Economical Equilibrium

by Ilya Kuntsevich

  A high unemployment rate is considered a bad thing for any economy because unemployed people don’t contribute and live on welfare, thus spending other people’s tax money. This is a common problem for developed economies these days because technology and outsourcing substitute labor, which means people need to learn new skills in order to stay competitive in the market. To the credit of the unemployed, the post-industrial world changes expectations of contribution and demand very quickly, but learning new skills takes a lot of time. The lifecycle of jobs decreases as technology advances.

  If an adult cannot find a job based on his or her qualifications, and thus cannot contribute, it means that he or she learned something that others don’t need and are not ready to pay for. Accordingly, high unemployment becomes an educational as well as an economical issue.

  Education

  Two famous quotes come to mind when I think about education: First one by John Keynes “Education is the inculcation of the incomprehensible into the ignorant by the incompetent”. Second by Immanuel Kant “… it is evident that the understanding is capable of being instructed by rules, but that the judgment is a peculiar talent, which does not, and cannot require tuition, but only exercise. This faculty is therefore the specific quality of the so-called mother wit, the want of which no scholastic discipline can compensate.”

  In my opinion, education of comprehensible matters, proven by hard evidence and facts, but not guesses and assumptions, is the only thing that is worth studying, and economics, accounting and finance should be no exception. While I acknowledge imperfections of human intellect, because we live in a constant discovery mode, critical reasoning should always be applied before facts and hard evidence are recognized as such. In the case of economics, accounting rules and finance models appear to be a long way from this ideal state. Otherwise we wouldn’t have recurring economic or financial crises and would be able to predict them.

  It should be acknowledged that life is an enormous learning experience and accusing previous models, which, in fact, worked fine in the industrial stage of expansionary economics, would be unprofessional and unfair. However, the new economic models that would work in post-industrial, highly competitive and technologically advanced economics are yet to be developed.

  One aspect I would like to highlight is the use of banks’ money to pay for education. When students borrow money and spend it for their education, banks pay to schools using students as intermediaries, and schools pay to professors, staff, etc. As such, the more students borrow, the more salaries get paid, but how does this help the economy? Especially when students learn something that is of little or no value to spur economic growth after they graduate? One can make an argument that by lending money and having this money spent, the banks help progress by having professors and staff do more research in order to figure out what to do next, but why not pay them grant money without making students repay the debt? After all, banks turn other people’s money to make profits for themselves – what is the use in the middleman?

  Theoretically students pay for the knowledge that will be later used to provide more value through selling goods and services, which will eventually pay back. If students want to learn and be indebted for their knowledge, only those who really deserve it should take the responsibility of assuming the debt. I should be careful, of course, in saying what should and shouldn’t be done, but my judgment tells me that if debt is assumed for future value, only extra value, which is not yet being recognized and exchanged, will generate enough cash to repay the debt. Otherwise the debt will become worthless (e.g. the soon-expected student loans bubble) and, therefore, a government could have prepaid for the education without hope of collecting the money in the first place.

  Wealth Distribution

  Wealth accumulates in inverse proportion to the number of people who possess it due to the profit motive, which dominates the business environment. The profit motive model makes money and everything of recognized and exchanged value accumulate with very few people, who are on the top of the “food chain” pyramid, while the wealth distribution pyramid is an inverted pyramid. The “food chain” pyramid is balanced with the inverted wealth distribution pyramid, portraying one of the ten postulates of Economical Equilibrium theory. It’s been like this for centuries and, unfortunately, mankind didn’t invent anything new in this sphere since the Egyptian civilization. Maybe this is the reason why we have pyramids in Egypt in the first place – they are symbolic of many processes in our lives, including economics.

  When money accumulates with very few people through the mechanism of profit making, discussed in Part I, it waits for allocation to grow the bottom of the pyramid either by increased tax revenue, or the issue of debt financing, in order to allow further expansionary growth for its base (consume more labor and natural resources). When such allocation is impossible (there is nowhere to grow), the bottom pyramid usually starts to rebel and overthrows the top. But the sad part is that when new members of society get to the top, they become hostages of the same pattern, and the cycle repeats itself over and over again, due to corrupt human nature.

  One of the main reasons why socialism didn’t work is because it is in direct conflict with the human society pyramid structure and requires wealth distribution regardless of contribution and demand. It also excludes ego and moneymaking motive, which seems to be entrenched in everyone these days. The modern economic system still needs more people at the bottom to do the work, less people in the middle to manage, and very few on the top to give orders. Theoretically socialism could have been possible if no one needed a “manager” or a “leader”, and was capable to sustain a living on his or her own, consuming subject to his or her contribution. Capitalism, on the contrary, has a pyramid structure for distribution of wealth and therefore brings inequality to the hierarchy by definition.

