Freitag, September 11, 2009

Understanding The Economy...And The Deadly Sin of Economics

This reminded me of the problems in my profession. And why economists really need to get out of academia.

Central to all modern economics is the bookkeeping of the economy. This is codified in what is called NIPA, for National Income and Product Accounts. This defines how GDP is defined and how it should be calculated. Basically, it calculates what GDP is, where it came from, how it is used, and where did it flow. This defines what I like to call the economic tripod: demand, supply and income.

The failing of modern economics is the obsession with one leg of the tripod, that of demand, to the point where most economists, when asked where GDP comes from, more often than not don't understand the question. Yet it is of fundamental importance: GDP, as the Gross Domestic Product of the economy, measures the value added to the economy during a time period. Only value added is calculated in order to avoid double-counting when a product of industry A is used in industry B: the inputs to industry B are subtracted from its end product to avoid counting the output of industry A as part of industry B.

The obsession with the demand side of the economy comes because, basically, it is the easiest to understand. We all know that demand drives general economic growth, and simply being able to apportion this to different categories allows for some elegance and aids in understanding why the economy grows the way that it does.

But it's not the only part of the equation, so to speak.

When trying to generate additional economic growth, which the Keynesian economists see as the panacea for turning economic downswings back upwards and generate full employment, the demand-side economists simply throw money at consumption to equal out the weakness of the markets. This works in the short-term when everything else is equal (ceteris paribus, that beloved phrase of economists everywhere), but fails to address the problem of full employment in the face of structural changes to the economy (which Keynes failed to anticipate entirely, concentrating instead on cyclical problems).

The supply side of the economy, in stark contrast, is where the jobs are actually created: the supply side provides the jobs and it is where structural changes to the economy are starkly apparent. The demand side of the economy ignores these problems entirely, and that is one of the failures of Keynesian policies, which if anything make structural changes more drawn-out and painful than they need to be, as artificially expanded demand for dying industries cannot sustain them and leads to misallocation of capital, which is - or should be - the deadliest of economic sins.

Understanding the supply side of the economy is not really all that more difficult than understanding the demand side: after all, it is the same thing. The sum of demand equals the sum of supply in an economy in equilibrium, with the single difference between the two being income from overseas sources (note: not net exports, but rather money transfers). But it also means understanding that the economy is made up of vastly different businesses working under significantly different conditions and serving specific markets, and that's where it simply becomes very complicated. Not impossible to understand, just complicated. The distribution of the supply side covers everything from agriculture to personal services (at one point one of the classification schedules included, in order, dating services, wedding services and funeral parlors one after the other, showing that even economists can have a sense of humor) and includes something called "imputed earnings of private households" which includes all the services that stay-at-home moms and dads provide (at extremely low wages...).

Understanding what drives each and every one of the the some 500 different industries that make up the supply side of the economy, of course, is a completely different thing than understanding what drives overall demand, which is why the demand side of economics is so popular (and also explains why those who really understand how the economy actually works are supply-side folks, like Alan Greenspan, who spent most of his career before the Fed running supply side models).

The third leg of the tripod is income: this is the most ignored of the three legs, since it appears to be simple accounting at the aggregate level, with earnings and taxes and the like. Generally speaking, it measures the flows of the economy, i.e. ties supply and demand together via people's incomes, since, after all, supply and demand have to be paid for by someone.

However, if you start to take a serious look at incomes, income distribution rears its pointy little head and the fundamental lack of decent data makes it difficult to do serious analysis of who is earning what and at what point in time.

Nonetheless, it is the third leg of the economy.

That is why when looking at things like the $787 bn spending program, it's never enough to figure out how it is going to effect demand. You also have to take a look at how supply and income are being affected, which is where the real hard work in economics lies. Giving people money to buy things distorts demand; cutting their taxes doesn't, since it also creates incentives. One-time stimulus packages can plaster over a small pothole for a while, but giving people a tax break allows them to rebuild the street.

But anyone who only understands the demand side of the economy can't see that they are seeing only one-third of the picture, and unless all three sides are seen and understood - and that is where the work becomes really hard - mistakes will be made, just like a tripod which has only one solid and strong leg will be only as strong as its weakest leg, not the strongest.

If one really wants to address the problems of any economy, let alone that of the US, then the models used need to fully take into account all three sides. While some pay some lip service, they do not really cover all three legs of the tripod. Not because they don't have the technical means to do so: it's because the economics profession lacks the generalists that can see all three and understand them.

It's not something that can be acquired in a couple of semesters, either: it literally takes years, and few are willing to make that commitment, given the obsession of economists, especially academics, with specialization. To paraphrase Robert Anson Heinlein, specialization is for ants: we need the generalist who understands that the economy has three sides and that government policy is made by viewing only one of those sides, and indeed, especially in the case of recent government actions, that something undertaken for the purported support of one side undermines the other two sides, essentially misallocating capital.

Which is one of the deadly sins in economics.

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