Interesting Economics That I Learned-Big Government is Better

[gravenewworld]

From the Investment savingings model (IS) equation GDP (Y) is a function of consumption C, Investment I, and government spending G

Y=C(y,r)+I(r)+G

Consumption is a function of disposable income (income minus tax. national income is also the same as GDP) y which is y=Y-T and the interest rate r. Investment is also a function of the interest rate r.

Now let's assume that the economy is in a recession and the government wants to boost GDP by either a) tax cuts or b) more government spending. Which one will be more effective?

Totally differentiating the IS curve we have dY=CydY-CydT+Crdr+Irdr+dG.

Cy=the derivative of consumption wrt to y, Cr is the derivative of consumption wrt to r, etc.

Now how does GDP respond to more government spending i.e. what is dY/dG?

Assuming taxes stay the same and interest rates don't move

We have dY=CydY+dG or dY/dG=1/(1-Cy) Cy is also known as the marginal propensity to consume which is how much people spend out of their entire incomes. The marginal propensity to consume of course 0<Cy<1.

Let's assume that the marginal propensity to consume for Americans is .9. Then if the government spends 1 dollar GDP will increase by 10. 1/1-Cy is also known as the multiplier for government spending.



Now let's look at what happens when the government cuts taxes. Assuming interest rates don't change and government spending don't change the totally differentiated IS equation becomes

dY=CydY-CydT

So how does GDP respond to tax cuts, i.e. what is dY/dT? Using simple algebra we find dY/dT=-Cy/(1-Cy). Assuming marginal propensity to consume is still .9 then for every dollar that the government cuts taxes dY/dT=9!
(the negative sign goes away since we are talking about cutting taxes). -Cy/(1-Cy) is also known as the tax multiplier.

Thus dollar for dollar increasing government spending/bigger government is better at stimulating the economy in a recession than tax cuts. But of course politicians won't tell you this since Americans think tax cuts are always better.

 

[Pengwuino]

A multitrillion dollar economy cannot be summed up in 2 equations with multiple impossible assumptions being made.

 

[gravenewworld]

True, but that is how professional economists think. You can throw in more variables to make the model more complicated and more reflective of the real world, but the mathematics becomes rediculous. That is why economics is a social science and economists use "models" of the economy.

 

[Pengwuino]

Yah, they are incredibly complex models of the specific economies in question. It just can't be reduced to such broad ideals.

 

[loseyourname]

Well, it's hard to disagree. Look at what got us out of the great depression. The government spending a ton of money on the war. The problem is that the government cannot create wealth, so that type of solution isn't sustainable. But it will work to create immediate growth.

 

[Smurf]

True, but that is how professional economists think.

professional economists don't *think*. There hasn't been any real innovation in economics in ages, they calculate according to their textbooks.

 

[gravenewworld]

Really? Then how could there possibly be a Nobel Prize in Econ every year if no new work was ever done?

 

[selfAdjoint]

I can think of a reason for that, can't you? Not that I believe it. There has been a lot of development in economics, just not a revolution in basics.

 

[EnumaElish]

Thus dollar for dollar increasing government spending/bigger government is better at stimulating the economy in a recession than tax cuts. But of course politicians won't tell you this since Americans think tax cuts are always better.

That's true as long as G and T are made of fungible units (e.g. same stuff that Y is made of). In reality, G and T have different effects on the composition of the resulting additional income. Higher G means higher government spending, so the government is in control when deciding what kind of expenditures should be made -- e.g. "guns vs. butter." (More national security, anyone, to go with your toasted bread?) With tax cutting, that decision is left to the consumers -- e.g. "a new car or a plasma TV?"

 

[gravenewworld]

Right. G (government spending) is a direct component of national income i.e. gdp (Y). Taxes work indirectly through consumer consumption, which is in turn effected by consumers' marginal propensity to consume. That is why the government gets more bang for the buck through government spending. Actually if you look at the historical data, Americans a majority of the time have not even spent tax cuts, they saved them. Economists try to attribute this to the fact that Americans perceive that the tax cuts aren't permanent, so they save them.

