Archive for March, 2012

A Few Questions for Exogenous Money Proponents

The Krugman/Keen controversy seems like as good a time as any to post my views on endogenous versus exogenous money.

Naturally, I support the endogenous money theory, as it has all the evidence behind it. Economists even seem to acknowledge that the standard textbook story is somewhat behind the times, although they then cling to the money multiplier model, choosing to add epicycles instead of abandoning their core theory (they have a habit of doing this).

As far as I’m concerned, the evidence is so overwhelmingly opposed to exogenous money the burden of proof is on them. So here are a couple of questions:

(1) Why do expansions of the broader measures of money generally precede rather than succeed expansions of the base? Surely in the money multiplier model banks would require reserves before expanding lending? Evidence:

There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

(2) A corollary of (1): why do fiat expansions not necessarily result in M1+ expansions? For example 2008:

and similar results can be found during the onset of the Great Depression:

(3) Surely, if banks can create deposits with loans (which they simply can in the real world), by definition a loan adds new purchasing power and increases nominal demand? So by extension, the level of private debt in the economy is crucial to understanding it? How else do you explain the robust empirical link between private debt growth and indicators such as unemployment, housing prices and GDP?

Attempts to answer this framework should also avoid the standard circular tactic of assuming the money multiplier, then describing everything in terms of the money multiplier. But even when doing that, I just don’t see how you can square all the evidence with the exogenous money model. Prove me wrong.


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On the Incoherence of ‘Marginalist’ Labour Economics

The labour market, along with finance/banking and development, is one of the areas where neoclassical theory has proven to be most off the mark. Although more advanced models of the labour market try to address some of the flaws in MVP theory, they generally do this by adding ‘frictions’ such as heterogeneity and job search problems. The general premise – as with much of neoclassical economics- is that without these ‘frictions’, the labour market would operate as described in the textbooks. But this is not true.

Production, by definition, requires that all the factors of production be brought together. As a result, labour is employed at the same time as capital (and land, but we can lump the two together for the purposes of this post) in every circumstance. A taxi driver without his taxi is worthless, and vice-versa. Adding an extra worker to an office necessitates an extra computer, desk and stationary. Adding another builder to a site necessitates tools. Hence any ‘marginal productivity’ can only be applied to the labour and capital as a whole (what Ricardo called a ‘bushel’).

Not only this, but the Division of Labour (DoL) means that it is often impossible to separate the produce of one worker from that of his colleagues. A construction site requires carpenters, plumbers, bricklayers, supervisors, semi-skilled labourers, labourers and many more. But what if you remove only the carpenter? You wouldn’t be able to construct the house. But it would be incoherent to claim his MVP were an entire house – you can only evaluate the product of the entire team together, including their capital. So the marginalist approach makes absolutely no sense, particularly in a society where the DoL spans global borders.

This is also a prime example of an area where historical context in teaching would be appropriate, for the fact is that John Bates Clark created his ‘Marginal Value Product’ theory – the reasoning for which is entirely circular – at the turn of the century, a time of unrest among the working classes, in order to try and settle them. Basically, it was a justification for the status quo: you are paid what you are worth, sorry that isn’t as much as you thought. This context is strangely absent in economics classes, though surely its presence would lead students to ask some questions.

Given that the only coherent way to think of produce is as a result of all of the factors of production combined, what determines each factor of production’s share of the produce? Each wants as much as possible, but each requires the others in order to gain any produce at all. So the share for one factor of production is determined by its relative ability to replace the other factors of production. Or, to put it another way, the produce is distributed by bargaining power. In absence of government, capital, being scarcer, generally holds this, and hence receives higher returns. History also suggests that when capital finds itself in a position where this isn’t true, it will use government apparatus to correct this injustice (increasing interest rates, busting unions).

The empirical failure of the standard theory with respect to the minimum wage is well documented*. Furthermore, employment was generally higher during the post-WW2 age of rising real wages and strong unions, and has been lower post 1980, the age of stagnant real wages and weak unions. This doesn’t suggest a causal link, but it does show that high employment is not incompatible with higher wages, and, along with Card-Krueger and the outright logical inconsistency of the MVP theory, makes me inclined to align with the bargaining power story.

*I’m aware that Card and Krueger do not adopt a classical bargaining power perspective, but their evidence still corroborates with it.

