When do we need science?

I often get into arguments with people and invariably I end up invoking science in a way to present evidence. Often this invocation of mine is countered with an accusation of, ‘you must admit science isn’t perfect’, where I am forced to admit that this is indeed the case. What is quite frustrating is that I more often find myself arguing against the blind application of science rather than for it, so when this accusation is levied at me, I find that a gross misunderstanding has occurred. With this in mind, I wish to attempt to clarify when the application of science is or is not appropriate or necessary.

Science is NOT appropriate for living, intuition dominates daily life. We do not need science to tell us how much pressure to put on the pencil so the tip does not break, this will be learned by trial and error. Similarly like Nassim Nicholas Taleb likes to say, we do need to ‘lecture birds how to fly’, birds can fly without understanding aerodynamics and the complicated physical laws that accompany them. A snake does not need to understand the mechanics of friction or momentum to learn how to slither. In this very same way science will very often shed light on things that we can already perfectly navigate through without this formalized mumbo jumbo. Religion would also fall in the intuitive domain.

Even science that is ridiculously close to the truth can often be insufficient for taking action due to the Precautionary Principle (a previous topic). Just because we find that something is unlikely does not make it less important, acting upon a hypothesis cannot be weighted without taking into account the magnitude of its implications. It follows from this that  it is worthwhile to invest in preventative measures when the consequences of an event are devastating even if the event is highly unlikely. An application of this is that it could be worth overreacting(a misnomer) to disease contagions such as Ebola and NOT to airplane accidents because the former does have a higher propagation effect (the probability of Ebola killing a million people is much higher than the probability of an airplane accident killing a million people).

With these devastating critiques of science, one might think I’m as anti-science as they come. However, this conclusion would be blatantly false; science is the most systematic way for humanity to approach objective truth. This truth need not imply anything about how we structure society or our lives. Yes, it may be misused but so can every possible freedom afforded to society, indeed this is the very definition of freedom. We avoid restricting freedoms of the masses based on what some people may do , we do not quarantine every individual because some people may be murderers. Free inquiry is a fundamental principle of every open society, the goal of science is to attempt to codify our knowledge, not to tell us how to use it. The fact that each person may infer from it what he wills is the very basis of an individualist society and why we need robust Kantian moral imperatives. This principled stance is vital to the open society so that when an inconvenient truth emerges, we have no need to change our social behavior; This is because our behavior was not derived from scientific principles in the first place but from irrefutable morality.

Science is not perfect and many hypothesis we take as temporarily right (a hypothesis can never be proven) end up being false; however when we are dealing with ideology and things away from intuition, science is how we put our biases in check. Inherently when one discusses ideology based on hypothesis which are out of the intuition of daily life and are contradicted by many other individual experiences, science must be invoked. The very first step to the scientific method outlined by Popper, before ANY empirical work is conducted is to clean up your hypothesis. If your hypothesis predicts the same observations an existing hypothesis predicts then your theory isn’t precise enough to be meaningful, much in the same way the hypothesis of ‘shit happens’ is not a credible theory. Any theory that cannot be disproven is fundamentally flawed and must be discarded or at least not believed in until it can be fleshed out to make observable predictions.

Technical point: The production of evidence is often a function of a function. What this means is that we cannot ignore the bias or effort that goes through the production process. If for instance there are ten thousand ideologically biased researchers who are searching to prove hypothesis x, then by pure randomness we can conjecture that at the 99% level, then there will be 100 studies showing an effect when none exists.

Finally, often we can come up with numerous theories that fit the same observations; invariably this happens in every field, so how do we choose one? The most philosophically consistent position to adopt in such situations is to choose the hypothesis that makes the least assumptions. This is often called Occam’s razor and it is possibly one of the most important elements in the selection of any scientific theory.

 

Big ideas: Design vs Evolution

This was supposed to be a single post but I don’t like talking about concepts I haven’t previously introduced on the blog so I’m making the first post about design and evolution and then following it up with a post on movies and series.

Design

A design is an article/product/item of manufacture that is the result of an architect’s vision. The key in design is the presence of the final vision from the initial stages of the process. Likely to be the biggest achievement of design thinking is the wheel.

wheel-invention

Intuitively, the wheel is uniquely the product of design thinking as half a wheel or a wheel with angles would be close to useless. Therefore, if we are calculating the marginal value of each design step and the steps are sufficiently small we would never come up with the wheel. This is because at most steps, the direction towards the wheel will never appear like an improvement. It is only when the wheel is completed (or close to it) that its value starts to emerge. Accordingly, it seems alternative improvements will always be chosen over those that will lead to the wheel.

Graph for blog

When the wheel is only 20 or 30 percent completed and only a step or two ahead can be envisioned, it is unlikely that the design process would continue and lead to the final product.

Design thinking does however make the product highly fragile. Since in essence it relies on the synergy of the components and not their value in isolation, damaging a component creates a non-linear loss in value. For instance, adding a couple of angles to a wheel quickly deteriorates its value as it can no longer roll smoothly. This fragility does not have to pertain to the object itself, it can emerge from the environment for instance a wheel’s utility is fragile to not being on flat ground.

