Why the G-20 plan is plain hogwash

“In times of change, learners inherit the earth, while the learned find themselves beautifully equipped to deal with a world that no longer exists.” —Eric Hoffer

“So we are finally going to save the world, eh?” she said, with a cup of coffee in her hand.

“Save the world?” I asked, putting my overtly sweet cup of coffee on the table.
“Yeah. The Group of Twenty (G-20) which met in London recently has announced a $1.1 trillion stimulus for the International Monetary Fund (IMF) and other international institutions.”

“So?”

“I feel that money will rescue the world.”

“You know what. You are talking like a politician who feels that just by allocating money to a problem, a problem is solved.”

“What do you mean by that?”

“Well. First, the $1.1 trillion is not all new money as it is made out to be. Around $600 billion of it has already been committed, long before the announcement. So the real plan is of the size of $500 billion and not $1.1 trillion. To get this new $500 billion, the IMF will print $250 billion as special drawing rights, its own form of currency. Of the remaining, China has said it will chip in with $40 billion. No one really knows where the remaining money will come from. From what I have read in the media, the US will chip in with a major share.”

“You sure keep track of things. But why did politicians come up with $1.1 trillion, when the fresh money coming in is less than half of that?” she asked.

“At times, it is very important for politicians to come up with a big number to show the world they are doing something. To give you a sense of proportion, it is nowhere near the $14 trillion the US has spent trying to get its financial system up and running again. Or take the UK, whose external debt stands at nearly $9.6 trillion, a large part of it spent to rescue the financial system in the country.”

“What are you trying to say?” she interjected.

“That if such huge amounts of money barely made a difference to their respective economies, the chances of the G-20 stimulus making any are rare. To elaborate, unemployment in the US reached the highest in 25 years. In March, companies axed 6.63 lakh workers, taking the number of unemployed to 1.3 crore or 8.5% of the total workforce. In the UK, unemployment has risen to its worst since 1971, with the number of unemployed reaching 2.03 million at the end of February.”

“But what is the link between the financial system and the job losses?”

“It’s like this. Countries have been rescuing banks so they can continue to lend. When they continue to lend, people continue to borrow. People continue to borrow and buy goods that companies make and services they provide. This helps companies earn money and thus keep people employed. The fact that companies are firing people means they are not earning enough, which in turn means that people are not borrowing and banks are not lending. This is despite the fact that governments the world over have pumped money into these banks.”

“But why is that happening?”

“The reason is psychological. When people see others around them lose jobs, the first thing they do is start saving for the rainy day. Economists call it the “paradox of savings.” As Bill Bonner, an economist and an investment letter writer, wrote recently, “When an economy goes into a downswing, people save money. This causes prices to fall… making savings more valuable. Then, people save even more. Instead of circulating, money goes into pockets, vaults, and mattresses; saved for a rainier day… and lower prices.” Banks don’t lend because a large portion of what they had lent over the last few years has gone bad. And they don’t have enough confidence in people returning the money they lend. So basically, money does not have enough velocity these days and so any plan that assumes people will borrow and spend money, will not work.”

“What do you mean by money not having enough velocity?”

“Let us say you earn Rs 50,000 per month. You save Rs 20,000 and spend Rs 30,000. Now, this Rs 30,000 is an income for a group of people. They in turn save Rs 12,000 and spend Rs 18,000. This Rs 18,000 is income for another group of people. And so it goes on. Basically, your spending creates income for others. In a scenario like today, you might decide to save Rs 30,000 and spend only Rs 20,000. This means income that others derive from your money will go down. So the velocity of money will come down, which in turn means companies will earn lesser money, which in turn means more people will be fired, and which will further lead to lesser money being spent. This is a clear case of where rational decisions at an individual level lead to an irrational decision at a broader level.” 

“Very interesting. I think I should start saving more. But tell me something, where is the US going to get the money for the G-20 plan?”

“Very good question — given that the US owes the world a lot of money, where will they get this money from? But the answer is straight forward — they will print it.”
“Oh, simple indeed. Tell you what? I have been thinking on a rather fundamental point. Most things sold in the international market are ultimately related to the US dollar. Be it apples, gold or even oil. Everything in the world is linked to the dollar. But what is the dollar linked to?” she asked.

“Think it over some more,” I said. “Oh, my coffee’s gone cold.”

(The example is hypothetical)
References: The Dollar’s Days are Numbered,
Bill Bonner, www.dailyreckoning.com, March 30,2009; Humpty-Dumpty Fiat Sat on the Wall….You Know the Rest!, Rob Kirby, www.news.goldseek.com, April 3, 2009; Brown’s illusory G20 deal, Fraser Nelson, www.spectator.co.uk, April 2, 2009.