Rational expectations, New Classicals, and Real Business Cycles Schools

  

A video conversation with LP Rochon and my co-author Bill McColloch on our chapter for the forthcoming book on the history of ideas. Many topics, including Friedman vs Lucas relevance, the Lucas critique, the empirical turn in the profession, and more. More info on the book soon.

The Economist thinks bubbles are rational

Or at least is what they suggest in the popular blog Free Exchange. They bring back Peter Garber's research on the Tulipmania, and more recent research by Earl Thompson, which suggests that "the market for tulips was an efficient response to changing financial regulation." They conclude by arguing that:

"It is easy to claim that bubbles are irrational. They seem to represent a deviation of prices from fundamental values—and they contradict basic economic theory. But there has been little attempt to understand how speculation actually works. The example of tulipmania shows the importance of doing that—rather than relying on lazy quips about 'animal spirits' or irrationality."

The notion is related to the idea of the Arrow-Debreu models in which short term prices (they don't have long term prices associated with a uniform rate of profit) do reflect the fundamental values associated to the preferences of agents and the given technology and factor endowments. In this context, the efficient market hypothesis (EMH) suggests that the prices of financial assets reflect all market information, and as a result those prices would not deviate from their fundamentals. In other words, according to the EMH, bubbles do not exist.

Rational bubbles assume that rational behavior may still be associated with deviations of asset prices away from their fundamental values. In general, a self-confirming belief that asset prices depend on a variable that is intrinsically irrelevant, that is, not part of market fundamentals, is assumed. Much discussion goes into the behavioral assumptions that would make rational bubbles possible. Justin Fox's The Myth of the Rational Market, which I reviewed here (subscription required) provides an accessible introduction.

John Eatwell (here; subscription required) noted that a more relevant question than the rationality or not of bubbles is whether they are useful or not. Railroads were built on bubbles, and the dot.com bubble even left some infrastructure in terms of telecommunications that has been useful. Other bubbles, like the one associated with the subprime, are less obviously useful.

Finally, note that the old capital debates are still important to understand the limitations of much of this literature. Garegnani and Petri have noted that even the short run Arrow-Debreu models must bring investment to equality to full employment savings, and as a result some notion of a natural rate of interest is implicitly needed. And then all the problems of the aggregative model apply. So it is not possible to show that long term prices do reflect fundamentals associated with preferences, technology and endowments.

PS: On the related topic of whether the Bubble Act (financial regulation), that followed the South Sea Bubble, led to lower rates of growth see here. For the capital debates go here.

New issue of ROKE is now out

The new issue of the Review of Keynesian Economics, with papers by Jerry Epstein, Jane Knodell, Bill McColloch, Valerio Cerretano, Juan Matías de Lucchi and Esteban Pérez and an introduction by the President of the Central Bank of Argentina, Mercedes Marcó del Pont, is out. Papers have, for the most part, been presented at the central bank, and are on the issue of the role of central banks in economic development. Enjoy!

Crowding out and the Industrial Revolution

A while ago I posted on Bill McColloch's paper on the role of financial regulation during the 18th century. One of the arguments that Bill's paper tries to refute is the idea that the revisionist views that suggest slower growth in England during the Industrial Revolution (Crafts and Harley here; subscription required) was caused by crowding out (see, for example, Jeffrey Williamson here). Bill correctly points out that interest rates remained low in England.

The graph below, from Dickson's classic book on the Financial Revolution shows that throughout the 18th century interest rates actually fell.

More importantly, British rates remained well below the levels of the French ones, and gave a significant advantage in their quest for global hegemony, as the graph below shows (source here).

Note that even if one accepts the lower rates of growth suggested by Crafts and Harley, the explanation for the lower rates of investment should not be that surprising. Yes, the accelerator. Lower levels of growth imply one needs lower levels of investment in order to adjust supply to growing demand.

A Shackled Revolution? The Bubble Act and Financial Regulation in 18th Century England

New Working Paper by Bill McColloch, which refutes anti-Keynesian (crowding out) views on the Industrial Revolution (IR). From the abstract:

"Revisionist estimates of growth rates during the British industrial revolution, though largely successful in presenting a more modest picture of Britain’s ‘take-off’ prior to the 1830s, have also posed fresh analytical difficulties for champions of the new economic history. If 18th-century Britain was witness to a diffuse explosion of ‘useful knowledge,’ why did aggregate growth rates or industrial output growth rates not more closely shadow the pace of technological change? In effort to explain this paradox, Peter Temin and Hans-Joachim Voth have claimed that a few key institutional restrictions on financial markets – namely the Bubble Act, and tightening of usury laws in 1714 – served to amplify the "crowding out" impact of government borrowing. Against this vision, the present paper contends that the adverse impact of financial regulation and state borrowing in 18th century Britain has been greatly overstated. To this end, the paper first briefly outlines the historical context in which the Bubble Act emerged, before turning to survey the existing diversity of perspectives on the Act’s lasting impact. It is then argued that there is little evidence to support the view that the Bubble Act significantly restricted firms’ access to capital. Following this, it is suggested that the “crowding out” model, theoretical shortcomings aside, is largely inapplicable to 18th century Britain. The savings-constrained vision of British capital markets significantly downplays the extent to which the Bank of England, though founded as an institution to manage the public debt, provided the entire financial system with liquidity in the 18th century."

