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Less income, less work, less income, more work!

I have some good news that some of you may have already heard about but it is worth repeating. Harvard deficit terrorist Gregory Mankiw, who poisons the minds of millions of economics students with his preposterous textbook is going to work less because he has faces lower income as a result of the temporary Bush high marginal tax rates cuts being terminated. Apparently, he is getting a sudden preference for leisure. While there is a desperate need for more fiscal expansion in the US at present it seems that the US government could help all of us by mixing the net spending injection with some marginal tax rate adjustments targetted towards high income earners. By fine tuning the top marginal rates they should be able to get Gregory to give up work altogether and then the rest of us would be better off as a result. Meanwhile, the UK government also claiming to be against budget deficits thinks it will make its poorest citizens work more by ensuring they have less income. Notwithstanding the lack of jobs the inconsistency of the logic is something else. Go figure!

Confused?

Mankiw’s latest New York Times article (October 9, 2010) – I Can Afford Higher Taxes. But They’ll Make Me Work Less – addresses the issue of whether it is sensible for the US government to “raise taxes on those earning more than $250,000 a year” as the Bush tax cuts reach their expiry date.

I dealt with the Bush tax cuts issue in detail in this blog – Income distribution matters for effective fiscal policy. The proposal is part of the obsessive debate that is going on in the US about the ways to cut the budget deficit. A correct debate should be focusing on how to expand the deficit while ensuring the benefits go to the poorest citizens and the net spending is job rich.

On August 22, 2010, Paul Krugman said in his column – Now That’s Rich that the retention of the tax cuts was an “expensive proposition” and he was affronted by the benefits being provided to the richest Americans. It is more accurate to relate the benefits to the highest income earners which may not be equivalent to the richest but that is an aside.

While not considering specifically whether the tax cuts were sensible in the first place, the notion of the tax cuts being an “expensive proposition” has no meaning per se in the context of a fiat monetary system. In terms of Modern Monetary Theory (MMT) such terminology is grossly misleading. The tax cuts just represent “numbers on a bit of paper” and the only issue that is needs to be considered is the volume of purchasing power that is embodied in the tax cuts (or the reversal of them) and how it is distributed.

From a MMT perspective, the purchasing power question really on matters if we think in real terms – that is, what real resources are at stake?

These questions are in relation to (a) the need to balance nominal aggregate demand growth with the capacity of the real economy to absorb it (relevant to the amount of purchasing power being withdrawn by taking back the tax cut); and (b) the aims of social policy to ensure that the benefits of economic activity are shared in some reasonable manner (relevant to the distribution of the tax burden).

The two issues are interrelated because different income groups have different propensities to consume which influences the impact of fiscal policy.

But Mankiw considers there is more at stake than this and suggests that without the higher marginal tax rates he would:

… have twice the incentive to keep working.

He says that given there are taxes “Is it any wonder that I turn down most of the money-making opportunities I am offered?”

He explains his conclusion by proposing he is paid $US1000 for some task and then compares what that would compound to after 30 years with no taxes to what the situation would be with and without the tax increases. There are several assumptions he makes which includes that the provision of public infrastructure provides zero real income to him or his family and what would be the impact on his net income position if he had to pay a private provider for all the public services (in the no tax scenario).

I am not suggesting the taxes provide the wherewithal for the government to provide these services – that is simply a false proposition – Taxpayers do not fund anything – but it is consistent with Mankiw’s own logic and frame of reference that without taxes there would be no spending. So in his world, the so-called $US10,000 he passes on after 30 years would be seriously eroded if he had to pay for access to all roads, bridges, buildings, protectoin from private police and armies, etc.

But that quibble is an aside.

The bottom line from his calculations is that with the tax hike he ends up with $US1000 after 30 years (that is, the tax effect wipes out the compounding effect) and without the tax hike his initial $US1000 payment grows to $US2000 over the same period. Hence, his “twice the incentive”.

Another inconsistency in Mankiw’s logic (before I get to the major issue) is his assumption of linearity in this thought experiment. Neo-classical economists such as Mankiw always invoke diminishing rates of utility and productivity in their analysis as a convenient, but totally ad hoc assertion about humam behaviour which just happens to get the demand and supply curves drawn in such a way that they intersect in price-quantity space and so give them an “analytical result”.

I recall the trivial example provided when I was a student to “demonstrate” this assertion. Accordingly, a consumer buys one cream cake and enjoys it a lot. The second cake is also very well received but by the third cake the enjoying is waning. By the nth cake, the consumer is vomiting and not seeing any extra gain in satisfaction from any more cream cake consumption. Hence, the more you have of something the less satisfaction you are alleged to get at the margin of extra units.

So why is the $US2000th dollar delivering the same “incentive” as the $US1st dollar? We have to be in a linear world it seems – when it suits.

Anyway, the point he is making is that the taxe increases will force him to work less and:

… don’t let anyone fool you into thinking that when the government taxes the rich, only the rich bear the burden.

Apparently, there are “particular actors” who will not make the “next movie” or “particular novelists” who will not write the “next book” or a “favorite singer” who will not perform in your local town if the tax hikes go forward. Further, you will be disappointed because just when you need a particular “highly trained surgeon” or “your child” needs “braces from the local orthodontist” you will find them unavailable – gone home because the marginal tax rate has risen.

Mankiw concludes that:

As they face higher tax rates, their services will be in shorter supply.

Where does he get these ideas from? Answer: his own textbook.

In Chapters 2 and 7 of my 2008 book with Joan Muysken – Full Employment abandoned – we consider the type of labour market that Mankiw considers relevant to the real world. It allowed us to develop the standard Classical view on unemployment which is still pushed down the throats of students today by the likes of Mankiw and the mainstream macroeconomics profession in general.

The Classical/neo-classical model is represented by the following graph:

For those who like equations, the lines in the graph can be written in algebraic form as follows:

Labour demand: Ld = f(w)    f’ < 0

Labour supply: Ls = f(w)    f’ > 0

Equilibrium: Ld = Ls

where w is the real wage which is the ratio of the nominal wage, W and the price level P.

