Ultimately, ethical imperatives must be absolute in nature. That is to say, it is invalid to use a relative measure to determine the morality of an action, unless that relative measure is used as an inference to some absolute state of affairs.
Suppose a person were to assert that "college students have a duty to get good grades". This imperative would be invalid if grades were rated on a curve such that some students must get bad grades. However, many people actually intend this statement merely as a surrogate for the statement that "college students should study hard and learn the materials to the best of their ability", with the assumption that some will inevitably not study hard and be the same students who do poorly.
Additionally, the assertion that "only the best alternative among good alternatives is morally acceptable" is nonsensical, as it represents a double evaluation. If an alternative can be seen as good, then it cannot follow that it is also not good. Typically, examples that fit this definition suffer from a lack of sufficient parsing, stringing together series of actions into a single object. It may actually be possible to define actions in such a way that better alternatives do not exist, by looking at each decision point as a separate action in which only one choice is the good one.
Wednesday, February 24, 2010
Monday, February 22, 2010
Trade: Dangers and instabilities
The political and media game in the midst of this Second Great Depression is sadly fixated on real estate and banking. Certainly, these sectors have played a role in the collapse that we have experienced, but it is wrong to attribute the full force and persistence of our malaise on just these sectors. At the very core of the economic problem, it is not currencies that are to blame. Balances of income and expenditure between various regions of the globe and sectors of the economy are what actually determine things like unemployment rates and other numbers of political importance. Additionally, the degree of achievable prosperity is constrained by the rate at which key natural resources are exploited. These two determinants of economic outcomes are aspects of economic geography and market structure.
A firm that follows a neoclassical business strategy will seek to maximize production efficiency by minimizing costs per dollar value of finished goods. Such profit maximizing philosophies are clearly the norm among large scale businesses. This model takes both workers and consumers as essentially being factors of production. The final product of the firm, in the mind of the firm's owner, is not the product for sale but the income stream that firm profits bring to him.
This maximization is best achieved through locating of factories where the necessary natural resources can be plentifully obtained and where costs of labor are low. The degree to which real estate costs affect this calculation seems to be minimal, in part because low cost of labor tends to correlate with low cost of real estate. Delivery of natural resources to the factory and a means of moving finished goods to port are the required infrastructure developments and these are also expressed in the production cost. Low shipping and transport costs (primarily the low cost of shipping on large tanker ships) make the possible market for goods global in scope, making distance to consumer largely irrelevant in all cases except for goods that are perishable. Therefore, manufacturing for non-perishable goods will tend to be concentrated where costs of production are lowest.
Regions that offer ideal locations are invariably those that have both persistent poverty and a well organized government capable of and interested in providing the necessary infrastructure to the factory. The goods produced will be sold on a global scale, directly to nations which are not ideal locations for new factories.
All factories eventually become depreciated to the point of needing to be shut down. Therefore, new economic growth is not a prerequisite for the relocation of these factories to more optimal regions. Rather, over time, industry in general will naturally move into those regions.
Firms in these factories' host countries will have revenue in the goods importing country's currency, but pay their workers in the local currency. Therefore, they must exchange most of the imported currency for local currency. With a floating exchange rate, this is merely the sale of that currency on the market. The imported currency's value is equal to that of the goods it can purchase - that is the value of manufactured goods offered by the goods-importing country.
If a simple system of comparative advantage emerged from this relationship, two effects would result. First, the goods-importing country would experience relatively fewer working hours and relatively lower prices for goods when compared to wages (higher standard of living) than the exporting country. Secondly, over time the exporting country's higher level of savings and lower unemployment would reduce poverty to the point that wages would be bid up, while the importing country's lower (or negative) level of savings and higher unemployment would cause wages to be bid down, effectively leading to a trend toward equilibrium (or, more likely, an equilibrium-centered oscillation) and a progressive reduction in the level of wage differences between the two countries.
This simple system of comparative advantage is complicated by three factors. New technology that is developed will tend to dramatically slow the trend toward equilibrium. Shifting balances of trade with other countries will create chaotic effects that contribute a high degree of uncertainty to the analysis of eventual effect. Finally, changes in output levels will alter the purchasing power of consumers in both countries and lead to a non-unique equilibrium.
New technologies that are available tend to originate through the research of wealthy countries that have the resources to spend on comprehensive education systems and research funding. These technologies become a market good that is exported from the goods-importing countries and slow the rate of convergence toward the equilibrium described above. This effect has the following characteristics: first, firms must save up or receive loans in order to make the costly technology purchases and implement them. This leads to a financial market that mediates (with occasional speculation bubbles) the collection of currency in the goods-importing country's denomination. Firms are unlikely to take loans in their local currency and attempt to then save up imported currency because this time consuming process has a large opportunity cost and may involve costly interest payments as well.
These new technologies will bring about three types of improvement for the firm that implements them: 1. Labor usage reduction; 2. Natural resource usage reduction; 3. Greater market share. For this reason, new technologies can accelerate the rate at which markets become monopolized, and can actually lead to lower levels of employment within markets.
Additionally, this process will affect both economies in different ways at the macro level. For the goods-importing country, the tech industry will sustain higher levels of employment. This will sustain higher goods importation rates for longer. For the goods-exporting country, the higher rates of market monopolization and lower employment levels that technologies bring will actually slow the rate of poverty reduction. Thus, the trend toward equilibrium is slowed by technology. Both of these factors, however, will eventually dissipate unless new technologies are introduced at a constant rate, or if a technology development industry develops in the exporter country. Because new technologies are actually developed erratically, markets will tend to spurt toward equilibrium, then stall, then spurt again, rather than moving smoothly. This can lead to oscillatory effects that prevent the existence of steady states.
The comparative advantage equilibrium is further complicated by the effects of the comparative advantage of other countries. If natural resource costs increase, or if exports to another sector increase or decrease, the labor and natural resource markets will transmit these effects throughout the market, affecting the balance of trade between all trading partners. The demonstration of oscillatory effects in complex equilibrium systems is a topic of high mathematical sophistication, but oscillating reactions have been discovered in chemistry, a discipline in which the units are approximately 21 orders of magnitude finer and therefore statistically better behaved than an economy.
Finally, the simple model is inaccurate in part because drops in exports, caused either by a loss of relative currency value of the importing nation or a drop in incomes due to higher unemployment, typically leads to an increase in unemployment or decreases in wages in the exporting country. This effect implies that increases in measured comparative advantage can lead directly to a diminished economic outcome.
Taking these things into consideration, where does our current economic position fit into this model? Likely, the United States and most of Europe have survived the past decade only by taking a technology provider role. As China and India and other major exporters develop science and technology programs of their own, what we have to offer in exchange for the constant stream of cheap goods becomes increasingly limited. The uses for US dollars correspondingly diminishes. Most likely for geopolitical reasons, the Chinese government has artificially stimulated demand for US dollars by buying US treasury debts. This has lessened the loss to Chinese manufacturing to some degree. Similar activity by other exporter countries all over the world, concerned with preventing collapse of their industries, has propped up the exchange values of importer country currencies. This has, in turn, prevented oil prices from going up. Ultimately, though, these measures will reach their limit. This is not unlike the catastrophic collapse of the globalized markets in the first great depression, but in our case, the supply of oil is not as plentiful nor can it be readily expanded, making the situation dire.
