Modern Monetary Theory

In a rapidly changing world, ways of thinking which served us well in other eras, become obstacles to understanding, and reacting appropriately to change. Traditional economic theories, currently being taught all around the world,blinded economists to the possibility of the global financial crisis.The Queen of England went to London School of Economics to ask why “no one saw it coming?”.The US Congress appointed a committee to study why economic theories “dismissed the notion that a financial crisis was possible”. At the heart of this failure arewrong ideas about the role of money in the economy. All major schools of macroeconomics currently being taught around the globe teach that the quantity of money only affects the prices, and does not have any other effects on the real economy. Economists write that “money is a veil” – it hides the workings of the real economy, but does not play any role in it. Economists were blindsided by the crisis because models currently in use for policy making do not have a role for money, credit, banking, and debt, even though these were the factors responsible for the Global financial crisis.

The crisis made clear to all and sundry the vital role of money in the economy. Surprisingly, the mainstream economics profession has been extremely resistant to change. The same textbooks, theories and models which failed so drastically, continue to be used in teaching and policy making throughout the world. However, the space for unorthodoxy has expanded substantially, and a lot of new theories of money have emerged to challenge mainstream views. Among these, Modern Monetary Theory, which provides a radically different perspective on money, has emerged as a strong contender. This article aims to summarize some of the key insights of MMT, which creates new ways of looking at the world of fiat money that we live in today.

The starting point of MMT is that our thinking about money is conditioned by the view that money is based on gold, which leads us to ignore the radical differences between gold-backed money and “fiat” money, which comes into existence by government decree, and does not require any backing. With a gold-backed currency, the concept of a government deficit makes sense – the government must have gold, in order to spend it. However, with a fiat currency, a deficit must always be self-imposed; the government chooses not to print money in order to pay its obligations.The idea that the government does not have money to fund social welfare or investment is wrong, because the government creates money by sovereign fiat, and can always print as much money as it likes. MMT raises the question of why the government should impose taxes on citizens to generate revenue – why not just print the money instead? Readers who have been conditioned by economic theories will eagerly proffer the standard answer: because this will lead to inflation! But this answer is neither sufficient, nor satisfactory.

Based on his experiences as Governor of the New York Federal Reserve Bank, Daniel Tarullo has written that at present we do not have a working theory of inflation. Similarly, Joseph Stiglitz has written that the stable relationship between money and inflation broke down in the 1980’s, leaving us with no reliable guide to monetary policy. The Quantitative Easing program that was adopted in major world economies after the Global Financial Crisis involved printing huge amounts of money. However, to the surprise of economists, no inflation resulted, in conflict with standard theories of inflation. So, the idea that if the government prints money, inflation will necessarily result is not credible.

As experience of the past few decades has shown, there is no automatic relationship between printing money and inflation. A more sophisticated analysis is needed. MMT provides rather different answers to when and whether governments should print money, as well as the why of taxation. First let us consider the printing of money. Whether or not it is inflationary depends on how the printed money is used. For instance, if it is deposited in the accounts of billionaires and adds to their financial wealth, without being used for any other purpose, then it will not have any inflationary effect. If the money is used to purchase goods in a sector where the economy has excess capacity for production, then the demand stimulus will create an expansion, with increase in employment and in production. This is the Keynesian phenomenon – in a recession, where economy is below it peak production capacity, a monetary stimulus can create increases in employment without inflation. If the money is used to buy goods in sectors where economy is at peak productive capacity, then it will create inflation in the short run. What happens in the long run depends on whether the industry can expand to meet the excess demand.

Against this Keynesian possibility where printing money increases production and employment, there are many possible ways that money creation can harm the economy.If money is spent on land and stocks, this will lead to inflation in their prices. Money can also be used for purchase of luxury foreign goods, or transferred abroad in various forms. In such cases, increased demand for dollars would lead to depreciation of the exchange rates. Keynesian economists have suggested that dropping money from helicopters would be a useful policy to reduce unemployment in recessions. Modern Monetary Theory tells us that we need to be more discriminating in targeting the printing and distribution of money. If money goes to sectors of the economy where there is excess capacity, it will stimulate production and employment, without causing inflation. If it goes to domestic sectors operating at peak capacity, it will lead to domestic inflation. If it is exchanged for dollars and flows out of the country, it will lead to depreciation.

One of the key resulting insights is that the “deficit” numbers by themselves – whether in percentages of GNP or in absolute quantitative terms – are meaningless. The government can “sustain” any amount of deficit by printing money to pay its obligations. Of course, this is not a license for irresponsible spending. Creation of money, and its utilization in ways which do not enhance productive capacity of the domestic economy are sure to cause harm to the economy. Rather, MMT provides us with a license for responsible spending. If there are worthwhile projects which will utilize resources currently lying idle, then there is no need to be scared of the deficit numbers in spending on these projects. Viewed in this light, the project of building a million houses is not constrained by the budget of the government. Rather it is constrained by the availability of resources which are required for this purpose. If there is idle productive capacity in terms of labor, land, and materials, spending is this area will utilize them to the maximum. If the capacity does not exist, then a carefully balanced spending strategy, which builds capacity in a way coordinated with the increasing demand for utilization of this capacity, can be funded by deficit financing, without causing harm to the economy. Of course, it goes without saying that this requires skillful management and planning.

