Category Archives: Economic Thought: History & Criticism

Religion, The Stock Market, and the Search for Meaning

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People want to understand phenomena.  We want explanations for what happens. Journalists, especially TV and radio journalists, want explanations that can be summarized in 1-2 sentences in a sound bite.  Randomness is pretty scary.  And anything that’s too complex to understand easily looks a lot like randomness.

So what triggered this little nugget of metaphysical social observation in an economics blog?  Reporting on the stock market!  Everyday we (those of us who read, listen or watch the news) are treated to not only reports of what the major stock market averages have done that day, but we’re always given a simple and easy explanation.  Just look at today in the NYTimes.  I’m not trying to pick on The Times, it was just the first thing showing on Google Finance as I wrote this – any source, any time and you’ll get similar simplistic explanations.

The move announced by central bankers on Wednesday to contain the European debt crisis led to euphoria in global stock markets…

Krugman posted this evening that he didn’t understand it.  But he approached it from the standpoint of “does this action by ECB make economic sense that should improve stock prices?’.  I think he’s right that it doesn’t make sense, but I think he misses a bigger point.  It’s foolish to try to attribute the movements of stock market averages on any given day to the any particular sentiment of investors or any particular logic of rational investors.

The markets are huge.  We’re talking hundreds of billions and trillions of dollars in trades. Daily volume is in the billions of trades everyday. It’s complex, folks. The reasons these trades happen and why they happened at the prices they did are really, really complex.   It’s kind of like ancient peoples trying to understand the stars and without even a telescope or any calculus! Unfortunately, like them, we want simple explanations.  So we invent them.  And like ancient peoples we make sure our explanations support and reinforce whatever religious or superstitious beliefs we have.  [readers are advised not to try to decide what my spiritual beliefs are based on that sentence - it's complicated].

There is a belief that supports much of this daily “this is what the market did and why” reporting. It’s actually based on the theory that markets are rational and “efficient”.  There’s an economic theory that holds that prices in financial markets accurately reflect the current state of all known information and news regarding the future flow of earnings and profits from firms.  It’s demonstrably false, but it has quite a following among neoclassical economists.  It cannot be proven and evidence exists to contradict the hypothesis (see Quiggin’s Zombie Economics), yet it’s taken as article of faith among many, many economists.  So much so that some non-believing economists have begun to refer to neoclassical economics as theo-classical.

The whole idea that there’s a single sentiment or key piece of news that drives the stock market each day is made even more absurd when we realize that most trading isn’t even being done by humans!  The significant majority of all trades are done by computers based on algorithms such as “buy this if the price has moved x in the last y seconds”.  Even more of the trading is done by casino-oriented short-term trading by large banks and hedge funds who are only trying to figure out what they think the other traders are going to do a few seconds before they do it. (also known as Keynes’ beauty contest).

Markets are the collective, sum judgement of lots of complex decisions.  Even if all the individual decisions were rational, there’s still no reason to believe the aggregate outcome can be represented as the decision of some hypothetical rational being.  So next time you hear or read some talking head pontificate that “the markets are saying…..”, just remember there’s little difference between that modern commentator and some ancient priest in long gown claiming that “the gods are saying….”

The Quantity Theory of Money and Fears of Inflation Are Nonsense

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We rarely get to conduct scientific experiments in economics, but for the last 3+ years The Federal Reserve has unintentionally conducted a test of an economic theory called the “Quantity Theory of Money” (QTM). QTM makes some very specific predictions – predictions that Ron Paul, conservatives on Wall Street, and others have been repeating a lot.  Unfortunately for them, QTM has failed the test.

First, some background on the theory. The QTM is and has been one of the foundations of both monetarist thought and Austrian economic thought.  In it’s base form, it’s based on an accounting identity that must, by definition, be true.  The notation sometimes varies, but the quantity theory of money is based on a definition called the equation of exchange.  This equation goes like this:

M times V = P times Q
where:
M: Money supply
V:  velocity of money, or the number of times the average dollar changes hands and is spent during the same time period as Q is measured.
P:    price level
Q:   real GDP (sometimes real National Income, Y, is used – same thing essentially)

So what does the equation say?  If you look at the left hand, M x V, you get a representation of the total spending in the economy.  It’s how much money was in circulation times the number of times that money was spent.  The right side, P x Q, gives us the value of nominal GDP.  It’s the value of all the real stuff we bought (Q, real GDP) times the Price level P which translates it into today’s prices.  Put the two sides together and you’ve got total nominal spending in money terms must be the same as the total value of the things we bought.  Duh.  Of course it is.  It’s an identity.   It’s the macro equivalent of saying that if I spend $5 each time (M) on 7 trips to the grocery (V) to buy 70 apples (Q) at $0.50 each (P), then I will spend $35 on $35 worth of stuff.

As an identity definition it’s not really very interesting.  It’s when economists begin to use it as a model of future outcomes that problems arise.

The typical way QTM is used, and the simple way folks like Ron Paul and a lot of folks who are upset at Federal Reserve efforts to stimulate the economy, is by thinking of what happens when M, the money supply, is suddenly increased.  The thinking is that an increase in M must result in an increase in P in order to keep the equation balanced.  This is the foundation of modern inflationary fears in the last  few years.  Typically folks using the QTM this way don’t say things like “an increase in M must lead to an increase in P”.  They say things like “The Fed is printing money like mad and that’s going to lead to inflation”  since an increase in the price level, P, is how we measure inflation.

