A brief critique on modern economic thought
A few months ago, The Strawman finally gave into his urge to have a call about Bitcoin. On that call, I remarked that in my mind at least, many of the basic tenets of currently accepted economic thought just don’t make sense. The Strawman suggested that if you say that to people, they look at your like you’re crazy. The purpose of this post, then, is to give a brief explanation of some problems I have with current economic thought.
I, obviously, am not an economist. My understanding of modern economics is thus largely drawn from one course of first year economics at university in 2014, and the subsequent year tutoring said course. I have also recently listened to a couple of audiobooks on Austrian economics as well, which have also had some interesting things to say about modern economics as currently taught in most universities. These books really helped me to articulate some of my thoughts which were just not well formed at the time. As the Strawman will tell you, writing down your thoughts is also a great way to help you organise them further, so this spiel is as much for me as it is for anyone else.
Equations, formulas and more formulae
The first thing that struck me studying economics is the constant use of formulas. Inputs that required multiple assumptions and seemed impossible to measure with any accuracy, were then combined with other such inputs via formulas to give results that were treated with great reverence. While many economic models can be invaluable for comparative analysis, such knowingly incorrect formulae are then often used by economists in the real world to give advice and indeed direction to others in business, investment, and politics.
Some authors have explained this phenomenon as economists having ‘physics envy’, wishing that economics can be reduced to a series of equations with accurately defined answers when in reality economics is more about the response of individuals to financial stimuli. What this envy leads to is that inputs to decision making models are chosen because of their ease / accuracy of measurement, as opposed to their validity as an input. In addition to these problems, the formulae themselves often do not measure what they purport to measure. The final nail in the coffin for me on this point was when I discovered the concept of Utils. This is a measure invented to effectively quantify happiness. This allows us to have happiness as an output (and sometimes an input) in highly questionable equations.
The problems with economic equations are best discussed via an example. I could have chosen a few different formulae here, but for sheer mischief it is hard to go past the aggregate demand (AD) equation as an approximation of GDP.
The Aggregate Demand equation – AD = C + I + G + (X-M)
While the way Aggregate Demand is measured is a bit problematic, the major problem is the level of importance placed upon it. For example, we all know recessions are bad, so we can’t possibly have two consecutive quarters of falling GDP, as then we’d be in a recession, and that’s bad! While I believe (and really hope) that the RBA’s decision making process on interest rate decisions (another future thread) is a little more intricate than this, I am quite positive that the pressure applied by the media / voters on politicians who then also pressure the RBA is NOT any more nuanced. ‘Finance journalists’ are a particularly problematic part of the picture here, many of whom have nowhere near enough understanding of the economy to deserve the first half of their job title, while also lacking the objectivity to deserve the second half.
The idea of the AD equation is to approximate GDP as, in a nutshell, all the stuff we make should be basically equal to all the stuff we buy – less an adjustment for imports/export. I am not sure if nothing ever gets thrown out at the producer level in this imaginary world, or if they make an adjustment for it. The formula itself tells us that we add Consumer spending, Investment, and Government spending before adjusting for net exports.
Consumer spending – this is where I had my first conniption at university. If we want AD (and therefore GDP) to be higher, all consumers must be encouraged to spend as much as possible, and certainly more than last quarter. The more they spend, the better for GDP. Has your rent just gone up $50 per week? Get over it, it’s good for the country! If consumers spend less than they could/should, then demand decreases, and the jobs of the people making the stuff are put in jeopardy.
I have ALWAYS been a big saver. I believe that my saving rate (and investment nouse) will allow me to spend more in future than I would have been able to spend if I just spent it all at once as I earn it. I absolutely believe that any individual’s long term financial position will be improved by how much they save, and I think most people know that to be true. How then, can an economy be in worse shape as people save more if ‘the economy’ is merely a collection of all the people in the economy? Part of this is rampant short-termism, but it also stems from ‘the economy’ not really being treated as the sum of its parts.
This need for constant spending is a large part of why we have this 2-3% inflation target which is my absolute number 1 pet peeve which will be addressed in a future thread/s.
Investment – so if someone makes an investment, like building a warehouse, then that goes onto AD. I have no real problem with this in concept, but obviously some investments are better than others, and the importance placed on ‘Investment’ as an input to AD can lead to questionable grant decisions being made by bureaucrats.
Government spending – According to economic theory, AD, and therefore GDP is increased by not only consumers spending as much as they physically can, but also Governments spending as much as they physically can. There is no adjustment for Government debt, or household debt. In fact, Keynesian economics wants us to believe that Government spending is the greatest spending that there is, because of the ‘multiplier effect’.
The multiplier effect posits that if the government gives you a $1,000 stimulus cheque, you might spend $800 of that on a new bike, the guy you bought it from might spend $640 on a new cricket bat and so on and so forth, stimulating far more financial activity than the $1,000 it cost them in the first place. Aside from the fact that the multiplier effect conveniently ignores where the money came from in the first place (i.e. taxation or increased government debt), it leans heavily on the acceptance that increased GDP is the be all and end all of economic health.
Adjustment for net exports – this adjustment is a little more confusing to conceptualise, so I will leave it alone.
Other pedantic points
While GDP includes paid work, it does not include unpaid work, such as domestic responsibilities. As such, if I care for my kids myself, nothing is added to GDP. However, if I pay someone $300 per day to look after my kids (which is not subsidised because my wife earns too much) so I can go to work and make $200 per day, then this increases GDP and is therefore good for the country! I am rolling my eyes both that these were real figures at one point in my life, and that is how GDP works.
