Policy

A Downward Spiral? Economics Made Too Simple

Cash money i i

Cash money Sandra Mu/Getty Images hide caption

itoggle caption Sandra Mu/Getty Images
Cash money

Cash money

Sandra Mu/Getty Images

When asked, the great mathematician John von Neumann intuited that money was somehow related to physical energy.

The intuition has rested there. I believe von Neumann was on the right track and it probably bears on our current economic mess.

In physics, energy is defined as "the capacity to cause change." The root of this in physics lies in Newton's three laws of motion.

The first law, we recall, states that a body in motion continues in straight-line motion at a constant velocity. Newton rests this on the concept of inertia, from Galileo. Technically, "velocity" includes speed and direction of motion.

The second law of motion is central to us: Any change in straight line motion at a constant velocity requires an outside force which changes, or "accelerates" that motion. The famous equation is F = MA. Force equals mass times acceleration, where acceleration is the rate of change, positive or negative of the speed of motion, or the direction of motion.

The third law will not concern us: For every action there is an equal and opposite reaction.

It is from the second law which defines force as that which "changes" motion, that we get with some manipulations, an expression for energy E = 1/2MV squared.

Fine. Some time ago a group of friends including myself and Mike Brown, former CFO of Microsoft and Chairman of NASDAQ were wondering how von Neumann could be right. We realized we needed an "Economic First Law of Motion." But none exists in the text books. So we invented one: It starts with "Trade or die."

Indeed, Mike had spearheaded an effort to build our proud agent-based "Partecon" model with agents and a set of goods. Agents had to trade within a given period or die.

Is this "trade or die" rule sensible? Yes. (It is the economic analogue of "inertia" in fact.)

It is 50,000 years ago. I have caught a rabbit today, you have caught nothing today. "I'll give you half my rabbit today if you'll give me an equal weight of what you catch in the next while," I offer you. You accept. Note that credit has just been created, for you owe me a share of whatever you catch in the next while, say a month.

Then, 50,000 years ago, with food scarce and problematic, we trade or die. If there are several goods and hunting and gathering, we hunt, gather (i.e. produce food) and trade or die. Sometimes we trade for what we like more but do not have, traded for what we have too much of, which is the economist's advantages of trade and Edgeworth box.

So we have a first law of economic motion: Trade or Die, within some bounded period is the roughly conserved average economic inertia. Then that first law states: In the absence of outside forces, the total rate of trade in the clan will be, on average, constant — like Newton's first law. Note clan GDP is constant.

Now let salt emerge as a favored good we all want and use as money to facilitate trade among many parties with diverse goods and preferences.

Now let paper money emerge. The Chinese were the first to invent it, and the emperor, it seems, entranced, printed vast amounts and induced fantastic, ruinous inflation.

Which brings us to the "money supply." In a simplest, steady state economic theory, if the money supply suddenly doubles, more money in our hands chases the same number of goods, so prices double. If this price doubling were to happen in an instant, the average rate of trade remains constant. The Economic First Law would hold.

But the steady state economic theory is wrong. Price changes lag a change in money supply. Suppose instead a slow, steady increase in the money supply. What will really happen in this case is that prices will indeed rise, but with a lag, say of eight months or so.

Then, given a slowly increasing money supply and a lag in price rises, we really do have more money per good at their current prices, even as money supply continues to slowly increase.

So what happens? We really do purchase more goods and produce more goods to match. In short, the total average rate of trades increases, and increases steadily if the money supply continues to increase and prices continue to lag.

We have our second economic law of motion: An increasing money supply and lagging prices increases (positively accelerates) the average rate of trade. The economy grows, clan GDP grows and there is slow inflation. The increasing money supply and lagging price increases is the analogue of F = MA, an economic force acting to accelerate the First economic law of motion of constant rate of trade. The appropriate integral of this force will be the analogue of economic energy added to the economy.

But conversely, and critically, if money supply gradually decreases and price drops lag, we really have less money per good and so purchase less and produce less. Trade slows, or decelerates. In short, the "velocity of money" slows, GDP drops and economic energy is drained from the economy.

Then what has driven so much growth in the First World since WWII? In some part, there has been a global fluctuating increase in debt, from credit card debt, to mortgage debt, to sovereign debt. This has slowly increased the money supply with lagging price increases, and so driven an increase of trade, i.e. GDP growth.

I suspect, with most of us, that the debt rubber band is very stretched. We have only to look at Greece, Ireland, Spain, Portugal, Italy and our own mushrooming debt.

At some point, say now, you do not repay my half-rabbit in a month but in five years. I'm no longer willing to extend credit to you.

We may be there now. A credit bubble may be about to start a long contraction with price drops lagging, sapping economic energy from our First World economy in a long downward spiral.

This world is not this simple. I'm sure von Neumann would smile, even if he liked this version of money as economic energy. But I doubt he would think the above is entirely wrong.

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