Prices and quantities

Mainstream economics suggests that prices and quantities should be treated simultaneously, as it should be if market prices as determined by supply and demand are at the center of the analytical framework. With supply and demand, it must be the case that the quantity produced, and the equilibrium price, both are determined simultaneously. Further, it is the case that, with price flexibility, the quantity produced is optimal from the perspective of the utilization of resources and the preferences of the agents. And if that is true for bananas, or any other commodity for that matter, it must be true too for labor and ‘capital.’

As I discussed before, in particular with respect to capital, this approach (supply and demand or marginalist), which contrasts with the surplus approach, has serious problems. Even if we dismiss, for simplicity sake, the subjective part (about preferences) and concentrate just on supply conditions, the difficulties are insurmountable. Producers only supply more at higher prices, which means that they must encounter increasing costs (diminishing returns). It cannot be the case that they are only willing to supply more at higher prices (higher remuneration) even if costs are not higher, since if one producer obtained higher remuneration free entry of new producers (attracted by the higher remuneration) would imply that more would be produced. So the supply curve depends on diminshing returns.

And diminishing returns are a highly improbable proposition, as Sraffa argued back in the 1920s. Not many producers, if any, would tell you that they don’t produce more because their costs would go up (and that would reduce demand as prices get higher). Most simply would reply that, although they could produce more at the same price, they don’t have enough demand. But the diminishing returns fetish dominates the profession (I won’t say anything here about imperfect competition, but Franklin Serrano noted here that this would be related to barriers to entry).

In the surplus approach, that concerns itself with the way in which societies reproduce themselves (usually in an amplified scale and with accumulation), prices and quantities are treated separately. Since costs of production, for a given technology, seem to be independent from the quantity produced (i.e. the cost would be the same if you produced slightly more or less), then the quantity can be taken as given for the discussion of the determination of prices. It is well know that, in that case, prices depend on the technology, which must allow for reproduction (including of the labor force) and by the way in which the surplus (what is left over, above and beyond the needs of reproduction) is divided between classes.

This separation between prices and quantities has been called by Garegnani the 'method of given quantities.' Note that it does not imply that the quantities are determined by supply or given at a level that is optimal from the point of view of utilization of resources. And that is why it is perfectly compatible with Keynes’ notion of a demand determined level of activity (yes you can, and should, add Sraffa to your Keynes, or Kalecki). Also, it does not mean that there is no technical change or that distribution does not affect output (all propositions that have been discussed here in the blog).

Be that as it may, I’m more interested in the macroeconomic implications of the mainstream views about prices and quantities. Since the late 1960s, these views have coalesced around the notion that, whereas there is a short run tradeoff between prices and quantities (the so-called Phillips Curve, PC), in the long run the tradeoff vanishes. Put simply, if you push demand too much (through fiscal and monetary policy), output would increase, unemployment fall (as per Okun’s Law: higher output implies lower unemployment) and inflation would accelerate. In the long run, however, the economy is self-adjusted and output cannot be above the optimal level, so the only effect of the expansionary policies would be inflation (Friedman dixit).

By the way, the same (the mainstream loves symmetry) is true for deflation. Yes it may cause some problems, but the system returns to full employment, even in the face of contractionary policies (the Greek should not worry about contraction, because markets would produce full employment if they are allowed to work; hence, the need of labor market flexibility). In the long run contractionary policies only would affect prices. In sum, supply and demand would lead to the optimal price and quantity, so if you get off my market (cranky old neoclassical guy would say), and stop expanding demand, there would be no inflation.

The evidence for a natural rate or for a PC is incredibly weak. In order to argue that there is a natural rate, the mainstream has basically suggested that it moves around all the time. So in the 1980s the natural rate was higher (in the US), when the actual unemployment was higher, than in the 1990s (particularly towards the end of the decade), when the actual rate was also lower. The ad hoc nature of the solution is evident. They tell you that the natural (which they measure as an average of the actual) is the attractor of the actual rate, and not the reverse.

The continuous ad hocery of the mainstream is on display now too. This is evident in discussion about the fears of inflation in the US, according to which the tripling of the monetary base would lead to hyperinflation (Krugman criticizes that here, and in several other places). Inflation does not take place, but it must be that expectations of inflation are low.

Also, it is evident in the IMF, the Bank for International Settlements (BIS) and other international institutions (since last year at least) arguments for fiscal and monetary contraction in the periphery (which is still growing faster than the center). The IMF believes fiscal expansion is no longer needed since “private demand has, for the most part, taken the baton” (IMF, 2011: xv). Moreover, the BIS argues that inflation is presently the main risk in an otherwise recovering world economy, and therefore suggests “policy [interest] rates should rise globally” (BIS, 2011: xii). According to this view then, if demand is controlled then prices would stop growing fast, and inflation would be under control.

Brazil actually did that last year, that is, fiscal contraction (with some monetary easing, but from a very tight stance, since it still maintains very high real interest rates). Output decelerated from 7.6% growth in 2010 to a mere 2.7% growth last year. A reduction of almost 5%. Did inflation then fell significantly as it should according to the mainstream? The Consumer Price Index (CPI) of the Fundação Getúlio Vargas increased from 6.24% to 6.36% in the same period, that is, it was almost constant. Something similar took place in Argentina between 2008 and 2009, when output decelerated around 10% (from high growth to negative growth), and inflation remained at high levels (fell perhaps around 6% or so, in an year that commodity prices collapsed). The mainstream argument is that the policies were not credible and as a result inflation expectations remained high.

In other words, it is not that the theory does not work, even though facts show that their predictions are false. It's a problem of the complexity of the phenomenon, and the need to account for expectations (anything can enter here, and no hypothesis can be tested if you take this seriously).

A simpler solution would be to admit that prices have little to do with demand (at most weaker demand and lower employment reduce the bargaining power of workers and reduce wage resistance). In other words, get rid of the notion of natural rate of unemployment and of a PC for which there is no reliable evidence (as should be done by any serious scientist). The contractions demanded by the IMF and the BIS led to recession (they affect quantities), and prices in Brazil did not fall because costs (which include imported goods and wages) did not fall. No need to suggest that expectations are responsible for inflation not falling. [Keen on his debate with Krugman has also referred to these subterfuges to keep theory in the face of lacking evidence; epicycles if you will]. By the way, expectations have been traditionally a way to argue that anything can happen, and allow theories that are not consistent with facts to get away with the incoherence. But I'll let that for another post.

References:

BIS (2011). 81st Annual Report. Basel, Bank for International Settlements, June.

IMF (2011). World Economic Outlook. Washington, DC, April.

Evidence of sticky wages

Econ 101 teaches us that prices adjust to clear supply and demand. Accordingly, in the aftermath of an economic boom when wages have risen, as recessions strike and unemployment rates climb, businesses lower wages which in turn lowers production costs and boosts investment and further hiring. In other words, high unemployment rates do not persist since wages fall proportionately to clear any labour market over-supply.

This has been used as a justification to oppose any government intervention to clear markets suffering from recessions. If the markets clear by themselves, it is argued, then where is the need for any discretionary fiscal policy intervention by governments. Though markets may deviate from the equilibrium, it is only a matter of time before the aforementioned dynamics takes over and restores stability.

However, as we have seen with the Great Recession and persistent high unemployment rate in the US, labour markets are not so accommodative. It is obvious that labour market does not clear so easily. In fact, the New Keynesian schools have long talked about "frictions" and "stickiness" with wages and prices which come in the way of markets regaining their earlier equilibrium. Economists like George Akerlof have pointed to downward wage rigidities, especially in conditions of low inflation.

