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The Role Of Uncertainty in Economics

So much of economic theory needs to be replaced. We now realize that. I am especially focused on getting rid of the artificiality of rationality and complete knowledge from our thinking. At best they are crude approximations to real life. At worst they totally undermine our ability to deal with real world economic issues. They obscure reality, which to me is riven through with uncertainty.
Indeed, it seems to me that uncertainty is the central fact motivating all economic activity. Without it we would be living in some kind of nirvana devoid of the problem of scarcity. Uncertainty bedevils all living things. It motivates the invention of problem solving, competition, cooperation, and search. More to the point the process of learning is a response to the constant need to press back against the shadows uncertainty casts. It causes us to create boundaries within which we protect and control resources. It impels us to plan in order to invent viable futures to act out. It forces us to build institutions to stabilize our relationships and thoughts. It encourages us to develop cultures to enable association, network, and interchange. And it requires us to be relentless in our creativity in order to fend off the degradation and consumption of whatever exists today.
Above all else it manifests itself as entropy and the perpetual loss of order in our lives and surroundings. That is the greatest threat of all. One solution we have arrived at in our defense is the construction of economies. For an economy is simply the imposition of a kind of order – a system – within which we can exchange, create, and consume so we can survive despite the prevalence of uncertainty in our environment.
It is because such an order necessarily involves our geographic locale, our institutions, our cultures, our depth of knowledge, our technologies, and the networks we construct with each other, that economics is profoundly heterodox in nature. In other words, that heterodoxy is directly derived from the problem represented by uncertainty that economic systems seek to “solve”.
This is why orthodox economics and its simplistic focus on the mechanism of constrained allocation fails to account for the richness of real world economics systems, and why it is insufficient either as an explanatory or predictive account of real economies. Economic theories must confront uncertainty, else they are not dealing with economics.

Addendum:

This is a re-post from an entry I made on the Real World Economics Review blog.

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Snippets: Columbus Day Style

Well the grumpy mood continues after the recent IMF meetings, and the economy lingers in the penumbra not quite sure whether to surge into sunlight or scuttle back into the dark. These are strange times. So, in no particular order some snippets from today’s news:

