A traveler walks into a small hotel in a small town, places a $100 bill on the counter, and asks the innkeeper to view a room that he might stay in for the night. The traveler goes upstairs to look at the room.
The innkeeper picks up the money and immediately goes to the town carpenter to pay his debt for repairs to the hotel.
The carpenter takes the money to the local grocer to pay his bill for food and supplies. The grocer, in turn, goes to pay off his debt to a traveling salesman from whom he bought goods for his store. The salesman goes to the innkeeper and pays his bill for the room he has been staying in while visiting the town. The innkeeper places the $100 bill back on the counter.
The traveler comes back from viewing the room, picks up his money, tells the innkeeper he will look for another hotel, and walks out the front door.
That story illustrates some of the basics of economics.
Notice first how borrowing and lending creates money and economic activity in an economic system, but without an actual increase in the money supply. There was not a central bank and its printing press needed to create the $400 of transactions among the innkeeper, carpenter, grocer and salesman.
While we are so often told about the “evils” of debt, without borrowing and lending, an economy could only grow as fast as production. The innkeeper would have to wait for a customer before having the carpenter make repairs. That would also slow down economic activity for both the grocer and the salesman.
Instead, lending allowed all these economic participants to produce and create wealth before the traveler walked into the hotel. Of course, if the hotel never had any future guests, the debt would be a problem for the town’s economy. Yet, even if the hotel defaulted on its debt, the carpenter could seize the hotel’s assets in payment for what he was owed and then pay his bills.
That is why governments should not be allowed by law to borrow money, because a government does not make enough income to pay its debt but must feed off the wealth creation of the people through taxes. If a government defaults, there are not any assets to take in lieu of
the payment.
The negative side of debt from this story is that all the debt was paid off without any increase in economic activity or production, except from the original debt and subsequent transactions. Had the visitor stayed the night at the hotel, then the town’s economic output would have increased. The innkeeper only “borrowed” from the traveler, and then was fortunate enough to immediately repay his loan.
That is what is happening in the global economy now. “Poor” countries have been borrowing from “rich” nations to pay off past debts to those same rich countries without any increase in total economic activity or wealth. Interestingly, countries like the Philippines that are increasing their economic activity are neither borrowers nor lenders and effectively are not part of the system anymore.
Another concept this story shows is the velocity of money (vm), the number of times a “piece” of money is used for transactions that create economic activity. In this case, the amount of money in the town’s economy was $100, but there were $400 worth of transactions with a vm of 4.
No school of economic thought likes this concept of velocity of money because, from time to time, it disproves their theories.
During optimistic times, people spend and the vm goes up. In 1997 the US’s vm was 2.2. Now, it is near a historic low of 1.6, showing that people are scared and hoarding cash rather than spending. The Philippines’s vm has been either slowly increasing or steady since 2009, as the economy continued to grow.
Velocity of money, in addition to reflecting economic activity, also mirrors general liquidity in the system. This is important not only for the stock market but for all other cash placements, like real estate, and for business expansion. For example, in all businesses, profits are important but cash flow is critical.
If a country is not experiencing a favorable vm, it is difficult, if not impossible, to experience sustainable economic growth.
Credit and money supply must expand. But without also showing a stable or increasing vm, you get an economic situation like the US, Europe and Japan are having. Be glad you’re Filipino.
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