Tuesday, September 13, 2011

Macroeconomic Policy and Fooling the Public

As policy leaders dispense with logic and grab at policy straws aimed at further demand stimulation, it is good to review the essential assumptions underlying the Keynesian model’s optimism about aggregate demand policy. The key assumption is something called Wage Illusion. A second one has gotten less notice but is something we might call Business Optimism illusion. I was going to call it Snake Oil but I had another JD and calmed down a bit.

While there are some who believe that economics and especially macroeconomic can be reduced to the terms hocus pocus (ie total nonsense) I cling to the notion that macro and macro policy have a basis in logic. When President Obama or one of his policy advisors recommends a stimulus package, the recommendation does not come out of the blue – it comes from a well spelled-out analytic framework. I keep resisting the urge to use this word – but I really should admit that our real world policy is based on THEORY. Whew, I went ahead and said theory. I feel a bunch better now.

One theory says that you might want to try stimulating demand as a way to exit a recession or improve the growth of the economy? Most of us learned something called Neo-Keynesian theory.  It turns out that Monetarists and Supply-Siders also pay homage to the Neo-Keynesian Model (NKM). While these groups of economists may disagree on policies and various technical aspects of the NKM, they tend to use the NKM to support their recommended policies. You might call the NKM an agreed common battleground. Monetarists and Neo-Keynesians do not usually agree about policy but they use the NKM to duke-it-out.
So let’s get back to stimulating the economy with a policy to increase spending or aggregate demand. It all sounds so reasonable. Give people tax cuts and they will spend. Give people bigger subsidies and they will spend. Have the government build roads and bridges and the people that build these roads and bridges will receive income from the government and they will spend. You have to admit, it sounds pretty straight forward and easy. Woowee!

I see that some of you are getting red in the face and are ready to inhale large quantities of funny cigarettes. So let me agree that the above oversimplified. Some of those people who receive the new incomes have big debts to pay and do not spend all of the money. And we know that at some point some tax payer will have to pay for the government handouts – and those who pay the extra taxes will spend less. So you can understand why some people might be doubtful that the government can create as much spending as I alluded (deluded?) to above. But that argument has already been made widely and loudly and I don’t want to get into that in my remaining three million pages below.

Let’s take a really big breath and just ASSUME that the government policy I described above does lead to more spending. So now we can imagine shops with more customers and companies enjoying higher sales and possibly higher profits. What does the NKM say happens next? First, business firms work down some of their inventories and given sanguine expectations about future sales they begin to hire more workers.  Workers are pleased as punch to take the job offers and are quite willing to accept the employment.  

According to the NKM, the firms have excellent foresight but the workers are a little dim. The workers are afflicted with a macro-disease called wage illusion. That is, they are willing to work at a very low wage simply because they are asked. It is sort of like the plain girl at the dance who agrees to have her feet tromped on by any hayseed who requests a quick belly rub (that means dance for you people with dirty minds). Firms are assumed by the NKM to fully appreciate the fact that a stronger economy will bring about higher prices and make the worker worth the bargain. The worker, however, is assumed to not anticipate or not care about the higher prices that will further erode their buying power.

Upshot – Wage illusion is the key and critical assumption of NKM that translates an increase in spending into an increase in employment. From there it is all (Four) roses and JD – once employment increases this facilitates even more spending and we are on the Staten Island Ferry bound for glory.

So what about this wage illusion thing? My guess is that if this psychological/informational disparity ever existed between workers and managers, it does not have a pot to piss in today. I use words like piss in a pot so that economists like Paul Krugman will understand what I am saying. And when I say today, I mean anytime after about 1969. After 1969, when inflation was beginning its notorious charge into the upper atmosphere, very few workers were not paying attention to the myriad ways that inflation eroded the buying power of their incomes. I recall when the coal miners went on strike at the end of the 1970s and were demanding a three-year wage hike of something like 39%. That doesn’t sound like dim workers to me. Today’s papers show Greek workers smashing pumpkins and otherwise displaying their displeasures with Greek austerity programs that would diminish their incomes.  Wage illusion simply has no relevance to today’s situation. Without wage elusion, you have more resistance of workers to job offers. It is not as easy as the NKM assumes to find and hire workers at wages that are favorable to firms, given the state of the economy.

And this brings me to the second part of the NKM illusions – the one about the firms having optimistic views about future prices and profits as a result of the government’s new program and the ensuing first round of spending.  Note that in the NKM once the spending starts flowing the firms soon decide they need more goods and to get the extra goods they need more workers.  So we might ask the following question. What makes the firms so sure that this new spending is going to be permanent? After all, the avowed stimulation policies of the government are meant to be temporary. By design they will be removed soon in the future. So maybe the NKM was assuming something we might call OPTIMISM ILLUSION when it automatically assumed that firms would place their stamp of approval on the fiscal stimulus and fall over each other trying to hire a bunch of workers.

