The International Labour Organisation… Almost Correct

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I have an article up on Al Jazeera this week. It may be the last journalistic article I write for some time as I start a new job next week. But this one deserves some brief discussion because the material it deals with is hugely important to the politics of the moment.

In the article I discuss a joint report by the ILO, the OECD and the World Bank. The ILO have clearly spearheaded this one. It has their fingerprints all over it. The ILO are pretty fantastic really. They are one of the only large-scale economic institutions that are talking sense today. Indeed, in the report the authors make a properly Post-Keynesian case for why the economy is stagnant: that is, it has to do with skewed income distribution and a low marginal propensity to consume among those in whose favour distribution is skewed in.

The problem, however, is that, like the trades unions that they represent, the ILO fundamentally buys into the deficit-scaremongering stories. They reflect the party line that we see in social democratic governments across the world: deficits are a Bad Thing and governments should be aiming at winding down their supposedly dangerous debt-to-GDP ratios.

It is ridiculous that center-left political parties, trade unions and the ILO often take this as their official line. Almost everyone I meet from these organisations know that it is a pile of silliness. So, why do they spout it in public? Honestly, I think it has to do with appearing as a Very Serious Person in public. There is still a taboo in place that requires people in public to pontificate on the Evils of government debt. Even though a lot of people don’t believe in this moral tale, they have to do it regardless.

After the Second World War the taboo was that no government official would be taken seriously who said that full employment was undesirable. In order to be taken seriously in public politicians and economists had to say that the primary economic problem was unemployment. Any scheme that was seen to generate unemployment was not taken seriously.

The question now is how we get back to that. Earlier this century it required a war. If the Great Depression and the current stagnation have taught us anything it is that capitalist democracies do not respond to problems of unemployment through their in-built institutional mechanisms. Even with very high rates of unemployment — say, 10%+ — the people that are unemployed do not make up a large enough voting constituency to force parties to adopt full employment policies. What is more, lacking leadership, this constituency are not all that sure what they should be voting for as they do not understand the nature of the problem.

Meanwhile, the left-wing and the workers’ organisations are weighed down by the stagnation of ideas to which they have succumbed. The left-wing, still believing that the early 20th century working class make up their key constituency, aim their rhetoric at anyone making upwards of £50,000 or £60,000 a year — when it is these people that they should be trying to win over. Indeed, the left-wing should just shut up about anyone earning less than about £120,000 if they want to sort out their electoral strategy. They would also do well to recognise that income distribution is not so much today to do with salaries as it is to do with asset holdings (CEOs paying themselves in stock options etc.).

In the meantime the labour unions have become over bureacratised and subject to ‘educated elite’ opinion through their hiring practices. Their ideology is the one derived from marginalist economics and typically has a vision of the union representative — now typically a well-heeled type from a major university who comes equipped with an economic degree — representing workers in a supposedly monopsonistic labour market. Yes, you can thank those lefties that bought into marginalist economics for much of the malaise in the ideology of today’s workers’ movement. Thanks boys!

Anyway, I rarely talk politics on this blog but these are the issues that we have to deal with if we want to get back to the old norms. Oh, and never trust a New Keynesian working in any nominally left-wing institution… ever. They do far more damage than you can possibly imagine. You only have to attend a few leftie trade union economic meetings to get a grip on that very quickly indeed.

Here is my article:

Global economic malaise driven by unemployment and low wages

Posted in Economic Policy, Economic Theory | 12 Comments

The Economic Consequences of the Overthrow of the Natural Rate of Interest

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For quite a few months I have, on this blog, been alluding to a paper that I had written which showed that the natural rate of interest is implicitly dependent on the EMH in its strong-form in order to be coherent. I have finally published this paper (in working paper form) with the Levy Institute and it can be read here:

Endogenous Money and the Natural Rate of Interest: The Reemergence of Liquidity Preference and Animal Spirits in the Post-Keynesian Theory of Capital Markets

Some notes on the paper.

