New Book from John Weeks!

My colleague John Weeks has just published a very relevant book laying bare the logical and practical problems with economic policies informed by mainstream economics. Please find a description below:

Economics of the 1%: How mainstream economics serves the rich, obscures reality and distorts policy ($19.99)
John F. Weeks
http://www.anthempress.com/economics-of-the-1-percent

Today’s ‘doctrine of choice’ assures adults that they are competent to make serious personal decisions about healthcare, education and retirement plans. At the same time, most people are convinced that they are so ignorant of economics that they are not capable of holding an informed opinion, and that economic issues must be left to experts. The so-called experts of the mainstream economics profession claim to have profound, inaccessible knowledge; in fact they understand little and obscure almost everything.
Understanding the economy is not simple, but it is no more complicated than understanding the political system sufficiently to cast a vote. In straightforward language, John F. Weeks exposes the myths of mainstream economics and explains why current economic policies fail to serve the vast majority of people in the United States, Europe and elsewhere. He demonstrates that austerity policies have little theoretical basis and achieve nothing but inequality and misery. He goes on to explain how the current deficit and debt ‘crises’ in the United States and Europe are ideologically manufactured, unnecessary and simple to overcome. Drawing on examples from around the world, this book provides a bold alternative to the economics of the 1%. Their failure to serve the interests of the many results from their devoted service to the few.

Piece by Me on Forbes.com

Decided to try to get a bit more publicity for Post Keynesian ideas!

Forbes.com

Nothing I haven’t said here before. It was very lucky in that they were willing to accept a 2400-word article. Even with that, however, the issue is complex and it bothers me that I couldn’t cover everything. Having said that, the majority of questions I have received so far were already answered in the article!

Why It’s Logically Impossible for Social Security to Go Bankrupt

The belief that Social Security may not be there when we retire is one that comes up on a pretty regular basis and the program itself is currently a potential target for cost cutting in an effort to balance the budget (something that is totally unnecessary, but that’s a separate issue addressed in other posts). However, those who think that it could go bankrupt simply do not understand how it works. It’s a logical impossibility and the confusion comes from trying to think of it from a micro (individual) rather than a macro (economy-wide) perspective. Social Security, indeed, retirement in general, is all about productivity.

To understand how this works, imagine the following. Let’s say there has been some sort of M. Night Shyamalan “Happening,” and everyone in the world has been killed but the following individuals (recycled from my debt and deficit example):

Adam
Betsy
Charlie
Danielle
Eva
Fred
George
Hannah
Isaac
John.

Further say that we have set about erecting a society in the post-Happening world, including an economy. We all have various jobs growing food, making clothes, et cetera, and in our primitive stage of development each person makes roughly enough for one person to live. Call the latter a “bundle o’ goods,” such that ten people produce ten bundles o’ goods, allowing ten people to survive.

How many people can retire in this situation? Obviously, zero. If one did, then the remaining nine would be producing only nine bundles o’ goods, which they would presumably keep for themselves. The one retiree would starve.

What if Adam, during an expedition to find canned food at the local Kroger’s, discovered that a Brink’s truck had been in the middle of unloading precisely when the Happening occurred? Can he now retire on the cash he found lying about? Of course not, because as soon as one person quits working, we are down to nine bundles o’ goods. The ultimate limiting factor is productivity, not money. The latter is absolutely irrelevant if we can’t make enough stuff (and it is almost trivial if we can).

Moving from M. Night to the real world, is our productivity sufficient? Right now, it obviously is or we couldn’t do what we are doing (granted we are in the midst of >9% unemployment–so take just four years ago, when it was 4.4%). As for the future, even if productivity rose as slowly as its slowest rate since WWII, we should still have no problem allowing the baby boomers to retire AND having enough goods and services for them and ourselves (at an even higher standard of living). Productivity, barring a natural disaster of some sort, is not an issue, so that bullet is dodged. And, to be honest, it’s the only real economic bullet. The rest is just politics.

Now let’s start raising productivity in the post-Happening world and see what happens once you allow for retirees. Let’s make the math easy and suddenly allow each person to make two bundles o’ goods per year. Now we have some real options. At one extreme, we could have everyone could keep working and just enjoy twice as much stuff. At the other, five of the survivors could retire and those still working would share half of what they produce, leaving them all at the same standard of living as before. In between, we can actually have retirees AND more output/person. This last option is basically what we do in the real world. Nice!

But how do we accomplish that? It’s easy in the post-Happening economy since we all know each other and can just agree to do it. In reality, it’s more complex. Note that there are two things we need to make sure of:

1. Workers don’t simply consume all bundles o’ goods themselves;

2. Retirees get the bundles o’ goods not consumed by workers.

Note that the entire economy cannot “save,” incidentally. This is one of the places where people get micro and macro mixed up. While you can take your $1000 pay check and put $200 in the bank for later, the US doesn’t earn a salary and can’t do that. It produces goods and services (or bundles o’ goods). I suppose it would be possible on some extremely limited basis, but in general we can’t produce 10 TVs in 2011 and put 2 aside for 2030–hell, they probably wouldn’t even work any more. Or build 50 houses, but “save” 5 for later. Or 100 haircuts, but put 20 on the shelf. For all intents and purposes, all goods and services produced today are consumed today, period. The United States of American can’t save.

So, if the ten people make twenty bundles o’ goods, all twenty must be consumed today. We can’t save them. What can be saved, however, is the revenue from producing the bundles, and if workers do that then they can’t buy all the bundles–which is what we are after according to point 1 above. Meanwhile, if the retirees have cash left over from back when they worked, they can use it to buy the bundles the workers didn’t consume–point 2.

