Archive for May, 2012
I thought I’d offer a brief note on Scott Sumner’s latest offering to the field of economics – the ‘Sumner Critique.’ Sumner offers an apt example of why macroeconomists who ignore TGT are basically wasting their time – virtually every macroeconomic insight is already in The General Theory. Sumner says he has ‘never been able to take the book seriously.’ Maybe he just needs to read it properly.
The ‘Sumner Critique’ states that if the path of NGDP is stable, all macroeconomic effects become classical in nature. Sumner and others appear to think this is new and original, but, unfortunately for them, it was stated 76 years ago by Keynes:
Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world. But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards. If we suppose the volume of output to be given, i.e. to be determined by forces outside the classical scheme of thought, then there is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them. Again, if we have dealt otherwise with the problem of thrift, there is no objection to be raised against the modern classical theory as to the degree of consilience between private and public advantage in conditions of perfect and imperfect competition respectively. Thus, apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before.
There you go. Replace ‘NGDP’ with full employment, and Keynes said it a long time ago. Keynes’ primary policy prescription of long term interest rates also has the benefit of being tried, and of working, after WW2. Conversely, NGDP targeting relies on expectations fairies and continually pumping up the value of asset prices. In other words: Keynes said it, but better.
Addendum: The riposte the NGDP and full employment are sufficiently different to make my criticism void does not hold. As Jonathan Catalan points out, for Keynes, ‘full employment’ was synonymous with ‘maximum effective demand, given potential output constraints.’ It’s hard to deny that Sumner uses something very similar.
Entering debates with libertarians has become somewhat tiring, as I seem to have to start every debate by explaining why they approach issues from an inherently biased perspective, using loaded terms and framing the debate in what I regard as a completely incoherent manner.
Many of these problems amount to false dichotomies: governments versus markets; positive versus negative liberty; distinctions between actions done under credible threat of coercion and those done ‘voluntarily’. Generally, the problem is that libertarians ignore certain institutions that they deem natural or desirable, and build their dichotomies under the implicit assumption that anything they perceive to be an ‘intervention’ is the opposing side of the argument.
While there may be some merit in retaining these dichotomies for formalistic discussion and analysis, they do not work well as a functionalistic approximation of what ordinary individuals experience day to day – which, after all, is what libertarianism is predicated upon.
For example, take positive versus negative liberty, where positive liberty is defined as having the resources to fulfil your desires, and negative liberty is defined as being restrained from doing this by another moral agent. For libertarians, the second is often the most – or only – important consideration here.
The distinction between positive and negative liberty is, functionally speaking, false. Why? Consider two people: a rich man who wants to buy a plane, but can’t because taxes have just been increased, and a penniless man who wants to buy an apple, but can’t afford it. For libertarians, the rich is the one who is constrained by the law and ‘coercion’. But reconsider the poor man – what is stopping him from getting an apple from a shop without any money? If he goes into the shop and tries to take the apple, he will, ultimately, be arrested. He is constrained by the law, the same as the rich man.
It could be said that property and contracts work in a similar way to taxes and laws. Property uses the law to constrain people’s access to certain resources; tax does the same. Contracts use the law to make people perform certain actions and restrain them from others; the law does the same. Of course, libertarians would respond that restraints according to property are the result of voluntary transactions, and that contracts are also entered voluntarily, so the various constraints and obligations are more justified.
Firstly, even assuming no injustice, property distribution results from a large amount of individual and collective decisions. While it might be said that those involved in the decisions have consented to the new distribution, it doesn’t follow that those who had no say in them – most notably the unborn – have consented. Most still face legal constraints on their access to resources that they had no part in creating, and many suffer as a consequence.
Secondly, if the alternative to entering a contract is starvation, the contract cannot truly be said to be ‘voluntarily’. Even if we assume full employment, it will never be favourable to an employer – due to competition for efficiency – not to maintain some discipline at their workplace. The fact is that – as it logically impossible for everyone to be a capitalist – a large amount of the population rely on working under hierarchical conditions to survive.
I should note that I’m not implying taxes and laws are exactly the same as contracts and property, only that their enforcement is functionally similar. Introspectively, it would be pretty unreasonable to argue that people’s lives don’t involve having their access to certain resources restrained, and also being forced to perform certain actions that they’d probably rather not, generally in exchange for various benefits. It would also be unreasonable to say that these constraints and compulsions only originate from taxes and (regulatory) laws, rather than private contracts and property.
The imaginary ‘free market‘, itself a highly contradictory concept, and one that causes its proponents to ignore anything inconvenient to their worldview, has helpfully offered up another 23 examples of its followers either flat out contradicting themselves, or holding a clear double standard in two similar situations.