The motivation for the paper was that when reading up on endogenous money during my degree I found that mainstream economists had largely integrated it in their more recent models. This integration, as the paper notes, usually took the form of a Taylor Rule. I should be clear that although this had become standard practice at some levels of the discipline most mainstream economists remained ignorant or confused (the famous Krugman debates were highly illustrative of this). Nevertheless, I found that the mainstream had conceded to endogenous money and yet, for some reason, they were not in agreement with Post-Keynesians on the implications for this in theory nor were they in agreement on important policy issues.

What I found was that they were able to avoid the important implications of endogenous money theory by resurrecting the loanable funds theory in a different way. They did this by effectively becoming neo-Wicksellian and replacing the exogenous money proclamations with the idea of a ‘natural rate of interest’. This device allowed them to keep the rest of marginalist monetary theory intact and served as a justification for the dangerous idea that the economy could be steered to full employment and prosperity through vigilant manipulation of the central bank’s overnight interest rate (I deal with the track record of that dubious policy here).

In my paper I show that such ideas implicitly rely on a strong-form EMH view of capital markets. Think of it this way: the central bank set a single rate of interest. Piled on top of this rate of interest are countless other rates of interest — the interest rate on mortgages, student loans, junk bonds, and so on. This ‘stack’ of interest rate will be affected by the central bank rate of interest but, and this is crucial, the spread between the central bank rate and these other interest rates are set by the market. The assumption of mainstream monetary theory is that the market will line each of these rates of interest up with their particular natural rate. So there the natural rate on each type of loan will be automatically hit by the market.

It is clear that what is being assumed here is that the market will price in all relevant information objectively. That, of course, is the EMH view of capital markets and it is one that has been completely refuted and dismissed by all relevant economists since the 2008 financial crisis. But once this falls apart mainstream monetary theory goes out the window with it. What we end up with is Keynes’ own monetary theory; one in which liquidity preference determines interest rates across the markets and animal spirits drive the rate of investment in the economy. These two key economic variables are now subject to the vagaries of human psychology.

I have since had the opportunity to try the argument out on a few very senior economic policymakers and former economic policymakers. The results have been very encouraging. They seem to see instantly the logic of the approach and how much damage it does to the mainstream theoretical underpinnings. They also see that this has massive implications for policy: it completely changes how we should understand central banks to operate and how economic policy should be managed.

No longer should we use the interest rate to steer economic activity. This will not work. In the last boom we saw the interest rates on mortgages remain low even as the overnight rate was rising and we saw animal spirits in the housing market cause overly high rates of unsustainable investment in this market. This is what the theory would predict: using interest rates to steer the economy will only result in speculative excesses and destructive boom-bust cycles.

While I do not outline the policy conclusions in the paper they should be familiar to Post-Keynesians. First, the interest rate should be ‘parked’ at some permanent low-level; somewhere between 0% and 2%. Secondly, central banks should have their role changed to (a) providing easy credit policies and (b) regulating excesses in potentially speculative asset and investment markets — I favour Tom Palley’s ABRR proposal here. Thirdly, the currency should be flexible but can be managed should needs require through central bank intervention in the foreign exchange markets. Fourthly, shortfalls and excesses in effective demand should be managed by government expenditure and taxation.

This, of course, outlines an entirely different regime to the present inflation-targeting environment. It is somewhat similar to the post-war arrangements but would probably be more aggressive if implemented with full force.

Posted in Economic Policy, Economic Theory | 24 Comments

Noah Smith Fumbles Argument, Endorses Post-Keynesian Endogenous Money Theory

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Economists say the darnedest things sometimes. They often say things that are factually inaccurate. Noah Smith put his foot in it recently when he claimed in a Bloomberg article:

It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.

Now, this seems odd to me. In the article he notes that Post-Keynesians and Austrians do in fact think that credit fuels economic growth. Given that many of these economists hold academic positions and publish in academic journals are we to assume that they are not among academic economists? We will give Smith the benefit of the doubt here and assume that rather than belittling his colleagues he is simply a fuzzy writer who would do well sharpening his sentences before professional publication.

