Thursday, April 10, 2008

The Economist's Brief on the Current Financial Turmoil

[The following was sent to The Economist magazine concerning their 'briefing' of current turmoil in the finance industry (22 to 28 March issue). - PEB]

Sir, - Your recent briefing on the current financial turmoil (March 22 to 28, 2008) was excellent, but solidly within the conventional wisdom. And herein lies my concern; this same conventional economic and financial ‘wisdom’ has led us all into this mess. We need to look deeper if we hope to understand its causes, and thereby avoid recurring and probably worsening repeats. In my view, at least four underlying issues have set the stage for this present mess but have not received much analysis as this crisis develops.  

First, over the past twenty-five or so years, we have seen macro-economics morphed into a sort of ‘bigger’ or ‘combined’ micro-economics. There is a radical, qualitative difference, however, between the micro and the macro perspectives. A sound macro economic view sees more than simply a repetition of micro-, or firm-level issues. The causes for the collapse of Bear Sterns’ or Enron or Barings included more than just intra-firm misconduct (chicanery, greed, accounting fraud, slipshod managerial oversight, etc.) That optic sees only the humanness of the players; whereas the dynamics of the financial sector as a whole have become flawed.
Investing has become increasingly a global casino of arcane games of chance. But it is not mathematically possible for every one to win the lottery or beat the average. When financial regulators see their role mainly as keeping the players, especially big ones, from going bust, they have lost focus on their more fundamental duty to the economy as a whole, namely ensuring an efficient and effective financial sector which fosters and assembles savings and then channels these savings into real investment and growth.

Second, the very language of financial discussions now generates more confusion than clear thinking. In the same article, we drift from ‘banking’ to ‘retail banking’ to ‘investment banking’ to ‘finance’ to ‘financial services’, with these terms being used more or less interchangeably. But they are not interchangeable. There is a real difference between ‘retail banking’ and ‘investment banking’, between a checking account and some shares of stock, between a hedge fund and an insurance policy. Unfortunately, these real differences get run together when the same firm does them all. Worse, they become increasingly less important to the regulatory authority as the process of regulation drifts more and more toward the firm or micro-level perspective. These differences are still real and still there; only, now, there is the additional problem of cross contagion - inherently risky activities undercutting the market(s) for investments which on their own merits are sound. (Observe the current situation with municipal bonds.)

Third, there is a common misconception about so-called ‘free’ markets. The function of any market is not to allocate resources but to clear supply with demand and transfer ownership. A ‘free’ market does this by (1) allowing whoever wishes to enter the market and transact, and (2) allowing the price to move up or down in order to “clear” the desires of buyers with sellers.
Resource allocation, on the other hand, concerns how a society determines what specifically to produce and, therefore, how to allocate its limited productive capacity. This is a more complex process, involving much more than buying over here and selling over there. We should not assume, therefore, that greater allocative efficiency will flow simply from more efficient markets; nor should we assume that widening access or tolerating greater price volatility will automatically make a specific market either more efficient or more effective.

Finally, the accounting practice of ‘marking to market’ has over the past decade invaded the financial world like the Spanish flu! As any one who bought Dutch tulip futures or certificates for land in Mississippi or stock in a knows so well, what goes up today may not go up tomorrow also; it may even go down!. And as the investors in Paribas’ funds found out, exit provisions can be nothing more than empty words. ‘Marking to market’ introduces fantasy into the balance sheet. As I said above, it is not mathematically possible for every one to win the lottery. It is not possible for all of us to withdraw our money from the bank. No market can clear a fundamental disequilibrium between buyers and sellers. By allowing this ‘creative accounting’ to become a standard practice in the financial industry, regulators have in effect leveraged up the herd instinct and made the whole sector more volatile.  

‘Marking to market’ also mixes up the concept of flow (income statement) with that of position (balance sheet). If I own a pork belly contract and the demand for pork bellies is on the rise, my balance sheet puffs up, but my income doesn’t change. Even when I cash in on the higher value of the contract, and then spend the new wealth, I am spending capital gains, not income! And if the price turns down, I experience a capital loss, not a fall in income.  

