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.