Change Your Mind And See What Was Always There

For a long time, I was convinced there was a kind of economics that was coherent, explained the past, and that provided helpful information to policy makers trying to make decisions about taxes, spending, and interest rates. After some close reading of the news and several economics blogs, I became convinced that this "useful economics" was the kind practiced by Paul Krugman and Brad DeLong.

Then I read this [How Deficits Reduce Investment] and thought: as a student of philosophy and logic, I know this cannot possibly be true:

When thinking about how budget deficits affect the economy, a different identity is typically used. This identity points out that for an economy at any given time, the total quantity of funds being saved must be equal to the total quantity of funds being invested. Or to spell it out a little more fully, the U.S. economy has two sources of savings: domestic saving, and the saving that flows in from other countries. The U.S. economy also has two sources of demand for those funds: private sector investment and government borrowing. Thus, it must hold true that when government budget deficits increase, some combination of three things will happen: 1) domestic saving will rise, to supply some of the funds needed for the rise in government borrowing; 2) the inflow of savings from foreign investors will rise, to supply some of the funds needed for the rise in government borrowing; or 3) private investment will decline, because the rise in government borrowing will "crowd out" some of the funds that would otherwise have gone to the private sector.

Again, this statement is not one where different schools of economics disagree; it holds true by definition, based on the meaning of these terms. Among professional economists, those who think budget deficits should be larger, or smaller, or about the same will all agree that if deficits rise, some combination of these three consequences must and will happen--by definition.

[My emphasis]

If everything about an equation is true by definition, then no amount of algebraic manipulation can ever tell you anything about the empirical world. Algebraic manipulation of definitions can help you to see the relationships that exist in the system created by your definitions. And those relationships may not be obvious, meaning that you might feel like you've discovered something through your manipulation. But there is only one way to learn about the world: interacting with the world.

When I asked the author, Tim Taylor, to explain his violation of the laws of logic, he sent me to [National Income Accounting for The Washington Post] which puts the above words into equations.

Starting at the beginning, we know that we can add up GDP on the output side by summing its components, consumption, investment, government, and net exports. This must be equal to the incomes generated in production. This gives us a basic identity that:

1) C+I+G+(X-M) = Y

where Y stands for income. This identity must always hold, it is true by definition.

We can then divide Y into disposable income, which is total income, minus taxes. This gives us:

2) Y = YD + T

We can then divide disposable income into savings and consumption, since by definition any income that is not consumed is saved. This gives us:

3) YD = C+S

since we now know that  Y = C+S+T, we can rewrite equation 1 as,

4) C+I+G+ (X-M) = C+S+T

we then eliminate consumption from both sides and we get:

5) I+G+(X-M) = S+T, rearranging terms gives:

6) (X-M) = (S-I)+(T-G)

This one actually has a clear meaning. X-M is exports minus imports, or the trade surplus, S-I is private saving minus private investment, and T-G is taxes minus government spending, or the budget surplus. This identity means that the trade surplus is equal to the sum of the surplus of private savings over investment and the government budget surplus. Remember, this is an accounting identity, it must be true.


But consider the accounting identity. The country has a large trade deficit, which means that X-M is a large negative number. It's currently around 4 percent of GDP (just under $600 billion), but would certainly be much larger if the economy were near full employment. Imports rise with income, so that with a higher level of GDP the trade deficit would expand.

If X-M is negative, then either or both (S-I) or (T-G) MUST be negative. This means either or both that we have negative private savings or we have a budget deficit.

We now have a very explicit claim about how the world works:

When a country has a trade deficit, it's people and companies will be in debt, or the government will be spending more than it makes, or both.

Does the world work like that? How the fuck should I know? More importantly: how the fuck would these economists know? Two blog posts, one by an economist (and textbook author) and one by a whole think tank full of economists and not a single person has bothered to look out the window and observe... anything!

It turns out, that my hero Paul Krugman has addressed this very same issue and seems to be as critical as I am. First, he describes an argument that is misleading because it uses an "accounting identity" to support a doctrine of "immaculate transfer":

“[S]ince the current account balance is equal to the difference between domestic saving and domestic investment, exchange rates can’t affect trade”.

