Testing
Economic Theory
Modern
economics is equilibrium economics, economies tending to a state of
satisfaction when prices cause the amounts supplied and demanded to be equal.
The following familiar diagram of supply and demand states the key assumption
of the market model of economics, that increasing prices result in lower demand
for a commodity and will, in turn, elicit increased supply. In a NYT 9/14/14 article,
Princeton economist Paul Krugman writes, "...(the) idealized vision of
capitalism (assumes) individuals are always rational and markets always
function perfectly."
Supply & Demand Curves of a Classical Economy
But what if labor
markets do not clear because of wage rigidities, lack of business confidence
and - most important - because structural economic change causes layoffs? What
determines the actual shape and position of these hypothetical supply and
demand curves relative to full employment? The market only observes the
intersection of these two hypothetical curves, where the amounts supplied equal
the amounts demanded after a large number of approximate transactions that
occur around an inferred intersection. The shapes and positions of these curves
depend upon factors exogenous to the model, factors that are usually ignored in
economic discussion. The Great Recession of 2008 has greatly disturbed the
classical model of marginal economic adjustment. The following describes the
present economics of supply and demand, and stock market behavior.
The Demand
Curve
Demand for the
entire economy is determined by the formula:
GDP =
consumption + investment + government expenditures + net exports
In spite of slow
economic growth, government expenditures as a % of GDP did not grow between
2005 and 2013 to offset decreasing private investment:
Percent of GDP
|
|
2005 |
2009 |
2013 |
|
Government Expenditures |
19% |
21% * |
19% |
|
Gross Private Domestic Investment |
19% |
13% |
16% |
|
Total |
38% |
34% |
35% |
|
* This illustrates the automatic
stabilizer effect of government expenditures, to an extent. However, the sum
total of each of these two columns decreased from 2005 to 2013. The bright
spot was a further 2.5% decrease in net imports due to an energy boom in the
capital-intensive process industries that created wealth, but less employment
than other investments. Jobs remain a large problem for the U.S. economy. BEA Table 1.1.5 GDP(1969-2013)
|
Interest rates
regulate what happens in a capitalist economy; they also determine the amount
of private investment and the amount of risk securities that people want to
hold. The product and financial markets can, furthermore, both be balanced at
the same interest rate (this is economics: through a second set of individual equilibrium
curves that Paul Krugman
discusses). Now imagine a situation where the economy is caught in a liquidity
trap where even zero interest rates (from a loose monetary policy) elicits no
increased Gross Private Domestic Investment. This is the present situation
where low business confidence results from the Great Recession of 2008. The
table above shows that in 2013, investment was low and government expenditures
(fiscal policy) did not compensate due to the legislative ideology of fiscal
austerity. The graph below indicates that for an economy caught in a liquidity
trap, the aggregate demand curve is vertical. Investment and thus
aggregate demand will not increase no matter what the level of interest rates.
In the above, we
have considered everyone’s response
to the Great Recession of 2008. What about a cause? The Great Recession of 2008
was unique because it was a balance sheet recession rather than a cyclical one.
In balance sheet recessions, very simply, the balance sheets of financial
institutions and individuals become overleveraged by the purchase of dodgy
assets, like derivatives based on subprime mortgage securities. When the bubble
finally bursts, the dodgy assets have to be written down; but the liabilities
remain and have to be gradually reduced by repayments or write-offs. In
lending, this is known is a loan workout, except here we have discussed a loan
workout for the entire economy - where
new assets aren’t created and existing ones are shuffled around in a battle for
trader investment survival to earn some profit.
The short-term
investment implication of this rather stagnant economic condition is…positive.
