Family Affair — Part I — Managerial Economics of Projects, Microeconomic Foundations, and Macro

A little more than a week ago I had an interesting conversation on a number of topics with colleagues in attending the National Defense Industrial Association Integrated Program Management Division (NDIA IPMD).  A continuation of one of those discussions ended up in the comments section of my post “Mo’Better Risk–Tournaments and Games of Failure Part II” by Mark Phillips.  I think it is worthwhile to read Mark’s comments because within them lie the crux of the discussion that is going on not only in our own community, but in the country as a whole, particularly in the economics profession, that will eventually influence and become public policy.*

The intent of my posts on tournaments and games of failure consisted of outlining a unique market variation (tournaments) and the high cost of failure (and entry), that results from this type of distortion.  I don’t want to misinterpret his remarks but he seems to agree with me on the critique but can’t think of an alternative, emphasizing that competitive markets seem to be the best system that we have come up with.  About this same time a good friend and colleague of mine spent much energy bemoaning the $17 trillion debt in light of the relatively small amounts of money that we seek to save in managing projects.  Both contentions fail on common logical fallacies, but I don’t want to end the conversation there, because I understand that they are speaking in shorthand in lieu of a formal syllogism.  Their remarks are worthy of further thought and elaboration, especially since they are held by a good many people who come from scientific, mathematical, engineering, and technical backgrounds.

I will take the last one first, which concerns macroeconomics, because you can’t understand micro without knowing and understanding the environment in which you operate.  Much of this understanding is mixed in with ideology, propaganda, and wishful thinking.  Bill Gross at Pimco is just the latest example of someone who decided to listen to the polemicists at CNBC and elsewhere–and put his investors’ money where his mouth was.  You have to admit this about the lords of finance–what they lack in knowledge they make up for in bluster, especially when handing out bad advice.

Along these lines, a lot of energy gets expended about federal debt.  There have been cases–which are unique and well studied where countries can hold too much debt, especially if their economic fundamentals show significant weakness, but a little common sense places things in perspective.  Of the $17 trillion in debt, a little over $12 trillion is held by the public in the form of bonds and $5+ trillion held by other government agencies, particularly the trust funds for things like Social Security.  The bonds are exactly the same: assets for an investment portfolio and assets for any other institution that holds them.  U.S. treasury bills are very safe investments and so are traded worldwide, even by other countries.  Some of this is often spun as a negative but given that the U.S. dollar and U.S. securities are deemed safe, it turns out that–short of us doing something stupid like defaulting on our obligations–the U.S. is a stabilizing force in the world economy.

So $12 trillion in debt held by the public is about 74% of Gross Domestic Product, that is, the value of goods produced in the United States in any given year.  This is about the same level that the debt stood relative to GDP around 1950.  In 2007 it stood at about 37% of GDP but we had this thing called the Great Recession (though for those of us who run a business we couldn’t quite tell the difference between it and a depression).  Regardless, the country didn’t go bankrupt in 1950 (or in the 1940s when the pubicly-held debt to GDP ratio was over 100%).  Great Britain didn’t go bankrupt during its period of hegemony with debt to GDP ratios much higher.  When making the comparison of government finances to households, folks like those at the Peterson-funded and Washington Post Fix the Debt crowd speak like Victorian moralists about how no responsible household would have garnered such debt.  Well, household debt in 2014 stands at $11.63 trillion.  Average credit card debt is about $15K and average mortgage debt is $153,500.  Then there are other types of debt, such as student loans, on top of that which averages about $35K per household.  Given that median U.S. household income is a little over $51K, the debt to income ratio of households is 400% of annual income.  Given that comparison our national finances are anything but profligate.** One could make a very good case that we are underinvesting in capital improvements that would contribute to greater economic growth and opportunity down the line.

