Well, three weeks into the Obama administration and we are getting a real lesson in the two major alternative approaches to macroeconomic analysis that exist within the profession of economics today. The first approach, generally favored by those supporting President Obama, is Keynesian in nature. The second approach, generally favored by those not supporting President Obama, but not necessarily Conservative in their leanings, nor do these people necessarily believe that they are of the Republican Party, tend to work with a different model of the macroeconomy.
The Keynesian approach, developed in the post-World War I era, contends there is a problem in how the macroeconomy works itself out if there is insufficient demand coming from the private sector. This initiating factor in this model is that business expectations about the future drop off considerably…there is a decline in “animal spirits”…and as a consequence investment expenditures collapse. The normal response to this when the economy has not fallen apart is to have the monetary authorities lower interest rates and this action will stimulate investment demand and re-charge the economy.
The problem with this is that when “animal spirits” really collapse and there seems to be a cumulative downward movement in the economy, the monetary authorities cannot stimulate business investment expenditures so that the central bank cannot stop and reverse the downward spiral. Keynes suggested that in such situations the only possible vehicle to stop the cumulative collapse is for the government to come into the picture and substitute government expenditures for the business expenditures that have gone away.
The government can either finance these expenditures by printing money or issuing debt. The idea here is that this spending, even if financed by printing money, will not have an impact on prices (inflation) because of the un-used resources in the economy. That is, the government expenditures will just pick up the slack in demand and then through the multiplier effect created by increasing incomes and consumption expenditures, aggregate economic activity will pick up.
The major question here is about the size of the multiplier. There is much speculation on this, but the figure most people feel that people in the Obama administration are using is 1.5. That is, if the stimulus bill totals about $850 billion, then the total impact on the economy of this program will be $1.275 trillion…a hefty boost to aggregate economic activity.
There are several attacks on this way of thinking that lead us into the conclusions presented by the second approach under review. The first one is that the Keynesian approach, as described above, does not take into account that Keynes constructed his model in a period in which international capital flows were severely limit. Thus, what was done in a sovereign country generally stayed in that country.
The international financial system broke down during World War I…this was the old gold standard system. Keynes fought hard at the Paris Peace Conference which followed the war for fixed currency exchange rates between countries and limited international flows of capital. One of the things that Keynes was most worried about was the Russian Revolution and the spread of the ideas connected with the uprising of the workers and the leadership of the Proletariat. This seemed to be a worldwide concern that lasted in the mid-thirties. The worst fears of many, many people were that economic collapse or depression would result in a movement in which the workers took over.
Economic nationalism was designed to prevent such an occurrence. Fixed exchange rates, restricted international capital flows, and protective tariffs were designed to achieve this result. This was why Keynes wanted countries to be independent of one another so that those that wanted to could follow they own stimulus program without having to worry about currency depreciation or an international loss of capital. His stimulus programs were designed to work in such a country.
This is not the world that we find ourselves…we have floating exchange rates…we have relatively open world capital markets and a free flow of capital to almost anywhere…and in recent years there has been great efforts to promote and expand free trade. The government expenditures promoted by those that support the Keynesian approach have not accounted for the difference between the construction of the world in the 1930s and the construction of the world in the 2000s. The modern argument is that the spending of the government will just be dissipated through open world markets and capital flows and will not be able to achieve the level of stimulus they hope for.
Furthermore, the Keynesian effort will just increase…by substantial amounts…the amount of debt that exists within the world. As I have reported in recent posts, Niall Ferguson has claimed that the proposals of these “born-again” Keynesians are treating a situation where too much debt exists by adding on major amounts of new debt. Or, in other words these proposals are attempting to solve the problem of too much leverage in the system by adding on more leverage. Ferguson, as reported, does not believe that this will work.
In terms of the alternative economic model we find two major editorials published in recent days that lay out some of the concerns of this other school of thought. These are the articles by Robert Barro, “Government Spending is No Free Lunch,” WSJ on January 22, 2009, (http://online.wsj.com/article/SB123258618204604599.html), and Gary Becker and Kevin Murphy, “There’s No Stimulus Free Lunch,” WSJ on February 10, 2009, (http://online.wsj.com/article/SB123423402552366409.html?mod=todays_us_opinion). They are not too optimistic that the Obama stimulus plan will be very effective.
