It is a disagreement about facts not ideology

In the wake of the decision by students at Harvard University to boycott an introductory economics lecture conducted by textbook writer Greg Mankiw, I thought this New York Times article (November 5, 2011) – Wanted: Worldly Philosophers – was interesting. It provides a much more reasoned assessment of what the issues might be than the response presented in the Harvard Crimson (the student daily) – Stay in School (November 3, 2011). The latter was signed “The Crimson Staff” and a link took us to an outlined photo of a “male” and the filename was entitled – noface_131x131.jpg. So no-one was even game to own up to the viewpoint. The male photo also suggests some inherent bias. I agree with the Crimson – walkouts should not be about ideology. But they are justified if a lecturer is offering material that is patently false and attempting to hold it out as the way the economy operates. That is why I would encourage students to walk out of mainstream macroeconomics lectures right around the globe. It is a disagreement about facts not ideology.

For reference, this is the photo that comes up when clicking on “The Crimson Staff” link to see if there are any actual people willing to take responsibility for the viewpoint that was presented as a header article in the Harvard Crimson.

The title of the New York Times Op Ed Wanted: Worldly Philosophers invoked memories of the great book by Robert Heilbroner – the 1953 Worldy Philospers, which according to Wikipedia is the “the second-best-selling economics text of all time” (after Paul Samuelson’s Principles). It was published in the UK in 1955 under the title The Great Economists.

It is a marvellous journey through ideas of the major thinkers in economics up to the time of writing. Heilbroner was an American economist who specialised in the history of economic thought and was first educated at Harvard. I only met him once when he was kind enough to take me out to dinner in New York after I had made a presentation there in 1998 on the Job Guarantee. It was a lovely evening – he was in his late 70s and full of brim and interest. The two of us had a great night talking economics – which might sound like a recipe for sleep!

The NYTs Op Ed was written by Keynes’ specialists Roger Backhouse and Bradley Bateman. Their argument is this:

… economists, to whom we might expect to turn for such vision, have long since given up thinking in terms of economic systems – and we are all the worse for it.

This wasn’t always the case. Course lists from economics departments used to be filled with offerings in “comparative economic systems,” contrasting capitalism and socialism or comparing the French, Scandinavian and Anglo-Saxon models of capitalism.

The traditional faire for students in economics included courses in economic history, history of thought, comparative systems as well as what went for mainstream principles.

There were also courses offered in Marxian Economics and a range of other challenging subjects which allowed a student who wasn’t attracted to the persuasion of the principles to explore alternative ideas and approaches.

The NYTs article suggests this pluralism was “in the context of the cold war” and was about showing the Soviet Union “that our system was better than theirs”. Perhaps that was the motivation but I also suspect that the intellectual debate was more fierce in those days and academics were more willing to make the diversity of their views known.

Universities have become increasingly managerial organisations and the old virtues of collegiality have lapsed – or should I say been driven out by managerial dictates. The trend has spread around the globe and there is no longer a sense of democracy in the university system. A professional class of managers now determine all the major policies. They also pay themselves handsomely (the senior managers at Australian universities are paid multiples of what our Prime Minister is paid).

Increasingly, they reward the managerial class with courtesy titles – “professorial” names – when no appointment committee has bestowed that status and on traditional criteria (research, teaching, community service) they would not attain in open competition.

Please read my blog – I have found an inflation threat – for more discussion on this point.

The increased managerialism of our universities has also led to a demise in certain disciplines and major changes in other disciplines such as economics. Business faculties have sprung up and have forgotten that the foundation discipline of all commerce is economics (and psychology). The broad array of subjects that used to be on offer to economics students have been narrowed down and concentrated on business-related material.

The NYTs article says that the motivation for pluralism “disappeared” once the Soviet system collapsed:

Globalization, so it is claimed, has created a single system of capitalism driven by international competition (ignoring the very real differences between, say, China and the United States). We now have an economics profession that hardly ever discusses its fundamental subject, “capitalism.”

