The reality of economic systems

The question of the “reality” of systems can quickly devolve into a philosophical battle about the nature of reality itself.  Much of the answer for systems research depends upon how you define the system – as to whether it refers to the things that you are trying to learn about, or the process that you are using to investigate.

The position that I have taken is that “Systems are real for us, as humans, to the extent that we enact them.” As noted in a previous posting, both pigeons and fear are “real” in the sense that each can be examined as a phenomenon.  Both may affect us in different ways, but though fear is more ephemeral, it is also real in its effect on human lives.

What, then, about something like money?  The economic meltdown of the last week or so will continue to be analyzed by experts and pundits for a long time – and may yet have more consequences than we know.  More importantly, whatever decisions are made in Washington, they are likely to affect all of us in very real ways.  So to the degree that we participate in the economy, it is real.

The debate that has stalled decisions is largely philosophical.  What is it that actually makes the economy function (i.e. what is the nature of the system)?  Some see it from Adam Smith’s perspective, that left unhindered it functions as a self-organizing, self-balancing system.  Others see it as a very human institution, controlled by powerful people and driven by greed and hubris.  If you believe the former you simply try to rebalance it with as little intervention as possible.  If you believe the latter you are inclined towards more regulation.  In truth, we are likely to end up with some of both remedies, but only if they address the actual functioning of the system will they do any good.

At the risk of being just one more voice in the noise expressing half-informed opinions, let me try to use this as an example to sort through questions about systems.

My own approach is to start with the largest picture that (potentially) puts the rest in perspective.  An economy is based on an exchange of goods and services.  In what I think of as hunter-gatherer tribes, there was undoubtedly some division of labor, but resources were shared communally rather than exchanged.  Once true exchange begins, there is a need to establish value of goods and services, even if it is for barter.  (I need to believe that the day I spent pulling weeds from your farm is equal the repair that you did to my wagon, etc.)  Bringing currency (e.g. paper money and coins) into the system just makes it more flexible, and less cumbersome to keep track of all of the actual exchanges and values in a barter system.  I can take the money I receive as a promise of value, and exchange it for any number of other goods or services unrelated to my original work.

The pattern of action that creates an economy, as a system, is exchange.  If the exchange stops the economy dies.  Much of the incentive that keeps exchange flowing is the need for goods and services that you cannot produce for yourself.  If we returned to living in communal tribes we could theoretically do away with economies – but we would have to get rid of most of the humans on the Earth in order to do that.  In the mean time, purified water and electricity and fuel and food and clothing mostly come from centralized production sources, and people need money to exchange for those, and many other things.

Moving from a simple economy of exchange, though, to the world of finance, complicates matters.  Systems of credit and debt let economies expand much faster than simple, direct exchange.  If I run a farm that produces grain, I could spend a significant portion of my time finding buyers and transporting grain to them.  If, though, I can count on you to sell my grain I can focus just on growing it.  Assuming that you don’t have the money to buy all of my grain outright I could decide to let you take it on good faith (credit) and pay me for it after it’s sold.  Alternatively, you could borrow the money from someone else (e.g. a bank), pay me now, and pay them after the grain is sold.  In that case, of course, you would have to pay them back not only what you had borrowed, but also an additional amount (interest) for the use of their money.  With the introduction of finance you have a whole new system – one that is related to the exchange of goods and services, but one on which money is used to make money.

The financial system, like the exchange of goods and services, has to remain in motion in order to survive.  If everyone went back to paying cash for all transactions, banks (if they existed) would become nothing more than centralized safes, for which people might pay a small fee.  If that were the case, though, very few people would ever have the kinds of houses in which they now live.  Most would find it impossible to save the money needed to pay cash for a house because they would have been paying rent every month in the mean time.  Likewise, businesses would have to accumulate cash in order to pay for materials and labor before goods and services could be sold, which would drastically limit their growth and the products they had to offer.  So the financial system became the lifeblood of the economic system, so to speak.

