Wednesday, January 20, 2010

Economic Fundamentals continued

Economic Fundamentals continued

We've observed that most consumption is by people with old "right to consume" tokens, or by people who intend to generate matching "right to consume" tokens in the future. This works fine when the amount of production per person is rising. The old money fades into insignificance and the people promising future production activity are relatively easily able to do that.

When production is declining the system of "right to consume" tokens (money) gets more difficult. If the people with existing money expect to continue the same rate of spending, then this reduces the amount available for everyone else by an even higher decline rate. This reprises a previous post saying that the inflation rate needs to be greater than the decline rate. On the other side consider borrowers who are consuming against future income. In a declining economy it will be difficult to expect to produce as much in the future so it will be hard to repay the real value of the capital. However the lender may well accept low or negative returns (in real terms) if the alternatives are worse.

When there is a period of economic decline then governments need to get a firm hand on the reins. This means making forcible adjustments so that money continues to act as a good way of valuing and exchanging, but doesn't attempt to be a store of value over time. However it is very hard for anyone to know where the economy is headed.

The reason is that everything in the economy is finely balanced. If anybody is making too much money then competitors move in and drive the price down. All non-monopoly activity is on the point of collapse: even if it is an activity that is essential. And when circumstances change and some input becomes increasingly expensive then there is huge incentive for substitution. But by definition the substitutes were not profitable before. So they aren't in use. So we have no idea at what cost they will operate until it actually happens. This is the case with energy now: with hundreds of ideas for energy future, but we have little idea which will actually work. If any. This is true of many things, so that a capitalist economy is fertile ground for scaremongers. And sometimes they will be right.