Since the economy remains entrapped at a low level of growth with very low
interest rates (the lowest since the Napoleonic Era), stock prices will remain
high and grow slowly in a “Goldilocks Economy.” For investors, what’s not to
like. However, there is a problem. Over the long-term, financial markets
ultimately have to conform to economic reality; financial speculations leads to
a lot of trading activity, at best, and financial crises at worst. An era of
prolonged low nominal, or negative real interest rates causes speculation (as
it did in the early 2000s) so a 12/12 Bank for International Settlements
working paper warns:
|
...there is risk that failing to recognize that the
financial cycle has a longer duration than the business cycle could lead
policymakers astray…policymakers may focus too much on equity prices and
standard business cycle measures and lose sight of the continued buildup (of
risk in) the financial cycle.....There are (deleterious) side-effects of
extraordinary accommodative and prolonged monetary easing. |
A 8/28/14 WSJ
article is titled, “Dangers of Betting with Borrowed Money…More People Are
Taking Out Loans to Invest, but Experts Warn of Risks…Conventional wisdom says
one of the best ways to use leverage is to buy bonds if you can make a nice
spread between your (short-term) borrowing costs and the bonds’ payout. But
that too could be a problem if borrowed money is used to buy risky debt like
junk bonds…Even safer bonds could be vulnerable if interest rates rise as is
expected as the U.S. ends its quantitative easing policies.” If this speculative leverage
continues, the result will be another market crash at very low short-term
interest rates, for which there will likely be no remedy.
The Supply
Curve
In the above we
have attributed slow economic growth to a generally deleveraging financial system and an
inadequate demand from fiscal policy, a response due to an ideology of
austerity – ignoring what would happen if everyone behaved in the same
way. But in real societies, events are often caused by the confluence of
several major causes. Another set of major causes are on the supply side of the
economy. In a 9/7/14 Washington Post article,
Harvard economics professor and former treasury secretary Larry Summers writes:
|
The U.S. economy
continues to operate way below estimates of its potential that were made
prior to the onset of financial crisis in 2007, with a shortfall of gross
domestic product now in excess of $1.5 trillion – or $20,000 per family
of four. Just as disturbing, an average economic growth rate of less than 2
percent since that time has caused output to fall further and further below
these estimates of potential…. (about the
demand curve) Secular stagnation, in my version, has emphasized the
difficulty in maintaining sufficient economic demand to permit normal level
of output. Given a high propensity to save (to deleverage), a low propensity
to invest and low inflation, it has been impossible for real interest rates
to fall far enough to spur the economy to its full potential, since nominal
interest rates cannot fall below zero…. (about the
supply curve) But…it may well be that now supply-side barriers threaten to
hold back the economy before constraints on the ability to create demand
start to bind…. Assume for
simplicity’s sake, that participation rates remain constant (an optimistic
assumption) and that the economy keeps on creating 200,000 jobs a month. A
simple calculation reveals that the unemployment rate would fall to the 4
percent range by the end of 2016…. Why has the
supply potential declined so much?... Part of the answer lies in the effect
of past economic weakness. Part of it is the brutal demographic realities of
an aging population, the end of the trend toward increased women’s labor
force participation and the exhaustion of the gains that could be won from an
increasing educated workforce. And part is the apparent slowing of
productivity growth. To achieve
growth for even 2 percent a year over the next decade, active support for
demand will be necessary but not sufficient. In the United States, as in
Europe and Japan, structural reform – to both increase the
productivity of workers and capital…is essential. Infrastructure investment,
immigration reform…development of energy resources and improvements to the
business tax system will become even more important. (our note) |
In addition,the
zero marginal cost nature of the information society’s digital revolution will
tend to shift the vertical demand curve to the left by eroding incomes.
Supply & Demand Curves of the Current
Economy
Due to a decreasing labor force, the supply
curve in the graph above also shifts upward to (Supply 2), increasing the cost
of remaining market-traded services. The implications of this for equity
investors are negative, as the Fed will be forced to raise interest rates (to a
degree), to slow already slow economic growth that is reaching the capacity of
the employable labor force. The combination of a vertical demand curve and an
upward-shifted supply curve are the symptoms of low economic growth. The
remedies lie in structural economic reform, involving fiscal policy, that will
restore a more normal demand curve, measures mentioned in the last paragraph of
the Summers article.
A former U.S. official said that, in many ways, the U.S. is a gifted country and shouldn’t mess things up with a divisiveness that paralyzes government. This divisiveness also exists within the two parties. The antidote for divisiveness is the traditional American attitude of practical problem solving (that naturally assumes the political opposition is loyal to the society).
In the same
9/14/14 article,
Paul Krugman also writes that economics theory can describe a great deal of what
happened after the initial Financial Crisis of 2007-2008. It is useful to
describe the economy with non-classical supply and demand curves and to assume
that the associated financial system will be episodically subject to manias,
panics and crashes, where increased capital buffers will help.
