Thursday, August 6, 2009

What is a Bubble? (Philosopher's Economics)

I've been thinking about economics a bit recently (I doubt I'm the only one), and a few things regularly creep back up into my mind. One of those is the question, "What is a bubble?" Now I'm not asking what people mean when they use the word - I know that much - I'm asking what it represents. In theory it's a disconnect between the perceived state of the market and its actual state, but I want to see what it is one level deeper than that. Where did the money lost go? Why is it that bad accounting results in our society being poorer?

Before we begin, full disclosure: I'm not an economist, and I'm not an expert on the intricacies of the market. In fact, I'm historically the kind of person that doesn't even like thinking about economics. In my defense, however, recent history has shown that many supposed experts on the market are nothing of the kind, and it's also forced many of us who would prefer to spend our time on other topics to think a bit harder about the economic system we live with. I'm also not going to try and explore the intricacies of the market here; we're going to be looking at fairly high-level concepts instead.

What I propose is a mental exercise: imagine, for the time being, that you do not know what "money" is, or quite what an "economy" is, and you are presented with our society ("our" meaning American society, here, but much of this will apply to other developed countries). You do know that the people in this society adhere to a complex codified system of behavior in order to allocate resources, which they refer to as "the economy".

So how does this system work? It seems to have a number of conditions and goals:

1) It seeks to produce value for the system as a whole. Unfortunately (very unfortunately, as we shall see), what qualifies as "value" is vague and isn't universally agreed upon.

2) The system needs to allocate resources so that they are spent on the projects best capable of adding value to the system (in order to fulfill the goal above). Note that just because a project contributes value today doesn't mean it will contribute value tomorrow, so this must be constantly re-evaluated.

3) The system motivates citizens to be productive by allowing those who create the most value to consume more of the value produced.

4) The system requires citizens to consume its products. This is for two reasons: first, the act of consumption is an expression of faith in and acceptance of the system. Second, and more importantly, it is a means of measuring the perceived value the system is producing.

So (4) ties back into (1) - it's how the system deals with the ambiguity of "value." If a citizen consumes or makes use of the products of the society, they are assumed to be getting value out of it (or else they would choose not to consume those products). Now you also have a way of measuring the productivity of projects - if their products are consumed, they are productive projects.

We have a basic idea of how this system likely works, now. When citizens produce value, they are rewarded by being able to claim or use up some of the value produced, and their consumption is an indicator that the producers of whatevever they consumed are contributing value, so these producers are also allowed to consume, etc. This is how it works once you "get the ball rolling", but how does the consumption chain start? Who is the prime mover, if you will?

In this case, it's financial institutions like banks that have the authority to declare that a citizen deserves to consume before they've proven that they're creating value. In theory this is because the bank has determined that the likelihood of this citizen producing future value is very high, and because the consumption chain needs to get started to keep the society as a whole productive. Since the objective is to have the rate at which value is created constantly increase, the rate at which value is consumed must also increase, so the purpose of these institutions is to bring the rate of consumption closer to the rate of production, so that the system gets more feedback.

At this point, things are starting to look pretty familiar, and we can see where the current crisis fits into this chain: bad predictions about how much value citizens are likely to contribute. However, let's step back and consider what that means.

In the case of a real estate bubble, we're talking about building houses. The financial institution is deciding that a citizen should have a house, but it turns out, eventually, that the citizen didn't create enough value to justify the consumption. In other words, the society has decided that the current house owner does not deserve the house. That's what the bubble means. The bubble popping is the large-scale recognition that house owners have not earned their houses, and the subsequent punishment enacted by the system.

Now you may not remember getting together with your fellow countrymen and having a vote where you decided to punish house owners. That's because there was no such vote - instead we have a tool in this system that automates the decision for us, called "money" (along with contracts and credit scores and such). If you remember, however, we agreed not to talk about money when describing the system, and there was a point: by giving ourselves a little distance we get a new view of the system. It is the same core system whether we vote to punish or not - money is just a means of implementation.

So back to the situation at hand: the system is punishing people, both house owners and financial institutions, but on a large enough scale that it has destructive consequences. When the financial institution loses sufficient authority in the system, it is no longer able to delegate resources, and the rate of consumption falls. This has a chain effect, or viewed another way, it interrupts the chain effect the system so carefully created. If you do not have consumption, you don't know where to allocate your resources (because you don't know who's contributing value), so resources will simply sit unallocated, and projects grind to a halt. In our society, this manifests in a rise in the rate of unemployment.

Now here's the weird part: at no point in this story was a problem caused by a decrease in the rate of value production. That's the result of the problem. The problem was actually too much value production, or rather, "unjustified" value production. Now we have nice houses, which carry a lot of value, just sitting around unused because we can't decide who should get to live in them.

From this perspective, our current situation is rather obviously absurd. As a society, we have the resources and infrastructure we need to be prosperous, but we're stuck in an extended period of indecision about how to allocate these resources. In order to fix the situation, you simply need to start allocating resources again (in fact, to a large extent it doesn't matter where you allocate them, as long as you enable consumption and get the chain effect restarted).

This makes recent proposals seem much more reasonable than they appear at face value to many Americans. Bailing out banks is, in this little model of ours, synonymous with "not punishing" those banks, so that they can continue to allocate resources. If (and this is a big if) you add well balanced regulations to the mix, you can force the bank to do a better job of allocating resources without interrupting its operation, and getting it to do a better job allocating resources was the whole point of the punishment feedback loop in the first place.

A stimulus package is an alternative of the same idea - but in this case you skip the institutions that performed poorly and have the government allocate resources directly. Again, as long as the policy enables consumption, we start getting feedback about value production, which allows the system to adjust resource allocation and slide back into an efficient state of operation.

Note that this doesn't say anything about how these policies are actually being implemented. Bailing out banks without adding regulation might reinforce their poor performance, and result in the chain effect starting back up, but at low efficiency. A stimulus might not allocate resources fast enough to effectively jumpstart the chain effect. Either way, the principles behind the policies clearly have some grounding.

We could go further, but I have to stop at some point, and going further into policy risks getting us too far away from the core concepts. So what's the takeaway? Well if you've gotten to this point and think that what I've said makes some kind of sense, I consider the post a success, but if there is one idea I want people to come away with, it's this: money is a means, not an end.

We were able to tell a perfectly coherent story about our economy without the concept of money being involved, and we can see where it fits in - it's the common unit of measure for the value of any product. Its purpose is to distribute the evaluation mechanism among all citizens in the system, which is important because, as mentioned before, our products need to be constantly evaluated to have efficiency in the system. In other words, dollar bills are evaluation tokens, or a mini-vote for a the value of things we consume. This is clearly not how citizens tend to think of them, however; since these tokens can be exchanged for items of value, we think of them as having inherent value, and treat them as property.

The first step to a more sane system might be recognizing what money actually is.

-Silent Ellipsis

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