> Opinion
Illusion and reality of the physical economy
By John Coulter (China Daily)
Updated: 2009-01-07 11:58

The financial crisis simply highlights the serious disconnect with our physical world, also known as reality. Our physical world around us is finite matter and cannot be made to grow. Growing food and mining and manufacture are simply transformations of the finite number of atoms at our disposal.

In the two centuries from the outset of the Industrial Revolution, economists characterized the improvements in people's lives as a growth model, through cleverness in improved technologies taking more and more resources from farther and farther away.

David Ricardo in his 1817 treatise on resources enshrined in the discipline the notion that nature was bountiful, and so such resources as water and distant lands were free.

Last year we are forced to recognize that the global economy is a subset of the apple skin-thin layer around the globe that humans live in - the land, sea and air that we mine, farm, fish and breathe.

For rough convenience it can be defined as 10 km above and below sea level, and all human activity takes place in it. This is our environment, and houses economic activities. It is only after two world wars that humans pushed industrialization, infrastructure and farming to the extent that our world was noticeably affected.

The flows and stocks of the physical economy were inconvenient to manage - realized long ago when paying labor at a fish a day, or storing a silos of grain.

The invention of money freed up economic activity to allow flexibility and mobility in trade and saving. But it is very tempting to have an eye for money per se and not on the physical goods or services represented.

There is a natural human tendency to disconnect between physical reality and representing it in currency, even as it distorts the original intention. Chinese ancient Taoist philosopher Laozi disdained surplus wealth and Jesus tipped over money changers' tables.

Recognized as the foundation of economics, Adam Smith's classic, The Wealth of Nations, assumed that money represented the physical, material goods and services in a rational and fair way, and encouraged pursuit of self-interest as the best way to benefit both the butcher and baker.

By the time of the 1987 movie classic, Wall Street, the star (based on real life creators of arbitrage and junk bonds) was preaching that greed is good, and backing up his motto claiming to have made $12 billion for companies in his last seven deals.

The gap between physical reality and dream billions then led to the dotcom bubble of the early 1990s with just the most notorious company, Worldcom, found out to be exaggerating its worth by $11 billion.

A decade later Enron defaulted on $70 billion. Its core business had been supply of natural gas, and had anyone asked where are the carbon and hydrogen atoms that comprise CH4, it would have been obvious that their material inventory of stocks and flows was far less than their assets boasted in dollar terms.

Despite the lessons of escalating fraud, still most people in what is now called the creative finance industry/charade/game had high incomes that translated into material wealth and lifestyle. The game seemed endless, with rewards for lenders building fancier packages to hide the impossibility of repayment under jazzed up glitz and subtle euphemisms.

When subprime turned to toxicity, with proud financial institutions calling for bailouts, and facing the end of the world, the language, concepts, visions and tools used to address the fiasco and grasp for solutions were those that had led to trouble in the first place.

Not only financial gunslingers but also methodical economists and advisors on the public good were stuck in the heady world of large dollar numbers associated with nebulous concepts of various relationships between institutions whose credo had become. Hope I don't get caught with the hot potato when the music stops.

For over 20 years it had become increasingly boring to ask, where are these numbers related to the real economy of manufacturing autos and growing grain, wages for waiters and managers, and for the profits of genuine business entrepreneurs?

The gross domestic product of the United States is reckoned to be about $14 trillion. The line items for autos, food, housing and health care are in trillion dollars 1, 1.4, 1.5 and 1.7 respectively.

Apart from these pragmatic goods, there are $2 trillion in services that can be readily defined and understood. These numbers can be presented and interpreted many ways, but whatever, there are still numbers that are called trillions of dollars that seem to have no physical basis. One clue to justification is borrowing from the future flows of real goods and services. This is fine if the goods and services are real and deliverable.

Financial services are almost impossible to do without, in, for example, opening up a new field for oil or coal or iron. Not even large mining companies have the cash in the bank to outlay hundreds of millions of dollars before the first of the commodity is paid for.

But the feasibility study showing proven reserves and achievability are document called "bankable", and the financial system works. At any time the institution can call in its own or other independent technical experts to check on reality.

Private borrowers wishing to purchase a home or car know how rigorous the reality check is. This is true in China, all Asia and Europe. It was true in the US two decades ago.

The financial mirage in US housing and credit burgeoned on the incentives lending officers were given for signing up more debtors. The crazier it became the more sophisticated the so-called financial products, hidden in the mesmerizing complexity of the web along which the velocity of money supply moved in the form of electronic pulses.

It is fair to say in hindsight that this became like a huge computer game that crashed last year. It is idiotic to idiomize the problem as if the economy was a plane in a "nosedive" or a nuclear reactor in "meltdown".

Our world economy is unimaginably complex, but the one basic truth not recognized by those who speak the language of finance is that the global economy is a subset of the global environment.

No financial wizardry can defy the fact that the number of atoms in a our valued resources - gold, iron, aluminium, and the atoms in hydrocarbon molecules of fossil fuels - are finite, fixed, cannot be created, produced, manufactured and for practical purposes cannot be imported from outside that thin layer we inhabit around the globe.

Without human action, or human presence, our Earth is an amazingly complex, fragile system. Without humans there is plant and animal life that live in complex cycles of chemistry, with specific elements such as carbon or oxygen traceable through the sea and soil to life and into the air and back again. Humans evolved into this and had negligible effect for millennia. The Industrial Revolution began changing all that.

China's three decades of 10 percent growth are the final spike that has drawn down the last of easily accessible resources and saturated the environment - air, water and land. Even US financial institutions have felt that market message and catastrophic correction.

Experts steeped in financial experience convinced the US president to sign off on a $700 billion bailout - and this will probably amount to much more. No one has stated or asked the specifics of how that number of dollars relate to real economic activity, or where it will be physically drawn from.

Now is the time to apply the concept of scientific development, with the physics, chemistry and engineering of economic processes understood and anchoring the financial accounting system on which management decisions are made.

The author is a Beijing-based independent Australian researcher collaborating with Tsinghua University and China Agricultural University

(China Daily 01/07/2009 page9)