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Putin v. Obama: It’s the Economy, Stupid

A couple of days ago, Daniel Drezner wrote an op-ed for the Washington Post commenting on a statement made by one of the candidates in the recent televised forum on national security.

Last week at a televised presidential forum on national security, Donald Trump continued his pattern of praising Russian President Vladimir Putin. In particular, Trump said the following:

I mean, the man has very strong control over a country. And that’s a very different system and I don’t happen to like the system. But certainly in that system he’s been a leader, far more than our president has been a leader. We have a divided country.

As my Post colleague David Weigel notes, this is simply Trump’s latest slathering of praise onto the Russian strongman:

Trump goes further than many Republicans. In his telling, Putin — a “strong leader” — epitomizes how any serious president should position his country in the world. Knowingly or not, Trump builds on years of wistful, sometimes ironic praise of Putin as a swaggering, bare-chested autocrat.

After the forum, his running mate, Mike Pence, who used to be more critical of Putin, doubled down on Trump’s claim:

Pence walked that line back a little Sunday, suggesting that he was trying to indict the “weak and feckless leadership” of President Obama — but you get the point.

Well, if we are going to compare the leadership of Putin and Obama, why not compare them by measuring what people really care about? After all, don’t we all know that “it’s the economy, stupid.”

So let’s see how what Putin’s leadership has done for Russia compares with what Obama’s leadership has done for the US? We all know that the last eight years under Obama have not been the greatest, but if it’s Putin that Obama is being compared to, we ought to check out how Putin’s “very strong” leadership has worked out for the Russian economy as opposed to Obama’s “weak and feckless leadership” has worked out for the US economy.

Here’s a little graph comparing US and Russian GDP between 2008 and 2015. To make the comparison on an even playing field, I have normalized GDP for both countries at 1.0 in 2008.

putin_v_obamaLooks to me like Obama wins that leadership contest pretty handily. And it’s not getting any better for Putin in 2016, as the Russian economy continues to contract, while the US economy continues to expand, albeit slowly, in 2016.

So chalk one up for the home team.

USA! USA!

Mercatus Center Conference on Monetary Rules for a Post-Crisis World

It’s been almost three weeks since my last post, which I think is my longest dry spell since I started blogging a little over five years ago. Aside from taking it a little easy during this really hot summer in Washington DC, I have been working on the paper I am supposed to present tomorrow at the Mercatus Center Conference on Monetary Rules for a Post-Crisis World.

After Scott Sumner opens the conference with welcoming remarks at 9AM, I will be speaking in the first panel starting at 9:10 AM. My paper is entitled “Rules versus Discretion, Historically Contemplated.” I hope soon to write a post summarizing some of what I have to say and to post a link to a draft of the paper. The conference proceedings are to be published in a forthcoming issue of the Journal of Macroeconomics.

I’m especially pleased to be on the same panel as one of my all-time favorite economists, David Laidler. That’s almost enough to lift me out of my chronic depression about the November elections. Other speakers include, Mark Calabria, Robert Hetzel, David Papell, Scott Sumner, John Taylor, Perry Mehrling, Kevin Sheedy, Walker Todd, David Beckworth, Miles Kimball, and Peter Ireland. A stellar cast, indeed. You can watch a live stream here.

On Liberalism, Political Correctness, and Illegal Immigration

Last week I wrote a post about criticism by some left-wing liberals of Tim Kaine. My post elicited a series of comments from Peter Schaeffer. I responded to his first comment in the comment section, and he has followed up with some further comments, which raise a number of important issues, partly historical and partly philosophical. While his comments are in some respects insightful, I think that are also very misguided. But it is certainly the case that many of the positions he takes are rather widely held, including by some well-known public figures, so I think that they are worth responding to. So even though some of what Peter and I disagree about are fairly obscure matters of British and American history, I think that it is worth taking the time to respond to most of Peter’s comments.

Peter begins by challenging the main point of my previous post, which was that the attacks on Tim Kaine for being insufficiently liberal, owing to Kaine’s support for free trade, were historically anomalous and ignorant, liberalism having originated in Britain as a political party and political ideology in the course of the mid-19th century struggle over free trade, in which liberals were the advocates for free trade. Peter takes issue with a comment I made in reply to Lars Christensen’s comment on my post. I wrote:

The idea that support for free trade means that you are not a liberal was just too hilarious for me to ignore.

To which Peter responded:

It’s not hilarious at all. It’s reasonable and serious. Modern liberalism is not British 19th century liberalism and doesn’t claim to be. Modern liberalism rejects the ideas (laissez-faire capitalism) and the consequences (extreme inequality) that British 19th century liberalism enthusiastically supported.

They may share the same word, they are not the same thing.

I am fully aware that modern liberalism and 19th century liberalism are not the same thing; much of my post was devoted to explaining why modern American liberalism moved away from 19th century liberalism. But the differences don’t mean that they are totally unrelated and have nothing in common. John Stuart Mill, unmentioned by Peter, was an exemplar of 19th century liberalism, and he surely was not indifferent to the extreme inequality resulting from pure laissez-faire capitalism. Nor did I deny that it is possible to be a liberal and oppose free trade. All I said was that it is a stretch to say that if you support free trade, you can’t be a liberal, which seemed to be the message of the “liberal” opponents of Tim Kaine.

Peter continued:

The nation of Columbia provides a good example. The Columbian Liberal Party was originally a liberal (using the old British sense of the word) party and is now a liberal party (in the modern sense of the word).

What point Peter is trying to make by citing the not very relevant or interesting (WADR) example of the obviously dysfunctional Columbian Liberal Party escapes me. And Peter goes on to show exactly how dysfunctional the party is by providing the following bit of historical trivia.

To put this in perspective, in 1982 Pablo Escobar (yes, that Pablo Escobar) was elected as an alternate member of the Chamber of Representatives of Colombia as a CLP candidate. Presumably, 19th century British liberals would not have welcomed Pablo as one of their candidates.

To which all I can say is: OMG! Perhaps, Peter would like to identify for us which liberals, other than the dysfunctional Columbian ones, he thinks would have welcomed such a one Pablo as a candidate.

From his confusing musings about the squalid state of Columbian liberalism, Peter moves on to a bitter attack on 19th century British Liberalism, accusing the Liberals of having been supportive of slavery and the South in the Civil War. He cites, as he has previously, the remarkable statement by a 19th-century British politician and diplomat, Charles Bowring (whose obscurity can be inferred his absence in the index of Morely’s three volume biography of Gladstone): “Jesus Christ is Free Trade and Free Trade is Jesus Christ.”

To show that this weird formulation was somehow typical of British Liberals, Peter cites Lord Palmerston, the Liberal Prime Minister during the American Civil War, who complained to Charles Francis Adams (US ambassador to Britain) about the Morril tariff, from which Peter infers that tariffs were more hateful to the British Liberals than was slavery. Peter also cites Gladstone as a Liberal supporter of secession. In fact, Palmerston and all the British Liberals were opposed to slavery. However, Palmerston believed that the national interests of Britain might be better served (Britain First?) if the Confederate States were to secede from the Union. It is true that Gladstone made a speech in 1862 in which he suggested that the early military successes of the Confederacy meant that the South had succeeded in creating a new nation, and that it might be best to acknowledge that reality. Gladstone later regretted that this speech, calling the speech “an undoubted error, the most singular and palpable, I may add the least excusable of them all. In the autumn of that year [1862] . . . I declared in the heat of the American struggle that Jefferson Davis had made a nation, that is to say, that the division of the American Republic by the establishment of a Southern or secession state was an accomplished fact. Strange to say, this declaration, most unwarrantable to be made by a minister of the crown with no authority other than his own, was not due to any feeling of partisanship for the South or hostility to the North.” J. Morely, Life of Gladstone, vol. 2, p. 81).

In addition, both Richard Cobden and John Bright, the two leaders of the Anti-Corn Law League, and the most fervent British supporters of free trade, were both equally fervent supporters of the Union. And I just found this 2013 article by Bill Cash, author of a recent biography of Bright showing that Lincoln and Bright were united by common ideals and deep mutual admiration.

For those who have seen the brilliant film Lincoln with Daniel Day-Lewis, you may have noticed in the scenes set within the study that there was a photograph in the left hand corner of the mantelpiece of a great British statesman, John Bright. I have that exact photograph in my personal collection, as described in my book, John Bright: Statesman, Orator, Agitator (IB Tauris, 2011). Bright was the leading advocate in Britain against slavery throughout the American Civil War and who was highly esteemed by Abraham Lincoln for his advocacy in the run up to the Emancipation Proclamation – which had its 150th anniversary on 1 January, 2013.

During the course of the American Civil War, Bright had devoted all his energies to protecting his beloved American democracy – a key influence on his own campaigns for parliamentary reform – centring his arguments on the moral repugnance of slavery. In this, he had the support of the workers at his own cotton mill in Rochdale who, even when impoverished during the cotton famine caused by the war, refused to accept Southern slave-grown cotton. Yet, the relationship between Bright and Lincoln was not merely a real influence on Lincoln himself but on the history of the civil war and the relationship between Britain and America from that time on and still today.

When Steven Spielberg and Day-Lewis were interviewed on television about the film, both of them revealed that what had fascinated them, as much as everything else, was the mind of Abraham Lincoln. And what the photograph in the film represented was the extent to which Lincoln himself paid his own tribute to Bright.

It was testimony to Bright’s influence that Schuyler Colfax (who, as those who have watched the film will have seen for themselves voted for the constitutional amendment in 1865) and Henry Janney – both of whom were confidants of Lincoln – wrote to Bright after the assassination telling him that his portrait and only his portrait was in President Lincoln’s reception room. Lincoln had sent two portraits of himself to Bright, and of the two portraits hanging in Lincoln’s own office, one was of Bright.

Vice-President Schuyler Colfax, then Speaker of the House of Representatives, wrote to Bright in 1866, requesting a likeness of Bright, saying, “Your face is quite familiar to me already, as your portrait hung up in President Lincoln’s Reception room, and often, in the many evenings I spent with him there, he referred to you with sincere regard & even affection. Every loyal man & woman in the land knows you, knows you and esteems you. But your correspondence with Senator Sumner, whom I often meet (& we often talk about you, you may be assured) has informed you of all this.”

