On Keynes’ Short-Period Analysis and Harrod’s Dynamics: A Reconciliation

When I first encountered the Harrod-Domar growth model I never interpreted it as a long-period representation. It seemed to me such a strange characterisation and, I’ll admit, when I first approached the growth literature that arose out of it I was completely flummoxed.

Let us start with the most basic form of the model itself.

Where I is investment, s is the propensity to save and lower-case sigma is the potential social average productivity. In order for full employment to be maintained the rate of investment — that is, the left-hand side of the equation — must be equal to the propensity to save times the increase in productivity brought about by the increased investment.

If the left-hand side of the equation rises too fast investment will outpace the accumulation of productive capital being built and inflation will result. If the right-hand side of the equation rises too fast savings and productive capacity will increase too quickly and there will be unemployment.

If that is not intuitive enough for the reader consider this. Let us imagine that the growth rate of investment is 5% and the increase in productivity from the last round of investment is 10%. What then will the propensity to save have to be for an equilibrium growth path to be achieved? It will have to be 0.5, of course. This will ensure that half of the increase in productivity goes to consumption and half of it goes to the new investment expenditure that is coming online. (For more examples in this regard see Bill Mitchell’s excellent series of posts).

The manner in which I have just described the equation is how I always saw the model. The model did not tell us where the economy would be at any moment in time. It was just a framework through which to view the world intuitively. Yet after its publication the equation got completely misinterpreted. It began to be thought of as a long-run growth condition. And economists thought that the fact that there was no mechanism in the model for stabilising the left and right-hand side of the equations represented some sort of “problem” to be “solved”. This problem became known as “Harrod’s knife-edge”.

The first to make this mistake was the editor of the journal in which Harrod sought to publish: John Maynard Keynes. Actually, that is unfair to Keynes. The latter was a practical thinking man and he never felt that unsolved or open-ended equation was by necessity some sort of puzzle to be solved. But he did think that Harrod was referring to a long-run problem. In his correspondence with Harrod he wrote (all quotes are taken from Jan Kregel’s excellent paper ‘Economic Dynamics and the Theory of Steady Growth: An Historical Essay on Harrod’s ‘Knife-Edge”):

You have shown I think, that steady growth can only occur as the result of a miracle or intense design. But this is essentially a long-period problem, and steady growth a long-period conception. As I have said above I do not see that the theory has any application worth mentioning to the trade cycle. (p100)

Harrod was completely befuddled by this. He was entirely in agreement that the trade cycle was a short-period phenomenon but he saw his equation as capturing this. Again, he saw it as a tool that showed the conditions in which the economy diverged from a steady state. Harrod was not viewing the equation as some sort of little model of the economy that had to be solved but rather as a tool with which we approach the real world. Kregel summarises in his paper:

Even if the trend did not describe any actual state in the cyclical process, it could still provide an outline for the analysis of the forces that acted to produce cyclical fluctuation. The formulation of the requirements for the existence of a steady trend rate was not meant to imply that such a rate was likely to be achieved in practice. Yet it could provide a reference point to show why steady growth did not exist, i.e. why cycles occured in the real world with such regularity. (ibid)

To me this was always what Harrod’s equation was saying. I found it intuitively hard to see it any other way. When others criticised it for not having a stability condition (when I first studied growth theory) I thought at first I was the idiot and I didn’t understand the equation. But it turns out my intuition was correct.

Understood correctly Harrod’s growth model is a fantastic addition to macroeconomics. And, to me at least, it provides the sort of framework that shuns completely any silly, ‘Kingdom Come’ notion of the so-called “long-run” trajectory path of an economy. A path that only exists in the Wizard of Oz-style fantasies of the economists themselves.

The whole thing got even worse when Bob Solow picked up Harrod’s equation and thought it to be a long-run condition. Solow then tried to argue that flexible wages and prices would lead to a long-run equilibrium result. But even getting away from the question of whether wages and prices are flexible in the long-run, Harrod is talking about the short-run. He is giving us an intuitive sense of how income and potential income diverge from one another. The picture of a capitalist economy that he gives is the same one that Keynes put forward in his letter to Harrod where he wrote:

The maintenance of steady growth is at all times an inherent improbability in conditions of laissez-faire. (p100)

What Keynes unfortunately failed to realise was that Harrod’s equation gave us a tool to make precisely that case. But growth theory unfortunately soon became a field of silly people trying to prove long-run equilibrium results and, in doing so, convincing themselves that they had said something of relevance about the real world.

 

The Efficient Markets Hypothesis Has Been Proved Wrong But Economists Do Not Want to Listen

The Efficient Markets Hypothesis (EMH) is wrong. It has been proved wrong. Do you think you’ve heard this before? You likely have, but the proof that you’ve heard that the EMH is wrong probably has not done the damage that you thought it had.

When I studied the EMH for my dissertation I noticed that many had thought that the financial crisis of 2008 had proved the EMH wrong. In one way this was true. Investigations undertaken by the authorities had uncovered that people within many markets were actively misleading the public about the underlying value of securities.

After being told that a security was not structured properly an S&P official said that they would rate it regardless. “We rate every deal. It could be structured by cows and we would rate it.” If the EMH says that markets price in risk perfectly then the markets were not operating in the manner the EMH predicted in the run-up to 2008.

Nevertheless, this mattered little for the other claim made by the EMH proponents. The EMH proponents said that you cannot beat the market consistently. Because all information is already priced in then any gains you make over the market will only be temporary. If you beat the market this year, the chance that you beat the market next year will be extremely low. If you beat the market both this year and next year then the chance that you will beat the market the year after will be lower still. Using this reasoning you will, in the long-run, be completely unable to beat the market.

I found this reasoning terribly troubling. First of all, just because most people cannot beat the market does not mean that the EMH is correct. A number of other hypotheses could also be correct. For example, the Post-Keynesian proposition that the future is inherently uncertain and thus that predictive techniques of complex market dynamics will likely fail could also be confirmed by the same observation.