This school of thought emphasizes more the supply side of the economy and is concerned that the appropriate incentives are set up. For one, both articles contend that the multiplier is substantially below 1.0…I have used 0.4 in my writing. If the multiplier is 0.4 then the $850 billion in government spending will only produce approximately $340 billion in additional output…not much bang for the buck. The reason why is that the spending part of the program will draw resources away from other, private spending so there will not be the add-on effect, but a substitution effect in which resources that would have been used in other areas of the economy are now drawn to these areas. In terms of tax cuts, they argue that the way the tax cuts are structured the additional funds available to consumers will go into savings or a “rainy day” fund to protect against future economic difficulties. Thus, in neither effort is the government getting much for its spending.
In terms of the “right” incentives, Barro would like to see a reduction or elimination of the corporate income tax. In this way Barro believes that the incentives would be right for businesses to spend and put resources to work for they would be getting that extra boost from the lower or non-existent tax rates. In this way the supply side of the economy is stimulated…which Barro contends will be much more effective than the spending and tax-reduction programs that have been proposed.
The differences are great and they are now starting to get full exposure. We will talk more about these in the future.
Showing posts with label Keynes. Show all posts
Showing posts with label Keynes. Show all posts
Tuesday, February 10, 2009
Saturday, February 7, 2009
Government and "Economic Shocks"
Elected officials, in general, have two fundamental incentives; the first is to get elected or re-elected; and the second is to do some good. The first is very straightforward and easily understandable. The second…well, the second creates a question…do some good…for whom? Generally, this question can be answered by saying that “for whom?” refers to people that will elect the officials…or will re-elect them.
Elected officials are often asked to behave in ways that reflect the common good…that ignore total self-interest. But, the very cynical argue that you can count on one hand the number of times that an elected official acted in ways that were solely for the good of all and did not reflect just self-interest. Others would argue that the number is larger than that…but to understand the elected official you must not ignore the fact that his or her position depends upon them acting in their own self-interest.
If a subset of the electorate elects an official, they do so on the expectation that the official will represent them and support their interests. If the official does not represent the subset’s interest to the degree that they expect the official to…then they have incentive to support another candidate. So, elected officials really only have one incentive in running for office…to get elected or to get re-elected.
The point here is that elected officials may have incentives that are different from the incentives that exist within the economic system. For example, if economic growth is slowing down…elected officials or those appointed by elected officials may have an incentive to stimulate the economy and increase employment if an election is near at hand. If elected officials or those appointed by elected officials express concern that the stock market may collapse, they may try and keep interest rates extremely low in order to avoid a stock market correction or a readjustment to a more realistic level. If elected officials or those appointed by elected officials believe that every American…or almost every American…should own a home, they will create and support programs that encourage such a result.
Every one of these efforts…and many more like them…can be traced back to efforts to get elected officials re-elected…and they are all aimed at a “good” thing…or a “good” cause. No one can disagree with the basic attempt by the elected officials or those appointed people.
Each of these efforts, however, is what the economist would call a “shock” to the economic system. Each of these efforts represents a response to a different set of incentives than those that exist within the functioning of markets and relationships in the economic system, itself. Economic models attempt to separate out the different factors that are at work within an economic system. Factors that do not respond to the regular incentives that exist within the economic system are called “exogenous” variables and changes in these variables are introduced independently of the system. Other variables that respond to the incentives that exist within the system, both those created by other non-exogenous variables as well as to the incentives created by the exogenous variables are called “endogenous” variables.
The importance of this distinction is that many of the “shocks” that an economic system receives is of the “exogenous” variety and are introduced into the economy for reasons other than allowing the economic system to work out all the incentives and dis-incentives that currently exist. In effect, these “exogenous” shocks are often aimed at preventing the economic system to work itself out in the direction it is going. And, as stated above, many of these interventions are for the “good” of the economy or for the “good” of, at least, some of the people in the economy.
The fact of the matter is that we don’t really have good theory to examine how these “exogenous” shocks come about. If we did, obviously, then they could be incorporated into the economic model and would become “endogenous” variables. Therefore, these “exogenous” shocks…government decisions…must stay exogenous and be introduced as they happen or are expected to happen.
