LARS P. SYLL

The balanced budget paradox

The balanced budget paradox is probably one of the most devastating phenomena haunting our economies. The harder politicians — usually on the advise of establishment economists — try to achieve balanced budgets for the public sector, the less likely they are to succeed in their endeavour. And the more the citizens have to pay for the concomitant austerity policies these wrong-headed politicians and economists recommend as “the sole solution.”

One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. But this does not hold for national debt which is owed by the nation to citizens of the same nation. There is no external creditor. We owe it to ourselves.

A variant of the false analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances. Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be made to our children or grandchildren and to nobody else. Taking them altogether they will no more be impoverished by making the repayments than they will be enriched by receiving them.

Abba Lerner The Burden of the National Debt (1948)

Few issues in politics and economics are nowadays more discussed – and less understood – than public debt. Many raise their voices to urge for reducing the debt, but few explain why and in what way reducing the debt would be conducive to a better economy or a fairer society. And there are no limits to all the – especially macroeconomic –calamities and evils a large public debt is supposed to result in – unemployment, inflation, higher interest rates, lower productivity growth, increased burdens for subsequent generations, etc., etc.

People usually care a lot about public sector budget deficits and debts, and are as a rule worried and negative. Drawing analogies from their own household’s economy, debt is seen as a sign of an imminent risk of default and hence a source of reprobation. But although no one can doubt the political and economic significance of public debt, there’s however no unanimity whatsoever among economists as to whether debt matters, and if so, why and in what way. And even less – one doesn’t know what is the “optimal” size of public debt.

Through history public debts have gone up and down, often expanding in periods of war or large changes in basic infrastructure and technologies, and then going down in periods when things have settled down.

The pros and cons of public debt have been put forward for as long as the phenomenon itself has existed, but it has, notwithstanding that, not been possible to reach anything close to consensus on the issue — at least not in a long time-horizon perspective. One has as a rule not even been able to agree on whether public debt is a problem, and if — when it is or how to best tackle it. Some of the more prominent reasons for this non-consensus are the complexity of the issue, the mingling of vested interests, ideology, psychological fears, the uncertainty of calculating ad estimating inter-generational effects, etc., etc.

In classical economics — following in the footsteps of David Hume – especially Adam Smith, David Ricardo, and Jean-Baptiste Say put forward views on public debt that was more negative. The good budget was a balanced budget. If government borrowed money to finance its activities, it would only give birth to “crowding out” private enterprise and investments. The state was generally considered incapable if paying its debts, and the real burden would therefor essentially fall on the taxpayers that ultimately had to pay for the irresponsibility of government. The moral character of the argumentation was a salient feature — “either the nation must destroy public credit, or the public credit will destroy the nation” (Hume 1752)

Later on in the 20th century economists like John Maynard Keynes, Abba Lerner and Alvin Hansen would hold a more positive view on public debt. Public debt was normally nothing to fear, especially if it was financed within the country itself (but even foreign loans could be beneficient for the economy if invested in the right way). Some members of society would hold bonds and earn interest on them, while others would have to pay the taxes that ultimately paid the interest on the debt. But the debt was not considered a net burden for society as a whole, since the debt cancelled itself out between the two groups. If the state could issue bonds at a low interest rate, unemployment could be reduced without necessarily resulting in strong inflationary pressure. And the inter-generational burden was no real burden according to this group of economists, since — if used in a suitable way — the debt would, through its effects on investments and employment, actually be net winners. There could, of course, be unwanted negative distributional side effects, for the future generation, but that was mostly considered a minor problem since (Lerner 1948) “if our children or grandchildren repay some of the national debt these payments will be made to our children and grandchildren and to nobody else.”

Central to the Keynesian influenced view is the fundamental difference between private and public debt. Conflating the one with the other is an example of the atomistic fallacy, which is basically a variation on Keynes’ savings paradox. If an individual tries to save and cut down on debts, that may be fine and rational, but if everyone tries to do it, the result would be lower aggregate demand and increasing unemployment for the economy as a whole.

An individual always have to pay his debts. But a government can always pay back old debts with new, through the issue of new bonds. The state is not like an individual. Public debt is not like private debt. Government debt is essentially a debt to itself, its citizens. Interest paid on the debt is paid by the taxpayers on the one hand, but on the other hand, interest on the bonds that finance the debts goes to those who lend out the money.

