On vibecession and progressive thinking about the macroeconomy

The numbers for the American economy are finally out, with a delay of two months. Growth was 4.3 percent in the third quarter, which is fundamentally related to an expansion of consumption. Investment is flat (a bit negative actually, so much for the AI investment boom), and government spending is positive (but not much), mostly defense. In the previous two reports it was barely positive. There is also a contraction of imports. Normally, that would imply a slowdown of the economy, but in this case part of it might be associated with the tariffs.

At any rate, what I had suggested all along throughout the year, in many debates, often against the grain, was that we were not on the verge of a recession because of tariffs, nor that tariffs would be inflationary. And I was correct. What happened is what I had suggested: we are seeing a continuous slowdown that had already started under Biden, simply after the expiration of many of the measures associated with the Pandemic and the fiscal expansion that followed it. Tariffs have not had a significant impact on quantities, and only a limited impact on prices. If they had an effect, it would be a one-off increase in the level of prices, not in the rate of growth of prices, meaning inflation. And inflation remains subdued.

There are a couple of things worth pointing out. First, there is this whole discussion about a “vibecession,” or whatever people want to call it. Most of the discussion, including this piece in the Financial Times, is not really about quantities. A recession is a decline in the level of output and employment. Employment numbers are not great, they reflect the slowdown of the economy. The last report in September, which I discussed here, does suggest that the economy is slowing down. Those things are connected. One of the few laws we have in macroeconomics, Okun’s law, tells us that a slowdown in the economy should be reflected in a softening of the labor market. But unemployment remains relatively low, so we are not in a recession, for what it’s worth.

The vibe is not one of recession, and it is also not really about inflation (really). The graph above from the Financial Times suggests that wages grew less than rents (shelter), largely due to high mortgage rates that feed into higher rental prices. Wages also grew less than food prices. So food and shelter are supposedly getting more expensive. But the wages shown there are average wages. Once you look at the wages of non-supervisory workers, those seem to be growing more or less at the same pace, still above average CPI inflation, and particularly close to rental inflation.

Wages at the bottom have not really lost much (red line). They did lose a little during the pandemic, but they recovered fast enough and have been growing at roughly the same pace as inflation.

Of course, there is a perception that things are not good, and things are not good for working-class people, but that does not mean that the problem is inflation. By suggesting that the problem is inflation, something Trump used against Biden, progressives miss the point. I have discussed how Bidenomics had been good in several respects, with many policies favoring working-class people, although many of them expired before the end of his term. The perception that things were not good was not because of inflation, but because the quality of jobs and the conditions facing the working class have been deteriorating for a generation, going back to the 1970s.

For a long period, productivity gains have not translated into better living standards or higher wages for people at the bottom. This is not a recent phenomenon. Anger has increased over time, and in particular after the failure to redress the injustices and unfairness of the system following the global financial crisis of 2007–2009, the so-called Great Recession. There was great hope that Barack Obama would bring a different kind of politics and economic policy, and the disappointment contributed to the backlash we see today.

People are now angry at Trump because of affordability issues, but this reinforces the idea that if Dems win and bring in someone not particularly different from Obama or Clinton, although Biden did move to the left of them, they may face the same problems. The issue is NOT inflation. I want to be absolutely clear: the issue is NOT inflation. That is what my graph above indicates.

The issue is the long run stagnation of wages, the quality of jobs, about future prospects, and about the inability of Dems to show that people will have a better quality of life in the future. Addressing this requires policies that promote higher minimum wages, that would have demonstration effects that would help lift wages more broadly; policies that tax the wealthy at higher rates so they are seen as contributing proportionally to the system; and policies that provide accessible healthcare. Healthcare in the United States is incredibly expensive and of poor quality compared to other advanced nations. The United States is the only advanced country without a single-payer national public health system, which makes it look, frankly, like an underdeveloped nation in this respect.

Also, progressives overemphasis on inflation will have a negative impact on macroeconomic debates, reinforcing very conventional views about how the economy works, as I noted in a piece I wrote for ProMarket, the magazine of the Stigler Center. This focus misses the real dangers facing the American economy. The real danger, as I have argued all year, is the Federal Reserve and its interest rate policy.

