Category Archives: Economic theory and policy

Krugman polemics

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The Rogoff/Reinhard v Krugman debate is more left propaganda than an actual genuine debate over economic theory or statistical measurement. There is a fascinating thread on the Econbrowser website which more than anything else demonstrates that so far as economics narrowly considered is concerned, this is not an area in which amateurs have anything to add. But as to the polemics of economic policy debate, it is an attempt, as usual, by the left to shut down and close out any discussion of views that are different from theirs. On the comments thread, I will start with the only comment that discussed the political side of this controversy:

It is rather telling to read the comments attacking Rogoff and Reinhart, and Professor Hamilton for defending them. In the Keynesian view, the notion that government spending cuts can be beneficial is so harmful that it must be fought with all necessary means. Proponents must be shown to be bad actors, hacks, liars.

If small cutbacks are beneficial, larger cuts may be proposed, and the next thing you know, the entire Keynesian edifice may be in danger. If people began to ask whether specific governmental expenditures are worth diverting funds from private use (through borrowing or taxation), then you have a problem. I think this fear is what drives the vehemence of the Keynesian crowd’s attacks on R&R and anyone who would defend them.

Now to the technical part. If R and R are wrong, who will ever know? Here is part of the defence this time from a different commenter who goes by the name Rick Stryker (which might even be his real name):

I understand the problem that many commenters aren’t familiar with technical arguments and so don’t know how to judge. Let me try to explain the weighting issue intuitively.

Let’s forget economics and look at a simple situation. Suppose we have to decide what what the legal drinking limit is going to be, i.e., the blood alcohol level before it’s unsafe to drive. We take 6 men and every day give them enough to drink to raise their blood alcohol level to some point, let’s say it’s 1 on some scale. Each day we measure each man’s reaction time. A reaction time greater than 10 is unsafe to drive. We want to know if a reading of 1 means that you are driving drunk.

We are lucky enough to do the experiment on the first man for 100 days but can only get 10 days of data each for the other 5

Here are the measured 100 reaction times of the 1st man.

8.6 8.2 10.0 7.5 9.8 7.5 10.6 8.2 7.7 8.7
9.2 9.2 8.2 10.1 10.1 7.4 9.0 10.3 8.2 9.6
8.6 9.2 9.1 9.3 9.0 7.0 9.5 9.0 7.9 9.9
9.9 8.4 9.4 9.0 7.5 8.3 9.5 8.3 6.8 10.5
8.2 9.3 7.4 8.6 10.4 9.0 10.4 8.5 10.0 8.6
8.1 8.3 9.9 8.8 9.2 9.2 10.0 8.9 6.5 8.7
8.2 9.3 9.7 6.8 8.6 7.5 8.9 12.1 8.9 9.6
9.0 10.3 10.1 7.4 9.7 7.5 9.2 7.3 8.0 9.1
8.6 8.8 7.7 8.0 8.6 10.2 8.5 9.2 9.9 8.3
9.5 11.8 8.5 9.2 7.8 6.8 8.9 10.1 8.8 9.0

You can see on many days he’s too drunk to drive but not on all or even the majority of days.

Here are the reaction times of the other 5 men.

2 3 4 5 6
1 10.4 11.5 10.1 11.3 12.5
2 9.0 11.3 8.3 12.9 13.2
3 11.4 11.6 10.0 13.2 14.0
4 11.2 12.8 9.3 11.5 12.1
5 9.5 11.1 8.7 9.9 12.8
6 11.4 10.5 8.9 13.1 12.5
7 11.4 11.7 11.4 12.6 13.1
8 11.2 12.5 10.9 11.5 13.2
9 10.8 13.2 9.2 11.5 12.5
10 12.2 12.5 10.0 11.4 13.9

Now how do we summarize our findings? If we assume that each man’s capacity to hold his liquor is the same as every other and that the only variations are in what they ate that day, etc., you would just take all 150 data points and average them. If you did that, you’d get a reaction time of 9.7. Thus, you’d conclude a blood alcohol level of 1 is OK.

However, what if you looked at the individual averages of reaction times? Here’s what you’d get for each man.

1 2 3 4 5 6
8.9 10.8 11.9 9.7 11.9 13.0

Here it becomes obvious from the individual averages that the first guy is different from everyone else–he’s much better at holding his liquor. In fact, everyone is different as we might expect but the majority are drunk on average. So, averaging the first man’s 100 data points in with the 50 of the other 5 men will exaggerate the first guy’s influence and make it look like they can all hold their liquor.

It would be better just to average the averages, in which case you’d get 11 and you’d conclude that a blood alcohol level of 1 is unsafe to drive. That summarizes what’s actually going on better.

HAP [the critics of R&R] did the first estimation and assumed that all the men were the same. R&R did the second method and assumed that the men were in fact different. You can see that the second method is more justifiable if you have any reason to believe that the men are different. Since R&R are talking about growth rates of countries, we certainly have reason to believe they are different.

Moreover, the assumption that the averages are different is the standard starting assumption when analyzing data that is both cross sectional (different men) and time dependent (different days).

Strangely enough, HAP and Krugman accused R&R of doing something non-standard and an “error” by using the second method. I hope it’s clear intuitively how this is wrong from this example. In fact, what HAP and Krugman are proposing is non-standard.

What I asked 2slugbaits [the commenter to whom this comment is addressed] to do would have established that the way we did the average over the 150 data points would have fallen out of the simpler model I gave him if he had done the math. That’s HAP. And the way we did the average of average estimates would have fallen out of the fixed effects model, if he’d done the math. That’s R&R.

