Sunday, May 6, 2012

The physical and the financial

On May 5th I participated in a conference called "Meeting the energy challenge for Otsego County: Local solutions, local control, local jobs." Our region has seen a lot of activity to prevent high-volume hydrological fracturing ("fracking" for short), both locally and and in New York state.  The question naturally arises, "If you're against gas, what are you for?" People have already been doing good work answering that question on the ground: retrofitting homes for energy efficiency, developing renewable energy sources, finding ways to reduce our energy demands. Adrian and Antoinette Kuzminski put together the conference to spread awareness of the work that's already being done and to stimulate new efforts.

I was asked to give the opening presentation, addressing issues of energy and money. This is adapted from the first part of those remarks. I eventually address the question of how to pay for energy alternatives, but I first wanted to lay the relationship between the physical part of the economy and the financial, starting with a simple example.

It's reasonable enough for an individual to think about saving up for retirement: as long as you're earning something more than what you need just to get by, you save up, and save up, and one fine day, you can stop working.

For the rest of your life, you  have the privilege of consuming without producing.

But of course it's a different story for a whole society. What if people saved up and then everyone retired?

That's pretty clearly impossible.

The reason it can't work is that when we save up, we're not setting aside a closet in our house packed with food, medical personnel, gasoline, electricity, ...

In other words, we're not saving up the actual fruits of our labor. We're saving up money.

We're saving up claims on the fruits of other people's labor. In the future, when we're retired, we're going to be buying things produced in that future, not things that are being produced now. So somebody has to be working then, to produce the things we'll be buying.

The lesson here is that the economy has two distinct components. There's the physical structure, which is all the labor, and skills, and resources, and machinery, and roads, ... with which we do work. It's also that work itself. And that work produces value, a concept I'll return to later.

The other component is the financial system, which deals in claims on the stuff produced by the economy's physical structure, claims on value. The financial system decides who gets these claims, it creates them, it stores them, and it destroys them.

Together, the physical structure and the financial system make up the real economy.

(As a side note, the term "real economy" is usually used to refer to what I've called the physical structure. But this usage suggests that the other part of the economy is "merely" money, as opposed to "real" things like production and employment. In fact, there's nothing "mere" about money. In the housing bubble of last decade, "mere" money caused real things to happen like houses to be built. When many of those mortgages couldn't be paid, "mere" money caused millions of people to lose their jobs. As Norm Farwell would observe later in the day, our economic problem was caused by building too many houses, and because of that mess, we now have more homeless people. It's not sane, but it is real. So I consider the "real economy" to be both the physical things that happen, and the financial system that helps direct themor misdirect them.)

So we need to understand the physical structure of the economy, and how it relates to the financial system. The place to start with that is with a basic understanding of ecosystems, because the physical structure of the economy is an ecosystem. What makes an economy different from an ecosystem is precisely the financial system.

Next: Ecosystem basics for economics

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