Keynes

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Economic Growth Disappoints

The latest revision to the third quarter GDP numbers produced a disappointing report. While most analysts had been looking for growth to be about 3.0%, which would have meant another slight upward adjustment, the final tally was only 2.6% and thus quite a bit short of expectations. The hope had been that growth would be picking up as we head into 2011, and that the new stimulus hidden within the recent tax deal would then catapult us higher into the mid 3.% to 4% range. Now such a spurt looks much more difficult unless the fourth quarter comes in unexpectedly strong.

The second revision to the third quarter figures released last month had shown growth at 2.5%, and with some sectors of the economy performing better than expected – sales of autos especially – many people had stared to believe the economy was in much better shape. Indeed there were rumblings that too much more stimulus would only show up as inflation rather than as real growth. Such thoughts are now to be banished. The economy is growing, but it is nowhere near growing fast enough either to tackle unemployment quickly, or to raise inflationary concerns. Instead we appear to be still stuck in a sideways crawl, like a crab on the beach not going anywhere in particular.

Indeed the pessimists might get support from the numbers. Much of the jump in growth from the second quarter, which saw GDP rise only 1.7%, was due to factors such as a drop in imports and a rise in inventories, both of which can have very ambiguous causes. Imports typically rise when the US is growing quickly as demand for finished goods and raw materials takes off. That imports fell could be an early sign of renewed stagnation. Likewise the fact the inventories continued to rise can also be interpreted as a weak sign: perhaps businesses overestimated sales and will have to cut production in order to get sales to inventory ratios back in line.

Of course there are more optimistic interpretations too. Especially for inventories. During the recession firms cut back drastically on inventories as they reduced their sales forecasts and generally hunkered down to weather the storm. As the recovery gained steam the need to rebuild inventories re-asserted itself and we saw a long and steady climb back towards more normal levels. Sales forecasts were raised, albeit only slightly, and production rose accordingly.

Obviously the key will be the holiday selling season. Early indications are that it is fine but not great. Steady as she goes seems to be the way to characterize the state of the economy.

And therein lies our problem.

We need much more rapid growth to work off the huge slack that still hampers the employment market. The longer we go without such a burst of activity the worse the situation becomes for those workers who have been unemployed for a long time. Their skills and enthusiasm will ebb, and with a hostile Congress their chances of getting more help is receding. Unusually for the US we are now, apparently, facing a very European like sclerosis in our vaunted job market. Flexibility used to be the watchword during our business cycles, with rapid increases and decreases in unemployment. The last two recessions should have warned us that our job market was getting very “sticky”, by which I mean the decrease in jobs took longer to reach bottom, and the recovery took much longer to re-absorb the unemployed. This cycle has been even worse. It truth it has been awful, not just in its severity, but in its stubborn lack of improvement. This more Euro style cycle is unnerving for America where the Euro style safety net does not exist, and old fashioned puritanical attitudes toward the unemployed resurface very easily. This comparative weakness in our safety net programs was all well and good when we had a youthful and dominant economy. Clearly the economy has moved on. Unfortunately our political thinking has not. It may take a few years of suffering for us to realize that this was not just another cycle, but was the end of a long term decline that we now need to arrest and address.

Which leads me to this:

I have said it many times, but it bears repeating, healthy economies and healthy societies do not privilege one part over another for long. They seek and try to maintain balance. During the 1950’s and 1960’s the US managed to locate a mother lode of wealth by staying in such a balance. Profits, wages, productivity, and wealth moved in a harmonic trend together. Neither wages nor profits soared at the expense of the other. Higher wages fed sales which created higher profits and so it rolled on. After the Reagan illusion set in and the economy shifted towards debt based growth and short term profit gain at all costs, the balance was lost. Or rather it was deliberately thrown overboard. The new generation of managers and politicians, steeped in Friedman and Hayek, tossed away any notion of social cohesion whilst in the misguided thrall of free market dogma. The result has been the steady rise in inequality, profits reaching record levels while wages stagnate, and the substitution of debt for equity at both the household and business level as the cost of keeping decent growth in living standards became ever more difficult. Our post 1980’s leaders formed an educated elite who drove home the advantage their education wrought. The bulk of the rest were left way behind.

