xkcd alt text: Hang on, I just remembered another thing I’m right about. See…
… There is also the problem of the relative levels of different types of earned income. Here we have the famous marginal productivity theory. In perfect competition an employer is supposed to take on such a number of men that the money value of the marginal product to him, taking account of the price of his output and the cost of his plant, is equal to the money wage he has to pay. Then the real wage of each type of labor is believed to measure its marginal product to society. The salary of a professor of economics measures his contribution to society and the wage of a garbage collector measures his contribution. Of course, this is a very comforting doctrine for professors of economics, but I fear that once more the argument is circular. There is not any measure of marginal products except the wages themselves. In short, we have not got a theory of distribution.
We have nothing to say on the subject which above all others occupies the minds of the people whom economics is supposed to enlighten.
– Joan Robinson, The Second Crisis Of Economic Theory, 1972. Link
There’s an article at Evonomics by Joseph Stiglitz, which is an excerpt from a chapter from a book. Stiglitz has denounced the marginal productivity theory. He says:
The trickle-down notion— along with its theoretical justification, marginal productivity theory— needs urgent rethinking. That theory attempts both to explain inequality— why it occurs— and to justify it— why it would be beneficial for the economy as a whole. This essay looks critically at both claims. It argues in favour of alternative explanations of inequality, with particular reference to the theory of rent-seeking and to the influence of institutional and political factors, which have shaped labour markets and patterns of remuneration. And it shows that, far from being either necessary or good for economic growth, excessive inequality tends to lead to weaker economic performance. In light of this, it argues for a range of policies that would increase both equity and economic well-being.
… Neoclassical economists developed the marginal productivity theory, which argued that compensation more broadly reflected different individuals’ contributions to society.
It reminds me of the debate between Paul Krugman and Thomas Palley some time ago. Paul Krugman completely denied all this. In his blog post at his blog for The New York Times, Krugman said in April 2014:
But doesn’t that show that conventional economics is indeed capable of accommodating big concerns about inequality? You fairly often find heterodox economists insisting that to accept the idea that capital and labor are paid their marginal products, even as a working hypothesis to be modified when you address things like executive pay, is to accept that high inequality is morally justified. But that’s obviously not the case: there are plenty of economists who are willing to use marginal-product models (as gadgets, not as fundamental truth) who don’t at all accept the sanctity of the market distribution of income.
So you have two mainstream economists: Paul Krugman defending orthodoxy and Joseph Stiglitz denouncing the marginal productivity theory.
The debate is around a paper Import Competition and the Great US Employment Sag of the 2000s by Daron Acemoglu, David Autor, David Dorn, Gordon H. Hanson and Brendan Price.
From the abstract of the paper:
Even before the Great Recession, US employment growth was unimpressive. Between 2000 and 2007, the economy gave back the considerable employment gains achieved during the 1990s, with a historic contraction in manufacturing employment being a prime contributor to the slump. We estimate that import competition from China, which surged after 2000, was a major force behind both recent reductions in US manufacturing employment and—through input-output linkages and other general equilibrium channels— weak overall US job growth. Our central estimates suggest job losses from rising Chinese import competition over 1999–2011 in the range of 2.0–2.4 million.
Now Paul Krugman explicitly agrees with this claim:
I basically agree with this conclusion, at least when we’re talking about manufacturing employment. But I’m troubled by some conceptual issues, which I think are important for interpreting the results.
As the second line of the quote shows, Krugman is reluctant to accept this. This shouldn’t be surprising. Krugman has been a champion of free trade and it will be difficult for him to accept that he has been wrong all around.
… it all depends on offsetting policies. If monetary and fiscal policy are used to achieve a target level of employment – as they generally were prior to the 2008 crisis – then a first cut at the impact on overall employment is zero
First, the United States didn’t have full employment before the 2008 crisis. So fiscal policy wasn’t offsetting enough. Instead if the U.S. had taken measures to protect manufacturing, unemployment would have been lower for the same fiscal stance. But that is not enough. Even if fiscal policy had offset all loss of employment due to trade, such a policy would not have been sustainable as it would mean that U.S. public debt and the net international investment position keep deteriorating relative to gdp.
So the U.S. could have been better off taking some measures such as non-selective protectionism as recommended by Wynne Godley in 1999 in his article Seven Unsustainable Processes.
