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Popular misconceptions about economy

by on 19/08/2018

The major popular misconceptions about economy.

In the public view there are several misconceptions about how economy works.

Taxes are collected to cover government spending.
Public debt and printing money, necessarily cause inflation.
Government’s deficit has always negative influence on the economy.
Private sector is always more efficient than the public sector.
Inflation is result of increase in the demand due to increased wages.
Increased wages reduce competitiveness in the economy.
Trade deficit is devastating for the economy of the country, while trade surplus is healthy always for the economy.
Money has to be backed by economically valuable precious item. (Rare metal like gold).
Money has fixed value, unless there is inflation in the sovereign country that issued the money.

A. Taxes are collected to cover government spending.

The reality is, taxation is aimed to fulfil several very different goals except to cover government expenses.

a. Increased equality in distribution of income, by progressive income tax, property tax or tax on heritage.
b. To protect local production from foreign competition by costume tarifs.
c. To regulate economic activity by fiscal economic policy, without to change the government spending. Tax release can spur economic activity of the private sector, while increased tax burden has opposite effect.
d. To regulate consumption, (Value Added tax, tax on alcohol or tobacco, fuel, private cars, etc.)
e. Return on government investments on national level investment projects, (federal road tolls, payments for national railways, electric grind, etc.)
f. Social security taxation. This taxation is special purpose taxation, aiming to transfer income from part of the society with higher income, to parts of the population with non or limited income.

The government activity can be divided between spending, that doesn’t increase the economic production capacity in the future and government investments, that do have positive impact on economic growth. The obvious government spending item is military spending, that usually has rather negative impact on economic growth, even if it increases directly the government spending and by doing that increases the aggregate demand. Other such item is social security system, that is a special kind of taxation, its purpose is to allocate income from economically active segment of population, to the less active segment, either because of their age, limited employment capacity, unemployment, etc. This kind of taxation doesn’t influence directly the government spending, but indirectly, by allocating financial resources from population with high income, their spending rate out of income is relatively low, to population with low income, with relatively high rate of spending out of income. The impact of social taxation is positive to increase in aggregate demand. On the other hand it reduces the income of the most productive segment of the society. Some economist believe, it negatively influences the economic growth.

Conclusion: Only one of many aims of taxation is to cover government expenses.

B. Public debt necessarily causes inflation.

Public or sovereign government debt by definition means government expenses exceeding tax income and government revenues from its activities. This debt is covered by government promissory notes in form of cash money or government securities and bonds. Since Government tends to increase its spending, and not so much reciprocally tends to increase taxes, it creates debts. These debts are translated to promissory notes, that become the basis for financial liquidity in the economy, the Monetary Base, without which economy couldn’t operate. These promissory notes circulate, and have reciprocal twin, the economic production, that circulates in opposite direction, and its value is represented by the value of these promissory notes exchanged against them. The rate of circulation of money, or the Velocity of the money, together with the volume of money in circulation is monetary expression of economic activity, and is called the Gross Domestic Product, or GDP. Change in value of promissory notes circulation changes reciprocally the value of production circulation, that is measured as GDP (including change in inventories). The equal opposite to GDP is GDI, that is the Gross Domestic Income, representing the Money value circulating in the economy. Only part of this circulation creates new economic wealth in form of savings its other side are investments accumulated as wealth. The rest is consumed or waisted.

Since the level of liquidity strongly influences the monetary circulation level, it influences the aggregate demand in the economy, and so the GDP. This is the state, until the economy reaches its objective potential, limited by certain resource, that has no substitute for similar price. If such a limit is reached, the result is price increase of a particular item, or many items, their supply is dependent on this limited resource. Such a basic limited resource can be a raw material or energy source, cereal grains, or available workforce, specialised or not specialised, etc.

Conclusion: Government deficit is inflationary only, if it creates additional aggregate demand in economy without enough production capacity. Otherwise it increases the volume of money in the economy, depending on money circulation velocity, it may or may not,
increase the total volume of money in circulation.

Comment: Due to development of the technology, usually such a limited resource on the short run causes price increase, that itself causes in market economy concentrated effort to develop technological solution for the shortage in resources, that on long run according to experience in the past solved this shortage. So it happened after oil price jump in seventies and eighties of last century, that caused development of photovoltaic technology, as substitute to carbohydrate fuels.

C. Government’s deficit has always negative influence on the economy.

Government deficit, if created in times of available production capacity, causes increase in aggregate demand, and usage of this unused capacity, meaning GDP growth, or increase in wealth. In time periods of limited resources, the government should run public surplus in its budget, that can be achieved by government budget cuts, or increased taxes. When government increases taxes to reduce deficit, the aggregate demand decrease will come from the private sector, while if the budget cut will be the major tool of the government to fight inflation, the aggregate demand decrease will be of the government.

