A video dear to my teaching philosophy

This YouTube video on video game design touches on points that I think are important to all sorts of teaching and learning. For 'video games', read 'economics', and for 'controller', read 'mathematical model'.

This post pre-empted by the US election

On Thursday: Galbraith, pre-Raphaelites, economic theory and internet fanfiction.

Selling search

A few days ago I asked my students the following question:

It's well-known that internet piracy of music is rampant. How is it, then, that iTunes can make a profit selling songs at 99 cents each? Someone who can use iTunes presumably has access to the rest of the internet. Apple is competing with other producers of an identical product who offer it at a price of zero.

One young lady made a very insightful comment - she pointed out that Apple is not so much selling the music so much as charging a transaction fee for the use of a convenient, reliable and safe search engine. The content may as well be free; it's the search that is being sold.

Finding a song on pirate sites can be difficult, due to spotty labeling, broken torrents, virus-infested files and so on. iTunes users don't have to put up with any of that.

The flat 99 cents that are charged for each song tend to bear out the 'transaction fee' idea. Neither popularity, nor file size, nor the original source of the content affect the charge.

This is the same model that some academic journals use for people seeking PDF files of their articles. The journals also compete with 'free' producers: most academics have free access to these articles at work. There's a big difference in this market, though: buying the reprints from individual journals is a painful process, requiring separate registrations and payment schemes for each publisher. Accessing the articles via a work-place portal is not only 'free' (in the sense that the employer bears the entire cost, usually fixed) but vastly superior in efficiency. Library web sites and databases such as EconLit look through the contents of dozens of publishers for each search.

The biggest search engine of all is Google. Search is free, and content found through the search is usually free. This engine is supported through ad revenue, which I find curious. Though I use it many times a day, I can't remember the last time I clicked on one of the sponsoring ads, even by accident. I don't think I'm alone in this.

It's not unheard-of in the offline world for human tour guides to share their take with those providing the sights of note - iTunes's model. The journal publishers are individual stalls in a bazaar, competing with a supermarket. Google hopes that passengers on the trip will buy from the in-flight boutique, or at least burn into their memory the sponsored posters on the walls.

Economists and regulation

Perhaps not surprisingly, the recent financial crises (note the plural) has led more than a few people to think that tighter regulation of money matters may not be a bad idea.

What IS surprising, or has been to a few of my students, is that some of these people are professional economists.

To the general public, the word 'economist' is tied up very closely with 'free trade' and 'free markets'. That they may support regulation seems at first a contradiction.

In point of fact, economists are responsible for much of existing economic regulation. This includes everything from rules for monetary policy, to deciding on the guidelines for the approval of a merger, to controls on firms' pricing policies to encourage competition.

Economics is all about the efficient use of scarce resources. The 'stuff' we have - natural resources, time, knowledge, health and so on - is limited. The stuff we want is unlimited, and the needs of the world's population, while arguably limited, are not being met.

In some cases, leaving markets alone will get the job done, getting stuff where it's most needed or desired without too much lost along the way. That's great.

In other cases, leaving markets alone may result in waste, or inefficiency, or some other loss of the potential available to society, given what we have to work with. It's in these cases that regulation is welcome.

When it comes down to it, economists and environmentalists think rather alike. Our focus just happens to be on different resources, different needs, and different desires. Sometimes. Environmental economics and resource economics are flourishing fields in their own right.

Just as environmentalists, while generally preferring 'free nature', may advocate conservation programs, seed banks and so on, economists, while generally preferring 'free markets', will often advocate helpful regulation.

Financial markets and change

Lately, I've been re-watching an excellent series of videos on the Industrial Revolution. The show tries to explain, in part, why the Industrial Revolution happened in England, and not in, say, Holland or France, either of which would have seemed more likely candidates to contemporary observers.

Their answer is that many unusual ingredients were required to go from a pre-industrial, static world to an industrial one in which growth was expected. England happened to have them all at the right time.

One of these ingredients, the show argues, was the existence of modern-style financial markets.

In general, before the 15th century-ish we don't see much paper trading in Europe. No stocks, bonds, or other fancy financial instruments. When people bought something, it was usually because they actually wished to own the object or service in question. If someone paid for the construction of a church, it wasn't to 'flip' it. It was because they wanted a church there. There wasn't much lending for the simple reason that most religions frowned on usury, and the law of most lands paid at the very least lip service to religion.

All of this contributed to the static nature of society. Things didn't change because no one was willing to take the risk. People bought what THEY wanted, and not what they hoped other people would like. Producers produced to known tastes, with changes in style or technique being unusual and revolutionary. There were relatively few risky ventures. Society consisted of haves, and have-nots. If you had money, then you usually were in a position to continue to have it. There was no reason for you to risk tossing it all away on something that may not pay off. If you didn't have it, there was (almost) no one willing to lend you the money, because they wouldn't be able to charge a very high interest rate, if any at all.

In general, then, yes, I'd definitely agree that the existence of modern-ish financial markets is absolutely necessary for the kind of prosperous, innovative, dynamic society we've come to know and love.

That doesn't mean that it's without its pitfalls...

According to the video, the Dutch invented modern finance. I'm not sure I agree with this, but let's take it as given for the sake of argument. If nothing else, the Dutch were certainly popularizers of the practice.

Holland started trading paper. A lot of it. Prior to the 17th-ish century, when you bought a share in a ship's voyage, that's exactly what it was. Trading ships were expensive, and so were trips to the Indies, not to mention risky. You bought a share in the ship in order to share your risk with other investors. When it came back to port, you took the corresponding share of the profits from her cargo. If she failed to return to port... well, you had a problem.

The Dutch made popular the practice of trading shares in these ships. Cargo futures, if you will. Instead of holding them to maturity, you'd sell your share to someone else, who could then hold it or share it, and so on.

The same happened with other types of risk and stream of income or future windfall.

What was one of the first uses it was put to?

Tulips.

The video series dwells on this for quite some time. Essentially, what happened was this:

Tulips were new to the Dutch. They imported them from the East. Certain kinds of tulip had ink-blot-like markings. These were considered especially beautiful. ulips grow from bulbs. Bulbs all look pretty much alike and don't tell you what the future flower will look like. Today, we know it was the mosaic virus that caused these markings. Back then, the Dutch thought it was just random chance.

What took place next may look a little familiar...

At first, people bought tulip bulbs because they actually valued the tulips they might grow into.

People noticed that some tulips were selling for extremely high prices, and decided to start selling tulips.

Other people noticed the people who noticed the rise in tulip prices, and joined in.

The rise in people buying tulips raised the price of tulips - even though these people were only buying them in order to sell them at a higher price later on.

The higher the price became, the more people joined in the market, driving the price even higher, which attracted more people.

Eventually, it all fell apart when a few people decided to... NOT pay the price of a house for a tulip bulb.

The Dutch economy went through a crisis, and people left holding tulips lost everything.

This type of bubble happens over and over again.

It's always caused by a large sum of people buying an asset only in order to sell again, without ever intending to act like an owner of the asset.

The bubble gains momentum when the relative price of the asset that is being traded rises for an extended period of time. (The relative price is the price of the good compared to the price of other goods in the economy. Let's say that tulips and onions both start selling for a dollar each. If the price of BOTH goes up to 2000 dollars each, that's not very interesting. If the price of ONLY tulips goes up to 2000 dollars, while that of onions stays at 1 dollar, then there's a problem.)

The tulip bubble is striking because everyone KNEW they were just flowers, and yet jumped in anyway.

The lesson? Buying to sell to others who are buying to sell is a good way to start a disaster. Modern financial markets make this easier than in earlier times, but in the end, the responsibility lies with the investors.

That's easier said than done, of course. It's difficult to stay out of it when someone tells you, 'sell me tulips, even if you think they're over-valued and part of a bubble about to crash, and I'll give you a hefty management fee'.

A tale of two Cities

Because they are self-contained economies, online games can lead to interesting natural experiments in economics.

Consider 'City of Heroes/City of Villains'. As the name suggests, this single game is divided into two distinct parts: good guys and bad guys. Subscribers to the game pay a monthly fee for the privilege of pretending to be a hero or a villain. The game world is shared by thousands of players, leading to a vibrant artificial economy.