This same logic applies to buildings, they are a product of design thinking. You know a skyscraper is designed because knocking down a small proportion of the building causes it be useless (collapse). It is designed to lean on certain components more than others. (I might come back to this in the form of urban planning in some future post).

Overall the weakness of design is its fragility. It does have potential for unprecedented efficiency but it is very reliant on its designer. If the designer has no sense of history he may not incorporate proper systems into his design which fragilizes the whole endeavor.

Evolution

Evolution is all about small steps, where you try different things in different directions and choose the one that better improve the outcome. There is a caveat of conscious versus unconscious evolution but it’s not important for my purposes.

Through evolution it is possible that the outcome be enormously complex. Perhaps one of the more famous examples is echolocation in bats or dolphins, which is an enormously complex process that is more efficient than most of what modern technology has pieced together. Perhaps a more intuitive example of evolutionary outcomes is in scheduling your calendar. Gradually adding routine things to your calendar (gym, dance, learning, etc) is an evolutionary process because you evaluate each addition separately.

Things that evolve through evolution are generally very robust to variation and damage. For instance in the scheduling example, if suddenly one activity gets cancelled, the value of the others is usually not suddenly damaged and you still have the value of the other activities and the free time you gained from the cancelling. Similarly half a lung is still very useful, though it will obviously be able to produce only a fraction of the full lung’s oxygen. In fact most (if not all) of the organs of the human body share this feature.

Technical note: When dealing with evolved entities its usually less misleading to rely on the Law of Large Numbers.

The thing about evolution that makes it robust is that it does not forget the past. It is conscious of history and has systems to incorporate the past into its future behavior.

Putting it together

To me evolution vs design is an important question in almost all domains in life. Should one plan or play it by ear and deal with things as they come along?

The truth of the matter is that nature (which is almost fully a product of evolution) has a statistical validity that makes arguing against it a highly challenging endeavor. Whatever was not robust was ruled out by millennia of evolution. Therefore a proposal that is an alternative to nature, to be credible must have a significance level that can be juxtaposed to these millennia of evolution. I.E though taking a car (a designed object) to work may appear universally more efficient, but the lack of walking may lead to heart problems, unbalanced psychology, etc. The thing about evolution is that it feels no pressure to inform its user what the benefit of a certain heuristic/habit is, so great care must be taken when trying to replace such heuristics. Evolution may give us instincts to delay gratification but a design thinker may not accept such a delay because he/she does not see the benefit, and if you do not see it, then you cannot design around it.

Evolution doesn’t have to be uniquely genetic or cultural. For instance the heuristic to look left and right when crossing the street is probably both a cultural heuristic and a genetic tendency, it is a method of taking the past and using it in the future.

Similarly the economics debates which used to be in large part dominated by either evolution (pure capitalism) or design (communism), have now become dominated with a mixture.  Ideas of pure design have mostly been shut down, they have been replaced with arguments about the provision of platforms and are inherently of higher sophistication. Property rights and the rule of law are seen as such a platform and debates over the welfare state can be interpreted similarly.  It does seem however that there is quite a lot of emphasis on this kind of design thinking without much mention of fragility, and it’s obvious to me that with things like nukes, the internet, and even central banking(I find this one particularly interesting), we are quite a bit more fragile than we have ever been.

Evidence vs proof. How to think about Global Warming and GMO’S.

This might be a bit of derivative post because I am just deciding to come back to blogging.

This topic has been resonating in my head over the last couple of weeks as I hear people saying the words “there is proof”. The difference between “proof” and evidence doesn’t appear to be an obvious one so let me try to clarify.

There are two kinds of proofs. Mathematical proofs, and legal proofs. Mathematical proofs are axioms which are internally coherent, there are many levels of sophistication in mathematics and some higher level proofs may not be deemed worthy of the title of “proof” by the purest of mathematicians. Legal proofs on the other hand are not nearly as related to internal coherence. It is merely the nature of the law to categorize things into binary states (guilty or not guilty), it is not meant to indicate a perfectly coherent internal structure but is meant to classify people so that decisions can be made.

The important thing to note here is that science and proofs are unrelated. Science is a negative endeavor, it never deals with saying anything is true, it works only in calling out untruths. When you read any paper that says “we show that there is a relationship between…” what they mean to say is “we cannot reject the fact that there is a relationship between these things…” You cannot show that something is true you can only show that it is untrue. If you do an experiment within a closed system a million times, it is STILL not proven.

You might think that all this means that the correct question is then: “at what point is the evidence strong enough so that we can lean on it to make decisions?” While the volume of evidence does matter, what could matter to a much greater degree is what it implies.

Let’s take global warming as an example. There is some correlational evidence but it is hardly convincing given that we know spurious correlations arise naturally. There are also some simulations but simulations can be made to show anything and always miss some real world nuances (given chaos theory, a half realistic simulation would take years to run on the best super computers). Though everyone treats human driven global warming as “fact” it is far from it. This however is irrelevant, the consequences of global warming, perhaps eventually making the planet uninhabitable to humans are so gargantuan that the standard of evidence we need is as low as it could be. In other words, the consequences of overreacting are comparatively minimal to the consequences of underreacting. Indeed when there is some probability, however small, that the world will end, the burden of proof falls to the other side.