Economics is a study of human behavior. Therefore, the predictions that come from economic models are going to be highly imprecise. Economic models are all incomplete and fallible. We just can’t do better than that when dealing with human behavior. Some situations lend themselves to more consistent behavior that allow for the making of better predictions…but other situations…like government decision making…are not systematic and so are almost impossible to model. And, we are finding out through the research in areas such as behavioral economics and behavioral finance that some situations that were, in the past, assumed to be fairly regular, are not that regular and need to be modeled with much less confidence about the accuracy of their predictions.
The name of John Maynard Keynes has surfaced a lot these days…and I am going to refer back to something that he wrote that, I believe, pertains to this very issue. In his commentary of the great economist Alfred Marshall after the great man died, Keynes discusses what makes an exceptional economist. In terms of Marshall, Keynes remarked that he was very learned in history. And then Keynes followed up on this by saying that anyone that wanted to be a top level economist needed to incorporate history into his or her explanation of how things worked. And, Keynes did not mean by history, incorporating a huge amount of statistical data into the model building process. Keynes was referring to the need to understand specific individuals and how those individuals made decision…how they were affected by their time…and how they were affected by their own experience and upbringing. He concluded that good economics required a good knowledge of history and biography…not something that is often taught in Ph. D. programs in economics or finance.
The point of this post is that in the policy making issues that government has to deal with we cannot just rely on assumptions of completely self-correcting free market economic systems where the incentives generated within the system are sufficient to work themselves out in a deterministic fashion. These systems will be continuously impacted by “exogenous” shocks that will bump the system one way or another, preventing the system from working itself out into a “new equilibrium” where everything is OK. These systems…for better or for worse…will be buffeted by these “exogenous” shocks and this will mean that we, in order to understand what is happening or what has happened, will need to introduce history and biography into the analysis we are going through. That is…economics cannot stand alone and provide all the answers.
This leads us into the position that we can…and must…look for bumps and shifts in the economy that are caused by governmental interference…usually with good intentions…and see how the government changes incentives…and how these changed incentives can divert the economy from one path onto another.
A good example of this comes in situations that create what economists call “moral hazard”…actions that lead people to do perverse things that they would not do under other circumstances. For example, people have to take risks in what they do…starting a business, buying a home, investing in securities, and so on. If a situation arises in which the people that have done one or more of these things get into dire straights…that is, they may face foreclosure or bankruptcy…elected officials can decide…for good reason…to protect them in some way. This presents a situation of “moral hazard” because those people that get protected may, in the future, decide to take on even higher levels of risk and make the economic or financial system more fragile. One can applaud of condemn actions that create “moral hazard” but it is a judgment decision. The elected officials must make a decision relating to the trade off between avoiding a bad situation now…protecting the people who have gotten in trouble…versus not protecting the people now and facing a economic or financial catastrophe. Where you set the tradeoff is a personal decision.
Elected officials are often asked to behave in ways that reflect the common good…that ignore total self-interest. But, the very cynical argue that you can count on one hand the number of times that an elected official acted in ways that were solely for the good of all and did not reflect just self-interest. Others would argue that the number is larger than that…but to understand the elected official you must not ignore the fact that his or her position depends upon them acting in their own self-interest.
If a subset of the electorate elects an official, they do so on the expectation that the official will represent them and support their interests. If the official does not represent the subset’s interest to the degree that they expect the official to…then they have incentive to support another candidate. So, elected officials really only have one incentive in running for office…to get elected or to get re-elected.
The point here is that elected officials may have incentives that are different from the incentives that exist within the economic system. For example, if economic growth is slowing down…elected officials or those appointed by elected officials may have an incentive to stimulate the economy and increase employment if an election is near at hand. If elected officials or those appointed by elected officials express concern that the stock market may collapse, they may try and keep interest rates extremely low in order to avoid a stock market correction or a readjustment to a more realistic level. If elected officials or those appointed by elected officials believe that every American…or almost every American…should own a home, they will create and support programs that encourage such a result.
Every one of these efforts…and many more like them…can be traced back to efforts to get elected officials re-elected…and they are all aimed at a “good” thing…or a “good” cause. No one can disagree with the basic attempt by the elected officials or those appointed people.