The slowdown of the economy suggests that the real issue is high interest rates. Shelter prices, which are the highest component in the graph, are being pushed up by high mortgage rates. These impact consumption more directly than any other mechanism. High interest rates may cause a recession in the United States, and the Fed needs to reduce rates much faster than it is willing to do (or at least that;s what it seems). Ironically, these strong GDP numbers may lead the Fed to keep rates relatively high because of the danger of inflation.

This raises another problematic issue: the idea that anything Trump says must be wrong (that's often correct). However, Trump is correct in arguing that interest rates should be lower. He is also correct in saying that there is no particular reason why the Fed should be independent of political power. I would not argue for direct presidential control, but the Fed should be more accountable to Congress, and to the people. Fiscal policy is clearly political, it involves the executive proposing a budget and Congress approving it. The idea that monetary policy is not political, should not be politicized, and should not be subject to democratic scrutiny is deeply entrenched in conventional thinking, but there is no reason it should be. Why is there no representative of labor on the Federal Open Market Committee? Someone who could point out, for example, that high interest rates raise mortgage rates, push up rents, and keep inflation higher. That it affects access to credit and consumption.

In this sense, progressives have played a role in reintroducing very conventional ideas into macroeconomic discussion: the idea that inflation is more central than employment and activity in policy matters, because it counts more for electoral purposes, and that the central bank must be independent of political power.

That’s it for the year. I don’t think I’ll blog again until 2026, so happy holidays to all!

Economic Regularities and "Laws" and the Riksbank Prize too

I've been reading The Nobel Factor: The Prize in Economics, Social Democracy, and the Market Turn by Avner Offer, Gabriel Söderberg, an interesting critique of the use of the Nobel Prize to undermine the Welfare State, essentially by conservative groups in Sweden, that were influential within the Central Bank (Riksbank), that disliked the Social Democratic policies in place in the 1960s. I have been critical of the Riksbank prize before (see, for example, here or here; check also Lars Syll's blog who often discusses the limits to the Nobel in economics), and this book is an interesting discussion of the socio-political forces behind the creation of the prize. I highly recommend it.

Having said that, I should note that the alternative to mainstream marginalist (neoclassical) economics is not Social Democracy. I guess one can actually be Social Democratic (Liberal in the US  New Deal sense of the word) and neoclassical. A good chunk of the Old Keynesians of the Neoclassical Synthesis sort were, and there are a few New Keynesians that are like that (many are simply Neoliberal). The alternative to marginalism, in my view, is a combination of the old surplus approach (classical political economy), particularly regarding value and distribution, and the Keynesian (and Kaleckian) analysis, regarding macro.

Also, I'm somewhat troubled by Offer and Söderberg tendency to read the Kuhnian ideas on the growth of knowledge in a nihilistic way, suggesting that economics cannot be seen as 'scientific' (surely a loaded term with more than one definition), and that there are no regularities in economics. They, for example, say that:

Feynman began by ‘looking for a new law’. But after three centuries, economics has yet to come up with a single non-obvious ‘law’, or universal regularity.

Don't get me wrong, regularities in economics are historically constrained, but there are more than a few. As any regular reader of this blog would know, I'm particularly fond of Okun's Law (and also of its inseparable fraternal twin Verdoorn's Law). I do think there is an important regularity behind the so-called Thirlwall's Law (that developing countries without a reserve currency face a balance of payments constraint more often than not), even if I don't think it is a "law" like the other two. In particular, I think that if one thinks of the persistent forces that operate within a particular mode of production, there are many other regularities that should (and to some extent are) part of economic analysis.

There are many mechanisms that capture the workings of those regularities in the economic system, like the multiplier and the accelerator. Theoretical constructs that are measurable, even if that is difficult and open to criticism. I guess I'm okay with the use of the term economic law, in a certain context. I suppose Marx also thought that capitalism, and other modes of production, were to some extent amenable of analysis on the basis of certain regularities, certain laws of motion, if one prefers (and, yes, that opens a discussion about determinism, but I'll leave that for another post).

