Our Economic Models are broken, and We can fix them

We often hear our politicians and central bankers bring out their economic models. Is there going to be inflation or deflation? Recession or not? What policy approach should we take? The prediction rates are generally lousy, and their approaches don’t work. Yet they keep going as if they know all the answers.

Background on Models

Part of the problem that economic models have is the over-reliance on one school of thought, or one model. According to Wikipedia, there are a number of different schools of thought that have been developed over the yerars: https://en.wikipedia.org/wiki/Economics#Theory Examples include classical economics (Adam Smith), Marxism, Neoclassical, Keynsian, Monetarist (Chicago School), and several others including the Austrian School, the Freiburg School, the School of Lausanne, post-Keynesian economics and the Stockholm school.

Models are essential in understanding the world, because the world is extremely complex. Any model is a simplification with a set of underlying assumptions which helps you solve certain problems or predict certain things. “Hard science” such as physics, chemistry and the like, is filled with models that we all know, such as Newtonian gravity and the Bohr atom. However, and scientist worth his salt will understand their limitations. Newtonian gravity doesn’t explain electromagnetic waves, subatomic particles, or the insides of a star. Bohr atoms can’t tell you how the electron moves throughout its shell, or explain why a neutron hitting U-238 at the proper speed will lead to nuclear fission. Testing can be much better controlled in hard science to show with conviction where models break down.

The Emotional and Political Pull of Economic Models

Economics is often considered as much an art as a science, because you can’t isolate the variables to see if you’re right or wrong. Even worse, the answers you get in economics are often very political – so a politician will more often look for a model that helps sell his plan rather than using several models to help formulate a plan.

A classic example in our modern world is due to the dominance of the “Chicago School” modernists in academia who tend to believe that free trade solves everything. They teach that one of the causes of the Great Depression was the Smoot-Hawley tariffs leading to a collapse in international trade. However, there are many examples of tariff fights that did not result in a collapse of trade or a steep recession – and there are many examples of world-wide asset bubble collapses which tend to cause steep recessions and collapses in trade even without tariffs present (such as that centered in 2009).

Reflect for a moment and see if you had an emotional pull to defend free trade after reading that. That’s the unfortunate thing about the political nature of economics … many people jump straight to the implications of real-world policy and their moralistic weightings, whereas a new theory on the nature of subatomic particles is just a remote curiosity. Back to free trade versus tariffs – that should just be a scientific system of tradeoffs: who benefits, who loses and is there compensation, are supply chains getting too exposed to a single country, can our country meet its own critical supply in times of war, etc. There is no easy right or wrong answer even though we are pulled to think that way.

Finding the Right Economic Models

Economic models all have assumed goals. Most people skip past that because it seems so innately obvious – but it actually isn’t because we are humans with vastly different views on what our primary goals are. Most people today assume that maximizing GDP growth while keeping the CPI low is the a primary goal. But what about wealth disparity? Poverty rates? Environmental impact? Economic stability vs fragility? Ability to withstand a crisis? Ability to survive a war? These are all tradeoffs. A good economic model should be able to take these things into account.

Moving the bulk of our manufacturing overseas helped immensely in meeting our primary goals of maximizing GDP while keeping the CPI low, but many are beginning to question the tradeoffs as tensions with China rise and our supply chains suddenly seem fragile.

What about wealth inequality? Homelessness? The cost of a college education versus the pay you can expect to receive afterwards? How do we deal with the high unemployment rate? These questions are have become generational issues as well as class issues, and people who feel they are losing unjustly in our highly competitive system have been protesting around the world – both in the streets and at the polls. This unrest is palpable – people of all political stripes admit it’s there – but the overall goals and solutions remain highly fragmented.

