Analyzing the economies without using economics

   Since I am an economics teacher, I am particularly concerned with the use of economics by its learners. Honestly, in the early stage of my teaching career, I didn't care about this at all. At that time, I had a strong belief that economics had something good in itself (such as its logic rigor as an analysis for the society). Even if its learners didn't appreciate, it was only a loss to the learners. We didn't need to care about this. 

   But now I have taught economics for years, and perhaps may retire in a foreseeable (though unknown) future. I have changed my attitude. Now, I do care about what my students have learned from me. Of course, there are good students who can learn very well for everything I taught them. Some are very keen to learn. However, I am not sure how many of them are so keen because of exams. If they don't need the exam results, will they still be so keen, or will they still be interested in economics? The answers to these questions are positive to me, but I am not sure if they are positive to most economics learners. As an aging teacher, I start to care about this. Towards a stage for me to review my career life, I am no longer indifferent to what I may contribute to this career.

   I know obviously that people may be interested in economics as there is a great demand for analyzing the economies. No matter you work in banking and finance sector, or in a company whose performance will be affected by business cycles, or you may simply need to do personal investment, you must not ignore what happen to the economies and need to formulate a perspective about it.  So, economics is useful. What I taught is useful!

   But is it? These years, I start to take note of the "economic" analyses that are circulated in media or among those who spoke publicly. Are they really using economics to do their "economic" analyses? Unfortunately, I found many were not. Some people did actually offer analyses for the economies but the concepts or even "theories" used are not from economics. Most of them blend some economics with some common sense that lacks economics foundations. Some basically use an economics terminology but distort the original meaning of the terms to suit for their own analyses. Unfortunately, I may not find too much evidence that economics is useful, from a common person's viewpoint. 

   But are these common-sense-based "economic" analyses good enough? Before making any judgments, let me share with you such an analysis first. 

   Recently, I have encountered a feature story, broadcasted by a news channel, about Japan economy. It is well known that Japan's economy has not been performing well since 1990s. The news feature interviewed a Japanese economic analyst, who gave an explanation for this weak performance. The key point, he said, was persistent deflations, which happened since 1990s and lasted for more than 20 years. 

   Well, deflation, or declining general price level, is a rather standard explanation for the weak economy in Japan. This is not controversial. But why deflation makes an economy bad? The analyst above went on: If prices kept falling, people would wait and see before they decided to buy goods. They would worry that prices might fall again. If they bought too early, they might miss the chance of buying at an even lower price. But this damaged the demand for goods and the economy. 

   It must be admitted that this analysis is easy to understand and may even be persuasive. But is it an analysis using economics? Which part of the economics? 

   In fact, the analysis given by the person mentioned above is more a common sense than economics. It doesn't mean that it makes no economic sense. It makes sense indeed. But it is not economics. 

   If so, what economics can be applied in analyzing the case of Japan? Is the analysis using economics better? Why do we need to use economics, not just common sense?

   Well, the economics concept involved is real interest rate. What matters to an economy is the real interest rate, which is approximately the nominal interest rate minus inflation rate (more exactly, the expected inflation rate). 

   As mentioned in a past post, in economics, what matters to an economy is the real variables, not the money nor nominal variables. How many goods (real values) we can use really matters to our living standard. How much money (nominal values) does not. We may have a  lot of money. But if the money can buy only few goods (as prices are higher), we are still not well off. 

   Now, real interest rate matters because it is the real variable that affects investments. Investment is essentially a delay of current consumption for a return (more consumption) in future. If someone lends funds to someone else for investment, the funds can't be used for her present consumption. The lenders delay today's consumption, enabling someone else to invest. Meanwhile, when someone borrows funds for investment, the borrower doesn't need to delay present consumption. But he must pay back the principal plus interests. His future consumption will be reduced by the interest payments. He has to pay back for not delaying his own consumption today. The motivation to invest is reduced if more is required to pay back. 

   But what is more to pay back? Is it about more money to pay back? Suppose borrowing $100 today must pay back $108 after a year. So, the nominal interest rate is 8%. It looks high. But suppose that inflation rate is 10% for the year. The borrower of $100 doesn't need to sacrifice present consumption worth $100, or 100 units of goods (assuming price is $1), today. After a year, he has to pay back $108 and sacrifice the future consumption worth $108. But since price has already risen to $1.1 (inflation rate of 10%), he sacrifices only 98 units (=108/1.1) of goods. The deal involves trade 98 units of goods next year for 100 units of goods today. It is indeed a very good deal for him. He will be happy to invest by borrowing. 

