Posts Tagged 'Larry Summers'

Jason Furman Hyperventilates about Wages and Inflation

Published March 20, 2023 inflation , Jason , Jason Furman , transitory inflation 8 Comments
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Jason Furman has had an admirable career as an economist and policy adviser. He was on the staff of the Council of Economic Advisors in the Clinton administrations, was Assistant Director of the National Economic Policy under Larry Summers in Obama’s first term served as Chairman of the CEA in his second. I am friendly with a really smart economist who worked under Furman for a couple of years at the CEA, and he spoke glowingly about that experience in general and about Furman in particular, both as an economist and as a person. So I’m not anxious to write a critical blogpost about Furman. But a blogger’s gotta do what a blogger’s gotta do.

Following the lead of his former boss Larry Summers, Furman has, for over a year, been an outspoken anti-inflation hawk, calling for aggressive tightening by the Fed to prevent an inflationary wage-price spiral from returning us to the bad old days of the 1970s and its ugly aftermath — the 1981-82 Volcker recession. So, after the January core inflation reports showed an uptick in core inflation in the second half of 2022, Furman responded with an overwrought op-ed (“To Fight Inflation, Fed Tightening Should Go Faster and Further”) in the Wall Street Journal.

The Federal Reserve has said repeatedly that it responds to data and doesn’t set interest rates on autopilot. The data have changed dramatically. The Fed should prove it means what it says by shifting from a 25-basis-point increase at its next meeting to a 50-point increase. It should also shift expectations toward a terminal rate of around 6%.

The Fed should never react too much to any single data point, but when the annualized three-month core inflation rate jumps from 2.9% to 4.7%, the central bank must take notice. When that happens after strong jobs data and faster wage growth, the Fed should plan on action. The expectation that inflation would melt away on its own was always unjustified, but the latest economic data have been especially unkind to team transitory.

Let me first observe that Furman seems to overstate the size of the January increase in core inflation. Core inflation, which excludes volatile food and energy prices from the two broader inflation indexes: the personal consumption expenditures index (PCEI) computed by the Bureau of Economic Analysis of the Commerce Department and the Consumer Price Index (CPI) computed by the Bureau of Labor Statistics of the Labor Department. The two charts below show the 3-month and the 6-month moving averages of the core PCEI and the core CPI. Neither of the 3-month moving averages show a January increase as large as that asserted by Furman.

Yet, Furman is correct that the January increase in core inflation was significant, and also correct to observe that the Fed shouldn’t overreact to a single data point. Unfortunately, he immediately reversed himself by demanding that the Fed respond to the January increase by quickly and significantly tightening policy, because core inflation, notwithstanding the assurances of “team transitory”, has not subsided much on its own.

I can’t speak on behalf of team transitory, but, as far as I know, no one ever suggested that inflation would fall back to the Fed’s 2% target on its own. Everyone acknowledged that increased inflation last year was, at least partly, but not entirely, caused by macroeconomic policies that, during the pandemic and its aftermath, first supported, and then increased, aggregate demand.

But, as I’ve argued in many posts in the past year and a half (here, here, here, here, here, here, here, and here), increasing aggregate demand to avoid a cumulative collapse in output and income was well-advised under unprecedented Covid conditions. Because much of the income supplements provided in 2020-21 were held in cash, or used to repay debts, owing to the diminished availability of spending outlets during the pandemic, rather than spent, increased aggregate demand led not to an immediate, but a delayed, increase in inflation once the economy gradually recovered from the pandemic. Without the macroeconomic stimulus of 2020-21 that became a source of inflationary pressure in late 2021 and 2022, the downturn in 2020 would have been even deeper and lasted longer.

But aside from the underlying macroeconomic forces causing inflation to start rising in 2021, a variety of supply-chain slowdowns and interruptions appeared, just as a Russian invasion of Ukraine was becoming increasing likely, driving up oil and other energy prices well before the actual invasion on February 24, 2022. The transitory component of inflation corresponds to both the delayed spending of cash accumulated from income supplements and other spending undertaken in the pandemic, and to the supply-side problems caused by, or related to both the pandemic and Putin’s war. By the middle of 2022, both of these transitory causes of inflation were subsiding.

That leaves us with a core rate of inflation hovering in the 4-5% range, a somewhat higher rate than I would like, or recommend, as a policy target. Does that mean that further tightening to reduce overall inflation to the 2% target is required? I agree with Furman and others who think it is required, but I disagree that the tightening should be either drastic or immediate, and I find Furman’s rationale for rapid and substantial further tightening deeply misguided.

What makes the current inflation particularly troubling is that all the hoped-for saviors have come and gone without reducing underlying inflation very much. Inflation was supposed to go away after base effects receded, when the economy got over the Delta and Omicron surges, when the ports were unclogged, when timber prices fell, when the fiscal stimulus wore off, when microchips were available, when energy prices came back down again after the Russian invasion. All of that has happened, and yet the underlying inflation rate remains above 4.5% on just about every time horizon and every measure.

What makes Furman’s inflation anxiety particularly annoying is that, while he and others had been warning that, unless the Fed sharply tightened, inflation would accelerate — possibly to double-digit levels — he continues to hyperventilate about runaway inflation, even as headline inflation over the past year has dropped substantially, and core inflation has also fallen, albeit by much less than headline inflation. Having learned nothing from his earlier exaggerated warnings about inflation, Furman is now using a one-month uptick in inflation as a pretext for continued inflation alarmism and tight-money advocacy.

