Understanding Macro II: Post-war prosperity

from Asad Zaman

In part 1 of this article (Understanding Macro: The Great Depression (1/3), we saw that Keynes challenged classical economics on many fronts. Against the classical idea that free markets will automatically eliminate unemployment, he argued that governments needed to adopt appropriate fiscal and monetary policy in order to create full employment, as a necessary condition for high economic growth. He also argued that money is not neutral, and that there is fundamental uncertainty about the future.  Widespread acceptance of Keynesian economics was one of the two major ingredients that led to prosperity in Europe and USA after World War II. We start with a discussion of the second ingredient, which was strict regulation of financial institutions.

It was obvious to all that irresponsible lending had caused the Great Depression. The creation of the Federal Reserve Bank in 1914 allowed banks to create credit freely. Banks could provide loans to anyone who asked for it, without minimal backing in cash reserves, since the Fed would provide them with cash in case of any shortfall in reserves. This was a windfall for the private banking sector, since they could provide credit for loans at zero cost to themselves, simply by making an entry on their books. Banks capitalized on this opportunity by creating a debt-based boom in the economy. Consumers were encouraged to buy everything, especially real estate, housing, and stocks on credit. Easy availability of loans created a boom in economy, referred to as the roaring twenties. As prices of land and stocks increased, people rushed out to get loans to buy more, in order to get a share of the easy profits due to soaring values. Eventually, a stock market crash in 1929 punctured this bubble, leading to the Great Depression of 1929. About 11,000 of 25,000 banks collapsed, wiping out the life-savings of millions, since there was no deposit insurance at the time.  read more

Decline of working hours over long-run

May 20, 2018 3 comments

Schumpeter — an early champion of MMT

May 20, 2018 9 comments

from Lars Syll

Evidently this phenomenon is peculiar to money and has no analogue in the world of commodities. No claim to sheep increases the number of sheep. But a deposit, though legally only a claim to legal-tender money, serves within very wide limits the same purposes that this money itself would serve. Banks do not, of course, ‘create’ legal- tender money and still less do they ‘create’ machines. They do, however, something—it is perhaps easier to see this in the case of the issue of banknotes—which, in its economic effects, comes pretty near to creating legal-tender money and which may lead to the creation of ‘real capital’ that could not have been created without this practice.sch But this alters the analytic situation profoundly and makes it highly inadvisable to construe bank credit on the model of existing funds’ being withdrawn from previous uses by an entirely imaginary act of saving and then lent out by their owners. It is much more realistic to say that the banks ‘create credit,’ that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them. And the reason for insisting on this is that depositors should not be invested with the insignia of a role which they do not play. The theory to which economists clung so tenaciously makes them out to be savers when they neither save nor intend to do so; it attributes to them an influence on the ‘supply of credit’ which they do not have. The theory of ‘credit creation’ not only recognizes patent facts without obscuring them by artificial constructions; it also brings out the peculiar mechanism of saving and investment that is characteristic of fullfledged capitalist society and the true role of banks in capitalist evolution. With less qualification than has to be added in most cases, this theory therefore constitutes definite advance in analysis.

The return of a Housing Bubble – (4 graphs)

May 19, 2018 5 comments

from C. P. Chandrasekhar and Jayati Ghosh

Even while optimistic assessments of growth trends in the global economy proliferate, concerns that the unwinding of inflated asset price markets could abort the recovery are being expressed. Interestingly, there appears to be a substantial degree of agreement on the cause for such uncertainty, which is an excessive dependence on monetary measures in the form of quantitative easing and the associated extremely low interest rate environment to address the post-crisis recession. That lever was not the most effective from the point of view of lifting growth. While the early resort to fiscal stimuli delivered a sharp recovery, the retreat from fiscal triggers and reliance on monetary measures led to a reversal and a new normal of low growth that has lasted almost a decade.

