The long run and short run of it

When you teach economics, you spend a fair amount of time dwelling on the distinctions between the short run and the long run.

If a firm is not making a profit but is meeting its short-run costs (e.g., wages, utilities), microeconomic theory says that the firm should continue in business rather than shut down.

In macroeconomics, we distinguish between the short and long run (and in some textbooks, the medium run) on the basis of what aspects of the economy are fixed and what are variable.  For example, if all workers received a 50 % wage increase tomorrow, they would all be about 50%  better off….for a very short time (how short depends on a variety of factors).  Once those higher wages were translated into higher prices, workers would have to pay about 50% more for everything that they consume and they would no longer be better off.  Thus, we say that the price level is “fixed” in the short run, but is variable in the medium run.  Things like the state of technology, on the other hand, are fixed for a much longer period.

Policy makers in the US and Europe have clearly demonstrated their confusion over this relatively straightforward concept, particularly in the fiscal arena.

  • Spanish lawmakers have taken steps toward enacting a constitutional amendment mandating a balanced budget.  Balancing the budget is a good idea; instituting a rule in the midst of a severe economic slowdownmandating that the budget be balanced  is not.
  • Europeans are pressing the Greek government to enact ever more severe austerity measures, even thought it is clear that there is little more that Greece can do to meet their demands without causing civil unrest.
  • In the US, Republican lawmakers–particularly Tea Party-affiliated Republicans–have prevented the enactment of necessary spending (e.g., extension of unemployment insurance benefits) on the grounds that this is fiscally irresponsible.  Achieving fiscal balance over a longer term is a good idea; forcing tight fiscal policies when we may be about to fall back into recession is foolhardy.

Most economists would agree that government budget policies in the US and Europe require substantial adjustment.  However, those who press for immediate resolution of those long term issues do so at the peril of ignoring the very real possibility of another severe recession.

The English economist John Maynard Keynes famously observed “in the long run, we are all dead.”  By confusing short-term and long-term problems–and remedies–budget hard-liners in Europe and the US are only making matters worse.