Second Krugman’s claim is that instead of purchasing manufactured imports, U.S. economic units would have non-manufactured imports. That is partly true, if the protectionism measure was selective. But even here, output would have been higher even if total imports were the same, non-manufactures instead of manufactures. In other words, what is more important is the import propensity, not imports itself.
In all, putting tariffs on trade can be highly expansionary for the U.S. economy and employment. China’s economy has expanded massively and has damaged the U.S. economy. China is in a position to expand output by boosting domestic demand rather than relying on exports because its international investment position is quite solid and it need not worry about balance of payments problems if it does so. Instead, China has a massively undervalued exchange rate and it gives unfair advantage to China. It is sometimes said that China should float its currency freely in the foreign exchange markets. Although this step would be great, it still relies on the market mechanism to solve problems and is not guaranteed to work. Who knows how much China’s currency would appreciate? Maybe it just appreciates 10% and not more. Moreover, it is not just China. U.S. faces competition from various other nations as well. So a non-market mechanism is needed such as non-selective protectionism. This will help the U.S. expand output without its debts rising in an unsustainable way.
Krugman’s back-of-the-envelope calculations are not really something which are obvious and the first cut to a right answer. The flawed ideology of free trade is behind Krugman’s numbers.
Needless to say, all this is not an endorsement of Trump. Strange times, when we defend politicians whose ideology we do not like. Even Bernie Sanders is not pro-free trade, although he hasn’t been as explicit as Trump.
Finally, on manufacturing versus services, Krugman says:
No matter what we do on trade, America is going to be mainly a service economy for the foreseeable future. If we want to be a middle-class nation, we need policies that give service-sector workers the essentials of a middle-class life.
I don’t understand what economists dislike so much about manufacturing. “Going to be” is different from whether it is correct to be and not do anything about manufacturing. It’s not a logical argument to say, “Oh! we are a service economy, manufacturing has lost its importance”. Because the U.S. manufacturing deficit was $831 bn in 2015.
Now Britain finds itself in an alarming new landscape, where our very ways of feeding ourselves, like so much else, look uncertain.
– Bee Wilson, The New Yorker
Paul Krugman has a post The Macroeconomics of Brexit: Motivated Reasoning? on his blog The Conscience Of A Liberal about how “experts” exaggerated claims of the impact of a result to leave in the recent UK EU membership referendum (“Brexit”). Quite agree with Paul Krugman. When Michael Gove told Sky News that people in the UK have had enough of experts, he was laughed at. Video here.
Needless to say this is not an endorsement of Michael Gove’s other political position. Strange times, when you defend someone with different political ideology. The above is just meant to highlight a point that experts exaggerated and that people knew.
John Maynard Keynes also said this in the GT:
But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;— a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.
Paul Krugman’s main point is that economists’ arguments were motivated reasoning, involved circular reasoning and assumed what they wanted their model to output.
But maybe Paul Krugman himself is doing so? Krugman claims:
I believe that Brexit is a tragic development, which will do substantial long-run economic harm. But what we’re hearing overwhelmingly from economists is the claim that it will also have severe short-run adverse impacts. And that claim seems dubious.
Okay, financial markets have improved after some initial panic caused by the fear of fear. and FTSE 100 is at year-to-day highs. But Krugman still wishes to claim that Brexit is bad long term:
OK, let’s start at the beginning. Brexit will almost certainly have an adverse effect on British trade; even if the UK ends up with a Norway-type agreement with the EU, the loss of guaranteed access to the EU market will affect firms’ decisions about investments, and inhibit trade flows.
This reduction in trade relative to what would otherwise happen will, in turn, make the British economy less productive and poorer than it would otherwise have been. It takes fairly heroic assumptions to make this into a specific number, but 2-3 percent lower income in perpetuity seems plausible.
So far, so good, or rather so bad: this is standard economics, basically Ricardo with a dash of new trade theory.
Firstly it claims that is takes heroic assumptions. Second, but more importantly, Ricardo’s theory? Seriously? Ricardo’s theory and new trade theory claim there is convergence of successful and unsuccessful economies under free trade but emperically what is observed is that because of the process of circular and cumulative causation, there is polarization, not convergence.
It should be possible for the United Kingdom to negotiate protective arrangements (especially in manufactures) in such a way that the EU does not impose punitive tariffs and its exports do not suffer. Trade won’t suffer because although the propensity to import reduces, the government can expand domestic demand since such policies might ease the balance of payments constraint and the volume of UK imports won’t fall.
