Wednesday, December 7, 2016

The shortcomings of Economics (and yes, it is once more about Trump…)

It will come as a surprise to exactly none of my regular readers (all two or three of them) that I am not especially fond of the discipline (I refuse to refer to it with the more exalted adjective of “science”) of Economics. After finishing my MsC in industrial engineering I halfheartedly pursued a degree in Business Administration for three years, but the sheer lack of structure and outright irrationality of the field (and the growing demands of my day job, it has to be said) finally made me to give up and shift my attention to other interests (although more than ten years would pass before I came back to academia, this time to pursue a PhD in philosophy which only this year I completed). It may be argued that trying to obtain a degree in a “social science” (a hodgepodge of some tidbits of knowledge successfully hidden within tons upon tons of half-baked opinion and crass ideology with no regard whatsoever for any semblance of “objective truth”, to the point that the very same concept of truth is utterly discredited and suspect) after getting one in engineering is like trying to bang a 10 $/hour hooker after successfully dating Giselle Bündchen (not that I especially fancy Ms. Bündchen, but I hope you get the idea). Be it as it may, I pride myself of being an intellectually curious guy and to follow whatever train of thought may help me to better understand the universe we inhabit, wherever such pursuit may lead me (I was also a victim of the dominant narrative, originated in Marx’s thought no less, that holds economic relations are somehow the “real” explanation behind how the world works).

As anyone who has ever held an unpopular opinion may readily concede (I hope a position most of my readers have experienced sometimes), being subjected to a constant barrage of dissent can make even the staunchest and sternest believer waver in his beliefs, so after more than a decade hearing from every reputable opinion maker how Economics is the “queen” of the social disciplines; how its epistemic status is undisputed and any other discipline aspires to reach its lofty position; how elections should be decided by the economic content of the platforms (“it’s the economy, stupid!”); how the more or less economic literacy of a candidate (or his/her advisers) should be the most important factor to consider when deciding who to vote for; how the economic impact of any election (most markedly in recent times in the cases of Brexit and the Colombian peace deal between the government and the FARC) should be the first aspect in people’s minds; I hope I can be excused if I say I felt gently pushed (or, more accurately, almost bludgeoned to death) to reconsider my initial distrust and even open scorn for the field and  give it a fresh new look.

Now, when I say “a new look” I don’t mean “let’s read a couple Wikipedia articles, peruse some issues of The Economist and weekly glance at the salmon press somewhat nonchalantly”. May be the way Economics was taught in the University I attended was just not good, maybe I was missing the real deal, and was just for all practical purposes unschooled, and thus my distrust was just a product of my ignorance. So, having made a firm decision to remedy such potential source of error, I went back to The Wealth of Nations (I had read it as moral philosophy, and wanted to check on the labor theory of value as seeming quite foundational for the whole field of Economics), to Ricardo’s Principles of Political Economy and Taxation and to Stuart Mill’s Principles of Political Economy (yup, the good ol’ Classical economists were not the most original of men when it came to giving titles to their works). Wow, wow, wow, you may say, that’s really old stuff! Nothing to do with how Economics has evolved and how it is taught in modern schools! I know, I know, just bear with me for a little longer. I just wanted to have a better grasp of how this kind of thing started, so I also read Steuart’s Enquiry into the Principles of Political Economy, Hume’s Essays having to do with economic issues (“of Money”, “of Interest”, “of the Balance of Trade” and “of Commerce”) and (more recently) the Tableau Économique by Quesnay. I’ll get into more detail about what I learned and what I think of such foundational works (short summary: mostly a befuddling mix of tautologies and wishful thinking), but let’s continue with what I did to ensure I was not judging the august body of knowledge unfairly: I then moved on to the neoclassical thinkers, reading Marshall’s Principles of Economics (interesting that the “political” part had been dropped), Jevons’ The Principles of Economics (that charming originality when it comes to titles, again) and Pigou’s The Economics of Welfare. All of them served as an appetizer for Keynes’ The General Theory of Employment, Interest and Money (with the Essays on Persuasion thrown in the mix just for fun). 

