Wide Angle 50 - How an Economy grows and why it crashes - Part 2

  Continuing the story of Usonia. Before that, the minor matter of having completed 50 wide angles – self pat on back. Last time, we saw how Usonia was all out of fish in their reserves and it was becoming impossible to match the value of the Fish Reserve notes (FRN) to actual fish since there were none left.

Sinopia to the rescue:

                The Fed was out of fish and the senators and current chief Lindy B met to discuss the way forward, some senators suggested they tell the truth to the islanders which was obviously not accepted. Lindy asked the brilliant economist Ben Barnacle to take over at the bank. Ben suggested inspiring confidence among the citizens by spending more FRNs so that they could start spending again – if needed, they could drop FRNs from palm trees. No one could figure out how to spend more when the problem rose from spending too much but they all kept quiet since they didn’t have Ben’s economic training. Fate intervened though, one of the island’s ambassadors from a far flung island called Sinopia brought some strange looking people with him.

                In Sinopia, the citizens still fished entirely by hand and they were ruled by an all-powerful king. In Sinopia, all citizens were required to fish but their catch did not belong to them. Instead, the fish were turned over to the king who then decided which subjects deserved how much. In this system, the king and his court dined on ocean delicacies while the average Sinopian got by on half fish per day. Much like Usonia before the first development of capital, Sinopia had no savings, no credit and no business. From the Usonian perspective, the Sinopian economy was stuck in the dark ages.

                What the Sinopian king had decided was that since the Usonian economy was prosperous he wanted the same level for his island. He also concluded that since the FRNs were used as money across the ocean by all so possessing them was a good thing. The Sinopian ambassador offered fresh fish in return for FRNs to the Usonians. The senators were overjoyed and the deal was struck. On asked by the ambassador whether the FRNs would always have real fish to back them, Lindy assured him, “Just look around, do you think we are short of fish?”

                The deal went ahead, each day, fresh fish filled canoes came from Sinopia which were exchanged for canoes filled with FRNs. The technicians of Usonia used these fish to replenish the Fish reserves at the bank and use them to prop up the currency. The Sinopian king did not know what to do with the FRNs so he decided to order the nets that Usonian manufacturers made so well to improve the efficiency of the Sinopian fishing. The rest of FRNs which was essentially trade surplus he left in the Fish Reserve Bank since Sinopia did not have a banking system.

                The transactions brought a boom to Usonia because of the foreign demand as well as deposits of Sinopian fish swelled the availability of credit. Even though the Usonians were spending more than they saved, there was still plenty of fish available to lend at low rates of interest. With plenty of real fish to add meat to bones of official fish, Usonia’s problem of fish-flation disappeared. With plumper fish, prices stopped rising and living standards rose again.

                The Sinopian king also added some incentive to his people so that they would keep fishing – those who purchased nets from the king could keep all the extra fish they caught. This resulted in an increase in the Sinopians’ daily fishing activities. They accumulated savings and expanded production. As a result, Sinopian entrepreneurs were now able to build factories to make other goods like spoons and bowls. Even though most Sinopians still lacked these things, they sold these goods back to Usoina for more Fish Reserve notes.

Service Sector steps up:

                The influx of Sinopian savings pushed down interest rates and the Usonian entrepreneurs came for loans for companies that required local workers to deliver a service since these jobs could not be outsourced and were less capital intensive. Celebrating this, Ben Barnacle explained that the Usonian economy had developed to the point where the lowly process of fishing and production could be relegated to poorer economies leaving Usonians free to pursue more sophisticated service sector jobs like chefs, storytellers, tattoo artists and the like. Evidence of this was the descendants of Charile who opened Surfing universities across the island striking a deal with Sinopian producers to manufacture the boards there. The activities like surfboard design and surfing instruction remained at home.

                The Usonians were now specializing in consumption while Sinopians were striving hard to work and save for a better future where they could stop fishing and live off the FRNs. Ben Barnacle theorized this by saying that Usonia had a comparative advantage at consuming and this was a great benefit to the entire ocean. The optimistic, can-do spirit of Usonia meant that their citizens never feared to spend as a result other islands could outsource consumption to Usonia. On the flip side, he explained that the Sinopians were considered best at generating savings and manufacturing products. Therefore it was more efficient to outsource production to Sinopia.

Fish Window closed:

                The other islands began to get wary of the acceptance of FRNs which was enhancing Usonia’s economic powers especially Bongobia. Chuck DeBongo, the charismatic leader of Bongobia started to send more and more of his financial agents to the bank’s fish window to exchange his notes for real fish. When those withdrawals started to make a real impact on the fish reserves, official fish started to become smaller again and fishflation came back. To prevent this, close the bank’s fish window to foreign depositors. From now on, the value of FRNS on the international market would be determined by what someone was prepared to trade for them, not because they could be redeemed for fish. In truth, the notes’ value would hang on Usonia’s status as a great economic and military power.

                This caused some flutter among islands who started to sell of FRNs but since the FRNs were a favoured mode of transactions across the ocean, the fall stabilized. The currency crisis was over, fishflation was under wraps and FRNs maintaining their status despite closing of the fish window, the Usonian economy settled down. A few years later, a boost to prosperity was provided by election of Roughy Redfish to senator-in-chief. He lowered taxes, rolled back burdensome regulations on business and reduced trade barriers. However, he failed to reduce government spending – the gap between what Senate spent and what it raised in taxes continued to grow.

Hut glut:

                We now enter familiar and recent territory. For generations, owning a hut was considered a dream on the island and people bought huts after saving for a lifetime paying cold, hard fish. Over time, banks started making hut loans to the island’s more secure borrowers. These loans had an underlying security which was the hut itself, if the buyer could not pay back, the hut could be sold. Some islanders resented the fact that access to hut loans was so unequal. The wealthy usually got loans easily while those who had no savings or poor credit were being denied. Sensing a potent campaign issue, the Senate got into action.

