More work on the book today. And so no posts of substance which is unfortunate because there are a few things I want to write about at the moment.
Anyway, in the meantime I would recommend that people buy tickets for the Rethinking Economics conference in London and also the FT Alphaville Camp conference in London while they still can. These are ample places with which to fill your brains with many wisdoms as yet unknown.
Do it! Now!
Well, I’m still slaving away on the book. I hope regular readers will appreciate the fall-off in posts in this regard. The book will be worth it. I promise.
Anyway, the ever present drip of my publications elsewhere should prove to be at least somewhat satisfactory. I have two pieces in the latest issue of the Journal of Regulation and Risk North Asia. The journal features pretty big names from time to time — Elizabeth Warren is in the current issue and the likes of Adair Turner, Andy Haldane and my favourite economist Paul Krugman have appeared in previous issues — what’s more the journal gets circulation around the major central banks of the world.
So, the two pieces that I wrote are finely tuned to target that audience. The first short piece (on pages 59-63) is an argument against the existence of a natural rate of interest. This is a fetish that central banks need to give up ASAP. The second longer piece (on pages 195-206), co-written with my friend and colleague Thomas Dwyer, is about the challenges facing central banks in light of the recent upsurge in nationalist sentiment across the world. This article is particularly pertinent to recent developments in the Eurozone as well as in Scotland and ties into the debates around austerity and expansionist policies. There is actually very little written on this important issue as of yet. But if it gets any attention our article might go some way in starting that very important debate.
Here is the link to the Journal which has been made freely available online:
Still writing my book. But here’s one of those articles that I do find time to write because I get paid for it! This one examines the BIG policy versus rivals like the JG and the AFT.
Also, for those who read Swedish or have access to Google Translate here is an article on Ireland and the financial crisis that I wrote for a Swedish newspaper.
Sorry for the radio silence, folks. Still writing that book. Nearly half way done now. In the meantime the Levy Institute has issued my paper on the Scottish monetary system with a nice preface by Dimitri B. Papadimitriou.
Readers may have noted some absence on the blog over the past few days. This is because I am currently writing a book which seems to be sapping all my writerly juices at the moment. I have about a third of it done and I expect to finish it in about two weeks. During that time I would imagine that my posts will be sporadic.
Anyway, as part of the research for one of the chapters I was reading Keynes’ Treatise on Money. The book, while fundamentally flawed due to its Wicksellian (perhaps even New Keynesian!) framework, has a lot of interesting material that the General Theory lacks (not least a theory of profits). It is also cast, as GLS Shackle never tired of noting, in an explicitly dynamic framework rather than the inferior comparative statics framework of the General Theory.
Anyway, in reading the book one of the Fundamental Equations caught my eye as being particularly relevant to the present moment. The Equation is the following and can be found on page 137:
Where P is the price-level, W are wages, e is the productivity coefficient, I and S are investment and savings respectively and O is total output.
For Keynes this equation said that the price-level “is made up, therefore, of two terms, the first of which is the level of efficiency-earnings… and the second of which is positive, zero or negative, according as the cost of new investment exceeds, equals or falls short of the volume of current savings” (p136).
We can easily translate the early Wicksellian Keynes into the later Keynes of the General Theory by converting this equation into an equation laying out the components of effective demand rather than a price equation. We can do this simply by assuming that it is quantities rather than prices that may adjust due to a change in any of the terms.
Now, what does this tell us about our present moment. Well, in order to contemplate this take a look at this well-known graph for the US:
That chart maps out the ‘efficiency earnings’ variable of Keynes’ equation. And as we can see real wages in relation to productivity — i.e. Keynes’ ‘efficiency earnings’ — have been falling since the mid-1970s. In Keynes’ discussion in the Treatise on Money this would, ceteris paribus, entail a fall in the price-level. And if we read the equation in terms of quantity adjustments it would entail, again ceteris paribus, a fall in employment and output.
