A Better Approach to Economic Policy

Perhaps one of the biggest roadblocks to effective economic policy is the usual impediment of both the public and politicians to get the big picture. As per usual, the subject of economics is viewed through the same black and white lens as is everything else. Everything can only be black or it can be white, there are no grays, there are no colors. The problem is that in reality, there are grays and there are colors and it is usually in these grays and colors that the most effective solutions are found. Economics is no different. When it comes to competitive free markets, the prevailing views are that of either a complete laissez-faire approach or that of onerous and stifling government intervention and control. One ideology says that the best solution is zero involvement by government while the competing ideology is that government must bludgeon the economy into submission. Both strategies are doomed to be ineffective solutions at best and outright disaster at worst.

To understand why this is the case, we must first understand how competitive free markets work. First, the principles and properties of markets is not a philosophy any more the the theory of gravity is a philosophy. We know that dropping an object, that object will fall in accordance with the laws of physics, and where gravity is the only force, that object must necessarily fall. No amount of philosophical debate will change how the physical laws act on that object. We don't need to know the math behind the laws that govern the laws to know their qualitative effects are real. The same is true with economics. The economic laws of supply and demand are fundamental economic laws, just as gravity is a fundamental physical law. It is also a fundamental fact that if there is insufficient profit opportunity to make it worthwhile for people (suppliers) to enter a market, they will simply take their effort and investment to other markets with greater opportunity for profit. The result being that if the profit opportunity is insufficient to entice people to serve that market, then that market goes under supplied and rationing results. It doesn't take a rocket scientist to understand this fundamental concept, yet people seem eternally unable to understand why free markets with price controls (or profit restrictions, or excessive punitive taxation) are subject to rationing. The key here is that unless forced labor is employed, all markets are necessarily "free" on the supply side. Unless people are forced into working particular markets, they are FREE to enter or leave any market as they see fit. If there is insufficient profit opportunity in a market to entice people to make the free choice to serve that market, they will freely choose to serve other markets. The point here being that treating markets as free markets is not a philosophical option, but a fundamental economic principle that must be considered in any economic policy.

Mathematically, the economy is represented as what is referred to as a "system of of equations." What those equations are specifically is not germane to this discussion. In fact, the equations are so complex that the exact forms of those equations are hotly debated and this is one of the reasons why attempts to directly control markets is a lost cause. If you don't even know the exact form of the math governing the economy, how can you hope to directly control the market without wrecking havoc? Fortunately for us, to construct a healthy, vibrant economy that serves us effectively and efficiently, we need not know the exact details of all of the equations.

One of my favorite illustrative stories is this. Years ago the Lotus Formula One race team embarked on a program to develop "active suspensions" for their race cars. An "active suspension" is one where computers and hydraulic rams directly control the movement of the suspension rather than with springs and shocks. What they discovered is that this approach yielded inferior results and at greater cost and complexity than conventional suspension designs. What was realized is that the classic spring and shock suspension was far more effective and efficient than direct control. The point being that if direct control could not produce better results than natural physical elements in something as relatively simple as a race car suspension, how can we conceivably hope to produce better results with direct control in something orders of magnitude more complex like the economy? To deploy an active suspension, engineers must know the exact form of all of the equations that govern race car suspension dynamics. But fortunately for race car engineers, the existing elements that compose a conventional race car suspension naturally "solve" those systems of equations effectively and efficiently. The same is true of economics in that the fundamental nature of the existing elements of economics already naturally, effectively, and efficiently "solves" the systems of equations that govern the economy, in whatever form they take, if we would only let them.

What does it mean to "solve" these systems of equations? First let me say that we don't need to know the entirety of specific details of the equations to know what the solutions look like. In mathematical terms, it would be said that we know the basic form the equations take and as such, we can also know the basic form the solution will take. So what does that mean? Its like if we see an image of a face, we don't need to know who's face of even be able to see much detail to know that it is an image of a face. OK but what does a "solution" look like? Well this is key to being able to develop practical and effective economic solutions - not what it looks like so much as what is a "solution."

Consider a bowl that occupies some space. In this example, the bowl represents what is referred to as a "solution space". Now imagine we have a marble the is free to roll around in the bowl. This marble represents what we call the "instantaneous state solution." Don't worry we're getting close. The location (and trajectory) of the marble represents inputs to the system of equations. If the system of equations are mathematically consistent with these inputs, this location is considered a solution of the system of equations. In our example, any place that the marble is located on the surface of the bowl will satisfy the system of equations that describes the bowl. If the marble is somewhere that is not in the bowl, the equations are NOT satisfied. Mathematically this means that the equation reduces down to something that is incorrect or inconsistent, such as 2=3, which is mathematically incorrect and therefore not a solution to the system of equations. So what does this mean physically and why can't we have the marble not on the bowl? Consider an articulated doll. There is a system of equations that describes the movements of the limbs and joints. Any positioning of the limbs that doesn't break the doll is thus a solution to those equations. If you attempt to put a limb in a position that is not a solution to the equations, the limb breaks or is damaged. Conversely, a position that breaks or damages a limb is not a solution to the equations that describe the doll. And this is the point in economics, if the economy is forced into a state that is not a solution to the equations that describe the economy, then things break and bad things happen to people. In extreme cases, this is things like rationing, starvation, people losing their homes and their jobs, etc.

