Thursday, February 02, 2006

Part 24 - Hyperwage Theory: The Violation of the Conservation Principle


Table of Contents

Part 2
Part 3
Part 4
Part 5
Part 6
Part 7
Part 8
Part 9
Part 10

Part 12
Part 13
Part 14
Part 15
Part 16
Part 17
Part 18
Part 19
Part 20

Part 22
Part 23
Part 24
Part 25
Part 26
Part 27
Part 28
Part 29
Part 30
Part 32
Part 33

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The Misadventures of the Street Strategist Vol 1 to 13


Chapter 24: The Violation of the Conservation Principle

Hyperwage Theory takes advantage of the concept of the multiplier although this was an unintended intellectual alliance. Furthermore, I never really appreciated Keynesian economics until I studied the role of the multiplier just recently. And I never understood the concept of the multiplier until I appreciated it from the point of view of the work of Karl Friedrich Gauss 300 years ago when he was still in his teens.

Of course, the Keynesian multiplier was invented or first used by Keynes’ student Richard Kahn. But then, I guess this was a good sign the teacher got the credit because Kahnnian multiplier is harder to pronounce than Keynesian multiplier.

Higher rate or more transactions?

But first, let me remind you that we are on the topic of whether the government in particular and the economy in general can afford Hyperwage.

Currently, our government works on the principle that it is better off if it invents newer and more ways to exploit and rob the poor masses with more and more taxation.

This is bad in many ways. First, the people have almost zero take home pay and now they pay for higher tax rates plus new kinds of taxes? Second, the government is such a corrupt institution and its leaders are so corrupt that taxes only fund their extravagant bureaucracy and corrupt personal lifestyles. Third, any tax always dampens the effect of the multiplier.

Faced with a deficit, should the government raise the tax rates and invent new ways to tax the people or should it encourage more commercial activities given the same tax rate?

I prefer the second because the economy is active with more employment, more consumption, more distribution of wealth around, and of course, it assumes that purchasing power should be placed first in the hands of the people.

Should we change the VAT from 10% to 12% or should we have more 12 transactions to obtain the same amount of tax? Should we have 12 transactions at 10% rate or 10 transactions at 12% rate?

Let me remind you that Singapore has only a 3% VAT and they were even reluctant to adopt VAT in the first place. On the hand, Hong Kong has zero VAT, no sales tax etc. The latter earns in some other forms of taxation because they know that VAT is eventually inflationary if the end-user cannot pass it on.

Besides, there is the so-called psychology of taxation. Businessmen raise prices higher than the proposed tax increase to cover themselves. If the new increase is 2%, the companies raise their prices by 15%.

That’s the psychology of taxation.

If the proposed tax is eventually rejected, the companies will never revert back to the original price.

Again, this is a non-economic factor, but a real-world market psychology. That is why economists who have never established their own businesses are out of touch with reality. They think their theory being covered by economic equations are workable in the real world.

Before we move on, what’s the link between Hyperwage affordability by the government, the multiplier, and Gauss? Don’t worry, I’ll link them together soon.

Conservation principles
As I said, I appreciated the multiplier only when I understood it from the point of view of Gauss.

Now, listen very carefully because I realized recently that even PhDs are not immune to the confusion about the multiplier. If a PhD is confused about the multiplier to the point that he thinks I’m the one who is confused, that is dangerous.

When I was in high school, I was fascinated with the new mathematical and scientific concepts that I learned every day.

Now, some of these principles or theorems have universal application that if you understand them, it would be easier for you to understand new scientific concepts

One of them is the law of “conservation of momentum.” Another is the law of “conservation of energy” which lasted for hundreds of years before Einstein modified it to become the law of “conservation of energy and mass.” And another basic principle is the “principle of least action.”

These principles are so basic that whenever there is a new theory that violates them, that latter theory is subject to skepticism. In other words, keep your conservation principles close to your heart and you will hardly be confused with the advanced topics.

Conservation of money
Then comes the danger that comes with little knowledge. When I was in college, I read a book about banking, and I was mystified with the explanation of how banks create money out of money.

The banking system relies on the fractional reserve banking that actually creates more money. If a person deposits $100, and the central bank requires a reserve of 10%, then theoretically, the entire banking community is benefited to the tune of $1,000 or by factor of 10. If the reserve was set at 20%, the total money created is $500 or a factor of 5.

That was mindblowing for a student like me. What happens when there is a withdrawal? Supposedly, the money in the banking system is reduced by a factor of 10 or 5 in our examples above. That is why a bank run is a terrible thing to allow to happen.

Anyway, I saw the formula explaining the creation of money, but I am not proud to say, I saw, but I didn’t conquer. For the life of me, I just couldn’t understand it. I knew the formula but I didn’t understand. It was knowledge without understanding.

Two things prevented me from understanding how banks make money.

First, I was a prisoner of a kind of brainwashing in science called the conservation principles. I was brainwashed into thinking that there is such a thing as the “law of conservation of money” that is, money can never be created nor destroyed, only transferred from one hand to another.

Second, the explanation involved the T-accounts, the dreaded debit and credit, and remember I read that book before I invented the world’s fastest method to learn debit and credit.

Given this combination, I couldn’t understand how banks created money, even after I knew how from reading the book.

In fact, it was only recently that I finally understood the entire scheme, and only after I appreciated the process using the mind of the seven-year old Gauss.

Don’t worry, I’ll link all of these together.

Anyway, what I want to say is that it was my brainwashing on the conservation principles that prevented me from understanding some economic concepts.

Now, going back to Hyperwage, one economist ridiculed the manner I cited the creation of money in the banking system as a manner of explaining the Keynesian multiplier to ordinary people in the street. He is the one confused, not me.

