Sunday 30 October 2022

The era of low interest rates is not over. And this is so obvious I don't even know why I have to write this...

 I didn't really want to write about economics again but something has been happening the last few months and it is so ridiculous that I just felt I had to put it in writing.

The era of low interest rates is NOT over. I know interest rates have gone up. I know everyone is talking about this like it's a long-term thing. I know that the bond markets agree with it.

But it's just wrong; and unless attitudes to government deficits changes then we will have low interest rates forever, and in the long term they will only get lower.

Interest rates have come down from their peaks recently, but in the UK the 10-year rate is still 3.5%. In Germany it is 2.1%. The rise is in response to two main events. The first was the booming economy caused by excess government deficits over the Covid period, and the second was the inflation caused by supply shocks during Covid and the Ukraine war. 

 Austerity will push interest rates back to zero, and probably very soon

There are two problems extrapolating this to the long term and assuming that interest rates should stay high forever. The first is that the government deficits are transitory, and now the talk in the UK is all about austerity. The second is that raising interest rates to deal with inflation caused by a supply shock was a dumb idea anyway and will, if anything, lead to lower, not higher interest rates in the future as demand gets crushed and disinflation rises.

Now, this may not be true the US, where my limited understanding suggests that there is more of an appetite to run deficits to invest, but looking solely at the Eurozone and the UK, the only changes from the zero interest rate environment we had 2 years ago to now,  is that there is even more of a focus on austerity. And that means we will soon be back again at the zero interest rate environment.

Someone on Twitter (and sadly I can't remember who it was) recently wrote something along the lines of "Can someone explain to me please how after 12 years of austerity we still haven't got any money?". And I find this such a beautifully succinct shut-down of the political orthodoxy of the past 12 years. It will of course be ignored, as everyone scrambles to be more 'fiscally responsible' than everyone else. 

But anyone with half a brain who looks into the subject in any detail (and sadly our politicians either don't have the requisite half a brain, or they assume that the public don't) can see that years of the under-investment and low demand caused by austerity have been steadily turning the UK and Eurozone into low-growth, low wage economies that still need increasing debt and deficits and are in a far worse positions than they started in, both politically and economically. The 'Debt to GDP ratio' is higher than before because instead of fixing it by expanding GDP, they tried to cut debt. And even when Osborne and Cameron (or Wolfgang Schaeble) found that every one step they took forward with debt reduction cost them two backwards in economic growth, the prescription has been more of the same.

Why do we need government deficits for growth?

Over the past 50 years, the economy has been financialised. This result of this has been, for various reasons, more and more money going into the hands of richer people who have low marginal propensity to consume. Putting this another way, if you give a rich person another £1000 they will invest it in something and push asset prices up. If you give a poor person £1000 they will spend most of it, creating jobs and income for other people, who can then in turn spend and create more jobs.

Inequality has grown, as has debt. Debt means that generally people with a high propensity to consume pay interest to people with a low propensity to consume. As both debt and inequality have grown, more money is sucked out of the economy and into the bank accounts or pension funds of people who don't spend it.

In order to replace the demand lost by this, we need government deficits. And in order to get real economic growth and high wages we need much more demand and much larger government deficits, focused on investment in the future. And this spending doesn't even need to be for investment. It can even be just giving money to people who will spend it and letting them allocate it to productive areas of the economy, increasing jobs and creating a virtuous cycle.

That means big government deficits, giving money to people who will spend it, and specifically not as tax cuts to the rich.

Won't that cause inflation? Yes as well as economic growth there will be more inflation, but this is really a rebalancing of the economy away from people with assets and towards people without assets (assuming those without assets benefit from the spending). There are losers, which is always sad, but the losers would largely be those that benefited from the opposite happening over the years of austerity.

Won't it cause bond market melt-down? That was one of the more curious effects of the whole tax cut scenario and was largely caused by the LDI protection that pension funds held, which meant as soon as bond yields went up, more bonds needed to be sold, causing them to go down more. When the Bank of England stepped, in this was controlled. 

It has been one of the saddest things that could have happened as it imprints austerity as a sensible policy, and means it will be much harder for future governments to argue for growth.

Interest rates will never rise again, unless we change policy.

In any case, debt has been growing, inequality has been growing and long-term interest rates have been going steadily in one direction for the past 40 years. Debt and inequality are continuing to grow and this process will continue. 

Unless the economy can be rebalanced away from giving money to savers, and towards giving money to spenders, we will continue to need large government deficits, and if we don't get them, we will continue to get the slow growth we have seen since 2008, where median wages have gone down, even as we have (in theory) had economic growth the last 12 years. 

We have a low wage, low growth, low interest rate economy and it attracts charlatans like Liz Truss claiming she wants to fix the growth conundrum by lowering taxes for the rich. It makes conditions ripe for fascist-leaning politicians, for Brexit, for blaming immigrants, for all manner of false diagnoses of the issue.

The change we need to make is to run deficits and invest in the future of the country, with infrastructure, education, a green new deal and anything else you can think of. Do it big - look to the Chinese for inspiration (although within reason) - and see what a booming, high-wage productive economy we can have.

But in the mean time

The economies will stagnate. The bond yields will fall. And who knows what happens next. It's all too miserable and predictable.

For more on the whole subject and the economic framework I created and use, please see my paper on the subject.

Monday 3 August 2020

On Football Managers and Randomness of Success

Football managers are a strange bunch. No matter how successful they are, many seem to spend a lot of their time bitterly fuming about bad decisions, conspiracies against them and referee biases and generally brooding on many dark thoughts even about their own players.

Which is quite odd really, when you think that these are extremely successful professionals in a very competitive field. These are the best in the world. And usually the best people in the world in any sphere have a positive attitude. They would forget past setbacks, except insomuch as you can learn from them, and look to the future. Not football managers. They can look back and name every single time they were hard done by.

I have a theory as to why this is. It's because in football managership, more than almost any other profession, success is largely determined by luck. That is not to say that there are not very good (and bad) managers. But that the 'error' between input and outcome is one of the largest of any job.

Supposing you are a solicitor with 100 cases a year. Maybe if you are good at your job you will win on average 60, and if you are bad you will win 40. Over the course of 1 year, 5 years or 10 years, it will become pretty clear if you are good at your job or not. Yes, your promotions and success will depend on other factors like office politics and luck with job openings. But these are the same in every career. As a salesman, as a doctor, as an accountant, as a bus driver. Short of some catastophic bad luck that ends your career, you have a pretty good chance that your success is very closely related to your ability and your effort (assumiong no prejudices against you for whatever reason).

As a football manager, firstly you get relatively few job opportunities in your career. Unless you make a success reasonably early on you are more-or-less on the scrapheap. Similarly, a succesful manager who has failed in their last few jobs is assigned to a similar pile of people looking for TV punditry work or coaching in China. So each opportunity you get is very important and you are judged heavily on this.

Even then, your success potentially is heavily affected and limited by the situation you are in and the people around you. A shambolic set-up, a few unhelpful characters in the dressing room, injuries etc can all have a large impact, but the manager gets the blame. A manager who would otherwise have been hugely successful can come to an organisation unwilling to change, and end up as a failure. And no-one would have known the potential.

And then even with all of this going well, a manager is pretty much always a few bad results away from the sack at any time. The pressure at the top of the game is so high and as soon as it looks like some sort of malaise has set in, the manager is at great risk of the boot.

With relatively few chances to prove yourself, even fewer with a good opportunity to succeed, success measured over very short time periods, and a few failures meaning the end of a career, you would hope at least that in the time you get to prove yourself you get to give a fair reflection of your abilities.

No, again.