Notice that this isn’t going to be neat and tidy since the amount workers choose to save is not necessarily equal to the amount retirees spend from their pension funds. In particular, retirees may find themselves able to buy more or less than they had expected compared to 20-30 years ago when they started saving. This can create some real problems, particularly if the pension had been held in financial assets whose value had collapsed (like, for example, you had the bad luck of retiring in November of 1929!). We then end up with the capacity to support the retirees–because, remember, this is always a function of productivity and we still have 20 bundles o’ goods–but they don’t have the income to buy the output. Ironically, even if the workers still only want to consume half the bundles, it doesn’t matter and retirees are screwed. And what would actually happen is that the macroeconomy would contract since retirees demand for goods and services dropped off. We would see workers becoming unemployed and bundles o’ goods production falling. Not good, and no underlying productivity reason for it.

This is one of the reasons we have Social Security, so this sort of scenario can be avoided. People can argue that they know better than the government how to invest their money, but:

1) no, they don’t–there have been many studies on how consistently even professional investors can beat the market, and the answer is they can’t;

2) in the event of a market collapse, everyone is screwed and we will have to deal with it as we aren’t going to leave the retirees to starve (particularly as it wasn’t their fault);

3) most importantly, it’s not being invested, anyway, it’s being handed over directly to retirees!!!

Social Security is not an investment fund. It is not now and it never was, and I hope it’s becoming clear why that’s true. What would be the point of taking tax dollars from today’s workers and “investing” them? The goal is to lower worker income sufficiently to make sure they can’t buy all the bundles, while transferring income to retirees so they can buy the remainder. And therefore the Social Security tax you pay today is going directly to your parents.

The effect of this (in that it reduces the consumption of current workers and raises that of retirees) is no different from what would happen if it were voluntary, except that it avoids the “oh my God, the stock market crashed and I have no retirement money left!” scenario. And this was, not surprisingly, a real issue back when Social Security was invented (and obviously remains so today). The transformation of American society also played a big role. In the days when agriculture dominated, aged members of the family lived on the farm with their children and grandchildren (and great grandchildren). This represented an informal and widespread social security system. However, as America industrialized, it wasn’t always as convenient or even possible to have grandma and grandpa move into the apartment in Brooklyn with the rest of the family. And so, the elderly became a poverty-stricken segment of society (particularly once the Depression hit). Social Security was intended to solve that by re-instituting an institution that had already existed, but in a formal way and without requiring that your parents move in with you once they get older. Funny, but when I explain it that way in class, I notice that students are very quickly strong supporters of the idea!

To reiterate, what Social Security does is take money from workers today to prevent them from buying as much as giving it to retirees so they can have the remainder. Of course, workers get to play that game, too, once they hit retirement age. And this is no different from a private system, except that it sets guaranteed levels. A financial-market crisis can’t wipe out your savings. And remember, so long as we have the productivity, we can afford it. It’s a question of how many bundles o’ goods we can make, not how much money we have.

At present, we do have money in a fund that we use to supplement the tax dollars we take from workers, but that doesn’t mean the workers are getting to keep more because there are still only twenty bundles o’ goods. The difference is that instead of taxing the income away directly, we give retirees enough money from the fund to bid bundles o’ goods away from workers. But I think you can see how that it’s really irrelevant. If that money ran out entirely, all we have to do is raise taxes to the point that gave us the same effective outcome in terms of bundles o’ goods transferred from workers to retirees. People would, of course, complain, but that’s because they ain’t smart like you! They wouldn’t realize that the outcome is identical and that it doesn’t matter how we finance Social Security. So long as we have the requisite productivity, we could create new money or tax to put ourselves in the position we want and only our own stupidity could stop us. America doesn’t need to save for Social Security because America can’t save anyway.

Economic Disaster Looming (and it’s my birthday)

Today is my 50th birthday (meaning I was born on the day JFK was inaugurated). It’s been very nice so far, with lots ad lots of kind wishes from friends and relatives, and I was really looking forward to enjoying myself today. Then I read this:

House GOP Lists $2.5 Trillion in Spending Cuts

The first sentence reads, “Moving aggressively to make good on election promises to slash the federal budget, the House GOP today unveiled an eye-popping plan to eliminate $2.5 trillion in spending over the next 10 years.” Absolutely terrifying. I haven’t felt this depressed and hopeless since Sept 11.

If anything close to this really happens, we can say goodbye to economic recovery any time in the foreseeable future. I’d go into details as to why that is true, but a) that’s the subject of the previous two posts (plus several before that) and b) it’s my birthday. Suffice it to say that the people in charge in our country fundamentally misunderstand how the economy actually works. They are more interested, anyway, in name-calling and political one-upmanship.

Debt and Deficit in a Nutshell: The Video!

My friend, Tschäff Reisberg, made a flash video of my blog post on the debt and the deficit and posted it to You Tube:

http://www.youtube.com/watch?v=Ei_B5MTJofI

Thanks, Tschäff! Very nicely done!

World’s Simplest Explanation of the Debt and the Deficit

(and why cutting spending right now would be an unmitigated disaster)

There may be no single economic concept that is more poorly understood by the lay public and most politicians (both varieties) than the federal government’s budget. I suspect that some of that is willful ignorance with an ulterior motive, but the vast majority is simply and solely because it has never been explained to them. They assume it’s like their personal or business budget. It’s not. It’s fundamentally different and lessons drawn from one cannot necessarily be applied to the other. I’ll try to make this as short as possible but, dammit, it’s sort of complicated! You can’t truly understand it, however, without this background–and you need to understand it.