The opposite example is GMO’s (Genetically modified organisms). The question is simple, should we genetically modify food on a mass scale? Well it is still unclear what such modification will do to humans and it could have strange long term interactions (which will almost never be fully controlled for in an experimental setting). Even if the evidence is unclear, this is grossly insufficient because the effects could take any form and if a large population of people were to be involved, the consequences could explode. The burden of proof quite obviously falls on the people pushing GMO’s. Ninety ninth percentile significance levels is not a metric that warrants application, if ninety nine percent of flights were safe, there would be over ten thousand people dying a day from plane accidents.

Technical note: When using Bayesian statistics it is easier to objectively apply this logic because we can just set extreme priors.

Consequences of inflation phobia

updated: added the summation of the factors for a -1.5 deflation rate.

I’m sure most people have heard that increasing how much money is going around generally increases prices (and the opposite holds true). Economists have a formal method for explaining this phenomenon:

M * V = P * Y

The model’s variables are aggregates representing different aspects of the economy. M is how much money there is (though unclear as to what money is). V is Velocity which is s how quickly money is circulating, this variable can tell you quite a bit about the economy and confidence. P is the price level of the economy (Consumer price index is a proxy for consumer), and Y is the total output (Gross Domestic Product is a proxy).

You generally have to get it logged so you can work in growth rates which help tell you better where the economy is heading. So that gives:

m + v = p + y

To clarify, that means that if GDP grows by 10% then y would be 10%. Rearranging for the price level gives us:

m + v – y = p

Now it’s just a question of plugging the right numbers in to predict what inflation will be. Money velocity is expected to be dropping by about 2.5% because of broken financial institutions and lack of confidence in the economy. GDP growth rate in the Eurozone is up for debate but for the sake of argument let’s say its 2%. The ECB is unwilling to be expansionary (thanks to Germany’s hyperinflation phobia) so money growth seems to be about 3%.

3 – 2.5 – 2 = -1.5

So why is this bad? Because when people expect deflation, they end up waiting more (since they expect their money to buy more in the future). This means that economic activity decreases even further and sends the economy further down a depressionary spiral. This includes not only consumers but investors, since consumers won’t be spending, investors won’t find fruitful projects. This comes back in the form of less stuff and less employment. This is not to say that the marginal effect of a deflation movement from 1 to 0 is worse than one from 0 to -1, but generally speaking, the more deflation, the worse things will be. 

Money velocity and GDP can be affected by fiscal stimulus that is, government spending more money. You can also affect velocity by increasing confidence in the markets which makes people not hoard cash as much. But both of these seem unrealistic in the Eurozone with its lack of political union where everyone seems to be obsessed with austerity. An easier solution would be for the ECB to say we are going to increase how much money there is in the economy by 10%, since money is something they directly control this is very easy to do, just print more money, but that won’t even be necessary, as long as they say it out loud, investors and consumers will all know to expect inflation and will invest or spend in the economy.

A note: the expansionary monetary policy would also allow government debt to become more sustainable which makes the other options easier to do.

Understanding Currency Areas and the Eurocrisis

I’ve been quite perturbed that most analyses of the Eurocrisis is done by politicians and doomsayer journalists to the extent that most of the content out there centers on the least likely events and fails to capture the spirit of the intellectual debate. Nice thing about blogs is that you can make things as complicated as you like, though in this case I will restrict myself and not use formulas or graphs for the sake of clarity.

Some helpful background

Devaluation is used as a mechanism to reduce real wages. The reason devaluation works is that workers fail to notice or respond to the inflation by raising their money wage demands. If wages were all tied to inflation(also known as indexation), as many multinationals do, the process would not work, and if some did and others didn’t, the process would disproportionately affect those without this adjustment. This power of devaluation is much more prominent the more the cost of living is reliant on the outside world and hence more likely to provoke a response from the labour force. From that point of view this makes the case for much larger currency areas since devaluation is possible without provoking a response. Devaluation can occur not only through monetary means but also by decreasing the cost of doing business which includes a decrease in taxation levels;

I would recommend reading my Unit of account post and Unit of Exchange post to fully understand the functions of money because they are directly relevant to this post.

The benefits of monetary union

These are microeconomic in nature and involve helping out small firms remain competitive as well as alleviating consumer burdens.

Transaction cost

The first benefit is a reduced transaction cost. Though fees on large currency transactions are quite small, currency turnover is extremely high, so cumulative costs can be higher than one might imagine. Although it’s easy to say that the transaction cost of a single currency is reduced, it is possible to overestimate the magnitude by which this is so. This mistake might be enabled by ignoring the fact that not all foreign currency loans are simply hedging exchange rate risk, indeed some of these are favourable because the foreign loans have a lower interest rate. Even so the reasons for this lower financing rate could not be related to the exchange rates whatsoever, an example of which is a multinational borrowing in the domestic market because its reputational capital can be leveraged into higher credit ratings. Additionally many of the potential perceived costs of foreign trade are simply rents extracted by financial institutions exploiting their economies of scale. This allocation of resources not only has an opportunity cost in terms of human labour but also causes inequality between industries by funneling money into finance.

