A long, late comment about that Omega point….

One of the problems with working all day and only writing here at odd moments in the evening, when I have energy and inspiration, is that I’m always late to every good party.  The Omega point discussion I want to write about is already very old news; it was on and over weeks ago, which is a few long epochs ago in interweb time.  But there were things about the whole conversation that enchanted me, and others that bothered me, so I might as well write those things down.

So here it is: a few interweb epochs ago there was an exchange of bewilderment between Martin Feldstein and Paul Krugman.  Feldstein was bewildered by the fact that the Fed’s flood of new money in the last few years has not yet created the corresponding flood of inflation or even the long run expectation of inflation that he (and many others) predicted, based on something like a quantity theory of money (“inflation is too much money chasing too few goods”).   And Krugman was bewildered by the fact that Feldstein was bewildered, since stable prices when interest rates are at the zero lower bound and the “natural, full-employment” interest rate would be much lower than zero is what HE predicted, based on something like the old Keynesian or Hicksian IS-LM liquidity-trap model.  

The contesting bewilderments between these two very smart economists does raise a question: why does it exist so strongly when both of them based their predictions and bewilderment on well known, widely taught economic theory?  Neither was dealing, I think, with any theory that the other did not completely understand and, in one way or another, even accept.

Then a few weeks ago Brad DeLong suggested an answer: what you predict depends on how far into the future you think the Omega point is, and how strong you think its influence is on the what is happening now.  

The Omega point??  I didn’t recognize that from my Econ 101 text.  I had to look it up.  If you feel up to an excursion into entropy and evolution and cosmology and the nature of time and God, follow the link to Pierre Teilhard de Chardin, But for now, let’s just say that the word that DeLong used may be non-standard in economics, but the idea is strong in the economic imagination: the point DeLong is talking about is an ideal, theoretical condition out there in the temporal distance that is pulling at us, tugging us toward it.   It is final result of all that is happening now, the time when all economic discord and turbulence will cease, when prices and wages all have adjusted, and the thing that people in the econ biz call the velocity of money will have stopped gyrating all over the place, and will have settled wherever it is supposed to be.  DeLong even says this directly; he says:

“At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. … And at that time the price level will be proportional to the monetary base.”

Assuming that nothing else happens to knock us off our course---no new crises, no earthquakes or tsunamis or plagues, no major wars, no long-simmering industries suddenly bursting  out and changing the world, no fundamental political changes that bend some cost curve up or down or sideways, no new bubbles or panics or manias, no out-of-the-blue, irrational desolation or exuberance---assuming that we are left alone to move where our current Omega point lures us, it is the point at which we will settle in the end.  It is, finally, the Fabled Economic Long Run.

And DeLong’s post starts by repeating the last phrase of the famous quote from John Maynard Keynes, in which he states that “in the long run we are all dead”.  Keynes was complaining, long ago, about economists who constantly refer to the long run and tell us all to be patient while we get there.  Keynes said: “Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.” And in saying that, Keynes tells us that he thinks that when times are very hard or very turbulent, whenever, that is, people or politicians might turn to economic theorists hoping they might at last be of some real use, precisely at those times something very basic has pushed us far from long run equilibrium, and the Omega point might at exactly those times have raced far, far ahead of us into the distant future.  In fact (I think he might be saying) we are in a hard and turbulent time because the Omega point has raced ahead, and because there are barriers of some kind between it and us, and because it will be hard to get to it.  If it were easy to get to and there were no barriers to keep us from it we would be in it already, and the ocean would already be flat.  At times like that, he’s saying, the Omega-point-long-run is often so far off that it’s not a proper subject for economic thought.  The proper thought during a storm at sea is not a daydream about how peaceful it will be when the storm is over.  That may be tempting, but it’s not useful.  There’s a lot more practical value in thinking about how to survive the storm with as little damage as possible.

One possible response to that view is to deny that the long run can really move as far as that into the future, but DeLong (along with most economists these days, I hope) has seen enough of reality to know that it does not look like that.  Another response, the one DeLong describes in his post, is this: the Omega point may be far away but it is still very powerful.  It may not even exist anywhere but in the imagination of economists and economic actors (like bankers or businessmen or workers or consumers). But the imagined Omega point changes their---our--- current behavior.  A whimsical analogy: it may seem serene sitting on the level sand in the top of an hourglass, but you know how an hourglass works.  If you were sitting there on that sand you would know that deep beneath you is motion and drift, and that soon you would feel it, soon you would have to react, soon serenity would dissolve and you would be pulled through the vortex to the Omega point below.  And knowing that, you might react immediately to prepare, even though the sand you now sit on seems placid. 

Of course it’s common, and has been since somewhere around 1950 or so, to see the short run as Keynesian, and the long run as classical, and where you sit on the spectrum of ideology may depend on, or may determine, which of those two models you find most immediately useful, and on when you think the long run will arrive.   But DeLong, I think, was saying it depends also, or also determines, how you think the short run becomes long.   He paints a vivid picture of a “backward propagation” of behavior that is caused by our awareness of the distant Omega point, and how that might create a quick, even nearly immediate, economic response to large rises in the money supply, since current economic actors would feel in their bones that someday, as the Omega point nears, that increase in money would create inflationary pressure.  They would feel in their bones that because of how they believe the economy works there is already motion and drift beneath them, invisible, but there, and they would begin to prepare for the vortex they know is coming.   Because inflation, the Quantity Theory tells us, is always and everywhere a monetary phenomenon.  And because economic actors, even though they may not understand it on a theoretical level, on a mathematical level, are nevertheless saturated with a devout faith in the Quantity Theory.

