There Are Two Ways of Studying Economic Theory

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There are two ways of studying economic theory. One approach is mathematical, and has been much enhanced by the computing power available to the individual economist. The other is historical and relies on the accumulated understanding of economic theory and practice.

The events of 2007 and 2008 have shown the limitations of the mathematical method. The credit crunch was not foreseen by anyone that I read, but it came as a shock to the number-crunchers – it took them completely by surprise. It did not come as a shock to the economic historians, who happily settled down to discuss the resemblances between this credit crisis and earlier ones, going back to the South Sea Scheme in 1720 or the Wall Street panic of 1907. The economic historians know that similar events had happened before, and had also learned, often by painful experience, that such events are quite common.

Neither group foresaw the actual events of August 2007, but the historians were quite able to put the credit crisis in a context of other crises. Even though both groups were taken by surprise, it was the mathematicians whose previous forecasts were stood on their heads. By and large, historical economists, who follow the example of major English economists such as Maynard Keynes or W.S. Jevons, do not regard timing as any more predictable for economic shocks than for earthquakes. One can say that there is a build up of stress in the system which will eventually have to be released. One cannot say that the release of pressure will occur next Tuesday or next August or even next century. Some say the big earthquake will happen along the San Andreas Fault in California. It may come tomorrow; it may come before 2050; it may not happen for 500 years. We can usefully predict what and where, but we can very seldom predict when. This makes expectation difficult to quantify, though all markets are based on expectations.

What we do know from economic history is that there is a cycle of debt which has to be relieved. In twentieth century history the war debts of the first war played their malign part in the European depression of the 1920s and eventually in the Great Depression of the 1930s. The Austrian School of Economics, and particularly Friedrich von Hayek, developed the Debt-Deflation theory of the business cycles. Hayek indeed foresaw the risk of a deflationary crisis as early as 1927.

Keynesian economics, as expounded in his General Theory, 1936, were criticised at the time for an inadequate appreciation of the negative aspects of excessive debt. Bankers of the Gold Standard era attached great importance to the balance sheet rather than the profit and loss account. I get the impression nowadays that people read the current account much more carefully than they do the capital account – partly because they think that off balance sheet financing has reduced the transparency of the balance sheet itself.

As a result, government balance sheets, bank balance sheets, corporate balance sheets and personal balance sheets have all deteriorated. Finance ultimately depends on the security of capital, and weak balance sheets, at any level, are exposed to risk and to problems of opportunity cost.

An old-fashioned banker would now be calling for strengthening of balance sheets at every level. But the liquidation of debt takes years to accomplish and diverts fund from current consumption. The 2007 credit crunch calls for liquidation of debt, but that is bound to have a deflationary effect.

William Rees-Mogg
for The Daily Reckoning Australia

William Rees-Mogg
Leading political editor William Rees-Mogg is former editor-in-chief for The Times and a member of the House of Lords. He has been credited with accurately forecasting glasnost and the fall of the Berlin Wall – as well as the 1987 crash. His political commentary appears in The Times every Monday. His financial insights can only be found in the Fleet Street Letter, the UK's longest-running investment newsletter.
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Comments

  1. Trying to work out what’s going on? Try http://www.professorfekete.com/articles.asp. In particular his Monetary Economics 101 lectures, a lot to get through but much will be revealed.

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  2. Can I ask a very basic question?

    ive been watching some youtube vids on the fedral reserve and banking in general..

    Q: where does the all the interest go that the RBA collects?

    there is over 1 trillion circulating in the aust economy so at 7.25% that would be over 72 billion collected, or do I have this completely wrong..

    anyone?

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  3. A very useful perspective, mathematics is interesting as it is a model of a defined reality. But it is not reality itself.
    Heisenberg set it out for science when he showed you can never really know what is going on with absolute precision.
    mathmatical modelling is useful but the map is not the territory.
    Invariably the assumptions become invalid, or should never have been assumed at all such as oil is infinite, a butterfly flapping its wings has no impact on this problem, or people behave rationally. Mathematics applied to the real world is only an approximation of reality and I am amazed that anyone would think otherwise.
    I am heartened to hear that there is a mention of balance sheet, it is just the items on the balance sheet need consideration, especially enabling assets such as the environment. i have lived by the concept Its not what you earn but what you keep and we should remember this.

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  4. It seems we are blessed in Australia to have columnists like Terry McCrann and Alan Kohler who have provided a mix of history, technical analysis and balance sheet information. Thanks to their most accessible and consistent commentary prior to 30/6/07 I took avdantage of last years “one off” superannuation contribution generosity on the warnings from those two and sold much of my holdings to put into super as cash. They are still bearish based on technical analysis, history and balance sheets.

    The only people who didn’t see this coming were those “experts” focussed on a specific aspect of activity. As always, the big picture observers win long term. But they get lost amongst the clamour for sexy short term gyrations.

    Kohler and McCrann may not have anticipated initially how badly this is panning out, but they were ringing warning bells and putting their credibility on the line well in advance of the inevitable happening. Actually, they were putting every other commentator’s credibility on the line.

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  5. it came as no supprise to me, i saw it 5-7 years ago when house and land prices in sydney grew beyond inflation. i was further tipped off when i found out real estate agents from neighbouring suburbs were bidding and pushing housing prices up. and the fact that wankers were buying shit they didnt need. :) and simple statistics like in 95′ it was said every man woman and child in australia owed $2500 in credit card debt, i didnt have any and thought which guy has my estimated debt. and the fact the govt was pushing and subsidising housing loans, that sent a shiver up my spine like nothing else as everything the govt pushes fails. private healthcare? fail superannuation fail workplace agreements fail. first baby bonus fail (we’re seeing the results of single parent greed in the news). im quite happy to see these people go broke and lose their houses as its a perfect punishment for not thinking freely and like sheep pulling the whole herd down the drain.

    one of the wolves
    July 21, 2008
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  6. Read Nassim Nicholas Taleb’s The Black Swan for a more comprehensive take on this…

    Joseph Phelan
    July 21, 2008
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  7. cjb

    Take a look at http://www.rba.gov.au

    Reply
  8. But this was a no brainer. It didn’t take math to see that we were headed into economic tumult. houses are not stocks. They can’t keep increasing in value every 3 months if employment income is not. Debt can’t keep being ladled on like gravy, if there is no money to pay for it? so I believe something larger was at work.

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  9. Confucius say “he who spends more than earns go broke”

    Reply

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