Hjalmar Schacht, Mefo Bills and the Restoration of the German Economy 1933-1939

So, I was doing a bit of that aimless reading one so often does on the internet and I came across the transcript from the trial of Hjalmar Schacht at Nuremberg after the war. Schacht was, of course, the chief architect of Nazi economic policy and the inventor of the infamous Mefo bill, which we shall discuss in more detail below. The transcript is fascinating because it includes a nice overview of Nazi economic policy during the war and the years of rearmament.

I’ll give some context first of all. As is well-known, after WWI the allies had banned the defeated Germany from having a size-able standing army. In the 1930s, however, after the election of Hitler in 1933 the allies moved more and more to appease the Nazi regime and effectively looked the other way as the Nazis rearmed. But rearmament still had to be done under something of a cloak of darkness. One of the restrictions on Germany was that the government was only allowed to borrow 100m Reichsmark from the Reichsbank (the German central bank at the time). With such a budget limit in place Germany could not obtain the funds needed to rearm. So Hitler turned to Schacht who was, with the notable exception of Albert Speer, one of the only higher-ups in Germany at the time with any degree of intelligence.

The first step, of course, was to obtain financing. In order to do this Schacht introduced the Mefo bill which the Nuremberg prosecution described as such,

Transactions in “mefo” bills worked as follows: “mefo” bills were drawn by armament contractors and accepted by a limited liability company called the Metallurgische Forschungsgesellschaft, m.b.H. (MEFO). This company was merely a dummy organization; it had a nominal capital of only one million Reichsmarks. “Mefo” bills ran for six months, but provision was made for extensions running consecutively for three months each. The drawer could present his “mefo” bills to any German bank for discount at any time, and these banks, in turn, could rediscount the bills at the Reichsbank at any time within the last three months of their earliest maturity.

It was not a terribly complex plan. The military contractors were paid in bills of exchange issued by a shell company. These contractors would then take the bills to a private German bank which would then gladly turn over cash to the holder because they knew that they could then hand the Mefo bill to the Reichsbank which would in turn convert it into cash using their money-issuing powers.

The resulting spending resulted in the German economic boom that took place under Hitler. Here is a nice graph from Erwin Mahe that compares the growth and inflation in Nazi Germany to that in the Netherlands in those dark years:

This is an incredible story from an economic point-of-view. After Hitler’s election in 1933 the Nazis were able to sustain between about 8-10% GDP for five years running with an inflation rate that would be the envy of the Bank of England and other inflation-targeters today. Now, we know how this growth was financed — that is, by money issuance — but how was it achieved? Here we turn back to the Nuremberg transcripts.

Well, first of all the capital markets were brought firmly under control so that rearmament became priority number one. The prosecution explains,

By a series of controls, they reduced to the minimum consistent with their rearmament program, all private issues which might have competed with Government issues for the limited funds in the capital market. Thus, the capital market was, in effect, pre-empted for Government issues.

Next Schacht seized control over the foreign exchange market to ensure that only those goods that were truly needed for the war machine — such as raw materials — were imported. This was referred to as the ‘New Plan’.

There were three main features of the “New Plan” as devised by Schacht: (1) restriction of the demand for such foreign exchange as would be used for purposes unrelated to the conspirators’ rearmament program; (2) increase of the supply of foreign exchange, as a means of paying for essential imports which could not otherwise be acquired; and (3) clearing agreements and other devices obviating the need for foreign exchange… These agencies, which were under Schacht’s control as Minister of Economics, decided whether given imports and exports were desirable; whether the quantities, prices, credit terms, and countries involved were satisfactory; and in short, whether any particular transaction advanced the conspirators’ armament program.

In addition to this Schacht took advantage of the clearing system that existed (and basically still exists) and allowed other countries’ exporters to send Germany raw materials in exchange for claims on the German clearing house. These claims are then only paid when Germany stops running a trade deficit and begins running a trade surplus. What follows is an amazing moment in Nuremberg where the truth of the international clearing system is laid bare for all to see.

The principle of the clearing system is as follows: The importer makes a deposit of the purchase price in his own currency at the national clearing agency of his country, which places the same amount to the credit of the clearing agency of the exporting country. The latter institution then pays the exporter in his own currency. Thus, if trade between two countries is unequal, the clearing agency of one acquires a claim against the agency of the other. That claim, however, is satisfied only when a shift in the balance of trade gives rise to an offsetting claim.

And why did the other countries’ clearing houses turn the other cheek and accept claims that may never be paid? Well, ask yourselves why China pegs its currency to the dollar and you’ll likely come up with the answer: they desperately want to take advantage of the aggregate demand provided by the foreign consumer. Here is the Nuremberg prosecutor making a far more savvy economic argument than many modern commentators manage in their lifetime,

This device was used by Schacht as a means of exploiting Germany’s position as Europe’s largest consumer in order to acquire essential raw materials from countries which, because of the world wide economic depression, were dependent upon the German market as an outlet for their surplus products.

How did Schacht dare to take what must have seemed to others to be enormous policy risks by bending both the domestic and international monetary system to the will of the Nazis? Because, it seems, Schacht was a very sophisticated economist who was not only far ahead economists in his own time but is also far ahead of most economists in ours. Here is a quote from Schacht… the Keynesian,

It has been shown that, in contrast to everything which classical national economy has hitherto taught, not the producer but the consumer is the ruling factor in economic life.