Loaning money to other people, though, is a double-edged sword.  It creates an income stream in the form of principle and interest that get repaid.  A $200,000 mortgage, for instance, repaid at 6.25% over 30 years creates over $243,000 in interest payments.  It also brings the risk that the borrower will not, for any number of reasons, repay the loan.  To offset that risk, lenders rely on legal contracts, binding borrowers to their obligations, and on collateral that lenders can theoretically repossess and sell if necessary.  On home mortgages, the houses themselves acted as the collateral, on the theory that they would be worth at least as much as the remaining principle of a loan if it went into default – a theory that got violated in the current financial meltdown.

Risk and reward became key principles in the financial system, and then turned into drivers of it.  The greater the risk that a loan will not get repaid, the more costly it will be for a borrower to get a loan.  This is not just a matter of poor character.  It also has to do with things like the political stability of the place in which a borrower lives.  Borrowers also become ill or die; businesses fail; buildings getting flooded or burn down, etc.  In a stable and predictable environment, the probability of such occurrences can be calculated with some accuracy.

One way to offset risk is through insurance.  In essence, insurers bet against the statistical odds.  Knowing that only a certain number of calamities are likely to happen in a given, average year, they could charge relatively small premiums to large pools of people and expect to pay out less than they collected.  In the mean time, the money that they held could be invested in other ways, allowing yet another income stream from it.  Being a regulated industry, though, they are required to keep substantial sums of money safe in order to assure that they could cover even extreme years of disasters.

Financial systems also involve many areas that are not protected against losses, such as shares (stocks) of publicly traded companies.  This has been the greatest pool of investments for businesses for generations, and also the central source of wealth for individual investors.  But here the risks and rewards multiply.  A good investment can multiply the money put into it many times over; a poor one can lose its entire value.  Theoretically, the value of publicly traded companies fluctuates according to their performance in free market systems.

Throughout the economic system as a whole there remains a basic principle – that the value of what is owned and traded has some rationality, even if it is exceptionally relative and fluid.  There are, for instance, formulas for calculating the intrinsic or fundamental values of an asset.  These values get forgotten when markets heat up at times, but only relative to the amount of excess capacity in the market (e.g. savings, business profits, etc.), or speculation.  When that capacity lessens, prices drop.  I may choose to speculate on a piece of artwork at an auction and find myself caught up in a bidding frenzy against another fanatic.  If I choose to pay an outrageous price to win the bidding I can hope that the artist gains popularity and favor with collectors, in case I decide to sell at some point.  But the price I can get at any particular point in time will be a factor of the desires of other buyers in the market – and of their ability to pay.

By some reports, at the height of the mania about tulip bulbs in Holland in the 1630s, one bulb cost the equivalent of $76,000.  Six weeks later, after the market crashed, it was worth $1.  This was the bidding frenzy and the reality of the market.  The ultimate price, though, was not a reflection of the financial capacity even of the very wealthy.  It was the result of speculation amongst those who saw the opportunity to make money.  Seeing prices rise, speculators with no interest in tulips per se took advantage of buying and selling, just as day-traders in stocks do today.  The extent of the mania in Holland has been questioned by later research, including the idea that it represented a “bubble” like the one that preceded the stock market drop in the US in 2000.  “For tulip mania to have qualified as an economic bubble, the price of tulip bulbs would need to have become unhinged from the intrinsic value of the bulbs” (http://en.wikipedia.org/wiki/Tulip_mania).  Apparently some research said that it did not.

There are aspects of speculation that seem to make sense.  If I know that I will need fuel for a fleet of vehicles in the future and I expect that the price of fuel will rise, it makes sense to pay less for it now.  If I don’t have any place to store it, it makes even more sense to pay a supplier for the rights to buy it at an agreed price in the future.  The supplier gets some money now and a known price for it then.  (This is what Southwest Airlines did, which gave it a great advantage over other airlines in recent years.)  The future price is a bet, and either I or the supplier will come out better on it, but it makes my future costs of business more predictable.

