"Our main task, therefore, will be to confirm the reader’s instinct that what seems sensible is sensible, and what seems nonsense is nonsense," said John Maynard Keynes in his 1929 pamphlet "Can Lloyd George Do It?". This is the chief task of any honest economist: not to explain a recondite and subtle science to the ill-informed layman, but rather to cut through the mass of lies and bullshit that cowardly, dishonest, and lazy economists have promulgated to confirm to the lay person that many of her instincts are correct. Of course, economics, especially macroeconomics, does have some counter-intuitive elements, but those counter-intuitive elements derive directly and simply from an intuitive basis. Bullshit — myths, lies, equivocations, circumlocutions, and willful ignorance — always grows around the justification of any class rule. Money is, of course, the basic justification for the rule of the capitalist class, and the basis of any class rule can never stand honest, clear-sighted scrutiny; class rule draws bullshit like nectar draws hummingbirds. To start to cut through the bullshit, therefore, we have to understand the nature of money: money is the primary element of a socially constructed economic control system.
What is a "control system"? There are many complex systems that we can usefully divide into a concrete real system and an abstract control system. For example, we can divide up a jetliner into its real system and its control system. The real system consists (primarily) of the engine(s), wings, horizontal and vertical stabilizers, and fuselage: the components that generate and/or directly respond to the four fundamental forces of flight: lift, thrust, gravity, and drag. The control system consists of everything in the cockpit: the yoke, pedals, and throttle; the gauges, dials, and indicators; and, of course, the pilot(s).
The division between real and control systems is not and cannot be absolute: for it to be a control system, the control system must somehow physically modify and respond to the real system. Turning the yoke changes the physical position of the ailerons, which affects the physical lift generated by the wings, causing the aircraft to turn. A change in the attitude of the aircraft causes a physical change to the attitude indicator (artificial horizon). Furthermore, the purely real system can have control effects. On an ordinary aircraft, the horizontal stabilizers on the tail generate a small amount of negative lift (the aerodynamics push down on the tail); when the pitch of the aircraft changes, the force on the tail changes in such a way that the aircraft returns automatically to a stable pitch. The horizontal stabilizers directly control the attitude of the aircraft.
But while the division is not absolute, it is determinable. The key is abstraction. The real system is directly connected to real-word physics. The fuselage must be streamlined to minimize drag. The wings must be shaped just so to generate lift. The engines must combine fuel and oxygen together (and do a lot of other mechanical things) in very specific ways to generate thrust. In contrast, the control system is much less connected to real-world physics. There's no particular extrinsic physical reason we have to use yoke, pedals, and throttle in the specific way that we usually do to control an airplane; we could, if we chose, use knobs, buttons, and switches. All that's necessary is that the control system have the degrees of freedom necessary to represent all desired change and states of the real system. But fundamentally, the more concrete a component is, the more it is part of the real system; the more abstract, the more it is part of the control system. Another key indicator is "removability": we can remove the entire control system of an aircraft and it will still fly; we cannot remove the real system, no matter how the control system is arranged.
Similarly, we can divide economics into a real system and a control system. The real system is people physically working to produce goods (physical things) and services for exchange with other people. The control system is money and the financial system. Work and exchange are concrete: we must do very specific physical things to produce a loaf of bread, a coat, a hat, a computer, or an aircraft. The control system of economics is money. Money is abstract: there's no particular physical reason we have to use small pieces of paper printed in green with pictures of dead presidents on them to control who works where and who consumes what's produced. Indeed, while money exists throughout recorded history, there have been many different control systems, notably communalism, barter, as well as slavery, and serfdom. We could have a real economy without any control system (pure barter), but we have no economy at all if we have only money, without people working and exchanging goods and services.
Indeed, the idea that money itself is part of the real economy, as ineluctable and directly physical as the horizontal stabilizers, is so nonsensical that it takes the most elaborate theological faith to hold that view. That's one reason it's so difficult to argue with hard-money libertarians; like Christians, they are so committed to a nonsensical delusion that they lose the ability to discuss the issue in good faith. Money might or might not be the best control system*, but the intuitive idea that money really is a control system is one that must be grasped and held onto despite the sophistry of the economic theologians.