UNDERLYING ECONOMIC PROBLEM

First off, you’ll need a basic understanding of the operation of the macroeconomy as a whole. Think of it this way. Say that there are eleven people in our economy playing the following roles:

1. Adam: worker
2. Betsy: worker
3. Charlie: worker
4. Danielle: worker
5. Eva: worker
6. Fred: worker
7. George: worker
8. Hannah: worker
9. Isaac: worker
10. John: worker
11. Kate: entrepreneur

There is no government and no foreign sector. Kate is the only potential employer in this world, and she has a factory that makes all the goods and services that everyone else demands. Kate’s factory can produce sufficient output for all ten workers (for simplicity I’ll ignore the fact that Kate needs to consume, too), but by employing only eight of them. Kate is not a charity–she has a family to feed, as well–so she won’t hire all ten just to be nice. She only needs Adam through Hannah to make goods and services for Adam through John, and therefore that’s all she’ll hire. But wait, that’s not quite right, is it? Because if Isaac and John don’t have job (recall that Kate is the only employer), then there is no point is making goods they can’t afford to purchase. Hence, Kate doesn’t even hire eight people. For sake of argument, let’s say that rolling back production to seven people creates an equilibrium in which Kate can hire Adam through George and they only create output for Adam through George.

Now we have the following:

1. Adam: working for Kate
2. Betsy: working for Kate
3. Charlie: working for Kate
4. Danielle: working for Kate
5. Eva: working for Kate
6. Fred: working for Kate
7. George: working for Kate
8. Hannah: unemployed
9. Isaac: unemployed
10. John: unemployed
11. Kate: earning profits associated with sales to seven workers

In the smallest nutshell possible, this is how the macroeconomy works. It is absolutely vital to understand this in thinking about the federal (though not state and local–they DO operate like your personal budget) government budgets.

Put in the front of your mind a fundamental fact about the above situation: we have the physical capacity to produce output for Hannah, Isaac, and John, but because we can do so relatively easily (i.e., without their help), they have to go without. Not only is this a really crappy deal for Hannah, Isaac, and John, but Adam through George are probably somehow supporting them (officially or unofficially) and Kate would love to be earning the extra profits associated with sales to those three. EVERYONE is made worse off by this situation. The underlying problem is that as productivity increases, so it becomes more and more difficult for the profit motive alone to generate full employment in a macroeconomy.

But note how incredibly easy this is to solve in a way that raises everyone’s welfare:

1. Adam: working for Kate
2. Betsy: working for Kate
3. Charlie: working for Kate
4. Danielle: working for Kate
5. Eva: working for Kate
6. Fred: working for Kate
7. George: working for Kate
8. Hannah: working for Kate
9. Isaac: soldier (government job)
10. John: police officer (government job)
11. Kate: earning profits associated with sales to ten workers

Let’s create a government sector and have them make Isaac a soldier and John a police officer. They are each paid a salary sufficient to buy what Kate is selling, and this leads Kate to hire Hannah (since she now needs to produce more output) and everyone is happy: Adam through George don’t have to support three unemployed people, Hannah, Isaac, and John can now share in the output that could already be produced for them, and Kate earns higher profits. In addition, not only did Adam through George have to give up absolutely nothing in terms of what they had been buying from Kate, but they how have protection from domestic and international aggression. EVERYONE is better off.

This is the essential role of the federal government in a mature capitalist economy. Without the government supplementing demand, the system breaks down and despite our ability to produce goods and services for everyone, we don’t. There will also be cyclical highs and lows (we are experiencing the latter at the moment, in case you had not noticed!), but in general we face the problems outlined above and this is something the private sector cannot solve on its own.

FINANCING GOVERNMENT SPENDING

Whence comes the money the government uses to pay Isaac and John?

Option 1: Taxes

They could tax those originally working (Adam through George), but then that means they won’t be able to buy the same volume of Kate’s products as they were before. There is no logical reason that Adam through George should have to settle for less, so that’s not a good idea. All we would be doing is changing who had the income generated in the macroeconomy (i.e., taking it from Adam through George and giving it to Isaac and John–recall that Hannah’s salary is created by private sector sales to Isaac and John). We need MORE income, not a redistribution. Again, there is zero reason why Adam through George need give anything up.

Option 2: Borrowing

The government could borrow money from those originally working (Adam through George) and use that to pay Isaac and John (Hannah gets paid from private-sector profits arising from sales of Kate’s products to Isaac and John). This assumes that Adam through George are earning enough to both buy from Kate and save some money, but if so, then this might be a useful thing to do. It would probably give Adam through George a relatively low rate of return, but a very safe investment. In fact, when they first introduced US government t-bills (during WWI), they were TOO popular!

However, our goal is not to give Adam through George an attractive means of saving, but to create jobs for Isaac and John (directly) and Hannah (indirectly). In addition, there is absolutely no reason to expect that the volume the government could borrow would equal what they need to pay the salaries of Isaac and John. It depends entirely on how much savings currently exist. Furthermore, people are least likely to be willing to tie up savings in such instruments precisely when we would be most in need of selling them: during recessions. And they would have less income to save, too. Furthermore, we don’t want people to become fixated on the idea that if the government borrowed, this means they have to pay it all back. Of course, each individual debt must be honored, but a) it need never be reduced to zero and b) so long as the debt is owed in dollars (as it is) then we can never go bankrupt. In fact, one of my colleagues actually has a page where he has promised $100 million to pay down the debt if anyone can prove that the US can go bankrupt:

http://moslereconomics.com/2010/10/22/press-release-3/

That’s a safe bet for him. It can’t happen.

Option 3: Printing Money

But, frankly, the most obvious and straightforward thing to do is this: print the money to pay their salaries. People typically react to this with shock, crying out, “But that will cause inflation!” No it doesn’t (for a more in-depth treatment, read my posts on inflation below).

The short story on inflation is this: printing more money can be inflation if no more goods and services are produced (but even then it doesn’t have to–see below). But remember that the whole point of raising the money supply here is to raise the volume of goods and services produced. We pay Isaac and John enough to make the production of goods from Kate’s factory profitable to her (and so that she hires Hannah, too). Hence, the level of output rises just as much as the volume of the money supply, and there is no inflation. Contrast that with the situation in a small, developing nation. Perhaps our productive capacity is such that we simply can’t produce enough for all ten workers, only Adam through George. In that case, giving jobs to Isaac and John just causes inflation–more money, but no more goods than before. That’s not the case in the US, however.