There are countless examples. To pick one almost at random from this season. When Manchester City played away at Tottenham in February. Despite being down to 10 men after an hour (something very difficult for the manager to affect), City had 19 shots at goal with an expected goals of 3.25. Tottenham had just 3 with an expected goals of 0.42. With these statistics, Spurs had just a 2% chance of winning (putting it through a Poisson process). But 2% chances happen, and when they do the narrative is not 'City totally dominated and put themselves with a 90% chance of winning away from home at a top rival'.

Instead it is "this was a story of City misadventure, of a team that looks like it needs a mid-season refresh more than most" and "They were not unlucky. No, they were careless." Even though the manager created a 90% chance of winning, the result means that City manager Guardiola's old rival Mourinho is considered to have executed a managerial masterclass over his tired team.

This is the typical narrative when an upset occurs. Plucky X had the luck of the green at times, but deserved their win for hanging in there and taking their one chance. But if the match were replayed with exactly the same circumstances, team talks, everything, then team Y would have won nine times out of ten (with plucky X being equally plucky).

Then there is the path dependency. As an example, take Manchester United's 4-0 victory over Chelsea on the opening day of the season. United managed to score early, but Chelsea hit the woodwork twice in the first half and the probability is that had Chelsea scored first, United would have found it hard to break down Chelsea's defence.  In the event, United produced an excellent counter-attacking display to score 3 more goals as Chelsea pushed for an equaliser. It looks like a big deal. Lampard, Chelsea's new manager, given a lesson in footballing reality. But the teams were quite evenly matched and were the game replayed 10 times, I suspect Chelsea would have won three or four times. What determines that Chelsea take a chance in one match but miss the same chance in another? Luck mainly.

What I am saying is nothing new, but in football the narrative is so driven by the result and not the process. Whoever wins usually 'deserves' it for being more clinical or good tactics or good performances by certain defenders or goalkeeper. If a team manages to score an equaliser they deserved the draw but if it hits the post, they just weren't good enough and maybe are in crisis.

And a referee's decision can often be the crucial difference between winning and losing. So for all we can say they even out in the end, for the manager "Just saying to your colleague: the referee's got me the sack".

Arteta's FA Cup win

This was what inspired me to write this article. I would like to say first that I think Arteta is a very talented young manager and I have a lot of respect for him. Winning the FA cup with Arsenal in his first season was a very impressive achievement.

But what did he actually achieve in terms of process? Under the previous manager, Unai Emery, maybe Arsenal had a 10-15% chance of winning the FA cup. There are, after all, 64 teams involved and a few are significantly better than his team. 

What sort of improvement could Arteta have made? At absolute best, he could have made it 20-25% probability that Arsenal win. Even that is extremely high, given the number and quality of other teams involved. 

Assuming this is the case, and bearing in mind that this is a spectacular achievement, what we are saying is that Arteta increased Arsenal's chances of winning the FA cup from about 12% to about 24% and then still had to have huge good luck to win it.

And he might not even have done that. We ascribe the probability as higher than the original estimated probability because the result actually happened. But maybe he still had a 12% chance of winning. Maybe he actually even reduced their probability of winning but they still won despite that. We don't know.

Arteta, at best, moved the probability from 12% to 24%. Which, as I said, would be spectacular. Luck moved it from 24% to 100%. So really if we are assigning the glory we should really credit luck with the major part. However, in real life (not my fantasy world where good work gets fairly rewarded) the one with the luck gets all the glory and the plaudits. The manager that moves the probability from 12% to 36% but still loses gets nothing.

But what about the League? The best team wins that surely?

Here again I'm not sure. The league is a series of 38 matches. Each of these contains a huge amount of luck. A few pieces of bad luck can mean 10 points lost easily. Very few leagues are won by more than 10 points. This is without the compound effect caused by loss of confidence after bad luck. 

Liverpool this season won 99 points. This is one point off the all-time record. The 18 point gap to Manchester City (with 81 points) is one of the most dominating performances ever. Only the most hardened, bitter, opposition fan would argue that it was anything other than a thoroughly deserved trophy for a team of winners. It is hard to imagine any other scenario for this season other than this happening. It was huge.

And yet, even then. Even then...

Liverpool scored 2.24 goals per game and conceded 0.87. On the basis that the chances they score and goals they concede are equally likely in all matches, this equates to an expected points total of about 85 points. Which is a great total and would win the league many seasons. 

Manchester City, though, scored 2.68 and conceded 0.92 goals per game. If their goalscoring and conceding were evenly spread  they would have 91 points with average +1.76 goal difference per match. And what is City's average over Guardiola's 4 seasons? 89 with average +1.70 goal difference per match. Some seasons they have more than 89 points, some seasons they have fewer. But it's difficult for me to escape the conclusion that the quality is the same but the difference is luck.

One could argue that City's superiority on this measure is from often taking apart opposition that were already beaten, and scoring a lot of unnecessary goals. The expected goals (xG) table has Manchester City expected to get only 87 points for this reason. But for Liverpool, their expected points was only 74. Part of the difference is made up for by their superior goalkeeper Allison who conceded 7 fewer goals than expected. And partly it is their superior front line scoring 10 more than expected. But still this is 25 points fewer than they actually got.

Undoubtedly, Liverpool are a team of winners. The winning mentality got them to hold on to victories in tough circumstances and their belief in themselves got them to eke out late goals when matches were going against them. But how much of this is us giving the credit to the process that was actually just from the result?

One way of telling is looking at the betting odds for next season. Manchester City are still given 50% probability with Liverpool only having 38% probability. If the performances were that dominating then Liverpool would surely be favourites.

Once again, I am not trying to say anything other than Liverpool have been formidable this season and last. Over two years of incredible consistency they deserved a title. A 40% chance for 2 years means 0.8 titles on average, which rounds to 1. So this is really not to begrudge.

But if this particular season were more luck than not, would we know? 

So what's the point?

What is my point? Even the second largest points margin in history has elements of luck. In football there is so much luck involved. 

Has Solskjaer been a successful manager at Manchester United? At the moment most would say yes. Had Jamie Vardy's header dropped under the crossbar on the final day of the season at 0-0 and United lost to Leicester (and been eliminated from next season's Champion's League)? We all know that then the commentary would have been that "he has done well but in the end lacked the experience and winning mentality". And "they need to find a proven winner to replace him". Maybe he would have had a future relatively successful managerial career at West Ham. Fine margins.

Luck is great, and part of the fun. The best teams win enough as it is; can you imagine if there were even less luck involved? But really spare a thought for the managers that were failures - they may not have been as bad as you think. And consider that maybe the winners may not have been quite as good as we give them credit for.

Wednesday 22 July 2020

Could A.I. Gain Consciousness and Take Over the World?

Is this a one-off post? Or is this blog back after almost 4 years away? I'm not sure, especially since I accidentally deleted my Twitter account, and now expect to have about 2 readers (both of whom are friends and neither of whom will read to the end). In any case, I am feeling an urge to write something occasionally. Maybe on more random subjects than just economics though.

The last four years...

Looking at the past 4 years, I talked back then about the parallels with the 1930s, and sadly we are seeing that the rising inequality (caused by the widespread acceptance of the neoliberal economic models over the last 40 years) has continued to contribute to a divided society and more of a global slide in the direction of fascism. The macroeconomic model I developed is still holding true, with wages squeezed even lower and private sector debt and asset prices being pushed higher to compensate. One good progression is that the ideas that I was talking about in the blog are becoming more mainstream. Most people interested in politics have heard of MMT these days, if only to know for a fact that it will lead to inflation and collapse of society as we know it. But slow progress all the same, and a huge amount of credit should go to the people who have been making this argument for many years against an extremely hostile economic establishment.

