Month: October 2013

Functional Finance and Sound Finance

Introduction

Anyone who who has been following debates on fiscal policy over the past few years will have noticed that, among those who think fiscal policy can be effective, there are two distinct camps. There is a minority who think that fiscal policy is not subject to a budget constraint; that is, that as long as a government borrows in its own currency, its existing liabilities never limit its ability to adjust taxes and spending to bring the economy to full employment. And there are the majority who think that governments are subject to a binding budget constraint; that is, that while adjusting spending and taxes can in principle be used to bring about full employment, it may be impossible or undesirable to do so when the level of government debt is already high. In this view, maintaining full employment should be left to monetary policy. Following Abba Lerner, I call the first position “functional finance” and the second position “sound finance.”

I believe there are important differences between these two positions. But I also believe that these differences have not been clearly articulated, and as a result these debates between them been unproductive. It is my view that there are no important differences in terms of economic theory between the two positions. A perfect application of a functional finance policy rule and of a sound finance policy rule are indistinguishable. The difference between the camps is with respect to policy errors — which errors are most likely, and which are most costly.

Alternative Policy Rules

The starting point is the idea of instruments, which are variables directly controlled by the policymaker; and targets, which are the variables the policymaker wants to set at some level but cannot control directly. When the target variable is not at its desired level, the policymaker adjusts one or more instruments to try to bring it there. This creates relationship between the current level of the target and the chosen level of the instrument. We call this relationship a policy rule. Both functional finance and sound finance represent policy rules in this sense. Tinbergen’s Rule says that for policy rules to be successful (in the sense that all targets converge to their desired levels), there must be at least as many instruments as targets. One policy lever cannot be relied on to achieve two separate outcomes.

We have two instruments in macroeconomic policy: the government budget balance, and the central bank-controlled interest rate. What are our targets?

At first glance, full employment and price stability appear to be two separate targets. But in fact, both Lerner’s functional finance and the sound finance of modern textbooks agree that inflation is the result of demand-determined expenditure departing from a technologically determined level of potential output. Less than full employment means falling inflation, or deflation; overfull employment means high or rising inflation. So full employment and price stability are not two separate targets, they are two ways of describing the same target.

Both camps agree that we can identify a unique target level of output, and they agree on what that target should be. They also agree that output rises with higher government deficits, and falls with higher interest rates. So when interest rates are too high, or budget deficits too small, we will see unemployment (and perhaps deflation); when interest rates are too low or deficits are too large, we will see inflation (and perhaps bottlenecks and rising relative prices of factors in inelastic supply).

This consensus is shown in Figure 1. The full employment locus shows all the combinations of interest rates and fiscal balances that are compatible with full employment and price stability. A fall in private demand will require a rise in the deficit and/or a fall in interest rates to maintain full employment, so it will shift the full employment locus down and to the left. Similarly, a rise in private demand will shift the locus up and to the right. But for any level of private demand, with two instruments and only one target, there are an infinite number of combinations that achieve full employment.

(It is convenient to think of the fiscal balance on the horizontal axis as the primary balance, that is, the balance net of interest payments. So we are implicitly assuming that interest payments do not raise aggregate demand. It is also convenient to think of the interest rate as the real rate, that is, net of inflation. It would be straightforward to incorporate the effects of interest payments and inflation into the story, but would not change it in any interesting way.)

The first point of disagreement is what to do at a point like a. Output is below potential, but which instrument should be used to raise it? Functional finance says, the fiscal balance: government spending should be raised (or taxes should be lowered), moving the economy to the left, until we reach the full employment locus. The modern sound-finance consensus says that the interest rate should be lowered, moving the economy downward to the full employment locus. Both agree that government should do something to raise output. The disagreement is over which instrument to use.

Whichever instrument is used to keep output at potential, there is one instrument left over for some other target. The logical candidate is the sustainability of government debt.

