The mood in the business community could best be described as that of frontline soldiers who have lost faith in their generals but are determined to keep fighting. It's a mood increasingly shared by the not-for-profit and public sectors and the public at large. The survey out yesterday showing that over half of Gen Z think the UK should become a dictatorship highlights this growing disillusionment (although it may say more about the failure of our education system).
This month, I thought I'd have a go at those advising the Generals - the staff officers living comfortably in their chateaux far away from the action. I.e. the economists.
It’s not just that economists don’t seem to have made any positive contribution in the past few decades; they may be the cause of our current economic troubles. Regardless of who is in Government, the influence of economists has remained a constant.
There is a long charge sheet: a failure to predict the financial crisis many others saw coming; the £1 Trillion of public debt, none of which has made its way into improving economic circumstances or improving public services, handed out in schemes designed by economists and money that has all but disappeared from the public pocket; the failure to fully understand the relationship between inflation, public and private debt, interest rates and economic growth over the past 15 years; and austerity policies to name a few of the big ones.
The problem lies in the way economics is currently taught.
Economics is taught as a mathematical science. A lot of algebra is used to try and explain the relationship between “measurable” aspects of economic activity. However, economic activity is very difficult to measure. Inflation, GDP, and productivity are all ‘made up’ numbers.
Economists focus on trying to measure things that can’t be measured and then apply them in abstract form to algebraic equations, which they interpret as cause and effect, and finally, they apply those relationships to economic policy. The big problem is that correlation is not causation, and the way economics is taught has created a confirmation bias which ignores other realities.
These economic models ultimately failed to understand and interpret the impact of globalisation on inflation between 2000 and 2020. In their models, the headline low inflation should have meant that low interest rates would drive significant economic growth. It didn’t. As defined by the model, inflation was artificially low due to the one-off step change in labour costs driven by the massive shift in manufacturing to China. Goods got much cheaper to buy, but domestic inflation remained. Overall inflation may have appeared low, but this was an offsetting reduction in the cost of buying manufactured goods set against an increase in the cost of domestic economic activity. Buying and owning things got cheaper, and doing things got more expensive. This is why, despite the low inflation of the 2000s, the middle classes felt poorer and poorer – they couldn’t afford to do the things they had previously enjoyed. Low interest rates then fuelled asset price inflation – ignored by the models. Current economic teaching has destroyed the middle classes and created an economic underclass dependent on the state.
So, what are economists fundamentally failing to understand?
First is the difference between wealth and prosperity. Prosperity is the thing that makes us feel good. Wealth is just a paper number. Prosperity should be defined as realised excess capital. On an individual basis, it is the difference between your wages and your necessary expenses. At a business level, it is your realised gains. Prosperity is not the paper value of your house. Increasing the UK’s prosperity means increasing the excess capital in the system and then reinvesting it productively.
The economic models say that if you have Foreign Direct Investment to balance your trade deficit, then all is good. But you are actually draining the excess capital from the domestic economy. The first thing economists should learn is the Return on Capital and develop policies to encourage return on capital-based investment; this is how businesses make decisions in the real world. If the Government wants to increase prosperity, it should focus on implementing Return on Capital models instead of monetary theory.
The second issue is that economics is a human behavioural science, not a mathematical one. What constitutes the “economy” is millions of individual human decisions made every day. What we buy, save, and do at work &c. To understand human behaviour, you only need to understand one mathematical model – the bell curve. All human characteristics and behaviours exist on a bell curve – the majority of people, based on a set of circumstances and choices, will make the same median decision, with a few extreme outliers on either side.
Consider human attitudes to risk; the majority of people will happily get on a rollercoaster but think twice about bungee jumping off a bridge, while a few will spend their weekends base jumping. We don’t make sophisticated risk calculations when making these decisions; we make them based on learning and instinct. We make ‘risk’ decisions every day when crossing a road. For example, most of us will use a pelican crossing when crossing a busy multi-lane road. Whilst when crossing an empty side street, we will just wander diagonally across. This is a basic, instinctive risk decision, and our economic decision-making behaviours are similar.
These bell curves do not remain static; there is a feedback loop. As we get older and our brains have gathered more information and experiences, our decisions may change. Likewise, external events might influence us. If there were a number of major plane crashes in a short period of time, then a lot of us would probably decide not to fly for a bit.
To understand how economic policies actually work, you need to understand their impact on behavioural and decision-making bell curves. In response to the NI and NMW increases, most business owners will behave similarly, cutting other costs and increasing prices. Economic theory completely ignores this continual feedback loop on economic decision-making.
The fact that more and more young people are not working is a massive example of this feedback loop shifting the bell curve. Young people look at the experiences of others and decide that the risk v effort v reward equation of going to work doesn’t make sense to them. Why copy the experience of your parents, who are working harder and harder just to feel poorer and poorer?
There are a number of people now railing against current economic theory and teaching; Gary Stevenson of Gary’s Economics, Prof. Steve Keen and Richard J Murphy are worth listening to.
Funnily enough, the last two of them are accountants. If we had fewer economists in Government and more accountants, I suspect the economy would be in much better shape.
