Economy
Nominal Versus Real Models
Modern economics uses “scientific” methodology, under the assumption that economic laws are invariant across time, space, and society. In previous posts, we saw how this leads to loss of precious insights about money gained from historical experiences (Monetary Economies: A Historical Perspective, Lessons from Monetary History: The Quality-Quantity Pendulum). In this post, we will discuss the modeling strategy we will use to derive lessons from history which extend beyond the particular historical context from which they are derived. Modern Economics uses nominal models (the as-if methodology of Friedman) which make it impossible to understand the role of money within an economy. We plan to use the alternative – realism – combined with Agent Based Models, to capture essential features of monetary economies.
Models are simplified representations of reality. When considering monetary history, the factors driving changes are notably intricate. Over the 20th century, the monetary system underwent significant transformations. World War I marked the breakdown of the gold standard, followed by unsuccessful attempts at restoration. World War II further hindered restoration efforts, leading to the Bretton Woods agreement and the adoption of a gold-backed dollar standard. Nixon’s actions in 1971 severed the link between the dollar and gold, ushering in an era of floating currencies detached from commodities. Distilling broader lessons from the complexity of historical specifics necessitates a methodological approach centered on models. Models abstract from specific historical details to illuminate structures which may be widely applicable across various historical and temporal contexts.
In this text, we will be using realist models – these differ greatly from the nominalist models used in conventional textbooks of economics. The difference can be explained as follows. Our world comprises observable phenomena as well as underlying structures that produce these observations. Nominalism holds that models should focus solely on explaining observables, disregarding whether they accurately reflect hidden reality. This notion, though counterintuitive, emerged due to the belief that hidden reality is unknowable, making the pursuit of matching it futile. Instead, nominalism advocates for assessing a model’s success based on its ability to explain observed phenomena. Conversely, realist models strive to mirror the hidden reality behind observations.
Friedman’s essay on “The Methodology of Positive Economics” strongly advocates the use of nominal models. This methodological principle has been widely accepted by economists. Friedman illustrates nominal models with the example of a skilled pool player. He suggests that even if the player lacks any understanding of physics, assuming knowledge of the laws of physics can lead to accurate predictions of their shots. In essence, the player behaves as if they comprehend physics, making successful shots based on calculations, despite their ignorance of the underlying principles of physics. This is known as the “as-if” methodology, and it is the dominant approach to models in modern economics.
In contrast, realist approaches reject such assumptions. For the pool player, a realist model might study his past experiences, and his skills at different types of shots. Realism aims to understand the internal workings of hidden reality, while nominalism accepts models that predict outcomes, without concern about matching hidden reality. Friedman developed his as-if theory in response to empirical surveys which showed the most firms do not maximize profits. He argued that the assumption of profit maximization, even if it did not match the motivations of the managers of the firms, should be assessed on the basis of its ability to predict decisions about hiring and production. However, by now, this methodology has been in use for several decades, and it has led to repeated failures. A good fit to observations for a particular finite set of data is not a guarantee of the validity of a model. It can, and often does, happen by chance. For a more detailed discussion of the superiority of real models to nominal models in the context of econometrics, see “A Realist Approach to Econometrics” (bit.ly/azrae)
We will use a recently introduced modeling strategy — Agent-Based Models (ABMs) – which has not made its way into mainstream methodology. ABM models have multiple agents – laborer, producer, shopkeeper, government, etc. – each of which has their own economic decisions to make, and behavioral patterns. This strategy has become feasible because of the vastly increased computational power now available, which permits us to run simulations and compute outcomes. The foundations of modern economic methodology, established around the mid-20th century, relied on simplifying assumptions to facilitate manual computations. For example. Leading macroeconomic models have only one agent, who has perfect foresight. Why? Because computations by hand would be impossible with two or more agents. At a Congressional inquiry into the failure of economists to predict the Global Financial Crisis of 2007, Solow testified that the GFC was caused by large scale deception and fraud. Macroeconomists could not predict it because these are impossible in models with only one agent. In contrast, models with heterogenous behavior are much better at capturing the complex internal structures of modern economies, in accordance with the principle of realist models.
