Paul Krugman (August 20, 2011) was bemoaning the loss of intellectual values in the current debate when he referred to this Wall Street Journal article (August 19, 2011) – Why Americans Hate Economics. On face value I concluded that the WSJ had stumbled onto something – that the mainstream economics profession was not worth its salt. I was wrong though. The WSJ author was making a case that we should return to the economics that dominated the world prior to the Great Depression. The problem is that it is this way of thinking that represents the dominant paradigm today. It is the paradigm which has caused all the problems. It is this mainstream paradigm that people hate. The WSJ author is very confused. But then Paul Krugman’s response is hardly meritorious. So this is why the World hates economics – by which we mean mainstream New Keynesian macroeconomics.
The WSJ article in fact was a rail against what they term “Keynesian economics” and why it “doesn’t make sense”. Its basic claim is that anyone who says that public outlays on unemployment benefits will put spending power in the hands of those without income and create growth in output and income is offering:
… a perfect Keynesian answer, and also … [and answer that is] … perfectly nonsensical.
Apparently it is nonsensical because this amounts to saying that “the more unemployed people we can pay for not working, the more people will work. Only someone with a Ph.D. in economics from an elite university would believe this”.
I assume any critical thinker will immediately appreciate the ridiculous nature of this logic.
Unemployment benefits are not a payment to stay home. Start with a situation where everyone is working (apart from a small proportion of frictional unemployment – people moving between jobs). Then impose a sharp drop in private spending (consumption and/or investment falls). We enter the inventory cycle.
At the current GDP level, inventories start to increase beyond the desired level of the firms. The firms react to the increased inventory holding costs and cut back production. How quickly this downturn occurs would depend on a number of factors including the pace and magnitude of the initial demand contraction. But the result is that the economy contracts – output, employment and income falls.
The initial contraction in consumption then would multiply through the expenditure system as laid-off workers lose income and cut back on their spending. This would lead to further contractions.
If the government does nothing, then with the economy in decline, tax revenue falls and welfare payments rise (of there are unemployment benefits) which would push the public budget balance into deficit (or a rising deficit) via the automatic stabilisers. The automatic stabilisers put a floor into the contraction by offsetting the drop in private spending to some degree.
If the government didn’t offer unemployment benefits – the contraction would be more severe and more prolonged and thus more people would lose their jobs.
I agree with critics that unemployment benefits are a poor response to a crisis and a much more preferable fiscal response would be direct public sector job creation. This should be built-in to the automatic stabilisers through the introduction of a Job Guarantee.
The problem that the WSJ article doesn’t recognise is that the many economists with a PhD from an elite university would agree with the idea and oppose unemployment benefits.
The WSJ author (Moore) offered a cute little anecdote to support his claim:
I have two teenage sons. One worked all summer and the other sat on his duff. To stimulate the economy, the White House wants to take more money from the son who works and give it to the one who doesn’t work. I can say with 100% certainty as a parent that in the Moore household this will lead to less work.
Well apart from the government not being a household – suspending disbelief and trying to work out the logic – we might say that this situation sounds like a balanced-budget. If the government really raised taxes to match their outlays on unemployments (which would be difficult anyway given the endogenous nature of the budget balance) then no immediate stimulus would be discernable. I am assuming here that the budget is balanced after the spending (that is, this is not a balanced-budget multiplier situation. Please read my blog – What is the balanced-budget multiplier? – for more discussion on this point.
Then we might examine the empirical evidence that tax incidence reduces labour supply. The evidence is very mixed and not convincing. At the macroeconomic level it is likely that there is no substantial impact.
But while I support the maintenance of an adequate safety net the best way to provide it is to offer guarantee jobs not income. There is so much more to life than just being considered a minimal consumption unit – which is what the logic of unemployment benefits implies. It is better to provide work so that the person can enjoy a secure income in addition to the social benefits of work (social inclusion, self-esteem etc).
So what the “White House” should do for the “Moore Household” is to offer the son who hasn’t a job the opportunity to work. Then both boys will be employed and everyone will be better off.
The article then raves on about how minimum wages:
Economic bimboism is rampant in Washington. The Center for American Progress held a forum earlier this summer arguing that raising the minimum wage would create more jobs. For this to be true, you have to believe that the more it costs a business to hire a worker, the more workers companies will want to hire.
