Scotland: After the Election and Moving Into the Future

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

Scotland’s future is still in doubt

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

What Scotland Should Have Done (And Still Should Do)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is Economics a Science? Dogmatic Economics Vs. Reflective Economics

The question asked in the title of this post is actually somewhat of a trick. It is a trick because it all depends upon how you define ‘science’. Often when people say that economics is a science what they are doing is defining ‘science’ in such a way that economics fits the bill. They can do this because there is no real, firm definition of ‘science’ that is widely held among philosophers of science, scientists or, most certainly, among economists (who are the most anti-intellectual of the three groups by far).

If we look at Wikipedia, for example, it gives a definition of science that is Popperian — despite the fact that Popper’s falsifiability criteria have been called into question since the 1960s.

Science (from Latin scientia, meaning “knowledge”) is a systematic enterprise that builds and organizes knowledge in the form of testable explanations and predictions about the universe.

By this criteria economics is probably not a science because it cannot undertake repeatable experiments. Even in a weaker form most marginalist proclamations can be tested and falsified in the sense that they can be shown to not hold given the data we hold yet they remain powerful arguments within the discipline and are taught to students.

Let me then give a different definition of science. I am not saying that this is the correct one but it appears to me to be the one that modern economics as a discipline tried to follow when it was being born in the 19th and 20th century. My definition is as such: science is the search for timeless laws.

Here the obvious reference is Newton and his physics. Now, while we know that Newton’s system was imperfect and was completely overturned in the early 20th century the spirit of what he was doing was, I think, what gave rise to the scientific impulse during the Enlightenment out of which economics was born. When you look at a supply and demand graph you are looking at a representation that is trying to copy Newton by giving us timeless laws. This is also how such constructions are taught to students (any concerns are whisked away using the mysterious ‘ceteris paribus‘ clause).

By this criteria I do not believe that economics is science either. Before undertaking such a discussion I will first lay out my underlying criticism which will be long familiar to readers of this blog: economics deals with historical time which is non-homogenous and thus cannot generate timeless laws. Anything that remotely resembles a functional timeless law in economics is in fact an identity and is true only by its tautological construction.

Let us turn to the precursor to classical economics to give a sense of what I am saying. I am speaking, of course, of mercantilism. In this regard it is worth noting a now somewhat obscure work by the Soviet Marxist economist I.I. Rubin entitled A History of Economic Thought. It has been recently made available online and it is well worth a read.

What is so interesting about the work is that it places the older economic theories in their historical contexts. Rubin discusses each theory with respect to the specific circumstances of the historical situation out of which it emerged. What Rubin tried to show was that mercantilist theory and policy was not a simple ‘mistake’ as the later classical economists tried to portray them. Rather the mercantilist period was a phase of development of the young capitalist states that would go on to conquer the world. He writes:

The basic feature of mercantilist policy is that the state actively uses its powers to help implant and develop a young capitalist trade and industry and, through the use of protectionist measures, diligently defends it from foreign competition. (p26)

When economies had finished with this stage of development and had developed sufficient industrial capacity they were then ready to open up to the world and dominate its markets. It was at this stage that the classical economists arrived on the scene with their doctrines of free trade. This accounts for why the free trade dogma was accepted at different times in different countries. The Americans and the Germans rejected it until the late-19th and early-20th century simply because if they had adhered to it in the early and mid-19th century they would have been dominated by British industry.

Seen in this light it becomes clear that it is fruitless to ask whether an economic doctrine is ‘true’ in some timeless sense. That would be like asking whether, say, feudal law is ‘true’. Feudal law is neither true nor false. Rather it is the formalisation of a code by which a certain type of society organised itself. For that particular type of social organisation it was functional. If we tried to transplant it into a modern capitalist democracy it would probably prove dysfunctional.

