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.

New Monetarists, scientists or engineers?

Back in 1994, when the New Keynesian (NK) label, if not the models, were relatively new, Ball and Mankiw argued that Milton Friedman was closer to the NK approach than the New Classical (NC)/Real Business Cycle (RBC) one. For them (see here, 1994, p. 9):

"although traditionalist are often called 'new Keynesians,' this label is a misnomer. They could just as easily be called 'new monetarists.'"

The whole point was that monetarists believed in the non-neutrality of money in the short run and in sticky prices, like NKs. Now there is an explicit New Monetarist model with sticky prices here, and a growing literature surveyed by Stephen Williamson and Randall Wright here. Williamson has a blog here.

New Monetarists seem to build on ideas developed by Thomas Sargent and Neil Wallace in the early 1980s (here, for example). A simple introductory presentation is given by Champ and Freeman (here). The theoretical framework is in general based on overlapping generations models, in which monetary policy can affect relative prices and, as a result, change the intertemporal consumption, labor supply, and investment decisions of rational maximizing agents.

As Williamson says:

"Monetary policy matters due to distortions in intertemporal prices, for example the anticipation of higher money growth and higher inflation acts as a tax on labor supply and reduces output."

Not sure if he thinks that the current slow growth is to be blamed on the expansion of the money supply after the recession, and higher inflationary expectations, leading to an increase in the demand for leisure time (a reduction on labor supply, that will be taxed by the higher inflation). That would explain why he thinks that the Fed should sell bonds, and raise the interest rate (not a joke!). At any rate, the whole New Monetarist approach is fundamentally, like New Classical authors in general, concerned with microfoundations. In this case, microfoundations in the money market.

This kind of approach reminds me of another Mankiw paper on the nature of macroeconomic research. For him macro, from the Keynesian Revolution until the rise of Lucas and the New Classical school, was dominated by what he calls engineers, that is problem solvers. From Lucas on it has been dominated by scientists, meaning those that search first principles.

So the first group was concerned with empirical regularities, like Okun's Law, while the latter emphasized rational intertemporal maximizing economic agent models, like in the Ramsey model. New Monetarists are clearly in the latter camp. So are we better off with the rise of the "scientific" macroeconomists? Here is why Mankiw's paper is so important. He candidly tells us (p. 19):

"The sad truth is that the macroeconomic research of the past three decades [the 'scientific' micro-founded stuff] has had only minor impact on the practical analysis of monetary or fiscal policy. The explanation is not that economists in the policy arena are ignorant of recent developments. Quite the contrary: The staff of the Federal Reserve includes some of the best young Ph.D.’s, and the Council of Economic Advisers under both Democratic and Republican administrations draws talent from the nation’s top research universities. The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering."

No kidding, great science that has nothing to say about the reality of how to solve actual economic problems. The rise of sci-fi macroeconomists. Welcome to the Twilight Zone!

Striking inanity

Mankiw thinks that the scatterplot below is striking. He should read an intro textbook (I imagine even his text presents the simple Keynesian model).

What drives both is the expansion of autonomous demand. Demand increases output, and as per Okun’s Law reduces unemployment. Investment follows the accelerator, that is, as output increases firm’s investment also increases to maintain the relation between productive capacity and income. How is this striking?

Okun’s Law: Is it broken?

Okun’s Law suggested that an increase in output would imply a fall of unemployment, and the relation was often assumed to be a 2:1 ratio in more recent times.  Jon Hilsenrath suggested recently, in a WSJ blog, that the relation is broken.  He argues that the average growth between 2007 and 2009, the recession years, was around 2.5% below its trend (the actual growth was slightly negative, around –0.22% in the three years), and that Okun’s Law would have implied and increase of unemployment of approximately 5% (he says little more than 5%, from 4.4% to 8.9%” [sic]), but it increased more, reaching 10.1% in October 2009.  That is the basis for the claim that the law is broken.  In fact, the average annual unemployment increased from 4.6% in 2007 to 9.6% in 2010, precisely 5%.  His fears about the breakdown in the recovery are also exaggerated.  What is really surprising is that he thinks that: “unemployment seems to be falling sharply.”  I need to find these rosy goggles WSJ bloggers use.