The economy is set up as neatly as an economics instructor could hope for. The 'City of Heroes' and the 'City of Villains' may be thought of as two closed economies. Each produces the same products. Handily enough, these fall into the textbook favourite of two categories: recipes and salvage. For the present discussion, it does not matter what these goods actually are, only that they exist.

As in textbooks, the only input required for the creation of these outputs is time. Heroes 'arrest' bad guys and villains engage in nefarious acts to produce these goods. For various reasons, the City of Heroes has an absolute advantage in the production of recipes. In particular, heroes have easier access to certain rare recipes than villains do. Heroes and villains produce salvage at roughly the same rate, though arguably heroes have an absolute advantage here, as well. Anecdotal evidence suggests that heroes tend to work in teams more than villains, leading to factory work (heroes) vs cottage industry (villains).

One quirk is that salvage and recipes are complementary in production: if you make one, you generally make the other, as well. For heroes, the recipe/salvage production ratio is on the whole larger than for villains. (For those in the know: due to quick Katies, etc.)

Each City has its own currency. Goods are traded for currency anonymously on a consignment market, under a system that is very close to a Vickrey auction. Sellers post their goods along with a reserve price. This reserve price is not visible to buyers. If a buyer places a bid at or above the lowest reserve price, the good is sold at the bidded price to the seller with the lowest reserve price. That is, this system encourages high bidding by buyers and low bidding by sellers. There is no penalty for changing a buyer's bid, but sellers are subject to a transaction fee for each time they change their price.

While the prices at which items are posted by sellers are not visible to other players, buyers have easy access to the prices at which the last five units of the item have actually sold.

Market prices in the City of Heroes are generally much higher than in the City of Villains. The exception is for certain rare recipes, which due to their scarcity and some differences in tastes are far more valuable for villains than for heroes. (For those in the know: Pool C drops and Pet Damage IOs go for a lot more villainside.)

Scarcity is a constant problem in the City of Villains. There are far less producers (that is, there is a lower population) than in the City of Heroes, and so many goods are not available at any price.

There has been some demand for a merging of the two markets - that is, opening them up to trade. Most opposition has come from dedicated merchants on both sides. These are players who spend a considerable fraction of their time in arbitrage, buying low and selling high - essentially ensuring that the market in each city functions like a market.

Salvage traders in the City of Heroes worry that the price of salvage will drop considerably if there is trade between the Cities.

Most dedicated traders in the City of Villains worry that the entry of more producers (and traders) will lower their profits - right now, the villain market functions much like an oligopoly.

What does basic economics tell us about what may happen if the markets are merged?

First, for the easy part: water seeks a level, and so do prices. If the markets are merged, we can expect hero prices to drop and villain prices to rise, with the exception of the rare recipes mentioned above, in which case the effect will be the opposite.

The more interesting question (for me, at least) has to do with the nature of the money supply, and the speed at which currency changes hands.

The minting of money in the game is very different than in the modern real world. There is no central monetary authority. Instead, players mint their own money. Every time heroes 'arrest' a bad guy or villains mug someone, the game creates new currency and deposits it in the player's account. These are the same activities that also generate salvage and recipes.

In other words, in this virtual world, the money supply rises automatically with the production of goods.

There are some money 'sinks', of course, to ensure that inflation does not get out of control. There are transaction fees, luxury and vanity services that may be paid for and so on. Perhaps most importantly, there are no inheritances. When a player stops susbcribing to the game, the currency in their account is taken out of circulation. There are also restrictions on the transfer of currency between players. It is possible, but intentionally cumbersome and potentially risky.

The Fisher equation, beloved of economists, may provide considerable insight into what's going on.

MV = PY, as the saying goes, where 'M' is the money supply, 'V' is the velocity of money - that is, the speed at which money changes hands, 'P' is the price level, and 'Y' is output.

All this equation says is that, all in all, the value of transactions in an economy (the left-hand side) must add up to the value of output (the right-hand side).

For the purposes of our game world, 'Y' is the aggregate of recipes and salvage.

The same process mints money and produces good, so let's suppose that the money supply is some multiple z of output. That is, suppose that whenever salvage or a recipe is produced, so are z units of currency.

Our equation becomes

(zY)V = PY

Dividing both sides by Y,

zV = P

We now have a formula for the price level.

I mentioned that heroes produce recipes more easily than villains. In a half-hour period (the time for a 'quick Katie' task force, an activity which guarantees the produciton of a recipe by each player), heroes can produce more recipes than villains. The amount of currency (and salvage) produced in this time period is much the same for heroes and villains.

Since z represents M/Y, the money supply over output, z should be smaller for heroes than for villains.

If V is the same for heroes and villains, this suggests that heroes should have lower prices, overall... but they don't.

There are two reasons for this.

One is simply due to my simplifying assumptions. I assumed that all recipes are the same, where in fact heroes only have an advantage in producing a particular subset of all possible recipes - and these are, indeed, lower in price for heroes than for villains. The lesson: be very careful in your assumptions when trying to apply textbook economic models.

The second, more interesting reason, is that the velocity of money is drastically different between heroes and villains. The population of the City of Villains is much lower than that of the City of Heroes. Despite the two cities having similar (but not congruent) tastes, the variety of goods available for sale is much greater for heroes than for villains. All in all, this means that the market is far more active for heroes than for villains, and in turn, money changse hands far more frequently among heroes than among villains. There's more stuff to buy, and it's bought more often.

In terms of our equation, V is higher for heroes than for villains.

Let's look back at the original equation:

MV = PY

Rearranging this,

P = V x (M/Y)

What this tells us is that the higher the speed at which money changes hands, the higher you can expect the price level to be.

If the markets in the City of Heroes and the City of Villains were merged, we should expect the speed at which money changes hands to increase overall, due to the larger effective population of each market. This, everything else being equal, WILL lead to a rise in the price level of BOTH cities.

City of Heroes/City of Villains is quite a popular and active game, and new players join all the time.

There is some worry that if prices keep rising, new players, who start with no currency, will be priced out of the market.

This will not necessarily be the case, of course. Since new players automatically become producers of salvage and recipes as they go about their adventures, a high price level means that they receive large amounts of money for the goods they sell, as well as being charged high prices for those they buy. As any self-respecting economics student will tell you, the absolute price level matters very little: it's relative prices that you need to watch.

Still, there are some valid reasons for being worried about the price level. Suppose that the 'government' - the game's developers - wished to step in and keep the price level below a certain threshhold. What can they do?

They could adjust the rate at which money is minted. By lowering z, they may lower the price level.

They could place additional restrictions on transactions, lowering the speed at which money changes hands. For example, they could code in a law that required a cooldown period of an hour (say) after any transaction involving currency, however minor. This would be annoying for players, but certainly has the potential of lowering the price level. It could also have the perverse effect of raising the price of many items. Since the market works as a blind auction, bidders may choose to bid values very close to their actual valuation of the good in question, since they may not have a chance to do so again before the end of the auction.

They could flood the market with goods, lowering their price. I have a sneaking suspicion that they already do this for certain items. Some salvage is only available for production in October. One would expect that as time went on, the price of this salvage would rise, and then fall as October neared again. Instead, the price of this salvage has stayed remarkably constant. Other prices in the market have been very volatile, but the price of this salvage has stayed at 300,000 units of currency for months, only falling again in October, quite suddenly, to 50,000 units. This suggests that the game's developers have used their control of the game world to create 'helicopter drops' of this product in exactly the quantity required to keep its price constant, and affordable. This is a rather roundabout, but quite effective, way of enforcing price controls. It works here because the goods are entirely identical, may be created by the government at zero cost, and cannot be created by the citizenry except during the month of October. These conditions are unlikely to hold in the real world, where, alas, price controls seldom work.

Another possibility: due to their absolute control of the game world, the developers may have set the price of that salvage to be equal to 300,000, no matter what. This is less likely. Due to the way in which the market works, it could be discovered by players attempting arbitrage. Such a discovery would have led to scandal. Quantity manipulation works better than price-setting because due to the anonymous nature of the market, it is not possible to tell who put a particular item up for sale.

Textbooks, lectures and problem sets are, of course, essential for obtaining a detailed understanding of modern economics.

There's a lot to be said for spending some time in these 'sandbox' economies, though.

A quickie

Don't Panic.

That's my advice to everyone asking for economic advice.

Really.

