Comments on Mark Perry's CPI "chart of the century"

Mark Perry at AEI published a CPI chart which was called the "chart of the century" by CBS Marketwatch. Here is the figure:

Source: Mark Perry's blog

The chart  is the inflation data of the BLS tracked by the sector where consumers spend their money, for a period of 21 years.

There are many conclusions which Mark draws from the chart (about government involvement, etc.) which are unfortunately not true. However, the chart does serve to show an important point.

That inflation data is largely noise: because depending on how you combine these elements, given that textbooks have gone up 180%  and hospital services by 211%, vs. TVs which have fallen 97% and Software which has fallen 68%, and if you can weigh them differently you will come up with a different headline inflation number for CPI. Furthermore, it also shows that my inflation is not someone else's inflation, because the way I spend my money in these groups is not the way someone else does. An example: A retiree will spend no money on college tuition and books, whereas a student in her twenties probably spends a lot of money on them.

I have shown previously the problems with inflation measurements, and this chart shows some additional confirmation of what was said there.

The BLS does some quality adjustments-they call them hedonic quality adjustments, which really is using statistics to fool the public. When you buy a coke from a kiosk vs a coke in a high end restaurant or in Disneyland, you pay not for the coke, but for the great furniture and ambiance in the restaurant, and the great place that Disneyland is (once inside, you have a ton of wonderful entertainment in walking distance,  that's what you pay for). Similarly, when you buy a hot dog from a street vendor vs. in a well designed mall, most of the cost of the hot dog is the privilege to be able to be in the mall. Hedonic adjustments make subjective judgments of quality and contributing factors by experts, but most of these factors are not visible. The point of the coke and hot dog example above is not to criticize the BLS experts, but simply to show that one can't determine the factors of what makes a product good or bad quality; they are sometimes hidden deep down somewhere. A store may make its parking lot bigger or better lit, put a better road connecting it to the highway, and raise prices-it is unlikely that BLS experts consider all these factors in their hedonic regression model to account for the price increase at the store.

But coming back to Mark Perry's chart, one can see that the inflation data depends on how you combine all these elements and their weights; you can give me a CPI number you want, and I can combine all these to come up with that number. The deviation in the prices of the constituents is so large that there is nothing representative about a headline CPI number.

Related article:
What is money and what are its uses

Making sense of economics data-M2 money supply

The biggest repository for economics data in the US and probably the whole world is FRED, of the Federal Reserve Bank of St. Louis. It really has some wonderful data series, but the sheer amount of economics data available ( more than 500,000 total series) shows that the economics data generators are spewing out data right and left, and most of it has to be irrelevant, or noise.

Let us analyze some good data series, often misinterpreted by not just the public but even the Fed officials themselves. I will analyze only the US data.

M2 money supply

This is a very useful data series. Here's the chart of the M2 money supply, non-seasonally adjusted, from 1959 to the present (2019). [Click on charts to enlarge]

M2 is a good measure of how much savings US households (primarily, also includes non-profits) hold in near liquid money. Most is held in savings accounts and checking accounts. The amount of about $14 trillion in 2019, and as you can see from the graph above, it basically keeps going up with time, even during recessions.

I am against adjustments of seasonality, etc. it is best to just look at  the raw data.

M2 is a good indicator of the advancement of the country. As the country overall becomes wealthier, the amount held in liquid money goes up with time. 

You may hear of absurd arguments like the Fed lowering or raising the fed funds rate to affect the money supply. Here is the chart of the Fed funds rate.

As one can see from the two charts above, the fed funds rate has no effect on M2. The money supply M2 keeps going up, while the Fed funds rate is all over the place. The big trend is that M2 keeps going up, without much correlation with the Fed funds rate. 

You may also hear of banks increasing money supply by lending. Unless someone borrows money and puts it right back into a bank (and certainly the banks will offer them lower rate than their borrowing rate) and wants to lose money, it makes no sense that loans end up back in banks. People borrow money to use in productive purposes, e.g. buying a car, house, etc. Note that the people who are borrowing are not the same people who hold these savings of money which shows up in M2-it is a different set of people. A retiree will have a large amount of money in her savings account; a student only a little. Borrowers are normally younger, and savers are older. It is only the aggregate data for the whole US population which shows in M2 money supply.

Banks and Fed can't change M2, these are net savings of people, and it is preposterous to believe that banks or the Fed can change the value or purchasing power of what you save by changing interest rates, reserve ratios, etc. (notwithstanding the odd theories of inflation). M2 is also very stable because of the FDIC guarantee of deposits of $250K per depositor per bank, people feel safe holding funds in their savings and checking accounts because of this reason. 

The banking system is a small part of the financial system, which is itself a small part of the economy, as I have already covered here.

Lastly, I will comment that another measure of money supply, M1, is an inferior measure of liquid money because of the large amount of money which people hold in savings accounts, which can have a check or debit card attached to it, which shows only in M2. One can safely ignore M1 in their analysis of the net liquid savings of the residents of  the US.

M2 and money supply in other countries

A growing M2 is certainly a good indicator of a steadily advancing country, but if M2 does not grow in a country, it does not mean that the country is not advancing. In certain countries, the banking system is not as reliable as in the US, and there you can have advancement without growth in M2-people will prefer to save their wealth in other forms like real estate, accumulating US dollars (as happens in Latin America) or Euros (as happens in Eastern European countries). 

Furthermore, some countries include government deposits in M2, and one must be careful about the definitions before coming to conclusions about M2 and what it means.

A primer on what is money and what are its uses.

The economics of real estate; density determines fundamental real estate values

One often hears about the rising costs of housing in a city, especially the big cities with >1 million population. But cities occupy less than 1% of the total land of a typical country, and more than 50% people live in cities in developed/developing countries. Clearly land is not scarce-and if people wanted to have a huge lot of land and a house built on it, they could; and you would not see densely packed cities at all. The density would be uniformly distributed over a country-each person having a hectare or two and a house on it.

However, people voluntarily want to live in cities, and they pay a monopoly price, the price of the land inside or close to a big city, to enjoy that privilege. It is a privilege-because you could live quite well in rural areas, basic necessities like food, shelter and clothing are covered in all developing and developed countries even in rural areas.

City life brings some discomforts; but overall, they must be nicer to live in, with many additional pleasures and activities you can only find in cities. As a country becomes more developed, cities become more and more densely populated, and rural areas less and less densely populated, relatively speaking (both urban and rural areas may increase in population, but the percentage increase in population is much higher for urban areas than rural areas).

Fundamentals of how real estate prices are determined

A house has two components to its price 1) the price of the land which it is built upon (the price of the lot); and 2) the price of the actual structure of the house, the materials and labor used to build it.

I will make two observations:

A) The structure of the house is a depreciating asset, its value goes down with time, because of general wear and tear of any physical structure. To prove this, consider a scenario where you have a single-family house built 10 years ago. If someone builds a replica of this house today at an adjacent lot of equal dimensions, it is likely that a potential buyer will pay more for the newer, less used house than an old house. This shows that the value of the structure of the old house is going down, because if it were remaining the same or going up, the buyer would pay the same or more for the older house.

B) In a big city like Toronto, Ontario, Canada, where single-family houses cost about $800,000 (all prices in USD, year 2018), within the metro area, most of the value of the house is in the actual lot which the house is built on. A similar house far away from the city would cost $300,000. The extra $500,000 is the difference in the value of the lot-the lot being quite cheap far away from the city.

