What Drives Trade Flows? Mostly Demand, Not Prices

I just participated (for the last time, thank god) in the UMass-New School economics graduate student conference, which left me feeling pretty good about the next generation of heterodox economists. [1] A bunch of good stuff was presented, but for my money, the best and most important work was Enno Schröder’s: “Aggregate Demand (Not Competitiveness) Caused the German Trade Surplus and the U.S. Deficit.” Unfortunately, the paper is not yet online — I’ll link to it the moment it is — but here are his slides.

The starting point of his analysis is that, as a matter of accounting, we can write the ratio of a county’s exports to imports as :

X/M = (m*/m) (D*/D)

where X and M are export and import volumes, m* is the fraction of foreign expenditure spent on the home country’s goods, m is the fraction of the home expenditure spent on foreign goods, and D* and D are total foreign and home expenditure.

This is true by definition. But the advantage of thinking of trade flows this way, is that it allows us to separate the changes in trade attributable to expenditure switching (including, of course, the effect of relative price changes) and the changes attributable to different growth rates of expenditure. In other words, it lets us distinguish the changes in trade flows that are due to changes in how each dollar is spent in a given country, from changes in trade flows that are due to changes in the distribution of dollars across countries.

(These look similar to price and income elasticities, but they are not the same. Elasticities are estimated, while this is an accounting decomposition. And changes in m and m*, in this framework, capture all factors that lead to a shift in the import share of expenditure, not just relative prices.)

The heart of the paper is an exercise in historical accounting, decomposing changes in trade ratios into m*/m and D*/D. We can think of these as counterfactual exercises: How would trade look if growth rates were all equal, and each county’s distribution of spending across countries evolved as it did historically; and how would trade look if each country had had a constant distribution of spending across countries, and growth rates were what they were historically? The second question is roughly equivalent to: How much of the change in trade flows could we predict if we knew expenditure growth rates for each country and nothing else?

The key results are in the figure below. Look particularly at Germany,  in the middle right of the first panel:

The dotted line is the actual ratio of exports to imports. Since Germany has recently had a trade surplus, the line lies above one — over the past decade, German exports have exceed German imports by about 10 percent. The dark black line is the counterfactual ratio if the division of each county’s expenditures among various countries’ goods had remained fixed at their average level over the whole period. When the dark black line is falling, that indicates a country growing more rapidly than the countries it exports to; with the share of expenditure on imports fixed, higher income means more imports and a trade balance moving toward deficit. Similarly, when the black line is rising, that indicates a country’s total expenditure growing more slowly than expenditure its export markets, as was the case for Germany from the early 1990s until 2008. The light gray line is the other counterfactual — the path trade would have followed if all countries had grown at an equal rate, so that trade depended only on changes in competitiveness. When the dotted line and the heavy black line move more or less together, we can say that shifts in trade are mostly a matter of aggregate demand; when the dotted line and the gray line move together, mostly a matter of competitiveness (which, again, includes all factors that cause people to shift expenditure between different countries’ goods, including but not limited to exchange rates.)
The point here is that if you only knew the growth of income in Germany and its trade partners, and nothing at all about German wages or productivity, you could fully explain the German trade surplus of the past decade. In fact, based on income growth alone you would predict an even larger surplus; the fraction of the world’s dollars falling on German goods actually fell. Or as Enno puts it: During the period of the German export boom, Germany became less, not more, competitive. [2] The cases of Spain, Portugal and Greece (tho not Italy) are symmetrical: Despite the supposed loss of price competitiveness they experienced under the euro, the share of expenditure falling on these countries’ goods and services actually rose during the periods when their trade balances worsened; their growing deficits were entirely a product of income growth more rapid than their trade partners’.
These are tremendously important results. In my opinion, they are fatal to the claim (advanced by Krugman among others) that the root of the European crisis is the inability to adjust exchange rates, and that a devaluation in the periphery would be sufficient to restore balanced trade. (It is important to remember, in this context, that southern Europe was running trade deficits for many years before the establishment of the euro.) They also imply a strong criticism of free trade. If trade flows depend mostly or entirely on relative income, and if large trade imbalances are unsustainable for most countries, then relative growth rates are going to be constrained by import shares, which means that most countries are going to grow below their potential. (This is similar to the old balance-of-payments constrained growth argument.) But the key point, as Enno stresses, is that both the “left” argument about low German wage growth and the “right” argument about high German productivity growth are irrelevant to the historical development of German export surpluses. Slower income growth in Germany than its trade partners explains the whole story.
I really like the substantive argument of this paper. But I love the methodology. There is an econometrics section, which is interesting (among other things, he finds that the Marshall-Lerner condition is not satisfied for Germany, another blow to the relative-prices story of the euro crisis.) But the main conclusions of the paper don’t depend in any way on it. In fact, the thing can be seen as an example of an alternative methodology to econometrics for empirical economics, historical accounting or decomposition analysis. This is the same basic approach that Arjun Jayadev and I take in our paper on household debt, and which has long been used to analyze the historical evolution of public debt. Another interesting application of this kind of historical accounting: the decomposition of changes in the profit rate into the effects of the profit share, the utilization rate, and the technologically-determined capital-output ratio, an approach pioneered by Thomas Weisskopf, and developed by others, including Ed WolffErdogan Bakir, and my teacher David Kotz.
People often say that these accounting exercises can’t be used to establish claims about causality. And strictly speaking this is true, though they certainly can be used to reject certain causal stories. But that’s true of econometrics too. It’s worth taking a step back and remembering that no matter how fancy our econometrics, all we are ever doing with those techniques is describing the characteristics of a matrix. We have the observations we have, and all we can do is try to summarize the relationships between them in some useful way. When we make causal claims using econometrics, it’s by treating the matrix as if it were drawn from some stable underlying probability distribution function (pdf). One of the great things about these decomposition exercises — or about other empirical techniques, like principal component analysis — is that they limit themselves to describing the actual data. In many cases — lots of labor economics, for instance — the fiction of a stable underlying pdf is perfectly reasonable. But in other cases — including, I think, almost all interesting questions in macroeconomics — the conventional econometrics approach is a bit like asking, If a whale were the top of an island, what would the underlying geology look like? It’s certainly possible to come up with a answer to that question. But it is probably not the simplest way of describing the shape of the whale.
[1] A perennial question at these things is whether we should continue identifying ourselves as “heterodox,” or just say we’re doing economics. Personally, I’ll be happy to give up the distinct heterodox identity just as soon as economists are willing to give up their distinct identity and dissolve into the larger population of social scientists, or of guys with opinions.
[2] The results for the US are symmetrical with those for Germany: the growing US trade deficit since 1990 is fully explained by more rapid US income growth relative to its trade partners. But it’s worth noting that China is not: Knowing only China’s relative income growth, which has been of course very high, you would predict that China would be moving toward trade deficits, when in fact it has ben moving toward surplus. This is consistent with a story that explains China’s trade surpluses by an undervalued currency, tho it is consistent with other stories as well.