We’ve discussed the math of government debt dynamics quite a bit on this blog. (See here and here and here and here.) The important thing for our purposes is that the long-run trajectory of the debt-GDP ratio depends on the primary balance, the interest rate on government borrowing, and the growth rate of GDP. If we write the ratio of government debt to GDP as b, and the primary deficit as a share of GDP as d, then for a given deficit, the equilibrium condition is b=d* 1/(g-r), where g is the average or expected growth rate of GDP over the period of interest. So for a given debt-GDP ratio b, the primary deficit required to hold it constant is d = b(g-r). (This is all just accounting; it does not depend on any economic assumptions.) It’s evident that, if we take the growth rate as exogenous, then for any given debt-GDP ratio there is a set of r, d combinations for which the debt-GDP ratio is constant. We can represent these values graphically in Figure 2. The dotted horizontal line is the growth rate. The diagonal line is the constant debt ratio locus. With a deficit or interest rate above the diagonal line, the debt-GDP ratio will rise; below, it will fall.

Note that the slope of the diagonal depends on the starting debt-GDP ratio — the higher it is, the shallower the slope will be. With no government debt, the line is vertical at the primary balance = 0 axis. So in any period in which the economy is at a point above the debt-sustainability locus, the diagonal rotates clockwise; in any period in which the economy is below the debt-sustainability locus, the diagonal rotates counter-clockwise.

What happens if the economy is off the constant-debt locus? It depends. In the area marked A (everything above the heavy line), the debt-GDP ratio rises without limit. In B, the debt-GDP ratio rises but converges to a finite value. In C the ratio falls to a finite value. In D, the debt-GDP ratio falls to zero and the government then accumulates a positive asset position, which eventually converges to a finite fraction of GDP. Finally, in area E the debt-GDP ratio falls to zero and the government then accumulates a positive asset position that rises without limit as a share of GDP. (If you are unconvinced we can go through the math.) Since the government budget constraint is normally taken to be the condition that debt-GDP ratio not rise without limit, we can ignore the distinctions between cases B through E and regard the heavy line as the government budget constraint.

We then combine this constraint with the full employment locus to give Figure 3.

Now we have two instruments and two targets. Or rather, one and a half targets: Since there is nothing special about the current debt-GDP ratio, we don’t need it to stay constant; we just need it not to go to infinity. So we don’t need to be on the debt-sustainability curve, we need to be on or below it. Point b, which satisfies the budget constraint exactly, is fine, but so is anywhere on the full employment locus below and to the right of b.

The functional finance-sound finance divide is just this: Functional finance says the fiscal balance instrument should be assigned to the full employment target and the interest rate instrument should be assigned to the debt sustainability target. Sound finance says the interest rate instrument should be assigned to the full employment target and and the fiscal balance instrument should be assigned to the debt sustainability target.

Functional finance and sound finance agree that the economy should be at a point like b. If policy were executed perfectly, the economy would always be at such a point, and there would be no way of knowing which rule was being followed. Since both target should always be at their chosen levels, it would make no difference — and be impossible to tell — which instrument was assigned to which target. The difference between the positions only becomes apparent when policy is not executed perfectly, and the economy departs from a position of full employment with sustainable public debt.

Consider a point somewhere above b, where we are have high unemployment but the debt-GDP ratio is rising without limit. What to do? Both orthodoxy and Lernerism want to get the economy back to a point like b, but they disagree on how.

In the sound-finance view, the interest rate instrument is committed to the output target. This means we must use the fiscal balance instrument free to meet the debt sustainability condition. This is how policy is normally discussed: An unsustainable upward trajectory in the debt position requires the government balance to move  toward surplus. In this case, that means that the government must cut spending or raise taxes, despite the fact that demand is already too low. Under Lernerian functional finance, on the other hand, the fiscal balance is committed to the output target, so the rule calls for higher deficits even though the debt position is already unsustainable. It is then the responsibility of monetary policy to adjust to maintain debt sustainability.

These alternatives are shown in Figure 4. The right-hand trajectory from c to b is the orthodox path. The left-hand trajectory is the Lernerian path. Implicit in the orthodox path is the idea that deficits must be brought down first, meaning a substantial period of high unemployment and output below potential; only once debt is on a sustainable path can interest rates be reduced to move back toward full employment. While the Lernerian path says in effect: If government debt is rising out of control, the central bank should intervene to force interest rates down to a level where the debt is sustainable. Then, if the resulting liquidity raises expenditure above the full employment level, you can subsequently raise taxes or cut transfers to bring demand back down.