But when I read that I thought it more than a bit curious. After all, don’t monetarists believe that in the short-run economic growth is dictated by the growth in the money supply? Hey, don’t take my word for it, here is Milton Friedman himself in his article famous ‘A Theoretical Framework for Monetary Analysis‘:

I regard the description of our position as ‘money is all that matters for changes in nominal income and for short-run changes in real income’ as an exaggeration but one gives the right flavor to our conclusions. (p217)

Or, if that isn’t clear enough for you try this quote from his paper co-authored with Anna Schwartz ‘Money and Business Cycles‘:

There seems to us, accordingly, to be an extraordinarily strong case for the propositions that (i) appreciable changes in the rate of growth of the “stock of money are a necessary and sufficient condition for appreciable changes in the rate of growth of money income; and that (2) this is true both for long secular changes and also for changes over periods roughly the length of business cycles. (p53)

Now, we must assume that Smith — being an academic economist — knows the formula for money supply growth. For those readers outside the citadel of academic economics here it is:

Growth in £M3 = Public sector borrowing – non-bank purchase of government debt + bank lending to the private sector + net external private sector inflow – increase in non deposit liabilities of banks.

You see those highlighted terms? Yeah… those would be credit growth. And since the monetarists thought that growth in M3 fueled — and, indeed, caused — real GDP growth in the short-run and nominal GDP growth in the long-run we can only conclude that credit does indeed fuel economic growth in monetaristland. Indeed, it even causes economic growth for the monetarists.

But here is where it gets even weirder: New Keynesians also believe that credit fuels economic growth! One of the defining features of New Keynesian economics is that it believes money is non-neutral in the short-run. You don’t have to be an ivory tower academic economist to figure this out either. You could just check the Wiki page for ‘New Keynesian economics’ which states in no uncertain terms:

New Keynesian economists fully agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions.

This is what led leading New Keynesian economist Greg Mankiw to state that New Keynesian economics should more properly be called ‘New Monetarist’ economics. You see, if money is non-neutral in the short-run then money growth does fuel real GDP growth in the short-run. And if the key component of money supply growth is credit growth then it follows that credit growth fuels GDP growth in the short-run for New Keynesians! This is all basic stuff that is given on undergraduate macro exams. How on earth can an academic economist like Smith get it so shockingly wrong!?

Well, actually if we examine his article carefully we see that Smith is just not writing clearly and that is what is leading to his confusion. He writes:

Here’s an alternative idea: Maybe credit is a follower, not a driver, of the boom-bust cycle. Maybe credit grows when the economy is growing, because of the need to finance investment, and shrinks when the economy is shrinking, because of the lack of investment. In retrospect, looking at a chart of credit growth vs. GDP growth, it might look like credit caused the cycle, but in fact it was just a passive tag-along.

Um… what!? Smith said earlier that academic economists “don’t instinctively believe in credit-fueled growth” but what he is talking about here is clearly… credit-fueled growth. That is, the growth is caused by other factors and fueled by credit! A car is fueled by petrol but driven by a driver. I am fueled by carbohydrates absorbed through my digestive system but my actions have something to do with mad electrical stuff going on in my brain. Smith’s writing is deeply and chronically confused. He has completely fumbled his entire argument by confusing the terms ‘to fuel’ and ‘to cause’. ‘To fuel’ is not ‘to cause’.

Interestingly, the argument that credit fuels growth but that growth is determined by other factors  like, as Smith says, “productivity changes, or changes in monetary policy, or changes in people’s sentiment and animal spirits” is the Post-Keynesian endogenous money argument. Here is a crystal clear statement from Post-Keynesian endogenous money theorist Basil Moore’s classic paper ‘Unpacking the Post-Keynesian Black Box‘:

The evidence suggests that the quantity of bank intermediation is determined primarily by the demand for bank credit. (pp538-539)

There you have it: the roots of Post-Keynesian endogenous money theory where credit/money is an endogenous variable. This is in contrast to, say, the ISLM where money/credit is an exogenous variable.

Smith is confused because, like most mainstream economists, he doesn’t know what he believes any more. Many of these people, for example, believed that the QE programs would drive (not fuel!) economic growth. But they were sorely mistaken. Now you see them fumbling around in the dark. Fortunately, they are arriving at the conclusions that heterodox economists arrived at decades ago. Welcome to the club, Noah, and please try not to insinuate that those academics who came to your own conclusions 40 years ago are not to be included under the heading ‘academic economists’. You may just be being fuzzy in your use of the English language but if this discussion has taught us anything it is that such fuzzy use of language can lead to substantial conceptual confusion.

