The inflation expectations fairy

There are confidence fairies and there is the inflation expectations fairy. It's a 4% fairy apparently. I'll explain. So Krugman correctly points out always that the more fundamentalist neoclassical economists (the Talibans that love price flexibility and instantaneous adjustment to full employment, not the moderates that also believe in a natural rate, but think it takes a while to get to it like Krugman himself) believe that the economy would recover if only a proper environment for investment was created. Hence, if confidence returned we would have a recovery.

They obviously invert causality between confidence and recovery. As noted by Marriner Eccles long ago: "confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time." Investment is the result of a growing economy, in which firms tend to adjust their capacity to demand. No demand for your goods no need to invest to create capacity to produce more. Plain and simple.

Now a dispute on what is the appropriate policy for the Fed, and what has been Bernanke's role has developed between Krugman and Bernanke (see here and here) [Ball has a more academic paper saying basically the same as Krugman here]. They argue that Bernanke has been correct in pursuing quantitative easing -- the buying of long term Treasury bonds to keep not just short, but also long term interest low -- and saving banks, but he has been reluctant to increase the inflation target to 4%. Blanchard has said pretty much the same about the need for a higher inflation target (this was hailed as new thinking in macroeconomics; with that criteria when Greenspan disregarded the 6% natural rate of unemployment level, believing it was somewhat lower, he was a radical innovator!). [I’ll leave for another post the question of why are we even talking about an inflation target in the US if the Fed supposedly doesn’t have one].

Krugman notes that Greg Mankiw actually has sent a veiled (or not so veiled threat, as he is the advisor to Romney, which may or may not have something to do with Bernanke’s reappointment in the future), saying that “if Chairman Bernanke ever suggested increasing inflation to, say, 4 percent, he would quickly return to being Professor Bernanke” (originally published here, yep Mankiw also writes regularly for the NYTimes).

So what is the mechanism according to Krugman (and the ‘progressives’ like the IMF chief economist Blanchard) by which a higher inflation target would lead to a recovery. In Krugman’s own words:

"If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher. … [and] higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea. "

So if the Fed says it’s willing to accept a higher level of inflation – without doing anything concrete and objective like intervening and forcing banks to refinance the mortgages of people in foreclosure – then if investors are persuaded they may be confident enough to spend more. And that’s not a fairy?! The problem with any theory, including the New Keynesian, that believes [or says it does in order to get published] that there is a tendency to full employment, is that it must end on some sort of confidence for spending story, since under normal conditions the system would actually do it anyways. The confidence fairy is dead; long live the inflation expectations fairy!

Shift happens indeed



The Chronichle of Higher Education has a very good piece on the 50 year anniversary of Thomas Kuhn's classic The Structure of Scientific Revolutions (SSR). It is worth remembering that the official methodology in economics remains Popperian.

The conventional history of ideas in economics, as represented by Schumpeter’s monumental History of Economic Analysis or by Mark Blaug’s work is one that emphasis the continuity and growth of knowledge. Hence, the frontier contains the set of accepted truths and the past is a history of how true knowledge was achieved. Knowledge progresses in a twofold process, first conjectures are made. Conjectures are not the ultimate truth, but are accepted while not proven incorrect. Then, tests are designed to falsify the conjectures. Hence, in Popperian terms theories can never be proven true or verified, but they can be accepted while they are not refuted. In other words, there is rational progress in science, including economics. Falsification is, then, the instrument to measure progress, since it provides the demarcation criteria to define what is and what is not scientific knowledge, and also to determine whether a theory is superior to the other.

Thomas Kuhn provided and alternative to the conventional approach. The evolution of scientific knowledge is tied to history and to the sociology of the scientific community. A paradigm can be described as the set of rules and methods accepted by a scientific community. Scientific knowledge is for the most part the result of normal science, that is, the work of scientists within the confines of their paradigm. However, normal scientists are sometimes confronted with critical anomalies that put in doubt the validity of the whole paradigm (Kuhn’s model of paradigmatic change is the Copernican revolution). An accumulation of anomalies leads eventually to a paradigmatic crisis, and to the emergence of new paradigms.

