A Few Thoughts on Tom Palley’s Asset Based Reserve Requirements Proposal

Tom Palley has an interesting paper out on the Fed’s attempt to taper its QE program. I have written about the tapering program before here and here and I have written about how QE works here.

Anyway, I will deal with the main policy proposal that Palley lays out in a moment but first I want to address a passage that I think slightly misleading. Palley thinks that the Fed’s tapering program gives an effective “tax cut for banks”. His reasoning runs as such,

Third, the payment of higher interest rates on excess reserves promises to be very expensive. It is also expansionary, which runs counter to the purpose of raising interest rates. The expense is very clear. Given banks hold $2.6 trillion in total reserves, every one hundred basis point increase in interest rates costs the Federal Reserve $26 billion. If the Fed’s policy interest rate returns to 3 percent, that would cost $78 billion. That is an effective tax cut for banks because the Fed would pay banks interest, which would reduce the profits it pays to the Treasury. The banks, which were so responsible for the financial crisis, would therefore emerge winners yet again. Taxpayers, who bailed out the banks, would once again bear the cost. Paying interest to banks would also run counter to macroeconomic policy purpose since it would be pumping liquidity into the banks when policy is explicitly trying to deactivate liquidity. That smacks of policy contradiction. (p4)

Frankly, I think this is nonsense. It’s not just the banks that would benefit from higher interest rates on reserve holdings at the Fed. It is basically any saver in the economy — pension funds and so on included. The Fed would effectively be offering a perfectly safe asset — that is, a deposit at the institution that creates the money — upon which savers can get an interest rate. Will the banks benefit from this? Yes. But so will other savers.

I also don’t think that this “smacks of policy contradiction”. By this criteria all changes in interest rates would “smack of policy contradiction”. Whenever the Fed moved to raise interest rates to quell aggregate demand they would simultaneously be increasing aggregate demand among savers. In this sense all monetary policy is “contradictory”. I suppose this is true in some sense but the question is one of net effects: does raising interest rates increase or decrease aggregate demand generally? The answer, I think, is that generally speaking raising interest rates works to decrease aggregate demand.

These points tie into Palley’s proposal to have what he calls Asset Based Reserve Requirements (ABRR). Basically, the idea is that banks should have to hold reserves against assets. This would effectively function as a tax on banks. Holding assets would become more expensive in the sense that the banks would have to hold reserves in order to keep the asset on their books. But Pally forgets to mention that this tax would affect anyone who holds assets — again, that is basically all savers in the economy.

Palley’s proposal would also have enormous effects on exchange rates. As Post-Keynesian economists stress time and again, a key determinate of exchange-rates are capital flows. Given that Palley’s proposal would impose a cost on holding assets in, say, the US this would affect capital flows into the US and could lead to a depreciation of the dollar. Palley actually recognises this when he writes,

…imposing ABRR might even cause some US outflows by financial capital seeking to avoid reserve requirements. (p7)

All that said, I actually like Palley’s idea because it allows central banks to steer asset markets in a far more direct manner than they currently do. Palley highlights this when he writes,

The specific effects on bond and stock markets would depend on the particulars of how reserve requirements were assessed. The stock market would likely strengthen if stocks were assessed with a zero reserve requirement while bonds had a positive requirement. This is because stocks would become relatively more attractive compared to bonds. Conversely, stock prices would likely drop if stocks were subjected to a positive reserve requirement and bonds were zero-rated. (p7)

I really like this aspect of Palley’s proposal. At the moment central banks use a very unfocused sort of monetary policy. This can lead to enormous contradictions.

Take the Greenspan years as an example. In the 1990s and 2000s the US economy was extremely weak and required low interest rates to get investment rolling. But this led to low mortgage rates and an explosion of mortgage lending. The Fed was thus caught between a rock and a hard place. On the one hand, if they wanted to quell mortgage lending they had to raise interest rates across the economy. On the other, this would dampen real investment and risked leading to a slump.

What’s more the Fed actually lost control of mortgage rates in this period. Take a look at the graph below which shows how mortgage interest rates didn’t respond to increases in the Fed’s overnight rate.

With Palley’s proposal, however, if the central bank ever found itself in this position again it could raise reserve requirements on mortgage-based asset classes. This would have the effect of raising the mortgage interest rate without raising other interest rates.

The problem with implementing Palley’s policy now is that the US economy, as I have written elsewhere, is highly dependent on savers and investors spending money. You can see this clearly in the following graph that I’ve taken from Steven Fazzari and Barry Cynamon’s excellent paper Inequality, the Great Recession, and Slow Recovery. The chart graphs consumption-to-income rates in the US based on income — specifically the bottom 95% of the population versus the top 5%.

As we can see it was a rise in consumption-to-income of the top 5% of the population at a time when the consumption-to-income ratio fell off for the bottom 95% and failed to recover.

My interpretation of this is that the top 5% have buttressed their spending with income made from capital gains. By this logic, any policy that hurts savers and asset investors could have enormously damaging effects on consumption. This could then lead to a fall-off of domestic investment as corporations and businesses saw a fall in demand for their goods and services.

I’m not saying that Palley’s proposal shouldn’t be enacted. But the current recovery is likely tied very immediately to the financial sector. And if the fall-off in demand that Palley’s proposal would cause is not replaced by some other source it could lead the US economy back into recession. Given the political situation in the US right now around the government budget it seems highly unlikely that policymakers could step in to fill this gap.

So, if we’re going to talk about Palley’s proposal we should do so with our eyes wide open. The fact that these are the conditions under which we have to make policy decisions is tragic and attests to decades of poor economic management (some of which reeks of class war). But the situation is as it is. And we have to ask ourselves the question: is it worth risking another recession to beat up on the banks? Because surely it will not be the banks that are hurt most if a recession occurs.

The Concept of Time Preference is Completely at Odds With Reality

A conversation that I was having yesterday reminded me of a rather funny point in economic theory. When we consider the value of a financial asset we take into two components: that is, it’s price and it’s income stream. It’s price is a sort of stock variable while it’s income stream is a flow variable.