I believe what Schacht is here getting at that, as Keynesian economists know well, it is the demand-side of the economy which is important in most respects. The supply-side — the producer — is of secondary importance.

Schacht also invented what was called the ‘aski’ system to ensure that money paid for imports was then only spent on German exports. This seems to have been done through negotiation and, despite the sometimes moronic trade laws that exist in our world today, would certainly be worth another look by development economists should we ever move into a more enlightened future.

This scheme likewise obviated the need for free currency (i.e. Reichsmarks freely convertible into foreign currency at the official rate-U. S. dollars, pounds sterling, etc). The system worked as follows: The German foreign exchange control administration would authorize imports of goods in specified quantities and categories on the condition that the foreign sellers agreed to accept payment in the form of Mark credits to accounts of a special type held in German banks. These accounts were called “aski”, an abbreviation of Auslander Sonderkonten fuer Inlandszahlungen (foreigners’ special accounts for inland payments). The so-called “aski” Marks in such an account could be used to purchase German goods only for export to the country of the holder of the account; they could not be converted into foreign currency at the official rates of exchange. Each group of “aski” accounts formed a separate “island of exchange” in which the German authorities, under Schacht’s leadership, could apply their control as the country’s bargaining position in each case seemed to warrant.

Schacht’s ‘New Plan’ for the foreign sector of the German economy was enormously successful and probably contributed significantly to the low inflation in Germany in those years noted above. But what was going on at home? We know that Schacht had suppressed the capital market in what can only be described as the ultimate historical instance of ‘crowding out’ and we know that he had freed up the fiscal system to be used in any way he pleased but what was going on in domestic industry? It is to this we now turn.

Well, this is a rather simple story and can be told in a single paragraph: Schacht basically turned the German economy into a control economy. Here it is probably best to allow the Nuremberg prosecution to explain,

Schacht adopted a host of controls over the productive mechanism of Germany, extending, inter alia, to the allocation of raw materials, regulation of productive capacity, use of abundant or synthetic substitutes in place of declining stocks of urgently needed materials, and the erection of new capacity for the production of essential commodities. The structure of regulation was built up out of thousands of decrees in which governmental agencies under Schacht’s control issued permits, prohibitions, and instructions These decrees were the outgrowth of carefully laid plans of the Ministry of Economics, of which Schacht was the head, concerning “economic preparation for the conduct of war”, and in accordance with its view that “genuine positive economic mobilization” demanded that “exact instructions for every individual commercial undertaking are laid down by a central authority’.

All in all there is much that can be learned from Germany’s experience in the 1930s. While their attempts to control production and consumption directly are probably not suitable outside of warfare or rearmament Schacht’s monetary manipulations were, by any standard, rather ingenious. They were also extremely brave in that they had never been tried before and Schacht was not, so far as I can see, working off any truly articulated Keynesian theory. Rather he was working from the basis of intuition — an intuition, it should be noted, that was rather sharp.

So, what happened then to Schacht? Well, it turns out that he was not the monster those he worked for undoubtedly were. Even the prosecution conceded that “he was not in complete sympathy with that aspect of the Nazi Party’s program which involved the wholesale extermination of the Jews” and that he “gave aid and comfort to individual Jews who sought to escape the indignities generally inflicted upon Jews in Nazi Germany”. That is more than can be said of many German soldiers and officers who went home to their families after the war. Nor was Schacht an official member of the Nazi party, in fact he was a former liberal politician.

The Soviets, who wanted to convict Schacht, saw him as the man who had, through his economic genius, facilitated the growth of the Nazi war machine. The British, on the other hand, saw him as another instance of a common character type: an ambitious functionary who tied himself to the power structure in Nazi Germany while maintaining his distance and they favoured acquittal. In their own way, both sides were probably correct. But Schacht was acquitted and he went on to found a bank and give economic advice to developing countries. My guess is that this advice was far superior to that given by modern day economists.

Gaze Not Into the Abyss: The KfW, Mitchell and Ramanan’s Misreading

Ramanan is attacking the Chartalists again. And as usual he assumes a stupidity on their part that, well, what was that Nietzsche quote again?

Battle not with monsters, lest ye become a monster, and if you gaze into the abyss, the abyss gazes also into you.

I’m not going to spend very much time on this because it’s just silliness. But we may as well nail it down for the record. Ramanan writes,

In other words, Prof. Mitchell seems to present a story in which the German government is using KfW as a tool to have a higher budget deficit than what it shows in its own books but it is in fact the opposite. This is because the combined entity KfW + Government of Germany has a lower deficit than the deficit of the government of Germany.

Eh, no. Mitchell was presenting a story in which the KfW was engaged in extending credit to the private sector — just as Ramanan says. This then allows for an increase in aggregate demand without the government having to engage in deficit spending. Thus, Mitchell’s story goes, economic activity is buttressed by the KfW so that the government doesn’t have to do the heavy lifting. Mitchell states this clearly at the very beginning of the piece when he writes,

[The KfW] has since grown (and diversified) into one of the largest banks in Germany (taken its main business units into account) and pumps millions of Euros in the domestic economy and the export sector (via IPEX, its 100 per cent owned subsidiary)… It is a major reason why the federal deficit has been reduced without scorching the German economy. (My Emphasis)

So, what’s the problem with this? Simple. The KfW is, for all intents and purposes, a government institution. Mitchell writes,

The company is run by an Executive Board who are “appointed and dismissed” by the Board of Supervisory Directors (Article 6).

