The Matrix effect or how digitalization shrinks our economy

minimum economy due to total digitalisation

In the movie Matrix, the human being lives in a bath, connected to an umbilical cord that nourishes him and with the brain integrated into a gigantic digital world. Millions of humans live in their hives, without cars, without houses, but perfectly happy in their digital world. If we lived like this, how big would our economy be? The imagined economy would probably be immense, but the physical, the real one, would be minuscule: just the cost of amortization of facilities, system maintenance and nutrition expenses.

This is relevant because there is an effect that, although similar to the substitution effect discussed in the article The Substitution Effect or how technology can destroy wealth, is even more deflationary: the substitution of real products by purely digital products.

The more we digitize our lives, the more we reduce our physical economy. This is a trend that we have been noticing strongly for a few years now. This Matrix effect, let us call it like that, is changing our lives and we are hardly aware of it.

Beyond the fact that no one wants to live in a water tank, is this good or bad?

Like everything else, it has two sides. On the one hand, digitalization brings us more and better services. Everything goes faster and is more efficient. We have access to more knowledge, it costs us less money and leaves us more free time.

On the other hand, as in the substitution effect, digital products and services contribute less to the economy than their traditional counterparts. We watch Netflix instead of going to the cinema, we listen to Spotify instead of buying CDs, language learning apps like Duolingo replace the language academy, Zoom saves a lot of travel and so on and so forth.

This is not a bad thing if it creates new needs and thus new jobs. When their business closes due to lack of demand, the cinema ushers or language teachers may relocate. This is what has happened throughout history over and over again. When tractors emerged, many farm labourers became unemployed but found new opportunities in the urban industry.

If thanks to the fact that I don’t go to an academy, I have more money available and something interesting to spend it on, my euros won’t be lost to the economy.

But what happens if I leave my savings in the bank or repay my mortgage? In the latter case, money disappears from circulation, as we saw in How money is created. It will no longer end on anyone’s payroll. Sooner or later, someone will be underpaid or fired. The sum of many people who are paid fewer causes my company to sell less or do it cheaper. In both cases, my salary will go down as well.

One may argue that the Internet creates many new opportunities and new businesses: the world of video games, streaming music, dating apps, social networking, e-commerce that brings products to far-flung places. But in the end we always find that a digital service cuts out the middlemen and, even if we pay for it, it will be a modest amount compared to what we used to pay academies, cinemas or record stores.

Digitalization creates technological deflation. As in the other cases discussed (deflation due to platforms such as Amazon or the substitution effect), there is an increase in services, but also a net reduction in billings. The economy shrinks, less money is in circulation and, consequently, lower wages or fewer jobs result.

If we take the substitution of real products and services by digital equivalents to the extreme we find our Matrix citizen, who enjoys all the services imaginable in the digital world, but doesn’t earn a penny in real life.

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