The capacity of the state and the open economy – Part 1

Wolfgang Merkel wrote in his recent Op Ed (February 5, 2016) – Economy, Culture And Discourse: Social Democracy In A Cosmopolitanism Trap? – that “we are dealing with a partially deliberate, partially careless surrender of the state’s capacity to regulate and intervene in an economy that structurally creates socio-economic inequality and erodes the fundamental democratic principle of political equality”. I highlight, the “partially deliberate, partially careless surrender” description of what has occurred over the last several decades as neo-liberalism has gained traction. Today’s blog continues my series that will form the content for my next book (due out later this year) about the impacts of globalisation on the capacities of the nation state. Our contention (I am writing this with Italian journalist and author Thomas Fazi) is that there has been no diminuition in the power of the state to impact on the domestic economy. The neo-liberal era has seen many commentators deny that proposition, yet, knowingly advocate use of these powers to further advantage capital at the expense of labour. The state is still central to the picture – it just helps capital more and workers less than it did during the full employment period in the Post World War II decades.

This blog continues the themes began in the blog – The Modigliani controversy – the break with Keynesian thinking

As background to this blog, the following articles were cited in Part 1:

1. Modigliani F. and Padoa-Schioppa, T. (1977) ‘La politica economica in una economia con salari indicizzati al 100% o più’, Moneta e Credito, 117, 3-53. Download

2. English version (1978) – The Management of an Open Economy with ‘100% Plus’ Wage Indexation, Essays in International Finance, Princeton University, 130, 221-259.

3. Cattabrini, F. (2012) ‘Franco Modigliani and the Italian Left-Wing: the Debate over Labor Cost (1975-1978)’, History of Economic Sword and Policy, 75-95]. He argued that the first cited paper began a vigourous debate in Italy at the time, which was influential in changing the way the Left thought about macroeconomic policy.

In Part 1, I considered some factors, which led to the essential insights in John Maynard Keynes’ General Theory being hijacked by the neo-classical school (of which the neo-liberals have come out of).

In part, this was due to Keynes himself accepting the essential neo-classical assumption that in the capitalist economy the real wage is set equal to the marginal product of labour (the so-called Postulate I).

This acceptance of Postulate I meant that Keynes accepted the idea of diminishing marginal productivity (that is, that as employment rose each additional worker would be less productive than the last), a fundamental neo-classical proposition.

In turn, this meant that he accepted the neo-classical proposition that “any means of increasing employment must lead at the same time to a diminution of the marginal product and hence of the rate of wages measured in terms of this product”.

In other words, he accepted that there was an inverse relationship between real wages and employment.

The causation that Keynes invoked to explain that association between employment and the real wage was different to the Classical theory. But in the General Theory, Keynes considered that the firms were always “on” their demand curve (Postulate I) and aggregate demand fluctuations shifted employment up and down that curve.

For Keynes, it was that aggregate spending determined employment, but with fixed money wages, as output rose, prices rose (he also assumed competitive prices) because unit costs rose as firms it diminishing marginal productivity. As a result, the real wage also fell (higher prices deflating fixed money wages), which established the inverse relationship between employment and the real wage.

But he understood that cutting the wage as a remedy to unemployment would not work because it would likely reduce spending and at any rate would reduce unit costs and prices would fall accordingly, probably leaving the real wage unchanged.

The point is that his underlying logic was blurred as other economists from the neo-classical tradition sought to reconstruct his theory of effective demand and make it compatible with the extant neo-classical doctrine, which Keynes had, in fact, thoroughly rejected (after a long struggle in his own work to do so).

Within a year of the General Theory being released, the English economist J.R. Hicks proposed the so-called IS-LM model of joint product and money market equilibrium, which became one of the centrepieces of the so-called Neo-classical Synthesis in the Post WWII period.

The model was not at all consistent with Keynes’ vision and eliminated, among other things, the importance of expectations and investment behaviour – a key idea in the theory of effective demand and the tendency of monetary economies operating under conditions of endemic uncertainty to generate mass (involuntary) unemployment.

In the early 1970s, the OPEC oil crises and the inflation that followed the rise in oil prices, provided the vehicle to extend this hijacking of Keynes’ work into more objectionable doctrine in the form of Monetarism.

After a long period of academic insurgency led by economists at the University of Chicago (led by Milton Friedman), their attack on interventionist fiscal policy embodied in what became known as Monetarism began to quickly permeate both the Academy and then the policy-making process.

In the same way that the ‘Keynesian’ rescue of capitalism after the Great Depression, had, in John Kenneth Galbraith’s words been motivated “not from businessmen, bankers or owners of shares but … from intellectuals” (the so-called “Mandarin Revolution”), the Monetarist rise to dominance came out of the Academy and was the product of a deep resentment among free-market economists with the practice of government intervention.

