Thursday, January 05, 2006

The Paradigm Problem (or why Brad Setser ain't wrong)

In the beginning the earth was without form, and void. And the economists said, let there be GNP based quantitative macro-economics and there was GNP based quantitative macro-economics. And the economists saw the GNP based quantitative macro-economics, that it was good: and the economists divided the GNP based quantitative macro-economics from the darkness.

Gene-money $1.01

It is the mark of an educated mind to be able to entertain an idea without accepting it. Aristotle

There I was on Tuesday night, with keyboard as chisel, trying to bring forth a word sculpture of a good idea. I read it this morning and what had been a fine word sculpture now became an exercise in pedantry (a wonderful word, see definition 2, although I wonder if using the term makes one a pedant?). "Dude," I thought, "nobody but a wing nut like you is going to want to read three pages of ancient Greek mathematics and astronomy to get to the punch line." "Dude," I said back to myself, "I don't even want to read it." OK then, enough showing off, or demonstrating my ignorance, depending upon your perspective, lets go for the cheap laughs, bathroom humor, and get to the punch line quick.

You ever wonder how a bunch of guys can sit in a small room filled with the overpowering smell of stale beer and the farts thereof, watching a game on TV? Simple, after a while the smell just fades into the background. It becomes absent from one's mind by its continuous presence. Of course, if you leave the room for a while and then try to come back, watch out. Let's leave the room, ideologically speaking.

You ever wonder how a culture could cling to an idea like Aristotelian-Ptolemaic geocentrism even when the evidence against it was overwhelming. (how that idea became mainstream is another interesting story, Aristarchus and Pythagoras proposed heliocentric models) Simple, once an idea is entrenched in a culture it fades into the background. Moreover, leaving the room was and still is a very difficult proposition, (channel Giordano Bruno if you doubt me) unless you practice the art of skepticism, quietly that is.

Just recently I discovered a new, to me at least, feature of the NYTimes web site, a search function which accesses a database going back to 1851. So I search "gross national product" and the earliest instance is in 1942. I search "gross domestic product" and the first instance is 1959. Why does this matter? Pick up an undergraduate macro-economic textbook, go on, it won't hurt you, just bore you to tears. I have Dornbusch and Fischer's Macroeconomics but Samuelson's is similar. These texts are based on the primacy of National Income accounting- the classic formula Domestic product = C+G+I+(X-M). GDP, the measure or map IS, according to these texts, the economy or territory and everything from the financial markets to public policy is supposed to be decided accordingly. The concept isn't introduced as one way to consider the issue but rather as the only way, like the geocentric view of the world was 5 centuries ago.

It wasn't always that way. Less than a century ago students of economics or rather political economy might read Keynes' General Theory, Mises' Human Action, or Ricardo or Smith as primary texts. Now these studies, if they are ever pursued, occur after indoctrination into national income accounting. A century ago students of political economy might debate the relative virtues of differing media of exchange, now they simply sing the praises of the US$. Indeed, it seems to me as if that is a good chunk of what economists do now, they sing the praises of a measure (GDP) whose relation to the real world seems an exercise that best recalls the old joke about Scholastics debating how many angels could dance on the head of a pin. Sillier than the joke about the Scholastics is the reality of economists debating dark matter. As Ptolemy might put it, more epicycles anyone?

In theory, it all seems nice. The state would produce a quantitative measure of economic progress, or the lack thereof and policy would be changed accordingly. Ah the seductive siren's song of public policy as science. It's a great idea unless you are the guy or party that has to take the lumps. Guys like George Washington and Cincinnatus who are willing to hand over power are the exceptions not the rule. Most guys who attain power are loathe to reliquish it, or even admit error.

As I noted a few days ago, I'd read Brad Setser's humble Things I got wrong in 2005 with interest. I had read and agreed with the sense of his paper co-authored with Mr. Roubini predicting tough times ahead for the current system of international exchange. But while I was reading his humble admissions of error I wondered if he had really considered the scope of his forecast. It is one thing to argue that Thailand's GDP will fall, as that idea fits within the current paradigm, but quite another to argue that the basis of the whole system is flawed. Just as the language of geocentrism isn't much use when describing a heliocentric system, so too will the language and metrics of national income accounting be of little use when the medium of exchange, on which that accounting is based, is failing.