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‘Free Market’ Double Standards 4.0

Welcome to the newest edition of my ‘free market double standards’ series! Strap yourselves in and enjoy the ride – this one actually contains a couple of contradictions in economic theory, but since I consider the free market  a neoclassical construct, and it’s my blog, it’s OK.

1. Dimishing Marginal Utility is an important cornerstone of economics. But increases in production and consumption are always desirable, no matter the stage of development.

2. Cantillion effects are an argument against government spending, but not capital controls or large firms.

3. Keynesianism is stupid and wrong! Wait, no it isn’t. I didn’t say it was.

4. We need monetary stimulus, but no capital controls to keep it in the domestic economy.

5. Capitalism is too complex and fraught with insider information to regulate. This is why we need more capitalism.

6. Aggregates are meaningless. But not the aggregates I constructed. They are better.

7. I champion individual responsibility. But when banks exploit government guarantees/policies by blowing up the economy, it’s the latter that’s to blame.

8. We need to encourage businesses to invest by reducing taxes and regulations. But let’s also increase their costs by raising interest rates.

9. Consumer sovereignty! But consumption taxes are the best (presumably because they are regressive).

10. The government should enforce property rights, and should pay for it with taxation. Taxation is theft.

11. The government is sufficient to punish/prevent things as pervasive and complex as force, fraud and theft. A single regulation? They don’t have the capacity or insight!

12. High tax rates punish success, but we should increase tuition fees.

13. As Austrian economists, we will side with market monetarism, but not Keynesians saying similar things.

14. Economics is the study of how we allocate scarce resources, but the fact that the economy is ultimately constrained by scarce resources does not factor into it.

15. The division of labour is a phenomenon that allows people to work together to produce far more than any one person could. But it’s all my income, I earned it!

16. All people have their own, valuable and useful local knowledge. But allowing experts to evaluate products like drugs for poisonous characteristics undermines this process.

17. Intellectuals are unaccountable, imperious, have big egos and value verbal beauty over logic or evidence. As such, they shouldn’t be allowed to comment so much on society. Except me. (HT to Daniel Kuehn)

18. Initiating force is bad. But allowing some to claim ownership of land and deny it to others by force, despite not having produced it, is fine.

19. The historical context of money matters. Well, not if history conflicts with my theories…

20. The market is the best judge of risk. But ignore what it’s saying about government debt levels, we need austerity NOW!

21. Justice is historical and depends on what actually happened. Capitalism is just. (Admittedly, probably borne more of ignorance than contradiction).

22. Perfect competition is defined as a state where everybody is a price taker. But there is still a price, despite the fact that nobody made it.

23. Raising taxes on the rich will achieve nothing because they will avoid it. But it will simultaneously destroy the economy, don’t do it!


We can safely abandon the doctrine of the eighties, namely that the rich were not working because they had too little money, the poor because they had much.

– John Kenneth Galbraith

Or maybe not.

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The Poverty of Mainstream Debate, Part III: On the Doubling Down of Neoliberalism

Neoliberal economics – otherwise known as ‘free market economics’ or ‘The Washington Consensus’, appears to have doubled down recently, despite clear empirical failings. Mainstream debate has no shortage of economists preaching the virtues of deregulation, austerity and trickle down, and governments across the world seem to be listening. How did this happen? Probably somewhere between people’s refusal to abandon an entrenched ideology, the influence of the rich and powerful, and the lack of a sufficient alternative. In any case,  here’s a series of facts that demonstrate quite how immune to evidence mainstream debate has become. I won’t offer much analysis here, just the neoliberal narrative of the crisis, contrasted with the facts, which I feel speak for themselves. This post is with a focus on the UK, but to some degree it applies to the US and Eurozone, too.

Firstly – the narrative goes – forget the ‘banking crisis’ – that’s over, now the real problem is the fiscal crisis:

Nevermind that debt is historically low, and that the market – which we praise for it’s ability to collect dispersed knowledge elsewhere – is saying that there isn’t a fiscal crisis:

In the UK, this invisible fiscal crisis is often pinned on the previous Labour government for spending too much in the boom years, long before the 2008 crash:

Note the fairly minimal deviations between taxes and spending prior to the crisis, during which, predictably, tax revenues fell and welfare spending shot up. Also note the refusal in the states to pin the deficit on Bush, whose pre-crisis policies actually did create a large chunk of the deficit. Anyway, I digress

Many on the right also claim that reported ‘debt’ is a red herring, and ‘off balance sheet’ obligations are far larger, for example future pensions:

I should note that this is with the Coalition’s pension reforms, but those reforms weren’t exactly revolutionary – just a bit of inflation reindexing and a few years of pay freezes. It’s pretty clear: at no point were pensions costs in any way a time bomb.

