Category: Equitablog

Must-Read: Simon Wren-Lewis: A General Theory of Austerity, Cynicism and Opportunism:

Was austerity an unfortunate accident?…

…For the major economies including the Eurozone as a whole, austerity could have been avoided completely by delaying fiscal consolidation by a few years…. There was no evidence that the financial markets had demanded the switch to austerity in 2010. Instead, the Eurozone crisis went beyond a crisis for the Greek government because of the ECB’s unwillingness (until 2012) to act as a sovereign lender of last resort. In other words, austerity at the global level was a huge and avoidable mistake. This naturally leads to the question of why that mistake was made…. The accident story might run as follows. The first unfortunate accident was Greece…. The second accident was that Greece’s situation occurred inside a Eurozone that was dominated by Germany…. While there is undoubtedly an important element of truth in both the unfortunate timing of the Greek debt crisis and the role of Germany in interpreting and reacting to it, there are three reasons why it cannot explain the dominance of austerity since 2010…. Within the Eurozone… there has been… little resistance to German views…. In the US and UK… the turn to austerity [as well]…. The damage done by austerity, and the special nature of the debt funding crisis in the Eurozone, were quite clear to most economists by 2014 at the latest…. Yet while the IMF’s own economists were prepared to make this admission, politicians (including those running the IMF) were not….

The idea that deficit concern was being used as a pretext to reduce the size of the state, which I will call the deficit deceit hypothesis, is based on two propositions:
1) Political parties on the right want a smaller state, but popular support for such a programme is, at best, mixed. 2) From 2010 there was strong popular support for reducing government deficits…. One strong piece of evidence in favour of deficit deceit is the form of austerity imposed. Republicans in the US called for spending cuts to reduce the deficit, while at the same time arguing elsewhere that taxes should be cut…. At first France appeared to be an exception, proposing to focus on tax increases to reduce deficits. European Commissioner Olli Rehn was not pleased…. An indication of the strength of popular support for cutting budget deficits came from the lack of opposition to these policies from the centre left….

Perhaps the most interesting argument in Wren-Lewis (2015b) is that the creation of independent central banks, coupled with a growing consensus that monetary policy and not fiscal policy should deal with macroeconomic stabilisation (Kirsanova et al, 2009), has helped reduce the extent to which policy makers and the media hear about the costs of fiscal consolidation in a liquidity trap…. The expertise in finance ministries. If governments have in effect contracted out the business of macroeconomic stabilisation to central banks, there is less need to retain macroeconomic expertise in these ministries. The second concerns the attitudes of senior figures in central banks to budget deficits. Mervyn King once remarked (King, 1995): “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” This follows from a historic concern that governments will force central banks to monetise debt, which outside of a recession could lead to large increases in inflation….

The deficit deceit hypothesis is therefore a general theory of why austerity happens when we are at the ZLB. It reflects opportunism on the political right… [that] will only work… [if] popular concern about government deficits must be strong… a generalised fear about the behaviour of financial markets… knowledge about the harmful effects of fiscal consolidation at the ZLB… weak within political parties, the apparatus of government and the public at large…. Popular concern about government deficits will be much greater if these deficits are at ‘record levels’, which they inevitably were following the deepest global recession since WWII….

There are also some trends that have helped create the conditions for deficit deceit to work. The most obvious is the growing power of a neoliberal ideology that puts such stress on the desirability of a small state…. The importance of deficit deceit in explaining recent (and in some countries, continuing) austerity means that it could easily happen again following another major recession….

There was no good macroeconomic reason for austerity at the global level over the last five years, and austerity seen in periphery Eurozone countries could most probably have been significantly milder. As austerity could have been so easily avoided by delaying global fiscal consolidation by only a few years, a critical question becomes why this knowledge was not applied. While the unfortunate timing of the Greek debt crisis undoubtedly played a small part, it alone cannot explain austerity in the US and UK, and the weakness of the European left in failing to oppose austerity…. Austerity was the result of right-wing opportunism, exploiting instinctive popular concern about rising government debt in order to reduce the size of the state. This opportunism, and the fact that it was successful (in its own terms), reflects a failure to follow both economic theory and evidence. This failure was made possible in part because the task of macroeconomic stabilisation has increasingly been delegated to independent central banks, but these institutions did not actively warn of the costs of premature fiscal consolidation, and in some cases encouraged it.

Must-Read: Is there anybody who can teach all of Hyman Minsky while standing on one foot? Yes: one person can:

John Maynard Keynes (1936): The General Theory of Employment, Interest and Money, Chapter 12:

So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself…

…and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest.

This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit.

A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition…

Must-Read: John Maynard Keynes (1937): The General Theory of Employment:

Now a practical theory of the future based on these three principles has certain marked characteristics…

…In particular, being based on so flimsy a foundation, It is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface.

Perhaps the reader feels that this general, philosophical disquisition on the behavior of mankind is somewhatremote from the economic theory under discussion.

But I think not.

Tho this is how we behave in the marketplace, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.