 

[EnumaElish]

Taxes are also one of the automatic stabilizers of Y -- when income falls, less tax is collected, so recovery becomes easier. G does not have this automatic effect -- it is deliberate, and often, too late to be really useful. The executive and the legislative are usually slow to admit to a slowdown in the first place, and even when they finally do, they are still slow to commit to increased government spending so that, with the possible exception of major depressions, G would not be increasing until the recovery had already started on its own, is my guess.

 

[Ratzinger]

professional economists don't *think*. There hasn't been any real innovation in economics in ages, they calculate according to their textbooks.

It's even worse. Most academic economics has become completely irrelevant for solving and explaining real world problems. I can't tell you how much waste of time it is, taking graduate courses in economics. When you believe that the good all IS-LM-AS model or Solow model in undergraduate macro is flawed ( not even talking about funny micro), then you have seen nothing yet. Pick up 'Recursive macroeconomics' by Thomas Sargent, that's state of the art graduate macroeconomics. Dynamic programing, time series econometrics plus a set of silly assumptions from silly neoclassical/ walrasian microeconomics has replaced all thinking and makes the young Ph.d. think he is doing real hard science.

Krugman once wrote that academic professors don't solve real world problems. Instead, they try convincing their fellow economists that they are clever by writing clever papers while they refill old wine in new bottles. Or as noble-prize winning Roland Coase put it, economics is blackboard science.
And as far as the noble prize goes, you know it was added in early seventies and nobody is happy now that they did (just compare the achievements of the phy, chem, med laureates with those from eco, embarrasing).

Of course, there is that other breed calling themselves economists. These people you see on TV forecasting stock prices and exchange rates, and giving you fancy explanations why things happened afterwards (and not the way they predicted).
Better than the educated fools with their Ph.d. titles living in their textbook world? I don't know.

What I know is that original thinking is needed. A new Marx, Schumpeter, Keynes. Economic problems have never been so pressing as now (1,5 billions living in absolute poverty, 300 people posses as much as the poorest third of the whole world population, globalisation,...), at the same time economics seems to have giving up. Frustrating and sad.

 

[loseyourname]

I'm not sure how you can say that academic economics has failed the world when no government on the planet will actually implement their recommended policies. Who knows whether or not they would work?

By the way, don't you think it's a little hyperbolic to say that economic problems have never been as pressing as right now? We're living in what? The second most prosperous decade in the history of the planet? Aside from the 90s, when exactly was the economy any better than now?

 

[Smurf]

Really? Then how could there possibly be a Nobel Prize in Econ every year if no new work was ever done?

Well firstly it's not a real nobel prize.
http://en.wikipedia.org/wiki/Bank_of_Sweden_Prize_in_Economic_Sciences_in_Memory_of_Alfred_Nobel

Secondly, have you seen what they win for? The latest two guys Finn Kydland and Edward Prescott, won "for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles". A.k.a. Statistics compiling and then writing a big speech.

It's ridiculous.

 

[Smurf]

I'm not sure how you can say that academic economics has failed the world when no government on the planet will actually implement their recommended policies. Who knows whether or not they would work?

As far as I'm aware they've never agreed on anything long enough to have "recommended policies".

By the way, don't you think it's a little hyperbolic to say that economic problems have never been as pressing as right now? We're living in what? The second most prosperous decade in the history of the planet? Aside from the 90s, when exactly was the economy any better than now?

Which economy, exactly, are you referring to?

 

[loseyourname]

As far as I'm aware they've never agreed on anything long enough to have "recommended policies".

Maybe not a concensus, but when has any government implemented the recommended policies of any academic economist at all? Basically, I just can't see how you blame them for not fixing problems when it isn't their job to fix economic problems. That is the job of politicians and individual business owners/investors.

Which economy, exactly, are you referring to?

