Thursday, February 11, 2010

The Infatuation with Elegance

Economics, as an institution, is one that has tended to have an infatuation with elegance, a notion that simple solutions will emerge from the proper approach, and that the layman's instinct to roll up his sleeves and fixate on minutae is a sign of simplemindedness. This tendency is most pronounced in the political gestures made by the prestigious minds at the forefront of the modern day's many schools of economic thought. They propose that an economy can be improved by some radical change to monetary policy, by a restructuring of the tax system, or by general policies of laissez-faire. Ironically, it takes but the smallest bit of critical thought to dispel this illusion, and to reveal the incredible complexity necessary in even the most rudimentary of public policies. It is not that these minds have an inability or unwillingness to think critically; rather, their very academic careers depend upon their continued championing of the school of thought to which their thesis represents an oath of allegiance.

Wealth is taken often to mean the total monetary value of an individual's assets. If this is the case, then the distribution of wealth alone can hardly be taken as an indicator of the general quality of life. Let us use a simple example, that of the production of bread, from overwintered wheat grains ready to be sown in the spring, to the point of consumption at the table. It is clear that one must look at details: what portion is the cost of a loaf of bread of a laborer's daily wage, and is this state of affairs inclined, without further intervention, to improve or to become more severe, threatening the laborer with starvation? Here again, it is not enough to simply look at the possible, to assess the amount of labor spent in baking the loaf - though a certain level of productivity is necessary for a given quality of life it is not a sufficient condition. Productivity gains can in theory be distributed in any way the firm owner wants between price reductions, cuts in number of labor hours, and expansions of the production level. If any part of the supply chain cannot expand to meet increased demand for its factor goods, prices will not tend to fall and output will not tend to increase, thus unemployment becomes inevitable. In some situations, prices may also rise.

It is also not the case that the combination of different industries, each with a certain level of complexity, is confined by a law of interrelation that limits the total effect to some predictable bounds. Though it is true that as new industries are added, complimentary pairing can arise that compensate for some supply issues, a survey of major economies today reveals a few "bottleneck" resources that can each prevent a smooth expansion of supply levels in every industry. Few industries can go without gasoline in the distribution of goods. Nor can industries go without at least one of electricity, water, fertile land, available real estate, healthy ecosystems, or a general public willing to be fleeced.

One must ask, what about technological advancement? But here, the general trend of history indicates that technology is correlated with increases in resource consumption rather than reductions. In any event, a fundamentally unpredictable thing such as technology cannot make the supply of essential goods more predictable. If, in theory, the economy can become predominantly information oriented, and a permanent, abundant supply of electricity can be secured, the massive production and replacement of electronic gadgets would remain a source of both uncertainty and toxic waste.

We can now turn to the specific limits of monetary measures in the prediction of economic conditions. The welfare of person A is wholly uncorrelated with the wealth of person B, so long as person A and person B consume the same goods and negotiate for the same prices on these goods. In fact, if person B has a great deal of wealth, he may even get a better deal on some goods than person A, simply because his wealth will open doors for him. Inevitably, though, person B will not consume the same goods that person A does, nor will he negotiate for the same prices.

If one charts the flow of money within an economy, one will find that it is constantly flowing from individuals to businesses, then from businesses to banks, and from banks back into businesses, who return a portion of it to individuals in their wages. Assume that times are prosperous and every sector is flourishing. Here, a few inequalities generally apply. Businesses must collect more from individuals (revenue) than they give out in wages and loan payments (we may leave out business to business transactions such as costs of services and utilities, as we are looking at businesses in aggregate; furthermore wages includes dividend payouts). Similarly, banks must collect more in loan payments than they give out in new loans and wages. Investors must collect more in dividends than they pay in loan payments. Finally, individual incomes (wages) must exceed loan payments and payments to businesses if individuals are to become more wealthy.

This is described symbolically as follows

I.Business > W.Business + L.Businesses
I.Banks > N.Loans + W.Banks
W.Business + W.Banks > I.Business + L.Individuals

Additionally, Loan payments by businesses plus loan payments by individuals is the sum of bank income. Thus,

I.Banks = L.Businesses + L.Individuals

But can this linear system be satisfied with positive values? Let us check:

Start by subbing out I.Banks:

I.Business > W.Business + L.Businesses
L.Businesses + L.Individuals > N.Loans + W.Banks

=> I.Business - W.Business > L.Business
L.Business > N.Loans + W.Banks - L.Individuals
=> I.Business - W.Business > N.Loans + W.Banks - L.Individuals (1)

W.Business + W.Banks > I.Business + L.Individuals
is equivalent to:
W.Banks - L.Individual > I.Business - W.Business (2)

(1) composed with (2) gives:
=> W.Banks - L.Individual > N.Loans + W.Banks - L.Individual

Which is equivalent to:
0 > N. Loans

Thus, the system cannot be all positive. In particular, new loan issues must be negative! In the real world, businesses and individuals actually accept new loans to offset various costs, meaning that many operate at a loss, hedging on better times ahead. However, these inequalities indicate that some sector is always going to lose out.

Indeed, these inequalities indicate that loans are being paid back in times of prosperity, such that eventually the banking system withers away and ceases to exist. Perhaps the banking system is a structural object, never intended to occupy a central place in economic life, but present only due to the persistent imperfections in the market. It is likely, then, that prosperity can be better insured through a policy of tight regulation of banking, and perhaps its confinement to single state charters or being an entirely government run enterprise.

Returning to the nice consumer pair A and B, what types of goods is the person B inclined to purchase? B will purchase the following:
  • Similar basic necessities to A
  • Real estate - B will bid up real estate that A is considering purchasing and lead to higher rental rates if A is renting
  • Land for its natural resources (This will benefit A if it expands economic growth, harm A if it causes environmental damage or the reverse if purchased for sake of squatting or conservation).
  • Luxury goods that do not appreciably increase B's quality of life but may compete for scarce resources and/or get A a better job.
  • Political favors, generally to give B an unfair advantage in the market place
  • Charitable donations
  • Investments in existing businesses (various effects, from good things like reduction of banking to bad things like monopolization)
  • New starting businesses
This last point, though, warrants some expansion. If a society has a coherent standard of civic virtue, B may develop his business for the sake of having a business. If he has ties to his community he may be content to run without a profit or with little profit (honest competition) simply because he will be cognizant of the benefits he is giving to the community. However, if the structure of industries is generally too concentrated (e.g. in megacorporations, box stores, etc.), B may not have any such opportunities. Furthermore, the society may be organized in such a way that genuine communities may be impossible (e.g. sprawling suburbs with no coherent design) or his culture may spend disproportionate amounts of time engaged in antisocial behavior (e.g. watching television or blogging).

Of course, having large amounts of money is different than having a high income. Assume the money supply in an economy expands in the following fashion: the dollars are distributed in an equal fraction to each member of the economy. Then any person who makes X more than the average income must have a total of Q individuals who make Y less than the average, such that X = Y*Q. In fact, net income within the economy (changes in dollar wealth) is equal only to the total amount of new money added to the money supply. Thus, unless prices drop as income becomes concentrated, the quality of life of those at the bottom tends to fall.

So on and so on, myriad details form a web of economic exchanges that has many dimensions and caveats. The interdisciplinary nature of proper analysis in this field ensures that those who focus primarily on mathematical models will not grasp the nuances necessary to make accurate predictions.

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