Causal Loop Diagrams and Economic Systems

We are passengers in time
Lost in motion, locked together
Day and night by trick of light
--The Fixx

Causal loop diagrams improve understanding of complex systems where variables work together in non-linear fashion (Senge, 1990). Feedback loops can be included to capture balancing or reinforcing effects. Let's try our hand at applying causal loop diagrams to economic systems.

Central to all economic activity is production and consumption. Alleviating axiomatic scarcity in resources required for existence and prosperity necessitates production. Production is the combination of labor with tools and materials that generates resources that can be consumed.

Consumption equates to standard of living. When consumption increases, standard of living goes up.

Here is a simple causal loop diagram that reflects the relationship between production and consumption:

The (+) means that production and consumption move in the same direction. The higher (lower) the production, the higher (lower) the consumption (and standard of living). Consumption feeds back to production. Consumption provides metabolic energy to enable future production. When consumption drops off, capacity for production does as well.

Because people have insatiable needs, then production and consumption are likely to reinforce each other over time in an "upward spiral of mankind" sense. But we know this loop as drawn is overly simplistic--other factors can influence this basic relationship in positive and negative ways.

Let's expand the system to account for more variables. While people can produce more by working longer, they can also produce more by being more productive--i.e., when they generate more output per unit of hour of labor.

Higher productivity requires investment in tools and equipment that enables labor to be more productive. Capital investment is only possible if some fraction of previous production is saved rather than consumed. As more is saved, interest rates (the price of borrowed savings) goes down, making it more attractive for tool-making entrepreneurs to borrow. The toolmakers convert some of the savings into capital equipment, and consume the rest (toolmakers must eat, after all). The expanded picture looks like this:

We begin with our original production-conumption loop in the upper left portion of the diagram. Now, however, there is another arrow coming out of the loop from consumption. Saving requires less consumption, thus the (-) betwen consumption and saving. Saving in turn has a negative relationship with interest rates. The greater the supply of savings, the lower the rate of interest on borrowed money (because there is more savings available to borrow).

Lower interest rates mean more borrowing, and vice versa. Borrowing can precipitate either a) capital investment (e.g., investing in tools) or b) more consumption (e.g., using loan to go on vacation).

When borrowing is used for solely for consumption, note that this reduces savings. Also note that saving's siphoning effect on consumption which reduces the 'virtual cycle' effect between production and consumption implied by our initial diagram above. With borrowing siphoning consumption, the production-consumption loop assumes a more balanced posture. We might call the production-consumption loop the 'Existence Loop' as it signifies the basic human process of working to live.

The loop created by borrowing to consume might be called the Debt Loop. When we borrow to consume, we take on debt. Savings are depleted and interest rates increase, which retards more borrowing. The Debt Loop is therefore a balancing loop.

When borrowing is used for capital investment, production goes higher. This is the Investment Loop. The increased productivity realized via the Investment Loop can take the entire economic system higher in reinforcing, virtuous cycle fashion, but only if saved resources are channeled in that direction.

In fact, perhaps the key take-away from this exercise is the critical role of savings in expanding productivity over time. It is readily apparent that if all production is consumed and nothing is saved, then capital investment is not possible.

The above diagram is not perfect, but it provides a sense of the dynamics that define economic systems in their natural, unhampered state.

In a future post, we'll add a final loop to the above diagram to further enhance its realism, and consider the destructive effects of policy intervention in the economic system.

Reference

Senge, P. 1990. The fifth discipline. New York: Doubleday.