Good bye and hello, as
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.
There are two
economic crises: overproduction crisis, and stagflation
Basically there are two kinds of economic crises:
The stagflation crisis (or underproduction
crisis) is the final effect of government-stimulated growth (or
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
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
Of course in the real world things are more complicated, and
sometimes crisis is some combination of two basic kinds of crises
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.
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
revolution), as an side-effect of government spendings of
and economic stagnation in Mediterranean region (because of trade
- 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
- Years of 1820(30) -1929 were the age of liberal
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
- 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
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:
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.
to build an simple example: there is only one
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
Virtual money, descriptive
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
- 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
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
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
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
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
Then comes a shock. It could be some unpredictable
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
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
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
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
However there are a few important reservations, we must
- Protectionism makes the diffusion channel “narrower”, and
could slow down the diffusion rate.
- According to the Solow's Model (see
Solow's Model at Wikipedia),
barrier for economic growth is technology level of the
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
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
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
their profits. It is very dangerous assumption, especially when
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
- 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
effect are responsible for most of barbarian expansions in
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
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
- 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
- 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 companies tends to ignore external costs that they
generate for the common environment.
Protectionist advantage of government-regulated
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.
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
a government-stimulated economy is like proving, that
has no advantage over smaller computer firms.
Laws for science and
Here, a few basic laws that are explaining the rate of
scientific, and technology development:
corrections, February-March 2006
- 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
- 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.