There are a lot of misunderstandings, myths and strong emotional charges attached to common economic concepts. The overviews here have been made as brief as possible. More detailed explanation and analysis is presented in the book “Fixing the Root Bug”.

Value, price, supply and demand

The word “value”, confusingly, has two very different meanings. Value often refers to a person’s subjective experience of the desirability of something. Values can be split in many ways. In the study of value, it is common to distinguish between aesthetic and ethical values (values which we expect others to honor as well). These kinds of value are always subjective and perceived and cannot be exactly quantified, although a person’s choices can “reveal” preferences between certain bundles of goods, experiences etc. and such preferences can be modeled as people valuing the chosen alternatives more than the dismissed ones. Economics is the study of how people behave in the context of allocating resources for desirable ends. Therefore, in economics, something being “more valuable” than other things usually means simply that a person chooses it over other things (a revealed preference) – regardless of what kind of feeling or subconscious trait actually triggered that choice.

However, the word “value” is also often used to refer the market price of a good or service: the “exchange rate” at which it can currently be bought or sold. This is also called “value in trade”. The market price is not a measure of the absolute “goodness” or importance of a resources, but determined by the “market forces”, supply and demand. However, a higher price can make something seem more desirable, as people tend to want what they think others want (pre-selection). This is just one “irrational” human trait.

The “market forces” are often talked about with a negative tone. However, the “market forces”, supply and demand, are essentially about people’s preferences and the availability of resources. “Supply” is the amounts of a type of good, service, work etc. that people and institutions are ready to sell for different prices. “Demand” is composed of the amounts that they would be willing to buy at different prices. When a market works “perfectly”, the price and the quantity of a good produced and consumed adjust according to people’s collective marginal willingnesses to produce and consume the good: At equilibrium, the supplied amount equals the demanded amount. The market equilibrium price is whatever price happens to bring the supplied and demanded amounts into balance. Market imperfections and the importance of the price elasticities of demand and supply are discussed in more detail in the book, Fixing the Root Bug.

When an activity is valuable to all participants, there isn’t necessarily a need to pay anything for that kind of activity – no matter how valuable to the society it is. “Parenting services” are one example of this. Dedicated and loving parenting is one of the most valuable things to do in a society, but there is no need to pay for it if people are ready to do it without pay. In some situations, economic incentives can actually do more harm than good. E.g. people donate less blood, when a small monetary reward is provided. This is an example of how monetary economic incentives can cannibalize e.g. moral or social incentives.

Wages are prices of different kinds of labor, work. Selling labor (doing work for a wage) is essentially selling services. The function of wages – and income differences – is to balance the supplied and demanded quantities of different kinds of work (not total work, which is the job of the market interest rate) and encourage people to develop skills that are in high need and that enhance their productivity. If variations in wages are unable to balance structural imbalances (e.g. (1) when education opportunities or operating licences for a profession are limited in quantity, (2) when wage changes are limited by e.g. collective bargaining or minimum wages or (3) when work is not  automatically shared and a fear of educating oneself in vain maintains a labor deficit in types of work requiring high education), there is hardly any justification for income differences – or paying wages at all. Higher pay does not always encourage people to work harder – especially not when the higher pay is expected to be available permanently.

Money

Traditionally, money is viewed as a “medium of exchange”. And for example Austrian economists insist that money is only that – a commodity that is used to facilitate trade. And if all money was redistributed evenly to everyone after each day of trading, we could consider it just that. But money also allows itself to be saved up for future purchases. Monetary savings represent claims on products and services produced by others in the future. Therefore, it is far more descriptive to consider it to be receivables – a type of credit!  If we can’t trust (Latin, credo) others in the future to be ready to provide anything for the money in the future, it has no value.

A commodity money advocate will now insist that e.g. gold coins or bitcoin are no other party’s debt (and possibly even insist that these have “real value” due to their scarcity. If some party has promised to give something in return for such a commodity or token (e.g. when the government accepts settlements of tax obligations in it), that commodity is implicitly credit on that party.

But what if no one has a legal or contractual responsibility to accept a currency? We can of course examine such a currency as a commodity, instead of a token of credit.

However, what do you call a situation where the value of a commodity is based on the expectation that others will give something back in exchange for it later, because they expect someone else to give something for it, because they expect someone else to give something for it etc.? 

A speculative bubble! A currency of limited supply is inherently unstable and prone to be hoarded speculatively. There is no way such a currency could involve a working interest rate mechanism (see: “capital” below).

