Household's financial burden

Matt Franko, via Mike Norman, shows that household financial obligations as a share of disposable personal income is at almost the level of the early 1980s. Deleveraging has been accomplished to a great extent. In part, this results from the Fed's low interest rate policy. However, if wages do not go up, or government does not step up spending, then only another bubble will get the economy going. Hope it doesn't come to that.

I'm out of here (for a few days at any rate). Happy New Year to all!

To Failure

The ministry of silly budgets

Philip Larkin was wrong; failure actually does come dramatically indeed. Or so it seems if you look at the failure of the fiscal policies of the Tory cabinet. John Lanchester has a great piece in the new issue of the London Review of Books showing the perverse effects of austerity. Yes the multiplier works, and it is rather large he contends.

As much as the story of the Cameron/Osborne failure [they've promised to reduce the deficit from 4.8% of GDP to 1.9% and delivered after two years a mild hike to 4.9%], or the problems with the 'independent' Office of Budget Responsibility [you have to love the name, it's like they work for the Ministry of Silly Walks] and the additional nuggets on IMF revisionism, there is an interesting take on the history of economic ideas.

Lanchester correctly points out that:

"About thirty years ago, when Keynes was in the depths of economic unfashionability, going up to a group of macroeconomists and trying to start a conversation about the multiplier would have been roughly like going up to a group of astrophysicists and trying to start a conversation about your star sign."

Lucas suggested that if you talked about Keynes at a conference people would giggle. Note that Richard Kahn, the one that formalized the multiplier in 1931, one of the few theoretical concepts that has direct economic policy applications and is passible of empirical falsification, did not win the Sveriges Riksbank Prize (known as the Nobel).

Even better, he actually gets a good definition of what would be essential in economics. In his words:

"Richard Feynman was once asked what he would pass on if the whole edifice of modern scientific knowledge had been lost, and all he could give to posterity was a single sentence. What axiom would convey the maximum amount of scientific information in the fewest possible words? His candidate was ‘all things are made of atoms.’ In a similar spirit, if the whole ramshackle structure of contemporary macroeconomics vanished into thin air and the field had to be reconstructed from scratch, the sentence which packs as much of the discipline into the fewest possible words might be ‘governments are not households’ (Italics added)."

Mine would be 'demand determines income,' but we are splitting hairs. The orthodox would be either 'markets are efficient' or 'supply creates its own demand.' And here lies a crucial problem. These last two are actually quite well known (Efficient Market Hypothesis and Say's Law), but the heterodox ones are not. Not only we have worse PR, but also when the mainstream fails it is very good at avoiding any blame. In fact, even Lanchester, in an otherwise perceptive discussion, falls into the trap that a good one sentence definition of the field of macroeconomics would be "nobody knows anything." Not true, 'the mainstream knows very little' would be better.

Thelma and Boehner or going off the fiscal cliff

Brad DeLong thinks we're going off the fiscal cliff. Brace yourselves then. What to expect, according to him:

"Running up to the explosion time of the austerity bomb has already reduced likely year-2013 real GDP growth from 3.0% to 2.5%. If no deal is reached until June 30 then our likely year-2013 real GDP growth rate will be -0.5%."

Unless I'm confused those look like the estimates of the Congretional Budget Office (CBO), run by

Douglas Elmendorf. According to the CBO:

"if all of that fiscal tightening occurs, real (inflation-adjusted) gross domestic product (GDP) will drop by 0.5 percent in 2013 (as measured by the change from the fourth quarter of 2012 to the fourth quarter of 2013)—reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year. That contraction of the economy will cause employment to decline and the unemployment rate to rise to 9.1 percent in the fourth quarter of 2013."

So the fiscal cliff, which is more or less a decrease of US$ 600 billions in the projected deficit next year, mostly tax hikes with a modest reduction in spending of about US$ 60 billion (not considering feedback effects caused by increased spending as a result of higher unemployment), will lead to a mild recession.

So not the end of the world, but not good. But better than destroying social security for sure. And yes, by February we'll be talking about the debt ceiling again.

PS: Yep, I know, in the cartoon it is the Aztec Sun Stone not the Mayan calendar.

PS': On the broader problems with the fiscal cliff and why the consensus that we need fiscal adjustment of some sort is incorrect read Jeff Madrick's piece at the NYRB.

Joan Robinson on neoclassical economics

Given Krugman's involuntary reopening of the discussion on the capital debates and the limits of neoclassical/marginalist economics, it would be good to hear this audio (here and here; not very good quality) of a lecture given by Joan Robinson (with a brief intro by Don Harris). H/t F*#k Yeah Piero Sraffa.

Technological Progress and the Capital Labor Ratio

So Krugman is again trying to make sense of his marginalist theory of distribution and the choice of technique. He suggests the following graph, which I slightly modified, to express the possibilities available to the firm.

