The Clash of Economic Ideas (part 2)

May 15, 2013

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Chapter 5 of Lawrence White’s book is devoted to “The Great Depression and Keynes’s General Theory.” I will also incorporate some ideas from later chapters that are relevant to Keynesian economics.

Keynes and Hayek disagreed fundamentally over the ability of the market economy to sustain full employment and economic growth without deliberate government stimulus. Hayek believed that the income generated by economic production would automatically stimulate further production, because the income would either support consumption or new investment. Either consumer goods or capital goods would be produced. Keynes, on the other hand, did not believe that income that people saved rather than consumed would necessarily support new investment. An increase in what he called the “propensity to save” might just reduce consumption without increasing investment, resulting in a lack of “aggregate demand” and a reduction in production and employment. Some Keynesians would say that a big reason for an excess of saving and a lack of demand is an income distribution favoring rich savers over lower-income spenders, but that argument was not essential to Keynes’s original theory. His point was simply that production didn’t necessarily create the demand needed to generate further production.

Keynes understood the Great Depression as a vicious circle of low demand and low production, with no short-run market solution. Hayek saw economic slumps as self-correcting as long as central banks properly managed the money supply. “Despite the reservations and objections of orthodox (often older) economists, Keynes’s theory quickly caught on among younger economists and completely eclipsed Hayek’s theory.” Keynesian theory dominated economic thought in Great Britain and the United States until the 1970s.

According to Keynesian economics, government spending in excess of taxes could increase aggregate demand and stimulate the economy. Only if the economy were already operating at full employment would that spending merely replace other kinds of spending with no net gain in aggregate demand and national output. At less than full employment, government spending would lead to a net gain in GDP (the size of which could be expressed by the “multiplier” ΔY/ΔG–the ratio of the change in GDP to the change in government spending). Keynesians rejected the classical economic view that running a deficit is as foolish for a nation as it is for a household. Otto Eckstein argued that a national debt is different from a household debt because “we owe it to ourselves.” In theory, we can repay it out of the larger income that deficit spending generates. This argument was more convincing before other countries began financing a large portion of our debt.

Critics of Keynesian economics such as James M. Buchanan argued that government spending had to burden either current or future taxpayers, and that the theory encouraged fiscal irresponsibility: “Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian messages, politicians can spend and spend without the apparent necessity to tax.”

Keynesian economist Paul Samuelson provided an additional rationale for government spending in his theory of “public goods.” As described by White, “the theory…views government as a faithful agent hired by the citizenry to provide desired goods and services having characteristics such that the market economy provides too little of them.” This elaborated on an idea already present in the writings of classical and neoclassical economists. Private entrepreneurs may not find it in their self-interest to produce something even if the public values it enough to pay for it. For example, they may not be able to make a profit financing basic research or general intellectual activity (as opposed to applied research to develop specific products), and yet the public may well wish to finance universities with their tax dollars. The problem for the entrepreneur is to “capture all of the potential gains from production and trade,” which is hard to do for ideas that spread freely. The failure to do so is a type of market failure known as a “Pareto inefficiency,” named for the Italian economic Vilfredo Pareto. Arthur Pigou related the problem to the concept of externality discussed in the previous post. Just as markets sometimes reward individuals for doing things that have negative externalities (social costs), they also fail to reward individuals for doing things that have positive externalities (social benefits). Public goods theory says that the government has a responsibility to discourage the first type of behavior and promote the second.

Critics of public goods theory have tried to show how goods and services that are commonly regarded as public could conceivably be provided by markets under the right conditions. In 1960, Ronald Coase argued that externality problems are often property rights problems, and the solution is often to expand the rights of producers to make sure they profit from socially useful activity. In the classic case he studied, radio broadcasting could become a profitable activity only when broadcasters owned the frequencies on which they broadcast so they were free of interference. The argument can be extended to justify many forms of privatization. On the other hand, some goods seem irrevocably public. Maintaining a favorable global climate requires public action, since no business can own the climate enough to have a profit motive to protect it.

