Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is “free.” A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and “risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today’s New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: “Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts.” ‘ Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also “to deal in debts of varying degrees of risk,” i.e., high grade private securities and perhaps state and local issues.

That’s a quote from The General Theory, with Hansen’s gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base – the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System’s lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It’s on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.

[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as “central bank independence freaks.”

Piketty and the Money View: A Reply to MisterMR

The last post got some very helpful comments from MisterMR (the regular commenter formerly known as Random Lurker) and Kevin Donoghue. Both of them raise issues that are worth posts of their own. I’ll reply to MisterMR now, and perhaps to Kevin Donoghue later. Or perhaps not — the biggest thing I’ve learned in four years of blogging is: Never make promises about future posts.

* * *

MisterMR is coming from what I hope he won’t mind my calling a classical Marxian perspective — a perspective I’m simpatico with, tho I haven’t been taking it here. One aspect of this perspective is the idea that capital can be understood in physical terms, as embodied labor. Now I agree that Marx does clearly say this, but I think this can be seen as a concession he is making to the orthodoxy of the day for the sake of the argument. Capital is subtitled “A Critique of Political Economy,” and I think we should take that subtitle seriously. In effect, he is saying to Ricardo: OK, let’s accept your way of thinking about capital, the system based on it is still conflictual, exploitative and in contradiction with its own conditions of existence.

I’m not sure how widely this view is held — that Marx adopts the labor theory of value ironically. Anyway, that’s not the argument I want to have here. What I want to do is clarify the perspective I’m offering in place of the labor theory. It’s more in the spirit of the other core Marxian idea about capital, that it is a social relation between people.

MisterMR writes:

I think that there are 4 different kinds of capital assets (though in reality most capital assets are a mix of the four kinds). 

1) There are some capital goods that are stuff that is materially produced, such as factories. This stuff has a cost of production, that arguably has some relationship with its “value”. This is what I would call “real” capital. The ambiguity in Piketty comes from the fact that he speaks as if all capital is “real” capital, and as if every money flow translates in “real” capital. 

2) There are some assets that are a finite resource that someone controls, like land. In fact, classical economists distinguished between “capital” and “land”. The value of land can’t be linked to the “cost of production” of land, because said cost doesn’t exist. So arguably the value is just the cashflow derived from the asset divided by the normal rate of profit. I’d call this kind of assets simply “land”. 

3) While land is certainly something that exists, there are some assets that have an economic value but that don’t relate to something that clearly exists or that can be produced: for example, ownership on patents, or a famous brand that has an high market penetration and visibility etc. I think that these assets have dinamics that are similar to land, although they are mostly non material. 

4) Finally, there is credit. Credit also is a non material thing, and is different from all the 3 previous classes of capital for these reasons: 

4.1) It doesn’t have a “cost of production”;
4.2) It isn’t related to any fixed resource, something that differentiates credit from both 2 and 3;
4.3) It has a fixed nominal value (which implies that the currency provider can literally print it out of existence).
4.4) It usually has a nominally fixed interest rate, something that can obviously cause chain bankruptcies. 

My problem with the “monetary view” is that it sounds like if assets of the 2 and 3 classes all are just a “montary” thing, as opposed to a “real stuff view” that sees all assets as if they were of the 1 class.

My response is that the money view is not a substantive claim about the nature of particular assets, but a way of looking at assets in general — “real” capital goods as much as the more vaporous claims in categories 2 through 4. It does imply some kind of ontology, but in itself, the money view is just a choice to focus on money payments.

But I do want to explain the broader view of social reality that, for me at least, lies behind the money view.  Here’s the way I want to look at things.

* * *

On the one hand, there is the human productive activity of collectively transforming the world and maintaining our conditions of existence, along with the conditions that make that activity possible. When you sit down and write a blog post, you are engaged in creative activity with the goal of building up our collective knowledge of the world, and you are also maintaining the network of social ties through which this kind of activity is carried out. Your ability to engage in this activity depends on a great number of objective conditions, ranging from your physical health to the infrastructure that communicates your words to the rest of the world. Many of these conditions are the result of past human activity.

