1 comment to Responses to John Cochran’s reply to Paul Krugman’s Attack
If Hayek thinks the economy is a calculating machine then mathematically model one.
What would the economy calculate? The yield curve, of course.
How would the economy compute? Using digits, of course.
What are digits? They are inventory steps in a finite length distribution network.
How does the economy choose them? By minimizing the total number of transactions as Hayek would point out.
How does the economy do that? By adjusting the lot sizes and transactions rates of each good at each step such that the volatility of inventory levels is equal (within the standard error) at each step. Hence each inventory level in a production system has equal probability of going to zero.
We call this achieving economies of scale.
Why does this result in asymmetry when we have a restructuring? (This is the big question the Keynesians and EMH folks can’t figure out)
Asymmetry results when a positive or negative shock to the production system causes the steps in production to drop by one (sudden constraint) or add one step (positive shock). Adding a step to production is inflation, more steps in production to deliver a greater variety of intermediate goods. A sudden constraint causes deflation, the removal of a step to get greater economies of scale.
In a restructuring, all the stages have to adjust their lot sizes and transaction rates such that the amount of the yield curve allocated to each step results in a fair share of the bandwidth. Bandwidth equals volatility management, and inventory volatility has to be minimized and equal across steps. This adjustment process is the recalculation that Arnold Kling talks about.
Does the entire economy seek that same number of step in production? Yes, in the aggregate the yield curve will be coherent, each goods being processed by the same number of steps, or a integer multiple thereof. That is, there must not be overlap of the space shared on the yield curve among the different steps of the different goods. Otherwise we get interference and price volatility, agents cannot tell self price volatility from correlated volatility. Call this coherence at equilibrium.
What is money? Just another good (sorry Austrians, money has no special role) But the financial system will deflate and inflate in response to shocks.
What is price? Price is exactly a constant time square root(volatility)/mean of a particular inventory at equilibrium. (Price is the inverse of signal to noise ratio at equilibrium.) In fact, at the impossible equilibrium point, all prices for all goods should be equal, because all inventory has a constant probability of dropping to zero.
Why aren’t we stuck at equilibrium? Because the acceptable uncertainty level of inventory measurement is not a fixed number, but an acceptable band. This uncertainty band is fixed by the biology of herding animals.
What mathematics should we use? Quantum Mechanics. Minimization of total transaction is your Hamiltonian. Minimization of inventory variance is the force. Quantization comes from having a relatively fixed band of measurement uncertainty.
As an aside, Hayek was there when physics adopted quantum mechanics, it must have influenced him.