Glasner and Zimmerman on the Sraffa-Hayek Bust-Up and the Natural Rate of Interest

David Glasner from over at the blog Uneasy Money has co-written an interesting paper on Sraffa and his critique of the natural rate of interest as it was put forward in Hayek’s business cycle theory. There is a lot that might be written about this paper as I believe that the debate has much contemporary relevance. Here, however, I will focus purely on the topic of the paper at hand. Namely, whether Sraffa’s critique of the natural rate of interest was coherent. I will also assume familiarity with the debate as, frankly, I’m too lazy to summarise it and interested people can read the paper which provides a fantastic overview.

Glasner and his co-author, Paul Zimmerman, quote Sraffa’s criticisms as such:

The “arbitrary” action of the banks is by no means a necessary condition for the divergence; if loans were made in wheat and farmers (or for that matter the weather) “arbitrarily changed” the quantity of wheat produced, the actual rate of interest on loans in terms of wheat would diverge from the rate on other commodities and there would be no single equilibrium rate. (p10)

Glasner and Zimmerman say that this disturbance would not persist. They write:

Deviations from equilibrium owing to fluctuations in the supply of real commodities would not persist; market forces would operate immediately to restore an equilibrium with all own rates again equalized, a tendency not mentioned by Sraffa. (p10-11)

They again quote Sraffa. In this quote Sraffa is saying that a market in which there is an increase in demand will go into backwardation. That is, a circumstance in which the forward price for a commodity is lower than the spot price.

Suppose there is a change in the distribution of demand between various commodities; immediately some will rise in price, and others will fall; the market will expect that, after a certain time, the supply of the former will increase, and the supply of the latter fall, and accordingly the forward price, for the date on which equilibrium is expected to be restored, will be below the spot price in the case of the former and above it in the case of the latter; in other words, the rate of interest on the former will be higher than on the latter. (p11)

Glasner and Zimmerman claim that Sraffa dropped the ball here. They say that he has confused nominal and real interest rates. The authors write:

What Sraffa called a multiplicity of own rates, was in fact a multiplicity of nominal rates reflecting the expected appreciation or depreciation of those commodities for which demand was increasing or decreasing. The natural rate, expressed as a real rate, (i.e., abstracting from expected price changes) remains unique in Sraffa’s exercise. (p11)

But this is not at all clear. The authors appear to be confusing expected price changes with actual price changes. This can clearly be seen if we lay out the process that Sraffa imagines to occur sequentially.

1. Demand switches from Commodity A to Commodity B.

2. Commodity B rises in price and Commodity A falls in price.

3. The financial market anticipates that this price discrepancy is only temporary. Thus the interest rate on Commodity B will increase and the interest rate on Commodity A will fall.

Note that the overall price level has not changed. The price increase in Commodity B has been offset by the price decline in Commodity A. In the future an increase in the supply of Commodity B will cause its price to fall and its interest rate to fall as it tends back toward equilibrium but this does not occur in the present. In the present we have a different structure of real interest rates. The overall price level has remained constant while the real interest rate on Commodity B has risen vis-a-vis the interest rate on Commodity A which has fallen.

In the period when the economy adjusts the quantity produced of Commodity A will fall and the quantity produced of Commodity B will rise. The price will fall back to equilibrium levels and so too will the interest rates. Again though, there is no actual change in the general price level. And the change in real interest rates that occurred in the previous period is still a fact that we cannot ignore.

Even in the case of a supply-shock this same mechanism will occur. If the amount of wheat produced falls below equilibrium level due to a change in the weather its relative price will rise. We then do have an increase in the overall price-level. The financial market in wheat will then go into backwardation and the wheat-interest-rate will rise. But unlike in the last example the other interest rates will not fall because demand for other goods remains constant. Thus we have a fall in real interest rates in these markets. Again the structure of real interest rates changes. The real interest rate on wheat has risen vis-a-vis the real interest rates on all other commodities by dint of the fact that the price level has risen while these interest rates remain the same in nominal terms while the nominal interest rate on wheat has risen.

As Sraffa showed in his paper this has policy implications as it completely befuddles Hayek who was trying to argue that the monetary authority should set the money rate of interest equal to the natural rate. The authors quote Sraffa on this point when he replied to Hayek’s reply:

Dr. Hayek now acknowledges the multiplicity of the “natural” rates, but he has nothing more to say on this specific point than that they “all would be equilibrium rates.” The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates. (p13)

This brings up the next criticism that the authors throw at Sraffa. I will deal with this in another post.

Uncertainty and Freedom

I am beginning to increasingly think that Keynes’ economics, with its every present emphasis on uncertainty, is actually an economics that takes the idea that humans are free seriously. That is, it is an anti-deterministic economics. I think that the only economist who recognised this was GLS Shackle.

At many points in Shackle’s work you find rather contemptuous references to philosophers. Shackle seems to be contemptuous of what he thinks to be philosophy because he seems to think that all philosophers argue in terms of a deterministic universe. I have no idea where Shackle got this idea but it is completely untrue. In fact, I think that certain strains of phenomenology — I think of the work of Jean-Paul Sartre and Maurice Merleau-Ponty — might well be the best point of departure when considering how human beings make decisions when faced with uncertainty or, what amounts to the same thing, when faced with the fact that they are free to choose.

I have a brief appendix on this issue in my forthcoming book and I am considering writing a paper on Keynes, Shackle and Sartre in the next few weeks so I will not go into this too much here. Suffice to say that it is rather amusing that marginalist economists are always talking about how in a market economy people are ‘Free to Choose’ (thanks, Dr. Friedman) but then they model human agents as pre-determined entities and study the economy as if there is no freedom of choice and everything is determined. It’s a rather silly self-contradiction but I believe it is one of the most damaging in economics.

