It is a profoundly erroneous truism, repeated by all copy-books and by eminent people when they are making speeches, that we should cultivate the habit of thinking of what we are doing. The precise opposite is the case. Civilization advances by extending the number of important operations which we can perform without thinking about them. Operations of thought are like cavalry charges in a battle — they are strictly limited in number, they require fresh horses, and must only be made at decisive moments.
Alfred North Whitehead, An Introduction to Mathematics, 1911
Part 1 in a series of posts on modern macroeconomics. This post focuses on Keynesian economics in order to set the stage for my explanation of modern macro, which will begin in part 2.
If you’ve never taken a macroeconomics class, you almost certainly have no idea what macroeconomists do. Even if you have an undergraduate degree in economics, your odds of understanding modern macro probably don’t improve much (they didn’t for me at least. I had no idea what I was getting into when I entered grad school). The gap between what is taught in undergraduate macroeconomics classes and the research that is actually done by professional macroeconomists is perhaps larger than in any other field. Therefore, for those of you who made the excellent choice not to subject yourself to the horrors of a first year graduate macroeconomics sequence, I will attempt to explain in plain English (as much as possible), what modern macro is and why I think it could be better.
But before getting to modern macro itself, it is important to understand what came before. Keep in mind throughout these posts that the pretense of knowledge is quite strong here. For a much better exposition that is still somewhat readable for anyone with a basic economic background, Michael De Vroey has a comprehensive book on the history of macroeconomics. I’m working through it now and it’s very good. I highly recommend it to anyone who is interested in what I say in this series of posts.
Although Keynes was not the first to think about business cycles, unemployment, and other macroeconomic topics, it wouldn’t be too much of an exaggeration to say that macroeconomics as a field didn’t truly appear until Keynes published his General Theory in 1936. I admit I have not read the original book (but it’s on my list). My summary here will therefore be based on my undergraduate macro courses, which I think capture the spirit (but probably not the nuance) of Keynes.
Keynesian economics begins by breaking aggregate spending (GDP) into four pieces. Private spending consists of consumption (spending by households on goods and services) and investment (spending by firms on capital). Government spending on goods and services makes up the rest of domestic spending. Finally, net exports (exports minus imports) is added to account for foreign expenditures. In a Keynesian equilibrium, spending is equal to income. Consumption is assumed to be a fraction of total income, which means that any increase in spending (like an increase in government spending) will cause an increase in consumption as well.
An important implication of this setup is that increases in spending increase total income by more than the initial increase (called the multiplier effect). Assume that the government decides to build a new road that costs $1 million. This increase in expenditure immediately increases GDP by $1 million, but it also adds $1 million to the income of the people involved in building the road. Let’s say that all of these people spend 3/4 of their income and save the rest. Then consumption also increases by $750,000, which then becomes other people’s incomes, adding another $562,500, and the process continues. Some algebra shows that the initial increase of $1 million leads to an increase in GDP of $4 million. Similar results occur if the initial change came from investment or changes in taxes.
The multiplier effect also works in the other direction. If businesses start to feel pessimistic about the future, they might cut back on investment. Their beliefs then become self-fulfilling as the reduction in investment causes a reduction in consumption and aggregate spending. Although the productive resources in the economy have not changed, output falls and some of these resources become underutilized. A recession occurs not because of a change in economic fundamentals, but because people’s perceptions changed for some unknown reason – Keynes’s famous “animal spirits.” Through this mechanism, workers may not be able to find a job even if they would be willing to work at the prevailing wage rate, a phenomenon known as involuntary unemployment. In most theories prior to Keynes, involuntary unemployment was impossible because the wage rate would simply adjust to clear the market.
Keynes’s theory also opened the door for government intervention in the economy. If investment falls and causes unemployment, the government can replace the lost spending by increasing its own expenditure. By increasing spending during recessions and decreasing it during booms, the government can theoretically smooth the business cycle.
The above description is Keynes at its most basic. I haven’t said anything about monetary policy or interest rates yet, but both of these were essential to Keynes’s analysis. Unfortunately, although The General Theory was a monumental achievement for its time and probably the most rigorous analysis of the economy that had been written, it is not exactly the most readable or even coherent theory. To capture Keynes’s ideas in a more tractable framework, J.R. Hicks and other economists developed the IS-LM model.
I don’t want to give a full derivation of the IS-LM model here, but the basic idea is to model the relationship between interest rates and income. The IS (Investment-Savings) curve plots all of the points where the goods market is in equilibrium. Here we assume that investment depends negatively on interest rates (if interest rates are high, firms would rather put their money in a bank then invest in new projects). A higher interest rate then lowers investment and decreases total income through the same multiplier effect outlined above. Therefore we end up with a negative relationship between interest rates and income.
