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Scarcity in a Macro Model

I made a bit of a breakthrough over the weekend that I eventually want to talk about.  First, though, I want to back up and discuss the philosophical foundations of macro theory to provide some context for what I will be discussing.

My main beef with all forms of Keynesian economics is that it assumes there is no such thing as scarcity.  Since economics is the study of the production and allocation of scarce goods, I consider this a highly undesirable characteristic of an economic model.  I have quoted Keynes on this subject in the past and I won’t rehash that here.  Instead I will highlight what I mean with a simple example using the IS/LM model.  In this model, if the government increases taxes and increases spending by the same amount, this causes an increase in output.  This is because output is assumed to be whatever demand happens to be and investment demand is assumed to be independent of savings.  This causes a spending multiplier

The reason for this is that saving is substituting for scarcity in this model.  The only thing holding down output and consumption is people’s stubborn tendency to save part of their income.  If everyone would just spend it all, output would be infinite and we would live in a socialist scarcity-free utopia.  When the government takes part of your income and spends it, that keeps you from saving some of it and this causes an increase in output. 

The obvious question that rarely gets asked is: where does that increased output come from?  The model doesn’t really answer this it just assumes that it will appear if it is demanded.  Frankly this is complete nonsense.  It may be true that increasing government spending increases output but if we get this result from a model with no concept of scarcity we haven’t really explained anything.  What’s more, we don’t know if this is desirable or not since we cannot have any concept of efficiency in a model with no scarcity.  More is always better and you always get more by increasing government spending or lowering interest rates. 

Similarly, this model assumes that if you lower interest rates, this increases investment demand.  Since investment demand is assumed to be independent of savings (and therefore independent of consumption), where does this increased investment come from?  The answer of course is that it just appears.  It must appear because we have assumed that it can’t come from anywhere except an increase in output.  For those who believe that some consumption must be foregone in order to invest, this model will seem very unintuitive. 

Now to go a bit farther, one might argue that adding aggregate supply introduces scarcity.  However, this is not the case because it still does not model any tradeoff between one good and another.  Because of this Keynesians believe in the concept of a natural level of output which prevents increases in government spending from having a long-term effect on output but anything that increases the natural level of output can only be considered beneficial.  What’s more, there is no reason within the model to interpret a temporary increase in output as undesirable and there is nothing preventing a series of progressive increases in government spending and/or the money supply (decreases in interest rates) from constantly distorting output above its natural level (sound familiar?).

In order to construct a theory with scarcity we must be very careful to focus on real goods or real wealth.  Our model must obey the following simple rule.  At any given point in time, there is a fixed quantity of real goods in existence.  This means that we have to consider carefully what we mean by real goods.  This must include all valuable resources in the economy.  For instance, it includes gold in a vault but not money in a checking account.  It includes a stand of trees that is sitting idle in the wilderness.  It includes minerals in the ground that are not yet dug up (although it may be appropriate to exclude these if they are unknown), and perhaps most importantly, it includes a quantity of that one important asset for which every person has an endowment just as rigidly fixed by nature — time.

When we think of wealth in this way, the idea of output takes on a different character.  The question is no longer about how much we have but how effectively we are maximizing the value of what we have.  The question is not how much will be created.  Instead it is into what form will the endowment we have be transformed.  To understand this consider the case of labor.  A typical view is to look at an increase in employment and a corresponding increase in “output” and say that we got more stuff so we are better off.  This is not precisely correct.  We did in fact get more stuff but we gave up some other goods to get it.  We transformed some amount of labor which could have been used for leisure or some other production, along with some other inputs most likely, into another form.  It is quite likely that this resulting form will be of higher value than the inputs, in which case it may be a Pareto improvement but when we lose track of the inputs we lose the ability to even consider this question.  The problem with unemployment from our standpoint is not that it causes us to have less but that it represents a situation where we are for some reason unable to transform the wealth we have into its most valuable form. 

In this context we can still talk about production and output but if we are to construct our model on markets that are in equilibrium on a micro level, then we will have to make the amount of output at any given time dependent on decisions made at previous points in time.  This is because any wealth which is capable of changing form instantly will naturally change to its most valuable form at that point in time.  Therefore, we may (and typically will) take these decisions for granted.  The important issue for our purposes will be how we arrived at that level of wealth, or to state it another way, how will we make decisions that affect the value of the wealth (output) in the future. 

What this boils down to is a distinction between consumption and investment, that is between using the wealth in existence at a given point of time to satisfy consumption at that point in time or to produce wealth at some point in the future.  For our purposes, we will assume that if wealth is consumed, it will be consumed in its most valuable form and typically that if it is invested it will be invested in its most valuable form.  This latter assumption marks the point of departure from Austrian business cycle theory, although it may at times be worth considering the possibility of “malinvestment.”  This would not be a significant change in approach so long as agents think that the chosen investment forms are of highest value at the time they are made.  Naturally, since there is some amount of time between the decision and the realization of the results, this belief could end up being incorrect, and if this happened in a systematic way it could constitute a valid theory of the business cycle.  Once we develop a model of a frictionless economy where markets clear, we can consider the effects of various market imperfections such as sticky prices or price controls.

With this approach in mind, we can consider the question which has been confounding me for some time until now.   If the decision between consumption and investment depends on the real interest rate, what happens if the Fed sets the nominal interest rate below the natural rate and manages inflation expectations in such a way that people actually perceive the real interest rate to be lower than the market clearing  rate?  This question is difficult because this describes a shortage of real investment.  In other words, lower interest rates should cause an increase in the quantity  of investment demanded but it should also cause an increase in the quantity of consumption demanded (decrease in quantity of savings supplied).  If more investment is demanded than supplied, how can this market clear without inflation expectations or interest rates changing?  Or in other words, when both consumers and investors are pulling harder on a fixed quantity of wealth, who wins?  Stay tuned for the answer.

Update: It’s worth noting that this approach is essentially that embodied in neoclassical growth theory so I don’t mean to make it sound that profound, just to contrast it with the approach taken by Keynesians.

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