04/16/2017

In Case You Missed It: Is The Economy A Machine? [Watch]

Pater Tenebrarum, Acting Man

A Science Goes Astray

Human beings have a strong tendency to look for patterns. The natural sciences have shown that the universe is governed by laws, the effects of which are observable and measurable in an objective manner. Mostly, anyway — there is, after all, the interesting fact that observers are influencing measurements at the quantum level by the act of observation. (For our lives in the “macro” world, however, this is not relevant. An engineer does not need to take relativity or quantum physics into account to construct a machine that works.)

 

machine

In the late 19th and early 20th centuries, a never before seen string of very rapid advances in scientific knowledge and technological progress occurred. It is hard to overstate the impact of inventions such as the automobile, radio, airplanes, and so forth. This happened while per capita economic growth in what is today known as the “developed world” reached its fastest pace in all of history — a pace never to be seen again.

Although we cannot prove it, we believe there was a good reason why this combination of vast economic and scientific progress took place at the time: governments were but a footnote in the lives of most people. By 1910, spending by the US government was a mere 4% of GDP. There was no central planning and no central bank, although there was of course a certain amount of crony capitalist government intervention, and the forerunner of the Federal Reserve System (the system of “central reserve city, city and country banks”) was already established.

 

1-US-GNP-per-capita-1869-1918
 

US real GNP per capita during the so-called “Gilded Age” – it has never again grown this fast or more equitably. This happened under a fairly sound, gold-based monetary regime.  Consumer price inflation was slightly negative for most of this time period – click to enlarge.

However, the astonishing advances in the natural sciences had an unfortunate side-effect: many scientists in the field of the social sciences — especially in the most developed branch of the social sciences, economics — began to develop a fascination for the methodologies of physics. They inter alia assumed that what had been lacking so far in economics was the availability of reliable statistics.

Armed with the proper statistical data, so it was held, economists would not only be able to “test” the theorems of economics, but would ultimately also be able to engage in proper macroeconomic planning. As Murray Rothbard put it in the foreword to Ludwig von Mises’ book Theory and History:

“'[R]eal’ science, it is alleged, must operate on some variant of positivism.”

In parallel with this, Alfred Marshall’s partial equilibrium approach as well as mathematical economics and Leon Walras’ general equilibrium approach gained greatly in prominence in economics, in stark contrast with the causal-realist approach of the subjectivist economics propagated by the Austrian School. In spite of Carl Menger having been one of the fathers of modern economics, his economic school of thought soon found itself overshadowed.

It can also be assumed that not too many economists in the Anglophone world were fully aware at the time of the extensive debate that had earlier raged in the German-speaking parts of the world over economic methodology — a dispute between economists who asserted the existence of universally and time-invariantly valid economic laws and the German historicists, who denied that such economic laws existed.

The debate continued to simmer though,  and was taken up again later with some verve. Milton Friedman e.g. strongly came out in favor of positivism in economic science. The reality of the matter is of course that if one looks closely at the arguments of those favoring empiricism in economics, it soon turns out that they too believe in the existence of economic laws — and are usually blissfully unaware of the contradiction this implies.

One may well wonder: if universally valid economic laws exist, why do economists seem so uniquely unable to come up with correct predictions? Well, they are neither speculators nor entrepreneurs, so as a rule they have no special talent for forecasting the future. Also, contrary to what seems to be widely assumed, furnishing precise predictions is actually not the task of economic science.

Sound economic knowledge can merely help to constrain one’s forecasts. One could also say that economic laws suggest that certain things are simply not possible. The fact that every slice of economic history is slightly different from every other, or the fact that economic development in different cultures seems to proceed differently, is due to what one can call “contingent circumstances”.

At any given point in time, a multitude of factors is at work in the economy, many of which are subject to varying leads and lags to boot. These are what produce concrete historical outcomes — but underneath, economic laws are always operative. For example, the law of marginal utility will never be suspended and  empirical testing is certainly not needed to ascertain its validity.

The positivists actually have it the wrong way around: one cannot use economic statistics or economic history to explain or advance economic theory. It is exactly the other way around: one must (inter alia) employ sound economic theory if one wants to properly interpret economic history.

 

The Economy as a Machine

We first became aware of Ray Dalio of Bridgewater a few years ago when we happened across an article extolling his success as a fund manager. Evidently, he and his team do indeed excel in asset management; we imagine it cannot be easy to achieve the strong long-term returns Bridgewater can boast of with funds of such immense size in terms of assets under management.

