Tuesday, March 27, 2012

Making Economic Models

All economic models are based a few fundamental Axioms. Axioms are statements that the public accepts as true. For Keynesian or conventional economic theory the Axioms come from Supply and Demand principles. N. Gregory Mankiw in his book, Principles of Economics, defines the Law of Supply and Demand as "the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance." N Theory, on the other hand, states the price of goods are established in a negotiation between Buyers and Sellers. Since the negotiation is between many individual Buyers and Sellers there are many prices for the same goods.

This break from conventional economic Axioms is what distinguishes N Theory from most economic schools. With a different economic foundation N Theory follows a different path in the way economic models are structured.  Unlike most economic models based on supply and demand mathematical relationships, N Theory takes a different approach. It looks at the way economic actors interact and tries to improve those interactions based on a set of principles or economic rules. This is the approach a mechanic would take to fix your car. He would look at how all the parts are supposed to interact and look for variances.

If your car doesn't start you could create a model that describes all the steps necessary to obtain ignition or you could look at likely causes due to operator error or inattention to necessary maintenance (lack of gas, clogged fuel line, dead battery). Conventional economics takes the first path and N Theory follows the second. The problem with taking the first path is that unless the car was built and maintained flawlessly there is a possibility of an unknown circumstance, a black swan (a circumstance not considered in the model) occurring that prevents ignition. Since the circumstance is not in the model it will never be discovered by running the model. Testing a model involves varying the inputs or increasing the precision of the data. An economist can spend a lot of time scratching his head and repeatedly running his model, but with a black swan in the car never find the problem.

N Theory, on the other hand, states there are two possibilities. Either the problem is in the car or with the driver. Analyzing both the car and driver covers all the factors affecting performance unlike the approach taken by conventional economists where the search is focused on the functioning of the vehicle. By looking at all the economic actors new problems can reveal themselves and make uncovering the black swan much easier.

The difference between N Theory and conventional economics is that N Theory looks at the economic system for flaws and conventional economics looks at the model or model outcomes for flaws. N Theory looks at how the system "works" and conventional economics looks at how the system "changes" with new inputs. Conventional economics cannot analyze how these new inputs affect the human perception of the "working" of the system. Through surveys and tests N theory can get a sense of the human or user response, but conventional economics depends on a solely mechanical or mathematical response by users.

Why waste time with a model? Conventional economics assumes you cannot determine whether the economic system is subject to failure or performance blips by looking under the hood or bonnet. Fortunately that is not the case there are numerous indications of potential failure. Fluid leaking out of the engine compartment is always a concern, a sudden change in the sound of the engine or a clicking sound from the starter are all indications that a mechanic should be consulted.

The Housing Crisis was missed, because the hood or bonnet was not opened. The signs of engine wear were obvious. These signs were not uncovered, because the mechanic was bent over his computer trying to predict an engine failure. He had all the evidence behind him in the garage.

Using an N Theory perspective it is quite clear the real villain in the Global Financial Crisis was the economic modelers. The credit agencies and the risk departments at the large banks failed their clients. They did not look at the products for performance in the real world and failed to evaluate how investors would respond to cracks developing in the master cylinder. It was not greed, but a total reliance on incomplete models that caused the crisis.

Trichet supports need for N Theory

Trichet in a speech at Harvard University cited a need for a better model to predict a financial crisis. In an article written by Justin Fox on March 22, 2012 for the HBR Blog Network, Justin reported on a speech given by ex-ECB President Jean-Claude Trichet before an audience at Harvard's Kennedy School. In his speech Trichet bemoaned the advice he received from economists during the Global Financial Crisis. He stressed that the most prevalent models (Dynamic-stochastic General Equilibrium models or DSGE) used by central banks were ineffective in predicting the turns in the Global Financial Crisis. He further stated that the assumptions underlying these models need to be challenged since the models failed to foresee that a disruption in the financial markets could cause a severe economic downturn.

Justin Fox quoting from a new book, The Assumptions Economists Make by Jonathan Schlefer, evaluates in the article whether the three leading economic theories are guilty of crimes against economic modeling. The first group of theorists to face the inquisition are the devotees of Rational Expectations. This theory which assumes the decision makers in charge of our financial affairs are omniscient and immune from missteps assigns a number of unrealistic abilities to the players in the economic game. It is assumed that knowledge of what is going on will enable these managers to sidestep disaster.

