all the emails in the archives.

I then deleted all emails on the Google accounts, and started uploading the email archives from Thunderbird… only to be presented with an error message indicating that the upload couldn’t continue because Gmail doesn’t allow attachments larger than 25MB in size.

Not a big deal, right? I could just sort the emails on Thunderbird by size, move the handful of emails of size larger than 25MB to a different folder, and upload the rest.

The Mail-Eating Bug

I sorted the emails and saw that there were only three emails of size larger than 25MB. I clicked on the largest one, and Thunderbird immediately became unresponsive. Half a minute or so later, the application became responsive again, but the number of emails in the folder somehow had declined by nearly 20,000. What on earth…?

I closed and restarted Thunderbird, and yes, all those emails really were gone. I wondered if there was something wrong with the email I had just tried to open, but quickly ruled that out as a possible cause because I was able to open it and its attachments just fine on our old email application.

A few online searches led me to this page within Thunderbird’s online documentation. According to it, in theory the maximum number of messages per folder is limited only by hard drive capacity, but in practice,“using folders greater than 4GB is not recommended,” and by the way, it’s better never to go over 2GB, because one could run into a bug which limits folder size “due to using a 32-bit signed integer manipulating the file.”

That is what happened to me: a software bug ate the emails.

Finally, Success

Lacking a quick or convenient way to figure out which emails were now gone from Thunderbird, I had to delete all of them and re-import them from our old email application. Another half a day.

This time around, I imported the emails into multiple folders, making sure to keep the size of each folder well under 2GB to avoid any possible unpleasant surprises, and then uploaded each of these folders separately to Google via IMAP.

It took several days, but it worked.

Waiting for The Future

On one hand, I find it impressive that my wife and I, as consumers, can access our email, calendars, contacts, and files seamlessly from our desktop computers, laptops, tablet, and mobile phones. It is nothing short of amazing that we can easily search through many years of emails and attachments and find the one we need in a moment’s notice — using a mobile phone.

On the other hand, I find it pathetic that at present, in the world’s richest, most powerful country, it takes three to four days to move a hundred thousand emails to the cloud – instead of three to four minutes, or less. It is pathetic: the country’s home Internet infrastructure lags far behind the amazing online services and applications available today, and doubtlessly is holding back the introduction of many new, innovative ones.

It is pathetic too that only one email application out of dozens can upload old emails correctly to a leading email service provider using a supposedly “standard” protocol (IMAP).  One can call virtually any phone in the world today and connect successfully on the first try regardless of whether the other phone is a traditional landline phone, a VoIP phone, a mobile phone in a GSM or CDMA network, a satellite phone, or even an application like Skype running on a tablet; shouldn’t one be able to connect and share data between any two applications on the first try too?

It is also pathetic that a leading email application’s documentation must warn users not to use folders greater than 2GB (a meaningless number to most people) because odd things could happen — like, say, loss of data.  Here we are, in the second decade of the 21st century, when a single Blue-ray disc can store 25GB to 50GB of data, but a leading desktop email application chokes with 2GB…!?

Finally, it is disappointing that Google, a leading email service provider, doesn’t allow any emails with attachments greater than 25MB — not even optionally at additional cost. There are no exceptions, even for old emails, period. Shouldn’t online services be flexible and adapt to people’s needs, instead of the other way around?

The future is not here yet.

Sigh.

The two tribes, G and P (image source: author).

By tradition, both tribes use as currency a small, shiny clamshell that has no practical use whatsoever but is easy to count, hard to find, and convenient to carry around in necklaces, so it works well as a socially-agreed-upon yardstick of value and repository of purchasing power. Indeed, the island has a vibrant economy, with people in both tribes buying goods and services from each other, within and across tribes, every day.

The island’s people care so much about money – I mean, shiny clamshells – that in both tribes there are even members whose sole job is to keep a record of all clamshell transactions. Both tribes, in other words, have accountants. (Luckily for these accountants, the grueling task of keeping track of and counting clamshells all day long is not just their job; it’s also their passion in life.)

The island uses rare, shiny green clamshells as money (image source: author).

Among other responsibilities, every year the accountants of both tribes get together and calculate the whole island’s gross domestic product, or GDP. They do so by adding up all purchases of new things and services produced in the island during the year, taking care not to double-count the value in any of them.

As the accountants often remind the chiefs of each tribe, GDP is a measure of economic activity: it grows when people buy more new stuff and services from each other, and shrinks when people do the opposite.  The chiefs, however, are less concerned with the volume of economic activity in the whole island than with their own tribe’s earnings.

Tribal Surpluses and Deficits

Every year, the chiefs of both tribes want to know how many clamshells their tribe earned or lost as a result of commerce, so they ask their respective accountants: “How many clamshells did our tribe earn this year?”

The accountants in each tribe figure out the answer by adding all clamshell incomes and subtracting all clamshell expenditures of all their fellow tribe members during the year. For instance, if at some point during the year someone bought a bag of vegetables at a cost of three clamshells, that counts as income of three clamshells for the seller’s tribe and as an expenditure of equal magnitude for the buyer’s tribe (which may or may not be the same tribe):

Every expenditure is a receipt of income, and vice versa (image source: author).

The accountants in each tribe do this for every commercial transaction consummated by every member of their tribe.

Trades between members of the same tribe cancel out in each tribe’s annual total (because in each of those cases, the income is added and the expenditure immediately subtracted), so the final tally is the whole tribe’s net gain or loss of clamshells. If the final tally is a positive number, the tribe gained clamshells (from the other tribe), so it ended the year with a surplus; if the tally is negative, the tribe lost clamshells (to the other tribe), ending the year with a deficit.

The island as a whole has no trade inflows or outflows, so, over any period of time, one tribe’s clamshell surplus is the other’s deficit – that is, if one tribe earns more clamshells than it spends, the other tribe necessarily spends an equal amount more than it earns, because both tribes can earn or spend clamshells only with each other. The two tallies, in other words, are always of equal magnitude but opposite sign, and therefore add up to zero:

Regardless of how much or how little economic activity (GDP) there is on the island, every receipt of clamshell income by one person is an equal expenditure by another, so adding all incomes and subtracting all expenditures, over any period of time, always totals zero.

The island’s accountants call this the income-expenditure identity, and they use it to verify that their annual tallies for both tribes are correct.

“No problem,” say the accountants to the chiefs every year.

Things Get More Complicated for the Island’s Accountants

This year, for the first time ever, the chiefs of both tribes, G and P, have agreed to allow trade with a third tribe who inhabits all other nearby islands in the area, as shown below. Let’s call this other tribe “F,” for “foreigners.”

The three tribes – G, P, and F (image source: author).

Unfortunately for the island’s accountants, tribe F doesn’t use the shiny clamshell as currency; it uses instead small ivory beads fashioned from the tusks of some animal found only in one of the other islands.

Complicating matters, the chiefs of all tribes have agreed to let everyone freely trade one currency for the other, such that the exchange rate of shiny clamshells and ivory beads will vary every day depending on the supply of and demand for each currency.

The foreigners use a different currency (image source: author).

“Surely this won’t be a problem, right?” – say the chiefs to the accountants in both tribes, who nervously smile back while thinking that of course nothing is ever a problem for the chiefs.

As soon as they can, the anxious accountants of G and P meet and, after much thinking and debate, come up with a simple solution: they will measure all ivory-bead transactions in clamshells – at whatever exchange rate happens to be prevalent on the day of each transaction.

For example, if on a given day someone on the island exchanges a dozen clamshells for six beads, the exchange rate that day will be two clamshells per bead; if later that same day someone on the island pays four beads to buy a set of hunting spears from a foreigner, that will count as income of eight clamshells for the seller’s tribe and as an expenditure of equal magnitude for the buyer’s tribe.

Thus, no matter what currency people on the island use to do business with the foreigners, for every receipt of income and for every expenditure on the island, the accountants will record an equal but opposite transaction for someone else (who may or may not be on the same island) – and all figures will be in clamshells.

At the end of this year, the accountants will calculate the island’s GDP exactly as before, by adding up all purchases of new things and services produced in the island during the year, again taking care not to double-count the value in any of them. The only difference this year will be that some of the island’s production will be purchased by foreigners.

Calculating each tribe’s annual surplus or deficit will also be done exactly as before: the accountants in each tribe will tally up their fellow tribe members’ individual incomes and expenditures during the year.