  Fractals In Economics

  Capitalism and its wealth distribution are best visualized as a hexagram, but without the top and bottom triangles. It also has a fractal nature, i.e. its little components have the same pattern as the entire diagram. Countries have a president, office, government and citizens. Companies have one leader, a few board members, more management and numerous staff. In a way we can view the global financial and economic system as a giant pyramid, where people who are within the system, are “fed” by the newcomers, both horizontally and in volume. It works well when newcomers increase in geometric proportion, i.e. by a power. Accumulation of wealth by the few and “food chain” pyramid growth are interdependent processes. When we see too much wealth on the top, which cannot contribute to the bottom through distribution of wealth or use of more labor / more natural resources, such diagram becomes unstable.

  Paradigm changes in the economic world transfers people, companies and countries within the global pyramid, leaving its overall shape constant. There could be multiple reasons for a paradigm change – new technology allows usage of more natural resources to boost consumption, the world moves from the industrial to post-industrial stage, socialist countries become capitalist, etc. Two major paradigm changes happened in the previous millennium – first, the steam age, followed by the industrial age. Two paradigm changes took place in the previous century – World War II and the demise of the Soviet Block. But, again, fundamentals of wealth accumulation and distribution never changed and, sadly, probably never will.

  Why was so much wealth created in the U.S. and Europe after the USSR fell apart? Fractal geometry explains it all quite well. The demise of the USSR opened new markets for the western economy – skilled labor and enormous natural resources, waiting to become a part of the bigger pyramid. This also explains why U.S. Dollars and Euros are now used in post-USSR territory as means of exchange along with Russian Rubles – Russia is in the lower part of the financial pyramid, feeding the U.S. and Europe with consumption and contributing its natural resources in exchange. A few Russian oligarchs, buying expensive yachts, soccer and basketball clubs, are just a tiny representation of we
alth created from the post-USSR territory for the benefit of the U.S. and Europe.

  The collapse of the USSR was preceded by two world wars, where Germany and Japan lost to the USA, UK and USSR, which subsequently shared their markets for the benefit of their economics. Subsequent to that, the Soviet Block started to compete with the West, which resulted in the demise of the former.

  Continuing this scenario, the next big question is which pyramid will win next – USA and Europe vs. China? As we all know, China is very protective of its internal affairs and is a unified nation state (unlike the former USSR and its territories). China now uses western technologies to develop its economy and is actively buying natural resources in Africa and Russia in order to support its continued growth. But as with all pyramids this growth will stop at some point. When this happens, the question will be which pyramid will survive – Western or Asian.

  Time Bomb

  I couldn’t ignore this section because worldwide income inequality is growing rapidly and sooner or later this time bomb will either explode in a much larger scale economic crisis than anything we’ve seen in the past, or, if handled intelligently, will be put off and, hopefully, defused forever. The reason behind the former is continuous replication of the existing economic models, based on a premise of expansionary economics. By replicating such models and imposing them on the developing world, we plant incorrect perceptions of how economics should work and create unsustainable world dynamics.

  In addition, by providing old technologies to developing countries, we are killing our planet by pollution of the environment and exploitation of non-renewable natural resources, including water and air. Using modern economic development and financial models, which first of all target profits and / or interest income (money), countries with natural resources are destined to receive a smaller share of the “surplus” product due to inequality of profit margin allocations in the final product. As the final products are sold to these countries by developed countries, the former need to produce more raw materials in order to purchase foreign goods and thus enjoy the benefits of “civilization”. Therefore, the accumulation of the surplus will be less than in the countries that produce the final product.

  One of the solutions to this problem could be a price increase of natural resources to a level when there is a balance of capital inflows and outflows between the trading economies – not at the expense of volume, but rather profit margin, charged by developed countries on the final product. Natural resources are scarce and should get an equal premium along with technology, keeping things balanced, especially if polluting technologies are being used.

  Let’s ask a broader question – what non-renewable natural resources are we using? Oil, natural gas, coal, radioactive materials. These resources are converted into heat, electricity and transportation. We need heat to keep our houses warm in winter, we need electricity to use computers and we need transportation to travel and commute. Given our modern technology to transform the above non-renewable resources into what we consume was created at least 50 years ago, but their global consumption increased disproportionately over the last 20 years, the pressure on non-renewable resources has substantially increased. Such trends were primarily caused by making technology available to developing countries. As a result, water, once renewable, has become contaminated with chemicals through its commercial use.

  I’m not an expert in technology or ecology, but my judgment tells me that replicating economic models and technologies that target growth at the expense of more labor, non-renewable resources or contamination of renewable ones, should stop immediately and start being accounted for. Otherwise Mother Nature will punish us sooner than we think. I wonder if anyone thought about building a model, taking these variables into account, in order to estimate the date when doomsday will come.

