Category Archives: Law of Markets

Real wages are, virtually to their full extent, the product of past labor

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Folks, I know no modern economist would think this way, but what worries me more is that I doubt they would even know what he is saying. This is from the great F.W. Taussig in his 1896 Wages and Capital: an Examination of the Wages Fund Doctrine. Moreover, it is from pages 26-27 of a 325-page book where he seeks to dispose of one matter right from the start before getting into any of the more difficult questions. This is mere trivia:

We are now in a position to give an answer to one part of the question with which this chapter opened; whether wages are or are not paid from present or current product. . . . Wages are certainly not paid from the product of present labor; they are paid from the product of past labor. . . . Real wages are, virtually to their full extent, the product of past labor. At this moment, or within a few days, the last touches toward completion have indeed been given to the commodities now being enjoyed. But the great bulk of the labor whose product all of us, whether laborers or idlers, now enjoy, was done in the past.

Our ability to produce is based on our capital base. If we fritter it away on the various value-losing activities that Labor has been indulging in, falling living standards is what you must expect. Labor has been progressively lowering our living standards by allowing our capital base to erode. This from today’s Australian: Joe Hockey’s sales pitch fails to reach the retail counter.

The worst retail sales report in ­almost a year and the biggest foreign trade deficit on record have signalled that Australia’s superior economic performance may be short-lived.

Retail comes at the end of a very long process that modern economic theory not just ignores but virtually denies in everything it preaches. I’m afraid that economic theory will have to go back to the nineteenth century to pick up the lost threads that Keynesian economics has trampled on.

What in economics is known as Say’s Law

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There I was just yesterday quoting Kevin Williamson in discussing Economics is quite simple and straightforward when today I find that he has now gone all the way and invoked Say’s Law.

Dollars have value because of the things for which we can trade them: Picasso paintings (or, ideally, paintings by some superior artist), coffee, cotton, cheeseburgers, sofa beds . . . checks, chickens, or pesos. This is an aspect of what in economics is known as Say’s Law, which holds that goods are paid for in goods — i.e., that we manufacture widgets or grow tomatoes or write novels because we wish to consume shoes and poached salmon and Buicks. The dollar or the euro is just a way to avoid the difficulties of trading a truckload of chickens (or a convoy of them) for Les Femmes d’Alger.

Say’s Law really wouldn’t be adding much of a point at all if the only thing it said was that spending is based on selling. What makes it important in a world of Keynesian economics is that it points out that demand which is not based on having produced and sold, ultimately leads to a fall in output and employment. Where spending is greater than available supply, the economy finds there are more than 100 units of output being bought for ever 100 units of output having been produced. It takes a while for the problems to show up, but eventually they must. When those down the expenditure track try to spend the dollars they receive, they find they cannot buy as much as they thought they would. Some firms therefore cannot pay all their bills and the economy slips a bit further back. The wheels of the economy do not mesh, but given the way we teach macro, hardly one in a million can understand why. Indeed, the worse our economies perform, it is often the very businesses being cheated by these deficits which ask governments for even more of the same to get them out of the problems that the first set of deficits had caused.

Modern economics is based on the fallacy that demand can be manufactured before there is production to match the spending. You can see that such policies do not work by the dismal state of those economies which tried deficit spending to generate growth. You just cannot find these policy failures explained in any of our economics texts, other than, of course, my own.

[My thanks to Dimitri for sending the link along.]

Economics is quite simple and straightforward

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By this stage, if you still accept Keynesian economics as a legitimate approach to understanding how an economy works, or how to find our way out of recession, you are basing everything on authority and simple faith. It’s in all the texts, but you would think that by now there would be a growing level of dissatisfaction about the irrelevance of textbook theory for making sense of the actual events of an economy. Kevin Williamson has written an article, Economics may be dismal, but it’s not a science, which refers back to an article written by Niall Ferguson, The Rise and Fall of Krugmania in the UK. So we have a journalist quoting an historian on the uselessness of economic theory.

