A Theory of Consumption and Speculation to Round Out Sraffa’s Theory of Production

The other day I discussed the fundamental differences between the Sraffian and the marginalist systems. Since then I was perusing Sraffa’s Production of Commodities By Means of Commodities (full PDF available here).

It’s a very nice piece of work. Tightly argued, elegantly written and quite illuminating in many respects. It is also completely free of nonsense; the argument makes no outlandish assumptions about how humans behave or firms operate or anything of the sort. Now, as I said in the original piece: Sraffa’s is just a narrative framework for broadly conceptualising how the economy kind-of-sort-of functions. Those who draw direct inferences from the work about the really existing economy are seriously misguided; or, put more clearly: you cannot apply Sraffian models to reality.

I have been thinking, however, what the main objection to Sraffa’s work might be. It seemed to me obvious that there are three potential objections. The first — and most obvious — is outlined by the Austrian economist Bob Murphy in a post with the silly title Sraffa’s Production of Fallacies by Means of Fallacies.

Why do I call the title ‘silly’? Because Murphy doesn’t actually note any fallacies in Sraffa’s argument (hint: on its own terms, there are none). Indeed, the word ‘fallacy’ does not appear in the body of the text at all and no actual fallacies are noted. (I should say that in order to get a good basic overview of Sraffa’s argument Murphy’s post is not a terrible place to start).

Anyway, the actual issue that Murphy raises is the most obvious one and, I believe, was the one raised by the mainstream economists in the 1960s. He writes,

Despite his interesting approach and clever results, Sraffa does not succeed in overthrowing marginal value theory. Rather than replacing the modern focus on subjective decisions made on the margin, Sraffa simply assumes them away. For example, in the simplest case of a subsistence economy, Sraffa just takes it for granted that the people in this economy will continue to produce 400 quarters of wheat and 20 tons of iron every period, forever. But why should they do this? Suppose the people don’t like iron or wheat!  Or, more to the point, suppose the people discover a better use for their stocks of iron and wheat than to simply make more iron and wheat. How are the people supposed to break out of their subsistence mode in Sraffa’s world?

What is the answer to this question? It is rather simple: Sraffa’s is not a theory of consumption, rather it is a pure theory of production. One of the key problems with the marginalist argument is that they try to make their theories of production and consumption almost identical in form and content. But there is no real-world justification for this; in reality the two spheres are separate and should be theorised separately.

So, how might we conceptualise consumption to take place in the Sraffian system? Actually, I think this is pretty simple. In order to do so we turn to some variant of Old Institutionalist theory — I think in particular, for example, of the work of John Kenneth Galbraith. Here’s a schema for how we conceive the consumption side of the economy in this regard.

Basically, firms set their prices in line with the Post-Keynesian theory of the mark-up. The equilibrium in the productive sector comes about by the fact that inputs are a cost and so these are transferred directly into the pricing mechanism through the mark-up pricing mechanism. The amount of the ‘surplus’, as Sraffian theory calls it, is also arrived at by the firm’s chosen mark-up. We need not, as Sraffa assumed, think that over some time period the surplus is equally distributed across firms. Rather we should just assume that a firm cannot generally gouge too much profit without consumers switching to a cheaper competitor.

But this still leaves Murphy’s question unanswered. How do the firms know when to sell different products without market demand signals that transmit information through price? Simple. As the Old Institutionalists knew well, they do this through surveys and market research. This is how things work in the real-world. Firms come up with new potential products and then they engage in extensive market research. If the market research shows that the new product will be popular they produce it; if the market research shows that there will likely be no appetite for the product it is not produced. This is precisely how things work in the real world and it allows for innovation without any need for marginalist-style price-signals.

The second potential criticism that may be put to Sraffa’s framework is more difficult but not, I think, unresolvable. It is basically this: through the use of marketing firms can actually raise prices on products that are otherwise identical. If we take two pairs of running shoes that have identical inputs but one of which is made by a firm that convinces a sports celebrity to wear them in public, that firm can charge a higher price for their shoes.

We can integrate this, however, if we go back to what we discussed above; namely, the idea that the surplus is not evenly distributed across firms. Some firms will always figure out how to get disproportionate amounts of the surplus and clever marketing techniques are one way of doing this. While it is tempting to view this as a sort of monopoly I think this is misleading — indeed, to even discuss monopoly in Sraffa’s system seems to me misleading. Rather we should see such actions as the Old Institutionalists did: as innovations that rest upon persuasion and power.

Note that this interpretation of Sraffa’s system means that we cannot allow for it to be an endorsement of the hoary old labour theory of value. In this interpretation value is subjective in two ways. First, because people have a substantial input into what they ‘value’ in the form of market research. And second, because there is an element of persuasion in the marketplace which gives rise to people valuing identical products for their purely symbolic attributes. (I have written about this latter aspect in more detail here).

Finally, there is the third objection. This objection, I think, is by far the most serious and it is this one that my own work seeks to address. This objection is basically as follows: prices can actually be subject to speculative pressures. In Sraffian language: if a person uses their share of the (monetised) surplus to bid up the price of a given commodity by buying it and hoarding it in order to increase their monetised surplus by reselling it at what they hope to be a higher price then price dynamics can be driven in this manner too.

This is more damaging to the Sraffian theory because Sraffa is very careful to try to evade questions of supply and demand in his work. But these simply cannot be avoided if we take into account the dimension of speculative price dynamics. Thus while Sraffa’s theory can provide the “base” of a general theory of economic production, an Old Institutionalist theory of consumption must be grafted on as a sort of “superstructure” together with a theory of speculative price-dynamics. I have, of course, been endeavoring to create such a theory of speculative pricing. And while the theory is by no means complete, the underlying structure is very much so in place.

Again, however, we must stress that the attempt to interpret Sraffa’s theory as being a labour theory of value theory becomes impossible. With a speculative component value becomes subject to the beliefs of investors/speculators facing an uncertain future. A piece of land or a house, for example, become worth simply what people think them to be worth at any given point in time.

