Economics is people not arithmetic


The non-reaction of the markets to the ratings agencies downgrades of European debt underlines a persistent characteristic of the markets that is all too often forgotten. Especially by economic commentators. If it were simply a matter of extending the arithmetic of current economic performance into the future, then economic predictions would usually be right. On the contrary, they are usually wrong.

This piece in the Financial Times has a salutary reminder of just that:

Perhaps the most honest perspective, and one cherished by forecasters, is that we have “low visibility” on the US economy. It is one of those catch-all phrases that might one day serve as an epitaph for our times. It may also help to remind ourselves just how bad the forecasters have been. A few years ago a Berkeley study apparently found that monkeys aiming at a dartboard were more accurate than professional forecasters.

Perhaps we need to hire those monkeys to help us anticipate where the euro crisis is going (dart boards don’t cost much). In the meantime, it is worth asking why economists are so often wrong. There are the obvious reasons. Too many “factors” to consider. The folly of projecting to the future what has happened in the past. The irrationality of those supposedly rational actors, with their paroxysms of fear and greed. There is the problem of poor or partial information. One person I know who works in the ratings agencies says they really know little about government finances, and in any case they are required to follow certain lines to please their pay masters.

Then there are some deeper reasons. The problem of non-linearity in complex systems, which makes them inherently unpredictable. The impossibility of including in any predictive model the knowledge that people have of that model. This of course renders any prediction fragile. In a sense it means that the only predictive models that can actually be considered reliable are those that nobody knows anything about. Those that are understood can of course be undermined by the development of strategies to exploit the predictions, and those strategies will, by definition, be outside the models.

One could go on, but I believe there is another blindness in economic commentary that is especially telling. Jane Gleeson-White, in her book “Double Entry” shows how economic statistics derive from the double entry system developed by the Italian mathematician Pacioli in 14th century Venice. It is a worthy reminder that financial transactions, the capital markets, are a social artifice, a created thing. They are not laws of the universe, immutable and sovereign. Yet that is how economists treat them and that is the prism through which we have come to see the world.

Gleeson-White tracks how ubiquitous the binary system of accounting has become in economic statistics and economic theory, including Marxism. Weber equates double entry with capitalism itself. She does not mention it, but the idea of “balancing the books”, credits matching debits, is implicit in General Equilibrium theory, which drives our idea that “economic imbalances” are to be guarded against (an idea with merit, of course, if transactions are not to be undermined).

The insistence on interpreting economic transactions as an inviolate system, like a natural system, that is subject to scientific laws is, I suspect, the main reason why economists are so wrong. They are not looking at a natural system, they are looking at a created, artificial system that need not be the way it is. The statistics, as Gleeson-White shows with her description of Keynes’ development of GDP and other national economic statistics, was based on a series of assumptions about what should be considered valuable. Different assumptions could have been made. If they had been, we would now have a different picture of economic progress and relative wealth.

So here’s a suggestion.

Maybe economists should view the “euro crisis” or indeed any other economic phenomenon, as a social artifice that must be interpreted using non-scientific methods — you know, look at the people involved, for instance. As for me, I suspect that the supposedly irresolvable arithmetic cul-de-sacs of European national finances are a bit of a mirage that the market will eventually tire of. That which is created can be uncreated. There is also something suspiciously biased about the concerns with, say Italian debt. At about $2 trillion, it is one sixth of Japanese debt and one eighth of American debt. It is little more than 1% of global debt. So why is it getting all the attention? The answer, I would suggest, is to do with ideology, politics and trading plays. People, in other words. Not arithmetic.

Comments

  1. When i was a relatively fresh COMSCI grad in the 80’s i read Pacioli. Not having an accounting background my immediate thought was that what he was trying to do was provide an accountant’s tool to record vectors.

    A few years later, when i was trying to manage a number of companies, i sat down and built my own accounting system from scratch. I did not read any accounting texts (though i had several all of which seemed to me to be quite insane). I based everything on vectors.

    Some time later while working on a financial accounting project for a major airline (building software to spec) i showed the project advisory accountant my system including the diagrams that modeled the various transaction flows i was tracking in my system.

    Once she understood what i had done she announced “you should win the Nobel Prize”.

    Some months later one of my companies was audited by the tax office. I showed the auditor my accounting system and diagrams.

    He smiled and said it was “interesting”, left, and that day sent me a letter and a bill for $6000 – because i had modeled my GST incorrectly.

    I bought an early copy of MYOB shortly after.

    pop

  2. Paul Ormerod’s 1994 book ‘The Death of Economics’ is a good read. The economic profession is so desperate to be seen along side the mathematical sciences as if to provide some sort of credibility to the science of economic theory. In reality, it is also a study in sociology, behavioural sciences with a dash of ‘chaos theory’ event randomness thrown in for good measure.

  3. Another way I have seen this expressed is “the markets are not physics”.

    It’s all social psychology innit. Not simple at all. Endlessly fascinating. One of the top three reasons why I trade, right up there with learning about myself and playing the greatest game of all.

    • “It’s all social psychology innit.”

      This is the only reason I give any credence to the chartists, AC. Everything I’ve learned about complex/chaotic systems indicates that the charts *should be* next to useless as analytical tools. But, with 1000’s of people out there hunting in the randomness for a narrative they can impose like some sort of weird recursive algorithm, order emerges from the chaos…

      It also helps that people like yourself have given me an enormously useful education in market behaviour. It’s like quantum physics. I don’t have to fully understand it to appreciate it.

      “right up there with learning about myself and playing the greatest game of all.”

      I agree with you, but I think we’re thinking about very different things. 🙂

  4. I can’t quite hook all this together and come up with any concise summary.
    I agree with Johnno’s comment.
    However I think that one of the mistakes economists make is to ignore the laws of the universe.
    “They are not laws of the universe, immutable and sovereign. Yet that is how economists treat them and that is the prism through which we have come to see the world.”

    The process of credit creation is, fundamentally, a belief that you can create something from nothing. Economists and most in these pages believe in credit creation. I don’t think the criticism that ratings agencies know little about Govt finances is a tenable criticism. I’d be (am) more worried about the groups who believe they understand Govt finances and believe that Govts are not constrained in creating money.

    Over a very long term, if you look at economies, you would have to conclude that the biggest threat to the environment is credit creation. It allows us to consume far more of the world’s resources than we are reasonably entitled to do. It aloows us to pollute far more than we would otherwise be able to do.

    It probably sounds ridiculous to most here especially to the younger. However as something of an ‘elder’ (alternately interpreted as ‘old b….rd who is past it! :)) and looking at the world over a long period I’ve concluded that everything we do outside the laws of the natural world screws something up.
    Modern economics and it’s tendency to ignore consequences, just because they are inconvenient, certainly fits in this category.

    • Great discussion topic SoN, And agree fully with flawse (as I usually do).

      ‘Modern economics’ has, IMO been hijacked and is currently held hostage by
      ‘modern financial capitalism’.

      Economics was never meant to become a tool of the finance industry but a lubricant between parties in competition for limited resources, including the environment.

      This departure from purpose, coincided with the seperation of ‘capitalism’ that produce goods and services and ‘financialism’ which facilitates debt, money creation and other weird stuff.

      Economics used to be a social science, now its attached itself to the marketing department of the finance ponzi scheme.

    • “The process of credit creation is, fundamentally, a belief that you can create something from nothing.”

      I may have misunderstood, but I thought credit was created from trust…

      • I may have misunderstood, but I thought credit was created from trust…

        The caveat to that is that the parties involved genuinely want to behave in a trustworthy manner.

        Too much moral hazard now absolve the consequences of acting in an untrustworthy manner.

      • Rusty, you may find Doug Noland’s discussion of interest:

        ‘…the rules of the game have become dangerously clear: policymakers will do any and everything to sustain a global Credit system some years ago exposed as dysfunctional and a risk to Capitalism. Governments are conspicuously against the bearing of consequences, and market participants are being heavily incentivized to play it that way.’

        http://prudentbear.com/index.php/creditbubblebulletinview?art_id=10623

      • I would classify that as learning to love your cancer before you’ve even attempted the cure.

