It is wrong to push the old into a quicksand

Francesco Giavazzi – the distinguished economist from Bocconi University, Milan, a frequent visitor to MIT – made two gaffes around September last year: about Lehman Brothers, and about derivatives markets. Then he lay low for about a year, to re-emerge now with two more gaffes: one on targeting the aged in order to cover the cost of fiscal stimulus, and one on a wishful drive towards global recovery. This just goes to show that the judgment of engineers who turn to economics should be seen as that of engineers.

Lehman Brothers

On 16 September 2008, the day after Lehman Brothers went bankrupt, Francesco Giavazzi expressed great enthusiasm for the US authorities’ decision not to bail it out. “Yesterday has been a good day for capitalism” (sic!), he wrote on LaVoce.info, adding that “Now the liquidity cushion needed by AIG will also be provided by the market”. First he had to add a postscript to his piece, acknowledging that the US government had bailout AIG only a couple of hours later. Then he had to recognize – in a joint book with Alberto Alesina on the global economic crisis – that “ex-post, the failure to save Lehman Brothers probably was a mistake” (La crisi. Può la politica salvare il mondo? 2008, p. 49), rather than the “victory of the market” he had hailed earlier. Compare with Chris Giles, in the FT of 13 September 2009: “The collapse of Lehman Brothers transformed an expected global slowdown into the worst recession since the second world war. Though the direct losses from the Lehman bankruptcy caused little trouble, the ensuing panic that engulfed financial markets, banks and companies hit the global economy harder than the Opec oil crises of the mid-1970s, the loss of control over inflation in the late 1970s or the dotcom crash at the turn of the millennium”.

Derivatives markets

Expressed enthusiasm for the inordinate growth of the derivatives market, on the ground that derivative products allow Indian farmers to reduce the risks surrounding their crops, and enable the homeless to buy their homes, was another economic error. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and at their peak earlier in 2009, when their total began to decline slowly, they had reached 1.14 quadrillion dollars (more precisely: $548 trillion in Exchange Traded Derivatives plus $596 trillion in notional Over-The-Counter derivatives). By comparison, the Gross Domestic Product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk turned into a multiplication of risk. Or else those Indian farmers and US homeless have been exercising a lot of leverage.

But clearly the statute of limitations leaves errors unpunished in economics. Giavazzi has now reappeared to fire two more shots, though his aim has not improved over last year.

Targeting the aged

In a post on Vox.eu asking “What’s the proper exit strategy from the crisis?”, Giavazzi argues that the exit will take a long time, probably a matter of years, and the real co-ordination necessary is not across countries, but between monetary and fiscal policy. What should be rescinded first, exceptional monetary accommodation or the fiscal deficit?

Jean Pisani-Ferry argued recently that first should come structural reforms, then the gradual withdrawal of fiscal stimulus, then monetary policy could be reined in. He feared that Central Banks would not accept a secondary role, and was right: on 11 September, at a Bank of Italy Conference in Rome, ECB Board member Lorenzo Bini Smaghi said: “The more delayed the fiscal exit, ceteris paribus, the more the monetary policy exit might have to be brought forward. Indeed, given the level of the debt accumulated in most advanced economies, any delay in the fiscal exit is likely to have an effect on inflation expectations, and may even disanchor them.
This is a risk that monetary policy cannot take, as it would undermine its overall strategy.” (Bini Smaghi 2009 “An ocean apart? Comparing transatlantic responses to the financial crisis”; I was there and could not believe my failing ears).

Now, this does not sound like co-ordination, more like blackmail. Giavazzi likens the strategies of Central Banks and fiscal authorities to a game of chicken, whereby two car drivers on a collision course may both refuse to give way and crash – a patently inferior solution to a cooperative one. Giavazzi instead recommends that Euro-zone governments should commit themselves irrevocably to future spending cuts, in order to stabilize expectations and allow central banks to wait longer before they remove monetary accommodation. This would avoid the demand contraction that earlier fiscal cuts would cause.

True, but Giavazzi singles out for future cuts the ageing-related spending over the next 15 years. According to The 2009 Ageing Report issued by the European Commission (2008), ageing related spending amounts to 7% of GDP per year in Holland, 5% in Spain, 3.5% in Germany, and 3.3% in the EU27. Thus the budgetary effects of ageing are several orders of magnitude larger than the fiscal cost of the crisis. In terms of present value of total age-related expenditure (note: over 15 years), the present value of fiscal stimulus (temporary, over only 2 years) naturally is much lower, comparatively negligible (see Giavazzi’s Fig. 1, from IMF data).

Figure 1. The fiscal costs of the crisis compared to age-related spending

Source: IMF

The trouble is that all these figures are utterly misleading. The incidence of pension expenditure, on GDP or on total government expenditure, is not comparable across countries because of different statistical conventions (for instance in the treatment of golden handshakes and of payments to invalids), and even less comparable across countries with different incidence of so called distributive, Pay As You Go (PAYG) systems, versus capitalized, fully funded pension systems. Necessarily countries with a dominant PAYG system look as if they were more generous towards the aged than they actually are, because pension contributions should, but usually are not, counted as government revenue against pension expenditure. Conversely, an entirely funded system will appear as making no claim on government expenditure at all, because pension contributions are credited to the pension funds financing pension expenditure: but there is no reason why PAYG pension expenditure and revenue should be accounted for any differently. Only for uniform statistical conventions and for a comparable incidence of redistributive/funded pension systems will government expenditure on pension indicate – as the IMF figure produced by Giavazzi suggests – governments’ relative generosity towards old-age pensioners. Reflect on the fact that in 2006 the Italian pension system actually showed a surplus of 0.8% of GDP which therefore made a positive, significant contribution to the funding of public deficit (See R.F. Pizzuti, Rapporto sullo Stato Sociale, 2008, p.21), rather than wrecking social accounts from now to Kindom Come. See also three earlier posts on this Blog, of 13 June, 23 June, and 30 June, as well as the theoretical backing of Nick Barr and Peter Diamond, Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (2009).

The same considerations apply to the additional expenditure due to population ageing, although its funding is not spelled out in the data quoted by Giavazzi. It is simply wicked to compare two item of expenditure in terms of their present value – two years in one case, 15 years in another. Besides, you cannot single out ageing as a specific source of expenditure, that can be cut at will regardless of the means provided by the recipients to finance the pension system as a whole. You might as well resort to the method – probably apocryphal but telling – that Federico Caffè used to quote when he discussed pensions: in some primitive society apparently the young brandish long pointed poles to decisively push into quicksand the aged no longer able to look after themselves. At the time of the Italian pension reform of 1995 the satirical magazine Cuore published a poster saying: “Your Government Needs YOU: Kill an Old-Age Pensioner”. Is this the Giavazzi solution? After all, it appears to be seriously considered by the IMF (2009).

