The Stocks & Flows of the Homo Economicus

Economists and sociologists debate whether the homo economicus exists and make rational decisions based on profit maximization and utility considerations or not. Critics of the neoclassical economic theory argue that a lot of people seem to behave differently, that markets are not always efficient, that power can play a big role, information is not available and that people have group-behavior. (e.g. debate in FD on 12 and 24 april 2014). Nico Lemmens argues that group-behavior and consensus seeking, love and emotion can still be rational from an ecological perspective. Sure.

What (neo-)classical economists and their opponents overlook is the fact that there are stocks and flows involved here. The debate described above is a debate with a linear world view. A happens thus B happens thus C happens and all in the same proportion. Even when emotions are to be included it is still linear: more love is more marriage.  This is not realistic and therefore it does not fit the empirical observations.

In Stock and Flow terms (hence “Flostock”) not only a quantity of matter is a stock, but also opinions and feelings are stocks. Any movement is a flow and linear behavior like selling or travelling is a flow.  But there is also other behavior and that is much less straightforward and non-linear. That is behavior in relation to the speed of response to a pulse. A person or a group of persons can adapt their opinion on a subject fast or slow. This behavior is rational, and rather stable over time, and for large groups it is therefore predictable, but it is non-linear.

Example: suppose a group of the population has a strong preference for supplier A (say Apple) and a second group has a strong preference for supplier B (say Huawei). Both preferences are stocks, with advertisements, coffee-machine conversations, user friendliness, price comparisons and other experiences as inflow. After a couple of years, the preference has become quite strong, a big stock. You could call this stock customer loyalty. This stock has a memory, of course, in fact it is a memory, and it generates a rather constant flow of buying products of supplier A respectively B. Now one of the two suppliers introduces a new toy, or one of the suppliers is found to be secretly spying on its consumers. This new experience and knowledge is an inflow into the preference stock and slowly changes its value. The speed at which it changes is a behavioral parameter and could be referred to as customer inertness. So customer inertness is the speed at which customer loyalty adapts to an inflow. Obviously if the stock is large and the inflow is small, the change in preference will be small. So a strong brand can survive a small PR mistake.  When the preference stock changes in value, the group will change its buying flow.  

By the way, there is a second non-linear determinant of the buying flow and that is the amount of products already owned by the group. This is also a stock and let’s call that the pool of toys. The pool of toys will make the buying behavior flow non-linear e.g. when saturation is almost reached. The speed at which the group wants to reach saturation is also a behavioral parameter that we could call customer eagerness. Customer eagerness is the speed at which customers want to follow a trend. High eagerness will create hypes, panic run-aways, bank runs and overshoots. Medium eagerness creates fashion waves. Low but positive eagerness creates stable growth.

No Capital Investments?

The Economist wrote an article “More bricks, fewer bubbles” early December that said that no one is quite sure why monetary loosening (QE) has so little effect on investment.  The answer is simple: capital investment is partially for replacement and partially for growth. As long as industrial production is lower than the 2008 peak in industrial capacity, there is no need for investment in growth.

 

The considerations behind this are described in the Flostock Laws of Demand, which can be found on http://www.flostock.nl/publicity/flostocklawsofdemand.html 

 

Stocks have a memory

Strange idea that a collection of goodies can have a memory. When you see pebbles on a beach, they don't look as if they have a memory. Yet I don't mean this in some sort of strange philosophical way: I believe stocks really have a memory, in the sense that a future change is already embedded in the stock before the future arrives. This can be the direction of the change, or the intensity, or the force.
Maybe this becomes more easy to understand if you include some thermo: When I did not know the answers to a thermodynamica question as a student, I just filled in: "because then the system moves tot the lowest energy level", and that is still the best answer to many questions about why things are happening.
The same is true for stocks with a memory: the stocks know there is a lower energy level and they would like to go there. A bucket full of marbles on a hill top that has just been toppled has a memory: the markbles "remember" that they will start rolling downhill. A bank account remembers it can deplete, so a credit card is burning in your pocket. When you start a holiday game with a full bank account, you know it is going to go down. A country full of youngsters knows it can expect revolution. A city full of hooligans knows it will see riots and drunkeness.
More practically, if you are the manager of a warehouse with a certain inventory and your boss wants you to increase the inventory towards a desired level, ordering new products and going to the desired inventory is like going to a lower energy level. In this sense the inventory had a memory of where it would want to be. If you have ordered a new gadget and it is being flown to your doorstep by a drone, the pipeline of goods in transit (also a stock) has a memory of where it is going.
An ocean full of warm water has a memory in the sense that the huricanes are already in the process of becoming. A class full of children has a memory of creating chaos. A chimney that has not been cleaned for a long time will ignite when the conditions are right. A car moving at a certain fixed speed has a memory in the sense that it will continue to do so untill it is stopped. So inertia is a form of memory. Kinetic energy is a memory property of a stock (e.g. the car).  Potential energy is a memory. And a banking account has potential energy. A warehouse has the potential to order replenishments. An empty stomage has the potential to be filled by eating.