Now that’s all rather simple and elementary. But once we subject these two variables to some degree of uncertainty it becomes impossible to truly calculate the value of the asset moving into the future in any meaningful way.

Let’s take a concrete example: that of a government bond. Let’s say that the bond is worth $1,000 and is paying 5% interest a year and must be redeemed in ten years. If time was completely homogenous and the future was identical to the present I can calculate whether I should hold this bond vis-a-vis another financial asset rather easily. The same is true if I know that the future is going to change and in what direction it will change. But if the future is uncertain it becomes well-nigh impossible — at least in any fully rational manner.

I don’t know what will happen in the market between now and the time I want to sell the bond. It’s value might rise substantially vis-a-vis other assets or it might fall. All I can really do is take a punt on it and hope that I have an edge on the other guy; hope that I noticed some trend developing that he missed.

Okay, well that’s all very obvious, right? But now consider the way economic theory tends to think about rates of interest and so forth. James Tobin discusses this on a nice paper entitled Commentary on Irving Fisher, The Nature of Capital and Income reviewing Irving Fisher’s early book on the nature of income and capital. His first example is quite illuminating in this regard.

Would you rather live in economy J or economy U, when U is currently producing and consuming more but J is building more capital facilities and is growing faster? Samuelson’s conclusion is in the spirit of Fisher and of Hicks. Do not compare current incomes on any definition. Instead, measure welfare as the discounted value of the expected consumption stream of an individual or an economy. (p8)

Note already the dreaded word ‘expected’ rears its ugly head. Samuelson and the other marginalists merely say that we should ignore present income and instead make a judgement based on future income. Not only would I argue that this is not the way many people behave but I would also argue that it is not particularly rational because we cannot know the future.

Take an example. Imagine that I am living in London at the moment. I have a free ticket to move to Paris. Real wages are higher in London and all other conditions are identical in both cities, except that house prices are rising faster in London than in Paris. Even though I think that I’m fairly good at spotting housing bubbles I am not sure at all whether there is actually a housing bubble in London, whether it will burst or whether it bursting will have a substantial effect on either my wages or my employment situation. I have quite simply no way of accounting for this. (Although most of this is fiction the situation with property prices in London at the moment is precisely as I say it is).

In such a scenario — which is not totally unrealistic — I have no way of “discounting my future consumption streams” and the decision that I would likely make would be to stay in the high-income city with the rising house prices and take my chances. Indeed, any attempt to try to measure future events on which I cannot even place a realistic numerical probability would be, when all is said and done, a bit deranged. I might as well take up astrology or fortune-telling. To spin such activity as being ‘rational’ is really a bridge too far and actually an affront to what I would consider actual rational discourse.

This goes to a more immediate problem, especially in financial theory. Tobin writes of Fisher’s book:

[The] most important [idea in the book is] that the value of an asset is the capitalization of the stream of future services thrown off by the asset. (p9)

He then goes on to say that in Fisher’s later work this idea would become the basis for “the equilibrium condition for determining interest rates” — in contemporary parlance Fisher would go on to construct a time preference theory of the interest rate (give up consumption now for more consumption in the future) and the equilibrium condition would be the point at which society would maximise its utility at a given moment in time.

But look at the problems this throw up. First of all, how do I measure the “value” of the future services the asset will throw off? I do not know what I will want two days from now, let alone six months from now. An expensive t-shirt is far more ‘valuable’ to me if we have a hot summer than if we have a cold and wet one but there is no way on earth I would base my purchasing decisions on weather forecasts 3-6 months out! Thinking that I can somehow determine how “valuable” the services given out by an asset are in the future in any exact way is as ludicrous as trying to make the decision based on some quasi-numerical calculation as to which city I should work in. What if I get bored of the service the asset produces, for example?

More important than this, however, is the indeterminacy surrounding the price of the asset in question. How can I compare the services of, say, a car or a house to other goods when the relative prices will change in the future in line with (highly uncertain) asset price valuations? For example, if my house is worth £500,000 today I can in some very limited sense compare the “value of its services” with other goods in the economy. But what if the market collapses tomorrow and it falls in value to £250,000? How can I try to calculate the future opportunity cost of not holding another asset when all assets are subject to highly uncertain price dynamics? Simple answer: I can’t. I can only take a punt.

I have a pretty economical mind. I like to think I’m pretty good at making financial decisions and making money. And given that I have a fair grasp of macroeconomics and tend to be able to spot trends I probably have an edge over a substantial amount of the population. If I can’t make these decisions in a perfectly calculating manner then how on earth can economists try to build their theories of how the economy functions based on the idea that everybody in the economy is doing such calculations?

The fact is that anything such a theory produces — any ‘results’ — will only be so much dross. They will have no relevance to the real world whatsoever. Not in this universe, anyway. And that is why the Keynesian idea of uncertainty literally destroys anything resembling mainstream economics — whether micro or macro. Robinson once quipped that Keynes hadn’t taken the twenty minutes necessary to learn the marginalist theory of value. I don’t know if this was actually true but it it was, it would be quite understandable. He had already constructed his theories of probabilities and studied the money markets in depth. What nonsense the old marginalist theory must have looked like to him!

What Constitutes a Money Crank?

I’ve been asking myself that question rather a lot in the past two weeks. This is because I have had two separate commissions for pieces of writing that require me jump down the rabbit hole into the land of the money cranks. One piece is for a magazine and is about gold bugs and their ilk. The other is for an encyclopedia and deals with the Real Bills Doctrine.

To be frank, the Real Bills stuff is actually in some ways worse than the gold bug stuff. Whereas the gold bug stuff is pretty straight-forward and basically in line with the quantity theory, the Real Bills stuff is all over the place. The basic “insight” is simple — that is, money-loans backed by assets that yield real income will not cause inflation — but the various and almost never-ending articulations and re-articulations become ever more murky and confused the digger you deep.

So, what then constitutes a money crank? Well, first of all let’s run through a few names and try to decide if they are money cranks. I will be doing this more so from intuition at this stage rather than by appeal to argument. I will try to build an argument around the intuitive examples I give thereafter.

