Wednesday, August 29, 2012

The Bain Model

Matt Taibbi wrote an incredibly important article on Bain Capital. Not so much because it explains what Romney did to get his fortune, which it does, but more importantly as a general explanation of the process of financialization. Bain is an equity firm. Taibbi basically tells you what equity firms do. In his words:
"A private equity firm like Bain typically seeks out floundering businesses with good cash flows. It then puts down a relatively small amount of its own money and runs to a big bank like Goldman Sachs or Citigroup for the rest of the financing. (Most leveraged buyouts are financed with 60 to 90 percent borrowed cash.) The takeover firm then uses that borrowed money to buy a controlling stake in the target company, either with or without its consent.

When Bain borrows all of that money from the bank, it's the target company that ends up on the hook for all of the debt.

Once all that debt is added, one of two things can happen. The company can fire workers and slash benefits to pay off all its new obligations to Goldman Sachs and Bain, leaving it ripe to be resold by Bain at a huge profit. Or it can go bankrupt – this happens after about seven percent of all private equity buyouts – leaving behind one or more shuttered factory towns. Either way, Bain wins. By power-sucking cash value from even the most rapidly dying firms, private equity raiders like Bain almost always get their cash out before a target goes belly up."
A win-win as they say, unless you actually work in a company acquired by an equity firm. Here is an example of an actual company.
"Take a typical Bain transaction involving an Indiana-based company called American Pad and Paper. Bain bought Ampad in 1992 for just $5 million, financing the rest of the deal with borrowed cash. Within three years, Ampad was paying $60 million in annual debt payments, plus an additional $7 million in management fees. A year later, Bain led Ampad to go public, cashed out about $50 million in stock for itself and its investors, charged the firm $2 million for arranging the IPO and pocketed another $5 million in "management" fees. Ampad wound up going bankrupt, and hundreds of workers lost their jobs, but Bain and Romney weren't crying: They'd made more than $100 million on a $5 million investment."
This is not only legal, but it is also possible because of a tax loophole that allows deductions on the interest on the money borrowed to take over productive firms. As Matt Taibbi tells us:
"The entire business of leveraged buyouts wouldn't be possible without a provision in the federal code that allows companies like Bain to deduct the interest on the debt they use to acquire and loot their targets."
So Taibbi is right when he says that Romney complaining about excessive debt is ironic, to say the least.

Tuesday, August 28, 2012

A reply to Wray - Part II

By Sergio Cesaratto (guest blogger)
“The EMU could easily have self-destructed even with no current account deficits anywhere.” (Wray here)

“Trade issues within the eurozone …will remain a point of economic and political stress even with a full resolution of the liquidity issues…” (Warren Mosler)
 In part I, I reviewed the MMT view that full monetary sovereignty is the key to full employment policies in all countries, provided that those with current account (CA) troubles have safe access to alternative sources of foreign liquidity - what is not the case in reality. I also examined the MMT’s claim that the Eurozone (EZ) cannot suffer of internal balance of payment (BoP) troubles as long as fiscal transfers from a significant federal budget backed by a genuine European CB are provided - what again is not the case in reality. In this post we shall return on Wray’s denial of the BoP origin of the EZ crisis. I agree with Wray, Bell-Kelton and other MMTs that in a currency union local states are partially deprived of fiscal policy as a tool to sustain aggregate demand[1] (without forgetting that this power is anyway in many countries subject to the foreign constraint even with full monetary sovereignty), while the institutional design of the EMU is not able to assure full employment and the preservation of the traditional European welfare state in a non-OCA. As Godley 1991 pointed out:
“The fact that individual countries no longer have their own currencies and central banks will put new constraints on their ability to run independent fiscal policies. However, the collective formulation of fiscal policy would be a far more difficult business than passive ‘coordination’. Fiscal policies of the whole Community could be co-ordinated and expansionary: but they could also be co-ordinated and contractionary. How is the common formulation of fiscal policy to be achieved? By what institutions and according to what principles?”
But Godley found even:
“more disturbing … the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports. Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure” (hat tip to Ramanan).
Indeed, the crisis did not stem from an undisciplined fiscal behaviour of some peripheral countries – they knew very well that “markets” would have punished them (the EMU was designed for this purpose – but from the lose of competitiveness of some member countries, as Godley feared, and from some additional events brought about by monetary unification that nobody (with one exception) foresaw .

1. Leaps forward and back
The problem with the second post by Wray (here), in which he focuses on the nature of the EZ crisis, is that at least three explanations of the crisis are provided and the reader might be confused by the leaps forward and back from one to another without much coordination among the three. Godley’s stock-flows three balances are sometimes evoked, but as such they are national account relations deprived of causal explanations.[2]

None of the three explanations is per se wrong, what is lacking is a consistent framework, perhaps obstructed by the “Nostradamus race”. Let us examine the single explanations first, pointing out their respective limits as they are presented by Wray, trying later to coordinate them in a more coherent picture. In doing this I will refer to Frenkel (2012), which is however substantially consistent with, si parva licet, Cesaratto & Stirati (2010-11), Cesaratto (2012), Bibow (2012) and others.[3] One thing we should premise: each EZ country involved in the crisis is like Anna Karenina’s family, unhappy in its own way, so generalisations are not easy (see here for a quick glance of the country cases). The three explanations are: CA crisis; sovereign crisis; banking crisis. Let us begin from the former.

1.1. A current account crisis
Wray (here) quotes a “prescient” paper by Kregel (1999) to show that MMT has not neglected the CA problems within the EMU due to a progressive loss of competiveness of more inflation prone countries (including not really peripheral countries like France and Italy). Kregel also argue that a weaker euro cannot compensate the loss of EZ markets for the inflation prone countries. I fully agree that Kregel was “indeed looking at the potential for current account imbalances once the Euro was launched”. If I may indulge in the Nostradamus race, many people including myself (hundred of students may witness this) were sure of this outcome. Without downplaying Kregel’s warnings, this was the easiest part. No doubt Italy lost competitiveness during the EMU years and the same happened to the other peripheral countries. In spite of the enormous disinflation process endeavoured by Italy, Germany did better, playing its traditional game of pursuing though labour discipline an inflation rate below that of the partners within successive fixed-exchange-rate systems (Bretton Woods, EMS, EMU, cf. Cesaratto & Stirati 2010-11). The cause of the CA imbalances is not only, however, in the real exchange rate advantages of Germany (this is especially true for Portugal and Italy), but in the relatively higher growth rate of domestic demand in some peripheral countries, Spain, Ireland and Greece.[4] And this was caused, in Spain and Ireland, by the housing bubble financed by foreign capital inflows. (I also used to warn Spanish Erasmus students that the high rate of growth of Spain was paper-made - or rather bricks-made - and that Spain was accumulating an enormous foreign debt). In Cesaratto & Stirati (2010-11) and Cesaratto (2012) this is described in Kaleckian terms: the mercantilist country finances the absorption of its trade surplus by lending to peripheral countries, a process favoured by financial liberalizations and fixed exchange rates. Frenkel (2012) regards these events as analogous to those who have traditionally taken place in emerging economies. De Grauwe (1998) foresaw that the EMU would have led to a housing bubble in Spain. To sum up: Wray is correct to refer to the CA crisis as an aspect of the EZ crisis, although this has more complex features than those that any single economist (Kregel or De Grauwe) could foresee before the events took place, features that we cannot neglect now.

