Thinking Like an Economist: When Does it Pay Off?

Few people think like economists or policy analysts.  It requires a combination of facts, methodology, and discipline.  Let me start with some background and  a couple of examples.

Policy Impacts

Most people have a simple test.  They merely want to know what worked.  The prevailing standard is some gut feeling about "what is good."  A true policy comparison looks at the "counterfactual,"  what would have happened in the absence of the policy change.  (If you do not understand this vital concept, please check out an article where I provided a nice illustration.)

Let me be perfectly clear about this.  A candidate for office who tries to talk in these terms is known as a loser.  A President who talks in these terms is likely to be known as a "former President."  The average person has absolutely no interest in what might have happened had things been different.

People want results!  Our political system rewards those who deliver results.  There is no "what if?" calculus.  In the long run, this works pretty well.

Examples

I was recently asked to participate in a poll of bloggers that had a number of dubious questions.  Typical was whether the Las Vegas City Center complex would add new traffic or would cannibalize the existing base.

This was an awful question -- typical "light switch" thinking.  It is what you see on financial TV and opinion blogs.  It encourages a terrible habit for investors -- thinking that something is black or white, instead of a distribution of results.  The honest answer (a little of both) does not make for an exciting story.

The Cash for Clunkers program is a similar example.  I did not care much for the policy, which I analyzed here.  A couple of months after the  program conclusion an old Street.com colleague wrote an article on the subject.  He carefully adjusted for seasonal effects in auto sales and demonstrated that there was a "pull forward" effect.  It was a nice piece of data analysis, but he was on a mission when it came to interpreting the results.  It was pretty obvious that the data also showed an extra sales impacdt.  He completely ignored this effect, even after I privately called him on it.  He was intent on proving his point.

More time has passed, so we now have more data.  The CEA analysis (HT Brad De Long) is clear enough that we can all see the evidence, even without seasonal adjustments.

The chart does not prove that this was a good program, nor that the expenditure was justified.

It does demonstrate that there was something going on in addition to "pulling forward" some sales.  This is  a completely typical effect, which we will eventually see is true of other government programs for housing, small business, and the like.

Investment Implication

I want to apply this lesson in a way that is relevant for current investors.  There is a clear example of the difference between the thinking of economists and investors -- the concern about inflation.

The broad body of market participants -- investors, bloggers, floor traders -- has one viewpoint about inflation.  They do not agree with official definitions or measurements of inflation.  Some think there is a conspiracy.  Others believe that they see things more clearly.  Some think that "bond vigilantes" will eventually enforces their viewpoint.

On the other side we have the economic community and the Fed.  The Fed does not even follow the CPI, preferring the core PCE deflator.  The Fed is not interested in non-core fluctuations, since these are not viewed as responsive to changes in policy.  A WSJ online poll showed that 83% of responding readers felt that inflation was a concern for the markets.

This is crazy!  As an investor, why fight the Fed, their staff, and the entire economic community?

Even if you choose to diasgree, I urge a pragmatic approach.  Feel free to express your opinion in blogs, in comments, at the ballot box, or anywhere else you want -- just not in your investments.

Meanwhile, if you want to join me in making profits no matter who is in power, you should be a political and philosophical agnostic.

Focus on predicting what will happen, not what you think should happen.

Comments

[oldprof]

VennData --

Heh heh. I have recommended holding some gold for a number of years, but I have not advocated stockpiling ammunition or buying farmland!

I like your style.

Jeff

[VennData]

Tea Partier, put down that flintlock, and sell your bonds.