The parts of a city which have the highest density (measurable by people/sq km,) have the highest house values. From B) above, it is the value of the lot which goes up in such spots. All spots of the city which have high density necessarily have a lot of action within walking distance: a very high number of commercial establishments or businesses-supermarkets, restaurants, nightclubs, coffee shops, etc. You don't need to buy a car when you live in the downtown core of big cities. You save the hassle and money involved in buying the car, and finding parking for it; plus you do not waste precious time commuting. Basically, the efficiency of life goes way up for people living in downtown areas. Obviously there are people who don't like the noise, the traffic etc. of  high density areas-but for most people, high density areas are the most attractive spot to live. This is easily proven- the per sq. m rents and the corresponding real estate values are the highest in the high-density, downtown areas. Land is a monopoly price, and the most expensive land is where there are already a lot of people living or working. When real estate agents talk about "Location, Location, Location" as the mantra which decides the value of a house, it should be changed to "Density, Density, Density", for in reality they are talking about the density of people in the location, which naturally brings all these commercial establishments around it. One must note that this density is variable, generally high in the weekdays, and low in the weekends. It is also low in the nights. Therefore, when I say density here, it is the average density of people per day, measured over a period, of say 30 days.

Since it is hard to estimate density of people circulating in an area, a good estimate is the number of buildings already constructed there, residential or commercial. Effectively, the total already constructed, existing floor space in a 1km x 1km area can be used as a good measure of density.

A good proxy for real estate prices are hotel room prices. Sites like Booking.com and Expedia.com give you an immediate idea of real estate prices all over the world by just looking at the hotel room prices. It is easy to see that the highest prices in a city are at the densest locations. As you move away from these spots, prices go down considerably.

One can think of high rise buildings as creating more real estate-the physical limitation of the ground is overcome, and many multiples of the actual real estate area are added by high rise construction. The limit of real estate is eased by this-and enables people to live closer together. Presence of high rises INCREASES rents per sq m, because it brings more people at that area, increasing the density even more. There is no end for this-every 10 years since 1900 we are adding 3 stories to the average height of residential towers in cities worldwide. New residential towers being constructed today are about 50 to 60 stories in NYC, Toronto, Canada or Osaka. They are slightly less taller in not so developed countries-Sao Paulo, Brazil or Santiago, Chile have newest residential towers which are about 30 stories. This trend will go one for many decades; unless we reach an upper limit from engineering reasons to maximum height.

What most real estate investors or renters pay for, therefore, is density. The way to improve density is to build vertically. A 40 story building will have 40 times more people living than a one story house on the same lot. This is why cities worldwide are growing vertically; the demand for high density and consequently high rise housing is very large, and it is quite conceivable that most of humanity inside metro areas will eventually live in high rises. This is already the case in Japan-I have lived in Osaka and the two highest density spots in Osaka, Umeda and Namba, have almost everything you ever need in a 100m walk from where you live. Futuristic movies do not show large mansions in the countryside-they show 100 story buildings. The trend for vertical living is here to stay.

Most of the value of the condos (apartments) in high rises is because of  the convenience of being around the action (high density area)-you are paying for this privilege. A similar condo far away from the city, in an isolated spot where there are no other condos or activity, costs maybe a tenth or twentieth of the price. The highest prices of condos per sq. m are in the densest part of the city. As you move away from high density spots, the price per sq m of the condo goes down.

Exceptions

While density is a good predictor of real estate values, there are cases where it may not. One has to account for poor neighborhoods, shantytowns and slums. In these areas the density is quite high, and sometimes they are right next to the "high-end or well-off" areas of a city, but real estate values are low. Developers are constantly looking to take over these poorer areas of a city and put high rises there-as long as there is a continuous connection to the better areas. In this way the slums and poor neighborhoods of a city gradually disappear, replaced in most cases by high rises. The good, well-off areas of a city expand to take over these poor areas. This is a good thing overall; however, this necessarily means that the poor have to move to the suburbs of the city. Many times the poor don't want to do this-and this is the reason downtown in most areas have a lot of homeless people living on the street. On a map of real estate values (measured in per sq m), this shows as a discontinuity-there is sudden drop in value when you cross a simple street or a river.

Another exception is when you have a residential development like a huge resort or apartment complex in the middle of nowhere, with no commercial stores. The real estate prices around the resort or apartment complex stay low. What attracts people is at least the presence of some commercial stores, and once you get a few, unless there are severe restrictions on putting more commercial establishments, whole cities can be born around what was once a resort or an apartment complex. Far flung malls for this reasons attach apartments to them; malls are like a city in themselves, you find everything there; and people are happy to pay for the privilege of living at walking distance from a big mall, which translates into high real estate prices for apartments next to, or sometimes attached to a mall.

An open-source, digital currency to facilitate commercial transactions worldwide.

Summary

A brief history of money and its uses is presented. A new digital currency, the Smith Unit, to facilitate commercial transactions is proposed. Shortcomings of cryptocurrencies (bitcoin), existing paper currencies (dollars, euros, yen, yuan, etc.), and gold and silver are covered. The Smith Unit is compared to similar products like the ECU (European Currency Unit-the predecessor to the Euro) and the SDRs (Special Drawing Rights) of the International Monetary Fund.

What is money and what are its uses?
(you can skip this section and go directly to "Defining the Smith unit (SMU)" if you are not interested in the economics and theory behind the existence of money and currencies)

Adam Smith in 'The Wealth of Nations'[1] shows us that the fundamental, true measure of the value of an object is labor-objects which need more labor to make, in general, are worth more than objects which need less labor to make. Allowance must be made for different skills and training involved: an object (or service) of labor of a few hours is sometimes worth more than the object of labor of many days, due to the higher skill and training required in the former.

However, it is inconvenient to talk about objects in terms of their labor content or units of labor they save the buyer; and since most objects are exchanged with one another rather than with labor itself, money becomes a more convenient measure of value.  This is the reason goods (and services) are quoted in money prices; but we must not forget that the true value of goods is measured in labor. You exchange the produce of your labor with the produce of others' labor. You get paid for your labor in money, and you exchange that money with the goods produced by other people's labor, is the real exchange going on in the world. Labor is the true price of all objects; money is their nominal price only.

There are two main uses of money; 1) As a facilitator for buying and selling of goods and services by being a unit to measure their value, e.g. 1 kg of potatoes for 1 Euro, and 2) As a measure of someone's worth, e.g. Maria is worth a million dollars. The use of the same term money to denote these two has caused substantial confusion for humanity, as covered by Adam Smith. However, the primary use of money is the former-a unit of the measure of the value of goods and services.

When considered as a measure of value of goods and services, money may be thought of as similar to the unit of mass, the kilogram (kg) or the unit of length, the meter (m), which from the Système Internationale (SI) units conventions, are standardized units of measuring mass and length.

We must remember that the kilogram and the meter are not absolute measures. When you measure something with a weight scale, it is never a completely accurate reading-because of the calibration errors in the weight scale against the 1 kilogram international prototype in Paris[2], which is the standard unit of mass in the SI convention (i.e. when you buy 1 kg of something, it is never really 1 kg). This error, the difference between the mass and the actual mass if you had the prototype in your hands, is tolerated depending on your applications-if you are measuring something ultra-sensitive, you need a very accurate and calibrated scale; whereas for most goods, an error of let's say 1% is acceptable (the 1 kg of oranges you weighed are really 990 g if the oranges were weighed by the Paris prototype, but you can live with this error.). Furthermore, the prototype of mass in Paris is itself a variable (recent attempts to put them in terms of physical constants notwithstanding)[3] and susceptible to drift over time-what it was a hundred years ago is not what it is today, because of corrosion, loss from use and wear and tear, etc. The point is-that even for a physical unit like the kilogram, there is no absolute measure, but we carry on our lives quite well despite the uncertainties and errors.

