Tuesday, November 7, 2017

The world is not digital

In a digital world, economic growth would look something like this:

But our world is not digital. Economic growth looks like this:

In our world it is difficult to tell what will happen next. In a digital world, it is true, the bottom could drop out at any time. But until it did, at least you would know whether your economy was "good" or not. Those would be the only choices in a digital world: It's good, or it's not good.

A digital world might offer a high level of confidence about the future. Our world offers only a low level of confidence about the future. Nevertheless, I confidently predict a good decade for the US economy. Where does my confidence come from, and why isn't everyone making similar predictions?

There are a couple different ways of looking at the economy. One way is to grab the most current data announcements you can find, because the most current announcements are nearest to what we want to know about: the future.

It's not a perfect method, because it doesn't really give you the future. But it does give you the closest thing.

The trouble with this method is that the world is not digital. The most current data announcements are up today and down tomorrow. Current data is all over the place. So you have to filter the facts, or prioritize the information, or assign weights to the data to determine what you think the future will look like.

The other way to look at the economy is to focus on everything but the most current data. Don't worry about the last ten minutes or (in this case) the last ten years. Focus instead on a lifetime of years before that. Look for patterns in that data. Give some weight to existing knowledge, and give almost as much weight to "heterodox" views, but always put the most emphasis on what you can see for yourself.

In Current GDP Growth Isn't Anything Special, Justin Fox is trying to see the future. He relies on the most current data announcements:

Real gross domestic product has now grown at an estimated annual rate of 3 percent or more in the U.S. for two quarters in a row (3 percent in the third quarter, 3.1 percent in the second).

"... but two quarters don't tell us much," he says. Fox reminds us that quarterly data is volatile and noisy. He considers looking at the 12-month change rather than one or two 3-month changes. That smooths things out a bit. And the longer wait provides more solid evidence. But when things finally do start getting better, you have to wait a year to get your evidence! And as Justin Fox says, "looking back four quarters is, well, backward-looking." It tells you about the past, not the future.

Fox has another thought: Look at different data, something less volatile than GDP. He references a 2015 study that uses "real final sales to private domestic purchasers". He looks at the most recent data for this series, and he writes:

By that metric, economic growth in the third quarter was just OK, at 2.2 percent... But there's really no sign from the GDP data yet that the slow-growth era is ending.

There might be a sign that the slow-growth era is ending. Those two most recent quarters of GDP growth might be a sign. We won't know for sure until the evidence is solid. But by the time the evidence is solid the improvement won't be news anymore. People want to know now. And if you have reasons for thinking that the economy is improving now, you want to talk about it now, not a year from now.

This goes back to the question that got me writing today: How can we know before it happens that the economy is improving?

Not by tracking the most recent data. You know it by studying the past until you think you understand how the economy behaves. After that, you start watching the recent data, looking for patterns that mimic patterns you've seen in the past. When you find those patterns, you make your prediction about the economy. Then you wait and see.

Recently I've been pointing out the most recent data myself: better productivity here, improved growth here and here. Upbeat data like that is not evidence; not yet. It will be, when there is enough of it. I point out such data to remind you of my prediction that our economy will soon be "good" for about a decade. Because in the context of my prediction, that data is evidence.

Hey, I could be wrong about the economy improving. But here's the thing. If I'm not wrong, then maybe the patterns I've found in the old data are significant. Maybe those patterns describe an area of study that economists ought to include in their work: Accumulated debt relative to the quantity of circulating money. Private debt relative to public debt. Debt service relative to income. Things like that. Today, economists nibble around the edges of such concepts, or miss them entirely.

That's why I so often bring up my prediction of a decade of vigor.

How do you predict the future? You want to look at what is sometimes called "fundamentals". Nobody ever defines fundamentals, of course. They only say the fundamentals are sound when they're telling us not to worry about some worrisome thing. But I'll tell you what "fundamentals" is, what my idea of it is: it is the cost of finance in comparison to the cost of labor and profit. And I'll tell you how it works: If the cost of finance is low, the economy can grow, and if the cost of finance is rising, the economy is growing. But if the cost of finance is high, there can be no vigor.

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