Tuesday, December 06, 2011


When I first was introduced to economics (Micro 101) in college, my basic understanding of the economy cause me no end of trouble in class. What the professor was discussing was so far from my experience I had to wonder if economics actually had anything to do with the economy. It took years for me to understand that in fact, the two had very little in common. Like a photographer evaluating the finest detail of a picture of an elephant, the economist sees only the surface appearance.

But the human brain is an amazing machine that can take just that appearance and determine a great deal about the 'elephant'. As long as you understand the limitations of the attempt, the economist can tell you a great deal about the economy. What they can NOT do is predict, 'what the elephant will do'.

The economy is made up of every actor that participates in it. My purchases, yours, our work, our choices, each create a part of the economy and drive it. Seven billion actors, each independently, and each as a group, from family to community, to state to nation, each a separate and independent actor combine minute by minute (in our digital age -billionth of a second by billionth of a second) to create the economy.

I once described the economy as the wind. You can measure it, you can determine it's direction, force and temperature. You can even, with those measurements, predict it's future direction. But you can not turn it, stop it, move it or entice it. Like light, the wind is both wave and particle. The economy is the wind, with trees and mountains, buildings and shade and water all impacting the flow. We can catch parts in cul-de-sacs or by opening a door and make precise measurements as it flows by, but the farther from a point of measurement, the less we know about it's behavior and future.

Take 100 people from very similar soc-economic situations (income, family, education, geographic location) and give each $5000 per month to spend on all expenses. Keep careful track of the expenditures over a year, Patterns will emerge, large scale consistencies. The edges will vary but the overall picture of those 100 economic units will be fairly clearly established. Now, take a new 100 people from the same soc-economic situation and predict how they will spend $4000 or $6000 over the next year. Many of the same broad categories will emerge, but 'centers of gravity' or 'attractors' will shift.

Further, if you take 1/3 of the group from a pool of people whose income the previous years was significantly less than $5000, 1/3 whose income was significantly more than $5000 and those that have earned $5000 over several years, the ranges within categories will vary broadly. Each person, each economic unit has a different starting point, a different center of gravity.

If it seems as if I am suggesting Chaos Theory, I am.

Many Economists hate to be lumped into social science departments - their attempt to mathematically model economic behavior (they say) is a hard science, steeped in the bowels of mathematics. However, each economic unit, each individual in the experiment above will NOT spend their $5000 each month exactly the same as the previous month. Use a mathematical equation to model their behavior and the error will be all over the map. The Economist will SAY, using math to prove it, that the error is distributed in a way that is measurable. Spending will fall into clear categories but the 'error' will be 'disposable income', a catchall that will encompass so much variety that attempts to minimize it will fail any real world explanation.

Economists will bring probabilities into the calculations. Of course an economic unit will be unable to purchase a jet plane and will probably not buy a single piece of gum so the range of potential purchases will be a probability problem. As a descriptor, it works well, but not as a predictor. This is the fallacy of economics: prediction of the behavior of an economic unit is NOT the sum of the probabilities.

"Adjusting one variable and keeping all the others the same" will predict one possible outcome out of an infinite range of possibilities. A useless result.

"Past experience is not a predictor of future behavior" is exactly the only possible result of economic analysis.

Does this mean we should toss our hands up and say, can't predict future economic behavior of economic units? No. There are some specific 'rules' that economists have been able to glean from their work. Like weathermen knowing that air flows from areas of high pressure to areas of low pressure, economic activity is greater in areas of higher monetary aggregates. Where abundance of resources exist, their value/cost is lower than in areas where the resources are scarce. Greater cost reduces usage. For our 100 people, increasing the income increases the range of possible purchases as reducing the income reduces the range of possible purchases.

These basic rules are often ignored by economists tasked with determining policies for government. What happens when economists ignore the rules and think they know how the wind blows?