Chapter 10: System dynamics part I




1st Introduction to the difficulty

2nd The question of the stability of an order

3rd Order and level of development

4th The interdependence of the orders

5th Support of an order by foreign powers

6th The influence of ideas and personalities

7th Internal dynamics of the systems

8th About the convergence thesis



1st Introduction to the difficulty


Orders have the task of coordinating individual decisions. Within the framework of the order analysis, the question is examined of which basic elements an order consists and which different order types are possible. Whereas an order conception shows which order systems are desired; it asks for the guiding principle of an order which, of course, varies according to the observer's worldview. Within the framework of a theory of the system dynamics, however, it is examined how orders change in the course of time, the question is raised which forces have led to the formation of certain orders and which forces lead to a ruin of an order.


An economic science theory of the order dynamics deals primarily with orders of the economic process. Within the scope of this treatise, we will see that societal orders are connected in diverse manners, that is, for example, that a very definite order of the economic system can only function properly within the framework of a democratic order of the political system.


Just for these reasons it is expedient to approach also the system dynamics of non-economic subsystems of our society. Such a comprehensive approach is not only appropriate on the basis of the inner connections of the individual systems of order, though. Furthermore, we have to assume that the individual subsystems of our society show common features. For example, Hans Freyer and Arnold Gehlen have coined the concept of secondary systems, which have developed within the last century and clearly differ from the primary systems of the family and the small group. Three subsystems of our secondary system are distinguished here: the cultural, the political and the economic subsystem.


The individual subsystems of the society are not only connected to each other, but have common characteristics, by virtue of these it has to be reckoned with similar laws. But in this case it is also expedient to use approaches of different scientific disciplines to analyse the system dynamics.


If we examine in the following the dynamics of the economic orders, it is primarily about the development of the overall economic system. We have already shown in the representation of the order analysis that an order is composed of a large number of individual elements, that for example, a market economy is composed of a large number of individual markets. Here, it can be useful to examine not only the development of the whole economic system, but also of the individual markets. So was analysed, for example, mainly the dynamics of monetary systems in the context of foreign economic theory and shown which currency systems have to be identified as unstable.



2nd The question of the stability of an order


With the conceptual pair "stable" and "not stable" we have already addressed the first topic of a theory of the system dynamics. The concept of the stability has been coined within the framework of the equilibrium theory. There it is distinguished between the question of the existence and the stability of equilibrium.


We speak of equilibrium when supply and demand correspond ex ante. Ex post correspond offer and demand ex definitione, that means: The offer which is actually distributed corresponds in its value to the actually demanded and obtained goods; supply and demand are ex post nothing else but two different sides of one and the same exchange process.


Whereas the ex ante view refers to the quantity of goods planned by the suppliers respectively planned by the demanders. Here, we can not assume that both quantities correspond always; since the supply and demand decisions are made by independent economic units (the enterprises and the households), it is even probable that the two variables do not coincide, that thus there is no equilibrium, that this equilibrium must be brought about by the market process initially.


In the framework of the equilibrium theory it is spoken thereof that there exists always an equilibrium (is possible) if the supply curve has a point of intersection with the demand curve, thus if a price is conceivable, at which the economic plans of the suppliers and demanders agree with regard to the considered good. The suppliers plan the same quantity of goods as the demanders.



Even if an equilibrium point exists now, this does not mean nowhere near that this equilibrium is headed for from any initial position (thus out of an imbalance) automatically. This problem is addressed by the question of the stability of the equilibrium. It can only be spoken of a stable equilibrium when the market itself, from an arbitrary starting point, reduces the imbalance, thus if an automatic trend to equilibrium is present.


This question of the stability of an equilibrium is of particular importance, since we must assume in reality that data changes occur permanently which lead to a shift in the supply and demand curves, and thus also of the intersection of both curves, so that the question for the stability of the equilibrium, is not only a one-time question, but is raised again and again.


In general, it is assumed that a market has a stable equilibrium because imbalances lead to price variations and these price changes also prompt the demanders to adapt their economic plans to this changed situation.