As DeLong says this idea explains why economists with the same theories might differ in their beliefs even about what the near future holds:

“…beliefs in 2008 and 2009 that economies’ stays in liquidity traps would be very short…and beliefs since then that those who believe will not taste death before, but will live to see exit from the liquidity trap and an outburst of inflation as the Federal Reserve tries and fails at the impossible task of shrinking its balance sheet to normal without inflation–all of these beliefs hinged and hinge on a firm and faithful expectation that this long run is at hand, or is near, or will soon draw near…

“Back in late 2009 I thought that the liquidity-trap short run was likely to be a three-to-five-year phenomenon. It has now been six….The duration of the short run thus looks to me to be, this time, not three to five years but more like ten. Or more. The backward-propagation of the induction-unraveling of the short run under pressure of the healing rays of the long run Omega Point is not just not as strong as Marty Feldstein thought, is not just not as strong as I thought, it is nearly non-existent.”

But to me this does not seem like a surprise. 

I’m not surprised by it partly because I’m pretty ambivalent about the quantity theory of money even as a long run concept, but partly also because I’m still back there with Keynes: when the Omega point is really distant, and the transition to it looks like it’s difficult and uncertain, it is very probably so far away that we will never get there at all.   At least one thing, a tsunami or a new industry or a bout of irrational exuberance or depression, one thing at least will happen to us long before we reach that Omega point, and whatever it is will create a new storm on our ocean, and will shift the Omega point to some new position.  Something will turn the hourglass upside down or knock it on its side, or tumble it end over end down a hill, or break the glass that forms it, or something, and preparing to whirl through the vortex to an imagined Omega point beneath us will do us no good when we’re sitting under a torrent of sand dropping on our heads from above, trying to bury us. 

How likely is it that something will happen to interrupt our trip to the Fabled Economic Long Run?  How stable and certain is the Omega point?  My own view is that unless the Omega point really is “at hand, or near, or will soon draw near”, it’s not very certain at all.  And what’s worse, it’s not uncertain in a way that’s easy to handle: it’s not just subject to some random variation around a long run expected value.  It’s not stochastic.  It’s unknown.   We can prepare for it by gaining strengths that will be useful no matter what the future is.  But we can’t rationally forecast it with a formula.

One example of this that I’ve used often is the World-Wide Web: in 1989 we could not possibly have predicted the dot-com bubble of just a few years later, because there was no dot-com start-up in existence in 1989.  The Internet existed---the capability of sending data between computers.  But there was no HTML, no JAVA, no Visual Basic; there was no such thing as a web app.  There were none of the basic building blocks of modern e-commerce beyond the existence of the network itself.   The creation of the real World Wide Web changed the way business was done, and left any prior vision of a long run Omega point that we might have had in 1989 floundering in the dust.

But that’s a one-time event, right?  Surely that kind of thing doesn’t happen all the time; surely our longer run expectations are more secure in “ordinary” times than they were at that point, on the cusp of a transforming technology, before the first wave of a new and transforming industry.  Right?

Let’s go back through a few decades to see what might have changed the Omega point in each of them.  I’ll mention just what comes quickly to my mind, which means I’ll leave out a vast number of important things that don’t, and I don’t doubt that you’ll experience some frustration with my lists because I’ll leave out the very things that you think were most important.  So just regard my lists as a start, as scratch lists, and feel free to add to them.

Imagine yourself not in 1989 but in 1999 trying to look at the long run, the Omega point over the next decade.  What would you have forecast?

In the following decade, the 2000s, we had two new wars sucking away our national wealth, and the horrific events that preceded those wars.  We had a Presidential election contested up to---and some say decided by---the Supreme Court.  We had the Bush tax cuts early on, an immense housing bubble through much of the middle of the decade, and then the largest financial crisis since the great depression.  We had the Tea Party, sequesters and fiscal cliffs.  On the up side, the iPhone and iPad and all of their competitors hit the market, creating an industry that is still expanding, and after that we not only could order things from abstract stores without walls, we could do it from our hand held computers (our phones) while we sat on a park bench.   Industry insiders may have expected each of those things, but most of us did not.  YouTube, Facebook and Twitter all were founded and blossomed; and even industry insiders did not expect those, because there were no industry insiders in the new industry of social media.  SpaceX was founded in 2002. In 2000 the Federal budget ran a significant surplus…remember that?  Which the CBO projected would continue through the decade and wipe out the Federal debt.   Alan Greenspan, the Ayn Rand acolyte and fiscally conservative Chairman of the Fed, went before Congress to warn them that the budget surplus was far too big, that we were paying off the national debt so fast that it was dangerous to our economic well being, and he then begged Congress to be more fiscally profligate.  Mid-decade we had Hurricane Katrina that trashed New Orleans; in 2010 we had an earthquake that devastated Haiti.  In 2004 there was a tsunami that pushed the Indian Ocean well inland across much of Southeast Asia.  Oh…and of course, a Republican President requested, and Congress enacted, a $700 billion bank bailout, an amount that at the time seemed almost inconceivably huge, and in quick succession after that we elected the first black President in US history, and the new President asked for and received from Congress a $787 billion economic stimulus bill on top of the bank bailout.  He also proposed, and Congress passed, a national health care bill that drove the Republican party to such frothy-lipped distraction that it would repeatedly bring the whole country to the brink of fiscal default by refusing to raise the ceiling on the debt that the CBO, at the start of the decade, had thought would shrink until it vanished. 