But then why hasn’t there been stagnation since the mid-1970s in the US. Well, if we take Keynes’ equation at face value then net investment must have been picking up the slack left by the fall-off in real wages. Keynes’ framework, however, ignore that the economy is open, has a government sector and that, crucially, money can be spent on final goods and services by a net change in debt. We can thus rewrite the equation as such:
We have made some fairly substantial changes here that we should probably explain. For one, we have replaced the term O with the more conventional term Y. We have also added time periods to highlight the dynamic nature of Keynes’ system in the Treatise. This was particularly important because (obviously) now that we have converted the price equation into a quantity equation we have the variable for output (Y) on both sides. Thus we must distinguish between them to show that they refer to output in different periods and thus cannot “cancel each other out”. Finally, we have opened up the equation to include a government and a foreign sector and added a variable, Cd, which denotes debt-fueled consumption.
Now we can speculate that the fall in efficiency earnings was probably counteracted by some combination of government deficit spending and debt-based consumption. (Note we also have to account for the US trade deficits in this year which produce a further drag on national income; thus we must assume high private sector debt levels and high government deficits or some combination thereof). When we turn to the statistics we do indeed see something quite like this. First, here are the sectoral balances of this period:
As we can see, it was mainly large government deficits in this period that propped up demand. But at the same time we also see the household debt burden rise relative to GDP. Here is a graph:
So there you have it! With a bit of modification Keynes’ old Fundamental Equations can be used to provide quite a nice account of the current stagnation in the US, which is basically a result of households pulling back on their debt-fueled consumption spending (and the reaction of investment to this loss of effective demand).
Well, a team at the FT under Chris Giles has claimed to have discovered serious errors in the data spreadsheets underlying Thomas Piketty’s work. A few housekeeping issues before I proceed.
First of all, I do not have the time needed to go through the spreadsheets to confirm Giles’ findings; I am not being paid by the FT to do so (offers to do so will be seriously considered however!). I am taking Giles’ data at its word. This is because Giles’ does not strike me as a hit piece at all. I think that him and his team have genuinely found what they claim to find.
Secondly, I pointed out that Piketty’s use of data was suspect after reading just a few hundred pages of the book. I was less so referring to the data used than in the manner in which it was used. Something that often gets lost in these debates about the accuracy of data is that data means effectively nothing unless you are careful in the manner you interpret it. Reading Piketty’s book I found numerous highly contentious interpretations of the data. That said, I can appreciate that we will all have our own interpretations and that the first step is to all agree on the data we are using.
The first thing to note is that Giles is dealing with the data on wealth inequality and not income inequality. The former is, and Piketty stressed this both in his book and in his response to the FT, far more uncertain than the latter. The ability to get data on wealth inequality is thwarted by any number of facts; from the reluctance of the rich to talk about their wealth holdings, to the fact that much wealth is held in a ‘dark zone’ overseas outside of the reach of statistical agencies.
That said, some of the errors that Giles uncovers are pretty embarrassing. Take, for example, the issue of averaging in Europe. Giles writes,
Prof. Piketty constructs time-series of wealth inequality relative for three European countries: France, Sweden and the UK. He then combines them to obtain a single European estimate. To do so, he uses a simple average. This decision (shown in the screen grab below) is questionable, as it gives every Swedish person roughly seven times the weight of every French or British person. Using an average weighted by population appears more sensible.
I don’t know why on earth you would use a simple average in this regard. This does not strike me as being a simple ‘fat finger’ error. Piketty must have thought about what he was doing. He must have said to himself, “oh, I’ll just do a standard average of these very different countries”. That seems to me a very silly thing to do indeed.
That said, the reconstructions that Giles puts forward seem to me completely out of whack. Here is the chart that he provides for wealth inequality in the UK. The blue lines are Piketty’s estimates, the red lines are Giles’.
From Giles’ reconstruction you would conclude that wealth inequality has not risen in the UK all that much since 1980. I have seen a lot of data related to this and I simply cannot believe this. It also does not really pass the ‘smell test’ — i.e. it does not really confirm with what we actually see day-to-day.
Consider the following graph from the BIS showing the evolution of the financial sectors in various countries from 1985-2006.
Since 1985 the size of the financial sector in the UK has increased by over 50% relative to GDP. It seems difficult to account for this rise of finance without assuming that there is far more idle wealth to be managed relative to GDP than there was in 1985. Since idle wealth disproportionately sits with the wealthy (otherwise they wouldn’t be called ‘the wealthy’, duh!) then we can only assume that wealth inequality has increased.