Each of these efforts, however, is what the economist would call a “shock” to the economic system. Each of these efforts represents a response to a different set of incentives than those that exist within the functioning of markets and relationships in the economic system, itself. Economic models attempt to separate out the different factors that are at work within an economic system. Factors that do not respond to the regular incentives that exist within the economic system are called “exogenous” variables and changes in these variables are introduced independently of the system. Other variables that respond to the incentives that exist within the system, both those created by other non-exogenous variables as well as to the incentives created by the exogenous variables are called “endogenous” variables.
The importance of this distinction is that many of the “shocks” that an economic system receives is of the “exogenous” variety and are introduced into the economy for reasons other than allowing the economic system to work out all the incentives and dis-incentives that currently exist. In effect, these “exogenous” shocks are often aimed at preventing the economic system to work itself out in the direction it is going. And, as stated above, many of these interventions are for the “good” of the economy or for the “good” of, at least, some of the people in the economy.
The fact of the matter is that we don’t really have good theory to examine how these “exogenous” shocks come about. If we did, obviously, then they could be incorporated into the economic model and would become “endogenous” variables. Therefore, these “exogenous” shocks…government decisions…must stay exogenous and be introduced as they happen or are expected to happen.
Economics is a study of human behavior. Therefore, the predictions that come from economic models are going to be highly imprecise. Economic models are all incomplete and fallible. We just can’t do better than that when dealing with human behavior. Some situations lend themselves to more consistent behavior that allow for the making of better predictions…but other situations…like government decision making…are not systematic and so are almost impossible to model. And, we are finding out through the research in areas such as behavioral economics and behavioral finance that some situations that were, in the past, assumed to be fairly regular, are not that regular and need to be modeled with much less confidence about the accuracy of their predictions.
The name of John Maynard Keynes has surfaced a lot these days…and I am going to refer back to something that he wrote that, I believe, pertains to this very issue. In his commentary of the great economist Alfred Marshall after the great man died, Keynes discusses what makes an exceptional economist. In terms of Marshall, Keynes remarked that he was very learned in history. And then Keynes followed up on this by saying that anyone that wanted to be a top level economist needed to incorporate history into his or her explanation of how things worked. And, Keynes did not mean by history, incorporating a huge amount of statistical data into the model building process. Keynes was referring to the need to understand specific individuals and how those individuals made decision…how they were affected by their time…and how they were affected by their own experience and upbringing. He concluded that good economics required a good knowledge of history and biography…not something that is often taught in Ph. D. programs in economics or finance.
The point of this post is that in the policy making issues that government has to deal with we cannot just rely on assumptions of completely self-correcting free market economic systems where the incentives generated within the system are sufficient to work themselves out in a deterministic fashion. These systems will be continuously impacted by “exogenous” shocks that will bump the system one way or another, preventing the system from working itself out into a “new equilibrium” where everything is OK. These systems…for better or for worse…will be buffeted by these “exogenous” shocks and this will mean that we, in order to understand what is happening or what has happened, will need to introduce history and biography into the analysis we are going through. That is…economics cannot stand alone and provide all the answers.
This leads us into the position that we can…and must…look for bumps and shifts in the economy that are caused by governmental interference…usually with good intentions…and see how the government changes incentives…and how these changed incentives can divert the economy from one path onto another.
A good example of this comes in situations that create what economists call “moral hazard”…actions that lead people to do perverse things that they would not do under other circumstances. For example, people have to take risks in what they do…starting a business, buying a home, investing in securities, and so on. If a situation arises in which the people that have done one or more of these things get into dire straights…that is, they may face foreclosure or bankruptcy…elected officials can decide…for good reason…to protect them in some way. This presents a situation of “moral hazard” because those people that get protected may, in the future, decide to take on even higher levels of risk and make the economic or financial system more fragile. One can applaud of condemn actions that create “moral hazard” but it is a judgment decision. The elected officials must make a decision relating to the trade off between avoiding a bad situation now…protecting the people who have gotten in trouble…versus not protecting the people now and facing a economic or financial catastrophe. Where you set the tradeoff is a personal decision.
Wednesday, January 7, 2009
What Conservatives Are Saying Now!
The United States is coming into 2009 having established one of the largest moves to socialization in the world. The prospects for the future do not provide any encouragement for this move to slow down!