Economists have never in all their endeavors managed to deliver a truly useful and broadly applicable model to policymakers, which is to say a model that is prospective, connecting policy changes to real-world outcomes in a predictable, accurate, and reliable manner. Given the complexity at work, that probably is an impossible task, and the record of economists for making predictions is not good; Krugman’s record is arguably worse than average, despite his straight-faced insistence: “I (and those of like mind) have been right about everything.” Right about everything would be a very high standard for a marine biologist or an astronomer — but for an economist?

Krugman is trying to set a kind of standard of sorts, for being able to deny reality longer than anyone else. You know that Keynesian inanity about changing one’s mind when the facts change. Keynesian economics will disappear around the same time that the left gives up on socialism and we all know how long that will take. These people will just have to be ignored, in the way they are in the UK.

Economics does provide useful models, ones that really do work and you can use to frame policy. But all such models start on the supply side and revolve around the specific efforts of entrepreneurs living in a world of innovation and uncertainty. In that sense, economics is quite simple and straightforward. The trick is to get 50%-plus-one to vote for policies that make everyone prosperous by making some people quite well off.

Please, Joe, stop looking for consumer demand to lead the recovery

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Joe was Great! There was not a moment in the whole of Q&A tonight that I thought he was behind, and this is enemy territory. But most importantly, this was even when the one-eyed Labor Party stooge, Tony Jones, tried to sandbag the Treasurer with a NATSEM study that had not been released EXCEPT TO THE ABC!!! And without showing the level of disgust he no doubt felt at such obvious ALP-ABC gotcha attempts to undermine the Treasurer, he simply turned it aside. He embarrassed the ABC for its obvious duplicity.

But I would have left this alone, except that there is one thing I think the Treasurer needs to tighten up on. He is trying to get there, in fact he is almost there, but his Keynesian minders or whoever it is that surrounds him, don’t quite let him see through to the point he is obviously trying to make. But if he gets there, he will be impregnable.

He was asked something like this, which I almost thought of as a friendly question, from Gai I think it was:

Why is household debt good but public debt bad?

Why are you encouraging people to borrow and spend at low interest rates when they may end up in serious trouble when interest rates go up?

Spending is not what you want. Joe, listen to me. Spending is not what you want to encourage. Growth and employment is not a the result of spending. Growth and employment are the result of VALUE ADDING production. That is, the result of production where the value of what is produced will, within a reasonably short period of time, create an income flow even greater in value than the value of the resources used up. That is the meaning of value adding.

Private households do not create value ever. A household uses up value, but it is not from households that economic growth occurs (except for the occasional plumber that gets called in). Growth comes from business. If you confuse personal spending with business spending you will never get these things clear in your head. There is personal consumption, which is the point of economic activity. And there is business activity which is continually trying to add value to the resources they use up. Please, Joe, stop looking for consumer demand to lead the recovery. It cannot be done.

One more reminder in the video below about the difference between those bad Keynesians, who used to be in government, and who thought about spending, versus you supply-siders, bless your hearts, who have replaced them, who are concentrating on value adding production.

Keynes the big loser in UK election

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Here’s a story that I can only hope our local right of centre party takes to heart: The UK Labour party should blame Keynes for their election defeat, written by Niall Ferguson no less. From yesterday’s Financial Times:

Credit where credit is due. Lynton Crosby is getting the plaudits for the Conservative party’s successful election strategy, but the real architect of this victory was surely George Osborne, the chancellor. Leave aside Labour’s collapse in Scotland, arguably the election’s most striking result. In England, the Conservatives won because Mr Osborne was right and his critics were wrong.

The comedian Russell Brand was not alone in having his celebrity endorsement of Labour roundly ignored by the voters. Even more ignominiously humbled were the Keynesian economists who have spent so much of the past five years predicting that the economic consequences of Mr Osborne’s policies would be disastrous.

In the vanguard of the Keynesian attack was Paul Krugman of The New York Times. In August 2011 he denounced the “delusions” of the chancellor whose “experiment in austerity” was “going really, really badly”.