[Reference: Galbraith, J.K. (2001) The Essential Galbraith, New York, Houghton, Mifflin and Harcourt. (Chapter The Mandarin Revolution, quote is from page 224)].

However, unlike the ‘Keynesian Revolution’, Monetarism was also bankrolled by the strong and growing involvement of so-called ‘think tanks’, which were well-funded by the corporate sector and deliberately designed to bias the public debate in favour of the Monetarist policy agenda, which had morphed into a full-scale assault on the economic intervention at both macro and micro levels by the state.

This ‘conspiracy’ to present so-called ideological polemic as independent argument and authority helped the neo-liberal approach gain traction, particularly within the political process.

The biases in the appointment promotion process, editorial policies of so-called learned journals, grant awarding committees tand the design of graduate programs in economics ensured the spread of Monetarist ideas were rapid within the Academy.

While the ‘Keynesians’ considered government intervention was required to ensure there was sufficient aggregate spending to sustain full employment, the Monetarists claimed that such efforts were, ultimately self-defeating and ended in accelerating inflation and no change in the unemployment rate, which they said would converge over time on what they called the ‘natural rate of unemployment’.

Another aspect in the rising Monetarist dominance was that it was argued that Keynes’ General Theory was written in a closed economy context (no financial flows or trade between nations) and, in the context, of the increasing globalisation of supply chains and cross-border financial flows in the 1960s, this meant the conceptual insights were unable to cope with the changing world.

Keynes had clearly demonstrated that there was no automaticity in the capitalist system to full employment if we abstract from international trade and finance.

But to say that he neglected any open economy considerations is untrue. He understood that when trade was introduced to the analysis the so-called spending multiplier would take a different value (leakages from imports, which were considered to rise when domestic income rose, would reduce the impact of a domestic government spending stimulus on real GDP).

He understood that there was little difference between an increase in foreign investment and domestic investment when considering the spending effects on employment.

He also understood that reductions in nominal wages might, under some circumstances, reduce a balance of trade deficit (via falling imports).

In the General Theory, Keynes explicity discussed the beggar-thy-neighbour of consequences of export-led growth strategies which combined domestic cost cutting with exchange rate devaluation. He argued that while this might reduce unemployment in one economy, it does so by increasing it elsewhere:

He saw “export-led growth policy” as being (382-83):

… a desperate expedient to maintain employment at homeby forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbour which is worsted in the struggle …

Accordingly, he advocated learned “to provide themselves with full employment by their domestic policy … there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbor” (p.382). So despite the existence of international trade and capital flows (albeit in volumes much lower than today), Keynes believed that the state could use its macroeconomic policy choices to maintain full employment in all nations.

But he also indicated (Keynes, 1980, p.25) that, at times, restrictions on capital flows might be necessary because:

Loose funds may sweep round the world disorganizing all steady business. Nothing is more certain than that the movement of capital funds must be regulated …

[Reference: Keynes, J.M. (1980) The Collected Writings of John Maynard Keynes, Volume 25, Moggridge, D. (ed.), London, Macmillan].

But despite this recognition, it is fair to say that the ‘Keynes versus Classics’ debate was not about the consequences of trade liberalisation or capital flows. Rather, it was focused on domestic policy choices, in particular, the impact of money wages on employment and the role interest rates play on real GDP levels.

That emphasis morphed into a central concern about balance of payments issues and market power in the 1970s.

The rejection of ‘Keynesian’ orthodoxy though was not only coming from the right, however. Even before the OPEC oil crisis, there was an emerging literature in the late 1960s and early 1970s, which declared in not as many words that the ‘Keynesian’ era had ended.

John Kenneth Galbraith wrote an article in The New York Times Magazine (June 7, 1970) where he argued that the inflation that was emerging in the early 1970s could not be exclusively explained in terms of the US government expenditure associated with the prosecution of the Vietnam War.

This would have constructed the inflation as a demand-pull event, which was totally consistent with the perceived ‘Keynesian’ wisdom of the day. Instead, Galbraith argued that it was a build up of cost factors (so-called ‘cost-push’ inflation) that were associated with the distributional struggle between labour and capital that were at the root cause of the emerging problem.

He argued that the idea that the ‘market’ was operational in determining the allocation of resources and the prices that emerged was outdated and that ‘market competition’ had been usurped by the emerging of large, price fixing institutions in the economy – trade unions and large, multinational firms.

These non-competitive institutions were able to fix wages and prices to the detriment of the general population through capricious use of their respective monopoly powers.

He noted that with rising unemployment rates in the US in the late 1960s into the early 1970s, that trade unions were still pushing for and gaining increasing wage settlements that outstripped any measures of labour productivity growth. He also noted that manufacturing firms were able to push up end prices for goods and services despite significant idle capacity being evident at the time.