As an example let’s consider a bid-ask spread (buying versus selling currency) of 0.05%. To the individual this might seem insignificant, but this is a very deceptive way of analysing the situation. Given that 600 billion in currency transactions take place in London, such a spread would represent 300million in costs per day. Even so, this element is frequently ignored by politicians because the savings might be negligible from the narrow view of an individual country, especially since a great proportion of the trading is done on behalf of foreign principals, this means that although monetary union would be a considerable savings cost, the UK perceives it as a booming export sector. Even so, the savings potential from a UK resident’s perspective of an EMU would be limited to transactions within the Eurozone. Academic estimates with all this taken into account estimate that the cost savings in transaction costs would be about 1% of EU income.

Accounting costs

Foreign flows being converted into a common currency for the consolidated balance sheet inherently introduce greater variability in forecasts of share prices and increases capital market volatility.

When evaluating risks of currency splitting we must be able to partition the arguments for what it does and doesn’t do. Any individual entrepreneur is likely to be less enthusiastic of any prospect if an additional risk of currency fluctuation is introduced. However when dealing with multinational firms this risk is not necessarily as large as it appears since a true multinational would have flows in both currencies and opportunities to finance from institutions in both currencies and so the risk is likely to be overstated if we just look at the variance of the exchange rate. If the company has accurate forecasts of these future cash flows it may even hedge, but this is a return to the previous point that this process funnels money into the financial industry. Perhaps most importantly we may overstate the cost of the currency risk because even if the foreign currency value does depreciate, this will be partially offset by the fact that the foreign production will become more competitive and in the process, increasing prospective cash flows. However these options are not present for smaller companies, which have to rely on financial institutions ability to mimic these advantages and generally are likely to reduce competitive forces within the economy since it offers more than just an economy of scale advantage to bigger firms.

Insulation from monetary disturbances and reduced political pressure

Given multiple currencies, it’s possible that the domestic prices are sticky (don’t adjust fast enough). This stickiness might lead to unnecessary and temporary fluctuations in the real exchange rate due to speculative bubbles.

Finally without the option of protectionist policies from myopic politicians, we reap the benefits from the most agreed upon economic policy of all: free trade.

Costs of monetary union

These are macroeconomic in nature (more about patterns of adjustment to disequilibrium) and would hence be up for rigorous debate. Some schools of thought, like the Austrian school of economics might even dismiss them completely and blame this thinking for the business cycle by enabling the allocating of resources to be done in a manner that does not reflect the preference of consumers, implying an inevitable crisis.

Monetary flexibility

This is perhaps the main cost being referred to. Currency union makes regions less able to respond to macroeconomic imbalances through specific monetary policy. This belief is mostly credible in the monetarist sphere of thought since fiscal stabilization is a very plausible alternative to most interventionists (and perhaps the only choice when interest rates hit the zero bound, ignoring of course the more unorthodox methods being suggested).

Monetary flexibility also includes financing government spending via inflation, by reducing the burden of public debt (e.g. if your currency is worth less, government bonds are worth less and easier to pay back). Though some would question such indirect measures of taxation as not being transparent it is an important option for extreme times such as wars. However EU wide tax and transfer systems reduce the need for this. Similarly seigniorage revenue in a common currency area (the ability of new money to buy goods and services) would need to split in very equitable ways.

Labour mobility is king

These arguments are all rendered irrelevant by one thing, a sufficiently high labour mobility (people willing to move across the currency zone).

To give an example lets imagine the price level dropped in a country by 10% and that foreign goods are responsible for 50% of the cost of living, so real wages have increased by 50*10%=5%(since you can now afford your previous lifestyle with less money). However given that the people can now buy more but their productivity has not changed this will make firms less competitive and apply downward pressure on the economy which will increase unemployment, bankruptcies and so forth. With sufficient labour mobility, employment will be restored without transitional unemployment because people will fleet to the new high wage country until the supply of people brings wages back to equilibrium.

The question as to how the existence of labour mobility comes about is of course a different one. Although Economists usually perceive it as a requirement for an optimal currency area, it is likely that action must first be taken to increase the labour mobility. Indeed since the Euro was introduced an increase of labour mobility has occurred within the Eurozone and the crisis has further fuelled this trend.

However it is obviously still insufficient and more could be done to encourage this trend, reforms to this end would include: a single language being used in business, transferable pensions, lower transportation costs(from country to country), standardized unemployment benefits, common legal systems…etc; This encouragement is not only important for Europe but also for the US where empirical estimates show that about six years are required for labour mobility to substitute the failure of wage levels to fall. From this point of view you could argue that even the US should be a candidate for monetary disintegration. I would also add that policies that encourage home ownership, which are taken by most governments are likely to reduce labour mobility.

Of course there is also the matter that entering a common currency usually leaves countries open to speculative attacks by investors. Though this has already been experienced by the EU in the early 1990s and paying any attention to this now is merely a sunk cost fallacy.

Expectations and Politics

Fixed exchange rates could theoretically offer many of the benefits of union without the costs. Though the assumption here is that the countries can keep this indefinitely, and if it would have been done indefinitely they would have just joined the monetary union. So in practice fixed exchange rates have a problem of credibility, how long will they keep doing this? In some cases the market will use immense capital to attack these fixed exchange rates and break down the regime.