The real wage is considered to be determined in the labour market, that is, exclusively by labour demand and labour supply. Keynes showed that this assumption is clearly false. It is obvious that the nominal wage is determined in the labour market and the real wage is not known until producers set prices in the product market (that is, in the shops etc).

The labour demand (Ld) function is the derivative of the production function with respect to labour input (the marginal product). The ad hoc imposition of the so-called law of diminishing returns ensures this derivative is positive but declining as employment is increased.

In English, they say that as extra units of labour are added to a fixed stock of capital they become increasingly unproductive and hence there is diminishing products (returns). Hence, the labour demand function is downward sloping with respect to real wages. The argument is that firms have to pay the real wage (an amount of actual product) to the marginal workers and so they will only hire extra labour if the amount the worker contributes to production is more than the real wage. The assertion of diminishing returns assures the demand curve will be downward sloping – so the firm will only be prepared to hire extra workers if the real wage is reduced.

This is a short-run relationship based on the fixity of other inputs like capital. In the real world, production processes rarely follow the model presented in the textbook. First, the idea that capital is fixed and production expands purely because extra workers are added seems not a reasonable depiction of reality. A cleaning firm who finds extra contracts do not force extra workers to share a single broom or vacuum cleaner. If there is extra work they add a worker and another broom!

So we have what are called “fixed factor proportions” which is just a fancy phrase meaning that workers and capital are added to production more or less in proportion dictated by the current technology. In that case, each additional worker is more or less as productive as the last. There is very little evidence in the real world to support the ad hoc assertion of the “law of diminishing returns”. It always amused me when I was a student how the mainstream attempted to infuse levity into their inane theories by referring to them as “laws” akin to a physical law in physics.

Once you see through this and realise that they are just assertions that these characters dream up (invent) which stand and fall on their empirical applicability you start seeing the nakedness ugliness of the neo-classical theory. I am glad I saw through this after about 1 minute because it meant I was able to devote my student efforts to reading much more interesting stuff.

The labour supply (Ls) function, which is based on the idea that the worker has a choice between work (a bad) and leisure (a good), with work being tolerated only to gain income. The relative price mediating this choice (between work and leisure) is the real wage which measures the price of leisure relative to income. That is an extra hour of leisure “costs” the real wage that the worker could have earned in that hour. So as the price of leisure rises the willingness to enjoy it declines.

The worker is conceived of at all times making very complicated calculations – which are described by the mainstream economists as setting the “marginal rate of substitution between consumption and leisure equals to the real wage”. This means that the worker is alleged to have a coherent hour by hour schedule calibrating how much dissatisfaction he/she gets from working and how much satisfaction (utility) he/she gets from not working (enjoying leisure). The real wage is the vehicle to render these two competing uses of time compatible at a work allocation where the worker maximises satisfaction.

I do this every day and I am sure you all do too. It makes it hard to get out of bed each morning. All these calculations!

So why is the labour supply function upward sloping with respect to real wages – that is, the theory asserts that as the real wage rises workers will continue to supply more labour hours.

This is where it gets really funny (at least I was amused by it when I was a student). The neo-classical analysis motivates the following thought experiment as an attempt to explain what happens when a “price changes” – in this case, the real wage.

They isolate two separate “effects” on such a real wage change (say a rise): (a) a substitution effect; and (b) an income effect.

The substitution effect refers to the impact on the worker’s decision to supply hours of labour when the real wage changes. So if the real wage rises, work becomes relatively cheaper (compared to leisure) and the mainstream theory asserts via the so-called law of demand that people demand less of a good when its relative price rises. So real wage up, less leisure, more work.

But there is another effect to consider – the so-called income effect. When the real wage rises, the worker now has more income for a given number of hours of work. The mainstream theory of normal goods (as opposed to inferior goods – the distinction is just made up largely) tells us that when income rises a consumer will consume more of all normal goods. The opposite is the case for an inferior good.

Leisure is considered to be a normal good as are other consumption goods the worker might buy with the income he/she earns. So as the real wage rises, the income effect suggests that the worker will demand more of all normal goods (because they have higher incomes for a given number of working hours) including leisure. That is the worker will work less!

Now think about a tax rate in this model. The labour supply function can be conceived of as expressing the relationship between the number of hours a worker chooses to supply and the net real wage (that is, the amount post tax).

So without a tax system, the model above describes the “perfectly competitive model” that students get beguiled by in their initial studies and they are told that this is the most efficient outcome. This is Mankiw’s dream world where his initial $US1000 payments compounds to $US10000 after 30 years.

The imposition of a tax rate now reduces the relative price of leisure (compared to work) because it amounts to a real wage cut for the worker. So in this model, the so-called income and substitution effects work in opposite directions. The substitution effect reduces the opportunity cost of leisure and thus leads to an increase choice for leisure. So the substitution effect says that the imposition of a tax causes a reduction in labour supply.

But the tax hike also reduces income at each level of hours worked. So for the same quantity of work, the person is able to command less goods. To enjoy the same quantity of goods as before they have to work more when there are higher taxes. In other words, the income effect predicts the worker will work more.

This is all very scientific but that is as far as it goes. It is dripping in rigour when it is taught mathematically and students are beguiled by it. How dare we challenge the authority of the mathematics?

However at this stage there are no possible “scientific” or rigorous conclusions to be drawn from the analytical framework. Which of these effects dominates? The model cannot tell us. There is a lot of ad hoc manipulation with various scenarios proposed but nothing can be advanced further from the model as it is set up.

So what do the mainstream economists such as Mankiw do? Answer: make up stuff. The so-called elegance and rigour of their framework gives away to them just asserting that the substitution effect dominates. It becomes as simple as that. So the supply function is upward sloping in terms of real wage (and pivots down but remains upward sloping if there is a marginal tax rate imposed).

If that wasn’t the case, then there is a danger the labour supply curve might not intersect the equally asserted shape of the labour demand curve and then the theoretical framework would not even predict an equilibrium relationship between real wages and employment, which is, after all, its purpose.

So never think that mainstream theory is anything more than stuff made up even if it is disguised as rigorously reasoned argument.