Since decrease in private sector activity also decreases the taxable income basis, budget cut is more efficient way to reduce the deficit and to fight the inflation than the tax increase, that decreases rather the tax obliged private sector activity. Government economic activity is either providing services for the population, as social services, education, health, or legal, personal and national security. Other government activity is investments to low yield, long term projects in national level. At times of unemployed production capacity, the government’s budget increase is usually focussed to governments investment activities. This means increased government activity is a more efficient tool to activate unemployed production capacity than tax reduction. Tax reduction may increase the aggregate demand too, but not necessarily by direct investments, it means it’s impact on economic growth will be rather short term and limited.

D. Private sector is always more efficient than the public sector.

In modern market economy, in principle, public sector should not be in competition with private sector activities. On the other hand exists necessary high risk economic activities on the whole national level, or very long term investment activities without obvious immediate reward. This is why governments many times invest in very visible white elephant projects, like unused airports highways, etc. with no direct profitability. Still government investments bringing indirect profits to the society on long run. As example of such activity is education for the whole population, minimum income security programs for all, but also wars preventing dangers of crumbling of the society, due to external or internal aggression. If these services and activities are neglected relatively to private sector activities, it’s more effective to the economy to increase public sector activity than private sector activity.

E. Inflation is result of increase in the demand due to increased wages.

Wages are only one of the elements in the production costs. Other production costs are capital income expectations as interest rates or yields on capital investments, franchise right costs, royalties right costs, rents on land and premises, raw material resources exploitation rights, etc.

While Labour and wages are always exchangeable for technological solutions, or increase in production efficiency, capital income expectations are hardly changeable, so less flexible.

F. Increased wages reduce competitiveness of the economy.

Wages increase may happen for two different reasons. Increase in productivity of production, or limited supply of labour. In case of increased productivity, the price of labour decreases relatively to produced value, and it causes tendency to wage increase, without to influence competitiveness. Increased wage means relatively less capital gains out of economy. Improved competitivity in economy is caused by new investments and initiations done by private sector. Does decrease in wages bring less initiations and investments. There is no necessary connection.

If wage increase is caused by limited supply of labour, it may causes general price increase. This means, the profitability will not be influenced by such wage increase on whole country scale, but in the particular case.

G. Trade deficit is devastating for the economy of the country, while trade surplus is healthy always for the economy.

Trade deficit is one of the components of the current account. It represents the total export minus the total import of goods of a specific sovereign country. If the number is positive it means trade surplus and if negative it means deficit. Trade surplus or deficit can be balanced by service account of current account. Services account includes all the international economic activities, excluding the items in trade deficit. As example, deficit or surplus from foreign tourism. Other example can be the difference on capital gains on foreign investments, compared to capital gains paid to foreign investors by local economic entities or the government.

If the current account has deficit, by definition it has to be balanced by capital account. Capital account includes all the foreign investments, foreign bank loans or non bank loans, etc. If current account has deficit, its balance by capital account creates indebtedness, either in form of loans and credits to foreign banks, or in form of equity liabilities created by foreign investments, causing foreign ownership rights on economic assets, like real estate, or company shares. If the current account deficit is created partly by government, this is balanced by government debts in form of treasury securities, that will be held by foreign investors, or governments. An unusual phenomenon is when the currency of a sovereign country like US is held by foreign governments as currency buffer stock reserve. In this case, the nation with the currency desirable as reserve currency has to have current account deficit, that is balanced by investments in US government promissory notes, usually in form of US treasury securities. Viz:
https://rodeneugen.wordpress.com/2018/07/19/money-debt-promissory-notes-reserve-currency/

Too much debt to foreign investors my cause dependency on foreign entities, be it private foreign investors or foreign governments. In the past, while the dominant global economic system was based on national economies, competing each other fiercely, this was important, but in today’s global economy, of international corporations, the differentiation of debt as foreign or local, lost its importance. More important is the level of investment attractiveness of certain country. This attractiveness depends not only on yield of this investments, but the trust in the stability of the country’s political and economic system.

Another reason why the differentiation between local and foreign investors is not relevant, can be understood from the silicon valley high tech corporations, that their management and research development are usually in US, while most of them are incorporated abroad and their production facilities are also abroad. Since the know how development costs and the corporation profits are significant part of their revenues, are at first accumulated in their foreign entities, then reinvesting back to US. In official statistics, these investments are registered as foreign investments. In reality this funds never left practically US.

H. Money is backed or should be backed by economically valuable item, with fixed high price. (The best, precious rare metal like gold).

This urban mythology still prevails, even if the connection between gold and money was disconnected officially in early seventies of last century, and in fact such a connection never existed. Even in times, when instrument of payment was precious metal coins, the relative price of the coin to products changed. If too much coin was minted, because new gold deposits were found, the product prices went up and vice versa. To understand how inefficient is gold as a fixed measure of value for product price, it’s enough to see the gold price in last years since 2008, jumping ten folds, then collapsing back again.

I. Money has fixed value, unless there is inflation in the country that issued the money.

Inflation means average price level increase, of either an average consumption basket, or of any other basket, defined by the economist. Such a basket can be energy items basket or house price basket, etc. Usually even if the average consumption basket is fixed and stable, there is always big price change diversity of specific consumption or investment item baskets. Usually housing and energy prices are characterised by big velocity, high tech products with downtrend tendency, and the classical food and basic consumption items with relative long term stability.

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