Defunct but still dominant and dangerous

I am reserving Friday’s for no blog, short blog or normal blog depending on whether I can do other things and keep my weekend’s free of blog activity. In general I will use Friday’s to put a Quiz up for Saturday and prepare the Answers and Discussion for Sunday. If I have some “blog” time left and there is something interesting to write about then I will post it – like today. There was an interesting article in the UK Guardian (July 21, 2010) by Robert Skidelsky who was the biographer of John Maynard Keynes. The article – What do deficit slashers wear under their hair shirts? – probes the “assumptions made by the economists who demand rapid ‘fiscal consolidation'”. I thought that was interesting given that most of the published justifications for austerity rather vaguely invoke failed economic theories like Ricardian Equivalence and Rational Expectations. Skidelsky’s point is that these defunct macroeconomic doctrines which got us into this mess are now resurfacing as the dominant narrative. That spells disaster.

Skidelsky begins:

All intellectual systems rely on assumptions that do not need to be spelled out because all members of that particular intellectual community accept them. These “deep” axioms are implicit in economics as well but, if left unscrutinised, they can steer policymakers into a blind alley. That is what is happening in today’s effort, in country after country, to slash spending and bring down budget deficits.

I think this is an essential point for people to understand. The mainstream economists hide behind lies. Most of the time they claim their policy recommendations are derived from economic theory. The reality is that they are not and economists lie and obsfucate.

There are many situations where strident policy suggestions – like the austerity packages – cannot be based on the economic theory that they are associated with – on the theories that economists use to give an air of authority and legitimacy to what are otherwise demands based on their blind ideology.

Unfortunately, the public is not in a position to judge and get swamped by the arrogance of economists. They never realise that the policy statements being made are rarely traceable in any legitimate way to the theories being held out as the authority for the statements. They never realise that most of the theories fail to have any traction if the underlying assumptions do not hold in their entirety.

Given they rarely (if ever) do, then there is no theoretical authority.

In 1956 two economists (Richard Lipsey and Kelvin Lancaster) came up with a very powerful new insight which was called the Theory of the Second Best. You won’t hear much about the theory any more because like all the refutations of mainstream theory it got swept under the dirty (filthy) neoclassical carpet and economics lecturers using homogenised, ideologically-treated textbooks continue blithely as if nothing happened.

The Theory of Second Best basically says that if all the assumptions of the mainstream theory do not hold then trying to apply the results of the theory is likely to make things worse not better. So “if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the ones that are usually assumed to be optimal” (Source).

Take the model of perfect competition which requires several assumptions to be valid (for example, perfect information, perfect flexibility of prices, perfect foresight, no market power being wielded by firms, workers or anyone etc) for the main theoretical insights (results) to have validity.

Economists often say that governments should try to dismantle real world “rigidities” (as they call them) so that they can move the economy closer (but not to) perfect competition – because in their fantasy comic book texts this is the ideal state.

The Theory of Second Best tells us that if you do not have that “ideal state” and you dismantle one “rigidity” but leave others then you can make things worse off. The other point is that often it is “better” for governments to introduce new “rigidities” to confront existing departures from perfect competition.

It is all in the “counting angels on the top of a pinhead” territory that us economists spend most of our tawdry careers engaged in as if it matters but the point is that the theory really destroys the capacity of the mainstream economists to use “perfect competition” models as an authority in the policy debate. The text book models have no legitimacy in the policy domain. You might like to read Paul Krugman’s take on Lancaster’s work.

Another example of the way theory is misused in the policy debate is in the application of Ricardian Equivalence. It is one of the theories being used at present to legitimise the austerity push The modern version was developed by Robert Barro at Harvard.

First, start with the mainstream view that: (a) In the short-run, budget deficits are likely to stimulate aggregate demand as long as the central bank accomodates the deficits with loose monetary policy; and; (b) in the long-run, the public debt build-up crowds out investment because it competes for scarce savings.

I have written countless words to show how farcical this view of the monetary system is. First, deficits put downward pressure on the interest rate and central banks issue debt to stop that downward pressure from arresting control from them of their target interest rate. Second, there is no finite pool of saving except at full employment. Income growth generates its own saving (investment brings forth its own saving) and governments just borrow back the funds (drain bank reserves) $-for-$ that the deficits inject anyway.

But lets just start with the mainstream view. Barro then said that the government does “our work” for us. It spends on our behalf and raises money (taxes) to pay for the spending. When the budget is in deficit (government spending exceeds taxation) it has to “finance” the gap, which Barro claims is really an implicit commitment to raise taxes in the future to repay the debt (principal and interest).