   Then, consider another case. Borrowing $100 today must pay back $102 next year. The nominal interest rate is only 2%. It looks low. But the inflation rate is -4%, or deflation rate at 4%. So, the deal is to keep a consumption of 100 units of goods for today but reduce future consumption by 106.25 units (=102/0.96). Many people would not find reducing 6.25% of goods a good deal. So, he may not invest even though the nominal interest rate is 2%. 

   Now, you can see why the real interest rate is nominal interest rate minus (expected) inflation rate. Nominal interest rate measures only how much more money one needs to pay back in future by avoiding sacrifice today. But what matters is not money. It is the real that matters. If inflation rate is high, the money to be paid back in future can be used to buy much fewer goods. So, this effectively reduces the sacrifice in future, or the burden of paying back. In contrast, if inflation rate is low, or even negative, the burden is high. Thus, inflation is something to be substracted from the nominal rate for calculating the real rate. 

   Back to the Japan economy, yes, deflation constitutes to be a problem because it implies a high real interest rate. When inflation rate is low, or even negative, real interest rate is high, at given nominal rate. Investors will find it not worthwhile to invest when investing requires them to sacrifice more future consumption, given deflation. Of course, this motivation looks quite similar to the common sense explanation that people won't buy when buying later is cheaper. But the key point is not only about the delay of buying (capital) goods today, i.e. investment. It is also about the difficulty of solving the problem. 

   High real interest rate, but so what? Why can't we simply make it lower? News reports frequently mention interest rate cuts. That seems to be an obvious method to solve the problem due to high rate. 

   But this method can solve the problem of high rate only if inflation rate is positive. It can't when inflation rate is negative. When deflation occurs, the real interest rate could be high even if nominal rate is low. To reduce the real rate, of course, cutting the nominal interest rate may help. But there is a limit for this: when nominal interest rate is already closer to zero, it can't be cut anymore. The lower limit of nominal interest rate is zero. It can't be cut to be negative. 

   What does it mean by a negative nominal interest rate? At positive rate, this means the borrower has to pay back more than what he has borrowed. At negative rate, this means the borrower has to pay less than what he has borrowed. Well, this looks good to the borrower. But don't forget that no one can borrow if no one will lend. So, who will lend at a negative nominal rate? If someone has money more than what she needs to spend at the moment, she may lend. Doing so she expects to get back some more money in future. But if nominal rate is negative, she is required to pay the borrower for borrowing her spare money. So, why should she do this? Why doesn't she hold the money, not lending it out? 

   Thus, it is clear that nominal rate can at most be cut to be close to zero. At a near zero rate, people will already simply hold money, not to lend or hold debt-equivalent assets (bonds) that give only zero (nominal) return. But if nominal rate is not negative, and real interest rate is high, given deflation, investors may not want to invest. That's exactly the problem in Japan. Japan's nominal rate was still positive in early 1990s. But then it was cut down, and since mid-1990s it approached zero, and stayed around zero for more than 20 years. 

   If nominal rate can't be cut down further, what about bringing positive inflation rate back to Japan? How? Again, from economics, we learn that increasing aggregate demand will do. Prices will keep rising if demand for goods keeps increasing. But how could we generate a growing demand? The prices are declining (deflation) exactly because demand was weak at the outset. 

   A conventional thinking in macroeconomics is that if the market is weak, the government may do something to counteract. There are mainly two ways for the government to stimulate an economy. The fiscal policy involves the government spending more, and more. This was indeed done by the Japanese government. But that was not sufficient in stimulating the weak demand. Furthermore, by spending more without taxing much more, the government deficits expanded dramatically since 1990s. Its government must consider the deficit problem when borrow to spend.  

   Another major method is monetary policy. But this policy is even more limited. Why monetary policy can stimulate an economy? Answer: as more money is supplied, given the same demand for money, nominal interest rate will fall, and so will the real rate. This will supposedly stimulate investment. But nominal interest rate was already close to zero in Japan and the rate couldn't be pushed down to be negative. If nominal rate couldn't be pushed down further, how could it stimulate demand so as to generate a positive inflation? So, we are back to the original problem mentioned above.  

