Archive for November, 2011

What Did Keynes Really Think of Stimulus?

It is well known that fiscal expansion was used long before Keynes, and I have noted that it wasn’t his main policy conclusion. But what did he actually think of it? Always ambiguous, it is difficult to decipher ‘what he really meant’. But he certainly supported it to some extent, particularly in depressions. Here he is in his letter to FDR:

In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months.

Interestingly, in this letter he places fiscal stimulus at the forefront of his analysis, before he goes on to talk about reducing the long-term rate of interest. However, he had been less enthusiastic just two years earlier, saying that he was:

In favour of an admixture of public works, but my feeling is that unless you socialise the country to a degree that is unlikely, you will get to the end of the public works program, if not in one year, in two years, and therefore if you are not prepared to reduce the rate of interest and bring back private enterprise, when you get to the end of the public works program you have shot your bolt, and you are no better off.

This could be interpreted as a fairly harsh evaluation of fiscal stimulus – Keynes did not believe that it alone could ‘kick’ the economy into full employment equilibrium as many of his modern day proponents claim. But why the disparity between the letter and the speech? One reason could be that he changed his views, as he was known to do. However, here is another instance of him being skeptical of fiscal expansion, this time in 1941:

Although the U.S. was not yet at war, Keynes urged increased fiscal restraint in the U.S. in order to be better prepared to prevent inflation resulting from our defense build-up and Allied purchases of war materials…Walter Salant and Don Humphrey, who sat opposite Keynes at the inside of the U-shaped table, argued strongly that increased fiscal restraint was not then needed in America as it would inhibit further progress in reducing unemployment…Finally Keynes, obviously somewhat displeased, pushed his chair back from the table and brought the debate to an end as he said, rather sharply, “On this point you are more Keynesian than I.” It was an electrifying moment, never to be forgotten!

Personally, I think the reason for the disparity between the letter and other times is two-fold:

(1) Keynes advocated stimulus more strongly in periods of severe depression, such as 1933.

(2) Keynes’ letter to FDR was actually incredibly critical, particularly of the NIRA, and Keynes was at pains to stress his sympathies:

You may be feeling by now, Mr President, that my criticism is more obvious than my sympathy. Yet truly that is not so. You remain for me the ruler whose general outlook and attitude to the tasks of government are the most sympathetic in the world.

Thus the slightly overstated support for fiscal expansion may well have been politically motivated.

Overall, it is clear that Keynes remained more concerned with monetary policy, which is why he was devoted to reducing rates at the Bank of England, despite the massive austerity program at the time. Keynes viewed fiscal stimulus as a short-term stop-gap more than anything; viable to get the economy going and keep people in employment, but not sustainable in the long run. In many respects, this would resonate more with Keynes’ modern day opponents than his supporters.

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Does Bad Economics Explain Bad Regulation?

I don’t mean this in the typical sense of economists providing intellectual justification for deregulation; rather, has neoclassical economics been a source of cognitive dissonance and therefore a form of regulatory capture? Most regulators, politicians and policymakers have training in neoclassical economics and so it is likely to affect their behaviour.

Consider banking. Textbook economics still assumes the money multiplier model, which is patently falsified by empirical evidence. Had they realised the endogenous approach, it would have been far more apparent to them that capital, rather than reserves, is the only thing that limits banks ability to lend except the bank themselves. Thus, it would have been clear that leverage and capital limits were incredibly important, and the afterthought-style approaches of Basel I & II (and III) would have been exposed.

Had they also realised that, as Keen notes in the former link (required reading), the level of private debt has to increase to increase AD, they would have realised how important it was that this credit was channelled towards productive activities that facilitated increased production and income, instead of towards speculation and consumers. In the case of the former, GDP can keep up with private debt increases, but in the case of the latter, we get asset price inflation, then debt-deflation when those prices collapse.

Regulating emergent properties

But the problem isn’t simply false beliefs about the economy – it’s the general approach and framing. In Economyths, David Orrell notes that in order for an economy to be stable, positive feedbacks loops – processes that create a self-perpetuating spiral, like high inflation – would have to be incredibly rare or weak. He then goes on to rattle off about 10 examples of positive feedback loops, and recommends a style of regulation that would identify these and transform them into negative feedback loops, which cancel themselves out.