This is the standard mainstream microeconomics view which falls foul of a fallacy of composition by concentrating only on the supply-side and only on a specific business. Perhaps, if a single firm faces the prospect of paying a wage increase and they perceive there will be no corresponding increase in demand for its output, then its profit margin is squeezed and they may reduce employment. It is not clear even at that level but it is possible.
But while wages are a cost (supply-side) they are also an income (demand-side) and the net effect of shifts in the supply and demand relations following a wage increase is far from clear. You cannot deduce theoretically which effect dominates although it is likely that there will be no negative effects on employment of a wage rise at the macroeconomic level.
At the macroeconomic level I do believe that paying higher wages to the lowest paid workers will increase employment overall – especially when we know how far real wages have lagged behind productivity over the last 2 or more decades. Perhaps some low productivity firms will go to the wall – but the extra aggregate demand (noting low wage workers spend close to 100% per cent of every extra dollar received) – will stimulate output and employment.
Importantly, there is no credible evidence that demonstrates that increasing minimum wages work to undermine employment growth. Please read my blog – Another conservative front opening up – minimum wages – for more discussion on this point.
The attack on minimum wages has been a major front of the conservatives (aided by poor analysis by the mainstream economic theorists). In the last 15 or so years, partly in response to the reality that active labour market policies have not solved unemployment and have instead created problems of poverty and urban inequality, some notable shifts in perspectives became evident among those who had wholly supported (and motivated) the orthodox approach which was exemplified in the 1994 OECD Jobs Study.
In the face of the mounting criticism and empirical argument, the OECD began to back away from its hardline Jobs Study position (which advocated cutting minimum wages).
In the 2004 Employment Outlook, OECD (2004: 81, 165) admitted that “the evidence of the role played by employment protection legislation on aggregate employment and unemployment remains mixed” and that the evidence supporting their Jobs Study view that high real wages cause unemployment “is somewhat fragile.”
The winds of change strengthened in the recent OECD Employment Outlook entitled Boosting Jobs and Incomes, which is based on a comprehensive econometric analysis of employment outcomes across 20 OECD countries between 1983 and 2003. The sample includes those who have adopted the Jobs Study as a policy template and those who have resisted labour market deregulation. The report provides an assessment of the Jobs Study strategy to date and reveals significant shifts in the OECD position. OECD (2006) finds that:
- There is no significant correlation between unemployment and employment protection legislation;
- The level of the minimum wage has no significant direct impact on unemployment; and
- Highly centralised wage bargaining significantly reduces unemployment.
In this blog – Low pay workers dudded again in Australia – for more discussion.
For these reasons, I thought the WSJ article was getting a little tangled. The author was trying to attack “economics” but, in fact, was using mainstream microeconomics to illustrate what he considered to be basic truths.
And then you realise – he hates macroeconomics and cannot see the need for it. We are back in the period prior to the Great Depression therefore.
So he decides to attack the “Mr. Obama’s thoroughly discredited $830 billion stimulus bill”:
We were promised $1.50 or even up to $3 of economic benefit – the mythical “multiplier” – from every dollar the government spent. There was never any acknowledgment that for the government to spend a dollar, it has to take it from the private economy that is then supposed to create jobs. The multiplier theory only works if you believe there’s a fairy passing out free dollars.
Once again the US fiscal stimulus was deficit-based. The government just entered the billions into computers and the sums popped up in various bank accounts as credits. We might question which bank accounts received the credits – and at that level – the stimulus design was very poor – it should have offered millions of public sector jobs and credited the bank accounts of the unemployed workers.
But no dollar was taken from the private spending stream via tax increase. In effect there was a “fairy passing out free dollars”. The point is that a sovereign government such as the US which has a monopoly over the issuance of US dollars doesn’t “have” any money. The dollars it spends come from nowhere and enter the economy electronically. There is no prior store of dollars needed for the government to spend.
And yes, we are back to that – the net spending was matched by the placement of Treasury debt in the private bond markets. But that isn’t a demand drain like taxes. It is a reserve drain – swapping one financial asset for another. There was no interest rate impact and no aggregate demand implications of the decision to (voluntarily) sell government bonds. In an operational sense, the government just borrows back funds that it has previously spent.