The root cause of this problem is really the false steady state model that seems to dominate economic thought. This model typically takes aggregates as stable objects and firms as permanent fixtures. In reality, firms are not permanent fixtures. Rather, they have a finite but indeterminate lifespan. Employment results from specific tasks that are undertaken by the firm during its lifespan. The natural trend in economies is toward wealth concentrations and high productivity. This inevitably leads to low employment and low quality of life. This is where the "equilibrium" rests. In truth, there is no guarantee that a job will last for the 30 years that our tradition defines as a career. Nor is there a guarantee that a person will be able to live off of the wage they are paid. Nor is there a guarantee that housing will exist for each citizen. And amid all of these human concerns, the environment will be exploited to the point of complete destruction, permanently reducing the possible quality of life for all future generations, over and over again.
In order to lift the masses out of squalor, a government must be able to occupy a strong negotiating position. The guarantee of high employment is not really possible unless productivity is artificially reduced, a deliberate endorsement of waste. However, high quality of life is possible through rigorous efforts at wealth redistribution and rules limiting working hours (such as shorter work weeks). But regardless of the solution proposed, the actual production of goods cannot occur outside of the jurisdiction of the government, so that reasonable regulations can be imposed. For this reason, and this reason alone, foreign trade ought be severely confined. But if a thinking person looks in detail at its actual effect, it is also clear that it is undesirable for other reasons.
A firm that follows a neoclassical business strategy will seek to maximize production efficiency by minimizing costs per dollar value of finished goods. Such profit maximizing philosophies are clearly the norm among large scale businesses. This model takes both workers and consumers as essentially being factors of production. The final product of the firm, in the mind of the firm's owner, is not the product for sale but the income stream that firm profits bring to him.
This maximization is best achieved through locating of factories where the necessary natural resources can be plentifully obtained and where costs of labor are low. The degree to which real estate costs affect this calculation seems to be minimal, in part because low cost of labor tends to correlate with low cost of real estate. Delivery of natural resources to the factory and a means of moving finished goods to port are the required infrastructure developments and these are also expressed in the production cost. Low shipping and transport costs (primarily the low cost of shipping on large tanker ships) make the possible market for goods global in scope, making distance to consumer largely irrelevant in all cases except for goods that are perishable. Therefore, manufacturing for non-perishable goods will tend to be concentrated where costs of production are lowest.
Regions that offer ideal locations are invariably those that have both persistent poverty and a well organized government capable of and interested in providing the necessary infrastructure to the factory. The goods produced will be sold on a global scale, directly to nations which are not ideal locations for new factories.
All factories eventually become depreciated to the point of needing to be shut down. Therefore, new economic growth is not a prerequisite for the relocation of these factories to more optimal regions. Rather, over time, industry in general will naturally move into those regions.
Firms in these factories' host countries will have revenue in the goods importing country's currency, but pay their workers in the local currency. Therefore, they must exchange most of the imported currency for local currency. With a floating exchange rate, this is merely the sale of that currency on the market. The imported currency's value is equal to that of the goods it can purchase - that is the value of manufactured goods offered by the goods-importing country.
If a simple system of comparative advantage emerged from this relationship, two effects would result. First, the goods-importing country would experience relatively fewer working hours and relatively lower prices for goods when compared to wages (higher standard of living) than the exporting country. Secondly, over time the exporting country's higher level of savings and lower unemployment would reduce poverty to the point that wages would be bid up, while the importing country's lower (or negative) level of savings and higher unemployment would cause wages to be bid down, effectively leading to a trend toward equilibrium (or, more likely, an equilibrium-centered oscillation) and a progressive reduction in the level of wage differences between the two countries.
This simple system of comparative advantage is complicated by three factors. New technology that is developed will tend to dramatically slow the trend toward equilibrium. Shifting balances of trade with other countries will create chaotic effects that contribute a high degree of uncertainty to the analysis of eventual effect. Finally, changes in output levels will alter the purchasing power of consumers in both countries and lead to a non-unique equilibrium.
New technologies that are available tend to originate through the research of wealthy countries that have the resources to spend on comprehensive education systems and research funding. These technologies become a market good that is exported from the goods-importing countries and slow the rate of convergence toward the equilibrium described above. This effect has the following characteristics: first, firms must save up or receive loans in order to make the costly technology purchases and implement them. This leads to a financial market that mediates (with occasional speculation bubbles) the collection of currency in the goods-importing country's denomination. Firms are unlikely to take loans in their local currency and attempt to then save up imported currency because this time consuming process has a large opportunity cost and may involve costly interest payments as well.
These new technologies will bring about three types of improvement for the firm that implements them: 1. Labor usage reduction; 2. Natural resource usage reduction; 3. Greater market share. For this reason, new technologies can accelerate the rate at which markets become monopolized, and can actually lead to lower levels of employment within markets.
Additionally, this process will affect both economies in different ways at the macro level. For the goods-importing country, the tech industry will sustain higher levels of employment. This will sustain higher goods importation rates for longer. For the goods-exporting country, the higher rates of market monopolization and lower employment levels that technologies bring will actually slow the rate of poverty reduction. Thus, the trend toward equilibrium is slowed by technology. Both of these factors, however, will eventually dissipate unless new technologies are introduced at a constant rate, or if a technology development industry develops in the exporter country. Because new technologies are actually developed erratically, markets will tend to spurt toward equilibrium, then stall, then spurt again, rather than moving smoothly. This can lead to oscillatory effects that prevent the existence of steady states.
The comparative advantage equilibrium is further complicated by the effects of the comparative advantage of other countries. If natural resource costs increase, or if exports to another sector increase or decrease, the labor and natural resource markets will transmit these effects throughout the market, affecting the balance of trade between all trading partners. The demonstration of oscillatory effects in complex equilibrium systems is a topic of high mathematical sophistication, but oscillating reactions have been discovered in chemistry, a discipline in which the units are approximately 21 orders of magnitude finer and therefore statistically better behaved than an economy.
Finally, the simple model is inaccurate in part because drops in exports, caused either by a loss of relative currency value of the importing nation or a drop in incomes due to higher unemployment, typically leads to an increase in unemployment or decreases in wages in the exporting country. This effect implies that increases in measured comparative advantage can lead directly to a diminished economic outcome.
Taking these things into consideration, where does our current economic position fit into this model? Likely, the United States and most of Europe have survived the past decade only by taking a technology provider role. As China and India and other major exporters develop science and technology programs of their own, what we have to offer in exchange for the constant stream of cheap goods becomes increasingly limited. The uses for US dollars correspondingly diminishes. Most likely for geopolitical reasons, the Chinese government has artificially stimulated demand for US dollars by buying US treasury debts. This has lessened the loss to Chinese manufacturing to some degree. Similar activity by other exporter countries all over the world, concerned with preventing collapse of their industries, has propped up the exchange values of importer country currencies. This has, in turn, prevented oil prices from going up. Ultimately, though, these measures will reach their limit. This is not unlike the catastrophic collapse of the globalized markets in the first great depression, but in our case, the supply of oil is not as plentiful nor can it be readily expanded, making the situation dire.
The root cause of this problem is really the false steady state model that seems to dominate economic thought. This model typically takes aggregates as stable objects and firms as permanent fixtures. In reality, firms are not permanent fixtures. Rather, they have a finite but indeterminate lifespan. Employment results from specific tasks that are undertaken by the firm during its lifespan. The natural trend in economies is toward wealth concentrations and high productivity. This inevitably leads to low employment and low quality of life. This is where the "equilibrium" rests. In truth, there is no guarantee that a job will last for the 30 years that our tradition defines as a career. Nor is there a guarantee that a person will be able to live off of the wage they are paid. Nor is there a guarantee that housing will exist for each citizen. And amid all of these human concerns, the environment will be exploited to the point of complete destruction, permanently reducing the possible quality of life for all future generations, over and over again.