Guess who is the Chairman of the all-powerful Board of Supervisory Directors?

None other than our sudoku-playing Bundesfinanzminister (Federal Minister of Finance), Dr Wolfgang Schäuble. The Board is packed with Federal government ministers, which is appropriate given the bank is state-owned.

Other features of the legal status of KfW:

1. It distributes no profits but allocates surpluses to reserves attributable to the shareholders (government) (Article 10).

2. It has the same status as the central bank with respect to taxes – that is, it doesn’t pay them.

The Kfw is thus unambiguously a state institution and provides loans at lower than commercial rates because its bonds are considered of equal status to the German government’s own debt-issues.

See the cheating here? The KfW, for all intents and purposes, is a government institution and has full government backing. The KfW is like a sort of shell company for extending credit that is effectively the same as if the government had to pay for these projects given that the board of the KfW is filled with government folks and the bonds are backed by the government. The trick is that this borrowing doesn’t appear on the government balance sheet so, given a level of aggregate net expenditure equal to,

[Government Deficit + KfW Lending],

the Federal deficit is lower than it would otherwise be if the government had to foot the bill for all this expenditure.

Ramanan writes,

For Mitchell’s claim on the deficit to be valid, KfW should be a net borrower each year of a big size. For the claim on the public debt, KfW’s net indebtedness should be large. Unfortunately for Mitchell, KfW is a net lender to the private sector and the rest of the world sector in the flow sense and a net creditor in the stock sense.

It is clear that he has simply not understood Mitchell’s argument. The lesson here? If you have an emotionally-charged gripe with some theory or other you should be all the more fastidious in trying to understand the argument of said theory before you criticise it. Otherwise there is ample chance that you will get carried away with yourself.

Anyway, I have no problem with what the KfW does per se. Nor, I think, does Mitchell. Government-backed development banks are an excellent means for providing aggregate net expenditure to the economy through government-directed lending without giving rise to government debts that cause hysteria among austerity hawks and politicians. Mitchell’s point is that Germany is being hypocritical in this regard because they are calling for contraction in net expenditure in the periphery. I agree. They are.

Addendum: More misreading

As readers ca see from the comments section Ramanan came on here and began to put words in my mouth. He made multiple claims about what I was supposedly saying that I never, in fact, said. He now has added to his post with some strange arguments. I will deal with the two main points here. The first one is in response to me saying that if the KfW did not lend then the government would have to engage in expenditure to keep the level of output up. Ramanan responds,

First, the government would not have to “foot the bill for this expenditure” if it were to lend directly to the private sector on its books because the lending would not be “expenditure” but a loan by the government and it would be making a profit on it. The loan would not add to the budget balance even if the government were to directly lend.

Yes, this is also a possibility. The government could lend directly. This is another counter-factual. But it is highly unlikely to actually happen.

His second point,

Further Pilkington seems to assume that another counter-factual in this case is less borrowing by the private sector and hence lesser private expenditure. No! this counter factual is the private sector borrowing from other banks – i.e, private banks. Why would German firms find difficulty in borrowing if they happened to show their creditworthiness to KfW?

This indicates that Ramanan thinks that lending and spending by the private sector is not determined by institutional issues and is only determined by their desire to lend. I think this shows clearly Ramanan’s weakness understanding institutional and political issues as they relate to economic issues. In short: I don’t think that he fully grasps how industrial policy works. In actual fact, in such ventures the government and the private sector team up and engage in undertaking activities together. That is what appears to be happening here.

 

Tyler Cowen and Daniel Kuehn Miss the Point of the Austrian Business Cycle Theory

There’s been a bit of confusion surrounding the Austrian Business Cycle Theory (ABCT) over at Lord Keynes’ blog. Regular readers of this blog will know that I try as best I can to avoid Austrian economics as it is absurdly primitive, but every now and again I get pulled into the mix. Given that I’m a bit of a history of ideas guy, it always irks me somewhat when people misrepresent ideas — even those I think nonsensical — by buying into modern presentations without going back to the sources.

The confusion surrounding the ABCT seems to stem from an article by Daniel Kuehn. Note that I have not read the article but so far as I can see the quote in question cannot really be taken out of context. Here is that quote,

Cowen (1997) points out that over the course of the business cycle, investment and consumption move together, a phenomenon he refers to as ‘comovement.’ For at least two reasons, Hayek’s theory predicts that investment and consumption should move in opposite directions during the business cycle, with investment rising in the boom and declining in the bust.

Two things should be noted. The first is slightly less important but should probably be posited for the historical record. The phenomena that Cowen apparently calls  ‘comovement’ is not something that Cowen in any way identified. Rather it is just a manifestation of the basic Keynesian consumption function. In the General Theory Keynes argued that consumption is a function of income and that income is a function of investment. So, when investment falls, income falls and hence consumption falls. Cowen may place a new term on an old theory but that strikes me as being rather pretentious.

The second point, however, is far more pressing: do Austrians really think that investment and consumption move in opposite directions over the course of the business cycle? I have looked around a bit and I have not found any evidence of this — a few vague statements by vulgar Austrians that might be misunderstood aside. Since the articles by the vulgar Austrians online are vague, being the good scholars that we are, it is probably better to go to a source. I take Ludwig Von Mises’ Human Action as it was written when Austrian theory had largely been fully developed. (It is also available online in PDF form which is handy!).

Now, what happens to consumption across the business cycle according to Mises? Well, let us take a number of quotes in this regard.