Was Irving Fisher, founder of the famous Quantity Equation, a money crank? I don’t think so. Was John Maynard Keynes in his Treatise on Money a money crank? Again, I think not. Were Milton Friedman and Anna Schwarz money cranks when they wrote their A Monetary History of the United States, 1867–1960? I would answer in the negative. What about Nicholas Kaldor in The New Monetarism and Joan Robinson in The Rate of Interest and Other Essays? Again, no. The MMT economists? I think not. Finally, what about David Graeber in his book Debt: The First 5,000 Years? Nope, I really don’t think so.

As the reader can appreciate that list contains a number of people with different opinions and different backgrounds. Most are trained economists, for example, but Graeber is an anthropologist and largely an autodidact on monetary theory. It also contains some people that I strongly disagree with on monetary matters, like Friedman and Schwarz. I wanted to include all of these to show that the criteria for what constitutes a money crank should have nothing to do with (a) academic background or (b) whether I disagree with the theories or not.

Now, let’s list some people who I do consider money cranks. Murray Rothbard is, I believe, a money crank. But he is of a more softcore variety. On the left is Silvio Gesell, albeit he is of a more softcore variety. Antal Fekete is what I would consider a hardcore money crank. What about media figures like Peter Schiff and Marc Faber? I don’t believe that these two constitute money cranks. Rather I think that they draw upon the stories spun by money cranks to sell their respective products — whether that be themselves as media figures or financial positions managed by their companies. They are better seen as ‘pop money cranks’ who spread the heavily condensed Gospel to the masses in the form of soundbites.

So, what are the commonalities that go to make a person a money crank? If I must summarise I think it would be as follows: in order for someone to be a money crank they must meet one of two criteria. One such criteria is that their analysis of money must be tied up with strongly normative views of how the money system should function. Now, obviously most monetary theorists will have some normative views about how the system should operate, but I think that we can draw a distinction between, say, the view of Friedman that central banks should stick to monetary targets and, say, the views of Rothbard.

We can get a clearer idea of the divergence by quoting from both writers. The chapter headings of Rothbard’s work What Has the Government Done to Our Money? are instructive in this regard (as is the title of the work itself). These include:

Government Meddling With Money

and,

The Monetary Breakdown of the West

The content is quite in keeping with the titles too. In the subsection entitled Government and Money Rothbard writes,

Furthermore, government meddling with money has not only brought untold tyranny into the world; it has also brought chaos and not order. It has fragmented the peaceful, productive world market and shattered it into a thousand pieces, with trade and investment hobbled and hampered by myriad restrictions, controls, artificial rates, currency breakdowns, etc. It has helped bring about wars by transforming a world of peaceful intercourse into a jungle of warring currency blocs.

Now compare this to some of Friedman’s writings on the desirability of his monetary policy rules. The following is from his paper The Role of Monetary Policy,

By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability. By making that course one of steady but moderate growth in the quantity of money, it would make a major contribution to avoidance of either inflation or deflation of prices. Other forces would still affect the economy, require change and adjustment, and disturb the even tenor of our ways. But steady monetary growth would provide a monetary climate favorable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth. That is the most that we can ask from monetary policy at our present stage of knowledge. But that much and it is a great deal-is clearly within our reach. (p17)

Note carefully the difference in tone. Rothbard gives off an impression that this is all quite personal. Someone has, in a very real sense, done him an injustice… personally. Terms like “meddling” and “tyranny” are thrown around to show that all the ills of the world are tied up with the money system. This highlights something of interest. Whereas in, say, Marx we find a similarly agitated tone, we do not find this tied to something occurring in the money system. That is why Rothbard is a money crank and Marx is not. Marx’s ire is primarily political, Rothbard’s is primarily tied to the money system — for Rothbard politics and the money system cannot be separated.

For Friedman, however, there is no indication that the money system gets him hot and bothered. For him it is just a means to an end. He has set goals in mind for society — goals that are largely in keeping with the economic consensus — and the money system is merely a means to bring about these goals. Whereas one can imagine Rothbard foaming at the mouth and genuinely affronted by a Federal Reserve open market purchase, one cannot imagine the same to be true for Friedman.

This criteria may be outlined as such: a money crank is a person who views the money system from a position in which they have substantial emotional investment.

Rothbard, however, is tame in comparison to a writer like Fekete. In his poorly written work The Gold Standard Manifesto: “Dismal Monetary Science” he writes,

Governments and academia have utterly failed in discharging their sacred duty to provide a serene environment for the search for and dissemination of truth regarding economics in general and monetary science in particular. This failure has to do, first and foremost, with the incestuous financing of research ever since the Federal Reserve System was launched in the United States in 1913… Under the gold standard government bonds were the instrument to which widows and orphans could safely entrust their savings. Under the regime of irredeemable currency they are the instrument whereby special interest fleeces the rest of society.

Or again,

Unknown to the public, at the end of the day the shill is obliged to hand over her gains to the casino owner, alias the United States Treasury. There is nothing open about what is euphemistically called ‘open market operations’. It is a conspiratorial operation. It has come about through unlawful delegation of power without imposing countervailing responsibilities. It was never authorized by the Federal Reserve Act of 1913. It defies the principle of checks and balances. It is immoral. It is a formula to corrupt and ultimately to destroy the Republic.

Such passages are pretty off-the-wall. The money system is portrayed as a vast conspiracy set up to defraud widows and orphans. Here we see that Fekete is far more hardcore than Rothbard. Whereas both agree that the government “meddles” with money and this is undesirable and leads to some sort of personal injury, Fekete goes one step further and portrays the system as an organised conspiracy set up against the vulnerable. Let us now turn to the second criteria that a person can meet to be considered a money crank.

This criteria is often, but not always, tied to the first. It is: the idea that all of society’s ills can be solved merely by reorganising the money system. Often the proposed changes must be extremely complex and little thought is typically given as to how really existing social institutions — which arose less by design than by necessity — will integrate the proposed changes. This, I think, is why Gesell falls into the category of money crank.