… or Possibly Social Scientists?

On the other hand!

If you’re thinking, yes, economists have a reflexive pro-market bias, then there is one question in the Booth polls to which the answer will be surprising: Are CEOs overpaid? Remarkably, a large majority says Yes.

As a friend points out, this result would almost certainly have been very different a few years ago. The financial crisis, OWS and the new political discourse of the 99%, or something else? I don’t know, but progress is progress, and it should be acknowledged, and celebrated. We on the left are a little too invested in our grumpiness sometimes, I think. A lot of people, ok, were overly optimistic about the extent to which the orthodoxies in macro would be discredited by the crisis and Great Recession. But still, something has changed.

Case in point: This paper (ht: AD) by Thomas Philippon and Ariell Reshef, on wages in the financial industry. It’s the same paper, but look how the abstract changes from pre- to post-Lehman. Before:

Over the past 60 years, the U.S. financial sector has grown from 2.3% to 7.7% of GDP. While the growth in the share of value added has been fairly linear, it hides a dramatic change in the composition of skills and occupations. In the early 1980s, the financial sector started paying higher wages and hiring more skilled individuals than the rest of economy. These trends reflect a shift away from low-skill jobs and towards market- oriented activities within the sector. Our evidence suggests that technological and financial innovations both played a role in this transformation. We also document an increase in relative wages, controlling for education, which partly reflects an increase in unemployment risk: Finance jobs used to be safer than other jobs in the private sector, but this is not longer the case.

And after:

We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector.

Look at the bolded phrases that appear in one abstract but not the other. In 2007, we have a story of skills, technology and compensating differentials. A year and change later, the star players are deregulation and rents, with technology demoted to “a limited role.” I don’t say this as a criticism of Philippon and Reshef, who deserve only credit for being willing to publicly change their beliefs in the face of new evidence. But this can cut both ways. That the same data can be, and is, used to tell such different stories, is a sign that there is something else going on here than disinterested social science.

Economists: Actively Evil Neoliberal Ideologues or Soulless Technocratic Hacks?

… or in other words, does economics (as it’s currently constituted) inherently promote a vision of markets for everything and no rights but property rights? (A vision that, obviously, conforms nicely to the interests of the owners of capital.) Or is the role of economics in upholding neoliberalism mainly the work of apolitical technicians, administrators and scientists manques, who could just as comfortably supply arguments for more regulation and a larger public sector if that’s what those in power were asking for?

Well, like nature vs. nurture, or whether to get the sweet brunch or the savory, it’s a debate that will never be fully resolved. (Go with savory, unless you’re, like, 12 years old.) But new evidence does sometimes come in.