However, unlike in previous years, when all trade occurred solely within the island, this year G’s and P’s annual tallies may not necessarily be the mirror opposites of each other. This is because the island itself could have trade inflows or outflows – with the other islands. This year, the sum of G’s and P’s tallies will be equal to the whole island’s surplus or deficit with the people of F:

A surplus for the island is necessarily an equal deficit for F, so we can restate this identity as:

If one tribe earns more than it spends, the other two tribes, combined, spend more than they earn by the same magnitude, and vice versa, because the three tribes can earn and spend only with each other.

Regardless of how much or how little economic activity (GDP) there is across all islands, every receipt of income by one person is an equal expenditure by someone else, so adding all incomes and subtracting all expenditures on this economic network, over any period of time, always totals zero.

The island’s accountants will again use the income-expenditure identity to verify all annual tallies.

“No problem,” they report back to the chiefs.

Is This True for Modern Market Economies Too?

Yes – of course. No matter how complex a market economy nor how large its GDP might be, every receipt of income by one entity or person is an equal expenditure by another, and vice versa, so adding all incomes and subtracting all expenditures over any period of time always totals zero. This is not theory but accounting fact.

Any modern market economy can be divided into three broad sectors: government, private, and foreign. The government sector includes all governmental entities at all levels (e.g., national and local); the private sector includes all households, businesses, financial firms, and all other non-governmental organizations; and the foreign sector consists of all foreign people and entities. Conveniently (but not coincidentally), these three sectors correspond to tribes G, P, and F:

The three sectors – government, private, and foreign (image source: author).

As before, adding up all incomes and subtracting all expenditures of both domestic sectors, government and private, gives us the whole country’s surplus or deficit with foreigners:

The government’s income consists of taxes collected from the other two sectors, and its expenditures consist of spending in public services and infrastructure.  When tax collections exceed government expenditures, the government has a surplus, and in the opposite case, a deficit.

The private sector earns income from and incurs expenditures in a broad range of activities. When the private sector’s total income exceeds its total expenditures, it has a surplus, and in the opposite case, a deficit.

Every year, accountants employed by the government sift through mountains of accounting records to calculate, not just GDP, but also the incomes and expenditures of both domestic sectors, and they keep a running tally of the country’s surplus or deficit in a bookkeeping account they have unimaginatively titled the “Current Account:”

Economists normally refer to this as the “national saving identity” because they distinguish between two types of expenditures: ordinary day-to-day expenses, which they call “consumption,” and expenditures in long-term assets like buildings and manufacturing facilities, which they call “investment.” Instead of subtracting all expenditures of a sector from its income at once, they first subtract the sector’s consumption to obtain its “saving,” and then subtract its investment to obtain the sector’s surplus or deficit, as shown here (click to enlarge image):

(Click to enlarge image.)

Sometimes you will find the identity stated as “(T-G)+(S-I)=CA”, where T is taxes, G is government expenditure, S is private saving, I is private investment, and CA is the current account balance – or some similar variation. (Click here to see a typical example.)

I will stick to colored blocks and plain English, however, to keep this post as friendly as possible to readers with no prior knowledge of the subject matter.

We can readily verify the identity for most countries thanks to the world’s many hardworking national accountants, who keep detailed records of all these commercial flows. Let’s take a look at the United States of America in 2010, for instance.

The U.S. National Saving Identity in 2010

The U.S. Bureau of Economic Analysis (BEA) regularly publishes what it calls the “National Income and Product Accounts” (NIPA) tables, which contain the information we need. Specifically, we will look at NIPA tables 4.1, “Foreign Transactions in the National Income and Product Accounts,” and 5.1, “Saving and Investment by Sector.”

As I write this, the latest table 4.1 shows that in 2010 the U.S. had total receipts from the rest of the world of $2,542.7 billion (line 1 on the table) and total payments to the rest of the world of $3,021.8 billion (line 13), so it ended 2010 with a balance in its Current Account of $2,542.7 – $3,021.8 = -$479.2 billion (line 29).

According to the most recent table 5.1, in 2010 the U.S. private sector had net saving of $1,244.5 billion (line 3) and net investment of $254.2 billion (line 51), and the government sector had net saving of negative $1,299.0 billion (line 11) and net investment of $171.3 billion (line 54). We also see that there is a “statistical discrepancy,” or measurement error, of $0.8 billion (line 43). So, the saving less the investment of each sector, added together and adjusted for the statistical discrepancy, is equal to ($1,244.5 – $254.2) + (-$1,299.0 – $171.3) – $0.8 = -$479.2 billion.

[Ed note: the calculation can also be done with "gross" saving and investment – that is, (line 44 – line 23) + (line 47 – line 26), adjusted for the same statistical discrepancy (line 43). If you are familiar with basic accounting concepts, the difference between gross and net figures is depreciation of the country’s fixed assets, shown on the table as “consumption of fixed capital” – line 15 for the private sector and line 18 for the government sector.]

In other words, the U.S. government and private sectors, combined as a country, spent $479.2 billion more than they earned in 2010.

The Saving-Investment Identity

As with the fictitious island above, whenever a country has a surplus, the rest of the world necessarily has an equal deficit, and vice versa, so we can restate the national saving identity as:

Whenever one sector earns more than it spends, the other two sectors, combined, necessarily spend more than they earn by the same magnitude, and vice versa, because the three sectors can earn and spend only with each other.

Economists refer to this as the “saving-investment identity,” because it shows that adding all saving and subtracting all investment always totals zero – and therefore total saving is total investment:

If this last bit is not immediately intuitive, you can think of the saving-investment identity as just a different way of expressing the income-expenditure identity you already know: the sum of all incomes is the sum of all expenditures; if you subtract consumption from all incomes, you get total saving; and if you subtract consumption from all expenditures, you get total investment. Subtracting consumption from both sides of the identity leaves it intact.

Another way to think about it is this: the three sectors can save and invest only with each other.

The Role of the Financial System

Modern market economies don’t use shiny clamshells or ivory beads as money; they use fiat money controlled (to a limited extent) by a central bank whose overriding goal is maintaining monetary and financial stability. This clever political arrangement ensures, among other things, that the parts of a government that spend money can not conjure it out of thin air, as it were; they must raise the money through taxation – or explicitly borrow it.

(Well, governments can raise money in other ways, like selling assets or begging for charity, but all such privatizations, receipts of economic aid, etc. are normally minuscule compared to government borrowing.)

Now, we know that whenever the government sector has a deficit, the two other sectors, combined, have a surplus of the same magnitude; so, to fund its deficit, the government somehow must borrow the other two sectors’ combined surplus.

Obviously, the government doesn’t go around calling businesses and households asking for piece-meal loans (“Hi Lisa, it’s the government… um, we need to borrow your personal savings this month to help pay for highway maintenance elsewhere…”).

What actually happens is that families, businesses, and other entities in the private and foreign sectors save their surpluses by depositing them in some corner of the financial system (such as in bank accounts, money-market funds, brokerage accounts, etc.), and the money is more or less simultaneously withdrawn by the government from a different corner (such as the government-bond operations of large financial institutions).

The same thing happens when people and entities in the other two sectors have deficits. For example, when a family has, say, a monthly deficit (that is, during a particular month they spend more than they earn), they withdraw money from a checking account, or from a credit card account, or from some other corner of the financial system, which then more or less simultaneously collects it elsewhere.

Similarly, when a company has a deficit, it withdraws money from an existing financial account or, if the company doesn’t have enough money readily available, it might get a new loan or issue new securities like bonds or shares of stock – again through the financial system.

The financial system is a complex web of domestic and foreign financial firms (each with its own individual surpluses or deficits) tightly interconnected with each other and ultimately linked, directly or indirectly, to central banks and multi-national organizations like the Bank of International Settlements and the International Monetary Fund:

The financial system (image source: author).

Just as an electric utility interconnects sources of energy with users of electricity via a network of power cables, the financial system interconnects persons and entities that earn surpluses with those that incur deficits via an ever-changing network of financial instruments – cash, deposits, loans, bonds, stocks, derivatives, etc.

A financial instrument is just a legal instrument – like a contract – that gives its owner a financial claim on the issuer, who therefore simultaneously assumes an equal but opposite financial obligation.

For example, if you deposit money in an ordinary bank account, the legal documents you must sign to open the account give you the right to earn some interest and get your money back at any time from the bank, which therefore assumes the obligation to pay you interest and redeem your deposit on demand. Your deposit is a financial instrument – it gives you a financial claim on the bank, which therefore has an equal but opposite financial obligation with you.

