“A flat tax is for a flat Earth”

This was my answer to Grzegorz Kolodko, Poland’s Minister of Finance and First Deputy Premier for the Economy (1994-97 and 2002-03), when in the mid-‘90s he asked me – his adviser sponsored by the European Commission – for an opinion on the feasibility and desirability of introducing a flat tax.  I recommended instead a reduction of indirect taxation and the introduction of a tax on capital gains. To his credit Grzegorz listened to me on the flat tax, he reduced the number and level of marginal tax rates but at the same time he raised public expenditure on investment and on re-distribution, introduced an industrial policy that did not seek to pick winners but promoted high value added and export activities, and his package worked well.

The introduction of a flat tax has become a major issue in the policy discussions on the eve of Italian elections, as it is being vigorously propounded by Silvio Berlusconi and the leaders of his right-wing coalition. My views on the flat tax have not changed at all in the the intervening years.

There are two main arguments in favour of a flat tax:

1) the presumed existence of a Laffer curve, whereby government tax revenue is supposed to rise with the increase of the tax rate up to a maximum, beyond which a higher tax rate would actually reduce tax revenue, and

2) lower taxation would encourage the emergence of activities that at present evade taxation, and therefore raise additional government revenue in that way. 

According to established legend (Wanniski 1978) in 1974 Arthur Laffer, then a professor at Chicago University, drew the curve named after him, depicting tax revenue as a function of the tax rate, on a napkin at a dinner in a Washington restaurant to illustrate the effects of President Ford’s tax cuts. Except that he did not draw it on the basis of empirical evidence, but simply noting that for a zero tax rate tax revenue would obviously be zero, and assuming that for a 100% tax rate there would be a zero revenue because nobody would work or invest for a zero after-tax return. He also presumed that there would be a continuous parabolic shaped curve in between those two points and drew a maximum around a 50% tax rate. Thus you could obtain the same tax revenue with a low tax rate on a large tax basis or with a high tax rate on a smaller basis.

Laffer (2004) acknowledged that already in the 14th century the Tunisian philosopher Ibn Khaldun had noticed this possibility, which had also been asserted by many other thinkers including Keynes: “… taxation may be so high … that … a reduction of taxation will run a better chance than an increase of balancing the budget” (quoted by Laffer).

  

The trouble is that actual empirical estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70% (Fullerton 2008, which fits with the “so high rate” stipulated by Keynes), while current tax rates in OECD countries average about half that rate. So much so that the IMF Fiscal Monitor of October 2017 actually recommends raising tax rates in a progressive fashion in order to reduce current excessive inequality of income and wealth, for “There is little evidence that increased progressivity reduces growth”.

More importantly, a 100% flat tax rate is plainly silly, for a progressive tax can reach fairly high marginal rates, historically even 90% and higher, without ever yielding a zero tax revenue. Indeed it has been argued that the Laffer curve might well be increasing monotonically, and in any case even a flat tax of 100% might yield substantial revenue in special circumstances like wartime or even in normal times depending on behavioural assumptions.

As for the second argument in favour of a flat tax, there is absolutely no evidence that a low tax rate – flat or not – encourages the payment of taxes otherwise evaded at higher rates. And why should it, as Schumpeter put it there is no good reason for anybody not reaping a benefit just because it is small.

Critics of a flat tax lament its lack of progressiveness.  Supporters – such as Berlusconi – are quick to point out that in most OECD countries, including Italy, there already is a flat tax on capital incomes, at a constant rate lower than the higher progressive rates on earned incomes, so that a uniform flat tax levied at an intermediate rate would be more progressive than the current system. And anyway the presence of a tax-exempt threshold maintains a degree of progressiveness, as required for instance by the Italian Constitution, art. 53; “The tax system shall be progressive”.

These answers to critics of the flat tax lack of progressiveness are not good enough, because the first comma of art. 53 states also that “Every person shall contribute to public expenditure in accordance with their capability”.  The progressiveness of a flat tax is minimal, depending exclusively on the size of the tax-free initial threshold, and may be regarded rightly as constitutionally inadequate: the average tax rate rises slowly approaching gradually from below the flat fixed rate on taxable income, and significant progressiveness would only be achieved for extremely large tax-free thresholds, counterproductive for tax revenue. The corresponding reduction in the current progressive tax on earned income would not benefit ordinary workers but only overpaid managers, making after-tax distribution of earned incomes more unequal. While the reduction of current excessively high levels of public debt, as well as the reduction of excessive degrees of inequality of income and wealth, are best served by a genuinely more progressive tax system of the kind recommended by the IMF (2017).

On 24 January last the Washington Post reported that Mike Hughes, a 61-year limo driver from California and a flat-Earth strong believer, has been planning to launch a self-built rocket to propel himself 52 miles into space in order to be able to see for himself that the Earth is flat, for “in many months of research I’ve not been able to prove otherwise” – he said. The trouble is that the project would cost 2 million dollars to finance the building and fuelling of the rocket, a space-suit and a hot-air balloon (Mike Hughes is a bit vague about his logistics), and he was only able to raise $8,000 from GoFundMe. As he now has a fellow flat-Earther in billionaire Silvio Berlusconi, it would be best for Silvio to fund the project in exchange for a lift in the same rocket, and all will end well both in California and in Italy, in the best of all possible worlds. 

Addendum 1
Trabandt and Uhlig (2019) estimate the Laffer curves for labour taxation and capital income taxation for the US, the EU-14 and individual European countries for 1995-2007. They find that the US can increase tax revenues by 30% by raising labour taxes and 6% by raising capital income taxes. For the EU-14 they obtain 8% and 1% respectively. Germany could raise 10% more tax revenues by raising labour taxes but only 2% by raising capital taxes. The same numbers for France are 5% and 0%, for Italy 4% and 0% and for Spain 13% and 2%. Only Denmark and Sweden are on the “wrong” side of the Laffer curve for capital income taxation.

Addendum 2 
In the latest Italian elections the Lega proposed a Flat Tax at 15% over the €7,000 tax-free threshold (plus minor further exemptions on households), while Berlusconi proposed its introduction at 23%. According to the Lega their flat tax would create an initial shortfall of €63bn (i.e. €103bn tax revenue from households and €18bn from companies instead of the combined current tax revenue of €184bn from IRPEF-IRES). 

They propose to cover this shortfall first of all from 25 expenditure cuts and additional taxes (including €5bn savings on centralised public procurement, €2,5bn on military expenditure, €5bn tax increase on gas prospection, €900mn from abolition of interest charges deduction by banks and insurance companies, €800mn for official cars abolition for hospitals, €700mn cuts in "golden pensions" (of dubious constitutionality). The bulk of the coverage would come, however, from the emergence of the black economy, reduced tax evasion, additional VAT and income tax on additional transactions and incomes expected from the tax reduction. Pie in the sky.

REFERENCES

Fullerton Don (2008). "Laffer curve", In Durlauf Steven N., Lawrence E. Blume, The New Palgrave Dictionary of Economics (2nd ed.), https://doi.org/10.1057%2F9780230226203.0922

International Monetary Fund IMF (2017), Fiscal Monitor: Tackling Inequality, October.

Laffer Arthur B. (2004), “The Laffer Curve: Past, Present, and Future”, 1 June, Backgrounder #1765, The Heritage Foundation, https://web.archive.org/web/20071201225944/http://www.heritage.org/Research/Taxes/bg1765.cfm  

Selk Avi and Amy B. Wang (2018), “Can this flat-Earther’s long-delayed rocket launch be saved? We may soon find out.” The Washington Post, 24 January, https://www.washingtonpost.com/news/speaking-of-science/wp/2018/01/24/can-this-flat-earthers-long-delayed-rocket-launch-be-saved-we-may-soon-find-out/?utm_term=.5a9d7e82d352

Trabandt Mathias and Harald Uhlig (2010), “How far are we from the slippery slope? The laffer curve re-visited”, ECB Working Paper Series No. 1174, April, Frankfurt, https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1174.pdf?344d6e77a58718332bd900b10e4d85b2

Marcello de Cecco (1939-2016)

The Department of Economics and Statistics of Siena University held a day-long conference in memory of Marcello de Cecco on 17 September, which would have been his 77^thbirthday. 

