The Skeptical Optimist

FQ.07.45: Favorite Quote for This Week

Contrary to social-science wisdom, almost no discovery, no technologies of note, came from design and planning—they were just Black Swans.  The strategy for the discoverers and entrepreneurs is to rely less on top-down planning and focus on maximum tinkering and recognizing opportunities when they present themselves.  So I disagree with the followers of Marx and those of Adam Smith: the reason free markets work is because they allow people to be lucky, thanks to aggressive trial and error, not by giving rewards or "incentives" for skill. 
—N.N. Taleb

Two different definitions of "inflation": Ron Paul's, and Ben Bernanke's

Yesterday I heard Rep. Ron Paul of the House Banking Committee questioning Fed Chairman Ben Bernanke about inflation and the value of the dollar.  It was at best a confused exchange, because, clearly, Ron Paul's definition of "inflation" differs from Ben Bernanke's definition of that same exact word.  (Ron Paul is using an old definition, according to the two definitions compared on this web page.)

It would seem important that our public servants in charge of "controlling inflation" should agree on the definition of "inflation" before debating what to do about it—wouldn't it?  Shouldn't the House Banking Committee, along with their counterparts in the Senate, eliminate the prevailing confusion by choosing one of the two (very different) definitions of the word "inflation"? 

Ron Paul defines inflation as any increase in the "money supply" (which, by itself, begs several questions; see the end notes).  Ben Bernanke defines inflation as an increase in the price level.  To Ron Paul, zero inflation happens when zero "new money" is created.  To Ben Bernanke, zero inflation is the scenario in which the prices we pay for goods and services do not increase in the aggregate. 

Let's temporarily make the dubious assumption that we are able to measure and control the "money supply"—in spite of Milton Friedman's admission that that's nearly impossible.  In a growing economy, there's a growing amount of goods and services, by definition.  It takes money to make and buy those goods and services.  How much money?  That's the question, and there are at least two possible answers:

• In Ron Paul's zero-inflation scenario, the "money supply" stays unchanged, which implies that, in a growing economy, wages and prices must decrease.  In simplified terms, the same amount of money paid out for producing and purchasing more goods and services translates to lower wages and prices in the aggregate.  Ron Paul's definition of zero-inflation, in a growing economy, equates to what many others think of as "deflation."  [Would you feel comfortable with a pay cut, just because Congressman X said "don't worry, prices are dropping too, and there's no inflation"?] 

• In Ben Bernanke's zero-inflation scenario, the "money supply" grows at the same rate as goods and services.  In simplified terms, x% more money paid out for producing and purchasing x% more goods and services translates to unchanged wages and prices in the aggregate.  [Wouldn't you feel more comfortable with constant wages and constant prices?]

Most of us, I think, implicitly agree with the "inflation" definition Ben Bernanke is using: rising prices = inflation; falling prices = deflation.  I also think most of us would be averse to wage cuts—even if prices were falling at the same rate—just to hold (Congressman X's definition of) the "money supply" constant.  [Can you picture a future economy, after decades of holding the money supply constant, in which a large pizza costs ten cents and the average wage is fifteen cents an hour?  I can't.  Apparently, Ron Paul can, however.]

But I've been wrong before.  If Ron Paul's definition of "inflation" is the one our public servants can agree on, I'll start trying to think of ways to convince my friends that falling wages are not a bad thing.  Either that, or I'll give up on the hope that growth can accelerate, because when wages and prices fall, people typically want to hoard money, instead of using it for economic transactions. 

In any case, wouldn't it be a good thing for the House Banking Committee to pick one definition or the other, to clarify the debate for us?

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End notes:
Ron Paul's position supposedly comes from the "Austrian" school of thought.  I'll have to reread Mises' writings on this subject, because I'm not sure he was as explicit about the money supply as the position Ron Paul is taking. 

Some additional questions for supporters of Ron Paul's constant-money-supply idea:

• Milton Friedman admitted in this interview that the "money supply" is almost impossible to measure.  If we can't measure it, we can't manage it.  How would we hold something constant if we can't measure it?

• Even if we could measure the "money supply," there are several possible definitions of that term: base money, M1, M2, and a revived M3.  Which one should be held constant, and why, and how?

Black swans, randomness, and the "perfect" forecast

I am in the middle of the second of two books by N. N. Taleb that have been tough for me to put down: Fooled by Randomness, and The Black Swan.  "Iconoclastic" is the best one-word description for both books.  I enjoy a good whack on the side of the head every now and then, and these two books are delivering a good combination. 

Themes: Especially in social outcomes, luck (i.e., randomness) is a much bigger factor than we think.  Highly improbable, unpredictable, surprise events (i.e., black swans) have overwhelming consequences that few of us can think to prepare for.  Those of us who can figure out a way to prepare, by the way, can reap large (relative) benefits—because the huge cost (or benefit) of a black swan is always the major component of the unpredictable surprise. 

Here's an example of his point about randomness: How many times have you heard about mutual fund X's "superlative performance over the last five years"?  Our typical reaction to that message is that mutual fund X must have better managers than other funds.  Reason: Our minds are built to assign cause-and-effect whenever possible, in spite of the strong possibility that random chance played a big role in the outcome. 

Below is an illustration of a "perfect forecaster" of the stock market.  (It's a hypothetical example I set up to illustrate Taleb's point about our natural tendency to assign cause-effect to events, and to ignore the role randomness can play.)