The whole formed by the “medium of exchange” framework, closely tied with the Quantity Theory of Money (assuming a long-run stable circulation velocity for such a currency of limited supply), and the idea that money should be a commodity of limited supply could be called the “commodity money religion”. These include completely senseless assumptions regarding people’s saving behaviour. Ironically, this collection of misconceptions is equally behind the conclusions of Austrian economics (advocating free private ownership of everything) and the Marxist conception of capital (see below). Remnants of this perception are evident in monetarist and New Keynesian models, which form a central part of the current “mainstream economics”. Its prevalence can partly be explained by the fact that even the expressions in our languages (the “conceptual metaphors”) assume that money is “thing”, when it is much more like a “relation” or “position” (which obey completely different laws).

Our current dollar/euro/yen coins, notes and “deposits” are explicitly credit. All money and other financial assets are backed by the liability of another party. We are practically just trading with each others’ debt – receivables from one another. And although this might sound intuitively perverted (because of our strong negative emotional association with the word “debt” and because of the afore mentioned quirks in our languages) such credit money is a much more stable base for an economy than any “commodity money” of limited supply (let alone e.g. bitcoin, which is practically a fully speculative “commodity” with no intrinsic value whatsoever – an interesting cross-breed between a Ponzi scheme and Pyramid scheme, as is explained in FtRB). This is because the “demand” for saving up this credit comes mainly from the fact that debtors (including mortgage holders and leveraged companies) need to acquire this credit to pay off their debts (or at least the interest) and are therefore ready to provide valuable services for the credit. If it seems enough of them aren’t willing to save, the “demand for money” can be increased by raising interest rates, which make people willing to borrow less and save more to pay off their debts. The interest rate essentially keeps people’s “demand for holding credit” and their “demand for being in debt” in balance. If a lot of the credit on the market is backed by government debt, the risk of hyperinflation increases significantly: the government’s ability to collect taxes is very inflexible and with little private debt and large amounts of monetary savings, it is difficult to induce people to save and prevent a masshysteric reduction in supply and increase in demand, when people lose their faith in the currency (see chapters “1.2.3 Money as Credit – Real Wealth vs. Virtual/Fiduciary Wealth” and “2.2.6 Post-Keynesian Solutions – Ignore Hyper-Inflation Risks and Guarantee Jobs” in Fixing the Root Bug for more detail on this.)

Credit relations are always two-sided: One party’s liability is another’s asset (i.e. property). In a closed economy, the amount of debt equals the amount of credit. The most significant conclusion arising from understanding this mathematical identity is that the amount of debt in the economy can only be reduced if net creditors (people with net monetary savings) buy services from net debtors. The only way to reduce the amount of debt in the economy (without credit defaults) is therefore to get people with savings to spend or invest them. And that’s why an obvious solution to our current economic downturn, the unsustainable size of the financial sector and soaring sovereign debts would be to allow negative real market interest rates and putting a price on the government guarantee on deposits, which would make it much less profitable to hang on to risk-free credit – i.e. keep others in debt. The trouble is that our outdated economic morals don’t allow us to say anything bad about “saving”, “frugality” and “hard-workingness” (which are unquestionably “virtues”). Hence, the idea of “punishing” savers seems somehow immoral. But when there is too much saving, the interest rate should “punish” for it – just likes price mechanisms in a market “punish” for anything done in excess by lowering the reward for it. Also, those few who might understand the nature of money are usually involved with institutions that have a short-sighted self-interest to maintain this “minimum wage” of capital (the zero lower bound) and subsidy on risk-free credit (the free deposit gurantee). Currently, a lot of capital is practically on hefty “unemployment support”.

Capital

Capital is quite an ambiguous term, with many different meanings depending on context. In economics, capital (e.g. along Irving Fisher’s Theory of Interest) is anything that provides anything of value (or allows easier production thereof) in the future. The following are examples of capital in this broad sense.:
– A building that provides accommodation services
– A machine that allows the production of a good with less labor than without it
– A skill (for example a language) that you’ve acquired, that allows you to do work or social interaction you otherwise couldn’t
Credit, i.e. someone else owing you something in the future. This includes money and bonds. (Note that credit is not “real capital”, because it is someone else’s liability, their “negative capital”).
Technologies and scientific theories that allow developing better products and processes
– A trusting client relationship allowing lower transaction costs and tighter cooperation with the client
– Natural resources (like land, ores, biodiversity) that facilitate production or a new innovation.

