Friday, October 10, 2008

Thoughts on economics...

Y’know, I just can not help wondering whether the current banking/financial meltdown/crisis and the attempts to rectify the problem are in fact treating symptoms to a far more serious disease.

I am now beginning to have considerable concern about the quantity of money various governments have been releasing to the existing structures in an attempt to “keep the Titanic, errr ooopps sorry, global economy afloat”. If I can keep the Titanic here for a moment it would be a little like loading icebergs onto the decks because they are lighter than water and hence should keep the boat afloat for a bit longer.

The second concern is that at some point someone is going to point to the Breton Woods accords and say that they need to be reversed; that we should return to a global gold standard. That, I fear would be akin to using cyanide as a chemotherapy to cure psoriasis.

The point here is that the real underlying cause of the current “crisis” has been the increasing availability and use of credit funding of consumption.

This is one of these “cycle” processes and I have to break into the ring at some (arbitrary) point..

Step 1 - As the global economy has grown (I have to take a global viewpoint as it is in fact a global problem) that has increased the amount of money in circulation (I use Samuelson’s models which is going to upset the Friedmanites in particular).

Step 2 – The increased money supply is split between investment and consumption. The increase in consumption drives the need for increased investment.

Step 3 – The increased funds now held within the banking system reduce interest rates; a factor that encourages borrowing to fund further productive investment (a good thing) and further consumption (also a good thing).

That completes the first cycle as the productive investment increases the activity and wealth of the global economy.

Step 4 - The marginal return of investment in production reduces as the process continues. Demand becomes inelastic – falling prices do not increase demand but reduce returns.

Step 5 - The decrease in marginal investment return from productive investment encourages an increase in “non-productive” investment. Those non-productive investments produce the “bubbles” such as the dot-com market, real estate, and “financial instruments”.

Step 6 – The profits gained from the speculative activities of these markets feed back into the initial cycle at Step 2.

That completes the second cycle. We now have a system that looks like a figure 8 (in one sense) but I prefer to think of it as a Mobius Strip. The two cycles are related, rather like taking a Mobius Strip and cutting it in half along its circumference.

There are several other smaller cycles involved in those two primaries – the impact of taxation and government spending for example. Those smaller cycles (when viewed on a global scale) generally have little influence on the primary money wheel.

The two critical elements of these cycles are –
 The feedback loop of consumption into the demand for credit to fund higher consumption.
 The process by which the available money supply has been increased in order to make further credit available.

The second of these two used to be known as “The Multiplier Effect” – may well still be.

The cycles that I have outlined apply as much to nations within the global economy as they do to your household and mine. Follow the Mobius Strip around your own actions as a consumer, your own attitudes and actions as an investor and you should see what I mean. In fact it might even help to write “consumption” on the edge of your Mobius Strip, turn it over and write “attitude” on the other.

Now take a pair of scissors and cut that Mobius Strip in half around its circumference. Look at the result (no go do it for yourself!!!) because that is where we go next.

We now need to think about the psychology of the market. I know very little about this so I am winging it (I am honest about that). No doubt there will be someone out there who can shoot my argument down, but I like it…

Step 1 – As individuals increase their “wealth” (the consequence of the growing global economy) the production investment needs to encourage the spending of that continuing increase in available income in order to maintain both profit growth and market share.

Step 2 –Individuals are encouraged to change behaviour toward consumption in preference to saving and investment. Encouraging others to spend rather than invest directly is also a protective device as it limits the development of competition. Those who save rather than consume are feeding the first cycle at step 3.

Step 3 – The enjoyment of increased consumption encourages increased spending in the continuing pursuit of “the good things in life”.

Step 4 – The feedback of enjoyment and encouragement to increasing spending requires the use of credit. This is no more than the spending of future income for current consumption.

Step 5 – The easy availability of credit is used to further fund the investment in non-productive investments. Think of 100% mortgages, the 3x3x3 HP agreements, “free credit”, multiple credit cards…

Step 6 – The market adds to its litany of “increase consumption”, the need for “maintaining confidence” in the market. That “confidence” requires further enjoyment of even higher levels of consumption.

