the economy of loaves and fishes

Kevin Phillips, as a populist, always gets under the skin of professional economists. And, of course, when a professional economist is put in a corner, he responds with professional jargon. Like Sganarelle in The Doctor in Spite of Himself, mixing up medical and rhetorical effects, economists will immediately revert to model talk when pressed, disregarding the fact that their enemy, the populist, is criticizing the very idea that those models represent economic reality. The economist will then defend himself with some reference to other sciences in which models are used, like physics. Thus, Tyler Cowen, the man who wants you to believe that there is no difference between trading between Austin and Dallas and trading between Austin and Bangalore, gave Phillips book the thumbs down in his review of it, which ends by saying: The author should spend a week locked in a room with the Solow model. Of course, as I have pointed out in my own post on trading the residual, the Solow model is very much about national economies. Since Cowen apparently believes the nation has no status as a unit of analysis in economics, it is hard to see what he thinks that model is going to do for him, since it presupposes that the nation is a unit of analysis. In any case, the model reference is almost always meant to impress the reader with the “science” of economics, and the science is supposed to be proven by the fact that the models can be built, just like in physics. Of course, there’s no reason to think that physical forces and economics forces are alike. If anything, the model should be behavioral, the reference should be to biology, and the reification of models should simply stop. The counter-revolution in economics, the overthrow of the post-World War II order (as the inevitable cracks showed up in capitalism – the declining rate of profit, as per Marx’s prediction, which was all over the seventies) was a return to the ‘foundation’ of economics as a science. Robert Lucas, when he wrote that equilibrium is the “condition of intelligibility” of economic thought, put the doctrine nicely. This is the great rule. Institutional economists, and the Keynes who has not been modified and smoothed into professional presentability, exist on the outskirts precisely because they dispute this idea.

However, this isn’t to say that Phillips doesn’t carry certain old superstitions into his attacks on the establishment, including one of the oldest, which is that the State should – for magical reasons – always try to balance its budget. This populist theme puzzles me. It turns the state into an abstraction – which is, of course, a large step in the direction of neo-classical economics. If the state could be seen as an intrusion on the efficient market sphere – instead of simply another aspect of the total economy, one having to do with the economy’s primary task of distributing wealth – then we dissipate the cloud of unknowing that settles over the economic system whenever economists pull the discussion of it into a discussion of “efficiency.”

That said, in this Harpers article, Phillips is right to point out that the picture of our economy painted by the government over time has been increasingly distorted by the desire of administrations, Democrat and Republican, to massage the numbers. And to put a gloss on the ideologies they are selling. The most startling of those distortions is the odd way in which the government treats housing.

“In 1983, under the Reagan Administration, inflation was further finagled when the Bureau of Labor Statistics decided that housing, too, was overstating the Consumer Price Index; the BLS substituted an entirely different “Owner Equivalent Rent” measurement, based on what a homeowner might get for renting his or her house. This methodology, controversial at the time but still in place today, simply sidestepped what was happening in the real world of homeowner costs. Because low inflation encourages low interest rates, which in turn make it much easier to borrow money, the BLS’s decision no doubt encouraged, during the late 1980s, the large and often speculative expansion in private debt—much of which involved real estate, and some of which went spectacularly bad between 1989 and 1992 in the savings-and-loan, real estate, and junk-bond scandals.”

Later on, Phillips writes:

“Nothing, however, can match the tortured evolution of the third key number, the somewhat misnamed Consumer Price Index. Government economists themselves admit that the revisions during the Clinton years worked to reduce the current inflation figures by more than a percentage point, but the overall distortion has been considerably more severe. Just the 1983 manipulation, which substituted “owner equivalent rent” for home-ownership costs, served to understate or reduce inflation during the recent housing boom by 3 to 4 percentage points.”

If you think about that for a minute, you will have a key to the odd behavior of the Fed – which is aligned with the odd behavior of the Bush administration. If housing prices had been fairly assessed, the Fed would have faced a big jump in inflation around 2004-2006. And it would have had to respond, at least by traditional rules, by raising interest rates to meet that inflation. Now, the Fed did raise interest rates over this period, but the addition of 3 to 4 percentage points to the inflation numbers would have caused a much bigger raise. At the same time, the Bush administration should have used the peak period to raise taxes – the state should have taken money out of an incipient inflationary spiral. What would have been the effect of that? If would, for one thing, have busted the housing bubble earlier. And for another thing, it would have strengthened the dollar. A stronger dollar, of course, would have significantly lowered the inflation in the price of a barrel of oil. Such being the case, the Fed would then have lowered the interest rate for a whole other reason over the last two years – with housing prices falling as they are. And presumably the price of oil, even with the rise due to the mad, bad aggression of the Bush people, would not have risen to over one hundred dollars a barrel. Instead, we have a typical third world misalignment between, on the one hand, deflation of the most significant asset most Americans are invested in, the house, and on the other hand, inflation of the one product that Americans depend upon most to maintain their lifestyles, oil.

Of course, the odd adjustments to the cost of living index explain other things too. If housing prices were really going down, by way of hedonic adjustments, when they seemed to be going up, then it would make sense that the number of buyers would be going up – there are more buyers for lower priced goods. Indeed, that happened. Unfortunately, it also happened that the majority of those buyers were using mortgages they couldn’t pay for. Somehow, they couldn’t hedonically adjust the mortgage terms so that they could pay it.

In a sense, what Phillips is pointing to is the separation between accounting, on the one hand, and economics assessments, on the other. Accounting, which should move policy, should simply be about the costs in the real living environment. Economists, however, are right that, from an absolute standpoint, Americans are living in a more prosperous world than, say, when they had to spend a third of their take home income on food. But they are dead wrong that anybody is living in an absolute standpoint. We all live in the relative. In accounting, if a company makes a better quality product, x, for the same cost it made the alpha line of x, and sells it for the same price, the company doesn’t thus lose money. No accountant in the world would put the company in the red for such a deal. What counts is simply the cash flow.

Now, of course, it is too late. What the Fed can or can’t do doesn’t matter so much at the moment. If the Government doesn’t understand where to cut unnecessary expenses – the Iraq war – and where to increase expenditures – unemployment benefits, health care, and a vast program for addressing the twin problems of de-industrialization and the environment - then this is going to be another period of severe recession for most Americans, followed by a silent recession for most Americans. It isn’t a good prospect.

On the other hand, if the U.S. is not going to do what it should to address the huge environmental problems its very prosperity has caused, a set of problems that the U.S., with its massive socialistic investments in higher education, is perfectly positioned to take on, maybe the cure is just a long, long slump.