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There's a lady who's sure all that glitters is gold
And she's buying a stairway to heaven
(And) when she gets there she knows if the stores are all closed
With a word she can get what she came for

There are two economies in the world, but they're not what you think. There's the Real Economy, which is based on real, physical things, like food and cars and clothes and your house. And there's the Paper Economy, which is based on money only, and which cannot be seen or touched, it can only be reflected in monthly statements from banks, brokerage firms, and financial institutions. Both are important. But there are big differences between them that you need to understand.

How they compute GDP

Don't let your eyes get glassy, it's not that hard.

GDP is based entirely on the Real Economy. The GDP is nothing more or less than spending for real things. The formula for computing GDP is I + C + G + (exports - imports), where I, C, and G are shorthand for corporate spending (called Gross Investment), Consumer spending, and Government spending. The spending parts are adjusted to only look at Real Economy spending. So other than the import/export adjustment, GDP is spending in the Real Economy, period. When the Real Economy does well, most ordinary people do well too. When the Real Economy tanks, a lot of ordinary people suffer.

As a general rule, you don't even get into the Paper Economy unless your own personal slice of the Real Economy is doing OK. If you're wondering how to pay the electric bill, chances are you're not socking money away in a 401K.

Poor people spend everything they have in the Real Economy. They need food, clothes, shelter, and a lot of other stuff they don't have. A poor person doesn't have a savings account, or if they do, there's nothing in it.

A middle class person spends a lot of what they have in the Real Economy too, but not all. A middle class person has some dealings with the Paper Economy: he or she might have a savings account, a 401K, a mortgage, and a car loan, which are all part of the Paper Economy.

The rich have most of their money in the Paper Economy, but still have enough left over for luxury items in the Real Economy too.

Spending, taxing, and borrowing: their actual effects

In order to increase the GDP, spending must go up, and that means spending in the Real Economy. Paper Economy spending doesn't count toward the GDP. Here's something most people don't understand: buying a stock isn't a real investment. It's a paper "investment" that doesn't help the Real Economy one little bit. Buying a stock may help support the stock's price, but stock prices are Paper Economy only. Buying and selling stocks and bonds is just moving the money around in the Paper Economy, which has no effect at all on GDP. If you forego buying a car to buy 100 shares in GM instead, you're not helping the Real Economy at all (in fact, you're hurting it). And you're certainly not helping GM! The real investment occurred years ago when GM sold the stock initially, and bought real plant and real equipment with the money. (The technical term for this is "gross investment", and it's the "I" in the formula above for how GDP is computed. But it's really just another kind of Real Economy spending.) After that initial stock offering, all the rest of the buying and re-buying and re-buying the stock is just moving around deck chairs within the Paper Economy.

That's why raising taxes on the poor and middle class can be (but not necessarily is) bad for the GDP. A poor person spends everything he has almost as soon as he has it, and he spends it in the Real Economy. So if you tax a poor person, every dollar taxed is a dollar unspent. Now if the government turns around and actually spends that dollar in the Real Economy, it's a wash: one less dollar spent by the poor taxpayer, one more dollar spend by the government, and GDP doesn't take a hit. But there's a good chance that the government won't spend it all in the Real Economy, but spend some of it in the Paper Economy instead, which would drive down GDP. (How does government spend money in the Paper Economy? By paying off debt, which moves money from the Real Economy into the Paper Economy. Paying interest on loans does the same.)

In fact, anything that moves money from the Paper Economy into the Real Economy will drive up the GDP. The reverse is also true: anything that moves money from the Real Economy into the Paper Economy drives down GDP. Taking out a loan is a good example: the bank takes some of its Paper Economy money, and gives it to you so you can buy a car in the Real Economy. The GDP goes up. When you pay back that loan, the money moves (slowly) back to the Paper Economy, and the GDP goes (slowly) back down. A loan is a big "boom" of GDP stimulus, followed by a long slow hiss of GDP hindrance.

That's why lowering interest rates is good for the economy, because it encourages more people to get loans, which moves more money into the Real Economy. That's also why deficit spending by the government stimulates the Real Economy: the government takes out loans to make up the deficit, and government loans are stimulative like any other. Raising interest rates has the opposite effect: fewer loans means less money moving into the Real Economy, while the slow hiss of old loans being paid back drags down the GDP.

The lowering of the capital gains tax (part of Bush's tax cuts for the rich) provided a huge incentive for people to move money out of the Real economy and into the Paper Economy, to take advantage of the tax break on stock ownership. Obviously, only those with means could do so, but the bottom line is that it was a huge blow to the Real Economy, which has since that time suffered through the slowest growth since the Great Depression. The paper economy was going like a rocket (at least before 2008), while the Real Economy has been on life support.

And that's also why taxes on the rich will – in fact must – stimulate the economy. If you tax a rich person his lifestyle won't suffer. He's still going to eat lobster, and he will just take the tax bite out of some small part of his paper economy. That's good for the GDP, because the government will spend most of that dollar in the Real Economy. Thus some of the money that was lost to the Paper Economy moves back into the Real Economy, which drives up GDP.