GWP per capita, if you can call it that. How many times in the history of the planet has it ever been higher than now? For that matter, how many times has poverty ever been lower? (Percentage-wise, obviously - it's going to be much higher in absolute terms because there are so many more people around these days.)

Look, I'm not trying to say we're in Wonderland here, but can't you at least agree that it's a tad bit hyperbolic to say that economic problems "have never been so pressing as now?" Are they really worse now than during pre-classical times? The entire medieval period? The Great Depression? What did the average person have in 1933, 1610, 1020, or 1500 BC that he doesn't have today? The only thing I can think of is a lot more open space, and overpopulation isn't a problem that is going to be solved by economists, no matter how innovative they may be.

 

[Ratzinger]

I'm not sure how you can say that academic economics has failed the world when no government on the planet will actually implement their recommended policies. Who knows whether or not they would work?

By the way, don't you think it's a little hyperbolic to say that economic problems have never been as pressing as right now? We're living in what? The second most prosperous decade in the history of the planet? Aside from the 90s, when exactly was the economy any better than now?

Again, the main research work and the stuff that's being taught at graduate programs is completely theoretically, disconneted to the real world and simply not useable for implementation in the real world. The job for a good economist is to come up with good and implementable police advice. Shock therapies, austerity measures while people living on one dollar are not. What you got is students from those silly Ph.d. programs all over the institutions (World bank, IMF, economic advisory boards) but they constantly fail the reality check.

Economic problems not pressing? It's true that world economy is growing, per capita income and wealth in the industrial world is highest in history and Asias economies are growing strongly.
But in absolute numbers there never been so many poor people on this planet.
There are regions that are completely left behind by world markets and where nothing will trickle down. I'm talking about billions of people.
Then you got this ridiculous wealth and income distribution in the world (or as a start in the US), also unprecedent in history. Add the coming stages of globalization and how it will affect also the rich world and then the word pressing seems to me quite appropiate.

 

[Telos]

The work presented in the first post is an extremely simplified version of the Keynesian model for GDP, which John Maynard Keynes used to invent what we now call "macroeconomics." Every student in the US who is taking a macroeconomics course this Fall is learning this right now, so I'm glad you brought it up!

Keynes recommended the opposite of what was common practice during his time. Governments did not go into defecits. At the onset of the depression, the US government cut spending and raised taxes, unknowingly making the depression worse. While trying to solve this problem, Keynes created a model that suggested the government should go into deficit spending. Roosevelt's "New Deal" programs, among other things, were a direct result.

However, that's not actually the model's best recommendation. But I'll get to that in a minute.

Yes, government spending money in its own economy will raise its GDP. But the conclusion reached in the title of this thread "big government is better" is very poorly worded, to say the least. The word "big government" is a loaded term and can mean many things, some of which that have nothing to do with economics.

Okay, gravenewworld, let me show you the version(s) of Keynes' model that I learned in my course, which mentions a couple important things I think you might have forgotten or didn't see as important. It incorporates a couple more variables, namely saving and exports.

$$Y \equiv C + I + G + NX$$

Y = national income = GDP
C = consumption
I = business investment
G = government spending
NX = net exports (imports netted out)

This is known as the expenditure approach of the Keynesean model because, as you might have already noticed, everything on the right side of the identity (consumption, investment, government, exports) are expenditures incurred by various parties (exports are foreign expenditures). The effect of a change any of these variables will have on GDP is clear. Although raising government spending would raise GDP, so would raising investment, consumption, or exports.

Another version is the income approach, where savings comes in.

$$Y \equiv C + S + T$$

S = savings
T = taxes

These two approaches are not incompatible in the Keynesean model, so let's bring them together.

$$C + I + G + NX \equiv C + S + T$$

Consumption cancels out and we're left with the following identity.

$$I + G + NX \equiv S + T$$

Subtract government spending and savings from both sides to illustrate a point.

$$(I + NX) - S \equiv T - G$$

Note that this is no longer an equation for national income (Y), but a relationship between two sets of variables. Economists call them "injections," the variables on the left, and "leakages," the variables on the right.

