May 24, 2012
Frequently, and with some validity, business people lambast economists for knowing nothing about the real world. They claim that economists dwell in ivory towers and just don’t get it. Some economists may well live in ivory towers but those of us who work for ourselves and employ people and try to make a living in the private sector are not as removed as the business people might think. In fact, we are business people. Yet the point is valid, as theoretical models of the economy do sometimes seem removed from reality.
However, the criticism can work the opposite way. Just because you run a business does not mean you understand how the economy works.
And when business people weigh into public debates about the economy, their pronouncements can vary from the vaguely embarrassing to the downright wrong. We are seeing this in the economics of the fiscal treaty debate.
Despite knowing nothing — or at least very little — about how the economy works, why is it that some business people speak with utter confidence on economics yet they get the basics wrong?
A business is not the same as an economy. An economy is myriad businesses and lots of other bits too that are not businesses, but may be customers of businesses.
Let’s just address the most basic proposition of the business people about the fiscal deficit and what the country needs to do to right itself. The favourite line of all business people is that the Government needs to balance its books.
If we can just balance our books, through cutting spending and raising taxes, all would be grand. Let’s just examine whether this is actually true.
The Government also borrows the language of the business person when it says that it is imperative that it balances its books.
There is no problem with both the Government and the private sector balancing their books — as long as they don’t do it at the same time. Doing it at the same time, as we are trying to do, destroys the economy.
Some propositions, which sound absolutely reasonable, when teased out a bit don’t make any sense.
It sounds perfectly reasonable to suggest that free-spending teenagers should learn the value of thrift. If you have teenage children, you might regularly tell them not to spend so much. You may threaten to cut off the supply of your cash to them. You might often tell them to go out and get a job. Or you might suggest that they save more.
So you tell them to reduce spending or increase savings. Do you ever urge them to reduce their income?
I didn’t think so.
Now consider the following. What is good for the individual might not be good for the collective. When you start to save to balance your books, that is good for you. But if everyone stops spending in order to balance everyone’s books at the same time, that is not good for everyone.
The reason is not hard to grasp. It is the paradox of aggregation. It begins with one of the basic rules of economics, which is that the vast majority of employed Irish people are employed in the domestic sector. This means that we buy and sell stuff to one another. This implies a golden rule, which many business people fail to grasp: your spending is my income and my spending is your income.
And then one more rule holds, which is that my income is the font of my savings. If my savings are the barometer of my prudential housekeeping, I need to have income out of which to save. But if I have no income because you are not spending, then I have no savings. And if I have no income and therefore no spending power, then ultimately you have no income and so on.
This is the paradox of aggregation: what is good for the individual is not necessarily good for the collective. This leads to another paradox, the paradox of thrift. The paradox of thrift means if we save at different times and spend at different times, then we can keep the income and spending channel open. But if we all save at the same time, then no one has income and we all suffer.
This distinction between the individual and the collective goes to the heart of macroeconomics and it shows why the business world view, which is looking at one balance sheet, is not that clever when it comes to looking at millions of balance sheets.
Now think of the fiscal treaty. The fiscal treaty says that the governments of all European countries should balance their books simultaneously, which sounds reasonable.
But now look at the fact that, with the exception of Germany, economic activity in every European country is weakening, and yesterday the OECD downgraded growth forecasts for all countries bar Germany. Slowing growth is a reflection of the private sector stopping spending and trying to balance our books.
But if we are saving and the Government is forced by law to save too, who will spend? And if no one spends, what happens to everyone’s income? And if everyone’s income is falling, what happens to austerity targets, which are expressed in terms of debt to income? As debt is expressed as a percentage of income, and income is falling while debt is fixed, it means the ratio is getting bigger rather than smaller.
Now let’s go from the teenage kids to my 10-year-old, who is learning fractions. Once he grasps the idea of a numerator and a denominator, he can maybe tell the business person what happens when the numerator is getting smaller faster than the denominator.
The denominator is the bit of the fraction below the line. The fraction gets bigger. So if the numerator (income) is getting smaller faster than the debt (the denominator), the fraction is getting bigger and you are missing your targets.
A recession is actually too much saving. I know it sounds strange, but that’s what it is.
The fiscal treaty will therefore deepen the European recession, which is the result of too much private sector saving as people are scared about their future employment and income prospects, so they save.
This is why austerity without debt forgiveness can’t work. School kids could figure this out. It also explains why what is good for the individual is not necessarily good for the collective and explains why everyone saving at the same time is good for no one.
This is why the fiscal treaty is Kamikaze economics for most of Europe, it is designed to suit the Germans’ short-term political interests and has nothing to do with macroeconomics as we know it.
As for the business people, they are right about economists sometimes. But other times they should stick to accountancy; economics uses a different part of the brain.