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As I have only recently come to realize, stabilizing the exchange rate at the wrong level can have massively harmful effects. One can trace major economic tragedies to such attempts. The British attempt to go back to the gold standard after post WW1 failed because they set the level too high (as Keynes pointed out). This attempt set of a sequence of events which had far reaching consequences. A similar story is told about Pakistan in “The Rupee is falling; let it crash”. Linked article shows that overvaluation of Pak Rupee de-linked the Pakistan and Indian Economies, which may the economic root of current political hostilities. Current problems of the European Union are a more advanced version of the same problem, where the rate of exchange between European countries cannot be re-aligned according to the gaps between their imports and exports. This is a subject worth exploring further, and if readers have more pointers/articles, I would appreciate learning more about it. The article below deals with the Dutch Disease in Pakistan.

Published as “Burning Billions” in Dawn, on 18th Jan 2019

Today, we can find, fairly cheaply, an amazing variety of imports from all over the world in Pakistan: honey from Germany, vegetables from Brazil, milk from Australia, and clothing from India. The Government of Pakistan subsidizes imports of luxuries for the elites by spending billions in foreign exchange to keep the price of the dollar low. Many different economic indicators show a pattern of consistent and maintained overvaluation of the Rupee over the past several decades. In contrast, many competitors who started out behind us, like India, Bangladesh, and China, have surpassed us in exports by keeping their currencies consistently under-valued.

Long term cheap availability of imports has a well-known effect called the “Dutch Disease”.  Normally, the Dutch Disease strikes countries which are rich in resources (like oil). This makes it possible for them to earn foreign exchange cheaply, without learning how to manufacture world class exports. When the exchange rate is too low, imports are cheap, and prevent the development of local industry. At the same time, exports decline because they are too expensive on the world market. Services sector enjoys a boom because services are locally produced and have no cheap foreign imports to compete with. Over the past few decades, the Pakistan economy shows all the characteristic symptoms of Dutch disease, with deindustrialization, declining exports, increasing imports, and a boom in the service sector.

The proxy war between US and Russia in Afghanistan made massive amounts of dollars available to Pakistan, creating favorable conditions for the Dutch disease. Remittances have also been a significant source of easy foreign exchange earnings. We did not have the wise leadership required to use the availability of foreign exchange to build productive capacity in the domestic economy. Instead, we fell into the trap of building a consumer-oriented economy based on cheap imports, which is attractive in the short-run, but enormously costly in the long run.

An agricultural country imports $6 Billion worth of agricultural products, like food, raw cotton, edible oil, only because over-valuation makes it cheaper to import than to produce. The government must burn billions of dollars to maintain an over-valued rupee, enabling the wealthy to enjoy foreign luxuries.  Unfortunately, the standard sources from which we used to borrow to finance our spending spree have dried up.

The future is in our hands. We can continue to borrow, from other sources, and maintain an economy driven by consumption, and by industries which make profits by using artificially cheap imports. Or we can bite the bullet and go for the structural transformation required to create productivity in the domestic economy, which is the only route to long run sustainable growth. But there are serious obstacles in the path of the needed structural transformation. Currently, when we pump money into the domestic economy, it is channeled into imports because dollars are cheap. If the exchange rate was higher, people would demand domestic products. However, currently, those domestic products do not exist. The industries which could have come into existence had imports been expensive were never born. There is no domestic capacity to fulfill the additional demand, if it is blocked from going into foreign imports. Thus, increased aggregate demand for domestic products will only lead to inflation – increased prices of domestic goods in the desirable sectors. Contrary to common belief, this type of inflation is not harmful. In fact, high prices are required to send a signal to the domestic sectors that extra production is desirable and will be profitable. If we can sustain the policy of keeping aggregate demand in domestic products high, higher prices in the desired sectors will lead to creation of extra productive capacity and stimulate domestic industry, which is exactly what is needed.

However, there are many obstacles in the path. When the subsidy of billions of dollars for imports is withdrawn, there will be a lot of rich and powerful losers. They will demand continuation of the previous policies which created huge profits for them. The potential beneficiaries of the structural change are as yet unborn, and therefore cannot speak in favor of the change.

