Question

1. Suppose you run a regression on past data to find the magnitude of consumption responses to changes in interest rates. What is the main error that you are making if you simply use this number to determine the optimal interest rate change to respond to an economic shock?

2. Why can limiting the choices of policy makers result in better long-term outcomes?

Answer 1

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1) The main mistake is assuming: ceterus paribus.

Let me explain. In cybernetics there's the concept of a black box. Let's take the case of an aeroplane for example. You hit the button, the aeroplance takes off. From this, an amateur at observational inference would draw a causal relationship between the pressing of the button and the aeroplance taking off - it is the pushing of the button which causes the aeroplane to go into flight. This is because the inner workings of the plance are invisible to us - it is a black box.

In reality, the button does not cause: it only triggers a chain of events to start inside the aeroplance body which eventually culminates in the aeroplance taking off.

The difference is that in the absence of an intermediate chain i.e. a direct causal relation, if the antecedent condition is satisfied then the subsequent condition must be executed.

Whereas for a chain, the forward transmission of the initiating signal may break somewhere along the chain - which would prevent the final condition (aeroplane takes flight) from executing.

Other factors have a role to play at different parts of the chain - they do vary across time and circumstance, so ceterus paribus is unrealistic.

Similarly in an economic system, the change in interest rate is the initiating signal. The intermediate chain of effect is through Investment then Output then National Income then Disposable Income and then Consumption.

Think of the intermediate points on the chain as switches: the initiating signal does or does not go forward to finality depending upon which positions the switches are in. There can be a number of unpredictable influences (shocks) on these switches such that the initiating signal (change in interest rate) fails to travel all the way through to bring about the desired result.

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But another important part of this answer should be that a proper economic shock may be a Black Swan event - unprecedented in qualitative and quantitative features, so cannot be tackled on models driven by past data alone.

During an economic shock, many implicit assumptions about the nature of the social fabric aren't valid anymore. These assumptions are so implicit, many if not most wouldn't even recognize them as assumptions since they're so taken for granted.

It's only when the contrary has been observed i.e. contextual non-validity of such an assumption, does it come under attention as an assumption - as an extrinsic (subjective, imposed by observer) rather than an intrinsic feature of the system under observation.

When these assumptions don't hold, "Economics" doesn't hold. Axioms are like pillars for a theoretical model. If the pillars aren't there, the model falls.

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2) This is the idea of via negativa, popularized by statistician and thinker Nassim Nicholas Taleb - it can be translated as "by the negative" or "doing by non-doing", i.e. shifting focus from what to do to what not to do.

It finds echo at least in Bruce Lee (whose martial art Jeet Kune Do translates roughly to "The Way of No Way")

and Far Eastern philosophy in general (Tao te Ching: "A truly good man does nothing, Yet nothing is left undone. A foolish man is always doing, Yet much remains to be done.")

In the modern context, policy makers are subject to the human frailty of informational inadequacy and emotional impulsivity. This can cause them to "overreact" to natural fluctuations in economic variables, microadjusting and overoptimizing at every juncture. These microadjustments need further adjustments, and the computational complexity of the task scales too rapidly for us (humans) to keep up.

Soon a narrative of resultant (unexpected) glitches and patchwork fixes is being written. Better that policy intervention be limited in number to the few cases where they are unambiguously warranted.