Non-Keynesian economists, especially James M. Buchanan and Gordon Tullock, have tried to counter public goods theory with “public choice” theory. It questions the very idea that government spending can work for the benefit of all. What is more likely to happen is that:

 …[I]ndividuals can use the powers of government for special-interest programs, or “rent-seeking,” gaining benefits for some at the expense of others….On an issue where the taxpaying majority is poorly organized, a well-organized special interest group may use plausible arguments (and campaign contributions) to persuade legislators to grant it monopolistic privileges or to tax the general public for the group’s benefit.

This is reminiscent of Adam Smith’s criticism of mercantilist government, favoring some economic interests over others instead of letting the market decide what’s best. Of course, a public goods theorist would question the assumption that what is most profitable is really best for society.

White concludes his treatment of public choice theory with the observation, “By rebuilding the intellectual case for the limited-government constitutionalism of the American founders, Buchanan and Tullock might today be called patron saints of the constitutionalist wing of the Tea Party movement.” This remark dramatizes the close association between economics and politics. Is the Tea Party trying to restore limited government and economic freedom, or is it trying to render government too impotent to stand up to powerful private interests and carry out needed economic reforms?


The Leaderless Economy

February 1, 2013

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Peter Temin and David Vines. The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press, 2013)

This is a work of both Keynesian macroeconomic theory and economic history, emphasizing the connections between the internal workings of national economies and the external relations among them in the global economy. “Economic theory provides a framework for understanding the relations between internal and external balances, and economic history shows the context in which these relations assume importance.” Since the book is directed at noneconomists as well as economists, the authors seem to assume that readers want more history than theory. They refrain from discussing their economic models very directly, providing only a sketchy introduction in the first chapter and then a somewhat more logical presentation in the Appendix. I would have preferred they explain their models more fully at the outset. As it is, they tell the story of “The British Century and the Great Depression” in Ch. 2, and then describe Keynes’s evolution as a theorist and a policymaker in Ch. 3, before going on to “The American Century and the Global Financial Crisis” in Ch. 4. Given the wealth of historical detail, the reader is hard-pressed to understand the events described without yet having a firm grasp of the theory that’s supposed to explain them!

For that reason, I will attempt to describe the economic models first, and then rely on them to illuminate the economic developments.

Temin and Vines summarize their perspective this way: “The aim of policy in a well-managed economy must be to ensure both external balance–which requires that exports are sufficient to pay for imports–and internal balance–which requires that resources be fully utilized. It is clear that to achieve both objectives at the same time requires a difficult balancing act.” Economists have long seen economic processes as balancing acts, especially the reconciling of supply and demand in a particular market through a pricing mechanism. The British economist John Maynard Keynes made great advances in understanding balancing processes involving two markets at once. This is the tradition the authors draw on to understand the connections between domestic and international markets.

Temin and Vines present two models of bi-market relationships in the Appendix, both of which derive from the work of Keynes, as interpreted and developed by James Meade.

The Hicks IS/LM Model

This model describes the simultaneous balancing of supply and demand in two markets within the same economy, the market for goods and the market for money.

The market for goods is balanced when the supply (Gross Domestic Product) is equal to all the forms of demand: Consumption, Investment, Government Spending and Net Exports. GDP is also equivalent to national income, and the forms of demand can be thought of as allocations of income.

In the Hicks model, the balance of supply and demand is expressed as the balance of Savings and Investment. That works because some income is saved rather than spent on consumption, government or imports, and the same amount must show up as investment in order for the supply-demand equation to balance.

The second market, the market for money, is balanced when the Real Money Supply equals the Liquidity Preference (the demand for cash). Liquidity preference includes the demand for cash for transactions as well as the demand for cash savings. Liquidity preference is closely tied to the Interest Rate (the price of money). The demand for cash pushes interest rates up, but on the other hand, high interest rates encourage people to lend money rather than keeping it in cash.

A change within either market triggers balancing processes in both markets. The possible system states are displayed in a graph with GDP on the horizontal axis and Interest Rate on the vertical axis. A change in either variable creates a new point of “general equilibrium,” the point at which supply would balance demand in both markets simultaneously. The relationships between the two variables are described by two curves, the LM curve and the IS curve, and the point of equilibrium is where they cross.

