Friday, November 22, 2013

Econ Evolution Diagram

Here's a diagram to go with the post below on selected highlights of recent economic history:

Evolution of Selected Economic Schools

Tuesday, November 19, 2013

Economic History

Selected highlights of recent economic history:
  • up to1930 -- Laissez-faire is the conventional wisdom in capitalist countries, supported by Say's Law, i.e.: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value."
    Shorter version of Say's Law: "supply creates its own demand".
  • 1895 -- The chartalist theory was introduced by German statistician and economist G. F. Knapp.  Important contributions were made by Alfred Mitchell-Innes in 1913-1914. Chartalism experienced a revival under Keynes and Abba P. Lerner, and has a number of modern proponents.  Chartalism is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money, i.e., fiat money. The name derives from the Latin charta, in the sense of a token or ticket. The modern theoretical body of work on chartalism is known as Modern Monetary Theory (MMT).
  • Great Depression -- Keynes emerges as preeminent economist noting need for government to step in when markets fail.  Full employment cannot be maintained via laissez-faire policies, but demand can be boosted via fiscal policy to stimulate the economy.
    Shorter version of Keynesianism:  "demand creates its own supply".
  • 1940-1970 -- Keynesian economics reigns supreme in US and Europe. John Kenneth Galbraith is perhaps the leading Keynesian economist.
  • 1940-1970 -- neo-Keynesian economics developed to integrate classical (pre-Keynes) economics with Keynesian economics.  Paul Samuelson is perhaps the leading neo-Keynesian economist, developing a neoclassical synthesis which still dominates mainstream economics.  His 1948 textbook became the standard.
  • ~ 1945 -- early liberal forms of Keynesianism:
    • 1943 -- Abba Lerner develops functional finance, a theory of purposeful financing to meet explicit goals, including full employment, no taxation designed solely to fund expenditure or finance investment, and low inflation.  Functional finance is based upon the effective demand principle and chartalism.
    • 1947 --  Lorie Tarshis writes first introductory textbook that brought Keynesian thinking into American university classrooms. The work swiftly lost popularity after it was charged with excessive sympathy to communism by McCarthyist activists. 
  • 1970-1980 -- Stagflation and lack of political will lead to loss of faith in fiscal policy.  Monetarist alternative promoted by Milton Friedman gains prominence
  • 1980 -- Laissez-faire economics regains prominence in Republican circles under the guise of Supply-side Economics.  This fits well with Milton Friedman's Monetarism.
  • 1990 -- New Keynesian economics develops as a successor to the dormant neo-Keynesianism and a response to the resurgent laissez-faire advocates.  This watered-down Keynesianism adds little that is new or interesting (in my opinion), but is popular with powerful centrist Democrats as it offers a practical alternative to the laissez-faire Republicans.
  • 1975-present -- (most of this section is from WikipediaPost-Keynesian economics emerges as a school of economic thought with its origins in the works of John Maynard Keynes. Keynes's biographer Lord Skidelsky writes that the Post Keynesian school has remained closest to the spirit of Keynes's own work.
             Post-Keynesian economists are united in maintaining that Keynes's theory is seriously misrepresented by the two other principal Keynesian schools:  neo-Keynesian economics which was orthodox in the 1950s and 60s – and by New Keynesian economics, which together with various strands of neoclassical economics has been dominant in mainstream macroeconomics since the 1980s.
             The theoretical foundation of post-Keynesian economics is the principle of effective demand, that demand matters in the long as well as the short run, so that a competitive market economy has no natural or automatic tendency towards full employment.
             The positive contribution of post-Keynesian economics has extended beyond the theory of aggregate employment to theories of income distribution, growth, trade and development in which money demand plays a key role, whereas in neoclassical economics these are determined by the 'real' forces of technology, preferences and endowment. In the field of monetary theory, post-Keynesian economists were among the first to emphasize that the money supply responds to the demand for bank credit, so that the central bank can choose either the quantity of money or the interest rate but not both at the same time.
             This view has largely been incorporated into monetary policy, which now targets the interest rate as an instrument, rather than the quantity of money. In the field of finance, Hyman Minsky put forward a theory of financial crisis based on financial fragility, which has recently received renewed attention.
  • 1994-present -- Modern Modern Theory (MMT) is a branch of Post-Keynesian economics and Functional Finance as well as the modern version of Chartalism.  Along with the features of Post-Keynesian economics mentioned above, MMT relies on the work of Wynne Godley who described the accounting-oriented sectoral financial balances which constrain the macro economy.  For example, government deficits generally correspond to private sector surpluses as a simple matter of accounting.
              As one would expect from the name, MMT describes the working of modern fiat currencies in considerable detail.  This provides stark contrasts and significant insights in comparison with conventional economic schools (New Keynesian and laissez-faire/neoclassical/monetarist) which are based upon gold standard monetary systems.
             MMT is somewhat unique among economic schools in that it has both liberal and conservative supporters.  While most in the MMT community are liberal and advocate liberal policies, MMT also has conservative advocates.  The descriptive aspects of modern fiat monetary systems stand alone and can be separated from any policy recommendations of MMT proponents.
Another good account of recent economic history is in this paper by David Colander - Functional Finance, New Classical Economics and Great Great Grandsons.