Similarly, a mortgage note gives its owner (typically a financial firm) the right to collect mortgage payments from a homeowner, who therefore has an obligation to make all payments; a corporate bond gives its owner the right to collect interest and eventually principal from the issuing company, which therefore has an obligation to pay both; and a share of stock gives its owner the right to a proportional share of all assets and earnings of the issuing company, which therefore has an obligation to run its business for the benefit of all stockholders; and so on.

Here are some concrete examples of financial instruments (click to enlarge image):

Concrete examples of financial instruments (image sources: Wikipedia, Google). (Click to enlarge image.)

Currency issued by governments in the form of paper notes is perhaps the financial instrument used by the greatest number of people.

In the past, such notes gave their owner (whoever happened to be carrying them) the right to exchange them for pre-specified amounts of precious metals like gold or silver, large reserves of which were stored in the vaults of a central bank, which had the obligation to hand over the metal upon presentation of the notes for redemption.

Such monetary systems based on precious metals proved unworkable, however, because in times of crisis or panic, people would start hoarding the metal instead of spending it, leading to deflation (the price of everything declining in relation to the metal), depression (a sharp, sustained decline in economic activity), and in the worst case, a collapse of the monetary system (if banking reserves of precious metal proved insufficient to satisfy the public’s demand for it).

At present, modern currencies give their owner (whoever happens to be carrying them) only the right to use the currency as legal tender within the territories of the issuing government, which therefore has only the obligation to maintain the currency’s status as legal tender – if necessary, using military force. As with all other financial instruments, government-issued currency has value only to the extent the issuer can fulfill its obligation.

Government-issued currency has value only to the extent the issuer can maintain and enforce its use as legal tender (click to enlarge image).

One of the benefits of the present system is that money can be issued (that is, created) and redeemed (that is, destroyed) as and whenever necessary to avoid the horrific problems experienced in the past by monetary systems based on precious metals.  But how and when, exactly, is money issued and redeemed in a modern monetary system?

Only the central bank can issue and redeem money, and only via two mechanisms, neither of which increases the net financial obligations of the government:

• The central bank actively buys and sells government bonds to expand or contract the amount of money in circulation and/or push interest rates up or down. When a central bank buys such bonds, it pays with newly issued money, thereby replacing one government obligation (bonds) with another (money) of equal magnitude; and when the central bank sells any government bonds it holds, the money it receives is taken out of circulation (i.e., redeemed out of existence).
• Certain private-sector financial firms can, under stringent conditions, borrow directly from the central bank, which in response lends them newly issued money, thus acquiring a new claim (a loan to a private-sector entity) and issuing a new obligation (money) of equal magnitude; when and as the loan is repaid, the central bank takes the money out of circulation, reducing government claims and obligations by the same magnitude.

[Ed note: The implementation of these two mechanisms can be quite complicated in practice, and they can change not only the amount of government-issued money outstanding and interest rates but also the private sector's expectations and behavior; however, a discussion of all such implementation details and complex cause-and-effect loops falls outside the scope of this post.]

There is nothing else, as it were, behind the curtain: a constantly-evolving network of financial claims and obligations holds everyone and everything together, with government-issued money as its fundamental building block. If one reflects on this for just a moment, it’s difficult not to be in awe (and also a little scared) of the financial system’s machinery.

Keanu’s reaction upon realizing the financial system is everywhere.

How Surpluses and Deficits Become Net Financial Claims and Obligations

Now, consider for a moment what happens when you personally have a surplus or deficit over the course of, say, a month. If you end the month with a surplus (that is, during the month you spend less than you earn), it means that during the month you acquire more financial claims (like cash, deposits, shares of stock, etc.) and/or you pare down your financial obligations (like credit card debts, bank loans, etc.); conversely, if you end the month with a deficit, it means that during the month you use up some of your financial claims and/or you assume new financial obligations.

Your surpluses and deficits, in other words, increase or reduce your net financial claims and obligations.

Exactly the same thing happens with the three sectors that make up an economy: when one sector has a surplus, it acquires more financial claims on the other two sectors (who else?) and/or pares down its financial obligations to them; and when a sector has a deficit, it uses up some of its financial claims and/or assumes new financial obligations.

Sectoral surpluses and deficits, in other words, increase or reduce each sector’s net financial claims and obligations.

The financial claims and obligations between sectors include every kind of instrument imaginable (as well as some not easily imagined, like this one), but for historical reasons, national accountants use the terms “net lending” and “net borrowing,” respectively, to refer to net increases in sectoral financial claims and obligations.

These words have different meanings in everyday language, so, to avoid confusion, I will use instead the expression “net change in financial position,” which I think is both easier to understand and more accurate.

Every financial claim by one person or entity is an equal obligation for another, and vice versa; so, adding all increases and decreases in financial claims and subtracting all increases and decreases in financial obligations across an economic network, over any period of time, always totals zero:

Regardless of how much or how little economic activity (GDP) there is, if the financial position of one sector improves, the financial position of the other two sectors, combined, necessarily worsens by the same magnitude, and vice versa, because the three sectors can issue, redeem, and trade financial instruments only among themselves.

We can readily verify this accounting identity too. Let’s take a look again at the United States of America – the subject of the rest of this post.

Net Sectoral Financial Flows in the U.S.

We will look at three NIPA tables this time: table 3.1, titled “Government Current Receipts and Expenditures,” 4.1, “Foreign Transactions in the National Income and Product Accounts,” and 5.1, “Saving and Investment by Sector.”

As I write this, the latest release of table 3.1 shows that in 2010 the U.S. government sector (federal, state, and local together) had total receipts of $3,982.5 billion (line 30 on the table) and total expenditures of $5,538.8 billion (line 33), so its net financial obligations increased by $1,556.3 billion (line 39).

According to the latest table 4.1, the country ended 2010 with a Current Account balance of $479.2 billion (line 29); adjusting for certain non-financial transfers (to foreigners) of $0.7 billion (line 32), the country’s net financial obligations to foreigners increased by a total of $479.2 + $0.7 = $479.9 billion (line 30).

The most recent table 5.1 shows that in 2010 the U.S. private sector increased its financial claims on the other sectors by $1,076.4 billion (line 37). This is equal to the sector’s net saving of $1,244.5 billion (line 3), less net investment of $254.2 billion (line 51), adjusted for non-financial transfers (from the government) of $85.3 billion (line 30) and the statistical discrepancy of $0.8 billion (line 43): $1244.5 – $254.2 + $85.3 + $0.8 = $1,076.4 billion.

Thus in 2010 the net financial obligations of the U.S. government sector (federal, state, and local together) increased by $1,556.3 billion, of which $1,076.4 billion was financed by the private sector and $479.9 billion was financed by the rest of the world. The three sectoral financial flows, of course, add up to zero (click to enlarge image):

U.S. net sectoral financial flows in 2010. Positive figures are net increases in financial claims, negative figures are net increases in financial obligations. (Click to enlarge image.)

The BEA’s data goes back many years, so we can do this for 2009, 2008, 2007, etc. The following chart shows the three U.S. sectors’ net annual financial flows as a percentage of GDP over the past five decades – positive figures are net increases in financial claims; negative figures are net increases in financial obligations (click to enlarge image):

U.S. net annual financial flows by sector, 1960-2010. Positive figures are net increases in financial claims; negative figures are net increases in financial obligations. (Click to enlarge image.)

Showing all three U.S. sectoral financial flows in one chart allows us to verify that yes, they always add up to zero, but makes it a bit difficult to see how each sector’s net claims and obligations have evolved over the years. Let’s look briefly at each one on its own, starting with the foreign sector.

Net Financial Flows Between the U.S. and the Rest of the World

As you can see in the chart below, the rest of the world has been accumulating net financial claims on the U.S. almost every year for roughly three decades (click to enlarge image):

U.S. foreign sector net financial flows, 1960-2010. Positive figures are net increases in financial claims; negative figures are net increases in financial obligations. (Click to enlarge image.)

Foreigners have done this by spending less than they earn every year – that is, by purchasing goods and services from the U.S. worth less than the goods and services they sell to it. Americans experience these trade deficits firsthand every day at the retail counter – whenever they buy mobile phones, laptops, televisions, and countless other products not manufactured in their country.

Whether one thinks the U.S. is better or worse off because of these persistent trade deficits, they cannot be easily or quickly eliminated (let alone reversed), because American businesses and consumers now depend daily on a constant supply of foreign goods – not just consumer merchandise but also business necessities like electronic components, networking hardware, machine parts, robotic equipment, computer servers, etc. for which there are no equivalent domestic alternatives. As the CEO of Vermeer Corporation, a U.S. manufacturer, recently explained to the New York Times:

We would prefer to buy everything in the United States, but some of our transmissions come from Europe … they are not made here in the sizes and capacities that we need.