As we can see, if we join Sraffa’s theory of production with the Old Institutionalist theory of consumption together with my own theory (still a work in progress) of speculative price-formation we get a far more realistic narrative about how the actual economy functions than we do in the old marginalist story. Yes, marginalist economists may object to this narrative because it disagrees with their own. But unless they can come up with compelling evidence that, for example, firms respond more so to price signals than to market research findings when opening up new product lines, or that speculative price-dynamics are unimportant to the functioning of capitalist economies, then they will only be arguing through recourse to pure self-assertion. But then, I suspect that this is precisely what they have been doing since the late-19th century.

Judge, Jury and Executioner: More Moralistic Cant From the High Priests of the Austrian School

Well, the money cranks have weighed in on my last article on the gold standard. The response, which didn’t actually link to my piece as is customary in such debates (does my interlocutor not wish that his readers might read the original lest they spot the egregious errors in his own post?), is what you would expect it to be. It’s lengthy, self-indulgent and highly moralistic… in other words: its Austrian economics at its finest!

Funnily enough the author engages in what can only said to be an act of disavowal. The author, for example, insists that he is not engaged in moralistic cant when he writes (I quote using .jpeg because I don’t seem able to copy and paste from the text of this website),

So, the author is making the case that he is not engaged in moralism or baking normative judgements in supposedly positive statements. In my last post I referred to the Bank of England’s analysis of the money creation process. Well, the author of the post ‘engages’ with this analysis in manner that… well… I’ll let the reader judge for themselves whether the following is the cool and balanced positive analysis that is characteristic of good monetary economics or is instead a deeply moral and normative series of statements about an institution that the author finds aesthetically objectionable.

Yes, that’s right… central bank operations are equivalent to fraud. By whose legal standards? By the author’s own, of course. What the author has done is constructed his own little legal system in his head. He then goes around judging various institutions by his own legal standards. He is powerless legally, of course, but that’s not the point.

This is a bit like when Austrian nuts tell you that taxation is theft. And when you ask them why, if taxation is theft, taxmen aren’t regularly defending themselves in the dock they start to grumble nonsensically about some fantasy legal system they have invented in their own minds. It’s all normative, moralistic rubbish of course, but that’s the nature of the game.

A good deal of the rest of the post is all nonsensical ruminations on the nature of ‘value’ and speculation on a wholly invented history (anthropologists call fictional historical accounts like this ‘myths’). It’s all just a big story peppered with half-baked metaphysics and sprinkled with implicit normative judgements. It is on these metaphysical foundations — highly speculative, mythic, story-telling basically — that the author builds his little castles in the sky by which he castigates the evils of contemporary institutions. It is only people of a certain type of emotional disposition that will buy into these arguments, of course, and so there is very little point debating on their terms.

The author also claims that Keynesian theory is “very sketchy” on the question of hoarding. We can only assume then that the author has never formally studied economics because, as every undergraduate knows, Keynes’ theory of liquidity preference is basically a theory of hoarding. Here is Keynes in the original,

The concept of Hoarding may be regarded as a first approximation to the concept of Liquidity-preference. Indeed if we were to substitute “propensity to hoard” for “hoarding”, it would come to substantially the same thing. (General Theory, Chapter 13)

He also says that Keynes thinks that “stable discount rates meant stable prices”. This is complete garbage, of course, as anyone who has read How to Pay For the War can attest to (good summary here and here). Keynes viewed inflation as having largely to do with distributional factors — especially surrounding nominal wage increases. But this is a less egregious mistake than claiming that Keynes’ views on hoarding are sketchy as proper Keynesian inflation theory is no longer taught in classrooms.

The author also says that I “take the side of the Bullionists” against the Banking School in the last post. In this regard, I simply don’t think that the author read my post at all closely and I shall not pursue this line of argument — if he reads the last post again he will note that I never mentioned the Banking School because their views were irrelevant to the specific point that I was dealing with. My rule is generally: if you can’t understand what I’m saying even after I have clearly written it down then I am not interested in your “rebuttal”. Anyway, I get the impression that the author of the post prefers monologue to dialogue so I see little point in trying to communicate myself any more clearly than I already have.

I do not, however, want to come across as the author of the post; that is, in lecturing my interlocutor on my views. That is altogether tedious and I have no interest in doing so.

Finally, the author circles back to my saying that monetary systems are a creature of convention. He then says that no, in fact they are a creature of force because they are put in place by the State. This, again, simply reflects the author’s own moral or metaphysical views about whether there should or should not be a state issuing fiat money. What I call ‘convention’ because I am relatively content with contemporary forms of social organisation, the author calls ‘force’ because he is not. Who is ‘correct’ in this regard? Well, that is subjective. So, there’s no real point of debating it.

Summing up, there is nothing of substance in the response. All the arguments are ultimately traceable back to whether you agree with what I refer to as the conventions of the contemporary monetary system (or ‘force’ if you insist on a more evocative nomenclature). If you accept these conventions you can move on and do some actual economic analysis. If you do not you can engage in social protest and construct ever more hackneyed and irrelevant mythic and metaphysical justifications for your subjective views.

There is no debate to be had here. It all depends on your emotional temperament. If you are by nature a practical person you will accept the current system for what it is and then pursue your goals within it. If you are by nature a person who prefers, as I called it in the last post, “self-enforced social isolation” then you will join the New Austrians and create your myths and your metaphysics that justify the particular lifestyle that you have chosen. It is up to you, dear reader, how you wish to proceed. But if you decide on the latter course of action I suggest you remove my blog from your bookmarks… because you won’t find much of interest on here.