But there’s actually four terms in this equation.  Any of them can change.  That’s where assumptions come in.  The advocates of QTM, whom I’ll call “inflation-phobes” for the moment since they’re always fearful of inflation, make some strong assumptions.  They assume three big things.  First, they assume that the velocity, V, is constant.  In other words, according to them, you and I always spend our money at exactly the same rate. Suppose I spend my whole paycheck every two weeks now.  They assume that I’ll always spend my whole paycheck every two weeks no matter how big or small that check is or whether I’m suddenly fearful of losing my job next month.  The evidence for the constant velocity assumption is weak.  You be the judge using the St.Louis Fed data:

To me, that doesn’t look constant.  If V is constant, then any increase in M also increases spending, MxV.  But if V isn’t constant, then an increase in M can be offset by simultaneous slowdown in velocity.

The next assumption is that real GDP is always at capacity.  In other words, there is no unused capacity in the economy such as unemployed workers or empty office buildings or factories running only 1 shift when they can run 2.  This is assumption is essential to the inflation-phobes because it means that Q can’t be increased.  This is necessary to their desired outcome because it would imply that the only way for PxQ to rise to meet an increase in MxV is by having P increase.  I won’t go to the trouble of showing data and graph to prove that Q isn’t at capacity.  If you have doubts, see last week’s update on employment and GDP.

There’s one more unstated assumption by the inflation-phobes.  They assume that any increase in base money, which is primarily the bank reserves The Fed makes available to commercial banks, will necessarily translate into M1, money in circulation among the public.  This too is a bad assumption.  There times, like the last 3 years, when commercial banks don’t want to or can’t lend.  In times like this bank reserves just sit there on the books safely tucked away from any kind of productive economic activity or spending.  The Fed can push reserves onto the banks’ books, but it can’t turn those reserves into loans or spending by customers. Another weakness in this assumption is the idea that even if the money ends up in private hands it will be used for spending on goods and services. Instead, what we’ve seen is that much of what little lending the big banks have been doing has been to finance financial market trading and speculation – things like oil futures.  Speculating in oil futures isn’t the same thing as actually refining and selling oil.  The speculation doesn’t create jobs and isn’t part of the circular flow. Production is.

So we’re back to the question of testing the QTM theory.  The QTM theory of money as inflation-phobes express it, says that increases in base money (M) necessarily must result in inflation (increases in P) at some time in the near future.

In 2008 and 2009 The Federal Reserve expanded bank reserves greatly.  It expanded the monetary base dramatically.  The Fed invented a variety of new names and methods for doing it, although almost all of them involved The Fed buying some kind of bond, security or financial asset.  If the QTM theory and the hard-money inflation-phobes are right, there should have been a dramatic increase in inflation.  They predicted it.  Again and again.  It simply hasn’t happened.  Paul Krugman put together an nice little graph showing the failure of the QTM theory:

The thing is, of course, that the past three years — the post-Lehman era during which the Fed presided over a tripling of the monetary base — have been an excellent test of that model, which has failed with flying colors. Here are the data — I’ve included commodity prices (IMF index) as well as consumer prices for the people who believe that the BLS is hiding true inflation (which it isn’t):

A couple of notes: for the commodity prices it matters which month you start, because they dropped sharply between August and September 2008. I use the IMF index for convenience– easy to download. (Thomson Reuters I use when I just want to snatch a picture from Bloomberg). But none of this should matter: when you triple the monetary base, the resulting inflation shouldn’t be something that depends on the fine details — unless the model is completely wrong.

So, we’ve had a test, a pretty substantial test of the Quantity Theory of Money and the assumption that any increase in monetary base must lead inevitably to an increase in prices and inflation.  The theory has failed.  It should be put to rest.  Milton Friedman, a man as responsible as any other for pusing QTM, once famously claimed that “inflation is anywhere and everywhere always a monetary phenomenon”.  He was clearly wrong, there’s more involved than just base money growth.

Rhetoric Is A Powerful Tool To Advance Moneyed Interests

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Money is essential to a successful economy.  But it’s money in circulation that’s useful.  Money that’s locked up in storage in vaults and savings doesn’t help.  The early economists understood this well and often used the analogy of money-is-to-economy as blood-is-to-human-body.  Circulating money, money that is used to buy things is as important to the economy as the blood in your arteries and veins.  The analogy works.  It leads us to realize that money, and more of it, can and usually is a good thing.

The analogy, however, doesn’t work for those economists and policy-makers who want are more interested in enabling the top 1% or so to profit at no risk by earning income on holding money.  Theoretically, the rich, the top 1%, could earn income from their large stores of wealth by investing it in production.  But the profit-by-investment-in-production method requires risk. It’s hard. It requires work to find and exploit good investment opportunities. From the perspective of the really wealthy, it can be more desirable to make money by simply owning money.  To do that, it’s necessary to that there be no inflation. They actually prefer deflation because then their cash wealth gets more valuable without being risked or used productively at all. The other approach to making money without risk by simply owning money is to lend it. Instead of starting, owning, and building a business, investing in equity, you make loans. Ideally you use your wealth and influence to get politicians to guarantee your loans – heads you win and tails somebody else loses. These approaches to making money by simply owning money require that money be scarce and hard to get.  It’s directly counter to the money in circulation paradigm.  A circulatory system deprived of money is good thing those who make money from money instead of labor.