Secondly, the proposition struck me as being tautological. Who was the ‘you’ in the statement ‘you cannot beat the market’? It seemed to me to be the idea of an ‘average investor’. But, as everyone knows, ‘the market’ is simply the outcome of the average decisions of all investors taken together. Thus, ‘the market’ is actually the expression of ‘the average investor’. The two terms — ‘the market’ and ‘the average investor’ — are actually synonyms. So, the statement ‘the average investor cannot beat the market’ could just as easily be read as ‘the market cannot beat the market’ or, alternatively, ‘the average investor cannot beat the average investor’. This struck me as being a purely tautological and highly problematic approach to studying markets. It appeared that EMH proponents were confusing the idea of the ‘average investor’ with any given ‘particular investor’.

Thirdly, tied to the second point and most importantly, it appeared to me that many people do indeed consistently beat the market. The probability of someone like Warren Buffett existing seemed to me, from an EMH perspective, entirely implausible. But then I found something even more unlikely: John Maynard Keynes had, in the 1930s, effectively tracked Warren Buffett’s stock market performance. In the graph below you can see Keynes’ investments plotted against both Buffett’s and the market return in his own time.

As John Authers wrote in his article ‘Keynes Stands Tall Among Investors‘ when he compares Keynes with Buffett:

What of Warren Buffett, the world’s best-regarded investor? The chart shows how the portfolio of Berkshire Hathaway, his main investment vehicle, has performed over the past 22 years – and the King’s endowment under Keynes did better. Had we chosen the first 22 years of Buffett’s tenure, when his portfolio was smaller, making it easier to outperform, Buffett would be ahead. But Keynes’ record places him in exalted company.

 

Now, this seemed to me beyond a coincidence. Maybe you could make the case that Buffett was an anomaly, an outlier on the probability map, but Keynes? This seemed doubtful. Was it merely a coincidence that one of the greatest and most famous economists of the 20th century — one who emphasised the unpredictability of the future and the irrationality of the financial markets — was also able to beat the odds? This seemed highly improbable.

 

But the plot thickened as I pursued this further: it seemed that Keynes had used a very similar investment strategy to Buffett. While in the 1920s he had tried to play some silly mathematical games he had lagged the market. But when he switched to the strategy that Buffett uses he saw his gains soar. Authers writes:

 

His performance lagged the market in the 1920s, when he used an elaborate economic model to time the market. It did not work, and he failed to spot the Great Crash coming. He admitted that this approach “needs phenomenal skill to make much out of it”. So he switched to picking stocks. Like Buffett, he said he became ever more convinced that “the right method in investment is to put fairly large sums into enterprises one thinks one knows something about”. His results speak for themselves.

 

Could this all be coincidence? It seemed to me that it probably was not. And then I stumbled on a famous 1984 article by Warren Buffett himself entitled ‘The Superinvestors of Graham-and-Doddsville‘. In the article Buffett discussed a group of nine investors who had substantially outperformed the market in a 20 year period. He accepted that these could all be simple probabilistic anomalies — black swans, as it were — but he noted one important point: they all came from the same school of investing.

Now this did not mean that they all bought the same assets. If they had that would explain the anomaly. But they did not. They all had different strategies and they bought different assets. But they all followed the same philosophy.

As Buffett said in the piece: if there were 1,500 cases of a rare cancer in the US and 400 of them were in a small mining town in Montana good scientists would probably go to the mining town and check the water. Economists do not do this type of research, however, which is what critical realists and other critics of econometric/probabilistic approaches (present writer included) always complain about. But if they did do true scientific research Buffett’s article would interest them greatly.

Looked at from anything resembling a scientific approach it is quite obvious that Buffett’s article proves the EMH completely wrong. It is also interesting that the investment strategy that Buffett, Keynes and the nine other investors discussed in Buffett’s article runs exactly contrary to the EMH assumption of information being priced into markets at all times. Indeed, their investment strategy rests on the idea that market prices often diverge substantially and for long periods of time from the underlying value of the assets.

So, what have the economists said in response? Nothing. Not being scientists but rather moralists and soothsayers they simply avoid contrary evidence when it is presented to them. As the investor Seth Klarman wrote in his book Margin of Safety:

Buffett’s argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice. (p199)

Economists and business schools continue to teach the EMH, of course. It continues to give off the mystique that markets somehow get the price ‘right’. It does so by being vague to the point of meaninglessness in many cases. But when it does manage to say something concrete and make a claim that can be falsified, it fails. And when it fails its proponents simply ignore the overwhelming evidence to the contrary. This is not science. It is ideology.

How Do Capitalist Firms Grow?

I’m currently reading Marc Lavoie’s new book Post-Keynesian Economics: New Foundations. This really is the defining text of Post-Keynesian economics today. Anyone who is really interested in Post-Keynesian economics should try to get their hands on it. It is a bit overpriced right now — so you can probably only realistically get it if you order it to your university library — but hopefully Marc can find a way to get it out for lower cost

The book is over 600 pages long and most of those pages are pretty dense. When I’ve finished it I will be either writing a review on the book or a full paper. I’m leaning toward the latter right now as I think there are a few things that might be worth saying. Anyway, for now I just want to discuss a single component of the theory that can be summarised in one neat equation.

In the third chapter of the book Lavoie discusses the Post-Keynesian theory of the firm. In Post-Keynesian theory firms are primarily interested in growth and expansion. They are only secondarily interested in profit accumulation. However, in the theory profit accumulation is a pre-requisite for growth so this largely amounts to the same thing.

The basic idea runs as such: firms want to expand. In order to expand, they must invest. But in order to invest they must accumulate profits. Now, the reader will probably think to themselves “well, they can borrow money to invest too”. This is true. But in the Post-Keynesian theory it is sometimes assumed that the leverage ratio of firms remains somewhat constant. We will come back to this in a moment. Let us now lay out the most basic form of the Post-Keynesian growth equation for the firm. It runs as such:

How should we read this intuitively? The most interesting component from our perspective is the convention that allows the firm to borrow, p. As we can see, when this term increases in numerical value this leads to a higher denominator. This means that a higher rate of growth, g, will be able to take place for a lower rate of profit, r.

This equation is perfectly fine. I can find nothing wrong with it. Lavoie goes on to give some more advanced versions that include the purchase of financial assets by firms. But I will not get into that here.