In order to lift the masses out of squalor, a government must be able to occupy a strong negotiating position. The guarantee of high employment is not really possible unless productivity is artificially reduced, a deliberate endorsement of waste. However, high quality of life is possible through rigorous efforts at wealth redistribution and rules limiting working hours (such as shorter work weeks). But regardless of the solution proposed, the actual production of goods cannot occur outside of the jurisdiction of the government, so that reasonable regulations can be imposed. For this reason, and this reason alone, foreign trade ought be severely confined. But if a thinking person looks in detail at its actual effect, it is also clear that it is undesirable for other reasons.
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)
Furthermore:
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:
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.
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)
Furthermore:
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
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.
Saturday, January 30, 2010
Value theories
Historically, currency had its value pegged to the value of the collateral that backed the currency. Thus, a paper bill was typically representative of some quantity of specie (precious metals or coins made of precious metal) held in a bank. Much of early economic theory was dedicated to the justification and promotion of this fact. Thus, the idea arose that the value of a unit of currency was based on what it represented - be it a share of a valuable object, a quantity of labor, etc. Thus, the argument goes, an expansion in currency available leads inevitably to a decrease in its value, as more units of currency exist for each unit of the backing object.
This classical line of reasoning has been hard to shake despite the fact that it was never justified in a scientific way. Observations that people think of currency in this way is evidence only of a body of beliefs, not a revelation of universal law. Moreover, currency and the specie that backs it are both currencies of sort. Many thinkers make the (rather sad) error of believing that a block of precious metal has value in and of itself. Precious metals are not used for anything other than as wealth holding assets, and it has always been the common belief in their value - arbitrarily decided by historical events - and nothing more, that creates the value itself.
The false theory of currency value as proportion of backing object value results from two big mistakes in the classical line of reasoning relating to currency value.
1. The classical line of reasoning ignores the possibility of underutilized resources.
2. The classical line of reasoning ignores the fundamental role that uncertainty plays in currency value.
Both of these points are made by Keynes in his General Theory, but I would like to expand on them here in my own direction. Incidentally, both of these are tied to a fundamental problem in economics: the failure of equilibrium models to rigorously represent equilibria as related rates.
First, the case of underutilized resources can be directly highlighted by a few examples:
Suppose that a king wishes to expand his treasury, and devises a brilliant strategy for quickly growing his gold-mining industry. He prints new bills of currency, backed by no matching specie, and enters into contracts with mining firms whereby they will provide him with a portion of the specie that they find, such that it directly matches the quantity needed to back the currency issued. Assuming that the results of the venture meet the king's expected value and that there is a high unemployment rate, how will this affect the value of the currency?
Looking first at time of initial issuance - one can expect demand to rise for machinery and chemicals used in the mining process. This change will then ripple into the spending habits of the producers of these components. The increased revenue of these "component firms" will, due to the assumption of surplus labor, primarily become increased plant capacity and profits for the firm owners. These owners will bid up investments of various types (including real estate), and may spend marginally more on luxury goods.
Having a larger paid labor pool will also have an effect - laborers may increase their food consumption, primarily by demanding greater food variety, but for the most part, increased income will be spent on goods and services. Landlords will see lower vacancy rates as laborers cohabitate less, prompting an increase in rental rates.
Generally, an increase in prices across the board represents a decrease in the value of the currency. However, in the case of currency issue, these increases are the response of suppliers to the increase in quantity demand. In many cases, the supply of a good is sufficiently elastic that only the quantity produced increases. In only a few situations is there a bottleneck such that the supply of a given good cannot increase easily, and it is in this case that a price increase will occur.
To calculate the initial stimulus effect of such an action by a Government, an economist should ask two things: 1)Are the natural resources that will see increased demand readily available for use? 2)Is the economy significantly below full employment? If the answer to both of these questions is "yes", then the vast majority of the quantity demand increase will be expressed in terms of increased output. If the answer to either question is "no", the vast majority of quantity demand increase will be expressed in terms of increased prices.
Next, let us turn to the point when the mining firms begin to transfer precious metals back into the King's treasury. It is hard to see how this could have any effect whatsoever. Other than the labor utilized for the actual movement, inspection, storage, and safeguarding of the specie, no actual changes take place. The King now simply has more of a valuable asset, which is kept out of circulation, and which he will be able to use to meet future obligations if necessary.
Theories that predominated during the time when currency was directly backed by assets most likely had a profound effect on the decisions of the speculative class. When exchange rates were fixed, speculation often surrounded the values of currencies. In any speculative atmosphere, the ideas and decisions of the herd were the primary determinant of changes in prices paid by speculators. Therefore, so long as a sufficient portion of speculators believed in a given economic rule, the market would behave in a way that allowed economists to draw statistical evidence for that rule from the market. The egoes of the wealthy had a further impact on the development of the discipline, in that they believed their own wealth stemmed not from the collective effect of an otherwise arbitrary belief, but from actual knowledge. It is the wealthy that control University endowments, and they want the world to know that they are people of virtue.
Uncertainty also plays a key role in currency value. I invite the reader to imagine an economy in which individuals do not have uncertainty. Note that risk should be treated as a type of uncertainty. The cognition of an individual who does not have uncertainty is really omniscience. Such a person does not respond in a nash equilibrium fashion because he is able to coordinate with others effortlessly. Furthermore, the psychological predisposition of the individual toward equality would be an overriding factor in his economic relationships. Specialized knowledge disappears, and thus workers are no longer differentiable from each other. The only (economically significant) differences between individuals in such a scheme is their preferences and their property.
This thought experiment highlights another aspect of economic life that is seldom mentioned: its ethical connotation as revealed by our impressions. I invite the reader to contemplate the following examples:
Considering our ethical impluses and our way of evaluating our own economic position, a society of omnipotent individuals will have a certain political equilibrium. Currency will not be necessary because the actions of each individual will be known to all. Each person will understand the full configuration space of individual action combinations and their consequences. Labor would be divided between individuals only on the basis of their preferences. Nobody would want to see the basic needs of others go unmet, and will balance this desire against selfish interests. Labor could not be divided between workers and management because management is completely unnecessary - the only possibility is the existence of a capitalist class who own the means of production, but even this is unlikely given that these capitalists would face perfectly coordinated resistance by the rest of the society and collective bargaining by their workers.
Individuals also have foreknowledge of all their future consumption needs. Therefore, individuals would be able to enter into contracts with each other for the direct exchange of goods between current and future dates. For example, I may work in a machine shop for an hour, with the understanding that this earns me a loaf of bread from the baker. The baker would understand how this settles some contract he is involved in, or establishes a future compensation for him.
Currency is really an effort at approximation of this system of contracts. Approximation is necessary because of the incompleteness of individual knowledge. This incompleteness is synonymous with uncertainty. Uncertainty has three principal effects:
1) The use of risks and estimates
2) Creation of search costs that establish a value for information.
