Economics, Say's Law & the paradox of thrift

Interesting report by David Uren in the Australian. I quote in part:

THE International Monetary Fund has warned that the forces that caused the Great Depression in the 1930s are again at work, as households, businesses and governments all cut back their spending.

In a briefing provided to finance ministers and central bank governors at last weekend's G20 meeting, the fund said the Australian government should stand ready to abandon its pledge to return the budget to surplus if the world economy took a turn for the worse......

In issuing its Great Depression warning, the IMF referred to the work of economist John Maynard Keynes, who showed that when everyone tried to lift their savings simultaneously, the total savings in the economy fell because there was not enough demand for goods and services.

"The overarching risk is of a global paradox of thrift as households, firms and governments around the world reduce demand," the IMF said.

"Downside risks have increased and are severe."

The Wikipedia article is not a bad introduction to the paradox of thrift.

All this got me thinking, in fact carrying me back into my economics studies in a now distant past. 

My studies in those dim and distant days threw up two things that puzzled me.

The first was simply the apparent failure in linkages between fields within economics. In formal terms, the discipline we studied then was broken into a number of main fields:

• macoeconomics, the study of movements in the broader economy. International trade theory could be classified as part of this or as an area in its own right.
• microeconomics, essentially value (what was produced and why) and distribution (how production and wealth was distributed). This included things like pricing, supply and demand and the theory of the firm.
• economic development, the study of movements in the economy over the longer term.

A number of fields were then linked to these including public finance, economic history and agricultural economics. There was also study of specific techniques

The difficulty was that those fields did not really link together into a coherent universal discipline. Discussions, for example, on the microeconomic foundations of macro constantly foundered.

It took me a while to work out that economics was an analytical process that examined variables and the relationships between them. To my mind, it was not possible to create a single unified discipline because the various fields were concerned with different issues in different time horizons and therefore looked at different questions and variables. Macroeconomic's concern with aggregate movements in the shorter term might give rise to different answers and indeed conflict with answers generated from longer term studies.

The second thing that puzzled me was the conflict between various schools of economics in general and individual competing concepts in particular. The conflict in ideas real enough. However, it seemed to me that the variations between schools linked to differing assumptions and models, while much of the conflict between concepts was more apparent than real. Two apparently competing concepts might both be right depending upon varying circumstances.

I no longer claim to be an economist. I am too out of touch with current thinking. That said, both of the features that once puzzled me are very present in today's discussion, along with a third that is relatively new.

I will deal with the relatively new element first.

Economic policy and indeed a fair bit of economics itself is based on the concept of national economies. In the past, much of the analysis took national economies as a given. To a degree, international trade and investment flows were exogenous factors. Trade theory dealt with flows between countries. We are, I think, still getting our minds around the idea of a global economy with its own dynamics.

Turning now to variations between fields, the global economy is going through a period of fundamental long term change, of tectonic shifts in the main economic plates. By contrast, much economic policy discussion in fora such as the G20 is concerned with macroeconomics and with short term stabilisation. The relationships between that and the longer term trends is not well articulated. Further, the discussion is centred on the first element I mentioned, the nation state and national economies. That's understandable, we are dealing with Governments, but it also acts to conceal broader forces.

Now if we turn to the concept level, we can also see the problem with concepts. To illustrate.

Says Law used to be summarised as supply creates its own demand. If there is surplus supply, prices will fall. As they do, demand will increase until finally the surplus supply disappears. As a general statement, that's pretty true. However, Say's Law cannot explain why there should be economic cycles, nor can it explain the catastrophic failure of the Great Depression.

Keynes addressed a different question, attempting to show how an economy could go into down turn.

By definition, savings and investment are always equal. If people decided to save more this feeds into reduced consumption. As a consequence, inventories rise. Savings and investment are still equal, but investment now includes increased stocks. As inventories rise, firms reduce production, reducing economic activity. Incomes fall, leading to a fall in savings. Savings and investment remain equal.

Now according to Say's Law, an increase in savings means an increase in loanable funds that in turn will reduce interest rates. A fall in interest rates leads to increased investment adding to demand. This increased investment balances the increase in savings. Both savings and investment are higher, with final demand shifting from consumption to production goods. Keynes defined circumstances, the liquidity trap, under which this might not occur. In these circumstance, Government spending whether on consumption or investment could act as a circuit breaker, bringing planned savings and investment back into balance.

I accept that this is a fairly simplistic explanation. However, it draws me to my puzzle in considering competing concepts. You see, both Say's Law and the Keynsian concepts are based on mechanical relationships. Both may be true and equally false depending upon the circumstances.

I don't have time this morning to discuss the implications of the points I am trying to make in this post. Further, aspects of my thinking are still cloudy. Still, my feeling is that a fair bit of the economic policy discussion that's around at the moment actually misses key points. Further, where the points are there, they are not properly integrated in a way that this dummy at least can understand.

I may be wrong, of course. I said that I no longer claim to be an economist! However, I will try to amplify my arguments a little later.

Postscript

I hadn't seen Nicholas Gruen's What’s wrong with ‘Freshwater economics’? (Hint: it is absurd). at the time I wrote this post. It deals with similar underlying issues.