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Are monetary and fiscal policies always effective? In Macroeconomics (Pearson, Canadian ed., 2015, ch. 11), IMF chief economist Olivier Blanchard and David Johnson discuss the Japanese economic downturn of the 1990s:
"...by the mid-1990s, the interest rate was down to less than 1%, and it has remained below 1% since. With little room left for using monetary policy, fiscal policy was used to sustain demand....Much of the increased spending has taken the form of public works projects, and a joke circulating in Japan is that by the time the Japanese economy has recovered, the entire shoreline of the Japanese archipelago will be covered in concrete.* The result of this strong fiscal expansion, however, has been a sharp increase in debt. The ratio of government debt to GDP, which stood at 13% of GDP in 1991, is now above 120%. Meanwhile, the Japanese economy is still in a slump: GDP growth, which averaged 4.4% in the 1980s, was down to 1.4% in the 1990s and 0.9% in the 2000s.
Several lessons appear from the Japanese experience. What has happened in Japan since 1990 is a tough warning to other advanced countries that it may take a a long time to recover from a slump associated with a collapse in asset prices. It is also noteworthy that Japan was able to run large government deficits for many years. The fiscal reckoning associated with the increase in deficits and debt may take many, many years to come about."
Fiscal and monetary policies primarily address a domestic economy's excess capacities, rather than its comparative trade advantages. These policies likely did not restore growth because the modernized sectors of Japan's economy were configured for export, and then lost their cost advantages to China and Southeast Asia. The U.S. economy; with its large domestic market, energy resources, world-class universities and enterpreneurial traditions is not like Japan's. Both economies require different reforms.
* Japan may have built many bridges to nowhere, but U.S. infrastructure (ASCE grade D) is truly in need of repair.
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Is economic policy more like physics or engineering? In theoretical economics, there is a lot of sophisticated math that attempts to derive universal economic laws from the elementary particle of a self-interested person (maximizing his utility). The model for theoretical economics is physics. But both physics and theoretical economics deal with only simple systems. They do not predict when confronted with complexity: physics, when trying to describe the exact behaviors of more than two particles (really) and theoretical economics, when describing how to increase the wealth of a nation.
Economic policy, we think, is more an art like engineering because the situation should determine the laws invoked. (We invoked the law of comparative advantage because Japan's economic performance is highly trade dependent.) Regarding neoclassical self-interest, of course it is relevant. But it is a mistake to consider self-interest the only dimension of a viable society.
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There was a time when the world's economy approximated the neoclassical price-auction model shown above; that time was the 19th century until W.W. I. In 2006, Harvard government professor, Jeffry Frieden, wrote an excellent economic history called "Global Capitalism" that proves the value of useful generalization. In that history, he describes how industrialization, the gold standard and a globalizing open market economy initially brought progress and prosperity to many and then the opposite.
"Each region specialized in what it did best. Britain managed investments, ran the world's banking and trading systems, and supervised and insured world shipping and communications. Germany produced iron and steel, chemicals, and heavy equipment for railroads, mines, plantations, and shipping lines. Argentina, South Africa, and Australia used British capital and German machinery to open new farms and mines...In earlier eras countries had tried to be self-sufficient, but now they focused on producing and exporting what they did best and trading for the rest." *
The Enlightenment assumed that society existed for the benefit of its members, but the flaws in the classical economic order were social. First, the dynamic system of industrialization produced considerable angst in those affected by social change. The result was a high degree of insecurity and W.W. I. Second, the classical economic model assumed all wages and prices were flexible; but labor naturally resisted the (very) severe austerity measures that the gold standard required to correct trade imbalances:
"It is controversial today to impose austerity measures to reduce inflation-that is, to keep prices from rising. It would be unthinkable to actually to force prices to decline by 20, 30, or 80 percent (sic). The principal source of this unthinkability is the virtual impossibility of forcing workers to accept such drastic wage reductions. But such reductions were common under the gold standard (since a country's domestic monetary supply was tied at a fixed rate to gold, whose flows were tied to international trade); indeed, they were essential to the operation of this pillar of the classical world economy...The burden of adjustment in the classical era was on labor." (p. 121)
It would be an understatement to say that the rules of the classical economy produced social strains. What finally blew that system apart was the Great Depression, which occurred for three main reasons.
1) Allowing the U.S. banking system to fail.