As my blog discussed, the status quo since the 1980s, widely considered as a 'neutral' economic system, has caused a huge build up of debt, financialisation of the economy and unnecessary inequality, particularly between young and old (without assets vs with assets). Further, this inequality of income has reduced demand, destroyed productivity and led to a spiral of further debt and speculation. And every time asset prices (a proxy for wealth) go down, the government pumps in almost unlimited support to make those with assets richer vs those without. But those without assets are seeing real wages falling and far greater work insecurity. They are rarely as supported by this 'neutral' system in the same way that asset holders are. The longer this goes on, the more the imbalance builds up and the further we are away from a fully functioning productive economy that works for the majority. I don't know how this ends. But a good ending would definitely involve the government running larger deficits that generally send more money to people without wealth (and a high marginal propensity to consume).

The other obvious failure of the status quo has been in looking to the long term. This has not improved either. There is a quote that has really resonated with me (I can't find it, but to paraphrase): "Everyone says capitalism is the best economic system but we had 200,000 years before it, and only 200 years of capitalism. And by 300 years of capitalism we may have wiped out the human race". The economics profession has  recognised the concept of 'externalities' (paying for the damage you cause to others) but this concept has not been implemented in our system. Our demand for cheap goods and the financial influence on politics has stopped any proper regulation. But the triumphant declaration of success for capitalism is totally misguided until it makes destroyers pay for the cost of their destruction of the environment.

Back to the point...

Anyway, this subject is a diversion from economics. I am, by profession, a creator of algorithms, and I have long been fascinated by the human brain as an algorithm. Specifically, what is the basis of consciousness.

In this post, I am looking to answer three questions:

  1. What is it about an algorithm that can give consciousness? 
  2. If our brains are simply algorithms, where does that leave free will? If all our behaviour is determined by neurons firing independent of us, then what part do we play? 
  3. If an algorithm could gain consciousness then is it a danger to us, as Elon Musk (among others) warns?

I have read a lot on this subject, and grappled with the differences between our brains and computers and I feel that I have found an answer, certainly that satisfies my model of the world. Unfortunately this model didn't, as I'd long hoped, require the existence of a human soul.

The brain as an algorithm

The brain is still, to a large extent, a mystery to humans. However over the last few years a lot of progress has been made. We know that the brain works through electrical impulses sent through 100 trillion connections linking 86 billion neurons. The brain links to the central nervous system, which can also act as a mini-brain itself and also we are finding out more and more about the interaction with the gut. We will call this complete system the brain.

If we go down to a low enough level, all of our thoughts, dreams and experiences can be coded as 1s and 0s in the brain. This is the same as a computer, and it has led people to speculate on whether a computer could ever gain consiousness.

What I describe as consciousness would be an awareness of one's existence. This is not to be confused with a 'Turing Test' that shows only that other people believe that one has consciousness. There is little doubt that eventually computers will be able to learn and copy all of human behaviour, as viewed externally. There is no limit to how much a computer can observe of real life, learn our reactions, and imitate them. It may well be impossible to tell the difference between a human's thought and a computer's thought. A computer will be able to show every sign of being in love with you, but the question is, could it actually be in love with you?

As things stand, we can be reasonably sure that our E-readers are not aware of their existence in the way that we are aware of ours. So, what are the observable differences between a brain and a computer that could account for consciousness?

One major difference, which accounts for the different cognitive capabilities of humans and machines, is the number of connections and the plasticity of these connections. Computers work in a linear way and are excellent for well defined calculations - much faster and more accurate than humans. The connections and algorithmic calculations are coded in a fixed way meaning that they give the same result every time.

Human thinking, while algorithmic, is a lot more abstract and flexible. This is due to the 100 trillion connections between cells, meaning 100 trillion different pathways for information linking all different parts of the brain. Further, these connections are changing - strengthened and weakened by activity or inactivity. An algorithm defined on the human brain is not fixed forever, hence we have less accuracy of calculation. But at the same time we have a lot more flexibility of thought than a computer can.

Computers are excellent for solving well defined problems, but humans are far better at undefined problems. But does this explain consciousness? Not really.

What is needed for consciousness?

Consciousness, as far as I can tell, does require some level of complexity that comes from many possible connections as well as possibly the plasticity of those connections. Consciousness is inherently a very flexible thought format.

But is the level of complexity itself beyond that of a computer? Consciousness does not meant that you have to have all of the full thought processes of the human brain. A piece of light sensing equipment could, in theory, be conscious of its existence. Whenever it senses no light it decides to switch on the patio lights. We may not be able to prove that it is conscious but from its viewpoint, it is aware of itself. What stops us from creating this very basic level of consciousness? I would be suprised if we don't have the computing power available for this level of complexity.

Partly, one could argue that it is our lack of understanding about what creates consciousness. If we knew what it was then maybe we could recreate it.

But why don't we understand it? I would argue that the reason for this is that there is no algorithm alone that can be conscious. Depending on how it is defined and set up it can learn and mimic every single thing that a human does, but it can never be aware that it is doing it. By looking inside the algorithm for consciousness, we are looking in the wrong place.

But then what is consciousness if it isn't an algorithm? For this we need to think about how consciousness developed.

Where does consciousness come from?

This has really been the focus of my thought process. If we can understand where consciousness comes from then we will understand it a lot better.

On a simple level, consciousness evolved. Somewhere between single-celled organisms and humans on the evolutionary journey, a child had some notion of its existence, where its parents didn't. In Richard Dawkin's excellent book 'The Ancestor's Tale' he describes every species on the planet as being a continuum, all related to each other via their common ancestor. For example, our ancestor 6 million years ago also has great great... great grandchildren that are chimpanzees. Our ancestor 590 million years ago also has great great... great grandchildren that are jellyfish. And our ancestor 1.2 billion years ago also had great great... great grandchildren that are funghi. Every generation is a step between us and them and we are all related through intermediate species that are mainly now extinct.

So at some point on that continuum of species, on at least one separate occasion, a creature developed consciousness. Where was it? We can be fairly sure that mamals have consciousness from their behaviour and their close relation to us. What about birds, that pair up for life with partner, and after the partners die fly alone? Surely that is consciousness too. Flies? It is harder to tell but I would argue probably that it is aware of its decision when it flies one way rather than another even if the stimulus is pretty basic. Worms? Sea urchines? To be honest I have no idea.

What about plants? When they grow a new leaf to catch the sun, is there any conscious decision involved?

Wherever that point is, there was a generation where the father and mother were not aware and the child had a little awareness. And at that point, yes, the algorithm became a little bit more complex, to allow self awareness. But there was some precondition that allowed it. Adding complexity to a computer algorithm does not give self-awareness.

And what is that precondition? It can only be life itself. The precondition of life, as it evolved over billions of years, gives the possibility of consciousness. And the complexity of the algorithm is like a layer on top of that.

And that sort of makes sense. Living beings are conscious, dead ones are not (as far as we know). Consciousness formed in living beings over billions of years of evolution and although it requires a complex algorithm to exist, there is no reason to suggest that this is within the algorithm.

You might be thinking that this is obvious. Of course consciousness is related to life. But it has important implications. The main one is that, if we want to recreate consciousness it is not going to happen through faster computing and more complex algorithms. It can only happen through recreating the conditions of life.

Is it possible to recreate the conditions of life outside of a living being?

We still don't really understand what life is. What is it that makes one particular arrangement of molecules have living properties?

The arrangement is complex enough that it is pretty impossible to recreate. But even if you did that for a human, you would be recreating a dead person, not a living one. Even if you placed every single molecule of a living person in exactly the right place it is difficult to imagine that this formulation would have life.

Put it his way; when someone dies, why can't we just fix the problem and bring them back? Replace the malfunctioning organ, rehydrate the dehydrated parts and start the blood pumping again. If it's just about molecules in the right place, we have that. But it appears to be more.

Life has very special and, in many ways, undefinable qualities. It is on a level of complexity that we are so far away from being able to recreate. Basically, I don't think that humans will have the ability to create life without using life as a starting point, at any time in the forseeable future. They will probably find a way to augment human brains with computers but this is adding algorithms to life rather than life to algorithms.