Thus economics, and with it economists, fall into two categories. On the one hand we have what I opt to call ‘dogmatic economics’. Dogmatic economists are basically ideologues. They think that they have access to timeless truths and are scientists in the Newtonian mold. These economists are probably apt to get most things wrong most of the time. They also likely change their basic discourse over and over again. In the face of an ever-changing history they roll with the times, all the while maintaining the pretense that they have access to timeless truths. Basically the interpret and reinterpret their dogmas in light of new facts. The purpose of the dogmas is not illumination, rather it is to lend what they say authority. Dogmatic economists make up the majority of academic economists and also some very high up policy economists in government and economic institutions.

The other category of economics is what I opt to call ‘reflective economics’. Reflective economists understand that what they do is provide interpretations of a given historical constellation. They understand that there are better and worse interpretations — just like a judge can recognise a better or a worse interpretation of a law — but they do not hold to the idea that there are timeless, Newtonian laws in economics. Much of the sort of theory that they promote might be said to be very loose-fitting in that the tools needed for such interpretation tend to be less precise than those exacting constructions put together by the dogmatists. Reflective economists make up the minority of economists in academia. But the vast majority of serious working economists are in practice reflective economists.

What is the relationship between dogmatic and reflective economists in our society? Here there is no firm answer. The dogmatic economists react to the reflective economists in two ways: condescension and deep suspicion/fear. Working economists who do not partake in theoretical debate can be safely condescended to by the dogmatic economists. But the reflective economist who actually tries to engage in theoretical debate will provoke confusion and frustration in the dogmatic economist who is not used to having his or her authority challenged. The main device utilised here is to simply ignore these reflective economists and try to push them out of the debate through social isolation.

The reflective economists also react in two ways to the dogmatic economists. Some build a relationship of what psychotherapists call ‘transference‘ to the dogmatic economists. They assume that the dogmatic economists do in fact have access to timeless truths and that they, the poor working economist, did not make the cut to gain access to these truths. This reinforces the dogmatic economists’ power and social prestige. The other reaction is one of overt hostility. These reflective economists know that the dogmatic economists are Emperors that do not wear any clothes and they make no bones about saying it in public. This makes them quite unpopular with the dogmatic economists who then try to avoid such awkward discussions by isolating the critical reflective economists.

GLS Shackle and the Link Between Theology and Marginalist Economics

Yesterday I came across an interesting and unusual paper by Bruce Littleboy entitled ‘Religious Undercurrents in the Writings of GLS Shackle‘. As readers of this blog will probably be aware Shackle is one of my favourite economists. I had never, however, associated anything that he wrote with religion and I was unaware until reading this essay that he was a devout Christian.

Frankly, I think that Littleboy is wrong to attribute any religiosity to Shackle’s writing. But, in being wrong, Littleboy has raised an interesting question — albeit not the one that he thinks he has raised; namely: what is the connection between theological and economic discourses. I will argue that it is actually the form of economics that Shackle attacks that aspires to the theological.

In the essay he quotes Shackle as writing:

Decision is not, in its ultimate nature, calculation, but origination. (p3)

In response to this Littleboy writes:

Origination is an attribute of the Divine, and Christian creed regards humans as holding as a gift some fragments of God’s nature. (p3)

This is the theme of the whole essay. In Shackle’s exploration of decision-making he found many themes which might also be found in religious texts. But Littleboy never really makes what seems to me the obvious point: economics and theology deal with very similar questions. They deal, ultimately, with how we should structure social relationships and moral norms.

When we use terms like ‘utility’ what we mean is the same as what the theologians meant when they discussed human beings pursuing ‘grace’. When we say that human beings maximise their utility we are basically saying that human beings seek grace in their everyday lives.

The words are different but the semantic meanings are basically the same. Both utility and grace mean something like “what is good”. These spectral and rather mysterious entities are never observed but they are assumed to exist. They are also discussed in very similar frames. Grace is discussed in a world where an omnipotent and benevolent God reigns supreme; while utility is discussed in a world where an omnipotent and benevolent Market reigns supreme. Both of these entities — again, spectral, mysterious and unseen — effectively do the same thing: they guarantee coherence and promote the ‘best’ outcomes. Literally they are different; substantially they are the same.