Why? Because, in seeking to bring the government’s deficit under control, Mr Osborne was worrying needlessly about business confidence. “The confidence fairy” was the term Mr Krugman coined to ridicule anyone who argued for fiscal restraint.

Unfortunately for Mr Krugman, the more he talked about the confidence fairy, the more business confidence recovered in the UK. In fact, at no point after May 2010 did it sink back to where it had been throughout the past two years of Gordon Brown’s catastrophic premiership.

Mr Krugman was equally relentless in predicting that austerity would lead to recession; indeed, he insisted that the UK’s economic performance would be worse than during the Great Depression. In April 2012 he warned darkly that Britain would “continue on a death spiral of self-defeating austerity”.

It was, he lamented, a “policy disaster” that would cause a double-dip recession and “cripple the UK economy for many years to come”.

In fact, there was no double-dip recession. The UK had the best performing of the G7 economies last year, with a real gross domestic product growth rate of 2.6 per cent. In 2009, the last full year of Labour government, the figure was minus 4.3 per cent. Moreover, far from being in depression, the UK economy has generated more than 1.9m jobs since May 2010. UK unemployment is now 5.6 per cent, roughly half the rates in Italy and France. Weekly earnings are up by more than 8 per cent; in the private sector, the figure is above 10 per cent. Inflation is below 2 per cent and falling.

I’m not often into book burning but these Keynesian texts, with their Y=C+I+G as the cornerstone of theory and policy, are genuine candidates. If reality actually matters, which it may not actually do, Keynesian theory must now disappear. It is already disappearing from policy. Eventually economic theory must catch up, eventually.

UPDATE: Niall Ferguson has done another similar bit of writing on his blog, which he titles, The Rise and Fall of Krugmania in the UK. But it’s not Krugman, it is Keynes who remains everywhere, just as he did after the “death of Keynes” in the 1980s after the Great Inflation, which could not happen, or at least could not according to Keynesian theory. Report of Keynes’s death are greatly exaggerated, in no small part because no economist can function without aggregate demand by their side.

My book launch

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There will be few moments in my life as exquisite as Wednesday when Peter Costello* came up to the University to launch the second edition of my Free Market Economics: an Introduction for the General Reader. It was a rare moment when the political side of my life, the academic side and my recognition of the importance of classical economic theory were brought together all at once, and was a moment I could share with my friends and family.

I may sometimes give the impression that the book is mostly about Keynesian economics and macro which is not the case at all. That is why I started it out, but the oddest thing for me was to find that as I wrote each chapter, that I harboured views that are far outside the standard textbook treatment. This starts even before we get to supply and demand, but I promise you this, by the time you finish with supply and demand you will know you are in a different economic world. Of course, there are demand-side market forces that limit the price that can be charged for a product, and forces on the supply side that put some kind of lower limit on the price. But the notion that there is a single equilibrium price for a product where two lines cross on a two-dimensional plane is unsupportable by even the most casual empiricism. As I point out to my classes, the price of a cup of coffee, starting from the $1 at the 7-11, to prices four and five times higher that are charged, all within a mile of the front door of our building, ought to make you appreciate that there is something else. I do teach the traditional S and D analysis, but my students also are made to understand that prices are not set by these two curves, but by entrepreneurs who are making decisions about their optimal pricing strategy, given all of the forces of the market that surround them. And most importantly, I do not let them forget that the information in a demand curve can never be known by anyone, ever. It is strictly for teaching purposes. Entrepreneurs in the real world have to work these things out for themselves in real time.

But if I have a villain on the microeconomic side, it is the MR=MC analysis and diagram. If economics had gone out of its way to find some means to cloud minds about what goes on in markets, I don’t think they could have come up with anything worse.

mc equals mr

I teach Keynesian economics, of course, but I won’t teach that. You can find it discussed in my book, but it’s in an appendix. Over the years of teaching this diagram and the explanations that surround it, I found that after going through markets and then supply and demand, you would come to this and stop a class cold. Eventually some could draw the diagram and some might have seen the point, but there would not have been many. I do, of course, teach marginal analysis, but not like this. If you would like to see how I do it, as just part of the way this book is different from any economics book you know, Quadrant Online put up a few pages of the book under the heading Margin of Success.

