Saturday, October 1, 2016

Money series: how commercial banks create money (part 3) - money creation and destruction

In our last post, we have examined on a very high level the four misconceptions that surrounds the process by which money is created by commercial banks.
Now it is time to dive into more details and provide an example of the way money is created when Mr. Smith goes to a bank and apply for a loan of, let's say, 20 k€.

Money creation
Let's imagine that the initial balance sheet of the bank looks like this.

Central Bank Reserves: 1000000
Shareholder equity: 1000000

For the sake of simplicity, we are assuming that the liabilities are only made by the shareholder equity, that sum up to 1M€. This money has been invested into assets for an equivalent value of 1 M€.

Now Mr. Smith steps into the bank and ask to borrow 20K€ for whatever reasons he may have. Let's suppose he needs to buy a new car for his business. The bank checks the financial situation of Mr Smith and grants him the loan.
Here is how the new balance sheet of the bank looks like:

New loan to Mr. Smith: + 20000
New account for Mr. Smith: +20000
Previous assets: 1000000
Shareholder equity: 1000000

Total Assets: 1020000
Total Liabilities: 1020000

We can see some important things, here:

1. In the immediate term, the bank does not need to find the money from anywhere, therefore...
2  ..there is no "lending" here. There is money creation.
3. The only thing that counts is that the bank considers Mr. Smith trustworthy to pay back the debt.
4. Most important: by increasing both sides of the balance sheets simultaneously, by 20K, the bank has created new money and this money is available to Mr. Smith that can spend it in the real economy, improving the GDP (he asked the money to buy a car for his business).

Let's suppose that the loan is for a duration of 2 years and the payment the interest to be paid is 5% year. Let's suppose that the bank is paying Mr. Smith 1% of interest on the deposit.
The margin for the bank is 5-1 = 4%. This spread is the origin of the profit for the bank. So, this is why banks makes money by creating money and applying a spread between the cost of money for the borrower and the cost of money that the bank has to pay for the depositors.

Money destruction
The very first day after he got 20 K€ from the bank in his account, Mr. Smith goes to a car dealer and buy a 20K€ car. Let's suppose that he makes a bank transfer from his bank to the dealer's bank, which is different from Mr Smith's bank. An intermediate balance sheet would look like this.

Existing loan to Mr. Smith: + 20000
Existing account for Mr. Smith: +20000 – 20000 = 0
Previous assets: 1000000
Shareholder equity: 1000000 -> 1020000

Total Assets: 1020000
Total Liabilities: 1020000

Since there is no money in Mr Smith's account, the liabilities entry for Mr. Smith goes to zero.
Nevertheless, he has still to pay his debt. So, there is no change in the assets column. Since Shareholder equity is the algebraic difference Assets - Liabilities, this means that the shareholder equity has increased by 20K.

Now, after one year, Jack can pay his debt to the bank, which is 20K, plus the interest: after one year, the bank got 5% of 20K, which makes 1K, and has reinvested this extra 1K in other assets.

Exist. loan to Mr. Smith: + 20000 - 20000 = 0
Exist. account for Mr. Smith:  0
Previous assets: 1000000
Shareholder equity: 1020000 -> 1001000
New assets: +1000

Total Assets: 1001000
Total Liabilities: 1001000

After one year, there are 19000 euros less. This money has been destroyed.
The extra shareholder equity, 1K€, is the profit of the bank, coming from the interest on the loan, that can be used to pay staff, taxes and the shareholders in the form of dividends.

During this loop of  creation and destruction, money has been used by Mr. Smith to buy a new car, the new car has been bought from a car dealer that has put the money of the sell in his bank account, in order to buy other goods and services on his turn. The process of how money flows from one bank to another is explained by the principle of fractional reserve, that we will cover with detail in a future post, dealing also with the study of what bank reserves are and what their use is for.
The bank has made profits by creating money and giving it to a customer who was believed reliable to pay back his debt. The shareholders of the bank got money thanks to dividends on the interest upon the loan of Mr. Smith.
And the government got money from a percentage of the profits of the bank, that is, again, as a percentage of the interest of the loan paid by Mr. Smith, who works hard in the real economy to pay back the principal and the interest on the principal.

