Macroeconomics and the Ideal Gas Law – Part 1

I took a graduate course in the late 1960’s in Macroeconomics and Forecasting.  It was (of course) based on Keynesian Economic Theory.  The conventional thinking of the time, based on Keynes’ theories, was that government spending in excess of taxes could provide a stimulus for economic growth.  That could be achieved with either tax cuts or increases in spending levels.  The Keynesian theory had been tested during the Kennedy Administration when income tax rates were cut and the economy expanded.

But it was not generally accepted that a continued government deficit was desirable.  One idea that seemed to make sence was the “full-employment budget”.  Under this concept, the Federal budget would be set at a level of what the tax revenue was expected to be if the economy was operating at “full employment”  (defined as an un-employment level of about 4-5%). During a recession, neither spending nor tax rates would be cut.  But, of course, with less employment tax revenue would fall and the resulting government deficit would stimulate the economy.  When the economy had fully recovered, the budget would be balanced again.

At the time, there was not much discussion of monetary policy except at the University of Chicago where Milton Friedman was.  Then in the early 1980’s, during the Reagan administration, Paul Volcker was running the Federal Reserve.  With inflation running rampant he raised interest rates, a recession followed, but the rampant inflation with no real growth (or stagflation as it was called)  of the 1970’s was reined in; interest rates were lowered and the next 15-20 years saw steady economic growth.  This was taken as proof that interest rates effected economic growth as well.   By the 1990’s, the government was thought to be able to control the economy, either through fiscal policy or through the Federal Reserve adjusting interest rates.  In fact, the period of economic growth was long and when there were bumps in the road, the economy had quickly recovered.  Things had gone so well for so long that in the late 1990’s the then chairman of the Federal Reserve, Alan Greenspan, declared us to be in a “new economy”.  But when we got to a new century the recessions returned.  We’ve had two noteworthy recessions since 2001.  The recovery from the last one has been painfully slow and it has been called the “Great Recession”.  It has been labeled that because it seems to be the worst down-turn since the Great Depression of the 1930’s.

Before I took economics courses in college. I had several science courses and a college undergraduate engineering degree.  The Ideal Gas Law is something that I think I first encountered in high school.  The Law is pretty simple, it says that the volume occupied by a gas will vary with the temperature, and pressure.  The lower the pressure, the greater the volume, and the higher the temperature, the greater the volume.  Three variables and a simple equation.  We seem to have simplified macro-economics down to three variables that have about the same relationship to each other as those in the ideal gas law.  The interest rates would be like the pressure.  The lower the interest rates, the greater the volume of economic activity.  Federal Deficits are like the temperature.  Higher deficits will make the volume of economic activity  expand. Pretty simple stuff.  And it’s theory that has been proved in practice – the deficit part in the 60’s and the interest rate part in the 80’s.

But the problem I learned in engineering school with the ideal Gas Law is that there is no such thing as and ideal gas.  If one is designing something to work in the “real world”, one needs to know what the “correction factors” (or engineering fudge factors) are.  These vary by type of gas, and are only good for a certain range of temperatures and pressures.  In fact, my senior year in engineering school, one of my lab projects was to determine correction factors for a fairly common gas for a range of temperature and pressures that had no published data.   The good news about the Ideal Gas Law is that the physical gas elements that will react the same way to the same stimulus every time.  Once you determine the correction factor you are free to design whatever you need.  It works the same way every time – no worries.

The problem with the economic equivalent to the ideal gas law is that it does not seem to work the same way every time.  At the beginning of the current recession we had federal deficits which were increased by a large spending stimulus package.  The Federal Reserve cut the interest rates to almost zero, and has not raised them in 7 years.  While there has been some improvement, we seem to still be in the doldrums.  We still have a large Federal Budget deficit.  The unemployment rate has come down, but so has the number of working people.  This reduced number of workers has been taken to be a result of people getting discouraged and dropping out of the work force.  And despite the low-interest rates, the corporate investment numbers are still anemic.

So what’s going on here?  Maybe the simple economic model needs some “correction factors” which have not been determined.  Maybe we’ve over simplified the economy, there are likely a lot more variables than three.  I believe that there managing it is a lot more complicated than managing physical gases.  The responses of  the economic factors do not seem nearly as consistent as even non-ideal gasses.

I think maybe one important difference s that the economy is made up of people.  People think, anticipate the future, and often act emotionally.  We don’t necessarily react the same way to the same stimulus as do  physical inanimate objects.  It turns out, Robert J Samuelson, an editorial writer with the Washington Post writers group who writes on economic issues (and is not political) had a recent syndicated column which reported on a Pew Research Center survey of attitudes of common people in some of the world’s largest economies – U.S., China, Japan, Germany, the UK, etc.  The data would indicate that at least a significant part of the problem, is in people’s confidence levels.  If people’s expectations are low, they will act differently than if they are confident that things will improve.  The Pew survey indicates that people’s’ confidence levels are not good and haven’t been since the start of the Great Recession.  In a previous post, I said I didn’t think people would not act normally unless they expected things to be normal.  The Pew data would seem to confirm that conclusion.

In Part 2 of this two-part post, I will share some of the reasons I think are affecting people’s confidence levels as well as some important things that have changed since the turn of the century.

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About tjc13

BE - Chem Engineering, Vanderbilt Univ, MBA, University of Tulsa - Worked for an energy and chemical company for many years and then started a management consulting business working for both for-profit and not-for-profit organizations.
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