But to persuade the mass of people, the 99%, the ones earning money from labor, it’s necessary to change the metaphor.  That’s been rather effectively in the second half of the 20th century.  It’s been done by extending a different metaphor.  Economists have long used the word liquidity for the idea of how easy it is to convert an asset into cash and therefore spent. For example, real estate (particularly in this market) is very illiquid.  I could own a $1 million house but be unable to buy a Coke from the 7-11 store because I lack any cash.  That’s an extreme example of illiquidity.  In contrast, a liquid asset is one that is either actually cash or easily turned into cash so it can be spent.  There’s a whole range of assets in between with varying degrees of liquidity.

This idea of liquidity and it’s association with cash has been used to push a metaphor that suggests the problem is too much money in the economy.  We’re peppered with phrases like “drowning in debt” or a house mortgage that is “underwater”.  It makes us feel that the liquid stuff is undesirable.  So we get  a central bank that’s reluctant to create and inject money into the economy because critics claim that will create too much liquidity and they falsely claim that it’s inflationary.  When the central bank does increase inject liquidity into the economy, it does it by getting the money to precisely the people who keep it from circulating.  We get a government that refuses to use it’s ability to directly inject money into the economy and get it into circulation.

Government ultimately is the source of all money.  Only government can define and create money.  It has two ways to do it. It can simply create (“print” or “mint” if you will, but it’s not that way anymore) money and spend it.  That puts money immediately into circulation in the circular flow of goods and services.  Or, the government could create money reserves for the banks, a riskier strategy.  The banks then can lend using a fractional reserve logic.  If the banks lend out the reserves, then money is created.  If the borrowers from the banks spend the borrowed money, then it’s in circulation.  If the borrowers use the money to simply buy other financial assets, then it’s not in circulation and is sterile.

In our modern system, the government (in the U.S. and many other nations) has delegated the responsibility for creating money and putting it into circulation to quasi-private central banks such as The Federal Reserve Bank.  In today’s workings of the financial system, these central banks have further delegated the responsibility and decision-making on money-creation to private commercial banks by providing reserves for whatever level of loans they choose.  When those banks choose not to create money or choose not to create and provide money in a way that puts it into circulation, the system suffers. We suffer from too little liquidity.

Daniel Becker at Angry Bear made this point very well in a long post there in June 2011.  He points out that we should really talk about “dehydrating in debt”, not “drowing in debt”.  The dehydration metaphor leads us directly to the solution – more money in circulation.  I from the conclusion to his post:

Got that? Let’s summarize: The share of income to the 99% of people declined from 1976 onward. At the same time the means of making money changed from labor production to money manipulation (producer economy to finanicialized economy) adding to the reduction in share of income. We also changed the ideology to one from relying on the vast population (as represented by the individual and We the People) to relying on a small portion of the population to distribute what money was created. We did this for 33 years. By 1996, people were borrowing as a means to sustain their standard of living (not increase it). If the people are not spending to increase their standard of living, then is the economy really growing? By 2006 people were no longer able to make the payments and consumption was declining.  Then gas hit $4/gal and winter heating was looking like another $4000 to $6000 would be needed.

To date, nothing has been done to address this. Nothing at all. And, by “this” I mean, the income inequality that has resulted in an an economy where a very small group of people (top 1%) are taking money out of the system (that is money that would fuel the engine) faster than the engine can make it which results in an ever faster declining share to the rest of the people. Instead, we have refined new fuel and dumped it right into the top 1%’s hands and wonder why the engine is still sputtering?

One other issue I have with framing and the words used today: Under water.

People are not under water. They are not drowning in debt. On the contrary, people are dehydrating. They are starving for water. Do you know what the symptoms are of dehydration? You get thirsty and then urinate less to conserve water. (debt spending) Then you stop making tears and stop sweating. (can’t borrow) Eventually your muscles cramp, the heart palpitates and you get dizzy. (close to bankruptcy, voting against your interest) Let it go long enough and you get confused, weak and your coping mechanisms fail. (Tea Party, etc) In the end, your systems fail and you die. (recession)

People are dehydrating and Washington is doing nothing about it because they believe it is drowning.  They are throwing out life boats to people in a desert.  That is the chart Ken linked to.

Sometimes Methodology Isn’t Everything

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Brad Delong points us to a study published in the British Medical Association jounal BMJ and quotes from it:

Smith and Pell: Parachute use to prevent death and major trauma related to gravitational challenge: systematic review of randomised controlled trials 327 (7429): 1459 — bmj.com:

No randomised controlled trials of parachute use have been undertaken

The basis for parachute use is purely observational, and its apparent efficacy could potentially be explained by a “healthy cohort” effect”

The full journal article is well worth following at the link he quotes.  Besides the laugh (warning: the positive health effects of laughing haven’t been proved by randomized controlled trials either), the authors suggest by parody an excellent point.  Sometimes rigid adherence to one single methodology in science is sometimes not only uncalled for and useless, it can also be immoral.  Some Austrian and New Classical economists might want to take note.

Brief History of Macroeconomics and The Origins of Freshwater vs. Saltwater Economics

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I and others, particularly Paul Krugman, occasionally make reference to “freshwater” vs. “saltwater” economics.  Here’s a little background to explain the terms and, I hope, shed a little light on current disputes in macroeconomic theory.

First, let’s go back in time.  The stuff that economists study, namely the economy, economic behavior, and markets, really emerged as it’s own discipline in the 1700′s with Adam Smith.  It had always been a topic for philosophers to discuss. Even Aristotle writes about the topics.  But it didn’t really emerge from “moral philosophy” into it’s own field of study until Smith.  Originally Smith and the subsequent economists such as Ricardo focused on markets and what we now  call microeconomics with a nod towards questions of political economy (public policy and the whole economic system).  The industrial revolution was in full swing.  The economic system wasn’t really “capitalist” because nobody knew what that was yet.  It wasn’t until the mid-1800′s that the word capitalism becomes commonly used.   Note:  Adam Smith was not a capitalist.  According to the Oxford English Dictionary, the earliest recorded usage of “capitalist” comes in 1792 in France, well after Smith wrote the Wealth of Nations.  

