Post-Keynesian Observations

Understanding the Macroeconomy

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.

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Written by rommeldak

June 13, 2009 at 2:05 am

9 Responses

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  1. Romm said: “… 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.”

    That’s only true if you do not include the Phillies.

    😉

    Just joshing. A good analogy Romm. And another interesting post with some points I’ve certainly never thought of.

    Thanks.

    But, you say “The economy as a whole cannot “‘borrow'” future resources … and thereby find itself facing some day of reckoning when it has to repay itself.” Is it not true though that the economy as a whole can borrow ON future resources, and hence find itself at that aforementioned day of reckoning?

    As per usual, please excuse me if that’s a naive question. As I’ve stated before, economics is beyond confusing for me, and exceeds my capacity of comprehension.

    I’d love to see you go toe-to-toe with Michael Shermer over at Skeptiblog (http://skepticblog.org/). He’s always proselytizing Libertarianism, and for a so-called skeptic he really fails in his facts.

    SicPreFix

    June 14, 2009 at 11:45 pm

  2. Sic, what do you mean by this?

    “Is it not true though that the economy as a whole can borrow ON future resources, and hence find itself at that aforementioned day of reckoning?”

    Can you give an example? My argument was that an individual can buy today what she really cannot afford until tomorrow by going into debt. Hence, her future can be mortgaged. But, an economy cannot build a car using steel that has not yet been produced. There is no borrowing resources that do not yet exist.

    I’ll check out the other website, but a wise person told me years ago that correcting fanatics is a full-time (and very unrewarding) job!

    rommeldak

    June 17, 2009 at 11:48 pm

  3. “Sic, what do you mean by this?”

    Well, truth be told, I don’t really know. Um, how are we/you using the term “economy” here? Is it a metaphor, or is it something more substantial?

    After re-reading the post, and my question, I suspect I am misunderstanding the term “economy”, and misassuming it is an ambiguous metaphor for the function and action of a large community of people, businesss, government, etc., and their combined real economic activity.

    In which I thought the “economy” could borrow on the future in the same way people, businesses, goverments, etc. borrow on the futture through such things as futures trading on the stock market.

    But knowing you as I do, and understanding your knowledge and experience with economics (and my lack therein), I think the more rational and realistic approach is to assume that I have woefully misunderstood the term “economy” in this instance.

    🙂

    And yes correcting fanatics is indeed a full-time (and very unrewarding) job! But it’s such fun to sit on the sidelines and watch: Go get ’em Rommy! Go get ’em!

    Heh, heh.

    SicPreFix

    June 19, 2009 at 8:30 pm

  4. […] 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. Rommeldak, Post-Keynesian Observations. […]

  5. Romm

    Picked up your blog via a recommendation from Duncan Weldon at Duncan’s Economic blog, he being by far the best post-Keynesian economist blogging in the UK at the moment, and a welcome counter to a lot of the mainstream media economic illiteracy.

    I like the cut of your economics jib, and I’ll certainly be adding you to my blog roll /recommending you.

    Great 13 part series (or was it 12?). Well done.

    I’m especially interested in ‘double dip’ issues at the moment as it’s so relevant to the choices a (changed?) UK government will take in 2010, so any analysis of that, perhaps linking into Duncan’s stuff on same, would be more than welcome.

    Paul

    June 28, 2009 at 3:35 pm

    • Sorry, Paul, I’ve been out of town for a funeral (my wife’s grandmother) and just getting back to approve this. Many thanks! I should start updating this more frequently if folks outside my circle of friends are going to read it! Won’t have time for a bit, I’m afraid, as I leave for London on Tuesday (Association for Heterodox Economics conference). I look forward to checking out both blogs when I return!
      John

      rommeldak

      July 3, 2009 at 7:38 am

  6. >>Finance and debt are about shifting spending power from one entity to another.

    It sounds like you don’t understand how banks work.

    When you get a loan from a bank – the money (credit really) is created. There is no transfer of spending power from the bank to you – there is simply the creation of money for you to use and a debt for you to later repay.

    Your analogy between cars and money is completely wrong because one is a physical item and the other is merely a record on an accounting ledger.

    Banks can continue to expand the amount of debt without limit. Indeed it is in their interests to do so since their profit comes from the interest payments. Taken to extreme it is possible to end up with more debt than can be supported by current incomes. At that point to Ponzi scheme collapses.

    jzw

    July 15, 2009 at 6:29 pm

    • Sorry! I have barely stopped by here in months! At any rate, I quite agree with your point on the endogeneity of money and in fact spent a long time arguing that very thing in another blog. I thought about addressing that here, but figured that it was best to keep it simple and focus instead on the core issue. What I was trying to point out about finance, however, was that while an individual can have net debt, a closed economic unit cannot. In retrospect, it wasn’t central to my argument and I probably should have tried to make the argument without it. The point was, the economy cannot live beyond it’s means–either we could make that big-screen TV, or we couldn’t.

      rommeldak

      February 4, 2010 at 11:05 pm

  7. Found an article today that reminded me of this entry:

    http://www.msnbc.msn.com/id/32505284/ns/business-the_new_york_times

    Charlie

    August 21, 2009 at 9:40 am


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