I once worked with a woman who had a degree in economics. Her boyfriend drove her crazy by arguing that the entire field of economics could be boiled down to the notion of supply and demand. Everything else, he asserted, was an unnecessary complication of the obvious. It's funny, but how accurate was the boyfriend?

Before we go on, I should confess that I have a degree in economics. All I remember from my college classes is that the professors talked like Charlie Brown's teacher (mwa-mwa-mwa), and something was said about supply and demand. So I don't approach this topic as an expert. I'm just a curious observer.

Some years ago, I attended a wedding and ended up seated next to two young chiropractors. They described to me the many benefits of the chiropractic arts, including - they claimed with straight faces - the ability to cure both AIDS and the common cold by boosting a patient's immune response. I just listened and smiled. I was smug in my knowledge that these two gullible simpletons believed in some sort of magic, whereas my economics degree - which is more like a real science - would allow me to predict the future and become wealthy without any real effort. At that point in my life, the benefits of my economics training hadn't yet kicked in, but I figured it was only a matter of time. Science was on my side.

Since then, I've achieved some humility about the value of my economic superpowers. For example, when I first started making serious money from writing Dilbert books, I paid financial experts to manage my investments. They invested my money in Enron, WorldCom, and several other sketchy companies with high price-earnings multiples. This was right before the dotcom bust. Do you know who could have done a better job with my investments? Answer: chiropractors.

All of this makes me wonder how one would go about analyzing the field of economics to find out if it's mostly legitimate, albeit imperfect - like weather forecasting, or mostly psychological, like horoscopes. Let's dig into that question.

In recent years, the definition of economics has broadened, thanks to popular books such as Freakonomics. Now when we speak of economics we can include scientific studies and analyses on just about any interesting aspect of life, from crime rates to prostitution. I consider that a red flag for the legitimacy of economics. In my experience, whenever someone tinkers with the definition of a thing, it's because the original thing is broken and no one is willing to admit it. Back in my cubicle days, if we failed to achieve a goal, we changed the definition of success until whatever fresh hell that was happening on its own fit the new definition. When I became a cartoonist, and the public astutely noticed that my art skills rivaled those of an inebriated chimpanzee, I defined myself as more of a writer. Be wary of shifting definitions.

I'll grant you that our newly expanded definition of economics - the one that involves studying human behavior as opposed to business and money - is legitimate and useful. And I will grant you that the common sense elements of economics, such as portfolio diversification, and paying off your credit cards, are legitimate and important. What I'm skeptical about is anything that involves complicated models and predictions about the future of the economy.

In my corporate days, I wrote business cases and created financial projections. Over time, I observed how well my predictions matched reality. In my perfect models of the future, I could estimate the likely outcomes with confidence. In the messy real world, the surprises always dominated the results. We never knew for sure what our competitors were cooking up. We didn't know to what degree our vendors were lying about their products. We didn't know management would change priorities mid project. The stuff we didn't know was always more important than the stuff we knew. My predictions were only useful for short term budgeting and to give the decision-makers some buttocks-shielding.

In this presidential election season, we see more babbling about economics than usual. You'd think the experts could agree on the basic stuff, such as tax rates and stimulus packages. But politics will always dominate those discussions. And economists are rarely in universal agreement on anything complicated. So even if we imagine that somewhere in the world an economist has a model that accurately predicts the future, as long as you feed it accurate assumptions, it still does us no good because there is no hope that the assumptions will be accurate.

If I haven't convinced you that rotten assumptions ruin all predictions, allow me to take another path to the same conclusion. Let's imagine there is an economist who has, against all odds, reliable assumptions and a good economic model for predicting the future. How would the world identify this lone genius so we could take advantage of his skills?

By analogy, there are over 10,000 individual stocks you can buy in the United States. Your first instinct might be to hire an expert to do the picking for you. But what if there are more than 10,000 experts and all of them have different opinions? Given that past performance is no indication of future performance, isn't it just as hard to pick the right financial expert as it is to pick the right stocks? As long as there are thousands of economists with different opinions, and some portion of them have a good track record by chance, we have no way to know who can predict the future best.

