In Condemnation of One-Equation Economics

I really don't like one-equation economics.

One-equation economics assumes that certain economic quantities are fixed in stone, examines one equation--usually an accounting identity--and concludes that somebody else's preferred policies will be ineffective and counterproductive. It does so by ignoring the fact that one of the aims or effects of the somebody else's policies will be to change the values of the economic quantities that are--by assumption and only by assumption--claimed to be fixed in stone.

Here's Stanford's Michael Spence. The one equation is the international savings-investment identity. The quantities assumed fixed are domestic saving and investment:

We Are All in It Together - WSJ.com: [I]t would be useful if we stopped pretending or alleging that China's exchange-rate policies are the root cause of our trade deficit.

If our savings rate is stubbornly stuck below our investment rate, and if China does allow its currency to revalue over time, then we will simply run a deficit with another collection of countries, and from a domestic point of view, nothing much will have changed. Except that we won't have this subject to discuss with China anymore.

"If our savings rate is stubbornly stuck below our investment rate." If. If. If. As Michael Mussa likes to say in these circumstances: if my grandmother had wheels, she would be a bus.

If China's central bank ceases buying its $200 billion a year of dollar denominated assets, and if nothing shocks the behavior of other central bank or collection of private foreigners, two things will happen: (1) the value of the value of the dollar will fall, and (2) U.S. interest rates will rise. The fall in the value of the dollar will boost U.S. exports and diminish U.S. imports, and the trade deficit will shrink. And--as long as the Federal Reserve is successful in avoiding recession--the rise in interest rates will reduce investment inside the United States and also lower asset values, which will make homeowners and investors feel poorer and increase their savings. It will thus reduce the gap between savings and investment, and so diminish the capital inflow.

Only if investment is stubbornly unresponsive to changes in the price of hiring capital and if savings is stubbornly unresponsive to housing and financial market wealth will Spence's "if" be true. But does Spence argue that investment is unresponsive? Does he argue that savings are unresponsive? Does he argue that there will be some other shock to the economy--that, for example, the Federal Reserve will fail to maintain full employment and thus that savings will fall because of recessions? No. He says "if." And he only says "if."

Now Mike Spence might argue that the Wall Street Journal does not give him much space, and that even if the Wall Street Journal gave him more space his readers would not give him more time. He might argue that he has to compress and simplify his argument: make it "clearer than truth." He might say that he is not a philosopher discoursing to fellow philosophers walking outside in the sunlight, but rather addressing the ignorant chained in the underground cave, and that it is his job to cast shadows on the wall that will lead those chained underground to support the policies they would support if they could understand the issues, if they were philosophers strolling in the sunlight.

And, Spence might say, it is his job to use whatever means are necessary to keep his readers from supporting destructive policies. He has to cast a shadow on the wall of the cave to get them thinking that tariffs and quotas on imports from China are not a way to reduce America's trade deficit and boost overall fand manufacturing employment.

Point taken: whatever effects (and there would be some) tariffs and quotas on imports from China would have on the level and distribution of employment in the U.S. would be accompanied by much more destructive blowback consequences. Tariffs and and quotas on imports from China are not a good idea. Getting China to boost consumption and domestic absorption would be a good idea. Closing the U.S. budget deficit would be a good idea. Boosting U.S. private savings would be a good idea. But doing none of those and doing tariffs and quotas instead? Not a good idea.

However, lowering the level of the debate by asserting that the Chinese government's purchase of $200 billion a year of dollar-denominated bonds doesn't affect the U.S. trade balance--that is not a good idea either. Those of us who walk outside in the sunlight and see reality as it is have a moral responsibility to bring others out of the cave: to raise the level of the debate, rather than to focus on casting handshadows that ultimately cannot but mislead.

---

UPDATE: Greg Mankiw compliments Michael Spence's one-equation international economics:

Greg Mankiw's Blog: Spence on the Trade Deficit: Economist Michael Spence (erstwhile Harvard prof) has a nice piece on the U.S. trade deficit and the Chinese exchange rate in today's Wall Street Journal. His bottom line:it would be useful if we stopped pretending or alleging that China's exchange-rate policies are the root cause of our trade deficit. If our savings rate is stubbornly stuck below our investment rate, and if China does allow its currency to revalue over time, then we will simply run a deficit with another collection of countries, and from a domestic point of view, nothing much will have changed. Except that we won't have this subject to discuss with China anymore.

