LARS P. SYLL

Bob Rowthorn questions two of Piketty’s central assumptions

Piketty uses the terms “capital” and “wealth” interchangeably to denote the total monetary value of shares, housing and other assets. “Income” is measured in money terms. We shall reserve the term “capital” for the totality of productive assets evaluated at constant prices. The term “output” is used to denote the totality of net output (value-added) measured at constant prices. Piketty uses the symbol β to denote the ratio of “wealth” to “income” and he denotes the share of wealth-owners in total income by α. In his theoretical analysis this share is equated to the share of profits in total output. Piketty documents how α and β have both risen by a considerable amount in recent decades. He argues that this is not mere correlation, but reflects a causal link. It is the rise in β which is responsible for the rise in α. To reach this conclusion, he first assumes that β is equal to the capital-output ratio K/Y, as conventionally understood. From his empirical finding that β has risen, he concludes that K/Y has also risen by a similar amount. According to the neoclassical theory of factor shares, an increase in K/Y will only lead to an increase in α when the elasticity of substitution between capital and labour σ is greater than unity. Piketty asserts that this is the case. Indeed, based on movements α and β, he estimates that σ is between 1.3 and 1.6 (page 221).

Thus, Piketty’s argument rests on two crucial assumptions: β = K/Y and σ > 1. Once these assumptions are granted, the neoclassical theory of factor shares ensures that an increase in β will lead to an increase in α. In fact, neither of these assumptions is supported by the empirical evidence which is surveyed briefly in the appendix. This evidence implies that the large observed rise in β in recent decades is not the result of a big rise in K/Y but is primarily a valuation effect …

Piketty argues that the higher income share of wealth-owners is due to an increase in the capital-output ratio resulting from a high rate of capital accumulation. The evidence suggests just the contrary. The capital-output ratio, as conventionally measured has either fallen or been constant in recent decades. The apparent increase in the capital-output ratio identified by Piketty is a valuation effect reflecting a disproportionate increase in the market value of certain real assets. A more plausible explanation for the increased income share of wealth-owners is an unduly low rate of investment in real capital.

Robert Rowthorn

It seems to me that Rowthorn is closing in on the nodal point in Piketty’s picture of the long-term trends in income distribution in advanced economies. As I wrote the other day:

Being able to show that you can get the Piketty results using one or another of the available standard neoclassical growth models is of course — from a realist point of view — of limited value. As usual — the really interesting thing is how in accord with reality are the assumptions you make and the numerical values you put into the model specification.

(h/t Erik Hegelund)

The Real Damage Done

The number of Britons living in poverty has more than doubled over the past 30 years, a report has revealed. About one in three UK families now live below the breadline, despite the British economy doubling in size over the same period.

The UK’s largest ever study into poverty in the country has urged the government to take measures to tackle growing levels of poverty. The Poverty and Social Exclusion in the United Kingdom (PSE) project, led by the University of Bristol, has revealed the wealth gap between the haves and the have-nots in the UK is widening still further.

Almost 18 million people are unable to afford adequate housing, while one in three do not have the money to heat their homes in winter.

“The Coalition government aimed to eradicate poverty by tackling the causes of poverty,”said Professor David Gordon, from the Townsend Centre for International Poverty Research at the University of Bristol. “Their strategy has clearly failed. The available high quality scientific evidence shows that poverty and deprivation have increased since 2010, the poor are suffering from deeper poverty and the gap between the rich and poor is widening.”

Perhaps the most interesting revelation unearthed by the report is the fact that most of the people living in poverty are employed, dispelling the myth propagated by ministers that poverty is a consequence of lack of work, the PSE report says.

It found that the majority of children living below the breadline live in small families with at least one employed parent.

In households that suffer from food deprivation, the study found that parents often sacrifice their own wellbeing for that of their children. In 93 percent of cases at least one parent skimped on meals “often”to make sure others had enough to eat.

According to the study, women were more likely to make sacrifices, cutting back on clothes and social visits.

“The research has shown that in many households’ parents sacrifice their own welfare – going without adequate food, clothing or a social life – in order to try to protect their children from poverty and deprivation,” Professor Jonathan Bradshaw, of the University of York, said in the PSE’s statement.

The report calls on the government to address the growing number of poor in the UK.