The drive towards global recovery

In the September issue of the latest IMF publication, Development and Finance, there is a piece on “Growth after the Crisis”. If the world economy is to recover, a replacement must be found for the newly frugal U.S. consumer. Giavazzi calculates a consumption shortfall of about 3% of US GDP (i.e. a 4% increase in the saving rate from zero, of over 70% GDP being disposable income, = 2.8%), that cannot be compensated by the growth of China India and Brasil. China in particular will need to improve the provision of finance to the private sector, introduce a public safety net and risk-sharing financial products (this time we are talking about health and life insurance, and pensions, not derivatives…) before the Chinese saving rate is reduced. Europe – and particularly an export-led Germany, cannot or is not willing to do much (especially after the German elections).

So, Giavazzi argues, “the only way to maintain full employment is through higher investment.” This cannot be higher public investment, given the limited opportunities especially in the United States (where it is about 3% of GDP) and the “high probability that some of it will be wasted rather than contributing to raising the productive level of the capital stock”. Private investment (which is close to 20% in the USA) then must be the answer. But what would induce firms to raise investment spending in the middle of a sharp recession, and without any prospect of a likely technological breakthrough?

Elementary: “the realization that the crisis will change the composition of world demand for the long term. To address such a change, the structure of world output would have to adjust, which requires industrial restructuring and, as a consequence, new investment.” Because the crisis has brought about “a change in the composition of world consumption”, which “cannot happen without substantial restructuring, and, therefore, substantial investment.” What would prompt firms to invest is “the anticipation of a change in both the geographic allocation and the composition of consumption—relatively more consumption in China, relatively less in the United States; higher demand for such things as basic appliances and relatively lower demand for high-end automobiles.”

At this point the production of a long list of instruments of industrial policy, powerful enough to promote this kind of investment in restructuring, might be expected. But no, Giavazzi candidly relies on the incentive that “Those countries that do the restructuring—and get it right, including the portion that happens through public investment—will come out of the crisis richer.” Thus Giavazzi's pronouncements on the crisis range from applauding the Lehman disaster to misunderstanding the size role and danger of derivative markets; from the targeting of social welfare provisions for the old to the rosiest, starriest-eyed version of economic planning, not via public investment because of its presumed inefficiency, but presumably through the resurrection of French-type indicative planning that never worked and never will. Since when, in this century, do western governments take national investment decisions as they appear to do in Giavazzi’s world? Are private enterprises really enlightened and optimistic to the extent of selflessly investing in the hope of collectively implementing a balanced plan, starting from a large scale, tangible imbalance?

Giavazzi’s article appears in a prestigious official IMF publication; are his views shared by Dominique Strauss-Khan and/or Olivier Blanchard? The mind boggles.

Singular Priorities

In a procession, in the line of succession to the throne, in the sequence of steps that form the critical path to complete efficiently and rapidly a course of action, a person/pretender/step necessarily takes precedence over all others in a pre-assigned ranking. In this one and only sense one can discuss the set of their priorities, for there is no trade-off between the inclusion of one person/pretender/step and the inclusion of others. Fine. And you can say, with the Mahatma Ghandi, that “Action expresses priorities”, because the ranking does not precede but follows the actual decision and there is no longer a trade-off. Or, with Steven R. Covey, "Priority is a function of context": this is precisely the point.

The trouble is that people in general, and in particular politicians and bureaucrats – and especially New Labour politicians and Brussels eurocrats – talk incessantly and over-abundantly about “priorities” in the sense of ranked policy-objectives, in situations in which there is a trade-off between them, both in the terms in which their relative achievement is feasible, and in the terms in which they may be regarded as substitutes by the decision-makers. This habit is sloppy, meaningless and misleading; it should be forbidden, penalized and eradicated.

Yet examples abound. A Google search gives about 34,100,000 entries for priorities, 10,100,000 for top priority, 21,100,000 for Obama’s top priorities for 2009. “Brown promises 'new Government, new priorities'” (27 June 2007). Tony Blair: “It is not an arrogant government that chooses priorities, it's an irresponsible government that fails to choose." Peter Mandelson: “Europe has to address people's needs directly and reflect their priorities, not our own preoccupations.” “This page [on President Barroso’s website] gives direct access to all information regarding the Commission's current priorities”. Angela Merkel: “You should know what our priorities are.” And again Merkel: “I think it is a right idea to stage a special summit, which would deal with the question of priorities of European politics;” and again: “It must be clear what the priorities on the agenda are.” Kofi Annan: “From this vision of the role of the United Nations in the next century flow three key priorities for the future: eradicating poverty, preventing conflict and promoting democracy.” John Berger: “It is not, as poverty was before, the result of natural scarcity, but of a set of priorities imposed upon the rest of the world by the rich”. US ex-Vice President Dan Quayle: "For NASA, space is still a high priority". Peter MacKay: "What Canada has to do is to have a government connected to the priorities of the people of which it is elected to serve. Those priorities include ensuring medicare is sustainable, support for the military, and tax and justice systems that work". Bill Clinton: “It's the American people who sent us here; it's our obligation to meet their priorities. So let's roll up our sleeves, get back to work and finish the work we were sent here to do".

“Di mamma ce n’è una sola” is an old Italian saying: you only have one mother. In the Roman Law sense of “mater semper certa” this has been falsified by progress with artificial insemination and wombs for rental. But strictly speaking, and in the sense of a unique emotional link with one special person, the saying remains true. My old friend Gemma, fed up with her little daughter’s apparent lack of respect, used to remind her adding: “Tutte le altre sono matrigne” (All the others are stepmothers). This is why I teach my students that priority is like your mamma: you can only have one. All the others are objectives, or targets - either independent of each other and therefore simultaneously pursuable without their having to be ranked, or impossible to rank without reference to 1) their actual trade-off with one another, in comparison with 2) the trade-off preferred by the decision maker, individual or government. Thus by definition you cannot have priorities, let alone top priorities; as you can have only one, that one can only be top, so the top is redundant.

