Common Cents

by Michael Harrington

  Time is what political and economic freedom can provide us. The true objective of a fine-tuned political economy is not a bigger GDP, but a society where we all have more freedom to enjoy this brief time of our lives. On this point I am as unequivocal as an economist can hope to be.

  I will close on a positive note with this quote from an article recently written by Walter Russell Mead titled, “The Future Still Belongs to America.” [74]

  The great trend of this century is the accelerating and deepening wave of change sweeping through every element of human life. Each year sees more scientists with better funding, better instruments and faster, smarter computers probing deeper and seeing further into the mysteries of the physical world. Each year more entrepreneurs are seeking to convert those discoveries and insights into ways to produce new things, or to make old things better and more cheaply. Each year the world's financial markets are more eager and better prepared to fund new startups, underwrite new investments, and otherwise help entrepreneurs and firms deploy new knowledge and insight more rapidly.

  Scientific and technological revolutions trigger economic, social and political upheavals. Industry migrates around the world at a breathtaking—and accelerating—rate. Hundreds of millions of people migrate to cities at an unprecedented pace. Each year the price of communication goes down and the means of communication increase.

  New ideas disturb the peace of once-stable cultures. Young people grasp the possibilities of change and revolt at the conservatism of their elders. Sacred taboos and ancient hierarchies totter; women demand equality; citizens rise against monarchs. All over the world more tea is thrown into more harbors as more and more people decide that the times demand change.

  This tsunami of change affects every society—and turbulent politics in so many countries make for a turbulent international environment. Managing, mastering and surviving change: These are the primary tasks of every ruler and polity. Increasingly these are also the primary tasks of every firm and household.

  This challenge will not go away. On the contrary: It has increased, and it will go on increasing through the rest of our time. The 19th century was more tumultuous than its predecessor; the 20th was more tumultuous still, and the 21st will be the fastest, most exhilarating and most dangerous ride the world has ever seen.

  Everybody is going to feel the stress, but the United States of America is better placed to surf this transformation than any other country. Change is our home field. It is who we are and what we do. Brazil may be the country of the future, but America is its hometown.

  ***

  Dear Reader,

  If you have come this far and enjoyed this book, or found it wanting, please offer a review on Amazon or Goodreads for the benefit of other readers and as feedback for the author. Crowd-sourcing through social media networks provides the new forum for book promotion and reviews. Digital publishing has expanded the number of books available to more than several million new books each year and informative reader reviews are the best means to help us all find the particular books we desire to read. If you wish to contact me directly, my contact information is on the copyright page at the frontispiece of this book. Thank you kindly for reading.

  Michael Harrington

  May 2014

  Appendix A

  A Gross Over-Simplification of Economics

  Consume now or later. These four words can help make sense of the macroeconomy, which is often presented with jargon-laden abstractions that non-economists find difficult to comprehend. In this brief appendix I will expound a bit on the logic of this statement and how it can be applied to real world events.

  Most people understand consumption—we are a nation of shoppers—but most people don’t stop to consider that everything we produce is ultimately consumed by someone or other. All resources and the production of goods and services are ultimately allocated toward one end: consumption. What we don’t consume today we may save and/or invest for future consumption, perhaps by our descendants, but ultimately everything is consumed. After all, “You can’t take it with you.”

  The real economy is generated by the millions of aggregate individual decisions on whether to consume now or later and the exchanges based on those decisions. The real economy can thus be represented by a simple conceptual relationship representing the trade-off between present consumption and future, or deferred, consumption. Symbolically we can represent the trade-off as:

  Cpresent versus Cfuture or Cp : Cf

  This basic conceptual formulation removes the distracting technical issues of savings, investment, interest rates, government spending, taxes, and currency values from the model. All these concepts can, nevertheless, be shown to flow from this initial framework. Savings and investment are inherently to this relationship because what we don’t consume today we save for future consumption and/or invest in production in order to increase that future consumption. We can see then that the level of future consumption depends largely on what we do with our savings, or deferred consumption. If we gamble or frivol it away, future consumption will be less. We might prosaically call this trade-off our inter-temporal consumption ratio (ICR), which represents all our aggregate economic decisions over whether to consume now or later.

  We can demonstrate the relationship to interest rates and economic growth if we take the formulation and express it as a divisor:

  Cf

  Cp

  This is not a mathematical ratio like ½ or ¾, but a conceptual ratio of a constantly fluctuating relationship. As the ratio increases—in other words, as present consumption is deferred and saved and invested for future consumption—we can associate this with higher economic growth rates. As the ratio decreases, we can expect lower economic growth rates. If the interest rate goes up, we would expect higher savings rates and more present consumption deferred because of the investment opportunity. This should lead to higher growth rates. If savings rates are lowered, that leads to higher present consumption, less investment, and lower growth.

