The problem with traditional economic models – part 1

 

The reason why economics, as we know it, cannot be considered to be a science is quite simple – it cannot explain many features of existing economic systems but, worse than that, it cannot make any useful predictions about them.
The reason for this is that all economic models contain the same fundamental flaw in them. This flaw is so basic that it means it is only necessary to make a very simple adjustment to the model to reveal the problem.
What follows is an explanation of the simplest of economic models, then the flaw, then various economic problems that, at present, seem inexplicable but can be explained using the new model.

The traditional model

Any economy consists of millions of people, hundreds of thousands of businesses and a large numbers of organisations, including the government. To see how this works it is useful to sort things out according to their role in the economy. For example, a particular individual may be a worker who earns money, as well as being a consumer who buys goods and is a taxpayer. (The word “goods” as used here really means “goods and services”.) We can then look at the economy as interactions between the members of households and businesses even though many people will fall into both of these groups.

Doing this makes it possible to make a simple model of the economy. It then becomes possible to see how the economy (might) work.

Perhaps the simplest model is to see the economy as consisting of firms who employ all the workers and produce all the goods and households who provide all the workers and consume all the goods.

This gives us two circular paths. In one, work goes from households to the firms and goods go from the firms to the households. The other path is that money earned by the workers goes from the firms to the households and, at the same time, money goes from the households to the firms to pay for the goods bought.

Up to this point all of the amounts in this model be they goods, labour or money are “flows”. They are not static amounts but amounts over a period of time. For example, we are not looking at a thing such as “income” but the total income over a fixed period, for example, a year.

In this model, at this point, the money paid for goods has to equal the money paid for labour. (In this model there is nowhere else for money to go.)

Suppose some of the people decided, for one reason or other that they did not want to spend all of their income and they saved this money by putting it under their mattresses.

This would mean that there would be less money to spend on goods and so there would not be enough money to buy all the goods that had been produced. In this situation, the producers, who still want to sell all that they can produce, might want to reduce their prices but they can only do this, without reducing their profits, if they can reduce their costs. Often, the biggest cost is labour. So if there is a shortage of money to buy the goods produced this will tend to reduce the demand for workers as well as the wages of workers.

If the demand for goods is reduced it can lead to a reduction in wages that will reduce the demand for goods still further. Usually this is countered, to some extent, by several factors including increases in productivity and the creation of credit.

The next item to be added to the model is what we might sum up as capital. This is the total amount of all the things that are needed to produce the goods that are produced. This would include all land, buildings, machines and stocks of material. It also includes all of the knowledge that is used to produce goods. This would include intellectual property. It also includes all of the skills and the knowledge of the workers.

Whereas income etc, is a “flow”, e.g. so many pounds per year, capital is a “pile”, i.e., just an amount worth, say, of so many billions or trillions of pounds.

Various types of capital produce different types of returns to the owners of these various types of capital. For example, housing that is rented out would produce rent for the owner, shares in businesses would produce profits that would go to the owners. Those who saved money in bank accounts would receive interest. All of these are forms of income for these owners.

We can now say that the income of all of the households is the sum of the income that is earned plus the return on the capital being used. At the same time some of this will not be spent but will be saved.

We can now say that all of the income people have is either spent or it is saved. If it is saved it will invariably be invested. That is, it will be added to the existing capital stock of the society. This is because there is just not enough cash for people to be able to put it under their mattresses. Almost all savings will end up in the hands of a financial institution, for example, a bank and the bank always wants to invest it rather than sit on it.

(It is being assumed here that any depreciation in the value of a business’s capital is paid out of the revenue of the business.)

Traditionally, it is assumed that money not used to buy goods directly is invested and is used to buy land, buildings and machinery and pay workers in new enterprises.

In this case, all of the income earned by households will be spent directly by the households or it will be invested by them, one way or another, and will then be spent buying other goods that have been produced. Therefore everything produced will be consumed one way or the other. In other words, the overall demand for goods and services will, roughly, balance to the supply of them.

Often other details such as government spending, imports, exports, taxes etc might be added to this model but, it will be seen, that what we have here, so far, is sufficient to expose the problem.

Everything, now, revolves round the meaning of the word “invested”.

If someone starts a business then all of the money he spends will go into paying people to do things, it will be used to buy materials, pay rent and, possibly, buy machinery. All of these forms of expenditure are various forms of consumption. This is what is traditionally thought of as investment.

In this case, total income will match the amount spent on goods that are consumed and on investment that will consume enough to mean that the supply of goods produced balances the demand for them.

