Economics for Ordinary People
Why economics is hard
Complex Systems and Magic Numbers
In How much money?, we saw how the supply of gold affected inflation, growth, spending and saving in a simple society of farmers and fishermen. Similarly, a central bank’s policy towards money supply affects these same factors in a modern economy.
How do central banks control the money supply? What policies might increase supply? And what policies might reduce it?
We won’t answer these questions in this article. Instead, we will demonstrate why answering them in particular and economics in general is hard.
The first reason: Complex Systems
In How much money?, we saw that increasing money supply increases inflation, people might spend more and save more. If they decide to save more, the effects on inflation might be reduced. Growth reduces prices (negative inflation or “deflation”). Again, that is assuming that people consume the same amount.
Reading the above paragraph, you might notice the following relationships between various factors:
- When Money Supply goes up⬆, Inflation also goes up⬆.
- Money Supply ⬆ Spending ⬆
- Money Supply ⬆ Saving ⬆
- Spending ⬆ Inflation ⬆
- Saving ⬆ Inflation ⬇
- Spending ⬆ Savings ⬇
- Growth ⬆ inflation ⬇
But we have a problem. These relationships only hold if everything else remains the same. When in pairs, we can find fairly simple relationships between economic factors, but once multiple factors start working together, it is very difficult to predict how they might affect each other.
For example, if Money Supply goes up, but (for some reason) saving also goes up relatively more, then spending, and inflation might come down. If saving goes up, but not by much, inflation might go up. That is if spending also goes up. If spending goes down….and so on.
We can go on considering more and more varied scenarios; all of which are possible in a complex system.
The second reason: Magic Numbers
In the previous article, we asked the “How much money?” question. To answer this, we need to answer several other “how much” questions; like “how much inflation?”, “how much spending?” and “how much growth?”
Let’s consider “how much inflation?”.
If inflation was too high, money would lose its value very quickly. Saving would be of no use. Everyone would want to spend as quickly as possible. This might, in turn, lead to more inflation (a vicious cycle known as “hyperinflation”).
If inflation was too low (negative say), people would prefer to save as much money as possible because it would be worth more tomorrow. Hence, they would not spend it on possibly worthwhile causes. For example, there might be insufficient investment in businesses, slowing growth.
Hence, generally, the central bank’s like to keep inflation positive but not too high. Positive, so that people have some incentive to spend money, and thus encourage growth. But also low enough not to cause hyperinflation.
But what does “low” mean? 0.1% per year? 1% per year? 10% per year?
No one really knows. Economists might have some consensus on what it should be, but too often with little sound basis. Hence, it is a “magic number”; one picked out of a hat, seemingly at random.
Another “magic number” is growth. How much economic growth should a country have? Is 1% enough? Is 10% too much? Most economists seem to believe in some number, but with little scientific justification.
In this respect, economics has been like a religion, with a creed and precepts to believe and follow without questions. Economists are the high-priests, and they expect us (the ordinary people) to follow them blindly.
Thankfully all this is changing. Both economists and ordinary people have begun to question many core beliefs of economics. However, the process is hardly complete, and it is still full of crackpot dogmas and magic numbers. Until it is, we need to be vary.
Questions for later
Complex Systems and Magic Numbers are just two reasons why Economics is hard. There are more reasons — which you could think about.
Here are a few more questions to ponder:
- We briefly discussed what happens when there is too high or too low inflation. Similarly, what happens when savings is too low? Or growth is too high?
- What are some other examples of complex systems in economics?
- “Economics is full of theories without a sound and scientific basis.” Is this statement reasonable or too harsh? Can you think of evidence to support or refute this claim?
- What are some other “magic numbers” you often read in the newspapers? Do you think there is enough justification for them?
- Aren’t the universal constants of hard sciences (e.g. the Gravitational Constant) or mathematics (e.g. PI or E) also “magic numbers”? How might these differ from the magic numbers in Economics?