A philosopher friend tells me that I am too literally minded: “Priorities” - she says - simply mean a set of objectives that are singled out as generally desirable, as opposed to all the other possible objectives which are regarded as less desirable, or indifferent, or undesirable outright. But I am adamant and unrepentant. If we have a list of undesirable things, their reduction or cessation or elimination must be regarded as desirable. Therefore ultimately something is either indifferent, or desirable in some form (including its opposite when it comes to undesirables). And the desirability of desirables cannot be stated in abstract, but is exclusively subject to its rate of substitution with other desirables, in the decision-maker’s system of preferences, being greater than the rate at which the desirable in question can be obtained at the cost of another desirable. Cost can also be measured in terms of a common desirable such as money, or the time and/or effort it takes to explore the desirability and substitutability of a desirable objective for another. There is no point in stating that something is desirable, without specifying up to what point it is desirable, either in terms of its direst cost in terms of money, time and effort, or in terms of the lower degree of achievement of other desirable objectives.

Anyone listing as alleged priorities a number of conflicting objectives, whether ranked or unranked, has said absolutely nothing about their relative desirability and the extent to which each one can/should be sacrified to the higher realization of another. This is what most of microeconomics is about: the comparison of the rate of transformation of one good into another in production and in the system of preference of a decision-maker, ideally both equalized to relative prices in the market. In the most general meaning of the word, prices are “the terms on which alternatives are offered” (Wickstead). Thus the wrong-headed concept of “priorities” - a contradiction in terms, the ultimate one-word oxymoron – may be forgiven to non-economists in common speech but is unforgivable when voiced by economists or people in charge of the economy talking about economics.

When there is more than one declared priority, nothing has priority. The Soviet economy was organized - to a different extent at different times in its history - mostly according to a system of multiple priorities, instead of a system of prices: the result was necessarily disorganization and chaos, ultimately leading to economic collapse. Multiple priorities were at their peak during War Communism (1918-21), when towards the end they multiplied beyond belief, to the point that even pen nibs were added to the senseless and useless priority list.

The multiple objectives meaninglessly classed as priorities can be qualitative as well as quantitative, as long as there is a possible conflict and therefore a trade-off between the fulfilment of one qualitative target and another. Indeed what prompted this post is a recent document of the Bruegel Think Tank, on Europe’s economic priorities 2010-2015 – Memos to the new Commission, Edited by André Sapir, Brussels, 2009.

A Big-Bang Euroisation? Not Now

Unlike the UK and Denmark, that negotiated an opt-out clause within the Maastricht Treaty, the EU New Member States of the 2004 and 2007 enlargements that have not already done so will have to adopt the euro sooner or later: it is part of their obligations of membership, the so-called acquis communautaire. In this respect their position is formally identical to that of Sweden, although Swedish euro-procrastination was backed by a national referendum. Slovenia and Slovakia have already adopted the euro. Except for occasional contrary remarks by Vaclav Klaus – when he was Minister of Finance, though, not as Czech President – none of the other New Members States has ever indicated unwillingness to join the euro-zone (or Economic and Monetary Union). They have all experienced directly, or indirectly, the high costs of monetary dis-integration – of COMECON (the Council of Mutual Economic Assistance), the Soviet Union, the Czechoslovak Federation, the Yugoslav Federation. Therefore they do not need persuading of the significant, symmetric advantages of monetary unification: lower transaction costs, greater stability in trade relations within the euro-zone, the ability to borrow in their own currency thus avoiding exchange rate risks, the greater attraction for Foreign Direct Investment and portfolio investment, low (though for some of them, like the Czech Republic, not necessarily lower) inflation and interest rates.

The Maastricht Treaty has set for euro-zone candidates a veritable obstacle course, with strict criteria for fiscal convergence, more strictly enforced than for old EMU members and for non-EMU-candidates, who are only subject to the looser constraints of the so-called Growth and Stability Pact. Candidates also have to satisfy criteria for monetary convergence, plus exchange rate stability vis-à-vis the euro for two years. [1] The main reason why the New Member States are not rushing to meet the criteria and join the euro is the pain involved in satisfying fiscal convergence.

The question arises whether early membership of the euro-zone might assist recovery from the deep crisis of 2009, which on average has involved a GDP contraction of 5% in the 28 transition economies that are EBRD clients, ranging from zero growth in Poland to -18% in Lithuania.
There is a presumption that small open economies would probably gain from being part of a large currency area in times of crisis, although Slovakia (where the euro only became legal tender on 1 January 2009) and the Czech Republic who is not a member have done rather well outside of it.

The IMF has been in favour of euro-zone enlargement for some time (see Susan Schadler, Ed., IMF, 2005). Barysch (2009) alleges that “On April 6th [2009] it emerged that the IMF would advise Central and Eastern European countries to adopt the euro, unilaterally and without meeting the EU’s strict criteria for the single currency, if necessary.” This recommendation - which was neither denied nor confirmed - is said to have been made “in a leaked report written in March”; it clashes with the long-standing EC decision that rules out the unilateral replacement of the national currency with euro by EU members and candidates; Kosovo and Montenegro have done it but were neither at the time. The EU allows a hyper-fixed link to the euro through a Currency Board, certainly before EU membership, as in the Baltics, Bulgaria, Bosnia & Herzegovina; presumably also after joining the EU but before applying for EMU membership, though this is not absolutely certain, as there are no precedents.

Currency Boards reduce the probability of a crisis at the cost of making the crisis catastrophic if and when it happens (as in Argentina in 2001), and European Currency Boards are not yet out of the danger zone, especially in Latvia where the Central Bank acts as a Currency Board and the lat has been on the brink of devaluation for the first three quarters of 2009.

The European Central Bank’s role as Lender of Last Resort is remarkably undetermined and left to informal arrangements with the Central Banks of euro-zone member states. Non-members with hyper-fixed links to the euro (whether unilateral euroisation or Currency Boards), or with an ordinary fixed exchange rate, might very well be left high and dry in times of crisis. Sweden and Denmark have been offered swaps by the ECB, unlike other non-members. Loans to Latvia have been primarily in the interest of European banks whose loans would have not been serviced otherwise (Bezemer, Hudson and Sommers 2009). Darvas (2009) points out that “The ECB accepts non-euro denominated securities eligible for refinancing in three currencies (US dollars, British pound, and Japanese yen, provided the security was issued in the euro area), but it should accept high-quality securities issued anywhere in the EU in all EU currencies. The ECB should also give access to ECB refinancing facilities for non-euro-area commercial banks, which could substitute the malfunctioning euro-area money market for these banks.”

The EU could well have admitted at least a few other New Member States to the euro-zone by loosening the Maastricht convergence criteria. In theory the criteria for fiscal convergence are looser than those of the so-called Growth and Stability Pact (GSP, which involves not only a 3% ceiling to government deficit but a stricter zero per cent over the cycle) and apply to all EU members regardless of euro-zone membership. In practice the GSP strictures and the associated penalties were considerably relaxed in March 2005 and further loosened de facto during the current crisis, whereas Maastricht criteria for joining the euro have been very strictly enforced. This glaring asymmetry is unreasonable and injust.