Posted in Economic Theory | 3 Comments

Keynes’ Theory of the Business Cycle as Measured Against the 2008 Recession

cyclediagram

In this post I will explore Keynes’ theory of the business cycle. He discusses his views in Chapter 22 of the General Theory and I think they hold up pretty well today. At the beginning of the chapter he notes that the business cycle — so-called, because it is not really a “cycle” at all despite what Keynes says in the chapter — is a highly complex phenomenon and that we can only really glean some very general features of it.

Keynes opens with a very clear quote on what he thinks to be the key determinate:

The Trade Cycle is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital, though complicated. and often aggravated by associated changes in the other significant short-period variables of the economic system.

Recall that the marginal efficiency of capital (MEC) is basically the expected profitability that investors think they will receive on their investments measured against the present cost of these investments. The key component in the MEC is, of course, investor expectations. Keynes is clear on this and distinguishes himself from those who claim that a rise in the rate of interest is the cause of the crisis. He writes:

Now, we have been accustomed in explaining the “crisis” to lay stress on the rising tendency of the rate of interest under the influence of the increased demand for money both for trade and speculative purposes. At times this factor may certainly play an aggravating and, occasionally perhaps, an initiating part. But I suggest that a more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.

This is extremely perceptive and, I think, entirely correct. A rise in the rate of interest will typically precipitate a recession. In the US, for example, it is well-known that when the short-term rate of interest rises above the long-term rate of interest (i.e. when the yield curve is inverted) there will likely be a recession. (This is probably not, however, the case in other countries).

But the actual cause of the crisis is, as Keynes says, a collapse in the MEC. Consider the case of the 2008 recession. This recession was initiated by a fall in house prices which led to a fall in housing construction. Below is the number of housing starts plotted against the interest rate.

housing starts interest rateNow Keynes would argue that the causal chain went as follows: interest rates began to rise => the MEC of investors began to fall => eventually the MEC reached a threshold point at which investors stopped building houses. A recession ensued.

This is extremely important because the alternative interpretation is that the interest rate reached a point that it choked off credit demand for new housing. But this is not empirically valid. Take a look at the following chart plotting the same variables in the 1990s.

housing starts interest rate 2

In this period we see interest rates rise continuously — and, what is more, from a higher base — and yet housing continues to rise in lockstep. Clearly there is no mechanical relationship between housing starts and the interest rate. So, Keynes’ interpretation bears out: for some reason — and we shall not get into it here because it is very complicated — but for some reason in 2006 the interest rate rises triggered a collapse of the MEC among home-builders.

What happens next? Keynes says that liquidity preference shoots up quickly after the MEC collapses, the economy enters recession and the capital markets get nervous. He writes:

The fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse in the marginal efficiency of capital, particularly in the case of those types of capital which have been contributing most to the previous phase of heavy new investment. Liquidity-preference, except those manifestations of it which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.

The effects of this are actually more difficult to perceive today than they were in Keynes’ time. Today central banks will step in and quickly flood the capital markets with liquidity when liquidity preference rises. Nevertheless, in extreme cases — such as a liquidity trap proper when the central bank loses control of interest rates — we will indeed see liquidity preference rise and interest rates on risky assets shoot up. This is precisely the case in 2008. Here is a graph showing interest rates on interbank loans shoot up vis-a-vis highly liquid treasury bills (which are money substitutes).

TED Spread 2008Keynes is quick to emphasise that monetary policy alone will ease interest rates and this may help recovery, but it will not actually provoke the recovery. He writes:

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough. If a reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But, in fact, this is not usually the case; and it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.

Again, if we turn to the data from the 2008 slump this will prove the case beyond a shadow of a doubt. The following graph maps gross private investment, the unemployment rate and the central bank interest rate.

impotent monetary policy

Meanwhile in the background the government deficit opened up massively and Congress passed a massive stimulus plan. After this investment picked up — very slowly — and unemployment started to fall — again, slowly. Because the stimulus spending did not plug the investment gap after six years we are still not back where we were in 2008 in terms of employment and investment has just about clawed back its losses.