Abba Lerner’s essay Functional Finance and the Federal Debt set out guiding principles for governments to adopt in their efforts to use economic – especially fiscal – policies in trying to maintain full employment and prosperity in economies struggling with chronic problems with maintaining a high enough aggregate demand.

Because of this inherent deficiency, modern states tended to have structural and long-lasting problems of maintaining full employment. According to Lerner’s Functional Finance principles, the private sector has a tendency not to generate enough demand on its own, and so the government has to take on the responsibility to make sure that full employment was attained. The main instrument in doing this is open market operations – especially selling and buying interest-bearing government bonds.

Although Lerner seems to have had the view that the ideas embedded in Functional Finance was in principle applicable in all kinds of economies, he also recognized the importance of the institutional arrangements in shaping the feasibility and practical implementation of it.

Functional Finance critically depends on nation states being able to tax its citizens, have a currency — and bonds — of its own. As has become transparently clear during the Great Recession, EMU has not been able to impose those structures, since as Hayek noted already back in 1939, “government by agreement is only possible provided that we do not require the government to act in fields other than those in which we can obtain true agreement.” The monetary institutional structure of EMU makes it highly unlikely – not to say impossible — that this will ever become a “system” in which Functional Finance is adapted.

To Functional Finance the choices made by governments to finance the public deficits — and concomitant debts — was important, since bond-based financing was considered more expansionary than using taxes also. According to Lerner, the purpose of public debt is to achieve a rate of interest that results in investments making full employment feasible. In the short run this could result in deficits, but he firmly maintained that there was no reason to assume that the application of Functional Finance to maintain full employment implied that the government had to always borrow money and increase the public debt. An application of Functional Finance would have a tendency to balance the budget in the long run since basically the guarantee of permanent full employment will make private investment much more attractive and a fortiori the greater private investment will diminish the need for deficit spending.

To both Keynes and Lerner it was evident that the state had the ability to promote full employment and a stable price level – and that it should use its powers to do so. If that meant that it had to take on a debt and (more or less temporarily) underbalance its budget – so let it be! Public debt is neither good nor bad. It is a means to achieving two over-arching macroeconomic goals – full employment and price stability. What is sacred is not to have a balanced budget or running down public debt per se, regardless of the effects on the macroeconomic goals. If “sound finance”, austerity and a balanced budgets means increased unemployment and destabilizing prices, they have to be abandoned.

Now against this reasoning, exponents of the thesis of Ricardian equivalence, have maintained that whether the public sector finances its expenditures through taxes or by issuing bonds is inconsequential, since bonds must sooner or later be repaid by raising taxes in the future.

Robert Barro (1974) attempted to give the proposition a firm theoretical foundation, arguing that the substitution of a budget deficit for current taxes has no impact on aggregate demand and so budget deficits and taxation have equivalent effects on the economy.

If the public sector runs extra spending through deficits, taxpayers will according to the hypothesis anticipate that they will have to pay higher taxes in future — and therefore increase their savings and reduce their current consumption to be able to do so, the consequence being that aggregate demand would not be different to what would happen if taxes were raised today.

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent, since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

The Ricardo-Barro hypothesis, with its view of public debt incurring a burden for future generations, is the dominant view among mainstream economists and politicians today. The rational people making up the actors in the model are assumed to know that today’s debts are tomorrow’s taxes. But — one of the main problems with this standard neoclassical theory is, however, that it doesn’t fit the facts.

From a more theoretical point of view, one may also strongly criticize the Ricardo-Barro model and its concomitant crowding out assumption, since perfect capital markets do not exist and repayments of public debt can take place far into the future and it’s dubious if we really care for generations 300 years from now.

At times when economic theories have been in favour of public debt one gets the feeling that the more or less explicit assumption is that public expenditures are useful and good for the economy, since they work as an important — and often necessary — injection to the economy, creating wealth and employment. At times when economic theories have been against public debt, the basic assumption seems to be that public expenditures are useless and only crowd out private initiatives and has no positive net effect on the economy.

