In yesterday’s blog, I mentioned that Paul Krugman gave a plenary lecture over the weekend just gone at a conference held at Cambridge University. The conference – 75th Anniversary of Keynes’ General Theory – seems to have been a remarkable event. First, I don’t know everything but I always know when there is a major “Keynesian/Post Keynesian” conference and sometimes I even go. In the case of the 75th Anniversary conference I didn’t even know it was being held. It seems that wasn’t exceptional. As Ann Pettifor points out the UK Post Keynesian Economics Study Group, which is a leading group who focus on studying Keynes and, arguably, has the leading UK Keynesian scholars among its membership, “found out about the conference by accident.” Second, if you examine the speaker’s list and read the papers that are available you might wonder what this conference had to do with Keynes. Certainly if the Cambridge organisers were aiming to “honour” the message that Keynes gave, then they had a strange way of doing that. The reality is that the celebration of 75 years since Keynes was a farce.
Second, if you examine the speaker’s list and read the papers that are available you might wonder what this conference had to do with Keynes. Certainly if the Cambridge organisers were aiming to “honour” the message that Keynes gave, then they had a strange way of doing that.
One might think that one of the major messages that Keynes sought to focus on was the role that effective demand played in creating unemployment – a state he considered to be beyond the capacity of the workers to remedy – hence his terminology involuntary unemployment.
The current economic crisis has brought mass unemployment into focus with some advanced nations enduring jobless rates of between 15-20 per cent and world leading nations struggling at around 8-10 per cent. After three years of crisis the unemployment situation hasn’t really improved.
Keynes would have had a lot to say about that and so I thought a conference “celebrating” his General Theory (published in 1936) at the height of the Great Depression would seek to have sessions staffed with experts in the field that explored this issue. After all, historically, the current crisis is the worst since the Great Depression so there is continuity with Keynes in that fact.
There was only one paper explicitly about unemployment in the program and was presented by an economist affiliated with the European Central Bank (ECB), which was one of the sponsors of the conference.
Over the last decade or so, I have noticed that the ambit of certain conferences has changed as they introduce new sponsors. In Australia, the once excellent Labour Market Workshop (an annual event) has become diminished (in my view) by the way in which the “new” sponsors – the Federal Government – manipulated the themes to promote papers that advanced their neo-liberal agenda.
The other insight is that the “unemployment” paper tells us that it was actually “Prepared for the NBER Macroeconomics Annual 2011 Conference, held in Cambridge, MA on April 8-9, 2011”. The NBER provides an avenue for the mainstream economists to build national prestige and a range of influential appointments. If you examine the research and publication agenda of the NBER you will appreciate that it continually promotes neo-liberal economic policies including the privatising the US pension and the health systems and the optimality of deregulating the financial sector. Please read my blog – Martin Feldstein should be ignored – for more discussion on this point.
The NBER Macroeconomics Annual Conference has always been a showcase for the worst in macroeconomics. So a paper that was written for that conference would hardly seem fit to be worthy of inclusion in a conference celebrating the work of Keynes.
The “unemployment” paper – Unemployment in an Estimated New Keynesian Model begins with a confession:
Over the past decade an increasing number of central banks and other policy institutions have developed and estimated medium-scale New Keynesian DSGE models. The combination of a good empirical fit with a sound, microfounded structure makes these models particularly suitable for forecasting and policy analysis. However, as highlighted by … [many economists] … one of the shortcomings of these models is the lack of a reference to unemployment. This is unfortunate because unemployment is an important indicator of aggregate resource utilization and the central focus of the policy debate.
DSGE – or Dynamic stochastic general equilibrium models are one of the latest fads of the mainstream – who are intent on remaining irrelevant.
Even mainstreamers like Willem Buiter described DSGE modelling as The unfortunate uselessness of most ‘state of the art’ academic monetary economics.