It is not hard to see how these issues reinforce each other. We are in a real tangle. There is no safe haven to ride it out; we’re all in it together; and we’re not likely to get through it either quickly or painlessly. It seems to me the wise thing to do, for our own sake as well as that of our children and grandchildren, is to face the facts squarely, to keep our heads clear and cool and un-ideological, and to dig down to the root causes which have got us into this mess, not just flirt about with quick-fix responses to some of the effects.  

Let’s face it. Some sort of public regulation of economic life is, paradoxically, necessary for a free society. An ideological myopia on ‘free markets’ can in its own way be as destructive as central planning. “Creative accounting” is fiction disguised as financial statements. And when discussing the economy and how to fix it, we should speak and write thoughtfully, with care and precision. This is, after all, a pretty important subject.

Paul E. Bangasser
Viejo San Juan, Puerto Rico

Tuesday, February 19, 2008

Too Good to be True

Sherlock Holmes and Lt. Colombo both teach us to look to the small things if we wish to understand. It is not the broad generalizations but the small details that contain the clues to unlocking complex riddles in life.
The New York Times’ financial section on 12 February 2008 carried an article on the spreading ‘subprime crisis’. The article mentioned two specific personal cases, Don Doyle in Northern California and Brenda Harris in North Las Vegas. Both these areas have been hard hit by the subprime crisis. Here is what the NYT tells us about Don Doyle.

“An example of the spreading credit crisis is seen in Don Doyle, a computer engineer at Lockheed Martin who makes a six-figure income and had a stellar credit score in 2004, when he refinanced his home in Northern California to take cash out to pay for his daughter’s college tuition.
“Mr. Doyle, 52, is now worried that he will have to file for bankruptcy, because he cannot afford to make the higher variable payments on his mortgage, and he cannot sell his home for more than his $740,000 mortgage.
“The whole plan was to get out” before his rate reset, he said. “Now I am caught. I can’t sell my house. I’m having a hard time refinancing. I’ve avoided bankruptcy for months trying to pull this out of my savings. ...
“In refinancing their home in 2004, Mr. Doyle and his wife were doing what millions of other homeowners did in the last decade — tapping into the rising value of their homes for home improvements, paying off credit card debt, college tuition and for other spending.
“The Doyles took advantage of the housing boom by refinancing their home nearly every year since they bought it in 1995 for $275,000. Until their most recent loan they never had a problem making their payments. They invested much of the money in shares of companies that subsequently went bankrupt.
“Still, Mr. Doyle does not regret refinancing in 2004. “My goal was clear: I wanted to help my daughter go through college,” he said. “It wasn’t like it was for us.”

Brenda Harris is featured slightly less in the article but has her picture in front of the house she bought in 2006 plus a video link. From the photo, Brenda is Afro-American. Here is what the article tells us about her.

“Home prices in the North Las Vegas neighborhood of Brenda Harris, a technology analyst at a casino company, have fallen 20 percent to 30 percent. The builder who sold her a new three-bedroom home on Pink Flamingos Place for about $392,000 in 2006 is now listing similar properties for $314,000. A larger house a block down from Ms. Harris was recently listed online for $310,000.
“But Ms. Harris does not want to leave her home. She estimates that she has spent close to $40,000 on her property, about half for a down payment and much of the rest on a deck and landscaping.
“’I’m not behind in my payments, but I’m trying to prevent getting behind,’ Ms. Harris said. ‘I don’t want to ruin my credit.’
“In addition to the declining value of her home, Ms. Harris, 53, will soon be hit with a sharply higher house payment. She has an option adjustable-rate mortgage, a loan that allows borrowers to pay less than the interest and principal due every month. The unpaid interest gets added to the principal balance. She is making the minimum monthly payments due on her loan, about $2,400.
“But she knows she will not be able to pay the $3,400 needed to cover her interest and principal, which she will be required to pay once her loan balance reaches 115 percent of her starting balance. And under the terms of her loan, which was made by Countrywide Financial, she would have to pay a prepayment penalty of about $40,000 if she chose to refinance or sell her home before May 2009.
“She said that she now wishes she had taken a traditional fixed-rate loan when she bought the home. At the time, she asked for a loan that could be refinanced after one year without penalty. She said her broker had told her a week before the closing that the penalty would extend until May 2009 and that she reluctantly agreed because she had already started moving.”