The LM (Liquidity Preference-Money) curve plots all of the points where the money market is in equilibrium. Here we assume that the money supply is fixed. Money demand depends negatively on interest rates (since a higher interest rate means you would rather keep money in the bank than in your wallet) and positively on income (more cash is needed to buy stuff). Together these imply that a higher level of income results in a lower interest rate required to clear the money market. An equilibrium in the IS-LM model comes when both the money market and the goods market are in equilibrium (the point where the two lines cross).
The above probably doesn’t make much sense if you haven’t seen it before. All you really need to know is that an increase in government spending or investment shifts the IS curve right, which increases both income and interest rates. If the central bank increases the money supply, the LM curve shifts right, increasing income and decreasing interest rates. Policymakers then have two powerful options to combat economic downturns.
In the decades following Keynes and Hicks, the IS-LM model grew to include hundreds or thousands of equations that economists attempted to estimate econometrically, but the basic features remained in place. However, in the 1970s, the Keynesian model came under attack due to both empirical and theoretical failures. Part 2 will deal with these failures and the attempts to solve them.
I have a lot to say on this topic. Over the next couple weeks I’ll have a bunch of posts dealing with it.
Individual man is the product of a long line of zoological evolution which has shaped his physiological inheritance. He is born the offspring and the heir of his ancestors, and the precipitate and sediment of all that his forefathers experienced are his biological patrimony. When he is born, he does not enter the world in general as such, but a definite environment. The innate and inherited biological qualities and all that life has worked upon him make a man what he is at any instant of his pilgrimage. They are his fate and destiny. His will is not “free” in the metaphysical sense of this term. It is determined by his background and all the influences to which he himself and his ancestors were exposed.
Ludwig von Mises, Human Action
Note: Although this post is my longest so far, 1500 words is not nearly enough to form a full argument on a topic as big as free will. I’m also not a philosopher so this post is very much outside my area of expertise. I don’t expect the words here to convince anybody, but they are what I believe and I hope they give some idea of the philosophy that drives much of my thinking on economics and politics.
I used to believe in free will. In fact, I hardly considered the idea that there was any other possibility. Success, I thought, was built entirely on making good choices, failure on making poor ones. And perhaps it was because I had been relatively successful that I was so averse to believing those choices came from anything other than my own free will. I chose to work hard, chose to stay out of trouble, chose to be respectful to others. Those choices led to good grades, good relationships, and a good life. Most importantly, those choices were mine.
Nobody can say I’ve never changed my mind.
“I don’t believe in free will.” I don’t remember how the conversation got to that point, but I do remember my feeling of disbelief when I heard a friend say those words at dinner one night in the Umass dining hall. My initial thought was to throw my fork at him, to flip over my plate of food, to do something so unpredictable that he would be forced to admit that the only explanation was that I did it of my own free will. Of course, I didn’t do any of those things. I did spend the next hour arguing with him and several hours after that furiously googling to find evidence that free will was real. What I found instead was that Einstein believed “everything is determined, the beginning as well as the end, by forces over which we have no control” and that neuroscience has offered evidence that free will is nothing but an illusion. The debate over free will vs determinism is complex and has not been settled, but in reading the various arguments, I consistently found myself drawn more to those that opposed free will. It was time to admit I was wrong.
Think about anything you’ve ever done, any choice you’ve ever made. Now try to think about the reason that you made the decision in the way that you did. I can’t think of any action I’ve ever taken that wasn’t fully shaped by my past experiences. For me, free will means that if I could repeat the exact same situation twice, I would make a different choice each time. But why would that be? The choices I make are the ones I believe to be optimal (broadly defined) at any given point in time and what I believe to be optimal can only come from what I have learned in the past. I was lucky enough to be born into a stable family in the richest country in the world. If I were an orphan growing up in inner-city Boston, would I be where I am today? Unlikely. If I were born in Kenya? Not a chance. The opposite thought experiment is also revealing. If somebody else lived through my life in exactly the same way I have until this point, wouldn’t they just be me? Why would they make any choice differently from the ones I make?
Take away all the people you’ve met in your life. Take away all of the books you’ve ever read, all the movies you’ve ever seen, all the websites you’ve ever visited. Take away your genetics. You didn’t have control over any of those things, so they can’t be the result of your free will. But without them, what is left? Are you anything more than everything you have ever experienced? I’m not so sure.
