How economists work

The model was amazing. It was neat and slick and smooth all around, had no edges. It looked just perfect.

"Does it float?" I asked excitedly.

"Of course!" The boat maker said. "Look!"

He went to the whiteboard and drew sketches, scribbled formulas and explained his theory of boat making in all details. It looked awesome.

"That's awesome," I said. "Now, does it float?" I asked even more excitedly.

"Yes", the boat maker said, "I just showed you". Then he summarized the most salient points of his theory while pointing here and there on his whiteboard.

"Great", I said slightly but back. "Can I put it in water and see it floating?"

"Ah.. it's not really necessary. We had this philosophical debate since the nineteen seventies. People will never agree about the facts, but it's logical: If you build boats according to the theory they'll float".

He turned to the door, where his secretary appeared. "I'll be right there", he called, then turned to me again. "You'll excuse me", he said. Then he left.

I stood there for a while, then I couldn't resist. I gently grabbed the model of the boat, walked to the tank in the laboratory and very gently put the model into the water. It sank like a stone.

I was shocked. How can that be? The theory said it would float. I walked to the whiteboard and checked the theory. It seemed flawless, but then I noticed something strange: In the boat maker's theory of boat making, there was no concept of water. Water was mentioned, but only in the most cursory manner: Because there cannot be any water inside the hull (otherwise the boat would be too heavy and would not float), water does not play any significant role to the details of the inner construction of boats, which after all is a container of sorts. Only what's inside a container matters. If there can't be any water inside the boat, water can be ignored, obviously. This is a valid simplification of theory. Because it is. You're not a boat maker, so how would you know. Perhaps you read a first year's boat making text book, before you discuss boat making theory.

I was shivering. Could it be that during the last 30 years since supply-side boat making came into fashion, we designed boats according to a theory where water was absent? Could it be that the boat sinking crisis of 2008 was due this flawed theory? After all, those boats were sinking in water.

How could we ever know. No boat maker has ever been called to account for the miserable failure in recognizing the boat sinking crisis of 2008. Indeed, the same flawed theory of boat making is still taught to this very day.

It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong. Richard P. Feynman

The Dog Leash Model of Economics

We're in unchartered territory. Billions of QE funds that don't appear to reach main street and don't appreciatively stimulate the economy. Business taxes are low, credit is free, yet there are practically no investments. What's going on?

This is an instance of what I call The Dog Leash Model of Economics.

Let me explain.

The economy works like a dog on a leash. There's an important property of a leash, that is totally underestimated: You can pull on a leash, but you cannot push. That's because of the way ropes of any kind, including dog leashes, are constructed. While they technically transmit forces equally well in both directions, this holds only true as long as there is tension in the leash. As soon as there is slack in the rope, you lose the ability to exert any force.

At this point, you may ask yourself, why I'm writing as if I'm addressing a moron. That's because most economists are. No offense.

Well, then how does a dog leash work? You can pull at the leash to slow down the dog. If the dog stops or lays down, you can pull at the leash to make him move (or stand up and then move) towards you. That's it. That's how dog leashes work. Note, that you cannot make a dog walk any other way. In particular, you cannot push a dog with the leash.

What about incentives, you ask. Well, what about them? They are number 4 on Gregory Mankiw's 10 Principles of Economics, you say: "Dogs respond to incentives". So, if I give in on the leash, the dog walks faster. Incentives! Well, Gregory Mankiw is a moron. Did he see the financial crisis coming? No? Then why is anyone still listening to him?

Alright then, what about opportunities? By giving in on the leash I can give the dog the opportunity to walk faster! Opportunities? Didn't see that one coming...

Still, that's not true. You cannot make a dog run faster by giving him slack in the leash. A dog that is walking will keep on walking even if there's slack in the leash. You cannot push a walking dog with a leash.

Then what about a running dog that's pulling you after him? By giving in on the leash, he can run even faster! Now, that is true, but note two things: first, this only works, if the dog is running already. You cannot make him walk or run in the first place. And second, if he's running so fast that he's pulling you behind him, perhaps you should not give in on the leash at all, because he may then run too fast for you and you may trip and fall and break your leg.

OK, I think I get it, finally... (rolling eyes everywhere). Now what has all this dog leash business got to with economics? Glad you asked! That's because the economy works exactly like a dog on a leash!

Let me explain.

Monetary policy works like a dog on a leash.