However when someone says he has invested some money in something, for example, he has bought some shares, this is quite different. In the vast majority of cases like this, when he bought these shares, he bought them from someone else. This other person has “divested” himself of his investment. It is significant that the word “divestment” was so little used it has been hi-jacked to mean selling a politically embarrassing investment. Similarly if someone buys a house it is usually one that is being sold by someone else. In both of these cases, no extra investment, in the sense of investment as described above, has been made.

The traditional argument is that if one person buys a house from another then the two sums cancel out – there has been no change in the value of anything. All that has happened is a change in the ownership of a piece of property.

At this point it might seem that we can treat this as not being an “investment”. This is how many books treat it. In this case all income can be seen as either being spent or as being (a real or traditional) investment. Both of these consume all the products produced.
We might refer to this as “real” investment because, as will be seen there might be other activities that might be thought to be investments but are fundamentally flawed as investments.

The problem is that “investing” in, for example, existing housing it not investment in the traditional sense and yet it is not a form of consumption. One way of treating this is to put it in a new category. Because it is not a form of consumption it might be seen as being a form of investment. But since it is not real investment we might call it a “fake” investment.

We now have two types of investment.

“Real” or traditional investment increases the value of the capital stock by the value of the investment. Added together these investments, overall, over time, produce a return on the investment, for example, in the form of profits. They increase the output of the capital stock. All “real” investments, overall, consume goods and services roughly by the amount invested.

“Fake” investments, by definition, only buy existing assets. The productive capacity of these assets stays exactly the same. So there is no return in the form of more profit. On the other hand, if large sums of money out of people’s incomes are used to buy existing assets which are relatively fixed (in the amount of them) then the price of these assets will rise. This process consumes almost nothing and as such provides no work for anyone, except, possibly, estate agents.

Another way of looking at this is to see that there is, within the whole economy, another flow of money that is far less conspicuous. This is that people who are earning money are saving some of it. But it is not being invested in the traditional sense. The two most obvious examples of this are that some of their income is being used to pay off mortgages and some is being used to pay for their future pensions. These are flows into the capital pile. The other side of the cycle is the money out of the capital pile in the form of pensions and capital gains made when they sell property and receive inheritances.

 

Consequences if one accepts the idea of “fake” investments

Firstly, and most important, is that within the economy as a whole, there is an acute and chronic shortage of demand.
In the traditional model, income that is spent and income that is invested add up to the total income so the demand for products appears to equal, roughly, the supply of them.
But, money invested in “fake” investments is money that is not being used to buy products that have been produced. This means that the money being spent to buy goods directly or by “real” investment is less than the total value of the goods produced. This is the deficiency in demand.
This deficient demand creates a constant pressure on employers to drive down wages. This is the prime cause of inequalities in the distribution of wealth and the poverty it causes.

Secondly, “fake” investments are, by their very nature, made in things that are risk free, for example, existing houses or established businesses. On the other hand, “real” investments are risky. They often involve new processes or technologies that are difficult for the investor to evaluate. If they go wrong the entire investment may have to be written off. The result is that, overall, “fake” investments become far more rewarding than “real” investments.

Thirdly, if the amount of existing assets, eg, houses, land, businesses, is relatively fixed but the amount of money available to buy them, ie “fake” investment, is significant then the price of these assets will rise even though they themselves have not changed at all. (I.e. their productive capacity has not increased).

These factors also interact in a very negative manner. The key parameter for making a “real” investment attractive is that there will be a demand for the product that will be produced by this investment. If there is a shortage of demand then this makes a “real” investments, overall, even less attractive than a “fake” investment.

In an economy where there are large differences in wealth the problem is made worse because the really rich cannot possibly consume even a fraction of their income. One might think they can and do buy houses and yachts but, of course, these are mainly “fake” investments. This surplus income is used to buy existing assets thereby, overall, increasing the value of these very same assets.

If people were forced to spend most of their income on goods and services that were then consumed then the economy would flourish. A system like this occurred during the Second World War. The government did whatever was necessary to produce as much as possible so that the entire productive potential of the nation was involved in the production of goods. Almost everyone was employed. Almost everyone earned enough money to live on. Vast quantities of goods were produced even though, unfortunately, most of these were almost immediately and completely destroyed.

It might seem that “real” investment must be the dominant form of investment and “fake” investment is just a secondary activity. If we consider that the vast majority of people hardly ever invest in the traditional (ie “real” sense) but do invest in the “fake” sense, that is, by buying existing assets through paying into a pension scheme or paying for a mortgage or buying shares in existing businesses we can see that the dominant form of investment is “fake” investment. “Real” investment is just a fringe activity.

