The Most Important Lesson Of Economics

Economics is a broad and vast field comprising intricate areas that would take years to master. This makes it very hard to summarise or reduce it to a simple point. However, if there was one simple lesson that I wished everyone knew about economics, one easy sentence or sound bite that could explain the essential core to people who know nothing else about economics, it would be: “My spending is your income”. This simple point, properly understood, explains everything you need to know about the important policy issues of the economy. It doesn’t explain everything, but it explains the important parts.

My Spending Is Your Income

What does the sentence mean and why is it important? Imagine you run a small shop, what is the one thing you want? Customers of course, to spend in your shop and buy goods. If people don’t spend then you will go bankrupt and lay off your staff. Hence your job and your income is dependent on the spending of others. If I go into your shop and spend my money, that keeps the shop going and pays the wages of the staff. But we are all employees somewhere, so I am in turn dependent on someone else spending money at my job. This means we are all interconnected and dependent on each other to spend money and buy each other’s goods.

This obvious point contains an important point. As we are all interdependent, if I decide to stop spending money and instead save it, that means some shop is going to suffer a decline in business. If it is steep enough, they may even have to lay some people off. Hence, what seems like being frugal and responsible on my behalf by saving money, if followed by enough people, hurts the overall economy and costs jobs. This is an example of when something makes sense on an individual level is inadvertently damaging on the national level (the economic term is “The Paradox of Thrift”). This is not to say that we should never save, but rather that excessive saving is damaging.

The important of this lesson is that it explains recessions and unemployment. If for some reason a group of people stop spending, the some businesses will suffer a decline in sales. If this decline is large enough then they will have to fire staff and may even close themselves. This has a knock on effect as these redundant workers now have less money and therefore spend less, thereby reducing someone else’s income. This means further business closures and further redundancies. Even those who are lucky enough to keep their jobs will probably face pay cuts. The economy slips into a downward spiral and the newspapers fill with stories of closures and layoffs. Now imagine you are a consumer in this economy (or just remember how it felt in 2009). You would be naturally very scared of having your pay cut or even losing your job. The natural response would be to cut back on spending and save as much as you can, in other words to batten down the hatches. However, if you remember the lesson, while this is sensible on an individual level, it only makes the national problem worse. It leads to more layoffs and actually increase the likelihood that you will have a pay cut. It is for this reason that cutbacks are self-defeating.

The lesson also explains what the solution to the crisis is. If the recession is caused by less spending causing lower income and uncertainty, then the solution is to boost spending and confidence. But who is to do the spending? It would be madness for a consumer to go on a spending spree, their income is limited and they are afraid of future cutbacks. Each individual is too small to have an effect on the economy, so no one will spend unless everyone else is spending too, with the result that no one spends. The economy would get a boost if businesses increased their spending, but what business is going to invest in this economic climate? Their sales are down already so it makes little sense for any individual to expand (this is the reverse of the problem above. What is illogical on an individual level makes sense on a national level). Therefore the only one left is the government. The government is the only body large enough that if it increased its spending it would have an impact on the economy. We must rely on it to pull the economy out of the recession, not for ideological reasons but simply because it is the only one that can. Furthermore if the government guarantees no further cutbacks and launches a program of large spending, then this will reduce the uncertainty in the economy. Consumers will no longer hoard money and delay expenses but will return to normal spending patterns. Businesses in turn will expand to meet this demand and thus boost the economy.

Now some might object to the government spending money as this will increase the national debt. But what is the point of the national debt if not something to be resorted to in times of emergency? Isn’t the point of borrowing to help us out of hard times? This is commonly practiced by consumers and businesses so why not the government too? Sure it will have to be paid back, but that is an action for the boom when the economy is doing well. In a recession, the government must spend or else the economy will stagnate (in which case the debt will never get paid back). When your car is caught in a ditch, your main concern is not using up too much fuel. Instead you have to (regardless of whether you want to or not or even if it was speeding that got you in the ditch in the first place) slam the accelerator to boost the car out of the ditch, whereupon you can return to focusing on fuel conservation.

Unemployment often seems like a mysterious force to ordinary people who cannot understand how people who want to work could possibly not find jobs. Where have all the jobs gone that makes them so difficult to find? The answer is lack of spending (or insufficient demand). Businesses hire people in order to make a good or perform a service. How many people they hire depends on how much sales they have or in other words, how great demand is. So if people do not spend enough, then businesses will not hire enough and unemployment results.  The easiest way to think of it is to imagine that the economy requires a certain level of spending in order that all resources used and people employed. When the economy falls below that level, unemployment results, while if we go above it (which is very rare) inflation results. The role of the government is to adjust the economy so that we get as close to this level as possible. This is done by spending to reduce unemployment or cutting to reduce inflation.