“The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment. The depression, on the other hand, is the way back to a state of affairs in which all factors of production are employed for the best possible satisfaction of the most urgent needs of the consumers.” (p573, My Emphasis).

That seems rather clear to me. In the boom there is both malinvestment — which is a form of overinvestment — and overconsumption. That looks like the so-called ‘comovement’ that Tyler Cowen ‘discovered’. So, what happens in the bust?

“Out of the collapse of the boom there is only one way back to a state of affairs in which progressive accumulation of capital safeguards a steady improvement of material well-being: new saving must accumulate the capital goods needed for a harmonious equipment of all branches of production with the capital required. One must provide the capital goods lacking in those branches which were unduly neglected in the boom. Wage rates must drop; people must restrict their consumption temporarily until the capital wasted by malinvestment is restored. Those who dislike these hardships of the readjustment period must abstain in time from credit expansion.” (pp575-576, My Emphasis).

Again, Mises seems crystal clear on this point: in the bust wages fall and people consume less. Again, consumption in the bust falls, it does not rise as Kuehn seems to think. This is just like Cowen, Keynes and anyone with an ounce of sense who has lived through a recession would think. Indeed, Mises is quite clear that everyone — both producers and consumers — feel better off in the boom.

Expansion produces first the illusory appearance of prosperity. It is extremely popular because it seems to make the majority, even everybody, more affluent. It has an enticing quality. (p567)

The trade-off, for Mises, is not that consumers starve while capital goods are produced, but rather that everyone feels the pain when so-called malinvestment unwinds and reallocates resources to their supposedly more productive uses. This is made clear when Mises writes the following,

Of course, the boom affects also the consumers’ goods industries. They too invest more and expand their production capacity. However, the new plants and the new annexes added to the already existing plants are not always those for the products of which the demand of the public is most intense. (p560)

What about investment? While I think that it would be unusual for anyone familiar with the Austrian theory of the ‘purging’ of malinvestment in the bust to assume that investment rises in a recession (indeed, it is clear that Kuehn was not making this case), for the sake of completeness let us get Mises’ take on this. Conveniently enough it comes in a passage where he again discusses consumption in the boom. The following is the clearest instance showing that Mises fully agrees with Cowen’s rediscovery of the consumption function under the guise of his so-called ‘comovement’,

Expansion squanders scarce factors of production by malinvestment and overconsumption. If it once comes to an end, a tedious process of recovery is needed in order to wipe out the impoverishment it has left behind. But contraction produces neither malinvestment nor overconsumption. The temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the part of discharged wage earners and the owners of the material factors of production the sales of which drop. (p567 — My Emphasis)

Again, Mises is quite clear: at the turn of the business cycle investment falls and so too does consumption while in the run-up of the boom both investment and consumption rise.

This seems to be well recognised by the more articulate of the internet Austrians. Paul Cwik writes,

The ABCT is a theory that contains both malinvestment at the higher stages of production and overconsumption!… When the interest rate falls it sends a signal not only to investors and entrepreneurs to invest more.  It also tells consumers that the return on savings has fallen.  As a result, income saved falls and income consumed rises.  Thus, the structure of production is split and torn apart in two directions.  For the mainstream macroeconomist, he sees C (consumption) and I (investment) increasing together, which is solid GDP growth.

So, what is this ABCT really all about then? Well, as I indicated above — and as is obvious to anyone who reads Chapter XX of Human Action — it has to do with malinvestment; that is, a mis-allocation of resources. Mises and other Austrians believe that the market allocates resources in a perfect manner, ensuring optimal outcomes. When this process is disturbed by an increase in the money supply and a fall in the interest rate entrepreneurs undertake investment in crappy goods that people do not ‘really’ want. Eventually the easy money dries up, interest rates rise and the malinvestment is shown to be what it is: investment in low-grade crap. Then a process of low production and consumption sets in where resources are gradually reallocated to accommodate what people ‘really’ desire. This is the recession or depression.

This is, in essence, a moral story. It is one of excess, of misrecognised desires and of human folly that is then followed by purging, a return to more austere desire and a sobering up. It is a nice moral story that speaks to something deep inside ourselves. One might say that it is even Catholic in its conception of the easy excesses of Sin and the uphill battle in search of Redemption.

But all this matters little to the key point: Kuehn and Cowen misrepresent Austrian Business Cycle Theory in their criticisms. Mises together with other sophisticated Austrians simply cannot be read in any other way. I would plead with economists: please, please adhere to standards of good scholarship and read sources carefully when engaging with various paradigms — opposing or otherwise. Poor scholarship has done such immeasurable damage to the profession that even misrepresentations of quasi-theological doctrines like those of the Austrians is something that should be avoided at all times.

Addendum: Hayek as a Neo-Keynesian

I thought that it might be interesting to provide a quote from the very paper that Kuehn cites as evidence that Hayek/ABCT states that there is an inverse relationship between consumption and investment across the business cycle. Here it is,

Prices of consumers’ goods are notoriously sticky. At first, when the demand for such goods ceases to increase or even begins to fall, this will check the tendency to increase capacity and thus (by decreasing the “multiplicand” of the acceleration effect without as yet changing the” multiplier”) will decrease employment also in those capital goods industries which till the end shared the prosperity of the consumers’ goods industries. This will further intensify the decrease of incomes and of consumers’ demand. (Hayek, 1939, p35)

As we can see, Hayek’s argument is neo-Keynesian and explains the sharp fall in output that accompanies a downturn not only with an appeal to price stickiness but also using the Keynesian language of the multiplier! This would, of course, baffle many internet Austrians. But it should not surprise us. As I stressed above: the ABCT is all about malinvestment. It is not about hyperinflations or any of that other gold bug nonsense.

