New Equations in Old Bottles

In his November 3rd speech entitled, Globalization and Monetary Policy, Richard W. Fisher of the Federal Reserve Bank of Dallas tried to explain away some of the problems central bankers have been facing in recent years by blaming them on globalization. Now don't get me wrong, this wasn't an anti-globalization speech by any means. Rather it was part of the never-ending attempt by modern economists to rationalize and justify their use of constantly changing models and equations that never bear more than a passing resemblance to the real world and that rarely if ever have the predictive capability their creators envision.

Mr. Fisher tries to introduce what he's talking about by stating that "The language of Fedspeak is full of sacrosanct terms such as “output gap” and “capacity constraints” and “the natural rate of unemployment,” known by its successor acronym, “NAIRU,” the non-accelerating inflation rate of unemployment. Central bankers want GDP to run at no more than its theoretical limit, for exceeding that limit for long might stoke the fires of inflation. They do not wish to strain the economy’s capacity to produce." He is speaking here of what he believes it is the Fed's job to do: manage economic growth and control inflation through changes in the money supply and tampering with interest rates.

What has always seemed strange about this idea is what it implies. During the early to mid 1900's one of the main economic debates raging on the world scene was the debate over socialism. Ludwig Von Mises (among others such as Frederic Hayek) played a crucial role in this debate and he is widely regarded as having proved theoretically that socialism is impossible; meaning that a centrally managed economy is a contradiction in terms. State ownership and management of resources means no price system and hence no way of determining how to allocate resources and no way of knowing or meeting consumer demand.

The idea that socialism is economic suicide and that a state-owned and managed economy cannot function in any meaningful sense of the word is now almost universally recognized. Mises spent much of the rest of his career attempting to show that interventionism, or the so-called third way where government allows private ownership and a certain amount of economic freedom, but then intervenes where it sees fit in order to correct "market failures" and produce politically desired outcomes is also destructive and unsustainable. It is most fortunate that the socialist calculation debate was resolved in favor of markets and capitalism. It is most unfortunate that the debate over intervention was not. In the modern world Interventionism has been enthroned as if it were the natural order of things, when in reality is just a mild form of socialism. And central to the interventionist system is the institution of central banking.

Central banking in what we consider to be "free," capitalist economies is a most curious form of hypocrisy. Here we have men who claim to believe in markets and economic liberalism who at the same time have adopted a socialist view of the market system. They believe the system is defective and that it must constantly be managed and controlled from the center in order to produce the correct results. This is very evident from the way they use certain words. For instance, in the above quoted section, Mr. Fisher states, "Central bankers want GDP to run at no more than its theoretical limit, for exceeding that limit for long might stoke the fires of inflation. They do not wish to strain the economy’s capacity to produce."

What is described here is an "economy" which operates in machine-like fashion, much like a car. To make it work we have to push on the gas sometimes, push on the brakes at other times and steer it in the direction we want to go. Central bankers have to "run" GDP according to the "theoretical limits" they have devised for it. They must be careful not to overheat the car by straining the "economy's capacity to produce." They must implement "monetary policy" (tampering with natural market processes like money supply and interest rates) in order to direct the economy in the paths of sustainable growth and to keep it away from inflationary expectations and downturns. Thus is the market reliant on its good shepherd, the central bank, to "maketh (it) to lie down in green pastures," and "leadeth (it) beside the still waters." They speak of the "economy" as if it were some man-made contraption rather than a naturally occurring phenomenon.

This view of an "economy" is extremely flawed. First of all, there is no such thing as an "economy." The word "economy" is much like the word "society." Neither one represents something that actually exists; rather they are words used to describe complex aggregates, (transactions and people in a certain geographical area.) Using aggregates can be useful at times if we are careful to remember what they really are, but they can also be very misleading. An economy is not like a machine. It is simply a word used to describe a group of individuals; their preferences, and what kinds of things and in what quantities they produce, consume, trade etc. It has no brakes and no steering wheel. Not only is a modern economy far too complex for any economist (or team of economists) to understand and accurately predict, but it consists of information that exists only in the heads of individuals. Even if we had the capacity to absorb and analyze all that information, it is ultimately unknowable.

Trying to centrally manage and direct an economy the way central bankers attempt to do is more like riding a bull than driving a car. Yes, the bull will react to external stimuli, but there is no way of knowing for sure how it will react. It is just as likely to throw you to the ground and gore you as it is to go in the direction you are trying to steer it. This is an imperfect analogy to be sure, but the point is correct. Thinking we can control modern markets in this fashion without incurring seriously, harmful side-effects is delusional.

Now, having said that, back to Mr. Fisher's speech. After explaining how confusing the late 90's were for central bankers and after praising Alan Greenspan for being a prescient observer and a shrewd market manipulator during that period, he makes the following statement. "The destruction of communism and the creation of vast new sources of inputs and production have upset all the calculations and equations that the very best economics minds, including those of the Federal Reserve staff—and I consider them the best of all—have used as their guideposts. The old models simply do not apply to the new, real world. This is why I think so many economists have been so baffled by the length of the current business cycle and the non-inflationary prosperity we have enjoyed over the past almost two decades."

And there you have it. It isn't economist's fault that their models don't work, or that they can't effectively manage an economy, or that they can't predict our economic future with any accuracy. It's the world's fault. Everything was running smoothly; they had everything figured out, but then the world changed and messed it all up. If only we could make the world conform to some static, easily controllable ideal. Then central bankers in all their arithmetical wisdom could truly lead us to into eternal prosperity without any further complications.

But alas, even Mr. Fisher recognizes that this is impossible. So what then is his solution? "From this, I personally conclude that we need to redraw the Phillips curve and rejig the equations that inform our understanding of the maximum sustainable levels of U.S. production and growth." Such is the thinking of the "best and brightest" modern economists, many of whom have been irreparably influenced by the John Maynard Keynes. Never once should we question whether or not it is wise to try and control the "economy" based on complex, highly problematic mathematical models and equations that are founded on enormous and therefore inaccurate aggregates. In the event that these things fail to give us the desired result we simply need to invent knew ones. It is the equations themselves that are the problem, not the methodological foundation they are based on. If you want a sense of how innacurate the Phillips Curve has been,read this. But despite this fact, the solution has of course been to "rejig" the curve as shown here. Good thing we have such wise men at the Fed who can no doubt come up with just the right equations in order to direct the "economy" in this new and different era.

Or perhaps trying to measure, manipulate and control the billions of transactions made between hundreds of millions of people every year, and the currency in which these transactions is denominated is not such a good idea. Maybe this thing we call the economy is far too complex for us to ever construct accurate models that can predict its behavior, or equations that can give us desirable outcomes without producing large, unintended consequences. Perhaps the fact that every fiat currency for the past 3000 years has failed and been replaced by some form of Gold-backed money should tell us something. But federal hubris seems to know no limits. We are determined to re-learn the lessons of history, and learn them we will. That is, as long as men like Richard Fisher are in charge of "managing" our "economy."