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.

Notes:
[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.

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.

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).

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.

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!

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.

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.

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.**

Notes:

* 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.

References:

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.

Paul Ryan -- the 'Sarah Palin' of 2012?

Breaking news late US Mountain time on Friday 8/10/12 indicates that Mitt Romney will name Paul Ryan, representative from Wisconsin, author of the so-called 'Ryan budget,' and Ayn Rand radical,  as his VP pick.

A desperation move given the recent polls - Romney has 'lost the summer.' The Obama campaign, and progressives, should be ecstatic. I would start by framing the Ryan budget as a European-style austerity budget for America which will further eviscerate the lower and middle class social safety net by transferring risk to the less fortunate among us, and point out that the current European unemployment rate is 11.3% and rising under Ryan-style budgets.

Just saying.

Update: Here is an L.A. Times link detailing Ryan's Ayn Randian infatuation.  Another inconvenient truth like Romney's taxes and Bain labor minimizing facts that the Romney campaign would sooner forget; I doubt Axelrod and OFA will let them do so.

A Keynesian Theory of Hegemonic Currencies

By Thomas I. Palley

Several years ago (June 2006) I wrote an article advancing a new theory of why the dollar is the world’s dominant currency and why it is likely to remain so. The article was published in the midst of the last boom and sank like a stone. But now debate about the cause of the dollar’s hegemony has been revived in an interesting paper by Fields and Vernengo titled “Hegemonic currencies during the crisis: The dollar versus the euro in a Cartelist perspective” (also here). Their paper provides an opportunity to revive discussion, so I am posting the article again. Here it is (subject to a couple of word edits):

The U.S. dollar is much in the news these days and there is a sense that the world economy may have become excessively reliant on the dollar. This reliance smacks of dysfunctional co-dependence whereby the U.S. and the rest of the world both rely on the dollar’s strength, but neither is well served by it.

Read the rest here.

Romney's economic plan and the confidence fairy

Romney's economic plan is out, and not surprisingly is all about confidence fairies. Glenn Hubbard, one of the co-authors (with John B. Taylor, Greg Mankiw and Kevin Hassett) argues in the Wall Street Journal that the recession has been caused by uncertainty. In his words:

As a consequence, uncertainty over policy—particularly over tax and regulatory policy—slowed the recovery and limited job creation. ...  the Obama administration's large and sustained increases in debt raise the specter of another financial crisis and large future tax increases, further chilling business investment and job creation.

So too much regulations and spending is what is causing the slow recovery. This is interestingly enough what the manuals of Hubbard, Mankiw or Taylor would say (all are supposedly New Keynesian economists, whatever that means), which still present the simple Keynesian model in which spending determines the level of output (the old 45o degree Hansen model, which encapsulates the logic of the multiplier).

So what is the solution for these GOP New Keynesians? Four points:
growth and recovery first, and it stands on four main pillars:

• Stop runaway federal spending and debt. The governor's plan would reduce federal spending as a share of GDP to 20%—its pre-crisis average—by 2016. This would dramatically reduce policy uncertainty over the need for future tax increases, thus increasing business and consumer confidence.

• Reform the nation's tax code to increase growth and job creation. The Romney plan would reduce individual marginal income tax rates across the board by 20%, while keeping current low tax rates on dividends and capital gains. The governor would also reduce the corporate income tax rate—the highest in the world—to 25%. In addition, he would broaden the tax base to ensure that tax reform is revenue-neutral.

• Reform entitlement programs to ensure their viability. The Romney plan would gradually reduce growth in Social Security and Medicare benefits for more affluent seniors and give more choice in Medicare programs and benefits to improve value in health-care spending. It would also block grant the Medicaid program to states to enable experimentation that might better serve recipients.

• Make growth and cost-benefit analysis important features of regulation. The governor's plan would remove regulatory impediments to energy production and innovation that raise costs to consumers and limit new job creation. He would also work with Congress toward repealing and replacing the costly and burdensome Dodd–Frank legislation and the Patient Protection and Affordable Care Act. The Romney alternatives will emphasize better financial regulation and market-oriented, patient-centered health-care reform.