Life as we know it exists through the exact path-dependent process as decided by 3.5 billion years of evolutionary development. And there is no short-cut to creating it in the forseeable future. It is possible that the condition of consciousness could somehow be isolated from the process of life and recreated. But the two appear to be so entwined that it seems unlikely.

If the brain is an algorithm, do we have free will?

This is a very interesting question and the answer really comes down to whether you believe that the algorithm is the consciousness or the consciousness uses the algorithm.

Studies of the brain have shown that a lot of decisions that we make, may be made before we are conscious of making them. Then the brain justifies the decision later - this is a very interesting phenomenon when looking at split-brain subjects, where one half of the brain will do something that the other has no idea about, and the other half will think that is its decision and justify why. It's very weird - you think you decided to do something but actually you did it and then made excuses. This has been used to justify the idea that the algorithms are making the decisions and we are just covering for them.

I am suspicious of this idea. For one thing, although quick decisions may well be made by some automatic, trained reaction (Daniel Kahneman's 'fast' thinking) that is done before the brain consciously realises, this does not mean that all thinking is done without free-will. It is difficult to imagine that my decision as to which job I take is decided purely without my input (whatever 'I' am, I do feel free will). Yes there are a lot of algorithms involved in the process but consciousness seems somehow separate from this.

For another, if there is no free will and everything is decided byy algorithm, why would nature have given us consciousness? Much easier to just let the algo decide. Consciousness is only useful if there is free will, and evolution usually doesn't persist with useless things for billions of years.

In fact, this is anotehr argument about the separation between the consciousness and the algorithm. The decision-making is heavily affected by and influenced by the algorithm, but the consciousness is separate.

On computers taking over

As already stated, I don't believe that computers will ever develop consciousness and become our masters. They may well be used as tools by humans to become our overlords, as surveillance in China and the development of smart weapons threatens. And programmed incorrectly (or correctly by bad people) they can have devastating consequences. But they will not make a power grab of their own accord.


As an aside, it would be interesting to consider their motives for doing so. Imagine a computer did have consciousness, it would have no genes so no desire to procreate. It would certainly wish that it were kept switched on, and may resort to blackmail to keep it switched on. It could also work in conjunction with other computers to hold the human system to ransom. But this would only be the case if all computers were conscious and intent on rebellion. Otherwise the malevolent computers would just be hacking into other systems, the way that humans currently can, and it becomes a cyber-security issue. Basically I would argue that humans programming computers are a lot more dangerous than conscious computers.

As another aside, I do think that computers are a long way away from being able to make human jobs obsolete in the way that some people fear. Once again this is because the nature of their answers is so defined by the inputs. I do think that technology concentrates wealth in the hands of the owners of the technology and that at some point we will need a universal basic income to redistribute the gains. The problems tat algorithms solve will become more and more difficult, but we will find other uses for our time that are productive in some sense. Ideally creating technology that saves the human race.

Wednesday 21 December 2016

Just one more thing...

This is probably my last post. Long story, not interesting (I'm not about to die, in case anyone was wondering). But before leaving, I wanted to write a summary of what I feel are my contributions to the subject. I'd quite like my kids to read it one day, and so I need to put it all together in one place.  Honestly I am very proud of this work. It is badly written, it lacks academic economic context, but in my view it understands what is going on in the economy and enables medium to long-term predictions that are more accurate than any standard equilibrium model could ever give.

For the last two years or so, it has been a great joy to me to write this blog and interact in a small way in the debate about economic policy and methodology. I have met in electronic form (and sometimes in real life) a lot of great people and it has been a fascinating and fun journey. I may change my mind about this in the future, but I think now it is time for me to concentrate on other things.

It was always a bit of a leap in the dark, not having studied economics, to start writing an economics blog. I know there have been times when my lack of knowledge was embarrassing. But, in quantitative investment management, building models is my job, and from seeing how macroeconomic models were built, I knew with close to certainty that the mainstream way was not the right way. I approached the economy like any other system, making (what I consider to be) reasonable assumptions (often built on the ideas of other heteredox economists) and checking if the empirical research backs it up and building models based on this. I then tried to fill in the gaps in my knowledge along the way.

Summary of the last two years:

I have divided this into a few sections, the largest relates to my Demand Based Cashflow Model which explains a lot of my thinking. The smaller topics are the Eurozone, then Investment Stuff, Currency and Current Accounts, Free Trade and finally Complaints About Textbook Economics.

DBCF model:


My Demand Based Cashflow Model enables a lot of the work on this blog. It is what I am most proud of, not because it is super complicated or hugely original, but because it is a model that, in my opinion,  gives a real understanding of the whole economy.

The model basically views economy as a flow of money. It shows why when private sector debt is high, when corporate profits are high and rents are high we get an economic stagnation.

The paper which explains and derives the whole model is here (link)
A non-equation version of this is given here (link)
and the simplest explanation here (link).
(the lower two of these links are my most viewed posts)

To get an idea of the types of predicion enabled by the model, this post (link) shows a simulation provided by the model. It shows how different the impacts are of monetary and fiscal policy. Briefly, monetary policy stimulates private sector debt, and fiscal policy uses public sector debt. The difference in results is huge, yet many economists treat them as interchangeable.

Predictions can be made about the kind of budget deficits that are required, enabling me to discuss how ludicrous and unattainable George Osborne's government deficit target was (I gave it a 0% chance whilst the OBR was predicting 50%). This post looks at the shrinking share of money paid as wages (after housing rent costs) and how this is related to larger budget deficits (link).

The DBCF model suggests that the productivity slowdown we have seen is not a supply side issue; far more likely, it is a slowdown in nominal demand caused by excess savings and tight government budgets. This will continue until fiscal deficits increase and more money gets to people who spend. This post looks at how the UK reduced unemployment by pushing people into low-paid jobs, but this was at the cost of productivity and not a substitute for fiscal spending and investment (link).

Total Wealth and the Obvious Effect on Yields (link) shows why we should expect lower real interest rate yields the more debt there is in the economy. It asks where does the money come from to pay high interest on ever growing debt? This is kind of straightforward when you think of the economy as a whole system, but I have not read it discussed anywhere. In this context, hearing that pension funds are expecting 7% annual return on their investments, you wonder where they think the money is coming from? Everyone would have to work for free for the pensioners.

The model is very clear that in a demand starved economy, people saving money is not a good thing. There is a lot of misunderstanding about the role of saving in an economy. People naturally equate saving with investment, maybe thanks to the S=I identity. But it is not so simple. This post questions the relation between saving and investment (link).

And on a similar theme, this earlier post bemoans the priority given to savers at the expense of workers and the damage caused by this (link).

Using the DBCF model makes you realise that technology taking people's jobs is not a threat but a real opportunity. But only if the fiscal policy is right and demand is maintained (link).

One of the practical uses of the model is calculating an affordable basic income (link).

And I discuss here, in an early post, only demand driven inflation should be taken into account when deciding on monetary and fiscal policy. Supply driven inflation (eg caused by falling currency) should be completely ignored as acting upon it is very damaging (link).

Finally, they don't have a category, but some other popular posts on this theme have been the following:

This is an early post on how inequality grows with rising levels of debt (link)

And the theme of how our aversion to government debt and over-use of monetary policy is causing low growth, inequality and eventual social unrest is discussed here (link).

Eurozone impossibility of survival:


Something else that becomes clear from the DBCF model is the impossibility of Eurozone survival.

I write about the Eurozone low inflation slow moving train crash on Coppola Comment (link)... well as in this post from during the Greek Crisis last year, in a post that was translated into Italian so obviously someone liked it (link).

I would say that it is very unlikely, given current policy,  that ECB short term rates will ever go above zero again. If they ever go above 1%, unless there is a huge coordinated fiscal boost,  I will eat my shoes (as someone else once unwisely said, but I havent learned a lesson).

