Fiscal austerity – the newest fallacy of composition

The origins of macroeconomics trace back to the recognition that the mainstream economics approach to aggregation was rendered bereft by the concept of the Fallacy of Composition which refers to errors in logic that arise “when one infers that something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part)” (Source). So the fallacy of composition refers to situations where individually logical actions are collectively irrational. These fallacies are rife in the way mainstream macroeconomists reason and serve to undermine their policy responses. The current push for austerity across the globe is another glaring example of this type of flawed reasoning. The very fact that austerity is being widely advocated will generate the conditions that will see it fail as a growth strategy. We never really learn.

The origins of this logical error lie in the way in which mainstream economics developed. It was largely concerned with microeconomic and started its a priori reasoning from the perspective of an atomistic individual. The single consumer or single firm. I won’t go into detail here but this body of theory soon got into trouble via the so-called Aggregation Problem.

So to make statements about industry or markets or the economy as a whole, the mainstream had to aggregate their atomistic analysis. Of-course this proved to be impossible using any reasonable basis and so they fudged the task and assumed things like the “representative household” to be the demand side of a product market and the “representative firm” to be the supply side. Together they bought and sold a “composite good”.

The fudge comes because in this sleight of hand the principles that apply to the individual were transferred over to the composite or aggregate.

Prior to the 1930s, there was no separate study called macroeconomics. The mainstream theory – which dominates still today – considered macroeconomics to be an aggregation of the individual. So the representative firm and household were just made bigger but the underlying behavioural principles that were brought to bear on the analysis were those that applied at the individual level.

So the economy is seen as being just like a household or single firm. Accordingly, changes in behaviour or circumstances that might benefit the individual or the firm are automatically claimed to be of benefit to the economy as a whole.

The general reasoning failure that occurs when one tries to apply logic that might operate at a micro level to the macro level is called the fallacy of composition. In fact, it is what led to the establishment of macroeconomics as a separate discipline. As indicated, prior to the Great Depression, macroeconomics was thought of as an aggregation of microeconomics. The neo-classical economists (who are the precursors to the modern neo-liberals) didn’t understand the fallacy of composition trap and advocated spending cuts and wage cuts at the height of the Depression.

Keynes led the attack on the mainstream by exposing several fallacies of composition. While these type of logical errors pervade mainstream macroeconomic thinking, there are two famous fallacies of composition in macroeconomics: (a) the paradox of thrift; and (b) the wage cutting solution to unemployment.

In first semester of a credible macroeconomics course, students learn about the paradox of thrift – where individual virtue can be public vice. So when consumers en masse try to save more and nothing else replaces the spending loss, everyone suffers because national income falls (as production levels react to the lower spending) and unemployment rises.

The paradox of thrift tells us that what applies at a micro level (ability to increase saving if one is disciplined enough) does not apply at the macro level (if everyone saves aggregate demand and, hence, output and income falls without government intervention).

So if an individual tried to increase his/her individual saving (and saving ratio) they would probably succeed if they were disciplined enough. But if all individuals tried to do this en masse, and nothing else replaces the spending loss, then everyone suffers because national income falls (as production levels react to the lower spending) and unemployment rises. The impact of lost consumption on aggregate demand (spending) would be such that the economy would plunge into a recession.

As a result, incomes would fall and individuals would be thwarted in their attempts to increase their savings in total (because saving was a function of income). So what works for one will not work for all. This was overlooked by the mainstream.

The causality reflects the basic understanding that output and income are functions of aggregate spending (demand) and adjustments in the latter will drive changes in the former. It is even possible that total savings will decline in absolute terms when individuals all try to save more because the income adjustments are so harsh.

Keynes and others considered fallacies of composition such as the paradox of thrift to provide a prima facie case for considering the study of macroeconomics as a separate discipline. As noted, up until then, the neo-classical (the modern mainstream) had ignored the particular characteristics of the macro economy that require it to be studies separately.

They assumed you could just add up the microeconomic relations (individual consumers add to market segment add to industry add to economy). So the representative firm or consumer or industry exhibited the same behaviour and faced the same constraints as the individual sub-units. But Keynes and others showed that the mainstream had no aggregate theory because they could not resolve the fallacy of composition.

So they just assumed that what held for an individual would hold for all individuals. This led the mainstream opponents to expose the most important error of the mainstream reasoning – their attempts to move from specific to general failed as a result of the different constraints that the macroeconomic level of analysis invoked.

Paul Krugman captured it in this way in his New York Times blog When consumers capitulate:

… one of the high points of the semester, if you’re a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone”s income. In fact, consumers’ income may actually fall more than their spending, so that their attempt to save more backfires – a possibility known as the paradox of thrift.

