Arnold Kling: The Economy is Not ONE Big GDP Factory

More on the GDP Week.

Blogger and Adjunct Scholar for the Cato Institute, Arnold Kling, writing at the Econolog (Library for Economics and for Liberty) distinguishes camping trip economics (macroeconomics) with woolen coat economics (complex patterns of specialization, production methods, trade, and innovation.) to arrive at the GDP myth. (bold mine)

In macroeconomics, the conventional misrepresentation treats the economy as one big GDP factory. Macroeconomists look at total output, as measured by GDP, and they think of it as produced by homogeneous labor and homogeneous capital. Again, this is camping-trip economics, with value assumed to be embedded in the endowment of labor and capital, rather than in the coordination required to create patterns of specialization, production methods, trade, and innovation.

Conventional economists use the term "potential GDP," and they will say that the economy is operating "below potential" during a recession. From a coordination point of view, the meaning of such concepts is in doubt.

A conventional economist would say that the U.S. economy was operating at its potential in early 2007, prior to the onset of recession. Subsequently, it was operating far below potential.

From the coordination perspective, one might ask what this "potential GDP" means. If the United States in 2009 had produced exactly the set of goods and services that it produced in 2007, would this have meant that it was operating at its potential? In particular, that would mean going back to building the same number of houses, creating the same number of mortgage securities backed by sub-prime loans, discarding any post-2007 innovations in health care or computer technology, and so on.

It certainly is true that there are fluctuations in the proportions of employed and unemployed workers. Thinking of the economy as a GDP factory leads to a very limited view of the causes of such fluctuations. If there is only one good produced, then the only meaningful choice that people can make is an intertemporal one. They can decide when to work more and consume more, and, conversely, when to work less and consume less. In fact, this stunted theory of economic fluctuations is what macroeconomics degenerated into in the 1980s, particularly at the "freshwater" schools of the University of Chicago and the University of Minnesota. Meanwhile, the "saltwater" schools of MIT and Berkeley retained the GDP factory with intertemporal choice issues while adding some relatively arbitrary rigidities in nominal wages or prices, to arrive at what was called New Keynesian economics.

Instead, thinking of the economy in terms of coordination, there are myriad reasons for employment to fluctuate. Consider all of the adjustments that would have to take place in order for the economy to shift some resources from woolen-coat production to the development of smart-phone apps. In fact, the U.S. government's data on JOLTS (job openings and labor turnover statistics) shows that millions of jobs are created and destroyed each month, compared to which the aggregate net gains and losses of 200,000 or so per month seem relatively minor.

Read the start here.
 
In my view, macroeconomics is heuristics (mental shortcuts) clothed by mathematical formalism.

Quote of the Day: The main difference between non-profit and for-profit

The main difference between non-profit and for-profit is that non-profits are accountable to donors and for-profits are accountable to customers. This means that the non-profit sector is going to be more elitist and more less efficient than the for-profit sector. It does not mean, as so many people think, that the non-profit sector operates from better motives or provides more social benefit.

I am not saying that a non-profit sector is a bad thing. Just remember that it is inherently paternalistic, and that is problematic.

(italics original)

This is from economist, author and entrepreneur Arnold Kling at his blog.

Quote of the Day: Quackroeconomics

In discussions of macroeconomic policy in Washington and in the press, these four propositions are taken as given:

(S) Spending is what drives the economy. Spending creates jobs, and jobs create spending. When unemployment is high, the problem is too little spending.

(M) Monetary policy must steer the economy carefully between overheating and slumping. Doing so requires high levels of skill and intellectual resources.

(F) Fiscal policy is just as important. When there is unemployment, monetary policy cannot do the job alone, because the Federal Reserve also has to keep an eye on inflation. So the Federal government must engage in deficit spending to stimulate the economy.

(C) Computer models are essential tools that enable economists to forecast the economy and assess the impact of alternative economic policies. Using computer models, the Congressional Budget Office is able to score the number of jobs a particular policy will add to or subtract from the economy.

These four propositions are what I term quack macroeconomics, or quackroeconomics for short. Like quack medicine, quackroeconomics is unproven, unreliable, inconsistent with the views of leading researchers in the field, and possibly dangerous.

This is from economic blogger and author Arnold Kling at his blog. 

I would add to quackroeconomics the mistake of rigidly interpreting statistical (historical-empirical) data as economic analysis.