Like those those polls of economists that the University of Chicago business school does; has everybody seen those? For those of us who’ve been debating this question, these things are a gold mine.

The latest question, on rent control, has Peter Dorman rightly exercised. As he points out, the question — whether rent regulations have had “a positive impact over the past three decades on the amount and quality of broadly affordable rental housing in cities that have used them” — omits the genuine goal of rent regulation, neighborhood stabilization:

The most compelling argument for rent control is neighborhood stabilization, the idea that social capital in an urban environment requires stable residence patterns.  If prices are volatile, and this leads to a lot of residential turnover, the result can be a less desirable neighborhood for everyone.  … not a single textbook treatment of rent control mentions stabilization as an objective, even though this is a standard element in the real-world rhetoric surrounding this issue. 

I would just add that a diversity of income levels in a neighborhood is also a goal of rent regulation, as is recognizing the legitimate interest of long-time tenants in staying in their homes. (Not all rights are property rights!) So by framing the question purely in terms of the housing supply, the Booth people have already disconnected it from actual policy debates in a way favorable to orthodoxy. Anyway, no surprise, orthodoxy wins, with only a single respondent favoring rent regulation. (And I think that one might be a typo.) My favorite answer is the person who said, ” Rent control will have similar effects to any price control.” That’s the beauty of economics, isn’t it? — all markets are exactly the same.

Some of the other ones are even better. Check out the one on education, which asks if all money currently being spent on K-12 education should be given out as vouchers instead. (Why not cash?) By a margin of 36 to 19 (or 41 to 23 when the answers are weighted by confidence) the economists vote, Hells yeah, let’s abolish the public school system. Presumably they’re mostly reasoning along the same lines as Michael Greenstone of MIT: ” Competition is likely beneficial on average. Less clear that all students would benefit leading to tough questions about social welfare functions” — which doesn’t stop him from signing up in favor of vouchers. The presumed benefits of competition are dispositive, while distributional questions, while “tough” in principle, can evidently be ignored in practice. On the other hand, props to Nancy Stokely of the U of C (strongly agree, confidence 9 out of 10) for spelling it right out: “It’s the only way to break the unions.” (Yes, that’s what she wrote.) So, hardly definitive, but definitely some ammo for Team Ideologue.

People sometimes say that academic economists just reflect the views of the country at large, or even the more-liberal-than-median views of other academics or educated professionals. And on some issues, that’s certainly true. (Booth also gets a solid majority in favor of drug law reform.) But come on. Replacing the public school system with vouchers is a far-right, fringe position in almost any significant demographic — except, it would seem, professional economists.

Back to rent control. Jodi Beggs enthusiastically endorses the consensus, but her conscience then compels her to add:

Techhhhhnically speaking [1], if none of the housing in an area was deemed “affordable” before the price ceiling, then the price ceiling could, I suppose, increase the quantity of affordable housing. (In fact, Pinelopi Goldberg specifically points this out.) [True. Goldberg’s answers in general are a beacon of sanity.] In most realistic cases, however, the rent control laws are going to make builders think twice about putting up residential properties and make potential landlords think twice about getting into the rental business. 

It’s awfully hard not to read the drawn out adverb as a parapraxis, indicating resistance to the heretical thought that, in fact, economic theory gives no answer to the question of whether rent control laws increase or decrease the supply of affordable housing. More concretely, Begg’s “realistic cases” are a figment of her imagination, or rather her ideology; in all actual cases rent control laws, at least in major American cities (there are only a couple) only apply to units built before a certain date. In New York City, for instance, rent regulations DO NOT APPLY to anything built since 1974. Hard to believe that builders are thinking twice about putting up new buildings because of rent stabilization, when it hasn’t applied to new buildings in nearly 40 years. But hey, why should you have to actually know something about the policy you’re discussing, to walk through the old familiar supply and demand graphs showing why Price Controls Are Bad?

“Nothing dulls the mind,” says Feyerabend, “as thoroughly as a sequence of familiar notions.”

(I can’t resist putting down the quote in full:

Writing… [is] almost like composing a work of art. There is some overall pattern, very vague at first, but sufficiently well defined to provide … a starting point. Then come the details — arranging the words in sentences and paragraphs. I choose my words very carefully — they must sound right, must have the right rhythm, and their meaning must be slightly off-center; nothing dulls the mind as thoroughly as a sequence of familiar notions. Then comes the story. It should be interesting and comprehensible, and it should have some unusual twists. I avoid “systematic” analyses. The elements hang together beautifully, but the argument itself is from outer space, as it were, unless it is connected with the lives and interests of individuals or special groups. Of course, it is already so connected, otherwise it would not be understood, but the connection is concealed, which means that, strictly speaking, a “systematic” analysis is a fraud. So why not avoid the fraud by using stories right away?)

“Real” Isn’t Real

Sorry, no, it’s not about Lacan.