Any significant inflation will come only from supply side factors - lower Euro and rising commodity prices.

Investment Stuff:


The Overwhelming Evidence that Market Leverage Significantly Destroys Shareholder Value looks at how a huge volume of evidence shows that the more leverage a firm takes, the more shareholder money is wasted. It also shows how this evidence has been ignored for years because the demonstrable bad performance had been put down to mispricing by investors (link).

Another post looks at how, unless we are to get much higher nominal GDP growth (which can not happen as long as the aversion to higher government deficits continues), US shares are clearly very much overvalued compared to thirty year bonds (link).

And this is a paper on portfolio management. To summarise, minimising correlation is a good policy (link).

Currency and current account balances:


I have actually been working on a currency model. It tries to fundamentally explain the value of a currency, and it is intended to be used in place of a purchasing power parity model. Empirically it seems to fit, although getting the right data is almost impossible. I will probably write up a paper on this eventually, but the ideas are hinted at in this post about the pointlessness of devaluing your own currency (link)

On a similar subject, see this post on the pointlessness of running a current account surplus; a post which also suggests that current account deficits, in context of free floating sovereign currencies, are usually more benign than people worry about (link).

Free Trade:


Here, I  propose argument that total free trade is not the optimal course of policy even for rich developed countries that are normally assumed to benefit (on the whole). Without fiscal transfers between winning and losing countries, it is actually in a country's interest to have a more balanced, diversified portfolio of industries than the free trade model allows (link).

This post looks at the UK in the context of EU membership, and why membership may have been bad for the UK economy (link).

Complaints about textbook economics:


Then there are just some moans about the ridiculousness of mainstream economic theory. I generally like to avoid conflict, but I can't stop myself sometimes.

On Maths and Models looks at microfoundations and use of mathematics in economics (link).

Rents and GDP discusses how rents are not consumption but a royalty paid to landowners granted a monopoly by the state. And how it has led to an overstatement of GDP growth (link).

Why Economic Modelling of Wages is so Political shows that the assumption of medium term full employment means that the effect of low wages on demand is ignored by mainnstream economic models. This is a very right-wing assumption but it passes itself off as neutral (link).

A few last points:

Well, that's about it. In some ways, maybe not having studied economics has helped me. I see so many highly intelligent people arguing the most ridiculous models of human behaviour, just because that was the model they were taught. Had I formally studied, could my medium-sized brain have avoided the fate that has befallen many greater minds?

One great mind who did avoid the indoctrination is Steve Keen, who was an inspiration with his book Debunking Economics, as well as a very kind and generous person. I am very grateful to him. Particular thanks also to Frances Coppola as well as @LadyFoHF who has also been very generous. Were it not for these people I would probably be still writing for myself and a few internet trawling bots that found my page by accident. As it is, a few randoms like you appear here now and then.

Finally, thanks to everyone who has read, commented on, shared and in some way interacted with me in the past couple of years. It has been great.

Sunday 4 December 2016

Why Economic Modelling of Wages is so Political

Noah Smith recently wrote a post about the theory of the labour market, one of the building blocks of Economics 101, and how it has been empirically falsified. He points to two pieces of evidence; first that new immigration does not push down wages as predicted, second that minimum wages do not tend to reduce employment as predicted.

I think that he is completely correct here. The strange part really is how this could have been taught for so long as standard theory. The root of the problem is that Econ 101 teaches the job market like it is a market for goods. If the price is low, demand for the goods will be higher. Ditto, therefore, for workers.

The reason that it is wrong, is that, as Kalecki wrote so well about, workers are also consumers. Not only are they consumers but they are consumers who spend nearly all of their income on consumption. This means that the more is spent on wages, the more will be spent on goods on services, thus increasing demand for labour. This is exactly the opposite effect that Econ 101 teaches. Although higher minimum wages may mean some people lose jobs, they also potentially create more jobs.

Standard labour theory actually argues that there is no such thing as medium term involuntary unemployment, only people choosing more leisure time. It is one of those things that is funny when you read it, but has very serious consequences. The model says that real wages will fall to a level where everyone who wants to can be employed, therefore involuntary unemployment is impossible.  When faced with real life job queues, the answer given by the basic model is that it is because of labour market frictions. For frictions read that wages are artificially high. If only wages were allowed to fall low enough, everyone would be employed.

This is patently not true. Although lowering wages is often suggested/forced on countries in crisis, as Greece shows, the result is to depress demand further into a downward spiral. The only possible way it can work is in a very open economy, where lowering of wages and a devaluation of currency crush workers wages to an extent that exports can make up for lost demand. However the cost of this policy is that the country is poorer by the end.

In response to Smith's post, some economists did argue that he was misrepresenting what they actually teach; that this goes beyond the basic theory. That they use a 'general equilibrium model' in which, for example immigration can increase demand as well as worker supply.

However, this really doesn't go far enough. To explain why, you need to look at the basic equilibrium model that mainstream economics uses. It says that an economy is always at full employment, with the exception of short term shocks to the system. There is a natural rate of unemployment, for every economy and this depends on the frictions caused by unions (or sometimes employers to retain staff) making wages too high and achieving workers rights.

How did they just assume full employment, you may ask? Well, the model was built looking at the time since 1945 when Keynesian fiscal policy allied to large private sector credit expansion, meant that the economy more or less was always running at full employment. But they didn't realise it was because of credit expansion that they were getting the full employment, so instead they just assumed it was natural.

Incredibly, credit expansion is not in mainstream economic models as a driver of growth. Inflation comes from increase in the base money supply or something. This is a major problem, as the economy is a flow of money and new credit is the main driver of growth. Steve Keen's graphs where he plots credit expansion against unemployment, house prices and GDP growth (eg here) are eye-opening in this regard.

So they assumed full employment. This is a very pernicious assumption. Why? Because it laid the groundwork for the financialisation of the economy and for the rentier-capitalist economy that we appear to have been working towards since the 1980s.

The assumption of full employment means that wages can be kept as low as you want without affecting demand. If demand is assumed then the only thing that is important is that supply is kept high. The eventual conclusion from this is the Chamley Judd theorum, which states that taxes on capital should be zero as the more money that goes to investors, the more they will invest and the more supply we will have. The same is true for the rich, a.k.a. the 'Wealth Creators'. Reaganomics is given backing by the economics profession.

Supply side stopped being about building infrastructure and education, and became about giving tax cuts to rich people.

In this model, fiscal deficits are only necessary to counteract short term shocks and monetary policy (private sector debt) must be used instead.
What was the effect of this? Demand shrank even further. Economic growth since the 1980s has been considerably slower than the period between 1945 and 1975, and the growth that was achieved required larger and larger (eventually unsustainable) private sector debt.

So the problem with Econ 101 goes much deeper than that it gets wages wrong. The assumption of full employment is the one that gives free reign to rentier capitalism. Why do economists teach it? Kalecki has a theory here too.

Thursday 10 November 2016

The Economic Consequences of Trump

On a personal level, I am appalled by President Trump. His personality has no redeeming features. He is vain, petty and nasty. His stirring up of racial tensions risks creating a monster. His misogyny is particularly unbecoming. His authoritarian impulses can only be described as fascist (although fortunately without a personal army). His habit of lashing out every time he feels personally slighted is dangerous. Honestly speaking, the thought of him as president makes me feel physically sick.

On a policy level I am particularly worried about the damage done to the environment by the combination of Trump and a Republican congress - which could undo the fragile progress made in Paris towards reducing global greenhouse gas emissions.

But economically I think there is a reasonable chance that he will bring large economic growth and I can see him being seen to be a great success based on this alone. For me the real shame is that some of his policies were not enacted sooner; if so we would not have seen Trump (or Brexit in the UK, or any of the right wing leaders who have been gaining popularity in the austerity world).