If that was always the case dodge ball would not be a fun game, since the game future is known. The other team is going to throw the ball back and try to hit someone with it. Armed with the knowledge of what the other side will do a player on your team will simply side step the incoming missile. Unfortunately, a player's performance differs greatly from what is predicted. Likewise, many knowledgeable players were knocked out of the economic game during the Global Financial Crisis even though they knew what was coming.

The Real Business Cycle theorists are the next group to go before the financial jury. The jury finds their predictions to be based on assigned human traits that do not fit with the reality of human responses especially during a panic or when the herd suddenly stampedes.

Finally, the judging panel returns to DSGE to evaluate why the most esteemed economic model did so poorly in the predicting the outcomes of the 2008 Global Financial Crisis. Schlefer concluding with the mildest of criticisms of Keynes and the DSGE models Keynes spawned was only found guilty of overstating the predictive power of their model.

A model that cannot predict a global financial crisis seems horribly flawed to me. That is why I proposed N Theory and crafted the rules of the theory to predict major financial disruptions. N Theory unlike the other theories identifies the major flaw (bank runs) in our current economic structure and alerts us to the fact it is an unresolved issue likely to re-offend. I am delighted Jean-Claude Trichet sees a need for new theories like N Theory.

Friday, March 23, 2012

Who decides to increase the Money Supply?

Who decides to increase the Money Supply? Throughout most of the world we are taught it is the central banks who perform this function. In the United States expanding the Money Supply is acknowledged to be one of the core functions of the Federal Reserve Bank. They are given this responsibility since it is a fundamental technique of monetary policy. The central banks were created to execute monetary policy and keep the economy robust. This monetarist is an outgrowth of a 17th century theory about money. This theory is known as the Quantity Theory of Money (QTM).

The current formation of the theory is captured in a short equation developed by Irving Fisher: M = (P + Q) / V , where M equals the Money Supply; P equals an average price; Q equals the quantity of goods and services offered for sale; and V equals the velocity of money or the number of hands money passes through in the period of study. In another blog the end of last year I showed V or velocity of money is an invalid concept. It really does not matter for the validity of the QTM idea. Let's assume you find the average price of all the goods and services for sale in a period and if all are to sell the amount of M or money must equal the total value of the for sale items.

The more interesting question is how do the central banks know what the total retail price of all these goods and services equals. The answer is they do not have much of a clue. The solution does not come from the top down. It percolates up from all the individual banks in a country and slowly rises through the bank system as wholesalers borrow to fund the acquisition and manufacturing of products. This results in more of a guessing game and less a matching game. There are huge gaps in the system that totally miss the banking industry. One such circumstance is the lending of short term credit between manufacturers and merchants and between suppliers and manufacturers. Numerous non-monetary transactions occur to incentivize sales and maintain trading relationships. This gets even more complicated when subsidiary companies exist or when multi-national companies engage in asset sales or transfers. The point is central banks are too far removed from the action to clearly see what action they need to undertake, and hopelessly out of the loop to be an effective mechanism for fine tuning the Money Supply.

Who does decide to increase the Money Supply? It is not the central banks. It is the community loan officer who chooses to make a bank loan. Her decision certainly facilitated by the central banking system, but her decision is what prompts the creation of "new" capital. "New" capital is money created out of air and put to use to buy products or services. Until money is spent in a financial transaction it is only an electronic notation in a ledger with no affect on the economy. In N Theory I explain it is incorrect to think that central banks play a significant role in expansion of the Money Supply. The recent Global Financial Crisis in 2008 and the huge cash creation strategies employed by central banks throughout the world show the ineffectiveness of their ability to create "new" money. The only person who can effectively do that is your local loan officer.

Here is a medical analogy to make this concept more easily understood. The National Medical Agency might train a 1,000 new doctors, but the health of the country will not improve until the doctor sees a patient and prescribes a treatment. Even though in the Global Financial Crisis the central banks polished up the balance sheets of the banks, it was not until the banks made "new" loans, that the economy got any better.

Difference between N Theory and Conventional Economics

N Theory and conventional Economics both exist to explain the factors affecting future commerce. It is assumed by both theories that understanding the factors will allow experts in the field to better describe what will occur when government takes actions that affect these factors or market conditions change.

The model of conventional Economics is a counting model. Adding up the current income of a country's citizenry can predict how much the economy will grow over last year. Prediction is strongly based on what happened in the past. Comparing the amount of copper ore available for sale with the amount needed by buyers will indicate whether the price will go up or down. Looking at the interest rates banks are offering for home loans will indicate how many homes will sell in the coming year. Knowing the number of citizens seeking employment will foretell the growth in wages.