   At this point, you can see what an analysis without using economics is about, and what an analysis using economics is about, in the case of Japan economy. The later may be more complicated but it touches more on the key point. The point is not only about deflation, which is bad for the demand, but also why the problem can't be easily disposed. In a way, we all should appreciate that common-sense-based analyses without using economics is useful as it is accessible by the common people so that they can learn something from it. But this doesn't mean that we can substitute non-economics for economics. If there is really something we can learn from Japan's experience, that should be the economics usable in analyzing its problems. Just using common sense, we will miss so many important factors involved. 

Think at the margin, but why? (3)

    I have already written two posts, (1) and (2), on "think at the margin", an important principle in economics. I basically have doubts on the applicability or the usefulness of this principle. I do not doubt that the principle is useful but just suspect how useful it is. In my view, its importance is over-stated. It is not as supremely important as what have been stated in textbooks. 

   I can understand why textbooks authors think that the marginal principle is important. The point is that maximization (of consumer's benefit or firm's profit) is a core problem in economics but the solutions to a maximization problem requires certain marginal conditions to be satisfied (a result perhaps surprising to those lacking the mathematics knowledge). For instance, marginal cost (MC) should equal marginal revenue (MR), and the marginal values (marginal utility over price) of consuming different goods should be equal. 

   But that's exactly where I will have doubts: These mathematical marginal conditions are right but the examples used by economists (to illustrate how marginals are important) can't be straightforwardly applied in these math conditions. Meanwhile, the examples illustrating the importance of marginal analysis are right but it is doubtful that they can illustrate how the math conditions can be used.

   Recently I come across an old textbook, William Baumol's Economic Theory and Operations Analysis (I read the 4th edition, which was published in 1977). Unlike newer textbooks, it devotes much more efforts to explain the marginal analysis (at least one chapter has been written for this). I have learned something from it but I don't think I will change my mind regarding my above comments on the marginal principles. Nonetheless, let me share with you some lessons from it.

   First of all, I got a new example for illustrating why marginal thinking is important from it: 

   "A manager is empowered to hire an additional salesman. He decides to send this man to St. Louis rather than to Cleveland because last year's orders per salesman were $60,000 in St. Louis and $43,000 in Cleveland. But it is possible that the difference in returns per salesman in the two cities occurred just because the size of the sales force in the former was well adapted to the number of retailers whereas the sales force in the latter was spread too thinly. If so, the new salesman may add little, if anything, to the company's orders in the salesman-saturated St. Louis market, but in Cleveland he might produce a substantial increase in sales. Clearly, if the firm's objective is to maximize its orders, it would in this case be better to send the man to Cleveland.

   "The figure giving the size of orders per salesman is referred to as the average return per salesman, whereas the increase in sales which results from the presence of an additional salesman is called the marginal return. The manager in the illustration was (inadvertently) acting contrary to the firm's interests by sending a salesman to the city where the average return per salesman was higher rather than to the area where his marginal return (the amount he could add to company sales) was higher. " (pp.21-22)   

   This example emphasizes the different messages from average values and marginal values. The average values are not a good indicator for what we should do. What we should do is to consider or estimate the marginal values. In a way, this example simply shows what should be obviously true (but easily forgot by decision-makers): what we are going to decide is the new thing (the new salesman's sale); so, we should estimate what the new thing will be (the marginal value); the old value (average value) may not be relevant. How could we have a more obvious principle like this: when deciding for new thing, estimate the value from the new thing? Well, normal people exactly often forget what should be obvious (they use average values for decisions). That's why reminding people to think at the margin is important.

   But perhaps the problem is not that people forget the marginal way of thinking but that in practice it is hard to obtain the data for marginal values. Baumol's book pays particular attention to this difficulty. In Section 7, Chapter 3, Baumol describes the problem (p. 34):

   "1. Almost all accounting information is in the form of average or total rather than marginal figures. Tax computations and a number of other uses of accounting data require that this be so....

   "2. By its very nature, marginal information often represents the answers to hypothetical questions -- information beyond the range of the firm's actual experience. One must ask, for example, what will be the effect on the firm's profits of an increase in expenditure..., whether or not the firm has ever tried it....

