Sunday, January 22, 2012

Real and financial economics

Part 1: What is "real"? (commentary)
Part 2a: Real microeconomics (demand shocks)
Part 2b: Real microeconomics (supply shocks)
Interlude: Real and financial economics

I come to economics and political science from an unusual place. I was a computer programmer for many years, and an avid reader of popularizations of science. When I'm thinking about science and engineering, I'm always keeping one eye on the physical. I'm always asking, "What does this have to do with what's physically happening?" I have to be especially careful about the physical as a computer programmer. I mostly worked on business information systems: my job was to help people track and control what was physically happening in their business. (I also had to worry about what was more-or-less physically happening with the bits and bytes.) We have to worry about what's physically happening with the economy, too. All too often, economics deals with money, but money — even hard money — is not itself physical. Money is still important, but it's not physical. It's not an end in itself.

Imagine that for a thousand years, everyone in the country (or the world) decided to consume nothing but the bare minimum necessary for physical survival (mud huts, rice and beans, etc.), work as hard as possible, and put all our (fiat) money in the bank to grow at compound interest. In a thousand years, would our descendents be fabulously wealthy? Of course not. Not only is it unclear what we would be working at, our physical productive capabilities would be geared towards producing only subsistence. The money in the bank would represent nothing real.

"Hard" money doesn't change anything. Imagine that for a thousand years we produced only subsistence goods, and with our extra time we all worked as hard as possible getting every possible gram of silver, gold, platinum, etc. out of the ground (we might even work on producing "hard money" by transmutation). Would our descendents be wealthy? Again, of course not: they would have a lot of yellow metal in vaults and the productive capability only to produce a lot of gold; they wouldn't have cars, televisions, cell phones, and they wouldn't have any more capacity to build such things than if we, their parents, had spent a thousand years masturbating.

To be wealthy in the real sense, we have to have physical goods and services that it gives us pleasure to actually consume. Money itself is not the end; money is the way we try to work out socially what physical goods and services to produce, and who gets to consume them. At a microeconomic level, how many lattes should we make? How many hours of yoga instruction should we provide? It's a trade-off: producing more of one means producing less of the other. We use money to try to balance the production of the two for maximum happiness. At the macroeconomic level, how much of our time and effort should we spend actually making stuff? How much should we spend investing, making factories, educating people, and improving our stuff-making technology? Again, these are trade-offs; we use actions such as monetary and fiscal policy to balance between consumption and investment.

If we lose sight of the underlying reality, of the physical production of goods and services, we enter the land of theology. Indeed, one economist I read (I can't recall which; JFGI if you're interested) calls this "theoclassical" economics. We do have to have a control system to manage a 300,000,000 person economy, and we do have to spend some time maintaining the integrity of the control system itself, but if we don't always think carefully about the effects on the real, physical production of goods and services, worrying about the properties of the control system itself is at best pointless and at worst mendacious.

(As an aside, and because I'll take shots at Ayn Rand whenever possible, it's notable that Rand has to handwave away the real economy to make her "strike" work. Without John Galt's perpetual motion machine and magic science, the strike would have failed: the strikers would have starved long before the lights of New York went out.)

As a more concrete example, think about what really happens when you put your money in the bank. It's not enough to say only, "Oh, the bank pays 2% p.a. interest, compounded quarterly." What's the underlying reality? Really, you are making a decision to invest rather than consume. If all goes well, your investment should make the production of goods and services more efficient: after a year, we will be able in general to produce stuff with less human time. Indeed, if all goes well, we should increase our productive capabilities by exactly 2%. That's why, if you invest rather than consume some amount of real stuff today, you should be able to consume 2% more real stuff next year: we have spent a year becoming more efficient at producing stuff.

One advantage of tying financial economics to real economics is that we can use the philosophy and all the tools and techniques of scientific examination to discuss the physical; we don't need to to descend into any "praxeology" bullshit.

Whenever you see an economist (or anyone else) talking about financial economics without referencing the underlying reality (or telling a false or unfalsifiable story about the physical economy), you should call bullshit. Does someone say that taxation, or debt, or fiat money, etc. is bad? These are just example of moving money around; they cannot be intrinsically bad or good, because money itself isn't real. Ask, "Under the current conditions, what are the effects of adjusting the control system (money) on the physical, measurable, scientifically examinable reality?" Always always always keep one eye on the physical.

1 comment:

  1. Man I love your writing Larry.


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