Using ABMs, we can capture three Keynesian insights, all of which are essential for the understanding of money, and all of which are missing from conventional textbooks:
Complexity: This technical term refers to a situation where the group behaves very differently from the individuals within the group. For example, that even though laborers and the firms which hire them may seek to lower the real wage, they can only negotiate on the nominal wage. The real wage involves the price level of the economy which is out of their control. Keynes argued that lowering nominal wages at the micro level throughout the group may end up increasing the real wage – a perfect example of complexity. This phenomenon is beyond the reach of conventional economic theory because the textbook models are oversimplified to prevent the occurrence of complexity.
Radical Uncertainty: In a model with heterogeneity, each agent has access to a limited amount of information. The economic outcomes depend on the actions of all agents, which can never be known to the agents. As a result, the agent operates in an environment where the outcomes of the decisions he takes are not predictable. Standard textbook models use intertemporal optimization, where the agent knows his future incomes, potential consumption bundles and prices. This is simply impossible in our agent-based models. Similarly, profit maximization is impossible for firms because they incur production costs in current period, but will produce and sell goods in the next period. The price at which they can sell will depend on decisions others make, and cannot be predicted. So profits are subject to radical uncertainty, and cannot be maximized.
Non-Neutrality of Money: Once we take into account heterogeneity and uncertainty, new insights into the role of money emerge, not available in conventional textbooks. Workers save money, and firms acquire money profits, but, due to radical uncertainty, no one knows what the value of money will be in the next period. A stable value of money allows for some degree of planning, but the QQ-pendulum shows that this stability cannot be relied upon. The assumptions of full information made in conventional textbooks make money merely an accounting unit, which does not play an essential role in the economy. However, with radical uncertainty, and differential information and behavior of different agents, money plays an essential role in the economy. Workers save money as insurance against adverse outcomes in the job market, and firms save money to guard against future losses. These different motivations for holding money, and the psychological aspects which relate to public trust in the future value of money, will come to the fore in our ABM models.
To wrap up, we have discussed two types of models – nominal and real. Nominal models dominate mainstream economics, and are judged for their ability to match observations. In contrast, Realist models are judged on whether or not they match the hidden structures of reality which produce the observations. In the next section, we will build some simple realist monetary models, and show that these produce results and yield insights outside the range of orthodox monetary models.
China’s worrying economic policy drift
The Rhodium Group, an independent research organisation with a focus on China, says the nation’s economic policymaking process has stalled with it refusing to announce meaningful actions to overcome its pressing property and share market crashes let alone forge a clear path for the future. The full paper can be accessed here. Here is my Continue reading »
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There are two things the prime minister needs to get into his head about tax. One is that saying he won’t make any further changes no longer works. The other is that negative gearing doesn’t do much to get people into homes. Anthony Albanese seemed to have taken the first point on board when he Continue reading »
Albanese’s proposal doesn’t fix bracket creep for low income earners
The Albanese Government’s proposed change to the Stage 3 tax cuts is clearly a broken promise; or, put another way, where was the political courage to offer an alternative when Stage 3 was announced (well ahead of the 2022 election)? But for the purposes of this analysis, let’s put those genuine integrity issues aside. While Continue reading »
Record highs: February market and economic review
Not only has the stock market shaken off its new year hangover but the All-Ords is now higher than after its Santa Rally in December 2023. Indeed, it has reached a record high. Bears say don’t be fooled by the index’s present spike. The aggressive monetary tightening in 2022 and 2023 will wreak havoc on Continue reading »
Shopping ‘Wonky’ Keeps Imperfect Goods From Going to Waste
Buying non-perishable products like tea, cookies, chocolate and soap from UK online retailer Love Health, Hate Waste has not only saved eco-conscious shopper Sylvia Tillman nearly $320 over the past year, but buying products that would otherwise go to landfill also puts her mind at ease.