However imperfect it may be, money (a dollar or a yuan, for example) is a measure of value just like the kilogram for the mass. Different observers will give a different value for mass, length, etc. for an object depending on the accuracy of the tools they have, or how much experience they have with similar objects; the same is true for value, wherein an object can be assigned different values by different observers. You can also think of value being measured in money terms as in imperfect units like the pennyweight, the cubit or the bag which were used until a few hundred years ago-when you do not need exact units, you get by with these cruder units just fine (e.g. a bag of coal).

Value thus may be considered to be a fundamental property of all objects just like the mass or the length, and we can say:

Object properties: Mass (kg), Length (m), Value (dollars, yuans, etc.), and other properties.

What we needed for mass or length in practice were standardized, easily reproducible international units-and the same is needed for the value of an object.

Before the standardization of mass in kilograms, countries and regions of the world had their own standards of mass (e.g. pound in the Great Britain, seer in India, momme in Japan), and some continue to be used to this day. However, the SI units with their standardized definition of kilogram really simplified things-and the SI unit of mass has gradually replaced all other standards in the last 100 to 200 years.

Great Britain might have insisted for national pride reasons that the international unit of mass be the pound, or Japan might have insisted on it being the momme, but the kilogram eventually was accepted in almost all fields of life in all countries.

Not just for mass, but the decimal based SI units have replaced region and country specific units for length, time, etc. as well. The same needs to happen for money-we need to give up the national pride issues falsely associated with a currency, and adopt a worldwide currency.

I propose a unit called the Smith unit. The unit is named in honor of Adam Smith, the founder of Economics.

Defining the Smith unit (SMU)

A Smith unit (SMU, or more simply, just the Smith) is a fixed currency basket derivable from published prices of major world currencies. The unit is 20% each of the US Dollar, the Chinese Yuan, the Euro, and the Japenese Yen and 5% each of the Brazilian Real, the Indian Rupee, the Swiss Franc, and the British Pound on 1 January 2011 and its value was set at one USD ( 1 SMU=1 USD) on this date. The methodology is very similar to how major stock market indices are calculated all over the world.

Based on these percentages and published exchange rates of major currencies in USD (data was taken from the Federal Reserve bank of St. Louis[4]) , the actual currency amounts in one Smith unit are shown in the table below (Column 3):

Table: Currency amounts in 1 Smith unit on 1 Jan. 2011

Currency	Currency Weight in Smith unit	Currency Amount in one Smith unit
US Dollar USD	20%	0.2
Chinese Yuan CNY	20%	1.32
Euro EUR	20%	0.150727
Japenese Yen JPY	20%	16.334
Brazilian Real BRL	5%	0.083155
Indian Rupee INR	5%	2.24
Swiss Franc SZF	5%	0.046845
British Pound GBP	5%	0.032484
Total:	100%	---

The weights were chosen to represent the approximate importance of these countries and their currencies in the world, and easily available public quotes for their prices.

Many other currencies could be included in the basket-but as mentioned above-currencies are not to be used to parade national importance,  and as long as we have a clear and simple standard for buying and selling goods and services, as the Smith unit is, we can use it to define the value of goods and services in all parts of the world, just like the mass of an object is defined in kilograms everywhere.

With the eight currencies above and the associated percentages, we get a good representative paper currency basket for the entire world. Most of the world trade involves at least one of these eight currencies-and adding more currencies to this basket is therefore not necessary.

The detailed Smith unit (or the Smith) calculations file can be downloaded here (.xls format).

The file to calculate the daily value of the Smith quickly can be downloaded here (.xls format).

The currency amounts in the Smith are fixed and not changeable, except when a re-balancing is required, which is covered below. I used data from 1 January 2002 to 31 December 2016 for calculating the Smith unit. Going before and after in time from 1 January 2011, the percentage of currencies in the Smith changes. The maximum weight of any currency was about 26% for the US Dollar, reached on 31 January 2002. The maximum weight of the Chinese Yuan was about 25%, reached on 19 March 2015.

The charts below show how the Smith unit has changed over time vs. the US Dollar since 1 January 2002 until 31 December 2016, a period of 15 years (click on the charts to enlarge them).

There is only one re-balancing rule for the Smith unit:

1. The Smith unit will be re-balanced if one currency becomes 70% of the unit. 

I would like the re-balancing (if needed) to be done by the SI, or the International Committee for Weights and Measures in it's General Conference, which is held every four to six years.

The Smith is an open-source currency, and can be thought of as a currency of an imaginary country called the Smith Republic somewhere in the High Seas, whose only goal is to facilitate the buying and selling of goods for the world.

The Smith Republic has no political connections or preferences for any country, and is most like the SI, which is why I propose that the re-balancing of the Smith, if needed, is to be done by the SI. Data from the last 15 years (2002 to 2016, both years inclusive) shows that no re-balancing has been necessary in these years.

When the world transitioned from gold and silver pegged currencies to floating paper currencies (Bretton Woods abolition in 1971), alarmists published all kinds of warnings-but the transition went about quite smoothly and no country ties it's currency to gold reserves anymore. There's nothing magical about a currency; it's only use is the ease with which it can help in buying and selling of goods by ascertaining their value.

As the proliferation of bitcoin in the last few years has shown, there is no need to involve the banking and financial systems of the world in choosing or controlling currencies-as long as people quote their products in bitcoin and someone (an exchange) converts existing currencies to bitcoins, the new currency can be used to buy and sell goods without issues.

We must agree that there is a real need for a standardized world currency to eliminate the massive transaction costs in conversions from one currency to another-especially in world trade. World travelers also will benefit considerably from a world currency-they lose every time they convert currencies. We will also get rid of the constant babble of countries trying to "manipulate" currencies, keeping currencies low for increasing exports, etc. (all these so called manipulations have no effect on the value of objects; much like changing the unit of mass from kilogram to pound has no effect on the actual mass of the objects).

Problems with the bitcoin

The bitcoin has some very serious shortcomings, which make it a risky currency for transactions: 1) Bitcoin can be mined, i.e. more bitcoin can be created by computers, etc. and if mining costs collapse, the currency will fall very considerably in price, or even go to zero and 2) it is liable to fraud-because it can be hacked or stolen (the biggest exchange of bitcoins, Mt. Gox, lost USD 500 million of its clients' money in 2014 and was shut down, Bitfinex lost USD 65 million of bitcoin in 2016 due to hacking). There are no such problems with using the Smith as a currency unit in transactions, assuming it is accepted as a true currency of a disinterested party. and 3) Governments of countries normally guarantee bank deposits (in the country's currency) upto a certain amount. The FDIC in the US guarantees deposits upto $250,000 per bank. No such guarantee exists for bitcoin deposits with banks, brokers, etc. This is a major risk for all holders of bitcoins, 4) bitcoin is very unstable against existing currencies, the volatility making it a poor choice as a global currency.

Moreover, the bitcoin (and other cryptocurrencies), because of its association with solving complex computing problems etc. is unnecessarily complicated. If science and progress is about simplifying complex things and not making simple things complicated, the Smith with its easy to implement calculations is a much nicer solution for a global currency than the bitcoin.

