In the operation of modern economies over the last 100 years, countries have come to rely on economists, and people trained by economists, to steer the economic ‘ship’ so to speak. As the economies have become more complex and the demand for economists has increased, economists have created increasingly mathematically complex models to explain and predict economic behavior and to advocate for policies that they believe are optimal. Many economists have even come to believe themselves to be scientists and have become quite self-assured in their pronouncements. However, the economic performance over the last 6 to 8 years has thrown some much need public doubt, and in some cases self-reflection, on the practitioners of this social science.

The first problem with economics is its pretension to be a science. While it certainly can make observations and perhaps even draw broad conclusions from them, it is not making these observations in controlled lab experiments. In order for something to be considered in line with the scientific method, it must be repeatable and falsifiable. In the real world, the economic ‘observations’ are data points that often occur within many different social, political, and cultural contexts. In other words, it is questionable as to whether these ‘observations’ can truly be classified as ‘repeatable’. While this by itself does not render them completely useless, it simply means that the lessons drawn from them can be of varying relevance when applied to other economies in other situations.  In addition, economic theories are not truly falsifiable in a scientific sense. One wag described an economist as a person who can be always wrong and still be considered an expert. If economic theories were truly falsifiable, and if economists were truly ‘scientists’, then there should be no socialist/Marxist/communist economists, just as there are no anti-gravity scientists. However, the fact that there are many of these types of economists in academia in the West is an indication that we are not dealing with true scientists. Just because central planning did not work to create wealth and prosperity in any context in which it has been tried and applied does not mean that no such context necessarily exists.

The second problem with economics as a science is its over-reliance on mathematics. Many economists create exotic mathematical ‘proofs’ of their assertions which implies a level of scientific precision that simply does not exist in that field. In the field of financial economics and financial portfolio management, theories, recommendations, and financial derivative products are based on statistical models that use past data to estimate and predict what the future will look like. The problem with this is that many of these models are based on observations drawn from one specific time in history (the last 80-90 years). While ‘Black Swan’ events can cause the economy to ‘change course’ as it were, economies (and economic expectations) can also change and evolve over time, with the upshot that the same policy applied at two different points in time can have very different results. One example of changes in perception would be that the generation that experienced the crash of 1929 and the ensuing Depression never really saw stocks as anything more than a wildly risky investment that one would be crazy to base ones retirement on, while the Baby Boomers, and to a lesser extent Gen Xer’s, see them as precisely that. Consequently, investing behavior changes and that changes the paths that stock prices take. A policy of low interest rates by the Fed is going to have differing impacts on stock valuations when applied to these different populations of investors. Note also that the bursting of two financial bubbles and the resulting economic fallout will have a significant, although as of yet unknown, impact on the psychology of those who have come of age during this period. What this means is that simply plugging in historical observations into a statistical model to try and predict the future won’t have the precision to justify the confidence of those making predictions. In the short term (6 to 24 months) price movements can be impacted by any unknowable random thing. In the long term (10 to 40 years), the world can change to such an extent that the prior observations are as meaningless as trying to devise a military strategy for a war today based on the military technology that existed in 1800. It is not likely to be a successful enterprise.

Simply put, the pretention of the field of Economics to be a science leaves a lot to be desired. This is not to say that the field of Economics hasn’t made important contributions to our understanding of how the world works. It most certainly has and will continue to do so. So has philosophy, religion, history and other academic subjects. However, the world is simply too complex and changing too rapidly to be accurately predicted by mathematical models based on historical observations. Remember that the next time someone on television or in the newspaper makes a prediction.

Over the past 5 years or so, economists and pundits have been puzzled with the sluggishness of the current economic recovery. This recovery has been so anemic to the point that more than half of all Americans still thought that the economy was in a recession, as of March of this year. Economic historians have noted that every economic recovery since the 1970’s has seemed to get weaker and weaker than the previous one. One historian has even noted that the reason unemployment fell to an extremely low 4% in the previous two recoveries (1992-2000, 2002-2007) is that the expansions lasted so long allowing for the accumulation of jobs, thereby masking the weakness of the job growth. This is in contrast with the immediate post-war recessions in which the downturns were met head-on with the Fed lowering interest rates and the economy resuming robust job growth shortly thereafter. However, economists have not been able to put their finger on what exactly changed and why public policy has not been able to engineer similar recoveries as it seemed to be able to in the immediate postwar period.

I think that when one is looking as to why the same policy (i.e. the Fed lowering interest-rates) does not have the same effect over various time periods, the answer lies in the underlying conditions in which the policy is being attempted. What is extremely clear is that the underlying economic structure of the United States has changed since 1980.

