Modern Economics Is Based On Desperate Misconceptions

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I think the Wall Street Journal said it best, with the headline of its article on the latest G-20 conclave shouting, "Currency Warriors Get a Boost at G-20 Meeting." Apparently these leaders, including the head of the IMF (which is ironic because the IMF's first job at its inception was fostering stability), are dissatisfied with everything from employment to inflation to structural overhauls, whatever that might mean in terms of government spending on something. Whatever form, the idea was that there needs to be "mass" monetarism in 2015.

Context is typically left out of these kinds of stories, by that I mean the delusion that there has been a particular absence of such things so far. It's not as if central banks have been idly observing from afar, patiently awaiting democratic invitation to "save us." The idea that the world "needs" mass monetarism is akin to an admission that they really don't know what else to do at this point.

And it should well be that case, as the first eruption of crisis is now seven and a half years into the rearview of history. What changed in August 2007, born out of a massive financial imbalance, was a total paradigm shift that no one seems able to come to terms with. Instead, the "elite" economic opinion of the world is simply redoing everything wrong from the history of the latter half of the 20th century.

I suppose that is to be expected given just bland human nature. Mistakes of the past are so easily dismissed because we have a tendency to think interim advances and innovations erase those past conditions. And to throw technology into the mix is to, in theory, completely rewrite assumptions that don't really amount to much difference in the final workout.

Economic history has never been one of primary subject material to begin with, but there is a clear hole in the middle of the last century. Perhaps that is due to the "great" events that dominated before and after, as the Great Depression took on an outsized role in pretty much anything and everything to do with advancement in thought and theory. As such, the focus of all new creativity about the economy at the dawn of the 1960's was again fixated on what seemed like a "structural" problem of unemployment - a persistent theme in these parallel ages.

Two key "advances" aided a theoretical rift in orthodox treatment of the subject. The first was A.W. Phillips' detailed relationship between inflation and unemployment after statistical study of economic behavior in the UK between 1861 and 1957. Published in 1958, this inverse relativity created a number of new policy alternatives and even new strands of thought (though contained within, mostly, the traditional Keynesian framework).

Among the most blinded by the implications of the Phillips Curve were economists Paul Samuelson and Robert Solow. In 1960, the pair published a now-infamous paper (for most) which prescribed that the Phillips Curve was not just an observed phenomena, it was eminently exploitable by the "enlightened" elite policymaker class. In simple terms, they believed not just that you could "buy" some employment with higher inflation, that it was every good statesman's duty to actually and actively pursue it.

"In order to achieve the nonperfectionist's goal of high enough output to give us no more than 3 percent unemployment, the price index might have to rise by as much as 4 to 5 percent per year. That much price rise would seem to be the necessary cost of high employment and production in the years immediately ahead."

This was not idle posturing on the part of two economists entwined in exclusively academic figuring. Instead, Samuelson in particular, who well fit that age, literally embraced the task of persuading every politician and policymaker to make the effort. Indeed, as soon as 1961, Samuelson was advising Congress and the Treasury Department on the state of "structural" unemployment, and how it was within the government's power and its ultimate economic job to end it as prescribed by Phillips Curve analysis.

Senator William Proxmire (D-WI) invited Samuelson that year to testify before a hearing of the Sub-committee on Economic Statistics of the Joint Economic Committee, ostensibly to lend understanding about this new "advancement" in economic scholarship.

"In the professional literature this can be pinned down very quickly by referring to the so-called Phillips curve. The Phillips curve is a relationship of an empirical and sometimes theoretical type between the unemployment rate and the percentage increase in money wages or the percentage increase in prices, which are not the same thing. With your permission, I would like to put into the record a joint article written a couple of years ago by myself and Prof. Robert Solow in which some of the statistical data relevant to a Phillips curve for the United States is presented."

Samuelson went so far as to make sure his paper was entered into the Congressional record, to which it was enthusiastically received beyond just Senator Proxmire. It probably isn't appreciated by the aging of five decades now, but at the time this was a monumental, so it seemed, change in the course of economic conception. And coming during the early 1960's it perfectly fit the growing and dominating idea of the new "enlightenment" of what many saw as the improvement of a planned world - market messiness was coming to be assumed as somehow more inefficient. Government was growing into a role of managerial competence (so they said) and to add an economic component seemed perfectly ideal (a redundancy in terms that actually fits the attempt).

