Is the Economy a Machine?

A Science Goes Astray

Human beings have a strong tendency to look for patterns. The natural sciences have shown that the universe is governed by laws, the effects of which are observable and measurable in an objective manner. Mostly, anyway — there is, after all, the interesting fact that observers are influencing measurements at the quantum level by the act of observation. (For our lives in the “macro” world, however, this is not relevant. An engineer does not need to take relativity or quantum physics into account to construct a machine that works.)

In the late 19th and early 20th centuries, a never before seen string of very rapid advances in scientific knowledge and technological progress occurred. It is hard to overstate the impact of inventions such as the automobile, radio, airplanes, and so forth. This happened while per capita economic growth in what is today known as the “developed world” reached its fastest pace in all of history — a pace never to be seen again.

Although we cannot prove it, we believe there was a good reason why this combination of vast economic and scientific progress took place at the time: governments were but a footnote in the lives of most people. By 1910, spending by the US government was a mere 4% of GDP. There was no central planning and no central bank, although there was of course a certain amount of crony capitalist government intervention, and the forerunner of the Federal Reserve System (the system of “central reserve city, city and country banks”) was already established.

Real US GNP per capita (1869-1918) (in 2009 dollars)

US real GNP per capita during the so-called “Gilded Age” – it has never again grown this fast or more equitably. This happened under a fairly sound, gold-based monetary regime.  Consumer price inflation was slightly negative for most of this time period.

However, the astonishing advances in the natural sciences had an unfortunate side-effect: many scientists in the field of the social sciences — especially in the most developed branch of the social sciences, economics — began to develop a fascination for the methodologies of physics. They inter alia assumed that what had been lacking so far in economics was the availability of reliable statistics.

Armed with the proper statistical data, so it was held, economists would not only be able to “test” the theorems of economics, but would ultimately also be able to engage in proper macroeconomic planning. As Murray Rothbard put it in the foreword to Ludwig von Mises’ book Theory and History:

“’Real’ science, it is alleged, must operate on some variant of positivism.”

Correctly applied, it makes use of a mixture of the empirical data of history as well as the deductively ascertained laws of praxeology and combines them by applying “understanding”.  To clear up the meaning of the latter term: a historian, for example, knows that Caesar crossed the Rubicon — this is an established datum. But in order to convey why Caesar did so, what precisely motivated his actions, he has to apply understanding, by pondering all that is known about the man, the time in which he lived, his journey through life and his character. This involves just as much uncertainty as coming to conclusions about the future.

The title of Mr. Dalio’s missive already foreshadowed that a critical examination would be required. The economy is actually not a “machine”, even though such analogies seem to make sense on a superficial level. Another well-known, but equally problematic, analogy is to describe the economy as being akin to an “organism”. It is certainly true that there is a division of labor and cooperation between the cells of an organism; in this sense, the comparison seems to make sense. But the processes involved are purely physiological in nature — cells don’t think or have volition.

We once again quote Mises on the matter (Theory and History, pp. 252–253):

“Human society is an intellectual and spiritual phenomenon. In cooperating with their fellows, individuals do not divest themselves of their individuality. They retain the power to act antisocially, and often make use of it. Its place in the structure of the body is invariably assigned to each cell. But individuals spontaneously choose the way in which they integrate themselves into social cooperation. Men have ideas and seek chosen ends, while the cells and organs of the body lack such autonomy.”

Mr. Dalio’s paper on the “economic machine” is actually quite interesting from a historical point of view. It contains examples of past debt accumulation cycles and the subsequent “deleveraging episodes”, and all of this represents quite valuable information. We would certainly regard it as helpful to investors. However, it does not explain “how the economy works” — and, more importantly, the economic policy advice derived from it is flat-out dangerous.

Recall the remark we made above about many economists becoming entranced by economic statistics and econometrics in the early 20th century. One economist who tried to derive a theory on economic cycles from the study of statistics was the Russian Nikolai Kondratiev.