Chapters 18 and 19 of Mankiw’s Principles (First Edition) consider the labour market. You will be taken through a journey of perfectly competitive markets where the interaction of supply and demand determine wage and employment outcomes. You will be encouraged to think of the labour input as an inanimate object such as a machine or a piece of land. There is nothing special signalled about the labour input other than “it is the most important factor of production, for workers receive the most of the total income earned in the U.S. economy”.

You will be led into believing that all “factors of production” earn what they contribute to production. Often you will read that a particular assertion – which his represented as a fundamental truth is – “widely accepted by economists”

You will not gain any appreciation that capitalism is a particular form of production organisation based on ownership of productive capital. You will not realise that in history – production has been organised in a number of ways and the labour market interactions and how the surplus production is distributed has varied in very significant ways as the ownership of capital has changed.

You will not gain any appreciation that in the labour market you have to delve deeper than the “exchange relations” which appear in Mankiw’s treatment if you are to understand what is happening and why. For example, in a simple commodity exchange, use values (the benefits of the commodities exchanged) are enjoyed after and outside the exchange. I buy a computer – the shop gets the money and enjoys that and I get the computer and enjoy that.

In the labour market, the worker sells his/her capacity to work (labour power) and the task of the capitalist (via some manager) is to extract the flow of labour from that capacity. The use value of the labour power is extracted while the worker is on the job and form part of the exchange. This is a fundamental different and raises a lot of questions – for example, what control mechanisms are introduced to ensure the worker once hired actually delivers surplus production? There is an extensive literature on supervision and control which address these issues.

The mainstream treatment leaves one to think that the transition from cottage industry to factory production, for example was because technological advances drove a cheaper form of organisation. But an understanding of history tells us that the move from house production to factor production essentially employed the same spinning jennies (same technology). The move “under-one-roof” facilitated an enhanced capacity to control the surplus production and ensure workers didn’t just work until they had earned enough to live.

These insights come from considering capitalism to be a special form of production and societal organisation. That approach to economics has disappeared as the neo-liberal dominance has grown.

In Mankiw’s Principles (First Edition) you will not read anything about trade unions (indeed in the whole book there is no index entry for trade unions). So the basic way in which workers organise to countervail the bargaining power in the wage contract held by the managers is totally ignored.

The NYT’s article notes that by focusing on narrow “technical problems” (as in the mainstream approach) we ignore the “vision about what the economic system should look like”.

It says that the great debates about capitalism between Keynes (who “believed it was the only system that could create prosperity, but it was also inherently unstable and so in need of constant reform”) and “Friedrich Hayek and Milton Friedman, who envisioned an ideal economy involving isolated individuals bargaining with one another in free markets” were the grist for all students before neo-liberalism suppressed the broader vision of economics.

The article notes that the “current crisis” has “undermined” the free market vision that was based on an antithesis to government intervention and a belief that self-regulating markets are stable and deliver optimal wealth.

The authors note that:

It took extensive government action to prevent another Great Depression, while the enormous rewards received by bankers at the heart of the meltdown have led many to ask whether unfettered capitalism produced an equitable distribution of wealth. We clearly need a new, alternative vision of capitalism.

The problem they note is that no new intellectual leaders are forthcoming out of the mainstream economics courses because the universities have suppressed a broader debate and have concentrated on just one approach – which is based on the free market perspective.

It is very hard for a free market economist to even discuss the role of the financial sector in the crisis because most of the models they use do not even include a coherent financial sector. They don’t even recognise concepts such as “power”.

The NYTs article notes that mainstream economics ignores “important pieces of human experience”:

To refuse to discuss ideas such as types of capitalism deprives us of language with which to think about these problems. It makes it easier to stop thinking about what the economic system is for and in whose interests it is working.

