“The fox knows many things, but the hedgehog knows one big thing.”

The quote is one Nate Silver is fond of. It can be found in his 2012 book The Signal and the Noise as well as in an article at his new site FiveThirtyEight. Silver says he wants to be a fox but some are, rightly, questioning whether he needs to know his subject matter a little more in depth.

Silver made a name for himself during the last few election cycles by predicting the outcomes through the use of statistics rather than the gut feelings, and wishful thinking most media pundits use. Before that he created a system of using baseball statistics for projecting player performance. In The Signal and the Noise he branched out a bit and covered several topics like the financial meltdown, weather forecasting, global warming, and even terrorism.

The book was pretty good I thought, if looked at as a primer on how statistics are used in various fields, and how they often fail. As investigative reporting however it wasn’t quite as good. The notion that there might have been malfeasance at work in the financial meltdown got merely a short mention before moving on to discuss faulty financial models with no relevant historical data to draw on. He drew the ire of global warming researchers by too easily falling for the critiques of deniers. He was clearly out of his element in either of these fields.

At the new site it appears that he is unaware of his shortcomings. The new site intends to delve into many topics outside his expertise. The thing is though, election prediction isn’t all that difficult a task, comparatively. You have lots of polls that are conducted by mostly competent firms. You can track the history of each firm as to their reliability. Throw in a few social factors (state of the economy, etc.) and you have a pretty robust model. Not everything is so clean cut.

The word model is fairly important there. If you don’t have a model how can you know what data is relevant in the first place? Paul Krugman:

Source: Tarnished Silver

It’s not the reliance on data; numbers can be good, and can even be revelatory. But data never tell a story on their own. They need to be viewed through the lens of some kind of model, and it’s very important to do your best to get a good model. And that usually means turning to experts in whatever field you’re addressing.

Unfortunately, Silver seems to have taken the wrong lesson from his election-forecasting success. In that case, he pitted his statistical approach against campaign-narrative pundits, who turned out to know approximately nothing. What he seems to have concluded is that there are no experts anywhere, that a smart data analyst can and should ignore all that.

Similarly, climate science has been developed by many careful researchers who are every bit as good at data analysis as Silver, and know the physics too, so ignoring them and hiring a known irresponsible skeptic to cover the field is a very good way to discredit your enterprise. Economists work hard on the data; on the whole you’re going to do better by tracking their research than by trying to roll your own, and you should be very wary if your analysis runs counter to what a lot of professionals say.

The link embedded in the Krugman quote offers a good example of just blindly looking at the data. Roger Pielke Jr. is the man in question and he wrote an article questioning the notion that more extreme weather is causing more damage to society. His data was that the increase in damage costs tracks the increase in Gross Domestic Product. Therefore, there hasn’t been an increase in damage, just an increase in wealth. Sounds pretty straight forward right? Well maybe not.

It turns out over the same time some of that increase in wealth has gone into building things that can better resist disasters. Because of that should we be seeing a decrease in disaster costs relative to the increase of wealth? Probably so. Researchers in the field seem to think so. At any rate it should show you why the model you use is so important. It tells you want data you need to pay attention to. It seems to me factoring in how well your buildings can withstand storm damage is something that belongs in the model.

Krugman is not the only critic. Long time Silver fan and libertarian(ish) economic commentator Tyler Cowen, along with several others, has been critical as well. Krugman points us to an article by a staffer about corporate cash hordes.

Source: The Piles of Cash That Never Existed

One of the early narratives of the economic recovery was that companies were “hoarding” cash. The story line made sense: Companies, burned by the credit crisis and cautious amid economic and political uncertainty, were stockpiling money. The data backed up the story: The Federal Reserve in 2011 reported that American companies had more than $2 trillion stashed away in overflowing vaults (or, in most cases, bulging bank accounts). As a share of all assets, cash holdings were at their highest level in nearly half a century.

Then the Fed revised its data. New figures released in early 2012, based on more complete tax filings, showed that American companies actually had close to half a trillion dollars less cash than previously thought. Companies did hoard cash in the early months after the financial crisis, but only up to the point that they had rebuilt savings they’d had to spend during the credit crunch. After that, cash holdings as a share of assets leveled off and have remained pretty much flat since. The revision didn’t just change the numbers—it undermined the whole narrative.

As Krugman points out, it is silly to say that it destroys any narrative. Why should a revision from $2 trillion to $1.5 trillion refute that narrative? What did the corporations spend the money on? Was it on their own businesses? Did they invest in Treasury bills? The article doesn’t say.