As to exports, only a sustained, long-term effort by U.S. industry, with government support, could possibly mobilize the resources and put in place the kind of infrastructure necessary for gradually boosting exports until they match or exceed imports, but any such effort would take years to bear fruition, and sooner or later would run into competing efforts by other countries to limit their imports and promote their exports. Consider what the CEO of Dow Chemical, a global conglomerate based in the U.S., said in the same article:

Overseas, I get tax incentives, and I get incentives to go to certain locations where they offer us utilities, infrastructure and land. I get access to human capital. I get all sorts of support to help train that human capital.

The two contrasting images below exemplify for me the numerous practical, nuts-and-bolts impediments to eliminating U.S. trade deficits in the near to medium term. The left image shows consumers buying foreign merchandise at a major retailer for their daily needs; the right one shows an abandoned industrial facility in the Rust Belt (click to enlarge image):

Left: U.S. consumers buying foreign goods at a major retailer (source: Stephen Wilkes). Right: Abandoned industrial facility in Detroit, Michigan (source: Angela Anderson-Cobb). (Click to enlarge image.)

Perhaps the “invisible hand” of the market, left to its own devices, eventually would balance the country’s trade flows with foreigners, but that could happen only over many years, possibly decades. In the near to medium term, realistically, the only way in which the country could materially reduce or eliminate its annual deficit with foreigners is with a sharp contraction in economic activity (GDP) – American businesses and consumers suddenly buying a lot less of what they need every day.

Barring such an economic catastrophe, the country will continue having trade deficits – and therefore will continue assuming more financial obligations with foreigners – for the foreseeable future.

This is widely understood, yet it renders silly the recent exhortations of many U.S. politicians. Nary a day goes by without one or another proclaiming that “Americans everywhere are tightening their belts, so Washington must tighten its belt too” – or some variation of the same slogan.

On the surface, the proposition seems sensible because it evokes the old-fashioned values of discipline and shared sacrifice: if the private sector is spending less than it earns in response to the economic downturn, shouldn’t the government spend less than it earns too?

Unfortunately for these politicians, the U.S. government and private sectors cannot both spend less than they earn, generating simultaneous surpluses, unless the country somehow reverses its trade deficit:

As we just saw, barring an economic catastrophe (a sharp contraction of GDP), that’s not going to happen any time soon.

Given the near- to medium-term intractability of U.S. trade deficits, if the government somehow manages to generate a surplus by cutting expenditures, as the politicians propose, the private sector would have to spend more than it earns, going into deficit by roughly the same magnitude, to maintain a comparable level of economic activity (GDP):

That’s a more realistic proposition.

It’s reasonable for politicians to demand that the government cut its expenditures, but only if they are pretty darn sure that the private sector will start spending more by at least a comparable magnitude to avoid an immediate contraction in GDP.

Wait a second, you must be thinking – aren’t the same politicians saying that the U.S. private sector is “tightening its belt” (that is, trying to spend less than it earns)?  If the government cuts its expenditures, wouldn’t the private sector continue “tightening its belt” too – in the face of intractable trade deficits with foreigners who are also trying to generate surpluses? Wouldn’t the result be a horrific contraction of economic activity – both domestic sectors trying to generate surpluses by spending less? Could that happen? Or would the private sector readily start spending sufficiently more to maintain or grow economic activity?

While you ponder this, let’s take a look at the U.S. private sector’s net financial flows.

U.S. Private Sector Net Financial Flows

The financial flows of the U.S. private sector over the past five decades are quite, um, interesting (click to enlarge image):

U.S. private sector net financial flows, 1960-2010. Positive figures are net increases in financial claims; negative figures are net increases in financial obligations. (Click to enlarge image.)

As you can see in the chart, from at least 1960 until 1996, the U.S. private sector only acquired net financial claims on the other sectors.  Then, in 1997, something changed and the sector went on a ‘borrowing binge’ (no other term, in my view, better describes what happened), during which it increased its net financial obligations to the other sectors every year until 2002. This borrowing binge fueled, among other things, a “dot-com bubble” and what turned out to be vast over-investment in fiber-optic infrastructure – a glut of which persists to this day. This borrowing binge is the first dip below zero in the chart.

The private sector took a short break in 2003, and then, from 2004 to 2007, went on another borrowing binge, this time led by a large number of households taking on mortgage obligations they subsequently couldn’t repay to buy residential properties they ultimately couldn’t afford, enabled by fee-hungry financial firms that somehow failed to do their homework. This second borrowing binge fueled vast over-investment in housing – a glut of which still sits empty across the country – and left the finances of many families in shambles. Ah, yes – and the end of this binge nearly brought down the financial system, which had somehow amplified its own exposure to the fiasco – more on this later. That’s the second dip in the above chart.

The second binge ended with the financial crisis of 2008.

Since then, the private sector has been “tightening its belt,” as the politicians say, spending less than it earns, reducing its financial obligations, and otherwise acquiring financial instruments perceived as safe, like cash and U.S. government bonds. In 2009 and 2010, the private sector improved its financial position by more in relation to GDP than in any other previous year during the last five decades – the two tallest bars in the chart above.

This doesn’t necessarily mean the private sector’s “belt-tightening” process is approaching its end. Consider that U.S. households, who led the second borrowing binge, have barely made a dent on their financial obligations – consisting of mortgage loans and other consumer debts.

The chart below shows that the total debt outstanding of households reached nearly 100% of GDP in 2007 – a level apparently approached only once before in U.S. history: right before the Great Depression. Should families and individuals decide they want to reduce their debt load to the norms prevalent before the two borrowing binges, they have a long way to go (click to enlarge image):

Total debt outstanding of U.S. households, 1960-2010 (click to enlarge image).

What households decide to do is of critical importance, because their spending on consumer goods and services is the main driver of the U.S. economy (as well as a key driver for quite a few foreign economies which make consumer goods primarily for sale to U.S. households). Every dollar a household uses to repay debt is a dollar it can’t spend on new products and services.

There is considerable debate as to what households want or don’t want to do and the potential impact of their actions on the overall behavior of the private sector (including the behavior of businesses that must make long-term investment and hiring decisions).

There is no debate, however, that the private sector’s recent surpluses must have come at the expense of some other sector willing to spend more than it earns.

U.S. Government Sector Net Financial Flows

The chart below shows the net annual financial flows of the U.S. government sector (federal, state, and local together) over the past five decades. The sector’s financial obligations have increased almost every year in the period, the only meaningful exception being a brief intermission in the late 1990’s during the Clinton administration. In 2008, 2009, and 2010, however, the government’s net financial obligations increased more in relation to GDP than on any previous year during the past five decades (click to enlarge image):

U.S. government sector net financial flows, 1960-2010. Positive figures are net increases in financial claims; negative figures are net increases in financial obligations. (Click to enlarge image.)

Almost all these increases in net financial obligations have been in the form of U.S. federal government debt, causing much consternation, and leading many politicians, economists, and pundits to warn about unsustainable federal government deficits, culminating in the recent “debt-ceiling crisis” – congress not voting until the very last minute to approve a routine increase in federal debt because some politicians wanted first to legislate drastic cuts in government expenditures. (The sharp increase in government debt is what prompted some politicians to make silly exhortations.)

This might be good time to revisit the question I posed earlier: given that U.S. trade deficits look intractable in the near to medium term, what happens if the government sector tries to generate a surplus by cutting expenditures? Would the private sector readily start spending more, perhaps going into deficit again, to maintain or increase GDP?

Aren’t there experts who could answer this question? What about professional economists, the people who study these things for a living? Yes, they should know the answer… shouldn’t they?

As it turns out, economists strongly disagree with each other on the answer to this question.

On this Corner…

In the view of one group of economists, if the U.S. government cuts its expenditures, the private sector would step in and start spending in its place, replacing every dollar of decreased government spending with a dollar of private spending, and the economic outcome would be superior because the private sector spends money more intelligently than the government. See these three articles by prominent U.S. economists, for example.

According to these economists, every incremental dollar of government debt absorbs a dollar of private-sector saving that would otherwise go to fund private-sector investment, so the idea of the government borrowing and spending to stimulate the economy – so-called “fiscal stimulus” – is silly to them. In their view, any jobs created by government spending are always offset by jobs lost from a corresponding decline in private spending. As one of the three articles linked to above puts it:

We can build roads instead of factories, but fiscal stimulus can’t help us build more of both.