Kindleberger (who I was lucky to see giving a talk in honor of Heilbroner years ago) wrote a little book on economic laws. The Iron Law of Wages, that Kindleberger discusses in his book, is very problematic (some discussion of that here), like the law of supply and demand, or the law of diminishing returns (they are not laws in my view, if that needs to be clarified). The other two Kindleberger discusses are much better, namely: Engel's Law and Gresham's Law. At any rate, for what is worth, I do think that there are many regularities that make economics scientific. Yes, sure social sciences are not like the hard sciences, but we do not live in post-modern world in which no regularities exist. But that does not undermine the authors' critique of the Riksbank prize, I might add.

The Economic Education of JFK: Arthur Okun's recollections

JFK with Dillon (first to JFK's right) and Heller (standing behind Dillon)

Nate has posted on JFK State of the Union address in 1963, when the tax cut was proposed to deal with the high level of unemployment of about 5.7 percent. Transcripts from an interview with Arthur Okun (of Okun's Law fame) conducted by David McComb and deposited at the LBJ Library tell the story of how that came to be.

Walter Heller was the chairman of the Council of Economic Advisers (CEA) at this time. Here is Okun on the CEA's views of the economic problem early in the JFK administration:

"The economist's diagnosis of the ills of the economy right at the start in 1961 was that it had been over-sedated with an excessively restrictive budget, which had so sapped its strength that you weren't getting the revenues from that budget; and therefore the budget looked as though it wasn't restrictive. Still you had a deficit, but the deficit was associated with trying to get too big a surplus and therefore holding down incomes and profits to the point where the revenues weren't coming in. We developed a concept called the 'full employment surplus' of trying to show where the budget would be if the economy was on a high employment growth path and trying to show that basically you had a much too tight budget, and that from the economist's point of view the right medicine was one of a more stimulative budget which would bring the economy to full employment, reduce unemployment,  strengthen investment, give us a lot more output for which there were and remain very urgent uses.  Obviously, this would mean in the short run that you'd have to do things which would make the budgetary deficit a lot bigger."

This was not the view held by Douglas Dillon, the then Secretary of Treasury, and a Republican one might add, and initially wasn't either Kennedy's view, since he had promised a balanced budget. As Okun's says: "There's no question that from the outset Dillon and Heller were giving President Kennedy quite different advice." Dillon remained a balanced budget defender. Okun tells the story of JFK's conversion to the Heller side.

"An amusing incident that I recall hearing about—President Kennedy made some statements that seemed to be wiggling off the hook of this balanced budget commitment at a press conference in August or September '61 . Dillon called him the next day and told him that we'd upset foreign bankers and urged him to clarify what he meant and reaffirm his determination. Walter, who had been delighted by the President's ability to see this more pragmatically, was told that Kennedy felt he had to do this, that he did indeed reaffirm that and that there was a balanced proposal in the fiscal '63 budget, which never materialized at all. I think the key manifestation of Kennedy's conversion to the Heller creed was the commencement address that Kennedy gave at Yale in June 1962, which was something—he really wanted to do this. And it was clear—again operating on other people's stories—he wanted a myth-exploding speech, and he ordered that it be focused on economic policy. He really went after the balanced budget myth as the key myth that needed to be destroyed."

On the substantive issue of what made JFK change his mind Okun is unclear, but Heller was central. And not just regarding the disputes within the administration. he says:

"I don't really know just how much of what kind of communication there was between Heller and President Kennedy. I know there was a flood of paper that went from the Council to the White House. Even after Kennedy was personally sold there was a further educational problem of convincing the public and convincing the Congress… Heller did a great job of public education. He got a lot of press attention to… try to popularize a notion that an underemployed economy was a great national waste. One of my first tasks on the Council was to try and estimate what our potential was. That estimate of potential output I guess remains my best known professional contribution as an economist. It's widely referred to as Okun's Law.’"

In fact, the education of the President, Congress and the public was in Okun's view the main task of the CEA at that time. In his words:

"But this was the first item on the priority list that the doctor could order for a patient. The problem was that of getting the patient to take the medicine rather than knowing what to prescribe. It was that that put all the emphasis on Educating the President, the Congress, the public, making the case publicly—you know, really improving the packaging, the labeling, the palatability of the medicine rather than improving the prescription at that time. Obviously, we did a lot of economic analysis on how big a tax cut we'd like ideally, what the appropriate unemployment target might be, what could be done to supplement general fiscal policy through manpower programs, how well guideposts could help to fend off the evil day that inflation reared its ugly head, and all that. But I think still you'd find that the largest emphasis of the Council's activity was on the salesmanship of a product rather than on the development of a superior product, because that was what the real need was."

