The economy 101: Trade, Capital Money Flows and Government spending (in terms that I can understand
I thought I’d go a bit off piste today, what with the current crazy world we live in, I over the past week have found myself thinking about the economy lots and what the future may hold. I should firstly say that I am no expert in economics. For a very long time I would listen to the news and feel fairly embarrassed that I did not really understand what was being discussed, I understood the gist but the specifics on GDP, deficits, capital flows, what caused the crash all went straight over my head. I’m sure that there are a few people who will find this incredible, how ignorant! But where are we actually taught about this stuff, certainly not at school. This post is therefore a very basic explanation on our economy, it is not exhaustive but it does give an overview and will hopefully help a few people understand some of the very relevant discussions happening right now.
Our economy is an extremely fine balancing act which is made up of, in its most basic form, money being put in and money being taken out. Just like our own finances the money going in and the money being taken out needs to balance. That is to say; if I spend more money that I earn, I end up in debt. For example, I love to buy new clothes and do so as much as I can. I can’t help it I just really like pretty things. Each time I buy something new I am reducing my own bank balance and passing money onto other people, who will in turn spend that money on things; this is me injecting money into the economy. I also save some money each month which although is good for me because it means I’ve got a back-up plan in case I lose my job, from the economies point of view its actually money that is now sitting (what might as well be under the mattress) and not being passed on for others to spend, therefore this is money being taken out of the system.
If we add the element of geography what we get is goods and services being made in the UK and goods and services being made elsewhere in the world. Using my clothing example from above, when I buy a new pair of hunters wellies so I can look all fashionable at the festivals (I have actually never been to a festival), I am putting money directly back into the UK economy because Hunters are made in the UK. When winter comes however and I want something a bit warmer I can go ahead and buy some of those super cozy Uggs that everyone now has (I am so down with the kids it’s insane). The problem is that Uggs are made in Australia (Straya for those born over there). So by buying Uggs I am not putting money into our economy but into the Australian economy.
This is what people are talking about when they talk about the trade deficit. It means that as a country we buy more stuff from abroad than we make here in the UK and sell abroad. That is we send more money overseas than they send to us….putting the country into a position of debt. If we sold more things that we bought and imported we would have a trade surplus. It is a fact that the UK has had a large trade deficit for a very very very long time. You only have to look around your house. Try to find 10 items that were made here in the UK. Even if you manage to find 10 I would bet that you have hundreds that come from abroad, coffee from Ethiopia, fruit from Brazil, furniture from Sweden, beer from Germany, clothes from India and every electrical under the sun from China.
That is not to say that trade is a bad thing. In fact trade is a great thing, it means we can buy things at more reasonable prices, buy things we otherwise couldn’t, improve relationships with other countries, and remember we do still sell a lot to other countries which brings in a lot of money to our UK economy.
The second major element to the economy are capital money flows in and out of the country. This holds the exact same principal as the goods and services (money in and money out) except it is concerned with financial products. For example, pensions are basically a pot of money that you contribute to which someone invests for you to help increase that pot. Where they invest that money will be across a whole bunch of places to avoid the all eggs in one basket problem. Much of the time at least some of that pot will be invested in developing counties because they can offer a greater return on investment and other parts of the pot will be invested in very stable companies, say American tobacco because it’s seen as a pretty safe bet. But both of these examples are investment outside the UK and therefore sending money out of the UK. On the flip side the UK has one of the strongest financial markets in the world and so other countries are constantly sending money here to invest in our banks, businesses, financial products. This investment from other countries is so much in fact it not only counteracts the money we invest elsewhere in the world but also re-balances the negative balance we would have been left with by buying more from abroad than we sell. That’s right, we may hate to admit it but our banking world contributes a huge amount to balancing our books.
Of course this is a simplistic view of the economy, throw government in the mix and it gets more complicated still but the principals are the same. We pay taxes which pay for services and benefits. If the taxes do not equal the amount we spend on services and benefits then the government runs out of money. This clearly does not happen in the UK and that is because we are seen as a very safe and stable country; why does that matter? It matters because people will in effect loan the government money (by buying government bonds) knowing that at any time in the future they can get their money back with a small return. This kind of investment is for the very risk averse person, it’s a lot like putting your money in a normal savings account. Unlike savings accounts which since 2008 have not really paid any interest, a government bond would have given you a little bit more but it’s just as safe as the savings account. In comparison and at the extreme, you would not buy government bonds from a country where there is a lot of political instability, where a dictator is in place or where the country is potentially going to be in civil war because who knows if you’ll get your money back.
So what does it all mean for us all as individuals? Well the UK government does in fact spend more than it earns, quite a lot more. Which is not too much of a problem because we are that safe, stable country where people are happy to put their money into for safe keeping. When something happens that upsets the stability of the political situation in the country, something like an unexpected referendum result, people get nervous that we might not be quite as safe as a savings account anymore. I’ve been talking about government bonds in particular but the same principal goes for UK businesses (a topic for another post). Rather than being seen as a very safe place to put your money the UK is seen as less so and therefore investors begin to withdraw money. The problem is all this political stuff makes people nervous. They don’t know what’s going to happen any more than we do and human beings are inherently risk averse. Therefore rather than take the risk and keep putting money in the UK, the sentiment is I think I’ll just put it somewhere else for safe keeping. This all basically means the government has less money to play with, that’s less money to fund the NHS, less money to give to people on disability benefits, on unemployment benefits on any kind of benefits in fact. Less money for anything that the government currently spends on. The answer is one of two things (or possibly both): increase taxes to get the money from internally or spending cuts to reduce the outgoings.
Now there are many other things that can be done which will impact the situation but that is for another post. I hope you found this helpful/interesting, if it was all a bit too serious and boring feel free to brows the other blog posts on sailing, travelling and my calamity prone life as an amature boat renovator.