Looking through his list of self-described errors I see exchange rates, interest rates, yield curves, reserve accumulation and an implicit nod to GDP in the sense of a lack of stress. This leads him to, in my view, confuse a sign of stress, $60 oil, as a sign of strength, in that, according to the metrics currently is use, this price rise hasn't caused problems. To me, the lack of measured stress in the data suggests they are measuring the wrong thing. Of course, having decided in the 70s that GDP must always be rising, except for the odd hiccup, this should come as no surprise.

When Schumpeter wrote about the ground giving way underneath the economists' feet, he was, I contend, referring to this confusion of the map and the territory. While the financial markets, by which I mean to refer to the paper kind, and the GDP based data to which they refer paint a wonderful picture, rising commodity prices, Wars, preparation for more Wars, energy shortages and threats of embargo, and even the rising price of Gold suggest an escalating problem.

Brad, if you read this, I think you and Mr. Roubini are more right that your writing suggests. The only error I see is an expectation that the powers that be would be as humble as you in admitting their error.

Addendum: Winston Churchill famously said, Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened. In similar fashion to Mr. Setser, Stephen Roach of MSDW has nagging doubts-things aren't going the way they should. Yet, within a few sentences of this report, he quickly picks himself up and hurries off. The idea that the statistics are so massaged as to be meaningless in any quantitative model and the markets so managed as to forestall any outcome that might suggest weakness is perhaps too scary for him. The question, in my mind, isn't, when are things going to get bad but rather when will our dire economic condition be admitted, i.e. when will the financial map better represent the economic territory.

ps I was talking to my friend Stephen Plant and he repeated an idea of his that seems pertinent to this argument. He noted that the door to get into Gold was too small for the big money. This has been a problem for the big money guys for years, but not decades. If you manage a few billion $, putting on a commodity trade that will meaningfully impact your bottom line risks moving that market substantially. One could think that this means that the Gold market is too small for the hedge funds. Steve thinks it just means that prices will need to find a level at which the hedge funds can play. I agree. Too much liquidity and too few goods and services.

4 comments:

jeff poppenhagen said...

Dude,

I believe that you have come to the crux of the problem. GDP is largely a measure of consumption. Over the years, however, it has also become a measure wealth creation in the minds of policy makers and the public....which GDP certainly does not measure. This is, in my opinion, the idea that has led to most of the bad economic policies of the past. No matter what, "GDP must not be allowed to fall" has been the rallying cry of most economic policy makers. This has led to obscene credit creation (claims on output)versus real output that will have huge ramifications....most notably in the price of gold IMO.

The economists of the Austrian persuasion long ago understood the differences between output, consumption and wealth creation. In their model GDP growth can be wealth destructive when it is accomplished by the artificial lowering of interest rates so that the incentive to save is crushed and the incentive to consume is elevated. Presto, GDP rises. This, however, has been accomplished at the cost of long-run wealth creation because savings is the driver of investment, productivity and wealth creation. Additionally, the malinvestment associated with the change in the artificial lengthening of the production process that comes with artificially low rates creates malinvestment that must, eventually, be expunged. Sadly, the Austrian voices have been drowned out over the years by the C+I+G+(X-M) cheerleaders. As a result, we now equate consumption with wealth when it is the ability to produce that creates wealth. Tragically, only the Austrians recognize that it is the ability to produce, and wealth creation, that is sacrificed when increased consumption via artifically low rates becomes economic policy. We have now completely stood liberal economic tradition on its head when we define the ability to consume as the ultimate arbiter of wealth. The shock will come with the recognition that productive capability is what generates wealth.

As for your discussion with Mr. Plant, I completely agree. It reminded me of a lunch that I had several years ago with a sell side gold analyst. While this analyst could tell you all about an autoclave and the benefits of heap leaching technologies, he was completely devoid of any ideas about money and credit. During our lunch he realized that I would favor a return to some type of gold standard and he responed by saying that can never happen as there isn't enough gold in the world. My response was that there was exactly the right amount of gold in the world once you slapped another zero onto the price. This is another Austrian concept that has been lost over the years, the idea that once something was adopted as money you never needed any more of it.

As the productivity of money and credit continues to fall due to our slavish devotion to GDP enhancing, but wealth destructive, policies I suspect that more and more investors will understand what the Austrians were talking about and that Roubini and Setser will be vindicated.

brad said...

Dude -- thanks. Alas, I think the combination of oil at $60, massive savings in the oil exporters and exchange rates in the oil exporters that haven't changed since 98 are a big reason why my short-term call was wrong. 06 could be a bit more interesting -- and I still don't think the current int. financial system is built on stable foundation.

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