John Kay, who was at a panel on curriculum reform at the INET conference in Paris last week, published an article at the FT summarizing his findings:

There is alternative medicine, but most alternative medicine remains so because there is no evidence that it works. The medical profession is often resistant to innovation, especially innovation that challenges accepted wisdom — in the 19th century the Hungarian doctor Ignaz Semmelweis struggled for decades to persuade his colleagues that the best thing they could do for patients was wash their own hands.

More recently, much effort was required to gain acceptance of the discovery that many ulcers were caused by the Helicobacter pylori bacterium. But good doctors are, in the end, persuaded by what works for their patients, as they were in these cases. Good alternative medicine becomes orthodox.

This is a very interesting metaphor. Let me stay in his metaphor and expand on what the viewpoint of heterodox economists would be. Heterodox economists would turn this metaphor around and accuse the orthodox view as the “alternative medicine”. Why? Against all the wisdom of heterodox economics and the IS/LM model, somehow the mainstream came up with lots of ideas that can be considered failures by now, like expansionary austerity (a cut in spending leads to a rise in incomes), the confidence fairy, bond vigilantes, Ricardian equivalence, targeting the inflation rate exclusively with complete neglect of everything else (Taylor rule, inflation-targeting), the idea that an increase in reserves can lead directly to more lending to the private sector (QE), that more flexibility on labor markets would increase employment, that cutting wages would increase unemployment, that Chinese savings would cause US interest rates to fall, and the list goes on.

Whereas “alternative medicine” is often a placebo kind of science – no harm done – the contemporary strand of macroeconomics is more like the practice of bloodletting. Instead of fixing problems it creates new and bigger problems! Austerity in Europe – this includes the treatment of the Greek case of insolvency as one ofilliquidity – was what really cause the troubles in the euro zone. The spreads of government bonds really start to increase only after January 2010 when the Greek situation leads to the imposition of austerity policies. These policies where discretionary and are not included in the European laws. It was a deliberate choice of European politicians, based on mainstream economic thinking. However, as Albert Einstein said: “We cannot solve our problems with the same thinking we used when we created them.”

So, I agree with John Kay on his last sentence: “Good alternative medicine becomes orthodox.” It’s just that paradigm shifts take some time – obviously, it can take centuries to root out dogmatic beliefs!

I was at the INET conference last week and met many interesting and knowledgable people. One conversation was with somebody from the OECD. He called for heterodox modelers to improve their models so that they can be used for policy advice. I was a bit astonished, given that the IS/LM model, which is not heterodox, says that austerity would not work, but the OECD chose to ignore even the work horse model of the mainstream! It seems that the OECD now opposes austerity, if Euractiv is right.

Nevertheless I would like to point to a discussion of models and reality. Lopez and Assous in their book on Michal Kalecki dig out a nice discussion from 1933. Kalecki tried to show with a models that “his system gave rise to a cyclical solution of constant amplitude for a special value of parameters” (p. 91). The authors then produce a quote from Goodwin (1989) via Sebastiani (1989):

Alas, Frisch was there to point out that since the Greeks it has been accepted that one can never say an empirical quantity is exactly equal to a precise number. Given his aim, this was a deadly blow to Kalecki […].

Thus, if Kalecki cannot “prove” with a mathematical model that capitalism is unstable, than the same must be said about DSGE models “proving” that there cannot be any inter-temporal problems of demand since any change in savings triggers a change in investment of the same magnitude.

History does not repeat itself. It seems like the economists got things right in the Great Depression, but this time around we are way behind the curve.

Posted by: Dirk | April 7, 2015

The US economy and its labor market

There has recently been a downward adjustment in the numbers of jobs created, as the NYT reports:

The nation added only 126,000 jobs in March, while the unemployment rate was unchanged at 5.5 percent. Those terrific numbers from January and February now look a bit less terrific, as revisions subtracted 69,000 positions from the previously reported job gains. In a silver lining to the soft numbers on job gains, average hourly earnings rose 0.3 percent, continuing the erratic, muddy picture that is emerging on whether American workers are starting to see meaningful wage gains.


