Hydraulic Macro: A Fable
By Arnold Kling
I came up with this while thinking of a way to explain the Keynesian model to my high school class. But scroll to the end to see comments related to the recalculation model.Once upon a time, Joe lived in Keynesiana, where he was a representative agent.
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. So the first week, that meant 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.
I see two problems leading to the need for government to spend Joe’s money for him.
1. There is no sign of the price mechanism at work here. The factory outlet sells less GDP than it wants to, but it does not cut price. Joe works less than he wants to, but he does not cut his wage.
2. The problem would go away completely if Joe would hold his savings in the form of GDP rather than in the form of cash.
Concerning (1): In terms of the recalculation model, we do not see instantaneous movement to a new full employment equilibrium. In a complex economy, where many people have to change jobs in order to adjust to new circumstances, it would be absurd to expect instantaneous adjustment. It also may be the case that sudden, sharp price changes would actually be destabilizing–causing too many people to make adjustments that later need to be reversed. So although prices and wages are not completely fixed, it is fair to say that the economy does not behave as if they were fully flexible.
Concerning (2): It is tempting to attribute macroeconomic significance to the role of money as a store of value. Keynes does so with the terms “liquidity preference” and “liquidity trap.” However, I think this is not a wise move. I think that it leads to more error than insight.
In a diverse economy with extensive division of labor, it is inefficient to pay people in the form of output. If I am the accountant for a bakery, it is not my comparative advantage to sell bread. Paying me in bread would lead to a waste of resources as I try to go out and exchange it for what I wish to consume. To take the point even further, picture me as an accountant in a hospital–am I to be paid in surgeries?
The problem is not that money is a store of value. The problem is that the plans of producers and the plans of consumers are not necessarily aligned. Edward Leamer, in Macroeconomic Patterns and Stories, puts it this way (p. 163):
The long supply chain characteristic of industrial economies necessitates the creation of capacity to produce consumer products many years before actual sales are made. With such long lead times, there is little possibility in a vibrant and growing economy that actual capacity will match actual sales month to month.
To the extent that consumer behavior changes slowly and/or predictably, plans are not too far off. The great calculation machine is able to keep most people employed. However, large unexpected changes in consumer behavior overwhelm the calculation machine. Until a new pattern of production and wants is established, there tends to be unemployment.
By the way, I will have more to say about Leamer’s book in a subsequent post.