  1. The Nobel Prize for economics was awarded over the weekend to three economists who all worked on issues to do with unemployment. Obviously they didn’t come with a fix. But, hey, who said that economists have to get their hands dirty in the real world? Anyway: Peter Diamond of MIT; Dale Mortensen of Northwestern; and Christopher Pissarides of the London School of Economics [yea!] all have written extensively on the way in which unemployment can persist even in healthy economies. Presumably all three deserve the prize, although I must admit that my cursory reading of some of Diamond’s work this morning left me decidedly unimpressed. His contribution seems to be more a tweak of the already insanely irrelevant macroeconomics models that dominate policy making, rather than anything startlingly new. Which reminds me: far too much work that is considered “breakthrough” in economic theory is simply a statement of some commonplace knowledge. The breakthrough then consists of the revelation that the real world bears little of no resemblance to the fantasy world of orthodox economics. Basically economists need to get out more and live a little. Then they would not treat these breakthroughs as being of any consequence. I mean: is it really stunning that wages do not instantly change in the face of unemployment increases? Or that workers are not always unemployed voluntarily? Or that technology may have something to do with economic growth? The list goes on. Economics is a shambles and an embarrassment. That markets don’t work well all the time should not be prize worthy thinking.
  2. Oh, and that “Nobel Prize” is not actually a Nobel Prize. Technically it is an award sponsored by the Swedish Central Bank, and is only administered by the Nobel committee. Economists yearn to be treated as true scientists, and so elide the reality of the prize. Which is odd given their predilection for pseudo precision in their theorizing.
  3. Those IMF meetings ended in official accord, but in unofficial discord. The problem is the looming trade and currency war. As countries realize the depths to which we have sunk, courtesy of the big banks, they are reaching for ever more desperate counter measures. Sooner or later a trade war was likely. This is particularly true when we consider China and its persistent rigging of its currency. The spat between the US and China will only get more heated. Ultimately the Chinese are going to have to allow their currency to rise in value. Their position right now hurts not just the US but all its trading partners: China, by fixing its currency value to the dollar – unofficially – prevents the normal process of adjustment to occur when a surplus or deficit opens up. That normal process is the revaluation of a currency in order to maintain balance between two trading partners. In our case the dollar should fall and the remnimbi rise until the bilateral trade deficit is eliminated. That is to say that goods manufactured using remnimbi should rise in price when their cost is translated into dollars. That reduces Chinese competitiveness here in the US and therefore reduces the trade gap between the two countries. By refusing to allow that adjustment, the Chinese are artificially inflating their export businesses at the expense of their domestic businesses. In effect they are exporting unemployment. Since unemployment is our number one issue their position is becoming untenable from our point of view. Hence the tension. Multiply this problem across many countries and many trade imbalances and we quickly enter the twilight zone of trade war. The problem is, of course, that no one really wins in such a war since everyone tries to outdo the other. A “race for the bottom” ensues that culminates in the loss of trade, and jobs, for everyone. This is something we all need to avoid. Trade is essential for global wealth creation since it allows resources around the world to be more advantageously employed than would be the case were everyone to meet local needs only from local resources. This general rule of comparative advantage is well established in economics, but is routinely forgotten and set aside. It is also one that needs constant vetting to ensure it does not open up the possibility of exploitation. We have a system of rules that govern trade and attempt to even pout the playing field, but those rules are too often tilted to favor the more advanced nations at the expense of the poorer economies. Nonetheless trade has its benefits and is worth protecting from the kind of rigging practiced by the Chinese.
  4. Krugman makes a fine point this morning: there is much talk in the media about increasing “big government” under Obama. The problem is that the facts do not support the claim. In fact there are about 350,000 fewer government workers now than when he came into power. The problem is that most of this reduction is at the state and local level – mainly teachers, police, and fire workers fired to help state budget cuts – and so the illusion of bigger government pervades at the national level even though it is fictional. When we look at the “big” programs of the last few years, the biggest expansion of government spending was the defense and Medicare programs of the Bush era. Bush was also responsible for bailing out the banks and TARP. The only new programs under Obama have been health car reform, which hasn’t kicked in yet and so hasn’t enlarged government; and the stimulus of early 2009. The stimulus didn’t increase government either, since most of the cash went into tax cuts or state and local government aid. There are no new government jobs programs and no government departments have expanded. Which only goes to show how effective the fact less and made up claims of the Republicans have been able to stick. Alternatively it also shows how ineffective the Obama team has been in communicating what it is doing. It is tough to run a good democracy in the absence of truthful information. Voters need to be better informed if they are to avoid making mistakes. Don’t hold your breath.
  5. Next, the banks continue to whine about the undue attention they are getting from regulators. Tough. They are responsible for the crisis, and, in my opinion have not yet paid for the problems they created. On the contrary regulators have trodden lightly compared with what should have been done. Nowhere have the mega banks been broken up, which is the single solution to the instability of finance. Nothing remotely draconian has been done. So-called stress tests were hardly stressful. Capital increases have been mandated, but will be implemented at a snail’s pace, and appear too low in any case. Bonuses are being attacked, but there is no international coordination mainly because the US is seeking to protect bankers who are very large campaign contributors to both parties. So banker power is still way too high for the safety of the global economy. Nonetheless bankers cry foul whenever their pay is called into question. I would too were I still in the industry. One interesting snippet today coms from the Financial Times Op-Ed page. The issue is this: should we force bankers to be paid their bonuses in stock options. In theory this ties them to the bottom line and should force them to behave less anti-socially. But: stock options have no value when the strike price is below market price. In this circumstance the incentive is perverse. Options out of the money can be forced back into value by reckless behavior. Workers who see their options without value may follow even more risky deals in order to pump up profits. It is interesting to note that the two biggest failures of the crisis: Lehman and Bear Stearns, both had very large management participation in their respective stocks. Both gambles recklessly in order to restore stock values for management. Not such a good idea. So maybe we need the payment of bonuses to be in the form of debt. Put management on the same footing as the secured creditors. That would eliminate equity participation and thus the incentive to pursue risky strategies and, at the same time, force managers to take a long term view.
  6. Oh! Wait. That won’t work either because banks are always bailed out and their creditors thus protected. So there would be no better alignment of incentives and bankers would still be able to trash the economy without punishment. That’s why we need to break the banks up and make them insignificant. That way they can fail, which is what the deserve if they are incompetent the way Bear Stearns and Lehman were. My problem is that the others, the ones we bailed out, never learned their lesson. They are still gambling away merrily and relying on us to create the conditions in which they can make big bonuses for themselves. Our safety net reduces investor risk and thus funding costs. This widens spreads and thus profits. We, the taxpayers, are underwriting those bonuses. The bankers are not earning them on merit. They are earning them on welfare. A nice scam if you can get in on it. And they still whine. What children. They should grow up and act as smartly as they keep telling us they are – without the training wheels.