The point, though, at which trading becomes purely speculative, and unhinged from any intrinsic value, is the point at which the lines between investing and gambling blur to almost no distinction.  While many might argue otherwise, this is one interpretation of what happened with the development of derivatives.  Here’s a quick and simple definition:

Derivatives are financial instruments that derive their value from the value of another security or object. Futures contracts on pork bellies, crude oil, sugar, or copper, options on Wal-Mart or the S&P 500, and a bewildering array of securities linked to the movement of currencies, interest rates, housing prices, or even events—like the likelihood of a company defaulting on its credit. All these are derivatives (http://www.slate.com/id/2142158/)

Why would anyone take the risk of investing in something like that when they could own stock in a solid, blue-chip company?

The volume and investor interest in derivatives have soared in recent years for a variety of reasons, in part because stocks of big companies have been boring and less volatile. It’s difficult for professional traders to find much of an edge in the trading of Wal-Mart or General Electric when they simply move sideways over a several-year period. Meanwhile, commodities such as oil, natural gas, gold, platinum, copper, and ethanol have become highly volatile. The main way to play these markets is through derivatives. And the explosion of government and corporate debt in recent years has led to the development of new products that allow investors to assume or hedge interest-rate risk (http://www.slate.com/id/2142158/)

There seem to be two areas of significant concern and impact at the moment, which also converge in the middle of the problem.  One is the failure of major financial institutions, and the other is the collapse in value of individual homes.

AIG was the first of the public financial institutions considered too big to be allowed to collapse.   It actually operates as two separate entities – one a regulated insurance company, and the other a financial conglomerate.  In all, it held over $1 trillion of assets through operations in 130 countries.

What do you do with $1 trillion in assets?  Actually, you do two things at once.  You use it to make more money, and you try to protect what you have.  If you can do both simultaneously, you’ve done a great thing.  The common strategy for protecting assets is hedging – essentially betting for and against the same thing at once.  If you’re lucky, your wins pay off more than your losses.  As derivatives got more and more complicated, though, all of this got more risky.  The type of hedge that is blamed for a huge part of the latest problems is credit-default swaps.  These are:

…private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won’t be able to honor its obligations. Firms use these instruments both as insurance — to hedge their exposures to risk — and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.  One of the big new players in the swaps game was AIG, the world’s largest insurer and a major seller of credit-default swaps to financial institutions and companies (http://online.wsj.com/article/SB122169431617549947.html)

On the housing side, speculation had taken over as well.  Buying a house is the largest investment that most families ever make, and for a long time represented the greatest source of assets.  When real estate prices started rising rapidly, though, especially in places like California and Florida, both buyers and lenders began speculating – and we were back to tulips.  On the lender side, though, it got more complicated.   Mortgage companies apparently lost sight of any fundamental value at multiple levels.  They lent far more money to people than their incomes and assets would justify, and they lent it on houses that were priced well beyond what could be justified – except by “exuberance.” They then offset their risks by bundling and selling packages of debt to other investors (after all, they were long-term, steady income streams, right?)  This spread the risk, and later the damage, far into the economy as a whole.

And now the vicious cycles of feedback have begun.  Those once-attractive adjustable mortgages ballooned so that homeowners couldn’t pay them.  Banks started repossessing homes which no one wanted or could afford, starting the fall in the value of real estate.  Banks and pension funds and investors who bought the debt lost large portions of their investments, driving down stock prices and the markets as a whole.  Until the whole system begins to stabilize there is no way to value what remains, and therefore to calculate losses.  Until that happens, banks are reluctant even to lend to each other, much less to small businesses or individuals.  Even consumers who still have jobs and savings are reluctant to spend, slowing sales and growth of businesses, which will eventually result in job losses and less spending capacity in total.

And this is obviously not just an American problem.  Markets around the world have been suffering significant losses, waiting to hear how this is going to get resolved.  The numbers involved are amazing.  As of 2005, there were $140 trillion worth of stocks, bonds and other financial assets, worldwide.  Over $47 trillion of that was invested through institutions in the US.  Moreover, the US has been the engine of consumption for a large part of the goods produced around the world.  We are drowning in oceans of debt which there may be no one to pay.

