Ask an Economist #30
It’s been a while since my last “Ask an Economist” article. I try to answer FEE Readers’ questions about economics regularly, so if you have a question, feel free to email me at [email protected].
This week’s question is from Vincente in Paraguay:
From Paraguay, why does the government give so much importance to the macro economy when what is most needed is the micro economy, whether in training, laws or financially?
I thought Vincente’s question was a really fruitful ground to discuss the micro/macro dichotomy, and hopefully along the way we’ll discover some reasons why the government tends to focus on macroeconomic rather than microeconomic concerns.
Microeconomics vs. Macroeconomics
Let’s begin with some definitions of microeconomics and macroeconomics to understand the differences. I’m going to pull from my preferred contemporary undergraduate economics textbook, Economics: Private and Public Choice by James D. Gwartney, Richard L. Stroup, Russell S. Sobel, and David A. Macpherson.
The authors differentiate between microeconomics and macroeconomics in the following way:
Microeconomics focuses on the decision-making of consumers, producers, and resource suppliers operating in a narrowly defined market, such as that for a specific good or resource. Because individual decision-makers are the moving force behind all economic action, the foundations of economics are clearly rooted in a microeconomic view.
As we have seen, however, what is true for a small unit may not be true in the aggregate. Macroeconomics focuses on how the aggregation of individual micro-units affects our analysis. Like microeconomics, it is concerned with incentives, prices, and output. Macroeconomics, however, aggregates markets, lumping together all 128 million households… What factors determine the level of aggregate output, the rate of inflation, the amount of unemployment, and interest rates? These are macroeconomic questions. In short, macroeconomics examines the forest rather than the individual trees.
So, microeconomics tends to focus on the logic of individual decision-making, and macroeconomics focuses on how things operate on a societal level. The forest vs. trees is a good analogy for macroeconomics and microeconomics respectively.
In one sense, I could claim to have already answered Vincente’s question. Macroeconomics is, by definition, about the whole economy. So any time the government tries to improve the economy, it is engaging in macroeconomic policy.
However, this answer is, at best, incomplete. To see why, we need to talk more about the different forms of analysis we see between microeconomic analyses and macroeconomic analyses.
Microeconomics builds up its analyses from observations about how individuals act. People, pursuing diverse ends with scarce means, will always buy something less as the price goes up, all else equal, because as the price goes up purchasing the good in question necessitates giving up more of their alternative ends. From this logic, economists construct the demand curve.
This sort of thinking about how rational people act is what the economist Ludwig von Mises called praxeology or what F. A. Hayek called the pure logic of choice. From logical deduction and introspection, we can learn about how individuals act.
Based on introspection and certain assumptions, microeconomics courses focus on how markets (and sometimes other institutional arrangements) will allocate scarce resources. The tools of supply and demand can be used to explain the world and analyze (often critically) policy proposals.
Macroeconomics has some superficially similar concepts such as aggregate supply and aggregate demand, but in reality, many of these models are not intrinsically connected to microeconomic reasoning. The field of macroeconomics has historically been split into models which are founded on microeconomic principles and models which eschew microfoundations.
For example, in 1971, economist Arthur Burns famously blamed the existence of high unemployment and high inflation (i.e., stagflation) on the fact that “the rules of economics are not working in quite the same way as they used to.” But this wasn’t exactly right. The rules of economics proper did not change; it was Burns’s macroeconomic model which was flawed.
In the 1960s and 1970s, macroeconomists largely accepted the concept of the Phillips Curve—a model which posited that there was an inverse relationship between inflation and unemployment. High inflation was, according to this model, incompatible with unemployment.
The Phillips Curve was not rooted in the logic of microeconomics. Microeconomics logic suggested that while inflation may increase nominal wages and trick the unemployed into taking jobs they otherwise wouldn’t take in the short run, their rational response to this would be to learn and adjust their minimum desired wage. So while there is a short-run trade-off between unanticipated inflation and unemployment, there is no long-run trade-off. The rules of economics worked fine—Burns’s macroeconomic model just didn’t use them.