  Imagine if the interest rate goes to zero. Would you be a lender? A zero rate means there is no compensation for risk, zero time value of money, and little to be gained from deferring the immediate gratification of present consumption. In the extreme, a zero interest rate implies a willful disregard, or disbelief, in the future. Naturally, when interest rates go to zero, or even negative numbers in real terms,[75] we expect the anomaly to be short-lived. We should question the Federal Reserve’s Zero Interest Rate Policy, aka ZIRP. Their policy intent is to stimulate present consumption, but at what cost? How concerned about tomorrow are today’s policymakers?

  Let us consider another real world example. It is estimated that the savings rate in China is around 50% of income, so present consumption is very low and investment is quite high. The savings rate in the United States varies somewhere between 2-6%. Is it any wonder that China has been growing at double digit rates? Some analysts attribute China’s higher savings rate to the lack of a social security safety net. Does this imply that the U.S. saves less and grows slower because of Social Security and Medicare? If we eliminate these programs, will we grow faster? Although this is an oversimplification, it does raise the right questions. It is more likely that China is growing so fast today because it simply did not grow for almost two generations. A lot of pent-up growth potential has been finally unleashed. We should also remember that every seller requires a buyer. Chinese exports depend heavily on foreign consumers. In terms of our model, we can see that China’s high growth rates are not likely to persist unless domestic consumption demand (Cp ) in China begins to expand, causing the savings rate to fall to a more reasonable level. Otherwise, the Chinese economy may run out of consumers for its vast production.

  The ICR could be used as a tool of analysis to understand the effects of potential changes in the economy or in policy. First, each of us can ask how the change will affect our desires to avert losses; and second, how these desires will affect our decisions on consumption, savin
g, and investment over time. As we extrapolate the answers to millions of like-minded souls, the inter-temporal consumption ratio can help demonstrate how economic equilibrium and growth is maintained through a balanced consumption ratio:

  Too much present consumption means less saving and investment and a slower growth rate for future consumption.

  Too little present consumption leads to insufficient demand, less production and more unemployment in the present.

  Too little present consumption can also lead to excessive investment, which may lead to volatile asset bubbles and busts (in real estate, securities, art, gold, etc.).

  Interest rates serve two purposes. First, they change the allocation between deferred and present consumption by increasing or decreasing the returns available to deferred consumption. Second, they balance present savings and investment, falling when savings supply exceeds investment and rising when investment demand exceeds the supply of savings. Equilibrium means savings equals investment. (Consumption and investment may also be borrowed from future time periods, but this is another unnecessary complication.)

  This guide has argued for smooth adjustments between present and future consumption in order to create long-term sustainability. We can move into more sophisticated analysis by examining various factors that may cause changes to the equilibrium ICR. The two most important factors over the long run are demography and technological innovation.

  Demography affects aggregate consumption due to the lifecycle pattern of consumption and saving, whereby we naturally consume more in our youth and old age and save more in our middle, or most productive, years (think Japan).

  Technological innovation raises the expected rates of return for deferring consumption and investing our savings. This reflects the fact that we prefer present consumption unless we are compensated for putting it off and can expect even more in the future. The higher the expected returns, the more we will defer (think IT revolution).

  The final factor affecting this ratio is the level of uncertainty that suffuses our economic decisions. Saving is a timeworn hedge against uncertainty. In times of volatility, saving increases while consumption and investment fall, irrespective of the interest rate. This explains the so-called savings trap where a decline in interest rates fails to stimulate investment and consumption because of the overriding effect of uncertainty.

  A final word on finance and price inflation/deflation. Financial markets are a complicated sideshow to the real economy and are important to the extent that they affect present and future consumption. The worldwide growth of finance has had a critical impact on the real economy, as witnessed with the 2008 financial crisis and its aftermath. Financial booms and busts lead to massive misallocations of capital and labor, reducing the economy’s potential growth rate. While general price inflation/deflation does affect uncertainty, it does not appear directly in the consumption model because it is a monetary phenomenon that reflects changes in the nominal value of goods and services denominated in currency units.

  Ideally, our simple model shows how the economy can achieve and maintain equilibrium between present and future consumption by constantly and smoothly adjusting to technological innovation and demographic change according to market price signals. Economic and social policy can enhance or impede this process.

  Appendix B

  What's Wrong with Economics?

  It is a question worthy of a graduate seminar in economics, but we will try to illustrate the key issues in a few pages. One of the central assumptions in general equilibrium (GE) models that are widely used in neoclassical macroeconomics today is that people are pretty much alike, or homogeneous in their preferences. Consumers, workers, savers and investors, for example, all want to maximize utility and profits. A second assumption is that these preferences remain fairly fixed over time and do not vary or adapt under different circumstances. Lastly, economic models assume the availability of requisite information and the ability of individuals to process that information accurately.