Imagine that you could see your future, not only the one that actually occurs, but every possible future based on every possible action you could ever take. In this case, it should be clear that there is only one set of choices that make sense, the ones that lead to the best life (again defining best in the broadest possible way – I am not saying that people have to be “rational” in the usual economic sense of the word). Adding uncertainty complicates the problem, but it doesn’t change the basic principle. Every decision has to have a reason for being made, regardless of whether that reason is based on a complicated calculation, a simple heuristic, or pure instinct. If I knew everything about you, from your memories to your genetics, from your predictions of the future to your emotional state, I claim that I would have enough information to predict exactly what you would do next because I would be able to observe exactly the thought process that led you to make the decision.
Although determinism seems like a scary idea – your path is already set before you make your choice – the alternative is actually worse. There is only one way out I can see, one hope for “free will,” and that’s pure randomness. Again consider the situation where you live the same life in the exact same way up to a decision point. There are only two options. Either you make the same decision each time, which is then by definition a decision that could be predicted given full information, or you make a different decision given the same circumstances, which means there must be randomness involved. It can’t be randomness like flipping a coin – knowing the speed at which your thumb moves, the air resistance, the weight of the coin, and every other factor means the result is fully determined before the coin lands. Quantum mechanics appears to offer the possibility of true randomness, where only the probabilities of an event can ever be predicted, and some have used this phenomenon as an argument against determinism. But decisions being driven by pure randomness does not really support free will either, at least not in the way most people would think about it. In this version of the story, your path may not be fully determined, but now it’s completely random. Either way, your choices have nothing to do with you.
Now you might be a bit confused. The previous argument is starting to sound something like “you didn’t build that,” a rallying cry for democrats like Obama and Elizabeth Warren to justify taxing the rich. And there is some logic to that connection. If you aren’t the source of your own actions, why should you be responsible for their consequences? Sure, most rich people worked pretty hard to make their money, but even that hard work only came because they had good influences pushing them in the right direction. Other individuals and institutions (yes, even the government) deserve much of the credit for their success and it therefore seems natural to redistribute some of the rewards. So how do I reconcile determinism with libertarianism? Why is my blog dedicated to Hayek rather than Karl Marx?
It’s all about incentives.
If people’s choices are entirely determined by outside forces, then the institutions and laws that define the environment in which they live become especially important. Without free will, taxing the rich is no longer a question of fairness, but without the reward, why should an entrepreneur take the risks required to start a new business? Why should a manager put in the work required to make that business run well? Why should a worker do any more than the bare minimum to avoid getting fired? Conceding that all people had help in achieving success is not an argument against allowing them to keep all of the benefits of that success, because those benefits are themselves one of the most important factors in pushing them to make good decisions.
In other words, I’m not a libertarian because it’s right. I’m a libertarian because it works. Free will doesn’t exist, but acting as if it does ensures that incentives push people to act in ways most would consider desirable.
So why should we care? If we are better off pretending free will exists even if it doesn’t, why bother with this discussion at all? I think it has to do with perspective. Next time somebody does something you disagree with, remember that they come from a very different place than you do. They didn’t have your parents, your teachers, or your friends and therefore they could never have developed the same set of values you have. It doesn’t excuse immoral actions, but it does shift the blame. Rather than hating people that do bad things, rather than strive for vengeance, or for harsh punishments, the goal should always be to change the environment that caused those actions in the first place.
But more importantly, rejecting free will can give you a better perspective on your own life. Every person’s life will be filled with success and failure, and it’s easy to take these results personally, to admire your own achievements and blame yourself for your flaws. These feelings are important – they drive you to become a better person. But I’ve found that recognizing the influence others have had on your life can remind you to never get too high or low. When you succeed, stay humble. And when you fail, remember that it’s not your fault.
“when it comes to government support of grants from the National Science Foundation (NSF) for economic research, our sense is that many economists avoid critical questions, skimp on analysis, and move straight to advocacy.”
There is the fact that man’s mind is itself a product of the civilization in which he has grown up and that it is unaware of much of the experience which has shaped it – experience that assists it by being embodied in the habits, conventions, language, and moral beliefs which are part of its makeup. Then there is the further consideration that the knowledge which any individual consciously manipulates is only a small part of the knowledge which at any one time contributes to the success of his action.
F.A. Hayek, The Constitution of Liberty, p. 75
In my post yesterday, I put up this graph, which has been used by many as evidence of major economic problems.