More generally, the solution of the problems of the world can come about if there is a concerted action, in which fiscal policy is coordinated and there are set of rules for balance-of-payments targets. In this system of regulated trade, world trade can rise because of higher world income as compared to a world with free trade.
Brexit should make economists realize that their models do not conform to empirical data. Ricardo and new trade theory can be cast aside.
Who is right? Answer: Neither. Global output will rise under non-selective protectionism (or has an expansionary bias, to be more precise). Protectionism reduces the propensity to import. That doesn’t mean imports will fall. Total imports of an individual nation will rise because of higher income. World trade will rise because of higher world income.
In other words, non-selective protectionism acts by reducing the propensity to import by price elasticity effects but raises volume of imports via income elasticity effects.
The world as a whole is balance-of-payments constrained, not just individual nations. Raising tariffs on imports incentivises producers to produce more as they will face less competition from abroad. Consumers will shift to domestically produced goods because of price elasticity effects.
Moreover, since governments of most nations won’t have a balance-of-payments constraint if there are large tariffs, they will be free to boost domestic demand by fiscal policy, limited only by the economy’s capacity to produce. If it is done, it will be a conscious behaviour by the government.
There is of course another way fiscal policy gets relaxed because of balance of payments. Reduction of current account deficits, relative to gdp, reduces the budget deficit, relative to gdp (as can be shown by a behavioural model and this shouldn’t be surprising as the two are related by an accounting identity). Typically governments follow some rules even if they aren’t explicitly required and their expenditure is endogenous to the government budget deficit: they tighten fiscal policy when the budget deficit goes out of a limit and relax fiscal policy when the budget deficit is within the limit. So improvement in a country’s balance of payments position would lead to a relaxation of fiscal policy, automatically.
To summarize, protectionism if done the right way can raise world trade because of rise in world income. There is no economic case against protectionism. There is opposition because few corporations want to increase their share in world markets. Protectionism reduces share of these mega corporations instead of reducing world trade. So “free trade” (which is managed trade for a few) only benefits a few and imposes a huge cost on the world economy.
All that is for the current world economic outlook. Typically in deep recessions governments take protectionist measures. In such scenarios, since output is falling, there is a tendency to confuse this with causation. It is more accurate to say that protectionism prevented a deeper implosion in such cases.
Thomas Palley has an op-ed on his blog on Paul Krugman’s views on free trade. Palley points out that Krugman has been a defender of free trade since 30 years, just slightly restrained as compared to the elite.
Palley’s post also has links to his articles from 1994 about a Left Keynesian interpretation of free trade.
[the page title is the link]
‘Free Trade Loses Political Favour,’ says the front-page of today’s Wall Street Journal.
Paul Krugman has two articles conceding that he held wrong views earlier.
But it’s also true that much of the elite defense of globalization is basically dishonest: false claims of inevitability, scare tactics (protectionism causes depressions!), vastly exaggerated claims for the benefits of trade liberalization and the costs of protection, hand-waving away the large distributional effects that are what standard models actually predict.
Krugman claims that he hasn’t done any of it but a reading of his 1996 article Ricardo’s Difficult Idea says the exact opposite.
The earliest cri de cœur of the U.S. balance of payments situation came from Wynne Godley in his 1999 article Seven Unsustainable Processes.
In his sub-heading ‘Policy Considerations,’ he says:
The main conclusion of this paper is that if, as seems likely, the United States enters an era of stagnation in the first decade of the new millennium, it will become necessary both to relax the fiscal stance and to increase exports relative to imports. According to the models deployed, there is no great technical difficulty about carrying out such a program except that it will be difficult to get the timing right. For instance, it would be quite wrong to relax fiscal policy immediately, just as the credit boom reaches its peak. As stated in the introduction, this paper does not argue in favor of fiscal fine-tuning; its central contention is rather that the whole stance of fiscal policy is wrong in that it is much too restrictive to be consistent with full employment in the long run. A more formidable obstacle to the implementation of a wholesale relaxation of fiscal policy at any stage resides in the fact that this would run slap contrary to the powerfully entrenched, political culture of the present time.
The logic of this analysis is that, over the coming five to ten years, it will be necessary not only to bring about a substantial relaxation in the fiscal stance but also to ensure, by one means or another, that there is a structural improvement in the United States’s balance of payments. It is not legitimate to assume that the external deficit will at some stage automatically correct itself; too many countries in the past have found themselves trapped by exploding overseas indebtedness that had eventually to be corrected by force majeure for this to be tenable.
