Macro Theories

Strangely enough for something which has long been characterised as a dismal profession, there are quite a few jokes and wry observations which originate with economists or economic historians, and more which have been enjoyed by them. Many of these observations have a ring of truth about them. One I like is adapted from psychiatry; economics has physics envy.

 That is to say, economists have often been characterised as people who would like to be like physicists, with ‘laws’ like those of Thermodynamics, and verifiable Bolzmann constants and so forth. Some economists have taken this approach further and have embraced Quantum economics, claiming, like Paul Ormerod, that this is a helpful perspective from which to try to understand money. People who are this certain about economics often end up so entangled in their own theories and arguments, and so disassociated from the world, that one wonders if they have any understanding of physics at all.

 

These circumstances are somewhat enhanced by the way in which almost every economics course in western universities, and those which are like them elsewhere, present economics as essentially a mathematical scheme based on the calculus and the measurement or prediction of change. A second stream is associated with probabilistic analysis and statistics, which in themselves are open to abuse.

 

I am going on about this because you need to understand this to understand the appearance of the major theory in academic economics, which is that collection of ideas associated with John Maynard Keynes. Keynes himself, as is often the case, was far less certain about things than those who came after him and who operated in his name, and he would have said that he had an humane approach, rooted in human nature and not maths. He did, after all, refer to ‘animal spirits.’ Yet his model is one in which a closed system in which income is a little like energy flows in a circular fashion and is neither created nor destroyed.

 

There are alternatives to Keynes, in particular those which go under the label of ‘supply side’ economics, and those which are monetarist. Such policies, which have very strong arguments in their favour, emerged from a variety of Austrian and American ideas, and are associated with people such as Friedrich Hayek, Ludwig Von Mises, Carl Menger, Milton Friedman, Friedrich von Wieser, Gary Becker, and Robert Lucas. I’ll deal with them in other podcasts.

 

Keynesians ask those who wish to understand the economy to start from a simple model. It posits a very basic economy. In that economy, there are only two categories of social organisation; households and firms. A firm provides employment and income to households via output. An household provides labour and consumption to firms. Therefore, all output should be reflected in income, which should be equal to consumption. In the simple Keynesian economy, output equals income and income equals consumption and, therefore, consumption equals output. Income flows in a circular fashion.

 

This is neat, in its way, but an absurd simplification, as Keynesians recognise. So they then posit a set of ‘injections’ and leakages, or withdrawals, in the simple economy. Things can obviously be withdrawn from the circular flow. Taxes come out, for instance, and go to the government. Savings come out, and are kept away from consumption by definition. Should our simple economy be trading with others, imports are paid for with money from within the economy, which therefore goes out.

 

An economy which was only experiencing leakages would of course collapse. So in the more complicated model of the economy, Keynesians point to the things which go into the economy. These can be crudely thought of as balancing the things going out. Thus, Savings can be taken out, but investment by banks and individuals can go in. Taxes can come out, but government spending can go in. Import payments go out, but the economy could sell exports, and bring money back in. If all these things balance in the aggregate, then nothing has been lost, and nothing has been gained.

 

This new, more complicated version of the economy can now both be subjected to mathematical interpretations of Aggregate Demand and Aggregate Supply, and compared to the real world. It is a less crude map, according to Keynesians, than that which we started with

 

Before I go on, I would like just to draw your attention to this idea of Aggregate Demand and Aggregate Supply. These add up all the markets and all the demand and all the supply in the economy. Those who are not Keynesians are very suspicious of this. The figures are based on National Income statistics, which were invented in Sweden in the 1920s, and which produce numbers like Gross Domestic Product, or Gross National Product, or Factor costs, or productivity, or things like that.

 

The numbers are largely based on tax returns, government surveys, and statistical exercises, but they have their own biases and, in the past, have only been as good as the way they were collected and the assumptions about their use. Otherwise sensible people sometimes worship these numbers and think them precise and correct. This is somewhat foolish. They are often quite flawed.

 

When Keynesians, armed with their new assumptions about output and income and leakages and withdrawals move to try to produce a diagram of the economy to illustrate their theory, they often turn to two famous ones. One is the AD-AS diagram that you will be familiar with. It is made up of a line showing AS and a line showing AD. AS looks like a letter L that someone has pushed onto its back. AD usually slopes downward from left to right, crossing the L at some point. The axes are labelled ‘real GDP’ on the bottom, and ‘price level’ on the side.

 

Think about that diagram for a minute. It is a very odd, simplified depiction of a complex situation.

For instance, the AS curve is largely flat across a reasonable amount of GDP, then moves upwards. This is because it represents available supply, and assumes that the machines and industries used to make that start at a certain level of capital, exhaust that, and then hit a ‘wall’ until new investment adds to capacity.