The debt limit crisis, coin seignorage, and inflation

When the government spends more than it takes in, it takes out loans to make up the deficit. This moves money out of the Paper Economy and into the Real Economy, which is good for GDP. But now with the debt ceiling crisis looming, there is a chance that government borrowing will be halted, which would immediately lower the amount of government spending. This would be a total catastrophe for the Real Economy: as government spending is reduced, the "G" in the GDP formula would go down, and the GDP would suffer a staggering blow of titanic proportions.

In the current debt ceiling crisis, some people have suggested that President Obama could use coin seignorage to eliminate the need for more loans. Basically, there is a legal limit as to how much cash the government can print, but there is a big loophole in the law when it comes to coins. The President has the authority to mint platinum coins in any denomination, regardless of how much platinum is really in the coins. So in theory, the President could order up a few small platinum coins with trillion-dollar face values, the money would be credited to the Treasury, and voila, debt-ceiling crisis solved: government spending would stay the same, the "G" in the GDP formula would stay the same, and the economy would continue struggling along at its current anemic pace instead of dropping like a lead zeppelin.

Critics of this idea say that this would be like buying a stairway to heaven: it would debase the currency and cause inflation. And that's true, but it's not necessarily a bad thing – as long as it's done in moderation.

Governments can create money out of thin air, and if the government spends this created money in the Real Economy, that will help GDP, as we've seen. And this will also usually lower the value of the currency, because then more money is chasing the same amount of goods and services. But in the current state of affairs, our industrial capacity is way underutilized, so when the supply side of the economy sees that extra demand, more goods and services can be produced almost overnight to meet it, without (much, if any) extra gross investment. Instead, manufacturers would simply hire an extra shift and make more widgets: employment goes up, GDP goes up, and as long as the economy hasn't been overheated, everyone wins.

Inflation would go up too, of course. But can be a good thing, if the inflation isn't too severe. That's because a most of the government debt (and probably most of your debt, too) is currently being held at very low interest rates. If inflation goes up to a rate higher than the loaned interest rate, the government (and you) end up paying off that debt in dollars that are worth less than the dollars you were initially loaned. In other words, less money is put back into the Paper Economy than was taken out to begin with. So that's stimulative, too.

In fact, most of our WWII debt was "inflated" out of existence in the 1950's and 60's in just this way. And times were good then, economically speaking.

The bottom line: Mint those coins, Mr. President!

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Comment Preferences

  •  Tip Jar (8+ / 0-)

    We are all in the same boat on a stormy sea, and we owe each other a terrible loyalty. -- G.K. Chesterton

    by Keith Pickering on Sun Jul 31, 2011 at 05:01:03 AM PDT

  •  Clear explanations Keith of a complicated topic (4+ / 0-)

    Nice job.

    The banks created a huge amount of money out of thin air when they pumped up the housing bubble. Inflation happened back then but it wasn't entered into official stats because they have a bogus measure of housing costs called owners equivalent rent. "Equivalent rent" is a perverse measure because it doesn't go up when the inflation occurs but it goes up after the bubble bursts when the market is deflating. Former homeowners who had to rent drove up rent prices after the housing market crashed.

    When that bubble burst, it was deflationary. Government debt has partially covered up the hole left by massive housing deflation.

    Our problems cannot be fixed without eliminating some of the personal and private debt. Credit card debt should be eliminated at bankruptcy, for example. The oligarchic financial sector is sucking money out of peoples pockets so fast that it's killing the real economy.

    look for my eSci diary series Thursday evening. "It's the planet, stupid."

    by FishOutofWater on Sun Jul 31, 2011 at 05:19:43 AM PDT

    •  Yes But During Clinton's Multi Reaganomic Bubbles. (0+ / 0-)

      Housing had already blown past 100 year peaks when we were all talking about Lewinsky. There were also the high tech, energy, stock and other bubbles fueling the "good" Clinton economy.

      Image Hosted by

      Even when calculated before the busts, Clintonian Reaganomics left the entire bottom 99% at an apparent dead stop.
      Image Hosted by

      But as you say, even that complete stop was a fantasy of bubble inflation. Once they all popped, we can see that the bottom 99% --or at minimum bottom 95%-- has lost real money ever since Carter.

      We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy.... --ML King "Beyond Vietnam"

      by Gooserock on Sun Jul 31, 2011 at 06:18:47 AM PDT

      [ Parent ]

  •  I actually understood your diary (2+ / 0-)

    and that says a lot about your ability to communicate, given my ignorance of economics.


    "The human eye is a wonderful device. With a little effort, it can fail to see even the most glaring injustice." Richard K. Morgan

    by sceptical observer on Sun Jul 31, 2011 at 05:38:30 AM PDT

  •  Do you know if anyone predicted how (1+ / 0-)
    Recommended by:

    surreal money would get when we went fiat under Nixon? Not that I'm against fiat money. I really don't know enough to be for it or against it. It just seems weird that you can create money to loan out of nothing but you can't make debts return to nothing. Why can't the government buy up bad debts and just shred them? I think they could and I think I know why they don't. It would lead to a lack of reverence for money. I'm back into Jubilee land aren't I? Just make it all go away and start over again.  

    •  ROFL! (0+ / 0-)

      Also, the premise that the government could be trusted to act responsibly strikes me as absurd.

      "Two things are infinite: the universe and human stupidity, and I am not sure about the universe." -- Albert Einstein

      by Neuroptimalian on Sun Jul 31, 2011 at 01:36:08 PM PDT

      [ Parent ]

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