Do You Understand Ceteris Paribus?

Since no one seems to take Latin any more, you probably cannot translate "ceteris paribus."

Real economists frequently cite the need to explicitly state the assumption that "all other things are equal."

In the blogging world, the biggest voices on economics are not economists. This should not surprise us. The pop economists are playing to our vision of reality:

1. State what the reader already believes;
2. Provide data that appears to support the belief; and
3. Add some bogus conclusion.

It happens every day.

Background

I am going to reveal something personal and unprofessorial. I like Jack Reacher – the character, the strength, the simplicity of needs, the moral compass, and of course, the ability to "connect."

Like many others, I was interested in the upcoming movie. How could Tom Cruise portray this giant? In reading about the story I discovered something interesting about investments. Lee Child is a pseudonym and the Brit who is actually writing is a guy named "Jim Grant." No, not that one!

In a great story by Brian Curtis at Grantland the author reveals why his work is so persuasive and sells so well:

Although he'd never lived in the U.S., Grant had visited frequently, had lapped up American TV, and had even married an American woman. "It was really a question of mimicking," he says. "If you're familiar with the rhythms and the word choices of the country and you can put them down on paper, it actually becomes their nationality." British drollery metamorphosed into a kind of hypnotic, Eastwoodian growl. Killing Floor, the first Reacher book, opens like this:

I was arrested in Eno's diner. At twelve o'clock. I was eating eggs and drinking coffee. A late breakfast, not lunch. I was wet and tired after a long walk in heavy rain. All the way from the highway to the edge of town.

Grant's wife, Jane, read his drafts and clipped out Britishisms. She called herself the Committee on Un-American Activities.

The Americanness of Lee Child's novels did not come from granular detail, from a novelistic sense of place. "You know you're in Nebraska because he says, 'We're in Nebraska,'" notes Otto Penzler, the owner of New York's Mysterious Bookshop. "You don't smell the cornfields."

No, Child aims to deliver a different American vision. When Reacher goes to Nebraska, as he did in Worth Dying For, Child borrows images from movies and TV shows — it's a "Nebraska" of our collective imagination. As Child puts it, "If you stick to that mental image, everybody says, 'That's a well-researched book.' If you actually supply the reality, people say, 'The guy's never been there.'" It's as if Child is feeding back to us the images America once beamed to England.

Investment Implications

Bringing this back to the world of investments there is a clear conclusion:

The great novelist of thrillers reveals the technique of the great fiction writers of economics!

They are telling you what you think you already know – not trying to inform.

Spotting These Imposters

The biggest tipoff to the pop economist is when he/she does not say, "ceteris paribus." This means that the author is trying to change only a single variable in a multivariate world – an amateur approach.

Here are two current examples:

1. Profit margins. We have all heard ad nauseam that profit margins are mean-reverting. The blunder of this one-variable approach is a failure to consider why profit margins are so high. Corporations have squeezed employment and costs. Think lean and mean. Those taking this viewpoint have been wrong and the multivariate approach which I endorsed two years ago and again last year has been correct. Profit margins will decline if and only if there is a massive increase in revenue and gross earnings. There is still time for investors to grasp this concept, since the wrong-headed bearish viewpoint prevails.
2. Interest rates. Suppose interest rates were to move higher, forcing greater government expenditures and offering a more attractive alternative to stocks. The Fed might go broke! I need to write more on this theme, but the concept is the same. The Fed is actively trying to increase inflation expectations. They want to encourage investment. That is the plan, little understood by traders. So there is no "ceteris paribus." When interest rates rise, the move will be accompanied by a vigorous economic rebound, including business and consumer investment.

Only the pop economists isolate on one variable and project the worst case.

Comments

[steve]

So by your logic anyone who doesnt say "ceteris paribus." is therfore a pop economist???

Perhaps too many poppies for you?

[Brett @ wstreetstocks]

Great analysis! Very few people are aware of this important economic concept.

[lou]

Good food for thought today Jeff, Thanks for posting.

[Proteus]

The Fed might go broke! Ha, that's a good one. The ECB hasn't gone broke. The Swiss National Bank hasn't gone broke. Even the Japan Central Bank hasn't gone broke, at least not yet :)

On a more serious note, ARE profit margins mean reverting? I mean, is the process known to be mean reverting - stationary, unit roots and all those other dangerous economic terms, or do people just look at a few years of data and proclaim it's mean reverting? For heaven's sake, we're not really even sure GDP is mean reverting, right?

Writing to hit a specific audience (American, today) is not trivial. I've never read him, but Grant has a tough job. Ever read any good fiction from, say, the 20's to the 40's? Almost unreadable. Even Ian Fleming is difficult.