1.2. A banking crisis
So we arrive to the second explanation of the crisis: a banking crisis. No doubt that the sequence financial liberalisation cum currency unification could not but let (with the benefit of hindsight, of course) to a banking crisis, at least in some peripheral countries (as foresaw by De Grauwe), associated also to a foreign accounts crisis and to a fiscal crisis once banks’ problems were taken over by the state. Saying good bye to Kregel, Wray, however, seems to refer to a different sort of banking crisis as the main and independent cause of the European crisis. He mainly refers to the crisis that involved Irish banks that engaged in risky financial activities in a way not dissimilar to those that involved the Icelander banks, but it extends the case to Spain as well:
“it is much more than a current account problem ... Any EMU nation can be blown up by its banks even while running a current account surplus. This is the ‘financialization’ or ‘Money Manager Capitalism’ story that comes from Hyman Minsky—probably well over 90% of cross-border finance has nothing to do with the current account, and it was that part of finance that blew up countries like Ireland and Spain… So far as I know, Warren Mosler was the first to fully understand this.” (Wray here)
I may concede that tiny Ireland had a banking crisis similar to that of Iceland (which is not part of the EZ) due to a particularly risky behaviour of banks (I am not expert enough to judge this). This is, however, generalised to all the EZ in a disputable interpretation of the crisis due to “financialization”, a view that is also shared by many mainstream economists. The banking crisis is almost completely detached from the story told by Frenkel and many others that led to the housing bubbles (that are just mentioned in passing, p.9) in Spain and, according to a World Bank report also in Ireland (and Greece!) too,[5] and to the ensuing the CA troubles. Certainly, no risky banking behaviour is behind the Italian troubles.[6] So the banking crisis as told by Wray-Mosler is of very limited if not of nil value. “Financialization” is part of the EZ story, but within the precise context that, to the best of my knowledge, only De Grauwe foresaw. [7]

More in general, “financialization” fits well in a Kaleckian (rather than Miskian) story that regards it as a way to sustain aggregate demand and the realisation of capitalists’ surplus either in the domestic market (as in the U.S. autonomous consumption bubble) or in foreign markets (as in the case of the core-periphery relations in the EZ).[8] Anyway, I myself suggested a convergence between Kalecki and Minsky in the view that capitalism is debt driven (Cesaratto 2012b)

1.3. A sovereign debt crisis
Wray is certainly correct to point out that banks’ troubles are transferred to the public sector once government bails them out. The question is then if the country has or not full monetary soveregnity:
“From the MMT point of view … the main problem with current account deficits in monetarily sovereign nations is the balance sheet situation of the domestic private sector (given a government budgetary outcome). …some EMU nations also ran chronic current account deficits. And if these had been monetarily sovereign nations (in the sense that they each issued their own floating rate currency), then the worry would have been over the private sector balance. But here the EMU nations diverged significantly from one another—some with current account deficits did not run up huge private sector debts, others did. The balancing item, of course, was the government balance. And, more importantly, these were not monetarily sovereign. Each dropped its own currency in favor of a ‘foreign’ currency—the Euro. So there are two issues: a current account deficit mostly offset by a private sector deficit, versus a current account deficit offset mostly by a government sector deficit. My argument is that for a monetarily sovereign nation only the first of these is a problem; but for Euro nations, either of these can cause trouble” (Wray here, my italics).

“we already addressed the current account story—easily understood through the lens of Godley’s sectoral balance approach: a current account deficit must be offset by a combination of a domestic private sector deficit and/or a government deficit. Since these are not sovereign currency issuing governments, private and government deficits can both lead to problems.” (Wray here).

“Our argument was that separating fiscal policy from currency sovereignty would raise questions of solvency that would constrain the ability of fiscal policy to expand when necessary. That was the basis of all these early MMT arguments.”
These passages are important because they show that the ultimate factor at the origin of the EZ crisis is, in Wray’s opinion, the absence of national sovereign central banks: indeed, CA deficits (as long as they correspond to public deficits only) or the associated banking crisis (as long as monetary sovereign states bail then out) appear ancillary/derived troubles.[9] We are somehow sent back to Wray’s arguments reviewed in part 1 LINK of the present post about the thaumaturgic values of either national monetary sovereignty that backs national public finances (the “born in the US” story), or of a fully federal EZ in which the ECB back a federal budget (the “had the EZ been like the U.S. it wouldn’t had a BoP crisis” story).

Beyond doubt, the EZ crisis has eventually become also a fiscal crisis. But this outcome must be placed in a fully consistent historical and analytical account of the events, otherwise the sovereign debt crisis story might perilously resemble the conventional story (mainly by the German economists and by Alesina and his associates) that the crisis originated from the fiscal profligacy of peripheral countries, a story that with (perhaps) the partial exception of Greece (with the political coverage of the Germans) is clearly false. And indeed, everybody in the European public debate knew that with the monetary unification the financial markets (not the Maastricht Treaty) were the watchdog of “fiscal discipline”. In fact, most of the peripheral government behaved in a very “disciplined” way during the EMU years and beyond. Wray and Kelton early warnings of a pending fiscal crisis in the EZ must be intended that had troubles arose from other sources – as they did – then the absence of monetary sovereignty (or of a genuine EZ central bank) would aggravate the crisis.[10]

The differences between Wray’s and my point of views are perhaps not so substantial as it may appear, since partially depend from the angle you look at the events. He finds the origin of the EZ crisis in the lack of coordination of fiscal and monetary policy either at the EMU level, as seen in part 1 LINK or, alternatively, in the lack of full national monetary sovereignty. Being in the middle (never forget out of an explicit choice of the political designers) the EZ developed a crisis that is in the middle between the U.S. crisis – sharing in common with it the housing bubble and the banking crisis – and the traditional financial crisis of the emerging economies as described by Frenkel and many others. The EZ no-solutions also depends on this being in the middle: neither the U.S. relatively efficient solution of a domestic financial crisis, not the traditional solutions in emerging economies in which the adjustment was helped by the recovery of a competitive exchange rate. Perhaps I prefer to stress the events as they unfolded in the given design, while Wray prefers to look at the wrong design of the EMU (but strangely neglecting the importance of an ordered account of the actual events that came out from the wrong design).

2. Comprehensive views
I believe that Roberto Frenkel’s (2012) synthesis of the EZ crisis can constitute a reference point and convergence field for many of us. In short, he sees a similarity between the EZ events (and those of the Baltic and Eastern European countries that pegged their currency to the Euro here) and those that typically took place in the emerging economies till the very beginning of this century. This view particularly applies to the case of Spain, Ireland and Greece. Much less to Italy that is closer to the Kregel loss-of-competitiveness case. The Irish case should also, in addition, be interpreted through the Mosler-Wray lenses of a “pure” banking crisis. According to Frenkel, the similarity with what I called the “this time is different” story (after the otherwise confused book by Reinhart and Rogoff)[11] stops here. There are al least three differentie specificae in the EZ crisis (as also pointed out in Cesaratto 2012a). One is that the EZ nations lack a lender of last resort, so that the fiscal crisis that followed the private sector crisis rapidly acquired an inertia by its own, as Wray, Kelton and Mosler presciently warned us it could. Nonetheless, a second differentia, the Eurosystem refinancing operations have made increasingly possible to domestic banks to sustain national states, so that now the fiscal and banking crisis are intertwined in a fatal embrace, one entity bailing out the other. A third is that the Target 2 scheme, as Wray (here) also points out, let the CA, banking crisis and what are called “sudden stops” (or capital flight)[12] not to explode in generalized banking and state defaults. For how long this situation can continue is not clear. It will explode for political or social reasons. But we must stop here and let this discussion for the (near) future as events unfold. (an excellent post in this regard is by Marshall Auerback).

An even more comprehensive view - that deserves further research – would read as follows. In the pre-crisis EMU years, in the Italian and Portuguese (and French) (PIF) cases the loss of competitiveness was such that a same (albeit moderate) pattern of domestic autonomous (private and public) demand was accompanied by lower output growth and growing external imbalances (notably those countries had not an housing bubble). In other words, the deterioration of the foreign competitiveness is such that the same pattern of domestic investment, autonomous consumption and government spending is increasingly generating a larger output abroad (say in the core-countries), and correspondingly less within her boundaries. Through the lenses of sectoral balances, this means that the country is running an external deficit, and by definition the foreign sector (say, the core-countries) is lending to her, what is not surprising since at the same time the foreign sector is enjoying a higher income, and therefore higher saving. The low interest rates due both to the ECB policy stance, the temporary disappearance of devaluation risk and fiscal discipline permitted to the deficit countries to keep their fiscal accounts under relative control. Nonetheless a trend leading to the deterioration of the domestic balances was there (rapidly in the Portuguese case, slowly in the Italian case; even more slowly in the French case). Once the crisis exploded, as the result of the transmission of the American and global crisis and of the mismanagement of the Irish-Greek-Spanish (IGS) situation by the EZ authorities, in particular the absence of a truly European CB to substitute the disappeared national monetary sovereignty, led to the explosion of a sovereign debt crisis in the PI. The story of the IGS countries is partially different from that of the PIF. Although they share the same underlying events of the PIF, in their case, domestic demand grew faster sustained by foreign capital flows following the Frenkel’s style course of events. The buoyant fiscal revenues gave the impression of sound fiscal finances, while the private balances rapidly deteriorated mirrored by the mounting foreign imbalances. The explosion of the housing bubbles in Spain and Ireland, the insolvency of the Greek government, and the bail out of the domestic financial sector – in the absence of the backing of a central bank - led to the fiscal crisis. As Wray and Cesaratto (2012a) say, had the EZ similar to the U.S. the crisis would have been managed as a domestic crisis involving local banks and states (letting some of them to fail, or to downsize, but supporting the local states through transfers). Had the EZ composed by monetary sovereign states, the crisis would have been managed as the typical financial crisis that often involved the emerging economies. Being in the middle, sovereign spreads reflects the solvency (not just liquidity) risk of the peripheral countries or, what it’s the same, the risk of the break up of the currency union. Be as it may, the scale of the crisis is larger than previous cases and its management very complicated, first of all from a political point of view.[13]

I am sincerely admired from the pieces of prescient views about the various deficiencies of the EMU that came from people associated to the Levy Institute. Yet, I feel, as many others (I’m sure many just keep silent to avoid troubles), uncomfortable with the Nostradamus race initiated by the MMTs that has, in my opinion, impeded them to work at a more comprehensive view of the EZ crisis, one that should have taken into account other contributions from a much, much larger community of heterodox (and even open minded orthodox) scholars. My impression is that the race to show that whatever others have said, one scholar associated to the Levy said it before (likely better), has let to a self-contradictory, disordered explanation of the crisis by some MMTs. I’m ready to use, cum grano salis, the insights from MMTs, while the Levy Institute is an essential lighthouse for all heterodox economists. Hope this is reciprocal. Humility is part and parcel of the scientific enterprise, especially for heterodox economists that already suffer the arrogance of the mainstream..

