Correlation Is Not Causation
The Limits of Economic Models
The Source of Growth
The Real Driver of Growth
Labor Day, San Antonio, and Washington DC
“It’s said that power corrupts, but actually it’s more true that power attracts the corruptible. The sane are usually attracted by other things than power.”
– David Brin in The Postman
“For every good idea, ten thousand idiotic ones must first be posed, sifted, sniffed, tried, and discarded. A mind that’s afraid to toy with the ridiculous will never come up with the brilliantly original.”
– David Brin, Orbit interview
As I begin my 15th year of writing Thoughts from the Frontline – some 700-odd newsletters plus 400–500 editions of Outside the Box, 6 books, and scores of special reports – I decided to take a random walk back through some of my writings (and your comments!). With some glaring and notable exceptions that I would like to take off the internet (but won’t because to do so seems somewhat intellectually dishonest), the body of work has held together pretty well. My writing style has matured and so has my thought process – or at least it seems so to me. Writing this letter has been the best personal educational tool I have ever experienced, enriching my life far more than I have probably enriched yours. I’ve done my 10,000 hours. Plus. No college, no course or seminar, could provide me with the wide range of materials I’ve studied.
And that is the thing that stands out to me: the wide variety of topics we’ve covered over the years. The themes vary from week to week and month to month. I write about what interests me that week – where my research and curiosity are taking me. I am, of course, influenced by my somewhat heavy travel schedule and the interaction I have with readers from all over the world (some 65 countries now), both directly and through correspondence. I seem to attract a number of readers who are quite willing to push back and make me think about all sides of an issue. For that I’m grateful.
I want to thank each and every reader, many of whom have been there for all 15 years and some who just joined my assembly of best friends last week, for the precious gift of your attention. In a world where we are all assaulted with multiple competing cries for our immediate focus – family, friends, business, social commitments, political and community involvements, household chores, trying to stay fit – all while trying to keep up with the vast flow of information coming at us 24 hours a day from 100 different sources – I recognize that when I show up two or three times every week, I am asking for the most valuable thing you have: your time.
Each week when I sit down to write, I strive to be worthy of your time. I try to bring some insights that will deepen your understanding of how the world works, not always just in economics, but always with a focus on making us better investors and people.
This letter has always been free, and it is my intention to make sure it always is. My style is more casual than that of many other writers, but that’s because from the beginning I’ve always seen this letter as something I’m writing to my best friends. So write back. I do read your comments and appreciate your thoughtful insights and suggestions. That’s how best friends stay in touch.
Sometimes the best ideas for a letter come in response to questions and comments from readers. Last week I responded to a letter from sci-fi writer, professional contrarian, and my good friend David Brin. We took a journey into the world of Adam Smith. You can read that here.
This week I will respond to the second part of David’s letter. Please note that David and I characterize our conversations as joyous deliberations, excited parry and thrust in the realm of ideas. I especially appreciate David because he forces me to think about many of my casual assumptions, although in a battle of wits with David I often feel as if I’m bringing a knife to a gunfight. (Every writer needs a few David Brins in his life. Sometimes I think I have more than my share.) The part of the letter I’ll respond to today is as follows:
John, excellent [Outside the Box] missive on automation. I share your overall optimism.
Still… although Keynesianism deserves lots of criticism for the 30% of the time that it has proved wrong… and Hayek had a lot of good and important things to say… it remains disappointing that you do not use your influence to help hammer nails into the coffin of the Rentier Caste’s catechism… Supply Side (Voodoo) Economics (SSVE), which is not just 30% wrong. It has proved to be almost 100% diametrically opposite to right, with every forecast that SSVE ever made having proved to be calamitously wrong.
David, I think there are more than a few problems with that paragraph. Since we don’t want to write a book here, let’s deal with just a few of them:
- You confuse correlation with causation.
- You make the common mistake made by many economists (which I’ve come to think of as the single biggest error in economics) in that your “model” simply does not take into account enough variables to enable you to draw the conclusions that you do. (I should note that here I am guilty of doing the same thing when I want to prove a point. It is an utterly human flaw, but one that politicians, philosophers, and economists have in abundance. There’s a 12-step program in here somewhere.)
- Further, I have no idea how you associate supply-side economics with what Adam Smith refers to as rentiers. Seriously, I know of no self-respecting supply-side or Austrian economist who favors crony capitalism. For that matter, I think it would be difficult to find a Keynesian who would admit to as much. Yet, in spite of no one’s being in favor of crony capitalism, somehow bureaucrats and politicians manage to create favored constituencies. Of course, each constituency rationalizes that the policies favoring it are necessary for the public good and are fair or whatever, but it seems that everyone wants their turn at the trough.
