Category Archives: Economic theory and policy

Fixing economics

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There is an article by Tim Thornton in today’s Age with the title I might have written myself, The problem with the way we educate economists. He thinks the problem is neo-classical economics which is the standard mainstream taught to everyone who seeks to become an economist. In saying he doesn’t like the way we teach economics, he is really saying he doesn’t like the standard theory found today or more particularly, the quality of the economics profession itself. These are the three problems with the way we teach he lists which are problems with the people who make economic policy:

Firstly, there is generally no required study of economic history or the history of economic thought. This produces graduates with dangerous levels of historical amnesia in regard to the world and to the discipline they assume they understand.

Secondly, contemporary economics students will rarely encounter any of the schools that compete with the neoclassical school: institutional, post-Keynesian, behavioural, Marxian, Austrian, feminist or ecological. These economics schools, which come from all points of the intellectual and ideological compass, make crucial contributions to building up our understanding of a complex and ever-changing economic and social world.

Thirdly, the curriculum fails to incorporate crucial insights offered by other disciplines such as politics, philosophy, history, sociology and psychology.

With any discipline what you teach depends on the question you want to answer. If you are interested in knowing how goods and services end up produced, incomes earned and output distributed, neo-classical theory is pretty reasonable. I say this even having major differences with the mainstream. The course I teach and the book I wrote cover all three of issues raised. I embed my course in history and the history of economic thought. I contrast modern theory with its classical alternative so no one comes away thinking there is only one answer to any question. I introduce politics, philosophy and history, although I must admit seeing little value in either sociology or psychology in answering any of the questions economists have traditionally asked.

Typically, those who would like to root out our modern neo-classical inheritance do so for some quasi-Marxist reason. They are seeking answers to different questions. Their interest is in explaining the distribution of power within a society. This is, of course, politics or sociology but it is not economics since even if you knew the answers to any of the questions a political scientist or sociologist might ask, you still wouldn’t understand how goods ended up being produced, what economic structures would give you the greatest output, how the community’s command over goods and services could be increased, what to do in recessions, or even what causes recessions in the first place. Instead what would be taught is some variant on the unfairness of the system and how it needs to change to ensure those who have the least wealth, which typically means those who have contributed the least to our communal flow of goods and services, can get a larger share of the pie.

Economics emerged as a separate study over two hundred years ago when our societies were extremely poor as they had been since the beginning of time. Now we, who live in economies where markets predominate, are astonishingly wealthy by any and every standard that an economist two hundred years ago might have listed as an aim and ambition. And because of the innovation machine that has been set in place by these same economic structures, we have a reasonable expectation that our wealth will continue to grow.

If someone has a better answer to the questions economists wish to answer, then they must convince other economists first. To take your ball and bat and go off somewhere else may make it easier to find someone to agree with what you say, but then you are talking into an echo chamber of your own construction. There is lots wrong with economics – lots – but to ask for a separate discipline, or encourage a schism within economic theory because you have a different view, is not the way these issues will ever be resolved.

But where I can overwhelming agree is that the economics establishment has built an edifice as strong and formidable as the one built by mediaeval theologians. The answers it gives to many questions seem wrong to me and many others. I hate to show disrespect to Her Majesty, but when she asked after the GFC why no one had forecast the recession, she was asking a question for which there will never be a solution. Recessions happen and it is precisely because they are unexpected that they turn out so badly.

What economists can, however, do is explain why that is, and try to provide answers on how to recession-proof our economies as best we can and hasten recovery when they turn down. Neo-classical theory, being drenched in Keynesian structures, will unfortunately never be able to find the answer to either question which is why a genuine review of economic theory and policy is so urgently required. But because a bunch of twenty year olds are dissatisfied with the answers that modern economic theory has devised is the worst possible reason for looking out for new answers to old questions, which in their case really turns out to be looking for old answers to different questions.

Politically a very nice piece of work

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Economically the budget is hastening slowly. The trend is right and really is a matter of taste. I wouldn’t expect any serious revival before 2015 but this has hardly been the savaging everyone was talking about. After 2015 it sets us up for a quite good recovery. As with everything in economics, there are so many unknowns of the known and unknown variety that nothing can be certain. But it puts us in a good position to catch any passing wind.