More detail is provided below, mainly from John Kenneth Galbraith...

Here are some notes I took from John Kenneth Galbraith’s book via a commenter named "from Mexico" at the Naked Capitalism blog:
Say’s Law, not a thing of startling complexity, held that, from the proceeds of every sale of goods, there was paid out to someone somewhere in wages, salaries, interest, rent or profit (or there was taken from the man who absorbed a loss) the wherewithal to buy that item. As with one item, so with all. This being so, there could not be a shortage of purchasing power in the economy….
Until Keynes, Say’s Law had ruled in economics for more than a century. And the rule was no casual thing; to a remarkable degree acceptance of Say was the test by which reputable economists were distinguished from the crackpots. Until late in the ’30s no candidate for a Ph.D. at a major American university who spoke seriously of a shortage of purchasing power as a cause of depression could be passed. He was a man who saw only the surface of things, was unworthy of the company of scholars. Say’s Law stands as the most distinguished example of the stability of economic ideas, including when they are wrong….
This was the doctrine, perhaps more accurately the theology, that Keynes brought to an end…..
To suggest that there might be oversaving now no longer cost a man his degree or, necessarily, his promotion. That the proper remedy for oversaving was public spending financed by borrowing was henceforth a fit topic for discussion — although it continued to provoke bitter rebuke. The way was now open for public action.
The Keynesian adjustment to an excess of savings is through a reduction in aggregate demand. When demand falls, something must give, and what gives must be either prices or production. If prices can be held up by the market power of the corporation, it is production that must fall. When production falls, so will employment. With corporate market power, unemployment will thus become a highly distinctive feature of the Keynesian adjustment.
What had always been believed, as against Keynes and the Keynesians, was an inordinately powerful thing. For two hundred years Americans of the truest blood had displayed a penchant for paper money. For seventy years they had agitated for silver. Monetary experiment in the United States was thus in an ancient and politically most acceptable tradition. It also retained a large political constituency. A congressman or senator, returning to Oklahoma or Iowa after urging an issue of green-backs to enhance prices and advance social justice, could be a hero. No such tradition and no such constituency supported the idea of deficit financing, a deliberately, promiscuously unbalanced budget. A man returning to Iowa after advocating this in Washington might be thought dangerously insane.
Wise governments had always sought to balance their budgets. Failure to do so had always been proof of political inadequacy; things need not be any more complicated than that….
Roosevelt did not disagree; in his first post-convention radio speech he said the country must “stop the deficits,” adding that “Any Government, like any family, can for a year spend a little more than it earns. But you and I know that a continuation of that habit means the poorhouse.” 23
The beliefs so affirmed by the two Presidents were still powerful five years later — still a formidable barrier against the ideas of a distant English don. There was also explicit in Roosevelt’s position what has come to be called the fallacy of composition. This too was a staunch bar to the Keynesian ideas — and it remains influential to this day.
An engagingly plausible mode of thought, the fallacy of composition extends the economics of the family to that of the government. A family cannot indefinitely spend beyond its income. So neither can a government. A parent who borrows to live leaves debts, not a competence, to those who come after. A government that borrows does the same. Both are morally deficient.
The comparison between family and state, on second thought, is implausible…. [I]t should be observed that the wealth and solvency of a nation depend on what its national economy produces. If borrowing and spending enhance production, as the Keynesian ideas held, then such borrowing and spending enhance solvency. Only rarely do borrowing and spending enhance wealth for a family. It was an enduring complaint of Keynesians that their opposition did not understand what they were trying to do. It was equally the case that the Keynesians did not understand the depth of the tradition to which their opposition was subject or the power by which it was governed…..
The Great Depression showed the patent ineffectuality of monetary policy for rescuing the country from a slump — for breaking out of the underemployment equilibrium once this had been fully and firmly established. For this only fiscal policy would serve. Only fiscal policy ensured not just that money was available to be borrowed but that it would be borrowed and would be spent. This was the lesson of John Maynard Keynes...
By the early ’60s it had become the conventional wisdom of the New Economics that, at full employment, the revenues raised by the Federal government were too large in relation to expenditures. The result was “a fiscal drag” upon output, income and employment. To lessen this drag, a horizontal reduction in taxes was deemed necessary. By now, public sophistication allowed of such action; taxes could be reduced and the deficit increased for the deliberate and exclusive purpose of increasing the budget deficit and so improving economic performance. In 1964, such a reduction, amounting to $14 billion in revenues, was enacted. It was “the most overt and dramatic expression of the new approach to economic policy.”
Implicit in this action, however, was the need to reverse it should an excess of demand start pulling up prices. And this, as later history would amply establish, was far more difficult.
If taxes cannot be increased except under the force majeure of war and public expenditures cannot be decreased much for any reason, it follows that Keynesian policy is unavailable for limiting demand. It can expand purchasing power but it cannot contract it. During the twenty good years no reliable method was devised for dealing with the wage-price spiral — with direct market power as a cause of inflation. And fiscal policy was also becoming unavailable for dealing with inflation. The goals were there; the instruments for reaching them were becoming distressingly inoperative. There was one exception, and that was monetary policy. Nothing in the decline of other instruments was as unfortunate as the increasing faith in this one.
The final flaw was this revival, during these years, of faith in monetary policy. In light of the history of this instrument it was as surprising as it was damaging.
[M]uch of the revival was owing to the effective evangelism of the most diligent student of monetary policy and history during these years, Professor Milton Friedman. As a devout and principled conservative, Professor Friedman saw monetary policy as the key to the conservative faith. It required no direct intervention by the state in the market. It elided the direct management of expenditures and taxation, not to mention the large budget, which was implicit in the Keynesian system. It was a formula for minimizing the role of government — for returning to the wonderfully simpler world of the past…. It was merely that the task was far simpler than previously assumed; Professor Friedman returned to Irving Fisher and held that attention need be paid only to the quantity of money in Fisher’s equation…. If these aggregates were so controlled as to allow for a steady moderate increase related in magnitude to the increase in economic activity, the task of economic management was accomplished. There is nothing more…. Professor Friedman’s case was not casually advanced; it was supported by massive evidence which, as necessary, was arranged to serve the author’s purpose. (Substantial changes in the velocity of money use had especially to be explained away. There was also the serious and unresolved problem just mentioned of what was to be counted as money.) In the years to come, Professor Friedman’s breathtakingly simple solution…would powerfully support the hope that all problems could be solved by the magic of monetary management. Alas.
Jonathan Schlefer, at The New York Times, provides a brief biography of Wynne Godley, full of praise.