But there is a good reason for the spike in national debt that we saw beginning in 2008.  In case you missed it, the housing bubble burst in 2007.  This caused an entire unregulated field of securities to become virtually worthless overnight.  The banking and insurance assets that backed them lost a great deal of value, homeowners lost equity in their homes, investors lost value in their funds, the construction industry and its dependencies then tanked since part of a large part of the bubble consisted not only of overvalued real property but extremely high vacancy rates brought on by overbuilding, bank lending seized up, businesses found themselves without liquidity, seeing the carnage around them people who had jobs tightened their belts and the savings rate spiked, and those who lost jobs tapped into savings and retirement funds, which lost a large part of their values.  The total effect was that the economy took a nose dive.  In all about $8 trillion of wealth was wiped out almost overnight.  Yes, those Wall Street, banking, and real estate self-proclaimed geniuses reading their Drucker, Mankiw, and Chicago School books (when not leafing The Fountainhead for leisure) managed to use other peoples’ money and–not only lose a good part of it but managed to sink the world economy.  Millions of people were thrown out of work and businesses–many of which were household names–closed for good.  People not only lost their jobs but also their homes, through no direct fault or negligence of their own.  Most of those who found new jobs were forced to work for much less money.  Though the value of their homes (the asset) fell significantly, the obligations for that asset under their mortgages remained unchanged.  So much for shared moral hazard in real estate finance.

Economic stabilizers that have been in place for quite some time (unemployment insurance, Food stamps, etc.) came into play at the same time that collections from taxes fell precipitously, since fewer people were making money.  The combination of the social insurance stabilizers and President Obama’s combination of new spending and tax cuts to provide a jolt of temporary stimulus–despite polemicists to the contrary–was just enough to stop the fall but was not enough to quickly reverse it.  Even with the additional spending, the ratio of debt to GDP would not have been so marked if the economy had not lost so much value.  But that is the point of stabilizers and stimulus.  At that point it just doesn’t matter as long as what you do stops the death spiral.

A lot of energy then gets expended at this point about private vs. public expenditures, who received or deserved a bailout, etc.  Rick Santelli–also one of the geniuses at CNBC who has been consistently wrong about just about everything–had his famous rant about bailing out “losers” (after the bankers and investors got their money) without blushing.  This is because, I think, that people–even those well educated–have been convinced that political economy is a “soft” science where preferences are akin to belief systems along the lines of astrology, numerology, and other forms of magical thinking.  You pick your side; like skins vs. shirts.

This kind of thinking cannot be more wrong.  It is wrong not only because our scientific methods have come along pretty far, but also because the “ideological” thinking that has been sold in regard to political economy undermines the ability of citizens in a democratic republic to understand their role in it.  “A nation is great, and can only be as great, as its rank and file,” said historian and later president, Woodrow Wilson.  This proposition is as true today as it was a hundred years ago.  More urgently, it is wrong because after the world’s experience with disastrous semi-religious ideologies and cults of personality in the 20th century capped off by Radical Islam at the start of our own century, the last thing we need is more bigotry and stupidity that demands sacrifice and revolution, harming millions in the process, in the name of some far off, Utopian future or to regain some non-existent idealized past.

On the everyday level, it is important to end the magical thinking in this area because that is the only way for those of us who are not the masters of the universe–with a billion or so in the bank with politicians and media clowns willing to backstop our bad decisions–can survive.

Fallacy Number One: our economic structure is based on “private enterprise” with public action an imposition on that system

I begin refuting this fallacy with this image:

U.S. dollar

Notice that our currency is issued by a central bank.  This central bank is the Federal Reserve.  George Washington, our first President, is on the $1 bill.  Other dead presidents are on our other denominations.  On the front of the dollar bill it clearly states “The United States of America.”  That is because U.S. currency and the economy on which it is built is a construction of the U.S. government.  The rules that govern market behavior are established within guidelines prescribed by the government of the United States or the various states.  The People of the United States, as in “We the People of the United States…” that begins the Preamble to the Constitution, establish the currency and good faith and credit of the country.  J.P. Morgan Chase, Bill Gates, the Koch brothers, Bitcoin, and every other participant in the economy are subject to the will of the sovereign–in this case the People of the United States–that establishes this currency.

This is important to know when talking about such things like the debt.  For example, once the economy is back to growing at trend, should we still consider the debt level too high, we can marginally raise taxes to balance the budget and even pay down the debt like we were doing just 13 years ago.  It is also important because it allows us to use our critical thinking skills even though we may not be professional economists when faced by specious claims, like that of the debunked study by econmists Reinhart and Rogoff that purportedly showed a link to economic stagnation when countries exceeded 90% debt to GDP ratio.  For example, since the Federal Reserve is the central bank, should we find that there is a magic point at which we are concerned about debt as a percent of GDP, the Fed can buy its own bonds back at low prices that it previous sold at higher prices, thereby reducing the debt to GDP ratio simply by swapping paper.  Of course this would be ridiculous.  The important metric is understanding if we can make the annual payments and the percent of interest against GDP.

