## Macro causality

David Backus writes:

This is from my area of work, macroeconomics. The suggestion here is that the economy is growing slowly because consumers aren’t spending money. But how do we know it’s not the reverse: that consumers are spending less because the economy isn’t doing well. As a teacher, I can tell you that it’s almost impossible to get students to understand that the first statement isn’t obviously true. What I’d call the demand-side story (more spending leads to more output) is everywhere, including this piece, from the usually reliable David Leonhardt.

This whole situation reminds me of the story of the village whose inhabitants support themselves by taking in each others’ laundry. I guess we’re rich enough in the U.S. that we can stay afloat for a few decades just buying things from each other?

Regarding the causal question, I’d like to move away from the idea of “Does A causes B or does B cause A” and toward a more intervention-based framework (Rubin’s model for causal inference) in which we consider effects of potential actions. See here for a general discussion. Considering the example above, a focus on interventions clarifies some of the causal questions. For example, if you want to talk about the effect of consumers spending less, you have to consider what interventions you have in mind that would cause consumers to spend more. One such intervention is the famous helicopter drop but there are others, I assume. Conversely, if you want to talk about the poor economy affecting spending, you have to consider what interventions you have in mind to make the economy go better.

In that sense, instrumental variables are a fundamental way to think of just about all causal questions of this sort. You start with variables A and B (for example, consumer spending and economic growth). Instead of picturing A causing B or B causing A, you consider various treatments that can affect both A and B.

All my discussion is conceptual here. As I never tire of saying, my knowledge of macroeconomics hasn’t developed since I took econ class in 11th grade.

1. derek says:

taking in each others' laundry

It's more like the farmer agrees to grow corn if the miner will agree to dig coal. But if the farmer won't get out of bed to grow corn, then the miner doesn't see why he should get out of bed to dig coal. Meanwhile, if the miner won't dig coal, the farmer doesn't see why he should bother growing corn. So they all grow cold and hungry for a bit, until someone breaks the impasse.

But I dislike these cozy stories that imply every actor in the story is a worker; the real story includes a big landlord who was paying both the farmer and the miner, but he got nervous that someone might just take his money and go drinking with it instead of working, so he put it in a safe deposit box where it might not make a profit, but at least it won't get lost.

Now no-one's working or getting paid until the landlord takes the money out and risks it on workers again. The trouble is that the landlord's business model is to make a profit selling corn and coal to… workers, who can't afford his wares because they're not getting paid.

2. Nameless says:

It is not uncommon in macro to have relationships that go both ways. Here it's entirely possible for consumers to spend less because the economy isn't doing well, AND for the economy not to do well because consumers aren't spending. So there is a potential here for positive-feedback loops.

The key here is that the "economy -> spending" link works through psychology and comes with a lot of noise. Therefore the feedback loop is easily disrupted. We can trigger a negative-feedback loop by an external event that causes temporary consumer retrenchment (like, say, a 800 point drop in the Dow). But, if there are no other reasons for consumers to avoid spending, that is not going to result in a 3-year-long recession.

We know that the economy has been in the dumps since 2008 and spending still has not recovered. It means that there is a third factor that either depresses spending below what's reasonable at any given state of economy, or depresses economy at any given level of spending.

Right now the most likely factor is the "wealth effect" – massive explosion in household debt in 2001-08 and the collapse in house prices that makes consumers feel poor and makes them direct an unusually high percentage of total income towards saving and repayment of debts, rather than spending. There are other candidates (say, persistently high oil prices could depress economy, like they did in 1973), but the wealth effect is best supported by evidence.

3. Bill Jefferys says:

Amplifying on Derek's comment:

4. Test Comment.

5. Kh13542 says:

How Backus gets from "the first statement isn’t obviously true" to "the usually reliable David Leonhardt" ain't all that obvious, either. Unless the statement is obviously false, it's hard to see how Leonhardt is being unreliable by relating it.

On the assumption that we are living in an economy that is all feedback mechanisms, all the time, what is obviously true is that demand is weak and growth is weak and employment is weak and credit growth is weak and they all cause each other, over and over. If Backus would prefer another story than the one Leonhardt tells, that may make Leonhardt an unreliable mouthpiece for Backus, but not unreliable in any other way.

6. guest says:

[…] that can affect both A and B.

7. […] get to the rest of the explanation, but first some background. The other day, I posted posted this remark from Backus: This is from my area of work, macroeconomics. The suggestion here is that […]

8. boo says:

I think Rubin's perspective makes a lot of sense but there is still much work to be done. The problem is that Rubin considers mainly discrete interventions T = 0 or 1. Economic policy (e.g. interest rates or tax rates) is continuous. Additionally, economic policy is conducted in a dynamic context, where the policymaker is considering a sequence of policy stances many years (maybe decades) ahead. Rubin's methods are developed mainly for a one-off intervention. Also economic policy is made more difficult in that expectations enter into the model (e.g. inflation today depends on expected inflation because firms mark up their prices to counteract expected inflation) and these are not easy to work with. All of this is compounded by time-varying parameters (the economy itself is evolving) and the fact that economists don't all agree on all the causal channels in the economy. I guess my point is, its really hard!

9. Misaki says:

The rich are consumers too, and they don’t need any helicopter drops of money. The only question is why they keep getting more money than they can spend; the answer is not “economic rent” (or “it’s the rentiers’ fault!”) since corporate profits represent voluntary purchases made in an insufficiently market, and those profits likely represent the majority of the money reaching the rich. For example, Apple’s profits are at record levels, and this is money which is obviously not needed to buy e.g. food. When helicopter drops of money just go towards iPods, it’s time to switch strategies.

Such as working less. http://pastebin.com/Wy8B0hK9

10. […] counterintuitively, household utilities). The piece generated considerable debate (see here and here), but everyone seems to agree on one thing: the outlook is definitely […]