Hope this helps.

I don’t know if it helped anyone else, it did help me. It didn’t help 2slugbaits who replied:

Rick Stryker You have completely wasted your time. First, what you described is not what normally passes for a fixed effects panel model. For starters, you either have to establish a separate dummy for each panel (which eats up degrees of freedom) or you have to subtract the global mean from each observation before regressing…which eliminates any time invariant variables and is one of the reasons why random effects models are preferred. You didn’t do either one, so yours is not a fixed effects model. So what you seem to think is a fixed effects model is not. Second, neither HAP nor R&R ran a fixed effects panel model. R&R just lumped things into four buckets, took a simple average of each country’s observations within each bucket, and then took an average of the country averages. That’s it. That’s all they did. HAP skipped the second step and just took an average of all observations within each bucket. That’s why I said that if you wanted to replicate what HAP and R&R and do it in an overly complicated way by treating it as a regression, then you should just regress the observations and against a constant. Which is exactly what you did:

HAP make the assumption that a(i) = a, an unknown constant, and estimate

Y(i,t) = a + e(i,t)

where “a” is a constant. But there is no need for a “t” subscript unless that is supposed to represent one of four buckets…in which case the natural choice would a “b”.

But why would anyone in his right mind do that? Why not just say “take the average”? Third, you have obviously misinterpreted what JDH was talking about when he said that R&R took a panel approach. He clearly did not mean that literally…and if he did then he should have his license revoked. JDH meant that the R&R approach captured the intuition of a fixed effects panel model in that it tried to pick-up each country’s unique features.

And really…we all know how to derive a regression using matrix algebra.

BTW, plenty of new number crunching on the R&R data came out today…and all of it crushed the core of the R&R argument. See especially Miles Kimball’s work. And he originally very sympathetic to R&R’s position but has reluctantly concluded that their work is deeply flawed and worthless.

So Rick Stryker went back again:

I’m certainly wasting my time trying to explain this to you. You are back to your semantics. What we call the models doesn’t matter. I stated precisely what the models were and asserted that estimation of one would lead to R&R and a special case of that same model would lead to HAP. I challenged you to derive the estimators and confirm or deny my claim. I could see that you didn’t seem to understand and wanted you to demonstrate some comprehension of these issues. I was very clear in what I asked you to do. You couldn’t do it. I gave you over 2 days. Now, I’ve shown you exactly how to do it and you still don’t understand. You obviously know nothing about the issues you comment about, not that that stops you or any of Krugman’s other defenders.

The point of all this was for you and others to see that when HAP and Krugman claimed that R&R did something “odd” and an “error” they were just flat out wrong. But you will not to see.

This is why I keep talking about Krugman zombies. The level of illogic and irrationality is breathtaking.

To which the following reply was returned:

This whole sorry saga of R&R is reminiscent of a similar issue with Martin Feldstein back in 1974 in which he claimed to show that Social Security reduced private savings. Like R&R, he used these results politically to push his pet cause, in his case a campaign against Social Security. Once again, years later, two other economists, after a long struggle to get the data, found a coding error in the computer program which when corrected, caused the claimed results to disappear.

Posted by: Joseph at May 30, 2013 08:57 PM

Rick Stryker I stated precisely what the models were and asserted that estimation of one would lead to R&R and a special case of that same model would lead to HAP.

So what’s your point? What I said was that the way you were approaching this is flat out stupid and convoluted. It is certainly possible to take data into something like EViews, run it through a pooled cross-sectional fixed effects model and get an answer that exactly matches the way R&R and HAP did things. But you will get exactly the same answer by taking an average of each cross-sectional unit and then taking an average of all cross-sectional units, which is how R&R actually did their analysis. Now if you want to call the former exercise a fixed effects approach, then be my guest, but it’s a mighty odd one. When people talk about fixed effects models they usually have in mind a model that has slope coefficients as well as just a constant and fixed effects deviations. No one estimates two-dimensional pooled cross-sectional data as a special case of a fixed effects model. JDH was not saying that R&R actually did anything as stupid as run the numbers through a fixed effects model. JDH’s point was that their approach tried to capture some of the intuitions of a fixed effects approach, but they did so in a more straightforward way; i.e., just simple averaging in Excel. Doing things your way makes about as much sense as wanting to go from New York to Chicago by heading east. It’s possible to do that, but not very bright. Same with your crazy example of finding a simple mean by regressing against a constant. Yes, you could also call a simple mean a special case of a linear regression, but no normal person would do that…except I will note that you in fact did just that. Go figure.

With your latest tangent I take it that you have given up trying to defend R&R’s analysis. Both of their key points have been fatally undercut. The 90% “threshold turns out to no threshold at all. And the causality issue has also collapsed. Not only do high debt/GDP ratios fail to predict lower future growth, weak exogeneity tests failed to show a causal relationship.

And as the final posting from Rick Stryker to which nothing more has been added since, we have this:

I know this is a waste of time to continue to discuss this with you, but for the benefit of whoever is not bored silly with this and wants to learn something, I’ll try again.

The question I want to answer is, “Is Krugman right that R&R used an odd estimation technique?”

In order to answer that, we need to understand what the underlying assumptions are in each estimation method. So we need to write down the conceptual models that are equivalent to the estimation techniques. I’m not saying that R&R and HAP literally ran these conceptual models using statistical software, but rather these models are equivalent to what they did. The advantage of writing the models down is that we can see the underlying assumptions clearly.