If something happens to you, personally, then by all means react to it.

If something specific is on the horizon that you need to plan and prepare for, by all means, please do so.

Preparing for vague 'hard times' because the TV says they're coming?

Well, that's half the reason bad times may be coming, right there.

Positive thinking isn't all that powerful in many situations, but in economics, it is.

If people think times are bad, then they'll spend less and invest less. This will ensure that times ARE bad for businesses that make a living by selling stuff to consumers and investors.

Even if everything was just fine and dandy before the gloominess, pessimism WILL see itself justified.

If people think times are going to be fine, the whole thing happens in reverse, and even if something DOES happen to go wrong, things will turn out better than they otherwise would, for the economy as a whole.

In brief: if there's something specific that you need to react to or prepare for, please do. If you wish to buy into the general gloom just because the media says you should, please don't.

If you THINK there's something specific about the current economic climate that you need to prepare for or react to, but can't tell what it is, then this is a perfect opportunity to invest in an education in economics.

(Disclaimer: these views are mine and mine alone, and don't represent those of anyone else. What's more, my personal views tend to change rather quickly, so they may not even represent my own thoughts, a few days from now.)

Malthus, price levels and the gold standard

(This will end up being posted on Wednesday, but I started writing it on Tuesday, honest!)

Lately, I've been reading Thomas Malthus's Principles of Political Economy (full text available at the link).

It's a fantastic book on basic economics, written before math was introduced to the subject. In fact, there's a brief section where the author wonders whether formal math should be introduced into 'political economy' at all, since the clarity it brings is at the expense of complexity.

What makes the antique text blogworthy at this particular point in time is what it has to say about price levels.

There are more than a few intelligent people of the opinion that much of the current (and past) financial turmoil was caused by leaving the gold standard.

Before the mid-twentieth century, most currency in the world was backed by silver, gold or a combination of the two. Effectively, this meant that there was a global currency. France may have its francs, and China its taels, but if both were convertible into silver at a fixed rate, then they were just placeholders for the true currency, precious metals.

This is what the 'gold standard' meant: that you could exchange paper money for a known amount of gold at any bank. There was never more money than there was gold. Because gold is a rare metal, many countries found it useful to use silver, as well. The rate of conversion between silver and gold was well-known.

This system collapsed during the Great Depression, in an interesting way that is too complex to summarize in this brief post.

These days, most currencies aren't backed by anything except the government that issues them. In daily practice, this works out pretty well, with some spectacular exceptions.

It used to be that money worked like the market for precious metals, because money WAS precious metals.

Now, money works more like the market for baseball cards, or artistic prints. If a government prints a lot of money, the currency becomes less valuable, just like if a baseball card company printed large numbers of a particular card. This is what's going on in Zimbabwe right now. If a government keeps its printing under control, then the value of the currency can be kept as high as it likes. Witness the British pound.

The argument for returning to a gold standard is that the current system is inherently unstable. Trusting governments to print the 'right' amount of currency has not worked, and instead has led to wild swings in prices, and in currency crises such as that in south-east Asia in 1997.

As far as the argument goes, there's certainly a lot of truth to it. If nothing else, a gold standard would make situations like Zimbabwe's current difficulties impossible... as long as countries stuck to the standard. The reason it collapsed in the first place was that, faced with financial crisis, several governments decided to abandon the standard.

(This is similar policy response to that seen in 1997. Several countries in the crisis zone had tied the value of their currency to the value of the US dollar, and abandoned that standard when under speculative attack.)

Suppose that the world did revert to a gold standard, and stuck to it.

...

Actually, that's a very complicated theoretical exercise. Instead, let's make things easier. Let's go back to a point in history where the world WAS on a gold (and silver) standard. The economic literature of the time should give a good idea of whether this brought price and financial stability.

This is where Malthus fits in. He was a keen observer of current events, a careful thinker and a compelling writer. The sections of his work that treat with price levels and financial crises of the time are eye-openers: in practice, the gold standard led to surprisingly volatile price levels, as well as the occasional currency crisis.

I've linked to the entire book in PDF form, so it's simple enough to search for 'gold', 'specie', 'silver' and 'currency' and read the relevant sections yourself, but I'll summarize one of his arguments, which struck me for its insight and simplicity.

Malthus noticed that prices in England, a wealthy country, were a lot higher than prices in poorer countries. He wanted to know why. After all, England was the workshop of the world - if it could produce things more efficiently than Sweden, say, then why was everything so much cheaper in Sweden?

The reason given by Malthus? Currency movements. Precisely because of the gold standard, these were very easy to think of and keep track of.

For the sake of argumetn, suppose neither England nor Sweden mined gold. England's goods were in very high demand by the rest of the world. As a result, other countries bought England's goods and paid for them with their gold. On the whole, gold flowed fromt the rest of the world, into England.

What about Sweden? Its economy was based on copper, wood, fish, small amounts of high-quality iron and other natural resources. It was nowhere as wealthy as England. In fact, it had to import many goods - gold tended to flow out of Sweden.

Note that I've only talked about gold movements. Since I assumed neither England nor Sweden produce gold, these movements do not affect production in either country.

Relative to the goods available at home, there is very little gold in Sweden, and a lot of gold in England.

By definition, the gold in each country MUST be enough to buy everything traded in that country. (Remember, the only currency IS gold.) The large amount of gold in England means that gold is relatively 'cheap' in terms of goods: price levels must be high. The small amount of gold in Sweden means that gold is scarce there: a small amount of gold must be able to buy more goods. Prices are cheap.

A really neat, simple argument, and evidence of puzzling price differences under a global gold standard.

I've simplified the argument considerably - Malthus is extremely careful in his thinking, as I mentioned, and he goes over all sorts of possibilities, variations and extenuating circumstances.

Definitely worth a read. Especially if you're currently of the mind that changing back to a gold standard will fix the world's currency-related problems.

How will the financial crisis affect YOU?

There's a lot of talk in the media about what's in store for banks, governments and financial institutions, but surprisingly little about what will happen to the average consumer. I don't mean in a vague way, such as 'loans may be harder to get', but in how you'll notice that there's something odd going on when you walk into the supermarket or try to get a part-time holiday job.

Let me try to help with that. Before I focus on consumers, though, I'll need to share some background on what's going on with firms.

One of the biggest things that's going on right now, as far as consumers are concerned, is the frozen market for commercial paper. Just like people, companies are occasionally short of cash for the day. If you go grocery shopping and find out at the till that you don't have enough cash to pay for what you put in your basket, then chances are you'll pull out a credit card. It's not that you're bankrupt; you just don't have the cash at that particular moment, and a credit card is a convenient way to borrow small amounts of money for short amounts of time. As long as you've been paying your credit card bills on time, there's very little reason for the card to be declined.

A company's equivalent of a credit card is 'commercial paper'. Let's say that Starbucks finds out on Wednesday that it doesn't have enough money to pay its workers on Friday. There are many non-scary reasons why this might happen. Starbucks may have a lot of its cash tied up in loans to other companies, or in long-term investments. Maybe some unexpected bills have come in. It could be that Starbucks itself is paid on Friday. In this case, it'll issue commercial paper: a very short term, very safe IOU. In the ordinary scheme of things, it isn't difficult to find a buyer for this IOU. If Starbucks says, 'Lend me a million dollars on Thursday morning, and I'll pay you back on Friday evening, with a thousand dollars' interest,' that's pretty much a free thousand dollars.

Or so you'd think.

Not too long ago, a whole bunch of lenders were burned when the company they lent a large amount of money to overnight went bankrupt - also overnight. (I think the company in question was Lehman Brothers, but I may be mistaken.)

This sent the financial world into a panic. There's a lot of money out there that WANTS to be lent (because loans earn interest). The problem is that no one knows who is safe to lend to, anymore.

The situation's very much like that of a person who fell in love, trusted the object of affection, and then was betrayed, only finding out when they woke up one morning to find their wallet emptied and the car keys missing. Lenders are in the 'I'll never love anyone ever again' stage of things.

The markets for commercial paper are pretty much frozen. Very few people are willing to make these short-term loans right now. Not even to really big, well-known companies such as McDonald's. Not even at a higher-than-usual interest rate.

What does this mean for consumers?

For the near future, companies in general are going to have to be a lot more cautious. They can't afford to run out of money, not even for a few hours, because no one is willing to lend it to them.

