Economics Is Mostly About Human Psychology
An African market: a place where economic balances are discovered
Photo Credit: Freeimages.com/Stewart Aston
Last night I was musing about how I could persuasively sell the idea that an economy’s functions are fundamentally based on microeconomic phenomena. Those who currently dominate the economic councils of government in the United States, Europe, and Japan, and probably most other places as well, have a very different mindset. What the economically powerful, the Keynesians, believe is that in economic bad times a simple macroeconomic push, provided either by the fiscal or monetary policies of government, can get a stalled economy running again. Their ultimately fatal error is not realizing that the health of an economy is determined primarily by a mind-bogglingly humongous number of relations between economic agents, not by aggregate demand and and aggregate supply.
The Microeconomic and Macroeconomic Views of an Economy
When economics began as a serious academic field during the age of Adam Smith, all attention was placed on what was later called microeconomics. Each of the economic laws formed between 1776 (the publication date of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, usually called simply The Wealth of Nations) through the marginal utility revolution of the 1870s focused on how individual economic agents — the suppliers and consumers of goods — interacted to determine amounts of goods produced and their prices. I do not mention services since they are just a different kind of good. The very first of those laws, the Law of Supply and Demand, showed what happened to amounts of goods produced and sold when the prices were close to a market equilibrium. The emphasis was on the interactions between suppliers and buyers. The second of those laws, Say’s Law of Markets, stated new production of a good would cause new demands for other goods to increase. The third neoclassical law, Ricardo’s Law of Comparative Advantage, told under what conditions an international trade between a supplier and a buyer in two different nations would be profitable to both nations. This law has the distinction of being the only one that possesses a rigorous mathematical proof. These three laws form the classical theory of economics.
Economics became neoclassical when the Law of Marginal Utility was discovered in the 1870s by Carl Menger of Austria, Leon Walrus of France, and William Stanley Jevons of England. All of the classical economists before them, from Adam Smith to Karl Marx, believed the economic value of goods was determined by the value of inputs used to create them, most particularly by the value of required human labor. The marginal utility revolution taught us that instead of valuing goods for the value of inputs needed to produce them, we value goods because of the utility they have for us. How much does a buyer value the utility of a good? For him the value of it’s utility is worth whatever he is willing to pay for it. Marginal utility then goes on to teach us how supply and demand are changed by changing circumstances varying the costliness of producing the good, or by saturation of demand. I will discuss some other implications of the utility theory of economic value shortly.
All of neoclassical economics was focussed on the direct interactions between buyers and sellers, what is now called microeconomics. Beginning with John Maynard Keynes during the Great Depression, focus was shifted to the simultaneous collective behavior of all economic agents in the economy. The variables of interest were the aggregates such as GDP, unemployment rates, aggregate supply, and aggregate demand that summed up the agents’ collective behavior. Keynes’ macroeconomic description of economic phenomena emphasized that demand for goods by the government could take the place of lost aggregate demand from private sector consumers during hard times.
Keynes explained the Great Depression by noting that in a time of deflation, people and businesses would hold on to their money for as long as possible. Because deflation was increasing the value of their money, all economic agents increased their buying power by buying only what was absolutely necessary and hoarding as much cash as possible. As a result, aggregate economic demand fell precipitously, decreasing the velocity of money and thereby increasing the deflation rate. In The Federal Reserve and Monetarism, I showed the connection between quantity of money, velocity of money, and the GDP as
Where P is a price index, M is the amount of money in the economy, V is the velocity of money (the average number of times the monetary unit, such as the dollar, is exchanged each year), and y is the size of the GDP. The Greek delta symbol Δ denotes a change in the variable it precedes, so that ΔP is the change of the price index over a year’s time and ΔP/P is the year’s fractional change, which when multiplied by 100% is usually called the inflation rate. If the inflation rate is negative, it is called the deflation rate. Everything else being equal, a negative ΔP/P (deflation) can be caused by a decrease in the velocity of money, ΔV < 0.
However, more was going on in the Great Depression than just a decrease in the velocity of money. Simultaneously, the Federal Reserve was making the horrendous mistake of decreasing the amount of money in circulation. Between 1929 and 1933 the Federal Reserve decreased the money circulating in the economy by one-third, allowing a large and negative ΔM/M to cause greater deflation (negative ΔP/P) and a decrease in the GDP (negative Δy/y). In addition other government intrusions into the economy combined together to depress economic activity and prolong the Great Depression.
From their point of view the Keynesians were puzzled in the 1930s about why their stimulus programs were not having a greater effect. This problem led the Keynesian economist Alvin Hanson to develop his idea of secular stagnation. The basic idea was corporations could not find profitable ways to invest to increase productive capacity, and therefore the economy could not grow, and that the reasons for this lack of profitable opportunities were market failures. In his 1938 book, Full Recovery or Stagnation, Hanson gave an extended Keynesian argument that without government fiscal stimulus programs, the economy would experience long-term stagnation and elevated unemployment. The secular stagnation problem ended with the advent of World War II, and with the higher economic growth of the 1950s, secular stagnation was forgotten by all but academic economists.