Lavoie then, however, introduces a notion that I find particularly problematic. He tries to establish a so-called ‘long-run equilibrium growth path’. He does this by assuming “a constant capital to debt ratio”. This I do not find realistic and, in fact, this speaks to a broader problem with Lavoie’s otherwise seminal book: there is no empirical data supporting any of the theory,

Take a look at the following graph. It is by Theodore Gilliland over at Marketminder and it shows the historical leverage ratio of US firms.

What we see here is what we might call a twofold ‘Minsky dynamic’. First of all, it is clear that the leverage ratio is rising over time (in the ‘long-run’, as it were). Second of all it is clear that the leverage ratio rises during expansions and then falls in the ensuing recessions.

So, it is quite clear that it is highly misleading to assume some sort of ‘long-run equilibrium growth path’. Indeed, such an assumption is a wholly imaginary one. Frankly, I find such thought experiments almost as misleading as those undertaken by marginalists. If it doesn’t fit with the real world, leave it out.

Lavoie borrows his idea from Kalecki. Kalecki also wanted to establish something about long-run growth dynamics. So, he assumed that firms would not want to take on higher leverage ratios. He called this the ‘principle of increasing risk’. Lavoie quotes Kalecki as such:

It would be impossible for a firm to borrow capital above a certain level determined by the amount of its entrepreneurial capital. If, for instance, a firm should attempt to float a bond issue which was too large in terms of its entrepreneurial capital, the issue would not be subscribed to in full. Even if the firm should undertake to issue the bonds at a higher rate of interest than that prevailing, the sale of bonds might not be improved since the higher rate in itself might raise misgivings with regard to the future solvency of the firm… It follows from the above that the expansion of the firm depends on the accumulation of capital out of current profits. This will enable the firm to undertake new investments without encountering the obstacles of the limited capital market or ‘increasing risk’. Not only can savings out of current profits be directly invested in the business, but this increase in the firm’s capital will make it possible to contract new loans. (p137)

There may well be some truth in what Kalecki says. Lavoie notes later on that firms with high levels of internal finance have high investment rates. But this does not justify us trying to think in terms of some long-run equilibrium growth paths. The data provided above shows beyond a shadow of a doubt that leverage ratios are simply customs that evolve through time. They are also cyclical in their nature, rising in booms and falling in recessions.

Anyway, the growth equation as laid out above remains a handy tool provided we recognise it for what it is. Lavoie’s book is also fantastic and I cannot recommend it enough. But it would have been helped if Lavoie had consulted the data more often and published this alongside the theory (Kalecki used to do this all the time, after all). I also remain highly skeptical of long-run modelling and of the usefulness of some of the comparative statics approaches that are deployed later in the book. These are some of the issues I want to address in the review when I eventually get around to writing it.

Interest Rates, Liquidity Preference and Inflation

On my post about Austrian and Marxian capital theory a commenter left a fairly predictable ‘Austrian comment’ which denied that they assume perfect foresight in their theory of interest rates and investment, gave a confused story about accounting identities (apparently if consumption rises then by identity profits fall; someone tell the NIPA crowd that they have it all wrong!) and insisted that I knew nothing about Austrian economics.

In the midst of this torrent of wrongness, however, the commenter made one interesting point that I haven’t heard before. He said that inflations and particularly hyperinflations proved the Keynesian liquidity preference of interest rates wrong. Here is the argument laid out in clear form.

1. Keynesian liquidity preference theory states that when liquidity preference rises interest rates will also rise as people hold onto liquid assets.

2. In a high inflation/hyperinflation environment we would expect liquidity preference to fall because the value of liquid assets is being eroded.

3. But in high inflation/hyperinflation environments we typically see interest rates rise together with the inflation.

Some sharp readers will roll their eyes at this. “Come on Phil, why are you dealing with this rubbish?” they will ask, “Obviously in times of high inflation/hyperinflation central banks will raise the overnight rate of interest to stabilise real interest rates.” Yes, of course this is the answer I gave to our Austrian friend and it is pretty obvious to anyone who deals with real world economic problems (as opposed to attending self-reinforcing libertarian meetings the purpose of which is to buttress a political ideology).

However, I thought that this incident might give me an opportunity to clear up some misconceptions about liquidity preference theory. You see, when we have a central bank setting the overnight rate of interest then the liquidity preference theory must be modified somewhat. Basically we must recognise that central banks have control over the interest rates but — and this is an enormous ‘but’ for anyone interested in financial markets — they do not control the spread between other interest rates and the overnight rate. This spread is dictated by liquidity preference.

In my forthcoming book I formalise this as such:

That reads as follows: the interest rate in any given market, i, is determined by the target interest rate as set by the central bank, irt, plus any transaction costs incurred from borrowing money at this rate, Tc, plus the liquidity preference in this market, Lpirt.

Thus what occurs in a high inflation/hyperinflation is quite clear. The central bank raises the target interest rate to keep up with inflation and hence keep the real interest rate stable.  And the end result is that interest rates rise with inflation. This is simply a decision taken on behalf of the central bank.

So, can we gain an understanding of market dynamics in such a environment using liquidity preference theory? This is difficult in an open economy with free capital flows. If there is high inflation in such an economy many investors will hold their assets in a foreign country with low inflation. Thus the domestic decrease in liquidity preference will often be felt in another country. But in an economy with capital controls we should indeed see a clear decline in liquidity preference and a boom in the price of risky assets during very high inflations and hyperinflations.

The case of Venezuela today is a perfect example of just this. The country is in what might be called a ‘contained hyperinflation’ in that the only reason that the extremely high inflation there has not turned into hyperinflation is because the government have prevented people from moving their money abroad. What happens in such a scenario? Well, liquidity preference falls enormously and the price of domestic risky assets booms. Just look at the Caracas stock index:

Just to put that verbally: between the start of 2012 and the start of 2014 the Caracas stock index rose by over 2,300%! At the same time investors piled into any risky, non-liquid asset they could get their hands on. The property market boomed to the extent that Caracas became more expensive than London! There is the effect of crashing liquidity preference at work.

Throughout this period the Venezuelan central bank set the overnight interest rate. But here is another very interesting feature of this case study that shows just how powerful the Keynesian theory of liquidity preference is: in the past few years the Venezuelan central bank never increased the rate of interest to keep up with inflation. And guess what? It stayed far, far below said rate of inflation. The below two graphs will clearly show that there is no Fisher effect going on here.