There are, in principle, four ways in which the net export demand can be increased: (1) by depreciating the currency, (2) by deflating the economy to the point at which imports are reduced to the level of exports, (3) by getting other countries to expand their economies by fiscal or other means, and (4) by adopting “Article 12 control” of imports, so called after Article 12 of the GATT (General Agreement on Tariffs and Trade), which was creatively adjusted when the World Trade Organization came into existence specifically to allow nondiscriminatory import controls to protect a country’s foreign exchange reserves. This list of remedies for the external deficit does not include protection as commonly understood, namely, the selective use of tariffs or other discriminatory measures to assist particular industries and firms that are suffering from relative decline. This kind of protectionism is not included because, apart from other fundamental objections, it would not do the trick. Of the four alternatives, we rule out the second–progressive deflation and resulting high unemployment–on moral grounds. Serious difficulties attend the adoption of any of the remaining three remedies, but none of them can be ruled out categorically.
[italics in original, underlying mine]
There has been a debate led by vicious attack by Paul Krugman that Bernie Sanders’ plans cannot achieve growth of 5.3%. And there have been replies by others.
Coming from a third-world country and seeing an annual growth rate of about 8% in the 10 years of the rule of the UPA government (mid 2004-mid 2014), —meaning real GDP more than doubling in 10 years — despite a global financial crisis and economic slowdown, it appears comical to me that Paul Krugman claiming such a thing is not possible for the United States.
I am a bit unsympathetic to those who quote historical data to try to sneak in an argument that 5.3% is possible. It sounds too apologetic.
If the U.S. fiscal policy was run with a restrictive bias since a long time, there is obviously a huge deflationary bias imparted by policy. So you cannot use that data to either argue one way or the other. The ones using data to try to show it’s possible are playing into the hands of economists such as Paul Krugman whose writing appears nothing but a support for Hillary Clinton.
For a closed economy, the only constraint to growth is the capacity to produce. The United States’ economy suffers no such constraint. At full employment, growth is constrained by rises in productivity and addition to the working population. But productivity itself is endogenous to production because of learning by doing. In addition, rises in incomes motivate people to work harder.
So imagine an economy in which the government’s fiscal stance is held constant for 10 years – i.e., the government expenditure and the tax rates are held constant. Output might fluctuate and even grow but finally the deflationary bias in fiscal policy will drag growth. But you cannot average out 10 years of economic data of hardly any growth to argue out that the economy cannot grow for the next n years.
But things are not easy. What surprises me is that in none of these discussions from either side, is there any discussion of the U.S. balance of payments. The U.S. does not have exports of just a couple of hundred billions and a GDP of some $16 tn. It has exports of about $2.5 tn and GDP of about $16 tn, meaning the GDP is a few multiple of exports. The United States is a net debtor to the rest of the world. So a rapid rise in growth by any means will come at the expense of terribly deteriorating balance of payments which cannot last long.
Of course the above doesn’t mean that things are as pessimistic. It depends on what is going on in the rest of the world and the United States being the economic center of world activity can convince others to boost their economies and there is no reason to assume that it cannot. if there is rapid growth in other economies, the U.S. balance of payments is not something to worry about.
The importance of balance of payments is seriously missing in all discussions. Use of historical data is so wrong here.
tl;dr summary: supply constraints cannot put a limit of some 5% on U.S. growth. It depends on policy makers’ decisions worldwide.
Recently, Paul Krugman reminded us of his “45 degree rule” on his blog Conscience Of A Liberal. This was a reference to his paper in 1989 which was a rediscovery of Thirlwall’s Law from 1979  which states that the long run rate of growth of any country is constrained by the rate of growth of exports divided by the income elasticity of imports. Krugman rediscovered this law but interpreted the causality in the opposite way. This shouldn’t be surprising because in neoclassical economics, growth is explained by a production function and it is then difficult to interpret the causality in Thirlwall’s way. In an essay , John McCombie explains:
Krugman (1989) rediscovered Thirlwall’s Law, which he termed the 45-degree rule, as empirically ε/π = y/z or, when the (log) of the former is regressed on the (log) of the latter, the coefficient is unity or the slope of the line is 45-degrees. (Krugman provides some empirical evidence providing further confirmation of this empirical relationship). Like McCombie and Thirlwall (1994), he rules out sustained changes in the real exchange rate as a factor in bringing the balance of payments into equilibrium. Consequently, it is necessary to explain why the rule holds. The Keynesian explanation is that it is growth rates that adjust to maintain the balance of payments in equilibrium, but this is rejected by Krugman on “a priori grounds” that it is “fundamentally implausible.” He continues that “we all know that differences in growth rates among countries are primarily determined in the growth rates of total factor productivity, not differences in the rate of growth of employment; it is hard to see what channel links balance of payments due to unfavourable income elasticities to total factor productivity growth” (Krugman, 1989, p. 1037).