Food for thought.

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What Jobs?

The jobless recovery chugs along. That’s the conclusion we draw from today’s very poor jobs report from the government. Total non-farm payrolls dropped by 95,000 in September, which was much worse than the consensus and August’s loss of 57,000. This is simply not good enough. The fact that private sector employment edged up by 64,000 was swamped by the loss of 159,000 government jobs. Some of the loss in the public sector was the reduction of temporary census workers and was thus entirely expected. The really bad number came from state and local governments who are cutting their budgets rapidly in order to met artificially imposed limits. Most states have to run balanced budgets, so when tax revenues fall they start to cut services. That means workers are fired. In September this process cost us 76,000 jobs. That some analysts were surprised by this is astonishing: we have seen the wave of state level austerity measures picking up steam for a while. I doubt we have sen the worst yet.

Amidst this gloom was a small ray of light: the unemployment rate stayed constant. Unfortunately this resulted from a slowdown in people entering the workforce. The ratio of workers to population continues to shrink as more and more people of working age simply stop looking for work and drop out. This is a sad and damaging trend for the economy. The implication is that our potential to generate wealth is becoming more limited as people decide not to participate in the economy. Long term this places a limit on growth. Skills atrophy and motivation disappears.

Also buried in the report were other down notes.

The average workweek has stalled. It remained unchanged overall and the factory workweek actually fell. Obviously businesses are not picking up steam. Plus the average weekly wage was unchanged in September, which means that wages have grown only 1.7% in the last year.

None of these numbers is a disaster in itself. But none are good either.

Add them together and we paint a very weak picture. Far too weak for an economy ostensibly in the throes of a recovery. Something is amiss and needs fixing fast. Otherwise we will linger in this muddle for a long time.

How long?

I am shocked at the variation in the predictions of the projected length of our malaise. It seems every week another economist tries to outdo the record for pessimism. Now it is commonplace for analysts to speak of a decade or so before we return to full employment. Some talk of two decades. No one argues for a quick return to normalcy.

As I have stated here endlessly: we have the means to fix this. It doesn’t have to be this way. Yet there is no political will to implement the policies needed. This is not a just failure of economic theory. It is a failure of national willpower.

And that’s just sad. Why would we want to wallow in misery when we can recover if we want?

You tell me.

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Jobs; Trade; Banks … Ho Hum And Bun Fights

This is getting dull. Really dull. The economy refuses to shift gears. Wall Street twitters on about nothing in particular. Central Bankers are even more confused and surly than usual. Businesses are sitting on piles of cash and complaining that no one cares about them. Banks are in a snit over being asked to play nicely. Consumers have all but disappeared. Government policy makers wring their hands and smile at the same time. The dark clouds of currency wars have rolled into view. And we go nowhere fast.

