Whats Wrong with Economics

In most sciences, the scientists make a model of the subject they are interested in, here, that includes applied sciences such as engineering. In some cases, actual models are made. An aeronautical engineer will make models planes, a naval architect might make model ships a chemist might make models of an atom using coloured plastic balls. In all these cases the scientists define the parts of the model and then work out mathematical equations to describe the relationship between these parts. Usually what is of interest is how if one part of the model changes what happen to the rest of the model over a period of time.

It is then possible to run the model and see how it would behave in the future. It is also possible to run it from a state it was in, in the past, and see if the result tallies with what we know happened later.

Economists also make models of economic systems. But they have a problem. They are looking at a system which exists, i.e. an economy, but they cannot change parts of it. But they can make a model of it. They can then make assumption of how it works and find mathematical relationships between the different variables. This can even be done on a spreadsheet.

The problem, in practice, with existing economic models is that these models can seldom explain many features of existing economic systems but, worse than that, they can seldom make any useful predictions about them either.

The reason for this is that all existing 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 these models 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. It is also worth pointing out certain things that this new model does not explain.

The following description might seem, at first sight, to be self-evident but unless the very first steps in a model are correct any subsequent steps stand on shaky foundations.

It might also seem that some details are included whilst others are excluded. This is true. But this model did not evolve in a straight line. It has been adapted and for each iteration the results have been tested. What is left is a model that produced some possibly useful results.

The traditional model

Any economy consists of millions of people, hundreds of thousands of businesses and a large number 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 also 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 businesses 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 businesses and goods go from the businesses to the households. The other path is that money earned by the workers goes from the businesses to the households and, at the same time, money goes from the households to the businesses to pay for the goods bought.

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.)

This is, of course, the essence of Say’s Law, which says, roughly, all income will be spent, one way or another.

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 certain 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.

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 is shown in fig 2.

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.

Notice that, in this case, money is leaving the system and goes into a sort of black hole. Of course, in this case, this would be nonsense. There would be no point in putting money under a mattress if it was to stay there for ever.  In practice, money that is taken out of this system, eventually returns as other forms of income such as interest, dividends, rent etc.

This is shown in fig 3

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.

In the diagram above, businesses, machines, land are represented by the box at the top. But the money flows associated with these businesses etc are separate and shown on the right. We could call this the financial sector of the economy. In real life a similar thing happens, a business might be in the north of England but the money invested in it might come from London. Similarly, its accounts may be in a bank in London and its profit distributed from London.

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 at any point in time.

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 dividends that would go to the owners – the shareholders. Those who saved money in bank accounts would, in normal circumstances, receive interest. All of these are forms of income for these owners of capital.

There is one other form of return. This is where the price of an asset rises. When this asset is sold the owner will receive, as income, this increase in value. This counts as a capital gain.

We can now say that the total income of all of the households is the sum of the income that is earned plus the return on the capital being used along with any capital gains.

Now all of the income, that is, earned income and income from investments, that people have is either spent or it is saved. Income is spent if it is used to buy something that is consumed either in the short term such as food or, in the long term, such as a car. Otherwise income is saved, i.e. not spent. If it is saved it will invariably be invested. That is, it will appear to be added to the existing capital stock of the society. This is because there is just not enough physical 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 will always find it more profitable 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 before profits are paid out.)

Traditionally, it is assumed that money not used to buy goods directly is invested and is used to rent land, buildings and machinery and pay workers in new enterprises. That is, the money invested is used to buy goods, including labour, that are consumed.

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 will, roughly, balance 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, the total income of all of the households will, roughly, match the amount spent on goods that are consumed and on investments that will consume enough to mean that the supply of goods produced, roughly, 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. (3) 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.

Or, as Keynes puts it:

If we reckon the sale of an investment as being a negative investment, ie disinvestment, my own definition is in accordance with popular usage; since exchanges of old investments necessarily cancel out.

The General Theory of…. P75

However, this might seem to be a not very important point but there are two factors that transform it.

Firstly, Keynes seems to assume that the supply of houses equals the demand for them so the prices at which they are bought and sold remains relatively constant. But, supposing, this is not the case and the prices slowly move upwards. Now, a person might buy a house at one price and sell it later for a higher price. He has now made a capital gain. His purchase of a house has now become an investment producing a return for him.

As more people do this more people will buy houses and soon they will be doing it precisely because of this return. Furthermore, the more people doing it the greater the return becomes.

Secondly, if this works for houses there is no reason why it should not be true for any other assets which are bought and sold without consuming any goods. Even though they may well produce other sorts of returns.

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 between them consume all the products produced. We might refer to this as “real” investment.