I dare say that a classical economist would readily admit this. But, even so, I think he has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led.

This is particularly the case in his treatment of Money and Interest. And our first step must be to elucidate more clearly the functions of Money.

Money, it is well known, serves two principal purposes. By acting as a money of account it facilitates exchanges with-out its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence. In the second place, It is a store of wealth. So we are told, with-out a smile on the face.

But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit. Why should anyone outside a lunatic asylum wish to use money as a store of wealth?

Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. Even tho this feeling about Money is itself conventional or instinctive, it operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.

Must-Read: David Glasner is a Clower/Leijonhufvud student. Listen to him. Mind you, I am not sure that the Clower/Leijonhufvud point-of-view is the best first approximation. But the argument made against it is never that it is a wrong approach, but always that it is difficult to do journeyman work in. Keynes was definitely very attracted to it, in some of his moods. For example:

Ricardian analysis… Marshall’s contribution…. Edgeworth and Professor Pigou and other later and contemporary writers have embroidered and improved… [while] still dealing with a system in which… At any given time facts and expectations were assumed to be given in a definite and calculable form; and risks… capable of an exact actuarial computation… probability… reducing uncertainty to the same calculable status as that of certainty itself….

There are two important sub-issues here that are often confused:

1. At the individual level, Bayesian probability versus Knightian uncertainty.

2. At the aggregate emergent-properties-of-systems level, the consistency of plans and expectations with respect to all of the missing futures markets:

David:

David Glasner: Price Stickiness a Symptom Not a Cause:

Nick [Rowe], following a broad consensus among economists, identifies price stickiness as a critical cause of fluctuations in employment and income….

The real problem is not that prices are sticky but that trading takes place at disequilibrium prices and there is no mechanism by which to discover what the equilibrium prices are. Modern macroeconomics solves this problem, in its characteristic fashion, by assuming it away…. Economists have allowed themselves to make this absurd assumption because they are in the habit of thinking that the simple rule of raising price when there is an excess demand and reducing the price when there is an excess supply inevitably causes convergence to equilibrium. This habitual way of thinking has been inculcated in economists by the intense, and largely beneficial, training they have been subjected to in Marshallian partial-equilibrium analysis…. But that analytic approach can only be justified under a very restrictive set of assumptions…. All partial equilibrium analysis involves a certain amount of hand-waving. Nor, even if we wanted to be careful and precise, could we actually dispense with the hand-waving; the hand-waving is built into the analysis…. I have often referred to these assumptions required for the partial-equilibrium analysis–the bread and butter microeconomic analysis of Econ 101–to be valid as the macroeconomic foundations of microeconomics….

So the assumption, derived from Modigliani’s 1944 paper that “price stickiness” is what prevents an economic system from moving automatically to a new equilibrium after being subjected to some shock or disturbance, reflects either a misunderstanding or a semantic confusion. It is not price stickiness that prevents the system from moving toward equilibrium, it is the fact that individuals are engaging in transactions at disequilibrium prices….

It is also a mistake to assume that in a world of incomplete markets, the missing markets being markets for the delivery of goods and the provision of services in the future, any set of price adjustments, however large, could by themselves ensure that equilibrium is restored. With an incomplete set of markets, economic agents base their decisions not just on actual prices in the existing markets; they base their decisions on prices for future goods and services which can only be guessed at. And it is only when individual expectations of those future prices are mutually consistent that equilibrium obtains…. So that’s why I regard the term “sticky prices” and other similar terms as very unhelpful and misleading; they are a kind of mental crutch that economists are too ready to rely on as a substitute for thinking about what are the actual causes of economic breakdowns, crises, recessions, and depressions…

Must-Read: John Maynard Keynes (1936): The General Theory of Employment, Interest and Money, Chapter 13:

The three divisions of liquidity-preference….

1. the transactions-motive, i.e. the need of cash for the current transaction of personal and business exchanges;

2. the precautionary-motive, i.e. the desire for security as to the future cash equivalent of a certain proportion of total resources; and

3. the speculative-motive, i.e. the object of securing profit from knowing better than the market what the future will bring forth….

A highly organised market for dealing with debts presents us with a dilemma…. In the absence of an organised market, liquidity-preference due to the precautionary-motive would be greatly increased; whereas the existence of an organised market gives an opportunity for wide fluctuations in liquidity-preference due to the speculative-motive…. Circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. For a large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preferences due to the security-motive may be strengthened; whilst opinion about the future of the rate of interest may be so unanimous that a small change in present rates may cause a mass movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ. Thus this method of control is more precarious in the United States, where everyone tends to hold the same opinion at the same time, than in England where differences of opinion are more usual….

The propensity of the public towards hoarding… determine[s] the rate of interest at which the aggregate desire to hoard becomes equal to the available cash. The habit of overlooking the relation of the rate of interest to hoarding may be a part of the explanation why interest has been usually regarded as the reward of not-spending, whereas in fact it is, the reward of not-hoarding…