If the economics profession takes on the challenge of reworking the mainstream models that famously failed to predict the crisis, it might well turn to one of the few economists who saw it coming, Wynne Godley of the Levy Economics Institute. Mr. Godley, unfortunately, died at 83 in 2010, perhaps too soon to bask in the credit many feel he deserves.
But his influence has begun to spread. Martin Wolf, the eminent columnist for The Financial Times, and Jan Hatzius, chief economist of global investment research at Goldman Sachs, borrow from his approach. Several groups of economists in North America and Europe — some supported by the Institute for New Economic Thinking established by the financier and philanthropist George Soros after the crisis — are building on his models...It was far from a first for Mr. Godley. In January 2000, the Council of Economic Advisers for President Bill Clinton hailed a still “youthful-looking and vigorous” expansion. That March, Mr. Godley and L. Randall Wray of the University of Missouri-Kansas City derided it, declaring, “Goldilocks is doomed.” Within days, the Nasdaq stock market peaked, heralding the end of the dot-com bubble.

Matias Vernengo (nakedkeynesianism) adds some commentary: 

Paul Krugman commented on the NY Times piece on Wynne. There are many little incorrect interpretations, which derive from his lack of understanding of the history of ideas. First, he equates Wynne's model with the old hydraulic Keynesianism (i.e. Neoclassical Synthesis) of Phillips (of Phillips curve fame, but also of the hydraulic model of the British economy). Nothing further from the truth...
Krugman then says these models were abandoned because they failed in the face of the Great Inflation of the 1970s, and because they did not deal with consumption in a coherent way. Here again he is wrong. First of all, Wynne's models had no trouble dealing with the inflation of the 1970s, correctly pointing out the effects of oil prices, devaluation, and wage pressures from the cost side rather than demand pull views, and he was one of the few that correctly foresaw the big recession that the Thatcher policies would cause. ...
PS: Full disclosure, I'm quite biased on this topic, having worked for Wynne at the Levy Economics Institute for two years in 1997-98.
PS': Two additional posts by Unlearning Economics and Philip Pilkington and a link by Lars Syll (h/t for the link to Unlearning)....

