Sometimes what works best as the optimal strategy at the microeconomic level has disastrous consequences at the macroeconomic level. Saving money is good! A balanced budget is good! But not when the economy is in a recession. My sales and profits may increase if other businesses pay their employees more so that their employees can spend more at my store, but my profits decrease if I have to pay my employees more as well. What is optimal for one may be detrimental for the larger group and vice versa. Individual interests and community interests can sometimes be in conflict.
One example is the Paradox of Thrift where in a recession you respond to your neighbor losing their job by trying to save more in case your hours are cut back or you lose your job. Since my expenditure is your income and your expenditure is my income, this attempt to save more at the microeconomic level during a recession leads to a reduction, rather than an increase, in total savings at the macroeconomic level. This is just one of many examples of where good microeconomic behavior can lead to bad macroeconomic outcomes.
The attempt of many European countries to balance their budgets by imposing austerity during the Great Recession of 2007 to 2009 led to a deeper and more prolonged recession than the shorter, less severe recession in the USA, which used an increase in deficit spending to revive its economy.
Supply-side economics follows Say’s Law that says that “supply creates its own demand.” But Say’s Law worked when food was very scarce and population would expand rapidly to consume whatever food was available. Any breakthrough in food production led automatically to a population explosion that quickly consumed the increased supply of food.
However, in recent decades Say’s Law has been reversed where birth rates have fallen well below replacement. Automation in farming along with much higher crop yields and a much greater supply of goods and services produced around the world has created excess supply and inadequate demand as explained in Daniel Alpert’s book “The Age of Oversupply.” This contrasts sharply with Milton Friedman’s book “Capitalism and Freedom” in 1982 that emphasized the importance of investments to stimulate supply with a focus on maximizing profits and shareholder value, while more or less ignoring the demand side.
Supply-side economics has created a very distorted economy in the United States. In recent years, the high return (10 percent to 20 percent a year) to investments in the stock market (and now crypto-currencies) has diverted money out of the real economy and into the financial markets in a money flow reversal that is suppressing productivity and growth in the real economy, which has now been growing at less than 3 percent a year.
Steve Jobs was excited about changing the world with new products and inventions. He wasn’t focused on making money. John Scully came along and, in effect, told Jobs: “Steve, you really need to increase Apple’s marginal rate of profit. You need to raise Apple’s stock price.” But Jobs stayed more excited about new products so Apple’s board replaced Jobs with Scully who worked hard to cut costs and raise profits. He got Apple’s stock price up by buying back millions of Apple’s stock shares with money that could have gone into product innovation. Then other technology companies began to overtake and surpass Apple in creating new and exciting products. The Apple board finally relented and brought back Jobs when it realized its mistake in focusing on profits and stock market share price. Creative people are much more motivated by the recognition and respect they get by “changing the world” than in accumulating huge amounts of money.
Too often economists confuse creative people with greedy people. They are entirely different. Economic policies that focus too much on maximizing investor return can sometimes suppress innovation and productivity in the economy. Economists tend to emphasize time and money because they are easy to measure. But there are things that money can’t buy and may be hard to measure. Creative people are more focused on gaining recognition and respect.
Arrow’s Impossibility Theorem caused economists to give up on trying to directly link economic well-being (“utility”) at the microeconomic level to overall well-being at the macroeconomic level. By default macroeconomic theory has been implicitly assuming that “a dollar is a dollar” of equal value to everyone. But this is very, very far from reality. As one becomes wealthier and wealthier, the marginal economic utility of an additional dollar drops dramatically. Poor people have the highest marginal propensities to consume. Give them an additional dollar and they will spend it right away. But rich people run out of things to buy so they have very low marginal propensities to consume and invest any additional money they get.
Under supply-side economics the Federal Reserve has pumped more money into the financial markets by purchasing Treasury securities and mortgage backed securities under quantitative easing (QE) when the economy was weak and needed more investment on the supply side, but over the last 50 years our economy has switched from inadequate supply to inadequate demand. Very little of the money provided to investors in the financial markets trickles down to middle class people with high marginal propensities to consume. To get much more “bang for the buck” the Federal Reserve could stimulate the economy more efficiently by giving the money directly to the people with the highest marginal propensity to consume instead of its current QE policy which follows supply-side economics in giving money to wealthy investors who are among those with the lowest marginal propensities to consume.
To avoid dealing with this, economists tend to invoke “economic efficiency” where we focus on motivating people to make as much money as they can. But exactly how do economists define “economic efficiency”? We often say that economic efficiency is using all our resources to bring about “the greatest good for the greatest number of people,” which is sometimes referred to as “the common good.” Even if we set aside the problem of defining “the people” as those in our own country or everyone in the world, economic theory has failed to provide a time span for achieving this objective. The whole discussion of Arrow’s Impossibility Theorem doesn’t even get to the problem of short-run optimization versus long-run optimization. Over what time horizon are we seeking to maximize “the greatest good for the greatest number“? A first attempt might be to use the average life expectancy of the existing population.
Economic efficiency also requires a more precise definition of “the greatest good.” This problem throws us right back to dealing with the problem of measuring and aggregating economic utility. Even if we think of gross domestic product (GDP) as how much we produce and gross national product (GNP) as how much we consume, we still have the problem of measuring economic well-being in an economic utility sense. Many commentators have pointed out that GDP and GNP are clearly not measuring what we are trying to maximize (“the greatest good“). All that food you grow in your backyard garden and eat or give away to your friends is not counted in GDP or GNP. You are not contributing to “the economy” (as measured by GDP or GNP) when you take care of your own children instead of dropping them off at daycare. According to these measures, growing your own food and taking care of your own children are not productive activities.