The profit maximizing firm will choose the 'labor-intensive' technique to the left of the intersection level between the two techniques. For example, at L/Y=0.4, where there is a vertical dotted line, now the firm needs less capital per unit of output (around half, approximately 0.3, rather than 0.6) to produce one unit of output. To the right of the intersection the opposite applies.

Note correctly that, as is well known by Krugman, the neoclassical theory of distribution applies here. The slope of the techniques is given by the negative of the capital to labor ratio, and relative remuneration of capital and labor are associated to the intensity of the use of the factors of production. In his words:

"and if you’re worried, yes, workers and machines are both paid their marginal product."

That is why the firm uses the labor intensive technique as real wages fall, and technical progress is associated with worsening income distribution. There is only one problem. The linear technologies of his example presume that all sectors have the same capital to labor ratio. That is a very peculiar assumption (the same needed for production prices to be determined by the amount of labor directly and indirectly incorporated in production, or what Marx referred to as the same organic composition of capital, by the way). If that proposition is dropped the whole thing is incorrect (see here).

Samuelson (1966; subscription required) was well aware of the problems brought about by the special assumption of his Surrogate Production function. It's time Krugman reads some of Samuelson's classic papers.

PS: Note that Krugman's point here is that maybe worsening income distribution was caused by technical progress, something he has been trying to deny in his recent research, suggesting that the increase in inequality was caused by political factors (conflict) and not skill biased technical change (technology). Make up your mind dude!

PS': Might be good to quote Samuelson directly. According to him (1966, pp. 582-83):

"There often turns out to be no unambiguous way of characterizing different processes as more 'capital-intensive,' more 'mechanized,' more 'roundabout,' except in the ex post tautological sense of being adopted at a lower interest rate and involving a higher real wage. Such a tautological labeling is shown, in the case of reswitching, to lead to inconsistent ranking between pairs of unchanged technologies, depending upon which interest rate happens to prevail in the market."

A tautology that may lead to mistakes. That's what marginalism produces when you want to understand income distribution and technical change.

How do you measure economic success II

Follow up on my previous post on Argentina. One of the typical critiques is that the current government has run very large fiscal deficits, spending well beyond its means. Figure below (Ferreres numbers again) shows the primary (without financial payments) and nominal fiscal balances.

Yep, no primary deficits at all until 2009. In fact, no primary fiscal deficit since 1990. And the largest nominal deficit just before the crisis in 2001 was at around 2% of GDP. That is an incredible amount of fiscal restraint. Yes fiscal spending increased, which explains a good part of the boom, but higher income led to higher revenues, with the consequence that the fiscal results have not been unbalanced.

On the state of macroeconomics: fashion versus logic and evidence

Yes there is something rotten in the kingdom of Denmark, and it is macroeconomics; pretty much as in every other country. There has been an ongoing debate on the blogosphere on the topic (see Krugman, Smith, Thoma, Williamson and Wren-Lewis, not in chronological order, by the way). The New Classical versus New Keynesian debate tends to be on two issues the relevance of microfoundations on the theoretical level, and the importance of price rigidities on the empirical side.

Scientists, as Mankiw put it, are the New Classicals that emphasize the microfundations. They have intertemporal maximization models based on rational representative agents. The New Keynesians are the engineers, again using Mankiw's dichotomy, that strive for economic realism. Or so is what you are expected to believe if you read their posts. Of course all of these presumptions are bogus.

Noah Smith correctly points out that they all use the same DSGE models. But Krugman notes that on policy debates the whole difference is based on the assumption of sticky prices. So they use the same models, but reach very different conclusions. Of course the tools are not neutral though. Using DSGE models has hurt the positions that New Keynesian want to take. For example, Krugman has been forced to argue that the reason for the poor recovery is that the natural rate of interest is negative (and hence the current rate is too high to bring investment and savings into equilibrium).

This is a much weaker position than the one taken by heterodox authors that suggest that the crisis is due to lack of demand associated to worsening income distribution over the last three decades, and the consequent expansion of unsustainable private debt to allow for consumption. So the poor recovery is associated to lack of demand, since wages are stagnant and private debt cannot increase (and the GOP is bent in not allowing public demand to grow).

Note that the Godley type models, which follow the heterodox perspective, were much better for understanding and foreseeing the crisis (see here). There is no reason for intertemporal maximization models, and their kind of microeconomics (Sraffians have better stuff for that). New Classicals, Mankiw notwithstanding, are not scientists (or at least not good ones), since their models do have significant logical problems, and you cannot be a good engineer, somebody concerned with practical applications of scientific knowledge, if you share a model that is flawed.