Wray (here) uses the expression “factors of production” (“One of the goals of European integration was to free up labor and capital flows, removing barriers so that factors of production could cross borders”). This term should not be employed by heterodox economists - unless you believe that a “factor of production” called “capital” measurable independently of income distribution exist, or you think that the question is irrelevant. I believe that capital theory, or distribution theory if you like, marks the boundary between orthodox and heterodox economics, no monetary issues – in principle you can be Chartalist or believe in endogenous money and be neoclassical – let alone methodological issues. Of course, once set free from the neoclassical constraints, good monetary theories and methodologies may give their best.

Further references
Barba A., Pivetti M. (2009) Rising Household Debt: Its Causes and Macroeconomic Implications-A Long-Period Analysis, Cambridge Journal of Economics, Vol. 33, Issue 1, pp. 113-137, 2009.

Cesaratto S. (2012b), Neo-Kaleckian and Sraffian controversies on accumulation theory, Università di Siena, Quaderni del Dipartimento di Economia politica e Statistica, forthcoming Review of Political Economy.

Cynamon B.Z., Fazzari S.M. (2008) Household Debt in the Consumer Age: Source of Growth—Risk of Collapse, Capitalism and Society, vol. 3, article 3.

Palumbo A. (2012), “On the Balance-of-Payments-Constrained Theory of Growth”, in Sraffa and Modern Economics (R. Ciccone, C. Gehrke, G. Mongiovi eds), London: Routledge.

[1] Partially because the balanced budget theorem and the possibility of redistributive fiscal policies from the wealthier to the poorer citizens suggest that some space is left to expansionary fiscal policies.

[2] This is not to lessen the important educative role that the “sectoral balances approach” has had on all us in telling macroeconomic stories that take into account the simultaneous evolution of the three balances. The “sectoral balances” must, however, be part of a consistent story. Here (fn 21) I commented a passage by Wray (2009: 6-7): “‘It is the deficit spending of one sector that generates the surplus (or saving) of the other; this is because the entities of the deficit sector can in some sense decide to spend more than their incomes, while the surplus entities can decide to spend less than their incomes only if those incomes are actually generated. In Keynesian terms this is simply another version of the twin statements that ‘spending generates income’ and ‘investment generates saving’. Here, however, the statement is that the government sector’s deficit spending generates the nongovernment sector’s surplus (or saving)’. The Keynesian multiplier is clearly alluded to, but Wray’s preference goes to the ‘stock-flow consistent framework’ (SFCA). The emphasis on the accounting identities may lead to overlooking the Keynesian mechanisms that lead from one equilibrium to another hiding the fact that when the balance of one sector changes, output is also changing. It might thus convey the impression that the argument is carried out for a given level of output. Despite this I do not deny the disciplinarian role that the SFCA has on our way of thinking, obliging us to always keep in mind the necessary interrelations between the three institutional sectors.”

[3] See, inter alia, World Bank (that quotes approvingly Bibow 2012) IMF, EU Commission, Federal Reserve Bank of St. Louis, Merler and Pisani-Ferry.

[4] I frankly felt some annoyance to read this: “How could anyone—let alone an Italian economist—attribute Italy’s problems to profligate consumption of imports? Heck, back in the bad old days before the EMU (when Italy had its “high” inflationary Lira) it actually ran current account surpluses. It was the set-up of the EMU that killed Italy’s exports—exactly as Jan Kregel had predicted.” No heterodox “Italian economist” has indeed accused Italy of profligacy. Had Wray the patience (or humility) to read Cesaratto (2012a), the Italian experience has precisely been illustrated along Kregelian lines. Incidentally, Wray cites several times the German Mercantilism. He could have perhaps learnt something about its nature from my papers (in turn, I was inspired by Marcello De Cecco, the senior Italian international monetary economist, and by the nationalist/mercantilist/political realist tradition in International Political Economy and development studies). It should also be said that, according to many experts, the Italian exports did not fare badly in the last years - and the case is the same for Spain. The problem was likely on the import side. For Spain that was certainly due to the relatively high growth of domestic demand due to the construction boom, and for both likely to the loss of competiveness in the sectors were they were already weak.

[5] “The crisis in Ireland is essentially one of a boom and bust of a real estate bubble. Encouraged by the fall in interest rates that went along with the adoption of the euro, banks obtained funding from British, German and US banks, usually in the form of short-term debt, foreign-owned bank deposits, or foreign-owned portfolio equity, to expand credit to the private sector. …

Fuelled by a rapid expansion of credit, Ireland‘s housing market began to expand in 2000, resulting in a boom in property investment and construction. The wealth effect from this boom spurred higher levels of consumption and helped sustain high growth rates. Boosted by the real estate boom, Ireland's banking system ballooned to five times the size of the economy, and its external debt to over 1000 percent of GDP at the end of 2010. When in the wake of the crisis funds from the US and Britain dried up, the banking system experienced a liquidity crunch, thus slowing credit to the real estate market. As borrowing became more expensive, the demand for housing started to decline, resulting in a fall in prices and an oversupply of housing. This put pressure on the balance sheets of banks many of which had relied extensively on profitable mortgage loans to boost their earnings. The authorities‘ extensive support as well as access to emergency support from the Central Bank was vital to address financial stability concerns. Yet, the bailout or purchase of failing banks also led to a crisis of confidence, as the government bailout package reached 20 percent of GDP and the budget deficit shot to 32 percent of GDP in 2010, leading to outflows of foreign assets.” (World Bank: 17:8). The interpretation of the EZ crisis advanced by this WB report is in line with those of Roberto Frenkel (2012), Cesaratto (2012a), Bibow (2012) and others: “Overall, at the heart of the euro debt crisis is an intra-area balance of payments crisis caused by seriously unbalanced intra-area competitiveness positions and the—largely private—accompanying cross-border debt flows. And as discussed above, the common currency was central to this outcome with its impact on interest rates (both for sovereigns and for credit to the private sector), financial integration and the encouragement of export-led growth in core countries and consumption-led growth in non-core countries.” (15).

[6] Italian banks have not been involved in risky international activities with the exception of lending to Eastern European countries that pegged their currency to the Euro, particularly Hungary, with the standard dire consequences.
[7] Paul De Grauwe’s foresaw in 1998 that financial liberalisation and monetary unification in the EZ would bring about a housing bubble followed by a banking crisis in Spain: the “future euro financial crises … will in one crucial aspect be different from the financial crises recently experienced in Asia. They will not lead to speculative crises in the foreign exchange markets. Thus, if Spain is confronted by a banking crises this will not spill over into the Spanish foreign exchange market because there will be no such market. One source of further destabilisation of the markets will, therefore, be absent. The founders of EMU have taken extraordinary measures to reduce the risk of debt default by governments. Maastricht convergence criteria and a stability pact have been introduced to guard EMU from the risk of excessive government debt accumulation. The Asian financial debacle teaches us that excessive debt accumulation by the private sector can be equally, of not more, risky. This has escaped the attention of the founders of EMU, concerned as they were by the dangers of too much government debt. In the meantime the EMU-clock is ticking, while the institutions that should guard EMU from financial and banking crises have still to be put into place.” This is the standard “this time is different story” of the financial crisis in emerging economies with, as we shall see, an important novelty in the EZ crisis.