On the other hand, N Theory is an attitude model. Knowing why people are settling for a certain salary increase or decrease will allow prediction of the total income for the coming year. Prediction is based on how attitudes will move the settlement point of negotiations in the future. Studying why copper buyers and sellers are settling at certain prices will give an indication of what factors will affect sales in the future. Surveying potential home buyers will indicate whether lowering interest rates will increase or decrease future sales. Surveying employers willingness to add new workers will allow predictions of future employment trends.

The purpose of economic modeling is to predict what will happen in the future. N Theory is much better at this task than conventional Economics that relies on supply and demand modeling. N Theory looks at the person making the decision and through their eyes at the factors determining what decision they will make. Conventional Economics only looks at the factors affecting a buyer or sellers decision.

Here is an illustration of the difference between the two approaches. Imagine you are given the task of determining how many miles will be driven in the next month in your county. Conventional Economics would answer this question by looking at gas prices, last years driving miles, possibly the weather and the income level of drivers. From this information an economist can predict that driven miles will increase by "x" percentage. N Theory would take a slightly different approach. N Theory would ask the driver's how much driving they intend to undertake and how this compares to last year, or better, compare this survey from the results of last year's survey. Both approaches require mathematical techniques to refine their predictions. The big difference is N Theory asks the economic "driver" what they plan to do. Conventional Economics looks at the factors that affect the decision. N Theory looks at these factors through the buyers' eyes. Conventional Economics looks at these factors through the eyes of an economist.

Thursday, March 22, 2012

Government protects its Own

Yesterday, I was listening to NPR (National Public Radio). There was a profile of Marine Pilots. The men and women that guide huge merchant ships into port. There is no doubt that this is a difficult job, but the pay should be comparable to other similar jobs. That only seems fair. These positions are almost always government jobs in the United States since the ports of America are the usually public facilities. Even so I was shocked when the narrator disclosed that pilots in Los Angeles earned in the mid $300,000 and a study of northeastern U. S. pilots had an average salary slightly above $400,000.

I have had positions of great responsibility and critical to the welfare of a portion of the country, but never earned that much money. Of course, I worked in the business sector where salaries levels are negotiated between two parties with "skin in the game." Clearly, most government sector jobs only have one party with skin in the game. There is no real negotiation in the government sector. The emphasis seems to be on making the employee happy.

This incident sparked me to recall an incident in San Francisco when on a trip with my family in the 1960s. The whole family was on a tour bus that made various stops around the city. At one of those stops the bus driver was outside the bus talking to a passenger about a possible upcoming strike by City bus drivers. I was standing with my Father nearby and we could hear the conversation. He was telling the visitor that the average salary for bus drivers was $60,000. I knew the average salary of the business people in our community south of Seattle was about $30,000. The visitor said that seemed like a lot of money. The bus driver interrupted him and explained it was very expensive to live in San Francisco. I pondered that thought since I had looked at a number of S. F. restaurant menus, purchased souvenirs and watched my Father purchase tickets to attractions. They had all seemed similar to Seattle prices. As we walked away my Father, a physician, leaned over and said his salary was about the same as the bus driver.

Later in the afternoon I listened to another NPR show about a "technology cluster school" in Greece.  The school Director stated at one point this school was needed since it was no longer possible in Greece to take your degree and get a government job. Herein lies the problem. The way to wealth in Greece up until the current financial crisis was to get a government job and live happily ever after.

In the United States I believe the average salary today is about $45,000. If you have a federal government employee making $400,000 and each private citizen pays federal taxes of $2,500 it takes 160 people to pay the public sector employee his salary. This does not seems so bad until you realize that if you calculate the cost of all government sector employees. Government sector employees are about 40% of the population and these employees earn much more than their business sector counterparts. Therein lies an impossible situation. The governments only choice is to borrow.

This inequality between the government sector and the private sector has effectively bankrupted Greece and is threatening to do the same to the United States in the next couple of years. A small business sector supporting an overblown government sector will never work. All activities of the government sector are funded from tax revenues from the business sector. I explain this in greater detail in my new book, the Rule of Money.

Tuesday, March 20, 2012

Can Government restrain its own bureaucracy?

As budget crises affect governments across the world, citizens are wondering whether their elected representatives have the spline to restrain even the government's own agencies charged with spending taxes efficiently.  Clearly, it is not a difficult task to specify a financial hurdle rate of return for a project to be considered. This is standard practice in the business sector.  No businessman would push a project that does not meet the specified hurdle rate. Unfortunately, that is not the case for projects in the government.

