Sunday, August 14, 2011

The Parable of the Mill: Introduction

Macroeconomics is counterintuitive for many people, or simply puzzling.  An economic depression, for example, presents a classic conundrum.
  • Factories are idle and workers are unemployed.
  • Factory owners won't hire people because they don't think they'll be able to sell enough product to make it worth paying wages.
  • The owners' fears are probably justified, because a lot of people are unemployed, and even the folks who still have jobs are more nervous than usual and less inclined to spend.
  • A couple years earlier, owners were hiring, and workers were spending, and everything looked great.
And if you've thought about macroeconomics at all, you can probably think of your own puzzle to add to my example above.

This situation isn't surprising.  We experience the economy as individuals, but the economy itself needs to be understood as a system.  We're used to thinking about the economy in terms of money, when what ultimately matters is the physical reality of what gets made, what gets done, by whom and for whom.

Sometimes economic models are framed essentially in barter terms: I'll give you this, you give me that.  This is helpful in taking the focus off of money and putting it on the physical reality, but it has its own pitfalls.  When we think of barter, we tend to imagine swapping two things that already exist.  But what makes economics interesting--and tricky--is that the system you're studying is constantly changing, and some of the most important exchanges we make are when we swap goods and services now for promises of what we think will be available in the future.  That is, some of our exchanges take the form of credit.  And just to add a layer of subtlety, the use of credit helps shape the very future about which we're making promises.

To understand it, we'd like to have a model that is:
  • A system of multiple, interacting parts, rather than a single actor;
  • Simple enough to get our heads around;
  • Grounded in physical reality;
  • Able to incorporate money, but also understandable without it;
  • Able to incorporate credit, with or without money.
If you want a fuller background for these criteria, continue reading below the jump.  If this brief explanation satisfies you, at least for now, go right ahead and enter Mill Village.

Because we experience the economy as individuals, we try to understand the economy as a whole by thinking about something familiar: our own households.  We think about our income, our expenditure, our decisions to save or borrow, and we extend those ideas to the government, and to the economy as a whole.

It's true that we need some sort of simplification of we're going to make any sense of something as complex as the economy.  But in this case we've chosen a simplification that leads us astray in a fundamental way.  Think about the relationship between income and expenditure.  Your household's income isn't fixed: You might get a raise, or lose your job.  You might leave the workforce to raise a kid, then come back several years later.  And these changes in income will affect your spending--if you don't cut back when you lose your job, you're headed for bankruptcy.  In contrast, a household's spending has no effect on its income.  If you  buy a big house or a small one, eat fancy or plain, vacation in Hawaii or the Catskills, your income is unchanged.  (OK, if your work depends on signs of status, you can lower your income by seeming "cheap," but that's not most peole's situation.) 

When you look at the whole economy, one person's expenditure is another's income.  So when you spend less, someone else earns less.  So we need a model that captures this kind of interaction.

The vision of reciprocal income raises a giddy prospect.  If my spending is your income, and your spending is my income, why don't we just agree to keep spending more and more, and watch our incomes ascend to the heavens, world without end?  This is where physical reality needs to reassert itself.

We're used to thinking of the economy in terms of money:
  • The U.S. GDP in 2010 was $14.5 trillion.1
  • In that same year, the country spent $1.6 trillion on investment.2
  • In 2009, the median household income in the U.S. was $50,000.3

But beneath those dollar amounts, there are physical realities.  The GDP is a measure of what our economy produces, from material objects like food, steel, and cars, to seemingly weightless services, which could be anything from a haircut to a college lecture to a doctor's appointment.  It's obvious that activities such as farming and manufacturing are physical processes, but economic services also involve the physical world.  At a bare minimum, the people performing the service need to eat, and in reality will consume a great many other physical goods.  The place where they work needs to be built, lit, and heated.  Their work depends on physical tools, from the haircutter's simple scissors to a complex piece of medical equipment.  And a service such as a restaurant obviously can't function without the food that it brings to your table.