Should anyone point out that household debt is declining and that the U.S. Federal Reserve is taking unusual steps to spur lending despite record-low interest rates, these economists explain that it’s likely because the financial system isn’t functioning properly. In the view of these economists, the financial system should be expanding – lending more so that businesses and consumers can finance increased investment and consumption. Click here to see a typical example of this argument. As one the three articles above explains:

The institutions that channel your and my savings into consumer and business borrowing are not working.

Should anyone point out that U.S. corporations don’t need to borrow because they are already hoarding record amounts of cash (and earning almost no interest on it), these economists reply that to the extent private-sector investment is being held back, it’s likely for lack of confidence – resulting from the uncertainty caused by rising government debt, inconsistent policies, and constant infighting by politicians. Click here to see a typical example of this argument. Some private-sector leaders agree. As the head of JP Morgan Chase, one of the country’s largest financial firms, recently said to the Wall Street Journal:

Confidence, the secret sauce, just isn’t there.

The government should cut its expenditures and ideally commit to generating surpluses by balancing its budget in the future, these economists recommend, so that private businesses can regain confidence and start investing more and hiring more people, leading the U.S. into an economic recovery.

These recommendations are based, not just on the accounting identities presented in this post, but also on abstract mathematical models that, “with notably rare exceptions” (like the financial disaster of 2008), fit the historical data quite well.

Explaining such mathematical models falls outside the scope of this post, but let me mention two of their most important elements. First, according to them, when government regulations are permanent and transparent (as opposed to transient and uncertain), markets tend toward stability and produce the best-possible economic outcome.

Second, these mathematical models ignore financial instruments because they are just a market mechanism for redistributing economic outcomes from one group (those with obligations) to another (those with claims), and therefore should have no significant impact on overall economic results – that is, so long as the financial system is working well.

Thus, for the economists in this group, the unusual growth of private-sector financial obligations between 1997 and 2007 is an irrelevant detail. (The three articles by leading economists linked to above do not even mention the growth in private-sector obligations.)

These economists support their arguments with the watertight, irrefutable logic of their mathematical models, so I call them “Platonists” – like Plato, they believe truth is to be found only in precise, consistent, abstract ideas.

(Image source: United Media.)

And on this Corner…

A second group of economists is sure or at least very concerned that if the government cuts its expenditures, the private sector would not increase its spending sufficiently to maintain the same level of GDP, and the result would be an immediate economic contraction, possibly triggering a downward spiral not unlike the Great Depression.

These economists recognize the internal logic and consistency of the Platonists’ mathematical models, but they believe such models do not capture all aspects of economic reality, which they think is more complex. They express frustration at what they see as the Platonists’ unwillingness to question abstract theory in the face of contrary evidence. As Paul Krugman, a leading economist in this second group, recently wrote:

When I look at a lot of what prominent economists have been writing in response to the ongoing economic crisis, I see no sign of intellectual discomfort, no sense that a disaster their models made no allowance for is troubling them; I see only blithe invention of stories to rationalize the disaster in a way that supports their side of the partisan divide.

Alas, the economists in this second group have widely diverse, in many cases divergent, opinions about what to do next. Some have turned for guidance to the insights of dead economists like John Maynard Keynes, Irving Fisher, and Hyman Minsky, all of whom lived through the Great Depression. Some are questioning fundamental assumptions about money and debt, literally trying to rethink economics from the ground up (click here to see one example, click here to see another). Some are not economists but academics from other disciplines who deride the mathematical models underpinning many complex financial instruments as naïve and dangerous (e.g., Nassim Nicholas Taleb, the late Benoît Mandelbrot). Others have long agreed with the Platonists and now find themselves baffled by current circumstances. And then, of course, there are all the idiosyncratic characters who belong to fringe schools of economic thought.

Despite their many differences, the individuals in this second group have two things in common: first, they point to messy empirical evidence that in their view contradicts the Platonists; and second, they believe the unusual growth of private-sector net financial obligations between 1997 and 2007 is NOT an irrelevant detail.

Let me try to summarize their key arguments and evidence here.

Small businesses in the U.S. say that their single biggest problem is poor sales, not lack of financing or government regulations. As the chart below shows, according to the latest survey of small businesses by the National Federation of Independent Businesses (NFIB), one out of every four small businesses in the U.S. say that their single biggest problem is poor sales: not enough customers willing to spend money on their products and services. As regards small businesses access to financing, the NFIB reports that “for the overwhelming majority, ‘credit supply’ is not a problem. Ninety-three (93) percent reported that all their credit needs were met or that they were not interested in borrowing. ” Only four percent of small businesses said that financing is their single biggest problem.  Click to enlarge image:

NFIB small business survey, September 2011 (click to enlarge image).

No effort to get the financial system to lend more to small businesses can succeed if they are not interested in borrowing more.  The problem is not lack of credit, but lack of demand for credit.

Beyond unemployment, debt seems to be preventing many households from spending like they did during the two borrowing binges. The burden of debt is very unevenly distributed in the U.S., with financial distress concentrated in households that are stuck in a “debt trap” – that is, they would like to get out from under the yoke of debt, but their current income is barely high enough to pay interest and fees, so they cannot pare down their debts quickly or at all. The financial system isn’t lending more to these borrowers because they are already over-indebted; and these borrowers will not increase their spending on new goods and services to anything resembling recent past norms until after their debt problems have somehow been permanently resolved. Some economists refer to this situation as a “balance-sheet” recession.  Others are calling outright for a “housing plan” to deal with the overhang of household debt.

A growing body of evidence supports these arguments, but the data is scattered and not easily summarized, so I will share here only four data points. The first chart below shows that 80% of all U.S. households own less than 13% of all private wealth in the country; the second chart shows that 73% of all U.S. adults – three out of every four – are concerned about their finances; the third chart shows that 64% of Americans who answered a recent poll do not have enough savings on hand to handle a $1,000 emergency; and the final chart shows that almost 28% of all U.S. mortgages – nearly three out of every 10 – have either negative home equity (that is, the homeowner owes more than the property is worth) or near-negative home equity (click to enlarge image):

A sample of the evidence pointing to millions of U.S. households currently being in financial distress (click to enlarge image).

These and numerous other bits and pieces of evidence point to many millions of U.S. households that currently have little or no savings, earn barely enough to handle ordinary expenses or nothing at all (in the case of the long-term unemployed), and owe more than they are worth. The exact number of households in financial distress is difficult to estimate with precision, but it’s at least a dozen million, and more likely in the order of several dozen million households. These families and individuals are unlikely to be in a position to spend more any time soon.

[UPDATE: There is now compelling evidence tying unemployment and the economic downturn directly to household debt.  See this article, this presentation, and these two papers recently published at the University of Chicago.]

For the human side of this national tragedy, see this.

Monetary policy, which normally encourages more lending and business investment, seems to have lost all traction. The U.S. Federal Reserve, the country’s central bank, can usually combat recessions by buying government bonds with newly issued money; this drives yields on government bonds down, causing investors seeking a higher rate of return to move into other financial instruments, pushing down other interest rates throughout the economy; and this normally entices businesses to invest and hire more, leading to an economic recovery. But the Federal Reserve has already driven interest rates to zero – what some economists call the “zero lower bound” – without the expected improvement in investment and hiring activity – and without inflationary pressures. In fact, as noted earlier, U.S. corporations are hoarding record levels of cash right now. Some economists call this situation a “liquidity trap.”

Left: the U.S. Federal Reserve has issued nearly $2.8 trillion worth of money in the form of bank reserves (source: Federal Reserve Bank of St. Louis). Right: interest rates on U.S. government debt have come down to near zero (source: Bloomberg, September 30, 2011). (Click to enlarge image.)

The structure and behavior of private-sector financial firms appear to have been a major destabilizing force leading to the crisis. From 1997 to 2007 (i.e., during the two borrowing binges), the private firms that make up most of the financial system created a vast network of complex financial claims and obligations of their own that greatly exceeded the real economy’s needs. These financial claims and obligations were at the center of the financial crisis.

Instead of just providing a mundane but critical service to the real economy (interconnecting surpluses with deficits), the financial system appears to have been driving the real economy prior to the crisis – for instance, by pushing up the prices of many assets, particularly residential properties, simultaneously feeding on and magnifying a housing bubble of historic proportions.