I first met Marcello in October 1963 in Cambridge. Our dear common friend the late Bruno Miconi, a fellow research student in economics, introduced him to me. I already knew and appreciated Marcello from his contributions to Mario Pannunzio’s Il Mondo, but I found him even more impressive in person. Flamboyant, brilliant, learned, ironical and witty, yet approachable, friendly, generous. We got on well immediately. I have been fortunate in having him as a friend and colleague not only in our Cambridge years but also at Siena University, at the European University Institute in Florence, and at the Sapienza University in Rome – in almost daily contact for a total of over 25 years out of the over 50 years of our association.

Marcello was an alert and insatiable observer of current economic, political and social affairs, never satisfied with simple explanations but searching for deeper causes, enquiring “come va il fatto”. I remember his surprise when the daily Il Fatto Quotidiano that follows a similar inquisitive approach was published. Bruno Miconi used to say that Marcello should have been a film scriptwriter.

A Pembroke man, Marcello was held in great esteem by his supervisor Michael Posner; given his interests in international finance he was also in touch with Kingsman Richard Kahn, who however suspected him (injustly) of monetarist inclinations, because of his contacts with Chicago and Milton Friedman. Marcello had created a considerable intellectual niche for himself through his work on Eurodollars – dollar-denominated deposits held outside the US, mostly in Europe, thus escaping regulation by the Federal Reserve Board including reserve requirements. In this area at the time he knew more than his teachers and his expertise was appreciatively recognised and utilised in seminars and discussions. We both were invited to become members of the Monday Group, a seminar in Economics held regularly if reservedly in King’s. We shared an interest in the history of economic thought, indeed in a little known Russian pioneer of mathematical economics, Vladimir K. Dmitriev; Marcello edited the Italian version of his Economic Essays on Value, Competition and Utility, I edited the English version. When it became apparent that we were working on the same thing Marcello simply said that nobody had a monopoly on that author. At a Faculty seminar we presented a joint criticism of the Modigliani-La Malfa model of the interaction of monetary and real aspects of the Italian balance of payments. Later we co-operated in other research projects, especially in Florence.

Marcello was unique – among Italian students in Cambridge – in that he had come with his Mother, not wanting to leave signora Antonietta on her own back in his home town of Lanciano (pronounced as if written Langiano). They looked after each other well. Somehow, in spite of linguistic obstacles compounded by the regional variety of food nomenclature, his mother always succeeded in securing from the butcher her desired cuts of meat. Marcello gave the delightful account of his mother meeting Piero Sraffa in Cambridge Market Square, when she greeted Mr Sraffa with: “I am delighted to meet you, Professor; my son has spoken very highly of you …”. Marcello theorised the optimality of driving only second hand cars, but he chose only beautiful comfortable large ones, including a memorable Jaguar. When a lectureship was advertised at the University of East Anglia, I encouraged Marcello to apply and supported his candidature strongly. His appointment was a great success, and there, too, he met Julia Bamford – the other great woman behind the great man – so that I could boast of involvement in his taking both a job and a wife.

When the prospect of Italy joining the Euro began to be widely discussed, in 1992 on the eve of the French referendum on the subject Marcello gave enthusiastic endorsement of Italian membership. He wrote an article for Repubblica – Affari e Finanza, entitled I disgregati del 2003, which marked the beginning of his long collaboration to Repubblica (18/09/1992, reprinted in L'economia di Lucignolo, Donzelli, see Marcello’s obituary by Carlo Clericetti). In that article Marcello described an apocalyptic picture of Italy as a member of a Latin Union (with France, Spain, Portugal and Greece) ten years later: backward, underdeveloped, impoverished, authoritarian, repressive, bigoted and male-dominated; the article ends with a decrepit professor, who dares teaching politically incorrect views about the evolution of the international monetary system, being arrested and taken away by police. By contrast the member states of the Mittel-European Union thrive and prosper even more than the Anglo-American Federation, and hire the young unemployed migrants from Italy, who send food parcels to their parents at home in spite of this being officially frowned-upon.

Marcello’s enthusiastic endorsement of the euro was tempered, when it actually happened, only by his disapproval of Berlusconi’s failure to contain price increases in the changeover from lira to euro, something experienced only by Greece and there to a much smaller degree. Marcello’s enthusiasm was right: the euro brought about significantly lower interest rates; that the fiscal space was not used to reduce public debt and on the contrary encouraged greater indebtedness is another matter. The euro also brought about a rate of inflation lower than that achieved in Germany by the Bundesbank itself, and greater European and global integration of trade and Foreign Direct Investment. It did not bring about economic growth, but this was due to poor economic policies and various factors both on the demand (e.g. increasing inequality) and supply sides (productivity slowdown, etc.).

Ten years after, there was a lot to justify Marcello’s evolving position as a Eurocritic. Austerity policies enshrined in the Treaties under German hegemony were self-defeating and suicidal, Marcello was a Keynesian dyed-in-the-wool and knew it well. The German trade surplus, which Marcello attributed primarily to the post-Transition integration of Germany with Eastern Europe regardless of the weakness or strength of the euro, contravened EU rules but was unduly tolerated, and pushed trade deficit countries to run public budget deficits. Improvements could have been made, even without renegotiating the Treaties. Failure to make progress not only towards a Federal Europe design, but even towards piece-meal improvements, justify Marcello’s latest position as Eurosceptic, especially considering that he never indulged in advocating Exitaly, the Italian exit from the Euro that many advocated and still advocate lightly and unthinkingly. On the Euro, Marcello was always right.

For Marcello, the current crisis of the Euro was triggered by the Deauville Summit of 19 October 2010 at which Angela Merkel and Nicholas Sarkozy announced that at least part of any default on public debt would be born by bondholders. At the time I disagreed strongly with Marcello: why should investors who had benefited from large interest differentials, knowingly taking the associated risk, not have to bear the entire cost of default? If worried by that risk they could always have covered themselves as much as they wished by buying Credit Default Swaps. Yet, with the benefit of hindsight, now I am inclined to agree with Marcello. It was the prospect of bail-in that created the spread and effectively split the euro area.

By displaying the richness and depth of Marcello’s contributions of a lifetime, the Siena Conference stressed how dependent on his wisdom many of us had become. Today I find myself often wondering what Marcello would have said about current problems. Many Conference participants asked themselves what he would have said about Brexit: the consensus was that his natural diffidence towards Britain as a free rider of European integration, and the various exemptions repeatedly negotiated by the British (no Schengen, no common currency, the British rebate), would have led him to conclude that European integration might have progressed and improved without Britain. But we have no hard evidence that he would have taken that line. And we have no clue on what view he would have taken about the European migration crisis or the Islamic threat or the US elections with their problematic presidential candidates. It is at difficult times like these that we miss him most.

P.S. On the Siena Conference see also contributions by Emiliano Brancaccio, 
Paolo Paesani,  Salvatore Settis and Carlo Clericetti.

Germany: Too Much Virtue Is A Sin

On 30 October the Office of International Affairs of the US Treasury issued its customary semi-annual Report to Congress on “International Economic and Exchange Rate Policies”, in consultation with the Fed’s Board of Governors and IMF management and staff. The Report usually concentrates on China bashing for the undervaluation of the renmimbi, and this time is no exception: “The RMB is appreciating on a trade-weighted basis [by 6.6% on a real effective basis], but not as fast or by as much as is needed [an additional 5-10%]”. But the Report in addition vigorously criticizes Germany for its record trade surplus, which is regarded as a brake on the recovery of the Eurozone countries that experience a corresponding trade deficit and on global growth.

Among the Report’s Key Findings (p.3):

“Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand growth and shrink their surpluses. Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy.”