The Illusions of Inaction

I watched a series on the life of Winston Churchill – a fascinating and powerful political leader. He was prime minister during a temperature inversion in back in 1952: https://www.history.com/news/the-killer-fog-that-blanketed-london-60-years-ago In the series, he ignores the problem completely saying “it’s weather, it will pass – now let’s get on with the other pressing issues”. In the series, events turn which force him to realize that it was a national crisis which could not be ignored – which ultimately saved his political career from an abrupt end. It has long seemed to me that the world leaders following the great financial crisis in 2009 have long been ignoring the social problems, just figuring that it’ll pass like the weather. The Covid-19 shutdowns have brought this to a head and these problems can no longer be ignored.

The Problems with our Current Economic Models

Our current leaders all tend to focus on the “Chicago School” monetarist theories popularized by Milton Friedman. They focus on inflation as the primary problem, as it was in the 1970’s, with a primary focus on money and debt levels. Labor is treated as a fluid commodity which will flow into jobs based on education levels as lower interest rates promote overall growth, or will pare back into the more productive areas as interest rates are raised to prevent inflation. Interest rates are the primary driver, and debt levels are the primary focus. After we started hitting the famous “zero-bound” with interest rates, the next big tool became “quantitative easing.”

Other prominent economic schools, such as the Austrian we hear so much about, point to the problems caused by overuse of low interest rates and QE – namely asset bubbles, particularly in land and housing, and zombie companies, as economic winners are bigger firms with outsized financial access rather than smaller firms which are more innovative or efficient. Unfortunately for the Austrian school, it tends to be more qualitative than quantitative – focusing on general directions instead of exact equations – and our policy makers like the illusion of control they get with these equations.

Another major flaw of interest rates and QE is that they never consider where the money actually goes. Here is a cute illustration I found to show why it hasn’t been working for the Federal Reserve or ECB since 2009 – or the Bank of Japan since 1989:

The implications are obvious. The Federal Reserve comes to the rescue with massive QE – buying assets such as treasury bonds, mortgage-backed securities, and corporate debt – and all asset markets shoot higher. Hooray for the top. Wages go nowhere and costs of living that are not reflected (or reflected well) in the CPI rise such as housing & rent, food, required health care payments, college tuitions, and so on. Ordinary people feel squeezed into a lower standard of living which is much more vulnerable to any crisis requiring cash (such as car trouble).

Our Biggest Economic Waste is Unemployment!

Our basic ideas of economic waste are dead wrong. We often turn a blind eye as the federal reserve buys up bonds in Apple that they’re using for share buybacks, and then demand “Austerity” as the only solution to pay down the national debt. We often hear that there is no other solution to the crisis – as the government is compared to a family that needs to cut it’s spending overall. The result – as we saw most clearly in the European Debt Crisis – is massive unemployment and a worsening of public balance sheets.

What if we consider unemployment itself as waste? Isn’t it wasteful to have huge populations of homeless who add nothing to society when they could be building infrastructure, cleaning beaches, or building real trade skills? Isn’t it wasteful to have highly educated graduates stuck doing rote work for micromanaging corporations because they have no way of competing on their own with small business?

Right to Work Legislation Why is No One Discussing This?

Most people would voluntarily join our economic system if there was a place for them. Why would they forego modern comfort and security to live in tents and scavenge for food? I understand that many would argue against this premise, but the only way to find out is to try it. Say the government re-created the CCC back from the FDR days. Anyone wanting a job – whether long-term homeless, a prior felon, or simply unemployed – would go to a recruiting office just like we do with the military. They can look at various opportunities, take aptitude tests, etc – but at the end of the day the government has to give them a uniform, a spot in the barracks, food, and ultimately find a use for them. If they don’t like regimented life, they can leave – but for many it will be a ticket back to the working world.

Student Loan Forgiveness and Morality/Fairness Issues

Student loan forgiveness is a rallying cry for many, but it tends to be particularly devisive. Does it make sense to saddle young people with massive debts because it’s the only way they can afford college? What about the people who paid all those off and feel miffed about that? How much should people be punished for their debts if they don’t pay them? How much responsibility does the lender have? What if the lender is the government aka “the taxpayer.” This doesn’t pose an economic problem as long as it comes with significant structural reform to curtail these loans and the need for them in the future.