The Fed’s tightening over the past year prevented core inflation from accelerating even as the transitory factors that had raised inflation to the highest levels in 50 years gradually dissipated, causing the sharp decline in the volatile non-core items in the CPI and PCE indexes. The argument between team transitory and team non-transitory was never an all or nothing dispute, but a matter of emphasis.

Many of those opposed to rapid and severe tightening understood that responding too aggressively to temporarily high inflation carries risks of its own, potentially plunging the economy into a recession because of an exaggerated estimate of the inflationary threat, an underrated risk that is one of the 1970s lessons that many, including Furman and Summers, seem to overlook, but a risk of which the events of the past two weeks have provided an unwelcome and frightening reminder.

The modest decline in core inflation over the past year was accompanied by a gradual decline in the rate of NGDP growth since the first quarter of 2022 from over 11% to about 7%. For inflation to decline further toward the 2% target, a further modest — and ideally gradual — decline in NGDP growth to about 5% will be necessary.

Whether the decline in NGDP growth is possible without further monetary tightening is unclear, but it’s unlikely that the effects of monetary tightening over the past year have yet been fully absorbed by the economy, so it seems reasonable to postpone any decision about monetary tightening until at least the preliminary Q1 GDP report is released in about six weeks. And given the heightened risk to the banking and financial system, any increase in rates would be foolhardy.

If total domestic spending is increasing at a rate faster than 7%, further increases in interest rates might be warranted, but the current inversion of the yield curve suggests that an increase in short-term rates is presumptively inadvisable (see my posts on yield-curve inversion here and here). If long-term rates are below short-term rates, notwithstanding the incremental risk associated with holding securities of longer duration, the relatively low yield of longer-term securities suggests either that the liquidity premium on money is abnormally high (a symptom of financial distress), or that there is an expectation of sharply declining yields in the future. In the former case, a lack of liquidity and increasing default risk drive up short-term rates; in the latter, the longer-term outlook suggests that the inflation rate, or the profit rate, or both, will decline. So the watchword about policy changes should be: caution.

After that warmup, Furman, in diagnosing “underlying inflation, goes from being annoying to misguided.

Fundamentally, much of the economy’s underlying inflation had nothing to do with base effects or microchips or timber prices.

Correct! But let’s say that the underlying inflation rate really is, as Furman suggests, 5%. That would be 3% above the target rate. Not trivial, but hardly enough to impose the draconian tightening that Furman is recommending.

Furman continues with, what seems to me, a confused and confusing rationale for monetary tightening.

[Underlying inflation is] a product of extremely tight labor markets leading to rapid wage gains that passed [sic] through as higher prices. These higher prices have also led to faster wage gains. Some call it a “wage-price spiral,” but a better term is “wage-price persistence,” because inflation stays high even after the demand surge goes away.

This passage is beset by confusions, explicit or implied, that require unpacking. Having started with a correct observation that the economy’s “underlying inflation had nothing to do” with increases in any particular price or set of prices, Furman contradicts himself, attributing inflation to “rapid wage gains” that got passed through “as higher prices,” which, in turn, led to “faster wage gains.” That this ancient fallacy about the cause of inflation would be repeated by a former CEA chair, now a professor of economic policy at the Kennedy School at Harvard, is, well, dispiriting.

What’s the fallacy? An increase in one price – presumably, including the wage paid to labor — can never explain an increase in prices in general. To suggest otherwise is to commit the “fallacy of composition,” or something closes to it. (See “Fallacy of Composition”) An increase in wages relative to other prices could just as well be associated by wages remaining constant and all other prices falling; there is no logical necessity for wage increases to entail increases in other prices.

Of course, Furman might not be asserting a logical connection between wage increases and price increases. He might just be making an empirical observation that it was rising wages that initiated a series of price increases and an unending process of reciprocal wage and price increases. But even if wage increases did induce subsequent increases in other prices, that observation can’t account for an inflationary process in which wages and prices keep rising endlessly.

To account for such a continuing process, an explanation of why the process doesn’t eventually reach an endpoint is needed, but missing. There must be something that enables the inflationary process to conintue. That additional factor is, of course, the monetary or macroeconomic environment that determines aggregate demand and aggregate spending. Furman obviously believes that the process can be halted by monetary or macroeconomic policy measures, but, focused solely on wages, he ignores the role of policy in initiating and maintaining the process.

Other, related, confusions emerge in Furman’s next paragraph.

Wage growth is currently running at an annual rate of about 5%. Sustaining such wage growth with 2% inflation would require a large increase in productivity growth or continually falling profit margins. I’d root for either outcome, but I wouldn’t bet on them. Falling wage growth could bring down inflation, but in an economy with nearly two job openings for every person looking for work, don’t expect it to happen. Instead, the most probable outcome is that if the unemployment rate doesn’t rise, wages will continue to grow at that pace, which historically is associated with about 4% inflation.

In a previously quoted passage, Furman asserted that wage increases caused underlying inflation. But that was not what actually happened in the current episode. Since January 2021, just before the current inflation started, prices started rising before wages, and until the last six months or so prices have been rising faster than wages, causing real wages (i.e. adjusted for the purchasing power) to fall.