How much of that did you predict in 1999?

For the 1990s we’ve already mentioned the emergence of the World Wide Web and the dot-com bubble.  Amazon was founded in 1994.   Web TV, Java, Google, and the first Gulf war.  Clinton was impeached by the House, and then acquitted by the Senate.   The Los Angeles riots in 1992. Did you predict all of that in 1989?  Do you want to argue that those things had no impact on the long run Omega point?

For the 1980s we can point to the emergence of personal computers as a major industry; it had really started in the 1970s, but IBM took it to the big time with the first IBM PC in 1981.  Those of you who are very young can’t begin to understand what a radical transformation that was.  MS Dos emerged; the Apple Macintosh was marketed with the famous Super Bowl ad.  At the end of the seventies there was a widespread fear that rapid inflation was built in to the system in a wage-price spiral, but a deep Fed-induced recession in the very early years of the 1980s killed inflation expectations by driving interest rates through the roof.  Then we had “morning again in America” in the middle years, as soon as the Fed allowed it, and recession again at the end.  In 1982 Israel invaded Lebanon.  Reagan fired 13,000 air traffic controllers, which reputedly so damaged the labor unions in the United States that they have not really recovered since.  Again, those of you who are too young to remember how things were before that event won’t really understand how transforming that act was, and how much it changed the economy we live in.  Congress, with Reagan strong encouragement, reduced the top tax rate from 70% in 1979 to, for a time, 28% in 1986.  Iran-Contra.  Nicaragua.  Oliver North sneaking secret documents out of the OEOB in his secretary’s undergarments, and his potted plant defending him at Congressional hearings.

Back another decade: what would you have predicted looking forward from 1969?  The 1970s ended the Vietnam War in somewhat chaotic fashion; President Richard Nixon was impeached and resigned; in 1973 OPEC imposed an oil embargo that sacked the US economy in many ways.  A Republican President imposed Wage and Price Controls, an almost Marxist intrusion of federal fingers into the operations of private markets.  Crude oil prices rose from under $2 per barrel in 1970 to over $36 per barrel in 1980. $36 per barrel may sound cheap by modern standards, but think what an18-fold increase in the price of oil from its current level would do to our economy now---from the current roughly $60 per barrel to over $1000 per barrel.  Think about that. Do you think that would have no impact on our long run expectations?  Other seventies events: Apple computers, Atari computers, Visicalc,  Ethernet and TCP/IP.  Floppy disks, microprocessors, videocassette recorders, LCD screens.  Word processors.  Pong and the beginning of computer gaming.

Looking forward from 1959?  In the sixties: lord---do we really have to do the sixties???  The riots, the civil rights movement, the anti-war movement---the Vietnam War itself?  The whole suite of New Frontier and Great Society programs, including Medicare and Medicaid?   Leaving the planet Earth, for the first time in history: we had barely left the atmosphere at the beginning of the decade, and by the end we had landed men on the moon.   The event itself has not yet impacted any Omega point, but the process of getting there surely did.  The Civil Rights Act, the Voting Rights Act.  The assassinations of John Kennedy, Robert Kennedy, Martin Luther King, Malcolm X, the Birmingham church bombing, Medger Evers, Chaney, Goodman and Schwerner.  Woodstock and Altemont. 

And the fifties: the Interstate Highway System, the Korean war, the invention of the credit card, radial tires and the transistor radio, Cobol, Fortran and, of course, the births of Barbie and Mr. Potato Head.  Sputnik and the start of the space race.  The House Un-American Activities Committee, and McCarthy in the Senate. 

Forties:  Nazism, Pearl Harbor and all of WWII, the Marshall Plan, the entire south walking out of the Democratic National Convention and forming their own separate States Rights Democratic party.  The beginning of the Cold War.

Thirties: New Deal, WPA, Great Depression, Social Security, the dust bowl, Hoover Dam, the Rural Electrification Administration and the Tennessee Valley Authority, and the publication of Keynes’ General Theory, which created modern macroeconomics, and also created a schism in the economic world that we have not yet resolved.

The point of all this is that if the Omega point is not too far away---if we’re fairly close to long run equilibrium---then its fire will warm us, and we will all react to it, and do our best to prepare for it.  If it’s close it’s powerful on its own as our “long run” destination, but also powerfully affects our short-run behavior, because we really believe in it, we can feel it.  But the farther it is in the future the less likely it is that we will ever get to whatever Omega point is pulling at us. It’s still a valid abstraction.   It is still the direction that the economic fundamentals are now moving us, in some sense.  But if the Omega point is a decade away, if too much has to happen to get us from here to there, then the odds are that a great deal of turbulence will intervene between now and that long run, and by the time it really could be at hand, or near, or soon draw near, by that time the Omega point that pulls at us will not be the one we see now.  By that time the Omega point will have moved to a very different place.  And I think most people can see that, and react as though they can see it.  The distant Omega point does not warm us.  It’s like a fire in another room, or even in another house. 

One quick word about the Quantity Theory and the money supply, and I’ll stop.  There seems to be a great deal of panic in some circles that the Fed has quadrupled the quantity of base money in the years since 2007.  That is the source of Dr. Feldstein’s original bewilderment and DeLong’s comment about the price level being proportional to the monetary base when we at last reach the Omega point.  But lost in this panic is the fact that the monetary base is never stationary: it doubles about every 10 years to accommodate a rising nominal GDP, and has been doing that for many decades.  Yes, the base money supply has quadrupled from its level at the close of 2007, but it’s already been 8 years since then.  The Fed will have to be alert, yes, and be ready to draw that supply down if it becomes necessary.  But as time goes on the amount that will have to be drawn down dwindles.  At that time, the Omega point time that DeLong sees in the future, the Fed’s scramble to “shrink its balance sheet to normal” may not seem impossible at all.  If the Omega point is 12 more years away, the Fed has already accomplished the task: all it has to do is stop expanding, which, in fact, it is doing.  The base money supply has held more or less steady for the last year.