Now, our Austrian friend was correct in that typically when we see high inflation/hyperinflation we will see interest rates rise. As we have seen he forgot to add: because central banks will typically force them to rise. But in cases where the central bank, for whatever reason, does not raise interest rates we will not see interest rates rise. The case of Venezuela today shows this beyond a shadow of a doubt.

This ties into something that I have discussed on this blog previously: namely, that central banks have full control over interest rates and that they can hold them down even as inflation soars ahead if they want to do this.

So there you have it. Liquidity preference must be understood in light of the fact that, in modern economies, the central bank controls the overnight rate of interest. Liquidity preference only dominates in the spread between this rate of interest and other rates of interest in the economy. When inflation gets out of control the central bank will typically raise the overnight rate. But this says nothing about liquidity preference theory. Finally, we had a nice opportunity to show that if the central bank doesn’t want to raise the interest rate then this interest rate will lag far behind the rate of inflation.

Meanwhile, In the Media

I’m a bit busy today but there are a few interesting things in the media this week that I wanted to highlight. First of all is a piece by me on research being done in University College London (UCL) about decision-making under uncertainty. I am fascinated by this work for a number of reasons. First of all, it is actual true empirical work into decision-making under uncertainty. This has led the researchers to undertake the bold step to actually formulate a true measure for ‘animal spirits’.

Secondly, the project is headed by David Tuckett. He is a psychoanalyst that is quite consciously opposed to what is being done in behavioral economics. This is a breath of fresh air for me for two reasons. Firstly, because I am very keen on psychoanalysis and dynamic psychology. And secondly because I think behaviorism is pretty awful. Finally, I am enthused that the Bank of England and the European Central Bank are very interested in this work.

Anyway, I have a four-page feature article commissioned on this topic which will explore it from a more journalistic angle. For now, here is the op-ed that went up today.

Volatile emotions are driving the world economy

Also in the media this week was an extensive interview with the institutional economist Bill Lazonick on Sam Seder’s Majority Report. I have not written much on Lazonick’s work before because institutional economics is not really my field. But I think that his is some of the most important work out there. The interview starts around the 6 minute mark.

Anyway, hope that’s enough to keep you occupied over the weekend.

Understanding the Current/Capital Account and the Value of the Currency

One thing that I notice on the blogs is that I don’t think I have ever seen anyone give a clear description of the external trade account of a country. Nor have I seen anyone give a clear explanation of what determines the value of a given currency. Now, I am sure that you can find some mainstream garbage where the external account always tends toward equilibrium and so forth. But that is obviously useless nonsense and anyone who has ever looked at the trade balances of countries and the currencies of those countries knows it.

Basically the mainstream theory states that if there is a trade deficit in a country two things will happen. First of all, interest rates will rise as the money supply contracts due to money ‘flowing out of the country’. Secondly, the value of the currency will fall in value as the domestic currency saturates foreign exchange markets. A combination of these two dynamics will reestablish equilibrium on the external account. The rise in interest rates will cause investment, GDP and, hence, imports to contract. While the fall in the value of the currency will decrease imports and increase exports.

There is so much wrong with this presentation that it would take a blog post in its own right to pick all the necessary holes in it. The most obvious error is the idea that interest rates would rise when these are obviously set by the central bank. In addition to this currency depreciations will not always correct the trade balance and trade imbalances will not always lead to currency depreciations. I could go on. I won’t.

Anyway, here I more so want to lay out a clear explanation of the external account and, in doing so, describe what determines the value of the currency in a floating exchange rate system like we have today. In fact, I do not need to do much of the heavy lifting here because G.L.S. Shackle has one of the clearest explanations of the external account that I have come across in his book Economics for Pleasure.

Since the book is hard to come by I’ve provided the chapter on the payments system here. I hope it will encourage people to seek it out because it is one of the best overviews of economic theory I have ever read. Shackle was a very gifted writer. Anyway have a quick read of the chapter, it is only a few pages, and then you should have a fair comprehension of the accounting involved.

I assume that you’ve now read the chapter. Good. Let’s turn to what determines the value of the currency in a modern system. The claims that foreigners make within the country that has a trade deficit can, as Shackle says, be either in the form of currency or securities. These are recorded in the capital account of the country running the trade deficit.

Let us break this down slightly. The trade balance is a flow. When the trade balance is in deficit more goods flow into the country than out of the country. A corresponding amount of claims flow out of the country into the hands of foreigners. Now, if the foreigners don’t want to hold these claims they may sell them and then convert the money they receive into money from their own country. This will drive down the price of the currency of the country with a trade deficit and drive up the price of the country with the trade surplus.

But we should be clear: this need not happen. There is every chance that the foreigners will hold the claims on the country running the trade deficit. If they do this there will be no effect on the value of the currency. Why might they do this? Any number of reasons really. Maybe they think that the country is a good investment. Or maybe the government of the surplus country wants to hold foreign reserves.

“But,” the reader might say, “these claims eventually have to be paid back and so the effect will eventually be felt on the currency.” Again, that is not altogether clear. For example, let’s say that all the claims are held in the form of stocks. Now let up say that these stocks were worth a total of $1bn. Basically what has happened is that foreigners have traded goods for these stocks. But what if these stocks half in value? Well then, the whole amount of the claim need not be ‘paid off’.

The key point to take away from this is that in order to understand trade dynamics in the modern world we must appreciate the financial dimension. Mainstream economists are altogether incapable of doing this and it completely blinds them to the real world. For them finance is just a veil. But for Post-Keynesians finance is very, very real. Most of the trade imbalances in the world today can only be understood by taking both finance and politics seriously. If you want to see how the mainstream prove unable to do this and why the Post-Keynesians give the only realistic view, check out this recent paper by Tom Palley.

Capital Theory: An Austrian-Marxian Synthesis

Readers of this blog will know that I am not generally very sympathetic to Austrian economics. There is one point on which the early Austrians did contribute an interesting idea to the world of economics: namely, their theory of capital. This does not mean that the Austrian theory of capital is valid — as I shall show in a moment it is deeply flawed — but there is an idea that can be salvaged from the wreckage that is Austrian capital theory.