This asymmetry eventually eroded the economy’s ability to self generate wealth in a steady even stream. Instead it became susceptible to Minsky like financial cycles and thus inevitably to implode. Bank caused bubbles are the new norm. The rentiers cling to their privilege by offloading the cost of recovery to the taxpayers who are now underrepresented within the halls of power. To belabor the blame due Friedman and Hayek: we were indeed “free to choose”, but we were led along the “road to serfdom”. A populist reaction was inevitable, and the Tea Party seems to be its first manifestation. People will lash out even if they lash out in the wrong direction, as they have done this time.

Free markets just don’t work in complicated societies reliant upon complex production to meet its needs. The market needs to be augmented by strong government intervention to prevent rent seeking imbalances from creating an uncontrollable yaw. When we fell for the free market illusion we condemned ourselves to exactly the kind of cycle we are now suffering through. And it looks as if the denouement is years of unsatisfactory GDP growth and prolonged unemployment. We hurtled back in time to the pre-Keynesian world of classical economics and a highly bifurcated society. We embraced red blooded capitalism in an age when global reach and rapid technological advances exposed us as easy prey to those with capital or lower costs, and those in control of the vast bureaucracies able to move resources around at will to seek profit from that capital or those lower costs.

How many times during this cycle have we been told that we need to swallow unpleasant medicine in order that the “system” be saved? Did we ever ask in sufficient depth who this system benefitted? If the market is so magical how come the system broke? Should those who benefitted not pay for its repair? If there is one lesson that history should have taught the average citizen: there is nor “fair” in laissez faire. When we start to be told about rising tides lifting all boats we should question who is on the biggest boat. When we are told that something trickles down, we should question whether a trickle is enough. Yet we fell for the illusion, and soldiered on getting ever more into debt in order to stay afloat.

We shut our eyes to history. That’s never a good thing.

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Time Warp Economics

One of my ongoing complaints about economics is that it seems hidebound and horribly out of date. It seems stuck in the steam age with its references to land, labor and capital. Its models conjure up images of the titans of industry forging new railways across open plains and building vast steel works or cotton mills in once pristine valleys. There are landlords preying on peasants, while workers labor away in Dickensian conditions. Words straight from those bygone years litter its lexicon. The very notion of the margin was born from the forced usage of the worst farmland as the population grew, and from the distances wagons had to travel to market towns in northern Germany.

Not that there’s anything wrong with this, as long as we add more modern stuff along the way.

And that’s the problem.

Even reading the 1950’s work on pricing is an adventure back into an archaic world. Nowhere, or at least not very prominent, are concepts drawn from all the advances of the last couple of decades. It may be useful to talk about production functions and cost plus prices, but they remind me of astrolabes while I live in an era of GPS devices.

Leafing through an average economics paper or book I am left imagining a world largely bereft of mega banks; international companies managed by large self serving bureaucracies; internet sales; digital transmissions; or computer use. Very little seems to be made of the vastly more rapid flow of information, or that many of our products nowadays are entirely information based. It’s as if we never left the industrial era.

This may not matter. But I suspect it does. I suspect that a finer breakdown of labor would reveal very different influences on wage patterns and inequality. Models that treat labor as one big glob probably miss this detail. The same goes for capital.

It may well be that the basic 1800’s categories are sufficient to explain a 21st century economy. But I would like to be sure.

We are often told that capitalism adapts. If so, why are we looking at it through the same old lens? Land, labor, capital. Is that it?

It seems to me that the economy moves from one state to another. Each state being the result of some vastly complex computation based upon a massive set of variables. The space of those states is thus practically infinite. Yet the movement of the economy from one state to another is heavily constrained. We made it thus. We set boundaries by establishing institutions and cultural norms. Its movement is constrained by geography and the resource limits that are associated with location. Our ability to exploit those resources hinges on our knowledge and technology. The networks through which we communicate limit the flow of knowledge and capital. Society with its classes and other fractures gets in the way of smooth operation. And, of course, each configuration of the economy limits the possibilities for the next. Then we must account for the feedback between our current activity and each of these constraints.