My working hypothesis is that economics can be divided into three categories. There's the common sense stuff, such as supply and demand, and diminishing returns. Then there's the extended definition of economics that includes looking at statistics in fields unrelated to money. And there is the third category, which might be called pure economics, existing in a smeared state of being potentially legitimate, but giving us no way to know for sure.

Here's my advice: If you meet an economist, ask him to adjust your spine so you no longer get the common cold. Then ask him for some specific investment tips and do exactly what he recommends. Let me know which one works out best.
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Mar 4, 2012
I once walked into a law firm with a sign on the wall behind the receptionist that read.

What is the difference between a Lawyer, an accountant and an econimist.

Lawyers : Know they are not funny
Accountants: Don't get this.
Econimist: Think this is funny but they don't know why.

Sage advice from a wall in lawyers office.

Mar 4, 2012
Scott - I agree that economics taught in college does boil down to Charlie Brown's teacher, intoning "mwa mwa mwa supply and demand mwa." However, I have read a treatise on economics that does help not only explain the only usefulness of economics in explaining human behavior, but also exposes the many misunderstandings of free market economics that permeate western systems: Human Action by Ludwig von Mises. Heavy stuff, but I think you would find the common sense within it fits with many of your own views.
Mar 4, 2012
Economics is a subject like any other soft science.

What a student of any subject understands, after a lot of study, are the limitations of his knowledge of the subject or the limitations of the subject itself.

All subjects have their limitations. There is a lot that science cannot explain, there is a lot that modern medicine cannot cure, there is a lot that astrology cannot predict, etc but that does not mean that all the knowledge or understanding obtained so far is useless.

It is the casual observer (as distinct from a person who has studied the subject and knows its limitations) who innocently expects 100% correct results or predictions from a subject’s practitioners. Also, some professional charlatans, in spite of being aware of their limitations, encourage other people to think that the ‘professionals’ know it all in order to line their own pockets.

If you put an economist and a well-read student of arts or history together, you may find that much of modern economic theory had already been distilled into one old proverb or another. The ancients knew the rules and because they also knew the exceptions and the limitations of their knowledge, they just did not give it an undeserved status by calling it a science or have any unreasonable expectations from such knowledge by deeming it infallible.

Unfortunately nowadays many common concepts and much of common sense is now sought to be packaged into a marketable academic qualification which serves two purposes, a) provides income to the universities and teachers of this knowledge and b) enables the students to later earn a living from spouting these concepts. In an age where traditional modes of employment are fast drying up, these fancy sciences serve this one big purpose – keeping the money rolling in the economy.

To prevent such professional witch-doctors of any discipline to take advantage of you, it is wise not to get impressed by people who have obtained academic qualifications and have a tendency to mouth jargon. Incidentally, the entire subject of behavioural economics if full of jargon - giving fancy names to commonplace concepts - BEWARE

Secondly, Economics is essentially a study of the behaviour of man. Man is a thinking creature. As a man's understanding of his own behaviour increases, his will adapt his behaviour in terms of the new knowledge he has acquired - which may make the knowledge obtained so far less accurately predictive than it was yesterday.

This applies to any field of human endeavour and the stock market most of all - where everybody is trying to outsmart everybody else.

+13 Rank Up Rank Down
Mar 2, 2012

It is evident that you don't remember much from your economics classes. The definition of economics has been and still is "the study of efficient allocation of resources." Prediction is less a part of economics and more in the realm of statistics.

Economics is neither like weather forecasting nor like horoscopes. It is more like the discipline of infectious diseases in medicine. Economists try to make positive analyses of an event ex post, attempting to answer why certain outcomes occurred (much the same way that I.D. doctors attempt to diagnose the cause of the symptoms).