Under capitalism, a subset of human productive activity gets marked off as “labor.” Labor has a number of special characteristics, most obviously that it is carried out at the direction of a boss. But for current purposes, the most important distinctive characteristics of the activity that we call “labor”  are (a) it carries a price tag, the “wage,” with labor that is somehow similar carrying a similar wage. And (b) labor becomes substantively more similar over time, with the disappearance of specific skills and increasing interchangeability among the human beings performing it; it follows from this that the wage also become uniform. To the extent that (a) is true, we can attribute a “cost” to some particular set of conditions and to the extent (b) is also true, that cost will correspond to the hours of labor expended maintaining those conditions. Of course all productive activity additionally requires many conditions, both natural and social, that are not reflected in labor hours. In particular, a great deal of passive social cooperation is required for any productive activity, especially when there is an extensive division of labor.

Even in the pure case, where labor is completely homogeneous and all production is carried out for profit, under identical conditions and with no barriers to competition, there will not in general be a unique mapping from labor hours to costs or relative prices. The best we can do is to reduce all the infinite possible sets of relative prices to variation along a single dimension, with one set of relative prices corresponding to each possible profit rate. (I think this is Sraffa’s point.)

So the description of assets in group 1 is correct — but only with respect to one particular way of describing one particular way of organizing production, not as statements about reality in general. The productive activity that takes place in a factory does, of course, require the past activity that resulted in the existence of the factory. But it requires lots of other activity as well, much of which is not counted as “labor.” And the fact that “labor” is a measurable input at all only holds to the extent that the productive activity has been deskilled and homogenized, a sociological fact that is never completely true and is not true at all in most historical contexts.

The think you have to avoid is believing that quantities like “value” or “cost” have any existence outside the specific social relations of capitalism.

The next question is what it means to “own” some conditions for productive activity, like a factory. The beginning of wisdom here is to recognize that ownership is a legal relationship between persons, not a relationship with a physical object. To own a piece of land means you have certain legal rights with respect to other people — to exclude them from the use of that land, to receive some equivalent from them if you do permit use of the land, to transfer those rights to someone else — and that no one else has those rights with respect to you. However, that’s only the first step. Next, we have to recognize that what constitutes “use” of piece of an asset is not a physical fact, but a social one. (As in the old story, the baker can exclude others from eating his rolls, but not from enjoying the smell of them.) So it would be more accurate to say that ownership of a piece of property is simply a form of social authority — a bundle of rights over other people. Indeed, if we want to relate the world of money flows to broader social reality, the most fundamental fact is probably this: The person who receives a money payment labeled “profit” gives orders, and the people who receive money payments labeled “wages” have to follow them. To say you own a piece of property is simply to say there is a set of commands that, if you issue them, other people are compelled to obey. Those rights are metonymously referred to by a label which bears a picture of some tangible good, just like the insignia on an officer’s uniform bear a picture of a leaf or a bird.

So:

When you say, here is a means of production, a factory, with a certain cost, you have already chosen: to ignore all the various conditions that make a certain form of collective productive activity possible, and let the existence of this one tangible object, the factory, stand in for all the rest; to ignore all the various forms of productive activity and social coordination that were necessary to bring the factory  (and the rest of the conditions of production) into existence, except for those we class as wage labor; to convert that wage labor to some common quantitative standard by measuring it in wage payments;  to assume some exogenously given profit rate, to give you the discount rate you need to add up wage payments made at different dates. Only then can you say the factory has a cost — and even then, this money cost is calculated by adding up a certain set of money payments.

At that point we have MisterMR’s category (1) as a concrete social reality. We still have to establish the profit rate, since it cannot be reduced to a marginal physical product. Only then do the issues specific to the other three categories come into play.

I should be clear: the money view is not a complete account of the sphere of social reality we call the economy. (And again, I’ve adopted the term from Perry Mehrling, it’s not my invention.) The money view is defined by making the atomic units of analysis bundles of money payments. I would argue that it is logically consistent to think of any capital good as simply a bundle of income streams contingent on different states of the world, in a way that it is not logically consistent to think of it as a physical object producing a stream of physical outputs.

The fact that this is a logically consistent account doesn’t mean it’s sufficient. Obviously the money view doesn’t give a complete story, since we don’t know why the income streams attached to different assets are what they are, or why they change over time, or why assets in the monetary sense are attached to tangible goods or production processes, or for that matter why anyone cares about money payments in the first place. But by adopting a consistent story about money payments and assets, we get a clearer view of these other questions. We distinguish the questions that can be addressed with the formal techniques of economics from other questions that require a different approach. This is a step forward from the perspective that mixes up questions about money flows with questions about tangible productive activities and so can’t give a coherent story about either.