*It's not the best, but it's better than some others.
Showing posts with label real economic crises. Show all posts
Showing posts with label real economic crises. Show all posts
Sunday, May 20, 2012
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.
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.
Saturday, January 14, 2012
Real Microeconomics (supply shocks)
Part 1: What is "real"? (commentary)
Part 2a: Real microeconomics (demand shocks)
Part 2b: Real microeconomics (supply shocks)
In the last post, I talked about real "demand shocks", when we want a lot more of something than we can presently produce. There are also real "supply shocks". A supply shock happens when something becomes considerably more expensive: given some set of resources, we can produce less of something we want or need than we could yesterday, with no compensation in the production of other things.
But what do I mean by "more expensive"? I'm talking about real economics, economics without money. The only resource we can arbitrarily change is how we spend our time. We cannot just arbitrarily make decide to have more iron: if we want more iron, human beings have to spend time digging it out of the ground. (We might also spend time creating machines to dig it out of the ground, or we might choose to use up some of the labor "embodied" in an already created digging machine to dig up iron instead of copper or uranium). So, by more expensive, I mean producing something requires more labor* than before, labor that has an opportunity cost, that could have been used to produce something else.
*Strictly speaking, socially necessary abstract labor time.
Real supply shocks tend to "creep"; in this sense, "shock" is kind of a misnomer. (In economics, "shock" just means something exogenous, i.e. in some sense outside the normal economic system.) We don't wake up one morning to find that hats suddenly take twice as much labor to make as yesterday. Rather, the real cost — the labor — tends to inexorably increase over a long period of time.
Oil is a good example of a supply shock. We believe (IIRC) we have in the last century extracted about half the oil that's in the ground. The problem is that we've already extracted the oil that's "easy" to get to, and increases in our productivity are starting to fall behind the increase in difficulty in extracting the rest of the oil. We're not going to "run out" of oil; oil will just take more and more labor time to extract, until the oil that's left is so expensive it will be used only for those things we really really want.
In a similar sense, agriculture before the industrial revolution was in a state of creeping supply shock. As the population grew, more and more land had to be put into food production. The problem is that we used the most productive and fertile land first; additional land was less productive than new land. This caused the average labor time for a given quantity of food to rise over time. Improvements in technology and the production of capital could not keep up with the loss of productivity, to the point where food production was a severe constraint on population growth. This sort of constraint is not pretty: people tend to actually starve to death.
Of course, supply "shocks" don't have to be crisis producing. As we create more capital, which makes labor more productive, and as technology improves, it requires less labor time to make most goods and services, which reduces the opportunity cost in terms of making goods and services that cannot have improvements in productivity. (One cannot, for example, greatly improve the productivity of live performances of classical symphonies.)
One interesting comparison of real economics vs. financial economics is that "positive" supply shocks (which can be abrupt), where the labor cost of something decreases, cannot produce a crisis in real economics, but can produce a crisis in financial economics. Curious.
Part 2a: Real microeconomics (demand shocks)
Part 2b: Real microeconomics (supply shocks)
In the last post, I talked about real "demand shocks", when we want a lot more of something than we can presently produce. There are also real "supply shocks". A supply shock happens when something becomes considerably more expensive: given some set of resources, we can produce less of something we want or need than we could yesterday, with no compensation in the production of other things.
But what do I mean by "more expensive"? I'm talking about real economics, economics without money. The only resource we can arbitrarily change is how we spend our time. We cannot just arbitrarily make decide to have more iron: if we want more iron, human beings have to spend time digging it out of the ground. (We might also spend time creating machines to dig it out of the ground, or we might choose to use up some of the labor "embodied" in an already created digging machine to dig up iron instead of copper or uranium). So, by more expensive, I mean producing something requires more labor* than before, labor that has an opportunity cost, that could have been used to produce something else.
*Strictly speaking, socially necessary abstract labor time.
