Economical Equilibrium
Page 1
Economical Equilibrium:
Geometry of Economics
ILYA VLADIMIROVICH KUNTSEVICH
Copyright © 2013 Ilya Vladimirovich Kuntsevich
www.economicalequilibrium.com
All rights reserved.
ISBN: 1492387517
ISBN-13: 978-1492387510
To my parents, Vladimir and Galina, for all their blessings
To my brother, Rostislav, for his spiritual support
To my wife, Galina, for her love, and
To my children, Anna, Vera and Ivan, for their inspiration and joy
CONTENTS
ACKNOWLEDGMENTS
PREFACE
PART I: FUNDAMENTALS
What Drives Economics
Value
Money
Value-add = Profit = Inflation
Debt
Banks, Loans and Interest
“Valuable” Accounting
Equity and IPO
Public Stock Market
Government and Taxes
Currency Purchasing Power
PART II: GLOBAL ECONOMY
Economic Growth
International Reserves
Pension Funds and Social Security
People and Jobs
Education
Wealth Distribution
Fractals In Economics
Time Bomb
Part III: ECONOMICAL EQUILIBRIUM
Geometry of Economics
Cash Value Ratio
Value Retention Ratio
Balanced Growth Model
Is a Country In Good “Shape”?
What Generates a Crisis?
Best and Worst Storage of Value
Ten Postulates of Economical Equilibrium
Back to the Future
INSTEAD OF IN CONCLUSION
BIBLIOGRAPHY
ABOUT THE AUTHOR
ACKNOWLEDGMENTS
I would like to thank everyone who inspired and supported me in the creation of this book and helped to get it published. A special THANK YOU goes to Professor William Cockrum, Roman Abdulin, Philip Landau, Frederick Elsea, Professor Edward Leamer, Keith Lupton, Cody Franklin, Joshua Nip, Professor Eric Sussman, Allen Morgan, Bill Gross, Marcia Goodstein, Professor Jeff Scheinrock, Natalia & Dmitry Arkhipenko, Professor Lawrence Wright, Ivan Lee, Timur Rodionov, Royce Disini, Wilton Risenhoover, Anatoly Miliukov, Leo Petrossian, Robert Hamilton, Dan Hanchey, Student Investment Fund of UCLA Anderson and UCLA Anderson School of Management Executive MBA Class of 2010.
PREFACE
Modern economics is a focus of many people, especially in the aftermath of the 2007–2008 financial and economic crisis. One has to wonder – what’s wrong with the economic system if it breaks down now and then? Should the modern economic theories, accounting principles and financial models be relied upon going forward? Could we devise an alternative economic system, which would be whole and sustainable, and allow a crisis-proof pace of economics? Could we design and build more intelligent tools and models in order to see the big picture and avoid future crises?
This book initially came about as a way to identify the root cause of an economic crisis. Only by taking something that doesn’t work apart, can we see the root cause of the problem. Therefore, the book starts with the fundamentals of economics, accounting and finance, exposing some of their obvious flaws and misconceptions, and continues with the analysis of the global economy’s modern condition.
As the book has progressed, Economical Equilibrium theory has evolved as a new economic system, assisted by geometry. A visualization technique, which allows identification of the cause and effect relationship using geometrical figures, rather than linear mathematics, aids Economical Equilibrium theory in multiple applications across all levels of economics.
Using its ten postulates, Economical Equilibrium theory is capable of both identification and prevention of economic crises, as well as effective design and management of sustainable economic activities. I also make certain recommendations on changes to the fundamentals of accounting principles and financial models, which should add transparency and accountability thereof. If followed diligently, these recommendations will alleviate concerns of people on the future of the global economy, and their individual well-being.
PART I: FUNDAMENTALS
What Drives Economics
Economics is a reflection of people’s activities; it is a mirror of what we do. Convenience, sense of accomplishment, satisfaction and aspirations are the key drivers of any economic system, because the world is driven by the desires of people to live a life they want – more comfortable, more satisfying to their needs and values. Modern economics is reflected by what is measured and exchanged quantitatively; the language of economics is numbers, currency and graphs.
An argument could be made that satisfaction doesn’t always come from the items that can be measured (e.g. with money). For example, love, conscience, friendship and happiness are invaluable features of our lives and provide infinite internal satisfaction. Nevertheless the external side of human nature doesn’t change – as if we are “programmed” to look for better living conditions and improve them to our desires, should an opportunity arise. A house, heating, transportation, supermarkets, telephone, internet – these are habitual representations of our modern civilization’s exterior. None of these amenities or conditions is provided by Mother Nature as is – natural resources are converted, or transformed, by human labor and technology into what we enjoy every day. Natural resources and technology provide what it takes to grow the economy through the transformation of the former.