The other major problem with Mr Obama’s fiscal stimulus was that it wasn’t large enough, wasn’t concentrated enough and is now waning. The reason for that is because the economists that the WSJ think should have more influence have too much influence. I will explain that.
Please read my blog – These were not Keynesian stimulus packages – for more discussion on this point.
The WSJ author asks “(h)ow did modern economics fly off the rails?”:
The answer is that the “invisible hand” of the free enterprise system, first explained in 1776 by Adam Smith, got tossed aside for the new “macroeconomics,” a witchcraft that began to flourish in the 1930s during the rise of Keynes. Macroeconomics simply took basic laws of economics we know to be true for the firm or family—i.e., that demand curves are downward sloping; that when you tax something, you get less of it; that debts have to be repaid—and turned them on their head as national policy.
He quotes some Austrian school economist who claims that “Macroeconomics was nothing more than a dismissal of the rules of economics”.
The problem with this is that the pre-Keynes view of economics could not deal with systems as a whole. What applied at the individual level did not necessarily (and rarely) applied at the system level. In other words, the pre-Keynesian economics that the WSJ seems to be longing for fell into the classical logical error of the fallacy of composition.
Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.
The origins of macroeconomics trace back to the recognition that the mainstream economics approach to aggregation at the time was rendered erroneous by the concept of the Fallacy of Composition which refers refers to situations where individually logical actions are collectively irrational. These fallacies are still rife in the way mainstream macroeconomists reason and serve to undermine their policy responses.
The current push for austerity across the globe is another glaring example of this type of flawed reasoning.
Prior to the 1930s, there was no separate study called macroeconomics. The mainstream theory – which dominates still today – considered macroeconomics to be an aggregation of the individual. So the representative firm and household were just made bigger but the underlying behavioural principles that were brought to bear on the analysis were those that applied at the individual level.
The origins of this logical error lie in the way in which mainstream economics developed. It was largely concerned with microeconomics and started its a priori reasoning from the perspective of an atomistic individual – the single consumer or single firm. This body of theory soon got into trouble via the so-called Aggregation Problem.
To make statements about industry or markets or the economy as a whole, the mainstream had to aggregate their atomistic analysis. Of-course this proved to be impossible using any reasonable basis and so they fudged the task and assumed things like the “representative household” to be the demand side of a product market and the “representative firm” to be the supply side. Together they bought and sold a “composite good”.
The fudge comes because in this sleight of hand the principles that apply to the individual were transferred over to the composite or aggregate.
So the economy is seen as being just like a household or single firm. Accordingly, changes in behaviour or circumstances that might benefit the individual or the firm are automatically claimed to be of benefit to the economy as a whole.
Thus prior to the Great Depression, macroeconomics was thought of as an aggregation of microeconomics. The neo-classical economists (who are the precursors to the modern neo-liberals) didn’t understand the fallacy of composition trap and advocated spending cuts and wage cuts at the height of the Great Depression.
Keynes led the attack on the mainstream by exposing several fallacies of composition. While these type of logical errors pervade mainstream macroeconomic thinking, there are two famous fallacies of composition in macroeconomics: (a) the paradox of thrift; and (b) the wage cutting solution to unemployment.
In first semester of a credible macroeconomics course, students learn about the paradox of thrift – where individual virtue can be public vice. So when consumers en masse try to save more and nothing else replaces the spending loss, everyone suffers because national income falls (as production levels react to the lower spending) and unemployment rises.
The paradox of thrift tells us that what applies at a micro level (ability to increase saving if one is disciplined enough) does not apply at the macro level (if everyone saves aggregate demand and, hence, output and income falls without government intervention).
So if an individual tried to increase his/her individual saving (and saving ratio) they would probably succeed if they were disciplined enough. But if all individuals tried to do this en masse, and nothing else replaces the spending loss, then everyone suffers because national income falls (as production levels react to the lower spending) and unemployment rises. The impact of lost consumption on aggregate demand (spending) would be such that the economy would plunge into a recession.
As a result, incomes would fall and individuals would be thwarted in their attempts to increase their savings in total (because saving was a function of income). So what works for one will not work for all. This was overlooked by the mainstream.
The causality reflects the basic understanding that output and income are functions of aggregate spending (demand) and adjustments in the latter will drive changes in the former. It is even possible that total savings will decline in absolute terms when individuals all try to save more because the income adjustments are so harsh.