In this context, an excellent study by researchers from the San Francisco Fed highlights the magnitude of this problem. They used individual-level survey data from 1980-2011 from the Current Population Survey (CPS), the monthly survey conducted by the Bureau of Labor Statistics used to measure the unemployment rate, to demonstrate the salience of downward nominal wage rigidity. They write,

Despite a severe recession and modest recovery, real wage growth has stayed relatively solid. A key reason seems to be downward nominal wage rigidities, that is, the tendency of employers to avoid cutting the dollar value of wages. This phenomenon means that, in nominal terms, wages tend not to adjust downward when economic conditions are poor. With inflation relatively low in recent years, these rigidities have limited reductions in the real wages of a large fraction of U.S. workers. 

In the current American context, since inflation is low and therefore keeping wages constant cannot reduce real wages, the only way for employers to lower wages is to actually cut nominal wages. The graphic below is an excellent illustration. The dashed black line shows a symmetric normal distribution, while the blue bars plot the actual distribution of nominal wages in 2011. The blue bar that spikes at zero shows that a large number of workers report no change in wages over a year. The prominence of this psike shows that disproportionately large numbers of employers simply kept wages fixed over the year. This proposition is also supported by the fact that the gap in the normal distribution and the actual wage distribution is much higher on the left side. This gap suggests that the spike at zero is made up mostly of workers whose wages otherwise would have been cut.

Similarly, the researchers also compare the trends in such wage rigidity over the past 30 years. They compared the proportion of workers in the same job who report no year-over-year wage change and find that their share rises in recessions and persist well into the recovery. Further, this proportion has risen sharply in the Great Recession for all categories of workers. They find that from 2007 to the end of 2011, the fraction of workers experiencing no yearly wage change rose to 16% from 11.2%. This is five percentage points higher than the average size of the spike at zero from 1983 to 2007.

The same trend is observed among all categories of workers.

See also Paul Krugman (also here) and Mark Thoma. 

Sraffian economics vs. Post Keynesian methodology

A very nice debate on the nature of heterodox economics took place yesterday in a heterodox conference in Buenos Aires. Sergio Cesaratto and Marc Lavoie (depicted above during the interval) presented alternative views which, in spite of some important differences, agreed that Sraffian economics is part of the broadly defined heterodox Keynesian camp (or Post Keynesian if one prefers the term). The question of the relation of Sraffians, and more broadly all of those that believe in the importance of the old classical political economy school (from Petty to Marx, including Quesnay, Smith and Ricardo), with non neoclassical Keynesians, that is, those that believe that unemployment does not result from some rigidity or imperfection (be that of the price, wage or interest rate), has been difficult to say the least.

Marc presented first. A version of the paper is here. Taking aside obvious confusions, and sloppy scholarship of the type that suggests that Sraffians accept Say’s Law, because in the determination of normal prices quantities are taken as given (the fact that those quantities are determined by demand in accumulation theory is, apparently, not understood by these critics), the main line of critique of Sraffians comes from what Marc refers to as Post Keynesian methodologists. For him, “the influence of methodologists ... felt through the study group around Tony Lawson at Cambridge ... that [argues that] proper economics should be based on critical or transcendental realism and ‘open’ systems” and that has led to an “‘open systems’ criterion to judge whether a model can be given a post-Keynesian stamp of approval” (Lavoie, pp. 6-7).

Marc correctly dismisses this supposition that from a methodological point of view the Sraffian approach is limited to closed models. As he clearly notes the Sraffian price equations require that one distributive variable (real wages or rate of profits) are determined exogenously outside of the system by historical and institutional circumstances, which by definition makes it an open system, that is, one in which there is an exchange with its environment. Marc, in fact, suggests that the strong case for a Sraffian-Keynesian interaction is based on the fact that the determination of the rate of profit by the exogenous short term rate of interest set by the central bank provides an obvious link to Post Keynesian endogenous money literature (Pivetti and Panico’s work in that area, among others, shows that Sraffians do have a lot to say about money too, by the way).

Marc notes that the main reason, however, why Post Keynesians reject the Sraffian approach is there is “little enthusiasm for any notion of long-period ‘prices of production’ as centers of gravity towards which short-period or market prices are supposed to tend” (p. 14). However, as Marc suggests there is little difference between prices of production and full cost pricing. Full cost pricing, in my view, should be connected to the Oxford Economists Research Group (particularly P.W.S. Andrews, a tradition that through Andrews’s disciple Wynne Godley influenced Cambridge Keynesians). In other words, I see full cost pricing as compatible with the normal prices in Sraffa, both being determined by a mark up, which represents the social conflicts that allow one class to subtract surplus from another, over costs, which are determined by the technical conditions of production.

My main disagreement with Marc’s exposition, then, is related to his argument that “if one wishes to connect Sraffian economics with the other strands of post-Keynesian economics, one needs to examine production prices in a different light, not as long-run or long-period centers of gravity to which market prices tend” (p. 15). This is also complicated by the incorrect notion that gravitation requires the use of marginalist principles in order to obtain that market prices converge to normal long term prices, which is not the case [I’ll leave the details of that for another post though]. It seems to me that Marc believes somehow that full cost prices are somehow not fully adjusted prices, and that firms do not use their normal costs rather than their short run costs when computing prices.

Sergio counter presentation (not available, but you can check some of his extensive publications here), was narrower in scope, and dealt with the difference between certain Post Keynesian growth models (in particular the so-called Neo Kaleckian school) and Sraffians (he also distinguished among certain Sraffian groups). I should note that Cesaratto agreed with Marc in his rejection of the critique of the so-called Post Keynesian methodologists, and suggested that their lack of understanding of the capital debates and its consequences, reduces the significance of their views. He correctly points out that the capital debates produced the only occasion that forced neoclassical economics to openly recognize its flaws, and, I would add, led to a significant change in the way they do economics, forcing the change in the notion of equilibrium and the development of disaggregated intertemporal short term models (i.e. without a uniform rate of profit, something first noted by Piero Garegnani).

Sergio notes that when dealing with models of accumulation there are three features that most heterodox groups would want to incorporate in their models, namely: (A) the Classical (or in general exogenously given) income distribution, (B) the Keynesian Hypothesis of an investment rate independent from an exogenously given rate of savings, and (C) normal accumulation paths, with the traditional corollary of a long run normal degree of capacity utilisation. Between these three features one obtains what Sergio refers to as the Magical Accumulation triangle.

Neo Kaleckian (NK) models (some of Marc’s models, particularly in his Foundations of Post Keynesian Economic Analysis are of this type, but not the ones in his book with Wynne Godley) tend to assume A and B, but not C. The absence of the notion of normal (or fully adjusted) positions, as we saw above with regards to prices, is the main difference between the NKs and what Sergio calls the supermultiplier Sraffians (which have A, B and C). The supermultiplier models (which are in a sense Kaldorian, on Kaldor and Sraffa see this paper) implies that long term capacity output (not optimal in the sense of full employment) is determined by the exogenous components of demand, and investment is derived demand (as noted by Sergio the key contribution here is Franklin Serrano’s PhD thesis).

Here it is important to note why long term normal positions are important. It has little to do with a belief that economic systems are stable and tend to optimal levels, since the normal positions are tendencies, and are, generally, below full capacity, and crisis are the norm. Normal positions are important because they show that the regular functioning of capitalist economies does not produce efficient allocation of resources. Without suggesting that those that deny the relevance of long term positions are imperfectionists in the same sense that neoclassical authors that believe that an accumulation path below full employment is due to price, wage or interest rate rigidities, the argument still relies on an inability of capacity to adjust fully to the exogenous growth of the autonomous components of demand. The question then is why would a business not invest enough to keep its capacity growing in line with the growth of its demand? Here, I believe, lies the fundamental difference between classical-Keynesians (or supermultiplier Sraffians) and Neo Kaleckians.