Which leads them to think that the “Occupy Movement” may not be “so misguided after all”. The questions they are asking:

… how do we deal with the local costs of global downturns? Is it fair that those who suffer the most from such downturns have their safety net cut, while those who generate the volatility are bailed out by the government?

Were the sort of issues that economics used to consider. The contention is that economists are no longer trained to develop thought in these areas.

The Harvard Crimson (the faceless men) take a different line on the walkout. The sub-tile of their commentary on the walkout was “Protesting a class’s ideology damages free academic discourse”.

The “faceless men” are critical of the “Occupy movement … for its many, and often contradictory, faces”. I laughed at this stage – at least the Occupiers have faces and publicly own up to their views

But the Harvard Crimson thinks that the walkout students in EC10 – share the contradictions they see in the Occupy movement. They say:

We find it troubling that students would protest a class because of its supposed ideological bent at an institution dedicated to academic integrity. Such an action sets a dangerous precedent of ideological discrimination against professors.

First, I agree that an academic should have free expression and free thought. There are challenging areas that sometimes make it hard to maintain that position. For example, should we allow studies of “child love” which start with the presumption that a child is not exploited in pedophiliac relationships by adults? Should we allow studies that deny there was a holocaust during the Second World War.

These are very challenging areas of “academic freedom” and the dividing line of acceptability is not clear. One cannot apply evidence-based rules to make it easier because the Popperian vision of science is so deeply flawed.

Second, the specific subject Ec10 is the first-principles course that is compulsory for majors. It is called Principles of Economics and was formerly named Social Analysis 10 as it is part of a major sequence offered at the University.

On September 14, 2006 the Harvard Crimson had this to say about Ec10 – Social Analysis 10, “Principles of Economics”:

Liberals criticize Ec10 as having a conservative bias and preaching a form of “free-market fundamentalism.” And it’s true that Mankiw-a former economic adviser to George W. Bush-did assign an article entitled “Two Cheers for Sweat Shops.” But hey, that’s economics, baby.

The article was written by “NO WRITER ATTRIBUTED” which is consistent with their record of “ownership” and fearless reporting.

So this was written by the newspaper that claims to represent Harvard students and criticise some fellow students who think that economics might be a bit broader than a free market religious seminar.

The point is that a compulsory introductory subject in a discipline should aim to provide a broad vision to students about what the subject matter and the evolution of the discipline is about.

The Mankiw textbook fails in that regard. I have no problem with students being exposed to particular viewpoints but not in compulsory subjects that represent themselves as the basics of the discipline.

The current Harvard Crimson attack on the boycott students considers that Mankiw curriculum:

… provides a necessary academic grounding for the study of economics as a social science. Professor Mankiw’s curriculum sticks to the basics of economic theory without straying into partisan debate. We struggle to believe that we must defend his textbook, much maligned by the protesters, which is both peer reviewed and widely used … Supply-and-demand economics is a popular idea of how society is organized, and Mankiw’s Ec 10 never presents itself as more than that. As such, including other theories would simply muddy the waters of what is intended; Ec 10 is an introductory class that lays the foundation for future, more nuanced, study.

So now we are not talking about ideology and perspectives but whether the material presented in this type of course and the textbook in question helps us understand how the economy works.

How society is organised!

I only choose to comment here on macroeconomics. Others who work in the area of microeconomics will have more incisive criticisms of the free market supply and demand approach – where demand curves are always assumed to slope downwards and supply curves upwards. It can easily be shown that some of the main conclusions of mainstream microeconomics are logically inconsistent.

In this blog – Do not learn economics from a newspaper – I consider broad critiques of Mankiw’s 10 Principles of Economics which students are confronted with in Chapter One of Mankiw’s textbook.

In the macroeconomics curriculum, students who rely on Mankiw to understand how the monetary system works much less how “society is organised” will be misinformed. This is not a critique at the ideological level but a plain evaluation of the “facts” that we can adduce from studying how the economy actually works.

Our private Modern Monetary Theory (MMT) E-mail group (mostly a few academics who write about MMT) exchanged some views over the weekend.