Still old news, and not much used to shape the economic thinking of contemporary students! Yup, I know, so after having gone through those mostly forgotten texts I went right away to Samuelson and Nordhaus’ Economics (not the latest edition, it was the eighteenth, printed in 2007, so it may have been updated -indeed, some of its final policy endorsements and criticism of fiscal policy vs. monetary seems way outdated), Friedman A Monetary History of the United States, 1867-1960, Becker’s The Economic Approach to Human Behavior (which, btw, I’ve repeatedly said is literally the worst book I’ve ever read) and then mostly papers and articles (of note was Coase’s The Nature of the Firm, from which I’ve profited nicely in my current line of work), as I couldn’t find any more books of similar standing to convey a good, comprehensive overview of the discipline.

There may be some picky reader that would object that my understanding of the field of Economics is still incomplete or not up to date enough (please feel free to leave your suggestions of what else I may read to correct such deficiency in the comments section or, not to put it too politely, STFU), I may only add that in sixteen years as management consultant(followed by five years as a C-Level executive in a multinational firm) I’ve been exposed to what a wide array of companies (mostly big corporations, with an oversized impact in their countries’ GDP) do to maximize their benefit and decide what to produce, how to distribute it and how to report it to the (mostly unsuspecting and hapless) public, so I honestly don’t feel like any professor may school me substantially in how a modern economy actually works.

Hoping to have stablished good enough bona fides for what is about to be said, let’s review a short selection of the problems I see with how the field of inquiry has been shaped from its inception:

The shape of Demands to come

The basic unit of analysis for Economics is supposedly what people “want”. When they get what they want they derive satisfaction from it, and such satisfaction is also known as “utility”. Thus, the maximization of utility is posited as the main goal of any rational being, and the means for such maximization are the consumption (or rather the acquisition) of the mix of goods that would yield the maximum utility. Such understanding of humanity is hopelessly flawed, and based on a purely circular logic (note that utility lends itself admirably well to maximization by being an unmeasurable quantity that just happens to be expressed as a function of what we consume) that leaves no space for things like being in a stable, fulfilling relationship, enjoying a clean environment, being in good health (rather the opposite, good natural and spontaneous health is a source of disutility, as it prevents us from spending in medicines) or enjoying a good book or music from the local library (which has costed us nothing).

But let’s leave aside for a moment the essential incompleteness of the economic understanding of men’s motives, and try to delve a bit deeper in how such understanding can at least be useful to model (and thus predict) at least some elements of people’s behaviors. According to economists (in their neoclassical, or marginalist, interpretation) the utility that people derive from the acquisition of a particular good is a function of how many items of that same good it has already acquired, so the value that a person would assign to adding one more item to its existing stock (hence what he would be willing to pay for it) can be calculated by just knowing the amount he already has. To be more precise, in the majority of cases it will be a decreasing function, as additional units will be less enjoyable, less useful (or producing less pleasure), thus less valuable. In the arch-famous representation devised by Marshall, the “demand curve” has a downward slope:
Seems intuitive enough, right? Unfortunately, a cursory reflection shows that this is not, by a long shot, how people think of most of the things they do, let alone about the things they buy. First, although it may make some sense for commodities (those items that are interchangeable, exactly alike) like loaves of bread or gallons of tap water, it doesn’t work so well for the growing percentage of purchases in a knowledge economy that are not commodities, like information or unique experiences (what is the value of purchasing a book you have just read or a song you have just downloaded and copied? It may very well be zero; what about a travel to a unique location? Ditto, after being there and ticking it off from your bucket list you may very well not want to return in a number of years… the demand curve would then be a single step, with a certain value for Q=1 and zero for every other value of Q). If you are a collector, the additional items of a certain category that you acquire to complete certain areas of your prized collection may not have a decreasing marginal value to you, but an increasing one. And finally, depending on the moment of the day, of the lifecycle, and the location, exactly the same item may have very different values to the same person, regardless of how many of those he already has (like the proverbial bottle of water after an exhausting workout in the gym that makes your regular bro be willing to pay three times the normal price, regarding of how many more he may have in his home’s fridge). In sum, the demand curve is an invalid construct as it does not “explain” in any meaningful sense neither an individual’s choice (how many money, or effort, he would be willing to forswear to obtain an additional unit of a certain good) nor the collective one (it can not be aggregated to guess how much a whole group would be willing to pay for a certain amount of said good, as it doesn’t accurately reflect the real value for any of the members of the group at any value of Q).

