Via Mark Thoma, Noah Smith* has a terrific piece on how to argue with economists. All the points are good, but I’d like to focus on Principle 4, “Argument by accounting identity almost never works.”
What he’s referring to, I assume, is arguments like “since savings equals investment, fiscal stimulus can’t affect overall spending”, or “since the current account balance is equal to the difference between domestic saving and domestic investment, exchange rates can’t affect trade”. The first argument is, more or less, Say’s Law and/or the Treasury view. The second argument is what John Williamson called the doctrine of immaculate transfer.
Why are such arguments so misleading? Noah doesn’t fully explain, so let me put in a further word. As I see it, economic explanations pretty much always have to involve micromotives and macrobehavior (the title of a book by Tom Schelling). That is, when we tell economic stories, they normally involve describing how the actions of individuals, driven by individual motives (and maybe, though not necessarily, by rational self-interest), add up to interesting behavior at the aggregate level.
And the key point is that individuals in general neither know nor care about aggregate accounting identities. Take the doctrine of immaculate transfer: if you want to claim that a rise in savings translates directly into a fall in the trade deficit, without any depreciation of the currency, you have to tell me how that rise in savings induces domestic consumers to buy fewer foreign goods, or foreign consumers to buy more domestic goods. Don’t tell me about how the identity must hold, tell me about the mechanism that induces the individual decisions that make it hold.
And once you do that, you realize that something else has to be happening — a slump in the economy, a depreciation of the real exchange rate, it depends on the circumstances, but it can’t be immaculate, with nothing moving to enforce the identity.
When it comes to confusions about the macro implications of S=I, again the question is how the identity gets reflected in individual motives — is it via the interest rate, via changes in GDP, or what?
Accounting identities are important; in fact, they’re the law. But they should inform your stories about how people behave, not act as a substitute for behavioral analysis.
*On his home page, Noah says he is named Smith like everyone else. No, not among economists. Many years ago I ran a small NBER conference that happened to include two Itos from Japan and two Parks from Korea; the conference director (Kirsten Foss) and I had a discussion about whether, as a courtesy, all the Americans should adopt the same name, and if so what name. We agreed that the generic name for an American economist was “Stein.”