Although this analysis is economic, it is impossible to ignore the effects of political framing on the markets. From the very outset the framing of North versus South has had an enormous influence on the markets and has greatly impeded the ability of governments to take action. When it was presented that the crisis is a result of Greek fraudulence and profligacy, it becomes difficult to aid them from a political point of view. If the crisis was framed in terms of economic interdependence and not of morality aka, helping the lazy Greek (some economists disagree with that stereotype) it is likely that bond spreads within the EU would not be as high as they are now and more credibility could have been given to weaker governments, as it is now stronger governments are able to retain market confidence. The more these benefits are spread out, the more consumers of these advantaged countries will lose out in terms of an increase in cost of living.

The idea that monetary union requires fiscal union has been spouted enough but it doesn’t go far enough. In addition to the measures that would encourage labour mobility, common deposit insurance, financial regulation, true lender of last resort abilities from the ECB and a federal constitution that overrides state power would all go a long way to unifying Europe.

Of course in ordinary times it is true that countries are able to borrow more than they would have otherwise due to the credibility of their neighbours, creating an incentive for governments to be unsustainable. In turn this increased spending creates inflation and boosts real wages (and hence, standard of living) to levels that don’t reflect the competitiveness of the country.

However, in another light all this talk about restricting countries from defaulting and requiring German taxpayers to bail out other sovereigns is nonsense. US states and local governments have defaulted in the past as John H. Cochrane’s puts it: “A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a litter bottle, that wouldn’t threaten the metric system.” Too much is done to enable bailouts either in more direct manners (ECB buying government bonds in the secondary markets) or indirectly (ECB lending to banks that lend money to the governments), which is not helping sustainability and will require hoards of EU taxes to fix or the Euro will be inflated away.

Governments and the ECB have been pressuring banks to keep buying their debts, the ECB is more of culprit since it gives conditional liquidity injections. These banks become more and more dangerous as this effect continues, Cyprus’s recent bank troubles are but a demonstration of this instability.

Possible endings

We could possibly kick the can down the road with just more bailouts but eventually wishful thinking will end and the true choices will emerge.

One of these is fiscal and monetary union, federal government issuing controls on government budgets and allowing for some of the above frictions for labour mobility to be eliminated.

The other is monetary union only, this would mean governments need to be able to default like companies, and banks would be allowed to treat sovereign debt like any other debt (something BASEL 3 doesn’t help with).

And the most costly option is the breakup, probably after a crisis and inflation. This would be seriously debilitating to all contracts that would have to be converted to a currency that doesn’t exist and would lead to immense capital flight and economic damage. Once again in the words of Cochrane: “The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.”

Money’s use: the unit of exchange

Picking up from my previous post on the value of money which talked about its use as the unit of account we continue here with the next benefit, unit of exchange.

So every good has two values, the first is its retail value, X. This is what people would pay for it because they want it (or need it). The second is its exchange value, Y; this is what people who don’t want it would pay for it and they would do this because they can exchange it later on. So by definition X should be higher than Y otherwise people would not buy it to sell it on since they would make a loss.

So, let’s take a situation. Let’s say person A wants to buy a cell phone, but the only thing he has in excess is a microwave.  So A goes to meet another person, person B (who has an extra cell phone) so he can exchange his microwave for the cell phone. It could be that B wants or needs the microwave, and if that’s the case, that’s what economists call a “double coincidence of wants”. In this case he will get fairly close to the X value of the microwave since person B wants it.

If however person B does not want the microwave then he will not want to exchange it. That is unless he is making a profit from this transaction, and the only way he can do that is by thinking he can exchange it for a higher value than he will get it for. So person A will get a value close to Y in this case.

This difference between X and Y is the cost that person A will suffer in the second but not the first scenario. It is the second transaction cost that takes place without money.

As I mentioned before, money is essential to the division of labor of society.As a last demonstration of division of labour’s important to the exchange value, let’s imagine that a bakers TV broke down. Without the presence of money, he will have to spend hours and hours on end trying to learn how this works, and then fix the TV. These hours are of considerable value to people, but with money, the baker can essentially fix the TV by baking cookies. He has the ability to liquefy his effort and make it take any form he wishes it to without suffering much of a transaction cost at all. I find this amazing, how you manage to achieve everything people can do with equal efficiency by doing just one thing what you can do most efficiently. That is unless labour prices are distorted.

Now so far we have assumed that both parties know the true value of what is being offered. If however B does not know what A’s product is worth the transaction is crippled since B would need to be educated. This education process is costly and if he is exchanging it for the purpose of reselling it, then he might also expect that who he sells it to will also need to bear an education cost. So the price person B will pay will be Y minus the cost of acquiring this information, which means A got even less value out of his product.

So in our economy with millions of products, we can introduce money and what this does is make X=Y.

Money isn’t some artificial thing that was dreamt up, it was a spontaneous process, one where people saw immediate benefit from its use. There was no real need for government to issue currency as medium of exchange; historically gold and silver fulfill an equally good role. The criteria for a good medium of exchange are durability, portability, recognisability, divisibility, homogeneity and scarcity (this one is tricky with elastic money). As a side effect, when something becomes the medium of exchange, its value is no longer determined by its intrinsic value but by its value for trading.

As a final note, it should be obvious that money is only worth something in the context of the economy’s output. If you have 10% of all money in the economy, you essentially own 10% of value of the economy. So printing money doesn’t really create value, it merely increases the medium with which to exchange things, the amount of things to exchange has not changed.