If you pull on the leash, i.e. raise interest rates, the dog (the economy) will slow down. That's because you inflict pain: you raise the price of money for banks. Banks will not shoulder the pain (would they ever?) and pass the higher cost on to the lenders. Lenders (businesses and consumers) will at one point feel that credit is too expensive now and stop taking any (and hence stop investing or consuming-on-credit). Pull, pull, pull. And thus the economy will gradually slow down. So, pulling on the leash, i.e. raising interest rates works.

But what if you lower interest rates, i.e give in on the leash? Well, if the economy is running already, it may run even faster. So fast indeed, that you trip and fall and break your leg. We call such a situation Financial Crisis of 2008. But an economy that is laying down or walking slowly cannot be made to stand up and walk faster by giving in on the leash i.e. by giving more and cheaper credit.

Because, what if the economy does not want to stand up or walk faster (does not ask for credit)? How can you make it? By pushing on the leash (forcing credit on him)? Won't work, because you cannot push on a leash.

What about incentives? Well, what about them. We have below zero interest rates, central banks are flooding the system with free money, even after all the tax breaks that business got. So why aren't they investing? What more incentives do they need?

You cannot push on a leash. The whole incentives thing is utter nonsense. People respond to incentives only, if the are already in the mood/ready/prepared to respond. But if they are already in the mood/ready/prepared they don't really need any further incentives. And if they are not in the mood/ready/prepared to respond, they simply won't -- with or without any incentives. Incentives don't work. Pain, however, always works.

Demand and supply works like a dog on a leash.

Demand means pulling on the leash. You want, so you pull. Supply is giving in on the leash. Here, take! Push. This is why supply-side economics never seems to work. You cannot push on a leash. Unless businesses produce for the warehouse, somebody sometime has to buy all that stuff, i.e. pull. To that end, they need money, because businesses are not giving their stuff away. So if you take money from those who buy and give it to those that produce, how is the buyer going to pay for the thing? But more importantly why should businesses hire more people or invest, if you give them the money? Why should they? Incentives? Incentives don't work, only pain does.

Businesses invest and hire only if they're forced to, i.e. if somebody pulls -- hard! -- on the leash. The shop owner orders new supplies only if the shelves are getting empty because of demand. The supply chain orders new supplies from the producers only if the warehouse is getting empty because of demand. The producers produce only if they're getting orders from the suppliers because of demand. Pull, pull, pull. And all of them hire only if they cannot keep up with the production/warehouse stacking/shelf stacking, i.e. if they cannot keep up with demand. Because if they don't respond, customers, suppliers will find another shop/producer, in other words, they will inflict pain on the original shop or producer, and we know, pain always works.

So there you go. You have now learned an important lesson about the economy, that most economists are totally unaware of: The Dog Leash Model of Economics, the only explanation of economic processes that really works.

If henceforth any economist or supply-sider ever wants to lie to you by saying that supply-side works or that incentives work or that the Dog Leash Model of Economics is bullpucky, you have now officially been licensed to hit them hard between the eyes, legs, or any other body part where it hurts most.

Because pain always works.

Update [14.12.2015]: Why are you saying that Gregory Mankiw is a moron, just because he didn't see the financial crisis coming? It may be true that the economic models that he teaches did not work when faced with the upheaval of the financial crisis, but they worked well all the time before!

Did they? How do you know? How can you say that an airbag that did not ignite in an accident "worked well all the time"? Perhaps it never worked, but you just didn't know because it was never tested. How do you know that a boat floats if it's never set in water? Of course, it never sank while the boat was ashore. It only sank, when it was set in water for the first time.

It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong. Richard P. Feynman

Open Letter to Leftist Parties of the World (plus Switzerland)

When (or if, depending on your point of view) Global Warming begins to hit us all, there's one thing nobody is able to ask: Why weren't we warned?

Oh, we were warned! For more than 20 years climate scientists keep reminding us about the potential dangers of Global Warning, but we chose -- and continue to choose -- to ignore them.

The situation with our economic situation is strangely converse to the situation in climate science. Indeed, we did everything economists asked us to do. We lowered taxes for the rich and corporations so they could invest more. We privatized public utilities so they would operate more efficiently and cheaply. We deregulated (or stopped regulating altogether) financial markets so the free market could allocate capital resources optimally. We liberalized labour markets so that free enterprise could employ workers more flexibly and effectively. And still, the global economy collapsed under the weight of a financial crisis that exceeded even that of the Great Depression. And nobody within the economics profession saw it coming.

