Which Way Is Up? Economists' Chainsaw Logic

In economic analysis, it's not just what you keep in, but what you cut out as well.
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Editor's note: This is part of a three-day series on the changing economy. To see more, click here.

Abstractions, like chainsaws, are powerful and dangerous tools. Abstract reasoning eschews unimportant details in favor of the fundamentals, enabling the logical manipulation of key elements of a system and allowing powerful inferences to be drawn. Of course, if the wrong unimportant details are ignored, this sort of reasoning loses its logical legs.

The abstract "models" that economists are tutored (or indoctrinated) to cherish, and with which ply their trade, have changed significantly over the years.

During the '60s -- a decade I devoted to book learning and certainly not to any of the other foolishness taking place on campus -- academic economists were still hung up on issues that arose out of the

Great Depression

. We learned how to "calculate the deflationary gap and fill it in." (Hmmm ... reminder: See if you can find your old college notes.) The central question was how the public sector, through its budget and monetary policies, could dampen the inherent volatility of the private market system and help guide it toward a state of full employment.

This question was, and still is, a great question, but it is hardly the only one. Focusing on that particular problem caused economists to neglect other complicating details in lieu of developing copious -- albeit often brilliant -- theories about deficit finance and regulation. The crucial issue was essentially understood to be the tricky relationship between between U.S. business and U.S. government.

Of course, these economists were aware that the "rest of the world" mattered. But other parts of the globe had yet to make their impact in America. During the postwar era, Germany had just begun to sell us cheap humpbacked

VW

cars in

Henry Ford's

original palette of colors, and our primary imports from Japan were those little umbrellas that came with the drinks down at

Trader Vic's

. These contributions, while significant in their own right, were the sort of "unimportant details" left out of the abstract "closed economy" model of the time. This model, which effectively ignores the rest of the world or treats it as an afterthought, was appropriate to the important issues of the day.

But a series of events -- culminating in the termination of the dollar's convertibility into gold in 1971 and the rise of

OPEC

as a strategic threat in 1973 -- resulted in the rest of the world making its presence felt. The important issue was no longer business vs. government; instead, it became us vs. them. What had been unimportant details became critical factors: The rest of the world needed to be taken explicitly into account and hence a new and different abstraction became appropriate. "Open economy macroeconomics" rose in prominence. Students were tutored in the intricacies of foreign exchange rate regimes, as well as current and capital account balances.

The world may not have changed much from, say, a geologist's viewpoint, but from the perspective of an economist, it had changed so profoundly as to render the old tools useless. By the late 1970s it was clear that Americans could no longer take the rest of the world for granted. OPEC and Germany and Japan, too, had influences on the state of the U.S. economy that were equal to or perhaps even greater than those of the federal government.

The "open economy macro model" may still be the lens through which problems are viewed today, but I think it is fading as a useful tool. The us vs. them essential nature of the model makes it awkward to use when U.S. economic interactions with the rest of the world have become so many, so varied and so intimate, making it difficult to tell where us ends and them begins.

Is it a German car if the parts are sourced globally and assembled in Alabama? Is

DaimlerChrysler

(DCX)

us or them? Are programmers in Moscow and Mumbai part of our economy if they do the same work as people in Redmond, Wash., or Palo Alto, Calif., and upload it to the same network? Do you know where your pension is invested? Do you hope that it's in your economy?

The interactions of the '80s and '90s have bred a degree of economic interdependence among the world's peoples that renders an us vs. them open economy macro model obsolete.

Fox Mulder

to the contrary, we live now in what amounts to a globally closed system. Everybody is on the inside. Everybody, no matter where located geographically, is integral to "our" economy.

Failing to pick up on this quickly enough has meant that we have made a number of mistakes that, presumably, we might not have made had we been quicker to realize the way the world has changed. Thailand may be different from the U.S. in its geography, climate, history and culture, but Thai banking is not different from U.S. banking. Banking practices are sound or risky -- not Thai or U.S., U.S. or Thai. Culture, schmulture -- what's your capital ratio, how closely do you manage your asset and liability duration match and how good is your credit work?

If it's a globally closed system, we are likely to see a tendency over time for "best practices" to spread. Many of those practices right now are flowing outward from the U.S. to other countries, but the implementation of lean manufacturing and just-in-time inventory practices shows that we can learn from abroad as well.

And so it comes full circle. Japanese monetary policy is just as much my business as

Fed

policy. The

LDP's

mismanagement is such that I'm going to vote them out of office the next chance I get. OK, so maybe we're not quite that evolved yet, but I'm glad that the people I do get to vote for are keeping up the pressure on Japan. My political will, once removed, is expressed in Japan. Their economy is so intertwined with ours that their country ought to be the 51st state.

Corruption, bribery, market-rigging, monopoly power, criminal enterprises -- if these things are happening anywhere, they are happening in my economy. I want somebody to do something about that. The role of government in refereeing the great game of global market capitalism is evolving toward the one under discussion in the closed economy model that was my early introduction to economics. That's not a bad thing; as I recall, the '60s were good times. (Yes,

Timothy Leary

did say that if you can recall the '60s, you weren't there -- but it has already been established that I was bookin' it.)

The abstraction that makes most sense to me in the circumstances that exist at the end of the 20th century, the chainsaw that cuts most quickly to conclusions and insights, is a globally closed economy model. Culture, history and geography are important distinctions within this planetary system, but they are becoming, more and more, the sort of complicating real world detail that one leaves out in devising a useful abstract view of how the world works.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. He welcomes your feedback.