So, in a nut shell, the initial creation of money is, in its essence, a risk management evaluation: is the guy asking for a loan able to repay his debt (principal + interests)?
This risk assessment is done by the commercial bank

Now we can start figuring out one important point: if bankers are skeptical about "lending"money to people and enterprises, you can imagine that on a long run, as long as  interests and capitals are paid back, the overall amount of credit in the economy drops.  This leads to recession. Because of this mechanism of credit creation and destruction, if the rate of credit destruction is higher than credit creation, the bridge between the present and the future (such as credit) is wearing out and we dive into a disaster, since the economy is tied up by the lack of credit. Credit, in the present monetary system for economy, is like what water is for a fish: if there is not enough water for the fish to swim and breathe, the fish slowly dies.

This is the precise reason why Central Banks have started injecting huge amount of easy credit in the economy. Since private banks did not lend, then the Central Banks had to intervene starting from 2008 not to end up into another Great Depression like the one in the Thirties. But this important topic is out of scope of the present post. We will talk about Quantitative Easing and negative interest rate policy in the future.

We conclude this post by saying that lending for productive activities to businesses, like the one of Mr Smith, is only a small fraction of the total lending by banks: on average, they account only for 7% of total lending by banks.

Tuesday, September 27, 2016

Money series: how commercial banks create money (part 2) - common misconsceptions

This article is part of the Money series in this blog.

In this figure, the money created by commercial banks in UK from 1969 to 2014.

The preliminary considerations I exposed last time were just an explanation of the methodology the I follow when I study economics. This led me to demolish some common misconceptions I had..

NOTE: an excellent book that explains how money is created nowadays is "Where does money come from?", by Positive Money think tank. It is not a super-easy book, nevertheless it is a mandatory read for everybody interested in the topic. The theories it carries on are very well documented. 

First misconception: the money that you deposit in a bank is yours. 
We have already covered this misconception in a previous post, extensively.

Second misconception: A bank lends you money when you apply for a mortgage or a loan.
The act of lending implies that you renounce to the possession of something for some time. For example, you may lend 20000 € to a friend of yours, who will give it back to you the next year.
In this case, for one year, you have 20000 € LESS at you disposal.
In the case of a bank, this is not true. Simply, the bank creates money from thin air when you ask for a mortgage. The bank does not take any money from anybody when it puts 20000 in your bank account. When a bank gives you money, it expands the money in circulation, by the same amount of your loan. That is why currently 97% of money in circulation, called M2 money, that is the money that everybody uses, is made of money created by commercial banks. Only 3% of the money in circulation is made by coins and notes, that are printed by the Treasury.

NOTE: this is extremely difficult for an average person to accept. I have done technical studies, and to me the first law of Thermodynamics,  that is , broadly speaking, nothing can be created or destroyed but only transformed, is a kind of basement in my brain. In finance, under current monetary system, it is not like that: Money is created and destroyed by banks.

So, a bank does not lend you any money, it creates money from nothing and gives it to you in exchange for the original principal plus the payment of interests. You and the bank are binded by a contract, for example the mortgage contract, that is an asset for the bank. More on this in a future post.
Remember, in today's world, there is no difference between money and credit, as I explained here.
You may wonder where the money for paying interests is coming from. Of course, on average, if we consider million people and transactions with the pertaining interest rates, it is money created in the future by other banks.

Third misconception: money is created by means of fractional reserve mechanism.
For an explanation of how fractional reserve works, please visit this page.

This assumption is not completely wrong, but it is strongly misleading.
First, it does not explain who creates money first. If you go to a bank and deposit, say, 10000 euros in your account, and this 10000 euros are turned into 100000 euros in the system thanks to a reserve ratio of 10%, you are missing one piece of the puzzle: who gave you originally the first 10000 euros?
Second, banks nowadays have many many ways to bypass the reserve ratio control, so actually it is up to the bank to decide how much money through loans and mortgages they want to inject into economy, and according to this figure the bank sets apart amount of reserves it needs to keep in liquidity to obey the law. It is not the way around, that is it is not the basic reserve that determines how much credit a bank can produce. Theoretically, there is no limit, no ceiling, to the amount of credit that a bank can create.
Third, this model assumes that Central Banks can control the amount of money in the economy, by changing the monetary base. More on this in future posts. This implies that there is no possibility that money supply can get out of control. Of course this is false, as the crisis of 2007 reminds us.