The challenge facing the current government is to manage the transition in a way which would minimize disturbances to the masses, and provide social support to those who need it the most. The greatest dangers come from the privileged classes, accustomed to extracting revenues without having to work. The billions pumped into supporting the rupees end up, indirectly, in their pockets. Withdrawing this subsidy will lead to loud screams by the rich and powerful, disguised to sound as if they are coming from the people. Whether the present government has the courage t

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This post is the third part of lecture 8 of Advanced Macro L08C: Fisher’s Debt-Deflation Theory of the Great Depression. In previous segments of this lecture L08A: Micro-Foundations for Keynesian Economics, and L08B: Keynesian Explanation for Great Depression: Seriously Incomplete, we examined the Keynesian explanation for the Great Depression, and found serious deficiencies in it. L08A explains that many different kinds of outcomes, with and without unemployment, are possible depending on how we specify details of the micro-structure that Keynes failed to specify. L08B explains that a simple deficiency in aggregate demand created by savings does not suffice to create unemployment because savings of current period is income/wealth of the next. It is necessary to look at abnormal savings, together with fixed prices, to create surplus production which signals shortfall in aggregate demand to the producers. Thus, many elements – micro-structure, role of debt, and different sectors of the economy – must be added to the Keynesian model to achieve the outcome of unemployment due to shortfall in aggregate demand that is at the center of Keynesian analysis.

This post deals with the last segment of the lecture, which explains Fisher’s Debt-Deflation theory of inflation. The lecture goes through and explains the article: Fisher, Irving (1933), “The Debt-Deflation Theory of Great Depressions”, Econometrica – making only minor commentaries. The goal is to understand what Fisher was saying, before attempting analysis, critique, and extensions. Many elements of this explanation are crucial to understanding the Great Depression, but are not available in the standard Keynesian analysis. Recently, elements of this theory have been picked up and presented as “Fisher-Minsky-Koo approach: Debt, Deleveraging, And The Liquidity Trap: A Fisher-Minsky-Koo Approach”  Gauti B. Eggertsson and Paul Krugman: The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513. In this lecture, we only present Fisher’s original paper. Post covers portion of lecture from 37m to 1:15m.

Summary of Fisher’s Econometrica paper on Debt-Deflation.
Fisher starts with an insight which comes straight from the experience of living through the Great Depression. An economic system is complex, subject to numerous conflicting forces acting simultaneously and repeatedly through time. It is unlikely to ever be in equilibrium. It is unfortunate the modern economics rejects this fundamental insight.

Fisher starts by asking how we can study disequilibria? In theoretical terms, the answer is to look at the forces which are acting in a given economic situation. Instead of looking at the long run outcome of how these forces would be resolved to arrive at equilibrium, we should use historical experience to judge the relative speed and strength of these forces. This would be a radically different methodology from the one currently in use in economics today.

By using this methodology, Fisher comes to the conclusion that the Business Cycle is a myth. There are many different kinds of economic forces which create multiple cycles. The complex of of forces can acting in tandem or at cross purposes. There are three types of tendencies (forces) – both cyclical and non-cyclical: (1) Those which create growth; (2) Those which create random fluctuations; and (3) Those which create cycles – these cycles can be stable and unstable, and they can be due to  (or interact with) internal factors, or external shocks to the economy.

He compares the economic system to a boat, which can resist small waves, but will capsize in a major storm. The system can accommodate small cycles, but may fall into crisis in big ones. There are some economic variables which can systematically deviate from equilibrium values. He names Capital Stocks, Real Income, Prices. In particular, Say’s Law is regularly violated. The production of goods can be in excess, or deficient, both in stocks and in flows. Forces in temporary disequilibrium will determine what happens next. Overshooting or Undershooting targets for production is common. BUT – this is NOT the cause of BIG disequilibria. The CENTRAL diagnosis of Fisher is the following:

The biggest cause of economic crises is: Too little money (too high price) mistaken for excess of goods!!

NOTE: This resonates with Friedman’s insufficient money supply explanation. Also, the Keynesian explanation, both of which work with short run fixity of prices.

In arriving at this diagnosis, Fisher lists and considers many common factors which lead to disequilibrium, and rejects them as sources of major crises. He then focuses attention on the Big Bad Actors – Debts and Deflation – as the cause of crisis. H says that the Apparent Causes are Over-Investment & Over-Speculation – this was obvious to all in the aftermath of the Great Depression. But Fisher thinks that the real Harm is caused by UNDERLYING debt which is used to finance this activity.

The mechanism which Fisher outlines starts with excess debt taken in a booming economy. Since assets like land, stocks are booming, people are happy to take debt at low interest, planning repay from the gains they make due to rapidly rising prices of stocks and real estate. Banks are happy to lend because they have the valuable asset as collateral for the loan, so even if the lender cannot repay, they will be able to cover their costs by selling the asset. Since banks create the money they lend, there is no check on the process, and loans increase geometrically leading to a situation with excess debt.

At some point, the bubble bursts. This is generally caused by failure of nerve of some party – either the banks, or the lenders. As indebtedness increases, people take loans to repay interest on past loans, and eventually, a steady stream of failures to repay emerges to public notice. At this point some people panic and start selling their assets, which sets off a chain reaction. As people sell to pay off loans, money supply contracts, and loans become less available. Now people who were relying on borrowing to repay previous loans start defaulting, or start to sell assets to cover loans. As more and more people sell assets, asset prices collapse. The collapse of prices leads to DEFLATION. Deflation increases the value of money, so that the debt burden becomes heavier. Paradoxically, the attempt to pay off debt puts people deeper into debt.