Anyway, I would encourage people to listen to the following lecture on the philosophy of Sartre if they want to get a better feel for what I am talking about here. Pay particular attention to the discussion of temporality around the 31.30 mark.

Mainstream Economists Completely Incoherent on the Effects of Monetary Policy

Bill Mitchell has a post up on his blog today criticising Mankiw’s textbook which apparently has a new edition coming out. Basically Mankiw is stuck in monetarist-land telling students that “banks control the money supply” and all that other nonsense that should have been done away with  years ago.

Mitchell’s critique is perfectly salient. But on one point I think that he drops the ball. Indeed, moving into the future I don’t think that criticisms will aim at New Monetarists like Mankiw because the profession is gradually giving up the old fashioned Friedman-esque doctrines. The point at which Mitchell makes a mistake is when he discusses the work of Wendy Carlin who is in charge of INET’s CORE curriculum reform committee. He suggests that she will likely be flogging the New Monetarist stuff when he writes:

Even so-called progressives who think they are on top of the situation like the iNET sponsored Wendy Carlin have embedded in their so-called – The 3-Equation New Keynesian Model — a Graphical Exposition – the view that savers provide the funds that the banks lend out for profit.

Well, the paper that Mitchell has linked to does not contain New Monetarist doctrines. Rather it substitutes for the LM-curve a central bank reaction curve that suggests central banks set an interest-rate target — a Taylor Rule. Thus the model recognises that central banks set the interest rate and do not seek to control the money supply.

Other mainstream textbooks have already integrated this insight. Although Paul Krugman has shown time and again that he does not remotely understand how the modern banking system works, his textbook Macroeconomics actually does contain an interest rate target rather than a money supply target (p351). This is not to say that this chapter of the textbook is not confused — it is, Krugman and his co-author flip-flop this way and that on the issue by providing a money multiplier at another point in the chapter (p331) — but they do provide the student with the idea that the central bank sets the interest rate.

The mainstream are a bit of a mess on this one. They still teach the money multiplier but they also teach interest rate targeting. Of course, the Bank of England has, as Mitchell points out, stated clearly that these two theoretical conceptions are mutually exclusive. But this is just more evidence that the mainstream don’t really understand their own theories: they just learn them by rote.

Nevertheless, if interest rate-targeting is the way of the future we must be clear that the criticisms of this approach lie elsewhere. Mitchell gives us some hints on this when he alludes to the fact that such theories are fallacious insofar as they assume instantaneous adjustment (logical time) rather than a realistic portrayal of the investment process (i.e. one embedded in historical time). He writes:

Essentially they claimed that if consumption spending fell as saving rose, more funds would be made available to the loanable funds market. The higher saving would drive down interest rates because there would be an oversupply of funds to the market relative to the current investment level.

The lower interest rates would stimulate higher investment and eventually the saving and investment changes would become equal at some lower rate than before and the spending lost to consumption would be made up by the higher investment spending. Therefore there could never be any deficiency in demand.

You will read that with a certain amount of incredulity I am sure as I did when I studied the rubbish. Basic first question – How does a firm that produces consumption goods suddenly become an investment (capital) goods producer? What about sectoral imbalances? What happens when the dynamic is the opposite?

These are important points. But the key criticism lies elsewhere: there is no natural rate of interest because, as Keynes showed us well, investment decisions are undertaken based on subjective expectations. Keynes assumed that interest rates did have an effect on investment but that these could be ‘drowned out’ by the lowered expectations of the investment community. Ultimately Keynes thought, quite rightly, that it was the expectations that were more important than the interest rate.

In fact, empirical work done since then has shown that interest rates seem to play little or no role in how businessmen and businesswomen decide on how much to invest. This is generally recognised today as Frederic Mishkin shows in his paper The Channels of Monetary Transmission: Lessons for Monetary Policy. He says that the general consensus is that the manner in which changes in policy interest rates have their effects are through the following channels:

1. Exchange rate effects — a fall in interest rates will (sometimes) lead to a weakening of the currency. This will boost exports and curtail imports.

2. Equity prices — a fall in interest rates might lead to rising stock prices which might stimulate investment and may also lead to a ‘wealth effect’ that raises consumption.

3. House prices — a fall in interest rates might lead to a pick up in house prices and thus to new investment in this sector.

4. Balance sheets — a fall in interest rates will cause financial instruments to become more valuable and this will strengthen balance sheets which may encourage borrowing/lending.

Note carefully that these affects might occur. It is by no means assured that they will occur. But even leaving this aside this is no longer a very straightforward question. In the textbook fairytale a fall in the rate of interest leads to higher investment. Thus there is some sort of nice equilibrium balancing going on. But if Mishkin is correct that the channels through which it actually works (when it works) are the above ones this does not fit nicely into the abstract fairytale model.

The above effects also do not suggest that the economy will move toward equilibrium. In the fairytale story the economy re-equilibrates through the assumed adjustment mechanism. But the above channels more so suggest that the economy will, at best, get a simple one-off boost. This is what Post-Keynesians like Joan Robinson, Nicholas Kaldor and Michal Kalecki said years ago. They never bought into the equilibration story because they were fundamentally dynamic economists (even though their theories occasionally didn’t reflect this) and they saw lowering interest rates as the equivalent of eating a sugary snack on an empty stomach: it might work once, for a few hours, but soon you’ll need another sugary snack or you’ll crash.