The first thing that comes to mind is that we're likely to see drastic reductions in what stores keep in stock.

That jalapeno jelly at the supermarket that you love, but no one else ever seems to buy? Gone. Your favourite obscure retro-steampunk-jazz-opera group that HMV always kept a few CDs of? Gone. The lonely copy of 'Care and feeding of elderly komodo dragons, a multivariate regression analysis with thirteen statistical appendices' at the local bookstores? Fuggedaboutit.

Stores will do everything they can to avoid being stuck with unsold goods. Bookstores will stock bestsellers and proven classics in overwhelming preference to anything else. Music stores, already hurting from the online onslaught, will focus on top 40 hits. Supermarkets will try to carry only fast-moving products.

The good news? You'll probably see a lot of clearance sales in the next few weeks as stores try to dump their poor sellers in order to open up inventory space for safer products. Enjoy them while they last.

If you're reading this, you have online access, and are probably able to shop online at places like Amazon. In that case, the loss of variety in stores won't affect you as much as everyone else. If you want your obscure Brazilian soap opera translated into French, you can probably find some place online that sells it, and don't need to rely on bricks-and-mortar establishments.

Less good is the impact this has on new, quirky stores.

I enjoy window-shopping and walking through the commercial parts of town. A lot of the fun comes from stepping into really weird stores that sell things you never suspected existed. (Hush, you. I mean the family-friendly sort of weird.) As fun as such stores are, they have very short life expectancies. With the current freeze on loans, chances are a lot of them will never be 'born' in the first place.

If it's difficult for established businesses to get loans, it's almost impossible for new and unproven businesses to do so.

A lot of stores that WOULD have opened if loans were more easily obtained, will now not open at all. The salaried accountant dreaming of starting his own flower shop will now have to continue dreaming, since a lot of the financing required to start up a business is (temporarily) unavailable.

When you're talking about one flower shop that doesn't get built, it's not so bad.

When you multiply that by all the new businesses that WOULD have started up all over the country, continent and world...

Well, we're going to see less jobs available these holidays. It's probably going to be noticeable if you're out there on the job market. I don't expect the jobs in the economy to actually fall - I don't think a lot of companies will actually fire their workers, at least in Canada... However, there will be much less of an increase in the number of jobs than there would have been without the crisis. People that would have hired, won't hire.

Related to this, you can also expect franchises to stop expanding as quickly as they have in the last few years. If you were hoping for an extra twenty Tim Horton's stores in Yellowknife, you're probably out of luck. Then again, the Tim Horton's nearest me seems to constantly have a lineup, even when other food outlets are doing poorly, so that may be one of the few exceptions...

Due to the inability for companies to get loans, I also expect a fall in the amount of courtesy services, freebies and promotions that are offered. Coupled with this will be a general rise in prices. Both of these will help to cushion companies against possible drops in their now-vital pool of reserve funds.

What does this mean? Coffee shops that used to give a free chocolate square with their drinks might stop doing so. Airlines will continue to cut back on things provided free of charge during flights. The Body Shop has already started charging a small fee for 'gifts' they used to give for free to shoppers who bought many products at once. Two-for-one promotions will become less generous. You may have noticed HMV moving from 2-for-40 to 2-for-60 for similar products in a short amount of time.

I suspect that stores will do what they can to keep posted prices from rising too quickly. They know this can drive away customers, especially if they're one of the first establishments to raise prices. It really looks bad if you're selling a DVD for 30 dollars when the store across the mall has it for 20, even if the store across the mall is THINKING of raising their price to 30 next week. Instead, prices will be raised less directly when possible. Reward or 'points' programs will be made less generous in difficult-to-understand ways. A planned 50% off sale may become a 40% off sale. The cosmetics department may offer half as many free makeup workshops this year than last year. That sort of thing.

That's not to say prices won't go up. They WILL. Not being able to get short-term loans means businesses need to keep around a pile of cash for rainy days. That pile of cash is an extra cost. At least part of the extra cost will be passed on to the business's customers. It's just that price tags won't go up by as much, or as quickly, as you might expect.

I have the nagging feeling that I've forgotten a lot of important consumer-related repercussions that I wanted to mention... Feel free to remind me of them in the comments!

Update: Frosted animal cookies have fallen prey to the commercial lending freeze.

Is the CBC inducing a recession?

Disclaimer: More so than the rest of my posts to date, this one is almost entirely opinion. There are many other equally valid views.

I'm an avid CBC Radio 2 listener, and was dismayed to hear their recent news programs focus on Canada's risk of a recession. My disappointment grew as I headed over to the CBC's web site and found several prominent articles on the subject.

Canada's economic fundamentals are sound. Not perfect (no country's are), but sound. Unfortunately, this does not make Canada safe from the antics of panicked investors.

At any given time, in a healthy economy, a lot of money is in motion. Not all of it moves at the same rate. Some money, such as that in chequing accounts, moves quickly. Other money is temporarily frozen in the form of bonds, or tied up in loans that cannot be called in on short notice. These days, foreign money that is invested in Canadian capital tends to be surprisingly mobile. Trading in Canadian assets is brisk; not a big surprise given our strong focus on commodities.

This system can be gummed up by a trusted source crying 'recession', just like the exits to a crowded theatre can be gummed up by someone crying 'fire'. It doesn't matter in the least whether the cry is actually true. All that matters is that it is believed temporarily.

Suppose, for the sake of argument, that Canada's economy is doing just fine, and that investors (domestic and foreign) trust the CBC as a news source about Canada. What happens if the CBC starts saying, loudly and often, in print, on the air and online, that Canada is entering a recession?

Domestic investors may delay their investments. If a bakery was thinking of buying a new bread machine, they may decide to put off that purchase. In a recession, people buy less of everything, including bread. They may also reduce new hires, for the same reason. Result: lower investment and unemployment. The announcement causes the very symptoms of a recession.

Foreign investors may, using similar reasoning, decide to pull out of Canada, or at the very least invest less in Canada than they would have otherwise. That's another induced slowdown in growth.

If (I admit this is a stretch) fears of recession in Canada are tied to fears of US-style bank failures, this may lead people who can afford it to pull their money out of Canadian accounts and into bank accounts in other countries. This may be enough to start a general bank run, causing banks to fail, even if these banks were perfectly healthy beforehand. Generally, banks only keep 10% or less of their deposits on hand as ready cash. The rest is out as loans. Many of these loans take time to call in, so a bunch of depositors asking for their money back at once will break the bank.

There's some evidence that the general public is losing confidence in Canadian banks. The stock value of Canadian retail banks has fallen drastically in the last few days. The timing is consistent with the start of news stories about a possible Canadian recession.

The prediction of a recession or a bank run is too often a self-fulfilling prophecy.

In the CBC's own words, "The mere mention of the word can cause serious jitters for Canadians who have a job, invest in mutual funds or are thinking about making a big purchase."

Exactly. So it'd be really nice if they'd stop mentioning it until it actually happens.

Talking about a recession once output has actually fallen - that is, during the recession itself - is just fine, and may actually prove quite helpful.

Talking about specific, well-defined economic issues that may lead to a recession is also great (e.g. 'Hey, maybe unregulated credit-swap markets aren't the way to go...').

Merely lumping together the punch lines of gloomy forecasts? Not so much.

Corporations and a free market

I've spent some time recently going over comments made on various blog and news posts regarding the current financial crisis.

Whenever someone complains about grotesquely large CEO salaries, golden parachutes, short-sighted boards or the herd mentality of stock holders, you are almost guaranteed to find a few posts later a reply along the lines of: "Suck it up. That's how the free market works. Capitalism at its finest."

This confuses me.

Few things are less representative of a free market than the modern corporation. It exists only because of very specific laws enforced by governments. Partly by design, partly by historical accident, this framework distorts the notion of 'ownership' into something scarcely resembling the original idea.

A truly free market would see all companies and their owners have unlimited liability (unless they bought insurance). 'Unlimited liability' means that if something goes wrong with the company - say, it goes bankrupt - then its creditors are free to take the money they are owed from the owners of the company.

A basic protection that requires only a touch of regulation is limited liability. In this case, the creditors are only able to take from the owners an amount of money equal to the owners' investment in the company. If you had $100 in a Betamax firm and $1000 in a VHS firm, as well as $10,000 in the bank, if the Betamax firm went bankrupt its creditors would only be able to ask for $100 from you.

