demandside

Administration may not have the full scope of policy options

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Plus a note on productivity.  Idiot of the Week from the Heritage Foundation, plus a digression on productivity.  First the digression, stimulated by the following letter from George B.

Mr. Harvey,

I heard you recently explain how we have too few dollars chasing too many goods. If you gat a chance a great subject would be to discuss productivity numbers. As I understand it they are actually up and I am wondering how this fits into the story. How can productivity be up but the economy be so miserable?

Great Job as always!

Thanks,  George Balella

Did I say that?

Too few dollars chasing too many goods?  That IS one way to deflation deflation.  And that is what we have.  I refer often to the absence of consumer demand.  Aggregate demand.  This has to do with dollars that are needed for the exchange.

But it is decades of stagnating incomes that have produced our current deflation, and the debt-inspired inflation of housing and other asset prices that we failed to acknowledge earlier in this decade, not a problem with the money supply that is creating the current deflation.

I have said that the Fed’s determination to monetary expansion is being contradicted by the private sector’s deleveraging.  That market panic and retrenchment has been the focus of the efforts of the Fed and Treasury to date.

Finally we are getting to producing public goods, which is the stimulus that is needed.

George’s question was something else.  How can productivity be up, but the economy be so miserable?  The economy is miserable because incomes stagnated.  Incomes should have risen at the same rate as productivity.  And they would have absent some special conditions.

You heard us bring productivity up in the context of inflation.  The so-called “core inflation” is inflation minus the influence of retail energy and food prices.  What is economic output minus these commodities.  It is the cost of labor.  So in a very general sense, core inflation is the increase in the price level of labor, while headline inflation includes everything.  You can see, then, when headline goes up 20 cents and core goes up 10 cents, the difference is labor not getting enough to buy headline.

At the same time, however, wages could go up by the increase in productivity without affecting prices at all.  Productivity is output divided by labor input.  If the same worker can produce 12 widgets where before he produced only 10, then he can be paid 20 percent more without increasing the price.

So both productivity increases not shared and wages lagging other price increases have led to the stagnation of real incomes over the past thirty years, nearly forty years now.

Of course, not all incomes have stagnated, only those below the top one-fifth.  But much of these incomes get lost in extravagance, saving, and are otherwise not recycled through the economy.  In a very general sense.

Productivity that is translated into corporate incomes is not so good for economic vitality.  We have talked about the consumption function.  At the top the consumption function, the amount spent out of each dollar of income, is lower than at the bottom.  This concentration of income translates into an accumulation of wealth.

And you may recall me picking this bone with Paul Krugman, who recently posited that it was not necessary to have a middle class to have a healthy economy.  I am very happy that our president has a different view.  The middle class, and the goods and services produced for it, is the basis of the economy.  The prosperity of the middle class into the 1970s corresponded with strong overall growth.  The stagnation of the middle class since that time, working more, making less, with more bills and less help, has corresponded with a halving of that growth trend.

Yes, GDP growth.  This is aside from the migration of income into the upper quintile.  Overall GDP growth has been far less in the years since Ronald Reagan than it was before.

In terms of George’s formulation, “too few dollars chasing too many goods,” I guess I would not dwell so much on the number of dollars, but on the act of “chasing.”  Dollars are not chasing because the consumer has cut back to cover his debts and hunkered down against the uncertain future.  Consequently business — which is dependent on consumer demand and not tax cuts as you may have heard — is in the process of de-investing.  You will see that disinvestment hit hard in the first quarter here, with the draw-down in inventories.

The increase in demand from the Obama stimulus plan will come primarily from the jobs created in infrastructure, health care, education and social services.  Countering these will be the jobs lost in the private sector.

It is the Fed’s idea that we can reinflate the economy by printing more dollars and it is my idea that deleveraging is a process of doing the opposite.  I do not believe this monetary confusion will not confuse demand in the real economy which will reawaken with the stimulus plan.

So there is more than you wanted to know, because you wanted to talk about productivity.  Productivity is great if the gains are shared.  They were not shared.  In addition it may be that productivity statistics were amplified from offshoring the low skilled jobs and retaining the higher skilled, more capital intensive jobs.  Again creating downward pressure on incomes.  And a third source of disconnect may be that areas like health care may be creating ever larger monetary returns that are not really increases in well-being or value, but the result of a market imperfection.

So thanks to George B for that letter, very much

and now it is Wednesday, so it is time for Idiot of the Week.

