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MECHANICS  OF  HISTORY  -  laws to understand the histtor

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Classifications and rules presented here are only subtle modifications of modern theory of economics, so is good to study at least the basic theory of microeconomics, macroeconomics and international trade to better understand the Mechanics of History.

Few links to online resources about economics:
Quite good introduction to Microeconomics and Macroeconomics from Wikipedia.
Lectures on Economics and Game Theory by Roger A. McCain.
International Trade Theory
History of Economic Thought
Library of Economics

There are two kinds of economic crises: overproduction crisis, and stagflation crisis

Basically there are two kinds of economic crises:

The stagflation crisis (or underproduction crisis) is the final effect of government-stimulated growth (or the war, which is no more that a special kind of government investment).
Just before the crisis (in the hidden phase) we can observe: shortage of goods, government regulation of the market (like rationing coupons or fixed prices), and the black market. These are signals of the increasing market unbalance.
When the crisis starts (in the evident phase) we can observe: unemployment, decline of the production, and inflation (or even hyperinflation), because publicity no longer believe in money offered by the government.

The overproduction crisis (or deflation crisis) is the final effect of growth stimulated by private financial institutions (like banks or investment funds).
Just before the crisis (in the hidden phase) we can observe: rocketing increase of prices on the stock market, and a periodical increase of inflation. These are signals of the increasing market unbalance.
When the crisis starts (in the evident phase) we can observe: sharp fall of the stock prices, unemployment, decline of the production, problems with selling goods (overproduction), and thus deflation.

Of course in the real world things are more complicated, and sometimes crisis is some combination of two basic kinds of crises mentioned above.
For example: when a country with government-stimulated economy borrows money from an external and free financial market (i.e. from abroad financial institutions abroad), the crisis usually begins with a drastic fall of the national currency (Mexican crisis of 1994 is a good example here). The reasons for the crisis are the same like in stagflation crisis but the course of the crisis resembles rather an overproduction crisis - because of free financial markets involved.

There are two basic economic strategies for countries: free trade, and protectionism

As there are two kinds of economic crisis, the same way there are two dominating economic strategies for a country. When most of the countries choose one of these two strategies, we can say that this trade strategy (economic schemas or phases) dominates in the world economy:

When economic growth in most of the countries is stimulated by private financial institutions, we can say that the World economy (or economy of a region) is in the free trade phase. Less-developed countries are financing their economic growth from external resources (usually using capital from high-developed countries).  We observe, usually short, overproduction crises, that easily propagate from one country to another, so crisis usually affects the whole world or large region.

When economic growth in most of the countries is stimulated by government, we can say that the World (or a region) economy is in the phase of protectionism. Countries are financing their growth from internal resources (like country savings). We observe, usually long (sometimes even a hundred years long) stagflation crises, that in most cases affect only one or a few countries.

Chronology of free trade (liberal periods), and protectionism periods:

Because for most of the history war was the most effective way to increase country wealth, the human history is generally the history of protectionism, and government-stimulated economy. There were only a short periods of time, when the trade was profitable enough to support “liberal” economy. Good example could be the Greek colonization in the Mediterranean region in ancient times. Moreover before the age of great geographic discoveries, there was no true global market but many local trade zones. Also, economic data are very fragmentary, so I start this simplified classification from the XVIth century.

After the 1500 AD, thanks to technology advances and global trade, liberal periods are longer:
  • In XVIth century there was a stagflation-like crisis (price revolution), as an side-effect of government spendings of Spanish Monarchy, and economic stagnation in Mediterranean region (because of trade routes shift).
  • In the first half of XVIIth century Netherlands promoted a free trade policy (with great fall on tulip market - a classic example of overproduction crisis).
  • The end of XVIIth century and most of XVIIIth century was the age of protectionism (and domination of mercantilism).
  • There was a short period of liberal economy between 1776-1789, ended with the Great French Revolution, and wars waged by France.
  • Years of 1820(30) -1929 were the age of liberal economy (laissez-faire) and the free trade. There were many short overproduction crises (more or less every 10 years).
  • Years of 1934 -1972 were the age of protectionism (domination of keynesism, substitution of import, etc.), ended with the stagflation crisis in 1973.
  • Since 1982 till know we observe a beginning of new free trade period (globalization).

Of course this is very simplified classification. Starts and ends of each period of protectionism and free trade were different for different countries (example South Sea Bubble - stock market crisis in Great Britain when European economies were generally government driven), and some countries were outside the main cycle. 

Free trade schema is more effective, but high-developed countries must have enough capital to suspend that schema.

There will be no economic growth without the virtual money

Exact mathematical proof could be quite long, so here is a short (very simplified) descriptive substantiation:

As every economist know, there is a closed circulation of money in a country economy: Firms pays households for means of production (as work, capital, knowledge), and then households are buying goods and services from firms paying with money earned before.

Lets try to build an simple example: there is only one factory manufacturing 100 cars a month, and all people work in this factory. Let say that this factory gains a new technology, and is able to increase production to 150 cars. But we have a problem. Households have money only to buy 100 cars (money earned last month), so if the factory increase its production, it will gain exactly the same amount of money as for 100 cars a month before. So, board of directors will see no reason to increase production. An thus there will be no economic growth...