At first glance, Don and Brenda seem to have much in common. They are about the same age, early fifties and therefore thinking probably about retirement. Each seems to have a pretty good job; and each got caught in a financial trap with a mortgage now higher than the current market value of the house which guarantees it, meaning they are in negative equity, with the mortgage payments increasing. They seem pretty representative of the thousands of others caught in similar situations.
But their stories also have significant differences when we look at the details. One obvious but unstated and never mentioned difference is that Brenda is both black and female – two strikes before she even gets to the plate.
There is also a major difference in these two different investments, even though each is its owners’ home. Mr. and Mrs. Doyle are speculating repeatedly on the rising value of their house in order to finance ‘investments’ in high-risk stocks. In short, they’re gambling. They have “refinanced nearly every year since they bought their house in 1995 for $275,000.” That means on the order of ten re-financings! They said they did it to finance their daughter’s college education. But what did they actually do with the money? They “invested ... in shares of companies that subsequently went bankrupt.”
There is a saying: “If it sounds too good to be true, it probably is.” Did the Doyle’s really believe their house’s value would increase by about 300% within a decade? (Nine years, actually. Less than a decade!) That’s simply too good to be true. They borrowed against their home about double what they originally paid for it; and within nine years had jacked up their debt to three times the initial price of the house. There’s another saying: “Never bet the ranch.” This is just what they did.
Had they taken these re-financings, paid off the original mortgage, and put the rest into even very conservative investments, they would now own their house free and clear and have well over half a million dollars of assets, providing quite nicely for their daughter to go to college as well as their own retirement.
While no doubt they did genuinely and sincerely want to send her to a ‘good’ college, and while no doubt they told themselves (and others) this was their objective, it doesn’t explain their conduct. This is what J. A. Schumpeter calls “the teleological error’, thinking we understand the causes of some human action by focusing on the actor’s purpose(s).
Let’s be honest. The Doyles were leveraging their home to gamble, with the game of choice being the stock market. And gambling is as addictive as tobacco or liquor or marijuana or cocaine, and potentially as destructive. Playing the stock market the way the Doyles were playing it is not about investing. It’s about the visceral thrill of seeing your stock jump in trading value; it’s about being part of an ‘inner circle’ of savvy players; it’s about having talking points at cocktail parties and Little League games; it’s about looking in the mirror and thinking “Yeah, I’m cool, too!” But it is not about building up a nest egg for one’s retirement. Someone planning and preparing seriously for the future doesn’t repeatedly mortgage their home to the hilt in order to put the money into speculative stocks.
That strategy doesn’t work. For every buyer, there must be a seller. For every winner, there have to be losers sufficient to generate the winnings. Actually, there have to be more losses than winnings because the house also gets its cut. It is not mathematically possible to everyone, or even most players, to win the lottery
Let’s not put all the heat on Don Doyle. He couldn’t have done this on his own. There were clearly bankers and financial advisers and stockbrokers involved, although the article doesn’t mention them. These were the ‘professionals’ who should have been able to see that Don’s game couldn’t go on. But they were likely getting fees based on each trip round the musical chairs. So why be the party pooper?
Brenda Harris’ case is quite different. Brenda only bought her house in 2006. With her good employment status, it is not clear why she got into such a convoluted mortgage instead of a more straightforward “Fanny Mae” mortgage. But then, after we see her picture and then learn about her getting hustled into double the penalty period she was expecting, we learn that the mortgage company was ... you guessed it ... Countrywide Financial!
Now the pieces fall into place. Given her gender and race and finance provider, there was no way Brenda Harris was going to get a Fanny Mae prime mortgage. Brenda wasn’t playing the market; she got played by it!
Both Don Doyle and Brenda Harris were, to some extent, victims of their own desires. Don wanted a quick and painless ride into wealth. Brenda wanted a crack at the American Dream. Each of them got his or her window of opportunity, went for it, and took the plunge. But as they dove, each made the same error; they put to sleep their natural sense of caution and critical judgment. Each slipped into the logic of hearing what they wanted to hear, of seeing what they wanted to see, of believing what made them feel good to believe. Verifying facts, seeking independent qualified technical advice, demanding full disclosures: these basic rules of prudence got buried under the hubris.
Both Don and Brenda will now have a devil of a time getting out of their fix. My sympathies go to them both, although rather more to Brenda than to Don.
I wish I could offer more, and be hopeful. But if I look honestly around, I don’t think I can. Today’s Financial Times carried an article about the US government’s Pension Benefits Guaranty Corporation – a sort of FDIC program for private company pensions – quietly deciding to shift its portfolio mix by doubling its “riskier assets such as equities” and “alternative investment vehicles including hedge funds”. Then, down inside the article, towards the end, came the explanation. “Last year the equity portion of the corporation’s investments returned 16.5 per cent while the fixed-income portion returned just 3.4 per cent.”
That sounds exactly like Don Doyle’s strategy, only writ larger, much larger. 44 million workers have their pensions relying upon that safety net. Yet an average annual return of 16.5% is simply not sustainable. You can get it on paper and on a small scale from time to time. But not in hard cash on a regular basis over several decades and for 44 million pensioners! That’s just too good to be true!
We should learn from Sherlock Holmes and Lt. Colombo! When we look honestly at the details, it is clear we can’t go on like this. The way our economy currently works is not sustainable.