This simple maxim, “My spending is your income” clearly explains the recession and the why the government policy of austerity is failing. Cutting spending only reduces income further and is the reason that after five years of cutbacks and austerity, Ireland is still mired in recession with only a slight improvement in the public finances. Every time the government cuts the wages of public servants, they spend less meaning businesses suffer and have to cut wages and lay people off. The government is actually making the problem worse! Austerity only pushes the economy lower and further reduces people’s income. As people have less money they pay less income tax, as they spend less they pay less VAT and as more are now unemployed, they cost the government more in social welfare. So not only is the economy worse off, but the cutbacks don’t even save any money.

The lesson applies to many public policy issues such as the minimum wage and trade unions. Traditionally people assume that higher wages cause unemployment, but this is only because they view wages solely as an expense. If wages are spent, then they are not an expense but someone’s income. So a higher minimum wage leads to increased expense but also increased sales. This simple lesson turns policy debates on their heads and should allow you to rethink the way we view government. In fact, in this light government spending should not be solely viewed as a burden on people but also as a source of income. So the next time someone boasts about how much can be “saved” by cutting government spending, remember that less spending means less income and net savings will be far less than the headline figure. This can be applied to all areas of government spending such proposals to cut social welfare, pensions, raise student fees, introduce a property tax, water charges or any form of tax hike or cutback. They all suffer from the same fault that they will leave less money in people’s pockets which will only make the recession worse.

My Spending Is Your Income

If there is one lesson I want to impart to everyone so that they can best understand the economy it is that “My spending is your income”. There should be monuments built with this slogan, it should be hoisted onto walls and tattooed onto economists. The solution to the recession is not further cutbacks because that will cause me to spend less and therefore reduce your income. Cutting spending only makes the recession worse. The solution is for the government to spend more for the simple reason that no one else will. You can call these policies Keynesian, but I call them essential.

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28 Comments

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28 responses to “The Most Important Lesson Of Economics

  1. Blue Aurora

    With regard to what people call “Keynesian economics” and “macroeconomics” more generally…allow me to put the point like this:

    Synergy requires that the whole is more than the sum of its individual parts.

    • So what wouldn’t work for individuals, works collectively (in the form of the government)

      • Blue Aurora

        Although I do lean to Keynesianism myself, I wouldn’t necessarily say that. I do agree that government action is needed in a situation of a severe economic downturn. However, we all must remember that humans are fallible, and thus, both the public sector and the private sector are far from perfect. This isn’t, of course, an excuse to be so cynical to the point of inaction and defeatist resignation – I do see a kernel of truth in the arguments made by the Public Choice School – people seeking political power (be it in an autocratic system or a democratic system) are self-interested. But if it becomes so obvious to so many people that they’re only out for themselves, who would want to work with them? Acknowledging the existence of human self-interest does not give one the excuse not to deal with the problem.

        As an aside, Robert…do you have any interest in decision theory?

  2. Robert,
    You are a National Treasure. I hope Ireland knows what it has got. If they treat you wrong, I’ll make a place for you here (Chicago, IL, USA)!

  3. Fantastic post. Sadly the Conservatives have ignored ‘My spending is your income’ and instead adopted ‘The Governments Spending Is Your Debt’.
    And as pointed out, debt can be repaid with incomes, brought about by spending, contributing to the revenue of the Government.
    But that part of the equation the Conservatives have shunned and instead are focused only on cutting spending as the way to reduce debt while doing nothing for incomes or revenue.

  4. Thanks for raising this important point. It is a point that Paul Klugman (among others) has raised over and over again here in the states. The deficit hawks hate it when they hear it but they can’t effectively oppose it in light of the obvious consequences of European austerity and now the effects of the Sequestration here.

  5. William

    Mr. Nielsen,

    Aren’t you aware/familiar with the work of one australian economy professor called Steve Keen ? He has devoted his time since 2004 to research the relationship between debts, income & GDP.

    He states that “GDP = Total income + change in debt.”
    As he was watching the australian economy he noticed that from say 1970 up to 2008 the growth of debt averaged 4% a year.

    http://www.debtdeflation.com/blogs/

    Search also for videos (e.g. Youtube) with professor Steve Keen.

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  7. I can almost hear a conservative respond to this: “not from my pocket”, as they always bring their “pockets” into every discussion. It’s very convenient, it forces the other side to engage in some platitudes about living in a society and being in the same boat, etc. It does not carry the same zing as “the pocket”.