Quote of the Day: Credit Allocation Determined by World’s Bank Regulators

The financial crisis served to differentiate two types of investments–the ones that get bailed out and the ones that don’t. Investors naturally have a preference for the former. That means big banks can get cheap credit. And what does Basel tell them they can do with their cheap credit? Buy government bonds.

So what we have had over the past ten years is a massive exercise in credit allocation by the world’s bank regulators. They offer explicit and implicit guarantees to banks that invest in assets officially designated as low risk, and now they are shocked, shocked to find capital pouring into exactly those assets.

This is from economist, author and professor Arnold Kling on his blog.

Quote of the Day: Protection-Racket Capitalism

Let’s see.

1. The Justice Department is suing a rating agency (Standard and Poor’s). The rating agencies are creatures of the SEC (which created their oligopoly and encouraged them to be paid by the raters rather than the customers of the ratings).

2. The SEC is suing Freddie and Fannie, which are creatures of the Department of Housing and Urban Development, under which the two firms were regulated and also given lending quotas for “affordable housing.”

So, when is HUD going to sue a company that is a creature of the Justice Department, just to complete the circle?

One way to view the period 2005-2009 is as a massive destruction of property rights by the government. First, they destroy the right of Freddie, Fannie, and commercial banks to maintain lending standards. Then they confiscate the property of holders of securities in GM and Chrysler to pay off the labor unions. Then they sell off AIG’s assets in order to bail out Goldman Sachs and several large foreign banks. And of course, the government has made every effort to keep banks from enforcing mortgage contracts, while extracting large fines from banks.

It’s beyond crony capitalism. It’s protection-racket capitalism

This is from author, economist and professor Arnold Kling at the Askblog on the financial crisis.

Quote of the Day: Central Banking Crony Capitalism

The second point made in the classic video is that open market operations are a handout to the dealer banks. Suppose the government is going to spend an extra $100 that it does not have, and it will finance this by printing $100. In practice, it borrows $100 from "the Goldman Sachs" by issuing a bond, prints the $100, then pays "the Goldman Sachs" to get its bond back. This second method of funding the deficit is costlier to the government, but yields profits to "the Goldman Sachs." It also yields profits to the Fed, because the Fed is the agency printing the money, while the Treasury is the agency issuing the bonds. However, from a taxpayer's point of view, the Fed's profits are a wash (all of the Fed's gains come at the expense of the Treasury), and the only net impact is the income transfer to "the Goldman Sachs."

The Fed's response to the financial crisis was to massively increase the size of its balance sheet, thereby massively increasing the income transfer to private financial institutions. In addition, in order to keep this additional money from leaking to businesses or consumers in the form of loans*, the Fed introduced a policy of paying interest to banks on reserves. This increased the value of the transfer from taxpayers to financial institutions.

That’s from Professor Arnold Kling.

Quote of the Day: Why Government is Not Private Business

From Professor Arnold Kling,

In business it is actually really hard to get people to do what you want. In fact, understanding that fact is exactly what sets CEOs apart from policy wonks. Policy wonks think that you write a law and that solves a problem. They think that you promulgate regulations and people do not figure out how to game those regulations.

Someone with business experience would never announce a mortgage loan modification program and expect it to be implemented in a matter of weeks (remember, a mortgage is a legal document that is somewhat antiquated with procedures that differ by state and local jurisdiction; remember that, prior to 2008, mortgage servicers had very few staff with any experience at all in loan modification; remember that when you introduce entirely new parameters into a highly computerized business process, somebody has to determine which systems are impacted, gather requirements, redesign databases, develop logic to protect against data input errors, develop a test plan,...). Someone with business experience would not enact a program that fines companies for failing to use a fuel that does not yet exist. Someone with business experience, I dare say, would understand that chaotic organization has consequences.

The fundamental difference between private business and government is the use of force.

To survive or to thrive, businesses must persuade consumers that their products or services offered are worth the use, the consumption or the ownership, in order for consumers to conduct voluntarily exchanges. Failing to do so means that these private sector providers would lose out to the competitors.

On the other hand government, operating as mandated or legislated monopoly, forces people to comply with their edicts or regulations under the threat of penalty (incarceration, fines and etc.) for non-compliance.

In other words, for businesses, the distribution of power to allocate resources is ultimately decided by the consumers, whom are guided by price signals and where the consumer represents as the proverbial 'king'. Whereas for government, it is the politicians and bureaucrats who decides, whom act based on political priorities rather than by price signals.

Social power, thus, is distinguished between market forces relative to political forces.

Yet there are many other significant differences.

So comparisons of “government run as business” is not only patently misguided but a popular fallacy which needs to be straightened out.