Then in the years just after the Napoleonic wars, England suffered some very severe financial crises and depressions involving the collapse of canal-building businesses.  At the time, Smith’s famous treatise was now 40-55 years old.  The authors now called economists argued about it’s causes and the policies needed to right the economy and restore full-employment.  The center of the debate revolved around questions of “whether there could ever be such a thing as a general glut of commodities”.  In other words, was it possible that the now industrialized economy with it’s newly enlarged banking sector and wide circulation of paper money could be too efficient?  Would such an economy always produce willing buyers for all the goods that sellers wanted to supply?

Two views emerged. One of them, later called “Classical” becomes the dominant thinking in economic circles.  The Classical view denies that long-term high unemployment is even possible as long as the government balances it’s budget and follows a laissez-faire policy of not interfering in markets.  A very mechanistic view of the economy as being constructed of self-adjusting markets that always return to equilibrium evolves.  The Classical view supports a very liberal (old sense) and anti-regulation view of government policy.

Critics existed but they failed to dominate the debate.  Karl Marx in the mid-1800′s writes some scathing critiques of Classical economics focusing on how the mechanism of market equilibrium cannot and does not work as described in labor markets.  Yet despite the critique, the Classical economists continue to dominate policy making and academic circles.  The debate, however, becomes more polarized with the Classicals of the late 1800′s and early 1900′s pushing even more extreme anti-government, pro-market policy positions and models than their Classical predecessors advocated. Many of the critics of capitalism and Classical economics move to the opposite end of the spectrum and embrace socialist, communist, or fascist/syndical economics, in effect taking a position that market capitalism is so fatally flawed that it must be completely replaced by a system of planning by the government.

Despite the dominance of the Classicals, there were always some economists laboring, researching, and writing about the cycles of business and the workings of money and banks.  They just didn’t get much attention or have a comprehensive framework to distinquish themselves from either the Classicals or the planned economy types.

Then came Keynes and the Great Depression.  Classical economics denied The Great Depression could happen – much like University of Chicago economists in 2010 who claimed that today’s high unemployment is the result of workers suddenly choosing to voluntarily have leisure instead of a job.  Keynes writes a powerful book called The General Theory of Employment, Interest, and Money.  Macroeconomics is born.

Keynesian macro focuses on a total systems approach to the economy instead of just assuming that whatever works in a micro perspective in each market will make the total system work.  Keynes attempts to avoid the fallacy of composition. Keynes’s analysis shows that an industrialized, capitalist market economy with a financial/banking sector is inherently unstable.  It tends to have cycles – business cycles.  It’s beyond the intent of this post to explain the reasons, but the bottom-line was that Keynes identified a role for active government and central bank policy to maintain full employment  and stable prices.  Keynes rapidly gained converts in economics and soon the field was split into microeconomics and macroeconomics.

The success of Keynesian economists and Keynesian policies in the 1940′s, 1950′s and 1960′s led to dominance of Keynesian viewpoints.  But there were two subversive trends underway that would eventually reverse the Keynesian dominance and return the Classical viewpoint to dominance.  One was an attempt to build a comprehensive mathematics framework for all economics built on the math of Newton’s physics.  This effort, called the neo-classical synthesis, originally focused on microeconomics.  But eventually it turned it’s attention to putting Keynes’s ideas into the same optimizing-behavior mathematics.  Unfortunately, Keynes himself was long dead by now and unable to clarify what he “meant”.  Some ideas are forced onto him that weren’t necessarily there in the original (such as insisting on static equilibrium).  The second trend was a small group of economists who never agreed.  They were in effect Classicals in exile.  Led by Milton Friedman at University of Chicago and Friedrich Hayek, they launched a two-prong attack.  Hayek’s attack led to what we call Austrian economics today and is often embraced by extreme libertarians.  I won’t get into that here, there’s not enough time.

Friedman’s initial attack focused on re-writing our understand of The Great Depression.  Friedman works to show that monetary policy by the central bank was at fault for the Depression, implying that a laissez-faire government fiscal policy would be best.  Friedman’s disciples at Chicago and elsewhere expanded the attack by insisting on “micro-foundations” in all macro-economic theories and models.  By micro-foundations, they mean that the only acceptable basis for a macroeconomic model is one that is based only on the micro ideas of perfectly rational individuals acting on perfect information with perfectly rational expectations about the future and the nature of the economy.  By the mid-1970′s the Friedman posse was clearly winning the academic wars, in part because their position lent itself easily to using neo-classical synthesis  mathematics and because it was consistent with “micro-foundations”.

Friedman originally took a modified Classical position.  Classicals denied that either fiscal or monetary policy could affect or correct the performance of the whole economy.  Friedman pushed the idea that fiscal policy wouldn’t work but that monetary policy would.  Eventually the next generation of Friedman students and disciples went further and returned to the Classical position that neither fiscal nor monetary policy would work.

As it turns out, these newly re-ascendant Classicals, now being called New Classicals, inspired by Friedman, often taught at universities located inland near some kind of “freshwater”.  The remaining supporters of Keynesian viewpoints, now under severe attack, taught at schools nearer the ocean.  Then in 1976 R.E. Hall pens a paper called Notes on the Current State of Empirical Macroeconomics and identifies this split and associates freshwater and saltwater with the split.