After Kennedy's assassination Heller's task of educating LBJ wasn't as difficult. Again, according to Okun:

"I don't think he had as much trouble breaking down the balanced budget myth all over again. I think that notion of fiscal orthodoxy had been pretty well dispelled. I'm not sure it ever played as much of a part in President Johnson's ideology as it perhaps had in President Kennedy's."

Of course the task is much harder these days, since the doctors don't understand the problem and their diagnosis is often incorrect. Rather than a problem of public education, there is a problem of educating the doctors, the economics profession. The balanced budget myth and fiscal orthodoxy are back with a vengeance.

Is labor productivity still pro-cyclical? Okun's Law is still fine

So there has been some talk about productivity not being pro-cyclical anymore. This is based on the notion that labor productivity increased during the last few recessions. Robert Gordon is the main source of this view. That is, it would seem that labor productivity is now anti-cyclical. Note that pro-cyclical productivity is what is behind Okun's Law. So below the data, from Fred. Labor productivity, the difference between real GDP growth and civilian employment growth and real GDP growth itself.

It is hard to look at the graph and suggest that the two variables are not positively correlated, even for the post-1980s period. But it is true that if you look at the shaded areas, which represent recessions, it seems that productivity fell before, and was already recovering in that period, at least since the Bush senior recession. This is more about the timing of the recessions, and how these are measured by the NBER, than about the strength of the pro-cyclical relation between productivity and output.

There are a few additional problems with Gordon's views. Note that Gordon does not explicitly deal with the structural relation between labor productivity and growth, the so-called Kaldor-Verdoorn effect, and that's why he finds that the Okun effect is weaker overtime. I had written before on this here (or here), and noted that the Okun coefficient has always been around 2 (by the way, with updated data still is; more on that on a latter post).

The inability to separate the cyclical and structural components of the relation is what causes the change in the short run coefficient (the Okun one). It is still true that as economies grow, productivity picks up, since producers try to adapt to increasing demand by utilizing more effective methods of production.

What macroeconomic policies were relevant for unemployment reduction in Latin America?

I was reading the book by Giovanni Andrea Cornia on Falling Inequality in Latin America, which suggests that the reduction of the skill premium and macroeconomic policies, together with the expansion of social assistant, in particular but not only by left of center governments, is behind the trend. I'll have more on some of the issues related to the skill premium, which rely heavily on both neoclassical labor market and trade theories. However, the chapter on the macroeconomic causes of reduced inequality caught my eye. The chapter, a previous version can be found here, written by Mario Damill and Roberto Frenkel says that:

"A competitive RER [Real Exchange Rate] provides a conductive environment for growth and development. This view has long been stressed by development economists* and recently documented in many econometric studies. The growth-enhancing attributes of a competitive RER operate through the enhancement of tradable sector profitability."

The idea is that a depreciated currency allows for more exports, less imports, a more relaxed current account, and higher levels of activity and employment. The real depreciation is expansionary. Also, the paper suggests that fiscal policies had been during the last decade more restrictive, and presumably this was a good thing. They say:

"...many countries implemented fiscal rules, fiscal responsibility laws or took discretional decisions oriented at correcting the pro-deficit bias of the past. In many countries these changes contributed to a generalized improvement in fiscal results as well as to a declining trajectory of the outstanding public debt."

Not clear why public debt in domestic currency was a problem. Arguably, they think that fiscal restraint was relevant for supposedly allowing for more price stability, since Frenkel usually has argued that inflation has been caused by excessive demand, which was also conducive to reduction in inequality.

However, the evidence in favor of these views is very thin at best. In fact, the whole mechanism by which a depreciated RER would lead to higher growth, lower unemployment and some improvement on income distribution, which is the change in relative prices and the effects on exports and imports, is never discussed. As I pointed out before, the best evidence still suggests that depreciation is contractionary (see the paper by Fiorito, Guaita and Guaita here, in Spanish).

In order to provide evidence for the positive effect of the RER on growth Damill and Frenkel used a partitioned regression. First they regress growth of GDP on the real exchange rate, they make a residual variable, GDP not affected by RER, and then regress unemployment change on the residual GDP and the RER, in what they term a variation of Okun's Law (sic). They find that unemployment is affected by the exchange rate, but to say that the model is misspecified, and that suffers from an omitted-variable bias is an understatement.

