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Behavioral Relationships, Equilibrium Conditions, Accounting Identities...

it turns out in economics to be remarkably hard for lots of people to distinguish between:

  • behavioral relationships--things that tell you how people will change their behavior to respond to changes in the economic environment and economic policy;

  • equilibrium conditions--things that tell you what configurations of the economic environment are consistent and are not rapidly-changing out-of-equilibrium phenomena seen for an eyeblink of time, if that long; and

  • accounting identities--things true by the metaphysical necessity of the definitions that are devoid of interesting substantive implications.

Mark Thoma tells us to look at Noah Smith on this, and related intellectual no-nos. And Paul Krugman chimes in:

Mistaken Identities: Via Mark Thoma, Noah Smith* has a terrific piece on how to argue with economists. All the points are good, but I’d like to focus on Principle 4, “Argument by accounting identity almost never works.”

What he’s referring to… is arguments like “since savings equals investment, fiscal stimulus can’t affect overall spending”, or “since the current account balance is equal to the difference between domestic saving and domestic investment, exchange rates can’t affect trade”. The first argument is, more or less, Say’s Law and/or the Treasury view. The second argument is what John Williamson called the doctrine of immaculate transfer.

Why are such arguments so misleading?… [L]et me put in a further word…. [E]conomic explanations… have to involve micromotives and macrobehavior… describing how the actions of individuals, driven by individual motives… add up to interesting behavior at the aggregate level.

And the key point is that individuals in general neither know nor care about aggregate accounting identities…. [I]f you want to claim that a rise in savings translates directly into a fall in the trade deficit, without any depreciation of the currency, you have to tell me how that rise in savings induces domestic consumers to buy fewer foreign goods, or foreign consumers to buy more domestic goods. Don’t tell me about how the identity must hold, tell me about the mechanism that induces the individual decisions that make it hold…. [O]nce you do that, you realize that something else has to be happening — a slump in the economy, a depreciation of the real exchange rate, it depends on the circumstances, but it can’t be immaculate, with nothing moving to enforce the identity.

When it comes to confusions about the macro implications of S=I, again the question is how the identity gets reflected in individual motives — is it via the interest rate, via changes in GDP, or what?

Accounting identities… inform your stories about how people behave, [they do] not act as a substitute for behavioral analysis.

Indeed.

You use the behavioral relationships to understand how people will act in the economic environment.

You then check the equilibrium conditions to see, given economic policy and the economic environment, which configurations of the economy are self-consistent equilibria.

You use accounting identities as part of the paperwork to keep track of what the behavioral relationships and equilibrium conditions are.

You don't base explanations on them. You don't say, as Eugene Fama does, that "when new savings are used to buy government bonds, the people who sold the bonds must do something with the proceeds. In the end, the new savings have to work their way through to new private investment…" and think that you have made an argument. You don't say, as John Cochrane does, that "if the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of “crowding out” is just accounting, and doesn't rest on any perceptions or behavioral assumptions…" and think that you have made an argument. At least, you don't if you know what you are talking about.


UPDATE: The thoughtful David Glasner points out that it's not (or not all) Cochrane's and Fama's fault:

Why Am I Arguing with Scott Sumner? « Uneasy Money: When Scott says he can derive a substantive result about the magnitude of the balanced-budget multiplier from an accounting identity between savings and investment, he is making a theoretically ungrammatical statement. My problem is not with whatever value he wants to assign to the balanced-budget multiplier. My problem is that he thinks that he can draw any empirically meaningful conclusion — about anything — from an accounting identity. Scott defends himself by citing Mankiw and Krugman and others…. I don’t have a copy of any of Krugman’s textbooks…. I was able to find the statement in Mankiw’s text. And yes, he does say it, and he was speaking incoherently when he said it. Now, it is one thing to make a nonsense statement, which Mankiw obviously did, and it is another to use it as a step – in fact a critical step — in a logical proof, which is what Scott did.

The unfortunate fact is that the vast majority of economics textbooks starting with Samuelson’s classic text (though not until the fourth edition) have been infected by this identity virus… introduced into economics by none other than Keynes himself in his General Theory. He was properly chastised for doing so by Robertson, Hawtrey, Haberler, and Lutz among others. Perhaps because the identity between savings and investment in the national income accounts reinforced the misunderstanding and misconception that the Keynesian model is somehow based on an accounting identity between investment and savings, the virus withstood apparently conclusive refutation and has clearly become highly entrenched….

It is legitimate to refer to the equality of savings and investment in equilibrium, but you can’t extrapolate from a change in one or the other to determine how the equilibrium changes as a result of the specified change in savings or investment, which is what Scott tried to do. So, yes, the mistaken identification of savings and investment is distressingly widespread, but unfortunately Scott has compounded the confusion…. Let me again cite as the key source identifying and tracking down all the confusions and misconceptions associated with treating savings and investment (or expenditure and income) as identically equal the classic paper by Richard Lipsey, “The Foundations of the Theory of National Income,” originally published in 1972 in Essays in Honour of Lord Robbins and reprinted in Lipsey, Macroeconomic Theory and Policy: The Selected Essays of Richard G. Lipsey, vol. 2…

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