Money and the Economy

Now we move to the role of money in the economy. Keep in mind that the essence of an economy, from my point of view, is control. Individuals are acting to produce products (goods and services) that are consumed as inputs. Each individual controls for consuming a reference amount of these products. To the extent that individuals are doing this successfully -- consuming the goods and services that they want -- they are in control. When there is specialization, the products that individuals in the group want to consume are, to some degree, produced by others. This means that all individuals in the group depend on each other, to some extent, to be able to control their own inputs.

What each individual depends on is having others -- farmers, hunters, child rearers, cooks, etc -- who specialize in producing certain products -- grain, meat, care, food preparation, etc -- provide the products they want to consume but that they don't produce themselves. The obvious way for individuals to obtain these products is to trade their own products for those produced by others. This exchange of products (goods and services) is, of course, a market.

As I noted in my earlier post, the market for exchange of products in small groups can be very informal; like the informal exchanges that go on in a family group ("if you make dinner I'll set the table") this wouldn't even look like a market. Some people in the group just agree to specialize in producing one product (perhaps a service such as child care) while others agree to produce another (a good such as food). The child rearers take care of the kids while the hunters are out producing food, which they bring back and share with the child rearers. Despite the specialization -- which (as Adam Smith noted) improves the ability to produce goods and services but makes individuals dependent on others for producing some of the products they want to consume -- everyone is able to control their inputs successfully because there is cooperation.

True markets, where there is what I would call quantitative exchange of the goods and services produced through specialization, probably emerged as both specialization and the size of the economic group increased. I imagine that the first quantitative exchange markets involved barter, which simply means that each person would exchange some amount of the specialized things they produce for the specialized things that others produce. So the potter trades a pot for some amount of grain from the farmer and some amount of childcare from the caregiver; the farmer trades some amount of grain for the a pot and some childcare; and the caregiver trades some childcare for grain and pots. The amount each trades for each is determined by a "bid-ask" control process; the bidder has some reference amount (of his own product) that he is willing to pay and the asker has some amount (of his product) he wants to get. This interactive control process will generally converge to a point where the bidder pays about what he's willing to pay and the asker gets close to what he wanted to get. This market process, then, determines what each product (of specialization) costs in terms of all the other products. It is quantitative in the sense that the cost of each good or service exchanged in the market can be measured in terms of the number of other goods and/or services needed to obtain it.

I imagine that the market process using barter would be somewhat cumbersome, especially when the goods and services to be traded are hard to subdivide. If a camel is worth 2 years of grain, 2 years of childcare or 10 ceramic pots, how do you use it to get the 6 mos of grain, 6 mos of childcare and 2 pots that are the products you actually want to consume. The answer is "money"; a common medium of exchange that would let you "divide" the camel into smaller purchasing parts (monetary units). So if the camel is worth 1000 units, then 6 mos of grain is 250 units, 6 mos of childcare is 250 units and 2 pots are 200 units. If you can sell the camel for 1000 units you can buy what you need and have 300 units left over to get other stuff.

Money itself is just a symbol for what things are worth in terms of what other things are worth. All that the money units themselves must be are relatively small (so it's easy to carry or store many of them), durable (so that they don't rot away) and hard to counterfeit (for obvious reasons). This is why gold is a good monetary medium; it has all these properties. It also has the property of being valued in itself This probably led to the belief that money itself must have value. But this is clearly not true as the success of paper money attests. It's not really value that is needed but agreement (a reference or goal shared by all individuals) that whatever is used as money will be accepted in exchange for the goods and services produced by the group.

So, for me, money is just a convenient quantitative symbol for how much of one good or service is needed in exchange of another. The exchange rate -- how may fractions of a camel are needed to but 6 mos of grain, for example -- is determined by the market. How this market works seems to have been the main interest of economists. As a non-economist, I'm content to accept that the markets work (trough the bid-ask control process mentioned earlier). The market works in the sense that the "exchange rate" for goods and services is fairly constant over time (ignoring inflation and deflation for the moment). The market provides a fairly stable solution to the assignment of monetary value to different goods and services.

What is interesting to me about money is not so much how it gets it's "value" (how the market works) but the fact that it is a way of dealing with specialization. Money facilities control of the products people want to consume as inputs but that they themselves have not necessarily produced. So money allows me to go to the market and buy the food I have not grown, take a ride in the airplane I have not built and fix the car that I can't fix. I do this by purchasing these products with the money that I am paid for the specialized goods and/or services that I produce. Again, an economy is, I believe, all about control; but it's about that special kind of control where many of the products each individual wants to consume are produced by others. Money is just a means of facilitating people's ability to control this consumption (input).

