Oh my. Do DSGE economists really misunderstand the concept of ‘government consumption’?

Do DSGE economists really exclude ‘government consumption’ from their concept of household prosperity? Yes, they do.

Scientific economists explain ‘government consumption’ as follows:

Government acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community is called government final consumption expenditure (GFCE.) It is a purchase from the national accounts “use of income account” for goods and services directly satisfying of individual needs (individual consumption) or collective needs of members of the community (collective consumption). GFCE consists of the value of the goods and services produced by the government itself other than own-account capital formation and sales and of purchases by the government of goods and services produced by market producers that are supplied to households – without any transformation – as “social transfers” in kind.

Source: Wikipedia, which shows that this isn’t any kind of secret – it’s  has been ‘received wisdom’ since the fifties of the twentieth century.

Also, total, i.e. individual (education) plus collective (property rights) government, consumption is a well-defined and fully measured part of the National Accounts. It’s not like a fuzzy, unmeasurable, pre-scientific concept like neoclassical ‘utility’. Look here for the most recent Eurostat estimates of  what’s called ‘Actual Individual Consumption’:

>Actual Individual Consumption consists of goods and services actually consumed by individuals, irrespective of whether these goods and services are purchased and paid for by households, by government, or by non-profit organisations. In international volume comparisons of consumption, AIC is often seen as the preferable measure, since it is not influenced by the fact that the organisation of certain important services consumed by households, like health and education services, differs a lot across countries. This indicator is listed among the recommendations of the Stiglitz-Sen-Fitoussi report.

Nevertheless, this well-defined, state-of-the-art, received-wisdom and fully measured concept seems alien to many Anglo-Saxon trained economists. As pointed out by J.W. Mason, in a blogpost titled ‘The nonexistent rise in household consumption‘:

Did you know that about 10 percent of private consumption in the US consists of Medicare and Medicaid? Despite the fact that these are payments by the government to health care providers, they are counted by the BEA both as income and consumption spending for households. I bet you didn’t know that. I bet plenty of people who work with the national income accounts for a living don’t know that. I know I didn’t know it, until I read this new working paper by Barry Cynamon and Steve Fazzari.

And indeed. Some sentences in an article by Ellen McGrattan (from the Federal Reserve bank of Minneapolis) alerted me to the fact that the neglect and misunderstanding of the concept ‘government consumption’ causes a deep, sound, non-trivial bias to DSGE models. She states:

For another example, suppose, instead, that the ratio of government consumption to output s(g) falls. The fall in spending acts like a positive wealth effect that increases consumption and leisure. Thus, households work less, and the growth rate falls.

Wow. This is another way of stating that when the government cuts funding of primary schools people will start to buy more cars and take longer vacations, as the government becomes ‘cheaper’. In reality, of course, people will try to make up for lower government spending on primary education by paying more of it themselves – there will be substitution between private and public consumption. Especially low-income families won’t be able to compensate lower government consumption and will experience a dramatic decline in total (i.e. individual plus collective) consumption. The ‘representative consumer’ which inhabits the DSGE models of course prevents neoclassical economists from even being able to define inequality, in these models! ‘There are no poor families… (as we defined them away)’ – but that’s not even the point. Government consumption has a cost – but it also produces lunches, to paraphrase Milton Friedman.

I’ve checked the idea that DSGE models misunderstand and neglect the welfare effects of  ‘government  consumption’ by using my ‘default’ DSGE model, the New Area Wide Model (the pet DSGE model of the European Central Bank). And indeed: households use individual consumption to maximize utility, public consumption is absent from the utility function of the households (the crucial indicator is {Pc,t} on p. 12, which implicitly rules out collective consumption as part of total household consumption).

There may be DSGE models which do include collective consumption as an argument in the utility function. One of the problems with these models is their lack of empirical and conceptual discipline – there are hundred and maybe thousands different models, each with their own assumptions and definitions. They are not bound by anything like the Periodic table of the Elements, which means that each model has its own implicit definition of ‘rational expectations’ (though macro-economists do have something like the ‘periodic table’: the definitions and concepts of the System of National Accounts – they just do not use it!). Please comment if you know about such a model. Until then, I’ll just state that the negative welfare effects caused by cuts to government consumption (Greece, Ireland, Spain, the Netherlands, …) are excluded from the welfare concept of DSGE models which causes, even within the context of the flawed idea of ‘perfect intertemporal utility optimization’ a misspecification of the consumption function, as substitution between private and government consumption is excluded from the models.