A letter from another of the confidants of Lincoln, Henry Janney (dated 24 April, 1865, immediately after the assassination), wrote to Bright relating how he “told the President I had a letter from thee and he requested me to bring it up and let him see it, saying, ‘I love to read the letters of Mr Bright.’ I complied, when he read carefully every word, then remarked to those around him, ‘my friend has show me a letter from Mr Bright. I believe he is the only British statesman who has been unfaltering in his confidence in our ultimate success – look there.’ I stepped up to the wall and seeing a familiar face read beneath it John Bright MP. It was the only portrait in the room.”

It is perhaps, then, no surprise that a long-standing testimonial from Bright calling for Lincoln’s re-election was found in Lincoln’s pocket when they were emptied immediately after his assassination. Bright was known to Lincoln’s intimate friends as greatly influencing the president’s mind.

In the midst of his anti-liberal tirade, Peter suddenly dives into a discussion of political correctness, possibly in reply something I wrote in response to his disparagement of the support that modern liberals lend to political correctness. Here’s what I said:

Political correctness can be problematic, but that doesn’t justify abusive speech in the public arena. Yelling “political correctness” in response to criticism of indecent and abusive rhetoric and incitement is just as reprehensible as suppressing legitimate debate under the guise of “political correctness.” Both sides of this idiotic debate are just sloganeering.

I thought that was a pretty clear statement of opposition to attempts to shut down debate in the name of political correctness; I was just pointing out that abusive and indecent speech cannot be justified or exempted from appropriate expressions of disapproval by the bare assertion that the speaker was merely objecting to political correctness. But Peter doesn’t see it that way:

It is naïve to view Political Correctness (PC) as some sort of antidote to “abusive speech in the public arena”. PC is a comprehensive system of authoritarian thought control that exists to exclude non-PC ideas from the public arena, no matter how innocently they are expressed and no matter if they are well-supported by facts. Note that PC has been highly successful to date in achieving its goals of censorship, oppression, etc.

Peter seems to imply that I believe that Political Correctness is an antidote to “abusive speech in the public arena,” but what I said was that abusive speech cannot be justified as an antidote to, or protest against, Political Correctness. Big difference – but, apparently, not big enough for Peter to grasp. Peter then goes on to cite the case of Larry Summers, who was subjected to considerable public criticism for his comments at an academic conference about the reasons for the under-representation of women in tenured positions in science and engineering at top universities and research institutions.

However, the pseudo-Stalinist show trial of Larry Summers (roughly derived from Saletan, Parker, Taylor, and others) is one of the best example. Larry Summers’s comments to the NBER conference were a model of legitimate, highly rational, scientific, academic discourse (read them in the original). For daring to mention (part of) what science knows he was pilloried around the world and driven from office. His subsequent recantations and groveling apologies would have made a communist show-trial judge proud.

The first thing to notice about Peter’s comment is his Freudian slip in referring to the “pseudo-Stalinist show trial of Larry Summers” when the Slate article by William Saletan to which Peter refers was titled “The pseudo-feminist show trial of Larry Summers.” And the second thing is that Kathleen Parker’s column about the rescinding of an invitation by the University of California to Summers to deliver a commencement address compared Summers’s treatment to McCarthyism not to Stalinism. I disapprove of how Summers was forced out of his position as President of Harvard, in part owing to his comments on the reasons for the under-representation of women in the sciences and engineering at top universities and research institutions. But to compare Summers’s treatment to Stalinist oppression is so far over the top that one has to wonder about Peter’s grasp on reality.

Certainly it was embarrassing for Summers to be subjected to verbal abuse and unjustified accusations of prejudice against women. He was also compelled to apologize more abjectly for his remarks than the substance of those remarks warranted. I don’t dismiss the possibility that discrimination is one factor in explaining the paucity of tenured female faculty in the sciences and engineering at top universities, and I can see why Summers’s remarks could have been misunderstood to deny that such discrimination is a factor reducing the number of females in those positions. But after being forced out of his position at Harvard – and his remarks about women were only one factor in turning the Harvard faculty against Summers – Summers received a quite lucrative severance package as well as an appointment as the Charles W. Eliot University Professor at Harvard. It was hardly to the credit of the University of California to rescind its invitation to Summers to deliver a commencement speech, but to suggest that such an action rises to the level of McCarthyism, much less Stalinism, is simply laughable.

If you want to know what Stalinism really looks like, read this article in Saturday’s New York Times about the recent show trials of four Chinese human-rights activists who were compelled to read self-denunciations in court after being convicted of subversive activities in promoting human rights and civil society.

BEIJING — Chinese lawyers and rights activists appeared in televised trials throughout this week in what seemed to be a new, more public phase of President Xi Jinping’s campaign to cleanse the country of liberal ideas and activism.

Legal experts and supporters of four defendants denounced the hearings, held on consecutive days in Tianjin, a port city near Beijing, as grotesque show trials. All four men were shown meekly renouncing their activist pasts and urging people to guard against sinister forces threatening the Communist Party, before they were convicted and sentenced.

But for the government, the trials served a broader political purpose.

By airing the abject confessions and accusations of a sweeping, conspiratorial antiparty coalition, Mr. Xi’s administration was “putting civil society in all its forms on trial, and vilifying them as an anti-China plot,” Maya Wang, a researcher on China for Human Rights Watch, said in emailed comments.

I don’t defend what was done to Summers, but the way that Summers was treated pales in comparison to what was done to those four brave Chinese activists. Peter continues:

The issue isn’t “abusive speech in the public arena”, but ideological suppression of anyone who dares to deviate from PC orthodoxy.

To restate the obvious yet again, I condemn the ideological suppression of opinions that deviate from PC orthodoxy. But waving the flag of opposition to PC orthodoxy does not give anyone a free pass to engage in abusive speech in the public arena. Which is exactly what abusive speakers are doing nowadays to evade responsibility for their abuse and their threats. Peter goes on to cite an excellent article by Jonathan Chait chastising liberals for siding with the PC police. And Chait makes the valid point that anti-liberal right-wingers and misguided liberals and leftists are all happy to conflate liberalism with left-wing ideology, ignoring the key difference between liberalism and left-wing ideology, which is that liberalism holds that there are certain neutral principles that take precedence over specific objectives and concrete outcomes. Or stated differently, liberalism stands for the idea that it’s not only the ends that people are trying to achieve that matters, it’s also the means that they use to achieve those ends that matters. Certain means are illegitimate no matter how noble the ends. One might have thought that this would satisfy Peter, but it doesn’t.

However, the issue here go further. Let’s say that PC only objected to “abusive speech in the public arena”. That’s not true (at all). But let’s say it was true. So what? Charlie Hebdo has no right to satirize Islamists? Didn’t Voltaire say “I Disapprove of What You Say, But I Will Defend to the Death Your Right to Say It”? What exactly is “abusive speech”? The church regarded Galileo’s claims as “abusive speech”. Was the church right to suppress Galileo? Today’s “abusive speech” may well be tomorrow’s truth. How can any society hope to find truth without allowing dissenting opinions?

Peter seems unable to grasp even basic distinctions. I can express disapproval of Charlie Hebdo without banning it, or tolerating, much less justifying, terrorist attack against the magazine and its staff. Being against abusive speech does not mean suppressing it; it means that those who practice abusive speech should be just as subject to criticism as is everyone else who ventures to expose his thoughts to public scrutiny. When you express an opinion, both the substance of the opinion and the manner in which you express it are legitimately subject to criticism. Trying to shield yourself from criticism by saying that you are being anti-PC is nothing but a dodge and a scam. And to suggest preposterously that Galileo was imprisoned for abusive speech is just a travesty. Legitimate criticism of the way in which an argument is presented is not the same as suppressing the opinion.

In a further comment, Peter responds to something I wrote in response to Benjamin Cole’s comment. I wrote:

I don’t dismiss the effects of trade on workers as some free traders do, but that doesn’t mean that all free trade does is harm workers. Same for the effects of immigration. Those effects are complex, and they are hard to disentangle. Property zoning is a real problem and I am certainly against criminalization of push-cart vending, just as I am against criminalization of non-legal (“illegal” is a pejorative misnomer, which invidiously connotes criminality as does the term “amnesty” when used in the context of immigration reform) immigration.

Peter wrote:

“Illegal” is a statement of fact. We have immigration laws. If you have violate them, you have done something illegal. Sort of like robbery, assault and battery, and arson. These acts are violations of the law. They are illegal. Stealing a car is illegal. If you steal a car and drive it, you are an illegal driver. If you rob a bank, you are a criminal. Calling car thieves and bank robbers criminals (illegals) isn’t pejorative, it’s simply a statement of fact.

“Illegal” is a statement of fact only insofar as there are statutes that declare immigration not in compliance with the statutorily established procedures for immigration to be illegal. But that doesn’t mean that illegal immigration is no different from robbery, theft, fraud, assault, battery, and arson. Robbery, theft, fraud, assault, battery, and arson are common law offenses. The act of immigration is not in and of itself a criminal, destructive, or anti-social act. Intrinsically destructive and anti-social acts are common law crimes even without a statutorily created offense. Illegal immigration is a crime only because statutes declare it to be such, not because any aspect of immigration is presumptively illegal. So the analogy between immigration and offenses at common law is completely false, without merit, pejorative, and invidious.

The fact that calling illegals, “illegals”, is now deemed to be non-PC (offensive even) is a classic example of how PC is used to censor honest discussion of the issues facing America.

Of course, everyone knows this. If illegals weren’t violating U.S. laws, why would anyone be trying to provide Amnesty for them? Why would any legalization be needed? The fact that the advocates of Amnesty demand “legalization” proves that “illegals”, are in fact illegal.

