Economics: The most important things in life are the least understood – Part One

Why are the most important things in life often the least understood? Economics, our economy, decides how the fabric of our society functions in terms of the things we use and do every day. It is huge, it is important, and its true function is very poorly understood by all but a few of the brightest minds in our country.

How can the average person ever hope to make intelligent decisions about something so important, and trust they are doing the right thing, when they barely understand even the basic concepts? The answer is they cannot. What usually happens is that they defer the decision to someone else that they trust, because they share some other unrelated interest. It may be a politician, a radio talk show host, or their next-door neighbor. The mistake is that the person they are listening to probably knows little more than they do.

I struggled with this problem for many years. I am not a professional Economist; I am actually a software developer. I decided however to stop letting other people decide how to think for me. This meant I needed to do a lot of research into an area where even the experts disagree. It was necessary to read all sides of the argument, and then decide for myself what the best course should be to take. Few of you have the time or inclination to spend thousands of your precious hours reading mostly boring books on the history of political economics, or current economic theory. Therefore, I will attempt in this blog to share with you some of what I have learned through my own research in the hope that I educate you enough to start thinking for yourself, and try not indoctrinating you to my own philosophy.

We first have to create a model to describe Economics in easily understood terms, then we need to explore what the right thing to do might be for each of us, and then finally we will discuss what each of us can do as individuals to alter something as large and complex as an Economy?

Throughout my 35-year career, I have designed software for a number of large companies as well as governments at every level from local to federal. In designing software I always strive to model complex systems in simple terms in order to understand the higher order processes that drive the organization. That same approach can be applied to economics to explain the very complex interactions in a model simple enough for the average person to grasp.

What is Economics

Economics is the study of how our economy functions. It looks at how all goods, services and money flows throughout society to create this extremely complex fabric of transactions. It defines what kind of society we live in, and is the single most important factor in establishing your quality of life. The study of Political Economics looks at the role government has in shaping economic policy.

The Transaction

To begin our discussion, we first have to understand what an economy is at the lowest, most basic level. Once we understand this, we can build up to ideas that are more abstract.

At the core of an economy is the transaction. Everything that happens in our economy when something of value is transferred from one entity to another is through a transaction. Every transaction, no matter how simple, has two components; the part given and the part received. If you are an employee, you give labor and receive a wage as money and benefits. If you are at the grocery store, you give money and receive groceries in return.

Capital is the term we give to the things transferred; capital is value, thus, we have a capitalist economic system. The diagram above illustrates a transaction between a business and a person. They are each represented by what I will describe in more detail in the next section as a tank of water. The amount of water in each tank represents the total capital, net worth of that entity. In a transaction, each entity gives something of value and receives something of value. If over time an entity receives more value than they give, they will see their tank fill up; their net worth will increase. Each tank then contains everything of value that an entity owns; cash, real estate, other assets, plus money due as receivables, minus money due as debt. The worksheet used to calculate the total is called the Balance Sheet, but that is starting to get into an area known as accounting, so we will stop here. Every entity can calculate their net worth with a Balance Sheet, people, businesses, even non-profit organizations.

The Abstract Model

The next step involves taking a step back and creating what we call in software design an abstraction of the model. In doing this we group like things together, and look at the interactions between the groups. This creates a simpler model of the system that makes it possible for average folks like myself to wrap their minds around it.

In the previous section we illustrated a business and a person with a simple transaction. In this model, we are going to create an abstraction of the entire economy by creating four groups. We will create one group to represent all businesses. We will then create three more groups of people to represent the different economic classes; upper income, middle income and lower income. Why these three groups of people? Because we want to explore the interactions between them, and it is very important in clearing up some poorly understood concepts that people have about each group.

We will stick with the water tank analogy we use earlier to describe these four groups. What you need to understand is that now each group is represented by a single water tank, that holds all the capital, the net worth of all those who are in that group. In doing this we can now look at our economy in action with only a few moving parts instead of the billions of individual transactions that take place without this abstraction.

The business tank represents an aggregation of all the businesses in our Economy. You can think of water flowing into the tank as income the business group receives from the sale of goods and services, as well as interest and dividends from investments. The water flowing out of the tank represents all of the costs incurred in the production of the goods or services sold. If more water (Capital) flows into the tank than flows out, then the value of the business increases.

The other three tanks represent three economic tiers of the population; upper income, middle income and lower income. As with the business tank, the other three tanks represent aggregate groups of the population with incoming and outgoing flows of capital. Incoming flows represent income from wages, interest, and dividends. Outgoing flows occur every time an expense is incurred; goods or services purchased. Flows can take place directly between population groups. If more water flows into a tank than flows out, the water level in the tank goes up and net worth of the group is increased.

It is important to note that included in all four tanks are all of the capital, assets, property and possessions currently owned by that group. There is a constant flow of money, goods and services flowing from tank to tank. We want to keep our model simple at first so that we can understand the basics without being bogged down in detail. Therefore, we shall ignore for a moment the Federal Reserve’s ability to add water to the tanks by printing more money, and the effect of international markets.

We now have a closed system, where the amount of water (capital) in the system is constant.

If the system is in perfect balance the flows into and out of each tank would be equal over time, such that the relative wealth of each sector would stay fairly even. No one sector or group could grow without a corresponding loss elsewhere. This does not imply that the amount of water must be equal between all groups. This is often the first thing most people think of when discussing the redistribution of wealth in economics. That was the communist model, and no sane person would recommend that. Rather, balance means that the relative share of wealth remains about the same. It means simply that if the lower income group has 5% of the water supply today, they will still have 5% of the water supply tomorrow. So, that dollar in your pocket is not really yours, your name is not on it, you are just holding it for a while until you pass it to someone else to hold. It is just a token used to represent how much value (capital) you possess.

One problem we see happen in free market capitalism is that it is never in balance. In fact, there is a strong tendency for the flows to favor business and the upper income group. This is because they tend to have more control over how the flows are adjusted to be in their favor. No one is saying that is not fair, it is just a fact of life, like the fact that the sky is blue.

If left unchecked however, wealth will accumulate at the top of the economic food chain with a corresponding drop in the lower and middle-income tanks. I know what many of you are thinking right now, because I always hear the same argument presented. They are just being rewarded for their hard work and making a profit, that is how our system works. That is true, we do not want to stifle innovation and hard work, but this is not a monopoly game, where one person has all the cash at the end and wins the game. Therefore, our challenge when trying to make decisions about the economy is how we structure the flows of capital in our system such that we maintain an orderly and functioning society without stifling rewards for innovation and hard work. I hope that you will agree that we need a system where we all can enjoy the opportunities available in this great country, a system where ANYONE with initiative and hard work can get ahead and create a better future for their children.

In my next post, I will discuss how human nature is to blame for many of the economic ills we face, and how that impacts decisions we make about our economy.


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