The prerequisite is, though, that the price reactions to market imbalances take place normally, so that demand surpluses lead to price increases, while supply surpluses lead to price reductions. Such a reaction is not always expectable. Let us take the case that the proportion of the fixed costs, that is to say the costs which arise irrespectively of whether and how much is produced, is particularly high. In this case, a decline in the demand and a thereby caused supply surplus leads to an increase in the cost per unit with the result that the enterprises are striving to increase the prices. Price increases, though, cause the demanders to buy fewer products, although the supply surplus could only be reduced in the case of an increased demand.


Also the responses in supply and demand to price variations must take place normally in order to speak of an equilibrium trend. It can be spoken of a normal demand reaction (elasticity of demand) always when price reductions lead to an increased demand and price increases lead to a lower demand. Analogous to this, a normal supply elasticity is present when price increases lead to supply restrictions, while price reductions lead to a decrease of the supply.


Also with regard to elasticity, we have to expect abnormal reactions sometimes. Let us take the case of the supply of the little boatmen, which have only one small boat, and whose incomes are on the edge of the subsistence level. If a general price reduction occurs, this little boatmen are compelled to broaden their supply, in order to still reach the minimum subsistence level, even though a equilibrium trend ceteris paribus could only be expected if the supply would decline.


The case of inferior goods shows that the demand can take place abnormally sometimes, too. In the case of inferior goods increases the demand at price increases. This reaction is explained thereby that a price increase reduces the real income and that especially recipients of a low-income are forced to shift their demand to inferior products. For example, instead of butter is then margarine consumed, although according to the assumptions the fat price has increased. (We insinuate here that margarine is considered as a less valued product.)


These considerations do not suggest, though, that the theory of equilibrium would assume that equilibrium can be expected at any moment or even in the majority of cases, or that it would be at least desirable for supply and demand to correspond as often as possible. On the contrary, we are assuming that the changes in data that trigger imbalances are desirable in general, as they either improve production technology (= technical progress) or consist therein that consumers adjust their demand to their individual needs. A household notices, for example, that it could increase its benefit if it would correct its previous demand decisions.


The only important thing is that these data changes and the imbalances caused thereby lead thereto that adaptation processes are triggered automatically, which prevent that cumulation and thus a permanent increase of the imbalance occurs. No economic unit has the capacity to tolerate arbitrarily large losses for arbitrarily long time.


Enterprises must file for bankruptcy and therefore leave the market process when the losses exceed a certain critical limit. Where this limit lies in detail depends on the amount of the capital and the creditworthiness of the individual enterprise. The same is true for households, which generally can only get into dept as long as they are creditworthy and / or dispose over assets.


We thus want to remember: a market can only be considered as stable if imbalances are reduced again and again. The stability will then depend in detail on how many data changes are actually occurring, to which extent these data changes lead to imbalances, how quickly and how strongly the prices react on these imbalances and, moreover, how quickly and how strongly supply and demand react on these price variations in normal direction.


Within the framework of the dynamic price theory (theory of the cobweb system) it has been shown, though, that we can not always assume that a continuous approximation process takes place at normal reactions of the market participants. Often the price approximates the new equilibrium in periodic fluctuations, as the approximation processes go beyond their goal, for example, lead to such large reactions in the supply that not only the supply surplus is reduced, but even a demand surplus arises.



In extreme cases, the market may even diverge more and more from the equilibrium point, or oscillate around the initial position again and again like a perpetuum mobile.






At our previous considerations, we referred our examination to a predefined market system with fixed, consistent rules. We can extend, though, our equilibrium consideration to the question of whether the market - the respective system under evaluation - is capable of adapting its rules to the changed situation in a way that the market system remains.


Let us take again the case of a large share of fixed costs. We can assume that the share of fixed costs was generally low at the beginning of the industrialisation, and precisely because of this the supply reacted normally to imbalances. In the course of the mechanisation of the production, the capital intensity of the production was more and more increased, though; with the result that the share of fixed costs in the total costs also increased more and more. We had seen above that in such a situation the entrepreneurs are in turn trying to compensate this increase in the fixed costs by way of price increases and that therefore anomalous price reactions have to be expected increasingly.


In such a situation, the market is no longer able to bring about an equilibrium trend while maintaining the hitherto successful rules, it becomes unstable. It is necessary to adapt the rules to the changed situation, and it will only be possible to speak of stable market systems if these enable such an adaptation of the rules.