The term paradox of thrift entered the nomenclature during the Great Depression as Keynes and others saw this particular problem as providing a prima facie case for government deficit spending which could replace the lost consumption as the non-government sector sought to increase its saving.

Therein lies the crucial role of the budget deficits – to finance the private desire to save. Accordingly, the national economy can produce a certain volume of goods and services in any period if it is fully employing all available resources (that is, unemployment = less than 2 per cent and no underemployment). This production generates income which can be spent or saved.

If the private sector desires to save, for example, $10 in every $100 it receives then that $10 is lost from the expenditure stream. If nothing else happens, unsold inventories will appear and firms will start to lay off workers because the production level is too high relative to demand. Firms project demand expectations and make their production decisions based on what they think they can sell in the forthcoming periods.

The decline in economic growth then reduces national income which in turn reduces saving, given that the latter is a positive function of total national income.

But if the economy is to remain at full employment all the output produced has to be sold. Enter the national government. It is the one sector that can step in and net spend the $10 in every $100 to fill the “spending gap” left by the saving. All the output is sold and firms are happy to retain the employment levels that created the output. The system is in what economists call a “full employment equilibrium”.

Yet, notice what has happened. The net spending by the government (the deficit) ratifies the savings decisions of the private sector. The budget deficit maintains full employment aggregate demand and the resulting national income produced generates the desired private saving level. So the budget deficit finances the private saving on a daily basis.

So there is no particular problem for the economy in households increasing their desired saving. The solution does not rely on private investment improving any time soon, although a rise in capital formation would quicken the pace of recovery.

The leakage from the expenditure stream that occurs as household increase their saving can be filled by a rising public spending “injection”. As long as the government sector “finances” that rising saving behaviour from the households economic growth can continue and the paradox of thrift effect thwarted. The rising net spending promotes income and employment growth, which combine to generate the rising saving capacity desired by the households. It is a win-win.

By recognising the importance of the fallacy of composition in mainstream economics at the time was a devastating blow to its credibility. How short our memories are? How the mainstream ideas that were discredited so comprehensively in that period have been able to reassert themselves as the dominant discourse is another story (of puzzling dimensions).

The other major fallacy of composition relates to the way in which the mainstream conceive of a solution to unemployment. Macroeconomics emerged out of the failure of mainstream economics to conceptualise economy-wide problems – in particular, the problem of mass unemployment. Please read my blog – What causes mass unemployment? – for more discussion on this point.

Marx had already worked this out and you might like to read Theories of Surplus value where he discusses the problem of realisation when there is unemployment. In my view, Marx was the first to really understand the notion of effective demand – in his distinction between a notional demand for a good (a desire) and an effective demand (one that is backed with cash).

This distinction, of-course, was the basis of Keynes’ work and later debates in the 1960s where Clower and Axel Leijonhufvud demolished mainstream attempts to undermine the contribution of Keynes by advancing a sophisticated monetary understanding of the General Theory.

The point is that prior to this the mainstream failed to understand that what might happen at an individual level will not happen if all individuals do the same thing. In terms of their solutions to unemployment, they believed that one firm might be able to cut costs by lowering wages for their workforce and because their demand will not be affected they might increase their hiring.

However, they failed to see that if all firms did the same thing, total spending would fall dramatically and employment would also drop. Again, trying to reason the system-wide level on the basis of individual experience generally fails.

Wages are both a cost and an income. The mainstream ignored the income side of the wage deal. The technical issue comes down to the flawed assumption that aggregate supply and aggregate demand relationships are independent. This is a standard assumption of mainstream economics and it is clearly false.

Mass unemployment occurs when there are not enough jobs and hours of work being generated by the economy to fully employ the willing labour force. And the reason lies in there being insufficient aggregate spending of which the net spending by government is one source.

The erronous mainstream response to the persistent unemployment that has beleaguered most economies for the last three decades is to invoke supply-side measures – wage cutting, stricter activity tests for welfare entitlements, relentless training programs. But this policy approach, which has dominated over the neo-liberal period, and reflects their emphasis on the individual falls foul of the fallacy of composition problem.

They mistake a systemic failure for an individual failure. You cannot search for jobs that are not there. The main reason that the supply-side approach is flawed is because it fails to recognise that unemployment arises when there are not enough jobs created to match the preferences of the willing labour supply. The research evidence is clear – churning people through training programs divorced from the context of the paid-work environment is a waste of time and resources and demoralises the victims of the process – the unemployed.

Case study: the parable of 100 dogs and 95 bones

Imagine a small community comprising 100 dogs. Each morning they set off into the field to dig for bones. If there enough bones for all buried in the field then all the dogs would succeed in their search no matter how fast or dexterous they were.

Now imagine that one day the 100 dogs set off for the field as usual but this time they find there are only 95 bones buried.