Later, Dalio came to our attention again as a critic of the Federal Reserve’s quantitative easing program and incidentally as someone who wisely pointed out that the monetary experiments of modern-day central banks strongly suggest that one should hold gold as an insurance policy. Still later, Bridgewater published a lengthy report entitled “How the Economic Machine Works”, which laid out Mr. Dalio’s economic views and the associated policy recommendations, topics to which he returns frequently in interviews in the financial media.

We think he is a much better investor than economist. We want to stress that we don’t want to pick on Mr. Dalio, but rather wish to refer to his paper as an example that helps to make a general point. It should also be pointed out that the study of historical cycles is a perfectly legitimate way for an investor or speculator, and even an entrepreneur, to proceed. But it is not economics. As Ludwig von Mises notes in this context (in Human Action, p. 334):

“In order to see his way in the unknown and uncertain future man has within his reach only two aids: experience of past events and his faculty of understanding. Knowledge about past prices is a part of this experience and at the same time the starting point of understanding the future.”

The faculty of “understanding” is the main talent of the historian. The reasoning of a speculator, as Mises says elsewhere, is akin to that of a man “looking with the eyes of a historian into the future”. However, although history is part of what Mises termed the sciences of human action (or praxeology, a term he introduced to replace the in his view tainted term sociology), it is a thymological, rather than a teleological science like economics.

Correctly applied, it makes use of a mixture of the empirical data of history as well as the deductively ascertained laws of praxeology and combines them by applying “understanding”.  To clear up the meaning of the latter term: a historian, for example, knows that Caesar crossed the Rubicon — this is an established datum. But in order to convey why Caesar did so, what precisely motivated his actions, he has to apply understanding, by pondering all that is known about the man, the time in which he lived, his journey through life and his character. This involves just as much uncertainty as coming to conclusions about the future.

The title of Mr. Dalio’s missive already foreshadowed that a critical examination would be required. The economy is actually not a “machine”, even though such analogies seem to make sense on a superficial level. Another well-known, but equally problematic, analogy is to describe the economy as being akin to an “organism”. It is certainly true that there is a division of labor and cooperation between the cells of an organism; in this sense, the comparison seems to make sense. But the processes involved are purely physiological in nature — cells don’t think or have volition.

We once again quote Mises on the matter (Theory and History, pp. 252–253):

“[H]uman society is an intellectual and spiritual phenomenon. In cooperating with their fellows, individuals do not divest themselves of their individuality. They retain the power to act antisocially, and often make use of it. Its place in the structure of the body is invariably assigned to each cell. But individuals spontaneously choose the way in which they integrate themselves into social cooperation. Men have ideas and seek chosen ends, while the cells and organs of the body lack such autonomy.”

The “Phillips Economic Computer”, a.k.a. the “MONIAC”,  designed by Bill Phillips in 1949. It is actually a great feat of engineering, but it also perfectly illustrates the mechanistic mindset that has taken root in economics (as the Science Museum in London notes, it “demonstrates in a visual way the circular flow of money within the economy” – which goes to show how superficial this mechanistic view actually is).  See also the video embedded at the end of this post which shows the machine in action.

Photo via sciencemuseum.org.uk

Mr. Dalio’s paper on the “economic machine” is actually quite interesting from a historical point of view. It contains examples of past debt accumulation cycles and the subsequent “deleveraging episodes”, and all of this represents quite valuable information. We would certainly regard it as helpful to investors. However, it does not explain “how the economy works” — and, more importantly, the economic policy advice derived from it is flat-out dangerous.

Recall the remark we made above about many economists becoming entranced by economic statistics and econometrics in the early 20th century. One economist who tried to derive a theory on economic cycles from the study of statistics was the Russian Nikolai Kondratiev.

He eventually became famous for his “Long Wave” theory of production, prices, and interest rates. The term “Long Wave” was actually popularized by Joseph Alois Schumpeter after Kondratiev’s untimely death (he was exterminated by Stalin, who deemed his theory to be “counter-revolutionary” after a US economics professor denounced Kondratiev as a closet capitalist in Moscow. Western intellectuals have always sympathized with socialism).

Schumpeter tried to refine Kondratiev’s work on cycles by integrating into it shorter-term cycles, the existence of which had been posited by other economists, such as Joseph Kitchin (inventory cycle), Clement Juglar (fixed capital investment cycle), and Simon Kuznets (infrastructure and demographic/immigration cycle).

[CAPTION] One of the still working “MONIAC” machines made by Bill Phillips is demonstrated at Cambridge University. This video is both funny and slightly scary. Unfortunately, our vaunted central planners really believe that they just have to pull the right levers and the economy will run perfectly (or attain “escape velocity”, like a space ship)…

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