The Real Economy

Hector McNeill¹
SEEL

In a recent Reith Lecture series, Mark Carney, stated that "Economics is not physics".

I think that it would be more accurate to state economics is physics because all production and distribution processes are physical and involve physical relationships.

On the other hand, monetarism and monetary policy is definitely not physics because its instruments do not, in reality, impact the stated policy targets that involve physical transactional relationships but they are in fact biased towards the bolstering the financial values of assets and rents; this leaves the rest of the supply side and wage earning segments of the economy in an undeterministic state of affairs.

Introduction

Mark Carney, in recent series of presentations under the BBC Reith Lectures 2020 stated that:

"You see, economists, myself included, generally suffer from physics envy. We covet its neat equations and crave its deterministic systems, and this inevitably leads to disappointment. The economy isn't deterministic. People aren't always rational. Human creativity, frailty, exuberance and pessimism all contribute to economic and financial cycles."

In another lecture he stated:

"Newtonian mechanics breakdown at the subatomic level and the search for the grand unifying theory of everything that matters persists in physics to this day. Market fundamentalism relies on people being able to calculate the odds of each and every possible scenario. We need to promote the values of responsibility, solidarity, integrity and prudence as best we can through pay, through codes and regulations, while recognizing that these can only be fully lived through culture and practice. So, while authorities must continue to put in place the infrastructure to make markets work, there is no simple unifying formula to break the destructive cycle of financial history. Physics won't save finance. Promoting a system in which all its participants live society's core values will."

In a question and answer session Lord O'Neill was responding to a rhetorical question made by Anita Anand as to whether, " ... economists are above politics?" stated:

"In typical economist’s behaviour, I'm going to respond by slightly answering you in a different way than you intend, really, but I want to refer back to one of the things Mark said at the beginning and where he ended. Part of the problem of most of my professional life is people treat economics as a science. Mark described it as “not physics.” It’s not physics. It is a social science of which many aspects of are very unknown. It has to be somehow brought more into the mind sets of people that want to pursue economic policies and that there are no definitive outcomes from one set versus another, and a bit more humility and open mindedness about potential outcomes I think would play a big role in bridging the gaps between users of economics, whether they be politicians or any others, but also, importantly, for those of us in the profession that try to advocate one solution versus another, to be a bit more humble about the likelihood of definitive success or not."

The operation of the economy, viewed from the ground up, consists of physical and information transactions. Production runs and levels of physical productivity are measured and projected on a constant basis throughout the supply side production and consumption world to take decisions on price setting and assignment of disposable incomes to necessities of life. To say economics is not physics is completely unconvincing for the supply side and consumers of products and services.

However, most would agree that basing macroeconomic policy decisions on the central imposition of pricing decisions based on arbitrary interest rates and levels of monetary injections based on debt, has no hope of guiding the decisions of an immensely diverse population of production and services companies and individuals. This is because their conditions range from the dire to enormous size and stability of cash flow. This is why monetary policy is so unpredictable and lacks traction. It is well-established that monetary policy generates winners, losers and those in a neutral policy-impact status. Unfortunately the losers, mainly supply side producers and wage earners employed by the supply side, outnumber the winners several times over.

It is therefore necessary to conclude that there is a major disconnect between monetary policy and economics and we have to conclude that it is not economics that is not physics but rather it is monetary policy that is not physics. This is why attempting to "manage" the economy through such strange ephemeral policy instruments is so ineffective as far as the supply side production and wage earners are concerned.

We therefore need to ask, if this is the case, why do monetarists imagine that their logic and exercise of power to manage the national economy through monetary policy can produce beneficial outcomes? After all, an ex-governor of the Bank of England has attempted to explain a trail of policy disasters on the basis that there is a disconnect between the policy instruments and the economy.

Why monetary policy is not physics

The Quantity Theory of Money is as follows:

M.V=P.Y
where M is money volume, V is circulation velocity, P is average price and Y is physical quantities of goods and services (real income). The total number of variables is 4.

As can be seen from the bullets on the left the M variable is split into eight (8) non-supply side goods and services encapsulated markets plus the supply side endogenous market cash flow; that is there are 9 variables all of which consist of physical objects and their respective prices.

Any child who has attempted O Level algebra knows that it is impossible to solve or predict the value of these nine variables based on the 4-variable QTM identity. M is essentially a demonic¹ black box. Therefore the QTM cannot be used to predict anything of value and is a baseless font of monetarist wisdom for orienting any macroeconomic decision making and the fate of the British population.