There have been lots of attempts at finding out which effect dominates when tax rates change. These include Econometric modelling, experimental studies and interview studies. All are rife with problems which I will not elaborate on here.

The results from the interview studies that have any credibility suggest that the aggregate effect of taxation on labour supply is small if there is any perceptible effect. Generally, these studies find that people try to work more overtime (if available) to make up the lost income – that is, the income effect of the tax dominates the substitution effect.

Notable studies of the affect of higher marginal tax rates (exactly the case Mankiw is considering) are inconclusive. One famous study (James and Nobes, 1998, The Economics of Taxation: Principles, Policy and Practice, Prentice Hall) summarised the literature on interview studies in this way (page 63):

… there appears to be no substantial disincentive effects from taxation. Instead, it appears that there are both small incentive and small disincentive effects which tend, of course, to offset each other, so that the net effect on the taxation of labour is likely to be small.

The results from the other methodologies are equally inconclusive.

Further, there is a notion in economics called rent. An economic rent is a payment to a “factor of production” which is in excess of that required for the current supply of that resource. So popular guitar players (who are scarce but in demand) will likely earn very high incomes – yet still be prepared to perform at the current levels with significant reductions in those incomes (as their popularity wanes, for example). I just thought of a concert that my host took me to when I was in Boston in June. It was a Ringo Starr concert and I am sure he still wants to perform even though his returns are (in real terms) much lower these days than when the Beatles were at their top. He was probably earning huge rents. So a tax impost on such a worker will have no impact on their labour supply.

There are many more problems with the orthodox labour supply analysis which I could discuss. For example, the model suggests a worker will only engage in paid empoyment if the real wage they are paid exactly offsets the pleasure they would have received from enjoying an hour of leisure. If you think of this workers are always on their “supply curves” and can never be “forced” by the market to work more or less hours than they desire.

In Mankiw’s model, the worker always enjoys working hours and real wages that maximise their utility – pleasure. They cannot be coerced into working more hours than they desire and never have to endure less hours than they desire.

So how do we explain the rising underemployment? That is why are there a growing number of part-time workers who want more hours but are rationed by a lack of overall hours in the labour market? This could not occur in the mainstream model that Mankiw is suggesting allows us to understand the real world.

Further, there is a major problem with the conception of the work-leisure choice. Is the extra satisfaction gained from an extra hour of leisure always positive? Further, is the extra hour of work always bad? Both assumptions are required to motivate the orthodox model.

The reality is different. First, there are different capacities to enjoy leisure depending on ones income. An unemployed worker with minimal income support is unlikely to value the extra hour of leisure more than a high income worker who can afford to buy high value-added leisure products (restaurants, concerts, ski vacations etc). Poverty and unemployment provides plenty of non-work hours but each one is miserable.

Second, work is not seen as intrinsically bad by most workers and unemployment is not seen as a state where a person is enjoying leisure!

Most of us gain satisfaction from working quite apart from the income it generates. We meet our partners, enjoy social esteem and in many cases actually enjoy the process of work. The opposite typically applies to the alienated and lonely existence that the unemployed are forced to endure.

So while the mainstream model characterises unemployment as a state chosen by the worker to maximise their utility given the current choices facing them all the studies by sociologists, psychologists and thinking economists suggest otherwise.

If we consider this discussion more broadly, then the diagram above can be used to consider macroeconomic situations. The important Classical result is that the interaction between the labour demand and supply functions determines the real level of the economy at any point in time. Aggregate supply (using the aggregation fudge of the so-called representative firm) is thus a technological mapping from the equilibrium employment determined by the equilibrium relationship into the production function. Say’s Law (in whatever version) is then invoked to assume away any problems in matching aggregate demand with this supply of goods and services.

The equilibrium employment level, E* in the graph (assuming it now applies to the overall economy rather than an individual), is constructed as being full employment because it suggests that every firm who wants to employ at the equilibrium real wage, w* can find workers who are willing to work and every worker who is willing to work at that real wage can find an employer willing to employ them.

The Classical economist thus considered the preferences of the workers always would have a bearing on the labour market outcome and through price adjustment (real wage flexibility) any changes in supply preferences would – via mediation through the demand side – result in a changing full employment level.

In other words, adoption of the competitive paradigm demands that departures from full employment are ephemeral at best. Any sustained unemployment (say BC in the graph) must be due to a real wage constraint (a real wage, w1, above the marginal productivity at implied equilibrium full employment) which would be competed away more or less immediately.

A fundamental aspect of this labour market conception, which you will find in Mankiw’s own text, is that fluctuations in unemployment reflect supply-side changes arising from imperfect information or reflecting changing preferences between leisure and work.

In this mainstream macroeconomics dream world, he considers the classical labour market model to be applicable to the real world. So to repeat – the real wage is assumed to be determined in the labour market at the intersection of the labour demand (Ld) function and the labour supply (Ls) function. The equilibrium employment level is constructed as full employment because it suggests that every firm who wants to employ at that real wage can find workers who are willing to work and every worker who is willing to work at that real wage can find an employer willing to employ them. Frictional unemployment is easily derived from the Classical labour market representation, as is voluntary unemployment.

Holding technology constant (and hence the Ld curve fixed), all changes in employment (and hence unemployment) are driven by labour supply shifts. There have been many articles written by key mainstream economists (such as Milton Friedman) that argue that business cycles are driven by labour supply shifts.

The essence of all these supply shift stories is that quits are constructed as being countercyclical despite all evidence to the contrary. This induces Lester Thurow in his marvellous book from 1983 – Dangerous Currents to ask:

why do quits rise in booms and fall in recessions? If recessions are due to informational mistakes, quits should rise in recessions and fall in booms, just the reverse of what happens in the real world.

So one of the most simple ways to reject the mainstream macroeconomics conception of the labour market, which constructs unemployment as being a supply side phenomenon and hence quits as being countercyclical is to look at the quit rate. If you examine any data on quit rate behaviour from any country you will sese that the quit rate behaves in a cyclical fashion as we would expect – that is, it rises when times are good and falls when times are bad. Many studies have demonstrated this phenomenon for several countries where decent data is available.