Only a few years thereafter, when the Johnson Administration was "doing its part" through the planning for the "Great" Society, Samuelson was again present in making sure that this "exploitable" Phillips Curve idea became policy reality. Back at his 1961 testimony, Samuelson argued that "general policy implications of the above analysis [Phillips Curve] are quite clear," so that the government should adopt "expansionary fiscal and monetary measures and the more direct programs for retaining manpower." He was already an economic advisor to the Kennedy administration, but wanted to be completely insistent on any government expansion under Johnson. A memo was prepared by the advisory committee, under Samuelson's guidance, that urged intervention in 1964 along these lines:

"An economy which is always near full employment faces a more persistent threat of inflation than a stagnant economy. The remarkable price stability which the U.S. has maintained over the past 6 years has in part been due to the high level of unemployment. One way of assuring a continuation of this price stability would be to tolerate continuing high unemployment. Like most Americans, we reject this "solution" to the problem of inflation. Yet the reconciliation of price stability with full employment is a thorny problem - one to which there are no tried and tested solutions."

Of course, in 1965 the Johnson Administration radically altered the pattern of past interference by increasing government spending (both the "Great" Society and Vietnam War) tied to a regressive tax cut, rather than the traditional financing of a tax increase. It was the vivid contours of Keynesian mythology combined with New Age monetarism, linked together by the Fed's non-independence independence of "even keel." Samuelson got exactly what he wanted, in a dual dose of "expansionary fiscal and monetary measures."

The inflation rate in the US, as measured by the CPI, was just 1% in 1964. The Great Inflation started, not coincidentally, in later 1965. By 1967, the world was a total monetary mess, though not all of that can be laid at Samuelson's hubristic "control" assumption of the exploitable Phillips Curve - some of it was just economic evolution. However, there can be no overstating the role this played in fomenting the Great Inflation, something that even contemporary economists were well aware in contradiction.

Most famously, Milton Friedman in 1968 and Edmund Phelps in 1967 were devastating in their takedown of the "exploitable Phillips Curve", with Phelps writing presciently, "If the statical ‘optimum' is chosen, it is reasonable to suppose that the participants in product and labour markets will learn to expect inflation...and that, as a consequence of their rational, anticipatory behaviour, the Phillips Curve will gradually shift upward..." It did so throughout the 1970's, giving rise to both the term and the phenomenon Great Inflation (which actually turned out to be Great, though for woeful reasons).

What has always struck me, personally, about the Samuelson/Solow paper in 1960 was its reference to what we would call today "tight money." Indeed, that is what the G-20 just basically proclaimed about the lack of recovery, and its rather scary dropoff of recent months, but there it was again in 1960 conditioned under much the same terminology, as if the passage of time and history had not altered any views on this very subject:

"The preponderance of the existing evidence and analysis suggests to me that something like two-thirds or more of the described increase in unemployment has been due to the inadequacy of overall dollar demand."

What makes that statement stand out is something that was talked about just over a decade later, at the August 1971 FOMC meeting. That meeting was highly contentious, of course, as it came just a little over a week after Nixon "closed the gold window" forever damning the "strong dollar" to nothing but historical longing. At that meeting, in what had to be a worried and extremely dubious atmosphere, the wreckage of international financial exchange was described succinctly as,

"The swap lines were frozen; so was the IMF; the status of the SDR's was highly questionable; and no foreign central bank would sell gold at $35 an ounce except in the most dire emergency. All that remained of international liquidity available for use at the moment was inconvertible dollars, of which there was no shortage of supply; rather, there was an acute shortage of official buyers."

The relation of that statement with Samuelson's "diagnosis" of high unemployment in 1960 could not be more "perfect." In the space of eleven years, the attempt to control for such economic variables in the new age of activism on the part of statist elements (for our own good, of course) had reversed the condition; whereas the world and US was supposedly plagued by "inadequacy of overall dollar demand" there was now "no shortage of supply." This was supposed to be Triffin's paradox, or where the US could not manage a "responsible" monetary program and still finance the world's trade needs as the sole (with sterling in persistent crisis) reserve currency.

Instead, the US did do both and blew it all apart; but rather than "cure" the condition of high unemployment that existed of the 1950's, "they" instead expanded it much, much further. Inadequacy of "dollar demand" was a figment, as business suffered nothing of anything like that - but the "enlightened statesmen" unleashed their destructive experiments anyway.

I think it is also lost to the passage of time just how desperate the early 1970's were, even before oil shortages became mainstream. There was no sure method of replacing the gold standard, which had already been seriously undermined in the 1960's by this kind of activism (including capital controls). The result was essentially the creation of another "dollar", called then the eurodollar (or Euro-dollar as it was often denoted contemporarily).