The history of the era of interest rate targeting bears this interpretation out too. We can basically date interest rate targeting in the US to around 1984 when monetarism and money supply controls were thoroughly abandoned. After this the interest rate was on a slippery slope downward until it hit the zero-lower bound. The following chart shows the real overnight interest rate in the US from that period (i.e. the nominal overnight rate minus the rate of inflation).

After 2008 the central bank basically ran out of sugary snacks and the economy slipped into a diabetic coma. (A similar story can be told for the UK although the monetarist era ended slightly later).

The empirical work done by the mainstream today suggests that there is no such thing as a natural rate of interest. Yet the modellers still assume that this does exist. This is yet more evidence of the incoherence in the mainstream that I have noted on this blog before. In this case it is because the modellers want to keep their equilibrium tools intact even though they do not fit the material that they are trying to use them on. This should also provide a serious warning for Post-Keynesian economists who have slipped into using comparative static tools to undertake what needs to be dynamic analysis.

Update: On the Krugman front Dirk Ehnts did a nice job last year showing how the good doctor flip-flops on this issue. When I read Krugman and Wells’ macroeconomic textbook I got the distinct impression that Krugman probably didn’t write the section on money creation and interest rates. If I’m wrong and he did then that is even worse because it means that he was cutting and pasting rather than understanding the material that he was putting together for students.

One point on which I would correct Ehnts is that the demand for loans can actually affect interest rates, just not in the way that Krugman thinks (i.e. not in the ‘loanable funds’ way). Interest rates in the economy gravitate toward the overnight central bank rate but the spread between this rate and other interest rates is determined by risk perceptions of the market (Keynes’ ‘liquidity preference’). So, if lots of people demand loans in theory the market could price in the fact that since more people are borrowing these peoples’ risk levels are higher because they are borrowing more.

But this is only one of many possibilities because risk perceptions are not what economists call ‘rational’. Rather they are set in line with subjective expectations. In a period of very buoyant borrowing risk perceptions will probably — ala Minsky — become far more accommodating. This is certainly what we saw in the run-up to 2008 and we have also seen it after the Fed’s easy money policies did their magic and dragged the economy out of a liquidity trap in 2009-2010 (yes, stop listening to Krugman about almost everything monetary; we are out of the liquidity trap for now). So, in contrast to what Krugman thinks at a time of very high borrowing it is quite likely that interest rates will actually fall as the good feelings and gnarly vibes work their way through that rather ridiculous hall of mirrors known as the financial market.

A Storm is Coming: On the Rethinking Economics Conference in London

I’ve published a piece on Al Jazeera that gives an account of the extremely impressive London conference that the students fighting to change economics put on at the end of last month. There are some nice anecdotes and I think it gives a good overview of the movement. Al Jazeera also allowed me to make two theoretical criticisms and a methodological criticism. How often does that happen!?

The fight to reform Econ 101

Keynes’ General Theory, the ISLM and Roy Harrod’s ‘Dynamics’

Too often discussions of the relationship between Keynes’ General Theory and the ISLM model focus on John Hicks’ 1937 paper ‘Mr. Keynes and the Classics‘. That paper appeared in the April edition of Econometrica, Volume 5, Issue 2. But Roy Harrod had already formulated the ISLM — in half-mathematical, half-verbal form — in the January edition of the same journal, Volume 5, Issue 1. I think that an appraisal of the relationship between the General Theory and the ISLM is far better done taking leave from Harrod’s paper ‘Mr. Keynes and Traditional Theory’ as it will allow us to clearly highlight the differences and why Harrod glossed over them.

In his paper Harrod claims that Keynes argues that investment is determined by equating the marginal productivity of capital with the rate of interest. He writes:

Of course, this is not in fact the case. Rather for Keynes investment is determined by the interest rate and the marginal efficiency of capital. The difference in the two concepts is absolutely key to understanding Keynesian economics proper. The marginal productivity of capital is a simple concept: it is the amount of output that is produced by an additional increment of capital. The standard theory says that investors will invest up to the point that the marginal productivity of capital is equal to the rate of interest. This makes sense on its own terms (that is, assuming perfectly rational, competitive etc. actors). If the rate of interest is, say, 2% and invested capital is throwing off profits of 3%, rational investors will step in and borrow at 2% to obtain the profits. Eventually the ‘spread’ between the two rates will become equalised.

Keynes’ theory of the marginal efficiency of capital is entirely different. In the General Theory he thinks this an important enough concept that he devotes an entire chapter to it in which he writes:

I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price… The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over… The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between to-day and to-morrow… The fact that the assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality. But the introduction of the concepts of user cost and of the marginal efficiency of capital, as defined above, will have the effect, I think, of bringing it back to reality, whilst reducing to a minimum the necessary degree of adaptation. (Emphasis Original)

The reader will appreciate the enormous difference here. Investment becomes wholly subject to expectations — what Keynes will elsewhere call ‘animal spirits’. He thinks that if this is not taken into account the theory of investment “imports into it a large element of unreality” and will thus, presumably, not be commensurate with the real world.

Harrod actually recognises this while he is expounding the ISLM view of Keynes’ work. But he then glosses over it.

Harrod seems to recognise to some extent the difference here and praises Keynes’ incorporation of expectations. But he then moves to gloss over this difference. In order to do this he introduces an interesting trope: that of the ‘working economist’. The ‘working economist’ appears to be, for Harrod, the dupe or the idiot who cannot properly understand the nuances of high theory and needs some simplistic explanation such as the ISLM.

“Oh, we clever economists know that the rate of investment is not really determined by the equalising of the rate of interest and the marginal productivity of capital,” Harrod says, “But there are lesser mortals out there who need a simple theory and we shall tell these folks that this is the actual theory.”