Under these conditions, Barro then proposes that current taxation has equivalent impacts on consumers’ sense of wealth as expected future taxes.

For example, if each individual assesses that the government is spending $500 this year per head and collects $500 per head “to pay for it” then the individual will cut consumption by $500 because they are worse off.

Alternatively, if the individual perceives that the government has spent $500 this year but proposes to tax him/her next year at such a rate that the debt will be cleared then the person will still be poorer over their lifetime and will probably cut back consumption now to save the money to pay the higher taxes.

So the government spending has no real effect on output and employment irrespective of whether it is “tax-financed” or “debt-financed”. That is the Barro version of Ricardian Equivalence.

The models suggest that individuals assess the total stream of income and taxes over their lifetime in making consumption decisions in each period.

On tax cuts, Barro wrote (in ‘Are Government Bonds Net Wealth?’, Journal of Political Economy, 1974, 1095-1117):

This just means that lower taxes today and higher taxes in the future when the government needs to pay the interest on the debt; I’ll just save today in order to build up savings account that will be needed to meet those future taxes.

So what are the assumptions that Barro makes which have to hold in entirety for the logical conclusion he makes to follow? Note this is not to say that any of his reasoning is a sensible depiction of the basic operations of a modern monetary system. It just says that if we suspend belief and go along with him for the ride then the only way he can derive the conclusions from his model that he does requires the following assumptions to hold forever.

Should any of these assumptions not hold (at any point in time), then his model cannot generate his conclusions and any assertions one might make based on this work are groundless – meagre ideological raving.

First, capital markets have to be “perfect” (remember those Chicago assumptions) which means that any household can borrow or save as much as they require at all times at a fixed rate which is the same for all households/individuals at any particular date. So totally equal access to finance for all.

Clearly this assumption does not hold across all individuals and time periods. Households have liquidity constraints and cannot borrow or invest whatever and whenever they desire. People who play around with these models show that if there are liquidity constraints then people are likely to spend more when there are tax cuts even if they know taxes will be higher in the future (assumed).

Second, the future time path of government spending is known and fixed. Households/individuals know this with perfect foresight. This assumption is clearly without any real-world correspondence. We do not have perfect foresight and we do not know what the government in 10 years time is going to spend to the last dollar (even if we knew what political flavour that government might be).

Third, there is infinite concern for the future generations. This point is crucial because even in the mainstream model the tax rises might come at some very distant time (even next century). There is no optimal prediction that can be derived from their models that tells us when the debt will be repaid. They introduce various stylised – read: arbitrary – time periods when debt is repaid in full but these are not derived in any way from the internal logic of the model nor are they ground in any empirical reality. Just ad hoc impositions.

So the tax increases in the future (remember I am just playing along with their claim that taxes will rise to pay back debt) may be paid back by someone 5 or 6 generations ahead of me. Is it realistic to assume I won’t just enjoy the increased consumption that the tax cuts now will bring (or increased government spending) and leave it to those hundreds or even thousands of years ahead to “pay for”.

Certainly our conduct towards the natural environment is not suggestive of a particular concern for the future generations other than our children and their children.

Barro’s theorem led to a torrent of empirical work, particularly after the US Congress gave out large tax cuts in August 1981, which was the first real world experiment possible (that is, if you consider the US as they do to be the real-world!).

The tax cuts were legislated to be given over 1982-84 to stimulate aggregate demand. Barro’s adherents all predicted there would be no change in consumption and saving should have risen to “pay for the future tax burden” which was implied by the rise in public debt at the time.

But, if you examine the US data you will see categorically that the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84).

Once again this was an example of a mathematical model built on un-real assumptions generating conclusions that were appealing to the dominant anti-deficit ideology but which fundamentally failed to deliver predictions that corresponded even remotely with what actually happened.

Barro’s RE theorem is a dismal failure and cannot be used as an authority for the type of statements I noted earlier. Please read my blogs – Deficits should be cut in a recession – We are sorry – Spending multipliers and Pushing the fantasy barrow – for more discussion on the poverty of the Ricardian Equivalence notion.

Skidelsky continued:

The chief task that John Maynard Keynes set himself in writing his General Theory of Employment, Interest, and Money was to uncover the deep axioms underlying the economic orthodoxy of his day, which assumed away the possibility of persistent mass unemployment. The question he asked of his opponents was: “What must they believe in order to claim that persistent mass unemployment is impossible, so that government ‘stimulus’ to raise the employment level could do no good?” In answering this question, Keynes reconstructed the orthodox theory – and then proceeded to demolish it.