Do we need patents/intellectual property?

It’s easy to think that industries can’t work without patents, and this is very true to some extent. Many biotech firms make a loss year in and year out, hoping to survive until that patent gets accepted. But this is a static view of the world; let’s take a moment to consider how the world would look without these patents. To be sure demand for medicine and this kind of research would still remain and as long as demand remains, then there will be solutions. Maybe the political process will create funding for such projects, though that would probably not be very efficient. So how can the private sector profit without patents?  How do other industries which don’t have the luxury of patents/IP(intellectual property) property do this? Let’s start with the latter question.

The theory

If a fashion designer comes up with a great new style of dressing, but can’t patent it and the next day all others do something similar what has he gained? Well reputation of course. Monetizing reputation is then easy; this fashion designer will be the first to be called by people who want something designed. Or if he has a certain brand or logo associated with him, it will signal competency to the consumer boosting his sales. This same process is also present in finance, most notably, investment banking, one bank invents(or finds) a market, then, the other’s join in, nobody can claim that investment banks don’t have the incentive to innovate, in fact most of the media coverage suggests they innovate in excess. Part of what allows them to thrive is this lack of patents, which allows instant liquidity through the duplication of products. Reputation actually works surprisingly like patents; they give you a great name (which you can use to profit) but fade with time. I’m sure it’s no surprise to anybody that having a good reputation allows a company to charge a premium for its products and if no premium is charged then they have an advantage over equally priced competitors.

Music

Music is to me is the industry which is most undeserving of IP. US copyright protection is active until 70 years after the author’s death! Not only does protecting music not produce better music(no surprise since it’s an art and not a science) but the structure of IP law doesn’t even take into account how the market works. Most of the profits of music are usually made within 10 years of release so protecting it for another century seems kind of insane. Especially if you wish to use an extract from one of these artists after he dies, you have to be chasing down his heirs (who could be anywhere) to ask for permissions.

The theory described above is probably the easiest to prove in the music industry. Artists can improve their reputation by releasing popular music (which can be done with almost no cost, thanks to peer to peer sharing) and can then monetize it by using their reputation, perhaps to advertise or in concerts. The greater their reputation the higher they can charge for their concerts, and the more money they can get from advertising. Businesses (like movie studios) may also wish to contract them to create music for them. It’s hard to make a statement that is “ceteris paribus”(all things being equal) consistent, but since illegal pirating has commenced, I would say music has grown much more popular, there are more artists today than there have ever been. This is in fact partly helped by youtube (an example of how artists can make money without IP) but this was the case before youtube ever started. There is no doubt in my mind that more pirating of a given artists music, boosts his concert sales. Perhaps the most frustrating thing the about the music industry is that they are crippling peer to peer networking technologies which have very high potential welfare benefits for the everyday consumer.

Pharmaceuticals

So now to the real challenge, how would pharmaceuticals get developed? Well in a very similar way really, though the industry would probably own a lot more hospitals. So a pharmaceutical firm develops something spectacular, let’s say they cure aids. Then their brand value will rise and their hospitals will be more popular because their doctors there will be perceived to be the best in class. Even without hospitals, their medicines would become more popular due to the prestige associated with their brand. There is still an incentive to create these products, in fact the incentive to innovate is strengthened like never before, since there is no chance to sit back and relax through rent seeking (royalties), you must now always be one step ahead of your competitors, you are forced to keep innovating, cure cancer, Alzheimer’s, death, etc.

You’ve got to remember that IP at the end of the day makes things much more expensive, and could bring things out of reach of certain people in the world. Although it might not be a big loss for people on the music end, it holds back the private sector from being able to distribute innovative medicinal practices to people all over the world. If a firm develops a technology, it is under no real pressure to start distributing it, since it can just sit back and claim royalties from others who wish to do the dirty work. However those others will have to overcharge for the product and will probably not have much incentive to do this. Whilst in a world with no patents, the incentive is for these pharmaceutical companies to get this product to all markets they can identify before anyone else. What’s their incentive to do this fast if they have 20 years until the patent expires and can claim royalties without effort or investment? Let’s not restrict competition, whoever can save the most people first, wins.

Software

So now with the big boy of patents tackled, let’s go down to some chumps. Whilst the pharmaceutical industry is extreme in that the ratio of cost to create to the cost of copying is very high there are other industries which file thousands of patents without this ratio. One most extreme example is the software industry, most software innovation is incremental, created by teams of software engineers at very modest costs, worse yet most of these technologies quickly become obsolete. Each device (laptop, phone, etc) could potentially have hundreds of thousands of patents. We saw this summer how apple won a case over having rounded edges on smartphones. This creates endless opportunity to hamstring competitors.

The costs

In practice of course all these processes are very costly to our economy; we produce lots and lots of lawyers to protect these patents. Patents increase the prices of goods, they allocate resources to patent races(which is not a good competitive trait to base competition on, see my other post), there is a cost of having to look through the Patent and Trademark office every time you do something, there is of course a lot of  filing of defensive patents, which are patents which won’t necessarily yield royalties but they are there because you are scared someone else will file it, and of course patents give birth to patent rent seekers who buy large number of patents and only make money through fees and if necessary by suing . It seems obvious to me that if we had less lawyers taking care of this stuff, the innovation process would be much quicker, not to mention that the lawyers might maybe join a profession that actually directly helps competitiveness(and not by cutting off opponents feet). Let’s also not forget that we as tax payers generally have to pay to keep these(e.g patent office) public institutions running.

