Archive for August, 2012

Arthur Laffer, Anti-Enlightenment Economist

The Wall Street Journal, building on its solid reputation for providing a platform for moderately to extremely well-known economists to embarrass themselves, featured an op-ed today  by Arthur Laffer. Laffer certainly qualifies as a well-known economist, and he takes full advantage of the opportunity provided so generously by the Journal to embarrass himself.

Laffer’s op-ed is primarily a commentary on a table constructed by Laffer, which I reproduce herewith.

For each of the 34 OECD countries, the table provides two numbers. The first number has the following description: “change in government spending as a percentage of GDP from 2007 to 2009.” This number is treated by Laffer as a proxy for the amount of stimulus spending to counteract the 2008-09 recession. The second number has the following description: “change in real GDP growth from 2006-2007 to 2008-2009.” The second number is treated by Laffer as a proxy of the effectiveness of stimulus spending. Laffer thus regards the correlation between the two numbers as evidence on whether government spending actually helped to achieve a recovery from the 2008-09 recession.

Now, there are multiple problems with this starting with the following: Laffer’s description of the first number is ambiguous to the point of incomprehension. Does Laffer mean to say that he is subtracting the 2007 ratio of government spending to GDP in each country from the same ratio in 2009? Or, does he mean that he is subtracting total government spending in each country in 2007 from total government spending in 2009, and expressing that difference as a percentage of GDP in that country in 2007. Which calculation he is performing makes a big difference. Suppose Estonia — Laffer’s poster child for Keynesian stimulus — kept spending unchanged between 2007 and 2009, but GDP contracted by one-third. If Laffer is calculating his first number by the first method, he comes up with an increase in government spending as a percentage of GDP of 33%, even though government spending did not change. That is just perverse. So how did Laffer perform his calculation?  He doesn’t say.  All he does is cite the IMF as the source for his table. Thanks a lot, Art; that was really helpful, but unfortunately, not helpful enough to figure out what you are talking about.

But I didn’t just give up; I persisted.  I thought to myself: “maybe I can calculate the number both ways for the US using readily available statistics on GDP and government spending and see which method allows me to reproduce his result of a 7.3% increase in US government spending as a percentage of US GDP between 2007 and 2009.”  And that’s what I did. Just one problem, though. Adding state, local, and federal spending as a percentage of GDP in 2007, I came up with about 35%. Doing the same calculation for 2009, I came up with about 40%, implying a change of slightly over 5%, well under Laffer’s number of 7.3%. Inasmuch as nominal US GDP in 2009 was greater than nominal US GDP in 2007, the alternative method would have given me a number even smaller than I got using the first method. So I have no idea how Laffer got his 7.3% number for the US, and I seriously doubt that there was any valid way by which he could have arrived at an increase in government spending as a percentage of US GDP between 2007 and 2009 greater than 7%. So why should I even bother checking any of his other numbers?

As if this were not enough, Laffer offers an equally mysterious second number, the difference between the 2006-07 growth rate in each country and the 2008-09 growth rate. But wait, 2008-09 was when there was a recession, not a recovery. So how does Laffer know that his second number is measuring the strength the forces of recovery rather than the strength of the forces of contraction?  Answer: He doesn’t. He doesn’t, because he can’t, there being no way to disentangle the two.

Finally – by which I mean, not that I am exhausting the criticisms that could be made of what Laffer has written, but that I am exhausting my own, and perhaps my readers’, patience – suppose that Laffer’s numbers had been accurately calculated, and second that his numbers actually mean something approximating what Laffer purports them to mean. Does the not-very-strong negative correlation that Laffer finds between increases in government spending and increases in the rate of growth of real GDP imply that government spending is useless in stimulating a recovery, as he claims it does? Not at all. As a former member of the University of Chicago faculty, Laffer should be aware of the concept of automatic fiscal stabilizers that none other than Milton Friedman often referred to in his writings on fiscal policy. Because almost all countries have some sort of social safety net, recessions automatically increase government spending through programs like unemployment insurance, food stamps, Medicaid and others that provide services and benefits to people who lose their  jobs in recessions. The worse the recession, the greater the automatic increase in government spending. Thus, the negative correlation between government spending and economic growth that Laffer purports to uncover is easily explained by the existence of automatic stabilizers. The worse the recession, the greater the induced increase in government spending.