Here’s the truth: the ocean is never ever flat.  There are calmer times and more turbulent times, but it’s never flat.  Even if the general economic models, the Keynesian short run and the classical long run, all capture real trends in our economic lives, and point to some economic destination that results from our policy choices, we can’t believe that ordinary economic actors will rationally treat that long run single-point destination as inevitable.  In fact, to turn that phrase backwards, we can’t think that it would be rational for them to think of it as inevitable, particularly when the process of getting there will take time, and has to leap a few hurdles.  Because, to abuse a phrase, the Omega point is just one damned thing, while real-world economies are one damned thing after another. 

Mobility, politics, parties and Gerson

I have tried before to climb far enough out of my winter doldrums to write here again, and in fact I’ve written a dozen or so comments that I never posted.  For some reason I think I want inspiration---so I wanted, for example, to respond to a fairly recent trend from Brad DeLong claiming, possibly to be controversial, that our national debt is too small for the twenty-first century.  I like the idea of being contrary on this issue, but my response got very abstract, and so I never posted it.  I think now that what I need to do is go back to the real stimulus that prompted most of my prior posts: not vaulting intellect, but plain old-fashioned irritation. 

So I guess I’ll respond to something that irritated me from yesterday’s (Saturday’s) Washington Post op-ed page.  Michael Gerson, probably my favorite Republican columnist, was talking about the two parties’ attitudes toward economic mobility and equality of opportunity.  And in the process I think he managed to trivialize both sides of the debate: his point was that the emergence of economic mobility as a campaign issue is a compromise, of sorts, and that Democrats in general would rather talk about inequality (of final outcome), while Republicans would rather talk about growth.  As he says it:

“When Democrats refer to stalled mobility, they are generally still talking about inequality. When Republicans embrace mobility, they often mean cutting taxes and reducing regulations.”

And he claims that to Democrats,

“the job of helping the poor is inseparable from cutting the 1 percent down to size.”

I’d actually reverse the causality in the first quote, and flatly deny the second.  Because I think this is one of the areas where thinking conservatives and thinking liberals have the same very basic goal, and only differ in how to achieve it. 

I think that when Republicans talk about growth they are really hoping that growth alone will create more opportunity, and more economic mobility.   And if growth is widely distributed, rather than hoarded by the top 10%, they might be right.  (I don’t agree with their belief that the best path to growth is through cutting taxes and reducing regulations, but that’s a different topic…)

And I think that when Democrats complain about inequality, they are most concerned that extreme inequality of wealth and income interferes with mobility and opportunity, which are the ultimate goals. 

I can’t speak for all progressives, but for myself I can say that I really have no big emotional response to the lifestyles of the 0.1%.  To me they are like Lectroids from Planet 10: they inhabiting a separate universe in a parallel dimension, and are unlikely to ever interact much with the rest of us.   I care that most of the income growth of the last 35 years seems to have gravitated toward the top 10% of the population not because of any envy that they have it---why should I care what they have?---but because it leaves the rest of the population with stagnant incomes and declining opportunity. 

And that is the whole of it.   

This isn’t something I just made up in response to Mr. Gerson’s column.  Here’s what I said in this post from over a year ago:

“the path to a more equal distribution of opportunity and more equal reward for work and talent may run through a more equal distribution of income, and … no amount of effort to provide opportunity can compensate for the disadvantage of being born into a poor family in a culture with extreme income inequality.”

Because

“opportunity is neither free nor distributed equally across the population.  Those who begin with high family incomes can buy more of it, for themselves and for their children, than those who do not.”

What I didn’t say in that post is that the marginal value of money spent on opportunity declines pretty rapidly after a certain level is reached: once you have the opportunity to eat and sleep, to go to school and study in relative security, and attend college without crippling the rest of your life under the Kryptonite boulder of student loans, you’ve achieved a very great deal of what money spent on opportunity can buy.  Yes, if your parents are 0.1-percenters, or even 1-percenters, you may be able to buy your way into elite schools and elite jobs, but those are the special opportunities on Planet 10, available only in a distant, alien dimension in the Hamptons.  Let’s start with a wider distribution of just the basic opportunities back here on earth.

Gerson’s advice to Republicans is, at least at the start, exactly right, and it’s his ability to recognize things like this that makes him my favorite Republican columnist.  He says that

“The entry-level commitment for Republicans in this debate is a recognition that equality of opportunity is not a natural state; it is a social and political achievement.”

Yes.  It is a social, political and economic achievement that requires eternal vigilance, and that disappears when it is left unguarded.  It takes a good deal of commitment, and (in this progressive’s view) strong government determined to maintain real opportunity, to achieve what Gerson says is

“America’s most urgent domestic priority: resisting the development of a class-based society in which birth equals destiny.” 

But if the entry level commitment for Republicans is the admission that universal opportunity is something that the culture, and the country, must provide through effort, what is the conversation’s entry-level commitment for Democrats?