Real supply shocks tend to "creep"; in this sense, "shock" is kind of a misnomer. (In economics, "shock" just means something exogenous, i.e. in some sense outside the normal economic system.) We don't wake up one morning to find that hats suddenly take twice as much labor to make as yesterday. Rather, the real cost — the labor — tends to inexorably increase over a long period of time.
Oil is a good example of a supply shock. We believe (IIRC) we have in the last century extracted about half the oil that's in the ground. The problem is that we've already extracted the oil that's "easy" to get to, and increases in our productivity are starting to fall behind the increase in difficulty in extracting the rest of the oil. We're not going to "run out" of oil; oil will just take more and more labor time to extract, until the oil that's left is so expensive it will be used only for those things we really really want.
In a similar sense, agriculture before the industrial revolution was in a state of creeping supply shock. As the population grew, more and more land had to be put into food production. The problem is that we used the most productive and fertile land first; additional land was less productive than new land. This caused the average labor time for a given quantity of food to rise over time. Improvements in technology and the production of capital could not keep up with the loss of productivity, to the point where food production was a severe constraint on population growth. This sort of constraint is not pretty: people tend to actually starve to death.
Of course, supply "shocks" don't have to be crisis producing. As we create more capital, which makes labor more productive, and as technology improves, it requires less labor time to make most goods and services, which reduces the opportunity cost in terms of making goods and services that cannot have improvements in productivity. (One cannot, for example, greatly improve the productivity of live performances of classical symphonies.)
One interesting comparison of real economics vs. financial economics is that "positive" supply shocks (which can be abrupt), where the labor cost of something decreases, cannot produce a crisis in real economics, but can produce a crisis in financial economics. Curious.
Tuesday, December 27, 2011
Real microeconomics (demand shocks)
Part 1: What is "real"? (commentary)
Part 2a: Real microeconomics (demand shocks)
One definition of microeconomics is the economics of individual firms (or consumers) by themselves, as opposed to macroeconomics, which is the study of the economy in the aggregate. Another definition, which seems especially useful for studying real economics, is that microeconomics takes the total level of output of an isolated* national economy for granted, and is concerned with optimizing the mix of goods and services within that economy.
Even the most casual reader should be aware of the standard supply and demand curves, with the equilibrium price at the point where the marginal cost of supply (the amount of something required to produce one more unit of the product) equals the marginal utility of demand (the amount of something for which a consumer will forego to obtain one more unit of the product). In financial microeconomics, the y-axis is the price level. In real microeconomics, the x-axis is still quantity produced, but real economics ignores money. So how should we label the Y-axis?
The supply curve increases not primarily because of diseconomies of scale, but primarily because of rising opportunity costs. Every coat we make means that we cannot make a hat*. To make the first, most demanded coat, we sacrifice the last, least demanded hat. To make the second, slightly less demanded coat, we sacrifice the second to last, slightly more demanded hat. And so forth, until we get to the point where we are making the coat that is just about as demanded as the hat we are not making. Therefore, in real economics, the y-axis represents opportunity cost, the quantity of all other goods and services that we're not making in order to make the quantity of the specific good or service under consideration.
*We can assume wolg that the trade-off is one-to-one and linear so long as the demand curves are monotonically decreasing.
For obvious reasons, it is not the case that the amount of each and every service is at exactly the correct level. Tastes, preferences, and costs are all constantly changing. Therefore, the quantity of most goods and services we're producing constantly changes. But in an industrial economy, we cannot simply turn on a dime and change production instantaneously. Suppose, for example, that we are producing too many coats. If we were to not produce some of those coats, we could produce more hats, which we want more than the coats. However, we cannot instantaneously just produce fewer coats and more hats.
We must undertake a two-step process to modify production. First, we have to invest. We have to make more hat-making factories, and we have to train more workers to make hats. Since we are making too many coats, we make (and maintain; factories wear out too) fewer coat-making factories than is necessary to sustain current production. Once we have the new hat-making factories, we have to actually make more hats, deliver them to stores, and distribute them to consumers. All of this activity takes time.