Press Release For My New Tax-Backed Bonds Policy Note at Levy

FOR RELEASE: 05/12/2013

Contact: Philip Pilkington

Telephone: xxxxxxxxxx

Email: xxxxxxxxxxxx

Tax-Backed Bonds Will Still Solve the Eurozone Crisis and Stop Austerity

The Levy Institute of Bard College recently released a follow-up policy note by Philip Pilkington on the continued relevance of tax-backed bonds as a means of solving the Eurozone crisis. The policy note reevaluates the revolutionary tax-backed bond solution to the Eurozone crisis in the face of ongoing changes in the monetary union.

Tax-backed bonds work by providing investors with a solid guarantee that in the case of a default by a Eurozone member country their sovereign debt can be used to make tax payments within the state. This would provide investors with a solid, 100% guarantee on their investment. Such a guarantee would ensure low and stable yields without the intervention of the monetary authorities and would allow the issuer of tax-backed bonds to halt any damaging austerity programs which they may be undertaking.

The original policy note which was co-authored with the originator of the plan economist and hedge fund manager Warren Mosler and was published in March of 2012. Since then there has been a lot of discussion about the proposal.

The Irish Finance Minister Michael Noonan raised the proposal in the Irish Parliament in May of 2012 but rejected it based on advice that he received from the National Treasury Management Agency (NTMA). The new policy note published by the Levy Institute addresses the Finance Minister’s concerns and concludes that the policy is still viable in light of the objections raised by the NTMA.

Press coverage of the proposal has been extremely positive so far, with a seminal op-ed being published by the famous anthropologist and author of ‘Debt: The First 5000 Years’ David Graeber in The Guardian. We are also awaiting an upcoming appearance of Philip Pilkington in a film about the debt crisis for French television that deals with the crisis as a whole.

To see the new proposal please follow this link. To see the original proposal follow this link.

We look forward to a lively debate surrounding the proposal in the coming months.

Technological Progress in a Below Full Employment Economy

I recently came across a rather interesting argument that the famous Post-Keynesian economist Abba Lerner made in relation to his well-known doctrine of Functional Finance. Basically Lerner said that labour-saving technological innovation in a below full employment economy was not particularly socially useful.

In a 2003 paper entitled Functional Finance and Unemployment: Lessons From Lerner For Today in the book Reinventing Functional Finance Matt Forstater laid out this argument. First he quotes Lerner himself to the following effect,

When there is unemployment… it is not important or even useful to use less resources in any task… There is no point, for instance, in managing to carry out some task with less labor if there are unemployed workers available, because the workers set free would not be utilized for other tasks any more than the workers who are already unemployed. They would merely be added to the unemployed. Where there is unemployment, an increase in efficiency in any particular productive process does not result in any increase in efficiency in the economy as a whole. (p163)

Forstater goes on to lay out one argument against this consideration and lays out Lerner’s objection,

Lerner does consider the possibility that, rather than producing the same amount of output with fewer workers, society could produce more output while maintaining the same amount of workers. Yet as he rightly points out, though increased saving results from increased income accompanying higher output levels — absent an exactly offsetting higher level of investment or government expenditure — the new higher level of output will not be sustainable, as all production will not be sold, and firms will cut back that production and lay off workers. (ibid)

Basically then, the higher level of output produced by the workers will not be purchased because the workers will have the same amount of income outstanding as they did before. And since we can assume that prices will not adjust, the adjustment must be made on the quantity side — i.e. by an increase in unemployment.

This is related to what is called the Domar Problem and which Randy Wray highlighted recently when he wrote,

When we turn to the subject of economic growth, it is not legitimate to ignore capacity effects as investment proceeds. Not only does investment add to aggregate demand, but it also increases potential aggregate supply by adding plant and equipment that increase capacity. To be more precise, a portion of gross investment is used to replace capital that is taken out of service (either because it has physically deteriorated, or because of technological obsolescence), while “net investment” adds to productive capacity. Further, note that while it takes an increase of investment to raise aggregate demand (through the multiplier), a constant level of net investment will continually increase potential aggregate supply. The “Domar problem” results because there is no guarantee that the additional demand created by an increase of investment will absorb the additional capacity created by net investment. Indeed, if net investment is constant, and if this adds to capacity at a constant rate, it is extremely unlikely that aggregate demand will grow fast enough to keep capital fully utilized. This refutes Say’s Law, since the enhanced ability to supply output would not be met by sufficient demand. As such, “more investment” would not be a reliable solution to a situation in which demand were already insufficient to allow full utilization of existing capacity.

When thinking in terms of technological progress it is by no means clear that an increase in aggregate supply by way of investment in new labour-saving, highly productive technologies will result in sufficient incomes for workers to then purchase the new goods and services.

There is, however, one aspect that Lerner did not consider in his example: namely, that an increase in productivity will lead to lower unit labour costs and increase exports as they become more competitive. It is indeed true that this might happen but in this case the economy that puts the new labour-saving technology in place will merely be exporting their unemployment abroad. This would then result in a classic ‘race to the bottom’ that would ultimately result in higher unemployment everywhere.

