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A Simple Guide to Understanding the World's Economy

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A quick guide explaining how the world economy works for people who have questions like, "How can governments just print money?"

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As the coronavirus is tightening its grip on the world, more and more countries are turning to ‘lockdowns’ where there is a complete restriction of movement.

In some countries, the only movement allowed outside of your house is going to buy groceries and get medication. That’s it.

Today was our 18th day (out of 35 — originally 21) of lockdown. That means aside from supermarkets and pharmacies, and the associated supply chains, all economic activity has come to a standstill.

No money is passing hands aside from what we need to live — food and healthcare. Some businesses have continued to operate, with their employees working remotely, and their services being offered virtually. For some businesses though, that’s not possible. Your genuine small businesses are the ones that are feeling the brunt of this.

Your neighborhood hardware store. Your favorite corner pizza place. The family-owned boxing gym.

So, what are the respective governments of the world doing to keep these businesses alive? Well, they’re giving away money.

For simplicity, we’re going to refer to the USA for the remainder of this article. The US government has announced relief packages for small businesses. Through the Small Business Administration (SBA), the government intends to distribute $350 billion in relief for businesses with less than 500 employees.

This is part of a larger $2 trillion relief fund proposed by the government for those affected by COVID-19.

But, there was no portion in the US Federal budget for small business rescue packages to the tune of $350 billion.

So, where is that money coming from?

That question, which is on a lot of people’s lips, sparked the motivation to write this article.

This is intended as a guide to anyone looking for some insight into how a country’s economy works, a brief overview of the world economy, what ‘printing more money’ does to your economy and what the world might look like in the post-coronavirus era.

We’ll be looking at terms like:

  • Inflation;
  • A recession;
  • Prime interest rates;
  • Macro and microeconomics;
  • Big Mac Price Indexes and more.

Ready to learn more about how the world economy works? Let’s go.

World Economy

To start off, we need to ask the question of, What is the economy, actually?

What is it?

At its bare-bones, the economy is the way people use their resources.

There are two types:

  1. Macro-economics: Economics in a larger context, for example, the US economy. This is the primary focus of this article.
  2. Micro-economics: Economics in a smaller context, like within a business.

Looking at the world economy is a study of macro-economics.

So, the world economy is essentially the way all of our respective country’s economies interact with each other to trade resources.

I’ve got coal, but I need apples. China has apples, but they need lemons. Turkey has lemons, but they need coal. The trading of resources allows the world to function in harmony. Well, relatively.

Any good or service that crosses a countries borders is part of the world economy.

Exchange Rates

As you have poor and rich people within a society, you have poor and rich countries.

Generally, the richer the country, the more valuable it’s associated currency is — and vice versa. Politics also plays a role in valuing a country’s currency.

If you have a resource-full country, but a very poor government that doesn’t allow for efficient extraction of those resources, your currency may be devalued somewhat.

A rich country becomes rich in one of two ways:

  1. Inherent resources within the country’s borders that other countries want, and
  2. Creation of resources that other countries want.

One way of valuing how valuable your country’s currency really is is through “purchasing power parity”. It’s a way of comparing what one person’s money can buy versus what another’s can.

Using the example of a Big Mac helps make it more understandable — and drool-worthy.

Because McDonalds is a massive company with an extremely stable and (mostly) consistent supply chain, the cost of goods around the world should be relatively standardized. By comparing prices of a Big Mac in one country to another, you can get a sense of how over or under-valued the currency is.

Here’s an example: In Russia, a Big Mac is on average 140 Rubles. In the USA, it's $3.99. So in theory, you should be able to buy 35 Rubles for one US Dollar (140/3.99 = Approx. 35). What’s the actual exchange rate? 73,52 Rubles/USD. That tends to suggest the Ruble is extremely undervalued in comparison to the US Dollar. And it is.

Another way of looking at the Big Mac Index. Source: The Economist

Free Market Exchange Rates

The value of a country’s currency was not always determined by the free-market (i.e. what people are willing to pay for it) though.

The US originally based the value of its currency proportionally to gold. So, a certain amount of US dollars could always be equated to a certain amount of physical gold.

This proposed a problem when gold reserves started running low.

The next system which was adopted was a fixed price exchange rate. Governments of various countries would decide what their currency is worth and when you wanted to buy the US dollar as a British citizen, you were forced to pay the going rate.

This soon fell away and gave rise to the free market economy in use today where prices of currencies are based on their economies.

