Sunday, January 21, 2018

Economics, The Dark Art

We can send Rockets to the moon but we really still cannot understand our own basic economic system.

It is fascinating to me that mankind has yet to figure out exactly how our economic system works. Economists have lots of theories, and indeed come up with new theories every year.  People win Nobel prizes for their theories and yet later on are often proven to be wrong or at least, inaccurate.

At first blush, it would seem that economics is a very simple science.  It is not as complex compared to say Calculus or Physics.  A person buys things another person sells things - it's about as simple as two plus two equals four.  But it is deceptively simple, as it is not just a mere system of exchanges. When you throw in the actions of dozens, hundreds, thousands, or millions of people - or indeed even billions of people - it gets far more complex.

And then when you add in the idea of investing and compound interest and even something called derivatives - term we also use in Calculus, it becomes infinitely more complex.  And it may just be possible that mankind is not capable of understanding its own economic system much as the human brain doesn't have enough memory capacity to comprehend its own structure to the minutest detail.

I have a theory about the latter - and maybe somebody else has expressed this more clearly than I have - that a machine or system is incapable of thoroughly comprehending its own structure.  You can't ask a toaster to describe how it works.  You can't expect a computer to completely and thoroughly understand its own workings.  There always has to be some higher authority who designed and built the equipment that has the understanding of how it functions.

And maybe this is why I am very skeptical of Psychology and Psychiatry or any other attempts to understand how the human brain works.  These are no doubt worthy endeavors, and people are finding out more and more fascinating information as each year passes.  However the idea that we can completely and minutely understand how every aspect of the human brain works, I think, will always elude us.

It is like the laws of quantum mechanics.  You can know the position or the speed of a particle, but you can't know both.  If we, human beings, could understand every aspect of our own human brains, we would in effect become Gods ourselves.   It seems to me to be sort of like an infinite loop or divide-by-zero situation.   I'm sorry I can't describe it more succinctly than that but it's how I feel. Eventually we will hit a wall and will be able to discover no more.

And I think the same is true with economic activity.  Our economic activity is, in effect, an extension of how our brains operate.  And thus, we will never fully and truly comprehend how our economic system works, as we are trying to measure it from the inside out and not from the outside in.  Perhaps if we were aliens in a flying saucer circling the earth, we could quickly comprehend how the Earth's economic system works.  But as people living on the planet Earth, participating in the economic system, our views are necessarily prejudiced by our experiences.  We can't measure economic conditions of humans, without affecting the measurement itself.   Again, quantum theory.

Economics has been called a dark art, or more famously "the dismal science" - a reference to Thomas Carlyle's characterization of the economic theories of Thomas Malthus, who claimed humanity was trapped in a world where population growth would always strain natural resources and bring widespread misery.   Of course, that theory has been proven wrong time and time again, as mankind finds ever new ways to expand food production and increase the population yet further.  The misery thing, he seems right about, though.

Maybe Malthus is right - maybe eventually, just as Moore's Law of semiconductor science hits the wall of the molecular level, there will reach a point where you just can't jam any more people onto planet earth, without something having to give.  And maybe we are seeing that already, with the extinction of species after species, destruction of more and more habitats to make room for humanity and of course, pollution and global warming. Eventually, the planet may become a mono-species environment  - but I think the system would break down long before that.   Dismal science, indeed!

But getting back to more mundane things, like why stock prices do what they do, and how futures and derivatives work, as well as why speculative bubbles not only continue to exist, but have been increasing in number and frequency lately, it seems that we are not getting closer to understanding economic theory, but further away.   Physicists yearn for the "unified field theory" that Einstein postulated - a theory that explains everything - and appear to be closer to this every passing year.  Economists, on the other hand, seem further and further from such an explanation of our behavior, with each passing year.

Of course the granddaddy of them all was Adam Smith - the Newton of Economics.   Just as Newtonian Physics describes the everyday interaction of objects on our planet, Adam Smith's "invisible hand" of the marketplace describes the basic functioning of our economic system.   Newtonian Physics breaks down, however, on the macro and micro levels.   When you start talking about black holes and supernovas, what you learned from apples falling from trees no longer is sufficient.   Similarly, when you study matter at a subatomic level, simple equations like F=ma no longer apply.

And perhaps the same is true with economics, which is why it has spawned the fields of macroeconomics and microeconomics.   And increasingly, we are applying the fields of psychology and things like chaos theory to this dark and dismal art - the only question being, of course is, what took so long?   In terms of human history, the advances in the science of economics seem rather late.  And perhaps our economic system is changing faster than economists can come up with new theories.