The Liquidity Preference-Money Supply (LM) Curve describes a direct relationship between GDP and Interest rate. The higher the GDP, the higher the interest rate needed to balance the supply and demand of money. A higher GDP increases the demand for money for transactions, putting upward pressure on the interest rate. But rising interest rates reduce the speculative demand for money; the desire to keep savings in cash declines because of the high interest available to lenders. So a change in GDP results in a new equilibrium in the money market, where money demand once again equals money supply, but cash for spending has increased relative to cash for lending, other things being equal (money supply assumed to be unchanged).

The Investment-Savings (IS) Curve describes an inverse relationship between Interest Rate and GDP. The higher the interest rate, the lower the level of production at which demand balances supply. Higher interest rates discourage people from borrowing in order to spend on either capital or consumer goods. The economy contracts and a new equilibrium is established at a lower level of both supply and demand. Similarly, lower interest rates encourage borrowing, spending, and a higher level of supply and demand.

The point at which the two curves cross is the point of general equilibrium. Other points represent situations of excess supply or demand in either the goods market or the money market, or both.

How can there be two different relationships—one direct and one inverse—between the same two variables, GDP and Interest Rate? Think of it like the relationship between a predator and its prey, such as foxes and rabbits. A larger rabbit population can support a larger fox population (direct relationship), but a larger fox population trims the rabbit population (inverse relationship). The result is a balance of nature in which neither population can become too large relative to the other. Similarly, rising interest rates both result from GDP growth and place limits on it.

That doesn’t mean that the economy tends toward a steady state, however. The equilibrium can be a moving equilibrium, where variables remain in some balance while moving together. In a growing economy, supply and demand can increase together in both the goods market and the money market. GDP and national income grow, but interest rates can remain stable if the increasing demand for money is offset by a steadily increasing money supply. For that to happen, however, the markets for goods and money must sustain a delicate mutual balancing act. Since some of the growth in income is saved rather than spent, growth in the aggregate demand for goods requires increases in investment as well as consumption.  (Recall that Savings must equal Investment for supply and demand to balance.) But GDP growth encourages higher interest rates because of the increasing demand for money, and high interest rates discourage borrowing for investment and consumption. So economic growth requires the money supply to increase just fast enough to balance GDP growth and money demand; if not, the GDP growth won’t be sustained and the economy will have to contract. On the other hand, if money supply outruns GDP growth, interest rates fall, consumers borrow and spend too freely, and that results in inflation. A delicate mutual balancing act indeed!

The Hicks model helps clarify the role of government, which is a central feature of Keynesian economics. If the economy were self-regulating and always near general equilibrium, there wouldn’t be much for government to do, except balance the budget and slowly increase the money supply to accommodate growth. Increasing government spending would just raise interest rates, discouraging producers and consumers from borrowing and spending. (This is the basis for the old idea, criticized by Keynes, that government spending just crowds out private investment.) And increasing the money supply too quickly would just be inflationary (too many dollars chasing too few goods). But Keynes was interested in policies to repair economies that are not in equilibrium. If the economy is in recession, with interest rates too high, money too tight and aggregate demand insufficient to absorb productive capacity, a more expansionary fiscal policy or looser monetary policy may provide needed stimulus. Writing during the Great Depression, Keynes was well aware that economies could get seriously out of balance, and that public policy made a difference for better or for worse.

The Swan IB/EB Model

This model relates internal balancing within the domestic market for goods to external balancing of imports and exports in international trade. It is the model most directly relevant to the authors’ discussion of the global economic crisis.

As in the Hicks model, the internal goods market is balanced when demand matches productive capacity, maintaining full employment without inflation. The external goods market is balanced when exports are just large enough to pay for imports, with neither a trade surplus nor a deficit.

Once again, a change within either market triggers balancing processes in both markets. Graphic presentations differ, but the Temin and Vines version plots Domestic Demand on the horizontal axis and Real Exchange Rate on the vertical axis. (Since at equilibrium output equals demand, it is not a big change to plot Domestic Demand where GDP was in the Hicks model. It’s still equal to Consumption, Investment, Government Spending, and Net Exports.) The Real Exchange Rate is the price of the country’s currency on world markets. (Technically that is the nominal–stated–rate of exchange adjusted for the ratio of domestic prices to foreign prices, since either a higher nominal rate of exchange or higher domestic prices make a country’s goods more expensive on world markets.) The exchange rate is inversely related to global competitiveness, since a high exchange rate makes it harder to sell goods abroad.