It is also unreasonable to subject countries that grow much faster than the euro-zone members and have relatively low ratios between public debt and GNP to the same fiscal stringency as stagnant and highly indebted euro-zone members (like Italy). It is more unreasonable to apply to prospective members fiscal constraints more stringent and inflexible than those applied to existing EMU members and to non-members who are not candidates. It is even more unreasonable to apply to prospective EMU members an inflation constraint linked to the “three best-performing member states of the EU in terms of price stability”, regardless of whether or not they are EMU members and arbitrarily interpreted as the three least inflationary EU members (with a non-negative inflation rate; see Darvas 2009). The very fact of EU enlargement from 12 to 27 members has implied – Darvas argues – a toughening of the inflation condition by virtue of this interpretation.

Lithuania, for instance, in 2006 was left out of the euro-zone only because its inflation exceeded the average inflation of the three least inflationary EU members by 1.6% instead of the 1.5% prescribed by the Maastricht Treaty – not exactly enlightened or rational behaviour, especially considering that two of those three least inflationary countries (Sweden and Poland) were not euro-zone members. Slovakia, on the contrary, was admitted in 2009 in spite of a 25% nominal revaluation of its crown in the two years before joining, which was a significantly greater departure from the basic parity than the stipulated maximum band of variation of +/-15%. “The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong” (Darvas and Pisani-Ferry, 2009, op.cit.; see also Nuti, 2006).

Piatkowski and Rybinski (“Let us roll out the euro to the whole Union”, FT 11 June 2009) now propose “a ‘big bang’ euro area expansion to introduce the euro in all 27 member states by 2012.” “Such a bold decision - they claim - would give a credibility boost to the enlarged euro-zone, accelerate replacement of the dollar by the euro as the global reserve currency and breathe new life into a united Europe.” This might have been a good idea when the euro was first introduced in 1999 - certainly not now with some of the countries in a financial turmoil, for membership of a single currency area is a preventive remedy, not a cure. The authors point out that “the combined GDP of all euro-zone candidate countries in central and eastern Europe amounts to less than 10 per cent” and therefore costs would be contained, but this “little-me-ism” by itself does not amount to a case.

The idea that Latvia should first devalue substantially with respect to the euro and then join the euro-zone in a hurry (Roubini 2009) does not make sense. Lat devaluation is probably unavoidable. Of course it would aggravate the prospective Latvian insolvency on euro-denominated debt and force a restructuring, but a crisis of the type and scale of Argentina 2001 seems impossible to procrastinate much further. However, euro-zone membership would not reduce the blow of that devaluation, only the risk of future devaluations; immediately after a devaluation there would be no hurry to join - other than to better milk resources from EMU taxpayers. And since the hyper-fixed exchange rate with the euro was Latvia’s problem, currency conversion even at a lower rate cannot be the solution. Yet the OECD (2009) is now advocating a similar solution for Iceland: join the EU, devalue and join the euro-zone as soon as possible. Here as well there is no case other than an unwarranted and expensive benefaction on the part of the rest of Europe. Reade and Voltz (2009) argue that Sweden should join the eurozone: no problem there, if only they asked.

Darvas (2009) recommends new rules which - he claims - are based on greater logic and common sense: 1) “All criteria should be related to the euro-area average”; 2) “The inflation, interest rate, and budget balance criteria should allow some deviation from the euro-area average”; 3) “The requirement for the ratio of government debt to GDP could simply demand that this ratio should not exceed the euro-area average, unless the ratio is diminishing sufficiently and approaching the euro-area average at a satisfactory pace.” “The suggested change in euro-entry criteria would still require substantial effort from the applicants, but it would ease their pain. It would also boost confidence, helping kick-start the private capital inflows – not western taxpayers’ money – that these countries desperately need.” (Darvas 2009).

However, focusing on average EU parameters would be disastrous, for it wouls trigger off a game of self-fulfilling expectations. In a crisis each member expects every other member to raise its deficit and debt, and possibly inflation afterwards; each therefore raises its own target parameters accordingly. Collectively, they cause a rise in average parameters, thus making it easier for them to satisfy average constraints individually: any macroeconomic discipline goes by the board. Imagine a party of diners, each of them on an expense account, and each having to pay out of pocket only the excess cost of their lunch over the average cost for all diners. Insofar as their choices of dishes are affected by cost considerations, each diner will have a more expensive lunch than otherwise. Average limits would tend to be high and to escalate fast,

It would be wiser, in order to encourage euro-zone membership, 1) to exclude any non-EMU member from the determination of monetary convergence parameters, and 2) to end the asymmetry that penalises candidates, thus modifying Maastricht fiscal parameters in line with the changes introduced in March 2005 to the so-called Growth and Stability Pact, softening them for countries characterised by fast growth, low debt, and high public-investment.
____________
[1] The well-known Maastricht conditions are: an inflation rate no more than 1.5% above the average rate of the three least inflationary members of the EU; long term interest rate no more than 2% higher than the average rate of the same three least inflationary EU members; government deficit no higher than 3% of GDP and public debt no higher than 60% of GDP, or within reach of those constraints and falling; and the additional condition of two-year membership of the Exchange Rate Mechanism II, holding a course within a +/-15% band around the euro parity agreed with the EMU monetary authorities before joining the ERM II.

Fiscal stimulus: larger, more balanced, co-ordinated

A United Nations source (World Economic and Social Prospects-Update as of Mid-2009) estimates that, since September 2008, Governments worldwide have made available massive public funding (amounting to $18 trillion, or almost 30 per cent of WGP [World Gross Product]) to recapitalize banks, to acquire ownership stakes in ailing financial institutions, and to provide ample guarantees on bank deposits and other financial assets. Further, recognizing the inadequacy of these monetary and financial measures to stave off a recession, many countries have also adopted fiscal stimulus plans, totalling about $2.6 trillion (about 4 per cent of WGP), to be spent over 2009-2011. ”While significant, this may still fall somewhat short of the stimulus of 2 to 3 per cent of WGP per year that would be required to make up for the estimated decline in global aggregate demand. “ (Ibidem).

