Fellow Shortrunners,

     Economists and philosophers of science have long debated the correct method for creating economic theories and models. One person to chime in on the subject was Nobel Laureate Milton Friedman, who wrote what is likely the most influential piece on the methodology of economics in the late 1950s.  Friedman espoused the view that what mattered when creating models was to strive for predictive power.  That is, models should aim to be accurate and to make a large number of predictions.  This fit well with the intellectual climate in which Friedman was immersed.  Along with fellow economists such as Frank Knight who pioneered what has come to be called neoclassical economics and the Chicago school, these economists made advances in modeling using a large range of simplifying and nullifying assumptions such as perfect competition and perfect rationality.

     Along these lines, economists such as Schelling and Akerlof have devised models which can tell us about the real world.  Schelling's checkerboard model describes how even slight preference differences can drive an entire community to become segregated.  Akerlof's famous lemons problem describes how the market for used car dealers has developed.  More importantly however, they tell us things about how individuals make choices, how they deal with uncertainty, and how specific institutions such as used car trading posts come about.  These models have sometimes been referred to as counterfactual worlds.  They are abstractions from reality, but at the same time they are used to gain insights about the world we live in.

     The main criticism of Friedman and other instrumentalist economists is that the assumptions used in their modeling are abstractions.  They are divorced from reality.  As a result, it is possible that their model could lead to inaccurate predictions.  Those who look for realism in their assumptions have come to be called Causalists.  The Causalists would find fault in Schelling and Akerlof's work.  The most common example cited is the Black-Schoales pricing model.  This model can value certain financial instruments.  Most people who use the model in the quotidian financial world don't know that there are certain situations in which it will not accurately value the instrument.  What can be taken away from such economics debates?

     It is clear that the Causalist's claim is far from the mark.  If the charge is that divorcing models from reality can lead to models that give false predictions, then Friedman's instrumentalist result would lead to models with perfectly realistic models.  Furthermore, examples such as the Black-Schoales model are failures not of models and theory but of application.  Economists must be careful to explain the effects of simplifying assumptions.  Those who take theory and apply it to the real world must be careful not to extend results to situations in which we know they don't hold.

Economic Releases
The data section provides charts and data for the most important economic indicators.

Construction Spending: -0.3%
Release Date: 6/02

• On Monday, the Commerce Department reported a decrease in US construction spending activity of 0.3%.  The broad index decline was unexpected by the market and was thus rather disappointing.  In spite of the decline however, construction spending is still buoyed by high levels of residential demand and low interest rates and should remain aloft in the near future. 

ISM Manufacturing Index: 49.4%
Release Date: 6/02

• The ISM manufacturing index suggested moderate contraction in manufacturing activity during May.  That said, the level of decline decelerated heavily, with the index reading improving from 45.4% the month before to 49.4%.  Improvement in the manufacturing sector is good news for the economy as new orders and production activity were both reported as growing.  

ISM Non-Manufacturing Index: 54.5%
Release Date: 6/04

• The non-manufacturing ISM report showed significant improvement during May as well.  Overall business activity expanded with the only major drag being employment.  It is interesting to note that despite falling producer prices as reported by the BLS, both the manufacturing and non-manufacturing ISM survey based reports suggested moderately rising prices.

1st Quarter Productivity Revision: 1.9% 
Release Date: 6/04

• Productivity in the non-farm business sector of the economy expanded at an annual rate of 1.9% during the first quarter.  Continued strength in productivity growth is essential for long-run economic performance as it leads to rising standards of living.  Unit labor costs, a measure of wage based inflation, expanded 1.5% during the same period.

Jobless Claims: 442,000
Release Date: 6/05

• Initial jobless claims rose to 442,000 last week from 426,000 the previous week.  Weakening in the labor market should continue to act as a drag on economic recovery and growth in the US.  This week's jobless claims figure will likely not have a large impact on the markets as participants will wait for Friday's BLS employment summary.

Consumer Credit: 7.25%
Release Date: 6/06

• During April, total consumer credit outstanding rose at an annualized rate of 7.25%, with the net result being that during the first quarter, credit activity expanded at an annual rate of 4.5%.  The majority of the rise in credit came in the form of non-revolving credit, a sign that Americans are still able to use low interest rates as an excuse to turn to longer-term instruments such as mortgages for financing activity.

Unemployment: 6.1%
Release Date: 6/06

• The BLS reported Friday that the headline unemployment figure rose to 6.1% in May.  Economists for the BLS noted that the majority of job gains made during the period were in construction-related activity with weakness being experienced in the manufacturing sector.

ECRI Weekly Leading Index: 123
Release Date: 6/06

• Economists for the ECRI declared this week that "the fog of war has cleared," referring to uncertainty experienced by US businesses during the conflict with Iraq.  The ECRI WLI index rose to 123 during the week ended May 30th from a figure of 121.5 the week before.

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Issue #155

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