[8] Non conventional economists are divided over the deep causes of the crisis that set off in 2007-8 (Palley 2010). Minskian authors, associated to the Levy Institute in the US, tend to see it as the result of periodic cycles of financial exuberance. Many conventional economists also share this view, as suggested by their rediscovery of Hyman Minsky’s lesson. Other heterodox economists go behind the financial excesses and find their origin in the necessity of capitalism, particularly in the US, to sustain aggregate demand after the big change in income distribution that occurred over the last thirty years, from the working and middle classes in favour of an affluent thin minority of capitalists (and relative attaches) (e.g. Barba, Pivetti 2009, Cynamon, Fazzari 2008). A few of open-minded mainstream economist also share this view (e.g. Rajan; Fitoussi, Saraceno).

[9] If, as in the MMT view, public debts backed by a sovereign CB are never a problem, why should the private debts be a problem as long as they can be transferred to the public sector?

[10] As Mosler suggests: “the conditions for a national liquidity crisis that will shut down the euro-12’s monetary system are firmly in place. All that is required is an economic slowdown that threatens either tax revenues or the capital of the banking system”

[11] I do not like this book, but it is not a case that Wray has critically reviewed it (here), while I simply believe that the “this time is different” story is analytically better told by Frenkel and the Latino-American tradition including the seminal paper by Diaz-Alejandro.

[12] That is the refusal by foreign capital to roll over public or private debts. To this capital flights from residents should be added.

[13] So I am very far from the naive views Wray attributes to me: “an Italian economist, Sergio Cesaratto called the MMT victory ‘spurious’. I’ll try to focus in on the main complaint, which seems to be that MMT missed the true cause of the Euro mess: current account deficits run up by some profligate EMU members” (here). Or (here): “Sergio (Remember him? …) sees all this as a current account imbalance. Those Irish and Icelander consumers just bought too many imports. Living the high life up north.” I never wrote this kind of things (let alone that Iceland is part of the EMU).

Krugman on the meaning of neoclassical economics

So what is neoclassical economics? According to Krugman it is basically maximization and equilibrium. In his words, neoclassical or marginalist analysis is:
"economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players. If nobody has market power, this comes down to the textbook picture of perfectly competitive markets with all the marginal whatevers equal."
This is clearly incorrect. First, classical authors, meaning those that followed the surplus approach (from Petty to Marx, including Quesnay, Smith and Ricardo) did assume that economic agents were rational and self-interested and they also believed that the economy could be represented by equilibrium outcomes. And they clearly were not neoclassical, meaning they did not believe that supply and demand determined long term prices (natural prices as Smith and Ricardo referred to them, or prices of production in Marx's terminology).

If profits were higher in a particular sector, capitalists would try to gain from those opportunities entering the industry, and in the process would lead to a uniform rate of profit. Market prices, determined by supply and demand, would gravitate around the long term equilibrium prices that were determined by the technical conditions of production, and the previously given real wage (by conflict), in modern parlance (on the issues raised by the Labor Theory of Value, and Sraffa’s solution just check other posts in this blog).

More importantly, there was no mechanism (even in the case of those classical authors, like Ricardo, that accepted Say’s Law) that implied full utilization of labor, capital or any particular means of production. Wage flexibility did not lead to full employment. The hallmark of marginalism is the notion that supply and demand determines simultaneously the equilibrium long term prices, and that price flexibility leads to full utilization of resources, something that the capital debates have demonstrated long ago it cannot be done. In this regard, Krugman decides (because it must be advantageous) to follow those that he criticizes, and remains oblivious to both logic and empirical evidence. If he wants to be coherent with his Keynesian ideas, he should get rid of the notion of a natural rate of unemployment (or and of interest).

A reply to Wray - Part I

By Sergio Cesaratto (Guest Blogger)

“The fact that individual countries no longer have their own currencies and central banks will put new constraints on their ability to run independent fiscal policies. … But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports. Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before…” Wynne Godley 1991
There are two aspects of the discussion that has taken place in the last weeks (here, here, here, here). The first mainly concerns my first post and regards whether monetary sovereignty is a condition both necessary and sufficient for any country to pursue development and full employment policies; the second concerns the Eurozone (EZ) crisis and was the subject of my second post. Wray mainly focuses on the second issue, and I will do the same. In part 1 of my reply I will, however, briefly dwell on the first aspect that is anyway preliminary and which will lead us to touch upon the EZ troubles anyway. The two questions we deal with in part 1 will, respectively, be: are balance of payments (BoP) preoccupations irrelevant for countries endowed with full monetary sovereignty? Can a currency union suffer of internal BoP troubles? Part 2 (will be posted later) will then be devoted to Wray’s explanation(s) of the EZ crisis.

1. Born in the US
The main argument of my first post was that monetary sovereignty, although a necessary condition for development and full employment policies, is not the magic wand to solve the foreign constraint to those policies. This constraint can be summarised as the necessity for peripheral countries – a set that include from developing countries to highly developed countries like France or Italy – to acquire enough international liquidity to finance the amount of imports generated by a satisfactory level of growth [a useful critical discussion of the theory of the balance-of-payments-constrained growth as presented by Thirlwall - and inspired by Kaldor - is in Palumbo (2012)]. Unless a country issues an internationally accepted currency, no monetary sovereignty would automatically allow fiscal policy to sustain domestic demand in peripheral countries without risking the vicious circle of a falling foreign exchange rate and high inflation. When Mitterand took power in 1981 with strong Keynesian ideas, few month were enough to change his mind – that is to realise that without the German cooperation, that was not there, no expansion in a single country was possible (unless you are ready to adopt more radical measures like import restrictions that, indeed, were in those years proposed by Godley). And that was France! This is not to say that full monetary sovereignty is not relevant, quite the opposite, in the first place in order to pursue a competitive exchange rate and in order to release more space to policies in support of domestic demand consistently with current account (CA) equilibrium. Unfortunately, at least until the late 1990s, peripheral countries have traditionally tried the shortcut of stabilising the nominal exchange rate and financial liberalisations in order to attract foreign capital inflows. In a meaningful sense the poor experience of a number of peripheral countries in the European Monetary Union (EMU) – including Spain, Ireland and Portugal - has been similar and is described on similar lines by Roberto Frenkel (2012), Cesaratto (2012a), Bibow (2012) and many others. We shall come back on this.

From the ensuing debate on blogs, FB etc, it seems that my position has convinced a number of people, likely opening the eyes to some.[1] This was very important for my country in which is very dangerous that too simple formulas enter into the political debate, already suffering of the mainstream vulgarities also influential on the left (see Cesaratto and Pivetti), and of “Berlusconism”. Of course, “Modern Monetary Theory” (MMT) as such has nothing to do with this.[2] I have also been careful to isolate the important messages that come from it, e.g. that a country with full monetary sovereignty cannot default on its sovereign debt if denominated in its own currency. This is important and refreshing, but we cannot stop there.

MMTs recognise of course that CA imbalances can be a source of troubles, but are likely not convinced. With which arguments? Let us quote in this regard a revealing passage by Wray:

“So, yes, the US (and other developed nations to varying degrees) is special, but all is not hopeless for the nations that are “less special”. To the extent that the domestic population must pay taxes in the government’s currency, the government will be able to spend its own currency into circulation. And where the foreign demand for domestic currency assets is limited, there still is the possibility of nongovernment borrowing in foreign currency to promote economic development that will increase the ability to export.

There is also the possibility of international aid in the form of foreign currency. Many developing nations also receive foreign currency through remittances (workers in foreign countries sending foreign currency home). And, finally, foreign direct investment [FDI] provides an additional source of foreign currency.”
So Wray recognise the particularity of the U.S. and of some other developed countries that, as Australia, have enormous endowments of natural resources and stable institutions. What the normal countries might do is then to appeal to official aid, to rely on remittances or on FDI,[3] or finally … to liberalise finance and commit to a stable nominal exchange rate in the attempt to attract foreign capital (what is implied by Wray’s suggestion of “nongovernment borrowing in foreign currency”). A similar position expressed by Bill Mitchell is quoted by blogger “Lord Keynes” (who has words of appreciation for my posts, thanks!) as a possible MMT reply to my view. What Mitchell says is that we should have a new and progressive IMF that alleviates the foreign constraint. But we have not it and we shall not have it, even admitting that it would be sufficiently powerful to solve the problems of big countries.[4] Well, anybody can judge the frailty of these replies.[5] So we remain with a single result: a sovereign central bank is a necessary, essential step, but is not the solution to any problem in all countries.[6]

2. Born in the EU
Of course, the renunciation to full monetary sovereignty is at the bottom of the EZ crisis, but as I argued in my posts, in the first place from the “external” point of view of the ensuing loss of competitiveness for peripheral countries and not-so-peripheral countries like Italy (we shall see in the second part, posted later, that Wray is close to recognise this in his reference to Kregel; monetary unification and financial liberalisation created further troubles on which we shall return in the second part). Wray tends, however, to deny that the origin of the EZ crisis is mainly in the foreign imbalances.