In the same document the UN makes a number of recommendations of preconditions affecting fiscal stimulus effectiveness: the adequate recapitalisation of banks; the “fundamental reforms of the international financial system… to overcome the systemic flaws which caused this crisis” (a “macro-prudential regulatory system”, “counter-cyclical capital provisioning”, supervision of all financial market segments in which systemic risk is concentrated, including hedge funds and cross-border flows); “a new framework for global economic governance”, attributing to the IMF the role taken until now by the “Group of 7, the Group of 8, the Group of 20 or other ad hoc forums, lacking the participation or representation of important parts of the international community, especially from developing countries.”

These preconditions would produce spillovers such as the reduction of tax evasion (enhancing development resources), of corruption, of drug trafficking and the financing of terrorism. The UN document stresses the need for mechanisms of debt restructuring, and for “a new global reserve system which no longer relies on national or regional currencies, as the major reserve currency must be created.”

But the most important policy recommendation of this UN document is that of a co-ordinated stimulus, “with global sustainable development objectives”. In truth this is understood to involve more than just co-ordination, and to include an increase and redistribution of the stimulus, 80% of which is coming at present from developed, deficit countries. Greater efforts are expected of surplus countries in order to reduce global imbalances and to contribute “about $500 billion extra over 2009-2012, compared with the uncoordinated scenario” to middle and low-income developing countries, strengthening their social protection systems and making long-term investments in sustainable development. “The additional resource transfers needed would include about $50 billion for the least developed countries.”

Global coordination should also eliminate unfair trading practices associated with many stimulus packages that provide subsidies to domestic firms, in order to benefit through trade those countries that cannot afford domestic subsidies and fiscal stimulus. There would be “concerted efforts to provide countries with greater access to developed country markets as envisaged in a truly developmental Doha round of multilateral trade negotiations.”

The WESP-Update reports that the UN Department of Economic and Social Affairs has made simulations with their global policy model, which suggests that the proposed larger, more balanced and coordinated global macroeconomic stimulus would yield significant gains in terms of global growth, compared with the existing scenario of uncoordinated fiscal stimulus being individually undertaken by national Governments. The simulations are summarised in the figures below. (Click to enlarge).


The figures illustrate economic recovery under coordinated and uncoordinated global stimulus, 2009-2015. Source: United Nations/Department of Economic and Social Affairs, based on policy simulation within the UN Global Policy Model. From: UN WESP-World Economic Situation and Prospects, Update as of Mid-2009, New York.

In such a coordinated, development-oriented policy scenario, the world economy would recover at an annual growth rate of around 4 to 5 per cent in 2010-2015, led by robust growth of about 7 per cent per year in developing countries. In the uncoordinated scenario, developing countries - including transition economies - would recover at only 3 to 4 per cent per year.

Developed countries would also gain from the proposed policy broadening and coordination, with their GDP growth accelerating to about 4 per cent per year, up from 2 to 3 per cent in the uncoordinated scenario. “Furthermore, the simulation results for the coordinated policy scenario predict a benign unwinding of global imbalances, keeping external asset and liability positions of major economies in check, which would, in turn, support greater exchange-rate stability.” Coordination would require monitoring mechanisms. There would be net gains all round.

All this might be considered as “pie in the sky”, but - especially at a time of generalised discussions of premature “exit strategies” it is a timely reminder of the generalised, large-scale additional gains, and the possible improvement in global imbalances, that are within the grasp of a slightly larger, more balanced, co-ordinated stimulus package.

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.

Ronald McKinnon: a concerted modest increase in interest rates?

Ronald McKinnon (Stanford), by way of comment to my post on exit strategies [Exit Wounds, 3 August] sent me an article of his, "Liquidity Traps and the Credit Crunch", that appeared in the Financial Times Forum of 14 August and "emphasizes the importance of getting out of the liquidity trap in order to restore the normal flow of credit even before full 'exit'".

In brief, "...starting from a position where interest rates are already low, say 2 per cent, reducing them to zero has only a second-order effect on expanding aggregate demand. But going from 2 per cent to zero leads to a tightening of the credit constraint on the supply side. Although there may be a “dead cat bounce” to the economy on the demand side in 2009, leaving the Fed funds rate at zero makes it impossible for the resumption of “normal” bank credit to support growth in future. A condition for restoring normal borrowing and lending in the interbank market is to have positive rates of interest at all terms to maturity. Only then will banks that are liquid lend to those that are illiquid. But if the risk free (i.e. federal funds) rate is close to zero, banks with excess reserves will not bother parting with them for a derisory yield." This - he argues - might lead to a trade contraction by causing supply constraints in the export sector, starved of credit.

I readily accept Ronald's general concern for the implications of low interest rates; I never thought - unlike Willem Buiter - that negative interest rates were the right policy to get out of recession, not least because they could not survive in globalised financial markets. But there are two points in RMcK's argument that I found difficult to accept. (1) While undoubtedly he is right on the importance of foreign trade credit, I could not bring myself to consider the cut in trade due to stricter credit constraints as a supply constraint (which term I would reserve for capacity constraints); (2) I could not see why low policy interest rates should deter banks from raising their margins between lending rates and policy rates to the point that it pays them to lend.

Faced with these objections, Ronald sent me an excellent reply, and developed the second point into a full-fledged argument that I reproduce below with his permission, for which I am most grateful. The bottom line of Ronald's argument is that "The Exit Problem: When to Reduce Monetary and Fiscal Stimuli?", has a "Partial Solution: concerted modest increase in interest rates?" [from his paper on "The Global Credit Crunch: China and the United States", Beijing 29 August 2009, which he also kindly sent me but is not reproduced here other than for figures 9 and 10 below].

"On your two points: (1) it is a matter of semantics. You may or may not like my referring to a credit constraint as a "supply" constraint. But credit is an input into working capital. If working capital is unavailable or restricted, then dumping more liquidity into the system will not increase output as if there was a constraint on physical capacity.

(2) Your second point: in the liquidity trap, why don't banks just raise their interest rates to final (retail) borrowers to maintain their profit margins and willingness to lend? This is an important and very subtle point which I did not explain very well in my FT post.

The willingness of banks to make forward commitments to lend at "retail ", to nonbank firms and households, depends very much on the wholesale interbank market. If the wholesale interbank market works smoothly without counter party risk, then even currently illiquid banks can make forward loan commitments--say 3 months in advance--to their retail customers. These banks know that if they are still illiquid when three months are up, then they can always bid for funds in the wholesale market at close to the "risk-free" interest rate to cover their retail commitment.

Now suppose some upsetting event, such as a crash in home prices that makes all mortgage related assets on bank balance sheets suspect. Then counter party risk becomes acute, and banks become less willing to lend to each other unsecured. The LIBOR market is unsecured. So illiquid banks become less willing to lend forward at retail because they don't know what their wholesale cost of capital will be 3 months hence. Indeed if any one bank tries to bid more than the going interbank rate of interest for funds, it is immediately suspected of being a more risky counter party!

