By: Troy Gold
In part I of this two part series, we defined economic growth more practically – using the simple example of an island economy, we illustrated the practical constituents of economic growth and introduced a handy graphic tool in the Production Possibilities Frontier (PPF), that better portrays the tradeoff we make between consuming and investing.
In part II, we aim to shed some light on the concept of recession and show how gold can be a valuable protective tool in this environment.
Economic growth occurs when we 1) save 2) invest those savings, and 3) produce real goods and services from the invested savings.
The real goods and services are then available to be consumed and enjoyed by everyone, raising the general standard of living for all in society.
It can then be deduced that the foundations of economic growth are savings.
The economy relies on people to save, which practically means deferring the immediate consumption of your salary, in favour of saving and investing those resources.
Savings can diminish in two key ways, namely 1) peoples’ consumption preferences change towards consuming more in the immediate term, or 2) if people are somehow disincentivised to save or even prohibited by law save.
In the first scenario, we will see that a shift in people’s preferences toward consumption causes a move upward along the PPF tier toward consumption, resulting in a smaller shift up for the frontier, or growth, as there is less investable resources available to produce with.
Scenario two is for more dangerous, as it causes unnatural distortions in society’s wants, and can ultimately prevent, or greatly deter prosperity.
Although nearly impossible for central authorities to implement laws that eliminate saving altogether, there are great attempts made at passing legislation that promotes consumer spending and disincentivises saving. Capital gains taxes and prescribed pension assets are some examples.
Ultimately, by far the biggest danger to the accumulation of savings is the slow and insidious erosion of our purchasing power and savings through inflation.
In a prior article (hyperlink article), we explained that when the currency supply is inflated (read: created out of thin air), society’s savings are eroded and lose value. The central authority uses its monopoly power for issuing currency to expand the currency supply in circulation and, in doing so, all existing currency units already in circulation are devalued.
One can then no longer rely on the purchasing power of one’s savings being maintained, and as such, people elect to rather consume their savings in the present by spending on real goods and services instead of saving.
Furthermore, as inflation erodes savings on a societal level, it follows that the savings foundation of economic growth is compromised resulting in ever-decreasing rates of growth, as there is less and less savings to power the production mechanism in the economy. Accordingly, the PPF frontier’s upward shifts get smaller and smaller.
We’ve considered some of the distortions which negatively impact the savings, but what happens when the engine for growth – the production mechanism – is thwarted?
The production mechanism, comprises the two-factor process of investing society’s savings and then producing real goods and services with these saved resources.
More specifically, investing is done with loanable funds in capital market and production is done via businesses. Banks, or the stock market, are good examples of sources for loanable funds, whereas entrepreneurs and their employees form the core of a business.
Entrepreneurs make a living by anticipating which goods and services society wants produced, and then co-ordinate a mix of savings, labour and land – to produce consumable good and services.
Banks, on the other hand, make a living by lending out society’s savings to these entrepreneurs. The bank charges and earns interest on these loaned out funds by way of levying an interest rate – which is the cost of money in society.
The main distortion to the critical pillar of production occurs when the interest rate is artificially manipulated. In a free market, the interest rate is set by natural the interplay of society’s wants and its available resources – this rate then functions as a coordinating tool for savings to be funneled into the correct businesses so as to create society’s most-needed goods and services.
So how then does the manipulation of the interest rate occur? And how does it actually cause the production mechanism to be distorted?
When news networks announce the central banking authority has ‘cuts rates’ or ‘hiked rates’, it means that central authorities have decreed the price of money to be a certain interest rate. The authority’s central banking committee, thus, becomes the coordinating instrument that influences where capital is most likely to flow, instead of the natural market mechanism as explained above.
So, in the event that the interest rate is set below the natural, free market rate, entrepreneurs capitalise on this ‘cheap’ money and tend to embark on long-term business projects like property development, malls, roads, heavy industry. If the interest rate is set above the real rate, the inverse occurs.
However, as we’ve learnt from the PPF graph, investment must always be underpinned by actual, available resources (savings). Accordingly, as an artificially lowering of the interest rate occurs and investment is ramped up, the equilibrium point on the PPF moves outside of what can be sustained by society. The end result is unsustainable growth and malinvestment – investments that weren’t demanded by society and should never have occurred.
This false shift, commonly called a boom, inevitably ends when these misallocated savings are liquidated by way of a recession, or a bust. The interplay between savings, consumption and investment returns once more to a sustainable level – in line with the real needs and wants of the society.
The result: output shrinks and economic growth turns negative. Today, this whole process is commonly referred to as the business cycle.
Gold and Savings
Previously we mentioned that gold can be a valuable protective tool amid a distorted recessionary environment. But how?
Gold is the ultimate store of value, or rather, store of SAVINGS. It has a 6,000 year track record of being the perfect store of a society’s savings, because it’s value cannot be eroded.
If gold is easily accessible to society, and anyone can quickly and conveniently convert their paper currency savings into gold savings, then the integrity of the savings pillar in the growth equation remains sound.
At Troy, we aim to do just that… with real gold, in your pocket.