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Re-enchanting the World

The strong focus on rationality, quantifiability, observability, and empiricism — putting the head over the heart — kills the marvelous magic of being alive — even a moment of life truly lived, packs a powerful punch — far greater than the lifetime of rational thought. Today, the catastrophic course which Descartes, the father of Western philosophy, took, has poisoned our lives, all over the planet. When one denies the immediate sensations, our pulsing hearts, racing breath, and tingling skin as evidence of our existence, and relies on the weak and faulty testimony of reason — I think therefore I am — this is equivalent to “feigning anesthesia”. Once this is done, it becomes possible to wonder — and have serious debates on — whether thought processes of the computers can be distinguished from those of humans, and derive ridiculous tests to assess this. Today, we need to learn to live as human beings again, instead of thinking machines, to bring back the magic to the beyond-words amazing gift of life in this un-imaginably precious world. Article below, published in The Express Tribune, June 20th, 2016, attempts to show how.

Max Weber wrote that “The fate of our times is characterized by rationalization and intellectualization, and, above all, by the ‘disenchantment of the world.’ Precisely the ultimate and most sublime values have retreated from public life …” The disenchantment of world leads to the modern view of the heart as merely a pump for circulation of blood.  The ancients had deeper understanding; as Pascal said “The heart has its reasons, which reason does not know. We feel it in a thousand things. It is the heart which experiences God, and not the reason. This, then, is faith: God felt by the heart, not by the reason.” Elevation of the head above the heart has led to a loss of wonder at the myriad mysteries of creation which surround us, and also caused deep damage to human lives in many dimensions. As our Poet Laureate Allama Iqbal emphasized: “At the dawn of Judgment, Gabriel told me, Never accept hearts which are enslaved by the mind.”

To make the best of the few moments that we are granted on this amazing planet, we must learn to appreciate the multiple paradoxes of this precious gift of life. On the one hand, “All we are is dust in the wind” – within the grandeur of the universe, and as just one among billions of people currently alive, my life is an insignificant speck. On the other hand, my life is all that matters to me, and the entire universe is contained within, and created by, my imagination. This simultaneous awareness of both truths diametrically opposed to each other, is not accessible to reason. However, poets have no difficulty with it; as Rumi said “You are not a drop in the ocean, you are the entire ocean, contained within a drop.”

When the heart and soul are removed from the picture, reason reduces man to a material object, just a drop in the ocean. Then it becomes possible say that the value of a man’s life is the sum of his lifetime earnings. Initial statements to this effect by secular and materialistic philosophers like Hume caused shock and horror. Nowadays, it has become widely accepted. The effects of this reduction have been profound in all dimensions of human life. Instead of recoiling with horror, we eagerly accept as the latest wisdom the idea of the “human resource”. Economists discuss human beings as inputs into the production process. The goal of the economic system is seen as the production of wealth, and the worth of a human being is calculated according to his ability to contribute to this goal. This comes from looking at only one side of the picture, the insignificance of a human life.

The other side of the picture is to realize that human lives are infinitely precious. Each human being is unique, with experiences and history like no one else. Each moment in our lives is new – no such moment has even existed before, and no such moment will ever arise in the future. Every moment presents us with unique opportunities to progress towards the infinite potential for growth planted within our souls. If we can grasp these opportunities, we can reach to heights that have never been scaled before in human history.

Consider the miracle of the seed, which defies all logic. The tiny seed has no arms, legs, eyes, or moving parts. Buried within the ground, it seeks out, and extracts from the soil, the hundreds of different chemicals required to manufacture roots, trunks, leaves, fruits, etc.  It unerringly sends roots downwards towards water, and the shoots upwards towards the sun, though it has no mechanisms to perceive directions. Within the seed, the Creator has implanted not just the design, but the full capabilities to manufacture not just a tree, but a forest. The potential planted within a human being is far greater. Those who realize it can achieve marvels. With training and discipline, humans can walk barefoot on fire, slow life processes down to survive being buried, break bricks with bare hands, accomplish incredible athletic acts, write literature and poetry of enduring excellence which inspires millions, and even greater spiritual feats which cannot be witnessed by others.

To put it in more prosaic and less poetic terms, the purpose of wealth is to provide the opportunity for all human beings to fulfill this potential, which cannot be measured in monetary terms. This reversal of the “human resource” idea is the central contribution of the capabilities approach to development, which emerged from the emphasis on Human Development pioneered by Mahbubul-Haq. This focus on the intangibles of human experience, which lead to the development of capabilities, is precisely what has gone missing from economic cost-benefit calculations.

Disenchantment, as reflected in the banishment of the ultimate and sublime values from the public domain, has resulted in impoverishment of human lives in many dimensions. We have learned the false and misleading lessons that our lives should be devoted to careers, production of wealth and the pursuit of pleasures. Recent research shows that while we are attracted by material possession, and short term gratification, long-run happiness comes from seeking enriching experiences, and emphasizing experiences over possession and consumption. Bringing back the magic into our lives requires paying heed to the wisdom of the ancients. Most important to our personal happiness is investing time on the social threads with which the fabric of our lives is woven. Generosity, acts of kindness, service to others, even at personal cost, contribute more to long run happiness than selfish maximization of short run pleasure. It is a central lesson of Ramazan that abstaining from desires, as well as other vices, and striving to do virtuous deeds, leads to spiritual growth. Spiritual growth is the core component of the development of character and capabilities. Let us use this opportunity to make a commitment to improving ourselves as human beings, as this is the most effective way of making the world a better place for all.