There are many, many ways of making this same argument in a roundabout way. All of the figures I have seen support the idea that wealth inequality has risen substantially in the UK. In fairness to Giles, he does admit this when he writes,
There is one important caveat. None of the source data at the basis of Piketty’s work is completely reliable. So while this post is clear about what is wrong with Piketty’s charts, it is much less certain about the truth.
Perhaps Piketty has mucked up some of the figures. But his is not the only study dealing with this issue. In that sense, I don’t think that this is a Reinhart and Rogoff moment that discredits the underlying thesis of Piketty’s book. Rather I think that it is just another lesson in data analysis for us all. Lies, lies and damned statistics, as they say.
In order to give an adequate definition of what has been called Keynesian kaleido-statics it is first relevant to define it against that out of which it grew. Keynes’ work, as has been noted many times, grew out of the work of Alfred Marshall. Keynes, in a very real sense, should be seen as an economist working in the Marshallian tradition.
What then defined the Marshallian tradition? Basically Marshall’s work was based on a partial equilibrium approach. The idea was to define an equilibrium position — that is, a position in which all activity had stabilised and come to a point of rest — and then change one variable while leaving everything else constant to see what effect this change had.
This was in contrast to the general equilibrium approach developed by Leon Walras. In the Walrasian approach systems were only really looked at from the point-of-view of full equilibrium. Walras and his followers were less interested in what changes might occur should one variable be altered and more interested in finding complete and total ‘solutions’.
In light of mainstream economics we might say that contemporary DSGE models, apart from being called ‘general equilibrium’ models are actually somewhere in between general and partial equilibrium models. When economists subject such models to random stochastic ‘shocks’ they are, in a sense, doing something similar to Marshall. But they are different from Marshall in that they always seek some sort of teleological ‘end point’ of general equilibrium. We might say that the difference is that while Marshall tried to deal with the movement of historical time — that is, time as it is experienced in the real world — DSGE modellers still do not aspire to do this and remain dealing with purified logical time.
Keynes took leave from Marshall on one very important point: he introduced expectations as not only an active element but the primary driving force behind economic activity. He utilised Marshall’s partial equilibrium method in the General Theory but he introduced changes in expectations that generated almost arbitrary points of partial equilibrium. This is why Shackle likened Keynes’ methodology to a kaleidoscope. In his book A Scheme of Economic Theory he writes,
There is a toy called a kaleidoscope, in which three mirrors face inwards in a tall pyramid and repeat in symmetrical reflections the random mosaic of colour formed by loose pieces of stained glass on the floor of the instrument. This toy seems strangely apt as an analogue of Keynes’s method. Even the randomness of the disposition of the coloured pieces at any moment of repose suggests the conventional character of the economy ‘at rest’. The economy is in the particular posture which prevails, because particular expectations, or rather, particular agreed formulas about the future, are for the moment widely accepted. These can change swiftly, as completely and on as slight a provocation as the loose, ephemeral mosaic of the kaleidoscope. A twist of the hand, a piece of ‘news’, can shatter one picture and replace it with different ones. (p48)
Each new formation that each different mosaic of expectations is, of course, a different employment equilibrium. Each of these employment equilibria is in turn generated by savings and investment decisions made by various people in the society and also by the society’s liquidity preference at any given moment in time. These in turn, as any cursory examination of the real world will tell you, are based purely on kaleidoscopic expectations. This is what Shackle calls the method of kaleido-statics.
There is also another method that, I think, supersedes Keynes’ method. That is what might be called kaleido-dynamics. This was developed by Gunnar Myrdal and Erik Lindahl from the work of Knut Wicksell. This method is similar to Keynes’s in that expectations — which are entirely contingent and, in a sense, exogenous to the system — play the key role in determining how the economy moves through time, but it also places an emphasis on dynamic movement. That is, it is not as concerned with each stationary employment equilibrium but rather the movement between them; a movement which, Shackle noted, Keynes never dealt with.
