Modern economics in one word

This is an important distinction that we need to grasp in economics, this division into macro and micro: obviously, meaning large and small. [Didact: Wrong. There is no distinction. But we'll get to that.]  But in more detail, macro is trying to explain the movements of the economy as a whole, what's about to happen to interest rates, foreign exchange, growth or unemployment. 
And as I've pointed out previously and recently we don't actually have enough computing power to be able to plan our economy. We don't even know what utility function we would be trying to solve if we did have that power. 
Trying to predict an economy is obviously a less intensive task: it doesn't really matter whether we have the right equations that we're trying to solve, that they work is good enough for us (and there really are people doing this sort of thing. Some good portion of HFT in the financial markets is people just trading correlations because they seem to work. They've got no idea why they work and the profits often disappear after a few weeks as the correlations do but people really are doing this). 
So, say we raise interest rates, we expect GDP growth to slow. We know there're (at least) two effects going to happen: debtors have to pay more in interest so they'll cut back on other things. But obviously savers will get those higher interest payments and so will have more to spend. We think that savers will save some portion of those extra payments thus there will be a drop in overall demand. 
But the point it that we don't actually know that this is true. We think it is, we've observed it a few times (and it's stunning how little empirical evidence we really have in this field. In any detail, for perhaps 30 countries over 5 or so business cycles over 5 or 6 decades - and that's about it, a very slim evidence base to construct an entire science upon) and it accords with what we think theory is. 
But we're still open to being confounded on this. To change the example a little we would expect people to save less money in a higher inflation environment: might as well spend and get something rather than see your savings losing their value. Yet savings rates tend to go up in even medium (ie, 5 % and above) inflation rate circumstances as people, well, no one's quite sure what they think they're doing. We can construct a story to say that they're trying to maintain the absolute value of their savings but who knows? 

Our models that we are computing this macroeconomy forecast with are based on all sorts of lightly observed linkages from our scarce evidence base and as we saw above, absolutely none of them managed to predict a recession when it was only months away. Or, if you prefer, we're just not very good at this macroeconomics stuff. 

As to how I predicted the US recession at least, that was simple. I just listened to Dean Baker (a lefty but still a good economist) who entirely ignored all that macro stuff and instead pointed to a piece of micro. 
There's something called the “wealth effect”. When our assets, stocks, houses, whatever, go up in value we tend to spend more as we feel richer. This is why house price booms raise GDP. But crashes obviously put that into reverse and Baker pointed out that the 2006 or so real estate crash in the US destroyed some $8 trillion of household wealth: of course we're going to have a recession as households reel from such a blow. 
On top of this scanty evidence-base problem for macro we also have a very sketchy command indeed of theory. I'll agree that I'm not omniscient in the subject but I'm unaware of any (I do mean any at all) statement of macroeconomic theory that you could get all macroeconomists to sign up to. 
For instance let's take two that are commonly thought to be true: Firstly, the Keynesian idea that if you're in a recession you ought to try to use fiscal stimulus (government increases the gap between what it collects in taxes and spends in the economy, bridging the gap by borrowing) and thus increase demand. This shocks the economy out of a low output equilibrium into a higher output one and Hurrah! we're no longer in recession. 
Hmm, well, the Austrians would say that the recession was caused by previous malinvestment and we've got to liquidate that first (and they've a point, the pre-2006 housing boom was in part fed by the fiscal stimulus applied to avoid a recession after the dotcom bust) before we can grow again. Real Business Cycle peeps will say that prices will adjust near immediately so don't screw that up by government action (as will the New Classicals to an extent) and Scott Sumner is probably right when he says that it doesn't matter because the central bank will adjust monetary policy so as to balance whatever government does with fiscal policy.
There is a very good reason why modern macroeconomics doesn't seem to make the slightest bit of sense. That is because, of course, it really doesn't. At least, not if you're paying attention to "mainstream" economic theories.

As the author of this El Reg article points out, there are many different competing theories as to why the global economy is in such a massive funk. What he fails to point out, perhaps because he lacks sufficient knowledge of and background in the subject, is that there are schools of economics that are much more accurate than others. 

