Saturday, April 26, 2014

Misery Index in perspective

One of the basic laws of the world is that no one factor is isolated, everything is interconnected, and focusing on one variable will inevitably miss the whole picture. No field of science is immune to this.

This is what makes economics such a challenging science in particular. It is extremely difficult to isolate variables in a global economy, testing is more challenging than most other science fields (except astronomy and political science) and when looking at real world-data it is hard to isolate variables to come to big conclusion. This is of course remedied by looking at gigantic aggregate samples, and computer models so we can have more control over our situation (assuming our underlying assumptions are well-formed) which helps us test particular variables. Spreadsheets are useful, but limited compared to a computer model which is the present and the future of economics.

With this in mind, one index that is particularly interesting to me is the Misery index which is quite simply adding together the inflation index and unemployment index to tell how a country is doing. The article from the Cato Institute has some interesting statements and issues.

First of all, they present the change in presidencies by presidency, which has one weakness in that it doesn't reflect changes in policies within terms. Ronald Reagan's first term has this, but leaves out some important details which I have already outlined in detail that they miss that the first and second halfs of that term saw very different monetary policies, which saw an immediate relationship in inflation which was very quick for economics, after which unemployment rose after that rise in inflation which helps understand the more complex relationship than a simple start and end graph could possibly give us. The fact that the CATO Institute does not provide (and frankly, neither does the website that gives us more data by month, which from what I can see is accurate) which is problematic in providing data and misleading. It leaves out the fact that Jimmy Carter's policies were both austerity and higher interest rates in his last two years which saw (as one would predict from Keynes general model) a decrease in planned investment which was followed by a decrease in GDP and an increase in unemployment. source These types of things are very important which help better understand what happens in the economy and are more than details. In politics, actions and rhetoric unfortunately do not always align. Merely resting on the knowledge and biases of the audience will lead people to incorrect conclusions. We need to pinpoint the policies that caused the changes, which is far more useful and accurate than pinpointing individual presidents.

If we were going to tag this graph with actual events, we will find a very different picture. I have graphed the index (which the CATO institute author didn't bother to do) which looks like this:

Here is a detailed summary of the several peaks in the graph:

  • The peak in 1951 was due only to inflation, as unemployment didn't budge significantly at this point in time. It was probably and aftershock of the recession of 1949 which was caused by a decrease in planned investment as the economy continued to adjust to a peacetime economy after World War II.
  • A brief peak above 10% in 1958 was due to unemployment which went as high as 7.4%.
  • We went above 10% in 1971 after a rise in inflation beginning in 1968 when the money supply had outgrown gdp growth. This tells us that money supply growth needs to match and not exceed GDP growth in times of expansion.
  • We skyrocketed up to over 19% in 1973-1974 (the oil crisis), when the increase in the cost of oil cause inflation.
  • In 1978 saw a reversal of federal reserve policies which saw the highest peak ever due to inflation from a lack of cash in the economy. The recession that started in 1978 with the loss of oil was lengthened by the austerity and tightening fiscal policy. This prevented the economy from speeding up by reducing Government spending which reduced GDP. We saw a steady rise in unemployment and a rise in inflation due to the lack of goods for sale from the lack of oil. There was little stimulus to get us out of recession quickly, so it lasted until the middle of 1983 when the monetary policy was looser and the economy could move again because it had the cash it needed.
  • Since the decrease in the misery index in the 1980s we have been hovering around 10 due to higher unemployment in good times with the almost unprecedented increase in technology.
  • The peaks in the 2000s are the product of a housing collapse followed by global austerity. We dropped below 10 because of deflation in 2009 despite high unemployment, which is the economy's way of correcting itself after a financial collapse. The misery index is currently hovering around 8% due to high unemployment.
The basic rules that can be learned from this graph are the following:

  1. Keep monetary supply relative to GDP growth in times of low unemployment and GDP growth. Don't put the economy in deflation by printing too little, and don't put the economy into inflation by growing too quickly. Follow the pack in this case. (1960s teach us this lesson)
  2. In times of GDP decline and high unemployment it is better to edge on the side of inflation to bring down unemployment and boost GDP through spending. If companies have no incentive to expand they won't, so the government must assume that role. (This is what the end of the early 1980s recession teaches us)
That is the message the misery index really says by correlating the peaks not to president's but to policy, and hopefully this post will help people see what is really happening with America's economy. This will help us make better policy in the future.

One final graph for your enjoyment:

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