Sonntag, Januar 25, 2009

Understanding The Economy ... Or Maybe Not

I'm an economist, have been one for over 20 years. We do several things: we try to understand how the economy works, and our fundamental truth is that goods are scarce, that all needs cannot be met by simply deciding who gets what. I'm a business economist, which means that I work in the real world, not academia. I do more in a month than some colleagues in academia do in a year, but that's because I'm not a scientist: I work in the real world, and while I use scientific methods and approaches, I don't have time or the inclination to turn each product into a PhD thesis. I've been a professional forecaster for close to 20 years, forecasting industries and their development, and recently, for my sins, have branched into demographics. I've saved clients literally millions of dollars by providing risk analysis for their model portfolios and simply getting things right. I don't have a PhD: I decided that was, at best and pun intended, an academic exercise at best.

Now, over at Shrinkedwrapped, a discussion has started up about Moore's Law, Information Economy and Socialism.

Let me add to this discussion.

The economy is best understood as structure and mechanism. Any economy, and I am deliberately including the gamut from the most primitive and the most advanced economies on this planet, has three sides. This isn't usually taught in your basic Econ 101 courses, because it's not all that simple, and the point of any introductory econ course should be - but often isn't - to introduce the new student to how economics works (the mindset) and understanding the basics of modern economics, the National Income and Production Accounts (aka NIPA).

And please do understand that I am simplifying enormously. Getting into detail is what I do every day in my job, and I work with enormous data sets, long time periods and more computer models than most can shake a stick at.

These three sides of the economy are demand, supply and wages.

Demand we understand well: that's consumption, investment, trade, inventories. That's what makes up GDP.

Supply is a tad more complicated: it's where the value is added. It covers the entire production side of the economy, where things are made and services rendered, where food is grown and people are buried. In the parlance of one classification system, it's from A to O, from agriculture to personal services, excluding only things that are very difficult to capture, such as the production of services in private households (the value of ironing and sweeping floors, of raising children and mowing the lawn yourself) and the "value" of production in supranational organizations like the UN or the IMF in the individual countries covered.

Wages are not simply wages, but also transfer income and wealth effects.

The fundamental thing to understand is that the separation of the economy into these three areas is an intellectual construct, because in reality they are different approaches to and different aspects of one and the same thing: the economy, the sum of what we all do each and every day to earn money and pay the bills, and more often than that every night as well, where we spend the money we've made.

Now, economics generally teaches that the first part of this triad is the most important thing, but that is simply not the case. It's just that it's the easiest one to understand, the easiest to teach and the easiest to see changes in.

A well functioning economy needs to have all three aspects of the economy working well. If an economy has imbalances in any single aspect, the results will show up in the other two, but because of the indirect effects, causality will be very poorly understood. This is very important, since someone who only know one aspect of the economy well - most economists, as there is enough there to generate literally thousands of PhD theses - will seek the causality of problems where they feel comfortable doing so. Like the drunk looking for keys under the street lamp, instead of in the darkness across the street where he lost them, he simply is unable to look in the right place.

The supply side of the economy is where really good economists live (okay, I'M biased, it's where I call home...). They're the ones who understand the minutiae of the economy, where value is actually added, and understand all the businesses that make up the economy, how they operate, what makes them possible (and profitable!), what they actually do (sometimes easier said than done...), and what is important to them in terms of laws, regulations and, most fundamentally, how they react. This is where Greenspan was at home, where he made his reputation.

You see, it's not enough to see how consumption changes, how private households change their consumption behaviors under changing circumstances, but you also need to see what that means for those who supply the goods and services consumed.

But let's get back to the third aspect, wages and income. This is the realm of labor economists, who more often then not are employed by unions and the like and have thus a certain taint, unjustly deserved (except for those whose partisanship has trumped their profession). This is also the most difficult of areas, since you have to know the government programs for transfer income quite well, as well as wealth effects for the upper income levels that can be several multiples of actual wages and salaries. This is also covered under NIPA, but getting into the details can be a complex exercise in accounting and an even more complex one in terms of corporate profits, bond yields and the wild and woolly world of private equity.

These three aspects of the economy are tied together by mechanisms. There are, of course, literally millions of such mechanisms, which is all about how the economy actually works, and these mechanisms, be they channels of information, operating parameters, or the way that goods and services are exchanged or performed.