On the other hand, the large-scale infusion of cheap liquidity that this form of intervention triggered saw increased activity in asset markets of different kinds, especially equity, bond and property markets. Two factors played a role here. First, punters of various kinds accessed cheap money to invest in assets that were expected to deliver returns significantly higher than the cost of capital. This affected bond, equity and property markets, where the sheer influx of liquidity resulted in the realization of the punters’ expectations. Second, excess liquidity triggered credit expansion, resulting in a revival of credit access even for those households which had not deleveraged fully to reduce the burden of debt accumulated prior to the crisis, which too was triggered by the last lending and borrowing spree.  Read more…

Utopia and markets

from David Ruccio


Maarten Vanden Eynde, The Invisible Hand (2015)*

We hear it all the time. On a regular basis. Having to do with pretty much everything.

Why is the price of gasoline so high? Mainstream economists respond, “it’s the market.” Or if you think you deserve a pay raise, the answer again is, “go get another offer and we’ll see if you’re worth it according to ‘the market’.”

Read more…

A short note on the production boundary of neoclassical macro models

May 18, 2018 1 comment

The neoclassical macro ‘DSGE’ models do not seem to have a rigorous model consistent ‘production boundary’.

A ‘prior’ in macro economics is the production boundary: what are we talking about? Famously, Adam Smith more or less excluded services – or at least services from personal servants. While the present national accounts  basically include everything which yields a monetary income, including illegal activities. The phrases ‘more or less’ and ‘basically’ of course indicate that delineating the boundary is not easy. Daniel Urban wrote a very clear piece about the classical boundary, the national accounts boundary, the neoclassical micro boundary (everything which yields ‘utility’, whatever that is) and the Marxian boundary (everything wich employs wage labour which produces surplus value which can be used to increase ‘capital’ or wealth of the owning class). But he does not discuss neoclassical macro models. I do not know about any serious discussion of the production boundary of these models.

Implicitly, the boundary seems to be quite narrow. Take the next phrase from a long paper by Jesus Fernandez-Villaverde, Juan Rubio-Ramirez and Frank Schorfheide  about how to solve neoclassical macro models: “Consumption is defined as Personal Consumption Expenditure on Services (PCESV) plus Personal Consumption Expenditure on nondurable goods”. One has to distill this essential information about the models from a footnote… Of course, one can argue that durable consumption goods are in fact an investment – but the whole 150+ pages piece only mentions ‘investment’ once, in the sense that the model could be enriched with ‘a non-negative investment constraint’. Which to me, also considering other models, means that durable consumer goods are excluded. And this is not the only thing excluded in most models. A list:  Read more…

Income inequality 1970 – 2015: USA and France compared

May 18, 2018 3 comments

Oh dear, oh dear, Krugman gets it so wrong, so wrong

May 17, 2018 3 comments

from Lars Syll

Economic-Model-1024x576Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time. The object of a model is to segregate the semi-permanent or relatively constant factors from those which are transitory or fluctuating so as to develop a logical way of thinking about the latter, and of understanding the time sequences to which they give rise in particular cases … Good economists are scarce because the gift for using “vigilant observation” to choose good models, although it does not require a highly specialised intellectual technique, appears to be a very rare one.

J. M. Keynes in letter to Roy Harrod (1938)

I came to think of this passage when I read “sort of  New Keynesian” economist Paul Krugman’s blog in the ongoing discussion on the state of macro. Krugman argues that even though he and other “sort of New Keynesian” macroeconomists use the same “equipment” as RBC-New-Classical-freshwater macroeconomists, he resents the allegation that they are sharing the same endeavour. Krugman writesRead more…

Capitalism doesn’t provide decent-paying jobs

from David Ruccio


The usual suspects have attacked Bernie Sanders’s proposal for the federal government to guarantee a job paying $15 an hour and health-care benefits to every American worker “who wants or needs one.”  Read more…

The return of the oil threat

May 15, 2018 2 comments

from C. P. Chandrasekhar

On the morning of April 24, the price of Brent crude, the global benchmark for oil prices, rose above $75 a barrel, touching its highest level since 2014 and signalling the return of an era of high oil prices. That is a $30 per barrel or 66 per cent rise from the previous low of around 10 months ago. As expected, this has made oil importers nervous. But, despite the benefits it would bring US shale producers, even President Donald Trump is rattled. In one more of his infamous early morning tweets he declared: “Looks like OPEC is at it again. With record amounts of Oil all over the place, including the fully loaded ships at sea, Oil prices are artificially Very High! No good and will not be accepted!”

