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Accounting Identities and the Fallacy of Equilibrium States

I avoid economic analysis because the subject is too complicated and far away from a true science although when I was in graduate school I found it fascinating. More fascinating to me was the fact that most economists tried to describe highly complex, stochastic dynamic systems with aggregate equilibrium conditions. There are several blogs nowadays that attempt to provide complete descriptions of the economy via the limited use and scope of equilibrium conditions while failing to understand that what is important in economics is not the equilibrium itself but at what level it is achieved. Here is an example:

In this post, Jerry Khachoyan, a young and very bright undergraduate student at UCLA, provides a video that explains the three sector balances and how they must add to zero. But the issue here is not that they must add to zero but at what level of interest and exchange rates they add to zero. The fact that they add to zero cannot provide an indication of the state of the economy. There are many other factors that affect the level at which the equilibrium is achieved and this is more important than the three sector balances.

The point is not for the government to stop spending but for it to stop spending a lot and for a long time. Because what you do not see in the aggregate picture is the stress on the economy from excessive government spending. Let me offer an example of another type of aggregate analysis: There is a box in equilibrium on a flat surface and there are two forces acting on it on the opposite sides so that they cancel. This is fine and we know when forces cancel out there is no motion. This is simple statics like in the video. But there is the dynamic aspect to this story: no material is unbreakable like no economy is unbreakable. If you increase the magnitude of the forces on the box you will create levels of stress that cannot be maintained and it will eventually break and its pieces will move all over the place. The same will happen to an economy if the government keeps on spending to maintain a large public sector and a high level of private sector savings. For example, at some point interest rates will have to rise because of a loss of rating (debt downgrade).  This will happen when investors think the stress on the economy is just too high, like when the forces on the box increase at levels beyond structural tolerance. When this happens, the equilibrium condition displayed on the video vanishes and the economy goes into an inflationary and chaotic mode where the static condition holds at each and every moment in time but the level of interest rate is so high that future economic activity is in a virtual stop and business and consumers begin to spend their savings to buy time and survive. While this is happening, the three sector balances always add to zero at every moment but on a different level.  This will be true for America but also for Zimbabwe.  Equilibrium conditions alone never tell you anything about the possibility of chaotic modes getting excited in the face of small perturbations from this static condition. This is why a period of running surpluses for the government decreases the probability of the chaotic modes getting excited. This must take place when there are signals that the situation is getting unstable, like the recent debt downgrade.

From the perspective of mathematics, the equation in the video in Jerry’s post is a linearized equilibrium solution of a tremendously complex non-linear dynamical set of equations with many hidden chaotic modes that affect and get affected by many other modes.  And like in the example of the box on which there are two forces acting on it on its opposite sides, the forces will always cancel even just before total destruction is about to happen.

Thus, I suggest to all those monetary realists to start considering the dynamic aspects of things. The equations may not be as simple as the three sector balances adding to zero but are certainly more exciting and I will offer a hint here: surprisingly enough, the backwards Euler method can often uncover many hidden modes not seen when considering the steady-state equilibrium condition. They will be amazed with the level of reality about economic conditions they will discover when they abandon the static view and move into the realms of dynamics, which is what reality is.

I promise no more economic analysis for this month 🙂