Usually, it all evens out. We're usually making just a little too many of some goods and services, a little too few of others, and everything evens out. We produce about the same amount for consumption and investment overall, month to month, year to year. Everybody is always a little bit dissatisfied: coats are a little bit too cheap, hats are a little bit too expensive, so people end up with coats they didn't want as much as the hats they couldn't afford. But again, this dissatisfaction is more-or-less constant, and drives long-term economic growth.
But sometimes there are more radical microeconomic shifts, radical enough that they deserve to be called "crises". For example, when the computer was invented, a whole lot of people suddenly really wanted one. It took more than one annual accounting period — about twenty or thirty years, all told — to invest enough to make enough computers (and computer programs) for everyone who wanted one (badly enough) to actually get one. That meant that for a couple of decades, we were consuming measurably less than we wanted and expected to, so we could invest in building computers. It eventually sorted itself out, but it took a long time.
At the real level, microeconomics is concerned with precisely what we should produce. Because the real microeconomy cannot "move on a dime", we have to predict, as best we can, not only what we're short of now, but what we'll be short of — and how short we'll be — in the future.
Part 2a: Real microeconomics (demand shocks)
One definition of microeconomics is the economics of individual firms (or consumers) by themselves, as opposed to macroeconomics, which is the study of the economy in the aggregate. Another definition, which seems especially useful for studying real economics, is that microeconomics takes the total level of output of an isolated* national economy for granted, and is concerned with optimizing the mix of goods and services within that economy.
*International trade notwithstanding, it's easier to consider the national economy as an isolated whole, and international trade doesn't substantially change the underlying theory.
Even the most casual reader should be aware of the standard supply and demand curves, with the equilibrium price at the point where the marginal cost of supply (the amount of something required to produce one more unit of the product) equals the marginal utility of demand (the amount of something for which a consumer will forego to obtain one more unit of the product). In financial microeconomics, the y-axis is the price level. In real microeconomics, the x-axis is still quantity produced, but real economics ignores money. So how should we label the Y-axis?
The supply curve increases not primarily because of diseconomies of scale, but primarily because of rising opportunity costs. Every coat we make means that we cannot make a hat*. To make the first, most demanded coat, we sacrifice the last, least demanded hat. To make the second, slightly less demanded coat, we sacrifice the second to last, slightly more demanded hat. And so forth, until we get to the point where we are making the coat that is just about as demanded as the hat we are not making. Therefore, in real economics, the y-axis represents opportunity cost, the quantity of all other goods and services that we're not making in order to make the quantity of the specific good or service under consideration.
*We can assume wolg that the trade-off is one-to-one and linear so long as the demand curves are monotonically decreasing.
For obvious reasons, it is not the case that the amount of each and every service is at exactly the correct level. Tastes, preferences, and costs are all constantly changing. Therefore, the quantity of most goods and services we're producing constantly changes. But in an industrial economy, we cannot simply turn on a dime and change production instantaneously. Suppose, for example, that we are producing too many coats. If we were to not produce some of those coats, we could produce more hats, which we want more than the coats. However, we cannot instantaneously just produce fewer coats and more hats.
We must undertake a two-step process to modify production. First, we have to invest. We have to make more hat-making factories, and we have to train more workers to make hats. Since we are making too many coats, we make (and maintain; factories wear out too) fewer coat-making factories than is necessary to sustain current production. Once we have the new hat-making factories, we have to actually make more hats, deliver them to stores, and distribute them to consumers. All of this activity takes time.
Usually, it all evens out. We're usually making just a little too many of some goods and services, a little too few of others, and everything evens out. We produce about the same amount for consumption and investment overall, month to month, year to year. Everybody is always a little bit dissatisfied: coats are a little bit too cheap, hats are a little bit too expensive, so people end up with coats they didn't want as much as the hats they couldn't afford. But again, this dissatisfaction is more-or-less constant, and drives long-term economic growth.
But sometimes there are more radical microeconomic shifts, radical enough that they deserve to be called "crises". For example, when the computer was invented, a whole lot of people suddenly really wanted one. It took more than one annual accounting period — about twenty or thirty years, all told — to invest enough to make enough computers (and computer programs) for everyone who wanted one (badly enough) to actually get one. That meant that for a couple of decades, we were consuming measurably less than we wanted and expected to, so we could invest in building computers. It eventually sorted itself out, but it took a long time.
