The necessity of growth

Chris Dillow had a thoughtful post recently on why governments, and by extension the rest of us, really want economic growth. This post, indirectly, reminded me of Tim Jackson's 2009 book: Prosperity Without Growth. I didn't like it, even though I think that many of its conclusions are probably sound, the analysis is very weak.

In particular, Jackson sets up a straw-man of a ‘conventional macroeconomics’ in which GDP growth is necessary, and then shows that this is not ecologically sustainable. However it’s not clear that ‘conventional macroeconomics’ does require this: disappointed growth expectations may lead to recessions etc due to frictions, but if the central expectation of economic growth was zero (and debt levels etc were consistent with this expectation) then in what way would our ‘conventional macroeconomics’ require a positive growth rate? (I link back to Chris Dillow's post for some thoughts on why there may be such a requirement - but you won't find any such thoughtful analysis along these lines from Tim Jackson).

I think that the postulate of ‘a conventional macroeconomics’ is just a disparaging line of attack from someone who chooses not to engage with economics and wants to portray it as monolithic and wrong. See these links for other complaints along these lines.

It is clear that ultimate limits exist but it’s in no way clear that this precludes a capitalist system, because it is in no way clear that a capitalist system ‘requires’ growth.

Accounting for growth - Ayres & Warr

Interesting paper from 2005 published in Structural Change and Economic Dynamics: http://www.fraw.org.uk/files/economics/ayres_2005.pdf

This paper starts by noting that under normal assumptions, i.e. a constant returns to scale production function, changing factor endowments cannot explain the change in economic output over the 20th century. We need to postulate an additional factor: usually `technological progress'. This conclusion is qualitatively unaltered even if we expand the factors we consider from labour and capital to also include energy inputs.

However, if raw energy inputs are converted into `useful work' using estimated efficiency factors, then the change in labour, capital and useful work, at least over the 1900 - 1970 period, does seem to explain the change in economic output.

Is this an anodyne statement? Is every technological improvement basically just an improvement in the conversion of energy resources into useful work? Should we be surprised by this result? In particular, are we comfortable with idea that the productivity of labour has stayed constant and it's just that each unit of labour has more capital and joules to play with?

The paper can be criticised for introducing non-standard production functions that just serve to confuse the issue - they may fit the data better, but if the driver is just the use of useful work as a factor of production then they should keep it simple by explaining the issue purely in these terms. The authors claim that their results hold even if we just use a Cobb-Douglas production function.

The other interesting issue brought out by this paper is the divergence of their economic output as predicted from labour, capital and useful work, with actual economic output, post 1970. The authors postulate that this could be due to labour and capital using useful work more efficiently as prices increased in the 70's oil shock (this explanation is akin to Hassler, Krusell & Olovsson) or perhaps to to the rise of information technology. My only thoughts here were that it's interesting that this is also the point in time at which there is the divergence (at least in the US) of GDP per capita and median income, and between the GDP deflator and the CPI index (so that the economic statistics are "either overstating inflation (and hence understating income gains) or overstating economic growth").

Assorted Links

Some interesting stuff I've read recently on negative interest rates:
The negative unnatural rate of interest
the return of secular stagnation
a theory of the recession
a theory of the recession, ctd
Toy models of inequality, negative interest rates, revolutions, and trade deficits
negative real rates of return

and, from longer ago, on land values:
the stickiest price land and recessions
http://www.overcomingbias.com/2010/02/is-the-city-ularity-near.html

Who should pay for mal-investment?

I like this:

"under (successful) NGDP targeting, any depressions that occur will be inflationary depressions. ... If depressions occur even while the NGDP path is stabilized, then they will reflect some failure of supply or technology. Our aggregate investment choices will have proved misguided, or we will have encountered insuperable obstacles to carrying wealth forward in time. It is creditors, not debtors, whom we must hold accountable for patterns of aggregate investment. There always have been and always will be foolish or predatory borrowers willing to accept loans that they will not repay. We rely upon discriminating creditors to ensure that funds and resources will be placed in hands that will use them well. Creditors allocate capital by selecting the worthy from innumerable unworthy petitioners. An economic downturn reflects a failure of selection by creditors as a group. It is essential, if we want the high-quality real investment in good times, that creditors bear losses when they allocate funds poorly. When creditors in aggregate have misjudged, we must have some means of imposing losses without the logistical hell of endless bankruptcies. Our least disruptive means of doing so is via inflation."