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 extra 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. This rise in prices will be referred to as “asset price inflation” from here on.

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 coming out of the capital pile in the form of pensions and capital gains made when they sell property and/or 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 a major cause of unemployment and the 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, e.g., houses, land, businesses, is relatively fixed but the amount of money available to buy them, i.e. “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). This is asset price inflation.

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” investment, overall, even more unattractive 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, country estates 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, either for immediate consumption or for real investment, 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, themselves, in the traditional (i.e. “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, for them, is just a fringe activity.

(It might be possible that most real investment is actually done by existing businesses using retained profits to do this).

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 (in normal times), because of asset price inflation, 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 other types of 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 in the “value” of this will be, again, about another £250b. So far, we have asset price inflation of about £500b. every year. To the taxman this sort of gain is known as a capital gain. 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 that are actually paid are about £5.0b and £3.5b per year respectively. On the other hand, as will be shown, some of this money is “recycled”, for example, as pensions, so this part is, ultimately, used to buy goods that have been produced. (2)

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 they can only maintain or possibly increase their share of the market if only they can reduce their costs. One of their 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 being unable to find jobs.

This leads to large numbers of people having living standards lower than they are happy with. This in turn creates pressure by these people for more growth in the hope it will improve their lot. It also creates uncertainty about their future prospects.

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 further consequence of 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 – Growth or the lack of it

It would not seem unreasonable to imagine that the rate of growth in the economy would be closely related to the rate of growth in the capital stock in the economy.

If investment buys assets that will produce a real return, i.e. real investment, then growth will be related to the amount of this investment. But most of what is deemed to be investment, at present, is only fake investment, which produces no real return – hence, negligible growth.

3 – 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.

Investing in property not only provides a return in the form of rent but there is also the rise in the value of the property in the form of asset price inflation. Furthermore, the risk of losing one’s investment is, in normal circumstances, very small. On the other hand, a real investment, e.g., a new business, will probably produce no return for an initial period, the return then might be not as much a hoped for and then the value of the assets of the business might well decline over time.

4 – 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 2008 crash. History is full of schemes whereby “credit” is created but, in the long run, inevitably fails.

5 – 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 – i.e., 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 £23b a year is spent on advertising per year in the UK.

6 – 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 that they would like to be able to sell than the potential buyers are able to and choose to buy.

7 -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.

8 – 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.

9 – 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.

The local population is then made, one way or another, to produce goods to pay for these imports. This is often at the expense of producing food for themselves.

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 passed. 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.

10 – How does the City of London make its money?

The City of London is one of the world’s largest financial centers (sic). 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 almost all 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 legally 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 and, in doing so, become the owners of these assets. 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, due to asset price inflation, then, 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 price of the assets that city institutions hold. 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.

11 – The 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 living 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.

12 – 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 size of the population. 

13     On printing money

Till recently it was widely believed that if a government printed money this would inevitably cause inflation. Recently some observers have noticed that governments have printed money on a large scale but this does not appear to have caused any inflation, so-called, “quantitative easing”.

Looking at the model described above the explanation is clear. Traditional models assume that total income is split into money spent and money saved/invested and that these two together equal the money spent on consumption. In this new model total income is split into money spent on real investment, money spent on fake investment and money spent on consumption.

This becomes clear if we consider the resources needed to produce goods. If in one year £X trillion in resources produces £y trillion of goods and £y*0.9 of this is used for consumption then next year the employers will only have £y*0.9 with which to pay their workers. In the simplest model, these workers are laid off and are unemployed.

But in terms of productive resources they exist but are not being used.

If the government prints £y*0.1 trillion and gives it to people who will spend it then the same amount of goods can be produced as in the previous year.

So, it would appear that, if the government printed a substantial part of this amount of money and handed it out to people who would spend it, this would not cause inflation.

( This does assume that money is spent on locally produced goods rather than imports).

Effectively, the amount of money “invested” in fake investments can be printed and used the fill the gap. (Allowance has to be paid to the fact that some of this money is recycled as pensions as mentioned earlier.)

This rather unexpected situation can be extended further. Suppose a society is dominated by a few monopolies making vast monopoly profits. The owners of these monopolies cannot possibly spend all of these profits so the money is invested. A lot of it will end up buying shares in these monopolies so increasing their apparent value.

At the same time the workers will not be paid enough to buy all of the goods produced by these monopolies.

However, it would be perfectly possible for the government to print the missing money and give it to the workers so it was spent.

Interest rates

It will be noticed that this model says nothing about interest rates.

Footnotes

3. It is significant that the word “divestment” was so little used it has been hi-jacked to mean selling a politically embarrassing investment.