Monday, December 14, 2015

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

Friday, December 11, 2015

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