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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.




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  1. January 2, 2012 at 6:19 am

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