Moreover, suppose we knew with certainty that government spending stimulates a recovery, and suppose that governments, secure in that knowledge, increased their spending in recessions to achieve a recovery. If you went out and looked at the statistics on GDP and government spending, what would you find?  You would find that governments increased spending when the economy was contracting and decreased spending when the economy was expanding.  So what empirical correlation would you expect to observe between government spending and growth in real GDP?  Exactly the one that Laffer finds and claims proves just the opposite of what we “know” to be true.

Art, heckuva job.

PS If Laffer had the sense to read Nick Rowe’s blog he might not have made such a ridiculous argument.

PPS Lars Christensen and Brad Delong are also exasperated with Laffer.

Thompson’s Reformulation of Macroeconomic Theory, Part II: Temporary Equilibrium

I explained in my first post on Earl Thompson’s reformulation of macroeconomics that Thompson posited a model consisting of a single output serving as both a consumption good and as a second factor of production cooperating with labor to produce the output. The single output is traded in two markets: a market for sale to be consumed and a market for hire as a factor of production. The ratio of the rental price to the purchase price determines a real interest rate, and adding the expected rate of change in the purchase price from period to period to the real interest rate determines the nominal interest rate. The money wage is determined in a labor market, and the absolute price level is determined in the money market. A market for bonds exists, but the nominal interest rate determined by the ratio of the rental price of the output to its purchase price plus the expected rate of change in the purchase price from period to period governs the interest rate on bonds, conveniently allowing the bond market to be excluded from the analysis.

The typical IS-LM modeling approach is to posit a sticky wage that prevents equilibrium at full employment from being achieved except via an increase in aggregate demand. Wage rigidity is thus introduced as an ad hoc assumption to explain how an unemployment “equilibrium” is possible. However, by extending the model to encompass a second period, Thompson was able to derive wage stickiness in the context of a temporary equilibrium construct that does not rely on an arbitrary assumption of wage stickiness, but derives wage stickiness as an implication of incorrect expectations, in particular from overly optimistic wage expectations by workers who, upon observing unexpectedly low wage offers, choose to remain unemployed, preferring instead to engage in job search, leisure, or non-market labor activity.  The model assumptions are basically those of Lucas, and Thompson provides some commentary on the rationale for his assumptions.

One might, however, reasonably doubt that government policy makers have systematically better information than private decision makers regarding future prices. Such doubting would be particularly strong for commodity markets, where, in the real world, market specialists normally arbitrage between present and future markets. . . . But laws prohibiting long-term labor contracts have effectively prevented human capital from coming under the control of market specialists. As a consequence, the typical laborer, who is not naturally an expert in the market for his kind of service, makes his own employment decisions despite relative ignorance about the market. (p. 6)

I will just note parenthetically that my own view is that the information problem is exacerbated in the real world by the existence of many products and many different  kinds of services. Shocks are transmitted from sector to sector via complicated and indirect interrelationships between markets and sectors. In the process of transmission, initial shocks are magnified, some sectors being affected more than others in unpredictable, or at least unpredicted, ways causing sector-specific shocks that, in turn, get transmitted to other sectors. These interactions are analogous to the Cantillon effects associated with sector-specific variations in the rate of additional spending caused by monetary expansion.  Austrian economists tend to wring their hands and shake their heads in despair about the terrible distortions associated with Cantillon effects caused by monetary expansion, but seem to regard the Cantillon effects associated with monetary contraction as benign and remedial.  Highly aggregated models don’t capture these interactions and thus leave out an important feature of business-cycle contractions.

