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.