BBC Scotland can't do economics

2 stories over the past month have been noticeable for the economically uninformed reporting on BBC Scotland:

The first was the call from Scottish Government for a change in approach towards more Keynesian counter-cyclical capital spending. When such calls are made by Ed Balls we get Stephanie Flanders at the "Big BBC" discussing it from an economics perspective. However, when "Wee" BBC Scotland reports on this it's always, frustratingly, framed as a Holyrood versus Westminster "spat".

The second story was of course the trams fiasco, on which there were two aspects that were badly reported. The first was the constant repetition that the costs of the St Andrews Square option would be more than £1B because interest payments are added to the contracted costs. This ignores the fact that the costs of cancellation cannot be met with borrowing because there is no asset against which to secure any new borrowing. Reporting it in this way is effectively saying that the ability to borrow is a disadvantage - a cost that should be reported. The huge difficulties that would be caused by not being able to borrow to meet the cancellation costs are just glossed over. It's also inconsistent with how any purchase is normally reported: nobody claims that their house costs double what it actually cost just because they had to take a mortgage out and they are including all the interest payments on the mortgage.

The other badly reported aspect was allowing the sunk cost fallacy to be willfully misrepresented. The sunk cost fallacy describes the situation where you have a project with, say, projected benefits of £40M and projected costs of £35M. The project goes ahead on this basis but when £10M has been spent, the remaining costs are reassessed as now being £45M (i.e. £55M total cost). The rational calculation to do at this point is to compare the value of doing nothing (costs to pay = 0, benefits received = 0, i.e. value = 0) against the value of proceeding (costs to pay = £45M, benefits received = £40M, i.e. value = -£5M) and so decide to cancel the project without taking the £10M already spent into consideration. However, those promoting the sunk cost fallacy as being a reason to cancel the trams were only mentioned the bit about not thinking we have to get something for the money already spent.

A very conservative calculation would give the benefits of the full (18.5km) airport to Newhaven tram line as £545M (since this was the original cost of the full line, which was approved and so we have to imagine that the benefits are at least this large) and the benefits of the truncated (13km) airport to St Andrews Sq line as £383M (=545*13km/18.5km). The options now are to cancel the project, which has a value of 0 (no asset gained and assuming total cost of ~ £600M = £440 already spent + £160M cancellation fees, is sunk) or continue, which has a value of £153M (asset worth £383M gained and differential costs of £230M (£830M cost of which £600M is sunk)). Clearly we should proceed.

The expansionary effects of balanced budget increases in expenditure

I saw an article by Robert Shiller in the NYT in July: "How to make the case for a new stimulus" and was reminded of this by another article by Shiller that I saw yesterday.

The mechanism relies on expenditures all being on consumption or investment, but matched taxes coming from a mixture of consumption and savings. The higher the proportion that comes from savings, the higher the boost to national income, and that's before multiplier effects.

Go back to my previous post but now add in private savings (firms still own all capital and produce all the output, so that gross profits, P = Y - W, and it's firms that make investments in capital stock K) so:

P = Sf + d = Y - W = C + G + I - W = W + d - Sa - T + G + I - W
i.e. Y = d + W + I + G - T - Sa

(the only difference now is that savings by firms are labelled Sf and savings by agents are labelled Sa). Therefore, assuming wages, dividends, investment all constant in short run, and assuming that raising T by 1 lowers Sa by 0.5 (i.e. 50% of taxes raised come from income that would otherwise have been saved), then raising government expenditure and taxes by same amount (i.e. balance budget expansion in government expenditure) would raise national income by 50% of the increase in the government budget. This would then be subject to multiplier effects since wages, dividends and investment are not constant in the slightly longer run.