The sharp rise in the price of oil does raise a host of questions. What explains the reversal of the late-2014 price collapse? Would the price recovery be sustained and where would it taper off? What would be the implications for economic performance of a global economy still burdened with the effect of the recession. And, why, if there is need for a sensible reason, is President Trump rattled?  Read more…

Busting the NAIRU myth

May 14, 2018 Leave a comment

from Lars Syll

Even as it became conventional wisdom, the supposed relationship between unemployment and increasing or decreasing rates of inflation was breaking down — notably in the 1990s. Unemployment got below 4 percent in 2000 without inflation taking off. Since the onset of Great Recession, the gap between theory and reality has only grown …

phillips-curve-lr-1Once we see how weak the foundations for the natural rate of unemployment are, other arguments for pursuing rates of unemployment economists once thought impossible become more clear. Wages can increase at the expense of corporate profits without causing inflation. Indeed, since 2014 we are seeing an increase in the share of the economy that goes to labor.

Even better, lower unemployment doesn’t just help workers: It can spur overall growth. As the economist J.W. Mason argues, as we approach full employment incentives emerge for greater investment in labor-saving productivity, as companies seek to keep labor costs in check as workers demand more. This productivity increase stimulates yet more growth.

The harder we push on improving output and employment, the more we learn how much we can achieve on those two fronts. That hopeful idea is the polar opposite of a natural, unalterable rate of unemployment. And it’s an idea and attitude that we need to embrace if we’re to have a shot at fully recovering from the wreckage of the Great Recession.

Mike Konczal/Vox 

Read more…

Krugman on Drugs

May 13, 2018 4 comments

from Dean Baker

I was glad to see Paul’s short post explaining some of the economics of the U.S. government negotiating drug prices with the drug companies; the route Donald Trump rejected. I thought I would add a few more points.

First, the monopoly profits earned by the drug companies provide a powerful incentive for rent-seeking. This is the standard story that economists always complain about with trade protection, except instead of talking about a tariff that raises the price of the protected item by 10 or 25 percent above the free market price, we’re talking about a government granted monopoly that typically raises the price of a factor of ten or even a hundred compared with the free market price. These markups are equivalent to tariffs of 1000 percent or 10,000 percent.

This not only encourages behavior like the payoff from Novartis to Trump lawyer Michael Cohen, it also gives drug companies an enormous incentive to misrepresent the safety and effectiveness of their drugs. We frequently hear stories of drug companies withholding evidence that their drugs are less effective than claimed or even harmful for some patients. Perhaps the most famous was the case where Merck allegedly withheld evidence that its arthritis drug, Vioxx, increases the risk of heart attack and strokes for people with heart disease. Needless to say, the costs from this sort behavior are enormous.   Read more…

Utopia and economic development

from David Ruccio


From the very beginning, the area of mainstream economics devoted to Third World development has been imbued with a utopian impulse. The basic idea has been that traditional societies need to be transformed in order to pass through the various stages of growth and, if successful, they will eventually climb the ladder of progress and achieve modern economic and social development.