Conservative columnist Chris Edwards in his Townhall.com article about the civilian projects of the U. S. Army Corps of Engineers asserts the agency "has a history of distorting its costs-benefit analysis." Why does this happen? Pork-barrel politics and the Corps own agendas are not subject to the restraint of the cost-benefit analysis. Chris Edwards points out "the priority of the projects is based not on the highest economic return, but whether a particular project is in a powerful congressional member's district" or a pet project of the Corps. Likewise, journalist Michael Grunewald found GAO reports that stated "the Corps analyses often understated costs and overstated benefits." From the GAO reports it appears the Corps used analysis to justify their actions rather than to verify projects were pursued in the proper order. Congress is similarly unrestrained in their pursuit of projects that do not pencil out. In a Congressional oversight meeting with the Corps, George Voinovich (R-OH) expressed the Congressional perspective when he stated, "We don't care what the Corps' cost-benefit is ... we're going to build it anyhow, because Congress says it's going to be built."

When government agencies and representatives ignore legislated restraints it makes a mockery of process.  In N Theory I discuss the role of restraints, termed constraints, in the business sector.  Constraints provide the foundation rules for the marketplace. Attention to these rules is essential to ensure success. Constraints are an essential factor in effective economic controls. When governments allow their own operations to function without these controls it creates a severe inequality between the business sector and government sector. It is like allowing government employees and contractors an exemption from traffic laws. Although not a egregious situation unless it is abused, it nevertheless sets a precedent and a perception that government employees are special. They are not subject to the same economic factors that constraint the rest of society.

This leads to the ultimate question. Why are these people given special rights?

Sunday, March 18, 2012

Currency Devaluations

There is a great deal of confusion among economists about what forces are in play when a country devalues their currency like Iceland did a couple of years ago, or the economic factors at play when a country does not devalue their currency like the path Greece is currently following. Both Iceland and Greece got into their financial difficulties by overspending by their national government. We call this situation a "sovereign debt" crisis. It is simply a situation where a country borrows more money than it can repay or allows currency speculators to overvalue their currency.

Iceland's solution was to decrease the value of their national currency. This allowed their export products to be less expensive increasing trade, and reduced the "real" income of their citizenry so they could not buy as many imported products. The result is people saved more increasing bank deposits and spent more on local products spurring the national economy. With the cash flow increases Icelandic businesses were able to reward their employees with more money gradually restoring the relative earning level of their citizenry to that of their competitors. Iceland appears to be well on their way to extracting themselves from the currency crisis that overwhelmed their financial system.

Greece does not seem to be finding its way. Although most citizens in Greece have suffered wage losses, the losses have not benefited Greek exporters since businesses still sell products at the same price. The rescue by other European countries has stigmatized Greek products and the demand is falling. The result is Greek companies have less business and must enforce harsh wages terms on their employees. Since the employees have less money to spend they cannot stimulate the consumer economy. The Greek situation is likely to get worse and end with their expulsion from the Euro zone or an internal strife. Neither will benefit the economic situation in Greece.

One of the great advantages of N Theory is that it provides a simple explanation of why currency devaluation is a better path to follow. In N Theory money is tied to earnings. If a currency is not accepted at the stated value it is because the amount received for work is excessive. A currency devaluation brings all present and past earnings into line with the earnings paid in other currencies. One step and it is done. By taking this step the Icelandic business sector adjusted to the new currency valuation and renegotiated with their suppliers and increased their exports. Simple. This adjustment corrected the error of over payment of wages in Iceland and solved the problem to the satisfaction of people inside and outside Iceland.

The technique Greece is trying does not work since it affects only current and future earnings, not past earnings. Greece cannot make the ultimate step since their currency valuation is set by the ECB. Greece and the ECB  are myopic. The two parties are only looking at the problem from the viewpoint of the government. The government wants to pay their bond holders so they are seeking a way to keep the same revenue streams. Unfortunately, this is impossible when their action is strangling the business sector making economic growth impossible. Without economic growth the government's tax revenues will gradually slide until default is inevitable. By focusing on the Greek government's ability to repay its debt, the ECB is suffocating the business sector. Growth of the business sector is the only way shown to restore a tax revenue stream sufficient to repay a capricious spending government sector.

Greece paid government workers more than they were worth and created far fewer business sector jobs than their spending required. N theory explains all this in the Rule of Money: It must be earned. Unearned wealth must be repaid. It is a debt after all.