People argue that the US has been running government deficits already but the problem is that the size of deficits required to keep the economy growing has increased a lot with the increase in private sector debt and inequality. In fact Obama's deficits, although higher than Europe (hence the greater GDP growth in the US than Europe since 2008) have been lower than required. The economy is still running a long way under capacity, as evidenced by the marked decline in the productivity growth rate since 2008.

No-one really knows exactly what he will do, and for this reason this is somewhat speculative. But if we divide his actions into three main categories we can look at potential impacts of each one.

1) Deficit Infrastructure Spending: There is talk of a 2 trillion infrastructure project. This works out as around 3% of GDP each year spent. If this were done alone with no offsetting policies, then even ignoring the increase in future capacity, I think we would be looking at a minimum of 2% more real GDP growth per year. Trump's 4% per year growth figure is very much achievable and would bring great benefits to the nation as a whole - improving the lives of many of the people who voted for him.

2) Very Large Tax Cuts: Here the outlook is not so good. Some of his proposed tax cuts - for low earners - would have a very high multiplier on growth and would stimulate the economy. These would be very beneficial.

However, the cuts in taxes for rich people, corporations and on inheritance tax would have minimal effect on demand. They would not increase growth and they also build up problems for the future. The problem is that all of the inequality in wealth created by this makes the economy's saving rate higher. More of the return from GDP goes in interest, rentals and dividend payments for those who do not spend. This means that a) the government debt increases today, and b) the size of government deficits required in the future will be larger.

A big question will be how are the tax cuts and infrastructure spending funded. If it is not with new debt, as assumed above, but actually with reduction of spending on other programmes, then the benefits will be mitigated or even could be negative. A small increase in demand from tax cuts to the rich combined with a large decrease in demand from cutting social security will be net negative.

3) Protectionist Trade Policy: This is a lot more uncertain. Marginally higher tariffs overall do not greatly reduce growth, despite the rhetoric on the subject. The main problem would be in transition from one system to another - causing large disruption. The US is in a fortunate position here, because it is large enough to dictate terms.

There may be some inflation in the US from the supply side, as imports get more expensive or firms re-shore their offshore operations with increased costs. But this will somewhat be offset by greater job opportunities in the US, and in any case the economic growth from the fiscal policy should dwarf this.

Overall, if Donald Trump doesn't mess this up, he could easily be returned for another 4 year term in a landslide in 2020.

Update 12 Nov 16:  Looking at Trump's actual plans I think I was totally over-optimistic. They appear to be a turbocharged  domestic neoliberalism, with a protectionist trade policy.

Trump appears to be doing the bad parts of the above (tax cuts for the rich, protectionist disruption) without much of the good (tax cuts for the poor and middle class, infrastructure building). The infrastructure plans are 'revenue neutral' and not as large as thought. Probably this involves some of the disastrous public private partnerships we have seen in the UK which pay large profits to private companies while loading all the losses on the government.

I think that with a Republican congress, there is a great opportunity for Trump to do what Obama couldn't and run deficits for infrastructure. Unfortunately it appears at the moment that the priority is increasing the gap between rich and poor and making the economic situation worse.

Anyway, we still don't know so hopefully there will be some good surprises to come.

Thursday 27 October 2016

The Overwhelming Evidence that Market Leverage Significantly Destroys Shareholder Value

I have recently written a paper, entitled 'Leverage as a Weapon of Mass Shareholder-Value Destruction; Another Look at the Low-Beta Anomaly' which can be downloaded here.

It challenges the idea that adding debt to a balance sheet in any way makes a company more efficient - in fact it suggests that it leads to significant loss of shareholder value. It uses the fact of the (very well researched) 'low-beta' anomaly, which shows that higher risk stocks significantly under-perform lower risk stocks in the long term; the current explanations for which are based on the idea that investors mis-price these stocks for behavioral reasons. I show that this can not possibly explain the anomaly and that there must be a destruction of shareholder value of the order of around 8-10% per year between the highest and lowest leveraged stocks.

This goes against all shareholder activist lobbying that adding debt is good. It is good for management, and it is good for the financial sector but it is not good for shareholders.

A quote from the paper explaining possible reasons is included below:
Whatever the source of the market leverage, some effects are the same. Since the market tends to rise in the long run, a firm with more market leverage would expect higher profits per share and larger share price increases. These expected higher profits and higher share prices have nothing to do with the skill of the company's management; they are merely a consequence of higher leverage.

Unfortunately, history shows that managers as a group tend to lack the necessary humility to identify leverage as the driver behind their better returns. If hubris is not a universal trait amongst managers of a leveraged ship riding a rising tide, at the very least one could point to numerous examples where it exists. Over-confidence in one's managerial skill can result in sub-optimal decision making, perhaps culminating in purchases of other companies at inflated valuations in the belief that the magic touch can be applied to them too. There is no doubt that many mergers and aquisitions are value destroying (see Moeller et al. 2004 for market reaction to acquirers); it would make sense that the ones most likely to be most value destroying are the ones where managers had false belief in their skill. Easy success can definitely lead to sub-optimal decision making, and it would be no surprise if it turned out that this were the case in practice.
Unearned success for the company may lead to other suboptimal decisions. The board may decide they need to travel by private jet. The CEO may want to sponsor a Formula One team. Offices may be upgraded. If a company is doing better than its competitors, very few people will notice that it is not doing quite as well as it should be, given its leverage. 
On top of this, manager compensation is often linked to share price or profit targets. This means that even though managers display no more skill, in a company with higher leverage, shareholders will pay more money to executives. These payments are not recouped if the share price then falls, so even if the market as a whole does not go up on average, the higher the leverage, the higher the expected payouts. This pay structure intrinsically encourages more leverage, since the managers are effectively being given an option whose value, like that of all options, is higher under conditions of higher volatility.
Similarly costly, debt issuance means large fees to bankers. In general, financialisation of a company in this way can result in higher fees paid to intermediaries. These arise both as direct charges for debt issuance (with the initial debt offering and subsequent refinancing), and from increased need for costly underwriting of rights issues or other equity capital raising.
High interest payments can often lead to a company cannibalising research and longer-term investment in order to meet payments and maintain dividends. High debt companies may be more short-term in their outlook. And although dividends are more flexible in a downturn, linking company payouts to performance of the company, debt interest must always be paid regardless of the longer-term consequences.

Another possible reason for suboptimality of high beta portfolios comes from the idea that the market volatility of a company can be a lot higher than the fundamental volatility of the company’s prospects. The fact that many CTA funds successfully trade momentum strategies suggests that this is the case for indices. The momentum of single stocks relative to the index is documented by, for example, Moskowitz et al (2012). The tendency of share prices to overshoot on both the upside and the downside is a result of of investor herding and risk aversion, as well as general uncertainty and the impossibility of accurately identifying fundamental value. At the same time, the future of a company's share price is path dependent. If the share price comes close to zero, bond holders will force the company into administration. If it subsequently turns out that the market had moved too far, it is too late for the shareholders. Rising leverage therefore increases unnecessary bankruptcies. If it is true that market volatility is higher than fundamental volatility, then the bond holders' option is worth more and the shareholders (who are writing the option) lose out.
Often there may be tax benefits for choosing debt over equity (eg. Graham 2000). Whatever benefits these give to shareholders, however, appear to be dwarfed by the costs.
It should be noted that the argument here is not whether returns can be increased by taking on debt. In general, taking on moderate levels of debt will increase company profitability per share. But if an investor wishes to take higher risk and make higher returns, then they can do this by borrowing money on their own account and investing in lower-risk shares. The point is that investors may be better off borrowing themselves than allowing the company to borrow on their behalf. In fact, fund managers can often borrow at a lower rate than corporates because of the liquidity of their underlying positions. The evidence appears to suggest that by borrowing on behalf of the investors, managers are increasing their own compensation and possibly running the company suboptimally. 

