Not entirely debauched by economics

The quote of the week (I should instate it as a policy) comes from a letter from Piero Sraffa to Joan Robinson:

"If one measures labour and land by heads or acres the result has a definite meaning, subject to a margin of error: the margin is wide, but it is a question of degree. On the other hand if you measure capital in tons the result is purely and simply nonsense. How many tons is, e.g., a railway tunnel? If you are not convinced, try it on someone who has not been entirely debauched by economics. Tell your gardener that a farmer has 200 acres or employs 10 men – will he not have a pretty accurate idea of the quantities of land & labour? Now tell him that he employs 500 tons of capital, & he will think you are dotty – (not more so, however, than Sidgwick or Marshall)."

That was in 1936. The reference comes from this paper by Velupillai on Krishna Bharadwaj’s contributions to economics.

A beautiful blind

Sylvia Nasar wrote a new book (the old and famous was the one on Nash's mind and life) on the history of economic ideas. Robert Solow is not too happy, since he thinks the book is superficial, and spends too much time on the economists lives and on what he thinks are second rate minds (e.g. Beatrice Webb, and I suspect for him Joan Robinson too). I did not finish reading the book, and hence will not review it here now, but I can comment on Solow's review, which is quite misguided.

In fact, the preoccupation with policy issues and the general context in which theories are developed is one of the good aspects of this book. In this sense, Nasar's book is in the direct line of descent of those, like Robert Heilbroner, that think that economics is (and should be) about the great questions (accumulation and the wealth of Nations, the quintessential themes of classical political economy) and that the economist's vision is as essential as, if not more so, than the analytical tools utilized.

For example, Solow complains that the book does not spend enough time discussing the theoretical achievements of Alfred Marshall. The fact, that somebody, with Solow's credentials, can write that after Piero Sraffa's devastating critique of Marshallian partial equilibrium (still in all textbooks, by the way), as if his technical achievement was not simply incoherent and irredeemably incorrect is a testimony about the poor state of our discipline.

Solow's complaints about Nasar discussion of Keynes are more puzzling, since he should be as neoclassical synthesis Keynesian be very comfortable with the 'developments' of Keynesian theory within the mainstream, which are after all the dominant model (the New Keynesian model with an IS, a monetary rule and a Phillips curve). He was instrumental in the creation of the current macroeconomic consensus, and his growth model (for which he won the Sveriges Riksbank Prize, also known as the Nobel in economics, although it's not one of the original Nobels) is the dominant view on growth. If the profession has failed, Solow is certainly responsible for it to a great extent.

If anything the problem with the book is that it shares with the mainstream (including Solow) a certain view of economics, and progress in the discipline, that has been established since the rise of marginalism in the latter part of the 19th century. In this view, there is a direct line of descent from Smith and Ricardo to Marshall (via Stuart Mill) to modern economics. According to this approach, the critical authors are, not the true heirs to classical political economy (that is from Smith/Ricardo to Keynes/Kalecki, via Marx), but critics of some aspects of capitalism that seem to have more heart than brains.

In all fairness, however, it's not surprising that a journalist/writer that is not an specialist economist buys the conventional wisdom on the history of ideas. The conventional history of ideas texts are fundamentally, like the parable in Bruegel's painting, written by blind professors to guide their blind students.

PS: The Sveriges Riksbank has been awarded to two professors (Sargent and Sims) that most likely believe that government intervention in the middle of the crisis is worse than some version of laissez faire. This is the reason, not the predictions about the end of times, why this is a dismal science.

Eclecticism, Complexity and Hypocrisy in Economics



In some of my posts there is an open critique of what I referred to the best in the mainstream, people like Krugman and Brad DeLong (and even Larry Summers), that have been in favor of fiscal stimulus, QE, and against tax cuts for the rich.  The critique is not about the soundness of their policy advice or even about their political views, which are liberal in the American sense of the word.  My trouble is the same that Joan Robinson had with the neoclassical synthesis, that is, that their policy propositions do not follow (logically) from their economic models.

Some people may think that this is just splitting hairs, an irrelevant exercise in taxonomy, to determine who is or is not heterodox. And that would certainly be a complete waste of time and energy. But the problem is that this inconsistency between reasonable policy advice and coherent economic theory is at the heart of the problems with the mainstream, and not just the crazy ones that believe in extreme versions of market efficiency (see for example Lucas’ Milliman Lecture; as I suggested these views could be referred to as the Intelligent Design version of economics. Krugman calls it the Dark Ages of macroeconomics).