This seems a rather strange maneuver on Harrod’s part. It is clear that there are a lot of ‘working economists’ who do appear to require such constructions in that they insist on closed, deterministic models. But I would argue that they are just bad economists. I do not see why it is so problematic to tell students (or whoever) quite clearly that investment is determined through expectational formation. Those students who cannot get their heads around this and insist that they must ‘close’ the model and make investment ‘determined’ by the marginal productivity can simply pack up and take their bags elsewhere. If you can’t deal with this aspect you will not be good at applying economic theory to the real world and your pronouncements on the economy will be suspect. End of story.

But Harrod isn’t just fobbing off his ISLM on the dupes. There is another motive for glossing over what appears to be the most important component of Keynes’ theory of investment. Harrod does want to integrate expectations but he wants to do it in a way that he insists is different from Keynes. He writes:

Harrod had been working on his ‘dynamic economics’ the whole time that Keynes had been working on his General Theory. There was thus a certain amount of rivalry between the two. So, Harrod thinks that expectations should only be brought in when dynamics are being discussed.

But this is just a miscommunication between the two men. Keynes is clearly interested in dynamics. That is why he writes that determining the rate of investment by equating the marginal productivity of capital and the rate of interest “has had the result of breaking the theoretical link between to-day and to-morrow”. What Harrod will try to develop in the ensuing years will be perfectly in keeping with what Keynes was doing. But Harrod felt the need to distinguish his work from Keynes’. That is why he suppressed the dynamic element in Keynes’ General Theory: so that he could claim that he was the first to introduce this aspect of economics. This is a narcissism of small differences if ever you may come across one.

Today, however, the men Harrod rather derogatorily called ‘working economists’ have won the day. Students are simply not taught the real-world truth: investment is determined by expectations about the future that are not subject to mathematical formalisation or reduction. One month after Harrod’s review appeared Keynes published a summary of his work in which he noted the danger inherent in the interpretation that Harrod was putting forward.

Keynes clearly saw the modern development that Harrod’s ‘working economists’ would begin to use probability theorems to determine investment decisions. He saw that this was already somewhat implicit in the theory yet never expressed. But he also knew that this would only produce unrealistic rubbish.

How then are investment decisions determined. In his article Keynes gives us some pointers. He writes:

Basically, people pretend ‘as if’ they know what is going on. But they do not and cannot. Keynes opened the way for work to be done on how people actually cope when faced with an uncertain future. GLS Shackle paved the way for work to be done in this area but it went largely ignored (except by a few obscure psychologists). Today, however, this black box has been opened once more by a team of researchers at University College London.

Using a mixture of empirical techniques, psychoanalytical theory and economic analysis these researchers have opened up a box that has been sealed for a very long time indeed. Their findings so far, some of which I believe are being taken quite seriously by the Bank of England, are extremely promising. Frankly, I think they might change the way that good economics is done. The ‘working economists’, however, will probably not be very happy about this at all.

Stock Market Crash!

Did that title get your attention? I’d imagine that it did. There’s nothing like predictions of a crashing stock market to get the attention of readers. Well, I’m not quite willing to make any firm predictions. Rather I want to comment on a recent post over at the excellent Philosophical Economics blogspot entitled ‘Who’s Afraid of 1929?‘.

The author obviously has a sense of irony because his Twitter handle is named after the famous stock market bear Jesse Livermore. But in the post the author chastises who he calls ‘permabears’, that is people who called the 2008 stock market meltdown and who have, ever since then, been saying that there would be no upswing in the financial markets.

I think I know who Livermore — or whatever his real name is — is talking about. He is likely referring to Austrian types like Peter Schiff who flog gold to their suckers… I mean, customers. Others that called the 2008 crash were not at all surprised that the stock market took off like a rocket afterwards. This is because they understood the dynamics of the easy money policies initiated by central banks around the world after the crash.

The fact of the matter is though that the stock market, and indeed most other financial markets, are very likely overvalued. Livermore himself seems to hint at this when he writes:

As for the future, the speculative spoils from here forward will go to whoever manages to correctly anticipate–or at least quickly react to–the forces that might reverse the trend of strong earnings and historically easy monetary policy, if or when they finally arrive.

I sort of agree. There is a chance that either of these two events might reign in the stock market. But there is another possible event on the cards that might do the trick: namely, the melting down of the global housing bubble that the IMF has recently identified. I wrote an article on this for Al Jazeera recently and there I said:

According to World Bank figures, together the nine bubble economies made up just under 15.5 percent of world GDP in 2012. By contrast, the United States accounted for a little less than 22.4 percent of global GDP that year. We should add Ireland and Spain to the latter figure because those countries also had substantial housing bubbles that burst in 2006 and ’07 and may have contributed to the worldwide downturn; so the bubble economies that crashed the world economy in 2006 and ’07 accounted for almost a quarter of world GDP.

Clearly the countries that the IMF thinks might be bubble economies are not as important to the global economy as are the U.S., Ireland and Spain. That said, the IMF’s bubble economies still account for a substantial slice of world GDP, and if they take as big a hit as the three countries that did in 2006 and ’07, this could spell bad news for the global economy. This is especially true if we consider the weakness of the current global recovery. A simultaneous bursting of housing bubbles in countries that account for over 15 percent of world GDP could have ripple effects and knock the global economy off balance.

I stand by this analysis to which I would add: if such an event occurred there is a possibility that it could pull the chair from under the market. Of course, this could lead once again to post-2008 dynamics taking place once more. A collapse of a global housing bubble could result in more central banks ramping up asset purchases and emulating the Fed, the BoE and the BoJ by engaging in easy money policies.