A better picture to use would be the labor force participation rate. It does not seem that the US economy is in a boom. Even though job creation wasn’t bad in the last quarters, the 63% participation rate is still very far from where it was since the late 1980s: somewhere between 66% and 67%. Policy makers would set too easy a goal if they would declare that the US economy is on its way to recovery.


Last Thursday, an open letter was published in the FT demanding more fiscal spending in the euro zone (also available here). I agree with the authors that quantitative easing is not the way to go (there are six pages on QE in my new book which is written in German), and I would have stressed that beggar-thy-neighbor policies as those that are in place now should be abandoned because they can’t work for the global economy as a whole. However, I agree with the conclusion: fiscal stimulus. At this moment, it is absolutely necessary to let government spending grow. As I have shown yesterday, Iceland’s success story of returning to positive growth after only three years of crisis has not been reached by austerity, but by letting government spending rise again. The same goes for Germany, which has been growing relatively well. Government spending has gone up, not down: gersuccess What we need in the euro zone is more aggregate demand. That additional demand means that someone must move into debt, because that someone will spend more than she has as an income. Traditionally, this is the role of government. Remember IS/LM? If expenditure is too low, spending has to go up. There is monetary policy, but when investment is interest-inelastic then a fall in the interest rate will not make investment go up. This is the problem that we seem to have in the euro zone rather than some kind of liquidity trap. Having lowered the interest rate all the way to zero, and having the ECB increasing reserves which banks hold as deposits at the central bank did have the desired effect on the economy. Why this is so can be examined later (although I have some ideas), but policy should react to this empirical problem by pulling the other lever: fiscal policy. The problem is: the euro zone has been constructed so that there is no spender-of-last-resort. The ECB is not allowed to directly finance governments, and hence all government can go bankrupt. Even the German government bonds are not risk-free. It is time to rethink the fiscal-monetary nexus of the euro zone.

The ongoing economic recovery in Iceland started already in 2010. The economic crisis (=recession), as you can see in the chart below, started in about 2007. Only 3 years and a loss of GDP of roughly 10% later, the economy started growing again. Look, however, at the amount outstanding of domestic debt securities for general government issuers. It has risen very fast in the crisis, probably because of falling tax income. After 2010, the increase in government debt continues, now growing at a lower rate, but nevertheless growing steadily. (I chose this data and not debt to GDP because it ends in 2012.)


Iceland is not the euro zone, as most commentators know. It has its own currency, which is part of the success story. It seems to me that the success consists at least to a part on the combination of flexible exchange rate with capital controls, discretionary government spending and no bank bail-out. Oh, and by the way: the Gini coefficient (0=complete equality of income; 1=inequality) in 2013 is back where it was in 2003: at .24.

In recent news (Bloomberg), capital controls are said to go within the next two years:

Most members of Iceland’s parliament say the coalition government led by Premier Sigmundur D. Gunnlaugsson will be able to lift capital controls before its term comes to an end in two years.

So, it seems that Iceland has an exchange rate regime that moves from capital controls and weak currency in bad times to flexible currency only in normal times and then might lead to a flexible exchange rates with exchange rate administration by the central bank in times of frenzy (just guessing here). This is an interesting development.

Posted by: Dirk | March 30, 2015

Krugman on Unreal Keynesians (IS/LM again)

Paul Krugman exchanges views with Lars Syll (from Malmö University, Sweden) over what makes a Keynesian. The former summarizes the exchange like this:

Brad DeLong points me to Lars Syll declaring that I am not a “real Keynesian”, because I use equilibrium models and don’t emphasize the instability of expectations.

One way to answer this is to point out that Keynes said a lot of things, not all consistent with each other. (The same is true for all of us.) Right at the beginning of the General Theory, Keynes explains the “principle of effective demand” with a little model of temporary equilibrium that takes expectations as given.

The is a lot that could be said. For instance, fundamental uncertainty is not the same as instability of expectations. However, it should be granted to Paul Krugman that he is a at least a Keynesian in the old policy-making sense: an economist who is not against an increase in government spending per se. And this, to me, seems to be the fundamental issue of macroeconomics. Keynes in his General Theory (1936) makes the point that neoclassical economics is a special case of his general theory: the one in which demand equals supply at full employment.

Keynes sets out to show that there are possible equilibria in which goods, money and bonds markets are in equilibrium while there is unemployment. Equilibrium means that supply equals demand, which means that every buyer finds a seller at the going rate, and every seller finds a buyer at that very same rate. At the end of the day, everybody is happy and the plan tomorrow of what to buy and what to sell stay the same. Hence in equilibrium we have stability in the sense that tomorrow is like today (or yesterday).

What’s wrong with IS/LM then? Lars Syll attacked the model for many flaws (see his original post). My own point of view is that IS/LM is mistaken in assuming that the central bank controls the money supply and that the sectoral balances (private and public) are not made explicit. You actually can get a lot of mileage out of the good old IS/LM model if you let the central bank set the interest rate on the short-term money market (horizontal LM curve) and – because of general depression – determine some level of expenditure (or demand) that does not react to changes in the interest rate (vertical IS curve). The resulting cross is so trivial that I tend to agree with Syll: maybe it is not the best idea to use a macroeconomic model to show that:

  1. Demand is exogenous and smaller than potential output
  2. The central bank creates the interest rate, but that doesn’t matter because of 1.
  3. Demand is exogenous, but government spending can add to that

Using a mathematical model with all eyes crossed and all teas dotted to then arrive at this conclusion really is a waste of time. How do we fix this?

I have published the so-called IS/MY model to show what could be done to improve on the shortcomings of the IS/LM model (working paper version here). First of all, the main idea is that expenditure equals spending in equilibrium. Then, net deposits (money) are created through three mechanisms that rely on the same balance sheet trick. A rise in net debt leads to a rise in deposits for each of the three sectors: private, public and external. The monetary circuit works well as long as the amount of deposits is increasing (given velocity, and ignoring complications of what is money).

The economy has two modes: thinking fast and thinking slow, if I may borrow from Kahneman. In the fast mode, firms maximize profits and they act on animal spirits. Investments is strong, debt levels increase and Hyman Minsky would start to look scared. When the Minsky moment is reached and suddenly the actors realize that the boom is over, prices adjust (both relative and absolute) and the economy turns into a social system ruled by people concerned about the liability side and, ultimately, insolvency. We have what Richard Koo termed a balance sheet recession as firms and/or households start paying off debt and stop taking out more loans.

This is when the public sector can stabilize incomes by creating and spending deposits, usually by issuing bonds and deficit spending. This creates more deposits in the economy which helps the private sector to deleverage. This, in a nutshell, is/my model. It is not perfect, but it might be better than the IS/LM model because its features are more realistic and it shows the external sector as well. That would then not only reveal the paradox of thrift, but also the paradox of net exports. As all countries try to get into a net exporting position by cutting imports, they all fail miserably.

The IS/LM model was not perfect, and never will be. Any alternative will face the same fate. However, it would be nice for the macroeconomist to have something small and “unbreakable” that works on the back of an envelope. The IS/MY model is based on (BoP) accounting relations and assume only that consumption and imports depend on income. Most economists should be able to live with these assumptions. What is left to the economist is to speculate about the quantity of investment, government spending and exports. These will, using the vocabulary of Wynne Godley, determine the fiscal and trade stance and allow discussions of sustainability of macroeconomic regimes.

Posted by: Dirk | March 27, 2015

Old economic thinking in the UK

There is a rift in the economics profession, and here is a very good example why. Economics textbook author Alain Anderton writes in The Guardian:

The first concept an A-level student may well learn is the principle of opportunity cost. If you buy a car, you lose the benefits of what you could otherwise have bought with that money. If the government cuts taxes, what are the benefits that are going to be lost as a result of that decision, benefits like higher government spending or a lower national debt? However, to some extent we get the politicians we deserve. Too many people seem to think that there are simple answers to complex problems; we don’t want to pay for the choices we make. For example, we want high-quality public services but we don’t want to pay for them in taxes.

Our grasp of economics would be more mature if the acceptance of costs and benefits that are being acknowledged in classrooms were also being acknowledged at our dinner tables, in our local council chambers and in parliament.

The funny thing is that Anderton is ignorant of the idea that the principle of opportunity cost holds only in microeconomics (the example with the car), but not in macroeconomics (the example with the taxes). How is that?

A household – or a member of a household – indeed loses the benefits of what she could otherwise have bought with that money. This is simple microeconomics, where we look at (single) households and firms. They face a hard budget constraint and a given supply of goods, at least from the perspective of the household.

With taxes, this is a different thing. Anderton writes: “If the government cuts taxes, what are the benefits that are going to be lost as a result of that decision, benefits like higher government spending or a lower national debt?” This is a macroeconomic question, which means we should think in terms of a system and not in terms of one (or more) individuals. So, if the government cuts taxes, this will not leave incomes (and GDP) at the old level. Economists of all stripes – including those of Reagan and Bush, or Thatcher and Cameron – agree that tax cuts leave the private sector with more deposits and, if cuts are across the board, this will lead to more spending, more output, more economic growth.

So, Anderton’s textbook must be an outlier, since most textbooks on economics clearly state that expansionary policies, like increasing government spending or cutting taxes, are expansionary. Thus, tax cuts lead to higher incomes, which lead to higher tax income. Opportunity costs hence do not work on the aggregate level. And I thought economists have known this back since the 1930s, not only because of this gentleman.

Iceland has withdrawn its bid to access the European Union last week, as Deutsche Welle reports:

One of the main challenges for countries like Norway and Iceland in joining the EU is the Common Fisheries Policy. For nations like these, where fishing is a significant industry but where domestic demand is far smaller than production, the law poses a problem as it dictates which member states are allowed to catch what types of fish and at what amounts. Iceland has long argued that its own quota systems – which are not compatible with the EU’s – are better both for business and for preserving populations. Iceland has criticized, in particular, EU quota policies that sometimes force fishermen to throw back caught fish – often dead fish – that are either too small, part of too large a catch, or simply of the wrong type.

This explanation is very nice, very diplomatic, and I don’t buy it. I think Iceland had its share of dealings with “the Europeans” after its banks collapsed in 2008. They have also seen how nations are treated that are members of the euro zone, which was sold to the public as a fun thing – no more money changes for vacations – and now seems to be like school: lots of homework to do, a strict (female) teacher, and absolutely no fun. Mass unemployment, deflation, suicide rates more than doubled, etc.

The European Union has a governance problem. Its rules are defunct, and because they are we have a crisis. (If the rules would work, why the crisis?) Europe will have to reinvent itself, like Iceland did. The effort should be worth it, as Statistics Iceland show:

  • GDP growth: 1.9% (2014)
  • Inflation: 0.8% (2014)
  • Wage index: 6.4% (2014)
  • balance of trade: positive
  • unemployment rate: 4.4% (2014)

And, last but not least:

Total catches in February 2015, tonnes 222,804

To sum it up: Iceland is a macroeconomic success story, because even though GDP is still significantly lower than in 2007, the country shows some good enough growth, low unemployment and has no problem with the current account. The idea that countries inside the euro zone weather financial crises better than those outside must be discarded. It seems that the Icelandic people see very little on the table that could be of advantage, so maybe this fish was the most important issue after all.

N.B.: Douglas Adams, who wrote fiction and has a book with the same title as this post, has died recently.

The recent “dialogue” between Athens and Berlin would not make you believe that the euro zone faces an economic problem: 11.2% unemployment in the euro area as of January 2015. The cause of that unemployment is not hard to spot. Look at gross fixed capital formation (namq_10_an6@Eurostat) and this is the picture:

Now, gross fixed capital formation is the biggest part of the macroeconomic variable investment (the smaller part are changes in inventory). Real estate construction is part of gross fixed capital construction, so in part the fall in investment has been caused by an end of the real estate bubble. Not all GDP comes from the production of investment (goods), though. Consumption goods and goods and services sold to the government are also part of GDP, plus net exports (exports minus imports).