By the way, as I noted before in the blog, the use of the term Kaleckians for the NKs is a bit of a misnomer, since the models derive really from Joan Robinson (and as noted by Sergio, Harrod and Steindl too). In part, I think, for her role in the rejection of normal positions and her views on history versus equilibrium, Sergio suggested that Robinson played a negative role in these debates.

There are several other things to discuss about this topic (the role of Joan Robinson among the important ones), brought about by the interesting, controversial, but very friendly debate between Marc Lavoie and Sergio Cesaratto which I’ll leave for other posts.

Monetary Cranks

Monetary cranks are an interesting bunch. Contrary to vulgar economists, which produced a defense of the status quo without scientific foundations, cranks tended always to provide a critique of dominant views. Often monetary cranks too lacked (and those around still lack) a solid foundation in theory. However, their critical perspective has always made cranks more interesting that the mere sycophants of the powerful that one associates with vulgar economics.

Dennis Robertson (1928), famous Cambridge economist that even though was close to Keynes (at least before the General Theory) remained thoroughly anti-Keynesian, said regarding cranks that:

"those who have Found the Light about Money take up their pens and write, with a conviction, a persistence and a devotion otherwise only found among the disciples of a new religion. It is easy to scoff at these productions: it is not so easy always to see exactly where they go wrong. It is natural that practical bankers, vaguely conscious that the projects of monetary cranks are dangerous to society, should cling in self-defence to the solid rock, or what they believe to be so, of tradition and accepted practice. But it is not open to the detached student of economics to take refuge from dangerous innovation in blind conservatism."

I have a more sympathetic view than Robertson about the cranks, which tend to provide critiques of the mainstream without being able to build coherent alternatives. Cranks usually liked paper currencies during the Gold Standard (like Silvio Gesell), and were concerned with the practical problems of unemployment (like William Trufant Foster). More often than not they understood that money was both endogenous, and that it had real effects on the economy, something that still puzzles the mainstream.

Keynes (in the GT) was wrong in putting Gesell, and Major Douglas (another monetary cranck) on the same group with Marx. From a history of economic ideas, while Marx is grounded on classical political economy, even if he is critical of several  aspects of Smith and Ricardo, Gesell and Douglas were not grounded on either the surplus approach (of the classicals) or the marginalist approach, even if they both had elements of the latter.

Reference:

Robertson, D. (1928), "Theories of Banking Policy," Economica, No. 23, pp. 131-14

More on the capital debates: Eatwell on Garegnani

Follow up on my previous post. Here is the link to the lecture given by John Eatwell in honor of Piero Garegnani (hat tip Revista Circus). It goes beyond the question of showing why and how mainstream (aggregative or intertemporal models) are flawed. It shows that the classical-Keynesian approach is rooted in a historical-institutional which makes it directly relevant for policy analysis. As he says:

"Economics is meant to be useful. Not only is it supposed to give a greater understanding of how a market economy works, but also it should be a guide to economic policy.

... classical value theory and Keynesian theory share a common structure that both are dependent upon empirical data from outside the theoretical core. Classical theory is dependent upon market structure, the composition of output and the distribution of income (or, to be more accurate, one of the distributive variables, the wage or the rate of profit). These data can be derived from the historical position of the economy, the stage of evolution in the history of technical progress, the structure of international trade, the structure of corporate enterprise, the financial and monetary system, the policies of the state, and so on, all of which are arrayed outside the core, but are vital to its specification. Similarly Keynesian theory is inconceivable without a clear specification of the structure of finance. The principle of effective demand is dependent upon the existence of a relatively sophisticated financial sector, and developments in the financial sector will in turn have an impact upon the determination of investment and the process of accumulation. It is one of the obvious failures of neoclassical theory that financial variables play no role in the determination of prices and outputs. It is an abiding strength of classical and Keynesian analysis that not only can financial variables be readily accommodated, some of the analysis will not work without them."

Read the rest here.

New Journal: Review of Keynesian Economics

Aims and Scope (for more infor go here)

It is widely recognized that economic crises can sometimes trigger enormous change, both with regard to economic theory and the politics of governance. Today, the global economy is struggling with the fall-out from the financial crash of 2008 and the Great Recession of 2007-09. The economic crisis that these events have generated, combined with the failure of the mainstream economics profession, has again put the question of change on the table.

With regard to the economics profession, it stands significantly discredited owing to its failure to foresee the recession and the financial crash; its repeated over-optimistic forecasts of rapid recovery; and lack of plausibility surrounding its attempts to explain events. Reasonable people do not expect economists to predict the daily movements of the stock market, but they do expect them to anticipate and explain major imminent economic developments. On that score the profession failed catastrophically, revealing fundamental theoretical inadequacies.

This intellectual failure has prompted us to launch the Review of Keynesian Economics. At a time of journal proliferation some may wonder about the need for another journal. We would respond there is a proliferation of journals but that proliferation is essentially within one intellectual paradigm. As such, it obscures the fact that the range of theoretical inquiry is actually very narrow. A journal devoted to Keynesian economics is therefore needed both to correct this narrowness and because events have once again confirmed the profound relevance of Keynesian theory.

Reflection upon the intellectual history of macroeconomics over the past seventy-five years can help to understand the current predicament and need for this new journal. That history traces an arc, which first saw the eclipse of classical macroeconomics by Keynesian macroeconomics, and then saw the eclipse of Keynesian macroeconomics by a revived and re-tooled classical macroeconomics.

The crisis associated with the Great Depression of the 1930s inspired John Maynard Keynes to write The General Theory of Employment, Interest and Money, a book that explained the persistence of unemployment in monetary economies. Keynes’ theory had enormous influence both inside and outside the academy, and his ideas on the importance of effective demand triggered a remaking of macroeconomics that saw Keynesian theory displace classical macroeconomic theory. That displacement was driven by the failure of classical theory to account for the Depression and the corresponding explanatory success of Keynesian theory. Moreover, not only did Keynesian theory provide an explanatory framework, it also offered practical policy recommendations. After World War II, the Keynesian theoretical revolution inspired new policy thinking that contributed to a twenty-five year period of unprecedented prosperity, now widely referred to as “The Golden Age” of capitalism or “The Age of Keynes”.

From 1945 to the early 1970s, the global economy witnessed an unparalleled period of prosperity that came to an end with the collapse of Bretton Woods (1971), the first oil crisis (1973) and the stock market crash of 1973-74. During this period of almost three decades, the world enjoyed rapid growth, low unemployment and reduced inequality, making Keynesian policies a success by most measures.

However, adherents of classical macroeconomic theory never accepted the legitimacy of Keynesian economics and they forged a counter-revolution, centered upon the University of Chicago and the work of Milton Friedman. In the 1960s and early 1970s the counter- revolution took the form of monetarism, and thereafter it evolved into new classical macroeconomics. The intellectual link between monetarism and new classical macroeconomics was animosity to Keynesianism and a dogmatic predisposition to laissez-faire conclusions.

The counter-revolutionaries were successful in their project and recaptured control of macroeconomics in the late 1970s. Their success was driven by a range of factors including their own intellectual imagination and innovation, intellectual staleness among Keynesians; the Cold War, which promoted laissez-faire ideology; and inflation and political conflict triggered by income distribution conflicts fostered first by full employment and then by the oil shocks of the 1970s.

Most importantly, the counter-revolutionaries opportunistically exploited the intellectual confusions created by the oil supply shocks of the early 1970s. Those shocks unleashed a new supply-side phenomenon of stagflation, which the counter-revolutionaries asserted disproved Keynesian macroeconomics. In retrospect, we know those assertions were false and Keynesian theories of conflict inflation gave a good account of developments, but the dispiritedness of the late 1970s initiated an era of reaction, which included reaction in economics.