I asserted that the R&R method is equivalent to estimating the model

Y(i,t) = a(i) + e(i,t) (1)

and averaging the estimated a(i). I also asserted that the HAP method is equivalent to estimating the model

Y(i,t) = a + e(i,t) (2)

If we can agree on that, then we can immediately see that HAP is a special case of R&R in which all means are assumed to be equal. We can also see that if anyone is making an odd assumption in cross sectional data, it’s HAP not R&R. We need to resolve this question because Krugman has asserted yet again in his latest post the unsubstantiated claim that R&R used an odd estimator.

You responded to this argument with a series of points that were irrelevant. For example, the fact that R&R and HAP didn’t literally run these models is irrelevant to the argument.

To keep us on track, I narrowed the point to just the question of whether the models I wrote down are equivalent to the estimators as I asserted. I asked you to derive the estimators. That way, it’s clear whether I’m right or not. If you derive the estimators and show that they aren’t equivalent to R&R and HAP, then my argument fails. But if you derive them and get HAP and R&R, then you will have demonstrated to yourself that a key assertion in my argument is correct.

But despite my request, you did not derive the estimators. Instead, you responded again with the irrelevant point that R&R and HAP didn’t actually run these estimators. At this juncture, I realized that you really don’t understand the point at all and can’t derive these simple estimators. I was frankly annoyed that I was wasting my time with you. I was also quite irritated that you are attempting to defend Krugman when you don’t understand these issues at all.

I gave you a day before I said anything. I thought that you might try look up the solution in an econometrics book. After 2 days, I did the derivation for you.

Amazingly enough, despite the fact that I laid out the derivations for you, you are still fundamentally confused. That’s why you need a conceptual model–to avoid confusion. For example, in your penultimate comment you said

“The R&R approach is also wasteful of information because it effectively throws away the country specific variance. That’s a bad feature of any model. The HAP model at least doesn’t throw away information.”

If you look at the models I wrote down and understand the derivations, then you can see that this statement is wrong. Look at the random effects model I wrote down:

Y(i,t) = a(i) + e(i,t)

where now the a(i) are iid random variables with mean a and variance v. Now, let v, the country specific variance, go to zero, i.e., throw away the country specific variance. What do you get? Not R&R as you claimed, but HAP!!

I think the argument I have laid out is exactly what JDH was saying. It must be frustrating for him too to watch this. He can blame me for not being clear enough in explicating it but his original point on fixed vs. random effects is absolutely right.

Also, I noticed that Krugman has backed away from one of the elements of his and HAP’s smear in his latest post, and is now saying that R&R’s excluded data was not intentional and perhaps unavoidable. But he still is claiming that the R&R estimator was “odd.” I wonder if he will back away from that assertion too? He should back away from both completely but that’s not enough. He should apologize.

Who’s right on the economics and econometrics, who can say? But who won out on the political side of the debate, it is a hands down win for Krugman. But if the American economy does start to tick up, it won’t be because of some stimulus but because of the sequester which is starting to bring down the rate of growth in public spending.

Krugman in excess supply

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Here in today’s AFR we find that Paul Krugman rant I referred to the other day. Such a stupid inane roll out of idiocies. I once thought that Keynesian economic theory would soon be rooted out of our textbooks but not so soon after all. Between the publishing industry with that backlog of a thousand macro texts sprouting Y=C+I+G, along with the apparent impossibility even for economists to work out why spending without creating net value is bad for an economy, we will just drive ourselves deeper into the bog. But whatever one might think of Krugman’s useless and damaging economics, he certainly does get around. Whether anyone else can read his stuff besides me is quite a question. I like it because it gives me a perverse pleasure to see just how ridiculously wrong what he writes is, but how does anyone else get through it? And are they any wiser at the end, as in, do they feel enlightened in any way?

Here are two examples of where large cuts to public spending and the deficit were immediately followed by a strong and prolonged upturn.

Case Study I: The end of World War II.

Case Study II: The Howard-Costello budgets in 1996 and 1997.

So this is how to understand the past four years and the problem with cuts to spending. We are in Adelaide and want to end up in Melbourne so we drive west for 1000 miles. When it finally dawns on everyone that we have been going in the wrong direction the problem is that by then you are 1000 miles further away than when you started out.

After the stimulus which began in a recession the first problem is reducing the wasteful stimulus expenditures. That will take you back to where you already were when the stimulus began. Then, if you go from there, you might actually make some progress.

But if you think that the solution to a problem caused by wasteful public spending is more wasteful public spending, then I leave you to your gurus and the nonsense economics you can pick up for a mere $3.30 from any newsagent.

Rogoff and Reinhart versus Krugman

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Unless you are explicitly anti-Keynesian you are for all practical purposes pro-Keynesian. There is one economic issue at the moment that is paramount and that is whether public spending can add to economic growth and employment or whether such expenditure actually damages a country’s growth and employment prospects. And building from that is the question whether a major part of the answer to contemporary economic problems are cuts to public spending.