The linkage among saving, investment, and the trade deficit is a topic that will feature prominently in ec 10 this spring.

Comments

[RT]

Now while Mankiw is often wrongheaded (hence his Bush service), he's not stupid, right?

Right?

[bigTom]

Well, taken as a discussion of one important factor -the fact that savings below investment means that to balance the accounts out, we necessarily import more than we export, his point is an important one missed by most of the public. I.e. as long as our national consumption is greater than our output, we will be running trade deficits. The simply minded thinking of most of the public is we are losing jobs because of predatory economic policies of our trading partners is pretty dangerous. I read that for the first time ever world economic growth has been 5% for a sustained period of five years. Globalization would seem to be working, i.e. its lifting lots of poor foreigners out of poverty. Of course it puts a real strain on middle class wages in the advanced economies.
So to get back toward to original topic, the fact that the average US resident is running a deficit, through increasing personal debt, as well as government debt is surely a large part of our trade deficit/ loss of jobs problems. Like all simple minded models, once the point is made we need to move on.

[Jon Fernquest]

"...the Chinese government's purchase of $200 billion a year of dollar-denominated bonds"

Insofar as this keeps the RMB from appreciating isn't this an export driven growth strategy?

In the same vein as South Korea's during the Cold War Era South Korea.

Casting blame: If our "savings rate is stubbornly stuck below our investment rate" then how collectively can all the savers change that? Is it just some big intractable cultural difference between Asia and the US?

Reducing the deficit (or at least reducing its rate of increase) but other than this how can government policy change collective behaviour?

Isn't China's US government bond buying a form of concentrated collective action that is supported by capital control laws and government policy?

[GeorgeNYC]

I simply do not understand the analysis. "If only we could raise our saings rate...." Well, "if only we could lower or gasoline consumption..." why that would solve this pesky energy crisis. If only we could just raise everyone's income's equally, that would solve this whole "inequality" thing. What on earth does that have to do with economics? Sounds like just wishful thinking tarted up to look like "analysis."

The question to ask is "why on earth are the Chinese so gung ho on American Treasury Bond and agency paper?" If the answer is "because they are such gosh darn good investments that match the profile they need" well OK then. We are just the beneficiaries of a harmonious cross-border investment equilibrium. If it is really any other answer then it is manipulation pure and simple.

Unfortunately I think that intentions here are important. We are dealing with a governmnet not a private individual. The usual investment "prudence" does not necessarily apply. They may fully believe that ultimately this will all become worthless paper but they need to keep buying dollars because they know the economic impact it has on exports. They are politicians, not investors. They would just as soon burn the whole pile of paper if they thought there was a political advantage to it.

I am not saying that this is the case. But, unlike a private investor who, at some level, you can expect will be following his/her interest to increase wealth, the goals of a government are not necessarily that clear.

[Sandwichman]

"One equation economics" sounds to me like a fancy name for the lump-of-labour type of fallacy. This is a pitfall that is intrinsic to all economic reasoning. It is simply not possible to say anything definitive about economics without making some fixed assumptions, the most common of which consist of the assumption that an adversary's assumptions are more fixed than one's own!

[larry birnbam]

You can have as many equations as you want. When it comes time to apply them to reality, context matters.

[andres]

"One-equation economics assumes that certain economic quantities are fixed in stone, examines one equation--usually an accounting identity--and concludes that somebody else's preferred policies will be ineffective and counterproductive. It does so by ignoring the fact that one of the aims or effects of the somebody else's policies will be to change the values of the economic quantities that are--by assumption and only by assumption--claimed to be fixed in stone."

Wonderful. I agree with Brad's sentiment wholeheartedly, but he's rather late to the party. In particular, I wonder where Brad was when Joe Stiglitz was being declared a vile heretic (by Rudi Dornbusch, Ken Rogoff and others) for making exactly the same criticism of IMF programs for developing countries which got into debt trouble, eg the Asian crisis.