And you might like to read the evidence that Robert Solow gave to the US Congress Committee on Science, Space and Technology – in its sub-committee hearings on Investigations and Oversight Hearing – Science of Economics on Jul 20, 2010. The evidence is available HERE.
Here is an excerpt relevant to the topic:
Under pressure from skeptics and from the need to deal with actual data, DSGE modellers have worked hard to allow for various market frictions and imperfections like rigid prices and wages, asymmetries of information, time lags, and so on. This is all to the good. But the basic story always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This can not be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.
An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.
Solow also said that the DSGE fraternity “has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the “conclusion” that there is nothing for macroeconomic policy to do”.
None of the DSGE models (or papers) anticipated the financial crisis despite the portents of it being obvious for at least a decade or more.
In our recent book (2008) – Full Employment abandoned – we consider the standard DSGE approach in detail. I summarised a bit of that discussion in this blog – Mainstream macroeconomic fads – just a waste of time.
The alleged advantage of the New Keynesian approach (which incorporates DSGE modelling) is the integration of real business cycle theory elements (intertemporal optimisation, rational expectations, and market clearing) into a stochastic dynamic macroeconomic model. The problem is that the abstract theory does not relate to the empirical world. To then get some traction (as Solow noted) with data, the “theoretical rigour” is supplanted by a series of ad hoc additions which effectively undermine the claim to theoretical rigour.
You cannot have it both ways – first, try to garner credibility by appealing to the theoretical rigour of the model – but then, second, largely compromise that rigour to introduce structures (and variables) that can relate to the real world data.
This is the fundamental weakness of the New Keynesian approach. The mathematical solution of the dynamic stochastic models as required by the rational expectations approach forces a highly simplified specification in terms of the underlying behavioural assumptions deployed. As Solow says this simplicity cannot remotely relate to the real world.
Further, the empirical credibility of the abstract DSGE models is highly questionable. There is a substantial literature pointing out that the models do not stack up against the data.
Clearly, the claimed theoretical robustness of the DSGE models has to give way to empirical fixes, which leave the econometric equations indistinguishable from other competing theoretical approaches where inertia is considered important. And then the initial authority of the rigour is gone anyway.
This general ad hoc approach to empirical anomaly cripples the DSGE models and strains their credibility. When confronted with increasing empirical failures, proponents of DSGE models have implemented these ad hoc amendments to the specifications to make them more realistic. I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.
But the worst examples are those that attempt to explain unemployment. Various authors introduce labour market dynamics and pay specific attention to the wage setting process. One should not be seduced by DSGE models that include real world concessions such as labour market frictions and wage rigidities in their analysis. Their focus is predominantly on the determinants of inflation with unemployment hardly being discussed.
Of-course, the point that the DSGE authors appear unable to grasp is that these ad hoc additions, which aim to fill the gaping empirical cracks in their models, also compromise the underlying rigour provided by the assumptions of intertemporal optimisation and rational expectations.
The Cambridge paper is no exception. It claims that in relation to the failure to include any fundamental explanation for unemployment, a number of DSGE papers “have started to address this shortcoming by embedding in the basic New Keynesian model various theories of unemployment based on the presence of labor market frictions”. None of these papers are capable of understanding mass unemployment.
Do they really want us to believe that the world economy just encountered a massive build up of frictions within a short period of time starting mid-2008?
The Cambridge paper has a new twist – unemployment in their model:
… results from market power in labor markets, reflected in positive wage markups. Variations in unemployment over time are associated with changes in wage markups, either exogenous or resulting from nominal wage rigidities.
Keynes would have turned in his grave. His concept of involuntary unemployment had nothing to do with frictions or rigidities. He absolutely rejected the idea that if you eliminated downwardly rigid money ways (and implemented the classical dream) involuntary unemployment would fall.
Indeed, it could get worse because the reduction in money wages may have caused a further reduction in aggregate (effective) demand. It was the state of demand (spending) at the macroeoconomic level that caused mass unemployment.
