Economies are graphs, study them as graphs

Economies are graphs. The workings of economies would be better illuminated if economics were developed as a study of graphs, the things with nodes and edges, instead of aggregate stocks and flows.

A person is a node in the graph. Real value (goods and services) flows from one person to the other in a direction that we label with an arrow, and sometimes money flows in the opposite direction. The purpose of money is to shortcut loops or debts of value reciprocity that would otherwise take too long to balance. When you want interdependence you don’t settle in cash, which is why you don’t pay for gifts or for the services of family members and co-workers.

An artisan is a person who delivers value directly to customers and gets paid immediately or soon along the same arc. In a market, like a Sunday fruit market, arcs are transient but in other situations arcs are long lived and capture trade relationships including trade debt. Customers can put up money at the end of arcs to motivate them, and we call this demand. The social function of money is largely to motivate value arcs that would otherwise be hard to negotiate. The fact that money sometimes accumulates is an aberration.

A market is a device for arc formation. A variety market such as a bazaar or department store serves to reveal and create the value arcs that meet demand, by rewarding certain links among the vast space of possible production. It’s a network phenomenon with persistence, like learning in the brain. The kind of commodity market much loved by economists is a much lesser creature. It aims to create and destroy arcs instantly, in atomic transactions, to avoid long term graph formation and only accumulate the money imbalance. At best it’s an inefficient method for optimising aggregates.

Companies and families are structurally the same, in that individuals send value to each other according to internal relationships without getting paid by the receivers. They’re explicitly not markets. Money arrives at some distinguished nodes and gets shared along different arcs than the value flow. People tend to identify and be invested with their outgoing value arc, not the incoming money arc – this is what I do, not that’s what I get paid – and when the opposite happens it’s a dysfunction.

People pass incoming value as well as add their own, such as when a leader or seller delivers a finished item, or when an academic synthesises the wisdom of others. Value creation is a graph process quite distinct from money capture. Everyone understands value creation by aggregating flow on their graph and most approach it with a well-developed moral sense, egalitarian or biased. Few people have the inclination or low morals to monopolise money capture in the opposite direction.

Value flows will in general be unbalanced, from the more to the less productive, in an economy or any meaningful subgraph or time period. They have to be unbalanced if they are optimally large. Debt will maintain unbalanced flows that may be desirable, but is not a device to achieve balance or fairness. We have to set up, as societies, the value flows that we want including unbalanced transfers for education, misfortune, or old age.

Money accumulates because the settlement of transactions is not perfect and economic graphs such as firms are set to aggregate this imbalance, though not as a direct mirror of value flow. Wealth aggregates to different people and more unequally than their value contribution, because graphs have evolved to make it so. There’s no guarantee or even tendency for wealth to mirror value creation in the long run; there are just emergent graph effects and motives to steer them.

Value flows matter. Money flows in the end should not, although today they do. In the short run and all other things being equal, money and finance serve to motivate and adjust value flows differentially. Beyond that, any large accumulation of wealth or debt is emergent and arbitrary. It should not be treated as power or bondage, but as a relative claim to future flows made self-limiting by inflation.

Someone who is unemployed has no outgoing arcs. No-one wants their value output, perhaps because they have no incoming arcs either: No training, no colleagues or equipment, etc. A menial service worker or someone in a predatory profession like a spammer recognises that they transmit zero or negative value. All are unhappy, in the psychological sense of lacking purpose or value, even if some money somehow flows in their direction by other means.

What about a person who cultivates themselves, through erudition or physical training? In graph theory that’s a node with an arc pointing to itself, and can be formalised the same as other value transfers. Perhaps value towards self will later join output for others, such as when studying before publishing. Leisure is then either a restorative value transfer, i.e. useful, or if it achieves nothing it’s the absence of value flow.

In either case, utility is a relatively transient attribute of the self. It’s things like energy, joy, hunger, tiredness, sleep, etc. People consume value including leisure to increase their utility and partly damage it by working, mostly in a daily or weekly cycle. Work is a disutility insofar as it damages us, and a utility when it makes us greater. In a graph theory of the economy utility is more of a temporary, limiting but also self-correcting, state of individuals than something that could be amassed, precisely calculated, or time shifted.

Incidentally a lazy person is someone who, for one reason or another, needs to consume more leisure to restore their utility. To be more productive, learn to rest more efficiently. Firms that emphasise the quality of the work experience recognise this. Grim dwellings for the poor destroy utility.

Most value flow is not in markets with transient arcs and immediate settlement but along economic relationships that have some permanence: Family, work, knowledge, reputation, trust, social contribution. People like to adjust their graph connections to gain higher status, but they don’t seek an extemporaneous, fully market disciplined existence.

Although utility and value transfers are in the here and now, people desire security for the future. The need for security is a preference for being included in the value graph of the future. People invest in their position in the graph of the present, by and large the outgoing value arcs, during their productive years, and expect some reciprocity i.e. to receive flows value in young and old age.

Ordinarily we treat these as social value-debts shared by the immediate graph neighbourhood: Family, professional guild, nation or other social group. Increasingly we’ve treated these time shift problems as money-debts: Student loans, private savings. Since the purpose of money is explicitly to avoid permanence or long-term reciprocity, this fails to engender security. Far too much money is amassed to achieve security for a few, creating a massive loss of utility. And that, too, is an aberration.

Economies are graphs. Study them as graphs.

A short critique of the Efficient Market Hypothesis

The so-called Nobel prize in economics has been awarded to Gene Fama for his Efficient Market Hypothesis. EMH states that markets instantly price in all available information and so nobody would be able to outsmart or otherwise outperform the market consistently in the long run.

Here’s my short critique of the theory.

The EMH assumes there’s an event horizon. Events behind the horizon, be they unknown future events or insider secrets, have no bearing on prices. Then events pop up over the horizon and instantly the market computes new asset prices to fully reflect the new information. Ergo you can’t out-compute the market.

The assumption that the market computes prices instantly is idealistic but we’ll go with that. The market is pretty fast, down to seconds or less.

Real-world events don’t flip from fully unknown unbiased probability to fully known outcomes. There’s a bias i.e. any particular event is predicted as more likely to happen than not, or vice versa, and better confidence estimates of the event’s probability become available over time. But so long as we assume everyone has access to the same stream of predictions the EMH still makes sense.

Where the EMH falls down is that prices don’t change to reflect the final valuation of a future state as soon as that future is known. New information gets priced in over time, from when the information is revealed to the time when the new situation actually takes effect and directly bears on the fundamentals. People see the instant tick of the pricing and say “ha, EMH!” but there’s a lot more pricing yet to come, and that’s why prices change continuously even in the absence of important news.

The reason markets price in information over time is twofold:

  • Market participants have different trading time frames. If we know for certain that the US will default in one year that will cause stocks to drop instantly, but there’s still time to invest and get out during the year, so people do. If the time frame is uncertain there’s more scope for price change. Miscalculations about trader’s ability to enter and exit cause bubbles to inflate and then crash.
  • Since the market isn’t pressured to price in the impact of future events until the exit window of each type of trader closes, it doesn’t, and how it will eventually price the impact over time remains unknown. Market participants have to predict prices at specific times and and the analyst with the better prediction of the market’s reaction wins. For example if you and I predict that a default will cause a 5% or 30% drop in asset prices tomorrow (not eventually when the default happens) one of us will come out looking smarter.

So, even in a world where everyone has full access to information about events, including likelihood and confidence, there are still opportunities. Opportunities arise from being better or worse at estimating how the market will compute price changes over time given known inputs, which is a notoriously hard but valid computational problem.