New paradigms explain the anomalies unexplained by the old one. More importantly, new paradigms often provide a new vision of the object of study. Hence, new paradigms imply that hypotheses are incommensurable in terms of the old paradigm. The methods of testing hypotheses are no longer accepted. Progress is then only possible within the paradigm. Comparisons between paradigms involve the values of the scientific community and the persuasive ability of scientists.

The Kuhnian model was developed to discuss scientific progress in the hard sciences, so a reasonable question is whether it applies to soft sciences too, admitting that economics is a soft science. In economics several paradigms co-exist for long periods, something that should happen only in periods of crisis. Also, the Marginalist Revolution took place even though there was no evident anomaly unexplained by the dominant paradigm (classical political economy; in all fairness Ricardian economics had been abandoned in the 1830s, and vulgar economics dominated the profession). Ideological reasons seem more important in that case. Further, the Keynesian Revolution, that occurred as a result of the high levels of unemployment (an anomaly if there is one for the normal marginalist science) that could not be explained by the dominant paradigm, was to a great extent aborted, and the idea of a natural rate of unemployment was reinstated.

A. W. Coats (1969; subscription required) notes that anomalies and critical experiments are not common, but still the concept of scientific revolutions may serve in economics as an ideal type to clarify the sociological elements in the development of economic ideas. SSR remains vital for economic methodology, in particular after the last crisis has shown, once again, the limitations of the self-adjusting marginalist paradigm.

Not so Keen on Krugman

I have been critical of the theoretical positions held by Krugman for a while now, even if he and DeLong, and even Summers, have been useful for policy reasons. Now a lengthy debate between Krugman and Steve Keen, a very pragmatic and reasonable post-Keynesian (and I guess part of MMT tradition) that understands endogenous money has developed [a good summary with all the links here].

First, and foremost endogenous money implies that the rate of interest is exogenous and determined by monetary authorities. That per se is not necessarily in contradiction with a neoclassical/marginalist view according to which the rate of interest equilibrates investment to full employments savings, as Krugman clearly believes. Wicksell [see here] certainly did not think so either.

For Wicksell in a giro system, in which all transactions were recorded as debit/credit relations, credit could expand indefinitely, but in the real world, bank reserves would vanish and lending would eventually collapse if the bank rate remained below the natural rate for a long period. That is fundamentally the reason why Krugman does not understand the notion that banks can create reserves, and that loans cause deposits. In other words, what regulates the bank rate is, ultimately the natural rate of interest.

Further, the natural rate of interest is NOT a banking phenomenon in marginalist analysis, and, as a result, cannot be exogenous to the system. It results from the marginal productivity of capital and the intertemporal decisions of consumers. Krugman is in fact very clear that he supports the loanable funds theory of interest.

Hence, Peter Cooper is correct to point out that ultimately the debate with Keen must revolve around a notion of a long term normal rate of interest that is institutionally determined by the central bank independent of the marginalist notion of the natural rate. That can only be obtained with the proper critique of the neoclassical notion of capital.

Neo-Wicksellian macroeconomics

Modern macro has more to do with Wicksell's Interest and Prices than with Keynes' General Theory. For one, the idea of a natural rate of unemployment derives directly from Wicksell's natural rate of interest, as Friedman noted. So here is a brief explanation of Wicksell's main argument in that book.

Wicksell distinguished between the natural rate of interest (R*) and the monetary or bank rate of interest (R). The former was determined by the marginal productivity of capital (I) and the intertemporal decisions of consumption (leading to savings S), along the lines of what became known as the loanable funds theory. The monetary rate was determined by bank decisions. That is, banks supplied credit (Ms) at the chosen rate of interest (R), according to money demand (Md). Monetary equilibrium occurred when the two rates coincided (see figure below). The natural rate is the gravitational center around which the bank rate fluctuates. Real and monetary shocks could cause deviations of the bank rate from equilibrium.