    • Great to read a discussion in this direction, i.e. the validity of economics as a science. For someone trained in physical sciences, economics definitely is not science. The other thing that economists do is to assume the system is infinitely linear, so as to extend their “marginal analysis” into the stratosphere. If they pay a bit more attention to the mathematics, they would realize that marginal change is the first derivative and applies to the vicinity of the point of analysis only, not to the entire universe.

      However, I slightly disagree with flawse with the nature of credit creation. I think credit creation within the limits of our productive capacity is a fine thing. Credit is essentially a promise to deliver something in the future, so as long as we have the capacity to deliver, credit creation is a great tool to aide commerce. However, when credit creation comes into a life of its own, then it quickly turns into false promises, lies and deception. Subprime credit is just such an example. And central banks have undeniable responsibility for such an outcome, as they are the keepers of the credit system.
      In fact, if we simply abandon the edifice of economics as a science, and return to a set of social rules, such as one shall not promise anything one can’t deliver, the economy might be much better off.

      • Dismal

        I agree with what you are saying and did not mean to imply that there should be no credit. Credit will always be necessary (as far into the future as I can see) How and in what amount it comes into existence is the problem.

  5. The process of credit creation is, fundamentally, a belief that you can create something from nothing.

    So without credit, how do we deal with our ability to create a whole that is greater than the sum of its parts ?

    How do we deal with our ability to genuinely create something from nothing (eg: music) ?

    • Credit created money is not backed by any current asset but by a promise of creating something of value in the future (music).

      Music is an asset something of value and often tradable.

      When money growth decouples from productivity growth its like giving students in my class top marks and A+ when they don’t know the subject.

      But I can give every student an A+ if they are all expert without compromising the system

    • Dr Smithy
      I apprerciate the idea of your post and am giving it a run round in my mind.

      My immediate thought is this…
      Music is not created from nothing. It takes human talent and endeavour.

      Thinking out loud…
      There is no doubt human endeavour can improve the world. We get a bit of red dirt, heat it, and make a tool! Yes I agree so far.

      I think the problem comes where you create an economic and social system that has virtually unlimited credit as it’s fundamental foundation and you then misuse the resources…for example you set the blacksmith making something useless with your free credit and he no longer makes agricutural tools.
      In GDP terms the system is fine. We think we have circumvented nature when the Bureau of stats tells us how clever we all are with this higher GDP.
      Next season there is a famine and we have no food.
      I hope I’m still on the point! 🙂
      I can see the point of what is defined as useful and what is not! However free credit economics makes that conundrum worse and more prone to error.

  6. “It is a worthy reminder that financial transactions, the capital markets, are a social artifice, a created thing. They are not laws of the universe, immutable and sovereign.”

    Which is why economics is no more a science than cricket commentary.

    • I suddenly have a fear that I am about to receive a lecture on the statistical rigour of cricket analysis.

      Time to go outside…

  7. Brilliant, what a great read.

    I especially liked:

    “The problem of non-linearity in complex systems, which makes them inherently unpredictable. The impossibility of including in any predictive model the knowledge that people have of that model. This of course renders any prediction fragile. In a sense it means that the only predictive models that can actually be considered reliable are those that nobody knows anything about.”

    It’s quite a problem isn’t it?

  8. In my opinion, Italian debt is getting all of the play in the media because it’s an easy story to beat up into a fear ad crisis story.

    The dumbed down readers of most modern media can understand “going broke”, “big debt”, “crisis talks”, and the dumbed down readers can cope with a 200 word article that talks breathlessly about the next set of crisis talks and billions of euro that Italy has to refinance soon. But the dumbed down readers aren’t prepared to read, or pay for, a 5,000 word article that looks at ten or twelve factors that have influenced Italy’s current situation and equal numbers of factors that affect current options and may affect Italy’s future budgetary and fiscal pathways.

    Even the supposedly interested, educated and articulate readers of this blog won’t read a 5,000 word piece (this blog is about 800 words and is a bit longer than most blogs), and our comments are five to ten lines each, because our time and focus is so fragmented and spread so thin.