One of the key problems with mainstream economics today is its evasion of the fact that expectations play a key role in determining the trajectory of the economy. Mainstream economists evacuate expectations because they want rigidly deterministic systems that they can study. This is because, in the main, rigidly deterministic systems are the easiest way to apply a very particular type of mathematics to the study of the economy. In an interview Tony Lawson laid this out rather clearly when he said,
The first thing to note is that all these mathematical methods that economists use presuppose event regularities or correlations. This makes modern economics a form of deductivism. A closed system in this context just means any situation in which an event regularity occurs. Deductivism is a form of explanation that requires event regularities. Now event regularities can just be assumed to hold, even if they cannot be theorised, and some econometricians do just that and dedicate their time to trying to uncover them. But most economists want to theorise in economic terms as well. But clearly they must do so in terms that guarantee event regularity results. The way to do this is to formulate theories in terms of isolated atoms. By an atom I just mean a factor that has the same independent effect whatever the context. Typically human individuals are portrayed as the atoms in question, though there is nothing essential about this. Notice too that most debates about the nature of rationality are beside the point. Mainstream modellers just need to fix the actions of the individual of their analyses to render them atomistic, i.e., to fix their responses to given conditions. It is this implausible fixing of actions that tends to be expressed though, or is the task of, any rationality axiom. But in truth any old specification will do, including fixed rule or algorithm following as in, say, agent based modelling; the precise assumption used to achieve this matters little. Once some such axiom or assumption-fixing behaviour is made economists can predict/deduce what the factor in question will do if stimulated. Finally the specification in this way of what any such atom does in given conditions allows the prediction activities of economists ONLY if nothing is allowed to counteract the actions of the atoms of analysis. Hence these atoms must additionally be assumed to act in isolation. It is easy to show that this ontology of closed systems of isolated atoms characterises all of the substantive theorising of mainstream economists. It is also easy enough to show that the real world, the social reality in which we actually live, is of a nature that is anything but a set of closed systems of isolated atoms.
What Lawson refers to as ‘closed-systems’ inhabited by ‘atoms’ are the models of economists that have evacuated phenomena like expectations. If we take expectations into account then one individual’s decision is influenced by another individual’s decision. Most of these decisions react to what Shackle calls the ‘news’. People are thus not deterministic, closed off ‘atoms’ or Leibnizian ‘monads’. Rather they are open onto the world around them and they, in a very real sense, make their own history.
Lawson goes on to pin the blame for this, correctly I think, on the form of the mathematical constructions that mainstream economists use. He says,
The defining feature of modern mainstream economics, as I see it, is its insistence on methods of mathematical modelling. It is this dogmatism that both defines the mainstream and is the problem. I see nothing wrong with individual economists experimenting with mathematical methods here and there in the hope that in the contexts of analysis, the relevant conditions hold. The mainstream does not own the methods or approaches they employ any more than they own mathematics. There is nothing wrong with mathematical methods per se only with the manner in which they are used. The problem of the mainstream is one of application of methods in inappropriate conditions. Mainstream economists insist that their mathematical methods be applied to all problems. They fail to differentiate the conditions of legitimate and illegitimate application. So ultimately the failure is one of ontological neglect, no doubt grounded in a cultural-ideological presupposition that mathematics is somehow necessary to all scientific activity, understanding and rigour. In this they are just misguided.
This, in turn, is tied up with how economists see themselves as ‘scientists’ of a certain sort. They believe that doing ‘science’ involves forming these rigidly deterministic systems and then applying them to data. Without getting into the issue about whether economics is a ‘science’ like physics — I don’t think that it is — even in sciences like physics there is a dimension of taking the contingent human observer into account; as in the case of Heisenberg and his uncertainty principle or, to a lesser extent, Einstein and his relativistic physics.
Why then do economists equate their method with doing ‘science’? This, I think, is largely a mystery. It seems based almost wholly on self-assertion. My feeling is that many of the conclusions of mainstream economics are so preposterous that they have felt the need to insist very loudly that they are doing science (much to the amusement of real scientists, I should add). The irony here is enormous, of course, because every faction seems to think that they are the only ones doing real science. So, New Classicals think that their New Keynesian colleagues are unscientific and vice versa. Ditto for behaviorist microeconomists and their more classical colleagues. When science is defined arbitrarily it simply becomes a stick with which to beat the other side. Needless to say, the real scientific disciplines are not plagued by this particular problem; disagreements are not voiced by saying that the interlocutor is not engaged in science. In this sense, modern mainstream economics less so resembles a bastion of science than a circus in which the clowns have taken over.