It is important to emphasize that the demise of Keynesian economics was not caused by profound logical flaws or lack of supportive empirical evidence. Keynesianism (and other paradigms too) was accused of lacking micro-foundations, when in reality it has always had micro-foundations but rejects micro-foundations predicated on the implausible assumptions of homo economicus and Walrasian characterization of market processes. That Walrasian characterization fundamentally misrepresents economic reality, assuming the existence of institutions that do not exist (i.e. the auctioneer) and ignoring institutions that do exist (i.e. money and money contracting). In doing so, it ignores the macro-foundations that for Keynesians are the twin of micro-foundations.

The inflationary pressures of the 1970s, with the concomitant rise of conservatism in the form of the Reagan-Thatcher movements, were instrumental in the revival of classical macroeconomics and the repression of Keynesian economics. These forces have now waned but they have locked-in a legacy that is hard to reverse. That is because notions such as the natural rate of unemployment are entrenched in macroeconomics discussions and, most importantly, in teaching manuals.

The consequences of the return of classical macroeconomics have been enormous. For society it has entailed an era of neoliberal policy dominance that has contributed to wage stagnation and massive income inequality, which is significantly responsible for the Great Recession and the prospect of stagnation. Economic theory and politics often march hand-in-hand, with theory reinforcing politics and politics reinforcing theory. Together, they both drive policy, making economic theory vitally important for society.

In the end, economic theory is a contested terrain that is fought over by different intellectual tendencies, which may reflect different political and ethical values. In the years after World War II Keynesianism was ascendant, but since the late 1970s classical macroeconomics has been ascendant. Such ebbs and flows are reasonable, and even desirable, in an open society. However, what troubles us is that the period of classical re-ascendance has been characterized by what we think is a closing and monopolization of intellectual space, whereas the period of Keynesian ascendancy was marked by intellectual pluralism.

This closing of economics is significantly attributable to the laissez-faire ideological predispositions of new classical macroeconomics. It has also has been driven by economists’ disdain for epistemological concerns, which has fostered intellectual intolerance and over-reach. Competing theoretical paradigms have been framed inappropriately in terms of truth versus error, a frame that inevitably drives exclusion of the paradigm labeled as being in error. This framing is supported by an erroneous belief that science produces a single true answer. Much vaunted mathematical rigor is built on conceptual narrowness and sloppiness, and the use of math is as much a rhetorical device for selective screening of ideas as it is for exploring the logical coherence of ideas.

These flawed practices have distorted the academy, and in doing so have had profoundly negative consequences for society. That concerns us in our dual identities as professional economists and citizens, and it is this concern that motivates the founding of the journal.

As the name signals, the journal is intended to promote research in a particular paradigm -- the Keynesian paradigm. We make no apologies for this. Journals on international economics promote research in international economics: journals on finance promote research in financial economics. We have no objection to journals promoting particular types of economic research or thinking. What we object to is general-purpose and field journals only permitting research in a particular paradigm.

We have intentionally titled the journal Keynesian without any qualifying adjective or prefix. Our aim is to encourage research and discourse in Keynesian economics – be it old Keynesianism, fundamental Keynesianism, neo-Keynesianism, Post Keynesianism, Sraffian Keynesianism, Kaleckian Keynesianism, or Marxist Keynesianism. The journal is open to all forms of Keynesianism, which we define as (1) holding that output and employment are normally constrained by aggregate demand, (2) holding that the problematic of aggregate demand shortage exists independently of price, nominal wage, and nominal interest rate rigidities, and (3) rejecting the claim that the real wage is equal to the marginal disutility of labor.

This openness to all forms of Keynesianism reflects a desire to avoid intellectual sectarianism, which we think has afflicted past Keynesian discourse. In our view circumstance and ability certainly contributed to the success of the classical macroeconomics counter-revolutionaries, but so too did intellectual and sociological failure among Keynesians. Their tendency to apply arbitrary litmus tests and engage in intellectual sectarianism did a disservice to their project, and in doing so did disservice to society. We want to avoid repeating that history.

The contract with the journal publisher, Edward Elgar, was signed in 2011. We, the founding editors, are very happy with this timing as 2011 marked the seventy-fifth anniversary of Keynes’ General Theory. The founding of the Review of Keynesian Economics is a fitting tribute and celebration of this anniversary. It is also part of the deeper response needed to meet these challenging economic times.

The journal will be dedicated to the development of Keynesian theory and policy. In our view, Keynesian theory should hold a similar place in economics to that held by the theory of evolution in biology. Many individual economists still work within the Keynesian paradigm, but intellectual success demands institutional support that can leverage those individual efforts. The journal aims to offer such support by providing a forum for developing and sharing Keynesian ideas. Not only does that include ideas about macroeconomic theory and policy, it also extends to microeconomic and meso-economic analysis and relevant empirical and historical research. We see a bright future for the Keynesian approach to macroeconomics and invite the economics profession to join us by subscribing to the journal and submitting manuscripts.

The capital debates: A brief introduction

Teaching on the capital debates this and last week. So here are some thoughts, based on my class notes and the required readings (see below). The capital debates remain a puzzling chapter in the history of economic ideas. Nearly everyone accepts that the British (as opposed to the Massachusetts) Cambridge won the debate, something Paul Samuelson acknowledged early on.[1] Yet, no one seems to grasp the full implications and relevance of the debate itself. Typically it is assumed that the capital debates relate simply to problems of aggregation, and that the use of aggregate production functions and aggregative measures of capital are still justifiable, for simplicity’s sake. However, contrary to this viewpoint the capital debates did not rest upon the possibility of building aggregate measures.

The capital debates are associated with the very notion of capital. Classical political economy authors, from William Petty to Karl Marx, including Quesnay, Smith and Ricardo, treated the process of production as a circular one. In this context, capital is a produced means of production,[2] rather than a factor of production used in the process of obtaining final goods. The most important result of the capital debates is that, once capital is defined as produced means of production, there is no direct relation between the relative abundance or scarcity of the means of production and its remuneration. Distribution, in other words, is not governed by supply and demand.

Since the Marginalist Revolution, and the rise of the so-called neoclassical school, the notion that relative prices are determined by supply and demand, and that these reflect the relative abundance or scarcity of all goods and services – including factors of production – became consensual. As a result, the supply and demand for capital became the determination for the remuneration of capital. The more abundant is capital, the lower its remuneration, and vice versa if it is scarce. Conflict has no role to play in the determination of distribution, and social classes vanished entirely from analysis.

Additionally, substitution leads to the full utilization of resources and their optimal allocation. If capital is scarce and expensive, and labor abundant and cheap, economic agents substitute labor for capital and fully utilize labor. Thus, despite the abundance of labor, its relative cheapness, through the principle of substitution, leads to full employment. Indeed, unhampered markets do lead to the veritable best of all possible worlds.

It is the logic of the principle of substitution, based on relative scarcities that the capital debates shattered. Contrary to the neoclassical parable, the capital debates showed that it is not generally possible to obtain a univocal relation between remuneration and relative scarcity. For example, assume that we have two commodities produced with capital and labor, and that one can be said to be univocally more capital abundant than the other. In this case, as capital becomes more abundant the profit-to-real-wage ratio will fall, more capital will be used, and more of the capital-intensive good will be produced. However, it is possible that one good would be more capital intensive at high levels of the profit-to-real-wage ratio, and that the other becomes the capital intensive good at lower levels of the same ratio. That is, we would have factor intensity reversal. In the instance of factor intensity reversals, the conventional relation between factor scarcity and relative prices breaks down.

In this situation, it would be possible that as the profit-to-real-wage ratio falls, more labor will be used, and more of the labor-intensive good will be produced. In other words, there would be reverse capital deepening and a lower rate of profit associated with a reduction in the use of capital. Substitution moves in the wrong direction, so to speak, and more of the scarce factor is demanded. A simple algebraic exercise may help understand the point.