It is tempting, in that face of this complexity, to simplify. We build models to explore pieces that interest us. Sometimes we dare to encompass the entire economy in one such simplification, and impute properties like equilibrium to tame the beast sufficiently for our imaginations to explore. We imagine that properties at one level of granularity flow untouched onto other levels either above or below. We remain faithful to the foundations of the discipline.

But if we don’t update our thinking, if we ignore progress, we run the risk of becoming anachronistic. Our models look quaint next to the reality they are supposed to explicate. We are condemned to add ever more sophisticated spheres to our Ptolemeic systems in order to keep up with emerging knowledge. We scramble for ever more ludicrous assumptions, and when all else fails we simply assert axiomatically that the world is the way we need it to be for our steam driven models to remain in touch with the electronic age. It is flat if we only have the tools to examine flat worlds.

One example: it is odd that it took such an effort to insert technology into our models as a driver of growth. In our zeal to cut the problem down to manageable size we eliminated most everything resembling an actual economy, and ended up focusing on allocation or heavily constrained optimization. That is pointless, because we are no longer examining anything that exists. Anyone familiar with complexity, self-organization and evolution is comfortable with systems that mutate, adapt and change from within. Technology is an obvious component of such change. It is entirely ordinary to consider it. Not extraordinary.

The mechanistic, individualistic, reductionist time warp that orthodox economics is trapped in does a disservice to our future. It is inappropriate. It is inaccurate. It is dated. So is the reliance on the same set of alternatives. Kalecki, Keynes, Sraffa, Robinson, the entire lot need to be freshened up. With them we moved from a goods based analysis to one inclusive of credit, money and finance. Now we need to embrace information. We need to move on and not keep arguing over the same time worn issues that occupied our forbears.

Here’s an idea: the information content of the economy has exploded. The products we make now are information intense. The algorithm needed to explain those products is more complicated and lengthy than that needed to explain the average product made seventy years ago. Our thinking about what an economy is needs to keep up.

And that goes for all you DSGE fans too.

Then again I may be wildly wrong. After all an astrolabe would still help you navigate the world. Sort of.

But I know it’s not flat.

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Krugman Fails To Take Up The Challenge

Sifting amongst the debris left after the recent collapse of economic orthodoxy is not easy. The big guns of the academy are clinging on for all they are worth to the idea that a few fixes and we are all back on track. They have the most to lose in reputation and standing, so I suppose this stubborn refusal to admit the extent of the defeat is understandable. But it is not acceptable. Things have to change in a more dramatic way for economics to rehabilitate itself as a credible body of thought upon which policies can be based. It is simply not enough to continue the old “freshwater” versus “saltwater” debate – that please recall is the argument between various grades of orthodoxy, the former ensconced in Chicago and other universities far from the coasts, and the latter based primarily on those two coasts.

Paul Krugman is a great example of the problem.

He presents a strong argument and defense of a Keynesian approach to macroeconomics. This is the part of economics that deals with the big issues that occupy policy makers, especially in times of recession. In this he finds himself ranged against the more orthodox ideas of the Chicago style thinking that has invaded and taken over most of the high ground in the discipline. So he thinks of himself as an insurgent of “heterodox” thinker, and likes to do combat as a rebel.

This is curious since the rebellion is simply an attempt to reinstate the Keynesian theoretical constructs that were so successful in the immediate post war years until they were dethroned by monetarist and then hyper rationalist versions of what is called neoclassical economics. That neoclassical set of ideas was largely initiated by Paul Samuelson in 1948, when he published his enormously successful textbook and sought to incorporate Keynes within the pre-existing classical tradition.

The problem this melding produced as its legacy is that there is an inherent and implacable break between Keynesian and classical economics. Keynes spoke to aggregate issues: before him there was no notion of “aggregate demand” as a concept to be studied, managed, or fitted into policy. He argued that uncertainty was axiomatic and that the classical notions of perfect competition and so on were thus invalid. Unfortunately Keynes did not follow through and give us a full replacement for the old classical system. He was a practical and conservative person dealing only with the larger issues: indeed he invented what we now called “macroeconomics” so he could propose solutions to those larger issues, especially the devastation wrought by the Great Depression.

