Category Archives: Economics 101

We’re being hurt by the fixation on economic growth at all costs – Larry Elliott. 

There had never been anything quite like the thick “pea-souper” fog that blanketed London 65 years ago. The wind dropped and the air grew damp. For five days, smoke from coal fires and power stations was trapped, making it hard to breathe. For the frail and elderly what became known as the Great Smog was deadly. Initial estimates put the death toll at 4,000.

The coal burned in the capital in 1952 turned the city into a deathtrap, but it was good for growth. It was cold and damp as well as foggy, and the more fuel that was bought, the better it was for the economy.

The same applies today. A thinktank, the New Weather Institute, estimates there will already have been 8,700 premature UK deaths this year caused by air pollution by the time of next week’s 65th anniversary. Some of them would have been avoided had more people worked from home or shared cars to the office. That would have meant fewer cars on the roads and less money spent at petrol stations. It would be good for the nation’s health but would reduce gross domestic product. As currently calculated, it would be bad for growth.

This is perverse. It is clear from the great smogs that engulfed Beijing in 2015 and New Delhi earlier this month that not all growth is good. Globally, one person dies ahead of their time every five seconds due to poor air quality. Yet the idea that success can only be measured by gross domestic product has become a fetish. When growth accelerates, it is a time for national celebration. When growth remains unchanged it is a cause for concern. When growth falls it is a time for the newsreaders to put on a long face.

Hence the response to last week’s budget, in which the Office for Budget Responsibility shaved around half a percentage point off its growth forecasts in each of the next five years. This was seen, unambiguously, as a very bad thing indeed. Commentators (me included, I hasten to add) vied with each other to find new ways of describing just how terrible it was.

Now, make no mistake, when it comes to the UK economy there is plenty to be concerned about. It is a worry that for the past decade Britain has had to work so hard just to stand still. It matters that people are taking on more debt to finance their spending habits. It is not a great idea to be investing so little and importing so much.

But it is absurd to believe that GDP provides the best – or even an accurate – picture of how well the country is really doing. Since the financial crisis, GDP has been going up, largely due to the increase in the size of the population. GDP per head is a better measure, but even then takes no account of how the growth is being divvied up. In recent decades the fruits of growth have largely been snaffled by those at the top.

GDP acts as a yardstick for things that can be measured in monetary terms, so it goes up if the defence sector exports more arms, if the City embarks on an orgy of speculation, or if betting shops double the number of fixed odds terminals. Simon Kuznets, the economist who first came up with the idea of GDP, had a point when he said it should exclude harmful things, such as military spending and advertising.

Bobby Kennedy agreed. On the campaign stump in 1968, he famously said GDP measured everything except that which made life worthwhile. “It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armoured cars for the police to fight the riots in our cities.”

The latest GDP figure shows Britain’s economy grew by 0.4% in the third quarter of 2017. The figure includes all the things Kuznets and Kennedy abhorred, but excludes quite a lot of good things that are not counted because they are done for free.

The government could increase the size of the economy by 50% at a stroke if it included all the cleaning, cooking, childcare and other tasks around the house that are done for free. If your neighbour pays you to mow his lawn, that counts as GDP. If you mow your own lawn, it doesn’t.

At one level, the strange way in which success or failure is measured doesn’t matter all that much. As the chief economist at the Bank of England, Andy Haldane, noted in a speech earlier this week, only 10% of the public can actually define GDP. What’s more, it doesn’t seem to care too much about whether it is going up or down.

In the year or so since the EU referendum, the debate about Brexit has been framed by what the vote has meant for GDP. In the first six months, the Brexiteers thought they had the upper hand because growth averaged 0.5% a quarter. In the first half of 2017, remainers thought the pendulum had swung their way because growth slowed to 0.3%.

Both sides were assuming that people can differentiate between an economy growing by 2% a year and one growing by 1%, which they almost certainly can’t. A more relevant guide to attitudes was the recent official survey showing that the public (in England at least) got a bit happier in the year after the referendum. This probably has something to do with the continued fall in unemployment, which research has shown is more closely linked to personal wellbeing than inflation. It is, of course, possible that happiness would have been still higher had the referendum gone the other way.

But the constant use of GDP does matter because it creates a “growth at all costs” mindset. A report by the Institute for New Economic Thinking at the Oxford Martin School suggests that the upshot is the depletion of the natural world, which is not being measured or valued properly. “There is clear evidence of widespread ecosystem degradation and declining resilience in food and water systems,” it says.

In recent years there has been some recognition of the need to find a better way of measuring how things are going. There are now alternative measures of wellbeing, including national accounts that consider environmental damage. But they have not gone nearly far enough to challenge the tyranny of GDP, which is why the clincher in any argument about the economy is still that something is “bad for growth”.