Why the Value of Contemporary Money is Not Dependent on the Value of Gold

I note that there is oftentimes confusion today when the gold standard era is brought up. The reason for the confusion when discussing this era is because the monetary system functioned in an entirely different way. The confusion goes two ways; both from the past to the present and from the present to the past. Austrian-style economists and gold bugs tend to project the manner in which the 18th and 19th century monetary system functioned onto today’s world. While more modern theorists tend to project the way that the monetary system of today’s world works back onto the system of the 18th and 19th century.

I’m not going to lay out how the contemporary monetary system functions here. Sorry, Austrians, but you’re going to have to do your own work in this regard (try the Bank of England here). So, I will assume that readers are familiar with what might broadly be termed the theory of endogenous money creation and/or interest-rate targeting through Open Market Operations (OMOs) in a flexible exchange-rate system (or even, to some extent, in a pegged system). I will draw on a rather nice account that is laid out in Roy Harrod’s book Money. (Note that some of the discussion in this book is otherwise rather confused).

Under the gold (and silver) standard systems, as everyone knows, money was convertible into precious metal. The central authority set the official rate of conversion and the market adjusted to this. When the gold price, for example, fell in relation to money, gold would flood the public mint to be converted into money. The opposite happened when the gold price went above the value of money; i.e. money would return to the mint to be converted into gold.

In a gold standard system the effects of new money issuance will be primarily on the value of the currency vis-a-vis the value of other currencies. In a floating system, however, the issuance of new money has its effects, in the main, on the rate of interest. All other effects that it has are purely secondary.

This is not actually a question of theory. Rather it is a question of definition. In a gold standard system — that is, one in which all countries are in some ways linked to gold — all value is defined in terms of gold. Thus if your currency is unstable with reference to gold then it is unstable period. Gold is the central point of reference. But this is only due to a definition — or, more properly, an edict put in place by an agreement between members of a monetary system.

In this regard, an example from the so-called Bullion debates in instructive. These arose in response to the move by England, in 1797, to a temporary fiat system of money issuance in response to growing military spending. When the move to the fiat system was undertaken the value of the pound fell in relation to gold. The Bullionists, like Ricardo, claimed that this was due to too much money issuance. They said that because the Bank had increased the money supply this had led to a fall in the value of the currency. This is today known as the ‘quantity theory of money’. The Bank, however, protested. They said that the value of money had not fallen at all. They said that, rather, the price of gold had risen.

Let us stop here. The Bank were actually incorrect even on their own terms. I will not get into why this was here. Rather I want to sidestep this issue and discuss the fact that this entire debate was primarily about definitions. In this regard, Harrod wrote,

The contention [by the Bank] is clearly open to a terminological rebuttal. We might say that, in relation to a gold standard, we define a depreciation of notes as a fall in their value in terms of gold, so that a high price of gold bullion was conclusive evidence of a depreciation; this could be reinforced by reference to the fall of sterling in terms of other currencies in the foreign exchange markets, and by the fact that the price of gold had not risen in terms of other currencies still convertible. (pp28-29)

This is what is really at issue here. It is the very fact that we are talking in the frame of reference to the gold standard that the Bank is wrong in saying that the pound had not depreciated but rather that gold had appreciated. What gives us the right to talk in this specific frame of reference? Simply that most other countries were on a gold standard and that this is what facilitated trade. In such a system of reference, even if the pound ‘floated’, we can still gauge the value of the pound with reference to the value of gold.

Thus in this frame of reference the quantity theory of money is (if we broadly ignore the velocity of circulation and the question of inflation) in some sense true. Or, at the very least, it will be true in relation to question of foreign exchange. Why? Because if a country issues too much money then there will be insufficient gold reserves to back this money up. The country will then be forced off the gold standard and the currency will be worth less than the market value of gold. In turn, the money will be worth less than all the other international currencies as these will still be fixed to the value of gold. (Note that once the gold standard is abandoned this relationship is in no way mechanical or ‘linear’ and in that sense the quantity theory becomes misleading once more).

The problem today is that some — I think of the Austrians, but also some quantity theorists — are still thinking with this frame of reference in mind. In extreme form some claim that when the gold price rises this proves a fall in the value of money. But they are committing the same fallacy as the Bank of England in the Bullionist debates. Namely, they are discussing the value of the currency outside of the dominant framework of reference. Because the value of international currencies is no longer defined in terms of the value of gold — i.e. because by general agreement countries do not use gold as a reference point — when money devalues in relation to gold this only has bearing for those who hold gold. It has no general macroeconomic bearing on the actual value of the currency.

This is rather amusing because it is in their very insistence on disagreeing with modern conventions for moral or metaphysical reasons (i.e. they think that the current fiat system is ‘Bad’ by the criteria of their own metaphysical ruminations) that they end up making simple factual errors. Because money is a creature of convention and common agreement then it follows that if you disagree with the actual, objective system of reference in existence at any moment in time — that is, if you disagree with this because you ‘don’t like’ contemporary convention —  then you are simply factually wrong.

It’s a bit like inventing your own numerical system because you ‘don’t like’ the existing one and then debating with someone who adheres to the decimal system. You are wrong by default simply due to the fact that the decimal system is the one that the vast majority of people use today. Thus in adhering to some sort of moral or metaphysical view of money rather than a pragmatic one, such thinkers and theorists are simply engaged in a sort of self-enforced social isolation. And as society continues to ignore their fringe moral and metaphysical views they find that their theories do not fit a world in which dominant conventions rule the day.

Why Economists Fail to Make ‘Rational’ Judgments and Why You Should Too

Recently Cameron Murray directed me to an interesting paper entitled Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science. The paper surveyed a whole bunch of professional economists to see if they could answer a basic question on the microeconomic theory of the ‘opportunity cost’.

The results were not so good. They are laid out in the table below — note that there is only one correct answer!

Most of the profession viewed this as some sort of failure of economic education. So too did Murray on his blog. But I’d like to put forward a different interpretation: what if the entire technical idea of opportunity cost is a load of rubbish?