Indeed, need it even be said that Adam Smith — the person who introduced the Market — had in mind the Protestant idea of God when he invoked the Hidden Hand? He quite literally borrowed the metaphor from theological discourse. That borrowing has since been buried but it is never buried too deep. The Market allows for perfection because It is benevolent.

So, what was it that Shackle was doing? The following passage from Littleboy’s essay points in the right direction:

Shackle’s framing of the human predicament is as much a contrast to God’s complete knowledge as it is to the similar claim of perfect knowledge in the hubristic (if not impious, even blasphemous) economic models of the orthodox kind. (p5)

Shackle, I think, saw the essentially religious underpinnings of marginalist economic discourse. He could see that this was, in fact, a form of pseudo-secular religion (how can it be truly secular when it so firmly believes?) and that struck him, as it strikes others, as absurd. He saw no place in rational discourse about the world for religious vagueness and so he tried to construct a theory of human decision-making that did not rely on a benevolent entity that reconciled all of our problems automatically.

Marginalist economics is modern religion. If you look closely you can see it when you listen to its adherents. They derive authority from doctrines that are effectively mystical. As the discourse becomes more mathematical it becomes increasingly difficult to tell what the underlying assumptions are. This leads to giving them even more mystical authority. Shackle’s work was an attempt to explore these underlying assumptions and remove from them any mysticism. He wanted a theory that was truly secular. He kept his religion, as it were, in another room.

Perhaps this is what gave Shackle the ability to see behind the mask. Perhaps he knew what belief was all about and he saw that many of the marginalist assumptions were in fact grounded in belief proper. Marginalists, for example, believe that the future can be known through objective probability estimates. Press them on why they hold this belief and they cannot answer. This is the same structure that dogmatic religious person’s hold; they do not even know that they believe because they have not even questioned what it means to believe.

Shackle was against dogmatism. He did not like it. If you think that the Market produces perfect outcomes you have to explain why and through what mechanism. That does not mean constructing a little piece of mathematics that builds in the assumption of what you are trying to prove. That is tautological. It means explaining how such conditions might be achieved given what we know about human psychology and lived experience. Likewise if you think that the future can be known with objective probabilities you have to either prove this by demonstration or you have to make a very convincing argument why we should assume this. Marginalists cannot do either. They never even consider these questions because, frankly, they are beyond them. All they have is their belief and they will cling to it like a dying man clings to life.

World Recession in 2015

Quite busy today. But a piece that I wrote for Al Jazeera on the prospect of a world recession in 2015 went up yesterday. It might be of interest to some readers. As the piece makes clear we cannot be sure that this will actually play out the way I outline. But there is certainly a distinct possibility. And for that alone it is worth commenting on.

Another US recession may be coming … sooner than you think

The Scottish Currency Question: A Solution

This week the Scots will vote on independence and the ghost of Bonnie Prince Charlie will ride once more… oh no! I’m not going there! Living in London and being from a country that declared independence from the crown last century I have seen up close all the cultural demons that the run-up to the Scottish vote has stirred up. It is not very pretty.

History is a funny old thing. It is something that people generally take as something resembling Holy Writ but in reality it is something that is written and rewritten over and over again. Reading the newspaper commentary in the run-up to the Scottish vote on both sides of what may soon be a border is like watching this rewriting take place before one’s eyes. Old events are summoned up and old prejudices simmer to the surface. The starting point of historical rewriting — and historians do not properly appreciate this — resembles something between historical hermeneutics and schoolyard joshing.

Anyway, let’s try to focus on the economics, shall we? I could write an eloquent post giving my little interpretation of the forthcoming election. But that would just be my opinion — the opinion of an Irish-born London resident whose ancestor appears to have been an English Catholic who fled to Ireland after he lent his support to the Jacobite cause in 1715. Another little story floating on a sea of other stories, each of them individual myths that contribute to the push and pull of the politics of this country. Better to drain the sea completely and try to catch a glimpse of the seafloor that supports it.