Stocks have much more memory than flows. Flows stop flowing immediately when stopped. When eatign stops the flow stops. But the stomage can still be half-empty, so it remembers that more eating should be done.

So stocks have a memory.

Bubbles are not bubbles

Economic bubbles are always compared with soap bubbles, but that introduces a misunderstanding, because economic bubbles are always flows, never stocks, while soap bubbles are objects, so more like stocks.  Soap bubbles "accumulate".

People probably use the analogy because they have no better way of picturing a flow. In general it is difficult to draw a flow, any flow. When you want to draw a river, normally you draw the banks, and the meandering. The trees next to it. When you want to draw the wind, you show clouds or leaves, floating in the wind. Or you show a giant cloud with a face that is blowing stripes of wind from his mouth.   In the same way it is difficult to picture a stream of goods or a flow of money. Movement is difficult to catch and difficult to picture. An inflated flow is also difficult to picture. The picture is static, the flow is dynamic.  The tulip mania and the south sea bubbles were not called bubbles in their time, because people did not look at them in a graph!

Is a price bubble a stock or a flow? Price has a flow character, I believe, much more than a stock character. It depends on transactions, on demand & supply, typical flows. What about a sentiment bubble like confidence (e.g. in bitcoins)? Yeah, that is a stock and indeed a bubble, filled with thin air. When punctured it will deflate fast.  But this is just the confidence behind the real bubble, which is price and transactions, so the real bubble that we talk about is a flow. Confidence itself is normally not depicted as a bubble.

Another point where this analogy goes wrong is when an economic bubble bursts. In reality it means that a flow reduces fast in size. The feeling we get from the soap bubble analogy is that some protective shield (like the membrane of the soap bubble) is punctured with as result that some pressure escapes and pieces of membrane spat on the floor. In economic bubbles there is no membrane, and there is no escaping pressure.

"So what?", you might say.

This is relevant because the analogy sets us on the wrong foot: when we study an economic bubble, we have to see it as a flow, not as a stock. A stock responds to a pulse completely different from a flow. Most stocks are integrals of flows, that means they accumulate a flow or they bleed into a flow. Stocks are therefore much more inert and more stable over time than flows. This gives a false sense of stability to economic bubbles.
An economic flow is always going from one stock to another stock, based on decisions by people (or based on algorithms in computers programmed by people). If people decide to do nothing, the flows stop immediately, but the stocks remain stable.  When we would see economic flows as flows, people would easier understand that an economic bubble is always finite because the stock where the flow comes from is finite.

So bubble is the wrong word.

Is there an alternative? How should we call an inflated, a swollen stream?  A comparison with an overflowing river that rises above its dikes is maybe appropriate. Maybe a dike in which a small breach is broadened by the overflowing river and a small stream grows into a giant flow.

I don't know. Any of the readers maybe?
. 

How do you like your Gini?

The End of History
Since the fall of communism, now more than 20 years ago, history as a struggle has ended according to Francis Fukuyama in his ground breaking book The End of History and the Last Man. There are no serious people any more who claim that communism is a realistic alternative for free market, democratic capitalism. Since then a lot of commentators said that state capitalism, as practiced e.g. in Singapore and China, could be an alternative for democratic capitalism. This piece of History has not ended yet, so it is too early to tell which system will survive. But I don't believe in state capitalism.

