Category Archives: Economic theory and policy

For goodness sake, do not introduce an effects test

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There I was, minding my own business, quietly reading the AFR at lunch when I came across a column by Chris Bowen that I agreed with. And not just a little, and not just a lot, but 100%. I cannot even believe this long-dead idea has been resurrected and brought to life by the Harper Review. My advice is to bring out the garlic, the silver bullet or whatever else it takes, and despatch this back into the nether worlds from whence it came.

This is the post but it is locked away inside the AFR, but the title tells you all you need to know: Government must steer clear of effects test recommendation. How it got through the Harper process you will have to ask them. One quote from the story:

Former ACCC chairman Graeme Samuel described the directions recommended as ‘bewildering’. Expensive and extended processes will no doubt ensue if the effects test is introduced.

An effects test is always sold as a friend to small business. It isn’t. But what it does do is make the economy run far less efficiently with no benefit to anyone at all. Why throw sand into the crankcase? This is stupid policy which no one should go anywhere near.

The RBA does the right thing

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Australia is blessed with the central bank most reluctant to lower rates in the world, but even so, of late it has not been able to resist the pressure up until now. But today was different. From Reserve Bank keeps rates on hold for a second month running.

Bucking the global trend toward zero official interest rates for a little longer, the Reserve Bank of Australia board today decided against cutting interest rates for the second time this year, opting to wait until first quarter inflation figures are released later this month.

The RBA board controversially cut the official cash rate to 2.25 per cent in February — ending a near-record 18 months of official rate stability — and strongly hinted it would cut rates again this year to help revive Australia’s flatlining economy in the wake of the resource boom.

Instead, as it did last month, the RBA today left the cash rate unchanged – keeping it at a record low of 2.25 per cent.

Lowering rates would be a catastrophic blunder. The dead-in-the-water nature of other economies who have tried to stimulate through lower rates ought to be a major warning. That the RBA even understands why they should not lower rates makes its previous decisions inexplicable, unless there had been pressure from Treasury or the Government.

The next change ought to be upwards and not down.

Do NOT raise taxes and do NOT lower rates

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If the Government’s suicidal tendencies continue, there will be no saving them from their own idiocies. It’s not even that raising taxes is politically popular. It is absolute voter poison. Raising taxes is guaranteed to lose you the next election.

But what makes it worse, is that raising taxes is also economic poison. The Treasurer has his eyes firmly fixed on 2055, forty years from now. I wish he would occasionally also glance at 2016 and 2017, which also happens to be when they will be trying to get re-elected.

It is bad economic management to raise taxes in a recession. Let me say this again with emphasis: It is bad economic management to raise taxes in a recession.

You have to stop looking at things from the perspective of those dunces in Treasury. All they can think of is how are they going to find the money for all of those programs you and Labor have committed us to?

If you really do think that recovery is in any way promoted by government spending, other than in a very very narrow and select range of areas, then you have not even got to first base in understanding how an economy works. Stop listening to these people and start thinking about who you really want to put purchasing power in the hands of.

It is business and the private sector that will give you growth and lower unemployment. It cannot come from any other source. And if you think that business will be encouraged by hearing that the budget deficit is fractionally lower, then you are so far off the beam that I don’t know where you think you are. Business is encouraged by making money. The economy grows through productive investment. Jobs and real increases in income are based on faster rates of private sector growth. If you think private sector growth driven by some form of government-financed activity is the same, then your whole basis of thinking about these issues is a FAIL.

And then there are the supposedly popular cuts to interest rates. Here’s a small test. Suppose interest rates went up by a quarter of a percent (which is what they should do, but won’t). You tell me: what would happen to the housing market? It would stall and possibly crash. Housing is already unaffordable. Why would you want to continue to finance a bubble that has now trapped every government so deeply, that it seems almost impossible to imagine rates going up any time soon. Although given past history, they will, in the month before the next election.

The worst possible question in economic theory – where will the money come from?

