Economic Model part II

The first part the economy is about three processes: Industry, banks and humans.
The third part Economic Model part III is about the consequences for import and export. In the third section also the crisis in Greece is discussed
In this part we will subdivide the three processes more further.

• Industry in: Government ( inclusif Central Bank and the judicature), the Military (inclusif the police), Health care and Education
• The banks in: Insurance business and pensionfunds.

We will get the next picture: (Not all flows are drawn)

 Raw materials ---.                                       ======= 
  Trade & Trafic  |                                      | (20)  |
                  V                                      ^       V       
     ..........................          (1)         ..................        ..............
    .                          .------------------->.                  . (14) .              . 
    .       Industry           .         (2)        .       Banks      .<---->.  Insurances  .<--
    .                          .<-------------------.                  .      .              .   |
     ..........................                      ..................        ..............    |
              ^ |       ^ |                            ^ |   ^ |    ^                            |
              | |    (7)| |(8)                         | |   | |    |                        (13)|
              | |       | |       ................  (9)| |   | |    |          ..............    |
              | |       |  ----->.                .----  |   | |    |  (16)   .   Pension    .   |
              | |       |        .  Government    .  (10)|   | |     -------->.              .   |
              | |        --------.                .<-----    | |              .    Funds     .   |
              | |                 ................           | |               ..............    |
              | |                       ^  |                 | |                      ^          | 
           (5)| |(6)                (11)|  |(12)          (4)| |(3)                   |          |
              | |                       |  V                 | |                      |(15)      |
              | |                 ................           | |                      |          |
              |  --------------->.                .----------  |                      |          |
              |                  .    Humans      .<=========> | <=====================----------
               ------------------.                .<-----------  
                                  ................
                                    ^     ^    ^
               (17)                 |     |    |          (19)
         .--------------------------      |     ---------------------.
         |                                |(18)                      |
         V                                V                          V   
   ..............                 ................             .............                  
  .   Military   .               .    Health      .           .             .
  .              .               .                .           .  Education  .
  .   Industry   .               .     Care       .           .             .
   ..............                 ................             .............                  

Each of the nine processes are characterised by three quantaties: Possessions, Capital and Energy (Labour and knowledge). The arrows show the changes in these quantaties.

• The government (inclusif the central bank and the judiciary) is the most important organisation which controls the amount of money. If you include the government in the original figure than you will observe that the total number of flows increases from 6 to 12. The incomming flows towards the government are mainly taxes.
• The Insurance Companies (IC) are a further subdivision of the banks. Flow 13 is in fact four flows. There is one labour flow and there are three money flows. One money flow in the form of salary towards the people and two money stream to and from the IC to effect and to pay out an insurance.
  Only one flow is drawn between the banks and the IC, but this should be two. Beside that there are much more flows from and to the IC. For example to and from the industrial processes and the IC.
• For the pension funds (PF) almost the same story exists as for the IC
• Not drawn are the mortgage providers (banks). You can drawn them graphical in the same way as the PF and IC. They are completely different from a functional point of view.
• The military industry (MI) is a subdivision of the industrial processes. Flow #17 indicates labour, salary and security. The relation with for example the government and the banks is not indicated.
• For health care about the same story applies as for the MI. Flow #18 indicates Labour, salaries and health (Energy)
• For education also the same story applies as for the MI. Flow #19 indicates Labour, salaries and knowledge (Energy).
• An important more detailed subdivision with industrial processes are the concepts: Raw material, Trade, Traffic. Additinal subdivisions are concepts like research and development and investments.

If you consider the total picture than this is a very complex network of connections between which all types of transport (trafic) takes place of money, products, services and labour. Beside that also internal transportation takes place.
The issue is to give values to all the quantities and flows (That means the changes of the quantities) involved and to describe the relations between those quantities and flows (how they interfer with each other, mathematically) This is very difficult because the issue is to predict what happens if you start to produce more, what happens if you increase taxes and or what happens if you start to print more money. In fact and that is the tragical part: nobody knows this exact.

Money flows part 1

If you consider the total picture than you can see that the whole a complex network of quantities (products) and flows (changes) is.
To get an idea how this works let us first study the money flows between the industrial processes, the banc, the government and the people. The total number of flows is 12.
What we are studying here are 6 pairs of flows. The flows 1 and 2 are a pair. The flows 3 and 4 are a pair etc.
The simplest situation that can occur is that all the pairs are equal. That means each day the same amount of money goes between the Industrial Processes and the banks, between the banks and the government etc. This is the ideal situation. The system is than in equilibrium, in balance. What is special in this case is that the amount of capital (money) which in each of the 4 processes stays constant.