Let’s assume that there are two methods of production, associated to the manufacture of capital (iron) and consumption (corn) goods respectively. The prices are determined by:

(1) pc=wlc+rpkkc
(2) pk=wlk+rpkkk

where the subscripts refer to consumption and capital, l and k are the technical coefficients of production, and w and r are the real wage and rate of profit. Using pc as a numeraire and solving for pk we obtain:

(3) pk=(1-wlc)/rkc

From (3) into (2) we get:

(4) [(1-wlc)/rkc]=wlk+rkk[(1-wlc)/rkc]

Simplifying, and solving for w we find:

(5) w=(1-rkk)/[lc+(lkkc-lckk)r]

If the expression in the small parenthesis in the denominator is equalized to zero we obtain a wage-profit frontier that is linear. This assumption is what Samuelson (1962, p. 225, n. 7) refers to as the equi-proportional assumption. Figure 1 shows the choice of technique under this assumption.

Figure 1

The firm chooses the highest rate of profit for a given real wage, which implies that as the rate of profit falls the firm must choose the more capital intensive (b in this case). In this case, the neoclassical parable works; there is an inverse relation between factor intensity and its remuneration.

Once, the assumption of equi-proportional capital to labor ratios in the machine and consumption sectors (which would mean in Marxist terminology the same organic composition of capital in both sectors) is dropped the wage-profit frontier is not linear anymore. If we assume that the capital goods sector is more capital intensive than the consumption sector then the wage-profit frontier will be concave (as shown in Figure 2).

Figure 2

In this case, we have two switches; at high levels of the rate of profit the firm choose technique a, which is more labor-intensive, and as the rate of profits falls it switches to b the capital-intensive one as prescribed by neoclassical economics. However, at even lower levels of the rate of profit, the firm switches back to the more labor intensive technique. Reswitching and reverse capital deepening, hence, result from the dismissal of the equi-proportionality assumption, which is what one would expect in a world with several goods.

The implications for neoclassical theory cannot be overstated. First and foremost, there is no relation between relative scarcity and the remuneration of factors of production, and, as a result, distribution is not simply the product of market forces. Further, there is no guarantee that all resources will be fully utilized.[3]

It must be noted that, even though the capital debates are fundamentally about the logical coherence of the neoclassical approach, the results of the capital debates have important empirical implications. Neoclassical theory makes strong predictions vis-à-vis substitution effects and the relation between relative scarcity and remuneration. Yet the capital debates suggest that some of those predictions might not be consistent, and, as a result, the absence of those relations might be expected in the real world.

The most obvious prediction is the inverse relation between investment (capital intensity) and the rate of interest (its remuneration). As it is well known, there is little evidence that investment is sensitive to variations in the real rate of interest. In a rare survey of the empirical literature on the determinants of investment Robert Chirinko (1993, p. 1906) argues, “[T]he response of investment to price variables tends to be small and unimportant relative to quantity variables.” In other words, interest rates have little effect on gross capital formation, and the substitution effects that imply that agents use the cheaper factor of production are not operative. Further, the empirical evidence suggests that investment reacts to quantity variables, meaning the level of activity. This suggests that the income effects tend to be larger tahn substitution effects and that a firm facing less demand will not buy capital goods, even if the interest rate is low. These results underscore the empirical relevance of the capital debates.[4]

Similarly, the capital debates highlighted the futility of using the aggregate production function to measure the growth and productivity performance of real economies. The theoretical problems with the aggregate production function, associated to the notion of capital as a scarce resource, are compounded by the impossibility of disentangling it from the identity of income with the structure of the functional distribution of income (Felipe and Fisher, 2003). In other words, if one runs a regression of income on capital and labor, as is often done by those using a production function, it necessarily follows that income grows because capital and labor grow. Furthermore, changes in income distribution also affect income growth, as total income (net of taxes) is by definition the wage multiplied by labor utilized in production plus capital multiplied by its remuneration.

In this way, the capital debates demolished the theoretical foundations of neoclassical economics, and provided significant empirical evidence that those neoclassical models and their resultant policy prescriptions should be viewed with a healthy measure of skepticism.

Faced with the impossibility of using both the notion of aggregate capital and the principle of substitution, neoclassical economics opted to apply the principle of substitution to each kind of capital good taken as a distinct factor of production, by using the Arrow-Debreu model of intertemporal general equilibrium (Garegnani, 1976; Milgate, 1979). Even though the idea of intertemporal equilibrium, in which capital is treated as a vector of heterogeneous capital goods, was first developed by Eric Lindahl and then popularized by John R. Hicks in the 1930s, and used by Arrow and Debreu in the 1950s, it was only after the capital debates that it came to be dominant within the mainstream.

The problem with the use of heterogeneous capital goods is that it implies a change in the traditional method of economics. Normal equilibrium positions are associated to a uniform rate of profit; however, when dealing with heterogeneous capital goods that are not substitutable between each other, it becomes necessary to discard the notion of long run equilibrium. In Arrow-Debreu models all prices are short run prices, associated to differential rentals for each capital good, and any change in the data of the system – preferences, technology, and information for given initial endowments – affects the direction to which the economy adjusts (Petri, 2003).

In other words, the forces of competition that lead capitalists to those sectors with higher remuneration and establish a uniform rate of profit do not operate in the Walrasian world.[5] Hence, the Walrasian models are incapable of ascertaining tendencies in real economies, a defect that is not mitigated with the introduction of imperfections (Stiglitz, 1993, p. 109), which Stiglitz calls the post-Walrasian and post-Marxist paradigm. Far from increasing the realism of the model, the casting about of such lifelines only complicates the results of an exceptionally unrealistic one.

Information imperfections, and other related imperfections like price rigidities or lack of rationality, once introduced leave the Arrow-Debreu model unable to produce Pareto efficient solutions, or even market equilibrium, since some markets may not exist. Additionally, the introduction of imperfections renders the aggregative model prone to suboptimal outcomes. Suboptimal results in the presence of imperfections suggest that in their absence markets would still produce optimal outcomes.[6]

Some authors tend to confuse the imperfectionist arguments, and the implicit support that they provide for policy intervention, as a break with orthodoxy. While it is clear that they provide space for flexibility in policy advice, they remain firmly based on orthodox grounds.[7] The capital debates, in contrast, showed that unhindered markets, free of imperfections of any type, do not lead to market efficiency in general.

Faced with the logical problems that neoclassical aggregative models are riddled with on the one hand, and the irrelevance of general equilibrium models on the other, neoclassical economists did what any rational agent would do: disregard the critiques and in so doing, their deleterious results, and proceed as if nothing had happened. However, an innovative, if not peculiar, development generated a curious division of labor within neoclassical economics. Aggregative models were deployed for the purposes of teaching and policymaking, while the Arrow-Debreu model became the retreat of neoclassical authors when questioned about the logical consistency of their models. In this response, a harsh tradeoff between logical consistency and relevance was cultivated in the very core of mainstream economics.

The degree of fragmentation – as Roncaglia (2005, p. 468) so aptly expresses it – and confusion in the mainstream today is the result of such inconsistency at the core of economics, and not uniquely, as is frequently asserted, because of the demise of the Keynesian consensus. The collapse of the certainties provided by the old aggregative neoclassical model has brought about an often cynical defense of market-oriented policies for their own sake. The return of Vulgar Economics, which “sticks to appearances … [and] believes that ‘ignorance is a sufficient reason’” (Marx, 1867, p. 307) is complete.

Notes:
[1] See Samuelson (1966). A typical position is that of Robert Lucas (1988, p. 36) who notes the victory of the British argument, and yet remains oblivious to the problems of using the aggregate production function in the same paper.

[2] For Marx (1867, p. 189) capital also involved a social relation between the owners of the means of production and those forced to sell their labor power. For him, capital “can spring to life, only when the owner of the means of production and subsistence meets in the market with the free laborer selling his labor-power.”

