Monthly Archives: September 2016

James Tobin On Real Business Cycle Theory

Lars Syll has a nice post quoting James Tobin’s views on the real business cycle theory (and dynamic stochastic general equilibrium (DSGE) models. DSGE models are just RBC theory models with some modifications but still retaining the core).

There’s also another paper, An Old Keynesian Counterattacks by James Tobin written in 1992 and devoted heavily on attacking all this.

Tobin says:

The crucial issue of macroeconomic theory today is the same as it was sixty years ago when John Maynard Keynes revolted against what he called the “classical” orthodoxy of his day. It is a shame that there are still “schools” of economic doctrine, but perhaps controversies are inevitable when the issues involve policy, politics, and ideology and elude decisive controlled experiments. As a lifelong Keynesian, I am quite dismayed by the prevalence in my profession today, in a particularly virulent form, of the macroeconomic doctrines against which I as a student enlisted in the Keynesian revolution. Their high priests call themselves New Classicals and refer to their explanation of fluctuations in economic activity as Real Business Cycle Theory. I guess “Real” is intended to mean “not monetary” rather than “not false,” but maybe both.

I am going to discuss the issues of theory, Keynesian versus Classical, both then and now. Since the main purpose and preoccupation of macroeconomic theory is to guide fiscal and monetary policies, the theoretical differences imply important differences in policy. Moreover, prevailing doctrines seep gradually into the ways the world is viewed not only by economists but also by students, pundits, politicians, and the general public. It is in this sense but only in this sense that I shall be talking about current events.

The doctrinal differences stand out most clearly in opposing diagnoses of the fluctuations in output and employment to which democratic capitalist societies like our own are subject, and in what remedies, if any, are prescribed. Keynesian theory regards recessions as lapses from full-employment equilibrium, massive economy-wide market failures resulting from shortages of aggregate demand for goods and services and for the labor to produce them. Modern “real business cycle theory” interprets fluctuations a moving equilibrium, individually and socially rational responses to unavoidable exogenous shocks. The Keynesian logic leads its adherents to advocate active fiscal and monetary policies to restore and maintain full employment. From real business cycle models, and other theories in the New Classical spirit, the logical implication is that no policy interventions are necessary or desirable.

Should we describe the macro-economy by two regimes or one? The old Keynesian view favors two regimes. In one, the Keynesian regime, aggregate economic activity is constrained by demand but not by supply. If there were additional effective demands for goods and services, they could be and would be satisfied. “Demand creates its own supply.” The necessary inputs of labor, capital capacity, and other factors are available, ready to be employed at prices, wages, and rents that their productivity would earn. Only customers are missing.

The second regime, which Keynes called classical, is supply-constrained. Extra demand could not be satisfied at the economy’s existing capacity to produce. The needed workers or other inputs are not available at affordable wages and rents. The supply limits bring about prices and incomes that restrict aggregate demand to capacity output. Should capacity increase, those prices and incomes will automatically generate just enough additional purchasing power to buy the extra output. “Supply creates its own demand.”

Keynesians believe that the economy is sometimes in one regime, sometimes in the other. New Classicals model the economy as always supply-constrained and in supply-equals-demand equilibrium. In their real business cycle models, the shocks that move economic activity up and down are essentially supply shocks, changes in technology and productivity or in the bounty of nature or in the costs and supplies of imported products. Although external forces of those kinds, for example weather, harvests, natural catastrophes, have been the main sources of fluctuating fortunes for most of human history, and although events continually remind us that they still occur, Keynesians do not agree that they are the main source of fluctuations in business activity in modern capitalist societies.

and in the end concludes by asking:

Why do so many talented economic theorists believe and teach elegant fantasies so obviously refutable by plainly evident facts? Trying to answer that question would take us into a speculative excursion on the sociology of the economics profession, beyond the scope of this paper.


Marc Lavoie On The DSGE Emperor

Marc Lavoie has an excellent new article at the Institute For New Economic Thinking website titled Rethinking Macroeconomic Theory Before The Next Crisis.


In this article, I have tried to stress that there is considerable dissatisfaction with the current state of mainstream macroeconomics and with the quasi-dictatorial directive that the only game to be played in town is the adoption of the DSGE model.

Some orthodox economists believe that mainstream economics holds under normal conditions (Richard Koo’s yang phase), but that it needs to be modified under zero-lower bound conditions or during balance sheet recessions (Koo’s yin phase). Macroeconomic theory needs to be revised both for the yang and the yin phases. Providing new clothes to the Naked Emperor of mainstream economics won’t do; the Emperor needs to be dethroned.

The title of this page is the link.

UNCTAD’s Annual Report

The United Nations Conference On Trade and Development’s annual report for 2016 is out and it’s worth reading as always. It’s generally written by non-orthodox authors.

Ambrose Evans-Pritchard of The Telegraph already has a good summary of it in his article UN Fears Third Leg Of The Global Financial Crisis – With Prospect Of Epic Debt Defaults.

There’s reference to Myrdal and Kaldor’s work on circular and cumulative causation: specifically the importance of manufacturing. See page 58 onward (page 92 of the pdf file).

Another thing which caught my attention is the share of wages in the national income.


Noam Chomsky On Neoliberalism

I have been looking at Noam Chomsky’s views on neoliberalism and I found a documentary Neo-Liberalism Ensnares Democracy by Richard Brouillette which I thought I should mention.

Noam Chomsky on Neoliberalism

Noam Chomsky in ‘Neo-Liberalism Ensnares Democracy’
Picture from the documentary’s site.

