Fenil's Library

People aren’t willing to spend money — neither their own, nor borrowed

Vivek Kaul. Mumbai

“So where do we go from here?” she asked early one morning as I sat watching the rain falling outside, sipping my cup of coffee.

“Why do we need to go anywhere from here? You know, I remember reading somewhere, we are where we are because that’s where we are meant to be,” I replied with a grin.

“Smart reply. I will let you be for the time being. But tell me something, I read this small snippet in the newspaper today that the consumer price inflation in the United States for the month of June 2009 was only 0.7%.”

“So?” I asked.

“Well, the US has been printing dollars big time and hoping to spend it in order to revive the economy. The money supply in the US has increased by more than 100% in the recent past (See graph). History tells us increased money supply leads to a situation wherein a lot of money chases fewer goods, leading to increased prices or inflation. But that doesn’t seem to be happening. Why is that?”

“The conventional answer is that due to a recessionary situation, the increased money supply is not leaving the banks. That is, banks are not willing to lend, which means people cannot borrow to buy goods, as they had been doing in the past. Take the case of automobiles. The average price of cars being sold in the US before the recession set in was $30,000. The only reason most people could buy such cars is because they had easy access to debt. Now they don’t, so car sales have collapsed. And when cars aren’t selling, car manufacturers obviously cannot raise prices. Other than this, people have also realised the merits of saving money. Savings in the US are now at around 5% of the gross domestic product (GDP), in comparison to a negative savings rate till sometime back.”

“But why this sudden spurt in savings?” she interrupted.

“Well you need to realise that since the beginning of the recession in December 2007, around $13.87 trillion of wealth has been destroyed. Most of it, of course, has been due to a crash in housing prices. A fall in stock market levels has also added to this wealth destruction. What this means is that people are feeling poorer. And when people feel poor, they do not go out and spend. The tendency is to save and hold on to what you have. Other than this, a lot of people have been fired from their jobs. Official figures suggest that nearly 9.5% of the US population is unemployed, and around 6.5 million people have lost their jobs. These numbers do not include people who are working part-time, but want to work full-time, and cannot do that because there are not enough jobs going around. Now, I need not tell you that the last thing on anyone who has lost his job is spending money. And of course, even those who haven’t lost their job will be doubly careful about spending money when they see people around them being fired,” I explained.

“But isn’t the US government spending money to revive the economy? A stimulus package worth $787 billion is being executed to revive the economy.”

“Yeah, it is. But remember the wealth destroyed stands at $13.87 trillion and the money being spent is $787 billion. It is like you losing a hundred rupees and I giving you six rupees to compensate for it. Obviously, that is not enough. When wealth destruction has happened on such a massive scale, any stimulus can only have a limited impact. Of the total plan of $787 billion, $287 billion was in the form of temporary tax breaks. This has been partly negated as many American states on the brink of bankruptcy have started to increase taxes. Increased taxes mean lesser money in the hands of consumers to spend. As I have told you before, nearly 70% of the US GDP comes from consumption. If consumption doesn’t pick up, GDP growth doesn’t pick up. And for consumption to pick up, people have to borrow and spend money as they did in the past. This is rather ironical given that it was excess borrowing that caused all these problems in the first place. The solution is what caused the problem.”

“There you go getting all philosophical again!”

“What all this means is that people are not willing to spend their own money, nor spend borrowed money. Which means you can’t have a situation wherein more money is chasing few goods. Hence, there is no increase in prices, and a low inflation of 0.7%. But that, as I said, is the conventional argument that everybody seems to be making.”

“Oh. Kahani main twist!”

“Yeah. What everyone seems to be talking about is that an increase in money supply hasn’t led to an increase in prices. But what nobody seems to be talking about, is how an increase in money supply has ensured that the purchasing power of money hasn’t gone up.”

“Purchasing power of money hasn’t gone up? What do you mean by that?” she asked.

“Let me explain. Money has a certain purchasing power. Let’s say you can buy 2 kg of a fruit for Rs 100 on a certain day. Sometime later, you may be able to buy the same 2 kg of fruit for Rs 75. What does that mean? It means the purchasing power of money has gone up. Why? It has gone up because the price of what you are buying has fallen and hence you can buy more goods with the same amount of money or the same amount of goods with a lower amount of money.”

“Okay. So I understand what purchasing power means. But what is its link with what
you have been trying to say?”

“If the money printing wouldn’t have happened, money supply wouldn’t have gone up. If money supply wouldn’t have gone up, the prices of goods and services — which have held up more or less constant — would have fallen. So, an increased money supply has ensured that some amount of money has chased goods and services. This has enabled companies to either hold on to their prices, or to not cut prices as much as they would have had to, in case there was no money printing.”

“Hmmm. I guess I understand now. But what is the trouble with prices not falling?”

“It leads to a situation where the mechanism of price is not allowed to work and prices of goods and services don’t reach their correct level. They are propped up by the increased money supply. Now money printing cannot keep continuing for eternity. Thus, there is always a danger of the prices falling more in the future, whenever the currency printing stops. And that my dear is a scary thought.”

“Well like you keep postponing the answer to my questions, I guess economies work the same way,” she said, having the last laugh.




References:
Inflation: What You See and What You Don’t See, Thorstein Polliet, June 30, 2009
The Financial and Economic Argument for No Green Shoots: No Deus Ex Machina for the Economy. 10 Charts Showing why There will be no Second Half Recovery in 2009, www.usagold.com, July 8, 2009