His main argument is that had the EZ been a currency area like the US, it could not have balance of payment crisis. This is so because in the US “we use fiscal policy [that is fiscal transfers] to try to overcome the negative effects on standards of living across states due to different multipliers and other factors related to these current account flows.” (Wray here). So the conclusion is that the EZ crisis “it is not a simple current account story. It is an MMT story about the constraints imposed due to the setup of the EMU, which separated fiscal policy from the currency.” Consider also (Wray here): “We went on to examine the claim that the Euro crisis is a simple BoP problem. That, too, is fallacious. If the EMU had been designed properly, it would not matter whether some member nations ran current account deficits—much as many US states run current account deficits.” So the problem is that the EZ is not the US, since if it were, no BoP crisis would have occurred! It is as one warns not to drive a car with three wheels and somebody else replies: don’t worry, just assume you have four. Warren Mosler’s (implicit) reply to my posts admits it: the CA imbalances are a problem that a sovereign central bank cannot solve and one solution is for the EU to have fiscal transfers of the size of the US and nobody would talk anymore of the EU imbalances. Well, but we have not this Europe and we shall never have it (I clearly myself wrote, as “Lord Keynes” correctly recalls, that the EZ could be a perfect MMT country).

To sum up, Wray’s reasoning is the following: the monetary unification might well have created CA problems (see in Part 2, to follow tomorrow, of this post his reference to Kregel). Transfers from a substantial federal European budget backed by a genuine European central bank (CB) could compensate those imbalances without much pain for the richest local states but as a component of full employment policies.[7] We may then deduct from this that since Europe has not this framework, then it suffers of a CA crisis (although a specific one, as Frenkel or myself have pointed out, we shall return on this). Wray, however, infers that since the EZ could have avoided the crisis, had it the right framework, then it is wrong to talk of a CA crisis. This sounds rather illogical, isn’t?[8] However, once the argument is presented in an ordered way – a wrong institutional design of a non-OCA precisely produces a (specific) BoP crisis – the distance be Wray and me may disappear (see Godley 1991 and Kregel). Notably, the origins of this “wrong institutional design” are not in the ignorance of the political designers. The same inventor of the OCA, the conservative economists Robert Mundell, has recently pointed out that the Euro has not been a failure as long as the ensuing disasters are leading to the destruction of trade unions and the social state, but I suppose this is also an area of broad agreement.

[1] A commentator wrote: “The balance of payments position is MMT’s Achilles hell and more and more people are starting to realise it”. I do not think this implies that MMT has not very interesting things to say once it becomes less self-referred.

[2] Things have changed in the meanwhile. Stephanie Kelton has showed great understanding for us, and I believe that her feeling is shared also by other MMTs. We are thinking about having an event together in Rome during her visit to Italy (with Auerbach and Mosler). Even if we shall not be able to organize it, the very fact that we tried is very encouraging."

[3] In an old paper, that I quote in Cesaratto (2012), Kregel warns that FDI is a dangerous form of foreign debt.

[4] I found particularly timely the reference by Ramanan, in the discussion of one of my posts, to the Mexican case of 2008 that well illustrates a typical case of a country with full sovereign monetary that has to recur to the IMF and accept its conditionality to avoid an exchange rate crisis. He rejects the thesis, that "with floating rate currency there are always takers [of the currency] at some price” since eventually it “would become extremely profitable for some to buy stuff from Mexico." To this Ramanan retorts that if “that were the case there would have been no need for Mexico to have gone to the IMF. Now you can start arguing that the central bank didn't use this huge line of credit offered but it’s the availability of this line of credit which gave confidence to the currency markets. In this case the IMF helped but it is not bound to rescue every time. And whenever such events happen, domestic demand has to give in to stabilize the external debt. You can't simply say that there is a price and the markets clear and this is the end of the story. A fall in the currency can stabilize temporarily but this is in expectation of something happening such as an intervention. Now, if the central bank doesn't react to this, it could have created a further outflow of funds depreciating the currency further. Also banks - most importantly - have liabilities in foreign currency and an outflow can further increase this with depreciation leading to banks ending up in trouble rolling over their liabilities. It is for this reason as well that Mexico used the Fed's swap lines. In other circumstances, there is sale of reserve assets, incurring of liabilities of the government in foreign currency etc to help the currency markets function. If what you think is true there would have been no need for Mexico to have gone to the IMF at all. Unfortunately that is pure fantasy stuff. There's a huge literature on how the growth of nations is explained by the balance of payments constraint and its funny how ‘modern monetary theory’ suddenly appears as Magic Pudding Economics!” Italy, a leading industrialised country, in a similar situation had to recur in 1975 to an official German loan (that the social-democrat Chancellor Schmidt accorded using nasty expressions about Italy)

[5] I wish to be conciliatory and avoid sarcasms in this note, but these replies remind me the sentence that Rousseau attributed to Marie Antoinette: « Enfin je me rappelai le pis-aller d’une grande princesse à qui l’on disait que les paysans n’avaient pas de pain, et qui répondit : Qu’ils mangent de la brioch » . Unfortunately, like Marie Antoniette’s brioches, neither conspicuous official aid, nor a progressive IMF, nor democratic FDI that distribute or reinvest profits in the host country, nor successful currency board are there to help.

[6] The non generality of the MMT’s view has been acknowledged by “Lord Keynes”: “MMT would work very well for (1) the US, (2) those nations with strong trade surpluses (say, Germany and Japan), (3) those nations that seem to run near perpetual current account deficits but attract a lot of foreign capital (say, Australia), and (4) even the Eurozone, if it were suitably reformed with a union-wide fiscal policy, would be able to achieve full employment via MMT-style policies. In short, for most of the Western world: it certainly makes sense, and can be regarded as just a more radical form of full employment Keynesian economics. That is why Post Keynesians, by and large, are reasonably receptive to it.

To this Ramanan replied that "for most Western nations" is inexact: “Most Western includes Spain as well which obviously has a constraint. You guys will always make overkills to prove a wrong point.” Interestingly Dan Kervick added: “On neo-chartalist principles, the scope of a county's ability to generate demand for its currency would be determined by the scope of its power to tax. If the Duchy of Grand Fenwick can successfully impose and collect a tax on its people payable in Fennies, then it can successfully create demand inside its country and among its own people for Fennies. That doesn't mean it can create demand for Fennies in Indonesia simply by imposing the tax on Grand Fenwickians”. And “Bruce said”: “MMT is not a magic pill that can convert a country that is deficient in vital scientific and business skills into a wealthy nation.” (I do not believe these people are Trolls, although I much preferred that everybody would use their proper name, particularly of academics, that are without problems of professional privacy). All quotations from here.

[7] The direct intervention of the ECB to sustain the public debts of uncompetitive peripheral EZ countries is a surrogate of fiscal transfers, as Wray alludes in a discussion with Ramanan (who, of course, fully agree): “’transfer’ is the wrong word. Uncle Sam issues the currency and does not have to reduce income in one state to increase it elsewhere. … If we had a fixed economic pie then in real terms we'd be transferring real stuff to the poor regions. But that ain't true, either, as outside WWII we've never operated continuously at anything approaching capacity”. In other words, it would be equivalent if, using the MMT’s wording, a federal Bruxelles “writes a cheque” (creating a deposit at the ECB) financing “fiscal transfers”, or if the ECB directly buys the deficit countries public debt (for a clarification of the MMT’s view see Lavoie).

[8] So the presentation of my thesis that Wray provided is rather unfair: “As discussed at GLF recently, Sergio Cessaratto [sic] (and others) think we got it wrong–our claim is ‘spurious’. MMT is not useful for helping to understand the crisis. It is not a sovereign currency crisis, it is a balance of payment crisis. They have not yet explained why South Dakota or Alabama or Mississippi is not suffering the fate of Greece.” Precisely because Greece is not South Dakota, that country is suffering that fate.

Further references:
Barba A., Pivetti M. (2009) Rising Household Debt: Its Causes and Macroeconomic Implications-A Long-Period Analysis, Cambridge Journal of Economics, Vol. 33, Issue 1, pp. 113-137, 2009.

Cesaratto S. (2012b), Neo-Kaleckian and Sraffian controversies on accumulation theory, Università di Siena, Quaderni del Dipartimento di Economia politica e Statistica, forthcoming Review of Political Economy.

Cynamon B.Z., Fazzari S.M. (2008) Household Debt in the Consumer Age: Source of Growth—Risk of Collapse, Capitalism and Society, vol. 3, article 3.