Wolfgang Streeck argues in Buying Time: The Delayed Crisis of Democratic Capitalism (2014) for an interpretation of the more or less steady increase in public debt since the 1970s as a sign of a transformation of the tax state (Schumpeter) into a debt state. In his perspective public debt is both an indicator and a causal factor in the relationship between political and economic systems. The ultimate cause behind the increased public debt is the long run decline in economic growth, resulting in a doubling of the average public debt in OECD countries for the last 40 years. This has put strong pressures on modern capitalist states, and parallel to this, income inequality has increased in most countries. This is according to Streeck one manifestation of a neoliberal revolution – with its emphasis on supply side politics, austerity policies and financial deregulation — that has taken place and where democratic-redistributive intervention has become ineffectual.

Today there seems to be a rather widespread consensus of public debt being acceptable as long as it doesn’t increase too much and too fast. If the public debt-GDP ratio becomes higher than X % the likelihood of debt crisis and/or lower growth increases.

But in discussing within which margins public debt is feasible, the focus, however, is solely on the upper limit of indebtedness, and very few asks the question if maybe there is also a problem if public debt becomes too low.

The government’s ability to conduct an “optimal” public debt policy may be negatively affected if public debt becomes too small. To guarantee a well-functioning secondary market in bonds it is essential that the government has access to a functioning market. If turnover and liquidity in the secondary market becomes too small, increased volatility and uncertainty will in the long run lead to an increase in borrowing costs. Ultimately there’s even a risk that market makers would disappear, leaving bond market trading to be operated solely through brokered deals. As a kind of precautionary measure against this eventuality it may be argued – especially in times of financial turmoil and crises — that it is necessary to increase government borrowing and debt to ensure – in a longer run – good borrowing preparedness and a sustained (government) bond market.

The failure of successive administrations in most developed countries to embark on any vigorous policy aimed at bringing down unconscionably high levels of unemployment has been due in no small measure to a ‘viewing with alarm’ of the size of the national debts, often alleged to be already excessive, or at least threatening to become so, and  by ideologically urged striving toward ‘balanced’ government budgets without any consideration of whether such debts and deficits are or threaten to become excessive in terms of some determinable impact on the real general welfare. If they are examined in the light of their impact on welfare, however, they can usually be shown to be well below their optimum levels, let alone at levels that could have dire consequences.

To view government debts in terms of the ‘functional finance’ concept introduced by Abba Lerner, is to consider their role in the macroeconomic balance of the economy. In simple, bare bones terms, the function of government debts that is significant for the macroeconomic health of an economy is that they provide the assets into which individuals can put whatever accumulated savings they attempt to set aside in excess of what can be wisely invested in privately owned real assets. A debt that is smaller than this will cause the attempted excess savings, by being reflected in a reduced level of consumption outlays, to be lost in reduced real income and increased unemployment.

William Vickrey

Why testing axioms is necessary in economics

Of course the more immediate target of Davidson in his formulation of the argument in the early 1980s was not Samuelson, but Lucas and Sargent and their rational expectations hypothesis … This was indeed the period when new classical economics was riding at its highest point of prestige, with Lucas and Sargent and their rational expectations assumption apparently sweeping the boards of any sort of Keynesian theories. Curiously, they did not seem to care whether the assumption was actually true, because it was “an axiom,” something that is assumed and cannot be tested …

This matter of “testing axioms” is controversial. Davidson is right that Keynes was partly inspired by Einstein’s Theory of General Relativity that was based on a relaxation of the parallel axiom of Euclid. So, Davidson argued not unreasonably that he would also be inclined to wish to relax any ergodic axiom. However, of course, the rejection of the parallel postulate (or axiom) did come from empirical tests showing that it does not hold in space-time in general due to gravity curving it. So, the empirical testing of axioms is relevant, and the failure of the rational expectations axiom to hold empirically is certainly reasonable grounds for rejecting it.

J. Barkley Rosser Jr

On this Einstein and Keynes are of course absolutely right. Economics — in contradistinction to logic and mathematics — is an empirical science, and empirical testing of ‘axioms’ ought to be self-evidently relevant for such a discipline. For although the economist himself (implicitly) claims that his axiom is universally accepted as true and in now need of proof, that is in no way a justified reason for the rest of us to simpliciter accept the claim.

When applying deductivist thinking to economics, neoclassical economists usually set up “as if” models based on a set of tight axiomatic assumptions from which consistent and precise inferences are made. The beauty of this procedure is of course that if the axiomatic premises are true, the conclusions necessarily follow. The snag is that if the models are to be relevant, we also have to argue that their precision and rigour still holds when they are applied to real-world situations. They often don’t. When addressing real economies, the idealizations and abstractions necessary for the deductivist machinery to work simply don’t hold.