Understanding this essential nature of the economy in which we operate, combined with our critical thinking skills, can also inform us regarding why the Fed bought securities to provide cash to the economy–what is known as quantitative easing (QE).  Paul Krugman, the Nobel economist and New York Times columnist, has also posted some useful slides here.  This was done in several stages by the Federal Reserve because the economy was in what is called a liquidity trap with short term interest rates near zero.  Thus, there were not enough liquid assets (cash), to keep businesses and banking going.  The housing market and other businesses dependent on liquidity and low interest rates were also deeply depressed.  In project management, start-up costs must oftentimes be financed.  Businesses don’t have a vault of money sitting around just in case they get that big contract.  The bank of last resort–the Fed–used its authority to buy up existing bonds to prime the pump.  Rather than some unheard of government intervention in the “private” economy, the Fed did its job.

As to political economy, Thomas Paine, the publicist of the American Revolution, put it best in Agrarian Justice, and the common sense that he expressed over two hundred years ago is still true today:  “Personal property is the effect of society; and it is as impossible for an individual to acquire personal property without the aid of society, as it is for him to make land originally…Separate an individual from society, and give him an island or a continent to possess, and he cannot acquire personal property. He cannot be rich.”  Private property in the definition of Paine and Adam Smith, who was a contemporary, is defined as real property or the means of production, not private possessions.  We are long past the agrarian economies observed by Paine and Smith, where wealth was defined by land holdings.  But Smith did observe in one mention in The Wealth of Nations that the systems he observed–those markets that existed in his day–acted as if controlled by an “invisible hand.”  Much cult-like malarkey has been made of this line but what he was describing is what we now know of as systems theory or systems engineering.

Given this understanding, one can then make two essential observations.

First, that our problems where bogeyman numbers are used ($17 trillion!) aren’t so scary when one considers that we are a very large and very rich country.  We can handle this without going off the rails.  Is there a point where annual deficits are “bad” from a systems perspective?  Yes, and we can measure these effects and establish models to inform our decision making.  Wow–this sounds a lot like project management but on a national scale, with lawyers, lobbyists, and politicians involved to muck things up and muddy the waters.

The other observation is that we can also see how government policy was responsible for the manner in which it exposed its manufacturing workers to foreign competition, undercutting the power of domestic unions, not some natural order dictated by “globalization.”  It demonstrates how the shrinking of the middle class since 1980 was also the result of government action, and how the slow recovery, with its lack of emphasis on either job creation or wage protection, was also the result of government action.

Those who throw up their hands and say that there is nothing to be done because the rich always find a way to avoid responsibility and accountability not only are wrong from an historical and legal perspective, they also commit the sin of an act of omission, which is unforgivable.  That is, when you let something bad happen due to cynicism, indecisiveness, or apathy.

This then leads us to Fallacy Number Two:  Capitalism Is Necessarily Complimentary to Competition and Democracy

Mark Phillips’ on-line comment paraphrased Churchill’s observation that our system is one that, while imperfect, is the best we’ve found.  But Churchill was not speaking of free market fundamentalism or our current version of capitalism.  The actual quote is: “Democracy is the worst form of government, except for all those other forms that have been tried from time to time.”  (Churchill, House of Commons, November 11, 1947).  It is hard to believe today that the conflict in Western thought before the Second World War, and the topic on which Churchill was reflecting, was not between Democracy and Totalitarianism and its ilk.  For most Europeans, as documented extensively in Tony Judt’s magisterial work Postwar: A History of Europe Since 1945 (2005), the choice was seen as being between Fascism and Communism, liberal democracy being viewed as largely ineffective.

Furthermore, the democracy to which Churchill was referring in both the United States and the United Kingdom at the time, was much more closely organized around social democracy, where the economic system is subject to the goals of democratic principles.  This was apart from the differences in the types of democracy each was organized:  the U.S. on a constitutional, representative bicameral legislature, and presidential system of checks and balances; and the U.K. on a parliamentary, constitutional monarchy.  The challenge in 1947 was rebuilding the Western European countries, and those on the Asian periphery, to be self-sustaining and independent based on democratic principles and republican virtues as a counter to Soviet (and later Chinese) domination.  The discussion–and choice–had thus shifted from systems that assumed that people were largely economic actors where the economic system dictated the terms of the political system, to one that where a political system based on natural rights and self-government dictated the terms of the economic system.