Winthrop B. Carlisle looks like a great forecaster, doesn't he?  Twelve consecutive correct forecasts can't be random chance, can it?  Carlisle is "obviously" a talented guy with one heck of an accurate algorithm. 

Let's see what that algorithm is...

Now click on the following thumbnail, a picture of one possible Winthrop B. Carlisle, implementer of the "perfect algorithm":

In summary, randomness and hindsight bias tell us:
• there will always be someone who gets it right twelve consecutive times;
• we won't know who it will be ahead of time; but...
• we will certainly hear about it after the fact from the one who did. 

Taleb's point: Randomness plays a much larger role in social outcomes than we are willing to admit—to ourselves, or in our textbooks.  Our minds, uncomfortable with randomness, are programmed to employ hindsight bias to provide retroactive explanations for just about everything.  Nonetheless, randomness is frequently the only "reason" for many events. 

By the way, I am enjoying Taleb's sense of humor.  Early on, it becomes obvious that he has little to no use for the typical attitudes and methods in a few specific professions; he pillories economists, statisticians, and Wall Street traders with entertaining regularity in both books. 

I was pleasantly surprised to find out that F. A. Hayek is one of his favorite thinkers from the past (...he doesn't consider Hayek an "economist").   Here's an excerpt:

In 1974 [Hayek] received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, but if you read his acceptance speech you will be in for a surprise.  It was eloquently called "The Pretense of Knowledge," and he mostly railed about other economists and about the idea of the planner.  He argued against the use of the tools of hard science in the social ones, and depressingly, right before the big boom for these methods in economics.  Subsequently, the prevalent use of complicated equations made the environment for true empirical thinkers worse than it was before Hayek wrote his speech.  Every year a paper or book appears, bemoaning the fate of economics and complaining about its attempts to ape physics.

I am as thoroughly enjoying The Black Swan as much as I did Fooled by Randomness.  I'll be looking at just about everything with an even more skeptical eye from now on. 

You can get an 80-minute feel for his themes by listening to Russell Roberts's interview of Taleb at this EconTalk web page: Taleb on Black Swans.

FQ.07.44: Favorite Quote for This Week

Do not waste your time trying to fight forecasters, stock analysts, economists, and social scientists, except to play pranks on them...  If you hear a “prominent” economist using the word equilibrium or normal distribution, do not argue with him; just ignore him, or try to put a rat down his shirt.
—Nassim Nicholas Taleb, in his book The Black Swan

Where the Jobs Went, Oct '07 vs Year-ago

Yesterday I caught Lou Dobbs on CNN for the first time in months.  Every time he worked his opinion about jobs into the conversation, he had the same look of contemptuous disgust on his face as he's had for a long time now.  His unsurprising message, communicated in no uncertain terms via words and body language: Those evil old US corporations (full of "idiots") are still exporting high-paying jobs from America to the Asian communists. 

Sadly, it was the same message I'd expected to hear from him.  But I remain optimistic: I keep hoping someday Lou Dobbs will surprise me, and actually take a look at the employment numbers in a little more detail before deciding whether the companies driving our economy are still worthy of his contempt and disgust.  That's why I plan to continue sampling his show on CNN frequently—specifically, every four months or so—before switching back to a more objective (and pleasant, and educational) experience with Larry Kudlow on CNBC—which I try to catch every weekday at 7pm Eastern, 6pm Central. 

With that plan in mind, I added a "Lou Dobbs information box" on this month's employment chart.  Do you think it will do any good?  In any case, below are the latest jobs numbers from the Bureau of Labor Statistics.  The economy added 1.38 million jobs (private nonfarm).  Lou Dobbs's favorite categories to flog, manufacturing and construction, "lost" 322,200 jobs that paid an average of $18.88/hr.  Happily, the companies driving our economy added 586,500 jobs that pay more than that ($20.55/hr avg), and also added 1,114,400 other jobs averaging $15.06/hr.  If those numbers aren't good enough, it makes one wonder what the numbers would have to be to deserve a smile instead of a sneer, doesn't it?   

Here are the usual charts; click to enlarge.

GDP growth, Oct 2007

Good news.  The first estimate of third quarter economic growth came in better than expected, and that includes not just the overall economy, but also its net effect on a per person basis: real disposable income per person is up 3.1% over year ago.  (The population is growing, but real after-tax disposable income is growing faster.) 

The first chart shows two quarters worth of GDP growth (nominal and real).  The second shows the good news regarding growth in personal spending (or saving) power.

These encouraging results show that our economy has been generating a robust improvement in both overall prosperity and average personal prosperity.  What a contrast with the unanimous message of economic gloom I heard from the Democratic candidates in Tuesday's debate; makes me wonder what the numbers would have to be to evoke a more positive assessment from them.

In any case, these growth results mean that both debt clocks at right should soon start ticking backwards a little faster, barring an unexpected October blip in the debt level.  I'm still waiting for any debate moderator, for either side's debates, to ask the following question:

"Both debt clocks are currently ticking backwards, indicating that the burden of the federal debt is decreasing.  Do you consider that good news?" 

I have a feeling I'll be waiting a long, long time for someone to ask that question.

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End note:
If only we had a breakdown, by income quintile, of real disposable personal income per person, we could test the questionable assertion that the middle class isn't benefitting from any of this wealth creation we've been experiencing.  Unfortunately, the BEA numbers aren't broken out like that.