These phenomena are eerily similar to the nonlinear feedback loops and network-amplification effects commonly observed in other complex, tightly interconnected, dynamic systems, both human-built and natural ones.  (Indeed, some economists are proposing the use of Darwinian frameworks to understand and explain the complex behavior of markets.)

Compare the Platonist view that complex, tightly interconnected, dynamic markets (financial and otherwise) naturally tend toward stable equilibrium with the single-minded focus on preventing unexpected catastrophic failure of people responsible for the day-to-day behavior of tightly interconnected, dynamic systems with orders-of-magnitude less complexity, like this one.  (Or compare the Platonist view with the inability of physicists to predict the behavior of even simpler two-person games with a maximum of 50 moves per person.)

The obvious implication is that private-sector financial firms should not expand in their current form but rather contract or be split into smaller, less concentrated sizes, become less tightly integrated with each other, simplify the complexity of their business and structure, and be managed and regulated more like boring utilities – to minimize and corral the potentially devastating impact of financial-system failure on the real economy. A financial system designed primarily to survive unexpected catastrophe and ensure uptime everywhere on the planet would look very different from the present one.

The most powerful evidence supporting these arguments is the sheer magnitude, suddenness, and unexpectedness of the financial crisis, and the utter unpreparedness for it of virtually all people running, working in, and regulating financial firms.

Additional evidence can be found in a recent paper by the Bank of International Settlements – a dense, technical document from which I will share here only a bit of data. First, the set of four charts below shows that gross financial flows into and out of the U.S. during the two borrowing binges vastly exceeded the net flows of capital reflected in the country’s current account, and that most of these excess financial flows came from and went to the United Kingdom (a major financial hub) and the rest of Europe – not Asia. The BIS paper provides additional data showing that emerging Asia, in particular, had little to do with the complicated financial instruments at the center of the financial crisis. Click to enlarge image:

U.S. gross versus net flows of capital (source: BIS). (Click to enlarge image.)

Also from the same paper, the chart below shows the sharp growth of gross financial flows worldwide in relation to global economic activity prior to the crisis, and illustrates that elsewhere around the planet too, the extra flows of capital were largely between “advanced economies” (the ones with major financial hubs). The emerging economies of Asia, despite their growing trade surpluses, were minor players in the disproportionate growth of financial claims and obligations prior to the crisis. Again, the BIS paper provides much more data and is worth a careful read. [Update: a very readable but irreverent summary of the paper is available in plain English here.]  Click to enlarge image:

Worldwide gross flows of capital in relation to global GDP (source: BIS). (Click to enlarge image.)

* * *

There might be other important arguments and evidence I could have overlooked in my effort to summarize the broad range of viewpoints of the second group of economists (and other individuals), but I think these are the main ones. Please don’t hesitate to bring up in the comments any others you think should be included here.

Who is Right? What Should be Done?

One can only sympathize with Harry S. Truman, U.S. President from 1945 to 1953, who once told his staff:

Give me a one-handed economist! All my economists say, “On the one hand, on the other.”

In my view, the economists and individuals on the second group are onto something, but rather than get up on my little soapbox and proclaim that I know how to solve the very complex economic problems facing the U.S., I will leave it up to readers to look at the evidence presented here and elsewhere, evaluate the facts and arguments, and decide on their own which group of economists might be more right – and what possible courses of action might make sense for the government of the United States.

Why Write this Post?

Because someone had to do it: Someone had to explain and demystify basic macroeconomic and national-accounting concepts, and expose the debate taking place between economists – in terms that anyone smart and curious can understand, regardless of their prior knowledge of the subject – all in one place.

This post is thus an effort to improve, even if only minimally and at the margin, the currently atrocious quality of public discourse on the subject of macroeconomics in the U.S. – particularly in the mass media, where catchy slogans so frequently substitute for knowledge and thought.

Economics is far too important to be left only to economists!

* * *

PS. Please don’t hesitate to point out any blatant errors, omissions, misstatements, and/or typos.  (Surely, there are more than a few given the long length, broad scope, complex subject, and target audience of this post.)

[Ed note: post updated between September 30, 2011 and November 18, 2011 to add a new quote, add new graphics, improve the legibility of several paragraphs, add and fix several links, and correct various typos and grammatical errors.]

PDF version of this post: On the US Economic Situation

For the record, I fully agree with Mr. Krugman that it would make no sense for any government to adopt Bitcoin as its economic unit of account, because that would make its economy susceptible to the very same problems the world’s economies experienced during the Gold Standard.

(If you don’t know what those problems are, but want to understand them, just read this book. The TL;DR version is this: it’s in the best interest of governments to be able to control the value of the money they issue – that is, avoid inflation or deflation – to help stabilize economic activity.)

However, I’m still persuaded that in the long run (think many years or even decades, not just a few years), Bitcoin is likely to gain wide adoption worldwide, both as a store of value and medium of exchange, and its price is therefore bound to rise far above current levels over time.

For Bitcoin, as Krugman clearly understands, is essentially a digital version of gold; and just like gold, it is bound to become another form of the people’s money: the one they turn to in times of crisis – whenever they worry about, stop trusting, or can no longer rely on their government’s money.

So long as Bitcoin’s technology works as intended, people facing crises around the planet are bound to turn to it as the store or value and currency of last resort. If Bitcoin passes the harsh tests of crisis again and again, nothing can prevent it from gaining as much credibility as gold over time.

More here.

In less than a year, the price of Bitcoin has increased from close to zero to nearly $9 as I write this (see below), prompting the digerati to question, only half-jokingly, if Bitcoin prices are in a “bubble” – see this post by economist Tyler Cowen for a typical example.  For the underlying conventional wisdom is that use of Bitcoin is highly unlikely ever to expand beyond a few niche markets – e.g., idealistic hackers, online gamblers, and miscellaneous underground characters.

The price of Bitcoin has risen from approximately zero to nearly $9 in less than a year.

I disagree with the conventional wisdom: I’m persuaded that in the long run (think many years or even decades, not just a few years), Bitcoin is likely to gain wide adoption worldwide, and its price is therefore bound to rise far above current levels over time.

Before explaining why and how, allow me to take a brief detour to discuss what happened in Zimbabwe on January 29, 2009 – just over two years ago. On that date, the BBC reported that this poor nation was forced to abandon its currency, the Zimbabwean dollar, because virtually no one inside or outside the country trusted it anymore. As I write this, Zimbabwe doesn’t have an official currency: for the moment its citizens are free to conduct business in any currency.

Hyperinflation led to the Zimbabwean dollar’s demise. The facts are almost surreal. At one point in early 2007, in an act of desperation, the government tried to control inflation by declaring it illegal, such that anyone who raised prices or wages would go to jail; in response, prices and wages began rising at a faster rate. By July 2008, the official inflation rate reached over 231,000,000%; the following month, the government stopped reporting inflation altogether. Not long after that, a newly issued hundred-trillion-dollar bill couldn’t even buy a bus ticket; by then just about everyone everywhere had lost faith in the currency.

This Zimbabwean dollar bill was issued shortly before the currency's demise. (Image source: Wikipedia)

Words cannot do justice to the chaos and terror inflicted by the demise of a currency: regular folk lose both their normal repository of purchasing power and their normal means of measuring the worth of everything – for many, degree of need becomes the new yardstick of value. As things spiral out of control, monetary authorities in desperation react by imposing increasingly draconian rules that serve only to accelerate the process. Those who can turn to the US dollar, gold – anything, really, that can possibly hold its purchasing power, so long as it’s not the dying currency.

Had it been possible and practical circa 2007, surely many desperate Zimbabweans would have traded at least some of their soon-to-be-obsolete Zimbabwean dollars for a global, digital currency actively traded abroad – especially one that is anonymous and decentralized like Bitcoin: better bitcoins of debatable value than Zimbabwean dollars of vanishing value. (By “practical,” I mean easy enough to buy, sell, and use for most individuals in the country.)

The same could be said for the people of Yugoslavia in the early 1990’s, who at one point saw newly issued banknotes with additional zeros worthless within days; or Argentines circa 2001, when their government subjected them to the so-called “corralito” – the nickname given to a law forbidding withdrawals from many bank accounts; or Mexicans in December 1994, when the Peso lost around half of its value against the US dollar in a couple of weeks as the Mexican government flirted with default; or Belarusians in the years leading to 2002; or Bolivians in the mid-1980’s; or Brazilians in the early 1990’s; or the Polish circa 1991; or Russians in August 1998; or Indonesians, South Koreans, and Thais in the summer of 1997… I could go on. The list of countries that have suffered a currency crisis, hyperinflation, or the outright demise of an official currency over the past few decades is long.