At the real level, microeconomics is concerned with precisely what we should produce. Because the real microeconomy cannot "move on a dime", we have to predict, as best we can, not only what we're short of now, but what we'll be short of — and how short we'll be — in the future.
Friday, December 16, 2011
Opportunity costs
Part 1: What is "real"? (commentary)
Part 2: Opportunity costs
To look at real economics, we're looking at economics in the absence of money. It's important, I think, to revisit a little of microeconomics 101 in real terms.
One thing that doesn't change in real micro is the production possibility frontier (PPF). The PPF basically represents the notion that, ceteris paribus, we can make only a finite quantity of goods: if we make more pizza, for example, we cannot make as much beer, and vice-versa. Since both axes are in quantities of real goods and services, money is not involved, and nothing changes between financial and real microeconomics.
A concept that does change is the partial equilibrium "price" given by the intersection of the supply and demand curves. In standard financial micro, the x-axis is the quantity of some real good (so it's the same in real economics), but the y-axis is the price, denominated in money. Since we don't have money in real economics, we need a new unit of measure for the y-axis. To get the y-axis, we need a narrative about why the demand curve decreases and the supply curve increases.
The demand curve falls because for any single good or service, the more units we already have, the less we "inherently" want yet another unit: the declining marginal utility of demand. The first hamburger keeps me from starving to death, the second makes me feel full, I want the third just because I really like hamburgers, and so forth. The the fifth or sixth hamburger might have negative utility: it'll make me sick. Not all goods and services are like this (think of Imelda Marcos and shoes), but overall it seems intuitively to hold, especially when we start talking about each individual consuming many different goods and services, and each supplier producing for many different consumers.
There are two reasons the supply curve falls. First, there are, especially in the short run (where one or more of the factors of production: land, labor, and/or physical capital are fixed), diseconomies of scale. If I have a certain number of pizza ovens, I can make only so many pizzas, no matter how many pizza-makers I hire. Similarly, for the pizza sector, we can't just magically make more pizza ovens overnight. Even trying to squeeze the maximum productivity out of the pizza ovens we already have becomes less and less efficient.
More importantly, though, if demand "inherently" falls, then, because of the PPF above, if we make more units of one good or service, we must make less of other goods and services. The first, most demanded pizza we make means we must forego the last, least demanded beer we could otherwise have made. The second, slightly less demanded pizza requires foregoing the second to last, second least demanded beer. At some point, we're going to have a coin-flip between the pizza and beer that are equally demanded. Thus the supply curve rises even in the long run (where no factors of production are constrained) because of rising opportunity cost.
We can also talk about demand not just in terms of "inherent" desire, but also in terms of opportunity cost: the "inherent" desire for one good or service minus the "inherent" desire for the most desirable good or service we have to give up to get the first. So in real micro, we can always think of the "price" axis (usually the y-axis) in financial micro as the opportunity cost.
Part 2: Opportunity costs
To look at real economics, we're looking at economics in the absence of money. It's important, I think, to revisit a little of microeconomics 101 in real terms.
One thing that doesn't change in real micro is the production possibility frontier (PPF). The PPF basically represents the notion that, ceteris paribus, we can make only a finite quantity of goods: if we make more pizza, for example, we cannot make as much beer, and vice-versa. Since both axes are in quantities of real goods and services, money is not involved, and nothing changes between financial and real microeconomics.
A concept that does change is the partial equilibrium "price" given by the intersection of the supply and demand curves. In standard financial micro, the x-axis is the quantity of some real good (so it's the same in real economics), but the y-axis is the price, denominated in money. Since we don't have money in real economics, we need a new unit of measure for the y-axis. To get the y-axis, we need a narrative about why the demand curve decreases and the supply curve increases.