The current account in Latin America improved mostly because of a positive terms of trade (TOT) shock, and was not the result of a depreciated RER, which at any rate as the authors note, was almost at the same level as before the boom by the end of 2000s [that's why Frenkel keeps asking for depreciation to promote growth]. The improved TOT were relevant because they allowed for fiscal expansions without leading to current account problems, and on top, the expansion of the economy allowed for increasing tax revenue and balanced fiscal accounts. In other words, the fiscal rules were not the cause of primary fiscal surpluses, but the result of the economic boom.

Fiscal expansion, and the expansion of real wages, were certainly more important for the reduction of unemployment. The authors are correct, however, in emphasizing the role of employment generation in reducing poverty and inequality. Note, also, that as real wages expanded all countries experienced RER appreciation, but the evidence suggests that income expansion is what led to a reduction in current account surpluses. That's why depreciation cum fiscal adjustment, that Frenkel correctly connects (in Spanish) with IMF policies, are not the solution.

By the way, unemployment fell because GDP grew, and the old and simple Okun's Law, without the exchange rate, still works very well.

* In fact, many development economists starting with Hirschman and the Diaz-Alejandro, later formalized by Krugman and Taylor, suggested the opposite, that depreciation was contractionary. See here.

World Bank thinks contraction in developing countries is good

The World Bank suggests that the slowdown in the periphery is good, since it has moved several countries from a positive output gap, with excess demand, to sustainable positions with negative output gaps, as shown in the graph below (h/t Otaviano Canuto; source here).

Note that Brazil, China, and India are in this category. Argentina still has excess demand. Potential GDP, which given Okun's Law imply a certain level of unemployment and connect the concept with the other neoclassical standard assumption of a natural rate of unemployment, are quite low in many developing countries if you believe the World Bank.

These are, in the World Bank's view, of course, supply side constraints that are not affected in any way by demand forces, even if the evidence in favor of the accelerator, which suggests that capacity adjusts to demand, is overwhelming.

The usual rules of economics

Krugman continues to defend his activist policies on the basis of the 'liquidity trap.' Beyond the usual confusion criticized several times here, he says that: "some of the usual rules of economics are in abeyance as long as the trap lasts. Budget deficits, for example, don’t drive up interest rates; printing money isn’t inflationary; slashing government spending has really destructive effects on incomes and employment." So according to him usually you have crowding out (higher interest rates with higher deficits), inflation is demand driven and caused by money printing (exogenous money), and cutting spending has no effect on employment (expansionary contractions).

None of this holds in normal times either, and he should know better. The evidence for the effects of budget deficits on interest rates, even in normal times, is not particularly favorable to the crowding out argument. The effects of a higher deficit-to-GDP ratio on long-term interest rates tends to be small, when it's statistically significant. And arguably even that small effect might be due to reverse causality, that is, the higher interest rate causes higher financial spending and higher deficits.

The same problems of causality plague the relationship between money and inflation too. And it has been accepted by almost everybody that central banks, always and not just in liquidity traps, control the rate of interest, not money supply. Unless you really believe that the economy in normal times is at full employment. If unemployment is the normal situation, then that would mean that the Fed sets the rate of interest, money supply is endogenous, and inflation, if it does exist, is cost driven. And if you really think that the 1970s inflation in the US was casued by money printing rather than the oil shocks and wage resistance, then it's hard to take you seriously.

Finally, wait, does he seriously think that, in non-liquidity trap periods, if you cut spending, then income and unemployment don't increase? I guess Okun's Law only works during liquidity traps. Oh well; and he is on our side. As they say, with friends like this...

Okun's Law at 50

The IMF has written a good paper on Okun's Law (here), suggesting (from the abstract) that: "Okun’s Law is a strong and stable relationship in most countries, one that did not change substantially during the Great Recession [and] accounts of breakdowns in the Law ... are flawed." nothing new really; I have said so a few months ago (here). Bill Mitchell has good post (here), which suggests correctly that the problem with the recoveries is not Okun's Law, but excessive fiscal austerity. I would add one more thing, not only Okun's Law works well in developed countries (advanced economies according to the IMF paper), but also in developing countries. Figure below is a crude representation of the Law for Argentina.

