Which Is More Accurate, ‘Say’s Law’ or ‘Keynes’s Law’?

This Mark Skousen article from 2017 is both thought-provoking and enlightening, so I am posting it here.

Students almost always get this wrong, until it is explained

“They say children are the future, but really teachers are the key to the future.” – Author Unknown

We all know that teachers, especially at the college level when students are away from their parents, can have tremendous influence.

My best example is when I ask my economics students “Which is more accurate, Say’s law or Keynes’s law?” Say’s law (defined below) is named after the 19th-century French economist J.-B. Say, while Keynes’s law is named after the 20th-century British economist John Maynard Keynes.

Most of the students have never heard of either law, so on the blackboard or PowerPoint, I simplify the definition as follows:

  • Say’s Law: “Supply creates demand”
  • Keynes’s Law: “Demand creates supply”

Before we have any discussion, I ask the students to intuitively decide which one makes more sense, and why.

Invariably, the vast majority of students side with Keynes. Demand, they say, is essential. Without consumers willing to buy a product, suppliers will go out of business. They conclude consumer spending drives the economy.

Currently, I am a Presidential Fellow at Chapman University in California, where I teach a course entitled, “Modern Political Economy: Who is Winning the Battle of Ideas?” I have 22 students. In the above exercise this week, fifteen students voted with Keynes, and seven voted for Say.

For the next hour, I took the students through a series of exercises, historical examples, and economic studies that suggest that Say’s law, not Keynes’s law, is a far more accurate view of the economy. I won’t go into all the arguments here but they can be found in chapter 2 of my history book, “The Making of Modern Economics” (3rd edition published by Routledge Publishers) and chapter 17 of my textbook, “Economic Logic” (4th edition, published by Capital Press).

Essentially, I demonstrate that economies grow not because consumers demand more and are willing to go into debt, but largely because of a willingness of entrepreneurs and businesses to save and invest in new products and technologies – the supply side of the economy.

I use Seattle as an example. Seattle residents did not become wealthy because consumers decided to demand more, but because creative businesses such as Boeing, Microsoft, Starbucks, and Amazon came up with new products and services (consumers didn’t know they wanted these things until they were created). I conclude that business is the catalyst of economic progress, and consumer spending is the effect, not the cause, of prosperity.

I end the lecture by quoting some experts on the subject, including CNBC economist Larry Kudlow, who says, “Though not one in a thousand recognizes it, it is business, not consumers, that is the heart of the economy. When businesses produce profitably, they create income-paying jobs, and then consumers spend. Profitable firms also purchase new equipment because they need to modernize and update all their tools, structures, and software.”

I also include in the lecture a discussion of gross output (GO), the new “top line” in national income accounting that demonstrates that business spending is almost twice the size of consumer spending in the economy. (See mskousen.com for more details.)

At the end of the hour, I ask if any of the students have changed their minds. In this case, it was 22-0 in favor of Say.

Teachers can make a difference.

Trickle Down Economics – Gaslighting At It’s Best

As Joe Biden and his cronies push tax increases and other hidden forms to increase their taxation take, you are seeing more and more articles published on why Trickle Down Economics doesn’t work.

Thomas Sowell, now 91, is known as an American economist, social theorist, and senior fellow at Stanford University’s Hoover Institution. In this April 2015 article, he explains that Trickle Down Economics as a theory never existed and is just a tool that Democrats have used successfully to thwart Republican efforts to reduce taxes.