3) Existence of liquidity
Returning now to an example of a theoretical "normal human" economy, if the total quantity of currency in circulation is X, during any given time period somewhat less than every unit in X (X-a) will change hands at least once. Of the exchanges that take place, some will be at a price that has not been actively reevaluated. When reevaluations do take place, the price-setter must generally plan for a price that will not need to be raised (or lowered) again for some time, meaning the change will be in greater proportion than what is initially required, and often will occur later than expected. In other words, price changes and rebalances do not freely propagate across economies, but actually move at a certain estimable rate. Furthermore, price changes may not be made at all if the cost threshold for change and accompanying discounting rate of the costs are not met. Therefore, even if the economy is at capacity when the currency supply is changed, the question is not merely by how much but for whom the change is taking place.
A tax can be seen as a transfer of currency from one group to another. It is paired with government services that are funded by the tax, and these services are, in turn, expressible as monetary savings for the individuals who benefit from these services. Often, the Government can provide services more optimally than the private sector. We may, in accordance with our ethical prerogatives, denote certain services as providing a greater contribution to quality of life than others. So long as tax policy shifts the balance of goods and services provided toward those that provide a greater benefit to quality of life, it is justified.
Returning to the concept of the money supply in contrast to the effective money supply, suppose that the money supply is expanded or contracted in some fashion. The economic effect of this change is wholly dependent on who receives the currency. Let us rank the individuals within a society based on (1) their propensity to spend an additional dollar received and (2) their propensity to take each dollar reduction in income from spending rather than savings. These two variables are bound to have some degree of covariance, but that is beside the point. Imagine a scale going from zero (will not spend) to one (will spend) for these measures. Then each individual will occupy a point on this scale. Savings are only reintegrated into the economy as loans. Thus, private debt is a function of the total level of savings. Payments on debt lead to income concentrations in the hands of debt holders. Thus, either price levels must fall, income levels must increase, or debt levels must increase for individuals to maintain their consumption levels over time. When left alone, the trend seems to be toward a glut of savings in the hands of the ultra rich, a lack of viable investments, and a inevitable drop in the price and employment level.
An injection of additional currency targeted to the least likely to consume will lead only to an increase in loan issuance. If the loans market is saturated, it will lead to a direct increase in savings and no overall change in the economy (X and a increase in parity).
An injection of additional currency targeted to the most likely to consume will lead to an increase in consumption levels. This will mean that the effective quantity of money has directly increased. Prices may rise, but they will not rise in a greater portion than income, as this additional currency is first expressed through income. However, the added currency will eventually reach the hands of those least likely to consume and it will "fall out" of the market in this fashion (X increases but a stays constant).
A tax placed on those least likely to consume will lead to a decrease in loan issuance, or to no change if the loans market is saturated. The direct decrease in savings will precipitate no change to the actual economy because the effective supply of money has not been changed (X and a decrease in parity)
A tax placed on those most likely to consume will lead to a direct contraction in the economy. It will precipitate a reduction in the effective money supply and would be very harmful to the economy (X decreases but a stays constant).
For the reasons just outlined, the policy of the US government of backing its deficit spending with bond issues is silly (actually I think of it as grand theft of taxpayer dollars). The government can simply issue additional quantities of currency and should not be concerned with balancing its books. Rather, it should pay attention to the macroeconomic effect of its actions and work to bring unemployment down.
This classical line of reasoning has been hard to shake despite the fact that it was never justified in a scientific way. Observations that people think of currency in this way is evidence only of a body of beliefs, not a revelation of universal law. Moreover, currency and the specie that backs it are both currencies of sort. Many thinkers make the (rather sad) error of believing that a block of precious metal has value in and of itself. Precious metals are not used for anything other than as wealth holding assets, and it has always been the common belief in their value - arbitrarily decided by historical events - and nothing more, that creates the value itself.
The false theory of currency value as proportion of backing object value results from two big mistakes in the classical line of reasoning relating to currency value.
1. The classical line of reasoning ignores the possibility of underutilized resources.
2. The classical line of reasoning ignores the fundamental role that uncertainty plays in currency value.
Both of these points are made by Keynes in his General Theory, but I would like to expand on them here in my own direction. Incidentally, both of these are tied to a fundamental problem in economics: the failure of equilibrium models to rigorously represent equilibria as related rates.
First, the case of underutilized resources can be directly highlighted by a few examples:
Suppose that a king wishes to expand his treasury, and devises a brilliant strategy for quickly growing his gold-mining industry. He prints new bills of currency, backed by no matching specie, and enters into contracts with mining firms whereby they will provide him with a portion of the specie that they find, such that it directly matches the quantity needed to back the currency issued. Assuming that the results of the venture meet the king's expected value and that there is a high unemployment rate, how will this affect the value of the currency?
Looking first at time of initial issuance - one can expect demand to rise for machinery and chemicals used in the mining process. This change will then ripple into the spending habits of the producers of these components. The increased revenue of these "component firms" will, due to the assumption of surplus labor, primarily become increased plant capacity and profits for the firm owners. These owners will bid up investments of various types (including real estate), and may spend marginally more on luxury goods.
Having a larger paid labor pool will also have an effect - laborers may increase their food consumption, primarily by demanding greater food variety, but for the most part, increased income will be spent on goods and services. Landlords will see lower vacancy rates as laborers cohabitate less, prompting an increase in rental rates.
Generally, an increase in prices across the board represents a decrease in the value of the currency. However, in the case of currency issue, these increases are the response of suppliers to the increase in quantity demand. In many cases, the supply of a good is sufficiently elastic that only the quantity produced increases. In only a few situations is there a bottleneck such that the supply of a given good cannot increase easily, and it is in this case that a price increase will occur.
To calculate the initial stimulus effect of such an action by a Government, an economist should ask two things: 1)Are the natural resources that will see increased demand readily available for use? 2)Is the economy significantly below full employment? If the answer to both of these questions is "yes", then the vast majority of the quantity demand increase will be expressed in terms of increased output. If the answer to either question is "no", the vast majority of quantity demand increase will be expressed in terms of increased prices.
Next, let us turn to the point when the mining firms begin to transfer precious metals back into the King's treasury. It is hard to see how this could have any effect whatsoever. Other than the labor utilized for the actual movement, inspection, storage, and safeguarding of the specie, no actual changes take place. The King now simply has more of a valuable asset, which is kept out of circulation, and which he will be able to use to meet future obligations if necessary.
Theories that predominated during the time when currency was directly backed by assets most likely had a profound effect on the decisions of the speculative class. When exchange rates were fixed, speculation often surrounded the values of currencies. In any speculative atmosphere, the ideas and decisions of the herd were the primary determinant of changes in prices paid by speculators. Therefore, so long as a sufficient portion of speculators believed in a given economic rule, the market would behave in a way that allowed economists to draw statistical evidence for that rule from the market. The egoes of the wealthy had a further impact on the development of the discipline, in that they believed their own wealth stemmed not from the collective effect of an otherwise arbitrary belief, but from actual knowledge. It is the wealthy that control University endowments, and they want the world to know that they are people of virtue.
Uncertainty also plays a key role in currency value. I invite the reader to imagine an economy in which individuals do not have uncertainty. Note that risk should be treated as a type of uncertainty. The cognition of an individual who does not have uncertainty is really omniscience. Such a person does not respond in a nash equilibrium fashion because he is able to coordinate with others effortlessly. Furthermore, the psychological predisposition of the individual toward equality would be an overriding factor in his economic relationships. Specialized knowledge disappears, and thus workers are no longer differentiable from each other. The only (economically significant) differences between individuals in such a scheme is their preferences and their property.