Related article: Social Revolutions – how individualism trumped social connections. My blog: An Islamic WorldView

The neoliberal policies of resilience

Economic conditions are constantly changing. Today, our generation is confronted with the outcomes of contemporary globalization that is a broader, complex, and multifaceted process characterized by new markets, new actors and new rules. Indeed, globalization has produced many changes in our economy, society, culture, and politics. As a result, deep pressures to conform to new standards of behavior, such as efficiency and competitive performance, have forced individuals and communities not only to rethink values and practices but also to rebalance tradition and change.

In the scenario of globalized markets, individuals and communities face many challenges to be resilient because of the changes in markets, wealth and power. Throughout the last forty years, most governments around the world supported the long-run process of neo-liberal reforms that turned out to be characterized by the financialisation of the capitalist economy. By negatively influencing labor and working conditions, it rendered increasingly difficult to reach (or even approach) the level of full employment. In this setting, changes in corporate ownership, through waves of mergers and acquisitions, created new business models where companies, while highly powerful and concentrated, turned out to be simply bundles of financial assets and liabilities to be traded (Madi, 2017).

Considering the labour markets, employability seems to be shaped by private strategies that aim cost reductions, labour flexibility and efficiency targets. Longer working hours, job destruction, turnover, outsourcing, workforce displacement and loss of rights have also been part of the spectrum of management alternatives aimed at cost reduction. Indeed, the current dynamics of labour markets favoured the vulnerability of workers, mainly young people, and precarious jobs. Therefore, job instability and fragile conditions of social protection turned out to put pressure on the redefinition of survival strategies. As a result workers turned out to redefine their skills, become informal entrepreneurs or migrate, among other examples of the current worldwide changes in their livelihoods.

In this setting, current neoliberal policies of resilience have been increasingly prevalent in current economic thinking and policies. The policy recommendations seek to foster the capacity of individuals and communities to cope with market uncertainties. BRASSET and HOLMES (2016) present a literature review on the neoliberal (and managerial) policies of resilience, characterized as a set of governance techniques aimed to manage uncertainty and achieve the adaptation of individuals and communities to global changes.  Considering the labour markets, for example, the neoliberal policies of resilience have turned out to enhance the workers´ adaptation to the “market discipline” and, therefore, there has been a re-distribution of the responsibilities for social adjustment among the state, business men, investors and workers. As a consequence, the evolution of unemployment results from the “unsuitable” or “inappropriate” behavior of workers to face a changing real-world.

As a matter of fact, in the frame of the neoliberal policies of resilience, human life turns out to be focused on the attempt to face exogenous uncertainties and risks in order to foster adaptive strategies. In short, the sole purpose of resilient individuals and communities seems to be survivability.

Indeed, in the light of current  global social and political challenges.  the spread of the  discourse of resilience calls for a critical thinking on the failures of economic thinking and economic policies.

References

BRASSET, J and HOLMES, C. (2016)  “Building Resilient Finance? Uncertainty, complexity, and resistance”, The British Journal of Politics and International Relations, 18(2): 370–388.

MADI, M.A.C. (2017) Pluralist Readings in Economics: key-concepts and policy-tools for the 21^st century, Book Series: Economics: Current and Future Developments.Volume 2.  Bentham Publishers

Microfoundations Matter for Keynesian Unemployment

Lecture 7 of  Advanced Macroeconomics , 9/26/2018 at PIDE, Islamabad.

The Lecture explains that Keynes provides a general broad outline — a model IDEA, and not a model. Within this outline, there are many ways to fill in the details — these are the so-called Microfoundations for Keynes. Depending on HOW we fill in the details, we can get to different types of models with different types of phenomena, which may be called effective demand. This means that microfoundations, left unspecified by Keynes, matter in both the interpretation of his theory of effective demand, and also in terms of whether or not the central phenomena: an equilibrium at which unemployment exists – can be demonstrated within the model.  This is the CENTRAL reason for the massive amount of confusion about about the concept of Effective Demand, and the resulting Unemployment Equilibrium, which Keynes described. Depending on how we fill out the micro details, we can get to many different possible definitions and interpretations of Keynesian Effective Demand.

The 95m Video Lecture is linked below. Also, for those with less time, Slides for the Lecture, which provide an outline and overview of the contents of the lecture, are linked below.

The slides are available on slideshare, and can be viewed below: An expanded outline, based on the slides, is also attached, just below the slides

An auto-generated transcript of the talk, using YouTube voice recognition (which may have many mistakes) is available from the website for the course. See:

Advanced Macroeconomics: MAC07: Microfoundations for Keynesian Economics

Lecture 7 of Advanced Macroeconomics,

26th September 2018. by Dr Asad Zaman VC PIDE

WEBSITE: https://sites.google.com/site/az4macro

To understand Keynes, we must  FIRST Understand Say’s Law: “the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output”

Production of goods has a COST = Aggregate SUPPLY price = Payment to factors of production + Profits.

Total Money generated as factor income is ALL the money that is available as demand. ALL goods are for sale. Money will be exactly enough to buy all the goods  (because prices will adjust to clear the market).

Consider Thought Experiment in Simple Model

Two factors of production: 40 Acres land and 40 laborers

Land Rent is 40xR, Payment to labor is 40×100=4000

Factor Income = 4000 + 40R, Total Product = 400 Corn.

Price of Corn = (4000+40R)/400=10+R/10

Demand = Supply; Price equilibriates.

