In the wake of the tragic loss of the submersible Titanic explorer in the North Atlantic on June 18th, social media has been filled with engineers offering their analyses of what went wrong with the vessel, and why it failed. An often-heard wisdom is that if the manufacturers and maintenance crews had listened more closely to engineering experts, the disaster could have been avoided.
I have no way of determining whether or not that is true, but as an expert in macroeconomics and economic policy, I sympathize with the engineering experts who believe that their words matter in the context of the disaster. I, too, like to offer my expertise where appropriate: in my case, on economic matters big and small.
One of the reasons for engineers to weigh in on the tragedy in the North Atlantic is, of course, that lives were lost. We would all like to help save lives when possible; when our professional skills and knowledge can be of help to that effect, we have a moral duty to weigh in.
Economists are never really put in situations where our advice can make the difference between life and death. But that is not to say that our expertise is inconsequential to people’s lives; our advice to governments on economic policy can make a big difference by separating social suffering from prosperity. The difference can be bigger than most people realize.
I fear that an economic disaster may be in the making in Europe (and to a lesser but not insignificant degree in America). Yes, disasters can happen to economies, and the consequences can be devastating for individual citizens. One of the best examples in modern times is the implosion of the Greek economy a decade ago. I covered it in an article last year, where I recapitulated how Greece lost one-quarter of its economy. It was like a tornado had ripped through the nation’s economy, tearing apart social welfare programs, dramatically raising taxes, grinding business investments to a halt, and throwing more than half of all young workers out into unemployment.
An experiment can help us understand the magnitude and impact of the Greek disaster. Cut away 25% of everything you earned over the past ten years, then raise the taxes on what is left by ten percentage points (e.g., from 25% to 35%), and compare what is left to what your actual take-home income was over that period of time. Your cost of living remains the same.
The Greek disaster, in which millions of people lost their livelihood and were chained to poverty for the rest of their lives, was totally preventable. It was inflicted upon Greece by arrogant politicians and incompetent economists.
I cannot do anything about political arrogance, but as an economist, I have a responsibility to point out incompetence within the ranks of my own profession. One reason is, of course, professional integrity; the more incompetence some economists exhibit, the more it reflects on those who don’t.
Another greater reason is that by explaining what causes economic disasters such as the Greek one, we can hopefully reduce macroeconomic malpractice among economists who give ill advice to politicians. We might also be able to cut the arrogance that leads politicians to make poorly informed, yet highly consequential decisions.
Today, economic conditions in Europe are moving toward the same critical juncture where politicians set the Greek disaster in motion. No country in Europe can afford to suffer through a similar disaster. As a preventative contribution, I am going to write an article later in the week about what role economists played in the Greek disaster. I will in particular emphasize the role that the International Monetary Fund, IMF, played. To do so effectively, today I will give a ‘crash course’ in economics.
For anyone aspiring to understand economic policy, the most basic concept is ‘gross domestic product’, or GDP. We are going to examine it carefully in the coming article about Greece and the IMF.
The GDP concept is as misunderstood as it is essential to economic analysis. It is an accounting unit for the sum total of all economic activity in a country during a specific period of time, normally a year. The definition of ‘economic activity’ is simple: it includes all legal transactions where one person delivers a good or provides a service to another person, in exchange for payment.
The activities that constitute gross domestic product are measured in three different ways. The first is production, specifically the value that is added to each stage of the product at each step from raw material to final consumer product.
As an example, consider the steps that transform raw materials into batteries for electric vehicles. A ton of cobalt is mined in Africa and sold to a Chinese company for €100 (to use a random number). The value added is equal to the sales price. The cobalt is now purified into an industrial product by a raw materials processing company, which sells it to a factory for electric batteries. Their value added is €100, which is added to the €100 value added by the cobalt mine.
The EV factory then builds a battery for an electric car, which is sold to the EV car company for €400. The EV factory’s added value is €200. The car manufacturer, in turn, adds up the value of all the inputs needed for a vehicle. Suppose its selling price is €1,000. By definition, the value added from all the inputs.
It also happens to be the value of the incomes earned by everyone involved in producing all the components that constitute the electric vehicle. This brings us to the second way to measure GDP. To focus specifically on the value of the EV battery, suppose that the €100 worth of raw materials from the cobalt mine is split evenly between workers and the owners of all the equipment used for mining and transportation. In the next step, the workers get €30 and the owners of the productive capital earn €70. The same split applies to the manufacturer of the EV battery.