2) The unwillingness of the United States to assume international leadership, to renegotiate allied war debts and to lower tariff barriers enabling the Europeans to earn dollars.
3) Overvaluing the British pound relative to gold after W.W. I.
Frieden writes: "The classical British economy had been heavily directed outwards, toward foreign markets, foreign suppliers, and foreign investment. In the United States, however, international economic exposure varied tremendously. Wall Street was deeply engaged, as were many farmers and some of the country's leading industries. But the bulk of American industry continued to look inward and remained insular and protectionist...the bulk of the country's economic leaders remained hostile or indifferent to conditions abroad. America had no British style consensus for international involvement or leadership....Classical policies to confront the catastrophe ranged from useless to counterproductive, yet governments driven by faith in (austere) gold standard solutions soldiered on as conditions worsened. The new organized capitalism of big businesses and powerful labor movements, along with financial fragility and wage and price rigidity, made the classical adjustment mechanism obsolete. (our note)...The classical world economy had failed. The halting recovery, the preliminary steps at reconstituting international economic order, the islands of growth in the midst of stagnation, and the newly available products and techniques could not disguise this basic fact. The old order did not deliver economic growth, or stability, or protection from chaos....The fact that rapid economic growth was restored only with the rush to rearm was cold comfort indeed." (p.p. 147,148, 193, 194)
Major nations subsequently adopted one of two remedies (here the author very usefully generalizes):
1) Economic autarky, with Fascism and communism as variants. "As the debtor countries turned toward autarky durng the 1930s, they rejected their foreign debts, reliance on world markets and comparative advantage. Their previous areas of specialization were taxed to stimulate sectors of the economy that had been hamstrung by foreign competition, especially national industry. They gave up on foreign capital and markets and turned inward to the domestic market and domestic finance. (Sounds like Russia in 2014.)...Fascism, communism and nationalist developmentalism delivered. They provided jobs, industrial development, modernization, and, less tangibly, national pride and cohesion. Fascism and commmunism did so at the (horrendous) expense of liberty and on the backs of their chosen enemies of the state...An alternative was slow to develop." (p.p. 198, 228)
2) Social democracy. "The democracies began to find an alternative in the middle 1930s. Parties of the Left came to power, with working-class and agrarian bases of support. They enacted more interventionist economic policies, expanded social programs, and increased government spending. And the new governments rebuilt cooperative economic ties among the democratic states....Social democracy was a new social and political order, even if most of its features had precedents. Governments backed by coalitions of workers and farmers took responsibility for macroeconomic management, social insurance and social security, and labor rights. Two countries experiences are particularly instructive: Sweden and the United States....Once he was in office, Roosevelt reversed himself and abandoned traditional austerity....The federal government dramatically increased its role during the New Deal. (But within the context of a slight federal budget deficit that peaked at 4.7% of GDP in 1936.) This was the American analogue to European measures to remake national labor and social policies." (p.p. 229, 230, 233, 235, website: usgovernmentspending.com)
Government measures in the United States were highly pragmatic. The economy had to be restarted, to get people back to work. In The General Theory (1936) Keynes laid the foundation for the economic analysis, whose consequences we show in the second graph above.
"(He argued) that deficit spending was essential to reactivate stagnant economies. The economy was caught in a trap from which only government spending could free it. (The federal deficit peaked at 29% of GDP in 1943.) Keynes put investment at the center of his argument. In most classical approaches, investors simply responded to profit opportunities. If wages got low enough, new investment would be forthcoming, and the economy would revive. But Keynes understood that investment depended also on the expectations of the behavior of others. No capitalist would expand his factory if there was no prospect of demand for his products - no matter how low wages or interest rates were....Expectations of stagnation would depress investment, which would ensure continued stagnation.
The market economy would not right itself." (p.p. 237, 238)
Emphasizing general demand management, Keynes left open how the government should invest. In 2014, it makes no sense to invest in the semi-skilled mass production jobs that have gone abroad. It does make sense to invest in useful infrastructure, basic research, encourage new businesses and to begin to ask how to structure society for those who are being displaced by an increasingly automated economy.
Above all, our elected representatives in Washington are supposed to solve problems and keep the system running, not tear it down.
* Jeffry Frieden; "Global Capitalism"; W.W. Norton & Company, New York; 2006; p. 21. Subsequent quotes list the pages.