As American writer Edward Abbey put it in his 1977 book The Journey Home: “Growth for the sake of growth is the ideology of the cancer cell.” He could not have been more right.

The Guardian

Rescuing Economics from Neoliberalism – Dani Rodrik. 

As even its harshest critics concede, neoliberalism is hard to pin down. In broad terms, it denotes a preference for markets over government, economic incentives over social or cultural norms, and private entrepreneurship over collective or community action. It has been used to describe a wide range of phenomena—from Augusto Pinochet to Margaret Thatcher and Ronald Reagan, from the Clinton Democrats and Britain’s New Labour to the economic opening in China and the reform of the welfare state in Sweden. 

The term is used as a catchall for anything that smacks of deregulation, liberalization, privatization, or fiscal austerity. Today it is reviled routinely as a short-hand for the ideas and the practices that have produced growing economic insecurity and inequality, led to the loss of our political values and ideals, and even precipitated our current populist backlash.

We live in the age of neoliberalism, apparently. But who are neoliberalism’s adherents and disseminators—the neoliberals? Oddly, you would almost have to go back to the early 1980s to find anyone explicitly embracing neoliberalism. In 1982, Charles Peters, the longtime editor of The Washington Monthly, published an essay called “A Neo-Liberal’s Manifesto.” It makes for interesting reading thirty-five years later, since the neoliberalism it describes bears little resemblance to today’s target of derision. The politicians whom Peters names as exemplifying the movement are not Thatcher and Reagan, but Bill Bradley, Gary Hart, and Paul Tsongas. The journalists and academics whom he lists include James Fallows, Michael Kinsley, and Lester Thurow. Peters’s neoliberals are liberals (in the U.S. sense of the word) who have dropped their prejudices in favor of unions and big government and against markets and the military.

The use of the term “neoliberal” exploded in the 1990s, when it became closely associated with two developments, neither of which Peters mentions. One was financial deregulation, which would culminate in the 2008 financial crash—the first that the United States had experienced since the interwar period—and in the still-lingering euro debacle. The second was economic globalization, which accelerated thanks to free flows of finance and to a new, more ambitious type of trade agreement. Financialization and globalization have become the most overt manifestations of neoliberalism in today’s world.

That neoliberalism is a slippery, shifting concept, with no explicit lobby of defenders, does not mean that it is irrelevant or unreal. Who can deny that the world has experienced a decisive shift toward markets from the 1980s on? Or that center-left politicians—Democrats in the United States, Socialists and Social Democrats in Europe—enthusiastically adopted some of the central creeds of Thatcherism and Reaganism, such as deregulation, privatization, financial liberalization, and individual enterprise? Much of our contemporary policy discussion remains infused with norms and principles supposedly grounded in homo economicus.

But the looseness of the term neoliberalism also means that criticism of it often misses the mark. There is nothing wrong with markets, private entrepreneurship, or incentives—when deployed appropriately. Their creative use lies behind the most significant economic achievements of our time. As we heap scorn on neoliberalism, we risk throwing out some of neoliberalism’s useful ideas.

The real trouble is that mainstream economics shades too easily into ideology, constraining the choices that we appear to have and providing cookie-cutter solutions. A proper understanding of the economics that lies behind neoliberalism would allow us to identify—and to reject—ideology when it masquerades as economic science. Most importantly it would help us develop the institutional imagination we badly need to redesign capitalism for the twenty-first century.   

Neoliberalism is typically understood as based on key tenets of mainstream economic science. To see those tenets, without the ideology, consider a thought experiment.

A well-known and highly regarded economist lands in a country he has never visited and knows nothing about. He is brought to a meeting with the country’s leading policymakers. “Our country is in trouble,” they tell him. “The economy is stagnant, investment is low, and there is no growth in sight.” They turn to him expectantly: “Please tell us what we should do to make our economy grow.”

The economist pleads ignorance and explains that he knows too little about the country to make any recommendations. He would need to study the history of the economy, to analyze the statistics, and to travel around the country before he could say anything. But his hosts are insistent. “We understand your reticence and we wish you had the time for all that,” they tell him. “But isn’t economics a science, and aren’t you one of its most distinguished practitioners? Even though you do not know much about our economy, surely there are some general theories and prescriptions you can share with us to guide our economic policies and reforms.”

The economist is now in a bind. He does not want to emulate those economic gurus he has long criticized for peddling their favorite policy advice. But he feels challenged by the question. Are there universal truths in economics? Can he say anything valid (and possibly useful)?

So he begins. The efficiency with which an economy’s resources are allocated is a critical determinant of the economy’s performance, he says. Efficiency, in turn, requires aligning the incentives of households and businesses with social costs and benefits. The incentives faced by entrepreneurs, investors, and producers are particularly important when it comes to economic growth. Growth needs a system of property rights and contract enforcement that will ensure those who invest can retain the returns on their investments. And the economy must be open to ideas and innovations from the rest of the world.