This already distorts the notion of ownership from that found in a free market. Because investors are partially protected from risk by the legal framework, there is an incentive, everything else being equal, to spread one's wealth among as many different companies as possible.

('Different' is the key word here. If the companies are all equally profitable but in completely different fields, then the more companies you spread your money about, the less likely you are to lose it completely. Suppose each company has a 50% chance of failure. Put your money in one, and there's a 50% chance you'll lose it all. Put your money in two, and there's a 25% chance you'll lose it all.)

In other words, limited liability already provides an incentive for an investor to split her attention among many different companies. I have a nagging suspicion that this may lead to weakened leadership and less capable entrepreneurs.

A corporation goes even further. Not only is liability limited, but the company itself is considered a legal entity, and if 'the corporation' goes bankrupt, then creditors may only try to get their money back from 'the corporation' - not from anyone who may hapeen to own shares of stock in the company.

These shares of stock are meant to be shares of ownership. This is why they (should) pay dividends, a share of the profits. By and large, they stopped being treated like shares of ownership long ago, and are now closer kin to horse race gambling chits.

'Ownership' has become so distributed in most corporations as to be meaningless. This is recognized in that they are run by a board of directors, ostensibly acting on behalf of shareholders. Unfortunately, most shareholders want nothing more than to play hot potato with their stock, selling it the moment they feel the price is high enough. This leads to an often lamentable focus on the short run, with predictably disastrous long-run consequences.

None of this would be possible without the laws that allow limited liability and incorporation. Modern corporations are antithetic to a free market, not symptomatic of it.

Mandatory thoughts on the bailout situation

I don't have a firm opinion or grasp of the situation yet, so this will be brief.

There's one aspect of the debate that has struck me as conspicuous for its absence: the trade-off between present and future comfort.

The current crisis exists because a lot of people made a lot of mistakes. Some of these mistakes involved investors taking on more risk than they should have.

If nothing is done, the consequences will be bad for the US (and possibly other countries) in the short run. There's no question about that. At the very least, lenders will be skittish and only the most sure-fire or well-connected of projects will obtain funding. This would lead to a slowdown in job creation, output growth and industrial innovation. (Rather like a more widely spread version of the dot-com bubble crash, come to think of it.)

In the worst-case scenario, the economic slowdown could be serious and last for years. Certainly through the next administration's first term.

Suppose instead that a true bailout takes place, in that the government uses taxpayers' money to pay for the private sector's miscalculations.

There's a chance such a bailout will work flawlessly, and bring the US economy back to its usual state in record time.

This is its own problem. Institutions that are bailed out may have difficulty learning from the mistakes of the past. There is nothing to stop the crisis from happening again, in exactly the same manner, with exactly the same consequences. After all, some people made out like bandits during the mortgage bubble, and those that would have lost money were bailed out.

If lousy investors lose their shirts over this, the usual market instincts will kick in and make it less likely that this will happen again for at least a few decades.

There's a tradeoff between what is convenient for the present, and what is best for the future.

Bailout: smoother sailing today, increased likelihood of a repeat tomorrow.
No bailout: harder times today, less risk of a repeat tomorrow.

What's 'right'? That's up to the US as a whole.

There are many other possibilities between these two extremes, of course. I've ignored and oversimplified a great many relevant factors for the purpose of this brief note.

Supply and demand?

When the word 'economics' is mentioned, many people first think of 'supply and demand'. This is considered by many to be the quintessential economic model - as close as one can get to a foundation for the discipline.

Astounding, then, that it is in large part a fairy tale.

I don't mean this as a criticism - fairy tales are useful. They teach life lessons, are memorable, and can even help to shape a culture, or provide insight on how to deal with life's difficulties.

Little Red Riding hood is a beloved cautionary tale, but few adults would think of taking it literally, or trying to attach real-world locations, names, numbers or even physical laws to the story.

To make my point clearer, consider a single farmer who owns an apple orchard. All she does is farm apples, year in and year out.

When customers at the nearby market are willing to pay more for apples, she farms more. The extra money makes the extra effort worthwhile. When these same customers are sick of apples, she farms less. It's no use farming apples that won't sell, or that will only sell at a very low price. This is supply.

Now consider the customers. When the farmer charges a high price for apples, they want to buy less of them. They can spend the money they save on oranges, or rabbit meat. When apples are cheap, they want to buy more of them. Maybe they use money that had been earmarked for a bushel of plums to buy three bushels of apples. This is demand.

Graphing supply and demand for the apple market is easy. We first draw two lines at ninety degrees to each other. We label one 'price of apples' and the other 'bushels of apples'. These are our axes. We then plot out all the combinations of price and quantity that the farmer is willing to supply at, and customers are willing to buy at. For example, maybe when apples are $1 a bushel, the farmer wants to sell 10 bushels, and when apples are $10 a bushel, she wants to sell 20 bushels. Connecting the dots will give us our 'supply curve'. Doing the same for demand will give us our 'demand curve'.

In general, the two curves will only meet once. At this point, the farmer is selling as many apples as she wants to sell, AND customers are buying as much as they want to buy. This is the 'equilibrium' point (after the Latin for 'equal weights', or 'balanced'). Economists like it, and solve for it, because the market will tend to move toward it. For example, if there's a shortage of apples - that is, the farmer sells less than people want - the price of apples will probably rise, encouraging the farmer to grow more of them. If there are too many apples, and a lot are rotting unsold or selling below cost, the farmer will lower production.

So far, so good. The model is useful, and it works.

The problem happens when we're talking not just about apples, but about apples AND plums, say. Or, on a larger scale, when an economist wants to look at the supply and demand for all goods produced by an entire country.

Suppose our farmer farms twenty different kinds of fruits, and we want to draw a supply-and-demand graph for fruit in general.

Let's start as we did before, with our axes. We have price on one axis, and quantity on the other.

Here's a problem: quantity of what? We could just label it 'bushels of fruit', but this wouldn't be very informative. We want to know how the farmer changes her willingness to supply when prices change. A bushel of apples is very different, in terms of value and effort required to produce it, than a bushel of raspberries.

The problem would be even worse if our farmer were a part-time shoemaker, and we had to add production of shoes to production of fruit.

Economists get around this by finding the VALUE of total production, and using THAT as quantity. In other words, 'how much does the fruit sell for at market? that's your output'.

If you're scratching your head at this point, you've probably understood everything correctly.

We want to know how the quantity of fruit supplied (and demanded) changes when price changes. However, our measure for 'quantity of fruit' INCLUDES the price level. This leads to a lot of problems, because it makes it very difficult to tell what's actually going on. Suppose the price of oranges rises. Total fruit production may rise as farmers are more willing to produce oranges. Even if production did not change at all, though, we'd STILL see a rise in MEASURED production, simply because the price of oranges rose.

It gets worse. What is our measure of 'price'? When we looked JUST at apples, it was the price of apples. When we look at twenty fruits... it's not as clear what price we should use. Economists often use a price index, such as the CPI, which tracks the price of a 'typical consumer's' spending. Suppose we use a 'fruit price index', which tracks the price of a particular combination of fruits, in a way similar to how a stock index tracks the value of various stocks.

Our supply and demand diagram is now a lot less useful than it was, because we're plotting not price against quantity, but the cost of a particular subset of production (whatever combination of fruits we choose) against the cost of total production.

It's not easty to untangle the various effects from each other.

This is why 'aggregate' or 'added-up' supply and demand is pretty much a fairytale. We can THINK about it - we can pretend that we can actually measure output. Doing so gives us a lot of interesting and useful results, such as allowing us to understand how an oil shock can cause a recession AND inflation, or why price controls seldom work. However, any attempt to take the story literally and apply real-world data to it is going to run into problems.

To be fair, professional economists often use advanced statistical techniques (such as regressions) to separate out the various effects, with a great deal of success.

This does not help much with a basic problem - that the textbook theory of aggregate supply and demand has been built on an awkward mathematical foundation. Geometry and simple algebra aren't the right tools for the task.

Privatization

Privatization is a divisive issue.

The term refers to taking something that was owned 'in common' or by the state, and granting ownership to a private individual or firm.