In the comments to my piece on Janet Yellen the hypocrisy of my position was pointed out, as it so often is, by a certain reader of this blog. What was my hypocrisy on this particular occasion? It was the fact that I complained about Yellen’s obsession with ‘closing’ models but, in other circumstances, champion Godleyian Stock-Flow Consistent (SFC) modelling which, of course, contains models that have ‘closures’ of various forms.
I think that it’s worth talking about this in a little bit more detail. I should say right off the bat that my endorsement of SFC modelling is purely opportunistic. I know that there are many people out there who make their living by ‘closing’ models and I doubt that I will persuade them to stop doing this. SFC models seem to me a nice compromise in this regard because they are actually didactically useful in that the person who explores their properties absorbs key lessons about how the macroeconomy actually functions and the importance of the national accounts. Those doing marginalist analysis, say DSGE, on the other hand are simply absorbing ideology. In short, SFC models actually convey something about the real-world, while DSGE models are a form of brainwashing that basically lobotomise those who study them and render them useless as economists.
Anyway, I think a good way of approaching the broader question here is through the work of GLS Shackle. In his wonderful book A Scheme of Economic Theory Shacle discusses two types of approaches. The first is Keynes’ own approach which he describes as such,
The General Theory of Employment, Interest and Money is the most paradoxical of books. Constructed on a purely static and equilibrium frame of formal argument, it clothes this frame in a rich and suggestive mantle of ideas about expectations and their precarious basis and their extreme unstable sensitiveness to ‘the news’. In the present book I have had to find a special term to indicate this quality of Keynes’s though, and I have called it kaleido-static. The patterns in a kaleidoscope change abruptly to something totally different, yet, given the exact character of the twist imparted to the instrument, these patterns no doubt have their own internal logic. Keynes saw in the business world a succession of highly unstable equilibria. In his formal construction he described the equilibrium of each situation, in his powerful gloss upon this formal argument he explained their almost explosive instability. (p5)
Shackle notes that a similar approach can be found in Roy Harrod’s work on growth theory and the business cycle. Another great macroeconomist whose work exhibits these characteristics was, of course, Hyman Minsky. There is an argument to be made that Joan Robinson’s work also tended in this direction but I do not want to deal with this here because poor Robinson was a very conflicted theorist, constantly at war with herself in this regard.
Shackle also notes that there is another type of economic theorising. This is the type of theorising that he attributes to Keynes’ other followers. He writes,
The image of the leaping cataracts, with pools of stillness between them, which is suggested to me by the General Theory, or the analogy with the kaleidoscope already proposed, are far from the deterministic, mechanical, cyclical and above all self-contained models which sprouted in such profusion in the fertile seed-bed of Keynes’s work… Kalecki, Kaldor, Samuelson and Hicks have in succession opted for a ‘business cycle machine’ complete in itself, to which regular and therefore predictable oscillation is as natural as the tides or the seasons. These latter models give no place at all to expectation and have no use for expectational time, but exemplify in the purest form the concept of a historical pattern seen ‘from without’ by a detached observer in whose mind it exists as a simultaneously valid whole. These, therefore, lie at the extreme of the ‘mechanical time’ ranking. (pp5-6)
I think that Shackle is basically correct. When he speaks of ‘self-contained’ models he is referring, of course, to what I was calling models with ‘closures’; that is, closed models. Note that while Keynes’ discourse puts the reader in the drivers seat, in that it includes the reader in the economic world that is being thought through, the ‘business-cycle machine’ theorists try to take a sort of God’s eye view of the whole situation. This is precisely, in my opinion, how not to train working economists. Economists should be able to consider their own position within the framework of the theory they are using and if they cannot they will not make exceptionally good policy economists.