We’re told that the “whole narrative” is gone; which narrative? Is the notion that profits are high, but investment remains low, no longer borne out by the data? (I’m pretty sure it’s still true.) What is the model that has been refuted?

It seems to me that Silver has overestimated his ability to just jump into any field and look at a few numbers and give us all the “straight scoop.” There is a reason people go to school for years and years to master fields like climate science and economics. He isn’t dealing with a bunch of hacks that are paid to say stupid and controversial things on a TV news program.

He’s in way over his head and should stick to political forecasting which he’s good at and where things aren’t looking so great for Senate Democrats in November.

Previous Parts: Part 1 and Part 1b

The take away for this last part is that if someone is against a budget deficit and against a falling dollar, then they are for a smaller economy and more unemployment.

For this last part I’m going to skip using phrases instead of equations. It would just be too long to write things out that way. The main point of these blogs is to point out the silliness of much that we hear in the media and from politicians. Somehow a worldwide financial crisis and the busting of the biggest real estate bubble in history has turned into an effort to cut the US budget.

That the proponents of these cuts are arguing that 2+2 doesn’t equal 4 doesn’t seem to bother them. Some have proposed that it is a feature not bug. The Republicans know what they are arguing will kill the economy but they see that as a way to wrest the Presidency from Obama. The other option is that they just don’t realize what they are saying is a war against basic arithmetic. I tend to throw my lot in with the first group. Clearly nothing the GOP has done, or refused to due, like allow the Senate to vote, has had anything to do with helping the country and everything to do with harming Obama.

We are all familiar with the Gross Domestic Product (GDP) measurement of the economy. It measures the value of all goods and services created in the economy during a set time period. Equivalently, it also measures the amount of income people have received in the economy. To understand why the two ways are equivalent we just need to realize that every dollar someone earns as income has to come out of the pocket of someone else as spending.

So lets look at the different components of GDP.

GDP = C + I + G + (Exp – Imp)

C is personal consumption. I is investment by firms. G is government spending. (Exp – Imp) is exports minus imports.

Just to help clear the cobwebs lets imagine for a moment that all the variables on the right side of the equation are independent. That is , if one variable changes that doesn’t imply any particular change in the other variables. The other variables stay the same. Hopefully it is clear that, in that case, when a particular variable goes down then GDP goes down. Consumption goes down, everything else stays the same, so GDP goes down. It may seem odd to argue for basic arithmetic but, as we shall see, those taking certain positions are essentially arguing against it.

On this basis it should be clear that anyone arguing one component of GDP can go down without the economy shrinking must be arguing there is some mechanism that makes another component go up. So what are the mechanisms and how do they apply to current conditions?

Consumption, Investment and the Interest Rate
Today the rate of consumption has dropped from previous levels. Mostly this is due to people realizing the the owe more than there stuff is worth. Housing prices have crashed and people now want to pay down their debt. The private savings rate has swung from -3% before the crash to +5% now.

In normal times a drop in consumption is not such a big deal. As the amount of money being saved goes up the interest rate drops and businesses borrow that saved money to invest. While that is happening now, it is not happening at a rate to make up for the lost consumption (increased saving). Back in Feb 2009 the Fed estimated that the interest rate would have to be -5% in order to induce businesses to invest enough to make up for the drop in consumption. But, banks don’t pay people to borrow money so the actual interest rate is 0% and can’t go any lower.

Crowding Out and Future Taxes
Now we have people who say they want to see G go down too. Even President Obama has said the government needs to tighten its belt too. As we’ve seen, if G is going down, then we have to have a mechanism for something else to go up or GDP itself will shrink.

Crowding out is a phrase most often thrown around by the right but all economists admit there is at least something to it. Imagine a healthy economy where the interest rate is just right to get firms to invest all the money people are saving. Now, imagine the government comes along and wants to borrow some of that money too. The increased demand for loanable funds will cause the interest rate to rise. Because of this rise, some firms will decide not to borrow in order to invest. So in this case G going up has made I go down.

There is debate about how important the crowding out effect is even during normal times. Some of the things government borrows for are not things the private world buys. Roads and education would be two good examples that are known to have very high returns in terms of growing GDP. So there is debate on how much of a government spending increase just raises GDP and how much of the additional spending are eaten up by decreased investing (crowding out).