As I see it, the major distinguishing feature of macroeconomics is its concern with fluctuations in real output and unemployment. The two burning questions of macroeconomics are: Why does the economy undergo recessions and booms? What effect does conscious government policy have in offsetting these fluctuations? These questions define the issues considered here. I will further restrict my attention to structural approaches, and will avoid discussion of the reduced-form approach, including its recent sophisticated manifestation (7).

As a gross oversimplification, current thought can be divided into two schools. The fresh water view holds that fluctuations are largely attributable to supply shifts and that the government is essentially incapable of affecting the level of economic activity. The salt water view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand. Needless to say, individual contributors vary across a spectrum of salinity). The old division between monetarists and Keynesians is no longer relevant, as an important element of fresh-water doctrine is the proposition that monetary policy has no real effect. What used to be the standard monetarist view is now middle-of-the-road, and is widely represented, for example, in Cambridge, Massachusetts.

1To take a few examples, Sargent corresponds to distilled water, Lucas to Lake Michigan, Feldstein to the Charles River above the dam, Modigliani to the Charles below the dam, and Okun to the Salton Sea.



 

			

	
		
	


				
					


		

		
Income Inequality Does Matter And It Makes Us Worse Off


				

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There is viewpoint that asserts that income inequality and wealth inequality are necessary, that they are the differences that motivate people to work and get ahead.  This viewpoint often implies that without wide income disparities that our economy’s growth would slow.  Supporters of such a viewpoint seem to suggest that the only choices we have are either:  a society of dramatic differences in income distribution or a society where everybody is equal but also poor.  This viewpoint is wrong. Absolutely wrong.  A simple review of U.S. history in the 20th century demonstrates the wrongness.  US GDP real growth in the 3 decades of 1950′s, 1960′s and 1970′s was much stronger than the 3 decades since 1980.  In the high-growth decades, income distribution was more equal and more fair.  Income distribution since 1980 has gotten worse.  But there’s more data to disprove the idea of “income inequality is good”.


Richard Wilkinson is a British researcher who has spent his life studying income inequality and the consequences for societies.  I strongly urge you to view in it’s entirety his TED talk on this subject.




Here are some excerpts from the transcript:


You all know the truth of what I’m going to say. I think the intuition that inequality is divisive and socially corrosive has been around since before the French Revolution. What’s changed is we now can look at the evidence, we can compare societies, more and less equal societies, and see what inequality does. I’m going to take you through that data and then explain why the links I’m going to be showing you exist.


…I want to start though with a paradox. This shows you life expectancy against gross national income –how rich countries are on average. And you see the countries on the right, like Norway and the USA, are twice as rich as Israel, Greece, Portugal on the left.And it makes no difference to their life expectancy at all. There’s no suggestion of a relationship there.But if we look within our societies, there are extraordinary social gradients in health running right across society. This, again, is life expectancy.


…Now I’m going to show you what that does to our societies. We collected data on problems with social gradients, the kind of problems that are more common at the bottom of the social ladder.Internationally comparable data on life expectancy,on kids’ maths and literacy scores, on infant mortality rates, homicide rates, proportion of the population in prison, teenage birthrates, levels of trust, obesity, mental illness – which in standard diagnostic classification includes drug and alcohol addiction – and social mobility. We put them all in one index. They’re all weighted equally. Where a country is is a sort of average score on these things.And there, you see it in relation to the measure of inequality I’ve just shown you, which I shall use over and over again in the data. The more unequal countries are doing worse on all these kinds of social problems. It’s an extraordinarily close correlation. But if you look at that same index of health and social problems in relation to GNP per capita, gross national income, there’s nothing there,no correlation anymore.


…What all the data I’ve shown you so far says is the same thing. The average well-being of our societiesis not dependent any longer on national income and economic growth. That’s very important in poorer countries, but not in the rich developed world. But the differences between us and where we are in relation to each other now matter very much.


…This is mental illness.


…This is violence.


…This is social mobility. .


The other really important point I want to make on this graph is that, if you look at the bottom, Sweden and Japan, they’re very different countries in all sorts of ways. The position of women, how closely they keep to the nuclear family, are on opposite ends of the poles in terms of the rich developed world. But another really important difference is how they get their greater equality. Sweden has huge differences in earnings, and it narrows the gap through taxation, general welfare state, generous benefits and so on. Japan is rather different though.It starts off with much smaller differences in earnings before tax. It has lower taxes. It has a smaller welfare state. And in our analysis of the American states, we find rather the same contrast.There are some states that do well through redistribution, some states that do well because they have smaller income differences before tax. So we conclude that it doesn’t much matter how you get your greater equality, as long as you get there somehow.


I am not talking about perfect equality, I’m talking about what exists in rich developed market democracies. Another really surprising part of this picture is that it’s not just the poor who are affected by inequality. There seems to be some truth in John Donne’s ”No man is an island.”


…


I should say that to deal with this, we’ve got to deal with the post-tax things and the pre-tax things.We’ve got to constrain income, the bonus culture incomes at the top. I think we must make our bosses accountable to their employees in any way we can.I think the take-home message though is that we can improve the real quality of human life by reducing the differences in incomes between us.Suddenly we have a handle on the psychosocial well-being of whole societies, and that’s exciting.


 

			

	
		
	


				
					


		

		
In Economics, the Zombies Walk Everyday, Not Just At Halloween


				

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In economics the zombies are with with us year-around, not just at Halloween.


