Musings about Macroeconomics

I was a reasonably good theorist in microeconomics when I did economic research for real (until 1995 after which I switched to learning technology).  I never did numbers at a research level and I never felt I understood macroeconomics at the same level of depth as I understood microeconomics.

Now, considering the future economic situation of my family, where I've done a little looking at our finances recently, and as a concerned citizen, where we know that there is a pretty strong correlation between macroeconomic performance and our national politics, I thought I'd go through several little exercises here so others reading this, who have less economics training, can consider the same issues from their own perspective.

Given my background, I'm going to go through a micro foundations set of considerations first.  Then I will consider macro policy.  In total I hope this might be a useful primer for some.

Your Income and Your Savings Rate

Since tax time is approaching, you might want to leverage the time spent assembling the information needed to complete the forms by also doing some tracking about your personal finances.  I'm going to talk it through here based on my situation.  Somebody else might build a generalized spreadsheet that you could use to make such calculations.

Leslie and I each get a W2 form.  I also get a 1099R form for my pension.  The IRS might consider the pension income unearned, but I like to consider it together with wages so as to make comparisons with earning pre and post retirement.   University employees can participate in a 403B plan, which is like a 401K plan for others.  That is one obvious place where people save financially.  In Leslie's case, the size of the contribution to the 403B plan was determined at the time of enrolling in the program.  Thereafter monthly contributions have been deducted from her paycheck.  Thus this sort of saving decision is quite passive.  Serious thought about it occurred once.  Thereafter, it is pretty much out of mind.

Another one that is like this happens if you have a mortgage.  We have a 15 year fixed rate mortgage.  So our payments are the same each month.  It is therefore quite easy to determine the annual payment.  The bank where we have our mortgage tells us how much of that payment is interest.  In a month or two they will send a statement with that to us.  In the meantime, I note that my online banking reports this.  The difference between the annual payment and the interest paid is equity built up in your home and should be considered savings.  It is another significant way that ordinary people who are homeowners save. Again, the decision to do this is quite passive.  Our mortgage payments are deducted automatically out of our checking account.

We do have some investment accounts where at our stage in life for the most part the money just sits there, for later use when the need arises.  These earn some return.  (In contrast, money in a checking or savings account now earns essentially nothing because the interest rates there are so low.)  The return is reinvested.  That is an additional form of savings.  Then you can look at checking and savings accounts and compare end of year balances between 2016 and 2015.  If the balances are higher in 2016, the difference represents the amount saved.  If is the other way around the difference will be negative and the absolute value gives the amount dissaved.

Some people have income from other sources (for example, they hold real estate or they are part owners in a small business).   In principle, there is no difficulty in handling these alternative sources of income.  In practice, particularly when there are capital gains or loses which are accrued but not realized (the capital gain is realized when the asset is sold, until then it is accrued), accounting for those can be more art than science, so I'm simply going to ignore such income in this discussion.  Likewise, when you purchase a consumer durable - a car, a major appliance, a piece of artwork or some furniture, etc., conceptually these things have resale value, so the consumption on the good is only the purchase price less the resale price after a year. The part that isn't consumption in the purchase price is then also savings, though in kind rather than financial.   If you are more anal than I am, you can do some tracking and calculations to figure out how much value is in your real property.  That's just too hard for me.  So I'm ignoring it here.

With the data we have so far you can compute a rough household savings rate.  I did that for my family yesterday.  I got around 25%.

How Savings Rates Vary

There are several factors to consider that matter a lot for determining the personal savings rate.   One is obviously income.   Low income households save very little if anything.   If low income persists for many years, such households may have little to no net worth.

Another factor is the age of household members.  When our kids where young, it seemed that there was nothing left at the end of the month to put into a savings account or into an investment account.  Spending directly on the kids, on family travel, and on the household took up pretty much all the take home pay.

Another factor is current indebtedness/current wealth.  Much has been made about incurring debt in college.  Those carrying substantial debt no doubt have that strongly influence their consumption choices,  keeping their current spending more modest so they can pay off their loans.  Conversely, those who have accumulated wealth, perhaps as a consequence of a bequest from parents, have that as assurance and likely spend a greater fraction of their current income.