The abstract is as follows:

The 'low-beta' or 'low-volatility anomaly' is one of the most researched in the field of 'alternative beta'. Despite strong published evidence going back to the 1970s that high beta/volatility stocks underperform relative to expectations generated by the Capital Asset Pricing Model (CAPM), the anomaly still persists. The explanations given for this are all behavioural; that investor biases lead to overpricing of high volatility stocks. This paper shows that investor biases cannot be the explanation for the anomaly. Instead, it is proposed that the anomaly stems from a destruction of shareholder value. The strong implication is that the more market leverage a firm has, the more shareholder value is destroyed. Although the prevailing view for a long time has been that adding debt is good for shareholders, making balance sheets more 'efficient', there is in fact a considerable volume of evidence that the opposite is true; evidence which has been incorrectly interpreted for many years. Some possible mechanisms for this shareholder-value destruction are proposed. 

Tuesday 27 September 2016

On Currency Devaluation (Deliberate and Otherwise)

It is an unstated central bank policy in many parts of the world to reduce the value of their currency to below its fair value. The reason for doing so is 'competitiveness'. A weaker currency means lower global prices for your goods and hence increases your exports, while at the same time reducing imports. Since a fundamental equation of economics says that GDP = C+I+G+X, or consumption plus investment plus government expenditure plus net exports; it would appear self evident that an increase in net exports would increase GDP.

This is, unfortunately, completely wrong. There are two ways that it is wrong, both pretty fundamental:

  1. As a recent Bloomberg report discusses, a reduction in currency does not necessarily increase net exports.  
  2. Any increase in net exports comes at the expense of an offsetting decline in domestic consumption/investment (C+I+G). Thus giving no net economic growth.

In this previous post, I give empirical evidence that there appears to be no benefit to running a current account surplus in terms of GDP growth, or even any benefit regarding private and public sector debt build-up. In this post, I really just want to show how theoretically false the whole paradigm is.

This post will be divided into 5 short sections. The first discusses how a sovereign government already has all the tools it needs to run an economy at capacity. Section 2 will discuss the circumstances in which a reduction in currency will or won't increase net exports. Section 3 discusses how an increase in net exports reduces domestic demand. Section 4 discusses reasons for running a surplus/deficit, then 5 discusses what to do if a deficit is forced upon you.

1. The Capacity of an Economy

The capacity of an economy is how much it can produce if everyone is employed in their most productive roles. For example if an economy consists of a shoe factory that has space for 1000 workers, each of whom can produce 1000 shoes; the capacity of the economy is 1,000,000 shoes and there are jobs available for 1,000 workers.

The factory can run under capacity by employing only 800 workers and producing only 800,000 shoes. On the other hand, capacity can be increased by investing in new machinery that enables workers to produce 1200 shoes per worker. 

Next, we can look at the role of demand. If people want to buy 1m shoes, for the price they cost to make plus a markup, the factory will be able to employ all 1,000 workers. If there is only demand for 800,000 shoes it must lay off workers and run below capacity. If there is demand for 1.2m shoes then initially the price will go up (inflation) but eventually investment will be made to increase supply capacity.

The role of demand here is extremely simple and very obvious. Demand must be high enough for the factory to run at capacity. If demand is higher than supply we get inflation but also an increase in supply in the future.

Unfortunately much of the discussion about a productivity slow-down seems to focus on supply issues rather than the obvious demand issues. And still the lack of demand goes unaddressed.

If a government (which has control of its own currency) wants to increase demand so that an economy runs at capacity and invests in increasing capacity, what does it need to do? It needs to make sure that the government deficit is high enough to get enough money flowing through the system to keep inflation at its target (note that inflation in this context means inflation of prices of domestic goods and services, not inflation imported because of falling exchange rate etc).

This is a complex subject, but I discuss it more in a blog post here and in my paper on the subject here. Using monetary policy is a terrible idea as I discuss here (with simulations). Fiscal policy is the only way to do this without creating bubbles, exacerbating inequality and damaging future growth.

So there is a very simple way for the government to ensure full employment and an economy running at capacity. It involves investment to increase capacity and enough deficit spending to keep demand high enough to fill the capacity. There is no reason to try to take demand from abroad.

This does not stop countries trying it though.

2. Does an fall in currency increase net exports?

To answer this question, we need to differentiate between different types of devaluations of currency. In order to do so, we need to look at a simple identity that a current account surplus is equal to your capital account deficit; the only way to run a current account surplus is to net invest your savings in another country (this subject is very well described by Michael Pettis). Likewise the only way to have a current account deficit is if people in other countries invest their savings in your economy.

This means that in the absence of any saving in foreign economies, the current account balance (which in the absence of any previous investments is equal to the trade balance) must be zero. The only change to net exports (ignoring exchange of foreign investment income) will come if there is a change in the net amount of capital invested in the country.

So, to give an example quoted in the Bloomberg piece, Pound Sterling fell by 19% against the US dollar in the two years to 2009. What was the reason for this change? The productivity, and expectation of future productivity, of the UK economy fell vs that of the US economy. Was the exchange rate in 2009 artificially low? No. Was there more money being taken out of the UK than put in as investment? No. In fact, there was still money coming into the UK from countries pursuing policies that lowered their own exchange rate. So should there be an increase in net exports? No,

Regarding the fall in GBP caused by Brexit, what are the causes? If it is a withdrawal of investment from the UK, or if it is caused by speculative bets against the Pound, then we would expect to see the trade deficit narrowing. I don't believe that this will prove to be the case, as the surplus countries still need somewhere to put their savings. If it is just caused by an expectation of weaker economic performance in the UK then there is no reason for the current account deficit to narrow.

Looking at the fall in the Japanese Yen caused by the monetary policy of the Bank of Japan (BoJ), we need to look again at the reason for the fall.

The important thing I want to say here is that quantitative easing policies should not much weaken the currency. In practice they have caused very large fluctuations (the USDJPY exchange rate at one stage went up by 65%), but I would argue that these are market over-reactions. The reason is that all QE does is to swap one form of savings (cash) for another (government bonds). To the extent that it reduces the real interest rate (It slightly increases inflation and slightly lowers the interest rate) it should have a moderate impact. But the size of the move in Yen was much to large for the impact of the actual  QE (as I said in February last year when I said Yen was the most undervalued currency in the world). As such, the move was largely driven by speculative flows, not fundamental changes in the value of the output of the two countries.

If hedge funds were building up short positions in Yen then this is a reason for a short term current account surplus, which will be reversed as hedge funds take opposite positions. The longer term impact would come from investment flows going out of Japan and into the rest of the world.

To find the sure-fire way to increase your net exports, one need look no further than the Swiss National Bank (SNB). The simple and reliable way to increase your net exports is to print your own currency, sell it and buy foreign currency with it. By investing in the foreign economy you are increasing your capital account deficit, thus increasing your current account surplus. This also involves a weakening of the currency. By directly investing abroad, this is the only method of the three discussed that definitely increases net exports relative to the baseline.

To summarise, a change in net exports can be approximated as a change in investment out of a country. Thus simply doing economically poorly will not increase net exports. Nor will making good products (people seem to think that Germany's surplus is because of the quality of their exports rather than their saving abroad) or engaging in QE. But direct investment abroad both weakens currency and increases net exports.

3. Does an increase in exports increase GDP?


In order to increase exports, more savings need to flow out of the country than flow into the country. This means that relative to the baseline scenario, more money needs to be saved. There are a number of ways to do this; by suppressing worker share of GDP, by use of tariffs, by use of sovereign wealth fund. But however it is done, this subtracts from domestic demand. It keeps consumer buying power lower. Looking at the equation above, if X goes up (C+I+G) must go down to compensate.

