Solving Economics

One of my few regrets is that I did not study economics at college. I was a bit of a maths prodigy so slid into that discipline, but I loved economics at school, and once I got to college I could still succeed at the maths but found little passion for it. So I flirted with changing, but ultimately stuck with the safe option. Who knows how things would have turned out, but a part of me still thinks I made a mistake.

I loved economics because it was live, empirical, unsolved, complex, but showed signs of being solvable, with a mixture of theory and experimentation. Since my school course in the 1970’s, text books have had to be re-written at least twice, and the discipline has learned a lot but arguably remains as far from lasting solutions as it ever was.

My guess is that this will change over the next twenty years. My belief is that there have been two big inhibitors to progress in the discipline.

The first has been in the nature of the subject: because so many variables are interacting all the time, and because most of these cannot be controlled (and others cannot be ethically controlled because they have too much influence on human well-being), the mass of available data has always had too much noise to be able to reach definitive conclusions. But this limitation might be vanishing, thanks to big data and machine learning. Economics is precisely the sort of field where this can help, and I believe the science will march forward as a result.

But economists will have to overcome the second limitation, that of lazy bias. Too many theories are set up to serve vested interests, usually the corporations and sponsors wishing to maintain their wealth. This had held up progress in many disciplines, for example healthcare and environmental knowledge, but in economics it has been everywhere, and politicisation of the subject has held back progress.

As an optimist, I am hopeful that once big data starts to make a difference, the political side will find it harder to resist more robust ideas. If The Economist is any guide (and I think it probably is) there are already promising signs. Over the last couple of years, the magazine has been more open to casting off tired shibboleths. Until recently, they thought that every problem in education could be solved by firing teachers, that trade was always good and that trade unions were always bad. Nowadays things are more nuanced, and the magazine also has a good new habit of posing open questions.

I would love to know more about the subject, to be able to understand more of the debates in the Economist and elsewhere and also to challenge and hone my own opinions. The complexity has increased with globalisation but so has the potential to create really robust models that can drive policy and progress.

Within the most recent edition, many articles were thought provoking and not dogmatic. The lead article looked at finance ten years after Lehman; the Britain section mused intelligently about low wage growth; there was a fascinating debate out why Turkey and Argentina seemed to be getting the same results from diametrically opposite policy stances, one of which the Economist would typically have lauded; and Larry Summers’ thoughts about secular stagnation were reopened. My hope and my guess is that in twenty years time all of these challenges will appear much more simple and open to attainable remedies.

One potentially useful tool in all of this is something that programmers, doctors and project managers use all the time; root cause analysis. A good example may be in understanding the causes of the Great Recession. It is too easy to blame the greed of bankers. I tend to agree that most bankers are greedy frauds; this week I enjoyed the movie The Big Short, which confirmed my bias but also set me thinking about possible deeper causes. Perhaps I will read Crashed, but yesterday in Barnes and Noble I flipped through its 600 pages and I am not sure my love for Economics goes that deep.

My pet root cause for much that goes on in the world of commerce and finance is 6% real. That has become the target rate of return for capital.

Fifty years ago, capital was managed in small pools. There were barriers to capital crossing borders. Individual firms could pursue their own strategies and goals. Governments could also mix policy objectives. Investors acted somewhat independently. Now all that has changed, and most of the world’s capital acts as one large pool. And like water it flowing downhill, capital seeks out its best risk-adjusted return. Any investment offering less than the average is starved.

This has happened because most barriers between states have been dismantled. Further, investors have merged towards a single block and have become tied up with governments. The largest investments are now pension funds, linked to regular citizens and of great interest to governments. Remaining investors have become like lemmings too, often using index-tracking funds, and, if not, getting data so frequently as to expose any portfolio offering below average returns.

In this environment, the financial world has become flat, and its level is at 6% real. Pension funds must assume a rate of return to balance actuarial inflows (today) with outflows (in many years time). At a time of boom, they chose 6%, and to change that now would require unaffordable write-downs. Governments would be on the hook for public sector funds and under pressure for private ones too. In a way, it is not that banks have become too big to fail; it is that almost the whole system has become too big to change its base assumption.

There are a few exceptions. Sovereign wealth funds could choose a lower target, though citizens might ask why. Privately held companies can also opt out, so long as they don't need to finance much debt. And governments can opt out too, choosing to impose capital controls and print money. Venezuela shows where that policy ends up. Argentina does too, as well as what happens when a country opts back in. Increasingly, there is no escape. One victim has been social democratic political parties, finding that in power, fiscal discipline constrains their actions, and then damages their brand and reduces trust among their possible voters.

Compared to historical averages, 6% real is a huge return to achieve sustainably. In one way, it has been good that the target is set so high, because it fosters innovation and hence human progress. Silicon Valley might have been less exciting if the 6% target had been lower. But the downside has been disastrous.

Companies have had to become reckless to continually produce plans to investors that flag 6% real returns. They diversify into risky financial products and pursue ambitious acquisitions. They rely on dodgy consultants and internal gurus and pay them far too much. They offshore and outsource. They sacrifice any thought for secondary goals such as fairness to customers, environment, legacy and workers – it is not callousness that has destroyed real wage growth, it is employer necessity. They buy back shares rather than investing, and especially avoid long-term, less certain investments. They pump up debt. Each quarter they announce earnings and a new plan to keep the plates in the air a little longer. If the plan is not deemed credible, they fire the CEO and find a better snake charmer. They also might collude, and certainly they lobby - even blackmail - governments fiercely to reduce regulation and corporate tax rates.

As a result, we have an economy permanently on steroids but filled with risk. Banks are just companies with even stronger steroids. Governments cannot escape either.

2007-8 is one obvious consequence. So is relentless growing inequality. There are other consequences as well, that I’ll look at next time I blog. Then I’ll also consider if there may be any paths out of the mess.