Dec 4, 2008

The mechanics of money

If you have a hundred dollars in your bank account, it is probably not earning interest, and if you leave it there, it will probably earn nothing except the grudging admission of your bank that you are, for the moment, still solvent.

If you take your hundred dollars out, however, and spend it on groceries, something quite amazing happens. The grocery store owner has an extra hundred dollars, he pays off his suppliers with $25 and places a new order, his staff receives $25 in pay which they spend, his wife buys a new dress for $25, the dress store orders another dress, and so on. Your hundred dollars is spent many times over, exactly how many times depending only on the speed of its passing on. Your humble hundred dollars, by virtue of the velocity of money, the speed at which everyone else receives it and spends it, has produced two thousand dollars of spending. This is what happens in a normally functioning economy, a healthy commercial state.

Note that ownership changes constantly. It is no longer "your" hundred dollars as soon as you have exchanged it for groceries (it belongs to the grocery store) but it remains quite clear and trackable (though a hundred thousand dollars would be better for real trackability) that it is the same hundred dollars, constantly changing ownership.

The calculation of a country’s GDP, its gross domestic product, or all the goods and services that country produces, is equally simple: take the total amount of cash in the country, and multiply it by velocity, that is, take all the money being spent on groceries, car repair, payments from abroad, and multiply it by the speed at which it goes round, since the same money can be spent many times over as people receive it and pass it on.

Now imagine that being unemployed, or suspecting that you soon might be, you decide to hang on to your hundred dollars in preparation for possible hard times ahead. Imagine further that the grocery store, noting that sales are slowing down, decides to build up its cash, cut orders to the wholesalers, and lay off some of its staff; imagine that your bank, worried about some unmarketable securities it has on the books from its last president, and unsure whether two or three other banks it deals with might not be going under quite soon, and all loans to them will be lost, also decides to hang on to as much cash as possible; and finally imagine that the government of the country, noting that its revenues are falling, its cities and farms are in trouble and demanding help, and no one is buying what it exports, takes the painful decision to welsh on some of its promises of aid to worthy causes, delays all rebates due, cancels a lot of expensive projects, even wonders about seizing some private assets on dubious grounds, and generally re-adjusts to being a much poorer country, which they are, of course: their GDP, the amount of goods and services produced in a whole year by the entire country has shrunk enormously, and is now much much smaller, most of it no longer being multiplied by anything except one, since its citizens, its municipalities, its financial and commercial institutions, and the other countries that are its trading partners are all tightly clutching their hundred dollars, fearful of the future and suspicious of any attempts to have them spend it.

This is called the credit crunch.

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