Today, despite the Keynesian revolution, the same question demands an answer. What do people who demand rapid “fiscal consolidation” amid heavy unemployment need to believe about the economy to make their policy coherent?

This is very important because the bullies (G20, the IMF and the OECD and the market economists and academic commentators) are all pushing the line that pro-cyclical budgets at a time when private spending growth is weak or non-existent “is the only way back to prosperity”.

At the very least this defies the logic that firms are not investing because they cannot sell enough goods and services at present and consumers are not spending because they fear rising unemployment and they are trying to reduce their debt levels.

All the empirical evidence points to this being an large-scale aggregate demand failure. That means a spending failure. If the non-government sector has cut its spending and is reluctant to restore its growth then there is only one sector left!

The mainstream austerity proponents seem to think that in this environment if the government joins the wowser brigade and cuts back too the private sector will start to feel good despite unemployment rising and sales falling and start spending. They apparently will start to relish the prospect of lower taxes in the future because the deficit will be lower.

And at that point I always conclude these proponents have not studied history properly and do not have a clue about the way budgets work and the way way they interact with the monetary system.

Skidelsky notes that:

When I ask this question, I never get a coherent answer; so let me retrace Keynes’s steps.

Mainstream macroeconomists are deft at avoiding discussion outside the narrow box they operate in. I have had a career of this sort of non-engagement. I have met so many walls of arrogant denial that I became used to it very early.

Skidelsky provides his readers with a refresher on the so-called “Keynes and the Classics” debate which pitted the UK Treasury view in the 1930s with the emerging views that became identified with Keynes but were also developed by several others (Kalecki, Marx etc).

A major flaw in the mainstream reasoning in the 1930s (and still today) surrounds the so-called “Say’s law” which claims that “supply creates its own demand”. Say’s law denies there can ever be over-production and unemployment. If consumers decide to save more then the firms react to this and produce more investment goods to absorb the saving. There is total fluidity of resources between sectors and workers are simply shifted from making iPods to making investment goods.

Keynes showed that when people save – they do not spend. They give no signal to firms about when they will spend in the future and what they will buy then. So there is a market failure. Firms react to the rising inventories and cut back output – unable to deal with the uncertainty.

The break with neoclassical thinking came with the failure of markets to resolve the persistently high unemployment during the 1930s. The debate in the ensuing years were largely about the existence of involuntary unemployment. The 1930s experience suggested that Say’s Law, which was the macroeconomic component and closure of the neoclassical system based on the optimising behaviour of individuals, did not hold.

The neoclassical economists continued to assert that unemployment was voluntary and optimal but that some factors not previously included in the model prevented Say’s Law from working. Keynes, following Marx and Kalecki, adopted the distinctly anti-orthodox approach and refuted the basis of Say’s Law entirely.

The theoretical push to reassert Say’s Law by neoclassical economists was severely dented by the work of Clower (1965) and Axel Leijonhufvud (1968). They demonstrated, in different ways, how neoclassical models of optimising behaviour were flawed when applied to macroeconomic issues like mass unemployment.

Clower (1965) showed that an excess supply in the labour market (unemployment) was not usually accompanied by an excess demand elsewhere in the economy, especially in the product market. Excess demands are expressed in money terms. How could an unemployed worker (who had notional or latent product demands) signal to an employer (a seller in the product market) their demand intentions?

Leijonhufvud (1968) added the idea that in disequlibrium price adjustment is sluggish relative to quantity adjustment. Leijonhufvud interpreted Keynes’s concept of equilibrium as being actually better considered to be a persistent disequilibrium. Accordingly, involuntary unemployment arises because the labour market is not in equilibrium and there is no way that the unemployed workers can signal that they would buy more goods and services if they were employed.

Any particular firm cannot assume their revenue will rise if they put a worker on even though revenue in general will clearly rise (because there will be higher incomes and higher demand). The market signalling process thus breaks down and the economy stagnates.

Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.

Skidelsky notes that:

Say’s law is alive and well among new classical macroeconomists such as John Cochrane and Eugene Fama. It amounts to claiming that the factors of production will always be fully employed, and that, in Cochrane’s words, “if the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment.”

So a theory that was categorically reduced to having zero validity in a previous time has remained alive in the conservative economics departments and is once again being used to justify the ideological policy positions. How many government officials who are designing these austerity programs are familiar with the “Keynes and Classics” debate and the subsequent contributions of Robert Clower (1965) and Axel Leijonhufvud (1968), for example? Not many!

