Friday, January 23, 2015

The Nature of Money and its implications

While in a simplified theory money appears to be a veil and a mere convenience for transactions, nuanced thinking in the matter suggests that money affects the real economy in a very profound way.
At the heart of the matter is the question of redistribution. The presence and persistent use of money in the economy continuously redistributes wealth/purchasing power. Thus monetary economics has an important political underpinning.

There is also the matter of focus of a society. Money through its enabling of financial wealth exerts significant influence over where the society’s resources are used. There is nothing rational or implicitly optimal about this resource allocation – contrary to the dogmatic belief of market theorists. (There is a tautological claim some of them make – the society gets what it deserves, and within bounds of feasibility, what it wants and that there is no need to question that. The problem with this approach is that it generalizes the entire population into a single organism that can deserve or want things whereas in real life the political economy is founded upon distinction amongst individuals within the society.)

Lastly, there is the matter of alteration in the value systems. While economic theory may choose to remain free from any commentary on the matters of value systems, it is prudent to note, without passing a judgment, that value systems of individuals get profoundly shaped by the idea of money as such (not merely as a means to an end.) This in turn reflexively boosts the importance of money in the society. If the aim of economics is welfare, this aspect cannot be ignored. Excessive centralization of our monetary selves into our personality is probably not utility-optimal. In other words, obsession with money for the sake of itself it distorting the way we lead our lives so much that collectively we are probably worse off. A long term aim of policy should then also be to decentralize money from people’s lives. This may not be achievable within the narrow toolbox of monetary policy. However, broader policy framework can use the ‘nudge’ approach to help people realize more diverse aspects of their being and lead more fulfilling lives. This may sound revolting to the opponents of ‘big brother’ or ‘soft paternalism’. However if drug rehabilitation is an acceptable agenda for the state, the monetary rehabilitation is not very different in principle.

Review of neoclassical position on money and its limitations
It is logical to expect that a small group of people transacting among themselves will not be subject to money illusion. Say, 5 people are trading just one good amongst themselves and have differing ‘income’ levels in a toy economy. Suddenly if everyone’s income were to be doubled, the price of the good might have a tendency to double as well. Most neoclassical economists take this simplistic notion too far and declare that there is no money illusion in the real economy as well. Whereas interestingly enough, even in a laboratory experiment, we might be able to detect deviations from fully rational behavior as people take time to get used to the new state of affairs and sometimes do not get used to it at all.

For example, some of them might suddenly decide to start saving. Some others may not want to increase price because of reasons of fairness. Still others may expect the incomes to go back to lower levels and hence play safe. Lack of knowledge, anchoring biases, fairness considerations, uncertainty will all contribute to people avoiding the jump to the doubling of price.

I am reasonably certain that even in the set-ups where knowledge is universal and available (all 5 are told that their incomes have exactly doubled simultaneously) and uncertainty is removed (they are also told that these doubled incomes are permanent and will not reduce), we will still not see the adjustment to double price for a while, and maybe never.

In the real life where below practical deviations occur, this is even more unlikely.
  •  Incomes do not rise in tandem. There is differential growth rate across sectors as a norm.
  •  Tendency to save is almost an exogenous variable in this picture. Income growth rate and consumption growth rate may deviate.
  • There are lots of different goods and services. The prices do not respond uniformly. Averaging camouflages this divergent response.
  • Consumers do not adjust their reactions to prices in real time. They react differently to different price increases.

Hence the expectation of prices going up uniformly in line with nominal incomes is a mirage. Of course in a closed economy, since total expenditure has to be equal to total incomes, the increase in nominal incomes will lead to rise in the total value of expenditure – price into volume. If the volume has not grown, prices will grow such that the totals match. The point however is what goes on below the surface, inside the averages and aggregates. The simplifying assumption of neoclassical economics is that everything is uniform. Since things are dealt with either at a single individual/firm level or only in complete economy-wide aggregates, the implicit hypothesis is that everything moves in tandem. On pointing out this extreme assumption, most supporters of the neoclassical theory would say that this is at best a model and we can always refine it using specific phenomena to incorporate the deviations.

That misses the whole point. Starting with a wrong model and theory and then trying to get closer to reality through refinements is likely to be epistemologically wrong. What is worse, it is likely to throw up fairly misleading policy prescriptions.

The model is oversimplified but that can be ignored since refinements will tide over that limitation. A bigger issue is that the model incorrectly models economic participants as REAs with complete knowledge and fully calculated rational responses. This is an assumption that cannot be improved incrementally through incorporating one behavioral bias at a time and one incomplete information point at a time. Wondering about this one comes to a more fundamental question – why do we need to cling to the neoclassical model and then refine it? Why can’t we think of a new model which also models reality but starts with more real assumptions and is likely to need less refinement to achieve the same outcome as regards predictions and recommendations? At the heart of it, the debate boils down to the modus operandi of conducting studies in macroeconomics. There is no right approach. The limitations of the neoclassical model seem to suggest that there is probably a much better way of modeling macroeconomic reality.

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