Collective Conscious

The per­fect story to sum­ma­rize my under­stand­ing of how macro­eco­nom­ics works showed up today, via Arnold Kling. Read it below, and then we’ll start from the begin­ning. Eco­nom­ics, after all, isn’t that hard.

Once upon a time, Joe lived in Key­ne­siana, where he was a typ­i­cal worker/​consumer.

Joe worked in a GDP fac­tory, mak­ing GDP. Every Mon­day morn­ing, he went to work, and he worked five days a week. He was paid $1 for every 24-​​minute seg­ment he worked, and he worked 100 seg­ments (40 hours), so he earned $100 a week. Every Fri­day after­noon, Joe cashed his pay­check and went to the GDP fac­tory out­let, where he spent it all on GDP.

One day, Joe decided that he needed to accu­mu­late some sav­ings. He made up a rule for him­self. Know­ing that he needed to con­sume at least $40 of GDP each week, he decided that his rule would be to save 20 per­cent of every­thing he earned over and above that $40. Since he made $100, his rule called for sav­ing 20 per­cent of $60, or $12. So he cashed his $100 pay­check, but that Fri­day after­noon he only spent $88.

Next Mon­day, morn­ing, Joe’s boss had some news. “A funny thing hap­pened last week. We sold 12 per­cent less GDP than usual. So this week, we’re gonna put you on a short week. You work 88 seg­ments, instead of 100.”

Joe was dis­ap­pointed, because this meant he would only be paid $88 this week. Stick­ing to his new rule, he resolved to save 20 per­cent of $48, or $9.60. So that Fri­day after­noon, he cashed his $88 pay­check and spent $78.40.

Next Mon­day morn­ing, Joe’s boss said. “Well, golly, it looks like we sold even less GDP last week. I’m afraid we’ll have to cut you back to 78.40 seg­ments this week.” Still fol­low­ing his rule, Joe resolved to save 20 per­cent of $38.40, or $7.68. So he spent only $70.72 at the GDP fac­tory out­let that Friday.

See­ing where this was going, the coun­try asked Krug Paul­man, the famous econ­o­mist, what to do. He said, “The stu­pid peo­ple are sav­ing too much. We need gov­ern­ment to spend what the idiots are not spend­ing.” So the gov­ern­ment bor­rowed $29.28 from Joe and spent it at the GDP fac­tory outlet.

Now, when Joe came to work on Mon­day morn­ing, his boss said, “Good news, we sold 100 per­cent of what we used to sell, so you can work 100 seg­ments this week.” Stick­ing to his rule, Joe saved $12 on Fri­day after­noon. But the gov­ern­ment bor­rowed the $12 and spent it at the GDP fac­tory out­let. They all lived hap­pily ever after.

There’s more to this story, and I’m going to con­tinue build­ing on it over the next sev­eral install­ments. But for today, there are a few key ideas to pull out.

First is the cir­cu­lar­ity of income and money. The $100 that Joe ini­tially earned and spent in each ‘period’ is the same $100. It can be visu­al­ized as a sin­gle bill end­lessly cycling betwixt him, the shop reg­is­ter, and the fac­tory ledger. At each stop, it rep­re­sents an abstract con­cep­tion of ‘value’; it is passed from the fac­tory to Joe in exchange for his hard work, then from Joe to the shop in exchange for the goods/​GDP pro­duced at the fac­tory, and then back to the fac­tory to pur­chase whole­sale those goods (ques­tions of markup and profit are saved for a more com­plex model).

The sec­ond major prin­ci­ple from the para­ble is what’s known as the ‘para­dox of thrift’. It’s plain to see that when Joe saves his money, the econ­omy gets worse. But we all ‘know’ that sav­ing is a Good Thing, so how can that be? What we don’t always real­ize is that we can’t all save up money at the same time — in order for one per­son to save, another per­son has to bor­row the money (usu­ally a bank, in the form of a deposit). We can work more on this later too.

Third is the ini­tial stage of a national account­ing the­ory. This sounds scary but it’s really not — it is more of a corol­lary to the sec­ond prin­ci­ple. By break­ing the over­all econ­omy into seg­ments, we can see where bal­ances have to occur in order to main­tain equi­lib­rium. In this case, we have Joe and the Gov­ern­ment. In equi­lib­rium, we see that what­ever Joe saves, the Gov­ern­ment must exactly match in deficit spend­ing. That is, Joe’s sur­plus equals the Government’s deficit — there’s no way around it in equi­lib­rium. Later we can add more to this con­cept, but it’s a very robust and impor­tant point even in this sim­ple form.

Stay tuned for more.