One of the problems with regulation now is that instead of focusing on flows and emergent properties, the big picture is generally ignored; regulators make each firm conform to whichever  criteria that might seem to make sense on an individual scale, but do not generally. To take an example, VaR is designed to stop banks from taking risk by forcing them to sell assets when the economy is more volatile to reduce their capital. The problem is, it actually creates a positive feedback loop because as the economy gets more volatile, more assets are sold and that increases volatility. Thinking about VaR from a neoclassical perspective blindsides regulators to dynamic processes like this.

This style of thinking would also surely be less vulnerable to regulatory capture. By focusing on flows and  emergent properties, regulators would not be deemed to be intervening in a particular firm’s operations. It would be a less personal approach than the current ‘check up’ one, with goals that did not necessarily vilify the firm in question. ‘We are trying to prevent a positive feedback loop’ is less contentious than ‘we are stopping you doing x’. This may sound airy, but it is similar to a recorded problem with public sector workers – once given targets and told what they should be doing, they lose the motivation to do it. Similarly, if managers/owners feel that they are not being targeted individually, they will probably be more likely to cooperate.

Despite the 2008 crisis, the attitude of many towards financial regulation is still hamstrung by the neoclassical approach. A bit of capital here, some transparency there, maybe let some banks fail – it’s a ‘tinkering’ approach that implicitly assumes the economy is close to equilibrium and just needs a tweak. Systemic problems that are greater than the sum of their parts are ignored, leaving us putting out fires all over the place, but not addressing the source of the problem.

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Unlearning the History of Thought

Little is taught in the way of the history of economic thought nowadays. Furthermore, what is taught is a combination of unquestioned sermonising – Adam Smith said this so it’s true – combined with caricatures of what thinkers actually said, as Robert Vienneau notes here. The fact that the history of thought is not given much attention explains many of the failings of neoclassical economics, as ideas that are deemed new are often simply dredged up old ones.

For example, during the recent Keynes-Hayek debate, Jamie Galbraith alerted us to this comment by Keynes:

The Conservative belief that there is some law of nature …that it is financially ‘sound’ to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable – the sort of thing which no man could believe who had not had his brain fuddled with nonsense for years and years…

This was made 40 years before Phelps and Friedman are credited with ‘discovering’ the NAIRU. Keynes was also no stranger to the so called Laffer Curve:

Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.

Neoclassicism has also done a good job of losing many key insights from the past – Brad Delong had a post a while ago that showed the 19th century economists coming to many ‘Keynesian’ conclusions long before Keynes. And as I highlighted here, Keynes’ main policy prescription, low interest rates, was also advocated by Adam Smith 150 years prior. Actually, the importance of low rates had been realised some time before Smith, as shown by Josiah Child in 1668:

The Profit That People have received, and any other may receive, by reducing the Interest of Money to a very Low Rate.

This in my poor opinion, is the CAUSA CAUSANS of all the other causes of the Riches of that people; and that if Interest of Money were with us reduced to the same rate it is with them, it would in a short time render us as Rich and Considerable in Trade as they are now…

In fact, although Adam Smith is often credited with ‘inventing’ economics, Joseph Schumpeter remarked that:

..the Wealth of Nations does not contain a single analytic idea, principle, or method that was entirely new in 1776.

In a similar vein, Dani Rodrik notes in his book that Henry Martyn produced an argument for free trade in 1701 that has strong echoes of Ricardo and Adam Smith about it, but was of course written long before they were born.

Furthermore, various examples of ‘enlightened’ policies of trade date back incredibly far; the Middle East are said to have been engaging in such practices in the 10th century. Empires throughout history have also used land taxes to fund their states, an important principle that has naturally been forgotten by neoclassical economics, and one that even modern day enthusiasts tend to credit to Henry George.