Welcome to the crisis part 2.

Oh: the very slightly good news is that new claims for unemployment assistance fell again last week. Whoopee. The drop was by 11,000 all the way to 445,000, which, in normal times, would be viewed as hopelessly inadequate, or a mere blip not worth mentioning, but was the reason that Wall Street roared briefly to life this morning. We exist – I won’t dignify our current state by using the word “live” – in such diminished times that even the most modest step in the right direction can be viewed as a triumph of the first order. Our era has so perverted our language that we no longer can use the word “modest” without feeling slightly apologetic. Personally I blame corporate America for its incessant hyperbole that has undermined the value of words that used to mean something.Modest used to mean, well, modest. Now it means a mix of useless and wimpy. Thus when we run into a putrid performance we have and reach for a proper descriptor we are apt to bring pablum out of our bag. This ends up confusing everyone, and allows the incompetent folks who buy and sell stocks for a living to justify anything. Thus today’s new claims data, which can only be described as the greyest of greys, is greeted in the manner once reserved for the returning Caesars of Rome.

My advice: ignore the hoopla. The claims number represents one of a long series of indifferent and indistinguishable data points, none of which tells us much other than that our malaise continues. Allow me to repeat: we need that claims number to be under 400,000. Better yet, we need it to drop to the mid 300,000 range before we reach for the celebratory fireworks.

Meanwhile ignore Wall Street. Remember they are the folks who trashed the place in the first place. The one fact we have at present is that they know nothing worth our learning.

In other news we are reading a great deal about the brewing trade and currency wars about to blight the world.

The reason is simple: practically every government facing a domestic crisis has written into its escape plan that it will grow out of crisis by pumping up exports. Those of you with an eye for detail will notice that there is a slight problem with this. Someone has to import. Not everyone can export. Whoops. In the old days the game was extremely simple. Japan, Germany, and China exported. The US and the UK imported. That meant that German, Japanese, and Chinese workers lived below their means while Americans and Brits lived above theirs. A better way to look at this is that the Germans, Japanese and Chinese exported unemployment by deliberately under-consuming goods that they made. The surplus was sent abroad. Further: the spare cash that this generated for those economies was recycled back into the US and UK where it pumped up asset prices. This “surplus” of savings on world markets created by the deliberate under consumption in the exporting nations was a major factor in the real estate bubble. At least that’s one theory doing the rounds. Bernanke is a leader of that train of thought.

Now, in the depths of crisis, the importers need to rebalance their economies and reduce the import inflow. But that implies the exporters have to adjust as well. Therein lies the source of tension. The exporters do not want to change their game. Too many local jobs depend on trade. In the case of China, whole industries depend on it, which means millions of recently displaced agricultural workers do too. That’s a big social problem waiting to burst if exporters have to change course. China’s middle class is insufficient to buy all those goods. At least not yet. So they need to keep on exporting. To us.

Which is why they rig their currency and try to play beggar-thy-neighbor with the rest of the world, and particularly with the US. If China were to allow its currency to float by unfixing its relationship with the dollar, it would be revalued upwards. That would make Chinese goods more expensive in foreign markets like the US and would thus reduce their exports. The displaced goods would have to be sold internally within China or those factories would have to close down. Either way the adjustment could be difficult. It would cramp Chinese growth which has averaged 8% a year for a while now. A slowdown from that pace would – potentially – hit their agricultural and poor workers the most since it would remove their opportunity to earn higher wages. The result? Civil unrest. The entire structure of the Chinese elite would feel the strain. It has already been hit by waves of strikes as workers lobby for better conditions and wages. Add in the loss of export industry jobs and the country gets shaky quickly.

Hence the current stand off.

