The Fed Gets Economics Wrong

Economics (in general) is populated at its core by a lot of bad ideas. And these bad ideas have come to be accepted as the correct interpretation of how the economy functions and thus have become the basis for economic policy. This news shouldn’t come as a shock since I’ve written about this many times over the years in Thoughts from the Frontline.

Economics is an enormously useful tool for those of us who are trying to understand business and investments and government policy. But to paraphrase Dirty Harry, “An economist has to know his limitations.”

Economics

The whole concept of an economy’s being “in equilibrium” is simply academic nonsense. The real world is a complex, dynamic, out-of-balance mess that doesn’t fit inside anyone’s box. Those theories and equations only work when you assume away the real world.

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Volatility"Surreal doesn't even begin to describe this moment," Seth Klarman noted in his second-quarter letter to the Baupost Group investors.  Commenting on the market developments over the past six months, the value investor stated that events, which would typically occur over an extended time frame, had been compressed into just a few months. He noted Read More


The people who best understand economics are the worst at managing it

One of my favorite Keynes quotes (and there are lots of them) is:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

How can the very people who claim to understand how the economy works be so bad at predicting and managing it? The quick answer is that the real economy is far more complicated than they’re willing to admit.

Fortunately, some economists recognize these limitations and are looking for better ways to understand the economy. Unfortunately, that group is vastly outnumbered by old-school economists in government, central banks, international institutions, corporations, and universities.

As much as I like to quote John Maynard Keynes (he does have the best quotes in economics), I find his basic thesis to be the fundamental flaw in current macroeconomic thinking.

There’s a fatal flaw in their assumptions

It’s that aggregate demand is the most important factor in economics, and that if aggregate demand isn’t sufficient, then it is up to the government to run deficits to stimulate that demand.

Essentially, Keynesians of all stripes see the recovery that followed a recession as the result of the deficit spending enacted to rescue the economy. Look, they say, it has happened every time.

They fail to recognize that the activities of individual businessmen and women, plus the self-interested acts of millions of individuals, were the true driving force behind the recovery.

Thus they unwisely prescribe even greater deficit spending and more debt to counter recessions but routinely fail to adhere to Keynes’s dictum that during good times, that debt is to be paid down.

They refuse to recognize the obvious connection between distorted debt levels and the lack of growth in an economy—a connection that has been demonstrated time and time again all over the world.

The point—as we will confirm in a moment when we reconsider classical economics—is that income is the driver for the economy.

The great majority of economists have been trained to see consumption and government spending as principal drivers of the economy. I see these two as secondary, and productive behavior in the private economy as the primary driver.

Central bankers should not be surprised

Then we come to the concept of general equilibrium. Pretty much every economist accepts some variant of the concept of general equilibrium. I have come to the point where I completely reject the notion: it’s utterly false. There is no general equilibrium of any kind.

Today’s most popular macroeconomic models come in a flavor called “Dynamic Stochastic General Equilibrium.” The cool kids call them “DSGE” models. They are “dynamic” because they show economic changes over time, and “stochastic” because unexpected shocks to any of the inputs can drastically change the outputs.

Central banks are the most enthusiastic DSGE model users. If you believe their policies have worked well in recent years, then you may be a DSGE believer. I am not. I think a main reason DSGE models fail is that they assume everyone is similarly informed and always makes rational decisions. Neither of those things is true in the real world.

This sort of equilibrium never exists in the real world because the real world never stops changing. Thus neither we, nor our estimable central bankers, should be surprised when DSGE models don’t deliver much useful information.

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