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The Elements of Deflation
If we don’t have a problem with inflation in the future, we are going to have far worse problems to deal with.
By John Mauldin
As every school child knows, water is formed by the two elements of hydrogen and oxygen in a very simple formula we all know as H2O. Today we start a series that starts with the question, What are the elements that comprise deflation? Far from being simple, the “equation” for deflation is as complex as that of DNA. And sadly, while the genome project has helped us with great insights into how DNA works, economic analysis is still back in the 1950s when it comes to decoding deflation.
((About the Author: Millennium Wave Investments president John Mauldin is author and editor of the Thoughts from the Frontline e-letter which goes to over 1,000,000 readers weekly.))
Notwithstanding the paucity of understanding we can glean from the dismal science, in the article below, we will start thinking about the most fundamentally important question of the day: is inflation, or deflation, in our future?
The Failure of Economics
Among the economists and writers I regularly read, there are some who, if they agree with me, I go back and check my assumptions–I must have been wrong. Paul Krugman is one of those thinkers. I admit to his brilliance, but his left-leaning philosophy does not particularly square with mine, and I find that most of the time I disagree.
That being said, I strongly encourage you to read his recent essay in the New York Times Magazine. It is worth the high price of theTimes to read it, if you can’t get it online. It is a very hard critique and analysis of the failure of current macro and financial economic thought, which didn’t even come close to predicting the current financial malaise. Indeed, as he points out, most schools of thought said the state we are in could not happen.
Krugman writes, as I have in repeated columns, that we have taught two generations of economists and financial practitioners faulty theories. Even now, believers in the Efficient Market Hypothesis and CAPM hold to their beliefs in the face of clearly contrary evidence. It is a very thought-provoking piece and worthy of a long weekend read. He names specific names and pulls no punches. This is as close to starting a barroom brawl as you get in economic circles.
He calls for a return to and fresh analysis of Keynesianism. Sigh. I would go further. A plague on all their houses. Whether Keynes or Friedman (monetarism) or von Mises (the Austrian school of economics) or the rather new school of behavioral economics, they all have deficiencies and (sometimes gaping) holes in their logic. At the same time, they all contribute to our general understanding of the world, and there are benefits to studying them.
Let me risk an analogy. It is like reading about some religious scheme for interpreting the world and then becoming a true believer, arguing for that point of view as received wisdom – it’s your belief system. Five Nobel laureates say this and seven say that. My guru is smarter than your guru. Look at how the math proves this point. And so on…
Krugman concludes: “So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit–and this will be very hard for the people who giggled and whispered over Keynes–that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.
“Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: ‘There is always an easy solution to every human problem – neat, plausible and wrong.'”
I agree we need to examine our assumptions. I am not sure that makes me want to unreservedly embrace Keynes. Keynesians missed as badly as anyone else in this crisis. Yes, the Austrians generally called some of the problem, but their solutions call for 25% unemployment and an unworkable global economy and a serious depression. Not sure that I want to sign up for that, either. And, they totally discount the concept of the velocity of money, which we will look at next week.
We need a new and better economic understanding, not some semireligious adherence to dogma laid down by men who were in no way familiar with current world conditions. Keynes, von Mises, Fisher, Schumpeter, Minsky, Hayek, Smith, et al. were giants. They absolutely must be read and understood. But a real science builds on the work of the former generations and does not hold onto theories as if they were scripture.
As much as many economists would like to think so, economics is not a precise science. A global economy cannot yield to hard math in the way that one can model a protein, at least not with any model that has yet been offered. At best, the models let us see through a glass darkly, suggesting the potential for connections between a few variables, while assuming that all others are held constant. It is precisely the illusion that we can model the economy that got us into the current mess.
(By the way, good friend Paul McCulley has written a very interesting essay on why the Fed has to change their models on inflation targeting – the Taylor Rule is not up to the task – and whether or not to deal with bubbles before the fact, rather than mopping up after they burst. What was assumed has clearly not worked. You can read it at http://www.pimco.com.)