Okay, gravenewworld, you say big government is good for the economy... but who's going to pay for it? The citizens via taxes (T). Okay, but we need to spend a lot of money (G) in order to help our economy, so taxes are probably not high enough now to cover it. That means...

$$T - G < 0$$

...we go into a budget deficit. So how are we going to finance this deficit?

In order to satisfy the identity in this model, one or some combination of the following must be true about the injections.

1) Business investment (I) must be very small so that firms can instead lend money to the government.
2) Net exports (NX) must be small so that foreigners can lend money to the government.
3) Savings must be very big so that citizens can lend money to government.

Right now the second condition is definitely true for the US. Our trade deficit is gigantic (we are importing far more than we are exporting, so our net exports are negative) and we're borrowing a ton from foreigners. And this has been the rising trend. If it continues the world will have us by the ass.

The best option would have been the third. But Americans don't save. Not as much as they did back during the time of Keynes.

So, gravenewworld, you mentioned a high marginal propensity to consume of 0.9 and how government spending took advantage of it to stimulate the economy. But how is it good for the economy when we spend so much and don't save enough to properly finance the deficit that big government created in the first place?

Don't worry if you don't know. If you could answer that, you would be the next Keynes

 

[Smurf]

Maybe not a concensus, but when has any government implemented the recommended policies of any academic economist at all? Basically, I just can't see how you blame them for not fixing problems when it isn't their job to fix economic problems. That is the job of politicians and individual business owners/investors.

GWP per capita, if you can call it that. How many times in the history of the planet has it ever been higher than now? For that matter, how many times has poverty ever been lower? (Percentage-wise, obviously - it's going to be much higher in absolute terms because there are so many more people around these days.)

Well I've never said that they've failed at anything. I just don't like economists because, like ratzinger said, they're dumbasses that fail reality checks every time. I mean right now in Canada all the economists are going off about how they want to start privatizing roads (i.e. toll roads) because it will 'reduce congestion'. And the politicians are starting to buy it. We're already biting and scratching just to keep public healthcare.

 

[loseyourname]

Economic problems not pressing? It's true that world economy is growing, per capita income and wealth in the industrial world is highest in history and Asias economies are growing strongly.
But in absolute numbers there never been so many poor people on this planet.

I didn't say economic problems weren't pressing, just that it is hyperbolic to say they are more pressing now that at any other time in history. In absolute numbers, we also have far more people doing well than we have ever had. The reason for this, and the reason we have a larger absolute number of poor people, is simply that we have an absolutely greater number of people that at any other time in history. Comparing absolute numbers across eras isn't going to get us very far.

There are regions that are completely left behind by world markets and where nothing will trickle down.

Perhaps, but you have to admit that the regions impacted positively be world markets have greatly expanded over the last hundred years. Since the end of overt imperialism in the early 1900s, the prosperity that was enjoyed by Northwestern Europe and the Northeastern US pretty much exclusively has spread to many other parts of the world. Wouldn't you say economic problems were more pressing then than now?

Then you got this ridiculous wealth and income distribution in the world (or as a start in the US), also unprecedent in history.

I don't really like doing that kind of analysis. If I have double the money today that I had ten years ago, should I be less happy because Warren Buffett has quadrupled his net worth? As long as most are getting richer, is it really that big of a deal if some get richer much faster?

Again, I'm not saying there is no problem here or even that most people are necessarily getting richer (though they are certainly richer than throughout most of history), but it is clear that you are using rhetoric to exaggerate a claim. Concentration of wealth is not unprecedented in history. Between 1500 until the early stages of the 20th century, almost all of the world's wealth was owned exclusively by England, Holland, and France (with Spain and Portugal in at the beginning and the United States in at the end), with the rest of the world outside of Russia and China (which managed to remain autonomous) losing out. Before that wealth was owned almost exclusively by a small noble class and the Church. Before that it was owned exclusively by several large Empires that exacted tribute from the rest of the world.