No, Peter, you are insisting that your narrative is factual and that mine is PC and censorious. So we are having an argument about how to describe the fact that people who cross a certain international border without complying with the procedures established for such crossings to be lawful are subject to punitive consequences for failing to comply with the prescribed procedures. You are simply invoking PC as a way of trying to get the upper hand in this discussion about a given factual situation. But PC is a completely irrelevant red-herring. Stick to the facts. And the fact is that, unlike robbery, theft, etc., immigration, i.e., crossing an international border, is not an offense at common law. Amnesty is your term. It implies that there was an offense, but the only offense was non-compliance with an administrative procedure specified by an arbitrary statute. There was no offense at common law, as you yourself acknowledge below. There is a huge difference between an amnesty for a technical administrative violation and an amnesty for offenses at common law.

Please observe that ”illegal” is not just a generic statement. Illegally entering the U.S. is a Federal crime (see below). Illegally residing in the U.S. (even after legally entering) is a Federal civil offense (deportation is the stated penalty). Of course, documentation fraud, Social Security fraud, identify theft, etc. are all Federal crimes and the vast majority of illegals have violated these laws.

Peter, you confirm that illegally residing in the US is not a criminal offense even under US law. And your further comments about the definition of “immigrant” under US immigration statutes do not change the fact that there is nothing inherently criminal or offensive about illegal immigration, and that the criminal status of illegal immigrants is the result of the administrative system created by US immigration policy, not the offensive nature of the actions of those who enter or remain in the US in violation of those administrative regulations.

I don’t dispute that the US, as a sovereign state, has the right to establish such regulations, but those regulations have no inherent moral content, as do common law offenses. They are purely utilitarian. And any assessment of how those regulations are being implemented, administered or modified should be made strictly on the basis of how the system as a whole contributes to or detracts from the benefit of the people of the US. And as I indicated in my reply to Benjamin’s comment, it is difficult to disentangle the effects that immigrants have on the well-being of current residents and citizens of the US. Platitudes about upholding the rule of law are simply question-begging when, unlike the basic laws of just conduct, the immigration laws in question have no moral content, but are merely instruments for achieving the goals of the current immigration policy of the US.

Trump’s Economic Advisers and Me

Donald Trump announced his stable of 13 economic advisers last Friday. Most of them are professional business types — hedge fund managers, bankers, financiers, real-estate men, one oil man — who have contributed heavily to Trump’s campaign.  Three of the advisers — Peter Navarro, Stephen Moore, and David Malpass — have some background as professional economists. Peter Navarro is a Harvard Ph. D. and a professor of economics and public policy at the University of California at Irvine, Tyler Cowen recently wrote a short piece about him for Bloomberg. Stephen Moore is a visiting fellow at the Heritage Foundation, a former member of the Wall Street Journal editorial board and a frequent contributor of op-ed pieces to the editorial page of the Wall Street Journal and other publications. David Malpass was undersecretary in the Treasury Department during the Reagan administration and later was chief economist at Bear Stearns before starting his own consulting firm.

I don’t know any of these people, but as it happens, I have written about both Moore and Malpass on this blog. In fact, both of my posts were written almost exactly five years ago in August 2011; they were both provoked — I choose that verb carefully — by op-ed pieces they wrote for the Wall Street Journal editorial page.

The first post (“There They Go Again” on 8/5/2011) was about Malpass. Here’s what I had to say about him.

In today’s Wall Street Journal, David Malpass, who, according to the bio, used to be a deputy assistant undersecretary of the Treasury in the Reagan administration, and is now President of something called Encima Global LLC (his position as Chief Economist at Bear Stearns was somehow omitted) carries on about the terrible damage inflicted by the Fed on the American economy.

The U.S. is practically alone in the world in pursuing a near-zero interest rate and letting its central bank leverage to the hilt to buy up the national debt. By choosing to pay savers nearly nothing, the Fed’s policy discourages thrift and is directly connected to the weakness in personal income.

Where Mr. Malpass gets his information, I haven’t a clue, but looking at the table of financial and trade statistics on the back page of the July 16 edition of the Economist, I see that in addition to the United States, Japan, Switzerland, Hong Kong, and Singapore, had 3-month rates less than 0.5%.  Britain, Canada, and Saudi Arabia had rates between 0.5 and 1%. . . .

As for Malpass’s next sentence, where to begin?  I won’t dwell on the garbled syntax, but, even if that were its intention, the Fed is obviously not succeeding in discouraging thrift, as private indebtedness has been falling consistently over the past three years.  The question is whether it would be good for the economy if people were saving even more than they are now, and the answer to that, clearly, is:  not unless there was a great deal more demand by private business to invest than there is now.  Why is business not investing?  Despite repeated declamations about the regulatory overkill and anti-business rhetoric of the Obama administration, no serious observer doubts that the main obstacle to increased business investment is that expected demand does not warrant investments aimed at increasing capacity when existing capacity is not being fully utilized. . . .

From here Malpass meanders into the main theme of his tirade which is how terrible it is that we have a weak dollar.

One of the fastest, most decisive ways to restart U.S. private-sector job growth would be to end the Fed’s near-zero interest rate and the Bush-Obama weak-dollar policy. As Presidents Reagan and Clinton showed, sound money is a core growth strategy—the fastest and most effective way to tell world capital that the U.S. is back in business.

Mr. Malpass served in the Reagan administration, so I would have expected him to know something about what happened in that administration.  Obviously, my expectations were too high.  According to the Federal Reserve’s index of trade weighted dollar exchange rate, the dollar exchange rate stood at 95.66 when Reagan took office in January 1981 and at 90.82 when Reagan left office 8 years later.  Now it is true that the dollar rose rapidly in Reagan’s first term reaching about 141 in May 1985, but it fell even faster for the remainder of Reagan’s second term. . . .

Then going in for the kill, Mr. Malpass warns us not to repeat Japan’s mistakes.

Only Japan, after the bursting of its real-estate bubble in 1990, has tried anything similar to U.S. policy. For close to a decade, Tokyo pursued a policy of amped-up government spending, high tax rates, zero-interest rates and mega-trillion yen central-bank buying of government debt. The weak recovery became a deep malaise, with Japan’s own monetary officials warning the U.S. not to follow their lead.

Funny, Mr. Malpass seems to forget that Japan also pursued the sound money policy that he extols. . . . In April 1990, the yen stood at 159 to the dollar.  Last week it was at 77 to the dollar.  Sounds like a strong yen policy to me. . . .

I will just note that, given Mr. Malpass’s affection for a strong dollar, it seems a bit odd that Trump, who constantly rails against currency manipulation and devaluations by other countries, which tend to raise the exchange value of the dollar against those currencies, has chosen Malpass as an economic adviser and that Malpass has agreed to advise Trump, who seems to want anything but a strong dollar. But then again, it’s a strange world that we are now living in.

Then almost two weeks after Malpass’s little masterpiece, along came Mr. Moore with another gem of the kind that the Wall Street Journal editorial page specializes in. The result was that I wrote this post (“The Wall Street Editorial Page is a Disgrace” 8/18/2011).

Stephen Moore has the dubious honor of being a member of the editorial board of The Wall Street Journal.  He lives up (or down) to that honor by imparting his wisdom from time to time in signed columns appearing on the Journal’s editorial page.  His contribution in today’s Journal (“Why Americans Hate Economics”) is noteworthy for typifying the sad decline of the Journal’s editorial page into a self-parody of obnoxious, philistine anti-intellectualism.

Mr. Moore begins by repeating a joke once told by Professor Christina Romer, formerly President Obama’s chief economist, now on the economics department at the University of California at Berkeley.  The joke, not really that funny, is that there are two kinds of students:  those who hate economics and those who really hate economics.  Professor Romer apparently told the joke to explain that it’s not true.  Mr. Moore repeats it to explain why he thinks it really is.  Why does he?  Let Mr. Moore speak for himself:  “Because too often economic theories defy common sense.”  That’s it in a nutshell for Mr. Moore:  common sense — the ultimate standard of truth.

So what’s that you say, Galileo?  The sun is stationary and the earth travels around it?  You must be kidding!  Why any child can tell you that the sun rises in the east and moves across the sky every day and then travels beneath the earth at night to reappear in the east the next morning.  And you expect anyone in his right mind to believe otherwise.  What?  It’s the earth rotating on its axis?  Are you possessed of demons?  And you say that the earth is round?  If the earth were round, how could anybody stand at the bottom of the earth and not fall off?  Galileo, you are a raving lunatic.  And you, Mr. Einstein, you say that there is something called a space-time continuum, so that time slows down as the speed one travels approaches the speed of light.  My God, where could you have come up with such an idea?  By that reasoning, two people could not agree on which of two events happened first if one of them was stationary and the other traveling at half the speed of light.  Away with you, and don’t ever dare speak such nonsense again, or, by God, you shall be really, really sorry.

The point of course is not to disregard common sense — that would not be very intelligent — but to recognize that common sense isn’t enough.  Sometimes things are not what they seem – the earth, Mr. Moore, is not flat – and our common sense has to be trained to correspond with a reality that can only be discerned by the intensive application of our reasoning powers, in other words, by thinking harder about what the world is really like than just accepting what common sense seems to be telling us.  But once you recognize that common sense has its limitations, the snide populist sneers — the stock-in-trade of the Journal editorial page — mocking economists with degrees from elite universities in which Mr. Moore likes to indulge are exposed for what they are:  the puerile defensiveness of those unwilling to do the hard thinking required to push back the frontiers of their own ignorance.

In today’s column, Mr. Moore directs his ridicule at a number of Keynesian nostrums that I would not necessarily subscribe to, at least not without significant qualification.  But Keynesian ideas are also rooted in certain common-sense notions, for example, the idea that income and expenditure are mutually interdependent, the income of one person being derived from the expenditure of another.  So when Mr. Moore simply dismisses as “nonsensical” the idea that extending unemployment insurance to keep the unemployed from having to stop spending, he is in fact rejecting an idea that is no less grounded in common sense than the idea that paying people not to work discourages work.  The problem is that our common sense cuts in both directions.  Mr. Moore likes one and wants to ignore the other.  (continue reading here).

So, no question about it, Mr. Trump, the man who chose Corey Lewandowski and then Paul Manafort to run his campaign, and selected Meredith McIver to work with Melania Trump on her speech to the Republican convention, proves again that he is a great judge of talent.