Orthodoxy says that budget problems must be addressed fiscally. But this is true only on the implicit assumption that the interest rate is not available as an instrument to target debt sustainability. Sound finance’s policy rule is a Taylor-type rule for monetary policy, combined with a long-term government budget position that satisfies the debt-sustainability constraint at that interest rate. Functional finance’s policy rule: (1) fix the interest rate at a level at or below the expected growth rate (maybe even zero); (2) adjust transfers and taxes until output is at the full employment/stable prices level. The claim that fiscal policy must be subject to a budget constraint, comes down to the claim that the central bank cannot or will not keep r sufficiently low to make the full-employment fiscal position sustainable.

Why is there such disagreement about which instrument should be assigned to which target? It seems to me that the most important argument from the sound finance side is that elected governments cannot be trusted with the instrument of discretionary fiscal policy. They will not set taxes and transfers to bring aggregate demand to the full employment level, but will choose a higher, inflationary level of demand. Only independent central banks can be trusted to bring output to its socially optimal level. In this sense, the functional finance-sound finance divide is not a debate about economic theory, but about politics and sociology.

There are also more specifically economic disagreements. The sound finance side is more confident than the functional finance side about how quickly and reliably a change in interest rates will affect output. If there is a long lag between the change in the instrument and its effect, hitting the target requires accurate prediction of the state of the economy farther into the future. The existence of the ZLB reinforces this concern, since it is really just a special case of interest-inelasticity. (The statement “output does not respond strongly to any feasible change in interest rates” is equivalent to the statement “the interest-rate change needed to achieve a strong output response is not feasible.”) The functional finance side also tends to see a greater social cost in falling below full employment than rising above it, while the sound finance side tends to see the costs as symmetrical.

That is the framework. Now consider some modifications and special cases.

Extensions

A natural objection to the functional finance view is that it may not be possible for the central bank to maintain interest rates low enough to keep debt sustainable. If we live in a world of high capital mobility and our government’s liabilities are close substitutes for liabilities elsewhere in the world, then the private sector will not hold them if their yield is too much lower. In this case — which is not unrealistic for small, open countries — the interest rate ceases to be a policy variable. This is shown in Figure 5, where r* is the exogenous work interest rate.

At a point like d in the figure, the public debt is stable but output is below potential. A move toward a primary deficit would raise output but put the debt on an unsustainable path. This case is not inherently implausible — one would need to think carefully about the concrete assumptions it embodies — but it is important to recognize that it rules out sound finance as well as functional finance. If the interest rate is set exogenously at the world level, it cannot be used to stabilize public debt or to stabilize output. An additional instrument is needed; the exchange rate is the natural choice. Since the exchange rate cannot straightforwardly be used to achieve debt sustainability, in this case there is a natural argument to switch the assignment of fiscal policy to debt sustainability and achieve full employment via the exchange rate.

Another possibility, which has been getting increasing attention recently, is that very low interest rates are destabilizing for the financial system. (I have criticized this idea before, but I don’t think it can be ruled out definitively.) Then we have another condition to satisfy, a asset price stability condition. Like the debt sustainability condition, this is asymmetrical, it doesn’t have to be satisfied exactly. But this one is a floor on interest rates rather than a ceiling. The is shown in Figure 6. Here, the asset price stability constraint does not initially prevent achieving both the other targets: As in Figure 3, point b initially satisfies all the constraints, as does any other point along the full employment locus below and to the right of it, down to the dotted line.

But what if a fall in private demand shifts the full employment locus far to the left? Here there is an important difference between the sound finance and functional finance rules. The functional finance rule says that the fall in private demand requires the government budget to move toward deficit. That is, we move left from b to the new full employment locus. This may in turn require a fall in interest rates, if the higher deficits would otherwise put the public debt on an unsustainable path. But public debt sustainability never requires an interest rate below the long term growth rate. So, since it is not plausible that the minimum interest rate compatible with asset price stability condition is greater than the growth rate, the possibility of asset bubbles should not limit the application of the functional finance rule.

The sound finance rule, on the other hand, says that the response to a fall in private demand should be a reduction in the interest rate. In other words, faced with the fall in private demand shown in the figure, we should move downward from point b  to the new full employment locus. Now there is the possibility that the required interest rate is incompatible with asset price stability. (In some views, this is precisely what happened a decade ago, setting the stage for the housing bubble.) This becomes an argument for setting interest rates higher than the conventional policy rule implies, even at the cost of higher unemployment.