Wicksell assumes that a positive productivity shock raises the natural rate of interest, and that banks maintain the initial monetary rate. Thus, with a low bank rate, investment exceeds savings and once the system reaches full employment prices would go up. However, continuous lending would reduce bank reserves, and as a result banks would be forced to increase the monetary bank until a new equilibrium was reached. Inflation resulted from a bank rate that was too low, as much as deflation (and temporary unemployment) from a bank rate that was too high.

The low bank rate implies overinvestment, and the need for additional savings. The inflationary process by reducing the ability of consumers to spend provides the additional 'forced savings.' Inflation acts as a tax that provides the additional resources needed to finance investment. The business cycle can be explained by exogenous shocks to productivity (the I curve), changes in consumers preferences (shocks to S), or by the misconduct of the banking sector (shocks to Ms). Wicksell, as much as the modern Real Business Cycle (RBC) School, favored the former.

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).

Dr. Krugman and the natural rate of interest



So I have said a few times here that, while Krugman has been extremely useful for Keynesians in recent policy debates, as a New Keynesian (neo-Wicksellian would be a better term for this school of thought), he is not properly a real Keynesian.  In a recent post he shows exactly my point.  He says:

"There is still a sufficiently low real interest rate that would produce recovery, but it’s a rate that’s hard to achieve."

In other words, there is a rate of interest that would increase investment and bring about the full employment level of savings.  In this post he surprisingly seems to say that liquidity traps or lower zero bound limits (rigidities) for nominal rates do not matter.

The reason seems to be connected to the fact that creditors must have a positive effect on their net wealth in a deflationary balance sheet recession, and their spending should go up.  Hence, creditors should spend more with a slightly lower interest rate.  Wealth effects have been the traditional neoclassical argument for a self-equilibrating economy since Pigou.  If this were true no fiscal policy would be actually necessary.

It's hard to believe that Wall Street bankers would spend sufficiently more for a recovery to follow.  And I doubt that Krugman believes that this effect is sufficiently strong in the real world.  But he does believe in some sort of natural rate, like Wicksell did, which is compatible with Friedman's natural rate of unemployment.

Keynes, on the other hand, thought that the very concept of a natural rate should be discarded.  In chapter 17 of the General Theory Keynes states that:

"In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. ... I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.
I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis."

So, in fact, there might be the case that NO long term rate of interest, a highly conventional one according to Keynes, would be compatible with full employment.  The socialization of investment, in Keynes' terms, then would be necessary.  In other words, effective demand matters in the long run, not just the short run, because there is no tendency for self-adjustment.

Since Friedman's infamous Presidential address to the American Economic Association the neo-Wicksellian approach has dominated macroeconomics.  In this view, the central bank pins the short run policy rate to the long run natural rate, and the economy (save for rigidities and imperfections) moves automatically to full employment.  No fiscal policy is necessary, again with the exception of short run imperfections.  That's why long term considerations about deficits and debt are important. 

My question is: should we be surprised that with this theoretical model as the dominant one, we are in a situation in which the administration is unable to understand and unwilling to promote the fiscal expansion necessary to get us to full employment (or at least lower levels of unemployment)?

PS: Keynes developed the ideas in chapter 17 on the basis of Sraff'a's critique of Hayek's theory of capital in 1932 (here; subscription required).  Note that while Keynes understood that the idea of a natural rate of interest that equalized investment to full employment savings had to be discarded, he did not get that his negatively sloped marginal efficiency of capital actually provided the basis for such a rate.

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.

It's the model stupid!

