All assumptions are not born equal
by Benjamin on February 17, 2009
All assumptions are not born equal, but it is not enough to just find the ‘simplest’ assumption in reverence to Occam’s Razor or most unrealistic assumption as Friedman suggests. I think it is time we distinguish between two types of assumptions. The first is of the kind which cannot be directly observed, and the second is of a nature which is a fixture in the economy. This may sound like structural / institutional analysis re-hashed, but hear me out. The former will still need unrealistic assumptions, but the latter should be purged.
My immediate point of reference is the money markets. Why do we assume in the ‘simplest’ case that money supply is a quantity set by a central bank with interest rates determined by demand? and in the best assumed scenario we argue that money supply is a function of the interest rate and demand? This makes no sense to me, as we can immediately verify how the money markets work: The central bank sets an interest rate for repurchase agreements (sometimes adjusted twice a day), banks borrow the amount of money they need to cover positions taken during the day and then offer the central bank collateral to borrow either in cooperation with other banks (in the UK) or individually (in the US). There is no need to assume very much about money supply, it’s all there, fixed in the economy, and yet we ignore such information in our theories. I would suggest that this has created a massive blind-spot in economic theory, as we are unable to explain the liquidity crunch and the current shortage of lending. The money supply increases we witnessed in the fall were the only policy conclusions we could find based on such faulty a premise.
“A small Difference in the first principles (especially of Hypothetical Arguments) always making a vast disagreement in the Conclusion”
Andrew Hooke 1750: 11
“The results of any theory depend on its assumptions – and if the assumptions depart too far from reality, policies based on that model are likely to go far awry.”
Joseph Stiglitz, 2006: 28-29
This issue of assumptions came up as I was reading through Andrew Hooke’s arguments about the national debts, and found a quote which rang true for both myself, the discipline, and Mr Stiglitz – so how do we start to integrate such knowledge into the underlying assumptions of our models is the question?
Andrew Hooke. 1750. An Essay on the National Debt, and National Capital: Or, the account truly stated, Debtor and Creditor. London: W. Owen at Homer’s Head.
Joseph Stiglitz. 2006. Making Globalization Work. London, England: , Penguin Books
Tags: assumptions, axioms, economic theory, liquidity, money supply
Would it make things simpler if the government was forced to print or coin all the money in order for the money to be a “fixture” that can be observed. Can you imagine people having to change real dollars in order to buy a $1M house. May sound crazy, but I have a strong feeling we could have avoided our housing “crisis”.
As economists, the is one assumption that must rule to even begin observation is that Free Markets exist, or that Freedom of Choice must be present. Given the rule towards “nationalization” of labor, one must unfortunately question this assumption.
A natural resource assumption that we can easily observe in reality is that Land is Scarce (Ricardo and Smith) and therefore demands an escalating price or rent in a Capitalistic Economy where land is most precious. I can then assume based on observations that land and labor prices rise and fall proportionately; and that such economies are presumed to be prone to cycles (Marx, Shrumpeter).
On another note, Adam Smith makes the distinction between circulating capital that constantly moves its way through the system and fixed capital (i.e. real estate). In any case, he concludes that they are both fixed capital as they must stay in the system in order for the system to act most efficiently and do not allow for a “(labor) profit”, but do allow for a fixed return (Say and Walrus). In other words, if any money supply is on the sidelines not being utilizing than there is equal amounts of labor and land that are also sitting on the sidelines. However, If such “money” or sideline capital is invested in renewable resources as opposed to “money”, you can assume that such money is fixed or renewable and will maintain its utility value.
Great piece!
To cherry-pick a few of the things raised above, I’d say that printing all the money and keeping track is just not a workable solution simply because money is in so many forms (and has been for the better part of a few millenia – letters of exchange e.g.). What we could do is try to model the money system itself – that should not be a huge issue, but remains undone.
Assume that the market exists or that freedom of choice exists… Why should I assume the latter? Freedom of choice is not universal, and the issue of power-relations, hierarchies, or the ‘uneven playing field’ persist across the markets and its institutions… So I wouldn’t want to do that…
Land may be scarce, but is that the real constraint? If we can raise farm land from the sea (as in the Netherlands) or expand the lands productivity exponentially (as in the green revolution[s]) then the physical nature of land isn’t really a constraint, but I agree you’d have to build in the fact that it is there to start with… Can that even be reconciled with economic theory today??
Land’s scarcity is a constraint because it creates short-term land rent increases. To simplify economic variables, when you think of RENT, don’t just think of your apartment rent or the grocery store rent, but think of rent applied to any and all land derivatives including copper, oil, wood, plastic etc. Such rent increases of scarce land is what drives labor wages up (proportionately) and is the root cause of inflation.
Land and labor costs proportionately inflate as we are forced to use less and less valuable land (Ricardo). For example, think about how deep oil rigs are now forced to go into the ocean as a result of depleting the scarce oil resources closer to shore. Rent for oil goes up as it becomes more precious from dwindling land supply.
So although we must assume land scarcity, we should not focus on it to reconcile with economic theory today. Instead we must use your idea of expanding lands productivity exponentially. The most relevant is your example of the green revolution. So in contrast to using more scarce land and labor resources, we must use the infinite utility value of air, water and light and human innovation.
Say, Jevons, Menger, and Walrus among others that taught final equilibrium touch on this green revolution. It is a progressive period of time that exponentially multiplies the utility value of scarce land resources of our economy.
“The sea and the wind can at the same time convey my neighbor’s vessel and my own. With land it is otherwise.” – Jean-Baptiste Say, A Treatise on Political Economy
“The indefinite latitude allowed to industry to occupy at will the unappropriated natural agents, opens a boundless prospect, to the extension of her agency and production” – - Jean-Baptiste Say, A Treatise on Political Economy
“When there is no natural limitation to the means of production, this means that more and more classes of society are able to consume the commodity at falling prices” Menger, Principles of Economics
It is a shame we continue to ignore our economic forefathers when trying to understand this economic “crisis” and to provide sustainable solutions. Such lack of economic education is also a great opportunity. For what if we could all make sense of the economy. Imagine the possibilities.
On another note, we must assume Freedom of Choice in order to study economic theory. Without it, any economic model falls apart. However, we should also assume that any lack of freedom of choice will directly result in inefficiencies in the economy.
I understand that printing all the money is not a workable solution, but we should appreciate how important it is to provide a constant ratio of circulating capital to fixed capital. In other words, although the digital money is increasing, local circulating capital (cold cash) that provides trade stability to local trade and employment markets is not keeping pace with increases in fixed capital. As a result, we have a lot of “money” in the economy but everyday local goods and services (i.e. food) are not able to trade in real time.