Beware of analysts bearing equations

Steve Saville
email: sas888_hk@yahoo.com
Apr 27, 2010

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 15th April, 2010.

In general, when an analyst uses an equation to make a point about where the economy is headed and/or what economic policies are required, you should immediately stop reading or listening. By directing your attention away from the equation-happy analyst you will run the risk of being uninformed, but if you continue reading/listening then you will very likely be misinformed. It is usually better to have no information than to have the wrong information.

In the past we've discussed the problems with the famous Equation of Exchange (PT = MV). The equation is of little value outside the classroom and can be dangerous if used to determine the appropriate monetary or fiscal policy. Another of these inherently useless equations that can be dangerous in the wrong hands is called the "National Income Accounting Identity". This equation is typically expressed with lots of variables -- as G - T = (M - X) + (Y - T - (C + I)), for instance -- but it boils down to: net private savings = government balance (government spending minus taxation) + current account balance. For an example of how this equation can be used to come up with wrongheaded conclusions and policy recommendations, refer to pages 5-7 of the report linked HERE. The writer of the afore-linked report tries to use the National Income Accounting Identity to show that higher government deficit-spending (a greater "government balance") is needed to offset the private sector's increasing desire to save.

Analysts who base their economics analyses on mathematical equations usually fail to properly account for cause and effect. They see what's on the surface, such as if one side of an equation rises then the other side must also rise, but they fail to see that cause and effect are inter-connected via such complex feedback mechanisms that their beloved equation is useless in the real world. Considering that the real world involves millions of people interacting to satisfy their myriad individual desires, is it any wonder that the economy can't be properly described by a mathematical equation?

An example of the sort of cause-and-effect feedback mechanism we are referring to stems from the fact that the government can only increase its spending by stealing (directly via taxation or indirectly via inflation) or borrowing more from the private sector. Looking at it in a slightly different way, if taxation is constant then the "government balance" can only increase via the borrowing of more money from the private sector or the central-bank monetisation of government debt (counterfeiting). To argue, then, that the "government balance" needs to grow in order to support the economy is, in effect, to argue that the economy will benefit if the private sector is forced to buy more government bonds or if the central bank counterfeits money on a grander scale. The reality is that increasing the "government balance" MUST have negative consequences for the private sector.

The main cause of Japan's economic malaise (the main reason why the Japanese economy has performed so poorly since 1990) is the massive increase in the "government balance" and the resultant massive non-productive investment of private savings in government bonds. And yet, many analysts (including the writer of the above-linked report) are now advocating that US policy-makers increase the "government balance". If they don't have a viable economic theory to lean on, you'd think they would at least be able to learn from the historical record.

Unfortunately, not only have they not learned from the historical record, they have generally learned exactly the wrong things. A classic example is the common belief that when the Fed tightened monetary policy during 1936-1937 it CAUSED the US economy to plunge back into depression, the implication being that the economy would have been just fine if not for the Fed's 'premature' tightening. The real problem was that the preceding (1933-1936) recovery was an illusion created by monetary and fiscal "stimulus". With the recovery being based on loose money and government spending rather than on profit-seeking investment, it was destined to collapse in a heap as soon as the "stimulus" was wound back. The alternative would have been to keep the "stimulus" going until the currency was destroyed.

Why, we wonder, have no lessons been learned from the economic downturn of the early 1920s? By a number of measures the first year of the 1920-1921 mini depression was worse than the first year of the 1930-1945 great depression. The main reason that the early-1920s depression was over within 2 years and was followed by a lengthy period of real economic progress appears to be that the government of the time did the OPPOSITE of what the Keynesian playbook recommends. Specifically, the government REDUCED its spending and its debt. Had the Keynesians been in control in 1920 then the economics textbooks of today would probably have a chapter devoted to the Great Depression of the 1920s.

In summary, the popular view amongst high-profile pundits is that the economy needs more government spending. Logic and the historical record tell us that the opposite is actually true, but these pundits won't be dissuaded because they have, in their possession, simple one-line equations to 'prove' their case.

The conventional wisdom being what it is and being unlikely to change anytime soon, we can reasonably expect that the trend towards a more expansive (and expensive) government will continue. Consequently, we should continue to put a lot of emphasis on gold-related investments. We can't stop policy-makers from doing stupid things, but at least we can profit from them.

An appropriate quote

In an address to Congressional Democrats in May of 1939, Henry Morgenthau, Franklin Roosevelt's Treasury Secretary, lamented: "We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!"

Similar sentiments have probably been expressed in the Japanese language over the past decade, and yet the same ill-conceived policies continue.

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Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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