Balance sheets of banks, and firms, contain assets which are priced according to their market prices (This is called Mark-to-Market in accounting terminology). When stock and real estate prices collapse, the net worth of banks and businesses can become negative. Similarly, mortgage loans go under-water; they have negative equity. In simpler terms, this means that the value of house you own is less than the amount of loan you must pay to the bank to get ownership of the house. In this situation, it pays for the homeowner to declare bankruptcy and walk away from the loan and the house. Similarly, businesses whose net worth has become negative can collapse. This leads to panic and loss of confidence about the future in the general public. As expectations about the future become negative, people stop investing, business stop producing and lay-off employees. Heavily indebted people lose incomes and ability to pay off loans. Negative expectations about the future become self-fulfilling prophecies.

In the “Fisher” Sequence of events which leads to major crisis, Fisher says that two diseases – excessive debt, and price deflation – act together to create crisis.The effort to pay off debt leads to falling asset prices, which leads to further increase in real debt, and decrease in ability to pay. This is a vicious cycle which leads to collapse. Either one of the two forces acting individually would tend to return the system to equilibrium. The system can take small shocks and return to equilibrium, but large shocks, acting in tandem, lead to collapse.

Some Comments on Fisher’s Debt-Deflation paper

Fisher attempts to define “over-indebtness” which would lead to crisis, but failed to do so satisfactorily. Here Hyman Minsky made a major contribution. Minsky identifies three stages of debt in the business cycle. In the first stage, people & firms borrow to invest, and their stream of earnings is enough to pay off the interest and the principal. In the second stage, earnings are not sufficient to pay the principal, but enough to pay interest. Now loans are re-financed when the principal is due. In the third stage, earnings streams are not even sufficient to repay interest, and borrowing is done to pay interest on the loan. This last stage is what Fisher wanted to define as “over-indebtedness”, but failed to do.

He attempts to quantify the size of loans relative to assets/income available to repay. He writes that debts in 1929 were at historically highest known levels. By 1933, debts reduced by 20%, Prices decreased by 55%. Value of dollar increased by 75% — real debt increase 40%. This provides support for his key hypothesis: As you pay off debt, you go deeper into debt

Fisher offers the solution as price reflation, breaking one of the two components of the vicious cycle. He thought that if we could take policy actions to prevent prices from falling, or to put them back up to pre-crisis levels, then the economic system would find its way back to equilibrium. However, subsequent authors have cast doubts on this, suggesting that the levels of debt are so high that they cannot be repaid, even if assets do not lose their value. Thus the only solution would be to require debt-forgiveness.

The Wikipedia entry on Debt-Deflation provides a good summary of key points of Fisher’s thesis, and also its influence on subsequent work, and later developments. In fact, Fisher’s theories were ignored and neglected in favor of Keynes for a long time, prior to revival of interest in the 1980s. One of the reasons for this neglect was the idea that debt did not matter. What is a debt of one person is an asset of the other, so debts cancel. This mirage – that debts do not matter – continues to mislead economists. It is the large-scale inability to repay debts which is ignored in this picture.

As debts mounted up, Fisher’s Debt-Deflation theory has enjoyed a resurgence in popularity. It seems clear from a lot of research that levels of debt play a very important role in leading to financial and economic crises. For example, Atif Mian and Amir Sufi in House of Debt, highlight the role of leveraged debt as a key factor in the Global Financial Crisis. “Deflation”, or a dramatic fall in inflated asset prices, also plays a major role, and when combined with leveraged debt, this creates the catastrophic combination that Fisher identified. In retrospect, it seems that the widely accepted Keynesian explanation for the Great Depression was seriously incomplete, and Fisher identified some key elements missing from Keynes. For an update on Fisher, see:   DEBT, DELEVERAGING, AND THE LIQUIDITY TRAP: A FISHER-MINSKY-KOO APPROACH  by Gauti B. Eggertsson and Paul Krugman, in The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513

Last Portion of Lecture 8 – from 1hr 15m onwards

The last portion of the lecture  L08D Friedman-Schwartz   discusses the Friedman-Schwartz book on the Monetary History of the United States, which puts forth yet another diagnosis for the reasons of the Great Depression. They argued that it was the sharp contraction in the money supply that was responsible. This diagnosis was the one that was actually followed by Bernanke during the Global Financial Crisis, who massively increased money supply via Quantitative Easing programs. This did prevent financial collapse, but could not prevent the Great Recession, invalidating the Friedman-Schwartz hypothesis about the causes of the Great Depression. Furthermore, as a result of Quantitative Easing, reflation of asset prices has also occurred, which was Fisher’s proposed remedy. This has not proven very satisfactory, in many different ways. Of the two problems, Fisher thought that taking care of Deflation would suffice, but it seems to be only half of the remedy. The other half is the “Debt”, which can be removed by various methods, such as debt-forgiveness.