Still an additional factor is how expected future income compares with current income.   Normally people just starting out in the labor market expect to climb the job ladder some and with that see their earnings rise.  Conversely, most people at or near retirement expect to see earnings drop in the future.  Future prospects impact the current decision to save.

Let me add one more factor here, irrational exuberance or its opposite, irrational pessimism.  From around 1999 till when the housing bubble burst, savings rates in aggregate for the U.S. economy were very low and I believe turned negative around 2004 or 2005.  Those who owned homes saw their home values appreciate and seemingly acted on the belief that those values would keep rising.  If you have capital gains income that is substantial, why save in other ways?  Of course, when the bubble burst such people found themselves in trouble.  Many ended up losing their homes.  The flip side of this (excessive pessimism) is taking savings and putting the money under the mattress for fear that if putting it into an uninsured investment it will not be possible to get the money back out when it is needed or to not trust that insurance will pay off when the investment fails even in an insured investment.  The flip side can create its own panic scenario - a run on a bank.

Marginal Propensity to Save/Consume

If you get an additional dollar of income, you either spend it or you save it or you divide it between the two uses.  The marginal propensity to consume is how much you spend out of that additional dollar.  The marginal propensity to save is how much you save out of the additional dollar.  The two taken together must satisfy the identity MPC + MPS = 1.  So if you say something about the marginal propensity to save, you are implicitly saying the reverse about the marginal propensity to consume.

One of the issues impacting the MPS is whether the person views the additional dollar as coming with strings attached or not. A loan of a dollar that must be repaid is quite different from a gift of dollar that implies no obligation of a return gift.  Another issue impacting the MPS is whether the additional dollar impacts the prediction of future income, in Milton Friedman's terminology it increases permanent income, or if it has no impact on the future, again in Milton Friedman's terminology it is an increase in transitory income.   The difference in the two notions is exemplified for the former by getting a pay increase at work while for the latter the income arises from winning at bingo at the church social.

A different factor that impacts the MPS is whether people are liquidity constrained or not.  Liquidity constrained people would like to borrow more (dissave) but can't because potential lenders view them as default risks, so won't lend to them.  The MPS of a liquidity constrained person is often zero and possibly negative. (The way it could be negative is if a lender trusts the person for a loan after the income increase where the person wasn't deemed trustworthy beforehand.)

For non liquidity constrained people, does the MPS vary with wealth?  This may be more of a contentious point.  My own belief is yes.  Uber rich people like Bill Gates or Mark Zuckerberg have MPS equal to 1.  They can afford to buy whatever they want.  If they don't buy something it's because they don't want it.  The affordability of something desired simply isn't an issue for them.  No doubt, there is more than a little hand waving in what I say next.  If liquidity constrained people have an MPS of 0 and the uber rich have an MPS of 1, it is not a bad assumption that the MPS of people rises continuously with wealth, once the liquidity constraint is no longer binding.

The point is that if you did income redistribution under this assumption and played Robin Hood, by taking a dollar of income from the rich and giving that dollar to somebody who is poor, aggregate consumption would rise (savings would fall).  Income distribution in the opposite direction would then have the opposite effect.

So Much for Households, What About Businesses?  

I'm going to say less about business because, frankly, I don't have the same ordinary experience as I do as a head of household.  I've never run my own business.  Nonetheless, I think I can get the fundamentals out so the discussion is balanced.

The operative decisions are:  How many people does the business employ? What wages are paid? How much investment in human capital (skill development of the staff) is made?  What about investment in physical capital (plant and equipment)?  Those are the input choices.  On the output side there are similar questions.  How is the product or service priced?  When is new product brought to market?  When is an old product retired?   Surely there are further questions to consider, like how should expansion into new markets geographically occur, how should the product be marketed so how much should sales be integrated with production, and how should the firm face emerging competition from other firms that are new to the industry?

For the sake of this discussion, the key way to think of these questions is to consider expectations about the future, near term and longer term, and how those compare with the situation at present.  If demand for product is expected to grow that is a reason to invest in human capital, physical capital, and increase the size of the work force.  If current profit margins are already low and competition is expected to heat up more, that is a reason to consider getting out of the business.