I’d suggest that it is the open recognition that the purpose of all of this discussion of income inequality is not to harm the rich, or resent the rich: it is to enable those below the top 10%, particularly the poor; it is to provide everyone with a real opportunity to pursue their own future with hope, and to make sure that everyone has what Elizabeth Warren has been calling a “fighting chance”.

Of course, even if each side can agree to start at their entry-level commitment, and we can agree that we all have a common goal of widespread opportunity, we still can’t hope for political agreement or policy progress.  Because progressives don’t believe for a minute that tax cuts and deregulation, the policies of choice for the last 40 years under both Republicans and Democrats, will get us there; in fact, I would say that if there is a general agreement on anything about economic policy among progressives, it’s that the constant habits of tax cuts for the wealthy and deregulation for businesses are actively harming economic opportunity for the poor by diverting all economic reward upward (and harming economic growth by starving investment in infrastructure, research and education, and much else). 

And conservatives, of course, are true believers in tax cuts and shrinking the government, and will accept no whisper of any other solution to any problem.

A picky, cranky, wonky blog post. Nice cloudy, cool afternoon, though.

I had leave time to burn up at the end of the year, so I’m still home and at my leisure on the Monday after Christmas, looking out my window at a beautiful drizzly gray day   So it’s curious and a little discordant that I’m slightly bugged about something.  And it bugs me that I’m bugged.  And what’s more, it bugs me that being bugged about this bugs me.

I’ve just read a Center on Budget and Policy Priorities report by Dean Baker, part of a more general CBPP discussion on full employment, in which I encountered a use of accounting that I think is just wrong, and for which I’ve chastised others.  To be clear, I agree with almost everything in the Baker paper; I almost always like Dean Baker’s posts and papers.  He’s one of the economists I go to when I find myself adrift and want a quick whack of reality.  And this paper is saying some very basic, very true stuff.  I agree with his premise, which is that the level of employment and the wage rate for workers in the United States would both improve if we could reduce or eliminate our trade deficit.  I agree with his primary conclusions, which are first, that the most direct and best way to do that is to reduce the value of the dollar against the currencies of our trading partners, and second that this is going to be politically difficult to do because there are a lot of vested interests against it.  And I agree even with his secondary conclusion, which is that the most obvious way to counter a large trade-deficit depressant is with a large budget-deficit stimulus.  

But along the way he uses accounting identities in a way that I think is misguided, and that seems to me to imply a misunderstanding of the word “identity”.   I know I have to be wrong about this, because almost every economist alive and most of the smartest economists in history seem to do the same thing that Baker does in this paper.  But the process he uses seems dangerous to me; if it’s accepted it seems to me as though we can prove a lot of things that are completely false, and that can lead us to harmful policy choices.  And for the life of me, I can’t figure out why I’m wrong, and why what he does is reasonable.  Please, if you know where my mistake is, write a comment.  

Here’s what he does that crosses my eyes. (I’m going to write these things so they look like algebra, but what they are really is just columns of figures that are summed---there’s nothing abstract or mysterious here, and nothing terribly mathematical.  This is accounting, not fluid dynamics.)  He lays out the usual absolutely elementary macro equations, starting with the first and foremost, which is precisely table 1 (or more specifically, table 1.1.5) from the National Income and Product Accounts:

(English translation: total national income, Y, is the sum of income from the sale of consumer goods C, the sale of investment goods I, sale of goods and services to the government G, and net export sales, meaning exports minus imports.  In the NIPAs those are all the recognized sources of income---and the result of this sum is generally reported as GDP.)

So far so good.  I like that part.  It’s unassailable.  In fact it should be written like this:

 Which makes it clear that this isn’t an accidental equality, not an equilibrium point that we’re trying to achieve: Y, national income, is defined to be the sum of the incomes received from all sources.  We measure all the variables on the right, and then we calculate Y by adding them up.  I want to emphasize this, because somehow everyone appears to lose sight of this about identities.  These accounts are tables; Y is the thing that appears at the bottom where you write “total”.   (The NIPA table puts it at the top just to confuse everyone.)  So no matter what the values on the right side of this equation do, the equation is always true, because Y is always just the sum of all the other variables.  If all the other variables magically double in an instant, the only result in the accounts is that Y doubles too.  

Having said that, I should hasten to add that there might be real world constraints that make it impossible for all the other variables to double at once; we have limited resources, limited existing plant and equipment, a limited population of workers.  But the constraints are in the world, not in the fact that this is an accounting identity.

Then Baker offers the other half of the equation we all saw the first day of macro-econ class:

Which actually doesn’t directly show up in quite that simplified form anywhere in the NIPAs.  It’s there, but is pretty spread out through the other tables.  I leave the equality sign as it is because this isn’t the definition of income.  It is the definition of something else, but I’ll come to that in a moment.

Then he rearranges these two equations this way:

This follows by simple algebra from the equations above, and it gathers the accounts into groupings that we read about all the time in the news.   The first term in parentheses is the trade surplus, and the last term in parentheses is the government budget surplus; both of these have been significantly negative in recent years, so they’re usually called deficits---the trade deficit and the budget deficit.  But my eyes are already beginning to cross, because it seems to me that this form already implies a bit of misdirection.  Because with this as a basis he tries to show that the X-M term, the trade deficit, somehow pushes around the T-G term, the budget deficit.  Here’s how he starts: 

“Let’s imagine for a moment that…all of the private sector’s savings is devoted to private sector investments.”

Now, why would we imagine such a thing?  More later on this, because this particular imagined equality is a very common motif in economics, and one with a long history, but let’s follow the logic here first.  Clearly he wants to say that the term (S-I) is zero, or at least fixed, so any change in (X-M) must be matched by an identical change in (T-G) in order to maintain this “identity”.  Voila!  The trade deficit creates a corresponding government budget deficit.  