Now, I have already presented my interpretation of the economics of independence in a paper that I published with the Levy Institute and gave to the SNP earlier this year. For an in depth view of the economic consequences of independence I suggest consulting this paper in full. Here is a very brief summary of the paper:

• The key problem for Scotland is that their export surplus and their government budget balance are tied to oil revenues.
• These revenues are volatile and any substantial deterioration would lead to a fall in tax revenues and exports.
• This means that any monetary framework must take into account the potentialities of these events otherwise it ties Scotland’s economic future to the volatility of the oil market — and to the sustainability of Scotland’s oil reserves.

And here is a brief summary of the consequences of this for various currency regimes:

• If the Scottish keep the sterling and if oil revenues fall a government budget deficit will open up. This will leave the fiscal position of Scotland in the hands of a Westminster government jilted by Scotland’s retreat from the union. Think: Eurozone but with more nationalistic bitterness.
• If the Scottish issue their own currency and oil revenues fall the current account will register a substantial deficit. This will put significant downward pressure on the new currency and could, in extremis, lead to a currency crisis.

Frances Coppola and others have said that Scotland should issue their own currency and then peg it to the sterling. This would simply lash the same constraints on Scotland as maintaining the currency union. They would not control their interest rate and they would be unable to run fiscal deficits without having the sufficient reserves of sterling to back them up. Coppola says (on Twitter) that this is the “least bad option”.

The reason Coppola makes the case for a peg is because she reckons that there will be very little demand for a Scottish pound. She writes:

North of the border, after independence, Scottish notes and sterling notes and coins would continue to circulate freely as competing currencies just as they currently do. But south of the border, Scottish notes would have much less value than they currently have – indeed they might be worthless everywhere except Scotland, just as the “Bristol pound” is worthless everywhere except Bristol. Only those who were doing business in Scotland or planning to travel there would want Scottish notes, and indeed as long as sterling was equally acceptable in Scotland, they might not bother with Scottish notes at all. So there would be a simply enormous exchange difference between Scottish notes and sterling.

I don’t follow this reasoning. Scotland has a far more robust macroeconomy than the UK. Here is a graph from my Levy paper showing the sectoral balances of Scotland:

Compare that to the UK sectoral balances and you see a much more robust macroeconomy. Here are the UK sectoral balances:

The key variable that you should be looking at is the current account. Scotland has a persistent current account surplus which it achieves by exporting massive amounts of oil and gas (and food, but the oil and gas are key). The UK, meanwhile, has a persistent current account deficit.

Now, is someone seriously going to make the case to me that a country that runs export surpluses of 5-10% of GDP a year is going to have a weak currency vis-a-vis a country that runs trade deficits of 2-4% of GDP a year? That is a bizarre argument and I hope that no one would take it seriously. Importers from other countries will need massive amounts of Scots pounds to buy those exports from Scotland. That will generate huge demand for the currency. Investors will soon see this and rush into Scottish capital markets.

Coppola may, however, have a point about the short-run and I noted this in my Levy paper. In the short-run God knows how investors will react. This is where my proposal comes in. I will not lay out all the details here but only the ones relevant to this discussion.

My plan is two-phase. In the beginning Scotland will have a dual currency regime. It will maintain the sterling but at the same time issue Scots pounds at a local level. It will do this by paying part of local public sector workers’ salaries in Scots pounds and also accepting these Scots pounds in payment of local taxes (I am open to the idea of accepting these for payments of national taxes too). In addition, the Scottish government should enforce that businesses in Scotland price their goods in both currencies. Some post-nationalist slogan would do wonders in this regard — something like “Scottish prices for Scottish people”; on this front the SNP can consult what I can only guess are their legion of PR people and focus groups.

After a while, this will establish a stable exchange rate between the sterling and the Scots pound. The Scottish government can then gradually increase the amount of transactions it undertakes in Scots pounds — eventually only accepting Scots pounds for the payment of any and all taxes. As more and more of the Scottish economy transitions to the Scots pound, Scottish exporters will begin to demand Scots pounds for goods and services because they will not want to have to exchange their sterling for Scots pounds. This will generate external demand for the Scots pound and lead to the gradual creation of a sophisticated international market for the Scots pound. The Scottish government and central bank should be holding the hand of the market every step of the way as this embryo develops into a child and then gradually reaches adulthood, at which point it can be allowed go into the world alone, fully formed.