Perhaps the most famous theory of the stages of growth was elaborated by Walt Whitman Rostow in 1960, as an answer to the following questions:  Read more…

On the vital importance of understanding international financial architecture

May 12, 2018 1 comment

from Asad Zaman

Part 1: Power/Knowledge – How Macro Theory is shaped by the Powerful

Why Understand Macro? If we understood macroeconomics, we would be able to understand the reasons for the major economic events currently going on all around us. For instance, increasing inequality, effects of austerity, Brexit, inequities of post-Bretton Woods dollar based financial system, impacts of emerging economy of China on global finance, and many other questions of vital importance for conduct of economic policy. Unfortunately, standard courses in Advanced Macroeconomics currently being taught at leading universities throughout the world are worse than useless for this purpose. Many leading economists have admitted that we need to replace the “entire edifice” of contemporary macro, that our leading models are strongly in conflict with everything we know about reality. For one sharp critique, see David Romer “The Trouble with Macroeconomics”, where he says that theorists completely ignore the strong disagreement between their theories and reality, and are content to build mathematical models which have no relation to the real world. Leading macro textbooks teach student how to do advanced mathematical manipulation, but teach nothing about the events going on around us, which is why economists were taken by complete surprise when the Global Financial Crisis occurred. According to all the macro models in use then (and which continue to be used today) such an event was impossible.

Textbooks teach Myths About Macro: It is not just that what is taught in the textbooks is irrelevant. It is actually misleading, and we can argue that it is deliberately so. Learning the truth about how the economy works would be harmful to the rich and powerful who benefit enormously from the myths that are taught in modern macroeconomics textbooks, and widely believed throughout the world. Many, many myths taught as realities could be listed, but perhaps the central one among them is the “Neutrality of Money”. According to this widely believed myth, money plays no important role in the economy, except to affect the price level. If we double the quantity of money, the prices will be double and there will be no other effects on the real economy. In other words, “money is a veil” and we have to see through this veil in order to understand the workings of the real economy.

Suppression of Keynesian Knowledge: read more 

Textbooks — peddling lies about money and finance

May 11, 2018 3 comments

from Lars Syll

slide_6A couple of years ago — in a debatewith James Galbraith and Willem Buiter — Paul Krugman made it perfectly clear that he was a strong believer of the ‘loanable funds’ theory.

Unfortunately, this is not an exception among ‘New Keynesian’ economists.

Neglecting anything resembling a real-world finance system, Greg Mankiw — in his intermediate textbook Macroeconomics — more or less equates finance to the neoclassical thought-construction of a ‘market for loanable funds.’

On the subject of financial crises, he admits that

perhaps we should view speculative excess and its ramifications as an inherent feature of market economies … but preventing them entirely may be too much to ask given our current knowledge.

This is, of course, self-evident for all of us who understand that genuine uncertainty makes any such hopes totally unfounded. But it’s rather odd to read this in a book that bases its models on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium – assumptions that convey the view that markets – give or take a few rigidities and menu costs – are efficient! For being one of many neoclassical economists so proud of their consistent models, Mankiw here certainly is flagrantly inconsistent!  Read more…

WEA Commentaries – new issue

May 10, 2018 Leave a comment

Download the issue as a PDF

In this issue
Game Theory—A Severe Case of ‘as-if’ Model Platonism
     Lars Syll
Utopia and Macroeconomics
     David Ruccio
A Better Way for Development Theory and Practice
     Habtamu Girma Demiessie
On Kurien’s new book, Economics of Real-Life
     Stuart Birks
Economics Education and Pedagogy
     Malgorzata Dereniowska interviews Peter Söderbaum

Announcements and WEA contact details

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Debunking the NAIRU hoax

May 10, 2018 7 comments

from Lars Syll

powemp3In our extended NAIRU model, labor productivity growth is included in the wage bargaining process … The logical consequence of this broadening of the theoretical canvas has been that the NAIRU becomes endogenous itself and ceases to be an attractor — Milton Friedman’s natural, stable and timeless equilibrium point from which the system cannot permanently deviate. In our model, a deviation from the initial equilibrium affects not only wages and prices (keeping the rest of the system unchanged) but also demand, technology, workers’ motivation, and work intensity; as a result, productivity growth and ultimately equilibrium unemployment will change. There is in other words, nothing natural or inescapable about equilibrium unemployment, as is Friedman’s presumption, following Wicksell; rather, the NAIRU is a social construct, fluctuating in response to fiscal and monetary policies and labor market interventions. Its ephemeral (rather than structural) nature may explain why the best economists working on the NAIRU have persistently failed to agree on how high the NAIRU actually is and how to estimate it.