“Production” is often referred to in the manufacturing sector as something generated by people. So many cars, or materials are “produced”; but are they really? I prefer to think of it as “conversion” or “transformation” because one cannot produce something out of nothing. The human contribution (labor, craftsmanship and technology) converts and transforms what Mother Nature provided to us in abundance (natural resources) to begin with, so we could maintain and improve our lives at its expense with no retribution.
Economics is driven not only by demand (consumption) of natural resources, as many of us tend to think, but also by the human contribution, required in order to transform these resources using labor and technology. It is a known fact that equilibrium exists when demand equals contribution, but regardless, whether it is balanced or not, economics depends entirely on the access to, and transformation of, natural resources. There would be no economics without availability of natural resources[1].
People buy new things in order to increase their living standards. So much iron ore, oil or gold is extracted and transformed into metal, gas or jewelry. Workers’ hours and technology contribute to manufacturing of specific products. Given that human labor and technology are the only two “contributing” factors in economics, economic growth is not possible without ever-increasing consumption of natural resources through further exploitation of human labor and / or technology. Therefore, economic growth tends to exploit everything and everyone, because everything is in equilibrium. Furthermore, we need to be mindful of the price at which economic growth is achieved – overexploitation and pollution of natural resources, not accounted for at present, will inevitably lead to a backlash by Mother Nature in the future.
Due to economic growth, natural resources, initially abundant, have become scarce due to extraction, transformation and resulting pollution (carbon dioxide, contaminated oil fields, water, and land). The price of natural resources tends to increase in order to restrain further depletion, but to whom do we pay the price? Earth? Pricing regulation helps, but only temporarily – the more the economy grows, the less resources are available, regar
dless of the price tag, because people still need them in order to accommodate their new lifestyles and / or simply survive. For example, drinking water, which used to be free, is getting more and more expensive. Nowadays we have to earn a living in order to buy drinking water, because we cannot live without water, regardless of how much it costs.
Scarcity and need features of natural resources create their measurement value and thus add to economics, but when it’s gone, how much money is it worth? What used to be abundant and priceless later becomes scarce and measurable, and finally nonexistent – three stages of non-renewable and in-demand natural resources.
When a particular natural resource becomes rare and there is not enough purchasing power (money) restriction to buffer further demand, people tend to take it over by force, and not necessarily because they need it to survive – sometimes it just glitters or allows a cheaper commute from point A to point B. But what makes things worse is a combination of scarcity of certain natural resources (e.g. oil & natural gas) and dependence of modern technology on them, in order to satisfy the needs and wants of people using it. In such cases, wars become inevitable, as we have seen repeatedly over the course of human history to date.
While we haven’t fully destroyed our planet yet and can still enjoy clean air and the natural beauty of parts of the world, drinking water, which used to be abundant to all of us, has become polluted in most regions, because we continue the mindless pursuit of economic growth without realizing that we keep doing it on the credit of Mother Nature without means of repayment. Accounting rules do not allow recording a liability in this case, because we cannot account for something that didn’t yet happen. What drives such pursuit from the economics stand point will be discussed in detail in later chapters.
To date we have created nothing to be proud of – an unsustainable civilization, which uses all that Earth provides through “cannibalistic” technology, slowly, but surely killing our planet. We appear to be extremely ignorant children of Mother Earth, that gave us everything for free, but not only do we not appreciate it, we continue to choose harm over harmony in order to satisfy our selfish needs.
Something could be fundamentally wrong with us humans, in that we seek immediate material values in life over an infinite idea of life and beauty. Maybe that’s why the best values in life are those that cannot be priced and, as such, will always stay outside of economics, accounting and finance. It must be the will of God, protecting us from ourselves, so we can see clearly what’s important and what’s not. If we want to keep our civilization alive, it is obvious that the ignorant, short-sighted view of economics, pursued by the business and political elites, stressing the importance of economic growth and profit-making at all costs, must evolve into a long-term vision of sustainable well-being of the world we live in.
Value
Any value has two components – recognition and exchange. Recognition is an invaluable component, while exchange is valuable and thus can be measured. If something has a recognition (e.g. love, friendship, conscience, happiness), but there is no possible way to measure it (because it is invaluable) by exchange, it will stay outside of economics, and thus will not contribute to it. Therefore both components (recognition and exchange) are required for any value item to become a part of the economic system.
Value is an extremely elusive concept due to its change, subject to human aspirations and demand. Something valuable today could have zero value tomorrow and vice versa. Besides, there is no such thing as universal value or measurement, because money, created as means of exchange, also has an ever changing value by itself. Therefore any item cannot be measured for exact value, although it can be approximated, until its exchange takes place.
One of the synonyms of value is wealth. Preservation of wealth is a daunting task for many people these days, because it is prone to volatility and loss of value. A new profession has been recently formed to help people manage their wealth – financial advisors.