Fourth misconception: banks takes money from savers (families) and lend it to borrowers, like firms (that can invest this money).
This is the story that everybody is told since their childhood. It is false. As we have already seen, banks create money from nothing. They do not take money from one party to give it to another party. Of course, banks make money by charging borrowers more for a loan than it is paid to depositors. But that is a complete different matter. Banks make money when they create money, by applying a delta between the cost of money for the borrower and the cost of money for the bank.

Since credit is the bridge between the present and the future for the population, you can imagine that if you leave the control of the credit erogation to a private company (a bank IS a private company), then it is only up to the mood of bankers if we are in excess of credit or in shortage of credit. If the banker feels insecure about giving me credit, then it does not issue mortgages. If he feels we are in a boom, he will give me the money. It is not that he does not give me the money because there are not enough deposits from savers in his bank to take the money from, for my needs!

So, after this introduction, two question may arise:
1. If banks can create money "ad libitum", at least theoretically, why can they go bust? Why cannot they create all the money they need to avoid bankrupcy?
2. If banks can crete money "ad libitum", at least theoretically, why are they so scared of a bank run, ie when a large number of depositors decide to withdraw their money?

I will answer these two questions in another post.

To conclude this post, I invite you to watch this excellent, yet professional, short video, by Positive Money, that shows the misconceptions I have written about so far. Subtitles are available in many languages.

Monday, September 26, 2016

Money series: how commercial banks create money (part 1) - preliminary considerations

This article is part of the "Money series" in this blog.

In our last post of the Money series, we learned that the money that you put in a bank is no longer yours. Legally, it belongs to the bank, which on its turn has a liability to you.
Nevertheless, after several posts about the origin of money, what money is, what it the deep meaning of an interest rate applied to credit, we still don't know who creates money.

This is one of the most important questions ever: where does the money come from?

It is odd that everybody uses money, yet they ignore who is in charge of creating it. I started questioning the origin of money in 2014, when I began studying investment strategies and macroeconomics. When the stock exchange collapses, and TV news claim that 3 billion euros were destroyed, where did they actually go? When there is a surge in New York Stock Exchange, where is this money coming from? When the FED claims they have printed 1 trillion dollars, how this money was created? where did it go?
And still: when you buy a house by means of a mortgage loan, and the bank gives you the money, how did get the money on the first instance? When you pay back the principal and the interests, on a monthly basis, to the bank, where is this money going?

Ok, let's get started.

There are two ways that money can be created:

1. By central banks
2. By commercial banks

In the following posts, we are going to cover the process of money creation by commercial banks. How money is created by central banks..well, I am still studying it. I have little time to dedicate to my studies in monetary economics, at work I am moving to other projects and I have to study also other engineering and product assurance documentation. In any case, maybe later than sooner, I will be able to explain also the exact way central banks create money.

Before moving on, it is important to get rid of some common misconception, which are unfortunately very popular by the people, also "supposed-to-be"economists and journalists. Bear in mind that economics is a very wide social science, therefore those who claim to be "experts" in economics are already lying: it is like asking a heart surgeon if he is also and expert in tumors only because he has studied medicine!
I consider economics as a social science because economy is a byproduct of human activity: to get and maintain a complex society, you need complex financial tools. Renaissance was born in Italy not because of the nice weather, but because the family of Medici invented extreme powerful financial tools to be able to survive for decades and fund artists and scholars. They turned from gangsters into banksters. One day I will cover this nice story in a dedicated post.
The financial tools are created by human beings so their behavior is not predictable like the motion of an electron in an electromagnetic field, which is easily described by Lorentz law.
As a consequence, those economists who claim they have found the perfect explanation of the law of economics make me laugh: how can you expect to have laws for humans in a world which is continuously changed by human beings? When demographic forces, technological innovation, information media, and many other factors altogether concur to change and influence each other?
That is why there are so many economic theories. Each theory has its flaws. You discover the flaws only after there is a change in history that cannot be explained by the former theories.

NOTE: The Nobel Prize for economy is a fake Nobel Prize. It is a marketing ploy.