Piketty and the Money View

I recently picked up Capital and the 21st Century again. And what’s striking to me, on revisiting it, is the contrast between the descriptive material and the theory used to make sense of it.

Piketty’s great accomplishment is the comprehensive data on wealth he has compiled, going back to the 18th century. He deserves nothing but praise for making that data easily accessible. (You could think of his project as an iceberg, with most of the substance hidden below the waterline in the online appendixes.) I have not seen any serious doubts raised about the accuracy of this data; and the descriptive generalizations he draws from it, while not above criticism, are obviously based in a deep study of the concrete historical material. But the connections between this material and the theoretical claims it’s mixed in with — r > g and all that — are tenuous at best.

It’s important to remember that all the underlying data is in nominal terms. All the empirical material in the book relates to stocks and flows of money. But when he turns to explain the patterns he finds in this data, he does it in terms of physical inputs to physical production. The money wealth present in a country is assumed to correspond to the physical capital goods, somehow converted to a scalar quantity. And the incomes received by wealth owners is assumed to correspond to a physical product somehow attributable to these capital goods. I am hardly the first person to suggest that this is not a sensible way to explain trends in private wealth as measured in money, and the money-income derived from it. But what I haven’t seen people say — even people who jump at the chance to revisit the Cambridge Capital Controversies — is the remarkable difference in the attitudes of Piketty the historian and Piketty the economic theorist to data. Shifts in the scale and distribution of private wealth are described on the basis of years of meticulous study of the tax records of various countries. But the production processes that are supposed to explain these shifts are described without any data at all, purely deductively.  You would think that if Piketty believed that the share of property income in total income depends on physical production technologies, returns to scale, depreciation, etc., then at least half the book would be taken up with technological history. You’d think he would spend as much energy studying the inputs and outputs associated with different degrees of mechanization of major production processes, how long is the useful life of different kinds of buildings in different eras and how much annual maintenance they require, and so on. After all, these are the kinds of factors that he believes — or claims to believe — drive the money-wealth outcomes the book is about. In fact, of course, these topics are not discussed at all. Terms like “production” and “depreciation” are black boxes, pure mathematical formalism. You would think that Piketty, who presents himself as a historian and is admirably critical of the deductive character of so much of economics, would have hesitated before staking so much on deductive, evidence-free claims about physical production.

Because when you take a step back and think about it, this is what Piketty has done:  He has carefully described the historical evolution of monetary wealth, and then postulated an imaginary physical reality that exactly matches that evolution. It’s a kind of economic preformationism, or like the folk psychology that tries to explain your actions by imagining a little homunculus in your head that is choosing them.  The “real economy” in Piketty is just a ghostly mirror-image of the network of money payments and money claims that is actually observed.

* * *

Let me give a concrete example. Piketty shows that around 1800, the wealth-income ratio was relatively low in the United States — about 300% of national income, compared with 600-700% in England and France. About half of this difference was the lower value of agricultural land, which totaled about 150% of national income in the US and over 300% in both England and France. Piketty suggests that this is because the great abundance of land in the New World meant that its marginal product was relatively low. This sounds reasonable enough — but it flies in the face of Piketty’s larger argument about the capital share. His big theoretical claim is that the capital share is determined by the growth rate of cumulated savings relative to the growth rate of income. And this only works if the return on “capital” is relatively insensitive to its scarcity or abundance. (This is the question of the elasticity of substitution between capital and labor, which has dominated economists’ debates about the book.) If having more land makes the share of land rents in national income go down, why won’t the growth of “capital” similarly push down its return?

This isn’t meant as a gotcha. Piketty frankly acknowledges the problem. He suggests two possible solutions: First, constant returns might only apply over some range of capital-output ratios. Beyond that that range, further accumulation might make capitalists as a group poorer rather than richer. Second, it might be easier to substitute between labor and modern capital goods, than between labor and agricultural land. Both these assumptions sound reasonable, altho I think they are both more problematic than they seem at first glance. But that’s not the argument I want to have right now. The point I want to make now is that Piketty just takes it for granted that behind the smaller flow of money going to land owners in US circa 1800, there must have been a smaller physical flow of output coming off the marginal piece of land. Of course this isn’t logically necessary — the money-value of agricultural land will also depend on the legal rights associated with land ownership, the terms on which new land can be acquired, the ease with which land can be sold or borrowed against, etc. Presumably the same physical mix of land, tools and people would have led to a different share of money income being claimed as land rents if frontier land in the early United States had been owned by a few large landlords, instead of being freely distributed to white families by the government. But these types of explanations are not even considered. For Piketty, behind each flow of money there must be an identical flow of stuff.