Thursday, December 13, 2007

#6 The Economy Doesn't Exist

We hear often about “the economy”. Some specific indicator – the stock market, employment or unemployment, interest rates, balance of trade, balance of payments, etc. - is up and this is good for “the economy”, or down and thus bad, or vise versa as the case may be. The author always means something much bigger and broader than this or that specific indicator. Yet one hardly ever finds a definition of this elusive thing called “the economy”. It is sort of like the ‘heffalump’ of Winnie the Pooh – everyone knows it is out there but no one can tell us just what it is.

Adam Smith, the father of economics, which has as its object the rigorous and systematic study of the economy, gives the following definition:
“... that great but expensive instrument of commerce (his Great Wheel) by means of which every individual in the society has his substance, conveniences and amusements regularly distributed to him in their proper proportions.”
[Wealth of Nations, Bk. II, Ch. 2]

Smith spent considerably more effort elaborating this Great Wheel metaphor than he did on his more famous Hidden Hand. To Smith’s credit this circularity notion was a major step forward from the simple accumulative notion of the predominantly mercantilist thinking of his day. But is this image of a Great Wheel supplying each of us regularly and proportionately with our “substance, conveniences and amusements” adequately capture what we mean by “the economy”?
I suspect not. In ordinary conversation, “the economy” covers more than the production and distribution of the goods and services we each consume. It includes in addition those things we consume collectively - defense, civil order, cultural events, although the economic aspect of these collectively consumed products may be relatively secondary. It certainly also includes the creation and then putting to good use of the many tools and machinery and infrastructure needed to carry on these directly productive and distributive activities. Most people, I think, would also want to include at least some aspects of things like participation in economic life, about freedom to choose the form of that participation, about sharing in the fruits of economic activity, about the effects of economic activities on other aspects such as the environment, about the implications of economic decisions today upon future generations, etc. In short, we instinctively see “the economy” within the context and from the perspective of our overall society.