Quatro Politica
There are too many wrong investments in state capitalism and not enough checks and balances. The Trias Politica should be expanded to a "Quatro Politica", and the fourth power, Business, should also be handled as a separate force. The other three forces are needed as a counter balance to the overwhelming forces of global Businesses. Think e,.g, of the military Industrial complex for which Eisenhower warned us, the lobying forces in "Supercapitalism" by Robert Reich, or -closer to home- the obscure funding behind some political parties in Holland.

All parties in the middle
Since the "end of history" in Europe, the fundamental differences between the old political parties are eroding. The importance of religion as a factor in politics had already been going down much longer. Now, communist parties are gone and traditional socialist parties have moved to the middel ground of the political spectrum.  As a result the old and comfortable left-right or communist - capitalist split is gone. All political parties have difficulty positioning themselves to keep their voters loyal.

How do you like your Gini?
The Gini curve (Italy,1912) can be used for measuring the spread of income in a population. The population is sorted on income, than accumulated into a graph, with vertical cumulative income and horizontal cumulative people. This is the Gini curve and it always runs from the left bottom corner to the right top corner. Depending on the spread of income the Gini curve is more round or more flat. When everyone has the same income, the theoretical communist ideal, the curve is a straight line. Needless to say that it was not achieved in communism: this was one of the reasons the system failed. When 90% of income is earned by 10% of the population, the curve goes almost vertical in the beginning, then makes a turn in the top left corner and goes almost horizontal to the top right corner. This was the shape in the dark ages, when absolute rulers were exploiting there population.
Economic discussion in parliaments everywhere is now dealing with the shape of this Gini curve. Representatives of lower income basically want a flatter curve, while free market adepts want a round Gini. Both try to argue that their view is best for society and for the economic growth as a whole. Venezuela and Cuba are trying hard to prove that a flat curve is wrong. A too round Gini has strong undesirable effects, such as extreme poverty and state debt. Ironically, recent American capitalism as well as the Russian oligarchy confirm this. The Gini-discussion is mixed with a debate about justice and equality, because there is probably not just one answer, but a reasonably large "sweet spot" for the ideal shape. Within that sweet spot the ethical discussion can be held.

What to vote?
What now? The result is that voters no longer know what to vote, because the Gini discussion is boring and technical and has a lot of unknowns and make-believes. Voters do not vote for the nuance of the sweet spot: they start to float and do not give the final call on what to do. The alternative is let history sort it out, but it takes years before the effects of a change in Gini become visible. History as a judge is ruthless, but slow. History convicted fascisme after 20 years, and needed more than 100 years to disprove communism. Now History is already taking 30 years to evaluate state capitalism.

Unwanted by effects
The result is that new parties come up around mono themes like age, animal rights, environment, euro- or xenofobia. Voters (who do not understand the Gini discussion and who no longer vote what the priest says) are shopping around for a nice face or a narrow interest or an underbelly feeling. Parliaments are no longer peopled by the best and the brightest, tried and tested in a long upward career of service to the country, but by opportunistic followers of populists who temporarily catch the limelight. This is not a good development, because it is making our democracy volatile. Maybe it is an unavoidable stage of development towards a true End of History.

Capital goods are the first derivative of consumer goods

When analyzing product demand, a distinction should be made between consumption goods,  like toys and clothes and capital goods, like machines and trucks.  Capital goods can be defined as goods that are used to manufacture consumption goods.  Demand for capital goods can again be split in demand for growth and demand for replacement. Demand for replacement of Capital Goods is not the issue here: we focus on Demand for Growth. Demand for growth means the production capacity needs expansion.  If the production capacity grows at a constant rate, growth-demand for capital goods is stable. If production capacity is constant, growth-demand of capital goods is zero. If there is overcapacity, growth-demand of capital goods is negative, and because you cannot return machinery, it is zero. This relation is equivalent to the mathematical expression that growth-demand for capital goods is “the first derivative”  of demand for consumption goods. This 4th Law of Flostock may seem trivial or overly mathematical, but it has important implications.

Growth demand for capital goods goes through a peak when the demand for consumer goods merely goes through its inflection point (i.e. the point where the curve goes from stronger and stronger growth to weaker and weaker growth). Since the inflection point is much earlier in the economic cycle than the peak of consumer goods, capital goods peak much earlier. So all companies that produce capital goods go through an earlier cycle than all companies that produce consumer goods.

