At a time when most people were arguing that the economy was doing well and getting better, a handful of other people were predicting the advent of the economic crisis we are now facing. It is obvious from this alone that we need a method by which to determine the health of the economic system, one that will warn us the system is about to collapse before it does. To put things in the form of analogy, we need to know how sick the patient is before he dies and thus prove that he was very sick indeed.
In economics as in science, the difference between something spiraling upward in a positive sense or the thing spiraling downward in a negative sense is the ability of the thing to create a surplus or a deficit. For example, the reason why we still cannot produce energy from the fusion of atoms is that in all the systems that the scientists have tested so far, more energy is spent to operate the system than the system can deliver at the output. A comparison between the input energy and the output energy has consistently shown that those systems were in deficit.
The same applies to a business as can be seen from this example: If your expenses are a million dollars a year and your earnings exceed that amount, you have a surplus, your model is sustainable and you will remain in business. But if the situation is reversed and your expenses exceed your earnings, you have a deficit and you will be out of business sooner or later.
The lesson to draw from this is that if you feel your set-up is not functioning well, you first check the bottom line to see if the model is sustainable. If the numbers show that despite the apparent troubles the set-up yields a surplus, you conclude that you have a workable model that may only need a tune-up. But if the set-up yields a chronic deficit, you must conclude that the model is not sustainable and that it should be overhauled or discarded.
Although this approach may work for a scientific set-up or a business, things become more complicated when it comes to the economic system of a country. The reality is that a country’s economy is of such size, it is divided into several sectors each of which containing many institutions, and each of those being defined by a myriad of numbers. It is nearly impossible to do a definitive testing of such a system using the standard procedure.
The way things are done in a purely capitalist system is that to some extent, the institutions experiencing a chronic deficit are allowed to go bankrupt. Thus, to determine whether or not the system as a whole can sustain itself, some people have suggested that all the institutions which are too weak to stand on their own be left to die. But this act will also bankrupt the entire country, a move that does not make sense given that the reason why we wish to determine the sustainability of the system is to save the patient before he dies. Consequently, the suggestion to let all weak institutions die must be rejected. But what is there to replace it?
Well, I wish to advance the theory that the economic system of a country can be tested to see if it will sustain itself by checking three key numbers: the money supply, the rate of inflation and productivity. And here is the equation that ties these numbers together:
M / (I x P) = C
Let me explain what this is about. I begin with the premise that a system is deemed to be stable or stagnant when the same number of workers making the same goods and services produce the same volume year after year. The system will be in chronic deficit if the workers produce less goods and services year after year; or it will be in surplus if the workers produce more goods and services. In fact, what is measured here is productivity, and this is represented by the letter P in the equation.
However, the trouble with a system as large as a country is that the demography is constantly changing, therefore the composition of the workforce is changing and so are the goods and services in demand. Thus, we cannot measure the numbers and compare them year over year with any accuracy, and we must therefore do something else. Luckily, another set of numbers can yield the desired result. These are the money supply (M) and the rate of inflation (I). Using these numbers as shown in the equation, we can determine the value of C.
From a purely aesthetic standpoint, it is tempting to wish that the C were a constant and that its value be a 1. But logic says that when human behavior is involved, nothing should be given an immutable value as an absolute constant. Thus the value of C in this equation must be considered a moving target that changes from time to time and from place to place depending on the sort of economy we have and the level of complexity that the economy has reached.
To see how the equation was constructed, we observe that there is a direct relation between the change in the money supply and the change in the rate of inflation because the two rise together and fall together. But when it comes to productivity and inflation, the relation is inverted because when one rises, the other falls and vice versa. It is easy to understand why this is so when we realize that a rising productivity makes more goods and services with less expenses which results in the reduction of prices.
Bringing these notions together, we can make the following mathematical argument: Inflation is proportional to the change in the money supply and inversely proportional to productivity. We express these words in symbols and we insert a constant to transform the proportionality into an equality. This becomes the equation which is then re-arranged and given a more elegant form such as shown above.
But before we start plugging numbers into the equation, we must put them in their proper form. Usually the numbers are given by some government agency as a percentage of the changes that take place year over year. For example inflation could be described as having risen by 5%. To plug this into the equation, we say that if last year’s prices were equal to 1, this year’s prices are equal to:
(1+ 5/100) = 1.05
And this is the number that plugs into the equation in lieu of the letter I. The same is done with productivity and with the money supply.
Let us now take a complete example. This year’s money supply went up by 8%, inflation by 5% and productivity by 2%. What can be said about this economy?
Plugging into the equation, we obtain this:
(1.08) / (1.05)(1.02) = 1.0084
The result here is that C is a little larger than 1. If it had been determined beforehand that the ideal value for C in this particular economy should be exactly 1, the result would have meant that the money supply is racing a little ahead of the system’s capacity to produce goods and services. The interpretation would be that either the economy is retooling to produce more goods and services in future periods or that it is showing signs of inefficiency. It must be watched closely to see if the current trend will continue.
Let us take another example. Here too, we assume that the ideal value of C is supposed to be 1. We are told that the money supply rose by 12.27%, inflation by 9% and productivity by 3%. What’s with this economy?
(1.1227) / (1.09)(1.03) = 1
The value of C here is exactly equal to 1 which is a good sign. However, we can still make the remark that the high rate of inflation is the result of the increase in the money supply. Luckily, there was a healthy productivity that helped to ameliorate the situation somewhat. And so, while the economy looks healthy for now, we need to see a further increase in productivity in the future or the economy will start to deteriorate. A quick measure we can take now would be to curb the money supply by physical intervention.
To have a healthy and robust economy that is even better than the previous example, we should have a slight increase in the money supply, a low rate of inflation, a strong productivity and a C that is less than the ideal value. Here is an example where the ideal value of C is again assumed to be 1.
(1.03) / (1.02)(1.04) = 0.971
But the value of C is only 0.971. This means the economy is not yet humming at full potential and has room to do better. Now, given that the other numbers look good, this economy will most certainly make further progress in the periods ahead. And this is the promise that makes it a robust economy.
Now, how do we determine an ideal value for C that suits each type of economy? We do this by taking an enormous amount of accurate measurements over a long period of time on different types of economies at different stages of their development. We put the data in the form of tables or we use it to produce what is called a family of curves.
And so, when we are handed an economy to diagnose, we look up the value of C for this type of economy in the tables or we locate the value on the curves. We compare that with the result given by the equation and we try to interpret what we see.
Would the use of this equation have predicted the crisis we are now facing? Probably not because the equation is not meant to unmask the intellectual dishonesty that went into the reporting of the economy’s condition by the government of the day.
What happened that helped to precipitate the crisis was that inflation was rising but was made to look tame. This was achieved through the use of two tricks. First, the data was cooked under the pretext that the manufactured goods were much improved over those of previous years. It was then argued that the improvements justified the rise in prices, the reason why the rise was not reported as inflation. Second, the price of gold and other commodities was suppressed to counter their tendency to rise. It worked for a while but then the prices rose.
In short, every weapon of mass deception was used by the neo con men of the day to con the people into believing they were about to enter the promised land of milk and honey and the constantly appreciating value of their home. But then the deception exploded like a Madoff scheme, and the catastrophe hit everyone like a biblical plague.