And it wasn't even an unforeseeable event like an earthquake. It was rather like a battered cruise ship running full with water and slowly sinking. Even an idiot like Captain Schettino recognized the danger and let himself "drop into a lifeboat" when the Costa Concordia sank. So why didn't economists see it coming? Or rather, why did the economy collapse in the first place, when we did all that was asked of us.

For the last 30 years the world's economic system has been market-liberalism (sometimes also called supply-side economics, trickle-down, neo-liberalism, globalization etc.). It centers around a set of claims made about economic subjects (that would be corporations. And us) and markets. These claims are the direct consequence of economic theory. These claims are positive, factual, verifiable propositions that can be tested. And when they are tested, they prove to be wrong, time and time again.

If competitive financial markets are efficient, as the efficient markets hypothesis claims (EFM, for which Eugene Fama received the Nobel price for economics), a financial crisis of the sort we witnessed in 2008 cannot possibly happen. We know (and economists agree) that financial asset markets are very close to the perfect competitive markets they believe in, because it has been vigorously deregulated -- or not regulated at all as in the case of derivatives -- and still the market imploded under its own weight in the credit crisis of 2008. Something can't be right.

We lowered the taxes on corporations and the rich (in Greece the latter seem not to be taxed at all), so why don't they invest as economists claim they will? Something can't be right.

Central banks flooded the markets with practically free money, so why don't banks extend credit? Or businesses ask for credit as economists claim they will? Why don't they respond to these incentives? Something can't be right.

The answer for us is obvious: lack of demand. But wait, according to economic theory supply creates its own demand, that's why it's called supply-side economics. The beneficiary of economic policy is supposed to be the supply side because demand-side economics that we had before the 80s didn't work. If the supply-side does well, demand will follow afoot. So why is there lack of demand? There can't be, if economic theory is right. Perhaps it isn't?

Economists claim that taxation of the wealthy depresses their incentives to work and invest, and will ultimately suppress all economic activity. But there had been a time called the Golden Age of Capitalism between 1946 and mid-1970s where the top marginal tax rate in the USA was 91% (until 1966 when it dropped to 70%). If the claim is correct there couldn't have been any economic activity in that time period -- at all! --, yet it is known as the Golden Age -- of capitalism. Something can't be right.

So why do economists make claims like these that when tested prove to be wrong, again and again? Why do they keep demanding economic policy that fails to fulfill any of their claims? Indeed, the regulated social market economy with strong publicly owned infrastructure industry (electricity, telephone, postal service, water supply, waste removal etc.) and moderate to high taxation consistently exceeded market-liberalism in every measure, from inequality, to output, to GDP growth rate, to the number and severity of crises and so on, and on, and on. We know that, because we have the figures to prove it. Why did we change it? The sad irony is that we used measures that according to economic theory can't work to fix a crisis that according to economic theory can't happen.

We know that market-liberalism does not work, because it never has in the 30 years we used its policies. We know that social market economy -- called Golden Age in the US, economic miracle in Germany -- exceeds market-liberalism in every measure. Isn't it time to finally stop the experiment and turn to something we know to work?

Why don't leftist parties base their economic policy on science instead of ideology? Why don't they tell the peoples of the world what they already know: namely that the economic system called neo-liberalism (or trickle-down, or supply-side, ...) doesn't work and indeed never has, at least on this planet? Why don't they argue for and advocate policies that support the middle-class that is and always has been the driver of the local (inland) economy? Why don't they ask, who is supposed to buy all the stuff being made, if incomes are being redistributed upwards? After all, a rich person may have 5 cars, but she doesn't have 5000 cars. So who's supposed to buy the 4995 remaining ones? And what are they supposed to pay them with? The wages that they have not earned, because wages keep being suppressed to pay for excessive bonuses of the CEOs? The tax increases that they had to pay, because the rich and corporations got tax breaks and somebody had to pick up the bill? The inflated prices of newly privatized formerly state owned enterprises that didn't have to make a profit and therefore could offer their services at lower prices?

In short, why don't leftist parties advocate policies that help the middle class (a.k.a "the people") and  hence the whole economy -- instead of policies that are allegedly business-friendly but consistently lead to more and deeper crises, more inequality and lower growth rates?