Mark comments that competition is the best system that we have found in terms of economics, and I don’t necessary disagree.  But my level of agreement or disagreement depends on how we define competition and where we find it, whether it approximates what we call capitalism, and how that squares against democratic processes and republican institutions.

For example, the statement as it is usually posited also assumes that the “market picks winners” in some sort of natural selection.  Aside from committing the logical fallacy of the appeal to nature, it is also a misunderstanding of the nature of markets, how they work, and what they do.  As a government contract negotiator, contracting officer, and specialist for a good part of my career, understanding markets is the basis of acquisition strategy.

Markets set prices and, sometimes, they can also reflect consumer preferences.  In cases where competition works effectively, prices are driven to a level that promotes efficiency and the drive for newer products that, consequently, produce lower prices or greater value to the consumer.  Thus, competition, where it exists, provides the greatest value to the greatest number of people.  But we know this is not always the case in practice.  Also, just to be clear, what markets do not do is naturally elect someone, reward merit, define “makers” or “takers,” nor select the best ideas or the most valid ones.  It often doesn’t even select the best product among a field of competitors.  Markets focus on price and value, and they don’t even do that perfectly.

The reason for this is because there are no perfect markets.  Under classical economics it is assumed that the consumer has all of the information he or she needs in order to make a rational decision and that no supplier or buyer can dictate the terms of the market.  But no one has complete information.  Most often they don’t even have sufficient information to make a completely rational selection.  This was von Hayek’s insight in his argument against central planning before we discovered its tangible evils under both Soviet and Chinese communism.  This same insight speaks against monopoly and domination of a market by private entities.  This is called information economics.

Given that there is no such thing as a perfectly competitive market (since we do not live in a universe that allows for perfection), information economics has documented that the relationship among the independent players in a market is asymmetrical.  Some people have more information than others and will try to deny that information to others.  Technology is changing the fundamentals of information economics.

Compounding reality is that there are also different levels of competition that define the various markets, depending on vertical, product, industry, niche, etc. in the United States.  Some approximate competitive environments, some are monopolistic and others oligopolistic.  There can also be monopolistic competition among a few large firms.  Markets where competition is deemed destructive to the public interest (predatory competition) or is a result of a limited market for public goods (monopsony) are usually highly regulated.  How these markets develop is documented in systems theory.  For example, many markets start out competitive but a single market actor or limited set of actors are able to drive out competitors and then use their market power to dictate terms.  Since we operate in a political economy, rent-seeking behavior (seeking government protection through patent, intellectual property, copyright, and other monopolies as well as subsidies) is common and is probably one of the most corrupting influences in our political system today.

Thus, there is a natural conflict between our democratic principles and an economic system, which is established by the political system, that is based on economic rewards meted out in a hierarchical structure based on imperfect markets and rent-seeking.  This is why capitalism can morph itself and coexist in Leninist China and Autocratic Russia.  Given this natural conflict our institutions have passed laws that modify and regulate markets to make them behave in a manner that serves the public and ensures the positive benefits of competitive markets.  They have also passed laws that play into rent-seeking behavior and encourage wealth concentration.

A good example of both types of law and the conflict outlined above is the U.S. health care system and the Affordable Care Act (that I’ve previously written about), also known as Obamacare.  There are several aspects of the new law, and sections of the omnibus bill that passed under its rubric read almost as if they were separate laws with conflicting goals.

For example, the ACA, under which it is also known, established the healthcare exchanges on which plans could be purchased from private insurance providers.  This aspect of the law set up a competitive marketplace with information about each plan clearly provided to the consumer.  In addition, the ACA passed what had previously been known as the Patient’s Bill of Rights, which established minimal levels of service and outlawed some previously predatory and unethical practices.  This structure is the real world analogue of a competitive market that is regulated to outlaw abusive practices.

At the same time other portions of the bill prohibited the federal government from using its purchasing power to get the best price for prescription drugs, and also prohibited competition from Canadian drugs.  This is the analogue of rent-seeking.  When combined with laws that establish drug patent monopolies which allow companies to keep prices 300 to 400 percent above marginal cost, it is no wonder why per capita expenditures on healthcare are almost twice any other developed nation, though the cost seems to be coming down as a result of the competitive market reforms from the healthcare exchanges.