In short, reduce taxes (the effective corporate income tax is well below 25% and several corporations do not pay much or anything in fact), which mainly helps the wealthy, and has little impact on income, cut spending (contradicting what they teach), cut and privatize Social Security and health programs, and more deregulation. The non sequitur with cutting welfare programs or the craziness (or dishonesty) of arguing for deregulation (eliminate Dodd-Frank) even if they call this disingenuously 'better financial regulation' is astonishing. And yes the idea is that somehow all these measures would create an environment in which job creators would feel safe to invest.

Brad DeLong and Menzie Chinn do a great job debunking this terribly poor and dangerous economic plan.

Hegemonic currencies during the crisis

The paper "Hegemonic currencies during the crisis: The dollar versus the euro in a Cartalist perspective," discussed here before, has been published in the Review of International Political Economy (subscription required). A previous version here. The paper suggests that the dollar is not threatened as the hegemonic international currency, and that most analysts are incapable of understanding the resilience of the dollar, not only because they ignore the theories of monetary hegemonic stability or what, more recently, has been termed the geography of money, but also as a result of an incomplete understanding of what a monetary hegemon does. The paper argues that the dominant view on the international position of the dollar has been based on a Metallist view of money. In the alternative Cartalist (or Chartalist) view of money, the hegemon is not required to maintain credible macroeconomic policies (i.e., fiscally contractionary policies to maintain the value of the currency), but to provide an asset free of the risk of default. Further, it is argued that the current crisis in Europe shows why the euro is not a real contender for hegemony in the near future.

Palley on the crisis and the policies for prosperity

Tom Palley has just published a new book of essays titled “The Economic Crisis: Notes from the Underground.” The book consists of short essays on the economic crisis; the economics and politics of globalization; monetary policy; global imbalances; and policies for restoring shared prosperity.

Phyllis Deane (1918-2012)

Phyllis Deane retired emeritus professor at the University of Cambridge and an authority on economic history, particularly the British Industrial Revolution, and the history of economic ideas, has passed away. Data collection on the British National Accounts led to her volume, with Max Cole, British Economic Growth, 1688-1959, which remains a classic on the Industrial Revolution, and later to her broader volume on the topic depicted above. She also wrote a very readable volume on the history of economic ideas, The Evolution of Economic Ideas.

Davidson on Mitt Romney's Sweatshop Capitalism

By Paul Davidson

Right now, a man whose predatory career has claimed the jobs of countless Americans is trying to wrap himself in the flag and call himself a “job creator” and “wealth creator.”

Does he mean miserable jobs in Chinese factories? Wealth for the 1 percent? Apparently that’s exactly what he means.

Republicans claim that Mitt Romney's entrepreneurial activities at Bain Capital have been good for Americans. The truth is that Romney has spent his career offshoring and outsourcing American production processes -- and associated jobs -- to countries like China where human labor is valued in the market at a very low wage rate.

Mitt Romney’s tenure as Bain’s CEO has long linked him to offshoring and outsourcing. Even today, although he is no longer in that position, Romney still makes a nice profit on undertakings done long after he left the day-to-day management of the firm.

Read the rest here.

The surplus approach and institutions: Diamond vs. Acemoglu & Robinson

By Sergio Cesaratto (guest blogger)

The European crisis absorbs me so much – also politically and personally since our lives are involved – that not much time is left for what now appear as a divertissement, more abstract economic research. So not much time to devote to this post then. Somebody might like, however, to develop this line of research.

If anybody wants to be persuaded of the correctness and fruitfulness of the 'surplus approach' by Sraffa (1951) and Garegnani (1984), a reading of Jared Diamond Guns, Germs, and Steel would be enough to convince herself.[1] What is surprising – but not really at a closer scrutiny – is that Diamond does not quote any classical economist in his book – he does not mention any economist at all indeed. The likely explanation is that he has only been exposed to neoclassical economics and, of course, he could not find anything interesting there.[2] Also Acemoglu and Robinson (A&R) are neoclassical economists. Their neoclassicism is shown by the role that they attribute to the 'right' institutions in setting the correct incentives to individual entrepreneurship. Although in a very diplomatic way, Diamond is very critical of their attempt to explain why some regions developed earlier while other developed later or not at all. In his review of Why Nations Fail in the New York Review of Books Diamond (2012a) aptly summarises A&R’s thesis:

“Different economists have different views about the relative importance of the conditions and factors that make countries richer or poorer. The factors [A&R] most discuss are so-called “good institutions,” which may be defined as laws and practices that motivate people to work hard, become economically productive, and thereby enrich both themselves and their countries… Among the good economic institutions that motivate people to become productive are the protection of their private property rights, predictable enforcement of their contracts, opportunities to invest and retain control of their money, control of inflation, and open exchange of currency. For instance, people are motivated to work hard if they have opportunities to invest their earnings profitably, but not if they have few such opportunities or if their earnings or profits are likely to be confiscated.”