As I argued somewhere else (subscription required, or preliminary version free here), there is a symbiotic relation between the best in the mainstream (what David Colander refers to as the cutting edge), that sound reasonable and provide rational policy advise particularly in times of crises, and the hardcore fundamentalists that stick to neoclassical/marginalist principles (despite logical problems). The problem is not a trade off between relevance and coherence in general, as Mark Blaug tried to argue with respect to Sraffians (his point being that Sraffians are rigorous and cannot be relevant for that reason; see the reply by Kurz and Salvadori here).  The trade off is a particular problem for the mainstream (that's why Blaug's argument is preposterous).

Rigorous arguments are NOT detrimental for empirical relevance, and they are essential for coherent policy advice. Part of the problem with the current state of the economics profession, what Alessandro Roncaglia has called the cultural roots of the crisis, is that the reasonable so-called New Keynesians, like Larry Summers and Ben Bernanke, were for deregulation and did not see (or didn’t want to see) the crisis coming. There is no intention to revise the foundations of economic analysis.

The whole argument of the best in the mainstream (and even some heterodox economists) is that conventional models are too simplistic and we need more sophisticated models.  In this view, the problem is the complexity of the real world.  Also, the mainstream is not monolithic, and there are several strands, some better some worse, with a high degree of eclecticism. I find the argument disingenuous, at best.  Sure the real world is complex, but the increase in the number of complex models have served since the 1970s as a way of introducing more realistic and often more relevant policy results while maintaining the respectability of the mainstream defense of the sanctity of market efficiency.  Some of these models are not even compatible among them, and, it is true that the mainstream is fragmented or eclectic.  In this sense, I borrowed the use of the term organized hypocrisy to describe, not the behavior of individual economists per se, but of the profession as a whole.

Organized hypocrisy implies that the mainstream can still maintain that markets are efficient, and that General Equilibrium models are a coherent proof of that (which allows the Tea Party version of the profession to go around and preach Real Business Cycles and Supply Side Trickle Down Voodoo Economics), while at the same time say that there are more sophisticated models, with imperfections, and alternative patterns of behavior, that explain reality.  Hence, whether Krugman and other cutting edge authors understand it or not, they have a role within the mainstream which actually serves to perpetuate their hold on the profession.  They are there to make the mainstream sound reasonable without the need to rethink the foundations of the subject.  Eclecticism is not a good feature of the mainstream, it reflects their lack of coherence and the inability to provide a theory that is both realistic and logically sound.

PS: Eclecticism should not be confused with pluralism. One is the result of incoherence, the other of tolerance with different approaches to economics.  For example, institutionalists take a different starting point than Sraffians, but say relevant and coherent things that add to understanding of the real world.  A pluralistic approach that encompasses some of the contributions of both schools is, therefore, quite reasonable.  The same could be said about other heterodox schools.

More on income distribution and growth (wonskish, as Krugman would say)

A few years back Sam Bowles presented a paper (Kudunomics: Property rights for the information-based economy) at the University of Utah. At dinner he reaffirmed his conviction that Arrow-Debreu General Equilibrium (GE) is compatible with different kinds of behavior and can be a force for progressive economics. Conventional marginalist theory suggests that income distribution is the result of relative scarcities, and, as a result, real wages should equal the marginal product of labor, i.e. labor productivity. When asked how he squares the belief in GE with the fact that wages in the US do NOT follow productivity since the 1970s, Bowles seemed puzzled. And the relation of income distribution and growth remains puzzling for the mainstream and its sycophants.

In the heterodox camp, the discussion has been centered, for the most part, between the so-called Kaleckian and Kaldorian models. First, I should note that from a history of ideas point, the Kaleckian name is a misnomer. Kalecki’s models where about the interaction of multiplier and accelerator, with shocks and lags, to produce fluctuations. In the various forms of his accelerator equation Kalecki included a trend, producing fluctuations around a trend. The so-called Kaleckian models derive from Harrod and Joan Robinson’s attempts to extent Keynes’ Principle of Effective Demand (PED) to the long run.

The PED says that an increase in investment is matched by an exact increase in savings, and that the level of income is the main adjusting variable (rather than the interest rate as in the Loanable Theory of Funds). The Kaleckian models basically normalize the IS identity by the capital stock, assume (in the extreme case) that the propensity to save out of wages is zero, and a propensity to save out of profits (s) between zero and one, and in Keynesian fashion have investment determine savings. The difference with the short-run story is that now accumulation (investment-to-capital ratio) determines income distribution (the rate of profits), a result often referred to as the Cambridge equation.