But economies can be derailed by macroeconomic instability, he goes on. Governments must therefore pursue a sound monetary policy, which means restricting the growth of liquidity to the increase in nominal money demand at reasonable inflation. They must ensure fiscal sustainability, so that the increase in public debt does not outpace national income. And they must carry out prudential regulation of banks and other financial institutions to prevent the financial system from taking excessive risk.

Now he is warming up to his task. Economics is not just about efficiency and growth, he adds. Economic principles also carry over to equity and social policy. Economics has little to say about how much redistribution a society should seek. But it does tell us that the tax base should be as broad as possible and that social programs should be designed in a way that does not encourage workers to drop out of the labor market.

By the time the economist stops, it appears as if he has laid out a full-fledged neoliberal agenda. A critic in the audience will have heard all the code words: efficiency, incentives, property rights, sound money, fiscal prudence. Yet the universal principles that the economist describes are in fact quite open-ended. They presume a capitalist economy—one in which investment decisions are made by private individuals and firms—but not much beyond that. They admit—indeed they require—a surprising variety of institutional arrangements.

So has the economist just delivered a neoliberal screed? We would be mistaken to think so, and our mistake would consist of associating each abstract term—incentives, property rights, sound money—with a particular institutional counterpart. And therein lies the central conceit, and the fatal flaw, of neoliberalism: the belief that first-order economic principles map onto a unique set of policies, approximated by a Thatcher–Reagan-style agenda.  

Consider property rights. They matter insofar as they allocate returns on investments. An optimal system would distribute property rights to those who would make the best use of an asset and afford protection against those most likely to expropriate the returns. Property rights are good when they protect innovators from free riders, but they are bad when they protect them from competition. Depending on the context, a legal regime that provides the appropriate incentives can look quite different from the standard U.S. style regime of private property rights.

This may seem like a semantic point with little practical import; but China’s phenomenal economic success is largely due to its orthodox-defying institutional tinkering. China turned to markets, but did not copy Western practices in property rights. Its reforms produced market-based incentives through a series of unusual institutional arrangements that were better adapted to the local context. Rather than move directly from state to private ownership, for example, which would have been stymied by the weakness of the prevailing legal structures, the country relied on mixed forms of ownership that provided more effective property rights for entrepreneurs in practice. Township and Village Enterprises (TVEs), which spearheaded Chinese economic growth during the 1980s, were collectives owned and controlled by local governments. Even though they were publicly owned, entrepreneurs received the protection against expropriation they needed. Local governments had a direct stake in the profits of the firms and hence did not want to kill the goose that lays the golden eggs.

China relied on a range of such innovations, each delivering the economist’s higher-order economic principles in unfamiliar institutional arrangements. Dual-track pricing, which retained compulsory grain deliveries to the state but allowed farmers to sell excess produce in free markets, provided supply-side incentives while insulating public finances from the adverse effects of full liberalization. The so-called Household Responsibility System gave farmers the incentive to invest in and improve the land they worked on, while obviating the need for explicit privatization. Special economic zones provided export incentives and attracted foreign investors without removing protection for state firms (and hence safeguarding domestic employment). In view of such departures from orthodox blueprints, calling China’s economic reforms a neoliberal turn, as critics are inclined to do, distorts more than it reveals. If we are to call this neoliberalism, we must surely look more kindly on the ideas behind the most dramatic poverty reduction in history.

One might protest that China’s institutional innovations were purely transitional. Perhaps it will have to converge on Western-style institutions to sustain its economic progress. But this common line of thinking overlooks the diversity of capitalist arrangements that still prevails among advanced economies, despite the considerable homogenization of our policy discourse.

What, after all, are Western institutions? The importance of the public sector, for example, in the club of rich Organization For Economic Cooperation and Development (OECD) countries varies from a third of the economy in Korea to nearly 60 percent in Finland. In Iceland, 86 percent of workers are members of a trade union; the comparable number in Switzerland is just 16 percent. In the United States firms can fire workers almost at will; French labor laws require employers to jump through many hoops first. Stock markets have grown to nearly one-and-a-half times national income in the United States; in Germany, they are only a third as large, representing one-half of national income.

The idea that any one of these models of taxation, labor relations, or financial organization is inherently superior to the others is belied by the varying economic fortunes that each of these economies have experienced over recent decades. The United States has gone through successive periods of angst in which its economic institutions were judged inferior to those in Germany, Japan, China, and now possibly Germany again. Certainly comparable levels of wealth and productivity can be produced under very different models of capitalism. We might even go a step further: today’s prevailing models probably come nowhere near exhausting the range of what might be possible (and desirable) in the future. 