If this played out we would expect to see the stock market take an initial hit but then, after it hit rock bottom, would rally once more as easy money poured in from all around the world. Those that were previously speculating in the global property market might turn to the stock market to play with their money. This could prove to be an enormous opportunity for any clever investor able to call the bottom and buck the trend.

Anyway, enough crystal ball-gazing for now. But if I were managing money I would watch this space… very carefully.

The Great Unwinding: Some Thoughts on the Incoherence of Mainstream Economics

A recent post by Lord Keynes inspired me to write up some very general thoughts on the state of mainstream economics. Today, I believe, mainstream economics is completely incoherent. What do I mean by that? Well, basically if you are in the mainstream you can pretty much believe in whatever you want these days.

Mainstream economics today can be made to say anything. But in being able to do this it says nothing. All the new gimmicks that have been introduced into the mainstream — from asymmetric information to rational expectations — have rendered it a total free-for-all. So, some of the mainstream will tell you that fiscal stimulus will have zero effect on the economy (Ricardian equivalence) while others will tell you that it is the key to future prosperity. Many will fall somewhere in the middle, unable to articulate their actual beliefs in any concrete manner.

In my experience the mainstream has become so incoherent that most of the time these economists will formulate their policy stance completely arbitrarily. Their opinions on the real economy are formed very much so the way the man in the street formulates his: either by assimilation of whatever is in vogue or by engaging in largely arbitrary construction (usually in line with the political predilections of the person in question).

How did this occur? I would argue that there were two key moments in the history of mainstream economics that led to this Great Unwinding. The first was the Cambridge Capital Controversies (CCCs). The results of the CCCs led to a fracture within the more pragmatic side of the mainstream. The object of attack in the CCCs was the standard marginalist production function. The production function sought to show two things. These were as follows.

(1) That the distribution of income in a market economy would be dictated by relative productivities of labour and capital. In more straight-forward terms that means that labour and capital get what they contribute.

(2) That market economies are inherently self-stabilising in the long-run. While planned savings and investment might diverge in the short-run causing unemployment or inflation they would equalise in the long-run. This avoided what came to be known as ‘Harrod’s knife-edge’. Harrod maintained that capitalist economies were inherently unstable in that planned savings and investment would only equalise by a fluke. This implied that continuous and vigorous policy intervention was required to stabilise a capitalist economy. (For more details on Harrod’s knife edge see here and here).

I think that Harrod was right. If you look at really existing capitalist economies government deficits are required to keep them ticking over most of the time. Take a look at the sectoral balances of the US below if you don’t believe me. Government deficits are clearly used almost constantly to offset private sector savings.

Government intervention to stabilise the economy when savings and investment diverge is the rule, not the exception. There is no ‘long-run’ process of adjustment. Otherwise we would see a balanced government budget in the long-run. We don’t. Not even in the 1950s and 1960s when there was no substantial current account imbalance (i.e. in what effectively amounts to a ‘closed economy’).

What the CCCs showed was that the marginalists could not even prove that a market economy was self-stabilising in the long-run in theory. This led the marginalists to retreat into ever more abstract and out-of-this world constructions. While the production function and the Solow growth model that grew out of it were at least somewhat realistic — that is, you could at least imagine applying them to the real-world — the general equilibrium models and later the microfounded models that came after them were blast-into-space unrealistic.

Solow himself noted this in his Nobel Prize lecture (he won the prize for his flawed work showing that the economy was self-stabilising in the long-run… which shows what passes for Nobel Prize-winning ‘science’ in mainstream economics). I will provide a long quote here because it is important to show how Solow felt about the tendencies generated in economics in response to the CCCs.

The end result [of the new highly abstract constructions] is a construction in which the whole economy is assumed to be solving a Ramsey optimal-growth problem through time, disturbed only by stationary stochastic shocks to tastes and technology. To these the economy adapts optimally. Inseparable from this habit of thought is the automatic presumption that observed paths are equilibrium paths. So we are asked to regard the construction I have just described as a model of the actual capitalist world. What we used to call business cycles – or at least booms and recessions are now to be interpreted as optimal blips in optimal paths in response to random fluctuations in productivity and the desire for leisure. I find none of this convincing…

But now I have to report something disconcerting. I can refer you to an able, civilized and completely serious example of this approach and suggest that you will find it very hard to refute. You can find non-trivial objections to important steps in the argument, but that would be true of any powerful macroeconomic model.

There is a dilemma here. When I say that Prescott’s [i.e. a proponent of rational expectations] story is hard to refute, it does not follow that his case can be proved. Quite the contrary: there are other models, inconsistent with his, that are just as hard to refute, maybe harder. The conclusion must be that historical time series do not provide a critical experiment. This is where a chemist would move into the laboratory, to design and conduct just such an experiment. That option is not available to economists. My tentative resolution of the dilemma is that we have no choice but to take seriously our own direct observations of the way economic institutions work. There will, of course, be arguments about the modus operandi of different institutions, but there is no reason why they should not be intelligible, orderly, fact-bound arguments. This sort of methodological opportunism can be uncomfortable and unsettling; but at least it should be able to protect us from foolishness. (My Emphasis)

Here you see the Great Unwinding in full force. Solow knew that on their own logical terms the new models were impossible to refute. In order to dismiss them he had to basically say that in his opinion they were unrealistic and also point out that there were a whole multitude of models that were logically consistent but arrived at different conclusions. This is where the debate remains today and it is this that accounts for what I have referred to above as the free-for-all within the discipline. But of course the data shows Solow’s own work not be realistic with respect to the real world. So, the invocation of realism — something that I would generally applaud — inevitably comes back to bite Solow firmly on the buttocks.

