Put down your Sargent textbook and step away from the econometrics!

The confusion among mainstream economist is amazing. Mark Thoma in his recent post on our under-performing economy highlights this fact. While going through various models illustrating the GDP gap he makes this statement:

“One way to think of these models is that variation in the red line arises from supply shocks, and variation around the red line -- shown by the blue line -- represents demand shocks. Thus, under this interpretation, the first two models assume that all variation in the economy is due to demand shocks. This is clearly incorrect -- certainly supply shocks matter too -- and therefore these models may not give a very good measure of the gap.”

What is simple amazing about this post and statement is that it is wrong on so many levels. The red line (GDP trend) Thoma is referring to is his trend generated from a regression run on the blue line (actual GDP). If the blue line represents demand, the red line is an average of that demand over the whole data set, not supply! Yes! it is a lack of demand in the economy. What supply shock is Thoma so concerned with capturing in his models? Supply is fine; there are 12.8 million people currently unemployed (officially). This is from a guy who is supposed to be “Keynesian”.

His last model attempts a RBC trick of allowing the trend to be stochastic. So the blue line is still the variations in the actual demand in the economy, and the red line is just a more elaborate average of that demand and still not supply. It’s great to see that the mainstream of the profession has such a firm understanding of theory and basic statistics!

Too many contradictions, not enough cumulation

In 1996, if I'm not wrong, there was a conference at the New School in honor of David Gordon, who had just passed away.  The late Andrew Glynn, gave a very nice talk, but he said something that left me uneasy.  For him, the NAIRU (Non Accelerating Inflation Rate of Unemployment) was our concept, meaning by our radical economics' idea, not mainstream's idea.  The point was that the NAIRU, in contradistinction to Milton Friedman's natural rate, does not imply full employment.

The NAIRU does suggest that output is supply determined, and that expanding demand beyond that level is inflationary, but the fundamental reason is that after that the bargaining power of workers increases and leads to wage-price spirals.  This could happen way before the economy is fully utilizing its productive capacity, and would depend on social factors like the relative strength of the trade unions, for example.

While that is correct, I noted, after the conference, that this still meant that demand had no role, in this view, in expanding the capacity limit of the economy (my students are rolling their eyes, and saying there he goes with Kaldor-Verdoorn again!).  Glynn's reply was a quote from a title of paper by David Gordon.  My views implied too much cumulation and not enough contradictions.  The notion is that if you think that the demand determines long term growth we should live in a paradise with full employment, since demand can be managed.

Of course, in developing countries that is almost never possible. You expand demand, imports increase, current account deficits balloon, and contraction follows.  The external constraint at work.  Well we are finally in an American example of the contradictions that impede demand expansion.  Today, the NYTimes tells us in the editorial that:

"When consumers are constrained, so is hiring, because without customers, employers are hard pressed to retain workers or make new hires."

Yep, the Times got effective demand right (it must be a Krugman thing)!  However, no fiscal package is at hand to solve this simple technical problem.  I'm not going to explain Republicans and American politics (wouldn't dare).  But the political contradictions associated with expanding demand are staggering.  It's a pity that only now I have a good answer for Andrew.

PS: The paper by David cited above is Gordon, D. "Kaldor's Macro System: Too Much Cumulation, Too Few Contradictions." In Nicholas Kaldor and Mainstream Economics, edited by Edward J. Nell and Willy Semmler, pp. 355-83. New York: St. Martin's Press, 1991.

The meaning of heterodox economics, and why it matters

Heterodox economics is often defined as potpourri of of schools, too many to mention. Further, most of these heterodox schools are defined against marginalism (or neoclassical economics, which is also a fragmented school of economic thought).  In this sense, the heterodox camp is defined in a negative (against orthodox) and fragmented (depending on what aspect of orthodoxy is contested) way.  I think that is a counter productive approach, and that heterodoxy should be seen as a set of principles.  A positive (in its own terms) and unified (in the sense of the minimum set of propositions that are universally accepted) definition of heterodoxy is necessary.

Two things are central from my point of view.  First, heterodox economists are concerned with the amplified reproduction of society, and this implies that the production and distribution of the social surplus is central for their theories.  This is part of a tradition that harks back to classical political economy.  The determinantion of the surplus implies that distribution is determined exogenously by social and institutional conditions (be that the real wage as affected by the bargaining position of the labor class, or the rate of profit as determined by the monetary rate of interest influenced by the central bank).  Further, the determination of surplus, for an externally determined distribution, and a given technology, provides an explanation of relative prices (value).

It is important to note that there are several particular theoretical ways of approaching each of these questions associated to the reproduction of the economy.  For example, some Marxists emphasize that relative prices are proportional to the amounts of labor directly and indirectly needed to produce the commodities.  Sraffa provides a different approach, that is compatible with Marx's views of the working of the economy.  Post Keynesian groups that emphasize the determination of prices according to full cost pricing are also compatible with this general preocupation about the determination of the social surplus.  In other words, several schools of thought are heterodox in the acceptance of the necessity of understanding how the surplus is generated and distributed, even if they have different theories (that are not always compatible among them).

The second essential proposition that defines heterodoxy is related to the theory of output and employment determination.  Heterodox economists believe that output is demand determined.  That is, autonomous spending determines the level of activity.  There are a few implications to this simple proposition.  First, the level of autonomous spending will only generate full employment of productive resources by chance, and unemployment is a permanent feature of the economic system.  Second, as the level of income equilibrates savings to investment, the rate of interest must be a monetary (not real phenomenon). Additionally, heterodox economists argue that effective demand is valid in the long run.

In sum, if one believes that prices reflect, for a given technology, the way classes struggle for higher income shares within the process of reproducing the material conditions for survival (including processes in which there is accumulation), and one believes that output and the process of accumulation are driven by the exogenous forces of demand, one may be called heterodox.

Some other issues are often seen as central for defining heterodox economics.  Endogenous money is a typical example.  And it is true that most, if not all, heterodox economists follow some version of endogenous money theory.  However, it is clear that even if money is not endogenous, the rate of interest is still a monetary variable in heterodox economics (e.g. in Keynes' General Theory).  Also, several mainstream economists have endogenous money, from Wicksell to those using the Taylor rule now. The same could be said about true or non-probabilistic uncertainty.  It is important, but neither the determination of prices of production or effective demand are directly affected by uncertainty.  And several Austrians (hardly heterodox according to the criteria above) are very fond of the idea of uncertainty.  The last additional issue that sometimes is used to define heterodoxy is complexity (or non-ergodicity), but is the least relevant.  The main difference between heterodox and orthodox are related to causality issues, and they can be reproduced in simple or complex theoretical frameworks.

The obvious question that anyone may pose is why does it matter to define heterodox economics precisely.  For example, Colander, Holt and Rosser (CHR) suggest that heterodox economists should not consider themselves heterodox but just economists, and try to influence the mainstream working with the best among the orthodox.  The problem is that logic and evidence can support either prices of production or supply and demand, and, by the same token, either Say's Law or Effective Demand must be wrong.  In economic policy compromise might be possible, but in theory principles cannot be compromised.  I replied to their paper here.

PS: My paper is published in the Journal of Post Keynesian Economics, with CHR's reply (subscription required).