This thought experiment highlights another aspect of economic life that is seldom mentioned: its ethical connotation as revealed by our impressions. I invite the reader to contemplate the following examples:
- A convicted murderer (about whose guilt there is no doubt) is released from prison due to a legal error by the prosecution. He purchases a lottery ticket and wins the jackpot, becoming a multimillionaire.
- A woman who works hard her entire life, saving a small amount of money from each paycheck, invests her money in a mutual fund that loses more than half of its value in the course of a year.
- A man witnesses a stranger help a blind person across a busy intersection and buys him a drink.
- A student who earns straight A's has her allowance increased.
- The city council passes a tax increase that affects only a single business owner.
- The city council passes a tax increase that includes an exemption that only a single business owner can take advantage of.
Considering our ethical impluses and our way of evaluating our own economic position, a society of omnipotent individuals will have a certain political equilibrium. Currency will not be necessary because the actions of each individual will be known to all. Each person will understand the full configuration space of individual action combinations and their consequences. Labor would be divided between individuals only on the basis of their preferences. Nobody would want to see the basic needs of others go unmet, and will balance this desire against selfish interests. Labor could not be divided between workers and management because management is completely unnecessary - the only possibility is the existence of a capitalist class who own the means of production, but even this is unlikely given that these capitalists would face perfectly coordinated resistance by the rest of the society and collective bargaining by their workers.
Individuals also have foreknowledge of all their future consumption needs. Therefore, individuals would be able to enter into contracts with each other for the direct exchange of goods between current and future dates. For example, I may work in a machine shop for an hour, with the understanding that this earns me a loaf of bread from the baker. The baker would understand how this settles some contract he is involved in, or establishes a future compensation for him.
Currency is really an effort at approximation of this system of contracts. Approximation is necessary because of the incompleteness of individual knowledge. This incompleteness is synonymous with uncertainty. Uncertainty has three principal effects:
1) The use of risks and estimates
2) Creation of search costs that establish a value for information.
3) Existence of liquidity
Returning now to an example of a theoretical "normal human" economy, if the total quantity of currency in circulation is X, during any given time period somewhat less than every unit in X (X-a) will change hands at least once. Of the exchanges that take place, some will be at a price that has not been actively reevaluated. When reevaluations do take place, the price-setter must generally plan for a price that will not need to be raised (or lowered) again for some time, meaning the change will be in greater proportion than what is initially required, and often will occur later than expected. In other words, price changes and rebalances do not freely propagate across economies, but actually move at a certain estimable rate. Furthermore, price changes may not be made at all if the cost threshold for change and accompanying discounting rate of the costs are not met. Therefore, even if the economy is at capacity when the currency supply is changed, the question is not merely by how much but for whom the change is taking place.
A tax can be seen as a transfer of currency from one group to another. It is paired with government services that are funded by the tax, and these services are, in turn, expressible as monetary savings for the individuals who benefit from these services. Often, the Government can provide services more optimally than the private sector. We may, in accordance with our ethical prerogatives, denote certain services as providing a greater contribution to quality of life than others. So long as tax policy shifts the balance of goods and services provided toward those that provide a greater benefit to quality of life, it is justified.
Returning to the concept of the money supply in contrast to the effective money supply, suppose that the money supply is expanded or contracted in some fashion. The economic effect of this change is wholly dependent on who receives the currency. Let us rank the individuals within a society based on (1) their propensity to spend an additional dollar received and (2) their propensity to take each dollar reduction in income from spending rather than savings. These two variables are bound to have some degree of covariance, but that is beside the point. Imagine a scale going from zero (will not spend) to one (will spend) for these measures. Then each individual will occupy a point on this scale. Savings are only reintegrated into the economy as loans. Thus, private debt is a function of the total level of savings. Payments on debt lead to income concentrations in the hands of debt holders. Thus, either price levels must fall, income levels must increase, or debt levels must increase for individuals to maintain their consumption levels over time. When left alone, the trend seems to be toward a glut of savings in the hands of the ultra rich, a lack of viable investments, and a inevitable drop in the price and employment level.
An injection of additional currency targeted to the least likely to consume will lead only to an increase in loan issuance. If the loans market is saturated, it will lead to a direct increase in savings and no overall change in the economy (X and a increase in parity).
An injection of additional currency targeted to the most likely to consume will lead to an increase in consumption levels. This will mean that the effective quantity of money has directly increased. Prices may rise, but they will not rise in a greater portion than income, as this additional currency is first expressed through income. However, the added currency will eventually reach the hands of those least likely to consume and it will "fall out" of the market in this fashion (X increases but a stays constant).
A tax placed on those least likely to consume will lead to a decrease in loan issuance, or to no change if the loans market is saturated. The direct decrease in savings will precipitate no change to the actual economy because the effective supply of money has not been changed (X and a decrease in parity)
A tax placed on those most likely to consume will lead to a direct contraction in the economy. It will precipitate a reduction in the effective money supply and would be very harmful to the economy (X decreases but a stays constant).
For the reasons just outlined, the policy of the US government of backing its deficit spending with bond issues is silly (actually I think of it as grand theft of taxpayer dollars). The government can simply issue additional quantities of currency and should not be concerned with balancing its books. Rather, it should pay attention to the macroeconomic effect of its actions and work to bring unemployment down.
Thursday, January 28, 2010
The Opinion game - variations on a voting game
In my own personal throwback to the 1970's, when these kind of things were all the rage, I have thought up a game, with a few variations, that I believe can be of use in the modeling of opinions formed by groups.
This game is played with one player. There is a stack of identically backed tiles, each having a color on the reverse side, one of m possible colors. In each round, a new tile is revealed, and the player must pick a color.
They are awarded points on the following basis:
+1 point if they pick a color that is shown on the greatest number of tiles revealed thus far
-4 points if they changed their color from last round (no penalty for this in the first round)
Naturally, the behavior of the player will depend on the distribution of tiles. If the tiles are chosen ahead of time from an equally distributed lot, they will behave differently than if each tile's color is an independent random event.
Because the analysis is easier when each tile is independent, I will focus on this case. If there are 2 possible colors - say red and blue - the minimum number of rounds that must pass before a rational player has an incentive to change his or her opinion is 8. This follows from the following argument and example (WOLOG):
Round 1:
Red tile revealed
Pick red
Round 2:
Blue tile revealed
Pick red (tied numbers; the "change cost" can be avoided)
Round 3:
Blue tile revealed
Pick red (at this point nine more rounds must be played for the expected value of changing to exceed 0)
Round 4:
Blue tile revealed
Pick blue (at this point, only 4 more rounds must be played for this choice to pay off)
Rounds 5 - 8:
regardless of tile revealed, player picks blue (see assertion 2)
Conclusions -
Studies of communication tend to emphasize the "deeply entrenched" nature of our opinions. This game confirms that if there is a social cost to changing an individual's opinion (such as alienation from your like-minded bretheren), a very large preponderance of evidence may be necessary to counterbalance this loss. Considering our number of choices in daily life, and the marginal benefits (if any) that abstract knowledge poses for the individual, it is no wonder that people tend to believe crazy things.
This game is played with one player. There is a stack of identically backed tiles, each having a color on the reverse side, one of m possible colors. In each round, a new tile is revealed, and the player must pick a color.