Thomas Sowell – Why attack ‘trickle-down economics?’ It doesn’t exist – and never has

During this election campaign, some intelligent people – politicians and columnists – have attacked “trickle-down economics” in the mistaken belief that it exists. Or that it ever existed. It’s a myth. In his classic book, Basic Economics, Thomas Sowell gives a brief history. Here’s the excerpt:

There have been many economic theories over the centuries, accompanied by controversies among different schools of economists. But one of the most politically prominent economic theories today is one that has never existed among economists – the ‘trickle down’ theory. Yet this non-existent theory has been attacked from the New York Times to a writer in India. Franklin D. Roosevelt’s speechwriter Samuel Rosenman referred to:-

“‘the philosophy that had prevailed in Washington since 1921, that the object of government was to provide prosperity for those who lived and worked at the top of the economic pyramid, in the belief that prosperity would trickle down to the bottom of the heap and benefit all.’
The same theme was repeated in the election campaign of 2008 when candidate Barack Obama attacked what he called ‘the economic philosophy’ which
“‘says we should give more and more to those with the most and hope that prosperity tickles down to everyone else.’
Whether in the United States or in India, and whether in the past or in the present, ‘trickle down’ has been a characterization and rejection of what somebody else supposedly believed. Moreover, it has been considered unnecessary to cite any given person who had actually advocated any such thing.

The phrase ‘trickle down’ often comes up in discussions of tax policies. Tax revenues have in a number of instances gone up when tax rates have been reduced. But any proposal by economists or others to cut tax rates, including reducing the tax rates on higher incomes or on capital gains, can lead to accusations that those making such proposals must believe that benefits should be given to the wealthy in general or to business in particular, in order that these benefits will eventually ‘trickle down’ to the masses of ordinary people.

But no recognized economist of any school of thought has ever had any such theory or made any such proposal. It is a straw man. It cannot be found in even the most voluminous and learned histories of economic theories.

What is sought by those who advocate lower rates of taxation or other reductions of government’s role in the economy is not the transfer of existing wealth to higher-income earners or businesses but the creation of additional wealth when businesses are less hampered by government controls or by increasing government appropriation of that additional wealth under steeply progressive taxation laws. Whatever the merits or demerits of this view, this is the argument that is made – and which is not confronted, but evaded, by talk of a non-existent ‘trickle down’ theory.

More fundamentally, economic processes work in a directly opposite way from that depicted by those who imagine that profits first benefit business owners and that benefits only belatedly trickle down to workers.

When an investment is made, whether to build a railroad or to open a new restaurant, the first money is spent hiring people to do the work. Without that, nothing happens. Even when one person decides to operate a store or hamburger stand without employees, that person must first pay somebody to deliver the goods that are being sold. Money goes out first to pay expenses and then comes back as profits later – it at all. The high rate of failure of new businesses makes painfully clear that there is nothing inevitable about the money coming back.

Even with successful and well-established businesses, years may elapse between the initial investment and the return of earnings. From the time when an oil company begins spending money to explore for petroleum to the time when the first gasoline resulting from that exploration comes out of a pump at a filling station, a decade may have passed. In the meantime, all sorts of employees have been paid – geologists, engineers, refinery workers, and truck drivers, for example. It is only afterward that profits begin coming in. Only then are there any capital gains to tax. The real effect of a reduction in the capital gains tax is that it opens the prospect of greater future net profits and thereby provides incentives to make current investments that create current employment.

Nor is the oil industry unique. No one who begins publishing a newspaper expects to make a profit – or even break even – during the first year or two. [note: Sowell was writing at a time when newspapers were profitable] But reporters and other members of the newspaper staff expect to be paid every payday, even while the paper only shows red ink on the bottom line. Similarly, Amazon.com began operating in 1995 but its first profits did not appear until the last quarter of 2001 after the company had lost a total of $2.8 billion over the years. Even a phenomenally successful enterprise like the McDonald’s restaurant chain ran up millions of dollars in debts for years before it saw the first dollar of profit. Indeed, it teetered on the brink of bankruptcy more than once in its early years. But the people behind the counter selling hamburgers were paid regularly all that time.

In short, the sequence of payments is directly the opposite of what is assumed by those who talk about a ‘trickle down’ theory. The workers must be paid first and then the profits flow upward later – if at all.

 

What Is Goodhart’s Law?

Goodhart’s Law states that individuals can anticipate the effects of a given policy when evaluating the outcome of its actions and then manipulate the policy.

When the focus is set in only a single measure, people will optimize that single measure.