The visiting economist in our thought experiment knows all this and recognizes that the principles he has enunciated need to be filled in with institutional detail before they become operational. Property rights? Yes, but how? Sound money? Of course, but how? It would perhaps be easier to criticize his list of principles for being vacuous than to denounce it as a neoliberal screed.

Still, these principles are not entirely content free. China, and indeed all countries that managed to develop rapidly, demonstrate their utility once they are properly adapted to local context. Conversely, too many economies have been driven to ruin courtesy of political leaders who chose to violate them. We need look no further than Latin American populists or Eastern European communist regimes to appreciate the practical significance of sound money, fiscal sustainability, and private incentives.

Of course economics goes beyond a list of abstract, largely common sense principles. Much of the work of economists consists of developing stylized models of how actual economies work and then confronting those models with evidence. Economists tend to think of what they do as progressively refining their understanding of the world: their models are supposed to get better and better as they are tested and revised over time. But progress in economics happens differently.

Economists study a social reality that is unlike the physical universe of natural scientists. It is completely man-made, highly malleable, and operates according to different rules across time and space. Economics advances not by settling on the right model or theory to answer such questions, but by improving our understanding of the diversity of causal relationships. Neoliberalism and its customary remedies—always more markets, always less government—are in fact a perversion of mainstream economics. Good economists know that the correct answer to any question in economics is: it depends.

Does an increase in the minimum wage depress employment? Yes, if the labor market is really competitive and employers have no control over the wage they must pay to attract workers; but not necessarily otherwise. Does trade liberalization increase economic growth? Yes, if it increases the profitability of industries where the bulk of investment and innovation takes place; but not otherwise. Does more government spending increase employment? Yes, if there is slack in the economy and wages do not rise; but not otherwise. Does monopoly harm innovation? Yes and no, depending on a whole host of market circumstances.

In economics, new models rarely supplant older models. The basic competitive-markets model dating back to Adam Smith has been modified over time by the inclusion, in rough historical order, of monopoly, externalities, scale economies, incomplete and asymmetric information, irrational behavior, and many other real world features. Yet the older models remain as useful as ever. Understanding how real markets operate necessitates different lenses at different times.

Perhaps maps offer the best analogy. Just like economic models, maps are highly stylized representations of reality. They are useful precisely because they abstract from many real world details that would get in the way. Realistic full-scale maps would be hopelessly impractical artifacts, as Jorge Luis Borges described in a short story that remains the best and most succinct explication of the scientific method. But abstraction also implies that we need a different map depending on the nature of our journey. If we are traveling by bike, we need a map of bike trails. If we are to go on foot, we need a map of foot paths. If a new subway is constructed, we will need a subway map—but we wouldn’t throw out the older maps.      

Economists tend to be very good at making maps, but not good enough at choosing the one most suited to the task at hand. When confronted with policy questions of the type our visiting economist faces, too many of them resort to “benchmark” models that favor laissez-faire. Knee-jerk solutions and hubris replace the richness and humility of the discussion in the seminar room. John Maynard Keynes once defined economics as the “science of thinking in terms of models joined to the art of choosing models which are relevant.” Economists typically have trouble with the “art” part.

I have illustrated this too with a parable. A journalist calls an economics professor for his view on whether free trade is a good idea. The professor responds enthusiastically in the affirmative. The journalist then goes undercover as a student in the professor’s advanced graduate seminar on international trade. He poses the same question: Is free trade good? This time the professor is stymied. “What do you mean by ‘good?’” he responds. “And good for whom?” The professor then launches into an extensive exegesis that will ultimately culminate in a heavily hedged statement: “So if the long list of conditions I have just described are satisfied, and assuming we can tax the beneficiaries to compensate the losers, freer trade has the potential to increase everyone’s well being.” If he is in an expansive mood, the professor might add that the effect of free trade on an economy’s long-term growth rate is not clear either and would depend on an altogether different set of requirements.

This professor is rather different from the one the journalist encountered previously. On the record, he exudes self-confidence, not reticence, about the appropriate policy. There is one and only one model, at least as far as the public conversation is concerned, and there is a single correct answer regardless of context. Strangely, the professor deems the knowledge that he imparts to his advanced students to be inappropriate (or dangerous) for the general public. Why?

The roots of such behavior lie deep in the sociology and the culture of the economics profession. But one important motive is the zeal to display the profession’s crown jewels in untarnished form—market efficiency, the invisible hand, comparative advantage—and to shield them from attack by self-interested barbarians, namely the protectionists. Unfortunately, these economists typically ignore the barbarians on the other side of the issue—financiers and multinational corporations whose motives are no purer and who are all too ready to hijack these ideas for their own benefit.

As a result, economists’ contributions to public debate are often biased in one direction, in favor of more trade, more finance, and less government. That is why economists have developed a reputation as cheerleaders for neoliberalism, even if mainstream economics is very far from a paean to laissez-faire. The economists who let their enthusiasm for free markets run wild are in fact not being true to their own discipline.