[3] Both results are important, for example, for the Keynesian possibility of unemployment equilibrium. Keynes’ (1936, p. 243) emphasis on the unimportance of the natural rate of interest not only implies that the supply and demand for capital (loanable funds) do not determine the equilibrium rate of interest, but also that the conventional rate of interest may be set at such a level that brings about persistent unemployment.

[4] In the same way, the empirical evidence seems to contradict the notion that higher wages would lead to substitution of cheaper factors of production for labor. The exemplary case is the well-know study of the fast food industry in New Jersey, which found a positive correlation between the minimum wage and employment (Card and Krueger, 1995).

[5] That GE models do not support the notion that the abundance of a factor of production will be associated with lower remuneration has been pointed out by a survey of those models (Bliss, 1975).

[6] The same is valid for Bowles and Gintis’ (1993, p. 84) notion that market exchanges are usually contested and endogenous enforcement costs are not zero, and, as a result, there are conflicts of interest among exchanging parties. Therefore, if enforcement costs were nonexistent the Arrow-Debreu results would prevail. It must be noted that all the literature on post-Walrasian economics presumes continuity between the classical political economy authors and the post-marginalist revolution economics, which would mean that there are no significant distinctions between Smith, Marx, Walras and Arrow.

[7] Colander et al. (2004), for example, seems to suggest that several of the post-Walrasian developments can be seen as breaking up with orthodoxy. For a critique see Vernengo (2010).

Additional Readings:

Bliss, Christopher (1975), Capital Theory and the Distribution of Income, Amsterdam and New York: Elsevier North-Holland.

Bowles, Samuel and Herbert Gintis (1993), ‘The revenge of homo economicus: Contested exchange and the revival of political economy’ The Journal of Economic Perspectives, 7(1), 83-102.

Card, David and Krueger, Alan (1995), Myth and Measurement: The New Economics of the Minimum Wage, Princeton: Princeton University Press.

Chirinko, Robert (1993), ‘Business fixed investment spending: Modeling strategies, empirical results, and policy implications’, Journal of Economic Literature, 31(4), 1875-1911.

Colander, David, Rick Holt, and J. Barkley Rosser Jr. (2004), “The changing face of mainstream economics,” Review of Political Economy, 16, pp. 485-99.

Felipe, Jesus and Franklin Fisher (2003), ‘Aggregation in production functions: what applied economists should know’, Metroeconomica, 54(2-3), 208-262.

Garegnani, Pierangelo (1976), ‘On a change in the notion of equilibrium in recent work on value: a comment on Samuelson’, in M. Brown, K. Sato and P. Zarembka (eds), Essays in Modern Capital Theory, Amsterdam: North-Holland.

Heim, John J. (2009), ‘Which Interest Rate Seems Most Related to Business Investment?’, American Society of Business and Behavioral Sciences E-Journal, 5(1), February.

Keynes, John M. (1936), The General Theory of Employment, Interest and Money, New York: Harcourt Brace.

Lucas, Robert (1988), 'On the Mechanics of Economic Development,' Journal of Monetary Economics 22 (1), pp. 3–42.

Marx, Karl (1867), Capital, NY: International Publishers.Capital, NY: International Publishers.

Milgate, Murray (1979), 'On the origin of the notion of ‘intertemporal equilibrium’,' Economica, 46(181), 1-10.Economica, 46(181), 1-10.

Petri, Fabio (2003), ‘A ‘Sraffian’ critique of general equilibrium theory, and the classical Keynesian alternative’, in F. Petri and F. Hahn (eds), General Equilbrium: Problems and Prospects, London and New York: Routledge, pp. 387-421.

Samuelson, Paul (1962), “Parable and Realism in Capital Theory: The Surrogate Production Function,” Review of Economic Studies, 29(3), pp. 193-206.

Samuelson, Paul (1966), ‘A summing up,’ Quarterly Journal of Economics, 80(4), 568-583.Quarterly Journal of Economics, 80(4), 568-583.

Vernengo, M. (2010), 'Conversation or Monologue? On Advising Heterodox Economists,' Journal of Post Keynesian Economics, 32(3), pp. 389-96.

A farewell to growth?



It has been common for certain progressive groups to suggest that better income distribution and no growth, or even degrowth more recently, would be better than the capitalist driven consumerist growth process [for a critical review of this literature go here]. Several different strands of thought are involved in this view, and it would probably be worthwhile to disentangle them all.

First, there is an obvious Malthusian flavor to this view, going back to the dire predictions by the Club of Rome in the early 1970s, as a result of limited availability of non-renewable resources. Peak oil has been predicted a few times since. And yes it may very well happen in the near future, but somehow I doubt it. Remember that we moved away from coal and steam engines to oil and combustion ones, not because coal disappeared or became truly scarce, but simple because technological change made it less important as a source of energy (and yes we still burn a lot of coal).

In that sense, our problem is less that we have reached the limits of the existence of renewable resources, but more that the consequences, which are associated to Green House Gas (GHG) emissions, will be and already are dire. It is very likely that climate change caused by GHG emissions will lead to increasing costs in terms of food shortages, for example. But the question there is less that we cannot grow [the Malthusian thing, food does not grow as fast as population; the quintessential anti-Malthusian was Ester Boserup, an early feminist economist, that showed that agricultural productivity was determined by population dynamics; in other words, higher population growth led to increasing agricultural productivity], but who bears the costs of growth.

We leave in a world in which many developing countries import food, in part as a result of very high productivity in agriculture in developed countries, and in part as a result of subsidies and trade policies imposed by developed countries. The costs of global warming will fall overwhelmingly over poor and food-insecure countries in dry and tropical regions, that largely depend on rain fed farming, mostly in Sub-Saharan Africa and South Asia.

That means that a more equitable system to redistribute the costs of climate change, and alternative trade and agricultural policies are needed, which provide food security around the globe. Further, to reduce the effects of climate change a huge increase in spending on R&D is necessary.A Green New Deal or environmental equivalent of the space race, and lots of regulation would do a great deal to promote new and cleaner technologies (see for example the 2006 documentary, “Who Killed the Electric Car,” on what a California regulation did for the electric car).

Finally, note that there is no evidence of sustained technological progress (call it division of labor, or productivity, and you see that the wealth of nations might depend on it) with zero growth or negative growth. Productivity is not only pro-cyclical, but also structurally connected to growth. No growth in demand means limited incentives to productivity increases. So only with economic growth there is a hope of getting cleaner technologies. Degrowth also might lead to all sorts of environmental degradation, since it is far from clear that a society with spiraling down output would manage resources efficiently.

Second, there is peculiar view of the relation between income distribution, consumption patterns and economic growth. The notion is that no growth is necessary, since better living conditions can be obtained simply by redistributing income. The presumption seems to be that income distribution will have no effect on patterns of consumption and on economic growth. It is true that the effects of income distribution on growth are ambiguous, but the presumption that they have no effect is very strong.

I have my own views on what is more or less likely under the particular circumstances we are in. It seems reasonable, that if the redistribution towards the less privileged that the no-growth/degrowth crowd want took place that a consumption boom would follow. Particularly in developed countries were wages have been repressed for a while and which the last few years of the recession have made worse. And that would lead to growth, which is the opposite of what they want. But as much as I would favor that sort of redistributive policy, alas it is not in the cards.

Further, although it is true that consumerism is in many respects created by corporations and several elements in the consumption patterns in modern advanced societies are wasteful, one might also be careful about the false moralism of the New Puritans, as James Livingstone refers to those that preach that all thrift is good and all consumption bad. Consumption is associated to growth, and to better living conditions for the poorest among us. After all it has been the consumer society created by the Industrial Revolution that allowed us to obtain several of the benefits that we now take for granted in civilized societies, with longer life expectancy and better quality of life.

