Morality and Government Part II
There are two ways to think about government. By far the most common is to think of government as a force over and above the citizens which has always just been there, which provides for them, which they are inherently bound and subject to, and which can be petitioned as one petitions God or a child petitions its parents for whatever they want by appealing to its morality. This is a bad way to treat government and I’m sure my libertarian friends will agree. The correct way of thinking about government, at least government among free people, is as a contracting problem. Most people have trouble thinking of it this way because when they hear the word “contracting” they think of contracting in a legal sense. This type of contracting requires a third-party enforcer (a government) to enforce the contract. In the absence of a third-party enforcer, there is still the possibility for contracts but those contracts must be self-enforcing. Consider some examples.
Contract 1: I come to you and ask for a loan. You give me $100 today and I will give you $110 one year from today. This contract is not self-enforcing because 1 year from now there is no incentive for me to pay you back. I already got what I wanted out of it, why should I fulfill my end of the agreement? If there is a third-party enforcer, it is in my interest to uphold the contract because if I don’t, then the enforcer will come and punish me. But without a third-party enforcer, this contract will not be possible even if it would be mutually beneficial.
Contract 2: I am a farmer and you are a swineherd. We agree that every autumn I will give you a portion of my crop and you will provide me with meat throughout the year. This contract may be self-enforcing because the benefits to both parties are continuous. This will be the case as long as the benefits to both of us from continuing the agreement are always greater than the benefits from breaking it.
The last post was intended to establish a framework for thinking about morality and ethics in the context of government. The purpose of this post is to analyze the morality of a specific government action, namely taxation. [Editor: it actually goes a little beyond that...] In order to do this we must assume a few things. Here’s the scenario we will consider: A group of people come together who want to form a libertarian government. They believe it is immoral to initiate violence against another person. So I aim to evaluate certain functions of government through this moral lens. I’m not trying to argue that this morality is the one true correct morality but this post is intended for people who generally share my libertarian views. Read more…
Morality and Government
This is a continuation of what I started in this post on morality and ethics. The position I am disputing is that government shouldn’t tax because taxation is theft and theft is immoral. Let me say up front, that a government which could accomplish its purpose without taxation would be ideal and I believe it’s possible that this could be achieved. If we could start a government from scratch with people who all believed as Thomas and I do, we might be able to fund the government with only voluntary payments (to be fair this is exactly the scenario he was dealing with in his original post). I won’t get into how that could be done but I’m not trying to prove that it’s impossible here. My issue is with the attitude that there is a universal morality which government must (or at least ought to) follow. And if we have any interest in fixing this thing before it gets so bad that we have to rebuild a society out of the ashes, we can’t have that approach. We are so far away from a national consensus that taxation is theft and should be outlawed altogether that if you adopt this position your only option is to wait for the collapse of society. The real important thing is that the government be prevented from using taxation to redistribute wealth and manage its distribution. This does not require a complete moratorium on taxation.
A government has no morals. It has no morals because it is not a creature. It is a tool created by people to perform some task. Tools do not have morals. A hammer can be used for building a house–a noble pursuit–or committing a murder–not so noble. If I am making a hammer, I cannot imbue the hammer with a moral objection to murder. There are however, some things I could do to make it more difficult to commit murder with my hammer. I could remove the forks on the back or perhaps put a layer of foam rubber around the whole head except for the face. If I really wanted to be sure, I could even cover most of the face leaving only a small hole in the foam rubber that would have to be lined up precisely with the nail on every strike in order to work. These things, while making it more difficult for someone to use my hammer for murder would also make it less useful for building houses. Read more…
On Means, Ends and Ethics
I promised I would write a post explaining why taxation is ok following this exchange on The Compassionate Conservative.
Thomas H.: Government can be funded through voluntary donation only. A lottery and payment for the protection of contracts are one way this can be achieved. These methods of raising funds, as well as private donations, would be enough to provide funding for a righteous system. The U.S. Patent system stands as an example of how this can be done.
Free Radical: A lottery wouldn’t be very profitable without a government-enforced monopoly which I assume you wouldn’t support. In fact this would just be the government competing in a market activity for profit which is a very bad idea. It would be better to just have taxes you just need to keep them from being used to redistribute wealth which is not all that complicated.
