MAIN POSTULATES

Please read this page before reading the page entitled PRINCIPLES AND THEMES OF MACRO-ECONOMIC DESIGN

The purpose of these pages is to lay down the science behind Macro-Economic Design as seen and as created by the Macro-economic Design Team.

This page covees the main postulates made for PART 1 of the Volume 1.

It may become a part of the book.

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This part of the forthcoming book is written for professional readers, and not for the general public.

It attempts to create a soundly based science out of what has been found in the researches.


Briefly, the whole of the explorations made to date by the Macroeconomic Design Team has revolved around how the economic architecture may be distorting prices. 

If prices are distorted by the way we behave, the structures and the laws and regulations that we impose upon our finances and the economy, then there cannot be a proper balance between supply and demand. 

The traditional response to this problem for the past century has been to gather huge quantities of data at enormous expense and then to do the best we can to manage the instabilities by selecting the interventions we think may be needed to cope them.

In these studies that approach is cancelled as being unnecessary. As long as those price distortions can be eliminated there may not be a distortion, or an imbalance, to be fixed.

The one remaining intervention is money creation – how it should be done, how fast, when, and how much data should be known before the intervention is made.

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I thought that writing the science was going to be easy – just listing everything that has been a guiding principle that were used during our researches. But to make it into a convincing science, it seemed that an exact definition was needed as a useful proxy for aggregate demand in the economy. And there needs to be a better definition of wealth than what we have now if we are to explain how wealth can be protected from distortions in the economy. We need economic structures / architecture that does not distort or transfer wealth from some people to others dues to, for example, inflation.

It was found that there is a significant link between the now preferred definition of wealth preservation in savings accounts and the now preferred definition of inflation of demand.

It seems that everything revolves around incomes. If nuclear scientists are looking for a unified theory of everything, this is like finding a unified theory of economics and finance.

Let us look first at the preservation of wealth.

Suppose that a century ago a very wealthy man left a fund for his grandchildren comprising half a typical person's lifetime income. Say 20 National Average Earnings / Incomes - or 20 NAE for short.

The fund increased in money value at the same rate as prices – which is the rate of inflation as we normally refer to it.

Unfortunately for the fund, National Average Earnings rose 3% p.a. faster than prices and the value of the fund got left behind. It got left behind so far that by the time the grandchildren inherited the money that it was valued at 1 NAE - a single year's National Average Earnings / Income.

So when we are talking of wealth preservation, as a result of these researches, we prefer to talk about preserving NAE.

In order to do that naturally, there should be a relationship between the rate of growth of NAE and the rate of interest. The rate of interest may be higher or lower than that rate, called the rate of Average Earnings Growth (AEG% p.a.), but if the rate of AEG% p.a. increases by 1% then we should look for market forces which will raise interest rates from what they were to a rate that is 1% p.a. higher. Normally we just say 1% higher.

At the same time, interest rates are a price - the price paid for borrowing money. If the demand for borrowing is high then the interest rate will be marginally higher than AEG% p.a. in order to balance the supply of money with the demand for it. This additional / marginal rate will transfer some wealth from the borrower to the lender.

And that happens - the data looked at showed that on average, for housing finance, the interest rate may be around 3% more than AEG% p.a. on average over the longer term.

It was hypothesised that this rate was a neutral rate. Above this rate borrowing and spending would slow and below this rate borrowing and spending would increase.

That 3% marginal rate may or may not be the rate that slows or increases borrowing in the housing finance sector, but as far as the economy as a whole is concerned, aggregate demand from borrowing and all other sources might be responsible for this average rate of marginal interest above AEG in the housing sector. Each sector has its own risk and demand related rate.

Above that rate the whole economy would start to slow. Below that rate the whole economy would begin to rise in its level of activity until there is full employments or full capacity utilisation.

Based upon this hypothesis it was decided to see how high the Federal Reserve Bank of America would raise interest rates in the run up to the financial crisis in their stated quest to curb inflation, as it was in the process of taking off.

The estimated figure for AEG% p.a. at that time was 4% p.a. rising to 4.5% p.a. and going higher. 

This meant that interest rates of 3.5% for housing finance would need to rise to 7.5% or to be sure to curbing inflation as incomes were still rising, say 8% p.a.

Would the Fed raise rates by 4% to 4.5% to achieve that? They tried. They got to 4.25% "with a little further to go" according to their then Governor, Ben Bernanke.

The implication for the housing sector with that debt repayment structure in force was a raise in the cost of repayments of over 50%. The whole economic structure fell apart. It was not necessary to have sub-prime loans. That just made matters worse.

So it appears that the level of NAE and of AEG% p.a. are key parts of the economy.

It is therefore hypothesised that all prices and that includes interest rates, should be able to respond nicely to changes to NAE in the case of prices and, in the case of interest rates, to changes in AEG% p.a.

If this is correct, then it appears to be the case that incomes inflation is what devalues money. 

If all prices, costs and interest rates an values adjust to changes in these indices, then what a sum of money can be exchanged for, (goods and services) will remain the same only if the amount of money increases at the same rate as NAE which is at the rate of AEG% p.a. This then, is the rate of devaluation of money.

