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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.

 

 

Keynes and Accounting Identities

In a post earlier this week, Michael Pettis was kind enough to refer to a passage from Ralph Hawtrey’s review of Keynes’s General Theory, which I had quoted in an earlier post, criticizing Keynes’s reliance on accounting identities to refute the neoclassical proposition that it is the rate of interest which equilibrates savings and investment. Here’s what Pettis wrote:

Keynes, who besides being one of the most intelligent people of the 20th century was also so ferociously logical (and these two qualities do not necessarily overlap) that he was almost certainly incapable of making a logical mistake or of forgetting accounting identities. Not everyone appreciated his logic. For example his also-brilliant contemporary (but perhaps less than absolutely logical), Ralph Hawtrey, was “sharply critical of Keynes’s tendency to argue from definitions rather than from causal relationships”, according to FTC economist David Glasner, whose gem of a blog, Uneasy Money, is dedicated to reviving interest in the work of Ralph Hawtrey. In a recent entry Glasner quotes Hawtrey:

[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment and saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary.

This is a very typical criticism of certain kinds of logical thinking in economics, and of course it misses the point because Keynes is not arguing from definition. It is certainly true that “identity so established cannot prove anything”, if by that we mean creating or supporting a hypothesis, but Keynes does not use identities to prove any creation. He uses them for at least two reasons. First, because accounting identities cannot be violated, any model or hypothesis whose logical corollaries or conclusions implicitly violate an accounting identity is automatically wrong, and the model can be safely ignored. Second, and much more usefully, even when accounting identities have not been explicitly violated, by identifying the relevant identities we can make explicit the sometimes very fuzzy assumptions that are implicit to the model an analyst is using, and focus the discussion, appropriately, on these assumptions.

I agree with Pettis that Keynes had an extraordinary mind, but even great minds are capable of making mistakes, and I don’t think Keynes was an exception. And on the specific topic of Keynes’s use of the accounting identity that expenditure must equal income and savings must equal investment, I think that the context of Keynes’s discussion of that identity makes it clear that Keynes was not simply invoking the identity to prevent some logical slipup, as Pettis suggests, but was using it to deny the neoclassical Fisherian theory of interest which says that the rate of interest represents the intertemporal rate of substitution between present and future goods in consumption and the rate of transformation between present and future goods in production. Or, in less rigorous terminology, the rate of interest reflects the marginal rate of time preference and the marginal rate of productivity of capital. In its place, Keynes wanted to substitute a pure monetary or liquidity-preference theory of the rate of interest.

Keynes tried to show that the neoclassical theory could not possibly be right, inasmuch as, according to the theory, the equilibrium rate of interest is the rate that equilibrates the supply of with the demand for loanable funds. Keynes argued that because investment and savings are identically equal, savings and investment could not determine the rate of interest. But Keynes then turned right around and said that actually the equality of savings and investment determines the level of income. Well, if savings and investment are identically equal, so that the rate of interest can’t be determined by equilibrating the market for loanable funds, it is equally impossible for savings and investment to determine the level of income.

Keynes was unable to distinguish the necessary accounting identity of savings and investment from the contingent equality of savings and investment as an equilibrium condition. For savings and investment to determine the level of income, there must be some alternative definition of savings and investment that allows them to be unequal except at equilibrium. But if there are alternative definitions of savings and investment that allow those magnitudes to be unequal out of equilibrium — and there must be such alternative definitions if the equality of savings and investment determines the level of income — there is no reason why the equality of savings and investment could not be an equilibrium condition for the rate of interest. So Keynes’s attempt to refute the neoclassical theory of interest failed. That was Hawtrey’s criticism of Keynes’s use of the savings-investment accounting identity.

Pettis goes on to cite Keynes’s criticism of the Versailles Treaty in The Economic Consequences of the Peace as another example of Keynes’s adroit use of accounting identities to expose fallacious thinking.

A case in point is The Economic Consequences of the Peace, the heart of whose argument rests on one of those accounting identities that are both obvious and easily ignored. When Keynes wrote the book, several members of the Entente – dominated by England, France, and the United States – were determined to force Germany to make reparations payments that were extraordinarily high relative to the economy’s productive capacity. They also demanded, especially France, conditions that would protect them from Germany’s export prowess (including the expropriation of coal mines, trains, rails, and capital equipment) while they rebuilt their shattered manufacturing capacity and infrastructure.

The argument Keynes made in objecting to these policies demands was based on a very simple accounting identity, namely that the balance of payments for any country must balance, i.e. it must always add to zero. The various demands made by France, Belgium, England and the other countries that had been ravaged by war were mutually contradictory when expressed in balance of payments terms, and if this wasn’t obvious to the former belligerents, it should be once they were reminded of the identity that required outflows to be perfectly matched by inflows.