Financial 'experts' are precisely that - financial experts (even if the degree of their expertise can be called into question.) If you had handed your money to an economist to invest it, s/he would have told you that on the one hand she could invest it in a certain portfolio or on the other hand invest it in another portfolio. An economist would have refused to recommend one over the other, as that would have been a normative recommendation. Your money would have remained uninvested and lost its value over time.

So the bottomline is:

1. No economist is capable of predicting the future, and if ever one claimed to be capable, they would no longer be an economist. The extent of their predictions go as far as a doctor's prediction that eating unhealthy food and leading a sedentary life could cause heart problems.

2. Definition of economics has remained unchanged. Economists study the allocation of resources ex-post, and the factors affecting it (including behavior).

3. Freakonomics is not a pioneer of applying economics to all aspects of life. The concept of utility and self-interest has been around long before the author of Freakonomics was even born.

4. Economists are not financial managers. They may have a degree in economics, but they are no more economists than cartoonists with a degree in economists are.

I would politely recommend that you save yourself some effort with your hypothesis of categorizing economics into three categories. There are some excellent and far more efficient categories already available, including macroeconomics, microeconomics, and behavioral economics.
-2 Rank Up Rank Down
Mar 2, 2012
Stimulus spending.
I can't believe that a significant portion of economists still believe in "stimulus" spending. Not only does it have a lousy track record, but it doesn't even make economic sense. There are only two ways that government can acquire the money with which to "stimulate":

1. Print it - which merely increases the money supply and therefore spreads more dollars across the same assets, a.k.a. inflation. Increasing the money supply (lower rates) can be stimulative, but the spending itself is separate and unnecessary.

2. Take the dollars out of the economy via either taxes or borrowing. Here, the government is merely moving money from where it was taxed/borrowed to where it is spent. Zero stimulus - unless it has moved from a less-productive use to a more-productive one. Fat chance of that, especially given the politics involved.

So lowering interest rates (by increasing the money supply) can help boost economy. But government spending itself could do so only if it increased the efficiency of capital allocation. Governments are likely to do the opposite.
+6 Rank Up Rank Down
Mar 2, 2012
Another economic rule: incentives matter.
+1 Rank Up Rank Down
Mar 2, 2012
hmm. If economics has problems then it seems that it's necessary to reduce of assumptions, increase agreement among all economists, and work with less abstractions. Recommendations:
a) Focus on resources instead of utility. Utility is a vague concept, probably measured more effectively by psychologists.
b) Observe the transportation of resources and correlate which resources were transported for other resources.
c) If it doesn't fit the theory, then remove it and try again from a different angle. Each experiment requires a defined concept of a success and it must have a certain percentage of successes to failures.
d) Assume that whatever laws of economics exist, must exist everywhere. (This promotes agreement and hopefully simplification).
* Resource means something that someone thinks they can possess eg $$, food, property, legal rights, nonlegal rights....
+1 Rank Up Rank Down
Mar 2, 2012
Arguing that economics could be boiled down to the notion of supply and demand is like saying computer science can be boiled down to understanding if a bit inside a device is in the on or off state. There is some truth there but ignores vast amounts of complexity that sits on top of that premise.

The problem in economics is that the rules of the game are continually changing. Nobody can predict when a massive earthquake will occur that alters the world economy, when some company fails to use the best possible blowout preventer technology on an oil well in the gulf, or when a country decides to start a war with a middle east country.
Mar 2, 2012
From the excellent Two Things site (http://www.csun.edu/~dgw61315/thetwothings.html) the two things you need to know about economics are:

One: Incentives matter
Two: There’s no such thing as a free lunch

Mar 2, 2012

You write:

"So even if we imagine that somewhere in the world an economist has a model that accurately predicts the future, as long as you feed it accurate assumptions, it still does us no good because there is no hope that the assumptions will be accurate."

But you forgot:

"and doesn't tell anyone the results"!