However you look at it, this is the core issue of Keynesian economic theory and the policy that comes with it. If it is your conclusion that increases in non-value-adding public spending can contribute to growth and employment you are a Keynesian. If that is not your conclusion, that you think it will make things worse, then you are not. There is nothing else to it. At a minimum 95% of all economists practising today accept the Keynesian premise. At a maximum there may be 5% of the profession who do not. Even with the dismal and disastrous effects of the stimulus everywhere to be seen, either the stimulus was insufficient or it saved us from far worse are the standard answers. That we are now living out the consequences of a major and fundamental error in policy is virtually stated nowhere. The debate over Keynesian economic theory has not even begun never mind having been brought to an end.

The supposed locus of anti-Keynesian sentiment was found in a paper by Carmen Reinhart and Kenneth Rogoff discussed here. R&R argued in a jointly published book that “when a government’s debt rises to 90 percent of its country’s gross domestic product, the country’s economy contracts by (on average) one-tenth of one percent per year.” Turns out that their maths may have been wrong and the descent not as precipitous as that.

The usual motley crew of Keynesians therefore piled on to discredit the very idea of fiscal sense. The most recent and central of this Keynesian assault has been a book review by Paul Krugman in The New York Review of Books under the catchy title, “How the Case for Austerity has Crumbled” which would have been far better titled, “Who You Gonna Believe, Me Or Your Lying Eyes?”.

As scholars, R&R have had their feelings bruised and are now attempting to reply to their critics. Rogoff has written an article which was forwarded to me from Canada’s Globe and Mail which came with the title, Anti-austerity: Keynes never met the euro zone. It’s not, you see, Keynesian economics that is intrinsically wrong, it’s only just that the particular circumstances of the Euro as a single currency unit that are at fault. Here is the final para of the article which tries to deflect attention away from Keynesian theory per se:

To my mind, using Germany’s balance sheet to help its neighbours directly is far more likely to work than is the presumed ‘trickle-down’ effect of a German-led fiscal expansion. This, unfortunately, is what has been lost in the debate about Europe of late: However loud and aggressive the anti-austerity movement becomes, there still will be no simple Keynesian cure for the single currency’s debt and growth woes.

“No simple Keynesian cure” of course leaves room for a more complex Keynesian cure which would be appropriate in a different set of circumstances. Since it’s all numbers without theory who knows what anyone believes about anything, and that even includes Rogoff himself who may be completely baffled by his own results.

But prior to that R&R wrote a joint post on Reinhart’s blog titled Letter to PK. Their problem is with debt, not with Keynesian theory. To wit from the paper:

Let us be clear, we have addressed the role of somewhat higher inflation and financial repression in debt reduction in our research and in numerous pieces of commentary. As our appendix shows, we did not advocate austerity in the immediate wake of the crisis when recovery was frail. But the subprime crisis began in the summer of 2007, now six years ago. Waiting 10 to 15 more years to deal with a festering problem is an invitation for decay, if not necessarily an outright debt crisis. The end may not come with a bang but with a whimper.

And from that Appendix, first Reinhart:

Reinhart Testimony before Senate Budget Committee, February 9, 2010. ‘In light of the likelihood of continued weak consumption in the U.S. and Europe, rapid withdrawal of stimulus could easily tilt the economy back into recession. To be sure, this is not the time to exit. It is, however, the time to lay out a credible plan for a future exit.’

And then Rogoff:

Farheed Zakaria, GPS ‘Krugman calls for Space Aliens to Fix US Economy,’ August 12, 2011, Ken Rogoff: ‘Infrastructure spending, if it were well-spent, that’s great. I’m all for that. I’d borrow for that, assuming we’re not paying Boston Big Dig kind of prices for the infrastructure.’

But how bout cutting all that wasteful public spending that is going on right now? Rogoff again:

The Economy and the Candidates, Wall Street Journal Report with Maria Bartiromo, October 21, 2012 (interview with Kenneth Rogoff) on Fiscal Cliff: ‘Hopefully we won’t commit economic suicide by actually putting in all that tightening so quickly. I like to see something like Simpson Bowles….If we did, we could have our cake and eat it too, we could have more revenue without hurting growth.’

And here the two of them signing off on a joint statement:

A couple of Senator Coburn’s quotes from us at the meeting, taken without the full context of our introductory remarks have been interpreted as saying we endorsed immediately closing the budget. This was at odds with our position, notably our work on slow and often halting recoveries from financial crises, which we also emphasized. In fact, taking into account our opening remarks, it is our impression that the Senators full well understood the urgency we were expressing referred to adopting a long-term Grand Bargain a la Simpson Bowles.

No one supports immediately closing the budget since it cannot be done “immediately” anyway. But as Simpson-Bowles will take more than a decade, you cannot interpret R&R’s underlying theoretical position as stating that wasteful spending is the problem that must be cured. As I read what they wrote my conclusion is that they don’t get it. They just don’t get it. They don’t see that the wasteful spending is the problem in and of itself. That they share this perspective with 95% of economists means that there is no constituency whatsoever in favour of taking the only kinds of actions that will actually produce a return to a solid foundation for future economic growth, higher living standards and full employment.

The anti-Keynesian free market tide is rising in China

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An interesting story about market reforms in China but this particularly caught my eye:

China’s leaders, including a group of pro-market bureaucrats who seem to have gained in the leadership shuffle this year, seem to think that more government spending could worsen economic conditions and that the private sector needs to step in. . . .

The new leaders, who took office in March after a once-in-a-decade leadership transition, seem more determined to change course. In his speech this month, delivered to party officials nationwide by teleconference, Mr. Li, the prime minister, said, ‘If we place excessive reliance on government steering and policy leverage to stimulate growth, that will be difficult to sustain and could even produce new problems and risks.’

