Guidebolt

Economics

2017.11.16

One of the best ways to understand the economy is to run a simulation in your mind. Start simple. Add complexity to increasingly mirror the real economy. Develop a true understanding of economics such that you can plan policies and investments for consequences that match your intentions. Align the real with the ideal.

As we assess different simulations, note three fundamental concepts. The consistency of supply and demand deals with how frequently and intensely people change needs, wants, and productive potential. The stability of equilibrium deals with how prosperously a certain economy can survive across the short-term and long-term. The velocity of money deals with the speed of transactions; how quickly people conduct trade by exchanging money for goods and services.

Boomerang Demand, Heavy Displacement

Consider an economy of two people, Gamma and Zeta. Each has $30,000 in savings. Every month, they trade at each others’ storefronts. Gamma sells $3000 of food and materials. Zeta sells $3000 of water and chemicals. This trade relationship is sustainable.

One day, an alien merchant ship lands in the area. The alien Alpha is selling water and chemicals for $1500; 50% cheaper than Zeta. The deal is too good for Gamma to miss. Zeta’s business plummets to zero.

Zeta takes a few months to plan and prepare another business. To conserve costs, Zeta reduces monthly spending to $1000. Gamma’s business plummets. With only $1000 per month, Gamma takes a monthly loss to buy their necessities from Alpha.

Zeta unveils their new product of special energy. Gamma really wants this, but is already strapped for cash. Zeta’s venture fails. Gamma tries to sell their food and materials to Alpha, but they are not interested. Gamma’s recovery fails.

Zeta has no income and very little money; Zeta is financially desperate. Gamma’s business plummets to zero. Gamma has no income and little money; Gamma is financially desperate.

The economy has failed.

The primary cause of failure was that Alpha did not demand anything from Gamma or Zeta. Gamma did not consider the income consequences when they switched from Zeta to Alpha for cheaper water and chemicals. When Gamma was buying from Zeta, the money had always boomeranged back for no loss of income on both sides. Gamma mistakenly assumed that Alpha would do the same.

This would not change even if Zeta’s venture succeeded. Gamma would buy $1000 of special energy, then Zeta would buy $1000 of food and materials; Gamma’s net income change is zero.

This would not change even if Gamma’ recovery partially worked. As long as Alpha boomerangs less than $1500 back to Gamma, Gamma will always take a monthly loss to pay the difference.

Alpha was simply a large hole in the economy that continued to pull demand until the population had no money left. In a stable economy, all households and businesses must spend an average of 100% of their income.

The secondary cause of failure was that Gamma and Zeta never returned to their prior arrangement. Zeta abandoned the water and chemicals business because the market was clearly won by Alpha’s enormous price advantage. If Gamma and Zeta discussed the calamity of their situation early on, they would have been able to make a deal to survive well and preserve their wealth. Note how Gamma should have just continued to pay doubly high prices to Zeta due to how income is affected by the boomerang demand.


Archived

The stability of an economy is marked by the prevention of artificial problems born of economic abstraction, and protection against real economic shocks due to natural, cultural, and technological shifts.

In this concise guide, we will evaluate the economy using the consistency-equilibrium-velocity model, then cover growth in that context. We will focus on boomerang demand and the significance of its flow. We will identify the primary killers of all modern market economies, velocity chokes and impossible boomerangs, then address them with general solutions.

Consistency

Consistency deals with the durability of supply and demand over time. A town certainly demands food. The town may demand apples. The town may demand 100 apples one day and 4000 apples on another. The town may strongly demand one type of apple or weakly demand twenty types of apples. If the apple farms are located in a safe, environmentally stable region, supply is likely to remain stable. Consistency of supply and demand brings the predictability that businesses desire towards low-risk revenue streams.

The study of consistency involves market saturation, cyclic demand, insurance plans, product substitution, production lead-time, subscription programs, demand evaluation, and re-training.