I am not an academic. I do not embrace a particular theory like a Taliban. I only want to understand how things work "hic et nunc", here and now. And to understand how money is created and transferred across the population is mandatory if you hope just to scratch the surface of how the world works nowadays. From the crisis of pension funds, to how everlasting wars can occur, to the rising of inequality in the Western countries, to the importance of private debt over government debt, to the generation of the Japan and Chinese bubbles in the last thirty years, and so on.

This long introduction was just to make you aware that for me the key point for a good post is to find somebody destroying my theories. It makes no sense in looking for evidences to support my findings: I had already these evidences when I formulated and explanation to the events I had observed! If I read ZeroHedge (Austrian school, basically) and I am convinced that the Doomsday is coming, and the Doomsday has not arrived yet, it is mandatory for me to accept the idea that they have to be wrong somewhere. Or, if I read Krugman (Keynesian) and he is one of the promoters of the super Quantitative Easing by the Bank of Japan, and this policy is not producing the expected outcomes, it is important to understand, if I am a long-term investor or a simple saver, the reasons behind all this and the delta between the propaganda and the reality. I can end up making money or losing money.

It is not only for a pure research of the Truth, with the capital T. Nobody knows that, you can simply come closer to that. The Truth is like a mathematical asymptote. You get as close to it as you can (providing that your life is finite and your free time is even shorter!), but never touch it.

Since the way money is created is by far and foremost the most important topic in economics, we will cover this in detail, with an open minded approach, and will examine the social consequences of all this, that are of extreme importance.

Wednesday, September 21, 2016

Lies, damned lies and statistics: emigration from Italy to UK

This article is part of the "Lies, damned lies and statistics" series.
In a past article, I wrote about the lies that information media produce each time they claim that a raise of the average wage in a Country is so important.
Now, let's talk about the figures of immigration/emigration. In time of crisis, these are key terms that are on everybody's mouth.

The newspapers and the TV news have hammered us with the story that the Brexit would be the end of Paradise for those Italians (and Spanish, and Rumanians. etc) living in the UK. There are articles claiming that half a million of Italians are resident in the UK!
Now, I have done some research.

To work in London you need a Nino (National Insurance Number). This is mandatory in order to have the possibility of going to the  family doctor or applying for a job or even studying.

So, an Italian that decides to live in the UK needs to be registered there,
If he has not communicated the AIRE (the official National bureo that tracks the Italians that are registered for living abroad) that he left his Country, the UK National Insurance Office does not care a thing. For the Italian Government, you are still in Italy, because you are not registered at the AIRE, even if you have been living for years in UK!

Now you start seeing something odd: UK National Insurance Office and Italian AIRE do not communicate with each other. This reflects dramatically in a huge error for the statistics of Italian emigration rate, that are based on the communication provided by AIRE.

Let's start digging into data.

According to the AIRE database, in 2012 (no info since then!!)  there were 210.000 Italians living in the UK.

According to the Dataset provided by the UK office for National Statistics (Table E of this file), in 2015 there were 192.000 Italians permanently resident in the UK.

Now we already see a problem. Apart for the three-years gap (AIRE data are available for 2012 only, UK data are updated to 2015), from 2012 to 2015 we know that many Italians left the Belpaese for UK. So, the numbers are biased: we would expect many more Italians in the UK dataset than in the AIRE dataset. Are they measuring the same thing?

Ok, things get complicated. Instead of looking at the residents, let's compare the country of birth: the reason is simple, maybe an Italian couple has had babies in the UK, the babies are Italian but they are registered in the UK.

So, there is this nice site, that takes data from the UK Office for National Statistics.

We can see from this graph:

that the Italian in the UK have been growing steadily since the crisis in 2008.
The difference between two consecutive years is therefore the net increase of Italians in the UK.

So, let's put some numbers:
2008: 105000
2009: 108000
2010: 118000
2011: 124000
2012: 133000
2013: 142000
2014: 150000
2015: 162000  //this is coming from Table A of this file

On average, in 7 years, the Italians that have left have increased by 60%!

NOTE: In Italy the Press is  crap, just have a glance at this article from a well-known newspaper, Il Fatto Quotidiano: they mention 550.000 Italians living in the UK in Jan 2014! THREE times as much as the real numbers! An error of 200%. I mean, if they cannot even read a table, just imagine the quality of their articles when it comes to economics and finance.