These aren’t normal times however. We’ve already seen that investment isn’t keeping pace with decreased consumption even. It is hard to imagine that the government increasing saving even more would somehow spur more investment. Another way to say this is , if interest rates want to be at -5% now and government spending, in effect, pushes that up to “only” -2% we are still at a desired negative interest rate. The actual rate will stay at 0% and there will be no crowding out.

Since there is no crowding out presently, the reverse case where we actually decrease government spending will cause GDP to shrink. There is no pent up, crowded out investment waiting to take over from the government. In fact, right now we should expect higher government spending to have a crowding in effect. Since all of the spending will go to propping up or increasing GDP firms should be slightly more willing to invest at any given interest rate.

Future taxes is another mechanism sometimes proposed for how cutting government spending might help. The idea is that by looking at the deficit people get so afraid of future tax increases that they stop spending or even drop out of the workforce because why work if it is just all taxed away. The problem is there is very little evidence that such an effect exists. There are many reasons for it but the bottom line is that most economists consider future taxes concerns as a disproved idea. See here for more.

So, it’s 2 strikes for deficit reduction. Now on to international trade.

The Exchange Rate
So, consumption is down, investment is not up enough, and the pain caucus wants to cut the deficit. That only leaves us with the trade portion of the GDP equation. Right now our Exports – Imports is negative, we import more than we export. Still this portion of GDP is actually pretty small. I forget the actual number but international trade (exports and imports) is only about the size of 10%-15% of GDP.
So there doesn’t seem to be a lot of hope to get to where we want with using trade. Still lets look at how we might go about growing exports.

The number one thing that drives the trade balance is the value of the currency. Let’s see how it works. Let’s say our currency goes up from a given level (becomes stronger). In that case it becomes more expensive for other countries to buy the dollars that they need to have to purchase American goods. On the flip side it becomes less expensive for us to buy the foreign currency we need to buy their goods. In this case our trade deficit would become larger. I.e. Exports – Imports becomes more negative. If the opposite happens we get the opposite results. It becomes less expensive for other countries to buy the dollars they need to buy American goods so they buy more. It also becomes more expensive for us to buy the foreign currency that we need to buy foreign goods so we buy less of them. In that case the trade deficit goes down.

This is the only short term mechanism known for changing the trade portion of GDP. If you are against the dollar falling then you are against the trade portion of GDP adjusting to make up for the shortfall in consumption (if it can even change that much realistically anyway).

Strike 3 you’re out
This is strike 3 for our group against deficits and strong dollar advocates. Consumption is down due to people paying off debts. Investment is not picking up all the slack due to a unpleasant economic outlook and interest rates not being able to adjust to negative values. But the pain caucus is ideologically opposed to keeping government spending elevated and to the dollar falling (they call it debasing the currency). So they have come out against the only two possible means to make up for the Consumption+Investment shortfall. There is only one conclusion. Whether they know it or not they are arguing for the GDP to fall and therefore for more people to be out of work. This conclusion has very little to do with any particular economic theory. It is a result of basic arithmetic.

Previous Parts: Part 1
Later Parts: Part 2

In this series of posts I’m looking at the relationships between various entities in an economy. Partly I’m trying to document, for myself, the information I have gleaned from the like of Paul Krugman, Dean Baker, Mark Thoma, and Brad DeLong. All of these guys have devoted a lot of time to explaining the foundations of macroeconomics at a layman’s level, but often that information is spread out over many blogs and many months. I’m trying to pull it all together and put it in my own words.

In the first part we saw how a person who wants to save or pay down a debt may be thwarted by the fact that no other part of the economy wants to pick up the slack from the saver’s reduced consumption. The desire for investment funds is low so the saver ends up with a pay cut and less saving than they had hoped. The key take aways were that when one variable changes in the GDP equation, one or more of the others must change as well, and how they do so will be determined by what mechanisms are available and plausible. If consumption goes down then either investment will go up, through the interest rate mechanism, or GDP will go down.

Morality Play?

Some  people want the results of these adjustments to be some kind of morality play. People in debt are bad people. After all, they are probably poor and we all know being poor is a sure sign of lax morals. They may not care that the person in our example last time saw his income go down. After all, he was in debt, he had it coming. Unfortunately for the people with this POV (not me by the way) the economy cares not for such things.

I want to look at the reason why by breaking down further our equation from last time. We’ll do this by breaking down our consumers in to 2 groups. The first group is our slovenly, indebted people and the second group is our virtuous debt free folks.