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How then should we think about globalization in order to liberate it from the grip of neoliberal practices? We must begin by understanding the positive potential of global markets. Access to world markets in goods, technologies, and capital has played an important role in virtually all of the economic miracles of our time. China is the most recent and powerful reminder of this historical truth, but it is not the only case. Before China, similar miracles were performed by South Korea, Taiwan, Japan, and a few non-Asian countries such as Chile and Mauritius. All of these countries embraced globalization rather than turn their backs on it, and they benefited handsomely.

Defenders of the existing economic order will quickly point to these examples when globalization comes into question. What they will fail to say is that almost all of these countries joined the world economy by violating neoliberal strictures. China shielded its large state sector from global competition, establishing special economic zones where foreign firms could operate with different rules than in the rest of the economy. South Korea and Taiwan heavily subsidized their exporters, the former through the financial system and the latter through tax incentives. All of them eventually removed most of their import restrictions, long after economic growth had taken off. But none, with the sole exception of Chile in the 1980s under Pinochet, followed the neoliberal recommendation of a rapid opening­-up to imports. Chile’s neoliberal experiment eventually produced the worst economic crisis in all of Latin America. While the details differ across countries, in all cases governments played an active role in restructuring the economy and buffeting it from a volatile external environment. Industrial policies, restrictions on capital flows, and currency controls—all prohibited in the neoliberal playbook—were rampant.

By contrast, countries that stuck closest to the neoliberal model of globalization were sorely disappointed. Mexico provides a particularly sad example. Following a series of macroeconomic crises in the mid-1990s, Mexico embraced macroeconomic orthodoxy, extensively liberalized its economy, freed up the financial system, sharply reduced import restrictions, and signed the North American Free Trade Agreement (NAFTA). These policies did produce macroeconomic stability and a significant rise in foreign trade and internal investment. But where it counts—in overall productivity and economic growth—the experiment failed. Since undertaking the reforms, overall productivity in Mexico has stagnated, and the economy has underperformed even by the undemanding standards of Latin America.

These outcomes are not a surprise from the perspective of sound economics. They are yet another manifestation of the need for economic policies to be attuned to the failures to which markets are prone, and to be tailored to the specific circumstances of each country. No single blueprint fits all.

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Before globalization took a turn towards what we might call hyper-globalization, the rules were flexible and recognized this fact. Keynes and his colleagues viewed international trade and investment as a means for achieving domestic economic and social goals—full employment and broad-based prosperity—when they designed the global economic architecture in Bretton Woods in 1944. From the 1990s on, however, globalization became an end in itself. Global economic arrangements were now driven by a single-minded focus on reducing impediments to the flows of goods, capital, and money across national borders—though not of workers, where the economic gains in fact would have been much larger. 

This perversion of priorities revealed itself in the way trade agreements began to reach behind borders and remake domestic institutions. Investment regulations, health and safety rules, environmental policies, and industrial promotion schemes all became potential targets for abolition if they were deemed to stand in the way of foreign trade and investment. Large international firms, rendered footloose by the new rules, acquired special privileges. Corporate taxes had to be lowered to attract investors (or prevent them from leaving). Foreign enterprises and investors were given the right to sue national governments in special offshore tribunals when changes in domestic regulations threatened to reduce their profits. Nowhere was the new deal more damaging than in financial globalization, which produced not greater investment and growth, as promised, but one painful crash after another.

Just as economics must be saved from neoliberalism, globalization has to be saved from hyper-globalization. An alternative globalization, more in keeping with the Bretton Woods spirit, is not difficult to imagine: a globalization that recognizes the multiplicity of capitalist models and therefore enables countries to shape their own economic destinies. Instead of maximizing the volume of trade and foreign investment and harmonizing away regulatory differences, it would focus on traffic rules that manage the interface of different economic systems. It would open up policy space for advanced countries as well as developing ones—the former so they can reconstruct their social bargains through better social, tax, and labor market policies, and the latter so they can pursue the restructuring they need for economic growth. It would require more humility on the part of economists and policy technocrats about appropriate prescriptions, and hence a much greater willingness to experiment.

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As Peters’s early manifesto attests, the meaning of neoliberalism has changed considerably over time as the label has acquired harder-line connotations with respect to deregulation, financialization, and globalization. But there is one thread that connects all versions of neoliberalism, and that is the emphasis on economic growth. Peters wrote in 1982 that the emphasis was warranted because growth is essential to all our social and political ends—community, democracy, prosperity. Entrepreneurship, private investment, and removing obstacles (such as excessive regulation) that stand in the way were all instruments for achieving economic growth. If a similar neoliberal manifesto were penned today, it would no doubt make the same point.