For a while, I’ve tried to avoid the common economic usage of calling the change in an observed variable, minus inflation, the “real” change. I prefer a more neutral and descriptive term like “inflation-adjusted.”

What we call nominal quantities really are real, in a sociological sense: they exist, they’re directly observable.Your mortgage or car loan requires a schedule of payments in dollars, in some fixed proportion to the value (also in dollars) of the original loan. Those are actual numbers you can see in your contract. The S&P 500 index is at at 1,286; a year ago it was at 1,282. Those are actual numbers you can look up in any financial website. You paid $2.50 for a tube of toothpaste; the bills and coins actually changed hands. Whereas the “real” values of all these numbers are constructions, estimated after the fact (and then re-estimated), involving more or less arbitrary choices and judgement calls. There’s no fact of the matter there at all.

To begin with, you have to choose your price index. It’s often not obvious whether the consumer price index, the GDP deflator, or some other index is most conceptually appropriate. [1] And it makes a difference! Just among the most important published price indexes, we see the increase in the price level over the past 50 years ranging from five times, to nearly eight times. Anyone who tells you something like, a dollar in 1960 “is equal to” 13 cents in 2010 is confused, or at least grossly simplifying.

And then there are the differences that don’t show up in the published indexes. The CPI is intended to be a price index for all urban consumers, but not every consumer is urban and not all urbs are equal. Robert Gordon estimates that the bulk of the college wage premium goes away if you correct for the higher cost of living in areas where college graduates live. Of course this only makes sense if college grads have to live in pricey urban areas in order to get their college wages. If you instead assumed that the cost of living is higher in urban areas because of various non-market amenities, which college graduates have a particular taste for, then Gordon’s correction would be inappropriate. [2] So again, while nominal values are real, in the sense that they observably exist, “real” values depend on assumptions about various unobservables.

And then there’s the after-the-fact adjustments which price indexes are always subject to. (As are nominal aggregates, to be fair, but to a much less extent, and almost always due to better data rather than conceptual changes.) That was what got me thinking about this today, in fact: rereading Dean Baker’s comments on the Boskin Commission. [3] Dean points out that if you take the Commission’s methodology seriously, you’d have to make even bigger downward adjustments to inflation in earlier periods, implying that when people in the postwar years thought the economy was threatened by inflation, it was “really” experiencing deflation:

If the size of the current annual overstatement [of the increase in the CPI] is 1.1 percentage points, the the annual overstatement may have exceeded 2.0 percentage points in past years, meaning that, at many times when there was public concern about inflation,  the economy was actually experiencing deflation. … Extrapolating the commission’s adjustment backwards implies that, throughout the 1950s and into the 1960s, prices were actually falling. This was a period when the president appointed a council to set wage-price guidelines to keep inflation in check.

It’s a problem. Obviously using just nominal values is deceptive in many cases, and there are plenty of cases where deflating by some standard index gives a more meaningful number. But one shouldn’t suppose that it is “real.” And certainly one can’t suppose, as the formalism of economics implicitly or explicitly does, that there are quasi-physical quantities of “utility” out there which the appropriate price deflators can convert dollar values into.

We have to think more critically about how the categories of economics join up with social and individual reality. Where goods exchange for each other in markets, they have a quantitative relationship: so much of this is, in some sense, “the same as” so much of that. (There’s a reason why Capital Volume I begins how it does, tedious as people sometimes find it.) But that relationship comes into existence in the process of exchange, it didn’t exist until then. So as soon as we are talking about goods that don’t exchange for each other, say because they exist at different moments, we can no longer regard them as being quantitatively comparable. In this sense, nominal figures are real, since they really describe the quantitative relationship of some stock or flow with others existing in the same pay community.  They are observable and are have direct consequences. Not so “real” figures, which depend on the implicit assumption that the only point of contact between the economy and human reality is the mix of goods that is consumed, and that there is a fixed consumption function that converts that mix into a quantity of utility. Without that assumption, there is no basis on which to say that two baskets of goods that can’t be traded for each other have any definite quantitative relationship.

Labor might seem to be a better universal standard than utility. There’s a reason Keynes made employment his standard measure of economic performance, and wanted to measure output in terms of wage-units. (And it’s certainly not because he thought the problems with capitalism originated in the labor market.) And there’s a reason why Adam Smith subtitled his chapter on “the Real and Nominal Prices of Commodities” (I don’t know how far back the distinction goes, maybe he made it first), “their Price in Labour, and their Price in Money.” Well, I don’t want to get into the labor theory of value here, except to say that I don;t think any other standard of “real” quantities is any more securely founded. My point is just that it may be, for questions we cannot answer with dollar values, there is no better, objective set of values we can use in their place. At that point we have to think about the various complex ways in which the system of monetary values interacts with the social reality in which it is embedded. For instance, the ways in which the costs of unemployment are not reducible to foregone output and income. The reproduction of society, let’s say, has quantitative, law-like moments; those moments are greatly distended under capitalism, but they still aren’t everything.