  Cree Indian prophecy: “Only after the last tree has been cut down. Only after the last river has been poisoned. Only after the last fish has been caught. Only then will you find that money cannot be eaten.”

  Part III: ECONOMICAL EQUILIBRIUM

  Geometry of Economics

  Economical Equilibrium is a theory that explains economics using geometry. Almost all processes in the world are better explained and can be visualized with geometric figures, rather than with conventional linear mathematics. More importantly, visualization, provided by geometry, provides an instant view of shapes and allows seeing these shapes in time.

  While, for simplification of understanding and initial application purposes, I’m presenting only two-dimensional (two axes) geometry (using ellipses, squares and triangles instead of spheres, cubes and pyramids, respectively), it can be turned into volume by adding a third axis, when analyzing significant volumes of data. Volume provides the third dimension as in spacial geometry, and, after adding the fourth dimension, time, one can learn how objects transform in dynamics. After all, we all live in space–time continuum, so why not treat economic processes any differently?

  Geometry allows seeing shapes that are otherwise hidden, e.g. market capitalization based on trading volume, debt and economic growth, wealth distribution and number of people, etc. Modern computing power is capable to create models that would allow us to see empirical data in appropriate visual format.

  Modern financial models, based on linear mathematics, use central limit theorem and perpetuity formulas to account for anticipated events based on the past – Standard Deviation, Net Present Value of Free Cash Flows (NPV of FCF) and Capital Asset Pricing Model (CAPM) are all based on the premise of linearity. Nevertheless, such models do not work because they cannot predict, hedge, or explain the relationship between multiple variables thereof, as was also proven by the recent financial and economic crisis. Despite the fact that such models show expansionary growth is possible at a certain rate (e.g. stock market, GDP), they don’t show the proportions at which such growth should be paced and how to take other important variables into account, e.g. trading volume, number of people, monetary base increases, interest rates, etc.

  Geometry-based models, on the other hand, represent a more concise, yet capacious view of economic events, their interactions and respective changes, adding time as a factor. It is also a better tool to analyze past, and estimate future, events, helping businesses and countries regulate their economies with more precision, thus leaving less chance of mistakes or misconceptions.

  While there is a lot of research and analysis necessary to implement Economical Equilibrium theory and make it useful in the everyday life of economists, some of the evidence, obtained using limited studies of data, shows that the theory stands up to scrutiny and can be applied in practice.

  Market capitalization based on number of shares traded

  Seeing the volume of shares traded versus total outstanding shares, on the one hand, and price change based on volume of trades, on the other, is a good geometrical exercise.

  Think about it this way. Market capitalization is a geometrical volume figure, but for simplicity we will show it in 2D. The number of shares traded is one axis and price per share is another. When a company does IPO and subscribers (investment banks, qualified investors) buy shares of a company at an agreed price, the market capitalization represents a cylinder (rectangle in 2D) with a long axis being the number of shares and short axis being the price of IPO:

  Given the knowledge of how modern financial models work, an IPO can be a success if, and only if, the expectations on the growth of a business are high – this is how underwriters and business owners “make” money. On the one hand, this fact explains the dot.com bubble and other IPOs, which went from boom to bust in a relatively short period of time. On the other hand, some IPOs were successful (e.g. Apple), and sustainable for some extended period of time, but the stocks’ performance could still be very volatile, subject to how the business was going and its future expectations thereof. The conclusion I draw from this experience is that investments in stocks, prices of which are driven by expectations, are very risky, and t
he financial models used to project the results cannot be relied upon to project future prices.

  I have a graphical solution for the hypothesis of IPO bubbles through analysis of shares traded after IPO on a secondary market. When shares start trading publicly, only a portion of issued shares is sold to the public immediately for further exchange. During the exchange, the same shares can change hands multiple times during a day. Unfortunately I couldn’t find an information source that would provide data on distribution of individual shares’ daily pricing in order to build a geometrical figure of the market capitalization’s transformation. Had such information been made available, we would be able to identify how a single share (or very few of them) traded multiple times during a short period of time, can increase or decrease market capitalization of the entire company.

  The only information available publicly is the volume of traded shares, which is the amount of shares that change hands from sellers to buyers, as a measure of activity. Even though this is only a half-, or quarter-answer to what we’re looking for, such data allows us to see significant distortions of how market capitalization can increase or decrease based on different volume of trades.

  My hypothesis is as follows. The fewer shares are traded of the total shares outstanding, thus causing price per share to go up, the greater the chance of a bubble occurring. My logic is that money, as an equivalent of exchange, is scarce, and may not be readily available to continuously buy stock at a higher price. Accordingly, as the money dries out, fewer and fewer shares can be bought. Let’s represent this logic geometrically:

  The top corner of the bottom triangle represents available cash to purchase shares at an increased price. The base of the upper triangle represents growing market capitalization of a company as its stock is going up. I call this diagram “inverted triangles”.