‘The market is the creator of social wealth and the wellspring of self-sustaining economic development,’ he said.

He spoke of deregulation and slimming down the role of government.

‘Li Keqiang thinks like an economist,’ said Barry J. Naughton, a professor of Chinese economy at the University of California, San Diego. ‘He wants the government to get out of the way.’

He actually doesn’t think like an economist, at least not an economist of the modern generation. But this is a tide that is rising. Watching the effects of regulation and the stimulus has been a very clarifying experience at least for some. The obstacles must be immense but at least there is recognition at the top about what now must change.

“A more sensible description of what grows the economy”

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Julie Novak, from whose all-seeing eyes nothing remains hidden, came across this article by Martin L. Mazorra with the perfect title, “Goods Buy Goods“. This is, of course, the classical definition of Say’s Law. I reproduce the entire blog post below:

One day last week, on CNBC’s Kudlow and Company, Larry gave his expert guest the last word: she justified her optimism for stocks by the fact that consumer spending appears to be trending higher and that ‘consumer spending is 72% of the economy’. Larry closed the evening’s show by telling her she had it ‘almost right’. That (words to the effect) what this economy needs is more saving, and business investment, as opposed to more consumer spending. I don’t always agree with Mr. Kudlow, but in this instance I believe he was spot on. Although I had no idea where she had it ‘almost right’. She was at least 72% wrong. Of course her assertion that ‘consumer spending is 72% of the economy’ comes straight from the GDP equation, and is an oft-quoted justifier for policies aimed at boosting demand. Once upon a time, I fell prey to the same misconception.

Here, in my (evolved) view, is a more sensible description of what grows the economy: From page 26 of Steven Kates’s Say’s Law and the Keynesian Revolution:

If one takes the annual produce of a country, writes Mill, and divides it into two parts, that which is consumed is gone. On the other hand, that portion which is used in the production process returns in the following year, with a profit. The more of the produce of a country that is devoted to productive uses, the faster that country grows.

And (from page 40) on the cause of recessions:

The basis of the law of markets is that goods buy goods, but only if the right goods are produced. If the wrong goods are produced, then they cannot be converted into the universal equivalent (i.e. money). If a proportion of goods cannot be sold, then their owners cannot buy. If one set of producers cannot buy, then a second cannot sell. The result is a general downturn in the economy and warehouses filled with unsold goods. But the cause of recession is not demand deficiency or over-production but the production of the wrong assortment of goods and services. The adjustment process thus required is the redeployment of capital from areas where there is too little demand into areas where there will be demand for the goods produced. There is no reason that the process of readjustment will be rapid, but there is no reason to believe that the downturn will be permanent.

So, under whose command should we expect the greatest likelihood of producing the right assortment of goods and services; a self-serving producer of goods and services, or a self-serving politician? Certainly the market, all on its own, can, for a time, produce the wrong assortment of goods and services. However, left to its owns devices—and to natural consequences—the market will adjust accordingly and purge its excesses. The politician, on the other hand, has a professional interest in circumventing the suffering of his supporters, and is adept at neutralizing the natural consequences for the producers of the wrong goods by spreading the loss among the entire population. And, alas, he in effect neutralizes the redeployment of capital from areas where there is too little demand into areas where there will be demand for the goods produced. Hence, a very slow recovery…

When one thinks about the last recession, housing comes to mind. Government-(explicitly)-backed mortgages (Ginnie mae), government-sponsored enterprises (Freddie and Fannie) and a variety of tax incentives are the brainchildren of politicians incentivizing the production of a particular good. Plus, the Fed had flooded the financial sector with liquidity enough to fund the manufacture of trillions of dollars worth of derivative securities designed to leverage—many times over—the housing market. In the end we had the definition of resources diverted to the production of the wrong good, and, thus, the greatest recession since The Great Depression…

This is exactly right and a perfect restatement of the classical explanation of the recession we continue to refer to as the Global Financial Crisis. The notion that consumers drive 70-plus percent of the economy is just one of the many Keynesian idiocies bequeathed to us today. When it comes right down to it 100% of the economy is devoted to raising consumption. Why else would anyone produce anything unless it eventually led to higher personal living standards. Retail is, however, less than ten percent of total economic activity if one looks at the value added data rather than at C+I+G. Most people across an economy are in the inputs industry, every one of which is directed towards satisfying consumer demand eventually, but only eventually. In the meantime they are producing iron ore and concrete, lumber and nails, factories and 747s, none of which are bought as consumer items. And this only begins the story of why the focus on consumer demand is absolutely misplaced if you want to understand how an economy actually works.

Why stop at free education?

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This is from Andrew Bolt and on the one hand it is hilarious but on the other it is downright disgusting. We talk about low info voters but the completely skewed ideas these people have is quite a scandal. These kinds of things are the typical province of students but I suspect that the Greens do not go much beyond this in economic sophistication if they go beyond it at all.

Has the Premier of China read my book?

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I have just posted this for my students so why shouldn’t I share it here. For anyone doing a conventional course in economics, specially one which does not include any history of economics, they would find what’s going on in China almost incomprehensible. It is an excerpt from a story in the Australian Financial Review by Angus Grigg published on Wednesday, May 21, 2013. I have added the bolding:

The key for China watchers will be how the new leadership, led by Premier Li Keqiang, plans to allow private enterprise to play a greater role in the economy. In a speech last week Li indicated this would begin by reducing red tape, which he labelled “informal barriers” and “glass doors”.