    Media beat-up is good for sales, because the intellectually lazy (including politicians) aren’t prepared to grasp the complexity (but then, why should they bother, it’s unlikely to affect them directly, they have no control over it and it takes a lot of time and energy to commit to read and understand a complex situation).

    So, you get crisis puffery to scare and thrill in 20 seconds a read. Talking about the US debt isn’t so sexy, because there’s no cliff anyone is “about to fall off”, so it doesn’t sell newspapers.

      • ‘Even the supposedly interested, educated and articulate readers of this blog won’t read a 5,000 word piece’

        I note the use of the word ‘suposedly’
        This is pretty typical of this school of thinking
        Open up by insulting the intelligence of everyone else and provide no reasoning.
        Oh I forgot! No reasoning is required because it’s a ‘revelation’

  9. Two points:
    It isn’t true that models have to be unknown by participants to work. Noisy Rational Expectations based models, built on the back of game theory, can allow for participant knowledge, so long as there is noise in the model to prevent participant knowledge being perfect. I think we can agree that participant knowledge of models will always be mediated by noisy observation, _especially_ in economics.
    Second point:
    The accounting equation is not an artificial construct. It will only be so if you eliminate the concept of ‘ownership’. Generally, resources have value if they are scarce. If they are scarce, then someone will claim/own them, as an owner or as a lender against them, Thus, in any society were ownership is accepted as a valid economic construct, the fact that claims on resources must equal those resources (i.e. the accounting equation, A=L+OE) must be true. Actually, it is therefore an identity, my my iPad seems not to give me easy access to the identity symbol.

    The first conclusion draws on work which I dw on n my PhD. The second was useful to remind myself of, as I will be teaching some first year accounting starting the day after tomorrow.

    Communism failed for two reasons. One, it pretended that we can abstract away ownership. Two, it presumed that humans have the mental capacity to simultaneously keep in mind multiple constraints and objectives over multiple resources (where multiple=a quite big number); but we know that you can usually only keep about 5 or 6 items in short term memory.

    In sum, psychology and sociology matter, but not as simply as you think they do.

  10. agree 100% on the title. economics and money are human creations, not science or nuture. one of the few things we actually are in control of in this world. I dont think this point gets enough attention. good post

    • “one of the few things we actually are in control of in this world”

      This is true, that we are all in control of it but as a consequence no-one is in control of it.

      The modern economy is a complex system of systems of billions of interacting participants that no-ONE fully understands for all the reasons given here and probably plenty more.

      • “one of the few things we actually are in control of in this world”

        Dr Bob…I can’t help but feel we THINK we are in control. In reality we are still subject to all the same laws of nature. Money is supposed to operate within them. Our illusion is that we think that with money we can circumvent them.
        (Maybe I’m repeating what I said earlier in different words!)

      • sorry flawse but you are wrong about this. in economics and money humans make the rules and humans change the rules. how is this in any way similar to what happens in nature? it aint.

      • GB
        Human rules only work in how we distribute resources between ourselves. Economics does not and cannot create anything.

        To this point the sort of economics that has been practised in our western democracies is the sort that confiscates from the prudent and redistributes to the profligate.

        We made up the rules that we could create excess credit ad infinitum. You think that economics can operate, both practically and a theory, outside the rules of science and of nature. There are no practical natural limits to limits to credit creation either privately or by Governments.

        We are being shown to be wrong in two ways.
        The first is that under this belief our economic system and indeed our civilisation is falling apart under this notion.

        Secondly it all operated fine while we, in the western world, seemed to have unlimited resources at our disposal.
        We needed more of anything we just got it from somewhere else in the world. Our system was, to our perception, infinite. We had the military and economic power. We wanted spices we got them. We wanted coal we got it. We wanted silk we got it etc etc In the last 50 years we needed more labour Japan Taiwan Korea China et al provided it.

