Saturday, December 20, 2008

Don't Follow the Money

Attempts are often made to "explain" financial downturns with the metaphor, "the economy is like an engine, and sometimes it overheats". This is more of a STFU than an actual explanation. No attempt is made to explain in what sense the economy resembles an engine, nor why it should overheat, or what that even means. There is perhaps an implication that there should be a "cooling off" period after a "boom", but no meaningful explanation as to why that should be so. The content essentially boils down to "shit happens". Shit does happen, but it doesn't JUST happen.

I think a great deal of confusion is caused by people being distracted by money valuations. Even when a dollar referred to a specific quantity of metal, the purchasing power of a dollar would vary over time. Now that a dollar doesn't mean anything in particular, it is particularly foolish to act as if a valuation in dollars is anything like a "true" measure of value.

Of course, there isn't and can't be a single number which is an absolutely true measure either of stored value or of productive capacity. The relative values of goods and services will change unpredictably over time, and there are no generic factories but rather there is the capacity to produce particular goods and services.

A speculative bubble happens when there is an unsustainable accelerating increase in the relative value of some kind of good or service. There are two related phenomena which characterize a speculative bubble. First, there is a great deal of illusory wealth. Income producing assets such as stock or rental property, are valued far above what they "should" be worth based on the actual amount of income they produce based on the belief that their future valuations will rise still higher. Second, there is a misallocation of resources toward production both of the overvalued goods and services themselves and of increasing the capacity to produce them still further.

There are two important points here. First, the "losses" incurred at the "bust" at the end of a "boom" are inevitable, because much of the wealth was never really there in the first place. Second, there is not and cannot be such a thing as a generic boom. The world has never had a problem with too much productive capacity for everything, and it is doubtful that it could. Excess productive capacity for certain goods can be harmful to those who possess skills or equipment which are useful only for producing those goods, but their problem is not so much that too many other people can produce what they can as that they can't competitively produce anything else either.

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