The demand curve falls because for any single good or service, the more units we already have, the less we "inherently" want yet another unit: the declining marginal utility of demand. The first hamburger keeps me from starving to death, the second makes me feel full, I want the third just because I really like hamburgers, and so forth. The the fifth or sixth hamburger might have negative utility: it'll make me sick. Not all goods and services are like this (think of Imelda Marcos and shoes), but overall it seems intuitively to hold, especially when we start talking about each individual consuming many different goods and services, and each supplier producing for many different consumers.
There are two reasons the supply curve falls. First, there are, especially in the short run (where one or more of the factors of production: land, labor, and/or physical capital are fixed), diseconomies of scale. If I have a certain number of pizza ovens, I can make only so many pizzas, no matter how many pizza-makers I hire. Similarly, for the pizza sector, we can't just magically make more pizza ovens overnight. Even trying to squeeze the maximum productivity out of the pizza ovens we already have becomes less and less efficient.
More importantly, though, if demand "inherently" falls, then, because of the PPF above, if we make more units of one good or service, we must make less of other goods and services. The first, most demanded pizza we make means we must forego the last, least demanded beer we could otherwise have made. The second, slightly less demanded pizza requires foregoing the second to last, second least demanded beer. At some point, we're going to have a coin-flip between the pizza and beer that are equally demanded. Thus the supply curve rises even in the long run (where no factors of production are constrained) because of rising opportunity cost.
We can also talk about demand not just in terms of "inherent" desire, but also in terms of opportunity cost: the "inherent" desire for one good or service minus the "inherent" desire for the most desirable good or service we have to give up to get the first. So in real micro, we can always think of the "price" axis (usually the y-axis) in financial micro as the opportunity cost.
Sunday, December 11, 2011
Thoughts on "what is 'real'"?
I apologize that this exposition is a little disorganized. I'm pretty much figuring this out as I go along.
A few thoughts come to mind after writing part 1.
I define the simplified fundamental identity of real macroeconomics as:
I also don't distinguish between public and private goods. Public goods, defined as non-rival and/or non-exclusive goods, are still, at the real level, still physical goods. I'm happy (for now) to leave the choice of which goods to produce, public or private, to microeconomics.
When I look at the world specifically as an economist, I don't judge people's wants. If a lot of people want Big Macs, or a badass military, then that's what they want.
I am not yet concerned specifically with distribution of consumption, although distribution will come into play soon enough. Even if one person in a 1,000,000 person economy is consuming all the surplus production of the current capital stock and remaining 999,999 workers' labor, we don't have a macroeconomic crisis unless we cannot produce enough to feed those 999,999, or, for some reason, some of these 999,999 are not working to supply what the one consumer wants to consume. For now, I'm pushing the question of distribution to microeconomics and politics.
I was going to wait to differentiate needs and wants until an actual chapter, but I think the explanation is short enough that I can just include it here.
A need is something we have to produce to maintain the productivity of the labor force. If, for example, we had 1,000,000 people in the economy, but we could produce only enough food to feed 900,000 of them (or feed them all only enough to maintain 90% average productivity) we would not be producing as much food as we need. In contrast, a want is something we want but do not need per the above definition. If, for example, each of those 1,000,000 really wanted an iPad, we would not be compromising our productivity by producing only 1,000.
A few thoughts come to mind after writing part 1.
I define the simplified fundamental identity of real macroeconomics as:
- Production = Consumption + Investment
- Gross Domestic Product = Consumption + Investment + Government + Net Exports
I also don't distinguish between public and private goods. Public goods, defined as non-rival and/or non-exclusive goods, are still, at the real level, still physical goods. I'm happy (for now) to leave the choice of which goods to produce, public or private, to microeconomics.
When I look at the world specifically as an economist, I don't judge people's wants. If a lot of people want Big Macs, or a badass military, then that's what they want.
I am not yet concerned specifically with distribution of consumption, although distribution will come into play soon enough. Even if one person in a 1,000,000 person economy is consuming all the surplus production of the current capital stock and remaining 999,999 workers' labor, we don't have a macroeconomic crisis unless we cannot produce enough to feed those 999,999, or, for some reason, some of these 999,999 are not working to supply what the one consumer wants to consume. For now, I'm pushing the question of distribution to microeconomics and politics.