A good example is the so-called “Cobra Effect”. In India, the government offered money in exchange for each dead Cobra that was turned in, to reduce the abundance of loose cobra snakes on the Indian streets. At first, the policy seemed to be successful: people killed loose cobra snakes for the reward.

But after some successful time, people began to house breed cobras and hand them to the government to receive the bounty.

After the government became aware of this strategy, they decided to scrap the cobra bounty program. Guess what happened: people released cobras free. Suddenly, the number of loose cobras on the street increased: the government policy failed!

What does this teach us?: When an optimization measure is set, people can manipulate it to meet the target.

Goodhart’s Law declares that when a measure becomes the target, it ceases to be a good measure.

Charles Goodhart was a British economist born in 1936. He was a member of the Bank of England’s Monetary Policy Committee and professor at the London School of Economics. The idea of Goodhart’s Law was first advanced in a 1975 paper. That paper was later used to criticize the monetary policy of the government of Margaret Thatcher.

The original formulation of Goodhart, made in 1975, was: Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.

Goodhart’s Law and related ideas are used in many areas of economics. The Law it’s implied by the idea of rational expectations: people are aware of the implications of its actions and act according to them.

Goodhart’s Law has been beautifully formulated by Jón Danı́elsson (an economist teaching at the London School of Economics): Any statistical relationship will break down when used for policy purposes.

Examples of Goodhart’s Law

  • Search Engine Optimization: For many years, Google used a system called PageRank to sort its search results. PageRank used the number of backlinks each webpage had as a strong proxy of its quality. Webmasters started to implement several tactics to increase the number of backlinks, instead of increasing the quality of the content. For example, they exchanged backlinks with each other or built (Backlinks Farms). Google modified its search results sorting algorithm to overcome Goodhart’s Law. Many aspects of the current system are not made public, to avoid Goodhart’s Law.
  • Sales targets: Many businesses set sales targets to increase the productivity of salespeople. For example, a car salesman needs to sell 20 cars per month to receive a bonus payment. At the end of the month, they will make a lot of phone calls and usually offer discounts or perks to reach the 20 cars target. This strategy may be detrimental to the business if the discounts reduce profits.
  • Coupons strategy: When companies regularly offer discount coupons, people can delay purchases to get future discounts.
  • Company perks: many startups offer nice perks to attract star employees. But maybe perks attract only employees interested in perks and not necessarily the best employees.
  • Call centers: Many call centers set average call time targets, like three minutes per call. This policy can be detrimental to the quality of services: many customer support specialists can be unhelpful to people to reduce the average time per call.
  • School and university notes: As a proxy for quality learning, students memorize for test grades instead of actually deep learning the content.
  • Research papers in the academic world: Researchers are eager to get their papers published because the quantity of published research is usually used as a proxy for academic productivity. But this has lead to many scientists manipulating the data to achieve statistical significance, for example, by using data subsets. This has lead to the bias of the publication to provide only impressive results, while many papers on the same subject that didn’t achieve statistical significance were not published.

Implications in Data Analysis

When a model based on past data is deployed to the real world, people may start altering their behavior. This could invalidate the model. In Data Science, Goodhart’s Law can also be expressed as follows: “the behavior may change because of the models’ presence”.

We can test for the presence of Goodhart’s Law using time series and comparing the model fit before and after the implementation of the model.

How to Overcome the Goodhart’s Law?

The first option is to use better measurements. Measurements that take multiple factors into consideration.

In cases where the rewards do not need to be explicitly communicated, agents will not have the proxy to optimize. They will use human discretion and try to optimize the overall outcome based on their common sense.

Avoiding large groups and hierarchies can also avoid the need for the introduction of targets or KPIs. Small groups will naturally take into account many indicators as a measure of success.

Breaking Down the Goodhart’s Law

Goodhart’s Law is present in many scientific and business fields. Scientists, policymakers, and business managers need to be aware of the Law and avoid falling into the trap of using a single KPI (Key Performance Indicator) as a measure for success.

About the Author: Federico Anzil is an economist and analyst.

Source: https://economicpoint.com/goodharts-law