Please read my blog – What causes mass unemployment? – for further discussion.
In the Cambridge paper, despite pages of mathematical reasoning, the essential message is the same as all mainstream approaches. Unemployment arises because workers insist on a real wage above the perfectly competitive outcome. So while they claim that at the “business cycle frequency” demand shocks drive unemployment this only occurs (in their model) because real wages are rigid and excessive.
So the fluctuations of unemployment around its “perfectly competitive or natural rate”:
… should thus be attributed to the presence of wage rigidities, interacting with the different shocks.
This is an anti-Keynes result.
The Cambridge paper provides a Figure 1 to outline their wage mark-up model in simple terms. It is a very standard marginal productivity classical labour market which I explain in more detail in this blog – Money neutrality – another ideological contrivance by the conservatives.
Here is a summary. The simple classical model (which the Cambridge paper doesn’t improve on but is consistent with) claimed that to examine household choice, we only need to know: (a) the initial goods endowment (wealth); (b) the terms of exchange between goods; and (c) Tastes and preferences of households. The first two define household income.
They consider two goods: (a) Corn (C); and (b) Leisure (L). The relative price of leisure is number of units of C that you give up to have one unit of L. Giving up L involves offering equal units of labour so relative price of leisure is the real wage rate, w. The relative price of corn is thus 1/w.
So the workers are deemed to have a labour-leisure choice (per day). Unemployment equals leisure.
The Classical labour market is represented by the following figure:
The real wage is w and 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 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 (in the simple model – units of Corn). 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.
There are complications when the real wage changes (which I explain in the more detailed blog) but essentially the upshot is that the worker will supply more labour when the real wage rises and less when it falls. Hence the positive sloped labour supply curve.
The model assumes there are millions of firms and labour is one factor of production and indistinguishable from any other (inanimate) input. The single good is produced (Corn). Technology defines a “production function” which maps how much output is gained by adding successive units of input to a “fixed” stock of capital.
The downward-sloping labour demand (Ld) function is determined by the ad hoc imposition of the so-called law of diminishing returns which claims 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.
There are many things wrong with this stylised interpretation which I explain in the referred blog.
So firms will only hire if what they get from the worker at the margin (the marginal product) is equal to what they have to give up in real terms (the real wage).
Given the assertion of diminishing marginal products the firms know that as the real wage falls (on the vertical axis of the labour market diagram) firms will hire an additional worker (who is less productive at margin than last hired).
If you put the supply and demand ideas together you get the classical labour market which guarantees continuous full employment. With no borrowing or lending (simplifying assumption), then a price adjusting economy (if excess demand, price rises) will always guarantee full employment. If there is unemployment (that is an excess supply of labour) then the real wage will fall and vice versa.
In the corn economy this is a simple proposition. If there are workers wanting a job who do not have one then the corn wage falls and firms react by hiring more workers because it is profitable to do so at the lower rate. The corn wage falls until all those who want to work have a job.
So unemployment can only arise if the real wage is above the competitive level (w*) at point A.
These models thus say that if the real wage is free to adjust then the economy would never have involuntary unemployment. There can never be what we call generalised over-production – that is, where firms supply more than is demanded in aggregate.
Keynes showed categorically that you could get generalised over-production with or without flexible real wages. In terms of the diagram above, consider the vertical line that hits the horizontal axis at E1. This is what we might consider to be an aggregate demand constraint on the labour market – that is, total consumption, investment, government spending and net exports generates this much demand for labour (E1).
You can readily appreciate that even if the “classical labour market” was a accurate depiction of how things work then the aggregate demand ration changes everything.
Imagine if we were truly at Point B initially (or the point in the Cambridge paper’s Figure 1 where they claim unemployment can exist). The real wage is at w1 and unemployment in this model (the difference between labour demand (B) and labour supply (C) at that real wage) is the quantity BC. So the Cambridge paper calls this a wage markup rigidity interacting with a shock!