For those firms who want to invest and/or expand the size of their work force, we can think of them in three different categories.  The first have sufficient cash on hand from retained earnings to entirely finance the investment themselves.  The second may not have that much cash but they are viewed as safe investments so can borrow as much as they want at market interest rates to finance the investments they plan to make.  The third are viewed as riskier than that.  These firms either have to pay a premium to secure a loan, an admission that default risk is present, or they can't raise capital at all and in that sense are like the liquidity constrained buyers out there.  They may perceive an investment opportunity but it dies on the vine and never turns into wine because they can't raise the financing.

Looking at some Macroeconomic Variables and their Values at Present

Given the recent to do about "alternate facts" let me make two observations that may trouble some readers.  First, there are many potential variables to consider.  Which ones to bring to people's attention and which ones remain in the background is something of an art form.  Second, people trained in the discipline agree much more on the microeconomics (what I said above) than on the macroeconomics and the efficacy of policy (or not).  Chicago School (free market) economists will come to quite different conclusions than Keynesians.  I am a Keynesian in my orientation/training.  I'll try to make my personal biases apparent at the appropriate time.

Three variables that are normally considered in macroeconomic performance are: the unemployment rate, GDP growth rate, and the inflation rate.  Better performance of the economy as a whole is identified with low unemployment, high GDP growth, and low inflation.

For the U.S. you can find data on these variables at various sources.  Here's a bit of a look:

Inflation Rates U.S. - There are some graphs at the link.  Inflation last year was quite low, below 1% much of the time.  It is beginning to heat up a little now and is currently at 2.1%.  If we could sustain that, it would be fine.  When it rises much above 2%, however, the economy begins to under perform because of inflation.

GDP Growth U.S. -  There are three components to GDP growth.  One is inflation.   Because of that, GDP graphs and inflation graphs will correlate positively.  Sometimes the inflation effect is netted out and what is reported is GDP in constant dollars relative to some base year.  That is not done in the graph which is linked.  The next component is population growth.  The final component is productivity growth. In the third quarter of 2016 GDP growth was 3.5% and much higher than earlier in the year, where it was less than 1%.

Unemployment Rate U.S. -  The unemployment rate varies through the business cycle. It is very high during a recession.  It is much lower when there has been high GDP growth for a sustained period of time.  That growth implies greater aggregate demand and gives a reason for firms to hire additional people.  There is some debate about whether the unemployment rate and the inflation rate are negatively correlated or not.  The Keynesians tend to believe there is such a correlation though it may be only operational at or near full employment.  When I was in graduate school in the late 1970s we went through a period of stagflation where this correlation was apparently severed.  History may matter on this.  There was a sustained inflation in the 1970s that preceded the stagflation.  We've had relatively modest inflation for quite some time, more than a decade, but we've also been below full employment for most if not all of that time.  The current unemployment rate is 4.6%.

There are some other variables that have gotten attention lately, consideration of which make the conversation richer, but also more complex.   The first one is the real wage, the wage adjusted for inflation.  A Keynesian view of the labor market would say that when below full employment real wages will be flat and changes in the demand for labor will be met by changes in the unemployment rate.   In fact, that seems to be the history for unskilled and semi-skilled workers, though not at all for highly educated workers.

Real Wages - Some other factors should be mentioned here to explain this history.  One is the decline in unions.  Another is increased mobility of plant location, so firms can credibly threaten relocation and get wages concessions even when there is a union present.  Likewise, the possibility of automating work acts as a break on wage demand.

The second variable is the labor force participation rate.  In the simplest conception, you look at total labor supply, total employment, difference those, and divide the difference by the total labor supply to get the unemployment rate.  But the Bureau of Labor Statistics takes a more nuanced approach.  A person who is not working is part of the labor supply only if the person has been actively looking for work.  People who are not actively looking are then deemed out of the market.