Finally, there is a naïve neoclassicism that is also part of the problem with the no-growth/degrowth crowd. It seems that for some, economics is synonymous with a certain view in which supply and demand determine everything, and, hence, the rejection of the consequences of those neoliberal policies must pass through the rejection of growth too.

Of course growth might not be associated to the market forces as suggested in neoclassical theory (and markets might actually work in very different ways than the mainstream thinks they do). Growth might often be the result of limiting the power of markets, and driving economic forces towards alternative goals. And, while it is certainly true that not all growth is good for the environment, an alternative (and Keynesian) perspective of what is behind growth and development processes might open the door for more environmentally friendly economic dynamics. A simple example would be to use the proceeds of say nationalized and heavily regulated oil extraction for investment in research and development of new technologies.

PS: Obviously all of the views discussed above are not held necessarily by any particularly person that believes that no-growth or degrowth is necessary. And I left a few additional views out, e.g. a view that capitalism is doomed and we are on the verge of a new (perhaps better) system (by the way, I don't agree with that one too; capitalism is doing fine, even if workers are not). But all of these propositions are part of the arguments used by different people to suggest that the benefits of economic growth are overrated.

MMT and its discontents

The Washington Post had a substantial profile on what is now termed Modern Monetary Theory (starts with Jamie Galbraith, and then goes on to the Kansas version of post Keynesian economics). A few reactions in the blogosphere. Two worth noticing are by Dean Baker and Jared Bernstein that provide qualified support.

Dean suggests that beyond fiscal deficits stimulus should also come from monetary policy (lower interest rate), and a more depreciated dollar. My guess is that, at least the Kansas MMTers would be fine with both, but suggest that lower rates of interest are not much in play now. But from what I understand a depreciated dollar has been seen as part of a solution by most progressive economists. Randy Wray, for example, is certainly less concerned with the size of a trade deficit than Dean, since the US is the issuer of the key currency [I have less confidence on flexible exchange rates as a way of solving balance of payments constraints in developing countries, but I'll leave that for another post].

My concern with Dean's notion of a more devalued dollar, which is generally fine and will not lead to the demise of the dollar in the near future, is that for the workers with low wages that depend on cheap imports at Walmart it implies higher prices and lower real wages. A boost to increase real wages would be necessary [see Jamie on that here]. So better income distribution should be the most important channel to boost consumption on a sustainable way.

Jared Bernstein fundamentally adds that taxes on the wealthy should be increased. Which he argues from a political standpoint, and I think it is quite reasonable, since that is one way (besides hiking minimum wages, and repealing right to work and other anti-labor legislation) to improve income distribution.

On a more personal level, my problem with the WaPo piece, and the general discussion of MMT, is that for the most part it sees MMT as just a policy program (the Kansas one is, for example, an Employer of Last Resort of some type, which is fine with me, by the way), and does not separate the theoretical discussions from the policy stuff.
Endogenous money, chartalism, and functional finance, are relevant because they fit the theoretical framework of a coherent heterodox alternative to the mainstream based on Keynes' Principle of Effective Demand [for a full alternative you need also long term pricing; in Kansas your man for that would be Fred Lee]. For my views on that go here. I think, hence, that a coherent alternative to the mainstream, beyond Keynesian economics, requires a good dose of the old and forgotten methods of classical political economy.

PS: My point about theoretical versus policy matters is driven by the fact that on certain policy issues, like the need for further fiscal stimulus, New Keynesians like Krugman and DeLong would be fundamentally in agreement with MMTers.

Amity Shlaes is a Keynesian after all!



Amity Shlaes has argued that the New Deal made things worse in the United States, prolonging the Great Depression in her popular book The Forgotten Men (for a devastating critique go here or here). Now she tells us that it was not so. True to her conservative convictions she argues that nation building abroad is a good thing. The explanation of why nation building is actually a good thing is where she gets confused and argues on the basis of Keynesian logic.

She says that countries that were occupied by American troops grew faster, and even uses the multiplier effect to show the consequences of troop withdrawals. She is aware that this is a bit dangerous, and suggests that "the usual explanation for the growth would be the multiplier effect. ... but multiplier effects don’t last, just as stimuli don’t last at home." Hence, even though the multiplier works, it does not work forever.

So her point is that if the multiplier has only limited effects then it is not a Keynesian argument! The notion that the multiplier effect is based on public choice (Mancur Olson) and not on her bête noire John Maynard Keynes –  whose ideas she describes as "sheer fallacies" (2008, p. 272) –  is farfetched.

The multiplier, developed by Keynes student and disciple Richard Kahn, says exactly that spending generates income, and leads to higher levels of output and employment. And of course it does not imply that the effects are unlimited, but only that they are positive (she used to argue that they were negative reducing growth, as in the New Deal).

Even if you say, like she does, that the multiplier only works in the short run or more precisely for a limited period of time, and then you need confidence or trust to maintain growth, it is still the initial spending that kick started the growth process. And yes she even gets that confidence is the result of the initial spending, and not vice versa. At the end of the day, she basically thinks Military Keynesianism works abroad. Perhaps the United States should invade the United States, and start nation building at home.

Keynes's General Theory: Seventy-Five Years Later

This volume, a collection of essays by internationally known experts in the area of the history of economic thought and of the economics of Keynes and macroeconomics in particular, is designed to celebrate the 75th anniversary of the publication of The General Theory.

The essays contained in this volume are divided into four sections. The first section contains three essays that explore the concept of fundamental uncertainty and its unique role in The General Theory. The second section contains five essays that examine the place of The General Theory in the history of macroeconomics since 1936. The third section contains three essays that explore the interrelationships among Keynes, Friedman, Kaldor, Marx and Sraffa and their approaches to macroeconomic theory and policy. The final section contains four essays that provide several new interpretations of The General Theory and its position within macroeconomics.

Keynes's General Theory is intended for those students and scholars who are interested in the economics of Keynes and the rich variety of approaches to macroeconomic theory and policy.

Yield curves and recessions

Let me get back to my discussion of the neo-Wicksellian macro model. One important feature of the model, is that it suggests that the central bank controls the rate of interest, and it should try to flatten the yield curve. That is, the bank rate (short run) should adjust to the natural rate (long run). In many respects this is the general rule behind all conventional stories about central banking. The Taylor Rule or the New Keynesian ideas behind Clarida, Galí and Gertler are basically a variation of Wicksell's story.

One thing that is also important about Wicksell's rule is that if the yield curve is negatively sloped (the bank rate is higher than the natural rate) then a recession (deflationary forces) are to be expected. The graph below uses the Fed Funds for the bank rate and the 10 year Treasury bond rate for the natural rate. In between the gray lines the official NBER recessions are shown.

As it can be seen, after the red line (Fed Funds) moves above the blue line (Treasury bonds rate) a recession always follows. There are many problems with the Wicksellian model, not the least the assumption of a natural rate of interest, that was severely criticized by Keynes in the General Theory. But the empirical notion that an inverted yield curve forecasts a recession seems to survive any possible theoretical critique. More on the critique will be left for other posts.

The euro is not money of account in Greece anymore

In Argentina, when the crisis got to the worst stage and reduced revenue and spending cuts were at the peak, local governments started using token currencies to pay state workers. The Buenos Aires province started paying its workers in patacónes, which became an alternative to the official currency, the peso, in 2001. In Greece we are already there. Local networks in which transactions take place using an alternative unit of account are taking place. These, if I understand correctly, are private and for the most part electronic networks, rather than public, as in the case of Argentina. No actual currency is being printed (as the 100 patacónes shown above).