The whole plan is based around the simple notion that exchange rates should be established gradually. Scotland’s economic fundamentals — so long as oil revenues remain buoyant — allow for the hope of a highly valued currency. But it is still uncertain what would happen if they float this on the market in a potentially explosive instant. A gradual approach would allow the demand for the pound — driven at home by taxation and domestic transactions and abroad by exports — to be established over a couple of years. The peg would not allow for this as any removal of the peg would result in a once-off adjustment that would be uncertain and potentially chaotic. The dual currency approach is much more organic and gradualist.

With a floating exchange rate regime in place the Scottish economy will be well placed to deal with economic shocks. Should oil revenues begin to decline for any reason the Scots pound can fall in value to register the necessary fall in real living standards required. Again, the gradualness of the process is the key to stability. In the case of a fixed exchange rate — that is, a peg — this would possibly lead to a nasty fiscal-cum-currency crisis as foreign reserves dried up. A floating exchange rate still allows the Scottish central bank to use their reserves to prop the currency up. But by not establishing a price target it does not incentivise speculators to do what they do best: speculate (see: Black Wednesday).

Scotland could then focus on their key long-term economic problem: namely, their over-reliance on oil and gas revenues. This requires massive public investment projects in fields like green energy that will allow Scotland to continue to export large amounts of goods and services moving into the future. By formulating the correct answer to the currency question the Scots can face the real economic challenges; those that have to do with the production of salable goods and the scarcity of natural resources. By ignoring the problem and taking a haphazard, poorly thought through approach — or, what is the same: simply emulating what they think to have been ‘done before’ — they risk everything, in which case they should probably just give up the whole game.

Finally a note on the politics. Some people will say: “Sure Phil, sounds like a good plan. Well thought through and all that. But it is too new. It sounds like something that has never been tried before, no politician would go for it.” First of all, while the plan is original most of the key components have been tried before — and with great success, I have not chosen these components arbitrarily. Secondly, the SNP is about to dissolve a union that is over 300 years old. This is a massive step into an uncertain new world — one we rarely see in our rather boring and repetitive politics today — and to compare my currency plan with this is to compare apples to oranges. Or, to make the metaphor more fitting by comparing something familiar with something exotic, it is like comparing apples with Jamaican ackee fruit.

Krugman at the Rethinking Economics Conference: Still Wrong on Monetary Theory

The Rethinking Economics conference in New York took place over the weekend. Anyway, Paul Krugman was on a panel with James Galbraith and Willem Buiter. The panel was interesting in and of itself. But what really caught my eye was when Krugman was confronted by an audience member on his support of NAIRU, the loanable funds theory and the theory of the natural rate of interest.

The audience member who asked this question was Rohan Grey, a friend of mine who runs the Modern Money Network who helped co-organise the event. You can see the question and the response in this video clip.

I don’t really want to get into the question of NAIRU too much as this would take us too far off track. But the other two questions provoked an interesting response from Krugman. First of all, he simply asserted that the loanable funds was true. Then he went on to assert that the natural rate of interest was true. “Clearly,” he said, “there is always some rate of interest that would produce more or less full employment”.

Let’s take each one first. Because Krugman is wrong on both counts. In his textbook co-written with Robin Wells, Krugman outlines the loanable funds theory in the form of the money multiplier. In the video linked to above he alludes to the fact that this may break down in what he calls a ‘liquidity trap’ but that in normal times it is nevertheless true. This is simply false (Krugman has also misunderstood the concept of the liquidity trap but that is a story for another day). The Bank of England released a paper earlier this year which stated crystal clearly that this misrepresented how money is created.

The reality of how money is created today differs from the description found in some economics textbooks:
• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits. (p1)

If that is not a clear enough refutation of the loanable funds theory, here is another:

The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. (p2 — My Emphasis)

When I raised this point on this blog before Krugman did a blog post the next day saying that the Bank of England paper said nothing that he did not already know. In the same blog post alluded to James Tobin’s work on money creation.