How Liberalism in America Became Synonymous with its Antithesis

In the run-up to, and immediate aftermath of, Hillary Clinton’s choice of Tim Kaine to be her running mate, one of the recurring comments was how unpopular Tim Kaine is with the liberals who supposedly comprise the bulk of Bernie Sanders’ supporters, and must somehow be coaxed, cajoled or persuaded to reconcile themselves with Kaine’s supposedly moderate centrist political views.

Here’s a typical description of Kaine’s liberal problem in the Washington Post:

Hillary Clinton has made her selection for vice president: Virginia Sen. Tim Kaine.

That will come as a disappointment to many liberals. After rallying behind Sen. Bernie Sanders in the Democratic primary and being teased with Elizabeth Warren as Clinton’s potential running mate — an audition that appeared to go very well — Clinton opted for a more boring, more moderate pick. This despite some liberal groups saying Kaine was unacceptable and even “disastrous.”

First, let’s run through why some liberals don’t love Kaine. Over at Wonkblog, Max Ehrenfruend details three issues on which Kaine could be a particular disappointment to the Warren/Sanders crowd: trade (he’s generally pro-free trade), banking (he has suggested softening some Dodd-Frank regulations) and abortion (he is personally pro-life but votes pro-choice).

So, according to this article, which I think accurately reflects the current understanding of what it now means to be a liberal in America, we have arrived at a state of affairs in which supporting free trade is sufficient justification for casting Tim Kaine out of the liberal fold. Or to make the point in a slightly different way, on international trade at least, Donald Trump’s views are more liberal than those of either Tim Kaine or Hillary Clinton. In this crazy year of 2016, we have witnessed all kinds of farcical events that no one ever dreamed would actually happen. But for protectionism to now be identified as a defining tenet of liberalism surely belongs on any list of the improbable plot twists in the tragicomedy of an election campaign that we have been watching in disbelief in America’s political theater of the absurd.Considered historically, the notion that you can’t be a liberal if you support free trade is nothing short of preposterous, the British Liberal Party having came into existence in the nineteenth century largely as a result of the great political battle over free trade in Britain in the 1830s and 1840s.

The Conservative Party was founded in 1834 as a combination of the Tories and a number of Whig followers of William Pitt the Younger. Led by Sir Robert Peel, the Conservatives were committed to protecting the interests of the landed aristocracy from whom the Tories were largely drawn, and were generally solicitous of the royal prerogatives. Although they too were drawn from the landed aristocracy, the Whigs were hostile to the royal prerogatives, seeking to enlarge the powers of Parliament and limit those of the Crown. In opposing royal powers, the Whigs were the natural allies of the Radicals, who represented the interests of the rising industrial and commercial sectors and the growing middle classes.

Reflecting the predominant influence of the Tory landed aristocracy, the Conservatives supported protective tariffs to keep domestic grain prices and land values high. Although the economic interests of the Whig landed aristocracy were also served by protection and high grain prices, the Whigs were prepared to sacrifice their economic interests (perhaps more diversified than the Tories’ interests) and to accept free trade as the price to regain power in concert with the Radicals, whose laissez-faire principles and economic interests strongly inclined them to oppose protection and high grain prices.

As Prime Minister in the 1840s, Peel reversed his previous opposition to free trade, having been persuaded by Richard Cobden, a Radical and the chief Parliamentary advocate of free trade, that allowing foreigners to increase grain exports to Britain would increase foreign demand for British manufactured goods. The famous, possibly legendary, story of Peel’s conversion to free trade has it that, after one of Cobden’s compelling Parliamentary speeches in favor of repealing the Corn Laws restricting grain imports into Britain, Peel, turning to his colleague Sidney Herbert, said: “Sir, you must answer him, for I cannot.” Whatever the motivation for Peel’s conversion to free trade, Peel’s decision split the Conservative party, with most Conservatives still opposing free trade, while about a third of Conservative MPs, including the future Liberal Prime Minister W. E. Gladstone, sided with Peel to form a separate faction.

Eventually, in 1859 the Whigs, Radicals and most of the Peelite Conservatives, joined to create the Liberal Party. So the British Liberal Party was formed as a coalition united by their support of free trade. Although the Conservative Party later came to support free trade, at the beginning of the twentieth century Conservatives turned against free trade, renewing the old conservative-liberal ideological divide.

Given the origins of liberalism as a political movement supporting free trade, it’s disconcerting to watch self-styled liberals transform liberalism into its own antithesis. I’m not trying to suggest that there is such a thing as a true liberalism, or that any departure from the original creed is a kind of heresy. All I’m saying is that leftist critics of Kaine show their own ignorance and ideological illiteracy — not to mention sheer arrogance — when they claim that support for free trade, which for almost two centuries was considered a basic liberal tenet, invalidates Kaine’s standing as a liberal.

I am also not saying that there are no good arguments to be made against free trade, though there are certainly a lot of bad ones, especially those that focus on the trade deficit as a measure of the harm caused by trade. I have actually written previously about the inadequacy of standard economic defenses of free trade, which doesn’t mean that attacks on free trade are right, just that those attacks are not necessarily countered by the standard defenses.

But we are now so disconnected from history that we habitually use terms as labels or as epithets in ways that are completely at odds with the meanings that the terms used to have. President Obama, for example, is routinely described as a socialist and even as a Marxist based, as far as I can tell, on nothing more than that he wants the federal government to reduce the inequality of income and wealth in the US. I have written some posts in the past suggesting why a lot of high income earnings from finance and intellectual property do not increase net social welfare, but I don’t  have a well-thought-out position about overall income and wealth inequality. As a starting point, I think Rawls’s difference principle that income inequality is justified only insofar as the inequality redounds to the absolute benefit of the least well-off members of society is a good way to think about how to handle income and wealth inequality in a free and democratic society. But I don’t think that Rawls gets us very far. The problem with the Rawlsian difference principle is that, in practice, it is nearly impossible to make the principle operational. I have no doubt that Ludwig von Mises would have been totally comfortable arguing that laissez-faire capitalism actually satisfies the difference principle. I believe that he actually made such an argument in Human Action.

But the point that I am making here is simply that it is entirely possible for someone to favor non-trivial redistribution of wealth and income from the wealthy to the less wealthy without being either a socialist or a Marxist. And in fact there have been many non-socialists and non-Marxists who have favored some degree of wealth and income redistribution. So the routine smear attacks on Obama for being a socialist or a Marxist as just typical of the degradation of our semantic environment.

Of course, there is nothing to stop anyone from defining “socialist” and “Marxist” so that anyone who supports redistributing income and wealth is both a socialist and a Marxist. But such definitions would be a trivial exercise with no historical basis. The exercise would be self-defeating if it’s artificiality were acknowledged. What “socialism” has meant historically is a political doctrine favoring the state ownership and operation of all or most of the non-human means of production. But as the number of people who believe in government ownership and operation of the means of production has fallen steadily over the last half century or so, the term “socialism” has gradually been transformed into a vague and nearly meaningless catchword.

What makes Bernie Sanders a socialist is not a belief that government should own and operate most industries, but a general ethos that he feels is captured and communicated by the term. “Socialism” is a convenient way to signal hostility to capitalism – though not a desire to replace it with state ownership and control — and support for wealth redistribution. Similarly, those on the right find “socialism” a handy term of abuse with which to vilify their opponents.

I am no expert on Marxism, but my understanding is that it is a belief in a particular theory of the (supposed) historical laws governing the past and future development of society, supposedly leading to the creation of a socialist state. I assume that there are still some Marxists out there, but if you really do believe that Barack Obama is one of them, there is a good chance that you are delusional.

But what strikes me as especially interesting is not just that liberalism, like socialism, no longer means what it used to mean, but that it has come to mean, in the minds of many, the exact opposite of what it used to mean. So I’d like suggest my own linguistic theory of how liberalism in America has come to take on a meaning so very different from what it once meant. What led to the transformation of liberalism in America was, I conjecture, the lack of a successful socialist political movement in the US. In one sense that was a good thing,  because socialism is not now and never was a sensible way to organize a society or to promote widespread prosperity. However, the failure of socialism in the US to become a politically viable left-wing alternative meant that “liberal” became one of the two default terms for moderately left-leaning political activists to use for self-description and self-identification, the other being the peculiarly American term “progressive.”For similar reasons, liberalism and progressivism also came to be associated with the political activism of organized labor. In Europe, however, socialism aka “social democracy” became a politically powerful movement, gaining the support of much, if not most, of the labor unions. So the contrast between the middle-class orientation of European liberalism on the one hand and the labor activism and socialist ideology of the left-wing parties on the other was much sharper than the contrast between middle-class liberalism and labor activism in the US.

Similarly, because American political parties were almost totally non-ideological, having developed as loose coalitions of diverse sectional and economic interests, the Democratic and Republican parties, unlike the European parties, developed few systematic political doctrines. The antebellum Democratic Party, for example, purported to espouse the doctrine of states’ rights, but professed adherence to that doctrine did not prevent the Democrats from insisting on a federal fugitive slave law requiring Northern states to cooperate with slaveholders to return runaway slaves to their owners, thereby overriding the laws of those Northern states that recognized runaway slaves as free human beings rather than the property. Until the Civil War, the slavery issue dominated political discourse, making the Democratic Party the pro-slavery, or the slavery-neutral, party. For sectional reasons, the Democratic Party also tended to be the anti-tariff party, while the Republican Party was the high-tariff party, rendering both parties unsuitable homes for liberal doctrines, thereby depriving liberalism of a coherent political voice.

The political failure of socialism in the US compelled reformist political movements to focus on piecemeal rather than comprehensive social and economic changes, e.g., the unsuccessful free-silver movement of the last quarter of the nineteenth century, and the whole panoply of Progressive measures enacted in the early twentieth century under the Republican and Democratic administrations of both Theodore Roosevelt and Woodrow Wilson. With no competing popular doctrine available, liberals and progressives occupied almost all of the left side of the political spectrum. So left-wing political activism in the US was co-opted by the liberal and the progressives instead of socialists or social democrats. In Europe, competing with the socialists to their left, liberals had good reason to emphasize their differences with the socialists as well as their similarities, and there was only limited incentive for liberal parties to try to compete with the left-wing parties by shifting to the left. In the US, however, there was an incentive for liberals to shift to the left to foreclose the entry of a new left-wing party or movement that might drain support from liberals and progressives.