Quote of the Day: Business Value of Austrian Economics

I came to Austrian economics because that is how business in the real world felt to me.

Bingo!

Professor Arnold Kling captures the essence of what has attracted me to Austrian economics…real world values applied to business and the finance.

Considering that my career has revolved around dealing with markets, I have long been immersed or indoctrinated with conventional methodologies based on formulaic sciences, pattern seeking models and of heuristics veneered as traditionalism that has only led to many frustrations and manifold errors.

Austrian economics has not only signified out of the box thinking, but most importantly has helped me survived the recent storms from its common sense approach to economic analysis, i.e. human action, law of scarcity, knowledge problem, and opportunity costs.

Quote of the Day: Sargent-Sims knees the groin of Hayek

From Professor Arnold Kling on the 2011 Nobel Prize winners Thomas J. Sargent and Christopher A. Sims, (bold emphasis mine)

Rational expectations in the Sargent-Sims tradition treats everyone as having the same model with which to form expectations. As Frydman and Goldberg point out in Imperfect Knowledge Economics, this assumes away the local knowledge and tacit knowledge that Hayek correctly identified as being very important in the economy.

Indeed, if Sargent and Sims represent a slap in the face to Keynes, they must be regarded as a knee to the groin of Hayek. Hayek coined the term "scientism" to describe the pretentious pose that economists strike when they equate mathematics with rigor. If scientism is a germ that infects economics, then Sargent and Sims were responsible for unleashing some of the most virulent strains.

Quote of the Day: Path Dependency

From Professor Arnold Kling,

…most respectable people think that Bernanke and Paulson and TARP and such SAVED THE WORLD, and so that is now the model going forward for handling any situation involving shaky large banks.

Graphic: Recalculation Theory

Jessica Hagy calls her splendid and evocative piece of graphic as “Somebody has to do something!”

Whereas my interpretation of this is Professor Arnold Kling’s Recalculation Theory.

This excerpt From Professor Kling,

``if the old patterns of specialization and trade are not sustainable, the economy faces the Recalculation Problem. New patterns of specialization and trade need to be created. While the economy is creating new patterns even in good times, when it faces a Recalculation Problem it cannot create new patterns rapidly enough to prevent widespread unemployment.” (emphasis original)

In the transition to the information age, the new pattern of specialization and trade is the discovery process called as the “seed of the start up”!

The Myths of Deregulation and Lack of Regulation As Causal Factors To The Financial Crisis

Professor Arnold Kling, former economist on the staff of the board of governors of the Federal Reserve System and also a former senior economist at Freddie Mac and presently a co-host of the popular EconoLog has an eloquent and impressive article refuting the popular myths peddled by liberal-progressives at the American.com, entitled Regulation and the Financial Crisis: Myths and Realities

His intro: (italics mine)

``The role of regulatory policy in the financial crisis is sometimes presented in simplistic and misleading ways. This essay will address the following myths and misconceptions

Myth 1: Banking regulators were in the dark as new financial instruments reshaped the financial industry.

Myth 2: Deregulation allowed the market to adopt risky practices, such as using agency ratings of mortgage securities.

Myth 3: Policy makers relied too much on market discipline to regulate financial risk taking

Myth 4: The financial crisis was primarily a short-term panic.

Myth 5: The only way to prevent this crisis would have been to have more vigorous regulation.

``The rest of this essay spells out these misconceptions. In each case, there is a contrast between the myth and reality."

In short, such misplaced arguments attempt to deflect on the culpability of the role of policymakers and their interventionists policies in shaping the financial crisis and instead pin the blame on "market failure" as justification for more government intervention.

Read the rest here

Professor Kling's conclusion:

``The biggest myth is that regulation is a one-dimensional problem, in which the choice is either “more” or “less.” From this myth, the only reasonable inference following the financial crisis is that we need to move the dial from “less” to “more.”

``The reality is that financial regulation is a complex problem. Indeed, many regulatory policies were major contributors to the crisis. To proceed ahead without examining or questioning past policies, particularly in the areas of housing and bank capital regulation, would preclude learning the lessons of history."

Yes, oversimplification of highly complex problems can lead to more prospective troubles than function as preventive or cure to the disease, especially when myopic prescriptions ignore the human behavior dynamics in the face of regulatory circumstances.

As David Altig, senior vice president and research director at the Atlanta Fed wrote in Markets work, even when they don’t, ``Markets are, everywhere and always, one step (or more) ahead of regulators"