Some will point to previous recessions where the interest rate was lowered and investment shot up as proof that monetary alone might be sufficient to steer the economy. I would say to them: take a look at the government budget balance. In all the post-war recessions the budget balance opened up — usually through the automatic stabilisers — and it was this that propped up demand. In absence of this some of these recessions would likely have become depressions.

Keynes is aware that the Austrians might pick up on his theory and then add their own ideologically motivated analyses of what constitutes ‘good’ and ‘bad’ investments. He makes clear something that I have tried to emphasise in a paper that I will be publishing shortly: we cannot say that the private sector will allocate resources effectively if left alone because they are subject to irrational swings of mood and do not engage in rational calculations as the marginalists (and Austrians) assume.

It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources; — which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment. But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent. in conditions of full employment are made in the expectation of a yield of, say, 6 per cent., and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2 per cent. in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent. in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.

The final point we should bring out is the policy implications of this. Keynes favours that the central bank holds down the rate of interest and the government maintains full employment throughout the cycle. He writes:

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

I think that this is overly simplistic but certainly on the right track. We can hold down the general rate of interest so that money is cheap but then have the central bank exercise control particular rates of interest in markets prone to speculative bubbles by using Tom Palley’s ABRR proposal. In this scheme the central bank controls overactive investment markets but does not really hold responsibility for ensuring that economic growth be maintained continuously. That is the role of fiscal policy.

Personally I think that democracies are seriously flawed and politicians generally stupid and short-sighted. For this reason I would recommend building institutions that automatically open up the fiscal deficit in times of unemployment. Many welfare state institutions do exactly that — and we have these institutions, not politicians, to thank for ensuring that we have not entered a serious depression between 1980 and today. My favourite of such institutions is the Job Guarantee program developed and supported by Abba Lerner, Hyman Minsky and the Modern Monetary Theorists. But I recognise that this should be an open debate.

Posted in Economic Theory | 17 Comments

On the Two Departments of Monetary Macroeconomics

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At the moment I am doing some research for a project that I might be working on soon. The project will be to provide a useable introduction to Post-Keynesian theory for those working in financial markets. Actually, I hope to write a book on this in the future, so this project is something that I have been interested in for a long time.

The more I studied Keynes’ own work and the work of some of his better interpreters the more I came to the same conclusion: Keynes was first and foremost a financial or monetary economist. I knew that others had also come to this conclusion — Hyman Minsky famously comes to mind — but I was not aware that a great deal of work had been done in this direction.

In actual fact, it has. HM Treasury economist Geoff Tily released a fabulous book in 2010 on just this topic entitled Keynes Betrayed. It is well worth a look. You can trace Tily’s work back to Minsky directly. Tily had his PhD supervised by Victoria Chick who was, of course, a student of Minsky himself.

My interpretation of Keynesian economics proper is very much so in line with these economists. I have always thought of myself as primarily a monetary/financial economist. Many find this ironic because — like Keynes and Minsky — I am very skeptical about using monetary policy as a tool to stimulate the economy. I believe that central banks should mainly be concerned with regulating financial markets and ensuring that they do their job while government must steer the economy on a continuous and ongoing basis. And yet, I would say that one of my main preoccupations is the interaction between central banks and financial markets; between the money creation process and interest rate formation. Why is this?

I think of proper monetary macroeconomics as having two departments, as it were. The first department we might call the ‘foundations’. The foundations are, broadly speaking, what are dealt with in the Keynesian framework that is (used to?) be taught in macro textbooks. That is: the savings/investment/national accounts identities; the multiplier relationship; the marginal propensity to consume; the marginal propensity to import; the accelerator effect and so on. In proper Post-Keynesian theory we also add to this a few things, namely: the distribution of income and thus differing marginal propensities to consume for different income groups; the production structure of real life firms that builds in excess capacity and so on.

I rarely deal with these issues on my blog. There is simply so much literature on these that they are not a focus of my attention. Also, I think these problems are basically solved in economics. The mainstream may have gone off into DSGE lalaland but the work is already done. If you want to study it you can find most of it laid out for you. Serious economists who are not fooled by the charlatanism that rules in economics departments can always track this work down and, indeed, you often find applied economists falling back on some of it in the real world.