This gives rise to a further hypothesis:
The rate of NAE inflation is the rate of inflation of demand which is the rate at which prices, costs, and values increase, which is the rate at which money falls in value.

Of course that can go into reverse, and then we have deflation and a rising value of money.

And of course, there are many things that can get in the way of this relationship in the short and medium term.

It is important to note that AEG% p.a. is not the same as a rate of change of GDP although GDP is supposed to be the aggregate of all incomes in an economy. But GDP also varies with population and probably other factors too. Some economists complain that it can be manipulated.

THE BENEFITS
If we can prevent the adjustment process from being distorted by the economic architecture that we use, then we can have:

Savings that can be protected from inflation or deflation, borrowing that is safe from inflation or in deflation, defined pension benefits for defined contributions, the cheapest possible way to borrow money because wealth gets protected if interest rates move with AEG% p.a. We can have an optimum level of employment and of economic growth...the list goes on and on.

INGRAM’S PARADIGM SHIFT
This is what Zoe Lindesay, a senior auditor on the capital side of Legal and General, the largest manager of capital in the UK, calls Ingram’s Paradigm Shift.

With some exceptions, when statistics are issued, adjustments will in future be made not to prices inflation but to incomes inflation – to AEG% p.a.

In future, government debt may be index-linked to NAE in order to protect wealth. This will be the cheapest way to borrow because the risk premium that has to be paid on the debt will be as low as it can go. And there is a kind (slightly unstable) match between a government’s net taxable income and the cost of borrowing in that way. The key point is that it is the cheapest way to borrow with the greatest market for debt that there could possibly be.

Governments will have to pay a coupon (interest) of course and they may currently sell this debt at a premium because interest rates are currently very much distorted. This, and the various ways to structure that debt to address market needs is discussed in the book.

Zoe Lindesay proposed that this overall rate of return should be used as a benchmark for the risk-free rate of return on any investment.

It is well known that all investment values are influenced by rising incomes and that pension funds invest heavily in assets like property and equities for this reason.

With the existence of Wealth Bonds which can be offered by governments, commerce, and lenders for housing, any business, insurance company or financial institution can use these bonds as a risk free or risk minimal asset for the preservation of their asset base in line with any inflation of their risk exposure, all else being equal – if the business is not expanding or contracting, for example.

For auditors like Zoe, this gives them a way to assess the risk exposure to the capital assets of a company. Hitherto, the risk free rate and the value of assets invested in government bonds has made a nonsense of such annual reports. There is no way to come up with a definite figure.

For lenders and borrowers, the concepts written above open doors to much less risky lending and borrowing systems. All of these kinds of things are those which are discussed in this book.

ONE CAVEAT
There is one important caveat which every economist picks up right away.

How should we define NAE and AEG% p.a.?

The fact is that the top 1% of all populations own a disproportionate amount of wealth and in many nations they have a proportion of the world’s income which seems to be steadily rising. Their share of national income is rising and so their income is growing faster than the national average.

It is even possible that this may continue until the time comes when no one has any significant employment except in entertainment and other forms of human interaction like the sax trade and Massage. Robots are coming. They may be able to do everything else for us including the production or harnessing of green / renewable energy. The means of production of those robots may be owned by what remains of the top 1%. We can expect some awkward political issues coming our way. And if they get resolved in good time, we may all look forward to that day.

Maybe robots will build or redesign and rebuild properties so fast and at no real cost that we will not need loans or incomes.

In the meantime, should we rather use the median level of income when it comes to designing ways to borrow money?

Does AEG and NAE really drive aggregate demand and thus prices in our economies?
These are interesting questions that need to be resolved in order to complete the science on that front.

Lenders, for example, may decide to have their own index of borrowers’ average incomes but they will still have to raise money at rates that compete with the rate of return on assets generally. Those assets may be responding to NAE and AEG. That will raise the marginal rate of interest compared to what borrowers’ incomes are doing. 3% above AE% p.a. may be higher than 3% above the median rate of earnings growth.

The mathematics of lending says that this is not a big problem as it can easily be taken into account. Much safer ways of lending can still be devised with just a small modification.

DOES IT MATTER
Does it matter if we cannot agree upon the best definitions of wealth, or NAE, or whether incomes really drive demand; or whether aggregate income actually drives aggregate demand for a given population?

Consider where we are now.

At present we have no way to protect wealth. There is no such guaranteed investment nor anything close to that.

Consider the way that mortgage repayment levels are currently determined making no allowance whatever for the possibility that incomes may start falling or that interest rates may have to jump up so high that we have an economic disaster.

Consider the struggles that central banks are now facing as they know that they must raise interest rates but most attempts made recently in the developed economies have been quickly reversed because the structure of bonds and hosuing finance for example, must be getting in the way.

It must be better to try something than to do nothing.

It must be better to make some adjustments for the inflation of incomes and the falling value of money than to do nothing.

When an engineer sees that a vehicle has square wheels it is better to replace them with oval wheels even if they are not quite round.

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