Thomas H.: I agree with you about the lottery comment, but that doesn’t change the fact that taxation is theft by definition and theft is wrong.
But that ended up opening a big can of worms so I have to do a preliminary post establishing some things about morality. I begin with the proposition that the ends justify the means. However, most people who rely on this adage are not applying it correctly because they are not accounting for all of the ends. For instance, if a man wants to bring about world peace, and goes about this by conquering the world leaving a trail of death and destruction in his wake and then claims that the ends (world peace) justify the means (trail of death and destruction) he is mischaracterizing the latter. The trail of death and destruction is part of the ends. You may still claim that it’s worth it for world peace but you are weighing ends against ends. If you must lie to accomplish something and lying harms someone else or harms your reputation, these are all ends. Depending on your morals it may or may not be worth it, but again, it’s ends against ends.
If all of the ends of a certain course of action taken together are justified then the means are justified. In fact there is no other way of justifying any means but the ends. The thing that makes a hammer a good tool is the fact that it is a means of driving a nail (an end) that is relatively easy (another end) and inexpensive (another end). You take all of these ends, put them together and if they are good, then the means (the hammer) are justified. If you tried to drive a nail with a herring you would most likely find that, if you can manage to get the nail driven at all, it will be at a much higher cost than some alternative method, thus the herring is not a justified means of driving a nail.
Believe it or not, that’s basically economics, so let’s turn to ethics now. For the purpose of this post, allow me to put forth two definitions. These are not exactly the common definitions of these words but they highlight an important distinction for our purposes.
Morals: The sense someone has about what is right and wrong.
Ethics: A rule or set of rules a person uses to make decisions about their actions and behavior.
Morals are subjective and are beyond our control. They can change but we can’t choose to change them. If we had perfect information about all the ends which would result from a course of action, then we could evaluate the morality of them in relation to our own subjective morals and decide whether that course of action is “justified.” If this were the case (perfect information), we would have no need for ethics. But of course this is not the situation in which we find ourselves.
In reality the consequences of any course of action are usually numerous and either partially or entirely veiled in mystery. Because of this it would be impossible to actually evaluate our actions based on the ends. If someone were to take this approach to morality, they would almost certainly commit frequent moral transgressions out of pure ignorance. In addition, in the presence of this ignorance, there are many forms of bias which are likely to creep into their decision-making. For instance, they may tend to minimize the importance of potential but uncertain adverse effects on others and magnify more certain advantages to themselves, or they may favor current benefits over those which are far-off. The bottom line is that, by adopting certain ethical rules, they may force themselves to make decisions which add up to a better life than if they tried to address the morality of every situation independently. These ethics may not lead you to make the correct moral decision every time, it is enough that they cause you to err less often than you would without them.
For instance, take the boy who cried wolf. This is a story about a boy who does not understand all of the implications of his actions. He knows that lying causes amusing results in the short run but is entirely unaware of the long-term consequences for his reputation. This condition applies to most children and that is the reason for the fable. It is meant to teach children about this other consequence and ideally instill in them the ethic “thou shalt not lie.” It is clear to most parents that if their child were to adopt this ethic they would end up better off than without it. Of course if they could somehow grant their child complete knowledge of the consequences of every action they take, this would be even better, but in lieu of this, “thou shalt not lie” is a helpful rule of thumb.
Of course, the boy who is convinced to adopt the ethic “thou shalt not lie” may eventually get married and be asked by his wife whether or not she looks fat. Assuming she does in fact look fat, a man who approaches each decision independently is likely to conclude that this is a situation where a lie is justified by the ends. Alternatively, if he makes the decision based on an ethic against lying, he will not even attempt this calculation and will simply tell the truth. The consequences of this may add up to something undesirable in this case. However, if the cost in this case and other similar cases where he may make the “wrong” decision based on his ethic are less than the costs from the “wrong” decisions he would make our of ignorance when making decisions in the absence of the ethic, then the ethic is beneficial. Similarly, he may find himself in a situation where the fate of the entire universe depends on him telling a lie, but this scenario is probably so unlikely that it is worth the risk. (In practice, of course, reason may often overrule an ethic in situations where it is sufficiently obvious that the result of breaking it will be more desirable than following it).
