The Exchange Economy, Part II Jude Wanniski February 4, 2005

Memo To: SSU Students
From: Jude Wanniski
Re: The Exchange Economy II

In our theoretical model of the exchange economy, remember, the “consumers” are taken for granted. In order to consume, people must produce. The suppliers of goods -- the producers -- are the primary actors in the economy. Hence, “supply-side economics.” In the barter economy a baker with extra bread swaps it on the spot for someone with extra wine. In the modern exchange economy, there are “intermediaries” who facilitate the exchange.

Imagine an economy where all the bakers live on one side of town and all the vintners live on the other side. In between are the intermediaries. The financial intermediaries buy up all the surplus bread from the bakers and all the surplus wine from the vintners. They are in partnership with distributors, wholesalers and retailers, who set up shop in the neighborhoods of both sides of town to get the surplus bread to the vintner and vice versa. The financial intermediaries can be bankers or brokers, who keep track of the transactions by using pieces of paper called “debt” or “equity.” A “unit of account” provides simplicity in keeping track of the bread and the wine by counting each in terms of a common proxy, i.e., a specific amount of a precious metal, i.e., gold or silver, a piece of paper “as good as gold,” i.e., a dollar, or a piece of paper with no definition in terms of a real commodity like gold or silver.

Debt requires fixed payments of bread or wine with “interest.” The second form, equity, permits payments as the bakers and vintners expand production by adding “capital goods” used to produce the bread and wine. These are riskier because there may be no profits after paying of debts, with no dividends. If there are ample profits, they pay the equity with “dividends.” If, instead of paying dividends they use the profits to buy even more capital goods, the equity may increase in value – if the decision was a good one, thus yielding the owners of that equity a “capital gain.”

There is in this model a government that produces or buys and distributes “public goods,” i.e., police and fire service, mail service, roads and bridges, parks and preserves, armies and navies, health and welfare. The government does this through fiscal policy, levying taxes on the bakers and the vintners and on the intermediaries. The taxes can fall on the incomes the producers pay themselves out of their profits for doing the work of baking bread and making wine or serving as intermediaries. Or the taxes can fall on the dividends paid out of profits or on the capital gains. The government also “regulates” the exchange economy, making sure the bakers and vintners produce good bread and wine that conform to standards of weights and measures and purities, also making sure the intermediaries live up to their contracts and do not cheat the producers or distributors. Taxes also pay for the courts and the prisons.

At least in the last century, the government has also taken on the responsibility of producing the money used as the unit of account and medium of exchange. In the United States, a “central bank” was created in 1913, the Federal Reserve Bank. The “Fed,” as it is called, stands above the private bankers and brokers who buy up the bread and wine and redistribute it. Prior to the 20th century, except for brief periods of experimentation, the U.S. Treasury maintained the unit of account, by requiring that the dollars produced by private banks be convertible into specific amounts of gold or silver. We won’t go into the mechanics of how all this works, which requires a separate lesson in an entire semester devoted to monetary policy. It is enough to say that the government’s management of fiscal policy, regulatory policy and monetary policy each in its own way impacts the exchange economy in positive or negative ways.

In future lessons on tax policy, we will show there is a law of diminishing returns on the amount of taxes that the government can extract from the producers and intermediaries in the exchange economy. That is, there is a point where higher taxes discourage production of bread and wine and the government actually gets smaller amounts of the products with the higher “tax rates.” The same is true of regulation. As the government issues more and more orders to producers that they must do this or do that in certain ways, the producers must divert attention from production of bread and wine and will produce less that is available for taxation. To the degree the regulation is preventing damage to the economy in the longer run, i.e., weights and measures that can’t be trusted or food or drugs that are harmful, the regulation pays for itself.

Monetary policy is also critical, for if the Fed mismanages the unit of account, there are inflations and deflations that force producers of bread and wine to pay out more of their production in the form of insurance against losses to each other.  Paul Hoffmeister of Polyconomics has found that in the years 1946 to 1971, a period when the dollar was fixed to gold, the S&P500 returned 7.5% annually, and since then the annual return has been 5%. In our classical model, we would have to expect much less economic efficiency with a floating unit of account because of the currency risks that transactors in the exchange economy must take.

In the first part of this two-part discussion of the exchange economy, we ended with the following comment about the people who are hurt the worst in the domestic economy “as the unit of account swings from inflation to deflation.” They are, I said, “those at the bottom of the socio-economic pyramid. As the national living standard declines, they are the least able to protect themselves. Inevitably, a fraction turns to illegal activities in the underground economy where the costs of currency changes can be offset by tax evasion. Another significant fraction turns to outright criminal activity, which is why federal, state and local prisons are now overflowing with 2 million Americans, most of whom are black or Hispanic.”

