Micro vs Macro

The difference between studying micro- and macro-economics is the difference between being easily influenced and easily influencing others.  In micro-economic studies you are looking at a small scale event, and so you can generally assume that most variables don't change much due to the event because if its small size.   Micro could be called the "all else equal" discipline because the stability of the greater economy allows you to isolate variables.  The converse is also true, you wouldn't want to conduct a microeconomic study in France from 1938-1950 because world events would dominate the data.  Macro studies should be focused on the opposite, macro events are (by definition) large and impactful, and thus macro investigation should be mostly about the feedback relationships caused by the event.  The obvious differences in how an event should be analyzed due to its size doesn't stop the overwhelming majority of experts on macro from using the tools that should be reserved for micro.

In a recent blog post Paul Krugman "investigates" the question- will a recently strong dollar be a drag on the US economy?  Let us skip to the last few paragraphs of the piece (emphasis mine).

In case #1, everyone sees the relative strength of US spending as temporary – either they see it as a one-time blip that will go away, or they expect the rest of the world to exhibit a similar surge in demand in the not-too-distant future. In that case the dollar doesn’t move, and the bulk of the demand surge stays in the US.

In case #2, everyone sees the strength of US spending relative to the rest of the world as more or less permanent. In that case the dollar rises sharply, effectively sharing the rise in US demand more or less evenly around the world. It’s important to note, by the way, that this is not just ordinary leakage via the import content of spending; it works via financial markets and the dollar, and happens even if the direct leakage through imports is fairly small.

So, what’s actually happening? The dollar is rising a lot, which suggests that markets regard the relative rise in US demand as a fairly long-term phenomenon – which in turn should mean that a lot of the rise in US demand ends up benefiting other countries. In other words, the strong dollar probably is going to be a major drag on recovery.

 You can read the rest of the piece to see that I am not taking anything out of context, but I will note that Krugman is specifically referring to a case where a country is at the zero lower bound to avoid any accusations of unfairness, though I don't think the distinction matters here.

Let me demonstrate the absurdity of the conclusion by extending the two scenarios into a future a little bit more while holding everything else constant.  In scenario 1 demand in the US rises relative to the rest of the world, and then falls back.  One way that this could happen is that there is an increase in demand in the US, with world demand staying at the same level, and then US demand declining.  Keynesians have a word for the decrease in demand, recession.  In the second scenario we would concluded that continually rising demand would cause a continually strengthening dollar.  Keynesians also have a word that starts with the letter R to describe a sustained increase in demand, recovery!  It gets stranger for the longer and stronger the growth in demand was in the US the stronger the US dollar would become, and so the more of a drag the dollar would become on recovery.  To sum up this position as succinctly as possible- a recovery (increase in US demand) will be "a major drag on recovery".

This is the extent to which micro style analysis (holding most of the world constant) can pervert your thinking in application to macro events.  Keynesians are probably the most frequent culprits of this type of error as their approach is extremely model heavy. Everything has to be aggregated and everything has to be expressed in a 1+1 = 2 type of way.  When their model predictions fail they are left reverting to "the world is different because of X", under condition A we use model B, under condition C we use model D, as we see in this piece as we swap from a normal time to a period at the zero bound.  What is conveniently ignored  is that policy makers lean more heavily Keynesian (not Keynesian enough! the cry always goes) than any other direction.  It is the adherence to model B that leads to the conditions where it no longer works.