For instance, market saturation causes demand to fall towards the rate of product expiration. Consider a population that has 1 million refrigerators that last 10 years. Although refrigerator sales might have been an incredible 500K per year for the first 2 years, the market is now saturated. As the population is only interested in replacing their refrigerators when they go bad, average demand falls to 100K per year. If the refrigerator industry wants to improve their annual revenue after hitting complete market saturation, they will have to trigger a resaturation curve by innovating a better refrigerator with compelling marginal value. If a new product is better by leaps and bounds, consumers will buy it much before their current one expires. Resaturation is particularly enticing for consumers when it is for products that have a performance drop-off curve, such as hard drives that fail intermittently and more frequently before they fail completely.

Equilibrium

Equilibrium is a sustainable state of the economy that has converged from a consistent balance of total supply and demand despite inconsistent individual actions.

In order to understand equilibrium, consider a simplified economy containing a population of households that work for and demand goods from 10 sectors such as food, water, housing, healthcare, ... , government, and other. Assume that the population spends all of their income on consumption uniformly across all sectors. Then simulate the monthly flow of demand where 100% of the population spends 10% of their income on the food industry to have its individual businesses pay 10% of the population for 100% of their incomes. Repeat this flow for the 9 remaining sectors to get 100% of the population spending 100% of their income to pay 100% of the population for 100% of their incomes. This is a 1-layer equilibrium model with both the population and the sectors on the same plane, rotating the demand for labor and goods on a monthly basis.

Equilibrium is largely determined by the boomerang trajectory of demand as it flows from all households to all businesses then back to all households. Every purchase represents the next step in the storm of boomerang demand within a greater equilibrium.

Equilibrium is complicated by the supply chains intertwined across businesses. The revenue of a single business cascades into the revenue of several other businesses. For example, grocery stores and restaurants are backed by separate companies that deal with freight, supplies, packaging, processing, and agriculture. Core industries such as water, fuel, and electricity are instrumental not only to all households but also to all businesses. Therefore the total revenue of an industry fragments into the partial revenue of other industries. Supply chains force our model to evolve into a multi-layer equilibrium where the population sits at the center of a sphere of industries with the closest being the first to catch household boomerangs.

Equilibrium requires that all households and businesses spend 100% of their income on average to prevent a deficit in boomerang demand. For instance, any household that spends only 90% of their income must be offset by a household spending 110% of their income by delving into their savings or credit. In a given month, if the average spending ends up less than 100%, then some household will lose income, whether directly through salary or indirectly through lower business profits. The spending can be any combination of consumption and investment. Complete spending is particularly important by the workers and owners of core industries as they are the foundation and final bastion of long-term equilibrium.

Equilibrium can survive incomplete spending in the short-term by having certain households and businesses spend from their savings or credit. A large money supply and healthy credit base facilitates this type of limited equilibrium. However, as savings dwindle and debts accumulate toward the precipice of bankruptcy, the return of complete spending becomes increasingly important.

When incomplete spending exerts sufficient pressure on households and businesses, they have a decision to either lower their spending budget or wait for a recovery in overall spending. If they lower their spending budget, the economy may re-establish an equilibrium at that lower point, generally with higher unemployment and lower median income. If they wait for a recovery by complete or excess spending, the burden falls on the cash wealthy to spend a late boomerang back to the rest of the economy. Notably, recovery from debt is harder than recovery from low savings because of the dependency on the financial sector to also boomerang their interest income back to the rest of the economy.

The resilient recovery of long-term equilibrium in the face of incomplete household spending is reinforced by central banking and business investment. Central banking provides the flexible money supply required to counteract idle money, the root of slow and impossible boomerang demand. Business investment provides new household income and attracts new boomerang demand, preserving or improving income and employment rates; importantly, through faster use of the remaining active money supply.

Effective equilibrium requires balance not only in total boomerang demand, but also with the flow of demand across enough of the population; so as to sustain the employment of each individual household. Consider an economy where the food industry sees a consistent monthly revenue of 1 billion dollars. Despite the consistency of total industry revenue, next month may see half of all food businesses grow by 50% in revenue and the other half lose 50%, enough to go out of business. Similarly, while most workers enjoy the stability of a fixed salary, their businesses still bear the burden of capturing demand flow. If enough demand does not flow to a specific business, it will go down along with its workers regardless of whether or not they feel the flow pressure. Clearly, a balance in total boomerang demand does not equal a balance in specific boomerang demand.