Virtual money, descriptive explanation

Solution of this problem are the virtual money. Money that are completely fictional, taken from nowhere. Money to buy that extra 50 cars. Using a metaphor, we can say that the virtual money are borrowed from the future (I mean: we are hoping that our GDP grows, and we will be able to repay our debts). Simple speaking virtual money are nothing more than a credit.

There are two basic ways to generate virtual money:

  • Government could print some paper (fiat) money (or spoil the metal coins), spending more money that gains from taxes, and thereby borrowing money from citizens. In this case growth is government-stimulated.
  • Financial institutions like for example banks could lend more money that they have deposits or give credit too easy. In this case growth is stimulated by financial institutions (government could help here with low interest rates).

Which of those stimulation is better? It depends.
But there will be no economic growth without any stimulation (or the growth will be slow).
And sometimes because of other factors, no mater as strong, and well-constructed it is, none of methods of economic stimulation is effective.

And moreover, this is a very simplified classification of methods used to produce virtual money. Some others include: credit cards, stock market options (and other derivatives), overvalued national currency rate, etc.

Basic scheme of economic crisis

At the beginning, when economy is in growth phase, growth is financed using virtual money. (Today’s debtors are borrowing money that have to repay tomorrow.) When the base for the economic growth is firm, debts made today will be repaid without any problem in the next period from the new, bigger GDP (income). Volume of virtual money is matching the expected future growth of income quite good (compare with the model of rational expectations).

But sometimes the parameters of economic environment (and thus the conditions for economic growth) could change in an unpredictable way. There are many reasons for these changes, but generally speaking most of them spring from politics, and political changes, or from changes in the volume of available resources.

When the change happens, such a high rate of growth, (as we expected before the change) will be no longer possible. However because of virtual money, there are debts that were made, when the expected rate of growth was higher. Because of natural inertia of political, and economic institutions, the rate of growth is still high for a some period of time, but it creates an extra cost of rapidly increasing debt. Publicity still believe in the virtual money. We can observe some symptoms of increasing market unbalance. This is the hidden phase of crisis.

Then comes a shock. It could be some unpredictable event or even a gossip. Publicity loses its belief in virtual money. This launches a rapid fall of prices of money, assets or goods, whose prices were partially created by the virtual money. We can observe a great fall of stock market prices, rapid fall of national currency value (inflation, and even hyperinflation) or rapid changes of currency exchange rates (when the growth was stimulated by money borrowed abroad).

Then comes the crisis - because the possible rate of growth is lower than before - and even the recession - because of the debt that must be repaid. When debts are repaid, or reduced by some political means, and there are natural conditions for growth, the crisis ends.

Wealth redistribution between high income and low income countries

When we have “rich”, and “poor” country, then under normal conditions there will be a continuous diffusion of wealth from the “rich” country to the “poor” country. Levels of wealth in both countries will equalize to finally end at more or less the same level.
This is the economy counterpart of the Law of Connected Vessels presented before.

Rate of this diffusion of wealth will be faster when:
  • Gap between the income levels of “rich” and “poor” country (measured for example as GDP per capita) is greater
  • Diffusion channel (i.e. volume of trade, and capital flows, etc.) between two countries is wider

However there are a few important reservations, we must consider here:

  • Protectionism makes the diffusion channel “narrower”, and thus could slow down the diffusion rate.
  • According to the Solow's Model (see summary of Solow's Model at Wikipedia), the final barrier for economic growth is technology level of the country.

Solow's model consequences:

  • When the level of technology in a country is constant, there is a point where economy stimulation will have no effect, because costs of the stimulation will be greater than the resulting increase of wealth. Only way to increase the country’s wealth in long run is to increase its technology level.
  • A country with low technology level could be under the stronger “diffusion pressure” (i.e. could be relatively richer), than a country that have nominally bigger GDP, but with higher technology level.

So, if we have one country with higher political system (which speed up technology development), and a country with lower political system, and government of both countries believe in protectionism, the technological gap, and thus the wealth gap between these countries may increase. Even when diffusion forces are still working.

But under normal conditions, the diffusion powers are the main reason, why economy stimulation is sometimes ineffective. And because of them, no matter what the government will do, the country’s economy will stagnate or even fall into recession.

Important conclusion is that the rate of economic growth depends strongly from its neighbourhood. If a small, poor country borders with a big, rich country, it will develop very fast. If a rich country borders with many quite large (i.e. very populated) poor countries, its economy will probably stagnate or even decrease - because of diffusion powers.