Love Health, Hate Waste sells products that are past their “best before” date, but not deemed to be expired and so still safe to consume, at up to 90 percent off the original retail price. Some of the packaging is slightly damaged too, but the products are unopened.
None of this bothers Tillman, who is based in Ramsgate, UK. In her work as a tension release exercise coach, she is always on the lookout for health food bargains, which Love Health, Hate Waste specializes in. The only downside, she says, is that its stock changes regularly, so shopping on the site can take some time. But Tillman actually appreciates this for the novelty it brings.
“I’m generally eco-conscious, and don’t waste resources anyway,” says Tillman. Courtesy of Sylvia Tillman
“As I love exploring new products that I’d never tried before, I love this aspect alongside the potential savings in money or of food to landfill,” says Tillman.
Buying flawed packaged products seems like a natural extension of the imperfect fruit and vegetable movement, which UK shoppers have embraced since supermarkets like Sainsbury’s and ASDA launched related promotions — the latter collaborating with celebrity chef Jamie Oliver in 2015. The term “wonky” has since become synonymous with products that have aesthetic flaws, but are otherwise fit for consumption.
Wonky fruit and vegetables have become a no-brainer in the UK as a way for farmers and retailers to cut down on food waste. Meanwhile, shoppers save money buying less-than-perfect produce that, a decade ago, would not have ended up on shelves at all.
Seventy-seven percent of UK adults YouGov surveyed last November said they’d be likely to purchase wonky produce next time they went shopping, with 72 percent driven by lower prices. Sixty-three percent are motivated to reduce food waste, with conservation group WWF finding that around 2.9 million metric tons of edible food is wasted on UK farms each year.
Often, what makes goods wonky is barely noticeable, like the slightly damaged lid of this instant noodle container. Courtesy of Love Health, Hate Waste
The trend is now extending beyond fresh produce, giving a new life to goods whose packaging has been bumped and bruised, leaving the inside item unharmed. For example, selling excess, obsolete and imperfect beauty products at half price or more, Boop launched its online marketplace in November 2023. Wonky Coffee, previously known as Odd Coffee, sources its flawed pods from a number of big brands and is said to have rescued around one million of these from landfill in 2021, its first year of business. It plans to reach 50 million by 2025. Earth and Wheat rescues wonky bread from its partner bakeries. And Amazon even opened a pop-up seconds store in London last year, selling returned goods at up to half price.
In the US, meanwhile, salvage stores, which stock damaged, discontinued, surplus and close-to-expiration-date items, are more popular than ever as grocery bills continue to rise, the New York Times reports, while rescuing $161 billion of food going into landfill each year. Shoppers are also finding deals on returned and surplus products on sites like Liquidation.com and Bulq, with some offering auctions on entire pallets.
What wonky means for retailers
Hema Stewart, founder of London-based recyclable wrapping paper brand Curlicue, introduced wonky gift wrap kits to Curlicue in 2019 as an avenue for selling wrapping paper that became slightly damaged after being transported for sale to market stalls. Sold at a 60 percent discount, the wonky kits include paper, tags and twine that have slight damage or are simply shorter than the ideal retail length. The kits now make up around 10 percent of Curlicue’s sales.
Curlicue’s wonky wrapping paper, tags and twine are very slightly damaged or just not the ideal retail length. Courtesy of Curlicue
“We had been looking at the wonky fruit and veg campaigns that had been going on, and now the ‘wonky’ phrase has really caught on in society. Our wonky kits became an easy way for me to make sure there wasn’t product wastage, and that we were offering something at a slightly lower price point for people,” Stewart explains.
Stewart has observed how the popularity of secondhand platforms like Vinted has normalized giving overlooked items a new lease on life, with shoppers incentivized by sizable discounts, as mainstream prices continue to rise.
“That shift has had an important effect on how people are buying, and a lot are going back to a more traditional mentality of how you reuse things, and make them last longer,” she says.