This confusion was amplified when the neo-Keynesian policy consensus began to unwind in the 1970s due to the inflation. Into this vacuum stepped Milton Friedman and his monetarism. It was noted many times that there were altogether mystical elements in Friedman’s argument and that it ran contrary to the facts but the profession swallowed it. This was because it gave them a common cause to rally to away from the confusion within the discipline.

The second point at which the Great Unwinding took place was when the monetarist policies failed. I have written about this before in extensive detail and if the reader is interested they can consult that writing for an account of the failure. After monetarism had failed the profession once again slipped into incoherence. Rather ironically, this gave rise to the profession asserting that they had reached a ‘New Consensus’. But they had done no such thing.

Whereas in the 1970s and 1980s everyone was talking about monetary control to stop the inflation, in the 1990s there was confusion all around. Economists became rather obsessed with the NAIRU — that is, the idea of a natural rate of unemployment which if the economy fell below it there would be inflation — but this quickly fell apart when unemployment in the US fell below the NAIRU level and no inflation resulted.

After the crisis of 2008 the incoherence became amplified. Today the lack of consensus and the confusion is shocking. While policy-making economists in central banks and the like have a fairly good idea of what is going on the profession is in complete turmoil. This, I think, accounts for why the chief economist at the Bank of England Andy Haldane and Benoît Cœuré at the ECB are calling for substantial curriculum reform. When I speak to people like Haldane they seem to agree with me that the discipline is in turmoil and has no clear-cut answers to the questions of today. The opinions of the leading lights seem formed arbitrarily according to their political or ideological temperament. (The more progressive elements like Summers and Krugman are scrambling to make sense of the world but in refusing to dump the theoretical baggage they have accumulated over the years their attempts appear weak and unconvincing).

What I have always found refreshing about Post-Keynesian economics is that there is and has always been a strong consensus on real-world issues. I may vehemently disagree with the politics of, say, a Marxist-Kaleckian but it is very likely that we will hold basically identical opinions on practical matters. This consensus exists not only across space but also through time. What I mean by that is that Post-Keynesians rarely change their stances on real-world issues after the fact. This is because they usually get it right first time so there is simply no need.

Because of this you also see a smooth evolution of Post-Keynesian theory over the years. You do not see it wracked by ‘crises’ thrown up by the real-world as you do the mainstream. Rather you see it build upon itself in different directions. While the mainstream have a seeming crisis of faith every five to ten years that calls for a complete shake-up of the discipline, the Post-Keynesians roll calmly from one development in the theory to another.

This is why I strongly support the pluralist movement among students. I believe that if all the options are put on the table the students will likely gravitate toward Post-Keynesian economics for the simple reason that it is the most comprehensive and coherent body of theory available. I am perfectly willing to let students make this decision on their own. It seems that it is the mainstream who insist that only their approach is taught. Their insistence on monopoly is, I believe, a sign of enormous insecurity.

Update: The following paper by Kevin Hoover provides a fantastic overview of the Harrod versus Solow issue as to whether capitalist economies are inherently stable or unstable. Hoover, whose work I have discussed here before, strikes me as very Post-Keynesian in this paper.

Against Marginalist Pricing Theory: US Consumer Prices and Capacity Utilisation

Marginalist economic theory tells us that when there is unemployment of capital resources prices should fall. Some marginalists like the New Keynesians and the neo-Keynesians will supplement this by saying that prices can tend to be ‘sticky’. Let us ignore these for a moment and come back to them in a moment. Let us first take the idea that prices should fall when there is unemployed plant and equipment.

First of all, some theory. The argument is extremely simple: if plant and equipment are unemployed then there is inadequate demand for the goods and services being produced. In marginalist theory firms should respond to this shortfall of demand by cutting prices. This will generate more demand at the lower price and the market should clear; i.e. the plant and equipment will be brought online once more.

If this argument is true then we should see prices fall when capacity utilisation falls. We should clear here: we are not saying that we should see inflation slow down when capacity utilisation falls. Rather we should see prices fall — i.e. we should not see inflation slow but rather we should see deflation.

During the extreme events of 2009-2010 we actually saw this relationship for a very brief moment in time. You can see how this relationship looks on the two graphs below. On the left is a scatter-plot diagram that maps the relationship between CPI inflation and capacity utilisation while on the right is a simple line graph depicting the same relationship. (The blue line is CPI and the red line is capacity utilisation).

Without getting into the debate as to how far prices should theoretically fall for a given fall in capacity utilisation we can at least visualise how such a relationship should look. (In actual fact we should see far larger amount of price deflation to clear markets where capacity utilisation has fallen below 68% as we see above, but regardless…).

Now, when we turn the the larger aggregates of data we see something rather different altogether. Here is the data for the inflationary period between 1967-1981.

Not much a positive correlation here at all. In fact we appear to have something of a negative correlation (indicated by the downward-sloping trend-line). We could probably do some arbitrary ‘lagging’ here to get a better fit but as we shall see we would then have to alter the lags significantly in the next time period to get a similar fit. Besides, at no point in this period do prices actually fall.

But maybe given that the inflation in this period was rather high this was just a freak accident. So, let’s turn to the era of the ‘Great Moderation’.

Here we have a slight positive correlation. But it is not very strong. Again, some lagging might do the trick. But a glance will confirm that the lags imposed on this time period would have to be very different from those applied in the last time period to make it fit. Frankly, I think any move in this direction would be the sort of statistical cheating that goes on so much in economics and should be dismissed well before it gets underway. Anyway, none of this should concern us too much lest we lose sight of the key argument.