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I went along to hear Joe Hockey talk about tax and the world in 2055, and while I understood the problem, I was underwhelmed by the analysis. It is one of the legacies of modern macroeconomic analysis, one of the absolute worst, to continually think in terms of money and not in terms of value added. This is one of the consequences of thinking in terms of aggregates which can only be denominated in money values. But once you sink into money as your mode of thought, you are almost never going to get your head around the problem, which is where will the capital stock come from, and how can we be sure that the capital we are building today is actually going to strengthen our economy over the longer term.

Money is all right as a means of thinking about accounting, which a budget basically is. It’s a balance sheet writ large. It is also why the central concern of those who don’t know any better is merely to try to balance the budget, as if money-in equals money-out is the issue.

The issue is resource use. All forms of production use up resources. Only some forms of production create more value than is used up. The only source of value adding production is the private sector. Governments virtually never create value, other than when they have a monopoly in the production of something, and even then it could inevitably be done better by the private sector. But if a government has a monopoly, they can create value, but the outcome is still far from being as productive as it might have been.

You need to divide all forms of production into three categories: wealth creating, welfare and waste. Only wealth creation makes you better off, and that is almost entirely the province of business. Welfare and waste are the province of government. And while I have no in-principle objection to welfare expenditure that doesn’t eat too deeply into the wealth-creation process, I have a large objection to welfare spending that does. Waste, of course, should be eliminated to the greatest extent possible. But if you are looking for a greater ability to spend on welfare, it is value creation that must come first.

As it happens, the only economics text in the entire world that truly examines and explains value added, outside of the typically useless discussions sometimes found in looking at the national accounts, is my Free Market Economics. If you know of another, feel free to let me know. If you don’t know of another, then you should read my book. It is only if policy makers understand value added properly, and are not muddling themselves up by thinking in terms of money, is there even a ghost of a chance they will get their policies right.

And if you don’t want to take my word for it, here is John Stuart Mill trying to say exactly the same, in Book I, Chapter V, Paragraph XVI of his Principles of Political Economy, the greatest book on economic theory ever written.

It is the intervention of money which obscures, to an unpractised apprehension, the true character of these phenomena. Almost all expenditure being carried on by means of money, the money comes to be looked upon as the main feature in the transaction; and since that does not perish, but only changes hands, people overlook the destruction which takes place in the case of unproductive expenditure. The money being merely transferred, they think the wealth also has only been handed over from the spendthrift to other people. But this is simply confounding money with wealth. The wealth which has been destroyed was not the money, but the wines, equipages, and furniture which the money purchased; and these having been destroyed without return, society collectively is poorer by the amount. It may be said, perhaps, that wines, equipages, and furniture, are not subsistence, tools, and materials, and could not in any case have been applied to the support of labour; that they are adapted for no other than unproductive consumption, and that the detriment to the wealth of the community was when they were produced, not when they were consumed. I am willing to allow this, as far as is necessary for the argument, and the remark would be very pertinent if these expensive luxuries were drawn from an existing stock, never to be replenished. But since, on the contrary, they continue to be produced as long as there are consumers for them, and are produced in increased quantity to meet an increased demand; the choice made by a consumer to expend five thousand a year in luxuries, keeps a corresponding number of labourers employed from year to year in producing things which can be of no use to production; their services being lost so far as regards the increase of the national wealth, and the tools, materials, and food which they annually consume being so much subtracted from the general stock of the community applicable to productive purposes. In proportion as any class is improvident or luxurious, the industry of the country takes the direction of producing luxuries for their use; while not only the employment for productive labourers is diminished, but the subsistence and instruments which are the means of such employment do actually exist in smaller quantity. [Bolding added.

I think my version is easier to understand, but this confusion of money with wealth causes endless damage. You may, of course, disagree with Mill and think that following the money is all there is to it. But it’s not, and if you wish to understand why, read Mill, or again let me suggest, the second edition of my Free Market Economics, especially Chapters 3 and 5.