Servaas Storm & C. W. M. Naastepad

Many politicians and economists subscribe to the NAIRU story and its policy implication that attempts to promote full employment is doomed to fail​ since governments and central banks can not push unemployment below the critical NAIRU threshold without causing harmful runaway inflation.  Read more…

Their beautiful recovery

from David Ruccio


Does anyone really need any additional evidence of the lopsided nature of the current recovery?  Read more…

Cheap fun with the stock market, arithmetic and CEO pay

May 8, 2018 1 comment

from Dean Baker

Everyone with a 401(k) has been impressed by the stock market’s run-up in recent years. Even adjusting for inflation, the S&P 500 is more than 20 percent higher than its peak in the 1990 stock bubble. Of course, the economy is nearly 40 percent larger, which makes the run-up somewhat less striking.

Nonetheless, the ratio of stock prices to corporate earnings is at unusually high levels. According to data from Nobel Laureate and economist Robert Shiller, the current ratio of the S&P 500 to corporate earnings is close to 25. That compares to a long-term average of less than 15.

The reason this matters is that as the price-to-earnings ratio rises, the dividend yield falls. Forty years ago, the dividend yield was well over 4.0 percent. It currently is just over 1.8 percent. This means that more of the return from stock depends on a rise in the stock price.

But if stocks rise just in step with the economy and profit growth (this assumes no further rise in profit shares), then capital gains are not going to be offsetting a weak dividend yield. Using the projections from the Congressional Budget Office (CBO), GDP is expected to grow at less than a 2.0 percent annual rate over the next decade. Add in a 1.8 percent dividend yield, and shareholders are looking at a real return of less than 3.8 percent.  Read more…

DSGE models in the ‘New Keynesian’ repair shop

May 8, 2018 7 comments

from Lars Syll

The problem of the DSGE-models (and more generally of rational expectations macroeconomic models) is that they assume extraordinary cognitive capabilities of individual agents. Recent developments in other disciplines including psychology and brain science overwhelmingly document that individual agents struggle with limited cognitive abilities, restricting their capacity to understand the world. As a result, individual agents use small bits of information and simple rules to guide their behavior.

aa-model-train-repair-584x300The fact that the assumption of rational expectations is implausible does not necessarily mean that models using such an assumption cannot be powerful tools in making empirical predictions. The problem, however, is that rational expectations macroeconomic model make systematically wrong predictions, in particular about the speed with which prices adjust. This empirical failure could have led the profession of macroeconomists to drop the model and to look for another one. Instead, macroeconomists decided to stick to the rational expectations model but to load it with a series of ad-hoc repairs that were motivated by a desire to improve its fit. These repair operations most often involved adding lags to the models so as to create sufficient inertia in variables. These repair operations most often involved adding lags to the models so as to create sufficient inertia in variables. These operations were successful in the sense that the fit was significantly improved. In another sense, however, they were failures because the inertia building tricks are really departures from rationality. As a result, the present DSGE-models create a dynamics the largest part of which is the result of the ad-hoc repair operations. These have nothing to do with optimizing behavior and rationality of expectations. In a way it can be said that these ad-hoc repairs introduced heuristics in the model through the back door.

The success of the DSGE-model has much to do with the story it tells about how the macroeconomy functions. This is a story in which rationality of superbly informed and identical agents reigns … We have questioned this story by presenting an alternative one. This is a story in which agents do not understand the model well, and use a trial and error learning strategy to discover its underlying logic …

Read more…