Revisiting our discussion earlier on debt, were our healthcare expenditures in line with other developed countries, we would be seeing budget surpluses well into the future.  The main driver of deficits is largely centered in Medicare.  Aside from cost cutting, other methods would be to expand, instead of shrinking, the pool of middle class workers which make up the broadest and largest source of revenue, with wages and salaries at least keeping pace with productivity gains.

In sum, competition is a useful tool and delegation of economic decisions is largely in line with our republican virtues.  But, I think, it is clear that there are hideous market distortions and imperfections that, in the end, undermine competition.  Many of these distortions and imperfections come about from competitive markets, which are then undermined once a market entity has gained control or undue influence.  Systems theory inform us about how markets behave and how we can regulate them to maximize the benefits of competition.

But the obscene fortunes that are held by a very small percentage of individuals–and the power that attends to them–represents in very real terms a danger to the institutions that we value.  So whether we can think of a better system is not the issue, taking incremental steps to reestablish republican virtues and democratic values is imperative.

Fallacy Number Three:  Microfoundations Determine Macro

Given the multiplicity of markets–and the mathematics and modeling that attend systems theory–it is clear that aggregation of microeconomic dynamics will not explain macroeconomic behavior–at least not as it is presently understood and accepted by the academic field.  Economics is a field that need not be “soft,” but which failed miserably to anticipate the housing bubble and resulting bursting of that bubble, and the blind alleys that some economists advocated that misled policy makers in the wake of the crisis exacerbated human suffering.  Europe is still under the thumb of German self-interest and an “expansionary austerity” ideology that resists empirical evidence.  Apparently 20% unemployment is just the corrective that peripheral countries need despite Germany’s own experience of the consequences of such policies in the 1930s–and extremist parties are rising across Europe as a result.

As a complex adaptive system, macroeconomic policies changes the behavior, structure, and terms of a market.  For example, ignoring antitrust legislation and goals to allow airlines and cable companies to consolidate encourages rent-seeking.  “Deregulating” such industries establish oligopolistic and monopolistic markets.  These markets dictate the behavior of the entities that operate in it, not the opposite way around.  The closed-loop behavior of this system then becomes apparent: successful rent-seeking encourages additional rent-seeking.  The consumer is nowhere in sight in this scenario.

Thus, we can trace the macro behavior of each system and then summarize them to understand the economy as a whole.  But this is a far cry from basing these systems on the behavior and planning of the individual entities at the microeconomic level.  Our insights from physics and tracing other complex systems, including climate, inform our ability to see that macro behavior can be summarized given the right set of variables, traced at the proper level of detail.

This then leads us to the fundamentals of the Managerial Economics of Projects, which I will summarize in my next post.

 

*I usually try to steer from these types of posts, especially since those that skirt politics and polemics tend to be contentious, but the topic is too important in understanding the area of managerial economics that involves projects and systems dynamics.  A blog, after all, is a public discussion, not a submission of an academic paper.  For those unfamiliar, my educational background is based in political science, economics, and business (undergraduate work and degree), and my graduate work and degrees focused on world and American history, business, and organizational behavior.  This is apart from my professional and other activities in software engineering, systems engineering, project management, group psychology, and the sciences, including marine biology.

**So the reader will not be scared of the big number for household income to debt ratios, keep in mind that the largest of these liabilities (and assets) is long-term.  For most mortgages this is 30 years.

4 thoughts on “Family Affair — Part I — Managerial Economics of Projects, Microeconomic Foundations, and Macro

  1. Excellent post, Nick. Note that much of that $17 trillion debt (not deficit, as in the second paragraph) is a consequence of the Bush tax cuts; Congress made a conscious decision to prioritize further accumulation of wealth in the hands of the wealthy over investment in public assets. Robert A. Heinlein cynically noted that a people get the kind of government that they deserve, but lately we’ve transitioned to the kind of government that the wealthy desire, courtesy of a simple majority of the Supreme Court.

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    • Thanks again for your very helpful comments. It is indeed debt as opposed to deficit and I’ve made the change. (I think I made the distinction later but for some reason confused the terms in editing).

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