RT.com

Wage rigidity and the importance of checking your model assumptions

The task of this book is to explain wage rigidities … It seems reasonable to hope that a successful explanation of wage rigidity would contribute to understanding the extent of the welfare loss associated with unemployment and what can be done to reduce it … Many theories of wage rigidity and unemployment include partial answers to these questions as part of their assumptions, so that the phenomena of real interest … are described in the theories’ assumptions. For instance, Lucas concludes that increased unemployment during recessions implies little welfare loss … Lucas’s policy conclusions are not strongly supported … Good support can come only from information that distinguishes his microeconomic assumptions from others yielding different policy recommendations.

A fanciful example may illustrate the danger of taking too narrow a view of instrumentalism. You are an explorer seeking contact with the Dafs, an isolated tribe about which almost nothing is known. You observe one of their villages through binoculars from far away … You observe that every morning on sunny days, men wearing bright yellow hats stand in the backyards and make sweeping gestures toward the sky … When you finally arrange a meeting with some Dafs, you meet a few men with yellow hats and a few other plainer people. Believing the first to be leaders, you offer them presents, at which point all the Dafs are outraged and assault you. What you have not observed is that yellow hats mark slaves, who throw grain to the household chickens in the yard on sunny days and inside on rainy ones … It would have been worth your while not to settle for treating arm waving and wearing yellow hats as the phenomena to be explained, but to test your assumptions about behavior by taking risks to sneak up closer and see precisely what the men were up to.

Did Keynes accept the IS-LM model?

Lord Keynes has some interesting references and links for those wanting to dwell upon the question if Keynes really “accepted” Hicks’s IS-LM model.

My own view is that  IS-LM doesn’t adequately reflect the width and depth of Keynes’s insights on the workings of modern market economies:

1  Almost nothing in the post-General Theory writings of Keynes suggests him considering Hicks’s IS-LM anywhere near a faithful rendering of his thought. In Keynes’s canonical statement of the essence of his theory — in the famous 1937 Quarterly Journal of Economics article — there is nothing to even suggest that Keynes would have thought the existence of a Keynes-Hicks-IS-LM-theory anything but pure nonsense. John Hicks, the man who invented IS-LM in his 1937 Econometrica review of Keynes’ General Theory — “Mr. Keynes and the ‘Classics’. A Suggested Interpretation” — returned to it in an article in 1980 — “IS-LM: an explanation” — in Journal of Post Keynesian Economics. Self-critically he wrote that ”the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better — is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate.” What Hicks acknowledges in 1980 is basically that his original IS-LM model ignored significant parts of Keynes’ theory. IS-LM is inherently a temporary general equilibrium model. However — much of the discussions we have in macroeconomics is about timing and the speed of relative adjustments of quantities, commodity prices and wages — on which IS-LM doesn’t have much to say.

2  IS-LM forces to a large extent the analysis into a static comparative equilibrium setting that doesn’t in any substantial way reflect the processual nature of what takes place in historical time. To me Keynes’s analysis is in fact inherently dynamic — at least in the sense that it was based on real historic time and not the logical-ergodic-non-entropic time concept used in most neoclassical model building. And as Niels Bohr used to say — thinking is not the same as just being logical …

3  IS-LM reduces interaction between real and nominal entities to a rather constrained interest mechanism which is far too simplistic for analyzing complex financialised modern market economies.

4  IS-LM gives no place for real money, but rather trivializes the role that money and finance play in modern market economies. As Hicks, commenting on his IS-LM construct, had it in 1980 — “one did not have to bother about the market for loanable funds.” From the perspective of modern monetary theory, it’s obvious that IS-LM to a large extent ignores the fact that money in modern market economies is created in the process of financing — and not as IS-LM depicts it, something that central banks determine.

5  IS-LM is typically set in a current values numéraire framework that definitely downgrades the importance of expectations and uncertainty — and a fortiori gives too large a role for interests as ruling the roost when it comes to investments and liquidity preferences. In this regard it is actually as bad as all the modern microfounded Neo-Walrasian-New-Keynesian models where Keynesian genuine uncertainty and expectations aren’t really modelled. Especially the two-dimensionality of Keynesian uncertainty — both a question of probability and “confidence” — has been impossible to incorporate into this framework, which basically presupposes people following the dictates of expected utility theory (high probability may mean nothing if the agent has low “confidence” in it). Reducing uncertainty to risk — implicit in most analyses building on IS-LM models — is nothing but hand waving. According to Keynes we live in a world permeated by unmeasurable uncertainty — not quantifiable stochastic risk — which often forces us to make decisions based on anything but “rational expectations.” Keynes rather thinks that we base our expectations on the “confidence” or “weight” we put on different events and alternatives. To Keynes expectations are a question of weighing probabilities by “degrees of belief,” beliefs that often have preciously little to do with the kind of stochastic probabilistic calculations made by the rational agents as modeled by “modern” social sciences. And often we “simply do not know.”