This is why monetary policy is not physics.

¹ It is notable that the first documented reference to the QTM relationship was produced by Jean Bodin (1530–1596) a French demonologist writing in the heyday of the Inquisition. In 1568, Bodin's interpretation of events, made the wrong cause and effect correlation so as to suggest an incorrect deterministic relationship. However, this endured with considerations added by John Locke, Richard Cantillon and David Hume in the late 17th and 18th centuries They referred to this relationship as a quantity theory. So, what became the QTM became the central core of 19th Century classical monetary analysis. But with this trajectory of over 450 years it still contains the errors of interpretation introduced by a demonologist.

Monetary illogic

This is a question that boils down to a question of professional integrity and responsibility in exercising due diligence to avoid placing the majority of the constituents of this country in jeopardy. Being "humble" and admitting monetary policy does not work does not solve the problem. The solution is for monetarists to stand aside and permit more rational objective bases for macroeconomic policies to be introduced.

The basis for monetary decision logic is based on a centuries old font of monetary wisdom, the Quantity Theory of Money (QTM), an identity that purports to show the relationship between money volumes and the unit prices of goods and services in the economy. However, the outcome of monetarism has been the creation of a disintegrated economy by splitting it up into unassailable closed capsules within which relatively closed and separate markets and their specific participants operate. These capsules are:

land and real estate as speculative assets
precious metals as speculative assets
cryptocurrencies as speculative assets
commodities as speculative assets
corporate shares as speculative assets
financial instruments such as derivatives and option conditions as speculative assets driving a grey market larger than the GNP and beyond the boundaries of any policy control
savings and cash reserves as non-circulating money
offshore investment and reinvestment of offshore profits in offshore activities often as a tax avoidance scheme

In basic terms, the QTM simply states that money volume is equal to average prices of goods and services multiplied by their physical quantities so that raising money volumes, if physical goods and services quantities remain the same, will raise average prices. Conversely this states if there is a decline in money volume prices will fall in order to "clear" the product and services markets. In practice this has never operated in this way. As money volumes have been increased during the last 12 years, under quantitative easing (QE), the increased money has flowed into the encapsulated markets listed above. This has drained the supply side production and service sectors of investment funds and as a result ability to pay better real wages. So, as we have witnessed rampant speculative inflation within the encapsulated markets, which feed back very little to the supply and wage earner sides, the economy production and wage earning segments remain in a depressed state characterized by rising income disparity and poverty levels. Inflation is creeping through into wage earner's cost of living as a result of leakage from the land and real estate capsules because wage earners are faced with rising rents and house prices and inflation is impacting supply side businesses as a result of rising land prices and rents and prices for office, warehouses, retail and industrial units as well as some commodity prices. This trend is exacerbated by the investmen by foreign groups, some offshore industries, in the speculative encapsulated asset markets and in particuar real estate. The commodity price increases are related to impacts on supply (Covid-19 and rising temperatures shortening growing seasons) thereby generating cost-push inflation exacerbated by some banks, as a result of relaxed financial regulations² (See, "The journey from 1971 to 2020 - the consolidation of financialization") operating companies who take positions and store and deliver commodities (including physical metals) to speculate at the expense of consumers. In addition banks, observing the depressed state of the "non-asset" supply side businesses and declining disposable real incomes of wage earners, have raised interest rates or refuse to advance loans for investment to companies in these sectors. Thus monetary policy has failed to benefit businesses wishing to invest in increased productivity.

The association of QE with next to zero base rates has meant savings have been liquidated and with this the fixed incomes of many retirees. The lack of sound investment options and with share buy backs raising share price speculation has raised prices to make earnings ratios meaningless destroying the function of the market price referencing mechanism. This has created a perilous state of affairs in stock markets, similar to pre-1929.

Monetarists have no effective explanation for this madness and disintegration of the economy and declining real wages which are a direct result on monetary policy. This is because their font of wisdom, the QTM, does not contain any of the variables representing the encapsulated markets listed above and this is why monetary policy is completely disconnected from the real economy.

For further information as to why the QTM is nonsense see A Real Money Theory II

¹ Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.

² In the article, "The journey from 1971 to 2020 - the consolidation of financialization" notice the entry for 1991: "The rupture of the Glass-Steagall Act (1933) in 1991 when the Commodity Futures Trading Commission provided Goldman Sachs with a “Bona Fide Hedging” exemption to be followed by similar exemptions for other banks."

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