The Gross Domestic Product (GDP) is a measure of the economic activity in a country. Because in modern times innovation has become a permanent feature of the economy, the latter must always expand to keep unemployment from rising. And when the economy expands, the GDP shows a growth which we express as a percentage.
But what is it that causes an economy to grow in the first place? Well, the way things are concocted now - as they have been for decades - is that the money supply is made to increase. It is done in one of two ways or a combination of the two. They are the use of the fiscal tool and/or the monetary tool to stimulate the economy.
The fiscal stimulus takes the form of the lowering of taxes or the outright handing of money to the citizens by the government. As for the monetary stimulus, it takes the form of the lowering of the interest rate by the central bank. This encourages the businesses to borrow and produce more goods and services, and encourages the public to borrow and buy those extra goods and services.
But when you think about it, you realize that the availability of more money in the system is really not the cause for the increased business activity or the resulting economic expansion; the mood of the public and its level of confidence are. The money is only the means by which the level of confidence is raised, the mood is elevated and business is nudged. If this theory is correct, it gives rise to an interesting question which is this: Can we have an expansion that is not predicated on injecting extra money into the economy?
In my opinion the answer is yes, and I show why with this example. If a new product or service hits the market and gains popularity, and if the public clamors to buy it but the government and the central bank refrain from injecting extra cash into the economy, the business activity surrounding that product or service will still pick up.
To make this possible, something happens automatically in the economy which compensates for the lack of infusion of money; the existing supply circulates at a faster rate. The evidence that this is happening is seen in the bank transactions where the cash flow in the current accounts rises significantly, the demand for loans rises at a slower rate and the savings rise at an even slower rate.
These measurements will have to be recognized as a more accurate indicator that money is exchanging hands at a higher velocity than would be indicated by the equation MV = PQ which is increasingly coming under criticism due to the ongoing crisis related to the collapse of the housing market.
What all this means is that we can now decouple the fiscal tool from the monetary tool and not be bound to think of both as if they were inseparable twins. More than that, we should be able to use one tool to do one thing, use the other tool to do another thing and do them both at the same time even though they may look like two contradictory activities.
Let us now do a thought experiment. Assume we lower the interest rate to stimulate the economy artificially. The resulting regime of easy money will encourage the existing businesses to expand and will prompt a few people to start new businesses. This will add to the production of goods and services and thus help expand the economy.
But not every one of these ideas will deserve to stay alive for the long haul. And in fact, the mere presence of shaky businesses in the system has always been instrumental in feeding the inflationary pressures that develop into a bubble. These businesses stay alive only because the high tide of inflation lifts all boats and in return they nurture the high tide.
If nothing is done to remedy the situation, those ideas will linger on as long as money is easy to have. So we face a dilemma; if we change the easy money regime we kill the expansion of the economy, but if we do not change the regime, the inflation or the bubble will damage the economy and kill the expansion. What do we do?
Faced with a similar situation in the past, the decision has been to fine-tune the economy but this course of action, if it worked at all, worked for a short period of time after which the economy inflated. So the question now is this: Can we find a way to have it both ways? That is, can we maintain the economy in the expansion mode more or less indefinitely and still avoid the inflationary pressures and the dreaded bubble?
I believe there is a way. By mentally decoupling the two stimuli as we have, we created a new tool that can help us achieve that goal. What we do is keep the interest rate low but raise the taxes either selectively or across the board. The rationale is this. The low interest rate will encourage entrepreneurs to come up with new ideas and realize them, and it will encourage the public to consume the fruits of those ideas.
But if any of these ideas are shaky, the high taxes will not allow them to survive longer than they should. This course of action, though painful at first, will prevent inflation from spreading and will maintain the economy in the expansion mode. New business activities will come into existence where new businesses will be incubated to replace the dying ones.
The principle around which this approach must be designed is that the money supply should remain steady or grow at no more than 3% a year as suggested by Milton Friedman. Thus, the government will have to watch the growth of the money supply and adjust the taxes to siphon off at one end of the pipeline the extra money that goes into it at the other end due to the low interest rate.
And because the money supply will remain more or less steady, money will automatically circulate faster and thus maintain the economy in a state of expansion. The net result will be that we will have it both ways; the expansion we want without the inflation we dread.
There is now the question of what to do with the money collected through the extra taxes. I here presume that the government will be enjoying a budget surplus in which case three priorities should be set up. The first is to pay the foreign debt. The second is to pay the local debt. And the third is to destroy the rest of the money.
That last point is based on the notion that there should be no money floating out there which is not someone’s debt that is backed by an asset equivalent to its value or better. And we will know this point has been reached when the destruction of the money begins to raise the value of the currency. And this will happen because the removal of money from circulation will have the same effect as a company buying back its own shares on the stock market.
And this is why the destruction of the extra money should be set as the last priority lest you pay the debt with a high valued currency.