Money matters deeply, and not just becuase it's the way we count the economy and keep track of it.  The way we use money and the way we create it shapes the functioning of the physical economy described above.  But our tendency to think about the economy primarily in money terms has two dangers.  The first is that, while we count in money, the pursuit of money is actually the pursuit of the real goods and services that money can buy: the house we live in, the food we eat, the medical care we receive, ...  For the second, we have to remember that, while money shapes the physical economy, it can't override the laws of physics.  In aggregate, we can't buy more than the economy is capable of producing.

The implication is that it would be useful to have a way of understanding the economy without necessarily using money.  That way we avoid the intellectual pitfalls that come with thinking in money terms, and when we do finally bring money into the system, we can see more clearly the role it plays.  So we want a model that doesn't have to include money.

We can now extend our criteria.  We need a model that is a system, not just a single element.  We need it to be simple enough to get our heads around.  We need to build it on the physical reality of income: the ability to obtain real goods and services.  And we want to be able to understand it without bringing in money.
On the other hand, we do want it to include credit.  This may seem strange, since we're so used to thinking of credit as the lending and borrowing of money: you lend me $100,000, I buy a house, I pay you $9,000 a year for 15 years, and we're quits.

But credit, like the physical economy, can exist without money, for credit is at its core an agreement that I'll help you now, and you'll help me later.

The importance of including credit may not be obvious, but it can be seen by thinking about how economies are like ecosystems and how they are different.  Both types of systems involve exchanges, and many of these involve a good that is useful now being swapped for a different good that is also useful now.
  • I give you grain, you give me milk.
  • I, the bean plant, make sugar in my leaves and send it to my roots, where you get to have some of it, and you, the bacterium, grab nitrogen from the air, convert it to a form I can use, and send it into my roots.
There are also exchanges where something that is useful now is swapped for something that will be useful later.
  • You give me wood and food now, and I'll give you an addition to your house later.
  • You, the plant, give me a sugary treat now, and I, the bird, plant your next generation, complete with starter fertilizer.
In terms of physical reality, exchange in an ecosystem is fundamentally analogous to exchange in an economy, whether the exchange is now-for-now or now-for-later.  The difference is in how the exchange is organized.

In an ecosystem, exchange is genetically controlled.  Most likely, animals and plants are not negotiating, weighing their options, and then deciding, "Yes, I'll do that for you if you'll do this for me."  They're following instinctive behavior that works, and the proof of its functionality is that it worked well enough for the ancestors that the current players are actually here.

In an economy, the parties to an exchange are people, and our interactions are only partly genetic.  Our exchanges can be governed by custom: I'm sharing with you the animal I killed today, and we both expect that if you kill an animal next week, you'll share it with me.  But they can also be governed by explicit agreements.

A "customary" society is slow to change, because customs tend to evolve only slowly.  In contrast, an explicit agreement can take any shape that you and I agree upon.  Any future that we can envision, we're free to act upon, and we're likely to act, if we believe our vision strongly enough.  The resulting change is what makes macroeconomics really interesting.

If an economy were always the same, there wouldn't be that much to study.  I give you grain, you give me milk, we both give her food so she'll repair our fences.  Next year we do the same thing, and the year after that, and ...  But what if in ten years we have new ways of growing grain, getting milk, fixing fences?  Or entirely new goods to exchange?  That means our economy doesn't look quite the way it did ten years ago, and the nature and cause of those changes is something to study.  And it's not only the changed end-points that are of interest, but the path from there to here.

Biologists say that, without the theory of evolution, their field doesn't make sense.  You could make a similar claim for credit, since in a modern economy credit is the tool that governs change and determines how the path of change affects us.

Now we've got our full list of criteria from before the jump.  Follow me into Mill Village and let's see what we find there.

1: Data are from Bureau of Economic Analysis, National Income and Product Accounts, Table 1.1.5, Gross Domestic Product, available at

2: Same data source as above, using "Fixed investment."

3: U.S. Census Bureau, State & County Quick Facts,


  1. I missed the part about the dancing hippos. I have heard economics described as trying to make sense of the movement of pigs in a pen, where you don't get to watch the pigs directly. All you can see are the tops of sticks attached the pigs' backs. Is it like that?

  2. I can think of a few more ways that spending affects income at the household level, beyond wearing nice clothes. If I don't spend enough on food, my ability to work and bring in income is compromised. If I spend some money on training or education, my ability to bring in income is enhanced, assuming I study something useful.