Saturday, January 30, 2010

Value theories

Historically, currency had its value pegged to the value of the collateral that backed the currency. Thus, a paper bill was typically representative of some quantity of specie (precious metals or coins made of precious metal) held in a bank. Much of early economic theory was dedicated to the justification and promotion of this fact. Thus, the idea arose that the value of a unit of currency was based on what it represented - be it a share of a valuable object, a quantity of labor, etc. Thus, the argument goes, an expansion in currency available leads inevitably to a decrease in its value, as more units of currency exist for each unit of the backing object.

This classical line of reasoning has been hard to shake despite the fact that it was never justified in a scientific way. Observations that people think of currency in this way is evidence only of a body of beliefs, not a revelation of universal law. Moreover, currency and the specie that backs it are both currencies of sort. Many thinkers make the (rather sad) error of believing that a block of precious metal has value in and of itself. Precious metals are not used for anything other than as wealth holding assets, and it has always been the common belief in their value - arbitrarily decided by historical events - and nothing more, that creates the value itself.

The false theory of currency value as proportion of backing object value results from two big mistakes in the classical line of reasoning relating to currency value.

1. The classical line of reasoning ignores the possibility of underutilized resources.
2. The classical line of reasoning ignores the fundamental role that uncertainty plays in currency value.

Both of these points are made by Keynes in his General Theory, but I would like to expand on them here in my own direction. Incidentally, both of these are tied to a fundamental problem in economics: the failure of equilibrium models to rigorously represent equilibria as related rates.

First, the case of underutilized resources can be directly highlighted by a few examples:

Suppose that a king wishes to expand his treasury, and devises a brilliant strategy for quickly growing his gold-mining industry. He prints new bills of currency, backed by no matching specie, and enters into contracts with mining firms whereby they will provide him with a portion of the specie that they find, such that it directly matches the quantity needed to back the currency issued. Assuming that the results of the venture meet the king's expected value and that there is a high unemployment rate, how will this affect the value of the currency?

Looking first at time of initial issuance - one can expect demand to rise for machinery and chemicals used in the mining process. This change will then ripple into the spending habits of the producers of these components. The increased revenue of these "component firms" will, due to the assumption of surplus labor, primarily become increased plant capacity and profits for the firm owners. These owners will bid up investments of various types (including real estate), and may spend marginally more on luxury goods.

Having a larger paid labor pool will also have an effect - laborers may increase their food consumption, primarily by demanding greater food variety, but for the most part, increased income will be spent on goods and services. Landlords will see lower vacancy rates as laborers cohabitate less, prompting an increase in rental rates.

Generally, an increase in prices across the board represents a decrease in the value of the currency. However, in the case of currency issue, these increases are the response of suppliers to the increase in quantity demand. In many cases, the supply of a good is sufficiently elastic that only the quantity produced increases. In only a few situations is there a bottleneck such that the supply of a given good cannot increase easily, and it is in this case that a price increase will occur.

To calculate the initial stimulus effect of such an action by a Government, an economist should ask two things: 1)Are the natural resources that will see increased demand readily available for use? 2)Is the economy significantly below full employment? If the answer to both of these questions is "yes", then the vast majority of the quantity demand increase will be expressed in terms of increased output. If the answer to either question is "no", the vast majority of quantity demand increase will be expressed in terms of increased prices.

Next, let us turn to the point when the mining firms begin to transfer precious metals back into the King's treasury. It is hard to see how this could have any effect whatsoever. Other than the labor utilized for the actual movement, inspection, storage, and safeguarding of the specie, no actual changes take place. The King now simply has more of a valuable asset, which is kept out of circulation, and which he will be able to use to meet future obligations if necessary.

Theories that predominated during the time when currency was directly backed by assets most likely had a profound effect on the decisions of the speculative class. When exchange rates were fixed, speculation often surrounded the values of currencies. In any speculative atmosphere, the ideas and decisions of the herd were the primary determinant of changes in prices paid by speculators. Therefore, so long as a sufficient portion of speculators believed in a given economic rule, the market would behave in a way that allowed economists to draw statistical evidence for that rule from the market. The egoes of the wealthy had a further impact on the development of the discipline, in that they believed their own wealth stemmed not from the collective effect of an otherwise arbitrary belief, but from actual knowledge. It is the wealthy that control University endowments, and they want the world to know that they are people of virtue.