This is Say’s Law – Factor Income is exactly the amount needed to purchase the entire amount produced – price creates equality

Crucial Question: What determines Rent & Wages

Share of Capital and Share of Labor?

Classical Answer: Rent is Marginal Product of Land, Wage is Marginal Product of Labor.

The two sum to total income from production under zero profit long run equilibrium.

Keynes agrees with classical answer: W=MPL; this determines capital share as well.

In order to compare with our own answer/model, we first REVIEW the neoclassical theory

According to Neoclassical Theory,  Shares are Determined by Marginal Product – Why?

Assume 40 Mini-Landlords, each has one acre of Land (K).

è K=1, L=1 produces 10 Units of Corn.

Suppose W=100 Rp, this is the numeraire. One price can be set arbitrarily, all others will adjust proportionately.

SOLVE for competitive equilibrium in this economy.

Fix K=1, every landlord has K=1 è

◉             First Order Conditions for Profit Maximization

For equations — see slides, or video lecture, linked above

Firms are price takers, p,w fixed in above equation, which gives the demand for labor by firms. At competitive price p, demand MUST come out to 1 unit of labor, otherwise excess or deficit demand for labor. Set L=1 to solve for competitive price. Fix value of b arbitrarily, say b=0.8. Solving for p in above we get:

For equations — see slides, or video lecture, linked above

◉             Competitive Solution

Each LL hired 1 unit of L at wage 100 Rp, produces 10 units of corn worth 12.5/unit, sells for 125 units, makes profit of 25 Rp, enough to buy 2 units of corn. Laborers buy 8 units of corn with 100 Rp. Factor Payments exactly equal demand. Say’s Law holds.

For equations — see slides, or video lecture, linked above

◉             Disequilibrium Dynamics: What Happens if p=15?

Revenue from Sales is 150=15×10, 100 goes to Labor, 50 to LL.

Laborer buys 6.66, LL buys 3.33, Demand=Supply for Corn.

BUT MPL > w.

Competition for additional laborers will drive up the wage, until the shares of capital and labor are 20-80

◉             Cobb-Douglass First Order Conditions

For equations — see slides, or video lecture, linked above

Competitive Equilibrium exists ONLY with Constant Returns to Scale. If  , then total revenue from sales will not equal payments to factors.

Other Production Functions Lead to Different Results

Key Point of this Lecture: Micro-Structure Matters

Little, Apparently Un-important Details, Make Huge Difference

Cobb-Douglass, CRTS, lead to W=MPL, R=MPK.

If α+β>1 IRTS (Increasing Returns to Scale), then MPL+MPK is less than Total Revenue.

If α+β<1 DRTS, than revenue is less than sum of shares to capital and labor. Both cannot be paid.

Competitive Equilibrium fails in either case.

As Usual, Economists adopt Ostrich Strategy: Assume it all works out — SO LET US ASSUME CRTS!

This assumption reflects an Ideological commitment to Free Markets & Competitive Equilibrium, we freely make assumptions, as required, to get optimality of free market.

In Leontief Production: Rents,Wages not equal to MPL

In constant proportions production function, both factors have FULL output as marginal product. When K=1, L=0, adding L=1 gives 10 units of output. When L=1,K=0, adding K=1 also gives 10 units of output. So BOTH factors have FULL output, factor payments CANNOT be made according the marginal products.

Central Question: What Determines Wage/Rent Shares?

Neoclassical Answer is Ideological Propaganda: Conflicting Technical Details are suppressed.

Impression: S&D holds everywhere: Reality: ONLY in Comp Eq

Impression: W=MPL, R=MPK; Reality: ONLY in CE with CRTS

What if NO CE or NO CRTS?

If we reject neoclassical views, THEN what determines share of capital and labor?

Marxist View: Labor Gets Subsistence Wage

Note that FULL output is Marginal Product of Labor = Labor Theory of Value (of course Full output is ALSO MPK).

To understand Marx, Start at arbitrary 50-50 share; determined by historical context and social norms.

Capitalism is competition among capitalists for profits.

Profits come from exploitation of labor. This means capitalists will use power to increase their share.

Exploitation increases until laborers revolt.

So: Is Wage Equal to MPL? Data shows clear divergence

Data strongly conflicts with the idea. To explain these differences, Economists List Six Theories

• Cheaper Capital lead to rise in investment in capital
• Increased Capital Mobility – substitution of cheap labor
• Resultant Reduced Bargaining Power. Fewer Unions.
• “Superstar Effect”: Externality gives massive returns to top
• Rents: Excess profits from patents, non-market effects
• Tax Policy

Above reasons are rationalizations – attempts to save neoclassical theory.

Real Reason: Financial De-Regulation in 1970s

Rise of FIRE: Finance, Insurance, Real Estate

Massive increase in payments of rents to FIRE sector (Hudson)

All productivity Gains are captured by the powerful – Marxist hypothesis: share is NOT according to marginal product, but according to relative POWER of the two classes.

Reagan-Thatcher revolution unchained finance, and created power necessary to capture gains in productivity.

Economics & Theories – driven by power struggles between classes.

Back to MAIN question:

How to Understand Unemployment after Great Depression?

Answer: use models which capture essential elements –

Models are necessary, because world is complex.

All intuitions cannot be put together in any simple way.

Models ensure coherence and consistency of entire structure.

Experience cannot be understood without models.

Models cannot be understood without experience.