Macro-Economics: Countries

Just as you control the speed of a car by how much gas (throttle) you apply, a country’s economy is controlled by the flow of money. Money is the gas of an economy.

This flow of money is controlled by governments and reserve/central banks. Each country has its own policies for how the flow of money is managed, and these two institutions are responsible for implementing those policies.

The general goal of any reserve bank is these two things:

  1. Promote economic growth — you want to get richer as a country;
  2. Keep inflation in check — more on this later.

The trick is, balancing the flow of money is not a perfect science. In today’s world, measuring economic growth by one metric (traditionally GDP) is an insufficient indicator, but the most appropriate for now.

Gross domestic product (GDP) is closely related to economic growth. It is the sum of the value of the total goods produced and services provided by a country in one year.

The GDP of the United States is $20.54 trillion USD. (2018)

The GDP of China is $13.61 trillion USD. (2018)

The GDP of Lesotho is $2.739 billion USD. (2018)

That means the economy of the US is approximately 8000 times bigger than Lesotho.

Balancing Act: Inflation vs Unemployment

The job of the reserve bank is to control the flow of money into the economy.

Using our analogy of a car, too much money in = the car goes too fast and you risk the engine overheating. But too little money in means the car slows right down and you risk stalling.

The economic equivalent of the engine overheating is rampant inflation.

The economic equivalent of the car stalling is unemployment.

Managing that balance is a difficult one, as policy changes or cash injections may take time to reflect in the economy and that lag in results can prove to be tricky — especially in a democracy where power is often changing hands regularly and policies come and go with new administrations.

Fiscal Policies

Another important factor in a government’s economics is its fiscal policies — the way they generate income and spend it.

Those policies are normally realized through taxation, budgeting, and borrowing. They are the way the government earns, spends and borrows money for a country.

Too much expenditure = a budget deficit. A budget deficit means they need more money and likely have to borrow.

Who do countries borrow money from?

You often hear stats about how many trillions of dollars different countries are in debt. For example, the US has a national debt of $25 trillion USD.

Source: World Economic Outlook (2017)

For a long time, that didn’t make sense to me. Where does a country borrow money from?

One answer is: Sometimes from themselves.

Governments often borrow from their own government departments. For example, in the US, a specific government agency might generate more income through taxation than it needs to operate. It can then loan that money back to the federal government instead of sitting on the cash.

Another answer is: From other countries.

This is where the majority of a country’s debt comes from. Debt to other countries is normally in the form of government bonds.

Government Bonds

A government bond is essentially a form of investment for the person buying it. It’s issued in the government’s name and usually entails that the person buying it will receive interest payments, as well as the invested amount in return, after a fixed period.

When a government wants to borrow money, it can sell government bonds to other countries.

Government bonds are backed by the strength of the economy of the country that is issuing them. So a government bond from the US government is much less risky (and therefore worth more) than a government bond from the Philippines (as a random example).

How government bonds work. Source: IG.com

World Bank

So how does the World Bank fit into the picture?

The World Bank was set up to help alleviate poverty. There are 188 members of the World Bank that contribute to it.

It provides very cheap loans to countries which are intended for the following use:

  1. To alleviate poverty;
  2. To fight inequality.

So, not really a big player in the free-trade world economy. It is an organization set up mostly for humanitarian pursuits.

Economic Movements

So we have a rough outline of how a economy works and what the drivers are behind various economies.

Now, a bit about how those economies grow and contract.

Inflation

Inflation is the rate at which the prices of goods increase year on year. If inflation is 6%, the average rate of price increase is 6%.

A number of factors affect inflation. The two main causes of an increase in inflation is:

  1. An increase in the cost of production of those goods;
  2. An increase in demand for goods.

From point 1, it's evident that commodity prices like oil would have an effect on inflation rates. Another example is an increase in labor costs due to a short supply of labor. This is known as cost-push inflation.

From point 2, when demand is increased and the goods required becomes more valuable, the price is increased. This usually happens in a good economic cycle when unemployment is low and consumer confidence is high. It is known as demand-pull inflation.

Due to its nature, inflation causes the devaluing of money over time. Quite simply, you would need $106 USD in 2020 to buy something that cost $100 in 2019 (using an example of 6% inflation).

In order to maintain the value of your money, you would need to match the rate of inflation year on year.

The central bank in America closely monitors inflation and aims for 2%.

Positive inflation is good. Too much positive inflation is not.