My own experience tends to confirm such uselessness of the model. After having covered the basic concepts of supply and demand in one of the subjects (“economic organization of production”) within the syllabus of my engineering training, I was mildly surprised that none of the companies I worked for had the slightest idea of what the demand curve for their products was (starting with my employer, a consulting firm, ad going through all my clients, be they telecommunication companies, utilities, industrial conglomerates or consumer products manufacturers). They did build predictive models of how variations in the price of their different product lines would affect the amount they would be able to sell, but they all had to resort to a host of additional variables that gave very little (if any at all) weight to the total amount they and their competitors poured in the market (or the amount their clients may already have).

OK, so may be Economics has not been very good at coming with a simple model able to predict the amount of any merchandise that clients may buy, no big deal as such imperfect model may still be useful when combined with the (similarly flawed) one used to predict how much of each merchandise the producers will supply. Fat chance, but that forces us to turn to

Supply and the supplyin’ suppliers

In the neoclassical model, consumption decisions are made by consumers (duh!) of each commodity in accordance with the demand curve. What about the decisions that determine how much of each commodity will be manufactured (and thus offered in the market)? As you may imagine, for symmetry’s sake an elegant model was devised to define how much (how many items) of any merchandise will be produced, based on how much it costs to produce the latest item (that is, the only variable taken into consideration is how many items are produced in total). Since the beginning it was supposed that each additional item would be more costly to produce, as it would require additional units of the different inputs that went into its production that would eventually interfere between them (in what has been considered an almost universal law of nature: the law of diminishing returns), so the equivalent of the demand curve would be a “supply curve” that would slope upwards:
Again, any person that has actually managed a production facility would scratch his head seeing this, as normally the opposite of what it depicts is the case: up to a certain extent (where you have to expand your facilities, incur in additional costs for new plant, machinery and labor and thus give a big boost to costs), the more units you produce the cheaper you can sell them, because you have more units between which to distribute your fixed costs and thus the average cost per unit (which consist in the sum of the variable cost, that tend to be constant per unit within certain range, and the fixed cost divided by the number of units produced) goes down with the increase in units.

As with the demand curve, I’ve seen (and led) complex projects to help my clients set up cost accounting so they could better understand how much it costed them to produce each unit (at the margins or not), and I can tell you that the total amount produced was the smaller of the contributors, dwarfed by the cost of the raw materials, labor, communications and transportation, amortizations (depending on the industry) and other financial costs. Yup, in the long term all of them could be treated as variable, but the production decisions are rarely taken “in the long term”, the problem managers have to solve is how much to produce (and what resources to commit) in the shortest of terms, in the next shift, in the current fiscal year, given the overall business cycle. So unsurprisingly nobody cares a iota for the classical supply curve (heck, nobody would even know what their supply curve, understood as the marginal cost of producing an additional unit based only on the total level of output, is).

So we have a theory which neither does adequately model how people make their purchasing decisions nor fares any better modeling how firms make their production decisions. What could go wrong? Of course, when you put those two together (technically adding every consumer’s decisions to create an “aggregate demand” curve, and doing the same for every producer’s to create the “aggregate supply”) you get the mythical spot where demand equals supply, and which defines the price at which the market “clears”: if the price is a bit higher, being above what consumers would pay for that amount the unsold inventories would pile up and force producers to reduce their output; if the price is a bit lower consumers would snatch up the existences, creating scarcities and inducing manufacturers to produce more. Which I dare to say is a big load of balderdash, and does not reflect what has ever happened in a market in the whole history of the human race (well, that may be too strong a statement, may be the pork bellies futures’ market in Chicago has some time or other seen such miraculous coincidence happen). To a certain extent, even economists recognize the very limited applicability of such model, as they proffer it is only valid to describe the expected behavior of “perfectly competitive markets”, which are again as doubtful of ever having existed (with the aforementioned exception of pork bellies futures) as the tooth fairy or the Easter bunny.

Let’s stop for a minute to take stock of where we stand. We have a theoretical framework that professes to be of some help to decide the “best” use of limited resources that have alternative uses (“best” being the one conductive to a greater sum of individual utility for those involved in the enjoyment of the products of such resources), but such framework is defective when it comes to decide:

·         How to allocate our (limited) consumption budget (i.e. what to consume)

·         How to decide what quantities to produce

·         How prices are set (and thus, if the price level is adequate, fair, conductive to a just distribution of the social effort, etc.)