The various incarnations of the Kaleckian models are defined by the way the investment function is specified. For example, in the influential paper by Bhaduri and Marglin (B-M) (subscription required) they argue that investment and savings are functions of the profit share (h) and capacity utilization (z). In other words:

I(h, z) = shz

Solving for z and deriving with respect to h we have:

dz/dh = (Ih – sz)/(sh – Iz)

Where Ih is the response of investment to profitability and Iz to capacity utilization. Assuming stability, that is, that savings respond to profitability more than investment to capacity utilization and the denominator is positive, the sign of the equation depends on the numerator. If investment is strongly responsive to profitability (Ih > sz), then the system is profit-led (exhilarationist in B-M terms). If not we have the wage-led (stagnationist) regime.

As I suggested in my previous post, there are some theoretical problems with the type of model used to argue that the US economy is profit-led, besides the empirical ones alluded before. The independent investment function suggests that capacity utilization affects capital formation, if capacity is low there is more investment, and vice versa when z is high. In other words, firms would try to adjust capacity to demand. If that is the case you would expect that a normal relation between capacity and demand would be established in the long run (in the neoclassical view demand adjusts to capacity; that’s Say’s Law), which could be seen as the relatively stable output-to-capital ratio over the whole period for the US, in my previous post.

If that is the case, investment is determined by the adjustment of capacity to exogenous demand in order to reach the normal capacity utilization, and it is essentially derived demand (the accelerator principle). It is not instrumental in determining the normal level of capacity utilization, which must be determined by the exogenous components of demand. This is the basis of the supermultiplier models, first developed by Hicks, and then by Nicholas Kaldor, and referred to as Kaldorian in the heterodox literature (for more on that see this paper).

That is the essential difference between the Kaleckian and Kaldorian models, whether investment is partially autonomous and determined by profitability or it is derived demand. Of course income distribution in Kaldorian models might have ambiguous effects on growth, but firms would not investment more if profits went up, if there is no increase in demand. In this sense, worsening income distribution might lead to higher growth if demand keeps going for some reason (say more private debt stimulates consumption; or stimulates the consumption of a higher income group). But in general profit-led growth that stimulates investment, as in the M-B framework seems hard to explain from a theoretical point of view. Hence, the confusion it generates empirically (e.g. in the case of the US the notion that a debt-led consumption boom is a profit-led story).

PS: The typical Kaldorian model is based on Thirlwall's work, but the book by Bortis and Serrano's dissertation (or his paper; subscription required) are essential readings.

Is the American economy profit-led?

In a recent post I showed the evolution of real wages and long-term real rates of interest in the United States from 1950 until now. The figure below shows the real rate of output (GDP) growth for the same period. Between 1950 and 1973 the average (red line) rate of growth was 4.2% and in the subsequent period it was 2.7%. In other words, the change in income distribution dynamics, with a significant slower rate of growth of wages, was accompanied by a significant reduction in the pace of economic growth (we also saw in the previous post that it also went hand in hand with higher real rates of interest).

Many authors (e.g. the late David Gordon), in particular when looking at the evidence post-1970s, argued that the American economy is profit-led. In other words, as profits (some emphasized profit shares while others prioritized profit rates; the profit rate time the level of capacity utilization gives the profit share) expanded, it stimulated investment, and this, in turn, led to output growth. Growth was driven by profits.

The idea is that, even though the reduction in wages has a negative effect on consumption and output growth, this is more than compensated by the increase in investment. However, there are some empirical problems (there are some theoretical issues that I’ll deal with in another post) with this kind of model (often referred to as Kaleckian, even though it seems that their origin should be traced to Joan Robinson’s Accumulation of Capital and the influential formalization by Bob Rowthorn in the early 1980s).

For starters, growth actually fell significantly after real wages stagnated. Also, the output-to-capital ratio (shown from 1960 to 2008 using a OECD measure), as can be seen in the graph below, does not indicate a marked shift in the 1970s. The output-to-capital ratio goes up in the Johnson and Clinton booms, and falls otherwise. The Reagan boom was mild at best. This is consistent with the accelerator. As the economy moves closer to full employment, the output-to-capital ratio, a proxy for capacity utilization, moves close to its maximum. The accelerator would suggest that investment adjusts capacity to output. Investment is not the locomotive of the system, is the rear car (the idea behind the accelerator principle).

Since the 1970s the drivers of accumulation in the United States have been consumption booms driven by debt accumulation. In other words, as Barba and Pivetti have argued, increasing debt has allowed American families to continue to consume, in spite of stagnated wages. This has been mistaken in the empirical literature as a profit-led boom. The suggestion here is that the booms have continued to be driven by consumption (as in more traditional wage-led cases), and that the benefits for capital have been financial and associated to higher interest rates. The last three booms have been more Wall Street debt-led booms, rather than profit-led investment booms. Wall Street, not the Silicon Valley, defines the current American economy. After all, we all remember Gordon Gekko’s “greed is good” (uttered in real life by Ivan Boesky) and nobody remembers an iconic phrase by Bill Gates!