The right occasionally make a curtsy to the need for growth. But according to them, the best cure for that is supply-side reforms. Deregulation:

…despite the fact that the countries where it is often claimed we need deregulation, are lowest on the regulation index above. And no, there is no (inverse) correlation between regulation and growth.

They also claim we need to cut taxes, particularly on the rich or ‘job creators’:

The above is a graph from a study by Thomas Piketty, Emmanuel Saez & Stefanie Stantcheva, showing the lack of correlation between cuts in marginal tax rates and growth.

Finally, there’s the policy the right always have time for – austerity! Magically, they claim, it achieves all of our goals at once. Firstly, it helps us balance the budget:

The bottom line, fleshed out with a lot of evidence, is one that others — including me and Christy Romer — have been arguing for a while: expansionary fiscal policy under these conditions doesn’t just aid the economy in the short run, it may well even improve the long-run fiscal prospect. And austerity may be self-defeating even in fiscal terms.

and secondly, it boosts growth by allowing the private sector to fill the gap:

This paper investigates the short-term effects of fiscal consolidation on economic activity in OECD economies. We examine the historical record, including Budget Speeches and IMF documents, to identify changes in fiscal policy motivated by a desire to reduce the budget deficit and not by responding to prospective economic conditions. Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP.

Austerity for everyone!

This is part of the reason my blog is so abstract – the policy prescriptions of neoliberalism have survived despite being obviously wrong, so all that’s left is to attack the intellectual underpinnings. Whilst I’m aware that neoclassicism =/= neoliberalism, the latter relies on the former for a large part of its assertions about the effects of taxes, regulation and the labour market. If this intellectual justification disappears, neoliberalism will have little left to stand on.

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Cutting Taxes on the Rich Causes Inflation, Again

In my previous post on cutting taxes on the rich and inflation, I explored Jame’s Kroeger’s thesis that, past a certain point, tax cuts for the rich just inflate the price of positional luxury goods and hence do not benefit the rich people. I found some supporting evidence, such as the CLEWI rise and the evidence that marginal tax cuts aren’t good for growth (i.e. don’t increase production).

Apparently we aren’t the only ones to note this type of argument, as I stumbled across something similar in Moshe Adler’s Economics for the Rest of Us. Adler argues that inequality may create price inflation, by giving firms with market power an incentive to provide fewer goods at higher prices. The logic is simple: if the distribution of income is more unequal, the rich will be willing to pay significantly more than the poor and so, in absence of ability to discriminate, the profit maximising price for a firm will be higher.

Adler has a variety of supportive evidence. Firstly, he cites the 14% decline in musicians performing at concerts, instead choosing to perform at private parties for larger sums, and netting a 20% increase in revenue to boot. Secondly, he notes that in New York, high square footage apartments bought by the rich have been on the up, in conjunction with a more than doubling of price per square foot. Thirdly, he mentions that doctors have begun to charge large sums for face time, and as a result are seeing fewer patients. To top it off, he presents survey evidence that rich people often only do these things because other rich people do them, rather than because they need the extra space/goods/time. This is in line with Kroeger’s ideas about positional luxury goods.

But the problem here isn’t just about price rises. As Adler notes, inequality actually reduces the size of the economic pie as well as altering the distribution of it, because fewer goods are provided at a higher price.

The net result of these effects is that fewer goods are produced, and the rich do not get anything that they wanted before other rich people had it, whilst the middle and poor get less. This is pretty substantital evidence against low marginal tax rates.



What Makes a Good Assumption?

My previous post on assumptions was not quite rigorous enough in its definition of assumptions, and attracted some skeptical feedback from the commenter named isomorphisms. Allow me to reiterate my point more clearly.

The distinction between hypotheses and assumptions was intuitively appealing, but of course all assumptions could be said to be hypotheses in a sense. However, I think most scientists would agree that a useful assumption has definitive characteristics, even if it’s difficult to pin down exactly what those are. I think they’d also agree that counter factual prepositions about the mechanics of a system are not useful assumptions. So what are?