Note that the coefficient is more or less the same as in the US or other advanced economies. An increase in GDP growth of 1.87% reduces unemployment in 1%. Close to the 2 to 1 ratio. A more sophisticated and better estimatimated version that takes into account trend issues associated with Kaldor-Verdoorn, by Fabián Amico, Alejandro Fiorito and Guillermo Hang is available here (but in Spanish).

Productivity slowdown and and the return of secular stagnation

Robert Gordon has recently argued that secular stagnation is a likely possibility. Alvin Hansen, one of the most influential of the neoclassical synthesis Keynesians, was the father of the idea. For Hansen the reasons were associated with declining population growth, the disappearance of labor-saving technology, and the closing of new frontiers.

His views were published in a famous book titled Full Recovery or Stagnation?, in which he argued that investment opportunities were lacking. Since Keynes theory was also dependent on the expansion of autonomous investment, and Hansen was a Keynesian, the stagnationist thesis was considered a Keynesian theory. All in all, Hansen's views are not very different from Gordon's position. However, it is important to note that Gordon presumes that productivity determines growth, which is not a very Keynesian proposition.

The table below shows the rate of labor productivity growth from 1948 to 2011, and the two sub-periods that start with the productivity slowdown in 1973. Note that productivity growth follows the rate of growth of output (GDP).

This is not the Okun's Law discussed before, since these are averages that eliminate the cyclical relation between productivity and growth. In other words, the relation above is about the trend, something referred to as the Kaldor-Verdoorn Law (KVL). KVL suggests that productivity growth is not the cause of growth, but the result, and it assumes that growth is demand led, in Keynesian fashion. This would suggest, at least from the technological point of view, that there are less reasons than Gordon suggests for his pessimism. Of course one may very well think that stagnation in the US will result from the political forces that do not allow demand expansion. And yes everything hinges on the thorny issue of causality.

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).

Prices and quantities

Mainstream economics suggests that prices and quantities should be treated simultaneously, as it should be if market prices as determined by supply and demand are at the center of the analytical framework. With supply and demand, it must be the case that the quantity produced, and the equilibrium price, both are determined simultaneously. Further, it is the case that, with price flexibility, the quantity produced is optimal from the perspective of the utilization of resources and the preferences of the agents. And if that is true for bananas, or any other commodity for that matter, it must be true too for labor and ‘capital.’

As I discussed before, in particular with respect to capital, this approach (supply and demand or marginalist), which contrasts with the surplus approach, has serious problems. Even if we dismiss, for simplicity sake, the subjective part (about preferences) and concentrate just on supply conditions, the difficulties are insurmountable. Producers only supply more at higher prices, which means that they must encounter increasing costs (diminishing returns). It cannot be the case that they are only willing to supply more at higher prices (higher remuneration) even if costs are not higher, since if one producer obtained higher remuneration free entry of new producers (attracted by the higher remuneration) would imply that more would be produced. So the supply curve depends on diminshing returns.

And diminishing returns are a highly improbable proposition, as Sraffa argued back in the 1920s. Not many producers, if any, would tell you that they don’t produce more because their costs would go up (and that would reduce demand as prices get higher). Most simply would reply that, although they could produce more at the same price, they don’t have enough demand. But the diminishing returns fetish dominates the profession (I won’t say anything here about imperfect competition, but Franklin Serrano noted here that this would be related to barriers to entry).

In the surplus approach, that concerns itself with the way in which societies reproduce themselves (usually in an amplified scale and with accumulation), prices and quantities are treated separately. Since costs of production, for a given technology, seem to be independent from the quantity produced (i.e. the cost would be the same if you produced slightly more or less), then the quantity can be taken as given for the discussion of the determination of prices. It is well know that, in that case, prices depend on the technology, which must allow for reproduction (including of the labor force) and by the way in which the surplus (what is left over, above and beyond the needs of reproduction) is divided between classes.

This separation between prices and quantities has been called by Garegnani the 'method of given quantities.' Note that it does not imply that the quantities are determined by supply or given at a level that is optimal from the point of view of utilization of resources. And that is why it is perfectly compatible with Keynes’ notion of a demand determined level of activity (yes you can, and should, add Sraffa to your Keynes, or Kalecki). Also, it does not mean that there is no technical change or that distribution does not affect output (all propositions that have been discussed here in the blog).