I cannot quote it at length here but the interested reader should have a look at the section of his work The Natural Economic Order entitled Description of Free Money. There you can see a highly complex exposition of how the money system should be changed to liberate mankind. The problem with such expositions are twofold. First, as already mentioned, it is well-nigh impossible to redesign institutions that have arisen organically — the money system is one of such systems. Second, the idea that the Grand Plan would work out just as it did on the back of the author’s envelope is deranged. No one seriously interested in economic policy could rationally believe such a thing. Plans only work when they are highly simplified — and even then they will have enormous unforeseen consequences.

So, let’s state this criteria in no uncertain terms: a person who believe that all, or the vast majority of, social ills are caused by the current money system and thus can be solved by implementing an imaginary money system that they have designed can be safely considered a money crank.

Anyway, I doubt that the above is completely comprehensive. But I think it lays down a few general observations that might help in distinguishing between monetary theorists and money cranks. Of course, as with most of these things there may be some that fall outside of the criteria here laid down who are nevertheless money cranks. In that regard, the reader can only but trust their own judgment.

Finally, I would say that we should not think that money cranks have nothing to offer. I am sure that right-wingers can find suggestive insights in Fekete’s work and I think that the left can find a few in Gesell’s work (in the General Theory Keynes certainly thought so). This is because of these writers almost monomaniacal focus on the money system. Most monetary theorists, as I have said, view the money system as a means to an end and thus they do not obsess over it any more than they need to. Money cranks do, however, and that can often lead them to generate minor insights that conventional money theorists miss. But a crank is still a crank. And that should be at the forefront of peoples’ mind when approaching the works of any money crank. Because it is far easier to fall down the rabbit hole than it is to crawl back out.

The British Financial Account 2002-2012

Today I published an article on The Guardian’s website entitled The left needs a deft touch in tackling the financial sector’s dominance. In the article I made the case that the value of the sterling is inherently tied up with inflows of foreign capital. These are due to the enormous financial center that exists in the UK and if they ever dried up the sterling would likely collapse and a sustained inflation would result.

In the article I had to greatly simplify the dynamics. In doing so I wrote the following,

Today, British consumers and producers send sterling abroad to buy imports, and this sterling then comes washing back into Britain in search of investment opportunities in the City. If investors ever found that they had nowhere lucrative to put their sterling, they would likely dump it on the foreign exchange markets. Such massive sales of the currency would drive its value into the ground.

This is not, of course, how the process actually works. Rather bank accounts in various countries are credited and debited. But in order to explain the process to lay people who are not too familiar with the monetary system I thought that the above parable was a rather good one.

Here I would like to lay out the details of these capital inflows. In doing so I will draw on the Financial Account in the ONS’s Pink Book — the statistics can be found here.

First off, some accounting. The British trade deficit — i.e. the deficit on the current account — should be matched by a surplus on the capital and financial accounts. Here are the surpluses on the capital and financial accounts in the years 2002-2012.

As we can see it is the financial account that is dominant in most of these years. This is actually quite handy because, while the breakdown of the financial account provides us with useful information on what is going on with regards to where these capital inflows are going, the breakdown of the capital account does not.

So, let’s break down the financial account into its various components. You might want to click on the following chart to enlarge it.

Here we see some interesting trends emerge. For example, debt securities were a key component of the financial account surplus up until 2008. Presumably investors lost confidence in these after the crash. Or perhaps the central bank bought them up during the QE programs.

Financial derivatives, rather unsurprisingly, became rather unpopular in 2008. But since then they have regained in popularity for foreign investors.

Equity securities became very popular in 2008. Frankly, I’m not altogether sure how to interpret this.

In 2012 the bulk of inflows was due to ‘Other Investments’. This is rather annoying because we have no idea what there ‘Other Investments’ are. Whatever they are they see to be very important in 2012.

Marginalist Microeconomics: The Path to Totalitarian Tyranny

Kevin Hoover, although not generally well-known in Post-Keynesian circles, is easily one of the most interesting economists writing on epistemology and ontology today. He was originally an applied macroeconomist but, like anyone who is remotely philosophically literate, he quickly began to see an awful lot of problems with both the econometric approach and with the models that were generally being used — most particularly, microfounded macroeconomic models.

In his article Microfoundations and the Ontology of Macroeconomics he makes any number of interesting points. One that Lars Syll recently picked up on and which I highlighted in a book review last year is that the Rational Agent in microfounded models is an identical construction to the Hegelian notion of ‘Geist’ which embodies Reason-in-the-abstract. That is, it is a construction that attributes a sort of teleological rationality to social processes that guarantee and ideal outcome before the fact.

In the paper Hoover touches on something else which I have insisted on before: namely, that the marginalist, extreme rationality research program is inherently totalitarian. Unfortunately, he only does this in a rather superficial way. In discussing the fact that many economists will concede that current microfounded approaches are not up to the task of explaining the economy they nevertheless insist that they will one day get models that will. In response to this Hoover writes that this view,

…underwrites a kind of tyranny of the future, which is typical of totalitarian politics: as vision of heaven on earth justifies any misdeed today as long as it aims toward the future good, even when the path between the here-and-now and the future is obscure. (p388)

I think that Hoover is on to something here but he just hasn’t quite grasped what it is. He appears to think that this sort of reasoning is merely tied to some sort of epistemological totalitarianism. That is, it provides economists who should know better with an excuse that allows them to continue doing dodgy theorising. This is, in itself, an important component of the whole microfoundations research program. But it is not the most important.

It seems to me that this sort of totalitarian mindset is tied to the entire of marginalist microeconomics. Marginalist microeconomics, through its doctrines of rationality, seeks to describe the supposed behavior of every actor within the economy. It has, as I have argued before, absolutely no tolerance for any behavior that deviates from its a priori principles. Thus, implicitly it views any behavior that deviates from its a priori principles as ‘unfit’ behavior. Through arguments based on competition marginalists then argue that such ‘unfit’ behavior will be weeded out of the economy.

If this sounds similar to a certain other type of reasoning prevalent in the late-19th and early-20th century it should; because this is pretty much the eugenics research program. Eugenicists made almost identical arguments but rather than appealing to market-based competition they appealed to evolution. The task then became to legislate policy that would speed up the evolutionary process. This, as is now well-known, resulted in atrocities; not merely in the extermination of the mentally handicapped in Nazi Germany (the Action T4 program), but also in the sterilisation of many types of ‘defective’ people in many Western democracies.