A rich person who is able in body and mind may be out of the labor market because the person doesn't need the income from working.  Such people definitely exist but they are few in number compared to the size of the economy as a whole.  Other people who are out of the labor market, people who are not rich, don't seek employment either because they are disabled in some way or because they are discouraged and have given up looking for work.  ADA is supposed to come to the aid of people in the first category.  I am not expert on how effective ADA is in achieving its goals.  But because it is present I'm simply going to lump those who are disabled but who can't find work into the second category.

Labor Force Participation Rates -  I am not sure what a healthy number is here, but if you think it should be at or above 90% and you see it is in the low 60s% and has been declining for a while, that is disconcerting.  It also explains, perhaps, some of Donald Trump's comments about the true unemployment rate, in his mind the one where the discouraged people are counted as unemployed rather than out of the market.

This document takes a longer view and disaggregates the information in a way to see more of what is going on.  Take a look at Table 1 on page 2.  There are participation rates by age and by gender.  Teen and young adult participation rates are lower as are participation rates of senior citizens.  This sort of difference allows the aggregate rate to be influenced by composition effects.  If there are more people overall in those age categories with low participation rates, the aggregate will fall.  If you look at the rates for males from 55 to 64 over time, that paints a picture that explains the disaffection in older males, particular if you couple it with doing the same type of comparison with the female participation rates for that age bracket and the next younger bracket.

The last of these sort of variables to consider is life expectancy.  Much of a to-do has been made about the recent decline in life expectancy among whites along with the associated increase in opioid use, assumed to be an indication of desperation rather than merely a recreational habit.  Given improvements in medical science, this sort of decrease is unexpected, and a warning sign that some things are not right.

Up till now I have focused on the U.S. only.  Now I want to turn to an international look.  There are two types of variables one might consider.  One type is exchange rates and how the currency of one nation appreciates or depreciates relative to another.  I'm going to ignore that here.  The other type is interest rates.  While there are many possible rates to look at, one way to compare countries is to look at the rate that the Central Monetary Authority charges member banks.  These are on short term loans, I believe one month, with the effective rate then annualized. 

Global Interest Rates Charged by Central Banks - In many countries this rate is quite low.  In Canada it is 0.5%.  In both Europe and Japan it is 0.0%.  In the U.S. the Fed currently has the rate at 0.75%.  Real rates of interest are the nominal rate less the inflation rate on that particular currency.  While I haven't verified this, the countries that have higher interest rates in the table also likely have higher inflation rates, though countries that are experiencing substantial real GDP growth and are already at full employment will have high real interest rates.  So, my interpretation of the low real rates is that the global economy is not growing much if at all beyond population growth, and may not even be keeping up with that.

Closed Economy or Open Economy

Here is an imperfect metaphor by which to consider the issue, but before I get to that I want to note that this is the section intended to bridge the gap from describing the macroeconomy to asking what is good macroeconomic policy.  The metaphor I have in mind is to look at states within the U.S.   If you live in Illinois as I do, should you focus on the economy of Illinois only (closed economy) or focus on the economy of the U.S. overall (open economy)?  When considering policy, which focus is appropriate if you are in state government and thus making that policy? 

Paul Krugman, a noted Keynesian and a vocal Liberal, has been recently making closed economy arguments about the U.S. economy as a whole.  He argues that we are at or near full employment, where we weren't there until quite recently.  Krugman is also dead against Trump.  The arguments Krugman has been making serve as a way to bash Trump.  So those arguments may be made for that reason instead of because they provide the right way to frame the question.

However, a friend who is an economist and is far less politically animated points out that longer term interest rates are rising in the U.S.  As I've already indicated above, there has been a recent blip up in inflation.   This is happening even while global interest rates are very low.  So maybe a closed economy view for the U.S. has some merit now, because full employment has been attained.

Let's make one further observation here.  In the U.S., states don't correlate their fiscal policy.  But, for example, economic activity in Illinois will be influenced by fiscal policy in border states, and vice versa.  And it may be that a policy meant to benefit residents in one state ends up benefiting residents in a neighboring state, while harming residents in the state of origin.   A closed economy focus will ignore those external effects.