Skidelsky says that the other contribution of Keynes is being ignored:

The second classical postulate Keynes identified was that the “real wage is equal to the marginal disutility of labour”. This means that, in a competitive labour market, real wages will always be instantly adjusted to changes in conditions of demand. In other words, there can never be involuntary, or unwanted, unemployment.

Keynes denied that real wages are set in the labour market. Workers bargain for money wages, and a reduction in their money incomes might leave total demand too low to employ all those willing to work. Yet today most economists model unemployment as “voluntary” – a rational preference for leisure rather than work. This reinforces the idea that “stimulus” cannot do any good, since workers have as much employment as they want.

The mainstream position on unemployment is based on a fallacy of composition. Macroeconomics emerged out of the failure of mainstream economics to conceptualise economy-wide problems – in particular, the problem of mass unemployment. Please read my blog – What causes mass unemployment? – for more discussion on this point.

Marx had already worked this out and you might like to read Theories of Surplus value where he discusses the problem of realisation when there is unemployment.

In my view, Marx was the first to really understand the notion of effective demand – in his distinction between a notional demand for a good (a desire) and an effective demand (one that is backed with cash).

This distinction, of-course, was the basis of Keynes’ work and later debates in the 1960s where Clower and Axel Leijonhufvud demolished mainstream attempts to undermine the contribution of Keynes by advancing a sophisticated monetary understanding of the General Theory.

The point is that prior to this the mainstream failed to understand that what might happen at an individual level will not happen if all individuals do the same thing. In terms of their solutions to unemployment, they believed that one firm might be able to cut costs by lowering wages for their workforce and because their demand will not be affected they might increase their hiring.

However, they failed to see that if all firms did the same thing, total spending would fall dramatically and employment would also drop. Again, trying to reason the system-wide level on the basis of individual experience generally fails.

Wages are both a cost and an income. The mainstream ignored the income side of the wage deal. The technical issue comes down to the flawed assumption that aggregate supply and aggregate demand relationships are independent. This is a standard assumption of mainstream economics and it is clearly false.

Mass unemployment occurs when there are not enough jobs and hours of work being generated by the economy to fully employ the willing labour force. And the reason lies in there being insufficient aggregate spending of which the net spending by government is one source.

The erronous mainstream response to the persistent unemployment that has beleaguered most economies for the last three decades is to invoke supply-side measures – wage cutting, stricter activity tests for welfare entitlements, relentless training programs. But this policy approach, which has dominated over the neo-liberal period, and reflects their emphasis on the individual falls foul of the fallacy of composition problem.

They mistake a systemic failure for an individual failure. You cannot search for jobs that are not there. The main reason that the supply-side approach is flawed is because it fails to recognise that unemployment arises when there are not enough jobs created to match the preferences of the willing labour supply.

The research evidence is clear – churning people through training programs divorced from the context of the paid-work environment is a waste of time and resources and demoralises the victims of the process – the unemployed.

Skidelsky’s final point is worth noting:

The classical view of the economy, which Keynes set out to demolish, is not only alive, but in recent years has been dominant, feeding the belief that competitive markets can be left to regulate themselves, will always provide as much employment as is wanted, and are immune to large-scale collapse. This also fuels opposition to government intervention, and to “stimulus” policies, which are supposedly redundant, if not harmful, since the events that require them cannot happen (but do).

Yes, and the application of these ideological beliefs to real policy will not only undermine short-term prosperity but will set the conditions for a further major crisis in the coming years and ultimately, ugly social unrest.

Conclusion

I heard an idiot from the right-wing Centre of Independent Studies last night being interviewed on the ABC’s new 24-hour news channel. I cannot find the transcript but it would have been a good way to finish the week – comic relief. He was talking about the Australian election campaign which is now in full swing. Both sides of politics are trying to win votes by preaching the virtues of austerity when we still have 12.2 per cent (minimum) of our willing labour resources not working! Go figure that!

His mantra was “the Government has run out of money. The government has no more money left. Whoever wins will have to cut back”. My eyes rolled at that stage and it is lucky I am not prone to temper tantrums or I would have replaced many TV sets.

The important point is that the ABC has the audacity to put this galoot in front of our nation in the first hour of launching their new channel. It was an appalling interview and shows that charlatans exist everywhere. It reminded me of something that Fox would show in America not something that our publicly-funded national broadcaster should be showing here. It just shows how far things have slipped.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow – even harder than last week!

That is enough for today!