I was going to wait to differentiate needs and wants until an actual chapter, but I think the explanation is short enough that I can just include it here.
A need is something we have to produce to maintain the productivity of the labor force. If, for example, we had 1,000,000 people in the economy, but we could produce only enough food to feed 900,000 of them (or feed them all only enough to maintain 90% average productivity) we would not be producing as much food as we need. In contrast, a want is something we want but do not need per the above definition. If, for example, each of those 1,000,000 really wanted an iPad, we would not be compromising our productivity by producing only 1,000.
Saturday, December 10, 2011
A real theory of economic crises
Part 1: What is "real"? (commentary)
To understand the current economic crisis, we must look underneath the abstraction of the financial to the real macroeconomy. Doing so is not an easy task, especially when the majority of academic and commercial economists are devoted to obscuring the real economy.
The underlying real economy consists of the use of physical things, such as human labor, steel, land, and machines, to produce other physical things, such as loaves of bread, cars, houses, lattes, and massages as well as (to stretch the definition of "physical" a bit) education, good health, and so forth.
On the supply side, microeconomics talks about how much of each individual good and service we should produce, given some total amount of production. Macroeconomics talks about how much we should produce in total, and how we should allocate that production between consumption and investment in physical and human capital. Macroeconomics also assumes that the national economy is an isolated whole. It is not really isolated, international trade does exist, but it is sufficiently close that the approximation is useful to understand the fundamentals, and the rules of international trade differ substantially from both microeconomics within and the macroeconomics of a national economy.
In a microeconomic crisis, we find ourselves with the productive capacity to produce too much of some things. Because microeconomics takes as given the total amount of production, that we are producing too much of some things implies that we are producing not enough of other things. This state of affairs produces a crisis because it takes time to reallocate the means of production from the surplus to the shortage. During that time, which may be a substantial fraction of or even longer than the traditional annual accounting period, the total production of final goods and services will drop: we will not see the final goods actually sold for consumption until all the capital apparatus has been created and has been in operation for some time. One way we account for this switch is by including investment spending directly in Gross Domestic (and National) Product. From a macroeconomic perspective, we deal with a microeconomic crisis by allocating more real activity from consumption to investment.
In a macroeconomic crisis, however, we find ourselves not producing all we need or want (I will explain the distinction later) to consume. Macroeconomic crises have two causes. First, we physically cannot produce all we need to consume. Alternatively, although we might be physically able to produce more, we are not producing all we want to consume and/or invest. We get into macro crises not because (or not just because) we are producing the wrong sorts of things, but because we are not producing enough things overall.
The fundamental identity of real macroeconomics is:
In addition stating to the fundamental identity of real macroeconomics, it is possible to restrict the factors of production — land, labor and capital — to just labor. First, we use labor to create capital (physical capital such as factories and machines, as well as human capital such as education and training). If we do not have as much capital as we want or need, we must use labor to create more. We can eliminate land (which includes the raw materials actually on the land) because the physical quantity of land (and its raw materials) is fixed; we cannot create more iron ore in the ground.
More importantly, the use of land is entirely in the domain of microeconomics. Most land and raw materials have a continuous (increasing) marginal cost of exploitation. Therefore, we simply add labor to using land until the marginal cost of doing so is in equilibrium with the (continuous, falling) marginal demand of producing the products and services requiring the land. Even when some kind of land or raw materials is discontinuously scarce, the only consequence is that more of the surplus value of labor will be allocated to the owner of the land rather than to other potential recipients.
Therefore, all we need to consider in macroeconomics is labor. A real macroeconomic crisis, therefore, is when the total amount of labor employed in production is less than what we need or want to employ.
I'll put all this together in the next post.
To understand the current economic crisis, we must look underneath the abstraction of the financial to the real macroeconomy. Doing so is not an easy task, especially when the majority of academic and commercial economists are devoted to obscuring the real economy.
The underlying real economy consists of the use of physical things, such as human labor, steel, land, and machines, to produce other physical things, such as loaves of bread, cars, houses, lattes, and massages as well as (to stretch the definition of "physical" a bit) education, good health, and so forth.