The trouble with this argument is that we don’t get to specify what is fixed and what is not in this accounting equation.  At least not due to the accounting.  Because the second equation up there, the other half of the basic-macro-class lesson, should be written something like this:

and substituting for Y in this, we can restate Baker’s equation above like this:

But the accounts only specify that S will change when the other variables change, not that the other variables must bear any specific relationship to each other.  Because savings is just whatever is left over after all expenditures are taken out of current income.   It’s what you would put at the bottom of the column of figures and call something like “net income” or “residual income”.  The NIPA accounts don’t see it as something we do, or a decision we make, it’s just the final result, the difference.   As far as I can recall without actually looking it up, there are only two kinds of things the NIPAs just define from their internal arithmetic: totals like Y, or residuals like S.  In fact all the totals are some variation of Y (GDP, GNP, NDP, NNP, etc), and all the residuals are some variety of S (corporate retained earnings, household savings, government surplus, etc.)

(A quick aside---notice that in the equation above, income is represented by I, G and X---income from selling investment goods, selling goods and services to the government, and selling goods and services abroad---and the subtractions are only T, taxes, and M, expenditures to sellers outside the country.  Why aren’t other expenditures included?  Because my expenditure is your income: every purchase from a domestic supplier subtracts that income from the purchaser’s account, but adds it to the seller’s account.  Total national savings doesn’t change.)

To be fair, I’m certain that Baker knows all of this very well; better than I do, I’m sure, since he gets to do this stuff all the time, and I can usually only do it in the evenings after work.  He knows that he needs some additional arguments outside the accounts to justify any relationship he asserts between the variables, and he’s careful later to specify that the trade-off between government deficit and trade deficit is implied only if we want to maintain full employment.  But the accounting sleight of hand is there, whether he really believes in it or not, even if he’s just using it as a way to introduce his topic. 

My point is that the belief that the trade and budget deficits are linked may be true, but it can’t be drawn as a conclusion from the accounting equation alone.  This may sound picky, but it matters; if we accept this logical process of using the accounting identity as a forcing economic function as valid then it would be possible to create a claim, from the accounting identity, that any one of the variables is “forcing” a change in any other.  Just fix everything else by assumption, and danged if the variables you have in mind aren’t the only ones that change! For example, let’s go with Baker’s assumption that S-I is fixed, or at least very sticky, and then assume that we’ve passed a balanced budget amendment so that the government deficit is always zero.  Then we have proved, from the accounting identity---haven’t we?---that any change in exports must always and instantly be matched by an exactly equal change in imports, and in the same direction.  If exports increase, then imports, by this logic, would also increase by an identical amount.  How on earth would that happen?  In any short run, I don’t have any idea.  It pretty much violates the usual views of how exports and imports change in the short run; they generally change in opposite directions due to a change in exchange rates.  But if we were allowed to fix everything else in the accounting identity above, it would have to be true.

I said above that this process of thought is dangerous.  Here’s why.  This kind of argument is very familiar; it’s exactly the kind of argument that makes people claim that budget deficits “crowd out” investment due to this same accounting identity.  To make that argument, you would rearrange the terms like this:

Then the “crowding-out” crowd would say, “Let’s imagine that the trade deficit (X-M) is fixed and savings S is fixed---then an increase in the budget deficit (G-T) must come out of investment!  Where else could it come from?  Those are the only two things we are allowing to change.  If all the other variables are fixed, how else can the equality, the identity, be maintained?”

But as I explained above, within the accounting we don’t get to decide what variables are fixed.  If we declare that any are fixed, or that there are relationships among them we have to add behavioral equations or other forces outside the accounting framework to explain those things.  The crowding out argument doesn’t get to say that S is fixed, unless they can show some reason that it should be: as we saw above, within the accounts S is whatever it needs to be to balance the equations; it is just the difference between income and outflow.

And what’s unfortunate in this case is that everything Baker needed to make his argument is in the first equation right at the top.  We have to add a “full employment” level of Y to get there, like this:

Where Y-hat is a fixed goal, full employment income, and to get Y to equality with Y-hat, the other variables have to be prodded into line.  If the trade deficit (X-M) gets “bigger” (more negative, but bigger in absolute value), then one or more of the variables on the right must be made to grow, not because the accounting says so, but in order to satisfy our desire to achieve the fixed Y-hat goal. This is straightforward demand management, which is where Baker was really going.  It’s where he did go, in fact.  But he could have stated that at the outset, and then proceeded to discuss how we could make the other variables cooperate with our goal.  There are alternatives.  For example: we could simply have the government spend more (increase G directly), but we have to take into account what that increase in income from a low Y might do to consumption or investment---as a matter of behavioral response, both of those might depend on total level of income.  Or we could decrease taxes, and depending on how we do that our action might increase investment, or consumption, or both.  

Or we could do what Baker is suggesting: try to lower the value of the dollar, so that we export more and import less, and the increase in net exports helps to push our domestic income toward full employment....

The comment on S=I that I promised will wait until another post.  It’s time to take a walk in the cool afternoon, and start thinking about what to make for dinner.

Plaid butterflies and other political visions

Like all good liberals I’ve been in mourning for the last few days.  I thought I was recovering, but I guess not.   So even though I generally try to stay largely rantless, I’ll allow myself this one rant as therapy.   