The logic of idealization is a marvellous tool in mathematics and axiomatic-deductivist systems, but a poor guide for real-world systems. As Hans Albert has it on the neoclassical style of thought:

Science progresses through the gradual elimination of errors from a large offering of rivalling ideas, the truth of which no one can know from the outset. The question of which of the many theoretical schemes will finally prove to be especially productive and will be maintained after empirical investigation cannot be decided a priori. Yet to be useful at all, it is necessary that they are initially formulated so as to be subject to the risk of being revealed as errors. Thus one cannot attempt to preserve them from failure at every price. A theory is scientifically relevant first of all because of its possible explanatory power, its performance, which is coupled with its informational content …

Clearly, it is possible to interpret the ‘presuppositions’ of a theoretical system … not as hypotheses, but simply as limitations to the area of application of the system in question. Since a relationship to reality is usually ensured by the language used in economic statements, in this case the impression is generated that a content-laden statement about reality is being made, although the system is fully immunized and thus without content. In my view that is often a source of self-deception in pure economic thought …

Most mainstream economic models are abstract, unrealistic and presenting mostly non-testable hypotheses. How then are they supposed to tell us anything about the world we live in?

Confronted with the massive empirical failures of their models and theories, mainstream economists often retreat into looking upon their models and theories as some kind of “conceptual exploration,” and give up any hopes/pretenses whatsoever of relating their theories and models to the real world. Instead of trying to bridge the gap between models and the world, one decides to look the other way.

To me this kind of scientific defeatism is equivalent to giving up on our search for understanding the world we live in. It can’t be enough to prove or deduce things in a model world. If theories and models do not directly or indirectly tell us anything of the world we live in – then why should we waste any of our precious time on them?

Are methodological discussions risky?

Most mainstream economists are reluctant to have a methodological discussion. They usually think it’s too ‘risky.’

Well, maybe it is. But on the other hand, if we’re not prepared to take that risk, economics can’t progress, as Tony Lawson forcefully argues in his Essays on the Nature and State of Modern Economics:

Twenty common myths and/or fallacies of modern economics

1. The widely observed crisis of the modern economics discipline turns on problems that originate at the level of economic theory and/or policy.

It does not. The basic problems mostly originate at the level of methodology, and in particular with the current emphasis on methods of mathematical modelling.The latter emphasis is an error given the lack of match of the methods in question to the conditions in which they are applied. So long as the critical focus remains only, or even mainly, at the level of substantive economic theory and/or policy matters, then no amount of alternative text books, popular monographs, introductory pocketbooks, journal or magazine articles … or whatever, are going to get at the nub of the problems and so have the wherewithal to help make economics a sufficiently relevant discipline. It is the methods and manner of their use that are the basic problem.

If scientific progress in economics – as Robert Lucas and other latter days followers of Milton Friedman seem to think – lies in our ability to tell ‘better and better stories’ one would of course expect economics journal being filled with articles supporting the stories with empirical evidence confirming the predictions. However, I would argue that the journals still show a striking and embarrassing paucity of empirical studies that (try to) substantiate these predictive claims. Equally amazing is how little one has to say about the relationship between the model and real world target systems. It is as though thinking explicit discussion, argumentation and justification on the subject isn’t considered required.

If the ultimate criteria of success of a deductivist system is to what extent it predicts and coheres with (parts of) reality, modern mainstream economics seems to be a hopeless misallocation of scientific resources. To focus scientific endeavours on proving things in models, is a gross misapprehension of what an economic theory ought to be about. Deductivist models and methods disconnected from reality are not relevant to predict, explain or understand real world economies.

No matter how precise and rigorous the analysis is, and no matter how hard one tries to cast the argument in modern mathematical form, they do not push economic science forwards one millimeter if they do not stand the acid test of relevance to the target. No matter how clear, precise, rigorous or certain the inferences delivered inside these models are, they do not per se say anything about real world economies.

Is there a EU housing bubble?

Low interest rates are criticized by some economists as these should encourage asset price bubbles. Houses are our most important asset. Are house prices in the EU at this moment increasing too fast?