The main text of the report develops this proposition further: much of the decline in global current account imbalances that occurred in recent years reflects a demand contraction in deficit countries rather than strong domestic demand growth in current account surplus countries. Germany in particular has continued to run a very large and persistent surplus, raising the eurozone's overall current account, which was close to balance in 2009-2011, to a surplus of 2.3 percent of GDP in the first half of 2013. “Germany’s current account surplus rose above 7 percent in the first half of 2013, while the current account surplus for the Netherlands was almost 10 percent. Ireland, Italy, Portugal and Spain are all now running current account surpluses as import demand in those economies has declined. Thus, the burden of adjustment is being disproportionately placed on peripheral European countries, exacerbating extremely high unemployment, especially among youth in these countries, while Europe’s overall adjustment is essentially premised on demand emanating from outside of Europe rather than addressing the shortfalls in demand that exist within Europe.”

The section on the Euroarea emphasises the point: “Expansion was supported by domestic demand growth in Germany - though growth in Germany still continues to rely on positive net exports, which continues to delay the euro area’s external adjustment process – and on domestic demand in France.”

Nobody can argue with such propositions, which are based on a correct interpretation of well established facts, and are not at all new. The adoption by Germany of more expansionary policies has been advocated by many economists, from Martin Wolf (FT) to Paul Krugman (Those Depressing Germans, NYT 3 November 2013), from Jean Pisani-Ferry (Bruegel) to Mario Seminerio (La Cura Letale, Rome, 2012), to the IMF Managing Director Christine Lagarde as well as several IMF documents. What is extraordinary is that the criticism should come from the US government and from research circles before it is raised by the European Commission. 

EC practice suffers from a totally arbitrary and unwarranted asymmetry in treating surpluses and deficit countries: a current account deficit of 4% of GDP triggers off a disciplinary procedure for the offending country, while a 6% surplus averaged over three years is necessary before the EC takes any notice of that imbalance, and even then only perfunctorily. In 2012 Germany recorded a 7% record surplus but the three year average was just under 6% and nothing was said.

This is a general problem that Maynard Keynes had tried to address at the Bretton Woods Conference (1944). His Plan assigned to every country a “bancor” maximum overdraft facility equal to its average trade over five years; a penalty interest rate of 10% would apply to deficit countries above that limit, as well as to surplus countries on anything over and above any surplus exceeding the size of the permitted overdraft by more than a half, forcing compensatory exchange rate adjustments or capital flows, and subject to confiscation of residual excess reserves above the permitted surplus at the end of the year. “Nothing so imaginative and so ambitious had ever been discussed", commented Lionel Robbins. But the US was then the world’s biggest creditor and the Plan by the US representative Harry Webster White was preferred by the 42 countries attending the Conference. The burden of balancing trade was placed on deficit countries and no limit was set on surplus countries, thus necessarily impressing a deflationary bias on the nature of trade adjustments. The replication of this approach by the European Union is one of the many EU original sins. 

There is a well known tenet of Keynesian economics, resulting from national income accounting and not at all dependent on the validity of Keynesian fiscal policies, and therefore unchallenged: the excess of exports X over imports M, plus the excess of government expenditure E over taxation T, plus the excess of private investment I over savings S, must necessarily add up to zero. Thus a country experiencing a trade deficit must necessarily run a government deficit and/or a compensatory excess of investment over savings, hard to accomplish in the face of an otherwise shrinking demand. In other words, the German trade surplus makes it all that much harder for its deficit trade partners to balance their public accounts.

On 2 November the Economist’s Charlemagne column Fawlty Europe commented on “Germany’s obsession with competitiveness”… “For Germany booming exports are the measure of economic virility.” It is true that Germany is reaping the benefits of wage and price reductions (the internal devaluation) undertaken before the crisis; in the middle of the crisis any country adopting the same policy would pay the price of worsening that crisis. Germany also benefits from earlier structural reforms politically hard to replicate, and from the relatively price-inelastic demand for its high technology exports. But surplus countries like Germany, the Netherland and Austria are also benefiting from an artificially low exchange rate, with respect to the increasingly stronger exchange rate that would prevail if those countries were using their own currency instead of the euro. And, be that as it may, by holding down wages and failing to promote investment and growth they make trade adjustment in Italy, Spain, Ireland, Portugal and Greece – which has occurred – deflationary. Debtor nations were forced, mostly under German pressure, into austerity eliminating trade deficits at the cost of perversely rising debt/GDP ratios (see our earlier post on the subject), while German surpluses persisted and their failure to adjust magnified the costs of austerity and contributed to keep the world economy depressed.

Charlemagne notes that Germany has also benefited from straight protectionism, having failed to liberalise its construction and services.  While these sectors are not a significant share of German exports, a recent OECD study stresses that in general services have a much bigger impact on trade and trade competitiveness if we look at their inputs actually embodied in exports, i.e. adopting a Value Added approach to trade accounting. Charlemagne also recommends too that Germany could do more to invest in education and infrastructure, and make child care available for working women. 

Moreover German energy-intensive producers are benefiting from an implicit subsidy on their electricity consumption, through exemption from the expensive surcharge used to finance Energiewende, the accelerated introduction of renewable energy scheduled to reach 35% by 2020 and 80% by 2050. Earlier this year European Energy Commissioner Günther Oettinger told a group of industry leaders that the price concessions for energy-intensive companies in Germany clearly amount to “inadmissible” subsidy levels. German business are concerned that they might have to repay hundreds of millions of euros to the German government.

Only on 13 November did Jose’ Manuel Barroso, the EU President, announce an “in depth analysis on the high German trade surplus”, with a view to understand whether Germany can make a larger contribution to the re-balancing of the European economy”. There is the prospect of a continued trade surplus of 7% in 2013, and the upwards revision of the 2012 trade surplus brings already the three year average above 6% in 2010-2012. Indeed “Following statistical revisions, the indicator has exceeded the threshold each year since 2007” and “the surplus is expected to remain above the indicative threshold over the forecast horizon, thus suggesting that it is not a short lived cyclical phenomenon” (EC 2013). German savings exceed investment, and despite boasting the second lowest share of private sector debt in GDP (firms and households) and low interest rates, private sector de-leveraging has continued, failing to boost demand; capital formation has declined last year. This calls for some action, not least to reduce the pressure for euro revaluation. But the bottom line of the EC document is simply that “Overall, the Commission finds it useful to conduct an in-depth analysis with a view to assessing whether imbalances exist” (italics in the original). This is a grotesque existential problem: what additional evidence is needed to establish that an imbalance exists, other than the imbalance itself?

German press and politicians have reacted to the US Treasury accusations and to the EC initiative with a combination of denials, hubris and cries of victimisation. The German Economics Ministry issued a strongly worded statement, saying that Germany's surplus is "a sign of the competitiveness of the German economy and global demand for quality products from Germany." It dismissed the accusations as “incomprehensible” and challenged the US to "analyze its own economic situation."

A memo to finance minister Schäuble reads: "The German current account surplus offers no reason for concern for Germany, the euro zone or the world economy"; Berlin is pursuing a course of "growth-friendly consolidation," and there are no imbalances "that would require a correction of our economic and fiscal policy." See also “Complaints about German Exports Unfounded”, by Jung-Reiermann-Schmitz,Spiegel.de 5 November, and “Raw Nerve: Germany Seethes at US Economic Criticism” by Alessi, Spiegel.de 31 October.

It has been pointed out that the prospective new grand coalition between the CDU, its Bavarian sister party, the Christian Social Union (CSU), and the Social Democratic Party (SPD) has already agreed to increase government investment and the minimum wage, both of which should stimulate domestic demand.  But the formation of that government – let alone its programme – is still under negotiation.

The real issue is an EU governance deficit. The worst thing that could happen to Germany as a result of an adverse “in depth analysis” by the Commission is a reprimand by Marco Buti's Directorate-General for Economic and Financial Affairs. No comment seems necessary.