However, I think that we can also name a third type of model. And it is under this heading that the likes of the DSGE and representative agent models fall. It is these models that are generally referred to as ‘microfounded’ but which might more properly be called ‘hermetically-sealed myopia machines’. These push the ‘business-cycle machine’ models in a far more extremist direction. The ‘business-cycle machine’ models at least dealt with aggregates. This gave the theorist some scope, even in the God’s eye position adopted, to take into account contingencies in the environment and think these through. The ‘hermetically-sealed myopia machines’ close this off entirely. They give the user a set of a priori, dogmatic list of behaviors that people can engage in.
Once formulated, these behaviors are never questioned. They must be rigid and deterministic otherwise they cannot be defined and formalised. But these completely blind the person using them to the real world in all its variety. In fact, I would argue that anyone who takes such models seriously is not actually an economist. Or, at least, they are not doing economics. Rather they are engaged in pure thought experiments with literally no connection to the real world. What these people are doing is something halfway between engineering and theology.
So, what can we now say about models? Well, those that make the best economists and the most fertile theorists — that is, those that are best able to spot novelty which is essential for any good working economist and any progressive theorist — should adhere as best they can to Keynes’ kaleido-static approach. Or, if they so feel, they should engage in a form of kaleido-dynamics if they can manage it. This requires a great deal of irony on the theorist’s part and a distinct ability to recognise that Truth is a slippery concept and that all we can do is try to weigh up rather general arguments and see which is, ordinally, the most likely. (Yes, readers of Keynes’ Treatise on Probability will see something of his underlying philosophy of knowledge here…).
Those who are better at writing textbooks and engaging in instruction should try to build the best ‘business-cycle machines’ that they can. In my opinion, the Godley approach — which is an outgrowth of Kaldor’s and Kalecki’s work — is the most promising field of inquiry. Such theorists should be very careful not to stray too far from the real world. I think, for example, that Samuelson and Hicks committed this particular sin (Hicks largely recognised this, Samuelson was blind as a bat). But with some discipline I think that there is little problem if economists build business-cycle machines and use these for didactic purposes. (But don’t try to test these thought-experiments against the data, please!).
Finally, those who are inclined to the ‘hermetically-sealed myopia machines’ should pack up and move on. There are other disciplines where the skills involved in constructing complex, rigidly deterministic systems are required. Engineering is the most obvious example. People inclined toward this sort of theorising would be better placed in these disciplines. They pay quite well and if you fall into this skill-set you will probably find some satisfaction there, but you will not make a good economist. Indeed, as I said, I don’t think that what you will be doing can adequately be called ‘economics’ and you will likely just spoil the discipline for the rest of us and annoy potential students.
In a previous post I wrote about the key reason that the natural rate of interest does not exist. There I discussed the Kahn Multiplier. We saw that when investment increased consumption increased along with it due to the fresh income received from the investment spending. The increase in consumption was then multiplied out into the wider economy in accordance with the Kahn Multiplier. This increase in consumption must be met by productive capacity that is already in existence. In this post, I want to get away from the fantasy constructions that marginalists use and explain how the multiplier functions in the real world.
A nice way to introduce this might be to tell a story from my own personal experience. About a year and a half ago I was at a party with an old school friend. He is an engineer and he was at the time working as a supervisor on a production line at a pharmaceutical company. He, like many engineers and practical intelligent people, is quite skeptical about economics and economists. I told him that he would get a real laugh out of the economic theory of the firm.
When I described the theory of rising marginal costs and marginal revenue he laughed. “Are you serious?” he said, “Do economists honestly think that we could run a plant on that basis? That is completely absurd.” I said that I knew it was and then laid out the Post-Keynesian theory of the firm. Then he nodded and said “Yes, that is basically how it works. I’m glad some of you economists have a clue what you’re talking about.”
So, what is the Post-Keynesian theory of the firm? Well, Lord Keynes has laid it out in detail in an excellent post over at his blog entitled Price, Average Total Cost, Average Variable Cost and Marginal Cost. If you want a comprehensive exposition with full references I suggest checking this post out. Here I will just go over the bare bones.
The Post-Keynesian theory of the firm is best laid out by the following diagram.