- Even were we to use the sophisticated analytic and predictive models based on multivariable dynamics that professional economists favor, we would still miss the core ingredients of growth.
Ultimately we are talking about economic growth, a topic you and I delve into frequently, and I want to spend the bulk of this letter on that topic.
Readers do not have the advantage of referring to our multiple previous discourses in which you argued that growth under Republican administrations and supply-side economics has been weaker than growth under Democratic and Keynesian policies. You have cool charts. I can also produce charts which show that, depending on how you choose your time frame (is the Clinton growth era a result of Gingrich-initiated policies?), supply-side economics and fiscal restraint were the drivers of growth in the ’90s. And you’re not going to get me to agree that the damaging surge in spending by the Republicans in 2000-2006 was reflective of supply-side economics. The tax cuts then produced more revenue, but a profligate Congress doubled down on spending and blew the benefits of the tax cuts.
But the reality is that there has been no pure, scientifically established experiment comparing differences in the application of various economic theories. We are in the field of conjecture here. As we will see in a moment, the key causes of growth in the last 100 years have lain entirely outside the fields of politics and economics, fiscal policy, and monetary policy. To conduct a rigorous economic experiment you would have to have multiple controlled environments where you could test your hypotheses. This is not possible in economics, and so we are subjected to endless rounds of speculation about cause and effect.
Politicians and monetary apologists are quick to take credit for positive economic developments and to blame negative developments on past bad decisions of the “other guys.” (Both sides do it. Bush had his “Clinton recession,” and Obama had his “Bush recession.” Reagan blamed the Carter years.) While fiscal and monetary policy are important, they are somewhere around numbers four and five on the list of the drivers of growth.
That being said, I readily acknowledge that bad economic policies can inhibit the sources of growth from being able to function. At the very least, good economic policy and good governance get out of the way of growth; and at best, they encourage and foster the drivers of growth.
The Limits of Dynamic Multivariate Economic Models
Along about the early part of the last century the economics profession developed a bad case of physics envy. It wanted to move from being a soft science to a hard science. At some point “we” (I use that term loosely) felt we were capable of creating mathematical models that would not only explain how economies worked but would also predict outcomes. There was a time, sadly not all that long ago, when I actually had the hubris to think such things were possible. Governments especially wanted these models, as they needed to be able to understand what the effects of their policies would be on the economy. And since everyone (except a few Luddites), no matter their political or economic persuasion, believed in the necessity of economic growth as a driver of improvement in the general good, we were all keenly interested in predicting what the outcomes of particular policies would be vis-à-vis growth.
Now, as I showed a few months ago, back at the very beginning of this new econometric world, politicians were looking for economic models that would allow them to pursue their desired political objectives. If your political objective was a small government footprint, you favored certain models which suggested that was the proper course of action. If your political objective was a larger government and income redistribution, you favored other types of models. The latter approach (Keynesianism) has won out so far.
The problem is that whichever model you choose – and they have become increasingly more sophisticated – they are all still lousy at predicting the future. They’re not even very good at analyzing the present or the past, because they are so fraught with errors implicit in the assumptions the modelers make. I should point out this is not just a problem with economic models; you can probably give me examples off the top of your head in the hard sciences, and the other soft sciences are riddled with such errors. Assumptions can be a bitch. (For new readers, that is a technical economics term.)
Still, I’m not against the use of models. I use them all the time. They are the best tools we have, and they are getting better. They give us insights into general trends and directions. If you understand the construction and the limits of CPI and GDP, for instance, then a model that utilizes those variables can be quite a useful tool. But if you view your input variables and accompanying assumptions as scripture, you’re likely going to make errors in judgment and policy. That is because you think something is true, in the sense of being black or white, when it is actually just a darker shade of pale. We see, said St. Paul, through a glass darkly. For economists, so far, the glass is really quite smoky. And held at certain angles, it distorts reality.
Something as complex as the economy of the United States, or even a relatively small system, cannot be adequately modeled, as there are just too many variables in play (many of them unknown). Further, economies are never in equilibrium, so even a multivariate dynamic-equilibrium model assumes a relatively static, and by definition closed, economy (though many economists would argue vehemently that that is not the case).
The real world is not so simple. It is the “surprises” in the system, the exogenous forces that impinge on your model, that always wreak havoc with your forecasts. And economics (econometricians’ protests notwithstanding), is still as much art as it is science. It is more philosophy than it is biology (or even psychology). We use models to try to show us where to put the pieces of the puzzle. Where we err is when we confuse the model for the puzzle.
For instance, one of the key assertions of John Keynes’s economic