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Likewise, rather than disposing of cosmetically damaged returns, bubble kit maker Dr Zigs offers a wonky range at half the usual price, also making up around 10 percent of its sales. And like Stewart, owner Paola Dyboski has noticed a change in shopper mindsets.
“People are wising up to the way brands have put a veil over our eyes to make us believe we have to have something that’s perfect. Now people think more about reusing and upcycling,” Wales-based Dyboski says.
The best part, she adds, is being able to help budget-impacted customers.
Half-price wonky bubble kits make up about 10 percent of Dr Zigs’ sales. Courtesy of Dr Zigs
“I’ve had so many messages, especially around Christmas, from customers saying they had always wanted to buy our bubbles but couldn’t afford it, and this has made it possible. That kind of feedback makes it worthwhile,” she says.
Helping people embrace the “perfectly imperfect”
Sustainable shopping expert Jennifer von Walderdorff confirms that the wonky shopping movement is helping people embrace the “perfectly imperfect” and move away from the social media-fueled desire to buy things to achieve a certain influencer approved look and lifestyle.
“Buying into this movement is not only smart but sustainable,” von Walderdorff says.
She notes, however, that culturally, there is still an element of wanting to hide that imperfection, meaning wonky products may reach a limited audience.
“Serving a meal with chopped-up wonky vegetables is one thing, as they can be concealed, as can the packaging you purchase your makeup in. But wearing a garment with an uneven hem, or having homeware that has decipherable imperfections is where the adoption may be harder,” she says. “If ‘wonky’ retail can be concealed, it will be the bargain of the century, but trying to sell this en masse may be tough.”
For that reason, Yasmine Amr, founder of beauty brand Boop, is focused on educating consumers about what it means to buy wonky. For example, two-thirds of the 300 UK women the company surveyed last year weren’t aware that it’s common practice in the beauty industry to destroy excess stock, products with damaged external packaging and unopened returns.
“A key challenge will always be consumer trust. Shoppers want to be sure they’re getting the real deal and their products will deliver results, even if the external box is missing or there’s been a misprint on the label,” says Amr.
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To tackle this, Boop only sources directly from brands to make sure all products are safe, haven’t been tampered with, and are within their best-before dates. The company layers its own quality control checks over this, too.
“We’re focused on educating customers about product waste and how using platforms like Boop can help them lead more sustainable lives without sacrificing quality and luxury. For instance, changing a shampoo’s name due to a brand marketing decision shouldn’t be a reason to destroy thousands of units if the actual product is identical,” says Amr. “If consumers are aware of that, they’ll see there’s nothing truly wonky about these products.”
For Silvia Tillman, it’s about a wider approach to not wasting resources throughout her everyday life and tasks. “I’m generally eco-conscious, and don’t waste resources anyway. I’m impressed by and always keen to learn more of old-fashioned household hacks, like cleaning with vinegar or bicarbonate of soda, and doing laundry with soap nuts or ivy leaves,” she says.
The post Shopping ‘Wonky’ Keeps Imperfect Goods From Going to Waste appeared first on Reasons to be Cheerful.
Lessons from Monetary History: The Quality-Quantity Pendulum
In the previous section, we saw how economic theories changed from Classical to Keynesian to Monetarist over the course of the 20th century. These changes were driven by historical events. Taking this historical context into account deepens our understanding of economic theories. This contrasts with the conventional methodology of economic textbooks, which treats economic theories as scientific laws, which are universally applicable to all societies. In this section, we describe one of the central lessons which emerges from the study of money over the millennia.
The transition of economic theories from Classical to Keynesian to Neoclassical can be seen as a miniature illustration of the Quality-Quantity Pendulum, which is a consistent pattern relating to money observed over millennia. Modern economic theory strips theories of their historical context, depriving us of critical insights into both theories and history. Before studying the QQ Pendulum, we will pause to discuss how this defective methodology was adopted by economists.