Politically, however, it looks even better. I teach of a Tuesday night so don’t get home till late and had to catch up by watching ABC News 24. And what struck me was the extent to which the critics were pretty subdued. No real heavyweight venom and anger, just the usual negativity about trying to repair what everyone knows needs repairing. We are the lucky country in the sense that the harder we work the luckier we get. Just as in 1931 the Lyon Government cut deeply into public spending allowing Australia to be the first economy in the world to emerge from the Great Depression, so the cuts and crafting of expenditure this time round will allow us to put ourselves on a very solid foundation for growth.

Even the supposed nasties, listening to some woman worrying whether she might be able to find the $7 to get to the doctor came across as a pretty weak and whiny complaint. The co-payment is designed to make you think twice in a way that a freebie doesn’t. For 98% of the country, if your illness isn’t worth paying $7 for the medical advice you get, you either have your priorities wrong or you have been wasting a lot of our precious medical resources because you’ve treating them as a free good. Well, it might have been free to you but not to the rest of us.

Same with cutting Newstart for the under-30s. Luckily again we are a community that doesn’t look benignly on living off the earnings of others although there are many still trying to expand this constituency. But what is more important is that it will mightily discourage many from a wastrel style of life. Falling into a welfare trap young and early is a disaster. Maybe it will save a bit of money but more importantly it may save a few lives from being lost and wasted.

We’ll see over the next few days and months how the politics plays out in the real world. In the meantime I think it is a job well done.

Very clever and impressive

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I find this such an interesting story on game theory, from an article by the authors of Freakonomics in The Wall Street Journal:

By the early 1980s, Van Halen had become one of the biggest rock bands in history. Their touring contract carried a 53-page rider that laid out technical and security specs as well as food and beverage requirements. The “Munchies” section demanded potato chips, nuts, pretzels and “M&M’s (WARNING: ABSOLUTELY NO BROWN ONES).”

When the M&M clause found its way into the press, it seemed like a typical case of rock-star excess, of the band “being abusive of others simply because we could,” Mr. Roth said. But, he explained, “the reality is quite different.”

Van Halen’s live show boasted a colossal stage, booming audio and spectacular lighting. All this required a great deal of structural support, electrical power and the like. Thus the 53-page rider, which gave point-by-point instructions to ensure that no one got killed by a collapsing stage or a short-circuiting light tower. But how could Van Halen be sure that the local promoter in each city had read the whole thing and done everything properly?

Cue the brown M&M’s. As Roth tells it, he would immediately go backstage to check out the bowl of M&M’s. If he saw brown ones, he knew the promoter hadn’t read the rider carefully—and that “we had to do a serious line check” to make sure that the more important details hadn’t been botched either.

I seldom think game theory tells us much more than the obvious, and this is another case in point. The example is not really theory in any sense – what can anyone else learn from this other than that there are often really innovative solutions to problems and in a free market people will work things like this out. Very impressive and clever.

Self-interested economic advice for Japan from the US

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I went to a seminar with an American trade negotiator today and what got to me was this incessant effort to get the Japanese to open their borders to American exports. I am not up on whatever passes for modern trade theory but even so it did seem a little self-serving. I therefore asked what was on my mind: since the point of comparative advantage is to show that both sides can benefit from free trade, who then is the loser if one of the parties doesn’t want to bother? Japan says it doesn’t want to lower its protection for its agricultural produce. OK, too bad for Japan. But what’s the difference to the US or Australia if they don’t want to buy food exports from us. Your bad luck. You’re the one missing out. We’ll go and trade around you ought to be the answer but somehow it isn’t. Given that everyone has a reasonable idea of their own self-interest, and given that self-interest is much more than just being able to buy more this year than last year, if the Japanese aren’t interested in cutting protection but the Americans (and Australians) really do want them to, just from this I can see there is something wrong with trade theory, or at least at that superficial level.