Uncertainty also plays a key role in currency value. I invite the reader to imagine an economy in which individuals do not have uncertainty. Note that risk should be treated as a type of uncertainty. The cognition of an individual who does not have uncertainty is really omniscience. Such a person does not respond in a nash equilibrium fashion because he is able to coordinate with others effortlessly. Furthermore, the psychological predisposition of the individual toward equality would be an overriding factor in his economic relationships. Specialized knowledge disappears, and thus workers are no longer differentiable from each other. The only (economically significant) differences between individuals in such a scheme is their preferences and their property.

This thought experiment highlights another aspect of economic life that is seldom mentioned: its ethical connotation as revealed by our impressions. I invite the reader to contemplate the following examples:
  • A convicted murderer (about whose guilt there is no doubt) is released from prison due to a legal error by the prosecution. He purchases a lottery ticket and wins the jackpot, becoming a multimillionaire.
  • A woman who works hard her entire life, saving a small amount of money from each paycheck, invests her money in a mutual fund that loses more than half of its value in the course of a year.
  • A man witnesses a stranger help a blind person across a busy intersection and buys him a drink.
  • A student who earns straight A's has her allowance increased.
  • The city council passes a tax increase that affects only a single business owner.
  • The city council passes a tax increase that includes an exemption that only a single business owner can take advantage of.
If these examples awaken any feelings of righteousness or outrage, it is because our economic life is inseparable from our ethical impulses. In fact, the motivation of individuals cannot be expressed only through self-interest. We care not just about our absolute gains but about the effect our actions have on others and on the society as a whole. We value our own success relative to the success of others.

Considering our ethical impluses and our way of evaluating our own economic position, a society of omnipotent individuals will have a certain political equilibrium. Currency will not be necessary because the actions of each individual will be known to all. Each person will understand the full configuration space of individual action combinations and their consequences. Labor would be divided between individuals only on the basis of their preferences. Nobody would want to see the basic needs of others go unmet, and will balance this desire against selfish interests. Labor could not be divided between workers and management because management is completely unnecessary - the only possibility is the existence of a capitalist class who own the means of production, but even this is unlikely given that these capitalists would face perfectly coordinated resistance by the rest of the society and collective bargaining by their workers.

Individuals also have foreknowledge of all their future consumption needs. Therefore, individuals would be able to enter into contracts with each other for the direct exchange of goods between current and future dates. For example, I may work in a machine shop for an hour, with the understanding that this earns me a loaf of bread from the baker. The baker would understand how this settles some contract he is involved in, or establishes a future compensation for him.

Currency is really an effort at approximation of this system of contracts. Approximation is necessary because of the incompleteness of individual knowledge. This incompleteness is synonymous with uncertainty. Uncertainty has three principal effects:

1) The use of risks and estimates
2) Creation of search costs that establish a value for information.
3) Existence of liquidity

Returning now to an example of a theoretical "normal human" economy, if the total quantity of currency in circulation is X, during any given time period somewhat less than every unit in X (X-a) will change hands at least once. Of the exchanges that take place, some will be at a price that has not been actively reevaluated. When reevaluations do take place, the price-setter must generally plan for a price that will not need to be raised (or lowered) again for some time, meaning the change will be in greater proportion than what is initially required, and often will occur later than expected. In other words, price changes and rebalances do not freely propagate across economies, but actually move at a certain estimable rate. Furthermore, price changes may not be made at all if the cost threshold for change and accompanying discounting rate of the costs are not met. Therefore, even if the economy is at capacity when the currency supply is changed, the question is not merely by how much but for whom the change is taking place.

A tax can be seen as a transfer of currency from one group to another. It is paired with government services that are funded by the tax, and these services are, in turn, expressible as monetary savings for the individuals who benefit from these services. Often, the Government can provide services more optimally than the private sector. We may, in accordance with our ethical prerogatives, denote certain services as providing a greater contribution to quality of life than others. So long as tax policy shifts the balance of goods and services provided toward those that provide a greater benefit to quality of life, it is justified.

Returning to the concept of the money supply in contrast to the effective money supply, suppose that the money supply is expanded or contracted in some fashion. The economic effect of this change is wholly dependent on who receives the currency. Let us rank the individuals within a society based on (1) their propensity to spend an additional dollar received and (2) their propensity to take each dollar reduction in income from spending rather than savings. These two variables are bound to have some degree of covariance, but that is beside the point. Imagine a scale going from zero (will not spend) to one (will spend) for these measures. Then each individual will occupy a point on this scale. Savings are only reintegrated into the economy as loans. Thus, private debt is a function of the total level of savings. Payments on debt lead to income concentrations in the hands of debt holders. Thus, either price levels must fall, income levels must increase, or debt levels must increase for individuals to maintain their consumption levels over time. When left alone, the trend seems to be toward a glut of savings in the hands of the ultra rich, a lack of viable investments, and a inevitable drop in the price and employment level.