The indictment Diamond moves to A&R is that, although the institutions they refer to are relevant:

“as readers may quickly confirm for themselves, it is indeed a fair characterization of Acemoglu and Robinson’s book to say that their theory is as if institutions appeared at random. Although their letter describes institutional variation today as a systematic outcome of historical processes, much of their book is actually devoted to relating story after story purportedly explaining how institutional variation developed unsystematically and at random, as a result of particular events happening in particular places at critical junctures.” (Diamond 2012b)

“Acemoglu and Robinson’s view of history is that small effects at critical junctures have long-lasting effects, so it’s hard to make predictions. While they don’t say so explicitly, this view suggests that good institutions should have cropped up randomly around the world, depending on who happened to decide what at some particular place and time.” (Diamond 2012a)

As well known, according to Diamond, complex political institutions emerged around 3400 BC in specific parts of the globe where material circumstances related, to the climate and to the availability of domesticable vegetable and animals (there are not so many) made profitable for the humans to transit from populations of hunter/gatherers to sedentary civilisations. With agriculture a surplus of food emerged that unlashed the possibility of creating a class of people not engaged in a daily fight to collect food and survive, but that could dedicate themselves (exploiting the rest, of course) to the political organisation of society, to write legal codes, to philosophy (that includes science and technology) and to war.

Any student of the classical economists will recognize the echo of Petty, Turgot and Adam Smith in this approach. It worth quoting at length:

“it’s obvious that good institutions, and the wealth and power that they spawned, did not crop up randomly. For instance, all Western European countries ended up richer and with better institutions than any tropical African country. Big underlying differences led to this divergence of outcomes. Europe has had a long history (of up to nine thousand years) of agriculture based on the world’s most productive crops and domestic animals, both of which were domesticated in and introduced to Europe from the Fertile Crescent, the crescent-shaped region running from the Persian Gulf through southeastern Turkey to Upper Egypt. Agriculture in tropical Africa is only between 1,800 and 5,000 years old and based on less productive domesticated crops and imported animals.

As a result, Europe has had up to four thousand years’ experience of government, complex institutions, and growing national identities, compared to a few centuries or less for all of sub-Saharan Africa. Europe has glaciated fertile soils, reliable summer rainfall, and few tropical diseases; tropical Africa has unglaciated and extensively infertile soils, less reliable rainfall, and many tropical diseases. Within Europe, Britain had the further advantages of being an island rarely at risk from foreign armies, and of fronting on the Atlantic Ocean, which became open after 1492 to overseas trade.

It should be no surprise that countries with those advantages ended up rich and with good institutions, while countries with those disadvantages didn’t. The chain of causation leading slowly from productive agriculture to government, state formation, complex institutions, and wealth involved agriculturally driven population explosions and accumulations of food surpluses, leading in turn to the need for centralized decision-making in societies much too populous for decision-making by face-to-face discussions involving all citizens, and the possibility of using the food surpluses to support kings and their bureaucrats. This process unfolded independently, beginning around 3400 BC, in many different parts of the ancient world with productive agriculture, including the Fertile Crescent, Egypt, China, the Indus Valley, Crete, the Valley of Mexico, the Andes, and Polynesian Hawaii.” (Diamond 2012a)

The graph (see the original in Diamond 1997) summarises the chain of material circumstances (including the easier communications and similarity of climate in Eurasia) that Diamond advances as an explanation of the variety of growth experiences.

As said, had Diamond been exposed to Classical Political Economy, he would have recognised the ancestors of his theory in Petty, Turgot and Smith. As known, Turgot and Smith shared a “stage theory” of growth very similar to that by Diamond (see Meek 1971; 1976).[3]

Few quotations from “On Universal History” (1750 [2011]) will confirm the similarity between Turgot and Diamond (and Adam Smith, of course) (my italics):

"Without provisions, and in the depths of forests, men could devote themselves to nothing but obtaining their subsistence. (p. 351)

There are animals which allow themselves to be brought into subjection by men, such as oxen, sheep, and horses, and men find it more advantageous to gather them together into herds than to chase after wandering animals.