Not yet in Southern Europe … However … Swedish prices are of the chart. Dutch prices are rapidly increasing (and continued to do so during the first six months of 2017). German prices have, by now, increased with a third (house ownership in Germany is less common than in many other countries but the increase means that there will, quite soon, be a push to sell houses to renters – who of course have to borrow from the big banks). Yes, there is a northern European bubble. And it is rapidly inflating: during the last six months (not in the graph) prices have continued to increase …

House prices show continued increases which are way higher than the increases of nominal income of households … Actions have to be taken: a gradual increase (with clear forward guidance) of land value taxes (the money raised has to be used to lower VAT on labor), a gradual decrease of Loan to Value ratio’s (with clear forward guidance) and a gradual banishment of tax deductions of interest paid (with clear forward guidance).

It won’t happen.

Merijn Knibbe

Yes indeed, house prices are increasing fast in EU. And more so in Sweden than in any other member state. Sweden’s house price boom started in mid-1990s, and looking at the development of real house prices during the last three decades there are reasons to be deeply worried. The indebtedness of the Swedish household sector has also risen to alarmingly high levels:

In its latest report on Sweden, The European Commission warns Sweden about rising house prices and spiralling household debts:

The government’s 22-point housing market plan addresses some underlying factors for housing shortage, including measures to increase the amount of available land for construction, reduce construction costs and shorten planning process lead times. However, some other structural inefficiencies, including weak competition in the construction sector, do not receive appropriate attention. The housing shortage is exacerbated by barriers hindering the efficient use of the existing housing stock. Sweden’s tightly regulated rental market creates lock-in and ‘insider/outsider’ effects, but no significant policy action has been taken to introduce more flexibility in setting rents. In the owner-occupancy market, relatively high capital gains taxes reduce homeowner mobility. A temporary reform of the deferral rules for capital gains taxes on property transaction was introduced, but this will probably have limited effect. Lack of available and affordable housing can also limit labour market mobility and the effective integration of migrants into the labour market, and contribute to intergenerational inequality.

Yours truly has been trying to argue with ‘very serious people’ that it’s really high time to ‘take away the punch bowl.’ Mostly I have felt like the voice of one calling in the desert.

Where do housing bubbles come from? There are of course many different explanations, but one of the more fundamental mechanisms at work is easy to explain with the following arbitrage argument:

Assume you have a sum of money (A) that you want to invest. You can put the money in a bank and receive a yearly interest (r) on the money. Disregarding — for the sake of simplicity — risks, asset depreciations and transaction costs that may possibly be present, rA should equal the income you would alternatively receive if instead you buy a house with a down-payment (A) and let it out during a year with a rent (h) plus changes in house price (dhp) — i. e.

rA = h + dhp

Dividing both sides of the equation with the house price (hp) we get

hp = h/[r(A/hp) – (dhp/hp)]

If you expect house prices (hp) to increase, house prices will increase. It’s this kind of self generating cumulative process à la Wicksell-Myrdal that is the core of the housing bubble. Unlike the usual commodities markets where demand curves usually point downwards, on asset markets they often point upwards, and therefore give rise to this kind of instability. And, the greater the leverage (the lower A/hp), the greater the increase in prices.

The Swedish housing market is living on borrowed time. It’s really high time to take away the punch bowl. What is especially worrying is that although the aggregate net asset position of the Swedish households is still on the solid side, an increasing proportion of those assets is illiquid. When the inevitable drop in house prices hits the banking sector and the rest of the economy, the consequences will be enormous.

It hurts when bubbles burst …

Economics as a religion

Contrary to the tenets of orthodox economists, contemporary research suggests that, rather than seeking always to maximise our personal gain, humans still remain reasonably altruistic and selfless. Nor is it clear that the endless accumulation of wealth always makes us happier. And when we do make decisions, especially those to do with matters of principle, we seem not to engage in the sort of rational “utility-maximizing” calculus that orthodox economic models take as a given. The truth is, in much of our daily life we don’t fit the model all that well.