The Krugman article is instructive because it goes to the heart of the question about the direction of causation. Drawing on new trade theory, monopolistic competition, and the importance of increasing returns, he argues that faster growth leads to increased specialisation and the production of new goods for sale in overseas markets. Thus high “export elasticities of demand” are due to a dynamic supply side and rapid growth, rather than vice versa.
[x is the growth of the volume of exports, π is the domestic income elasticity of demand for imports, ε is the world income elasticity of demand for exports, and z is the growth of world income]
For a more forceful defence of Thirlwall’s Law, see McCombie’s paper.
In my opinion, the causality runs in both directions. However I am more sympathetic to Thirlwall and McCombie. And because the causality runs in both directions, there is still a balance-of-payments constraint. Complex economic dynamics still benefit richer nations and immiserate others. To an extent, this is already present in Kaldorian models. Growth brings in rise in productivity and this effects price competitiveness and hence beneficial to balance of payments generally. However, I also consider the income elasticity as being affected by growth at home and abroad.
In an Op-Ed for The New York Times, Japan’s Economy, Crippled by Caution, Paul Krugman is seen using a highly Monetarist language:
As I said, you might think that ending deflation is easy. Can’t you just print money? But the question is what do you do with the newly printed money (or, more usually, the bank reserves you’ve just conjured into existence, but let’s call that money-printing for convenience). And that’s where respectability becomes such a problem.
When central banks like the Federal Reserve or the Bank of Japan print money, they generally use it to buy government debt. In normal times this starts a chain reaction in the financial system: The sellers of that government debt don’t want to sit on idle cash, so they lend it out, stimulating spending and boosting the real economy. And as the economy heats up, wages and prices should eventually start to rise, solving the problem of deflation.
… When you print money, don’t use it to buy assets; use it to buy stuff. That is, run budget deficits paid for with the printing press.
Now, there are several things wrong about this. The most important one is the implicit assumption in the “model” that fiscal expansion via increased government expenditure is about neutral and that domestic demand is boosted only because of the way in which the government debt is financed – i.e., central bank purchases of government debt. In other words, Krugman is saying that if there is deflation and if there is an expansion of fiscal policy via a rise in say government expenditures, it will have little effect when the central bank doesn’t purchase government debt. Put it in another way, it is saying that the government expenditure multiplier effect acts mainly because of central bank purchase of government debt and not because of the increase in government expenditure per se.
This is silly intuition and the cause of this is the notion that fiscal policy is more or less neutral except in special circumstances.
In reality, it is the other way round. If the government expenditure rises, and if the central bank purchases government debt, the rise in output is mainly attributable to the former. This can of course be seen in a stock-flow consistent model but can also be seen by simple accounting and flow of funds. A rise in government expenditure on goods and services raises output directly and also via the multiplier effect. The central bank has a huge control over interest rates and the additional debt is simply absorbed by the bond markets easily. There’s no competition with other borrowers as the wealth of the private sector rises. In addition, if the central bank purchases government debt, it is hardly clear if households know if inflation is going to rise and increase their consumption because of “inflation expectations”. Even if they think that if inflation is set to rise, they might reduce consumption as inflation might reduce their real wealth.
Which is not to say that asset purchase programs of the central bank or “quantitative easing” has no effect on demand and output. It works via capital gains in wealth leading to higher consumption and the feedback effects of this. It also works if economic units shift their portfolios to buying non-financial assets. The effect of all this is unclear. In addition, as mentioned earlier, casual Monetarism like the language used by Paul Krugman mixes up correct attributions of government expenditure and central bank government debt purchases on output, misleading everyone.
Simply say “raise government expenditures”. Why all this casual Monetarism with “printing presses”?