Ignoring the problem of how to aggregate individual utilities to promote the common good is clearly not working. One possible step toward a more realistic solution may be to define the utility of a dollar as being the inverse of the amount of wealth that a person has. If Elon Musk has 425 billion dollars (where one billion is a thousand million dollars), then we could measure the utility of an additional dollar to Elon Musk as one divided by 425 billion. Of course, to be fair we would have to theoretically “monetize” everyone’s other possessions and include that value as part of a person’s net wealth to properly measure the long-run value of a dollar to that individual. This does not solve all the difficulties raised by Arrow’s Impossibility Theorem but does not completely ignore the problem altogether as most economists have done. (Note: This is similar to choosing a voting system where ranked-choice voting is not perfect but generally much more likely to result in more representative legislators than traditional plurality voting.)
Right now in the United States we have exactly the opposite situation, where under the Supreme Court’s “Citizen’s United” decision, having lots of money buys you a great deal of political influence. Instead of one-person one-vote, we have changed the fundamental basis of our constitution to mean one-dollar one-vote. In effect, we have changed the definition of “the common good” to mean primarily benefiting the wealthiest of the wealthy in our economy. By giving up on developing a more reasonable and precise definition of “the common good” in the face of Arrow’s Impossibility Theorem, we seem, in effect, to be inadvertently minimizing “the common good” under any reasonable definition of the term.
The December 7, 1941 attack on Pearl Harbor changed everything. Americans had been divided on whether to be isolationist and stay out of the war or join in the battle against the fascist enemy. Before the Pearl Harbor attack, some such as the famous celebrity aviator Charles Lindbergh seemed to be Nazi sympathizers. But suddenly we were all joined together in the war effort and finally in 1945 came out of the war as a united people, where rich and poor had fought along side one another in the difficult and sometimes brutal effort to stop the enemy.
World War II united Americans to pursue “the common good” with strong unions and shared prosperity during the population explosion in the 1950s and 1960s called the baby boom. Many CEOs treated their workers as family and provided pensions for them in retirement. As output per worker rose, compensation per worker rose along with it, allowing a male worker to serve as the sole breadwinner, as married couples produced a bumper crop of babies. Supply-side economics was working to produce more for everyone.
Using taxpayer money, President Eisenhower pushed through a bill funding the Eisenhower Interstate Highway System that allowed businesses to distribute their products much more quickly and efficiently throughout the economy. Back then, investing in America was a great thing to do, even if it was not “profitable” for the government. We understood that government’s laws, rules and investments created and maintained our free enterprise system. The role of government was to enhance free market efficiency whenever and wherever possible.
The distain for government grew after a popular Hollywood actor, Ronald Reagan, became president. To President Reagan and his supporters the smallest possible government was the best possible government. Large corporations promoted this idea as a way to expand their power with less government interference in their determination to drive up their profits by suppressing unions and competition. Buying up competitors or driving them out of the market reduced most major industries to a few large firms with a well-defined leader that set the prices and rules for firm behavior. For details, see the book by Jonathan Tepper and Denise Hearn called “The Myth of Capitalism.”
As a consequence of increased corporate power and less government “interference,” compensation per worker leveled off in real terms around 1976, but automation continued to drive output per worker (and profits) upward. As industry became more concentrated and many states passed “right-to-work” laws to suppress unions, workers could no longer buy back the value of the goods and services that they produced and had to go deep into debt to feed their families. Having children became very expensive even with both parents taking jobs. Supply was plentiful, but demand was inadequate. Wealthy people were becoming much, much wealthier but could not consume enough goods and services to maintain an adequate level of demand.
A K-shaped economy emerged, where the top 20 percent got much wealthier, while the bottom 80 percent lost ground economically in real terms. According to Federal Reserve data 93 percent of the stock market is now owned by the 10 percent wealthiest people. Consequently, demand for exclusive properties has shot up. But driving up the price of Picasso paintings does not bring Picasso back to life to produce more paintings. Wealthy people’s marginal propensity to consume new goods and services dropped sharply as soon as they reached the multi-million dollar level. Supply was abundant but demand was inadequate. Say’s Law had been abruptly and profoundly reversed.
Private debt skyrocketed. But even that was not enough to keep the economy out of recession. Both Democratic and Republican politicians complained that the federal debt was too big and deficit spending needed to stop. But to stimulate the economy to stay out of recession, Democrats passed big spending bills and Republicans passed big unpaid-for tax cuts that increased the federal deficit, because they were afraid of losing votes if they allowed the economy to slip into a recession. Say’s Law has been reversed. Instead of inadequate supply, the diversion of money to the wealthiest Americans (who just reinvest any additional money they get) and away from the workers (who are no longer paid enough to buy back the value they create) has produced inadequate demand.
A balanced budget is not the same as a balanced economy. Sometimes achieving a balanced economy means running a deficit and at other times a surplus. It also means paying the middle class adequately instead of diverting enormous amounts of money to already wealthy stock market shareholders. Government plays a key role in the economy but needs to develop better and more effective tools to keep the economy running smoothly. This led Stephanie Kelton to help develop modern monetary theory and publish the New York Times bestselling book “The Deficit Myth” in 2021. A new powerful savings tool to stop inflation, improve free market efficiency and provide an automatic stabilizer for our economy is described in this short YouTube video: https://www.youtube.com/watch?v=nnMT7DVyK0g .