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.

Friday, March 2, 2007

#1 - Why consider normative economics?

Economics sets out to describe the economic aspects of the real world. That is, economic theory is supposed to provide a coherent, usable and more or less complete package of conceptual tools for analyzing, understanding, explaining, and especially for improving the world in which we live – well, the economic aspects at least.
Does it succeed? Personally, I think there is room for improvement. Economic theory could be significantly more user friendly, and thereby more useful. Part of the reason for this current situation is a traditional distinction within the profession between so-called positive and normative economics. At the very beginning of his or her studies, the would-be economist is trained to make a sharp distinction between what “is’ and what he or she or others may think what “ought to be”. Statements about what “is” can be tested empirically, and their rightness or wrongness can be objectively determined. They are “positive” statements. On the other hand, statements about what “ought to be” are by their nature not empirically verifiable; they are value judgments; they are normative. The “science” part of economics, therefore, is taken to lie in the positive domain, since only what can be empirically verified (or unambiguously refuted) can be “true”. Thus, only positive economics is really “scientific”.
I think this distinction has been overplayed, to the detriment of both the profession and its potential users. Verification through quantification is not the only path to truth, nor are personal judgments beyond improvement through honest discussion, nor are intrinsic values inappropriate for collective analysis. In short, the economic tool kit will be both more relevant and more useable if normative analysis is also added in.
Hence this blog site. In a more or less logical manner I will offer views on several distinct but still related aspects of contemporary economics. First is a series of “corrections”, or nuancing of positive economic principles, with a view to enhancing and enriching their real world applicability. The second are some normative economic principles needed, I think, to complement the arsenal of currently available concepts and tools of positive economics.
Warning: this is not a site for the profession, although other economists are most certainly welcome. This site might be called, with a tip of the hat to George Bernard Shaw, “the intelligent person’s guide to useful economics”. The focus is utility; the target is the non-professional; the standard is, albeit often abstract, sensibleness and relevance and practicabillity. Good economics should be useful to ordinary people making real decisions.