GDP obviously also doesn’t tell us how all this economic activity is spread across income percentiles, or even what it was spent on. There’s also the difference between nominal GDP increases and real GDP increases, and the current trick of having per capita GDP falling while actual GDP is rising so we’re not in a recession (which is bad). Hey presto! If our definition of a recession didn’t involve GDP, would the Government be allowing record high immigration while we have a housing crisis?
Anyway, the point here isn’t to suggest that GDP is completely useless, but that it has a lot of problems. With all the problems that it has, the reverence with which we treat it is grossly misplaced. In my mind, there is a similar story for many other complicated economic formulas.
Factors of production
Prior to my one semester of economics, I had some success investing in residential property. As such, I was interested to hear how real property flowed into the economic equations. At least in the class that I was taught, the factors of production were limited to ‘capital’ and ‘labour’. Real property was just lumped in with capital which, given its importance in my mind, was difficult to reconcile with my lived experience. I have since read other theories on the factors of production which included capital, labour, land and entrepreneurship, which I much prefer. I have no idea what is currently being taught at universities, but the two factor model got me offside quickly.
Investors v Economists
It appears to me that the way prominent investors think about the economy is VERY DIFFERENT from the way that economists think about the economy. Come to think of it, why aren’t more economists very successful investors? Not only are they in the best position to judge what’s coming next because they have all the models, but they know how politicians will react to what is happening next, as they are the ones advising them. It’s like legalised insider trading!
I have listened a lot to people like Ray Dalio, Warren Buffet and Peter Lynch and compared how they view the economy with how economists view the world. They appear to be really very different. For example, three years ago, Jerome Powell said that the M2 level ‘does not really have important implications’, whereas in a recent interview Ray Dalio said that quantitative easing is going to lead to inflation. He didn’t even bother justifying or arguing for his ‘opinion’ – he just treated it as fact because that’s what it is. Interestingly, Powell isn’t even an economist – but I am assuming he has some of them on his staff. Neither is Lagarde – she’s a commercial lawyer turned politician. Michele Bullock and Philip Lowe are both economists, so at least we have sailors guiding the ship.
If we accept that economists and investors view the world differently, then who do we listen to? Do we listen to the world’s top investors? People who, if they miscalculate the incoming economic trends lose their livelihood? I would encourage the reader to read / listen to Ray Dalio discuss how he misunderstood the market’s reaction to going off the gold standard (i.e. Nixon defaulting) in 1971 and how that changed his approach to investing and life in general. Or do we listen to the economists, who are free to make any prediction they like, and if they’re wrong, they get to keep their 6 figure salary and suffer absolutely no consequences at all – they are unlikely to even lose their ‘talking head’ roles.
Ray Dalio has developed his opinions by studying hundreds of years of financial history, while Buffett has developed his financial world view by living through hundreds of years of financial history ????. Economists, in my opinion, develop their opinions from textbooks and models using provably false formulae.
Also, remember that it was an economist who told us that he couldn’t see any reason why interest rates would go up for something like 3-4 years in 2020. I didn’t hear any leading investors saying that they couldn’t imagine any inflation coming in response to unprecedented government spending and printing.
A brief word on Keynes
I don’t love a lot of what Keynes has introduced into the world. However, I suspect even he would be appalled by what the world – specifically the EU and the US at the moment – is doing in his name – like God and The Crusades level appalled.
I must also point out here that Keyne’s much quoted line of ‘in the long run, we’re all dead’ has been grossly misrepresented. This was part of a longer quote, justifying why the economy needed intervention at times, as opposed to total free market economists who believed the economy would always sort itself out again ‘in the long run’. Keynes was NOT saying that countries should perpetually spend more than they earn, print/create the difference, sell bonds to the nearest bond ‘investor’ (or better still, legislate that T-bonds don’t count as debt when held by commercial banks, while also allowing the Fed to buy those securities from the commercial banks which increases their reserves) and keep doing that forever until the economy goes to hell because we’ll all be dead then, so who cares?
Governments saving money in good times (OMG! But what about the effects on GDP!) and spending more money in bad times to reduce the height of the booms and the lows of the busts is just objectively a good idea. It aligns with the principles of good household finance, and to pretend the principles behind good household finance and creating a strong economy are different is the crux of many of the world’s problems. If this is done from a position where the money we need in the bad times is saved first during the good times, then have at it. However, this is not what has happened for some time. The other part of the equation – adjusting interest rates to drive demand levels, rather than allowing interest rates freedom to respond to macroeconomic conditions – is in my view an impermissible interruption to the free market economy. If there had been a history of central banks making these decisions judiciously, or even always being on the same page as the government, then that would be at least worth analysing.
Unfortunately, there is no such history. As a tax accountant at the time, I remember my incredulity as I learned the federal government were extending the Temporary Full Expensing (TFE) Rules (allowing full immediate deductions for assets that businesses usually have to depreciate over a number of years), along with the associated loss carry back rules, for another year AFTER the RBA had started raising interest rates. The government was trying to increase spending, give out more tax deductions, and buy votes, while the RBA was putting on the handbrake.
Summary
Obviously, these are just my semi-educated thoughts. Hopefully we have some economists in the forum who want to leap to the defence of how the country / world is currently run and add some context of which I was not aware.