Ideas an American President should mull over on his way to China.
A great deal of the knowledge I have acquired in economics happened because I decided one day to compare the flow of money inside an economic set-up of which I knew very little with the flow of electrons inside an electronic circuit of which I knew quite a bit. Thus began my passion to twin the set-up of one with the circuit of the other and decipher the mysteries of economics by analyzing the equations of electronics. And I must admit I still find the exercise to be pure joy every time I dip into it.
Interestingly enough, the comparison also helps to clarify the misconceptions that arise in both fields. For example, the misconception that students of electronics envisage most frequently before they get into the course concerns the concept of amplification. Likewise, the misconception that laymen envisage most frequently in economics concerns the multiplier effect. And when we compare amplification with the multiplier effect, we see how closely the two concepts parallel each other.
Most students begin the course believing that to amplify means to take a small bundle of energy and make it big. Because this is a false notion that has the potential to create serious trouble later on, the teacher must erase it from the mind of the students early on and thus eliminate the source of a big headache down the road. And the best way to do this is to replace the notion with the correct definition of amplification using a visual example.
Here is how I used to do it. I would ask the students to count the number of light bulbs in the classroom and multiply by the wattage of each bulb so as to find the total consumption of energy. Let us say they find it to be 1,500 watts which is the equivalent of 2 horsepower. I tell them that an athlete pedaling a stationary bicycle attached to an electric generator produces about 100 watts of electricity. This means it would take 15 athletes to generate enough electricity to light up this classroom. I then ask the students to guess how much energy a single finger can generate and they correctly guess 1 watt or less.
I now walk to the light switch and use my finger to flick it up and down a few times so as to flicker the lights on and off. I explain that with 1 watt of finger power, I was able to control 1,500 watts of light. And I underscore that this is a demonstration of the concept of amplification. I further explain that I was able to do this amplification not because my finger generated the energy of 15 people or 2 horses but because the hydroelectric company supplied this energy and that my finger only controlled or modulated the flickering of the light. The lesson to be learned here is that electronic gadgets need an outside source of power such as a battery or a wall socket to feed them and do the work they are expected to do. This supply is separate from the small power that modulates it inside the gadget. The two powers remain separate at all time; and even though we call the outcome of the operation amplification, the small power does not transform into the larger power. In more general terms, it also means that no small bundle of energy can ever be turned into a large bundle – so say the unbreakable laws of Thermodynamics.
This brings us to the Power Law. The power (W) in electricity is measured in watts, and it is made of two parts. There is the current (I) which is measured in amperes, and there is the potential (V) which is measured in volts. The product of the two yields the power as expressed by the equation:
W = I x V
We now draw a parallel between the power law of electricity and the GDP law of economics. We make the Money supply the analogue of the current and call it (M). We make the Velocity of money the analogue of the voltage and call it (V). It turns out that the GDP is the product of the Money supply and the Velocity of money as expressed by the equation:
GDP = M x V
Notice the resemblance between those two equations. The GDP being equal to the quantity of Money multiplied by its Velocity, we see that we can increase the GDP by increasing M or increasing V. However, the Central Bank and the Treasury of a country control the money supply and they are usually reluctant to increase it because the move can lead to inflation. This leaves the velocity of money as the only tool by which to grow the GDP safely. But the trouble here is that for some reason, the people sometimes prefer to maintain their economic activity at a low level or even decrease it. In doing this, they slow down the velocity of money; and there seems to be very little we can do to counter that. Or is there?
To study what motivates people to engage in economic activity at one level or another, we examine Ohm’s law in electricity and see if we can draw a parallel between it and Economics. Ohm’s Law is written like this:
V = I x R
Voltage = Current x Resistance
This is the Resistance of the circuit to conduct electrons.
Its analogue in economics would be this:
V = M x K
Velocity = Money supply x Keenness
This is the Keenness of the people to spend money.
Note that even though Resistance and Keenness are opposites in the vernacular of every day speech, they are interchangeable in mathematics depending on the value that is taken by the variable K. For example, K in this context can be one of three things. It can be (a) greater than 1 thus indicating that the people are keen to spend money or (b) equal to 1 thus indicating that the people are neutral about spending money or (c) less than 1 thus indicating that the people are not keen to spend money. This last part means that the people resist the idea of spending money which is analogous to a circuit that resists conducting electrons. As for the value of K, it can be determined by creating an index that tracks same store sales and other such indicators.