It did not take long for the pastoral way of life to be introduced in all places where these animals were met with: oxen and sheep in Europe, camels and goats in the east, horses in Tartary, and reindeer in the north.

The way of life of hunting peoples is maintained in the parts of America where these species are lacking. …

Pastoral peoples, whose subsistence is more abundant and more assured, were the most numerous. They began to grow richer, and to understand better the idea of property. (p. 352)

Pastoral peoples in fertile countries were no doubt the first to move on to the state of agriculture. Hunting peoples, who are deprived of the assistance of animals to manure the soil and to facili­tate labor, were unable to arrive so soon at agriculture. If they culti­vate any land at all, it is only a small quantity; when it is exhausted they move their habitation elsewhere; and if they are able to aban­don their nomadic life it is only by infinitely slow steps.

Husbandmen are not by nature conquerors; the cultivation of the land keeps them too busy. But, being more wealthy than the other peoples, they were obliged to defend themselves against vio­lence. Besides, with them the land can sustain many more men than are necessary in order to cultivate it. Hence people who are unoc­cupied; hence towns, trade, and all the useful arts and accomplish­ments; hence more rapid progress in every sphere, for everything fol­lows the general advancement of the mind; hence greater skill in war than in the case of barbarians; hence the division of occupations and the inequality of men; hence slavery in domestic form, and the sub­jection of the weaker sex (always bound up with barbarism), the hard­ship of which increases in proportion to the increase in wealth. But at the same time a more searching enquiry into government begins." (p. 355)

From these quotations the sequence food surplus à complex institutions is clear.[4]

In their reply to Diamond, A&R (2012) argue that:

"Diamond’s theory predicts that the Neolithic Revolution would happen first in Eurasia, but cannot account for differences in prosperity today, which are huge within Eurasia and not explained by the timing of the Neolithic Revolution."

This is the challenge to future research. How the surplus approach may help to explain recent growth episode and differentials? Of course the theory of long-period effective demand is central in this regard. Possibly, the efficiency of the wage-goods sector has had a role in facilitating growth in episodes of strongly export-led growth, by allowing a constant increase of the standard of living of workers in a non inflationary environment. Or, on the other hand, a too big size of the social surplus becomes a problem in advanced capitalists economies as Marx, Rosa Luxemburg and Kalecki taught us. Workers must share a part of it, letting wages to go beyond the subsistence level, to let the system to work. Well, it time to stop and leave the stage to other voices (see the post by Matias Vernengo for a start).

AppendixEGT, Diamond and the surplus approach on population growth and human development

In Cesaratto (2010) on EGT I wrote (inspired, at least partially, by Franklin Serrano):

“According [to the EGT exponent Charles Jones, e.g. 2002, 2004) productivity growth depends on population growth. Jones fervently defends this sort of causality (e.g. 2002, pp.103-104). After all, he argues, humans are the ultimate fuel of the process of research, and it should not be surprising that faster population growth has a positive effect on the generation of new ideas. Jones’ favourite quotation is from Phelps (1968, pp.511-512), according to whom: ‘One can hardly imagine …how poor we would be today were it not for the rapid population growth of the past to which we owe the enormous number of technological advances enjoyed today. …If I could re-do the history of the world, halving population size each year from the beginning of time on some random basis, I would not do it for fear of losing Mozart in the process’. One might certainly argue that halving the German speaking population of the eighteenth and nineteenth centuries would entail the risk of losing many of the greatest musicians ever, but this could be done to other populations of comparable size, in that or other periods, without much fear of losing outstanding talents. Ruling out genetic factors, something therefore seems to be missing from this population-driven mechanics of growth.

Jones (2004, pp. 48-56) discusses these possible objections at some length. Looking at different regions of the world in the very long term (12,000 years or so), some relationship seems to emerge between population size at the beginning of the period and their technological rank measured at the year 1000/1500 or so (before European explorations ended the isolation of various areas). The rationale of this correlation (ibid, p. 56) would lie in the following virtuous circle: at the beginning a small population could only generate ideas over long periods of time. Low productivity levels and subsistence kept the population constant. However, once one idea was produced subsistence levels and fertility rose, leading to a larger population. This in turn facilitated the production of new ideas over shorter lapses of time, and so on and so forth (see also Jones and Romer, 2009, pp. 10, 14, 24-25).