And some of the theories of the recent past - which many still think are valid today - seem almost laughable.   Communism, for example, has been shown time and time again to simply not work.   And if you've ever worked in a factory, you'd understand why.  The workers, given a chance to control the means of production, immediately vote themselves a raise and time off.   It is a system that simply doesn't work, yet many today pine for it, still.

Worse yet, others pine for economic systems that are not even systems at all, such as libertarianism or anarchy.   They are just vague ideas from people who don't want to work for a living and are convinced "the other guy" has it on easy-street.  And  maybe that is the problem with our economy and government (worldwide) today - it is up to the average schmuck to determine what our economic system is like, and the average schmuck is going to vote for what he thinks is to his own advantage in the short-term, even though it works against him in the long-term.

And many of these folks decry "capitalism" as a flawed system, not realizing that it is not an external construct imposed on people by political means (as Communism is) but rather the default mode of human operation.  And therein lies the folly of Communism or Socialism or any other political or economic theory that promises to instill order from the top-down.   Even in a Communist country, people operate in a Capitalist way - buying and selling products, legally or illegally, based on the laws of supply and demand.   The Venezuelan government might set an "official" exchange rate for the bolĂ­var, but the real market - the so-called "black market" (which is just a market) sets the real exchange rate.

And it is interesting how the pressures of the marketplace work and really cannot be held back for long.   In postwar Europe, the occupying allied forces imposed price controls in Germany and other countries to keep prices reasonable and prevent shortages and hoarding.  One of the greatest movies of all time, The Third Man, is based on this scenario, in post-war Vienna.   The allied occupying forces tried, to no avail, to shut down these black markets and institute order.   Things only changed when a new commander was appointed who immediately eliminated all price controls.   There was chaos for a few weeks, as people bid prices through the roof, and people were hoarding goods, but eventually, the market reached equilibrium, and shortages and hoarding disappeared, and prices came down due to competition.   This is not a "system" of economics or politics, no more than Newtonian Physics or Quantum Mechanics are imposed "systems" that force how masses or particles behave.  It just is how things work.

The fact that our economic theories - just like our theories about Physics - are incomplete or inaccurate, does not make them wrong, just not finished.   And inventing new ideas out of whole cloth is not the answer.   Communism or flat-earth theory are the same thing - saying things should be so because you'd like to believe it to be so, in spite of evidence and data to the contrary.   It is belief, not science.

And I think people get away with this today because our economic theories are so primitive and incomplete - despite the best efforts of Nobel-winning economists.   Take basic things like interest rates and inflation.    The basic economic theory about inflation has been that if you increase inflation, people will spend more today and prime the pump of the economy.   They will perceive that they can pay off debts in the future with money that is worth less, so they will borrow more now.   They also perceive that goods will be more expensive tomorrow, so they will buy now.  It gets more complicated than that, of course, but from what I understand, it is the general idea.

To decrease inflation, so the theory goes, you raise interest rates - which should decrease inflation:

There are three main ways to carry out a contractionary policy. The first is to increase interest rates through the Federal Reserve. The Federal Reserve rate is the rate at which banks borrow money from the government, but, in order to make money, they must lend it at higher rates. So, when the Federal Reserve increases its interest rate, banks have no choice but to increase their rates as well. When banks increase their rates, less people want to borrow money because it costs more to do so while that money accrues at a higher interest. So, spending drops, prices drop and inflation slows.

The problem I have with this sort of model is that it has been proven wrong time and time again, and also it relies on the idea that the average consumer does this sort of math when making purchases.  When I came of age, we were in an era of "stagflation" which arguably was triggered by the Arab oil embargo of 1973.   Oil prices rose quickly, and in an economy where everything is based on oil, prices rose spectacularly as well.   One of my professors at GMI claimed that in order to make a glass of milk - from the farming for crops, keeping the cows, processing the milk, refrigerating it, and shipping it to stores by truck - you would use the equivalent of a half-a-glass of crude oil.   I don't know if that statement is entirely accurate, but it is probably not too far off.

So by the late 1970's, we had been through several "oil shocks" including incidents where there was no gasoline to be had on some occasions, to the point where we were rationed to buying gasoline on even and odd days, to prevent long lines and hoarding of gas (many people back then had 5-gallon cans of gas in their trunks - sometimes several of them - out of fear of running out.  This was a safety problem, to be sure, and the hoarding aspect added to the shortages).

Inflation was running rampant - by American standards, anyway - at 10% or more.  Unemployment was well over 10% and interest rates were as well.  Mortgage interest was 14% or more - stifling the demand for new houses and tamping down housing prices (which exploded in the late 1980's when rates went down to "only" 10% or so).  Increased interest rates slowed the economy - to be sure!  But they did not tamp down inflation one whit, largely because inflation was due to an external force (the increase in the price of oil) than it was due to increased economic activity.