The reality of course is different. The people want something else, they want more.

Let us consider a certain company that wants to produce the same product at a complete different way. That means you need different raw materials and you have to build a new plant (production process) If you want to do that with the same people (assume they are flexible) the only solution is to completely stop the present production plant. The immediate consequences are:

• That money flow #5 decreases because the product stream to the people decreases.
• That the company needs extra money. Partly for building, partly for new equipment and partly to pay the salaries of the new production plant.

If the company has enough capital there is no problem. If not than the company has to borrow money from the banks (money stream #2 will increase). The result is that money flow #6 (wages) will stay equal.
The final result is capital transport from the banks towards the people. This proces stops when the new production plant is finished and there is production. Moneystream #2 will decrease until its old value and moneystream #5 ( counterpart product stream) will increase.

Money flows part 2

The conclusion of part 1 is the clasical law in economics: Saving = Investing. But is this true ?

• First what are the flows 5 and 6 ?
  • Flow #6 is a money flow (cash flow) from the companies to the people representing the salaries.
  • Flow #5 the money flow (cash flow) from the people to the companies showing the payments for goods bought.
  Normally both flows are equal. During the temporary period that the new plant is build flow #5 will decrease. The people will consume less and own more money.
  This was the situation roughly 50 years ago. Presently a lot less cash payments are done and all money transfer is handled directly by the banks. Every company and every individual has an account by a bank. In between those accounts transactions take place. In fact all those transactions take place intern and in between the banks. This is money flow #20
• In the above example it is assumed that as a result of the decrease in production there is no change in price. The result could be that the whole investment will be payed by the people in the form of bonds
  It is also possible that the whole investment will be paid by the banks in the form of loans.
  It is also possible that the prices will increase because of the decrease in production. The temporary result will be that companies in the same branch will make a profit.
• In the above example it is assumed that when the project is finished both production and price will be the same as before. The result will be that the money flows #5 and #6 again will be in equilibrium..
  This does not have to be true. Both the new product can be better and the demand for the product can increase.
  Now two things can happen:
  • If, at the beginning of the rebuilding project, it is taken into account that with the same people it is possible to produce more than there will be a profit and with that money the loan can be payed off.
  • There will be less demand for the competitors. If labour costs stay the same they will incur a loss.
  This means there will be a transfer of capital within the process: Industrial production.
• It is also possible that the demand for the new products decreases.
  The solution is to borrow again from the banks and or to decrease production and or to fire people. It than becomes a problem for the government who has to pay unemployment payment end partly via incentives should try to stimulate new business.
• It is also possible that the company goes broke. The problem is than with the banks because they loose there money, they are the loosers.
• Normally what the banks do, in order to take care for a possible loss, they calculate a yearly interest to be payed by there customers. This accumalated interest is no profit for the bank but a buffer from which future losses can be paid. The amount of this interest depent about the chance that a company goes broke. This is the risc of the bank. To reduce this risk it is better to make small loans to many companies that one large loan to one company.
• The banks can also resell this loan. However this is dangerous for those who buy this.

The purpose from all this is to show that, as a result of a simple renovation there are a number of possibilities (based on different assumptions) with complete different result. Those results, because the different processes involved depent on each other, can be quite complex.

A mathematical model.

Econometrics is a part of the economy involved with the study of mathematical models
The starting point of a mathematical model are different quantities and mathematical equations. The mathematical equations describe how the quatities change in time.
A very simple equation with the quantity n is:

n(t+1) = n(t) + din - dout

In words this equation looks like:

The quantity n at the moment t+1 is equal to the quantity n at the moment t plus the quantity din (delta in) minus the quantity dout (delta out)

You can also read the quation as follows:

The quantity Euro's (money) with a bank at-the-end-of-a-day is equal to the amount of Euro's at-the-start-of-the-day plus the number of Euro's that the bank has received during-the-day minus the number of Euro's that the bank has spend during-the-day.