 

The scale of the problem
The value of all residential property in the UK is about £5t. If this value rises by 5% in a year even allowing for new property, improvements etc, this totals about £250b. This represents a gain which people who own property received in the year but did not spend on goods that were produced but “spent” it on increasing the price of existing assets. (Of course a part of this increase might be due to acute imbalance of supply and demand in the housing market.)
This is, probably, a gross underestimate since it is very likely that a large part of the increase in the value of many types of other property such as land, existing businesses and works of art are due to the same cause. This is probably worth another £5t so the increase the “value” of this will be, again, about another £250b.
Not only is this a staggering generous gift to property owners but it is almost tax free to them not because there are no taxes on these gains but they are mostly avoidable. Capital gains tax and inheritance taxes are about £3.5b per year.
On the other hand, as will be shown, a large part of this money is “recycled”, for example, as pensions, so it is, ultimately, used to buy goods that have been produced.

A second measure of the scale of the problem is that the level of wages for most people is so low that most of them are dependent upon the state to pay for services, which the state regards as essential, such health, education, housing, pensions etc. These payments form very nearly three quarters of all government expenditure.

 

Problems explained by using this model
1 – The cause of low pay, unemployment and poverty

The most serious problem caused by deficient demand is that there is a continual squeeze on labour. Many producers in a market where there is deficient demand will always feel that he can only maintain or possibly increase his share of the market if only he can reduce his costs. One of his biggest costs is often labour. This leads to a continuous downwards pressure on labour.
This shows itself in two different ways. Firstly for many workers it is difficult to even maintain the level of their wages in real terms. Secondly, there is, always, a shortage of jobs. This leads to large numbers of people unable to find jobs.

There is an interesting side effect of this. Since for most workers there is a shortage of jobs, they are usually in difficulties if they lose their job. This means an employer can take advantage of a worker in this position. This is why many workers suffer from all sorts of abuse from an employer because to take any action against the employer could mean they might lose their job. A variation on this is that many employees are probably aware of criminal behaviour by the employer, for example, paying bribes, breaching health and safety laws, but cannot afford to take action for fear of losing their jobs.

 
2 – Why is there always a lack of investment?
It has often been suggested that British industry has, for a very long time, suffered from a serious lack of investment. The reason is that it has always been easier and safer and, probably, more profitable, to invest in property, i.e., a “fake” investment, than in a productive activity, i.e., a “real” investment.

3 – Why do we need so much credit?
The shortage in the demand for goods is not because people do not want to buy them but because too many people do not have as much money as they would like to buy some of the things they would like to buy. One way of increasing the ability of these people to buy goods is to lend them money.
This leads to a vast industry of lending money not only to individuals but also to the state. Of course, this cannot, in the long run, solve the problem as we have seen in the recent crash. History is full of schemes whereby “credit” is created but, in the long run, inevitably fails.

4 – Why do we need advertising?
The most obvious sign that there is a shortage of demand is that there is always plenty of anything anyone might want to buy.
If there is a shortage of money that is available to buy goods then, the producers of goods have a great incentive to go to considerable effort to get those who have money to spend to spend it on their products rather than on their competitor’s.
The most obvious example of this is advertising. We do not have people advertising that they want to buy something. There is no need. All advertising is about selling. It only happens because there is not enough money available for buying the goods that have been produced – ie, there is insufficient demand. In countries where there was more money than was needed to buy the goods available, e.g., communist Russia, there was no need for advertising.

This leads to other industries that are paid for by advertising. Newspapers are largely paid for by the advertising they carry. Most “free” radio and TV channels are paid for by advertising. These in turn pay other industries to provide material to attract audiences. Many sports are largely funded by advertising. Large parts of the internet are funded by advertising or collecting information about people that is useful to advertisers, for example, Google, Facebook, etc.

Of course, if there was sufficient demand, advertising would not be necessary to induce a buyer to buy one product rather than another. It would exist but mainly to inform buyers so they would be able to buy the most appropriate product for themselves.

If advertising, as we know it, did not exist, it would not necessarily mean that other services currently supported by advertising would disappear. Instead people would have more money and would have to pay directly for what they actually wanted.

The enormous role advertising plays in our lives is merely a sign of how large the deficiency in demand is.

About £20b a year is spent on advertising per year in the UK.