An injection of additional currency targeted to the least likely to consume will lead only to an increase in loan issuance. If the loans market is saturated, it will lead to a direct increase in savings and no overall change in the economy (X and a increase in parity).

An injection of additional currency targeted to the most likely to consume will lead to an increase in consumption levels. This will mean that the effective quantity of money has directly increased. Prices may rise, but they will not rise in a greater portion than income, as this additional currency is first expressed through income. However, the added currency will eventually reach the hands of those least likely to consume and it will "fall out" of the market in this fashion (X increases but a stays constant).

A tax placed on those least likely to consume will lead to a decrease in loan issuance, or to no change if the loans market is saturated. The direct decrease in savings will precipitate no change to the actual economy because the effective supply of money has not been changed (X and a decrease in parity)

A tax placed on those most likely to consume will lead to a direct contraction in the economy. It will precipitate a reduction in the effective money supply and would be very harmful to the economy (X decreases but a stays constant).

For the reasons just outlined, the policy of the US government of backing its deficit spending with bond issues is silly (actually I think of it as grand theft of taxpayer dollars). The government can simply issue additional quantities of currency and should not be concerned with balancing its books. Rather, it should pay attention to the macroeconomic effect of its actions and work to bring unemployment down.

Thursday, January 28, 2010

The Opinion game - variations on a voting game

In my own personal throwback to the 1970's, when these kind of things were all the rage, I have thought up a game, with a few variations, that I believe can be of use in the modeling of opinions formed by groups.

This game is played with one player. There is a stack of identically backed tiles, each having a color on the reverse side, one of m possible colors. In each round, a new tile is revealed, and the player must pick a color.

They are awarded points on the following basis:
+1 point if they pick a color that is shown on the greatest number of tiles revealed thus far
-4 points if they changed their color from last round (no penalty for this in the first round)

Naturally, the behavior of the player will depend on the distribution of tiles. If the tiles are chosen ahead of time from an equally distributed lot, they will behave differently than if each tile's color is an independent random event.

Because the analysis is easier when each tile is independent, I will focus on this case. If there are 2 possible colors - say red and blue - the minimum number of rounds that must pass before a rational player has an incentive to change his or her opinion is 8. This follows from the following argument and example (WOLOG):
  1. We may limit ourselves to the simple case where one red tile is revealed then all blue tiles after that.
  2. It never makes sense to change one's mind within four rounds of the last round
  3. If red is behind by p tiles, the total expected payout of changing is derivable from the binomial distribution as follows: let n be the number of rounds remaining; the payout is a function of the path traveled to the final distribution. There are 2^n paths; we care about the difference between this outcome and the continuation of the red choice, thus equality of red and blue tiles is worth 0. Each path decomposes into previously calculated paths.
The shortest game in which switching makes sense is as follows:
Round 1:
Red tile revealed
Pick red

Round 2:
Blue tile revealed
Pick red (tied numbers; the "change cost" can be avoided)

Round 3:
Blue tile revealed
Pick red (at this point nine more rounds must be played for the expected value of changing to exceed 0)

Round 4:
Blue tile revealed
Pick blue (at this point, only 4 more rounds must be played for this choice to pay off)

Rounds 5 - 8:
regardless of tile revealed, player picks blue (see assertion 2)

Conclusions -

Studies of communication tend to emphasize the "deeply entrenched" nature of our opinions. This game confirms that if there is a social cost to changing an individual's opinion (such as alienation from your like-minded bretheren), a very large preponderance of evidence may be necessary to counterbalance this loss. Considering our number of choices in daily life, and the marginal benefits (if any) that abstract knowledge poses for the individual, it is no wonder that people tend to believe crazy things.

Wednesday, January 27, 2010

Availability of capital - modeling aggregate investment levels

Given persistent payments on business investment I and loans (at interest) L, aggregate fixed costs F, quantity sold Q, expected revenue per unit R, and per-unit cost V, profit in time period t is:

profit(t) = (R-V)Q - F - L - I

Ceteris Paribus, a business that shows profit could in theory pay down its loans and buy back its stock over time, increasing long run profits. Such a business could also continually fail to meet profit expectations, in which case expenses will be paid in left to right order. One can expect investors to receive dividends or other benefits only if a surplus reaches them. Thus, they are in the highest risk position. One can also expect corporations in particular to generally be unable to pay down investments, instead maintaining constant investment levels and paying out dividends in lieu of buying back, as this is a more lucrative path for the controlling shareholders to take.