In this context, however, a definitional problem of the identification arises. An order system is just characterised by a set of rules. If these rules change, the question arises whether one can still speak of the same system, whether the change of even a single rule means that a changed order system has emerged.


There are two possible answers to this question. According to the scope and quality of the change, it is possible to distinguish between constitutive and accidental changes, and speak of the same order system, as long as only accidental rules have been changed. Thus the order systems show in reality a series of historically determined features, which are of subordinate importance to the equilibrium process. It may therefore be appropriate to distinguish only between changes in the features which are constitutive for the coordination mechanism. However, at this approach remains the problem that in reality the market process has certainly undergone also changes in constitutive features, but nevertheless we are still talking about market processes.


A second possible answer to the identification problem is that each system is understood as a historical structure which, like living beings, has a beginning, continues to evolve and adapts to the changes in the environment permanently and withers away one day. In this case, only at a complete collapse of the market system it would be spoken of the transition from one to another system of order.


Now just the example of the Weimar Republic shows that this approach encounters difficulties also. The market economy system was namely so heavily undermined by numerous dirigiste interventions in the market during this time that it could not fulfil its actual functions any more; from a purely external point of view, there still existed a market economy system, which, however, could no longer fulfil its actual functions, so that in reality a transition to another system was actually present already.


It is therefore expedient to prefer a middle course; one will specify a narrowly defined set of features which are constitutive for the existence of a particular system of order and without these it can no longer be spoken of the same system, nevertheless it can be referred to as a system which has been altered but is still a market economy system, if  the rules have changed in a manner that the adjustment process is ensured.


We have already discussed now that the question of the order dynamics can be made not only for the societal systems as a whole, but also for a subsystem e.g. for individual markets. The problem of the stability of an order can be illustrated very clearly by the development of the monetary order or the foreign exchange market.


After the Second World War, a system of fixed exchange rates with the dollar as the reserve currency was established within the framework of the IMF system (International Monetary Fund). At the beginning of the 70s, this system was replaced worldwide by a system of flexible exchange rates. Whereby a system of fixed exchange rates, the EMS system (European Monetary System), was created in turn for the European countries however, with the ECU as artificial basket currency.


Now it can be shown that the IMF system constituted a remarkably unstable system. The final collapse of this system in the 70s was primarily system induced, thus meaning anchored in the structure of the system itself. In this system, mismatches in the foreign exchange balance, which were triggered mainly by the expansive economic policy of individual countries, are only reduced thereby that merely the non-reserve currency countries were forced to provide for a compensation of foreign exchange balance by the intervention of the central banks on the foreign exchange markets. Whereas the central currency country can reduce a deficit in the foreign exchange balance at any time by expanding its own money supply and by paying deficits with an international currency which is also the currency of the reserve currency country.


This system is unstable for two reasons: One reason is that the member states maintain the right to an autonomous economic policy and want to keep the currency relations constant concurrently. But both of it is not possible at the same time.  To the extent that imbalances appear consistently in the foreign exchange balances due to data changes, can these imbalances in turn be reduced within a liberal system only by adapting either the national price levels or the exchange rate to this changed situation.  In the long term, it is not possible to keep the exchange rate stable while at the same time permitting the member countries to pursue an independent, autonomous economic policy. If the member countries cause foreign exchange deficits of varying degrees by their expansive economic policy, then only the non-centralised currencies are obliged to take care of the reduction of the imbalances by monetary policy measures.


The other reason is, that the central currency country (the USA) had the possibility of settling deficits in the foreign exchange balance at any time by increasing its own currency, and this contributed not only to trigger a worldwide inflationary trend; and since thereby the relationship between the gold reserves of the USA and the international money supply was becoming increasingly diluted, the readiness of the central banks of the non-central currency countries to keep their currency reserves in dollars waned; the probability that the dollar could be converted into gold at any time if required was reduced drastically, with the result that an increasing number of countries - France ahead - were striving to convert their foreign exchange positions into gold. Thus one day the US was forced to stop the free exchange of dollars into gold.


This danger could have been avoided only if the US had voluntarily - without having been forced to do so - abandoned to expand its own money supply by expansive monetary and fiscal policy.