One famously controversial example is the British enclosure movement of the mid-1800s.

Village common land was 'enclosed' with fences and turned into private properties. What had been places where anyone could go for a walk, grazing or firewood became exlusive property.

Those for enclosure argued that the land was being used very inefficiently. The tragedy of the commons is that when the land may be freely used by all people, no people will take care of it. This is a good point. Much of the land enclosed was in very bad shape, and was not being used with any semblance of agricultural efficiency.

Those against enclosure pointed out that the community was losing rights and privileges that were important to it. This is also a good point, and one which it is difficult to overstate. For example, largely as a result of the enclosure movement, there were no green spaces available for working class Britons for much of the 19th century. Imagine a life with no greenery, no parks, no walks, no fresh air. (This is before modern sewage treatment, as well.)

Nowadays, the privatization argument is likely to center around national industries. Perhaps the government owns an electric company, and is thinking of selling it to the private sector. Or maybe a government decides to purchase a controlling share in what had once been a private investment firm.

Those for privatization argue that government industries are often poorly run and ineffective. There are a lack of incentives to excel, and a surfeit of red tape before anything can get done. The pro-privatization crew has a point, as I can attest from personal experience.

On the other hand, those against privatization argue that a private company will care only about profits. Everything else, possibly including things that the community cares about (such as non-agriculturally-efficient garden spaces and grazing lands) may be lost.

For a long time, I thought privatization with government oversight was a combination that should work most of the time. If the community, hopefully represented by the government, is so concerned about garden spaces (say), then simply include their maintenance as a clause in the purchase agreement. If the garden spaces are not kept up, the land reverts back to the government.

These days, I'm not so sure this is a good idea.

IF the government representing the community and the firm have identical goals, then I continue to believe that the firm will be able to do the job far more efficiently than government.

The problem is that the goals of government and the private sector seldom overlap.

If the community owns land through the government, then there's a good chance that the government will do a half-baked job of fulfiling its objectives.

If a private firm owns the land and signs an agreement with clauses imposed by the government, then it will fulfil the letter of the contract very efficiently... but ONLY the letter of the contract, and only if it can't find a legal loophole that will allow it to slip out of the clauses that lower its profits.

My current opinion is that in many cases, a government that honestly tries to achieve the community's goals but does so inefficiently is a lesser ill than a private firm that fulfils the community's goals in an efficient but perfunctory and unwilling manner.

Advocates of privatization would probably agree that privatization brings the most benefits when government is inefficient, or when the private sector is very efficient. Unfortunately, a government that is inefficient at handling a resource is probably also inefficient at ensuring that the provisions of a contract are met. A firm that is very efficient at running a resource is probably also efficient at evading inconvenient regulations.

In other words, the very times that privatization is most helpful are the times when non-profitable community goals are the most endangered by it. The combination of a high rate of enclosures, competent landlords and incompetent monitoring certainly helped to make the village green vanish for nearly a century in the United Kingdom.

I'm not greatly attached to my opinions, so it's entirely likely that I'll be of a different mind next month, if not next week.

Price controls

Price controls are popular, in the sense that people often ask for them. At first blush, they seem like the most reasonable response to a certain kind of problem.

The price of gas is high? Government should step in and put a cap on how much people are allowed to charge for gas.

People are starving because of a huge rise in the price of rice? Someone should force rice farmers to sell at a reasonable price.

There's just one problem with all of this: price controls seldom work. (I was tempted to write 'never' instaed of 'seldom', but I CAN think of a few isolated cases where they may actually work - not often, though.)

When a government tries to control the price of a product, the result tends to be shortages, inflation, or both. This is true even when price controls are enforced through force - just ask Zimbabwe's citizens. Rather than accede to price controls, the country now produces nothing, and much of the population survives on food aid. In the 1980s, Jose Sarney's Brazilian government tried to freeze prices in order to control inflation. I was a child at the time, but I still have vivid memories of my father waiting in line for black market chicken. None was available at the official price, even though there was no shortage of poultry.

Hopefully, my position is clear - it is my belief and experience that price controls do not work, and only lead to hardship.

That being said... I'm all for their implementation when this is clamoured for by the population of a democratically elected government (or a fair approximation of such).

If people want price controls, politicians should first try to tell them exactly what will happen if price controls are put in place: shortages will get worse, and goods will go to the well-connected or those most willing to wait in line instead of to the richest. This appeal will probably be ignored, but it allows the government to say 'I told you so' later on.

If the people of the country, after hearing arguments against them, still speak with one voice, and say that they want price controls, the government should do as it is asked.

Ideally, any price controls will be put in place when nothing else of note is going on in the national economy. In practice... well, fat chance. Usually price controls are called for as a response to some economic crisis or another.

What happens next?

Best case scenario: the controls aren't terribly onerous. Citizens are happy because they were heard. There are some lineups, perhaps a black market forms, but everyone grudgingly accepts it as an acceptable tradeoff. There is no reason to remove the price controls in this case. Good enough is good enough. If people want greater 'efficiency', they'll ask for it.

Likeliest scenario: shortages caused by the price controls cause genuine hardship. People complain about lineups, shortages and having to buy goods on an expensive and possibly dangerous black market. The population asks the government to do something about all this.

In this case, the government should, of course, remove the price controls - first, though, it should explain exactly WHY the shortages became worse.

I believe it is self-evident that price controls don't work. A crucial element in the formation of this belief, was living through them.

Just as people should be allowed to make their own mistakes, if they are to ever evolve and grow, so should nations be allowed to make their own mistakes.

IMF loans (to pick an example beloved of activists) with 'common-sense' provisions such as the immediate abolition of all price controls do no one any favours when such controls were put in place at the request of the general public. Worse, since such loans are usually given in times of dire economic crisis, such a policy may lead people to believe that the abolition of price controls worsens a crisis.

If a population with a (kind of) democratic government believes it's had enough of the problems caused by price controls, it'll say so to its chosen rulers. At that time, the country itself can get rid of them.

Until then, well-meaning 'fixers' should restrict themselves to educational campaigns. By all means, explain to people why trying to cap the price of gas may lead to gas shortages - but don't go about removing the caps yourself, unless you are asked to by the country as a whole.

Super-models

Runway fashion has more in common with economic theory than may at first appear.

Consider the models that are required by the world's top designers.

The important thing, for a designer, is the outfit. The clothing. That's what's being shown off during a fashion show.

The perfect runway model is one that does not distract from the clothing. She must have all the features generally expected in a human being, but nothing more. No extra fat, no tell-tale shapes, no quirks of personality or appearance that would allow her to outshine the ensemble she is paid to display.

In brief, she is to be a person only in the sense that she has enough features shared by humans to avoid drawing attention to herself via their absence.

This non-beauty has often been mistaken for the ideal of beauty. The end result? Predictably tragic. Eating disorders, anxieties, and worse.

"To speak the truth," a female artist recently wrote, "I always hear guys saying something like that. Somehow media lie to us, telling that 'everyone prefers the thin tall types', but then you never find that 'everyone'..."

Exactly so. Those yearning for a model's body largely miss the point.

Economic models work in a very similar fashion to runway models.

The bare models are very seldom the point. The best constructed models are lauded for not being unnatural, for not having any feature that will draw a reader away from the world being woven to think, 'that's not right; that's not the world I live in'.

Models are as bare and featureless as possible, in their general form. The less there is to them, the more widely they may be applied.

These applications are the true point of economic models. They are the 'clothes' we put upon them. Shocks, new policies, a novel twist, these are where the excitement comes in, where the focus should be. The rest? Just a hanger, which, if it performs its duty, bears the weight of the sumptuous garment without distorting its shape.

If a basic model ever resembled an ACTUAL economy (say, that of Peru) in all its richness and complexity, it would immeditaley be rejected from use in most academic papers and policy briefs. When tacking on a rise in oil prices to a simple supply and demand model, everyone can see what the consequences are. If the same rise in oil prices were put through a 'true' model of the Peruvian economy... who knows what would happen? The peculiarities of that place and that culture at a given time would give the seemingly simple shock its own flavour, and may lead to - horror of horrors - a result or advice that cannot be generalized to other countries or times.

Similarly, if a normal, healthy woman were to model runway fashion, some of her body's personality would necessarily shine through... and this is a no-no when it is supposed to be the designer, and only the designer, on display.

