Annotated links and updates. Flawed (neoclassical) models and flawed (neoclassical) metrics edition.
1) The lack of empirical discipline of ‘micro-founded’ models. Simon Wren-Lewis has an interesting post about the difficulty of reconciling ‘micro founded’ models with data on consumption. But the problem runs a lot deeper than Wren-Lewis thinks. ‘Micro founded’ does not mean ‘founded upon micro relations and data’ but ‘applying the outdated and refuted neoclassical model of the consumer to an entire country, as if this country was an individual being’. Indeed, pretty weird, but when you do this, you have to be consistent and coherent and change your micro definition of consumption. On the (real) micro level, individual consumption (defined as purchases) can be explained by income, availability of credit, consumer confidence (which we do measure) and wealth of a household or individual.
On the macro level, this is more complicated as consumption of households does not only consist of purchases of households but also of ‘government financed consumption’ like, in the UK, most of health care. Somehow, the model used has to account for this. New-Keynesian models try to ‘solve’ this problem by assuming that all government expenditure is ‘wasteful’. Which isn’t the case, of course. Also, the boundary between household purchases and government financed consumption changes all the time. Examples are the building of the USA interstate system way back, or more recently, increasing fees for public higher education in the UK. This means that consumption private consumption suddenly increases or decreases whenever this boundary changes, which is of course an inconsistent approach to consumption (statisticians solve this problem by using the concept of Actual Individual Consumption, look here). The remarkable thing: the assumption of wasteful government expenditure is, in Neo-Keynesian models, not a necessary assumption. Look here for an article by Kuehn, Muysken and Veen with a New Keynesian model which allows ‘useful’ government expenditure which seems to explain the data much better than the models mentioned by Wren-Lewis. The ‘wasteful’ assumption of course highlights the ideological nature of these models. But the point: unless the concept of consumption used is adapted to the concepts of the models (or the other way around) – the models are essentially explaining nothing. Please, let us be consistent and coherent in our reasoning and put some order and discipline to our thinking, instead of using the ad-hoc micro founded models!
2) A very stupid spanish price metric. Spain has introduced a new price metric which, as I understand it, has to play a pivotal role in wage negotiations. And it is sooooo stupid. It’s called ‘the ‘competitiveness guarantee index’ (auch):
The index establishes a rate of review of prices consistent with the recovery of competitiveness in the Eurozone. This rate will be the same as that of the Harmonized Index of Consumer Prices (HICP) of the UEM minus a part of the loss of competitiveness accumulated by Spain since 1999. When the variation rate of this index stands below 0 per cent, this value will be taken as reference, which will equal the application of the rule of no revision. When the variation rate of this index surpasses the ECB short-term annual inflation objective (2 per cent), this value will be taken as reference. This way, we ensure that contracts to which this new index is applied contribute to guarantee the maintenance of short-term economic competitiveness.
Wage increases based upon this official government index will, i.e., be between 0 and 2% but when you do the arithmetic (and use the assumption that Euro Area inflation will be pretty low) it shows that they will be 0% for quite some time to come. The whole idea that productivity can increase, which means that 2,5% increases of wages might result in 1,5% inflation, is left aside. And 0% wage increases in tandem with productivity increases will lead to quite some deflationary pressure. I, for one, am not too afraid for moderate deflation, provided that nominal wages do not decrease. But in a Eurozone country like Spain with no monetary sovereignty, high levels of non performing loans and a rapidly increasing government deficit even moderate deflation will lead to large debt deflation problems. Aside from this, it is pretty daft to use the consumer price index as a robust indicator of the price level of the economy. The graph shows that there has been quite a bit of deflation already, especially of fixed investment prices which is of course caused by the housing bust.
But this deflationary decline already did lead to a large decline of tax receipts for the state and a very significant deterioration of the balance sheets of companies and households: Spain is a financially wounded country and this wound is inflicted by: deflation (and of course the preceding boom and the run up in debts). The same holds to a lesser extent for the price level of government consumption (mainly wages of government employees). Also, while lower wages for teachers might not improve the competititive position of Spain, lower costs for construction do. Spain i.e. tries to solve a problem which, to an extent, never existed (exports of Spanish companies did not do too bad, before 2008!) and which to an extent already has been solved. It also reneges on the best way to do go ahead (increase productivity) and runs the risk of invoking a bout of totally unnecessary debt deflation by using this flawed ‘Kindergarten’ metric, based upon totally uninformed ideas about a modern economy.