Mainstream economists avoid these problems by assuming that prices will adjust downwards at some point. Yes, in the short-run such considerations may be important but in the long-run the increases in productivity will lead to lower prices on output which can then be bought at the new higher real income levels. There is probably some truth to this as technological goods do have a tendency to fall in price, but to believe that this will occur automatically is, quite frankly, utopian in the extreme.

To understand this consider, for example, the television. Are televisions today cheaper than they were 20 years ago? Yes and no. They are probably cheaper in the sense that we get a much better television for a similar amount of money as we got a far inferior television 20 years ago, but their real money price is probably somewhat the same. If it were the case that there is higher capacity to produce the better quality televisions relative to the lower quality ones of 20 years ago then there is no price adjustment process that would ensure adequate demand all is being equal.

At the very least, such adjustments will be enormously complex and it requires heroically unrealistic assumptions about market adjustments to believe that such adjustments will cancel each other out perfectly. It is far more likely that increased capacity not met by gains in real wages will lead to depressed demand and unemployment.

With that in mind I leave the reader with a particularly colourful quote from Lerner on the problem,

Economizing resources by the use of more efficient methods is like pouring water into a broken vessel with a large hole in it that is already holding as much as it can hold. No matter how much more is poured into it there will remain no more than at the beginning. The savings due to greater technical efficiency merely go to waste in further unemployment just as any additional water merely goes to waste through the hold. (ibid).

More Hypocrisy From Krugman: The Grumpy Old Men of Macro

Well, it looks like I wasn’t the only one taking Krugman to task the other day for defending mainstream economics because he’s actually responded to some of the flak he has received. It’s a bland response (as usual) and more so resembles Krugman talking to what he imagines his opponents to be saying rather than what they are actually saying. (Fantastic way to stifle a debate…).

But there are a few points that I think should be brought out to show just what some of the problems are. I’ll keep this short and sweet. Krugman writes,

You may say that what we need is reconstruction from the ground up — an economics with no vestige of equilibrium analysis. Well, show me some results. As it happens, the hybrid, eclectic approach I’ve just described has done pretty well in this crisis, so you had better show me some really superior results before it gets thrown out the window.

According to Krugman if you throw out equilibrium analysis you get nothing. But of course there are two types of equilibrium in economics: market equilibrium and stock-flow equilibrium. The former is, for example, characteristic of the ISLM model in that the equilibrium is determined by the supply and demand of loanable funds (among other things). But then there is also the stock-flow equilibrium approach which is, for example, characteristic of the Godleyian SFC modelling framework. This is an entirely different approach to economics but Krugman has dismissed it on his blog before as being ‘old fashioned’. In his response to an article on Godley he wrote,

But it is kind of funny to see a revival of old-fashioned macro hailed, at least by some, as the key to a reconstruction of the field.

Funny that when you compare it to his latest,

But must we reconstruct all of economics? No. Most of what we need, at least for now, is in those old books.

Frankly though, I don’t think that Krugman is up-to-speed on these debates, he looks like a man flailing about in unfamiliar water. Why is this? Because he appears to live in something of an echo chamber. When he encounters Wynne Godley’s path-breaking work (which performed far better than ISLM garbage in the run-up to the crisis — remember Godley and others at the Levy Institute predicted the crisis) he pooh-poohs it as old fashioned (without examining it). Then when he encounters criticisms of the ISLM and like frameworks he complains that there are no alternatives. He asks to be “shown superior results” and then when he encounters them he calls them old fashioned… and then says that we have to go back to old fashioned ISLM models.

Let’s get this straight. According to Krugman its amusing to see something as old fashioned as SFC modelling being hailed as a way to reconstruct the field. But then he says that we don’t need to reconstruct the field because… we have old fashioned ISLM modelling. Bizarre.

Krugman is lagging in this debate badly. He looks like he’s in over his head. Here’s a thought: the only people that are being old fashioned are Paul Krugman and the other economists who, confronted with a crisis in mainstream macro, retreat to their schooldays and the very first macro lessons that they ever learned. Yawn.

What Caused the ‘Great Moderation’ and How is it Related to the 2008 Crisis?

Today most mainstream economists, even those who call themselves Keynesians, hold to the idea that something like a ‘Great Moderation’ existed between the mid-1980s and 2008. This period, characterised by low inflation and moderate GDP growth, was then and is now generally interpreted as being due to the perfection of the use of monetary policy as a macroeconomic stabilisation tool. It is this rather unusual specter of an argument that lies behind the assumption that once we exit our present so-called ‘liquidity trap’ we will be back to business as usual.

Why do I call this a specter of an argument? Simply for the reason that it is never made clear what the link between the crisis of 2008 and the supposed Great Moderation actually was. What I mean by this is that it is impossible for any serious economist to avoid the fact that the Great Moderation must be viewed, retrospectively, in light of the 2008 crash and the stagnation that followed. To avoid doing this, as it seems to me most commentators today have done, is to show oneself to have a blind spot so massive that I do not believe such people should be taken at all seriously.

The Post-Keynesian community, of course, have a perfectly clear answer to this question. They always said that the 1990s and 2000s were characterised by a chronic lack of demand due to, in the cases of the US and the UK, large trade deficits, tight government budgets and stagnant real wages. This lack of demand was then papered over by the growth of a financial sector that expanded private sector debt enormously and generated bubbles — first in the stock market, then in the housing market. When these bubbles ran their course the plaster was ripped off the wound and the effects of the underlying demand shortage became known.

