The Theory of Money, Part 40

Image credit: Wong Sze Fei

Ok I’m still doing clean up of the other principles and questions to be discussed that didn’t arise using the fictitious society narrative. Last week, I explained what would happen to our money if the government paid off all its debt.

This week, I’ll address two last things.

First, a question that arises as a result of the discussion last week: What will happen if the government suddenly has a large expenditure need and can’t create money at will anymore?

In this case, I think of how individuals prepare for an unexpected financial challenge. For the largest unpredictable and potentially financially catastrophic expenses, they buy insurance. I don’t think that’s an option for a government. Can you imagine a huge insurance company being willing to sell war insurance to a government? Absolutely not, especially because governments usually (but not always) have a fair amount of control over whether they get into a war, so war insurance would almost act like an incentive to for the government to go to war because now their insurance company would be paying for it.

So, aside from getting insurance, how else do people prepare for large unpredictable financial challenges? The individuals with foresight and motivation usually do this crazy thing called saving up an emergency fund. Usually that means saving 3-6 months’ worth of expenses. That way, if the primary breadwinner of the family suddenly loses their job, or if their house burns down, or whatever, they already have enough money to cover the gap in income or the large unexpected expense.

What I’m suggesting, then, is that governments save up for an emergency.

What I think would be amazing is if a government could save up enough that they could continue spending indefinitely by only spending the interest. It would be like a university with a huge endowment. There would be no more taxes!

But, realistically, maybe saving up something like 50% of annual expenditures (equivalent to a family’s 6-month emergency fund) would be a good solution. No politician would be able to convince enough people to forego all their urgent funding requests to ever make this happen, so a requirement to do this would probably have to be written into the country’s constitution. Maybe it would say that the government is required to save 5% of all income every year until it has built up an emergency fund that is equal to 50% of the most recent year’s spending. And the tricky part would be figuring out how to define an emergency that would allow that money to be used and not abused. But when any of that money ever gets used, then the 5% savings requirement goes back into effect immediately once the emergency is over.

But having a fund like that also may incentivize governments to go to war, so maybe there should also be a required war tax implemented any time the country goes to war. That way, the cost of it is felt directly and immediately by the people, so politicians would be more likely to take the unpopular cost of a war tax into consideration when they are deciding whether to enter or start a war.

These ideas probably sound crazy, but that’s only because we’re so used to governments creating money whenever they want. And the two main problems that creates are (1) their spending choices are insulated from public opinion because they’re not directly seen and (2) we pay for the emergency through inflation instead with all its associated costs.

Overall, spending for an emergency through inflation is just such a worse way of doing it, but we’re used to it, so it seems more normal than a government actually saving up an emergency fund.

Second, I want to list a few of the other ways that inflation hurts the economy and slows wealth building:

  • It messes up calculations of the profitability of companies, especially companies that have asset depreciation as a major portion of their costs. Here’s an example. Let’s say a small factory owns a single machine that makes bolts. They bought the machine for $300,000 and expect it to be used for 30 years, making 20,000 bolts per year. They will depreciate the machine by $10,000/year so that it will be fully depreciated at the end of its 30 years. They have other costs of about $5,000/year. If they are selling bolts for $1 each and selling all of them, their revenues are $20,000/year, and their costs are only $15,000/year ($10,000 of which they are putting into their business account because they’re slowly saving up that money they’re counting toward depreciation for a new machine that they’ll eventually need to buy). Pretty profitable! Then serious inflation strikes–100% over a very short period of time–and they are able to raise their prices to $2/bolt. Their other costs also double from $5,000/year to $10,000/year. So their revenues are now $40,000/year, and their costs, assuming they stick with the same depreciation plan for their machine, are now $20,000/year. Now they look even more profitable! Their stock price soars, and tons of other investors start bolt-making companies because of how profitable of an industry it appears to be. But then, at the end of the 30 years when that machine is fully worn out and they go to buy a new one with the $300,000 they saved up (by putting $10,000 in their account every year for 30 years, remember), they find that the cost of a new machine is $600,000 due to inflation. Suddenly everyone realizes that the profitability of the bolt companies are super overvalued because they hadn’t been adjusting their depreciation for inflation! Investors’ decisions were also totally skewed because of the complexities inflation caused in accurately evaluating the profitability of different industries. Which means investments were not going to the highest-potential projects.
  • Long-term fixed contracts become much more risky when the risk of inflation is larger. Businesses usually need large investments to get going or to try new things, so long-term contracts are the foundation of most innovations. But when those contracts are more risky, more of them fail simply because of the impossible-to-predict changes in the value of the money they borrowed.
  • Inflation suspends the market’s punishment of unprofitable firms because everybody seems to be profiting until prices finally adjust.
  • Inflation encourages people to buy sooner than later because they believe things are cheaper now than they’ll be tomorrow. Thus, inflation encourages going into more debt than would otherwise be prudent.
  • It contributes to business cycles, as I have shown already in this series.

All right, I did it. I got through those last two things I wanted to address before moving on (next week) to a few thoughts about how to fix all this.

There are, of course, so many other things about the theory of money that I haven’t even touched. For example, there are theories out there about bankers and their control over governments (especially when it comes to decisions about war) because of their power over money and how much they stand to gain when they finance those wars. And I haven’t covered the different stages in the modern international history of money, including the stepwise abolition of the gold standard, fixing exchange rates, the Bretton Woods Conference, sneaky ways governments have transferred wealth to other governments, etc. And don’t forget about the curious and questionable things the International Monetary Fund and World Bank are doing!

But I can’t. I have to stop somewhere. This isn’t a money blog (believe it or not). The things I’ve talked about were the things I felt like needed to be explained because I wasn’t satisfied with how other writers have explained them. I hope it has been illuminating and that it provides a launchpad for understanding any other money issue out there.

My plan is to write one or two posts on my ideas of how to fix our money issues, and then I’ll get back to healthcare. Part 41 here.

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