A start-up will have a risk position that is a point within the bounded range between the maximum expected profit and minimum expected profit (negative being loss) that determines interest rates and total loan credit available. A business proposal does not give an incentive to the prospector (for purposes of this essay the prospector will be the person who creates the business proposal) to safeguard investments or loans received. Rather, the prospector's primary incentive is his own desire to attract the investment, meaning he is interested in making a convincing argument regarding the business venture. The prospector enters into negotiations with investors and banks in which he will make an argument regarding his risk position within the minimum-maximum range.

Similarly, any business looking to either expand operations or replace depreciated equipment may have need for temporary capital. The same process will take place, but in models featuring incomplete information, more complete information than in the prospector case should be assumed.

This negotiation is best modeled by empirical data. In a theoretical sense, such a negotiation is irresolvable due to it being empty of a priori content. Games or market models that may be superficially similar show similarity only insofar as they make assumptions about the players that are grounded in empirical reasoning.

The risk position is dilated or contracted when aggregate demand changes. An economic decline will generally shift the minimum expectation down slightly and the maximum expectation down greatly. Similarly an economic recovery will shift the minimum up slightly and the maximum up greatly. Typically, the level of aggregate demand is a significant determinant of the risk position of any business. This in turn determines the results of negotiations and the aggregate investment level. The loan offerings available to a business will also change based on the state of the economy. Generally, loans are more secure during economic downturns due to their lower risk position than investments, and will expand less during upswings due to bank attitudes regarding speculation - meaning they will generally have a higher price than investors during good times and a lower price than investors during bad times.

The distribution of business financing between investments and loans will also depend on the interest rates offered on loans. Businesses and prospects will each have both a credit rating (which partially determines loan offerings) and a risk position (which partially determines investment offerings). Thus, businesses can be divided into three categories:
  1. Businesses which attract loans at a lower interest than investments
  2. Businesses which attract loans and investments at the same interest
  3. Businesses which attract investments at a lower interest than loans
An important psychological factor comes into play in this distribution: the desire of investors and businessmen to maintain various degrees of control over businesses. For this reason, loans and other indirect investment mechanisms will have some edge over the introduction of new investors who could conceivably interfere with existing leadership structures. This means that even in boom times where there are many investors, institutions will still feature loans as a significant part of their portfolio.

Looking specifically at economic downturns, on the supply side investors will generally move assets into "safe" financial instruments. This will reduce the potential investor pool, driving up the price of each investment (in the form of dividend payouts). Therefore, loans will become a greater portion of business portfolios - meaning more businesses will be in category 1. This is accompanied by an increase in interest rates that is somewhere in between previous term interest rates and the new price of investment. Generally businesses become saddled with higher costs and less repayment flexibility during recessions.

Economic conditions may also prevail in which speculative investment increases in real estate, commodities, and other factors of production. This has the effect of driving up other aspects of business cost. Ceteris paribus, this forces businesses to seek additional investment, loans, or curtail operations. In fact, general decreases in prices seem to reach real estate last - meaning that real estate proportionally increases in cost during recession periods even as it shows no net increase in investments. Such changes bring about a long-term shift in the profit functions of businesses and force a decrease in hiring.

Arguably, it is these two effects which have the largest role in explaining the business cycle. Before venturing on, it is worth reviewing a key concept described in a previous blog entry regarding the distribution of money between the financial and real parts of the economy. Ignoring possible increases in the money supply, even if divided in a totally arbitrary fashion, it is clear that a two sector economy will have a relationship in which one sector gains money only as another loses it. If one takes the position, as I do, that loans do not actually increase the money supply, the following points will hold true.

Economies display a certain degree of stability. This stability is the result of the stimulus effect of incidental profits and losses. Within any given time period, some businesses will fail and investors will lose their money. However, so long as these failures are not interpreted by investors (or economists!) as a sign of changes in aggregate demand, average investor behavior will not change. These incidental losses must exist to balance against the unexpected successes (incidental profits) of other investors. Each time such an event occurs, aggregate demand is either stimulated beyond its equilibrium (in the case of incidental losses) or drawn below equilibrium (in the case of incidental profits). This follows from analysis of the relative stimulus effect of dollars in the financial relative to the real sector: since a failing business must by definition inject net dollars into the hands of noninvestors and a profitable one must do the opposite.