The story would end there except that money introduced some interesting new capabilities (and problems) that have to be considered when trying to model an economy. I think the most dramatic new capability introduced by money is "time binding", to use Korzybski's felicitous phrase. In this context it may be better to call this "anticipatory control". Unlike many of the goods and services that money can buy (such as food and paper plates), money doesn't spoil (well, it can spoil people but the money itself stays the same). So it can be stored (saved). This saved money can then be used to time bind by being loaned to purchase goods and services now with the promise of payback in the future. This capability led to the development of a banking and financial sector of the economy. Banking and finance involve individuals providing products (financial goods and services) that allows them to control present inputs using outputs that will occur in the future. I'll try to deal with this in the next episode.

What is an Economy?

My ideas about economics start with imagining the simplest possible economy; a single individual human. I view this individual as an economy of one. Being a purposeful agent, this individual acts to control his inputs, the most important being those that are necessary for survival: food, water, and oxygen, etc. These inputs are controlled relative to specifications that are set autonomously inside the controller himself. In order to control, say, water input, the controller must vary his actions appropriately (going to different locations to find filled streams, building a cistern to collect rain water, etc) to compensate for disturbances (dried up streams, drought periods, etc) and keep the water input at its specified level.

This control process embodies the main components of an economy: production and consumption. The controller is acting to produce products that it can consume as inputs. So the simplest economy is the controlling done by an individual. At the level of the individual, then, economics is the same as psychology; it is simply the science of control. Economics separates from psychology once many individual controllers are involved. But it's not just the number of controllers that matters; what matters is how these individuals organize themselves into societies of controllers. As Adam Smith points out, the most significant thing about a collection of humans that makes up an economy is specialization in terms of production. From a control theory perspective, specialization means that now individuals in a group no longer produce everything they consume; part of each person's controlling is done by others. The individual who used to control his food input by doing his own hunting, butchering and cooking now depends on others to do this, while he takes care of producing other things, perhaps services like child rearing, which help control inputs for others as well as, possibly, himself.

Once we have specialization we have people depending on each other for the control of their own inputs; cooperation is essential. This makes specialization somewhat risky; non-cooperation by those producing the food could mean loss of control of food input by those who are specializing in child care, for example. But apparently people are very good at cooperating, at least in their own tribal groups, so specialization probably got started very early in human evolution. Small bands of humans were, thus, the first multi-individual economies, with some people specializing in hunting, others in food preparation, others in child care, etc. At this point there was probably no need for bartering or money; with very little specialization it is probably easy to share the fruits of specialization; the food producer just shares food with the child raiser and doesn't worry about how much child rearing is needed to get a certain amount of food. Anthropology might help at this point; it would be interesting to know whether there are small groups of people where there is some degree of specialization (division of labor) that allows individuals in the group to control for what they need (survive) without the need for barter or money.

So the essence, for me, of a multi-individual economy -- the kind of economy studied by economists -- is specialization, where each individual's ability to control their inputs depends, to a certain extent, on what is produced by every other individual. An economy is interdependent or "collective" control by a group of individual control systems. The interdependence is required by specialization. The success of this kind of control depends on cooperation; sharing. If the people who makes the food won't share with the people who take care of the kids, for example, then specialization won't work;it is literally every man (and woman) for himself (controlling alone).

Dear Robert Reich

Here's a little note I sent to Robert Reich in my never ending attempt to find out why economists think taxes are recessionary. Apparently, Reich doesn't think they are, which is a nice surprise. So I wonder what he knows that all the other economists don't. I don't really expect a reply from Robert. I also wrote to Paul Krugman and he hasn't replied, even though we share birthdays.

This is an excellent article, Robert. But I have one question. You say, regarding the conclusion of the Bank of America Merrill Lynch report that Congress and the White House should be careful not to raise taxes on the top 10 percent, that "this logic is morally and economically indefensible". I agree that it is morally indefensible but I wonder why you say it is also economically indefensible. All economists, liberal and conservative, seem to agree that raising taxes is always recessionary. I had always assumed that this consensus was based on data. But I recently did an analysis where I looked a the relationship between annual growth rate (dGDP/dt), annual top marginal tax rate (TR) and annual unemployment rate (UR) for the years 1947 to the present and got these results:

dGDP/dt w/TR.....0.18
UR w/TR...........-0.23

These correlations go in the "wrong" direction: increasing the top marginal tax rate is associated with increased growth and _decreased_ unemployment rate. Did you know about these relationships when you said that the recommendation not to raise taxes on the top 10 percent was economically indefensible? Are you the only economist who knows this? Why are not more economists using this readily obtainable data to rebut the lie that increasing taxes on the wealthy is recessionary? Why in the world have so many economists assumed that taxes are recessionary in the first place?