Technically, we cannot choose to simply print money to fund government spending in the US–but, de facto, we can if we use Option 2, and the Federal Reserve buys the debt (they are already the #1 single owner of federal government debt). Since they will pay with brand new dollar bills, the new spending is created with new cash. This creates new demand without draining it from somewhere else in the macroeconomy or creating the illusion of a burden on future generations (actually, the illusion might still be there, but I suspect that people are less worried about us owing the Fed money than the Chinese!).

CONCLUSIONS

I am horribly, horribly tempted to write more (in fact, I did, but I’m cutting it), but I really wanted to make this as short as possible while getting the main point across. So, I’ll stop here. My main points are these:

1) It is critical that the government generate demand in the macroeconomy if we are to reach full employment–and it doesn’t cost anyone anything for them to do so since we are starting at less-than-full capacity. If we don’t do this, then we are–I don’t know how else to say it–royally screwed. THIS is the key problem.

2) In a technical sense, we don’t need to “finance” any of the spending. In other words, it’s not necessary for us to find someone with extra cash to loan us. We can simply print it (or have the Fed buy the debt), and in fact that makes the most sense since our goal is to expand demand, not rearrange it.

3) Since the debt is issued in our own currency (Greek debt was not, incidentally), we cannot possibly go bankrupt. That concept does not make sense in this context.

A private budget is fundamentally different from the federal one. Going into debt with the former represents an attempt to purchase something we could not otherwise afford. The goal of going into debt at the federal level represents jump-starting what we could have already done in the first place if, ironically, productivity had been lower and Kate had needed all ten workers.

Unfortunately, we all have a gut feeling that debt is bad and surplus is good, but that’s because we are transferring logic from our own personal lives to the federal government. It simply doesn’t apply (it is, as Paul Samuelson once said, a myth that is useful only insofar as it imposes a cost on government officials who might have a little too much fun spending money). Furthermore, if we not only do not spend more money right now, but begin to cut back, then we are doomed to a Japan-like, decade-long period of recession. To be honest, I think that’s where we are headed. Not only do the Republicans, now in greater power than before, believe that is what we need to do, but Obama only disagrees with them in degree, not in principle. Remember how the Great Depression ended? The massive government spending from WWII. Only under such circumstances were we able to make people forget about what they think of as “fiscal responsibility” and focus instead on (inadvertently, of course) economic responsibility.

I have a funny feeling the Japanese aren’t going to save us this time.

P.S. We owe China so much money because of the trade deficit, not the budget deficit. See the discussions of the debt and deficit below.

Nice Post by Thomas Palley on Econ Policy

You can find the original here:

http://blogs.ft.com/economistsforum/2010/09/plan-b-for-obama-on-the-economy/#more-11616

Not sure what the first commenter on that page is talking about. This is hardly from the same school of thought that brought us the crisis.

Plan B for Obama on the economy
September 6, 2010 4:54pm
By Thomas I. Palley

TO: President Obama
FROM: Thomas I. Palley
RE: How to avoid stagnation and restore shared prosperity
DATE: Labor Day, 2010

Mr President,

With hopes of a V- or U-shaped recovery fading, there is the increasing prospect of an L-shaped future of long stagnation, or even a W-shaped future in which W stands for something worse.

The reason for this dismal outlook is economic policy is trapped by failed conventional thinking that can only deliver wage stagnation and prolonged mass unemployment.

Your administration’s current economic recovery programme has been marked by four major failings:

1. Inadequate fiscal stimulus.
2. Failure to cauterise the housing market
3. Failure to neutralise the trade deficit
4. Failure to restore the link between wage and productivity growth

If your policy team remedies these four failings our economy will quickly begin robust recovery. However, the longer you wait the greater the challenge, because recession creates new facts in the form of bankruptcies, foreclosures, destroyed credit histories, job losses and factory closures.

Suggested remedies:

1. Let the Bush administration tax cuts expire and use the savings for additional targeted stimulus

The economy needs a further demand boost to establish recovery momentum. The majority of the Bush tax cuts were an income redistribution program favoring the wealthy rather than a stimulus or growth program. That makes extending them bad policy.

The Bush 10 per cent bracket and marriage provisions should be retained, while everything else should be allowed to expire with the savings used to fund new temporary fiscal stimulus.

Half the funds should be directed to state and local governments to help avoid another round of job losses, this time in state and local government. The other half should fund an immediate lump sum non-taxable payment to all individuals earning less than $50,000 ($100,000 for married couples). This means 80 per cent of households will continue benefiting and the total paid to these households will actually increase.

Moreover, the lump-sum design will increase the benefit going to those at the bottom, which will further stimulate demand and also lower income inequality. This temporary stimulus should be repealed once self-sustaining recovery is underway.

2. Cauterise the housing market

The second critical measure is to cauterise the housing market. Throughout the crisis, policy has disproportionately benefited banks and corporations. It has largely failed to help households directly and has instead relied on hopes of trickle-down effects from banks, combined with expensive tax subsidies to attract new home buyers.

The failure to directly help households has been a grievous policy error. Along with banks and corporations, households have needed debt relief but this has not been forthcoming. Banks have resisted meaningful loan modifications, while many households have been unable to refinance mortgages at lower interest rates because of zero or negative home equity. Consequently, the household sector has remained distressed and trapped in a foreclosure tsunami that has traumatised the economy.

Policy must immediately put a floor under existing homeowners. The solution is to use the Federal Housing Administration to refinance Fannie Mae and Freddie Mac mortgages with low or even negative equity and then have Fannie and Freddie repay some of their federal government borrowings. The test criteria should be whether the mortgage is viable once refinanced at low rates.