[Reference: Galbraith, J.K. (1970) ‘Wage-Price Controls-The Cure for Runaway Inflation’, The New York Times Magazine, June 7, 1970]

The following year, Galbraith wrote a further Op Ed article in the The New York Times (July 20, 1970) where he said that “Keynes has become obsolete” as a result of the monopoly power exerted by big business and the powerful trade unions. The problem that Keynes had addressed related to demand-side (spending) deficiencies, which led to mass unemployment, whereas the contemporary issue for Galbraith was was on the supply-side – the struggle between labour and capital for greater shares on national income.

[Reference: Galbraith, J.K. (1971) ‘GALBRAITH URGES WAGE-PRICE CURB; Asks Permanent Controls on Big Unions and Concerns Galbraith Urges a Permanent Wage-Price Curb’, New York Times, July 20, 1971].

Canadian Keynesian economist John Cornwall brought his earlier work together in the 1983 book – The Conditions for Economic Recovery where he sought to explain why the 1970s was marked by low real GDP growth, “high and rising unemployment” (p. 199) and continuing inflation.

He considered that Keynes’ General Theory “had been written in response to another major breakdown, revealed largely in terms of mass unemployment” (p.199).

Keynes had rightly identified that elevated and persistent unemployment was “part of the natural evolution of capitalism; a failure of industrialized capital to generate enough aggregate demand to provide full employment” (p.199).

However, Cornwall’s argument “was that for employment, affluent capitalism generates new problems … a propensity to overspend, not just for employment but even when the economy still has a good deal of slack” (p.199).

He argued that during the so-called ‘Golden Age’ following World War II (p.199-200):

… as the economy moves towards full employment, different groups intensify their efforts to increase their share of income (through price and wage increases) in order to increase their demands on output … this inflationary bias was revealed in a noticeable acceleration of inflation rates …

In turn, “governments responded with restrictive aggregate demand policies … [which] … led to an increase in unemployment rates … [and] … a reduction in rates of growth of productivity. The additional restrictive measures undertaken almost everywhere in response to balance of payments difficulties, brought on by OPEC, only accentuated these policy-induced problems” (p.200)

[Reference: Cornwall, J. (1983) The Conditions for Economic Recovery, Oxford, Martin Robertson].

The idea was that this inflation bias introduced asymmetries in the way wages and prices responded to fluctuations in aggregate spending. So in bouyant times, wages and prices might accelerate upwards relatively quickly, as big business and unions battled it out for higher income shares, but when spending was weak, wages and prices would not fall quickly, if at all.

So there was a ratcheting up of wages and prices – with powerful and increasingly militant unions tending to the interests of their own members rather than considering the overall well-being of workers and big firms who were well aware that lengthy industrial action could lead to declining market share.

He argued that both realities prevented the wage price system adjusting to detrimental supply-side shocks. For example, at a time when a major deterioration in a nation’s terms of trade occurred (say, due to an oil price rise), there were no mechanisms in place to allow the economy to adjust to the decline in real income, that the external input price shock generated.

Real wage resistance and profit-margin push both prevented a non-inflationary resolution to a national real income loss from occurring.

Cornwall, however, rejected the idea that using “restrictive demand policies to curb inflation without a painful, prolonged period of high unemployment” could work (p.200). He argued that this approach also undermined the incentives for private investment, which, in turn, reduced labour productivity growth – and stagnation ensued.

Also, the lower rate of capital accumulation, lowered potential real output growth, which then undermined any attempts to reduce unemployment by increased fiscal spending. The recessed economy would hit the inflation barrier much more quickly as a result of the lower potential real output.

Importantly, Cornwall noted that these problems did not prove “that the Keynesian emphasis on aggregate demand is incorrect … the existence of asymmetrical responses of wages and prices in no way disproves the Keynesian view of the output and employment effects of changes in aggregate demand. Increases and decreases in aggregate demand have symmetrical (Keynesian) output and employment impacts” (p.200).

The correct conclusion, according to Cornwall was that “demand management is a most unsuitable instrument for reducing inflation” (p.201).

This insight the supported the call for wage and price guidelines that Keynesian economists such as J.K. Galbraith, Sydney Weintraub and John Cornwall had advocated to attend to the distributional struggle on the supply side without the need for costly mass unemployment, which was implied by the Monetarist approach.

After US President Nixon effectively abandoned the Bretton Woods fixed exchange rate system on August 9, 1971, he took the advice of economists such as J.K. Galbraith, and a week later (on August 15, 1971), he introduced price controls in the form of a 90-day freeze on wages and prices.

This was in expectation that as the US dollar floated freely, it would depreciate and impart import price rise impulses into the domestic economy, which was already enduring higher inflation rates than were deemed acceptable.