After the Global Crisis

Conjectures about the post-crisis future of the global economy are path-dependent, i.e. they necessarily depend on the course of events envisaged for getting out of the crisis.

The current global crisis was the consequence of financial de-regulation and the general dominance of hyper-liberal policies in the United States, in the UK and in the global economy. It started around August 2007 as a US banking crisis arising from toxic sub-prime assets in banks’ balance sheets; it turned into a credit crisis that depressed enterprise investment; it spread globally through the decline of foreign trade and the slowdown and often reversal of capital flows, including Foreign Direct Investment; and then - with the large scale cost of rescuing financial institutions by government budgets, the rising cost of labour unemployment and the decline in governments revenue - it grew into a fiscal crisis and, ultimately, a widespread crisis of sovereign debt, particularly in the Euro-zone.

Initially the decline in industrial output, foreign trade volume and stock exchange values replicated the scale and the pattern of the 1929-32 crisis. Soon the impact of the crisis and cross-country contagion were mitigated by simultaneous, internationally co-ordinated, monetary expansion and fiscal stimulus, introduced at the end of 2008 and early 2009. But monetary expansion failed to re-launch economic growth, while concern about fiscal sustainability soon led to a simultaneous, premature exit from fiscal stimulus in most countries. Current prospects - apart from those of BRICS (China, Russia, India, Brasil, South Africa, now accounting for 18% of world GDP and the bulk of its growth) - are of widespread stagnation and double-dip, indeed of a second and even more serious recession.

The macroeconomic policies followed appeared to have a keynesian flavour, stimulating aggregate demand via tax cuts, monetary expansion and low interest rates. But keynesian remedies would have required public investment instead, whereas tax cuts temporarily fuelled private consumption, and the effectiveness of low interest rates - which mostly were not passed on to borrowers and simply involved higher profits for financial intermediaries - was limited by liquidity preference.

The rescue of financial institutions involved a massive transfer of wealth from taxpayers to bank creditors, including depositors and shareholders. This solution was clearly inferior to any of the alternatives, whether support for bank debtors, or partial nationalization of supported financial institutions, or outright loss-taking by imprudent lenders. Income inequality, whose depressive effect on effective demand had been reduced by credit expansion - one of the contributory factors of the crisis - increased further as a result of labour unemployment and continued payment of managerial super-bonuses awarded mostly to those responsible for the financial debacle not by markets but by a semi-feudal process of self-serving decisions by a managerial caste.

The current generalized advocacy of strict fiscal discipline, demanded by international financial institutions and often enshrined in national constitutions as a balanced budget obligation, is particularly anti-keynesian, and is bound to be counter-productive in the middle of a recession.

First, a balanced budget is neither sufficient nor necessary to the sustainability of government debt, because a primary surplus (net of interest payments) may or may not be necessary to debt sustainability - depending on whether the economy grows at a rate slower or faster than the average interest paid on government debt.

Second, the keynesian lesson has been forgotten or ignored, that the balance of government expenditures minus revenues, plus the balance of private investment minus savings, plus the external balance of exports minus imports, must necessarily add up to zero as a matter not of theory but of accounting consistency. Therefore the budget balance cannot be a policy instrument, but only a target that may or may not be achievable depending heavily also on the behavior of national economic agents and of global trade partners (including the elimination or large reduction of Germany’s trade surplus vis-à-vis the rest of Europe, and China’s gigantic trade surplus). Generalized efforts by all governments to balance their budgets simultaneously might actually result in a perverse combination of budgetary (and trade) imbalances as well as a lower level of employment and income worldwide than would be the case without such efforts.

By the same token, generalized efforts to promote employment and growth via higher international competitiveness - whether achieved by external devaluations or by domestic deflation of wages and prices - can also be competitively self-defeating: another clear keynesian lesson is that lower wages can raise employment through higher exports in one country, but cannot resolve unemployment as a world problem. Nor can world unemployment necessarily be reduced by a generalized reduction of employment tenure and other labour welfare provisions, or the replacement of collective bargaining by firm-level bargaining: the only certain effect of such policies, also very popular in anti-crisis policy packages under the pretext of “structural reforms” (e.g. see the European Central Bank’s guidelines to the Italian government in their letter of 5 August 2011) is the deterioration of the quality of work and labour incentives.

Often it is believed that the impelling necessity of environmental improvements, required by the reduction of global warming and of general pollution, and the forthcoming exhaustion of natural resources, will create a new important opportunity for investment and growth. However - apart from the observably controversial nature of global warming - these are all opportunities for public or public-funded investment, desirable in itself (not absolutely but up to some point) but competing with alternative uses of scarce public funds whose expenditure today is supposed to be kept under control in the interests of fiscal sustainability.

The chances of world leaders suddenly learning keynesian lessons, and implementing them with the speed and on a scale adequate to propel the global economy out of stagnation are remote, indeed would amount to a miracle. Even those who would like to do it are prevented by the electoral challenge of populist competitors (as is Barack Obama by his Tea-Party Republican challengers). By comparison the prospect of Wealth Sovereign Funds coming to the rescue of highly indebted governments might seem a more normal occurrence, but this would be the true miracle and is simply not going to happen: it worked in 2008 to the advantage of financial stabilization, but now WSFs have run out of trust.

The fact that the US can always “print” the dollars it owns to pay its creditors does not make the US debt indefinitely sustainable: at some point the resulting dollar inflation will make dollar bonds unpalatable at less than crippling interest rates so high that they would necessarily involve eventual insolvency. Other countries face even stricter debt sustainability conditions, without the same initial room for manoeuvre. Where private wealth largely exceeds the difference between current debt and its sustainable level, it is always possible to apply a once-and-for-all or recurring wealth surcharge to achieve solvency. Italy, for instance, has a public debt of euro 1,900 bn, but in 2008 it had a household wealth of euro 8,600 bn, 45% of which was concentrated in the top 10% of households; but wealth taxation is unpopular and the political will to introduce it is scarce. Privatization of public assets is often considered as a way to reduce sovereign debt, but the potential revenue obtainable from this source is usually overstated with respect to the depressed values realizable during a crisis, when it is infelicitously timed.

An insolvent country, like Greece, has only three alternative options: 1) instant orderly default with significant “hair-cuts” negotiated with creditors; or 2) instant dis-orderly default; or 3) delayed default, whether orderly or dis-orderly, preceded by roll-over of debt with the assistance of international financial organizations (like the IMF, or the European Financial Stability Fund soon to become the European Stability Mechanism, or the European Central Bank with its controversial purchases of government bonds in secondary markets) followed eventually by actual default, as in all schemes of pyramid banking, to which such rollover of uncovered debt has been likened.

The three default options are ranked above in order of increasing cost. However it should be remembered that non-default by insolvent debtors is also very expensive, as witnessed for instance in the large scale fall (of the order of 25%-30% in just one quarter in mid-2011) in the capitalization value of stock exchanges in temporarily solvent Euro-zone countries with uncertain longer-term solvency.

Partly the probability of default, assessed by Rating Agencies (like the oligopolistic three: Standard and Poor’s, Moody’s, Fitch), reflected in the interest spreads with respect of bonds regarded as totally secure (like German Bunds) and in the price of insuring bonds against default by buying Credit Default Swaps, expresses political as well as economic judgments (as in the recent case of Italy, handicapped by a corrupt, disreputable and divided government short on credibility).

Of course Rating Agencies have proven to be highly fallible and often biased, for they have their own agendas to drive forward, have positions of conflict of interests (“issuer pays” instead of “buyer pays”) and opportunities for insider trading. Alternative, public Rating Agencies have been advocated, for instance in Europe, but such institutions could not be regarded as independent and therefore their credibility would be low. Better still, “the use of ratings in financial regulations should be significantly reduced over time” (as was suggested in the de Larosière Report of 2009 under Recommendation 3, but never acted upon by European authorities).