Some dogs who were always very sharp dig up two bones as usual and others dig up the usual one bone. But, as a matter of accounting, at least 5 dogs will return home bone-less.

Now imagine that the government decides that this is unsustainable and decides that it is the skills and motivation of the bone-less dogs that is the problem. They are not skilled enough.

So a range of dog psychologists and dog-trainers are called into to work on the attitudes and skills of the bone-less dogs. The dogs undergo assessment and are assigned case managers. They are told that unless they train they will miss out on their nightly bowl of food that the government provides to them while bone-less. They feel despondent.

Anyway, after running and digging skills are imparted to the bone-less dogs things start to change. Each day as the 100 dogs go in search of 95 bones, we start to observe different dogs coming back bone-less. The bone-less queue seems to become shuffled by the training programs.

However, on any particular day, there are still 100 dogs running into the field and only 95 bones are buried there!

You can find pictorial version of the parable here (for international readers this version was very geared to labour market policy under the previous federal regime in Australia and was written around 2001).

In the US there are about 90 bones for every 100 dogs and in Spain 80 bones for every 100 dogs!

The point is that fallacies of composition are rife in mainstream macroeconomics reasoning and have led to very poor policy decisions in the past.

The household-government fallacy

Another major source of erroneous reasoning in mainstream macroeconomics which is driving the call for fiscal austerity is the flawed analogy between the household and the government budget. I have covered this often.

In a fiat monetary system, a sovereign government is never revenue constrained because it is the monopoly issuer of the currency. But the household uses that currency and is always financially constrained. That is a fundamental difference.

My friend and sometime co-author Randy Wray produced a very interesting blog last year entitled – Teaching the Fallacy of Composition: The Federal Budget Deficit – where he dealt with these issues in some detail.

He notes that the household and the government budget analogy “ignores the impact that the budget deficit has on other sectors of the economy”. He uses the standard sectoral balance approach to show that:

At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income).

And, if the “if we have a balanced foreign sector, there is no way for the private sector as a whole to save unless the government runs a deficit. Without a government deficit, there would be no private saving. Sure, one individual can spend less than her income, but another would have to spend more than his income”.

So the spending-income relationships between the three sectors which can be expressed in terms of the sectoral balance accounting framework are binding on each individual sector.

This has relevance for the way we think of the current austerity drive.

We know that if the government sector tries to run surpluses when there is an external deficit and the private domestic sector wants to save bad outcomes will occur. The fiscal drag reduces spending power which damages output and income growth and ultimately forces the private domestic sector to run down their wealth holdings.

The only way to offset the damage arising from the fiscal drag is to have a greater external surplus (net exports) adding spending to the local economy and supporting income growth and the desire to save. This is the Norwegian situation.

So we know that if the private domestic sector desires to save overall and acts out those desires and the nation enjoys an external deficit then the only way this can be sustainable is through continuous budget deficits. They should be on-going and scaled to match the spending gap left by the other sectors.

Further, this is the only way to achieve private sector reductions in debt exposure when the external sector is in deficit.

And this brings me to the idea that the austerity drive is itself falling into a fallacy of composition – just as damaging as all the others that pervade mainstream macroeconomic thinking.

Austerity as a fallacy of composition

The IMF has been pushing export-oriented growth strategies onto developing countries for years. Sometimes based on manufacturing (South Korea, Taiwan, Hong Kong and Singapore) while other times relying on cash-crops or resource extraction for the exports. While the earlier manufacturing export strategies of the Asian tigers (which pre-dated the IMF structural adjustment program onslaught in the last 1970s and on) were successful the research evidence is very clear – the most poor nations went backwards under the programs.

In the case of trade, the fallacy of composition becomes an “adding-up” constraint on the capacity of nations to simultaneously export goods to external markets – which often amounts to many nations trying to penetrate the same markets.

The IMF and now the austerity crazies will invoke the usual arguments. First, there will be no demand-side constraints because the wealthier nations will grow fast enough to support the higher import volumes and avoid supply gluts depressing export prices. Second, the poorer nations will start trading between themselves. Third, poorer nations steadily introduce capital-intensive production techniques and make way for other nations to export labour intensive goods.

If you read the extensive research literature on this topic you will discover that in reality demand-constraints that arise from competition in limited export markets are binding. Further, glutted markets saw export prices continually collapsing for less developed countries who then had to borrow further from the IMF to make ends meet. In the meantime, these nations undermined their subsistence agriculture by turning it into cash crops and so people starved.

But the current austerity plans have some similarities with the flawed IMF development strategy, which is no surprise given the IMF wrote the recent G20 response endorsing the austerity programs.

The Economist Magazine (July 1, 2010) had an interesting article – Austerity alarm – where they said that “Both sides in the row over stimulus v austerity exaggerate, but the austerity lobby is the more dangerous”. It was a turnaround from the usual neo-liberal analysis that you read about in this magazine.