A scholar quoted in this regard is Jared Diamond (1997) who is, however, totally misinterpreted by these authors. In his famous book, Diamond argues that some environmental advantages, in particular the availability of suitable vegetable and animal species, made possible to some luckier populations some 10 thousand years ago to realise a food surplus and to become “large, dense, sedentary, stratified populations” (1997, p.87 and passim). More precisely, the realisation of food surpluses permitted these populations to grow more rapidly and to support a political class that, at the price of the exclusive control of the surplus, provided organisational, institutional, and military leadership. Moreover, the surplus allowed for the sustenance of those who Adam Smith would have called ‘philosophers or men of speculation, whose trade it is, not to do anything, but to observe everything’ (1776 [1979], p.21). It is clear from Diamond that population growth is not and cannot be the original source of “ideas” since both division of labour and population growth both logically and historically originate from the emergence of food surpluses. This is enough to show the closeness of Diamond to the Classical economists’ surplus approach, as well as his distance from the poor growth mechanics of EGT.”

This was what I wrote few years ago. I may add this. Turgot puts the question in a way similar to Smith: given two populations of the same size, it is education (that is the degree of division of labour) that makes the difference:

“The original aptitudes are distributed equally among barbarous peoples and among civilized peoples; they are probably the same in all places and at all times. Genius is spread through the human race very much as gold is in a mine. The more ore you take, the more metal you will get. The more men there are, the more great men you will have, or the more men capable of becoming great. The chances of education and of events either develop them, or leave them bur­ied in obscurity, or sacrifice them before their time, like fruits blown down by the wind.)” (p. 378).

Diamond, as the Classical economists, regards the size of the population, or its concentration in smaller territories towns etc. as an advantage from many points of view. But the material conditions that set off the emergence of a food surplus are the trigger:

“correlations suggest strongly that regional population size or population density or population pressure has something to do with the formation of complex societies. But the correlations do not tell us precisely how population variables function in a chain of cause and effect whose outcome is a complex society. To trace out that chain, let us now remind ourselves how large dense populations themselves arise. Then we can examine why a large but simple society could not maintain itself. With that as background, we shall finally return to the question of how a simpler society actually becomes more complex as the regional population increases. We have seen that large or dense populations arise only under conditions of food production, or at least under exceptionally productive conditions for hunting-gathering. Some productive hunter-gatherer societies reached the organizational level of chiefdoms, but none reached the level of states: all states nourish their citizens by food production. These considerations, along with the just mentioned correlation between regional population size and societal complexity, have led to a protracted chicken-or-egg debate about the causal relations between food production, population variables, and societal complexity. Is it intensive food production that is the cause, triggering population growth and somehow leading to a complex society? Or are large populations and complex societies instead the

cause, somehow leading to intensification of food production?

Posing the question in that either-or form misses the point. Intensified food production and societal complexity stimulate each other, by autocatalvsis. That is, population growth leads to societal complexity, by mechanisms that we shall discuss, while societal complexity in turn leads to intensified food production and thereby to population growth. Complex centralized societies are uniquely capable of organizing public works (including irrigation systems), long-distance trade (including the importation of materials to make better agricultural tools), and activities of different groups of economic specialists (such as feeding herders with farmers' cereal, and transferring the herders' livestock to farmers for use as plow animals}. All of these capabilities of centralized societies have fostered intensified food production and hence population growth throughout history.

In addition, food production contributes in at least three ways to specific features of complex societies. First, it involves seasonally pulsed inputs of labor. When the harvest has been stored, the farmers' labor becomes available for a centralized political authority to harness—in order to build public works advertising state power (such as the Egyptian pyramids), or to build public works that could feed more mouths (such as Polynesian Hawaii's irrigation systems or fishponds), or to undertake wars of conquest to form larger political entities.

Second, food production may be organized so as to generate stored food surpluses, which permit economic specialization and social stratification. The surpluses can be used to feed all tiers of a complex society: the chiefs, bureaucrats, and other members of the elite; the scribes, craftspeople, and other non-food-producing specialists; and the farmers themselves, during

times that they are drafted to construct public works.