This is as it should be! Like war not being left to the generals, the economy is too important to be left to economists. So we need to find a broader definition, one which draws the mind to include these wider, contextual aspects of economic activities.

Consider the following passage from the philosopher Bernard Lonergan:
“(Humans) strive in many fields: they organize human society by politics and war; they orientate their lives by philosophy and religion; they augment knowledge by science and perpetuate intuitions through art; they cool passions and regulate equity by law; they protect and hasten health by medicine; and generation succeeds generation in this heritage of culture through the testament of education. All of this is a rhythmic transformation of natural potentialities by human effort; none of it is, strictly, economic activity. Yet conditioning all culture and inextricably confused with it, there is the economic factor. Governments must have budgets even when they do not balance them; religion and law must have their churches and courts, their books printed and housed, their ministers trained; art needs its materials and its galleries, science its laboratories, medicine its hospitals, education its far-flung hierarchy of schools, colleges, and universities. Thus, the material fabric of culture’s living home is economic, and underlying this superstructure there stands as foundation the purely economic field concerned with nourishment, shelter, clothing, utilities, services, and amusements.”
[Collected Works, Vol. #21, “For a New Political Economy”, pp. 11-12]

This vision of economic activity seems to me to capture better what most of us instinctively mean by the economy. First, It locates “the purely economic” field into its relationships with other human activities. Education, arts, law, religion, medical care, politics, war, governance: each of these distinct domains not only depends upon the “purely economic” as a general foundation but also includes at least some economic activities within its own dynamic. In other words, all the various fields of human striving both rest upon and also include within themselves at least some measure of what we ordinarily mean when we say “the economy”.

Second, this vision of the economy keeps us grounded in the wholeness of human life. Like an individual, a society cannot be healthy in one part while sick in another. It is quite possible to have a broken leg and a healthy liver. Notwithstanding my healthy liver, the whole me is still suffering from the broken leg. Similarly with a society, it is foolish to think that a dysfunctional judicial or educational system is not affected by the economy, or vice versa.

Perhaps a better way to conceptualize the economy would be to look at it similar to the way we look at color. On its own color doesn’t exist. We can see that an object, say an apple or a shirt, is red; but in each case its color is only one aspect of the object. We can find other things which also have this aspect of “redness”. We can formulate the notion of color and define meaningfully “red”, “green”, “blue”, etc. But we can never find color itself, on its own; we can only find the aspect of color embedded into something, along with all the other aspects which make that thing that thing and not some other thing.

In a similar way, “the economy” is only one aspect of human life. The so-called “purely economic” dimension of any society will be very much affected if that country is, say, at war. The quality and coverage of education profoundly affects future economic activity. The law of the land establishes and enforces notions of property and contract, both of which are essential social foundations for economic activity. Religion gives substance and specificity to Smith’s “proper proportions” for distribution of the fruits of collective economic effort. In short, the “purely economic” domain is as affected by the other domains of human activity as those domains are affected by the economic. Indeed, the very idea that there exists a “purely economic” domain is as much a collective fiction as is the notion of color.

Like the apple or the shirt, human society is an integrated whole (albeit an extremely complex one) and “the economy” is only one aspect of it. Any discussion that abstracts out a single aspect of this whole and then holds that aspect up as though it were independent of these other aspects is necessarily incomplete, and therefore potentially dangerous. While this collective habit is tolerable for purposes of analysis and efficient discussion, when we move on to synthesis and remedieshe perspective must move back to embrace the whole social organism, not just a part of it. Otherwise we can get into trouble, like the sorcerer’s apprentice.

Because of convention and custom and easier communication, we will probably continue using the phrase “the economy”. Still, we ought not forget that we are talking about more, much more, than just GDP. After all, the economy on its own doesn’t actually exist.