Of course this scenario is being played out across the globe as countries seek to devalue their currencies to dampen Chinese and other exports and boost their own. It is particularly acute in Europe where the German refusal to rebalance their economy is weighing heavily on places like Spain. Since Spain and Germany use the same currency the poor Spanish cannot devalue. They have only one option which is to throw themselves into massive austerity programs. The Germans meanwhile preach such austerity, apparently oblivious that their failure to boost domestic demand created the excess cash that blew Spanish real estate into its bubble – all those German second homes on the Mediterranean coast, not to mention the tourists and their wads of Euros – and is now exporting unemployment along with those BMW’s.

I won’t mention the dire straits the poor Irish are in. Suffice to say that they make the Icelanders look like amateurs when it comes to self destruction.

So, all of a sudden, attention worldwide is on how to rebalance the flow of trade so that excess cash doesn’t slop about creating bubbles, and the exporting nations don’t foist unemployment on everyone else. The recipe for a full blown trade war is nearly complete. Which is very worrisome, since one of the factors that made the Great Depression truly “great” was the trade war of the 1930’s.

And, finally, on a more comical note: the banks are at it again.

This time they are all in a huff over the new capital regulations introduced by the folks in Basel, which is where the organization that dictates these things is based.

The banks argue, rightly, that higher capital implies less credit available. This is correct because capital is held in proportion to assets. So if that proportion is forced higher, the banks have two choices: they can raise more capital and not deploy it as loans; or they can keep their current capital, and reduce the amount of loans from where they now are. Either way the level of lending will drop. The entirely neutral analysts at Goldman Sachs tell us that the drop could cut about 1% off of GDP over the next few years. Conveniently we are not told how much GDP was destroyed by the excess lending of the last few years – that would mess up the story. In any case, the bleating from the banks is now very loud. Fewer loans means lower profits. And we all know what that means: lower bonuses. So I think we can ignore the warnings of lower GDP and cut straight to the one thing we know they care about: that fifth New York apartment. Or: how awful that they might have to forgo the Hamptons home and the Aspen retreat. How mean spirited of us to force such choices on the poor dears. Now this is a true national policy issue.

Not really.

A cursory review of Hyman Minsky and his financial instability hypothesis tells us that less lending is a very good thing. It reduces long run volatility because more of the economy’s wealth relies on equity funding and not debt. That makes it less susceptible to the swings of interest rates and thus more stable. This is good. Very good. The cost for getting this stability is that we will generate less wealth on paper. GDP will, indeed, grow less quickly. But, as we recently learned, wealth that relies on debt is often an illusion – just as illusory as Lehman’s asset values were.

Frankly we could do with less illusion and more reality. Hence we should gird ourselves to ignore the weeping and wailing of Wall Street, even if they have a technically correct point. After all our economy is not theirs to play with. It’s ours.

Not only that, but we want it back.

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Weak Jobs News, So Where’s The Stimulus?

The payroll processing company ADP released its regular report on payroll growth today. The news was not good. The private sector payrolls covered by ADP shed 39,000 jobs in September. Anyway you cut it this is a weak performance. The consensus amongst Wall Street analysts had been an expectation of poor growth, by about 20,000, so an outright decline like this is something of a shock. Clearly the summer doldrums took their toll.

The decline was also widespread which is a blow to those who argue we are facing some sort of structural employment problems. Usually such a problem manifests itself as a lopsided jobs market: some industries growing while others are fading. The ADP data has weakness everywhere except in services, and even there the addition to payrolls was a paltry 6,000. Meanwhile manufacturing lost 17,000, which along with the weaker reports coming from the Institute of Supply Management portray an economy stuttering along rather than in strong recovery mode. The latest ISM report had their manufacturing index at 54.5% down from its 2010 peak of 65.9% back in January. While any reading over 50.0% is good – it means that over half of all companies are expanding activity – the trend is disturbing. There is no momentum we can look to as the driving force for growth.

The ADP jobs data simply confirms this weak trend.