This is wrong, says, Krugman, but he doesn't see the same problem I do. Instead, he says something... strange:

And the key point is that individuals in general neither know nor care about aggregate accounting identities. Take the doctrine of immaculate transfer: if 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.

This is where I change my mind.  Krugman is not criticizing the "misleading" method of reasoning at all. He just thinks it's boring! Sure, he says, the identity tells us about the empirical world, but what I'm interested in is "mechanisms".  Wrong.

Having understood this error, I now start to notice that other people agree with me, and have been saying so in places that I saw, read, and ignored! Here's one of them, the blog "Uneasy Money" commenting on the above passage by Krugman:

Here is where Krugman, after skating on the edge, finally slips up and begins to talk nonsense — very subtle nonsense, but nonsense nonetheless.

After quoting more Krugman, he continues:

There are no macro implications of an identity; an identity has no empirical implications of any kind — period, full stop. If S necessarily equals I, because they have been defined in such a way that they could not possibly be unequal, then there is no conceivable state of the world in which they are unequal. Obviously, if S and I are equal in every conceivable state of the world, the necessary identity between them cannot rule out any conceivable state of the world. That means that the identity between S and I has no empirical implications. It says nothing about what can or cannot be observed in the real world at either the micro or the macro level.

Let's step back and consider the implications. It's important to remember that Krugman is criticizing other economists' "misleading" use of the "accounting identity", but he is not criticizing their general method. And that general method is one where economists lean back in their chairs, picture the world, define various things like "savings", "investment", "money supply" and "actors" (you and me!), write down some equations about how these things interact with each other, and then look at the world to find the mechanism behind the equations. Notice what never happens: no one ever looks at the world without having already decided how it (the world) works.

This caricature can't possibly be true, can it? In a recent post, Krugman explained what it means to "do useful economics":

So how do you do useful economics? In general, what we really do is combine maximization-and-equilibrium as a first cut with a variety of ad hoc modifications reflecting what seem to be empirical regularities about how both individual behavior and markets depart from this idealized case. And people using this kind of rough-and-ready approach have done really well since 2008, on everything from inflation to interest rates to the effects of austerity.

Translation: useful economics starts with two assumptions about how the world works, one about how people behave, and one about the math that causes this behavior to perfectly balance itself, and then it looks out at the world, notices that these assumptions are false, keeps the assumptions, adds "modifications" until all the math produces numbers that are near the numbers we get when we measure the real world and then makes recommendations. We know this is a good way to do things since it told us that in a depression the government should borrow money and spend it.

Shorter translation: yes the caricature is correct. But look, it gave the same advice that any idiot with a passing familiarity with history would have given, and that was good advice.

Now, if that is "useful economics", then what are these people doing:

"Rather, government has increasingly used its power to tax to take from Peter to pay Paul. Discussions of the benefits of government services should not distract from this fundamental truth."

Defending The One Percent, by N. Gregory Mankiw, Robert M. Beren Professor Of Economics, Harvard University.

"Stocks of wealth stimulated invention by liberating creators from the immediate demands of the marketplace and allowing them to explore their fancies, enriching generations to come."

Capital Punishment, by Tyler Cowen, Professor of Economics, George Mason University.

"While the president now wisely acknowledges the importance if mobility, the underlying difficulty concerns the way the problem is framed. Inequality is not in itself necessarily undesirable. People earn more or less depending on how old they are, how hard they work, and how useful are the business or creative aptitudes they possess. This is a normal feature of a competitive, dynamic economy."

Obama Is Failing To Extend New Opportunities To The Poor, by Glenn Hubbard, Dean, Columbia Business School.

Combine these endless examples of economists telling us the best way to run the country and the world, with what we know about the bankrupt method underlying economics and the conclusion is obvious:

Economics is just moral philosophy as practiced by mathematicians.

Turns out I'm not the only one to come to this conclusion, either.

More to come...