Similarly, insofar as liberals shifted to the left to foreclose a more left-wing alternative, it became easier for moderate or right-leaning liberals to shift their  political allegiance to conservatism than it would have been for European liberals to switch their allegiance to conservatism, because many American conservatives more or less shared the liberal values espoused by liberals, as those values were enshrined in the founding documents of the American Republic. European conservatives, unlike most American conservatives, were ideologically hostile to the basic democratic and liberal values that most American conservatives also acknowledged, notwithstanding the hypocrisy of supporting or tolerating legal segregation and other forms of legal racism. Even in Britain, the cradle of liberalism, the Liberal Party, which had governed Britain for most of the second half of the nineteenth century up to and including the First World War, was eventually reduced to insignificance when the rise of a Labour Party to its left drove Liberal voters, fearing a Labour victory, into the Conservative camp.

Thus, liberalism in Europe retained a more distinct character as a middle-class, democratic, secular, non-socialist ideology than American liberalism. American liberalism was drawn steadily to the left, becoming increasingly attuned to the political agenda of organized labor and becoming increasingly identified with left-wing economic ideas that were not necessarily socialist in the traditional sense, but were also not compatible with liberal doctrines like free trade. Many moderate and right-leaning liberals found it preferable to adapt to the political program offered by an American conservatism that seemed to have embraced many of the key elements of classical nineteenth century liberalism, but without totally rejecting the post-war consensus of a limited welfare state providing a social safety net for the less fortunate, than to follow the leftward drift of American liberalism.

So with the transition of many American moderates and liberals into conservatives, American liberalism has evolved into a left-wing ideology that has animated and energized the Sanders political revolution of 2016, thereby creating the impression in America, among both liberals and non-liberals, that liberalism is more or less interchangeable with left-wing or socialist ideas, albeit socialist ideas that have little relationship to socialism in the original sense of the term. This doesn’t mean that all American liberals are leftists. Many, if not most, American liberals w remain politically moderate, but the ideological energy of American liberalism seems now to be headed in a leftward direction. Years of ideological confusion have obliterated the distinction between liberalism and “leftism,” so that liberalism as an economic doctrine no longer stands for anything — in the American context — other than a demand for government intervention to reduce income equality, to raise wages, which is basically all that socialism now signifies. Disconnected from its historical origins and meaning, American liberalism now represents nothing more than a vague term more or less synonymous with an equally vague “socialism” whose meaning is no more definite than the sentimental message of John Lennon’s song “Imagine.”

 

What’s Wrong with EMH?

Scott Sumner wrote a post commenting on my previous post about Paul Krugman’s column in the New York Times last Friday. I found Krugman’s column really interesting in his ability to pack so much real economic content into an 800-word column written to help non-economists understand recent fluctuations in the stock market. Part of what I was doing in my post was to offer my own criticism of the efficient market hypothesis (EMH) of which Krugman is probably not an enthusiastic adherent either. Nevertheless, both Krugman and I recognize that EMH serves as a useful way to discipline how we think about fluctuating stock prices.

Here is a passage of Krugman’s that I commented on:

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

My comment was:

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities.

Scott had this to say about my comment:

David is certainly right that Krugman’s statement is “inexactly worded”, but I’m also a bit confused by his criticism. Certainly “weakness in investment spending” is not a “symptom” of low interest rates, which is how his comment reads in context.  Rather I think David meant that the shift in the investment schedule is a symptom of a low level of AD, which is a very reasonable argument, and one he develops later in the post.  But that’s just a quibble about wording.  More substantively, I’m persuaded by Krugman’s argument that weak investment is about more than just AD; the modern information economy (with, I would add, a slowgrowing working age population) just doesn’t generate as much investment spending as before, even at full employment.

Just to be clear, what I was trying to say was that investment spending is determined by “fundamentals,” i.e., expectations about future conditions (including what demand for firms’ output will be, what competing firms are planning to do, what cost conditions will be, and a whole range of other considerations. It is the combination of all those real and psychological factors that determines the projected returns from undertaking an investment, and those expected returns must be compared with the cost of capital to reach a final decision about which projects will be undertaken, thereby giving rise to actual investment spending. So I certainly did not mean to say that weakness in investment spending is a symptom of low interest rates. I meant that it is a symptom of the entire economic environment that, depending on the level of interest rates, makes specific investment projects seem attractive or unattractive. Actually, I don’t think that there is any real disagreement between Scott and me on this particular point; I just mention the point to avoid possible misunderstandings.

But the differences between Scott and me about the EMH seem to be substantive. Scott quotes this passage from my previous post:

The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion.

Scott responded as follows:

I don’t think it’s correct to say the EMH is based on “solid fundamentals”.  Rather, AFAIK, the EMH says that asset prices are based on rational expectations of future fundamentals, what David calls “opinions”.  Thus when David tries to replace the EMH view of fundamentals with something more reasonable, he ends up with the actual EMH, as envisioned by people like Eugene Fama.  Or am I missing something?

In fairness, David also rejects rational expectations, so he would not accept even my version of the EMH, but I think he’s too quick to dismiss the EMH as being obviously wrong. Lots of people who are much smarter than me believe in the EMH, and if there was an obvious flaw I think it would have been discovered by now.

I accept Scott’s correction that EMH is based on the rational expectation of future fundamentals, but I don’t think that the distinction is as meaningful as Scott does. The problem is that in a typical rational-expectations model, the fundamentals are given and don’t change, so that fundamentals are actually static. The seemingly non-static property of a rational-expectations model is achieved by introducing stochastic parameters with known means and variances, so that the ultimate realizations of stochastic variables within the model are not known in advance. However, the rational expectations of all stochastic variables are unbiased, and they are – in some sense — the best expectations possible given the underlying stochastic nature of the variables. But given that stochastic structure, current asset prices reflect the actual – and unchanging — fundamentals, the stochastic elements in the model being fully reflected in asset prices today. Prices may change ex post, but, conditional on the realizations of the stochastic variables (whose probability distributions are assumed to have been known in advance), those changes are fully anticipated. Thus, in a rational-expectations equilibrium, causation still runs from fundamentals to expectations.

The problem with rational expectations is not a flaw in logic. In fact, the importance of rational expectations is that it is a very important logical test for the coherence of a model. If a model cannot be solved for a rational-expectations equilibrium, it suffers from a basic lack of coherence. Something is basically wrong with a model in which the expectation of the equilibrium values predicted by the model does not lead to their realization. But a logical property of the model is not the same as a positive theory of how expectations are formed and how they evolve. In the real world, knowledge is constantly growing, and new knowledge implies that the fundamentals underlying the economy must be changing as knowledge grows. The future fundamentals that will determine the future prices of a future economy cannot be rationally expected in the present, because we have no way of specifying probability distributions corresponding to dynamic evolving systems.

If future fundamentals are logically unknowable — even in a probabilistic sense — in the present, because we can’t predict what our future knowledge will be, because if we could, future knowledge would already be known, making it present knowledge, then expectations of the future can’t possibly be rational because we never have the knowledge that would be necessary to form rational expectations. And so I can’t accept Scott’s assertion that asset prices are based on rational expectations of future fundamentals. It seems to me that the causation goes in the other direction as well: future fundamentals will be based, at least in part, on current expectations.

Stock Prices, the Economy and Self-Fulfilling Prophecies

Paul Krugman has a nice column today warning us that the recent record highs in the stock market indices don’t mean that happy days are here again. While I agree with much of what he says, I don’t agree with all of it, so let me try to sort out what I think is right and what I think may not be right.

Like most economists, I don’t usually have much to say about stocks. Stocks are even more susceptible than other markets to popular delusions and the madness of crowds, and stock prices generally have a lot less to do with the state of the economy or its future prospects than many people believe.

I think that’s generally right. The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion. So the fundamental idea on which the EMH is premised that there are fundamentals is itself fundamentally wrong. Fundamentals are no more than conjectures and psychologically flimsy perceptions, and individual perceptions are themselves very much influenced by how other people perceive the world and their perceptions. That’s why fads are contagious and bubbles can arise. But because fundamentals are nothing but opinions, expectations can be self-fulfilling. So it is possible for some ex ante bubbles to wind up being justified ex post, but only because expectations can be self-fulfilling.

Still, we shouldn’t completely ignore stock prices. The fact that the major averages have lately been hitting new highs — the Dow has risen 177 percent from its low point in March 2009 — is newsworthy and noteworthy. What are those Wall Street indexes telling us?

Stock prices are in fact governed by expectations, but expectations may or may not be rational, where a rational expectation is an expectation that could actually be realized in some possible state of the world.

The answer, I’d suggest, isn’t entirely positive. In fact, in some ways the stock market’s gains reflect economic weaknesses, not strengths. And understanding how that works may help us make sense of the troubling state our economy is in. . . .

The truth . . . is that there are three big points of slippage between stock prices and the success of the economy in general. First, stock prices reflect profits, not overall incomes. Second, they also reflect the availability of other investment opportunities — or the lack thereof. Finally, the relationship between stock prices and real investment that expands the economy’s capacity has gotten very tenuous.

To put this into the slightly different language of basic financial theory, stock prices reflect the expected future cash flows from owning shares of publicly traded corporations. So stock prices reflect the net value of the tangible and intangible capital assets of these corporations. The public valuations of those assets reflected in stock prices reflect expectations about the future income streams associated with those assets, but those expected future income streams must be discounted so that they can be expressed as a present value. The rate at which future income streams are discounted into the present represents what Krugman calls “the availability of other investment opportunities.” If lots of good investment opportunities are available, then future income streams will be discounted at a higher rate than if there aren’t so many good investment opportunities. In theory the discount rate at which future income streams are discounted would reflect the rate of return corresponding to the marginal investment opportunities that are on the verge of being adopted or abandoned, because they just break even. What Krugman means by the tenuous relationship between stock prices and real investment that expands the economy’ capacity will have to be considered below.