Further, rates of layoff and discharges, which reflects the demand-side of the labour market are always firmly counter-cyclical as we would expect. Firms layoff workers when there is deficient aggregate demand and hire again when sales pick-up. Again this is contrary to the orthodox logic.

The clear significance of this behaviour is that the orthodox explanation of unemployment that Mankiw considers to be reasonable is not supported by empirical reality.

This sort of empirical reality induced famous institutional economist Lester Thurow to once ask (tongue in cheek):

… why do quits rise in booms and fall in recessions? If recessions are due to informational mistakes, quits should rise in recessions and fall in booms, just the reverse of what happens in the real world.

Given that quits are not countercyclical then the orthodox labour market model that constructs unemployment as being a supply-side phenomenon is plain wrong.

UK welfare cuts

The imposition of the ad hoc assertion that the substitution effect outweighs the income effect means that a rising real wage will elicit increased labour supply and vice-versa. What this means is that the rising cost of leisure is deemed (that is, asserted) to be a more important motivator than the extra income that the worker earns and so they work more as the real wage rises.

Okay, now we cross the Atlantic from Boston (where Mankiw hangs out) to the UK.

I arrived in the UK late Sunday and read the Independent (October 10, 2010) which carried the story –
Coalition hints at bringing end to universal benefit
– which outlined some of the details of the proposed welfare cuts that are being pursued in the UK to cut back the budget deficit.

You all know that I consider that the UK government should do exactly the opposite – increase the deficit so I won’t talk about that again in this blog (time!).

I will also write another blog another day on the concept of targetted benefits which I fully support. That is, there has been a creeping tendency under neo-liberalism to reward those with more political voice with government handouts (for example, in Australia the public subsidies to the private wealthy schools is a disgrace). So some of the UK welfare reforms are fine by my reckoning although the spending loss still has to be replaced.

However, the welfare-to-work reforms raised my ire. The Government policy changes will see:

3.5 million disabled people miss out on £9.2bn by 2015 – with the plan to move disabled people on to jobseeker’s allowance accounting for half the losses … The first wave of long-term claimants of incapacity benefit will be ordered back to work from tomorrow as new figures reveal the bill for keeping two million people on the sick has topped £133bn in the past decade.

So despite there patently not being enough jobs to go around the British Government is going to cut the income of the most disadvantaged citizens to “provide them with incentives” to work harder.

Think about Mankiw’s model which the UK conservatives would fully endorse given the economics they preach. A benefit cut is equivalent to a real wage cut. In the mainstream economics model, which rules in Boston, a real wage cut leads a worker to work less because the substitution effects (lower price of leisure) outweigh the income effects (lower income).

So in Boston, a lower real wage (net) allegedly forces a worker to work less whereas across the Atlantic a lower real wage is allegedly going to force a worker to work more.

My recommendation is that the conservatives get their stories straight.

My other recommendation is that they stop making stuff up and look out the window and represent the empirical literature faithfully.

In the case of the UK, where there is a major job shortage – workers are not on their “supply curves – that is, they are being significantly rationed by a lack of jobs. Cutting welfare entitlements and not providing extra jobs in return is just a cruel joke. All that policy will do is increase the hardship already experienced by the most disadvantaged.

In Mankiw’s case, I really wish his “textbook” model was an accurate description of how the world worked and the US government hiked taxes at the top end – then he might “go fishing” and stop lying to his students.

Conclusion

Weather is good here in London – chilly but dry. I went for a nice run in Hyde Park this morning so I could stomach the thought of writing a blog about Mankiw. Now I have other interesting things to work on.

That is enough for today!

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    This Post Has 44 Comments
    1. Most cabbies tend to work until they’ve earned what they feel is an adequate amount of money.

      This is actually a rather silly strategy because it means they work longer when demand is low.

      The smart cabbies work longer when demand is high, so they earn more money for doing less work.

    2. The Tea Party lunacy here in the States is obviously the marginally employed celebrating the decisions they made thirty years ago to have more leisure when the plutocracy they began to support back then finally succeeded in monopolizing all the resources of the nation while convincing the government it was powerless to do anything about it! See, rational actors do have perfect foresight: if the Tea Partiers get their way we will all get to enjoy the leisure they’re so avid for us to have!

    3. Let’s not forget the marginal competitive effect.

      Mankiw’s incentive to work in higher tax environment is decreased, so someone else takes his place and publishes an article. Mankiw continues to go on strike, defending his principles. The market substitutes other writers; some becoming well-known and respected.

      Mankiw is marginalized.

    4. “Further, there is a major problem with the conception of the work-leisure choice. Is the extra satisfaction gained from an extra hour of leisure always positive? Further, is the extra hour of work always bad? Both assumptions are required to motivate the orthodox model.”

      I could not help thinking of the theory of the protagonist in Alberto Moravia’s book, “The Empty Canvas”, that human progress is the result of boredom. ;)

    5. Well, I didn’t use to believe much in the backwards bending labor supply curve, but Mankiw is a perfect example of someone who will turn down paid work, so if he is paid less he might very well work more.

    6. Stupidity rules the world, one is amazed that it works at all.

      There must be plenty of subversive people out there that blatantly break the “laws” of economics on a regular basis.

    7. stone: (pre-emptive comment)

      Your comments about the financial sector and their bloating has got me thinking about how to regulate their speculative rubbish. It occurs to me that all legal contracts, no matter what their nature is, are backed by the government. If someone invests in a derivative, they are confident they will get some kind of asset back in return rather than the broker just running off with their money. This is because they sign a contract that is enforceable in the courts system. So state power is implicitly invoked in each contract.

      That means governments support derivatives trading by backing speculative contracts. They don’t have to! After all, right now you can’t legally take out a life insurance policy on another person (unless you are a corporation in the US – “dead peasants insurance”). Of course any mafia-style organization could in theory do that, but they could also just take your money and laugh at you – so it doesn’t happen.

      Hell, even the very concept of shares in a company is backed up by government fiat. I give a startup company money in return for “shares”. They are then legally bound to let me own a bit of the company – an obligation backed up by state power though the courts system.

      So the government doesn’t actually have to do anything to stop this stuff going on – they just have to stop actively supporting speculative behavior by not recognizing speculative contracts and they will go away.