The cause of corruption
Many forms of corruption are, essentially, a process where a buyer is induced to buy one producer’s goods rather than those of another producer. This can only happen because suppliers have more goods they would like to be able to sell than the potential buyers are able and choose to buy.

Built in obsolescence
If the demand for goods is limited then a manufacturer producing, for example, cars, can produce cars so they have a limited life so the buyer will have to buy a new car rather than spend his money on something else.
Most of the car industry can be seen, not as making new cars, but as making replacement cars.
A car might have to be replaced because it is worn out but manufacturers then design new versions of their existing cars so the old ones become “out of date”.

The whole of the fashion industry is based on the same idea.

The effect of this on the environment must be obvious.

Innovation
One alternative to selling an existing product when the demand for it is limited is to come up with a new product that might be a preferred way of spending money rather than to buy existing products. The motivation for most innovation can be seen as a result of deficient demand.
We might see innovation as being a good thing. But, if we consider what the very affluent can already buy, we have to ask if they really need anything else. On the other hand there are very many people whose lives could be made incomparably better if only they could afford some of what is already in existence.
There are two main exceptions to this. One would be the production of new medicines and medical treatments. The other would be the preservation or restoration of the environment.

Why did countries need colonies?
Another way of getting rid of surplus goods is by exporting them. Since all economically advanced countries have a surplus of goods, great effort is put into exporting these. In the past powerful countries have found it useful to have countries they could dominate which would provide an exclusive market for their surplus goods. The outcome of this is colonisation. A colony provides a protected market for the surplus goods produced at home.
It hardly seems necessary to point out how many wars have been fought in order to acquire colonies and to force them to buy goods they did not really want.

The global free market
It might appear that the age of colonies has past. It has but what it used to achieve for the benefit of the richer states is now achieved by different means. This is the so-called “global free market”. Of course, a free market as conceived by Adam Smith, meant the free movement of capital, goods AND labour. The global free market might allow the free movement of capital and goods but certainly does not allow the free movement of labour.

How does the City of London make its money?
The City of London is one of the world’s largest financial centers. This is based on a long history of trading where businesses provided services to these traders such as insurance and banking.
Over time, these activities that once existed all over the country, have now been taken over by similar businesses that just happen to be based in London. At the same time laws came into being that made the possibility of starting a new business of this sort elsewhere impossible. The headquarters of all but one of the major banks in England are in London. Over the years they have taken over all the other banks. At the same time the banks have taken over almost all of the building societies. It is almost impossible for anyone outside London to start a new bank or a building society. Many people would be surprised to know that, once, most cities in Britain had their own stock markets.
This monopolisation and concentration of financial institutions means that almost any form of saved money, including cash in bank accounts, payments into pension funds and mortgage payments, ends up in the hands of a London based institution.
These institutions then use this money to buy assets of any sort. Doing this means that they not only receive any return, for example, rent or dividends on this investment but if the price of the investment rises this goes to the institution as the owner of this investment.

In short, the bulk of what passes for economic activity in the City is paid for by the rising price of the assets that are owned by city institutions. When one sees a room full of dealers busy buying and selling, they are mainly just buying and selling from each other. Any money they appear to make is from the inevitable rises the value of the assets that city institutions hold. For one dealer to make profit another probably loses a similar amount.
This frenetic buying and selling of essentially the same bundle of assets converts the inevitable, unearned capital gains from asset price inflation into what appears to be profits produced by the labour of a vast army of extravagantly paid bankers.

This also explains why businesses are always complaining that banks are so reluctant to lend them money. The answer is simple. The return to the bank by buying existing assets is far higher than it can get by lending to business. It is also far less risky.

Causes of inflation
Even if there were no other causes of inflation in the system, the existence of asset price inflation creates inflation by itself. Since most “fake” investment is in existing property (i.e. houses, buildings and existing businesses) the owners of this sort of property expect a return on it related to its continually inflated price.
For people in rented property this means their rents will continually rise.
This is particularly pernicious because, for many workers, rent is often a very large part of their expenditure. A 5% rise in rent when his rent is 50% of his income means a decline of about 10% in his disposable income.

Why do house prices continually rise?
One of the most anomalous features of the UK economy is the persistent, excessive rise in house prices. Part of this is due to asset price inflation. But it is made much worse because of the way that the amount of housing available has failed to keep up with the demand for it. The real problem is the way planning system works. The need for planning control is useful but the system has turned from controlling what is built into a system for preventing buildings from being built at all.

Since the population is continually rising from natural growth but also from immigration it is essential that the supply of housing at least increases in line with the population.
 

 

 

 

 

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