Thursday, August 16, 2007

#5 - "Soft" vs. "Hard" Money

The financial press has been busy recently with “sub-prime mortgage funds” and how some hedge funds in this sector are getting “into trouble” because of it. A recent article reported about the French bank Paribas refusing to pay off some hedge fund participants in “its” hedge fund in this risky area who wanted out. Yet, as Sherlock Holmes and Inspector Colombo teach us, the interesting evidence is often what is NOT said or what did NOT happen.
If I read the article correctly (the phrasing could be taken in more than one way) Paribas "declined" to honor withdrawal desires of some weak-hearted investors on the argument it could not "fairly value" these investors' interests. In other words the market for the assets which these investors owned a share had frozen up, like a stock having its trading suspended. There was therefore at that moment no orderly and smooth-functioning market (in Paribas’ opinion, at least); so “marking to market” was impossible and these investors’ “fair share” couldn’t be calculated.
I imagine they were given this news very politely; but it takes us back to some basic issues about “investing”. First, consider the following situation: Joe sells a thousand widgets to Harry for $5 each. Assuming that Joe doesn’t have to sell nor Harry to buy, does this mean that my 100 widgetts have a "fair value" of $500. Well, sort of, for the lack of any other way to get a number for their value. But it is basically a “soft” number, not something upon which I can rely.
Instead of widgetts, lets talk about something real. Suppose a neighbor sells her house for a tidy sum; and I extrapolate what I think my house might bring. This is the kind of mental arithmetic we all do, but it can only yield a “soft money” figure. Maybe my house would raise this much, and maybe it wouldn’t. We’ll never know, unless of course I actually sell it. But then it would not longer be my house. The amount I own on my credit card, on the other hand, is “hard money”. There it is month after month earning interest and waiting to be paid in full – very precise, very concrete, very real.
“Marking to market” - that is, extrapolating from a transaction involving something over here in order to get a valuation for another asset over there - can only produce a “soft money” figure. The best this can ever be is an estimate – maybe reliable, maybe not. No investor should ever loose sight of that fact.
A second basic point often overlooked is the issue of getting out of a placement if things go poorly, as indeed this case shows they sometimes do. The Paribas investors discovered their exit required a “normally functioning market” which would sustain the calculation of a “fair market value”. Yet it just such times as a very un-normal when you are likely to want out. My hunch is the formal documents, even if they did in fact say something about exit, didn’t specify meaningfully what “fair market value” means nor how or by whom it was to be designated. So the Paribas investors were actually in a situation where exit was at the discretion of the fund manager, who also has a vested interest against exit. When the market for that fund’s assets went crazy, the fund manager simply said: “Sorry ... no exit! I can’t do the numbers.”
This reply by the fund manager, although it is self-serving; is nevertheless logical. “Hard money” and “soft money” don’t have the same values, whatever the accounting arithmetic says. If there isn’t a market, there isn’t a valuation. Paper profits come and go; but cash has no “soft” edges, no fuzziness. There it is - blunt, concrete, unambiguous. This is another basic principle any investor should keep in mind.
Indeed, a thinking investor (as distinct from one who is siimply following the herd) will have learned from Sherlock Holmes and Lt. Colombo. It is not just what the perspectus says that counts; it is also what the perspectus doesn't day.