What is most important, as we have said, is that we actually only see one period in which prices actually fall (2009-2010). Even when we do see the positive correlation that we are looking for in other periods — however slight that might be — it is only a manifestation of a slowing of inflation and not deflation.We can see this particularly clearly if we zoom in on the period of the 1981-1982 recession which, apart from the recession of the late-00s, is the largest on record after World War II.

As we can see, we have a very tight positive correlation between inflation and capacity utilisation. But all we see is a fall in the rate of inflation. We never see actually see a fall in prices (i.e. deflation) and as we have said: for the marginalist argument to work prices have to actually fall when demand dries up and capacity utilisation falls.

Okay, but no one really believes that prices adjust in the short-run, right? As I said, the New Keynesians argue that prices are indeed ‘sticky’ and so we should not expect them to fall when demand for goods and services dries up. But my question then becomes: where is this ‘long-run’ period in which prices do fall in response to a shortfall in demand? If the long-run is merely a series of short-runs — and, indeed, what else can it be? — then when or where does it come about?

I suspect that it is not actually an entity that we can track in time-series data because it is not actually an entity that exists outside the minds of marginalist economists. When they say that prices adjust in the long-run they are saying nothing at all, or at least nothing that corresponds to anything that happens in the real economy. The New Keynesians hint that markets will clear up low capacity utilisations in the ‘long-run’ but this long-run never turns up in reality because it is a mystical and spectral entity. Indeed when we consult Wikipedia we see that the ‘long-run’ is actually a tautological entity.

In macroeconomics, the long run is the period when the general price level, contractual wage rates, and expectations adjust fully to the state of the economy, in contrast to the short run when these variables may not fully adjust.

The long-run is thus defined as being when the price level falls to soak up excess capacity. Now, when we examine the data this never appears to happen. Does this not then mean that, by the above definition, the long-run does not exist in the real-world? I would argue that this is indeed the case: the long-run as so defined does not exist in the real-world. It is either a tautological thought experiment or it is nothing at all.

So, why do the marginalists hold to such a tautological thought experiment? I believe that this is ideology plain and simple. It is simply a belief — not subject to empirical validation or invalidation (i.e. in Popperian terms: non-falsifiable and thus non-scientific) — that the marginalists believe because they want to believe in it. When you start to dig this deep you start to see what this particular wing of the profession actually are and what purpose they serve in society. But let us not address such issues here.

The Reformation in Economics: Table of Contents

So, my book is super close to being finished (I know… I keep saying that…). And I have an agent currently considering it. They have said that they want this to be published as a popular book which is exactly what I’m going for (think: Steve Keen’s Debunking Economics although my book is an entirely different creature).

Anyway, none of this is set in stone and we’ll have to see if it plays out according to plan. In the meantime, however, I’ve finished the Table of Contents which might give readers of the blog a feel for what the book is likely to contain. I would imagine that people will quickly see that there is nothing like this on the market at the moment. And yet the people that I have run the drafts by confirm that it is very internally coherent. This is not a free-for-all by any stretch.

 

The Reformation in Economics­­­­

 By Philip Pilkington

Table of Contents

1. Preface
2. Introduction
3. Macroeconomics: A Dangerous Idea
4. The Limiting Principle: Paul Samuelson and the Death of Economics
5. Homo Economicus: Our Utility-Maximising Friend
6. Schemata: Abstraction and Modelling
7. Equilibrium: Static, Dynamic, Expectational
8. Money: A Means to an End
9. Profits, Prices, Distribution and Demand
10. Finance and Investment
11. Coping With Uncertainty
12. Free Trade: Against Dogma
13. Conclusion
14. Philosophical and Psychological Appendices
    1. Determinism Versus Free Will: An Age Old Debate
    2. Traversing the Fantasy: Psychoanalysis, Behaviourism and Economics

___________________________________________

Update: Someone has requested the bibliography. It is not quite finished but for those interested here it is so far.

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Beware the Scholastics! Some Thoughts on the Curriculum Reform Movement

With the Rethinking Economics student movement in full swing the topic of curriculum reform is once again on the table. For those of you who read this blog and are uncomfortable with this: sorry, you’ve already lost that debate, you just haven’t realised it yet. The question is now which direction this curriculum reform will take.

The Institute for New Economic Thinking (INET) looks set to be the organisation that will build the platforms and generate the content which will be made available to those who are self-interested enough to notice that they will rapidly slip into obscurity if they don’t change with the times. The debate within INET on this topic, however, is nothing short of fierce; or, at least, without going into too much detail that is what I have heard.

Perhaps then it is worthwhile rewinding the cassette tape of history to the moment when INET curriculum reform was first publicly conceived. This moment was at INET’s Bretton Woods conference that took place between 2010 and 2011. Thankfully the relevant sections were recorded and uploaded to Youtube and can be viewed at the bottom of this webpage.

At this moment in history the two key participants were Lord Robert Skidelsky and Perry Mehrling. Skidelsky was dealing with curriculum reform in the UK and Mehrling was dealing with curriculum reform in the US. I will deal with each in turn.

Mehrling is not an orthodox economist by any stretch. So far as I can tell from his published work he was trained as an orthodox economist and gradually broke through the confines that this necessarily imposes today. His main interest appears to be in financial theory and he seems to be something of a follower of Fischer Black — an economist whom I have not said very nice things on this blog in the past (see here and here).