While the type of market-eugenics implicitly promoted by marginalist microeconomics is not quite as dangerous it is, nevertheless, tyrannical in its own ways. Microeconomists working in this tradition will try to seek out policies that will weed out ‘inefficiencies’ through ‘simulated competition’ in various non-market sectors. Sometimes, in very limited spheres, this can work quite well. But when it is applied directly to trying to manage human behavior it will time and again prove disastrous. It will inevitably lead to absurdist micro-tyrannies, a good example of which were the target systems put in place in much of the British public sector in the 1990s.

Fortunately the totalitarian tendencies of marginalist microeconomics are kept in check in Western democracies to a very large extent. But one can imagine the social chaos that might be unleashed were a government ever to get in that allowed to microeconomists free-reign. Given the opportunity — especially by an authoritarian government — their attempts to impose their bizarre notions of rationality on the population could quickly turn into something out of a dystopian science-fiction novel.

Of course, the microeconomists will say that I’m misrepresenting them and that their doctrines are based on the idea of individual choice. This is entirely untrue, of course, because, as I have written before, in marginalist economics people are nothing but calculating machines — not actual decision-makers. But then, tyranny always comes selling itself as the path to greater freedom, now doesn’t it? And the harbingers of this tyranny often come wearing the frocks of the scientist and insisting on the ‘total objectivity’ of the evils that they do.

Making Sense of the Sterling Depreciation of 2007-2008

Something rather strange happened in Britain around the time of the financial crisis. The sterling tanked, import prices rose substantially and yet the inflation rate didn’t respond as much as we might assume.

Other weird stuff happened too. For example, export prices rose rather than fell and the trade deficit worsened. Although these two aspects seem to totally contradict macroeconomic theory I’m not as concerned about them. In our newly globalised world exports, outside of small open economies, don’t increase as much as economists might assume. I’ve known this since I started examining the data — and Nicholas Kaldor was well aware of this by the late-1970s and early-1980s too. The fact is that in modern developed economies price elasticities don’t matter nearly so much as they did in the past. I have some ideas as to why this is but I won’t get into it here.

I have never, however, come across an instance where a substantial depreciation of the currency has not resulted in substantial price increases in an import-dependent economy like Britain. Indeed, the Office of National Statistics thought that these trends were pretty weird too and so they published an excellent report entitled Explanation beyond exchange rates: trends in UK trade since 2007 which I will draw on for many of the graphs in what follows.

Okay, first of all let’s take a look at the exchange rate versus the trade balance. The period that we are interested in is between 2007 and 2008.

As we can see, there was a massive depreciation around 2007-2008 and the trade deficit stayed open. At the same time import prices went up by a fairly large amount as can be seen in the graph below. Export prices rose too, as we can see — which, of course, is not in line with economic theory.

Now, here’s where the mystery that concerns me comes in: while inflation rose in this period it did not rise as much as I would have expected. CPI inflation did more than double — which is by no means insignificant — but I would have expected it to rise maybe four or fivefold.

So, what is the explanation for all this? Well, I think it runs something like this.

First of all, companies that import goods to use in order produce goods that they export passed on the cost to foreign buyers. As we saw above and in contrast with macroeconomic theory, export prices rose after the depreciation by more than import prices. I think that we are seeing the pass-through effect in the data quite clearly.

Secondly, and most important from my point of view: companies selling on the domestic market used the sharp fall in wages in this period to absorb the higher costs so that they didn’t have to raise prices and could thus maintain market share. Take a look at the following graph plotting earnings against inflation in this period.

At the same time as firms saw their import prices increase they saw their wage bills fall dramatically. So, they didn’t have to increase prices too much because they just passed through the savings they were making on wage costs. Ultimately workers saw their standards of living fall dramatically but rather than see this manifest as maybe 8-10% price inflation, they saw instead 4-5% inflation and negative real wage growth which went from an average of about +2% to -2% — a decline of about 4%. The net effect on living standards was probably about the same, it just shows up in different data aggregates.

What is the key lesson from this? Well, it seems that the UK didn’t experience substantial price inflation in 2007-2008 after the depreciation of the sterling because of the unemployment and rock-bottom wage growth that occurred at the same time. The effects on actual living standards were probably largely the same as if there had been substantial inflation but you have to look for it in different data.

If a substantial depreciation of the sterling ever took place in a period when there was tight labour markets and healthy wage growth we would likely see a large uptick in inflation. We would also see feedback effects in that the trade deficit would rise as price rises were passed through to foreign buyers which would then put further pressure on the currency. The whole thing could get very ugly very quickly. And that’s not even to raise the specter of a wage-price spiral in a time of low unemployment.

This brings us to our final question: why was there a large depreciation of the sterling in this period? Well, because the value of the sterling is tied up with the price and turnover of financial assets in the City of London. The UK is not in a position like the US which has the world’s reserve currency  and so when asset prices took at massive hit in 2007-2008 the sterling did too. This shows just how sensitive the sterling is to any chaos that might occur in the financial markets. It also shows just how sensitive the currency would be if a government ever moved to shut down the City.

The UK economy after Thatcher is hooked on finance. And it would take quite a bit of policy ingenuity to ween it off its drug of choice.

Misdirection: Galbraith on Piketty’s New Book on Capital

I’ve been waiting for this for some time but now Jamie Galbraith has come out and provided an extensive discussion of Thomas Piketty’s new book Capital in the Twentieth Century. While I haven’t yet read Piketty’s book its difficult not to have heard about it given how much of a response it is getting among economics types.

The moment the hype started I thought that something was amiss. In 2012 Galbraith and his team published an extensive empirical investigation of income distribution using new datasets that they constructed. Beyond the interview I did with Galbraith and a few other articles and the like the release of the study didn’t get much play among economist types. The reason should be obvious: whereas Galbraith arrived at heterodox conclusions, Piketty’s are mostly orthodox.

As Galbraith notes in his review Piketty seems to put some weight in the idea that the problems with income inequality that we face today are mainly to do with technology and education. Galbraith and his team, on the other hand, point to something that should be intuitively obvious to anyone following political and economic events in the past decade; namely, finance.

