Wednesday, August 6, 2008

Why do Economists get it so Wrong?

Note: For some reason I am getting large numbers of people coming in directly to this page, which suggest that it has been a worthwhile post and is generating considerable interest. However, it is an unusual entry point to this blog, and the post assumes that you are one of the regular readers. As such, I would ask for your forbearance, as it assumes an element of knowledge of previous posts (having the effect of creating a strong interest in what is explained). As such I have not made it as easy as I might have. However, if you do stick with the post, it does stand alone, and may prove to be a revelation about the functioning of the today's economy, and why the UK and the West are in trouble . Alternatively, you may wish to start with the rather neat summary provided by a commentator at the end of the blog ( just scroll down) before returning to the main entry. You may also want to take a look at the post 'The Cigarette Lighter Problem' for a (perhaps unusual) context on the problem that the West faces, and this will help in clarifying why I am suggesting the UK (and the West) is in such deep trouble.

Original post starts here....

Today, I will make a rather belated (apologies for this) reply to a comment from a few days ago in response to my post 'Can the Economics of the Past be used to Predict the Future?' The comment was as follows:
'However, I still keep hearing 'experts' being quite complacent about the situation. On The World This Weekend at lunchtime Vicky Redwood, economist at Capital Economics, said that the reluctance of banks to lend to each other meant we might have a "technical recession" but hopefully not as bad as the early 1990s. (I asked around, and in my circle, nobody could remember the recession in the early 90s!). Another expert seemed to be suggesting that the problem is a "contagion" spreading through the economy, which makes it sound less than a fundamental problem.

As I understand it, both of these analyses are very shallow (only looking at the symptoms, not the causes), and these experts tacitly admitted that they are having difficulty making accurate forecasts. It made me wonder whether it ever occurs to them to step back and look at the 'bigger picture'. I suspect not.'
I did not see the interview, so I am unable to comment on the specifics of what was said. However, I think that this comment captures one of the problems of current economic thought. The world economy has changed significantly since the early 1990s. I have given an explanation for why this is the case in my post 'The Root of the Problem'. My argument is that there has been the development of a situation in which there is a massive over-supply of labour in the world economy, and that this makes the critical difference to the way in which the world economy is operating.

It may be worth reiterating how this provides a problem. Imagine that there are three factories that use commodity x, and the factories use a total of 100 workers (workers have a particular meaning outlined at the end). Each worker uses 1 unit of commodity per week in order to produce up to 100 units of product z. There is demand for 98 units of product z. There are 3 commodity companies who together can extract up to 105 units of the commodity per week. As such there is an oversupply of the commodity and a very small oversupply of labour, and this helps keep prices down.

Then something changes. It starts with one or two extra workers becoming available, and a new small factory is built to utilise their labour. Each of the new workers can supply half a unit of product z, but only adds a quarter of a unit of demand for product z. Initially, this is not a problem. They make very little impact upon the supply and demand, though their ability to produce more without greatly adding to demand holds down the price of product z.

However, because they can make the product z without demanding so much of product z in return means that this prevents the three original factories from raising their pay to their workers. As time goes on, the one or two extra workers start to increase in number, and as time goes by, they start becoming better at production so that they can produce just under 1 unit per week per unit of labour.

This is all fine, but suddenly there is a little too much of the product being made. The price of the product starts to drop, and with the drop demand overall increases, as more people can afford more of product z (including the workers in the new factory). The three original factories start to struggle, as they have too much labour. The price has fallen with the increase in supply, but their workers demand too much of product z in return for their labour, in comparison with the new factory. They realise that they must lay off workers, until such time as demand for product z increases to the point where prices will rise enough to give their labour what they demand.

As fast as the original companies lay off workers, new workers are appearing at the new factory. As each new worker is added, there is a new pressure on the price as the lost production capacity is replaced with labour that demands less of the product in return. Meanwhile the overall demand for the commodity is rising, along with demand for product z, as more workers can afford to buy it. The commodity extraction company notices that demand is rising and starts extracting more, but each week only add a fraction of a unit of the commodity to supply, such that supply in comparison to demand is slowly falling.