Keynes and others considered fallacies of composition such as the paradox of thrift to provide a prima facie case for considering the study of macroeconomics as a separate discipline. Up until then, the neo-classical (the modern mainstream) had ignored the particular characteristics of the macro economy that require it to be studies separately.
They assumed you could just add up the microeconomic relations (individual consumers add to market segment add to industry add to economy). So the representative firm or consumer or industry exhibited the same behaviour and faced the same constraints as the individual sub-units. But Keynes and others showed that the mainstream had no aggregate theory because they could not resolve the fallacy of composition.
So they just assumed that what held for an individual would hold for all individuals. This led the mainstream opponents to expose the most important error of the mainstream reasoning – their attempts to move from specific to general failed as a result of the different constraints that the macroeconomic level of analysis invoked.
The WSJ article seems to be in denial of all this. It claims that:
The grand pursuit of economics is to overcome scarcity and increase the production of goods and services. Keynesians believe that the economic problem is abundance: too much production and goods on the shelf and too few consumers. Consumers lined up for blocks to buy things in empty stores in communist Russia, but that never sparked production. In macroeconomics today, there is a fatal disregard for the heroes of the economy: the entrepreneur, the risk-taker, the one who innovates and creates the things we want to buy.
The scarcity-abundance juxtaposition is exactly what the debate is about. Systems can fail to generate enough demand to purchase all the goods that firms expected to be purchased. These expectations drove the production decision. When firms realise they are wrong they cut back production. Recessions occur when there is too much production and inadequate spending.
I imagine if I was a psychologist I would consider the author’s reference to communist Russia in this context to be a sign of a deep-seated anxiety and it would be this anxiety that is driving the irrational argument being made.
The macroeconomy economy in Soviet Russia did not respond to aggregate demand. It was largely a supply-determined system and relied on planners determining the quantities and distribution of production. This type of system – which could be much more effectively implemented now with the computer networks that are now available was not a modern monetary economy.
Further, entrepreneurs respond to consumer demand and do not distinguish between public and private spending. Why doesn’t the WSJ do a survey of the private firms who rely on public contracts for their existence? What do you think would be the answer if we said “all those government orders you just processed are undermining your business”.
When I go to the supermarket I am not asked whether the dollar I am spending is derived from a public sector job (which in my case it is) or a private sector job. A dollar spent is a dollar of income. That is the logic of the spending system. Employment growth is driven by that logic. Firms employ people to make goods and services which can be sold to buyers.
At the macroeconomic level, we know that there are broadly four “buyers”: (a) private consumers; (b) private investors (building capital equipment); (c) net foreign demand (exports less imports); and (d) government.
There are no mysteries. For a given capacity (labour force and capital equipment) there will be an implied output (determined by productivity). In dollar terms that output has to be matched by nominal aggregate demand (spending) for the firms to fully utilise that output. The spending can only come from the four “buyers”. If one or more “buyers” reduce their spending then the gap has to be filled by other “buyers”. Otherwise, output and employment falls.
A focus on “scarcity” or what happens at an individual firm doesn’t tell us much about these macroeconomic requirements.
While the WSJ article blames “macroeconomics” for the American hatred of “economics”, Paul Krugman thinks that it is time for the Fancy Theorists of the World Unite, which was in reference to the WSJ article carrying the sub-title “fancy theories of macroeconomics defy basic common sense.”
Paul Krugman said that:
Gosh, if that’s the way the right is going, the next thing you know they’ll reject the theory of evolution.
I agree with Paul Krugman that “(s)ome people find it commonsensical that if the government puts people to work, that adds to employment; it takes fancy arguments from the likes of the WSJ to convince them otherwise”.
But the problem is that to some extent the WSJ article is correct – although for all the wrong reasons. As noted above the macroeconomics that students undertake in universities these days are hardly “Keynesian”. The dominant paradigm especially in graduate schools is New Keynesian – and Paul Krugman falls into this camp although he stands out as one of the more reasonable and pragmatic members of the paradigm.
The reason why mainstream economists have failed our nations is because New Keynesian economics has built a raft of myths about the way economies operate and the legitimate role of government. The New Keynesian paradigm is behind the emphasis on monetary policy (with inflation targetting), the elevation of the NAIRU as a central concept (but anti-full employment), the continued focus on government budget constraints and the dangers of budget deficits etc.