In order to contain the unavoidable disruption and turmoil involved by a country’s default, it would be essential to anticipate its adverse effects and counteract them beforehand, by re-capitalizing commercial banks exposed to the cross-effects of default, including central banks and above all the European Central Bank that has been acting (probably exceeding its mandate) as Lender of Last Resort to the governments of “peripheral” (meaning “high spread”) countries. An experience of default is bound to depress the price of, and thus raise yields on, old and new government bonds for the whole area; therefore contagion would worsen the sustainability conditions of debt, and therefore slow down the speed of subsequent recovery.

Furthermore, a post-crisis global economy should have renewed efforts to establish some form of global governance rather than have in place the many and inadequate ad hoc institutions cobbled together to, at present, provide some semblance of governance. But in order to be established global government now would have to be universally accepted not only in its initial form, but also in all its rules for the continuous adjustment to future, unforeseen and unforeseeable, circumstances: such acceptance now is probably out of the question. Besides, the demotion of the nation state is not necessarily desirable. For the nation state provides a layer of authority that can protect citizens from global corporations as well as from a necessarily monopolistic global governance authority that could easily misbehave out of democratic control, and without any remaining territory to which one could run for cover.

Eventually the post-crisis economy - sooner or later - will begin to recover, thanks to the profitability of production and investment being raised by depressed wages (due to mass unemployment), the accumulation of new profitable technical inventions and opportunities, the progressive depletion of existing inventories and production capacity. Once started, recovery would tend to be amplified by indirect effects, such as the usual interaction between multiplier and accelerator, until potential capacity constraints are met again and some cyclical mechanism is set in motion again in reverse. Such is the inexorable logic of the market economy. But reliance simply on market self-regulation will most probably lead to recovery much later than possible with government intervention and jump-starting. It is unfortunate that the inadequate policy responses of 2008 and their premature withdrawal should have grossly diluted their effectiveness thus making the implementation of growth policies harder today.

Changes must also be attempted in order to prevent the operation of factors that facilitated the last global crisis, or to better cope with them. The increase in banks’ capitalization, envisaged by the Basel-3 new rules, will have an initial adverse effect on the volume of lending but longer term benefits for financial stability. A new composite currency is bound to emerge, in place of the US dollar or the euro.

Regulations on the separation of credit and investment operations of banks (à la Glass-Steagall Act) are bound to be reintroduced, as already proposed in the UK by the Vickers Commission. The Over The Counter derivatives trade might be subjected to stricter regulations, such as the requirement of an underlying “insurable” interest for taking up a position in that market, or the prohibition of short-selling, temporarily introduced in the European Union on shares and government bonds. The traditional principle of Central Bank independence in the exclusive pursuit of inflation targeting - based on the now discredited theory of rational expectations and the consequent de-coupling of inflation and unemployment - is bound to change into the even more independent pursuit of multiple targets including employment and competitiveness. We might witness attempts to protect domestic industries and stop immigration - largely unsuccessful in view of the irresistible force of underlying trends.

Currently, by and large, the economic system emerging from the crisis is bound to be substantially very similar to the pre-crisis one, improved in some respects, but worsened by large scale cuts in welfare expenditure made necessary by the (debatable) purpose of achieving fiscal balance. The post-crisis system will be more conflictual and insecure, more unequal and less cohesive, less rather than more “green” - basically a more unpleasant world in which to live. It need not be so.

Schuldenbremse [debt brake] by Constitutional Law? No, Thanks

In 2009 the German Constitution was amended to introduce a balanced budget provision, or Schuldenbremse [debt brake]. Starting in 2016 the German federal government will be constrained to a deficit ceiling of 0.35% of GDP; from 2020 the Länder will not be permitted to run any deficit at all. An exception can be made for emergencies such as a natural disaster or economic crisis. All USA states except Vermont have a similar constitutional provision (Oregon is constitutionally bound to return to taxpayers any surplus in excess of 2%), though of course this does not stop them from incurring large debts. In any case States or Länder balanced budget commitments do not interfere with either a Federal macroeconomic stimulus or inter-state fiscal transfers, so that the restraint does not really matter all that much. There is a balanced budget provision is in the Swiss Constitution. Such a provision has been variously recommended also for the US Federal government but never achieved the support of two/thirds majority of states in both houses for it to be introduced.

Last year President Sarkozy proposed a return to balanced budget in France. On the eve of the Eurogroup meeting of 14 February 2011 the German Finance Minister, Wolfgang Schauble, leader of European Democratic Conservatives, proposed the introduction of a German-style constitutional ceiling in other EU countries. In the coming weeks the French Premier François Fillon is expected to present a Constitutional amendment committing France to a specified time-path of progressive reduction of the deficit from €150bn (2010) down to zero, to be approved by Parliament before the summer and to be monitored by the Constitutional Council.

Let us leave aside questions of the political feasibility of introducing such an amendment into a country’s constitution, and of the credibility of a government commitment to implement it. It is clear that current levels of sovereign debt are excessive and insustainable in most EU member states, and that deficits will have to be cut in order to stabilize and reduce them. The real question is about the effectiveness of government policies aimed at expenditure-cutting and tax raising. Such policies would reduce the deficit coeteris paribus , but at the same time are bound to reduce demand and therefore GDP and tax revenue to an even greater extent: their final outcome is indetermined.

Victoria Chick and Ann Pettifor (FT, 4 October 2010), using UK data from 1918 to 2009, show that a persistent expenditure cut is correlated with a rise in the debt/gross domestic product ratio; and expansions in expenditure with a fall in debt/GDP. They explain that “This result arises because government is not in a position to determine its own deficit/surplus. The size of the budgetary outcome depends on the plans of the entire economic system and its reactions to the government’s planned actions.”

“Since the deficit is not something that government can control, setting out to reduce the deficit is to look at the problem through the wrong end of a telescope: the way to reduce a deficit in a time of unemployment and feeble recovery is to spend (preferably wisely) to promote employment and permanent improvements to our infrastructure, including our “human capital””.

“Keynes looked through the telescope the right way round: “Look after the unemployment, and the budget will look after itself.” "(Chick and Pettifor, 2010).

What is worse, a simultaneous collective round of expenditure cuts and taxation increases is obviously going to have a greater impact on each country than its adoption by a single country – which is why the recessionary impact of deficit reduction is frequently under-estimated and neglected.

In any case, while a balanced budget might be a reasonable stance (possibly and conditionally) in an effort to stabilize public debt, surely this cannot be in a single year: not unnaturally, in 2003, approximately 90% of the members of the American Economic Association agreed with the statement, "If the federal budget is to be balanced, it should be done over the course of the business cycle, rather than yearly."

The case for a balanced budget is often construed as a way to prevent a burden on future generations: thus fiscal stimulus is regarded as “little more than an exercise in the redistribution of wealth from our grandchildren to today’s special interest groups” (Darrell Issa, "Obama's Keynesian failures must never be repeated“ , FT Comment, 8 February 2011)

John Eatwell commented that “If government borrowing were indeed a burden, then real per capita income of future citizens would be reduced.”

“But where there is borrowing there is lending, so that payments of interest and repayments of capital that may result from stimulus packages are from taxpayers to lenders – no loss of real income there, just a transfer payment.”

“The assertion must therefore rest either on the argument that government spending “crowds out” private investment, not very credible with the current output gap and interest rate policy, or that there is a behavioural link from current borrowing to present and/or future levels of investment and growth.”

“It is possible to build models and select empirical evidence that go either way. What is not possible is to make the unambiguous assertion of future “burden”.” (Burden on our grandchildren’ is ambiguous talk, FT Letters, 10 February).

The “crowding out” idea is indeed what lies behind advocacy of balanced budgets : public expenditure multipliers are deemed to be small, less than one, “close to zero” according to Barro. Individuals are believed to follow the principle of Ricardian equivalence: when government reduces expenditure today they expect lower taxes in the future and therefore they rush at once to work, earn and spend more . Thus fiscal consolidation is deemed to be expansionary, see the latest “Public finances in the EMU” report, or Rother, Schuknecht and Stark, “The benefits of fiscal consolidation in uncharted waters”, ECB, (2010).