Mehrling’s talk is rather more pragmatically American than Skidelsky’s. Rather than putting forward a Grand Vision he talks about how to disseminate new economic thinking. His thoughts on these matters are very good and I believe that INET has since adopted them to a large extent. On matters of content I think that Mehrling was slightly more vague. He did emphasise his own hobbyhorse, namely real-world money and finance — a topic that readers of this blog will know is also my own hobbyhorse — but he did not really lay out a vision as such. This left Mehrling’s diagnosis of the problem rather weak. Something similar could be said of the short history he gives of the root of the problem at the start.

Skidelsky’s talk is far more visionary. He has in mind the type of economic student that he would like to see emerge from universities. He says that most of these students will not go on to be professional economists and yet contemporary teaching implicitly assumes that they will. I completely agree with Skidelsky on this point. So he wants the average student to come out the other side of an undergraduate degree being economically literate and able to critically evaluate and deconstruct an economic argument put forward in, say, the Financial Times.

I cannot stress how important I think this is. In my experience most PhD level economists, professors even, cannot actually do this. They can learn mathematical formulas by rote and they can manipulate these to no end, but when it comes to the theories that underlie the formulas they get completely and utterly lost. Often they speak a language that resembles meaningless bureaucratic babble: a collection of terms (‘output gap’, ‘natural rate of X, Y or Z‘, etc.) that they do not properly comprehend the meaning of and cannot explain in any theoretical detail. The face of Orwell’s Big Brother often bubbles up to the surface of my mind when I am forced to listen to this.

This leads may “economic experts” to become like jellyfish floating on the tide of whatever is popular at a given moment in time. Thirty years ago they favoured monetarism; twenty years ago, inflation-targeting; today some sort of NGDP-targeting and so on. At social gatherings this becomes nothing short of embarrassing. The number of times I have felt socially obliged to change the subject because I could see in an “economic expert’s” eyes that they did not want to be pressed on the underpinnings of their argument is a very sad metric to consider indeed.

“Oh, you favour monetary expansion,” I might ask a seemingly passionate advocate, “And how do you conceive of the transmission mechanism? How does the money get from the banking system into the real economy.” Their previously held confidence and boisterousness fades in an instant and a look of  something between fear and anger clouds their eyes. “Actually that is a rather boring topic,” I interject before an emergency bathroom break ensues, “So, you say you flew in this morning…?”

Skidelsky wants to train students not to be jellyfish. He wants to give them fins and allow them to swim. In his vision students should be able to take apart economic arguments and put them back together again. They should be able to read and critically examine the news, not swallow it whole as an idiot would an anchor. This, I think, is the most important reformation that needs to take place in economics education. But it requires a much broader education than the one now offered. It requires a plurality of different intellectual approaches; raising questions as to the status of methodology and economic modelling; some philosophy of the underlying mathematics being used; a more than passing account of the NIPA and Flow of Funds accounts; real-world knowledge of the banking systems and how financial markets really work; the list gets long rather fast. But students are keen to learn this stuff. At the Rethinking Economics conference I chaired a panel hosting Donald Gillies and Tony Lawson that dealt with the status of mathematical modelling in economics. I thought that this was just a slightly idiosyncratic focus of mine but the room was completely packed and the amount of questions — together with their depth and penetration — made a substantial imprint on my mind that will not quickly go away.

What is offered today in economics departments today, on the other hand, is somewhat similar to learning Medieval Latin in the Middle Ages, except that Latin has been replaced with differential equations and linear algebra. Yes, this ‘learning’ gives one social prestige but it does not give rise to either wisdom or knowledge. As Montaigne said of the Scholastics of his day:

Let him remove his academic hood, his gown and his Latin; let him stop battering our ears with raw chunks of pure Aristotle; why, you would take him for one of us — or worse. The involved linguistic convolutions with which they confound us remind me of conjuring tricks: their slight-of-hand has compelling force over our senses but it in no wise shakes our convictions. Apart from such jugglery they achieve nothing but what is base and ordinary. They may be more learned but they are no less absurd.

Replace ‘Latin’ with ‘calculus’ and ‘linguistic convolutions’ with ‘mathematical constructions’  and you have a pretty good summary of economic discourse today.

Where Skidelsky’s talk failed was that he had no real vision for how to implement his reforms. Mehrling was far ahead on this count. But even if Skidelsky had taken over Mehrling’s framework it is unclear that things would have been straightforward: after all, many economists today cannot teach a student to read the Financial Times because they cannot do so themselves.

This is why I find the student movement so refreshing. They are learning on their own. These students are not fooled by piecemeal reforms. They have tapped into an internet with seemingly unlimited resources. That is why they cry out for pluralism.

That said, such autodidacticism will not replace higher education. It saddens me when I meet students that have to ‘fake it’ in university and then teach themselves in their own free time, only being rewarded by the recognition they receive when their meet their fellow dissenting students. Recently a student told me that he had put forward an alternative conception of how the banking system functioned in a university essay — one that is now accepted by the Bank of England — and his lecturer marked him down without explaining why the theory was supposedly wrong. Being an extremely bright student the lower grade did not affect him greatly but it was the principle of the matter that irked him so much: “Why on earth should I pay exorbitant amounts of money for this degree?” he asked me, “When I know that the man teaching me is dinosaur and a closed-minded fool?” (I paraphrase for effect, but this was the essence of it…).

This is why the groundwork for curriculum reform still needs to be firmly laid out. The students know what they want, their future employers know what they want, now it is up to the profession and pressure groups to ensure that they get it. They do not want piecemeal reform. They want a truly pluralist education. And if the profession continues to bury their heads in the sand they will find themselves rendered redundant and overtaken by a new generation of economists who find them, as Montaigne did his hooded Scholastic mumbling meaningless babble in Medieval Latin, absurd.