February 7, 2017

What do Donald Trump and Germans Have in Common? More than You’d Expect!

Unless you live in tornado alley, there’s probably a pretty small chance of a powerful windstorm causing downed limbs and fallen trees on your house or surrounding property; a small chance, but not zero. If you estimate the probability of such an occurrence to be high enough, you may even find it worthwhile to take some precautions and prepare a few items in case you are affected. Maybe you purchase a chain-saw or even a generator, to be ready in the event that a storm does strike. What happens though, if one day your neighbor drops by looking to borrow your chainsaw to cut down some trees on his property? If you think the chance of you needing the saw soon is small, you’ll probably be happy to let him borrow the saw. But what if you happen to catch the weather report on the news, and they're airing a special segment on the devastating impact of past storms. If a statement like that causes you to increase your estimate of a storm’s likelihood, would you change your actions and decide that lending out the saw is just too risky? You may be asking yourself, what does all of this have to do with Donald Trump and the German government? The answer is, both Donald Trump and the German government have made some interesting statements in the previous year that warrant some discussion of how they may cause people to change their actions.

Image: Donald Trump's statements on the probability 
of default may have interesting effects.
(Photo credit: Gage Skidmore on Flickr)

In the case of Trump, he made statements in May of 2016 to the effect of saying that the U.S. can’t default on its debt, because it has the ability to print more money to pay off those debts. How does this statement affect expectations? In order for the U.S. to borrow money and take on debt, it has to find people who are willing to lend the money. The interest rate that those lenders require in order to agree to lend their money depends on how likely it is for them to be fully paid back. For instance, if I were offered the opportunity to purchase a U.S. Treasury Bond today that was worth $100 one year from now, two things would affect how much I would be willing to pay for it; the interest rate and the likelihood of default.

First, I’d factor in how likely it was that I would actually be paid the $100 next year; that is to say, the probability that the borrower (U.S. government) would default on the loan. If you’re lending money to your sketchy neighbor, you might say it’s pretty likely he’ll default. If you’re lending money to Mother Theresa, you may be less skeptical. Here Donald Trump is reinforcing the perception that the probability of the U.S. defaulting on a loan should be approximately zero. This is good from the perspective of the borrower, since it should lead to a lower interest rate that the U.S. has to pay to borrow the money.

Image: What determines your willingness to lend money?
(Photo credit: quazie on Flickr)

The interesting portion of Trump’s statement, however, is how it affects the interest rate in a different way. If you’re lending money, you want to be sure that the money you’re paid back in the future will be able to buy more goods than you could buy with it today. This is the compensation for you delaying your purchase. You’ll therefore decide the minimum amount of interest you must be paid by examining how the rate compares to expected inflation. Trump’s statement seemed to indicate that the U.S. would be willing to print money to pay off current debts. While this makes it cheaper to pay off previous debts in the short-run, it means previous lenders aren’t getting as much buying power as they expected. In the long-run, printing more money unavoidably leads to inflation. Printing a lot of money leads to a lot of inflation. This devalues the currency, meaning you need to trade more dollars for the same number of goods. If you announce intentions to potentially print a lot of money in the future, then lenders will require a higher interest rate now in order to maintain the same amount of purchasing power after the value of the dollar decreases.

In the case of Germany, the German government advised citizens last August to stockpile food and water for ‘civil defense’ purposes. The statement was urging citizens to have 10 days of food and water in reserve, in case of a national emergency that temporarily cutoff supply lines. If people take this statement seriously, it could create some economically interesting short-term adjustments. The demand for stockpile-able items, such as canned food and bottled water, would increase as more people entered the market for these goods. As such, we would expect both the price and quantity sold of these goods to increase, in a short-term bump. However, this increased demand would presumably return to normal levels after the stockpiles were accrued. What would be even more interesting to observe is how producers of these goods read the signals of the higher demand, not knowing that it was only temporary. If suppliers misinterpret the short-term increase in demand as a permanent shift, then they may invest in long-term capital expenditures (such as new machines, larger plants, etc…) to try to keep up with the heightened demand. Unfortunately, these investments would soon prove unprofitable, as demand fell. All because people’s perceptions were changed by a simple statement.

Image: Germans were encouraged to stockpile food and water.
(Photo credit: Julie & Heidi on Flickr)
As you can see, it is not only concrete actions which can have a profound effect on an economy. Mere statements on a topic can alter people’s perceptions and expectations, and expectations form an extremely important part of our decisions on what actions to take today. As always, it’s important to think before you speak, and consider the ramifications of information you convey.

What’s your take on the impact the statements discussed above may have had? Have you recently changed your actions based on a change in expectations (perhaps you purchased a new car or television after your expectation of a raise or promotion at work increased)? Feel free to discuss in the comments below!

No comments:

Post a Comment