At the very minimum, the Japanese see no value in disrupting its rural sector. They manage to eat, no one is starving, they’re content with how things are, so why should we make a fuss? But of course we do because we want to sell because we think that’s good for us. From the nature of the conversation, and the persistence with which this is pursued, the Japanese would be doing us a favour in cutting tariffs and would be doing themselves harm. I’m very suspicious of arguments that are premised on this is for your own good.

While no one says it, I also think the Japanese are all too aware of – but much too polite to mention – the last time they took economic advice from the Americans. That was in 1993 just after Bill Clinton took over the White House. At the time, we were all coming out of the 1991-93 recessions. Clinton, because he wanted the Japanese to help the Americans with their own dull levels of activity, virtually demanded that the Japanese provided a stimulus to their economy. And so began the twenty year lost decade. Not that these sort of things happened to me often, but I happened to be sitting next to the Japanese Minister of Finance or something, when he was in Australia and being the economist was given the seat next to him. So I said to him that I thought it would be a mistake to try a Keynesian policy, and he said, “Don’t you care about the unemployed?” An exact quote which I have never forgotten. So off they went and did what they did but their economy has never recovered.

If you ask me, self-interested advice like that is something we can all do without.

A failure to deal with debt

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yellin us federal debt

The only bit that is ridiculous in this story is that the timeframe is projected into the future, Fed Chair: ‘Deficits Will Rise to Unsustainable Levels’. What do they think happens when the government diverts output down various plug holes, that the entire country disappears into thin air? What happens is that over so slowly real incomes begin to fall and the communal environment begins to crumble. There will certainly still be many wealthy people, but the average will move in only one direction.

In the US they pretend that time is on their side but it isn’t. Things are long past being just line ball. There will be a fall in living standards. The only question is whether there will be a recovery and if so when. Personally I do not see the slightest evidence of a will to change things around in the US.

But at least here we do have just that chance. We are dealing with a junior version of just this debt problem ourselves. The ALP talks about what geniuses they had been since debt-to-GDP was only about 37% when they left office. They never dwell on the figure when they came into office – ZERO – nor where debt levels are likely to go if nothing is done.

This stuff is hard and generally uninteresting for most people. Just gimmee the loot or I’ll bring in the other mob who will. We here may not quite be at that stage but perhaps we are. What Janet really would like to say is what Joe Hockey’s been saying: HELP! HELP! HELP! THE HOUSE IS ON FIRE! but she can’t because she does not wish to bite the hand that fed her. But she knows.

Say’s Law and the failure of Keynesian economics

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I am very happy to say that the best paper I have ever written was just yesterday accepted for publication. It’s on John Stuart Mill’s Fourth Proposition on Capital which he published as part of his Principles of Political Economy in 1848. In his own lifetime it was never challenged. Leslie Stephen (who incidentally was Virginia Wolf’s father) described it in 1876 as “the best test of a sound economist”. And yet by 1890 and ever since, although some of the great minds of economics have had a go at it, no one has been able to make straightforward sense of what Mill had meant. And when I say some of the great minds of economics, I am including Alfred Marshall, Friedrich Hayek and Allyn Young.

I should also add that understanding Mill may be amongst the most important issues of our time. Keynesian economic theory, which argues the exact opposite of what Mill had written, has had a devastating effect on every economy in which a Keynesian policy has been applied. Our economies are sinking under the weight of useless public spending and misdirected expenditures under the delusion that such spending will actually do us some good. Mill and every one of his classical contemporaries perfectly well understood that wasteful non-value-adding spending would not only do no good, it would actually do positive harm.

So what was this Fourth Proposition. It may not look all that formidable but in it there lies a truth that may yet save our economies. What Mill wrote was this: “Demand for commodities is not demand for labour.” Or restated using the jargon of today: an increase in aggregate demand will not lead to an increase in employment. The principle stated here is the classical pre-Keynesian meaning of Say’s Law, which has vanished from amongst economists and been replaced by the Keynesian theory which had been specifically designed to refute Say.