On the supply side, microeconomics talks about how much of each individual good and service we should produce, given some total amount of production. Macroeconomics talks about how much we should produce in total, and how we should allocate that production between consumption and investment in physical and human capital. Macroeconomics also assumes that the national economy is an isolated whole. It is not really isolated, international trade does exist, but it is sufficiently close that the approximation is useful to understand the fundamentals, and the rules of international trade differ substantially from both microeconomics within and the macroeconomics of a national economy.
In a microeconomic crisis, we find ourselves with the productive capacity to produce too much of some things. Because microeconomics takes as given the total amount of production, that we are producing too much of some things implies that we are producing not enough of other things. This state of affairs produces a crisis because it takes time to reallocate the means of production from the surplus to the shortage. During that time, which may be a substantial fraction of or even longer than the traditional annual accounting period, the total production of final goods and services will drop: we will not see the final goods actually sold for consumption until all the capital apparatus has been created and has been in operation for some time. One way we account for this switch is by including investment spending directly in Gross Domestic (and National) Product. From a macroeconomic perspective, we deal with a microeconomic crisis by allocating more real activity from consumption to investment.
In a macroeconomic crisis, however, we find ourselves not producing all we need or want (I will explain the distinction later) to consume. Macroeconomic crises have two causes. First, we physically cannot produce all we need to consume. Alternatively, although we might be physically able to produce more, we are not producing all we want to consume and/or invest. We get into macro crises not because (or not just because) we are producing the wrong sorts of things, but because we are not producing enough things overall.
*If we physically could produce more, but no one wants to consume more, i.e. for everyone the marginal utility of more leisure exceeds the marginal utility of more consumption, then there is no macroeconomic crisis. Alternatively, macroeconomists consider the situation where we do not need to consume more, but we want to consume more than we physically can produce, to be the normal situation, the cause of long-run economic growth.
The fundamental identity of real macroeconomics is:
- Production = Consumption + Investment + Net Storage + Waste
- Production is the total amount of real goods and services, final or investment, produced for trade.
- Consumption is the total amount of real final goods and services used up to enjoy their use values. Investment is total amount of physical and human capital created (either anew or to replace earlier investment used up in the production of goods for consumption) to create final goods that will be consumed (perhaps in a later accounting period).
- Net Storage is the total amount of real final goods* produced and then placed in storage less real final goods taken out of storage and consumed**.
- Waste is the total amount of final goods and services produced but destroyed (or allowed to decay) without being used.
- Production = Consumption + Investment
*We typically cannot store services.
**In financial macroeconomics, we usually count Net Storage as the inventory subcategory of investment spending.
***To avoid a lengthy (although interesting) philosophical debate, here I consider things such as military spending to be consumption.
**In financial macroeconomics, we usually count Net Storage as the inventory subcategory of investment spending.
***To avoid a lengthy (although interesting) philosophical debate, here I consider things such as military spending to be consumption.
In addition stating to the fundamental identity of real macroeconomics, it is possible to restrict the factors of production — land, labor and capital — to just labor. First, we use labor to create capital (physical capital such as factories and machines, as well as human capital such as education and training). If we do not have as much capital as we want or need, we must use labor to create more. We can eliminate land (which includes the raw materials actually on the land) because the physical quantity of land (and its raw materials) is fixed; we cannot create more iron ore in the ground.
More importantly, the use of land is entirely in the domain of microeconomics. Most land and raw materials have a continuous (increasing) marginal cost of exploitation. Therefore, we simply add labor to using land until the marginal cost of doing so is in equilibrium with the (continuous, falling) marginal demand of producing the products and services requiring the land. Even when some kind of land or raw materials is discontinuously scarce, the only consequence is that more of the surplus value of labor will be allocated to the owner of the land rather than to other potential recipients.
Therefore, all we need to consider in macroeconomics is labor. A real macroeconomic crisis, therefore, is when the total amount of labor employed in production is less than what we need or want to employ.
I'll put all this together in the next post.
Subscribe to:
Posts (Atom)