Krugman maintains that, over the past two decades, even though the economy as a whole has not done all that well, stock prices have increased a lot, because the share of capital in total GDP has increased at the expense of labor. He also points out that the low — even negative — real interest rates on government bonds are indicative of the poor opportunities now available (at the margin) to investors.

And these days those options [“for converting money today into income tomorrow”] are pretty poor, with interest rates on long-term government bonds not only very low by historical standards but zero or negative once you adjust for inflation. So investors are willing to pay a lot for future income, hence high stock prices for any given level of profits.

Two points should be noted here. First, scare talk about low interest rates causing bubbles because investors search for yield is nonsense. Even in a fundamentalist EMH universe, a deterioration of marginal investment opportunities causing a drop in the real interest rate will, for given expectations of future income streams, imply that the present value of the assets generating those streams would rise. Rising asset prices in such circumstances are totally rational, which is exactly what bubbles are not. Second, the low interest rates on long-term government bonds are not the cause of poor investment opportunities but the result of poor investment opportunities. Krugman certainly understands that, but many of his readers might not.

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities. The mystery deepens:

This may seem, however, to present a paradox. If the private sector doesn’t see itself as having a lot of good investment opportunities, how can profits be so high? The answer, I’d suggest, is that these days profits often seem to bear little relationship to investment in new capacity. Instead, profits come from some kind of market power — brand position, the advantages of an established network, or good old-fashioned monopoly. And companies making profits from such power can simultaneously have high stock prices and little reason to spend.

Why do profits bear only a weak relationship to investment in new capacity? Krugman suggests that the cause  is that rising profits are due to the exercise of market power, firms increasing profits not by increasing output, but by restricting output to raise prices (not necessarily in absolute terms but relative to costs). This is a kind of microeconomic explanation of a macroeconomic phenomenon, which does not necessarily make it wrong, but it is a somewhat anomalous argument for a Keynesian. Be that as it may, to be credible such an argument must explain how the share of corporate profits in total income has been able to grow steadily for nearly twenty years. What would account for a steady economy-wide increase in the market power of corporations lasting for two decades?

Consider the fact that the three most valuable companies in America are Apple, Google and Microsoft. None of the three spends large sums on bricks and mortar. In fact, all three are sitting on huge reserves of cash. When interest rates go down, they don’t have much incentive to spend more on expanding their businesses; they just keep raking in earnings, and the public becomes willing to pay more for a piece of those earnings.

Krugman’s example suggests that the continuing increase in market power, if that is what has been happening, has been structural. By structural I mean that much of the growth in the economy over the past two decades has been in sectors characterized by strong network effects or aggressive enforcement of intellectual property rights. Network effects and strong intellectual property rights tend to create, enhance, and entrench market power, supporting very large gaps between prices and variable costs, which is the standard metric for identifying exercises of market power. The nature of what these companies offer consumers is such that their marginal cost of production is very low, so that reducing price and expanding output would not require a substantial increase in their demand for inputs (at least compared to other industries with higher marginal costs), but would cause a big loss of profit.

But I would suggest looking at the problem from a different perspective, using the distinction between two kinds of capital investment proposed by Ralph Hawtrey. One kind of investment is capital deepening, which involves an increase in the capital intensity of production, the idea being to reduce the cost of production by installing new or better equipment to economize on other inputs (usually labor); the other kind of investment is capital widening, which involves an increase in the scale of output but not in capital intensity, for example building a new plant or expanding an existing one. Capital deepening tends to reduce the demand for labor while capital widening tends to increase it.

More of the investment now being undertaken may be of the capital-deepening sort than has been true historically. Aside from the structural shifts mentioned above, the reduction in capital-widening investment may be the result of declining optimism by businesses in their projections about future demand for their products, making capital-widening investments seem less profitable. For the economy as a whole, a decline in optimism about future demand may turn out to be self-fulfilling. Thus, an increasing share of total investment has become capital-deepening and a declining share capital-widening. But for the economy as a whole, this self-fulfilling pessimism implies that total investment declines. The question is whether monetary (or fiscal) policy could now do anything to increase expectations of future demand sufficiently to induce an self-fulfilling increase in optimism and in capital-widening investment.

 

What’s Wrong with the EU? Part 1

Since the Brexit vote last week, I have been trying to sort out my disparate thoughts about the EU. In doing so, I have been thinking about the early history of the EU and its origins in the early 1950s and the convoluted process by which Britain came to join what was then called the European Common Market. In the process I have also been thinking a lot about the fascinating but disturbing figure of Enoch Powell who became the foremost opponent of Britain’s entry into the Common Market and the reasons for his opposition. What follows is my reconstruction of the early process by which the Common Market came into existence and Britain’s entry into the Common Market in 1972 and Powell’s role in both Britain’s entry and in the first attempt only a few years later to undo that entry. I will try to carry the story a bit further in my next installment and, if possible, draw some of the many threads of the narrative together and offer some judgments about what really is wrong with the EU and maybe even what could be done about it.

The EU, as of now including 28 states, began its first incarnation with the Treaty of Paris in April 1951 as the European Coal and Steel Community (ECSC) comprised of six states — France, West Germany, Italy, Belgium, the Netherlands and Luxembourg – in which coal and steel would be traded freely within the community but with a common tariff applied to imports of coal and steel from outside the community. The Treaty also created four supranational bodies to administer the agreement, an executive body (the High Authority), two legislative bodies (the Assembly and the Council) and a Court of Justice. The members of each body were appointed by the governments of the six countries.

The UK, under a Labour government that had recently nationalized the steel and coal industries, was disinclined to join an institution that would constrain its authority to manage the physical and human resources under its control and therefore opted not to join the ECSC. The Labour government was voted out of office in October 1951, Winston Churchill, at the age of 77, becoming prime minister for the second time. Churchill was pro-European, having often given voice to the ideal of a united Europe, even speaking favorably in general terms about a United States of Europe. However, Churchill, still hoping to preserve what could be salvaged of the remnants of the British Empire and emotionally tied to a special relationship with the United States, was no more eager to take concrete steps to join the ECSC than his Labour predecessor.

The 1957 Treaty of Rome expanded the ECSC into a broader European Common Market encompassing all cross-border trade within the six member estates, eliminating all internal tariffs on imports and exports within the Common Market and creating a customs union with a uniform tariff on all imports from outside the community. In the mid-1950s, even after Churchill’s retirement, Great Britain, still in the thrall of its dwindling empire, which it quixotically hoped to recreate in the guise of a British Commonwealth whose member states would enjoy preferential access to each other’s markets, could not bring herself to sever the fraying ties to her former empire to join the soon to be created European Community. So the British government, now led by Harold Macmillan, chose not to participate in the negotiations to draft the Treaty of Rome and did not seek to join once it was created.

However, the rapid growth of the six economies of the Common Market produced a change of British opinion about entry into the Common Market. Among the first English politicians to argue that the UK should abandon its pretensions to being a great power and instead promote economic expansion by joining the Common Market was a brilliant young Conservative MP named Enoch Powell. Fluent in at least a dozen languages, a classical Greek scholar who had once been the youngest classics professor in the British Empire, Powell, an autodidact in economics, had become the most articulate Parliamentary advocate of free-market economic policies, though such views were then regarded as almost embarrassingly out of date even among staunch Conservatives. Powell thought that attempts to maintain a vestigial Empire as a Commonwealth were pure humbug, a costly illusion diverting resources that could be put to much more productive use if left under the control of private enterprise. Powell was not alone in favoring entry into the Common Market, but he was more radical than most in favoring a complete reorientation of British economic and foreign policy toward the Continent.

So in 1962, the Conservative government headed by Harold Macmillan, in which Powell served as minister of health, applied for admission to the Common Market in 1962 only to have its application, along with those of Denmark and Ireland, vetoed by Charles de Gaulle with the concurrence of Prime Minister Adenauer of West Germany, because de Gaulle, deeply mistrustful of the British and especially the Americans, feared that Britain would be more loyal to the US than to Europe. In 1967, Britain again applied for admission to the European Community, this time under a Labour government headed by Harold Wilson, but once again the application was vetoed by de Gaulle.

After de Gaulle’s departure in 1969, his successor George Pompidou was more amenable to British entry into the European Community, creating an opportunity for a third British attempt to enter the EC; the other five members were also eager for British entry, so that continued French opposition would have placed France and Pompidou in an awkward position. In 1970, the Conservatives, now led by Edward Heath, defeated Labour. Heath had been elected leader of the Conservatives by a vote of Conservative MPs in 1965, the first selection of a Conservative leader, the leader having formerly been chosen by an informal process understood only by a few well-placed party leaders. Heath narrowly defeated his main opponent, Reginald Maudling, by a small margin. Enoch Powell came in a distant third with only 15 of the 298 votes cast. Maudling was an economic interventionist and an advocate of what was then called an “incomes policy” to control inflation by using statutory or informal controls over wages and prices to limit the growth of money income. As a minister in Macmillan’s government, Heath had been deeply involved in the negotiations for entry into the EEC, and he was known to be a strongly in favor of British entry into the EC.

Heath included Powell in his shadow cabinet giving him the defense portfolio; he remained in that position until April 1968 when Powell gave a speech calling for a halt to non-white immigration from Commonwealth countries. The speech known as the “rivers of blood speech,” because Powell quoted a passage from Virgil alluding to a vision of the river Tiber foaming with blood. Powell’s intention in quoting that passage was not clear, but it was widely interpreted as a prediction of a coming race war, and the speech was condemned even by Conservatives as racist, a charge Powell denied. But the rhetoric of the speech, even if it wasn’t motivated racial animosity or prejudice on Powell’s part, was clearly inflammatory. Heath quickly dismissed Powell from the shadow cabinet, and Powell never again held a leadership position. However, the speech transformed Powell from a relatively obscure, overly intellectual and eccentric figure in the second rank of the British political hierarchy into perhaps the most popular politician in Britain, becoming a sort of folk hero to large segments of the British white working class who immediately began demonstrating in large numbers in his support.

