A Taxonomy of Piketty's reviews

Brad DeLong wrote a lengthy review of Piketty's Capital, paraphrasing in the title the famous ISLM (ISLL in Hick's original terminology) paper by John Hicks, which deserves a review by itself. In particular the discussion of Piketty's analytical model, which is, as noted before, incredibly problematic. It is worth noticing that Brad argues somehow that there two kind of reviews, namely: those that are useful and worth reading, in which he includes Tyler Cowen's review (which I've only indirectly alluded to here and here), and the ones that are wrong and are 'distracted by irrelevances,' which include Galbraith and Palley's reviews.*

Brad's idea is not bad, I mean of a taxonomy of the reviews of Piketty, but his take is neither useful to understand the differences, nor constructive for dialogue. So here is my very brief taxonomy.

There are only a few that I included, not because these are the more important necessarily, but because they seem to be representative. I made two analytical distinctions. Mainstream and Heterodox, which is based on the theoretical background, and whether the authors accept the Neoclassical paradigm or not (Murphy and Austrians do, in a confused way). Also, reviews are classified as favorable or critical of the policy prescriptions in Piketty's book. Basically, one distinction is theoretical and the other is policy oriented.

Note that the interesting thing that emerges is that there are NO, at least to my knowledge, Critical Heterodox views, that is, heterodox authors that are against higher taxes and wealth taxes.

The basis for the mainstream critiques (Cowen and Murphy) is that taxes create distortions and lead to lower growth making things worse. After all greed is good, or something like that. This comes from the more radical fringe of the pro-markets are efficient wing of the profession. The conventional defense of Piketty is basically based on New Keynesian (or old in the case of Solow) views, and it suggests that market imperfections are sufficiently large that there is space for redistribution, and tax policy is the main way to go to redress the increase in inequality of the last 30 years.

Finally the Heterodox views (Galbraith, Palley and Lance Taylor), and here I included a non-economist, David Harvey that follows a distinctly Marxist view,** which all suggest that Piketty raises and important point, which has been discussed by heterodox economists forever, that the empirical analysis is also an addition to our understanding of inequality, but that there are theoretical flaws, which both mainstream groups (Piketty would be closer to a New Keynesian, and he is a Socialist, or at least supported Holland in the last election) share, and that this limits, but does NOT disqualify the argument for redistribution.

This illustrates also a point made in this blog for a while. On the one hand, heterodox groups are politically closer to some New Keynesian authors, which, however, remain firmly based on the orthodox notion that markets unimpeded by imperfections produce optimal outcomes. Once, the New Keynesians get rid of some of the limitations of their theoretical framework, the essential being the natural rate (of interest or unemployment), their political argument would be more coherent and stronger.

* The ones that are wrong or distract point to the logical flaws in Piketty's theoretical model, by the way.

** I didn't include Cassidy's good review, simply because as a journalist the mainstream/heterodox distinction doesn't quite apply, but his views are fundamentally favorable. By the way, the Financial Times, also would not fit that dichotomy, but it certainly fits more clearly the political one, and has come clearly against Piketty for his empirical mistakes (here). For a response see Branko Milanovic here (h/t Daniele Tavani).

Oskar Lange theory of interest and the ISLM

By Roberto Lampa (Guest blogger)

In two previous posts, dated 2011 and 2013, Matías Vernengo clarified that the ISLM model can accommodate changes that incorporate the criticisms of several heterodox groups. In particular, he stresses that the ISLM can accommodate an investment function in which the level of activity (rather than the rate of interest) is central, so that the accelerator can be incorporated. More importantly, he also states the ISLM does not imply a natural rate of unemployment, thus allowing for relevant discussion of policy issues.

Both these aspects can be found in Oskar Lange's 1938 contribution to the neoclassical synthesis, in which he assumes that investment (mostly) depends on consumption, which in turn is permanently distorted by the “irrational” distribution of income, typical of any capitalist economy. More precisely, Lange outlines the mutual dependence of investment and consumption as a sort of ‘indirect’ relationship.