Starting from a position of full equilibrium, an exogenous shift creates a temporary equilibrium with Keynesian unemployment when there is an overall excess supply of labor at the original wage rates and some laborers mistakenly believe that the resulting lower wage offers from their present employers may be a result of a shift which lowers the value of their products in their present firms relative to other firms who hire workers in their occupations. As a consequence, some of these laborers refuse the lower wage offers from their present employers and spend their present labor service inefficiently searching for higher-wage jobs in their present occupation or resting in wait for what they expect to be the higher future wages.

Since monetary shifts, which are apparently observed to induce inefficient adjustments in employment, also change the temporary equilibrium level of prices of current outputs, we must assume that some workers do not know of the present change in the price level. Otherwise, all workers, in responding to a monetary shift, would be able to observe the price level change which accompanied the change in their wage offers and would not make the mistake of assuming that wage offers elsewhere have not similarly changed. . . . (p. 7)

The price level of current outputs is only an expectation function for these laborers, as they cannot be assumed to know the actual price level in the current period. This is represented . . . by allowing labor’s perception of current non-labor prices to depend only on last period’s prices, which are parameters rather than variables to be determined, and on current wage offers. (p. 8)

Because workers may construe an overall shift in the demand for labor as a relative shift in demand for their own type of labor, it follows that future wage and price expectations are inelastic with respect to observed increases in wage offers. Thus, a change in observed wages does not cause a corresponding revision of expected future wages and prices, so the supply of labor does not shift significantly when observed wages are higher or lower than expected.  When wages change because of an overall reduction in the demand for labor destined to cause future wages and prices to fall, workers with slowly adjusting expectations inefficiently supply services to employers on the basis of incorrect expectations. The temporary equilibrium corresponds to the intersection of a demand curve and a supply curve.  This is a type of wage rigidity different from that associated with the conventional Keynesian model.  The labor market is in equilibrium in the sense that current plans are being executed. However, current plans are conditional on incorrect expectations. There is an inefficiency associated with incorrect expectations. But it is an inefficiency that countercyclical policy can overcome, and that is why there is potentially a multiplier effect associated with an increase in aggregate demand.

The Money Multiplier, RIP?

In case you haven’t heard, Simon Wren-Lewis tried to kill the money multiplier earlier this week. And if he succeeded, and the money multiplier stays killed, if it has indeed been well and truly buried, I for one shall not mourn its long overdue passing. Over the course of my almost thirteen months of blogging I have argued on a number of occasions that, contrary to the money multiplier, bank deposits are endogenous, that they are not so many hot potatoes that, once created, must be held, never to be destroyed. This view has brought me into sharp, but friendly, disagreement with some pretty smart guys whom I usually agree with, like Nick Rowe and Bill Wolsey, but I’m not backing down.

My view of bank deposits has also put me in the same camp — or at least created the appearance that I am in the same camp — with the endogenous money group, Post-Keynesians, Modern Monetary Theorists and the like, whose views I only dimly understand. But it seems that they deny that even the monetary base (i.e., currency plus bank reserves) is under the control of the monetary authority. This group seems to think that banks create deposits in the process of lending, lending is undertaken by banks in response to the demands of the public (businesses and households) for bank loans, and reserves are created by the monetary authority to support whatever level of reserves the banks desire, given the amount of lending that they have undertaken. The money multiplier is wrong, in their view, because it implies that reserves are prior to deposits and, indeed, are the raw material from which deposits are created, when in fact reserves are created to support deposits.

So let me try to explain how I view the money multiplier. I agree with the endogenous money people that reserves are not the stuff out of which deposits are created. However, there is a sense in which base money is logically prior to deposits. Every deposit is a promise to pay the bearer something else outside the control of the creator of the deposit. That something is base money. Under a fiat money system, it is a promise to pay currency. Under a gold standard, it was a promise to pay gold, coin or bullion. This distinction is captured by the distinction between inside money (deposits) and outside money (currency).