Additionally, the Federal Reserve must continue with purchases of mortgage-backed securities to ensure that mortgage rates stay low until the housing market has stabilised.

Refinancing such mortgages will yield a huge boost to the distressed corner of the household sector that is currently unable to refinance. It would reduce foreclosures; boost consumer demand by lowering mortgage payments; and it is urgent because adjustable rate mortgages issued late in the bubble are still resetting upward.

The problem has always been inability to service interest costs, and the foreclosure wave could have been avoided if lower interest servicing had been made immediately available to households. Policy did this for the business sector via the TARP and various Federal Reserve rescue facilities but failed to do so for households.

3. Neutralise the trade deficit

The third critical measure is to neutralise the trade deficit. The adverse effects of the trade deficit can be understood through the metaphor of a bathtub. Fiscal and monetary stimulus is being poured into the tub but that demand is leaking out through the plughole of the trade deficit. Moreover, it is not just demand that leaks out, but also jobs and investment due to off-shoring.

The trade deficit and off-shoring are significantly attributable to China’s under-valued exchange rate, which also forces other countries to under-value their exchange rates to stay competitive. This has resulted in an over-valued dollar which makes the US economy internationally uncompetitive.

As China refuses to correct its under-valued exchange rate, it is long past time for the US to take protective action. That can be done via administrative interventions and legislation to make countries with under-valued exchange rates subject to countervailing duties.

There may be trade disruption and retaliation, but the costs of inaction and appeasement are far worse. The problem of under-valued exchange rates was visible a decade ago yet policymakers have failed to take action with devastating consequences.

The choice has always been pay now or pay more later. Inaction means working families have already paid enormously and continued inaction will compound their devastation.

4. Restore the wage – productivity growth link

Finally, policy must address the central problem of the last 30 years: the destruction of the income generating process and severing of the wage – productivity growth link.

Rebuilding that link is critical to recovery and shared prosperity, and it requires rebuilding worker bargaining power. One immediate measure is passage of the Employee Free Choice Act that will enable unions to organise on a level playing field.

A second measure is to index the minimum wage to the median wage. That will create a real wage floor and limit wage inequality because the minimum wage will automatically increase as median wages rise with productivity.

5. Do it all

It is important these measures are enacted as a comprehensive package. Implemented alone they will be far less successful.

Without tackling the trade deficit, fiscal stimulus and the benefits from cauterising the housing market will leak out of the economy. Similarly, increasing union membership and wages will result in an acceleration of job and investment off-shoring.

Fixing the trade deficit without fixing the income generation process and lightening households’ debt burden will leave the economy permanently short of demand.

Escaping the Great Recession requires jumpstarting the economy by increasing demand. Preventing the economy falling back into stagnation requires rebuilding the income and demand generating process. That is why success needs the full policy package.

Thomas Palley is a Schwartz Economic Growth Fellow at the New America Foundation

Great Cartoon..

…although I’m not sure there shouldn’t be a couple of donkeys offering the same advice as the elephant.

It would also be more realistic if the lions were kittens. Apparently, the cartoonist had not read my posts on the debt and the deficit!

Inflation: What Really Causes It and What We Truly Have to Fear

I’ve been putting off doing this one, in no small part because we don’t have a problem with inflation at the moment. However, since a) people are starting to talk about it as a possible consequence of the debt/deficit and b) it is the only economic concept that I think is even less properly understood than the aforementioned debt and deficit, I thought I’d type something up. It’s actually not all that terribly complicated but is misunderstood for the same reason the budget deficit is: people try to think of what is going on in micro terms (the individual household) rather than macro terms (the whole country). That’s understandable since these people aren’t professional economists and you naturally use what you know as your reference point. What is extremely difficult to understand is why so many of my colleagues are also in the dark on this issue. And what’s downright dangerous is the fact that so is the Federal Reserve.

What are the causes and costs of inflation?

Let’s start with just thinking about the household since that will be familiar. Say you have a family, the Microns, whose annual income is $50,000 and the average price of whatever it is they purchase is $5. In that case, they can buy 10,000 “things” every year: 10,000 x $5 = $50,000. In economics, we would call the $50,000 the Microns nominal income and the 10,000 their real income: on the paycheck it says they earn $50,000, but what the really earn is 10,000. And now, to make the math simple, assume inflation of 100% such that by next year, the price of the average thing rises to $10. Now the Microns can only buy 5000 things. Their nominal income is still $50,000, but real income has fallen to 5000. That’s inflation and by this story the cost is obvious and it appears that inflation is unequivocally bad. The only problem is, it’s wrong. To understand why, you have to take a macro view.

Think about this for a moment: if the Microns were paying twice as much for each thing they purchased, where did that money go? Into a sinkhole in Florida? Of course not, it went to another family (or business–but then that ultimately goes to a family, too). This is because the prices the Microns pay represent the income another economic entity is earning. This is the true impact of inflation: it is always and everywhere a redistribution of income. If the microns real income has halved, someone’s (or some combination of people’s) has doubled. Rising prices mean, for others, rising incomes. It is mathematically and logically impossible for it to be otherwise since when you pay more, someone gets more–there is someone standing on the other side of that cash register If you pay more, someone gets more. If you pay more, someone gets more. If you pay more, someone gets more. I’m saying this over and over because it is so poorly understood, even in economic theory, and to understand what follows you need to keep it in the front of your mind. Rising prices = rising incomes.