Fair use

In law “fair use” is a defense allowing for copying of short excerpts from a copyrighted work without a license. The rationale for this is that the transaction cost of negotiating a license for these is likely to exceed the value of the license. Yet even this law that has potential for being economically rational is so ill defined that the copyright owners can bring down this “short” phrasing to its bare minimum, for instance film studios insist that even a minute of their film is too much. Innovation comes in many forms, yet the most common is not the popularized “radical” but the “incremental” one. The lack of fair use objectivity in law is very damaging to the latter.

Global patents

One of the most vital advantages of the Chinese economy is in fact this lack of respect for patents, it allows their firms to have much lower costs of production, and this cannot be duplicated in the west because we fear the courts reining in on us. In fact in developing countries there is a reluctance to file patents, since it is in essence just telling your competitors your recipe. Another well documented global phenomenon is that patents cause inequality in society, a fact shown by various studies that should not really surprise anyone.

Some inventions are not patentable and could be just as valuable to society but having patent systems is funneling innovation to only occur in areas which are patented. For instance, the theory of relativity could not be patented, same for the theory of evolution, and our understanding of DNA and more recently the Higgs Boson breakthrough. Patenting directs our scientists to projects that can be patented rather than on pure scientific research(which might have much more productive output in the long run).

A video game called lord of the rings online, was initially a product you paid for, and once sales started dropping the owners made it free to play (making money through in game purchasing), and the game saw its profitability rise higher than ever before not to mention a much bigger player base (which will likely be beneficial on the next release of this company).  This is an example how the private sector can build models based around other ways of making profit. If every purchase gets duplicated by the net, then in the future we might see consumers cooperate to see products see the light of day, this is perhaps what kickstarter is accomplishing, if you expect that after the release the whole world will be playing your game and you’re not too sure about making an in-game profit system then you can just put your projects on kickstarter and wait for consumers to cooperate and give you funding for it.

We need to call out things by their real names, so what is a patent? It’s very simple, it’s a monopoly. In short I would not call for elimination for the whole patent system; I am not that extreme (though I obviously understand where that argument would come from). I would however wish for patents to end for all products except drugs and maybe some other expensive but easy to copy technology (emphasis on the maybe), this moderate stance is only because I’m afraid to meddle with a chicken that lays golden eggs (medicine).

Open source movements have definitely shown me that people will create not only for money but because they love creating, it’s self-fulfilling (an opinion shared by Akira Kurosawa in Ikiru). The private enterprise is resilient enough to find ways to satisfy demand without such artificial methods. Government intervention should be done when systemic and chronic market failures exist, these conditions are not met in our world as far as patents and IP are concerned.

Money’s use: the unit of account

As expected, during times of crisis people start critiquing the system.  Most notably I hear a lot about the evil of money. To really understand money we must first understand division of labour, people specialize in different fields, the often cited classic examples of division of labour are professions such as a farmer, butcher or carpenter. This division has allowed humanity to achieve enormous productivity gains(obviously this is a shameful summary). However when these professionals wish to exchange their product or service with another being, they are prone to suffering a transaction or accounting cost. This is because they do not know the value of their good in context to the rest of the world.

This is where the first of three functions of money comes in, in this first post of three I will talk about the first function, the Unit of account:

If the economy has n amount of goods or services, in an economy without a unit of account, the number of prices is denoted by:

Whilst in an economy with a unit of account, the number of prices around is merely:

So if the economy has seven goods, Beef, Carrots, Chairs, Pants, Chimay(Belgian beer), Water and Ipads. There are possible 21 possible combinations. These are:

Beef-Carrots, Beef-Chairs, Beef-pants, Beef-Chimay, Beef-Water, Beef-Ipads, Carrots-Chairs, Carrots-Pants, Carrots-Chimay, Carrots-Water, Carrots-Ipads, Chairs-pants, Chairs-Chimay, Chairs-Water, Chairs-Ipads, Pants-Chimay, Pants-Water, Pants-Ipads, Chimay-water, Chimay-Ipads, Water-Ipads.

The reason its n-1 and not n is because you assume they will use any one of these goods as a unit of exchange. For instance you could make chairs the unit of account, and everyone would agree to price their goods in chairs, so if the brewer wanted to buy an ipad, he would bring like 50 chairs to Steve Jobs(may he rest in peace) and exchange it for an Ipad. So now you only need to know six prices these are:

chairs to beef, chairs to Chimay, chairs to carrots, chairs to pants, chairs to water, and chairs to ipads.

It’s very troublesome to carry around all those chairs, what about something valuable but small then? Well maybe microprocessors? Well then how would you buy water? You might be forced to buy it by the tonne. If you try to add another object for less valuable transactions then the number of prices you need to know doubles(+ the exchange with the first unit of account).

So a convenient way to do this is to just have contracts entitling you to a certain value. In fact that’s what money IS, in the olden days bank notes were something you could literally go to the bank and redeem for gold, but even then nobody did because you could conduct all this business without ever having to lay a hand on the gold.