It is my position that the quantity of inside money produced or created in an economy is endogenously determined by the real demand of the public to hold inside money and the costs banks incur in creating inside money. Because banks legally commit themselves to convert inside money into outside money on demand, arbitrage usually prevents any significant, or even insignificant, deviation between the value of inside and that of outside money. Because inside money and outside money are fairly close substitutes, the value of outside money is determined simultaneously in the markets for inside and outside money, just as the value of butter is determined simultaneously in the markets for butter and margarine. But heuristically, it is convenient to view the value of money as being determined by the supply of and the demand for base money, which then determines the value of inside money via the arbitrage opportunities created by the convertibility of inside into outside money.  Given the equality in the values of inside and outside money, we can then view the supply of inside money and the demand for inside money as determining the quantity of deposits and the interest rate paid on deposits. Under competitive conditions, the interest paid on deposits must equal the bank lending rate (the gross revenue from creating a deposit) minus the cost of creating a deposit, so that the net revenue (the lending rate minus the deposit rate) equals the cost of creating deposits.

What determines the value of base money? The monetary authorities (central bank plus the Treasury) jointly determine the amount of currency and reserves made available. The public (banks plus households plus businesses) have demands to hold currency when tax payments are due, demands to hold currency for transactions purposes when taxes are not due, and demands to hold currency as a store of value, those demands depending as well on the expected future value of currency and on the yields of alternative assets including inside money. The total demand for currency versus the total stock in existence determines a value at which the public is just willing to hold the amount currency (base or outside money) in existence.

This theoretical setup is analogous to that which determines the value of money under a gold standard. Under a gold standard the amount of gold in existence is endogenously determined as the sum of all the gold ever mined from time period 0 until the present. But in the present period the total stock can be treated as an exogenously fixed amount. The total demand is the sum of the monetary plus non-monetary demands for gold. The value of gold is whatever value is just sufficient to induce the public to hold the amount in existence in the current period. Given that all prices are quoted in gold, the price level is determined by the conversion rate of money into gold times the gold value of every commodity corresponding to the equilibrium real value of gold. The amount of inside money in existence is whatever amount of convertible claims into gold the public wishes to hold given the yields on alternative assets and expectations of the future value of gold.

The operation of a gold standard requires no legal reserves of gold to be held. Legal reserve requirements were an add-on to the gold standard – in my view an unnecessary and dysfunctional add-on – imposed by legislation enacted by various national governments for their own, often misguided, reasons. That is not to say that it would not be prudent for monetary authorities to hold some reserves of gold, but the decision how much reserves to hold has no intrinsic connection to the operation of the gold standard.

Thus, the notion that there is any fixed relationship between the quantity of gold and the amount of convertible banknotes or bank deposits created by the banking system under the gold standard is a logical fallacy. The amount of banknotes and deposits created corresponded to the amount of banknotes and deposits the public wanted to hold, and was in no way logically connected to the amount of gold in existence. Similarly, under a fiat money system, there is no logical connection between the amount of base money and the amount of inside money. The money multiplier is simply a reduced-form, not a structural, equation. Treating it as a structural equation in which the total stock of money (currency plus demand deposits) in existence could be juxtaposed with the total demand to hold money is logically incoherent, because the money multiplier (as a reduced form) is itself determined in part by the demand to hold currency and the demand to hold deposits.

So it’s about time that we got rid of the money multiplier, and I wish Simon Wren-Lewis all the luck in the world in trying to drive a stake into its heart, but somehow I am not all that confident that we have yet seen the last of that pesky creature.

PS I hope, circumstances permitting, tomorrow to continue with my series on Earl Thompson’s reformulation of macroeconomics. This post can perhaps serve as introduction to a future post in the series on alternative versions of the LM curve corresponding to different monetary regimes.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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