Let us start with Five Fundamental propositions, which would be startling to the general public, but familiar to my current audience of heterodox economists.

  1. Mainstream modern economic theory is complete garbage. This is true of Micro, Macro, Econometrics, Trade, Monetary, Industrial Organization — EVERYTHING.
  2. It is very EASY to prove this assertion. Fundamental principles on which the entire discipline is built are easily proven to be wrong. The axiomatic theory of human behavior encapsulated in homo economicus has no match to real human behavior. The theory of perfect competition devised to explain prices and markets has no relation to the realities of oligopolies, multinationals, excess production, and shaping of demand by advertisements and culture. The welfare theory implicit in maximization of lifetime utility is exceedingly harmful to our human welfare, which comes from social associations and character traits, rather than excess consumption. The optimization/equilibrium methodology is a complete failure. Humans do not and cannot optimize; they lack the information required to do so. Dynamic systems cannot be understood by looking at their equilibria. Standard econometrics techniques can be used to prove anything at all, given any data. In any place you look, the theory is flawed beyond belief. The young earth theory, as well as the flat earth theory are more defensible, in comparison.
  3. Many leading economists are aware of the astonishing conflicts between economics and simple facts of observation. See Quotes Critical of Economics for a choice collection of quotes to prove this assertion.
  4. The Global Financial Crisis of 2007 created widespread public awareness of this catastrophic failure of Economics. The Queen of England went to London School of Economics to ask why no one saw this coming. The US Congress appointed a commission to study why economists not only did not foresee the crisis, they confidently predicted that such an event could not happen.
  5. What is most amazing is the (lack of) response of the Economics Profession to the Crisis. As documented by many, there has been NO response. The same old theories which failed miserably continue to be taught the world over. Teachers continue to believe in, and preach, the same sermons which led to global disaster. Students continue to be indoctrinated into the same poisonous doctrines which ruin our own personal happiness, and destroy possibilities of building a good society. The same ARCH/GARCH models which failed to predict the volatility of stocks in the GFC continue to be used. The same monetary policies which led to the crisis and could not prevent the Great Recession which followed are lauded and praised, and continue to be practiced. There seems to be increasing general awareness of this failure of the profession as a whole; see, for example,  “Economics: The Profession that Refuses to Change”.

In light of the five propositions listed above, there are two major tasks that emerge as important for the heterodoxy. One of the tasks is to prove the truth of the five propositions. This is generally where most of the effort is being made. The present post also deals with this same issue — how to prove the five propositions listed above. One way to do so is to read the article on “Trouble with Macroeconomics” by Paul Romer, which is summarized below.

However, I believe that the SECOND task, not undertaken here, is much more important, as well as greatly neglected, and not well understood. We must reflect on the nature of a world where lunatic asylum class theories are propounded at leading universities throughout the world, and taught to the brightest (but innocent) students who come to believe them.  What is the nature of knowledge? How do we come to believe in ridiculous theories? How is knowledge transmitted from generation to generation? Very serious meta-questions about all of these issues arise, which must be studied seriously and deeply in order to be able to craft a coherent response to the state of affairs summarized in the five points above. When talking among ourselves, as in this blog and the RWER blog, it is not worth repeatedly re-establishing the five propositions. Rather, we should take these five as axiomatically agreed upon, and proceed to the more difficult tasks that emerge in terms of understanding a world where bright people can be convinced of absurdities, and how we can undo this damage. I will defer this task to a later date (although many of my earlier posts do deal with many different aspects of this issue which require study), and study the article of Paul Romer below.

Paul Romer, recent Nobel Prize winner in economics, wrote “The Trouble with Macroeconomics” which contains a devastating critique of modern macroeconomics.  In particular, Romer writes that modern macro got started when Lucas and Sargent wrote that predictions based on Keynesian economics “were wildly incorrect, and that the doctrine on which they were based is fundamentally flawed”. But after three decades of research, during which the profession has gone backwards, losing hard-won insights into the nature of the economy, exactly the same criticism can be leveled at modern macro theories — they give wildly incorrect predictions and are based on fundamentally flawed doctrines, beyond the possibility of repair. The LAST section of the paper is the most interesting — Romer asks why he is unique in making such a strong critique, basically saying all of modern macro is complete nonsense; others have voiced sharp critiques but stopped short of saying what Romer has said. He says that this is due to the extreme pressure in the profession to conform, and to kow-tow to the mainstream. While others major economists privately agree to his views, they cannot afford to say so in public, because of the serious damage it would do to their careers.  A Video lecture which provides a coherent summary is linked here

Below I pick out some choice quotes from the paper which also provide an outline of the contents of the paper, for those with insufficient time to watch the video-lecture. My own interpolations and explanations are italicised and enclosed in double square brackets [[ ]] below — Other material is direct quotes from the paper itself.