There is a point here: economics is not difficult. Low interest rates, trade and land taxes have been recognised as key to prosperity for centuries and even millennia. However, it seems these things are systematically unlearned – perhaps as the discipline is subverted by vested interests for financial gain, perhaps because people are, quite simply, that stupid. In any case, learning neoclassical economics would only equip you with the idea that ‘trade is good’ – it completely fails to mention land, lumping it together with capital, and marginalises the role of interest rates. The fact that it misses probably the two most important macroeconomic insights – ones that have been known for centuries – should surely raise serious doubts of its efficacy.

I should note that I am not a free trade zealot but do believe that trade is fundamental to creating prosperity.

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‘Free Market’ Double Standards

Free market economists/libertarians spend a lot of their time reacting against proposals, often mixing up technocratic discussions with ideology (something for which we can thank Milton Friedman). The result is that they often contradict themselves somewhere along the line. Here are a few examples:

1. Voluntary cooperation is justified and produces superior outcomes, except when people join unions.

2. People maximise utility and should be free to do what they want, except when they vote.

3. Rational self interest is to be celebrated and encouraged, but should be ridiculed in the case of envy.

4. Rational self interest is optimal for society, except in the case of political movements.

5. Local knowledge is how we should process information, except when we’re talking about inequality.

6. Excessive wages are bad and cause unemployment, but CEO pay is always justified.

7. Voluntary exchanges are always just and right, but not in the case of fractional reserve banking.

8. Protecting people from risk with benefits, deposit insurance and consumer protection is bad – what are limited liability laws?

9. Government funded job creation is unnatural and inflationary, but throwing money at banks is not.

10. Bail the banks out, but any subsequent tightening of regulation is an invasion of the free market.

11. The broken window fallacy is always a fallacy, but creative destruction is a vital part of capitalism. (That particular book is linked because he puts Schumpeter and Hazlitt right next to each other, apparently without realising the irony).

12. Top-down planning is bad, but we should never question the actions of corporations.

13. Public debt needs to be attacked, but private debt doesn’ t matter – let’s increase it.

14. Obama is a Socialist! But eliminating oil company subsidies is un-American.

15. Left wing governments make people dependent on welfare for votes, but drug companies doing something similar should be ignored.

16. Public choice theory means the government can’t do anything right, but it doesn’t apply to economists themselves.

17. Capitalism is stable. But when the government doesn’t intervene we can blame them for the Great Depression (and also the Great Recession).

18. State intervention is bad, but the government should increase interest rates to stop wage inflation.

19. Nudging people is wrong, but we shouldn’t regulate advertising and packaging. (OK, this one is probably based on the fact that most haven’t read or don’t understand Nudge).

20. Investors need to be confident about the future. No, we shouldn’t shore up their confidence by injecting money into the economy! What on earth…

21. If the government spends money it will crowd out private investment. If the private sector spends money it won’t crowd out other private sector investment.

22. Committee think is a terrible way to do things. But shareholder value capitalism is the best system ever designed.

23. Aggregate demand is a meaningless concept, but Say’s Law still holds.

24. And of course, the classic: government shouldn’t interfere in people’s lives, except when it’s telling them exactly how to behave.

 

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Keynes Figured it All Out a While Ago

I regard it as a tragedy that even prominent Keynesians think Keynes had little to say about the cause of busts other than ‘Animal Spirits’. Keynes was incredibly clear on why downturns – particularly severe ones – took place:

I see no reason to be in the slightest degree doubtful about the initiating causes of the slump….The leading characteristic was an extraordinary willingness to borrow money for the purposes of new real investment at very high rates of interest – rates of interest which were extravagantly high on pre-war standards, rates of interest which have never in the history of the world been earned.

Adam Smith shared this view, and offers a typically readable, if lengthy, explanation of why it leads to problems:

The legal rate, it is to be observed, though it ought to be somewhat above, ought not to be too much above the lowest market rate. If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into the those which were most likely to waste and destroy it. Where the legal rate of interest, on the contrary, is fixed but a very little above the lowest market rate, sober people are universally preferred as borrowers to prodigals and projectors. The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people, then in those of the other. A great part of the capital of the country is thus thrown into the hands in which it is most likely to be employed with advantage.

