Over the last couple of years, I’ve been showing how all economic activity consists of extremely simple economic actions, each of which affects what one person owns, is owed or owes — and which usually has an equal and opposite effect on one other person. We can represent each action with a colourful arrow from the person whose raw net worth1 decreases to the person whose RNW increases.
Most discussion of economics treats the transaction as the building block of economic activity. A typical transaction is Alice and a bookshop swapping £10 for a book. (More generally, a transaction is a set of actions where all the people involved agree that as soon as the first action occurs, all the others occur at exactly the same time).
One beautifully-illustrated example of transaction-based economic analysis is Ray Dalio’s video, How The Economic Machine Works. But there are some big advantages to splitting the economic activity even further into the individual economic actions:
Some crucial economic activity isn’t part of a transaction:
Production and consumption
Gifts and theft
Taxation and public services
Perhaps more importantly, there’s no obvious way to group together transactions so that each group is self-contained2. But if you’ve seen the series on macroeconomics, you may remember that this can be done with actions. We can group all of the actions which involve the same tangible asset or the same debt.
In this article, we’ll use this tangible asset / debt grouping of actions to see what insights we can get from last week’s example of Alice, a farmer, borrowing to buy seeds to sow.
A new perspective on an old scenario
If you haven’t yet seen last week’s article, now would be a good time to at least look at the diagrams. Alice only has enough seeds to sow half of her farmland, so she borrows £1,000 from Eve’s bank for buying seeds to sow the rest. There are 9 transactions split into 3 groups:
Borrowing phase
Repaying principal phase
Paying interest phase
This week, we’ll see exactly the same arrows3, but grouped by the tangible asset or debt involved. This will make it clear that most of the actions are undone by other actions, and their purpose was really to facilitate what amounts to barter.
Each tangible asset or debt gets its own diagram:
The original £1,000 deposit created by the bank (originally owed to Alice).
The £1,000 loan created by Alice (owed to the bank).
The £25 interest debt created by Alice (owed to the bank).
The £25 deposit created by the bank (originally owed to Eve, paid as a dividend).
The 200 bushels of wheat originally owned by Alice.
The 200 bushels of wheat which Alice bought from Bob.
The 20,000 bushels of wheat which Alice harvests.
For each of the 7 diagrams, you should work out how each person’s assets and liabilities (and RNW) change, both at each step, and cumulatively over the entire diagram. If you need help, check this table (and if that doesn’t help, leave a comment!). Don’t skip this step — it’s crucial for understanding exactly how the economy works. The first one is done for you. “[A]” shows changes to assets, “[L]” shows changes to liabilities, and “[RNW]” shows changes to raw net worth.
Original deposit
Action 1
Bank: [L] + £1,000, [RNW] - £1,000.
Alice: [A] + £1,000, [RNW] + £1,000.
Action 2
Alice: [A] - £1,000, [RNW] - £1,000.
Bob: [A] + £1,000, [RNW] + £1,000.
Action 5
Bob: [A] - £1,000, [RNW] - £1,000.
Alice: [A] + £1,000, [RNW] + £1,000.
Action 6
Alice: [A] - £1,000, [RNW] - £1,000.
Bank: [L] - £1,000, [RNW] + £1,000.
Total
Bank:
[L] + £1,000 - £1,000 = 0
[RNW] - £1,000 + £1,000 = 0
Alice:
[A] + £1,000 - £1,000 + £1,000 - £1,000 = 0
[RNW] + £1,000 - £1,000 + £1,000 - £1,000 = 0
Bob:
[A] + £1,000 - £1,000 = 0
[RNW] + £1,000 - £1,000 = 0
Notice that the combined effect of these actions is that nobody’s balance sheet changes at all. The deposit is created, is transferred a couple of times, and is finally written off.
Loan
This is an easy one.
Interest
Notice that this is just like the loan.
Dividend deposit
This one isn’t just there and back again, but notice the total.
Alice’s original wheat
This one involves consumption of a tangible asset (by sowing).
Alice’s bought wheat
This is a transfer and then consumption of a tangible asset.
Alice’s harvested wheat
This involves production (harvest) and transfers of a tangible asset.
Conclusions
The effect of the actions involving a debt over its lifetime is to leave everyone’s assets, liabilities and RNW exactly as they started.
So this scenario is reduced to one in which wheat is transferred, consumed (in sowing), produced (in harvesting) in greater quantity, and transferred again, leaving everyone unambiguously better off than they were at the start.
Think of debts as temporary things — promises which have been made but not yet kept. Once a new debt is written off, all that remains is the effects of the other economic actions in the economy. Ultimately only the real economy of goods and services is what counts. Debts, when generally honoured, exist to make the real economy (much) more efficient.
Someone’s raw net worth (RNW) is what they own plus what they’re owed minus what they owe (i.e. their assets minus their liabilities). It is a “heterogeneous” sum/difference, which just means that things of different types are added and subtracted, not monetary “values” which have been assigned to them.
Economists usually group transactions by the time period in which they occur — typically a year. But one year’s transactions can affect a later year’s e.g. when debts increase one year and are due to be repaid later. Making decisions as though these groups are independent of each other leads to subtle errors which I believe can destroy civilisations.
The only difference is that sowing the wheat, which in last week’s diagram was shown as a single consumption arrow for 400 bushels of wheat, is shown here as two separate consumption arrows for 200 bushels of wheat each. This consumption could have been shown as 2 separate consumption arrows last week, but I think that would have looked a bit strange.