Wednesday, December 24, 2014

Economy Basics and Real Wealth Creation

In my previous post, I discussed the importance of NGDP growth as a number and what it tells us. Keep in mind that I also (vaguely) mentioned how RGDP is a relatively useless number dependent on how inflation is measured and the measurement of inflation depends on the basket of goods and services consumed, which can vary depending on how we measure it. A single number cannot measure the health of an economy, but there are ways we can detect if an economy is healthy.

An economy is a self-organizing bottom-up organism. It's much more like an ecosystem or the human body or an animal than it is like a car or a washing machine or anything man-made. Economies have the ability to be self-regenerating and start to fade out and die when the cease to be self-regenerating. What does this imply? It implies that we cannot have regions or cities or towns that're dependent on the center. What this implies is that we cannot even have a nation that comes from the center if we want the nation to sustainably accumulate wealth.

I've just spoken about the qualities, properties of an economy without actually talking about or properly defining what an economy actually is. My view of an economy is basically like an ecosystem: an economy has inputs and outputs with the outputs effectively paying for your inputs. Economics is the study of how inputs are turned into outputs.

Economy—An organization of human beings (coming from a nation, city-state, etc.) that turns inputs into outputs.
Economics—The study of how the inputs of an economy are turned into the output of an economy.

Now that we've defined an economy as a self-organized mechanism for human beings to turn inputs into outputs whereby the outputs pay for the inputs, we can start to see how this kind of organism would survive. However, we first need to address the point of those who belief economics as a study/discipline is bullshit. I have often criticized the foundations of economic thought repeatedly, but being anti-economics is really just retarded. Economics is an essential part of social life and an essential part of anyone’s life. Just like an economy has inputs and outputs, so do we as people.

Most of us work jobs (or have family members that work) that produce outputs so that we can pay for our inputs. After all, feeding, providing shelter, and providing other things must be supported somehow. The Laws of Thermodynamics tell us that we cannot create something from nothing, which means that everything we do converts matter/energy from one state to another.
Since an economy turns inputs into outputs, we must first discuss what the most common/primary economic inputs are. These inputs are things like:
· Natural resources (hard commodities, energy inputs like oil and natural gas, etc.)
· Capital (including social, political, entrepreneurial, and financial forms)
· Imports from other places (capital and natural resources can be imported)
· Labor (more people means more production assuming everything else is fixed)

If an economy is a way of turning inputs into outputs, then the economy can only expand by either using inputs more effectively or by increasing the amount of inputs. Depending on how we define capital, the easiest way we can expand our living standards by either accumulating real capital (like skills, know-how, better social/political systems, better financial institutions to transfer resources from those not using them to those who can use them well, etc.) or by learning how to use other inputs like natural resources, imports from other places, or labor more effectively or by simply using more natural resources.

First, I will discuss the effects of using more natural resources. Extracting natural resources can often times be very destructive and have negative impacts down the line, which means that using more natural resources can—and often times does—create tail risk. The possible risks are:
1. Running out of natural resources (usually not an issue in market based economies)
2. Risk of environmental degradation whereby the costs are borne by the young and unborn.
3. Import natural resources

Case 1:
Case (1) usually isn’t much of a risk in market economies simply because as natural resources become scarce, the price of natural resources goes higher. This may have an impact and reduce economic growth/economic outputs, but it also shifts the incentives of economic agents and the economy can adjust by substituting inputs/imports. Economies that experience a rise in natural resource prices often either adjust systematically or they experience massive drawdowns in production (often times both as the latter can lead to the former). However, these types of adjustments must occur often and regularly—even though they can be painful—simply because delaying the adjustment causes the agents of the system to not think the adjustment is coming. The longer the adjustment is postponed, the greater the risk of the system runs of experiencing “collapse” (or a sharp drawdown in production).

The shifts in prices (volatility) effectively disseminates information for agents. If the price shift is delayed or prevented, the information simply isn't transferred and creates tail risk. Often times, authoritarian/autocratic systems run into such issues because commodity/food/energy prices are fixed and supported by subsidies on the supply-side. The prices are often fixed, which means that even though the underlying inputs become more expensive, agents still behave as if the inputs are the same. The subsidies become more and more expensive to maintain while the costs of the government begin to balloon all while economic agents still behave like input costs are relatively cheap.