Even economists are beginning to notice there is something wrong with economic theory

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The New York Review of Books ran a seminar series on “What’s Wrong with Economics” which may be found here, including the videos of the various sessions. It has taken more than half a decade for the penny to finally drop that the policies we have been applying do not work and that there may be something wrong with the economic theories we have been applying. This is the “preface” from the NYRB which is so wrong-headed in even setting out the issues that you can already see there is no possibility that they are going to get anywhere near the right answers. But at least the questions are finally being asked, because there is finally recognition that things have gone badly wrong.

This conference is taking place eight years after the onset of the Great Recession in December 2007, and nearly six years after the recession was declared to be officially over in the US in June 2009. Yet the events of six and eight years ago continue to haunt us. One of the great powers of the global economy, the Eurozone, has yet to put the recession behind it, while the uneven performance of the US economy—spurts of growth accompanied by stagnant real wages—has led economists such as Paul Krugman and Larry Summers to ask whether the US has succumbed to “secular stagnation”: Is the economy now burdened with structural impediments which will make strong and sustained growth difficult to achieve?

The Crash of 2007-2008 was an acute crisis of market disequilibrium which has imposed itself upon an economics discipline still giving pride of place to models where market forces nudge economies in the very opposite direction—towards equilibrium. Crises of disequilibrium have occurred with increasing frequency over the past thirty years: with the Latin American debt crises of the 1980s, the American Savings and Loans collapse of the late 1980s, the Scandinavian banking crisis of the early 1990s, the Asian and Russian financial crises of the late 1990s, the American “dot-com” bust of 2000, and the Crash of 2007-2008 itself which has been global in impact.

Yet treating these crises as a series of near-identical events susceptible to economic modelling does not, on the face of it, do justice to the complexity and singularity of the forces which combined to bring them about. Many of these influences seem to have had their origins well beyond the home territory of economics. Doing justice to these outside forces may require a knowledge of ethics, anthropology, contemporary history and politics, public policy, and an understanding of the beliefs, frequently delusional, which seized many of the economic actors before and during the crises.

Among these disciplines it is, unsurprisingly ethics which intrudes questions of value deepest within the territory of economics, and forces a reappraisal of where the discipline stands in the disciplinary continuum between the humanities and the natural sciences. The overwhelming preference of economists themselves is to be as closely aligned as possible with the natural sciences. But with the intrusion of such ethically charged issues as the human fallout from the Crash, and the unrelenting growth of economic inequality in the US and most European countries, the scientific and the normative in economics are becoming increasingly difficult to keep apart.

Disputes between economists which seem to derive from disagreements about data and methodologies may on closer examination be rooted in profound disagreements about values. So it can be argued, and often is, that all of us are responsible for making the best of the opportunities open to us. Those who have ended up on the wrong side of the inequality divide must have failed to make the best of these opportunities and must bear responsibility for their errors, with the state providing just enough support to save them from destitution.

Or, an opposing view, that those falling behind are very often the victims of circumstances beyond their control—globalization, technological change, corporate restructuring—and that the state has a strong obligation to support them generously through difficult times and to provide them with the knowledge and skills needed to cope with new technologies and work practices. But how are these conflicts of values embedded in conflicting views about policy to be resolved?

It may be that these are disagreements of a kind that arise frequently in political and moral philosophy and reflect conflicts of plural values which do not arise in the natural sciences and which cannot be resolved by the forms of reasoning employed by scientists. They may have to be resolved either by the choices and compromises achieved through the practice of liberal democracy, or by one set of values prevailing over another through intellectual and electoral force majeur—as for example the arguments for the legal equality of women prevailed over their opponents in the course of the twentieth century.

Once again a network of beliefs and judgments extending well beyond economics may be called into play, and once again these may be strung out along the ontological continuum between the humanities and the natural sciences. Does this mean that the economist as scientist is slowly but surely being displaced by that hybrid who seems better placed to bridge these divides—the political economist?

