Economic LIteracy: Do You Meet the Test?

As we all plan our investments for 2009, no factor is more important than the economy.  It is a subject on which everyone has an opinion.  That is the natural state in the American democracy, dating back to the observations of Alexis de Tocqueville.  His famous work, Democracy in America, is still read by every student of political science.

While a complicated work should not be summarized in a sentence, the Wikipedia article includes a good warning:

Democracy in America predicted the violence of party spirit and the judgment of the wise subordinated to the prejudices of the ignorant.

The 21st Century

Democratic opinion has advanced into the 21st century.  Modern scholars are impressed with how well de Tocqueville's work has held up, but there are some changes.  With the help of the Internet, everyone is able to offer an opinion about anything and everything.  Millions of readers are consumers of these opinions.

Readers motives vary.  Many simply want to confirm existing beliefs.  That is easy.  Those seeking information and analysis face a challenge:  How does one identify an expert?

In particular, how can an investor form intelligent opinions about the economy.  At a minimum, one needs basic economic literacy.

A Few Elements of Economic Literacy

Bob McTeer's blog, once again, provides some valuable information for us all.  In his article, Economic Literacy:  A Few Basics, he cites ten principles that anyone should know before drawing conclusions.  They are all great points, but let us pick a favorite, as follows:

Decisions are made at the margin-a little more of this means a little less of that. You maximize profit when the marginal revenue from the last unit produced just matches the marginal cost of producing it. Fixed costs don't count. Once you've bought the tickets, their cost is irrelevant the next day when you're deciding whether to go to the game.

Anyone who thinks an economic question is some black and white causal relationship does not understand this fundamental point.  Pundits who do not understand marginal analysis say things like the following:

• There is no "pent-up" demand for housing.  This is wrong because housing demand is a continuous function, more demanded at any lower price, more offered at a higher price.  The question of whether demand (or supply) curves will shift is a microeconomic problem that might be affected by public policy decisions.
• Stimulus packages do not work.  This is wrong because any stimulus creates new demand at the margin.  Professionals can debate the magnitude, but the broad-brush, X or Y conclusions are inaccurate.
• Retail is dead.  This is over-stated because the level of sales is a continuous function.  Reductions are in percentages.
• And many more similar examples of business and consumer spending and employment, all continuous functions.

Here is another good principle from McTeer:

The fallacy of job counting. We will always have more work to do than workers to do it. Therefore, let's not count jobs; let's make jobs count. Workers are scarce and will go where their return is highest. Politicians focus on creating jobs for their own sake. If they focus on real needs, the workers will come. The false idea that there is too little work to employ all willing workers leads to things like France's 35-hour work week.

Many pundits focus on this count of jobs.  In fact, jobs are created all of the time.  Even in bad times the US economy creates over 2 million new jobs each month.  In bad times of course, even more jobs are lost.  It is not a question of whether jobs are created, but rather how many, and how quickly.  The net job change is the result.

These are just examples.  Readers can test themselves -- and they should - by checking out the entire article.

Conclusion

There are two important conclusions for investors.

1. It is important to realize what you know, and more important to realize what you do not know.  Many investors are making decisions -- right now-- based upon their personal conclusions about the economy.  They fail to realize that they are consumers of the economic conclusions of others.  They are just reading the newspaper or a pundit.
2. It is important to choose sources who understand these principles, not just "pop econ" journalists who throw around some economic terminology.

Our Take

Many of the popular pundits and journalists would come to a standstill if asked to do the following practical open-end essay test:

Take a legal pad and start writing what you really know about economics.

It would be interesting to see how many would stall out at page one.  The pop econ approach does not extend very far, but it resonates with readers whose knowledge is at exactly the same level.

The current Internet democracy, an echo of de Tocqueville, does not serve the investor.  Pundits have media appearances that consist of barely-challenged sound bites.  Journalists assume the role of the expert rather than that of wise communicator.  Readers must figure it out for themselves.  To do so, one must have economic literacy.

A wise investor knows his happy zone, a concept we borrowed from the Splendid Splinter.  The investor must also know when a pundit is swinging at an outside pitch.

Comments

[Miriam]

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

Miriam

http://www.craigslistdecoded.info

[oldprof]

Chris -- Thanks for the little history lesson. I am old enough to remember those days.

Jeff

[Chris Tinker]

Hi Jeff,
Happy New Year to one and all. As someone who trained as a market economist back when you had to examine all parts of the National income statement and reconcile how the individual forecasts for the private sector demand model related to the balance of payments model etc. etc. I think that the biggest challenge for casual observers of the economy is to understand the concept of an interdependent system. Too many people operate at a balance sheet level - start at the top of the page and read down to a conclusion at the end. Back in the 1950's the big thing was the Phillips model - a water model of the economy complete with pipes, sluices and valves to try and physically model thr impact of changes in the policy levers on the economy. It certainly had its problems as a forecasting device, but the principles of interdependence were central to the process - a far cry from the single variable isolation and extrapolation process that seems to dominate the pop economist approach of today.

regards

Chris

[oldprof]

Thanks Paul.

We live in the same world, with many people looking for sound advice in a time of turmoil.

Jeff

[oldprof]

Highgamma --

Good observation. I would add that there is "pent up supply" when looking at the microeconomics issue. If prices firmed up, there are those who might offer homes.

My main observation was that casual observers do not make this distinction. There is always demand at lower prices and supply above current prices.

There is also micro-behavior, as you wisely note.

Thanks for helping me to sharpen this up.

Jeff

[Paul Nunes]

Jeff; This was very insightful and a challenge for those of us in the markets everyday advising clients. Words of wisdom; Thanks!

[Highgamma]

I feel that the term "pent up demand" typically refers to the fact that the demand curve for housing has an expectations component. Given that people expect housing prices to fall, they are less willing to buy houses now. If these expectations changes (say, by having housing prices stabilize for a while), these consumer may be willing to buy at the current price, leading to a rightward shift of the demand curve.

Voila! Pent up demand.