◉             How to Understand Unemployment?

◉             What caused Unemployment after Great Depression?

 

Say’s Law – if producers produce, process of production will generate enough income for factors to enable purchase of product. No danger of insufficient demand.

OBSERVATION: Producers had CAPACITY to produce – laborers were there, factories were there. BUT they did not produce – WHY? If Say’s Law is VALID, then there was no danger from producing an excess. When we supply, the process will create its own demand.

This is why Keynes STARTS by rejecting Say’s Law.

Keynes’ Intuition: Producers thought they would be unable to sell

That is, Say’s Law does not hold. BUT WHY?

Intuition: Producers think there will be insufficient aggregate demand. (and they are right!)

Intuition: What happens at the aggregate level is DIFFERENT from a scaled up version of what happens at MICRO level.

IDEA: Work solely at Aggregate Level – Unique Innovations of Keynes – invented MACROECONOMICS.

Translate Intuition into Model

Keynes painted broad details – Intuition about Complexity: Behaviors of Aggregates not scaled up Micro Behavior.

Omitted the Micro Picture, concrete details of what happens at the micro level which leads to this Macro.

This led to the critique: Keynesian Economics LACKS Micro-Foundations.

Responses to Micro-Foundations Critique of Keynes

One Response: Macro Picture does not depend on Micro – Chemical properties of molecules have no relation to properties of sub-atomic particles.

Another Response: Create Micro Picture – New Keynesian/ Neo-Keynesian

Crucial Issue: Micro Details MATTER – Is production function Cobb-Douglass CRTS, or Substitutable with IRTS, or Leontief? This MATTERS for theory of effective demand.

Important Point: Neoclassical Micro-foundations lead to REJECTION of Keynes (contrary to Keynes own ideas). This is why Post-Keynesians often resist demand for micro-foundations.

Massive Confusion About Effective Demand: Different Ways of Filling out Micro Details lead to Different Theories

How should we fill out the micro detail?

Try for REALISM – closest approximation to hidden reality.

Approximation is good (enough) if it reproduces observed phenomena. [This is ONLY Criteria: Friedman’s Folly – match between model results and observation is important, but NOT the sole criterion for validity of model]

Critical Realism: Trying to find the HIDDEN structures of reality. In addition to matching empirical evidence, model should provide a PLAUSIBLE explanation of the hidden causal structure which leads to the observed phenomena.

Questions we need to answer – in terms of match between HIDDEN structur

◉             What is the Production Function?

◉          Do We Have Perfect Competition? S&D Theory Holds?

◉             Cobb-Douglass with CRTS required for S&D

◉             Sraffa’s Critique: IRTS & DRTS are not compatible with S&D

◉             CRTS leave SCALE indeterminate.

◉             C-D with CRTS implies MPL is below subsistence level.

So – to find out what model is suitable, we must ask: How did the real wage behave in GD?

Keynes speculates that it increased.

◉             Bordo, Michael D., Christopher J. Erceg, and Charles L. Evans. “Money, sticky wages, and the Great Depression.” American Economic Review 90.5 (2000): 1447-1463.

GRAPH (see slides or video lecture linked above) show steady decline in prices and wages during the great depression, while the real wage remains roughly constant.

Cobb-Douglass: As more labor is hired MPL should decrease.

◉             Links to Relevant Materials

Website for course: Advanced Macroeconomics

Related Post  Subtleties of Effective Demand

Information about Author: About Me section of asadzaman.net

 

 

The Subtleties of Effective Demand

(Continuation of   Lectures on Advanced Macroeconomics  )

As I read more and more about effective demand, I got more and more confused — how can I explain this concept to my poor students, if I don’t understand it myself? There are a huge number of articles with different and conflicting views and interpretations of this concept, which Keynes describes as being central to his theory. Let me proceed to clarify the insights that have resulted from struggling with this material, and going through many iterations of revisions in terms of how to make sense of this theory.

Keynes and followers — both the Hicks-Hansen-Samuelson variety, as well as true blue post Keynesians — argue that it is deficiencies in the Aggregate Demand which lead to the unemployment equilibrium which is central to Keynesian economics. Stated in very simple terms, the argument can be phrased like this. The process of production generates factor incomes. These incomes are exactly the source of the demand for the product. If all the income generated is always spent on purchase of products, then the aggregate demand will exactly equal the aggregate supply — this is Say’s Law. In this case, there is no concept of shortfall in aggregate demand which could lead to unemployment.

However, Keynes and his followers deny the equality. They argue that some portion of the factor income could go into savings, thereby lowering the aggregate demand. Now the aggregate demand could be greater or lesser than the aggregate supply. An equilibrium would occur when the two are the same, but there is no guarantee that this equilibrium would occur at full employment. The standard diagram used to illustrate this idea is given below:

For our purposes, we can assume a direct proportionality between N, the amount of labor employed, and Y, the value of the output produced. Furthermore, it makes no difference for our argument whether prices are fixed or flexible, so let us assume them to be fixed for simplicity. The X-axis just measures the value of total output Y (equivalent to N, rescaled, since the two are directly proportional).  The 45 degree line just measures the total factor income generated by the production of output worth Y — by definition. The consumption function is C=a+bY, where a>0 and b<1 is the marginal propensity to consume. When Y is low, the laborers/consumers demand is greater than the total product. However, since the slope b is less than 1, this consumption demand must intersect the 45 degree line. At points beyond the intersection, we have deficient demand. Both deficient and excess demand would set in motion processes to eliminate the disequilibrium so that equilibrium would occur at the point at which the demand for consumption generated by factor incomes is exactly equal to the value of the total output. This intersection can occur at a point at which full employment does not occur, demonstrating the existence of an unemployment equilibrium — which is the CENTRAL goal of Keynes.