Despite his expulsion from the front bench of the Conservative Party, and ostracism by many of his colleagues, Powell remained a Conservative MP and stood in the 1970 election in which the Conservatives, led by Heath, won a surprise victory, a victory credited by some to Powell’s popularity with white working-class voters who would have otherwise have voted for Labour. The personal popularity that Powell achieved through his attack on non-white immigration and his references to a breakdown in law and order and a recital of white grievances against non-whites mirrored a similar campaign being undertaken across the Atlantic by another frustrated candidate for high office, George Wallace, who was successfully launching a third-party bid for President in 1967, under the banner of the American Independent Party. Wallace had run for President in 1964 as a Democrat, gaining shockingly high vote counts in primaries in a number of Northern and Border states like Wisconsin, Michigan, Ohio and Maryland. Certainly Powell could not have been unaware of Wallace’s popularity with white-working class voters owing to his skillful use of inflammatory and racially-charged, if not explicitly racist, law-and-order, anti-elitist rhetoric, and it would be naïve to suppose that political calculation was absent from a mind as powerful and as concentrated as Powell’s when he made his April 1968 speech about non-white immigration and adopted an alarmist rhetorical strategy in composing that speech. Though Powell did indeed choose the path of political incorrectness, he hardly chose the path of political inexpediency. His only miscalculation was in supposing that Heath would lose the next election and that the Conservative Party would then turn to him.

Substantively there was little difference between Heath and Powell in 1970. Heath had largely embraced the free market position that had once made Powell an outlier even in the Conservative Party, and he had pledged to stop further non-white immigration from the Commonwealth, though he refused to bar immigration by the family members of existing immigrants, nor would he take any steps to repatriate legal non-white immigrants, as Powell advocated. And on the question of entry into the Common Market, Powell in 1968 had not yet repudiated his earlier stance in favor of entry into the European Community. Heath’s unexpected election therefore largely dashed Powell’s hopes of becoming leader of the Conservative Party.

Although there seemed to be a consensus in the 1970 election in favor of entry into European Community, that consensus was more apparent than real. In fact, the Labour Party, which had historically opposed entry into the Common Market until the Wilson government, despite the being forewarned that a French veto would inevitably follow, applied for entry in 1967, was deeply divided on the question. Wilson continued to support entry, but a majority of the party was actually opposed, viewing the Common Market as a basically capitalist institution and an obstacle to implementing their economic program. And although the Conservatives seemed united in supporting entry, few Conservatives supported entry into the EC as unreservedly as Heath; most Conservative supporters were conflicted, viewing entry as a purely pragmatic decision, with advantages only marginally outweighing disadvantages, making a final decision sensitive to the terms on which entry could be secured. Only the Liberals, holding just six seats in the new Parliament, and a small number of Conservatives and Labourites shared Heath’s unqualified enthusiasm for entry.

But with all parties nominally supporting entry in the 1970 election, the question of entry into the European Community was not an issue and was not debated. The official Conservative position was relatively circumspect, favoring negotiations to secure entry, but making no pledge to enter, so that Heath could not claim convincingly that his election provided a popular mandate for bringing Britain into the EC on whatever terms he negotiated. But entry into the EC had become the chief policy goal of Heath’s political career. Charles de Gaulle having retired from public life in 1969 and succeeded by his protege Georges Pompidou, Heath’s task in securing entry into the EC consisted in securing Pompidou’s assent to British entry. Unlike de Gaulle, Pompidou did not regard the idea of Britain being part of the EC as inherently repugnant, but if Britain were to enter it would have to be on French terms, meaning that Britain would have to accept the existing Treaty of Rome without change. The Treaty of Rome had been drafted with by the six original members with a view to provide protection for their large agricultural sectors by keeping out cheap agricultural imports to support high prices for domestic agricultural products. Britain, on the other hand, with a far smaller agricultural sector than those of the six, was an importer of agricultural products from Commonwealth countries, providing cash payments to domestic farmers. Accepting the common agricultural policy of the EC as it existed would require Britain to shift from low-cost Commonwealth imports to high-cost EC imports of agricultural products, imposing a net transfer from the British economy to the six original members, especially to France with the largest agricultural sector in the EC. That acceptance was the price for British entry into the Common Market

Pompidou’s assent in principle to Britain’s application for entry once Heath accepted the Treaty of Rome and all existing EEC regulations with no substantial changes meant that Britain’s entry into the Common Market was assured. Less than a year after meeting with Pompidou, Heath signed the Treaty of Rome on January 22, 1972, and a bill was introduced in Parliament assenting to Britain’s entry under the agreed upon terms and accepting the Treaty of Rome and EEC regulations. With a Conservative Parliamentary majority, the support of the Liberal Party and many Labour MPs, the bill passed easily. But Enoch Powell voted against, having begun speaking out against entry into the Common Market the previous year. Powell’s argument was that, under appropriate economic policies, Britain could thrive as an independent trading nation and therefore had little to gain, and much to lose, owing to the Common Agricultural Policy, by joining the European Community. Beyond the economic argument against joining the Common Market, Powell had two more fundamental objections: 1) that entry into the EC implied a surrender of British sovereignty because powers that had historically been exercised by Parliament such as the power to set taxes and enact legislation, were being transferred to the European Commission, and 2) that so momentous a decision should not be made without giving the British people an opportunity to express their opinions on the matter, and the Conservative Party, having won a Parliamentary majority promising only to negotiate for entry into the EC, had no mandate to take Britain into the EC without a further expression of support from the voters.

While Powell’s opposition to entry into the EU can certainly be understood as a natural outgrowth of his nationalistic and Tory conception of England and Britain, the timing and the abruptness of Powell’s attitude toward the Common Market invites the inference that Powell, in making opposition to entry into the Common Market the central cause of the last phase of his political career, was influenced by a political calculation. After all, when Harold Macmillan first proposed British entry into the Common Market, a decade before Powell declared his opposition to entry, Hugh Gaitskell, leader of the opposition, had made a similar argument to Powell’s: entry into the Common Market would replace Parliament with a supranational body as the supreme sovereign authority of the British nation. Powell had surely understood what Gaitskell was arguing in 1962, but he didn’t abandon his support for entry into the European Community until his hopes of becoming leader of the Conservative Party were dashed by Heath’s election. It is probably more likely that Powell had been insincere in favoring entry before 1971 than that he was insincere in opposing entry after; as long as he hoped to become leader of the Conservative Party, he may well have intended to reverse his public stance on Europe after becoming leader. But it is hard to believe he was not insincere in holding at least one of his two positions on entry into the Common Market.

It is characteristic of Powell that he framed the question of joining Europe as a matter of high principle: preserving British identity as self-governing, autonomous nation state, whose Parliament was the ultimate law making and governing institution of the realm, not subservient to any foreign external authority. For Powell the supremacy of Parliament was akin to a metaphysical imperative, even a religious duty, and to compromise that imperative would have been a betrayal of all he believed and stood for. Reading such rhetorical absolutism, one again comes back to the question how Powell could have explained or justified his own earlier support, however lukewarm or insincere, for British entry into the Common Market.

For Powell, unwavering opposition to joining the European Community was the ultimate expression of his Toryism, but considered from another perspective, his absolutist mentality was profoundly unconservative. Elevating the single abstract principle of Parliamentary sovereignty and supremacy above and beyond all other principles and considerations was characteristic of a metaphysical extremism that runs strongly counter to the conservative disposition described by Michael Oakeshott in his essay “On Being Conservative.” Indeed, Oakeshott, perhaps the leading academic British conservative of his generation, was loath to express any opinion about British entry into the Common Market notwithstanding his own reservations about federalism as a mode of government, believing that sovereignty is indivisible, a very British idea that baffles us Americans. Some claim that Oakeshott was actually opposed to entry into the Common Market, but even so, Oakeshott’s reticence in voicing that opinion seems very much at odds with Powell’s absolutist frame of mind wherein opposition to joining the European Community became the overriding object of Powell’s life to which all other considerations were subordinated.

Powell’s antagonism toward Heath was further inflamed when Heath abandoned the anti-inflation policy his government had followed in its first two years, adopting the strategy of monetary and fiscal expansion combined with wage and price controls that, a year earlier, Richard Nixon had implemented to win re-election after his initial strategy of fiscal and monetary restraint produced disappointing results. As had Nixon, Heath initially succeeded in promoting an economic expansion, but the policy soon ran aground, because, with inflationary pressures rekindled by monetary expansion, labor unions, refusing to accept the limits Heath wanted to impose on wage increases, called strikes. The most damaging strike was by the coal miners, which led to a curtailment of electricity production that forced the government to impose a three-day work week to conserve electricity.

Meanwhile, the Labour opposition gradually coalesced around demand for a referendum on entry into the Common Market proposed by the left-wing Labour MP Tony Benn. While continuing to support entry into the Common Market, Harold Wilson pledged that if returned to power, a new Labour government would renegotiate the terms of Britain’s entry, and put the renegotiated terms to a vote of the British public, a pledge that caused the pro-European deputy leader of the Labour Party, Roy Jenkins, to resign his position, eventually leaving the Labour Party with a handful of other pro-European Labourites to start a new Social Democratic Party (which subsequently merged with the Liberal Party).

Locked in a confrontation with striking coal miners over their strike for wage increases above the statutory limits of the Government’s incomes policy, Heath, in the winter of 1974, called a general election to secure a mandate for enforcing the statutory limits on wage increases for the miners, framing the election as a contest between a popularly elected government and a narrow special interest group over who would govern the nation. Almost alone among Conservatives, Powell had spoken out consistently against Heath’s economic policies and especially against entry into Europe. When the election was called, Powell denounced the move as pretextual and unnecessary, an increase in miners’ wages being justified by the steep increase in energy prices precipitated by OPEC the previous October. More shockingly, Powell declared that he would not stand for re-election to Parliament, being unable to support the policies that the Conservative Party was committed to implement if returned to power. And then even more shockingly still, Powell, just four days before the election, implicitly endorsed Labour as the only party that would renegotiate the terms of Britain’s entry into the European Community, and submit the terms of entry to a vote of the British public.