6  IS-LM not only ignores genuine uncertainty, but also the essentially complex and cyclical character of economies and investment activities, speculation, endogenous money, labour market conditions, and the importance of income distribution. And as Axel Leijonhufvud so eloquently notes on IS-LM economics — “one doesn’t find many inklings of the adaptive dynamics behind the explicit statics.” Most of the insights on dynamic coordination problems that made Keynes write General Theory are lost in the translation into the IS-LM framework.

Given this, it’s difficult to see how and why Keynes in earnest should have “accepted” Hicks’s construct. 

Piketty’s Second Fundamental Law of Capitalism

When Piketty introduces this law in the text of Capital in the Twenty-First Century, he abbreviates it in the form β = s/g for the benefit of the general reader. But he then follows up that introductory statement with several pages of explanatory text and warnings to the reader that make it clear that that his intent is only to describe the value toward which β would converge in the long run, if s and g remain relatively constant. Unfortunately, the abbreviated statement of the law has thrown many people off. Economists are in the habit of using equilibrium methods to turn long-term asymptotic limits of processes that evolve over time into unchanging constraints on some idealized steady-state equilibrium. So rather than use the inherently dynamic accounts of wealth, income and the capital-to-income ratio that are partially explained above, and that Piketty uses to study the dynamical evolution of the structure of economic inequality as it evolves over time, some commentators have instead gone right to a steady-state model in which β is set constantly equal to s/g, and from which they then fallaciously deduce immediate (and absurd) changes in β from the fluctuations in s and g. This is quite far from Piketty’s intent and misrepresents his framework.
Since part of the point of the Second Fundamental law and its surrounding framework is to analyze what happens as the capital-to-income ratio increases over time, not what happens in the less usual conditions when it is stable, the focus on steady-state conditions seems to me misguided. For example, if a society begins in 2014 with a capital-to-income ratio of 4, a savings rate of 10% and a growth rate of 1.5%, then even if the savings rate and growth rate remained constant indefinitely, it would take a very long time for β to get near its limiting value of s/g = 6.7. Specifically, β would not get to within 10% of s/g until the year 2115; it would not get to within 5% of s/g until the year 2159; and it would not get to within 1% of s/g until the year 2159. The distance between the present value of β and the present value of s/g is a measure of the present strength of the “force” pushing the capital-to-income ratio higher. Since some of the forces generating inequality depend on the rapidity with which β is increasing, it is the strength of this force and the direction in which β is moving that are important. Piketty’s Fundamental Law should not be interpreted as the statement that β is approximately equal to s/g. Under ordinary conditions β can be quite far from s/g. That’s part of the point.

Dan Kervick

Skidelsky on the need for an economics curriculum reform

In a manifesto published in April, economics students at the University of Manchester advocated an approach “that begins with economic phenomena and then gives students a toolkit to evaluate how well different perspectives can explain it,” rather than with mathematical models based on unreal assumptions.

The Manchester students argue that “the mainstream within the discipline (neoclassical theory) has excluded all dissenting opinion, and the crisis is arguably the ultimate price of this exclusion …

Today’s “post-crash” students are right. So what is keeping the mainstream’s intellectual apparatus going?

For starters, economics teaching and research is deeply embedded in an institutional structure that, as with any ideological movement, rewards orthodoxy and penalizes heresy. The great classics of economics, from Smith to Ricardo to Veblen, go untaught. Research funding is allocated on the basis of publication in academic journals that espouse the neoclassical perspective. Publication in such journals is also the basis of promotion …

For now, the best that curriculum reform can do is to remind students that economics is not a science like physics, and that it has a much richer history than is to be found in the standard textbooks …

Indeed, mainstream economics is a pitifully thin distillation of historical wisdom on the topics that it addresses. It should be applied to whatever practical problems it can solve; but its tools and assumptions should always be in creative tension with other beliefs concerning human wellbeing and flourishing. What students are taught today certainly does not deserve its imperial status in social thought.

Robert Skidelsky

Ricardian equivalence — total horseshit

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent, since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

Why?