First of all, we are much less industrialized economy and more of a service economy. It is possible that an economy that makes things is more responsive to changes in interest rates than one in which specializes in intangible type services. While it may not be abundantly clear why this would be the case, it could be that investments in production capacity anticipate economic expansion, whereas those in service type businesses react to economic expansion. For example, service-type businesses often have labor as their main factor of production, which means that firms often wait until their existing workforce is stretched before adding service providers. This means that service companies will tend to be adding workers later in the expansion cycle, all things being equal, than a production business which has to make a guess on what future orders will be, hire the people, buy the raw material, produce the product, and then hope that the demand is there.

Second of all, the last 30 years has seen a massive growth in business regulations. While regulations were growing for decades prior to 1980, they have continued to grow. It could be the mountains of regulations have simply started to weigh down the economy so that it can’t recover as fast due to growing red-tape. We do know that if you start from an unregulated economy and start adding regulations over time, eventually you will reach a point at which your economy will slow, then stagnate, and then, in an extreme case (i.e. the Soviet Union) collapse. While we may not be at the Soviet Union stage, the fact is that there has been no major rollback of regulations for decades. And consider for a moment all of the regulations that have been written since 1999. We lived very well in 1999 without any of the regulations that have been added since then, and we did so very, very, well. Which leads one to ask, were all of the new regulations (which impose an economic cost) that have been instituted over the last 15 years really necessary?

Finally, there is the matter that trade has become freer, economies that were previously closed (Soviet Union, Eastern Europe & China) that have entered the international arena to compete with the U.S. American companies have been able to outsource work overseas (even some service jobs) that they were not able to do before. This means that any given economic expansion will mean more jobs in the U.S. and more jobs overseas to meet U.S. demand, whereas previously it meant more U.S. jobs to meet U.S. demand. While this is highly simplified, and while freer global trade has meant cheaper goods for U.S. consumers, at some level it has meant fewer U.S. jobs in an expansion than would likely have been the case a generation ago.

Overall, the sluggishness of the U.S. economy is likely due to these factors, as well as other factors that I haven’t mentioned. One thing to notice though is that for all of the political squabbling about the economic policies of this Administration or the previous Administration the factors that I have mentioned preceded either of the Administrations and are largely factors beyond the control of any given Administration, Democrat or Republican. While there are certain things a given Administration could do to improve the situation (i.e. roll back regulations), we will likely never return to the 1945-1980 era economically because the world has fundamentally changed. Get used to sluggish recoveries.

Judging by the Right Track/Wrong Track numbers on Realclearpolitics.com (-37%) it seems clear that America is going through a crisis of confidence. While Republicans might point to the number as a sign that Obama has steered America in the wrong direction, the simple fact is that the numbers were negative under George W. Bush as well. Congress has approval ratings permanently stuck below 15%, and these numbers are only slightly better when Democrats hold both houses of Congress. Looking at the numbers, listening to pundits, and talking with ordinary people, it is hard to escape the sense that something has gone dramatically wrong, and it is not clear that anyone has the answer to the problems that the country faces.

While there are many factors contributing to what is happening, at a political and governmental level, the institutions are outdated, and it is not clear that they can be changed. One of the genius features of the American institutional structures up to this point in time has been their ability to change with a changing world. Another way to look at it is that America, up until now, has not had its mistakes “baked” into the system.

However, at a political level, the political parties are wedded to out of date ideologies, and prisoners to interests that were created decades ago. The ideologies are a way of explaining the world. The problem for us today is that the dominant ideologies did work at certain points in time. For example, the Democrats ideology of a government solution for every problem worked in the 1930’s, and the result Democrat dominance of the White House, and often of Congress too, for the next 36 years. Many conservatives of the day argued, unsuccessfully, that the Democrat policies would bring ruin to America, but they didn’t. For the Republicans, their ideological affinity for tax cuts and military spending came in the 1980’s. Many argued that Reagan’s view tax cuts would spur economic growth was erroneous, and that an insane military build-up would provoke a war with the Soviet Union. But it didn’t. The economy boomed and the Soviet Union, America’s arch-nemesis, collapsed. However, the lessons that both political parties have taken and institutionalized is that government programs cure everything on one side, and that tax cuts cure everything on the other side. The response of George W. Bush to the 2001-2002 recession, and the response of Barack Obama to the 2008-2009 recession were simply textbook Republican and Democrat responses to recessions with no real thought to the fact that the 21^st century might need different policies than were needed in the 1930’s and the 1980’s.

A further outdated set of institutions are the government bureaucracies. The institutional structure that we see today was largely created in the first part of the 20^th century, expanded upon rapidly in the 1930’s, and been steadily added to ever since. While this structure might have made sense in a world without computers, the internet, various technological productivity enhancements, it makes no sense today. In addition, there are certain services that government (or quasi-government entities) were created to do, that the private sector now has methods for accomplishing the same task (i.e. the post office). While the private sector has had a couple of retooling/ reform periods, our government operates largely as it did in the 1950’s.