Now that we know how many Italians, born in Italy, are living in the UK year per year, we can compute a net saldo of migration for each year, with the data coming from UK statistics.

2009: +3000
2010: +10000
2011: +6000
2012: +9000
2013: +10000
2014: +8000
2015: +12000

Now, let's compare this data with the data provided by the Italian ISTAT (at this page), that stops at 2014 (indeed they are a bit lazy in updating the website! and also to personalize the graph is a bit cumbersome...)

NOTE: the website of AIRE is crap, we need something more professional. ISTAT is definitely better

Italians Leaving Italy for UK:
2009: 5042
2010: 5251
2011: 5378
2012: 7404
2013: 12962
2014: 13491

Italians Entering Italy from UK (maybe they were fed up of pudding and soups..):
2009: 2255
2010: 2208
2011: 2283
2012: 2202
2013: 2152
2014: 2398

We are almost there...
So, net saldo according to ISTAT, which is based on data coming from AIRE (sic!) is:

2009: 5042-2255 = +2787
2010: 5251-2208 = +3043
2011: 5378-2283 = +3095
2012: 7404-2202 = +5202
2013: 12962-2152 = +10810
2014:13491- 2398 = +11093

For example, in 2014 2398 Italians left UK for Italy, 2398 left Italy for UK, so anet of 11093 Italians left Italy for UK. Simple as that.

So, we can finally compare the data from the UK office for National Statistics and the data from the Italian office for National Statistics.

Total Italians that left Italy from 2009 to 2014 (UK Statistics): +46000
Total Italians that left Italy from 2009 to 2014 (IT Statistics): +35000

A graph explains things better than a thousand words.

On the Y axis, the net number of Italians that each year have left Italy.

There is a huge difference between the two data-sets: simply stated, many Italians did not registered by the AIRE the same year that they registered in the UK. The two plots are completely decorrelated, i.e. each of them follows its way regardless of the other's. We can see that in the middle of the crisis, in 2009, there was a boost of Italians leaving Italy (red line).
But in a period of 6 years this is not sufficient: simply, many Italians have NEVER registered at the AIRE, and I guess this is for a simple reason. When they go back to Italy, they can still go to the family doctor, to the hospital for free, have many rights that otherwise would be deleted in their home country. Just imagine if you are being paid by the government if you have lost your job: you do not declare that you are working abroad and you go on taking the monthly the unemployment benefit. Not a nice news for the ones who still live in Italy and who are paying taxes also for those who left.

NOTE: in case you are wondering, I have registered my family at the AIRE. I pay taxes and services both in the Netherlands AND in Italy. In the Netherlands the social security number is called BSN.

So, on average, we can say that, on a mid-long term, the statistics from AIRE are suffering from a  (35000-46000)/35000 = 31% of error, ie 31% of the Italians are not known to the Italian Government to be living abroad.

Since I do not think that the Italians that go to live in the UK are so different from the Italians that go to live in the Netherlands or Germany, I am pretty confident that ALL the statistics of the Italians living abroad are suffering from the same bias.

On average, the Italians living, eating, working, etc. abroad permanently are 30% more than what the official Italian statistics claim.
There are not 1 million Italians in the UK, or 500 thousand, but 192000, including children born in the UK from Italian families.
Now you have the right figures and you can have conversation and comment news about Italians living abroad with a bit of background knowledge.

Another point worth noting is the following: the difference of 30000 people in 2015 between the Italians living in UK (192000) and the Italians living in UK that were born in Italy (162000).
This means that roughly 30000 children were born in UK from Italian parents in recent years. This is going to be an interesting topic for a future post.

Monday, August 29, 2016

King Dollar

Imagine you want to buy 100 thousand barrel of oil. The oil is coming from Saudi Arabia. Are you paying Saudi Arabia in riyal? In other terms, are you going to go to your central bank, convert your euros to riyal, and with those ryial you buy the oil? This would seem to easiest thing to do.
No, you are paying Saudi Arabia in dollars.

Oil is traded in dollars worldwide since the early 70's. That's why we talk about petrodollars.