Finally, food production permits or requires people to adopt sedentary living, which is a prerequisite for accumulating substantial possessions, developing elaborate technology and crafts, and constructing public works.” (pp.185-6)

References:

Cesaratto, S. (2010), Endogenous growth theory twenty years on: a critical assessment, Bulletin f Political Economy, vol.4, n.1, working paper version Quaderni del Dipartimento di Economia politica, Università di Siena, n.559

ID (con F.L.Serrano) (2002), As Leis de rendimento nas teorias neoclasica de crescimiento: Una critica Sraffiana, Revista Ensaios FEE, vol.23. (English version www.networkideas.org – International Development Economics Association).

ID (1999), Savings and economic growth in neoclassical theory: A critical survey, Cambridge Journal of Economics, vol.23.

ID (1999), New and Old Neoclassical Growth Theory: a Critical Assessment , in G.Mongiovi, F.Petri (a cura di), Value, Distribution and Capital: Essays in Honour of Pierangelo Garegnani, Routledge.

Acemoğlu, D. & Robinson, J. A. (2011) Why Nations Fail: The Origins of Power, Prosperity and Poverty, Profile.

Acemoglu D. and Robinson J.A., reply by Jared Diamond, The New York Review of Books, 16 August 2012.

Diamond J. 2005 [1997], Guns, Germs and Steel: A short history of everybody for the last 13,000 years (London: Vintage).

Diamond (2012a), ‘What Makes Countries Rich or Poor?’, The New York Review of Books, June 7:

Diamond J. (2012), Reply to A&R, The New York Review of Books, 16 August 2012.
Garegnani, P. (1984) Value and Distribution in the Classical Economists and Marx, Oxford Economic Papers, 3: 291–325.

Meek R. (1971) Smith, Turgot and the Four Stages Theory, History of Political Economy, 3, 9-27.

Meek, R.L. (1976) Social Science and the Ignoble Savage. Cambridge: Cambridge University Press.

Jones, C. (2002) Introduction to Economic Growth, New York: Norton.

Jones, C.I. (2004) ‘Growth and Ideas’, NBER Working Papers: no. 10767.

Jones, C.I. and Romer P.M. (2009) ‘The New Kaldor Facts: Idea, Institutions, Population, and Human Capital’, NBER Working Papers: n. 15094.

Phelps, E.S. (1968) ‘Population Increase’, Canadian Journal of Economics 1: 497-518.
Sraffa, P. (1951) Introduction to Ricardo's Principles, in Ricardo, D. (1951-73) Works and Correspondence of David Ricardo,(Cambridge: Cambridge University Press) Vol. I.

Turgot (2011), The Turgot Collection, Writings, Speeches, and Letters of Anne Robert Jacques Turgot, Baron de Laune, Edited by David Gordon, Mises Institute, available at http://mises.org/document/6298/The-Turgot-Collection-Writings-Speeches-and-Letters-of-Anne-Robert-Jacques-Turgot-Baron-de-Laune


Notes:

[1] Franklin Serrano suggested to me to read Diamond many years ago.

[2] On Endogenous Growth Theory (EGT), the most ambitious attempt by the mainstream to explain economic growth, see Cesaratto 1999a, 1999b, 2010, and Cesaratto & Serrano 2002. See also the appendix.

[3] Meek (1976) points out that both Turgot and Smith regarded the protection of property rights as a result of development rather than a cause of it.

[4] True, Turgot as much as A&R dismiss the role of the climate as a determining factor: “A reason for these differences which are found between nations has been sought in differences of climate. This view, modified a lit­tle and rightly restricted only to those climatic influences which are always the same, has recently been adopted by one of the greatest geniuses of our century. But the conclusions which are drawn from it are hasty, to say the least, and are extremely exaggerated. They are belied by experience, since under the same climates peoples are dif­ferent; since under climates which resemble one another very little we very often find peoples with the same character and the same turn of mind” (379-80) But I do not believe that this would change much my argument.

PS: Also read the following post on the same topic here or here where the argument extends to William McNeill and other historians.

Leading nowhere indicators

Leading indicators precede aggregate economic activity and signal policy makers about the state of the economy. Construction spending is usually considered a reliable leading indicator, and the figure below shows that total construction spending fell considerably before the beginning of the Great Recession (the shaded area).