I’ll keep on adjusting nominal figures for inflation; what else can you do? But let’s not call them real.

[1]  It’s worth noting that writers in the Marxist tradition are often more sensitive to the differences between price indexes than are either (Post) Keynesian or mainstream economists. The possibility of a systematic divergence between the price of wage goods and the price of output as a whole was a question Marx gave a lot of thought to.

[2] I.e., the premium on urban areas implies there’s some desirable thing there that’s not being measured, but is it a consumer good or an intermediate good?

[3] Not for fun, for course prep, for my macro course, which I’m hoping to make fodder for blogging this spring. Thus the tag.

Anti-Mankiw

Elsewhere on the World Wide Web: Some UMass comrades have revived the internet tradition of the grudge blog with this interesting new blog, with the Stakhanovite goal of refuting (tho thankfully not fisking) every post Greg Mankiw makes. It’s an ambitious goal, especially since the average wordcount ratio of an anti post to its underlying Mankiw post is running around 50:1. But they’re managing so far. You should read it. And if anyone wants to take a swing at the pinata, I think they may still be looking for new contributors.

So why aren’t I contributing? Mainly because time is scarce and I am very lazy, so blogging-wise I’m tapped out just keeping up a trickle of content here. But also, to be honest, because I have some qualms about the anti-ness of the left in economics generally. Anti-Mankiw is a great project, and I have nothing but admiration for the students who walked out of Mankiw’s class. But there’s a certain assumption here that we on the left have a well-developed alternative economics, which the Mankiws of the world are ignoring or suppressing. If only that were true.

Right now I’m teaching macro, and I’m presenting basically the same material as everyone else. ISLM, AS/AD, and their open economy equivalents. How come? Well, partly because I feel a certain professional duty. Students signed up for a course in intermediate macroeconomics, not in J.W. Mason Thought. (That will be next semester.) But mainly because it’s the path of least resistance. I don’t know any good textbook that presents the fundamentals of macroeconomics from a genuinely Keynesian or radical perspective. And working up a course by myself would be vastly more work, and I don’t think I could do it justice. A downward sloping AD curve, let’s say, is absurd. There’s no real economy on earth in which the main effect of deflation is to stimulate demand via a real balance or “Keynes” effect. It pains me to even put it on the board. But what’s the counterhegemonic model of inflation I should be teaching in its place?

It’s not just me. I know a number of people who are unapologetic Marxists in their own work, yet when they teach undergraduate macroeconomics, they use Blanchard or some similarly conventional text. It’s a structural problem. I don’t mean to defend Mankiw, but in some ways I think those of us on the left of the profession are more to blame for the state of undergraduate economics education. We spend too much time on critiques of the mainstream, and not nearly enough developing a systematic alternative. Some people criticize radical economists for just talking to each other, but personally I think we don’t talk to each other nearly enough.

The anti-Mankiw that’s needed, it seems to me, isn’t a critique, but an alternative; as long as we’re arguing with him, he still gets to decide what we’re talking about. That’s one reason I prefer to spend my time debating people like Krugman, DeLong, John Quiggin, and Nick Rowe, who I respect and learn from even when I don’t agree with them. (Another reason is that attention is a precious resource and I prefer giving the bit I get to allocate to people and ideas that deserve it.)

It’s true that the ideological policing in economics is very tight—but mainly at the top end, and even there mostly not at the level of undergraduate teaching. As far as I can tell, most places nobody cares what you do in the classroom; there’s already plenty of space for alternatives at schools that aren’t Harvard. But people mostly aren’t using that space. In my experience, even when people want to bring a “radical” perspective to undergraduate econ, that means presenting the mainstream models and then dissecting  them, which preserves the mainstream view as the default or starting point, when it doesn’t just leaves students confused. “Radical” economics almost never seems to mean simply teaching economics the way we radicals think it should be taught.

So yes, Occupy Mankiw, by all means. But maybe we should also think more about the classrooms we’re already occupying. Or as a graffito that should be familiar to the male fraction of anti-Mankiw says:

Start your own hit band or stop bitching

EDIT: If anyone reading this wants to suggest good models or resources for what an undergrad economics course ought to look like, I’d be thrilled to hear them.

FURTHER EDIT: Lots of suggestions. I need to walk back a little: There are more good alternatives to Mankiw  & co. than you’d guess reading this post. But the key point is still, we need to move past critique and develop our own positive views. As long we’re responding to him, he’s setting the terms of the conversation. Read about, say,  Paul Sweezy in the 1940s — he was so admired not because he had such a cutting critique, but because he so clearly and confidently offered an alternative. (And because he was so charming and good-looking, but that sort of goes with it, I think.) We’ll be getting somewhere when, instead of rushing to rebut everything Mankiw says, we can say, “Oh, is that guy still writing? Well, forget about him — here’s the good stuff.”