Of course not telling anyone kind of defeats the purpose, except ...

recall that Keynes made a fortune in the markets before he promulgated his theories.

+3 Rank Up Rank Down
Mar 2, 2012
The fact that the economy cannot be predicted is precisely the reason why being a successful trader is not really about knowing what to buy and when, but about risk management. Thats what portfolio diversification is for. Its not just about investing in different stuff, but investing in stuff that don't share the same risk, avoiding single points of failure.

Understanding an economy also requires understanding the paradigm it operates under, because that affects which assumptions are likely to hold or not. So shifting paradigms is what needs to kept a close eye on. My experience is that paradigm shifts are preceded by warning signals, and that the warnings follow a simple pattern: they don't make sense under the current paradigm. If you need to struggle to make sense of it, its more likely that whatever happened didn't originate from the current paradigm.
Paradigms can also be stacked upon one another. Paradigms can also undermine the very paradigm they're built on. Identifying paradigm dynamics like that are invaluable when assessing risk.
0 Rank Up Rank Down
Mar 2, 2012
Not even "portfolio diversification" belongs to the common sense part of economics, if you ask me. My father, who is now 82, lives of the dividend of his investments since roughly 30 years. He invests only in the single stocks of two or three companies, and doesn't change much. One is a big bank, another one is an oil company (Shell). Every now and then an "advisor" comes along and tells him that he should diversify, because this is too risky. He ignores that. Now that is common sense.
Mar 1, 2012
Scott, at the end of the day, a report has to be sent. A deliverable hangs over everyone's head at any given time. Accuracy is not the priority, delivery is. Even for the expert.

Only true Engineers seem to worry about accuracy in their work. Especially in their personal time. I've seen Engineers get more depressed about a crashed database than many doctors have gotten over dead patients.

Mar 1, 2012
My God, in reading this, I first think that you're starting to grow up. And then I wake up, and say, "nah."

Why nah? Simple. You have realized the worthlessness of economic models toward predicting how the economy will react, yet you still believe in computer models of anthropogenic global warming. Go figure.

I was watching Bill Martin on KTVU tonight (Scott and I both live in the SF Bay area). He's their weather guy. He was showing a computer model of the weather for the next two days. He might have some chance of being right - he'll probably be close for the next two days. Beyond that, he'll probably have some chance of being right for the next week. But beyond that it all breaks down. So how do the AGW zealots tell us they can predict the next 100 years?

Scott correctly says that the models all revolve around the assumptions you make going in. If you assume that the Earth is going to warm by X degrees, and then ask the computers to give you an idea of what that will do, they'll come up with something. Unfortunately, that something has no connection with reality because the assumptions were wrong and the other factors that can't be controlled (or even predicted, such as sun spots) weren't factored in.

Beyond that, chaos theory tells us that a small change in the initial state of a system can have enormous effect on the end state. Duh.

Similarly, economic rules don't take into account human nature. But investment doesn't have to be a slave to emotion. Scott mentioned that his financial advisor (whom I would categorize, in my opinion, with the term "idiot") put him into speculative stocks such as Enron.

My financial advisor (whom I will call, "enlightened,") doesn't depend on one stock, or any combination of stocks. He invests in sectors, through ETF's. When Enron went belly-up, the worst effect it had on any of his advisees' portfolios was. . . (wait for it. . .) a negative .03%. So if you had had a $1,000,000 portfolio with them, the adverse affect of Enron going bust would have been $300. That's REAL diversification. Investment is not speculation. Scott's advisor was a speculator, not an investment manager. Take heed, oh you who wish to make money through investment.

But back to Scott's main point. Economics is great in theory, but as with any theory, it depends on examining each portion of that theory in a vacuum. In effect, what it says is, "If everything else is stable, then a rise in supply results in a decrease in price." OK, that's right. But guess what: nothing exists in a vacuum. So when you try to apply a theory-in-vacuum to the real world, you'll always break down.

