The Economy is like Walking -A Controlled Fall – Not Lying Down

Inappropriate physical analogies have been the curse of neoclassical economics. In 1909 Walras in his article ‘Economie et Mechanique’ used the model of a mechanical lever in equilibrium as the model for prices at rest.  This physics envy, of Walras, Edgeworth and others is well documented.  In samuelson’s hands the mathematics of thermodynamics was used to describe the deviation from and return to equilibrium of a system of prices.

In doing so it adopted the model of a system at rest.  The ability for the system to break down on occasion has led to increased attention to disequilibrium models. This is a healthy corrective, however most of the time some predictability about the broad state of economic variables is the norm.  Were it not investment, saving etc. would be near impossible.  The broad stability of expectations of the economy is the norm and fascinated economist from the  classical period as to why this was so.

The problem is not the focus on equilibrium but the wrong kind of equilibrium.  A thermodynamic equilibrium is a system at rest and at minimum energy. no external energy is necessary to maintain the system at rest.  The more common and normal situation is nature is a a steady stat, in which all state variables are constant in spite of ongoing processes that strive to change them.  This requires a continuous input of energy.  This is a dynamical system, like Sisyphus using energy to try to push his rock up a hill, only to be opposed by gravity.

Walking at a constant speed is a good example, using energy to propel the body forward through using instability, constant falling. to propel the body forward, and an input of energy to maintain the body erect and balanced.

This kind of system is a much better economic analogy as it involves the constant input of work, and a background of constant change, both factors lost in the thermodynamic equilibrium analogy, which in its most extreme form posits a universe at heat death, where nothing has changed and can ever change. Growth, change and economic cycles being essential economic attributes.

The ‘surplus/cycle’ approach of classical economics had this at its heart, and because its mathematisation involves feedback loops and state changes it is inherently suited to the modelling of dynamic systems.  Much of their usefulness is in helping us to understand the preconditions for economic growth and price stability.

Let us consider first a very simple two commodity model, or corn, a subsistence good and also acting as the numeraire, and a single capital good – lets call it lime – which increases productivity of corn production by a fixed coefficient.  This simple classical model had a hidden assumption, which Torrens as usual was first to spot.  corn was also a capital good, as it had a non zero turnover period.  As this turnover period was the same as the period of production no capital theory problems arose however.  Assuming the ‘pure’ capital good lime has the same turnover period, and fixed labour-capital inputs we produce the ricardian result that economic growth through input of capital has no overall change to the price level, as all prices are measured in terms of corn.

Let us introduce sovereign issued money, in it simplest form of a pure commodity money, fixed in supply and not produced.  The wet dream of crypto currency fans as to how it might operate.  This shows dramatically the problems with such ‘money’ with economic growth prices depreciate with a non-corn numeraire.  If you have economic growth of 3% prices depreciate by 3%.  The optimum investment rate is no longer r the rate of profit but the real rate of r (the fisher rate).  In such an economy there would be no premium on investment.  The present value of future consumption would be the same as present, so investment would be diverted to consumption.

To get investment and economic growth we need a constant depreciation of the currency at rate r.  One means of doing so is to make the currency a state currency.  if the deficit in the state currency to the private sector is equal to r then the currency will depreciate to the extent that produced the optimal investment level of r.

Introducing a multi currency model you will find that although the currency depreciates at simple interest rates the economy grows at compound interest rates.   This means that the purchasing power of a days wage in a currency with an optimum  state deficit will be greater than the equivalent amount of  a country where the numeraire is fixed but with a balanced budget.  In an important sense the central bank issuing a deficit is banking on the rising purchasing power of the currency it issues in the same way a bank loan is ‘backed’ by the expectation of productive investment. In this manner state money is backed in exactly the same way as long as deficits are run.

How does such an economy keep growing? Unless the margins of cultivation and urbanisation can continuously expand, profits will be absorbed by rent and driven to zero.  If the return from land is higher than capital then the price of land will rise and its return falls, and vice versa.  This potential arbitrage between investment and land purchase means that the natural rate of interest (as Schumpeter and Keynes argued) is only zero an economy with either no private ownership of land or where all rents are taxed, otherwise in an economy with a spatially expanding margin arbitrage will contain the rate of profit to the rate of rent at the margin of production.  In such cases there will be no differential rent, but there will be an absolute rent driven by how much the level of total production falls short of effectual demand.

Note here the ‘constraint’ on deficits is not future surpluses but future repayments of debt, the level of debt repayments being equivalent to the NPV of future repayments.  It is perfectly possible to reduce debt overhead whilst increasing a deficit.  Imagine a situation where all governments spending in one period is switched to principle repayment. But new debt if taken on to pay for some current spending.  In this case the deficit will increase but the debt decreases.  This shows how poor a metric debt/GDP is (mixing a stock and a flow).   Rather than there being a government budget constraint there is a non-binding inflation constraint.  Net flows from deficits to spending increase the denominator value of the numeraire of sovereign currency.  If this is done at a rate greater than the natural rate of interest r it is inflationary, less it is deflationary.

This kind of model is interesting in that we can produce the same class of results as a ‘Swan Solow’ growth model but without falling into capital theory traps as we are solely dealing with originary factors and technical coefficients.

Thi simple model illustrates how fragile capitalist growth is, depending as it does on the ability to expand without shortages of land and labour and with a state supported currency regime optimal for growth.

 

 

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