The paper by Temin and Voth is here. Their recently published book is here.

Crafts and Harley's re-interpretation of the IR in Britain, alluded to in the text, is available here (subscription required). The classic book on the British IR that Crafts and Harley try to supersede is by Deane and Cole (here). A discussion of the two views by Temin is available here.

On whether the British government had a role in financing the IR, it is worth remembering Pressnell's (subscription required) words, for whom:

"Amongst the half-truths of economic history is the generalization that British Governments did not finance the Industrial Revolution. That public financial aid was not a regular and conscious process cannot be doubted; equally, it is indisputable that Government was not distinguished during the eighteenth and early nineteenth centuries by the provision of financial facilities commensurate with a period of economic expansion. In practice, however, a considerable volume of public money swelled the funds of private bankers, and in this indirect fashion helped to fructify private enterprise."

Pressnell suggests that country bankers were often tax collectors, and closely related to industrial activities. The incredible growth of public debt, to 260% of GDP by the end of the Napoleonic Wars, and the increase in government revenue to pay for debt service, implied a signiifcant increase in liquidity which is associated to the financing of the IR.

PS: Newton (pictured above) lost his pants in the South Sea Bubble, and also was famous for getting the exchange rate between gold and silver wrong (he was the Master of the Mint), leading to hoarding of silver, and the beggining of an effective Gold Standard in Britain.

What makes capitalism capitalism?

So I had a debate (the sort of debate you can have with 140 characters) in Twitter a few days ago with Unlearning Economics and Jonathan Finegold, among others (links are to blogs not to the twitt feeds). The main question was the definition of capitalism. It is a peculiar feature of modern economics that very few mainstream authors would actually discuss the issue directly, even if there has been a revival of some related issues associated to the relevance of institutions (vis-à-vis geography and culture) in the rise of the West. Robert Heilbronner used to say that the best kept secret in economics is that it was is about the study of capitalism.

I'm not going to get too much into the topic here, but it is worth a brief summary. As discussed before (here) in the blog, the surplus approach suggests that economics is the study of the material reproduction of societies. The existence of a surplus allows for specialization and progress, and the ways in which the surplus is produced and distributed is central for the understanding of reproduction. Broadly speaking, what Marx referred to as a mode of production is comprised of two elements, the material conditions of production or the forces of production, which include the means of production that incorporate a certain technology, and the social relations of production, which include the organization of production and the customs, laws and rules that guarantee the property of the means of production.

For Marx the manifestation of the capitalistic character of the manufacturing process is that the workers do not own the means of production and must sell their labor power. The reason being that an essential condition for capitalists to be able to buy labor power is that workers do not own means of production and are forced to sell in the market their labor force (see Capital, Volume I, Part II, chapter 6). The essence of the capitalist system is that workers sell their labor force, and are in this particular way exploited. That's the specific way in which capitalists obtain a surplus beyond what is necessary for social reproduction.

On the notion of the mode of production Marx perceptively tells us (Vol. I, Book I, Part I, ch. 1) that:

"The mode of production in which the product takes the form of a commodity, or is produced directly for exchange, is the most general and most embryonic form of bourgeois production. It therefore makes its appearance at an early date in history, though not in the same predominating and characteristic manner as now-a-days. 

Even Adam Smith and Ricardo, the best representatives of the school, ... treat this mode of production as one eternally fixed by Nature for every state of society ..."

That's exactly what Max Weber (and many modern authors too, by the way) does. He often refers to capitalism when discussing the middle ages in Western Europe, or ancient China, or the Roman Empire (see for example his General Economic History). This naturalization of capitalism is also typical of mainstream authors, that tend to confuse the existence of markets, or the profit motive, with capitalism.

Production for exchange in the market existed for sure before modern times, and so did exploitation. But the difference with previous modes of production is not simply the more developed material conditions of production associated with the factory system and machinery. It is the specific social arrangement that allows capitalists to control the means of production and extract a surplus from workers that must sell labor power in the market, and are liable of being exploited (more or less according to their bargaining power) that sets capitalism apart. So it is the way in which labor is exploited, one in which workers sell labor power in the market, that makes capitalism capitalism, so to speak [this has interesting implications in the Dobb and Sweezy debates on the transition from feudalism to capitalism, for example, that I'll leave for another post].

Note that while this definition of capitalism is clearly Marxist it builds up on the surplus approach, and is one of (not the only one either) the main contributions of Marx to the surplus tradition (he was critical of the bourgeois elements of classical economics, but built on the analytical structure of the school). In fact, Turgot and Smith both describe the evolution of societies in terms of stages related to the mode of production. It is the economic character of production that governs other aspects of social relations. The four stages were hunting, pasturage, agriculture and commerce. Bill McColloch suggests (see here) quite convincingly that Marx builds on the work of Steaurt.

Also, note that the notion that the profit motive is the differentia specifica of capitalism is tied to the typical methodological individualistic stance of the mainstream. It is hard to say, however, that individuals (merchants, for example) in previous modes of production (say in the ancient mode of production, which was based on slavery) had no desire for profits. If they did, however, what's different about capitalism? That's also why all the alternative theories of history (to the surplus approach) tend to fetichize the role of the entrepreneur (see Landes's last book for the epitome of that approach, which was also displayed in the History Channel's The Men Who Built America). It's the return of Carlyle's hero-worship and the Great Men theory of history.