One need to look no further than Osama bin Laden to see how a handful of individuals were able to use basic everyday items that really didn’t exist in the 1950’s to attack the most powerful nation on earth; an attack reminiscent of the Pearl Harbor attack that took the power and resources of a first world nation to pull off 60 years prior. And let’s not forget that it was private citizens on United Flight 93, and not anything that a government agency was doing, that thwarted the mission of the last plane, and may have saved the lives of people in Congress or the White House. The point is that the world moves much faster than it did 60 years ago, and bureaucracies simply aren’t designed to keep up.

Additionally, the lack of faith in institutions is also due to the fact that expectations have changed. People used to a slower paced life might not like standing in line for a government service, but they know that there is, in many cases, no private entity that could accomplish the task. In addition, there experience with the bureaucracy is likely not completely divorced from experiences in other aspects of their lives. With the internet, facebook, online purchases, Amazon, 500 cable channels etc., as well as the ethos that the customer is always right (i.e. have it your way), the one-size-fits-all, slow moving, inefficient, expensive, and often incompetent government service provider stands in stark contrast to the everyday experience of the American consumer. When one considers this, it is no wonder that Americans have lost faith in the ability of the institutions to deliver what is promised.

Finally, there is perception on both left and the right that the game is rigged against the average American. When bankers can engage in illegal and unethical activity and crash the economy, or when the IRS can improperly target some Americans due to their political views, and nobody ends up going to jail, there is a sense that there is one set of rules for the powerful and politically connected, and another set of rules for everyone else. While the American promise was that everyone is equal before the law, that seems to be less and less true.

Going forward, if there is no substantial reform, America will be a different place. Trapped by the battles and institutional structures of the past, she will be unable to win the future (regardless of which political party is in power in Washington). It was the governmental institutions and structures of the past than made people willing to take risks and create global companies, products and technologies that have lifted millions out of poverty and created the most powerful, wealthy society that humanity has ever seen. Without some sort of updating of institutions (and discarding of those that no longer function), America will someday find itself eclipsed by countries whose institutions are more relevant for the the 21^st century.

On this 4^th of July weekend, as we celebrate America’s 238^th birthday, many of us will be visiting friends & family and enjoying some food and fireworks. A few of the more philosophical might spend some time thinking about freedom, perhaps the Constitution, and perhaps be grateful that they live here and not somewhere else. However, I dare say that few, if anyone, will be thinking about economics. And yet, it is the economics that makes America attractive to people today.

Although it may sound sacrilegious to say it, freedom is like air: you only notice it when you don’t have it. A person once told me that most people don’t really care whether they live in a democracy or a dictatorship, just as long as their needs are being met. While we, in America, like to think that people want to come here to be free to say what they think, to vote their conscience, etc. etc., the truth is that the illegal immigration issue that we have is not because people are so desperate to write a letter to the editor that they hire smugglers to get them into the U.S. It is because they want a higher standard of living than they can have in their own countries. To them, it probably doesn’t matter whether America is a democracy, an oligarchy, or is being run by Vladimir Putin, it is substantially better than what they are running from, and that is enough.

However, it is the economic freedom that America won 238 years ago and has developed in the intervening years that has allowed the U.S. to become the economic (and military) superpower that it is today. It is the freedom to develop ones potential to the maximum extent possible, as opposed to having your economic destiny determined by who you your father was, or determined by what those in authority dictate that it should be, that has allowed America to harness the talents of its people (i.e. its human capital) and create unheard levels of wealth. It was economic freedom found in America that allowed a group of college dropouts to create computer companies that have completely changed the human experience. It was economic freedom that allowed Henry Ford to develop assembly line techniques that allowed undreamt of numbers of automobiles to be produced. It was economic freedom that allowed two guys from Ohio to spend their time experimenting with flight and eventually produce the first airplane, etc. etc.

Economic freedom is not only found in America of course. The idea of economic freedom has spread around the world in the last 200 years, and many of the richest countries in the world (i.e. Western Europe) have high levels of it relative to countries that are poorer.  However, in America, the economic freedom ethos is not only legal, but cultural. Economic freedom is not only the freedom to succeed, but the freedom to fail. Economic freedom means that you can try several different paths to figure out which ones suits your talents the best. Economic freedom means that failure in one area does not brand you as a failure for life. Germany is also a fairly economically free country. However, one thing that I learned there as an exchange student at a business school was that trying to start a business and failing would make it very difficult to get a second chance to start another one. The American ethos, on the other hand, welcomes second chances. A failure in one area, doesn’t mean that one can’t try and be successful at something else. I remember an immigrant from India saying to me when he realized this that “I love this country. I can screw up, and it doesn’t ruin my life”. To me, that statement is the essence of economic freedom.

So during this weekend and you drive your car to friends, and enjoy simple things like air conditioning and indoor plumbing, microwave ovens and video games, DVD players and cell phone calls, etc, remember that none of these things would have been possible without economic freedom. Like air, life without economic freedom is very different than life with it.