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.