It’s one thing to say that wage increases cause the prices of things made by workers to increase; it’s quite another to say that wage increases cause the price of the things made by workers to increase faster than wages increase. By blaming current inflation on the current increase in wages, Furman is, in effect, calling for permanent real-wage cuts. Since wage increases cause “inflation persistence,” Furman proposes a restrictive monetary policy to reduce the overall demand for labor and the rate of increase in nominal and real wages.

Real wages (adjusted for the CPI) were barely higher in Q4 2022 than in Q4 2019 even though real GDP in Q4 2022 was 5.1% higher than in Q4 2019 and per-capita real GDP was 4.1% higher in Q4 2022 than in Q4 2019. If inflation is (in my view mistakenly) attributed to a distributional struggle that labor is clearly losing, then it’s obvious that it’s not wages that are to blame for inflation.

Furman makes another astonishing claim in the next paragraph.

Monetary policy operates with long and variable lags. Given that most of the tightening in financial conditions was already in place 10 months ago and, if anything, the real economy and demand have strengthened in recent months, it would be foolish to sit and wait for the medicine to work.

How long and variable the lags associated with monetary policy really are is a matter of some uncertainty. What is not uncertain, in Furman’s view, is that most of the tightening had occurred 10 months ago (May 2022). The FOMC began raising the Fed Funds target exactly a year ago in March 2022. How Furman can plausibly assert that most of the effect of the Fed’s tightening were in place 10 months ago is beyond me. The Table below shows that 10 months ago (May 2022) the effective Fed Funds rate (St. Louis Fed) was still only 0.77% and has since risen to 4.57% in Feburary.

Below is another table with the monthly average yield on constant maturity 10-year Treasuries, showing that the yield on 10-year Treasuries rose from 2.13% in March 2022 to 2.90% in May (reflecting expectations that further increases in the Fed Funds rate were likely). But the rate on 10-year Treasuries rose from slightly more than 2% to nearly 4% between March 2022 and October 2022, with rates fluctuating since October in a range between 3.5 and 4%.

So I can’t understand what Furman could was thinking when he asserted that most of the Fed’s tightening of financial conditions were already in place 10 months ago. The real economy has indeed strengthened, but that strengthening reflects the unusual economic circumstances in which both the real economy and monetary policy have been operating for the past three years: the pandemic, the partial shutdown, the monetary and fiscal stimulus, the supply-chain issues that initially obstructed and hobbled the return to full employment even as unemployment was falling to a record low rate of 3.5%.

Dramatic evidence that the effects of the tightening since January had not been fully absorbed by the economy was provided within days after Furman’s op-ed by the failure of SVB and Signature Bank and only days ago by the rescue of Credit Suisse. And there is no assurance that these are the last dominoes to fall in the banking system or that other effects attributable to the increase in rates will not emerge in the near future.

Furman also overlooks the permanent withdrawal of workers (mostly but exclusively babyboomers nearing retirement age) from the labor force during the pandemic. Despite a rapid decrease in unemployment (and increase in employment) since the summer of 2020, and total employment in February 2023 exceeded total employment in 2020 by only 1.9%. The labor-force participation rate has dropped from 63.3% in February 2020 to 62.5% in February 2023.

With fewer workers available as businesses were responding to increasing demand for their products, competition to hire new workers to replace those that left the labor force is hardly surprising. However, a largely transitory burst of inflation in the second half of 2021 and the first half of 2022 outpaced a perfectly normal increase in nominal wages, causing real wages to fall. But it would be shocking – and suspicious — if normally functioning market forces didn’t drive up nominal wages sufficiently to cause a real wages to recover given the increased tightness of labor markets after a significant negative labor-supply shock.

For Furman to suggest that a market adjustment to a labor-supply shock causing an excess demand for labor should be counteracted by tight monetary policy to reduce the derived demand for labor is extraordinary. There may be – and I believe that there are — good reasons for monetary to aim to bring down the growth of nominal spending from roughly 7% to about 5%. But those reasons have nothing to do with targeting either nominal or real wages.

In fact, lags are precisely why the Fed should do more now—considering it will take months for whatever the central bank does next to have a meaningful effect on inflation.

Furman seems to envision a process whereby wage increases are necessarily inflationary unless the Fed acts to suppress the demand for labor. That is not how inflation works. Inflation depends on aggregate spending and aggregate income, which is what monetary and macroeconomic policy can control. To subordinate monetary policy to some target rate of increase in wages is a distraction, and it is folly to think that, with real wages still below their level two years ago, it is the job of monetary policy to suppress wage increases.

Supply Shocks and the Summer of our Inflation Discontent

Published July 18, 2022 Uncategorized 5 Comments
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This post started out as a short Twitter thread discussing the role of supply shocks in our current burst of inflation. The thread was triggered by Skanda Aramanth’s tweet arguing that, within a traditional aggregate-demand/aggregate-supply framework, a negative supply shock would have an effect sufficiently inflationary to cause the rate of NGDP growth to rise even with an unchanged monetary policy if the aggregate-demand curve is highly inelastic.

Skanda received some pushback on his contention from those, e.g., George Selgin, who dismissed the assumption of an inelastic aggregate demand as an implausible explanation of recent experience.

Here are the tweets by Skanda and George.

