Wednesday, December 30, 2009

The global economy is the one true macro

Nick Rowe set up an interesting discussion on the pitfalls of using micro concepts to approach macro issues. He rightly argues that macro is different from micro. When you look at the economy as a whole, every micro trade that clears the market involves two parties whose gains or loss from the trade merely offsets each other. Therefore, policymakers cannot generally improve macro conditions, by changing the rules to increase gains for one party, because mostly it will also result in a loss in another part of the economy. Here are Nick’s main points:

If I cut the price of apples, holding money incomes constant, holding all other prices constant, then consumers are better off in real terms. They can afford to buy more goods, and if apples are a normal good, they will spend some of their increased real income on buying more apples...

This "income effect" is total rubbish in macroeconomics. If there are 100 apples sold, and I cut the price of apples by $1, then consumers of apples are $100 richer. But producers of apples are $100 poorer. No effect on aggregate real income. Real income is the quantity of apples. It's GDP! And money income is the price of apples times the quantity of apples....

A fall in the price of apples, relative to the price of other goods, means consumers will substitute away from other goods and into consuming more apples. That makes sense in micro, where we draw the demand curve of apples holding the prices of other goods constant. But in macro, where the price of all goods is on the vertical axis, it doesn't make any sense at all. If the prices of all goods fall, what are they substituting away from? And why?....

If one worker tried to sell his apples for a higher price than the other workers, he might be unemployed. Nobody would want his apples. But then there would be an excess demand for other workers' apples, and an excess demand for their labour. There is no way the labour market/apple market as a whole could be in excess supply, because on average, the price of apples must equal the average price of apples...

And if people want to hang onto their money, rather than buy apples with it, the demand for apples, and the demand for labour, will be deficient. A deficiency of aggregate demand has got nothing whatsoever to do with a deficiency of income. Income is always sufficient. It's always the same as goods sold. A deficiency of aggregate demand is a deficiency of peoples' willingness to get rid of money. The "Paradox of Thrift", and the "Paradox of Toil", are merely corrupt versions of, or way-stations to, the Paradox of Money. Each individual can increase his stock of money by buying less; but in aggregate they fail, but cause unemployment as a side-effect.

I commented that when you have an open economy in a globalized environment, the micro assumptions can hold, and macro assumptions of a closed economy break down.
1. If you make apples $100 cheaper, domestic producers can potentially sell more apples, regardless of the level of demand domestically. It becomes a substitute to apples (or oranges) everywhere else in the world.
2. Hence, even if there is an excess supply of apples in the domestic market, it can still (potentially) sell as much output as it wants.
3. And even if the “paradox of thrift” holds in the domestic economy, the excess supply of apples could clear elsewhere in the global economy. (It also helps if your government controls the value of your currency, which in actuality is an integral part of what you trade in a globalized economy).

Nick replied: If you are talking about a small open economy, (under fixed exchange rates, with a common currency) you are absolutely right. In fact, I would say that SOE macro isn't really macro at all. It's micro. The only true macro is closed economy, and therefore global macro. But if we have national currencies, then I think there are some aspects that can only be handled from a macro perspective.

This reminded me of a post I made in August last year, which argued that national monetary policies (especially of small open economies) were becoming more and more insignificant in a globalized environment. Now that capital mobility is global…
1. If one country hikes its interest rate to contain domestic inflation, it can attract more capital from overseas, nullifying the hike. Similarly, if the country cuts rates to spur investment, capital might leave the economy for better rates elsewhere.
2. An aggressive money supply policy in one country can spill over excess liquidity into the global system, spreading inflation globally.
3. One country’s active currency management policies artificially inflates/devalues free floating currencies.
4. Because of points 1, 2, and 3, one Central Banker’s monetary policies to cure domestic unemployment might be rendered ineffective.
5. Financial crisis that start in one country can easily spread to other economies….

My speculations of a global central bank were rightly trashed in this forum over at EconomicsUK. But nonetheless, there seems to be a disjoint in economics theories as they are applied in a global setting. More importantly, there is a lack of coordinating institutions that would ensure the fair administration of monetary transactions worldwide. We don’t even know how to make them work, if there is a way to make them work.

Globalizing trade and financial flows without the corresponding globalizing of human capital movements has only led to repeated global imbalances. Because governments are still local (or national, for that matter) they still adhere policies that will result in what is good for their local populations. it is they, after all, who are stuck with the net gains and/or losses from globalization. A gain is made for them if a country creates more jobs, decreases its cost of capital, and maintains a stable inflation rate. So a local/national government will do what it can to achieve these aims, no matter if the gains from these aims end up being offset by a loss in another part of the world.

We either need to get rid of nation-states altogether, or we enforce stricter rules on nations participating in global trade.

No comments: