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Mistaken identity

May 23rd, 2005

Brad DeLong coins a useful phrase. Referring to Bernanke’s global savings glut theory. He says

I’m very skeptical. It is of a brand of macro that I think of as one-identity-economics. You take an accounting identity. You assume that certain terms of it are fixed. And you then derive conclusions–in this case, that the growth of the budget deficit has moderated the fall in private savings.

The problem with one-identity-economics lies with the assumption that certain terms in it are fixed. There are lots of channels of adjustment in the world economy, and it is a safe bet that with different levels of interest rates and different levels of wealth we would see different levels of corporate investment and of net exports.

Some other examples of one-identity-economics are the crowding out hypothesis and the twin deficits hypothesis.

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  1. derrida derider
    May 24th, 2005 at 10:42 | #1

    Yes, it is a useful term. But its important to note that one-identity economics is not always and everywhere a mistaken phenomenon (to paraphrase someone who built a worldview from one identity). It is simply *might* be wrong because the fixed terms *might* not be fixed in practice. So it’s a useful approach to generating testable hypotheses – ceteris paribus thinking in an extreme form.

  2. Dave Ricardo
    May 24th, 2005 at 11:23 | #2

    Correct me if I am wrong, but it seems that this version of one identity economics says that budget deficits have no effect on the current account, whereas our own home grown version, the twins deficits hypothesis, says that budget deficits increase the current account deficit, dollar for dollar.

    This is obviously contradictory. But both versions, it would appear, involve chains of reasoning that follow from accounting definitions (which must be right) and assumptions about things that are held to be fixed (which might or might not be right).

    All this seems to owe more to politically inspired justification for whatever budgetary policies happen to be in place than any objective analysis of how economies actually function.

  3. jquiggin
    May 24th, 2005 at 11:31 | #3

    Dave this is about right. Bernanke’s version is much the same as the full crowding out hypothesis.

    What’s interesting is that people who instinctively like crowding out also tend to like twin deficits even though they are directly contradictory. Of course, the opposite is also true to some extent.

  4. James Farrell
    May 24th, 2005 at 12:53 | #4

    1. Why is it ‘one-identity economics’ rather than just ‘identity economics’. The essence of the approach is that it relies on identities, not that it relies on only one. (I’m also still waiting for someone to tell me why using money circumvents the need for a ‘double coincidence of wants’, rather than just a ‘coincidence of wants’).

    2. There can be no such thing as a global savings glut. This concept is absurd. The global economy is a closed economy, and in a closed economy savings are determined by investment. The economy’s capacity to generate saving puts an upper limit on investment, but there is no way an increase in saving can cause an increase in investment. Anyone who denies this simply does not understand macroeconomics.

    3. There is far too much unnecessary confusion about twin deficits. Discretionary fiscal measures that worsen the fiscal balance will also worsen the current account. Likewise an exogenous increase in exports will improve both balances. On the other hand, exogenous increases in domestic investment or consumption will imporove the fiscal balance but worsen the trade balance. These effects will be closer to dollar-for dollar as the economy is closer to full employment.

    4. John: Did you ever find out the origin of the term crowding out? I couldn’t find it in any pre-war writing at all, nor in any of Alvin Hansen’s four post-war books on fiscal and monetary policy. Nor in 1960s macro textbooks. In the journals there are a couple of good surveys from the 80s of the theory, but they don’t discuss the origin of the term itself. Is it possible it appeared as late as the 70s?

  5. May 24th, 2005 at 14:21 | #5

    JQ, the linked article about crowding out etc. is fairer than what you’ve just put. As hypotheses they do precisely what DD said – offer up something to test, without falling into the logical error you describe here (but not at the linked article).

    As for people believing “directly contradictory” stuff, it’s far more likely that you are caricaturing pessimists who have narrowed down the pessimistic options to two. I’m one of them, but that doesn’t mean I believe both simultaneously. If anything it means that I hold the Keynesian variant in as much suspicion as the Ricardian, and I reserve judgment as to whether there is any sloshing about between one or another pessimistic option.

    One thought experiment I sometimes do is, what would happen with a silver standard, given the industrial production of silver in the economy? It comes out as a direct product and as a by-product, which damps out some responses, so to speak. This thought experiment is only an aid to creativity and a comparative, not a practical plan I hasten to add.

  6. May 24th, 2005 at 15:08 | #6

    James Farrell Says: May 24th, 2005 at 12:53 pm

    There can be no such thing as a global savings glut. The global economy is a closed economy, and in a closed economy savings are determined by investment.