And yes the indicator shows that a very slow recovery is now under way. We are around the levels of spending of 2003. Note that the fall in construction spending in the previous (and milder) recession was almost imperceptible (we were in the beginning of the housing bubble after all). Also, this is one of the problems with the collapse of housing bubbles, not only deleveraging implies that consumers are less capable of spending, but also the overinvestment in housing during the boom implies that a key sector, construction, has a very slow recovery.

Further, today the jobs' numbers were released with 163,000 nonfarm payroll jobs created, up from 64,000 last month. It is hard to see this as a prove of strenght in the labor market, as the Conference Board suggests. We needed to be creating something more like 400,000 for a healthy recovery. Unemployment ticked up to 8.3%.

Lucas in retrospect

I said it before, but it's worth repeating when one discusses the so-called Lucas' Critique and microfoundations. Lucas and the New Classical Rational Expectations (and RBC) School are the intelligent design of economics. In their view, markets work and this must be the result of some sort of high power, with which mere mortals and governments should not interfere. Lucas and his followers should have the same status as defenders of intelligent design in the scientific community (for the original claim go here).

If you have any doubts go check his paper on what should be the priorities of macroeconomic research just a few years before the crisis (Lucas, 2003), when several heterodox economists had already warned about a bubble and impending crisis. In his own words:

"My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows."

Yes, business cycles problems have been solved, and there is no need for counter-cyclical fiscal policy. And this guy got the Sveriges Riksbank Prize, sometimes referred to as the Nobel!

But the point I wanted to make really is that there is less than meets the eye to the so-called Lucas' critique. The problem for Lucas was that the parameters of macroeconometric models (mostly of the Cowles Commission, CC, or the Cambridge-Levy stock flow with coherent accounting, SFCA, types) were not invariant to policy changes, and could not, in fact, be taken as parameters. Even if you take the neoclassical/marginalist approach seriously (meaning forget its logical problems revealed by the capital debates), as noted by Ray Fair (2012) (one of the last defenders of the CC approach within the mainstream):

"The Lucas (1976) critique says that the coefficients may not be stable if they are based on expectations that change over time or change when a new policy regime replaces an old one. This problem is part of the larger problem of potential coefficient instability, and it may not be the most serious. If expectations are not rational or if regimes do not change very often or by very much, any instability caused by Lucas-critique related issues may be small relative to instabilities caused by other things, like the changing age distribution of the population."

The fact, is that parameters are to a great extent invariant to policy changes, and there are a lot of parametrical regularities in macroeconomics, e.g. Okun's Law, Houthakker-Magee effect, or relations with changes in size that are not dramatic, like the size of fiscal multipliers, accelerator coefficients and pass-through effects, for example. And you can go on, for example, it's not a new thing that expansionary fiscal policy and higher debt levels have almost no impact on interest rates, that is, also, a fairly established macro regularity. That is why one can talk about macroeconomic stylized facts.

And it should be no surprise then, that models that do not use the mainstream assumptions of reversion to mean (to the optimal levels, by the way, the reason why Lucas thought cycles were solved and no macro policies where needed), and that depend on the macro accounting and the proper Keynesian causalities fared better during the last crisis (see here).

Palley on the Fed’s 2% inflation target trap

Thomas Palley

The Federal Reserve has now openly adopted a two percent inflation target, with both Chairman Bernanke and the Federal Open Market Committee publicly committing to holding inflation at that level. Though not a problem today, this two per cent target represents a policy trap that will undercut the possibility of future wage increases despite on-going productivity growth. That promises to aggravate existing problems of income inequality and demand shortage.

The Fed’s new policy is tactically and analytically flawed. Tactically, at this time of global economic weakness, the Fed should be advocating policies that promote rising wages rather than focusing on inflation targets. Analytically, its inflation target is too low and will inflict significant future economic harm.

Read the rest here or here.

Microfoundations and the capital debates

Steve has commented on the ongoing debates about microfoundations of macroeconomics, mainly between Paul Krugman and Simon Wren-Lewis (for my comments and Simon's reply on his blog go here, and scroll down to the last comments). I just want to further clarify what I think is, from the point of view of the history of ideas, a significant confusion in the debates about microfoundations, and one (oh yes, here he comes again) that is ultimately related to the capital debates (the Rosetta Stone of the history of economics ideas; if you prefer Sraffa's PCMC, as I tell my students, is the Rosetta Stone. To get an idea of what is the meaning of the capital debates go here).