Ok, now you live in the Netherlands decide to buy a large amount of, let's say, TV screens from Japan. Are you going to pay them in euros? Yes, you can. They would accept euro in exchange for TV screens.
What does it happen if you live in Argentina and want to buy the same Japanese TV screens? well, unless you have yens, that is you convert your pesos in yen and buy Japanese goods, you cannot do that. You have to convert pesos in dollars, and with those dollars you buy the Japanese goods.

In other terms, from these two examples, you can already see that the dollar is used as a currency medium for trade exchange between two different countries.

The International Monetary Fund (IMF) considers a basket of five currency, to be used as reserves for international trade.
They are:
  • US dollar (41%)
  • Euro (31%)
  • Chinese Yuan (11%)
  • Japanese Yen  (8%)
  • Pound Sterling (8%)
The percentages in brackets refer to the composition of each currency as its weight to the IMF Special Drawing Rights (SDR), a kind of currency that is issued by the IMF. This "currency" can only be used and exchanged by Central Banks. So, it is not a real currency (you do not buy bread at the grocery store and pay with SDR). A pie chart is even better to show how the situation has evolved in the recent years.

(in light yellow the new entry: the Chinese Renmimbi)

As you can see, the dollar is by far the biggest weight in the IMF's basket. Recently (2015), Chinese Yuan was added in the basket at the expense of the Euro (mainly), the Yen and the Sterling. The dollar weight was unchanged.

So, let's recap: when two firms in two different countries decide to trade, they typically exchange goods or services paying in dollars.

Three important questions:
1. Why do they need to use a foreign currency?
2. Why is the dollar the most used foreign currency?
3. What are the consequences for the USA and all the other countries?

First question: Why is there the need to use a foreign currency if two countries decide to trade between themselves?
Answer: let's use an example. If I am Polish and I need to buy a Toyota, theoretically I could pay the Japanese firm in zloty. The Japanese could convert my zloty and get their yens. But if Japanese do not want any zloty, we should go for a barter. The Jap could buy some stuff from Poland in exchange for the Toyota car. Of course this is impractical. That's why they both decide to use a currency that everybody wants.
Of course nobody prevents Japan from accepting Polish zloty. If Japan has zloty as a currency reserve, they can accept a payment in zloty. But this would imply that that the Japanese Central Bank should hold reserves for all the currencies in the world, which is inconvinient. It is easier to have just a bunch of currencies to be used as reserve, possibly from the biggest economic areas in the planet.

Second question: ok, for international settlements of payments, we need a common currency which we all agree upon. But why the dollar and not, let's say, the argentinian peso or the canadian dollar?
The easy answer is: the USA are the biggest economy in the world, so everybody does business with them, and needs their currency.
The other answer is more complex: the USA won the Second World War, and, according to the Bretton Woods agreement in 1944, the dollar became de facto the global reserve currency, mainly replacing the Pound Sterling. Following the collapse of the gold standard in the period between 1969 and 1973, the USA created the petrodollar, making deals with Saudi Arabia and other OPEC countries: you want oil? pay in dollars. Who prints dollars? the USA. So, since everybody needs oil, everybody needs dollars. This has been keeping the demand for dollars high.

Third question: so, everybody needs to use dollars. What are the consequences for the USA and for the other countries?
The consequences, even if they are not known by the people, are huge: I am not exaggerating, the consequences are so important that they have shaped the world we know today. Since the abandonment of the gold standard, and with the raise of petrodollars, the US has been having an increasing trade deficits. They got goods and services from developing countries, and paid with money paper, ie dollars, in exchange for that. This has created:
1. raise in the economies of the Asian countries (Japan, Malaysia, Vietnam and nowadays China)
2. huge bubbles in the stock market
3. lowering interest rates in the cost of money for the US government, because the exporting countries, with all those dollars in excess, have reinvested the dollars in US treasuries: since the demand was high, the yield was lower and lower. So the US government could refinance with little expense, so increasing expenses on social welfare.
4. loss of jobs in industry in the US, because industry could pay a few euros a chinese worker instead of paying hundreds euros per day a worker in Michigan.
5. stagnating wages for middle class, since industry was disappearing and there were too many workers to be absorbed by industry and all the service companies working around industry.
6. surge of private debt (household debt) because, in order to keep the same quality of life, and thanks to low interest rates (point 3) families found it easy to increase their level of debt.

and many other things. In a nut shell, a huge acceleration of production worldwide, speed-up of globalization and huge increase of consumption (due to the low interest rates on loans), and net decrease in the savings rate (because you do not earn enough). All of this has led to a shrinking middle class in the US.