At their heart, assumptions are intended to simplify analysis – this is an oft-used defence of economists. But the crucial way in which assumptions are able to do this is by eliminating a specific complication. Of course, this alone is not a sufficient condition. Assumptions also need to have a clear impact on the analysis, too, so we can be sure what happens when they are relaxed.

How many economic assumptions meet these two criteria?

Firms equating marginal cost to marginal revenue certainly doesn’t, as it’s a preposition about the nature of the firm, rather than an assumption that simplifies the nature of the problem – in fact, cost-plus pricing is far easier to calculate and also appears to be used far more widely used.

Perfect information can’t be said to eliminate a specific complication – it’s simplifying in a sense, but it potentially ‘simplifies’ the analysis to the point of undermining it, hence creating its own complications (you’d eliminate most real-world firms). Analysis is entirely possible without this assumption – ‘Schumpeterian’ economics uses imperfect information to its advantage.

Rational self maximisation, on the other hand, is a good example of an assumption that is defensible, as it allows us to simplify how people make decisions and has clear implications. Furthermore, it can easily be modified to include behavioural characteristics such as loss aversion (though economists seem unwilling to do this any time soon).

I stand by the idea that assumptions are an appropriate target for criticising economics, and feel this is a much more coherent and useful definition of what makes a good or bad assumption.

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Good Assumptions, Bad Assumptions, and Economists

It is a major bone of contention of mine that the word ‘assumption’ is used interchangeably when in many cases it should be replaced with ‘hypothesis’ in economics – for example, that firms equate MR=MC is a hypothesis that can be falsified in its own right, rather than an ‘assumption’ in the purely scientific sense of the word.

Economists enjoy demonstrating that they don’t understand the difference between a good and a bad assumption. For example, here are the SuperFreakonomics guys:

There are some 237 million Americans sixteen and older; all told, that’s 43 billion miles walked each year by people of driving age. If we assume that 1 out of every 140 of those miles are walked drunk — the same proportion of miles that are driven drunk — then 307 million miles are walked drunk each year.

Convenient if you can’t be bothered to do your research, but scientifically worthless. This is a hypothesis about how people behave, and the analysis follows directly from there. If the hypothesis is wrong, the analysis is simply wrong and we need to start over.

Now, here’s Scott Sumner on the Diamond and Saez ‘Marginal Tax rates’ paper:

 And S-D also seem to lean toward the “assume a can opener” school of policy analysis:

“In the current tax system with many tax avoidance opportunities at the higher end, as discussed above, the elasticity e is likely to be higher for top earners than for middle incomes, possibly leading to decreasing marginal tax rates at the top (Gruber and Saez, 2002). However, the natural policy response should be to close tax avoidance opportunities, in which case the assumption of constant elasticities might be a reasonable benchmark.”

So there you are.  It’s just too much to ask of our policymakers to actually make hedge fund managers pay labor taxes on their labor income, but S-D have no problem waving a magic wand and assuming away all tax loopholes.  

Of course, this is perfectly good assumption from a scientific point of view, as the presence of tax loopholes has a fairly simple (albeit hard to calculate empirically) impact on a variable, e. We can easily adjust the analysis to change this later on.

I feel it is important that, to progress, we need to differentiate between assumptions, for which a relaxation has a clear mathematical impact on the analysis, and hypotheses, which themselves need to be empirically verified, and for which a relaxation causes a model to collapse completely.

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The Poverty of Mainstream Debate, Part II: ‘The Government Caused the Crisis’

It’s difficult for me to believe that people have internalised the ‘the government caused the crisis’ arguments, but sadly this is a view that many still cling to – with a healthy dose of wishful thinking, and often an unhealthy dose of concern trolling. I would ask the same people to list five examples they can think of where private enterprise failed significantly – if they can’t, it says a lot about their bias.

Let me note that for the purposes of this post, I am putting considerations over Central Banking failures to one side.

In essence, debates over whether the government ’caused’ the crisis are basically nonsensical and are mired in both Adam’s Fallacy and governments versus markets framing. Even if the government encouraged/incentivised homeownership and loans to the poor, the fact that banks exploited this by committing massive fraud is not the government’s fault. If you think it is, then we should logically blame limited liability laws for the crisis, since that was an example of the government ‘intervening’ to protect enterprise from predatory lending and encouraging start ups, and had the ‘unintended consequence’ of creating too much systemic risk.