Another term that requires an introduction is value-add. Added value is created at the transformation stage of natural resources or through innovation and / or invention. Value-add of iron ore is metal, value-add of Wolfgang Mozart is the music of a genius, value-add of Steve Jobs and Steve Wozniak is Apple. Profit, the key driver of the modern economical and financial system, is the measurement tool of value-add.
The relationship between value, money and profit is very important in economics. Ask yourself three questions:
- Could profit be recorded without money?
- Could value be recorded without money?
- How much uncapped value and profits are out there?
If we want to figure out how economics works, we have to understand the activity at the resolution of each component. Let’s break things down to small parts, in order to really understand how they work. This is the only way we can fix specific components that need to be repaired, and not disturb ones that are more or less operational.
Money
I like to think of money as one of the greatest inventions in human history. Money is needed in order to both measure value of the items and conduct their exchange. These two processes do not have to coincide – one can approximate value with money, but it will not be confirmed until money changes hands.
The evolution of money is nothing but exciting. Initially something of tangible and hard substance (sea shells, gold, silver, something rare) money later evolved into paper, and then into an electronic form. Electronic payments via PayPal, VISA, MasterCard, AMEX and other platforms have become widely used, and have eliminated the cost of printing money in its entirety. Electronic payments are more common these days than cash. Pink Floyd’s “Money – it’s a gas” is a very precise poetic expression of its very substance and quality, because money is an ether, a necessity of the modern financial and economic world. Whether “Money is the root of all evil today” depends on how one uses it, of course.
There is a famous cliché that money makes the world go round. After people are “sold” on new values, their first thought is where to get the money in order to satisfy the demand. Going back to the previous chapter, money is the driver of economics, because no exchange takes place without it. Money is also a reflection (mirror) of economics, something with which it is measured and recorded, based on accounting rules.
The economic system reflects the contribution and demand of value, measured with money. Money serves as a means of exchange of value within the economic system. There are a number of participants within the economic system – individuals, corporations, banks and government. Individuals work and consume, corporations contribute and consume, banks manage money and governments collect and distribute taxes to provide security, infrastructure and social benefits; and they all need money in order to transact with each other.
Values, measured with money, can’t be received for free – people first need to contribute value in order to get a comparable value in exchange (otherwise this would be called a donation). There are many ways to make such contributions and receive something in return – grow food, provide health treatment, build houses or roads, operate transport, etc. The more activity between economic participants, the more value is exchanged, and more money is needed to sustain it, taking its circulation speed (velocity) into account.
Money has a relative, or implied, but never an absolute (denomination) value, as some tend to think. For example, a $100 bill denomination buys you a good dinner for two people in a very nice restaurant in the U.S., but probably a whole day’s meals for the same two people in a drive-through restaurant, and maybe a couple days of food if these two were to buy groceries in a store and choose to cook for themselves. Time is another factor in relative / implied valuation of money – money loses value in the long-run due to monetary inflation. The next chapter addresses the mechanism of how money loses value over time. The same $100 value dinner will probably be more like $150 (or more) in 5–10 years.
Money used to have a quasi-absolute value, called
the “gold standard”, where prices were “fixed” to a specific weight of coins due to scarcity of gold, but those times are long gone. Why? Such metamorphosis occurred because people needed a bigger volume of “measurement units” available in order to conduct the exchange. An interesting thesaurus comparison – the word “currency” is derived from “current”, or “flow”.
To keep the exchange under control, money can’t be printed or issued electronically by everyone – it is a prerogative of the world’s central banks and treasuries, operating within a given country.
Since the abolishment of the “gold standard”, money has obtained the quality of a necessity for the economic system to function. Regarding too much versus too little money, here’s an interesting example: if there’s too much oxygen (gas), people tend to get light-headed and carried away. If there’s too little, people become depressed, their body functions slow down and life is not great anymore. As such, an economic system needs just the right amount of “gas” to keep doing well.
Money is not a guarantee, but a promise to receive value in exchange at a later time. Therefore, it has a “delayed” value, backed by the faith that such a promise will be honored. As with all promises, they can be kept or broken. If the Federal Reserve comes up with the news tomorrow that old $100 bills are being replaced with the new ones, the old $100 bills will lose all of their value instantly, unless the Federal Reserve also announces that it will continue accepting the old bills. People and companies that kept money in Cyprus banks in early 2013 had a very unpleasant surprise when they heard that the country’s financial system was insolvent and they had therefore lost some or all of their money.
Money’s denomination by itself is a fiction, because it is either a number printed on paper, or held in electronic form. It is the acceptance and entitlement features of money backed by stability of the financial system, which gives it a “delayed” value. Such value is derived from an immediately preceding exchange transaction. Going back to the example above, if you had a dinner at a nice restaurant two weeks ago and want to go there again, you will probably take another $100 bill with you in order to have a comparable meal. The same is true for goods and services – how much money it took to exchange them recently is what determines the value of money.