Again from Phil Pilkington's blogPilkington and Syll find evidence of a 1996 debate between Krugman and Galbraith...

Lars Syll has brought my attention to a very interesting exchange between Jamie Galbraith and Paul Krugman from 1996 that is archived on the latter’s website (or a website created for him, I cannot tell). Much of the discussion is on long dead arguments from the 1990s that now look as antiquated as early episodes of Friends. But there are two things that are interesting about the debate.
First of all, in retrospect, it looks to me like Krugman is on the wrong side of pretty much every issue. He seems cavalier about the rising income inequality in the US — something he has since renounced (but only due to reality really beating him over the head). He shrugs off a falling labour share in national income — something which has since become so obvious that not even the flashiest debater could cover it up. At one point his support of Pete Peterson’s Social Security privatisation campaign is mentioned (yep, old Pete Pete was selling that hoary “Social Security is imminently broke” line back in ’96 and Krugman at one point fell for it).
There also seems to be a sense with Krugman that the Washington Consensus would lead to general prosperity, although it is hard to pin — one year before the Asian crisis and the subsequent fracturing of said consensus. And then there’s the move toward a budget surplus by the Clinton administration; something now argued by many to have precipitated the rise in private sector debt that ultimately led to the financial crisis of 2008.

Friday, November 15, 2013

Lowering Interest Rates is Deflationary by Definition

When Ford Motor lowers the price of a car, that is a deflationary act by definition.  The possibility that the lower price may lead to the sale of more cars does not alter that fact.  The fact that consumers may have some extra money in their pocket after purchasing their car, and use that to buy something else, does not alter the basic fact that lower prices are the realization of deflation.

When the Federal Reserve lowers the price of borrowing, that is a deflationary act by definition.  The fact that the lower price may lead to more loans does not alter that fact.  The fact that borrowers may have some extra money in their pocket after making payments on loans does not alter the fact that the lowered price for borrowing represents deflation in and of itself.

Compounding this obvious first order deflation, the lowered interest rates lower the fiscal balance and thus result in a smaller injection of money from the government into the economy.

There are undoubtedly other effects of lowering interest rates, but these are not so cut and dried as commonly assumed.  Any private loan has two private parties.  Lowering the price for the borrower lowers revenue for the lender, with no net change in income.

An in-depth analysis of the various effects of interest rate changes on the economy will reveal a number of additional considerations.   The argument that is generally made by proponents of monetary policy is that lower rates will lead to increased investment, since the lower price of bank loans will make them more attractive.  But, as we see via Phil Pilkington,
[Keynes'] account of a boom is to say that a high rate of investment causes a fall in expected profits as the supply of productive capacity increases… one thing he would have never have said is that a permanently lower level of the rate of interest would create a permanently higher rate of investment.
This ties into Kalecki’s argument that if central banks try to control the level of effective demand through the interest rate they will find that they will have to drop the interest rate over and over again as each boom peters out until, ultimately, they end up at the zero-lower bound. As Steve Randy Waldman of Interfluidity notes, this appears rather prescient if we look at the period after 1980 when central banks moved toward trying to steer the economy by using the interest rate alone. He presents the following graph which shows precisely this dynamic...
Randall Wray provides additional detailed analysis:
Some years ago I co-authored a paper with my colleague Linwood Tauheed, titled SYSTEM DYNAMICS OF INTEREST RATE EFFECTS ON AGGREGATE DEMAND, that investigated the likely impacts of interest rate changes on aggregate demand. We used conventional estimates of interest rate elasticities for investment spending, as well as for parameters like the marginal propensity to consume...  In particular, pay attention to the discussion of conventional estimates of interest rate elasticities—which are surprisingly small
If the price of lumber goes down by a small amount, this doesn't automatically mean that the demand for houses will surge.  Similarly, if the price of borrowing money goes down by a small amount, this doesn't automatically mean that the demand to build new factories will surge.  The cost of borrowing is just one factor among many.  Deflation in borrowing costs is deflationary in and of itself.  The second and higher order effects are subject to debate, but the empirical data from recent U.S. history shows lower interest rates highly correlated with decreasing inflation (and vice versa).  As evidence in support of this assertion, here's my favorite graph: