Blinded By Natural Science

For at least the past hundred years, economists have attempted to forge an alliance with the natural sciences. The goal: for economics to develop theories supported by and substantiated with mathematics. The attraction is alluring; mathematics ups the bona fides quotient with the certitude that numbers impart.

Like their counterparts in the natural sciences, economists have taken mathematics to sometimes bewildering, Greek-lettered heights. But simple is more expedient, as John Maynard Keynes discovered. Keynes mathematically distilled the world to Y (income) = E (expenditures), and then expanded Y to C (consumption) + I (investment) + G (government spending). These three components are distinguishable by their level of stability: stable (C), unstable (I), and stabilizing (G). 

Keynes postulated that if demand for a firm's output or worker's services were higher, the firm or worker could sell more output without lowering prices by raising output. If demand falls, there is little the firm or the worker can do to counter the requisite drop in prices. In either case, Keynes believed government spending could be introduced to stabilize or improve the situation. Keynes' deceptively simple foray into ratiocination armed an army of demand-driven, math-centric economists with the theoretical cudgel needed to pound government into intervention. 

The consequences of upping the power to demand are many, and not always intended. When government is given the green light to intervene, it will inevitably intervene to its liking. The monetarist branch of economics believes that government must intervene to inflate the money supply (a strategy, according to Friedrich Hayek, that Keynes opposed). 

Inflation has an unsavory reputation -- Wiemar Republic Germany, Gideon Gono, Zimbabwe -- which is why economists have elevated inflation to the euphemistically innocuous "quantitative easing," with "quantitative" referring to the quantity of money created and "easing" referring to reduced bank pressure. The Federal Reserve accomplishes both feats by creating money ex nihilo ("out of nothing"), then uses the ex nihilo money to purchase financial assets (government bonds, mostly) from banks and other financial institutions (known as open-market operations). The purchases give banks the excess reserves required to create even more money ex nihilo through fractional reserve lending. The end result: price stability and increased consumption and investment, all ex nihilo.

Of course, the gummy reality of quotidian life always seems to bind the theoretically fluid gears of interventionist economics. Monetary stimulus has only moved the needle in the financial markets, so government spending -- Keynesian fiscal stimulus -- has been commissioned to fill the void vis-à-vis the $787-billion American Recovery and Reinvestment Act of 2009. With ARRA 2009, the federal government rolled up an unprecedented skein of tax credits, subsidies, direct payments, and welfare payments to key constituents.

Support for fiscal stimulus is particularly robust among Northeast Keynesian elites. The royal triumvirate -- Joseph Stiglitz, Paul Krugman, and Alan Blinder -- would have surely blessed ARRA, had it not been, in their opinion, too austere. Though according to Messrs. Stiglitz, Krugman, and Blinder, we would have suffered a more sour economic pickle had ARRA not occurred (an impossible-to-prove supposition, given the lack of parallel universes, but one forwarded nonetheless).

There is an emperor's-new-clothes element to fiscal stimulus when its atomized to its basic elements. If government were to pay someone a $1 million to glaze a clay ashtray, everyone would laugh...except a Keynesian economist, who would argue the $1 million would then be spent and invested by the recipient -- rolling through the economy, leaving more jobs, demand, and investment in its wake. 

But there is a fatal flaw in the logic: how the money is spent matters. Milton Friedman offers four categories of spending in Free to Choose. According to Friedman, (1) you can spend your money on yourself, (2) you can spend your money on someone else, (3) you can spend someone else's money on you, and (4) you can spend someone else's money on someone else. Category one is the most efficient; the spender seeks maximum utility and value. Category two generates maximum value but less utility. Category three generates maximum utility but less value. Category four is least efficient all the way around.

Government spending slots into category four -- and that's the ineradicable problem. The money spent to pay the ashtray glazer was money confiscated from individuals -- through taxation, inflation, or debt issuance -- which would have been, by Friedman's definition, put to higher, more sustainable uses. The hypothesis that $787 billion spent to modernize public housing, build roads, hire teachers, fund job-retraining will multiply when it reaches private hands, and thus lead to sustained economic growth, is a Disneyland-sized fantasy (see the Soviet Union). 

One could counter-argue that the glazer will realize the most utility and value with whatever he voluntarily does with the money, thus achieving Friedman's top level of efficiency, but that doesn't negate the fact the money was confiscated from the original owners, thus preventing them from putting their money to the highest utility and value. What is more, the glazer never would have owned the money had the transaction occurred in the private market, nor would he have been able to rouse the malinvestment associated with his manufactured demand. 

Mathematical functions -- including Y = C + I + G -- imply that human actions are set in motion by various factors, so just pump up G if C and I are lacking. But this equation suffers from a fallacy of composition: Every individual decides the allocation of his income between consumption and savings, and the proportions are always in flux. Yes, people respond to changes in their incomes, but the response is erratic and impossible for mathematical formulas to predict. An increase in an individual's income does not automatically imply that his consumption will follow suit any more than it implies that a teenage girl who likes the color pink will continue liking the color pink.

Mathematical modeling of economic objectives is a fool's errand led by the most hubristic fools. Human beings, unlike the roll of a fair die, are governed by freedom of choice; therefore, the various mathematically modeled policy analyses -- scenario or multiplier analyses -- are little more than parlor games. To assume that a change in government policy would leave the structure of equations intact would mean that individuals cease to act and are, in fact, frozen in time.

Scottish historian Thomas Carlyle educed the famous "dismal science" epithet to describe economics. Carlyle was only half-right; economics is a dismal science only when interventionist, math-addled economists insist on making it one.