Without official buyers of dollars in August 1971, the FOMC was very concerned about what might happen (and what that might trigger of Great Depression-type fears).

"The likely consequence [no official buyers of dollars] was that if and when one of the major European countries got into trouble again, it would not waste much time in defending its currency; instead, it would allow the market to drive down the rate and so put pressure on its neighbors. That was how the competitive depreciations of the 1930's had emerged and brought about the proliferation of defensive measures in the form of trade and capital controls."

Now the entire world joins together in trying to devalue everything all at the same time, whereas "defending its currency" is totally ill-mannered. There is no use defending something that no longer functions as an arbiter of true value, instead exists solely as a means of intrusion and control. Samuelson lost the battle over the Phillips Curve but won the war of economics as a government dominion - they simply moved to other tools and theories. Ironically still, one of the most influential theories that has produced such widespread central planning (in monetary form) was the very critique used to quash Samuelson's "exploitable Phillips curve", namely rational expectations theory.

Apparently, in the circular world of economic commandeering, we are back at Square One, whereby the "updated" methodology post-Great Inflation has hit its final end. High unemployment remains despite all the past means of exploiting it (including in the US which has a very deep participation problem, as the unemployment rate is not supposed to "improve" via the denominator almost exclusively). "Somehow", however, there is no new Samuelson to offer a creative solution, even if it is ultimately wrong in the end. The status quo as it exists right now cannot even allow a minor alteration to even slightly outside the box.

A great deal of that is certainly political, as nobody wants to give up authority and it is certainly not within the nature of bureaucracies to revert. However, there is something deeper at work here that also parallels the decreasing market affection that is so obvious in modern economics.

Economics as a discipline has always had reverence for the idea of scarcity. That has been an animating factor for as long as humans have associated with one another. But that wasn't always the significant influence on economic thought as it dominates today. In fact, far more of a concern used to be given to the construction and maintenance of wealth. After all, Adam Smith's book was titled The Wealth of Nations, not The Economic Scarcity that Nations Fight Over.

The lack of appreciation of true wealth is staggering in its absence, an absence made possible by the "advances" of the 1960's. Again, there is no "strong dollar" where there is nothing to anchor that dollar, and what took its place, in eurodollars, has led to the establishment of debt as supreme. Worse than that, despite all the flaws directly traceable to the current run of monetary intervention and the lack of appreciation of wealth, there will be nothing allowed to disturb that supremacy - to the point that policymakers and officials fight over which disproved theory can be asserted next; and then next after that.

Inside the capsule of monetarism as it exists now, the idea of redistribution makes sense because scarcity is the dominant regime. Reworking orientation to wealth leads to the conclusion that redistribution is insanity with official imprimatur - you cannot create wealth by official sanction of theft, to one designated "winner" from one designated "loser." The transaction is paramount under redistribution, whereas in a real economy the transaction itself is incidental.

The attitudes about "money" in the current age largely parallel those thoughts. Samuelson's contribution was to suggest and institutionalize, perhaps not intentionally and certainly not without aid from many others, that wealth was incidental and that businesses operate solely on the basis of transactions. That was the entire idea of "aggregate demand" in that everything is interchangeable, so why not encapsulate it into actionable theory and prescription. The unfortunate part, and the lesson that won't stay "learned", is that business is susceptible to the ideas of monetarism and Phillips Curves in unpredictable ways, largely because businesses that do actually operate on true wealth are simply perplexed at all the continued instability (or hiring lobbyists to best take advantage at everyone else's cumulative expense). In the capitalist system, profits are the ultimate arbitration of activity, so disruption there is playing with fire.

In one sense, this is all just another sad case of history repeating. But the fact that the only "solutions" are the same old garbage is more than that, namely that moving outside the paradigm means its total obliteration; something only those redistribution "winners" fear. That may be happening by sheer will of imbalance anyway, contributing no small part to the current and perpetual state of dysfunction, as I have grave suspicion that the "dollar" rupture of August 2007 is permanent. By of just scarcity or transactions it means that the whole of modern economics is based on, if not a lie, then certainly heavy and desperate misconceptions. In that view, we have a very fitting monetary system in the global "dollar" - itself a misconception without beginning or end. It is the perfect embodiment of redistribution and the transactional nature of current economic features, most especially debt of an exponential pathology.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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