Formally, the ZLB is identical to the asset price stability condition: both set floors to allowable interest rates. It is curious that, while concern with the ZLB and with the destabilizing effects of low interest rates often come from opposite political positions, they are — at least in this framework — equivalent in their implications for policy. Both are arguments for a reliance on fiscal policy to offset fall in private demand in general, rather than waiting for the floor to be reached — that is, for some form of functional finance.

Finally, consider the case where the fiscal balance is exogenously fixed, as shown in Figure 7. I think this is the case most critics of functional finance have in mind. If the budget authority, for whatever reason, is committed to tax and spending policies corresponding to a primary deficit, there may be no interest rate that can deliver both debt sustainability and full employment. The central bank must choose one. If it chooses debt sustainability, we have a situation known in the literature as “fiscal dominance.” The central bank must increase its liabilities as needed to finance the government deficit, even if that results in aggregate demand rising to inflationary levels. This is the situation at point e.

It is important to stress that Figure 7 is not what is advocated by functional finance. There is an understandable but unfortunate confusion between the claim “deficits can be at whatever level is needed to reach full employment” and “deficits can be at whatever level you want.” Functional finance says the former, not the latter. A functional finance rule would call for the government to raise taxes or cut spending at a point like e — not to balance the budget, but to eliminate the inflation. The practical problem for functional finance supporters is to convince skeptics that such a rule will be followed by an elected government.

Conclusion

Advocates of functional finance say that a government that borrows in its own currency never needs to adjust its taxes or spending on account of its current deficit or accumulated debt. The fiscal balance can always be set at whatever level is needed to achieve full employment. Their sound-finance critics reply, “It’s true that a deficit will raise current output. But over the long run you need a primary surplus to ensure that the government stays on its budget constraint. If the central bank is forced to monetize the debt instead, you will have runaway inflation.”

The critics are correctly describing the situation in Figure 7, where it is true that the government budget position has been set without regard for debt sustainability, the central bank is monetizing the debt (this is simply another way of describing holding interest rates low enough to maintain a stable path for government liabilities), and there is uncontrolled inflation. But the inference the critics draw from this possibility — that fiscal policy must target debt sustainability — is not correct. The correct inference is that at least one of the two instruments must target debt sustainability, and at least one must target full employment. The problem in Figure 7 is that budget balance is being set without regard for either condition — that is, it is in violation of both policy rules. Either the sound finance rule, or the functional finance rule, or any linear combination of the two, would ensure that the economy does not remain at a point like e but instead converges to one like b in Figure 3.

The debate between sound finance and functional finance cannot be resolved as long as they are framed in terms of what kind of rule is feasible in principle, and what outcome results when it is followed exactly. The disagreement is about what kinds of rules policymakers can be expected to adhere to in practice, and about the relative costs of different policy errors.

[This post was inspired by this talk by Brad DeLong, and by some comments by Nick Rowe which I cannot locate now.]

The Puzzle of Profits

Part II of Capital begins with a puzzle: In markets, commodities are supposed to trade only for other commodities of equal value, yet somehow capitalists end up with more value than they start with.

In the world of simple exchange, money is just a convenience for enabling the exchange of commodities: C-M-C is easier to arrange than C-C. But profit-making business is different: the sequence there is M-C-M’. The capitalist enters the market and buys some commodities for a certain sum of money. Later, he sells some commodities, and has a larger sum of money. This increase — from M to M’ — is the whole point of being capitalist. But in a world of free market exchange, how can it exist?

Let’s put some obvious misunderstandings out of the way. There’s nothing mysterious about the fact that people can accomplish things with tools and previously acquired materials that they would be unable to with unaided labor. The problem is not that “capital,” in the sense of a stock of tools and materials, is productive in this sense. To the extent that what appears as “profit” in the national accounts is just the cost of replacing worn-out tools and materials, there’s no puzzle. [1]

The mystery is, how can someone enter the market with money and, after some series of exchanges, exit with more money? In the sequence M-C-M’, how can M’ be greater than M? How can the mere possession of money seemingly allow one to acquire more money, seemingly without end?

Before trying to understand Marx’s answer, let’s consider how non-Marxist economists answer this question.