So, the good stuff.

I should have mentioned two excellent macro texts that, while they are too advanced for the students I’m teaching now, really comprehensively describe the state of the art alternative approaches to macro: Michl and Foley’s Growth and Distribution and Lance Taylor’s Reconstructing Macroeconomics. If, like me, you;re more more interested in short-term dynamics than growth models, you might get a little more out of the Taylor book, but both are very good.

In comments, NKlein suggests Godley and Lavoie’s Monetary Economics: An Integrated Approach, which I know other people recommend but I’m afraid I haven’t read (tho it’s on my Kindle), and mentions that Randy Wray and Bill Mitchell are working on a new textbook. I believe Wray currently teaches undergraduate macro at Kansas City using Keynes’ General Theory as the primary textbook, which is not a terrible idea (tho it would probably depend on the students.)

A lot of people like Understanding Capitalism, by Sam Bowles, Richard Edwards and Frank Roosevelt. Sam’s microeconomics textbook is also supposed to be good, if, god forbid, you have to teach that. (But the orthodox-heterodox divide doesn’t really exist in micro, I don’t think.)

Meanwhile, over on anti-Mankiw itself, Garth suggested — more or less simultaneously with this post — Steve Cohn’s Reintroducing Macroeconomics, and linked to a long list of heterodox texts. I’m only familiar with a few of the books on the list, altho most of the ones I do know are grab-bags of critical essays, which is not quite what I’m looking for. But clearly there’s a lot out there.

Bond Market Vigilantes: Invisible or Inconceivable?

Brad DeLong is annoyed with people who are scared of invisible bond-market vigilantes. And he’s right to be annoyed! It’s extraordinarily silly — or dishonest — to claim that the confidence of bondholders constrains fiscal policy in the United States. As he puts it, “Any loss of confidence in the long-term fiscal stability of the United States of America” is an “economic thing that does not exist.”

So he’s right. But does he have the right to be right?

I’m going to say No. Because the error he is pointing to, is one that the economics he teaches gives no help in avoiding.

The graduate macroeconomics course at Berkeley uses David Romer’s Advanced Macroeconomics, 3rd Edition. (The same text I used at UMass.) Here’s what it says about government budget constraints:

What this means is that the present value of government spending across all future time must be less than or equal to the present value of taxation across all future time, minus the current value of government debt. This is pretty much the starting point for all mainstream discussions of government budgets. In Blanchard and Fischer, another widely-used graduate macro textbook, the entire discussion of government budgets is just the working-out of that same equation. (Except they make it an equality rather than an inequality.) If you’ve studied economics at a graduate level, this is what government budget constraint means to you.

But here’s the thing: That kind of constraint has nothing to do with the kind of constraint DeLong’s post is talking about.

The textbook constraint is based on the idea that government is setting tax and spending levels for all periods once and for all. There’s no difference between past and future — the equation is unchanged if you reverse the sign of the t terms (i.e. flip the past and future) and simultaneously reverse the sign of the interest rate. (In the special case where the interest rate is zero, you can put the periods in any order you like.) This approach isn’t specific to government budget constraints, it’s the way everything is approached in contemporary macroeconomics. The starting point of the Blanchard and Fischer book, like many macro textbooks, is the Ramsey  model of a household (central planner) allocating known production and consumption possibilities across an infinite time horizon. (The Romer book starts with the Solow growth model and derives it from the Ramsey model in chapter two.) Economic growth simply means that the parameters are such that the household, or planner, chooses a path of output with higher values in later periods than in earlier ones. Financial markets and aggregate demand aren’t completely ignored, of course, but they’re treated as details to be saved for the final chapters, not part of the main structure.

You may think that’s a silly way to think about the economy (I may agree), but one important feature of these models is that the interest rate is not the cost of credit or finance; rather, it’s the fixed marginal rate of substitution of spending or taxing between different periods. By contrast, that interest is the cost of money, not the cost of substitution between the future and the present, was maybe the most important single point in Keynes’ General Theory. But it’s completely missing from contemporary textbooks, even though it’s only under this sense of interest that there’s even the possibility of bond market vigilantism. When we are talking about the state of confidence in the bond market, we are talking about a finance constraint — the cost of money — not a budget constraint. But the whole logic of contemporary macroeconomics (intertemporal allocation of real goods as the fundamental structure, with finance coming in only as an afterthought) excludes the possibility of government financing constraints. At no point in either Romer or Blanchard and Fischer are they ever discussed.

You can’t expect people to have a clear sense of when government financing constraints do and don’t bind, if you teach them a theory in which they don’t exist.