The graph shows a growing gap between the production of an average worker and the compensation they receive for that production. The Economic Policy Institute (which is the source of the graph above), claims that this gap represents a failure of wealth to “trickle down” to workers. The economy is growing, but workers don’t see any of the benefits. I agree that this story, if true, would be deeply concerning. But I’m not so sure it’s true.
First, I wanted to make sure I could recreate the gap on my own. I used FRED to plot real compensation per hour against real gross value added divided by total hours (to proxy for productivity). I’m not sure if these are exactly the series used by EPI above, but the pictures look pretty close.
Notice, however, that in order to get these data into real values, I deflated by two different price indexes – CPI for compensation and an implicit price deflator for productivity (if you aren’t sure what the difference is, here’s the BLS explanation). FRED also provides real values for each of these variables and they also use different inflation measures for each. I assume other people that have made this graph have done the same. Although it might make sense to deflate these series using different measures of inflation in some situations, it does not allow for an easy direct comparison between them. Looking at the difference between the two measures over time reveals a familiar looking gap.
So what happens if instead of trying to look at real values using different (and imperfect) measures of inflation, we just put everything in nominal terms? Bye-bye productivity gap:
Now, maybe there’s still something to be concerned about here. The CPI is supposed to measure the goods actually purchased by consumers. If the prices of these goods are growing faster than average, then the value of a worker’s compensation is lower. I’m not sure I have enough faith in either measure to even grant that point, but at the very least can we start calling it an inflation gap rather than a productivity gap?
One thing, in fact, which the work on this book has taught me is that our freedom is threatened in many fields because of the fact that we are much too ready to leave the decision to the expert
F.A. Hayek, The Constitution of Liberty p. 50
In the last few weeks I’ve seen multiple people on Facebook claiming 2016 is the worst year in history. After I checked to make sure I wasn’t in an alternate timeline where events like the Black Death, the French Revolution, and World War II (among many others) never happened, I concluded they were probably exaggerating. Still, it seems like many people have started to believe the idea that overall welfare in the world is on a downward trend. Luckily, they couldn’t be more wrong.
Let’s take a look at some of the main complaints about the world in 2016. Our World in Data is a great source to visualize these long run trends and is where I got most of the graphs below. Check it out if you’re interested in topics I didn’t cover here.
If you listen to the media, you might be a little bit scared to go outside. Mass shootings, terrorist attacks, and police brutality seem to be perpetual components of the nightly news. I of course do not want to trivialize any of these problems. Any level of unnecessary violence above zero is something we should try to eliminate. But violence has always been a part of this world. Has it been getting worse? No.
Homicide rates in the US, for example, are around their 50 year low and other countries show similar trends
You might think that restricting the focus to gun homicides would show a different trend. As Mark Perry explains, gun violence has actually fallen even as the number of guns has steadily increased.
We still have a long way to go, but it looks like we’re on the right track.
(off topic: notice how high US violence is relative to other countries even in the early 1900s. Might there be an explanation that has nothing to do with our gun laws?)
In the US, you have probably heard that income inequality is up, middle class incomes have stagnated, and the poverty rate hasn’t fallen in over thirty years. All of these statistics are true on the surface, But as Don Boudreaux likes to point out, being poor today is not the same as it was in the past. In another post, he notes that most Americans today live much better than the absolute richest American a century ago. He asks how much money would be required in order for you to prefer living in 1916 than in 2016 with your current income. I don’t think I’d be willing for any sum of money. While I’m sure being rich in 1916 has its benefits, I’ll take my computer and airplanes any day.
On middle class incomes, this graph is commonly cited
I’ll deal with this apparent gap between labor compensation and productivity soon in a later post, but for now just take my word for it that it’s not exactly what it seems.
Another important point is that anybody born in the US (or any other first world country), has already won life’s most important lottery. Eliminating poverty in developing countries is a much more pressing issue. Here is what has happened to global poverty over the last 200 years. Since 1970, around the time when many would tell you the neoliberal agenda sent the world into a spiral of misery, the number of people living in extreme poverty has fallen from around 2.2 million to 700 thousand.
Democrats will tell you that too many people are uninsured. Republicans that Obamacare is destroying the country. Meanwhile life expectancy has been rising steadily for decades in every region of the world
While child mortality has fallen
These are of course not the only factors that matter. The rise in healthcare spending (both public and private) in the US and other countries is concerning and we will need to figure out ways to deal with this issue, but once again, the trend seems to be going the right way.
You might say that I’ve cherry picked statistics to fit my story. That’s true. There’s a lot of bad things happening in the world right now. But we hear about those all the time. I think it’s important to also appreciate the stuff that is working and I do believe that the vast majority of people are far better off now than they have been at any point in the past.