Without weighing in on the plausibility of the inelastic aggregate demand curve assumption, not being very enamored of the aggregate demand/aggregate supply paradigm, which strikes me as a mishmash of inconsistent partial-equilibrium and general-equilibrium reasoning based on a static model with inflationary expectations uneasily attached, I offered the following alternative account of our recent inflationary experience.

There were two supply shocks. The first was the pandemic, in 2020-21. That was followed in late 2021 by the prelude to Putin’s war which sent oil prices up from $50/barrel in early 2021 to nearly $100/barrel by the end of 2021.

The first supply shock required income support for basic consumption during the pandemic resulting in a buildup of purchasing power in the form of cash balances or other liquid assets for which there was no immediate outlet during the pandemic.

The buildup of unused purchasing power implied that the end of the pandemic would involve a positive but transitory shock to aggregate demand when the economy (production and consumption patterns) returned to normal as the limitations imposed by the pandemic began to ease.

The alternative to allowing the positive but transitory shock to aggregate demand would have been to adopt a restrictive policy as the pandemic was easing, which made neither economic or political sense. The optimal policy was to accept temporary inflation during the recovery, rather than impose a deflationary policy to suppress transitory inflation.

The transitory inflation was exacerbated by various supply bottlenecks and shortages of workers and other productive resources, which were reflected the difficulties of ramping up production quickly after lengthy production shutdowns or curtailments during the height of the pandemic.

These transitory difficulties would have likely worked themselves out by the end of 2021 had it not been for the second supply shock associated with the months long buildup to Putin’s war which was anticipated for months before it actually started in February 2022,  causing a second increase in inflation just when the first burst of inflation in the second half of 2021 would have tapered off.

No doubt, it would have been better for the Fed to have started tightening earlier so keep the NGDP from increasing so rapidly at the end of 2021 and the start of 2022, but the scare talk about unanchoring inflation expectations has been overdone.

Financial markets clearly reflect expectations that the Fed is going to rein in aggregate demand so that the excess growth in NGDP in 2021 will have little long-term effect. Even with the continuing potential that Putin’s War will cause further supply disruptions with short-term inflationary effects, the current and likely future conditions seem far better than result than that would have produced by the Volcker 2.0 policy for which Larry Summers et al. are still pining.

On Liberalism, Political Correctness, and Illegal Immigration

Published August 8, 2016 Uncategorized 7 Comments
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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.

John Cochrane on the Failure of Macroeconomics

Published July 2, 2014 John Cochrane , macroeconomics , New Classicals , New Keynesians , Uncategorized 35 Comments
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The state of modern macroeconomics is not good; John Cochrane, professor of finance at the University of Chicago, senior fellow of the Hoover Institution, and adjunct scholar of the Cato Institute, writing in Thursday’s Wall Street Journal, thinks macroeconomics is a failure. Perhaps so, but he has trouble explaining why.

The problem that Cochrane is chiefly focused on is slow growth.

Output per capita fell almost 10 percentage points below trend in the 2008 recession. It has since grown at less than 1.5%, and lost more ground relative to trend. Cumulative losses are many trillions of dollars, and growing. And the latest GDP report disappoints again, declining in the first quarter.

Sclerotic growth trumps every other economic problem. Without strong growth, our children and grandchildren will not see the great rise in health and living standards that we enjoy relative to our parents and grandparents. Without growth, our government’s already questionable ability to pay for health care, retirement and its debt evaporate. Without growth, the lot of the unfortunate will not improve. Without growth, U.S. military strength and our influence abroad must fade.

Macroeconomists offer two possible explanations for slow growth: a) too little demand — correctable through monetary or fiscal stimulus — and b) structural rigidities and impediments to growth, for which stimulus is no remedy. Cochrane is not a fan of the demand explanation.

The “demand” side initially cited New Keynesian macroeconomic models. In this view, the economy requires a sharply negative real (after inflation) rate of interest. But inflation is only 2%, and the Federal Reserve cannot lower interest rates below zero. Thus the current negative 2% real rate is too high, inducing people to save too much and spend too little.

New Keynesian models have also produced attractively magical policy predictions. Government spending, even if financed by taxes, and even if completely wasted, raises GDP. Larry Summers and Berkeley’s Brad DeLong write of a multiplier so large that spending generates enough taxes to pay for itself. Paul Krugman writes that even the “broken windows fallacy ceases to be a fallacy,” because replacing windows “can stimulate spending and raise employment.”

If you look hard at New-Keynesian models, however, this diagnosis and these policy predictions are fragile. There are many ways to generate the models’ predictions for GDP, employment and inflation from their underlying assumptions about how people behave. Some predict outsize multipliers and revive the broken-window fallacy. Others generate normal policy predictions—small multipliers and costly broken windows. None produces our steady low-inflation slump as a “demand” failure.