Paul Romer: The Trouble With MacroEconomics

For more than three decades, macroeconomics has gone backwards

Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes

[[Modern macro started with the Lucas critique of incredible identifying assumptions used in econometric models, but, after thirty years of work instead of progress, there has been regress]] Canova and Sala (2009) signal with the title of a recent paper, we are now “Back to Square One.” Macro models now use incredible identifying assumptions to reach bewildering conclusions.

[[Romer finds it incredible that a leading macroeconomist would feign ignorance about effects of monetary policy]] To appreciate how strange these conclusions can be, consider this observation, from a paper published in 2010, by a leading macroeconomist:
… although in the interest of disclosure, I must admit that I am myself less than totally convinced of the importance of money outside the case of large inflations.

Macroeconomists got comfortable with the idea that fluctuations in macroeconomic
aggregates are caused by imaginary shocks, instead of actions that people take, after
Kydland and Prescott (1982) launched the real business cycle (RBC) model.

In this [RBC] model, the effects of monetary policy are so insignificant that, as Prescott taught graduate students at the University of Minnesota “postal economics is more central to understanding the economy than monetary economics” (Chong, La Porta, Lopez-de-Silanes, Shliefer, 2014).

[[After discussing an episode of tightening of monetary policy by the FED]] If the Fed can cause a 500 basis point change in interest rates, it is absurd to wonder if monetary policy is important. Faced with the data in Figure 2, the only way to remain faithful to dogma that monetary policy is not important is to argue that despite what people at the Fed thought, they did not change the Fed funds rate; it was an imaginary shock that increased it at just the right time and by just the right amount to fool people at the Fed into thinking they were the ones who were the ones moving it around.
To my knowledge, no economist will state as fact that it was an imaginary shock
that raised real rates during Volcker’s term, but many endorse models that will say
this for them

Macroeconomists got comfortable with the idea that fluctuations in macroeconomic
aggregates are caused by imaginary shocks, instead of actions that people take, after
Kydland and Prescott (1982) launched the real business cycle (RBC) model. The real business cycle model explains recessions as exogenous decreases in phlogiston (an unexplained residual).

The noncommittal relationship with the truth revealed by these methodological
evasions and the “less than totally convinced …” dismissal of fact goes so far beyond
post-modern irony that it deserves its own label. I suggest “post-real.”

Once macroeconomists concluded that it was reasonable to invoke an imaginary
forcing variables, they added more. The resulting menagerie, together with mysuggested names now includes:
• A general type of phlogiston that increases the quantity of consumption goods
produced by given inputs
• An “investment-specific” type of phlogiston that increases the quantity of
capital goods produced by given inputs
• A troll who makes random changes to the wages paid to all workers
• A gremlin who makes random changes to the price of output
• Aether, which increases the risk preference of investors
• Caloric, which makes people want less leisure
With the possible exception of phlogiston, the modelers assumed that there is
no way to directly measure these forces. Phlogiston can in measured by growth
accounting, at least in principle. In practice, the calculated residual is very sensitive
to mismeasurement of the utilization rate of inputs, so even in this case, direct
measurements are frequently ignored.

To allow for the possibility that monetary policy could matter, empirical DSGE
models put sticky-price lipstick on this RBC pig. The sticky-price extensions allow
for the possibility that monetary policy can affect output, but the reported results
from fitted or calibrated models never stray far from RBC dogma. If monetary policy
matters at all, it matters very little

FWUTV: Facts with unknown truth value [[Romer shows that in order to identify parameters, we feed in lots of arbitrary assumptions — which he calls FWUTVs — into the model. Shows several specific examples of this in action. Lucas critique said that use of arbitrary assumption to identify econometric models made estimates unreliable. However, their techniques introduce even more arbitrary assumptions to identify their models.]] “Post-real macroeconomists have not delivered the careful attention to the identification problem that Lucas and Sargent (1979) promised. They still rely on FWUTV’s. All they seem to have done is find new ways to fed in FWUTV’s ”

[[Romer explains how identification is achieved by hiding the assumption within a maze of mathematics almost impossible to track down, and never made explicit. He provides a specific example where an assumption the E log u = 0, about an unobservable error creates identification. Assumptions on unobservables are hard to spot, and harder to challenge, since they are, after all, unobservable — hence the term FWUTV. Another way to achieve identification is via Bayesian priors. You can put anything you like into the priors, which are arbitrarily chosen, and achieve identification. This section reminds us of the following Keynes quote: Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. GT Book 5, Chapter 21,Section 3, p. 298  