Now enter the central bank concerned with the drying up of retail bank credit. It reacts in a text book fashion of flooding the interbank market with liquidity so that the interest rate on federal funds is driven to zero. Bank trading in federal funds is collateralized--usually through short-term re-po agreements, where the collateral is usually U.S. Treasury bonds.

Normally, without significant counter party risk in banks, there isn't much of a difference between the interest rate on federal funds and LIBOR. (See Figure 9 for January 2006 to July 2007 [reproduced below with RMcK's permission, from his Beijing paper quoted above, 29 August 2009]). Then when the crisis struck beginning in July 2007, LIBOR increased substantially above the Fed funds rate indicating the reluctance of banks to lend unsecured. This inhibited banks from making forward retail commitments .

(Incidentally, we could do a similar parallel analysis for foreign exchange transacting. Forward foreign exchange contracting in "wholesale" inter bank markets becoming difficult when bank counter party risk rises. The constriction in the forward market increases currency risk for both exporters and importers and inhibits the granting of trade credit--including letters of credit. Whence the surprising crash in foreign trade.)

However, by August 2009, we are in a purer form of the liquidity trap where both interest rates have been driven toward zero (Figure 9). Now we are in the situation referred to in my FT paper that liquid banks, those with excess reserves, won't bother parting with them for a derisory return. So I would guess (without knowing) that interbank trading is now at a low level .

The implication for all of this is that retail lending in the U.S. has stagnated (or fallen slightly) since August 2008 even when base money in the U.S. has skyrocketed--as shown in Figure 10 [also reproduced below, from the Beijing paper of 29 August 2009].

Figure 9. U.S. Short-term Interest Rates in the Liquidity Trap


Source: FRED and globalfinancialdata.com. From: Ronald McKinnon, "The Global Credit Crunch: China and the United States", Summer Palace Dialogue, Aug 29, 2009, Beijing

Fig. 10. Loans of U.S. commercial banks, Base Money and M2 (2006 Jan = 100)
Source: FRED. From: Ronald McKinnon, 2009, cited.

Markets: Incomplete, Inefficient, Self-Fulfilling – But Irreplaceable

A major review of “The state of Economics” was published by The Economist of 18 July 2009 (printed version; online version 16 July). It consisted of a general introduction on What went wrong with economics – And how the discipline should change to avoid the mistakes of the past, and two articles on “The turmoil among macroeconomists”, The other-worldly philosophers and on the foundations of financial economics: Efficiency and beyond, (all three pieces unsigned).

The review has both the merit and the demerit of being non-partisan, trying to be impartial and, therefore, being doomed to inconclusiveness. For instance, while it begins by defining Robert Lucas as “one of the greatest macroeconomists of his generation” it reports on many of the telling criticisms to which Lucas has been subjected. On The Economist‘s Blog (16 July), maxreuter soberly but most effectively commented on Lucas:

“Surely you jest. A more accurate description would be ‘successful economist’ or perhaps ‘leading economist’ of his generation. Remember, this is the gentleman who claims that there is no such thing as ‘involuntary unemployment’ – that all unemployment is purely voluntary. No doubt he believes that what happened during the Great Depression, and what is going on now is really an epidemic of laziness.”

“As the article points out: ‘...economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out’. To refer to an economist whose theories were in large part responsible for much of the above as 'great' is a somewhat unorthodox use of the word indeed.”

“Finally a memorable quote from the 'great' Mr Lucas: ‘...the central problem of depression-prevention has been solved, for all practical purposes...’ – Robert Lucas, Presidential Address to the American Economic Association 2003. Perhaps we should leave it to history to judge the greatness of Mr Lucas and the usefulness, if any, of his contributions to economics.”

In spite of inconclusiveness, by and large The Economist’s review is useful and timely. There is no point in trying to summarise it, as it is already dense and condensed, it is available online and has been subjected to various commentaries in the press and on the blogs.

Three comments are offered here instead, on the importance of markets incompleteness and sequentiality, on the implausibility of the so-called Efficient Markets Hypothesis (EMH), and the frequent self-fulfilling nature of expectations. While these arguments amount to a strong criticism of any market system and its efficiency, in the end it must be emphasised that markets – for all their incompleteness, inefficiency, self-fulfilling nature – are the irreplaceable engines that keep an economic system moving. When these engines are running, a government can try and steer the economic machine. This machine may get out of control on its own, or the government itself may drive it off the road, or crush it. But when the markets/engines are not running, the whole economic system grinds to a halt. However, financial markets are different and do not deserve the same positive appreciation and the consequent free reins.

Incompleteness

The Economist‘s review rightly criticises those economists who conveniently “assume that markets are ‘complete’ – that a price exists today, for every good, at every date, in every contingency”. These are the followers of the modern general equilibrium approach developed after Léon Walras by Kenneth Arrow and Gérard Debreu (Econometrica, vol. XXII, 265-90; Debreu’s Theory of Value 1960, etc).

An irrefutable criticism, as futures markets – apart from a handful of currencies, and standardised raw materials over a short time horizon of 3-6 months – are not the rule but the exception, not to speak of contingent markets. But this is the least of those economists’ worries, for they can and do argue – as Christopher Bliss did when I raised this issue with him a long time ago – that markets have a cost, and therefore only those markets will be activated whose expected benefits exceed their costs. Thus in spite of missing markets we remain in the best of all possible worlds.

As a matter of fact the incompleteness of markets cannot be dismissed, for there is one commodity – labour services – for which a forward market could be contemplated only in a society of serfs or slaves, not in a society of free individuals. An irrevocable commitment to deliver one’s labour services in the future to a given master, or a given firm, at a price agreed in the past, would involve a feudal/slave tie inconceivable in a capitalist economy characterised by wage labour (a tenured job involves an option to sell one’s labour at a predetermined wage, but not an obligation to deliver it). Therefore market incompleteness is not a question of costs exceeding benefits of missing markets (unless we tautologically define an institutionally impossible market as infinitely costly), but of the incompatibility between capitalism and feudal institutions in labour relations. It is no accident that Gérard Debreu never speaks of capitalism, but of an unspecified exchange economy. It is not (only) a question of realism, but of which economic system we are talking. One thing are the “parables” often indulged in by neo-classical economists, another thing the science fiction of imaginary planets on which with absolute certainty nobody has ever set foot or ever will.