You are probably starting to realize the fine balance that needs to be maintained to keep the system in equilibrium. Too much inflation and the cost of goods can become too expensive for consumers. Too little inflation and your country could slip into negative inflation. Cost of goods decreases which means the cost of production must too, which means lower labor costs, which leads to lower cost of goods and so the downward spiral continues.

What happens then?

Recession

A recession is technically defined as two successive quarters of the reduction of a country’s GDP. So if your economy is shrinking, you’re in a recession.

A recession is bad because if a country’s economy is decreasing in size, but the same amount of people live there, your currency is devaluing, your money is becoming worse less on a global scale, and there is less money going around within the country.

It likely means your government will not collect the amount of tax that’s required to meet its income-generating budget, leading to a shortfall.

What happens when hyperinflation takes hold. Source: Economicshelp.org

A continued recession can destroy a country’s economy. Look at what happened to Zimbabwe as a prime example. Recession leads to rampant inflation in the country’s economy.

Before the switched over to the US Dollar as their main currency, the Zimbabwean Dollar was denominated in notes that got as high as $100 Trillion ZWL (ZWL = Zimbabwean Dollar). At the time in 2009, $100 Trillion was good for a loaf of bread.

Another example is the German hyperinflation crisis in the 1920s.

The Zimbabwean One Hundred Trillion Dollar Note. Source: Bloomberg.com

So, recession — not good.

Remember this: Macro-economic decisions largely have an effect on unemployment and inflation.

What’s Going to Happen After the Coronavirus?

The question on everyone’s lips.

The truth: No one knows.

Anyone who says any different is either lying or guessing.

What we do know is that until the virus has a vaccine, it is unlikely that the world will return to economic activity.

We may be able to operate in less strict conditions compared to national lockdowns, but some scientists are predicting that social distancing may be a norm for the next year or so until a vaccine is ready and available. This makes sense.

If we are to keep the rate of infection at any sort of manageable level, we can’t be going about life as normal and interacting with each other as normal. That means we’re going to be operating at reduced economic levels for a long time.

The current situation is this:

  • US stock markets are in turmoil. Volatility is at an all-time high.
  • Unemployment is at an all-time high with 17 million + claims for unemployment.
  • A huge drop in GDP (Morgan Stanley is projecting 38% for the second quarter).

All of these point towards a deep, severe recession — which some say will be worse than the Great Recession of 2008.

What About Government Aid?

Well, remember that inflation we spoke about earlier? That’s where this comes in.

The thing is, most governments haven’t got a ‘rainy day’ budget that is even close to big enough to help ease the effect of economic collapse this big. So where is the $2 trillion + in aid that the US government is discussing coming from?

Well, they’re printing it.

If you inject a bunch of money into an economy where there are the same (or less) amount of goods and services, there is a sudden increase in demand. That means prices go up.

As an exaggerated example: $1.5 is now required to buy a pre-inflation $1 candy bar. Same item, more money required. The value of your $1 has decreased.

I can hear you thinking, “But what if everyone is saving money, not spending it?”

Great question. It is especially true for the current situation.

Lots of Money, Nowhere to Put It

So let’s say there is now a bunch more money floating around the economy, but there are two things affecting whether people will spend it:

  1. There is very little place to spend it. No restaurants, bars, restricted shopping, etc. means the usual circulation of money is disrupted.
  2. Everyone is wary of the current situation. They are not inclined to spend money when they are uncertain about the future.

So, more money in the economy: Tick.

A place for it to be spent:?

This is the case in a depressed economy. What’s known as the velocity of circulation is decreased. Money isn’t changing hands. If that’s the case, then there is very little to no inflation. The US did this after the Global Recession in 2008.

What this means, is that as we come out of this period, that cash is still going to be sitting in the US economy. A delayed increase in inflation and a decrease in the value of the dollar relative to other currencies is a possibility — unless the total production increases too.

The other option is that the money will be paid for in the future by an increase in taxation from the government. This would need to be closely monitored because too-high taxation can cause an out-flux of cash from the country as businesses and individuals looking for places to keep their money where they aren’t so heavily taxed.

The thinking coming from economics experts is that more aid is better than too little. Rather take the risk of the future devaluing of the currency by injecting more help, than too little.

Too little aid results in a very long road to recovery post-coronavirus. With too little aid, businesses will collapse, consumers will lapse on repayments, everyone will be short on money and things will be very tight when the world returns to normal. When there are no places to spend money, and no money to be spent, it’s a very dark recession-hole to dig yourself out of.