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Nine Economics Mysteries Explained

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Matt Yglesias of Vox has posted a list of “9 things only neoclassical economists will understand.” Well, the good news is, we at Bloomberg View don’t believe there is anything that you, the reader, can’t understand! That’s why I, your friendly neighborhood economics columnist, will explain Yglesias’ nine things in layman’s terms.

No. 1. The Cobb-Douglas Production Function

A “production function” is just like a recipe -- it’s a way of describing how inputs get turned into outputs. For example, you can have a production function that describes how much pizza you can make out of a certain amount of pepperoni, cheese, crust and sauce. The Cobb-Douglas production function is no different: it tells you how much gross domestic product you can get if you put in a certain amount of labor and capital, such as buildings, trucks and computers.

The Cobb-Douglas function has a nice property, which is that it predicts that a country will spend constant percentages of its national income on capital and labor. In other words, if labor’s share of national income is two-thirds, then two-thirds of all money earned in the U.S. in a given year will go to wages, salaries and bonuses. Recently, labor has been taking home a smaller percentage of national income, which has caused a lot of worry.

No. 2. Liquidity constraints

This one is easy. “Liquidity” means cash. So “liquidity constraints” mean you can’t get as much cash as you’d like. Which basically just means you can’t borrow as much money as you like, since borrowing money is how you get cash once your bank account runs out.

If people can’t borrow money, then they can’t spend money. That could make a recession worse. So some people think that the way to ease the pain of recessions is to have the government lend people money, an idea otherwise known as federal lines of credit.

No. 3. The Hodrick-Prescott Filter

I actually talked about this one before. Suppose you think that the economy has a long-term growth trend, and short boom-bust cycles. How do you separate the two? The Hodrick-Prescott Filter is a mathematical tool for separating trends from cycles. But it requires you to make a guess about what time-scale you think represents the short-term and long-term. If you guess wrong, the filter gives you bad data about business cycles. Garbage in, garbage out, as they say.

No. 4. Dynamic Stochastic General Equilibrium

This is just a long, ugly name for a kind of model that macroeconomists use to try to describe the economy. “Dynamic” means that it involves the long-term, not just a snapshot. “Stochastic” means that it involves randomness. “General Equilibrium” is supposed to mean that markets clear -- that supply equals demand at all times -- although recently it has lost this meaning, and now those words don’t really mean much at all. The thing to understand about DSGE models is that they try to predict the macroeconomy by describing the behavior of people and companies in the economy.

So far, DSGE models haven’t found much use outside academia, though they have won a couple of Nobel prizes.

No. 5. Ricardo-De Viti-Barro equivalence theorem

This says that if the government borrows money and mails you a check (for example, in a fiscal stimulus), you won’t spend any of it. Why? Because you know that the government is going to have to raise taxes in the future to pay back the money it borrowed, and those taxes are going to have to come out of your pocket. So you save your stimulus check to pay your future taxes.

In the real world, this probably isn’t what happens.

No. 6. The IS-LM model

Yglesias calls this “a macroeconomic model so simple even an undergraduate can understand it,” so it’s not clear why only economists will ever understand it. IS-LM says that there’s a relationship between GDP and interest rates. On the one hand, higher interest rates lower GDP, since they choke off investment -- that’s the “IS” part. On the other hand, higher GDP raises interest rates, since when the economy is booming, people try to take money out of banks so they can spend it, forcing banks to raise interest rates to lure money back.

The IS-LM model says that these two forces balance out to determine what GDP and interest rates are. It also says that if you increase government spending or have the central bank print more money, you raise GDP. Academic macroeconomists don’t use this type of model anymore, but most private-sector macroeconomists use something like it, and so does the Federal Reserve.

No. 7. Michael Woodford’s textbook

Mike Woodford, of Columbia University, is the most important academic macroeconomist in the world. I actually did have to explain his book in an essay for a class with Miles Kimball at the University of Michigan. The essay was assigned over spring break. Grad school stinks, folks.

The book is all about how the central bank can control GDP and inflation by changing interest rates. Basically, a lot of people already think that if the Fed raises interest rates, inflation goes down and growth goes slows (for example, under Fed Chairman Paul Volcker in the early '80s), and if the Fed lowers rates, GDP gets a boost but inflation looms. Woodford tries to provide a model for why that would happen.

No. 8. Modigliani-Miller

This is an economic theory that says that, under certain conditions, it doesn’t matter if a company funds itself with debt or with equity. Why? Because if a company doesn’t borrow money, its investors can just go borrow money instead, and use it to buy the company's stock. So either way, the amount of money a company can raise will be the same whether it tries to borrow money or sell stock.

Obviously this doesn’t work in the real world, but it’s interesting to think about, since it makes you think about why companies use more debt funding or more equity funding.

No. 9. The Heckscher-Ohlin theorem

This is a theory about trade. It says that countries with more capital -- industrialized countries such as the U.S. or Japan -- will tend to make things that are more capital-intensive. And countries with more labor -- such as India -- will tend to make things that are more labor-intensive. That’s why the U.S. makes a lot of semiconductors (which require huge fabrication plants), and India makes a lot of clothes.

You knew that, right?

So there you go. The mysteries of neoclassical economics explained in one Bloomberg View article.

(Corrects spelling of Heckscher in ninth item.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net