We start where we left off with this,

Total Income = (Individual Income – Individual Saving) + (Investment)

and break it down into our two groups

Total Income = (Indebted Income – Indebted Saving) + (Debtfree Income – Debtfree Saving) + (Investment)

Lets use some numbers.

$20,000 = ($10,000 – $0) + ($10,000 – $0)  + $0

As we saw last time, when our indebted person tries to pay down his debt by $1000, only $500 of it got picked up as new investment and so total income went down by $500. In this case that would mean,

Total Income = $19,500 = (? – $500) + (? – $0) + $500

But who takes the income cut? There is no mechanism in the economy that makes sure the guy that is in debt will take the hit. In our example the person paying down debt decided to get the money to do so by cutting out his morning trip to Starbucks. It could be the case that our virtuous debt free guy works there. It might be the case that he is the one who takes all of the hit and it could look like this,

$19,500 = ($10,000 – $500) + ($9,500 – 0) + $500

If we could get our virtuous person to spend more by taking on some debt himself (have a negative saving rate) then we would be OK and Total Income would never have to fall in the first place:

$20,000 = ($10,000 – $1000) + ($10,000 – (-$500)) + $500

Unfortunately this mechanism is blocked for the same reason the investment mechanism was blocked. The interest rate is already at zero  and can’t move any lower. So the economy will shrink and it doesn’t care how virtuous the recipient of this pain is.

Does the Interest Rate need to be negative right now?

I thought I should back up my claim about the interest rate needing to be negative. This is from about a year and a half ago but it is a good example of what I’m talking about. I, unfortunately don’t have a more recent number but we can infer the Fed thinks the number is still negative from their actions. There is no talk of raising rates any time soon, in fact they have embarked on a new measure intended to emulate negative interest rates, quantitative easing.

April 27 2009

The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve’s last policy meeting.

The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.

A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent.

People are saving?

Remember, we are defining saving as anything not spent on consumption. So you can be in debt and be saving at the same time. All we care about for determining Total Income is how much of their personal income people are spending on purchases. Unfortunately the term “saving” gets used in a lot of different ways in the press. Sometimes an article is just referring to how much people are putting in a savings accounts so it can be confusing. I’ll use a graph from the Fed that is defining saving the way we are using it.

Graph: Personal Saving

As you can see, saving is indeed way up since the collapse.

Go Investors Go

Investment has been picking up some of the slack fortunately. Taking a look at this GDP table we can see that it increased at a pretty steep pace earlier this year, it just hasn’t been enough to take up all the extra saving.

Later Parts: Part 1b and Part 2

Cutting budget deficits is all the rage. After all, everyone “knows” that being in debt is a sure sign of someone with lax morals. At least, that is how it is sold. It is claimed that, somehow, getting the US budget deficit under control will lead to growth and prosperity, i.e. jobs. What most people care about right now is the jobs part of the equation; getting new ones, keeping old ones, and making sure their income doesn’t go down at the ones they keep. But, will cutting the budget deficit do the trick in the current environment? The answer is no, and not because of any particular economic theory. It isn’t the result of a liberal theory, or a conservative theory. It starts from basic arithmetic followed by examining the actual situation we find on the ground in the economy today.


Many people hate math but my hope is that sticking to basic arithmetic will make this all more palatable to read. I plan to start with a simple model of the economy and work my way up. The point here is to learn how to reason about relationships in the economy and in later parts to specifically talk about government deficits. I’m using phrases in the equations instead of the typical variables but this all ties back to how economists calculate things like total output of the economy (GDP). Let’s look at an economy that has producers and consumers with no government and no other countries and look at the size of the economy.

First we note that, for any given time period, it must be true that:

Total Income = Total Spending

This is not an economic theory, this is just basic double entry bookkeeping. A dollar that comes out of someone’s pocket as spending, must show up in someone else’s pocket as income or something has gone wrong with our record keeping. It should be noted that producers and consumers both show up on both sides of the equation. Producers can have income and can also spend by buying new equipment and the like from other producers.

It can be useful to break these quantities down in to different components so we can see how parts of the economy interact.

Total Income = (Individual Consumption) + (Investment)

Individual Consumption is what people buy for themselves and investment is spending by firms on equipment, buildings, etc.

Let’s assume that Investment doesn’t change but individuals would like to consume less (save more) and have income stay the same (i.e. have the economy not shrink). Can they do it? No. Obviously if Individual Consumption goes down and Investment stays the same Total Income must fall. If we want the size of the economy to stay the same we will have to get rid of our assumption that Investment doesn’t change.