Four major flaws of the Comparative Advantage Theory

The Comparative Advantage Theory is the model used by economists to explain, why the free trade is more effective than protectionism. It is generally true, but there are cases when it will not work. Here are three major weakness of that theory:

  • First, it ignores merchants who are transporting goods from one country to another. The Comparative Advantage Theory assumes that they gain no profit, and have no ability to control prices in both countries to maximize their profits. It is very dangerous assumption, especially when merchants from one country monopolize international trade. Everyone interested in history, knows that many wars were waged only to gain an privileged position in international trade.
  • Second, according to the Comparative Advantage Theory, large country (i.e. country with large market share) could maximize its profits manipulating the prices (natural ability of a big market-player). Under the normal conditions it does not matter, because free trade (for both large, and small country) will be still more profitable than protectionism.
    But when the World economy is shrinking (it is in crisis phase), it could be very important, how large is a market share (and thus profits from international trade) of each country, because both the large and the small country have debts to pay (see the description of economic crisis above).
  • Third weakness is the Polarization effect. The Comparative Advantage Theory is true only when the number of traded goods is GREATER than the number of countries participating in international trade. If this number is smaller, one (or more) countries will not be able to sell any product on the world market. (See Polarization effect, descriptive explanation)
    Normally this is not a problem, because the number of tradable goods is almost always much larger than the number of countries. But when the global economy is in the crisis phase, protectionist efforts of rich, and poor countries, taken to prevent their global market shares (see above), will form two large groups of goods: capital-intensive plus capitals (sold by rich countries), and labour-intensive (sold by poor countries). In consequence the middle-income countries will have serious problems with selling their products on the global market (there are 3 groups of countries but only 2 groups of goods). So, their economic situation may become critical, and this could effect in political chaos.

This effect is for example responsible for Argentina trade problems in 1997-2002. Polarization have also an impact on political balance inside country - could destroy the prosperity and political power of middle-class (more or less the same way as described above: no one want to buy goods and services sold by middle income-citizens). Social processes launched by the polarization effect are responsible for most of barbarian expansions in medieval and ancient times, and also for the expansion of France in times of Napoleon, or for NSDAP (Adolf Hitler’s party)  successes in elections in Germany.

  • And Fourth and most important: The Comparative Advantage Theory DO NOT PROVES that a country, where the prices of all goods are higher, will export any of these goods to the country where prices of all goods are lower. In this case we have to take into consideration another, special kind of goods: money. A very rich country will have comparative advantage AT MONEY, and will be exporting money (either as “pure money” - it means will have a negative trade balance - or as a capital). In other words: we cannot use relative prices in economic models of trade exchange. See substantiation

Why the free market is better?

Here some most important advantages of the free market in comparison to government-regulated economy:

Advantages of free market

  • Competition eliminates the weakest, and most ineffective firms.
  • Line of control (distance) between capital-owners, and people, who use capital to production is shorter, so it is easier to control if the capital is used in a reasonable way (i.e. is not wasted or stolen).

As you can see, great private company with monopolist position on the market could be the same way ineffective, as government owned companies are. On the other hand government-owned companies that have to compete on a free market could be very effective.

  • Small firms are exploring economic opportunities that are too expensive for large companies.
  • Diffusion of new technologies, and scientific knowledge is faster.
  • Time of reaction to unpredictable external events is shorter, and the economy faster revives after external shocks.

Disadvantages of free market

  • Transaction costs are higher than in government regulated market.
  • Market companies tends to ignore external costs that they generate for the common environment.

Protectionist advantage of government-regulated market

When the tax rate is very high (and taxes are progressive), and government generally buys goods manufactured in the national economy, that policy will have an extra protectionist effect, because it lowers tendency to import. (Money that normally could be spend by the richer citizens on goods imported from abroad, now will be spend on goods manufactured in our country.) 

Protectionism makes diffusion channel narrower, thus slowing the technology diffusion between rich, and poor countries.

Government-stimulated economy could lead to overexploitation of natural resources and thus could be very vulnerable to catastrophic natural disasters.

Government-regulated works like a monopoly, and thus could give a country all advantages of scale. It is especially important in some sorts of economic activities like for example: export of natural resources or waging a war.

Government-regulated economy has all strengths and weaknesses that a monopoly has. Usually is less effective than a free-market economy, but not always. Argumentation that free-market is always more effective than a government-stimulated economy is like proving, that Microsoft has no advantage over smaller computer firms.

Laws for science and technology development

Here, a few basic laws that are explaining the rate of scientific, and technology development:

  • The higher are expenditures for science the higher is the rate of development (well, its a very trivial law).
  • The higher is the volume of gathered knowledge, the faster it increases. Science evolves in geometric progression (warning: this is a simplification, obvious when you think of the math behind).
  • Rate of science, and technology development is faster in every higher political system (i.e. it is faster in populistic system than in feudal system, and faster in democratic system than in both two other systems).
  • During the free market (liberal) periods the rate of science, and technology development is faster than during the periods of protectionism.
  • When the country made a transition from government-regulated economy to free-market economy, we can observe a “scientific evolution” which is a consequence of practical implementation of theoretical knowledge gathered before (i.e. during protectionism period). That was the reason for “industrial revolution” in England in late XVIIIth century, and “computer & Internet revolution” in USA in last two decades of XXth century. 
Stylistic corrections, February-March 2006
Slawomir Dzieniszewski

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MECHANICS  OF  HISTORY  -  laws to understand the histtory