Li described how one company needed 50 separate administrative approvals across 27 different government departments before being able to begin a project.

“We need to get rid of the controls which are not needed,” he said.

Speculation is mounting that China will abolish one of its five layers of government to help achieve this.

But the market won’t be satisfied with cutting red tape. Economists are looking for reforms that will drive productivity gains over the next decade and allow China to keep growing at elevated levels.

That means the pressure is on the leadership to articulate how it will reduce the role of state-owned enterprises, which control more than one-third of the economy and are given preferential access to the most lucrative areas, such as energy and financial services.

“Private capital has money but nowhere to invest, it can’t invest,” Li said in his speech last week.

This was interpreted as strong support for markets, which the Premier said had a “self-adjusting mechanism”.

“The market is the creator of social wealth, it’s the internal source of economic development,” he said.

While Li’s comments were likened to Adam Smith, they are also perhaps an acknowledgement that China’s system of state-sponsored capitalism has run its course. This can be seen in how the government has been unable to significantly boost the economy in recent months, despite directing state-owned banks to massively increase new loans.

At the end of last year China’s credit to GDP ratio topped 180 per cent – up 60 percentage points in just four years – but it is having less and less impact.

Fitch Ratings estimates that each new yuan of lending between 2009 and 2012 only generated 0.3 yuan of additional GDP. This is less than half the figure achieved between 2005 and 2008. This supports theories that China is like a junkie that needs increasingly larger hits of credit to have the same impact.

And it’s leading to dire warnings on the state of China’s banking system.

The latest to join to throng was famed short-seller Carson Block of Muddy Waters Research, who says China’s financial institutions hold more toxic assets than Western banks did before the 2008 financial crisis.

Resolved: That Keynesian economics is junk science

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This goes back to 2011 but has re-surfaced. Here is the original letter from Ben Eltham dated 28 August 2011:

Dear Steven

As someone who finds myself in consistent disagreement with your opinion writing on economics, I was wondering if you’d be interested in a public debate on some of the issues you’ve advanced in recent times, for instance concerning the effects of Keynesian stimulus.

I think it might be quite a fun event and I’m sure we could ensure a good attendance from interested parties from both the left and right of the political spectrum.

If you’re interested, let me know and I’ll investigate what venues are available. The Wheeler Centre might be interested.

Sincerely,

Ben Eltham

Leaving out the various emails in between, this was my last response dated 12 October 2011.

Dear Ben

When I had not heard back from you before, I just assumed that you had gone cool on the idea so I am pleased that you would still like to have it on. Seems like a potentially very festive occasion.

So please do go ahead and organise something. I am in Melbourne between now and Christmas aside from a week at the end of November. The Wheeler Centre or anything else would be fine. I do not expect either of us will change a lot of minds but for both of us there are serious issues involved in thinking through what needs to be done in the face of the inevitable downturns in the cycle.

I should also apologise for not writing back immediately when you sent your note. I am in what I not-so-whimsically call ‘marking hell’. I gave a test to my 180 students last week, which was the penultimate week of the course, and now I have been buried marking them so that they can have some feedback before they plunge into the final on Hallowe’en. Just finished an hour ago.

But please do organise something. And many thanks again for your willingness to take this on. BTW, we should also meet for a coffee if you are ever around the CBD.

Kind regards

Steve

From that day to this month I had not heard back. But now this dated 15 May 2013:

Hi Steve

We obviously let the idea of the debate get away for a time, but seeing as you seem keen to renew the discussion, perhaps its time to lay down some guidelines and set an appropriate date?

best

Ben

I am unfortunately more busy now than I was then. The claims on my time have reached crisis proportions, but nevertheless, last night I finally replied but only after five days which has been the time I have been doing the mulling:

Dear Ben

I have mulled over your original letter to me and the time just wandered by. I am not particular averse to debating the Keynesian issue. What has stayed my hand in replying is whether you actually understand enough of what I am trying to get at to make it a fair debate. But then again, not many others would either, specially if they have studied Keynes and take aggregate demand as gospel so why should I worry.

We were going to have this debate at the Grattan Institute or somewhere but it was not going to be at RMIT. I will leave that to you. The only stipulation I would make if you are actually interested in this, that this is the resolution we put to the floor:

That Keynesian economics is junk science.

I would then speak to the resolution and you could reply. After that, we could think about what to do next. One-on-one; two-on-two. Anyway, make a concrete proposal and I would be happy to be in it. Might be fun.

Kind regards

Steve

Which is where matters now stand. Will report when there’s more to report.

“Living within your means is not mindless austerity – it’s simple prudence”

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The best line from Tony Abbott’s sensational reply to the Budget.

And might I compare this with the opening of Adam Creighton’s article in The Australian last weekend:

IN 1946 George Orwell famously pointed out how politics degraded and abused the English language for the sake of political ends. The same is true in economics. The word austerity, used to describe European and even US fiscal policy, has been a clever ruse by opponents of measures that may cause any reduction in the size of government.

No objective, sane person could describe, in a relative or absolute sense, fiscal policy in Europe or the US as austere, a word stemming from the Greek meaning harsh or severe.

‘The word austerity entered into the conversation once it became clear what a disaster the debt-financed stimulus was going to be,” says Steven Kates, an economics lecturer at RMIT University, referring to the failure of repeated and colossal budget deficits to resurrect economic growth across advanced countries, almost five years after the end of the global financial crisis.