Paradoxically, the stability described above can only be maintained in an economy where there is a great deal of uncertainty among investors. Typically, the stability itself will lead to the perception of greater certainty as investors look to specific examples as test cases (regardless of the actual significance of these tests) and investors will turn toward a new strategy. It is extremely unlikely that investors will allow the economy to move toward a higher aggregate demand position through their own changes, as this would entail, in the short term, a higher risk position in the context of an average expected investment profit that is close to zero in the long term. In the event that mistakes are made and investors make bad investments, the immediate stimulus effect may roll the economy over to a new equilibrium. If mistakes are not made, investors will precipitate a recession because the opening time periods of the recession will promise them the largest profits. It is likely that some increased investment has occurred in commodities and real estate, further deteriorating the risk position of businesses.

Economic recoveries (and the prevention of recessions) generally occur through a combination of four factors:
  1. Increased spending by Governments
  2. Collapse of commodity and real estate markets
  3. Significant expansions in the dollars available to the poorest (perhaps through welfare or other deficit income transfers).
  4. An exogenous increase in the propensity to spend by consumers
Each of these, in sufficient magnitude, will produce a stimulus that has the potential to push the economy back to a new equilibrium.

Tuesday, January 19, 2010

Taxonomy of Incentives and Production; Optimization

Each good or service provided by an economy has its own means of production, marketing, and consumption. These differences are not rooted in government policy or market structures, but rather in the physical realities of the natural resources, available technologies, and cultural paradigms involved. If one were to compose a list of all the different types seen in these three categories, one could then describe each good or service according to which of the types are present. The means by which a good or service is consumed is an important aspect of consumer demand and helps to make consumption patterns predictable, e.g. the correlation between cigarette and alcohol consumption. Furthermore, the characteristic given by the combination of means within each category partially determines the incentive structure that predicts the behavior of the business leaders controlling the production and marketing of the goods or services, e.g. the prevalence of beer commercials and absence of gasoline commercials. Therefore, the particular quirks of each product constitute an extra-market force that can be corrected by government policy, irrespective of concerns relating to market structure and externalities. It is worth noting that in this capacity, it is not the individual preference but the individual benefit with which the economic analysis is maximally concerned, and that even when benefits accrue to the individual, there is nothing to suggest that costs are passed exclusively to individuals in practice.

Production is described by a capitalization rate, which is the portion of the cost of production of each unit of finished good that depreciation of the capital assets consumes. The remainder of the cost of production is labor cost. Capitalization will come from natural resources, factor goods, and machinery.

Marketing is described by three cost categories: advertising, distribution, and pricing. Advertising is a direct cost calculated to stimulate demand at a given price level; distribution is mostly correlated with the inclusion or exclusion of various geographic markets; pricing costs are costs incurred through coupons, promotions, sales, and other temporary price variations designed to stimulate demand or reduce inventory levels.

Consumption is described by probable aggregate goods consumption bundles given household budget levels. This is further divided by demographic. For each good at a particular price with a particular marketing and production strategy, there is a predicted consumption level (a mean with a standard deviation) and covariance with each other good available or changes to budget levels. In practice, the predicted consumption levels for each good are empirically determined. Accepted business practices and rules of thumb dominate over any "assumption of rationality" and so none is needed.

Businesses attempt to maximize profits by coordinating both production and marketing strategies. Businesses are constrained from an absolute realization of efficiency by limits to their own strategic abilities. Many choices made by a business are probabilistic in nature, meaning that as a business approaches its maximum profit level, the probability of moving closer to maximum profits decreases. Thus, the uncertainties of the production and marketing of any given good create an efficiency ceiling for the business. Furthermore, businesses typically have steeper cost discounting curves than either the "firm as a sovereign entity" would have or the society at large would agree on (in fact, it is arguable that society does not discount future costs at all).

In order to realize the true scale of the possible improvements to quality of life, the behavior of consumers must be described in such a way that it becomes possible to criticize it. A model such as a revealed preference model is not sufficiently rich in its psychological descriptors to be of service in this capacity. For this purpose, I would rather develop a marginal benefit impact for each consumed good. Underlying such a measure would be the assumption that rather than measuring individual welfare relative to no consumption, the more common concern is the effect of changes when measured relative to existing consumption levels. There would be no assumption of self-rationality; we merely observe that individuals tend to pick goods that benefit them, but that these are not always optimal choices nor are individuals aware of every possible budget composition available to them. The actual values used would be based on health and lifestyle data and sociological studies.