The United States has moved into a new era…and who would have thought that it would be the Conservatives in America that created the environment for this to happen.
The Conservatives were always the people who believed in discipline…of not living beyond ones means and capabilities. Yet, it became the Conservatives that led the way to uncontrolled and irresponsible behavior…on the part of the government…and on the part of the private sector.
When did it start?
When Nixon claimed that “We are all Keynesians now!”?
Did this lead to the policies of Ronald Reagan who promoted Supply-Side tax cuts that led to large deficits that went on and on?
And this led to Bush 41 and Bush 43 and their undisciplined fiscal behavior?
The Republican Party…like most parties…is a conglomerate of groups with disparate or even conflicting positions. But, Nixon drew up the new boundaries of the party and created the new culture at the top. And, what were these new boundaries?
I would like to concentrate on three: making the Republican Party the party of the South and the religious conservative; the move to fiscal and monetary irresponsibility; and the emphasis upon loyalty to creed as the primary criteria for membership.
There is no question that the Nixon “Southern Strategy” became the foundation of the ‘new’ Republican Party. Lyndon Johnson basically disenfranchised the South with his policies on civil rights and welfare. These programs completed upset the social stratification of the South and caused many citizens of that part of the country to look for a new home.
Richard Nixon provided them with that new home. But, in doing so the Republican Party had to be open to two things…even if they were sublimated in all discussions concerning the party. These two things were, first, that the party had to accept the racist leanings of the Southerners that were brought in under the ‘big tent’, and, second, the party had to openly support a religious leaning that was more fundamentally orientated. Up until the late sixties, the Republican Party had been the home of the mainline Protestant denominations. That was to be no more…they were ‘too liberal’.
These two themes brought in the South and also appealed to more rural areas of the United States. This provided a background for ascending to the Presidency, but also to provide a strong bloc of support in both the Congress in Washington, D. C., and in state houses throughout the country. It also provided a funnel for future leaders of the Party.
The second boundary had to do with the economic policies of the Federal Government. Nixon was so paranoid about getting re-elected as President that he did whatever was necessary…the rest-of-the-world be damned. Consequently, the conservative policies of ‘hands off’, constraint, and discipline did not appeal to him. This made him susceptible to advisors around him…especially John Connolly…that led him in a totally different direction. That direction included ideas about ‘big government’, deficits in the budget, wage and price controls, and an easy monetary policy. And, the last item there was connected to the withdrawal of the United States from the gold standard that served as the basis for stable economic policies. Even Franklin D. Roosevelt did not dare get rid of this peg during the Great Depression.
Richard Nixon became a “Big Government” President opening the door for a succession of ‘Conservative’ big government presidents…like Ronald Reagan (a former Democrat), Bush 41, and Bush 43. And, “Big Government” for the Republicans included building up the military…for this was the patriotic thing to do. American was the leader of the free world and therefore it needed more and more resources for the military.
The problem with “Big Government” is that taxpayers in the United States will generally not support the taxes needed to run a big government so that the big government will have to be financed by selling bonds…or monetizing the debt. Nixon did both…but, to combat the possibility that inflation could get worse he also froze wages and prices in the economy.
Whoa ! ! !
The third boundary had to do with loyalty. Since the things discussed above became the ‘religious’ beliefs of the Republican leadership, adherence to the ‘religion’ became paramount…no matter how ridiculous the stance one had to take. Loyalty to the line became the most important criteria for membership in the leadership.
And, this loyalty transcended talent, ability, or experience. If you did not believe the way the Party did…you had no chance to help the Party regardless of how good or how successful you were. How else can we explain the incompetence of the Bush 43 administration? How else can we understand the ignoring of facts and of reality? How else can we explain the lies and the cover-ups?
In the past, the Conservatives were always the Party of reality, the Party of discipline, the Party of incremental movement.
I think that these Conservatives can now say…”We told you so!”
I think that these Conservatives can now say…”If you lose your discipline, you will eventually crash!”
I think that these Conservatives can now say…”Once you crash because you have lost your discipline, there are no good choices!”
I think that these Conservatives can now say…”There is only one way to ‘right the ship’ and that is by re-establishing your discipline!”
I think that these Conservatives can now say…”Re-establishing your discipline is VERY, VERY painful!”