Another way of thinking about this is that in the last three decades, even while the S&P 500 has gone up, the national living standard has not. The rich have gotten richer but those on the bottom of the socio-economic ladder who were living productive lives in the gold era have been making license plates.

Given our metaphor of a town divided into bakers and vintners, when poor tax or regulatory or monetary policies of government become burdens to the exchange economy, there is less bread and wine produced and exchanged, and the citizens who feel the distress the most are of course those who are the least able to operate in distress conditions. Over the years, I’ve asked black and Hispanic political leaders if they could have one thing for their followers, what would it be? Invariably, the answer is “access to capital and credit.” They would like to produce bread or wine (or other goods or services) to earn a living, but the errant policies of the national government will not permit the financial intermediaries to give them capital or credit from the available pool, which has been diminished by the errant policies. If there is no change in those policies by government, the black and Hispanic leaders turn to a second-best solution for their needs, as they must, asking the government to force the financial intermediaries to give them a share of the capital from the limited pool, thus taking it away from more “creditworthy” borrowers. The economic system suffers overall, but under this arrangement at least the pain is shared.

If the economic system suffers greatly, no relief to those on the bottom is possible, even with diversions of capital from those who are more efficient at making bread and wine to those who are less efficient. When there is no capital and when there is no work, those shut out go into the underground economy, out of sight of the tax collector. When even that avenue is closed off, the only avenue left open is crime, the physical theft of bread and wine, or cars or banks.

Are you with me to this point? If not, make a note to ask questions, best done in TalkShop. But now we do take a great leap out of the exchange economy in the United Staes to the entire world exchange economy. Instead of thinking of the both baker and vintner as Americans, think of the baker being an American and the vintner being a foreigner, of a developed country, of a semi-developed country, or of an impoverished country. There are those three examples we will consider.

First note that if the United States changes its tax policy toward domestic bakers and vintners in a negative way, the brunt of the error falls on the domestic producers. The same with a thoughtless regulatory reform that simply benefits one producer at the expense of another, with a political payoff closing the deal. Bakers and producers both produce and exchange less, and as a result some will be forced to postpone a vacation in France or buy a German or Japanese sports car. That is, the world economy is damaged to a degree when producers in the US are damaged to a large degree. “When the U.S. sneezes, Europe catches a cold,” is an old expression that really should note that “When the U.S. sneezes, the world economy catches a cold, with those at the bottom of the world economy getting pneumonia -- perhaps even civil war, AIDS, famine and disease.

It is when the US makes an error in monetary policy that we see the reverse “domino effect.” It is because the United States dollar is at the center of the world’s many units of account that an error at the center is amplified as it moves through the other nations of the world. It is the “key currency,” in which yellow gold and black gold (oil) are priced. The strongest nations in Europe and Japan feel the effects and are hurt by even small swings of the dollar’s value against gold – the little inflations and deflations. But at the other end of the scale, you have the black African nations who are crushed because of the absence of a unit of account that can support their domestic exchange economy. Most of the 50 or so black African nations really are one- or two-commodity producers. This means when the dollar swings a little bit in New York, it can make or break the African economy that is counting on trade within the dollar world economy.

In the middle of the spectrum are economies that are on their way to maturity, hoping to soon join the ranks of the developed nations. Several Latin American nations were in this category at the time the US broke the dollar/gold link in 1971. Brazil and Argentina compounded their problems by monetary and fiscal errors and have dropped into the category of struggling economies. Several Asian economies were doing well in the 1985-97 period when the dollar was more or less stable against gold at $350 per ounce. When fiscal errors by the Clinton administration caused a 10% inflation, with gold going to $385, the Asian central banks followed suit. When the tax cuts of 1997 led to a market demand for dollars that was not supplied by the Fed, the dollar became scarce and the gold price slid sharply, to $330 by mid-97, and the Asian economies were dragged down by the deflation because they had pegged their currencies to the dolla. They had to scramble to reassert themselves. The African nations, with their commodity-based economies, could not pull themselves out of the deflation ditch and a majority remain in dire straits.

It is this hypothesis that led me to assume years ago that there is nothing that would bring greater relief to the world’s poorest economies and to America’s poorest citizens than a fixing of the dollar unit of account to gold. America’s 285 million people would feel a small positive change, the richest of them feeling the smallest positive change, the poorest the greatest. The same would be true around the world. The poorest countries of Africa, Asia and Latin America would not know why, but they would soon realize that it has become easier for them to produce and exchange.

At the margin, there would be less reason for them to kill each other for calories. This is a nostrum I have been advancing for decades. It is one of the reasons I take the trouble of giving these lessons at SSU, hoping one or more of you will one day climb a political ladder to make this happen. All it takes is the signature of the President of the United States on an executive order instructing the Treasury secretary to do so and the whole world will have the benefit of keying off the key currency once again fixed to gold. The smallest effort with the greatest gain. 

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