Zombie Economics
Zombie Ecnomics


Thanks to ACEMAXX-ANALYTICS for the graphic.   And thanks also to John Quiggin (who also writes at CrookedTimber) for authoring the book Zombie Economics, a must read for understanding how current “mainstream” economics got so far off track from reality.


 

			

	
		
	


				
					


		

		
The Difference Between Physics and Mainstream Economics


				

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Newspapers this morning were full of the story of how physicists at CERN in Geneva have demonstrated that a particle (sub-atomic one) could go faster than the speed of light.  I’m no physicist, (although I do make extensive use of the principles of gravity and inertia), but this appears to be a rather startling result – one of those things current accepted theory says can’t happen.  The Globe and Mail report:


 A fundamental pillar of physics – that nothing can go faster than the speed of light – appears to be smashed by an oddball subatomic particle that has apparently made a giant end run around Albert Einstein’s theories.


Scientists at the world’s largest physics lab said Thursday they have clocked neutrinos travelling faster than light. That’s something that according to Einstein’s 1905 special theory of relativity – the famous E (equals) mc2 equation – just doesn’t happen.



Mr. Gillies told The Associated Press that the readings have so astounded researchers that they are asking others to independently verify the measurements before claiming an actual discovery.


“They are inviting the broader physics community to look at what they’ve done and really scrutinize it in great detail, and ideally for someone elsewhere in the world to repeat the measurements,” he said Thursday.


Scientists at the competing Fermilab in Chicago have promised to start such work immediately.


“It’s a shock,” said Fermilab head theoretician Stephen Parke, who was not part of the research in Geneva. “It’s going to cause us problems, no doubt about that – if it’s true.”


Wow. What a difference. So when reality demonstrates something that theory says can’t happen, the physicists think it’s a problem and set out to: (a) verify the results, and (b) revise theory to account for it.  In mainstream macroeconomics as it’s been practiced since the 1970′s, they do just the opposite.  If something happens in reality that theory says or assumes can’t happen, mainstream macro-economists will just ignore facts. After all, an elegant mathematical theory is just too beautiful to abandon.  Why describe the workings of the real world when you can build models of hypothetical mathematical worlds that can never exist.   </end snarky sarcasm>

			

	
		
	


				
					


		

		
Obama’s So-Called Keynesian Stimulus Efforts Aren’t Very


				

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The simple version of Keynesian economics suggests that if the economy is suffering from too little economic activity and high unemployment there are some policy options.  Specifically Keynes suggests there are three general kinds of policy options:


    

  1. The central bank (The Fed in the case of the U.S.) could lower interest rates and create money by buying bonds on the open market.  This is called stimulative monetary policy. It is supposed to work by making private sector borrowing more attractive and more profitable so that businesses in particular increase their spending on business investment goods like equipment and factories.
    2. 

  2. The government could increase it’s budget deficit by borrowing more money and cutting taxes.  This is fiscal policy by tax cuts. It works by putting more cash in the hands of households and firms (increases their after-tax income) who then increase their spending.
    3. 

  3. The government could increase it’s budget deficit by borrowing more money and directly spending the money itself, either by direct transfer payments to needy individuals, or by buying things like new dams or construction projects, or by hiring the unemployed itself. This is fiscal policy by spending.
    4. 



There’s nothing to stop a country from pursuing all the above options simultaneously if it chose.  But not all of these options are equal in either effectiveness.


NOTE: This is old-style John Maynard Keynes style Keynesianism, not the  ”New Keynesian” theories that have dominated some academic circles in the last couple decades. It’s also based on the real thing, not the caricature that it’s opponents paint which is usually without foundation. 


NOTE 2: It’s really not a good idea to try to simplify Keynes.  When you do, you’re likely to over-simplify and really miss powerful insights and nuances.  Nonetheless, I will plunge ahead with full knowledge of the risk.


The real richness of Keynesian theory though lies not just in these prescriptions, but the analysis of when to use which one, whether it is likely to work, and under what conditions.  The first option, monetary policy, is to be preferred in cases of  mild recessions when interest rates are “normal” and the slowdown is largely for mild, temporary factors such as an outside economic shock. Monetary policy is quick and easy to implement. It’s also relatively easy to reverse course when the time comes.


Keynes had two key insights about monetary policy though that are highly relevant to our present situation.  Monetary policy can be become impotent if interest rates drop to near zero and we get into a liquidity trap.  This is when people and firms become fearful of the future and come to expect continued weakness or even GDP declines and deflation.  In a liquidity trap, people just sit on money rather than spend or invest it.  Monetary policy is relatively ineffective in such cases. We have been in a liquidity trap since late 2008 and that’s why the record 3 years of a virtually zero Fed Funds interest rate and The Fed’s QE1 and QE2 programs haven’t worked. Liquidity traps aren’t common, but they do exist and they aren’t extinct.  We were in one in the 1930′s Great Depression and Japan has struggled with one for the last 15+ years.


Keynes also had insights about the two fiscal policy approaches, tax cuts vs. increased spending.   In particular, tax cuts will only be effective to the degree that households and firms actually spend the money.  If they use the money to pay down debts or to save, then it really won’t improve conditions.  Later research in the 1950′s and 1960′s strengthened these insights. Later research showed that it also makes a big difference who gets the tax cuts and whether they think the tax cut is permanent.  Temporary tax cuts are much less effective than permanent ones because people tend to save them more.  Also, high-income individuals tend to save more of the tax cut (proportionally) than more desperate lower-income folks. Finally, later research showed that when a recession comes about because private debt got too high, then tax cuts are least effective.  Notice a pattern here?


