Saturday, December 10, 2011

A real theory of economic crises

Part 1: What is "real"? (commentary)

To understand the current economic crisis, we must look underneath the abstraction of the financial to the real macroeconomy. Doing so is not an easy task, especially when the majority of academic and commercial economists are devoted to obscuring the real economy.

The underlying real economy consists of the use of physical things, such as human labor, steel, land, and machines, to produce other physical things, such as loaves of bread, cars, houses, lattes, and massages as well as (to stretch the definition of "physical" a bit) education, good health, and so forth.

On the supply side, microeconomics talks about how much of each individual good and service we should produce, given some total amount of production. Macroeconomics talks about how much we should produce in total, and how we should allocate that production between consumption and investment in physical and human capital. Macroeconomics also assumes that the national economy is an isolated whole. It is not really isolated, international trade does exist, but it is sufficiently close that the approximation is useful to understand the fundamentals, and the rules of international trade differ substantially from both microeconomics within and the macroeconomics of a national economy.

In a microeconomic crisis, we find ourselves with the productive capacity to produce too much of some things. Because microeconomics takes as given the total amount of production, that we are producing too much of some things implies that we are producing not enough of other things. This state of affairs produces a crisis because it takes time to reallocate the means of production from the surplus to the shortage. During that time, which may be a substantial fraction of or even longer than the traditional annual accounting period, the total production of final goods and services will drop: we will not see the final goods actually sold for consumption until all the capital apparatus has been created and has been in operation for some time. One way we account for this switch is by including investment spending directly in Gross Domestic (and National) Product. From a macroeconomic perspective, we deal with a microeconomic crisis by allocating more real activity from consumption to investment.

In a macroeconomic crisis, however, we find ourselves not producing all we need or want (I will explain the distinction later) to consume. Macroeconomic crises have two causes. First, we physically cannot produce all we need to consume. Alternatively, although we might be physically able to produce more, we are not producing all we want to consume and/or invest. We get into macro crises not because (or not just because) we are producing the wrong sorts of things, but because we are not producing enough things overall.

*If we physically could produce more, but no one wants to consume more, i.e. for everyone the marginal utility of more leisure exceeds the marginal utility of more consumption, then there is no macroeconomic crisis. Alternatively, macroeconomists consider the situation where we do not need to consume more, but we want to consume more than we physically can produce, to be the normal situation, the cause of long-run economic growth.

The fundamental identity of real macroeconomics is:
    Production = Consumption + Investment + Net Storage + Waste 
  • Production is the total amount of real goods and services, final or investment, produced for trade.
  • Consumption is the total amount of real final goods and services used up to enjoy their use values. Investment is total amount of physical and human capital created (either anew or to replace earlier investment used up in the production of goods for consumption) to create final goods that will be consumed (perhaps in a later accounting period).
  • Net Storage is the total amount of real final goods* produced and then placed in storage less real final goods taken out of storage and consumed**.
  • Waste is the total amount of final goods and services produced but destroyed (or allowed to decay) without being used.
Because Net Storage tends to zero in the long run (too many goods stored too long tend to be wasted), and since we always want to minimize waste***, we can simplify the fundamental identity to:
    Production = Consumption + Investment
Because we have eliminated the term for Net Storage, it becomes apparent that in a macroeconomic sense, saving does not mean putting actual physical goods into storage, which tends to be wasteful. Instead, savings means allocating relatively more production to investment and relatively less to consumption.

*We typically cannot store services.
**In financial macroeconomics, we usually count Net Storage as the inventory subcategory of investment spending.
***To avoid a lengthy (although interesting) philosophical debate, here I consider things such as military spending to be consumption.

In addition stating to the fundamental identity of real macroeconomics, it is possible to restrict the factors of production — land, labor and capital — to just labor. First, we use labor to create capital (physical capital such as factories and machines, as well as human capital such as education and training). If we do not have as much capital as we want or need, we must use labor to create more. We can eliminate land (which includes the raw materials actually on the land) because the physical quantity of land (and its raw materials) is fixed; we cannot create more iron ore in the ground.

More importantly, the use of land is entirely in the domain of microeconomics. Most land and raw materials have a continuous (increasing) marginal cost of exploitation. Therefore, we simply add labor to using land until the marginal cost of doing so is in equilibrium with the (continuous, falling) marginal demand of producing the products and services requiring the land. Even when some kind of land or raw materials is discontinuously scarce, the only consequence is that more of the surplus value of labor will be allocated to the owner of the land rather than to other potential recipients.

Therefore, all we need to consider in macroeconomics is labor. A real macroeconomic crisis, therefore, is when the total amount of labor employed in production is less than what we need or want to employ.

I'll put all this together in the next post.

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