For decades, neoliberal evangelists replied to such objections by saying it was incumbent on us all to adapt to the model, which was held to be immutable – one recalls Bill Clinton’s depiction of neoliberal globalisation, for instance, as a “force of nature”. And yet, in the wake of the 2008 financial crisis and the consequent recession, there has been a turn against globalisation across much of the west …

It would be tempting for anyone who belongs to the “expert” class, and to the priesthood of economics, to dismiss such behaviour as a clash between faith and facts, in which the facts are bound to win in the end. In truth, the clash was between two rival faiths – in effect, two distinct moral tales. So enamoured had the so-called experts become with their scientific authority that they blinded themselves to the fact that their own narrative of scientific progress was embedded in a moral tale. It happened to be a narrative that had a happy ending for those who told it, for it perpetuated the story of their own relatively comfortable position as the reward of life in a meritocratic society that blessed people for their skills and flexibility. That narrative made no room for the losers of this order, whose resentments were derided as being a reflection of their boorish and retrograde character – which is to say, their fundamental vice. The best this moral tale could offer everyone else was incremental adaptation to an order whose caste system had become calcified. For an audience yearning for a happy ending, this was bound to be a tale of woe.

The failure of this grand narrative is not, however, a reason for students of economics to dispense with narratives altogether. Narratives will remain an inescapable part of the human sciences for the simple reason that they are inescapable for humans. It’s funny that so few economists get this, because businesses do.

Yes indeed, one would think it self-evident that “the facts are bound to win in the end.” But still mainstream economists seem to be impressed by the ‘rigour’ they bring to macroeconomics by their totally unreal New-Classical-New-Keynesian DSGE models and their rational expectations and micrcofoundations!

It is difficult to see why.

Take the rational expectations assumption. Rational expectations in the mainstream economists’ world implies that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds, since an economy can hardly be conceived as being completely replicated over time. It is — to say the least — very difficult to see any similarity between these modelling assumptions and the expectations of real persons. In the world of the rational expectations hypothesis we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel. And that’s also the reason why allowing for cases where agents make ‘predictable errors’ in DSGE models doesn’t take us any closer to a relevant and realist depiction of actual economic decisions and behaviours. If we really want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make we have to replace the rational expectations hypothesis with more relevant and realistic assumptions concerning economic agents and their expectations than childish roulette and urn analogies.

‘Rigorous’ and ‘precise’ DSGE models cannot be considered anything else than unsubstantiated conjectures as long as they aren’t supported by evidence from outside the theory or model. To my knowledge no in any way decisive empirical evidence has been presented.

No matter how precise and rigorous the analysis, and no matter how hard one tries to cast the argument in modern mathematical form, they do not push economic science forwards one single millimeter if they do not stand the acid test of relevance to the target. No matter how clear, precise, rigorous or certain the inferences delivered inside these models are, they do not say anything about real world economies.

Proving things ‘rigorously’ in DSGE models is at most a starting-point for doing an interesting and relevant economic analysis. Forgetting to supply export warrants to the real world makes the analysis an empty exercise in formalism without real scientific value.

Mainstream economists think there is a gain from the DSGE style of modeling in its capacity to offer some kind of structure around which to organise discussions. To me that sounds more like a religious theoretical-methodological dogma, where one paradigm rules in divine hegemony. That’s not progress. That’s the death of economics as a science.

Is the economic system self-adjusting?

Paul Krugman has repeatedly over the years argued that we should continue to use neoclassical hobby horses like IS-LM and AS-AD models. Here’s one example:

So why do AS-AD? … We do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run.

I seriously doubt that Keynes would have been impressed by having his theory being characterized with catchwords like “tendency to return to full employment” and “money is neutral in the long run.”

One of Keynes’s central tenets — in clear contradistinction to the beliefs of mainstream neoclassical economists — is that there is no strong automatic tendency for economies to move towards full employment levels.

Money doesn’t matter in mainstream neoclassical macroeconomic models. That’s true. According to the ‘classical dichotomy,’ real variables — output and employment — are independent of monetary variables, and so enables mainstream economics to depict the economy as basically a barter system.

But in the real world in which we happen to live, money certainly does matter. Money is not neutral and money matters in both the short run and the long run:

The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

J. M. Keynes A monetary theory of production (1933)

Krugman vs Syll on the IS-LM model

Some time ago yours truly ventured to question Paul Krugman for his unadulterated devotion to the IS-LM model. For years self-proclaimed “proud neoclassicist” Paul Krugman had in endless harpings on the same IS-LM string told us about the splendour of the Hicksian invention.