To put it bluntly: economics became a mess.

At the big picture level the emergence of Keynesian thinking split the subject apart. The saltwater versus freshwater fight is the result of this division.

But at the lower level much of the classical tradition survived untouched. The magic of markets; the workings of rational agents making perfectly rational decisions; the possibility of a “Pareto Optimum” – that mystical point at which an economy reaches its most efficient allocation of resources; and the other paraphernalia of classical “microeconomics” remained supreme.

So economics was cleft in two. The Keynesian constructs at policy level were based upon a worldview at odds with the micro analysis economists still relied on to understand the workings of the marketplace.

One response within economics was to replace Keynesian macro with a cobbled together version based upon classical micro. The mantra became “macro built upon a micro foundation”. This new classical tradition is the basis for freshwater thinking.

The other response was simply to ignore the contradictions between Keynesian macro and classical micro. This was the basis for saltwater macro.

Krugman falls into the second group. He voices little concern about the contradictions. Indeed he accepts them.

The obvious parallel is with physics, where the physics of very small things, known as generally as quantum mechanics, is incompatible with the physics of very large things, which is the relativity of Einstein. If physics can exist with a great divide, Krugman argues – I am putting words in his mouth – so too can economics.

This, frankly is rubbish.

Why?

For two reasons:

One, is that physics at each level is supported by empirical testing to an extraordinarily high degree of accuracy.

Two, is that physicists the world over are striving to connect to the two traditions. they do not find it acceptable to have deep contradictions within their thought, and so have set out to look for the necessary theoretical breakthroughs needed to reconcile them.

Not so in economics,according to Krugman. We, apparently will have to make do with the odd supposition that aggregate constructs are subject to inherent, and axiomatic, uncertainty. While our understanding of the deeper workings of the markets, firms, and consumer behavior from which those aggregates are composed are subject to no such thing. On the contrary those lower order objects behave supremely rationally in a world admitting of no uncertainty at all.

Talk about a muddle.

That this muddle persists is indefensible. It is time to eliminate the error left in the aftermath of the Samuelson synthesis. If Krugman won’t take up the challenge, then others will. Building a new micro based on the acceptance of uncertainty as its central axiom is the work we now need to undertake. Much has been done, much is yet to be done. One thing is clear: the challenge must be met.

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Record Profits

Let’s all note today’s news about corporate profits: they hit an all time record by reaching an annual rate of $1.659 trillion. Clearly business is not hurting.

This record setting pace comes in large part from the increase in productivity businesses have wrung from their operations. They have learned over the past two years to manage with far fewer workers. They have shipped operations abroad to lower costs. And they have expanded their market share in emerging markets where growth is strong at the moment. From the perspective of shareholders this is a great time.

Workers not so much.

This simply repeats a pattern we have seen for a decade or more now. The only element of the economy that performed well during the Bush regime was corporate profit. Everything else, especially anything to do with worker compensation, fell steadily behind historic trends.

Even so the huge piles of cash being accumulated by our large companies is extraordinary. That they see no reason or need to invest in the American economy is attributable to its sluggish growth and the fact that they can still squeeze workers some more.

This does not portend well: sooner or later, as Keynesians point out, the diversion of the national wealth into profits results in such an imbalance that the economy is thrown into reverse. There are any number of Keynesian models of the economy – Kaldor’s for instance – that point to a decline if the balance between worker wages and profits is not restored.

One last thought: the so-called “Golden Era” of the 1950’s was built entirely upon such a balance. Profits were kept in check; income inequality shrank; CEO pay was limited to sensible ranges; unions produced high blue collar wages; and the economy grew strongly. Republicans argued for increased health care coverage and bemoaned defense spending.

How long ago that all seems.

Where did it go wrong?

One word: Reagan.

Corporate profits have now grown for seven – count them – straight quarters. Some of those quarters, like this last one, have set all time records for growth. Business is the one part of the economy flourishing under Obama. So big business must love him.