The Economist says:

… the rich world looks set for a collective fiscal adjustment worth around 1% of its combined GDP next year, the biggest synchronised budget contraction in at least four decades.

To Keynesian critics the switch to austerity is a colossal blunder … [which] … will push the world economy into a depression. With unemployment high, output far below its potential, private spending still weak and interest rates close to zero … fiscal stimulus remains an essential prop to the economy and that deficit-cutting now will spell stagnation and deflation.

… supporters of … austerity believe it is both essential and appropriate: deficit spending cannot go on for ever, and by boosting firms’ and households’ confidence and lowering the risk premium on government debt, well-designed fiscal consolidation can actually boost growth … fiscal thrift will increase private spending by reducing uncertainty about government tax policy and debt.

It is clear that the deficit terrorists do not spell out how they would answer the question: If the government takes out x per cent of overall spending, what will replace it? But, moreover, the replacement has to add more than the government takes out to get growth going.

Apart from the amorphous hints that a sort of reverse-Ricardian equivalence will work – so consumers and firms will suddenly spend the cash they are saving up to pay for the alleged higher taxes once they realise budget deficits are falling – there is very little hard argument presented to support the austerity case. Please read my blog – Pushing the fantasy barrow – for a discussion about the absurdity of the Ricardian equivalence arguments in mainstream economics.

In last week’s WSJ (July 1, 2010), Thomas Frank wrote that we have to Avoiding the Austerity Trap:

Deficit reduction is an unhealthy obsession.

Recent increases in the federal deficit have made the pundit class tremble, but they aren’t really mysterious. They are, for the most part, a product of the recession, which has reduced tax revenue, justified the bailouts and last year’s stimulus package, and brought unemployment insurance and other “automatic stabilizers” into effect.

Solve the recession and we’ll eventually bring the deficit back down, too. The real danger is that instead we will decide to regard the deficit as a problem entirely unto itself – a quasi-moral issue that needs to be addressed independently of the larger economy – and that we will proceed to budget balance ourselves right back into the economic ditch. For a glimpse of how this works, take a look at once-booming Ireland, where a starvation diet designed to control the deficit has made the recession more or less permanent.

Austerity would be a dreadful choice at the moment, but the urge to blunder burns hotly among the policy priesthood these days. One reason for this is that deficit reduction is often a proxy for something else, some object of political desire that must remain obscure because it is too distasteful to discuss openly.

I was reminded of the literature on strategic deficits when I read that article. This was a phrase coined by President Ronald Reagan’s budget director David Stockman “to describe the usefulness of creating long-term budgetary shortfalls to undercut political support for governmental spending” (Source).

So there are clearly political agendas lying behind the call for austerity.

But the best case that the crazies make is usually presented in terms of trade and it is here that we encounter yet another damaging fallacy of composition. I have seen a few papers come out in recent months allegedly documenting cases where austerity has led to growth. Two countries are often held out as exemplars of this approach – Canada and Sweden in the 1990s.

In both cases the governments cut back their net spending and growth emerged in subsequent years. The Economist article notes that:

But in most of these instances interest rates fell sharply or the country’s currency weakened. Those remedies are not available now: interest rates are already low and rich-country currencies cannot all depreciate at once. Without those cushions, fiscal austerity is not likely to boost growth.

So while Canada may have been able to offset the public spending cuts by an improving external sector helped along by increased competitiveness via exchange rate adjustments, this solution cannot work if all countries engage in austerity. That is the fallacy of composition.

At present, Ireland has shown a GDP spurt on the back of US and British growth. But both those nations are now slowing down themselves as they also introduce austerity programs either explicitly or implicitly via the expiration of the stimulus packages.

So the export-led growth strategy cannot apply for all nations which are simultaneously cutting back on their domestic demand.

It is also ironic that the largest of the fiscal interventions (China) has provided some global growth. And even that injection of spending is likely to be trimmed in the coming year.

The upshot is that you get the typical EMU policy strategy – scorch the domestic economy by undermining pension entitlements and the wages and conditions of the workers – and hope for an external boost. One country might get away with it but not all countries.

The only reliable way to avoid a fallacy of composition like this is to maintain adequate fiscal support from spending while the private sector reduces its excessive debt levels via saving.

That strategy is also likely to be the best one for stimulating exports because world income growth will be stronger and imports are a function of GDP growth.

The austerians are not only undermining the rights and welfare of the citizens but are also undermining the source of the export revenue – domestic aggregate demand.

Digression: RBA keeps rates steady

Today the RBA decided to hold interest rates constant in Australia at 4.5 per cent. You can read the Statement to find out why. Basically, they are becoming a little pessimistic about the external environment.

I would have cut rates!

Conclusion

That is enough for today!