It is new types of income that are tied to asset price valuations that are important to explain rising inequalities. Galbraith makes this clear when he writes that what is really at issue today is a rise in rents. Piketty remains blind to this because he has a fairly woolly notion of what exactly constitutes ‘capital’ (the start of Galbraith’s piece discusses the implications of some aspects of the Capital Controversies).

If Piketty had distinguished between earned and unearned income — between income generated as a result of productive physical plant and income generated from financial assets — he would have been able to discuss his findings much more consistently. But unfortunately he does not and this, to Galbraith, renders his analysis confused.

Galbraith also makes clear that Piketty’s policy proposals — mostly dealing with higher taxes on the rich — are probably not fit for purpose in a globalised, financialised economy. Rather Galbraith asks us to consider alternative approaches.

If the heart of the problem is a rate of return on private assets that is too high, the better solution is to lower that rate of return. How? Raise minimum wages! That lowers the return on capital that relies on low-wage labor. Support unions! Tax corporate profits and personal capital gains, including dividends! Lower the interest rate actually required of businesses! Do this by creating new public and cooperative lenders to replace today’s zombie mega-banks. And if one is concerned about the monopoly rights granted by law and trade agreements to Big Pharma, Big Media, lawyers, doctors, and so forth, there is always the possibility (as Dean Baker reminds us) of introducing more competition.

I think that Galbraith is on the right track here. More importantly from my perspective, however, is that Galbraith’s analysis provides us with a much more immediate way of focusing the discussion. In order to get people to understand what is going on in the economy these days we need to point the finger time and again at the financial sector. The general public already sense that the main purpose of Big Finance is to redistribute income and this needs to be supported by the opinions of those who claim to be experts.

Ultimately, Piketty’s work will not refocus the opinions of the experts in this regard. And that is unfortunate. Rather it will speak to a worn-out left that is unable to properly articulate itself. While its base intuitively sense that something is up with Big Finance, policymakers and experts continue to talk in outmoded tones.

From what I have seen so far the logical outcome of Piketty’s book is the government of Francois Hollande — with its insistence on high marginal tax rates for the sake of high marginal tax rates; an economic policy based on envy with no real productive aspect. And the logical outcome of the government of Francois Hollande will be, if the Socialist Party in France is unable to reformulate itself, the rise of the Front National.

 

Was Marx Right?

Well, it looks like The New York Times has opened a bit of a can of worms by asking Was Marx Right?. I generally find that this question to be a bit annoying. Was Marx right about what, specifically? That labour is the True and Only source of value? No, he was wrong on that. That communism was an inevitable outgrowth of capitalism? He’s been wrong on that — so far, at least. That capitalism was prone to financial crises? Yes, he was quite right about that.

I suppose I’ve made my point. Marx said a lot of things. It would be rather unusual if he were right about everything he wrote and it would be equally surprising if he was wrong about everything he wrote. Marx was right about some things and wrong about some things. Although the man had a marked tendency to play the prophet in truth he was really just a man, no matter how much some of his contemporary acolytes may insist to the contrary. He was right sometimes and wrong sometimes.

Anyway, the series gives me an opportunity to clear up a few Marxian myths. The first is propounded by Brad Delong in his piece Marx Was Blind to the System’s Ingenuity and Ability to Reinvent. It runs like this,

Marx could not fully grok that rising real material living standards for the working class might well go along with a rising rate of exploitation and a smaller labor share. Thus he takes a demonstration that labor’s share of income might fall and without noticing turns it into a claim that the working class will starve.

I don’t know why this myth continues to bounce around. Everyone and their mother seems to think that Marx was dead sure that real living standards of workers could not rise under capitalism. But this is simply not true. In Volume III of Das Kapital Marx does run through some scenarios where real wages rise and the rate of exploitation remains constant. Joan Robinson noted this in her preface to the second edition of An Essay on Marxian Economics where she wrote,

In Volume I of Capital, the existence of the reserve army of labour keeps the level of wages more or less constant, though there may be phases of rising wages when the accumulation of capital runs ahead of the growth of the available labour force. But in Volume III, in connection with the falling rate of profits, we encounter a constant rate of exploitation, along with rising productivity. In Volume I, labour-saving technical progress tends to raise the rate of exploitation and is likely to lower the wage rate, because it reduces the demand for labour. In Volume III it leaves the rate of exploitation more or less constant, and the rate of profit is squeezed. The movements of the level of wages in Volume I depend upon the relative bargaining strength of capitalists and workers and on the political balance of power. The constant rate of exploitation in Volume III is not explained, and the fact that it entails a rising level of real wages is not noticed. (ppviii-ix)

When Robinson was writing her essay in 1942 this was not generally noticed but after the 1960s I think that it was. The issue was raised in Ernest Mandel’s preface to the first volume of Das Kapital that was written in the 1970s. He dismissed it in that typical lackadaisical and lazy manner that characterises much Marxian economic analysis, but he does raise it. I don’t know why people like Delong (but also many self-professed Marxists) miss this. There really is no excuse these days. Marx did not argue that real wages could not rise under capitalism. End of story.

The second confusion arose in Doug Henwood’s piece entitled A Return to a World Marx Would Have Known. It runs like this,

How can this [i.e. the current economic situation] all be explained? The best way to start is by going back to the 1970s. Corporate profitability — which, as every Marxist schoolchild knows, is the motor of the system — had fallen sharply off its mid-1960s highs. Stock and bond markets were performing miserably.

I don’t know where this stuff comes from. I know that Marxists want to bring every crisis down to some sort of crisis of profitability but really, the data is readily available. Below are two graphs showing the year-on-year percentage change of corporate profitability in the US. On the left is the mid 1960s through to the end of the 1970s. On the right is the late 1970s through to the beginning of the 1990s.

As we can see, there was just as much volatility in both periods. Yes, there was a dip in profits in the late 1960s and early 1970s but there was also a dip in profits in the early 1980s and in the late 1980s too. The point I’m trying to make? Corporate profits are pretty volatile. Get over it.

