Tuesday, August 25, 2009

Money is the body-without-organs of capitalism

One of the things I've had to do in the last year as an investor is read a bunch of macroeconomics.  This didn't use to be necessary, because the type of investing I do is generally just a sort of comparative analysis -- my company will eat your companies lunch.  It doesn't directly depend on the overall economic level, so it's easiest to just bracket the complexity of determining changes in that level, and assume that we are at equilibrium.  There are some obvious exceptions to this way of thinking about things.  The tech bubble and the housing bubble were both pretty obvious, and of course in investing there's no way to ignore the secular trends that are always changing what the "equilibrium" looks like. But the bubbles were so enormous and so obvious that you could just turn them into exceptions and special cases, stay out of the way, and never fundamentally confront the fact that there is no possibility that our economic system is anywhere near equilibrium.  You could do this, that is, right up to the point where the whole system broke down, and went through what was quite obviously a sort of phase transition. 

Unfortunately, I have discovered that you cannot go looking for an explanation of the non-linearity and instability of the economy in traditional macroeconomics.  Despite the fact that macroeconomics as a discipline was actually born out of the Great Depression, and the fact that Keynes explicitly wrote a General Theory of Employment, Interest, and Money (so as to distinguish it from the special case neo-classical single equilibrium theory that had ruled up to that point) macroeconomic's real genius appears to have lain in proving that nothing like its birth could ever have happened. 

There are lots of reasons why macroeconomic theory is not terribly useful, but in my opinion, the biggest problem is that these guys never take the idea of money seriously.  They are always basically assuming money away as just a fiction useful for the exchange of real goods.  Needless to say, money exists.

As far as I can make out, the one good thing that macroeconomics offers is a view of the economy as a closed system.  Your perspective on the economy changes when you realize that one guy's spending is another's income.  A simple idea which is appalling easy to lose sight of.  While this insight is fundamental, I think it was historically as much a blessing as a curse.  The limited mathematics (ie. no computer simulations) people used to deal with such systems back in the formative years led them to adopt techniques from statistical physics that describe linear closed systems that inevitably tend towards equilibrium.  The classic drunk looking under the lamp post for his lost keys type stuff that characterizes a lot of science.  Nowadays, of course, after chaos and complexity theory and computer simulations and whatnot, we find it easy to imagine closed systems that don't tend towards equilibrium over relevant time scales.  And we find it very easy, in fact necessary if we want to talk about the physics of life, to think of themodynamically open systems, that continue to be "systems" precisely because they don't come to equilibrium.

Which bring us to today's article.  I link to Mark Thoma's version of it, because he makes some good comments and because you have to love a guy who is sitting on the side of the Utah highway writing about what the Japanese think we should do with our toxic assets.  But the main show here is the Keiichiro Kobayashi article that you will have to scroll down to read.  Here's the punch-line (for my purposes, his main point is actually that you need to do something about the toxic assets to get any recovery)

I have elsewhere attempted to construct a theoretical model that satisfies these requirements, in which I assume that assets such as real estate now function as media of exchange given the development of liquid asset markets but are unable to fulfil this function during a financial crisis (see Kobayashi 2009a). With a model like this, we can regard a financial crisis as the disappearance of media of exchange, which triggers a sharp fall in aggregate demand. In this case, both macroeconomic policy (fiscal and monetary policy) and bad asset disposals can be understood as responses targeting the same goal – restoring the amounts of media of exchange (inside and outside monies).

This model sounds interesting because it amounts to the hypothesis that trust (or credulity or suspension of disbelief and resulting greedy speculation or whatever) spontaneously creates money, and lack of trust destroys it.  This is a nice model of a non-linear two state system.  The trust/suspicion switch is sort of ad-hoc here, but later you might go back and try to understand what combination of endogenous variables causes this (ie. understand the change as a phase transition). 

Of course, you're not done at that point.  Once you've got a non-linear model that incorporates money and finance into the closed system, you still have only described a part of it. Today there's a large actor in the system now that doesn't obey the classical equations.  It's become pretty clear that government is "pumping" the system from outside (just don't call it pump and dump).  This is by Keynesian design of course.   Keynes's reached a certain level of generality in pointing out that the Depression was a (local) equilibrium phenomenon resulting from the paradox of thrift, and that the government, being outside that system at the time, was the only thing that could knock it out of the bad equilibrium it had settled into where people were too poor to save anymore.  Now, we actually have to reach a higher level of generality that incorporates the government within the system, because it has become so large that there is no way to analyze things without it. 

What's that you say?  Did I hear you whisper something about the capitalist axiomatic, that most abstract synthesis of state and industry?

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