Critics often point out that this emphasis on economics debases and sacrifices other important values such as equality, social inclusion, democratic deliberation, and justice. Those political and social objectives obviously matter enormously, and in some contexts they matter the most. They cannot always, or even often, be achieved by means of technocratic economic policies; politics must play a central role.

But neoliberals are not wrong when they argue that our most cherished ideals are more likely to be attained when our economy is vibrant, strong, and growing. Where they are wrong is in believing that there is a unique and universal recipe for improving economic performance to which they have access. The fatal flaw of neoliberalism is that it does not even get the economics right. It must be rejected on its own terms for the simple reason that it is bad economics.

Boston Review 

The General Theory at 80: Reflections on the History and Enduring Relevance of Keynes’ Economics – Matias Vernengo. 

New paper by Thomas Palley. From the abstract:

This paper reflects on the history and enduring relevance of Keynes’ economics. Keynes unleashed a devastating critique of classical macroeconomics and introduced a new replacement schema that defines macroeconomics. The success of the Keynesian revolution triggered a counter-revolution that restored the classical tradition and now enforces a renewed classical monopoly. That monopoly has provided the intellectual foundations for neoliberalism which has produced economic and political conditions echoing the 1930s. Openness to Keynesian ideas seems to fluctuate with conditions, and current conditions are conducive to revival of the Keynesian revolution. However, a revival will have to overcome the renewed classical monopoly.

Read full paper here.

Naked Capitalism 

The Moral Identity of Homo Economicus – Ricardo Hausmann.

Two recent books indicate that a quiet revolution is challenging the foundations of the dismal science, promising radical changes in how we view many aspects of organizations, public policy, and even social life. As with the rise of behavioral economics, this revolution emanates from psychology.

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CAMBRIDGE – Why do people vote, if doing so is costly and highly unlikely to affect the outcome? Why do people go above and beyond the call of duty at their jobs?

Two recent books – Identity Economics by Nobel laureate George Akerlof and Rachel Kranton and The Moral Economy by Sam Bowles – indicate that a quiet revolution is challenging the foundations of the dismal science, promising radical changes in how we view many aspects of organizations, public policy, and even social life. As with the rise of behavioral economics (which already includes six Nobel laureates among its leaders), this revolution emanates from psychology. But while behavioral economics relies on cognitive psychology, this one is rooted in moral psychology.

As with most revolutions, this one is not happening because, as Thomas Huxley surmised, a beautiful old theory has been killed by ugly new facts. The ugly facts have been apparent for a while, but people cannot abandon one mental framework unless another one can take its place: in the end, beautiful old theories are killed only by newer, more powerful theories.

For a long time, economic theory aspired to the elegance of Euclidean geometry, where all true statements can be derived from five apparently incontrovertible axioms, such as the notion that there is only one line that connects two points in space. In the nineteenth century, mathematicians explored the consequences of relaxing one of those axioms and discovered the geometries of curved spaces, where an infinite number of longitudinal lines can pass through the poles of a sphere.

The axioms underpinning traditional economics embody a view of human behavior known as homo economicus: we choose among the available options that which we want or prefer the most. But what makes us want or prefer something?

Economics has long assumed that whatever informs our preferences is exogenous to the issue at hand: de gustibus non est disputandum, as George Stigler and Gary Becker argued. But with a few reasonable assumptions, such as the idea that more is better than less, you can make many predictions about how people will behave.

The behavioral economics revolution questioned the idea that we are good at making these judgments. In the process, they subjected the assumptions underlying homo economicus to experimental tests and found them wanting. But this led at most to the idea of nudging people into better decisions, such as forcing them to opt out of rather than into better choices.

The new revolution may have been triggered by an uncomfortable finding of the old one. Consider the so-called ultimatum game, in which a player is given a sum of money, say, $100. He must offer a share of that money to a second player. If the latter accepts the offer, both get to keep the money. If not, they both get nothing.

Homo economicus would give $1 to the second player, who should accept the offer, because $1 is better than zero dollars. But people throughout the world tend to reject offers below $30. Why?

The new revolution assumes that when we make choices, we do not merely consider which of the available options we like the most. We are also asking ourselves what we ought to do.

In fact, according to moral psychology, our moral sentiments, on which Adam Smith wrote his other famous book, evolved to regulate behavior. We are the most cooperative species on earth because our feelings evolved to sustain cooperation, to put “us” before “me.” These feelings include guilt, shame, outrage, empathy, sympathy, dread, disgust, and a whole cocktail of other sentiments. We reject offers in the ultimatum game because we feel they are unfair.

Akerlof and Kranton propose a simple addition to the conventional economic model of human behavior. Besides the standard selfish elements that define our preferences, they argue that people see themselves as members of “social categories” with which they identify. Each of these social categories – for example, being a Christian, a father, a mason, a neighbor, or a sportsman – has an associated norm or ideal. And, because people derive satisfaction from behaving in accordance with the ideal, they behave not just to acquire, but also to become.