Despite this experience, however, economists still use these same levers to control the economy based on the same theories - even as past experience has proven them wrong.   More disturbingly to me, it seems these economists drive like old people do here on retirement island - alternately slamming on the brakes and then pounding the gas pedal.   I kid you not about this - we sit on our front porch and see and hear people drive by, the engines on cars going "whooo... whooo...." as they pump the gas pedal as though it were a bicycle or an old pump organ or player piano.   The idea of using the cruise control and going at a nice, steady speed seems to elude them.

Cruise control for the economy - what a neat idea.   Rather than jerk the levers of the money supply and interest rates, gradually control these for a smoother ride.   Republicans complain that the eight years of the Obama administration didn't have enough growth.   Coming off the worst recession since 1929, we had eight years of steady, if not spectacular growth.    Maybe the economy wasn't skyrocketing, but it wasn't crashing, either.

Today, the GOP gets its wish - the economy is taking off based on little more than exuberance.   And if you read the financial papers closely - the articles citing experienced traders and Nobel laureates, you see a pattern.   Most are predicting that the bull market will have to end - and it will end - sometime this year or next.   And the longer the exuberance carries on, the worse this ending will be.

But as others have pointed out, a nice boring steady market doesn't provide the wild profits for a few individuals.   It spoils the whole speculative bubble party!   As I noted in A few win a lot, a lot win few, these ups and downs of the market are excellent vehicles for a few wealthy and knowledgeable people to take a little bit of money (by their standards, of course - like ten grand) from a lot of little people, and make themselves fabulously rich.   Best of all, they don't really "take" the money - we schmucks give it to them with our blubbering thanks.

As I noted before, wealth inequality in our country didn't occur because the rich "stole" it from us, but because we, as a people, decided that having cable teevee or a jet ski was more important than having money in our 401(k).   Read any sob story about Mr. and Mrs. Middle-Class, who are lurching toward retirement with no savings.   Odds are, you will hear comments here and there in the story about how hard they have it, as they can barely make the Harley payments or can no longer go on vacation to Las Vegas to gamble.

You give these folks a chance to vote, they lurch from far-right policies that don't favor their own interests at all - tax cuts for the rich, and gutting the Consumer Protection Agency to the point where it now protects payday lenders instead of prosecuting them.   Once they are fed up with this, Johnny and Josephine Lunchbucket will decide that "guaranteed annual income" and a $15 minimum wage are the answer and vote for extremist solutions of the opposite sort.

And these sort of lurches, from one economic extreme to another and one political extreme to another, seem to be increasing in frequency.   Something has changed in our economy over the years that has affected how we behave.   And maybe social media - the latest iteration of electronic communication - is partly to blame.   In Adam Smith's era, you went down to the "market" with your basket, and exchanged a few ha' pennies for some rutabagas or whatever.  The data available to you as to what was a fair price or not, was somewhat limited to what you saw in the market, or perhaps the gossip you heard down at the well.   Even in the larger markets and stock markets in London, data was pretty limited in terms of availability.

Enter the electronic communications age.  Telegraph, radio, then television.   Now economic data is beamed into every home - and sold in the form of advertising.  Demand for products can be created out of whole cloth merely by repetitive advertising.  But it was a top-down system - a single message broad-casted (thank you very much, Mr. Sarnoff!) from a single source.   Today, we have social media, where anyone can generate a message, which may take off in a viral fashion.   In fact, the description of social media posts as "viral" is fascinating in and of itself.   It describes, in a way, the sort of thing that accompanies speculative bubbles - things just take off, on their own, and get out of control.

So, rather than our economy becoming more and more mature and stable over time, it is doing just the opposite - with more and more bubbles and market ups and downs, with increased frequency.   A mere decade after one of the worst market collapses in the last 100 years, we are sitting on a number of bubbles - which have been clearly identified as such by economists - that are set to burst.  Cryptocurrency, real estate, dot-com stocks, gold - all the usual suspects.   And when one bubble bursts, it likely will burst the others - and take down the overall market, at least temporarily.

And once again, we will ask ourselves, why?   Why did we let this happen?  Why did people blindly believe that some guy on YouTube had the secret answer to fabulous riches?  Why did we loosen regulations just at a time when we needed them most?  Why did we cut taxes to "stimulate the economy" when it was in fact, already over-stimulated?   Why do certain people think that high rates of growth are always a good idea?

Of course, we will never get these answers - or ponder them very long.   We will once again enact new regulations to limit speculation and rein-in predatory practices.   And before long, the people who profit from those enterprises will cry once again that the economy is being stifled by the inability of organized crime to charge the very poor 300% interest on a title pawn loan.

And once more, we go back into the breech!