The lack of future markets for labour services is also why lower wages may not deliver higher labour employment – because those lower wages cannot be guaranteed to continue in the future once unemployment falls – and why a social contract between capital, labour and government may be a superior arrangement with respect to labour market flexibility.

Sequentiality of markets

Nevertheless, the real problem is not so much markets incompleteness but their sequentiality, which is largely ignored. For markets to deliver an efficient resource allocation they should open for the very short time, ideally an instant, that it takes for all economic agents (including representatives of future generations, but let this pass) to express their demands for and supplies of all goods, on the basis of their individual preferences and original “endowments”, thus determining inter-temporal, contingent, equilibrium prices and quantities. Then, once an intertemporal equilibrium is reached for all states of the possible world, markets should shut for ever while all transactors and their successors execute without fail all their transactions to kingdom come. (We leave aside here the thorny issues of existence, uniqueness and stability of such equilibria; complications with externalities, increasing returns, public goods; and the only too often forgotten departures from perfect competition, not because these issues are negligible or unlikely but because they are too large and complex to handle here, and even in their absence there is more than enough to shake anybody’s complacency).

Fortunately for us, and unfortunately for market efficiency, our markets do not function as in this unknown and grotesque economic system. Markets open, shut and reopen incessantly, indeed in the global economy today they seldom shut, for almost invariably you can transact anything at any time of the day and the night somewhere or other on the globe.

In the world as we know it, in order to secure a good’s availability tomorrow, we do not have to express our demand for it today, even if in principle the good could be transacted today in any number of future markets. Therefore all the time, beside taking into account current prices of current goods, we act on the basis not of today’s spot prices of future goods, but of our expectations of their spot prices tomorrow (and of the quantities associated with them). This is the ultimate foundation of the keynesian theory of unemployment due to lack of effective demand; of liquidity preference and of the associated need for fiscal policy. If today’s savers had to express today a demand for future goods, current investment would be activated for their future supply and a generalised excess capacity could only be structural, i.e. due to mismatching of the structure of capacity and of demand. As things are now, whoever saves creates unemployment unless his savings are being spent simultaneously by someone else. It is odd that even critics like Joseph Stiglitz should concentrate on markets incompleteness (as well as asymmetry of information, see his Whither Socialism?, Cambridge Mass, MIT Press, 1994) and neglect their sequentiality.

The trouble is that the Arrow-Debreu model is the only rigorous theory that would support the claim of an efficient market economy. From this viewpoint we can conclude that an efficient market economy is a utopia, in the literal sense that it does not exist, it has never existed and will never be capable of existing anywhere. What had began as an attempt to theorise the efficiency of markets ended up, by the successive tightening of all the conditions necessary to such efficiency, conclusively demonstrating their inefficiency.

Paradoxically the most effective critique of this kind of general equilibrium theory has come from within that same theoretical tradition, from Jacques Drèze and his work on temporary equilibrium. This is a Hicksian concept (from Value and Capital), infinitely more destructive and promising, at the same time, than anything produced by neo-marxian or neo-ricardian or neo-keynesian economists, so much so that it leads straight to keynesian conclusions.

The Efficient Market Hypothesis

In the 1960s Eugene F. Fama at Chicago University and Paul A. Samuelson at MIT independently put forward the Efficient Market Hypothesis, i.e. the proposition that “prices fully reflect all available information” (Fama 1965). The title of Samuelson’s 1965 article, ‘Proof that Properly Anticipated Prices Fluctuate Randomly’ says it all: if markets are informationally efficient, in the sense of prices incorporating the information and expectations of all market participants, price changes cannot be forecast, and viceversa. Everybody will exploit the slightest informational advantage in profitable transactions. As the old story goes, if you see something looking like a $100 bill on the pavement you should leave it where it is, for if it really was a $100 bill someone else would have picked it up already.

Lucas (1978) buttressed this hypothesis with his notion of “rational” expectations, efficiently embodying the sum total of economic information (although really we should call them “successful” expectations, for there is nothing rational or irrational about them). These are the foundations of the denial of the Phillips trade-off between unemployment and inflation; of the presumed ineffectiveness of government policy; and of the theory of Central Bank Independence with sole responsibility for inflation targeting.

This Panglossian view of the efficiency of markets is reminiscent of the parallel claim, by Soviet planners, that their central planning was always necessarily optimal, because if they had known any better they would have made it better. Admittedly it should be easier for countless, decentralised market transactors to recognise mutually advantageous improvements through bilateral exchanges, than for a single central planning agency to spot and implement planning improvements unilaterally; but if plan construction was decentralised, as Oskar Lange had proposed back in 1937, mutatis mutandis the Efficient Market Hypothesis and the Optimum Planning Hypothesis would be equally plausible (or, rather, equally implausible).

The Economist‘s review covers some of the criticisms raised in the literature to this construct. “In 1980 Sanford Grossman and Joseph Stiglitz [AER 70, 393-408], pointed out a paradox. If prices reflect all information, then there is no gain from going to the trouble of gathering it, so no one will. A little inefficiency is necessary to give informed investors an incentive to drive prices towards efficiency.” This is a confusion between the properties of the end-result and those of the process by which that end-result is obtained.

The Economist‘s criticisms of EMH include also the neglect of “institutional frictions” in markets, such as the presence of some less well-informed “noise traders”. But The Economist‘s strongest criticisms rest on the challenge to markets’ inherent rationality raised by behavioural economics in the past decade.

The behavioural approach

Andrew W. Lo (2007), a contributor to the EMH who now seeks its synthesis with behavioural economics, i.e. the Adaptive Markets Hypothesis, characterises the behavioural approach thus:

“Human decision-making under uncertainty” exhibits systematic biases “several of which lead to undesirable outcomes for an individual’s economic welfare – for example, overconfidence (Fischoff and Slovic, 1980; Barber and Odean, 2001; Gervais and Odean, 2001), overreaction (DeBondt and Thaler, 1985), loss aversion (Kahneman and Tversky, 1979; Shefrin and Statman, 1985; Odean, 1998), herding (Huberman and Regev, 2001), psychological accounting (Tversky and Kahneman, 1981), miscalibration of probabilities (Lichtenstein, Fischoff and Phillips, 1982), hyperbolic discounting (Laibson, 1997), and regret (Bell, 1982). These critics of the EMH argue that investors are often – if not always – irrational, exhibiting predictable and financially ruinous behaviour” (see Lo’s references list for bibliographical details).

The latest contribution to this approach is Animal Spirits, by George Akerlof and Robert Shiller, entitled after what Maynard Keynes regarded as the ultimate urge to practice enterprise and to invest[1]. More power to their elbows. But ultimately the strongest criticism of EMH is epistemological, for that hypothesis is based on a peculiar theory of knowledge.