If we could somehow get the Investment to rise then we would be ok. It could just happen that firms want to invest more just at the right time that people want to consume less but it is not a given. In fact, seeing less spending(demand) for their goods may have exactly the opposite result. Fortunately, in normal times, there is a mechanism to encourage this increase in Investment. It is the interest rate. You can kind of think of the interest rate as related to supply and demand of loanable funds. As people spend less and have more to lend, the price of borrowing that money goes down.

This introduces the concept of a mechanism. If one of the variables changes then there are two other variables that change with them. Consumption changes so either Investment, Total Income, or both will have to change. The mechanism without an interest rate is that firms see less orders for their goods so they cut back on production , i.e. lay off workers, and the Total Income goes down. With an interest rate, the interest rate itself is the mechanism which brings things back to equilibrium , hopefully at the same Total Income level.

There can be several reasons why consumers as a whole may decide to cut back on spending. The most obvious are to put money away for the future or to pay down debt. We can break down our equation even further to look at how this desire to save interacts with the economy. First, lets look at a very special case where individuals spend everything they personally earn as income. In other words,

if, (Individual Consumption)  = (Individual Income),

then Total Income = (Individual Income) + (Investment)

Now lets introduce the concept of saving. In that case we have,

Total Income = (Individual Income – Individual Saving) + (Investment)

It should be noted here that we are defining Saving as any income the individual isn’t using for consumption. In the real world this could mean putting money in the bank. It could also mean paying down an old debt or buying a bond. None of those are consumption and would show up in our bookkeeping as investment once a firm borrows the money back out to buy something or uses the money you gave them for the bond to buy something.

Going back to our example of a person who wants to change their spending habits we can use our equations to look at a scenario. I think at this point it is best to use some numbers in the equations instead of asking people to imagine what happens when a variable is changed. In the example we will assume that changing the interest rate is not possible. This is not so far fetched. It is in fact the situation we are in right now in the real world. The rates banks can borrow from our central bank, the Fed, are as low as they can go. The rates banks give are of course higher but this is because they must account for administrative cost and the risks they perceive in the economy. There is nothing we can do to drive these rates lower because the central bank rates are already essentially at zero. In the examples we’ll assume that some of what is saved is used for investment but not all of it.

Lets start with someone who wants to save a certain amount but that amount is flexible. He used to spend every dime they made but he has decided he really doesn’t need that coffee from Starbucks every morning. He might as well sock that money away. He starts by making and spending a fixed $10,000 every month. He decides to cut his expenditures down to a fixed $9,000 a month and save the rest.

We start here,

Total Income = (Individual Income – Individual Saving) + (Investment)

$10,000 = ($10,000 – $0) + $0

Now he tries to save,

? = ($10,000 – $1,000) + $500

= $9500

Oops. Income went down because not all of his saving got picked up as investment. This guy is flexible though. He just wants to spend $9,000 a month and save the rest. He can just save less to bring things back in to balance at the new , smaller , total income (GDP) of the economy.

$9500 = ($9,500 – $500) + $500

He tried to save $1000 but instead he saved $500 and got a pay cut. The mechanism in the case is that , seeing lower demand for goods his employer cuts back on production, i.e. cuts our saver’s hours.

I’m going to stop at this point. The key idea to take away from this is that this result is not from any particular economic theory. It is a result required by basic bookkeeping . In order for one person to save more another person must spend more. Otherwise the person that wanted to save won’t be able to save as much as they planned.  The key fact to take away is that right now we are in a situation where the interest rate can’t adjust anymore. There needs to be a negative interest rate for things to balance out but you can’t have a negative interest rate. This discrepancy between rates is important for understanding why things that might normally have bad consequences don’t right now. It is important to understand these bookkeeping relationships and demand from anyone that claims doing X will produce Y what mechanism they propose will be at work to make it happen.

I hope to be able to tackle the next part that includes the government this weekend. We’ll see. I don’t blog much and this is hard work when you have a 2 year old running around. In any case, consider what the government’s role might be with respect to the missing $500 above. Also, consider what might be the case if government spending was a part of total income and was cut at the same time as people saved more. Finally, consider what might happen if the person saving is actually paying down a debt and can’t reduce the amount they are trying to save. Our simple model implies this could lead to a downward spiral. Only half of the $1000 ever gets invested and so total income must keep falling to try to get back in equilibrium.