Obviously fully deficit financed expansion in government expenditure would be even more expansionary (100% of the increase rather than 50% as above). Ideally you'd set tax rates and expenditure such the goverment was running a small surplus at full employment, so that it could afford to engage in this counter-cyclical policy during downturns. Also, just need debt levels not to grow as a percentage of GDP over the cycle - you don't need to balance the budget in pounds and pence over the cycle if there's economic growth.

However, maybe there won't be economic growth in future?

The evolutionary roots of the morals of 1001 Nights

Went to see 1001 Nights at the Festival last week. Excellent. The main theme though seems to be sexual jealousy from husband towards apparently adulterous wives. The moral message from some of the stories is that it's OK to brutally murder such a wife, but make sure you have your facts correct first!

With honour killings, Sharia law, and, maybe to a lesser extent, everyday attitudes, this moral code clearly persists. Why? A simple model of investment costs towards the next generation might explain this:

Suppose both parents invest the same (in terms of effort, resources etc) in the children that they bring up within the family unit that they live in. Clearly, pre-birth, men and women both have an incentive to seek the highest quality genes in their partner, but the costs of infidelity at this point are perhaps assymmetric.

The evolutionary cost to women of male infidelity is that the man chooses to live with someone else and make this investment elsewhere. The infidelity may change the ex-ante probability of the man choosing another partner, but despite the infidelity there is still some probabilty that there will be zero cost to to woman (i.e. the man stays).

The evolutionary cost to men of female infidelity is that the child is not theirs. Their investment will therefore be, from the point of view of their own genes, wasted. There is no probability one way or the other (there may be uncertainty that looks like a probability distribution, but the die has already been cast). Women never have a reason to doubt where to make their investment since they always have proof that the child is theirs.

It may be (game theory's not my game so I'm not going to attempt to construct a full model of this strategic interaction) that the evolutionary costs of female infidelity to men are higher than the evolutionary costs of male infidelity to women, and if so then maybe there's a biological basis for the moral code expressed in 1001 Nights.

This could be sorted in these modern times by genetic testing and putting the biological father on the birth certificate. This is perhaps not the best social policy from a child-centred point of view and maybe feels wrong from some sense of fundamental morals. But morals are not fundamental: they have a biological basis that is embedded in a cultural framework. Choosing social policy on a child-centred basis is not playing evolution's game: if we want to change morality so that sexual jealousy and sexual violence are less of a problem then we need to change the evolutionary biological incentives.

Joseph Stiglitz on New Directions For Economics

I enjoyed the Joseph Stiglitz lecture at Lindau. He presented two main areas as a research agenda in macroeconomics: networks and contagion; and structural transformations in the economy.

I'm very interested in possible structural transformations, but it seems Stiglitz has in mind productivity improvements in one sector exceeding growth in demand and causing an economy wide slump as labour gets trapped in the declining sector. The example is agricultural productivity improvements prior to the great depression only sorting itself once this surplus labour had managed to move to manufacturing.

The hypothesis is perhaps this is happening now and we are seeing manufacturing productivity gains outstripping demand, and causing a slump that will be righted only once enough formerly manufacturing labour has made its way to services.

This doesn't seem right to me and I'm concentrating on the structural transformation implied by a reduction in the energy flux to the economy. Stiglitz's idea and model will be worth keeping in mind and/or following up though.

Corporate savings are the inverse of government deficits: implications

At the moment both government deficits and corporate savings are high. It is non-obvious but there is a close relationship between these quantities:

Let corporate profits, P = corporate savings, S + dividends, d
These profits are generated by paying wages to the labour force, W, using the capital stock owned by the corporate sector, K, and producing the economic output of the economy, Y i.e. P = Y - W
Households income is wages, W + dividends, d, less taxes, T, and is spent entirely on consumption, C (i.e. we assume all saving is done by the corporate sector).
The government raises taxes, T and buys government purchases, G from the corporate sector, running a deficit, D = G - T.
The corporate sector can also 'buy' some output from themselves to augment the capital stock, i.e. investment, I is used to increase K.

These relationships can be combined:

P = S + d = Y - W = C + G + I - W = W + d - T + G + I - W = d + D + I
i.e. S = D + I

Therefore, corporate savings is, under some assumptions, equal to government deficits + corporate investment. So when we see corporate savings as the mirror image of government deficits then all we're really seeing is constant (and very low) corporate investment.