The fiscal policy “stimulus” efforts that we have pursued since the Great Recession began have been very, very heavily tax-cut oriented.  Bush’s original stimulus effort in early 2007 in an effort to “nip the recession in the bud” was all tax cuts.  The Feb. 2009 stimulus bill of Obama (the ARRA) was between 40% and 50% tax cuts.  The meager effort passed in Dec 2010 was all tax cuts. And now, the proposal is again very tax cut heavy.  Not only have the fiscal stimulus efforts been heavily tax cut-based, but the cuts have temporary cuts targeted at either high-income folks or only offering a meager amount to low-income folks.  Further, we still have a huge private sector debt overhand that people want to pay down before they spend more. In sum, the dominant response which many have labeled as “Keynesian” really hasn’t been what John Maynard Keynes suggested. Many have asserted that “Keynesian policies don’t work” and cite our weak economy despite several fiscal policy stimulus attempts as proof.  But that’s not really a valid test.  It’s like claiming some physician is a total quack because you took pills like he recommended but you didn’t take the exact same pills as he recommended. You took something else. Now you’re still sick.  It’s not the physician’s prescription that failed, it’s your refusal to follow the prescription and the diagnosis that failed.


Critics will counter with a “yes, but there was still some spending stimulus in the Obama bills and our failure to fully recover is proof the fiscal spending as stimulus prescription is quackery.”  But have we really had an increase in government spending anywhere near large enough to fill the gap?   Let’s look at some trends (courtesy of Brad Delong):


We simply have not expanded government purchases as a share of potential GDP in this downturn:


FRED Graph  St Louis Fed 4


 


The graph shows the relative changes in share of GDP of four key portions of GDP: exports, business equipment investment, government purchases, and residential construction. (everything in the graph is scaled relative to 2005 -that’s why the lines all meet at o in 2005).  The whole Keynesian idea is that if exports, business equipment investment, or residential construction go down then government purchases should go up and vice versa.  That hasn’t happened at all.  Instead, government purchases has consistently declined since 1995!.  In other words, actual changes in government purchases have not only not been a stimulus, but they have been contractionary.  Government spending policy has been contractionary for over 15 years!  We didn’t notice it because strong increases in business equipment investment and housing were doing the stimulating prior to 2006. In the period 1995-2000, it was probably appropriate in a Keynesian sense to have declining government purchases and a contractionary policy – it was countercyclical to the dot-com boom and the housing boom.


But after 2007, residential construction collapsed. For awhile in 2009 both business equipment investment and exports declined sharply.  The only appropriate Keynesian response would have been a very, very large government purchases program.  But we didn’t do that.  Instead, the so-called 2009 stimulus bill was barely enough new spending at the federal level to offset the declines and cuts at the state and local levels. Overall, government spending did not increase. It went neutral for a couple years. But in late 2010, we resumed the march to contractionary policies.  The ARRA wound down.  State and local governments accelerated their budget cuts. And Washington became pre-occupied with imaginary threats of impossible debt crises at some point 10 years from now.


To continue the earlier physician and disease metaphor, we did try a little of the prescription but we took too little.  It’s as if we went to the doctor, the physician diagnosed a very severe infection and prescribed heavy doses of anti-biotics.  We went home took a lot of aspirin instead and only a couple of the anti-biotic tablets.  Now folks want to blame the doctor and his “failed prescriptions” when we didn’t take them.  None of this is what Keynes or 1960′s style Keynesians would have recommended. To conclude that Obama has tried Keynesian policies and they have failed is dead wrong.  The policies have largely failed to stimulate and re-ignite growth, but they weren’t Keynesian.

			

	
		
	


				
					


		

		
What a Liquidity Trap Looks Like in Pictures


				

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I want to follow up a little on my discussion of the liquidity trap that we are have been in. Brad Delong has an excellent post today called “Four Years After the Wakeup Call”.  In it he shows some graphs which illustrate very well our the liquidity trap.


Delong first serves us two graphs on the Federal Funds rate since early 2007:


The daily gyrations of the usually-placid Federal Funds market starting in late 2007 told us all that banks were really worried that other banks had jumped the shark and turned themselves insolvent.


FRED Graph  St Louis Fed 7


 


The Federal Funds rate is the interest rate that banks pay to each other when they borrow reserves from each other.  Despite the name, the rate isn’t set by The Fed. It’s set by market supply-and-demand.  It’s a large and brisk market.  When the Fed Funds rate is high (or at least rising), we can infer that banks need and are desperate for reserves, typically because they have profitable opportunities to make loans based on those reserves. When The Fed Funds rate is low and/or dropping, it means that a lot of banks have excess cash on their hands and don’t see any useful or profitable ways to use that money. In other words, a low Fed Funds rate means banks are willing to lend their reserves to other banks because it’s better than nothing and they don’t see any good ways to loan out the money. At the same time, a low rate also shows that few banks are interested in borrowing – again because they don’t see much useful to do with it.  While The Federal Reserve doesn’t set the funds rate, it does set the interest rate for the alternative: direct borrowing from The Fed.


What we see from the first graph is that things were cruising along in early 2007 and then mid- to late 2007 (August to be exact), the rate starts dropping.  We’re moving toward a recession.  Banks are finding it harder to make good loans so they don’t want to borrow more reserves.  Banks start hoarding their cash and assets.  So instead of balance sheets that are full of loans, bonds, and securities, the banks decide they want/need more cash.  Their reserves grow in order to provide a cushion for what was then being seen as the inevitable losses on mortgages and mortgage securities.  Things appear to stablize and then in Sept 2008 comes the Lehman moment.  Fed Funds rate goes virtually to zero.  It’s been stuck there ever since.  Banks have plenty of reserves. They have the cash to lend.  There’s no willingness to lend (banks don’t see many credit-worthy borrowers) and there’s little interest or demand to borrow.


