Saturday, 21 August 2010

Money, bank credit and wealth

Money is not wealth.

Bank credit is not wealth.

Wealth is what you can buy with money or bank credit - goods and services. If this isn't immediately clear, imagine a country called Somewhereia which has a population of 10, and produces exactly two things: flour (1000kg/year) and cheese (100kg/year). (The staple diet of Somewhereia is cheese pies). There are 1000 shillings of money in Somewhereia - some in the Bank of Somewhereia and some in cash.

Somewhereia is a dictatorship. The dictator of Somewhereia decides one day that he wants everyone to be richer. So he decrees on the first day of 2010 that the BoS and the retail banks double the deposits in each bank account, and that anyone presenting a bank note or coin printed or minted before 2010 at the BoS can exchange it for two new ones dated 2010, each for the same number of shillings as the original.

Is Somewhereia now wealthier? Clearly not. All that's happened is that a shilling dated from 2010 onwards is worth half a shilling from a date up to 2009. Everyone can buy exactly the same quantity of goods and services as before. If anything, the situation is a bit worse, because people had to put in effort to modify bank balances and take money to the BoS to exchange, when they could have spent that time and effort producing flour and cheese so that they could consume more cheese pies.

Wealth is generated when people produce more goods and services (that people wish to consume). For example, if everyone in Somewhereia works for 9 hours per day instead of 8, they can produce 12.5% more cheese and flour (assuming that the raw materials are plentiful), and so consume 12.5% more cheese pies. Or if someone manages to find a way to waste less flour when producing it, say by pouring it into bags through a funnel instead of just tipping it straight from a large sack, then there is more flour to go round and overall the people of Somewhereia are better off.

It all goes back to the axiom that in order for something to be consumed, it must first be produced, as discussed in an earlier post.

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