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  10. GM

    I’m saddened that we have passed the point beyond which you could say that Keynesianism fails. I guess it barely matters. I no longer expect it to be abandoned until the most extreme economic failures demand the textbooks to be completely rewritten.

    It fails because it completely misses the mechanism by which wealth is created.

    Wealth is created by the accumulation of ever more advanced forms of physical and human capital: machines, buildings, vehicles, skills, intelligence, data. The almost complete absence of these things is what characterises pre-historic societies of hunter-gatherers. The development and proliferation of these things is what produces modernity and civilisation.

    Capital is created through investment: the choice to devote present resources to production instead of to consumer goods. This process is what enables the creation of a greater quantity and quality of future consumption goods, but it requires us to defer gratification in the short-term.

    This can be easily illustrated. All business owners (including shareholders of publicly listed companies) could enjoy massive consumption in the present by liquidating all of their investments. The sales proceeds could be used on a spending binge which might be extremely enjoyable in the short-term.

    The consequence of this, however, would be that no businesses would remain to produce any goods in the future. Bereft of capital, we would quickly return to a medieval standard of living.

    Appropriate levels of investment are fostered by environments of normal (ideally market-determined) interest rates, sound money, low taxes, etc.

    In contrast to this simple and logical theory, we have the Keynesian “spending is income” game. I will leave aside the many tragic flaws of their business cycle theories, but merely point out the basic economic error. Spending can’t be the source of wealth, because the act of spending is not a productive act. Spending is a method of acquiring an already-created good. Furthermore, spending more on something simply prevents somebody else (in effect, the second-highest bidder) from consuming it. Spending more is great for the seller (e.g. it’s great for the worker who is selling their labour), but it’s very bad for the people who might otherwise have bought the good in question (e.g. rival employers) and is very bad for the buyer too, unless they are truly benefiting from the transaction.

    Keynesian have no capital theory, so they don’t understand the true source of wealth (capital accumulation). They see an economy with lots of money flying around, and think that if the money didn’t flow so quickly, society would be poorer. But again, that’s merely because they don’t know what the source of poverty is (lack of capital). Because of this basic blindness, they can’t comprehend how an economy might heal from money flowing less quickly sometimes or, heaven forbid, the money supply occasionally contracting and interest rates occasionally rising.

    “My Spending Is Your Income” is directed from the high-spending consumer to his supplier; it should be redirected to rival consumers and written: “My Spending is Your Poverty”,

    • My point was not about the creation of wealth but rather how to keep the economy going, out of recession and in full employment. As they say in college, you made the common error of answering the question you wanted rather than the question that was asked.

      You see all the investment in the world is useless unless someone buys the goods produced. Likewise there is little point in creating newer products unless they are eventually consumed and improve our standard of living (for all goods end as consumption). So consumption and investment are not opposed but rather linked together.

      “the act of spending is not a productive act.”
      Economics is not solely about production but also about the transfer of resources from one resource to another.

      “spending more on something simply prevents somebody else (in effect, the second-highest bidder) from consuming it.”
      Now you’re just being silly. So when I buy something, anything in the shop, I am denying someone else that good? Have you never heard of excess capacity? You are taking crowding out theory to a ridiculous extreme.

      • GM

        I’m answering the important question, not the one that I was asked.

        If you insist on maintaining the short-term illusion that everything is ok, by pumping up spending and maintaining high employment at the expense of the capital structure of the economy, then you are really destroying the economy.

        Ireland had a lot of spending and a lot of employment during the Celtic Tiger, but it destroyed the economy because capital was misallocated.

        Consumption and investment are indeed linked together. The purpose of investment is future consumption, indeed. But if we devote fewer resources to producing goods for short-term consumption, we can create more producer goods which will ultimately lead to a greater supply of consumer goods. This is the trade-off between the short-run and the long-run.

        And yes, when you consume something, you are denying it to somebody else. Your consumption may incentivise the production of further units of that good, but such production must take place within the limits of the capital structure available to us, and will use up resources which may have been available for the production of other consumer goods. The first rule of economics is scarcity.

        • “at the expense of the capital structure of the economy”

          Who said it would be at the expense of the capital structure? GM, I feel you are not only not answering the questions asked, but answers questions I’ve never heard of, so that it is hard to understand quite what you are arguing for or against.

          “Ireland had a lot of spending and a lot of employment during the Celtic Tiger, but it destroyed the economy because capital was misallocated.”