Be that as it may, I’m more interested in the macroeconomic implications of the mainstream views about prices and quantities. Since the late 1960s, these views have coalesced around the notion that, whereas there is a short run tradeoff between prices and quantities (the so-called Phillips Curve, PC), in the long run the tradeoff vanishes. Put simply, if you push demand too much (through fiscal and monetary policy), output would increase, unemployment fall (as per Okun’s Law: higher output implies lower unemployment) and inflation would accelerate. In the long run, however, the economy is self-adjusted and output cannot be above the optimal level, so the only effect of the expansionary policies would be inflation (Friedman dixit).

By the way, the same (the mainstream loves symmetry) is true for deflation. Yes it may cause some problems, but the system returns to full employment, even in the face of contractionary policies (the Greek should not worry about contraction, because markets would produce full employment if they are allowed to work; hence, the need of labor market flexibility). In the long run contractionary policies only would affect prices. In sum, supply and demand would lead to the optimal price and quantity, so if you get off my market (cranky old neoclassical guy would say), and stop expanding demand, there would be no inflation.

The evidence for a natural rate or for a PC is incredibly weak. In order to argue that there is a natural rate, the mainstream has basically suggested that it moves around all the time. So in the 1980s the natural rate was higher (in the US), when the actual unemployment was higher, than in the 1990s (particularly towards the end of the decade), when the actual rate was also lower. The ad hoc nature of the solution is evident. They tell you that the natural (which they measure as an average of the actual) is the attractor of the actual rate, and not the reverse.

The continuous ad hocery of the mainstream is on display now too. This is evident in discussion about the fears of inflation in the US, according to which the tripling of the monetary base would lead to hyperinflation (Krugman criticizes that here, and in several other places). Inflation does not take place, but it must be that expectations of inflation are low.

Also, it is evident in the IMF, the Bank for International Settlements (BIS) and other international institutions (since last year at least) arguments for fiscal and monetary contraction in the periphery (which is still growing faster than the center). The IMF believes fiscal expansion is no longer needed since “private demand has, for the most part, taken the baton” (IMF, 2011: xv). Moreover, the BIS argues that inflation is presently the main risk in an otherwise recovering world economy, and therefore suggests “policy [interest] rates should rise globally” (BIS, 2011: xii). According to this view then, if demand is controlled then prices would stop growing fast, and inflation would be under control.

Brazil actually did that last year, that is, fiscal contraction (with some monetary easing, but from a very tight stance, since it still maintains very high real interest rates). Output decelerated from 7.6% growth in 2010 to a mere 2.7% growth last year. A reduction of almost 5%. Did inflation then fell significantly as it should according to the mainstream? The Consumer Price Index (CPI) of the Fundação Getúlio Vargas increased from 6.24% to 6.36% in the same period, that is, it was almost constant. Something similar took place in Argentina between 2008 and 2009, when output decelerated around 10% (from high growth to negative growth), and inflation remained at high levels (fell perhaps around 6% or so, in an year that commodity prices collapsed). The mainstream argument is that the policies were not credible and as a result inflation expectations remained high.

In other words, it is not that the theory does not work, even though facts show that their predictions are false. It's a problem of the complexity of the phenomenon, and the need to account for expectations (anything can enter here, and no hypothesis can be tested if you take this seriously).

A simpler solution would be to admit that prices have little to do with demand (at most weaker demand and lower employment reduce the bargaining power of workers and reduce wage resistance). In other words, get rid of the notion of natural rate of unemployment and of a PC for which there is no reliable evidence (as should be done by any serious scientist). The contractions demanded by the IMF and the BIS led to recession (they affect quantities), and prices in Brazil did not fall because costs (which include imported goods and wages) did not fall. No need to suggest that expectations are responsible for inflation not falling. [Keen on his debate with Krugman has also referred to these subterfuges to keep theory in the face of lacking evidence; epicycles if you will]. By the way, expectations have been traditionally a way to argue that anything can happen, and allow theories that are not consistent with facts to get away with the incoherence. But I'll let that for another post.

References:

BIS (2011). 81st Annual Report. Basel, Bank for International Settlements, June.

