By Dr Frank Shostak
In order to make the data “talk,” economists utilize a range of statistical methods that vary from highly complex models to a simple display of historical data. It is generally held that by means of correlations, one could organize the historical data into a useful body of information, which in turn could serve as the basis for the assessment of the state of the economy.
Things are however, not as straightforward as they seem to be. For instance, it was observed that declines in the unemployment rate are associated with a general rise in the prices of goods and services. Should we then conclude that declines in unemployment are a major trigger of price inflation?
To confuse the issue further, it was also observed that price inflation is well correlated with changes in money supply. Also, it was observed that changes in wages display a very high correlation with price inflation. So, what are we to make out of all this? On this Friedman wrote,
The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
By popular thinking, so long as the theory/model “works,” it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the theory/model breaks down, we look for a new theory/model. The tentative nature of theories implies that our knowledge of the real world is elusive. Since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a model are. In fact, anything goes, as long as the model can yield accurate predictions.
For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Once this view is validated by means of statistical methods, it is employed as a tool in the assessments of the future direction of consumer spending. If the model fails to produce accurate forecasts, it is either replaced, or modified by adding some other explanatory variables.
The predictive capability as a criterion for accepting a model is questionable
The popular view that sets predictive capability as the criterion for accepting a model is questionable. For instance, a theory that is employed to build a rocket stipulates certain conditions that must prevail for its successful launch. One of the conditions is good weather. Would we then judge the quality of a rocket propulsion theory on the basis of whether it can accurately predict the date of the launch of the rocket? The prediction that the launch will take place on a particular date in the future will only be realized if all the stipulated conditions hold. For instance, on the planned day of the launch it may be raining. The quality of the theory, however, is not tainted by an inability to make an accurate prediction of the date of the launch.
The same logic also applies in economics. Thus, we can say confidently that, all other things being equal, an increase in the demand for bread will raise its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future?
This cannot be established by the theory of supply and demand. Should we then dismiss this theory because it cannot predict the future price of bread?
The pool of savings is the heart of economic growth
Now, economics is not about GDP, or CPI, or other economic indicators as such, but about individuals’ purposeful activities that seek to promote their lives and well-being. Individuals operate within a framework of means and ends; they are using various means to secure ends.
Purposeful action implies that individuals assess or evaluate various means at their disposal against ends. The ultimate goal of most individuals is to maintain their life and wellbeing. Now, to maintain life and wellbeing, an individual must have at his disposal an adequate amount of consumer goods. These goods, however, are not readily available – they have to be extracted from the nature. Without tools at his disposal, the individual can only secure from the nature very few goods for his survival.
The state of the pool of consumer goods determines the quality and the quantity of various tools that can be made. What determines this pool is the production of consumer goods less its consumption by the producers of consumer goods i.e. savings. The pool of savings sustains individuals that are employed in the various stages of production. The size of the pool of savings sets the limit on the projects that can be implemented.
Note again, that the enhancement of the infrastructure is what sets in motion economic growth. The enhancement of the infrastructure in turn can take place only as a result of the increase in the pool of savings. Hence, anything that weakens this pool undermines the prospects for the economic growth.
Monetary expansion and the pool of savings
When money is generated out of “thin air” it leads to a weakening of the pool of savings. The newly generated money sprang into existence out of “thin air” so to speak. The holder of the newly generated money can use it to withdraw consumer goods from the pool of savings with no prior contribution to the pool. Hence, this puts pressure on the pool.
One could infer from this that when money is generated out of “thin air” it diverts savings away from wealth producers who have contributed to the pool of savings towards the holders of the newly generated money. Consequently, all other things being equal, wealth producers are likely to discover that the purchasing power of their money has fallen since there are now less goods left in the pool.
As the pace of money generation out of “thin air” intensifies, this puts more pressure on the pool of savings. This in turn makes it much harder to implement various projects as far as the maintenance and the improvement of the infrastructure is concerned. Consequently, the flow of production of various consumer goods weakens, which in turn makes it much harder to make provisions for savings. All this in turn further weakens the infrastructure and further undermines the flow of consumer goods production.
The expansionary monetary and fiscal policies, which aim at growing the economy, are in fact achieving the exact opposite – these policies are depleting the pool of savings. As long as the growth rate of the pool of savings stays positive, this can continue to sustain productive and non-productive activities. This also generates the illusion that expansionary fiscal and monetary policies grow the economy.
Trouble however erupts, when, on account of expansionary monetary and fiscal policies, a structure of production emerges that tie up much more consumer goods than the amount it releases. (The consumption of final consumer goods exceeds the production of these goods).
This excessive consumption relative to the production of consumer goods leads to a decline in the pool of savings. This in turn weakens the support for individuals that are employed in the various stages of production resulting in the economic recession.
Once the economy falls into a recession because of a decline in the pool of savings, any government or central bank attempts to revive the economy is going to fail. Not only will these attempts fail to revive the economy, they are going to deplete the pool of savings further, thereby prolonging the economic slump. The shrinking pool of savings exposes the erroneous nature of the commonly accepted view that an expansionary monetary and fiscal policies can grow an economy.
The only reason why it appears that these policies “work” is because the pool of savings is still expanding. By assessing the intensity of the fiscal and monetary policies, which are the key factors that undermine the pool of savings, one could ascertain qualitatively the conditions of the pool. Hence, rather than focusing on many economic indicators it is much better to try ascertaining the state of the pool of savings. This in turn is going to assist in the assessment of the state of the economy.
Conclusion
Contrary to popular thinking an increase in an economic indicator such as GDP does not imply improved economic health. Without the increase in the pool of savings no lasting economic growth can take place. Economists and various other financial experts who derive their knowledge of the state of the economy solely from statistical correlations of the various historical pieces of data run the risk of misleading themselves and their audiences.