Krugman’s response contained nothing new. In an earlier post on his blog, Krugman had argued that ‘Keynesian’ macroeconomics more than anything else “made economics the model-oriented field it has become.” In Krugman’s eyes, Keynes was a “pretty klutzy modeler,” and it was only thanks to Samuelson’s famous 45-degree diagram and Hicks’s IS-LM that things got into place. Although admitting that economists have a tendency to use ”excessive math” and “equate hard math with quality” he still vehemently defends — and always have — the mathematization of economics:

I’ve seen quite a lot of what economics without math and models looks like — and it’s not good.

Sure, ‘New Keynesian’ economists like Mankiw and Krugman — and their forerunners, ‘Keynesian’ economists like Paul Samuelson and (young) John Hicks — certainly have contributed to making economics more mathematical and “model-oriented.”

But if these math-is-the-message-modelers aren’t able to show that the mechanisms or causes that they isolate and handle in their mathematically formalized macromodels also are applicable to the real world, these mathematical models are of limited value to our understandings of real world economies.

If economic regularities obtain they do it (as a rule) only because we engineered them for that purpose. Outside man-made mathematical-statistical models they are rare, or even non-existant. Unfortunately that makes most of contemporary mainstream neoclassical endeavours of mathematical economic modeling rather useless. And that goes for Krugman and the rest of the ‘New Keynesian’ family as well.

When it comes to modeling philosophy, Paul Krugman has in an earlier piece defended his position in the following words (my italics):

I don’t mean that setting up and working out microfounded models is a waste of time. On the contrary, trying to embed your ideas in a microfounded model can be a very useful exercise — not because the microfounded model is right, or even better than an ad hoc model, but because it forces you to think harder about your assumptions, and sometimes leads to clearer thinking. In fact, I’ve had that experience several times.

The argument is hardly convincing. If people put that enormous amount of time and energy that they do into constructing macroeconomic models, then they really have to be substantially contributing to our understanding and ability to explain and grasp real macroeconomic processes.

For years Krugman has in more than one article criticized mainstream economics for using too much (bad) mathematics and axiomatics in their model-building endeavours. But when it comes to defending his own position on various issues he usually himself ultimately falls back on the same kind of models. In his End This Depression Now — just to take one example — Krugman maintains that although he doesn’t buy “the assumptions about rationality and markets that are embodied in many modern theoretical models, my own included,” he still find them useful “as a way of thinking through some issues carefully.” When it comes to methodology and assumptions, Krugman obviously has a lot in common with the kind of model-building he otherwise criticizes.

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging is made, macroeconomic model building is little more than hand waving that give us rather little warrant for making inductive inferences from models to the real world. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

If macroeconomic models – no matter of what ilk – make assumptions, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypotheses can be bridged, are obviously non-justifiable.

A gadget is just a gadget — and brilliantly silly simple models — IS-LM included — do not help us working with the fundamental issues of modern economies any more than brilliantly silly complicated models — calibrated DSGE and RBC models included.

Marx and the Matthew effect

People who are short of money are often desperate to borrow and so willing to pay high interest rates to loan-sharks, payday lenders or car finance companies. If you lack negotiating power, you’ll get a bad deal.

This is an example of the Matthew effect …

All of this means there’s some truth in the old cliché: “the rich get richer, the poor stay poor.” Although the ONS says that the UK has a relatively low rate of persistent poverty, I suspect this is the result of people shifting to just above the poverty line rather than into great fortune. Other ONS evidence (pdf) shows that half of those who were in the bottom income quintile in 2010 were still there in 2014, and that a further quarter were in the next quintile, implying that only a quarter made it into the top 60%.

You might think all this is trivial. Maybe. But there’s another arena in which the Matthew effect operates: capital-labour relations. Exploitation, thought Marx, arises because the worker’s poverty puts him in a weak bargaining position. He “has no other commodity for sale” than his labour-power and in “bringing his own hide to market…has nothing to expect but — a hiding.” This is still, generally, true. Yes, there are some instances whereby labour can exploit capital (such as top-league footballers or chief executives) but these are rare exceptions. In most cases, it’s capital that has bargaining power and labour that doesn’t, and this gives us another Matthew effect.

Chris Dillow

So true, so true. But you won’t find it in Greg Mankiw’s textbooks. Wonder why …