For example Georgism and classical economics further distinguish natural resources (that cannot be produced with human labor) from other “capital” into “land”, a third “factor of production” (in addition to labor and capital). This is a very relevant distinction, because the assets that cannot be produced with labor behave very differently on the market – and have peculiar theoretical implications in terms of

But the distinction is not as clear as Georgist would like to think. E.g. intellectual property rights (IPRs) “behave” in many ways more like “land” than (other) “capital,” even though they are not “natural resources.” It might be more relevant to distinguish two “special” types of capital from the rest: (1) non-producible natural resources and (2) privileges (operating licences, limited academic degrees, patents.. etc.). Also, different natural resources behave very differently, depending on whether they are renewable or not, permanently destructible or not etc. Also, whether the location value of real (which is the more common definition of “land”) is more a natural resource or a privilege is debatable.

Different types of "capital" (from Fixing the Root Bug, Ch. 1.1.8)

Different types of “capital” (from Fixing the Root Bug, Ch. 1.1.8)

In finance and accounting, “capital” more often refers to “financial capital” (distinct from the economic concept of “capital”): the money invested in a company or the financial assets like company shares and bonds that then grant the holders claims to income generated by the company. The function of these financial asset is essentially to allocate the risks and potential profits of made investments to different investors. The Marxist view of “capital” as “money which is used to buy something only in order to sell it again” “for a profit” is closer to the concept of financial capital than to the economic concept real capital (which Marxists would likely refer to as “the means of production“). However, “financing” does not actually mean “giving money”, but carrying the risks of an investment or activity. E.g. an entrepreneur can finance a company with “sweat equity” – working for the company without immediate compensation. And despite “deposits” being credit finance for banks, the depositor is not actually financing the bank, as he isn’t carrying any of the bank’s business risks. (More on this in chapters 1.1.10 of Fixing the Root Bug.)

The creation of capital – or acquiring the use rights of existing capital from others – requires work in advance, before it can yield any benefits. Also, the resulting benefits are uncertain – in many ventures very much so. These are the two reasons why capital has a cost – a profit-requirement – i.e. why credit receives interest and why equity investments in companies are required by shareholders to make a profit. The profit requirement of investments is determined by:
– The investor’s time preference: How much people value future products and service (and leisure) compared to current products services (and leisure).
– The risk-premium the investor attributes to the investment: How much extra expected profit does he require to be ready to carry the uncertainties and risks of the outcomes of the investment.

The profit requirement for an investment is also called the annual discounting interest rate for the cash flows (or other benefits) an investment provides. The sum of discounted cash flows is the “net present value” of an investment. Only an investment with a positive net present value is worth making, i.e. “profitable”. (See: Fixing the Root Bug for how a company/investment can be profitable at a loss!)

And for the decision of how much one wants to save for the future (versus spend now), one’s discount rate is completely subjective. However, if an investor has already made the decision to save instead of spend, the profit requirements of individual investments are usually determined by comparing them to the risk-free investment option available (usually cash deposits and bonds of governments with their own sovereign currency). So the only way to reduce the overall profit requirements in the market is to reduce the risk-free interest rate (or somehow make investors less risk-averse).

It is noteworthy that both time preference and the perceived cost of risk can be negative! Gambling is a case where risk can be thought to produce value – i.e. to have a negative cost. If most people prefer to “first work, then play” and there are few productive real investment options available (due to e.g. slow technological development or reducing demand causing over capacity), then risk-free savings need to make a loss! In working market economy, capital should also subject to supply and demand: when there is too much of it, the return on it has to go down. That is why an (growth-independent and stable) economic system needs to have to possibility of negative real interest rates. Currently, the “zero-lower-bound” of interest rates is practically the “minimum wage” of capital – and the fact that the government provides a deposit guarantee free-of-charge is practically a subsidy to all capital, but especially to banks. And what’s worse, it encourages banks to take irresponsible risks by rolling risks on to taxpayers by overleveraging themselves.

Companies – Competing Organizational Forms

Companies are competing organizational forms for the production of goods and services. The beauty in the system of fiercely competing companies is how it mimics the process of biological evolution without any people having to starve. Organizational form fails e.g. due to its function becoming redundant or it being replaced with a form that fulfills the function better. A most interesting implication of this is that companies – in a sense – serve the economy best when they go bankrupt!

Many people are concerned with the fact that companies only aim to maximize profits for shareholders (in the case of unlisted companies, this can also mean producing value for shareholders in another form). But there is nothing wrong with this as competition works fairly works fairly and unsustainable actions, imposing other externalities and fraud are prevented. It is fallacy of composition to conclude that because each company aims to maximize profits to shareholders, this would be the function or purpose of the whole industry or economic system.

