Thursday, December 4, 2008

Turning Chinese

PREFACE: Scattered thoughts on money from more than a year ago, with a small contemporary addendum at the end.

The more you read, the more you realize that despite enormous amounts of noise and hand-wringing about what we should do, the bigger question is what China is going to do. Exactly like the US in 1929, China is really the linch-pin of the global economy right now. If they fall into protectionism and purposefully try to devalue their currency, we are all likely to go down together -- trade will grind to a halt, and the dollar will skyrocket and then implode, a chart we are all very familiar with right now.

Brad Sester has the best explanation of this stuff, though the Martin Wolf editorial he cites is a close second and a good summary.
China can try to support its own growth by taking a larger share of a shrinking pie, but that hardly helps the world. The G-20 isn’t just meant to bring countries together to discuss the global economy. It also needs to encourage countries to take into account the global implications of their economic policy choices. If China – which has by far the best balance of payments position of any major economy – feels like it has to direct its government policy toward maintaining export market share, efforts to rebalance the world economy will be set back.
Let me try to explain more clearly why China is so important to the current global system.

Recently, I've been thinking a lot about the charts you can find here from Steve Keen (warning: those with heart conditions are advised not to read his blog). In particular there is one that I feel like you simply have to explain, which is the one at the top of this post. So, they send us this chart, and we're supposed to shit ourselves with fear? What's the matter with a little debt? If the system is closed, one man's debt overhang is another's surplus, so where's the problem?

As far as I can make out, the argument about the unsustainability of debt in real terms is quite subtle. First, let's simplify the question and assume that we are on the gold standard or some other system where the amount of money is fixed. Further assume that the system is rolling along more or less close to equilibrium -- that is, that everyone is working and making stuff, and is swapping it for other stuff that everyone else is working and making. It helps to think of capitalism (and science and everythig else for that matter) as an animal behavior pattern. Money is just the index of all the swapping going on, just a way of counting it.

Here you can see the first way that money could get you into trouble. Because, you need different amounts of it to facilitate different structures of swapping. For example, if the economy consisted of two large centralized and vertically integrated agents (China and the US let's say) then all the specialization necessary for production could be swapped internally, without the need for money except at the last step of the interchange between the two agents. So the US could make all kinds of sophiticated goods like blue jeans and rock'n'roll, and at the last minute, we could swap these goods for cheap plastic shit that the Chinese had made. Here you only need enough money to count the value of the final swap, not the value of all the swapping necessary for the specialized production, because you are assuming that this production is organized along the lines of barter or command-and-control or something. In other words, you only need enough money for the swapping of the net value added by the US and by China, which at equilibirum would be equal.

If, however, instead of two vertically integrated agents, your economy consists of millions of tiny producers that need to swap with one another to make one sophiticated good, you are going to need more money to facilitate all of those transactions. You are going to need gross money, rather than net money, so to speak. I think this is basically the essence of the velocity of money. Now you can see how reducing the supply of money suddenly could get you into trouble all by itself, even if nothing changes (or in fact precisely because nothing changes) in the real economy. If I'm used to converting my production into money and swapping that money for the things I need, and there is a sudden scarcity of money, then we will have a calamity. The lubrication has all gone out of the system, and to continue to produce the same amount as before, it needs to be reorganized so that more of the swapping occurs internally to the production. This sort of reorganization is possible, but it can't happen overnight; in the meantime you have a crisis that appears economic but in reality is more an information crisis than anything else. Perhaps if we let Google run our economy we would need less money.

Anyhow, getting back to the debt question. Let's throw this whole system into motion. After all, in a static equilibrium, why would you ever have anything more than the very short-term debt necessary to finance trade receivables? If at all times, everyone were only consuming the amount they were producing, debt wouldn't exist. So, to state the obvious, debt is an inherently time-indexed structure.

UPDATE 090620:

The thing that throws the whole works out of equilibrium is the fact that not everyone is consuming just as much as they are producing. In fact, part of the specialization of modern economies is that some people are busy investing now (and investment is a form of consumption) in order to produce stuff later. And each year, the scale of this investment tends to increase. We live in a capitalist economy, which is not the same thing as a free market economy, in part because it requires large concentrations of capital that are otherwise alien to a perfect market. Once you introduce the idea of large capital projects that need to be financed, you inherently need someone saving and someone investing. While a system like this certainly can reach an equilibrium, isn't it obvious that it must be a dynamic one? And isn't it obvious that this is unlikely to be as stable an equilibrium as one in which each producer and consumer is essentially self sufficient?

I continue to chug through Minsky, and my update here is coming mostly from that line of thinking. He makes the very interesting observation that capitalism is inherently unstable precisely because it is not capable of incorporating large capital projects in a stable way. I'm sure I'll write some more about this later, but his basic idea is straightforward -- stability breeds instability as the initiators of large projects and their lenders over-extend themselves. His ideas put the actual functioning of money and finance back into economic theory (don't even ask why they left it out to begin with, it's a long story). The dismissal, until just recently, of all his ideas is part of what made it so difficult and heretical feeling to think about all of this stuff last year.

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