The long reach of the conservation law

Derivative tradings are zero sum games. Wherever there are winners, there are losers. This is the conservation law. There are also high costs associated with tradings, fat salaries and bonuses. Overall, there are net losses for the whole derivative industry. In an unregulated free market, derivative business will always be a boutique industry, incapable of causing much collateral damage to the rest of the world.

In 1998, LTCM (Long Term Capital Management) failed. LTCM was a famous hedge fund. Robert Merton and Myron Scholes, two Nobel laureates, were partners of this hedge fund. LTCM was highly leveraged. Without the help of the Federal Reserve, the collapse of LTCM will cause serious damage to its counterparties, which include most of the high finance. A hard hit finance industry would have much less appetite for highly leveraged gamblings. It would not be capable to generate a global financial crisis ten years later. Instead, FED intervened. This encouraged the further increase of leverage of the financial industry. It sowed the seed of much larger financial crisis in the future.

In 2008, ten years later, Lehman Brothers, the fourth largest investment bank, collapsed. Within a week, Goldman Sachs and Morgan Stanley, the two largest investments, became commercial banks, becoming directly insured by the federal government. Merrill Lynch, the third largest investment bank, was acquired by Bank of America under the government prodding. AIG, the giant insurance company, was bailed out with two hundred billion federal fund. Without the help of the government, the investment banking industry and the global finance system would largely decimate, greatly reducing the yoke on the general public.

After 2008, the US stock market experienced the longest bull market in history. The authority claims that this justifies the government interventions during financial crisis. But from the iron law of conservation, without genuine economic growth, the bull market in the financial market must mean the bear market somewhere else. Indeed, the US fertility rate has dropped sharply to the lowest point ever recorded after 2008. Globally, the fertility rates of the highly financialized nations are capped far below the replacement rate. The gain of financial market is the loss of the biological market.

In 2020, due to large scale lock down related to global pandemic, economic activities tumbled. So did the stock market, which is supposed to reflect the market condition. However, governments worldwide began the largest money printing in history, boosting the stock market. From the conservation law, something has to give.  Sure enough, the money printing generated a huge inflation, amid an economic downturn when many people are very vulnerable.

The term, unintended consequence, is often used in the press. From the conservation law, unintended consequences are really the inevitable result of intended consequences.

In physics, we often use conservation law to infer the properties of physical variables that are difficult to observe. In economics, we may use conservation law to infer the properties of social variables that are difficult to observe, or unwilling to observe by the mainstream.

In economics, conservation law may not be exact. But it often provides a good approximation. It often provides a good starting point for further investigation.

P.S. In the following notes, the distribution between income to labor and capital can also be understood from the conservation law.

Insights from GDI

We often talk about GDP, but rarely GDI (Gross Domestic Income). Since product value always goes to someone, GDP = GDI. But we rarely use GDI in our discussion about economics.

Income may go to capital or labor. So GDP =  GDI = income to capital + income to labor. Suppose GDP grows at 2% per year, income to capital grows at 8% per year. What is the income growth to labor?

GDP = income to capital + income to labor.

Probably there is little income growth to labor. This is exactly what happens. In the past twenty years, the world has experienced the longest bull market in history. At the same time, the median income of the household is virtually unchanged. From the relation GDP = income to capital + income to labor, this is obvious.

The standard explanation of the disparity between capital labor income growth is the change of technology. It seems nothing can be done by the society. But the real reason is the change of the tax system. In the United States, in 1950, corporate tax accounted for 26.5% of the total tax revenue. In 2019, corporate income tax accounted for 3.9% of total tax revenue. In 1950, excise tax, which is levied mostly on luxuries, accounted for 19.1% of the total tax revenue. Today, it is negligible.

Capital is very liquid. Labor is much less liquid. Wealth from labor stays in a community and country. Capital is much less so. 

But the world is dominated by capital. That is why policies favor capital over labor.