Such is life. However, that is the realms of microeconomics, which sometimes is compared with the nebulous relationships postulated as much as observed between the evanescent entities of quantum dynamics. It may be similarly said that even though we are not very sure of what it is that we measure and predict when talking about an elementary particle’s spin or mass or momentum, but when we just blindly apply the model and solve the equations what comes out happens to coincide surprisingly well with how the world (at a macroscopic level, amenable to measurement) behaves. Stretching our analogy, when we put together the simple but powerful models of supply and demand and apply them to the goods market, the labor market and the money market we obtain the triple equilibrium (or general equilibrium) that actually describe how a modern economy works…

Balancing the balances (it’s not Karma, it's even better!)

Do not pay attention to the inconvenient fact that almost not a single market works according to the dynamics of classical supply and demand. If there are markets that deviate from such model, they surely are the market for salaried workers (labor market) and the market for means of payment (the money market). Hell, even most goods are either subject to heavy regulations or offered by a very small number of suppliers that can exert an unduly influence both in the amount of merchandise offered for exchange and in its price. But that doesn’t prevent the whole field to have swooned over the stroke of genius of linking together precisely those three types of exchanges:

Just brilliant, now you really understand how the total production of goods and services of an economy (national Gross Domestic Product), the price level, the employment rate (more or less dictated by the total hours worked), the salaries paid, the amount of money in circulation and the interest rate all relate to each other, and by varying one of them you know how all the other variables may vary. Wow! Really something. When I learned about all this I really wondered why there were still cyclical depressions (I learned it in the early 90’s, quite dire times in Europe although the USA were beginning its longest recorded expansionary phase). And do you know what the answer is? Pick at random literally any post by Paul Krugman in the NYT and Ken Rogoff (latest one in the Grauniad: The dark side of Rogoff) and you will soon find out. Keynes may have been a respected genius, but nobody knows how to separate heads from tails regarding his brilliant insights, and none of the models built after them has stood too well the passing of time (the stagnation of the 70’s is widely understood as having driven the proverbial last nail on the coffin of standard Keynesianism, thus what we have today is “neo-Keynesianism”, which battles with neo-Fisherism and neo-monetarism and a bunch of other old novelties for a supremacy that never seems to be attained for long). None of the above presented curves is really known (by any accepted methodology), so really the best prediction of how much a country’s GDP may improve if we raise 1%the interest rate is anybody’s guess. The best prediction of how much we could reduce the rate of unemployment by the same raise? Anybody’s guess. The best prediction of how much inflation we would have if we increased aggregate demand by a certain amount through public purchases, or public investment in infrastructure? You already know the answer: anybody’s guess…

Not surprising, giving that the elementary components used to build the integrated model are, each of them, highly dubious and of questionable validity. Even calling them “models” is a misrepresentation, as all they really are are attempts to pass as a continuous function (represented by an equation, unfortunately one whose terms are never known) what is nothing but a bunch of individual, isolated observations which only seem to share a regression coefficient (something that really we, as observers, impose on the data, and not something we could claim the data present us with).

But what, then about the brilliant mathematical models that the discipline has developed and that have been empirically validated? Every time I hear such comment I tend to ask what models are we talking about, because what I’ve mostly read in the more detailed, supposedly more advanced literature are “ghosts” of functions that are differentiated (and equaled to zero to find their maxima or minima as if that was a highly esoteric, highly respectability-enhancing procedure that could stand for the lack of true understanding of what kind of relationship they were supposedly revealing) but about whose underlying nature very little is actually said or presented as evidence (the worst offender in this area is, as far as I’ve seen, Becker, whose debunking would merit a post of its own). But from a ghost of a function, from the formal structure of what a function would look like (but with very little actual content of what it actually poses) very little can be either predicted or actually measured. No kidding the falsifiability of most economic theories has proved so hard, and all the “neos” I mentioned before have shown such a resilience, regardless of how many economists have come out saying they had been thoroughly disproved.

However, how much of such disproving has actually succeeded will be the subject of a future post, along with how such failure indeed explains in part the success of Trump in the latest USA presidential election.

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