In fact, many of the macroeconomic missteps over the last few decades follow this exact pattern. A relationship between two macroeconomic variables is proposed. Policymakers manipulate one variable in order to affect the other, and they find that their models did not sufficiently account for the responses of individuals.
The Nobel Prize-winning economist Robert Lucas famously developed the Lucas Critique in response to this issue. The simple version of the Lucas Critique is that oftentimes the macroeconomic models used by policymakers assume that people will not respond to and learn about policies. To quote Lucas:
Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.
In other words, macroeconomic models which fail to account for optimal microeconomic responses of individuals are not a useful picture of the world, given that we live in a world of rational individuals. The Phillips Curve debacle is one example of this playing out.
Another example from fiscal policy is taxation. If the government lowers taxation in an effort to stimulate economic activity, but politicians do not decrease government spending, then there will be higher deficits. A high deficit means that, in the future, people will have to pay higher taxes. As a result, individuals who recognize this realize that their taxes have not been cut; they’ve simply had the burden shifted forward. If it is recognized that there is no real tax cut, the attempt to stimulate based on the illusory tax cut will fail.
In short, macroeconomics untethered from microeconomic foundations is not really economics at all. As Mises wrote:
A consistent macroeconomic approach [as construed by certain authors] would have to shun any reference to prices and to money. The market economy is a social system in which individuals are acting. The valuations of individuals as manifested in the market prices determine the course of all production activities. If one wants to oppose to the reality of the market economy the image of a holistic system, one must abstain from any use of prices.
The Political Draw of Untethered Macroeconomics
There is lots of good macroeconomic work founded on microeconomic principles, but it seems that politicians and bureaucrats can’t help themselves from returning to the use of untethered macroeconomic models. Why? We need to look no further than Thomas Sowell for a succinct answer:
The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.
Macroeconomic models which are divorced from microeconomics are conceptually divorced from the reality that rational people make decisions in a world of scarcity. By buying into models like the Phillips Curve, it appears as though we can get a free lunch for society. In the case of the Phillips Curve, the promise is that we can get people jobs if we just print more money! Wouldn’t that be nice? Alas, the consistent microeconomic reality rears its head.
Vincente’s question can be understood in this light. Why do politicians often focus on these big models dealing with large-scale statistical problems on topics like GDP rather than the detailed microeconomic problems? It’s often because focusing on some historical statistical correlations can provide comforting, though ultimately wrong answers to difficult questions.
On the other hand, if the politicians were to focus on things like training or firm-specific issues, they might often find no silver bullet solutions, or, in some cases, they may find their own policies at the root of the problems.
As Adam Smith once said of government involvement in the economy, “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice.” This doesn’t offer politicians much in terms of promises to special-interest groups ready to write big campaign checks.
Since Adam Smith, the lesson has only been reaffirmed. When you measure what sort of policies make for a healthy macroeconomy, economic freedom consistently rises to the top. But when times are bad, politicians aren’t popular if they say, “We’ll let free people fix things on their own.” Voters seem to prefer “Policy A will fix this problem for you.” As a result, the kinds of policies that hold nations back from prosperity continue to receive broad support.
None of this is to say that macroeconomics is not important to focus on. A sound macroeconomics, tethered to microeconomics, is very important for understanding why economies function well rather than poorly. Money is half of all exchanges, so focusing on big macroeconomic topics like inflation is central if we want to understand the world. But as economist David Prychitko has pointed out, “Economics puts parameters on people’s utopias.”
We must resist the siren call of policy-driven utopia. It’s no coincidence that proposals of this ilk often involve ignoring microeconomics. A solid macroeconomics is one which considers the pure logic of choice in reference to the institutional context of the individuals in society. Only through this focus can we escape the trap of ignoring scarcity in our policy.