For this reason, supermodels tend to be featureless, with faces like a Teflon pan. Their bodies are skinny for much the same reason that a coat-hanger is skinny: it allows the clothing to keep its own shape. A curvy woman, a woman with an actual figure, very seldom looks like another woman of the same height and weight.

It is tragic when a healthy woman decides to emulate a supermodel, mistaking glamour for beauty.

It is equally tragic when a healthy economy decides to emulate an economic model, mistaking elegance for efficiency.

Equilibrium

"What's going to happen to the economy over the next six months?"

That's a question often asked to economists, and one which they are ill-equipped to answer.

An economy is a complicated, moving thing comprised of a myriad interacting forces, each of which affects the others, causing repercussions by which it is affected in return.

By and large (pace, time series analysis) economists gave up long ago on trying to figure out what happens to the economy as it moves. Instead, they focus their efforts on calculating what the economy will look like once it stops moving.

Wait - didn't I just say an economy is always in motion?

Quite so.

This is why shocks - stuff well out of the ordinary - are the darlings of economics. "What's going to happen in this complicated but smoothly-run economy that hasn't had a crisis in a hundred years?" is a very difficult question. "What's going to happen to the economy now that every forest in the country has burned down?" is much easier to answer.

A shock is something that happens suddenly, and has ripples that disappear in finite time. By looking at a long enough time scale, an economist can find a 'resting-point', and describe the characteristics of the economy once the shock has run its course. This can be the basis of useful advice, allowing governments and individuals to prepare and plan for the future.

The resting-points are called 'equilibria', after the Latin for 'equal weights'.

When equal weights are placed on either side of a scale, it is balanced. Eventually it will reach a state in which the two sides of the scale are at an equal height. All forces cancel each other out. The weights have no reason to rise, or to fall. The dust has cleared, and all influences have played their course.

To see how economic inquiry works, consider a kitten.

A kitten is in the living room. If you're lucky, the living room is sealed off from the rest of the house. A friend asks you, "What's the kitten going to do over the next six hours?"

It is a hopeless task to try to calculate the exact motion of a kitten in advance. There are too many uncertainties and random factors at play to be able to make anything other than a wild guess.

A reasonable non-economist would answer the question with, "I dunno. Walk around? Swat at things? Meow? Hopefully not make a mess..."

An economist would answer, "The kitten will be neither asleep nor awake, but on the cusp of both states."

(There's a reason many physicists become economists.)

"Buh?" the startled friend may answer.

This is where the economist would pull out a graph.

Assume that the kitten's behaviour can be entirely described by the changes in its exertion over the six-hour period. Everything else is, by this assumption, constant.

The two forces driving the kitten are curiosity and exhaustion. The kitten exerts itself in order to satisfy its curiosity - running over to a promising shiny thing on the other side of the room, for example. Exertion, therefore, lowers curiosity. If we plot Curiosity on a graph with Exertion as the horizontal axis, it should look like a downward-sloping... well, something.

We have no idea how it is that the kitten's curiosity varies with exertion, exactly, so we'll just assume the relationship is linear, and draw a downward-sloping straight line.

What's that you say? There could be trouble with our results if it turns out the true relationship is more of a curve, or an M-shape, or the outline of a gazebo? Or if we're out to lunch entirely and pulling our assumptions from somewhere unpleasnt? Okay, sure, but that's something for the econometricians (economists who work with real-world numbers) to figure out later. This is theory.

Now for exhaustion. Clearly, as the kitten exerts itself, its level of exhaustion rises. So we draw an upward-sloping line on our graph to represent exhaustion.

We have an upward-sloping line, and a downward-sloping line. If they cross at all, they cross exactly once - and they MUST cross.

This is actually easy to prove. Suppose the kitten has not yet exerted itself. Exertion is zero. Its curiosity must be very high, and its exhaustion must be very low. In particular, curiosity must be higher than exhaustion - otherwise the kitten would just sleep forever. Hunger? Oh, we're assuming that's constant. Yes, forever. No, the kitten won't die from starvation.

If curiosity starts out higher than exhaustion, and curiosity is a downward-sloping line while exhaustion is an upward-sloping line, eventually they MUST cross - after which they'll never cross again.

Before they cross, curiosity is higher than exhaustion. This means that the kitten will keep exerting itself, in order to satisfy its curiosity. We'll keep moving to the right on our graph, in the direction of increasing exertion.

After they cross, exhaustion is higher than curiosity. The kitten is too tired to explore, and falls asleep. Sleep can be modeled as a state of negative exertion - resting allows the kitten to recover energy and renews its curiosity, possibly due to a very short attention span and lousy short-term memory. We move left-ward on our graph, in the direction of decreasing exertion.

The end result? There is only one equilibrium in this model: the point at which exhaustion and curiosity are exactly equal to each other. The kitten is not exploring, since curiosity is not higher than exhaustion, but neither is it sleeping, because exhaustion is not higher than curiosity. The two forces are completely balanced. Should the kitten by some random accident wander away from this equilibrium, circumstances would conspire to move it back to this odd state, as we have argued above.

Hence, the answer to the question "What will the kitten do for the next six hours?": "The kitten will be neither asleep nor awake, but on the cusp of both states."

I DID mention economists were lousy at talking about the motion of a smoothly-functioning economy, right?

Introduce a shock, though...

Suppose that the living room is flooded with poison gas while the kitten is still inside. If the economist is again asked the same question, she will answer correctly: "The kitten will eventually be dead, and will remain in that steady state for the rest of time, assuming that there are no (presumably electrical) shocks to its system."

I leave the diagram for that situation as an exercise to the reader. It's distressingly similar to the one I walked you through.

I've been reading Naomi Klein's Shock Doctrine at the request of a student. It's an excellent book, and well worth reading by anyone who feels comfortable with the English language. The discussion is more about psychology, power and politics than economics, but it does talk a lot about economists and the phenomenally tragic consequences that can follow their mistakes.

One thing that struck me while reading the book is that many of the worst economic mistakes it refers to were made by people who appeared to have taken economics's focus on equilibrium literally. That is, these people acted as if they believed that because equilibria are what economists solve for, they must therefore be the only relevant thing, and everything else should be swept aside. The results are predictably tragic.

Consider our kitten example, and a well-meaning but much too enthusiastic economist. After modeling the kitten's situation, she comes to the following conclustion:

"No matter how you draw the two lines of curiosity and exhaustion, the result is always the same: the only equilibrium, and the point the kitten will move toward, is the twilight state of 'barely awake'. The only thing that distinguishes one equilibrium from another is the amount of exertion at which this state is reached."

The policy implications? That's clear enough. The economist's advice would be as follows:

"Clearly, it's better to be at an equilibrium with low exertion than one with high exertion. It is more restful, and on the rare occasions when due to random chance the kitten stumbles into momentary wakefulness, there is a higher level of curiosity, which is good for the mind. I will therefore drug the kitten with morphine, so that it is always in this twilight state, even when its body tells it that it is fully rested."

What about possible side effects from giving morphine to a kitten? Addiction? Shouldn't the kitten be fed once in a while? Wasn't it going to be in the living room for only six hours?

None of those considerations are in the model. And if they were, well, those are matters for other specialties to consider. The economist has done her job, and besides, the reasoning is mathematical and ironclad.

It's not terribly difficult to see how an economist who is too enthusiastic about models can wreck an economy.

At the same time, an economist can be of great help to an economy. That's why I'm in the profession, after all. I truly believe that educating others about economic thinking can help the world - more than that, I believe that economic education is absolutely necessary if the world's situation is to improve. At least as much harm has been done through ignorance of economics as by its earnest misapplication (see Zimbabwe).

The economist's profession is one of the few that can actually help to end world hunger. This is a great opportunity, and a terrible responsibility - the same force that can end starvation may also inflict it, if misapplied.

What is economics, anyway? (Part 2: Goddesses)

In the last post, I suggested that it might be fruitful to look at the similarities between the Greek and Roman goddesses of household management. The idea was that by finding where they overlap, we could gain insight into the basic nature of economics. After all, not only were they goddesses of the hearth and household (microeconomics), but also of the state (macroeconomics).

As it turns out, this wasn't easy. Or flattering to economists.