    8. Bill,
      One of the “reforms” the coallition are making is to make people on Incapacity Benefit (ESA as it is now called) go through a 20 minute test to find as many reasons to deny them benefit as possible. This is not a flippant remark – it has happened to me!

      I would urge you to read the following report (if you have the time) from the Citizens Advise Bureau (CAB) – you will then understand the forces of darkness operating through both this and the last government – the new test proposed is even worse! The ‘Work Capability Assessment’ described is more-or less what I went through. It is meant to focus on what people ‘can’ do rather than what they ‘can’t’ do – so if you can brush your teeth then you can get-a-job!? In particular read the example cases printed in blue:

      Not Working

      They tried to kick me off benefits by lying about what I had said in my assessment. As a result of losing my benefits my family lost patience with me and kicked me out (again). They did not speak to me for 2 years. I went to a tribuneral and managed to get my Incapacity Benefit restored, but by then my anxiety and depression had got so bad that I was no longer able to take care of myself. I’m better now, but many people would have killed themselves having gone through that (and probably did).

      I now suffer from very poor memory and concentration (- I read your blog to exercise my brain and restore my concentration. This works very well (though it sometimes makes my depression a bit worse!?)).

      Kind Regards
      Charlie

    9. What is the point of having taxes at all in the MMT system? (leaving aside individual behaviour modification eg cigarette taxes) I understand that taxes were historically vital to the introduction of a fiat money system, but this function is largely superceded by the complete monetisation and bank credit-debt driven nature of the modern economy; all government has to do to ensure fiat paper retains value is to say that contracts not denominated in fiat paper will not be enforced by the courts.

    10. JamesH,

      Without progressive taxes we will very quickly realise who are the lords and who are the peasants. Not that it isn’t obvious today.

    11. JamesH:

      The problem would be high inflation. In the same way that an employment gap should be filled automatically with deficit spending (via automatic stabilizers like the Job Guarantee), high inflation should be dealt with semi-automatically by surpluses (minus JG outlays) when things are good. If you don’t have taxes, how can you possibly run a surplus (aka reducing net financial assets)?

      I say semi-automatically because unfortunately there doesn’t seem to be a program that can squeeze the private sector in a simple and automatic way to reduce an inflating economy. I understand that if the government wants to stabilize prices, it should let the JG take care of employment with a fixed wage and run a surplus in the rest of its budget. How much of a non-JG surplus it should run, however, is a difficult question to answer. So I don’t know of a symmetrical sister program that can do to inflation what the JG can do to unemployment.

      It would be awesome if there was such a program! Then you could have an economy that practically runs itself.

    12. “I say semi-automatically because unfortunately there doesn’t seem to be a program that can squeeze the private sector in a simple and automatic way to reduce an inflating economy.”

      The government can set prices it is prepared to pay for supplies. If it doesn’t get those prices then it stops spending. That reduces the money in supply and causes a deflation.

      The other option is a property value tax. Property doesn’t move and heat generally ends up as asset expansion. So tax property values.

    13. Neil,

      “The government can set prices it is prepared to pay for supplies. If it doesn’t get those prices then it stops spending. That reduces the money in supply and causes a deflation. ”

      A government isn’t good at setting prices, especially when it isn’t revenue constrained.

      If the government sets prices above the existing clearing price, then the price automatically rises to that level, and reduces the real spending capacity of the population.

      The other alternative is that all products have cleared at a certain price, or surplus exists, and government buying all the remaining products, then a company no longer has the structural price signal to decrease production.

    14. “A government isn’t good at setting prices, especially when it isn’t revenue constrained”

      Then it needs to get good at it, since that is one tool to control inflation.

      “If the government sets prices above the existing clearing price”

      Yet another ‘if’.

      I didn’t say that. I would suggest that it is a percentage below the current clearing prices to take into account the governments rapid and guaranteed payment. If prices move ahead of that, then government spending ceases on non-essential procurement forcing the prices back down due to a lack of currency injection into the economy.

      Essentially an ‘automatic stabiliser’ for government procurement spending to add to the ‘automatic stabiliser’ of the Job Guarantee. Both should work in cycle.

    15. I think the “linear” argument in this particular case is not valid. As far as I understand the Greatest Self-Promoting-Human-Robot inn Economics on Earth he makes his extra mental exercises on the margin not for selfish reasons. He wants to bestow as much financial wealth as possible on his kids. Apparently he assumes the little Mankiws will later in life inhabit a different economic universe. They will live a productive work life and render valuable services to humanity beside their rent income from Dad being such a successful fairy tale teller in economics.

      I hope in the coming days there will be a blog about the latest Nobel in Economics? I’ve never heard of a Peter Diamond et al. But now links to their work are of course all over the Internet and I had a short look. My impression so far: this Nobel seems to be the latest installment of the series “award for a brilliant mathematician for another proof that you can’t nail a pudding to the wall”. But I might be very wrong?

    16. Grigory Graborenko “So the government doesn’t actually have to do anything to stop this stuff going on – they just have to stop actively supporting speculative behavior by not recognizing speculative contracts and they will go away.”
      I think the massive problem is identifying what are and what are not speculative contracts. I think it is the same problem I have with Tom Hickey’s assertion that “economic rent seeking” can be distinguished from productive investment such that one is taxed away whilst the other is allowed to florish. I completely agree with you that the oligarchy are entirely dependent on government fiat to enforce property law. That is why I think all tax should be in the form of a wealth tax where inorder to own something (such as a speculative contract :) ) you would have to be up to date with having paid tax on it.

    17. JamesH “What is the point of having taxes at all in the MMT system?” -to me the point of them is to prevent a build up of savings in the non-government sector.

    18. Grigory Graborenko says:
      Wednesday, October 13, 2010 at 9:36
      stone: (pre-emptive comment)
      “It occurs to me that all legal contracts, no matter what their nature is, are backed by the government. If someone invests in a derivative, they are confident they will get some kind of asset back in return rather than the broker just running off with their money. This is because they sign a contract that is enforceable in the courts system. So state power is implicitly invoked in each contract.”