Labor in this comparison is also a Capital Good and there is supply of labor (hiring) for Growth and supply of labor (hiring) for Replacement. When consumer goods go through their deflection point, supply of labor for growth goes through its peak and starts going down. Supply of labor for replacement continues to take place untill the consumer goods go through their peak, then becomes negative and people are fired. Temporary labor suppliers like Randstad always remind us that they are early-cyclic, therefore they are a leading indicator. This is true, but they are only a good indicator because it is easier to see a peak than to see an inflection point. For the rest temp labor is just the first derivative of the main cycle. 

China is another implication of the 4th law : China has grown strongly over the last 25 years, but mainly in capital goods for the own industry and export of consumer goods. When the export growth slows down (so it is still growing, only slower), Chinese production of capital goods will decline.  If China does not manage to get its population to increase their consumption fast, and it is unlikely that they will, the Chinese industry will decline. This has already started. If the export of consumer goods will reach its peak, so when export markets become saturated, growth demand for capital products will be zero (or negative). In addition, the Chinese industry is young, so there is not yet much demand for replacement. This means that both types of capital goods production will stop.

On the other hand (because I don't want to stop with the word 'stop'), if demand for consumer products starts growing again, as it may be doing in the USA, Japan and Europe, growth demand for capital goods will once again see a strong growth indeed.

The Hoarding Cycle

In an economy that grows year-on-year, for centuries, the total amount of possessions will grow too. There is however a physical limit to what our houses can contain,  so either we stop buying and start saving, or we throw away faster, or we miniaturize our possessions. The miniaturization then is especially the investment  per cubic meter, so we can hoard more cumulative income in the limited space of a house. An iPod takes up less space than a CD-collection, which is again smaller than the same amount of music in vinyl. An Xbox is smaller than a baseball, an e-reader is smaller than a book case, a flat screen takes up less space than a classical TV-set and 100 euros worth of jewelry in gold is smaller than 100 euros worth in silver. But at some point the house is full and we have to throw things away if we want to buy new stuff. Despite the miniaturization and throwing away, the result over the centuries is that the amount of possessions increases. Let’s call this the Hoarding Trend.  

There is a big destabilizing effect of this amassment of goods: people have so many possessions that buying many types of new goods is for a large part discretionary. When a crisis hits, people may  decide to postpone buying new things.  The notorious Men’s Underwear Index describes this phenomenon, but it also applies to many other material goods. Some collections of material goods (“fleets” in Flostock terminology) will age fast and  at some time will need replenishment, whether the crisis is over or not, either because of wear or because of fashion (which could also be seen as a kind of wear).  This applies to cars, underwear, clothing in general and maybe it applies to music as well. But it does not apply so much to furniture, home decorations, books, kitchen utensils, sporting equipment or gardening. For those categories of fleets of material goods fashion is not changing so fast and a little aging is not directly visible (at least not for a middle-aged guy like me J). So in these categories people can postpone the rejuvenation of their hoard, their fleet of possessions over a longer period.

So what is the point? Point is these material possessions are a stock that in a crisis may undergo aging without changing in size, but with a big change in flow. Example:  Suppose the maximum life of a couch was 10 years before the crisis, so the fleet of couches had an average age of 5 years. In the crisis people decide to wait longer with buying a new sofa and thus to let it age to e.g. an average of 6 years. In that case the furniture retailers see a 17% drop in sales.  Underwear sales dropped in the crisis, but you cannot postpone buying new shorts longer than a couple of years, so sales must have recovered by now. So a crisis drives delays in buying for stocks of possessions, which delays worsen the crisis. For goods with a potential long life the effects are biggest.

After the crisis, when consumer confidence returns, people want to go back to the average age of their hoard and buy a bit more for a while, creating an upturn in the economy and creating a new, young fleet of stuff, ready to be aged again in the next crisis. This we can call the Hoarding Cycle. The Hoarding Cycle waves around the Hoarding Trend. Question is whether the Hoarding Cycle is driven by the long term economic cycle or the other way around. And since the discretionary part of the possessions is getting bigger over time as the Hoarding Trend curve goes up, the amplitude of the Hoarding Cycle might be growing as well, predicting bigger crises in the future.