Brad DeLong, that together with Krugman has been a force for sanity within the mainstream, arguing for more fiscal expansion, shows why we need heterodox economists.  He says in a recent post:

This is a bad time to be an economist. If you were fresh from the womb and had no past opinions to defend, if you had never said anything notable before, it might be a fine time to be an economist. If you are one of those soap-opera characters who has complete amnesia and no memory of anything that they ever said or did or any intellectual position they took before January 1, 2010, it might be a fine time to be an economist. But for the rest of us--we who are now looking back at our opinions and analytic judgments and statements and pronouncements of the past 15 years and thinking: "how could I ever have been so stupid; how could I have missed so much?"--it is a bad time to be economist?

Four years ago we economists were writing learned papers about the "Great Moderation": about how it looked as though the governing institutions of the world economy had finally learned how to control and moderate if not completely eliminate the business cycle--the epileptic seizures of the economy that leave us with pointlessly high unemployment, pointlessly idle capacity, and pointlessly rusting away machines in spite of there being no fundamental cause for machines to be idle, factories closed, and workers unemployed.

Funny, I know of several economists that suggested that an economy based on debt-led consumption, on the basis of asset bubbles, was not sustainable and that a crisis was coming.  It would be tedious to cite all, and I'm lazy and don't want to find links to their papers, but a limited list of names (do a google search) would include Dean Baker, Jane D'Arista, Jerry Epstein, Jamie Galbraith, Wynne Godley, Thomas Palley, Bob Pollin and Lance Taylor (before hand I'm sorry for any significant omissions).  I knew enough to be sure that it was not sustainable.

But I'm glad that the best in the mainstream admit that it was stupid not to see it coming. I would suggest to him that part of the problem of the inability of the mainstream to see it coming is their theoretical framework.  The consensus macroeconomic model, based on an IS curve, a monetary policy rule, and a Phillips Curve with a natural rate of unemployment, in particular because it assumes that the economy automatically returns to the natural rate, is a flawed basis for understanding the real world.

The natural rate of unemployment

Two economists at the Federal Reserve Bank of San Francisco (FRBSF) have written a paper in which they claim the natural rate of unemployment (i.e. the one consistent with price stability) is not around 5% anymore.  Now it is close to 6.7%.  It reminds me of a talk given by Solow at SCEPA in 2000, in which he said at the beginning  that the natural rate did not exist, and by the end he suggested it was 5.2%.

There are several ways of trying to measure the unobservable natural rate.  One is to use the inverse relation between vacancies and unemployment (the so-called Beveridge Curve).  The idea is that if there are more vacancies than regularly observed for a given level of unemployment, then the normal level of unemployment must be higher. Further, the idea is that job vacancies are completely driven by supply conditions (this is often omitted in explanations of the curve).

If that is the case, supply changes drive the vacancies up, and the level of unemployment consistent with price stability adjusts upwards.  So why did job vacancies went up?  For one, mainstream economists (the ones that missed the bubble and the recession) argue that it is a mismatch between skills required by new technologies and workers capabilities. Also, it is argued that the extension of unemployment benefits discourages unemployed workers to look for jobs.  The FRBSF economists argue that 50% of the increase in the natural rate is explained by unemployment insurance.  And, at least, they note that the increase in actual unemployment is explained by a cyclical fall in demand.

It is interesting to note that the natural rate changes with the actual rate of unemployment.  A period with high levels of unemployment on average leads to economists' claims that the natural rate is higher.  The Beveridge Curve is used to justify then the idea that it is the natural rate that drives the actual rate of unemployment.  Of course it could be a simple case of reverse causality.  Higher levels of unemployment on average imply that the normal (that somebody decided to call natural; Mr. Milton Friedman, by the way) would be higher.  In other words, what drives the natural rate is the actual rate.  Job vacancies can also go up as a result of higher levels of unemployment on average.  For example, it has been reported that many recruiters do not want to hire unemployed workers.  The workers may have the skills, but the perception is that if they are out of a job they must have done something wrong.

Logic suggests that it is unemployment that causes the increase in graduate student applications, but I would not be surprised if an economist claims it is the other way round. The point is simple. Perhaps one way of bringing down both the normal unemployment level, and the Beveridge Curve is to promote the creation of jobs now!