For non-economists, the IMF approach is based on the accounting identity:

(Sp - I) + (T - G) = X - IM

where Sp is private saving, I is investment, T is tax revenues net of transfers, G is government consumption, X is exports, and IM is imports. The IMF assumes that in order to service debt obligations by increasing X - IM, governments need to increase public saving by increasing T and reducing G.

Problems:

(1) Sp and I are assumed to be fixed, but they aren't. In fact, they often move in the same direction as (T - G): government contraction leads to reduced spending, lower capacity and a fall in I and an increase in Sp, especially if deflation sets in. Of course, this backlash may end up reducing T, thus making it more difficult to meet fiscal balance targets even if a recession leads the trade balance to improve.

(2) Internal balance ie, the equation C + I + G + (EX - IM) = aggregate supply is ignored, resulting in IMF programs often (though not always) leading to a sharp fall in total spending and output. The IMF brushes the second equation aside by saying that renewed capital flows will eventually lead to a resurgence in I, but this doesn't happen by default, especially if (a) the borrower country defaults and foreign lenders refuse to renegotiate, or (b) the recession is followed by a political turnover, or (c) contagion effects lead foreign capital to reduce its exposure to the region for the indefinite future.

(3) The distributional effects of IMF programs (through higher interest rates, reduced government spending, de-indexation that causes wages increases to fall behind inflation) are also ignored, leading to a situation in which future aggregate demand becomes more precarious and much more dependent on exports and investment rather than consumption.

Macroeconomics as a science has a long way to go before many of its practitioners become disillusioned with one-equation obsessions, alas.

[anne]

http://www.aeaweb.org/annual_mtg_papers/2007/0106_1640_0101.pdf

The Missing Motivation in Macroeconomics, By George A. Akerlof

ABSTRACT

The discovery of five neutralities surprised the economics profession and forced the re-thinking of macroeconomic theory. Those neutralities are: the independence of consumption and current income (given wealth); the independence of investment and finance decisions (the Modigliani-Miller theorem); inflation stability only at the natural rate of unemployment; the ineffectiveness of macro stabilization policy with rational expectations; and Ricardian equivalence. However, each of these surprise results occurs because of missing motivation. The neutralities no longer occur if decision makers have natural norms for how they should behave. This lecture suggests a new agenda for macroeconomics with inclusion of those norms.

[Here then we find George Akerlof re-defining macroeconomics at the current meeting in Chicago.]

[anne]

http://www.nytimes.com/2007/01/06/business/06econ.html

January 6, 2007

Encouraging More Reality in Economics
By LOUIS UCHITELLE

CHICAGO — The annual meeting of the American Economic Association, which opened here on Friday, is usually a pretty esoteric affair.

But this year it could resonate much more broadly as the departing president of the organization, which represents most of the nation's academic economists, tries to push prevailing economic theory further away from the free market approach that has generally held sway for the last four decades.

The protagonist in this drama is George A. Akerlof, a Nobel laureate, who is using the same platform that the late Milton Friedman adopted in 1968. As president of the A.E.A. back then, Friedman laid out new theoretical justifications for a market system that he argued performs most favorably for nearly everyone when the government avoids tinkering with its operation.

The hundreds of economists who listened that day to Mr. Friedman's memorable speech did not immediately embrace his ideas. Keynesian economics, with a big role for government, still held sway.

But over time the Friedman approach took hold, eventually having profound effects on politics and government policy far beyond the ivory tower. This was partly because of Mr. Friedman's insistent, larger-than-life personality, and partly because Keynesian economics failed to adequately explain and respond to the simultaneous outbreak of higher inflation and rising unemployment that emerged in the 1970s.

Mr. Akerlof's style, in contrast, is more diffident and modest. But he has already contributed significantly to a revamping of the economic theory that Mr. Friedman championed. Now, at 66, he is hoping to spread that debate by taking on some of the profession's most sacred cows.

And he is doing so at the moment when income inequality, more concentrated wealth and upheavals from expanded globalization are straining faith in a relatively unfettered market system.

"I am trying to effect a return to sensible economics," Mr. Akerlof said in an interview. "And what is sensible economics? It is very pragmatic. You think about problems in the world and you ask: can government do something about that? At the same time, you maintain your skepticism that government is often inefficient." ...