The other strange thing is that, despite his insistence that money flows are fully explained by physical conditions of production, Piketty shows no interest in investigating those conditions. The numbers on the level and composition of money wealth in US are meticulously sourced and documented. The claims about physical production conditions, on the other hand, are entirely speculative. There is no shortage of material you could turn to if you wanted to ask whether whether land was really more abundant, in an economically meaningful sense, in the early US than in France or Britain, or if you wanted to know if adding an acre to an 1800-era American farm would increase its output proportionately less or more than adding an acre to a similar-sized British or French farm. But Piketty doesn’t even gesture at this literature.

* * *

I draw two conclusions. First, it’s hard to say anything sensible about the book until you realize it consists of two distinct, almost unrelated projects. There is the historical data on money wealth and money incomes. And then there is the whole rigamarole of “laws of capitalism.” The book is mostly written as if the latter somehow distill or summarize the former, but they are really very loosely articulated. Let me give one more quick — but important — example. You might think that with all the huffing and puffing about r > g, the data would tell a story in which the share of wealth in national income rises in periods when r is relatively high and g is relatively low, and falls when g is high and r is low. But the data tell no such story.

The great fall in the capital share took place between 1913 and 1950, according to Piketty. But his own data show that this was the period of the highest returns to capital, and the lowest growth rates, in the whole 240 years the book covers. I’ve reproduced his graph of r in the UK below; the figures for other Western European countries look similar. Meanwhile, he gives an average growth rate for Western Europe over 1913-1950 of 1.4%, compared with 1.8% in the high-capital share 19th century, and 2.1% in the period of rising capital shares since 1970. This is exactly the opposite pattern that we would expect if r and g were the central actors in the story.

Of course Piketty has an answer for this too: The fall in the capital share in the first half of the 20th century is explained by the World Wars and the destruction of the old social order in Europe. No doubt — but if factors like these dominate the historical trajectory of wealth and income, why not tell your story in terms of them, instead of a few dubious equations from the orthodox growth model? Unfortunately, discussion of the book has been almost entirely about the irrelevant formalism. I think that is why the conversation has been so noisy yet advanced so little. To return to the earlier metaphor, it’s as if everyone is ignoring the iceberg and talking about a little igloo built on top of it.

My second conclusion is that the disconnect between the two different Pikettys shows, in a negative way, why what I’ve been calling the money view is so important. The historical data assembled in Capital in the 21st Century is a magnificent accomplishment and will be drawn on by economic historians for years to come. Many of the concrete observations he makes about this material are original and insightful. But all of this is lost when translated into Piketty’s preferred theoretical framework. To make sense of the historical evolution of money payments and claims, we need an approach that takes those payments and claims as objects of study in themselves.

LATE UPDATE: A friend forwards the following (verbal) comment from Joe Stiglitz:

“There is a confusion in Piketty on valuation and physical stocks. In France, the main ‘increase’ in wealth is because of higher prices of land. Do we really think that France has become wealthier (using Piketty’s physical understanding of wealth in his model) because while the manufacturing capital stock has declined, the Riviera has become more expensive?”

FIRE in the Whole

Maybe the most interesting paper at this past weekend’s shindig at Bretton Woods was Duncan Foley’s. [1] He argues, essentially, that it’s wrong to include finance, real estate and insurance (FIRE) in measures of output. Excluding FIRE (and some other services) isn’t just conceptually more correct, it has practical implications — the big one being that an Okun’s law-type relationship between employment and output is more stable if we define output to exclude FIRE and other sectors where value-added can’t be directly measured.