Conservation confusion
I have to confess I was a slave to the conservation principle which was the reason I failed to develop the Hyperwage Theory fast enough.

But I’m not the only one confused. A PhD in criticizing Hyperwage said something like this:
When the employer gives P10,000 to the helper, her purchasing power is increased by P10,000 but the employer will be set back by the same P10,000 thereby lowering his purchasing power by the same amount. Therefore, according to this economist, there is zero net increase in purchasing power in the economy. This is a simple transfer of purchasing power.

The above argument succumbed to the conservation of money fallacy. If you were like me when I was in college, I will forgive you for such ignorance. If you are a PhD in economics and you use this argument against the Hyperwage theory, think twice before doing it.

Why? Because that transfer is not a mere transfer. No sir, it’s not that simple. There is the magic of the multiplier that applies to the money once it is transferred to the poor. We will discuss the full implications in an integrated explanation later on.

Multiplier confusion
Another argument by PhDs, which I find very surprising because it comes from PhDs, is that the money multiplier operates as such because of the fact that banks are under the regime of fractional reserves.

Thus, the critics are implying that since there is no reserve system in the economy in general, the theory of bank multiplier does not work in the same way as they Keynesian multiplier.

Again, if you are a PhD, think twice about making such statements. Why? Because it betrays your misunderstanding of the multiplier.

Gauss to the rescue
Now let me integrate Gauss, taxation, money creation and the multiplier.

Gauss, at 6 or 7 years, invented the formula for the arithmetic progression. Naturally, he developed the formula for the geometric progression. At 17, he proved the fundamental theorem of algebra, a feat I have discussed a few years ago when I related how I invented the Street Strategist’s accounting rules.

In my view, the best way to teach the multiplier is to teach it using the geometric progression. In fact, it was only when I realized that the multiplier can be derived using geometric progressions that I finally grasped the intuitive aspect of the multiplier.

Of course, this method sounds absurd. How can we teach a strange concept such a multiplier using another strange concept called the geometric progression?

I must admit, this method is unorthodox but it will prevent PhDs in economics from committing the two confusions discussed above.

One of the benefits of using the geometric progression concept is that you will not make the mistake of stating the money creation concept of the banking system is not the same as the Keynesian multiplier.

Why? Because you will realize that these two are mathematically the same. Yes, they have the same mathematical basis and concept; only the environment differs.

Also, you will realize that transferring the money from the employer to the maid is not a simple process of transfer. This exactly has the same mathematical basis as depositing money with the bank.

In short, mathematically, the process of depositing money with the bank and the process of increasing wages of the helpers are mathematically the same. If there is money creation in the banking system, there is also money creation in the economy.

Thus, two concepts which confuse PhDs in economics, are resolved by using the mathematical formula developed by a 6-year old 300 years ago.

Isn’t this neat?

Geometric progression
A geometric progression is a series where each term is a multiple of the previous term. For example: 1 + 3 + 9 +27 +…. the constant (or common ratio) is 3.

Now what happens if the we add all the terms from 1 to infinity of a geometric series (and the common ratio, r, is less than 1)?

The sum looks likes this:

The above formula is valid only if the absolute value of r is less than 1.

Now, the sum of an infinite geometric series is actually dependent only on one variable, r, which is actually the ratio of the successive terms.

You are screaming by this time. That’s more difficult than any other method of explaining the multiplier.

Well , yes and no.

In the first place, geometric progressions are discussed in college algebra, everybody is supposed to know this.

Second, this concept is so important because many economic and financial concepts can be understood or appreciated as geometric progressions.

Common concept
How do you value the stock of Microsoft Corporation? Probably you have heard of the Gordon growth model, well that formula is derived from a geometric progression (the assumption of a 10% annual growth is a geometric progression.) Have you read of the dividend discount model? Have you heard of present value analysis? Have you heard of discounted cash flow?

All of these are geometric progressions in one way or another. Thus, if you understand what a geometric progression is, then you understand its formula, then you understand the financial or economic concepts involved.

Geometric progressions are more common than you think.

Multiplier, money and consumption
When banks accept deposits and lend them onward, there’s a geometric progression with r=0.85 if the reserve requirement is 15%.

When people spend money 80% of their money, then the marginal propensity to consume is 0.80, and the mulplier is 5 given that r=0.80.

All I’m saying for the moment is this: whenever there is a geometric progression, we can adopt the mulplier formula. Adopting the multiplier formula forces us to abandon the conservation principles.

Given this insight into the multiplier aspect of economic activities and their theoretical maxima we have an idea of the effect of our actions. I will explain more about how the geometric progression works but suffice it to say, it is a lot easier for us to understand the multiplier if we identify the presence of a geometric progression.

As a strategy policy guide, look for actions or policies that tend to generate a geometric progression and you will obtain the multiplier effect. Since a multiplier is a leverage, we achieve more with less.

For example, for a multiplier of 5 (mpc = 0.8), every $1,000 dollar spent by a consumer redounds to the economy as income (not expense) of $5,000. That’s the magic. Do you think the currency of a country which has a higher income will weaken? This alone is an argument against the unwarranted fears that our currency will weaken under Hyperwage.

Before I go, I would like to point out that even Kahn or Keynes did not realize immediately the geometric progression aspect of the Keynesian multiplier because their derivation was different.

The student will learn deeper and wider if he is taught to identity a progression, then apply the formula, then derive the multiplier. In this manner, he will not be as confused as the PhDs who have weak grasps of the mathematical foundations of the multiplier.

(Thads Bentulan, Oct. 20, 2005)
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