Wednesday, March 14, 2012

Can Borrowing create Wealth?

Most countries in the developed world are trying to cross a debt high wire. Today, their ability to balance on the wire is essential to the financial stability of the world. How did all these countries get into such precarious positions? Largely, the blame can be assigned to borrowing. Such an obvious assertion does not explain much.

We need to go further back and understand why each country began borrowing. Unfortunately, the answer is simply, because there were lenders willing to loan money. No country evaluated their capacity to repay the loans. Political leaders depended on the lenders to evaluate their country's capacity to repay the loans. This task was done about as competently as the risk evaluations of subprime bonds. In fact, there is a parallel between subprime borrowers and Finance Minister borrowing. Both assumed the willingness of a lender to give them money implied they must have the capacity to repay the loan. In both cases this was a flawed assumption. The lender was not evaluating their capabilities, but only the quality of the collateral in the case of subprime borrowers and the implicit gurantees of repayment in the case of sovereign borrowers. Each evaluation only scratched the surface of what needed to be evaluated.

Risk Managers of subprime lenders did not look at the stability of the entire market. Their focus was only on the specific property.  Risk Managers of Sovereign lenders did not look at the competing demands of tax revenues, but only whether a "guarantee" was implied. No one probed into whether the guarantee could be fulfilled. The Global Debt Crisis is largely a result of sloppy lazy work by all sides.

Even so, the negative consequences of this laziness might have been avoided if the borrowers and lenders had made loans that made sense. What is a loan that makes sense? It is a loan that generates sufficient revenue to repay the principle and interest. What kind of loan is that? The simplest example is a toll road that will generate enough income to repay principle and interest. Very few public expenditures meet this standard.

Let's review some of the more common public expenditures that get countries in trouble. All defense borrowing is of this type, but there are others. Surprisingly many of the most egregious examples are the funding of education. Most of the developing countries in the Middle East are using funds from their oil rich brethren to educate their populous. Admirable, but once educated these graduates cannot find jobs. Consequently, the poor countries hire many of them in "make work positions" funded with precious tax revenues insufficient to pay their salaries and meet the principle and interest payments for the colleges and universities funded with borrowed funds. This is a classic example of loading the camel before having a market destination to travel to. Development of the private sector must proceed the education of the employee.

In N Theory the requirement of being able to repay a loan is the Finance Rule. Failure to consider the Finance Rule when making a borrowing or lending decision ends in a Debt Crisis. Escaping from a Debt Crisis after the fact is extremely difficult as we are learning. Every country should make the Finance Rule part of their governing documents.

Saturday, March 10, 2012

Dualistic Boundaries

Dualism, the condition of opposites, plays a large role in N Theory. Dualism is embraced as a necessity. Dualism defines the world through contrast with the opposite concept. Black is clearer when contrasted with White. Republican positions are better understood by American voters when contrasted with Democratic positions. Health is valued when placed beside sickness. Peace is fully appreciated after the ravages of war. Grace is adored when it replaces boorish self-interest. Harmony is delightful when it follows discord.

If Dualism is defined by opposites, then there must be a boundary between the two polar terms. The boundary between black and white is gray. The boundary between U. S. political parties, Republicans and Democrats, is occupied by Independents. N Theory argues it is at this boundary that change occurs, just as in a black tunnel when enough light enters to allow the walls to reappear and enable a lost spelunker to reorient. Likewise, two adversaries cannot understand the other sides' position unless they travel far enough to stand on the other side of the boundary. A child will never understand why a parent is asking them to behave unless the child is allowed to slip on the parent's shoes for a moment. 

There are numerous Dualistic Boundaries that must be crossed for conflict resolution to occur. For parents who want their children to be successful, the parent/child boundary  should be straddled whenever a teaching moment occurs. In economics the Business Sector/Government Sector boundary should be heavily traveled. In politics it is important members spend more time on the fence than on building fences. In international relations it is important leaders understand as much about their country as those countries that threaten them. Gates are more important than walls. Open your hearts and hands to paranoid fence builders. Beware of countries that build warships.

In economics the importance of dualism is to realize one side is material and the other immaterial. Although the two opposite positions clarify each side and make the contrast vivid, one is right and one is wrong; or both are wrong and the best solution is a compromise. To arrive at the best solution requires intelligence, a good ear and a willingness to cross the boundary and look at the problem from all possible perspectives. The ability to meet your adversary and listen to his argument makes a great leader.