Romer shows how members of the Chicago school support each other, even in face of conflicting evidence known to them. He explains the sociology of knowledge, how the publications process ensures loyalty. He explains that he is free of the constraints, and therefore free to express his deep dissent, because he is no longer operating within an Academic environment: “Parenthetically, it is similarly true, that I can make very bold attacks on economics and economists ONLY because my pay, promotions, publications are no longer dependent on how professional economists in the USA evaluate me.” Those operating within the Western academia find that severe penalties are imposed upon them if they dare to step outside the boundaries of permissible dissent. ]]

Back to Square One: I agree with the harsh judgment by Lucas and Sargent (1979) that the large Keynesian macro models of the day relied on identifying assumptions that were not credible. The situation now is worse. Macro models make assumptions that are no more credible and far more opaque.

[[Romer argues that the Chicago School criticized Keynesian harshly for failing to predict stagflation. However, the Lucas prophecy that there would be no more recessions is an even more dramatic prediction failure.]] ” what Lucas and Sargent wrote of Keynesian macro models applies with full force to post-real macro models and the program that generated them: That these predictions were wildly incorrect, and that the doctrine on
which they were based is fundamentally flawed, are now simple matters of fact …
… the task that faces contemporary students of the business cycle is that of sorting through the wreckage …(Lucas and Sargent, 1979, p. 49)”

Some economists counter my concerns by saying that post-real macroeconomics is a
backwater that can safely be ignored; after all, “how many economists really believe
that extremely tight monetary policy will have zero effect on real output?”
To me, this reveals a disturbing blind spot. The trouble is not so much that
macroeconomists say things that are inconsistent with the facts. The real trouble is
that other economists do not care that the macroeconomists do not care about the
facts. An indifferent tolerance of obvious error is even more corrosive to science
than committed advocacy of error.
It is sad to recognize that economists who made such important scientific
contributions in the early stages of their careers followed a trajectory that took them
away from science. It is painful to say this so when they are people I know and like
and when so many other people that I know and like idolize these leaders.

Economists do not understand inflation. Daniel K. Tarullo. Former Governor, Federal Reserve Board should surely be in a position to know. I will list some key conclusions from his paper with the revealing title:  Monetary Policy Without a Working Theory of Inflation :

  1. We do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policy-making
  2. Many … good monetary policymakers … have an almost instinctual attachment to some of those problematic concepts and hard-to-estimate variables.
  3. (Nonetheless!) Going forward, monetary policy decisions will need to be made with as much, if not more, emphasis on the constellation of observable indicators with which the FOMC is confronted
  4. (Despite all this!) Macroeconomists (should) continue to play a decidedly leading role.

The italicized words are mine, not in Tarullo’s paper. If we pause to reflect, these are breathtaking conclusions. Tarullo says — quite clearly and explicitly — that current theories of inflation are NOT of use for real-time monetary policy. Furthermore, despite their evident failure, economists are blindly attached to these theories — they are “ unmoved by lack of correspondence between their theories and facts of observation “. But, regardless of these, for reasons that I could not fathom, Tarullo advocates going forward with using current constellation of observable indicators, and having the blind macro-economists continue to play a leading role in monetary policy decision making.

The real reason that economists do not understand inflation is because it is an outcome of the class struggle between laborers and capitalists. This topic is taboo in conventional economic theory — it has been ruled out of bounds of the subject, and to study it is to commit professional suicide. My post on “ Marxism Revisited ” shows how graduate students are taught to ridicule and hold Marxist theories in contempt.  As an illustration, the Daniel Tarullo article cited above does not mention the conflict theory, even though he surveys all theories of inflation to show that they do not work. Like Vol-de-Mort, the conflict theory cannot even be named in order to be rejected.

Let me mention that it was in the process of teaching Macro from the MMT Textbook by Mitchell, Wray and Watts that I first came across this theory, which makes eminent sense. The heterodoxy has such a low profile that I did not even know about the existence of this theory until recently. According to the conflict theory, the workers demand higher wages in order to get a bigger share in the revenue pie. Firms usually find it easier to meet their demand and pass on the prices via markup pricing, rather than resist demands and risk a strike. This creates a spiral, as workers try to regain real wages lost due to inflation. There are many reasons why this story disagrees with neoclassical views. For one thing, the marginal productivity theory suggests that each party — capitalist and laborers — get exactly what they deserve in terms of marginal product. Furthermore, this share is technologically fixed, so that a struggle cannot take place. Even though the theory is absurd and easily refuted both empirically and theoretically, it continues to occupy dominant position in neoclassical textbooks. For a theoretical refutation, see my post on Simple Model Explains Complex Keynesian Concepts which shows that with a Leontief type production function, both the marginal product of capital and labor is the same at the total marginal product, so sharing between the two must be based on different principles — relative power of the two parties or the institutional structures which is often a concrete embodiment of this abstract power. Each factor cannot get its own marginal product because this would be twice the marginal revenue.