If you want to see things properly, you will, in my view, have to start if not exactly here, at least somewhere nearby. Paul Krugman can think we have fallen into some kind of secular stagnation which is not far from being the stupidest of all possible explanations. Having backed the stimulus and the fall of official interest rates to zero, he has no idea that there are others who think that is more than enough to account for the present dismal outcome. They are clueless in New York. I would leave them to their own devices except that they are likely to take the rest of us down along with them. With these people as the leaders of the profession, it is indeed a dismal science.

AND AN ADDED BONUS: There is also Jeff Madrick on Why the Experts Missed the Recession. And why was that? Whatever the reason, here’s why I know he doesn’t know:

By lowering the target rate of interest, known as the federal funds rate, the members of the FOMC can stimulate economic growth, and by raising it, they can dampen growth and inflation.

Hey hey FWA – how many jobs did you kill today?

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The economic arguments in favour of the minimum wage are for all practical purposes non-existent. But our National Wage Case is an established ritual that will not be disappearing any time soon since it continues as the linchpin in our system of industrial relations. But for the system to work as it needs to, those who make the decisions have to understand in their bones that there are no good economic reasons for raising the minimum wage. It keeps many people unemployed who otherwise would have jobs. If anyone on the Fair Work Commission panel adjudicating this case believes they have a convincing and contrary argument to make, they ought to write it up and send it off to a journal. They would thereafter maintain an enduring fame as the person who showed that a higher cost of labour did not lead to a reduced demand for employees. Many have taken up that challenge, but no one has yet succeeded. It is something like the economics equivalent of squaring the circle.

Given that raising the minimum wage will cost jobs, the absolute necessity for those who make these wage decisions is that they balance the economic harm against whatever industrial relations peace it might bring. You cannot count on unions understanding any of this, but you would hope that the Commission does. With the first round of this year’s submissions having been submitted on Thursday, we will see all of this reach a peak sometime in June when the decision is brought down.

I mention all this for a second reason. I am, with Sinclair, on the editorial board of the Journal of Peace, Prosperity and Freedom whose third ever edition has just come out. As its editor, Sukrit Sabhlok, says, it is edited “by a graduate student (me) without administrative/marketing support”. He therefore adds that “letting your local libraries/databases know about print subscriptions would be appreciated”. He further adds that “the journal is the only Austrian economics, free market economics, libertarian academic journal in Australia.” So if you would like to subscribe, you can subscribe here.

And as one of many reasons to subscribe, let me draw your attention to the latest issue in which there is an article with the title, The Irony of the Minimum Wage Law: Limiting Choices Versus Expanding Choices written by the extraordinarily eminent Walter E. Block (PhD, Columbia University), the Harold Wirth Eminent Scholar and Professor of Economics at Loyola University New Orleans, whose co-authors are Robert Batemarco and Charles Seltzer.

Here is the abstract, whose contents will be of no surprise to anyone who understands economics, or indeed to anyone who possesses an ounce of common sense.

Persistently high unemployment among specific sub-groups, namely teenagers, African-Americans and workers with low skills has been a serious problem in the United States. In this paper, we trace a large portion of that problem to the existence of minimum wage laws that have been in force nation-wide since 1938. These laws remain popular despite their adverse effects because of a lack of economic understanding among the general public. In this paper, we aim to make clear even to those without advanced economic training why the minimum wage law is not a viable solution to the problems of those its proponents purport to help, but rather a cause of worse problems for them. Our method is to use elementary economic logic to show that the minimum wage must harm many of those it is claimed to help by costing them their jobs and to review the data to show that it always has harmed them. Our conclusion is that minimum wages have not achieved their putative goal, but have served the ulterior motives of limiting the competition faced by labor unions. Our recommendation is to repeal minimum wage laws, and failing that, to at least lower their rates, and in their place to help low-skill workers by reducing the barriers to their receiving enough education to raise their marginal revenue product so as to permit them to earn higher wages in a way that does not remove their employment opportunities.

As for the title, I know I am using the Commission’s now discarded name, Fair Work Australia, but then if I used its real name, it wouldn’t rhyme. I, of course, trust that you will know what I mean. But will they?