Cochrane’s characterization of what’s wrong with New Keynesian models is remarkably superficial. Slow growth, according to the New Keynesian model, is caused by the real interest rate being insufficiently negative, with the nominal rate at zero and inflation at (less than) 2%. So what is the problem? True, the nominal rate can’t go below zero, but where is it written that the upper bound on inflation is (or must be) 2%? Cochrane doesn’t say. Not only doesn’t he say, he doesn’t even seem interested. It might be that something really terrible would happen if the rate of inflation rose about 2%, but if so, Cochrane or somebody needs to explain why terrible calamities did not befall us during all those comparatively glorious bygone years when the rate of inflation consistently exceeded 2% while real economic growth was at least a percentage point higher than it is now. Perhaps, like Fischer Black, Cochrane believes that the rate of inflation has nothing to do with monetary or fiscal policy. But that is certainly not the standard interpretation of the New Keynesian model that he is using as the archetype for modern demand-management macroeconomic theories. And if Cochrane does believe that the rate of inflation is not determined by either monetary policy or fiscal policy, he ought to come out and say so.

Cochrane thinks that persistent low inflation and low growth together pose a problem for New Keynesian theories. Indeed it does, but it doesn’t seem that a radical revision of New Keynesian theory would be required to cope with that state of affairs. Cochrane thinks otherwise.

These problems [i.e., a steady low-inflation slump, aka “secular stagnation”] are recognized, and now academics such as Brown University’s Gauti Eggertsson and Neil Mehrotra are busy tweaking the models to address them. Good. But models that someone might get to work in the future are not ready to drive trillions of dollars of public expenditure.

In other words, unless the economic model has already been worked out before a particular economic problem arises, no economic policy conclusions may be deduced from that economic model. May I call  this Cochrane’s rule?

Cochrane the proceeds to accuse those who look to traditional Keynesian ideas of rejecting science.

The reaction in policy circles to these problems is instead a full-on retreat, not just from the admirable rigor of New Keynesian modeling, but from the attempt to make economics scientific at all.

Messrs. DeLong and Summers and Johns Hopkins’s Laurence Ball capture this feeling well, writing in a recent paper that “the appropriate new thinking is largely old thinking: traditional Keynesian ideas of the 1930s to 1960s.” That is, from before the 1960s when Keynesian thinking was quantified, fed into computers and checked against data; and before the 1970s, when that check failed, and other economists built new and more coherent models. Paul Krugman likewise rails against “generations of economists” who are “viewing the world through a haze of equations.”

Well, maybe they’re right. Social sciences can go off the rails for 50 years. I think Keynesian economics did just that. But if economics is as ephemeral as philosophy or literature, then it cannot don the mantle of scientific expertise to demand trillions of public expenditure.

This is political rhetoric wrapped in a cloak of scientific objectivity. We don’t have the luxury of knowing in advance what the consequences of our actions will be. The United States has spent trillions of dollars on all kinds of stuff over the past dozen years or so. A lot of it has not worked out well at all. So it is altogether fitting and proper for us to be skeptical about whether we will get our money’s worth for whatever the government proposes to spend on our behalf. But Cochrane’s implicit demand that money only be spent if there is some sort of scientific certainty that the money will be well spent can never be met. However, as Larry Summers has pointed out, there are certainly many worthwhile infrastructure projects that could be undertaken, so the risk of committing the “broken windows fallacy” is small. With the government able to borrow at negative real interest rates, the present value of funding such projects is almost certainly positive. So one wonders what is the scientific basis for not funding those projects?

Cochrane compares macroeconomics to climate science:

The climate policy establishment also wants to spend trillions of dollars, and cites scientific literature, imperfect and contentious as that literature may be. Imagine how much less persuasive they would be if they instead denied published climate science since 1975 and bemoaned climate models’ “haze of equations”; if they told us to go back to the complex writings of a weather guru from the 1930s Dustbowl, as they interpret his writings. That’s the current argument for fiscal stimulus.

Cochrane writes as if there were some important scientific breakthrough made by modern macroeconomics — “the new and more coherent models,” either the New Keynesian version of New Classical macroeconomics or Real Business Cycle Theory — that rendered traditional Keynesian economics obsolete or outdated. I have never been a devote of Keynesian economics, but the fact is that modern macroeconomics has achieved its ascendancy in academic circles almost entirely by way of a misguided methodological preference for axiomatized intertemporal optimization models for which a unique equilibrium solution can be found by imposing the empirically risible assumption of rational expectations. These models, whether in their New Keynesian or Real Business Cycle versions, do not generate better empirical predictions than the old fashioned Keynesian models, and, as Noah Smith has usefully pointed out, these models have been consistently rejected by private forecasters in favor of the traditional Keynesian models. It is only the dominant clique of ivory-tower intellectuals that cultivate and nurture these models. The notion that such models are entitled to any special authority or scientific status is based on nothing but the exaggerated self-esteem that is characteristic of almost every intellectual clique, particularly dominant ones.

Having rejected inadequate demand as a cause of slow growth, Cochrane, relying on no model and no evidence, makes a pitch for uncertainty as the source of slow growth.

Where, instead, are the problems? John Taylor, Stanford’s Nick Bloom and Chicago Booth’s Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? Ed Prescott emphasizes large distorting taxes and intrusive regulations. The University of Chicago’s Casey Mulligan deconstructs the unintended disincentives of social programs. And so forth. These problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth.

Where, one wonders, is the science on which this sort of seat-of-the-pants speculation is based? Is there any evidence, for example, that the tax burden on businesses or individuals is greater now than it was let us say in 1983-85 when, under President Reagan, the economy, despite annual tax increases partially reversing the 1981 cuts enacted in Reagan’s first year, began recovering rapidly from the 1981-82 recession?