‘Those who support public spending and deficits prefer to characterise those who oppose them as wearing a hair shirt, rather than wanting to reduce public waste and have governments live within their means,’ he adds.

The other side will have to find some other scare word because this one is not working like it used to.

Supply-Side Development Theory

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I was asked to review a book on economic development by a former head of the Bank of Korea by a publisher which wondered whether it ought to be published. I thought the book was extremely eccentric but quite worthwhile for all that. It was eventually published but not by them as Supply-Side Development Theory: Growth Policies for Developing Countries Based on Successful Korean and Chinese Economies. But as Mr Park informed me, it was on the strength of this review that he ended up with the book being published. This was the review

Sung Sang Park: Growth Policies for Developing Countries:
Based on Supply Side Economic Development Theory and Successful Korean and Chinese Policy Experiences

To begin at the beginning: I believe this book deserves to be published and ought to have a large and interested readership.

I concede that its arguments go very much against the grain of modern development theories and that some of its proofs are often amateurish and will carry little weight in any serious academic discussion. But the author, rather than being a professional economist, actually helped direct the Korean economy into its present highly successful state. Moreover, he did so following the various precepts that are outlined in the book. Just listening into the way he thinks about the various issues is a strong reason to encourage publication.

But that is only just the start. The book really ought to make economists who are rusted onto existing theories of development take a second look at how one of the architects of an extraordinarily successful economy explains how that economy went from abject poverty to first world living standards in under two generations. The theory may require some refinement and polish to fit into the latest journals, but the common sense and practical value of its specific prescriptions ought to make others take notice.

What makes this book different is that it begins with the assumption that the chronological profile of how the first industrial revolution progressed provides a contour map of what an underdeveloped economy should do today. Why wait for the invisible hand to make visible the structure of growth? Instead, just copy what others have already done. And the basis for this copying is in following through with a series of classical and semi-classical propositions as the guiding principles.

Classical Concepts

The following are the five classical concepts that are used to explain the general approach to development policy. They seem to make an integrated and sensible framework, although far different from anything one might find in a modern text.

Say’s Law – The central proposition is the supply side concept built around Say’s Law. Development can only occur through production of what others want to buy. The continued use of Keynes’s version, “supply creates its own demand”, does emphasise the supply-side nature of his argument. Nevertheless, it would be more accurate to re-phrase the concept as, “supply is the basis of demand where what is supplied is what is demanded” although using Keynes’s expression allows a reader to accept the arguments since this is the standard form of words. Based on supply-side theory and Say’s Law, the author proposes that the government encourages the domestic supply side by encouraging the production of those particular manufactured goods that are both import replacing and exportable.

The proposal requires a very high level of government involvement. Governments control credit growth and foreign exchange and ensure that both are allocated towards productive manufacturers and virtually no one else. Businesses are chosen for their proven ability to produce efficiently and given what amounts to a ten year or more licensed monopoly. The assumption is made that if your most ruthlessly efficient profit maximising businesses are given the right to go ahead and make as much money as possible, that they will do just that, and raise productivity levels for the population at the same time.

The book is also very dismissive of demand-side economic theories which are seen to be inapplicable for developing nations. Will others understand why this is so? The worry is that they will not, but the argument is sound and would apply just as much to a developed economy, although that’s neither here nor there as far as this book is concerned.

Law of Colin Clark – The concept here is that the historic profile of development as agriculture gives way to manufactured goods and then on to services is a pattern that should be expected to play out in any underdeveloped economy. Governments should therefore insist that manufacturing industry is given every assistance as the industry that, if supported, will pull all of the others out of their poverty.

Moreover, he makes the distinction between forms of services. Services to business will form as manufacturing expands. Consumer services will come eventually but are not first in line. Business services will thus expand the proportion of activity that are classified as services but should not be seen as the immediate origins of a service economy. But in this the ontology of the historical pattern will be seen to predominate.

Schumpeter’s Entrepreneurial Class – Found this very interesting and very much like Adam Smith. The book is 100% free market and looks to business people to be the authors of economic prosperity. But at the same time, there is a sense in which these same business people are more of a necessary evil than a virtuous group whose values epitomise the nation. I positively loved this:

“We should not expect private businessmen to follow social ethics and extreme social justice, because the profit-oriented, selfish-motivated, and money power-oriented private businessmen are providing new and better consumer goods that make people richer and provide jobs and income that make the poor people in huts and villages happier. Socialistic idealism-oriented politicians and scholars, who hate rich businessmen, overlook this important contributory role of Schumpeterian businessmen that can benefit the very poor people in their own country.

“In fact, the profit-oriented and rich businessmen actually help poor people more than the noisy socialist-oriented politicians and scholars.” (p. 138)

Entrepreneurs who know how to get things done are the key ingredient. Governments have no role in running businesses and should keep absolutely out of the boardrooms. These business people know how to take care of themselves and will make their businesses profitable. And where they do not, well then, out they go.

The government role is to create an environment in which these sharks of the business world are able to achieve the specific ends the government has in mind. It is not entirely left for businesses to make their own decisions without government poking their noses in to see what they are doing. The government is seen as having a very large interest in making sure that these businesses are following the national plan of developing productive industries where import replacement and export growth are seen as having the highest value. Very collaborative, but once the general direction is set, the government appears to have little further role.