The Battle of Methodologies: As Geoffry Hodgson has detailed in his book entitled “How Economists Forgot History”, a challenger to the dominant historical and qualitative methodology emerged in the late 19th Century. The new methodology was quantitative, mathematical, and empirical, in imitation of scientific methodology. The devastation of World War 1 destroyed the prestige of the traditional approach to social science, so that this scientific approach became the dominant methodology in economics by the 1950s. This ahistorical approach blinds us to the fact that all social theory is developed to analyze a particular society situated in a particular historical context. Treating it as a universal scientific law, invariant across time and space, is hugely mistaken.
Lessons from History: In this section, we will discuss some insights about the nature of money, and monetary economies, derived from the study of history by Glyn Davies in “A History of Money: From Ancient Times to Modernity”. Davies writes that: “… despite the antiquity and ubiquity of money its proper management and control have eluded the rulers of most modern states partly because they have ignored the wide-ranging lessons of the past or have taken too blinkered and narrow a view of money.” For example, Keynesians and Monetarists agree that a contraction of the money supply was the immediate cause of the Great Depression of 1929, ill effects of which persisted until the outbreak of World War 2 in 1942. From a broader perspective, a study of the history of money should have made both the nature of depression, and the remedy, abundantly clear. Unfortunately, as the previous quote indicates, policymakers ignored the lessons history teaches us about the role of money, and made errors which caused misery to millions for decades.
Money as a Social Institution: A study of history shows that money has played a central role in shaping history across the centuries. Also, history teaches us money is not purely a transaction technology; it is deeply embedded into the social fabric of society. Use of money requires building social consensus on trustworthiness of the monetary institutions. Building this trust requires building high quality institutions and mechanisms, which guarantee the value of money in the eyes of the public. The quality of money refers to the public trust and social consensus both on the value of money, and the stability of this value across time.
High Quality Money: History provides us with an incredibly diverse set of examples of monetary institutions which provided society with trustworthy money with stable value across time. Cattle and cowries in Africa, paper money in China, Wampum in America, and Yap stones in Pacific Islands, were used as money for centuries. Many systems even survived in competition with modern monetary systems. So, we conclude that there is a wide variety of ways to create high quality money.
The Gold Standard: One of ways to create high quality money is to use gold or silver. These metals have characteristics – discussed in textbooks – which make them particularly suitable for use as money. There is very little public awareness that there are many different varieties and conflicting interpretations of what “gold standard” means. The best reference for this is Morrison’s England’s Cross of Gold: Keynes, Churchill, and the Governance of Economic Beliefs. The strictest form of the standard – use of actual gold – has been very rare, historically. Coins of minted gold have been far more popular. The mint certifies the quantity and quality of gold in the coin, making it far more convenient for public use.
Minted Money and Token Money: The highest quality of money comes from minted coins which have value equal to the content of the metal (gold or silver). This is because the coin itself is the guarantor of its own value. There is still the question of what it is about gold and silver that creates nearly universal consensus on their intrinsic value? Perhaps the answer is that love of gold and silver has been built into human nature, as an ayah of the Quran suggests. The numismatic evidence from buried coins shows that high quality gold coins are almost always followed by “debased” coins – coins with significantly less gold content than the face value of the coin. History tells us of the varied reasons for such debasements. Most often, high expenses of wars require vast amounts of money, beyond available stocks of gold. Governments resort to debasement, to get more money from the same gold stock. Since gold is very valuable, even the smallest gold coins are not useful for daily transactions. So, token monies, made of copper or other cheap metals, are often used for small change. The metal value of these coins is not equivalent to their market value – instead, these coins considered as fractions of the gold coin, and are exchangeable.