To my mind there are only two coherent theories of capital — and the mainstream possess neither. The first is what might be called the Ricardian or the Marxian. This is what might be called the ‘labour theory of capital’. The idea is that capital is effectively embodied labour or, to use Marx’s colourful phrase, ‘dead labour’. Marx unfortunately contaminated this concept with moral judgements, as he so typically did. In Das Kapital he wrote:

Capital is dead labour, that, vampire-like, only lives by sucking living labour, and lives the more, the more labour it sucks. The time during which the labourer works, is the time during which the capitalist consumes the labour-power he has purchased of him.

But it is perfectly possible to extract the interesting point being made here: capital is accumulated labour. That is, when a machine is built it is built using human labour and in that regard it ‘stores up’ this labour. To the extent that it is built using previously accumulated capital, it is also effectively using previously accumulated labour time.

The second approach to capital is the Austrian one. In the Austrian theory capital is effectively embodied time, in the sense that it is time spent on the production of one good or service rather than another. G.L.S. Shackle provides an interesting gloss on this in his book Economics for Pleasure. He writes:

[Böhm-Bawerk] gathered ‘produced means of production’ of every kind under the heading of capital. And capital, he said in effect, is the visible symptom of the part played in the productive process by the lapse of time between the putting-in of services of labour and land, the ‘original means of production’, and the enjoyment of the fruits of that process at a later date. How can we say that ‘time’ is productive? Because given quantities of human effort and of ‘land’ can yield a larger quantity or better quality of product if we are willing to wait longer for it. (pp212-213 — Emphasis Original)

Do you see the slight inversion taking place here? What Böhm-Bawerk did was to change the emphasis. Rather than saying that capital was embodied labour, he said that it was embodied labour time that could have been spent on something else. The emphasis was laid less on the ‘labour’ and more on the ‘time’.

The idea here is that we as a society could work to produce consumption goods in lesser quantity/quality now or we could use our efforts to produce investment goods that will in turn produce consumption goods in greater quantity/quality in the future. While this is not a bad way of looking at the problem it quickly runs into problems when Böhm-Bawerk and the Austrians try to turn it into a theory of the interest rate.

This was because they were pre-Keynesian and the Austrians did not understand that real capital — machines etc. — must be firmly distinguished from financial capital and that the market for the latter operated in an unusual way. They assumed, implicitly, some sort of perfect knowledge on the part of the market. So, left to itself the interest rate would tend to equality with the profit rate on investment goods. Thus, the rate of profit would come to represent the ‘reward for waiting’, as Alfred Marshall would put it. Of course, after Keynes we came to know that what determined the interest rate was actually the liquidity preference of the market.

This is because financial actors — that is, savers and their investment managers — are faced with an uncertain future. They thus evaluate various investments not so much by their real return but rather by their prospective liquidity. When people feel pessimistic about the future they increase their holding of liquid assets, causing interest rates to rise, while if they feel optimistic about the future they increase their holding of non-liquid assets, causing interest rates to fall.

Another way to think about this was that the Austrians and the other marginalists confused stocks with flows. They assumed that the interest rate was reflective of savings flows. So, savings would flow into a pool of investment at a given rate. This rate of savings would determine the interest rate which would in turn determine the profit rate and thus the investment rate. But the way this really works is that there is already in existence a big pool of accumulated savings. There is also the ability for financial investors to borrow and thus create additional financial savings. When sentiments change this pool of investments may suddenly shift. For example, if people become pessimistic more people will hold more liquid assets and interest rates on everything else will rise. The financial markets are thus a bit like that scene in Alice in Wonderland where the Mad Hatter tells everyone at the tea party to change places.

There is also a disconnect between the interest rate and investment. The Austrians and the other marginalists assume that there is some sort of linear relationship here. But there is not. The rate of investment in real capital is dependent on the state of confidence. This, in turn, is mostly dependent on the level of effective demand that is present in the economy at any given moment in time. You can see that there is no relationship in the graphs below which plot the rate of investment against the real interest rate.

Lagging the investment rate by a quarter to allow for time for the interest rate to transmit to increased investment makes basically no difference. The R-squared remains basically the same. This can be seen intuitively from the chart anyway.

If we detach Austrian capital theory from the Austrian theory of the interest rate, however, we get something far more usable. We can also easily couple Austrian capital theory with Ricardian/Marxian capital theory. Once an economy reaches full employment — which we need not assume as some sort of ridiculous teleological end-point — the main constraint on production is labour. We then recognise that the question becomes for society where they want to allocate its labour time. Here we can emphasise either the Austrian time component or the Ricardian/Marxian labour component. It really makes no difference. If the amount of labour time is constrained then we have to decide how much is channeled into consumption and how much is channeled into investment for future consumption.

There is one more point, however, that needs to be stressed and which is not contained in either theory: namely, that of technology. How do we conceive of technology in this framework? We cannot, after all, consider it like land; an ‘original’ or ‘given’ means of production. Rather we must see it as a product of a type of labour; namely, intellectual labour.

Now this where another approach might be interesting to supplement the above mentioned ones. This is actually a neo-Marxian approach that has recently been developed in philosophy by the French philosopher Bernard Stiegler in his three volume work Technics and Time. Stiegler draws on the work of the phenomenological philosophers to argue that technology is actually a physical embodiment of human memory. Think of it this way: all technology is the embodiment of human intellectual labour. In other words: all technology is the embodiment of human thought. Technology is then a sort of ‘deposit’ of human thought. In this sense it is very similar to memory.

Thought of in this sense capital becomes a number of things. It becomes, first and foremost, embodied labour time — whether we want to emphasise the time aspect or the labour aspect is completely arbitrary. But it also becomes embodied memory or embodied human knowledge.

Ultimately though these are all just metaphors. And really capital theory is a very secondary, perhaps even tertiary, part of macroeconomic theory. We really cannot say a great deal about it. We can tell stories and create metaphors but beyond that we can say little else. Trying to understand the interest rate, for example, in terms of the theory of capital is a total dead-end. But also trying to come up with some ‘objective’ theory of distribution as Marx did is also a dead-end.