Bear in mind that everybody is accepting dollars in exchange for goods and services because they think that the dollar is stable and trustworthy. Now, you may say it is not true: due to inflation the dollar is losing purchasing power, the Fed has been printing trillions of dollars in the last 8 years and China is growing and piling up gold. Nevertheless, when I hear this objection, I raise an eyebrow and start to ask: what is the alternative? As far as I can see, in economics, there is not good or bad, there are better or worse solutions. Everything is relative, not absolute.
The euro zone is a disaster, China is an unknown (following the same steps of Japan in the 80's), Japan has been in stagnation for twenty years and the UK lives mainly with the finance industry.
And the same monetary policies that the Fed has been running through, are the same that other central banks are using! so, there is no clear winner. If dollar loses purchasing power, and governments may become wary of the US currency, what currency should they keep in their (electronic) vaults? everybody is trying to weaken their currency!
In such a bad scenario, it makes no surprise that currently the dollar is stronger with respect to all other currencies.

Tuesday, August 23, 2016

Lies, damned lies and statistics: median income or average income?

Keep calm and don't panic.

I want to talk about this

and NOT about this (even if it should be more appropriate, for an academic but I am not an academic :-)

Would you prefer having a household (ie family, for those people who are not native English speakers) income of 29000 € or 20000 €?

They seem close, but 29000 is almost 50% higher than 20000. A raise by 50% in salary would be amazing, wouldn't it? :-)

The aforementioned figures are:

Average household disposable income in Italy: 29000 USD
Median household disposable income in Italy: 20000 USD

NOTE: USD stands for United States dollars. Typically these figures are given in a currency that is widely used in the world to let economists make comparison among different countries, without being bored with currency rate conversions. The US dollar is by far the most used currency in the world.

Typically the average income is reported by Italian, French and Dutch press: it is simple to understand, you take a bunch of people, sum up their incomes, and divide the result by the population. Easy.

But misleading.

In fact, if there are 99 guys earning 20'000, and 1 guy earning 200'000 (that is ten times more than the majority) per year, the average is

(200000 + 99*20000)/100=21800

So, you can see that the average is hiding a huge difference of income in the population. Most of the people are earning 20000, not 21800, which is almost 10% more!
Let's make another example, and suppose that there are ninety people earning 20000, 9 earning  200000 (ie ten times more than the majority) and a lucky guy earning 2000000 (2 million, 100 times more than the majority). Total population is still 100 people.
The average income becomes

(2million + 9*2hundred thousand+90*20 thousand)/100 = 56000

That is, according to statistics, the average salary is 56 thousand, that is 1800 % more than the majority.

Now you start to grasp the surface: in a society where there is an important different among the incomes of the population, talking about the average is meaningless.

NOTE: if this has triggered your curiosity, then have a glance at a very simple yet teasing post that I wrote on the Pareto's principle applied nowadays.

There might be an increase of wealth (see GDP, the ubiquitous Gross Domestic Product), yet this improvement goes only to the richest. The average GDP per capita, that is GDP divided by the population, can't see this. Maybe the majority got poorer but according to statistics on average we are all richer.

Is there a better metric to be used? First of all you have to understand that journalists (and policymakers) typically have a humanistic background, ie they cannot sum up 2 plus 2, they simplify complex things to the extreme, and in Italy they are even proud of being ignorant in mathematics.
And mathematicians, physicists and engineers are proud to claim themselves ignorant in economics. They are scientists, and do not want to be bored with this stuff like stocks, GDP, interest rates, that pertain to human creation and not to the laws of Mother Nature.
So, it is difficult to get from mainstream media this information. You have to use internet.

In any case, the good news is that a better metric does exist, and is called median.

You simply sort the incomes from the lowest to the highest, and pick up the value in the middle, which is called the median of the population.
So, in our first example (99 guys earning 20K, and one guy earning 200K), the median is 20K, because you put in a row all the people according to the salary, but it turns out that the fiftieth guy still earns 20K. So the median is 20K.

In the second example (90 guys earning 20K, 9 guys earning 200K, 1 guy earning 1M), the median is still 20K.