Keynes formulated a rigorous theoretical explanation for this, applying the concept of irreducible uncertainty – risks to which we are unable to assign a probability – to economics. According to Keynes, investors were inclined to hold cash rather than invest it in bonds, as the former was more liquid and hence responsive to unforeseeable events. The interest rate was thus the premium offered for parting with this liquidity, and in a world of uncertainty would probably be too high to approximate full employment, which he considered the ‘special case’ of neoclassical economics, as opposed to his ‘General Theory’.

Consequently, the monetary authorities were required to intervene to keep it permanently low to encourage sustainable investment. High rates both discouraged investment and forced those who borrowed into more speculative and risky endeavours. Keynes considered speculation a significant source of inflation, and thus low rates killed two birds with one stone. International stabilisation, particularly capital controls, was required for governments to maintain low rates in their own currency.

Keynes was, unfortunately, incredibly naive in that he was primarily concerned with communicating his ideas to policymakers rather than students, fellow academics or the general public. He managed to establish the BW system and encouraged governments around the world to adopt a policy of low long term rates. Rates in the UK fell to a steady 2-3% at the end of WW2, which is why unemployment was incredibly low, despite an austerity program even more vicious than today’s. This stability – including low inflation – continued until BW was dismantled in the 1970s, and as stagflation set in ‘Keynesian’ economics was abandoned. Since then, long term rates have been far higher and, unsurprisingly, growth and employment have been lower and more unstable.

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The Ceteris Paribus Fantasy

I have referred to the fact that neoclassical models are internally contradictory. In doing so I have a particular criticism in mind: ceteris paribus is automatically violated by almost any change in a neoclassical partial equilibrium model, as changes generate ripple effects throughout the rest of the economy. One of the clearest examples of this is Williamson’s Managerial Utility model – a standard, run of the mill model of oligopolistic firms that most students will encounter. Let’s take a look:

Williamson’s model basically says that some firms do not maximise profit, but have a disconnect between management and ownership. Managers then seek to maximise their own utility rather than that of the owners or the firm. Williamson defines a utility function of a manager as a line where the balance between ‘staff expenditure’ and ‘discretionary profits’ is acceptable:

Manager 1 will be happy with any point on u1, manager 2 with any point on u2, etc.

We then have the relationship between staff expenditure and discretionary profits*:

Combining the two:

The point at which the two curves cross satisfies maximum utility and so determines the level of discretionary profit and staff expenditure.

Here’s the problem: you cannot change staff expenditure whilst holding all other things constant. Why? Because if you change the amount of staff you employ, you will change the wage share of the economy. This will alter the composition of demand for goods and services, generating Cantillion-esque effects and trickling through until it affects the firm in question. This creates a feedback loop, meaning the curves will be shifting constantly.

This is a massive problem with the equilibrium models that are widely used by economists. Arguments of this type do not only apply to theories of the firm – supply and demand and IS/LM are subject to similar criticisms. Whilst some of the qualitative aspects of mainstream economics are acceptable, these types of internally contradictory models have to be abandoned in favour of dynamic ones before it can move forward.

*If you are wondering why on earth these curves are shaped the way they are, you should know this is exactly how economics is taught. You are not told how the diagrams are derived, what purpose they serve, and theories are rarely filtered based on whether or not they are empirically verified. In fact, many models, including this one, are almost impossible to verify empirically.

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How to Unlearn Economics

As the title of this blog is ‘Unlearning Economics’, I thought I’d start by noting a few of my main objections to economics as taught in schools and universities. Neoclassical theory injects a certain type of framing and a number of hidden assumptions into your head, many of which become second nature, even amongst left leaning economists. They are all, of course, interlinked, and together they can form an incredibly skewed world view.