According to Keynes, classical economics is based on Say’s Law, which requires C=Y — the consumption function has a=0 and b=1, so that the consumer demand is exactly the same as the factor income, and there is zero savings. In this case the consumer demand is exactly the same as the aggregate supply function — both are the 45 degree lines, and equilibrium can occur at any point — however much is produced, it will generate exactly enough demand required to purchase and consume it. In this case, standard economic forces will automatically drive the economy to full employment.  Keynes, and post-Keynesians argue that consumer savings will disrupt the operation of Say’s law, and create a divergence between the demand for consumption at a given level of factor income Y (which will be C=a+bY) and the supply of goods at the same level (which will be Y). Because of this violation of Say’s Law, equilibrium will not occur at all possible levels of production Y. It will occur only at one particular point of intersection, and that point could easily be an unemployment equilibrium.

This idea actually works in a one period static economy, which was the mode of analysis used by Keynes. However, despite a lot of effort, I was unable to make it work in very simple dynamic extensions of the same economy. After many trials, I realize that this savings argument is much more subtle than it appears at first blush. The problem in the dynamic, multi-period setting is actually very simple. Today the consumers/laborers SAVE a portion of their income S=Y-C, reducing the aggregate demand. However TOMORROW this same saving will be available to the consumers as additional amount of money, over and above the factor income. When we talk about saving for the future, then we cannot ignore what happens in the future as a result of this saving. Furthermore, in a dynamic setting, except for the very first period, every period has a past as well as a future. Let M(T) be the total money in the hands of the consumers in period T. This amount is split into C(T) and S(T), the consumption and savings in period T. Now, in period T+1, the money holdings in hands of consumers will be M(T+1)=F(T+1)+S(T) — the factor income PLUS the amount the consumers saved. The consumption function should be defined using THIS amount, and not just the factor income amount — if savings plays no role (as it does not in a one period static analysis) then the model is not logically consistent.

Once we realize that for logical consistency, savings MUST enter into any dynamic analysis, we are led to the realization that it MUST also enter into even a static one-period analysis. This is because we must have M(T)=F(T)+S(T-1). The money in the hands of the consumers today must be the factor incomes in the current period PLUS the savings from the previous period. It is logically inconsistent for a model which has savings in current period to ignore the savings from the previous period.  But, as soon we put in the CRUCIAL missing variable S(T-1) into the analysis of the current period, the savings gap appears in a very different light — as we shall soon see. To the extent that today’s saving reduce current demand, yesterdays savings offset this by adding to demand. Let S* be a normal level of savings. Then in long run equilibrium S(T-1) = S* = S(T), and so the savings gap created by present savings will be exactly made up for by savings coming in from period T-1.

As this analysis demonstrates, normal levels of savings S* do not create deficiencies in aggregate demand, and hence cannot create unemployment. However, abnormal levels can indeed create such deficiencies, and lead to the kind of unemployment that Keynes wanted to explain. To see how this can happen, suppose we are at a full employment equilibrium, with shortfall in aggregate demand from saving S* being exactly compensated for by the increased income due to savings S* from previous period. Now suppose that there is a catastrophic crop failure. The Landlords have cushions, but the laborers draw down their savings and go into debt to survive. Come planting season, the landlords note the general misery in the land, and how the general population is in debt, and times are tight. They wonder whether they should go to the trouble and expense of producing a huge amount of crop. Who will buy it? Would it not become surplus, and drive down the price of crops? In this situation, they are likely to restrict production to have enough for self-consumption, and a moderate surplus for sale. The concept of restricting production to get good prices on crops is well known. The aggregate demand has gone down because the normal savings cushion S* of the laborers has been wiped out. Now, when they are paid wages, instead of using it to buy corn, they will use it repay debts, and to build up their savings back to the normal levels. This abnormally high savings is what causes the collapse of aggregate demand. This corresponds exactly to the analysis of Atif Mian and Amir Sufi in the House of Debt. See my brief analysis and summary in “Why does Aggregate Demand Collapse?“.

The relation between debts and depression was emphasized in the debt-deflation theory of Irving Fisher. Even though Keynes was aware of the links, he chose not to emphasize this in his General Theory. Making the connection explains why “helicopter money” would go a long way towards ending the depression. A moratorium on debt repayments, and an infusion of money to rebuild savings and restore aggregate demand create full employment. This would then create prosperity which would allow people to pay off debts. The Aggregate Demand Depression leads to loss of jobs which further inhibits the ability of people to pay of debts, creating a vicious cycle, as has been noted by many.

