My Little Island

To give you a very rough understanding of how a monetary system works and how inflation is created lets illustrate a very basic economy for an imaginary world called “My Little Island” (MLI). Only you and I live on the island to begin with and the money supply is $100. At the start I have the $100 and use it to buy a cake from you, and then you in turn use the $100 to purchase some fruit from me.

We have just created $200 “MLI” gross domestic product, and if we were to continue buying and selling from each other the same amount every month the annual GDP for “MLI” would be $2400 from a $100 money supply.

So what that tells us is that GDP is not only how much money is in the system but how fast it moves around too. Trying not to get too technical the equation for this is product equals money x velocity (the average speed the money is spent).

Let’s complicate things a little bit now, let’s imagine “MLI” is booming, 10 factories have popped up, and now the money supply is $1m. Each of the 10 factories does approximately $100k of business per month this would mean “My Little Islands” GDP would be $12m (12 times the $1m monthly production).  Around about this time a banking family “Golden Stash” sets up on our island to help the money supply move more smoothly. The economy is healthy and everyone on the island is happy.

After a few years a couple of senior employees from 2 of the factories decide they know enough about the businesses to break away and go it alone. With their business knowledge, and already possessing a list of eager customer’s, right away they are successful and are producing the same amount of goods as the other factories.

Because the money supply has not been increased but there are 2 extra factories the demand from each has gone down. Overall production is the same, but divided up among more businesses. So accordingly the prices fall and now they are producing approximately $80k each. GDP as remained at around about $12m and to the factories it seems as if “MLI” is in a recession and they begin laying people off and spending less.

To allow the economy to grow and for all the factories to start producing the same money as before more cash needs to be added to our monetary system, but how much? If we were to add too much, let’s say we doubled the $1m we already have to $2m our GDP would then rise to $24m but would that be a true reflection of the economy if production has only grew by 20%? No it wouldn’t, it would be an artificial increase in GDP, and inflation would kick in.

Because there is more money in the system the factories would start producing $200k per month and spending more money on supplies and services. They would start bidding up the prices of what they need and cause inflation across “MLI”, everything from food to energy would rise in price. Too much money flow means it is not as valuable as it was before.

Golden Stash advise “MLI” central bank that only 20% more cash needs to be printed and added to the system to come in line with the extra 20% of production from the 2 new factories. So an extra $200k is pumped into the economy and all the factories start to produce $100k per month again and GDP rises to $14.5m which is a true reflection of the economy.

Very impressed by Golden Stash’s advice we make our biggest mistake and reduce regulations on the banking system, we state because they are experts in what they do it would make sense for them to govern themselves (like anyone would do that right). Again the economy seems to be on the up, and the “MLI” natives are happy and content.

A few years go by and Golden Stash has become mischievous and greedy, they start to make risky investments with the money passing through them. They go to the “MLI” central bank and lay their cards on the table; they have lost $1m of the money through their risky endeavors. They tell MLI central bank that they need to be bailed out, and that if they aren’t production would stop as there wouldn’t be enough liquidity in the market to fulfill purchases and orders by the companies that use them.

MLI central bank are worried and immediately print the $1m to bail out Golden Stash, what does this mean to our little economy? Yes it helps the economy to keep chugging along; money owed can be paid. But what you need to know about investments of any kind is that they are what we call a zero sum game, for every loser there is a winner. The $1m lost originally by Golden Stash has not been swallowed up by a black whole; someone on “MLI” won it, for every one buying an investment someone is selling it and visa versa. So what that means is that the money lost by Golden Stash is still in the money flow.

So by printing and adding the $1m bailout to the system we have effectively doubled our monetary system, we have started the wheels of inflation in motion. Eventually we will have the first scenario; the factories will bid up supply prices, having a domino effect which will increase the cost of everything on our island. The everyday islander whose salary has not increased will feel the strain and happiness and contentment will be a thing of the past.

Now take our “MLI” economy and times it by 10’s of millions of international companies trading globally, a population of billions growing at 1% a year, a money flow in the trillions and bail outs to banks in the trillions too. It is not hard to see why some expert economists are very worried. We may not see it for another year or even longer but eventually it will come. And the problems in the Middle East pushing up commodity prices are only going to speed up the arrival of inflation.

Written by Terry Hunter & Christopher Spiers, Senior Wealth Managers at Faramond Capital Partners. terry.h@faramond.com Contact: 0885006694 or 0898887231