How Micro Minds Make Macro Mistakes

Originally published May 3, 1982

AN OLD TEACHER of mine once tried to “motivate” (a word he would never have used) his sullen pupils by arguing that Latin is the road to success in any line of endeavor. He was ready for us when we cited Henry Ford as an exception. “Ah, yes,” he replied, “but think of how much more successful Mr. Ford would have been if he had studied Latin.”

That kind of argument provides the principal, if not the sole connection between macroeconomics (the economics of the nation or world) and microeconomics (the economics of the firm or individual), as they are at present understood. Ordinarily the link is silently assumed. The root of both branches, like the root of both words, is the same. Surely, too, it is obvious that the prosperity of the nation depends on the prosperity of the entities that make it up.

I shall nevertheless dare to express doubt. For I have had the experience, not once but several times, of seeing the firm for which I work prosper in what were generally judged to be bad times. And, I am sad to report, I have also seen the contrary. There used to be, moreover, a bit of folk wisdom to the effect that the book business is, for various almost plausible reasons, depression proof. (Some say that it is prosperity-proof, as well.) In the face of all this, how can one assert a connection between macroeconomics and microeconomics?

My old Latin teacher would have had no trouble with that question. He would readily have granted that our firm could prosper in bad times, and then rejoined: “Think of how much more prosperous you’d have been if the times had been good.” That is a hard argument to meet and an impossible one to formulate. It seems the most obvious of common sense, but there is no way to test it. The fact of the matter is that our company sometimes-not always-prospered in bad times; beyond this fact we have merely wild surmise.

Indeed, I would suggest that the connection between macroeconomics and microeconomics actually is silently denied about as often as it is silently affirmed. The former head of General Motors who served as President Eisenhower’s Secretary of Defense, Engine Charlie Wilson (so called to distinguish him from Electric Charlie Wilson, at the time head of General Electric), was greeted with derisive laughter when he made his way into the dictionaries of quotations with the howler, “What’s good for General Motors is good for America.” You don’t have to cudgel your brains to think of lots of examples of business doing good for itself at the expense of the national interest. In such instances, macro and micro seem to be at war with each other rather than mutually supportive.

Many college curricula are also unmindful of a possible connection. It is not unusual to be able to take an introductory semester of micro without macro, or vice versa, or a semester of each in either order. It doesn’t matter, because the truth is one doesn’t depend on the other.

The discontinuity is not to be wondered at but to be expected. For we have here another instance of the fallacy of composition (see my “Productivity: The New Shell Game,” NL, February 8, on how this turns up in discussions of productivity). Webster’s New International Dictionary, using almost identical language in both the second and third editions, defines the misleading reasoning as follows: “The fallacy of … assuming that what is true of each member of a class or part of a whole will be true of all together.” Websters then gives an example from economics: “If my money bought more goods, I should be better off; therefore we should all benefit if prices were lower.” The fallacy of composition might well be called the characteristic economics fallacy.

In its relatively benign form it may underlie proposals to operate the government on “sound business principles”- that is to keep accurate accounts. Somewhat more dangerous is the belief, widespread at least among businessmen, that success in business is an indicator of probable success in government. This can lead to a lot of benefit- cost analysis and similar foolishness. Or it can lead to reliance on bankers (who are not, properly speaking, really businessmen) to settle monetary and financial questions (what is good for Citibank and Chase may in fact be very bad for America, as the Polish crisis has shown).

It is in the fields of taxation and regulation, however that the most dangerous misapplications of microeconomic principles to macroeconomic problems come. Reaganomics is frankly built on such reasoning, and the Democrats have been floundering because they tend to accept the same fallacies. As things stand today, their uneasy feeling that it is bad to be mean to the helpless is what distinguishes them from the Republicans. The sentiment is a credit to them; in a rational world it would be a badge of honor to be called a do-gooder. Yet feelings are an inadequate response to a ruthless and fairly consistent program, especially if one has the despairful suspicion that the theory behind the program may turn out to be pragmatically correct.