1. Truck and barter. The most popular answer, among both classical and modern economists, is that the M-C-M’ sequence does not exist. All economic activity is aimed at consumption, market exchange is only intended to acquire specific use-values; when you think you see M-C-M you’re really looking at part of some C-M-C sequence(s). The classical economists are full of blunt statements that the only possible end of exchange is consumption. In today’s economics we find this assumption in the form of the “transversality condition” that says that wealth must go to zero as time goes to infinity. That’s right, it is an axiom in modern economics that accumulation cannot be a goal in itself. Or in the words of Simon Wren-Lewis (my new go-to source for the unexamined conventional wisdom of economists): “It would be stupid to accumulate infinite wealth.” Well OK then!

2. You earned it. Another answer is that the capitalist brings some additional unmeasured commodity to the production process. They are providing not just money M but also management ability, risk-bearing capacity, etc. In this view, if we correctly measured inputs, we would find that  M’=M. In its most blatantly apologetic form this is effectively skewered by comrades Ackerman and Beggs in the current Jacobin. For unincorporated businesses, it is true, it is not straightforward to distinguish between profits proper and the wages of managerial labor, but that can’t account for profits in general, or for the skewed distribution of income across households. If anything, much of what is reported as managerial salaries should probably be called profits. This is a point made in different ways by Piketty and Saez  and Dumenil and Levy; you can also find it offered as straightforward business advice.

3. It was the pictures that got small. The other main classical answer is that profit is the reward for “abstinence” (Senior) or “waiting” (Cassel). (I guess this is also the theory of Bohm-Bawerk and the other Austrians, but I admit I don’t know much about that stuff.) It appears today as a discount rate on future consumption. This invites the same question as the first answer: Is capitalist accumulation really motivated by future consumption? It also invites a second question: In what sense is a good tomorrow less valuable than the same good today? Is the utility derived from a glass of wine in 2013 really less than the utility derived from the same glass consumed in 2012,or 2010, or 1995? (So far this has not been my experience.) The logically consistent answer, if you want to defend profit as the return to waiting, is to say Yes. The capital owner’s pure time preference then represents an objective inferiority of output at a later date compared with the same output at an earlier date.

This is a logically consistent answer to the profits puzzle, and it could even be true with the right assumptions about the probability of an extinction-event asteroid impact/Khmer Rouge takeover/zombie apocalypse. With a sufficiently high estimate of the probability of some such contingency, M’ is really equal to M when discounted appropriately; capitalists aren’t really gaining anything when you take into account their odds of being eaten by zombies and/or suffocated by plastic bag, before they get to enjoy their profits. [2]  But I don’t think anyone wants to really own this point of view — to hold it consistently you must believe that economic activity becomes objectively less able to satisfy human needs as time goes by. [3]

4. Oops, underpaid again. We can take the same “profit as reward for waiting” idea, but instead of seeing a pure time preference as consistent with rational behavior, as modern economists (somehow) do, instead interpret it like the classical economists (including Cassel, whose fascinating Nature and Necessity of Interest I just read), as a psychological or sociological phenomenon. Consumption in the future is objectively identical to the same consumption today, but people for some reason fail to assign it the same subjective value it the same. Either they suffer from a lack of “telescopic facility,” or, in Cassel’s (and Leijonhufvud’s) more sophisticated formulation, the discount rate is a reflection of the human life expectancy: People are not motivated to provide for their descendants beyond their children, and future generations are not around to bargain for themselves. Either way, the outcome is that exchange does not happen at value — production is systematically organized around a higher valuation of goods today than goods tomorrow, even though their actual capacity to provide for satisfaction of human needs is the same. Which implies that workers — who provide labor today for a good tomorrow — are systematically underpaid.

5. Property is theft. The last and simplest possibility is that profits are always just rents. Capitalists and workers start out as just “agents” with their respective “endowments.” By whatever accident of circumstances, the former just end up underpaying the latter. Maybe they are better informed.

We could develop all these points further — and will, I hope, in the future. But I want to move on to (my idea of) Marx’s answer to the puzzle.