The United States has moved into a new era…and who would have thought that it would be the Conservatives in America that created the environment for this to happen.
The Conservatives were always the people who believed in discipline…of not living beyond ones means and capabilities. Yet, it became the Conservatives that led the way to uncontrolled and irresponsible behavior…on the part of the government…and on the part of the private sector.
When did it start?
When Nixon claimed that “We are all Keynesians now!”?
Did this lead to the policies of Ronald Reagan who promoted Supply-Side tax cuts that led to large deficits that went on and on?
And this led to Bush 41 and Bush 43 and their undisciplined fiscal behavior?
The Republican Party…like most parties…is a conglomerate of groups with disparate or even conflicting positions. But, Nixon drew up the new boundaries of the party and created the new culture at the top. And, what were these new boundaries?
I would like to concentrate on three: making the Republican Party the party of the South and the religious conservative; the move to fiscal and monetary irresponsibility; and the emphasis upon loyalty to creed as the primary criteria for membership.
There is no question that the Nixon “Southern Strategy” became the foundation of the ‘new’ Republican Party. Lyndon Johnson basically disenfranchised the South with his policies on civil rights and welfare. These programs completed upset the social stratification of the South and caused many citizens of that part of the country to look for a new home.
Richard Nixon provided them with that new home. But, in doing so the Republican Party had to be open to two things…even if they were sublimated in all discussions concerning the party. These two things were, first, that the party had to accept the racist leanings of the Southerners that were brought in under the ‘big tent’, and, second, the party had to openly support a religious leaning that was more fundamentally orientated. Up until the late sixties, the Republican Party had been the home of the mainline Protestant denominations. That was to be no more…they were ‘too liberal’.
These two themes brought in the South and also appealed to more rural areas of the United States. This provided a background for ascending to the Presidency, but also to provide a strong bloc of support in both the Congress in Washington, D. C., and in state houses throughout the country. It also provided a funnel for future leaders of the Party.
The second boundary had to do with the economic policies of the Federal Government. Nixon was so paranoid about getting re-elected as President that he did whatever was necessary…the rest-of-the-world be damned. Consequently, the conservative policies of ‘hands off’, constraint, and discipline did not appeal to him. This made him susceptible to advisors around him…especially John Connolly…that led him in a totally different direction. That direction included ideas about ‘big government’, deficits in the budget, wage and price controls, and an easy monetary policy. And, the last item there was connected to the withdrawal of the United States from the gold standard that served as the basis for stable economic policies. Even Franklin D. Roosevelt did not dare get rid of this peg during the Great Depression.
Richard Nixon became a “Big Government” President opening the door for a succession of ‘Conservative’ big government presidents…like Ronald Reagan (a former Democrat), Bush 41, and Bush 43. And, “Big Government” for the Republicans included building up the military…for this was the patriotic thing to do. American was the leader of the free world and therefore it needed more and more resources for the military.
The problem with “Big Government” is that taxpayers in the United States will generally not support the taxes needed to run a big government so that the big government will have to be financed by selling bonds…or monetizing the debt. Nixon did both…but, to combat the possibility that inflation could get worse he also froze wages and prices in the economy.
Whoa ! ! !
The third boundary had to do with loyalty. Since the things discussed above became the ‘religious’ beliefs of the Republican leadership, adherence to the ‘religion’ became paramount…no matter how ridiculous the stance one had to take. Loyalty to the line became the most important criteria for membership in the leadership.
And, this loyalty transcended talent, ability, or experience. If you did not believe the way the Party did…you had no chance to help the Party regardless of how good or how successful you were. How else can we explain the incompetence of the Bush 43 administration? How else can we understand the ignoring of facts and of reality? How else can we explain the lies and the cover-ups?
In the past, the Conservatives were always the Party of reality, the Party of discipline, the Party of incremental movement.
I think that these Conservatives can now say…”We told you so!”
I think that these Conservatives can now say…”If you lose your discipline, you will eventually crash!”
I think that these Conservatives can now say…”Once you crash because you have lost your discipline, there are no good choices!”
I think that these Conservatives can now say…”There is only one way to ‘right the ship’ and that is by re-establishing your discipline!”
I think that these Conservatives can now say…”Re-establishing your discipline is VERY, VERY painful!”
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