In fact, if all prices rose by 10% at the very same time as all incomes rose by 10%, it would be inconvenient but would otherwise have absolutely no impact on people’s real incomes. But, of course, that never happens because the inflation has to start somewhere and some prices are affected more than others. Just think about the 1970s and the early 1980s as the classic example. This was a period of terrible inflation. Look at the numbers below (I left a bit of the 1960s in for reference):

US Inflation
1968 4.2%
1969 5.4%
1970 5.9%
1971 4.2%
1972 3.3%
1973 6.3%
1974 11.0%
1975 9.1%
1976 5.8%
1977 6.5%
1978 7.6%
1979 11.3%
1980 13.5%
1981 10.4%

These were unprecedented numbers and you keep having to remind yourself that the increases compounded–the relatively moderate 5.8% in 1976 was on top of 9.1% the year before that, which was on top of the 11% the year before that, and so on. And this inflation was a worldwide phenomenon. People across the globe were paying higher prices for the goods and services they purchased. Of course, these increases were not uniform and the prices of some goods and services may have fallen. But, on average, there was a large increase.

Did everyone’s standard of living across the globe decline? You are probably already way ahead of me on this one and you know that the answer is clearly and emphatically “no.” Some folks were much better off, because even though the prices they were paying had risen, their incomes had risen far more. That’s because the amount of money they earned was a direct function of those prices that had risen most: those for oil. For the oil industry and oil exporting countries, this was a magnificent period. Their incomes were rising at the expense of those not in the oil industry. Income was being redistributed to them, and that’s how inflation works. Prices start rising in one sector, pulling extra income towards it. The sets into motion a chain reaction, raising some, but not all, other prices. The inflation we report in the news is just the average: the winners saw the prices of what they sell go up by more than the average, while the losers saw their prices rise by less (or even fall). It’s always this way (though it’s easiest to see in the 1970s because the source of the inflation is so obvious).

Not that this is necessarily a bad thing. Think for a moment about the reasons a price can rise. Maybe demand has increased. Why shouldn’t you make more money for selling something people want? Good for you, that’s what capitalism is supposed to be all about. The rising prices enrich you, they encourage others to sell whatever it is you are making, and it causes consumers to look for substitutes: all of these are useful reactions in terms of how the free market is supposed to work. This is, incidentally, what economists call demand-pull inflation (because demand pulls prices up). Hence, if the huge jump in oil prices in the 1970s was simply because driving your car became much more popular, then so be it.

But there are other reasons the price could rise, which generally fall under the category of cost-push inflation. In these cases, basic costs of production cause a rise in the price. I remember reading in an economics textbook of the example of anchovy fishing off the coast of Portugal. Apparently, anchovies are not juts for pizza. They are also a major part of cattle feed. One year, for some reason the anchovies didn’t show up in their usual places and so the harvest was very light. Since there had not been a chance in the demand for the tiny, salty fish, this caused a rise in price. It cost cattle-feed manufacturers more to produce cattle feed, meaning that ranchers had to pay more, too, and on down the line. The fact that the anchovies didn’t show up caused inflation, which affected the incomes of those involved. Who won or lost in this case gets more complicated than in the above scenario as it will depend on various elasticities and other parameters, but clearly standards of living are affected. Again, however, this is what the market is supposed to do. If the supply of a resource changes, prices need to change to create the appropriate incentives (to find new sources, develop alternatives, etc.). This is something that happens in an otherwise healthy capitalist economy–and it’s not what happened in the 1970s. The rising prices were not a result of us running out of oil.

There is a second kind of cost-push inflation, however, one that is a function of market power. Market power is the ability to avoid competition (for an extended discussion, see my posts on the health care industry: http://tinyurl.com/264j4lq). This is a bad thing. The problem is that business people are greedy. As the father of capitalism, Adam Smith, wrote:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

Dirty bastards! Many people think of capitalism as a pro-business system, but it’s quite the opposite. Set up properly, it leaves business as powerless, at the mercy of the folks that Adam Smith really wanted to see in charge: the consumers (again, there is a much more detailed discussion of this under health care reform in this blog).

Of course, businesses, consistent with Adam Smith’s characterization, do what they can to avoid this. It is obviously a lot more fun to be a monopoly than to be in competition, and they will do what they can to get as close to their ideal as possible. It is the job of government policy makers and economists to make this difficult (hence the existence of anti-trust laws, for example). It’s a never-ending battle, and you win some and you lose some (part of that battle is businesses and their lobbyists arguing to the general public and politicians that capitalism is about making life easier for businesses–ha, now you know better!).

Again, you are probably ahead of me on this: those businesses successful in gaining market power for themselves can raise prices, and this causes inflation and a redistribution of income towards those with the market power. However, unlike the other two cases above, there is not underlying good here. It serves no greater economic purpose to have those who have avoided competition get more of your money. If someone gets rich by facing competition and winning, good for them. They must have been selling something other people wanted when they had a choice. But, that’s not the case here, and it’s not just firms who can have market power. So can workers and, in some cases, countries. And now we are finally to an explanation of the 1970s.

Four letters: OPEC, or Organization of the Petroleum Exporting Countries. It’s a long (but fascinating, in no small part because my first love is military history) story as to how they came to decide to exercise their power at the close of 1973. In short, they, being primarily Arab nations, were very upset with US support of Israel in the 1973 Arab-Israeli War (which the latter came perilously close to losing). This gave them the focus to agree on how they would go about raising prices by voluntarily reducing supply. You can have a glance at the results here:

http://www.eia.doe.gov/aer/txt/ptb1107.html

Saudi crude oil jumped from $2.10 in 1973 to $9.60 in 1974. By 1982, it was $34. This was not demand-pull and it was not the kind of cost-push related to acts of God (like anchovies not showing up or hurricanes destroying resources). It was market power, pure and simple, and it was a massive redistribution of income to OPEC countries and oil companies. It served no useful purpose (unless your goal was to see the West punished for helping Israel–it certainly did that).