One other thing to clear up first: profit versus interest. Both refer to money tomorrow you receive by virtue of possessing money today. The difference is that in the case of profit, you must purchase and sell commodities in between. What is the relationship between these two forms of income? For someone like Cassel, interest has priority; profit is a derived form combining interest with income from managerial skill and/or a rent. For Marx on the other hand, and also for Smith, Ricardo, etc., profit is the primitive and interest is the derived form; interest is redistribution of profits already earned in production. (Smith: “The interest of money is always a derivative revenue, which, if it is not paid from the profit which is made by the use of the money, must be paid from some other source of revenue.”) In other words, are profits an addition to interest, or is interest as a subtraction from profit? For Marx, the latter. The fundamental question is how money profits can arise through exchange of commodities. [4]

Marx gives his answer in chapter four: The capitalist purchases labor-power at its value, but gets the results of the labor expended by that labor-power. The latter exceeds the former. In other words, people are capable of producing more than it takes to reproduce themselves, and that increment is captured by the capitalist. In four hours, you can produce what you need to live on. The next four or six or eight or twelve hours, you are working for The Man.

This is the answer, as Marx gives it. Labor power is paid for at its value. But having purchased labor power, the capitalist now has access to living labor, which can produce more than the the cost of its own reproduction.

I think this is right. But it’s not really a satisfactory answer, is it? It’s formally correct. But what does it mean?

One way of fleshing it out is to ask: Why is it even possible that labor can produce more than the reproduction-costs of labor power? Think of Ricardo’s world. Profits are positive because we have not yet reached the steady state — there are still natural resources available whose more intensive use will yield a surplus beyond the cost of the labor and capital required to use them. The capitalist captures that surplus because capital has the short side of both markets — there is currently excess land going unutilized, and excess labor going unutilized. [5]

Another way: There is something in the production process other than exchange, but which is captured via exchange.

I want to think of it this way: Humanity does have the ability to increase social value of output, or in other words the aggregate capacity to satisfy human needs from nature does in general grow over time. This “growth” happens through our collective creative interchange with nature — it is about pushing into the unknown, a process of discovery — it is not captured beforehand in the market values of commodities.

In a proper market, you cannot exchange a good in your possession for a good with a greater value, that is, with a greater capacity to satisfy human needs in general. (Your own particular needs, yes.) But you can, through creative activity, through a development of your own potential, increase the general level of satisfaction of human needs. The capitalist by buying labor power at its value, is able to capture this creative increment and call it their private property.

Our potential is realized through a creative interchange with nature. It’s not known in advance. What can we do, what can’t we do — we only learn by trying. We push against the world, and discover how the world pushes back, in so doing understand it better and find how it can be reshaped to better suit our needs. Individually or collectively, it’s a process of active discovery.

You as a person can exchange the various things you are in possession of, including your labor power, for other things of equal value. (Though for different use values, which are more desired by you.) But you will also discover, through a process of active learning and struggle, what you are capable of, what are the limits of your powers, what creative work you can do that you cannot fully conceive of now.

Through the process of education, you don’t just acquire something that you understood clearly at the outset. You transform yourself and learn things you didn’t even know you didn’t know. When you do creative work you don’t know what the finished product will be until you’ve finished it. I still — and I hope for the rest of my life — find myself reading economics and having those aha moments where you say, “oh that’s what this debate is all about, I never got it before!” And science and technology above all involve the discovery of new possibilities through a process of active pushing against the limits of our knowledge of the world.

The results of these active process of self-development and exploration form use-values, but they are not commodities. They were not produced for exchange. They were not even known of before they came into being. But while they are not themselves commodities, they are attached to commodities, they cannot be realized except through existing commodities. I may produce in myself, through this process of self-testing, a capacity for musical performance, let’s say. But I cannot realize this capacity without, at least, a sufficient claim on my own time, and probably also concrete use-values in the form of an instrument, an appropriate performance space, etc., and also some claim on the time of others. In this case one can imagine acquiring these things individually, but many — increasingly over time — processes of self-discovery are inherently collective. Science and technology especially. So specifically a discovery that allows cheaper production of an existing commodity, or the creation of a new commodity with new use-values, can only become become concrete in the hands of those who control the process of production of commodities. By purchasing labor power — in the market, at its value — capitalists gain control of the production process. They are thus able to claim the fruits of humanity’s collective self-discovery and interchange with nature as their own private property.