        We are about to come up against a very severe problem that you don’t yet see. On the other hand, although I’m not blessed with great wisdom, I have had the privilege of being a frequent visitor to China et al for 30 years. I see the changes. At some time in the future, not too far away, the Western world will come up against the rising prosperity of Asia. They will no longer be cheap labour to make whatever we need because we are too lazy to do it for ourselves. Secondly, because of their hard work and prudence, they will have the wealth to outbid us for other limited and essential resources in other parts of the world. Our unlimited credit creation rule is about to come back to bite us. We failed to recognise the long term consequences. We thought we were Gods! We aren’t.

        In summary, the sort of economics we have practised, thinking we are above the laws of science and nature, will be shown to be entirely false.
        Human rules only work in how we distribute resources between ourselves. It doesn’t create anything except illusions.
        To this point the sort of economics that has been practised in our western democracies is the sort that confiscates from the prudent and redistributes to the profligate.
        It’s all coming unraveled and, with apologies to Shakespeare, unfortunatley the sleep we are in is not one that knits this raveled sleeve.

      • Sorry to be repetitive there. I did a copy and paste from the bottom to the top instead of a cut and paste.
        My memory is still good enough, mostly, to remember where I started in a short post! 🙂

      • flawse that is all good and well but you are off on a tangent. the point is that the hard and fast and undisputable rules that govern science and nature DO NOT APPLY TO ECONOMICS. You and so many others dont seem to be able to accept this but it is true. It explains why despite endless claims from people over the history of mankind who have called “the end of the world” have all been wrong, including those here in the comments section that were making similar claims just a few months ago. here is an example. If a tsumani (natural disaster in motion backed by the laws of physics) is coming you better get out of the way or you are gone. nothing you do or say can change the outcome. In economics when a hypothetical tsumani is coming we can and do change the rules which in turn creates a different outcome. im not saying those outcomes are good or bad, or wont have consequences because they will but thats not the point. the point is humans make the economic rules becuase its a system created by mankind, not science and nature.

      • Again GB you make assertions but have no case. You can shout all you want. Just because you shout doesn’t mean you are automatically right. i don’t know why you think it does.
        You just say I am wrong…end of argument as far as you are concerned.
        Re the Tsunami…you say when it is coming we can just change the rules. All you do is get a bus and get yourself out of the way and ship some other poor soul take your place in its path.
        Let’s deal with the real world example that I was using which you conveniently ignored.
        We have lived for 50 years presuming that Asia will always and forever provide us with cheaper and cheaper goods. Our whole economic system is currently based on this presumption. The school of thought you follow relies on this presumption. As such it is nothing new despite its self proclamation.

        Yet the evidence is that we do not have access to an ever expanding pool of people who will work and save to keep us in the manner to which we have become accustomed. This will not be so. So you think economics can just proscribe that, despite the reality of this old assumption ending, we can just go on creating our money and getting cheap goods. Further you hold that if we continue with this policy it will have no negative consequences (in aggregate).

        All you can change is who is going to pay the price but the price will be paid.

        We think we can change the rules by economics. What economic rules will you create that will change the sequence of events that are about to befall us?
        Remember here, in any case, it doesn’t matter whether I am right or wrong about this event. The assumption is that it is in motion.
        You cannot just change rules so that the consequences can be avoided. That’s one of the great fallacies of your school of thought. Print a few dollars and everything will be hunky dory!

        Now to say to you what you say to me in your arrogance.

        You are wrong. You don’t get it. You don’t understand and you are incapable because you have lead a narrow life, has few real life experiences,never worked managing nature, people and money all at the same time,had a narrow education.

        I’ve stood in the path of the economic tsunamis. The academic profession, the politicians, the public servants get themselves out of the way and create the rules so it doesn’t affect themselves. You make some one else pay the price for everyone.

        You think in your analyses 10 years is long term. I’ve seen it quoted over at Billy Blog in some of his correlations. If it hasn’t happened in 10 years you presume it can’t.

        I’ve studied economics for 50 years and i can tell you frankly the long term is longer than that. I don’t know how long it is because I was born after the start of this current phenomenon and i am guessing i’ll depart this mortal coil long before this cycle is over.
        I’m not so presumptuous as to think I’m bigger and smarter than it or nature. Such thinking is pure unadulterated arrogance and stupidity.