What do I mean? Well, in order to get where I’m coming from take a look at the question that was asked.

The correct answer is B, by the way. This is because we have to take the subjective value of the Dylan ticket into account, that is $50, and then subtract from it the actual cost of the Dylan ticket, that is $40.

This, as we shall see, is a very particular way of measuring worth. Indeed, it is little more than an accounting trick based on a priori definitions (opportunity cost = potential utility – actual cost) that tells me nothing of substance about the subjective valuation. I can just as easily come up with a new accounting definition; this is entirely arbitrary.

So why do I say that the results prove the theory to be garbage? Well, because each question got somewhere around a 25% response rate. They seem to be, as the paper notes, basically randomly distributed.

And why does this imply that the theory is garbage? Because in microeconomic theory people are supposed to maximise their subjective utility. In order to do so they obviously have to be able to calculate the opportunity cost of forgone purchases. But if economists cannot even do this then why would we expect anyone else to do it?

Let’s go one further. Let’s assume that all of the economists had a vague notion that opportunity cost meant “amount of utility forgone in order to gain another amount of utility”. Then we can also infer that all the economists had different subjective conceptions of how much utility they were forgoing in order to go to the Clapton concert.

This is not actually unreasonable. I can see how people could view this in different ways. I could say, for example, “well the Dylan ticket is worth $50 to me, so I’m giving up $50 worth of utility to go to the Clapton concert”. Indeed, according to the responses this seems to be what most of the economists thought.

Alternatively, I could say to myself, “well, I prefer Clapton to Dylan so I’m not really giving up any utility at all because I don’t care much about counterfactuals or alternative universes”, in which case I would choose answer A. This all depends on how I view placing worth in something which ties back to the idea I put forward earlier that the a priori accounting definition underlying the question is arbitrary.

While only one answer is correct given the definitions laid down in microeconomic theory, this does not mean that any of the choices made by the economists when they placed themselves in the subjective position of the concert goer was incorrect. They simply manifest different manners in which different people order their preferences.

The way that I order my preferences or you order your preferences is not subject to objective judgment. If I choose to view the Dylan ticket as being worth $50 and hence that I am forgoing $50 worth of enjoyment to attend the Clapton concert that is my business, not your’s. (I can even make a pseudo-sophisticated argument based on the fact that I have very limited time and that carrying an extra $40 in cash with me to the Clapton concert does not yield me any utility at all).

This ties back to the tone of the paper. The tone fits into what I have said before about marginalist microeconomics being a manifestation of normative ethics. You can see that the authors of the paper are chastising the economists for not… choosing as economists should choose. This implies that their training should have made them choose in a predetermined manner.

The point is that the idea of opportunity cost is counter-intuitive to how many people (apparently 78% of economists!) actually think when they are weighing up their subjective preferences. This casts serious doubt on whether any theory of behavior based on it is useful for describing the real world. What’s more, trying to subject people to a normative view of how they should view this is an act in moral indoctrination. It has little to do with economics in any sense I understand that word.

Has the UK Got Another Property Bubble?

I note that Lord Keynes has a post up on property prices in the UK in which he says that they’re in a bubble. I’ll get to that in a moment but first I want to show how messy the statistics are.

Lord Keynes uses Steve Keen’s statistics that are taken from the BIS Property Price index. I worked with this index last year as a research assistant and all I can say is that it is a total and complete mess. This is not the BIS’s fault, rather it is due to the size of the database. Frankly, I think the BIS was a little over ambitious putting it together.

To get an idea of how bad this database is let’s take a look at two measures of UK property prices contained within it. In fact the database has a total of five measures but I want to highlight the most inconsistent. (Click for larger image).

As we can see, these two data sets tell very different stories. Exhibit A tells us that property prices have stabilised since they crashed around 2006-2007, while Exhibit B tells us that they are back up to their 2007 peak. Obviously one would draw very different conclusions about the state of the market from each graph.

Now compare these against what I think to what I think to be a far more reliable (and extensive) database, namely the Nationwide House Price Index.

Here we see a story somewhere in the middle: while prices have not quite reached their 2007 peak they are nevertheless very nearly there. Indeed, as we enter the 2nd quarter of 2014 they might well hit that peak. This strikes me as being more realistic than the BIS data.

Using the Nationwide data we can also break down the data by region. This is very, very instructive. I have laid out this data below. (Again, click for larger image)

As we can see, it is the London property market that has bounced back most robustly. Indeed, it has even topped its peak. We also see that the Northern Irish property market — which underwent massive bubble-dynamics and sank completely — is probably more so tied up with the Irish property market than it is with the UK.

So, is there a bubble? This is tough to say. Across the UK I do not think that there is yet evidence of a true bubble. It seems to me that the property prices will have to accelerate a little more before we can say that. But London is a different question altogether. The acceleration of prices that we saw after the crash in London does exhibit bubble-dynamics.

Let me, however, give a potential alternative: what if this isn’t like a typical bubble? In a typical bubble borrowers borrow money and pour it into the market. But when they start to be unable to meet their loan repayments defaults occur, foreclosures follow and prices tank.

But the London property market is being driven by the rich. They seem to be using London property as a safe investment in a volatile, low-yield investment environment (a result of the QE programs). This doesn’t resemble a classic bubble. It seems to me that as long as the rich continue using high-end property as an investment then property prices can continue to climb.

There is, however, another consideration: what about when the people at the bottom of the market get truly priced out of buying? There is then a potential that demand might collapse at this level and lead to a crash. But again, there might be an alternative scenario. What if investors buy these properties and rent them to people at the bottom of the market? What if we see a move away from property ownership and towards a sort of neo-rentier society. Viewing this situation from Ground Zero tells me that it is in no way unlikely.

In short, it is very difficult to make a call on the London property market right now. But if I were someone buying a home I would be very careful indeed and if I were going to take the risk I would do it with my eyes wide open.