These are the three kinds of inflation. I’ll call them demand-pull, cost-push/act of God, and cost-push/market power. All three redistribute income, but the first two do so on a basis that makes economic sense. They enrich those who should be enriched and thereby create signals for entrepreneurs and consumers regarding what should happen next. If the prices of lumber go up because there has been a massive boom in housing, then the fact that lumber manufacturers get more money acts as a signal to others to enter that industry (which is what consumers want) and it is an incentive to builders to find a substitute for lumber. If the prices rise because a forest fire burned down our trees, it still makes sense for lumber prices to increase. That’s the appropriate signal to the market. Only inflation created by market power is clearly harmful. We should stop it. But how? What policies are available to us?

Policies to prevent inflation

The obvious way to stop demand-pull inflation is to lower demand. The government could, because there is a housing boom leading to bottlenecks in the building industry, throw the entire macroeconomy into recession. That makes little sense, however, because demand-pull inflation sends appropriate signals and redistributes income on a logical basis. And, anyway, it’s hard enough to get the economy in expansion without causing recessions on purpose. What moron would do that!? (HINT: The Federal Reserve. More on this in a moment.)

With cost-push/acts of God, there is little that can be done (prayer?) directly and, besides, the price changes make sense. The government could act to make any transition easier, but if there ain’t no anchovies, there ain’t no anchovies.

Cost-push/market power is bad, about that there is no question. Unfortunately, while solving it in theory is very easy (get rid of the market power!), doing so in practice is messy. You have to directly address the problem, meaning that you’ll have to fight some business, labor group, country, or set of countries that really, really like having market power. If it’s one of the first two, they’ll line up their lawyers and economists and fight it out with the government’s. Who wins is an open question. Not that I am suggesting that we shouldn’t do this–we absolutely should, the survival of capitalism depends on making sure that accumulations of market power like this do not occur. They will because those greedy business people are also smart. But, we have to fight back. Unfortunately, there is no magic wand we can wave to make it all better. The only basic defense here is a general understanding on the part of citizens and their government that this is a constant problem, one for which we must remain vigilant. It’s funny that Americans, to whom democracy is supposedly such an important ideal, have very little trust for their democratically-elected government and yet at the same time have such faith in the market system. In terms of giving power to the people, it works just about as well as democracy: it’s not terrible, but it’s certainly not perfect. Keep a close eye on both.

Policies we actually employ

I entitled this post, “Inflation: What Really Causes It and What We Truly Have to Fear.” What I’ve said so far is that demand-pull inflation and cost-push/act of God are reasonable responses to economic stimuli but that cost-push/market power is all-around bad. However, my reference in “What We Truly Have to Fear” was not to market power, but to the Federal Reserve. In the US (and most other countries), policy does not follow what I’ve discussed above. Cost-push/market power inflation is almost completely ignored (maybe this is starting to turn around again, but since the 1980s we have had a very lax anti-trust attitude in the US) and it has been demand-pull inflation that has been made out to be the villain. The economists at the Fed see it as their job to force the US economy into recession when they see demand-pull inflation threatening–and they see all inflation as demand-pull. Hence, they act to stamp out expansions in response to the perfectly reasonable response of the market to increases in demand (I have a whole class in how they would have developed such a theory, but it’s a bit much for the blog).

If you are old enough to remember the early 1980s, you may recall the incredibly high interest rates. This was on purpose, a policy response of the Voclcker Fed to the inflation caused by OPEC. It caused the worst recession since the Great Depression (a title it only lost very recently!). Unemployment skyrocketed from 5.9% in 1979 to a peak of over 10% during 1982. This was all done on purpose in order to control inflation that they viewed as demand pull. It was, of course, not.

Unfortunately for those of us uncomfortable with the government causing unemployment on purpose (and for no good reason, assuming there is a justification for such a policy), it appeared to work. Here’s the last bit of the numbers above, with a few more tacked on:

US Inflation
1978 7.6%
1979 11.3%
1980 13.5%
1981 10.4%
1982 6.2%
1983 3.2%
1984 4.4%
1985 3.5%
1986 1.9%

WOW! 1.9% inflation! That’s incredible given what had preceded it! It looks like we should give the government carte blanche to cause the worst recession since the Great Depression whenever they need to! After all, demand-pull inflation is terrible since it enriches people who sell things that others want and it creates appropriate signals to entrepreneurs and consumers.

What this story leaves out is the following. First off, our hands are obviously tied when it comes to market power being a function of something that lies outside our legal jurisdiction, as happened with OPEC. We can find ways of making what they sell less important to us (as we did), but that’s about it. We can’t drag them before a Congressional committee and accuse them of anti-trust violations. Fortunately, however, we didn’t have to. They fell apart on their own.

On September 22, 1980, Iraq invaded Iran. The war, which resembled the Western Front in WWI but with missiles and jets (and included chemical weapons), dragged on for eight long, bloody, and terribly expensive years. With both countries in terrible financial straits, they started cheating on the OPEC agreements they had made (the agreements that had led to the high prices). And, if they were going to cheat, others decided to do so, too. Take a look at the figures again and see when the inflation starts to fall. And things got much worse for OPEC (and better for the rest of us!) as their agreements collapsed. Oil prices fell and inflation suddenly and miraculously came under control. What solved US inflation? Saddam Hussein’s dreams of empire, not Paul Volcker’s economic policies!

The debt, deficit, and inflation

I suggested in the opening paragraph that part of my motivation to write this now was because people were saying that the debt and deficit could cause inflation if we tried to pay them off by monetizing them (i.e., by simply printing money). I think this entry is probably long enough so I’ll be brief here. Two things: 1) printing money doesn’t cause inflation if the economy is not already at full employment, i.e., if we are not already at the point where we are at maximum capacity. Otherwise, it just creates jobs and output. 2) If it does create inflation, it’s demand-pull.

And that’s enough for today!

Government Deficits as Necessary to Capitalism

I thought I’d add a short addendum to my original post on the debt and the deficit so that I can drive home the central points.