Stephen Mauzy is a CFA charterholder, a financial writer, and principal of S.P. Mauzy & Associates. He can be reached at steve@spmauzyandassocaites.com.
For at least the past hundred years, economists have attempted to forge an alliance with the natural sciences. The goal: for economics to develop theories supported by and substantiated with mathematics. The attraction is alluring; mathematics ups the bona fides quotient with the certitude that numbers impart.

Like their counterparts in the natural sciences, economists have taken mathematics to sometimes bewildering, Greek-lettered heights. But simple is more expedient, as John Maynard Keynes discovered. Keynes mathematically distilled the world to Y (income) = E (expenditures), and then expanded Y to C (consumption) + I (investment) + G (government spending). These three components are distinguishable by their level of stability: stable (C), unstable (I), and stabilizing (G). 

Keynes postulated that if demand for a firm's output or worker's services were higher, the firm or worker could sell more output without lowering prices by raising output. If demand falls, there is little the firm or the worker can do to counter the requisite drop in prices. In either case, Keynes believed government spending could be introduced to stabilize or improve the situation. Keynes' deceptively simple foray into ratiocination armed an army of demand-driven, math-centric economists with the theoretical cudgel needed to pound government into intervention. 

The consequences of upping the power to demand are many, and not always intended. When government is given the green light to intervene, it will inevitably intervene to its liking. The monetarist branch of economics believes that government must intervene to inflate the money supply (a strategy, according to Friedrich Hayek, that Keynes opposed). 

Inflation has an unsavory reputation -- Wiemar Republic Germany, Gideon Gono, Zimbabwe -- which is why economists have elevated inflation to the euphemistically innocuous "quantitative easing," with "quantitative" referring to the quantity of money created and "easing" referring to reduced bank pressure. The Federal Reserve accomplishes both feats by creating money ex nihilo ("out of nothing"), then uses the ex nihilo money to purchase financial assets (government bonds, mostly) from banks and other financial institutions (known as open-market operations). The purchases give banks the excess reserves required to create even more money ex nihilo through fractional reserve lending. The end result: price stability and increased consumption and investment, all ex nihilo.

Of course, the gummy reality of quotidian life always seems to bind the theoretically fluid gears of interventionist economics. Monetary stimulus has only moved the needle in the financial markets, so government spending -- Keynesian fiscal stimulus -- has been commissioned to fill the void vis-à-vis the $787-billion American Recovery and Reinvestment Act of 2009. With ARRA 2009, the federal government rolled up an unprecedented skein of tax credits, subsidies, direct payments, and welfare payments to key constituents.

Support for fiscal stimulus is particularly robust among Northeast Keynesian elites. The royal triumvirate -- Joseph Stiglitz, Paul Krugman, and Alan Blinder -- would have surely blessed ARRA, had it not been, in their opinion, too austere. Though according to Messrs. Stiglitz, Krugman, and Blinder, we would have suffered a more sour economic pickle had ARRA not occurred (an impossible-to-prove supposition, given the lack of parallel universes, but one forwarded nonetheless).

There is an emperor's-new-clothes element to fiscal stimulus when its atomized to its basic elements. If government were to pay someone a $1 million to glaze a clay ashtray, everyone would laugh...except a Keynesian economist, who would argue the $1 million would then be spent and invested by the recipient -- rolling through the economy, leaving more jobs, demand, and investment in its wake. 

But there is a fatal flaw in the logic: how the money is spent matters. Milton Friedman offers four categories of spending in Free to Choose. According to Friedman, (1) you can spend your money on yourself, (2) you can spend your money on someone else, (3) you can spend someone else's money on you, and (4) you can spend someone else's money on someone else. Category one is the most efficient; the spender seeks maximum utility and value. Category two generates maximum value but less utility. Category three generates maximum utility but less value. Category four is least efficient all the way around.

Government spending slots into category four -- and that's the ineradicable problem. The money spent to pay the ashtray glazer was money confiscated from individuals -- through taxation, inflation, or debt issuance -- which would have been, by Friedman's definition, put to higher, more sustainable uses. The hypothesis that $787 billion spent to modernize public housing, build roads, hire teachers, fund job-retraining will multiply when it reaches private hands, and thus lead to sustained economic growth, is a Disneyland-sized fantasy (see the Soviet Union). 

One could counter-argue that the glazer will realize the most utility and value with whatever he voluntarily does with the money, thus achieving Friedman's top level of efficiency, but that doesn't negate the fact the money was confiscated from the original owners, thus preventing them from putting their money to the highest utility and value. What is more, the glazer never would have owned the money had the transaction occurred in the private market, nor would he have been able to rouse the malinvestment associated with his manufactured demand. 

Mathematical functions -- including Y = C + I + G -- imply that human actions are set in motion by various factors, so just pump up G if C and I are lacking. But this equation suffers from a fallacy of composition: Every individual decides the allocation of his income between consumption and savings, and the proportions are always in flux. Yes, people respond to changes in their incomes, but the response is erratic and impossible for mathematical formulas to predict. An increase in an individual's income does not automatically imply that his consumption will follow suit any more than it implies that a teenage girl who likes the color pink will continue liking the color pink.

Mathematical modeling of economic objectives is a fool's errand led by the most hubristic fools. Human beings, unlike the roll of a fair die, are governed by freedom of choice; therefore, the various mathematically modeled policy analyses -- scenario or multiplier analyses -- are little more than parlor games. To assume that a change in government policy would leave the structure of equations intact would mean that individuals cease to act and are, in fact, frozen in time.

Scottish historian Thomas Carlyle educed the famous "dismal science" epithet to describe economics. Carlyle was only half-right; economics is a dismal science only when interventionist, math-addled economists insist on making it one.

Stephen Mauzy is a CFA charterholder, a financial writer, and principal of S.P. Mauzy & Associates. He can be reached at steve@spmauzyandassocaites.com.

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