However, recent empirical work (such as Christiano, Eichenbaum and Rebelo, “When is the government spending multiplier large?”, 2009 or Corsetti, Meier and Mueller, “What determines government spending multiplier?”, 2010) has shown that public expenditure multipliers “are likely to be much larger, between one and two, when monetary policy is at the zero lower bound, when exchange rates are fixed and when a large number of households are credit-constrained. This is more or less the case in the current situation: a number of countries are experiencing de-leveraging by households, the central bank’s interest rate are low, preventing an accommodation by the central bank of a budgetary contraction, and the Eurozone countries have, by definition, fixed exchange rates.” (Raphael Cottin, Public finances in 2011: happy austerity, Eurointelligence.com, 28.01.2011).

Cottin notes that the European Commission services implicitly recognize this: the latest “Public finances in the EMU” report mentions (Part III, section 6) that fiscal expansions are likely to be expansionary under the current conditions: “but the symmetrical argument, that fiscal consolidations are likely to be contractionary, is carefully avoided.”

The Italian writer Vittorio Alfieri (1749-1803) is famous, among other things, for having himself knotted tightly to his chair with rope, in order to discipline himself to hard work and uninterrupted study. This is traditionally taken as evidence of his strong will, as claimed in his celebrated statement "Volli, sempre volli, fortissimamente volli". Surely if Alfieri really had such a strong will he would not have needed to be tied so tightly to his chair. Sarkozy and Schauble may tie themselves and their own budget in knots but leave other member states alone to pursue a more rational and enlightened fiscal policy.

A Hayek vs. Keynes Rap Anthem

YouTube is offering a "Hayek vs. Keynes Rap Anthem: Fear the Boom and Bust "
http://www.youtube.com/watch?v=d0nERTFo-Sk.

Good stuff, though it comes with a warning by Dr M G Hayes, Secretary of the Post Keynesian Economics Study Group (www.postkeynesian.net), that the rap repeates "the standard claim that Keynes is all about sticky wages … the video bears witness that Keynes may be back in fashion temporarily, but only as the economics of depression."

Akerlof & Shiller, Animal Spirits: A Misnomer for Their Sound Economics

Animal Spirits - How Human Psychology Drives The Economy, and Why It Matters for Global Capitalism, by George A. Akerlof and Robert J. Shiller, was published earlier this year by Princeton University Press, Princeton and Oxford, 2009. It is a timely book, as it addresses the questions of why most economists failed to foresee the current global crisis, to provide explanations for its occurrence and to suggest effective remedies to counteract it. But above all it is a refreshingly original, formidable set of economic propositions, corrosive and at the same time constructive, with pointed and valuable policy implications.

Bob Solow’s book-cover endorsement - “… a sorely needed corrective” - is an understatement. The book should be highly recommended in the reading lists of all social sciences students in every year of their curriculum, and made compulsory reading for government officials, businessmen and anybody operating in credit and financial markets. If I could afford it I would do for the book what a US millionaire is reputed to have done for Joseph Heller’s Catch 22, advertising in the press to give away free copies to the general public.

Akerlof and Shiller claim that “Keynes appreciated that most economic activity results from rational economic motivations - but also that much economic activity is governed by animal spirits” (p. ix). They understand these as “individual feelings, impressions and passions” (p. 1), “a basic mental energy and life force” (p. 3) and “describe five different aspects of animal spirits … confidence, fairness, corruption and antisocial behaviour, money illusion, and stories” (p.5). Confidence changes interact with the state of the economy and amplify disturbances. Concerns about fairness affect the setting of prices and wages. Temptations of corrupt and antisocial behaviour have a significant role in the economy. The public is confused by inflation and deflation and suffers from money illusion. “Finally, our sense of reality, of who we are and what we are doing, is intertwined with the story of our lives and the lives of others. The aggregate of such stories is a national or international story, which itself plays an important role in the economy” (p.6). The book first describes how these five animal spirits affect economic decisions, then argues that they play a crucial role in answering eight crucial questions:

“1. Why do economies fall into depression? 2. Why do central bankers have power over the economy, insofar as they do? 3. Why are there people who can’t find a job? 4. Why is there a trade-off between inflation and unemployment in the long run? 5. Why is saving for the future so arbitrary? 6. Why are financial prices and corporate investments so volatile? 7. Why do real estate markets go through cycles? 8. Why does poverty persist for generations among disadvantaged minorities?”. Moreover, a post-script to Chapter 7 includes their analysis of the current crisis and policy recommendations.

Akerlof and Shiller criticise and de-bunk many conventional economic theories, the foundations of the hyper-liberal tradition associated with the Thatcher and Reagan governments: from rational expectations to the efficient market hypothesis, from the natural rate of unemployment - and the associated denial of a trade-off between unemployment and inflation - to the very notion of voluntary unemployment, from the alleged benefits of de-regulation to the significance of Tobin’s q (the ratio between the current stock exchange valuation of a company’s shares and bonds and the replacement cost of its productive assets: a high q is supposed to promote investment but not always does). We are presented, instead, with waves of optimism and pessimism, manias, euphoria, panics, dishonesty, booms and busts, and the problems of how to put back together again the broken pieces of the financial Humpty-Dumpty.

The conclusion is that “… capitalism can give us the best of all possible worlds, but it does so only on a playing field where the government sets the rules and acts as a referee. Yet we are not really in a crisis for capitalism. We must merely recognise that capitalism must live within certain rules”. “And … in our view capitalism does not just sell people what they really want; it also sells them what they think they want. Especially in financial markets, this leads to excesses…”(p.173).

All very convincing, but for reasons largely different from the ones they offer. Keynes mentioned “animal spirits” as a shorthand for the driving force of entrepreneurship in general and particularly investment. Akerlof and Shiller turn it into a generalised motive that pervades and dominates the whole economy; they dissect the genus into the five species listed above, quite arbitrary and each of them still something of a black box. They identify animal spirits with 1) irrational behaviour and 2) non-economic motives, which is neither necessary nor useful. A powerful critique, but we are left clutching only a few straws. In the end animal spirits become a trite and somewhat irritating cliché, like the fuzzy drawings by Edward Koren supposed to capture them, and of little value added for our understanding of the modern economy.

Irrationality and non-economic motives

The inclusion of irrational behaviour and non-economic motives in macroeconomics is crucial for Akerlof and Shiller: “Picture a square divided into four boxes, denoting motives that are economic or noneconomic or responses that are rational or irrational. The current model fills only the upper left hand box; it answer the question: How does the economy behave if people only have economic motives, and if they respond to them rationally? But that leads immediately to three more questions, corresponding to the three blank boxes: How does the economy behave whith noneconomic motives and rational responses? With economic motives and irrational responses? With noneconomic motives and irrational responses?”.

“We believe that the answers to the most important questions regarding how the macroeconomy behaves and what we ought to do when it misbehaves lie largely (though not exclusively) within those three blank boxes. The goal of this book has been to fill them in” (p. 168).

The question of whether Keynes meant animal spirits to imply irrationality has been the object of a debate, completely ignored by Akerlof and Shiller. R. C. O. Matthews (1984) [“Animal spirits”, Proceedings of the British Academy, 70, 209-229, pay per view] backs the irrationality implication. He argues that Keynes first heard about the term in a lecture in Modern Philosophy on Descartes and other philosophers: in his lecture notes, Keynes commented on animal spirits: "unconscious mental action" (p. 212). Also for Roger Koppl (1991) [“Retrospectives: Animal Spirits”, Journal of Economic Perspectives, 5 , no. 3, 203-210, pay per view] Keynes believed that "the actions induced by animal spirits are irrational." (p. 205). Koppl also conjectures a connection with Descartes for whom, he says, blood that was heated in the heart and transported to the brain could be "animated" and as such make the person "act contrary to their best judgment."

Sheila and Alexander Dow, (1985) [“Rationality and Animal Spirits” in Tony Lawson and Hashem Pesaran, Eds, Keynes' Economics: Methodological Issues] on the contrary claim that explanations based on animal spirits do not imply irrationality: "If evidence is scant for the propositions put to business decision-makers, then they may legitimately weigh them lightly as offering little in their way of prescience. This behaviour is wholly rational, as is the use of direct knowledge (such as business intuition) in such circumstances." Hans O. Melberg [“A Note on Keynes' Animal Spirits, Critical notes on the use of Keynes' suggestion that animal spirits can "explain" economic instability". (Observation, 14 February 1999)], also strongly criticises the inference of irrationality. Akerlof and Shiller conveniently ignore all these arguments and plunge for non-economic motives and irrational responses without making a case for either of them. In their book even trust and confidence are irrational, rather then born out of experience or a plausible game strategy: “The very meaning of trust is that we go beyond the rational” (p. 12)

What Keynes actually said is: "our knowledge of the factors which govern the yield of an investment some years hence is usually very slight and often negligible." (General Theory, p.149). "If we speak frankly we have to admit that our basis for knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of patent medicine, an Atlantic liner, a building in the City of London amounts to very little and sometimes nothing ...)" (p. 149-150)

"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." (161-162) "... human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist ... it is our innate urge to activity that makes the wheel go around ..." (p. 162).

Now, there is nothing irrational, or uneconomic, in pessimism and optimism. The same applies to the “spontaneous urge to action rather than inaction”, seeing that the particular course of action we select on that basis remains unspecified; until we know such a course we cannot rule on its rational and economic character or otherwise. If “a weighted average of quantitative benefits multiplied by quantitative probabilities” is not available, spontaneous impulses rooted in moods (pessimism/optimism) are perfectly rational and economic. What Akerlof and Shiller themselves define as “a basic mental energy and life force” does not lend itself to characterisation as either irrational or uneconomic. Rightly or wrongly one feels that Shiller - the successful author of Irrational Exuberance (Alan Greenspan’s famous expression) - may have led Akerlof farther in this direction than he would have gone on his own.

Moreover what Keynes actually said or meant is immaterial, what counts is the validity of whatever today he is understood or claimed to have meant. All that remains of Keynes’ proposition about animal spirits today is the volatility of investment decisions, their dependence on “the state of the news” as well as the interest rate relatively to the perceived marginal efficiency of capital, or the internal rate of return of investment projects. (Keynes was wrong, here, to consider the expected internal rate of return of investments, instead of the expected present value per unit of investment as a suitable criterion; but not seriously wrong in so far as internal rates of return and present value criteria normally lead to the same screening of investment projects into profitable and unprofitable, though with a different ranking).

And what is irrationality in this context, anyway? According to the New Oxford Dictionary of English, irrational means: ”Not logical or reasonable. Not endowed with the power of reason.” As opposed to rational: “(of a person) able to think clearly, sensibly and logically. Endowed with the capacity to reason. … from Latin ratio, reckoning, reason; ... based on or in accordance with logic or reason”. In economic terms irrational can only mean: “knowingly and deliberately acting against one’s perceived interest” (my definition, for Akerlof and Shiller do not provide one; compare with Koppl’s “a person act[ing] contrary to [his or her] best judgment”).

True, economic agents can be and often are misguided: superstitious, gullible, incompetent; they may believe in dreams, ghosts, miracles, magics, Unidentified Flying Objects, kidnapping by alien visitors, metempsychosis, after-life punishments and rewards, luck and unluck; horoscopes; the ability to predict lotto or roulette numbers from their recorded infrequency, and to predict stock exchange trends by drawing charts; casting the evil eye and getting rid of it, love potions; proteins-only diets, homeopathy, aromatherapy and acupuncture. Economic agents may be addicted to drugs; suffer from mental illnesses; be psychopaths. These phenomena and their intensity and distribution are all aspects of society’s history and culture, but do not necessarily imply irrationality in the sense of “knowingly and deliberately acting against one’s perceived interest”. They are data like the state of technology or the distribution of primary resources; they only matter when they change rapidly, radically and systematically. There is method in human action, no matter how mad humans are: even the actions of masochists are ultimately directed towards the pursuit of their happiness. I for one am completely indifferent to whether or not the three empty boxes that worry Akerlof and Shiller are ever filled or remain empty.

Expectations are most certainly never “rational” in Lucas’s terms. This does not make them “irrational”, though: there is a long-standing tradition in the theory of expectations - rigid (tomorrow’s values like today’s, as in the cobweb or pigs’ cycle), regressive (tending to return to a normal value when falsified, as interest rates in Keynes’s liquidity preference), extrapolative (projecting past rate of change into the future, perhaps the most common model), adaptive (adjusting expected change to the degree of success of the last prediction), with any number of lags and distributed lags. And of course often expectations are self-fulfilling. None of these expectations models can be said to be “irrational” or “uneconomic”. The question is whether one or another expectations model is right or wrong, or at any rate performs satisfactorily or does not, in a particular market at a particular time and place.

An alternative to Akerlof’s and Shiller’s five animal spirits

Is the concept of animal spirits the only unifying approach, or let’s call it umbrella, for the five phenomena which Akerlof and Shiller characterise (exhaustively, one presumes) as animal spirits? Namely, “confidence, fairness, corruption and antisocial behaviour, money illusion, and stories”? Suppose instead that we choose as a unifying approach a fairly conventional “intertemporal allocation”, and split this into “expectations, aspirations, enforcement of contracts and laws”. Do we miss out anything of all the things that Akerlof and Shiller include under the allegedly innovative five categories of animal spirits?

We do not. Confidence issues arise primarily in an inter-temporal framework, that must be backed by means of inter-temporal contract enforcement, if only to reinforce confidence; while simultaneous bilateral transactions only require a minimum of law and order. Fairness is a question of aspirations, which may be inconsistent in the judgement of several agents, something that is otherwise missed when we talk of fairness tout court. Corruption - which Akerlof and Shiller use not so much in the sense attributed to it by Transparency International but as associated with antisocial behaviour - is covered squarely by our notion of law enforcement; it is true that antisocial behaviour is a broader concept, for it would include also moral hazard, i.e. opportunistic behaviour, but this is a first and most conspicuous omission from the analysis offered by Akerlof and Shiller, so they would not miss it. Money illusion, especially in the way it is used by A&S in the inflation-unemployment trade-off, is precisely a matter of expectations and aspirations, and would be well covered by our alternative framework. [Incidentally, here there is second inexplicable omission from A&S, namely the principle of Central Bank Independence that is strictly derived from the lack of an inflation-unemployment trade-off, a lack that they rightly so strongly criticise]. As for “stories”, they are simply the experience (or presumed experience, that sometimes may have been wrongly distilled from available facts, or glorified into false myths) which is at the basis of expectations, nothing else.

Under the heading “Inter-temporal allocation”, and its three subheadings “expectations, aspirations, enforcement of contracts and laws”, one could still address the eight questions whose analysis is regarded as the pay-off of the theory of animal spirits developed by Akerlof and Shiller.

Eight Issues: 1. Depression

“Why do economies fall into depression?” Because markets do not guarantee inter-temporal efficiency, or rather because they guarantee inter-temporal inefficiency. Because savings depend on the level of income and investment on its rate of growth, so that their equilibrium is not necessarily automatic and anyway takes time. Because of the interaction between the multiplier and the accelerator (Paul Samuelson once wrote that economics is the science of optimisation under constraint - except for the interaction between multiplier and accelerator - one of the most eloquent statements of the inadequacy of neoclassical economics). Because economic growth along the long term trend of population and productivity has a full employment ceiling, and a floor due to the fact that net investment and feasible subsistence consumption cannot fall below zero. As the ceiling or the floor are approached, without necessarily being hit, the growth slowdown turns into decline and the decline slowdown turns back into growth. Because booms cause wage growth thus carrying the seeds of their own bursting, while recessions depress wages and restore profit margins allowing the financing and the encouragement of new investment. Because on top of all this there is also the political cycle first investigated by Michal Kalecki. I am very happy with the Harrod-Domar knife-edge growth paths, Dick Goodwin' growth cycle and Hyman Minsky's financial cycles.

2. Central Banks powers

“Why do central bankers have power over the economy, insofar as they do?” Because on the basis of a faulty theory (of rational expectations and the associated denial of a trade-off between inflation and unemployment) since the late ‘eighties they have been given Independence from the government and discretionary powers over inflation targeting, while they are allowed to ignore the wreckage they often inflict on output and employment (the Fed is not so bad, because it is less independent and its remit includes also interest rates, employment and the exchange rate).

3. Unemployment

“Why are there people who can’t find a job?” Because in a closed economy (and the global economy is closed to the outside by definition) unemployment cannot necessarily be solved by lower wages, for these lead immediately to lower consumption, which may or may not be compensated for by higher investment - not least because lower wages will tend to lower also the investment intensity of new capacity. In the open traditional non-global economy these considerations apply to a lesser extent, but they are still operational if import and export weighted elasticities with respect to prices add up to less than unity.

Some unemployment is “classical”, i.e. caused by the lack of equipment in a quantity sufficient to employ everybody even at subsistence wages, or rather at the efficiency wages that minimise labour costs per unit of output. Some unemployment is “neo-classical”, i.e. due to the money value of the marginal product of labour measured at its competitive price being lower than money wage. Some unemployment is Keynesian, i.e. due to the lack of effective demand and to imperfect competition.

The most important cause of unemployment of all is probably imperfect competition - which does not gets a single mention in the entire ambitious theoretical construction by Akerlof and Shiller. For under imperfect competition producers will value the marginal product of labour not at its price but at its marginal revenue, which may become zero or negative well before full employment of labour is reached, therefore preventing full employment even if wages were flexible downwards right down to zero. Apart from the fact that even if the full employment marginal product of labour reckoned at its marginal revenue was positive, and the wage rate fell down to its level, entrepreneurs might regard as unrealistic - on the basis of experience - the continuation of such a low wage into the future, necessary to make investment pay, and still refrain from additional investment thus maintaining unemployment.

By comparison with this set of explanations, the one provided by Akerlof and Shiller is not at all satisfactory. People - they say - are perfectly willing to work for the wage rate per unit of time that would correspond to full employment, but then employers will take into account the positive feedback of higher wages on productivity (through higher morale of employees and the like), and will go and pay wage rates per unit of time higher than the full employment rate in an effort to reduce, indeed minimize, the wage cost per unit of effort, or for unit of product. At this higher wage rate, lots of willing workers remain unemployed. But this is just another form of a naïve theory of voluntary unemployment, because the implication is that the unemployed would be willing to work for a lower wage but would then supply a more than proportionally lower amount of effort or product. If this is the problem, there is a simple remedy: linking wages to productivity, but A&S do not take it into consideration. And their neglect of imperfect competition is a damaging omission in any serious discussion of unemployment.

4. The Phillips Curve

“Why is there a trade-off between inflation and unemployment in the long run?“ Because there is at least some money illusion, A&S say. This is one way of looking at it; more rigid inflationary expectations will also do the trick. Except that the question of whether or not there is a trade off is ultimately an empirical question, and empirical verifications of the Phillips curve linking inflation and unemployment are not particularly satisfactory.

5. Saving

“Why is saving for the future so arbitrary?” Because the inter-temporal trade-off between dated consumption of an individual or of households depends on too many, too uncertain factors, and on different responses. For instance people might save more at a higher (real? nominal?) interest rate, but a target saver will save less to obtain a given consumption transfer into the future. And there is absolutely nothing in saving behaviour to support the necessity for a positive real interest rate, as usually presumed by the Bretton Woods institutions. Here again, as for the Phillips Curve, it is not enough to note or even explain the erratic nature of saving behaviour, but it is necessary to positively identify and verify empirically the impact of the many factors that might be at play.

6. Volatile assets prices

“Why are financial prices and corporate investments so volatile?” This one is easy. The market valuation of the shares of a company, if market work, will correspond to the current dividend d per share, cumulated at its expected nominal growth rate g per year, and discounted at the appropriate nominal discount rate r. Thus the slightest change in the rates g and r expected to prevail in the future will generate disproportionate, massive changes in the share price. If both the expected growth rate g and the discount rate r were constant, and r>g, the price of the share will be equal to d/(r-g). If g>r the share price would tend to infinity with the time horizon tending to infinity. Conversely, the generalised downwards revision of g relatively to r (as in the bursting of the dot.com bubble) will precipitate a stock exchange crisis [With apologies to readers for an earlier ambiguous formulation of this problem]. This is the beginning of an answer. Add securitisation, originating assets not to hold but to sell, leveraged betting on derivatives (never mentioned by A&S as such) and a credit crunch, and Bob’s your uncle.

7. Real estate cycles

“Why do real estate markets go through cycles?” Because there is a cycle in building activity, just as there is in pig production or in general investment: high rentals lead to high capital values of existing buildings and to new construction; as new houses and commercial buildings are built their rental and therefore market value fall, and so on for the time it takes to reduce the buildings stock to an equilibrium level, which will then tend to overshoot. And for the same reasons of optimistic expectations, non sustainable asset price increases, the slowdown in capital gains leading to a decline in asset prices, etcetera etcetera in reverse.

8. Poverty Traps

“Why does poverty persist for generations among disadvantaged minorities?” From the impact of so-called stories of minority discrimination, - say Akerlof and Shiller - to be remedied by stories of positive role models and “affirmative action”, that “can play a a significant role in breaking down the barrier between the two Americas” (p. 164). But look at it another way, as Branko Milanovic does in a recent paper [“Global inequality of opportunity. How much of our income is determined at birth?”, mimeo, World Bank, February 2009]. “Suppose that all people in the world are allocated only two characteristics over which they have no control: country of citizenship and income class, within that country, of their parents. Assume further that there is no migration.” Under this premise, Milanovic shows that “at least 80 percent of variability in income of almost 6 billion people in the world is explained solely by these two characteristics. Thus, globally-speaking, the role of effort or luck in improving one’s income position, cannot be large. On average, “drawing” one-notch higher parental income class (on a twenty-class scale) is equivalent to living in an eleven-percent richer country” (Milanovic, op.cit.). This makes A&S’s concern for disadvantaged minorities pale into insignificance. And let there be no doubt that Milanovic’s kind of explanation and analysis rests on no notion of animal spirits.

The current crisis and its remedies

A post-script to Chapter 7 of Akerlof and Shillers includes their analysis of the current crisis and policy recommendations. This is one of the best parts of the book, but their kind of analysis is by now more and more widely accepted. It does not sound very different from, say, the analysis by one of the most conventional, shrewd economists around: the ECB President Jean-Claude Trichet, [“The ECB Enhanced Credit Support”, a keynote address given on 13 July 2009 at the University of Munich].

The only original new remedy proposed by Akerlof and Shiller is a credit target, in addition to the traditional interest rate and fiscal stimulus. “The aggregate demand target will indicate, on the one hand, the fiscal stimulus and interest rate policy needed for full employment. The credit target will show what judicious application of methods 1, 2, and 3 [respectively: expansionary discount window, direct investment in banks, and use of government sponsored enterprises] must achieve: together they must create the financial flows - the issuance of commercial paper, bonds and other instruments - that are also associated with full employment” (p.96). And “of course the two target approach and Humpty Dumpty [meaning coping with the irrevocable fall of financial markets, see also earlier reference] do not apply only to the United States but internationally as well” (Ibidem).

The alleged originality of the animal spirits theory that Akerlof and Shiller have been developing in their book is exposed as another way of speaking of what is well understood in standard analysis.