The Psychological Field of Economics
The problem of slow economic growth over the past eight years or so has again placed Keynesians in the situation of trying to explain why their ideas are not working very well. With Hanson’s past example, Keynesians led by the eminent economist Larry Summers are trying to revive Hanson’s old idea, justifying an extended period of government intervention into the economy.
However, to take such an approach presents a number of dangers, not the least of which is to mistake the actual causes of economic problems leading to recession. Let us consider for a moment what in fact causes a recession. We first take note of a recession’s onset when we see a falling GDP causing losses for companies and increasing unemployment. So what causes the falling GDP? So long as what companies produce is completely bought by consumers with little surplus left over, the GDP will not fall and could even increase if some of the production is devoted to investments in new productive capacity. If for some reason demand falls, companies continuing to produce what they did in the past will produce more than what is bought and will have to endure the cost of warehousing the surplus. They will then cut back production until sales prunes the surplus, and will lay off employees as not needed for more production. GDP will be reduced.
On the demand side what happens if instead of a surplus, there is a shortage of goods? This situation can also lead to recession if the shortages are of raw materials or intermediate goods needed for the making of final goods for the consumers. Not having enough inputs to make their product, companies will lay off workers, keeping only enough to make what product they can. Such shortages can be generated for example by sudden political events, such as the oil shocks of the 1970s, or by some natural event such as droughts or the vanishing of a natural supply of a raw material. If enough of all supply-demand balances are upset, the sum of all reductions in GDP may be enough to tip an economy into recession.
Any modern economy consists of a vast, finely-grained network of two-way relationships between suppliers and consumers. Anything that upsets the balance of the demand of a good with its supply by causing either surpluses or shortages will reduce total economic output, i.e. GDP, and therefore employment as well. What makes all this even more interesting is the role of human psychology in determining economic value. A good’s economic value is determined by its utility to the buyer, which as I noted earlier is completely subjective. Therefore, if a government economist crafts a Keynesian stimulus, he or she must take care that what the government is demanding with their “stimulating” expenditures is a product that people really want. In fact, if the stimulus is completely efficient, it will purchase the selected goods only to the same amount as people would buy without the government in a healthy economy. Otherwise, when the stimulus program comes to an end, people will not continue to purchase the stimulated good. Then, all the capital that went into producing the excess stimulated good would have been wasted, and the capital’s use denied for projects that would have satisfied private-sector demands.
In fact the very complexity of the interknited desires of a country’s people makes a truly efficient fiscal stimulus virtually impossible. What government stimulus programs usually do is to make expenditures for a very limited number of goods, and those usually which are naturally demanded by a government. Demand for expansion of infrastructure, particularly for roads and bridges, is typical, as well as subsidies for jobs and job training. All of these could be found in the Obama administration’s main “stimulus”, the American Recovery and Reinvestment Act of 2009. However, if one examines how GDP behaved at the same time the stimulus became effective, there is little evidence the act had much influence on unemployment or on GDP growth.
Why Economic Systems Are Chaotic
The reason why fiscal stimulus programs are generally inefficacious can be found in the microeconomic supply-demand balances (or lack thereof) that constitute any economy. An economy can be described in terms of interactions between economic agents, defined as those who either buy or sell a good. In the post Chaotic Economies and Adam Smith’s Invisible Hand, I described how to define a state space for an economy in terms of numbers of suppliers and consumers for each economic good in the system. An interaction between these economic agents, i.e. a sale or trade, is then local in this state space, with the effects of the trade rippling through the economy through trades that either enable or are enabled by the local trade. The interactions between these agents are fundamentally psychological, as each decides on whether they should buy or sell. The locality of the interactions between the basic components of the system, the economic agents, together with the huge number of these components, which are the degrees of freedom of the system, force any economy to be a chaotic system.
The mathematical theory of chaos is the study of systems that are highly sensitive to initial conditions. Another way of saying this is that chaos theory is the study of complicated systems exhibiting a characteristic called the “butterfly effect”. This term was coined by Edward Lorenz, a Massachusetts Institute of Technology meteorologist who studied computer simulations of weather. He was renowned for showing how unreproducible these simulations could be because of the chaotic nature of the system. Small round-off errors in the inputs of initial conditions would be sufficient to produce huge differences in the system state at a later time. The coining of the term “butterfly effect” came from the title of one of his papers in 1972, Predictability: Does the Flap of a Butterfly’s Wings in Brazil Set off a Tornado in Texas?.
Two traits are shared by both weather systems and economic systems, the very traits that make them both chaotic. The first is that interactions between system components (in the case of a weather system, air molecules interact locally by collision) are local in the state space. The second is they both possess a very large number of degrees of freedom. Because of an economy’s chaotic nature, an attempt to affect the entire economy globally through a stimulus program will generate changes to a great many of the supply-demand balances within the system, unbalancing a great many of them. Thwacking an entire economy with a global perturbation will see that perturbation propagate in many unpredictable directions in the state state, unbalancing even more supply-demand relations as the perturbation passes. The only way the economy can reliably find balances for most such relations is to remove the obstacles to them that most government economic intrusions create. The balances will then emerge naturally at a microeconomic level.
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