Or let’s try a different approach. In 1960 corporate profits stood at $31.1bn and by the end of the decade in 1969 they stood at $56.7bn. That’s an increase of around 80%. Meanwhile in 1970 they stood at $51.5bn and in 1979 they stood at $211.1bn.  That’s an increase of nearly 200%. Not bad for a period that Henwood characterises as being one of profit stagnation!

You could probably cut this data in funny ways to try to prove Henwood’s point. But I don’t think that it would an honest approach. A cursory glance at the data suggests that looking for some fundamental change taking place in corporate profitability in the 1970s is a red herring.

Anyway, all that considered let’s reformulate the question: is Marx relevant for understanding the world today? Frankly, I don’t think so. The key problem today is that wealth inequalities are tied to financial markets. Speculation in assets is what drives most Western economies but it is also what drives the bulk of the inequality (see the work of Jamie Galbraith and his team on this). You cannot find this anywhere in Marx and it is the most pressing economic question today. Some economists are beginning to ask questions surrounding the links between income distribution and finance, but it is new territory altogether. You won’t find much of use in Marx in this regard.

Why Long-Run Theories of Profit and Accumulation Fall Short

Nothing gets heterodox economists quite so fussed as the long-run theory of the rate of profit. Yet, Keynes did without one altogether and when examined closely there is no way that such a theory can say anything tangible about the real world. In order to lay this out I am going to take my leave from Joan Robinson’s excellent book Economic Heresies: Some Old-Fashioned Questions in Economic Theory.

When Robinson discusses Keynes she says that he had no real interest in a long-run theory of profits and accumulation. In the long-run, Keynes famously said, we are all dead. All that matter is short-term analysis. Crucially Keynes thought that profits and accumulation could not be discussed without reference to expectations — that is, to his ‘animal spirits’ — and thus any discussion about profits and accumulation in the long-run is only building so many castles in the sky.

In her book Robinson takes Keynes to task for discussing financial markets rather than the actual sphere of production. The Marxian and Ricardian influences on Robinson are clear when she writes, for example,

Keynes rather lost his grip on the distinction between the rentier and the entrepreneur. His discussion of the ‘state of long-term expectations’ is devoted to the Stock Exchange rather than to the accumulation of means of production. (pp31-32)

I think in this instance Robinson is reading her own biases into Keynes’ work. I don’t think that Keynes was confused at all. I think that he had probably considered the question of accumulation in the long-run and dismissed it as something that could not be adequately or usefully theorised.

Throughout Robinson’s discussion of accumulation in the long-run in the book you can feel that this doubt is nagging away at her. She is at pains to justify the idea that such an analysis might produce useful results but she never quite manages to do so.

The book was first published in 1971 and I think that in the next few years Robinson would basically give up on trying to theorise accumulation and more so focus on the idea that, since non-homogenous historical time is what we really deal with in economics, most of these attempts at theorisation are only so many parlor games. I think you get a distinct impression of this in her 1974 Stanford lecture entitled What is Wrong With Neoclassical Economics?.

But as I said, in 1971 she was still trying to justify a long-run theory. And when you read her sections on Ricardo and Von Neumann you can sense the doubt in her mind. Take the following passage, for example,

Reality is never a golden age. There are disturbances due to markets in which supply and demand rule, mistaken expectations, and unforeseen events. The rate of profit on capital is neither uniform throughout the economy nor steady through time. Nevertheless, the concept of a natural rate of profit determined by investment and the propensities to save provides the framework of a general theory within which detailed analysis can be built up. (pp47-48)

Robinson is by far one of my favorite economists but she is simply wrong here. The future is completely uncertain. In order for us to conceive of some sort of ‘natural’ rate of profit (always prick your ears up when you hear the word ‘natural’ used in economics!) we would have to assume that investors know with what frequency investments fail and with what frequency they succeed. We would have to conceive of the world as being full of objective probabilities and investors as knowing these probabilities and integrating them into their investment decisions.

In short, we would have to conceive of the link between investment and accumulation as resembling the strong-case Efficient Markets Hypothesis (EMH) where investors have access to objective information about the future. Keynes knew that this was nonsense and that is why he did not try to construct a long-run theory of accumulation. He said so explicitly when he wrote,

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. (The General Theory, Chapter 12)

With that statement Keynes threw out any notion of a ‘natural’ rate of profit or any misguided attempt to try to work out the realities of the process of accumulation on the back of an envelope — a great tradition stretching from Ricardo through Marx to Robinson and Pasinetti.

Is this to say that their contributions are entirely useless? Some of them undoubtedly are; most of Robinson’s The Accumulation of Capital has no relevance to the real world at all — and, again, I think Robinson came around to seeing this toward the end of her life. But there were a few nuggets of gold that should be salvaged. The basic growth theorems laid down by Kaldor and improved upon by Pasinetti do provide some insights which may be relevant so long as we treat them with care. The idea that different savings propensities lead to different distributive dynamics is an interesting one indeed.

But, as I have pointed out before, it is by no means adequate to explain distribution in the real world alone. For that we need to understand the role of financial markets and asset prices. Something which I have spent the past year working on and which, if I can ever sit down and really thrash it out, I might be able to shed some light on. In the meantime the empirical work of James Galbraith and Steven Fazzari is where its at. Anyone trying to theorise distribution should start there and only look to the old accumulation theories as a well-bred girl looks upon a love letter, as the great German philosopher Hamann said in a different context.

Krugman Uses ISLM to Proclaim Looming Fiscal Crisis, Denounces Those Who Don’t Use ISLM

Some people often ask why I complain about Krugman. “Hey Phil, Krugman is a good guy. He likes government spending. You like government spending. Therefore you must like Krugman,” says our budding young Socrates. Well, I’ll tell you why: because Krugman is a pretty awful economist who pushes completely outdated views and tricks people into thinking that they’re cutting edge. Anything that is of interest he poaches from elsewhere, typically engages in dubious accreditation and ultimately gets it wrong.

The reason for this? Because Krugman loves models and hates books. He loves little simplifications of the world and hates complexity. That is why he has been wrong on most substantive issues over most of his career. What are the roots of this hatred? From his public writings it appears to have something to do with the influence of JK Galbraith and American institutional economics (which, in Krugman’s mind, is tied up with all heterodox economics).