Palumbo A. (2012), “On the Balance-of-Payments-Constrained Theory of Growth”, in Sraffa and Modern Economics (R. Ciccone, C. Gehrke, G. Mongiovi eds), London: Routledge.

Sunday, August 26, 2012

Industrialization, Wages and the Terms of Trade

The quote above is from Raúl Prebisch's classic paper "The Economic Development of Latin America and Its Principal Problems," the so-called Development Manifesto (available in Spanish here), published in Spanish and Portuguese in 1949, and the following year in English.

Note that his explanation for the tendency of terms of trade of commodities to fall over time (the so-called Prebisch-Singer hypothesis) was based on the fact that in the boom wages went up in the center, but not so much in the periphery, since industrial workers in the center were organized and could demand higher salaries, while that was not possible for the agricultural and mining workers in the periphery. So in the recession, while prices of commodities and wages fell in the periphery, they didn't in the center. Class conflict, and not just technological change, was at the heart of the asymmetries between the center and the periphery.

Hence, industrialization in the periphery, and the re-organization of the labor force, would imply that more workers in the periphery would be able to keep part of the benefits of higher productivity. Industrialization would be good for the production of the commodity sector, since prices of commodities would go up, with higher wages in the periphery.

Also, note that this explanation of terms of trade suggests that if wages in the periphery fall, then the prices of commodities fall too. And it is worth remembering that a depreciation of the currencies of peripheral countries implies lower wages.

Friday, August 24, 2012

The Economist is Cartalist

Well not really, but they do cite the Cartalist approach of Charles Goodhart and wonder about it and the meaning for US dollar hegemony. They contrast Cartalism (or Chartalism) with the marginalist approach of Menger, but do not cite Georg Knapp or Abba Lerner or Keynes (of the Treatise on Money) as precursors of Goodhart, or any MMT author for that matter, following the tradition that the acceptable critiques of the mainstream have to come from within. Interestingly the specific take of the piece, the relation of Cartalism and dollar hegemony, has been the theme of our posts (here, here and here), and at least one paper. What are these guys reading?

PS: The classic book by Knapp on Chartalism is available here.

Okun's Law is doing fine

A comment on a previous post suggested that Okun's Law is not valid anymore. Not the first time this claim is made, by the way (see also previous discussion here). So let me be clear, there is as much reason to believe that Okun's Law is gone as you might have about the demise of the Law of Gravity.

The graph below shows an admitedly very crude econometric rendition of the Law using annual data from 1948 to 2011 (data available here). It says that if you grow approximately 1,91%, then the unemployment rate falls 1%, which is close to the 2 to 1 ratio to be expected.
Further, and more importantly, note that what Okun's Law says is that productivity is pro-cyclical. That is, unemployment changes less than output, so in a boom you hire less workers, since they are more productive and can increase output more than proportionally, while in the recession you fire less workers than you would need to produce given the fall in output, meaning that their productivity falls (usually explained as a result of the costs of training the labor force, so firms keep workers idle, because in a boom it would be worse if they had to retrain the labor force). Graph below shows the evolution of output growth and productivity growth for the same period.
Clearly labor productivity was and still is pro-cyclical. Sure enough in very short periods you might have that the relation between output an hiring changes, and it gives the impression that the Law is broken. Also, it might happen that the magnitude of the relation is variable, and you have less hiring with an increase in output (like in a jobless recovery, which would be the last three recoveries including the current).* But the Law still works, that is, more output does lead to more hiring of workers at a less than proportional rate, and labor productivity is pro-cyclical.

Note that, in part, the political reason for suggesting that Okun’s Law is broken is to argue that expansionary policies cannot solve the unemployment problem. That argument is bogus. So don’t worry, Okun is doing fine. Be happy!

* I personally believe that the changes, and the so-called jobless recoveries, are not directly related to the Okun component of the relation between growth and productivity, but to the long run or trend component (the so-called Kaldor-Verdoorn's Law). I have written on the subject here (or here).

Thursday, August 23, 2012

Nick Rowe on Reswitching and the Capital Debates

Nick Rowe gives a shot to the capital debates, which is a nice development indeed. [Robert Vienneau has a lenghty reply here.] In spite of the importance of the topic, and the previous engaging of mainstream economists like Samuelson, Solow – to cite two prominent ones – the topic has all but vanished from modern mainstream economics, with a consequent loss of understanding.

Let me clarify a few things before we get to Nick’s post. As I argued in a previous post, classical authors (e.g. Smith, Ricardo and Marx) understood that they needed to determine the rate of profit independently from relative prices to avoid circular reasoning. The Labor Theory of Value (LTV) provided a solution. Prices were determined by labor incorporated (or commanded for Smith) and profits, and the surplus, were determined on that basis [Sraffa’s solution to the problems with the LTV build on Ricardo’s use of a commodity, corn, to measure the profit rate as a ratio of two physical quantities]. However, most neoclassical/marginalist authors today are completely oblivious to the fact that their theory too must deal with the independent determination of the rate of profit and relative prices, and that this is problematic if you also accept the notion of a uniform rate of profit (a natural rate of interest).

Also, and before I show why the problem is a general one, that any theory has to deal with it is essential to note that the rate of profit and the rate of interest must be in the proverbial long run (when everything is flexible and there is no ceteris paribus) in equilibrium. That is, either the rate of interest adjusts to the rate of profit (the position taken by Ricardo and Wicksell, which called the real variable the natural rate of interest), or vice versa (as Tooke and Sraffa believed; Marx and Keynes pose more problems to be clearly defined, but I would put them in this camp too).

In the case of neoclassical economics, if you want to determine the natural rate of interest by the interaction of the discounted profitability of investment and the intertemporal savings (i.e. consumption) decisions of agents, you must be able to bring the gains to present value (as in the examples provided by Nick). That means that the discount rate (to bring the investment schedule to present value) must be known, while the rate of interest you want to determine requires knowing the value of investment (the demand for capital goods). Thus, we encounter the circularity of the determination of the natural rate of interest in the Loanable Funds Theory, noted by Joan Robinson long ago.

Note also that the process implies that the rate of interest (which in equilibrium is equal to the rate of profit) is a variable that is determined by intertemporal decisions, which must equalize the rate of profit associated with the production of capital goods (i.e. produced means of production). What happens if, as Nick suggests, “There isn’t just one future period; there are many future periods.” Nothing much really happens, since for all those possible future periods, there must be a uniform rate of profit. For several different capital endowments, or several different sets of preferences (which seems to be what Nick has in mind), the interaction of investment and savings will solve for the rate of interest. But the inconsistency is still there.

But really what Nick is suggesting is that one might have a multitude of interest rates (which he refers to as the term structure, but think more of a term structure of interest rates associated with different capital goods, rather than financial ones, even if you do have monetary rates too). In fact, that is exactly what the mainstream did, when they changed the notion of equilibrium, as noted by Garegnani in his 1976 paper. It was only then, after the capital debates, that the Arrow-Debreu (AD; not Anno Domini) intertemporal general equilibrium notion became dominant. In that case you must give up the notion of a uniform rate of profit. Note that you cannot have both (in his replies to my comments Nick seems to believe that you can have it both ways; scroll down for the various comments which are worth reading I might add).

Nick says:
“I hadn't realised, until I read your comment just now, that *maybe*, when some people talk about “uniform rate of profit”, they mean something very different to what I thought they meant. I thought they meant: A uniform rate of profit across different industries (adjusting for or ignoring risk). But you seem to mean: A uniform rate of profit across different periods of time (i.e. a flat term structure). I would say that arbitrage is what creates a uniform rate of profit across different industries (or different assets). I would say that *nothing* creates a uniform rate of profit across different periods of time. The term structure is not (in general) flat. It could slope either up or down, or wiggle around. Even if we are talking about Wicksellian “natural” rates of interest. E.g., if everyone wants to go on a big consumption binge every 7 years, and fast for the remaining 6 years, (and if everyone knows about this), we are in general going to see a big spike in the term structure at 7 year terms.”

So let me clarify what I mean. Capital goods, the produced means of production, are an heterogeneous set of goods, but if one believes in competition (in the classical sense of free entry) then one must believe that a uniform rate of profit on the supply price of those goods will be established (not as a real world phenomena, but as a tendency; the long run is a theoretical construct). So what is established by free entry (and not arbitrage, which would be associated with the equalization of prices in an exchange economy) is a uniform rate of profit across sectors.

