Saturday, May 24, 2014

Overly Simplified Economics and Confused Interpretations


NOTE: These 12 essays are being reproduced from my now defunct blog Random Notes, as I intend to cite them in my upcoming essay on the use of words will emotion-heavy connotations and little in the way of actual denotation (such as "need" versus "want", or "exploit" and "fair").

How often have we heard headlines saying that the number of bankruptcy filings are up? Or the number of jobs created this quarter were down from last? Or, if we watch more "educated" economic news, how often have we heard about the number of housing starts? The CPI? Producers' indices? Leading economic indicators?

Yes, all of those have become convenient shorthand for economic growth or contraction. And yet, even though they have the seal of approval not just from reporters and government types, but even from economists, the fact is they can often be misleading. In fact, what is supposedly good news can often be bad, while nominally bad news can be good.

Let us look at one I have addressed before, bankruptcies. ("Environmentalism For The Economy?" , "Why"Negative" Economic Indicators Are A Good Thing", "Bad Economics Part 11", "Defending Freedom?") I agree that when the economy takes a turn for the south, bankruptcies tend to increase. Not always, but usually. Companies that have borrowed based on projections of increasing sales, or firms with large operating costs and narrow profit margins are especially susceptible to such pressures. However, if companies have maintained larger reserves, borrowed very cautiously, relying on savings and capital investment for expansion, and otherwise operated in a very conservative manner, we could actually have a severe downturn with very few bankruptcies. (Not to mention that in modern times, the tendency of government to intervene makes it possible bankruptcies may be completely divorced from the actual economic situation die to a tendency to bail out major employers as well as politically connected, unionized or otherwise influential industries.)

And, on the other hand, a huge number of bankruptcies may accompany strong economic conditions. As I argued before, inflation may presently be keeping bankruptcies artificially low. A "normal" economy may actually have several times as many bankruptcies as we have now. but even ignoring that, in a strong economy, there are many reasons bankruptcies may increase. First, with capital available, it may be easier to start a new venture. However, as more ventures are launched, more will also fail. Not just because there is a natural percentage which will always fail, but because the more new firms, the greater the competition and the more firms that will not succeed. Or, if things go the other way, and borrowing is difficult due to the huge number of firms competing for capital, then it may be hard for start up firms, and others strapped for cash to borrow, and such firms may fail. In both cases it is hardly a sign of economic weakness, but simply an indication that less successful or stable firms are being liquidated to make way for better firms.

A second example can be drawn from employment. As I wrote before, our present employment numbers are terribly distorted by the government, through the monetary manipulation which attempts to implement the laughably idiotic Phillips Curve, through government grants of power to unions which maintain a level of chronic unemployment and underemployment, and through the many subsidies, such as unemployment and disability insurance, along with welfare, which allow many to survive without working, keeping able bodied workers off the market ("Bad Economics Part 14", "Government as Indulgent Parent"). The insurances and unions tend to have one, predictable effect, a degree of chronic unemployment.The inflationary schemes are harder to predict. At some points the additional cash, including the cheap capital, may allow for the employment of normally idle resources. This can increase the apparent employment levels, though often the output is actually not profitable, only inflationary distortions make it seem so. ("Inflation and Uncertainty", "The Rubber Yardstick") In other cases, the inflation may so distort economic signals that companies deplete capital by paying it out as profits, leading to eventually collapse and massive unemployment. 

But if we ignore inflation and government intervention, it is still hard to say what we can determine from "job creation" numbers.

Let us start with a simple example, if a bit of an absurd one. Let us suppose the government decrees that all goods must be transported by truck or car. Rail, boat and air are to be used only for passengers, cargo may not use them. At that point we would see, initially, a sharp decline in jobs in the areas of shipping, rail and air. However, almost immediately, we would see an even larger increase in cartage firms, auto manufacturers, mechanics, gas and service station employees and related firms. Doubtless, in the end, we would see a net gain in total jobs. However, viewed objectively, we would be much poorer, despite the increase. ("Jobs, Jobs, Jobs, and More Jobs", "War Stimulates the Economy? Let's Nuke San Francisco!",  "Free Trade, Employment, Outsourcing, and Protectionism", "Capital Investment", "Smaller Government , Fair Weather Friends and Special Cases","Antibiotics, Automobiles and the Free Market")

Having written that example, I realized some protectionists, and others who have been too strongly influenced by their fixation on jobs over wealth, may not agree with my analysis. So let me offer an even more absurd example, certain to show that jobs and wealth are not synonyms, and, hopefully, that employment numbers and economic health are not the same.