This is very simplified, and perhaps reflects the way that Keynesianism evolved in industrial countries which did not have access to very fast mobility of capital and cheap labour abroad, or to technology to re-tool. It also fits into a world-view in which demand in a sense creates supply which then hits capacity barriers requiring some sort of market management—a contradiction of an older idea, called the ‘Law of Markets’ or ‘Say’s Law.’

The second notable thing is that the only thing which can move and be manipulated on the diagram is aggregate demand. This fits with the general feeling of Keynesians that AD could be managed. They think that AD is made up of consumption plus investment plus net government spending plus investment plus net exports; C+I+G+X-M.

This exposes another odd feature of the diagram. The diagram is necessarily two-dimensional. It has to fit into papers and textbooks, obviously. Yet it depicts a situation which really exists in four dimensions. In macroeconomics, aggregate demand and supply are intimately connected.

Students are always told in microeconomics never to say that demand affects supply, or that supply affects demand. This is true. In microeconomics, one is looking at individual markets, and doesn’t know where the demand or supply have come from, just how they interact and the individual influences on them.

Secondly, economic diagrams are photographs, not videos. They do not show the dynamic passage of time easily or at all. Over time, supply and demand in the aggregate do very much adapt to each other.

So the danger of the AD-AS diagram is that it gives a false sense of assurance, and of control, which of course appealed to politicians who wanted to believe that their use of fiscal policy could ‘fine tune’ the economy, as though it was an engine. There is an analogy to the twentieth century idea that the mind was a kind of computer which could be adapted, altered, or fixed, by psychiatry, drugs, and brain surgery.

I mentioned earlier a second Keynesian diagram that fits into this view. That is the one which you will have encountered known as the 45 degree line.

That diagram attempts to show why the AD-AS diagram looks the way it does and is normally drawn beneath it.

Part of the reason for this diagram existing was that Keynes himself wanted to show that the market tended to imbalance. Although he did agree with Say that this imbalance, based on a cycle of overproduction and debt, did exist, he thought that it was needless prolonged and that governments could intervene to fix it. On the forty-five degree diagram, he tried to show that real life was different from projection. If you projected a line in a closed system showing how income and output were related, it would go up at a 45 degree angle.

However, AD doesn’t work like that. AD starts at a minimum level of consumption and government spending to provide for basic needs, public and merit goods, and basic investment, exports and imports. So it isn’t a forty five degree line. Plot this consumption function, as the line is called, it over such a forty five degree line, and the intersection is ‘macroeconomic equilibrium.’ If the diagram is drawn beneath the AD-AS diagram, then a line up from that point will show where AD and AS meet. The lower ‘gap’ between the consumption function, and the 45 degree line will represent borrowing; the gap after equilibrium will be saving.

Keynes thought that the economy, even though it always grew over time, would go up and down in booms and busts (he called them positive and negative output gaps). These were driven by reactions to too much production, and too much consumption, or to unemployment and a lack of demand creating low prices and cheap exports. Keynes therefore thought that Governments should manipulate AD to keep it at equilibrium or just above. This would lead to more investment, which would lead by definition to more AS, which was growth.

 

Keynes’s theories didn’t discount a world economy. He grew up, after all, in the British Empire, which was a very globalised but economically stable space, and lived through the 1920s and 30s.  However, he thought that the job of governments was to stabilise their own economies, and to create a stable but flexible world order that held the tendency for boom and bust in check. He achieved this through the Bretton Woods system, and the idea of a system of limited protectionism. I’ll talk about this in another podcast. What it is important for you to remember is, Keynes wanted AD managed; he saw AS, and monetary policy, as largely passive and reactive; he believed that governments could use fiscal, trade, and exchange rate policy to manipulate the economy; and, by definition, he wasn’t too worried about inflation.

 

What Keynes and his followers were worried about was unemployment and a lack of AD. They thought consumption came mostly from income, and income from jobs (not unreasonably.) Therefore, a downturn would make itself worse if a panic or a collapse created extensive unemployment, and also if there was not a safety net of welfare to keep people’s consumption at some basic level. Thought the market might fix this, letting it do so over a longer period of time than necessary was outrageous, and, as Keynes quipped, in the Long Run we are all dead anyway.

 

This is why Keynesian economists came up with ideas like the Phillips Curve—of which more later—and managed currencies, and why they were so keen on social democratic politics and governments that managed demand to stop unemployment in a bust, and excessive spending in a boom through higher taxes. They also thought that any injection or leakage into the economy would be multiplied according to how much people spent—the multiplier model—and accelerated by a link between consumption and investment called the accelerator. More of those later too.

 

Politicians and others periodically condemn Keynesians as out of date, or misinformed, or unaware of the disciplines of the market or too dismissive of business. However, Keynesian ideas also, periodically, appeal to electorates. We have been lucky, in some senses, not have experienced one of the big depressions that took place every fifty years or so after the 1830s recently (though we may, if prediction is any guide, be due for one in the 2020s). If we had one, great Keynesian schemes like road, rail and airport building, moon shots, and huge engineering projects, along with an emphasis on welfare schemes, might quickly come around again.