Real Keynesians and the long run

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For sheer emptiness, you can now try this by Jonathan Schlefer: Not even Paul Krugman is a real Keynesian. And why not?

But isn’t Keynes now mainstream? No, say Foley and Taylor. The mainstream still sees economies as inherently moving to an optimal equilibrium, as Wicksell did. It still says demand causes short-run fluctuations, but only supply factors, such as the capital stock and technology, can affect long-run growth.

EVEN PAUL KRUGMAN, a self-described Keynesian, Nobel laureate, and New York Times columnist, writes in the 2012 edition of his textbook: “In the long run the economy is self-correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run.” He says Keynes and Wicksell are in key respects “essentially equivalent.”

Krugman does point to one exception: If interest rates are nearly zero, as during the financial crisis, markets lose restorative force.

The article is not worth the trouble, but the quote from Krugman does seem to suggest he is being pushed by reality. In the long-run (a year or two perhaps) Say’s Law dominates, the economy is production driven.

And there is this by John Cochrane, which was published in The Wall Street Journal in December: An Autopsy for the Keynesians . A bit premature so far as the academic world goes, but I think this is absolutely true:

This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

C+I+G remains as the basic brainwashing tool, but even here it seems that the sleepers awake.

A UK jobs miracle and the continuing death of Keynesian theory

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Let’s start with the conventional view which is from an article whose title begins, A jobs miracle is happening in Britain:

At the start of this government, Ed Miliband predicted a jobs armageddon — austerity would inevitably mean mass unemployment. Osborne would cut 500,000 public sector jobs, he said, with ‘no credible plan to replace them’. And surely government spending is synonymous with prosperity? Boldly, he forecast a ratio: one private job would be lost for every public sector job lost — leading to the loss of ‘a million jobs in all’.

The conventional Keynesian wisdom, to which Miliband subscribed, is that government spending cuts make the economy weaker: fewer public sector workers means less money spent in the shops, so less demand, therefore more unemployment. Osborne saw things differently. What if the problem was not the supply of jobs, but the supply of willing workers? If you cut taxes on low-paid work, it becomes more attractive: more people want to move from welfare. Especially if welfare reform makes it harder to game the system.

What else would someone who learns his economics from a Keynesian text believe? So let us then go to the actual situation as it has now turned out:

In five short years, Britain has gone from having mass unemployment to jobs galore. Unemployment is falling at a rate that confounds the economists, and employers are starting to panic. Maths teachers, chefs — the list of ‘shortage occupations’ grows ever longer. Construction companies are not tendering for work in London because they can’t find bricklayers. Financially this is a headache, but economically it’s a problem of success. The Prime Minister set out to get rid of the deficit. He failed. But instead he has presided over a jobs miracle — one that economists and policymakers are still struggling to understand.

Just before the Budget was published, the latest figures came out — all of them smashing records. There are 30.9 million of us in work, the most ever. That’s an employment ratio of 73.3 per cent, the highest in history. Employment is up by 1.7 million since Cameron took power and 1.5 million of these jobs are full-time. The number on Jobseekers Allowance fell by 30 per cent last year alone and the youth claimant count stands at its lowest since the 1970s. Birmingham added more jobs to its economy last year than the whole of France; Britain is adding more than the rest of Europe. David Cameron can take credit for creating more jobs than any first-term prime minister in postwar history.

The article attributes this turnaround entirely to tax cuts. Even though he notes that the central feature of Government policy has been the “austerity” program, even the writer here, who no doubt was mis-educated on Keynesian aggregate demand, cannot see, really see, what is happening before his eyes, even though he can see the outcome. Of course taxes should also be cut, which is part of the way we reduce even the ability of governments to spend. But the diversion of our resource base into productive activities is the key.

It’s this Keynesian economics that will blind you to reality. But slowly but ever so surely it is entering the dust bin of history. Shame the same cannot be said about our economics texts which still continue with the same as before.

[And my deep thanks to DB for sending this article along.]