We were all distracted by the stuff about never ending bubbles and whatnot, but Larry Summers in his recent IMF speech had a pretty funny bit where he said:
Now think about the period after the financial crisis. You know, I always like to think of these crises as analogous to a power failure, or analogous to what would happen if all the telephones were shut off for a time. The network would collapse, the connections would go away, and output would of course drop very rapidly. There’d be a set of economists who’d sit around explaining that electricity was only four percent of the economy, and so if you lost eighty percent of electricity you couldn’t possibly have lost more than three percent of the economy, and there’d be people in Minnesota and Chicago and stuff who’d be writing that paper… but it would be stupid. It would be stupid.
In context, Summers is poking fun at the “freshwater macro” guys, who were arguing in 2008 that the shock to the financial sector shouldn’t affect real GDP too much. In this post, Krugman explains the broader argument, and of course endorses Summers’ critique of this silly guys.
It’s a great critique. It reminds me of the time I busted a different economist, a saltwater one it just so happens, who had made the same mistake in the context of international trade (rather than the financial sector). This economist (whose identity for the moment I will keep a mystery) had argued:
There are a lot of good things you can say about international trade. But it does not, repeat not, do anything to alleviate a shortage of overall demand. Yes, if you liberalize trade countries will export more. But they will also import more. If you’re worried about C+I+G+X−M, it’s a wash, because X and M rise equally.
Which makes this WaPo editorial on things Obama should be doing about jobs truly bizarre. Even if the proposed trade deals with Korea and Colombia were remotely big enough to bear mentioning in the context of the crisis — which they aren’t — they wouldn’t be job creation measures.
To show how silly this was, I explained:
Imagine a small but productive island nation, similar to Hong Kong, which has an enormous export sector. Its Keynesian parameters have the following values:
C = $74 billion
I = $10 billion
G = $15 billion
X = $100 billion (exports)
M = $99 billion (imports)
Thus the GDP of our island nation is $100 billion, which is consumption plus investment plus government spending, plus the $1 billion in net exports.
Y = C + I + G + (X − M)
100 = 74 + 10 + 15 + (100 − 99)
Now suppose that a rival nation surrounds the island with warships and completely seals it off from international trade. According to [the mystery economist's] logic, we should expect GDP to fall 1 percent, down to $99 billion. Now some of the islanders might say, “Huh?! How the heck are we supposed to even eat if we lose our access to the world economy? We have no oil or other natural resources, and we import most of our food. If we can’t trade, our cars and trains will come to a standstill and everyone will have to cut meat out of his diet.”
[The mystery economist] would laugh at such medieval, verbal reasoning. He would patiently explain to the frightened islanders that the numbers don’t lie. Yes the economy would lose $100 billion in exports, throwing all those people out of work, but domestic consumers would have to switch their demands away from the $99 billion they previously spent on foreign goods. Net exports only contributed $1 billion to GDP before the blockade, so the complete cessation of trade wouldn’t have much of an impact. Right?
No, of course that’s not right. After the blockade is put into place, we ask macroeconomists (before they starve) to tabulate the national accounting identity one last time. This is what they report:
C = $15 billion
I = $0 billion
G = $5 billion
X = $0 billion (exports)
M = $0 billion (imports)
Rather than the 1 percent drop [the mystery economist] had forecasted, GDP actually fell a shocking 80 percent, down to $20 billion. No businessperson in his right mind is investing in this environment; the government has had to slash its spending because of the collapse in revenues; and consumers have scaled back their purchases to an extreme austerity budget. The island is devastated by the naval blockade. Duh! Of course it is: that’s why warring countries blockade each other.
So you see, our mystery economist had committed the exact same fallacy as the freshwater guys–a mistake that Summers called “stupid” (a label Krugman endorsed) by deploying their argument in the context of electricity. I instead made the point with a small island that imports a lot of its food, but it was the same critique, and the underlying “stupid” mistake was the same.
At this point, I’m sure no one needs to click the link to learn the identity of my mystery economist.