Demand flow can be evaluated in terms of its directness to working households in the population. Some paths are quite direct, such as buying food from the grocery store or a house from a construction company. Some paths lead to a vortex of idle money and inefficient boomerang ratios, such as high stakes gambling where a large sum of money may sit around and exchange hands but largely not where it can easily flow back to households. An efficient flow of demand circulates across households with sufficient uniformity for survival and a degree of prosperity.

Having covered the significance of boomerang demand and its specific flow, we can now expand our equilibrium model to consider different types of investment spending.

Spending on simple wealth, such as precious metals or housing, has similar effects as consumption- when demanding from a producer, such as a construction company. Yet, simple wealth from a secondary market usually has poor flow because the boomerang path is more connected to the rebalancing of a wealth portfolio than towards the income of working households. Simple wealth that provides a necessity, such as home ownership in place of rent, promotes stability through the reduction of dependency. Simple wealth that provides trade value, such as selling gold during hard times, promotes stability as protection against flow shocks.

Spending on issuing debt, such as supplying student loans or acquiring company bonds, can be treated like owning a part of the debtor’s income as it flows in. Debt payments incur an extra transaction on flow. Consumer debt generally hurts total boomerang demand because of higher marginal savings rates and lower flow efficiency on concentrated income.

Spending on business wealth, such as ownership of a convenience store or manufacturing company, affects equilibrium and useful value with wide variance. Automation frees up time spent in drudgery, but causes technological unemployment that shocks both boomerang and flow, necessitating re-training. A business that supplants an existing one may sell a better product, but may not improve boomerang or flow as the other business and its employees are beaten out. A business that truly improves equilibrium is one that offers new value, attracts untapped demand, and builds short paths for specific boomerangs to flow, ideally within the local area.

Velocity

Velocity deals with the speed and value of transactions in the flow of demand, often modeled as the velocity of money.

The factors of velocity determine the speed limits and flow compatibility of equilibrium.

Consider a large economy that requires a 10 billion dollar monthly boomerang, but tries to function with a money supply of only 1 million dollars. Even with fast transfer technology and excellent flow paths, the economy will have great difficulty circulating just its survival boomerangs. For example, even if all households and businesses with money make 10 transactions per day, that only yields a velocity of 300 million dollars per month- far lower than the required boomerang value. A stable economy requires a sufficiently high velocity of money that is enabled by a large money supply.

Consider a small economy that has an unusually high tax rate, but tries to function with slow government spending and a barely large enough money supply. Businesses hold onto the tax money until the next tax payment date, causing idle money. The government holds onto the tax money after it is received, causing idle money. Although the government can eventually spend the money towards effective demand flow, the economy may still decay from an overly slow boomerang effect due to the constant inefficient flow into holding accounts. Yet if money transfer technology improves enough, the economy may recover a prosperous equilibrium. A stable economy requires a sufficiently high velocity of money that balances the strength of velocity factors against the efficiency of demand flow.

Credit transactions, where the promise of payment is used in lieu of immediate money, are an excellent way to commit transactions by artificially extending the money supply. However, while credit transactions clarify the path of future money flow, the money transfers themselves still remain speed-limited by technology and settlement delays.

The overarching imperative of velocity is for households and businesses to be willing and able to spend their money quickly. Unfortunately, modern households and businesses are not incentivized for immediate spending for several reasons. First, most households have salaried jobs that would not directly benefit from boomerang demand even if it comes back to the business they work for. Second, strong cashflow protects businesses from short-term risks, so they have a defensive reason to hold onto money until nearing the due dates of their payables. Third, the returning benefits are unclear and risky because demand flow is complex to predict with modern economic tools. Fourth, the time value of money incentivizes holding money to earn a small, safe, short-term return on investment until the time comes to settle payables. Fifth, households and businesses take time to decide on spending decisions.

Because most households earn a fixed salary, full employment caps the velocity of consumer spending, moving the economy towards a zero-sum consumer market. Before full employment, consumer velocity improves simply by hiring new workers. After full employment, consumer velocity improves only when workers receive greater income. Thus an important factor of improving consumer velocity is for new entrants in the workforce to earn greater income than their predecessors.