Optimization across these categories takes the following form:

1. marginal benefit - marginal cost = net gain

2. predicted consumption level * effective price - distribution costs - advertising costs - capitalization costs - labor costs = business profits

3. business profits are maximized when the marginal business profit is zero; but since the function is multidimensional we must also calculate the Jacobian to assure ourselves that we are in fact viewing a global maximum (rather than, for instance, a saddle point). In general, this situation shows the failure of automatic market correction because the under(or maybe even over)supply of financing to businesses can lead to inefficient capitalization ratios. High(or low) advertising and distribution costs can also affect the general level of sales of the entire business.

4. Even when the situation exists that all externalities and market structure inefficiencies are properly counterbalanced by regulation, two situations will tend to exist in the market provision of any good: 1. The marginal benefit will be less than the individual's perceived marginal benefit. This follows from the effects of advertising and the incompleteness of individual strategies. 2. The marginal costs will be greater than strictly necessary because businesses cannot realize maximum efficiency levels and have steeper future discounting curves.

5. If marginal benefits are well known, government policy can be organized around changing the various cost and incentive structures affecting businesses and individuals to push them toward decisions that maximize marginal benefits. Generally, this means 1. Ensuring adequate capital flow to emerging or expanding businesses. 2. Ensuring media diversity and access so that all types of business that seek to advertise have the opportunity to. 3. Planning local, regional, national, and international infrastructure to ensure that markets are accessible to distributors at a low cost. 4. Relatively high educational subsidies to promote competence within organizations and to ensure that individuals have adequate self knowledge to build good consumption bundles in the first place.

It is worth noting that this only looks at the individual business and consumer. It does not consider externalities or market structure issues (e.g. monopolies). Public goods and various types of Government activity are also justified by the existence of these situations. In particular, wealth redistribution and monetary policy are crucial functions of Government.

It is also worth noting that existing Government policies do not always reflect solutions to problems, but can often be problems in themselves. The best way to put the policy recommendations that follow from a principled economic analysis is not "regulation" or "deregulation" but "reregulation" as many problems exist on both sides of the issue.

Wednesday, January 13, 2010

General Nature of Economic Model Dependency Schema

Following on the heels of my previous post, this essay will classify the different types of economic predictions and trace them back to their source data by following the paths that this data takes through the models (dependency scheme). In keeping with this approach, the objective of this study is to evaluate the degree to which various assumptions play roles in the actual conclusions observed within a given model. Once the structure of the model is understood it can be critiqued as being more or less scientific on the basis of the criteria described in my previous post: correspondence between model elements and observed reality, the degree to which it addresses the original questions of its scope, and the degree to which it behaves as a way of observing through the creation of structure of reality theories.

Below is a schematic depicting the dependencies for a classical economic model.

Three important observations can be made:
  1. Wages do not alter commodity demand in this model, as decreases in wages mean increases in profits (not separated schematically), which in turn increases in other factors. Similarly for wage increases. This is an example of the type of troublesome details that seem unavoidable in models built this way.
  2. This model, though predicated on the use of calculus as maximization, does not feature equilibrium in the sense of related rates. Thus, the model is "always in equilibrium", with equilibrium being nothing more than the (assumed unique and extant) solution to a linear system of constraints.
  3. Exogenous factors disturb a key point in the system - commodity demand, which feeds both the aggregate supply and the aggregate demand side of the equilibrium. Unless some means is devised ad hoc for bounding or predicting these exogenous factors, the predictive power of the model is compromised.
Generally, similar criticisms can be made of other economic models.

The key scope question asked by macroeconomics is How do changes in Government policy affect the parts of the economy? This question, in turn, spawns the following questions: How are the parts of the economy best described in terms of their functional relationships? And, What effects are economically relevant when reviewing or proposing policy changes? In addition, the first question can be pushed back to encompass brainstorming by asking What changes are occuring in the economy under the status quo? And What policies should be implemented to address changes in the economy?

Rather than addressing the question of whether a model matches observations as a whole, it is important to ask whether this model matches the behavior of its component groups. Generally, one should ask how the component groups behave when analyzed in this model, then examine the behavior of individuals and firms based on historical records and experimental data. Having fewer variables involved reduces the effect of exogenous factors. Additionally, without such analytic separation, progress is rendered impossible when particular errors cannot be identified because the solution space is too large to practically check them all.

Next a system of accumulation and exhaustion rates must be formulated to allow the model to have equilibrium generated not by constraint but by the equality of countervailing rates. This introduces the temporal element to the equations, and allows the direct description of economic trends, growth, etc. When these things are directly described, they may be directly compared to observations.