The framing of issues as governments versus markets

It pains me to see otherwise intelligent critiques of market fundamentalism held back by this framing. The idea that there exists some entity, a ‘market’, which is then passively ‘intervened in’ by government simply makes no sense in the real world. To start, well-defined property rights are necessary for a capitalist economy to function effectively*. But defining property rights is highly complicated – intellectual property, public property, zoning, environmental property rights are all open to debate. Contracts, too, are highly complex; ask anyone trained in law. Fraud is also open to interpretation – predatory lending and ‘looting’ can both be considered types of fraud; some consider FRB and fiat to be fraud. The line between fraud and information asymmetry is blurry to the point of non-existence.

Furthermore, there are many ‘regulations’ that are not commonly considered to be interventionist. Limited liability laws are one, as are immigration restrictions, and laws that protect shareholders and define shares themselves. Where the government levies taxes will also affect the workings of an economy, as will what they choose to accept as payment. I could go on – but my point is clear: from the start, decisions made by the government about the legal system will affect how the economy works. Any line they supposedly cross at some point, that means they are ‘intervening’ and as a consequences the result is now a ‘government failure’, is arbitrary.

I will accept that direct government provision of goods and services makes sense as a government failure, but short of that it’s simply not credible to label some regulation as more interventionist than the last.

Adam’s Fallacy

In the interests of consistency I have named this after Duncan Foley’s book of the same name, though admittedly it might be unfair to attribute it to Smith, who would surely not endorse what current economists have made of his work.

Adam’s Fallacy refers to the separation of the economic sphere from the political and social spheres, classifying it as one where private self interest is optimal and any ‘interventionist’ action is unnatural. Thus, if we implement a regulation, we are forced to follow the responses of private actors to their logical conclusions, without questioning them along the way.

One of the most persistent example can be seen in the recent crisis. It is often asserted that government guarantees, encouragement of homeownership or regulation x led companies to invent CDOs, CDSs and engage in fraud. The fault is then attributed to the government for getting involved, rather than simply questioning the responses of these actors. This is equivalent to a vandal defending himself by pointing out that ‘someone just left a pile of bricks next to the shop window’. It is a glaring example of begging the question, but one that is completely hidden and, as a consequence, rarely noticed.

The real economy as a deviation from models

You will often see an academic economist say something along the lines of ‘in the real world, we accept that conditions for perfect competition are rarely, if ever, fulfilled’. At first glance, this sounds OK. But imagine if physicists modelled orbits as perfectly circular, and then noted that ‘the conditions for perfectly circular orbits are rarely, if ever, fulfilled’. You’d immediately be inclined to ask: why on earth do you still model orbits as circular?

Yet economists do not question the presence of perfect competition models**. Similar logic is applied to the Arrow-Debreu theorem – economists start from a remarkably unrealistic premise and proceed to ‘tweak’ the model to try to make it resemble the real world (in the case of Arrow-Debreu they are unable to tweak it much before it collapses, which is perhaps a further sign they should abandon it). This is what makes economics so vulnerable to the Theory of the Second Best, which on its own is enough to refute many of the policy prescriptions of the last few decades. Eliminating these unrealistic models as a starting point for analysis is crucial if we want to understand the real economy.

These errors and others like them are the anatomy of what it means to ‘think like an economist’, something many regard with a strange triumphalism, even in the wake of the field’s recent failures. They erect, as Keynes put it, a ‘vast logical superstructure’, ominous and impenetrable to outsiders. This is what allows economists to cut themselves of from criticism and dismiss non-economists as ignorant. The reality is that the economists themselves are mostly ignorant to how the economy works, and many fail to grasp the internal contradictions of their own models.

The economy is a complex, dynamic system whose structures are defined by the government, no matter how small that government is. It is not, at any point, in a particularly special or sacred state, and as such new rules and regulations should not be treated as an unnatural intervention or deviation from an ideal.

*There are a few examples of vaguely anarcho-capitalist societies, but the fact is that the most successful capitalist economies have had states.

**I am aware that most of microeconomics is based around oligopolistic analysis, but this doesn’t change the fact that perfect competition is still taught, and competitive markets are often cited by economists in the public eye as a starting point. Also, defending neoclassical oligopoly models is probably not a great position to be in, something I will cover in due course.

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