The 45m Video Lecture below on Employment and Inflation goes through Chapter 11 of the Mitchell, Wray, and Watts Intro to MMT textbook. This deals with evolving conceptions of the Phillips curve and the central role it has played in the making of Monetary Policy. In particular, the chapter documents how wrong theories of inflation have guided monetary policy with DISASTROUS effects. Even though inflation has been successfully controlled, the costs in terms of low growth and high unemployment have been extremely high. Again the conflict theory predicts this outcome, as the costs of this type of monetary policy have been paid by the powerless labor class, while the benefits are enjoyed by the powerful capitalist class.

 

For access to lecture notes, slides, and other course materials for my Advanced Macroeconomics course, use the link below:

 Advanced Macroeconomics at PIDE, Sep 2018, by Dr. Asad Zaman 

Published in Dawn, 7th Dec 2018 with title: A Lopsided System

SADLY, it is true that ‘money makes the world go round’. But, it is also true that very few people understand how. This article is an attempt at explaining the basics of our global trading system.

A good starting point is the Bretton-Woods conference which took place in 1944, while the Second World War was still raging. The two World Wars had drained the treasuries of the European states, making the gold standard impossible to maintain. An entirely new system had to be created to enable global trade for the post-War era. At the Bretton-Woods conference, the most sensible proposal for the global trading system was created and advocated by John Maynard Keynes. Unfortunately, the political power of the United States enabled it to quash this proposal. Instead, gold was replaced by the dollar standard, with the proviso that dollars could be exchanged for gold.

When the Vietnam War forced the US to print an excessive amount of dollars, president Richard Nixon declared in 1971 that dollars would no longer be backed by gold, creating a brave new world of currencies without any backing. Just like a fixed exchange rate is the natural consequence of pegging currencies to dollar or gold, so too a floating exchange rate system emerges naturally when there are no pegs for any currency

Today, the dollar is at the centre of the global trading system, and is as good as gold once was. Everyone needs dollars as reserves to back up their currencies. To acquire dollars, all countries other than the US, must strive to increase exports — this is how one earns dollars. The US can increase imports just by printing dollars, while the rest of world exports goods and services to earn dollars. Because dollars are the gold of the modern financial system, the US can print money without adverse consequences. For instance, the US printed trillions of dollars to finance the Iraq war, and other trillions to bail out the financial sector from the global financial crisis that was created by it.

If we pause to reflect, the consequences of the dollar-based global trading system are truly breathtaking. Because of mutual dependencies, no one can opt out of the global trading system. Everyone within the system needs dollars, and must strive to increase exports, in order to earn dollars. Net exports cannot increase, and cannot earn dollars, unless the US increases imports. In this financial colonisation of the world, everyone must strive to pay tributes in terms of goods to the US, while the latter country prints dollars to pay for them.

For anyone who falls behind in their payments of tributes, the IMF is there to ‘help out’ by extending a loan, which puts the borrowers deeper in debt enslavement. The results of this system whereby the US prints dollars in return for tributes in real goods provided by the rest of the world are obvious in terms of the immense disparities between American levels of consumption and those of the rest of the world.

A rough measure of how much tribute has been extracted is the current level the US debt, which is $21tr. About $15tr of this total amount has been acquired since 2000. As a benchmark for comparison, note that the world GDP, excluding the US, was around $60tr dollars in 2017. Many more details are required for a more accurate calculation of benefits which accrue to the US due to this dollar-based global trading system, which requires all of us to work hard at increasing exports, while the US printing presses work hard to print dollars to pay for them.

What can be done to replace this immensely lopsided and unjust global trading system, which gives tremendous benefits to the US at the expense of the rest of the world? The first opportunity was lost — rather, suppressed — when Keynes’ proposal for a symmetric trading system was rejected at the Bretton-Woods conference. Keynes’s original proposal continues to be attractive to this day, but many new ideas for how to structure global trading have also emerged over the past few decades.

There are two main concepts at the heart of all such proposals, which differentiate them from the current system. In any fair trading system which treats all countries equally, the target for all countries would be to balance exports and imports. The second concept is to place the burden of adjustment on countries with excess exports as well as those with excess imports. This is more equitable than the current system which places all the burden on the weaker country. With the emergence of China and the European Union as major players, the time is ripe for the demise of the dollar. With multiple centres of economic power, we may hope for a transition to a more equitable global trading system.

POSTSCRIPT: For deeper understanding, see my post on The Vital Importance of Understanding Global Financial Architecture.  This explains the rise and fall of the Gold Standard, leading up to the Bretton Woods Conference, which made the dollar the king.  The continuation, Understanding Global Financial Architecture Part II, goes from Bretton Woods to the Nixon Shock, where the gold-backing of the dollar was removed, and consequences.