The issue ofcourse is what are the values of din and dout. You can also combine din and dout and then the above equation becomes as follows:

n(t+1) = n(t) + dn(t)

And the probleem is what is dn(t), what is delta_n(t).
If n(t) is the amount of money at the banks than delta_n(t) depents about the economical developments in trade and industry, the governement, the military apparatus, health care, the people, the weather etc. Specific is written "the weather" because if there is a lot of snow this can easily influence the produktion processes which can result that the companies have to borrow more.
It will be clear that it is very difficult to define delta_n(t) accurately

In Nature of 12 April 2012 there is an article which discusses this problem. See: Scientists and bankers — a new model army. This article als contains a comment with my name. In my opinion the writer of the article is to optimistic.

The artist

What is the moral value of this story ? What we are discussing here is trade within the process "The people". It is a transport of spending-power but at the end nobody get any richer because nothing new is produced.
Exactly the same happens if we trade shares. With the trade in share we do not become any richer, except the person who original bought the first shares. He is the investor. This is the person who caused an increase in production. All the others did not.
This is a wise lesson for the pensionfunds. More in the next paragraph

Pension Funds

The purpose of a pensionfund is to take care that after you stop working (65 year) you have some income to provide for your own support, that you own a pension. A part of these income you get from the government and an extra part via the companies you have worked for. This is the part you have build up during your working live.
In fact what happens during the time that you work, money is put in a "box". One part of this money comes from your salary and one part is put directly in this box by the company. In fact both part are costs for the company. You can also see this as: What is in the "box" is delayed spending-power

Not only goes money in the "box", but also out the "box". From your "box" goes money after you reached 65, but that is not the way its works.
If you consider a population who is stable (that means every year the same number of people are born and die) than the total input for each year from the working population should be identical as the pay out to the population above 65. If that is the case than the content of the "box" at the end of the year should be empty.
This is not the case. In the first place each year less children are born. The result is that the working population decreases. Besides that the average health of the population increases. The people die later. From a financial point this means that the pension funds should have created a buffer in the past, in order to pay its future obligations.

There are two important questions:

1. What is the purpose of the funds. 2. What do we do with the yearly income of the funds.

• There are two possibilties to answer qusetion 1, about the purpose:
  • The fund guarantees something. For example the fund guarantees that someone who has paid 40 years into the fund, after retirement will get 70% of his last earned salary (on average over the last 5 years, with inflation correction)
    If the fund makes such a guarantee than it is difficult for the management to maintain this promise when the economy slows down. Specific for the people older than 65 and who get money.
  • We guarantee nothing. Everyone gets after retirement proportional what he has paid, including a certain part from the money paid by the people died before retirement.
    To calculate this amount in a honest manner, is not so easy.
• With question 2 the issue is: What does the fund do with the extra income each year.
  In fact there are 3 possibilities:
  1. Nothing 2. Buy bonds 3. Buy shares
  • Do nothing means to maintain everything in cash. This is the simplest and savest method. Specific when ther are no guarantees involved.
    An alternatif is to reinvest it in a capital account.
  • with bonds you are sure you have a fixed income, if you do not sell the bonds during the term length. If the funds manager follows this rule chances are very small things go wrong aan he can fullfill possible garuantees
  • with shares in principle you can earn the most but also lose the most.
    With trade in shares only he who buys them at the day of issue is an invester. All the others are really only speculators. They hope to profit by trading. The company in which they trade in fact has no benefits from this trade.

  The biggest problem

Insurance business

The purpose of an insurance is that the society pays for the possible costs of an event of an induvidual. For such an insurance you pay a premium. The issue is how much in this premium
In order to calculate the premium two issues are at stake:

• How much is the total damage (on average) you have to pay by one year.
• About how many accounts are we speaking.

The first minimum estimate of the premium is than for each account: "total damage"/"total accounts". In reality you have to adapt this formula for the issured amount for each account.

Personal thoughts

• There should be a rule that banks should not be allowed to resell their loans. The same is true for insurances and mortgages. Banks should also trade in shares for themselves.
• Banks should be subdivided in privat banks (retail banks) and business banks. It is better to have more small than one large bank.
• Banks, insurance companies and pensionfunds should be separated. The type of business for each is completely different.
• Pensionfunds should not deal in shares.

It should be clear for the reader that each of these three institutions don't add any real value to the economy. A rich country is a country that produces by and for there own people. Of course countries who are rich in rawmaterials have a benefit. Top universities and research are not a necessity. The fact that most people learn a trade and use it, is the most important.

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