        All we can ever do is try to work out how best we can all live within the confines of the resources given us. That’s economics.

  11. People cannot even START to be understood without appreciating their Nature and their Worldviews, the bases of their beliefs for absolutely everything,

    From this stems the Value System; and from the Value System stems individual’s notions of “Value”; and from “notions” of value comes Morality.

    And from the notions of Value, Morality Community, stems this arbitrarily delineated field of human interaction we call “Economics”.

    Therefore, you cannot understand Economics if you cannot understand the true Nature of People and their respective worldviews, what their values and morality are.

    This is very pragmatically expressed in an old Sales addage I learnt at the beginning of my career, and have never forgotten (and never will!):

    “No Trust, No Sale”.

    Read everything I said above into “Trust”; and everything else arbitrarily defined as “Economics” into “Sale”.

    QED?

    My 2c

    Regards,
    Stewart

  12. “The process of credit creation is, fundamentally, a belief that you can create something from nothing.”

    I will agree slightly; but then disagree slightly.

    To me, if credit creation is anything fundamentally, it is an expression of the beliefs that:

    i) the person to whom credit is being extended can be trusted to pay it back (which would then destroy it);

    ii) the person to whom credit is being extended will then act (morally) responsibly, and with wisdom and discernment, with the grace that has been extended to them, and not go and abuse that grace by making promises they can’t keep based upon the promise they have just made to another (by accepting credit), etc, etc, etc…

    ie. Resultant “problems” from this scenario would be seen as accounting and/or economic or financial.

    But, in fact, their ultimate nature is Moral, rooted in the morality and wisdom of the one extending the credit, and their subsequent actions whilst the transaction is, effectively, still “open”; and, similarly, for the one who accepted the credit, with their wisdom and morality, and their subsequent actions whilst the transaction is, effectively, still “open”.

    You see, “credit” does not just “leverage” – it is also links and binds! It creates an economic/social/moral structure of its own, upon which lives become structured upon and around…in economic terms, this means businesses, jobs, institutions and even governments. All upon, and made from, a Moral fabric.

    This/these credit “structures”, with their nature as such, are why economic failure can render such non-linear problems: all these morally-based, open/linked transactions suffer from effects in other linkages “up the various chains”.

    It helps us understand why credit-laden systems fail so catastrophically and unpredictably: they fail as badly as relationships fail when morality is broken (usually, Trust); they ARE moral systems, and an “open” promise effectively broken because someone else even unwittingly broke their promise to you, is still a promise broken, with very real consequences.

    “Do to others as you would have them do to you” is as true and fundamental today as when it was first spoken, and is part of every persons very fibre of being; As is “Let your ‘Yes’ be ‘Yes’; and your ‘No’ be ‘No'” – keeping our word/promises.

    In my honest opinion, this all becomes a whole lot simpler when viewed through such a lens.

    My 345344565 cents

    😉

    Stewart

    /ramble off

    • Burb
      I’m not disagreeing with you however in modern economics as we have made up the rules the ‘trust’ has not been required,
      at least, little trust is required.

      If the credit can be created from nothing then there is nothing lost when the credit is mis-allocated and wasted. Trust is not required as, if it fails, nobody loses anything. It’s this perception that we have allowed to dominate our thinking. That has been economics practised through my whole life of economic awareness that now extends, unfortunately, over almost 50 years.

      On the other hand, if I work hard, save, postpone my desired consumption so that you can have money to invest, I’m damned sure going to want to trust that you will invest the money I lend you, or invest with you, wisely so that you will pay it back to me…with interest.

  13. Thanks for a though provoking article. In general I agree. However,

    “There is also something suspiciously biased about the concerns with, say Italian debt. At about $2 trillion, it is one sixth of Japanese debt and one eighth of American debt. It is little more than 1% of global debt. So why is it getting all the attention?”

    There’s nothing suspicious, as you said, “That which is created can be uncreated.” This is a concern for Europe not America nor Japan. Which is why I’m comfortable holding USD but not Euro.