Now the critical thing here is Step 4. Please remember when I am talking of “nations” here, I am NOT talking of government, government spending or taxes. “Nation” and “National” is the agglomeration of individuals, their actions, their intentions.

I have quoted Mr Micawber several times in relation to where this is all heading –
"Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

As individuals and as nations we have all, to greater and lesser extent, been spending “twenty pounds ought and six”. The extent of that overspend? Well, Germany believes that a total bailout of their banking system (in the form of the government liability for guaranteed savings) is equivalent to eight years of the current GDP. The country (unlike NZ) probably owes very little abroad. NZ faces a double whammy as a very large proportion of that credit has been spent on enjoyable consumption imported from outside. That being the case, and taking the German lead at 8 years GDP, NZ could owe that amount to the ROW. It is not that we are insolvent, you understand. It is just that we have spent the readies, sold the silver service (several times now), put the car on Ebay (Trade-me in NZ) and mortgaged the kids earnings for the next 20 years if you believe the Good Doctor.

Remember that Mobius strip that we cut in half? Pick it up, and with a pair of scissors cut around the circumference.

That is what an economic system looks like…

To quote Mr Micawber again, only not I suspect in relation to the economy but his own circumstances –
Welcome poverty!..Welcome misery, welcome houselessness, welcome hunger, rags, tempest, and beggary! Mutual confidence will sustain us to the end!

Very a propos to the economy at large.


T. F. Stern said...

You seem to have caught the issues just about right. Living beyond the limits of responsibility will bring any individual down; couple that to an entire country (world economy)living beyond its means and you have the recipe for meltdown.

Eugene Tan said...

I'm about half his age and I saw the same. So I deserve to get twice his kudos? :) I jest.

But I love the Mobius strip thingy. Maybe if you look at a triple or quadruple strip, it'll be more exciting.

Anyway, the main purpose here is to share this: A cranky old spinster asked my advice on how she can ride out the financial crisis with her money intact. I told her it's going to be tough. Apart from suggesting she buys properties and perhaps diversify into many bank accounts (to the state guaranteed amount), I told her tongue in cheek that we could help her spend the money.

I'm sure that would help keep Titanic afloat for an additional minute or two, when I'm divesting her cash, consuming for myself!

Al said...

The second concern is that at some point someone is going to point to the Breton Woods accords and say that they need to be reversed; that we should return to a global gold standard.

Bretton Woods would have done a better job of limiting the damage, Nixon abrogated that agreement in '71 because it wouldn't allow us to inflate our money supply enough to "pay" for the Vietnam War and the War on Poverty.

As the global economy has grown...that(?) has increased the amount of money in circulation....

The amount of money in circulation is controlled by central banks and treasuries. If only they were impersonal and non-political. How does Samuelson feel about the Fed?

The rest of your analysis looks right to me, though, of course, demand remains inelastic through the second cycle, except for fads like hula-hoops, pet rocks, tulips, swampland in Louisiana, etc.

We are about to find out what's really necessary. That is, real wealth.

The probligo said...


Samuelson had a "money circulation" model that was one of those things one had to know in detail.

Additions to the quantity (not necessarily "value") of money in circulation includes -

Decrease in taxation
Increase in profits
Increased government expenditure

Decreases included -

Increased taxation
Decreased government expenditure

Yes, central banks can influence the money supply. But, in NZ at least, they have no control over the money supply. There is considerable debate about whether the RBNZ should be permitted to to control money supply. Given the governmental inputs outlined, I doubt whether it will happen.

ET, try the "triple Mobius strip". From memory the result is quite startling. The "quadruple twist" version I can't remember. Must try it some time.

Al said...

I thought I'd already said thank you for the clarification, but apparently not.

I just did the mobius strip "thingy." You're right. I believe it is like that.