The instability of the IMF system resulted due to even a further reason, though. The circumstance that the central banks of the non-central currency countries are forced to keep the exchange rate on the foreign exchange markets stable by intervention (i.e. by buying and selling foreign exchange) has changed the way of speculation. Now we distinguish in general between stabilising and destabilising speculation. In the case of stabilising speculation expects the speculator, on the basis of an anticipated increase in the rate of exchange, that the exchange rate will fall again sooner or later, and will therefore divest foreign exchange; he thus contributes to the reduction in the rise of the exchange rate and at the same time causes the foreign exchange balance mismatch to be reduced.


Whereas in the case of the destabilising speculation expects the speculator that the rate variations will continue (i.e. that the current price increase lasts), he will therefore already satisfy his future demand for foreign exchange by a presently purchase so that the demand for foreign exchange increases and thereby eventually increases the rise in price. Thus the imbalance increases with destabilising speculation.


Now it can be assumed that a stabilising speculation is predominantly made by knowledgeable brokers, whereas a destabilising speculation can be observed especially in the case of laypersons, whose information on the foreign exchange market is limited. The system of fixed exchange rates now favours speculation among the laypersons. The fact that the central banks are obliged to a stabilising intervention on the foreign exchange markets entails namely that the currency risk at the buying and selling of foreign exchange is extremely low. If namely the deficit of the foreign exchange balance is permanently high, i.e. more foreign exchange is demanded than offered in the long run, then the pressure on the deficit countries will rise in order to increase the official exchange rate since no central bank is able to offer foreign exchange for an indefinite period of time and thereby supporting the hitherto fixed rate.


If one therefore speculates in the context of a system of fixed exchange rates, then the associated risk is extremely low; the worst thing that can happen is that the realignment of the exchange rate keeps waiting. But the increase of the exchange rate will come sooner or later in any case, so one will not experience any surprises in the long run and can therefore divest the foreign exchange, bought before the valorisation, with profit again.


Often it is argued that speculation occurs predominantly in systems of flexible exchange rates, but not in systems of fixed exchange rates. Speculations about exchange rate changes could only be expected if the exchange rate can fluctuate actually. If the exchange rate was completely constant in the course of time, no speculation would have to be expected at all.


This approach misjudges two things. On the one hand, speculation as such does not act necessarily destabilising. This is only true for part of the speculations, namely, the so-called destabilising speculation, but precisely this is increasingly taking place in systems of fixed exchange rates. On the other hand, in a system of fixed exchange rates, it must also be expected that fluctuations in exchange rates are indeed taking place in the short term, so that the exchange rate can only be kept constant in the longer term. Data changes take place in each system; In addition, it should be considered that precisely the fact that in the traditional systems of fixed exchange rates the central banks had the right to pursue an autonomous economic policy which leads automatically thereto that the extents of economic policy measures are different and that just therefore mismatches of foreign exchange balances and by this short-term exchange rate fluctuations are to be expected increasingly.


The thesis that the systems of flexible exchange rates are more unstable because the scope of speculation would be greater at flexible exchange rates, and thus the scope of exchange rate fluctuations had to be necessarily larger than in systems of fixed exchange rates, is therefore wrong, since only a part of the speculation increases the instability and since a system of fixed exchange rates increases the share of destabilising speculation. In systems of flexible exchange rates, however, it is not clear how the exchange rates will develop in the future. Just for this reason, a part of the speculators will be expecting rising exchange rates, while another part will be expecting a falling exchange rate; these differing expectations, though, contribute to reduce the negative impact of speculation.


In favour of a system of fixed exchange rates, it is often argued that international trade could only be expected if exchange rates were largely stable. Only this way could the risk that is associated with foreign trade be reduced to a level that allowed foreign trade at all.


Foreign trade was indeed welcome as it increased the productivity and thus the welfare level of the nations. It was also true that every entrepreneur is taking risks with his productive activities to a higher or lower degree, since no entrepreneur could be certain that consumers will be asking for their products in the offered scale and in the offered quality. The risk in international exchange transactions was much higher than in comparable national exchange deals, though. On the one hand, it would be much more difficult to obtain reliable information from abroad than from the interior. On the other hand, any data change in the world was entering into the free exchange rate, while the national price ratios always refer to only relatively few data changes in the interior. In order to make international trade possible at all, it was necessary that the exchange rates were kept reasonably constant.


