Post-Keynesian Observations

Understanding the Macroeconomy

Archive for June 2009

Spending too much or earning too little?

with 9 comments

I’ve seen a lot written on how the current downturn is a result of us “spending beyond our means.” This is a classic example of fallacy of composition, or the false assumption that the properties of the phenomenon at the individual level match those at the aggregate. Consider, for example, this statement:

If the Texas Rangers baseball team could improve their pitching then, everything else being equal, they would win more games.

Fair enough. But, does this translate to all of Major League Baseball?

If all baseball teams could improve their pitching then, everything else being equal, all teams would win more games.

Of course not, since at the aggregate level it is a zero-sum game: for every win there is a loss. The winning percentage for all of baseball is always 50%, regardless of what changes are made to the quality of the teams.

There are times, however, when the properties of the phenomenon at the individual level match DO those at the aggregate:

If the Texas Rangers baseball team added more free-giveaway nights, then they would sell more tickets.

And…

If the all baseball teams added more free-giveaway nights, then they would all sell more tickets.

Very possibly. The trick is knowing when the properties transfer and when they don’t.

Returning to economics, many have argued that our current problem is that people and firms “spent beyond their means.” The implication is that they took on commitments that, given their incomes, they could not honor. This led to default and economic contraction.

Is this possible for the individual? Of course. I could prove this very quickly by rushing out right now and buying a new car, house, big screen TV, etc. I can obviously do so to the point that I will not be able to repay (particularly over the past decade when banks were very eager to loan and not so eager to double check your credit score!).

HOWEVER, THE ECONOMY AS A WHOLE CANNOT SPEND BEYOND ITS MEANS!!!

The macroeconomy seen as a single unit does not have to “finance” projects. In fact, it cannot. Either we have the resources, technology, and productive capacity to make a big-screen TV or we don’t. If we don’t have enough steel, for example, to make a car today, then the economy cannot borrow “future” steel and thereby find itself facing some day of reckoning when it has to repay itself. Finance and debt are about shifting spending power from one entity to another, and that can only happen on the individual level. Thus, while individuals can find themselves with debt they cannot repay, the economy as a whole cannot. Therefore, it is incorrect to say that we tried to live beyond our means. The standard of living enjoyed up to the recession was perfectly within our means and there is no logical reason why it should not have continued.

So what was the problem? Think about this: if, as a macroeconomic unit, we had the resources, technology, and productive capacity to produce all those houses, cars, TV’s, meals at nice restaurants, etc., then why did people have to go into so much debt??? Why weren’t our incomes sufficient to buy those absolutely-affordable goods and services without debt or at least with minimal, and thus affordable, debt? Therein lies the problem. We didn’t spend too much, we earned too little. Not only is there a systemic issue with respect to market economies being unable to generate a reasonable number of jobs for all those willing to work (see the discussion below), but income distributions have been becoming more and more uneven. Those who form the backbone of consumer demand, the middle class, have been losing relative income shares to the rich. This is all great fun for the rich in the short run, but it leads to what we have right now in the long run: falling sales, default, unemployment, recession, etc.

Hence, the focus of policy right now must not be on cutting back spending. Why should we? We can afford all that stuff, and buying it is what creates jobs and incomes for others. Rather, policy should create income and offer incentives for spending money. The private sector cannot do this alone because as we stand right now, all individual incentives are to restrict spending.

Advertisements

Written by rommeldak

June 13, 2009 at 2:05 am