“Still in mourning” may not be quite right; it’s more that I’m still very concerned about what may happen in the next few years.  In fact I’m uncomfortable about some of the early things we’re already hearing from the new majority in the Senate---Mitch McConnell saying, for example, that if Obama uses his legal authority as President to do anything sensible about immigration that would be like “waving a red flag in front of a bull” to the newly elected Senators.   I’m shaking my head in utter flabbergastion, if that’s a word: Senator McConnell, what, exactly, has not been a red flag to Republicans over the last 6 years?  Your entire careers have been built on purple-faced rage, spittle-filled bellows and gnashing teeth.  If Obama bent over and kissed your---um, feet---that would be a red flag to you.  Why is it, Mr. McConnell, that Obama always has to please you, whether you win the election in 2010 or 2014, or lose it in 2008 or 2012?  Why do you never have to worry about waving red flags in front of the rest of us, which you do constantly? 

And there was a letter to the editor in the Washington Post yesterday, wondering if this election would mean we could come to some kind of “compromise” on the Keystone XL Pipeline.  What did this letter writer have in mind?  This is basically a binary decision, yes or no.  Build it or don’t.  What does a binary “compromise” look like? Is he suggesting that we build half of the pipeline?   Perhaps we should build segments in alternating states---maybe build the segments through Montana, Nebraska and Oklahoma, and leave out the segments through Texas, Kansas and South Dakota?  Or maybe he’s thinking the Republicans will offer something the Democrats want in return for building the full pipeline.  What is he thinking the Republicans are likely to offer?  My guess is: nothing.  To Republicans, nothing but complete collapse from the other side is acceptable, and real compromise is not an option they will consider. 

Frankly, I do expect the pipeline to be approved.  Obama has been waffling on it for years, which means that he won’t fight against approval when Congress sends that bill to his desk.  So the Post’s letter-writer will get his way: Obama will accept a Republican-style one-sided “compromise” on the pipeline, and get nothing in return.  

Of course what bothers me most is my expectations about what a Congress dominated by modern Republicans will do to the economy, and to government.  I expect them to decimate both.  Their economic beliefs seem to me to be so wrong-headed, so blind, that they will almost inevitably blunder us into a new recession.  The Fed is looking forward to raising interest rates next year, because they expect that we are finally returning to what they think of as a normal, fully employed economy.  I think that would be a little optimistic even if we did not have this group of budget-slashers about to take control of the Senate.  The next round of sequester budget cuts are to be enforced in January, and I expect the Republicans to insist on them---except, of course, for defense spending, where they will want sequester relief.   I expect Obama to accept this “compromise” as well, since his inner heart has always tended toward fiscal hawk, and that dose of austerity will slow what looks like a still meager recovery.   And of course we will face a new round of debt-ceiling negotiations somewhere around next March.  So my hazy expectation is that by the end of next year the steady fall in the unemployment rate may have stalled.   The numbers will still be much better than they were two years ago, so it won’t cause panic.  But by the middle of 2016, after the full impact of a new Republican budget, we may be where Europe is now: stalled completely and facing a possible new recession.   The Fed’s hopes for a “normal” economy, where they can once again use a positive interest rate to restrain corporate investment exuberance in excess of our potential production limits, may be gone.

That’s what I expect, to be honest.  But I may be wrong.  I hope I am.   In 2008 a large number of conservative economists made terrible predictions about what would happen if the Fed continued with monetary stimulus too long, or if we tried a fiscal stimulus.  They predicted soaring interest rates and inflation.  They were wrong, or at least they have been wrong so far, but I believe they were sincere in their beliefs.  Like Yogi Berra said, “predictions are tough, especially about the future.”    And these expectations I have are really no more than mood right now; I haven’t even done so much as a back-of-the-envelope calculation.  We don’t yet know what the Republican budget will really be, so we have no basis for a calculation even as rough as that.

So maybe, hopefully, my predictions are wrong too.  Maybe the recovery is stronger than it seems.  Maybe it’s truly robust, a surging tide that can’t be stopped.  Maybe the new Republican Senate will want real compromise, rather than one-sided collapse from Democrats. Maybe their budget cutting zeal has been sated, at least a little, by sequester and all the rest, and they will pass budgets that actually get things done.  Maybe the whole capital will soar into the blue, blue sky carried by a flock of paisley butterflies.

But it will be entertaining to watch the Senate struggling with the inevitable Ted Cruz bill to repeal Obamacare.  In order to pass it they need 60 votes, unless they eliminate the need for cloture---in effect, eliminate the filibuster in the Senate, by some parliamentary maneuver, for this bill.  But if it’s possible for this majority to do that for this bill, it’s possible for any majority in the future to do it for any bill.  McConnell is not so blind that he can’t see the danger for himself, and for his own party, in that.  At least maybe he’s not.  And maybe he can control Ted Cruz and the rest of the Senate Republicans.

Maybe the butterflies will be plaid.

Malala Cakeonomics

So.  This is supposed to be an economics blog, so I promised to turn yesterday's cake into economics somehow.  What on earth are the economics of cake?  Well, let’s see.  Actually, there are a lot of directions I could go with this, but I think I’ll write about a topic that I’ve been meaning to talk about anyway: the problems with GDP as a measure of economic production.  These are all well known, but they get buried in the political fluff that passes for front-page news these days, and even economists generally just dismiss them and continue to uncritically treat GDP as the whole truth in discussions.  I do it too.  And GDP is the best measure we have.  But it’s wrong, or at least incomplete.  So how do we get to that from cake?