Update: I note that there has been some interest in my comment to the effect that what we might be seeing in the property market is a sort of emergence of a new type of rentier class. Someone in the comments section mentioned REITs. Actually one of the things I had in mind are the new rental-backed securities which basically allow hedge funds and the like to generate streams of revenue from home rental in the form of interest payments. These seem to be an extremely safe investment — no major default risk like the old MBS security class — and they will likely prove highly stable. On the other hand, however, they provide a glimpse into a potential future where a disembodied class of rentiers own the homes of the vast majority of the population. Cause for concern, at least.

 

 

Arguments Against Free Trade and Comparative Advantage

In response to Krugman’s awful dismissal of heterodox economics the other day (see here) Ramanan has dug up an old quote reminding us that Krugman actually got his Swedish bank prize for being a defender of the status quo. In a 1996 lecture paper Krugman lays out a propaganda plan so that economists can argue in favour of free trade.

Krugman is, rather interestingly, very self-conscious in thinking that he is pushing an orthodox line while playing at being a rebel — something interesting to note given that he is taking what seems to be a very similar line today when it comes to the ISLM and what he thinks to be a liquidity trap. He writes,

(ii) Adopt the stance of rebel: There is nothing that plays worse in our culture than seeming to be the stodgy defender of old ideas, no matter how true those ideas may be. Luckily, at this point the orthodoxy of the academic economists is very much a minority position among intellectuals in general; one can seem to be a courageous maverick, boldly challenging the powers that be, by reciting the contents of a standard textbook. It has worked for me!

Anyway, leaving aside the parallels between what Krugman does today with regard to the ISLM and what he used to do back in the 1990s regarding free trade let us turn to the actual ideas. Krugman is referring in the paper, of course, to Ricardo’s theory of comparative advantage. He calls this ‘Ricardo’s difficult idea’ but, as any student of economics knows, it is one of the simplest ideas in economics. Krugman is calling it a ‘difficult idea’ to flatter his audience (of economists) into thinking that they uphold an esoteric truth that others simply cannot grasp.

He seems to think that no lay person grasps free trade and that only economists have sufficient wisdom to recognise its Truth. Well, yes some groups of people do recognise the ‘wisdom’ of free trade agreements — namely, corporations looking for cheap labour — and they will push so-called free trade rather hard in the policy arena; just look at the recent debacle around the TPP. Likewise Krugman must know this as he is writing two years after the NAFTA agreement had been set in place. But, of course, his real audience is left-leaning intellectual types. Being a good Clinton democrat Krugman wants to convince all those people who were skeptical of the likes of NAFTA that it was a good idea.

So, what are the problems with the old Ricardian theory? Well, Joan Robinson dealt with it rather well in her book Aspects of Development and Underdevelopment. First of all she lays out the supposedly difficult idea as such,

Modern teaching is still based upon the case that Ricardo made against protective tariffs in England in the early nineteenth century. The classical argument against prtection was that it produces a misallocation of resources inside the country that imposes it. Ricardo’s analysis of comparative advantage is often misunderstood. The comparison is not between the costs of production, in money terms, of particular commodities at home and abroad; it is a comparison between the real costs (in terms of labour and other resources) of different commodities at home. The argument was that, when protection is taken off, resources will move from the production of commodities with high real costs (which can then be imported) to those with lower real costs so that their productivity is increased. (pp102-103)

She then goes on to point to various logical and empirical problems with it.

This argument applies when all resources are always employed. It has no force for a country with massive unemployment where the potential surplus is far from being realised. Moreover, the argument requires that exports pay for imports so that an increase in the value of imports (following the removal of protection) will automatically be accompanied by a corresponding increase in exports of the commodities in which the country has a comparative advantage. In fact, the value of exports for any one Third World country largely depends on the state of demand in the world market for whatever primary commodity it can sell (and on the prices offered by rival suppliers). (p103)

Already the problems with the argument are beginning. In a situation of high unemployment the opportunity cost of employing labour in a sector that is, by international standards, inefficient is zero. Given that most countries are not, contrary to the mainstream theory, in a situation of full employment most of the time this does real damage to the theory.

Also, as Robinson points out, the theory depends upon a stable demand for exports (this is tied up with the full employment assumption but also tied to the idea that prices for commodities and the like are stable). This is deeply problematic. Swings in demand for commodities can have crushing consequences for developing countries that have geared their economy to narrow markets.

The classic case is that of Ghana which became heavily dependent on the cocoa market after WWII and whose economy collapsed when cocoa prices fell in the 1960s. Another more contemporary case is that of Scotland which relies far too heavily on oil exports which, at some point in the future, will dry up.

But there are other deeper and, arguably, more important problems with the Ricardian doctrine too.

The most misleading feature of the classical case for free trade (and the arguments based upon it in modern textbooks) is that it is purely static. It is set out in terms of a comparison of productivity of given resources (fully employed) with or without trade. Ricardo took the example of trade between England and Portugal. He argued that England, by allowing imports of wine from Portugal, would expand the production and export of cloth to pay for it. Ricardo, of course, was thinking of the English side of the exchange but the analysis is perfectly symmetrical; it implies that Portugal will gain from specialising on wine and importing cloth. In reality, the imposition of free trade on Portugal killed off a promising textile industry and left her with a slow-growing export market for wine, while for England, exports of cotton cloth led to accumulation, mechanisation and the whole spiraling growth of the industrial revolution. (p103)

From a developmental perspective this, I think, is an extremely forceful argument. Innovations in certain sectors — notably manufacturing — have knock-on effects into other sectors. If a country simply continues exporting, for example, a primary product, the rest of its economy is highly likely to remain in the Dark Ages. Many of the Middle Eastern oil producers like Saudi Arabia that have ignored the rest of their economy maintain this structure; with literal Kings sucking up the oil revenue and allowing it to trickle down to a few of their subjects while the rest live in huts. Meanwhile, oil producers with active industrial policies, like Iran, much more so resemble truly modern or at least modernising economies.