In principle, I have no problem with such a use of accounting identities. There’s nothing wrong with pointing out the logical inconsistency between wanting Germany to pay reparations and being unwilling to accept payment in anything but gold. Using an accounting identity in this way is akin to using the law of conservation of energy to point out that perpetual motion is impossible. However, essentially the same argument could be made using an equilibrium condition for the balance of payments instead of an identity. The difference is that the accounting identity tells you nothing about how the system evolves over time. For that you need a behavioral theory that explains how the system adjusts when the equilibrium conditions are not satisfied. Accounting identities and conservation laws don’t give you any information about how the system adjusts when it is out of equilibrium. So as Pettis goes on to elaborate on Keynes’s analysis of the reparations issue, one or more behavioral theories must be tacitly called upon to explain how the international system would adjust to a balance-of-payments disequilibrium.

If Germany had to make substantial reparation payments, Keynes explained, Germany’s capital account would tend towards a massive deficit. The accounting identity made clear that there were only three possible ways that together could resolve the capital account imbalance. First, Germany could draw down against its gold supply, liquidate its foreign assets, and sell domestic assets to foreigners, including art, real estate, and factories. The problem here was that Germany simply did not have anywhere near enough gold or transferable assets left after it had paid for the war, and it was hard to imagine any sustainable way of liquidating real estate. This option was always a non-starter.

Second, Germany could run massive current account surpluses to match the reparations payments. The obvious problem here, of course, was that this was unacceptable to the belligerents, especially France, because it meant that German manufacturing would displace their own, both at home and among their export clients. Finally, Germany could borrow every year an amount equal to its annual capital and current account deficits. For a few years during the heyday of the 1920s bubble, Germany was able to do just this, borrowing more than half of its reparation payments from the US markets, but much of this borrowing occurred because the great hyperinflation of the early 1920s had wiped out the country’s debt burden. But as German debt grew once again after the hyperinflation, so did the reluctance to continue to fund reparations payments. It should have been obvious anyway that American banks would never accept funding the full amount of the reparations bill.

What the Entente wanted, in other words, required an unrealistic resolution of the need to balance inflows and outflows. Keynes resorted to accounting identities not to generate a model of reparations, but rather to show that the existing model implicit in the negotiations was contradictory. The identity should have made it clear that because of assumptions about what Germany could and couldn’t do, the global economy in the 1920s was being built around a set of imbalances whose smooth resolution required a set of circumstances that were either logically inconsistent or unsustainable. For that reason they would necessarily be resolved in a very disruptive way, one that required out of arithmetical necessity a substantial number of sovereign defaults. Of course this is what happened.

Actually, if it had not been for the insane Bank of France and the misguided attempt by the Fed to burst the supposed stock-market bubble, the international system could have continued for a long time, perhaps indefinitely, with US banks lending enough to Germany to prevent default until rapid economic growth in the US and western Europe enabled the Germans to service their debt and persuaded the French to allow the Germans to do so via an export surplus. Instead, the insane Bank of France, with the unwitting cooperation of the clueless (following Benjamin Strong’s untimely demise) Federal Reserve precipitated a worldwide deflation that triggered that debt-deflationary downward spiral that we call the Great Depression.

The Pot Calls the Kettle Black

I had not planned to post anything today, but after coming across an article (“What the Fed Really Wants Is to Reduce Real Wages”) by Alex Pollock of AEI on Real Clear Markets this morning, I decided that I could not pass up this opportunity to expose a) a basic, but common and well-entrenched, error in macroeconomic reasoning, and b) the disturbingly hypocritical and deceptive argument in the service of which the faulty reasoning was deployed.

I start by quoting from Pollock’s article.

To achieve economic growth over time, prices have to change in order to adjust resource allocation to changing circumstances. This includes the price of work, or wages. Everybody does or should know this, and the Federal Reserve definitely knows it.

The classic argument for why central banks should create inflation as needed is that this causes real wages to fall, thus allowing the necessary downward adjustment, even while nominal wages don’t fall. Specifically, the argument goes like this: For employment and growth, wages sometimes have to adjust downward; people and politicians don’t like to have nominal wages fall– they are “sticky.” People are subject to Money Illusion and they don’t think in inflation-adjusted terms. Therefore create inflation to make real wages fall.

In an instructive meeting of the Federal Reserve Open Market Committee in July, 1996, the transcript of which has been released, the Fed took up the issue of “long-term inflation goals.” Promoting the cause of what ultimately became the Fed’s goal of 2% inflation forever, then-Fed Governor Janet Yellen made exactly the classic argument. “To my mind,” she said, “the most important argument for some low inflation rate is…that a little inflation lowers unemployment by facilitating adjustments in relative pay”-in other words, by lowering real wages. This reflects “a world where individuals deeply dislike nominal pay cuts,” she continued. “I think we are dealing here with a very deep-rooted property of the human psyche”-that is, Money Illusion.

In sum, since “workers resist and firms are unwilling to impose nominal pay cuts,” the Fed has to be able to reduce real wages instead by inflation.

But somehow the Fed never mentions that this is what it does. It apparently considers it a secret too deep for voters and members of Congress to understand. Perhaps it would be bad PR?

This summary of why some low rate of inflation may promote labor-0market flexibility is not far from the truth, but it does require some disambiguation. The first distinction to make is that while Janet Yellen was talking about adjustments in relative pay, presumably adjustments in wages both across different occupations and also across different geographic areas — a necessity even if the overall level of real wages is stable — Pollock simply talks about reducing real wages in general.