The massive appreciation in the value of the bitcoin against all currencies since its creation shows that it is being used as a store of wealth (the second use of money, pointed above) and speculation, rather than as a currency to help exchange in the buying and selling of goods (a new currency should be stable in value against existing currencies). The large number of cryptocurrencies launched after the invention of the bitcoin show that it is not that hard to come up with cryptocurrencies-and the creators and promoters of these currencies stand to make a lot of money as long as the bubble keeps going up. It reminds me of Internet stocks of the late 1990's who went up fast, only to collapse later on (I believe that the bitcoin and all other cryptocurrencies will stop being used as currencies, but may continue to be used as a store of wealth and investing like baseball cards, collectible cars, or art and jewelry). A new global currency solution should be relatively stable vs. other major currencies and provide a smooth and continuous transition from them. The Smith meets that criterion well, by its very design.

One must note that a block chain/distributed ledger system is different from bitcoin the currency (Nakamoto's amazing contribution is the design of the block chain/distributed ledger system, and not the bitcoin), and can work well with existing currencies and the Smith.

Problems with existing paper currencies (dollars, yuans, etc.)

The main problem of using a dollar or a yuan as a world currency is that the currency is thought of as a matter of national pride, because of incorrectly thinking of money and currency as being a national asset, and not an instrument to facilitate trade of goods and services (the same confusion mentioned above, in the two uses of money), and countries for this reason like to have their own currency and full control over them. If a country X doesn't have a good relationship with the US, it is hard to convince the businesses in the country X to accept the US dollar. In some cases, e.g. Ecuador and Panama, countries have accepted foreign currencies to be used in every day lives, and do not see any problems, with most goods in these countries being quoted in US dollars. However, there is always the risk that Ecuador goes back to using the Sucre, because a currency being a matter of national pride is well entrenched in society. Italians still debate about going back to the Lira and the Greeks blame their problems on joining the Euro, and want to bring back the Drachma. Worse still, many countries do not want their currency circulating outside their borders (e.g. China and India). Adopting the apolitical Smith, which is a simple mathematical derivative of some of the world's major currencies, solves this problem.

Another problem is best illustrated with an example. If country Y want to use the US dollar as its currency, as long as as there are paper US dollar bills in circulation, the country Y needs to depend on the US Treasury Department (who prints the bills) in some way. The US Treasury has a monopoly over printing US dollar bills, and that makes it very inconvenient for country Y to adopt the US dollar. The US dollar can be adopted for digital transactions in country Y, but it cannot be adopted for bills if country Y does not want to depend on a foreign entity for the circulation of bills within the country. If the US Treasury allowed printing of US dollars outside of the US, just as the one kilogram prototype of mass in SI has many copies all over the world to replicate the kilogram, it would not be an issue, and US dollar bills could become a world currency to replace all paper currencies.

It is unlikely that the US Treasury will give up this exclusive right to print dollar bills-and it is therefore best to start afresh, with a new currency like the Smith, which if needed can have bills in the future, emitted by the SI, with the same methodology used today for replicating the one kilogram prototype.

In this example I took the US dollar and the US Treasury as starting points-but you can imagine the difficulty of adopting the Japanese Yen or the Chinese Yuan as international currencies-because they are even less popular than the US dollar. Coming up with a basket of currencies seems to be good way to solve this problem.

Countries generally guarantee deposits in their banks. They however do this only for deposits in the country's currency; and foreign currency deposits are not guaranteed by the country (this is completely irrational and very awful for the savers; the Argentinians found this out the hard way in the Argentine crisis in 2001-2003, when their US dollar deposits were converted to Argentine Pesos forcibly). Chilean banks will accept deposits in Pesos and US Dollars, but the State entity for guaranteeing the deposits only guarantees the Chilean Peso deposits. All international governments will be more amenable to guarantee deposits in a neutral, worldwide currency like the Smith and not limit the guarantee to the home country currency.

Countries like Ecuador and Panama have adopted the US dollar as their official currency, and loans and interest rates are also quoted in US dollars. Clearly if currency and money was such an important thing as people are told by nationalistic rhetoric, this would not be possible.

If  Norway were to adopt the Euro, it would not change the real price of anything in the country, but would be a considerable benefit for Norway's citizens and visitors to Norway, who would not have to lose money while converting from kroner to other currencies, or the reverse. The risks to Norway of adopting the Euro are largely imaginary-as is clearly seen by how efficiently the Euro was adopted in various Euro zone countries. Norway can stay a separate country and still adopt the Euro as its official currency, to the tremendous benefit of its citizens. If the United States decided to adopt the Euro as its official currency, nothing would change inside it, and business would carry on as usual, with everything quoted in Euro. Instead of pushing for the Dollar or the Euro or the Krone as a world currency, adopting a neutral, basket-based currency solution like the Smith would be an amicable solution for all countries.

Comparison to the European Currency Unit (ECU) and the Special Drawing Rights (SDRs) of the International Monetary Fund

The ECU was the predecessor to the Euro. It was a basket of currencies just like what is proposed for the Smith here, and the Euro zone did transition successfully to the Euro from the ECU[5]. The major problems with the ECU were 1) That of other paper currencies emitted by countries-a vehicle of national and regional pride. The ECU was used as a political instrument to suppress smaller countries-wherein bigger countries were given larger weights in the basket and apparently because they were more important to Europe. Outside the Euro zone, it was promoted as a tool to further Europe's interest, etc. which made it a bad choice for adoption by other countries and 2) Too much re-balancing, apparently to reflect the share of European trade, making it an arbitrary rule. The meddling finance types would calculate the share of European trade every five years and adjust the weights of currencies in the ECU. They forgot that trade data itself is approximate and quite volatile, just as most other economic data is.

This is the reason that the Smith has just one re-balancing rule, of a currency becoming 70% of the basket, because wide variations in it's composition are completely okay, as long as the market knows how to convert the various world currencies to the Smith in a transparent manner.

If the Euro did not have these shortcomings, it would serve as a good worldwide currency.

Despite all these problems, the Euro's overall success in replacing all the member states' currencies does show that a currency basket can be used as a currency of many countries, and therefore ensures that if the Smith is adopted by the world, it will become successful as a global currency.

The SDRs of the International Monetary fund[6] have the same problems as the Euro 1) Political unit  2) Arbitrary re-balancing. There is an additional problem with the SDRs-they are too heavy on the US Dollar and the Euro already and are very unlikely to be adopted by a country which doesn't not consider the US or the Euro zone to be their ally.

Using a major stock market index as a world currency

Anything whose value is clear and easily accessible to the general public, and which cannot be manipulated easily, can serve as a currency. The US S&P 500 Index is such an index. One can base a currency off it, and use that for transactions worldwide. Divisions of SPY (SPY is the most popular ETF connected to the S&P 500 Index) can be used to buy and sell things on eBay for example-you are just debited the amount in SPY instead of dollars or euros or yuans. That's easy to implement, and does not need too much regulatory oversight-after all the S&P 500 is guaranteed by the faith of the US capital market system and therefore indirectly the US government. You could make coins of fractions of SPY as well.

The problem with using a stock market index as a currency is that there is high volatility with respect to currencies in certain periods e.g. in 2008. Combining many stock market indices of the world to come up with a new currency doesn't help because stock markets worldwide are massively correlated  (when they go down, they all go down together).

Implementation guidelines

Having covered how the Smith can be used as a currency, here are some implementation guidelines:

1. Businesses and retailers need to set up a new currency, the Smith, and if needed, tie it to a new country, the imaginary Smith Republic, in their accounting systems. They need to quote the price of their products in Smiths in addition to other currencies.

2. Exchanges need to convert existing currencies to the Smith (much like what they do for bitcoin), so that consumers can use the Smith to buy goods from retailers who accept the Smith. The Smith needs to be quoted in several currencies for this-and exchanges can use the formulas mentioned above to calculate the current price of the Smith.