To clarify the first two: John Bates Clark originated the theory of marginal productivity, which holds that labourers are paid pretty much exactly what their labour is worth. Yet he also endorsed the notion that labour is worthless unless it was combined with capital, and that the division of labour allowed groups to produce more than they could individually. The latter two imply that you cannot separate a single labourer’s productivity from other factors.
1. The division of labour is an amazing phenomenon that allows groups of labourers to cooperate to produce more than they could if they worked alone. But each labourer has their own discernible marginal value product (which they are, obviously, paid because free market).
2. Labour has nothing without capital; that entrepreneurs combine their capital with labour justifies their profits and benefits both sides. But labour, on its own, has a discernible MVP (which…see above).
6. We were upgraded – proof that austerity works. We were downgraded – this is why we need more austerity.
7. Sin taxes don’t discourage addicts because they need the products that much. High taxes on the rich, however, will discourage them, despite the fact that they are the most driven and innovative individuals in society.
8. We emphasise choice and market diversity, but model the economy as a single person with set preferences who responds robotically to incentives, and as such does not have any real choice.
10. If rich people felt they were getting a good deal from taxes, they’d pay them. But benefits cause people to free ride.
13. We will emphasise that all government spending creates crowding out, but remain silent when cuts do not crowd in.
14. Local knowledge is great for coordinating prices, despite the fact that market participants having disparate knowledge opens the door to fraud.
15. High pay doesn’t matter, you’re just jealous. But the pay of union bosses and members is ground for dissent.
16. Wages are too high, it’s increasing company’s costs. Profits are never too high.
17. Large firms benefit from economies of scale. Supply curves slope upwards, implying the opposite.
18. Force is bad, except if we’re forcing countries to accept ‘free trade’ agreements.
19. We must look at how economic systems and decisions affect all groups of people and across time, rather than just one and at the time it is implemented. But we adopt a Anglo-centric perspective on capitalism, ignoring its global impact.
In 2007/8 asset prices fell because expectations of future NGDP fell which was priced into current asset prices. This lead to a fall in real GDP contemporaneous with a fall in NGDP, but both were caused by fall in expectations of future NGDP as is argued by adherents (cultists?) of NGDP targeting. Asset prices are forward looking and money is an asset, hence you have to look at expectations of future NGDP rather than looking at which moved first by a few months, RGDP or NGDP.
I’m not sure this is the full story. A bubble bursts when people realise that there is no real production underlying the growth of nominal income. If this sounds too economisty, I’ll phrase it in a different way: a bubble bursts when people realise that income is only rising because everyone expects it to rise. Ultimately, NGDP targeting relies on a claim that bubbles are not an important phenomenon for the macroeconomy.
The CB can continue buying assets – even housing – and so spur nominal income, by definition. But does pushing nominal income actually help the real economy? Take a look at this, via Bubbles and Busts:
During the 1970’s the US was plagued by high inflation that at times drifted into the double digits. This led to a brief stint of monetarism at the end of the decade into the early 1980’s. Monetarism, at the time, attempted to target a quantity of money rather than price. As can clearly be seen in this chart, the relationship between NGDP and RGDP is least correlated in the post-WWII period during this time of high inflation and quantity targeting.
For those convinced that NGDP targeting will be successful, the task is to explain why changing policy to promote higher inflation today will not cause a breakdown in the correlation of the past 30 years, similar to the 1970’s. Otherwise it seems perfectly reasonable to expect that NGDP targets will be met with increasing inflation, not real growth.
What’s the point in turning recessions into stagflation?
Left Outside asks what NGDP targeting failure would look like. My answer is either number 1:
NGDP does not reach trend because the bank lacks credibility and the policy is abandoned.
or number 3:
NGDP reaches trend but nominal growth consists (almost) entirely of price changes.
with the possibility that ‘price changes’ are predominantly in various assets, real production is marginally affected, and once the CB runs out of assets to buy we face the mother of all crashes.
Tyler Cowen, in the interests of making the blogosphere waters ever muddier, has written a deeply misleading and confusing post about what exactly constitutes ‘austerity’:
Let’s say that private gdp is 100 and government spending is 100. Gdp then suddenly goes up to 200, so government spending as a percentage of gdp falls from 50% to 33.3%. This is not a contractionary event. It is fully possible to argue “government spending should go up too, to slot more public goods into the larger output,” but the initial change is expansionary, even though government spending as a percentage of gdp took a steep dive.
OK, here’s the problem: this is an absolutely ridiculous scenario that, for all intents and purposes, cannot happen. GDP and government spending/revenue are inextricably intertwined, so an increase in one will almost certainly affect the other. The only way this wouldn’t be true would be if the sector of the economy that grew were completely taxless, and so separate from the other sectors of the economy that it could barely be considered a part of the economy*.