As I said at the end of my presentation, there are three features of the book that I stress over and again: the role of the entrepreneur, value added and the crucial importance of uncertainty. Each is part of what must truly be understood by marginal analysis: entrepreneurial decision making in the face of the unknown future. And the point I make about the entrepreneur, as I said on the night, is that we now talk about market forces and the invisible hand, but the reality is that there is only one force that matters in a market economy, and that is the entrepreneur. And I don’t mean entrepreneur as in someone who innovates and causes change. I mean entrepreneur as in the captain of a ship in the midst of a storm a thousand miles from land.

_____

* For non-Australians, Peter Costello is the nearest equivalent we have to Ronald Reagan. He ran the economy for eleven of the best years economically this country ever had. Not only was the Asian Financial Crisis a non-event when every one of our major regional trading partners was in recession, but we ended up with 5-6% at the same time. And not only budget surpluses year after year, Australia was, until Labor took over, the only country in the world that had ZERO DEBT! The momentum given to the economy by Costello meant that we travelled through the GFC with hardly a ripple. Our problems have come since due to the debts and deficits Labor piled up. We will never see zero debt again in anyone’s lifetime, and will be lucky even to see our budget balanced any time this side of 2025.

Economic sinners

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I am in the middle of so many projects in which the modern version of economic theory is at the centre, that I find my thoughts overflowing into these blogs. A blog is not, however, supposed to be anything other than an overview shared among like-minded people. Comments on my post on the sins of economics are reasonable and temperate, but still fill me with some dismay which has me led me to go over some of that ground again. The sense of inevitability for the Industrial Revolution in the midst of the pastoral settings of eighteenth century England is not one I share. What did happen is not necessarily what had to happen. As Tel, no doubt intending to be ironic, points out:

I dunno, it’s probably more important that Isaac Newton invented gravity… I mean, without gravity you could slip easily, lose your footing and fly off into space. Sorry, but Newton is much more important in the scheme of human progress.

As it happens, Newton’s three laws did not change all that much about anything, but it did change the climate of thought. Certain ideas matter. It was not Adam Smith by himself and on his own, although he did have a fair share to do with it. The period 1770 through to about 1830 was the only period in history when being anti-establishment meant being pro-market. It was in that relatively brief span of time that the market economy was allowed to come into the foreground in the teeth of opposition from the landed aristocracy to the Luddite opponents of new technologies. Economic theory has been trying to backtrack ever since, whether the Marxist variety or the Keynesian variety and now even the mainstream. With Green policies so insidious, where to from here is not all that obvious, although I think that with the market genie out of the bottle, it remains almost impossible to stop. But Schumpeter in 1942 was already predicting that capitalism’s success would be its downfall.

Ray has then added:

I trust we are not ascribing the growth experienced during the Industrial Revolution to Adam Smith. It was not until after the repeal of the Corn Laws and Navigation Acts in 1846 and 1849 respectively, more than seventy years after The Wealth of Nations was first published, that the teachings of Smith and Ricardo, began to dominate policy matters. Until then, the Mercantilists ran public policy, very much the antithesis of everything Smith taught us.

A climate of opinion is essential for any system to take hold. If opinion didn’t matter, if the structure of beliefs made no difference, then elect socialists and get on with spreading equity instead of wealth. These things matter now and they certainly mattered 1770-1830.

And this was brought up from the Zero Hedge list, which is supposedly an example of seeking greater market regulation:

The benefits of free trade outweigh the costs of a country losing its manufacturing sector as a result; the fact that domestic companies have to comply with much stricter and costlier regulations than their foreign competitors is of no consequence.

If you don’t think domestic regulation affects an economy’s ability to produce, just have a look at the mining industry before and after Labor. Try adding in a measure of carbon pricing and see how the aluminium industry prospers. The phrase “internationally competitive” has a meaning. This may not be phrased to your liking, but it makes a point worth thinking about.