Exchanges need to offer an easy mechanism to convert the Smith back into other currencies (a two-way market). The indicative value of the Smith will also be published on this website periodically.

3. The Smith is proposed as a unit to facilitate commercial transactions. It is not designed as an investment or a speculation vehicle, or that it will appreciate in time, etc. against other currencies. Clearing and security of Smith accounts and transfers from them should be the same as for currency deposits today. The Smith needs the active involvement of banks and financial institutions and governments worldwide to be successful. It is not a currency to hide wealth, taxes, etc.

4. There is no paper currency for the Smith, it is purely digital. There are no Smith coins either. The decision to emit paper currency or coins of Smith can be made in an SI General Conference.

5. Much like the slow and gradual adoption of the ECU in the Euro zone before the complete phasing out of individual country currencies like the German Mark and the French Franc and the launch of the Euro, a switch to Smith as a world currency should be a slow process, with the businesses and consumers always having the choice to deal in whatever currency they are comfortable with-it is important to launch the Smith as a parallel currency, and not a replacement for other currencies. If businesses and consumers see the advantages in buying and selling their goods using the Smith, they will automatically start shifting to it, as happened in the Euro zone with the ECU.

Some people have disagreed with me on thinking of money as a unit of measure of value, like the kilogram for the mass, or the meter for the length. They say that value is not a physical property like the kilogram or the meter. I may remind them of the notion of time, measured in seconds, or temperature, measured in Kelvin, as both being man-made intangible, non-physical properties as well, just like the value. If we have universal units for time and temperature, we certainly can have a universal unit for value. The value of objects may be different at different places and times (the same bottle of water costs a lot different in downtown Paris vs. a small town in Portugal), we all know this and are fine with it; a standardized unit of value worldwide would be like extending the Euro over the whole planet, instead of limiting it to just the Euro zone.

We have moved from gold and silver coins to paper currencies successfully in a period of a few hundred years. However, we now have hundreds of paper currencies-and we need to move forward and standardize everything on one global currency. The Smith is proposed with that final goal in mind.

Originally published on the Smith Money site in March 2017

This work is licensed under a Creative Commons Attribution 4.0 International License.

What is money and what are its uses? From gold to paper money to electronic money

Adam Smith in 'The Wealth of Nations'[1] shows us that the fundamental, true measure of the value of an object is labor-objects which need more labor to make, in general, are worth more than objects which need less labor to make. Allowance must be made for different skills and training involved: an object (or service) of labor of a few hours is sometimes worth more than the object of labor of many days, due to the higher skill and training required in the former.

However, it is inconvenient to talk about objects in terms of their labor content or units of labor they save the buyer; and since most objects are exchanged with one another rather than with labor itself, money becomes a more convenient measure of value.  This is the reason goods (and services) are quoted in money prices; but we must not forget that the true value of goods is measured in labor. You exchange the produce of your labor with the produce of others' labor. You get paid for your labor in money, and you exchange that money with the goods produced by other people's labor, is the real exchange going on in the world. Labor is the true price of all objects; money is their nominal price only.

When considered as a measure of value of goods and services (the most common use of money), money may be thought of as similar to the unit of mass, the kilogram (kg) or the unit of length, the meter (m), which from the Système Internationale (SI) units conventions, are standardized units of measuring mass and length. An open source cryptocurrency based on a this idea, Smith Money, here.

From gold and silver to paper money, and now to electronic money

Many things have been used as currencies in the past-salt, cattle, sea  shells, dried fish, etc. Paper money started becoming popular in the times of Adam Smith (around 1760).  However, banks were still required to hold reserves in gold and silver, and the paper currency was backed by gold. This would later be formalized in 1944 by the Bretton Woods agreement, where all currencies were required to be backed by reserves in gold, and someone could exchange their currency for gold by going to a bank at any time.

The Bretton Woods system came to an abrupt end in 1971, when the US, the main original creator of the Bretton Woods agreement, opted out of the convertibility of the US dollar to gold. This was credited to President Nixon, and many economists and finance types predicted the end of the world and run away inflation after this was instituted.

None of the crazy things predicted by the economists happened after 1971. The US continued to become a richer country, and floating currencies (currencies with no gold backing) became the norm after that time.

How could this be? How could a country (US) or the world, transition to a completely paper based currency system, and still have no major catastrophes? A paper currency bill guarantees nothing except that you can exchange it with another one of the same denomination at the bank, now that the gold backing was removed.

The faith in the dollar bill is a faith in the US government, because all collections of taxes are in US dollars, and the US government runs all its operations in that currency - pays the government workers in dollars,  makes payments in dollars for purchases made from private companies, etc. This is why the people could accept a freely floating currency- they realized that as long as the US government collects taxes and runs its operations in dollars (it may help to think of the  US government as a the largest non-profit corporation in the US, which employs about 10% to 20% of the population, directly or indirectly. If the biggest employer in a country runs their operations in US dollars, all smaller entities are fine using the same instrument), their money will always have good value, for the government would not manipulate an instrument it uses itself for its operations (this lesson unfortunately is not understood or followed everywhere, which is why Venezuela's currency has no value). With the removal of the gold backing, the banking system became less relevant.

This successful transition to floating currencies also happened because prices are a time series, and people work hard at an individual level to provide price stability, and in reality exert a constant downward pressure on prices (the inflation data and story is a big lie). When millions of Americans (and the same thing happens in other countries) go out to buy stuff in the grocery store today, they use the prices of yesterday (or whenever they went to the grocery store last) as an anchor, because their wages have not jumped up suddenly in 24 hours. They naturally try to get the most amount of goods for the X dollars they want to spend in the grocery store today. If prices of a product jumps up suddenly, they will buy a much smaller volume of that product, or in many cases will not buy that product at all. This behavior, coupled with the thousands of products which they can spend their money on, forces the prices of goods to fall constantly. This in effect means that dollars saved are worth more tomorrow than today, because they will buy more goods tomorrow that today, even if you just hold the dollar bills and get no interest.

This general stability of money value is also the reason that in most developed countries, people will buy a house on a 20 or 30 year mortgage. They know that prices of goods are generally stable, and so are their jobs. If they were not sure of the general stability (or downward movement) of the prices of goods or their wages (if they lose their job, they can find another job in a few months) they would never enter into such an onerous contract as buying a house on mortgage. They also have some liquid savings in paper dollars (or the country's currency), which can cover the monthly mortgage payment in case they can't earn anything for some months. All this shows an inherent stability in the system-and there was no need for them to rush to a bank to turn their dollars into gold. This happened BEFORE the gold standard was removed; the banks were rarely being called for converting their dollars into gold in the US before 1971. The paper currency took a value of its own, and with a stable government and a reasonably responsible banking system backed by a central bank (which doesn't give money out to people for free) which in turn is backed by the US government, the system in the US and all countries successfully transitioned to freely floating currencies without any backing of gold.

Together with this there was an important development-the invention and acceptance of checkbooks (checks are an extension of paperless bank-to-bank transfers, where previously you had to go to a bank to transfer money from your account to another account. You could now do it much more easily by issuing checks). Checkbooks are a predecessor to credit and debit cards and electronic money-they removed the necessity of carrying around wallets and suitcases (if you buy expensive objects) full of dollar bills. Once checkbooks became an acceptable form of payment, the banks needed to print even less dollar bills, because many payments, especially the larger ones (e.g. buying a car, a house, or company-company payments), could be made via checks.