Firstly, he states that, as in traditional theory, in his model an increase in the propensity to save induces a decrease in the rate of interest. However, his reasoning runs along more unconventional lines than the (Neo)-Classical interaction of both supply (of) and demand (for) capital curves:

"…an increase in the propensity to save [implies that] expenditure on consumption is now lower. This causes (…) a lower quantity of investment (…). Total income decreases (…). The consequence is a fall in the rate of interest." (pp. 17-18)

In other words, in Lange's view the immediate effects of an increase in the propensity to save are a decrease in consumption, investment and total income. Therefore, as recognized by Keynes himself:

"The analysis which I gave in my General Theory of Employment is the same as the ‘general theory’ explained by Dr. Lange on p.18 of his article, except that my analysis is not based (as I think his is in this passage) on the assumption that the quantity of money is constant." (Keynes J.M., 1973a, p.232n)

Following this train of thinking, we deduce that it’s only afterwards that the decreased level of the rate of interest will stimulate investment, consumption and total income. The final result of an increase in the propensity to save will then depend on the ‘specific weight’ of each of these two effects.

Not coincidentally, Lange explicitly assumes in equation (3) – by drawing on Karl Marx's realization crisis – that consumption directly affects investment, as an excessive growth in saving (i.e. an excessive contraction of consumption, investment and total income) cannot be counter-balanced by the subsequent decrease in the rate of interest, as it destroys any incentive to invest, "at least in a capitalist economy where investment is done for profit" (Lange, 1938, p.23). He thus firmly rejects the (Neo)-Classical assumption that any abstinence from consumption implies automatically an increase in investment: according to him, such a direct relationship holds only until a certain limit (i.e. the optimum propensity to consume), beyond which the collapse of the demand for investment goods will drastically diminish investment itself. Therefore, the real issue becomes if and how it is possible to determine (and to maintain) such an optimum propensity to consume, given a market economy. Lange's opinion is definitely non-optimistic:

"In a society where the propensity to save is determined by the individuals, there are no forces at work that keep it automatically at its optimum, and it is well possible, as the under-consumption theorists maintain, that there is a tendency to exceed it." ( p.32)

In other words, the result of Lange's analysis converges with (and radicalizes, as well) Keynes' pivotal idea, that is, the tendency towards a chronic under-consumption crisis.

Recently, I have published a detailed analysis of this rather obscure work in the Cambridge Journal of Economics. I explore in depth Lange's theory of interest and its tortuous relationship with both Keynes’ General Theory (1936) and Hicks' synthesis (1937), developing two graphical models that show the non-linearity of Lange's investment function as well as the consequences of his equilibrium solution. Through an unedited manuscript, I also reconstruct Lange's beliefs about the chronic sub-optimality of the capitalist economy and his scientific endorsement of the socialist economy.

Full paper is available here.

P.S. It is worth noting that Keynes himself was prompted to reflect that Lange's article "follows very closely and accurately my line of thought" (Keynes, 1973a) notwithstanding the analytical differences. Lange was, after all, standing on the same "side of the gulf," as he clearly rejected the notion that capitalism could be a "self-adjusting system" (Keynes, 1973b).

Lars P. Syll On What’s wrong with IS-LM?

By Lars. P. Syll

Yesterday, David Fields of Naked Keynesianism wondered what was my position on the fact that many heterodox economists would consider the IS-LM framework “to still be relevant if given enough flexibility without neoclassical synthesized elements.”

I will sure come back on this when time admits a more thorough analysis, but let me start by giving at least a tentative answer — focusing on where I think IS-LM doesn’t adequately reflect the width and depth of Keynes’s insights on the workings of modern market economies.

Read the rest here.

Prabhat Patnaik - Finance and Growth Under Capitalism

By Prabhat Patnaik

Once we reject Say’s Law and recognize that capitalism is prone to deficiency in aggregate demand, we have to accept that sustained growth in this system requires exogenous stimuli. By exogenous stimuli I mean a set of factors which raise aggregate demand but are not themselves dependent upon the fact that growth has been occurring in the system; that is, they operate irrespective of whether or not growth has been occurring in the system. Moreover, they raise aggregate demand by a magnitude that increases with the size of the economy, for instance with the size of the capital stock. They are in other words different from “erratic shocks” on the one hand, and “endogenous stimuli”, such as the multiplier‐accelerator mechanism, on the other: the latter can perpetuate or accelerate growth only if it has been occurring anyway.

Read rest here.

ISLM: a further explanation and a defense

I noted before  the traditional representation of the ISLM is problematic. Yet as I also noted the ISLM model can accommodate changes that incorporate the criticisms of classical-Keynesian, post-Keynesian and other heterodox groups. There is no need for an investment function based on the marginal productivity of capital and the principle of substitution. The accelerator can be incorporated, and the inverse relation with the rate of interest would result from the effects of interest rates on other components of demand. Also, endogenous money can be incorporated easily, and for the most part this has been done in New Keynesian models (the ISMP).