From Quality to Quantity: The lesson of history, repeated across the globe, and across the centuries, is that the temptation to expand the stock of money – more quantity – proves irresistible in the long run. A modest expansion of money stock via small dilutions of gold content or small issues of token money, brings major economic benefits. Small expansions of money stock beyond gold content do not cause noticeable changes in the public trust which is the central guarantor of the value of money. However, over a longer period of time, the temptation to expand the quantity over safe limits becomes irresistible. Events like wars, or private greed, or government need, lead to over-expansion of the money stock. An excessive quantity of money causes inflation, a loss of value, and a breakdown of public confidence in money. The drive to expand the money stock leads to low quality of money. But large fluctuations in the value of money disrupt the lives, and cause distress to all members of a monetary economy. As a result, consensus builds on monetary reforms required to create high quality money. Eventually, excess money is removed from circulation, and a high quality money is restored, to complete the swing of the pendulum between quality and quantity.
The Pendulum of Economic Theories: Many authors have noted that history is a battle between the creditors and the debtors. In eras of high quality money, money is scarce, and the creditors are few and powerful. They propagate pro-creditor economic theories which favor “sound” money: high quality with restricted quantity. However, the need for expansion of money stock becomes overwhelming in many different scenarios. Then the pro-debtor economic theories emerge. These favor the expansion of the money stock, and cite numerous advantages from doing so. Creditors argue in vain against the slippery slope of modest expansions leading to ruin. The benefits from expansion are immediate and obvious to all. But in the long run, their gloomy predictions turn out to be valid. Over-expansion destroys the quality of money, and also the reputation of the pro-debtor economic theories.
This drama has played out over the centuries in many different guises, and with different terminologies in use to describe the two opposing schools of thought about money. Confusingly, the quantity theory of money (QTM) advocates maintenance of high quality money, and argues against expansions of the money stock to bring prosperity to the masses. The Real Bills doctrine versus the QTM, the Anti-Bullionists versus the Bullionists, the Banking School versus the Currency School, Keynesians versus Monetarists, and most recently, Minsky’s Financial Fragility Hypothesis versus the Real Business Cycle theories, are all illustrative of the quantity-quality controversy which spans centuries of monetary history.
Long-Run Versus Short Run Perspectives: Davies emphasizes that this quantity-quality pendulum becomes discernible only in the long run. Over any short period of time, spanning a few decades, the immediate benefits of one or the other school of thought seem overwhelming. When tight money is creating recession and unemployment, the benefits of looser money seem obvious to all, and tight money adherents find little support for their positions among the masses. However, in periods of high inflation, the harms of loose money again appear obvious, and tight money policies gain public support. Over any short period of time, one or the other policy seems obviously superior. It is only a long-term examination of history which shows the regularity with which the pendulum swings between the two poles.
There are three conclusions we would like to draw from the quantity-quality pendulum, which emerges from the study of millennia of monetary history.
- The study of equilibrium is an illusion. A stable and high-quality money creates an irresistible temptation towards expansion, leading to a breakdown in quality. Also, excessive money stock which destabilizes the value of money creates powerful forces which seek to stabilize its value and create high quality money. At no point in the trajectory of the monetary pendulum do we see any resting place, or equilibrium.
- The value of money rests on the social consensus created by confidence in the monetary institutions governing the creation of money. History is full of examples where this confidence was weakened or strengthened, leading to changes in the value of money. Recently, a crisis of confidence in the Euro was stemmed simply by an announcement by Mario Draghi the he would do “whatever it takes” to stabilize and protect the Euro. Conventional treatments of money pay no attention to these psychological aspects of money.
- The historical perspective provides deeper insights into monetary theory than conventional methodology. When the Great Depression created tight money, Keynesian theory favoring expansion of money stock emerged and became popular. Inflation in the 1970’s led to rejection of Keynesian theory and a return to the tight-money policies implemented by Volker. Conventional methodology searches for absolute scientific truths, without realizing that truth may be relative to a particular historical context.
Links to Related Materials
- Bit.ly/ME01: Monetary Economies: A Historical Perspective
- Bit.ly/MONE02: Writeup of THIS video-lecture
- Bit.ly/WEAmom: Method or Madness? (battle of methodologies)
- Bit.ly/MONBX: Books on Monetary Theory and History
- Bit.ly/Azmmai: Modern Money and Inflation
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