On an interesting note, Krugman's main complain about Noah Smith's position is that he doesn't understand that the New Classicals have basically treated New Keynesians as outcasts. In his words:

"the freshwater [New Classical] types simply didn’t accept the legitimacy of what the New Keynesians were doing — in fact, didn’t even bother to read any of it, because anyone who actually worked with that kind of model would know that fiscal policy can indeed have an effect in that framework."

The problem is that they don't think he is legitimate. In fact, that is true. Williamson says:

"It doesn't surprise me that Paul Krugman isn't up on what is going on in macroeconomic research. Why should we expect him to go to macro conferences, spend time in seminars, and talk to his colleagues at Princeton? He has plenty on his plate, what with delivering two NYT columns per week, blogging, talking to pundits, and giving speeches. But if he's not up on the field, what purpose does it serve to make up outlandish stuff for people to read?"

Indeed Williamson's critique is that Krugman is not up to date, on the cutting edge, Colander would say. So he has missed the last fashion season in macroeconomics. And Wren-Lewis makes a point that he is a Karl Lagerfeld of macroeconomics (not sure if that is a correct fashion quote). Wren-Lewis points out that:

PK [yes, Paul Krugman] was very much at the forefront of analysing the Zero Lower Bound problem, before that problem hit most of the world. While many point to Mike Woodford’s Jackson Hole paper as being the intellectual inspiration behind recent changes at the Fed, the technical analysis can be found in Eggertsson and Woodford, 2003. That paper’s introduction first mentions Keynes, and then Krugman’s 1998 paper on Japan. Subsequently we have Eggertsson and Krugman (2010), which is part of a flourishing research programme that adds ‘financial frictions’ into the New Keynesian model. You would not think of suggesting that PK is out of touch unless you are in effect dismissing or marginalising this whole line of research.

So he is pretty much au courant, according to his New Keynesian friends (and that sounds right to me too, by the way). No fashion problem with Krugman and New Keynesians. They are trendy too. Good for them.

Yet, what it is expected of science is not fashion, but relevance following logic and evidence. And yes Krugman is right, there is evidence for price rigidity, and also no evidence for the sort of theory of distribution implicit in the mainstream neoclassical DSGE models (productivity equals remuneration of factors of production), or for a natural rate for that matter. And that is the problem with Krugman and his New Keynesian friends, too much preoccupation with fashion, not enough with logic and evidence. If the profession remains concerned with fashionable models it will continue to be irrelevant and impractical.

Pimping out Glenn Hubbard

So how much does it take to get Glenn Hubbard's consulting expertise. Matt Taibbi has the scoop.

"So how much does it cost to get the Dean of Columbia Business School to say that Countrywide customers weren't injured by fraud? Well, MBIA's lawyer, David Freeburg, asked Hubbard that very question:

Q. How are you being compensated?
A. I'm being compensated at an hourly rate for my work.
Q. Do you know your hourly rate?
A. Yes, it's $1200 an hour.

For comparison's sake, $1200 an hour is about what Natalia, the woman New York Magazine called "America's #1 escort" in a famous profile many years ago, made early on in her career working for Jason Itzler, the self-described 'King of All Pimps.'"

So the same that a high end, but not top of the line prostitute, according to Taibbi. Seems about right. A must read. The rest here.

Macroeconomics and the financial cycle

Claudio Borio from the BIS has written a widely cited paper. The Economist has linked to it and suggested that so far his advice for including the financial cycle into macroeconomics has only been followed by a few. Besides Borio, Minsky, Godley and Lavoie and Keene are also cited by The Economist. The paper by Borio (he only cites Minsky), which has been a very influential voice suggesting that capital flows were pro-cyclical and more regulation was needed before the financial crisis, is somewhat underwhelming though.

For starters the definition of the financial cycle is based on individual perceptions. In his view, financial cycles result from "self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts." Then there is the question of the theoretical features for modeling the financial cycle according to Borio. There are three that are essential according to him. First, that financial cycles have endogenous causes, second, that debt must be present, and last but not least a different measure of the output gap. The last one is really the central theoretical modification in his scheme [note that heterodox models, like Kaldor's 1940 cycle model were endogenous, and Keynes had debt in the General Theory, in chapter 19 it is central, in fact].

The new output gap measure would include financial variables. He correctly notes that output gap measures take into consideration only inflation, when ascertaining whether the economy is above the potential or not, and that "it is quite possible for inflation to remain stable while output is on an unsustainable path" [and you can have inflation without being at full employment too, I would add]. His measure of the output gap would include information about asset price inflation too (property prices and measures of credit booms) and is shown for the US and Spain as the red line below.