The school that he references in passing, the Austrian School, is actually the only major school of modern economic thinking that is truly consistent, and that has anything like a full explanation of the Business Cycle. This term simply means the series of events that we seem to keep repeating between and during economic booms and busts.

If you will indulge me for a moment and allow me to assume that you have no idea what this means, I will endeavour to explain it, briefly. (For a far more comprehensive, detailed, and entirely correct explanation, I refer you to Vox Day's Return of the Great Depression.)

Essentially, the ABCT revolves around the idea of time preferences. Intuitively this is a very simple concept- it is the value that you and I and everyone else places on current versus future consumption of something. It is an entirely subjective value- the worth of a root beer float to you is quite different to its worth to me, on any given day and at any given time. Generally speaking, if you have high time preferences, you prefer immediate consumption to future consumption- a root beer float is worth far more to you right now than it is, say, six months from now.

Every one of us has what are called "natural" time preferences for various things. Those time preferences are influenced quite heavily by, among other things, interest rates- in other words, the cost of borrowing money. That cost of borrowing money will also influence how much future production of any particular good or service will take place, since producers of said items need to figure out how relatively expensive various factors of production will be in the near versus the far future. This exact purpose is served by the term structure of interest rates.

If those borrowing costs are left to adjust freely and easily based on the innumerable wants and needs of the individuals who make up the economy, then there can be no misalignment between what producers anticipate will be the future demand for their products, and what consumers are willing to spend.

However, if those borrowing costs are tinkered with- by, say, a central bank looking to significantly increase current consumption and thereby drive up some statistical measure of economic growth- then a significant misalignment occurs, and it gets worse as the meddling increases.

Eventually, the mismatch becomes so severe that there are no consumers with the funds available to buy the vast stockpile of goods that producers have created- and let us note that they have done so with finite and sometimes irreplaceable resources. At that point, a severe liquidation process takes place, and economic growth and production severely contract as producers desperately try to get rid of the oversupply of unsaleable stuff that they have put into the market in the misguided belief that there would be buyers.

The ABCT therefore places blame for business cycles quite squarely on the government- which is precisely where it belongs. The beauty of the ABCT is that it makes no distinction whatsoever between "micro" and "macro" events- the entire structure of ABCT starts and ends with the individual.

Contrast this with the nonsense that is neo-classical "macro" theory. This starts with the standard guff about "aggregate" demand versus "aggregate" supply- as if you could somehow aggregate millions or billions of different demands for the same good into a single unified curve, and as if you could separate out producers from consumers, when in reality they are one and the same.

Modern macroeconomics has been turned into a highly mathematical and statistical subject by people with a severe case of the academic equivalent of penis envy- they would dearly like to be taken as seriously as mathematicians and physicists are, so they turn the entirety of macroeconomic thinking into a series of ridiculously convoluted mathematical equations that operate on extremely shaky assumptions.

And then they come up with some brilliant prediction and are inevitably left scratching their heads when the same prediction blows up in their faces. It is not for nothing that Paul Samuelson- the grandfather of modern macroeconomics- once quipped that "economists have successfully predicted 9 of the past 5 recessions!".

The reason that modern economics is such pants is because we have abandoned the simple ideas and principles that the Austrian school is built upon, and have instead resorted to mathematical mummery and hand-waving to explain phenomena that, ultimately, simply cannot be explained using mathematics.

We would be far better served as a species if the entire discipline of economics, as it is currently defined, were abandoned entirely, and we started over from first principles.

Perhaps then we would rediscover certain basic truths: that government interference in the economy is always and everywhere a nuisance; that welfare-statism is ultimately self-defeating; that free trade is a deeply flawed and ultimately unsustainable idea; that a central bank is quite simply an agent of chaos and destruction; and that the single best way to ensure economic growth and prosperity is simply to leave people alone to the greatest extent possible.

These are the teachings of the Austrian School of economics. They are not complete, and they sometimes run into certain rather unpleasant realities about race and genetics that many Austrian scholars would rather we ignore. But on balance, there is no better way to describe real-world economic interactions than the Austrian School. If we turned back to it, perhaps we would be able to prevent a repeat of the (currently ongoing) financial crisis and Second Great Depression.

Comments

Popular Posts