At any rate, they go to the heart of the money question, i.e. they serve as alternative units of account.  Money is, after all, the unit of account that allows economic calculation to take place and facilitates the creation of credit and debit networks. Keynes said in his Treatise on Money that: “money of account comes into existence along with debts, which are contracts for deferred payment, and price lists, which are offers of contracts for sale or purchase.... [and] can only be expressed in terms of a money of account” (p. 3). This indicates that the euro is not playing that crucial role of money for the Greek people anymore.

Lucas in context, Keynes out of context

Krugman decided to try his hand at history of macroeconomic thought in one of his last posts. That's great, since history of thought is essential to understand how we got here. It's also bad, since Krugman is still very much a mainstream author, and misses the point of Keynes' contributions, and the limitations of neoclassical (or more properly, marginalist) approach. He suggests correctly that the New Classical (NC)/Real Business Cycle (RBC) project was a failure, but both the reasons for that and his interpretation of the Keynesian project are misguided.

The first proposition in Krugman's reassessment of the recent history of macroeconomics, is that Keynesian models were ad hoc, and assumed wage and price rigidity. The whole of chapter 19 of the General Theory (GT) is about the effects of price and wage flexibility, and how it does not produce full employment. It was with Franco Modigliani's PhD dissertation, done at the New School for Social Research under Jacob Marschak, that the sticky wage version of Keynesian theory that would dominate the neoclassical synthesis was concocted.

Keynes is actually quite explicit about the negative effects of wage reductions. He says (GT, ch.19-link above):

"A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.

What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume. The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But if rentiers represent on the whole the richer section of the community and those whose standard of life is least flexible, then the effect of this also will be unfavourable. What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable."

Hence, the fix-wage version of Keynes' thought is the result of misconception, that suggests that if markets worked well, without imperfections, they would move to full employment. Unemployment is a disequilibrium, by definition a short run situation resulting from a rigidity.

The whole point of the neoclassical synthesis was to suggest that one could continue to teach that markets are efficient, and that supply determined the price and quantity of equilibrium in all markets including those of "factors of production" (i.e. the labor and capital markets), and as a result unemployment could only result  from rigidities in the labor market. Nothing revolutionary there, and in that case, as Keynes foresaw, people would think he was quite wrong or said nothing new.

By the way Krugman does not believe that rigid wages are behind our current lack of full employment (in his view it is the downward rigidity of the rate of interest; Keynes also did not believe in the liquidity trap as the cause of depressions), which makes it more difficult to understand why he defines Keynesians (Old and New) as pragmatic rigid price and wage modelers. You cannot blame then Laurence Kotlikoff for his confusion (here and Krugman's reply and here; Jamie Galbraith, also implicated, gives a better answer since he never said that Keynes is about wage rigidity; scroll down for Jamie's and Kotlikoff's back and forth).

Krugman's second point is that Friedman and Phelps in the 1960s were trying to provide microfoundations to wage and price rigidity. Actually, the microfoundations agenda had more to do with the theoretical development of theories for consumption (Modigliani, Friedman), investment (Eisner, Tobin) and money demand (Baumol, Tobin) behavior. The Phillips Curve (PC) debate and the Friedman-Phelps notion of a natural rate of unemployment is associated to the idea that there is a supply side constraint to the economy, and stimulating demand would ultimately have only effects on prices and not on quantities. The economy naturally moves to full employment, unless there are restrictions, and what is needed is to eliminate the restrictions not stimulate demand.

In other words, the monetarist approach of Friedman accepts the neoclassical synthesis notion that it is the rigidities that cause unemployment. It just proposes a different policy solution. By pointing out the existence of a natural rate of unemployment analogous to Wicksell's natural rate of interest (which Keynes' criticizes in the GT) Friedman was just emphasizing that if one believes in the neoclassical theory of value and there are no restrictions the system moves to full employment. In fact, Friedman's (1970) theoretical framework, an ISLM cum PC and natural rate model, is remarkably close to the neoclassical synthesis models.

In that sense, the Lucas Revolution and the subsequent move, after Kydland and Prescott's work, of most New Classicals , including Lucas, to the Real Business Cycles camp is a not a break with Friedman, and the New Keynesians (NK) that accept everything (including the natural rate) are part of the same tradition. The difference is that some emphasize the long run neoclassical principles and others the short run rigidities that demand policy action.

The fundamental problem of the neoclassical/marginalist approach, and the importance of Keynes analysis, can ONLY be properly understood in light of the 1960s capital debates (for a good reference go here). The point, for the purposes of our discussion here, is that if there is unemployment and real wages fall, neoclassical theory tells you that according to the principle of substitution, more labor is demanded (the cheap thing that is in excess supply) and less machines (capital) are used, since they are relatively more expensive. However, since labor (which is cheaper) is used in the machine sector too their price should fall too, and is not generally true that there is a tendency for the full utilization of "factors of production" according to their relative scarcities. Further, even if the substitution effects go in the right direction, and more labor is used, the income effect of lower real wages tends to be large and have a negative effect on demand (put simply, workers cannot buy stuff), which implies that less of all "factors of production" are used. In other words, there is no natural tendency to full utilization of labor or capital, and both the natural rate of unemployment and its evil twin the natural rate of interest do NOT exist.

So it is peculiar that Krugman thinks that "NK economics [is] useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism." What logic? New Keynesian models assume a natural rate, and that the economy (without rigidities) moves to full employment! The problem with the NC/RBC/Lucas' type of theory is not that it failed to predict the 1980s recession or that they think that most crises are caused by real shocks (although both propositions are obviously wrong), as Krugman seems to believe, but that they do maintain the fiction of an efficient market that clears (in their case too fast for Krugman's taste) and that produces a natural rate. If he wants to move in the right direction Krugman should follow Galbraith and announce that it is time to ditch the natural rate hypothesis.

PS: That means that progress in economics is not linear, and that one can and should learn from old and forgotten traditions (classical political economy did not assume full utilization of resources).

Macro vs. Micro

A debate on the relation between micro and macroeconomics has been raging in the mailing list of the Societies for the History of Economics (SHOE; yep that's the acronym they went for!).  The main question being discussed is whether micro-foundations are necessary for coherent macroeconomic theory. I have argued in a previous post that, in fact, this is the other way round, macro-foundations for microeconomics are essential.

From a history of thought point of view, it is important to note that the distinction is a relatively modern one, starting in the 1930s.  The term macroeconomics was first used, most likely, by Ragnar Frisch in his lectures notes in 1933-34, and first used in print by Jan Tinbergen and Eric Lindahl in 1936 and 1939, respectively (for a full discussion see Vela Velupillai, 2009; subscription required).  Keynes did not use the term in his General Theory, even though the book is considered the foundational book of macroeconomics. To a great extent the work of John Hicks -- both his ISLM paper and his Value and Capital -- is central to understand the direction in which the profession developed.

Yet, Keynes book was central in the eventual split of macroeconomics and microeconomics.  In particular, because Keynes defied the conventional wisdom, associated with marginalism, that the rational maximizing behavior of firms and individuals would lead to the optimal (meaning full) utilization of resources, including obviously labor resources.  Full employment was not the normal equilibrium position of the economy.  In that sense, Gary Mongiovi provided the most enlightened note to the SHOE debate.  He tells us:

"the macro/micro distinction actually arose after Keynes's theory took root, and students had to be taught two distinct and apparently incompatible stories about how market economies work: (1) a neoclassical distribution theory in which the real wage adjusts to bring the S & D for labor into line with one another; and (2) a Keynesian story about how the economy could settle into an equilibrium in which the labor market doesn't clear."

That incompatibility and incoherence is still with us.  Students are taught that markets are efficient in their micro text, and some imperfectionist story is told in order to provide a foundation for the Keynesian macro story (at least in salt-water departments).  Of course an alternative would be to discard the marginalist approach altogether, since it does have insurmountable problems as admitted by Paul Samuelson during the capital debates in the 1960s.  But that's another story for a different post.