In the mid-1990s Krugman used to write awful reviews of Galbraith’s books. The motivation appears to have been to consign the true economic progressivism and eclecticism that Galbraith represented to the bin and promote a new type of thick-skinned liberal of the type that Krugman saw himself to be. In his review he wrote,

The truth is that constructing and maintaining a good society has turned out to be far more difficult than anyone imagined a generation ago. To be a serious liberal, one must confront that difficulty, make hard choices, and persuade others to do the same. It is therefore a cause for sadness that America’s most famous liberal economist has produced a manifesto that simply assumes most of the difficulties away.

This was the 1990s, of course; in the middle of the era of Clinton and all that. While heterodox economists were warning about income inequality and the dangers of running a fiscal surplus and a trade deficit at the same type (by identity this means rising private sector debt), Krugman was proclaiming that the welfare state in Europe was causing the unemployment there and that, well, Pete Peterson might have a point about cutting social security. That is what being a ‘serious liberal’ meant to Krugman in the 1990s and attacking heterodox economics — which he associated with institutional economics — was his way of promoting his creed.

Yesterday, Krugman discussed the always excellent Lars Syll’s criticisms of the ISLM and the old demons bubbled up once more to the surface. He claims that Syll is promoting some sort of model-free institutional economics. He gives a tired (and incorrect) little history of American economics that basically says that while the institutionalists were fumbling in the Great Depression, Paul Samuelson delivered the country from evil with his neo-Keynesian doctrine.

Actually, the real history is much more complicated and involves a textbook by Lorie Tarshis that was rejected due to a right-wing conspiracy launched by William F. Buckley and a massive war that allowed for budget deficits. Samuelson had very little to do with any of this history. But he was the one who succeeded in popularising neo-Keynesian economics to students in the 1960s (while losing debates against the real Keynesians at Cambrige, UK…).

Anyway, back to ISLM. Krugman’s main contention is that while us silly heterodox types are fumbling with our clumsy ‘institutionalism’ Paul Krugman and his ‘serious liberal’ friends are taking a hard-headed view of the world and calling for fiscal stimulus. What’s more, he’s utilising the ISLM framework and, according to him, the ISLM framework makes True predictions about the world. He writes,

You see that a lot among people who reject IS-LM as too simple and unsubtle: what they have ended up doing in practice, for the most part, is predicting soaring inflation and interest rates, because whether they know it or not they have effectively reverted to crude quantity-theory and loanable-funds models.

Meanwhile, those of us working with IS-LM, and arguing that we had entered a liquidity trap, predicted little effect from the Fed’s balance sheet expansion, certainly not an explosion of inflation; low interest rates despite government borrowing; severe adverse effects from austerity. And we were right – because in reality, using a “silly” little model is a lot more sophisticated than talking grandly about complexity, and then trying to make diagnoses with no explicit model at all.

Okay, apparently the two alternatives are (i) worship ISLM or (ii) predict soaring inflation and interest rates. I don’t know who Krugman is writing for these days but only the most ignorant idiot with no interest in economics and no access to the internet could believe such preposterous tripe. But given that Krugman thinks that his little ISLM is such a great predictor let’s see how it fared when he applied it in what he would call a non-liquidity trap environment.

Back in 2003 Krugman saw George W. Bush run up large fiscal deficits to fund the war. While most heterodox economists were reluctantly saying that this bout of Military Keynesianism would buttress a US economy greatly weakened by the dot-com crash a few years before, what was Krugman and his little toy models telling his readers? Well, in an article entitled A Fiscal Train Wreck he was telling them that interest rates would soar and there would be a fiscal crisis.

With war looming, it’s time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.

From a fiscal point of view the impending war is a lose-lose proposition. If it goes badly, the resulting mess will be a disaster for the budget. If it goes well, administration officials have made it clear that they will use any bump in the polls to ram through more big tax cuts, which will also be a disaster for the budget. Either way, the tide of red ink will keep on rising.

Whoops! In March 2003 Krugman was calling for mortgage rates to rise… just at the beginning of what would turn out to be the biggest housing bubble in US history. What actually happened? Mortgage rates basically flat-lined for the next 5 years.

Of course, rising interest rates were precisely what his little ISLM model told him would happen. He figured that since the economy was not in what he calls a ‘liquidity trap’ then a rise in the budget deficit would lead to a rise in interest rates across the board.

But the heterodox types were more focused on the fall-off in demand that had occurred three years earlier and the rising private sector debt that was starting to fill in the gap. This, together with the Iraq War, were what was going to drive the economy forward in the next few years. They were not concerned with interest rates rising because they knew that the Fed ultimately sets interest rates and that money is endogenous.

In his book The Predator State ‘non-serious liberal’ JK Galbraith’s equally ‘non-serious liberal’ son laid out what actually happened in this era (note that interest rates are not even mentioned because to heterodox economists the idea that fiscal deficits cause a rise in the interest rate is manifestly absurd),

From 1997 to the peak in 2000, business nonresidential fixed investment rose by around $300bn 1996 dollars, a gain of about 2 percent in relation to GDP, or from 12.2 to 14.4 percent. Most of the gain was technology investment. In the two years after the peak, the falloff was on the order of $150bn. The entire falloff in business investment was then replaced by the increase in the military budget put in place by the Bush administration following the terrorist attacks on September 11, 2001, and the invasion of Iraq in 2003. As a result the US economy returned to nearly full-strength by mid-2006, and once again the stock market recovered. (p100)

So, what is the lesson here? Simple. The ISLM is a crappy tool for understanding the economy. Krugman is not a very good forecaster and is more often wrong than right (a broken clock and all that…). And what Krugman thinks to be ‘institutionalism’ (i.e. heterodox economics) is a far better paradigm if you want a realistic view of macroeconomics. If you want to learn outdated and oversimplified rot while playing at being a ‘serious’ and ‘hard-nosed’ liberal read Krugman; if you want to gain interesting perspectives on economics and fight for true progressivism read Syll and Galbraith.