The number of people alive who have suffered through such currency disasters is therefore enormous – around a billion live in just the countries mentioned above.

Argentines protesting the "corralito" of 2001-2002. The sign reads "THIEVING BANKS - GIVE BACK OUR DOLLARS." (Image source: Wikipedia)

The number grows considerably larger if we include all people who have suffered through other types of man-made disasters, whether economic crises, political turmoil, religious and ethnic strife, revolution, or war. (As a reference point, Wikipedia lists over 100 wars occurring worldwide since 1990.) The expanded figure is in the order of billions of people – a sobering fact for anyone who has experienced only the relative stability of the developed world in his or her lifetime. (In late 2008, people in the developed world got only but a brief hint of how it might feel to suffer through such full-on disasters.)

When people are forced by fate to face the extreme uncertainty of such circumstances, they often seek to diversify away from local currencies facing existential risk and turn to the US dollar, gold, or anything else, really, that can possibly hold its purchasing power under all but the most dire of scenarios. Unsurprisingly, a majority of all US dollar bills in circulation – the cumbersome ones made of actual paper – are held outside the US, for when even the viability of banks has been rendered in doubt, no bank deposit can ever substitute for cash.

Had it been possible and practical (in the sense explained further above) when things looked hopeless, surely many among those billions of people would have traded at least some of their holdings of local currency for a global, decentralized, anonymous, digital currency actively traded abroad – especially one with the properties of Bitcoin.

Properties of Bitcoin

Bitcoin is not just global, decentralized, and (optionally) anonymous; it is also the most versatile form of cash introduced to date. For a bitcoin is just a long sequence of digits with certain cryptographic attributes, so anything one can do with numbers, one can just as easily do with it. In practical terms, this means Bitcoin is easier to secure, transport, hide, and backup than all prior forms of cash ever used by civilization. (Actually, no prior form of cash ever in use – whether made of paper, metal, or other material – could be backed up like Bitcoin.)

As an arbitrary example of Bitcoin’s extreme versatility, imagine, say, a US government agent in hostile territory who needs to send cash to a second agent located a few miles away, but there is no safe transportation, no phone line, no Internet connection, and no third party who could serve as an intermediary. With Bitcoin, it can be done: the first agent can encrypt a bitcoin wallet on any computing device and send the resulting sequence of encrypted digits via almost any means available: radio broadcast, lighthouse beam, drumbeats, even smoke signals. (Transmitting many thousands of digits via smoke signals might take a long time, but it can be done.) Anyone intercepting the message would obtain just the encrypted sequence. Whether embodied as radio signals, light beams, sound waves, or columns of smoke, actual cash would be securely traveling from one agent to the other. Being numbers, bitcoins can be sent over almost any medium.

Having been only recently introduced, at the moment Bitcoin requires a minimum of technical expertise to use (specifically, installing a software application on a personal computer). However, judging by the growing number of new tools, services, and infrastructure being developed worldwide for and around Bitcoin, I would expect it to become much easier to use in the not too distant future – easy enough, say, for anyone who can use a mobile phone.

Bitcoins are much harder to forge than paper currencies, because the sequence of digits that makes up each bitcoin is practically impossible to replicate without access to the original. In fact, it’s easier for a criminal to make counterfeit US dollar bills that can fool people on the street than to make ‘counterfeit bitcoins’ that can fool Bitcoin’s peer-to-peer network: the former can be accomplished with paper, ink, and printing equipment; the latter would require breaking state-of-the-art cryptographic hashing (currently SHA-256 and RIPEMD-160) and signing (currently ECDSA) algorithms.

Bitcoins are scarce by design – their supply will grow to a maximum of 21 million by 2030 – but, being  numbers, they can be subdivided into arbitrarily smaller parts. (At the moment, subdivision is limited for practical purposes to eight decimal points of precision, but this limit is not inherent to the design.)  The subdivided parts of a bitcoin, being numbers too, have the same exact properties as the whole; thus, should the need ever arise, the world could just as easily deal in milli-Bitcoin (a thousandth of a bitcoin), micro-Bitcoin (a millionth), etc. as in Bitcoin.

Finally, as the first-ever form of “crypto-cash” to gain brand recognition and market momentum, Bitcoin is now benefiting from growing network effects.  Bitcoin, in short, has gone viral – something that would be extremely difficult, if not impossible to replicate by any would-be competitors. (As a side note, I can’t help but smirk whenever some or other expert on the subject of cryptography finds out about Bitcoin and almost immediately proposes some other design as superior, failing to realize that at this point it doesn’t matter.)

Intrinsic Value versus Price of Bitcoins

Adam Smith, the father of modern economics, distinguished between “value in use” and “value in exchange” – in his own words:

The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called ‘value in use;’ the other, ‘value in exchange.’ The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any use-value; but a very great quantity of other goods may frequently be had in exchange for it.

Bitcoins, being just numbers, have zero use-value. (Actually, their use-value is slightly negative, because they have tiny carrying costs – every moment one holds a bitcoin, one is paying for it with the consumption of resources such as storage space or electricity; but we can ignore these tiny carrying costs.)

Thus bitcoins can have only value in exchange: to the owner of a bitcoin, its value depends solely on what other people are willing to trade for it; should no one else want to trade anything for it (for example, if Bitcoin’s network were ever shown to be susceptible to concerted attack), the bitcoin’s exchange-value would revert to its use-value: zero.

For the sake of familiarity, let’s use the more common terms “intrinsic value” and “price,” respectively, to refer to the concepts of value in use and value in exchange. We can restate the above as follows: Bitcoin has no intrinsic value but may trade at any price, as set by supply and demand. In this regard, Bitcoin is like all other currencies in circulation today.

Trial by Fire

Given that over the past few decades billions of people have suffered financial, economic, and political crises and collapses, religious and ethnic conflicts, revolutions, and wars, shouldn’t we expect billions to live through more such man-made disasters in the coming decades?

The optimist in me hopes there are no more such horrible disasters anywhere in the world ever again; the realist in me has no choice but to expect them to occur from time to time.

In fact, they are always occurring.  As I write this, European countries like Portugal, Ireland, Greece, and Spain are staring down at full-blown economic and political crises, and the Middle East is in the midst of a sudden, unexpected wave of political transformation, the ultimate consequences of which are uncertain.

A Greek police officer runs from protestors in Athens on May 5, 2010. (Image source: Wikipedia)

The anonymity, decentralized nature, and extreme versatility of Bitcoin make it an ideal form of cash for coping with the extreme uncertainty inherent to such unstable situations. Financial crises, collapsed economies, toppled governments, military conflicts: Bitcoin can survive them all.

As Bitcoin becomes easier to buy, sell, and use by regular folk, its use in extreme, difficult circumstances therefore seems inevitable to me. When people are desperate, they tend to be more willing to try new things. So long as Bitcoin works as intended, people around the planet are bound to turn to it as the currency and store or value of last resort.

Trial by fire: that is how Bitcoin will have to prove its mettle.

If Bitcoin passes the harsh tests of crisis again and again, it will slowly gain credibility in the public’s mind, both as medium of exchange and store of value. Over a period of many years or even decades, as the world gradually learns via trial-and-error how to use Bitcoin, becomes familiar with its properties, and ultimately comes to trust it, nothing can prevent it from gaining as much credibility as, say, gold.

The world’s existing legal and regulatory regimes may not welcome Bitcoin at first – few governments are likely to take kindly to the emergence of a decentralized, anonymous, global currency beyond their control. Sooner or later, however, governments will adapt to the changing circumstances, as they always do. I would expect governmental acceptance of Bitcoin to occur initially in less developed countries, as many of them are already used to having their fortunes tied to a global currency beyond their control: the US dollar.

If I am right, in the long run, as man-made crises of all kinds erupt all over the planet from time to time, global demand for Bitcoin should gradually expand from niche markets to the broader population. Ultimately, global demand for Bitcoin should be enormous.

Quantifying Demand for Bitcoin in the Long Run

The primary goal of the analysis that follows is to get the orders of magnitude roughly right, not to come up with precise figures that would surely be wrong. A secondary goal is to provide you, the reader, with a simple framework you can use to quantify Bitcoin demand (and potential price) based on your own views about its future.

Global demand for Bitcoin over time should come in two forms: demand for it as medium of exchange, and demand for it as store of value. Let’s consider the former first.