EDIT: Let me spell the argument out a little more. In conventional economics, time is just another dimension on which goods vary. Jam today, jam tomorrow, jam next week are treated just like strawberry jam, elderberry jam, ginger-zucchini jam, etc. Either way, you’re choosing the highest-utility basket that lies within your budget constraint. An alternative point of view – Post Keynesian if you like – is that we can’t make choices today about future periods. (Fundamental uncertainty is one way of motivating this, but not the only way.) The tradeoff facing us is not between jam today and jam tomorrow, but between jam today and money today. Money today presumably translates into jam tomorrow, but not on sufficiently definite terms that we can put it into the equations. (It’s in this sense that a monetary theory and a theory of intertemporal optimization are strict alternatives.) Once you take this point of view, it’s perfectly logical to think of the government budget constraint as a financing constraint, i.e. as the terms on which expenditure today trades off with net financial claims today. Which is to say, you’re now in the discursive universe where things like bond markets exist. Again, yes, modern macro textbooks do eventually introduce bond markets — but only after hundreds of pages of intertemporal optimization. If I wrote the textbooks, the first model wouldn’t be of goods today vs. goods tomorrow, but goods today vs. money today. DeLong presumably disagrees. But in that world, macroeconomic policy discussions might annoy him less.

Summers on Microfoundations

From The Economist’s report on this weekend’s Institute for New Economic Thinking conference at Bretton Woods:

The highlight of the first evening’s proceedings was a conversation between Harvard’s Larry Summers, till recently President Obama’s chief economic advisor, and Martin Wolf of the Financial Times. Much of the conversation centred on Mr Summers’s assessments of how useful economic research had been in recent years. Paul Krugman famously said that much of recent macroeconomics had been “spectacularly useless at best, and positively harmful at worst”. Mr Summers was more measured… But in its own way, his assessment of recent academic research in macroeconomics was pretty scathing.For instance, he talked about all the research papers that he got sent while he was in Washington. He had a fairly clear categorisation for which ones were likely to be useful: read virtually all the ones that used the words leverage, liquidity, and deflation, he said, and virtually none that used the words optimising, choice-theoretic or neoclassical (presumably in the titles or abstracts). His broader point—reinforced by his mentions of the knowledge contained in the writings of Bagehot, Minsky, Kindleberger, and Eichengreen—was, I think, that while it would be wrong to say economics or economists had nothing useful to say about the crisis, much of what was the most useful was not necessarily the most recent, or even the most mainstream. Economists knew a great deal, he said, but they had also forgotten a great deal and been distracted by a lot.Even more scathing, perhaps, was his comment that as a policymaker he had found essentially no use for the vast literature devoted to providing sound micro-foundations to macroeconomics.

Pretty definitive, no?

And that’s it it — I promise! — on microfoundations, methodology, et hoc genus omne in these parts, at least for a while. I have a couple new posts at least purporting to offer concrete analysis of the concrete situation, just about ready to go.

Why Do We Need Heterodox Economics Departments?

A comrade writes:

Economics is too important to leave it to the mainstream. Economic ideas and economists are very powerful at shaping and influencing the societies in which we live. We, heterodox economists, are a minority and we need our voice be heard. I’m afraid that the radicalism of “I don’t care the mainstream, I do my own thing” is the most conservative strategy. It leaves us as college professors teaching mainstream stuff with a heterodox twist but without any significant influence in the real world. Please, don’t take this wrong. I respect and admire those who like teaching at colleges as a way of life. I’m just saying that as a collective output is a suicide. Our battle is at research universities, central banks, finance ministries, international institutions and think tanks, where the presence of mainstream economist is overwhelming. We need to challenge and persuade them and for that we need to know their theories and methods.

I disagree.

Of course we don”t want to be cloistered. But there are many possible channels by which our work can reach public policy, social movements and the larger world. Shifting the mainstream of economics is only one possible channel and not, in my judgment, the strongest or most reliable one.

To take a personal example: I recently agreed to do some research work for a couple of state-level minimum-wage campaigns,giving them numbers on the distribution of workers who would be covered by the bills by industry and firm size and the profitability of the major low-wage sectors in those states. The people organizing the campaigns are now using those numbers for position papers, talking points for canvassing, op-eds, etc. I even went down to Maryland a couple weeks ago to testify before the legislature.

Of course you need some basic knowledge of econometrics and the relevant literature to do this kind of work. But do you need the kind of knowledge you’d need to be a cutting-edge labor economist? No, obviously not; I’m not a labor economist of any sort. And yet, I would argue, this kind of direct work with practical political campaigns/organizations is at least as likely — more likely, IMO — to produce concrete policy changes and to shift the public debate, than an effort to master the techniques of mainstream labor economics, publish sufficiently on the minimum wage to move the consensus of the profession, and then count on the “official” representatives of the profession to pass the message on to policymakers. Fundamentally, I don’t agree that our battle is at research universities, central banks, etc. Our jobs may be at those places. But our battle is with people engaged in practical political work and organizing. This isn’t (just) a moral stand; I think the implicit assumption that the consensus of the economics profession is first shaped by the quality of the arguments made on various sides, and then transmitted to politics, is not applicable to the real world. If you want to contribute to political change, you need to be part of a political project; winning debates within the economics profession doesn’t help. The recent history of macroeconomics shows that clearly, no?