Microfoundations are first and foremost about the determination of relative prices, the core of what we now call microeconomics, and used to be called before the theory of value. Individual behavior, rational or otherwise, is relevant to the extent that one thinks that behavior of individual agents is central for price determination, and that was at the core of the Marginalist Revolution.

The point is that if individual workers (using the figure of a representative rational utility maximizing worker), for example, in the labor market, confronts rational individual profit maximizing firms (again a representative firm), the free play of the market would produce an optimal outcome. Krugman is very clear why he thinks microfoundations are important. He says:

“if the assumption of perfect rationality breaks down even in the most standard of micro settings — if consumers behave in a way inconsistent with full maximization even when doing something as mundane as choosing which type of gas to put in their tank — how absurd is it to insist that, say, Keynesian stories about the economy can’t be right because we can’t fully derive them from intertemporal maximization?”

In other words, if workers say are not concerned with maximizing utility in terms of higher real wages, but in terms of relative wages, or if firms have limited knowledge about the workers willingness to work, and have an incentive to pay wages above the reservation wage (the one that compensates workers for the trouble with parting with leisure time), then the imperfection implies that the labor market will not clear and you might have unemployment. This is basically the efficiency wage story that New Keynesians use to justify unemployment (note that unemployment does result from real wages above the equilibrium level, and not from lack of demand as in Keynes).*

The capital debates show that even if you have workers trying to maximize utility in the normal fashion, and firms too have full information, that is, in the absence of any imperfection, there is no guarantee that lower real wages would imply more intensive use of the labor ‘factor.’ It is actually quite simple, if commodities are produced with commodities, then a reduction in wages also reduces the price of all goods, since they are produced with labor too, and there is a possibility that the fall in the price of commodities that do not use too much labor falls more than proportionally, so the increase in their demand does not lead to an increase in the hiring of new workers. Also, as wages are central for the consumer’s demand, the income effect of any reduction in wages would trump any (if it is positive) substitution effect. In other words, why would a firm hire more workers (even cheap ones) if nobody buys their products?

Further, PCMC does provide a sound way of determining relative prices. Long term normal prices are determined by the technical conditions of production, given one distributive variable (either real wages or interest, or if one prefers, for a given wage-profit frontier). It does take long term patterns of demand as given obviously, since producers would not supply, in the long term, goods and services for which there is no demand. The analysis of the determinants of effectual demand, the long term patterns of demand, are at a lower level of abstraction, and include all the institutional factors associated to fashion, conspicuous display of power, the effects of marketing, etc., that Veblen, Galbraith (father) and other institutionalist authors suggested were relevant.

Also, workers are rationally trying to obtain a fair wage, and to consume according to their tastes and the other social and institutional factors that determine their behavior. But those are taken as given for the determination of long run prices. And firms do maximize profits, and this implies that they add a mark up on their full costs. These models were developed by the authors of the Full Cost Pricing School, and the literature on barriers to entry, e.g. Sylos-Labini, Steindl and others, and the empirical evidence tends to be favorable.

In that sense, heterodox (classical-Keynesian, by which I mean Sraffa’s prices cum Keynes/Kalecki’s effective demand) does have a coherent determination of long run prices, based on rational behavior, as the foundation of the macroeconomic theory. Markets do not produce optimal outcomes and unemployment of productive resources is the normal, long run, position of the economy. In fact, the capital debates not only say that classical political economy (the surplus approach) provides sound microfoundations, but also that it is NOT possible to do so within the neoclassical/marginalist paradigm.***

* Interestingly enough Krugman’s argument for the current recession is not a rigidity in the labor market, but one in the money market, that is, a rate of interest that does not allow for investment at the level of full employment savings, the so-called Liquidity Trap.

** And yes there is empirical evidence in favor of this view, since there is no support for the effect of lower real wages and higher employment. Real wages tend to be pro-cyclical, go down in a recession, and up in the boom.

*** Arrow-Debreu also does not provide a way out of this conundrum.

PS: For the implications of Sraffa's contribution for Keynesian economics see this paper, and this post.