They are awarded points on the following basis:
+1 point if they pick a color that is shown on the greatest number of tiles revealed thus far
-4 points if they changed their color from last round (no penalty for this in the first round)
Naturally, the behavior of the player will depend on the distribution of tiles. If the tiles are chosen ahead of time from an equally distributed lot, they will behave differently than if each tile's color is an independent random event.
Because the analysis is easier when each tile is independent, I will focus on this case. If there are 2 possible colors - say red and blue - the minimum number of rounds that must pass before a rational player has an incentive to change his or her opinion is 8. This follows from the following argument and example (WOLOG):
- We may limit ourselves to the simple case where one red tile is revealed then all blue tiles after that.
- It never makes sense to change one's mind within four rounds of the last round
- If red is behind by p tiles, the total expected payout of changing is derivable from the binomial distribution as follows: let n be the number of rounds remaining; the payout is a function of the path traveled to the final distribution. There are 2^n paths; we care about the difference between this outcome and the continuation of the red choice, thus equality of red and blue tiles is worth 0. Each path decomposes into previously calculated paths.
Round 1:
Red tile revealed
Pick red
Round 2:
Blue tile revealed
Pick red (tied numbers; the "change cost" can be avoided)
Round 3:
Blue tile revealed
Pick red (at this point nine more rounds must be played for the expected value of changing to exceed 0)
Round 4:
Blue tile revealed
Pick blue (at this point, only 4 more rounds must be played for this choice to pay off)
Rounds 5 - 8:
regardless of tile revealed, player picks blue (see assertion 2)
Conclusions -
Studies of communication tend to emphasize the "deeply entrenched" nature of our opinions. This game confirms that if there is a social cost to changing an individual's opinion (such as alienation from your like-minded bretheren), a very large preponderance of evidence may be necessary to counterbalance this loss. Considering our number of choices in daily life, and the marginal benefits (if any) that abstract knowledge poses for the individual, it is no wonder that people tend to believe crazy things.
Wednesday, January 27, 2010
Availability of capital - modeling aggregate investment levels
Given persistent payments on business investment I and loans (at interest) L, aggregate fixed costs F, quantity sold Q, expected revenue per unit R, and per-unit cost V, profit in time period t is:
profit(t) = (R-V)Q - F - L - I
Ceteris Paribus, a business that shows profit could in theory pay down its loans and buy back its stock over time, increasing long run profits. Such a business could also continually fail to meet profit expectations, in which case expenses will be paid in left to right order. One can expect investors to receive dividends or other benefits only if a surplus reaches them. Thus, they are in the highest risk position. One can also expect corporations in particular to generally be unable to pay down investments, instead maintaining constant investment levels and paying out dividends in lieu of buying back, as this is a more lucrative path for the controlling shareholders to take.
A start-up will have a risk position that is a point within the bounded range between the maximum expected profit and minimum expected profit (negative being loss) that determines interest rates and total loan credit available. A business proposal does not give an incentive to the prospector (for purposes of this essay the prospector will be the person who creates the business proposal) to safeguard investments or loans received. Rather, the prospector's primary incentive is his own desire to attract the investment, meaning he is interested in making a convincing argument regarding the business venture. The prospector enters into negotiations with investors and banks in which he will make an argument regarding his risk position within the minimum-maximum range.
Similarly, any business looking to either expand operations or replace depreciated equipment may have need for temporary capital. The same process will take place, but in models featuring incomplete information, more complete information than in the prospector case should be assumed.
This negotiation is best modeled by empirical data. In a theoretical sense, such a negotiation is irresolvable due to it being empty of a priori content. Games or market models that may be superficially similar show similarity only insofar as they make assumptions about the players that are grounded in empirical reasoning.
The risk position is dilated or contracted when aggregate demand changes. An economic decline will generally shift the minimum expectation down slightly and the maximum expectation down greatly. Similarly an economic recovery will shift the minimum up slightly and the maximum up greatly. Typically, the level of aggregate demand is a significant determinant of the risk position of any business. This in turn determines the results of negotiations and the aggregate investment level. The loan offerings available to a business will also change based on the state of the economy. Generally, loans are more secure during economic downturns due to their lower risk position than investments, and will expand less during upswings due to bank attitudes regarding speculation - meaning they will generally have a higher price than investors during good times and a lower price than investors during bad times.
The distribution of business financing between investments and loans will also depend on the interest rates offered on loans. Businesses and prospects will each have both a credit rating (which partially determines loan offerings) and a risk position (which partially determines investment offerings). Thus, businesses can be divided into three categories:
Looking specifically at economic downturns, on the supply side investors will generally move assets into "safe" financial instruments. This will reduce the potential investor pool, driving up the price of each investment (in the form of dividend payouts). Therefore, loans will become a greater portion of business portfolios - meaning more businesses will be in category 1. This is accompanied by an increase in interest rates that is somewhere in between previous term interest rates and the new price of investment. Generally businesses become saddled with higher costs and less repayment flexibility during recessions.
Economic conditions may also prevail in which speculative investment increases in real estate, commodities, and other factors of production. This has the effect of driving up other aspects of business cost. Ceteris paribus, this forces businesses to seek additional investment, loans, or curtail operations. In fact, general decreases in prices seem to reach real estate last - meaning that real estate proportionally increases in cost during recession periods even as it shows no net increase in investments. Such changes bring about a long-term shift in the profit functions of businesses and force a decrease in hiring.
Arguably, it is these two effects which have the largest role in explaining the business cycle. Before venturing on, it is worth reviewing a key concept described in a previous blog entry regarding the distribution of money between the financial and real parts of the economy. Ignoring possible increases in the money supply, even if divided in a totally arbitrary fashion, it is clear that a two sector economy will have a relationship in which one sector gains money only as another loses it. If one takes the position, as I do, that loans do not actually increase the money supply, the following points will hold true.
Economies display a certain degree of stability. This stability is the result of the stimulus effect of incidental profits and losses. Within any given time period, some businesses will fail and investors will lose their money. However, so long as these failures are not interpreted by investors (or economists!) as a sign of changes in aggregate demand, average investor behavior will not change. These incidental losses must exist to balance against the unexpected successes (incidental profits) of other investors. Each time such an event occurs, aggregate demand is either stimulated beyond its equilibrium (in the case of incidental losses) or drawn below equilibrium (in the case of incidental profits). This follows from analysis of the relative stimulus effect of dollars in the financial relative to the real sector: since a failing business must by definition inject net dollars into the hands of noninvestors and a profitable one must do the opposite.
Paradoxically, the stability described above can only be maintained in an economy where there is a great deal of uncertainty among investors. Typically, the stability itself will lead to the perception of greater certainty as investors look to specific examples as test cases (regardless of the actual significance of these tests) and investors will turn toward a new strategy. It is extremely unlikely that investors will allow the economy to move toward a higher aggregate demand position through their own changes, as this would entail, in the short term, a higher risk position in the context of an average expected investment profit that is close to zero in the long term. In the event that mistakes are made and investors make bad investments, the immediate stimulus effect may roll the economy over to a new equilibrium. If mistakes are not made, investors will precipitate a recession because the opening time periods of the recession will promise them the largest profits. It is likely that some increased investment has occurred in commodities and real estate, further deteriorating the risk position of businesses.