Thomas Piketty and Joseph Schumpeter (and Gerard Debreu)

Published May 28, 2014 capital , inequality , Larry Summers 25 Comments
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Everybody else seems to have an opinion about Thomas PIketty, so why not me? As if the last two months of Piketty-mania (reminiscent, to those of a certain age, of an earlier invasion of American shores, exactly 50 years ago, by four European rock-stars) were not enough, there has been a renewed flurry of interest this week about Piketty’s blockbuster book triggered by Chris Giles’s recent criticism in the Financial Times of Piketty’s use of income data, which mainly goes to show that, love him or hate him, people cannot get enough of Professor Piketty. Now I will admit upfront that I have not read Piketty’s book, and from my superficial perusal of the recent criticisms, they seem less problematic than the missteps of Reinhart and Rogoff in claiming that, beyond a critical 90% ratio of national debt to national income, the burden of national debt begins to significantly depress economic growth. But in any event, my comments in this post are directed at Piketty’s conceptual approach, not on his use of the data in his empirical work. In fact, I think that Larry Summers in his superficially laudatory, but substantively critical, review has already made most of the essential points about Piketty’s book. But I think that Summers left out a couple of important issues — issues touched upon usefully by George Cooper in a recent blog post about Piketty — which bear further emphasis, .

Just to set the stage for my comments, here is my understanding of the main conceptual point of Piketty’s book. Piketty believes that the essence of capitalism is that capital generates a return to the owners of capital that, on average over time, is equal to the rate of interest. Capital grows; it accumulates. And the rate of accumulation is equal to the rate of interest. However, the rate of interest is generally somewhat higher than the rate of growth of the economy. So if capital is accumulating at a rate of growth equal to, say, 5%, and the economy is growing at a rate of growth equal to only 3%, the share of income accruing to the owners of capital will grow over time. It is in this simple theoretical framework — the relationship between the rate of economic growth to the rate of interest — that Piketty believes he has found the explanation not only for the increase in inequality over the past few centuries of capitalist development, but for the especially rapid increase in inequality over the past 30 years.

While praising Piketty’s scholarship, empirical research and rhetorical prowess, Summers does not handle Piketty’s main thesis gently. Summers points out that, as accumulation proceeds, the incentive to engage in further accumulation tends to weaken, so the iron law of increasing inequality posited by Piketty is not nearly as inflexible as Piketty suggests. Now one could respond that, once accumulation reaches a certain threshold, the capacity to consume weakens as well, if only, as Gary Becker liked to remind us, because of the constraint that time imposes on consumption.

Perhaps so, but the return to capital is not the only, or even the most important, source of inequality. I would interpret Summers’ point to be the following: pure accumulation is unlikely to generate enough growth in wealth to outstrip the capacity to increase consumption. To generate an increase in wealth so large that consumption can’t keep up, there must be not just a return to the ownership of capital, there must be profit in the Knightian or Schumpeterian sense of a profit over and above the return on capital. Alternatively, there must be some extraordinary rent on a unique, irreproducible factor of production. Accumulation by itself, without the stimulus of entrepreneurial profit, reflecting the the application of new knowledge in the broadest sense of the term, cannot go on for very long. It is entrepreneurial profits and rents to unique factors of production (or awards of government monopolies or other privileges) not plain vanilla accumulation that account for the accumulation of extraordinary amounts of wealth. Moreover, it seems that philanthropy (especially conspicuous philanthropy) provides an excellent outlet for the dissipation of accumulated wealth and can easily be combined with quasi-consumption activities, like art patronage or political activism, as more conventional consumption outlets become exhausted.

Summers backs up his conceptual criticism with a powerful factual argument. Comparing the Forbes list of the 400 richest individuals in 1982 with the Forbes list for 2012 Summers observes:

When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members of the 1982 list would have qualified for the 2012 list if they had accumulated wealth at a real rate of even 4 percent a year. They did not, given pressures to spend, donate, or misinvest their wealth. In a similar vein, the data also indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.

But something else is also going on here, a misunderstanding, derived from a fundamental ambiguity, about what capital actually means. Capital can refer either to a durable physical asset or to a sum of money. When economists refer to capital as a factor of production, they are thinking of capital as a physical asset. But in most models, economists try to simplify the analysis by collapsing the diversity of the entire stock of heterogeneous capital assets into single homogeneous substance called “capital” and then measure it not in terms of its physical units (which, given heterogeneity, is strictly impossible) but in terms of its value. This creates all kinds of problems, leading to some mighty arguments among economists ever since the latter part of the nineteenth century when Carl Menger (the first Austrian economist) turned on his prize pupil Eugen von Bohm-Bawerk who wrote three dense volumes discussing the theory of capital and interest, and pronounced Bohm-Bawerk’s theory of capital “the greatest blunder in the history of economics.” I remember wanting to ask F. A. Hayek, who, trying to restate Bohm-Bawerk’s theory in a coherent form, wrote a volume about 75 years ago called The Pure Theory of Capital, which probably has been read from cover to cover by fewer than 100 living souls, and probably understood by fewer than 20 of those, what he made of Menger’s remark, but, to my eternal sorrow, I forgot to ask him that question the last time that I saw him.