The EMH suffers from what we could call the X-Files Syndrome, “The Truth Is Out There”. Out there is The Truth, some of which is naked and visible to all market participants; some of which is covered in such a way as to be visible only to some of them – either with total certainty or with an attached probability which is the same for all – and the rest of which is unknown but is known with certainty to be unknown. Information available therefore is somewhat limited, but what information is available is true – or likely to be true with equal probability for all those who share it – otherwise its privileged use would not necessarily give an advantage.

Instead of which, in the world as we know it, market participants have different beliefs about the probability of truth of the information they possess; the same “quantum of information” may be viewed as a gold nugget by some and as utter rubbish by others (for instance, the time sequence of numbers generated by a fair roulette to date, with a view to predict future numbers). Otherwise it would not be possible to even talk of “noise traders”; whoever uses this concept should explain what can be relied upon to contain the noise level below a critical, deafening number of decibels, while a bubble inflates up to the point when it bursts. I guess one can belong to the behavioural school without even realising it.

Self fulfilling expectations

If he were to re-write The General Theory – Maynard Keynes wrote in the Introduction to one of its later editions – he would distinguish between economic agents acting on the basis of wrong expectations and of right expectations. He also wrote: “For if we consistently act on the optimistic hypothesis, this hypothesis will tend to be realised; whilst by acting on the pessimistic hypothesis we can keep ourselves forever in the pit of want” (Preface, Essays in Persuasion, 1931). Joan Robinson used to quote Shakespeare to express the possibility of self-fulfilling expectations: “[… for there is nothing either good or bad, but] thinking makes it so”(Hamlet to Rosencrantz, Act 2, scene 2).

The Economist‘s review states: “… Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.” But in a recent, inspiring article (Economics is in crisis: it is time for a profound revamp, FT 21 July 2009). Paul De Grauwe explains beautifully the self-fulfilling nature not just of expectations but of dominant economic theories.

“Take government budget deficits, which now exceed 10 per cent of gross domestic product in countries such as the US and the UK. One camp of macroeconomists claims that, if not quickly reversed, such deficits will lead to rising interest rates and a crowding out of private investment. Instead of stimulating the economy, the deficits will lead to a new recession coupled with a surge in inflation. Wrong, says the other camp. There is no danger of inflation. These large deficits are necessary to avoid deflation. A clampdown on deficits would intensify the deflationary forces in the economy and would lead to a new and more intense recession.”

“Or take monetary policy. One camp warns that the build-up of massive amounts of liquidity is the surest road to hyperinflation and advises central banks to prepare an ‘exit strategy’ [see our post on “Exit Wounds”, 3 August 2009]. Nonsense, the other camp retorts. The build-up of liquidity just reflects the fact that banks are hoarding funds to improve their balance sheets. They sit on this pile of cash but do not use it to increase credit. Once the economy picks up, central banks can withdraw the liquidity as fast as they injected it. The risk of inflation is zero.”

“Does it matter that economists disagree so much? It does. Take the issue of government deficits. If you want to forecast the long-term interest rate, it matters a great deal in which of the two camps you believe. If you believe the first one, you will fear future inflation and you will sell long-term government bonds. As a result, bond prices will drop and rates will rise. You will have made a reality of the fears of the first camp. But if you believe the story told by the second camp, you will happily buy long-term government bonds, allowing the government to spend without a surge in rates, thereby contributing to a recovery that the second camp predicts will follow from high budget deficits.” …

“This conflict matters not only for market participants, but also for policymakers.” … “The cacophony of analysis helps to explain why policymakers react in different ways to the same crisis and why it is so difficult for them to come up with co-ordinated action.”… “How to resolve this crisis in macro-economics? The field must be revamped fundamentally” (De Grauwe, cited).

Back to the drawing board, then: “We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called ‘animal spirits’ are fundamental forces driving macroeconomic fluctuations” (De Grauwe, cited).

Markets as indispensable homeostatic mechanisms

Well, markets are incomplete, sequential, inefficient, self-fulfilling… So what? All of these considerations taken together do not eliminate the absolute need for markets in resource allocation, for they are irreplaceable homeostatic, self-regulating mechanisms that adjust prices to excess demand (Walras), quantity produced to excess price over cost (Marshall), and actual capital stock to desired capital through investment decisions. Axel Lejonhufvud stressed long ago the markets’ self-regulating role (which should not be confused with self-regulation of their own functioning). More generally, markets also adjust production capacity and production of inputs to those of outputs (Dick Goodwin on the Multiplier as a Matrix).

Sometimes the self-adjustment is too fast, sometimes it is too slow - as it happens with all homeostatic mechanisms, like thermostats - but it is there; the alternative is manual control, i.e. central planning. As I tell my students, there may be special circumstances in which manual control is superior to an automatic mechanism. In Star Wars, when Luke Skywalker targets the heart of the Empire, he disables automatic controls and goes manual, and succeeds. But he only had one target; there were only two alternatives, hit or miss; and … the Force was with him. In Central Eastern Europe, on the contrary, the inability to introduce markets in almost forty years of attempted reforms – primarily because of persistent endemic excess demand, but also for the leadership’s fear of loss of political power and control – was the ultimate economic cause of collapse of centrally planned economies in 1989-91.

We could paraphrase Wiston Churchill’s dictum about democracy, and say that the market economy is the worst economic system except all the others that have been tried. But markets alone do not, on their own, characterise an economic system. We are engaged now, as never before, in an intellectual struggle over what ownership mix, what rules of the game, what share of government expenditure, what social and re-distributive policies, what global governance institutions should prevail in the modern market economy. While economic arguments are used, the choices involved are essentially political, and attempts to control or replace markets as the economy’s engines are always grabs for political power and control.

Except…

… that the markets' homeostatic properties praised above demonstrably do not apply to most credit and financial markets, where products may multiply instead of reducing and spreading risk; securities may go toxic; transactions are more likely to be fraudulent because of lack of transparency; there is a corporative system of rewards masquerading as a market for managerial skills; leveraged bets in derivatives markets can inflict massive damage on innocent bystanders; banking pyramids proliferate; profits are privatised and massive losses are eventually socialised. Here the primacy of markets must give way to effective regulation, first national then global.


[1] “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.” (The General Theory of Employment, Interest and Money, 1936, pp.161-162). Akerlof and Shiller take “animal spirits” to imply irrationality, but the urge to action rather than inaction could well be a rational survival strategy, instead of the neglect of reason.