The mainstream New Keynesians failed to see the crisis coming and have failed to offer systematic explanations for it and its resolve. Most of the articles that form the basic of New Keynesian thinking have no labour nor financial markets.
The link to the WSJ article is that the defining feature of New Keynesian macroeconomics is their belief that “Keynesian” macroeconomics lacked the “microeconomic foundations” that WSJ thinks are the basis of economics.
Please read my blog – Mainstream macroeconomic fads – just a waste of time – for more discussion on this point.
So the discrediting of economists during this crisis really should focus on a rejection of New Keynesian thinking.
But Paul Krugman characterises the WSJ attack on macroeconomists as being a resort to “anti-intellectualism” which he says is “all they have left”. Yes and no!
It is not anti-intellectual to dismiss a paradigm that has failed and is degenerating (in the Kuhnian-Lakatosian sense). Such a rejection is in fact the embodiment of scientific advance.
I agree with Paul Krugman that the principle predictions from the mainstream paradigm have all proven to be wrong over the last years. For example:
1. “common sense as the WSJ sees it — would tell you that massive government borrowing would send interest rates soaring”.
2. “common sense as defined by the WSJ said that a tripling of the monetary base would lead to a huge increase in prices”.
But these predictions come from the core of New Keynesian thinking not Modern Monetary Theory (MMT) or its allied “Keynesian” overtones.
And further Paul Krugman considers the “past three years have in fact been a stunning confirmation of one fancy theory — namely, the theory of the liquidity trap, which is part of the broader construct of Keynesian economics”. He often suggests that we are in a “special case” at present and once things return to normal then the usual New Keynesian results will hold – that is, interest rates will rise with rising budget deficits and inflation will rise as a result of the tripling of the monetary base.
In effect this is what the recent debates between MMT advocates and Paul Krugman have been about. The reality is that – Whether there is a liquidity trap or not is irrelevant.
The mainstream view – for those who believe that liquidity traps “switch off” monetary policy effectiveness and “turn on” fiscal policy effectiveness is that once the economy recovers there is a massive inflation threat sitting in the system in the form of the build up of the monetary base – if the central bank had acted contrary to their advice and believed that monetary policy could still stimulate demand.
This is of-course the current situation. Central bank reserves around the globe have expanded dramatically – especially in the US and UK (and Japan) as central banks have pursued quantitative easing to little end.
But in a true liquidity trap, there is no demand for government bonds because everyone forms the view that interest rates can only go in one direction, which means that if they purchased bonds they would be expecting capital losses. There is currently very strong demand for public debt and there has been for 20 years in Japan.
It is clear that bond markets will buy whatever debt is being issued at high prices (low yields).
None of this has any traction from the perspective of Modern Monetary Theory (MMT). Several brief points can be made (which I have made before). You can get background detail the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.
First, monetary policy is a dubious tool to use to counter-stabilise aggregate demand. It is not entirely clear (or predictable) which way the interest rate effects will go with respect to spending. The distributional complexities of an interest rate cut (creditors lose, debtors gain) make it hard to know what will happen. Further, the policy tool is blunt, indirect, cannot be targetted and is subject to unknown lags).
So the narrative that says that monetary policy is effective outside of a liquidity trap and powerless during a trap is highly questionable.
But we can take it even further. Whether there is a liquidity trap or not (and whatever that is) it is moot from the perspective of MMT. The fact is that a recession occurs when spending persistently falls short of the sales expectations of firms, which conditioned their decisions to employ and produce. Not wanting to accumulate inventories, firms reduce production and lay off workers.
The reasons why private spending collapses are many as are the reasons why it might not recover quickly. They can mostly be summarised by the term “lack of confidence” which is exacerbated by rising unemployment and the loss of income that accompanies it.
The early idea of a liquidity trap does not explain why bond markets cannot get enough debt even with interest rates low. There is no capital loss expectation with cash (other than via inflation) whereas bond prices are more likely to fall when interest rates (and yields) as so low than they are to rise.
At any rate, the MMT prognosis is clear. Irrespective of the level of interest rates and the state of private desire to hold cash balances the way forward when private spending collapses is for public spending to take its place.