1. We have the ability to create plenty of goods and services, but, ironically, we can do so too easily. Because with our productivity we can satiate short-term demand without using the services of all those who are willing to work, unemployment is created. Even more results from the fact that no one is hired to produce the goods and services the redundant workers would have consumed, but now cannot afford. Because there is no profit in hiring any of those unemployed workers, the private sector is of no help in resolving this dilemma. Only a sector of the economy willing and able to spend without expectation of profit can help, which is, of course, the government. If they spend sufficiently to guarantee the hiring of the redundant workers, then this raises the overall standard of living without asking anyone to settle for less. In a capitalist economy, it is absolutely critical that the government play this role, that of the sector that is willing to spend without expectation of return, because it is the only one that can afford to do so. By acting in this way, they increase the real wealth of the nation, goods and services. Employment rises, output rises, tax revenues rise, and welfare and unemployment payments fall–deficits are ironically likely to be smaller than when the government foregoes this role (not that that’s really necessary).
2. Government budget deficits add wealth to the private sector and allow firms and households to pay off debt and save; government budget surpluses drain wealth from the private sector, reducing the savings of firms and households and putting them in debt.

Given 1 and 2, who would recommend that we should, in the midst of the worst economic crisis since the Great Depression–reduce the deficit? It makes no sense whatsoever, particularly in light of points 3 and 4:

3. We did the exact same thing during the Great Depression with disastrous results. By 1936, we had finally reduced unemployment from 25% to 14% (can you even begin to imagine what that must have been like, particularly in the absence of all the social programs we have today?). But, there was a public outcry against what was, by today’s standards, a very small debt and deficit (and, just like today, people were calling it socialist and the destruction of America). The government heeded the call, and unemployment shot back up to 19%. It took three long years to get it back to 14% again (which is still well above what we have today). Shortly after that, WWII started, the deficit and the debt skyrocketed, and unemployment plummeted–and for some reason, no one was complaining! If we follow the same route (i.e., if we try to cut spending as we did in 1936), we are unlikely to be “saved” by a world war this time.
4. The government is not a household and the essential logic underlying its operation is very different. Not only do they not need to balance their budget, we should not want them to do so. It is counter to the purpose they are supposed to serve. Consider this. In a capitalist system, members of the private sector cannot exist as viable economic entities if they are unable to convince other entities to give them something they are not allowed to make for themselves: dollars. In fact, they need to attract at least as many of these as the number they need to exchange for the goods and services they would like to consume–and hopefully more than that so they can accumulate savings. The means by which they convince other entities to give away their dollars is in exchange for goods or services. They key to the advantages of using a capitalist system is the word “convince.” If you want my dollars, then you need to make some good or service that I’d like to have (actually, this works properly only if several other conditions hold, relating primarily to the level of competition that exists, but I won’t go into that here–see my discussion of health care for more on that). Those who are successful must have been doing a good job creating goods and services other people like. Good. Those who go bankrupt aren’t doing things the rest of the society finds useful, and their bankruptcy acts as a signal: don’t sell what they are selling! That’s how the private sector is set up and, therefore, the fact that entities there can go bankrupt can, if everything else is set up properly, actually serve a useful purpose. It makes sense that we don’t allow private citizens or companies to print their own money becuase if we force them to make them earn it by selling things others are willing to buy, this creates wealth for all of us.  We don’t need the government to play this same role. It is supposed, in the first place, to do things that are inherently not profitable, but socially necessary: national defense, education, NASA, etc. Hence, by nature, the government is forced into a situation where it could not earn profit in the same way the private sector does even it wanted to. It cannot and should not play the same game. Second, because of the issue raised in point 1, we need it to generate more spending than it drains away in taxation. Taxes are a useful mechanism for altering spending patterns in order to achieve certain social and economic goals (giving tax credits for charitable giving, encouraging home ownership by making interest and property tax payments deductible, using a progressive system to keep income distributions more even and thus generate more consumer demand–the poor and middle class spend more of their incomes than the rich), but the government doesn’t actually need them in the same way WalMart needs to charge for stuff on its shelves. Why? Because the government, unlike agents in the private sector, may print their own dollars. The US government does not operate under the same sort of budget constraint and if they are to fulfill their role in society, they cannot. It’s not simply that it’s not set up like the private sector, it shouldn’t be–and the private sector is better off for it. Trying to understand the federal government budget process by thinking of it as a household or a firm is to commit a fundamental error of logic. They simply are not analogous. Unfortunately, because we are all so familiar with the way budgets work in our private lives, we cannot help but make the “obvious” but invalid leap.

Note, incidentally, that people are quite right to assume that state and local governments face a budget constraint similar to that of the private sector. The State of Texas does not print its own currency (at least not until we secede) and so if the state government does not collect in revenue as much as it wishes to spend, it faces a real problem. They can borrow, but repayment is a function of future tax revenues, period. They have no other option. Of course, if the deficits are financed by selling debt to Texans, then when the debt is repaid it is basically a redistribution of income within the state: taxes are collected from the population at large and some of those funds go to those who had purchased the bonds that allowed the state to spend in deficit. The situation in Greece was similar to that of a state or local government and hence has very little in common with the US. The primary difference is, they don’t issue their own currency–they are on the euro. Hence, Greece–which should never have been allowed entry into the EU because its periphery status almost guaranteed a problem like this would emerge–was put in the position of a private-sector firm. If they were going to pay their debt, they had to sell (export) more than they purchased (import).

The one and only useful purpose that the balanced-budget fiction plays at the federal level is this: it constrains the power of government officials who, if they realized there was no realistic constraint, might well go just a little crazy. I will not deny that this is a real issue. But, if the only means of solving it is to drain income from the private sector, causing unemployment and stagnation, then there simply is no hope. But surely not.

Say, maybe one of my earlier comments that realistic economic analysis cannot be reduced to something that fits on a bumper sticker is wrong:

Political Reform: Yes Budget Balancing: No