My basic analogy - and bear with me, since I want to take you along a difficult path and I am simplifying this enormously - is that of a mechanical watch (I collect vintage watches and moderate the Vintage & Pocket Watch Forum at Watchuseek, aka WUS, the largest watch forum on the Internet, with over 40 thousand members and 1.5+ mn posts).

Consider how a mechanical watch works: a mainspring drives a gear train that is controlled by a balance that controls the gear train to show the time accurately.

I'm not going to bore you with details - join us over at WUS for that - but suffice to say that this is an analogy of also how the economy works: the driving force behind the working of the economy is demand, but without the gear train - supply - and the escapement - wages - the thing simply doesn't work, and the accuracy ot how the movement keeps time tells you how the economy is working efficiently. Get anything wrong in the design of the movement and you'll never get the rest right (the problem of command economies is that you can't simply tell the hands to move); if you've got the right design, but keep on fiddling with the gear train, replacing this wheel with that one, the actual work doesn't get done; if you've got the design right and the gear train is working smoothly, but the balance wheel has too much or too little amplitude, then the watch is going to tell lousy time.

This is a simplistic anology (and needs a lot of work before it's right: it's something I've been thinking about for a while, but never have really put into so many words), but it's a clear one: if you don't have all aspects of the economy down right, things are not going to work as planned. If the movement/economy is not efficient, you'll find yourself winding up the mainpsring a lot, but doing more work than you really need to; if the gear train is missing teeth or if the ratios are wrong, then timekeeping won't work well; if things get dirty and gummed up, then the watch slows down and stops, and if you keep on using the movement when it is dirty and inefficient, you can actually destroy the movement as the oils and lubricants pick up dirt and change from lubricants to cutting agents. And perhaps most importantly, little problems left unattended can ruin the movement, but it may take, literally, years of use before the movement freezes up and must be either completely rebuilt or simply replaced. Of course, this applies to the economy as well, with one major caveat: you can't simply replace the economy, and rebuilding because of negligence - and its bad cousin, deliberate and willful negligence - turns out to be more expensive for the economy than it is for the watch owner. Most importantly: a properly designed movement can, with the right maintenance, run over 100 years or longer (and there are literally hundreds of thousands of such movements our there) without losing its time-keeping qualities.

No economy works perfectly and without friction. The mechanisms for transferrence of money, work, and products are manifold, to use an obscure meaning of that word, and are impacted in ways both clear and immediate and obscure and slow. Causality in the economy is never simple and the law of unintended consequences was really invented for economics.

I guess what I am trying to say is that it's not easy to understand the economy as a whole. Classic economists, those whose bread and butter are the arcane minutae of the NIPA, show no small disdain for the supply-side economists, and indeed a great deal of disdain has been dumped on these poor souls for daring to point out that it might be simpler and more efficient to look at the supply side of the economy than it is to try  to get the balance, to use my anology, to change amplitude by working on the mainspring (which, if you're curious, simply can't happen) by changing structures by trying to shunt demand in one direction or another.

What is perhaps easier to understand is what sort of damage can be done by not understanding the mechanisms by which the economy works. The fundamental mechanism is that of markets, which in the real world are ruthlessley efficient and work in ways that even the best economists can not say with great accuracy (not that they don't say it with authority). Fiddling with market mechanisms is foolhardy at best and downright ignorant at worst: market mechanisms have a proven track record of defeating attempts to change their fundamental workings, and every attempt to by-pass them simply doesn't work. To put it in the vernacular: Markets rule.

Unfortunately, this is what has happened. In the deeply misguided attempt to make poor people rich - by letting them buy houses that they can't afford without them, well, stop being poor - the government meddled with the market mechanisms by turning off risk. This alone is an enormous moral hazard, and has failed abjectly. It's the fundamental cause of the destruction of literally trillions of dollars, and unfortunately for us all the lunatics are not only in charge of the asylum, they're now working on making insanity the norm, rather than the exception.

So bear in mind when discussing the economy: it's one hell of a lot more complex than you can imagine and it always finds a new path of getting supply to demand. The market mechanisms are ruthless and broke no competition, not because there are no other ways, but rather because efficiency is everything to an economy. The law of unintended consequences is the ruling law of the economy, and it's not so much that you can't anticipate what they will be - they'd then be anticipated consequences, after all - but rather they will be in areas completely unexpected and more likely than not result in the nullification of what you wanted, especially if you are trying to do something dumb.

And for the folks over at Shrinkwrapped discussing the information economy: it's not that simple.

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