Governments budgets’ balloon and politicians are forced to either borrow massively (usually causing debt/income ratios to skyrocket), adjust input costs appropriately, or cut other spending in order to maintain subsidies and support prices. If the subsidies are cut, inventories become empty and we eventually see shortages. If input costs are allowed to adjust, we see short term pain while production and employment fall sharply. There can be major political ramifications. The third option is debt/income increases, which aren't sustainable as debt servicing costs eat up a larger and larger portion of the government budget while debt grows much quicker than debt servicing capacity. If this process keeps going, we eventually see a debt crisis and a complete collapse of the economic system (this process usually takes the political system with it. The third scenario usually leads to the first scenario as the subsidies (usually) get larger and larger and eventually lead to borrowing.

Case 2:
The second case is that in order to maintain production levels, environmental degradation is allowed to take place on a massive scale. The problem with environmental degradation is that we’re playing around with what we do not know. The environment is much more robust than us (via the Lindy Effect), which means that when we damage the environment, it will find a way to adapt (as it usually does—harshly). We do not know the consequences of our actions, which means that the losses could possibly be large enough to cross the risk of ruin. In other words, the risk of ruin is bigger than zero. From here, we now apply Murphy’s Law, which makes ruin inevitable from environmental degradation.

Note that when we deal with tail risk, the lower the probability of occurrence, the higher the impact of the event. In other words, we’re risking it all on the line for a fixed benefit. In other words, such policies make no sense. We may benefit in the short run, but it’s our children and grandchildren that pay the price.

Case 3:
We can simply import more natural resources, but we need a means by which we can pay for those natural resources. If we import more natural resources, we can produce more and if our production increases by more than the cost of the natural resources, the system ends up “better”. However, the system runs the risk of being more sensitive to shifts in input costs (which can come from not only a rise in economic inputs but from a fall in the currency as well).

If the outputs do not support the cost of importing more natural resources, the gap can be filled with debt. However, we run into the problem of rising debt/income ratios until you hit debt capacity constraints. Once that point happens, the process will reverse and the results will depend on the debt dynamics of the particular economy. All we know about the debt dynamics of the economy is that the economy will not benefit, but we do not know any bounds on the possible cost of the potential outcome which leads us to tail risk issues.

From here, we have shown that the only sustainable ways to accumulate real wealth (i.o.w. improve living standards) is by:
1. Either accumulating capital
2. Using natural resources more effectively (which can be considered capital depending on how capital is defined)
3. Having a system whereby imports and exports are constantly being replaced via a continuous, never-ending process
4. Using labor more effectively (can be defined as capital accumulation)

Using debt to sustain imports or importing more natural resources without having any way to use them more effectively/having the ability to replace imports is not a sustainable way to increase living standards. Such methods will work in the short term, but if sustained, will create economic/financial crises that may turn into social/political crises. Authoritarian systems (democratic systems can be authoritarian) are, in particular, prone to such collapses by the way the incentives become aligned.

Politicians/political leaders often have incentives that favor short term benefits at the sake of a longer term loss because their job is to get reelected. Similarly, bureaucrats have similar incentives as their job is to effectively cover their ass. Centralized societies run by bureaucrats and politicians are especially vulnerable to these kinds of economic/financial collapses that can lead to social/political crises. Often times, these kinds of policies are ones that can lead to all kinds of wars between nations, empires, and even civil wars.

Expanded Definition of Capital:
The skills, know-how, entrepreneurial ability, the efficacy of social/political systems, the ability to extract and refine natural resources, and the efficacy of labor usage.

If we use the expanded definition of capital listed above, we now only have two real ways of increasing real wealth. We must either be:
1. Expanding/increasing capital inputs
2. Have an ability for the economy as a whole to have the ability to substitute inputs and diversify among those inputs and outputs while constantly substituting/replacing inputs and maintaining the diversification among outputs

This brings us to the next question: why are undiversified outputs dangerous?
An economy with undiversified outputs is at risk of seeing a collapse in production if the demand for a decline in the demand for outputs (or for a strengthening of the currency). If an economy is sufficiently diversified among its outputs, the drop in demand of a single output cannot cause an economy to go down. The economy may even benefit by being able to adjust, adapt, and strengthen to the shock

An undiversified economy, on the other hand, suffers a major shortfall of revenue which reduces output revenue and will eventually force inputs to fall. Historically, one of the most dangerous situations for an economy to be in is to be a large commodity/energy/natural resource exporter. The reason is because if the price of the commodity/energy/natural resources falls, the economy must eventually contract its inputs and will experience a sharp drop in living standards.

