Toward a New Macro Economic Theory

by: Kimball Corson

It is well know that Keynesianism deals with flow variables, looking to current income or GDP, current consumption, current savings and current investment. Income and interest rates are largely the adjusting variables. The presumption is that we want to maximize consumption subject to various restraints because that maximizes utility. Stock variables like wealth and total debt are out of the loop and are not really considered.

That is why Keynesian economists are so willing to run big current deficits to stimulate the economy and hopefully increase GDP and consumption, even though it means incurring more public debt, and why they do not worry about the consequences of that debt. Keynesians, of course, have their critics, me included, but our criticisms have obviously been less than effective.

Ironically, Keynes had the answer there too. He said it takes an idea to beat an idea. So in this post, I want to step beyond my criticism of Keynesianism that it is too much focused on flow variables and maximizing consumption and say in outline form what I really think is going on and how we can integrate the flow variables analysis approach of Keynesianism and the stock variables analysis that is largely missing.

Unfortunately, I am in no position just now to do that in more detail than what I have written here, but I do not, at the same time, want to sit on these ideas. Here what I have so far.

Let us alter our perspective and take a different view. Consider this as a step toward changing our thinking. We might look at the world most simply this way. Human behavior is not so much interested in maximizing or minimizing current flow variables such as income, savings and borrowings during the current period, for example, as it is in maximizing the stock variable of personal wealth, subject to a current consumption restraint, and minimizing the stock variable of total debt and other liabilities, subject to maximizing total wealth.

In short, the real focus is not so much on the income statement as it is on the balance sheet. The income statement is only relevant in so far as it affects the balance sheet. It is the tail, not the dog and as its tail, it should not be allowed to wag the dog, as Keynesians believe it should.

The problem then becomes that other economic factors then enter into the analysis, over and above the obvious flow variables, to impact those stock variables. These factors include all those which impact asset valuations, appreciation and depreciation and therefore wealth, as well, of course, as interest rates, transaction costs and all the other variables which in turn affect those variables and impact asset prices, wealth and total liabilities.

Consumption and GDP are no longer subject to being maximized, but instead are relegated to supporting roles, literally. This perspective integrates flow variable analysis and stock variable analysis and is a much more useful and powerful causal perspective on human economic behavior than that afforded by current economic flow models and the thinking that assume utility, current consumption and GDP maximazation are the proper goals. They are not; wealth is. This theory can be modeled just as Keynesian macro economics is modeled. We need to get to it.

The theory outlined has serious implications, too. Anything that increases total wealth, both personal and of the nation, is desired and anything that increases total debt or unfunded obligations raises problems. If that is the case, then consider these facts. The U.S. is seriously awash in debt. All debt in the U.S., both public and private and including unfunded liabilities of the government trust funds such as Social Security, now comes to a humongous $57 trillion dollars and we do not owe it all to ourselves. Much is owed to foreign nations and individuals.

This is all debt of every kind generated in the U.S., public and private. This $57 trillion dollar figure amounts to $185,041 per person in the U.S. or $740,164 for a family of four. Just the federal government debt alone is $12 trillion dollars or $38,956 per person or $154,624 for a family of four in the U.S.

These are staggering figures, especially when you think about paying them back and the fact that our GDP (Gross Domestic Product) was only $14.4 Trillion at the end of 2008.

Although households do not have to directly make payments of principal or interest on the governmental and corporate portions of this debt, they know that they or their children are ultimately responsible and it affects their taxes or further indirect debt obligations. The real culprit here, of course, is the federal government which cannot stop growing and spending money it does not have.

The problem, in significant part is made worse by Keynesians who focus on GDP and consumption and have an insatiable desire to prime the aggregate demand pump, but ignore the longer term stock variables.

Thomas Jefferson was likely closer to the mark than he realized when he said, “ . . .public debt [i]]s the greatest of the dangers to be feared." Too, Adam Smith’s great book was not entitled, The Income of Nations.

As we can see, efforts to maximize personal income or GDP and its partial mirror consumption are flow aggregations that can badly miss the mark as a model of human behavior when, for example, asset prices such as that for housing are dropping or stock and bond prices are changing for various reasons. All the factors, including the intangibles and expectations, that affect asset values then come to have a direct bearing on household wealth, impact the desire to maximize it and consequentially affect human economic behavior much more.

The focus on the obvious flow variables is wrong. That is why Keynesians got caught by surprise during the last financial crisis and, indeed, by this recession. Krugman is off base in his assessment of why economists were so blindsided. It is not that we need more behaviorialsim in Keynesian macro models, as it is that we need a new macro theory that focuses on the relevant stock variables which Keynesianism does not. The financial crisis and the recession were a lot to not see coming. Smarter heads on Wall Street were much more prescient.

In short, economic developments which affect or which threaten to affect the principle stock variables adversely or beneficially are what really govern human economic behavior, with current consumption as a constraint, much more so than the obvious current flow variables on which Keynesians doggedly focus.

Positions: no disclosures