We can estimate maximum possible global demand for Bitcoin as medium of exchange with a mental experiment. Imagine if all countries worldwide decided, en masse, to replace all currencies in circulation with bitcoins, all at the same time, in coordinated fashion – more or less in the same way that the initial members of the European Monetary Union replaced their respective national currencies (German Marks, French Francs, Italian Lire, etc.) with the euro on December 31, 1998. Obviously, such a wholesale replacement of all currencies for bitcoins will never happen, but please entertain the notion for a moment.

For such a replacement to be completed, all cash across all currencies carried around in wallets, locked in cash registers, packed in briefcases, stored under mattresses, secured inside safes, etc. – the total amount of ‘pocket change,’ as it were, the world needs to function every day – would have to be exchanged for bitcoins. The remaining components of the world’s monetary base (e.g., bank deposits, money funds, etc.), which by and large exist only in the form of accounting entries, would continue to exist as such, but denominated in bitcoins. (This is just like what was done to create the euro.)  [Ed note: there are some additional complications involved that I feel are not worth delving into here -- e.g., see this comment on Reddit.]

Immediately after this wholesale replacement of all currencies, Bitcoin would be, to a close approximation, the only medium of exchange in the planet. Since everyone would be using Bitcoin, demand for it as a medium of exchange would have reached its maximum possible. It follows that total cash in circulation across all currencies (or more precisely, the goods and services that could be purchased with it) constitutes maximum possible global demand for bitcoins as medium of exchange at any point in time.

How much cash in circulation is there worldwide? According to the US Federal Reserve, as of May 2, 2011, the aggregate value of all US dollars in circulation is approximately $955 billion. According to the European Central Bank, at the end of March 2011, the aggregate value of all euros in circulation is approximately €846 billion (€824 billion in large denominations and €22 billion in small denominations), equivalent to approximately $1.2 trillion at current exchange rates. The aggregate market value of all US dollar and euro bills in circulation worldwide, at current exchange rates, is therefore around $2.2 trillion.

The US dollar and euro economies, in nominal terms, represent approximately half of the world’s annual economic output, so, all else being equal, we can assume that the aggregate market value of all other currencies in circulation used by all other economies in the world, at current exchange rates, is likely around $2.2 trillion too. (The figure may be lower because the US dollar and euro may enjoy wider use as “hard” currencies, but it could also be higher, because most of those other economies have lesser developed financial systems and therefore tend to rely much more on cash as opposed to electronic transactions. As a first approximation, for simplicity’s sake, let’s assume the figure is roughly the same.)

Thus cash in circulation today, across all currencies, totals around $4.4 trillion. You can think of this rough figure as the amount of pocket change the world needs, in total, to function every day. With world population currently estimated at nearly 6.8 billion, this works out to roughly $650 for every person alive. This per-person average seems reasonable to me given that it includes not just all cash held by individuals, but also that held across all organizations.

By implication, should a sufficiently large group of people ever adopt Bitcoin as their main medium of exchange, all else being the same, they would need around $650 worth of bitcoins in ‘pocket change’ circulating for every person in the group. (The figure will vary widely for some groups versus others, but one can easily adjust for such variations as and when necessary.)  For simplicity’s sake, you can think of this figure as global average demand per person who adopts Bitcoin as his or her currency.

Demand for bitcoins as store of value is much harder to quantify, because so many types of assets – both financial assets like cash itself, bank deposits, government bonds, and shares of common stock, as well as real assets like property, artwork, jewelry, and precious metals – are regularly used for this purpose. I know of no way to estimate, in any remotely accurate way, which of all those assets, nor to what extent, could ever be displaced by Bitcoin as a store of value. (Complicating matters, the figures involved are barely fathomable. According to McKinsey & Co., just the world’s financial assets totaled approximately $178 trillion at year-end 2008, or roughly 40 times the amount of cash in circulation worldwide.)

Perhaps the most comparable asset to Bitcoin as a store of value might be gold: throughout history it has been used for that purpose; its supply is fixed to the amount that ultimately can be mined from the ground; its ownership can be anonymous; there is no single central authority that controls it; it pays no interest; and by and large no one uses it as currency today.

For simplicity’s sake, let’s limit ourselves to estimating what the demand for Bitcoin as store of value might be should the world ever adopt it for that purpose to the same extent as gold today. This demand would be in addition to any demand for Bitcoin as medium of exchange.

According to the World Gold Council, 165,000 tons of gold have been mined since the beginning of civilization, all of which are still with us. At $1,525 per troy ounce, all this gold is currently worth around $8.1 trillion. The World Gold Council estimates that over a third is held by investors and central banks for investment, worth approximately $2.7 trillion, or around $400 for every person alive. This, roughly, is how much gold the world owns as store of value.

By implication, should a sufficiently large group of people ever adopt Bitcoin as a store of value to the same extent as gold today, the group would need around $400 worth of bitcoins for every person in it. (The figure would obviously vary widely for some groups versus others, but one can adjust for such variations as and when necessary.) For simplicity’s sake, you can think of this figure as global average demand per person who adopts Bitcoin as a store of value to the same extent the world uses gold for the same purpose today.

Global demand for Bitcoin is therefore worth, on average, around $650 for every person who adopts it as his or her currency, plus $400 for every person who adopts it as a store of value to the same extent gold is used today. Don’t forget that these two figures are, first of all, rough estimates, and second, worldwide averages, so they will vary widely from person to person. Also, please note that both figures are in current US dollars; all else remaining the same, they will grow with US dollar inflation over time.

Bitcoin Price Will Be a Function of Adoption

Global supply is fixed at a maximum of 21 million bitcoins, so over time their price will necessarily be a function only of demand: the more people worldwide who want bitcoins, the greater their price. Price will thus be a function of adoption. Using the per-person averages calculated above, we can guesstimate what Bitcoin’s price might be under any adoption scenario.

For example, say that over the next 10 years, 100 million individuals worldwide adopt Bitcoin as a store of value (to the same extent gold is used today), but no one adopts it as his or her currency, and annual US dollar inflation is 3% over the entire period. By 2021, each of these individuals would need to own an average of $400 × 1.03¹⁰ or around $540 worth of bitcoins. Multiplying this figure by 100 million gives us around $54 billion worth of bitcoins needed by all these individuals as a group in 2021. Dividing this last figure by the number of bitcoins then outstanding, around 18.3 million, we obtain $2,950 per bitcoin, or $2.95 per milli-bitcoin (a thousandth of a bitcoin) – so, in the order of a few US dollars per milli-bitcoin.

For a more optimistic (likely unrealistic) scenario, say that over the next 20 years a billion people adopt Bitcoin both as their currency and as a store of value (to the same extent gold is used today), and annual US dollar inflation over the period is 3%. By 2031, each of these individuals would need to own an average of ($650+$400) × 1.03²⁰ or around $1,900 worth of bitcoins. Multiplying this figure by a billion gives us around $1.9 trillion worth of bitcoins needed by the whole group in 2031. Dividing this last figure by the number of bitcoins then outstanding, 21 million, we obtain a price of over $90,000 per bitcoin, or $0.09 per micro-bitcoin (a millionth of a bitcoin) – so, in the order of a handful of US cents per micro-bitcoin.

One thing becomes evident to me from this exercise: should Bitcoin ever gain wide adoption, its price should rise by at least several orders of magnitude.  The forecast, of course, will vary widely depending on the assumptions used, so I would encourage you to play with them and reach your own conclusion.

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Addendum

Using similar logic, we can guesstimate Bitcoin adoption at any time. For instance, as I write this, there are just over 6.3 million bitcoins in existence, each trading for around $9, for a total Bitcoin market capitalization of around $57 million. (You can see the current number of bitcoins in existence here and their current trading price here.  [Ed note: BitcoinWatch shows all this data and much more in one place.])

The early adopters who own these bitcoins by and large seem to be hoarding them and speculating like day-traders using Bitcoin as a store of value, not as a currency; and they likely own more than the global average per person of $400 worth of bitcoins we estimated above, because they’re more technologically sophisticated and therefore wealthier than the average person on the planet.

Nominal economic output per capita in developed countries is roughly three to five times higher than for the world as a whole, so let’s say Bitcoin’s early adopters own, on average, four times the $400, or $1,600, worth of bitcoins. Dividing the current market capitalization of $57 million by this last figure, we obtain a guesstimate of current Bitcoin adoption: around 36,000 – so, in the order of a few dozen thousand individuals worldwide.

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[Ed note: post updated between June 2 and 20, 2011 to correct typos, add clarifications and examples, and fix/add some links.]