Wednesday, March 9, 2011

Why Do Modern Macroeconomists Get It So Wrong?

I have written before about why inflation and government spending do not provide general prosperity, and yet time and again inflation and increases in government spending are what modern macroeconomists and policy makers call for in the face of tough economic times. Why is this? Why is it that so many professional economists advocate policies that are useless at best and destructive at worst?

Robert Higgs indicates, rightly in my opinion, that a primary reason for such persistent and maddening error is that modern macroeconomists live in a world of extreme aggregation in which the root of all economic phenomena--personal human action--is either downplayed or utterly ignored. Failing to remember the first principles of human action, modern macroeconomists fail to take into account the importance of time in the production process. In doing so, they fail to see that the entire social economy is integrated into a vast, complex, multi-stage structure of production. They further miss, therefore, that entrepreneurs must allocate specific land, labor, and capital goods of the right quality in the right quantity to the right uses at the right time for the entire production structure to be directed toward meeting the most highly valued ends of those who make up society.

Higgs nails it as he explains:
A serious problem lurks, however, in the way the mainstream experts think about the economy, and hence in the kind of analysis they undertake to assess its current performance and its likely future changes. All too often, they model the macroeconomy as a black box into which flow undifferentiated “labor” services and “capital” services and out of which flows a uniform substance called “output,” measured empirically by estimates of real GDP. Units of this output command a price known as the “price level,” measured empirically by the GDP deflator; otherwise, prices play no role in the model. The interest rate plays only a limited role as a determinant of the demand for money and as a minor determinant of saving and investment spending. Time is essentially irrelevant. There is no time structure of production in which certain kinds of production must precede others in a process running from raw materials to intermediate goods to completed consumer goods because, as mentioned, such distinctions among different kinds of goods are ignored in favor of positing a single homogeneous “output.” Just as time plays no role, and hence the interest rate (the price of goods available now relative to goods available later) plays no role in resource allocation, so location does not matter. It’s as though all production took place at a Euclidian point, and therefore no one need worry about, say, the government’s injecting “stimulus” money into Connecticut in order to lower unemployment in Nevada.

The more I consider the opinions of professional economists regarding the causes of the Great Recession and what to do to get out of it, I am increasingly convinced of the importance of doing economic analysis within the right framework--one that takes human action and its implications seriously.

As I explain in the chapter 11 of my book where I introduce the concept of macroeconomics:
The production of every consumer good in the economy is supported by a structure of production. The existence of a production structure for every consumer good has a very important implication for our analysis of the overall economy. Our analysis of the overall social economy must include the entire capital structure. Because all production takes time, if we leave capital out of our analysis, we will be ignoring a key aspect of economic theory that is necessary to explain how production occurs, what leads to economic expansion, and what causes recessions. In short, it is absolutely necessary to understand the production structure in order to understand the workings of the social economy as a whole.

It is not surprising, then, when professional macroeconomists and policy makers, who fail to take into account the nature of the production structure, make such bad policy recommendations.

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