Monthly Archives: October 2011

Looking for the Newton of Economics

Economics is currently in it’s pre newton era.  There is no second law of motion yet in economics.  The closest thing we have is an understanding of supply demand curves, that set the price.  But even within that, we have to contend with the sound bytes that “any correlation between price and marginal cost is coincidental”, and demonstrations of pricing anomaly related problems (see this, for an example in the market for diamonds).  At just a slightly higher level, we have the problem of applying the same demand and supply dynamics to a set of metrics published by a company, and thereby predicting its value (the consruct widely know as the stock market).  At a governmental level, maturity of economics comes under scanner at a much more rapid pace.  People still can’t agree on if the raising of taxes will actually increase the government’s revenue or not.  What is the right taxation rate?

Sure my taxes are down, but..My experiences of effects of taxation are rather personal, but credible.  The hours at the Fairfax County Regional Library in Centreville have been steadily reduced.  That too, in this era where learning, education and training are broadly accepted to be the pillars on which our economic recovery hinges.  So, is this desirable that we save a few dollars in taxes, but the community library is only open for 4 hours on certain days, and doesn’t open till 1 PM on other days?  Fiscal conservatives can argue against it in two different ways.  Firstly, in a colorful way, by underscoring the fact that I used the word “community”, they can claim that clearly, I must be a communist :-).  This neo-McCarthyism may be weak humor, but humor can be a powerful device.  Secondly, the fiscal conservatives can argue that they have no problem with having the library open for 10 hours, but that can “easily” be done, without the need to raise taxes, and anyway, what guarantee do we have that these liberals will expand the library hours even if they manage to raise the taxes.  This second kind of “everything is too complex” argument is more difficult to counter since it uses the fear factor.  That is my first argument that economics is in it’s infancy – everything in Economics is too complicated and subjective.  The argument presented is as much governance as it is about economics, but within governance it is squarely about budgets and funds.

This idea that the economics is in it’s infancy is far reaching, provocative, attention grabbing, and confrontational.  This is especially so, considering that we have had many PhDs in economics who have graduated in the past x years, and that we have had roughly the same number of nobel prize winners in economics as in physics.  Why should then anyone accept this diminutive and terse line as something worthy of discussion? That I leave up to you, and your judgment on the progress in the field of economics.

Classification is the root of all evil and the basis of all scienceSecond main argument that I have about economics being in it’s infancy is that it is full of subjective labels.  Communists, capitalists, and all of that.  Is US a capitalist country?  It sure is.  Is Sweden one?  Yeah, sure.  Is US “more” capitalist than Sweden?  Most people would say so.  Some would argue.  That doesn’t happen in physics.  When a controversy arises about a certain heavenly body being a certain label (say, a planet), scientists gather around a (big) round table and lay out the classification principles.  Now, you could feebly argue that if it really was that important to classify Sweden (or India for that matter) as capitalist or not, sure we could do it, but it just isn’t worth anyone’s lunch.  But nearly the same thing could have been said about Pluto being a planet or not.  Science literally means knowledge, and implies (and implores) clarity of thinking.  A related problem between these labels (communist and capitalist) is that the economic labels have become deeply intertwined with forms of government (totalitarianism and democracy).  The economists have done themselves no favor by not being able to separate the two issues.  Consequently, the labels get misused often.  Again, in a scientific subject, this does not happen – chemists maintain a distinction between metals and non-metals, borderline cases are enthusiastically classified into these groups by scientists, and the distinction does not change simply based on the whims of the metal traders.

Classification is the root of all evil and the basis of all science.

But let us not get stuck just with labeling.  Let us talk the numbers, the frameworks, the measures.  What are some of the best measures that we have to define the “capitalism” index of a nation?  Perhaps we could start by using the GDP, per capita, originating from public sector and compare it to GDP originating from the private sector.  Can we define such a thing clearly, like the gravitational mass of a heavenly body?  If we have that, then we have a basis of classifying, and building on these ideas.

Let us return to the first argument – the question of taxation.  Can we argue how much taxation is necessary?  Starting from the basics, the point of taxes is to provide some common services, such as emergency services, roads, bridges, and the like.   (Libraries can be considered as core infrastructures by some, and not by others.)  In developing economies, it is common to see roads that are filled with pot holes.  As people drive on the streets, each car bears the full brunt of each pot hole, damaging its body and making the pot hole bigger and bigger.  The average life of a car in developing economies is, on average, about 50% of the average life of car in developed economies.  Thus, one notes that, it isn’t only the price of the car itself  that can be used to compare  the purchasing power of people between developing and developed economies.  Rather the potholes also play a (significant) role in the determination of the purchasing power!  The potholes themselves can be filled quickly if enough road taxes can be collected, and of course, assuming that corruption is not dominating.  So, if one can calculate the total cost of road maintenance, one can argue that appropriate component of “road tax” can be calculated.  That, in short, is the budgeting process that countries go through each year.  No magic there, except that the level of transparency in that entire process has not yet reached a critical mass so as to be useful to lay people.  And of course, the road scenario discussed above is the simplest of scenarios – more complicated ones can be easily envisioned.

Imagine a scenario in which all infrastructure that is needed, has been built.  There are enough roadways, enough bridges, enough hospitals, enough museums, and the country has a stable population.  Contrast that situation with that of a country which lacks some of the same infrastructure, and suppose that the two countries have identical incomes. Then, do we need the same taxation rates in both countries?

A third argument about economics being in its infancy is that it is relatively unclear on how to measure the (economic) wealth of countries. Which countries are richer than others?  What does richness of a country mean?  Is GDP per capita, purchasing power parity adjusted a good number?  To answer that question, let us start by observing that a country’s riches are determined by its public assets and by the standard of living of it’s people.  The latter may be a function of the former, so there may be some hidden double counting if we were to count those two measures separately and combine them in some fashion.  The discussion of standard of living of people though is hard. How can we measure the representative standard of living – is it the average, the median, or the bottom 25%?

To answer that, we observe that some people depend more on the public infrastructure.  Every country will always have 20% of it’s people defined (circularly) as the 20% poorest people of that country.  Their standard of living may be more of interest than the 20% richest people.  If the bottom 20% can travel by transportation that is safe, convenient and functional, that is a positive statement.  If those bottom 20% can picnic in parks that are well kempt and beautiful, that is a positive statement as well.  If they can walk on sidewalks that are safe and clean and walkable, that is a positive statement as well.

I have left 3 arguments, or 3 questions to be answered. Surely, there are more, and a better synthesis of these three questions likely exists, that may point to the hypothesis that economics is still in its pre-Newton era.