If GDP grows, we expect government spending as a sector of GDP to grow by roughly the same amount**, in the absence of any changes to policy. This is because taxes are collected as a percentage of income, and as income grows governments must pay their staff more, too (I despair that I had to write that sentence). If the government were to pay its staff comparatively less this would be contractionary.
Let’s take the UK economy as an example. The government hasn’t really adopted any major new functions since the welfare state was established post-WW2:
Anyone familiar with UK economic history will recognise the various fluctuations, but overall, spending has hovered around 40% of GDP, even though the economy has obviously grown a lot over the same period. For government spending to decrease as a % of GDP, there would have had to be tax cuts and spending cuts (e.g. what happened around 1980).
There’s also the point that overall spending doesn’t tell us much about what’s going on in individual departments. As many on the left have been pointing out for quite some time, if you cut some areas too fast and during a downturn, you may create unemployment and so welfare spending will go up. This is what has happened in the UK. However, it doesn’t mean that large spending cuts aren’t taking place.
Government spending as a percentage of GDP doesn’t tell us everything, but it’s a good guide as to whether a country is cutting spending or not, even if you do need to factor in tax increases. In any case, it’s certainly better than real or nominal magnitudes with no context whatsoever.
*Insert snarky comment about the financial sector.
*Actually we’d expect it to increase due to Baumol’s Cost Disease, but I’ll put that to one side.
NGDP targeting has been catching on across the blogosphere, and, to a more limited extent, in the mainstream. So far, it appears to be the best response to the crisis that mainstream economists can come up with. However, I remain unconvinced – the whole thing, to me, appears to beg a lot of questions.
The rationale for NGDP targeting is roughly as follows: macroeconomic policy can only reliably influence the nominal; the distribution between real income and inflation is determined partly by long run supply-side factors and is partially out of our control. Hence, if we keep nominal spending constant then we will know there is never an AD deficiency – any problems lie elsewhere.
Firstly, I have to agree with Rogue Economist:
Wow. Imagine, business planners and executives will have no more compunctions about claiming to their investors that they will attain at least 5% nominal revenue growth year in year out. If they don’t achieve it via additional sales volume, the Fed is going to make sure they achieve their targets via inflation. Recessions will be a thing of the past. Woohoo!
To believe that we can magically promise stable income growth, no matter the state of anything else in the economy, is to hand wave away the problem of macroeconomics in its entirety. How can it be so easy? Why hasn’t this been adopted before – after all, it’s not a new idea?
The fact is that no rigorous theoretical case has been made that supports NGDP targeting. As evidence, advocates of NGDP targeting offer no more than a graph showing that NGDP declined during the recession, with the implicit assertion that nominal income is what drives the macroeconomy. But is this true? Left Outside’s endorsement of NGDP targeting included this graph, showing that low NGDP is correlated with low RGDP:
This is a clear example of confusing correlation and causation. When looking at two correlated variables, a good question to ask is which one moves first – here, the drop in RGDP clearly precedes the drop in NGDP. This suggests that the decline in RGDP is not a result of the decline in NGDP; rather, its the opposite.
So what happened in 2008? Obviously, the conventional story is true: a large drop in asset prices made many households and firms realise they were less wealthy than they thought; this caused firms to lay off workers; real production decreased; nominal income followed; expectations dropped; this created a spiral. The NGDP-driven story doesn’t withstand scrutiny, else we’d expect the NGDP drop to come first.
Another example of the lack of concrete justification for NGDP targeting is its proponents completely refusal to discuss transmission mechanisms at the zero bound. As we know, government bond yields across the world are about as low as they’re going to get, so ‘traditional’ monetary policy measures are exhausted. What to do?
The CB could begin buying other assets, but that leads us to the question of what happens when these reach the zero bound, or worse, when there are no more assets left to buy. This is at least theoretically possible. Furthermore, there is the obvious observation that merely purchasing assets will not do anything for the real economy. What if NGDP is 5% and RGDP is -5%?
Expectations are often touted as highly important to NGDP targeting, but if expectations are relied on as a transmission mechanism when all other transmission mechanisms become impotent, this undermines itself. For if the CB wishes to make a ‘credible commitment’ to a certain outcome, and this ‘credible commitment’ is vital to the outcome materialising, then that suggests the CB does not have any other way to create the outcome, and hence undermines the credibility of the commitment. To put it another way: the CB can only change things by making people think it will, if it is able to change those things without relying on people thinking it will. Expectations are a product of very real phenomenon, rather than something that can be magically manipulated to produce any desired outcome. Furthermore, even if they could be, evidence suggests that they don’t have that much of an impact.