The nonsense that has permeated academic economics may be pernicious but it is not due to the fact that there is nothing superior; rather it is a combination of social ideology and the desire on the part of certain people inclined toward insulated puzzle-solving to try to make their second-rate understanding of mathematics say something important about the real world. Basically, people who would never usually be given any modicum of responsibility in society being allowed to sit at the King’s banquet table; the King then uses them as a justification for whatever policy he is deciding to pursue on any given day. Because they tend to have no idea what they’re saying and thus no real confidence in any actual statements about the real world they make they are extremely labile and easy to manipulate.

When I did some straight economic journalism I prided myself on being able to get quotes from economists that said precisely what I wanted them to say by simply playing a few quotes from authority figures off these economists until I got the quote that I wanted. All the other journalists knew similar tricks but they tended to have a list of economists that they knew would give different cookie cutter responses; the journalist would then select the economist that best fitted the ‘mood’ of the news story being written. I tended to find that you could get better quotes by simply playing statements off a single economist until they said what you wanted them to say; often this was exactly the opposite of what they had said when you first engaged them! Perfect pawns on the chessboard of ideological persuasion. Anyway, enough digression…

A more peripheral, but important, aspect of the foundations are theories of the price-level. In standard neo-Keynesian theory this is represented by a Phillips Curve. Taken in its original form — that is, the notion that there is a trade-off between wages and inflation rather than unemployment and inflation — is a useful starting point. But then we have to loop this back in with Post-Keynesian distribution theory. After that, theories of the price-level must be considered part and parcel of the second department of proper monetary macroeconomics.

The second department of proper monetary macroeconomics is, as it were, the building. The building is the superstructure of the whole device. The foundations simply establish certain relationships. We might almost say that these relationships — like the multiplier — are almost simple identities. Once we plug in a variable the outcome is known. The building or superstructure seeks to explain how these variables are determined. Why is, for example, income distributed in this way? What is the relationship between the interest rate and investment? And so on.

Much of this is solved by simply examining the empirics. Is there a relationship between the interest rate and investment? Well, look it up. You’ll find that there is not a strong relationship at all. But when it comes to the determination of interest rates we cannot simply ‘look it up’. Nor can we simply ‘look up’ the effect that changes in central bank interest rates have on the financial markets. That requires theory and that is what I am most interested in. It is also what Keynes and Minsky were most interested in. This, to me, is where economics is both most challenging and most interesting. It is also, I think, where you can most embarrass the mainstream of the profession whose theories in this regard are simply ideology proper. If you ever want to see an academic economist properly melt down in conversation just start discussing the guts of the financial markets with them.

What is so interesting about the second department of monetary macroeconomics is that in order to understand it you have to appreciate both certain logical relationships and a certain amount of institutional psychology. The latter causes the former to constantly shift. So, you often find yourself chasing an ever-changing chameleon. But although the chameleon changes its colours it is still the same underlying animal at all times. Something similar can be said about the financial markets. Once you understand certain logical relationships — often quite difficult ones — you have the keys on hand. But you have to be able to apply these keys, as it were, to a door that moves and shifts around. It is not the easiest practice but then who ever gave up on a challenge?

The two key concepts in the second department of monetary macroeconomics are ‘animal spirits’ and ‘liquidity preference’ of which I think the latter is most important. I will stop here because in the next week or two I have a paper being published that shows exactly how an understanding of these two key concepts completely undermines the mainstream macroeconomic theory that is prevalent today.

Posted in Economic Theory | 3 Comments

Scotland: After the Election and Moving Into the Future

scotland future

I have some writing to do today, so I’m not doing a post. Yesterday, however, I published a piece on Al Jazeera America about the future of Scotland after the election. It might be worth a read.

Scotland’s future is still in doubt

If you are interested in this issue — and I think that it is an extremely interesting issue as Scotland still has the potential to be a country ripe for economic experiment — I highly recommend the following piece by Frances Coppola. In it she plugs my dual currency plan but that is not the only reason I link to it. It is also a fantastic piece on the new trajectory that the Scottish government needs to take once Westminster devolves more economic power to them.