This shows us something interesting: any economic theory that gets overly bogged down in the theory of capital is probably not a very interesting or useful economic theory. Thankfully, since the 1970s Post-Keynesians have moved away from capital theory. Indeed, Joan Robinson said it was a dead-end after the capital debates in the 1970s — something that Nicholas Kaldor recognised in the 1960s while everyone else was obsessed.

The Austrians and the Marxians are still obsessed. But all they are doing is weaving ideological narratives out of metaphors and in doing so thinking they are doing something scientific. What they are really doing is engaging in storytelling that justifies their a priori political belief systems. As we have seen above we can tell very nice stories and deploy very nice metaphors. But they are just stories and metaphors.

Interesting work is being done on capital accumulation, however, by the Schumpeterian school. The most popular of these is Mariana Mazzucato. They eschew the model-oriented approach and instead go out and look at how technology and knowledge become embodied empirically. Their results are very interesting. In a later volume of Review of Keynesian Economics (ROKE) I will be publishing a review of Mazzucato’s book (see early draft here) where I tie what they are doing back to Post-Keynesian economics using the old, and still very flexible, Harrod-Domar growth model.

On Open-Mindedness, Open-Systems and Open Economics Education

I recently came across a fascinating paper by Victoria Chick entitled ‘The Future is Open: On Open-System Theorising in Economics‘. I want to focus on a specific aspect of the paper; namely, Chick’s discussion on the psychological possibilities of actually teaching open systems. But first I suppose I should make clear what the term ‘open systems’ means. The Wikipedia page actually has a rather nice summary.

In system theory, an open system is a system which continuously interacts with its environment or surroundings. The interaction can take the form of information, energy, or material transfers into or out of the system boundary, depending on the discipline which defines the concept. An open system is contrasted with the concept of an isolated system which exchanges neither energy, matter, nor information with its environment.

The first sentence is, I think, the most important. The key to open system theorising is the notion of constant interaction. In philosophy there is a long tradition of this type of thinking which goes right back to Socrates. It is known as the ‘dialectical method’. This was given its modern dynamic form by the likes of G.W.F. Hegel but much reasoning you find in philosophy is quite dialectical even if it does not explicitly say so.

Basically the idea is that thinking is a process of development. I suppose the best way to think about this is to consider how you interact with your environment. You do not go out into the world with rigidly prescribed rules — of what direction to walk, how fast, when to turn, when to extend your arm to open a door and so on — rather you continuously interact with the world around you. Likewise, if you engage someone in conversation you tend not to approach it with pre-established sentences. You may have a general notion of what topics you want to address — or you may not — but the conversation will evolve through continuous interaction.

Open systems thinking or, if you prefer, dialectical thinking applies the same idea to economic theorising. The idea is that you don’t want to produce a closed-system that gives you a single answer. Rather you want to have a series of tools, concepts or ideas which you approach the world with. This is the method adopted by Keynes in The General Theory. Indeed, I believe you can trace actual exposure to dialectical ideas in Keynes’ interaction with the likes of the philosopher G.E. Moore who was heavily inspired by the British Hegelians of the late-19th century.

Now, back to Chick’s paper. She makes the case that teaching open systems thinking to students risks encountering particularly difficult problems. Chick draws on studies in the psychology of education to argue that some people have an innate conservativism when it comes to thinking. What she means by that is not that they are politically conservative but rather that they tend to think in a very specific manner. Chick, following the psychologist Milton Rokeach, distinguishes between open minds that are capable of handling open systems and closed minds that are averse to them. She writes:

As a ‘primitive’ belief, the closed mind perceives the outside world as hostile, threatening, the open mind as friendly. Although we rely on external authority to tell us more about the world than we can experience directly, the belief that the world is threatening is responsible for the closed mind’s conflation of the course of information and the information itself. Authority for them, in the learning context as elsewhere, depends on the ability to mete out reward and punishment. Knowledge thus imparted by the subject’s authority figures is taken as a ‘package’ that the subject cannot dismantle into its components, making it difficult, if not impossible, to evaluate particular ideas on their merits. New ideas that do not conform to her/his belief structure are either rejected or modified to fit into that structure. (p64)

Regular readers will, of course, recognise in these words many of the problems with the mainstream economic profession. Some of it is manifest in the structure of the theory itself. The threatening world is represented by the cynical, self-interested agents that only interact with each other to obtain some sort of personal gain. Other aspects are inherent in the sociology of the discipline. The authoritarianism of the profession and the inability to pick apart models to examine their components, for example, and the slavish devotion to authority figures particularly manifest in the fact that it doesn’t so much matter what is being said as who is saying it (the idea of ‘stagnation’ that has been popular in Post-Keynesian circles since the 1930s is only picked up when Larry Summer and Paul Krugman start talking about it and even now experts in the field are not consulted when the topic is broached etc).

The economics profession has, for the past six or seven decades been sustaining itself by attracting students that have this type of mindset. It has evolved in such a way that students that do not have this sort of mindset will generally migrate into another more ‘open’ discipline. But the students with innately closed minds will tend to stay. Every generation the number of open-minded economists grows thinner and thinner until we reach the point where we are today. The halls of economics become populated by a certain personality type that literally cannot even understand some of the criticisms being leveled at it, much less the fact that thousands of students with a more ‘open-minded’ personality type launch a worldwide campaign against the curriculum and method of teaching. But when the world begins to look scary the closed-mind retreats in upon itself.

The difference could not be more marked. Chick writes about the characteristics of the ‘open’ personality type.

Openness can be characterised by the degree to which a person can react to relevant information from outside her/his belief system on its own intrinsic merits, without contamination. The extent of rejection of the disbelief system is less for the open minded, so new information, if considered valuable, is assimilated not by distorting the information to fit but by altering the belief system. The borders of the belief system are permeable. (p65)

The open systems approach is one that is inherently — and one might even say: primarily — empirical. Rather than altering the facts to fit the theory, one alters the theory to fit the facts. And if the facts begin to look like they completely overwhelm the theory then the theory is easily dropped and another one constructed in its place. In an open systems approach theories are mutable and non-permanent. Different theories may suit different situations and the thinker is always ready to create a new, provisional theory if the facts seem to merit this.

