Macroeconomic Paradoxes

Macroeconomic Analysis: Macroeconomic Paradoxes

1. What are the macroeconomic paradoxes?

• Macroeconomic paradoxes (or fallacies of composition) refer to emerging properties that contradict the pure aggregation of a representative agent.
• When a macroeconomic paradox holds, what seems reasonable for a single agent leads to unintended consequences or even to irrational collective behavior when all agents act in a similar way.
• Macroeconomic paradoxes also refer to phenomena that emerge from macroeconomic relationships and contradict conventional wisdom.
• Microeconomic analyses are not sufficient to understand how economies work in reality due to the existence of macroeconomic paradoxes.

2. Three Traditional Macroeconomic Paradoxes

1) The Paradox of Thrift

• Although it might be individually rational to save more, if all individuals try to save more at the same time this might lead to less spending and hence to less output and lower total saving.
• This paradox draws on Keynes and can play an important role during periods of recession when households and firms tend to save more in order to protect themselves from the uncertainty about their future incomes and profits.
• This paradox can also play a significant role when households and firms are over-indebted and collectively try to reduce their debts by saving more.

2) The Paradox of Costs

• Although it might be individually rational for a firm to reduce the wage cost, if all firms try to do the same at the same time this might lead to less profits and to higher unemployment.
• The rationale behind this paradox (which relies on Michal Kalecki and Robert Rowthorn) is that a general reduction in wages reduces consumption and thus the sales of firms.
• If the reduction of sales is more important than the reduction of costs, then firms will suffer from lower profits. Moreover, lower sales can lead firms to fire workers.
• As Kalecki (1971, p. 26) explains:
  ‘…one of the main features of the capitalist system is the fact that what is to the advantage of a single entrepreneur does not necessarily benefit all entrepreneurs as a class. If one entrepreneur reduces wages he is able ceteris paribus to expand production; but once all entrepreneurs do the same thing the result will be entirely different.’

3) The Paradox of Public Deficits

• Although entrepreneurs tend to prefer their government to avoid public deficits, in fact it might be the case that the more the government spends (relative to taxes) the higher the firm profits.
• The rationale behind this paradox (which relies on Michal Kalecki) is that government spending increases the sales of firms. For example, more social benefits can increase the consumption of low-income households and more spending on infrastructure can directly increase the sales of construction companies.

3. Three Paradoxes Tied to the Financial System

1) The Paradox of Debt

• Although it might be individually rational to reduce indebtedness (e.g. debt-to-income ratio) by cutting or postpone spending, if all households and firms do the same at the same time indebtedness might increase.
• The rationale behind this paradox (which relies on Joseph Steindl) is that the spending of a household or a firm affects the income and profits of other households and firms and, hence, their indebtedness.
• The paradox of public debt can also be applied to the public sector.

2) The Paradox of Banking Refusal

• Although it might be individually rational for a bank to refuse to grant new loans during a period of recession, if all banks do the same at the same time the recession will be exacerbated and the losses of banks from non-performing loans might increase.
• The rationale behind this paradox is that bank loans constitute a significant source of investment and consumer spending. Hence, a reduction in the provision of loans might lead to the reduction of income for households and firms that have to repay accumulated debt.

3) The Paradox of Tranquility

• The longer an economy is in a tranquil state of growth, the less likely it is to remain in such a state. In other words, stability is destabilizing.
• In a world of fundamental uncertainty, a string of successful years diminishes perceived risk and uncertainty.
• As time goes on, memories fade and economic agents dare to take on higher levels of risk. In practice, this means that households, firms and banks have a higher tendency to participate in debt contracts that might increase the financial fragility of the economy.
• The paradox of tranquility stems from Hyman Minsky. Minsky (1977, p. 24) argues that:
  ‘Over a period in which the economy does well, views about acceptable debt structure change. In the deal-making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activities and positions increases.’

4. An Open Economy Paradox

The Paradox of Profit-Led Demand

• The paradox of costs might not apply when we have an open economy: the reduction in domestic consumption caused by a decline in wages can be compensated by the increase in net exports (since lower wages can increase price competitiveness).
• If this is the case, we say that the demand of a country is profit-led: an increase in profits (relative to wages) leads to higher demand and higher output.
• However, the paradox of profit-led demand implies that the policy of reducing wages is successful only if it is not implemented by many countries at the same time.
• Although it might be rational for a profit-led economy to cut wages in order to increase economic activity, if many other countries do the same at the same time, this might have detrimental effects on economic activity.
• The paradox of profit-led demand (which relies on Robert Blecker) is explained by the fact that Planet Earth is a closed economy: the exports of one country are necessarily the imports of another country, and hence globally net exports are nil.
• This means that the beneficial effect of wage cuts on net exports might not materialize.

5. Summary of the Macroeconomic Paradoxes