If there was no change in the macroeconomic level of aggregate demand (so the vertical ration line remains fixed) and we somehow cut the real wage to w* would we eliminate unemployment?
The answer is no because the level of employment is a function of the level of effective demand (the vertical ration line). Even if workers are “cheaper” to hire firms will not take on extra workers to produce things they cannot sell.
The argument gets more complicated than that but I will leave it there.
The point is that this paper on unemployment at the 75th celebration of the General Theory and at a time when unemployment has clearly sky-rocketed around the world is a disgrace to our profession. It is just another gymnastic exercise that has no relevance to the real world.
Krugman at Cambridge
And as to Paul Krugman’s plenary lecture which I only touched on yesterday – here is a glaring example of where his analysis goes astray.
After attacking the mainstream paradigm for not learning the lessons provided by Keynes, Krugman writes:
I’m not quite done here. If much of our public debate over fiscal policy has involved reinventing the same fallacies Keynes refuted in 1936, the same can be said of debates over international financial policy. Consider the claim, made by almost everyone, that given its large budget deficits the United States desperately needs continuing inflows of capital from China and other emerging markets. Even very good economists fall into this trap. Just last week Ken Rogoff declared that “loans from emerging economies are keeping the debt-challenged United States economy on life support.”
Um, no: inflows of capital from other nations simply add to the already excessive supply of U.S. savings relative to investment demand. These inflows of capital have as their counterpart a trade deficit that makes America worse off, not better off; if the Chinese, in a huff, stopped buying Treasuries they would be doing us a favor. And the fact that top officials and highly regarded economists don’t get this, 75 years after the General Theory, represents a sad case of intellectual regression.
Here is the full article by Rogoff that is being referred to – After the Scandal, More of the Same at the I.M.F. (June 15, 2011).
We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings. This claim is particularly potent in the current US-China context which Krugman acknowledges.
He refutes that claim by arguing that: (a) there is already plenty of savings in the US at present given the collapse in private spending; and (b) if the Chinese stopped buying government bonds this would manifest in a smaller trade deficit which he thinks is good.
From the perspective of Modern Monetary Theory (MMT) trade deficits make a nation better off – not as Krugman suggests worse off. We normally measure standards of living (or welfare) in real terms (that is, separating out the inflationary impacts from what lies underneath – access to real goods and services).
I realise that the conception economists have of welfare and real income is highly flawed given that it typically fails to incorporate transactions that are not included in the narrow GDP measure – such as, environmental degradation. But that failure doesn’t alter the point.
In MMT, the “Chinese are bailing us out” claim makes no sense. A trade deficit can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the trade deficit. This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the trade deficit, which, in turn, enjoys a net benefit (imports greater than exports). A trade deficit means that real benefits (imports) exceed real costs (exports) for the nation in question.
A trade deficit signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance our trade deficit) on its head in recognition of the true nature of exports and imports.
Subsequently, a trade deficit will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the trade deficit gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.
We should also comprehend what a trade deficit means for a nation in financial terms. It is essential to understand the relationship between the government and non-government sector first. A common retort is that this blurs the private domestic and foreign sectors. But the transactions within the non-government sector are largely distributional, which doesn’t make them unimportant, but which means you don’t learn anything new about the process net financial asset creation.
In the case of a trade deficit, what mostly happens is that local currency bank deposits held say by Australians are transferred into local currency bank deposits held by foreigners. If the Australian and the foreigner use the same bank, then the reserves will not even move banks – a transfer occurs between the Australian’s account in say Sydney, to the foreigner’s account with the same bank in say Frankfurt.
The point is that the AUD never leaves “Australia” no matter who is holding it. The same goes for the USD and all the fiat currencies.
If the transactions span different banks, the central bank just debits and credits, respectively, the reserve accounts of the two banks and the reserves move.