I noted that the general point is that the dispute about Mankiw and Ec10 at Harvard is not just a debate about “different” views – orthodox versus heterodox. My view is that mainstream macroeconomics (as taught by Mankiw) is really an exercise in the history of economic thought rather than being a course in principles that allow one to understand how the macroeconomic system operates.

Randy Wray succinctly noted that the Ec10 curriculum is akin to teaching bloodletting in a modern Medical school.

If you read Mankiw’s textbook (and my presumption form your views of the way the economy works by studying Ec10 at Harvard) you will leave the course totally uneducated about how the modern monetary system actually works.

For example, how is monetary policy implemented in a modern monetary economy? Mankiw’s students learn that monetary policy describes the processes by which the central bank determines “the total amount of money in existence or to alter that amount”.

In Mankiw’s Principles of Economics (Chapter 27 First Edition) he say that the central bank has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system” and the second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

How does the mainstream see the central bank accomplishing this task? Mankiw tells his students:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

This description of the way the central bank interacts with the banking system and the wider economy is totally false. My objection has nothing to do with Mankiw’s alleged free market bias or ideology. That is a quite separate issue.

The objection is that students should not be mislead. The reality is that monetary policy is focused on determining the value of a short-term interest rate. Central banks cannot control the money supply.

The Mankiw approach is a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. Hence the “bloodletting” reference – indicating a historically past set of ideas.

In a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.

The theory of endogenous money is central to the horizontal analysis in Modern Monetary Theory (MMT). When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 (Currency plus bank current deposits of the private non-bank sector plus all other bank deposits from the private non-bank sector) is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves.

Further expanding the monetary base (bank reserves) as I demonstrated in these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

In this regard, Mankiw’s students also learn that the money multiplier links the central bank’s capacity to manipulate the “monetary base” with the money supply. The concept also underpins the assertion that “Prices Rise When the Government Prints Too Much Money” (Mankiw’s Principle No. 9).

After a torturous rendition of the banks accepting deposits and then lending them out, Mankiw says (Chapter27) that:

The amount of money the banking system generates with each dollar of reserves is called the money multiplier

So the student will think that banks wait for deposits and then use the funds to extend loans. They will form the view that banks are reserve constrained. Please read my blog – Lending is capital- not reserve-constrained – to see why that is not a valid depiction.

Also please read my blogs – Money multiplier and other myths and Money multiplier – missing feared dead– for more discussion on this point.

If you want to understand how banks operate and interact with the central bank you have to abandon the Mankiw approach.

The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the central bank does not have the capacity to control the money supply. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves. In this regard the causality implied by the money multiplier is the reverse of what occurs in reality.

The banks create the need for reserves which then endogenously adjust (with the central bank standing by to ensure there are sufficient reserves in the system).

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

Students in Ec10 will learn nothing about the way bank reserve dynamics impact on monetary policy settings. Unchecked, movements in reserves can undermine the desired monetary policy stance (as summarised by the policy interest rate setting) and this requires central banks to engage in liquidity management operations.

What are these liquidity management operations? Well you first need to appreciate what reserve balances are.

The New York Federal Reserve Bank’s paper – Divorcing Money from Monetary Policy – said that:

… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

So the central bank must ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. But, equally, it must also maintain the bank reserves in aggregate at a level that is consistent with its target policy setting given the relationship between the two.

So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Many countries (such as Australia and Canada) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like the US and Japan have historically offered a zero return on reserves which means persistent excess liquidity would drive the short-term interest rate to zero.

The support rate effectively becomes the interest-rate floor for the economy. If the short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

There are many issues that arise from this understanding. But it is clear that Mankiw’s students don’t even get to first base on this. They “learn” that open market operations are ways the central bank controls the “money supply” which means they learn nothing of relevance to the way the system operates.

Please read my blog – Understanding central bank operations – for more discussion on this point.