Add the coming stages of globalization and how it will affect also the rich world and then the word pressing seems to me quite appropiate.

What about the coming of globalization do you see making the economic problems of today even worse tomorrow? Historically speaking, the majority of countries and regions that go through a period of being an exploited, disadvantaged, peripheral zone of the world economy generally grow out of that (although Russia and most of Eastern Europe eventually took a step backwards under the Soviet Union). Even the richest country on the planet was once a colony. The major exceptions seem to be Africa and large parts of Latin America. Are the reasons for these exceptions really economic, though, or are they sociopolitical?

 

[loseyourname]

Keynes recommended the opposite of what was common practice during his time. Governments did not go into defecits. At the onset of the depression, the US government cut spending and raised taxes, unknowingly making the depression worse. While trying to solve this problem, Keynes created a model that suggested the government should go into deficit spending.

It's interesting that Keynes gets credit for this when Alexander Hamilton had advocated deficit spending 150 years earlier.

 

[loseyourname]

Well I've never said that they've failed at anything. I just don't like economists because, like ratzinger said, they're dumbasses that fail reality checks every time. I mean right now in Canada all the economists are going off about how they want to start privatizing roads (i.e. toll roads) because it will 'reduce congestion'. And the politicians are starting to buy it. We're already biting and scratching just to keep public healthcare.

Privatizing certain roads worked very well to alleviate congestion in many parts of Southern California. It's also because of tolls that the entire highway and bridge system of New York City is as well maintained as it is. What exactly is so bad about this proposal?

 

[Ratzinger]

I didn't say economic problems weren't pressing, just that it is hyperbolic to say they are more pressing now that at any other time in history. In absolute numbers, we also have far more people doing well than we have ever had. The reason for this, and the reason we have a larger absolute number of poor people, is simply that we have an absolutely greater number of people that at any other time in history. Comparing absolute numbers across eras isn't going to get us very far.

I have to disagree, absolute numbers do matter. One billion extremely poor people (fighting for survival every day) in 2005 is worse than 300 million poor and extremely poor people in 1500. The fact that there are 2.5 billions living in the middle-income world and one billion in the high-income world today, does not help the extreme poor and the poor (living above mere subsistence, another 1.5 billions) of our ages.
The astonishing economic growth of the last 200 years can not hide the fact that never on this planet surface have so many people suffered from poverty than today.

Perhaps, but you have to admit that the regions impacted positively be world markets have greatly expanded over the last hundred years. Since the end of overt imperialism in the early 1900s, the prosperity that was enjoyed by Northwestern Europe and the Northeastern US pretty much exclusively has spread to many other parts of the world. Wouldn't you say economic problems were more pressing then than now?

Agree.

I don't really like doing that kind of analysis. If I have double the money today that I had ten years ago, should I be less happy because Warren Buffett has quadrupled his net worth? As long as most are getting richer, is it really that big of a deal if some get richer much faster?

If most are getting richer, I wouldn't be concerned. But is it so? Well, I'm not talking about you and Warren Buffett.

Again, I'm not saying there is no problem here or even that most people are necessarily getting richer (though they are certainly richer than throughout most of history), but it is clear that you are using rhetoric to exaggerate a claim. Concentration of wealth is not unprecedented in history. Between 1500 until the early stages of the 20th century, almost all of the world's wealth was owned exclusively by England, Holland, and France (with Spain and Portugal in at the beginning and the United States in at the end), with the rest of the world outside of Russia and China (which managed to remain autonomous) losing out. Before that wealth was owned almost exclusively by a small noble class and the Church. Before that it was owned exclusively by several large Empires that exacted tribute from the rest of the world.?

You might be right here. But reading the Forbes list and the UN poverty report can be a disturbing experience.