 

 

 

 

Kant’s Blunder

What is a model? How does it relate to reality? This question has been discussed thoroughly in previous post on  Models and Reality , and briefly in previous lectures. Western understanding of models was derailed by a complex set of historical accidents. This is a tangled tale with bewildering twists and turns, some aspects of which are discussed in “Deification of Science and Its Disastrous Consequence“, and some others in Logical Positivism and Islamic Economics . The reason we need to tell this story is because without understanding it, it is impossible to understand why Friedman could say, without being laughed out of court, that “Truly important and significant hypotheses will be found to have “assumptions” that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions.” Similarly, how could Lucas and Sargent make assumptions that are certifiably crazy, and receive Nobel Prizes and accolades? To understand why completely crazy understanding of models currently dominates the economics profession, it is necessary to understand some aspects of this story. Nonetheless, it is too long and difficult a task, so we will vastly oversimplify, and pin all the blame on poor stodgy German philosopher Kant — not that he does not deserve a lot of blame, but he also had a lot of accomplices, both before and after. A more nuanced account must be left for a much longer treatment by someone much more knowledgeable about Western philosophy and intellectual history. For students of economics, a brief explanation can be provided by looking at a key turning point, called a “Copernican Revolution” by Kant himself:

Kant’s Blunder: Kant argued that the nature of hidden reality, which generates the observations that we see, CANNOT be known to us. This is true almost by definition, since observations are all we can see – we can only guess at the nature of the hidden reality (Thing-In-Itself), and our guesses can never be confirmed by cross-checking against the truth, because the truth about hidden reality will never be accessible to us. So far so good – we have no disagreement with this. HOWEVER, from the impossibility of getting certain knowledge about hidden reality, Kant argued that we should ABANDON this pursuit, and give up on trying to make guesses, which can never be confirmed, about hidden realities. Instead we should focus on a different problem: how does our mind assemble and organize what we observe, to create a coherent mental picture of reality. A diagram can help us to understand Kant:

The underlying idea, which I have called Kant’s Blunder, is that if we have to guess at something, and can never be certain about our guess, then we should not make such guesses. This is an outcome of the idea that REASONING is the central tool for the acquisition — while guesswork, intuition, plausiblity, heart-knowledge — these are all anti-thetical to rational knowledge. This drive for certainty based on logic and rationality, which is embedded with current Western conceptions of knowledge, has led to hopelessly bad misconceptions about the nature of knowledge, and how we should approach the acquisition of knowledge. Western philosophy has been unable to recover from the false track on which Kant put it; as a result, current concepts about the nature of models and their relation to reality are hopelessly muddled. See my lecture on   The Search for Knowledge   to understand more details about an Islamic approach to knowledge, and how it is dramatically different from Western conceptions.  Despite the fact that Kant is seriously wrong, and his misconception is seriously damaging to our quest for knowledge, his ideas became widely accepted, and continue to underlie modern notions of knowledge in the West.

Why is Kant wrong? Basically the idea that knowledge must be JTB: Justified True Belief, sets the bar for knowledge too high. This level of certainty is almost impossible to achieve. We operate in our daily lives with a much lower level of certainty. The idea that if we cannot achieve certainty, we should ABANDON the attempt to guess, would lead to paralysis. When I am driving, I am constantly guessing at what other drivers intend to do – whether they are going to go speeding through the red light, or stop, for example. Very often, my life, and that of others depends on such guesses. We don’t think that since I cannot be sure about such guesses – how can I be certain about the intentions of the person sitting behind the wheel – I should abandon the attempt to make such guesses. Simlarly, in our personal relationships, in nearly all important aspects of our life experiences, our decisions are guided by guesses about possible future outcomes which would result from our actions. Abandoning making such guesses because we cannot have certainty about them is almost unthinkable. Yet this is precisely the principle that Kant advocates.

Once we accept the idea of Kant, that there is no need to check for a match between our mental models and the hidden reality which generates the observations, there is no longer any need to confine our models to sensible ideas about what might be hidden beneath the surface observations. The only criteria for a good model is whether or not it can generate a good match to observations. This is sometimes called “Saving the Appearances”. An example will serve to illustrate and clarify.

When I was in graduate school at Stanford, top ranked game theorists Robert Aumann and Mordecai Kurz, discussed a paper in our classes regarding tax structure. They considered a game where any coalition can form, and the majority coalition can enforce any tax rule it likes on the whole group. This game turns out to have a trivial solution. If N+1 is the smallest majority coalition, this coalition will form and tax away EVERYTHING from the minority, taking it for themselves. Now this has no resemblance to the tax structures we see in the real world. So this is not a good model. Aumann and Kurz thought about how to get more realistic outcomes. They modified the game as follows. Those in the minority have one additional move which they can make. They can simply burn their entire endowment, instead of giving it up in taxes. This forces the majority to make less draconian tax levies, to ensure that the minority prefers to pay taxes rather than burn their possessions. With this slight modification, the tax structures which emerge from solving the game appear a lot more realistic. The paper they co-authored looks at the match between the outcomes of the game and real world tax rules in the USA, and finds it a reasonable fit.

On the traditional approach of matching model with reality, we would IMMEDIATELY reject Aumman-Kurz taxation model — it is completely ludicrous, and has no relationship with how tax laws are made in the Congress. However, on the Kantian understand of models, this lack of realism has no bearing on whether or not the model is good. This is exactly in line with the Friedman quote, that models can be “wildly inaccurate” as descriptions of reality. This then is the conventional Western understanding of models, as exposited in modern textbooks of economic theory, which cite Friedman’s methodological approach with approval.

In our Macro course, we will work with a radically different understanding of what models are, and how they function.  Models are not meant for producing a match to observations. Nor do they provide accurate maps of the hidden reality which produced the observations. Rather, models are extreme simplifications of a complex reality, designed to enable us to understand the real world. Models are meant to be easy to understand, to strip away elements which are not essential, and to highlight and focus on the central elements of the real world which produce the phenomenon we would like to study. It must be emphasized that the goal of models is to help us UNDERSTAND reality — not necessarily to facilitate predictions, nor to produce good match to observations. Again it is helpful to provide an explicit example.