If Tobin actually did make the case for endogenous money, and I am not entirely convinced of this, but if he did then he overturned the loanable funds theory. If Krugman states that he adheres to the view put forth in the Bank of England paper which he claims he learned from Tobin then why does he continue to endorse the loanable funds theory when asked about it? The two views are mutually exclusive and the Bank of England makes this clear in no uncertain terms.

The fact of the matter is that Krugman is self-contradictory on this point. And self-contradiction is the surest sign that one is simply incorrect or has not thought through a particular point on any great amount of detail.

Now, how about the idea that “there is always some rate of interest that will lead to more or less full employment”. This idea is grounded in the notion that there is a mechanical relationship between investment and the rate of interest. But anyone who has read Keynes — especially Chapter 11 of the General Theory — knows that this is not the case. Rather investment is driven primarily by the expectations of investors. The rate of interest plays an entirely secondary role — if it plays a role at all given that most studies have shown that businessmen do not think about the interest rate when they make investment decisions.

Tied to this last point, mainstream economists have now recognised that monetary policy actually works through some rather odd channels; its effects are not felt through the investment channel as such. So, even reading the recent literature on monetary policy from some mainstream economists makes clear that it does not work through the investment channel as is laid out in the ISLM model that Krugman constantly endorses.

But let us be less abstract and bring this discussion down to earth. What would likely happen if the rate of interest went substantially negative? Would investment and thus employment really increase? I don’t think that it would. Far more likely that, in a closed economy, money would flee safe assets as liquidity preference fell and would rush into riskier assets. This might just fuel a speculative credit bubble.

In an open economy money would probably partially run into the speculative financial markets and partially flee the country. This latter tendency would drive down the currency. Given that we must already assume some inflation since we are talking about negative real interest rates this could lead to a hyperinflationary collapse.

This is precisely what we see today in Venezuela where, as I have noted before, substantially negative real interest rates have resulted in a stock and housing market bubble. Meanwhile investment has not shot up and unemployment has stayed on trend and rather high (note that the significant negative real interest rates were enforced around the start of 2013).

Substantial negative real interest rates of around -20% to -30% were brought into effect in the second quarter of 2013. But the upswing in investment you see in the above chart occurred prior to this in the final quarter of 2012. There is absolutely no evidence that significant negative real interest rates have increased real investment or driven unemployment down in Venezuela. All they have done is led to massive bubbles in the financial and housing markets and to an enormous attempt by capital to flee the country which is reflected in the black market rate for dollars soaring. If there were not strict capital controls in place there is no doubt that Venezuela would be experiencing hyperinflation today.

What does this mean for policy in the advanced economies? If central banks in these countries were able to generate real negative interest rates — and I have outlined how they might do this before (Krugman says that it is impossible… wrong) — it is likely that this would simply generate stock and housing bubbles. Real investment and unemployment would probably not be much affected. But when the bubbles eventually collapsed this would likely have negative effects on both.

Krugman’s monetary theory is almost entirely wrong. He flip-flops on the loanable funds question and he is simply wrong on the question of a natural rate of interest. He also holds to an incorrect view of what a liquidity trap is that he picked up from John Hicks. While it is extraordinarily unlikely that he will give up on these ideas — he has dug in far too much now to concede these points and he seems unwilling to even openly debate them — I only hope that his errors will help to ensure that others do not make the same mistakes.

On Gold Buggery

My piece on gold bugs, their culture and their silliness is now online at The New Internationalist website for all you lousy folks that didn’t bother picking up a copy. It was one of the most fun pieces I ever wrote for an actual publication. Here is my discussion of it and the piece itself is linked below. Enjoy! And please refrain from buying gold or filling your ‘bug out’ shelter with cat food for the coming hyperinflationary meltdown of society.

The Gold Standard is Nothing but a Shiny Distraction

 

Academic Sophistry: Dart-Throwing Monkeys and the EMH

The other day I did a post on the Efficient Markets Hypothesis (EMH) that generated some discussion. I want to deal with a few of the issues raised in a some upcoming blogposts.