To start with, we need to notice that the cake we’re talking about is not just cake, but cake made from scratch at home.  That gives us an excuse to get into the issue household non-market production  by observing that rather than buy a cake ready-made, I produced a cake from raw materials that I bought from a relevant input supply vendor---that is, from a grocery store.  We could notice that a huge fraction of the production of any nation takes place like this, by households buying raw materials and performing the final production tasks themselves, and that production inside the household, which is really the basics of everyday life, never shows up in the GDP.  How much this matters is hard to measure; here’s a Bureau of Economic Analysis (BEA) study on it that reports on a number of different attempted measures of household production in the United States, and finds that the estimated value of that household production is somewhere between 12% and 58% as high as the measured value of market based GDP (see section 8, particularly the top of p.9).  That's a lot:  GDP is around $17.5 trillion this year.  The lower figure is what we get if work in the house is valued at the minimum wage; the higher figure is what we get if household work is valued at the average hourly wage of professionals doing the same kind of work---in the case of my cake, for example, chefs or professional bakers.  But in either case, that means that the measured GDP that’s reported in the newspapers is actually pretty far off from the real total product of our nation.  And having observed that fact, we could take one more step and observe that not only GDP but also measures of economic growth are impacted by this, because some measured economic growth might result from simply moving existing production from households into the market economy: the same amount of production takes place, but what used to be invisible is suddenly revealed to the National Income and Product Accounts.  That’s what would have happened if I had gone out to buy a cake on the market instead of making one at home. 

The proportion of total production that takes place within households, rather than in the market, varies widely across cultures and countries, which is one reason you might want to take strange statements like “the average Ziltonian peasant lives on $3 a year”, or whatever, with a very, very big grain---maybe a boulder---of salt.  What it really means is that the average Ziltonian peasant lives almost entirely outside the market economy: he hunts, farms, gathers, builds, makes his own tools, cooks and so on without buying much of anything from a store.

And that’s just the economics of what did happen.  But here’s something that could have happened but, in my house in this instance, didn’t.   As an inexperienced cake maker, I could have made some horrible mistake.  I could have gotten my tie tangled in the egg beater, and in the resulting chaos of physics ended up with an injury that induced a trip to the emergency room.  Or I could have forgotten the cake until my smoke alarm alerted the local fire department, and caused them to send fire trucks to my house.  Or I could have actually started a fire that burned down my house with all that’s in it.  In every one of these cases the GDP would record the response from the market---my treatment at the emergency room, the construction of a new house, the cost of sending a fire truck and all manner of emergency responders to my house---as a positive thing, an increase in the GDP.  They are all things the market did, products the market provided.  But none of the losses would have shown up in the GDP at all.  Think about that a bit: wherever there is destruction, the GDP records the replacement of whatever was lost, but does not deduct the loss itself.  A hurricane, a volcano, even an accident on the highway, all add to the GDP.  But they aren’t the kind of thing we think of as an improvement in our lives.

I have a book to recommend on this if you’re interested in the topic: Mis-Measuring our Lives, edited by Joseph Stiglitz, Amartya Sen and Jean-Paul Fitoussi, with a introduction by Nicolas Sarkozy---yep, that’s right, the former President of France.  Here’s a quote from that introduction:

“We have wound up mistaking our representations of wealth for the wealth itself, and our representations of reality for the reality itself…We have built a cult of data, and are now enclosed within.”

It’s a little overstated, perhaps, but he’s a politician and should be forgiven for drama.  It’s basically true.  And it’s good to constantly keep in mind not just that our data misrepresents reality, but how: that among other flaws with the GDP is the flaw that omits our “leisure” time (the time we spend pursuing our own goals, or with friends or family), our household work, our hobbies; these are simply not counted, but they are important parts of our real economic product.  And the repair of our disasters are counted as adding to economic good, rather than simply restoring what was lost.  And finally, a corollary of the last point, is that damage that is done and never repaired---like environmental damage from smokestacks or car exhaust---are never subtracted from the value of the market processes that produce them. 

Ok.  Finally, I can’t ignore this.  I know this recipe is not just homemade cake, it’s homemade Malala cake, and the issue she’s known for is not the household production function, but women’s right to education. So in keeping, perhaps, with Ms. Yousafzai’s focus on women, I should point out that a very big fraction of household production is performed by women---how big varies across countries and cultures and is just as hard to measure, and for the same reasons, as the total amount of household production, but at least in the United States two-thirds seems like a reasonable first rough guess from Table 2 of the BEA study linked above.

On the issue of women’s education, or more generally, gender differences in education around the world---that would take a book to explore, not a blog post, and it’s not a topic on which I have any expertise at all.  I’ll leave the explanation of that topic to Malala.  But here’s a starter book: the UNESCO Atlas of Gender Equality in Education.  This is a very accessible book, mostly graphics showing various comparisons, and the problems it depicts are not always those faced by young women: some are problems faced by young men.  From the book:

“An important theme is that although girls are still disadvantaged in terms of access to education in many countries and regions, they tend to persist and perform at higher rates than boys once they do make it into the education system. Another theme is that all countries face gender equality issues of some sort, including situations where boys are disadvantaged in one way or another.”

Why is this education issue in an economics blog?  Well, because it’s my blog and I can put whatever I want in it.  But it shouldn’t take a lot of thought to realize that any nation that simply refuses to educate a significant part of its population, or mis-educates them, or damages their ability to learn by pushing them into classrooms that don’t suit their natures or capabilities, or educates them and then under-employs that education---any nation that does those things is seriously hampering its prospects for economic growth. 

But that’s a blog post for another day.