Notice that the boy who cried wolf has no moral aversion to lying. If he did, then he would have no need for an ethic against it. This too is representative of most children. The things our morals relate to are all ends. Admittedly I am defining “ends” in such a way that this must be true, so if a child did have a natural moral aversion to lying (which is certainly possible since morals are subjective) then not lying would become an end in itself. But typically, we don’t have this moral naturally which means lying is a means to some other set of ends (known or unknown) which allow for some moral evaluation. If someone did have a moral aversion to lying, then the ethic may not be necessary (it’s possible that this moral may come into conflict with another moral and if, when this happens, the complete consequences are unknown and tend to favor not lying, then the ethic may still be beneficial). Indeed, the ethic often becomes a moral aversion to lying eventually and this is relevant to my ultimate point about government but you will have to wait for the next post to see what I mean.
It’s worth noticing that children, whose knowledge and reasoning capability are much less developed than those of an adult, rely most heavily on ethical rules. Ethics are a way of taking some widom about the world that someone may not be able to completely grasp and put it into a form that is easy to understand. It is not possible to explain to a child all of the possible consequences of lying, but it is possible to convince them that lying is bad. (I think the largest cause of casualties among the ranks of objectivist types who decry all systems of ethics is that they eventually have children) As we grow older and wiser we often relax some of our ethics because we become more comfortable with our ability to make decisions individually without that guidance. However, most of us still hold on to many of our ethics because our knowledge and reasoning ability always remain far short of perfection.
So to sum up, God (or nature or whatever you want to call this thing) has endowed us with some set of morals. In addition, we have been endowed with the ability to reason but this is imperfect and cannot always inform us of all the consequences of our actions before hand. This leaves a gap between where we stand at any moment and the ends which we ultimately wish to pursue or avoid. “Means” are the various ways in which we can bridge that gap. Our morals determine what we want to pursue or avoid but do not tell us how to get there. Approaching every situation with the pure force of our own reason is likely not the most effective way to approach life so we adopt certain ethics which are rules of thumb regarding means designed to lead us more often than not to the ends which we find morally desirable.
“Recess” Appointments
Obama escalated the war on congress today. He’s basically doing whatever he wants now and claiming an “obligation to act on behalf of the American people.” This is very troubling.
Savings = Investment
I was poking around on Nick Rowe’s blog, and came across this piece on Keynesian economics. If you recall in this post I recently pointed out a peculiar aspect of Keynesian economics:
[H]ow is it that if savings equals investment and savings equals income minus consumption, that when you lower interest rates investment increases but consumption stays the same?
When I was reading Nick’s post, I couldn’t help but think about this and think how ridiculous Keynesian economics would seem to people if they explained what they were really doing in the same way I think about it in my mind. So naturally I figured I should take a stab at this.
As Nick explains, the model begins with two identities (assuming a closed economy and no government for simplicity): Y=C+I and S=Y-C. This gives you S=I as an identity. In other words, given the way we have defined the variables, this must be true. This is different from an equilibrium condition such as quantity supplied = quantity demanded which is true only in an equilibrium. So at this point no economics has been done.
In order to do some economics, you must assume some values of variables and some causal relationships which determine the values of the other variables. The way Keynesians go about this is to assume the following equations from Nick’s post (to simplify even further I will assume that autonomous spending, which is “a” in his model, is equal to 0)
8. Cd = b*Y (where a>0 and 0<b<1)
9. Id = Ibar
Where Cd and Id are desired consumption and investment respectively. Then if you assume that in equilibrium C=Cd and I=Id, you have a model (6 equations and 6 unknowns). But here is what we have done in plain english:
1. We have assumed that investment is equal to a certain value no matter what. This value is not explained in any way in this model and nothing in the model can change it.
2. We have assumed that consumers spend a certain proportion (b) of their income on consumption. This proportion is not explained in any way by the model and nothing in the model can change it.
3. Based on our definition of savings, savings must be the amount of income not consumed, which by assumption is (1-b)Y.
4. Since, by definition, savings is always equal to investment, we know that the amount of savings must be equal to the value we assumed for investment. (Ibar=(1-b)Y)
5. The only thing we haven’t assumed yet is Y (output) so that must be whatever value makes the proportion we assumed would be saved equal to the value we assumed for investment.