As if we needed more, bigger dangers may loom in the future.  With baby boomers starting to retire, there is a $53 trillion debt for Social Security (there are no savings – it gets funded by deductions from current workers) and that debt rises $2-3 trillion per year.  It is not a pretty picture.

So where do you begin to target what is “real” – what will actually cause effective change – around all of the immense complexities and vested interests, in order to keep things afloat?

If the fundamental basis of the economy is exchange then that is what must take place.  The Bush administration seems to have believed that by encouraging citizens to “spend the country out” of recent economic slowdowns (prior to this actual collapse.)  That was the rationale for giving most Americans a special tax refund in the spring – increasing the national debt even further, of course.  The theory would seem to be that debt doesn’t matter, you just have to keep the economy active until it recovers on its own.  (That seems to be much akin to the idea that if you gamble long enough you’ll eventually win big and cover your debts, but I’m no economist.)

Ultimately, the economy survives on human activity.  So there would seem to be some essentials about the functioning of the system related to that.

The first and most essential function is captured in economics as risk – but in human terms is about trust.  Trust is fundamentally about the fulfillment of expectations.  Promises and agreements that get made are kept.  Information that is important gets disclosed.  A value that is asserted gets confirmed (e.g. “yes, it’s really gold”).  If I get cheated there is recourse, and so on.

At one level, people are not going to stop participating in exchange anyway.  At least half of the world lives in cities, and few people still know how to hunt, farm, or weave cloth for making clothes.  But the way that they approach exchange, even for basic needs, can be affected.

Much more at stake are the trillions of dollars of investments that have flowed through US banks and financial institutions.  They have been at the heart of an international financial system which created trust that a fundamental value for assets could be established, and that despite periodic fluctuations in markets, sound investments over time would grow.  That has been further evidenced by the importance of the US dollar as a key international currency, and the willingness of other countries to invest in it.

There is an aspect of “games” about economic systems.  They are an ever-emerging pattern of interactions between humans.  They exist because we participate in them.  But our trust in them requires that there be some basis of rules – of acknowledged patterns – by which they function.  Otherwise, there is no reason for people to save and invest for a time in the future when they are too old to work.

The danger of recent events is the perception that there is much more to be gained by manipulating the rules than by playing by them – that numbers in accounts have a reality unto themselves, with no need for a connection to the mundane things of life like sweat and soil.  That is an expression of ignorance or hubris, or both.  Left unchecked it could undermine the patterns of exchange in which people have been willing to participate, and tear at the very reality of economic systems.

One thought on “The reality of economic systems

  1. Wading into discussing economics systems certainly gets deep (and wide) pretty fast

    Since I am trained in economics up to the graduate level, I’ll give two opinions.

    (1) There’s a lot of bad economics amongst economists. The most simple-minded economists don’t make a differentiation between money and utility. Utility theory is at the foundation of microeconomics, and recognizes that (a) not everything can be monetized, and (b) preferences can be ordered (i.e. as ordinal utility) but not necessarily added up (i.e. cardinal utility).

    (2) There are too many economists who look at economics reductively, in the sense that they don’t take interactions with other systems into account. They should understand the influences of political economy and economic sociology. The latter is a much more recent field, where common practices of gift-giving and ritual are included. (Those concepts give economists lots of issues).

    That being said, I do like economics (when well done) as a way of understanding tradeoffs. I believe that books like Freakonomics help, where courageous economists can show up lesser thinkers.

    On speculation, you’re describing the paradox of value, where value in use (use value) and value in exchange (exchange value) are out of sync with each other. A pure free market economist might argue that markets will return to equilibrium, but Keynes said “In the long run, we are all dead”.

    I’ve been influenced by the thinking of Timothy F. H. Allen, who has said (something to the effect that) unlike economists, ecologists recognize that systems sometimes die.

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