What about the coming of globalization do you see making the economic problems of today even worse tomorrow? Historically speaking, the majority of countries and regions that go through a period of being an exploited, disadvantaged, peripheral zone of the world economy generally grow out of that (although Russia and most of Eastern Europe eventually took a step backwards under the Soviet Union). Even the richest country on the planet was once a colony. The major exceptions seem to be Africa and large parts of Latin America. Are the reasons for these exceptions really economic, though, or are they sociopolitical?

What I mean here is when China and India keeps picking up (which is of course a good thing) than there will be a lot more painful transformations in the rich world than already seen.

 

[loseyourname]

I have to disagree, absolute numbers do matter. One billion extremely poor people (fighting for survival every day) in 2005 is worse than 300 million poor and extremely poor people in 1500. The fact that there are 2.5 billions living in the middle-income world and one billion in the high-income world today, does not help the extreme poor and the poor (living above mere subsistence, another 1.5 billions) of our ages.

Fair enough, but it just doesn't make sense to me. If we go by a purely absolute standard, then a world of 500,000 where 90% live in poverty is better than a world of 5,000,000 where 10% live in poverty. You could almost advocate complete eradication of the human race as a solution, as there would then be zero poverty.

 

[gravenewworld]

"Yes, government spending money in its own economy will raise its GDP. But the conclusion reached in the title of this thread "big government is better" is very poorly worded, to say the least. The word "big government" is a loaded term and can mean many things, some of which that have nothing to do with economics."

True, but I have to make the title of the thread somewhat provocative/interesting to get people interested in reading it.


"Okay, gravenewworld, let me show you the version(s) of Keynes' model that I learned in my course, which mentions a couple important things I think you might have forgotten or didn't see as important. It incorporates a couple more variables, namely saving and exports."


No I didn't forget them. Net exports are a function of income Y, foreign income Y*, and exchange rate r*. I chose to use a closed economy model because it is simply easier. Totally differentiating wrt to those variables only increases the complexity of the problem. On top of that if you include net exports your IS LM model must incorporate World Interest rates. Simply throwing in the XM term adds a lot more challenge when trying to analyze your model. I also didn't forget savings. The IS/LM model takes into account investment and savings for the economy. Remember equilibrium is reached when national desired savings=national desired investment.

"The effect of a change any of these variables will have on GDP is clear. Although raising government spending would raise GDP, so would raising investment, consumption, or exports."

True, but the government can't effect these variables directly.


"Okay, gravenewworld, you say big government is good for the economy... but who's going to pay for it? The citizens via taxes (T). Okay, but we need to spend a lot of money (G) in order to help our economy, so taxes are probably not high enough now to cover it. That means...

$$T - G < 0$$


...we go into a budget deficit. So how are we going to finance this deficit?
"


Thats the point, running up deficit in hopes of future returns. Remember when the government spends, the effect this can have on income in the future is multiplied by several factors. As income rises government tax receipts will increase. However, I will be the first to say that running up extremely large deficits is also bad (for reasons I will not discuss here). Well coordinated Fiscal AND monetary policy is the key. Trying to keep a balanced budget during a recession only prolongs it and makes it worse.

 

[selfAdjoint]

Thats the point, running up deficit in hopes of future returns. Remember when the government spends, the effect this can have on income in the future is multiplied by several factors. As income rises government tax receipts will increase. However, I will be the first to say that running up extremely large deficits is also bad (for reasons I will not discuss here). Well coordinated Fiscal AND monetary policy is the key. Trying to keep a balanced budget during a recession only prolongs it and makes it worse.

I would say the major premise here is silly, except for recent history. Everything was copacetic and we grew like crazy UNTIL we balanced the budget, up till then we had been growing on the huge debt from the Reagan administration. As soon as we balanced the budget evrything went to hell, the dot com bubble burst (and who's to say what forces poked the needle into it), and Dubya was elected and all. Keynesian debt forever!

 

[gravenewworld]

When Keynes was asked how a government should respond to the problems arising from large govt deficits in the long run he responded "Who cares I'll be dead."