So let me finish with this quote from Rich:

A seed takes time to grow to a tree that bares fruit, and in that time it needs its protectors and proselytisers.

If economics in 1776 was like economics today, how likely would the Industrial Revolution have been then?

The sins of economics

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I was directed to a post by Tyler Durden with the title, The Farce That Is Economics: Richard Feynman On The Social Sciences. As it happens I disagree with Feynman about the social sciences, and especially with his criticisms of economics. That it did not occur to him, or perhaps he did not even notice, that it was only since the publication of Adam Smith’s The Wealth of Nations that the world has achieved the kind of prosperity that was not even within the imagination of the most visionary man alive in the eighteenth century. Economists have learned a very great deal, which is why we have become so well off, but have also forgotten almost as much, which is why mainstream economic theory is such a disaster zone. But we still keep our eye on the functioning of markets, which if left to themselves will make us progressively wealthier in spite of everything we might do.

But Tyler goes on with his own list of economists’ sins which I not only agree are disastrous, and genuine, but happen to be dealt with, each and every one, in my Free Market Economics, the second edition which may be found here. This is more or less a list of economic concepts that economists have managed to unlearn over the past half century. Indeed, it is because he can see how wrong these are that he can even put together this list.

  • Saving money is a sin and should be penalized; speculation is a virtue and should be encouraged
  • The government does not need to run its finances like every other company and individual in the country; what is good for the latter is bad for the former
  • Inflation should be kept at 2% forever; that’s the exactly right number, no more, no less; if you start paying less for your food, rent and healthcare, the central bank must intervene
  • Those who take personal risks to create prosperity and jobs have obligations; everyone else has rights
  • The state can spend its citizen’s money much more intelligently than they can
  • Business cycles are bad so we must always stimulate the economy
  • When a boom in demand pursuant to a boom in credit inevitably fades away, we should create another boom in credit to revive demand again, and again, and again
  • Creating debt at a rate above an economy’s incremental productive capacity generates wealth
  • Anyhow, debt does not matter because that liability is someone else’s asset
  • Demographics don’t matter either
  • You generate so much prosperity in your job over 40+ years that you can comfortably live in your retirement of 20+ years
  • Foreign lenders only need to be concerned with regard to banana republics; the others will always pay them back
  • The capital markets follow nicely shaped probability bell curves, and so shocks and crashes are extremely rare events; the markets are “efficient”
  • The benefits of free trade outweigh the costs of a country losing its manufacturing sector as a result; the fact that domestic companies have to comply with much stricter and costlier regulations than their foreign competitors is of no consequence
  • Human behavior is governed by mathematical equations and models, even when oversimplifying assumptions are used
  • The next generation will figure out a way to pay for all the massive debts that we are creating today; otherwise the central banks will solve the problem
  • The way to create prosperity in a society is to take away resources from the productive sector and distribute them amongst the unproductive sector
  • We all admire the free markets; we just can’t let them work

The missing ingredient from economics today, as I often mention, is value added, the central concept surrounding Say’s Law. No economics text ever mentions value added outside a brief discussion of the national accounts, and I actually think very few economists, although familiar with the phrase, have any idea what it means or why it matters. If they did, they could not possibly have endorsed the stimulus, and Keynesian economics in all its forms would now be dead.

What’s wrong with economics in a single sentence

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I have been reading David Romer’s Advanced Macroeconomics for some work I am doing and came across this. He is trying to explain why a particular equation doesn’t seem to capture the actual reality of the world. So he writes:

“There are other possible interpretations: the education and skills of the labor force, the strength of property rights, the quality of infrastructure, cultural attitudes toward entrepreneurship and work, and so on.”

And having noted all this in passing, he goes on his way.

To which I have added after a post in the comments which read: “Romer is referring to technology in Solow’s exogenous growth model and he does not simply move on. In fact, Romer devotes chapters 3 and 4 to a discussion of the drivers of technological growth.”