In total, the €300 that the EV car manufacturer pays for the battery is split into €110 in labor income and €190 in capital income.
The latter is not to be misunderstood as ‘profit’ or even ‘shareholder earnings’. Capital income is a gross term; the owners of the factories use that money to pay for all inputs needed to run their stage of the production chain.
Last but not least, GDP can also be measured from the spending side. In this case, the person who buys the EV pays a price equal to the value added by all the inputs that go into the vehicle. The spending falls into one of four categories:
- Private consumption—a family buys the car to use as their personal vehicle;
- Business investment—the same family buys the car but uses it in their wedding-cake business; the vehicle is used to deliver the cakes;
- Government spending—the EV is bought by a police department and used as a patrol car;
- Exports—the car is put on a train and shipped to a buyer in another country.
By understanding these intricacies of how to measure GDP, we can gain significant insight into what damage the IMF did to the Greek economy. Our insights are further enhanced by understanding a key term in macroeconomic analysis: the multiplier.
Once we understand the concept of GDP, we can more easily understand how and why it changes over time.
We refer to the changes in GDP as the business cycle, which has growth periods and recessions. In the old days, i.e., circa 60 years ago, economists considered the movements in the business cycle to be regular and highly predictable. A recession, they said, lasted for 12-18 months, while growth periods lasted for approximately two years.
This view was based on observations of macroeconomic activity in developed, industrialized economies primarily in the 1950s. Curiously, business cycles were not very predictable before that decade, and they turned out not to be after the 1950s either. Since the 1970s, we have had 5-7 years of a growing economy with two-year recessions in between. However, the growth periods have gradually become weaker, making it increasingly difficult to predict them, as well as the recessions.
It would be rash to assume that the new pattern, with 5-7-year long growth periods, is going to last. Based on that experience, we are either overdue for a recession, or not due for one, yet it is fairly certain that Europe is entering a recession and America is on the edge of one.
Economic policymakers need to be able to predict the business cycle with a high degree of accuracy. If they don’t, their policy measures can end up being ineffective—or do more harm than good to the economy. This is precisely what happened in Greece: the economists who advised the IMF on what policy demands to impose on the Greek government badly miscalculated the effects of the fiscal policy they suggested.
There are two key terms in the forecasting of what effects economic policy will have. The first term is uncertainty: the higher the rate of uncertainty, the weaker any policy measure will be. It is essential to understand the role of uncertainty in economic activity, but for our purposes here the second term is actually more important. This is the concept of the multiplier.
The discovery of the multiplier is often attributed to John Maynard Keynes, but it was another British economist, Richard F. Kahn, who first established the quantitative relations that form the multiplier (“The Relation of Home Investment to Unemployment”, Economic Journal, June 1931). Keynes contributed significantly to the understanding of the multiplier by putting it in a systemic context (see his eminent book The General Theory of Employment, Interest and Money).
The multiplier is a mechanism that transmits and magnifies the effects of spending in the economy. A long-term increase in consumer spending means more money in the pockets of workers within the industries where the spending increase took place. They, in turn, spread their new earnings throughout the economy, where other workers earn more money, etc.
Each new multiplier round spends a little bit less of every euro, simply because people tend to save part of their earnings. Needless to say, taxes also take a toll on the multiplier effect. Over time, therefore, this chain reaction of increased spending dies out.
Just like a chain reaction, or multiplier effect, can make the economy expand, it can cause the economy to contract. Mechanically, the multiplier works the very same way when it brings the economy into a recession as when it makes the economy grow, but there is one important difference. When people reduce spending, they usually do so because their economic confidence has weakened: their more pessimistic outlook on the next year or two motivates them to reduce spending out of a given income. The decisions to do so have a quicker impact on the economy than decisions to expand spending. We are averse to risk and uncertainty, therefore our reaction time to bad news that causes us to cut spending is shorter than it is to good news that motivates us to spend more money.
The influence of uncertainty on a contracting economy is universally overlooked by economists who make highly quantitative outlooks, i.e., econometric forecasts. As we will see in the next article, this ignorance of the role of uncertainty played a decisive role in how the economists of the International Monetary Fund contributed to the destruction of one-quarter of the Greek economy. There is incalculable value in learning the lesson from their mistakes.