For me, the disastrous outcome of the application of Keynesian policies was a certainty. It was beyond any doubt in my mind that the stimulus would not just fail but bring ruin in its wake. I put my views into print in February 2009 just as the stimulus programs were being put into place and my five-year review was published in March this year. In 2009 it was mostly just theory although there had been plenty of Keynesian failures before that. By 2014, the evidence has become so overwhelming that there should no longer be the slightest doubt that a Keynesian stimulus will sink your economy into a coma and leave it that way for years on end. If you want to know why, you can read Mill, or if you find a thousand pages of mid-nineteenth century prose a bit on the heavy duty side, you can read this instead.

Read my lips: no new taxes

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Here’s some interesting news from just yesterday for those capable of learning from history: George H.W. Bush honored for courage with 1990 tax hikes, honoured by Democrats, that is:

Former U.S. President George H.W. Bush showed courage in breaking his “read my lips: no new taxes” campaign pledge to broker a 1990 budget compromise that may have cost him re-election two years later, the John F. Kennedy Library Foundation said on Sunday.

The organization honored the 41st U.S. president with its 2014 Profile in Courage Award, praising the Republican leader’s “decision to put country above party and political prospects” in the deal with congressional Democrats.

“America’s gain was President Bush’s loss,” Jack Schlossberg, grandson of former president John F. Kennedy and a member of the award committee, said during a ceremony at the library in Boston. . . .

In September 1990, two years into George H.W. Bush’s first term, the United States was saddled with a $200 billion budget deficit. Months of partisan wrangling over possible tax increases and spending cuts had ended in a stalemate.

Despite the potential political backlash, Bush announced a compromise with congressional Democrats that would cut $500 billion from the deficit in five years, in part by raising “luxury taxes” on items including yachts and pricey cars, among other tax hikes.

“The time for politics and posturing is over,” Bush said in an October 1990 speech. “The time to come together is now.”

The budget passed, but Bush’s concession on a tax increase rankled members of his party and stood at odds with his “no new taxes” campaign promise. He lost re-election to Democrat Bill Clinton in 1992.

The selfish generation

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I have just gone through a large section of Simon Newcomb’s Principles of Political Economy published in 1886 just as I was reading The Economist and The Financial Times 2013 book of the year, When the Money Runs Out: The End of Western Affluence. The difference in substance and depth is so profound it leaves me in despair.

But I want to focus on one particular aspect of what really is a book of junk ideas and simplistic formulations. Lots of dross gets published but only one book per annum is rated the best of the year. If this is what economic journalism sees as the finest flowering of contemporary thought, there cannot be all that much economic thought in contemporary journalism.

The author is Stephen D. King who is Chief Economist for a bank, HSBC in particular. He is therefore fixated on the monetary side of economics with the actual productive side having a mere shadowy existence somewhere deep in the background. No evident consideration of value added and production, just shifts in aggregates, most of which are financial.

But let me leave all that to the side along with his smugness and self-satisfaction. No admirer of contemporary economic thought myself, his bizarrely superficial economic recommendations that rest on his support for nominal GDP targeting show him to be about as deep as anyone could be who never thinks in terms of the entrepreneur and value adding activity. That is not, however, why I have bothered to bring his book up.

You see, he blames my poor generation, we baby boomers, for our economic problems today. And while I also think of my generation as the beginning of the rot, I don’t think of things in quite the same sort of way. If anything, where I feel we baby boomers may be most at fault is producing the generations that have come after. So with this in mind, let me take you to what he has to say (all quotes taken from page 243) about our current economic problems in relation to my generation:

“The boomers’ preferences have dominated society’s choices since they first reached adulthood in the 1960s and 1970s. In their twenties and thirties they accepted higher inflation; their mortgages were, in effect, partially written off even as pensioners saw their savings destroyed.”

In 1970, as the Great Inflation was getting under way, even the oldest of the baby boomers was no more than 25 and most were under twenty. We didn’t cause the inflation and I would hardly say we had accepted the acceleration in prices given that we did what we could to end it. If you want causes, you have to go back to the generation before. But if you want solutions, who were our political leaders that we first voted for and put into office? In the US it was Ronald Reagan and in the UK, Margaret Thatcher. Where are your equivalents today? There is not a ghost of a chance that his generation would ever put either of these into office. They were giants compared with the pygmies who have come since. He goes on about my generation, here in a continuation of the above quote:

“Now in their fifties, sixties and seventies, they insist on low inflation, fearing the erosion of their lifetime savings as they head into retirement. The boomers have had their cake and made sure they could eat it.”