      That comment has me in stitches.
      Um, a derivative is an over-the-counter agreement BASED ONLY on the performance of some underlying physical commodity or financial instrument.
      ie. it is NOT a physical asset per se.

      To imply there is any government collusion or backing is ludicrous. Perhaps the nature and obligations in the agreement between the 2 parties may be enforceable in a court of law but that would be it.

      I find it interesting how the MMT’ers take particular aim at banks and those in the financial markets when arguably there is far greater injustice within the ‘real’ economy. Unscrupulous businesspeople, bribery within the government, whole industries consistently avoiding payment of taxes and promotion of the cash economy. These bear far more hardship and financial burden on the average Joe Taxpayer over the long term than what those evil scheming investment banker devils ever could.
      Then again it is probably more a case of good old Aussie tall poppy syndrome from our learned academics and their career students.

    19. Ray:

      “ie. it is NOT a physical asset per se.”

      That’s why I said “some kind of asset”. Doesn’t change the fact that it can be onsold and converted into currency – an asset is something that’s worth something. Doesn’t have to be physical. Just like numbers in a bank account.

      “To imply there is any government collusion or backing is ludicrous. Perhaps the nature and obligations in the agreement between the 2 parties may be enforceable in a court of law but that would be it.”

      That backing in the court of law is critical precisely because of how intangible derivatives are. A derivative is basically nothing BUT a contract. The worth of a contract is completely dependent on their enforceability. If there was no state backing, no one would buy them because their worth would entirely rest on trust, and there is precious little of that amongst strangers.

    20. stone:

      “I think the massive problem is identifying what are and what are not speculative contracts.”

      That may be in part due to how the financial sector has deliberately made these securities as confusing as possible to avoid regulation. It might be fairly easy if you start from a “what don’t we ban” perspective. Stuff to keep would be insurance on your own physical property and health (or physical assets directly owned by a company). Direct shares in companies. Patents. Stuff that can be justified as being productive in a fairly simple way. No more of this put and get options rubbish.

      It seems like destructive bubbles need two things: lack of regulation (ie state enforcement of pretty much any contract you can think of) and income inequality. Both need to be dealt with.

    21. Ray, I don’t make any pretense not to be grossly ignorant of the financial world. I apologize if I make criticisms based on ignorance and really welcome corrections. About your point: “Perhaps the nature and obligations in the agreement between the 2 parties may be enforceable in a court of law but that would be it.”-Isn’t Grigorys point a valid one that that legal enforcement is extremely important. People will buy/enter into? (if that is the correct term) an option or future or whatever they are in Wall Street or City of London but they would not in say Somalia because of the legal system backing it. You say derivatives are not assets. To my mind if something can be exchanged for cash by one or other party, then it is an asset for someone. Is it not possible to do that with a derivative? The financial report for the Wellcome Trust is my default place to look at to try and get a window into that world. They say that for 2009 they had “options (£5M), futures (£827M), futures and options collateral offset (£832M)”. Clearly they are somehow relating a value (or liability?) in £ to those derivatives. I suspect that Australia is much less far down the financialization path than we are in the UK and USA and perhaps that is why it seems so much worse from over here.

    22. Grigory Graborenko, my impression is that if money for investment had much greater scarcity value then that in itself would help a great deal with causing the financial system to shift from ponzi investment to seeking real earnings. I do agree that bamboozalment is a critical weapon in the financialization armoury. Basically “smart money” wins by out smarting “dumb money” and the more complex and impenetrable the system the greater the scope for the “smart money” to rip off the market. The futures and options hedging contracts seem to the uninitiated (like me) to be a way for “smart money” to smooth out volatility so allowing greater use of leverage and also to suffer less “buy high sell low” losses than the “dumb money”- and in so doing beat the market (ie rake money in from pension funds who are the “dumb money”).
      Ray- You seem to say that people overstate the significance of the FIRE sector- do you deny that as a proportion of corporate profits or GDP it is expanding massively? The proportion of people in the fortune 400 who are from the FIRE sector has gone up decade by decade. I’m not convinced that that is not the key problem. I don’t blame the people involved especially- I think that it is just an inevitable symptom of having an expanding currency system (expanding both from bank created money and from government created high powered money).

    23. Ray,

      “MMT’ers take particular aim at banks and those in the financial markets when arguably there is far greater injustice within the ‘real’ economy. Unscrupulous businesspeople, bribery within the government, whole industries consistently avoiding payment of taxes and promotion of the cash economy. These bear far more hardship and financial burden on the average Joe Taxpayer over the long term than what those evil scheming investment banker devils ever could.”

      I know you work in the sector and it is a sensitive topic. But there are a lot of people who will disagree with you. The financial sector has unique talents. They have the ability to touch each and every one of us in every aspect of our life. When the sector screws up, we have little or no choice but too accept the consequences. If banks decide to relax housing credit criteria, every one who owns a house will pay more for housing. When the banking industry creates too much credit and puff a bubble everyone is impacted. Yes there are RE agents, over leveraged borrowers and developers who also have an odorous taint, but the master pupeteers are in the big banks. In addition the financial sector is the conduit of all financial scams.

      If some businessman overcharges on cabbages or cheats on TV warranty, we can often choose other trusted brands. By and large we can avoid most corrupt businesses. I don’t despise every finance worker. I’ve met a few good ones. I will always reserve a special place in my heart for financial misdemeanors. They make the biggest screw ups and have a bigger negative impact on my life than any other industry. I also dislike the telecomm, oil and coal industries if that’s any consolation.

      I will let up, when I see the financial sector deliver good utility to society in an efficient manner. They are a long, long way away today.

    24. @stone

      “to me the point of them is to prevent a build up of savings in the non-government sector.”

      That’s because your gun is off target. There is nothing at all wrong with a build up of savings in the non-government sector. That is voluntary economic suppression that takes spending out of an economy and at a micro level people need to save to defer consumption for later when perhaps their earnings are not as great.

      Anything that interferes with that is a political non-starter.

      It’s the flows that cause the problems.