We have now reached a pivotal moment. Either we take up the challenge and do what is necessary to fix our ills, or we wallow in the morass. I suspect we will choose to wallow. As a nation we don’t have the courage to deal with this problem. Or at least the current signs are that we don’t.

There is a weariness in our policy elite that is almost fatalistic. They simply cannot bring themselves to convince the public of the effort required. They elide, dodge, and confuse instead of leading.

This weakness translates into inaction or inadequate action. That, in turn, fails to solve the problem and is interpreted as confirmation that our policy choices are exhausted. That leads to ennui and a feeling of powerlessness. We have lost our will to fight.

The problem is this: we have two weapons to use. Monetary policy, and fiscal policy. Monetary policy is the preferred option, as it has been for decades. That means using lower interest rates to boost borrowing and thus consumption and the economy overall. The problem as we all know is that rates are now so low we have nowhere to go. It’s worse in Japan, where just this week rates were dropped to 0.1%. Even that is thought not to be enough. Here we have marginally more room left, but given the size of the problem there is no way we can reduce rates to have sufficient impact. Using the rule of thumb measure I have described before, we need rates at about -5.0% to get traction against the current malaise. That’s not possible. So we are stuck. As they say in the trade we have hit the “zero bound” where normal policy fails.

This leaves the Fed with little option but to use abnormal and creative ways to pump liquidity into the economy.

The term used to describe these unusual policies is “quantitative easing”. This policy involves the Fed buying securities in the open market and holding them on its balance sheet. The idea being that the cash they use to buy the securities adds to the money available in the economy.

But even this is beginning to fade in its effect.

The problem is that when the Fed buys US bonds and other low risk securities, which is its first choice, it is simply substituting one risk free instrument, cash, for another. It isn’t shifting the yield curve, and it isn’t shifting the propensity to save. The reason for this is that the economy is already awash with liquidity. People are hoarding cash. Giving them more doesn’t alter their desire to hoard. Taking their US bonds and giving them cash simply means they hoard cash instead of risk free bonds which most investors regard as equivalent to cash anyway.

One way around this would be for the Fed to get even more funky and buy high risk assets. This would reduce the risk profile of investor portfolios and presumably allow them to hold less cash as a risk hedge. Look for the Fed to play this game, by purchasing commercial paper, medium term paper of various sorts and maybe even some more distressed assets. Whether this will work is open to doubt. The clouds hanging over the economy are dark enough that even this effort may fail. Or at least it may not prove to be as effective as we need.

Besides, as I have reported here before, there is an intense debate going on within the Fed as to whether it needs to take any action at all. So looking for leadership there might be a fool’s game.

That leaves us with one reliable approach: fiscal policy. The problem here is that the country is now gun shy of the debt needed to make this work. We have used one round of moderate stimulus which was hobbled by its poor design and slow implementation. Far too much of it was in the form of tax cuts which are well known to be ineffective as a stimulant. Political concessions to ameliorate opposition further weakened that effort. So while it was an unqualified success – much to the chagrin of the opposition – is was barley enough to slow the fall, much less induce a recovery.

It was a massive national failure of will. The price for which we are now paying.

But fiscal policy remains our only hope. We need to summon up the fortitude to do the right thing and pile on the deficit until the economy hums again. this implies running up the debt to GDP ratio to levels we have not seen in peacetime. Then again, we have not had to deal with a crisis like this since the Depression, so it is not unreasonable for our response to break records.

For those of you who fear the repercussions of that debt let me repeat my warning: the alternative is worse. The cost of the additional debt has to be weighed against the amount of lost wealth and the damage to our businesses and households. Since we are now operating at about 6% below our potential, that loss of wealth is accumulating at an alarming rate. Issuing enough debt to get us back on track, and thus to close that gap, is a worthwhile investment in our future. Not to do so is to succumb to a false short term perspective, and to fail to understand that we have the power to stop the rot.

I won’t hold my breath of course.

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