You really do have to help me out here, Stephen. We didn’t cause the inflation of the 1970s since we were not in political charge but have worked hard ever since to make sure inflation does not take off again. Was this the wrong call? Should we have had more inflation? Do we need more inflation now? What’s your point? Well here are his thoughts about how to deal with this baby boomer generation for whom he has a name of his own.

“One answer would simply be to wait for the selfish generation to expire. By that stage, however, the damage may have been done: their gains will have been the rest of society’s losses.” [My bolding]

Yes, we could wait for us all to die off, but that’s such a slow process, he thinks. So what to do? In a continuation from the previous sentence and in the same para he therefore suggests this.

“Another would be to recognise the futile nature of the large amounts of medical expenditure for those approaching the final curtain, a use of resources for which the returns are, sadly, lacking [!!!]. It seems unlikely [!!!], however, that society is yet [!!!] willing to embrace voluntary euthanasia – let alone the involuntary kind – any time soon [!!!], or to become indifferent to death, whatever the age.”

This is not written as a joke in “a modest proposal” sort of way. You can quite clearly see that even if he’s not game to say it, his actual real answer is to leave us all to die off as quickly as possible. If we are no longer productive, we should no longer be allowed to absorb resources.

This man is an absolute caricature, a Monty Python version of a merchant banker.

And while he has a chapter he titles, “Dystopia”, these answers are in the following chapter, the one he titles, “Avoiding Dystopia” where he has put all of his suggested remedies. And while Charles Moore in The Daily Telegraph may believe, as it says on the cover of the book, that “it is alarmingly difficult not to disagree with Stephen King”, if he really believes that, I think he might have had the wrong Stephen King in mind.

When the Money Runs Out – the government’s guide to policy

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Simultaneously reading today’s papers on the Commission of Audit report and the Economist and The Financial Times 2013 book of the year, Stephen D. King’s When the Money Runs Out: the End of Western Affluence, I can see what the latest fashion in economic policy has become. Here I heave a sigh of despair. This from page 54 sums it up:

With poorly performing asset markets and much lower prospective economic growth, our entitlements are about to take a hammering. On current plans, only wishful thinking on economic growth stops government debt from spiralling out of control in the decades ahead. If the wishful thinking proves to be wrong, we will be in serious trouble.

And if you doubt that the wise heads of Treasury and the Government have not been reading this book, this is how it is described by the publisher:

It’s not just the end of an age of affluence, he shows. We have made promises to ourselves that are achievable only through ongoing economic expansion. The future benefits we expect—pensions, healthcare, and social security, for example—may be larger than tomorrow’s resources. And if we reach that point, which promises will be broken and who will lose out? The lessons of history offer compelling evidence that political and social upheaval are often born of economic stagnation. King addresses these lessons with a multifaceted plan that involves painful—but necessary—steps toward a stable and just economic future.

And so here we are.

I am the last person in the world to argue that wasteful and unproductive spending can go on forever. Cut waste. Live within your means. Do what is required to cut non-value-adding expenditure. But this book is half the story of what needs doing or possibly even less, just as the Commission of Audit doesn’t to my mind get there either. So far I have not come across a single sentence in the book that indicates the importance of the “private sector”, “the role of business” or “entrepreneurial activity”. The words don’t show up in the index and nothing in the contents goes anywhere near these issues. It is all about government policy, the financial system, the level of entitlements and containing outlays on entitlements. Nothing about what is needed for growth, and as the subtitle suggests, “The End of Affluence”, is entirely pessimistic about our economic possibilities.

And if you follow the guidelines found in the book, you would have to agree. We can no longer afford our way of life, our living standards must contract and therefore the only thing governments can do is cut various entitlement programs but strangely leave public sector infrastructure spending more or less as it is. No discussion of cuts to public waste, those useless money-losing operations that are everywhere absorbing our scarce savings for a negative return. If the real economy is discussed at any point along the way, I have not come across it. It’s all money, finance and interest rates. Encouraging business investment, cost containment, reducing government regulation – of these there’s not a word.