The Democrats have been kidded into believing that President Carter was from their ranks, and that his failures proved the Great Society was a bum idea. As a result, they have not only supported the Reaganomic tax breaks for the rich but have mindlessly tried to outbid the Republicans for the favor of the oil industry. Several, not excluding notorious liberals like Teddy Kennedy, are demanding credit for being in the forefront of actions to dismantle some regulatory agencies. The reasoning, again, is a fallacy of composition.

Current theories of microeconomics assume that the purpose of business enterprise is profit maximization, and a now well established principle of successful business management is that it is sensible to cut your losses. Any fledgling MBA has a quick eye for seeing how a firm’s activities can be divided into _ semiautonomous “profit centers,” plus a quick ear for hearing which profit centers are yielding a desired rate of profit, which ones can be made to do so, and which ones are hopeless. Those in the last category may be profitable; they are simply not profitable enough. The minimum acceptable rate of return is the money-market rate. If you can get roughly 15 per cent by lending your money to someone else, there clearly is no point in bothering to run a business that earns less. Or if in the normal course of your business you borrow money from banks, and pay the prime rate of roughly 16.5 percent, you’re obviously losing money on a profit center that doesn’t earn that much.

So the weak profit centers should be sold if possible, liquidated if not. You will probably have to take a loss, but more than half of your loss will be paid for by the government via the reduction of your income and hence of your tax bill. The funds thus freed can then be applied to the promising profit centers, or put into the money market, or used to reduce your corporate debt. Whether you sell or liquidate, the overall profit of your company will be improved.

There is no doubt that this barbarism works. Consider a profit center that is earning 5 per cent on invested capital of a million dollars, while the firm’s target is 15 per cent. Even if the weak profit center-workers, customers, machinery- is abandoned at a total loss, the after-tax result will be that more than a half million dollars will be available for use in the centers that earn 15per cent or more. Fifteen per cent of a half million dollars is $75,000, while 5 per cent of a million is only $50,000. It’s as simple as that, and the underlying principle is similar to that of the Blitzkrieg.

Let us note in passing that this sort of thing is encouraged by the corporation income tax, and that a higher tax would encourage more of it. It is of course also encouraged by the interest rates produced by the Federal Reserve Board’s monetarist policies.

NOW TRANSFER this microeconomic thinking to macroeconomics. Just as in a firm there are many profit centers, in a nation there are many firms. In the same way, therefore, that a firm is strengthened by eliminating relatively weak profit centers, the nation will be strengthened by eliminating relatively weak firms. From this, Reaganomics follows as night the day. And in the long dark night it makes sense to foster the strongest and starve’ the rest. It makes sense to embrace the reality that in monetarist economy strength is a question of financial-not productive-capacity, even though that may be literally counterproductive. It makes sense to keep the interest rate high and to push the bankruptcy and unemployment rates higher. It makes sense to promote the amalgamation of whatever industry remains.

If you stop to think about it, none of this makes sense. It is the most vicious, most debilitating nonsense you could imagine. But it is what results from the application of microeconomic principles to macroeconomic problems.

I hasten to emphasize that this sort of thinking is not the exclusive province of the Business Roundtable and other far out Republicans. During a Democratic administration alleged to be liberal, I was involved in discussions with representatives of the Federal Trade Commission and was told that bookstore chains deserve much better terms than individual stores because economies of scale benefit the consumer. Had the FTC lawyers looked at the actual situation rather than at their doctrine, they would have noticed that the chains, for a variety of reasons, would collapse without the more favorable terms. But my main point is that the notion of economies of scale is a notion in microeconomics. When the government-in this case the FTC-gets involved in microeconomics, it usually makes or perpetuates a mess.

Until the Democrats learn this lesson, we will have no relief from Reaganomics. It may well happen that the Republicans will achieve disaster so quickly that the Democrats will win in the fall elections. But so long as the Democrats, too, are bemused by microeconomic doctrines, the dark night will continue.

The President pleads for patience, for more time to allow his program to “take hold.” He will probably get his time give or take a few wrist-slaps at the Pentagon budget-because the Democrats, like him, are in the thrall of theories that have proved successful on the level of individual firms and individual banks. Let it be stipulated that those theories do in fact work on that level; they are uncivilized even there, but they do “work.” But let it some day soon be understood, and insisted upon, that the economy of the nation-and of a free market-is based upon entirely different principles.

The New Leader

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