Anyways even though you’ve simplified the process of knowing a little, it’s not sufficient because in an economy with so many products as our own it’s still very troublesome to know all the prices.

Price System: some assumptions

This randomly came up today and I got to thinking about when the price system is the best way to distribute things, I should mention that this is off the top of my head so it might not be a textbook complete answer. This is related to my other post about price gouging.

So the assumptions i’m going to talk about are going to be in order of ascending rarity: unequal utility; limited resources; limited wealth inequality; and rational people.

Unequal utility, this assumption is the easiest to meet, its hard to even think of a situation where utility is the same. This is because not everybody values things in the same way, even if its their life you are talking about, some people may be suicidal, whilst others might be willing to kill a hundred babies to live. The trick here is an element of perception of utility, one might perceive a higher or lower utility than the actual one he will get and that might distort things, but this is probably more relevant in the rational people section.

Limited resources, this is also fairly easy to assume, there’s never an infinite amount of resources. If you have an infinite amount of television sets available to people then they will maybe use the first 3 to watch 3 channels at once, maybe more if they handle more than that, then, the next couple will be for backup, then maybe you would like to use the next couple as chairs around the house, then the couple maybe for releasing stress by dropping them off the 7th floor. The point is that there is diminishing marginal utility from these televisions but since they are free you have no reason to stop getting them. Of course what matters is not whether or not the resource is infinite, but whether your access to it is infinite.

Limited wealth inequality is touched on in my last post but its also an important assumption. Relatively more money allows for relatively more leisure, if there is a heart for sale and someone only has 10 dollars and is willing to use it all to purchase this heard because his is about to expire. But someone else who is in fine shape whose heart is only 0.1% likely to fail him in the next decade but who has a trillion dollars, would maybe be willing to pay 1000 dollars to buy the heart and freeze it somewhere as insurance. Here excessive inequality has led to the item in question not being used to its highest utility.

I should mention that the wealth doesn’t have to be a liquid asset, even a house or future promises to achieve something, maybe even offering yourself up to be a sex slave, in this case even gender creates inequality, since if the vendor is a straight man, then females will have an extra option to exchange for the heart.

Rational people is in my mind the most far reaching assumption. This is because you might have people who use morals, religion, or have some other irrational mechanism with which they make decisions. There are many cases of people not adapting to their environment to offer up the service or product required to achieve their end means because of morals. You might be desperate for food and find someone selling a loaf of bread for 1000 dollars and think that he is ripping you off and so you decide to wait for someone cheaper to come along, without knowing if this cheaper vendor even exists.

Worse yet, even if there is perfect equality, and a given person x has a higher utility than everyone else and there is only a single unit of the product that will save him, and he knows that there is only one unit and only one chance to buy it(heck it could even be free), he might still decide to forego it due to religious reasons.

We must also assume rationality from the vendor’s side, although its perfectly rational to accept only cash if you don’t trust the people around you. If he does trust everyone to a good degree then he should be able to accept illiquid forms of cash as long as the time value of money is taken into account in the form of interest. It is also true that for the vendor to perfectly utilize the price system he must be able to analyze and calculate the perfect price for his product at any given time in order to make sure that he sells it at the highest price where it is going to be sold out. Even if you sell a bottle of water for 100 dollars, you would have been better off selling two for anything over 50, so its important to be able to price things as optimally as possible.

Shut up Romney, here’s why trickle down doesn’t work!

So you often hear right wingers advocate for cutting tax rates on the rich. Bush did this and so were born the “Bush Era” tax cuts. And now you have Romney advocating for the same thing if he is to be elected.

The logic they apply is probably not bad at all at face value. If you cut taxes on the rich then they will spend that money to create jobs by investing in society.

What it does miss however is one of the first things you read in an economics text books: a company will hire an employee if it can extract more value out of them than it has to pay them. So this means that the only thing that matters is how productive the employee is. The minimum wage creates a minimum level of productivity required so after a certain level of productivity is reached, then a company would hire. All of this is of course under the conditions that the markets the company is operating in are expanding or that it thinks it can steal market share with these new employees.

But maybe an employee isn’t productive the moment you hire them, but they have to take training and will learn on the job, so the company has to take a loss, and maybe the company can’t afford the loss(even though companies are sitting on record levels of cash in their bank accounts). And in some countries/states interning for free is illegal, so they can’t get rid of that loss or reduce their risk by evaluating candidates with on the job testing.

However companies can also borrow money, either from banks or by giving out bonds or whatever. And these days the cost of borrowing money is ridiculously low, a company should easily be able to find a 1% interest rate. But Romney is right, he will create jobs, it will just be the jobs that previously could not work because the company was not able to extract more than 1% value out of that employee. An example is someone who’s going rate at the job market was 70k but with the current interest rate they would only have been able to pay them 69.3k… a very rare occasion indeed, somehow the company could not afford to pay 700 dollars/pounds/whatever more, which would be much less with average incomes. So the jobs will ONLY be generated for cases where they can spare 69.3k but can not 70k, and these tax cuts are only for the richest, who are likely to have millions… so whats the probability that people with over 100k(in all likelihood, people who are millionaires) income, can’t afford to spare 700 dollars? not very high…