No lion or rabbit is concerned with the sustainability of the ecosystem – they mainly aim to survive and reproduce. Yet the result is a balanced and evolving ecosystem. No fish or choral at the Great Barrier Reef is concerned with making the reef look prettier. And the result is a beautiful ecosystem with massive biodiversity. No individual football player or sprinter aims at making the match or race as exciting and enjoyable as possible for the audience – they just all do their best to win. And the result is often an exciting match or race for the audience. If a team or runner who is clearly in the lead, started purposefully holding back to let others catch up, this would not make the game any more enjoyable – quite the contrary. Just as there is a big difference between “nature conservation” and “animal rights activism”, there is a big difference between a “pro-market” approach and a “pro-business” approach.

Similarly, when companies are all aiming to maximize the profits and competition forces them to do so by maximizing value to customers and employees, this results in better products and services and more efficient processes. (However, currently a big problem is that, companies don’t always have to compete over employees – which is a symptom of the Root Bug.

When we start feeling pity for individual companies and don’t let them go bankrupt and don’t punish them severely enough for their breaches, then the system turns against us. Organizational forms, fighting a constant battle for survival should not be given any mercy or power over political decisions. Nor should the rules incentivize whining or blackmail: e.g. “we need X or jobs will be lost“.

From another perspective, companies are contract and ownership bundles. A bunch of assets (preferably worth more than the sum of its parts), owned by creditors and shareholders. Shareholders practically own what is left over of the company after credit liabilities are subtracted. The “book value” of equity is the estimated liquidable remaining value of the assets as represented on the company’s balance sheet. However, the market value of the company’s shares tends to exceed this book value, as it is dependent on the perceived profit-making potential of the company (i.e. the value it’s assets are thought to have collectively).

Note, that the company’s liabilities – it’s sources of “finance”, i.e. equity and debts – carry it’s risks of operation. Credit that doesn’t carry any business risks (e.g. cash, deposits or government bonds) is not productive. Hoarding risk-free credit up is practically just keeping others in debt. Having your money “in the bank” is not “keeping your money circulating.” Contrary to conventional wisdom, retail banks do not “lend on” the savings of other people or “channel savings to productive use”. They  “create” “deposits” (a misleading term, yes) by issuing new “loans.” Even when banks engage in “proprietary trading” – investing on their own risk – they don’t “invest their depositors’ money”, but practically just credit (i.e. increase the number on) the account of the previous owner of these assets. Remain previously existing “deposits” and reserves are untouched.

Banks have to – or should have to – cover the risks of any assets they acquire, credit they issue and other investments they make with their shareholder equity and risk-bearing (non-liquid) credit from other institutions or private investors. Unfortunately, they can leverage themselves so that they impose significant risks on bank deposits as well. In this case, it is not your savings that are productive for the bank – but the government guarantee on your deposits, as that is what is carrying part of the business risks. This free insurance is an incentive for banks to overleverage themselves, and a significant subsidy to “unemployed” capital.

Economic Growth

Economic growth is one concept involving a lot mysticity and having various meanings that cause confusion. Sometimes the term is used for “people becoming richer”, i.e. the increase in “wealth” (as e.g. Encyclopaedia Britannica defines it): the value of net assets people are holding. Of course, “wealth” can also often be considered to mean people’s productive capability or the total real income (a.k.a. “economic wellbeing”), which Adam Smith considered to be the essence of “the wealth of nations.”

Economic growth is not the growth of anything physical, but, in economics, usually refers to an increase in economic activity and is most commonly measured as changes in the Gross Domestic Product (GDP), the market value of goods and service produced annually in a nation. Essentially it is determined by total domestic consumption and investment plus how much more (or less) the nation exports than imports – its foreign trade balance. Total domestic income in a nation  (Gross National Income, GNI) is additionally affected by factor income (e.g. dividends, interest and rents) paid abroad and received from abroad.

Many economists (especially “supply-side” economists) like to consider economic growth (as in economic activity or GDP) to be caused by increases in labor productivity. And assuming a constant amount of traded labor, this can be considered a valid conclusion: By definition, total production can only increase if the amount of used labor increases or labor productivity increases – hence, when the amount of labor cannot be increased, increases in productivity are required to increase production. But increases in productivity do not necessarily lead to economic growth (unless “economic growth” is defined as “an increase in the capacity to produce goods“, as some sources do) – if local consumption or exports don’t grow also. One cannot sell if no one buys. Production that is not for consumption goes to waste.

