Friday, May 10, 2013

I'm Not an Economist But ... [IS-LM and What they Teach in 1A]

This may be old stuff to everybody but me but this morning I was reading Krugman on IS-LM and a light dawned about econ is taught to beginners, and later to others (it's a wonderful piece, by the way, whether my inferences are correct or not).

Here's the deal: in 1A (and again in 100A) we all learn boot camp supply and demand: price goes down, demand goes up.  But it turns out that macroville, it doesn't quite work that way.  As K says: 
 [W]e are at minimum talking about two variables, not one – GDP as well as the interest rate. ... That means that loanable funds doesn’t determine the interest rate per se; it determines a set of possible combinations of the interest rate and GDP, with lower rates corresponding to higher GDP. And that’s the IS curve.
So far so good.  But what struck me is that this is only one place where the 1A relationship doesn't hold.  Here's another: call it "Soros reflexivity" or if you want to be less hifalutin, just "herd behavior."  Anyway, suppose everybody starts to dump BigCo stock.  From 1A,  you would think that the drop would draw new buyers into the market and firm up the price.  But no: a big drop may lead to an even bigger drop--ask former British Prime Minister John Major what George Soros did to the pound, and watch him sputter.  Which, again, is not what they taught us.

I can think of another: portfolio insurance.  You can sketch a fairly simple model (ninth grade algebra only) where you buy some stock and protect against losses by buying some bonds.  You here the stock is going into the dumper, you want to stay insured so you sell even more stock, driving the price down further (use the same model--this may look like a special case of the previous example but I think the motivation is different.)  It's what (a) did (b) did not cause the flash crash of '87.

There's also the little matter of Giffen goods--price of potatoes go down, people buy fewer potatoes.  Actually I gather this one they sometimes do teach in 1A but I don't think anybody believes there are (m)any Giffen  goods to begin with.

That's it.  Maybe there are more. But my point is that the world is a lot more complicated than it looks in 1A.


bjdubbs said...

If you have quantity, time and price, what more do you need? You can hunt around forever and never find demand (and every supply is a demand and vice versa). It's as if supply and demand came together and had a baby, Price Supply-Demand. But nobody's ever seen the parents.

Larry, The Barefoot Bum said...

call it "Soros reflexivity" or if you want to be less hifalutin, just "herd behavior."

Keynes called it "animal spirits." In finance, the return on an investment is often based not on the fundamentals of the investment (e.g. the actual profitability of the company) but on other people's expectations of the return on the investment. You buy Tulip Bulbs, or Amazon stock, or CDOs, not because you believe that these investments will be profitable, but because you believe that everyone believes that everyone else believes they will magically rise in price.

Hence the need for financial regulation even from a capitalist perspective: we need some agent to ensure that people invest on the fundamentals, not on expectations of expectations (of expectations ad infinitum).

very supply is a demand and vice versa

Ah, Say's old fallacy. This is true only in a pure barter economy, or an economy where liquidity cannot be saved.

Buce said...

I believe in animal spirits but I don't think it is a good description of what Soros was up to. He was looking for--and found--ways to game the market (entirely lawfully, so far as I know). Dump a lot of X; scare the daylights out of others by convincing them you know something they don't know--they dump more and you accomplish your purpose. I am tempted to say it is not all that abstruse, but with the concession that he is a multi-billionaire and I am not.

Agree on Say's old fallacy.

Ebenezer Scrooge said...

It's amusing to compare Econ 101 to Physics 101. Both are largely false, based on simple ideas that have been discredited. Both are pedagogically sound beginnings. But the difference, I think, is that a person who takes Physics 101 and stops there has learned something useful. A person who does the same with Economics 101 has a lot to unlearn before s/he reattains their previous level of sophistication.

I think that law school is comparable to Econ 101.

Larry, The Barefoot Bum said...

I believe in animal spirits but I don't think it is a good description of what Soros was up to.

Dunno. I think we're talking about the same thing from two different perspectives. Blind men and elephants?