News From The Bookshelf

I'm just reading Economics: The User's Guide by Ha-Joon Chang, Professor of Economics at the University of Cambridge. It is a very accessible introduction to economics by the writer of the no. 1 bestseller 23 Things They Don't Tell You About Capitalism.  Both books are real eye openers, and required reading for anyone who wants to be taken seriously when debating economic policy.

Chang is a heterodox economist, i.e. he doesn't follow the economic mainstream which -- as you'll remember -- failed spectacularly in predicting the Financial Crisis of 2008. Or even recognizing it when it happened, and, no, it wasn't like an earthquake that nobody could have seen coming but rather like a ship running full of water. I mean, you can say what you want about Captain Schettino of Costa Concordia notoriety, but at least he knew that the vessel was sinking and made an exit.

Alright then. Buy the book and read it. NOW!

Die Tragödie des Merkels

Im Blog Never Mind The Markets des Schweizer Newsnets (Tages-Anzeiger, Finanz und Wirtschaft, Berner Zeitung und andere) diskutieren die Autoren regelmässig die Situation im Euro-Raum und im Besonderen die Rolle Deutschlands. Als wichtigste Volkswirtschaft und Haupt-Exporteur innerhalb des Euro-Raums hat Deutschland einen massiven Einfluss auf (und Verantwortung für) die Situation der übrigen Länder und speziell der Krisenländer an der Peripherie.

Ein Problem für die EU sei, so schreiben die Autoren, dass Deutschland zu viel exportiere und zu wenig importiere. Letzteres sei darauf zurückzuführen, dass in Deutschland zu wenig konsumiert werde, was wiederum daher herrührt, dass die Löhne in Deutschland im Vergleich zum während des letzten Jahrzehnts erwirtschafteten Produktivitätsgewinn viel zu tief seien. Diese Besonderheit Deutschlands wird oft als Kritik an dessen Erfolg aufgefasst, auf die dann in den Kommentaren mitunter säuerlich reagiert wird. Tatsache ist, dass das Erfolgsmodell Deutschland -- dessen Soziale Marktwirtschaft -- immer mehr einem angelsächsisch inspirierten Markt-Liberalismus weicht, mit Tiefsteuern für Unternehmen, dem Abbau von Sozialen Leistungen und Privatisierungen von Staatsunternehmen und Rentenkassen. Wie überall, führen diese Massnahmen auch in Deutschland zum Niedergang des Mittelstands.

Das Tragische an der Situation Deutschlands ist, dass die Staatsführung, insbesondere Bundeskanzlerin Merkel Grundkenntnisse in Wirtschaft fehlen. Das ist kein Vorwurf, sondern eine Tatsache. Hier die Begründung:

Angela Merkel 1990

1. Bundeskanzlerin Merkel ist als "Ossi" in einem sozialisti­schen Wirtschafts­gebiet aufgewachsen und geformt worden. Ihr fehlt daher das vegetative Gefühl für die Funktionsweise einer westlich, d.h. markt-ideologisch geführten Wirtschaftsordnung. Da sie kein Gefühl dafür hat, wie eine Marktwirtschaft funktioniert, kann man ihr jede ideologische Verdrehung unterjubeln.

2. Vor dem Mauerfall hatte in Deutschland gerade das grösste Experiment der neueren Geschichte begonnen und Fahrt aufgenommen: der Umsturz der Sozialen Marktwirtschaft in eine deregulierte, privatisierte und steueroptimierte Liberale Marktwirtschaft. Die bittere Ironie der Geschichte war ja gerade, dass die Montagsdemonstranten vor der Wende in der DDR "Keine Experimente" skandiert hatten, weil sie keinen neuen "Dritten Weg" beschreiten, sondern einfach die Westliche Wirtschaftsordnung unverändert übernehmen wollten. Wie konnten sie ahnen, dass man im Westen gerade dabei war, die ersehnte Wirtschaftsordnung unzustürzen und damit ein gigantisches Experiment zu starten. Viele der impliziten Versprechen wie Verteilungs- und Steuergerechtigkeit, die während des Kalten Kriegs dem Kapitalismus abgerungen worden waren, wurden im Nachhall nach der Wende von den Liberalen aufgekündigt. Das konnte Bundeskanzlerin Merkel natürlich nicht wissen. Ihr ökonomischer Referenzpunkt wurde wie bei einem Hütchenspieler unter der Hand abgeändert.