This is just accounting, so there's no consideration of incentives or causality here. A freshwater/conservative reading of the current situation might be something like: we take corporate savings as given and governments choose the level of deficit that they run. Therefore government deficits cause the lack of corporate investment by providing an alternative home for these savings.

My reading of the situation is more like, governments choose the level of their spending, G, and they choose the tax rate - but the level of economic activity ultimately determines the tax revenue, T and so deficit, D is endogenous. Expectations of demand determine corporate investment I. Therefore low demand expectations means low investment and is strongly suggestive of low tax take and so high deficits. Corporate savings is still the sum of D and I, but these are driven in opposite directions by demand expectations. If larger government spending now was such that demand expectations were boosted to a level that raised investment, then any inertia in corporate savings would require that the deficit was actually reduced by the increased government spending. Chris Dillow has a post on this too: I don't completely agree with his take on Labour's fiscal policies during the 00's since, given global imbalances it must have been possible to realise that government revenues from the financial sector were not sustainable. If this income had been spent on capital investment rather than revenue spending then his argument is fine though.

Of course it could be that there is no inertia in corporate savings, and so the increase in investment could be accompanied by an increase in corporate savings. This could be achieved by a reduction in dividends - probably reducing tax take and increasing the deficit - and so a reduction in private consumption i.e. higher government consumption merely crowds out private consumption. However, this implies that an economy with unemployed resources chooses to meet an increase in demand from the government by reducing private demand. Quite possible that unemployed resources are used to meet the increase in demand which would allow investment to increase without corporate savings increasing, requiring that the deficit falls.

Again, if we want the investment, required to mitigate resource constraints and climate change, to actually be made, we need to ensure demand is maintained. 

Statement of Investment Principles

Idea: get pension fund trustees to explicitly state their investment views on savings that fund consumption now (and in return you get an IOU which says that the consumer will pay you back essentially from future growth), against savings that fund investment now - and actually generate the productive infrastructure for that future growth.

It should be possible for people to invest their pensions in e.g. solar panels, rather putting money into the stock market where corporations are supposedly already sitting on a huge cash pile that they don't know what to do with. Especially at the moment when attitudes must be fairly dead set against such investment ("some of that investment will be in the big bad banks wooooo")

Basically interested in generalising something like this to pre-retirement savings as well as lump sum cash.

Exactly

The media coverage of the S&P downgrade was utterly dreadful. Markets did not fall on fears over US debt. If they had then the price of this debt would have fallen. It rose. Instead markets fell because the S&P downgrade makes the political case for more austerity seem stronger (hand in hand with the dreadful media coverage), this makes expected growth (even) lower which hits stock markets and makes government debt seem like a good investment.

The best commentary on the subject can be found at:
Exactly, exactly & exactly.

A semantic dispute about the reasons behind the financial crisis?

Steve Randy Waldman provides a convincing explanation of how bank and sovereign behaviour interacted to cause the financial crisis. But he seems to be writing this as a critique of Tyler Cowan's theory that the crisis was caused by the “we thought we were wealthier than we were” mechanism. I think perhaps this could be resolved simply by accepting that Waldman's story is what lead to aggregate behaviour that was equivalent to "us" (or to our "representative agent") behaving as if we thought we were wealthier than we actually were. See also Chris Dillow .

My view is that there was a lot of (effective) "we thought we were wealthier than we were" behaviour over the 00's - for whatever reason. This imagined wealth increase lead to households making a portfolio rebalancing decision to lever up against this higher value for our assets (houses), and so to collectively borrow to consume. The financial crisis was caused when commodity supply constraints (a small supply shock) lead to price pressures (eventually $140 oil) which lead to an effective re-evaluation of our wealth and a consequent massive retrenchment (large demand shock). The appropriate policy now is Keynesian demand creation, as per Krugman, to maintain employment and allow households to repair their balance sheets. This provides a tremendous opportunity for public direction of investment whilst the state is taking up the slack and it should be 100% piled into energy investments since that relatively small supply constraint is only going to grow.

Austerity is completely the wrong response.