In the standard neoclassical consumption model — used in DSGE macroeconomic modeling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

c_t + c_f/(1+r) = f_t + y_t + y_f/(1+r),

where c_t is consumption today, c_f is consumption in the future, f_t is holdings of financial assets today, y_t is labour incomes today, y_f is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(c_t) + au(c_f),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u'(c_t) = a(1+r)u'(c_f).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u'(c) = 1/c, the Euler equation can be rewritten as

1/c_t = a(1+r)(1/c_f),

or

c_f/c_t = a(1+r).

This importantly implies that according to the neoclassical consumption model changes in the (real) interest rate and consumption move in the same direction. And — it also follows that consumption is invariant to the timing of taxes, since wealth — f_t + y_t + y_f/(1+r) — has to be interpreted as present discounted value net of taxes. And so, according to the assumption of Ricardian equivalence, the timing of taxes does not affect consumption, simply because the maximization problem as specified in the model is unchanged.

That the theory doesn’t fit the facts we already knew.

And yesterday, on Voxeu, Jonathan A. Parker summarized a series of studies empirically testing the theory, reconfirming how out of line with reality is Ricardian equivalence.

This only, again, underlines that there is, of course, no reason for us to believe in that fairy-tale. Ricardo himself — mirabile dictu — didn’t believe in Ricardian equivalence. In Essay on the Funding System (1820) he wrote:

But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.

And as one Nobel laureate had it:

Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.

Joseph E. Stiglitz, twitter

The Grossman-Stiglitz paradox

In general the price system does not reveal all the information about “the true value” of the risky asset …

The only way informed traders can earn a return on their activity of information gathering, is if they can use their information to take positions in the market which are “better” than the positions of uninformed traders. “Efficient Markets” theorists have claimed that “at any time prices fully reflect all available information” … If this were so then informed traders could not earn a return on their information.

When the efficient markets hypothesis is true and information is costly, competitive markets break down … As soon as the assumptions of the conventional perfect capital markets model are modified to allow even a slight amount of information imperfection and a slight cost of information, the traditional theory becomes untenable. There cannot be as many securities as states of nature. For if there were, competitive equilibrium would not exist …

Because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation. There is a fundamental conflict between the efficiency with which markets spread information and the incentives to acquire information.

Sanford Grossman & Joseph Stiglitz

Here is my own take on the paradox (only in Swedish, sorry).

IMF warns of Swedish housing bubble

A new IMF report warns of rising financial instability and unsustainabe household indebtedness in Sweden:

Financial instability is an increasing concern. House price increases have picked up again, exceeding 71⁄2 percent annual growth for single-family homes and 121⁄2 percent for tenant-owned apartments in April. Household credit growth also remained strong, pushing household indebtedness to almost 175 percent of disposable income in 2013, and over 190 percent if debt from tenant- owned housing associations is included. Recent data indicate that household debt ratios are high across all income groups, but particularly so for indebted lower-income households who are especially vulnerable to income, interest rate, and house price shocks. The aggregate net asset position of households is solid, but a large share of assets is illiquid and has limited value as a buffer. As a consequence, a large and sudden drop in house prices would lower consumption, employment, and growth, and ultimately impact the banking system.

The increase in house loans – and house prices – in Sweden has for many years been among the steepest in the world.

Sweden’s house price boom started in mid-1990s, and looking at the development of real house prices since 1986, there are reasons to be deeply worried:

Source: Statistics Sweden and own calculations

The indebtedness of the Swedish household sector has also risen to alarmingly high levels, as can be seen in the figure below (based on new data published earlier this month by Statistics Sweden, showing the development of household debts/disposable income 1990 – 2012):

Source: Statistics Sweden and own calculations

Yours truly has been trying to argue – for two years now – with “very serious people” that it’s really high time to “take away the punch bowl.” Mostly I have felt like the voice of one calling in the desert, and up until now neither the Swedish central bank, nor the government, has been willing to listen. Compairing the above figures with the one below (source) could perhaps give some refreshing perspective …

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Where do housing bubbles come from? There are of course many different explanations, but one of the fundamental mechanisms at work is  that people expect house prices to increase, which makes people willing to keep on buying  houses at steadily increasing prices. It’s this kind of self-generating cumulative process à la Wicksell-Myrdal that is the core of the housing bubble. Unlike the usual commodities markets where demand curves usually point downwards, on asset markets they often point upwards, and therefore give rise to this kind of instability. And, the greater leverage, the greater the increase in prices.