The Federal Reserve has responded during the same period by creating new base money like crazy.  [NOTE: Contrary to the fears of the inflation-fearful crowd, it's not really "money" until it's in circulation with the public. It's only bank reserves - the monetary base.  It creates the ability to create money for the public, but that would necessitate having a bank lend it first. ]  Again Delong shows up graphically just how The Fed has been willing to create new monetary base:


And while the Federal Reserve has taken the monetary base to previously-unimaginable levels–up from $900 billion to $1.7 trillion in late 2008, up to $2 trillion in let 209, and up to $2.7 trillion in early 2011–it has never adopted Milton Friedman’s recommended policy that it start buying bonds for cash and keep buying bonds for cash until nominal spending is on the path that the Federal Reserve wants it to be on:


FRED Graph  St Louis Fed 5


We only need one more graph: GDP.  More precisely a comparison of GDP to an estimate of what GDP could be if we were at full employment and operating at our long-term trend.  Again Delong:


And so right now nominal GDP is $15 trillion/year when it ought to be $16.7 trillion/year:


FRED Graph  St Louis Fed 6


I’ll save inserting the employment graph here.  I’m sure you all know what it looks like. Same story.


And that story is that we had signs of trouble 4 years ago.  Three years ago things went really into the tank.  The economy seriously declined until mid-2009. Ever since then, it’s struggled to hold on.  There really isn’t any recovery.  It’s just going sideways.  We have, in effect, taken a huge chunk of the economy, a huge number of workers, put them on the sideline and said “we’re not interested in you participatin anymore.  We don’t want or need your contribution. We’re happy being smaller”.


So we’ve had monetary stimulus efforts, we’ve had low interest rates, we’ve had the central bank create base money.  There’s plenty of cash out there.  But it’s all in the banks. It’s in deposit accounts. It’s in reserves.  It’s not working. It’s not being used to buy things. It’s not being used for consumption or investment. It’s just sitting around impotent.  That’s a liquidity trap.


Mainstream economic theory, the stuff called “New Classical” or “New Keynesian” (never confuse “New Keynesian” as being “Keynesian”), says keeping interest rates this low for this long would /should fix everything by now.  For over 30 years now, the dominant, orthodox view in the academic and professional world of economists has been that monetary policy exercised by a wise central bank can fix all.  Any weakness in the economy can be solved via lowering interest rates and having the central bank create new bank reserves.  These “modern” theories told us that the concept of a “liquidity trap” was nonsense, a relic of some past era and/or the invention of some crank called Keynes.  These theories claimed that everybody was perfectly rational, all markets (particularly financial markets) were efficient, and uncertainty/risk about the future was unimportant.  They were wrong. We are left with the ideas of the mid-20th century, the stuff that we were told to forget about.  Again Delong:


Four years ago nearly all mainstream economists would have said that, even though the situation appeared serious, by now the economy would be back to normal. …


Very few of us thought that it would be long and nasty…


And as it turned out to be long and nasty, recent economic theories of macroeconomics have fallen like tropical rain forests. The–already implausible–claims that downturns had real causes? Fallen. The claim that downturns lasted only as long as workers misperceived their real wage? Fallen. The claim that the labor market cleared in a small number of years? Fallen. Those of us who believed that the long run came soon, that the cause of downturns was transitory price-level misperceptions, or that downturns had real causes need now to be looking for new jobs, or at least new theories.


And we are left with the live macroeconomic theories being those of the 1960s, at the latest. This is embarrassing for those of us who want to belong to a profession that is a progressive science, rather than an analogue of medieval barbering.


So what would the economic theories of the 1960s and before tell us to do?


    

  • Milton Friedman: monetary expansion, and more monetary expansion–quantitative easing as deep and as broad as necessary to get nominal GDP back to its trend.
    • 

  • John Maynard Keynes (or at least one of the moods of Keynes): have the government borrow and buy stuff, and keep buying stuff until real economic activity is back to some normal trend value.
    • 

  • Jacob Viner: Why choose? Do both! Print lots of money and have the government use it to buy stuff and hire people.
    • 



The odd thing is that none of those three recommended policies–all of which are sponsored by economists with the purest of purebred pedigrees–have been followed.


It’s time to do two things.  At the policy level we need to go back and try the policies that we understood back in the 50′s and 60′s (economy did pretty well back then, BTW).  Some serious, bold attempts at effective government spending would be nice instead of the weak, too-small, too-timid, niggling efforts dominated by tax cuts we’ve been doing.  And even on the monetary front, it would be more useful to do as Friedman suggested: actually have The Fed keep buying bonds for cash (real circulating money instead of just bank reserves) and keep it up until people start spending it.


On the economics side, we need to get past the perfect rationality and rational expectations stuff (and it’s absurd mathematics) that has dominated the profession.  It would be a good idea to take a more serious look at the heterodox ideas and theories that actually did foresee the crash, the ones based upon realistic models of human behavior and models instead of the perfectly rational, knows-the-future home economicus of the New Classical and New Keynesian models.  We need to seriously look at ideas of Modern Monetary Theorists (MMT), Minsky, the Post-Keynesians, and the behavioral economists.