The Internal Balance (IB) Curve describes a direct relationship between Domestic Demand and Real Exchange Rate. The higher the domestic demand, the higher the exchange rate at which demand will balance supply. Higher domestic demand tends to push up prices, making the real exchange rate higher even if the nominal rate remains the same. The nominal rate would also go up if a lot of the demand is coming from foreign buyers, pushing up net exports and the price of the currency foreigners need to buy them. But a higher exchange rate makes exports more expensive and imports cheaper, which brings the demand for domestic goods back down toward supply.

The External Balance (EB) Curve describes an inverse relationship between Real Exchange Rate and Domestic Demand. The higher the real exchange rate, the lower the level of domestic demand at which imports will balance exports. At equilibrium, the income earned from exports provides the means to buy imports. If a country’s currency is very strong (high exchange rate), that encourages a trade deficit by making exports expensive and imports cheap. But that trade deficit lowers the national income, depressing the demand for imports. Lower demand offsets the higher exchange rate and restores the balance of trade.

Once again, the point of general equilibrium is the point at which the two curves cross. In this graphic presentation, points to the right of the upwardly sloping IB curve represent inflation, and to the left unemployment. Points above the downwardly sloping EB curve represent trade deficit, and points below the curve represent surplus. The one point that is on both curves is the equilibrium.

In the Hicks model of internal markets, GDP growth stimulates a higher interest rate, which in turn limits GDP growth. In the Swan model of internal and external markets, domestic demand stimulates a higher exchange rate for the domestic currency, which in turn limits domestic demand. That doesn’t mean that demand for a country’s products can’t grow at all; it just means that growth is constrained by certain “other things being equal” conditions, in this case the success of competing economies in creating demand for their products. If all countries are increasing their production of desirable goods by the same amount, demand can rise everywhere and exchange rates don’t have to change to anyone’s disadvantage.

Now consider two trading partners, one whose goods are more in demand than the other. The one whose goods are more in demand is a net exporter with a trade surplus, and the other is a net importer with a trade deficit. The balancing processes should go like this: High demand for the exporter’s goods should increase its real exchange rate, making its exports more expensive and bringing the demand back down. In the other country, low demand for its goods should reduce its real exchange rate, making its exports cheaper and bringing demand up. Where exchange rates are free to adjust, trade imbalances should be self-limiting.

However, countries often resist adjustments to exchange rates. Some countries, like China, deliberately maintain a cheap currency to make it easy for other countries to buy their exports. Other countries, like the US, enjoy the buying power that a strong currency provides. And countries in the European Monetary Union share a common currency whose exchange rate may be set too high or too low for the economic health of a particular member state. In theory, real exchange rates can change through price inflation or deflation, even if nominal rates remain the same, but those changes may not be welcome either. Wage or price cuts that would make American goods more competitive may be resisted by labor or business.

Without appropriate currency adjustments, trade imbalances may persist, turning a net importer into a debtor nation and a net exporter into a creditor nation. Temin and Vines are especially interested in how these persistent external imbalances affect the internal balancing acts of nations, often resulting in economic crises. How would a country with a persistent trade deficit maintain internal balance, that is, full employment without inflation? How would it keep its industries operating at full capacity if foreigners aren’t buying its goods and its own citizens are buying a lot of imports? It could offset the low global demand for its products by increasing other components of aggregate demand. It could direct a larger proportion of its national income toward spending rather than saving. Its consumers could buy domestic as well as foreign goods by saving less, borrowing more and spending more. Government could encourage consumer spending by cutting taxes and holding interest rates low, as well as by keeping its own spending in excess of government revenue. Foreign saving and lending could help finance borrowing by consumers and government, as well as provide investment capital to compensate for the low rate of domestic saving. In this way, a debtor nation could grow its economy for a time. But when economic growth based on increasing indebtedness proved unsustainable, a severe contraction would occur. (Does any of this sound familiar?)

Temin and Vines argue that internal balance and external balance must be considered together. The story they tell about the global economy is largely a story of international trade imbalances perpetuated by unwise policy responses, which greatly complicate and ultimately overwhelm efforts to maintain balanced economies running at full capacity. I think that their perspective adds an important dimension to discussions of the recent financial crisis.