Although Hestia and Vesta were considered extremely important deities, not much is known about them. Their cults were results-driven. As long as the state and household survived, they were paid lip service. When things went south, the goddesses were invoked with unusual fervour, and their followers punished. In neither case was the history, personality or nature of the goddess the point.

This is not entirely unlike the cult of economics today. Most people know that economic thinking exists, and have a vague idea that it has something to do with spiky graphs, dollar signs and an unfortunate fashion sense. As long as the economy is thriving, economists and their discipline are paid lip service. When things go south, magic words ("Trickle-down!" "Free trade!") are invoked with unusual fervour, and practitioners of economics are punished. In neither case is the history of economic thought or the nature of current economic thinking the point.

We'll start our analysis with Hestia. Hesiod mentions her a few times in his Homeric hymns.

First, in a hymn to Aphrodite:

"Nor yet does the pure maiden Hestia love Aphrodite's works. She was the first-born child of wily Cronos and youngest too, by will of Zeus who holds the aegis, -- a queenly maid whom both Poseidon and Apollo sought to wed. But she was wholly unwilling, nay, stubbornly refused; and touching the head of father Zeus who holds the aegis, she, that fair goddess, sware a great oath which has in truth been fulfilled, that she would be a maiden all her days. So Zeus the Father gave her an high honour instead of marriage, and she has her place in the midst of the house and has the richest portion. In all the temples of the gods she has a share of honour, and among all mortal men she is chief of the goddesses."

In other words, Hestia doesn't care much for passion, and would rather stay at home than marry the richest gods - Apollo, of medicine, music and the sun, and Poseidon of the seas.

The second mention of Hestia in the hymns makes her decision all the stranger:

"Hestia, you who tend the holy house of the lord Apollo, the Far-shooter at goodly Pytho, with soft oil dripping ever from your locks"

Although Hestia refused to marry Apollo she is his housekeeper. And has hair so oily that it drips. (I did say this wasn't flattering to economists.)

This minor mention is important combined with the last - it shows that Hestia's nature is management. This is what fulfils her; this is what she does willingly, even as she refuses the conjugal advances of a sun god.

A sacred fire, representing the hearth, was an important part of her cult. It was not just a sacred fire, it was the sacred fire, and so a share of any sacrifice to the gods was reserved for Hestia.

Now on to Vesta.

Not much is known about Vesta herself. She is mentioned a few times in the Aenid, mostly invoked or sworn by in times of great duress.

We do know a lot about her followers - the Vestal Virgins.

Yes, that's right. One of the shared attributes of the goddesses is the focus on chastity and an utter lack of interest in the carnal.

Did I mention this wasn't flattering to economists?

The most important duty of the Vestals was maintenance of the sacred fire, representing the goddess's protection. If the sacred fire went out, it was often assumed that one of the Vestals had broken her oath of chastity. This was punishable by live burial. The Vestals were also responsible for making a special flour that was a required ingredient in public offerings to any god.

When we overlap Vesta and Hestia, what do we get?

1. Both were virgins. This was a Big Deal.
2. Both were hearth goddeses, the hearth being a symbol of the home.
3. Both had a sacred fire that must not go out.
4. Both were considered essential for the well-being of the state.
5. Both had a part in sacrifices to any god.
6. No one seemed terribly interested in the personality or history of either.
7. No one felt the need to explain their roles in detail.

Points six and seven are more important than they may appear at first - another case of a dog not barking in the night.

We know these goddesses were extremely important. Hestia the 'first and last', Vesta, state goddess of Rome. This suggests a very basic function. That this function was never explicitly named in turn suggests that either it was very difficult to summarize, or (and?) it was so obvious that it did not bear mentioning in a literary work.

Household management and its extension to the national 'household' fit these clues. Everyone lived in a household, and everyone knew what was involved. The moment the phrase 'hearth goddess' was uttered, it summoned images of cooking, budgeting, hospitality, planning and so on. No further explanation was needed, and in fact, any explanation at all would have been overly pedantic.

The lack of personality and lack of stories involving the goddesses goes hand-in-hand with their virginal status. Zeus's monumental libido made for great stories. Hestia's scrupulous chastity? Not so much.

There was no passion, no emotional drive to the actions of the hearth goddesses - they could not afford such. They had to be pragmatic and in a sense, compassionate, taking into account not their choices, but those of the household members when making their decisions as managers.

This enforced neutrality may well be the reason why Hestia was invoked in matters of law, and Vestals were given privileges when in court, such as not having to swear the customary oath.

Love and passion would introduce bias, and so were out of the question. Hestia would gladly be Apollo's housekeeper, but never his wife. A Vestal who broke her oath of chastity would withdraw the goddess's protection from the city, and be sentenced to death. Vesta's servants could show no bias of this sort.

The goddesses were essential to the state, because of their status as household managers - the allocation of scarce resources among competing needs and desires is the business of the state. Their fires could not be allowed to go out. Even among the feasts and festivals, a thought must always be given to these considerations, or the state, like any unminded household, would collapse.

What of the final attribute, the share in any sacrifices to the gods? It did not matter whether the prayer was for love, wealth or victory - at its source, and at its granting or denial, it had to interface with a world of scarcity. Where there is scarcity, there is the need for management.

Such is the essential nature of economics according to the ancients, then. The practical management of the household, be it a family or a nation. Economic considerations are found in all things, and must never be lost sight of or be allowed to go astray through momentary passion or an inordinate fondness for one group or individual.

On Tuesday, I'll talk about the concept of equilibrium. And kittens.

What is economics, anyway? (Part 1: Etymology)

Someone coming across the word 'economics' for the first time could be forgiven for thinking it was a dislike of sustainably-produced food: 'eco-' is clear enough, as in 'ecology', 'nom' is an onomatopaeia that refers to the eating of food, as in 'nom nom nom', and '-ics' refers to ickiness.

Hence, 'eco-nom-ic(k)s' - the state of finding ecologically sound food icky.

Organic food is expensive, so that would explain all the mentions of money, interest rates and loans. As for international trade, well, that's how the best products are obtained. Coffee from subsistence farmers in Tanzania, bananas from Costa Rica, and so on.

Our hypothetical amateur etymologist would not be entirely wrong. All of this is in fact covered by economics, but the subject is at the same time far more general and far more basic. So basic, in fact, that the ancient Greeks had a goddess of economics, and considered her among the most essential of their pantheon. The Romans also had such a goddess, and placed her at the center of one of their most important cults.

The Greek and Roman goddesses are very similar to each other - so similar that they are often mistaken for 'copies' of each other, when in fact they were developed by each culture, independently.

This is very promising.

By looking at the traits that are shared by these goddesses and their cults, we may gain some useful insight into the essential nature of economics.

How so?

Suppose you've only ever seen a pig in the form of spam. This is akin to modern economics, a heavily refined and modified version of the original material that includes other ingredients, some of which are difficult to decipher, and others whose relevance is not obvious at first sight. If you were to take spam as your point of reference, you might reasonably conclude that a pig was some sort of sponge, or possibly a fungus.

Now suppose you're curious about what this 'pig' thing looks like before it goes through the spam factory. Despite your best attempts, you are unable to find a live specimen, but you do have the next best thing: two statues, each one a religious icon from a culture that worshipped pigs. They share a lot of things in common, but one has wings, and the other has six legs.

By noting what the statues have in common, you may hopefully come away with an idea of what an actual pig looks like. Any significant differences between the statues are likely to be attributable to historical or cultural influences. (This is interesting in its own right.)

This is the technique that we'll be using to understand what lies at the root of economics.

Before we do this, we should stop and consider the true etymology of the word 'economics'.

It comes from ancient Greek - oikos, for 'house', and 'nomia' for 'management'.

At its roots, economics is the study of household management - of how to make the best use of a family's limited resources in order to satisfy the many competing needs and wants of its members. If the baby needs a new cot, it must be paid for. Will it be through more work, or reducing existing spending? Who will work more? Doing what? What expenses will be cut? For how long? Is it possible to build a cot from scratch? What about borrowing?

The 'household' can range from an individual to a family to a firm to a nation and beyond, but the issues remain remarkably similar. This is perhaps why both Hestia, the Greek goddess of household management, and Vesta, her Roman counterpart, were deities of both the family and the state...

...but that is a topic for the next post, where we'll begin our analysis of classical goddesses as signposts for the essential nature of economics.