Let us imagine the government, in a fit of honesty, takes protectionism to its logical conclusion and forbids all trade of any kind. Families will be allowed to exchange goods among themselves (though even that was fiercely debated), but no one else can trade anything. Clearly, this would result in the elimination of almost all traditional jobs, as it would be impossible to run almost nay modern business, or even a relatively primitive ones, without the ability to trade cash for labor, exchange money for materials, or sell finished goods. So we would see almost every job disappear. On the other hand, as no one can trade, and that includes charity, we would then see a sudden increase, as almost every adult, including many once called disabled, and most children, as well as the elderly, even those previously retired, take to various subsistence level activities to support themselves.Granted, all of those adults, children and elders would likely be farming submarginal patches of land, scavenging for useful scrap, foraging for food and otherwise producing very little value beyond mere survival, but, on the books, employment would, by traditional measures, be well above 100%, as it would include "unemployable" children and seniors, as well as adults considered disabled or unemployable under old criteria.But I do not think there is, at least I hope there is not, anyone who would claim the entire populace reduced to scavenging would be economically healthier than our present economy.

But we need not resort to such extremes to provide examples. (Though it does make the argument much more clear.) Let us simply imagine a vibrant economy with strong firms, high capital investment and a highly motivated, highly trained workforce. Under such conditions, it may be too expensive to hire existing labor for many activities. Under such conditions, new firms may have a hard time hiring as many employees as they would like, and even existing firms might be reluctant to create new positions. The economy would, by any measure, be considered a success, but new jobs would be very low, and, by traditional criteria, the employment picture would be considered a sign of a weak or stagnant economy.

On the other hand, a shaky economy may have a large number of new jobs, and lack a commensurate number of jobs lost. For example, a firm may be started, offering a number of jobs. As the economy is too shaky to provide payment for those jobs, the positions may never be filled, and recruiting may cease, but on paper the jobs never went away. But they would never be filled either. Similarly, weak economies often create lots of short term, temporary and otherwise impermanent positions, which look better on paper than they actually are. So a very weak economy may show more job creation than a stronger economy.

And, of course, there there is one other fact we left out. The number of new jobs does not consider the pay or quality of the position, making a minimum wage job working irregular shifts the same as a CEO in a fortune 500 firm. Yes, there are other figures which do take this into account, but even there it can be misleading. An average, or even median wage, while providing some information, can be skewed by a few outliers, not to mention inflationary increases in salaries. And, as I mentioned above, just because a position was created does not mean it was ever filled, so even the officially listed jobs may mislead, as some high paying jobs may have been created on paper but never filled, leading to numbers more positive than the reality they supposedly describe.

Other indicators suffer from similar possible confounding factors. For example, producers may buy up stockpiles of raw materials because they anticipate heavy demand, bu they may also buy in anticipation of price increases. Similarly, borrowing by companies could be the indication that they expect future revenues to be high, but it could also be a sign of cash strapped firms attempting to stave off bankruptcy, or even simply a sign that some borrowers anticipate inflation to be higher than creditors do, and so they are borrowing in hopes of profiting on declining monetary values.

I could keep going, but I think my point is obvious. We turn to these indicators so much, and we blindly accept the conventional interpretation that we rarely, if ever, ask ourselves what those signs mean. Even the economists who supposedly look for a more comprehensive picture very rarely do more than make a few connections between two indices. I have never heard anyone take a look at all of these indicators, much less dig into the aggregate numbers upon which they are based to look into the raw data. And yet, that is what we need to do to really understand the economy. All too often the indices, in isolation, yes, but even taken together, give a mistaken impression.

I know it sounds like a small problem, something which can be safely ignored, but unfortunately it is not. The indices, the ones I have shown to be so easily misunderstood, are used to drive a host of government programs. From spending to bailouts to regulatory approaches to all forms of economic meddling, taxes and government spending, all manner of activities are based on these figures. Not to mention decisions about the manipulation of the money supply. All of them rest on these numbers. And, as I have shown, these numbers regularly mislead.

So, what is the answer? Do I have a better index? Or set of indices? Should the economist take a look at lower level data?

No. The answer is not another index or a set of rules. The answer is even more simple. As I argued in "The Limits of "Scientific" Management", "The Limits of Technocracy", "The Limits of Econometrics", "Knowing Our Limits", "Bad Economics Part 4" and "Bad Economics Part 16", we just cannot develop numbers reliable enough upon which to regulate the economy. (Of course, as I argeud in "Planning For Imperfection", "Greed Versus Evil", "In Praise of Contracts" and "Clarifying a Reality of Capitalism", the free market manages well enough that it needs no interventions. See also "The Threat of Perfection ".) Rather than trying to find a better number upon which to base our regulation, I think the solution is to admit we do not know enough to regulate the economy. (Even if we did, we don't know what to regulate. See "The Inherent Disappointment of Authoritarianism", "The Right Way" and  "The Wrong People" .)

So, rather than decry the numbers and look for better regulatory tools, let us, for once, give up attempting to improve a flawed system, admit it is broken, and let it go. Maybe it is time to recognize our limits and try freedom once more. ("Recipe For Disaster", "The Endless Cycle of Intervention",  "The Cycle of Compassion", "The Inevitable Corruption of Protectionism ")

Originally posted in Random Notes on 2010/06/27.


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