Economic recoveries (and the prevention of recessions) generally occur through a combination of four factors:
profit(t) = (R-V)Q - F - L - I
Ceteris Paribus, a business that shows profit could in theory pay down its loans and buy back its stock over time, increasing long run profits. Such a business could also continually fail to meet profit expectations, in which case expenses will be paid in left to right order. One can expect investors to receive dividends or other benefits only if a surplus reaches them. Thus, they are in the highest risk position. One can also expect corporations in particular to generally be unable to pay down investments, instead maintaining constant investment levels and paying out dividends in lieu of buying back, as this is a more lucrative path for the controlling shareholders to take.
A start-up will have a risk position that is a point within the bounded range between the maximum expected profit and minimum expected profit (negative being loss) that determines interest rates and total loan credit available. A business proposal does not give an incentive to the prospector (for purposes of this essay the prospector will be the person who creates the business proposal) to safeguard investments or loans received. Rather, the prospector's primary incentive is his own desire to attract the investment, meaning he is interested in making a convincing argument regarding the business venture. The prospector enters into negotiations with investors and banks in which he will make an argument regarding his risk position within the minimum-maximum range.
Similarly, any business looking to either expand operations or replace depreciated equipment may have need for temporary capital. The same process will take place, but in models featuring incomplete information, more complete information than in the prospector case should be assumed.
This negotiation is best modeled by empirical data. In a theoretical sense, such a negotiation is irresolvable due to it being empty of a priori content. Games or market models that may be superficially similar show similarity only insofar as they make assumptions about the players that are grounded in empirical reasoning.
The risk position is dilated or contracted when aggregate demand changes. An economic decline will generally shift the minimum expectation down slightly and the maximum expectation down greatly. Similarly an economic recovery will shift the minimum up slightly and the maximum up greatly. Typically, the level of aggregate demand is a significant determinant of the risk position of any business. This in turn determines the results of negotiations and the aggregate investment level. The loan offerings available to a business will also change based on the state of the economy. Generally, loans are more secure during economic downturns due to their lower risk position than investments, and will expand less during upswings due to bank attitudes regarding speculation - meaning they will generally have a higher price than investors during good times and a lower price than investors during bad times.
The distribution of business financing between investments and loans will also depend on the interest rates offered on loans. Businesses and prospects will each have both a credit rating (which partially determines loan offerings) and a risk position (which partially determines investment offerings). Thus, businesses can be divided into three categories:
- Businesses which attract loans at a lower interest than investments
- Businesses which attract loans and investments at the same interest
- Businesses which attract investments at a lower interest than loans
Looking specifically at economic downturns, on the supply side investors will generally move assets into "safe" financial instruments. This will reduce the potential investor pool, driving up the price of each investment (in the form of dividend payouts). Therefore, loans will become a greater portion of business portfolios - meaning more businesses will be in category 1. This is accompanied by an increase in interest rates that is somewhere in between previous term interest rates and the new price of investment. Generally businesses become saddled with higher costs and less repayment flexibility during recessions.
Economic conditions may also prevail in which speculative investment increases in real estate, commodities, and other factors of production. This has the effect of driving up other aspects of business cost. Ceteris paribus, this forces businesses to seek additional investment, loans, or curtail operations. In fact, general decreases in prices seem to reach real estate last - meaning that real estate proportionally increases in cost during recession periods even as it shows no net increase in investments. Such changes bring about a long-term shift in the profit functions of businesses and force a decrease in hiring.
Arguably, it is these two effects which have the largest role in explaining the business cycle. Before venturing on, it is worth reviewing a key concept described in a previous blog entry regarding the distribution of money between the financial and real parts of the economy. Ignoring possible increases in the money supply, even if divided in a totally arbitrary fashion, it is clear that a two sector economy will have a relationship in which one sector gains money only as another loses it. If one takes the position, as I do, that loans do not actually increase the money supply, the following points will hold true.
Economies display a certain degree of stability. This stability is the result of the stimulus effect of incidental profits and losses. Within any given time period, some businesses will fail and investors will lose their money. However, so long as these failures are not interpreted by investors (or economists!) as a sign of changes in aggregate demand, average investor behavior will not change. These incidental losses must exist to balance against the unexpected successes (incidental profits) of other investors. Each time such an event occurs, aggregate demand is either stimulated beyond its equilibrium (in the case of incidental losses) or drawn below equilibrium (in the case of incidental profits). This follows from analysis of the relative stimulus effect of dollars in the financial relative to the real sector: since a failing business must by definition inject net dollars into the hands of noninvestors and a profitable one must do the opposite.
Paradoxically, the stability described above can only be maintained in an economy where there is a great deal of uncertainty among investors. Typically, the stability itself will lead to the perception of greater certainty as investors look to specific examples as test cases (regardless of the actual significance of these tests) and investors will turn toward a new strategy. It is extremely unlikely that investors will allow the economy to move toward a higher aggregate demand position through their own changes, as this would entail, in the short term, a higher risk position in the context of an average expected investment profit that is close to zero in the long term. In the event that mistakes are made and investors make bad investments, the immediate stimulus effect may roll the economy over to a new equilibrium. If mistakes are not made, investors will precipitate a recession because the opening time periods of the recession will promise them the largest profits. It is likely that some increased investment has occurred in commodities and real estate, further deteriorating the risk position of businesses.
Economic recoveries (and the prevention of recessions) generally occur through a combination of four factors:
- Increased spending by Governments
- Collapse of commodity and real estate markets
- Significant expansions in the dollars available to the poorest (perhaps through welfare or other deficit income transfers).
- An exogenous increase in the propensity to spend by consumers
Tuesday, January 19, 2010
Taxonomy of Incentives and Production; Optimization
Each good or service provided by an economy has its own means of production, marketing, and consumption. These differences are not rooted in government policy or market structures, but rather in the physical realities of the natural resources, available technologies, and cultural paradigms involved. If one were to compose a list of all the different types seen in these three categories, one could then describe each good or service according to which of the types are present. The means by which a good or service is consumed is an important aspect of consumer demand and helps to make consumption patterns predictable, e.g. the correlation between cigarette and alcohol consumption. Furthermore, the characteristic given by the combination of means within each category partially determines the incentive structure that predicts the behavior of the business leaders controlling the production and marketing of the goods or services, e.g. the prevalence of beer commercials and absence of gasoline commercials. Therefore, the particular quirks of each product constitute an extra-market force that can be corrected by government policy, irrespective of concerns relating to market structure and externalities. It is worth noting that in this capacity, it is not the individual preference but the individual benefit with which the economic analysis is maximally concerned, and that even when benefits accrue to the individual, there is nothing to suggest that costs are passed exclusively to individuals in practice.
Production is described by a capitalization rate, which is the portion of the cost of production of each unit of finished good that depreciation of the capital assets consumes. The remainder of the cost of production is labor cost. Capitalization will come from natural resources, factor goods, and machinery.
Marketing is described by three cost categories: advertising, distribution, and pricing. Advertising is a direct cost calculated to stimulate demand at a given price level; distribution is mostly correlated with the inclusion or exclusion of various geographic markets; pricing costs are costs incurred through coupons, promotions, sales, and other temporary price variations designed to stimulate demand or reduce inventory levels.
Consumption is described by probable aggregate goods consumption bundles given household budget levels. This is further divided by demographic. For each good at a particular price with a particular marketing and production strategy, there is a predicted consumption level (a mean with a standard deviation) and covariance with each other good available or changes to budget levels. In practice, the predicted consumption levels for each good are empirically determined. Accepted business practices and rules of thumb dominate over any "assumption of rationality" and so none is needed.