Finally, the development of metrics must go beyond mere measures of aggregate production. Single index values are not acceptable because many ethical systems are predicated on deontological standards such as minimums, rights, duties, and social orders. These must be integrated into the economic variables in such a way as to preserve their original meaning, and this requires knowledge of both the relevant philosophy and the economic model. It is important that this development be scientific, because in this way it can remain based on observations, allowing critique not merely of the economic methods but the philosophic ones as well.

Tuesday, January 12, 2010

"Measuring" the effect of Stimulus

The AP recently wrote what can only be called a hit piece targeting the Obama administration that alleged that the stimulus has not created any jobs. This is the result of a study conducted by the AP and reviewed by "independent economists at five universities". Unfortunately, the study itself, which the AP quotes in its own article, does not seem to be available for review by the general public. This is troubling, because the study is certainly methodologically flawed. The claim that the stimulus has not been effective, which is what many readers will take from this article, is not one that an economist can make in good faith.

The claim is suspect for three reasons.

First, the study seems to make a serious error in counting of jobs. A key hint comes from a quote by Emory University Economist Thomas Smith, who reviewed the study:
"As a policy tool for creating jobs, this doesn't seem to have much bite. In terms of creating jobs, it doesn't seem like it's created very many. It may well be employing lots of people but those two things are very different."
Most likely, this study is counting "jobs" as the secondary stimulus effects, or ripples in the private sector created by the public spending. This type of counting is wrong. In terms of stability and growth, there is no functional difference between a job in the private and public sector. The difference is at the level of the firm, meaning that expanding the public sector undermines efficiency at the firm level, assuming that firms function more efficiently than government. Workers who are employed by the government do not spend less or create less demand for production materials than private employees.

Suppose that a law were passed that had the effect of taking $40,000 annually from the single richest person and using it to hire a single laborer - then so long as there is not a shortage of laborers, the number of jobs in the economy is increased by 1. One might here ask whether that wealthy individual will now be deprived of capital that he could use to hire an employee. But two conditions must be met before the wealthy individual will fund such a job - he must have the capital and there must be sufficient demand for the product. In our economic situation, as in most economic situations, the second effect is certainly dominating over the first. In keeping with this analysis, a $20 billion dollar stimulus could be expected to create 500,000 jobs if it was raised totally from taxes. However, in the case of this stimulus plan, the stimulus comes from government issued debts, which are held as safe assets by banks, meaning that they are sold on the market only to wealthy individuals who do not have a better investment option (such as going into business). This makes the stimulus much less likely to trigger capital shortages by potential investors. Certainly, though, there are mitigations, such as disbursement costs that make the initial effect somewhat less. So, this number could be trimmed further, maybe even cut in half, but it is still not zero. If it is not a large enough number, then it is evidence, as many economists have argued, not for abandoning the stimulus concept but for making a much larger stimulus - on the order of $800 billion or so, which is about what the total stimulus adds up to. That is the opposite spin from what many people got from the article.

Secondly, there are persistent questions that need to be asked about the measurement of economic variables. Since many things in the Economy are in constant flux, and since the Economy itself is unpredictable, it is not possible to separate the variables involved without depending on one's economic models. In other words, economics can only ever compare reality to the theoretical. It cannot create or observe any experimental controls. The very term ceteris paribus is a transition to the theoretical.

Many economists sadly use a neoclassical model that posits the economy in a constant trend toward an equilibrium labor employment that is set by a unique equilibrium given by the labor market. Even the Oregon State's official economists use such a model, and as soon as the economy started to go downhill, this model predicted a recovery. In fact, I have seen one rather hilarious graph which shows a series of three predictions, each made two months apart, that doggedly showed the same upward trend in the coming months, each being wrong.

We have known that such a model is wrong since Keynes wrote the General Theory. Though the assumptions, first formulated by Ricardo, about the way labor behaves were almost certainly wrong, Keynes also pointed out that the classical model was based on circular logic. But just to add perspective to this issue, Keynes' primary academic opponent in the General Theory was Pigou, who pioneered many aspects of welfare economics and advocated for subsidies to correct market failures. I highly doubt that were Pigou alive today, he would advocate against government intervention in our economy.

In other words, without knowing if things were going to get better or get worse without the stimulus, it is impossible to tell with any accuracy how many jobs the stimulus created. If one uses a classical model, one is likely to predict a recovery too soon and therefore underestimate the effect. Even finding the stimulus ineffective does not endorse inaction.