Another problem is that larger countries often have protected industries. The US, for example, has a heavily subsidised agribusiness sector. When NAFTA was passed cheap subsidised food imports flooded Mexico and ruined its agricultural sector. This led to an influx of impoverished farmers into the urban centers which in turn led to a rise in crime and, ultimately, this precipitated the rise of the drug cartels that are currently plaguing the country — not to mention the border of the US.

The fact is that many successful countries have built their industries using protectionist measures. The most obvious example is the US. Founding father Alexander Hamilton was one of the first theorists of protectionism. He pointed out that, in line with Robinson’s last criticism, that if one nation had an already-established manufacturing base it was absurd to assume that another nation might have a fair chance getting their industry off the ground. In his seminal Report on Manufactures,

The superiority antecedently enjoyed by nations who have preoccupied and perfected a branch of industry, constitutes a more formidable obstacle than either of those which have been mentioned, to the introduction of the same branch into a country in which it did not before exist. To maintain, between the recent establishments of one country, and the long-matured establishments of another country, a competition upon equal terms, both as to quality and price, is, in most cases, impracticable. The disparity, in the one, or in the other, or in both, must necessarily be so considerable, as to forbid a successful rivalship, without the extraordinary aid and protection of government.

Even though a myth exists today of the US as a bastion of free trade, historically this is completely contrary to the facts. Ironically, this myth is often pushed by people who claim to be constitutionalists. But the US Constitution has a very clear passage mandating the government to control the volume of trade. In Article I, Section 8, Clause 3 the US Constitution gives Congress the power

To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.

This is not to say that free trade is always a bad thing. Dean Baker often makes a very good case to open up certain professions to free trade. But economists need to look at these things on a case by case basis. The Ricardian dogma is attractive to, well, dogmatists — people that are more interested in pushing their supposedly profound and esoteric ideas onto others than they are in engaging with the real world. But serious policy economists should view free trade arguments with a heavy amount of skepticism.

New Layout!

Well, as I assume most people have noticed the blog has a new layout. It was basically inspired by the new header which I found a few days ago. I hope everyone likes it.

I was going to say that I would give a prize for anyone who could guess the reference. But given that I don’t really want to give out prizes and anyone can simply Google the reference that seems like a bad idea.

How about this instead… The quote in the new header has a very large number of meanings for me; meanings tied up with the content of this blog. It is, as the linguists say, overflowing with polysemy — a signifier with a great deal of signifieds. The person with the best suggestion as to how it might be interpreted can, oh I don’t know, request me to write a post on any economic topic.

Make as many suggestions as you like. Suggestions for how the quote ties into the quote’s author’s own work are also more than welcome and will be considered on par with suggestions as to how it ties into the blog’s content.

Have fun!

Piketty’s Regressive Views on Public Debt and the Potential Impact of His Book

Piketty’s Wikipedia page says that he’s a Keynesian. Well, I don’t see it at all. His book contains a section on the public debt in historical perspective and it is desperately misinformed.

A caveat first though: I actually like Piketty’s book in a lot of ways. While not extremely well written, it is highly readable (if you are an historical data sort of person). And it is very nice to see what is effectively a work of economic history get so much play. Because economists should be far more interested in reality than in modelling and this book could spur that interest.

But the history presented in Piketty’s book is selective and, I think, ultimately untrustworthy. Even the way he chooses to present data — both in terms of the averaging of the time periods and aggregates used — is often quite misleading. I don’t want to get too far into this here but I’m pretty concerned that people who are broadly ignorant about economic history are reading this book and coming away, in many ways, misinformed.

Anyway, let’s deal here with one issue; namely, that of how Piketty treats the public debt. He discusses two countries: Britain and France. Both of these countries ran up massive debts in their late-18th century wars (mainly with each other!). France pretty much cleaned its slate during the French Revolution through a combination of partial default and sustained inflation. But Britain carried its debt into the 19th century.

Piketty takes a sort of crude socialist view of the debt as a tax on society. He sees it — as Marx did too, mind you — as a means to redistribute money by taxing goods and services bought by workers in order to pay rich rentiers. He tells us, for example, that in Britain the owners of the debt were obtaining fairly high interest payments. I don’t really see the rates of interest in these years as being particularly high. They basically fluctuated just below the 5% mark.

Frankly, I’m a bit wary of Piketty’s interpretation of the taxation system in this time period. He seems to hold a very narrow view in that he seems to think that the taxation system is merely a means by which redistribution takes place and in this period that redistribution is from poor workers to rich debt holders. While this is one function of the taxation system, it is not the only one. But in this chapter Piketty pretends that it is. This is altogether not very Keynesian.

He also notes that Britain had fiscal surpluses throughout this era.

For an entire century, from 1815 to 1914, the British budget was always in substantial primary surplus: in other words, tax revenues always exceeded expenditures by several percent of GDP—an amount greater, for example, than the total expenditure on education throughout this period. (p132)

Piketty views this from the perspective of rentiers sucking wealth from the population in the form of taxes. In some sense this might be true — although I really doubt that interest payments on government debt were a key component of inequality in 19th century Britain, as any cursory reading of the history of the industrial revolution will confirm. But I suspect it is misleading in terms of the wider picture. In fact, Britain was very likely running a budget surplus in this era because, being the workshop of the world and penetrating colonial markets, it was running large trade surpluses (Piketty notes this elsewhere in the book but fails to make the connection).

Update: Phillipe has kindly linked to a Bank of England paper in the comments section entitled The UK recession in context — what do three centuries of data tell us?. It provides us with the data on the current account and the public fiscal balance for this period. As can be seen from the graph below the current account was indeed in substantial surplus for the entire 19th century. This was probably the main component of the fiscal surplus, just as simple logical deduction would lead us to assume.