What Keynes was trying to understand was unemployment. According to economic theory, the free market automatically eliminates unemployment. Anyone who wants a job at the going wage rate can find one. This is in conflict with our own observations and experience — all of the students are anxious about whether or not they will be able to find jobs after graduation! Keynes also witnessed large scale unemployment in England, and in other advanced economies of the time. He wanted to understand why this happened, especially since it was in conflict with dominant economic theories at that time. Models help us to achieve such understanding. To see how, let us try to construct a model in which we can see the phenomenon of unemployment.

Note that our model must contain some employers and some employees. That is why we have some landlords, and some laborers in our models. Now let us look for the simplest possible model in which unemployment can be observed. As students soon saw in class, with fixed proportions technology, every landlord can only employ laborers upto the number of acres that he has — with 5 Acres, a maximum of 5 laborers. Beyond that, laborers cannot add to production and are useless. So a clear and simple model with unemployment is one where we have an excess of labor, beyond the maximum possible to employ usefully. Note that even though this model is completely unrealistic and inaccurate, it provides a reasonable explanation for unemployment which would be transferable to the far more complicated real world. If labor is already being utilized in all jobs, and the economy is at its maximum possible productive capacity, then further labor cannot be used, and will therefore be unemployed.

However, this simple model is NOT useful for understanding the kind of unemployment witnessed by Keynes. That is because the economy was functioning at full capacity just prior to the Great Depression, and unemployment rates were near 3% in the USA. This shot up to nearly 25%, and remained above 10% until WW2. So economy was not working at full capacity. Hence the mystery: the economy was capable of providing jobs to nearly all seekers, and had done so in the past. Without any material changes, the same economy was not providing jobs. We seek to build a model to understand why.

The   simple model    discussed earlier has some very interesting features. The marginal product for each laborer is 10 units of corn — this remains constant from the 1st to the 40th laborer. The real wage is significantly lower — it is 7.5 units of corn in the baseline model. Every landlord wants to hire more laborer. All laborers want to get jobs because they would starve to death otherwise. Now it is a real puzzle as to WHY unemployment would exist in such a model. If we can make plausible how unemployment could arise in such a model, we have some hope of understanding how it could happen in the real world. Note that our model, while extremely simple, is nonetheless fairly realistic. The assumptions are line with reasonable beliefs about the real world. The point of simplicity is NOT to be wildly unrealistic — the point is to show that all of extremely complex worldly structures are not needed to produce (and hence to understand) unemployment. If we can produce unemployment with an extremely small number of operational factors which drive the model, then we have an explanation of unemployment, which leads us to some understanding of the real world mechanisms which cause unemployment. This is always subject to Kant’s warning — we can never be sure of the truth of our models. But we make plans for tomorrow without being sure that we will be alive; similarly, working with models, and with guesswork, without certainties, is part of the human condition. In fact it is not at all easy to come up with a model which will produce unemployment under the set of conditions which the model satisfies — marginal product of labor is higher than wages, so every landlord wants to hire, and the economy has ample capacity — many more acres of land than laborers required to work them. It was the genius of Keynes to discover a REASONABLE model (not a grotesque Friedmanian caricature of a model) which could create unemployment for reasons which we can understand. This model was discussed in the previous lectures, and will be discussed some more today. This particular post is restricted to a discussion of the approach to modeling we take in this course, and how this is different from the standard approach currently in use in economics.

Models and Reality

Linked below is a 95m Video Lecture on the previous post on “Simple Model Explains Complex Keynesian Concepts“. In Chapter 2 of General Theory, Keynes has two points against the classical theory of the labor market. He points out that laborers react strongly (with strikes) against wage cuts, but show no similar reaction to inflation. This means that the decision to supply labor does not depend on the real wage — instead it must depend only on the nominal wage. The SECOND point, which he regards as fundamental, is that the bargain between firms and laborers is conducted in terms of nominal wage — this decision does not determine the real wage. The real wage is an emergent property; it comes out of the system as a result of collective decisions of all, and is not controlled by any two parties. One of the KEY contributions of the SIMPLE MODEL discussed in the previous post, and in the video lecture below, is to show how this works — regardless of how the laborers and landlords negotiate and decide on the nominal wage, the real wage does not change. It is amazing that there is no understanding of this — which Keynes calls the “fundamental point” in the literature on labor economics. Current labor textbooks seem to completely ignore Keynes, and I am not aware of an explication of this anywhere else either [Readers: please provide pointers to clear explanations elsewhere if you know of some]. This can be considered as the main contribution of the simple model explained in the video lecture linked below (and the previous post, linked above).

THIS post (below the video lecture on previous post) is actually an assignment to the students to construct variations on the simple model. However, I start by discussing a crucial methodological issue: the relation between models and reality. I explain how this has been radically misunderstood by economists, due to some fundamental mis-steps in Western philosophical tradition. As a result the working concept of an economic model is disastrously different from what it is supposed to be. I provide a very brief summary of the differences between current western concepts and the correct notion of a model, and explain it with some simple examples. An extended discussion of this concept, and a 45m video lecture on it, are also linked below. This is followed by some exercises in model building for students.

95m Video Lecture on: Simple Model Explains Complex Keynesian Concepts

1      Models and Reality