It’s a provocative argument. He’s certainly right that the definition of GDP involves some more or less arbitrary choices about what is included in final output. (The New York Fed had a nice piece on this, a couple years ago, which was the subject of the one of the first posts on this humble blog.) However, I can’t help thinking that Foley is wrong on a couple key points. Specifically:

While in other industries such as Manufacturing (MFG) there are independent measures of the value added by the industry and the incomes generated by it (value added being measurable as the difference between sales revenue and costs of purchased inputs excluding new investment and labor), there is no independent measure of value added in the FIRE and similar industries mentioned above. The national accounts “impute” value added in these industries to make it equal to the incomes (wages and profits) generated. Thus when Apple Computer or General Electric pay a bonus to their executives, GDP does not change (since value added does not change–the bonus increases compensation of employees and decreases retained earnings), but when Goldman-Sachs pays a bonus to its executives, GDP increases by the same amount.

This seems confused on a couple of points. First, unless I’m mistaken, value-added in FIRE is calculated exactly in the way he describes — sale price of output minus cost of inputs. (The problem arises with government, where there is no sale price.) Second, I’m pretty sure there is no difference in the way wages are treated — total incomes in a sector always equal the total product of the sector, by definition. There is a question of whether executive bonuses are properly considered labor income or capital income, but that’s orthogonal to the issues the paper raises, and is not unique to FIRE. In any case, it is definitely not correct to say that higher compensation implies lower earnings in non-FIRE but not in FIRE.

It seems to me that there is a valid & important point here, but Foley doesn’t quite make it. The key thing is that there is no way of measuring price changes in FIRE. That’s what he should have said in place of the paragraph quoted above. The convention used in the national accounts is that the price of FIRE services rises at the same rate as the price level as a whole, so changes in nominal FIRE incomes relative total nominal income represent changes in FIRE’s share of total output. But you could just as consistently say that FIRE output grows at the same level as output as a whole, and deviations in nominal FIRE expenditure represent relative changes in FIRE prices. [2] There’s no empirical way of distinguishing these cases, it really is a convention. Doing it the second way would imply lower real GDP and higher inflation. I think this is the logically consistent version of Foley’s argument. And it would motivate the same empirical points about Okun’s Law, etc.

There’s another argument, tho, which I don’t quite have a handle on. Which is, what are the implications of considering FIRE services intermediate inputs rather than part of final output? If a firm pays more money to a software firm, that’s considered investment spending and final output is corresponding higher. If a firm pays more money to a marketing firm, that’s considered an intermediate good and final output is no higher, instead measured productivity is lower. I think that FIRE services provided to firms are considered intermediate goods, i.e. are already treated the way Foley thinks they should be. But I’m not sure. And there’s still the problem of FIRE services purchased by households. There’s no category of intermediate-goods purchases by households in the national accounts; any household expenditure is either consumption or investment, so contributes to GDP. This is a real issue, but again it’s not unique to FIRE; e.g. why are costs associated with commuting considered part of final output when if a business provides transportation for its employees, that’s an intermediate good?

He raises a third question, about the possibility that measured FIRE outputs includes asset transfers or capital gains. There is serious potential slippage between sale of financial services (part or GDP, conceptually) and sale of financial assets (not part of GDP).

Finally, it would be helpful to distinguish between services where measuring output is practically difficult but conceptually straightforward, and FIRE proper (and maybe insurance goes in the previous category). It seems clear that capital allocation as such should not be considered as part of final output. Whatever contribution it makes to total output (modulo the deep problems with measuring aggregate output at all) must come from higher productivity in the real economy. The problem is, there’s no real way to separate the “normal service” component of FIRE from the capital-allocation and representation-of-capitalist-interests (per Dumenil and Levy; or you could say rent-extraction) components.

But whatever the flaws of the paper, it’s pointing to a very important & profound set of issues. We can’t bypass the conceptual challenges of GDP, as Matt Yglesias (like lots of other people) imagines, with the simple assertion that labor is productive if it produces something that people are willing to pay for. Producing a consistent series for GDP still requires deliberate decisions about how to measure price changes, and how to distinguish intermediate goods from final output. Foley is absolutely right to call attention to these problems, that most social scientists are happy to sweep under the rug [3]; he’s right that they’re especially acute in the case of FIRE; and I think he’s probably right to say that to solve them we would do well to return to the productive/unproductive distinction of the classical economists.

[1] I wasn’t there, but a comrade who was thought so. And he seems to be right, based on the papers they’ve got up on the website.

[2] Or you could say that FIRE output is fixed (perhaps at 0), and all changes in nominal FIRE output represents price changes. Again, this problem can’t be resolved empirically, nor does it go away simply because you adopt a utility-based view of value.

[3] Bob Fitch had some smart things to say about the need to distinguish productive and unproductive labor.