Businesses attempt to maximize profits by coordinating both production and marketing strategies. Businesses are constrained from an absolute realization of efficiency by limits to their own strategic abilities. Many choices made by a business are probabilistic in nature, meaning that as a business approaches its maximum profit level, the probability of moving closer to maximum profits decreases. Thus, the uncertainties of the production and marketing of any given good create an efficiency ceiling for the business. Furthermore, businesses typically have steeper cost discounting curves than either the "firm as a sovereign entity" would have or the society at large would agree on (in fact, it is arguable that society does not discount future costs at all).
In order to realize the true scale of the possible improvements to quality of life, the behavior of consumers must be described in such a way that it becomes possible to criticize it. A model such as a revealed preference model is not sufficiently rich in its psychological descriptors to be of service in this capacity. For this purpose, I would rather develop a marginal benefit impact for each consumed good. Underlying such a measure would be the assumption that rather than measuring individual welfare relative to no consumption, the more common concern is the effect of changes when measured relative to existing consumption levels. There would be no assumption of self-rationality; we merely observe that individuals tend to pick goods that benefit them, but that these are not always optimal choices nor are individuals aware of every possible budget composition available to them. The actual values used would be based on health and lifestyle data and sociological studies.
Optimization across these categories takes the following form:
1. marginal benefit - marginal cost = net gain
2. predicted consumption level * effective price - distribution costs - advertising costs - capitalization costs - labor costs = business profits
3. business profits are maximized when the marginal business profit is zero; but since the function is multidimensional we must also calculate the Jacobian to assure ourselves that we are in fact viewing a global maximum (rather than, for instance, a saddle point). In general, this situation shows the failure of automatic market correction because the under(or maybe even over)supply of financing to businesses can lead to inefficient capitalization ratios. High(or low) advertising and distribution costs can also affect the general level of sales of the entire business.
4. Even when the situation exists that all externalities and market structure inefficiencies are properly counterbalanced by regulation, two situations will tend to exist in the market provision of any good: 1. The marginal benefit will be less than the individual's perceived marginal benefit. This follows from the effects of advertising and the incompleteness of individual strategies. 2. The marginal costs will be greater than strictly necessary because businesses cannot realize maximum efficiency levels and have steeper future discounting curves.
5. If marginal benefits are well known, government policy can be organized around changing the various cost and incentive structures affecting businesses and individuals to push them toward decisions that maximize marginal benefits. Generally, this means 1. Ensuring adequate capital flow to emerging or expanding businesses. 2. Ensuring media diversity and access so that all types of business that seek to advertise have the opportunity to. 3. Planning local, regional, national, and international infrastructure to ensure that markets are accessible to distributors at a low cost. 4. Relatively high educational subsidies to promote competence within organizations and to ensure that individuals have adequate self knowledge to build good consumption bundles in the first place.
It is worth noting that this only looks at the individual business and consumer. It does not consider externalities or market structure issues (e.g. monopolies). Public goods and various types of Government activity are also justified by the existence of these situations. In particular, wealth redistribution and monetary policy are crucial functions of Government.
It is also worth noting that existing Government policies do not always reflect solutions to problems, but can often be problems in themselves. The best way to put the policy recommendations that follow from a principled economic analysis is not "regulation" or "deregulation" but "reregulation" as many problems exist on both sides of the issue.
Production is described by a capitalization rate, which is the portion of the cost of production of each unit of finished good that depreciation of the capital assets consumes. The remainder of the cost of production is labor cost. Capitalization will come from natural resources, factor goods, and machinery.
Marketing is described by three cost categories: advertising, distribution, and pricing. Advertising is a direct cost calculated to stimulate demand at a given price level; distribution is mostly correlated with the inclusion or exclusion of various geographic markets; pricing costs are costs incurred through coupons, promotions, sales, and other temporary price variations designed to stimulate demand or reduce inventory levels.
Consumption is described by probable aggregate goods consumption bundles given household budget levels. This is further divided by demographic. For each good at a particular price with a particular marketing and production strategy, there is a predicted consumption level (a mean with a standard deviation) and covariance with each other good available or changes to budget levels. In practice, the predicted consumption levels for each good are empirically determined. Accepted business practices and rules of thumb dominate over any "assumption of rationality" and so none is needed.
Businesses attempt to maximize profits by coordinating both production and marketing strategies. Businesses are constrained from an absolute realization of efficiency by limits to their own strategic abilities. Many choices made by a business are probabilistic in nature, meaning that as a business approaches its maximum profit level, the probability of moving closer to maximum profits decreases. Thus, the uncertainties of the production and marketing of any given good create an efficiency ceiling for the business. Furthermore, businesses typically have steeper cost discounting curves than either the "firm as a sovereign entity" would have or the society at large would agree on (in fact, it is arguable that society does not discount future costs at all).
In order to realize the true scale of the possible improvements to quality of life, the behavior of consumers must be described in such a way that it becomes possible to criticize it. A model such as a revealed preference model is not sufficiently rich in its psychological descriptors to be of service in this capacity. For this purpose, I would rather develop a marginal benefit impact for each consumed good. Underlying such a measure would be the assumption that rather than measuring individual welfare relative to no consumption, the more common concern is the effect of changes when measured relative to existing consumption levels. There would be no assumption of self-rationality; we merely observe that individuals tend to pick goods that benefit them, but that these are not always optimal choices nor are individuals aware of every possible budget composition available to them. The actual values used would be based on health and lifestyle data and sociological studies.
Optimization across these categories takes the following form:
1. marginal benefit - marginal cost = net gain
2. predicted consumption level * effective price - distribution costs - advertising costs - capitalization costs - labor costs = business profits
3. business profits are maximized when the marginal business profit is zero; but since the function is multidimensional we must also calculate the Jacobian to assure ourselves that we are in fact viewing a global maximum (rather than, for instance, a saddle point). In general, this situation shows the failure of automatic market correction because the under(or maybe even over)supply of financing to businesses can lead to inefficient capitalization ratios. High(or low) advertising and distribution costs can also affect the general level of sales of the entire business.
4. Even when the situation exists that all externalities and market structure inefficiencies are properly counterbalanced by regulation, two situations will tend to exist in the market provision of any good: 1. The marginal benefit will be less than the individual's perceived marginal benefit. This follows from the effects of advertising and the incompleteness of individual strategies. 2. The marginal costs will be greater than strictly necessary because businesses cannot realize maximum efficiency levels and have steeper future discounting curves.
5. If marginal benefits are well known, government policy can be organized around changing the various cost and incentive structures affecting businesses and individuals to push them toward decisions that maximize marginal benefits. Generally, this means 1. Ensuring adequate capital flow to emerging or expanding businesses. 2. Ensuring media diversity and access so that all types of business that seek to advertise have the opportunity to. 3. Planning local, regional, national, and international infrastructure to ensure that markets are accessible to distributors at a low cost. 4. Relatively high educational subsidies to promote competence within organizations and to ensure that individuals have adequate self knowledge to build good consumption bundles in the first place.
It is worth noting that this only looks at the individual business and consumer. It does not consider externalities or market structure issues (e.g. monopolies). Public goods and various types of Government activity are also justified by the existence of these situations. In particular, wealth redistribution and monetary policy are crucial functions of Government.
It is also worth noting that existing Government policies do not always reflect solutions to problems, but can often be problems in themselves. The best way to put the policy recommendations that follow from a principled economic analysis is not "regulation" or "deregulation" but "reregulation" as many problems exist on both sides of the issue.
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