Such dynamics too should be seen as the cause of the low inflation of that era. In a 2003 paper entitled Are These Trade-Offs Necessary? in the book Reinventing Functional Finance the Old Keynesian economist James Duesenberry noted how, in the case of the US, it was the underlying causes of these dynamics that accounted for the low inflation of the period.

In my opinion, the changes in personnel management, the increasing role of foreign competition and the weakening of trade union bargaining power noted earlier have played an important role in limiting inflation. (p132)

These changes are, of course, the result of what is usually referred to as ‘globalisation’ and they tend to hold wages in check. This even in the case of the low levels of unemployment that we saw in the 1990s — levels which had the NAIRU theorists, who assumed some rigid relationship between unemployment and inflation, scratching their heads.

So why don’t the mainstream economists who realise that what economies are suffering from is a chronic lack of demand recognise these obvious truths? After all, heterodox economists were making these arguments rather vocally in the 1990s and 2000s and I am fairly confident that at least some of those economists that I am referring to are aware of them. I would say that this is for two reasons; both of which are interlinked.

On the one hand these theorists continue today to cling to the notion of a ‘natural rate of interest’ that implies that central banks can overcome any structural issues in the economy (which, according to these theorists,basically cannot exist in the long-run anyway) and create a full employment savings-investment equilibrium. On the other, and tied to this theoretical stubbornness, it was these theorists who pushed for many of the ‘reforms’ that led to sluggish wage growth, deregulated financial markets and widened trade deficits throughout the so-called Great Moderation.

In short: to recognise the real causes of the Great Moderation would be, for many established commentators, to basically discredit their life’s work. And that is a hard cross for any man to bear.

Something is Rotten in the State of Macro: Krugman’s Continued Hypocritical Defence of the Status Quo

Paul Krugman is out again defending mainstream economics against students and others who rightly suspect that it has taken a wayward path. I won’t go too much here into Krugman’s own history as a gatekeeper for orthodox economics, having dug up some of the rather embarrassing historical record on this blog before.

Let me just note two rather large ironies with what Krugman is saying here. First of all there is the obvious one. On the one hand Krugman claims that all is right with the state of macro. Yet on the other hand he himself is publishing papers that try to absorb certain heterodox theories into the profession.

Thus he is talking out of two sides of his mouth. He is at once saying “ignore those heterodox guys” and at the same time saying “read my papers that integrates their important theoretical insights”. I don’t think it would require too much psychological subtlety on the part of the reader to understand what Krugman is doing here, whether consciously or unconsciously.

The second irony is rather more technical but also highlights something important about mainstreamers like Krugman: namely, that they don’t properly understand the implications or theoretical foundations of their own theories. In his recent post Krugman says,

Efficient markets theory arguably deserves more blame for the failure of too many economists to recognize the housing bubble, but textbook economics always presented EMT as a baseline, not a revealed truth.

That sounds nice, right? Well, not really. It’s become something of a cliche for mainstreamers to attack the EMH. This feeds into the whole ‘saltwater’ versus ‘freshwater’ pantomime that the mainstream has been playing at for over 30 years.

Beyond that many of Krugman’s own formulations require an implicit EMH. Krugman himself doesn’t understand this, of course, but again I contend that mainstreamers don’t understand a very good deal about their own theories because they lack detached theoretical and historical perspective on such matters.

So, which formulations require an implicit EMH? Well, the natural rate of interest theory for one. As I wrote here (apologies in advance for the long quotation but I see no point in repeating the argument here):

Note carefully that [mainstreamers like Krugman when they refer to a natural rate of interest] refer to this interest rate in the singular, not in the plural. This is because, as we have already seen, they assume that the rate that needs to be set in line with the natural rate is the central bank overnight interest rates – what used to be called the “money rate of interest”. However, the central bank overnight interest rate is but one of many interest rates in the economy. There are, in fact, distinct interest rates on every financial asset in the economy. There are separate interest rates, for example, on triple-A rated company debt and on low-rate junk bonds; there are separate interest rates on personal mortgages and on credit-card debt – and so on and so on.

The reason that the Bastard Keynesians ignore this fact is that they assume – quite correctly – that when the central bank raises or lowers the overnight interest rate, all these other interest rates respond accordingly. The central bank rate of interest can properly be seen as the “risk-free” rate of interest while all the other interest rates integrate whatever risks the borrower is seen to represent. To understand this better let us imagine that the central bank risk-free rate is set at, say, 4%. Investors and savers know that by parking their money in government bonds they can get this 4% without incurring any risk. So, if they are to put their money into, say, a risky junk bond that has a high risk of default they will demand maybe 15%.

Now, say that the central bank lowers the risk-free rate to 0%. Well, now the investors and savers are going to be willing to accept a much lower return from the risky junk bond. Their choice is no longer between a risk-free rate of 4% and a risky rate of 15% but is instead between a 0% rate of return that incurs no risk and a risky asset with a high default risk. Thus they might be willing to buy the junk bond if it has, maybe, an 11% rate of interest or so.

This is all well and good if we assume that savers and investors are perfectly rational and price in risk perfectly. After all, if investors and savers are not subject to irrational swings and do not misprice risk because they essentially know the future then this whole process should work like clockwork – or, more poignantly, like an enormous series of neoclassical supply and demand curves that exist all across the money markets. However, if investors and savers are not perfectly rational and cannot price in risk perfectly because they do not know the future, then the interest rates on everything except the risk-free rate set by the central bank is completely and utterly indeterminate and is subject to the whims of investors…

The idea of a natural rate of interest then implicitly rests on the idea that investors and savers in the economy are perfectly rational and have perfect information about the future. Indeed, it actually implicitly relies on the Efficient Market Hypothesis in its strongest form.