Note that the new output gap shows the economy growing way beyond its potential in both the US and Spain before the crisis, more than in the alternative measures using a Hodrick-Prescott filter (green) and a conventional production function (blue). He concludes that: "potential output and growth tend to be overestimated" by conventional methods. Further, his point when arguing that the cycle is endogenous is that excessive booms are the cause of the collapse, so what is needed is to smooth out the boom. The prescription is to grow less and avoid to surpass the potential level, which is supply determined and exogenous presumably (since no word on this is uttered).*

He wants then to constrain booms, and macroprudential policies should be used for that aim. Further, while noting that in balance sheet recessions (following Koo) it is important to deal with agents losses head on, he suggests that "fiscal policy is less effective than in normal recessions" and that as a result of excessive monetary expansion after the bust "the central bank’s autonomy and, eventually, credibility may come under threat." So one really needs to kill booms, since nothing much beyond re-writing debt down and acting as lender of last resort with moderation can be done after.

I have several problems with these views, even if there are some good things, beyond good intentions, in Borio's paper. In fact, I think that there is significant evidence for the notion that potential output varies with demand expansion (Kaldor-Verdoorn Law), so that if a revision of the way potential output is measured it would be in the opposite direction. Mind you, if you check the chart above it means that Spain now is close to its potential level. I guess the natural rate of unemployment in Spain is around 20% or so (slightly below the current level). Note, also, that in Latin America we have been smoothing the boom with the consequence that our crises are not milder than Asia, but we end up growing less (see the paper by Pérez and Pineda linked here).

However, in my view the biggest flaw in the approach to financial cycles proposed by Borio is the absence of any discussion of how debt-deflation (the balance sheet recessions) affect and are affected by income distribution. There is no understanding of how wage stagnation in the center was as instrumental as financial de-regulation for the collapse, as noted by Barba and Pivetti (link here) or Jamie Galbraith's last book, not by chance called Inequality and Instability. This is again something that heterodox economists have known for a while and that the mainstream still has to learn.

* The reasons for the excess in the boom are associated to excessive finance [which he calls excess elasticity of the system], as in Shin's (2011) global banking glut, and not excessive savings, since he correctly points out that "expenditures require financing, not saving."

Where are we on the Fiscal Cliff?

This graph from the Washington Post shows the several proposals so far. As you can see Obama has been moving on Social Security and Medicare/Medicaid cuts in the direction of Boehner.

Don't get me wrong, but even proposal #1 conceded too much.

PS: To be precise US$ 350 billion too much in the #1 offer (i.e. the entitlement cuts). You may give some discretionary cuts, and negotiate how much you increase the taxes on the rich, but you cannot after winning an election, that clearly meant that people want to preserve Social Security and Medicare/Medicaid, cut those very programs.

Krugman and the natural rate again

Krugman again (re-channeling Hicks) restates his argument that the problem with the US economy is that the natural rate of interest is negative. Note that he also admits, as did recently Goldman Sachs or anybody that looks at data, that the accelerator is what determines investment. Not only his stance has serious logical problems, but also it weakens his own arguments about confidence fairies and so on. And there is no empirical evidence favoring the view that in any period, not just now, non residential investment is significantly affected by variations of the rate of interest. But yes we do need more fiscal expansion, even if lack of full employment is not simply a market failure.

PS: Note that Krugman's second graph, showing the equilibrium of I and S with a negative natural rate, implies that either we had a negative shock to I or a positive shock to S. That is, either a negative productivity shock or a change in preferences about present and future consumption. Real shocks. So what, now he is a Real Business Cycle (RBC) guy? Just drop the natural rate already. Evidence and logic require it.

Energy sources in Latin America and Asia

The graphs below (World Bank data) show the sources of energy in a few selected countries in Latin America and Asia. The first thing to notice is that Asia burns way more coal than Latin America, which tends to depend more on hydroelectric and natural gas sources (the US is a natural gas and coal country, by the way).

One reason for the difference is that Latin America does not have a significant share of the global coal reserves. China and India have a reasonable share (the US has the largest reserves of coal, followed by Russia).

In terms of the environment hydro sources are considerably better for emissions (zero) than coal, but do have other impacts, associated with flooding, reduced streams and negative impact on fish migration patterns among the worse. Natural gas is also better than coal. So Latin America is slightly more environmentally friendly. Coal tends to be cheaper (although fracking may be changing that in the US), which gives a competitive edge to Asian countries.

Note that energy is essential for the functioning of the economy. Lenin said that: "Communism is Soviet power plus the electrification of the whole country." Paraphrasing, capitalism is power to the corporations and electrification of the whole world. Note that this implies that sometimes, at least, the constraint to the expansion of demand could come from a supply restriction. Interestingly enough, more often than not, it still manifests itself through an external constraint, since many developing countries are net importers of energy.

New book on fiscal issues

Well not really. My co-edited book The Means to Prosperity: Fiscal Policy Reconsidered is now in paperback, for a third of the price. So buy three copies please.