So, what does this mean. Well, the UC-curve stands for ‘unit costs’. These fall over time due to increased economies of scale. That is, until the reach the point FC. FC stands for ‘full capacity’. I will describe this in a moment. We should note beforehand that the MC-curve, that is, marginal costs, is flat up to the point FC.
So, what is this point FC? That is full capacity. At this point costs will begin to rise. This is because workers will have to be paid overtime and machines will be operated for longer than they should be and will not get sufficient repair. The point FCth is theoretical full capacity. This is the point at which a plant will be literally pushed to the limit. I.e. when machines are literally operating at full capacity and no more units could possibly be cranked out of them.
Now, the important thing is that firms will typically be operating at the point where the MC-curve is flat and the UC-curve declining. This is because they build excess capacity into the plant. A typical plant, during an economic upswing will be operating somewhere around 90% of capacity. (My engineer friend reported that in the wake of the serious recession in Ireland his plant was operating below 80% of capacity which was exceptionally low).
The engineers build this excess capacity in to keep slack in the system. They know that the real economic world is tumultuous and so they have many ‘buffers’ in place in the production process to ensure that everything goes smoothly. Their nightmare is a plant operating at the point FC. For them to even consider their plant operating at the point FCth is, although an interesting thought experiment, a little bit ridiculous.
Anyway, back to the multiplier. When investment increases and consumption rises in line with the multiplier what happens is that some of this slack is picked up in the production process. Typically this will not lead to increased costs — indeed, it may even lead to decreased costs as economies of scale kick in. But during a major boom we might see plants reach the point FC for a short period of time. The main thing causing the rise in costs and hence in prices here will increased overtime payments.
This is, of course, why Post-Keynesians stress the wage-led nature of inflation over the demand-led inflation that many mainstream economists instinctively think about. When demand rises past a certain point, it is wages that rise first. These are then passed on to consumers in the form of higher prices. The process is not one where consumers go into supermarkets and start using their larger pay packets to bid up prices. That is ridiculous and only exists as an oddity in the minds of economists who never got away from Walras and his auctioneer.
So, that is how the multiplier works in the real world. When investment increases the inbuilt slack in the production process allows for the increased consumption without price inflation. This is not just in manufacturing plants either. Even barbers have inbuilt slack in the form of extra chairs in their barber shops. Again, prices will only start to rise if overtime is being paid for an extended period. The vast majority of the time, however, the economy is not up to the point of full capacity and wages will only rise in line with productivity growth. (Indeed, since the 1970s they haven’t even kept up with productivity growth!).
One more point. If the economy were kept at high full employment — I would estimate that this would be around 2-3% unemployment — for a very long period of time, maybe 5-10 years and this looked like it might be a permanent state of affairs, then producers would increase the level of excess capacity and hence slack in the production process. A new norm would be built into the production process. There is a chance that the level of high full employment could then be increased. We have never seen such an experiment tried before, however. Any time the economy has been pushed this hard — I think of wartime — wage and price controls were in place to manage demand directly. So, we do not know if such an effect would ever occur in the real world. It would be interesting to study, however. But these days we can barely even dream of even low full employment.
I just want to make a quick note on the multiplier and the theory of liquidity preference that is not generally recognised. When the full implications of this argument are recognised and integrated with marginalist theories of savings and investment (including the Austrian theory) these theories basically fall apart unless some very restrictive assumptions are put in place.
In his book The Years of High Theory, GLS Shackle sums up the problem of the multiplier nicely and succinctly as such,
The Kahn Multiplier multiplies extra income not matched by extra consumable output, and it is of no consequence to the people of one country, seeking a means to increase their own employment, whether that original extra income is generated by the extra output of tools, or of goods for export uncompensated by extra imports, or whether it is a free gift of the government or private philanthropy. Kahn chose road-building as his example, doubtless because it is unnecessary to explain that roads cannot be sold to consumers. (p186)
This gets right to the heart of the matter and Shackle highlights precisely the sentence that is most important so that I don’t have to. When investment is increased new consumer goods do not become available immediately and thus the multiplier effects generate income and consumption that must be matched by the current output capacity of the economy or else they will cause inflation.