Restoring Fiscal Policy as an Option

Immediately after Obama took office, in January 2009, there was a large stimulus package passed by Congress.  During the lame duck session of 2010, before the Tea Party would shift the House majority to the Republicans, there was a second stimulus package passed.  Some have also argued that ACA would have a substantial impact to stimulate employment, by holding down the costs of health care and therefore controlling the costs of hiring additional employees.

There is debate about whether these stimulus packages worked.  In the popular conception, there was also some confounding between the initial stimulus and TARP, which was passed while Bush was still President.  TARP was enormously unpopular, in large part because it seemed to benefit the bankers and financiers who caused the crisis.  The view of the initial stimulus has been similarly tarnished.  But most Keynesian economists think the opposite.  The stimulus prevented a second Great Depression.  An even larger stimulus, and one that didn't include so much in tax cuts for wealthy people, would have done even better.

Since 2011, the Republicans have controlled at least one branch of Congress and in 2011 there was the Debt Ceiling Crisis.  Fiscal policy at the Federal level has been much more contained since.  Republicans have taken control of many state legislatures and governorships as well.  Consequently, fiscal policy has been more contained there.

The consequences have been perplexing.  I will illustrate by going back to a microeconomics look at the situation where I live.  Our house is right across the street from a park.  The park is popular with residents and with non-residents who have little kids.  Often, cars will be parked outside my front door and I see parents taking there kids to the playground where there is a sliding pond and a swing and a sandbox.  The playground is on the west side of the park.  On the east side there is a flower garden that is quite attractive in the spring and summer.  The flower garden is visible to everyone who drives  into the development from the entrance on Duncan Road.   It makes an immediate good impression of the neighborhood.

The park in one of many parks that are part of the Champaign Park District.  They maintain it and do a good job with the upkeep.  The commons areas that surround the walkways in our community are also maintained by the Park District, and that is kept up quite nicely as well.  I believe the entire funding for the Park District comes out of the local property taxes that we pay.

In contrast, many of the roads in the area, including Windsor Road, which is a main drag and heavily utilized, are in a horrible state of disrepair and have been this way for many years.  Some roads, such as Curtis Road, have recently been redone and are in much better shape.  The repaving of Curtis Road was done as an adjunct project to them putting in a new Curtis Road exit on Interstate 57.  So it isn't as if it is impossible to redo the roads.  The issue for why it doesn't happen more broadly is lack of funding.  And here I'm guessing that such funding comes from overlapping jurisdictions - perhaps some Federal funding, certainly some State of Illinois funding, and then perhaps some local Champaign funding as well.  You only have to drive down Windsor Road once to know that it should be redone.  But the politics of getting that to happen now seems will nigh impossible.

During the last campaign there seemed some growing consensus about doing a major infrastructure  package at the Federal level.  We'll see if it comes to pass.  Even if it happens, my guess is that it will be too small and not sustained for long enough.

The construction work that one associates with infrastructure investment generates income for those people doing the work on the project.  Thus, legislation that calls for infrastructure investment is often described as a jobs bill.  If done sufficiently intensively, it can be used as policy to address both low labor force participation and to raise the real wages of unskilled and semi-skilled workers.

Paying for that type of investment requires raising taxes.  If the taxes are put disproportionately on the very wealthy, they will no doubt object to that.  But the macroeconomic consequence should be like the Robin Hood sort of income redistribution discussed earlier.  That is the Keynesian view. 

Wrap Up

My motivation in writing this piece is to consider professionals like myself (doctors, lawyers, accountants, university professors, etc.),who have done quite well in the income distribution, even if we don't consider ourselves rich.  We are much better off than the median household.   We should be paying more in taxes, not for our own private benefit, but for the good of the order.  Further, as there are many more such professionals than there are those who are uber rich, our paying more in taxes sets an ethical tone that the uber rich should pay more in taxes too.  Indeed, they should pay a lot more.

The Republicans as they are currently structured are an anti-tax party.  So the argument I just made will not fly with them.  The question is whether it can fly with upscale Democrats.   It seems to me that if it can the Democrats can get past the critique that the elites don't care about ordinary people.  In contrast, if upscale Democrats appear like Republicans on taxation, I'm afraid they'll fail to put together a winning coalition, even as the country flounders now.