An Islamic WorldView

Most people admire and appreciate my educational credentials — BS Math 1974 from MIT completed in 3 years at age of 19, and Ph.D. Econ 1978 from Stanford at age 23.  They would find it difficult to imagine that it has taken me decades of life experience to recover from the damage that this education has done to me. The damage was done in so many different dimensions that it is hard to even catalog the whole list. However, before explaining this in greater detail, I must answer some questions which immediately arise whenever I make such statements.

Q1: Do I regret having had this education? To the contrary, I deeply appreciate having had this chance for training at the finest educational institutions that currently exist in the world. This type of education currently shapes minds and thinking of people all over the planet. Without having it, I would be…

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Concluding Paragraphs of Radical Paradigm Shifts, as edited and published in current RWER issue No. 85 — (reposted from RWER Blog)

The outcome of all this discussion can be summarized metaphorically by saying that we all use glasses to see the world. The direct world out there is a jumble of sensations – a matrix of points – which makes no sense by itself, and must be interpreted using our own frameworks, represented by the glasses. This means that ALL observations are tinged with subjectivity, and interpreted within the frameworks created by our past experiences, successes and failures, in viewing the world.

A paradigm shift occurs if we remove the glasses we use to view the world, and instead put on a different pair of glasses. A famous experiment  conducted by Professor Theodor Erismann, of the University of Innsbruck put reversing glasses on his student and assistant Ivo Kohler. It caused extreme disorientation and discomfort at first, but after about a week of stumbling around, he adapted to this new way of seeing the world. His subjective interpretative equipment learned to interpret the reversed image by performing an additional reversal within the brain to arrive at a correct image of the world. Now, when the glasses were removed, the world appeared to be upside down to Ivo.  On a much larger scale, this is what happened in Europe due to the Great Transformation[1] which transformed traditional society to a market society, where everything is viewed a commodity for sale.  Later, these ways of thinking were spread throughout the world by colonization and Western education. We learned to value everything according to its market price, and forgot that the most precious things cannot be purchased. Then it became easy to kill a million children, and destroy entire nations, for corporate profits. 

We can now understand the extreme difficulty of creating a paradigm shift. For those who have spent lifetimes learning to see the world with a specific pair of glasses, these glasses become melded into the flesh, and are impossible to remove. After failing to convince his contemporaries about his Quantum theory, Max Planck disappointedly realized that science progresses one funeral at a time. Thomas Kuhn also noted that paradigm shifts do not occur by converting those faithful to the old paradigm, but by inducting the young into the new worldview. Unlike the older generation, for younger and more flexible minds, it is possible to take off glasses manufactured in the Euclidean factory, and put on non-Euclidean glasses. Nonetheless, it is still a disconcerting and uncomfortable experience, which will not be undertaken unless there is some expectation of a great reward for this struggle and sacrifice. The costs of paradigm shift must be paid upfront – one loses the ability to talk to the mainstream when one describes the world using an alien framework. The rewards are in the future, and highly speculative and uncertain. Nonetheless, for reasons explained elsewhere,[2] it seems essential to make the effort – the survival of humanity is at stake.      read more 

[1] See my “Summary of The Great Transformation by Polanyi

[2] See Evaluating the Costs of Growth or Ecological Suicide.

IMPORTANT IMPLICATIONS: Article ends as above, but there are some very important implications that follow from this analysis. The first is that there are no objective facts. This strikes at the core of Logical Positivism. LP takes the observations as concrete, objective reality out there, which is independent of the subjective viewer. While it is likely true that there is an objective reality, our only access to this reality is using our own subjective apparatus for sensing reality, and what we see is the product of THREE factors — Objective Reality, Sensing Apparatus, Interpretation  — two of these factors are subjective, and are inevitably jumbled. It is impossible to extricate an objective reality.

When this was posted earlier as Radical Paradigm Shifts”  on RWER, there were 117 comments. Many of the commentators thought that THEY had the objective facts, the right model, they were frustrated at the inability of others to see what was so obvious, and thought that my article explained why. The realization that NO ONE has access to objective reality leads to a dramatic shift in perspective. What appears as objective reality to me (due to my failure to distinguish between my glasses, and what is out there), is just a subjective recreation, a picture in my mind. No one else can see this picture. So all effort at “explaining” is an effort at persuading others to look at the world from MY point of view. This means that FIRST we must appeal to the hearts of the people, to persuade them to listen to us, and to make the effort to see the world from my point of view. . However when we are in possession of facts (when we mistake our subjecive interpretation for objective reality), then those who do not agree with us are blind to reality, and insane (unable to see plain facts or use simple logic). The idea that there are objective facts, and that I can access them leads to arrogance. Subjectivity, and the need to persuade others to think like us requires humility.