Credit and debit cards took out checkbooks from the equation. As I write this (in 2017) a large amount of purchases are done by credit and debit cards. We can safely say that in many countries, and this includes not just the wealthy and developed countries, but even developing countries like India and Chile, that most transactions in money are electronic; via bank-to-bank transfers, checks, debit cards and credit cards. I would guess that more than 95% of the total value of the transactions in any developing or developed country are non-cash, i .e. electronic (Sweden reports that only 2% of the country's transactions are using paper money). Most transactions are electronic because most of the total wealth held in money by individuals or companies in any developed or most developing countries is held in electronic form in banks as deposits, with only a fraction, maybe less than 5%, held in actual paper currency. We don't carry around large amounts of paper currencies in most countries; and it is safe to say that we have now moved from paper money to electronic money in the 21st century. The advent of the Internet which simplifies bank-to-bank transfers, worldwide credit card companies like Visa and Mastercard, and payment wallets like Paypal and Venmo are all aiding in a complete elimination of paper currencies, and I surmise that in a couple of decades they will cease to exist altogether, with all money being completely electronic. Sweden already has committed to a completely electronic money system from 2020 onwards.

Every individual or company keeps a small part of their wealth in money (the only exception is the financial sector). Most individual assets are in real estate, household objects and furniture, cars, jewelry and gold; and stocks, which represent ownership of assets via a stock exchange. Companies hold assets which are saleable and do not want to hold money...they would rather own objects which they can sell for a profit than money. Companies hold some money only for liquidity purposes, to assist in the buying and selling of the goods or services they trade in. Most money being already electronic in most developed and developing countries, it follows from this than even a smaller portion is held in paper money (dollar bills, other currency bills) and coins.

When a country like India implemented demonetization to target this small wealth of people which they hold in paper money, they wasted everyone's time rather than rooting out corruption or tax-evasion, because they did not realize that most wealth of individuals is not held in paper money.

The total amount of money in a country is published by central banks. In the US, the money supply M2 most closely matches the electronic money and cash which could rightly be called money. Here is an article about M2 money supply and its meaning.

Currencies and money

Most countries emit their own currencies to run domestic operations, both government and private. Taxes to government are paid in a domestic currency, which give the most direct value to it.

It is helpful to think of goods (and ultimately, labor) as deciding the value of a currency, not the other way around. If you have a fair government which doesn't borrow too much money and is generally responsible in running its accounts, paying its interest on time, etc. people will have faith in the currency of such a government, and people will keep a part of their wealth in that currency.

If a currency goes down against many other currencies in a short period of time (as is the case for Argentina, Venezuela and Turkey in 2018 and 2019) it is not that the goods in these countries are going up in price; it is because the currency has lost its value against these goods. Goods are traded worldwide and is the reason why world trade exists; currencies often are not exchangeable outside a country. Goods maintain their value worldwide. This is very obvious with high value goods like electronics, computers, etc. which can be easily transported across borders if there is a substantial price difference between two countries. This arbitrage or profit opportunity prevents the value of goods from deviating too far between countries-if the arbitrage opportunity is large, people find a way to get the goods in or out of a country. A sudden fall in the value of a currency against all other currencies is an indicator of a problem with the government or central banks, which is not running its account in a responsible manner. This is why capital controls or currency pegs fail; the government cannot force people to accept a currency if it itself misuses it (e.g. by giving out silly loans which are never called back, as normally happens between central banks/banks and government entities).

Currencies are often blamed for crises. Italy blames the euro for a bad economy, and wants to bring back the lira. The same is the case with Greece, who says the euro caused it to become bankrupt, and the drachma should be brought back. Argentina on the other side says completely the opposite-it says that the peso is the cause of all its problems, and adopting the dollar is the only solution. All these currency blame games are without any basis. As explained above, money is a unit of measure, of value, and the value of something doesn't change if you change the units. Just like if you switch from meter to foot, dimensions of objects do not change. The value of assets of a country's citizens do not change if you measure them in dollars, pesos, euros, liras or drachmas.

Role of the banks and financial system

There is a lot of confusion in investment and financial circles on the meaning of money and the role of the banking and financial system. More on the role of banks here.

For an updated version of this article download my Economics book on Amazon Kindle here

Business-margins vs. volume; why low taxes are good for a government, demand functions

As a general rule in business, as you lower prices of your goods, your profit margin (net margin of profit, as a percentage of revenues) goes down but you more than make it up by selling higher volume. This happens because people are more likely to buy or buy more of a product when it gets cheaper; or the demand of a product goes up with a decrease in price.

Conversely, if you raise prices of a product, people find alternatives, or simply do not buy as much of it-they have a thousand other products to buy with their money.

Walmart operates at a low profit margin of about 3%. A small kiosk has a very high profit margin, maybe 50% or even 100%. Who makes more money? If the profit margin percentage is the measure, the kiosk seems to make more money. But the kiosk won't sell much volume at those high prices. Your total profit is normally proportional to the total revenue, which is the volume of goods sold multiplied by price, and since your goal is to increase your total profits, you must never forget to consider volume when you consider setting prices for your goods. Volume of goods sold does not increase linearly as you lower prices, it increases in a power law or exponentially as you lower prices (how it does exactly is not known to anyone...more on this below). The key to a successful business which gives you large dollar profits is high volume, low prices or low profit margins. It is better to sell 1000 oranges at $1 each than sell 10 oranges at $10. Assuming oranges cost $0.50, your total profit in the first case is $500, whereas in the second case, only $50.

I often hear people complain about higher prices (sometimes disguised as inflation, covered in detail here). Any time a business raises prices they give up volume. The reason the McDonald's burger costs $2 and not $20 is because they won't sell much volume at $20.

A good businessman friend of mine, Rajesh Santlani, once said to me-if you want to make money, operate at low profit margins, and sell high volume. For success in a business, the name of the game is volume . It is as true for governments (taxation) as it is for businesses-if the governments ran themselves as a good business, and you can think of the government as a large non-profit or zero-profit business in one sense, they should lower taxes as a percentage of the value of goods, and never increase them.

Let us say the government increases the sales tax on a consumer good from 10% to 12%. Politicians often vote for these kinds of increases, because they think of this as easy money; they forget to consider that if the volume of goods sold goes down by more than 20%, the government will actually take in less money than before. For example, for a $100 value of goods sold, the net tax collection was $10 in the original scheme, and if the volume of goods sold decreases to $70, the net collection will be $8.40, which is less than before.  The net tax collection goes down when the percentage of tax is increased.

Assuming that a government wants to increase its total tax collection revenue, which would mean the net dollar amount collected by the taxes to support the government, the best strategy is the same as a strategy for a large business-lower the tax percentage and try to get more volume of goods to tax.

This is also true in taxation on imports. Keeping taxes on imports low (as a percentage of the value of goods) increases the volume of imports, and it is a good idea to keep trying to lower the taxes if a government wants to collect more total taxes at customs. Often times the clamor of nationalists and "buy home made products" clouds this policy, and imports are taxed highly; they effectively kill the volume of imported goods in the  country, to the great disadvantage of the government itself, who could pick up more total taxes if they kept the percentage of taxes low. This also hurts the consumer, who is left with less choices of goods in the home market.

Demand functions and how price and volume of goods sold vary with each other

From what I have said above, we can model an approximate demand function. If "V" is the volume of goods sold and "P" is the price:

V is proportional to 1/P^2

or V = K/P^2 where K is a independent of P.

With this formulation, the Revenue, R, is:

R= PV = K/P

which agrees with the observation that revenue goes up as the price decreases.