That discussion was an example – of many I could have provided – where the students

Take another case – inflation. Principle 9 says that “Prices Rise When the Government Prints Too Much Money” and suggests that:

When a government creates large quantities of the nation’s money, the value of the money falls. As a result, prices increase, requiring more of the same money to buy goods and services.

First, the proposition assumes that governments spend by “printing money”. Mints print money for use by banks and their customers who desire to hold some of their liquidity in the form of notes and coins. This proportion of total financial assets held by the non-government sector is very small.

Governments rather spend and tax by crediting and debiting bank accounts. This is the way new net financial assets denominated in the currency of issue enter the economy. Why obscure this fact? Why not explain as a basic starting point to understanding how the modern monetary system operates how the government interacts with the non-government sector works?

Using emotive imagery of “printing too much money” is indoctrination not education. But that is only a minor terminological point and doesn’t go to the heart of the problem.

Second, inflation is a complex matter and arises because there is an imbalance between nominal demand growth and the real capacity of the economy to absorb that growth.

There is a rich literature tracing this to the income distribution struggle between workers and firms. They both seek to advance their claims on real output by pushing up their nominal claims (wage push, profit-margin push). Trade unions are central to this story.

Going back to the earlier discussion about labour being an inanimate “factor of production” – you can see that students are not exposed to any notion of a class struggle – workers want more for less and bosses want more for less – which is at the heart of the inflation process (historically).

In the conflict theory of inflation, the “incompatible claims” on nominal GDP ultimately drive nominal demand growth ahead of real income and inflation is the only way of resolving this incompatibility without policy intervention.

The Mankiw view is that poorly functioning governments cause inflation and this leads students to form erroneous views about government spending. His textbook uses Wiemar as an example. Why relate inflation as a starting principle when discussing fiscal policy? Students introduced to the topic in this way quickly form the view that inflation is intrinsically related to fiscal policy. It is not. It is related to nominal spending per se which could include excessive net exports, excessive private consumption, excessive private investment as well as excessive net public spending.

It is also intrinsic to the competing claims on national income that are mediated through price and wage setting power. That word – power – enters the fray again. There is nothing “simple” about supply and demand. It is mediated through social institutions that allow the exercise of power. What happens in the economy cannot be divorced from these considerations.

Further, from the perspective of public purpose, why would a government want to deliberately push the economy beyond full employment? It is easy to imagine an investment boom that was the result of uncoordinated private actions creating a nominal spending boom that went “too far” but why would a single entity (the government) not see the folly of doing it?

Conclusion

There are many examples of why Ec10 at Harvard misleads its students and prepares a particular approach to the economy – one which has lead to policy changes which allowed the inherent and destructive dynamics of the capitalist system to manifest in the form of the crisis.

If you just think that “simple supply and demand” explains most things economic then you will be left scratching your head trying to work out how this crisis occurred.

You will spend days in unresolved confusion trying to work out why interest rates are low yet deficits higher than usual.

You will be confused trying to explain where the money multiplier has disappeared to given the significant expansion of bank reserves and the slower growth in broader money aggregates.

And then you will flip out because inflation is largely stable if not falling.

And then you will remember there is a nation called Japan that has the largest public debt ratio of all nations, significant budget deficits, zero interest rates and falling inflation – and if you remember there is something called history – you might learn that Japan has been in that state for two decades now. Trying to understand Japan by applying the “simple supply and demand” principles in Mankiw will leave you totally confused.

The Harvard Crimson left us with this thought:

That being said, even if Ec 10 were as biased as the protesters claim it is, students walking out to protest its ideology set a dangerous precedent in an academic institution that prides itself on open discourse. This type of protest ignores opposition rather than engages with it. Instead of challenging a professor to back up his claims, it tries to remove him from the dialogue.

The point is not the bias. Ec10 purports to be an introductory explanation of how the economy works. In many instances it doesn’t even get to first base.

That is enough for today!