This argument does not stand to reason. An entrepreneur who avoids the risk associated with the exchange rate has always the possibility to transfer this risk to others by means of forward transactions. Precisely because the ideas about the further development of the exchange rate are diverging on free foreign exchange markets, there will almost always be traders who are ready for terminations and the risk associated therewith (against a surcharge). A risk-averse importer who expects foreign exchange revenue only for the future period can therefore offer this foreign exchange, which will be arising only in the future, for a known price today.


Both currency systems covered so far are characterised by the fact that price and volume changes are always triggered by variations in supply and demand. The system of flexible exchange rates differs from the system of free exchange rates only thereby that the central banks appear on the foreign exchange markets as suppliers or demanders and that these can influence the currency exchange rate decisively due to their weights.


Now, a part of the economists was sceptical for a long time about the question of whether the price elasticities on the foreign exchange markets were sufficient to bring about a reduction in the mismatches of foreign exchange balance. Now this is a problem that applies principally to all markets. An equilibrium trend is only present if supply and demand are reacting to a sufficient degree to price variations.


Nevertheless, there is a substantial difference between general goods markets and the foreign exchange market. On general goods markets, it is sufficient that supply and demand react normally and that the sum of the elasticities is larger than zero. For foreign exchange markets, however, the tightened condition (the Marshall-Lerner condition) applies, that the sum of the demand elasticities (with infinitely large supply elasticities!) is greater than one.


This difference can be explained by the fact that the price on general goods markets refers to the quantity of goods, but that the exchange rate refers to magnitudes of value. The good traded on foreign exchange markets is the foreign currency; the scale of the demanded foreign exchange depends, though, not only on the number of imported goods but also on the level of the prices at the same time.


If e.g. the foreign exchange rate rises, then emanate two differently proceeding effects on the foreign exchange demand. The demand for imported goods declines in the normal case, but the price to be paid effectively will increase. It depends now on the elasticity of the volume demand, whether the demand for foreign exchange increases or decreases. If the elasticity was just one, then the volume effects and price effects would cancel each other out, and the demand for foreign exchange would remain constant despite the rise in the exchange rate. Only if the elasticity is larger than one then the rising price effect prevails and the currency demand rises as well. The Marshall-Lerner condition applies, according to which there is only an equilibrium trend on the foreign exchange markets present if the sum of the import demand elasticities (of interior and abroad) is larger than one.


What’s more, the question of the sufficient level of import demand elasticities is raised equally for systems with flexible as well as with fixed exchange rates. In the case of flexible foreign exchange rates it is the exchange rate; in the case of fixed exchange rates it is the changes in the national price levels which trigger the adjustments on the foreign exchange markets. Thus the import demand of the interior depends finally always on the national prices of goods. In the system of flexible exchange rates the exchange rate is changing initially, but with it also the amount of domestic monetary units which must be paid for an import goods unit; in the system of fixed exchange rates, the domestic prices are directly changed by means of changes in the domestic money supply.


Thus, if one is convinced that the actual import demand elasticities are not sufficient to bring about a reduction in the foreign exchange balance deficit, then the system of fixed exchange rates fails as well as the system of flexible exchange rates. In this case, a currency exchange command economy is necessary in order to bring about a compensation for supply and demand of foreign exchange.


Empirical investigations carried out in the period after the Second World War seemed to confirm the elasticity pessimism. The sum of the determined import demand elasticities seemed in fact to be less than one, so that the Marshall-Lerner condition did not seem to be fulfilled.


In the meantime, one is more optimistic on the issue of elasticities. On the one hand, it could be shown that the actual import elasticities are greater than originally assumed; the negative results could only be achieved by ignoring the fact that in addition to price variations also quantity variations took place in the observed period.


On the question of the elasticities that are necessary for an equilibrium, attention was drawn to the fact that generally we are by no means able to assume infinitely large supply elasticities in reality, but that at the assumption of finite supply elasticities the sum of the import demand elasticities may be somewhat lower in order to bring about a reduction of imbalances in the foreign exchange balance. A formula developed by J. Robinson teaches hereby about the precise extent of necessary demand elasticities.


To be continued!