We see from the last equation that the velocity of money (V) can be made to increase by increasing the money supply (M) or increasing the keenness of the people to spend (K). However, having determined previously that increasing the money supply can cause inflation; we try to avoid doing that and we work on K alone. To put things succinctly, Keenness increases the Velocity of money which grows the GDP without increasing the Money supply that tends to create inflation. Neat, isn’t it! But how do we increase the keenness of the people to spend?
To do that, we make use of the amplifier/multiplier effect. In electronics, we use the vacuum tube or the transistor to amplify. These are sophisticated switches that do not need a finger to turn on and off but need a small signal at the input to do that. This signal modulates the large power that is taken from the wall socket or is supplied by a battery. Once modulated, the large power appears at the output as an amplified version of the small input signal. Now, every amplifier has a factor by which it amplifies, and we use the Greek letter Beta to represent this value. In the function of the amplifier, we find that the power at the output (Po) is equal to the power at the input (Pi) multiplied by Beta, and we express all this with the following equation:
Po = Pi x Beta
But where do you find the Beta of economics? Well, I define this Beta in two parts (1) having the ability to motivate people to engage in economic activities and (2) giving the people the financial means to engage in such activities. Indeed, a healthy level of economic activity is generated when the people are presented with a product or a service they want, and when they have the money to buy it with or at least have access to reasonable credit. Usually, the invention of a new product or the creation of a new service starts the ball rolling in this direction. Thus, innovation and the trust that creditors have in their borrowers are responsible for causing the increase in economic activity and they are what gives Beta a high value.
But we must be careful how we interpret what we see here by being aware of the following: The growth in GDP does not happen because we create something out of nothing; it happens when we produce what the buyers want at a price they can afford. The mistake that people make at times is that they rely on past accomplishments to splurge now in the belief that they are not paying a price for what they get. This leads to the formation of bubbles and to economic crises at which point the people realize they were not amplifying something small into something big but were living off the accomplishments of their ancestors and off the future toil of their descendants.
The second mistake that people make is that they neglect to take full advantage of the multiplier effect. They seem to forget that even though they cannot transform something small into something big, they can modulate what is already there and make it work better. To do this, they need to take stock of the material resources and the human capital they have, assess their own potential to innovate and get into the business of adding value to that which is valueless or has a small value. They can do this by gaining confidence in their own abilities and by restoring the trust they used to have in each other. This done, they will start taking risk again and gladly extend credit to each other. The result will be that every dollar anyone of them borrows from the bank will be matched by several dollars worth of credit they will extend to each other. And this is the multiplier effect that will cause the GDP to grow beyond the nominal value of the money borrowed from the bank, thus giving the economy a higher rate of growth without causing inflation.
But what exactly is the potential to innovate? To innovate does not necessarily mean to invent something that no one has seen before. It can be something that your economy never had or maybe had it once then lost to competition. When you bring this thing back to your consumers, you will have innovated because the result to your economy will be the same as inventing something completely new. In fact, what is urgently needed in America today is the availability of American-made goods that people are accustomed to buying at discount stores and the low end types. These would be the durable and non-durable goods that sell at a reasonable price. The American people spend a good part of their disposable income on such goods which are now imported from abroad. And what the people do not do is stay up at night to fantasize about innovations they wish their fellow Americans would produce when they cannot even imagine what these things would look like. What they fantasize about are jobs that the old industries might create to offer them one at a salary that will allow them to buy what they produce.
In conclusion, what the government spends to encourage the invention of futuristic products is a waste of public money. Instead, the government should encourage the revival of the old industries that will produce what the people want now. But if the government still wants to dabble in the business of innovation, it should bear in mind that only the loafers who know how to live off government handouts will get their hands on this money. As for the nerds who come up with real and useful innovations, they do not go after government money because they do not need it, and if they did, they would not know how to get it out of a government bureaucracy. Instead, the nerds rely on the venture capitalists who have the wherewithal to look for new ideas and the incentive to separate the worthy from the unworthy.
Given that productive nerds are who they are because they do not waste their time learning how to live off the government handouts or how to protect themselves against the scheming loafers, what they need from the government are rules with teeth that will protect them from the loafers who will get the subsidies from the government then whip up schemes to steal their ideas too. This practice is widespread, it is sickening and it must come to an end.
Do the right thing, America, and you’ll restore your old industrial glory; chase a useless dream and you’ll construct a fool’s paradise. So says Electro-Economics to which I say amen.