Second, the idea that the build up of bank reserves represent a pot of funds that the banks will eventually loan out completely misunderstands the role of bank reserves. As I have noted before banks do not loan out reserves. Reserves facilitate the payments system – that is, the system that assures the millions of transactions between banks (as customers write cheques and deposit them throughout the banking system).
Banks do not make loans on the basis of the reserves they hold. They respond to demands from credit-worthy customers and have in mind what it will cost them to make the loans under current conditions. When the transactions that follow the creation of a loan transpire it might be that the is short of reserves to ensure the payments clear. It has various options. It can seek funds from wholesale markets (other banks or other lenders), use deposits (not an overnight option really) or, ultimately, it can source the funds from the central bank.
The very fact that the central bank sets a non-zero target policy rate means that it has to manage liquidity (reserves) to ensure that the rate sticks. This is an example where demand and supply rules. The centrral bank loses control of its interest rate target if there are excess funds in the system (and it doesn’t pay a return on those balances).
The point is that the chain of causality is: Demand for loan from credit-worthy customer => bank loan creates deposit => any necessary reserves to maintain payments integrity added afterwards.
So the increase in bank reserves (as in the current period) only really impacts on the central bank’s capacity to pursue a non-zero policy rate. It has to offer a return on the excess reserves to the bank equivalent to the policy rate to stop the competition in interbank market from driving the rate to zero as banks individually try to eliminate their holding of excess reserves. In aggregate, the bank transactions cannot eliminate a system-wide excess.
Liquidity trap or not, the size of the monetary base (currency plus bank reserves) is largely irrelevant. It does not increase the risk of inflation. It does not increase the funds available to banks to lend.
Please read my blog – The role of bank deposits in Modern Monetary Theory – for more discussion on these points.
Third, what about this idea that the liquidity trap occurs when cash and bonds are near substitutes so people are indifferent between them. Note again this is a perversion of Keynes.
The options for the central bank are simple. if they want a non-zero interest rate and there are excess reserves (perhaps from deficits) they can either pay a return on the reserves or sell bonds to drain the reserves. If they pay a return on reserves (equal to its policy rate) as they are doing now in many nations then cash and bonds remain near substitutes.
If they choose not to pay a return on reserves then they have to conduct open market operations to ensure the demand and supply of reserves is at the level commensurate with the policy rate they desire. There are not other options. In that case, if there are excess reserves they have to sell bonds and then cash and bonds become imperfect substitutes (because the latter earn interest). So what? Nothing!
The fact that at times people do not care whether they hold bonds or cash is irrelevant to the main cause of recession. Fiscal policy can always restore aggregate demand irrespective of private portfolio preferences.
The point is that you can get various levels of bank reserves depending on how the central bank pursues its liquidity management in order to hit its target policy rate. None of those levels have any particular operational significance.
The mainstream then argue that if the central bank mops up these reserves it will be less inflationary than if it leaves them in the system. This view is based on the spurious – banks lend reserves argument. The inflation risk associated with government spending is the same whether the government issues debt to match its deficit or not. The inflation risk arises from the impact of the spending on the state of capacity in the economy.
The monetary impacts of the deficit spending – in the form of increased bank reserves – do not add to the inflation risk. They emerge after the transactions have taken place. Bond sales just swap on asset for another (a reserve balance or a deposit).
At any time, a bond holder could cash their bonds in and spend up big. Just about as easily as they could cash in a bank deposit and spend up big. There is no “constraint” on spending involved in the government selling bonds.
The reason why Americans should hate economics lies in the way in which it is taught and practised in their universities. In my view mainstream macroeconomics has stifled the capacity of governments to use their fiscal capacity to resolve this crisis quickly.
The financial crisis was the direct result of governments listening to economists (many in the pay of Wall Street banks) who were extolling the alleged virtues of self-regulating financial markets. They were wrong.
Then once the private debt spiral collapsed the governments could have insulated the real economy by making sure the private spending collapse was initially offset with public spending. By avoiding the rapid rise in unemployment the government could have restored private sector confidence much more quickly.
Now we are in the worst of all worlds – economies slowing again with very high unemployment and the governments reciting the scripts that the mainstream New Keynesian macroeconomists have written – saying there is no more money to spend.
That is enough for today!