To make this even simpler consider a numerical example. Assume the following:
1. People consume half of their income and save the rest.
2. Investment is $100.
3. Savings equals investment.
Now it follows logically that Income is $200. Why is that? Well it’s simple, since savings equals investment and investment is $100, then savings must be $100. And since people save half of their income and savings is $100, then their income must be 2×100=$200. This does nothing to explain where income actually comes from! Now if, for some reason, people decide to save only 1/4 of their income, then, by assumption, investment doesn’t change so the amount of savings must still be $100. But since people are saving more, their income must be higher in order to generate this arbitrary amount of savings. Therefore, income must increase to $400 to bring the model into equilibrium. This is essentially how Keynesians arrive at the “paradox of thrift,” by assuming that savings will have to be a fixed amount so if people insist on saving a smaller proportion of their income, then income will have to get larger to make that smaller proportion equal to the presumed constant level of savings.
This model works mathematically but it is a terrible way to do economics. Proper economics assumes some scarcity fixed by nature and some purposeful economic agents which choose between different ways of dealing with that scarcity. In other words, the degree of scarcity is constant and the model determines what people do in the face of it. On the other hand, this Keynesian approach takes human behavior for granted and assumes that the degree of scarcity in the system adjusts to make an equilibrium given this behavior. It’s an economic paradigm custom-made for people who think that human nature is the source of all the world’s problems and if only we could get better at social engineering, everything would be great. But this is a mistaken view of reality, and it leads to a mistaken view of economics. Perhaps more troubling, is that the converse is also true. Tread carefully, “practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
Note: If I were a Keynesian I would probably be fuming at this post and I would point out that the Keynesian cross is only *part* of the Keynesian model, and that it is misleading to present this part as a complete model. For instance, in the larger model, investment is not fixed, it is determined by interest rates. However, it still enters the Keynesian cross part of the model independently of the other variables in that part. It is my belief that the same general criticism is valid with regard to the larger IS/LM model but my goal here was to make the case as simply as possible and it would be much more complicated to analyze that entire model in the same way. So, I will leave it to the interested reader to look into it further, but this should get you started seeing it for what it is.
More Austrian Economics
http://platform.twitter.com/widgets/hub.1324331373.html
Here is a perfect example of what I’ve been talking about regarding Austrian economists. In this post, the author takes an observation that mainstream economists find puzzling and tries to convince you that it isn’t puzzling to Austrians and this is evidence that Austrian economics is superior. But in the process he demonstrates total ignorance of mainstream economics, claiming that it does all sorts of things which it does not, and then proceeding to do exactly those things but in a simplified way that leads one easily into confusion. Then he confusedly arrives at the conclusion that something puzzling actually makes perfect sense.
Let us begin by establishing what the endowment effect means. The endowment effect is a phenomenon whereby an economic actor places a higher value on something if they own it than if they do not own it. In other words their ordinal ranking of preferences changes merely because their endowment changes. To put it in the form of an Austrian example, this means that a man who prefers an apple to an orange when he has an apple but not an orange may prefer an orange to an apple when he has an orange and no apple (holding all other things equal). In either case he is not willing to trade. Observing this should make you scratch your head no matter what economic philosophy you subscribe to, it’s just a thing that doesn’t make that much sense. Look what I mean:
From a mathematical-economic point [sic] view, the endowment effect demonstrates the inability of formal economics to explain what drives human action. Indeed, the endowment effect seems to shift an actor’s indifference curves, and thus his subjective valuation of goods and services, depending not on qualities in the good itself or its price but on the contextual, circumstantial characteristics and psychological state of the instant and situation. The economic explanation to market valuation is therefore at odds with real valuation and the models need to be expanded to include psychological drivers of subjective valuation. And therefore economics must embrace behavioral studies and neuroscience.