So the foundation of NGDP targeting – that the CB controls NGDP so they should control NGDP – is completely circular; evidence suggests that nominal spending does not drive the real economy; it is not at all clear exactly how the CB would go about controlling NGDP, and it’s also not clear that targeting NGDP is a particularly desirable policy. Bearing all of this in mind, I’m inclined to agree with Winterspeak – NGDP is just the latest in a long line of mainstream stupidities.
Something that often strikes me about libertarians is that they seem to see the government as a single, homogeneous mass that must be combated in its entirety. The percentage of GDP spent by the government is often cited as an indicator of how ‘big’ government has gotten, and it is thought that combating this will help reduce the evils of government in general.
However, ‘the government’ is not a unified entity; it’s a web of different and sometimes conflicting interests that are fragmented across space and time. There is no reason to think that stymieing some of its activities will have an impact on the others – for example, most libertarians object to the military industrial complex and the war on drugs, but then view social security or public healthcare as part of the same beast, and think that it is contradictory for leftists to object to the former and want to expand the latter. Quite clearly, however, the latter has very little impact on the former – you are dealing with completely different sets of interests, departments, locations and laws.
This can also be seen in the libertarian view of government as something that comes along and ‘corrupts‘ capitalism; the expansion of welfare and education is seen as part of this. But this makes no sense – the corrupt forces that give us patent law, bailouts and other corporate welfare are completely different to the democratic forces that give us health and education. In neither case does an entity called ‘the government’ come along and act in its own interests; in both cases groups of people utilise the tool of legislation for their own gain. The difference is that in one case this gain goes to a significant number of people whereas in the other it goes to a few. But it is fallacious to equate both just because of the presence of the state.
I have said before that class is a far superior tool for analysis than the somewhat incoherent ‘government’ and ‘market’ that debate has been boxed into. Seeing ‘governments’ as the same across space and time and as homogeneous entities – ones that can be combated by a single metric like the percentage of the economy for which they are responsible – allows very little room for meaningful analysis. This is because the activities of governments are a reflection of the societies they represent, rather than an outside interference dictated by a uniform entity. To paraphrase Scott Sumner, ‘never reason from an action of the state’ – that law or program has been demanded by a group of interests, or the need for it has been brought to light by certain events. In order to understand the activities of government, you have to place them in political context.
Ultimately, the ‘state’ doesn’t actually exist – it’s a web of different classes and individuals using the tool of legislation to advance their own interests, either through representatives or more directly through lobbying and political movements. Libertarians appear to think that cutting back any of this spending has an impact on all of it, but what we actually need to do is ensure that the interests of relatively few people do not have a disproportionate impact on the state’s activities – unfortunately, this is not currently the case.
Suppose there are ten people on a desert island. One, named Able Abel, is extremely able. With a hard day’s work, Able can produce enough to feed all ten people on the island. Eight islanders are marginally able. With a hard day’s work, each can produce enough to feed one person. The last person, Hapless Harry, is extremely unable. Harry can’t produce any food at all.
He then goes on to the obvious conclusion that forcing Abel to work is not fair just because the others can’t fend for themselves.
Here’s the problem: what does this have to do with income distribution in a modern capitalist economy? The answer is as follows: nothing. Absolutely nothing. In this island there is no state; people do not cooperate (actually they appear not to have any relationship whatsoever); there is no injustice; there is not even trade. So the thought experiment is worthless.
But the fact is that analogies are generally pretty awful, for the simple reason that they aren’t, by definition, the same as whatever they are purported to represent. They are often said to illuminate a few important aspects of a situation, but this is an illusion. I will demonstrate it by offering two oft-used and reasonable sounding analogies for the economy, one suggesting that monetary policy is impotent at the zero bound, one suggesting that it isn’t:
(2) Money is like a hot potato that people pass around until the supply matches the demand.
All these analogies help us do is come to the conclusions that we already had in mind. When building analogies people sift through various images until they find one that satisfies the story they wanted to tell. There are an infinite number of feasible sounding metaphors that can go either way: maybe the economy is like a car, and fiscal stimulus is a push from a few friendly passers by; maybe it’s a dog race and the fed sets the speed of the rabbit; maybe it’s a babysitting coop. Or maybe it’s none of those things.
This has important implications for economics. In her 1986 book ‘The Rhetoric of Economics‘, Deirdre Mckloskey argues, among other things, that economic models are basically just metaphors. This is true. As economists like to point out, they seem to care little about whether a model adequately represents the structural mechanics of a system and instead they (supposedly) look at its conclusions. In other words, we don’t have a model of the economy – we’ve got a metaphor for what the economy could look like if it were something different. This is not useful.
P.S. The blogging hiatus didn’t last