Powell’s last-minute virtual endorsement of Labour may well have been critical to the outcome of the election. Although Conservatives won the most seats in the new Parliament, they fell short of a majority and could not reach an agreement with the Liberal Party to form a coalition government, allowing Harold Wilson to form a temporary minority government. A new election was called for the fall, and Labour gained a slim majority in Parliament, a second defeat in succession leading to Heath’s ouster from the leadership in February 1975 by Margaret Thatcher, an outcome that was undoubtedly deeply satisfying to Powell, especially as he had played a crucial role in Heath’s undoing. However, if his ultimate aim was to keep Britain out of the Common Market, his satisfaction was short-lived, because when the question of entry into the European Community was finally put to a vote, 67% of British voters cast their votes in favor of entry.

While Thatcher strongly opposed Heath’s economic policies, though as a minister in Heath’s government she had never spoken out against them, she did not criticize Heath’s position on the Common Market. Powell was returned to Parliament as a pro-Unionist member from Northern Ireland in the November 1974 election, but he was no longer a member of the Conservative Party and no longer had any influence in the party. So when Mrs. Thatcher became leader of the Conservative Party, the only politicians who wanted Britain to leave the Common Market were Enoch Powell, a lone voice representing pro-Unionists in Northern Ireland and the far left of the Labour Party. The far left would eventually gain control of the Labour Party after Mrs. Thatcher was elected Prime Minister, but a significant Euro-skeptic faction in the Conservative Party would not come into being for another decade.

But the point with which I want to end this post is simply that although in 1976 a large majority of the British public seemed to have acquiesced in British membership in the European Community, and opposition seemed to be confined to a substantial segment of the left-wing of the Labour Party and a single charismatic figure who seemed to be permanently estranged from the Conservative Party, the consensus favoring membership was largely accidental and was not based on any clear principle of integration into Europe or any clear economic advantage. Edward Heritath’s enthusiasm for entry into the European Community was almost as unique as Enoch Powell’s abhorrence of it. Most of the support for British entry into the European Community was purely contingent and opportunistic, a fact that de Gaulle had perceived in the 1960s when he twice vetoed Britain’s entry. Given Britain’s ambiguous relationship to Europe, her ambivalent feelings about belonging to Europe, and the unclear balance of economic advantages and disadvantages, Britain’s entry into the European Community lacked any strong basis either in principle or in economic advantage.

It is a twist of history that Britain would up in the European Community only because Edward Heath was elected Prime Minister in 1970, and his election in 1970 might not have occurred but for Enoch Powell’s 1968 speech opposing non-while immigration into Britain, which caused a sufficient swing to the Conservatives give them an unexpected majority and to make Heath the Prime Minister, thereby depriving Powell of the leadership of the party which had been his life’s ambition.

What’s Wrong with Econ 101?

Hendrickson responded recently to criticisms of Econ 101 made by Noah Smith and Mark Thoma. Mark Thoma thinks that Econ 101 has a conservative bias, presumably because Econ 101 teaches students that markets equilibrate supply and demand and allocate resources to their highest valued use and that sort of thing. If markets are so wonderful, then shouldn’t we keep hands off the market and let things take care of themselves? Noah Smith is especially upset that Econ 101, slighting the ambiguous evidence that minimum-wage laws actually do increase unemployment, is too focused on theory and pays too little attention to empirical techniques.

I sympathize with Josh defense of Econ 101, and I think he makes a good point that there is nothing in Econ 101 that quantifies the effect on unemployment of minimum-wage legislation, so that the disconnect between theory and evidence isn’t as stark as Noah suggests. Josh also emphasizes, properly, that whatever the effect of an increase in the minimum wage implied by economic theory, that implication by itself can’t tell us whether the minimum wage should be raised. An ought statement can’t be derived from an is statement. Philosophers are not as uniformly in agreement about the positive-normative distinction as they used to be, but I am old-fashioned enough to think that it’s still valid. If there is a conservative bias in Econ 101, the problem is not Econ 101; the problem is bad teaching.

Having said all that, however, I don’t think that Josh’s defense addresses the real problems with Econ 101. Noah Smith’s complaints about the implied opposition of Econ 101 to minimum-wage legislation and Mark Thoma’s about the conservative bias of Econ 101 are symptoms of a deeper problem with Econ 101, a problem inherent in the current state of economic theory, and unlikely to go away any time soon.

The deeper problem that I think underlies much of the criticism of Econ 101 is the fragility of its essential propositions. These propositions, what Paul Samuelson misguidedly called “meaningful theorems” are deducible from the basic postulates of utility maximization and wealth maximization by applying the method of comparative statics. Not only are the propositions based on questionable psychological assumptions, the comparative-statics method imposes further restrictive assumptions designed to isolate a single purely theoretical relationship. The assumptions aren’t just the kind of simplifications necessary for the theoretical models of any empirical science to be applicable to the real world, they subvert the powerful logic used to derive those implications. It’s not just that the assumptions may not be fully consistent with the conditions actually observed, but the implications of the model are themselves highly sensitive to those assumptions. The meaningful theorems themselves are very sensitive to the assumptions of the model.

The bread and butter of Econ 101 is the microeconomic theory of market adjustment in which price and quantity adjust to equilibrate what consumers demand with what suppliers produce. This is the partial-equilibrium analysis derived from Alfred Marshall, and gradually perfected in the 1920s and 1930s after Marshall’s death with the development of the theories of the firm, and perfect and imperfect competition. As I have pointed out before in a number of posts just as macroeconomics depends on microfoundations, microeconomics depends on macrofoundations (e.g. here and here). All partial-equilibrium analysis relies on the – usually implicit — assumption that all markets but the single market under analysis are in equilibrium. Without that assumption, it is logically impossible to derive any of Samuelson’s meaningful theorems, and the logical necessity of microeconomics is severely compromised.

The underlying idea is very simple. Samuelson’s meaningful theorems are meant to isolate the effect of a change in a single parameter on a particular endogenous variable in an economic system. The only way to isolate the effect of the parameter on the variable is to start from an equilibrium state in which the system is, as it were, at rest. A small (aka infinitesimal) change in the parameter induces an adjustment in the equilibrium, and a comparison of the small change in the variable of interest between the new equilibrium and the old equilibrium relative to the parameter change identifies the underlying relationship between the variable and the parameter, all else being held constant. If the analysis did not start from equilibrium, then the effect of the parameter change on the variable could not be isolated, because the variable would be changing for reasons having nothing to do with the parameter change, making it impossible to isolate the pure effect of the parameter change on the variable of interest.

Not only must the exercise start from an equilibrium state, the equilibrium must be at least locally stable, so that the posited small parameter change doesn’t cause the system to gravitate towards another equilibrium — the usual assumption of a unique equilibrium being an assumption to ensure tractability rather than a deduction from any plausible assumptions – or simply veer off on some explosive or indeterminate path.

Even aside from all these restrictive assumptions, the standard partial-equilibrium analysis is restricted to markets that can be assumed to be very small relative to the entire system. For small markets, it is safe to assume that the small changes in the single market under analysis will have sufficiently small effects on all the other markets in the economy that the induced effects on all the other markets from the change in the market of interest have a negligible feedback effect on the market of interest.

But the partial-equilibrium method surely breaks down when the market under analysis is a market that is large relative to the entire economy, like, shall we say, the market for labor. The feedback effects are simply too strong for the small-market assumptions underlying the partial-equilibrium analysis to be satisfied by the labor market. But even aside from the size issue, the essence of the partial-equilibrium method is the assumption that all markets other than the market under analysis are in equilibrium. But the very assumption that the labor market is not in equilibrium renders the partial-equilibrium assumption that all other markets are in equilibrium untenable. I would suggest that the proper way to think about what Keynes was trying, not necessarily successfully, to do in the General Theory when discussing nominal wage cuts as a way to reduce unemployment is to view that discussion as a critique of using the partial-equilibrium method to analyze a state of general unemployment, as opposed to a situation in which unemployment is confined to a particular occupation or a particular geographic area.

So the question naturally arises: If the logical basis of Econ 101 is as flimsy as I have been suggesting, should we stop teaching Econ 101? My answer is an emphatic, but qualified, no. Econ 101 is the distillation of almost a century and a half of rigorous thought about how to analyze human behavior. What we have come up with so far is very imperfect, but it is still the most effective tool we have for systematically thinking about human conduct and its consequences, especially its unintended consequences. But we should be more forthright about its limitations and the nature of the assumptions that underlie the analysis. We should also be more aware of the logical gaps between the theory – Samuelson’s meaningful theorems — and the applications of the theory.

In fact, many meaningful theorems are consistently corroborated by statistical tests, presumably because observations by and large occur when the economy operates in the neighborhood of a general equililbrium and feedback effect are small, so that the extraneous forces – other than those derived from theory – impinge on actual observations more or less randomly, and thus don’t significantly distort the predicted relationship. And undoubtedly there are also cases in which the random effects overwhelm the theoretically identified relationships, preventing the relationships from being identified statistically, at least when the number of observations is relatively small as is usually the case with economic data. But we should also acknowledge that the theoretically predicted relationships may simply not hold in the real world, because the extreme conditions required for the predicted partial-equilibrium relationships to hold – near-equilibrium conditions and the absence of feedback effects – may often not be satisfied.

Benjamin Cole Remembers Richard Nixon (of Blessed Memory?)

On Marcus Nunes’s Historinhas blog, Benjamin Cole has just written a guest post about Richard Nixon’s August 15, 1971 speech imposing a 90-day freeze on wages and prices, abolishing the last tenuous link between the dollar and gold and applying a 10% tariff on all imports into the US. Tinged with nostalgia for old times, the post actually refers to me in the title, perhaps because of my two recent posts on free trade and the gold standard. Well, rather than comment directly on Ben’s post, I will just refer to one of my first posts as a blogger marking the fortieth anniversary of Nixon’s announcement, which I recall with considerably less nostalgia than Ben, and explaining some of its, mostly disastrous, consequences.

Click here.

PS But Ben is right to point out that stock prices rose about 4 or 5 percent the day after the announcement, a reaction that, of course, was anything but rational.

 

 


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.

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