And indeed he goes on with an assembly of other factors of which the ones in the list are largely the specific ones ignored, such as the importance of property rights, say, or cultural attitudes, and the role of and attitude towards entrepreneurship.

If you cannot quantify some cause, so far as economics today is concerned it may as well not exist.

Economic Council of Tribal Elders

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This is a self-explanatory letter I have written to Professor Richard Lipsey. It was a Saturday afternoon, my most whimsical moment of the week. I have re-read it now on Monday morning, my least whimsical moment, and it still works for me. While my proposal for encouraging change was not intended to be taken literally, something really does need to be done.

Dear Professor Lipsey

I hope you won’t mind my invading your email account but following your posting on the SHOE website, I wanted to continue that conversation because I think this is an issue of no small importance. I have posted the correspondence up on my blog so you can look at my more considered thoughts here.

About myself, I will mention only four things: (1) Canadian born and educated though living in Australia for the past forty years, I have learned and taught from your Positive Economics; (2) I have been trying in my own way to save the history of economic thought from oblivion an outcome it seems destined to achieve [see my Defending the History of Economic Thought (Elgar 2013)]; (3) I am in the smallest of all current heterodox groups – the John Stuart Mill Classical School of Economic Theory for which I have written the textbook: Free Market Economics: an Introduction for the General Reader (Elgar 2nd ed 2014); and (4) virtually all of my career was spent in politics as the Chief Economist for Australia’s national organisation of employers which has warped my approach to issues, both economic and academic (see below).

I think there is a crisis in economics at the moment that no one is facing up to. The Queen supposedly put her finger on it by asking why no one had forecast the GFC. I think the crisis comes from no one being able to guide us out of the recession. You will have seen that I think that is because of the Keynesian models we have embedded, on which I may be right or wrong. But what troubles me is that no one has made a serious effort to revisit economic theory and worry over where the problem is. If I were to be classified using any of the modern schools, I would probably find myself, like you, within the Evolutionary Economics camp (my close associate at RMIT is Jason Potts who I understand is well known in this area). But whatever fuss has been made seems very muted, so muted I have been unable to detect anything at all.

In fact, until I read your post, I had no idea that you had these views. There may be many others who hold views similar to your own, who are, like yourself, individuals with genuine stature who are concerned about the way things are going. The minute I saw your post, I knew whatever thoughts others may have had to take potshots at me – and there may well have been none – they would be instantly suppressed. I am also very conscious of how narrow economic theory is, but as presently designed, it is both seductive and empty. The MC=MR diagram drives me crazy, and I won’t teach it, and in fact, instruct anyone who has ever come across it, to do all they can to forget it. Yet everyone who has learned it, cannot be lured away from its seductive grasp. I make the notion of equilibrium something that should be shunned and a concept devoid of serious economic content but on it goes even though economies are absolutely open ended and with so many cross-currents, the very notion is pointless. I think the stimulus was as deranged as anything I have ever seen inflicted on a peacetime population in my life but seriously, aside from myself, no one seems to be taking up arms against the underlying theory that has led to these policy outcomes. But my point is that although everyone can understand what is in my text, their careers would be cut dead if any of them ventured into this kind of territory, enemy territory to the mainstream (although a couple of them have, brave souls).

The nature of what we teach and the way we restrict what is in and what is not in, so far as a mainstream department goes, is astonishing. For whatever reason, the latitude given is near zero. You could drop your first edition into any course today and it would hardly make a difference compared with the latest, most up-to-date text just off the press. I came back to teaching after 35 years away and I didn’t have to learn a single new thing.

I don’t know whether there is something that can be done. But an Economic Council of Tribal Elders made up of people like yourself seems to me to be the only answer. A student uprising, as at Manchester and discussed by Hugh Goodacre, can only go so far but must stop. No one will pay attention, and I’m afraid, no one should either. But persons such as yourself in league with others of a similar stature, people who are no longer worried about contract renewals and finding their next job, can make the difference that I think needs to be made.

You must know others like yourself who are dissatisfied with the mainstream plod. Perhaps it is too hard, but perhaps it is also not too late.

With kindest best wishes.