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January 27, 2015

Economics and Plato's Cave

boorstin.jpgIf you had occasion to take a Philosophy 101 course in college, you may remember the allegory of Plato's cave. Plato meant it as a discussion of what "reality" is -- whether it is an absolute thing, and whether humans can experience "reality" in its totality or if we are limited only to what we can experience and measure. The idea is that what we can sense and measure is only a subset of a larger reality that we cannot perceive directly.

I've long thought that this allegory works quite well for economics in many ways, especially as it pertains to concepts of money and wealth.

Take a dollar out out of your pocket and look at it. What is it? It's many things, actually: it is money, so it must be a store of wealth, a unit of account, and a medium of exchange; it is a manufactured good, intended by its manufacturer to be used as currency; it is a work of engravers' art; it is a complex piece of technology (especially modern bills with the various anti-counterfeiting countermeasures); it is a carrier for the oils, dirt, and germs of the people who have handled it; and so on.

You can think of money as a special kind of battery, only instead of storing electricity, it stores up economic value which can be expended at a later time. And just as a battery can store energy but not create it, money can store value but not create it.

It turns out that this dollar bill is a pretty complex object, all things considered. And yet it isn't a "real" thing in the sense Plato was speaking of. Whatever else it may be, a dollar is not in itself valuable; it is rather a signifier of a real thing we cannot see directly. A unit of money -- whether a dollar, a franc, a pound, or a quatloo -- is only "real" insofar as it signifies some existing value in the economy. (We can think of some value as being latent as opposed to realized, as it often is with investments. We invest in expectation of value being created and providing some kind of return on the investment. No value appears spontaneously out of the void. The invested capital is based on already-existing assets; a return is only realized if the endeavor creates additional value. Interest income or dividends don't just magically materialize -- interest income is your share of the value added and payment for the time-value of the money you invested. Nothing comes from nothing, as Parmenides reminds us.)

That dollar you hold in your hand is the shadow cast by something of value in the world of real things.*

If that much is true, then it follows that the dollar's purpose, its whole reason for existing, is bound up in the real-world thing that casts the shadow. Without the real-world good or service, there can be no shadow cast on the wall for us to see. If that connection is broken between signifier and signified, a good or service and the money that carries its value into the marketplace, then money loses its fabulous utility and becomes just a piece of ornately-printed paper.

That's why it's so important for us to talk about economics in terms of the real physical world (or at least the part of it we can interact with and experience), because this is where scarcity operates. The world of real things, where the allocation of scarce resources drives every economic engine, is where we have to anchor our understanding of economics. Money -- and all the complexity of finance, monetary and tax policy, etc. -- happens at a higher order of abstraction. Money is not value; money signifies value. Money allows value to move about on the marketplace in a fairly fluid and transparent fashion. Money is a carrier, not a generator, of value.

One of the major problems in the world economy right now is that this fundamental link between money and the world of real things has become terribly attenuated. This is partly due to the near-universal move to fiat currencies; partly due to the securitization of much of the economy (allowing investors to leverage at ratios from 10-to-1 all the way to 100-to-1 or more); and the increasing indebtedness of the world's sovereign governments. We are behaving as if the concept of "scarcity" no longer applies.

This mindset has caused a lot of problems, but the most pernicious is in the corruption of the pricing mechanism. The pricing mechanism is how a marketplace determines the value of a good or service, by using supply and demand to adjust prices upward or downward. Prices are not fixed; a good or service is worth what the market will bear. (In an efficient economy, prices will adjust to market-clearing levels.) However, this mechanism has been systematically undermined by governments, particularly during the age of fiat currency. Governments and their central banks attempt to harness market forces to move in the direction they desire, but often cause unintended (and harmful) side-effects.

As a result, it is becoming very difficult for the market to accurately price an asset. It's hard to tell what a good or service is actually worth, because the pricing mechanism of the market has been systematically (and deliberately) corrupted over the past several decades. Both supply and demand have been manipulated to the point that a "natural market state" is almost impossible to determine, which has the knock-on effect of breaking the pricing mechanism. This makes both investing and consumer purchasing far less efficient in market terms.

Governments and their central banks believe they know what prices should be, but they suffer from Hayek's "knowledge problem" -- they cannot fathom the amazing complexity of the national economy well enough to know what prices ought to be for the myriad goods and services, even to a rough approximation. Communist governments in the 20th century tried the central-planning approach and failed miserably, but it seems like the supposedly-capitalist governments of the 21st century have not taken those lessons to heart. Over-regulation, interest-rate manipulation, bad laws, a focus on financial tricks rather than productive output, and out-of-control entitlement spending (hence higher taxes), chronic and systematic indebtedness -- all are components of the problem.

If you remember nothing else about economics, remember this: money only signifies value insofar as it maintains a link to the world of real things. When that anchor is broken, an economy loses coherence because it becomes impossible to set an accurate price on any good or service. A marketplace without accurate prices is not a market at all, but a gambling den. You might get value for your money, and you might not.

In a sense, one of those real things that a dollar represents is something that cannot be touched, or felt, or seen: trust. Trust has real-world value (it is one of the most valuable commodities there is!), and it is in fact the most essential kind of value a fiat currency must anchor to.


*One way in which the Plato's Cave allegory doesn't work well in the monetary sense is when considering an essential property of money: fungibility. For money to be money, it must be fungible -- that is, a dollar bill is exactly like any other dollar bill in terms of how it behaves in a monetary sense. I can buy a candy bar with any dollar, not just one specific dollar. The Plato's Cave allegory draws a 1-to-1 linkage between the "real" object we cannot perceive and the shadow we can perceive, but with money it is more like a probabilistic wavefront that only collapses when you spend the dollar.

This means that, in the economic sense, our "shadow" of a real world good or service is not a particular dollar but any dollar.

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posted by Monty at 09:00 AM

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