In some cases, this is quite literal. Recall Smith’s argument that one of the great advantages of the division of labor is that it allows specialized workers to discover improved ways of carrying out their tasks. “A great part of the machines made use of in those manufactures in which labour is most subdivided, were originally the inventions of common workmen, who, being each of them employed in some very simple operation, naturally turned their thoughts towards finding out easier and readier methods of performing it.” Who do you think gained the surplus from these inventions? This still happens. Read any good account of work under capitalism, like Barbara Garson’s classic books All the Livelong Day and The Electronic Sweatshop. You’ll find people actively struggling to do their jobs better — the customer service representative who wants to get the caller to the person who can actually solve their problem, the bookshelf installer who wants it to fit in the room just right. The results of these struggles are realized as profits for their employers. But these are exceptional. The normal case today is the large-scale collective process of discovery, which is then privately appropriated. Every new technology draws on a vast history of publicly-available scientific work — sometimes we see this directly as with biomedical research, but even when it’s not so obvious it’s still there. Every Hollywood movie draws on a vast collective project of storytelling, a general collective effort to imbue certain symbols with meaning. Again see this most directly in the movies that draw on folktales and other public-domain work, but it’s true generically.

It is this vast collective effort at transformation of nature and ourselves that allows the value of output to be greater than the value of what existed before it. Without it, we would eventually reach the classical steady state where the exercise of labor could produce no more than the value of the labor power that yielded it. So when Marx says the source of profits is the fact that labor can produce more than the value of labor power, lying behind this is the fact that, due to humanity’s collective creative efforts, we are continuing to find new ways to shape the world to our use.

Capital is coordination before it is tangible means of production. Initially (logically and historically) the capitalist simply occupies a strategic point in exchange between independent producers thanks to the possession of liquid wealth; but as the extension of the division of labor requires more detailed coordination between the separate producers, the capitalist takes over a more direct role in managing production itself. “That a capitalist should command on the field of production, is now as indispensable as that a general should command on the field of battle.”

There is another way of looking at this: in terms of the extension of cooperation and the division of labor, which is realized in and through capitalist production, but in principle is independent of it. I’ll take this up in a following post.

[1] Marx makes this point clearly in his critique of the Gotha program.  Elimination of surplus as such cannot be a goal of socialism.

[2] It would seem that we have enough evidence to rule out a sufficiently high probability of world-ending catastrophe to explain observed interest rates, assuming the minimum possible return on accumulated wealth is zero. But of course in some conceivable circumstances it could be negative — that’s why I include the Khmer Rouge takeover, where your chance of summary execution is presumably positively related to your accumulated wealth. Also, maybe we have reason to think that  catastrophe is more likely in the future than we would naively infer from the past. It would be funny if someone tried to explain interest rates in terms of the doomsday argument.

[3] There has been a lot of discussion of appropriate social discount rates in the context of climate change. But nobody in that debate, as far as I can tell, takes the logical next step of arguing that excessively high discount rates imply a comprehensive market failure, not just with respect to climate change. There is not a special social discount rate for climate, there is an appropriate social discount rate for all future costs and benefits. If market interest rates are not the right tool for weighing current costs against future benefits for climate, they are not the right guide for anything, including the market activities where they currently govern.

[4] Yes, interest exists independently of profits from production, and indeed is much older. Marx recognizes this. But capitalism is not generalized usury.
[5]  And substitution between factors is impossible — Marx’s “iron law of proportions” — or at least limited.

Cavafy on the Debt Ceiling

What are we waiting for, assembled in the forum?

            The barbarians are due here today.

Why isn’t anything happening in the senate?
Why do the senators sit there without legislating?

            Because the barbarians are coming today.
            What laws can the senators make now?
            Once the barbarians are here, they’ll do the legislating.

Why did our emperor get up so early,
and why is he sitting at the city’s main gate
on his throne, in state, wearing the crown?

            Because the barbarians are coming today
            and the emperor is waiting to receive their leader.
            He has even prepared a scroll to give him,
            replete with titles, with imposing names.

Why have our two consuls and praetors come out today
wearing their embroidered, their scarlet togas?
Why have they put on bracelets with so many amethysts,
and rings sparkling with magnificent emeralds?
Why are they carrying elegant canes
beautifully worked in silver and gold?

            Because the barbarians are coming today
            and things like that dazzle the barbarians.

Why don’t our distinguished orators come forward as usual
to make their speeches, say what they have to say?

            Because the barbarians are coming today
            and they’re bored by rhetoric and public speaking.

Why this sudden restlessness, this confusion?
(How serious people’s faces have become.)
Why are the streets and squares emptying so rapidly,
everyone going home so lost in thought?

            Because night has fallen and the barbarians have not come.
            And some who have just returned from the border say
            there are no barbarians any longer.