In the post (linked by David here) that prompted this sort of defense of a changed ISLM, Lars Syll correctly notes that New Keynesians are often right on policy, but incorrect on theory. And I for the most part agree with Lars intentions. Yet, he suggests that the problem lies in that:

"If macroeconomic models – no matter of what ilk – assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable."

As I noted in my debate with Noah Smith, the problem with marginalism (neoclassical economics) is NOT rationality, utility maximization or supply and demand (not quite the same list raised by Lars). Here I would add that although one can certainly add heterogenous agents, assumptions that simplify and assume representative agents maximizing profits, for example, are not really problematic at all. Classical political economists and Marx did assume something like that and still did not reach the conclusion that the system was efficient in the sense of providing full utilization of resources.

Also, the idea that agents use all information per se is not necessarily bad (Tom Palley favors some sort of rational expectations, which he refers to as model consistent; see his old manual here). The problem is that the model used, by New Classical and other mainstream authors, has logical problems. Last but not least equilibrium per se is not a bad concept (on this there is the whole thing that Post Keynesians have inherited from Joan Robinson that makes things confusing for many heterodox economists). Equilibrium is actually quite essential for long-term analysis. And I would actually argue that it is relevant since it DOES have real world applications. In other words, real economies do fluctuate around long-term equilibrium positions that are sub-optimal.

The problem with mainstream theory is the notion of a natural rate, which is based on the principle of substitution which allows for 'factors of production' to be fully utilized. These are the problems that Keynes, by negating the idea of a natural rate, and Sraffa, by showing the logical problems of the principle of substitution, undermined. An ISLM without the natural rate is not only possible, but actually reasonably good as a tool for analyzing real economies.

PS: Note that Keynes wrote to Hicks on the ISLM that: "I found it very interesting and really have next to nothing to say by way of criticism." Keynes did not criticize the investment function in Hicks model, but note that this problem also was integral to the General Theory (GT). And yes Keynes was being nice, but he was nice too about Harrod's review of the GT, but did tell him that he did not mention effective demand.

Robert Skidelsky on Hayek, Keynes and Common Sense

Robert Skidelsky at a Liberty Fund event, not too long ago. Note that in the opening remarks he says: "I'm going to talk about the conditions of liberty, which seems a good topic of conversation for a Liberty Fund event. Owing to the hazards of the weather, I find myself the sole representative of common sense this afternoon." Not sure what the weather conditions had to do with it, but I must agree, given the venue.

The whole thing here. My only major disagreement is that I really do not think that Hayek is the great rival of Keynes, or even one of the major economists of the 20th century, given his contributions. On the neoclassical front, Hicks, Modigliani, by bringing neoclassical results in the long run, but opening space for Keynesian policies in the short run, associated to rigidities an imperfections, and even Friedman, with the return of the concept of the natural rate, were more relevant than Hayek.

Who was Keynes great rival? While he was alive his debates were with his Cambridge peers, Pigou and Robertson, more than with Robbins, Hayek and the LSE economists. In fact, a good chunk of the younger LSE economists became, in different degrees, Keynesian (e.g. Hicks, Kaldor, Lerner, and even Shackle). But if I had to say, his great rival was himself, which would probably fit his very elevated sense of self-worth. In particular, his inability of getting rid of marginalist (neoclassical) elements of his theory is what ultimately opened the door for the Neoclassical Synthesis.

Krugman on Friedman, Austrians, and Paradise Lost

I was a bit busy this week and did not weigh in on Krugman's latest incursion (and here too) on the history of economic ideas. He correctly dismisses Conservative economists in pre-Keynesian times, and particularly Hayek (and Austrians), who suggested that recessions and depressions were useful, as not relevant. And also, notes Friedman was more sophisticated. He also notes correctly (as was pointed out here before), that Friedman used when he was forced to present a complete model and ISLM with a Phillips Curve, that was not very different from the more Keynesian versions of the model done by the Neoclassical Synthesis authors.

He is more positive about Friedman because:

"He [Friedman] was willing to give a little ground, and admit that government action was indeed necessary to prevent depressions. But the required government action, he insisted, was of a very narrow kind: all you needed was an appropriately active Federal Reserve... [But Krugman does not ] want to put Friedman on a pedestal... [since] the experience of the past 15 years, first in Japan and now across the Western world, shows that Keynes was right and Friedman was wrong about the ability of unaided monetary policy to fight depressions."