At the same time the Industrial Revolution was roaring and the private sector was probably investing heavily. Thus it is not a big surprise that the government was running a budget surplus for much of the 19th century. After all, that is what the sectoral balances identity would tell us. And since unemployment was very low in this era the combination of a large export surplus and high domestic investment probably required the public sector to run a surplus. Yes, the tax could have been imposed on, say capital gains, rather than on workers, but come on… this was 19th century England!

This sets the stage for the moral tone that Piketty takes with regards to the public debt for the rest of the section. He notes that it is inflation which kept the public debt levels down in the 20th century — even when they spiked after wars. He seems to equate this with the borderline hyperinflation initiated by the Jacobins and thinks of it as a sort of partial default. I think that this is deeply misleading.

In fact, people who hold government debt are used to such levels of inflation — Piketty is, after all, only talking about an average rate of 3% inflation a year in the era spanning from 1913-1950. This leads him to come out sounding like an Austrian warning about the impending doom if some inflation is maintained. I will quote him in the original here:

Second, the inflation mechanism cannot work indefinitely. Once inflation becomes permanent, lenders will demand a higher nominal interest rate, and the higher price will not have the desired effects. Furthermore, high inflation tends to accelerate constantly, and once the process is under way, its consequences can be difficult to master: some social groups saw their incomes rise considerably, while others did not. It was in the late 1970s—a decade marked by a mix of inflation, rising unemployment, and relative economic stagnation (“stagflation”)—that a new consensus formed around the idea of low inflation. (p134)

There’s lots of this sort of unsophisticated stuff in Piketty’s book. And it seems to me likely that this is because, in some ways, the book is a mess owing to a lack of a solid macroeconomic framework. I only take the example of public debt because I know that many of my readers will be all to familiar with this silliness and will be immunised against such thinking.

The more I read Piketty the more I see him as synonymous with the Hollande government in France; proposing taxes at a time when these would ruin the economy while maintaining very mainstream opinions on the role of the public debt in the economy.

Again, I like Piketty’s book overall but I really don’t think his macroeconomic credentials are up-to-scratch. This leads to a lot of silly sections and a lot of misleading interpretations. If you’re not fairly familiar with economic history and don’t have a good grasp of basic macroeconomic principles, I suggest that you handle this book with care. I suppose that warning would apply to the vast majority of working economists too. And for that reason I find it very unlikely that Piketty’s book will have much of a theoretical impact.

Much more likely that various people will cast various contradictory interpretations of the accounting identities that Piketty refers to, rather grandiosely, as ‘laws’. Thus, Piketty’s should be seen as one of those books that will open discussion on a topic without much contributing to it. His accounting identities — like the r > g identity — provide a sort of blank screen upon which commentators will be able to project whatever theory they have concocted with regard to the cause of inequality.

This will likely give rise to an academic industry ruminating on such questions — indeed, such already seems to be taking place and I think that it is the exodus of major figures like Krugman into this new land that has led to the media hype surrounding Piketty’s book (even academics do PR!).

For those of us interested in the study of inequality this is wonderful. Although expect a debate that has been taking place behind the scenes in a very focused manner to quickly become filled with sludge as every would-be expert puts forward their little model explaining, in one fell swoop, the rise of income inequality while simultaneously handing us the silver bullet to rid us of it.

On Rising Inequality and Piketty’s ‘Laws’

I note that some readers might be interested in some of my journalistic economic writing. So, I’m going to start posting it on here. Here is a piece that I wrote for Al Jazeera that was published today.

Our fragile economy of stock bubbles and luxury goods

Also, while on the subject of stock markets and inequality and so forth, I started reading the Piketty book and I must say that Galbraith’s criticisms — especially regarding the measurement of capital — strike me as rather damning. I really don’t think that this is a silly gripe on Galbraith’s part at all.

Piketty’s work does indeed seem to suffer from considering capital from the standpoint of its (highly volatile) valuation while at the same time trying to write a theory around this with a conception of capital-as-machinery lying in the backdrop.

Finally, I should also note that Piketty strikes me as having a marked tendency to confuse accounting identities with laws. Indeed, he refers to the following as the ‘First Fundamental Law of Capitalism’:

                                                α = r × β

Where β is the capital-to-income ratio, r is the rate of return on capital and α is the share of capital in income. Well, that’s not a law. That’s an accounting identity. This leads him to some other rather dubious ‘laws’. For example his ‘Second Fundamental Law of Capitalism’ is as follows,

the higher the savings rate and the lower the growth rate, the higher the capital/income ratio (β).

Again, that doesn’t strike me as a law at all. That, again, strikes me as an accounting identity. All of Piketty’s so-called laws strike me as heavily watered down versions of the Cambridge Equation.

The Sraffian Versus the Marginalist Worldview: A Strong Case For Academic Pluralism

Well, as I pointed out yesterday the Capital Controversies have come up once more. Now, again, there were a number of important issues in the controversies — the measurement of capital being one as this leads to some very salient criticisms of using production functions in empirical work — but I want to follow up on the same theme I discussed yesterday; namely, income distribution.

The mainstream economists have a very difficult time figuring out why Post-Keynesians and Sraffians get fired up on this point. After all, they insist, you can account for various aspects of income inequality in their marginalist models. What’s more you can do this without assuming that capital and labour receive a share of the national income in line with their marginal productivities. This is, as I pointed out yesterday, quite true.

A semi-regular commenter on here, ivansml, made this point over at Vernengo’s blog. He wrote,

Competitive equilibrium is just one kind of a market structure. In markets with monopsony or bargaining, wage doesn’t have to equal marginal product of labor... I’m aware that Sraffian authors reject marginalism (well, the basic idea, at least). Aware and unconvinced. I don’t see any evidence that disaggregated general equilibrium models suffer from logical inconsistency, just because Sraffa wrote down a model where prices are indeterminate – if you ignore demand and preferences, then of course you’ll find you have more unknowns than equations, and Sraffian models can be recast as special cases of GE anyway (Hahn, Cambridge J. Econ. 1982; Mandler, Rev. Econ. Stud. 1999). But I guess that as a rhetorical strategy for those already convinced, a blanket dismissal of neoclassical theory as a way to avoid engaging any arguments of substance, it works quite well.

