Macroeconomics: Fairy Tales can come true and so can Nightmares!

What is real and what is fantasy? I think most of us know the difference. The gym I go to has mirrors on most of the walls and despite trying not to actually look at any of them I do once in a while see my entire hulking mass. That is reality despite the fact that it is just a reflection off a glass. Then I close my eyes and imagine the future LSD with the tiny waistline and six pack abs.  Betwixt the fact and the fancy I am motivated to do one more set of sit-ups before adjourning to a sumptuous lunch. This introduction about reality and Fairy Tales brings us to Macroeconomics and GDP. It also brings us to today’s economic difficulties and why our traditional policies seem to make things worse.

GDP exists only in the minds of theoreticians and mathematicians. No one has even bit into a GDP and no one has ever paid a CPI. These are abstractions or fantasies – just like an image of me with a waistline– the fantasies do not in fact exist. But fantasies can matter. Fantasies can be very useful or very devastating. If images help me to be more healthy and youthful then they are valuable despite the fact that they are pure fantasies. If these same images cause me despair and depression, then they are not so helpful. Either way, they are impactful.

GDP is defined as a nation’s output – it is a number that we get by adding up everything that was reported as produced within the borders of a nation. While it is a real concept it has no physical counterpart that we can associate with it. Just imagine all that stuff that got produced last month in a big pile in the street in front of your house. Our imaginations run wild as we think of this one thing that is the result of somehow melting down or bolting together every good and service that got produced that month.

Okay? So a GDP is a concept or a fantasy and is nothing you can really sink your teeth into. The nation’s price level is the same. So is the nation’s interest rate, unemployment rate, exchange rate, and so on. In fact, it is worth pointing out that a nation is also a concept and not so much a real thing. Wikipedia says “… a nation may refer to a community of people who share a common territory and government; and who often share a common language, race, ...”  Try to bite into that!

It is important to do two things with respect to these macro fairytales – first admit that they are not real and second understand to what extent they can be useful (or not). Dr. Seuss books are about fantasy characters that never existed – but they sure did a nice job of helping me put my kids to sleep. The headless horseman of the Legend of Sleepy Hallow, in contrast, wasn’t always the best thing to read right before bedtime! What I try to do in this posting is to argue that today’s situation macro policy is a little more like Sleepy Hollow than Dr. Seuss. Despite what a host of so-called macro experts are saying today, we would be better off ignoring macro and focusing instead on the “little pictures.”

So as a card-carrying macroeconomist let me be the first to admit that GDP, CPI and other things I teach about are figments of our imagination. None of us buys all the goods and services that get produced and few of us directly experience the calculated cost of living. When the unemployment rate is 9% only a small fraction of us experience the actual state of unemployment. And while we might live in Indiana many of us might share more personal characteristics with people from Poland or Canada than the yokel who lives down the street and let’s his dog bark all day (and sometimes all night).

While Macro was A TOPIC OF CONVERSATION BEFORE Sir John Hicks invented the IS/LM Model, that innovation can be given a lot of credit/blame for the propagation of Macro’s usage. For example, Keynes’ widely read and quoted General theory of Employment Interest and Money was instrumental in popularizing macro by focusing attention on national macroeconomic policy. But it took Sir John Hicks’ representation to create an academic or classroom revolution. Before Hicks, Macroeconomics was mostly story-telling among a small group of intellectuals. Today we have Hicksian models taught to millions of university students each year. Each of them learns a model – sometimes offered in mathematical equations but more frequently portrayed with graphs. The star players of these models are labeled Y and r. In expanded versions of the Hicksian IS-LM models are also found N and P. The focus of these models is what determines a nation’s output (Y), interest rate (r), employment (N), and price level (P). Economists and journalists have used these models and similar variants to analyze and debate the roles played by monetary and fiscal policy in generating superior paths for these variables.

Without getting into macro policy debates, let’s agree that whether you attribute this all to Keynes, Hicks, or a host of other great minds, the truth is that they collectively defined and gave us a set of unreal concepts by which to measure the performance of a nation’s economy. They also gave us a set of debatable doctrines that helped us approach the questions of if and how we might improve the nation’s economy.

For example, if measured GDP was forecast to fall by 10% next quarter, we would all be very concerned. Some segment of our population would immediately ask the Fed to begin an expansionary monetary policy. Others would ask for income tax cuts. Still others would prefer a government spending program that enriched entitlements or spent more on shovel-ready projects. These approaches are designed to remedy problems that have broad impact and might be appropriate. But just like you don’t take a bubble bath to wash your hands after a trip to the restroom – macro policies are not always the most appropriate remedies when problems do not stem from macro sources.

If the only tool you have is a shovel, then you are ready to use a shovel for any or all your problems. If you learned a lot of macro, then you are quite ready to approach economic problems as if they could all be remediated by monetary and fiscal policy. But that was never true and never will be. While our macro indicators like GDP are by definition impacted by almost anything, the truth is that the sources of many problems are not national in scope and are not macro issues for the USA:

                A real estate collapse in New York

                Banks failing in California

                Canada stops buying US exports

                The inflation rate hits 10% in China

                US consumers decide to take more Mediterranean cruises

The solution for the person with only a shovel is to buy a saw and a hammer – because some problems are better handled without a shovel. The solution for a country’s economic ills is to realize that not all economic problems are macro problems requiring macro solutions. Some problems are better handled directly.

Despite the fact that some of today’s political leaders cannot walk two feet without mentioning changes in the distribution of income or the plight of the poor, how many of them have fashioned a comprehensive policy aimed directly at the sources of poverty and income inequality? It seems easier to call for tax and spending policies that continually press the entire economy to grow faster. But this is an extremely inefficient way to help a minority of the population catch up to the rest and totally ignores those factors that perennially keep them behind.

Y, r, N, and P are all valuable macro indicators and have their place in policy. But just like a flat tire does not necessitate a full overhaul of the car, changes in these macro variables do not always indicate a need for a national macroeconomic policy. Perhaps if we understood this we would make fewer mistakes and take better care of the peoples’ money.  Could we have averted the last recession if we had paid attention to our knitting? Did real estate need some attention before the bubble burst? Was excessive financial leverage not something that could have been addressed? Could we have worked harder at free trade agreements? Could we have paid more attention to imbalances in global commodities markets and adjust our energy production/uses with specific policies?

Macro is a fantasy but a useful one. But like many useful things it can be used wrongly or poorly. Today we suffer from macro-mania as we struggle with the aftermath of a deep financially-induced recession. Abnormal psychology makes the point that it is the extreme or special cases that help us better understand normality. We are learning from our special situation today that macro tools do not work as well as we thought they would. Maybe it is time to realize that not every problem needs a shovel and not every economic problem is macro. We have a lot of tools we just need to use them.