Rick Marken

Government, Business and Freedom

Here's some thoughts from William T. Powers that were "inspired" by some of my discussion of taxes. I think they are worth making a Mental Note of:

A sudden thought inspired somehow by this thread. Maybe it was the back-and-forth between government spending and private spending. It suddenly struck me that what is meant by "private" is not the consumer or wage-earner, but the dictatorships that divide the United States into both large and small power centers: businesses.

Businesses are not democracies. They are owned; their policies are determined by their owners. The rules that govern the workers are not voted upon; they are announced. The division of income between workers and owners is whatever the owners find they can get away with and still have the business function; the owners almost always take a share vastly larger than any one worker's share. When economic conditions reduce the owners' income, workers are simply disposed of and left to fend for themselves. Workers who complain publicly about the business policies, or who reveal illegal or dishonest activities by the business, can be dismissed without trial or hearing. Businesses compete; they do not work together for the common good.

I'm sure that many other aspects of the business dictatorships could be spelled out. Other terms, of course, could be substituted, such as kingdom or duchy or fiefdom, as long as the meaning is "control of the many by and for the benefit of the few." I think that is the main underlying conflict in the United States and elsewhere.

I wonder what would happen if this view were more publicly discussed?

Are Taxes Recessionary?

I recently saw another economist interviewed on the news last night who repeated the same old economic "truth" that all economists seem to believe in: taxes are recessionary. He said it in the context of a discussion of the weak economic recovery that seems to be starting in the US. At the same time as the economy is recovering (GDP is staring to grow) the deficit is increasing. It was in this context that this economist said that, of course, tax increases (to reduce the deficit) are out of the question because that would hurt the recovery.

I want to know why in the world to economists believe this? They must know that the modest tax hike implemented by Clinton (in 1993) had no adverse effect on the economic recovery happening at that time. Moreover, there is data, readily available at the Federal reserve economic data site (http://research.stlouisfed.org/fred2/), that should prove to anyone with a spreadsheet that taxes and growth are, at worst, unrelated and at best positively related (increased taxes being associated with increased growth).

Here is a little analysis I just did on the relationship between annual growth rate (dGDP/dt), annual Top Marginal Tax Rate and annual unemployment rate. I only had unemployment rate data back to 1947. Here are the relationships, expressed as correlation coefficients.

dGDPdt w/Top Marginal Tax 1928-2008 0.28
dGDPdt w/Top Marginal Tax 1947-2008 0.18
Unemployment Rate w/Top Marginal Tax 1947-2008 -0.23

The correlations are not huge; indeed, the second two are not even statistically significant. But I don't see how any economist could conclude from these correlations that taxes are recessionary. And all economists must be familiar with this data, right? It's pretty basic stuff. The first correlation shows that annual growth rate (since 1928) has been _positively_ related to the top marginal tax rate that year (the top rate has been as high as 94%; it's now 35%!). In other words, the observed growth rate of GDP increases when the tax rate increases; the observed relationship between taxes and growth is _non-recessionary_. Of course, this correlation does not mean that high taxes _cause_ high growth. But it seems to me that one is unlikely to conclude, based on this observed relationship, that high taxes cause low growth (recession). Nothing like that is observed.

The correlation between growth and tax rate for the period starting from 1947 (after the depression) is smaller than for the period that includes the depression, but still positive. Since the correlation is not significant, the best one could conclude from this is that there is _no_ relationship between taxation and growth. Yet economists persist in believing (and arguing) that taxes are recessionary. What gives?

I guessed that perhaps the economists mean that taxes are recessionary in the sense that increased taxes lead to increased unemployment. So I got the unemployment data (from 1947-2008) and correlated that with the tax data and found (to my surprise) that the correlation was _negative_; increased taxes are associated with decreased unemployment. This negative correlation is not significant, but that just means that one can't conclude that there is really any relationship between taxes and unemployment. Again, taxes are, at worst, irrelevant (unrelated) to unemployment or negatively related (increased taxes are associated with decreased unemployment).

This is what the data say. Why in the world do economists believe the opposite of what their data says? I think it must be because they trust their theories more than their data, which is rather amazing, considering that economists want to consider themselves scientists. Anyway, here's what might be a relevant aphorism for these economists from one of our great American poets:

Experiment escorts us last --
His pungent company
Will not allow an Axiom
An Opportunity
-- Emily Dickinson