Friday, May 6, 2011

Counting paper chickens

One recurring problem with mathematics is that mathematical models of reality tend to be mistaken for reality itself. I’m becoming more convinced that this is happening with economics.

Let’s look at money: pieces of paper (formerly pieces of precious metals) of arbitrary value traded in exchange for goods and services, also of a more or less arbitrary value, because it’s simpler than trading chickens and cows. In theory, it’s a refinement of barter, where one traded goods and services in exchange for other goods and services. Currency is in essence an IOU: “I don’t have a chicken, so I’ll give you this instead.”

The point to remember, though, is that the value of the exchange medium — gold coins, pieces of paper, wampum belts, whatever — isn’t in itself but in what amount of goods and services one can obtain with it. Objectively, the true wealth isn’t in the possession of cash but in the goods and services one can access.

But considering the bewildering variety of goods and services available on the market, wealth is nigh unto impossible to express unless reduced to some common denominator. So economists track the dollar values rather than the goods and services … and money becomes completely abstracted from what it represents.

Now, last year we saw what happened when Stephen Hawking, an eminently respectable physicist, forgot that gravity is simply a number representing the effect of space-time and matter on each other and not a real force separate from the two. He stated quite confidently that gravity could pull mass out ex nihilo, as if gravity existed apart from mass and as if mass existed apart from matter. Scientifically — not to mention philosophically — this is nonsense; yet because Hawking said it, a lot of unreflective people bought into it.

Over the last four hundred years, more and more money has been earned by trading media of exchange: commodity futures contracts, company equity shares, even currency … all of them debt instruments. In the same time, more and more of our economy reflects the creation of these debt instruments rather than goods and services.

Along the way, currency has become completely detached from the goods and services they’re supposed to represent. Put graphically, there are a lot more chickens on paper then there are in poultry farms. We’re now seeing a situation where paper chickens are multiplying faster than real chickens. But since economists regard currency as the basic expression of wealth, their formulae treat the paper chickens as having the same value as real chickens.

Here’s an example closer to the real world of what I mean:

Schmuckatelli Enterprises has assets of $10 million, liabilities of $8 million, and 1,400,000 shares outstanding on May 1, 2011. In accounting terms, each share really represents $1.42 86 of Schmuckatelli Enterprise’s equity. However, the common stock (NYSE: SCHE) traded at close at $22.38 per share … about 1,566.69% of its true equity value.

Fred McGuffin bought 10,000 shares at $21.25; when he sold, he made $11,300. Schmuckatelli Enterprises didn’t produce or sell any more or less widgets[1] than they would have had McGuffin held on to his stocks, or if the value had dropped to $20.50. Yet by trading shares back and forth, McGuffin made almost as much money as he would have had the corporation sold its assets and satisfied its liabilities while he still possessed the stock (and probably more than he would have at the next dividend payment). Moreover, his profit is treated as contributing to the gross domestic product as much as the equivalent value of widgets Schmuckatelli produced that day.

Of course, the increase of the nominal value of debt instruments means the decrease of purchasing power of each unit of currency. Moreover, because of the arbitrary nature of the values, a significant chunk of these debt instruments are created because one basic human need — the homestead — is beyond the reach of most people to buy without borrowing. Nor is it in the interests of those who create debt instruments to allow one to pay off his debt and own his house outright: hence, equity loans and lines of credit.

This is simply one of the reasons I suspect the metrics economists use to measure our national economic health are misleading, if not way off-base. In the simplest terms, not only are they measuring paper chickens, the paper chickens have only the most tangential connection to real chickens.

Moreover, I have to wonder if economists know what a healthy economy really looks like. Both financial wealth and real wealth have been trickling up to a smaller and smaller segment of the economy, as higher-paying jobs are outsourced and replaced by lower-paying work and as more of the lower-income segments are facing heavier debt loads, seeing more of their declining incomes being drained off in interest payments, and less turned into savings and assets for their retirements.

In fact, it very much looks as if capitalism is sawing off the branch it’s sitting on. Once too many paper chickens have been produced, consumers will no longer be able to purchase real chickens. At that point, the whole Ponzi scheme will collapse on itself.

And then you know what will come home to roost.

[1] Here I’m using “widget” in the classic accounting sense, as a placeholder word for a physical product: shoes, cars, banjos, Fabergé eggs ….