He eventually became famous for his “Long Wave” theory of production, prices, and interest rates. The term “Long Wave” was actually popularized by Joseph Alois Schumpeter after Kondratiev’s untimely death (he was exterminated by Stalin, who deemed his theory to be “counter-revolutionary” after a US economics professor denounced Kondratiev as a closet capitalist in Moscow. Western intellectuals have always sympathized with socialism).

Schumpeter tried to refine Kondratiev’s work on cycles by integrating into it shorter-term cycles, the existence of which had been posited by other economists, such as Joseph Kitchin (inventory cycle), Clement Juglar (fixed capital investment cycle), and Simon Kuznets (infrastructure and demographic/immigration cycle).

  A Science Goes Astray Human beings have a strong tendency to look for patterns. The natural sciences have shown that the universe is governed by laws, the effects of which are observable and measurable in an objective manner. Mostly, anyway — there... - Click to enlarge

The “Phillips Economic Computer”, a.k.a. the “MONIAC”,  designed by Bill Phillips in 1949. It is actually a great feat of engineering, but it also perfectly illustrates the mechanistic mindset that has taken root in economics (as the Science Museum in London notes, it “demonstrates in a visual way the circular flow of money within the economy” – which goes to show how superficial this mechanistic view actually is).  See also the video embedded at the end of this post which shows the machine in action.

Kondratieff-Cycle, Juglar-Cycle, Kitchin-Cycle, Composite Function

Schumpeter’s version of the Long Wave with Kitchin and Juglar sub-cycles – the Kuznets cycle was added by later scholars and is not included in this chart (its length would be approx. 17-20 years, or one third of a Long Wave cycle). The fixed periodicity of these cycles is a mirage, and to the extent they exist, they are solely the result of credit expansion.

Most idiosyncratic business cycle theories such as Kondratiev’s Long Wave and its subsets fail already on the grounds that there is no such thing as a non-monetary business cycle — the expansion of money and credit and the associated manipulation of interest rates are the sine qua non for the cycle to be set into motion. However, Mr. Dalio looks at credit expansion purely in a Keynesian spending-income circular flow context. The problem with this framework is that it completely misses the essential problems caused by the business cycle.

Unsound Credit and Malinvested Capital

Mr. Dalio’s main concern is the “deleveraging” part of the cycle; this is to say, a period in which more debt is paid back than is taken up and unsound debt is liquidated — or at least would be, in an unhampered free market economy. He posits that this point is generally reached once central banks are finally at the end of the “stimulus” rope — namely, once they have manipulated interest rates to zero.

We would note that the subset of history on which he bases this latter assertion is one that offers an extremely small sample size. Many different monetary systems are thinkable and possible and have operated throughout history. The modern pure fiat money system is relatively young and should be seen as just one facet of the unique contingent circumstances characterizing the current economic backdrop.

A term Mr. Dalio has made famous in this context is “beautiful deleveraging” — as opposed to the ugly liquidation of unsound debt by means of write-downs. As he points out, every debt is someone else’s asset, and the liquidation of unsound debt is therefore liable to create a kind of “reverse wealth effect”, by destroying the wealth of creditors. He believes this should be avoided, because it would undoubtedly be quite painful and would hamper “aggregate demand”.

However, it would actually be more precise to state that the wealth that would be “destroyed” is simply wealth which creditors erroneously thought existed. By the time debt becomes unsound, this wealth has in reality already been consumed. Easy money invariably leads to the misallocation of capital, as it distorts relative prices in the economy. This in turn falsifies economic calculation, leading to malinvestment and a distortion in the time structure of production.

This means that the balance between saving, investment and consumption will no longer be optimally aligned. Businessmen will underestimate current consumer demand and overestimate both currently available savings and future consumer demand. An inevitable long-term result of this is that investment is directed toward the wrong lines and capital consumption will eventually ensue. Money and credit are providing the impetus for this process, but what is actually consumed is real capital.