What happens next depends on the approach the commercial banks take to the reserve positions. We know that, in the absence of a central bank payment for excess reserves held with it, then the existence of excess reserves put downwards pressure on overnight interest rates and may compromise the rate targetted by the central bank.
The only way the central bank can maintain control over its target rate and curtail the interbank competition over reserve positions is to offer an interest-bearing financial asset to the banking system (government debt instrument) and thus drain the excess reserves. It can also just offer a return on excess reserves.
Krugman also thinks that Americans will be better off with less imports relative to exports. This is a common thread that runs through the mainstream view – that policy should be focused on eliminating trade deficits. From the perspective of MMT this would be an unwise strategy.
First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.
Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).
Second, trade deficits reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.
A trade deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.
As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.
However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.
Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.
The national government can always service its debts so long as these are denominated in domestic currency. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.
In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.
Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.
Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.
I would qualify this assessment in this way.
Ross Gittins (Sydney Morning Herald economics writer) wrote today (June 22, 2011) in – Iron-clad formula for decades of prosperity that:
For many years – most of the second half of the 20th century – it looked like Australia was on the wrong tram. In a world of ever-more high-tech, sophisticated manufactured goods, we were hewers of wood and drawers of water. To put it less biblically, we paid for our imports mainly by growing things in the ground or digging stuff out of the ground.
His basic hypothesis is that for years Australia was considered backward because we hadn’t developed high-tech IT and value-adding industries. We were after all a whole in the ground and when we weren’t digging up and exporting minerals we grew things and exported them instead. Steadily, our export prices were falling and it was predicted we would end up a backwater. I sympathise with the view expressed by Gittins in this article.
But for our purposes, when MMT considers exports to be a cost and imports to be a benefit it doesn’t specify absolutes. Digging huge holes in the ground and loading the contents onto ships to be used elsewhere is definitely a cost in the sense that these resources could have been deployed in domestic uses. The other angle to the cost argument is the legacy that certain export industries leave once they decline or relocate. If you ever catch a small plane from Newcastle and head west you soon see the incredible scarring that the coal industry (one of the world’s largest areas of mining) has left. The damage to the natural terrain is substantial.
The question then is how much of a cost giving up some minerals represents. Very few labour resources are deployed in the mining sector. What better use could the ore be put to? My sense is that the “cost” to us of exporting our minerals is relatively small when measured in opportunity cost. Having said that I would prefer them to be left in the ground and we developed eco-tourism instead.
The point is that the real terms of trade are very much in our favour. Other nations desire a resource that I doubt we could use (to the same value) ourselves. In return, because the terms of trade have moved so far in our favour, we can enjoy a range of products that we cannot make ourselves.
The last word on the Cambridge Conference goes to Ann Pettifor:
The impression created is of an economics profession actively seeking to exclude any Keynesian challenge to an orthodoxy that has so patently failed society. As we seek solutions to rising unemployment, bank and business failures, debt-deflation and sovereign debt crises, the determination of a group of economists at an elite University – Keynes’s University – further to close down debate on alternatives should be a matter of the greatest possible concern to the public at large.
My profession has set up an elaborate set of checks and controls to suppress debate – journal editorships, grant body stacking, appointments bias, curriculum domination and more.
I guess the “Keynesian” group in Britain especially are miffed that they have been boycotted by this event.
But the Post Keynesians themselves have not been very productive in imposing themselves on the debate and if you examine the majority of the literature (with notable exceptions) you will see that it falls into the deficit dove category which I think leaves them open to being sidelined by the mainstream neo-liberals.
Too often the debate comes down to how large the “cuts” have to be, or “when” the fiscal consolidation has to take place, or “how large” is a safe public debt ratio. Once that debate begins the progressive agenda is lost.
But I agree with Pettifor it is a disgrace that this sort of conference was held under these terms.
This is what happens when volcanic ash strands you at an airport.
A tough day – chaos at the airport today with tens of thousands stranded because of the volcanic ash clouds. Luckily I got a flight home albeit later than scheduled.
That is enough for today!