Wednesday, June 8, 2011

Reality in 4C

Why have economists been mostly wrong not only in prognosticating future economic outlook but also in rationalising past events? The root cause is the university and college economics curriculum. All over the world we are churning out armies of economists who've been wrongly taught and who in turn are preaching deviant thoughts. To stop accepting their economic nostrums, we must have ready a credible alternative.

To be sure, not all economists are clueless. Some really understood the workings of the economy; among them John Maynard Keynes, Hyman Minsky, Wynne Godley and Charles Kindleberger. Sadly they are all deceased. Outside the mainstream, the Austrian school of economists provides a good alternative viewpoint but in this case restrict yourself to just their view of the business cycle. Nikolai Kondratieff, a Russian economist executed by Stalin in 1938, was another proponent of the business cycle but he did not come out with a persuasive explanation to support his theory. Had he lived longer, he might have come out with one. As a result many successive 'experts' have come out with their own ideas which have no strong theoretical basis either.

What should we resort to? Nikolai Kondratieff's long waves are actually a good starting point. What we need is a sound underpinning in the form of a framework. It can only come after an exhaustive study of ancient as well as the modern post-Industrial Revolution societies. Only if the framework can successfully explain the rise and fall of all these societies, can we accept it as a valid theoretical basis.

No, this framework is not going to contain any mathematical symbol nor algebraic equation. Economics is about people, not numbers which should be restricted to the physical sciences and mathematics. With people, emotion generally trumps reason. The melancholic state of economics nowadays is a result of the field being taken over by the quants who have so much blind faith in mathematics. In finance and banking, they have wreaked havoc. Unknown to many, they also are doing much more serious damage to economics but till today such harm has yet to be exposed. The father of this movement is Paul Samuelson who happened to be the author of the widely used college economics text. Not surprisingly, Ben Bernanke was a student of Samuelson. So now you know why the Federal Reserve still can't get a handle on the US economy.

The framework which is meant to undo this damage has been tested against the economic waxing and waning of the societies of Ancient Greece, Ancient Rome, Charlemagne's pre-medieval Europe, the Dutch Republic, the British Empire and the US Republic. In addition the framework must also be able to prognosticate the future economic outlook. The framework, consisting of four components - Capacity, Communication, Consumption and Currency - abbreviated as the 4C, is depicted below. In reality, the structure is a dense network with many-to-many relationship instead of the circular one-to-one relationship. However, understanding comes through simplification as long as the simplification doesn't change the substance of the subject matter.

Don't be deceived by the simplicity of the 4C. Remember Albert Einstein's dictum: "Everything should be made as simple as possible, but no simpler." In the 4C's simplicity lies a powerful tool enabling us to understand the past and foresee the future.

Let's walk through the framework. We know that an economy revolves around the exchange of goods or services. This implies that you must first produce goods or services surplus to your own needs. A self-subsistence existence on the other hand has no need for any economic exchange or trade. Capacity to produce surplus is thus the precondition for trade. But having capacity is useless unless the surplus production can be transported to those who want to consume it. Hence the communication and consumption legs. Finally a common measure, i.e., currency is needed to enable the exchange. Barter doesn't cut it because a plethora of prices will emerge to overwhelm the exchange. For example, under a barter system, 10 items will result in 45 prices, that is (10 x 9)/2, the formula being n(n-1)/2, whereas a common currency produces only 10 prices.

Currency doesn't have to be physical. In fact, most of our economic transactions are conducted using credit, the virtual currency that forms more than 90 percent of our money. Those who disparage fiat paper currency should have redirected their denunciation towards credit instead. Ancient and traditional societies with surplus economic goods also resorted to credit simply because there was not enough physical money, be they shells, beads or precious metals, to meet the needs of trade. And the main reason for the collapse of the discredited gold standard was its failure to meet the shortage of money.

In our modern day, the capacity and communication legs of the framework are primarily powered by technological advances. Hence to really understand them you need to have a full grasp of the history of technology. Historically, capacity has come in the form of cheaper and more plentiful energy and materials. Those are two out of the three hallmarks of the Industrial Revolution, the other being the setting of the work pace by machines.

Communication which can be either physical or virtual is the leg that drives stock market booms. The consumption leg on the other hand is tied up with demographic growth. Consequently a history of demography is a must. As population growth used to be highly dependent on food, a history of food is also in order. However in modern times, food and population no longer move in sync as fertility rates rapidly decline in the developed world though in the poor developing nations, high fertility rates and declining food production are storing up future troubles.

Only the currency aspect is within the purview of economists. Guess what do you need to know to master this? A history of economics for sure. Not the theoretical stuff peddled in universities. In effect, economists know only probably 20 percent of the knowledge needed to explain monumental shifts in economic conditions. No wonder their predictions go haywire and their rationalisations of the past fail scrutiny.

In the 4C framework, the circle or cell can represent an individual, a corporation or a state. A cell must be a producer (capacity) as well as a consumer (consumption). The purpose of an economy is to keep the network moving so that everybody produces and consumes; if he stops producing, he also cannot consume. If this happens to be a business enterprise, it can be made bankrupt. But you can't do that to humans or nations. That explains why good CEOs make poor politicians.

To support the flow of goods and services, the communication lines must keep the flow moving and there must be enough currency to lubricate the economic exchanges. Like a production planner on the factory floor, the aim is to balance the load along the network. There's no point in making some cells highly efficient in producing goods that the idled others cannot consume. The resources should have been diverted to the slow producing cells so that they can start producing and thus accumulate the wherewithal to pay for their consumption.

Among the four components of the framework, only the currency leg can be manipulated by policymakers. During the first half of any Kondratieff Wave, they would hike the interest rate in order to reduce credit growth. Because the interest rate is the price of money, the higher it is, the less money is borrowed. Through this means, they control consumption so as to be in line with capacity which is still trying to meet demand. A runaway inflation would be subdued in this manner.

Conversely, during the second half, they would reduce the price of money so as to stimulate demand for money. It works, but in the form of a borrowing and spending binge on real estate, and only for a very short duration. To understand why, you must drag in the capacity and the consumption legs. During this stage, the capacity has become lopsided with a few extremely efficient producers cornering the market. As a result the consumption also fails since many cells have been knocked out of the economic game because of their inefficient productive capacity. If this were a factory, you'd see harried economists confusedly scurrying around trying to fix a production flow that heaped superfluous parts at the wrong work cells while starving others of needed parts. So even at zero price or interest, there are no takers for the money. Nobody can borrow if they have no income to repay the loan. Borrowings plummet and money supply drops. Deflation ensues morphing eventually into a depression. A new beginning takes place only when a new 4C replaces the outmoded 4C.

The real life stories are more interesting and will be posted over time. In fact, with this framework as a guide, history will appear to you as a jigsaw puzzle capable of being solved. You'll spot gaps in the narratives of even noted historians. History will no longer be the boring stuff but a fascinating subject offering many lessons and patterns for the future. But one thing is certain, once you've viewed reality in 4C, you'll never want to go back to 3D.

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