One can of course choose to pretend that unsound debt is just fine, so as not to have to write it off — but that cannot alter the fact that real wealth has been consumed. Demand will as such never be a problem as long as there are unsatisfied human wants. The problem is rather whether the means to pay for this demand exist — and this has nothing to do with money, which is merely a medium of exchange.

The wealth represented by real capital does not depend on whether the amount of money in the economy is X or Y. Or putting it differently by way of an example: If the government’s central economic planning committee gives every citizen one million rubles, but the shops are at the same time completely empty, then the money can at best be used for heating purposes.

A Dangerous Idea

Unfortunately, the solution Mr. Dalio proposes — the thing that is supposed to make the deleveraging “beautiful” — is that central banks should print money to make debt service easier, by so to speak “inflating the debt away”. Not to put too fine a point on it, this isn’t exactly a revolutionary new idea. Rather, it is precisely one of the reasons governments have been so eager to establish central banks and a monetary system that makes nigh unlimited money creation ex nihilo possible.

It is also an extremely dangerous idea (wrongly believed to work based on misunderstood historical examples). First of all, central banks have balance sheets, too — in today’s system, base money (currency and bank reserves) is their liability, which is offset by assets, most of which consist of debentures issued by governments (leaving aside that some central banks are even buying equities nowadays). These in turn are a claim on the government’s ability to tax away a sufficient amount of wealth from its citizenry in the future.

The only way in which central banks can create additional money without at the same time causing an offsetting increase in debt somewhere in the system and with it the potential for this new money to disappear again (if/ when said debt is actually paid back), is by making the increase in money supply “permanent”.

Note: We are not so naïve as to believe even for one second that the money supply increase they have caused so far is somehow not going to turn out to be permanent. However, in theory it isn’t: every bond on the central bank balance sheet will eventually mature.

  A Science Goes Astray Human beings have a strong tendency to look for patterns. The natural sciences have shown that the universe is governed by laws, the effects of which are observable and measurable in an objective manner. Mostly, anyway — there... - Click to enlarge

The true broad US money supply TMS-2 (excludes all credit transactions and includes everything that is actually money) – it is extremely unlikely that the Fed will ever allow it to shrink again.

Presumably, it would be replaced with a $1 trillion platinum coin as Mr. Krugman once proposed in a different context — after all, something has to replace the extinguished debt on the balance sheet. A finger-painting made by Mr. Kuroda under the influence of too much sake might for instance be used by the BoJ. It could be declared a work of art worth one quadrillion yen.

Another idea is for governments to issue “perpetual bonds” directly to the central bank, which will then simply grace its balance sheet for all eternity. This is supposed to encourage more spending, since citizens will no longer fear being taxed in the future so as to enable the government to repay its debt.

All these ideas have a few rather major flaws in common. One of them we have already mentioned above: issuance of additional money cannot alter the state of real wealth. Not one iota in additional real capital will be created; all that will happen is that the existing supply of money will be diluted.

An associated flaw is that in the longer term, even more real wealth will be consumed as a result, as nothing (money from thin air) will be exchanged for something (real resources) by the earliest recipients of the newly created money. This also implies that real wealth will be redistributed, primarily from the prudent to the well-connected and the irresponsible (and due to the uneven manner in which the price effects will spread, as a rule also from the poor to the rich).

The idea that economic growth is created by “spending” is fundamentally misguided anyway; saving, wise investment and production are what creates wealth, not spending and consumption. One cannot put the cart before the horse and expect to actually get somewhere that way.

There is also a considerable danger that resorting to issuing any form of “helicopter money” will simply destroy the public’s confidence in central bank-issued money. After all, the pretense that money is still “backed” by something — even if it is only the future wealth creation capability of the citizenry and the State’s ability to extract a share thereof — will then be abandoned completely. What remains to support faith in the currency after that is a thin reed, indeed.