If we wish the euro zone to have less unemployment, there most be more goods produced. Goods are only produced if people demand them, so the question comes down to who is going to finance the purchase of additional goods. There are three potential sources: the private sector can spend more than it earns by running up debt. It does this by borrowing from banks. However, in most of the euro zone private sector firms and households are not in the mood to move into debt further. The second possibility to increase growth is for the public sector to spend more than it earns (taxes). This seems like a possible way to go, since the German “black zero” is not strictly necessary. Last but not least the rest of the world can buy more of the euro zone’s goods. For this a depreciation of the currency would be helpful, and the ECB has just engineered this by quantitative easing, which means an increase in central bank money held by banks. However, if pushing the exchange rate down leads to more exports for Europe (and that is a big if), then at some point Europe will grow stronger and investors will come back to invest. This would drive the euro up again, which would lead to weakness of demand once again.

In the last 4 years the euro zone authorities have tried to increase investment by talking up markets (“confidence”), by low interest rates (ECB), by pushing wages down, by deregulating and privatizing. After all this did not work, it is now a depreciation of the euro that is supposed to increase aggregate demand in the euro zone? Is this not the beggar-thy-neighbor strategy that Germany imposed on the rest of Europe which led to the crisis in the first place?

Well, the euro’s exchange rate is not fixed, and other countries will retaliate against “gains in competitiveness” that come via depreciation of the euro by depreciating their own currencies. Hence the solution to Europe’s economic woes – low investment – cannot lie with the rest of the world. It must lie in Europe.

Posted by: Dirk | March 16, 2015

Low interest rates: a Schumpeterian view

I am just about to finish reading Schumpeter’s “Theorie der wirtschaftlichen Entwicklung” (The Theory of Economic Development: …) in the original first edition in German. Schumpeter was Austro-Hungarian, and one of the most clever economists of his time, some say. I would like to focus on a single issue which Schumpeter brings up:

Interest is paid out of entrepreneur profits.

This is a fundamental insight. Schumpeter imagines the economic process of development like this. Entrepreneurs have ideas on how to combine inputs in a different way than is usually done, so that they can sell at higher profits, produce at lower costs, sell more, or combinations of the before. Entrepreneurs are willing to pay an interest rate because they believe that there will be enough profits out of which this cost of business can be paid. The cost of capital is the cost for being able to command purchasing power without which it would be impossible to start production, given that the entrepreneur is not already rich.

In the light of this insight, which I find hard to refute, what can be said about the current situation of low interest rates? At this moment in time, potential entrepreneurs do not judge their profits to be high enough to even afford paying very low interest rates. Whereas central banks hold interest rates at the zero lower bound, the interest rates that entrepreneurs face is still positive. I would think that it must be somewhere between 3-8% for projects that are risky, but only moderately so and in which some collateral is present to help the bank expand a loan.

Schumpeter is very clear in pointing out that a loan creates deposits for the entrepreneur, but does not take away deposits from anybody else. This function of the banking system is one of the main pillars of capitalism as he sees it (the other two are innovation and entrepreneurs). Let me add a bit to Schumpeter by expanding on the monetary circuit. If banks do not lend because entrepreneurs judge their expected profits to be too low, then the economy faces a period of stagnation. It thus interesting to understand in a next step what determines the profits of entrepreneurs. The answer to this question can be found in due time here.

Summarizing this post, our Schumpeterian view of economic crisis has led us to understand that the reason why interest rates are low that expected profits by (potential) entrepreneurs are low to non-existent, so that these do not feel inclined to borrow. Modern central banks, to help entrepreneurs make the decision to invest, have subsequently lowered interest rates in order to adjust to the pessimistic expectations of entrepreneurs. This is where we are today and leads us to the next question: what determines entrepreneur profits?

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