GDP does not include the goods that are not paid for, such as household chores or voluntary work. Hence it does not fully encompass the (development of) value produced or experienced in the economy. Interestingly, if something has previously been paid for, and it then becomes cheaper (e.g. as a result of increased productivity), it remains with the same value in real GDP. But if, instead, it is offset by some other free service (like Google Translate might cannibalise professional translation services), it is no longer visible in GDP. This is one factor that significantly distorts measurements of both growth and productivity increases. Additionally, any incurring costs that can’t necessarily be considered to “produce additional value” compared to a previous state (such as natural catastrophes, wars, epidemics, litigation costs, crime prevention etc.) also increase GDP. Considering any increase in GDP an absolutely “good” thing makes very little sense.

Inflation

Infation is probably one of the concepts with the most dangerous and strongest myths attached to it – ones even imbedded in its etymology. In modern mainstream economics, “inflation” means a rise in the general price level, i.e. a reduction in the purchasing power of the monetary unit used. “Deflation” is conversely a drop in the price level.

Inflation is commonly measured as the change in a consumer price index (CPI), which is calculated using a weighted average of the prices of a predetermined (but often frequently updated) basket of goods and other living expenses.

As mentioned under money, “the commodity money religion” sustains belief in the Quantity Theory of Money – that the value (purchasing power) of money strongly depends on the amount of it in circulation. Many Austrian economists even define “inflation” as:

“an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.”  (von Mises 1912, p. 240)

Which means that the assumption of a causal relationship between the quantity of money and its purchasing power is included in their definition.

But the quantity theory has no logical grounds and little empirical predictive power in today’s credit money system where all money is an explicit debt relationship and most of it is “created” by banks “extending credit”: Why would the price level depend on how much people owe each other?

If we look at this from the perspective of the “demand and supply of money”, then, when private banks “create money”, they also create demand for it, as the people holding the debt will be willing to save money (work for it more in excess of their spending) to pay off their debts. If interest rates are high or the economic situation is uncertain, an increase in the money supply through granting of private credit might actually even cause an increase in deflationary pressures, as the indebted will be very eager to save a lot while those with the monetary savings might not be in any hurry to spend off their savings, which accumulate interest. Japan is a good empirical case example of how a constant increase in all monetary aggregates (e.g. M1 and M3) has not resulted in significant inflation (although the constant increase in government debt can be argued to increase risks of eventual hyperinflation).

Inflation is more determined by aggregate supply and demand. And currently, central banks control inflation by controlling the profitability of saving and the costs of borrowing by controlling their policy interest rate: the market rate for risk-free credit. Central banks have little control over the quantity of money – i.e. the “money supply” is endogenous to their policy. The “supply of money” is infinitely interest-rate-elastic – i.e. the interest rates on new “loans” does not depend on the quantity of debt people have already taken on (btw “loans” and “lending/borrowing money” are very misleading expressions, as section 5.1 in Fixing the Root Bug explains).

In a market economy, the price of each kind of good or type of labor is determined by supply and demand. When the demanded amount exceeds the supplied amount, prices are pushed upwards and vice versa. The price pressures on different kinds of goods – and, ultimately, their main factor of production, labor – together determine the overall price level. When the upward pressure is caused by an increase in demand, there is “demand-pull inflation“. When increases in costs – e.g. due to natural resources becoming harder to access – cause inflationary pressures, this is called so-called “cost-push inflation“. Supply and demand imbalances accelerate inflation (instead of e.g. resulting in a proportionate inflation while they persist). Hence, even with supplied and demanded amounts roughly in balance, there can be “built-in inflation” due to inflation expectations that for example make constantly rising wages and prices the default assumption for employees.

Non-accelerating inflation does not necessarily mean that supply and demand are exactly in balance. For example wage regulation, collective bargaining and social support tend to decrease the downward pressure on wages induced by oversupply in some sectors, resulting in a bigger need for oversupply needed to compensate for rises in wages caused by a labor deficit in other sectors. But even without supply and demand imbalances and wage regulation, a market economy is doomed to least some unemployment (the NAIRU, Non-Accelerating Inflation Rate of Unemployment) – as long as the unit of labor is a human being! How making sharing work profitable would nearly eliminate the NAIRU (often considered a “natural economic law”) by making structural imbalances occur as under- and over-employment instead of unemployment and labor deficits is explained in more detail in Fixing the Root Bug.

Fixing the Root Bug – making sharing work profitable – would cause structural imbalances to rather appear as temporary over-employment and under-employment of individuals instead of unemployment and labor deficits and would cause them to balance out much faster. Eliminating unemployment risks would also allow lowering the temptingness of social support and maximal mobility would remove the justifications for wage regulation. Hence unemployment could be eliminated almost completely (see: Economic Instability).