                Senator Cliff Codd argued that hut ownership was at the core of the Usonian dream and he mandated creation of two agencies – Finnie Mae and Fishy Mac to buy hut loans from the bank. These loans would be ultra low interest and with little down payments. The hut buyer would then pay back the agencies directly. The bank would immediately get back its money which it would use to make new loans and be rewarded a generous fee. With the Senate guarantees in place, the bank dropped interest rates as it no longer needed extra revenue to protect from default.

                Another agency, Sushi Mae was devised to underwrite loans for youngsters wishing to enrol in surfing school. With easy access to Sushi Mae loans, tuition fees were increased aggressively without worrying about pricing its customer off the market. Soon, tuitions began rising much faster than the overall rate of fishflation. Most economists assumed that the higher prices were reflective of the increased social value of a surfing degree. In a few years, surfing school tuition became one of life’s most daunting costs.

                Due to low interest rates, demand for huts rose astronomically and the peripheral industries like hut decoration etc. grew too. So did prices of huts and this resulted in a hut glut. Everyone hailed this as a revolution and a period of tremendous economic boom  followed with the huts at the core of the whole mania.

Hut rut:

                Even more familiar and more recent territory. One particular luxurious hut complex called Crater View condos went unsold because of high prices. Suddenly, everyone began to sell which resulted in an over supply of huts in the market and prices plummeted. Finnie and Fishy crashed leaving a pile of useless loans. The senators and chief George Bass and then Barry Ocuda tried to raise customer confidence by providing stimulus packages – they wanted to get customers spending again buying houses in fear that falling prices would mean a deteriorating economy. This of course did not work because the prices were beyond anyone’s reach and hence no one was buying, however more incentives were given to buy. In addition, Ocuda decided to transform the economy by adopting Llama based carts (which were thought to be less polluting) and re-laying the paths across the islands for Llamas to boost the economy. Nothing worked and the economy remained in a rut.

Sinopia wises up:

                Sinopians were still working very hard and producing things and savings but they barely had a life. The Sinopian king was made to realize this by a simple farmer – why not use the goods we make and fish we create and trade them inside the island thus satisfying our own needs instead of going after worthless FRNs. The value of FRNs was only because of Sinopian fish and they had made the products too so all they had to do was trade their goods for real fish.  The king agreed and decided to stop trading fish with FRNs.

Fish hit the fan:

                As the fish supply dried up, fishflation came back and when the fish disappeared from vaults, the island returned from where it had started  -  no savings, no credit, no investment. The senators were arguing on how to stimulate the economy but no one had an answer what they could stimulate it with. Suddenly, they saw Sinopian ships coming towards the island. Everyone was overjoyed that the Sinopian fish were now available but what the Sinopians simply did was bought everything on the island with their FRNS and real fish. Since no one on Usonia had any real fish, the Sinopians could outbid everyone, while leaving they left behind the worthless FRNs.

                The senators surveyed the devastation and wondered where it had gone wrong. They had spent so why did the economy not grow. Finally, it dawned on them, it was simpler than they thought. Addressing the population still looking for answers, Senator Ocuda uttered the most honest words any politician could say ,”Does anybody here remember how to make a net? I think it is time we all went fishing.”

Analysis:

                This Wide Angle was not meant for my own thoughts since the story itself says so much. However a few parting thoughts – an economy is quite similar to a home. You cannot spend more than you make. You can only spend inside what you earn. You save and then invest thus improving what you do and also to earn more and pave for a better future. That is the same for a country. Governments often get into trouble by spending more than they have. When the gaps get too big, difficult choices arise.

                One is to increase revenue by raising taxes, which is quite unpopular. Another option is to cut government spending like subsidies, bad loans, expenditure on salaries etc. Politically, this is more difficult than raising taxes since no government wants to give things up and the affected parties vote. To avoid these unpopular options, governments choose to default i.e. tells its creditors that it cannot pay the full debt. The fourth and often favoured option is to inflate money i.e. simply printing more notes that pays the creditors but what they get is not worth much. Inflation is simply a means to transfer wealth from anyone who has savings in a particular currency to anyone who has debt in the same currency.

                Another peculiar problem for the US is that its citizens are not saving but taking loans – the savings are being done in developing countries like China and India. The reserve status of the dollar is basically helping keep this imbalance of trade afloat. Like it happened in Usonia, this arrangement is going to break some day and the resulting crash will be devastating – it started in 2008 but the stimulus provided by the administrations has delayed the pain.

                Closer home, we never had  good policies to begin with because of the whole emotional, socialist, left ward political management of the economy. There was brief hope from 1992 to 2004 when successive governments committed themselves to fiscal discipline, disinvestment and reducing subsidies. However with the “aam aadmi” government back, we have seen the worst of economic decisions like NREGA, loan waivers to farmers and almost no reform. What we are seeing is results of that mismanagement, inflation rate nearing two digit (remember inflation was at 3% around 2003-2004) and economic problems for everyone. The sad fact of India is that these things are not even remotely close to discussion in anyone’s minds, they should be because it is your taxes and economic potential that is being mismanaged and it will bite you in one way or other in the future – in the past, one had Western countries to escape to, that may not be such a great option anymore since they are in a Usonia like situation themselves.

                Finally, the voice of the free market advocate is generally a lone cry in the dark since despite being simple, these concepts are technical and more difficult to grasp than emotional statements like “there should be no poverty, garibi hatao” or “aam aadmi ko kya mila”. This book and this column are representations of that lone cry, hope someone hears it.