The Dismal Science’s Identity Crisis?

Economics has come under attack  because of its failure to spot the significant structural imbalances that led to the financial and economic crisis: these imbalances have been building over time and, apart from a few individuals, it would appear that a great many  economists considered the financial and economic status quo as one that was stable and risk optimal.

I have tended to ascribe this failure to understand the dynamics of excess, to the general equilibrium models underpinning modern financial economics and the input of static, linear, historical relationships into the often complex forecasting models.  

While I still believe that using general equilibrium assumptions (see modern portfolio theory), past data and a heavy reliance on linear models are key candidates for the myopic condition of modern financial economics, I think there is another important perspective to this issue.

That perspective relates to identities: economists are unable to identify whether an identity poses a structural risk or not.   Moreover, they appear unable to establish the true identity of a relationship, preferring to believe that the identity flying at the masthead is the true one, irrespective of risks to that identity.      

For example, for every debt there is a corresponding asset and for every interest payment there is a receipt: in total, debt and interest payments are offsetting and the economy is in balance.   Likewise when wages and salaries as a % of GDP decline, profits as a % of GDP rise, and again, the structure remains in balance as the extra return to owners of equity offsets the lower return on labour. 

Merely assuming that either side of an identity offsets within the greater whole ignores at its peril the dynamics of a system that is out of equilibrium:

One side of the identity crisis is exemplified by the relationship between house price inflation and consumer debt in an economy: in many economies real asset prices (driven up by excess asset focussed money supply growth) rose above the level implied by future real growth in economic output; to bring back asset prices and future output growth into balance we needed either a fall in asset prices or a rise in inflation.   Well, to date, we have experienced a decline in asset prices, which combined with an inability to meet interest and capital repayments on that debt resulted in debt defaults.  The true identity was in fact lower levels of debt and lower asset prices: merely assuming that a debt and an asset and an interest payment and a receipt offset each other ignores the necessary relationship between short and long dynamics. 

Another aspect of the identity has ignored the important relationship between demand for future economic output and the distribution of income needed to support demand for future output.  As more and more income and wealth becomes concentrated in the hands of the few, the less economic demand there is to support the valuations of assets and earnings on and derived from those assets: consumption to wealth ratios are far higher for the less well off than for the extremely wealthy. 

Future growth in output from current economic structural imbalances will be far less than those derived from historical relationships.  Merely assuming that current identities are the correct ones, ignores the true potential values of those identities.

A third aspect relates to the imbalance between consumption and saving in one economy and production and investment in another, especially where the imbalances is aggravated by weaknesses in the prior two identities.  

In fact, many decisions that are being made with respect to the sustainability of government debt and the ability to reduce government debt (austerity) are likely being based on incorrect economic identities. 

Current values do not represent the true discounted present values or risks to values based on current structural relationships or imbalances.   Econometric models assume current nominal identities are correct, hence economics facing a crisis of identity! 

Leave a Reply