2012-08-29

The Unfixable Economy

Here's another great quote with a vague origin:
An infant industry, if coddled, tends to remain an infant industry and never grows up or expands.
Many people have said that that "infant industries never grow up," but this may be the first instance of the phrase I've seen that is attributable to a specific person. In this case, the late John James Cowperthwaite, a British civil servant who worked in Hong Kong.

What I like about this quote is that it uses an economic metaphor many of us can easily understand: parenting.

It's Sub-Optimal; What's Not To Fix?
The majority of prescriptive economic policy consists of noble intentions held by smart people who like the way things work, but want to tweak economic conditions to perfection. Things are great, they say, but there's just one thing... Either some people aren't making as much money as they could, or the environment isn't quite as clean as it could be, or some companies could be managed a little more fairly, or other countries aren't quite playing by the best rules. Something isn't quite optimal. Something is sub-optimal.

Imperfection begs for improvement. Smart people are good at improving things. Smart people also tend to like to think about economics, even if they aren't economists (present company included). It's natural to want to fix things, if you think you have an idea how they might be fixed. We all do it, all the time.

But the problem with an economy is that it is far more complex than even the smartest people out there give it credit for being. Like a child who dismantles a radio to see how it works, smart people start tinkering with the economy and end up with a table heaping with parts that require a new set of expertise to put back together again. There's that parenting metaphor again

Disequilibrium, not Equilibrium
One of the ways I think the field of economics has failed ordinary people is in its perpetuation of the mistaken idea that the economy ever reaches an equilibrium. It does not. Let me explain...

When you buy something, the fact that you value what you're buying more than the money you give up to recieve it is implicit. If you did not value what you're buying more than the money, you wouldn't have bought it. The same is true for the seller: He/she values the money more than what he/she is selling you; if not, the sale wouldn't occur.

Because each party values what they're receiving more than (as opposed to equal to) the thing they're giving up to get it, in a certain sense everyone engaged in a transaction "is getting a deal." Both parties are made better off in any given trade. The trade is inherently "unequal" to each party because they're getting more than what they had before.

Right away, we see that the "equilibrium price" arrived at in the sale almost feels like a disequilibrium. The valuations of both parties are unequal. At any rate, the sale occurs at an agreed-upon price, which perhaps in some sense is a single equilibrium price for that lone transaction.

But no two people value the same product in exactly the same way. While you and I may pay the same price for a gallon of gasoline, we each value it a little differently. When the price of gas goes up, Peter will continue to buy the same amount of gasoline, but Paul will buy a little less, or else drive a little less. Therefore, Peter values gasoline more than Paul does, even though they both pay the same price for gasoline.

From this example, it is obvious that the macroeconomic clearing price of gasoline is not a point of macroeconomic satisfaction. In a certain sense, the economy has reached a point of efficiency, but people are still dissatisfied. When conditions change again (say, when Paul finds he needs to drive to the next town for some reason), the valuation of goods and services change, too. Paul's additional gas purchases diminish Peter's available supply (minutely), and the seller is better off having sold a little more gas.

All of these extremely small adjustments in the economy impact the decisions of real individuals in very small ways. But none of them can be predicted. More importantly, at no point in the future will conditions ever return to any notion of a "previous equilibrium." The equilibrium never really existed. It was merely an approximate range of valuations during a snapshot of conditions.

Instead, Paul was always a little dissatisfied with the price he had to pay, Peter would like to pay less, but continues to grudgingly buy gas at all recent prices, and the seller would like to sell more gas at any price, but especially a higher price.

Everyone is cheering for a new set of conditions that will make them better off. Dissatisfaction is the norm. Macroeconomic conditions are always in disequilibrium, not equilibrium.

You Can't Fix What Isn't Broken, But You Sure Can Break It
It should be obvious where I'm going with this. If reality is a world in which disequlibrium is always the case, then all policy attempts to establish an equilibrium in any sense of the word are vain.

If we're dissatisfied with the price of some good or service - or indeed, if we are dissatisfied with the total macroeconomic price level - it is only because we all wish to be wealthier and better off. Obviously, this is a fact of the human experience: we always want a little more, we always want our conditions to improve a little bit. If we didn't, we wouldn't be human. Even zen Buddhism can't eliminate our human desire for more. It is well-ingrained in our psychology.

The source of our dissatisfaction is internal. Its external incarnation is the ever-changing nature of the macroeconomy and the general disequilibrium we face out there every day.

The point is that there really isn't anything to do to the economy to make it better. We can flood the economy with additional dollars, but all that will do is create a new set of sub-optimal conditions, a new disequilibrium. We will still want. We can raise taxes and tariffs and trade quotas and force our countrymen to stop buying products from foreign producers, but all that will do is create a new set of sub-optimal conditions, a new disequilibrium.

A key innovation of the Austrian school of economics (beyond the insight that economies are always in disequilibrium, not equilibrium) is the fact that when conditions are artificially modified by planners, those changes distort the expectations of individuals. The government can save a domestic factory job by refusing to allow foreign imports into the country, or by taxing them; but the result of this is a higher consumer price: One job saved at the expense of someone who can no longer afford the product in question (to say nothing of the foreign job that may have to be eliminated). Total production decreases, and prices increase. We are made worse off, not better.

And to top it all off, disequilibrium persists, begging the very smart people I mentioned before to tinker further with the economy.

Infant industries never grow up, and neither do children who believe that tinkering with the economy will result in an improvement. The economy is a naturally dissatisfying place, precisely because human wants are unlimited.

Therefore, the economy cannot be "fixed." It isn't broken, it simply is.