Chomsky argues how neoliberalism is not really “neo” and that it is what created the third world. He goes on to argue how this happens: In his language, free capital flows creates a virtual parliament of investors and lenders who carry out moment by moment referendum on government policies. Governments hence face a dual constituency and that neoliberalism is power-play.

The documentary length is 160 minutes (2h 40m). Chomsky appears at 23:06, 57:20, 1:10:22, 1:46:38, and 2:33:18.

TARGET2 Balances And “QE Recycling”

During the crisis which started in 2007 and especially around mid-2011, TARGET2 liabilities of some National Central Banks (NCBs) of the Eurosystem increased drastically (chart below) and led to heated discussion among economists and became a political subject.

Recently, the (im)balance has been increasing again but it seems that it’s mostly because of what some call QE recycling.

Peter Praet, Member of the Executive Board of the ECB explained this in his speech yesterday.

First the chart from his talk:


Sum of all positive TARGET2 balances. Source: ECB.

As Praet shows using T-accounts, what happens if Banco de España purchases securities from a German counterparty, Bundesbank’s TARGET2 assets—claims on the rest of the Eurosystem—will rise and so will Banco de España’s TARGET2 liabilities to the rest of the Eurosystem.

Once the German counterparty sells the securities to Banco de España, it will try to find the nearest substitute which may not be a Spanish security. So this is nothing to be worried about unlike earlier where TARGET2 balances were symptomatic of capital flight from some countries threatening financial meltdown.

Of course one has to be careful. Not all the recent rise may be attributed to the QE effect. But at the same time this analysis should throw some light on the topic.

Physics Envy

Economists have a terrible physics envy.

In 1954, Chen Ning Yang and Robert Mills formulated what is now called “Yang-Mills theory” or “gauge theory” in Physics. It took a while for their work to be used as an empirical theory. The Electroweak Theory was discovered in 1967 and Quantum Chromodynamics around early 70s.

The point of the above is that sometimes theory is ahead of experiments in Physics. Around the 80s, some (and not all) theoretical physicists started working on string theory.

But if you had asked Mr Yang and Mr Mills what the usefulness of their work was in 1954, their answer wouldn’t have looked satisfactory. In the same way, string theory is something which possibly is ahead of its time but just that the connection to experiments seems longer. It is however fashionable to see people writing about string theory and debunking it as pseudoscience without any knowledge of it whatsoever.

Case: Paul Romer’s article The Trouble With Macroeconomics. The abstract says:

In the last three decades, the methods and conclusions of macroeconomics have deteriorated to the point that much of the work in this area no longer qualifies as scientific research. The treatment of identification in macroeconomic models is no more credible than in the first generation large Keynesian models, and is worse because it is far more opaque. On simple questions of fact, such as whether the Fed can influence the real fed funds rate, the answers verge on the absurd. The evolution of macroeconomics mirrors developments in string theory from physics, which suggests that they are examples of a general failure mode of for fields of science that rely on mathematical theory in which facts can end up being subordinated to the theoretical preferences of revered leaders. The larger concern is that macroeconomic pseudoscience is undermining the norms of science throughout economics. If so, all of the policy domains that economics touches could lose the accumulation of useful knowledge that characteristic of true science, the greatest human invention.

Although the new consensus macroconomics is all trash, there are three things wrong with this:

  1. String theory is not pseudoscience. It is a perfectly respectable theory. It comes tantalizingly close to describing the physical world with a few principles. It produces Einstein’s theory of general relativity as a “low-energy approximation” and some solutions of it look very much like the real world, though not exactly. It however has many problems. That it works only in 11 space-time dimensions (!!) isn’t a problem. This is solved by what is known as “compactification”. The real trouble is that it has many solutions and string theorists are stuck at how to proceed. Otherwise its methodology are highly scientific and are being applied in increasing our understanding of quantum field theory which describes fundamental particles and their interactions.
  2. Romer’s equivalence to string theory gives the new consensus macroeconomics some respect. This is totally undeserved.
  3. The new consensus macroeconomics is not the only answer. Keynes made a fundamental breakthrough in macroeconomics in the 1930s and his colleagues and followers have improved upon his work greatly. So there’s a Cambridge revolution. The new consensus however is based on a bastardized version of Keynes: it’s Keynesian only in the name. Otherwise it has everything else Keynes so passionately debunked.

Even outside Cambridge, such as the work of Morris Copeland – his flow of funds approach and the work done by Tobin and subsequently used by Post-Keynesians have contributed to a much better understanding of economic dynamics.

Anyway, economists seem to have a physics envy and should stop comparisons to it. I find it amusing that economists have made a mess of their subject and struggle with basic flow of funds concepts venturing into critiquing string theory.

Paul Krugman Is More Orthodox Than Joseph Stiglitz

… 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.

[italics in original]

– 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 Federal Reserve Must Rethink How It Tightens Monetary Policy

Thomas Palley:

After more than 7 years of economic recovery, the Federal Reserve is positioning itself to tighten monetary policy by raising interest rates. In light of the wobbly reaction in financial markets, an important question that must be asked is whether raising interest rates is the right tool.

It could well be that the world’s leading central bank is going about the process of tightening in the wrong way. Owing to the dollar’s preeminent standing, that could have severe global repercussions.

Just as the Fed has had to rethink how it combats recessions, so too it must rethink how it transitions from an easy monetary policy stance to a tighter stance.

Click the title of the page to read more.