So what does that mean about the term structure? First, the term structure of monetary rates (i.e. the Fed Funds versus the ten year Treasury bonds) depends on the actions of the central bank, among other things (and I’ll let that for another post; mind you as you see I tend to think the monetary rates rule the roost, as Tooke and Sraffa). Nick is talking about the real or natural rate, having for reasons associated with the demand (the preferences about consumption in the future) different levels. That is, there would be more than one natural rate, associated with different preferences regarding consumption [echoes of the Sraffa-Hayek debate about the existence of several own rates of interest perhaps].

Yet, the point still is whether you have competition (free entry) or not. So if more people, as in Nick’s example, want to consume more in 7 years, wouldn’t the supply of capital adjust, to provide more in that year allowing for the consumption binge, and reduce the gains associated with providing more goods in that period? After all there is no reason for profitable opportunities, unless there are imperfections (e.g. lack of capital mobility or lack of information, which does not seem to be what Nick is arguing, since he says that "everybody knows"), to be left unfulfilled. The intertemporal nature of the decisions, meaning the decisions are being made now with all the information available about the future, does not affect the equalization of the rate of profit (interest). So competition should also lead to a uniform rate of profit not across different periods of time, but now for different states of preferences and the capital endowments (and technology of course).

Hence, the existence of a myriad of capital goods, or changing preferences (or technological change, which used to be the one that the capital debates concentrated more), do not per se justify abandoning the notion of a long term uniform rate of profit. That is what the AD model does. In the process it abandons the classical notion of competition (free entry) for one that has less meaning from the point of view of understanding capitalism (atomistic agents that are price takers; both links to the New Palgrave require subscription I'm afraid).

Note that the centrality of the results of the capital debates is that one cannot say that changes in relative prices govern decisions about the allocation of resources in any clear way. Not only capital will not be used more intensively with lower rates of interest (even if lower rates of interest may stimulate other forms of demand, not capital, and eventually lead to more demand for means of production), but also lower real wages (the relative price of labor force) might not lead to higher employment. Think of the policy implications of this result for Europe now.

But let me finish saying that beyond the differences we might have, real or of interpretation (and I think both things play a role), I think it is important to thank Nick for thinking about the relevance of these issues and taking them seriously, which can only lead to clarify differences and provide a better understanding, if not of the real world, about what economists think about the real world. And that is a step in the right direction.

Tuesday, August 21, 2012

Full employment, why it is important

In my intermediate macroeconomic classes at the University of Utah I always start by asking students what do they think is a more socially relevant problem an increase in inflation of 1% or the same 1% rise in the unemployment rate. Although the answers vary somewhat according to the macroeconomic circumstances, it is almost always true that the vast majority of my students think that inflation is the real problem.

When pressed on why do they think inflation is worse than unemployment they rarely suggest that inflation may hurt the poor more than the affluent, which would show a concern with income distribution, or seem to understand that moderate inflation might be good. Further, they have no idea that deflation is considerably worse than inflation, and that the reason for that is that deflation causes severe unemployment. The point is that they seem to think that unemployment does not hurt them more than inflation; after all they are getting a college education (which is not much of a guarantee these days, but I leave that issue for another post).

I then tell a personal story about inflation and unemployment and why one should be concerned with unemployment. In the Fall of 1999, fresh out of graduate school, I was hired as the Assistant Director of a small think tank. As I learned afterwards, there were another 5 candidates for the position. The average unemployment rate in 1999, I might add, was approximately 4.2 (see here). As it turns out I had another interesting piece of information that one seldom has about a particular position, namely: the number of applicants for the same position the previous time it opened up in 1995.

I always ask my students then, if you know that the rate of unemployment was around 5.6% (here again), that is, 1.4% higher than in 1999, how many people do they think applied for that same position back in 1995. They never get anything close to the 300 or so that vied for the job. In other words, in this particular case, a 1.4% higher unemployment rate implied an overwhelming difference in terms of competition. Of course one cannot, and should not generalize from one observation, but the anecdotal information fits the more substantive evidence for a tight labor market in the late 1990s, in which we actually saw increases in real wages for average workers in the Unites States.

If for no other reason, students, and everybody else, should be concerned with unemployment, because 1% more in the rate can hurt considerably more than the equivalent change in prices [ and that is why Okun's Misery Index, which adds the unemployment and inflation rates makes little sense; it mixes apples and oranges]. But even further, it is important to remember that whereas inflation hits everybody more or less equivalently – even if people have different consumption baskets – unemployment is a divisive social problem, which makes some ‘losers’ and others ‘winners,’ causing deep divisions in society (e.g. immigrants rob our jobs).

It is for that reason that full employment is the most important economic and social policy, the foundation on which to build the other policies. Work defines our lives, to a great extent, and gives dignity to people. And I do not mean just the poor. As I tell my students, I am a big believer in the ethics of hard work, and that is why I think rents and wealth should be heavily taxed, so that everybody needs to work to earn a living. That is full employment for all!

Monday, August 20, 2012

More on Sraffa and the theory of value and distribution

Two posts by Alejandro Fiorito, at the Revista Circus blog, and Robert Vienneau follow up my previous post on Sraffa and the Labor Theory of Value (LTV). The former is on the debate between Garegnani and Samuelson, just published in a book edited by Heinz Kurz. Garegnani, who debated with Samuelson since the latter's seminal paper on the production function as a parable back in the early 1960s, basically argued against the notion that Sraffa's system can be seen as a special case of Walrasian General Equilibrium, which was ultimately Samuelson's position.

Vienneau discusses several issues. One that I think it's particularly relevant is Steedman's view that one might have a positive profit rate and negative aggregate surplus value. Serrano and Lucas (not that Lucas!) have written a paper on the subject which suggests that Steedman's counterintuitive results are basically irrelevant. At any rate, as noted by Robert, "Marxist political economy should remain a live and exciting field of scholarly research," and this is to a great extent possible because of Sraffa's legacy.

Thursday, August 16, 2012

Raúl Prebisch on the business cycle

This paper analyses Raúl Prebisch's lesser-known contributions to economic theory, related to the business cycle and heavily informed by the Argentine experience. His views of the cycle emphasize the common nature of the cycle in the centre and the periphery as one unified phenomenon. While his rejection of orthodoxy is less than complete, some elements of what would become a more Keynesian  position are developed. In particular, there is a preoccupation with the management of the balance of payments and the need for capital controls as a macroeconomic management tool, well before Keynes  and White's plans led to the Bretton Woods agreement. In the process it is clear that Prebisch developed several ideas that are still relevant for understanding cyclical fluctuations in the periphery and that he became more concerned with the ability to take advantage of cyclical booms to maintain sustained economic growth.

Read the paper here.

Tuesday, August 14, 2012

Alternative Theories of Competition

New book by Cyrus Bina, Patrick Mason and Jamee Moudud has just been published. A few friends from the New School and elsewhere, and at least one alumnus from the University of Utah. From the jacket:

"The history of policymaking has been dominated by two rival assumptions about markets. Those who have advocated Keynesian-type policies have generally based their arguments on the claim that markets are imperfectly competitive. On the other hand laissez faire advocates have argued the opposite by claiming that in fact free market policies will eliminate "market imperfections" and reinvigorate perfect competition.

The goal of this book is to enter into this important debate by raising critical questions about the nature of market competition in both the neoclassical and Kaleckian traditions

By drawing on the insights of the classical political economists, Schumpeter, Hayek, the Oxford Economists' Research Group (OERG) and others, the authors in this book challenge this perfect versus imperfect competition dichotomy in both theoretical and empirical terms. There are important differences between the theoretical perspectives of several authors in the broad alternative theoretical tradition defined by this book; nevertheless, a unifying theme throughout this volume is that competition is conceptualized as a dynamic disequilibrium process rather than the static equilibrium state of conventional theory. For many of the authors the growth of the firm is consistent with a heightened degree of competitiveness, as the classical economists and Schumpeter emphasized, and not a lowered one as in the conventional 'monopoly capital' and imperfect competition perspectives."

Contributions by Rania Antonopoulos, Serdal Bahc¸e, Cyrus Bina, Scott Carter, Benan Eres, Jason Hecht, Jack High, William Lazonick, Andrés Lazzarini, Fred S. Lee, J. Stanley Metcalfe, Jamee Moudud, John Sarich, Anwar Shaikh, Persefoni Tsaliki, Lefteris Tsoulfidis, and John Weeks.

Sraffa and Marxism or the Labor Theory of Value, what is it good for?

An old, but not completely closed, debate revolves around whether Sraffa was a Marxist or instead he should be seen as Ricardian, hence the term Neo-Ricardian used derisively by Bob Rowthorn (subscription required) and other Marxists authors (and also by Frank Hahn, again subscription required). From a personal point of view there is little doubt that Sraffa identified with Marxism, and close friends like Antonio Gramsci and Maurice Dobb would agree. But the important question is whether his contributions in Production of Commodities by Means of Commodities (PCMC) should be seen as a development or a criticism of Marx's theoretical tradition.