Thursday, March 8, 2007

#4 - Markets

Consider a word one hears often in discussions of economics and the economy – “the market”. Markets, meaning a physical place where sellers and buyers congregate and transact, have been around for millennia. Virtually every town of any consequence has had a market for livestock, grain, fresh produce, wool, whatever was produced or trafficked in the area. These are the kinds of markets Adam Smith had in mind in his Wealth of Nations.
As economic activity and economic thinking evolved, the word “market” has become applied to more abstract “products”. The first “stock market” started out beneath a tree in Amsterdam. Lloyds of London was originally a coffee house where those interested in buying and selling insurance contracts congregated. In some respects, these nascent markets resemble the boys playing football in the park I mentioned in an earlier blog (#3). People gathered at the tree or in the coffee shop because they were interested in what happened there and they also wanted to “play”. However, and like the boys, they were not strangers to each other; they lived within the same society, probably went to the same churches and schools, knew each other’s family background and friends etc. In addition, they understood the same technical language of joint stock companies or of insurance. And, as with the boys, it is easy to underestimate how important this social fabric is for their market to function smoothly.
A market needs more than just willing buyers and sellers. It needs a shared ethic, some kind of collective code of conduct. It needs a language to give precision and mutual understanding about what exactly is being bought and sold and what precisely are the terms of the transaction. The market needs a means to identify and qualify would-be participants, so that different trading parties know with some confidence whom they are negotiating with. Finally, and perhaps most tendentious, every market needs an effective enforcement mechanism, to demand respect for the code of conduct, to clarify and settle differences over terms and conditions, to require specific performance, to verify the bona-fides of the participants: in short, to keep the market running smoothly.
This is what a market economy is about – smoothly functioning, transparent and open markets, with sensible and reasonable regulations firmly and consistently imposed. But this is often not what we hear in the public dialogue. Under ideological banners of “Free Markets” and “Free Enterprise” we hear calls for what is really de-regulation, which is something rather different and deserves its own analysis.
As a concluding point, it seems worthwhile clarifying just what a market is supposed to do for the society, as distinct from what it does for its participants. One often hears that markets “allocate resources”. In fact, this is not correct. The function of a market is to “clear”, to bring supply and demand into harmony. When all the various markets of a society are “cleared” then the society itself (or at least its economic aspects) are “in equilibrium”. Whether or not this “equilibrium” is also the “most efficient allocation of resources” is, like de-regulation, also another question deserving its own examination.

Tuesday, March 6, 2007

#3 - Social Consensus as a Precondition for Economic Activity

When I was a boy, I often went to the park to play “sand-lot” football. Soon after school had restarted and the Fall season settled into its rythm, a number of us kids would gather after school on a big grassy field in a nearby park and play football. About fifteen to twenty boys aged roughly eight to twelve; only boys, never girls! Weather permitting (never something assumed lightly in Seattle), we would gather about 4 o’clock and play till dark or dinner time, which ever came first.
There were no grown-ups around to be "in charge”. The “field” was simply an open grassy part of the park, no lines or markers, no “permission” to be sought or granted. There were no regular “teams”. The sidelines and goal lines would be marked out with strategically place jackets or sweaters or bikes. Since there were no goal posts, we simply did away with field goals. We didn’t even have referees. Any one who wanted to just came; the sides were made up of whoever showed; and everybody played.
There were, of course, a full measure of bruises and bloody noses; but nobody ever got really hurt. There were also occasional scuffles and even sometimes real fights, with blows. But only between two; and if the combatants themselves didn’t cool down after the first furious exchange, then the others would pull them apart, and we would all get on with the game. And we all had a great time.
How to explain such a Normal Rockwell scene? The observer of libertarian or free-market bent might say, “See! Get government out of the way and things work themselves out.” A more dirigiste observer might say, “Just imagine how much better we could make it by getting the boys a proper field, nice uniforms, organizing teams and practice sesseions , etc.” Each would be wrong; and not only because they miss our basic objective, to have fun by playing football, not to play football and hopefully have fun. Playing football was the only activity, but not the only objective, not the only benefit. They would also be wrong because each seriously underappreciates HOW we kids were able to have fun and play football.
We shared quite a lot in common besides a love of football. We knew each other. We lived in the same neighborhood. Some went to the Catholic school; some went to the public school. We all lived within a few minute’s walk or short bike ride of the park. Family incomes certainly differed, probably significantly, but nobody was crushingly poor or flagrantly rich. Many of us knew each other’s families, where he lived, his brothers and sisters, what his father did. We also shared attitudes and assumptions about things like fair play, unacceptable or inappropriate conduct, minimum standards of mutual respect. And, of course, each of us understood that you can’t play football alone. It is more fun for me when every one enjoys the game; if other kids don’t also have fun, they will stop coming; and then it will stop being fun for me as well. In short, we certainly all liked to play football, but we also shared a general consensus about what kind of conduct was acceptable and what was not.
That social consensus formed a sort of base platform for the football. It was never articulated or discussed or even thought about. It was simply there. But because it was there, we were able to enjoy those autum afternoons in the park.
I think there is a similar kind of social platform necessary for economic activity. It takes place within, and in a sense “upon”, an underlying social consensus. Large portions of this consensus are outside what we usually think of as “economics”, both the activity as well as the science. And so, as disciplined “experts”, we put them outside our “terms of reference”.
This practice leads to several pitfalls. First, we drift into talking about “the economy” as though it were a sort of insulated domain, with its own separate dynamics largely independent of other forces within the society. Then we start counting and measuring economic variables without much regard to other things, rather like an army not counting “collateral damage” among civilians as casualties. But the real damage starts when we start intervening and proposing with our eye on the “economic” indicators but not also on these other “extraneous” dimensions. And we are soon deep in the Sorcerer’s Apprentice problem.