What Scotland Should Have Done (And Still Should Do)

Posted in Economic Policy | 2 Comments

On ‘Coherence’ in Asset Markets: Everything is Going According to Plan

futurama

The author of the Philosophical Economics blog has a post up that caught my attention on the supply and demand dynamics of asset markets. It caught my attention because it looked, at first, very similar to my own dissertation that was published in working paper form last year by the Levy Institute. At first glance the author’s approach looks very similar to my own: what he/she appears to be doing is trying to put together what I referred to in the paper as a ‘stock-flow’ approach to asset pricing. But as I read on I realised that the author was not doing this and what they were instead doing was reintroducing the old textbook supply and demand fables.

The key point at which this begins to happen is about halfway through the post. You can see it crystal clearly when he/she writes:

For buyers, let’s suppose that this price range begins at $0 and ends at $500,000.  At $0, the average probability that a generic potential buyer–any individual living in an apartment–will submit a buy order in a given one year time frame is 100%, meaning that every individual in an apartment will submit one buy order, on average, per year, if that price is being offered (to change the number from per year to per second, just divide by the number of seconds in a year).  As the price rises from $0 to $500,000, the average probability falls to 0%, meaning that no one in the population will submit a buy order at that price, ever.

I am unsure why the author uses the language of probability here. The same result can be derived by simply saying, for example, “as the price rises from $0 to $500,000 no one will buy a house”. This is the standard textbook exposition and it makes far more sense than using the language of probability. In reality there is no need to use the language of probability here. All the author needs to discuss is the number of people willing to buy at a given price; he/she does not need to discuss the probability that someone will buy at that price. That is a level of abstraction that is simply unnecessary and only obscures the underlying argument.

Anyway, whether deploying the language of probability or simply saying that at a higher price less people will buy an asset the author comes to the same conclusion. Namely, the downward sloping demand curve that we see in textbooks. The author then supplements this with the upward sloping supply curve by assuming that at higher prices sellers will offload more of the asset. The author then goes on to explain why they make this assumption:

Over time, buyers and sellers become anchored to the price ranges that they are used to seeing.  As the price move out of these ranges, they become more averse, more likely to interpret the price as an unusually good deal that should be immediately taken advantage of or as an unfair rip-off that should be refused and avoided.

Um, I don’t think so. In fact, as I discuss at length in my dissertation, prices in asset markets can very often call forth more demand. This is known as ‘speculation’ and is a key feature in financial markets. During the housing bubble in the mid to late-2000s, for example, people bought houses precisely because the prices were rising. They did this because they thought that they might be able to lock in capital gains as prices rise. Similar phenomenon can often be seen in the stock market and in many other asset markets. As I discuss in my dissertation (pp13-17) this completely overturns the market equilibrium framework that attempts to use as its base model the familiar Supply-Demand (S-D) cross diagram.

The author begins to realise this when he/she writes:

Anchoring is often seen as something bad, a “mental error” of sorts, but it is actually a crucially important feature of human psychology.  Without it, price stability in markets would be virtually impossible.  Imagine if every individual entering a market had to use “theory” to determine what an “appropriate” price for a good or service was.  Every individual would then end up with a totally different conception of “appropriateness”, a conception that would shift wildly with each new tenuous calculation.  Prices would end up all over the place.

Yes, in such a situation prices would end up “all over the place”… which is precisely what we see in financial markets! But what the author seems to imply is that this would be completely chaotic and any semblance of orderliness would break down. So, prices would go from $0.01 to $100 and back again in moments. Why is this not the case? Well, there are other somewhat stabilising forces in the market. They are stabilising forces that we see across society and they were well articulated by Keynes in his famous 1937 article ‘The General Theory of Employment‘. There he wrote:

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.

(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.

(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average. The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.

It is the third of these that is key — indeed, the other two are really just derived from the third. And it is this that ties back into the famous ‘beauty contest’ theory of asset prices that Keynes put forth in the General Theory when he wrote:

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.

Such behavior is known as imitation in anthropology, psychology and sociology. In psychoanalytical psychology it is known as identification. Whatever one chooses to call it basically everyone is in agreement that it is a key part of the socialisation process. Whenever we, as human beings, find ourselves in a new social environment we begin to imitate the behaviors of those around us by assuming — somewhat unconsciously — that they are somehow more ‘proper’ than ones that we might either create ourselves or arrive at by using our critical faculties.