No?

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It’s Love “Schumpi” Day

When last I wrote here I repeated a quote by Joseph Schumpeter, that Paul Krugman used to lambast the classical opposition to government interference in the economy.

True to form, I was immediately set upon by the one man Austrian economist defense force – Stephan – who managed to dig out the original text from which the quote was cut. His purpose being to draw my attention to the softer tones used elsewhere in that document.

I agree. Schumpeter was not as clear cut a terror as Krugman made him out to be. While we all know Schumpeter as the inventor of the phrase: “the gales of creative destruction of capitalism”, he was so much more.

His influence was muted by the fact that his long career always seemed to leave him out of the limelight, he was eclipsed by Keynes for instance, and never part of a dominant school of thought. He was a teacher, at Harvard, of a number of subsequent “Nobel” prize winners, but his books and papers put him outside of the emerging mainstream of American economic theory.

In many ways Keynes was more orthodox than Schumpeter.For instance, Keynes, for all his rebellion against classical theory, was still committed to static equilibrium style thinking. That in his system equilibrium could imply less than full employment was startling, and controversial. But his thinking was focused on the properties of economies as they tend toward or away from such equilibrium. It was Patinkin who pointed out that Keyne’s great innovation was to locate the equilibrating force within his novel conception of “effective demand”. Everything else in The General Theory flows from that idea, and the tools Keynes used were borrowed and adapted from others, such as theeconomist Fisher.

By contrast, Schumpeter was never interested in equilibrium. He saw the economy as in perpetual flux and never in the kind of static equilibrium that has come to dominate orthodox economics since the mid-20th century. This is why he was led to discuss “creative destruction”. The central actor in his conception of an economy was the capitalist innovator driven by profit to search for new products and new methods of production. It was this innovation that, in Schumpeter’s view, provided the engine driving wealth creation and social welfare generally. Along the way capitalists make mistakes, they over produce or over invest, this leads to periods of adjustment and the need to revalue assets. These periods are what we call recessions or depressions, and are the times when those mistakes are wiped away. Hence the destruction. Naturally once the adjustment has been made and past mistakes expunged, the now chastened capitalist class powers forward again, driven once more by the profit motive, only this time free of the encumbrance either over valued assets or ill advised investments. Hence the creative aspect to Schumpeterian economics.

Drucker draws the difference between Schumpeter and Keynes nicely. Keynes, he said was merely a heretic. Schumpeter was a full blown infidel.

Unfortunately for Schumpeter his notion of an economy being dynamic and subject to cyclical upheaval flew directly in the face of classical theory whose goal was to place economics firmly into a Newtonian firmament both mechanical and determinist. This misfortune was compounded by the success of people like Arrow and Debreu who, a few years after Schumpeter’s death, were able to create the mathematics necessary to articulate a model of general equilibrium and thus obviate the need for younger theorists to explore the seeming chaos of the Schumpeterian world.

Oddly, sixty years after his death, Schumpeter seems more relevant than before. His ideas could be re-cast as being evolutionary, and the great theme of evolution is one possible way in which economics can regain the relevance and connection with reality it lost after Arrow-Debreu. His importance to current events is even more significant when we consider his long view for capitalism. It was a system, he thought, that would choke itself on its own success. Not through the results posited in the Marxist critique, but because of something altogether more mundane: he feared that capitalism would spawn a great bureaucracy populated by elitist “hangers-on” to the entrepreneurial machine. These elitists would be highly educated workers like lawyers, accountants, and bankers who would eventually sap the system of its vitality through their ability to impose non-productive costs on the innovative process. They would rent seek, draw off funds, and starve capitalists of the means to keep the engine running.

This scenario sounds eerily familiar. It also accords with the work of a protege of his nemesis. It was Minsky, a follower of Keynes, who correctly developed a theory describing the instability within finance – one of Schumpeter’s feared bureaucracies. So, perhaps, within a Minsky moment we can detect the imprint of Schumpeterian creative destruction.

If so, there is hope for a conjunction of the theories of two of greatest non-classical thinkers of twentieth century economics.

And we need all the new ideas we can get.

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