An economy that doesn't have capital inputs or a diversified economy that substitutes inputs and outputs constantly is an economy that’s inherently fragile. Such economies cannot be wealthy. These economies can be rich for periods of time, but they will not have the ability to sustainably accumulate real wealth.

Note: The concept of import/export diversification and capital accumulation, in the real world, usually go hand in hand. It's difficult to have one without the other. Usually, economic systems that don't have both tend to be fragile and won't exist for any extended period of time.

Friday, December 19, 2014

The Importance of NGDP Growth (as a number, not an economic target)

In this post, I'll talk about something that rarely goes discussed: what the nominal GDP (NGDP) growth actually tells us. Usually when people use GDP growth, they use real GDP (RGDP) growth and find RGDP by using NGDP and subtracting inflation--usually measured by CPI. However, NGDP tells us something very valuable: it tells us the nominal value of the economy at a given point in time. So what does NGDP growth tell us? It tells us the shift in the nominal value of the economy per unit time. In other words, it tells us, in nominal terms, the growth of the real economy, and thus the nominal return of real assets on average.

Why is the nominal return of real assets so important? There's several reasons why it's important:
1. It's the growth rate of the real economy
2. It's the "opportunity cost of capital"--by the opportunity cost of capital, I mean that it is the return capital would receive instead of being put to use somewhere else (like foreign assets, government bonds, equities, etc.)
3. The real cost of transferring capital is ALWAYS the nominal return of real assets because it is the opportunity cost of capital

Many people including economists (particularly statists, socialists, and others who subscribe to authoritarian economic ideas) often claim that when the government issues zero interest loans all the time and all the government has to do is invest in anything that returns more than 0%. Of course, such ideas are complete and utter nonsense because they don't account for the real cost of transferring resources.

It's important to note that the real cost of transferring capital is ALWAYS the NGDP growth rate. In order for a project to be economically justifiable, the increase in productivity generated by the asset must be larger than the NGDP growth rate, not cost of the liability created (assets and liabilities must be created simultaneously).

The Relationship Between the NGDP Growth Rate and Interest Rates:
Now that we have a basic idea of why the NGDP growth rate is so important, we can now move on to what interest rates tell us. For the sake of simplicity, I will be talking about the short term money market rate of interest.

Recall that a traditional bank makes money by charging interest on long term loans by paying out interest on deposits. Bank deposits don't have a term period and are short term liabilities. Basically, (traditional) banks are long the longer end of the yield curve and short the shorter end of the yield curve.

Since NGDP is the nominal return of holding real assets and the growth of the economy and an (weighted) average return of real assets, we must compare the short term interest rates to the NGDP growth rate in order to determine the real effects of interest rates. Recall that the money market rate of interest is effectively the same (assuming a negligible risk spread, which is usually the case) as the return of holding deposits. Note that bank deposits are the primary monetary assets. In other words, bank deposits are money (not the bank reserves, like most people think).

If the return of holding monetary assets is higher than the NGDP growth rate, the sector that's long monetary assets will see the percentage of the income they hold go up while other sectors must see the proportion of the income they hold fall because the growth rate of the real economy in nominal terms is the NGDP growth rate. If the return of holding monetary assets is less than the NGDP growth rate, the sectors long monetary assets will see their share of the pie fall.

Remember that we can separate an economy into roughly three sectors: households, corporations, and governments. The household sector is the primary sector that is long monetary assets while corporations/governments are almost always short. Therefore, the cost holding short term interest rates below NGDP growth is primarily borne the household sector.

Note: The sophistication of the financial system matters in terms of how much households lose out on negative real lending rates (interest rates minus NGDP growth). If there's sufficient sophistication and diversity in a financial system/economy, households have alternatives to place their savings into equities, capital backed assets, etc.. Therefore, the impact of interest rates also depends on the financial system. A country like the US imposing negative real lending rates won't see the same depreciation in the household share of income than a country like China with the same negative real lending rates.

P.S. I've had final exams and been slammed, but now they're over and I've had about a week to recuperate. I'm starting to get a lot of writing done and will probably have several posts up over the next couple of weeks.