This is what gives asset prices the modicum of stability that they display. It also accounts for the fact that bubbles can occur; after all, if the herd moves in a certain direction most people are simply going to imitate. It is this view of financial markets that I tried to get a grip on in my dissertation and I think it is a far better representation of actual asset markets than anything that incorporates the old S-D cross diagram. Indeed, using the latter leads to bizarre conclusions. The author of the post, for example, writes:

Housing markets represent an instance where these two phenomena–anchoring and disposition effect–are particularly powerful, especially for sellers.  The phenomena is part of what makes housing such a stable asset class relative to other asset classes.

He/she then produces a graph of nominal home prices that he/she claims shows stability in this market. Stability? In the market for homes? Really? The only reason that the author’s graph displays anything remotely resembling stability is because it is measured in nominal dollars and is thus pretty much constantly rising (as will be most graphs produced in nominal dollars). Here is a more realistic portrayal of the supposed stability of house prices (it is a largely stationary time-series which is the type that we typically use in statistics; the author’s own is non-stationary which is well-known to have misleading statistical properties):

house prices

That sure doesn’t look like a ‘stable asset class’ to me. It looks like prices bounce all over the place. They sometimes boom, rising up to almost 20% year-on-year, and they sometimes crash, falling nearly 10% year-on-year. Do we even need a chart to show this? Is this not intuitively obvious in a post-2008 world wracked by the consequences of property bubbles in multiple countries?

In order to get away from the type of thinking that is ingrained in us by learning the old S-D cross diagram by rote we need a different way of thinking about asset prices. While the approach I put forward in my dissertation was by no means perfect it at least pointed in the right direction. Thinking about prices in this way will ensure that we are not blindsided by bubbles in the markets. Because what the old S-D cross diagram and its derivatives really sell to the public is the vague notion that Markets ‘work’ and that whatever is going on in them at any given moment in time is sustainable (see Keynes’ points (1) and (2)). This, as I never tire of pointing out, is pretty much akin to a theological argument about a benign God that ensures coherence and justice in the world. Since what we are ultimately dealing with in both cases is belief there is no real logical cleavage between both types of ideas.

Rather than realising that prices rely on the beliefs that people hold about prices and, beyond this, that one’s own understanding of prices relies on the beliefs that one holds about the beliefs that others hold — scary thoughts that inject elements of arbitrariness into the way we organise our economies and our markets — people tend to fall back on some ‘fundamentalist’ vision that relies on the old Market metaphor. The Market provides coherence in a world the true structure of which is one of intertwined and interdependent beliefs. It is an easy way out and it stops reflection in its tracks by providing us with vague metaphors. But pretty as it is, it ain’t true.

Recent work by David Tuckett, a psychologist studying financial markets at UCL, and his team of economists and computer scientists has provided evidence that what people in the financial markets actually do when they think about problems is provide themselves with ‘conviction narratives’. These allow them to be confident about what they believe. Tuckett writes:

Our argument is that financial actors act by constantly and actively managing to modify in their mind s the threat uncertainty poses to their operations and ontological security. They do this by creating, proclaiming and maintaining what we call conviction narratives. Such narratives relate past and present to the future in an emotionally believable way and so manage day-to-day the cognitive and emotional elements necessarily and irreducibly created by decision-making under uncertainty. Constantly, but always tenuously, such actors have to create a sense of conviction as to their expertise, capacity to act and skill. They do it through developing stories told to themselves and others which combine (a) to exploit the opportunity element in uncertainty while (b), at the same time, to hold any doubts at bay. (p4)

If Tuckett is correct, and I think that he is, then the hoary old S-D cross diagram metaphor is what might be called the ‘master conviction narrative’. It is a key that turns any lock. Unfortunately, it does not open any door worth entering. Because what it really does it sell us the most simplistic of myths; precisely the ones that Keynes outlined in his 1937 paper. Everything is okay, everything will be alright, all will go according to plan. Or, as a Russian dissident poet once put it:

And the Perestroika is still going and going according to plan.
And the mud has turned into bare ice.

And everything is going according to plan.
And everything is going according to plan.

Posted in Economic Theory, Media/Journalism, Psychology, Toward a General Theory of Pricing | 14 Comments