Bowles shows that we have distinct frameworks for analyzing situations. In particular, giving people monetary incentives may work in market-like situations. But, as a now-famous study of Haifa daycare centers showed, imposing fines on people who picked up their kids late actually had the opposite effect: if a fine is like a price, people may find that it is a price worth paying.

But without the fine, coming late constitutes impolite, rude, or disrespectful behavior toward the caregivers, which self-respecting people would avoid, even without fines. Unfortunately, this other-regarding view of behavior has been de-emphasized both in the corporate and the public domain. Instead, strategies have been derived from the view that all our behaviors are selfish, with the intellectual challenge being to design “incentive-compatible” mechanisms or contracts, an effort that has also been recognized with Nobel Prizes.

But, as George Price showed long ago, Darwinian evolution may have made us altruistic, at least toward people we perceive as members of the group we call “us.” The new revolution in economics may find a place for strategies based on affecting ideals and identities, not just taxes and subsidies. In the process, we may understand that we vote because that is what citizens ought to do, and we excel at our jobs because we strive for respect and self-realization, not just a raise.

If successful, the new revolution may lead to strategies that make us more responsive to our better angels. Economics and our view of human behavior need not be dismal. It may even become inspirational.

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Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is Director of the Center for International Development at Harvard University and a professor of economics at the Harvard Kennedy School.

Project Syndicate

How the actual magic money tree works – Zoe Williams.

Shock data shows that most UK MPs do not know how money is created. Responding to a survey commissioned by Positive Money just before the June election, 85% were unaware that new money was created every time a commercial bank extended a loan, while 70% thought that only the government had the power to create new money.

The results are only a shock if you didn’t see the last poll of MPs on exactly this topic, in 2014, revealing broadly the same level of ignorance. Indeed, the real shock is that MPs still, without embarrassment, answer surveys.

Yet almost all our hot-button political issues, from social security to housing, relate back to the meaning and creation of money; so if the people making those choices don’t have a clue, that isn’t without consequence.

How is money created?

Some is created by the state, but usually in a financial emergency. For instance, the crash gave rise to quantitative easing – money pumped directly into the economy by the government. The vast majority of new money (97%) comes into being when a commercial bank extends a loan. Meanwhile, 27% of bank lending goes to other financial corporations; 50% to mortgages (mainly on existing residential property); 8% to high-cost credit (including overdrafts and credit cards); and just 15% to non-financial corporates, that is, the productive economy.

What’s wrong with that?

On the corporate financial side, bank-lending inflates asset prices, which concentrates wealth in the hands of the wealthy. On the mortgage side, house prices rise to meet the amount the lender is prepared to lend, rather than being moored to wages. The lender benefits enormously from larger mortgages and longer periods of indebtedness; the homeowner benefits slightly from a bigger asset, but obviously spends longer in debt servitude; the renter loses out completely.

Is there a magic money tree?

All money comes from a magic tree, in the sense that money is spirited from thin air. There is no gold standard. Banks do not work to a money-multiplier model, where they extend loans as a multiple of the deposits they already hold. Money is created on faith alone, whether that is faith in ever-increasing housing prices or any other given investment. This does not mean that creation is risk-free: any government could create too much and spawn hyper-inflation. Any commercial bank could create too much and generate over-indebtedness in the private economy, which is what has happened. But it does mean that money has no innate value, it is simply a marker of trust between a lender and a borrower. So it is the ultimate democratic resource. The argument marshalled against social investment such as education, welfare and public services, that it is unaffordable because there is no magic money tree, is nonsensical. It all comes from the tree; the real question is, who is in charge of the tree?

What could we do instead?

We could do QE for the people, overt monetary financing in which a government creates money for social benefit, such as green infrastructure or education. Or helicopter money, a central bank distributing it to everyone, either in a one-off citizen’s dividend or a regular citizen’s basic income. The nature of centrally created money should itself be opened up for debate, whose starting point is: if we agree that commercially created money is skewing the economy, can we then agree that it should be created by a public authority, even if we don’t yet know what that authority would look like.

The Guardian

ARE WE AS BRAVE AS LABOUR IN THE 1930s?- Bryan Gould.

New Zealanders like to think that we are, in most respects, up with – if not actually ahead of – the play. Sadly, however, as a new government is about to emerge, there is no sign that our politicians and policymakers are aware of recent developments in a crucial area of policy, and that, as a result, we are in danger of missing out on opportunities that others have been ready to take.

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The story starts, at least in its most recent form, with two important developments. First, there is the now almost universal recognition that the vast majority of money in circulation is not – as most people once believed – notes and coins issued on behalf of the government by the Reserve Bank, but is actually created by the commercial banks through the credit they advance, using bank entries rather than cash, and usually on mortgage.