He starts out correctly, well not the very start but once he says “the endowment effect seems to shift an actor’s indifference curves, and thus his subjective valuation of goods and services, depending not on qualities in the good itself or its price but on the contextual, circumstantial characteristics and psychological state of the instant and situation” he is saying something correct. But this is not at odds with mainstream economic models. There is no law in mainstream economics that subjective valuation can’t change based on “the contextual, circumstantial characteristics and psychological state of the instant and situation.” It’s just that there isn’t much use in going around making models where people’s tastes change in random ways. Therefore, classical consumer theory assumes that people’s tastes don’t change in the middle of the analysis. This is not because we think people’s tastes never change it’s just that there is no way to base a scientific examination of human action on tastes which could be anything at any time. But when we see tastes appearing to change in a systematic way that doesn’t seem logical we stop and scratch our heads and wonder what’s going on there. We would like to come up with something better than just “well tastes change depending on whether you own something,” we want to find a logical reason why this would happen in a systematic way. Maybe there isn’t one but it’s not crazy to wonder about.
On the other hand, we have here and Austrian who thinks he can explain it. Here is a list of mistakes he makes.
Money Creation
Now we get to the real reason Austrian economics can’t save us from the Keynesians. Austrians know that Keynesian economics doesn’t really make sense. Unfortunately they don’t know that Keynesian economics kind of makes sense. It’s just that they Keynesians are not very clear about what they are really doing. They give things misleading names and explanations and make assumptions that are not very good but end up leading to conclusions which are right in many ways. I don’t know whether they do this on purpose or not but if they explained what was happening in a way that made sense I suspect many people would become very concerned about the way our economy actually works. So, ironically, this task falls to me.
To put it simply, the Keynesian conclusions that printing money or increasing government spending can increase output in the short run are correct but only because the economy is constrained by the monetary system and doing these things temporarily relax this constraint. They don’t magically create more wealth and prosperity, they just diminish the destruction for a while. To understand this requires a careful modelling of the money creation mechanism. So let’s start there.
Consider the market for loanable funds. By this I mean the market for borrowing and lending money. This is not to be confused with the market for savings and investment in a real sense. This market is depicted below. The horizontal axis is dollars and the vertical axis is the nominal price of borrowing a dollar, namely the nominal interest rate (i). At higher interest rates, more loanable funds are supplied and less demanded (holding all other things constant).
Figure 1
In a free market with a money supply determined by nature (such as commodity money), the nominal interest rate would be determined as that rate for which the quantity supplied and quantity demanded for loanable funds are equal or i* above.
When the fed “prints” money, they don’t just drop it from helicopters into the economy, they lend it into the market. At this point we have to choose a way to speak about the Fed’s policy goal. This is actually a source of a serious misconception in Keynesian economics which I will get to later but the issue that confronts us currently is to either say that the Fed targets an interest rate and creates the appropriate amount of money to achieve it or to say that they target the money supply and let the market determine the interest rate based on that money supply. At this point these two approaches are interchangeable, so it doesn’t really matter which we choose. I will choose the former. So assume that the Fed chooses an interest rate below the market rate. Call this i’. Notice that they can only lower the rate by lending. If they wanted to raise it above i*, they would have to become net borrowers which would mean they would have to create a new kind of security that as far as I know has never existed so it is safe to say that the Fed always sets rates less than or equal to what it would be with zero money creation.
At the target rate, the quantity of loanable funds demanded is greater than what is supplied. In other words people want to borrow more at this lower rate but they want to lend less. This is why this rate is not an equilibrium with zero money creation. However, the Fed can solve this problem by simply printing the money and lending it. In other words, they allow people to borrow money that nobody was willing to lend. Thus the new money created is equal to the amount of the shortage in the loanable funds market.
Figure 2
Now my hypothesis, as I have tried to explain in the past, is that it isn’t really the interest rate which the Fed targets (or at least it shouldn’t be). The problem is that they need to keep the money supply growing at an increasing rate. If the money supply stops growing fast enough things fall apart. I won’t try to convince you of this here just go along with it for now. You can read some previous attempts though [1] [2]. This means that the shortage in the loanable funds market must be growing at an increasing rate. There are essentially two ways it can grow.
The first way is if the Fed lowers the target interest rate. This is what Keynesians call “monetary policy.” If you lower the rate, holding supply and demand constant the shortage gets larger as in figure 3.
Figure 3
The other way is for demand to increase or supply to decrease (often the line between these two things is not very clear). This would happen because of a change in the real economy, and would cause the shortage to increase as in figure 4.
figure 4
Just from thinking about monetary policy in this way we notice several things. For instance, if the real economy is growing, the demand for loanable funds is likely increasing and the shortage is increasing at a constant nominal interest rate. This is essentially what Keynesians count on during expansions. If the economy is growing fast enough, they may even need to increase rates to keep the money supply from growing too fast. On the other hand, if the economy is not growing fast enough, they would need to do something else to keep the money supply growing.