One issue of interest was that many EMH proponents said: “Sure, Warren Buffett and Keynes beat the market over a long-period we’re not saying that this is impossible. Some people might beat the market out of pure luck.” Well that seems like rubbish to me.

Think about this. If the EMH says that no one single person can beat the market over the long-run that is a testable proposition. But if they then say that some people might but this is “by luck” that is not testable. That is, in fact, based on an a priori assumption that anyone who beats the market did not do so by skill.

Now, personally I think that some people beat the market by skill. The fact that very few beat the market is not remotely surprising given this interpretation. Most market participants, by definition, will fall around the average and track the market over the long-run. Some really bad participants will fall way behind (these people would just be “unlucky” according to EMH Gospel, I’d be more inclined to say that they are bad at their jobs). And some people — not very many — will come out ahead.

The same is the case in anything. Most football players will be average. Some will be awful. Some will be top class. Is this “by luck”? Well, in terms of their genetic make-up and the environment they grew up in, it is in some sense. Our skills and talents are partially derived by us through what might be called “luck” or “chance”. But this is not what the EMH proponents mean. They mean that you cannot really apply skill to beat the market.

Personally I think that the EMH is a tautology masking as an argument. By definition the average investor cannot beat the market (which is the average outcome of investor decisions). Just like the average runner in a race cannot beat the average outcome of the race. But particular investors may well beat the market. The EMH says that this is not through skill but due to luck. That is not really a testable proposition. And it seems unlikely if we look at the real world.

If we look at the people who consistently beat the market they seem like very hard-working individuals who know the markets intimately and have very well-developed ideas about how to invest. I don’t see any charlatans amongst these. Nor do I see monkeys throwing darts at the stock indices. This leads me to conclude that these people got there by hard work and ingenuity. The onus should be on EMH proponents to produce dart-throwing monkeys that get the returns of Warren Buffett. My sense is that the laws of probability will not allow this any more than they will allow — in the real world — a monkey with a typewriter to produce the works of Shakespeare.

The EMH proponents want us to basically think that there is no skill involved when people beat the market. But again, this is an a priori assumption. They only think this because they assume it. When we look at the real world it appears unlikely. As I wrote in the last post: is it just a coincidence that one of the most important financial economists of the 20th century just “got lucky” and beat the market in the 1930s? The odds of a person being both one of the major financial economists of the 20th century and one of the few people to beat the market in the 1930s strike me as very low. But they need not be if we assume that there might be a link between Keynes being a brilliant financial economist and a brilliant investor.

So, we have established that this assumption by the EMH proponents is a priori. It has the status not of science — it is not testable — but of dogma. Why then is it held? I think that there is a very simple psychological/sociological reason for this that is actually quite obvious when you think about it.

People who teach the EMH claim to be experts on financial markets. They claim to have knowledge of how the markets work that is objectively correct. Now, this is slippery game indeed. Why? Because if someone jumps up and says “I am an expert on the financial markets and I know how they work” society as a whole can reply “Okay then, go and use this knowledge to play the markets and win”.

This causes a huge problem for financial economists. But if they say that their expertise on the financial markets tell them that anyone who beats the market only does so by luck then they are insulated. They can still claim to be experts while at the same time never having to prove their expertise because their expertise now needs no proof. It is a bit like me walking around saying that I am the best driver of flying cars in the world. Then when people tell me to prove it I turn around and say “Why of course I cannot prove it… everyone knows that flying cars don’t exist!”.

Well, that is all very well and good. Perhaps I can trick some gullible people into believing that I am indeed the best driver of flying cars in the world. That will not do much harm. Unfortunately, these “financial market experts” get into positions where they are allowed to dictate how financial markets are regulated. That will tend to cause enormous problems should I be right and should these people be largely engaged in sophistry.

Media Etc.

Too backed up to do a new post today. But a piece of mine went up on Al Jazeera yesterday that deals with the OECD’s very ambitious report from a few weeks ago. Readers might find that of interest.

The OECD’s latest report is burdened by economic myths