Why economists often get it wrong

When theories they follow no longer work in practice

The recent article by Moneyweb columnist, Magnus Heystek, challenging the reliability of predictions by rank and file economists, draws attention to the tenuous basis on which many forecasts rely. It was something of an offhand comment on social media by one of the more outspoken and challenging members of the profession, Mike Schussler, that points to a much deeper malaise – the divergence between conventional theory and practical experience. This indicates that it is not so much that economists are often getting it wrong, but that the assumptions they make are based on economic laws that may no longer hold true.

At the root of the problem is the massive accumulation of investment funds coupled with a growing capacity to generate these funds incestuously. It does so through large scale leveraging and speculation with a never-ending supply of money through debt. In the process it has rewritten a very old classic economic law that enterprise, or the production of goods and services, leads and capital follows. In essence that law means that enterprise creates value which in turn collateralises debt and ultimately redeems it. This holds true even for Governments who have to rely on tax income from enterprise to fund and redeem their debt.

Latest figures show that global debt stands at some $200 trillion. That is nearly 3 times gross world product (or the sum of national GDP’s), and $56 trillion more than it was before the financial crisis in 2007. In theory, debt should expand money supply, leading to increased consumption and demand, which boosts production and in turn increases incomes of workers and returns for investors. Hi-ho, hi-ho, it’s off to market they all go to spend for even more prosperity. That’s classic “trickle down” stuff that has been the basis of convincing arguments for capitalism. Indeed those that scoff at concerns about current levels of global debt rely largely on an assumption that in time that dynamic will kick in and we will see a return to the old and real world of value creation responding to consumer demand to gradually redeem that debt.

They point to the level of massive debt after the war, and how the world was able to restore equilibrium in subsequent years. Of course, what is ignored in that assumption is that reconstruction after wars not only needs massive debt expansion but also leads to considerably enhanced productive economic activity through repairs, renewal and replacement of destroyed property and factories. Combined with giant leaps in technology, it is virtually guaranteed to introduce an era of abundance.

But this time it is very different. Debt and low interest rates have not fuelled consumer demand which in turn would encourage production and higher economic growth. For that reason it has also not encouraged investment in productive capacity, with corporate reserves globally at high levels. In South Africa alone latest estimates put company savings at a staggering R600 billion. This is a fundamental break from conventional economic modelling, something which policy makers refuse to acknowledge with successive bouts of quantitative easing first in Japan decades ago, then the United States and now Europe. Today, there is an inconsistent combination of a system flooded with low cost money, low interest rates, low inflation, and low growth, causing untenable imbalances with which most readers will be familiar.

It is common knowledge that an inordinate amount of money has been flowing into speculative instruments, including high-end property, stocks, bonds and derivatives. Latest estimates put the last mentioned alone at some 20 times greater than Gross World product. The feverish speculation in shares is reflected in the U.S. where trading of securities in a year is nearly 130 times the value of underlying IPO’s and secondary offerings -- $32trn to $250bn.

This has fundamentally changed the relationship between finance and real value creation. In an earlier Moneyweb article I questioned whether financial services had not become a parasitic monster. It is no longer “fringe” or outrageous to question not only whether the sector adds value, but whether it may indeed be destroying it. The champions of speculation, derivatives, and trading in financial instruments have always argued that these activities “smooth” market adjustments.

This holds true only as long as the conventional model of enterprise leading and finance following is observed. When the roles are switched and the tail wags the dog you no longer have a smoothening effect, but the opposite. This is especially true when that tail is manipulated by anticipation, expectation, rumour and greed of a bunch of skittish, sometimes even cavalier actors. According to speculative theory one should never have enduring states of overbought or oversold, based on the underlying fundamentals.

It is not that those fundamentals are completely ignored. It is just that they are seldom properly assessed, given sufficient weight and can sometimes even be swayed and influenced by the speculation itself to become self-fulfilling prophecies. In these circumstances one cannot entirely blame economists for preferring a consensus view. Of course we should admire those that don’t; those that stick their necks out. There are few enough of them and it is indeed a great pity to see their heads blown off for breaking ranks and trying to emerge from the trenches of consensus or expedience.

But even when they do, one can only wonder how they cope with so many irrational variables. It’s a bit like trying to make sense of a conversation in a lunatic asylum.