At any rate, treating capital as a homogeneous substance that can be measured in terms of its value rather than in terms of physical units involves serious, perhaps intractable, problems. For certain purposes, it may be worthwhile to ignore those problems and work with a simplified model (a single output which can be consumed or used as a factor of production), but the magnitude of the simplification is rarely acknowledged. In his discussion, Piketty seems, as best as I could determine using obvious search terms on Amazon, unaware of the conceptual problems involved in speaking about capital as a homogeneous substance measured in terms of its value.

In the real world, capital is anything but homogeneous. It consists of an array of very specialized, often unique, physical embodiments. Once installed, physical capital is usually sunk, and its value is highly uncertain. In contrast to the imaginary model of a homogenous substance that just seems to grow at fixed natural rate, the real physical capital that is deployed in the process of producing goods and services is complex and ever-changing in its physical and economic characteristics, and the economic valuations associated with its various individual components are in perpetual flux. While the total value of all capital may be growing at a fairly steady rate over time, the values of the individual assets that constitute the total stock of capital fluctuate wildly, and few owners of physical capital have any guarantee that the value of their assets will appreciate at a steady rate over time.

Now one would have thought that an eminent scholar like Professor Piketty would, in the course of a 700-page book about capital, have had occasion to comment on enormous diversity and ever-changing composition of the stock of physical capital. These changes are driven by a competitive process in which entrepreneurs constantly introduce new products and new methods of producing products, a competitive process that enriches some owners of new capital, and, it turns out, impoverishes others — owners of old, suddenly obsolete, capital. It is a process that Joseph Schumpeter in his first great book, The Theory of Economic Development, memorably called “creative destruction.” But the term “creative destruction” or the title of Schumpeter’s book does not appear at all in Piketty’s book, and Schumpeter’s name appears only once, in connection not with the notion of creative destruction, but with his, possibly ironic, prediction in a later book Capitalism, Socialism and Democracy that socialism would eventually replace capitalism.

Thus, Piketty’s version of capitalist accumulation seems much too abstract and too far removed from the way in which great fortunes are amassed to provide real insight into the sources of increasing inequality. Insofar as such fortunes are associated with accumulation of capital, they are likely to be the result of the creation of new forms of capital associated with new products, or new production processes. The creation of new capital simultaneously destroys old forms of capital. New fortunes are amassed, and old ones dissipated. The model of steady accumulation that is at the heart of Piketty’s account of inexorably increasing inequality misses this essential feature of capitalism.

I don’t say that Schumpeter’s account of creative destruction means that increasing inequality is a trend that should be welcomed. There may well be arguments that capitalist development and creative destruction are socially inefficient. I have explained in previous posts (e.g., here, here, and here) why I think that a lot of financial-market activity is likely to be socially wasteful. Similar arguments might be made about other kinds of activities in non-financial markets where the private gain exceeds the social gain. Winner-take-all markets seem to be characterized by this divergence between private and social benefits and costs, apparently accounting for a growing share of economic activity, are an obvious source of inequality. But what I find most disturbing about the growth in inequality over the past 30 years is that great wealth has gained increased social status. That seems to me to be a very unfortunate change in public attitudes. I have no problem with people getting rich, even filthy rich. But don’t expect me to admire them because they are rich.

Finally, you may be wondering what all of this has to do with Gerard Debreu. Well, nothing really, but I couldn’t help noticing that Piketty refers in an endnote (p. 654) to “the work of Adam Smith, Friedrich Hayek, and Kenneth Arrow and  Claude Debreu” apparently forgetting that the name of his famous countryman, winner of the Nobel Memorial Prize for Economics in 1983, is not Claude, but Gerard, Debreu. Perhaps Piketty confused Debreu with another eminent Frenchman Claude Debussy, but I hope that in the next printing of his book, Piketty will correct this unfortunate error.

UPDATE (5/29 at 9:46 EDST): Thanks to Kevin Donoghue for checking with Arthur Goldhammer, who translated Piketty’s book from the original French. Goldhammer took responsibility for getting Debreu’s first name wrong in the English edition. In the French edition, only Debreu’s last name was mentioned.

The Internal Contradiction of Quantitative Easing

Published November 18, 2013 Federal Reserve , Fisher equation , Paul Krugman , real interest rates , Scott Sumner 22 Comments
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Last week I was struggling to cut and paste my 11-part series on Hawtrey’s Good and Bad Trade into the paper on that topic that I am scheduled to present next week at the Southern Economic Association meetings in Tampa Florida, completing the task just before coming down with a cold which has kept me from doing anything useful since last Thursday. But I was at least sufficiently aware of my surroundings to notice another flurry of interest in quantitative easing, presumably coinciding with Janet Yellen’s testimony at the hearings conducted by the Senate Banking Committee about her nomination to succeed Ben Bernanke as Chairman of Federal Reserve Board.

In my cursory reading of the latest discussions, I didn’t find a lot that has not already been said, so I will take that as an opportunity to restate some points that I have previously made on this blog. But before I do that, I can’t help observing (not for the first time either) that the two main arguments made by critics of QE do not exactly coexist harmoniously with each other. First, QE is ineffective; second it is dangerous. To be sure, the tension between these two claims about QE does not prove that both can’t be true, and certainly doesn’t prove that both are wrong. But the tension might at least have given a moment’s pause to those crying that Quantitative Easing, having failed for five years to accomplish anything besides enriching Wall Street and taking bread from the mouths of struggling retirees, is going to cause the sky to fall any minute.