Leontief’s Industrial Linkage Effects – The notion here is that manufacturing is the linchpin of the entire economic system. As goes manufacturing so goes the rest. It is built on his own reading of the lessons from the input-output table. Hard to say if he has this right, but it is not entirely certain whether he has to be right about this for the rest of his programme to work.

Moreover, if he is right, then this is an important contribution. It is for him to put the proposition on the table and for others to perhaps investigate.

Fisher’s Quantity Theory of Money – Presented here is a very different theory of finance and interest rate adjustments from that found I suspect almost anywhere else. The basic theory of saving generation is that the only addition to saving that can come from the economy generally is from households. Governments have their expenditures and business profits get ploughed back into business. But household savings are too paltry to make any serious difference, especially in the early days of trying to generate growth, but even afterwards as well.

This part I found unfortunately more vague than I would have liked, but my understanding is as follows. To supplement the savings available from the population generally, the central bank should just increase the flow of newly created money year by year by around 15%. It should also insist that nominal interest rates are kept low. Both of these principles provide the stimulus for growth. The swing variable that allows a government to do so is to permit, indeed insist on, a continuous fall in the value of the currency.

Allowing credit to expand by 15% or so beyond the actual saving level of the community represents the classical concept of forced saving. Money is put into the hands of businesses whose spending pushes up the price level but also changes the internal terms of trade in their direction. As businesses have the first use of purchasing power, they attract resources more readily than do others, so that there is a bias in the growth of the economy towards productive activity. Definitely inflationary, but as it seems that wages policy is accommodating, workers are bought off through being paid at higher levels, but the growth in wages is kept within relatively tight constraints. Part of the process is to make the head of the trade union movement the Minister of Labour.

Clearly inflation is not allowed to be the core of policy. Instead, policy is driven by the desire to grow the productive side of the economy to the largest extent. And so long as the working population is being allowed to share in the growing prosperity, no one is going to complain.

At the same time, because of the relatively faster inflation rate, the exchange rate is under continuous downwards pressure, and this seems to be a matter of policy. Keeping parity with the US dollar or any other currency is seen as a fool’s game. Better is to allow the currency to fall to promote exports and accommodate the inevitable inflationary pressures that the programme of forced saving must inevitably lead to.

Lastly, nominal interest rates are kept low. I’m not entirely sure how this is done given all else, but the underlying reasoning seems worthy of attention. Business borrowing is a tragedy for any firm that gets locked into the kinds of interest rates that are prevalent in a high interest rate economy. It becomes a game of chasing one’s financial tail and heads a firm into the bankruptcy rocks once it loses control in a world of compounded high rates of interest. This is what the policy attempts to prevent.

Some Comments

The question is this: how much of this book is total nonsense, how much is relevant only to Korea with its own historical circumstance and particular society, and how much is transferable to other economies? Very hard to judge. But at the core of the book are a series of practical ideas that others may find of value. The supply-side orientation based around Say’s Law seems a crucial part of the necessary understanding within any economy that is seeking to find its way into sustained rates of economic growth. Hammering that alone ought to make the book worthy of finding its way into print.

I also found the writing style engaging, but only after a while. It is certainly repetitive, but eventually I found the constant repetition of the various phrases and tag lines pleasant. Perhaps one does not have to hear about “poor people in huts and villages” page after page, but the quote is from John F. Kennedy and it is intended to make a serious point. Others may find it annoying, but I found it sort of Homeric in its constant repetition of these various epithets. (It occurred to me that the book is really a series of essays and speeches he gave in the past which have been tied together since things are stated over and over.) There is work for a good editor in bringing out the underlying concepts and text but without ruining the style of the author. For myself, once I entered into the rhythm of its style, I had no problem reading it through. The question is whether a book that is written in such a relaxed informal way will earn the credits its underlying ideas ought to earn.

However, in regard to his stylised facts found in the various contrived arithmetical examples he provides, I found those worse than unconvincing since they are too superficial to ever prove his point and their very flimsiness will, I think, lead readers to discount the book’s otherwise sound ideas. I think they work against his basic arguments since I think (but on one reading cannot be certain) they are profoundly wrong as he has put them together. They often feel like the sorts of examples that you might find in some early nineteenth century work on economics before there had been any bedding down of the fundamental concepts and ideas. They are hardly necessary and seem misconceived. Someone needs to go through them with the author to make sure that they genuinely do make sense. Certainly, they are not well explained and as found in the text feel wrong.

I might also note that his use of the Will Rogers quote, that mankind’s three greatest inventions have been fire, the wheel and central banking, was a joke and not necessarily intended as a serious comment. Rogers was a humorist and not a social philosopher. Some early indication that this is understood would help with the book’s credibility. Also, I wonder whether the weight put on Antonio as an entrepreneur and on the Merchant of Venice generally as a pivotal presentation that altered the idea of usury is all that sound. Perhaps it doesn’t matter; to me it merely added to the book’s charm.

Let me just finish with this. The first industrial revolution, mainly amongst those nations bordering on the North Atlantic, were basically a trial and error process of floundering within the particular cultural and religious atmosphere of those times. And while these unusual times may well ultimately have permitted free markets to develop and flourish, there is no certainty that this is the only way for an economy to develop now that the course has been charted. Focusing on export-led import-replacing manufacturing industries may be sub-optimal in some cosmic sense in which everything is known in advance. However, where the alternative is prolonged poverty and repeated error, it may make more sense to use the historical knowledge available to policy makers to repeat the same process by force of will rather than repeating the same mistakes of the past 250 years.