And now, what’s going to happen to us without barbarians?
They were, those people, a kind of solution. 

Default and the Dollar

Government shutdown, debt ceiling deadline just around the corner. Were you watching this show when it was first on, in the summer of 2011? People were predicting that even the possibility of a technical default (which almost happened), or credit-rating downgrade (which did happen, on Aug. 11) should lead to a sharp rise in US interest rates and a fall in the dollar. Neither of these things took place. There were some interesting discussions why not, which are worth revisiting now.

Here is something I wrote at the time:

How is it possible that a downgrade in federal debt could increase demand for it? One obvious reason is that it could increase the political pressure for austerity, making lower growth more likely, and owners of financial assets might recognize this.
But there’s another explanation, which is the that federal debt is a kind of Giffen good. This Baseline Scenario post makes one version of the argument. Here’s my version. 

Wealthholders choose their portfolio to maximize risk-adjusted return, but subject to a survival constraint such that expected probability of returns at each future time t falling below some floor is subjectively zero (less than epsilon, we can say.) The existence of this kind of floor is one of the central things that distinguishes the Minskyan view of the world. (Minsky would talk here about cashflows rather than returns, but the logic is the same.) 

Now suppose the riskiness of the portfolio increases. Then to keep the distribution of returns from crossing the floor, investors need to shift toward lower-risk assets. This is true even if the increased riskiness of the portfolio came from the lower risk assets themselves. 

Here’s another way of looking at it, more in the spirit of Holmstrom and Tirole. Making a risky/illiquid investment requires holding a greater quantity of money-like assets to ensure a zero (or less than epsilon) probability of the investment pulling you below your survival constraint. In effect, this lowers the return on the investment, since the total return has to be calculated on the cost of the asset itself plus the cushion of money-like assets you need to purchase along with it. If safe assets are less safe, you have to hold more of them to cushion the same risky asset. This means that an increase in the riskiness of safe assets implies a shift in demand toward safe assets and away from risky ones.

I also wrote this, about the appreciation of the dollar following the downgrade:

There was a very interesting piece from the BIS recently about why a fall in the price of US assets may be associated with an appreciation of the dollar. (It’s the McCauley chapter in the linked document.) They argue that many purchasers of dollar assets wanted the asset, not the foreign-exchange risk, so they hedged it by simultaneously selling the dollar forward, or otherwise issuing a dollar liability of equal value to the asset. But this means if the value of the US asset declines, they are overhedged, they now have a short position in the dollar. To get rid of that foreign-exchange risk they have to liquidate the dollar liability, which means buying dollars. 

If this sort of hedging were universal, it would have somewhat counterintuitive implications for the exchange rate. Changes in demand for dollar assets would then have no effect on the value of the dollar. And changes in the dollar value of US assets would induce opposite-signed changes in the value of the dollar. According to the BIS, this kind of hedging is very common among European investors in US assets, but not at all common among US purchasers of foreign assets — for US purchasers, the foreign-exchange risk is part of the asset, not something they want to get rid of.

I don’t see any reason to have a strong prior that hedging the forex risk cannot be common among purchasers of foreign assets. If it is common, this sort of “perverse” movement of exchange rates in response to asset-price changes is not just possible, but predictable. And if the hedging is asymmetric, as the BIS study suggests, then we would expect a global rise in asset prices to lead to a decline in the value of the dollar, and a global fall in asset prices to lead to a rise in the price of the dollar.  

Going a step beyond the BIS study, I think there’s a sociological element here. Actual portfolio choices are very seldom made by the ultimate owners, they’re made by intermediaries who are typically specialists of some kind. Now if, let’s say, European purchasers of US equities are largely made by intermediaries, who specialize in equities (domestic and foreign), then they’re going to want to hedge the forex risk — that’s not what they have the expertise to manage. Whereas if US purchases of European equities are largely made by intermediaries who specialize in European or in general foreign assets (equities and otherwise) then they are not going to want to hedge the forex risk, managing it is part of how they get their returns. And I think this question is going to depend on the specific kinds of financial institutions that have developed historically in each place, you can’t deduce it from any underlying tastes or endowments.  

But in any case I think we have to accept that it’s perfectly possible for a decline in the value of US assets to lead to a rise in the value of the dollar, even if it seems implausible at first glance.