I remind you that for the newspapers, reporting the average, the income would have been 56K, while a vast majority (80% of the people) only get 20K per year!

This is a first dip into the magician sea of statistics, ie how I can screw you over whenever I need to.

So, I am going to give you an advice: if you want to see how a country has been performing since 1971 (when Bretton Woods system collapsed and inequality started increasing) look especially at median per capita figures. You are not interested in the overall wealth of a country, you are interested first in the wealth per family (is it increasing?) , and especially if the difference between average salary and median salary is increasing over time: this means that the middle class is shrinking.

Sunday, August 21, 2016


My work is going to increase in the following months so my posts will be more sparse in the upcoming weeks. It is a pity, I have lots of ideas running through my mind, but it requires time to write them down. Each time I write a post, I need to get information here and there, save pictures, organize thoughts and that requires time. And time is the most important resource for us all, because it tends to be more and more scarce, especially when you have a family.

So, today I am going to write about a Country I have recently visited: Poland.

I have been close to the Czech border of Poland: what struck my attention was that the roads, the squares were all tidy and clean. The woods, the lakes and the forests were wonderful.
Yet, many of the buildings were in a very poor state: the country is not rich, and this is reflected by the purchasing power of the local currency, the zloty. Living in Poland is extremely cheap for an European citizen.

At present, with one euro you buy 4.25 zloty.

But, if you try to withdraw zloty from an ATM in Poland, the currency they give you is one euro = 3.95 zloty! that is 7% less. Damn banks!

The main town in the region I visited is Wrocław, the fourth-largest city in Poland: in 2016, the city is  European Capital of Culture and World Book Capital.
The city is really worth to be visited, especially the wonderful Market Square: it is full of life, with children playing all around making soap bubbles, street artists everywhere and nice bars and restaurants overlooking the square, which is a pedestrian zone. No cars around.

There is a very well done site that lets you compare the cost of living between several towns in different countries. The site is Numbeo.

Keep in mind that the average Polish meal is far far better and more abundant  than the average Dutch meal (this is said by an Italian, and I am always complaining about the food outside Italy, not to mention the coffee!).
So, let's make a comparison between the cost of living in The Hague (Netherlands, close to where I live) and Wroclaw.

Indices Difference
Consumer Prices in Wroclaw are 47.35% lower than in Den Haag
Consumer Prices Including Rent in Wroclaw are 46.61% lower than in Den Haag
Rent Prices in Wroclaw are 44.54% lower than in Den Haag
Restaurant Prices in Wroclaw are 58.02% lower than in Den Haag
Groceries Prices in Wroclaw are 47.38% lower than in Den Haag
Local Purchasing Power in Wroclaw is 44.69% lower than in Den Haag

I know numbers are impersonal, but what you see here is interesting. Everything is cheaper, roughly 50% cheaper, nevertheless a Polish family father is 45% poorer than a Dutch family father, even if he lives in an European country so cheap like Poland.

The point is simple: the cost of living is a ratio between what you buy and what you earn. So, yes, things are inexpensive, but the salary must be far less that the Dutch salary.

It turns out that, after tax, a folk in Poland gets, on average, 730 € per month, less than one third of a Dutch's, which is 2472 €.

So, we can conclude that Wroclaw is cheap for a Dutch, and is expensive for a Polish.

I can't even imagine what would happen if Poland becomes part of the euro-zone. I think they would simply become a colony of Germany, given the current Polish economy, which is far too weak than the German one. House prices would skyrocket and people would fall into deep debt. Speaking with people in Poland (bartenders, hotel managers) it seems they understand that joining the euro-zone would be a bad deal for them.

In a future post, we will look inside the Polish macroeconomic data and demography.

But, before that, I leave you with a nice picture (it is not meant for vegetarians, sorry).

This hamburger "monstre" with fries and all sort of things horrible for your health but nice for your belly costed just a few euros.
So, yes in your read that

                                                          Den Haag         Wroclaw     Difference

Meal, Inexpensive Restaurant15.00 €
(64.64 zł)
4.64 €
(20.00 zł)
     -69.06 %

but it does not mean that you get the same quality and amount :-)

I told you that numbers are impersonal. Useful, but impersonal.