I don’t want to address some of the technical points here in detail — but in passing I will note that it is well-recognised that General Equilibrium models suffer from logical problems as was shown in the Sonnechein-Mantel-Debreu theorem — rather I want to deal with the overarching theme.

The theme of ivansml’s comment is that the Sraffians are saying the same thing as the General Equilibrium theorists, just in special case form. This is mistake often made by the mainstream — and sometimes, but less often, by heterodox authors — and it makes them myopic, insular and arrogantly blind to any need for academic pluralism. Basically it is a mistake of misrecognising what an economic model is and what it does.

An economic model is a sort of parable. Intuitively, every economist should know this. You lay out assumptions — that is, a framework for a logical narrative — and then you follow these assumptions through to the narrative endpoint. But the assumptions are not arbitrary. Indeed, I would argue that they are key to the whole model and to what it conveys.

Think of this like a film script. The assumptions give the story a narrative structure. Thus they determine whether the model is Sraffian or Marxist or marginalist, in the case of economics, and whether the film is a horror, a comedy or a romance, in the case of a film script. The different narrative structures — or genres, if you like — convey different things to the people who use them.

There are many features that makes, in this case, Sraffian models different to marginalist models. But I want to focus on how the two view prices and distribution. In doing so I will lay out two short parables. These are not themselves true Sraffian or marginalist models but they capture the differences in the narrative structures.

Parable 1 — In the Beginning There Were Prices

On Marginalist Island lots of men and women live in peaceful coexistence. They have established for themselves a system of property rights and they use either money, barter or a numéraire to engage in trade with one another. There are a given number of goods and services in the economy. These include labour services and previously accumulated capital. The capital is an accumulation of past savings — people putting aside consumption at one point in time for consumption at another point in time. People have set preferences and want to maximise their utility in line with these. Everyone meets at a given instant in time and exchanges their goods and services — including labour services — with one another. Prices are set through a bartering process ruled over by an auctioneer and profits are equalised through competition. People give up their labour in line with their desire to earn a given wage offset by their desire for leisure. While owners of capital get compensated for the use of their machines (or whatever) by the income they generate.

Parable 2 — In the Beginning There Was Distribution

On Ricardo Island lots of men and women live in a far from peaceful coexistence. Property rights are in place and people use either money, barter or a numéraire to engage in trade with one another. Again, there are a given number of goods and services in the economy — including labour services and previously accumulated capital. This capital is an accumulation of past labour inputs — it is a result of people having worked in the past to produce goods that would increase their productivity in the future. People have no set preferences and care little about utility — the manner in which they consume is either arbitrary or subject to rules of thumb and so does not concern us. Everyone meets at a given moment in time and exchanges their goods and services, including their labour services. But the meeting is not between people bargaining and bartering. Rather, some of the community have power over other parts of the community and try to use this to negotiate how high their share of the total income will be. Some of the community own more of the capital than others and they try to keep down wages in order to maximise their profits, although the profits of the capital owners as a whole will be equalised through competition. The prices that the system ultimately generates will be completely based on the distribution of resources among different groups.

Back Down to Earth

Do you see the difference in the narrative structure between these two scenarios? I hope you do because if you don’t you are likely a dogmatist who will try to reduce one narrative to the other — that is, you are likely a person who does not tolerate difference of perspectives and tries to reduce everything to your own perspective and pretend that it is the only one. In this case I suggest that you seek advice from family and friends.

To everyone else it should be clear that the narrative structure of the two parables is different. In very boiled down form: in the marginalist stories prices are set by preferences and distribution follows while in the Sraffian story prices are set by distribution. Yes, we could add in more elements to either story. In the marginalist story, for example, we could introduce trade unions and monopolists. But that does not change the narrative structure. And the narrative structure is what is interesting. Why?

Because, as we have said, these are just parables, stories, fictions. So too are the actual models that economists in either tradition work with. There is no inherent truth to these stories, they are just stories. But they are stories that colour how we view the world. If we view the world in line with Parable 1 we will have a very different approach to it than if we view the world in line with Parable 2. Different perspectives will mean that we will view different real world events in different ways.

When we start doing economics we inevitably adopt a narrative structure. This will have an enormous power over how we think about the world. To the less self-conscious among us — and, sadly, economists are generally less self-conscious than people in other social sciences — they will even shape our world in ways that we do not recognise.

The problem today is that students of economics are offered only one narrative structure. They are not given a choice. By the time they have encountered others they cannot tell the difference between the two and try to reduce everything to their own point-of-view (well, not all of them, but most). Indeed, most of the students who would have been inclined to greater narrative choice — that is, greater pluralism — have already been driven out of the discipline. Even those who did encounter different narratives early on find it very difficult to get work because they live in a world where others have closed their minds to everything but their own narrative structures.

At the end of the day, we can have different schools of thought attack each others models all they want. That’s fine. All in good fun. But if they ever become convinced that their’s is the only way of looking at the world that is when things start to get dangerous. That is when dogma sets in and academic pluralism is closed off.

The Sraffian view in economics got a far later institutional start in academia and that, largely, accounts for its marginalisation now. Whether it can begin to make its way onto the curriculum is an open question. Whether it will or not has to do with institutional structures. Privileged academics who insist that only their view is Truth will always move to defend their privilege. Such people will likely be so convinced that their’s is the only way that they will not even realise that they are marginalising others — these are the zealots. They need to be overcome by people who want to see more choice for students and a more open discourse in economics.