    25. Ray I needed to check it out “Tall poppy syndrome (TPS) is a pejorative term used in the UK, Ireland, Australia, and New Zealand to describe a social phenomenon in which people of genuine merit are resented, attacked, cut down, or criticised because their talents or achievements elevate them above or distinguish them from their peers.”- If you consider that the achievements of the FIRE sector elevates them above their peers- then please put me right. If you are just saying that the talents of the FIRE sector elevates them above their peers- then who gives a shit about that :). I totally agree that bankers typically work harder and are smarter than those such as me who slag them off. I also consider that a particularly stupid argument for an enlarged unregulated FIRE sector. Somali pirates put their lives on the line in order to rip us off- does that justify what they do? If someone is cleverer than me then I think they are LESS deserving of hand outs. Let’s face it creaming off money due to having manipulated the government into relaxing regulations and fostering asset price inflation is at best receiving a hand out.

    26. Ray:

      Um, a derivative is an over-the-counter agreement BASED ONLY on the performance of some underlying physical commodity or financial instrument.
      ie. it is NOT a physical asset per se.

      Say, you agree today to buy heating oil at $3 a gallon to be delivered to your house by a heating oil company in a month (or on a regular basis). Would oil be an un-real physical asset ?

      Say, you buy a pair of shoes by entering into an implicit contract between you and the seller. Would a pair of shoes be an unreal physical asset ?

    27. Neil Wilson “at a micro level people need to save to defer consumption for later when perhaps their earnings are not as great.”- I totally agree with that- but for every such person there is another person at a different life stage or whatever who is drawing down savings. Letting global aggregate net savings increase is just increasing money that is never to be spent and yet consumes manpower in managing it and distorts the economy by creating a ponzi effect on asset prices.

    28. Neil,

      > “A government isn’t good at setting prices, especially when it isn’t revenue constrained”

      “Then it needs to get good at it, since that is one tool to control inflation.”

      It will never get good at it, it’s an inherant feature of government to be poor at pricing. If a party is not reenue constrained, it’s will automatically be less discerning at what price it will pay. Democratic governments in particular will succumb to populist sentiment in determining the acquisition of a product, and price will be a secondary consideration.

      ————

      > “If the government sets prices above the existing clearing price”

      “Yet another ‘if’. ”

      Of course another if. In the event of a government procuring product, a pricing condition has to be met. It isn’t a null hypothesis.

      “I didn’t say that. I would suggest that it is a percentage below the current clearing prices to take into account the governments rapid and guaranteed payment.”

      Erhhh, if the proper clearance price is in existence, then a surplus will not exist. A surplus will not exist if the price is too high. There will be no incentive to lower this price if government guarantees to buy the product.

      “If prices move ahead of that, then government spending ceases on non-essential procurement forcing the prices back down due to a lack of currency injection into the economy.

      Essentially an ‘automatic stabiliser’ for government procurement spending to add to the ‘automatic stabiliser’ of the Job Guarantee. Both should work in cycle.”

      It won’t work at all. An increase in productivity should see an decrease in real prices. There will never be an incentive to increase productivity if a floor in real prices is set by government. Extra product will be made knowing it will be sold, without attempting to achieve a reduction in the marginal cost of production, which is what enterprise seeks to do to ensure an increase in the standard of living.

    29. Aaron,

      You are forgetting the monopoly power of the currency issuer.

      From Warren Mosler’s ‘7 deadly frauds’ book. pp114 –

      “What does this mean? It means that since the economy needs
      the government spending to get the dollars it needs to pay
      taxes, the government can, as a point of logic decide what it
      wants to pay for things, and the economy has no choice but to
      sell to the government at the prices set by government in order
      to get the dollars it needs to pay taxes, and save however many
      dollar financial assets it wants to.”

    30. “Democratic governments in particular will succumb to populist sentiment in determining the acquisition of a product, and price will be a secondary consideration.”

      Then you outsource it to an ‘independent’ quango, as they have done with Interest Rates.

    31. Grigory Graborenko says:
      Wednesday, October 13, 2010 at 20:46
      “The worth of a contract is completely dependent on their enforceability. If there was no state backing, no one would buy them because their worth would entirely rest on trust, and there is precious little of that amongst strangers.”

      GG, that is actually a very interesting point.
      Disputes between banks about who did or did not honour their obligations with complex financial derivatives once plagued courtrooms which did not have the precedent not brain power to resolve. A bit like asking corporate lawyers to resolve whose version of string theory best describes life, the universe and everything.

      While all derivatives are agreed with a common legal jurisdiction (usually London), 99.9% of disputes are resolved by negotiation and conscience as the parties know the costs of re-educating judges each time they have a spat. The other 0.1% is usually NY DA’s looking for self-promotion or stupid US State Treasurers looking to pin their ineptitude and poor investment decisions on someone else.

    32. Stone,
      “You say derivatives are not assets.”

      No I didn’t, I said it “is NOT a physical asset per se”.

      They have financial value (ie. if fly 1 climbs up the wall before fly 2 then Bank A pays Bank B $1mm) and therefore may sit as assets or liabilities on each of the Banks’ balance sheets at their mark-to-market valuations but it is credibility of the writer of the derivative which often gives accountability rather than the legal system. For example if a Somalian warlord wrote a contract to you based on how many ships his pirates could steal in a year, I doubt there would be payment even if it was struck under UK law. And because the UK Govt was not a party during the striking of the contract, they may allow the dispute to be heard in one of their courts but their verdict would not then give you the right to sue the courts for damages.

      The distinction is between financial asset and physical asset and this is where the legal system stumbles in its ability to understand and enforce.

    33. VJK says:
      Thursday, October 14, 2010 at 0:58
      “Say, you agree today to buy heating oil at $3 a gallon to be delivered to your house by a heating oil company in a month (or on a regular basis). Would oil be an un-real physical asset ?
      Say, you buy a pair of shoes by entering into an implicit contract between you and the seller. Would a pair of shoes be an unreal physical asset ?”

      The derivative is the contract struck between the 2 parties NOT the commodity. At the time of striking the deal there is no exchange, therefore no physical asset. On your 2nd example there is no price or performance/timeframe mentioned so it is not even a financial derivative.