So there we are. Our fellow macro policy activists assume: (1) labor wage illusion and (2) Business Optimism Illusion. What happens if neither of these illusion assumptions really hold today? What happens if workers acknowledge that prices will rise in the future? What happens if firms are somewhat skeptical that government has addressed underlying factors that caused the recession in the first place? I wrote a blog post in the past where I likened recent monetary and fiscal stimulus to pushing the blood back into the patient. We want the doctors to address what caused the blood to flow out – not push the blood back in.  What if business firms worry that the government has not adequately addressed housing, finance, too big to fail, excessive and corrupt leverage, excessive government regulation of business, and other factors that caused the recent recession?

Wouldn’t it be nice to use a version of the NKM that assumes that both workers and managers are rational enough to take care of themselves properly? Do we really want our policies based on assumptions about illusions and people who do not know how to take care of themselves? I doubt it.

So if you agree with me you understand that liberal macro activists are misleading our poor government leaders into doing things to the economy that will either have little effect or will make things much worse. Also, if you agree with me, you can quote me on this new concept called Business Optimism Illusion and support my nomination for the Nobel Prize (for excessive creativity)) or at least for the Guinness Book of Records. Or you could just send money. 


  1. Thanks again Larry for an entertaining post. I recently read an article in the Guardian's about the patient (the global financial system) still being in critical condition. It said that the 'F' word is back in the mind of the market (and leaders). That is 'F' for FEAR. Fear of a relapse of another economic crisis. The Euro crisis, UK riots, sovereign debt, etc. are all causing leaders to reconsider austerity measures that might topple their country's fragile economies. I agree that the wage illusion and business optimism illusions will be seen through if not by rational workers and businesses, but by very FEARFUL ones. There is genuine fear that governments aren't doing what is necessary regarding financial reform. And in return, politicians and central banks are fearful of not acting in time. So, once the FEAR genie is out of the bottle, how do we deal with it? As Marx said, "The philosophers have only interpreted the world, in various ways; the point, however, is to change it." One could very well replace philosophers with economists I guess.

  2. I feel about Keynes as I do about Bear Bryant. Why don't the Alabama faithful let Coach Bryant rest in peace instead of digging him up every fall? Why do the rookies in DC continue to dig up JMK? Bryant I can almost see. At least his scheme worked. Keynes, not so much.

    I was doing OK without taking any deep breaths until you brought up Krugman. He's living proof that the Nobel Prize for anything is irrelevant.

  3. A little too intellectual for me. I want to put it in a more "on the street" perspective. I have a manufacturing company (I know it’s an anomaly). In 2006 at the peak of the housing bubble we were selling $1M in product used to seal pool deck and driveway paver bricks. The funding came from a false source...home equity loans. By 2009 that segment of our business had all but vanished. The coating installer dropped prices to the point that they could no longer make a profit and eventually quit buying from us. We in turn redirected out marketing efforts to hospital bathroom tile and grout because they had sustainable funding, the installer could get a fair price and competition had not discovered this niche yet. Problem is that the margin on the tile and grout product is 25% less than that on the paver brick product. So our net profit fell even though we had a sustainable growth market and were making more gallons.

    It is now almost 2012 and not much has changed. Forty percent (40%) of the homes are underwater so there is no hope for the paver brick market to return in the next 5 years. A new health care program will start to take place by 2012 in earnest and it appears this will drive down the fees at the hospitals thereby delaying any new capital expenses on such luxuries as tile and grout sealing.

    My point here is that the "new norm" was building on itself for the last 30 years and now it is here. Government's temporary spending in portions of the economy where the lowest worker income portion of wages exists will not translate to higher home values, more capital spending...etc. It will translate to people being able to feed their families and buy stuff made off-shore...for the most part. No tax credits will get me to employ any unemployed if I do not need them and we have fully automated our production and sales systems to cut cost of operation. We have joined the "new norm" and so have thousands of other small businesses.

    When the temporary government stimulus stops so does nay real impact because of the reasons Dr. Davidson gave above and the lack of our government to understand that they cannot create sustainable private sector jobs. All they can do is impact the environment in which these jobs should be created and we are no longer the only player on the world's stage for economic success.

  4. Thanks Brad. Yes, fear is taking over the markets and for good reason. Yet our politicians here and in Europe do not get it. As for economists taking over from philosophers, you might call that the blind leading the blind. The question remains -- which philosophers? Which economists? :-)

  5. Al,

    So this means you are not going to send money?


  6. James,

    Intellectual I am not sure. For the economists in the crowd I wanted to speak in model terms -- to emphasize why the stimulus is not working. They have the wrong assumptions in their models. But if I read you correctly you are pretty much saying the same thing. Assuming that the government can make firms more optimistic is questionable or just wrong... especially when their policies are barking up the wrong tree.

  7. You want money? Hang on while I fire up my printing press.