Friday, December 2, 2016

Putting the Cart Before the Horse

Macroeconomics is generally not an experimental science. It’s observational.

One of the advantages of an experimental science is that you can control causes to isolate their effects. You can come up with different stories about what the causes are, but in principal you can confirm whether those stories are supported by the data. In some sense, you can go “fishing”.

In an observational science, you have to get your story about causality straight first. By that I mean what effects you expect to see and what you should not see. Then you can go and check your data.

Unfortunately, we’re bombarded with GDP data, but not with stories about the causality that generates it. This leaves a lot of room for getting things wrong.

Which brings us to Trump’s nominee for Secretary of Commerce: Wilbur Ross. Here’s his theory (taken from a Wall Street Journal editorial entitled “Trump’s Money Men”):

… Mr. Ross wrote, “It’s Econ 101 that GDP equals the sum of domestic economic activity plus ‘net exports,’ i.e., exports minus imports. Therefore, when we run massive and chronic trade deficits, it weakens our economy.”

Who taught him that? Imports are subtracted in GDP calculations to avoid overstating domestic production, not because they make us poorer. …

The causality Ross presumes is pretty clear: “… trade deficits … weaken…”

This is weird: GDP (and trade deficits) are something we measure after they occur. They’re a description of what did happen, not an explanation of how it happened.

It’s more correct to say that a trade deficit might be a symptom of a weak economy, rather than a cause.


Ross is making a ridiculous logical mistake here, but one that is all too common in thinking about macroeconomics.

First off, GDP is what we count up after production and consumption happen. And as we’re counting, perhaps we divvy it up into different bins, including (gross) exports and (gross) imports.

  • This is analogous to going to one of those old-fashioned machines where you put in a quarter and it dumps out a handful of, say, Skittles. That’s your macroeconomy.
  • Then you count up your Skittles. That’s your measure of your economy’s GDP.
  • Then you divide up the Skittles by color, and call the yellow ones exports. And then you announce that if you’d gotten more yellow Skittles you would have gotten more Skittles in total.

A child might make that mistake. An adult should not.

Secondly, there are interconnections within GDP besides Y = C + I + G + X. Let me introduce 4 alternative variables:

  • DP►DC, this is Domestic Production that goes into Domestic Consumption
  • DP►FC, this is Domestic Production that goes into Foreign Consumption
  • DC◄DP, this is Domestic Consumption that comes from Domestic Production
  • DC◄FP, this is Domestic Consumption that comes from Foreign Production

My notation is a little bit weird: do not think of the the ► as a >, or the ◄ as a <. But there is a method to my madness.

Note that DP►DC and DC◄DP have to end up with the same number (although you might make a measurement error here or there).

In terms of the conventional textbook items:

  • C + I + G = DP►DC (or DC◄DP)
  • Gross Exports = DP►FC
  • Gross Imports = DC◄FP
  • GDP = DP►DC + DP►FC – DC◄FP (or DC◄DP + DP►FC – DC◄FP)

The cool thing about this is that we can think of these new variables in this way. Remember the fable about getting a mule to move with a carrot and a stick? The stick is work, and the carrot is your reward:

  • DP►DC, means that your carrot and stick are balanced
  • DP►FC, means that you’re all stick
  • DC◄FP, means that you’re all carrot

Now let’s think about some naive policy ideas.

Let’s export more! So we’re going to make DP►FC bigger. This means we have to both work more here, and somehow get foreigners to buy stuff they weren’t before. Maybe we could advertise to make the latter happen. But there’s only two ways to handle the former part: actually work harder (by using more stick), or divert some of our work by making DP►DC smaller to make DP►FC larger. Except that we can’t make DP►DC smaller without making DC◄DP smaller. If you think about it, this amounts to giving away our carrots. So there you have it: a proposal to increase exports either means more stick or less carrots.

Let’s import less! You can probably see where this is going. This means making DC◄FP smaller. One way to do that would be to make DC◄DP larger. That way we could keep the number of carrots the same, but just get less of them from foreigners. But again, it gets weird: we’re getting the same number of carrots, but because DC◄DP = DP►DC, we have to work harder. So there you have (part of) it: you get more imports with more stick and no extra carrots. You can work out on your own that you could also get less carrots with the same amount of stick.

I understand that these examples are not easy. But that’s the point: trade policy is not something that most people think about very clearly … including people we put in charge.

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