Now, here’s the problem for marginalist theory: if the economy is operating at full capacity, as is the typical case in a marginalist model, then how does an increase in investment not lead to inflation? The answer is familiar to any undergraduate who has done his homework: the new investment must be stimulated by a rise in savings. The process here is conceptualised as one in which the causality runs, not from investment to savings, but rather from savings to investment.
Economic actors decide that they will decrease consumption and increase savings. This lowers the rate of interest and investment increases. Thus the multiplier effect that the investment produces is offset by the rise in savings that precipitated the rise in investment (in formal terms cY is offset by sY). Down the road, when the savers go to spend their savings they will find that the extra productive capacity that their invested saving has brought online will allow them to increase their consumption in real terms (i.e. without price increases)**.
Sounds pretty tidy, right? Well, it is… until you introduce Keynes’ theory of liquidity preference. Then the whole thing gets completely mucked up. In simple form the liquidity preference theory states that there exists pools or hoards of money that people hold based on their expectations of the future. When they are optimistic about the future they dump more of the hoards on the market, lowering the rate of interest; when they are pessimistic about the future they extract money from the market, raising the rate of interest.
This means that the rate of interest is no longer governed by the savings desires of economic actors. Rather it is governed by the money markets and the levels of confidence that exist therein. If this level of confidence becomes overly optimistic the rate of interest will be lowered and a boom will be produced. In this boom it is likely that many malinvestments will be made (think of the redundant real estate put in place after the housing boom in, for example, Ireland). These malinvestments will not cater to the desires on the part of savers to consume in the future and since the losses will only accrue to money that would have anyway been hoarded, consumption in the future will outstrip the productive capacity of the economy. Inflationary tendencies will result. In the opposite scenario, we will get deflationary tendencies***.
The key here is that these whims are not the result of some ‘intrusion’ by the central bank, as is the case in the Austrian Business Cycle Theory (ABCT). Rather, they are a natural result of the fact that in the money market it is expectations in the face of an uncertain future that reign supreme. This eliminates the idea of a natural rate of interest that can be arrived at through market processes. The only way of salvaging this notion is to assume some variant of the strong-form Efficient Markets Hypothesis (EMH) in the money markets so that all investors have perfect knowledge of the future and integrate this into their investment decisions.
Given that no Austrian worth their salt would accept this idea, the ABCT falls apart completely. As for the mainstream marginalists, only the New Classicals and the Chicagoites, with their highly artificial theories of the financial markets, have a coherent theory of a natural rate of interest. All the other schools accept that there are imperfections of varying degrees in the money markets. Thus all of these schools implicitly reject the natural rate of interest. But, of course, myopic as they often are, they still continue to use it in most of their models and most of their proclamations about policy. (Even Paul Krugman believes in a natural rate, as do many central bankers).
If we accept that there is no natural rate of interest what conclusion does this lead to? Well, it leads to the conclusion that a central authority should try to lean against the speculative impulses in the market. Given that these impulses are a response to the fact that expectations have to be formed in the face of an uncertain future, the central authority — that is, the central bank — should try to make this future as certain as possible by guiding interest rates. In practice, this is done by controlling the overnight rate of interest.
This is, however, a rather blunt instrument and we have seen in the past that it is not a good means to counteract speculative build-ups in specific sections of the financial architecture. If we accept the above argument then it would be far better for the central authority to intervene in different financial markets directly and give them guidance in accordance with their tendency toward speculative excess. The challenge for central banks moving into the future is to build tools that will allow them to do this. I have suggested what one such tool might be elsewhere. Another challenge will be to start producing the tools needed to try to identify speculative excesses in the markets. This, I think, is one of the biggest challenges that economics faces moving into the future.
___________________
**Actually, the process here is far from simple. The savings must come out of the profits accrued to the new investment. Thus there are some hidden mechanics here that, if they are explored in any detail, may well undermine the argument unless very restrictive and unrealistic assumptions are made. But we will not concern ourselves with this here.
*** Note that these are highly stylised arguments. In reality the dynamics are much more complex. But I am merely taking the models on their own terms here to make the case from within, as it were.
++ I have submitted a paper laying this argument out in far more detail to a journal. If it is published I will try to make it available here in the future for those interested to read.
Fixing the Economists 