Before we get into that, I have to complain again about the non-information being promulgated in the mainstream media.  I just finished listening to Meet the Press with David Gregory interviewing Steve Forbes, Mark Zandi and a journalist.  The two famous names were not right on, in spite of Zandi’s well-timed reversal early in 2008.  It would be good to ask each guest whether they anticipated the downturn and where they think the economy came from.  I do not see why those who could not see weakness in an over-indebted bubble economy and blew the recession call until months after the collapse of the financial sector should be treated as if they know what they are talking about.  Particularly Forbes, who now prescribes cuts in capital gains taxes for the stimulus, just as he prescribed cuts in capital gains taxes for every public policy question, from immigration to the Iraq War and teenage pregnancy.

The media again confuses debate with information.  Much as it did with the Iraq War.  Even now, those conservatives and neo-cons who blew the call completely are trotted out as experts.  One of the most recent made-for-media controversies is the one led by pseudo-economist Amity Schlaes, who has cooked the numbers and ignored sixty years of contrary opinion to now promote the idea that the New Deal did not work.

It worked, and the debate is testiment to nothing other than the control of media by controversy.  The New Deal is still working.  Can you imagine our situation today with no Social Security, no FDIC, no unemployment insurance?  And how much better off would we be if we still had the New Deal protections against financial sector agglomeration and manipulation?

In any event.  Today’s idiot of the week is the Heritage Foundation.  In spite of their heavy funding, these guys are crackpots.  I don’t care who is fronting for them.  Today we have South Carolina extremist conservative Senator Jim DeMint in our second piece, followed by a couple of folks from the Reagan and first Bush administrations.  We could have, but did not, throw in George Will, who has made a career of being wrong, very wrong, but with a plausible story.  First, here is the Heritage Foundation’s leader, speaking as if he had something to say other than, look boss, “I’m still spouting the party line, no matter the facts.”

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The Chicago School, market efficiency theory, forget what worked.  We continue to marvel at the bad economics that is promoted by the unreconstructed Right Wing free market fundamentalists.

After a quick look at the bonuses scandal on Wall Street, we get into Paul Krugman, Mart Thoma and Brad DeLong, and Joseph Stiglitz on the resiliency of stay the course economics even after the ship is on the rocks.  Well, folks, it’s either the compass or the pilot or the map, but whatever it is, it put us in a hell of a place.

At the end, we’ll produce the Heritage Foundation audio we promised.

First, though, here is David Goldman on the Wall Street bonuses.  From his blog at Inner Workings under the head, “Make them buy stock.”

Make them buy stock

Rather than claw back already-paid bonuses of about $18 billion, as some grandstanding Democrats suggest, Wall Street firms should issue common stock to employees in that amount and require them to invest the after-tax portion of their cash bonuses in the stock of their firms. The proceeds should be used to repay the government for funds injected into their firms. That will satisfy the public, which quite reasonably objects to the use of its tax money to compensate bankers who make an order of magnitude or two more than the average taxpayer, and it will incentivize the bankers to work hard and manage risks well.

Most financial equity is trading at option value (that is, the price of the stock is about the same as the standard models’ price for a lon-term option on the stock). If the firms propose to continue in business with taxpayer support, they must believe that their equity will be worth a multiple of its present price. Any employee who has a different view clearly does not share the business philosophy of the firm and should find other work.

In fact, most bankers have lost most of their net worth in the past couple of years. It is typical for Wall Street types to leave their stock in the firm and treat it as a long-term investment, while spending the cash portion of their bonus (and many borrow against stock as well). With CItigroup and B of A trading around a tenth of their peak prices, bankers have given back most of their bonuses of the past several years. Those who still are employed might as well be all in.

In the future, bonuses should be paid in restricted stock that cannot be sold for a couple of years. A substantial part of bonuses at firms that have given the government equity warrants should be paid in equity options with a strike price set at $1 above the government’s strike price. It should be clear that if there is a windfall, the taxpayers get paid first. No-one will object if bankers get rich three or five years from now, if the taxpayers get a windfall first.

Goldman is a creative thinker and accurate analyst.  His hedge fund is probably the most successful, since it closed early last year prior to the market debacle.  Everybody got their money back.

Now Mark Thoma from his blog “Economist’s View” on the Dark Age of Economics.

Quoting an email [from Paul Krugman], economists who “have spent their entire careers on equilibrium business cycle theory are now discovering that, in effect, they invested their savings with Bernie Madoff.”

I think that’s right, and as they come to this realization, we can expect these economists to flail about defending the indefensible, they will be quite vicious at times, and in their panic to defend the work they have spent their lives on, they may not be very careful about the arguments they make.

