The Production Function View Of The World

Recently FT published an interview with Adair Turner, chairman of the UK Financial Services Authority- who supposedly thinks of himself as heterodox!

Here is from the interview:

Lord Turner: Well, I think there is a challenge of macroeconomic policy which, for the last 30 years, we have largely, appropriately, located in central banks, which is the management of the pace of increase of aggregate nominal demand.

And we have had a philosophy, which I think is a right philosophy, that there is a macro challenge of making sure that aggregate nominal demand is growing at an appropriate pace, but all that can do is ensure price stability. And, within the constraint of price stability, the return of an economy to a full, or close to capacity level, and that there is no ability of those set of levers to change the trend growth rate of real output. And I think that was the shift in the orthodoxy, but this bit of the shift in the orthodoxy was absolutely right, I think, during the 1960s where there had been a previous tendency on the part of some economists to believe that you could call macro levers, fiscal and monetary levers, in a way that would increase the trend real growth rate of the economy.

So I think I’m clearly in the camp who believe the trend real growth rate of the economy is driven by a set of supply factors, the exogenous rate of technological growth, the growth of the labour market, the pace of capital formation, etc, and that the rejection in the 1960s of the idea that we could stimulate that by running large fiscal deficits or by monetary policy was quite correct.

Which is entirely inaccurate and super-neoclassical.

In the interview Turner also talks of “money-financed” stimulus – a crude and entirely misleading way of looking at fiscal policy. His interview summarized in another article Print money to fund spending – Turner seems to have irritated mainstream analysts as well 🙂

In Monetarism, fiscal policy is financed by the government and the central bank by issuing bonds and cash and this is decided by the two authorities by deciding on the proportions (as if the preference of the private sector’s portfolio allocation does not matter). A high proportion of issuance of cash leads to price rise with no increase in real output and the opposite case leads to a rise in interest rates. So fiscal policy is not only impotent but also has negative effects according to Monetarism.

Now mainstream economists have conceded that fiscal policy can have positive effects but tend to argue that it works in exceptional circumstances only and Turner’s view of the world is around that theme.

The notion of the production function seems to be the main point in Turner’s view of how the world works. In the interview he talks of “poison” when discussing fiscal expansion. Why do economists think of  the use of fiscal policy as immoral? One example below:

Production Function

In neoclassical theory, output is determined by a production function. Supply creates its own demand.

So one writes

GDP = C + I + G

assuming a closed economy and symbols with their meanings.

Now, in neoclassical theory, output [or GDP – although not the same thing because the latter excludes intermediate consumption for example] is determined by a production function. Unless you don’t understand Keynes, this seems to be a reasonable assumption but remember what Joan Robinson said – “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists”.

Unfortunately it does not work that way and in (post-) Keynesian economics, demand creates its own supply. It has been difficult for economists to appreciate this because they would have to give up the concept of the production function. The aggregate production function is crucial to neoclassical economics. Without it, neoclassical economics cannot live.

Post-Keynesians have written the most devastating critiques of this fantastical object. In this post – humble compared to the critiques – I will just consider one aspect.

So the production function is

Q(t) = F(L(t), K(t); t)

This is a relationship which says that output is determined by factors of production. To simplify, only land, labour and capital are taken as inputs. To make it slightly more general, it is also assumed that the function is dependent on time – in order to allow technical change.

Since output and hence GDP is determined by this in this way of thinking, the left hand side of “GDP = C + I + G” is determined by the production function. It is then argued that since the left hand side is fixed, higher government expenditure can only work to reduce investment and consumption. Hence government should reduce its expenditure!

Also, since it supposed to hold inflation-adjusted as well, expenditures by the government can only increase prices – together with the earlier result of “crowding out”. Also further arguments – in discussions about interest rates etc. – this argument is further supported by the authors – with results such as increased government expenditures invariably leading to higher interest rates etc in the absence of “monetary financing”. So allegedly independent central bank does not “money finance” the deficit and the opposite case – central bank losing some independence leads invariably to higher inflation. This is connected with the notion of an exogenous stock of money and the standard neoclassical description is such that increased government expenditure leads to shortage of funds available for investment.

Such is the crude world of neoclassical economics. The concept of the chimerical production function goes hand-in-hand with the widely held damaging view that fiscal policy is not only neutral but also “poisonous”!

This is also presented another way. GDP is also equal to the sum of disposable incomes of all sectors of an economy. Since GDP is given by the supply side (the production function), a higher tax revenue for the government implies lower disposable incomes for the private sector. So the government should reduce taxes – by reducing the tax rates. In a demand-side description, although there is some truth to this – it is due to different reasons. A decrease in the tax rate leads to an increase in demand – as people will be left with more disposable incomes and will spend more and this acts to increase output but also brings in more tax receipts for the government because of the increase in total taxes due to higher economic activity.

Of course, supply-siders are misled by demand-side theories because they incorrectly tend to view them as if the theories assume that there is no supply-constraint at all. That takes one to “endogenous growth theory” but understanding the basic demand-led growth story is a Herculean task for most economists that such discussions rarely happen.

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