Furthermore, as it is apparent that a new factory offers the ability to produce the product more cheaply than the original factories, a trend of building ever more new small factories starts. Add to this that the new factories have improved on the amount of product z that each new factory produces per worker, and that the amount of the product z that the new workers are demanding for the labour is increasing slowly, and the situation sees a further escalation in demand.

The question here is; what happens next?

We have an ever increasing number of units of product z being produced as the original factories laying off of staff lags increases in supply (they are responding to the market signals), and we have an ever increasing supply of labour that wants comparatively less of product z per person, and we have an overall increase in supply of, and demand for, product z in comparison to the increase in supply of the commodity.

I was tempted to do this as a formula, but would rather let you use a heuristic/estimation approach (in part because I do not have the time, in part because it is clearer if you think about it).

We have several problems in this scenario. The first is that, as workers are laid off, there should be a decrease in demand for product z. In the real world this is not the case and the question is how this can be so? The other problem is that, where commodities are not keeping up with demand, what happens when commodity supply can no longer meet demand?

The second problem is relatively easy. With only so much increase in supply of the commodity, there will be a situation in which there will one day be excess capacity of labour in relation to the supply of the commodity, in particular in a situation where more and more workers are being added. This is the situation today. In this situation, only the factories that can manufacture product z with the least demand from the workers for product z will be able to to be supplied with the commodity. There is only so much of the commodity to go around, and only the most efficient factories will survive.

The other problem is that with only so much of the commodity, for a while, there will be an increase in the cost of the commodity, and therefore the price of product z will increase, thereby lowering demand, as the product becomes more expensive. In part this is offset by the increase in labour keeping demands for return for labour low, and the greater productivity of the new labour, but eventually the increase in the price of the commodity outstrips these factors.

Now, in a perfect economic world, what should have happened is that, as the new factory opened and commenced production, the workers in the original factories should have reduced their demand for so much of product z in return for their labour. Instead, they continued to demand the same amount of product z, and this led to their factories progressively shutting down. As this happened, there should have been a drop in the demand for product z, but this did not happen. Here is the mystery of the world economy. How is it that demand continued from the original factory workers? It does not make sense.

We are now in a position where one of the original factories has shut down completely, the remaining two are much smaller, and there are a mass of new factories. Available labour has now outstripped the capacity of the commodity. The price of product z has started to rise dramatically, and demand is therefore falling back. Sill the mystery remains of how it is that demand did not adjust with the closing of the original factory and the lay off of so many workers from the original factories.

It is here that we come to the 'economic miracle' of the last ten or so years. The new factories could produce product z without so much demand for workers for their labour of product z. This gave them a greater surplus per worker, and they then invested this surplus. Furthermore, as the commodity producers enjoyed ever greater demand, they made ever greater profit, and also invested this.

We now need to step away from this simplistic explanation, as it can not explain what happened next. This investment is the surplus generated from the emerging economies such as China, and the profits of the commodity producers. They invested this money into the governments of the West, and the Western consumers, thereby delaying the day when demand for product z would drop. It is only now that the supply of commodity is inadequate for the supply of available labour, that the problem has come to light. Demand should have fallen back a long time ago, but was propped up by bad investment of the surpluses that were created. Without a commensurate increase in supply of commodities, the growth could not continue. and without a lowering in demands from labour in the West, they were going to lose the competition for the allocation of the commodities.

We now have a mess. The west is in debt, prices are rising, demand is falling. The amount of commodity is only 120 units per week, but the number of workers is 140 and still growing. Someone somewhere is going to lose out. The amount of commodity per worker has fallen, and is falling further, despite the amount of commodities overall increasing. As such, the world as whole is richer. What has changed is that, whilst the world as whole is richer, the original workers must accept that the distribution of the commodities has changed.

When the original factories were in the West, they were using nearly all of the commodities, and were therefore the primary beneficiaries of the commodities. When the emerging economies entered the market, then the amount of commodities per worker was redistributed, such that some of that share was being transferred away from the West. Had commodities kept up with demand, then eventually (albeit with some painful adjustment along the way) everyone in the West could have remained wealthy, and the rest of the world become wealthier. However, in order for this to be the case, then there needed to be an increase in supply of commodities such that every single worker has the same amount of commodity per worker as we had in the beginning in the original scenario.

