by David B. Collum Professor of Chemistry and Chemical Biology Cornell University In chemistry, there is an experiment called a temperature jump or T-jump experiment. It is known for its capacity to monitor rates of very fast reactions (like enzyme-catalyzed reactions). You start with a system at equilibrium. Such a system might have a number of chemical species interconverting with each other, but they do so at rates that cause their populations not to change over time. (Think of an analogy with a balanced ecosystem; highly fluxional yet stable.) In the T-jump experiment, you shock the system with a rapid pulse of energy. The system now has all the species at their original concentrations but it is no longer at equilibrium because it is at a new (higher) temperature, which changes their preferred populations. (Using the ecological metaphor, you might think of it as introducing a new species to the mix.) Following the fast perturbation from equilibrium, one can then watch how it returns to equilibrium under these new conditions. The analogous economic experiment might be a money jump or M-jump experiment. You start with an economy at equilibrium. Supply and demand are in balance. Providers of goods and services (stores, pharmacies, contractors, etc) are sustained by the inherent demand: The rate of production matches the rate of consumption. Of particular import, people have savings and debt, but they also have a firm grasp on the two. Debtors are acutely aware that some portion of their future output will be used to pay off creditors, and they have planned accordingly. Cash-depleted creditors can count on revenue streams to replenish savings. Inflation is non-existent in this utopian economy at equilibrium. To the extent that occasionally some clever soul finds a way to improve production, a modest price deflation (the good kind) would be expected. There certainly exists a positive gross domestic product or GDP; goods are produced and services are provided. The corresponding net domestic product or NDP (NDP = GDP minus depreciation) would be fairly close to zero. For the most part, the economy produces what it needs and consumes what it produces. So here is the M-jump experiment. This economys version of the Fed decides the equilibrium unemployment levels are too high for comfort or even that the system could thrive even better. Whatever their motivations, the Fed decides to solve some real or imagined problem by simply adding money to everybodys savings over night. They write stimulus checks. This jump in the money supply--this so called M-jump experiment--represents a displacement from equilibrium. The economy didnt increase production of goods or services over night, yet the average person (Joe Sixpack) feels richer. The monetary expansion associated with the M-jump produces an instantaneous gap between perception and reality. I am neither a Fed governor nor an economist (thank God), so I can only guess what they were thinking. We must assume the Fed is not just comprised of a bunch of fools. This causes the story to take on a fictional quality to the more jaded, but bear with me. One presumes they attempted translate the perception of increased wealth into an increased capacity to produce goods and services. (Recall fundamental axiom of wealth: You grow it, make it, or mine it.) The Fed is betting that the shoemaker (one of many Joe Sixpacks) buys a machine to produce shoes faster; the storeowner purchases inventory software to decrease inventory costs; and the carpenter buys a new tool (maybe a pneumatic nail gun) to build houses faster. Of course, somewhere in the economy somebody had to work a little harder than usual to produce these new tools, but hopefully there will be a disproportionate increase in output and commensurate improvements in quality of life. As the story goes, society either produces much more with a modest increase in effort or produces the same with less effort. Both seem like admirable achievements. If you were a betting person, however, what would you think Joe Sixpack would do with the new money? Joe might buy a car, put a porch on his house, go to the movies, take a vacation, or even cut back on the long hours at work. Many of these behavioral changes--the increased consumption of goods and services--serve to decrease rather than increase Joes output. Joe now consumes more and produces less. The increased demand for goods and services and decreased work ethic, however, causes the shrinking number of workers to charge more. Joe begins to notice rising prices. Whereas monetary inflation--the M-jump experiment--was instantaneously, price inflation lags and surfaces unpredictably. Over time, the money sloshes from the consumers/spenders to the shrinking population of producers/savers until the consumers start feeling less resilient. Of course, the consumers can borrow from the savers to delay belt tightening, but eventually they owe too much money and must cease consumption rather drastically. Curiously, the producers/savers find that their newly acquired wealth buys less than they expected also. How disappointed must be the savers experiencing muted gains. In short, the perceived spike in wealth was an illusion. Because the displacement from equilibrium caused by the M-jump prompted over consumption and underproduction, it was destructive. The economy produced less overall while the misperception of wealth flourished. People bought stuff they didnt need with money they didnt have. Families eventually felt poorer and tightened up their spendthrift habits. The producers/savers now find they are not as rich as they thought, forcing them to keep working. Eventually the spenders/borrowers go back to working more and consuming less. The system begins to produce what it needs and only consumes what it produces. As this pattern becomes widespread, the Fed realizes their monetary injections caused the recession. They recognize the err in their ways and stop intervening in free markets. Everybody lives happily ever after. What a delightful fairy tale. The reality, however, is that a huge gap between perception and reality--a large displacement from equilibrium--emerged over decades in both the US and the World. Serial monetary injections by central banks to solve the problems du jour elicited more consumption than productivity. Nothing could be more emblematic--monuments to the malinvestment--than the McMansions built with leveraged finance. They are stone heads on Easter Island...but less durable. According to the physicist Carnot, it is impossible to perform a function and return back to the starting point without a net loss in energy. Unwinding malinvestment has a tax too. Unused goods and services are wasted human and natural resources. A modicum of understanding of physical science reveals something else: Large displacements from equilibrium produce systems that are shock sensitive and prone to violent and destructive returns to equilibrium. Think bombs, avalanches, earthquakes, houses of cards, and, of course, credit bubbles. The global crisis is forcing the enormous perception-reality gap to narrow violently. At some point, we will regain our collective sense of what we have saved, what we owe, and how much we can afford to consume. Equilibrium will represent an alignment of perception and reality. The ongoing economic correction, the unwinding of malinvestments by a currently unknowable path, will cause pain. David B. Collum Professor of Chemistry and Chemical Biology Cornell University

Back to News