The initial 90-day freeze in August 1971, in fact, didn’t end until 1973. They provided the federal government with non-inflationary fiscal space to introduce expansionary policies aimed at increasing domestic growth and reducing unemployment

This is the context that the input of Modigliani and Padoa-Schioppa becomes relevant. The Monetarists were implacably opposed to the wage and price controls with Milton Friedman constantly attacking the government for interfering with the free market system.

Among the measures they opposed were automatic escalator clauses built into labour contracts to preserve real wages in the face of rising inflation.

In many countries, governments introduced indexation systems to protect wages as the oil shock-induced inflation increased and threated to erode real living standards for workers.

As an example, Italy, modified its wage indexation system by “establishing of a 100% indexation of wages to the rate of inflation” in 1975 (Cattabrini, p.2).

Modigliani and Padoa-Schioppa adopted the Monetarist ‘natural rate’ concept at the outset, despite there being major disputes about its validity (see Mitchell and Muysken, 2008).

They claimed that “ther exists, for each level of the … real wage, at most one level of output and employment that is consistent with price stability” (p.2). They called this level of output the “noninflationary rate of output” or NIRO (p.2).

Its importance in their theoretical structure was that (p.2):

If output is maintained above the NIRO by appropriate demand policies, then, even if output is maintained below fullemployment, a process of continuous inflation will be set into motion. The rate of inflation will tend toward a steady value that is higher the greater the excess of output over the NIRO. There is thus a tradeoff between the rate of inflation and output, and it is monotonically increasing.

Any increase in unit labour costs will worsen this trade-off (higher inflation at any given output level). So given that wage indexation (or any increase in the temporal adjustment of wages to inflation) would push up unit production costs, such a policy move would worsen the trade-off.

So fiscal policy, designed to maintain lower unemployment than is implied by the NIRO, is ultimately powerless to “affect the rate of output” (p.3) because it only feeds into accelerating inflation.

They argued that this problem is amplified when they consider the open economy. They said that new considerations include the observation that “prices may be directly influenced by foreign prices through foreign competitition in both international and domestic markets” (p.19).

Business firms thus might be unable to fully pass-on wage increases ahead of productivity growth because they are restricted by international competitive pressures.

Further, they introduced the ‘balance-of-payments constraint’, which says that the excess of imports over exports is limited “by the availability of foreign reserves” (p.20). Of course, this form of external constraint is binding if the nation determines that it will peg its exchange rate to another or a basket of currencies. Otherwise, trade imbalances not offset by capital flows will lead to an exchange rate shift rather than lost (or gained) foreign reserves.

Their main conclusion was that attempts to index wages to price movements would stifle profit rates because “international competition on foreign and domestic markets prevents firms from passing through to prices the entire increase in labor costs” (p.23), which also pushes out imports and worsens the balance of payments.

The external deficit can only persist if “the rest of the world is ready to finance …” it. But “the need to balance the foreign accounts implies the existence of a tradeoff between real wages and output just as in the closed economy” (p.23).

The government then has to stifle imports via restrictive demand policies or else devalue the currency. The latter drives up import prices, which then feed into the domestic price level, and sparks off further wage demands (and rises if indexation is in place).

However, when exchange rates float, the external balance is maintained at acceptable levels judged by foreign speculators, but the domestic inflation rate still behaves as it does when unit labour costs rise or fall in a closed economy.

[BILL NOTES: I WILL BE CONTINUING THIS IN PART 3]

Interestingly, Modigliani and Padoa-Schioppa qualified their rejection of fiscal policy as an instrument to stimulate domestic demand.

They said (p.3, and p.14)

These generalizations must be qualified only in the sense that the noninflationary rate of employment may be affected by direct government employment policies …

Contrary to the monetarist tenet,there is one conventional fiscal measure, the expansion of public employment, that can increase total employment even though it cannot increase private output …

In this sense,the swelling of public employment can offer a solution to the unemployment-inflation dilemma … It should be clear, however, that this is a sick type of solution which replaces productive private jobs with presumably less productive public employment and which,in the long run, will tend to worsen the situation by reducing investment and incentives in the private sector.

Conclusion

This is a further part of a series I am writing as background to my next book on globalisation and the capacities of the nation-state. More instalments will come as the research process unfolds.

The series so far:

1. Friday lay day – The Stability Pact didn’t mean much anyway, did it?

2. European Left face a Dystopia of their own making

3. The Eurozone Groupthink and Denial continues …

4. Mitterrand’s turn to austerity was an ideological choice not an inevitability

5. The origins of the ‘leftist’ failure to oppose austerity

6. The European Project is dead

7. The Italian left should hang their heads in shame

8. On the trail of inflation and the fears of the same ….

9. Globalisation and currency arrangements

10. The co-option of government by transnational organisations

11. The Modigliani controversy – the break with Keynesian thinking

The blogs in these series should be considered working notes rather than self-contained topics. Ultimately, they will be edited into the final manuscript of my next book due later in 2016.

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.