Sunday, February 01, 2009

Flat Earth Economics

A few hundred years ago, it was widely believed that the Earth was flat and that the Sun revolved around Earth (Geocentrism). Now we all (?) know that the Earth is round and revolving around the Sun, but we could perhaps find it understandable that people actually believed in those things with their more limited level of knowledge. I mean, after all, when we look around, this planet doesn't appear to be round, it appears to be flat. Or well, not exactly flat, there are mountains, hills, and valleys, but on average it appears to be flat. Similarly, we do in fact seemingly see the sun move, rising in the East in the morning and setting in the West in the evening. And if it was Earth that was moving shouldn't we feel that we were moving, just like we felt that we were moving when we were riding on a horse?

Similarly deceptive appearances exist in Economics. When for example (almost) all companies report that sales are declining, it seemingly appears as if Keynesians are right when they say that the crisis is caused by "insufficient aggregate demand". If it were true as Austrians and some other non-Keynesians say, that the crisis was caused sector specific overinvestment, then surely we should see some sectors boom while others contracted. But as all sectors suffer, the Keynesian aggregate demand explanation appears more plausible.

What the Keynesian theory overlook is of course while "aggregate demand" in a statistical sense may indeed fall, the explanation that this is the root cause of problems assume that the reason why people demand less goods is that they simply don't want more of it, which is not true, if anything people are less content with their level of spending during slumps. The cause is instead that they can't afford these things any more because a large part of the nation's productive capacity has turned out to be malinvestments, and so cannot generate income for the people who worked and/or invested in that sector. Or in other words, as the malinvestments means that these workers/investors can't supply any goods, they can't demand goods from other sectors. The supply shock that the revelation of malinvestments implies will thus later result in what later appears to be a decline in aggregate demand, but the root cause remain the sector specific malinvestments.

Similarly, how could increases in the money supply possibly be responsible for higher prices, when it is often the case that immediately following a money supply increase, no significant price increases can be seen. And how could money supply increases be responsible for price increases when the time lag between the two usually vary? And how could it be responsible for price increases when some prices increase dramatically while others fall? Surely, if money supply was responsible for price increases, then all money prices should rise equally? As prices behave differently, surely there must be more specific explanations for each price movements (greedy price gouging capitalists, droughts, terrorist attacks or whatever).

This fallacy is complicated that it is often true that non-monetary factors move specific goods up or down and that for various reasons the exact time lag between money supply changes and price changes vary. But the money supply increase means that prices that rise for non-monetary reasons as well will move up more than otherwise, and that other prices will rise even though they would have been flat or even falling without the increase in money supply.

But while the theories that aggregate demand is responsible for the business cycle and that price movements are unrelated to money supply movements are of course as false as the Flat Earth theory or the Geocentric theory. But they are also as seemingly plausible at first glance, which is why it is easy for people to get deceived by these theories.

But while natural scientists today of course reject the Flat Earth theory and the Geocentric theory, most economists instead argue for the false theories created by false appearances. Frederic Bastiat once wrote that what separates good economists from bad is that the former when evaluating certain actions looks beyond the immediate effects for some and also looks at the effects for others and the long term effects for all. What also separates good economists from bad is that the former when explaining certain things look beyond the appearance created by the visible symptoms, and looks at the more complex root causes.


Anonymous Anonymous said...


I am not so much familiar with Austrian theories, but I want to ask - what does this imply for policies to counter economic downturns?
Do governments have to increase their spending during economic slumps, but
1)NOT BY bailing out unproductive industries (like car-manufacturing in US), as without serious restructuring they will continue to produce malinvestments and shift away scarce economic resources from other industries
2) NOT BY stimulating general consumer spending (by lowering taxes, making rebates, etc.), as the problem is not insufficient demand, but malinvestments instead
3) BY increasing infrastructure spending, as resources are cheap during slumps, and it creates (productive) jobs for the people (of course, money must go to the best infrastructure projects, not divided among states, as the latter would cause states to spend on unnecessary projects)
4) BY increasing social benefits for poor and jobless, by enough to make it possible for them to survive trough the slump, but not more than this as that would make more people to choose unemployment benefits as their main source of income instead of job salary (assuming free vacancies have become available)

Am I correct?

Lastly, what is your take on Latvian/Baltics situation. Is the path chosen by IMF/Latvian government correct? (cuts everywhere, deflation instead of devaluation, no government intention to make any expansionary moves, although GDP is projected to fall 10% this year (Swedbank), and moreover - decision to increase VAT - although other EU countries are doing the opposite...)

reader form Latvia

8:57 AM  
Anonymous Anonymous said...

Enjoyed this post.

9:02 AM  
Blogger stefankarlsson said...

Latvian reader: I'll return in a later post for a longer analysis of policy implications of Say's law. For now, let's just say though that focus should be on liquidating the malinvestments and instead use production factors in sectors that produce what markets really demand.

As for Latvia, I'm afraid that a really sharp slump is inevitable given the massive excesses in your country. While not endorsing all of the specific points, the kind of "internal devaluation" strategy now chosen is preferable for several reasons to a formal devaluation. Both forms of devaluations create an increased debt burden for some, but with an internal devaluation the adjustment process goes faster because real interest rates are higher.

5:38 PM  
Blogger Ke said...

Haha, I really enjoyed this post, especially how you compared Keynesians to Flat earth geocentrists.

7:31 PM  
Blogger Celal Birader said...

I have to say you have indeed brought some clarity to my mind about this notion of 'aggregate demand' which i had imbibed in my economics courses.

You have shown me that perhaps this may not be as logically sound an approach as my economics education has 'brainwashed' me to think.

I have also come across this expression 'output gap' as used in some economic analysis.

Is this a tool of analysis or a concept used by Austrian economists ?

9:02 PM  
Anonymous matt silb said...

>A few hundred years ago, it was widely believed that the Earth was flat and that the Sun revolved around Earth (Geocentrism).

People have known that the Earth was round since the ancient Greeks, they even measured it. Hell, Columbus was over 500 years ago. And Copernicus published 450 years ago. That is more than a few. If you are going to make a point at least be factually accurate.

2:15 AM  
Anonymous tomash said...

The sad truth is most people still believe in Keynesian "Geocentrism". Mass-media and educational system have done their job.

All the best from Poland!
PS. We do not have crisis here ;o)

1:26 PM  
Anonymous Per-Olof Samuelsson said...

Well, it is true (as Matt Silb points out) that "flat earth" and geocentrism are not the same thing. But that doesn't change Stefan's point, does it?

5:22 PM  

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