The natural rate of interest is, of course, central to Krugman’s basic understanding of macro. It is also central to many of the policy recommendations that he makes; such as the idea that in ‘normal times’ monetary policy alone can be used to steer macroeconomic activity.

This is the problem with people like Krugman. In their zealous defence of a status quo that has been failing them for years (again, see this post) they are completely blind to what their theories actually imply. Meanwhile they pick the bones of the heterodox economics that they actively try to suppress in order to form models with which to explain the crisis to one another. Something is rotten here indeed.

In the Short-Run We Are All Dead: Probability Theory and Short-Termist Investment

Keynes famously said that in the long-run we are all dead. What he was counseling against was the tendency on the part of economists to discuss economic processes in terms of the so-called ‘long-run’. This idea, which I have written about more extensively here, often leads economists to think in the most metaphysical of terms, concocting imaginary worlds in which logical processes work themselves out with ease and then conflating an confusing these imaginary worlds with reality. Keynes’ implicit advice was that economists should largely concern themselves with the short-run.

Yesterday I attended a conference at which a number of economists considered the long-run at length but in a way that, I think, Keynes would have approved. The conference was entitled Financial Governance for Innovation and Social Inclusion and it was largely concerned with the fact that capital markets are very poor at financing long-term investments — particularly those that have to do with basic research. Centered around the excellent work of Marianna Mazzucato, who organised the conference, a variety of economists tried to trash out the implications of what this empirical fact has for the future developments of the capital infrastructure of our economies.

Long ago Keynes recognised that long-term investments carried with them an enormous amount of uncertainty. In chapter 12 of the General Theory Keynes wrote,

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.

These considerations led Keynes to conclude that there was a major role for the state in making investments that carried with them a very high degree of uncertainty.

Here, however, I think it might be interesting to highlight and emphasise the last sentence in that quote as it resonates very loudly today in our modern world of risk-modelling that is used to channel resources in our economies. Such risk-modelling is geared, quite organically, to the short-term. In order to understand why consider the CAPM, a financial model that is often used to price assets in capital markets. (I have written extensively on and criticised the CAPM here).

The CAPM tries to estimate the price of an asset based on how risky it is vis-a-vis the rest of the market. This effectively comes down to how much volatility the asset has relative to the overall volatility of the market. The reasons that this favours short-termism should be obvious; first of all, it requires data to be inputted and since data is unavailable for a new innovation or an asset that will have a very long life running into the future it is clear that the CAPM is completely unsuitable for such investments; secondly, it requires a measure of probabilistic risk that will only likely hold (if it holds at all) into the very near term.

Of course, CAPM is not the only means to mathematically estimate the return on investments, but other methods face similar difficulties. When we discuss a market for an asset that has long been in existence and our position in that asset is only fairly short-term, using probability estimates may be somewhat functional. If, however, we are talking about a new innovation or a very long-term investment that we will have to carry far into the future such models are quite literally meaningless.

And yet the capital markets are becoming increasingly dominated by such techniques by the day. Why? Because, despite the mythic figure of the private sector entrepreneur that our press and politicians present to us, the reality is that private sector investors are usually extremely risk averse. They are usually looking for a great deal of certainty that their investment will make an x% return of a set period.

We should not blame private investors for this, indeed it is their savings that we are talking about here, but the fact of the matter is that they then employ legions of managers to try as best they can to reduce uncertainty and make the returns that they require. This, in turn, results in a massive proliferation of financial bureaucrats that seek desperately and as best they can to meet portfolio targets in a manner not unlike how a government bureaucrat tries to meet their set targets. The result is an industry that is irreducibly conservative, grey, dull and boring.

This truth — which is so obvious to anyone who has even ventured onto a website of a modern day financial firm — tends to turn the myths that we are fed every day on their heads. Private sector capital tends to be extremely conservative in its uses. Such capital is channeled to rather dull people who try desperately to control the world based on probability estimates and who resemble less a rugged entrepreneur and more a Soviet bureaucrat trying to meet production targets.

But now that we are coming more and more to rely on these bureaucrats to manage the capital structure of our economies we can be sure that innovation will gradually slow to a crawl and short-termism will increasingly come to the fore. Unless states act to the contrary more and more people who should be doing real scientific research will be channeled into the Politburos that we call ‘financial districts’ in our major cities in order to try to control the future in the tragi-comic way that brainy bureaucrat-types tend to try to control things over which they have no grasp.

Such a future is nothing short of bleak. Where the planners in the Soviet Union tore that economic system apart with their misguided attempts to steer a vehicle over which they had no command, our modern planners have gained control over the money needed to channel resources in such a way that the capital infrastructure of the economy develops in an innovative manner.

Yanis Varoufakis Publishes Some of My Ramblings on the State of Ireland

Yanis emailed me for my thoughts on Ireland’s recent return to the bond market. He has published his own analysis with mine thrown in at the end here.

Note the Freudian slip wherein I misspell ‘Fianna Fail’, who are the former center-right party of governance that are now trying to re-brand themselves as center-left, as ‘Fine Fael’ which looks remarkably like the spelling of the present governing party, Fine Gael. It doesn’t take a psychoanalyst to figure out what that slip is all about.