But there is a second, more subtle distinction to make here as well, and that distinction makes a big difference in how we understand what the Fed is trying to do. Suppose a reduction in real wages in general, or in the relative wages of some workers is necessary for labor-market equilibrium. To suggest that only reason to use inflation to reduce the need for nominal wage cuts is a belief in “Money Illusion” is deeply misleading. The concept of “Money Illusion” is only meaningful when applied to equilibrium states of the economy. Thus the absence of “Money Illusion” means that the equilibrium of the economy (under the assumption that the economy has a unique equilibrium — itself, a very questionable assumption, but let’s not get diverted from this discussion to an even messier and more complicated one) is the same regardless of how nominal prices are scaled up or down. It is entirely possible to accept that proposition (which seems to follow from fairly basic rationality assumptions) without also accepting that it is irrelevant whether real-wage reductions in response to changing circumstances are brought about by inflation or by nominal-wage cuts.

Since any discussion of changes in relative wages presumes that a transition from one equilibrium state to another equilibrium state is occurring, the absence of Money Illusion, being a property of equilibrium,  can’t tell us anything about whether the transition from one equilibrium state to another is more easily accomplished by way of nominal-wage cuts or by way of inflation. If, as a wide range of historical evidence suggests, real-wage reductions are more easily effected by way of inflation than by way of nominal-wage cuts, it is plausible to assume that minimizing nominal-wage cuts will ease the transition from the previous equilibrium to the new one.

Why is that? Here’s one way to think about it. The resistance to nominal-wage cuts implies that more workers will be unemployed initially if nominal wages are cut than if there is an inflationary strategy. It’s true that the unemployment is transitory (in some sense), but the transitory unemployment will be with reduced demand for other products, so the effect of unemployment of some workers is felt by other sectors adn other workers. This implication is not simply the multiplier effect of Keynesian economics, it is also a direct implication of the widely misunderstood Say’s Law, which says that supply creates its own demand. So if workers are more likely to become unemployed in the transition to an equilibrium with reduced real wages if the real-wage reduction is accomplished via a cut in nominal wages than if accomplished by inflation, then inflation reduces the reduction in demand associated with resistance to nominal-wage cuts. The point is simply that we have to consider not just the final destination, but also the route by which we get there. Sometimes the route to a destination may be so difficult and so dangerous, that we are better off not taking it and looking for an alternate route. Nominal wage cuts are very often a bad route by which to get to a new equilibrium.

That takes care of the error in macroeconomic reasoning, but let’s follow Pollock a bit further to get to the hypocrisy and deception.

This classic argument for inflation is of course a very old one. As Ludwig von Mises discussed clearly in 1949, the first reason for “the engineering of inflation” is: “To preserve the height of nominal wage rates…while real wage rates should rather sink.” But, he added pointedly, “neither the governments nor the literary champions of their policy were frank enough to admit openly that one of the main purposes of devaluation was a reduction in the height of real wage rates.” The current Fed is not frank enough to admit this fact either. Indeed, said von Mises, “they were anxious not to mention” this. So is the current Fed.

Nonetheless, the Fed feels it can pontificate on “inequality” and how real middle class incomes are not rising. Sure enough, with nominal wages going up 2% a year, if the Fed achieves its wish for 2% inflation, then indeed real wages will be flat. But Federal Reserve discussions of why they are flat at the very least can be described as disingenuous.

Actually, it is Pollock who is being disingenuous here. The Fed does not have a policy on real wages. Real wages are determined for the most part in free and competitive labor markets. In free and competitive labor markets, the equilibrium real wage is determined independently of the rate of inflation. Remember, there’s no Money Illusion. Minimizing nominal-wage cuts is not a policy aimed at altering equilibrium real wages, which are whatever market forces dictate, but of minimizing the costs associated with the adjustments in real wages in response to changing economic conditions.

I know that it’s always fun to quote Ludwig von Mises on inflation, but if you are going to quote Mises about how inflation is just a scheme designed to reduce real wages, you ought to at least be frank enough to acknowledge that what Mises was advocating was cutting nominal wages instead.

And it is worth recalling that even Mises recognized that nominal wages could not be reduced without limit to achieve equilibrium. In fact, Mises agreed with Keynes that it was a mistake for England in 1925 to restore sterling convertibility into gold at the prewar parity, because doing so required further painful deflation and nominal wage cuts. In other words, even Mises could understand that the path toward equilibrium mattered. Did that mean that Mises was guilty of believing in Money Illusion? Obviously not. And if the rate of deflation can matter to employment in the transition from one equilibrium to another, as Mises obviously conceded, why is it inconceivable that the rate of inflation might also matter?

So Pollock is trying to have his cake and eat it. He condemns the Fed for using inflation as a tool by which to reduce real wages. Actually, that is not what the Fed is doing, but, let us suppose that that’s what the Fed is doing, what alternative does Pollock have in mind? He won’t say. In other words, he’s the pot.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. 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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