Growth

Growth can lift an economy in equilibrium into ever-greater heights of prosperity. Yet growth of certain parts of the economy can be the roots of its downfall.

Let us consider the primary killers of all modern market economies: velocity chokes and impossible boomerangs.

Velocity chokes are best understood using an example with debt. In the section on equilibrium, we covered that loans are like owning a part of the debtor’s income, just with an extra payment transaction. Loans were also deemed fine for equilibrium as long as the financial sector returned their income to preserve total boomerang demand. Now consider a case where consumer debt has grown so large that the financial sector is unable to spend and return their income fast enough, even despite knowing what they will spend it on. Additionally, immense pressures are placed on the outward flow from the financial sector to move the money fast enough. More specifically, consider a trillion dollar money supply funneled into the financial sector through a trillion dollars of monthly debt payments. Such over-concentration of flow is inevitable if the financial sector is only and riskily willing to spend on new loans from a population drunk with debt-fuelled speculation. This was the cascade of events leading up to the 2008 financial crisis. Debt is the one type of investment spending that cannot be sustainably accumulated, lest it choke the economy as its equilibrium needs break through modern velocity limits. Velocity chokes come from the convergence of flow that surpasses the velocity limits of the funneling node, regardless of the efficiency of the remaining flow map.

Impossible boomerangs are best understood using an example with idle money. In the section on equilibrium, we covered that incomplete spending was compensated by central banking and business investment- providing both a flexible money supply and the market force to accelerate the active money supply. Accordingly, recovering households would have time to improve their financial conditions through the accelerated spending of middle class households. In the advent of the 2008 stockmarket crash, households and banks and other businesses all became sharply reluctant to invest their money. As incomplete spending skyrocketed, immense pressure fell on the private sector to accelerate middle-class demand towards an overall economic recovery. Unfortunately, the flow map was saturated with such lingering debt and dead end pressure that even great business investments looked to evaporate into idle money. Facing the prospect of a depression, the public sector stepped up to inject active money into the economy by taking on debt from those who were too risk-averse to invest in business but accepting enough for national debt. A difficult recovery ensued. Boomerang demand is an absolute requirement of a stable economy dependent on circulating money across wealthy sectors. Impossible boomerangs come from the fragmentation of flow that surpasses the acceleration limits of the active money supply, regardless of the potential velocity of the remaining flow map.

General solutions exist against velocity chokes and impossible boomerangs. While velocity chokes can occur from different means such as debt or taxes, they fundamentally build up from an exponential or overly disproportionate relationship in the economy, such as the market for home construction and ownership against the mortgage industry. Home mortgages backed by sound income are sustainable, while boundless speculative mortgages are simply not. The private and public sectors can avoid velocity chokes by understanding the equilibrium constraints of the real economic relationships they play within the greater flow map- several levels of rationality above the speculative prospect of profit. Moving on, impossible boomerangs land from the simple reluctance to spend money, with flow efficiency as a secondary concern. Given any money supply, some households and businesses are holding all that money. Households in debt and with low net worth should not be expected to overspend, so it’s up to the middle class, upper class, and wealthy institutions to shoulder the responsibility. As explained before, spending on loans does not work here sustainably, akin to issuing new debt to have debtors pay old debts. Simply, the economy can avoid impossible boomerangs with sufficient consumption, producible wealth investment, business investment, and philanthropy. Consider both velocity chokes and impossible boomerangs as vehicles of economic war between those who see, teach, value, and spend appropriately on real economic relationships- and those who want or care too little to let the nation slide into a state of disrepair.

Economic growth is effectively measured in real GDP, but we must be steadfast in prioritizing sustainability and real marginal value as well. Sustainability deals with not only the stable abstractions of boomerang demand and its flow map, but also the physical constraints of the real world. Real marginal value constitutes technologies and experiences that are proactively better; the reactive recovery after a natural disaster is good and grows the economy, but generally does not put people’s lives in a better position than before the disaster. The bright road to great economic growth is multi-faceted and finds stability in the strength of smart institutions, patriotic investors, and meaningful middle-class jobs.