The volume of goods sold can go up slower or faster as price decreases, but will always increase as price decrease, so we can say, in general:

V = K/ P^n , where n>1

This relationship between price and volume is independent of the number of actors in the marketplace, competition or monopoly power, etc. Even if there is only one company which has a complete monopoly over selling a product, as this company decreases prices, it will find that it can sell higher and higher volume. Therefore, even for this monopoly it makes sense to lower prices to increase profits. The common theory that only in the presence of competitors prices go down is flawed; a smart monopolist still comes out ahead if it lowers prices. However, monopolies are lazy and do not always act in their own best interest, and do have a tendency to maintain or raise prices.

Business school and finance types will talk about stuff like price elasticity of demand and prices, Giffen goods (goods whose demand go up as their price goes up), etc. They have little experience in running a business in real life, and do not realize that businesses, especially the stable large ones, have a simple rule of success-to lower prices constantly and increase the volume of sales to increase their total revenues and profits. They do not pay much attention to maximizing profit margins-as long as they are profitable even at a very low, e.g. 1% profit margin, they will keep selling their goods. Because the goal of a good business is to take in large and increasing amounts of net total profits (in dollars or euros, or whatever), not to maximize profit margins.

How international trade works-balance of trade-equality of exports and imports

Balance of trade is an often talked about subject by countries. The United States whines about a negative balance of trade with China, China whines about a negative balance of trade with South Korea, etc. etc. This was covered by Adam Smith in his Wealth of Nations [1]-but needs a new look in the present context.

Rule: Value of Annual Exports=Value of Annual Imports (E=I). The net balance of trade of a country with the rest of the world, i.e. all other countries taken together, is always zero.

Money and currencies (dollars, euros, yuans, etc.) are just a way to facilitate the exchange of goods (and services) between countries. The existence of currencies simplifies barter; but in the end, all trade is ultimately barter. What Chile imports annually from the world, is necessarily equal in value to what it exports annually (the major exports of Chile are copper, wines, fruits, and salmon. The major imports are construction materials, cars, electronic goods, machinery). Everything which Chile sends out in the form of exports, comes back in the form of imports. The reason to consider this over a year (annual) is because there may be a delay in the accounting of exports and imports and there may be a month to month variation where a surplus or deficit might run in a month because of not receiving the money in the same month, but over a longer period of time, say of one year (assuming payments in 30 to 90 days), the net exports should be equal to net imports. Chile is not sending its good anywhere for free; and neither is any country giving away their stuff to it for free (ignoring the small amounts of goods countries send out as charity/aid). The equality of exports and imports is a necessary condition for trade.

In practice, Chile first exports its goods to the outside world (more precisely, it is the companies in the Chilean exports sector who do this), gets US dollars (or yuans or euros) for it, and uses those dollars to buy goods to be imported to Chile (the companies who import goods into Chile do this part). Currencies serve as intermediaries to facilitate this underlying exchange.

The only reason to export goods (or services) outside your country is to buy objects or services produced by other countries, i.e. to import stuff (exceptions to this are covered later below).

It follows that if you export more, you import more. Similarly, if you export less, you have to import less. The value of what you export is the upper limit to how much you can import into a country.

Note that this is for a country with all the rest of the world taken together. However, Chile may run surpluses or deficits with any one country for a long period of time or forever, without this rule being violated. That's because countries are trading with each other, and surpluses with country A cancel out a deficit with country B.

Let us imagine a world with only three countries-Chile, USA and China. The numbers are just for example purposes, and are not real.

Chile exports 10 million dollars worth of wine to USA.
Chile exports 5 million dollars worth of Salmon to China.
Chile receives 15 million dollars worth of machinery and automobiles from China.

Therefore, against USA, Chile is always running a surplus in trade balance, because it is only exporting, but importing nothing from it.

But the surplus against USA must be exactly equal to the deficit against China, as you can see, to make sure that the net exports are the same in value as net imports for Chile.

There must be some form of trade between USA and China, where USA must be exporting something to China and running a surplus with China for exactly 10 million dollars.

An example might be

USA exports 500 million dollars of airplanes to China
USA imports 490 million dollars worth of computers from China

Taken all the data together, as shown in the figure above, makes every country's exports exactly equal to its imports.

Even if Chile is forever running a surplus against USA and a deficit against China, it all needs to add-up perfectly for it, where all exports come back as imports, directly or indirectly.

Note that in this example, USA always runs a surplus against China.

This example can be extended to 4, 5 and hundreds of countries, with similar results.

Hopefully you can see with this explanation that there's no fuss to be made about a country running a deficit with a particular country. It is just the nature of trade. For every surplus, there must be a deficit with a different country somewhere.

You can extend this concept to smaller divisions within a country (to States), to counties and ultimately to even to the individual level.

Therefore, Texas has a net trade balance of zero with the rest of the USA+other countries. What goes out of Texas, must come back into it, either from other States in the US or from other countries directly to Texas.

For an individual-what you produce, you must eventually exchange for what others produce. You eventually exchange what you produce with the what others produce.

My trade balance with Walmart is always negative-I only buy stuff from Walmart, but don't sell anything to it. Does that make me worse off? Not at all. If I was to profess equality of trade surplus and deficit with Walmart and each company separately, I would have to sell something to Apple, Walmart, Home Depot, and thousands of other companies I buy stuff from, individually making sure that I don't buy anything from these companies if I don't sell anything to them. What I do normally is sell my labor to some company, get dollars for it, and with these dollars, buy a load of stuff from Walmart, Apple, Home Depot, etc. More on this here.

Another way to look at this is by considering the whole planet earth. The net trade balance of the earth as a whole is zero-the earth doesn't export or import anything to anyone outside of earth. If you divide earth into just two countries-what goes out of one as exports is equal in value to what it receives in return from the other country as imports(unless one country is perpetually stiffing the other...). If you divide the second country into smaller countries, this result won't change. Thus the trade balance of a country with the rest of the world is exactly ZERO.

Corrections and adjustments to the rule

A couple of corrections need to be done to the rule, 1) when a country is loaned a large amount of money by foreign countries e.g Greece or Puerto Rico, whose governments were loaned large sums of money by foreign entities and 2) when a country has a good fraction of earnings coming from tourism e.g. Costa Rica. For these countries the annual exports will not be equal to the annual imports (exports will be smaller than imports), because a loan from a foreign entity or a tourist bringing in money are effectively an assignment to bring in additional imports. When an American tourist goes to Costa Rica and spends a few thousand dollars there, those dollars are in reality used by Costa Rica to buy imported goods. Same with loans to Greece by the German banks-the loans are in Euros, and Greeks will buy stuff using their Euros for their country, without having to export any goods. When the rule is skewed by foreign loans, as in the case of Greece and Puerto Rico, it is temporary, until the loan is paid off or the country defaults, as has happened with Greece and Puerto Rico. When it is by tourism, as for Costa Rica, Bahamas, Thailand, etc. the deviation from the rule, or the imbalance of exports and imports, is stable and can continue on forever.

Let's examine the case of a tourist country like Costa Rica in detail. The net imports of Costa Rica will be considerably more than the exports for Costa Rica.
The tourists who come to Costa Rica will sort of bring in their own consumption rights to the country-in the form of foreign currency bills, normally US dollars. It as as if these tourists saved up loads of things to be consumed in their home countries, but instead of consuming them there, they came to consume them in Costa Rica. This increases the importation of goods for Costa Rica, because these foreign tourists in Costa Rica have the right to bring goods from foreign countries, which they normally express by carrying US dollar bills.