  Using these three basic assumptions, economic theory employs higher-order mathematics to build very complex and powerful models that enable us to study and understand the economic world we live in. Straight (or convex curve) functions usually yield clean solutions, known in economics as optimal equilibrium solutions. A good example is the graph of supply and demand curves that intersect at the equilibrium price. However, we have found that the assumptions cited above are frequently violated by real people acting in the real world, with significant implications for the results of the models. As argued in a recent book on the limitations of economic and financial models, the behavior of individuals determines value—and people change their minds.[76] The basic problem, according to the author, is that "in physics you're playing against God, and He doesn't change His laws very often. In finance, you're playing against God's creatures." And God's creatures use "their ephemeral opinions" to value assets. Moreover, most financial models "fail to reflect the complex reality of the world around them." The most serious weaknesses we have identified result from information failures and the ways in which we rationally adapt to these failures.

  To conceptualize the difficulties of economic modeling, imagine a box of dried spaghetti pasta. Each strand of spaghetti represents an agent in our model. The individual strands can bend slightly without breaking, but they are mostly rigid and straight as an arrow. They cannot be folded back on themselves or twisted into a pretzel. Now, imagine building a model of a house or some other structure, such as a globe, with these sticks. The straight lines will intersect at many different points where you can glue them together. Depending on how big your model or how small the lengths of noodles, you can create a pretty good representation of curved surfaces using only straight lines. The model looks reasonably good, we can see what the model is meant to represent, and the structure holds together well.

  Now, imagine trying to build the same model with wet, cooked spaghetti. Impossible. The strands wiggle around like worms, twisting and turning and refusing to retain a fixed shape. The model collapses into a tangled, gooey mess. This crude comparison illustrates the difference between an economic model that is built with simultaneous straight line equations that yield optimal solutions—those based on assumptions of homogeneous fixed preferences that don’t change over time and that reflect perfect information—and the often sad reality of a messy world. Economic behavioralists have discovered that our preferences vary, they change over time as we receive feedback and our circumstances change, and often they are not fully informed because we lack the requisite information. People are not like dried spaghetti noodles, they are like cooked noodles – unpredictable. They are plagued by the uncertainty of their environment and are dominated by loss aversion. This creates serious limitations for modeling specific economic puzzles, especially those that relate to distributional dynamics characterized by variable preferences, feedback, and adaptability. Examples include inequality, the business cycle, networked market solutions, and information cascades. So, what are we to do?

  First, let’s not throw out the baby with the bathwater. Neo-classical GE models based on higher-order mathematics are very useful and powerful tools for explaining a wide range of market phenomena. Computer technology now offers us another powerful tool with simulation modeling. The exploding processing power of computers allows us to build market models from the bottom up using individual “agents” that can behave according to any number of simple rules that can be used in combination to create complexity. Individual agents can be unique in their preferences and adapt in an instant to changing circumstances, so our model doesn’t need to be constrained by rigid, representative agents. We can simulate how these programmed agents interact, as in a market, and observe the results. In effect, we can build ourselves interactive economic worlds that mimic the real world and then observe how these models behave as we change parameters.

  I believe these techniques will allow us to fill in the gaps of conventional economic theory an
d improve our understanding of market dynamics.[77] This promising new branch of economics is called agent-based computational economics. It’s not as elegant or intimidating as general equilibrium models, but it can do things GE models cannot. It is a sign of progress that hopefully in fifty years we won’t still be grappling with the same epistemological problems and policy failures.

  Appendix C

  The Credit-Debt Machine

  The Credit-Debt flowchart graphic illustrates the “credit-debt machine” that underpins the U.S. monetary system in its present configuration. Let us examine this in detail. As explained in the section in Chapter Two titled Financial Alchemy, the credit creation process starts with the Federal Reserve when it issues borrowing credits or provides liquid funds through open market purchases of bonds to the banking system (green arrow labeled Borrowing Credit$), buys toxic banking assets from banks (TARP), or purchases bonds directly from the Treasury (QE credit$). The banks and shadow banks then turn these credits into high-powered money through fractional reserve lending (Credit Multipliers) to businesses, consumers, and mortgage borrowers, and through margin loans to investors. The banks make money by receiving interest payments on these loans in excess of what they pay to the Federal Reserve. Banks and investors also buy Treasury bonds, providing credits to the government at the market interest rate.

  The U.S. Treasury must fund Federal government expenditures (Gov. Spending and Entitlements), either through taxes or through borrowing (by selling Treasury notes and bonds to private investors, banks, the Fed and foreigners). The Treasury must pay back principal and interest on these obligations (all the red arrows coming out of the Treasury). The principal is constantly rolled over by selling new bonds at the prevailing interest rate. The government never has to pay back all its debt; it only has to service its borrowing needs (and we know it really doesn’t even have to do that!). This is because the government has an infinite life, so it never needs to “settle up.” However, if it needs to rollover an old bond at a low interest rate into a new bond at a higher interest rate, its payment liabilities will increase significantly.