          But what if the capital was not misallocated? What if it was invested in more sustainable industries? We certainly would not have had the crash we had. You seem to be confused over the reasons for the crash. It was not caused by spending or employment. In fact employment is the solution not the problem.

          • GM

            If an economy is structurally deficient, temporary unemployment is what fixes it. There has to be a period when people skilled in the unproductive, bubble-induced parts of the economy find something else to do, and they will probably be unemployed for a while until they do.

            Capital also need to be redeployed. There may be a period of time when entrepreneurs, shaken by the failure of the bubble, are unsure about where to redirect their efforts.

            How do I know this? Because I know that it takes time to develop physical and human capital. It takes time, effort, and risk-taking.

            And so trying to keep the money flowing and to keep as many people in jobs as possible without letting the market restructure the economy means keeping the capital structure distorted. It means condemning the economy to a much longer and more painful period of restructuring. It means limiting future consumption possibilities as capital continues to be misdirected and ultimately wasted.

            Mainstream economics makes simplifying assumptions, particularly with regard to capital, which I feel are at the heart of the problem. Capital is not an undifferentiated blob of resources that can be summarised by a single variable. Capital is an extremely complex and inter-related set of resources. The outputs of one process become the inputs to another, with demand imputed all the way back from the final consumer. A multitude of factors produce a unique set of competitive dynamics in each sector, while interest rates regulate the demand for financing.

            It’s impossible to understand economics without accepting the incredible complexity and inter-relatedness of the capital structure. I appreciate Austrian economics because it does not make simplifying assumptions when it comes to this structure. Mainstream economists either make simplifying assumptions or fail to comprehend the complexity of the structure to begin with, which is one of the reasons their theories are fundamentally unrealistic.

            The Keynesian/mainstream focus on money flow is a symptom of their ability to only look at the surface, at the measurable, at the short-term and at that which they think they can control.

            I recommend that you throw away your textbooks and reflect and refine your understanding of how the real world actually operates. Look under the hood of the economy.

            Here’s a short essay explaining the complexity and inter-relatedness of the real world:

            http://en.wikisource.org/wiki/I,_Pencil

            • “If an economy is structurally deficient, temporary unemployment is what fixes it.”

              There is so much wrong with this statement. Unemployment is no more a cure for anything than smacking your head off a wall. Both cause unnecessary pain. The biggest problem with this statement is that it is completely contradicted by reality. Five years into the recession, developed economies are still plagued by high unemployment, that shows little sign of decreasing anytime soon. There is absolutely no reason to think that this is in anyway improving the economy.

              “There has to be a period when people skilled in the unproductive, bubble-induced parts of the economy find something else to do, and they will probably be unemployed for a while until they do.”

              How could you look at the economy and reach this conclusion? It doesn’t take five years for construction workers to retrain or find something else to do. How do you explain the huge numbers of people who work in areas unrelated to the property boom who are now unemployed? If it was simply a case of retraining the recession would have only lasted months. There would not have been such a sudden collapse nor would we be dealing with the problem of emigration.

              “Mainstream economics makes simplifying assumptions, particularly with regard to capital, which I feel are at the heart of the problem.”

              Post Keynesians also disagree with the neo-classical view of capital. See “Cambridge Capital Controversies”

              “I recommend that you throw away your textbooks and reflect and refine your understanding of how the real world actually operates.”

              That’s what I did and that’s why I am a Post Keynesian. I think the track record of Austrian economics and reality is quite poor.

              I never found “I, Pencil” that interesting a story or that convincing an argument about capitalism. After all, the Soviet Union had pencils and Communism is also capable of organising resources. In fact any economic system can organise resources.

              • GM

                If you want to talk about empirical case studies, and the recessionary modern times, then hopefully you can already guess my responses.

                I’m not sure what the point is though, because you’ve revealed (again?) your favourable opinion of Communism. This, again, is another piece of utter insanity which is only made possible by your diligent study of mainstream economics.

                The same year that Soviet communism collapsed, Paul Samuelson wrote in the most-used economics textbook of all time that “Contrary to what many skeptics had earlier believed, the Soviet economy is proof that … a socialist command economy can function and even thrive.”

                Economists get everything wrong.

                • “you’ve revealed (again?) your favourable opinion of Communism”

                  I’m a Communist? How did you reach that conclusion?

                  I don’t see why you’re criticising Samuelson, an economist who I disagree with. Saying economics gets everything wrong doesn’t make any sense. Its like saying history gets everything wrong. Some historians make mistakes, some get it right, so we build on the good and drop the bad.

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