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Tuesday, April 11, 2006

Prediction Tuesday

The Washington State Input-Out Model is a favorite playground of local economic guru Dick Conway. He got his start with early versions of this I-O model, in connection with the Minnesota Implan Group, which at one time had a proprietary interest in the thing. A couple of years ago Conway directed an update. The I-O model has been footnoted and cited innumerable times, but it remains a thing of mystery to me.

It is advertised as a tool for gauging the impacts of specific known stimuli as they circulate through the economy. It appears to be a spreadsheet, at the top and continuing to one side is input, on the left and continuing down is output, by sector, or SIC, and in the intersecting cell there is a ratio to three digits.... well, here's the link.

The most recent update was begun in 2002 and released in 2004, with tables specific to 1997. I do not see government in the table. So demand is seen as a function of specific industry demand, for which reason it is a supply-oriented tool. For forecasting, it could provide an early warning signal, with a lead time that might be helpful for earthquakes. But that is not its purpose.

As long as I have you here, though, and have failed to make connections with the relevance of this effort, I will emphasize that output is determined by effective demand, not supply. All schemes dedicated to improving the economy by improving the lot of the supplier, the corporation, the investor, and so on, "supply side" schemes, have disappointed.

The I-O model reminds me of a larger problem in economics – the overuse of mathematics. Algebra is great. Mathematical symbols can describe complex relationships clearly. But a whole wing of the house of economics has been built on the faulty premise that the economic system is a closed system. Another wing, the statistical wing, has been built on the presumption that there are independent variables. The two wings often connect to the detriment of good understanding.

With the assumption that economics is the science of a closed system, mathematicians have applied the tools of thermodynamics to an area of human behavior. With the assertion that there are independent variables, statisticians have mapped a course to the point upon which they are already standing.

A notorious example of things gone awry is that of Long Term Capital. A couple of Nobel Prize-winning economists established a hedge fund strategy based on mathematical and statistical analyses of arbitrage (exploitation of price differences in different markets, often bond or securities markets). It worked fine for awhile, until it didn't. When Russia defaulted on its bonds in 1996, the high leverage (heavy borrowing) of the scheme nearly broke the back of the financial system. It took some late-night arm twisting before a consortium of banks and finance houses bailed Long Term Capital out. At one time it had derivative positions of about $1.25 trillion. To my knowledge, the principles did not return the Nobel Prize nor its generous endowment.

All of which has little to do with the Washington I-O Model, which is not particularly mathematically sophisticated, but simply arithmetically complex (as far as I can tell). And before you scold me, I see its intent, I just don't see that the logic in its assumptions. Are these relationships considered to be stable? What about general income effects? And where is the conduit of government?

I bring it all up because this is prediction Tuesday here at the blog, and I don't have any competitor's predictions to talk about. The best I can find is the word "moderate" used as a verb. "Inflation will moderate." "Job growth will moderate." Is that, "Look for the same only less so?" "Or more so?"

Give me something, or I'll dust off the Economic Report of the President for next time.