Nor, come to think of it, does the faux populism of the attack on a rising stock market and of the crocodile tears for helpless retirees living off the interest on their CDs coexist harmoniously with the support by many of the same characters opposing QE (e.g., Freedomworks, CATO, the Heritage Foundation, and the Wall Street Journal editorial page) for privatizing social security via private investment accounts to be invested in the stock market, the argument being that the rate of return on investing in stocks has historically been greater than the rate of return on payments into the social security system. I am also waiting for an explanation of why abused pensioners unhappy with the returns on their CDs can’t cash in the CDs and buy dividend-paying-stocks? In which charter of the inalienable rights of Americans, I wonder, does one find it written that a perfectly secure real rate of interest of not less than 2% on any debt instrument issued by the US government shall always be guaranteed?

Now there is no denying that what is characterized as a massive program of asset purchases by the Federal Reserve System has failed to stimulate a recovery comparable in strength to almost every recovery since World War II. However, not even the opponents of QE are suggesting that the recovery has been weak as a direct result of QE — that would be a bridge too far even for the hard money caucus — only that whatever benefits may have been generated by QE are too paltry to justify its supposedly bad side-effects (present or future inflation, reduced real wages, asset bubbles, harm to savers, enabling of deficit-spending, among others). But to draw any conclusion about the effects of QE, you need some kind of a baseline of comparison. QE opponents therefore like to use previous US recoveries, without the benefit of QE, as their baseline.

But that is not the only baseline available for purposes of comparison. There is also the Eurozone, which has avoided QE and until recently kept interest rates higher than in the US, though to be sure not as high as US opponents of QE (and defenders of the natural rights of savers) would have liked. Compared to the Eurozone, where nominal GDP has barely risen since 2010, and real GDP and employment have shrunk, QE, which has been associated with nearly 4% annual growth in US nominal GDP and slightly more than 2% annual growth in US real GDP, has clearly outperformed the eurozone.

Now maybe you don’t like the Eurozone, as it includes all those dysfunctional debt-ridden southern European countries, as a baseline for comparison. OK, then let’s just do a straight, head-to-head matchup between the inflation-addicted US and solid, budget-balancing, inflation-hating Germany. Well that comparison shows (see the chart below) that since 2011 US real GDP has increased by about 5% while German real GDP has increased by less than 2%.

US_Germany_RGDP

So it does seem possible that, after all, QE and low interest rates may well have made things measurably better than they would have otherwise been. But don’t expect to opponents of QE to acknowledge that possibility.

Of course that still leaves the question on the table, why has this recovery been so weak? Well, Paul Krugman, channeling Larry Summers, offered a demographic hypothesis in his column Monday: that with declining population growth, there have been diminishing investment opportunities, which, together with an aging population, trying to save enough to support themselves in their old age, causes the supply of savings to outstrip the available investment opportunities, driving the real interest rate down to zero. As real interest rates fall, the ability of the economy to tolerate deflation — or even very low inflation — declines. That is a straightforward, and inescapable, implication of the Fisher equation (see my paper “The Fisher Effect Under Deflationary Expectations”).

So, if Summers and Krugman are right – and the trend of real interest rates for the past three decades is not inconsistent with their position – then we need to rethink revise upwards our estimates of what rate of inflation is too low. I will note parenthetically, that Samuel Brittan, who has been for decades just about the most sensible economic journalist in the world, needs to figure out that too little inflation may indeed be a bad thing.

But this brings me back to the puzzling question that causes so many people to assume that monetary policy is useless. Why have trillions of dollars of asset purchases not generated the inflation that other monetary expansions have generated? And if all those assets now on the Fed balance sheet haven’t generated inflation, what reason is there to think that the Fed could increase the rate of inflation if that is what is necessary to avoid chronic (secular) stagnation?

The answer, it seems to me is the following. If everyone believes that the Fed is committed to its inflation target — and not even the supposedly dovish Janet Yellen, bless her heart, has given the slightest indication that she favors raising the Fed’s inflation target, a target that, recent experience shows, the Fed is far more willing to undershoot than to overshoot – then Fed purchases of assets with currency are not going to stimulate additional private spending. Private spending, at or near the zero lower bound, are determined largely by expectations of future income and prices. The quantity of money in private hands, being almost costless to hold, is no longer a hot potato. So if there is no desire to reduce excess cash holdings, the only mechanism by which monetary policy can affect private spending is through expectations. But the Fed, having succeeded in anchoring inflation expectations at 2%, has succeeded in unilaterally disarming itself. So economic expansion is constrained by the combination of a zero real interest rate and expected inflation held at or below 2% by a political consensus that the Fed, even if it were inclined to, is effectively powerless to challenge.

Scott Sumner calls this monetary offset. I don’t think that we disagree much on the economic analysis, but it seems to me that he overestimates the amount of discretion that the Fed can actually exercise over monetary policy. Except at the margins, the Fed is completely boxed in by a political consensus it dares not question. FDR came into office in 1933, and was able to effect a revolution in monetary policy within his first month in office, thereby saving the country and Western Civilization. Perhaps Obama had an opportunity to do something similar early in his first term, but not any more. We are stuck at 2%, but it is no solution.

About Me

David Glasner
Washington, DC

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

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

Follow me on Twitter @david_glasner

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