    This is tautologically true, but maybe functionally false. The problem lies in the gremlins that lurk in the innocent phrase “closed economy”. Isnt the dysfunction of liqudity trap correspond to a savings glut? That is, there maay be a level of savings – at a given rate of interest and profit – that cannot be usefully consumed or profitably invested. So the funds are (“hoarded”) under the bed, or perhaps futiley recycled (“gambled”) in trading frenzies.

    In short, financial agents (whether as households or intermediaries) can go feral or postal.These uneconomic uses are, at least as a theoretical possiblity, potential chinks in the global “closed economy”.

    Certainly no one denies that a local savings glut is a real empirical plausibiity. This is the problem, I take it, with the NE Asian economies. They cannot find, or allow, sufficient local investement opportunities or consumption indulgements, to expend their savings stock.

    Of course, the US is a “channel” (in De Long’s terms) for a global equlibrium, since the US consumer has no trouble in spending like there’s no tomorrow. And US equity and property “investors” will always find a use for loose funds, “greater fools” and “their money will soon be parted”, etc

    The $64 question is whether the US can continue in its role as global equlibirator of the closed economy. If so, then the market is dealing with the adjustment b/w local and global disparities in its orderly way. If not then we will face the mother of all global structural disequilibriums shortly – with Central Banks pushing for all their worth on a string that resolutely refuses to budge.

    The economy’s capacity to generate saving puts an upper limit on investment,

    That is necessarily true, since todays longer term investment expenditure necessarily entails a deferral of todays shorter term consumption expenditure. One (“closed economy”) cannot spend on current goods, as consumer, savings one has plunged, as an investor, into capital goods. And one cannot invest more than one saves.

    Of course savings gluts imply that one can invest less today than what one saves today. This seems to imply that a global savings glut is a theoretical possibility.

    but there is no way an increase in saving can cause an increase in investment.

    An increase in investment necessarily implies an increase in savings. But an increase in savings does not necessarily imply an increase in investment. So we have the finally stumbled on the legendary mthical beast of logicians – the one-way identity!

  7. Chris C
    May 24th, 2005 at 16:23 | #7

    2. There can be no such thing as a global savings glut. This concept is absurd. The global economy is a closed economy, and in a closed economy savings are determined by investment. The economy’s capacity to generate saving puts an upper limit on investment, but there is no way an increase in saving can cause an increase in investment. Anyone who denies this simply does not understand macroeconomics.

    I presume you mean in the long run? In the short run, given that savings and investment decisions are made completely independently of one another, we would expect that there would be mismatches in the two aggregates, surely?

  8. Chris C
    May 24th, 2005 at 16:35 | #8

    John, I was very intrigued to read this:

    What’s interesting is that people who instinctively like crowding out also tend to like twin deficits even though they are directly contradictory. Of course, the opposite is also true to some extent.

    It would appear to me that of the two components of national income that are supposed to have to ‘yield’ to an increase in Govt spending (assuming full employment), it would really depend on what the increase in G is comprised of. Probably the greater the proportion of increased G spent on import-substitutable goods, the greater the yielding of NX vis a vis Investment??

  9. James Farrell
    May 24th, 2005 at 21:27 | #9

    Jack

    The liquidity trap has nothing to do with savings. And how can it be a tautology to say that X determines Y. I don’t get your point.

    On the other hand, this statement is a non-sequitur:

    ‘Of course savings gluts imply that one can invest less today than what one saves today. This seems to imply that a global savings glut is a theoretical possibility.’

    On the contrary, if a saving glut means investing less than one saves (which is impossible in the aggregate) a global savings glut is therefore not a possibility.

    Chris

    In answer to your question to me: no, realised (ex post) saving cannot exceeed investment. The world as a whole cannot save without accumulating capital or inventories.

    I’ll take the liberty of answering your second question as though, though John may answer it differently. If the increase in G is all spent on tradables, net exports will fall accordingly as you imply. If it’s (all, let’s say) spent on nontradables then it depends whether the economy is at full employment. If not, as John says, GDP can rise to match additional demand (which will include some induced consumption). If we are at full employment, there will be inflation. This will cause the central bank to raise the interest rate, but it will also appreciate the real exchange rate. These mechanisms will reduce investment and net exports respectively, but in what proportions they do so depends on: the interest sensitivity of investment, the reaction of foreign currency traders to the interest rise, the price elacticity of imports, and the downward flexibility of real wages.

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