Modern Economics, A Cursory Explanation

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My friend was writing an article explaining a few bits of contemporary economics to high school students, but he scrapped it midway through after realizing his hypothesis on a prisoner's dilemma causing a separation between theory and practice is manifested in public choice theory. I thought I would salvage some of his raw graphics and write up my own shorter explanation for the community here.

Caveat lector: this post simplifies some economic and financial theory to create an easily enjoyable experience for the everyday reader. I would love to see some discussion in the comments though.

Let's first posit the existence of business cycles (boom/bust, prosperity/poverty, bull/bear) just like economists before us have: Charles Dunoyer, Jean Sismondi, etc. This post uses a sin(x) function to represent the aforementioned vicissitudes for simplicity.

To counteract these naturally occurring cycles, Dr. John Maynard Keynes prescribed a dose of saving during periods of economic prosperity and spending during periods of economic prosperity.

The reasoning behind his remedy was that societies could sacrifice some of the upside during boom and reallocate it during bust to limit the severity of the negative period. His theory assumes an underlying premise that individuals are suspect to a diminishing marginal utility of money, meaning that the next dollar earned is worth less than the previous dollar. Likewise, the second dollar lost hurts more than the first dollar lost. As such, Keynesian theory doesn't change the "expected value" or long term well being of society, but it limits the movement in both directions.

Keynesian economics worked extremely well for the United States (controversial) in the FDR era, so the United States maintained a general policy of deficit spending ever since then. This means that the US spends during bear markets, just as Keynes would have it, but also in bull markets. This means that the US deficit spending policy isn't pulling money set aside from periods of saving, rather it's simply incurring greater debt each time.

Australian policy is just as weird and follows their stereotype of being an upside down country.

While it may appear intuitive to spend during the good times and save during the bad, it runs completely contrary to Keynes' counter-cyclical policies of saving during good and spending during bad. Here's a -sin(x) function for comparison.

I'm a firm believer that economics (utility maximization) drives decision making. Many individuals may loathe policymakers and label them as idiots, but they've at least managed to make it into office. Let's then assume, even if just for a moment, that they're perfectly rational beings. Why would they deviate from theory? Why do the Americans do it one way and the Australians another? Let's take a look.

Based on the model (which uses arbitrary numbers to illustrate the point), policymakers aren't following the books because there's a prisoner's dilemma. This means that as a whole, society is best off if both players just follow the damn book. The only problem is that most voters are "rationally ignorant", meaning that they don't necessarily understand the reasoning and ramifications behind all political decisions since it isn't worthwhile for them to do their homework given how diluted their vote will be. What happens then, is that the policy with short term gains looks sweeter. Id est, the perks of spending look much better than cutting back, especially when the economy prospers.

So that's why we spend during the good days.

Now why do the Australians save during the bad?
It's the same reason, really.
When the economy is in recession, intuition tells us to cut back on spending. Wouldn't a politician look like a total asshat if he suggested a nice fat budget to stimulate the economy? Yes, yes he would. Especially if another politician were recommending a budget cutting back. If the average Joe were initiated in the school of economics, perhaps we would see a different outcome.

Thanks for sitting through my $.02!
Thoughts? Was this useful? Let's discuss.