Tuesday, January 31, 2012

The Economy Stimulus Story

In the midst of the European sovereign debt crisis, I would like to share with you a story that I came across a few years ago about the economy and how it is stimulated through spending. Here's the story:

The story started with a rich tourist came to a town in which everyone
living there was in debt. The tourist put down a 100 Euro note for the hotel owner as a deposit while he went round to check the conditions of the rooms. With the 100 note on hand, the hotel owner quickly ran to pay off his debt – his supplier, the butcher. The butcher received the money and he quickly settled his debt with the pig grower. Next, the pig grower used the receipt to pay off his debt with his supplier of feed and fuel. And this supplier ran to pay off his debt to his creditor - the prostitute, and finally, the prostitute went to the hotel owner and settled her debt with the hotel owner with the same 100 Euro note.

The hotel owner then put the 100 Euro note back on the counter as it was the deposit of the tourist. The tourist decided not to stay and took his money back.

After all these drama, amazingly, the whole town is now without debt and everyone looks to the future with a lot of optimism. In the final sentence of the story, it says: “This is how the United States Government is doing business today.”

“Does the story make any sense?” I’m sure most of you are pondering hard about this story. In fact, I’m truly amazed that this little story has embraced a number of important economic concepts that I’m going to explain next.

First, the story has brought out one major economic theory - the Keynesian mulitiplier theory. The initial 100 Euro note has changed a number of hands, from the hotel owner, to the butcher, to the pig grower … and back to the hotel owner. Starting with 100 Euros, the economy has created 600 euros worth of market transactions. In order for the Keynesian multiplier theory to function, the initial 100 Euro has to be an autonomous (independent) injection in the form of investment, government spending or exports to the economy. In this case, the rich tourist’s 100 Euro note is treated as exports because the rich man is a foreign tourist, the money is considered as an outside independent source of injection to the economy. (For simplicity, I have left out the multiplier formula here)

Next, we come to the most important concept of the multiplier theory that says that the injection of money creates round after round of spending. In other words, the cycle of ‘one man’s spending creating another man’s income’ repeats itself round after round just like the story.

But the story says each of them “pay back” their individual debt, not “spending” as stated in the multiplier theory. I would argue that the spending has been performed before each one received the 100 Euro note, which means they spend first and pay later. Just like most of us are doing now.

So, did the people in the town really get rid of their debt? The answer is “Yes!”

Because during each round of spending, income is created at the receiver’s end. This means that no matter what is the source of income (be it borrowed money or earned money), the economy is stimulated in the form of more economic activities created by the many rounds of spending. As long as the rate money earned is faster than the rate of debt increased, by theory, we can settle the debt. But in real world, most government in the world is building their debt at a much faster rate than the collection of taxes because in a democratic society when the government is elected based on people's votes, the ruling party tends to run into budget deficits.


Hence, this is how most of the governments in the world are doing business today!


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