Because of the fact that in economics we deal with non-homogenous, historical time where two situations are never exactly the same, any closed system approach will always necessarily fail. It would be like if historians were still using the same historiography of the Ancient Greek historian Herodotus to try to understand events in the 20th century. The result would be a mess. Since economics effectively deals with historical material the same is true for the approach that it must take.

The key problem here is pedagogical. It is obvious that those who possess closed minds and who have been trained to think in terms of closed systems will not be able to alter their views. Indeed, if attacked they will bunker down and use every means necessary to try to maintain their monopoly so that they never even have to entertain the idea that there might be a fundamental criticism directed against their systems of thought. But what about students? Chick notes that many psychologists in the field claim that such personality traits are developed in childhood and cannot be truly overcome. She does not like this and she writes:

Rokeach’s and Rotheim’s characterisations seem static, reflecting the importance of childhood experience in the formation of personality. If character were so fixed, about all the teacher could do is identify the students to whom open systems will make sense and those to whom it will not. But hope is at hand: Rokeach speaks of learners becoming ‘more and more open in their belief systems’. (p65)

I would err on the side of pessimism here. I do think that some people who are inherently closed-minded, if caught at an early age — maybe their late-teens or early-twenties — can be made to open up a bit. But I think this should be a secondary concern. My reading of the student movement for economic reform is that it is made up of the portion of the economics class — and they are typically the majority in first year — that have more open minds. What they are fundamentally reacting to is that the find the modes of reasoning employed strange and alienating.

Their call for pluralism can thus provide a satisfactory solution to the problem at hand. If economics were allowed to be taught in a multitude of different ways then every personality type could find their natural homes. The closed-minded students would gravitate toward the closed-minded lecturers while the open-minded students would gravitate toward the open-minded lecturers. A sort of evolutionary process would then do the rest of the work. By introducing competition into the field it would soon be clear who was producing better and who was producing worse economists. What is more, this would involve no coercion but simply a more open-ended and pluralistic approach to teaching. But be sure that the closed-minded types will guard against this zealously as it will appear to them a threat. For all their talk of competition they are, in practice, monopolists.

 

Against Gold-Buggism: The September Issue of The New Internationalist

The September issue of The New Internationalist is in shops now. The theme is all about the rise of gold on both the right and left of the political spectrum. It includes a piece by me on the economics of the whole thing entitled ‘Bunker Economics’. So, if you’re bored, don’t have access to the internet and see a hard copy of the magazine for sale somewhere feel free to pick it up.

I noticed the goldbug trend way back when the crisis started and I’ve been on the front-lines of fighting that nonsense since it started. What I found so fascinating was that many people on the political left were picking up the narrative. But anyone who knows the history and the economics of the gold standard knows that it is an inherently right-wing device. The main rationale for the gold standard is to prevent governments from being able to run large deficits and debt. Thus, with the gold standard much of the counter-cyclical aspect of government spending is automatically reigned in.

If the gold standard were reenacted today most countries around the world would have to engage in extreme austerity of the type we see in Greece. What I found so fascinating about the rise of the goldbug narrative on the left was that the same people who supported it as a means to supposedly stop ‘private banks creating money’ were completely shocked and appalled by what was happening in Greece. Yet they were implicitly calling for it to be applied elsewhere when they demanded a return to the gold standard.

The most interesting outlet for this contradictory narrative was the television station Russia Today. Russia Today generally takes a very left-wing perspective on most issues. But from time to time you will see them drag on some right-wing conspiracy nut. Still, the main editorial stance is generally left-wing. But after the crisis the goldbugs completely took over the station.

What was so interesting about this to me was that it became clear that at the time the left had no coherent economic narrative that it could push. Thankfully this has largely changed due to pioneering blogs (like Naked Capitalism, New Economic Perspectives and The Financial Times Alphaville, especially the work of Izzy Kaminska), David Graeber’s bestselling book Debt: The First 5,000 Years (which I think was the big game-changer on the left and which launched after the interview I conducted with Graeber back in the summer of 2011) and the collapse of the gold market (which I called just before it happened).

I think that the latest issue of The New Internationalist is really the final nail in the coffin of this nonsense. But a few people will likely hold out. That is unfortunate. But many in the financial markets think that gold has a long way to go yet before it reaches a bottom. Perhaps what an appeal to Reason cannot chip away at, a very large hit to their portfolio can.

Econometricians, Financial Markets and Uncertainty: An Anthropological View

I recently read a paper by the anthropologist David Graeber entitled ‘The Sword, The Sponge, and the Paradox of Performativity: Some Observations on Fate, Luck, Financial Chicanery, and the Limits of Human Knowledge‘. Graeber sent it to me because we are hoping to write an article on the emergence of probability theory and its application in the financial markets.

The working title of our paper is ‘The Betrayal of Freedom and the Rise of the Future Machines’. The basic idea is to show that the predictive powers of social sciences — including economics and finance — were shown to be fairly vacuous in the 1960s from a variety of different directions. The response by the horrified professions was to bury the evidence and double down on probabilistic prediction. This coincided with the rise of finance and the whole thing produced the weird world of meaningless numbers and extreme instability that we face today.

Anyway, here I will provide a gloss on Graeber’s excellent paper as an accompaniment to my recent piece on the anthropology of the economics profession. It is not available online except behind a paywall but I urge readers to seek it out. It is one of the best psychological/anthropological descriptions of how and why people — from village elders to econometricians — try to use arcane and difficult methods to predict the future and dictate how people should organise themselves socially and economically. In order to discuss the paper I must first introduce to non-anthropologists two key terms.

The first is ‘mana‘. This is a difficult term to pin down as it has any different dimensions in many different cultures. But Graeber’s main angle of attack in the paper is that mana is a power that people believe they can gain control over to predict and influence the direction of future events.

The second is ‘performativity‘. Performativity is a sort of ‘thinking/doing makes it so phenomenon’. For example, the Queen of England is the Queen of England because everyone believes her to be the Queen of England. If everyone in the world stopped believing tomorrow that she was the Queen of England she would cease to be the Queen of England. Her social position is literally only real insofar as we believe it. Her royal actions and symbolism are thus a way to ‘perform’ this belief and reinforce it.