There’s a second point. The idea that we should be orienting our training around learning to persuade the mainstream assumes that “we” already know what we want to persuade them of. But that’s not the case. On most of the big questions, we don’t have any consensus on what the right answers are, even if we’re confident they’re not what’s taught in most programs. And the project of developing an alternative economics is very different from the project of persuading people of an alternative economics. The second would require talking — and having the tools to talk — with others. But the first requires primarily talking among ourselves. And the first has to come first. Economics is hard! And Marxist, post-Keynesian, feminist, institutionalist economics is just as hard as mainstream economics. (Albeit in different ways — less math, more fieldwork & history.) Unless we — meaning we heterodox/radical economists — are systematically building on each others’ work, there will never be an alternative view to persuade the mainstream of. Which means there needs to be spaces for conversations within radical economics, where we can critique and develop our own approaches, and for getting the training necessary to take part in those conversations.

All of us tend to exaggerate our own intellectual autonomy. (It’s a legacy of the Enlightenment.) We think we’re rational beings, who know what we want and choose the best tools to get it. But , means and ends don’t always separate so cleanly. You say you want a prestigious position only in order to have a better platform from which to advance progressive ideas, but soon enough the means becomes the ends. (I’ve seen it happen!) There can’t be left ideas without a sociological left — without a group of people who feel some objective connection with each other, have shared experiences and interests, share a common identity. Because ideas will accomodate to the situation of the person who holds them. (Erst kommt das Fressen, dann die Moral.) We all think, no not me, but yes us too. If there aren’t at least a few settings in which specifically radical economics is professionally rewarded, we shouldn’t take it for granted that it will continue to exist.

The Lucas Critique: A Critique

Old-fashioned economic models (multiplier-accelerator models of the business cycle, for example) operate in historical time: outcomes in one period determine decisions in the next period. That is, agents are backward-looking. The Lucas critique is that this assumes that people cannot predict what will happen in the future. The analyst on the other hand can derive later outcomes from earlier ones (or we would not be able to tell a causal story), so why can’t the agents in the model?
Lucas says this is an unacceptable contradiction, and resolves it by attributing to the agents the model used by the analyst. (Interestingly some Post Keynesians (e.g. Shackle) seem to see the same contradiction but they resolve it the other way, and take the inability to predict the future attributed to the agents in the model as a fundamental feature of the universe, so applicable to the analyst too.) But is the idea of predictable but unpredicted outcomes such an unacceptable contradiction?

One reason to say no is that the idea that agents must know as much as analyst rests on a sociological foundation – that institutions are such as to foster knowledge of the best estimate of future outcomes. This need not be the case. For example, consider the owners of an asset that has recently appreciated in value, where there is some doubt about whether the appreciation is transitory or permanent, or whether further appreciation should be expected. Those asset-owners who have a convincing story of why further appreciation is likely will be most successful at selling at a higher price, and so will increase their weight in the market. And to have a convincing story you should yourself be convinced by it – this is true both logically and psychologically. Similarly with various arm’s-length relationships that must be periodically renewed – the most accurate promises are not necessarily the most likely to bring success. Or on the other side, classes and organizations to maintain their coherence need their members to hold certain beliefs. This could take the deep form of ideology of various kinds, or the simple form of the practical requirements of organizational decision-making implying a limited set of inputs. The other reason comes if you carry the Lucas critique through to its logical conclusion. Those who accept rational expectations also use the method of comparative statics, where transitions from one equilibrium to another is the result of “shocks”. One set of technologies, tastes, endowments, policies, etc. yields equilibrium A. Then a shock changes those parameters, and now there’s equilibrium B. Joan Robinson objected to this procedure on grounds that it ignored dynamics of transition from A to B, but there is another problem. Evidently B is a possible future of A. The analyst knows this. So why don’t the inhabitants of A? Unless the shock is literally divine intervention, presumably its probability can be affected by the their actions, so doesn’t the analysis of A have to take that into account? Or, even if the shock is indeed an act of God, it’s possibility must be known – since it is known to the analyst – and so it must affect decisions made in A. But in that case the effects of the shock can be hedged and nothing happens as a result of the shock; there is no longer two equilibria, just one. So we either have agents with perfect knowledge of everything and no knowledge of shocks, which must literally be divine interventions; or we can have only a single equilibrium which nothing can change; or we can become nihilists like Shackle; or we can reject the Lucas critique and accept that there are regularities in economic behavior that are not anticipated by the actors involved.