IMF (2011). World Economic Outlook. Washington, DC, April.

New Monetarists, scientists or engineers?

Back in 1994, when the New Keynesian (NK) label, if not the models, were relatively new, Ball and Mankiw argued that Milton Friedman was closer to the NK approach than the New Classical (NC)/Real Business Cycle (RBC) one. For them (see here, 1994, p. 9):

"although traditionalist are often called 'new Keynesians,' this label is a misnomer. They could just as easily be called 'new monetarists.'"

The whole point was that monetarists believed in the non-neutrality of money in the short run and in sticky prices, like NKs. Now there is an explicit New Monetarist model with sticky prices here, and a growing literature surveyed by Stephen Williamson and Randall Wright here. Williamson has a blog here.

New Monetarists seem to build on ideas developed by Thomas Sargent and Neil Wallace in the early 1980s (here, for example). A simple introductory presentation is given by Champ and Freeman (here). The theoretical framework is in general based on overlapping generations models, in which monetary policy can affect relative prices and, as a result, change the intertemporal consumption, labor supply, and investment decisions of rational maximizing agents.

As Williamson says:

"Monetary policy matters due to distortions in intertemporal prices, for example the anticipation of higher money growth and higher inflation acts as a tax on labor supply and reduces output."

Not sure if he thinks that the current slow growth is to be blamed on the expansion of the money supply after the recession, and higher inflationary expectations, leading to an increase in the demand for leisure time (a reduction on labor supply, that will be taxed by the higher inflation). That would explain why he thinks that the Fed should sell bonds, and raise the interest rate (not a joke!). At any rate, the whole New Monetarist approach is fundamentally, like New Classical authors in general, concerned with microfoundations. In this case, microfoundations in the money market.

This kind of approach reminds me of another Mankiw paper on the nature of macroeconomic research. For him macro, from the Keynesian Revolution until the rise of Lucas and the New Classical school, was dominated by what he calls engineers, that is problem solvers. From Lucas on it has been dominated by scientists, meaning those that search first principles.

So the first group was concerned with empirical regularities, like Okun's Law, while the latter emphasized rational intertemporal maximizing economic agent models, like in the Ramsey model. New Monetarists are clearly in the latter camp. So are we better off with the rise of the "scientific" macroeconomists? Here is why Mankiw's paper is so important. He candidly tells us (p. 19):

"The sad truth is that the macroeconomic research of the past three decades [the 'scientific' micro-founded stuff] has had only minor impact on the practical analysis of monetary or fiscal policy. The explanation is not that economists in the policy arena are ignorant of recent developments. Quite the contrary: The staff of the Federal Reserve includes some of the best young Ph.D.’s, and the Council of Economic Advisers under both Democratic and Republican administrations draws talent from the nation’s top research universities. The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering."

No kidding, great science that has nothing to say about the reality of how to solve actual economic problems. The rise of sci-fi macroeconomists. Welcome to the Twilight Zone!

Striking inanity

Mankiw thinks that the scatterplot below is striking. He should read an intro textbook (I imagine even his text presents the simple Keynesian model).

What drives both is the expansion of autonomous demand. Demand increases output, and as per Okun’s Law reduces unemployment. Investment follows the accelerator, that is, as output increases firm’s investment also increases to maintain the relation between productive capacity and income. How is this striking?

Okun’s Law: Is it broken?

Okun’s Law suggested that an increase in output would imply a fall of unemployment, and the relation was often assumed to be a 2:1 ratio in more recent times.  Jon Hilsenrath suggested recently, in a WSJ blog, that the relation is broken.  He argues that the average growth between 2007 and 2009, the recession years, was around 2.5% below its trend (the actual growth was slightly negative, around –0.22% in the three years), and that Okun’s Law would have implied and increase of unemployment of approximately 5% (he says little more than 5%, from 4.4% to 8.9%” [sic]), but it increased more, reaching 10.1% in October 2009.  That is the basis for the claim that the law is broken.  In fact, the average annual unemployment increased from 4.6% in 2007 to 9.6% in 2010, precisely 5%.  His fears about the breakdown in the recovery are also exaggerated.  What is really surprising is that he thinks that: “unemployment seems to be falling sharply.”  I need to find these rosy goggles WSJ bloggers use.