Did Enhanced Unemployment Benefits Cause Inflation?

After the Pandemic was announced, governments around the world started shutting down major sectors of the economy. People were told to stay at home, even if it meant they couldn’t work. The enhanced unemployment benefits were meant to replace their incomes during this time, and essentially that’s what they did. These people were living in apartments and eating food before the shutdowns – and this money enabled them to continue paying for rent and food during the shutdowns. From that standpoint it didn’t cause inflation – rather it prevented an enormous wave of evictions and food shortages. During the Great Depression, farmers were paid to plow over their crops to discourage overproduction while people starved in the streets. I tend to think temporary income replacement was a better, more humane method of tackling the problem.

What about the resulting debt? Note that there is no asset to set against the debt … the food was eaten and rent was paid by people who would’ve performed services in restaurants, bars, hotels, airports, and so on that no longer needed to be performed during that time. If the government continued a policy of enhanced unemployment benefits throughout the pandemic and just left the debt on the federal reserve’s balance sheet, it would serve to keep demand level, production level, and prices level. Not paying this money would increase homelessness, vacancy, food waste due to decreased paying demand, and so on.

Note that the effect on the labor force that this policy has is an entirely different question. Keeping people unemployed is a waste – and the government should ultimately focus on getting people working again. However, this brings back the considerations of the pandemic … how long should the government promote distancing, and how can they set the stage for companies to predictably hire? Those are tough political questions – I’ll just say that it’s difficult to run a business and hire employees when the rules are fluid and you can be told to shut down again at moment’s notice.

What about Universal Basic Income?

The idea of a UBI can vary quite a bit – from a small top-up check to support wages to a complete cost of basic living so that you don’t have to work if you don’t want to. Most people for the idea promote the former while most people against it argue about potential problems with the latter.

I’ll start by addressing the top-up idea, keeping the assumption that it helps you meet basic needs but you still need to work to survive. Our economy is driven by a cash system – development and growth goes where money is spent. If money is stuck with the top 0.1%, then much of it is re-invested into assets such as stocks, bonds, and real estate while some is directed philanthropically based on the current whims and some is spent on lavish housing and entertainment. If money is spent by governments then it typically focuses on infrastructure projects, research projects, or the political whims of the day. If money is spend by ordinary people, then it goes toward meeting their basic needs and increasing their standards of living.

How will this top-up affect inflation? The economy will shift to meet the additional spending power that ordinary people have. The price spread between hot dogs and steaks will probably widen as more people move to higher quality foods, but it will find a new equilibrium. The price of rent is a different question … up until the lockdowns, rent was going sky-high in the big cities as most young people had no other choices if they wanted a decent job. In other areas like Michigan, housing was being demolished as there were not enough jobs to support people to live in them. In other words, rent is highly regional and dependent on a number of variables. As for other goods? Our economy is constrained by demand rather than supply in most areas, as new technology greatly increases productivity while decreasing the demand for labor.

What about the second idea – having a UBI that supports a complete cost of living making work somewhat optional? Well, there is the obvious need for some people to work, and excess unemployment is inherently wasteful, but there is something to consider here. We have an existing welfare system with programs such as social security disability, food stamps, and so on that highly discourages or even prevents people from productive participation in our economy. If this system could be replaced by a UBI which allows the current welfare class to keep their existing standard of living while providing sufficient reward to entice some of them into the productive economy then it would be more productive overall.

Last Note

I hope that my readers can find something to think about here, regardless of their individual political leanings. We have an amazing country and an amazing system. Problems such as high unemployment, political unrest, economic security, and how to achieve growth as a nation affect all of us.

Before you go, I encourage you to consider two questions:

  1. What do you think our economic goals should include?
  2. How does our economic world in practice differ from how it should be?

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
This entry was posted in Uncategorized. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s