[david]

From the same article:
"What Mr. Akerlof sees as missing content, Mark Gertler, a New York University economist, describes as “frictions” that distort accurate theory.

“What Akerlof is doing is stepping out of line,” said Mr. Gertler, who did research with Ben S. Bernanke before Mr. Bernanke became chairman of the Federal Reserve. “A lot of people are correctly taking rational behavior as a baseline and are adding frictions, such as constraints on borrowing, that can lead to temporarily inefficient markets.”

I have no idea how someone could believe what this seems to say Gertler believes.

[anne]

Andres and David:

Nicely added, and you have brought us round to the argument between Michael Spence and Brad DeLong. I expect the argument about one-equation economics will continue for years, but the failure of development economists to understand chronic disappointments in development tell me that DeLong and Akerlof are correct.

[gordon]

No doubt a blog is as constraining as the editors of the NYT, and nobody can keep more than a very few balls in the air at one time, but I would like to insert a query on the conventional idea of investment. Brad deLong says "Only if investment is stubbornly unresponsive to changes in the price of hiring capital..." , but what counts as investment? We are presently re-running the 1980s mania for essentially unsecured lending, with a large proportion of private equity securities rated as "junk". Much of this money is being used (1980s again) to fund M&A activity. When they talk about investment, maybe it is time for economists to be a bit more discriminating about what sorts of investment they mean, and what the effects of investment on the productive economy actually are.

[Jon Fernquest]

"...We are presently re-running the 1980s mania for essentially unsecured lending, with a large proportion of private equity securities rated as 'junk'. Much of this money is being used (1980s again) to fund M&A activity."

Perhaps the most critical question is when the big man in the sky is going to hit purge cycle on the washing machine at which time a large fraction of the financial community once again loses their job and sells their Ferrari and **we enter another cycle of collective amnesia and forgetting** except for the fond memories of the Ferrari.

Markets might be smart at microscopic levels but at macroscopic levels don't they just take a myopic random walk through stubborn social space? arrogantly bumping into walls, insisting they're not walls, falling over all o'er the place, slipping off unconscious in one's own muck instead of socializing with other street dwellers (aka "interdisciplinary collaboration").

Hopefully Akerlof will save'em from 'emselves giv'em a buck and send'em on a bus back to wife and kids.

[walkingtheline]

Any economic theory makes problematic assumptions. What is the problem here?

Spence and Mankiw are doing the right thing in critizing those who would blame the lender for the problems of the borrower. Those who see the Chinese trade surplus as a threat and want to eliminate it through inflation in China should be working to bring down the US budget deficit and stop issuing so many Treasury bonds.

Spence and Mankiw are indirectly (and appropriately) critizing the President and the former Congress for their prodigal and spendthrift ways. They should be encouraged to do so, especially since the other right wing approach to this issue is to engage in xenophobic blame passing which has negative consequences for US-China relations, global economic growth, human rights and more.

[Ponzi Q. Globalization]

"Spence and Mankiw are doing the right thing in critizing those who would blame the lender for the problems of the borrower."

Agreed. Why should the leaders of China be blamed for transferring 21st century production from America to their nation's shores? This is a strategy that will pay off in terms of real power in the world. By real power I mean the ability to inflict suffering on others if they don't do what you want.

The hardest part of the strategy may be placating or scaring a large enough percentage of their population so that their position isn't threatened.

It's the myopia of the American intellectual elite and short-term greed of the American business and political elite that is blameworthy.

[David Graves]

Brad Setser over at Roubini Global Economics www.rgemonitor.com/blog/setser/ thinks that in addition to whatever one makes of this discussion, Spence flat got his facts wrong.

[kevin quinn]

How about two equations? Spence seems to be assuming a small open economy. The US is a large open economy. US demand for funds (I-S) is a negative function of the (world) interest rate. Foreign supply of funds is a postive function. A decrease in Chinese demand for our assets is a backward shift in the foreign supply of funds, leading to a higher interest rate and a lower equilibrium level of US I-S, and thus a lower trade deficit. Am I missing something?

[No. You're not missing anything. But Spence assumes that both domestic savings and domestic investment are unresponsive to interest rates and to wealth.]