…

A Dark Age of macroeconomics (wonkish), by Paul Krugman: Brad DeLong is upset about the stuff coming out of Chicago these days — and understandably so. First Eugene Fama, now John Cochrane, have made the claim that debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity.

John H. Cochrane

Myron S. Scholes Professor of Finance

University of Chicago Booth School of Business

john.cochrane@chicagobooth.edu

Webpage

Version 2.3 Jan 29 2009

Eugene F. Fama

The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business

There has been a tendency, on the part of other economists, to try to provide cover — to claim that Fama and Cochrane said something more sophisticated than they did. But if you read the original essays, there’s no ambiguity — it’s pure Say’s Law, pure “Treasury view”, in each case. Here’s Fama… And here’s Cochrane…

There’s no ambiguity in either case: both Fama and Cochrane are asserting that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment — period.

What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line. … [A]fter a change in desired savings or investment…, if interest rates are fixed, what happens is that GDP changes to make S and I equal.

DEMAND SIDE ASIDE:

We recently addressed this error of the many which accepts the equality of savings and investment as the evidence of a causation of investment by savings.  In our previous treatment, we suggested the cause goes in the opposite direction, from investment to savings.

We offered the simplistic notion that people save to invest, such as with a house downpayment.  In fact, the causation is as Krugman asserts here, through the action on GDP or income.

I like the image of a hot air balloon.  The balloon — GDP or income — rises to the point that the pressure inside and outside the balloon are equivalent.  S = I.  It is not the outside pressure that causes the inside pressure to be the same, nor the reverse.  It is the altitude of the balloon that equates the two.

Investment may cause income to rise to the point that the savings equals the investment.  We know that savings is directly related to income.  Rich people save more than poor people.  People save more the more they make.

Investment causes income to grow.

There is no obvious way that savings should generate automatically investment.  In fact, we see that enormously high rates of savings in Japan and China have not produced the investment in those countries that would be expected.  Instead the investment has come in the U.S. and elsewhere where returns on investment are high.

Back to Krugman.

In this picture savings plus taxes equal investment plus government spending, the accounting identity that both Fama and Cochrane think vitiates fiscal policy — but it doesn’t. An increase in G doesn’t reduce I one for one, it increases GDP, which leads to higher S and T.

Now, you don’t have to accept this model as a picture of how the world works. But you do have to accept that it shows the fallacy of arguing that the savings-investment identity proves anything about the effectiveness of fiscal policy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

Mark Thoma chimes in

Given their understanding of macroeconomics, and I mean the basics not the hard stuff, it’s becoming a lot easier to understand how financial economists missed the developing bubble and the effect it would have on the macroeconomy. We specialize mightily in academic economics, people will work on very narrow questions for their entire careers and become world class experts on that question, but they tend to forget what they learned in other areas over time, and they can’t possibly keep up with developments outside their areas of specialization.

So we rely and depend upon the expertise of others to inform us about areas in which we don’t normally work. One thing I’ve learned from the current episode is not to automatically trust that the most well-known economists in the field have done due diligence before speaking out on an issue, even when that issue is of great public importance, or even to trust that they’ve thought very hard about the problems they are speaking to. I used to think that, for the most part, the name brands in the field would live up to their reputations, that they would think hard about problems before speaking out in public, that they would provide clarity and insight, but they haven’t.

In fact, in many cases they have undermined their reputations and confused the issues. People have been deferential in the past, myself included, and these people have been given authority in the public discourse - even when they are demonstrably wrong their arguments show up in the press as a “he said, she said” presentation. But, unfortunately for the economics profession and for the public generally, the so called best and brightest among us have not lived up to the responsibilities that come with the prominent positions that they hold.

Mark Thoma

Berkeley economic historian Brad DeLong is similarly amazed:

Milton Friedman disagreed with James Tobin about the relative effectiveness of monetary and fiscal policy in “normal” times. I agree with Friedman (and disagree with Tobin) about the relative effectiveness of monetary and fiscal policy in “normal” times. But Friedman thought Tobin was worth debating–Friedman did not have the stupids to claim that Tobin was completely wrong as a matter of “just accounting.”

Brad DeLong

We at Demand Side have held this view, that economics is in the Dark Ages, for some time now.  Our book, which I think is still available on the web site in draft, makes this point.  Not only for the particular point about crowding out here, but for the larger and more devastating point, that the efficiency of markets which the Chicago School takes on faith is an absurdity in the face of global poverty, climate destruction, overuse of fossil fuels, patent misallocation of resources and the rest.  The market has not efficiently allocated resources, and the starvation of the public sector by those who insist the private market can do better in all cases is absurd.

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