However, even if we accept the framing, the facts simply don’t add up:

– For every $4 of bad loans, only $1 was issued by an institution covered by the CRA. Whether or not these loans themselves were a result of the CRA is debatable, as the penalty for not complying with it appeared to me little more than a slap on the wrist. An estimate by Fed economists for the amount of bad loans due to the CRA was about 6%. In fact, the case for the CRA causing the crisis is so weak that Barry Ritholtz has challenged anyone who thinks so to a debate, where the loser pays $100,000 to the winner.

– Fannie and Freddie are often painted as drivers of low income housing, but it’s quite clear that they follow the market and pick up the slack when private institutions experience trouble:

if you go further back, the only reason they had a large market share in the early 200s was from mopping up the S & L mess:

They did fail due to bad management, and they pushed standards as low as they feasibly could within  their remit. But despite this, they were not at all involved in the worst of subprime.

– Regulations like Basel II and deposit guarantees are a last resort for government blamers, but the fact is that a single, completely unregulated hedge fund, Magnetar, accounted for between 45-60% of demand for subprime loans by pushing CDOs. The main source of funding during the run up to the crisis was also the repo market – again, completely unregulated. Neither Magnetar or the repo market had anything to do with Basel or deposit insurance.

Furthermore, countries like the UK, Iceland and Ireland, despite having no GSEs or CRA, experienced similarly severe crises, whilst those such as Germany and Sweden, with tighter regulation, did not. And even if it hadn’t been housing it simply would have been something else – banks have a history of creating crises out of whatever they can get their hands on, and the only common theme throughout them is a lack of regulation.

Whichever you paint it, it’s simply not credible to blame the government on a crisis that was clearly created by the private sector.

My main sources here are Michael W. Hudson’s The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America – and Spawned a Global Crisis and Yves Smith’s ECONNED

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Can Governments Spend Your Money Better Than You?

A standard objection to tax and spend policies is ‘how can the government know what to spend better than millions of individuals?’ Allow me to try and provide an answer to this question.

Firstly, the truth of modern capitalist economies is that large amounts of the process of production go towards creating demand that wouldn’t formerly be there – advertising, marketing and so forth. Standard rebuttals to this point tend to rest on the idea that people behave like perfectly logical robots, but the fact is that people are influenced by advertising to buy things they didn’t previously know they wanted – if they weren’t, it wouldn’t exist. So a decent proportion of private spending is ‘artificially’ created, and hence people wouldn’t miss it if it were gone.

Secondly, consumption tends not to increase happiness past a certain point, as humans fall victim to two cognitive biases that, as Jonathan Aldred says, put them on the ‘happiness treadmill’:

  • Adaptation. This is when people become accustomed to new things they have, and their happiness level adjusts back to where it was previously. This is pretty extensively documented – there are many examples of lottery winners who do not feel any happier than previously, and there is the well known phenomenon of ‘buyer’s remorse‘.
  • Rivalry. This is the fact that a large part of our desires for consumption rest on what we see around us and what our neighbours have – ‘keeping up with the Joneses‘.

So people buy things because others have them, and quickly adapt, resulting in no net gain of happiness or utility. This continues, fuelled by advertising, and growing consumption fails to deliver the goods, so to speak. Hence, reducing people’s private purchasing power does not necessarily make them less happy, though of course it depends on the stage of development and on the type of good.

Even if you accept this, you might ask ‘well how can the government improve on this once it has the money?’ The answer is actually very simple, neoclassical (!) economic theory: the government provides public or quasi public goods, which would be under provided or not provided at all in the private sector. Private individuals do not have the incentive to provide these goods, so the government is required to step in. After all, it’s better than spending money on things for which demand has been artificially created, and which do not appear to increase people’s happiness.

The idea that governments can spend money better than the private sector has been suggested as as a reason for high tax rates appearing to be a net positive for economic growth, though there are numerous other possible explanations. It also may help to explain the relative success of the Scandinavian economies, where consumption (and other) taxes are high and advertising is strictly regulated. As a result, consumerism is lower and public services are, broadly speaking, the best and most well-funded in the world.

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