The most obvious approach would be to lower interest rates. This works as long as interest rates are high enough to lower. If you lower them all the way to zero though you can’t lower them any more. This is the Keynesian liquidity trap but with a different explanation. Instead of being able to increase the money supply without changing the interest rates, they are unable to change the money supply because they are unable to lower interest rates. (Note that by “money supply” I mean the broader money supply not just base money) If this happens they must do something that changes the supply or demand for loanable funds. In Keynesian economics they call this “fiscal policy.”
By far, the simplest solution to this problem is to have the government borrow more. This increases the demand for loanable funds directly which increases the shortage and allows the money supply to grow. It doesn’t matter what they spend it on, it is the monetary effect that is important. This effect can exist along side the “broken window” effect. This is what Austrians don’t get. The wasteful effect of government spending is the Scylla to the Charybdis of monetary collapse. It’s not that Scylla is good, it’s that the alternative is even worse.
Another alternative is to convince people that future inflation is coming. This also increases the demand (and/or decreases the supply) of loanable funds, increasing the shortage and the money supply. In the short run, this is a self-fulfilling prophesy because the new money will raise prices, causing the expected inflation to materialize. Whether or not this is sustainable indefinitely is an open question, although I contend it is not. At any rate this is why you see the Fed going out of its way to look like they have additional “arrows in the quiver.”
Finally there are a number of policy options that can cause an increase in the shortage without the government borrowing directly. Chances are you would have never thought of these policies in this way but they provide a powerful part of the explanation for how this system has been able to go on for this long and present a frightening picture of how deep into this we are and how little is left to support the continued growth of money.
In the thirties, the government created Fannie Mae (and later Freddy Mac in 1970) “to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities.” Translation: to make it easier for people to get home loans thereby increasing the demand for loanable funds.
In 1935 the government created social security and in 1965 expanded it and added medicare. These programs take money from workers when they are under 65 and pay it back to them when they are over 65. This money goes into the general fund and is spent on whatever the government wants rather than saved/invested for the purpose of paying future benefits. The expectation is that the future benefits will be paid out by future workers. The effect of this is that workers don’t save as much (possibly nothing at all) in expectation of these future payments and this reduction in private savings is not offset by any increase in public savings. In other words, the supply of loanable funds decreases which increases the shortage.
Unemployment insurance (also originating in the 30s) removes the incentive to save “for a rainy day,” thus decreasing the supply of loanable funds.
Federal student loan programs encourage people to go to college by borrowing money, increasing the demand for loanable funds.
The Dodd-Frank bill lowered the fees banks could charge on debit cards, making credit cards more profitable and leading to more incentives for people to use credit rather than debit cards.
Of course this is a very abbreviated list. These examples go on seemingly without end and once you start thinking about things in this way you will notice them all over the place. One result of this is that we treat waste as production because waste causes additional demand for money. Another is that we are now a highly leveraged society and getting more so all the time. Just as anyone whose life is financed by debt our reality will come crashing down around us when we run out of equity to leverage. The man who finds himself in this situation is often surprised to learn that he doesn’t actually own anything. We would do well to realize it before that point.
Mainstream (Keynesian) Economics
Since I recently took on Austrian economics, I would be remiss if I didn’t turn my ire on mainstream economics before moving on to my ultimate purpose. First of all, mainstream micro is great (at least most of it), even though it sometimes falls back on cardinal utility. My problem is with the macro. Mainstream macro is essentially Keynesian. I’m already on record as thinking the neoclassical synthesis is the worst thing that ever happened to economics. I want to focus on a particular aspect of modern macroeconomics though which I think is the root of most of its issues.
In an economic model there are two types of variables. There are certain variables representing the state of nature which are determined exogenously. These exogenous variables represent the scarcity which is inherent in nature. Remember this line about mainstream economics:
It begins with the premise that resources are scarce and that it is necessary to choose between competing alternatives.