You want growth, cut back on government take up of resources. I love the headline on this story because of its cluelessness: UK AUSTERITY TO STAY DESPITE GROWTH PICK-UP. This is re-stated in the first para:

Austerity will remain the U.K. government’s mantra, Treasury chief George Osborne said Wednesday — even as he lauded the stronger than expected economic recovery.

The people who write such stories think “austerity”, the name its enemies give to cutting back on public sector waste, is bad for the economy, and because of their Keynesian mindset can only be harmful. They have no idea that it is the austerity itself that has led to the higher than expected growth. They cannot even understand what possible connection there could be. Moreover, a return to a stronger economy is not a warrant for higher public spending. The lesson that ought to learned and understood is that non-value-adding outlays slow an economy down. Reducing those outlays allow the economy to re-adjust towards faster growth. And already the Treasurer is talking about personal tax cuts in the lead-up to the next UK election. If only the same would happen here.

What’s the matter with our own economic managers in this country? If they really do want to take Australia down into some kind of American never-ending recession, then maintain or possibly even increase public sector outlays, raise taxes and do next nothing to encourage private sector growth. That way, the money most surely will run out but it didn’t have to be that way at all.

Post-Crash Economics

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The secret is getting out. And what secret might that be? That modern economic theory is next to useless, or at least useless if your interest is either to understand what’s going on or to manage the economy in a productive way with high employment and low inflation. This is from the introduction to The Report which has been issued by the Post-Crash Economics Society in the UK, organised round a group of students at Manchester University:

Economics education is monopolised by a single school of thought commonly referred to as neoclassical economics. Crucially, very few economists working within this mainstream predicted the Financial Crisis. Afterwards many concluded that the best predictions came from those economists that had been marginalised by the mainstream. Despite this alternative perspectives are still close to non-existent in undergraduate programmes. We demonstrate this through a detailed analysis of Manchester’s syllabus, which itself is representative of economics syllabuses around the UK. This lack of competing thought stifles innovation, damages creativity and suppresses the constructive criticisms that are so vital for economic understanding and advancement. There is also a distinct lack of real-world application of economic ideas, with the focus being on abstract modelling that often seems devoid from reality. Finally, the study of ethics, politics and history are almost completely absent from the syllabus. We propose that economics cannot be properly understood with all these aspects excluded.

I have just the book for them, the second edition to be co-published in July by the Institute of Economic Affairs in London. In fact I have two books since The Report makes a point of stressing how important studying the history of economic thought is to understanding economics.

There is a write up of all this in an article, Bank of Englands’s Haldane Backs Broader Economics, found in the Wall Street Journal. Economics must change and I am extraordinarily pleased to see the revolution is finally about to begin.

UPDATE: Some further comment of my own based on the thread at Catallaxy:

For me there are a few issues of comfort in spite of some sense of pessimism.
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First, I am just happy to see the logjam of modern neoclassical economics finally broken. This is the first step in a much needed process even to have a declaration of disquiet about the way economics is taught. I cannot think it could get any worse than it is. They may not call themselves socialists but economic theory as currently taught is for all practical purposes a form of centralised economic management, with the level of G the most important driver.
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Second, that the coming Chief Economist of the Bank of England and Steve Davies of the Institute of Economic Affairs are willing to buy in on this gives me some sense that this is not some Marxist thought based around expropriating the expropriators. But whatever the basis of the theory, the issue is to force the mainstream to defend their theory and its practical value.
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Third, and very oddly, Post-Keynesian economic theory, so far as the business cycle is concerned, is almost identical to the classical theory of the cycle. Very odd to me to find this but I have even begun to write a paper on this very issue. I’m not sure they even are aware of the difference it makes, but in much that is written, they substitute effective demand for aggregate demand which means they are actually restoring Say’s Law since Say’s Law was the core of the explanation behind what made demand effective. It is no longer just a total but in this way becomes a theory of economic activity.
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Fourth, bringing back the history of economics and economic history can only be positive. The attempts to shut these out are attempts to shut down various forms of debate.
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Fifth, we shall see.