Does this mean that theory is booshwah? No. It means that making decisions based solely on theory is idiotic. So what should be done? Try things on a small scale. See how they work. Make adjustments.

Then, look at the reality that any attempt to plan an economy centrally is worthless. The larger and more diverse the economy, the worse the central planning will be.

One needs to take into account the many variations of the real world, and realize that the more you decentralize, the better you can address the many variables that happen when you're different than the other people on your block, not to mention those in a different county, or those in a different state, or those in a different country.

Remember this: complex systems have more chance of breaking down. The more you centralize a system, or make assumptions on the macro level when there's a lot of micro going on, the more chance your assumptions will be wrong. Not just a little wrong, but wrong in a big way. Chaos theory - remember?

You've been warned. You're welcome.

Mar 1, 2012
My father has a degree in economics... After college he landed a job at the chicago board of trade, in the pit trading soft commodities, like soy beans,corn, wheat...

The people My father worked for had him attend seminars by "successful" more senior traders. My fathers assessment of these "successful" traders was that they where full of hot air.

My father understood probability and weather enough to know better.
A year latter he came to the conclusion that commodities trading was nothing but glorified gambling.

Nothing but a game of chance.

How can you predict a drought in any particular part of the world two years in advance?

About a year into it My dad didn't feel right gambling with others peoples money, life savings, business, that he quite trading completely.

He never gambled, except put a few dollars into the lottery every once in a while... 1:400,000,000 is better than 0 : infinity . chance.

He said you would be amazed by the addictive traits most of the traders expressed. Alcoholism, drug use. " This was the early 80's of coarse"

Trading was kind of like a "skinners box" at a grand scale I assume.
Mar 1, 2012
Hearing your history in more detail makes me understand your admiration of the Chinese system of engineered economics. The most interesting developments in economics in the last 20 years have been the nobel prize-winning works in behavioral economics which show how irrational people are, and how they screw up the models.

The Chinese government is trying to control human behavior and irrationality and it has a fearsome capacity to do so. So it must be fun for an econ major to watch it working so well for China. But its clearly only a matter of time before human irrationality and actual Chinese human beings will screw it up. For example, the housing bubble will collapse, the society will panic, and their economy will crash and burn because the Chinese engineer economists in Beijing have 1.3 billion variables they cannot control.
-1 Rank Up Rank Down
Mar 1, 2012
Macro-economics seems hard for a reason: it's bogus, the economics equivalent of astrology.

Economics is the science of human motivation. The guy who wants to boil it down to "supply and demand" should start by reading this: !$%*!$%*!$%*!$%*!$%*!$%*!$%*!$%*!$%*!$%*!$%*!$%*
Mar 1, 2012
This article is about physics, but the same observations may well apply to economics. It turns out that figuring out the rules for a system based on observations is computationally implausible, even if both the rules and the observations are perfect.

Mar 1, 2012
1. Stock-picking and timing the market are not economics. They are gambling.

2. Economics includes the "common sense stuff", as well as some counter-intuitive stuff, like, for example, rent control does not make affordable housing more available. It has the opposite effect.

3. As one of my economics professors is fond of repeating: macro-economics is hard!
Mar 1, 2012
Scott, you give economics too much credit!

Here's how scientific method works: 1. get an idea. 2. test that idea. 3. if the results look good, keep the idea, else throw it away.

Here's how economics works: 1. get an idea. 2. test that idea. 3. if the results look good, keep the idea, else blame the test results on some specifics of the situation and keep the idea anyway.

As an example - almost every introductory economics textbook claims that raising the minimum wage will increase unemployment, because doing so will destroy jobs which create less value than the minimum wage. It's almost *the* textbook example of how governments can mess things up, I'm sure you know it... but did you know that around 30 years worth of econometric studies have failed to conclusively prove it happens in practice? What on earth happened to the "throw it away" part?!

If you're interested the above example comes from "The Economics Anti-textbook" (Hill & Myatt) which was probably the best thing I read last year.
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