Why a micro solution may not work in macro

P.J. O’Rourke nailed the distinction between the two areas of economics when he wrote, “micro-economics concerns things that economists are specifically wrong about, while macro-economics concerns things economists are wrong about generally.”

O’Rourke’s humor doesn’t just illuminate the silliness in our pretensions. He has a rare gift for making his victims laugh as hard as everyone else — even while being skewered.

In classrooms across America, introductory course students learn that macro-economics is the study of economic aggregates such as investment, consumption and government. Microeconomics, by contrast, looks at how individuals and firms make decisions and allocate resources.

What is not discussed usually is that macro and micro do not play well together. There is no unifying economic theory that satisfactorily integrates what we have learned about the two areas of study.

The gap between the two received a lot of attention and discussion during a recent economists’ pow-wow in Philadelphia — and that is very good news for economists and for our economy.

There is a reason behind the newly fired-up concern about this gap, which had been gathering dust for decades: the colossal failure of the economic models to predict either the economic collapse of 2008 or the persistent, recession-like recovery we have endured since then.

There have been efforts to incorporate microeconomics into the models’ math, primarily by adding functions and algorithms based on the behavior of individuals and institutions. This eventually resulted in the current generation of the forecasting tools known as Dynamic Stochastic General Equilibrium models, or DSGEs.

The DSGEs were always a work in progress, although that was rarely admitted, and they had some theoretical and practical issues that were unadvertised specials.

The primary theoretical issue questioned the structure of the models. Could a model based on the statistics of past behavior be an accurate predictor of economic growth, which is inherently based on behavior change?

The second issue was a practical one, not unrelated to the first as it turned out. What is the correct test for an economic model’s validity, the ability to explain the past or its ability to predict the future?

The interaction of these two issues produced a family of economic models that turned out to be more than satisfactory, even excellent, at predicting small changes — and were totally clueless about large ones.

All of this may seem (besides boring) too airy-fairy theoretical to interest anyone still connected to the real world, but it is the critical factor in a pocketbook issue for all of us.

There have been many arguments in favor of a government mandate raising the minimum wage, some based on the vaguely-defined “living wage” and others rooted in adjusting the wage floor to match today’s devalued dollar and resultant price levels.

One argument gaining support is based loosely on a book, “The Good Jobs Strategy,” by Zeynep Ton, an adjunct associate professor at MIT’s Sloan School of Management. Professor Ton’s important book explores the experience of some successful companies in the competitive retail sector that have raised their wage scales substantially.

The idea behind the strategy was that firms would use their knowledgeable, motivated employees to improve customers’ shopping experiences, thereby boosting sales and profitability.

There are certainly some success stories — Costco, and, more recently Ikea, for example — but there is a big difference between a business strategy and an economic policy, a difference that is just about the same size as the gap between micro- and macro-economics.

Depending on the market a business is in and the characteristics of its mid-level management, a higher wage, “good jobs” strategy can be an effective way to gain an advantage over the firm’s competitors and capture their customers, sales and profits.

What is a good, sensible strategy for one business, though, doesn’t work if all the businesses do the same thing. If all businesses pay higher wages there is no longer a competitive advantage for any of them; all they’ve got is a higher-cost structure and lower profits, a situation that can often lead to layoffs.

It is possible that instead of layoffs in that market sector, the entire sector expands — initially, at least, at the expense of other sectors. That, among other things, is what happened when Henry Ford doubled the prevailing wage for workers on his newly-conceived assembly line for the Model T. If the wage hike had been a government mandate for all workers, though, it would have been a different, unhappier story; one we should bear in mind when considering minimum wage increases.

The “What’s good for one isn’t necessarily good for all” problem is called the “Fallacy of Composition.” It’s an exception to P.J. O’Rourke’s definition; one of those things that economists got right – specifically and generally.

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