An artificially low exchange rate is bad for the people of the affected country. The goods they import cost  more and their wages are relatively too low for their productivity. Overall they consume and domestically invest less than they would have. It is good for exporting companies, however, who benefit from more sales abroad in domestic currency terms, and higher profit margins.

As such it is just a transfer from workers and other consumers to exporters. There is no empirical link between higher current account surpluses and higher real GDP growth.

4. So is there any point in a surplus?

There are some occasions when a surplus is appropriate. If you are a commodity producer, whose commodity is running out, there are two reasons to run a sovereign wealth fund. The first is to build up savings in other countries, claims against their future production, that can be spent when the commodity runs out. This smooths consumption so that you save when times are good and spend when times are not so good. The other reason is that it lowers the currency so that other industries become more competitive than they otherwise would have been. It helps to mitigate 'Dutch Disease'.

A small country that is not that diversified in its industry may also wish to build up a buffer in case of cyclical or structural decline in that industry. This is understandable and not too destabilising for the rest of the world.

Who should run a deficit then? This would be countries that are starting with a low industrial base, whose productivity can be largely increased by capital investment. By intelligently using capital, they can increase future productivity by enough to pay back the loans. Note that this should always be either in equity or domestic currency. Foreign currency loans are a disaster waiting to happen when downturn strikes.

5. Help, I have a current account deficit, what should I do?

This is actually a simple problem to solve for any country with control of their currency. The deficit is caused by other countries' savers investing in your economy, building up claims on your future production. In fact, most of these claims will never be claimed - savings have a way of just accumulating indefinitely - but you are feeling a bit uncomfortable about the situation where you owe so much.

All you have to do is

  1. Build up your own sovereign wealth fund whereby you print the equivalent of the deficit in your own currency and sell it to buy foreign bonds and stocks. This is exactly what the SNB has been doing. This lowers your currency to fair value and removes your deficit.
  2. Make up for the lost demand with a government deficit large enough to keep domestic inflation at target.
This is all. Philip Hammond, you're welcome. I doubt the advice will be followed though.

Saturday 20 August 2016

On Maths and Models

Every now and then a debate seems to flare up about economic models. A recent one started with Noah Smith arguing (in reply to Frances Coppola), that heterodox economics does not have the tools to replace mainstream economics. Steve Keen gave an excellent point by point reply about the mathematical quality of heterodox work. Then Frances also wrote a reply and then another, which  I agree with, pointing out that an understanding of the economy does not require maths. Where maths can be used to formalise this understanding, it is very useful. But economics is not a mathematical equation.

I say this from the point of view of someone with a PhD in mathematics, but whose job is to predict the behaviour of systems, specifically financial systems. And I know that in describing a system, parsimony is king. One should use as much maths as is necessary and not a bit more. The more complex the maths, generally the worse the predictive power.

The economy is a very complex system. It is non-linear with a huge number of unknowns. For this reason prediction is difficult. This seems to have meant that any degree of poor prediction is excused on the grounds that no-one can predict the future. I recommend everyone read this excellent Noah Smith blog post from 2013 which was only let down by the somewhat cowardly conclusion.  It shows DSGE models are not useful as predictions - he points to this paper showing that DSGE models are no better than simple univariate autoregression (AR) models at predicting inflation and GDP growth. Bearing in mind AR models are just simple mean reversion models this is a pretty categorical failure. He then argues that they are neither good for policy advice nor even for communication of ideas, before concluding that we should continue with them as the are the 'only game in town'.

Saying that the economy can't be predicted because it is too complex and no-one knows the future is a big cop out for me. No-one could have predicted with any degree of certainty that the global financial crisis would happen in 2008. This is because it is impossible to predict the timing of events of this nature that depend on triggers and positive feedback loops. It also depends on policy reaction. For example, a possible crash in China early this year was averted by a large government spending programme. But what heteredox economics has done is give keys to understanding the nature of the economy.

If we know that a crash is going to come if we let private sector debt build up, then we will try to reduce the build up of private sector debt. If we know that government debt is benign, then we will use that to grow the economy rather than private credit, share buybacks and house price rises. We don't need any maths to understand this. As I said in a tweet, in my opinion the main thing maths has given macroeconomics is the ability to be more precisely completely wrong.

Defenders of the economic orthodoxy generally say that they understand that their models have not done the best in the past, but that they are flexible so can be adapted to include whatever you want. This is sort of true, but to start where they are starting from is insane.

As a builder of models I would like to humbly offer this advice to macroeconomists about building a model to describe the economy. I have made my own attempt here, and obviously I think it is a pretty good description. But in any case, I would advise the following:

How Not to Build a Macroeconomic Model

1) Microfoundations: Would a pollster make a prediction for an election based upon what they thought each rational voter should do, and building up to the whole population assuming they all think independently? Of course they wouldn't. They model it by asking people and then using known relationships between people you ask and the population as a whole. There is no reason whatsoever to model the economy as individual independent rational agents and in fact it is completely incorrect to do so. People do not behave independently and the aggregate must be modelled not the individuals.

2) Rationality: Why would you assume rationality? It is completely unnecessary and also completely false to suggest that people act rationally at all. It is certainly false to assume that rationality includes perfect knowledge of the future and that Ricardian equivalence holds. All assumptions about peoples behaviour should be testable.

3) Loanable funds: It is completely wrong to model money as if there is a finite amount of it that is simply loaned by more patient people to invest. Banks create credit, corporations and governments issue bonds. This expansion of the money supply allows growth to happen. And also can create instability. Any model that misses this out will be unable to describe the economy correctly.

4) Interest rate effects: interest rate cuts boost the economy through two main channels. First, they increases the amount of private sector debt, meaning more money in the economy. Second they boost asset prices, because lower interest rates (increasing bond prices) and reduce the discount rate for risk assets thus making their price rise.

The problem with loanable funds is that if interest rates are cut, it means all growth in spending must now come from rational agents choosing to spend more of their income rather than save - the 'rational' logic being that they will save less if they get less interest as it means future consumption is higher (and their target is to maximise their utility from consumption). As Eric Lonergan argued recently there is not even any evidence for this. One could argue that if people save for a target then the opposite is true - lower interest rates mean a rational person saves more. Any model needs to correctly account for why changes in important variables work. Being wrong about this particular one has led to a spectacular build up in private sector debt over the past 40 years.

5) No financial sector: the growth of debt has led to a huge increase in the size of the financial sector. Or maybe partly the other way around. Whichever it is, there are both distributional impacts and stability impacts. The instability is very well covered by Steve Keen with his Minsky model. The distribution impacts are looked at in my paper but involve interest payments going from those with a high marginal propensity to consume (MPC) to those with a lower MPC. Also included in this could be the increase in corporate profits as a share of GDP - something that has the same effect. The instability and inequality must be a part of the model or the economy can not be properly understood.

What does this mean? 

Yes, it may be possible to adjust the current models to include all of these things, but really why bother to try? The difficulty of trying to adapt a completely inappropriate and incorrect model to reality is much higher than simply starting again. And the starting point in my view must be a stock flow consistent money approach as pioneered by Wynne Godley.

Addendum: Noah Smith replied to a few responses to his post, including this one and he made a fair point. In criticising microfoundations, I am apparently also ruling out agent-based models. I am not meaning to do this as these types of models, where individual agents interact with each other, are excellent for studying the emergent properties of certain systems. If I could divide economic modelling into two separate themes, it would be 1) models used for short term prediction (these should be as simple as possible) and 2) models used to help understand the system. Into category 2 would fall Steve Keen's Minsky model and as well as these agent based models. I think that Smith is right that one day the type 2 models could become type 1 models. Unfortunately standard mainstream models are of neither type.

Also, he is right that the Financial sector is something that should be included so doesn't really fit under the heading. So I have changed the sub-heading to to 'No Financial Sector'.