   "3. Even where some relevant data are available..., it is much easier to collect the statistics required for average than for marginal figures. A single observation, that the total cost of producing 500 units of some output is $15,000, yields the information that its average cost is $15,000/500 = $30. But it takes at least one more observation, say, that the total cost of 510 units is $15,050, to yield the guess 

that the marginal cost is $5... And, in practice, many more than two observations will usually be required for any sort of reliable guess on marginal magnitudes."

   Baumol's observations above perhaps explain why economists have to emphasize so much about the marginal principle. It is difficult to apply it but still you must. 

    Well, Baumol also gives us some advises. We can approximate marginal values by average values via a well-known rule: If average value is increasing (decreasing) with the units, marginal value must be higher (lower) than the average. So, if you have a set of average data, you can guess the range of the marginal data by this rule. In a normal microeconomics course, this rule has been covered. The logic in it is, however, completely arithmetic: if the new data is higher than the average, the new average after adding the new data must be higher than before. 

   In many aspects I think Baumol's treatment of marginal analysis is careful and good. But still this can't convince me. I still think the examples offered by economists are good for illustrating why marginals are important but these examples are a different matter for the mathematical conditions in an optimization problem. The conditions for validating the examples used by these economists and the optimization problems are rather (if not vastly) different. In fact, a case used by Baumol (Chapter 4) for illustrating the relation between differential calculus and marginal analysis reveals this non-equivalence (though Baumol indeed wants to use the case to illustrate why the two things are closely linked). 

   Baumol considers a case of advertising. The first $1000 on ads can generate extra sales of $40000 but the second $1000 generates no effect while a further $1000 actually reduces sales by $10000. The marginal effect of ads on sales is the change in sales divided by the change in ads. But what should the change in ads be measured? If it is just $1000, then the marginal effect is 40 (=$40000/$1000). If it is $2000, then the marginal effect is 20 [=($40000+$0)/$2000]. If it is $3000, then the effect is 10 [=($40000+$0-$10000)/$3000]. Then, the marginal values could be quite misleading. If we choose $3000 as the unit for measuring the change in ads, the marginal effect is found as 10. It is positive and so it suggests that the money ($3000) should be spent. But actually only $1000 should be spent as spending more generates no extra sales or even negative sales.

   The lesson that we can learn from this case, Baumol thinks, is that the unit of change should be as small as possible, or we may be misled by something like above (an example with large change as a unit). This is the reason why differential calculus is relevant for marginal analysis as it exactly considers the smallest possible change (infinitesimal change). 

   Well, perhaps Baumol is right. Using a smaller unit is less likely to make things wrong. But is this lesson relevant for what is supposed to be illustrated by the case of ads as above? 

   Yes, we should spend $1000 instead of $2000 or $3000. But, if smaller is more appropriate, should we spend $1 first (and spend more if the marginal effect is positive), or $10 first or $100 first? It seems that spending $1 first is more careful than spending $10 first, or $100 first, or $1000 first. But spending $1 first is often not right as it is not practical to spend so small. Furthermore, if we know already that the marginal effect is 40 from $1 to $1000 and beyond $1000 it will drop to be zero, we can simply spend $1000 instead of trying $1, $10 or $100. 

   So, in my view, marginal analysis that opts for small changes is indeed useful. But it is only sometimes useful, not always. Whether it is useful or not depends on the information mastered by the decision-makers. If we know too much, such a marginal analysis is redundant. In the example above, we know so much already. So, we should choose $1000 directly. We don't need to consider whether the marginal effect is positive at $1, $10 or $100.  

   Nevertheless, if we don't know much -- we know that the marginal effect is diminishing with units, we know it will be positive at first but then decline to zero or even negative, but we don't know at what units the effect will become zero and negative, then, in such a case, marginal analysis is truly useful. In such a case, we should try at the margin: take a small step to see if positive marginal effect will be resulted. If so, go on and try more until we meet the zero marginal effect. We don't need to try further as we know the effect is diminishing (once it hits zero, it won't bounce back). 

   So, when we know the pattern of the marginal effect (diminishing or not) but not the exactly values of these effects (non-positive when spent more than $1000), marginal analysis is particularly important. Marginal analysis is truly useful only when we know something but not everything. This is a point that I have already made in my first post in this series (see the example of climbing mountain). I still hold this point. Having read Baumol's insight discussion, I still won't change my mind.