Third, the very small nature of the stimulus studied in this article makes it harder to measure. For reasons not explained, this study looked only at a small part of Obama's total stimulus package. In an economy with 300 million people and GDP in the trillions, the aggregate employment effect of a $20 billion disbursement at the national level is going to be rather diluted.

Furthermore, this measure was offset directly by State Governments cutting their budgets. Here in Oregon, we were smart and knew that gutting the State budget would only make our economic situation worse. Even so, we may be forced into such a situation, and we could even lose our super-majorities in the legislature. The tax increases that Oregon passed are really a good option for our economy, but you would never learn this by reading what newspapers like the Oregonian have published. Referring to the disastrous way that budget cuts by Herbert Hoover exacerbated the great depression, Paul Krugman warned of the state legislatures becoming "Fifty Herbert Hoovers".

Sadly, the media remains a pawn of business interests. This manipulative relationship is formed in part by the inability of journalists to see through the economic deceptions created by conservative economists. The best way to describe such economists is ironically through their own language of regulatory capture. I would say that these people have been captured by corporate interests. With their help, corporations can expand their grasp, to capture the media. We must work diligently to build our own information networks for political and economic information, because the evidence is mounting that advertising-based media cannot be trusted.

Monday, January 4, 2010

Some Philosophy of Science

This post is my exploration of various concepts and standards in the philosophy of science. The purpose of the exploration is to define clear criteria for the inclusion and exclusion of various approaches within economics as being scientific. Unfortunately, the existing literature and philosophy dealing with what science is are crude and unhelpful for a variety of reasons. The many myths about the scientific or nonscientific nature of particular arguments or models within economics are probably due to this deficit. Thus, it must be addressed if the discipline is to obtain practical clarity and a real public policy vision.

In particular, This is intended to be an exploration of the essence of the science, the science itself, rather than its practical application. The definitions given of what science is, such as in Thomas Kuhn's Structure of Scientific Revolutions do not generally make this distinction, often blending the institutions of science with the science itself. Generally, there may be a vast number of institutions and rituals surrounding a particular practice of science that are not part of the science itself. To the degree that these things are necessary for the science to exist, there must be some requirement - a property of the science itself - that creates this necessity.

The essential, classifying property of science is that science is a way of observing. The development of sciences is really the development of different ways to observe phenomena. When a conscious being observes a phenomenon, it initiates a mental process whereby it assigns a meaning to what was observed. The theories of science are particular techniques for assigning these meanings.

The type of technique that is created for the purpose of assigning meanings is what I'll call the structure of reality theory. This theory defines and creates the objects used by the observer of a given phenomenon in his explanation of that phenomenon. This is typically a partial replacement of whatever other intentionality might exist for the phenomenon, but I can't say that there aren't cases of pure augmentation. Science isn't the only thing that creates structure of reality theories; rather these theories are, in my schema, an essential component of all human understanding. Their totality provides a cover for the domain of object definitions in the thought process itself. As a dynamical system, the thought process is always drawing from this domain of object definitions to create the objects of thought corresponding to observed phenomena, memory, and mere imagination. The thought process is apparently also capable of making changes to these structure of reality theories based on the qualities of the objects of thought that are created, and of communication to other individuals (and to itself) of a fragmentary form of both objects and structures. In this way, the system evolves and the thought process of the individual changes.

Science is differentiated from other methods of creating structure of reality theories in that science attempts to base its structure of reality theories on only observed phenomena and formal logic. Properly speaking, this is impossible, as phenomena are not accessible to the consciousness prior to their interpretation into objects. Once the object is created, it has already been processed by the structure of reality theory in which imagination, memory, and communications from other consciousnesses may have exerted significant influence. Remembered or communicated objects trace their origins back to either imagined or observed phenomena. Therefore, to establish a record of pure observation, science needs a way to systematically exclude imagined phenomena and any phenomena of unverified origin.

Science is also differentiated from other methods because it seeks a specific explanatory telos. In more general terms, this means that each science has a defined end-point at which it is fully understood. It poses a finite set of questions, which, when answered completely, would constitute a complete structure of reality theory that cannot be improved to better answer these questions. At first glance, this might seem to be nothing more than a descriptive property, but it has a key function to the development of the science itself. When we talk or think about reality, we tend to forget that each topic to which we turn our attention has its own collection of concepts, defined in relation to each other, that collectively constitute the topic. These are an expression of the structure of reality theory that we have with respect to that topic. The science must have an origin, and this origin is in the criticism of objects that arise through a less scientific structure of reality theory.

Neither of these are unique to science. Rather, sciences are the ways of knowing that exhibit both of these characteristics.