If you have to troops to foreign lands-major countries like Russia, USA and France have a large number of troops outside their borders, they are indirectly fed and supplied by exports from the home country. What the French troops consume in Algeria needs to be exported out of France in some way.

Some adjustments must be made for credit and foreign currency accumulation-for Chile might export stuff and instead of exchanging them for other goods right away, maybe hold US dollar reserves, to buy something later in the US or in other countries. This is a small correction to the rule E=I, because dollar or foreign currency reserves are a small part of the net value of goods exported or imported-they are  like the liquid cash any businessman holds to facilitate transactions.

If you see recent data it seems that the US is running a constant trade deficit with the rest of the world for many years. On the other hand, China seems to be running a constant trade surplus with the rest of the world. This is a problem with incomplete or bad data- not everything which goes out of  or comes into a country shows in the exports and imports numbers at customs. For example, Chinese have bought a lot of real estate in Canada, and that purchase must have been financed by something exported out of China (the goods exported from China have been exchanged with a house in Vancouver, BC, Canada). Chinese tourists are the biggest tourist group to Thailand-and are known to purchase massive quantities of goods in that country. That purchasing power also comes from what China has exported from its shores in some way. As explained above, these activities of Chinese citizens will not show in the customs declarations or the standard export and import numbers.

The US stock market attracts capital from all over the world, and that will also not show up in the raw export and import numbers reported by customs. These investments have the same effect as a loan to a foreign country-they will make the exports figures be less than imports. This can continue on for many decades, as long as the US stock market keeps attracting foreign capital to it.

Similarly, exports and imports of intangible goods like software (software exports are a large part of exports for some countries like the US and India), and digital games, digital movies, etc. do not show up in the customs and import-export declarations. Corrections need to be made to our rule for this.

Some countries have a large amount of money coming into them from remittances by their expats abroad (e.g. Mexicans in the US). These will also not show up in customs import or export declarations, warranting another  correction to our rule.

Trying to encourage domestic industries by restricting imports has the opposite effect, it actually discourages domestic industry overall

If you agree that this basic equality of exports and imports holds, we can show that if you restrict imports in industry A to improve domestic industry in A, you must at some other place restrict the domestic industry B, which was producing B domestically, which was being exchanged for the imported product in industry A.

Before the restriction, imported industry A products must have been exchanged for something which went out of the country, products of industry B, for the trade equality to hold at that time. The moment you restrict imported industry A products, ostensibly to increase the production of industry A in the country, because you have restricted the total amount of industry A products now coming into the country from foreign sources, you must be exporting less of some domestic products of industry B.

A reduction in importation, by encouraging a domestic producer, automatically results in a reduction in exportation, and the industries which were exporting will be hurt indirectly.

A government must never restrict importation of industry A, and let the market take care of itself, because the skilled part of the country is the industry B, who by their great products and skillful exports were getting the imported products of industry A into the country.  The country has built a comparative advantage in B, that's why it is able to sell those products outside the country, and you don't want to handicap your strongest player to support your weaker players, which is what happens when you restrict imports in a particular industry.

Free trade (a trade without restrictions on imports, or exports for that matter) therefore automatically allocates capital in what the country does best.

You should not get worried at all of you see imported goods in your country, in fact, you should celebrate it, as I show here. You can be sure that a fellow countryman of yours must have exported some goods outside of your country for these goods to be imported in the first place.

To explain this important idea better, let me give you an example. The Indian government has a very misplaced "Make in India" drive to encourage domestic manufacturing. Apple is being encouraged to buy mobile phone components from domestic Indian companies, or if they want to import them, they shall be taxed heavily. What they do not realize is that the imported mobile phone components can be brought into India only by India exporting something out of the country. By forcing Apple to buy domestic components, they are hurting another (unknown) domestic industry whose products must have been exported to bring in the imported components. The US also has a "Make in USA" rhetoric, which is equally hurtful to the US because of the same reason.

What is true for capital is also true for jobs. By restrictions on imports, you push extra capital, and together with it, extra jobs into the hands of your weakest industries. The job gains in the domestic sector where imports are restricted is compensated by job losses in industries which are exporting.

Physics fans will realize that the Rule E=I is like the conservation of energy principle-energy can never be created or destroyed (except the modifications due to Einstein).

What does the actual trade data for countries look like?

With the disclaimer that trade data is very difficult to capture and what is declared sometimes in importing or exporting is not exactly the value of goods, let's see if what I have proposed above agrees with the data.

Import Export Data by country, top 20 countries by nominal GDP
All values are in billions of US Dollars, year 2016
Data source: World Bank trade data-see this link for details

Country	Imports	Exports	Ratio (Imports/Exports)
USA	2248	1450	1.55
China	1588	2098	0.76
Japan	607	645	0.94
Germany	1061	1341	0.79
UK	636	411	1.55
France	560	489	1.15
India	357	260	1.37
Italy	405	462	0.88
Brazil	137	185	0.74
Canada	403	389	1.04
South Korea	406	495	0.82
Russia	182	285	0.64
Australia	189	190	0.99
Spain	303	282	1.07
Mexico	387	374	1.03
Indonesia	136	145	0.94
Turkey	199	143	1.39
Netherlands	398	445	0.89
Switzerland	269	305	0.88
Saudi Arabia	164	201	0.82
		Mean	1.01
		Std. Dev.	0.26

The mean value of  the Import/Export ratio is (surprisingly) close to 1. However, the data has a large standard deviation of 0.26, with the range being between 0.64 to 1.55.

I found another data set for imports exports, and here is the table for imports and exports in 1970. It is adjusted for today's US Dollars (inflation corrections etc. stuff I don't agree with, but still, I will present the data as is, from this independent source, and way back in time, 1970. I chose that year to be several decades behind today to make it two independent snapshots in time).

Import Export Data by country, top 20 countries by value of imports, 1970
All values are in billions of US Dollars (year 1970, adjusted, see link for details of adjustments)
Data source: Barbieri, Katherine and Omar M. G. Omar Keshk. published in 2016. Correlates of War Project Trade Data Set Codebook, Version 4.0. Online: http://correlatesofwar.org

Country	Imports	Exports	Ratio (Imports/Exports)
United States of America	42.70	43.22	0.99
Germany	29.96	34.23	0.88
United Kingdom	21.73	19.35	1.12
France	19.09	18.01	1.06
Japan	18.78	18.96	0.99
Canada	15.18	16.75	0.91
Italy	14.92	13.18	1.13
Netherlands	13.39	11.76	1.14
Russia	11.74	12.80	0.92
Belgium	10.85	11.03	0.98
Luxembourg	10.85	11.03	0.98
Sweden	7.01	6.78	1.03
Switzerland	6.49	5.16	1.26
Australia	4.99	4.78	1.04
German Democratic Republic	4.85	4.58	1.06
Spain	4.75	2.39	1.99
Denmark	4.40	3.35	1.31
Poland	3.97	3.55	1.12
Norway	3.70	2.38	1.55
Czechoslovakia	3.70	3.79	0.97
		Mean	1.12
		Std. Dev.	0.26

The mean value of  the Import/Export ratio is 1.12, close enough to 1. The data has a large standard deviation of 0.26, with the range being between 0.88 to 1.99.

I believe that the data sets of these two widely different years, 2016 and 1970, confirm reasonably well what I tried to show in the article, that the value of imports is approximately equal to the value of exports.

This article is very closely related to the article here about anti-dumping duties, restriction on imports because of bad trade balance numbers with a country, supporting domestic producers, etc.