Sunday, March 4, 2007

#2 - Positive Economics – a Sorcerer’s Apprentice

Economics is concerned with the production and distribution of goods and services within a society, that is, with the material dimension of society as distinct from its cultural or religious or aesthetic or political or other dimension. An easily overlooked part of this definition is the “as distinct from”. This is very different from “as separate from”. Economics looks at life; and life is whole, fluid, dynamic, fragile. But life is bigger than theory - any theory, indeed all theory. No scientific discipline, nor even all of them combined, can grasp life fully. Yet each can provide some insights from its specific optic.
This presents us with a rather serious problem. The “expert” in our world plays a prominent role. By definition, an expert is someone who knows the cannon of theory in whatever field he or she is “expert” – an economist economics, a sociologist sociology, a lawyer the law, a doctor medicine, etc. etc. etc. Once a “problem” is identified, we like to isolate it, call in the appropriate “expert’, and say, “Fix it.”
Warning, however! Experts are people too. We can hardly them to be immune to the temptations of self-interest and self-aggrandizement. This plus the fact that any real life problem has dimensions beyond the particular cluster of concepts and theories any expert can muster to address it, and we can easily find ourselves with a Sorcerer’s Apprentice situation. The expert tinkers with things only partially understood at best, and may easily destabilize an equilibrium of forces entirely outside his or her understanding or even perception. But you and I – We the People – get left with the consequences.
I find this problem acute in contemporary economics. The rigorous focus on observable economic phenomena, an obsession for quantification and measurement, and an inclination to prefer mathematics as the language of choice for expressing and debating concepts: these propensities have undoubtedly brought much clarity onto economic activity that had hitherto been only sensed intuitively.
There has, however, been a cost. Economic debate, especially discussions on issues of public policy, has drifted either into arcane exchanges between “experts” or the preaching of simplistic platitudes by those with specific agendas. Meanwhile the economic aspects of our lives, about which We the People are expected to make sensible concrete decisions, have become increasingly complex and intertwined both within themselves and with respect to other aspects.
Economics is supposed to provide useful conceptual tools for improving real life, not just “economic life”. If crime is high, if literacy is declining, if domestic violence is endemic, ... these issues have economic dimensions on both the cause side and the effect side, even though economics may not be the principal discipline for understanding them. Similarly, a comparative analysis of labor markets which looks only at employment statistics and turns a blind eye to these other indicators of a society’s health is necessarily seriously flawed. When it comes to real life situations, the ceteris paribus axiom (“all other things being equal”) of which positive economics is so fond, is not simply inappropriate (because it is not true, other things are never the same); it is dangerous. It leads to policy prescriptions which are quite likely NOT to achieve their objectives and also have unintended and unforeseen side effects
Economists have a lot of normative work to do on their own cannon, and some humble pie to eat with respect to other social sciences.