So what does this mean for economic policy? Well, first let me just say, this is why policies that attempt to force the economy into a state that is not in the "solution space" are a bad thing. The big problem when trying to force the economy into a particular state is how do you know when a state is in the solution space or not? The problem is, given the complexity of the system, you don't. Remember the race car suspension? The good news is that just like that, we don't need to know exactly what the solution space is, if we skillfully use the properties of the natural elements we have available to us. In the example of the race car suspension and the marble in the bowl, these are what are called "equilibrium seeking systems." In the case of the race car suspension, the suspension naturally seeks equilibrium between gravity and the action of the spring against the weight of the car. In the marble in the bowl, being at the bottom is the equilibrium state and the marble will naturally roll to the bottom. The marbel also represents what is wrong with laissez-fair government policy. If the marble rolls down one side, it then rolls past the equilibrium point and up the other side. The marble could keep doing this forever unless there is some amount of rolling resistance such that it eventually stops the marble at the bottom. Obviously, never stopping at the bottom of the bowl, economically speaking, is not a good thing. This is what we refer to as an "under-damped" system. The Tacoma Narrows Bridge is a classic example of what can happen in an under-damped system. The motion of the marble in the bowl is what we call a "trajectory." The good news is that economics is also naturally an equilibrium system. The bad news is that, just as in the case of the marble rolling in the bowl, "equilibrium seeking" does not mean that equilibrium is reached in what we might consider a controlled fashion. And that being the case, the resulting trajectory could take the economy into realms where disaster results. This is at the core of arguments against free market economics. The problem with this as an argument is that it doesn't disprove the reality of market economics. This is the same as attempting to use the fact of someone dying from falling off of a cliff to disprove gravity as a philosophy. At a fundamental level, we can't understand how it is that person died if we deny gravity on philosophical grounds. Similarly, we can't understand economic calamity and take action to rectify the situation by denying market principles on philosophical grounds. You can't just nullify laws of physics or economics because you disagree with them on philosophical grounds, no matter how earnestly you hold that philosophy.

Now we have enough to get to the meat. Consider a chalet at the base of a hill. At the top of the hill is a large boulder that is rolling down the hill toward the chalet. Now, those subscribing to an ideology of government control of the economy would attempt to stop the boulder in its tracks. Obviously the first problem is simply not just getting run over by the boulder in the process. The second problem is, even if we are successful is stopping the boulder, we can't hope to simply hold it there forever. On the other hand, those subscribing to a laissez-faire ideology, would simply do nothing and let the boulder smash the chalet since philosophically, the trajectory of the boulder must not be tampered with. Obviously, both ideologies produce unacceptable results. Now what we can and should do is to deflect the boulder from it's current trajectory. This effectively uses the existing physics already at work to effectively and safely save the chalet in a sustainable manner with little effort on our part.

The best most effective economic policy is one that leverages the principles of economics that naturally and effectively "solves" the system of equations that is the economy but yet directs the trajectory of that solution into a direction that is beneficial and not counter-productive or outright destructive. In the example of the race car suspension, this is analogous to tuning the spring rates and shock rates, and choosing the geometry of the suspension components. Rather than trying to do all the work ourselves with computers and hydraulic rams with sometimes disastrous results and at great cost and complexity, let the springs and shocks and suspension components do the work that they already do effectively and tune them to produce optimal results. The key to such an economic policy, as is suspension design, is to create what is referred to as a "critically damped" system. Just as the shocks control the speed at which the suspension reacts, we can also attempt to moderate the rate at which the economy reacts. We already do this to a degree by influencing interest rates. However, when expressions such as "irrational exuberance" start creeping into the daily lexicon, that should be a indicator that we are dealing with an "under-damped" system.

The key to economic policy is thus not to attempt to directly control the economy into a state that subverts the natural equilibrium or obstructs or prevents the natural equilibrium seeking forces or, at worst, that is not a solution to the system of equations and the concomitant resulting disaster, but rather, to leverage those natural equilibrium seeking forces in a controlled manner that safely, effectively, and efficiently arrives at a sustainable equilibrium via a trajectory that the produces the maximum benefit and minimum damages.

And now for the extra credit. However, in reality we know that the economy is not a static system. The equilibrium point is a continually moving target. It is not like it is simply a problem of finding equilibrium and we're done. A simple example is a "fad". When something becomes more or less popular, this moves the equilibrium point. This is readily apparent by the fact that when something becomes more or less popular, the demand changes accordingly. Shopping for Christmas toys is usually a pretty stark example. If the producer of a popular toy, underestimates the popularity of that toy, the supply and demand equilibrium for that toy is totally thrown out of balance. This is why it is doubly important to leverage the natural "equilibrium seeking" aspect of market dynamics to function properly. It is impossible enough to directly control an economy whose equilibrium never changes, but to make that a moving target makes it yet orders of magnitude more complex a task as the shifting market must also be factored into those direct controls.