      Derivatives are financial assets, not physical ones.

    34. “The derivative is the contract struck between the 2 parties NOT the commodity. ”

      The forward contract above ultimately requires commodity delivery, thus it’s not divorced from the underlier. In any case, it’s not separable from the underlier.

      A contract to purchase a house with a closing date one/two months away would be a forward contract as well.

      A better example may be convertible bonds and warrants that are in fact assets while being derivatives. So, the difference between assets and derivative is not so clear cut as one might imagine.

    35. Ray:

      “99.9% of disputes are resolved by negotiation and conscience”

      Of course! That’s one of the main points of the legal system – to provide a smooth and stable environment for commerce. The negotiation takes place because both parties don’t want to enter the court system. Even in the most amicable conversation between business people, there is always awareness that they operate in a rule-based economy ultimately enforceable through the courts. Everyone knows that if push came to shove, contracts have real power – state based power. Consider it a deterrant, or implicit threat.

      It’s like saying murder isn’t discouraged by the government because 99.9% of people don’t get charged for murder. It’s the 0.1% that are punished by the state that create the safe conditions for the rest of us. That’s what I mean by implicit backing through the legal system – the assumption that if things go wrong, the government will be there for you.

    36. ‘balanced budget’ stone:

      Let’s say current account def is 3% of GDP, private sector saving 7% and budget deficit 10%. You’d actually favour balancing the budget and forcing the private sector to increase it’s net debt by 3% of GDP?

      Strewth.

    37. Ray, how about enforceability of derivatives in Iraq? What would be your estimate of out-of-court settlement, in-the-court settlement and trading volumes in general?

    38. Neil,

      “Aaron,

      You are forgetting the monopoly power of the currency issuer.

      From Warren Mosler’s ’7 deadly frauds’ book. pp114 –

      “What does this mean? It means that since the economy needs
      the government spending to get the dollars it needs to pay
      taxes, the government can, as a point of logic decide what it
      wants to pay for things, and the economy has no choice but to
      sell to the government at the prices set by government in order
      to get the dollars it needs to pay taxes, and save however many
      dollar financial assets it wants to.”

      That just says the government has to spend it on something. However I’d rather the government not engage on spending on ‘stuff’ the economy doesn’t need. If the right clearance price is set by the producer, and can be met by the consumer, there will be no surplus for the government to then buy the remaining.

      What you’re encouraging is a producer, and by default every producer to produce an amount in excess of the consumers needs or desires, up to the point where it marginal production costs still remain below the purchase price offered by the government.

      >“Democratic governments in particular will succumb to populist sentiment in determining the acquisition of a product, and price will be a secondary consideration.”

      “Then you outsource it to an ‘independent’ quango, as they have done with Interest Rates.”

      These independant bodies are still prone to government pressure, or ideologues penetrating and corrupting it. The GFC is the surest sign of this.

      Inflation had been systematically understated, thus cash rates world wide set too low. The systmeatic fault came from ideologues driving the measurement criteria.

      What we had was an arbitrary measure of inflation imposed on savers, which didn’t reflect on reality and savers had no recourse. There is two sides of the equation when parties of the private sector borrow off another party of the private sector, and this should happen at the real price. With an arbitrary measure from this ‘indepedant quango’, savers had no power to be a price maker.

    39. MMT Proselyte:”Let’s say current account def is 3% of GDP, private sector saving 7% and budget deficit 10%. You’d actually favour balancing the budget and forcing the private sector to increase it’s net debt by 3% of GDP?”- I’d actually favour balancing the budget and so force the trading partners to spend the USD they are currently hoarding by for instance paying their workers more such that the workers can afford to buy goods from the USA etc. If you have balanced budgets it becomes an accounting impossiblity to run long term trade deficits. That is one of the key reasons why I consider it essential to have balanced budgets so as to prevent the gross inequities of long term trade deficits. Lets face it credit is only available to the wealthy anyway. The least well off people in the UK certainly can not access credit. Some well off people might respond by going into debt but that could only be a temporary thing, sooner or later there would need to be balanced trade.

    40. Aaron,

      I’m an operational kind of guy. And I don’t believe I mentioned anything about clearance pricing or buying things that aren’t required.

      Is Warren right or wrong in what he’s saying? A government sets a price of £2 million for a school and gets no bids, so it shelves the project. Assume that if this had been spent net-saving would have been covered. Will the £2 million spending shortfall in the private sector economy tend to force prices down or not.

      In other words does the government have monopoly pricing power via its ownership of the currency.

    41. Aaron: “What you’re encouraging is a producer, and by default every producer to produce an amount in excess of the consumers needs or desires, up to the point where it marginal production costs still remain below the purchase price offered by the government.”

      I do not think that that is what Mosler is saying. For one thing, it isn’t just the consumers’ needs or desires, it is also their ability to pay. In a depressed economy their ability to pay is greatly diminished. For another, one way of describing our current predicament is as a general glut — except for the medium of exchange. So excess production is not really being called for, I think. For instance, an infrastructure project might use resources that were not specifically earmarked for infrastructure, but were readily available. Now, it might also use resources that were not readily available, but if that were mainly the case for projects in general, the economy would be humming along, wouldn’t it? And then the gov’t would not need to spend so much, would it?

    42. Stone – a balanced budget means something’s gotta give; we agree that. But hoping that the trade deficit will give first seems unwise. You may be right that the poorer 50% may have less access to credit, but they’re also the ones who disproportionately want to delever – and a balanced budget slows that process.

      Your argument that a balanced budget means no long term trade deficits also looks dubious – the limiting factor is the propensity of the private sector to run up debt – so to test your theory we’d end up pushing all sorts of leverage-driven asset bubbles to see at what point the imbalance snaps back towards balance. Disastrous.

    43. MMT Proselyte-I guess the exchange rates would become much more sensitive to trade deficits if there were non-expanding currencies. The much sharper exchange rate effects would be what would prevent trade deficits. The whole idea that if money is tight, people go into debt seems so dubious to me. People went into debt on the belief that rising asset prices would give them a free lunch- it was all “equity release”. If house prices had not been increasing the loans would not have been made.

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