Monday, August 23, 2010

Is Modern America Like 16th-Century Spain?

Imagine for a minute that everyone on Earth just had an interesting windfall: every dollar, every euro, every peso and yen and renminbi, just cloned itself. So the total amount of money just doubled instantaneously. Here's the question: is anyone richer?

A moment's thought should convince you that the answer is no. The amount of money has doubled, but the goods that can be bought with that money are no more plentiful. So more money is chasing the same number of goods and services. What we would expect to see is the value of money falling by exactly half, just enough to offset the windfall in cash. At the end of the day, no one is actually any better off.

The situation is a little more complicated when you imagine a windfall in a single nation. There are now two effects we care about: domestic production and imports. More money means that domestic prices will likely rise, for the same reason that they would rise worldwide in the global windfall scenario. But imports would remain cheap, so we would expect an increase in imports. And because domestic prices rose, exported goods become more expensive, and hence exports should fall. As a result, the balance of trade becomes negative: our windfall begins to drain out of the country into other countries.

When you look at 16th-century Spain, that's basically what happened. Spain's New World possessions generated immense amounts of gold and silver - free money! - but did nothing to increase Spain's actual productivity. The results were just as I described: prices of Spanish goods rose, imports went up and exports fell. Spanish gold flowed to other nations. The experts of other nations traveled to Spain to work. The short-term consequences for Spain were largely positive: people were able to consume more and their lives were somewhat easier than they otherwise might have been. (Of course, 16th-century Spain had plenty of problems, too, what with the Inquisition and so on.) The long-term consequences were mostly bad, though, as Spain was left behind by its more cash-starved northern European competitors, and their American colonies, who ultimately leveraged productivity increases into wealth and power on a scale Spain never realized.

So is modern America following the same path as Spain? Obviously we have not discovered a New World filled with riches, poorly protected by feather-clad tribesmen wielding stone weaponry against our armored knights and cannons. But we have greatly increased the store of money in our nation. That volume of money has been sloshing around for over a decade, creating a stock market bubble here, a housing bubble there. Just as in Spain, our balance of trade is highly negative: that money is flowing outward. And just as in Spain, foreigners are flocking to our shores to work.

Here's another crucial link: just as Spain controlled a huge portion of the world supply of the primary currency at the time, so does the United States control the world's reserve currency, the U.S. dollar. In the 16th century, the mercantilist system prevailed, under which your national economy was considered strong if it had a lot of gold and silver in it. These days, gold is a marginal store of value (the total quantity of gold ever mined in the world is about a third of U.S. GDP), but the U.S. dollar can be created in as great a quantity as the U.S. Treasury decides.

It's a common worry that China will stop buying Treasury bonds at some point, and that this will starve us of easy credit. That's a legitimate concern. But the comparison with Spain illustrates an additional long-term danger: that our productivity will be hindered by easy access to cash. The United States is still a far more innovative, flexible economy than Inquisition-era Spain. But why risk it? We need to drain the sloshing overage of cash out of our economy, take the painful lumps that will ensue, and get back to what we do best: producing goods and services for the world.

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