This is key, we will come back to it. Other variables are determined in the model (endogenously). These are the result of the actions people take to deal with the scarcity inherent in nature and are the things the model tries to explain. So in the model of the market for some good, incomes, tastes, prices of other goods, and costs of production are exogenous. They represent the nature of the scarcity faced by these economic actors (buyers and sellers). The model takes these exogenous variables and uses them to determine the endogenous variables price and quantity. When the exogenous variables change the endogenous variables change in predictable ways. This is economics. Note that when modelling the market for a good, when the quantity of that good increases it comes at the expense of other goods which are not produced.
The Federal Reserve has had a subtle but pervasive corrupting influence on macroeconomics. Pretty much every modern macro model treats interest rates as an exogenously given policy tool. This is because that’s what they are….now. The Fed sets interest rates (sort of). Economists want to predict what will happen in the real world. To us the “real world” is one in which interest rates are set arbitrarily by a handful of people in private with unknown motives. In other words it’s exogenous to the economy under study. Mainstream economists basically take this for granted. After all it’s been that way their entire lives. But this is not the natural role of interest rates. Interest rates are a price: the price of money today in terms of future money. In a free market, prices are determined in the market. They adjust due to changing market forces (exogenous variables) in order to bring the system into equilibrium. Once you make them exogenous you remove the whole mechanism by which markets allocate scarce resources between alternate uses.
This leads the thoughtful student in intermediate macro to some confounding paradoxes. For instance: how is it that if savings equals investment and savings equals income minus consumption, that when you lower interest rates investment increases but consumption stays the same? The astonishing answer, according to the model is that you just get more stuff. Where did that stuff come from? What competing use were these resources taken from? There is no such competing use. Income just increased. Why? Because it must have increased if investment increased and consumption stayed the same, and investment must have increased if interest rates decreased. In other words, by making price (interest rates) exogenous, they have to let another variable adjust to bring the model into equilibrium. Keynesians assume that this is output. So in this model, you exogenously lower the price and this reduces scarcity. The whole model is turned upside down!
To better see what I mean consider a simpler example. You observe a dam on a river with a reservoire behind it. Water flows out of the mountains and into the river from sources unknown. You observe that the pressure with which the water flows through the dam depends on how high the water is in the reservoire. You construct claculate an equation which gives the water pressure as a function of the height of the water behind the dam. Let’s call this P=f(L) where P is pressure, L is the water level and f() is some function. You declare that for any amount of water behind the dam the water pressure flowing through must be the value determined by this equation. This is good science.
This is bad science. You take the equation above: P=f(L) and declare that this must hold, therefore if you increase the pressure with which the water flows through the dam the water level behind the dam must increase. You build a pump that forces the water through at a higher pressure and assume based on the above equation that this will cuase more water to flow down from the mountains from parts unknown and raise the level of the reservoire. It’s the same equation but these relationships which make perfect sense when causality goes one way make absolutely none when it is reversed.
This same flaw leads to other head scratchers like: if the government increases taxes and spending by the same amount output increases. Where do these additional resources come from? The model doesn’t say anything about where output comes from (parts unknown….?) or what tradeoffs are involved. It is just a set of monetary equations which must hold in equilibrium. As it turns out the only real source of scarcity in the model is the tendency of people to save some of their income. If people just didn’t save at all then money would keep circulating infinitely making everyone infinitely wealthy. That is the actual implication of the model: infinite output if nobody saved. So naturally, if the government takes some of your money and spends it all they are spending what you would have plus what you would have saved so this somehow magically causes more goods to come into existence.
This is why our whole economic understanding is upside down. We treat spending as the genesis of economic activity not production. I just heard my hero, Charles Barkley, say that they were helping the economy because they had to hire a translator for Shaq. While hilarious, this is “turrable” economics. We treat waste as production. This is all because of an upside down model.
If you really want something to think about try this one: If the real rate equals the nominal rate minus the inflation rate, and the real rate is determined by real factors like time preferences and marginal productivity, then how is it that lowering the nominal rate increases inflation?
All of these paradoxes are not paradoxes when the proper things are endogenous and exogenous. But remember, the Fed was created in 1913. Keynes was doing most of his damage in the 30s. The change in economic thought is the result of a real change in the economic system. It is this change in the system which really needs to be undone but in order for that to happen we will have to start analyzing the effects of this change, which means creating a model with real scarcity and causal relationships with the dependency going in the right direction.