For the most part the question revolves around the relation between Sraffa's prices and the labor theory of value. Several authors tend to believe that the latter theory is central for Marx's theory of exploitation. Recent interpretations such as the so-called New Interpretation (NI) and the Temporal Single System (TSS) would agree on that point.

For example, Foley and Duménil (2008; subscription required) argue that:
"Central to Marx's framework of analysis in Capital is the labour theory of value (LTV), which defines the value of a commodity as the ‘socially necessary’ labour time required by its production, that is, the labour time required by average available techniques of production for workers of average skill. 
The LTV is central to Marx's theory of exploitation, a term he uses to describe a situation in which one individual or group lives on the product of the labour of others."
On the similar claims by the TSS Marxism see Mongiovi (2002; subscription required). [Vienneau provides a list of readings on the TSS topic here.]

The question then is what was the role of the labor theory of value in Marx and the classical authors, i.e. for the surplus approach. The initial problem that Smith was trying to deal with the LTV was to determine the rate of profits independently of prices, since profits were considered essential for capital accumulation. Note that one needs the prices to determine profits, in particular the price of the means of production advanced for production, but one needs the rate of profit (the normal uniform rate of profit) to determine long term normal (or production) prices.

Smith (1776, book I, chapter 6) makes the value of commodities depend on the quantity of labor required to produce them is where there has been no accumulation of capital or land. In his words:
"In that early and rude state of society which precedes both the accumulation of stock and the appropriation of land, the proportion between the quantities of labour necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them for one another."
But when profit and rent make their appearance alongside the worker's income, the rule is no longer applicable. The price of a commodity is then obtained by 'adding up' its component parts, namely: wage, profit and rent. The adding up theory implied that profits and wages had an independent determination. Hence, if profits went up, and prices too, real wages might not decrease. As a result, one cannot determine profits independently of prices.

Ricardo saw the limitations of the adding up theory. In his early writings he solved the problem by presuming that the economy produced corn (grain) with corn and labor, and the surplus was a physical amount of corn, so the rate of profit could be measured as ratio of corn (the surplus) to corn (the means of production advanced for production). He, then used, the labor theory of value as an approximation to the solution in his Principles, knowing that prices were not exactly proportional to the amounts of labor directly and indirectly used in production.

That was, also, essentially the role of the LTV in Marx's volume I of his masterpiece Capital. That is, the LTV allows Marx to determine the rate of profit independently of prices. Note that Marx was also aware that relative prices determined by the amounts of labor directly and indirectly incorporated are incorrect once you have produced means of production. However, Marx thought that embodied labor redistributed by the process of competition meant that in the aggregate total surplus value  corresponded to total profits, even if prices of production deviated from embodied labor. As a result, on the basis of the LTV it was still possible to obtain the correct rate of profit. As it turns out, there is no reason for positive and negative deviations of prices of production from the labor values to cancel out. You cannot argue with the algebra.

Marx had no way of knowing this. Only with Bortkiewicz, Dimitriev and Tugan-Baranovsky's work, early in the 20th century, this was clearly understood. If in general commodities do not exchange at labor values, then there is no reason why that should be correct for two composite commodities that make the total physical surplus and the physical advanced means of production.

Sraffa's solution, based on the standard commodity (to be discussed in another post), shares with Ricardo's corn model the idea that one can measure the rate of profit as a share of a particular commodity (Sraffa's being a composite commodity, that is, composed of several goods). It also shares with Ricardo the fact that only basics (commodities that enter the production of all goods including their own production), which for simplicity can be related to subsistence goods, affect the rate of profit, while non-basics, or luxury goods, are not relevant. Further, as noted by Sraffa too, his solution resembles Smith's since the standard commodity can be seen as akin to the former's idea of labor commanded, that is relative prices are proportional to the amount of labor that they can command (buy). In that sense, Sraffa's prices are firmly based on a certain notion of the labor theory of value.

Mind you, in the central issues Marx's theory was correct. Once you determined exogenously the real wage, and the technical coefficients of production are given, one can determine the rate of profit, and it is inversely related, everything else constant, with the real wage. Hence, the theory of distribution based on class conflict which is the central element of the surplus approach, including Marx, is logically consistent [which is more that can be said about marginalism, as showed by the capital debates].

But does the Sraffian system mean that exploitation as interpreted by Marx is not valid anymore, since, as noted above, some Marxist authors think that the LTV (narrowly interpreted as prices of production proportional to embodied labor) is essential for that part of the Marxian project? Petri (2012)* has published an excellent review of the limitations of the NI and TSS. He clearly states (p. 3) that:
"The proof that labour is exploited, in particular, does not lie in the validity of a quantitative correspondence of surplus exchange value with surplus labour time; this is a misconception that derives from a mistaken acceptance of the argument that the inability to prove such a correspondence might mean that the capitalists contribute to production, that profits reflect their contribution, and that this is the reason why commodities do not exchange in proportion to labours embodied – the argument of the ‘vulgar’ economists and then of the marginalist critics of Marx" (emphasis added).
Why is that the case that there is no correspondence between the LTV and whether labor is exploited or not? Note that for Marxists this is a necessary condition because workers work more time than what is needed for their reproduction, and that is the supposed basis for exploitation. It is worth quoting Petri at length here:
"Imagine an isolated market economy where production is carried out by self-employed artisans and cooperatives, and the rate of profit is zero: prices of production are proportional to labours embodied. One day Gengis Khan’s army invades this community, but instead of killing everybody Gengis Khan announces that he will be content with collecting a yearly monetary tax at a rate r=20% on the value of the capital employed in each productive activity, a tax he will then use to buy goods on the market. The community is obliged to accept, and prices of production come to include a 20% tax on the value of capital which has the same effect on relative prices, and on real wages, as a 20% rate of profit. Relative prices are no longer proportional to labours embodied, Marx’s r=S/(C+V) does not work, but production is still performed by the same labourers, and the goods appropriated each year by Gengis Khan with the income deriving from the tax do not reflect any productive contribution of the oppressors. One would have little hesitation, it would seem, to say that Gengis Khan is exploiting this community. But if Gengis Khan had imposed the tax as a given percentage of wages, with the rate of profit remaining zero, then relative prices would have remained proportional to labours embodied, but exploitation would be still there. On the other hand, imagine that the 20% tax rate on the value of capital is imposed not by Gengis Khan but by unanimous popular vote because it is decided to use it to help for some years another community struck by an earthquake: in this case the surplus product would again be associated with an impossibility to explain prices with the labour theory of value, but few would call the surplus product the fruit of labour exploitation. All this shows that the proportionality or non-proportionality between exchange values and labours embodied reflects, not the absence or presence of other productive contributions besides that of labour, but only the specific way the mode of appropriation of the surplus product affects relative prices; the origin of the surplus remains to be ascertained" (emphasis added).
Hence, as the simple example shows one might have exploitation without the LTV, and no exploitation with the LTV, which should be a black swan for those that think that Marxism stands or falls with the narrow definition of the LTV. For our purposes what matters is that the correct solution of the problem of the determination of the rate of profit independently of prices, provided by Sraffa, actually strengthens and is a development of the theories of Marx and the other authors of the surplus approach. Sraffa is the author that makes Marx's conclusions possible.**


* Petri provides a critique of NI and TSS solutions of the transformation problem too. A different solution, that is more Ricardian in assuming that embodied labor provides a good empirical approximation to production prices, is provided by Shaikh (1977).
** Interestingly Petri quotes several passages in which Foley tends to suggest that Marxism and marginalism are not necessarily incompatible.


Foley, Duncan and Gérard Duménil (2008). "Marxian transformation problem." The New Palgrave Dictionary of Economics. Second Edition. Steven N. Durlauf and Lawrence E. Blume. (eds.), The New Palgrave Dictionary of Economics. Palgrave Macmillan.

Mongiovi, Gary (2002). "Vulgar Economy in Marxian Garb: A Critique of Temporal Single-System Marxism," Review of Radical Political Economics, 34(4), pp. 393-416.

Petri, Fabio (2012). "On Recent Reformulations of the Labour Theory of Value," Quaderni del Dipartamento di Economia Politica e Statistica, Università degli Studi di Siena, No. 643.

Shaikh, Anwar (1977). "Marx's Theory of Value and the Transformation Problem,"in Jesse Schwartz (ed.), The Subtle Anatomy of Capitalism. Goodyear Publ. Co.