3. Als Physikerin ist Bundeskanzlerin Merkel darauf konditioniert, dass Wissenschaftler eine Ahnung von ihrer Materie haben, und dass Lehrbücher den Stand des Wissens wahrheitsgemäss wiedergeben. Beides ist im Fall der Ökonomie nicht gegeben: Ökonomen haben wohl Ahnung von Ökonomie, aber keine Ahnung von Wirtschaft, und Lehrbücher, vor allem einführende Literatur, verfälschen oder ignorieren den Stand des Wissens (vor allem Tatsachen, die empirisch widerlegt wurden) und haben einen von Ökonomen durchaus unbestrittenen pro-Markt-Bias.

Diese teuflische Dreifaltigkeit von fehlender persönlicher Erfahrung, Täuschung über den wahren Charakter der eigentlich herbeigesehnten Wirtschaftsordnung (unterschobene Liberale statt  erwünschte Soziale Marktwirtschaft) und schliesslich Täuschung über den wahren -- nämlich ideologischen -- Charakter der Wissenschaft Ökonomie, führt dazu, dass Bundeskanzlerin Merkel wirtschaftliche Massnahmen ergreift, die nicht funktionieren und immer weiter von einer gerechten, effizienten und krisenarmen Sozialen Marktwirtschaft wegführen.

On typical cost curves

I have written extensively about perfect competition and the fact that the claims associated with it cannot be proven scientifically. In fact, computer simulations of perfect competition show conclusively the same price and amounts as in a monopoly. I've also written about Joseph Stiglitz' explanation of why this might be a logical outcome of the theory.

There is a further point that I want to make, and that Hill and Myatt make in their excellent book The Economics Anti-Textbook. It is the point about the "typical cost curve" that underlies the theory of perfect competition.

For the theory to produce the results that economists claim, firms must be so small that they don't have market power: any change in production quota is too small as to affect market prices. The chief thing that guarantees their small sizes is the typical u-shaped average cost curve, because profit-maximising firms will stop producing when marginal cost of production equals the marginal revenue from sales. The problem is, that the typical u-shaped average cost curve is a total fabrication pulled out of thin air. What economists call "typical" is known at least since 1952 to have no factual base whatsoever.

In a survey by Wilford J. Eiteman and Glenn E. Guthrie in 1952 (published in The Shape of the Average Cost Curve, American Economic Review, 42.5: 832–838) managers of 334 companies were shown a number of different cost curves, and asked to specify which one best represented the company’s cost curve. A stunning 95% of managers responding to the survey chose cost curves with constant or falling costs. That leaves at most 5% for the "typical" u-shape.

A. S. Blinder, former vice chairman of the American Economics Association, conducted the same type of survey in 1998, which involved 200 US firms in a sample that should be representative of the US economy at large. He found that about 40% of firms reported falling variable or marginal cost, and 48.4% reported constant marginal/variable cost (Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York). A minority of about 11% of those surveyed reported the typical u-shape.

What does all this tell us? Economists know at least for 60 (that's sixty) years that the tale of u-shaped cost curves -- and as a consequence the majesty of perfect competition that rests heavily on this claim -- is a falsehood, yet it's still the staple of every economics textbook. Note that also the Wikipedia page linked above did not mention the fact that the claim has been empirically proven to be false, until I added it on January 3, 2015 (see page history).

The u-shaped cost curve is not a simplification either, because assuming a constant average cost would be much simpler. But then, constant average cost does not guarantee the firms to remain small, and hence perfect competition to work.

No, the typical u-shaped cost curve is a complete fabrication pulled out of thin air in order for the theory of perfect competition to yield the results that economists wish it to have but cannot produce otherwise. After all, who wants to know a truth that contradicts the dogma of perfect competition?

Now, how's that for a value-free and results-open science!

Update [28.12.2015]: I just noticed that the Wikipedia page that I edited (see above) has been modified to begin with the statement: "Some argue that cost curves are not typically U-shaped." If nothing else, this shows how insidiously economists misrepresent facts. Indeed, the statement "some argue that..." makes it seem as if the not-U-shaped cost curves are a position held by a minority of economists ("some") when what follows is actually real evidence. Not just "theory", but observations in the real world. Something that "some" people call science. I modified the article to state "Evidence shows that cost curves are not typically U-shaped." Let's see how long this modification lasts.