Now, onto the essay. Graeber thinks that many of the phenomena that anthropologists know as mana are actually very similar to concepts that we in the West employ such as fate, luck, chance and probability. Graeber notes that we as a society have been taught to think of events in terms of probabilities. But this is not present in non-Westernised cultures. He cites the following conversation he had with an educated Malagsy while he was in Madagascar doing fieldwork:

David: What do you think the chance is that a bus will come in the next
five minutes?
Zaka: Huh?
David: I was thinking of running up the hill to get some cigarettes. I figure
it’ll take maybe five minutes. What do you think the chance is that
a bus will come before I’m back?
Zaka: I don’t know. A bus might come.
David: But is it likely to?
Zaka: What do you mean?
David: You know, what’s the chance? Is there a very large chance it will
come? Or just a small chance?
Zaka: A chance can be big or small?
David: Well, is it more like 1 in 10? Or more like 50–50?
Zaka: How would I know? I don’t know when the bus is going to arrive. (p32)

It is clear that Zaka the Malagasy thinks David the American’s questions to be absolutely bizarre. It simply does not make any sense to him. Despite being educated he does not even think to ascribe to chance a numerical estimate. Graeber concludes:

Even when my Malagasy did become fluent, I never heard people employing language in the way that people would do so in America, for example, “I’d say 3 to 1 the cops won’t even notice that I’m parked here.” In fact, I discovered not only that such a way of thinking was unknown to most Malagasy, but also that, once explained, it seemed just as peculiar, exotic, and ultimately unfathomable as any of those classic anthropological concepts, such as mana, baraka, or s´akti, regularly employed in other parts of the world to put a name on the play of chance or to explain otherwise inexplicable conjunctures or events. Once I began to think about it, I realized that this puzzlement was a pretty reasonable response. Chance actually is a very peculiar concept. Zaka was right: the main thing is that we do not know when the bus is going to arrive. This is the only thing that we can say for certain. Anything could happen—the bus might break down, there might be a strike, an earthquake might hit the city. Of course, all these things are, from a statistical perspective, very unlikely, million-to-one chances, really. But it is that very application of numbers to the unknowable that struck my Malagasy interlocutors as bizarre—and not without reason. What a statistical perspective proposes is that we can make a precise quantification based on our lack of knowledge, that is, we can specify the precise degree to which we do not know what is going to happen. (pp32-33)

I am entirely in agreement with Graeber here. We can assume that the bus was not on a strict timetable because we are not dealing with an advanced and well-organised society. Thus giving the chance that the bus would arrive while Graeber went to get cigarettes a numerical estimate was a pretty mystical thing to do altogether. (I do find it amusing that Graeber said that the chances of a strike, the bus breaking down or the earthquake hitting were ‘a million-to-one’ though… it seems like even he finds it difficult to get away from his pre-conceived cultural way of thinking about such things!).

Think about this. If I have a coin that is fairly balanced I can give an objective probability estimate. The chance of the coin landing on either heads or tails is 0.5 or 50%. This number is not mystical. It is objective. But when Graeber asks what the chance of the bus turning up is or whether the cops will notice that he is parked illegally, these estimates are not objective. They are entirely mystical. They are, in fact, as Graeber rightly points out, the same sorts of magical thinking that many so-called primitive cultures use to try to grapple with the future.

The amusing thing, however, is that we actually employ people and give them social prestige to engage in these mana-like numerical concoctions. This is just like in supposedly more primitive societies where soothsayers and astrologers are given status as village elders and power to decide how the society should be organised. In our Western societies we hire economists and financial experts. Graeber writes:

Almost invariably, too, there are certain specialists who claim privileged, exclusive knowledge. In very hierarchical societies, elites will either try to monopolize such matters themselves (e.g., Azande princes maintain exclusive rights to officiate over the most important oracles) or attempt to forbid them as forms of impiety (both Catholic and Sunni authorities have been known to do this at one time or another). There is also a frequent, although not universal, tendency for these techniques to draw on forms of knowledge seen as foreign and exotic: the Arabic lunar calendar in Madagascar, Chinese numerology in Cuba, Babylonian zodiacs in China, and so on. (It is not the past, perhaps, but the future that really is a foreign country.)
From this perspective, it is quite easy to see that economic science has become, in contemporary North America above all, but in most of the industrialized world (or, perhaps better said, financialized world), exactly this sort of popular ‘technology of the future’. There are specialists who try to keep a monopoly on certain forms of arcane knowledge that allow them to predict what is to come, although in a way that, insofar as the situation becomes political, inevitably slips into performativity. At the same time, fluctuations in the financial markets, speculation on stocks, investments, and the machinations of commodities traders or central bankers, all these have become the stuff of everyday arguments over coffee or beer or around water coolers everywhere—just as they have become the veritable obsessions of certain cable watchers and denizens of Internet chat pages. There is also a tendency—quite typical of such popular technologies of the future as well—for idiosyncratic (‘crackpot’) theories to proliferate on the popular level. (pp39-40)

Graeber is absolutely correct here. This is where we come to the notion of ‘performativity’. If we examined the situation objectively we would quickly see that these people are mostly engaged in soothsaying but we do not. Why? Because the performance buttresses our hierarchical social and economic structures and lends them credibility and weight. We do not want to know the reality: namely, that our social structure is determined in line with political and social power. And thus we create fictions that ground it as being somehow ‘objective’.

The statistical estimations are mostly about performance in this regard. They are similar to a symbolic ceremony by the Queen of England. And in the financial markets this performance generates dynamics of its own. For example, when everybody is convinced that the markets will be calm they will get statistical read-outs saying that the markets will be calm precisely because they are acting as if the markets will be calm. But when they start to panic because something unseen happens, their statistical read-outs will suddenly change.

In truth their ‘future machines’ are just feeding back to them their own activity. It is like an animal looking in a mirror and thinking that another animal is staring back at them. In reality, it is just their own reflection. The whole situation would be hilarious but these dynamics are wreaking havoc on our societies. They are also trapping us as political actors because they give us a sense of fatalism about the future. They encourage us to think that the ‘experts’ have the whole thing figured out and that ‘politics’ should be structured in line with this. This is the true poison of modern economics and it is what makes modern economists such dangerous clowns. The unfortunate thing is that almost every single one of them, wrapped in their socially-sanctioned delusion of scientificity, have absolutely no idea what they are doing.