Note that Krugman also notes Friedman's critique of Austrian business cycle theory (see here), which shows that in spite of being marginalist and part of the mainstream, still the extreme laissez faire view makes them part of the fringes  of the profession. In other words, Austrians stand for the mainstream as the Tea Party stands for the more moderate right wing.

Perhaps the most important point in Krugman's reflection on the state of the profession is his confession that he used to consider himself "a free-market Keynesian — basically, a believer in Samuelson’s synthesis. But [he is] far less sure of that position than [he] used to be." Good enough. Note, however, that what he means by a 'free market' Keynesian is a peculiar mix.

The Neoclassical Synthesis, was based on Hicks ISLM and Modigliani's fixed wages. The fundamental idea is that with wage flexibility the system would lead to full employment, a proposition that Keynes denied in the General Theory. In addition, the capital debates have shown, and Samuelson admitted in 1966, two years before Friedman re-introduced the Wicksellian notion of a natural rate, that the neoclassical parable in which substitution led to full employment of factors of production does not hold.

So, beyond the ideological stance (which made more sense at the time of the Old Neoclassical Synthesis, during the Cold War) Free Market Keynesianism was always kind of a misnomer. Remember that Keynes in 1926 suggested that Liberalism (in the traditional European sense of Laissez Faire) was dead.

Krugman and the natural rate again

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

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

So? None of your conclusions follow from your arguments

Krugman has a post on the effects of technological change on employment. Here is a very illustrative case of the limitations of mainstream marginalist (neoclassical) economics, which leads a reasonable and intelligent economist to all sorts of mistakes. He says:

"start with the notion of an aggregate production function, which relates economy-wide output to economy-wide inputs of capital and labor. Yes, that sort of aggregation does violence to the complexity of reality. So?"

Implicit here is the incorrect notion that the problem with the aggregate production function is over-simplification. Nope, that is a feature of all theories of course. The problem is far worse; it is that it leads to logical mistakes.* So, as we will see, none of Krugman's conclusions follow from his analysis, and that is kind of a problem. Lack of logical coherence and empirical evidence are after all the two main criteria of demarcation between scientific knowledge and the half-baked notions of ideologues.

His first point, which is based on the marginalist theory of distribution**, is that:

"in competitive economy ..., we would expect the labor force to achieve full employment by accepting whatever real wage is consistent with said full employment."

In other words, wage flexibility guarantees the full utilization of labor. A reduction in the real wage in the case of unemployment would lead to full employment (yes, he actually does not defend this in policy discussions, because he thinks that nominal wage rigidities preclude adjustment; mind you his real preocupation is that the rate of interest of equilibrium is negative, precluding adjustment in capital markets).

Of course this is nonsense. A reduction in real wages, and I'm not even talking about the effects of deflation on demand which were discussed by Keynes in the chapter 19 of the General Theory, may not lead to an increase in the demand for labor. First, it must be noted that if wages go down, since wages are part of the cost of production of produced means of production (i.e. capital), the price of the latter also goes down. There is a priori no reason to say that firms will substitute labor for capital (on capital debates go here; really Krugman should read this stuff).

Second, once the idea that the intensity of the use of a 'factor of production' is inversely related with its remuneration is abandoned (by the way there is no evidence for the notion that real wages are inversely related to employment utilization, in fact, if anything, the evidence points in the other direction, with real wages being slightly pro-cyclical), there is no reason to believe that real wages are connected to productivity (and again there is no evidence for that relation either, which means that when Krugman asks "what is that real wage?" and replies that it is "the marginal product of labor at that point," he is also incorrect). Yes real wages have stagnated, since the bargaining power of the working class has deteriorated, with productivity still growing since the 1970s.

So, what is the problem Mr. Krugman? That your conclusion, that the effects of technical change on employment are ambiguous, does not follow logically from your arguments. Ricardo's discussion of the effects of technical change on employment, in his famous chapter on machinery, is far more interesting and coherent than Krugman's (see the paper here). Not just the idea of a natural rate has to be abandoned, but the essential principle of substitution, which allows for the natural rate, must be dropped too. Logical coherence and evidence require it.

* For a serious discussion of the limitations of the aggregate production function go this paper by Jesus Felipe and Franklin Fisher here.

** The quote of Hicks classic presentation of the marginalist theory of wages leaves little doubt of where Krugman stands, if you had any.