In other words, the only way that everyone could have won was to have exactly the same level of commodity extraction and production per worker as at the start of the change in the world economy.

The reason why economists have got it so wrong is that they have ignored the fundamental problem in the world economy. You can only grow the world economy if you have the raw materials to provide the means for growth. If not, then the raw materials will simply be redistributed. Redistribution means winners and losers.

It really is that simple.

Note: If anyone would like to do a scenario with all the numbers to illustrate the point, then this will be welcomed! Just add it as a comment, and I will publish it (it may also reveal some faults with my scenario?)

A note added to the post later: I mentioned that, as more labour enters the market, and commodity extraction increases, the world will be getting richer. I perhaps did not make one point clear enough. The overall wealth of the world on average has increased, but the likely outcome is that the wealth of the West will, on average, decrease. As such, whilst the world gets richer, a share of that wealth will be redistributed to the emerging economies such as China. In crude terms if we say that each of our Western consumers averaged a usage of 1 commodity unit per week, then the world must produce the same additional amount of that commodity for each new worker for everyone to reach the wealth of the West at the start. Where there is only 0.6 units of commodity per worker, then not everyone can be as rich as the West at the start. The question then arises as to how the new commodity per worker will be shared amongst different workers. More to the point, what happens when ever more labour is pouring into the market?

I should also clarify that a worker is a person with sufficient capital and infrastructure supporting their entry into the world labour market.

Another Note added 8 August: I just thought I would mention that I have been guilty of implying that the key differential between the emerging economies and the West is wages. It is not just wages, but all of the other 'benefits' that come with living in the West that are also part of the differential. These are structural problems. I address this issue in a rather unusual way in my post 'The Cigarette Lighter Problem'.


  1. Mark

    I do look forward to checking your blog for a new post every morning, and this one is a particularly good one. I've read through it twice, and my brain is still aching a bit, but I think I'm beginning to get the idea. In my own woolly mind I already had a vague inkling of what was happening, but I hadn't worked it through.

    At the risk of showing that I don't in fact, understand anything, could the situation be summarised as follows:

    (a) Approximately 10 years ago, the hitherto dormant China made a conscious effort to enter the capitalist world, providing a new workforce of millions.
    (b) Low Chinese wages made the West uncompetitive in manufacture.
    (c) Low Chinese wages drove prices down, and demand up, for manufactured goods.
    (d) In the face of such competition the West began to move away from manufacturing, but didn't suffer, because:
    (e) Prices for manufactured goods were falling, and anyway the Chinese 'invested' (loaned) the West's money back to it, assuming, like us, that the West would always be rich, and able to pay it back with interest.
    (f) Easy money increased the West's demand for Chinese goods even further.
    (g) This was unsustainable, and eventually bottlenecks in commodity supplies resulted in a sudden interruption and collapse of the process.
    (h) The now bloated, decadent West is in a mess, owing a lot of money to the Chinese but with no ready way of paying it back.
    (i) China is temporarily in a mess because it has a lot of workers, but demand for its goods has ceased.
    (j) In the longer term, the West will pay off its debts to the Chinese by abandoning its 'decadent' lifestyle and giving away its assets.
    (k) The Chinese must cope with a temporary drop in their growth (which will cause problems for them), but will ultimately reap their rewards.

    Is that anywhere near being correct?

  2. lemming, your point (e) should recognise that the Chinese could not repatriate their dollars back into their home currency. If they had, the exchange rate would have shot up, and suddenly their labour would not be so cheap anymore.

  3. Chaps

    This is all well and good but completely ignores the total collapse of the banking and financial system that is underway.

    The greenspan bubble and the gigantic mass of fake assets that it represents has now exploded, and unless concerted action is taken by governments to control this crisis and create a new system, we will all be dead within a few years from now - assuming we survive to the end of this year, given the nuclear brinkmanship that is going on with Russia.


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