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The truth of this proposition, so long denied, is now explicitly accepted by the Bank of England, and was – as long ago as 1994 – explained in a letter written by our own Reserve Bank to an enquirer, and stating in terms that 97% of the money included in the usually used definition of money known as M3 is created by the commercial banks.

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The proposition is endorsed by the world’s leading monetary economists – Lord Adair Turner, the former chair of the UK’s Financial Services Authority and Professor Richard Werner of Southampton University, to name but two. These men are not snake-oil salesmen, to be easily dismissed. They have been joined by leading financial journalists, such as Martin Wolf of the Financial Times.

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The second development was the use by western governments around the world of “quantitative easing” in the aftermath of the Global Financial Crisis. “Quantitative easing” was a sanitised term to describe what is often pejoratively termed “printing money” – but, whatever it is called, it was new money created at the behest of the government and used to bail out the banks by adding it to their balance sheets.

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These two developments, not surprisingly, generated a number of unavoidable questions about monetary policy. If banks could create billions in new money for their own profit-making purposes, (they make their money by charging interest on the money they create), why could governments not do the same, but for public purposes, such as investment in new infrastructure and productive capacity?

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And if governments were indeed to create new money through “quantitative easing”, why could that new money not be applied to purposes other than shoring up the banks?

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The conventional answer to such questions (and the one invariably given in New Zealand by supposed experts in recent times) is that “printing money” will be inflationary – though it is never explained why it is miraculously non-inflationary when the new money is created by bank loans on mortgage or is applied to bail out the banks.

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But, in any case, the master economist, John Maynard Keynes, had got there long before the closed minds and had carefully explained that new money could not be inflationary if it was applied to productive purposes so that new output matched the increased money supply. Nor was there any reason why the new money should not precede the increased output, provided that the increased output materialised in due course.

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Those timorous souls who doubt the Keynesian argument might care to look instead at practical experience. Franklin Delano Roosevelt used exactly this technique to increase investment in American industry in the year or two before the US entered the Second World War. It was that substantial boost to American industrial capacity that was the decisive factor in allowing the Allies to win the war.

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And the great Japanese (and Keynesian) economist, Osamu Shimomura, (almost unknown in the West), took the same approach in advising the post-war Japanese government on how to re-build Japanese industry in a country devastated by defeat and nuclear bombs.

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The current Japanese Prime Minister, Shinzo Abe, is a follower of Shimomura. His policies, reapplied today, have Japan growing, after years of stagnation, at 4% per annum and with minimal inflation.

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Our leaders, however, including luminaries of both right and left, some with experience of senior roles in managing our economy – and in case it is thought impolite to name them I leave it to you to guess who they are – prefer to remain in their fearful self-imposed shackles, ignoring not only the views of experts and the experience of braver leaders in other countries and earlier times, but – surprisingly enough – denying even our own home-grown New Zealand experience.

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Many of today’s generation will have forgotten or be unaware of the brave and successful initiative taken by our Prime Minister in the 1930s – the great Michael Joseph Savage. He created new money with which he built thousands of state houses, thereby bringing an end to the Great Depression in New Zealand and providing decent houses for young families (my own included) who needed them.

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Who among our current leaders would disown that hugely valuable legacy?

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Bryan Gould, 2 October 2017

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BryanGould.com

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Shares v houses. The winner is clear – Mary Holm.

Question:
You will no doubt have read Brian Gaynor’s recent column in which he says: “Thirty years ago, on Friday, September 18, 1987, the long-standing NZX benchmark index reached an all-time high of 3968.89. This capital index, which is now called the S&P/NZX 50 index, has never returned to this level and is still 8 per cent below its 1987 high.”
This doesn’t quite fit with your mantra that you have to be in the share market for at least 10 years to avoid the lows, does it? However, there have been good dividends on a lot of shares along the way, so all is not totally lost.
Will you admit now that property (including rents) has been the better investment over the past four decades?
Still, I wouldn’t be putting any bets on the property market continuing the ridiculous run of the past few years over the next decade. For the sake of our children, I hope it levels out for a while and gets back to a reasonable ratio to median income.

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No, I won’t “admit” any such thing. As you say, the index Gaynor writes about doesn’t include dividends. And that makes a bigger difference than you apparently realise.

Our graph shows this clearly. Although the New Zealand share index excluding dividends (S&P NZX50 Capital) has indeed gone nowhere since the 87 crash, the index that includes dividends (S&P NZX50 Gross) has quadrupled. And it would have grown a bit more if there had been an index that included dividends in the 1980s. We had only the Barclays Top 40 – which excluded dividends – until 1991.

Why on earth would you exclude dividends in share returns? Some people spend dividends rather than reinvesting them, but they’re still part of the return. Excluding dividends is like excluding rent in rental property returns.

But hang on a minute. Isn’t that what the graph does? The QV Housing Index shows growth of detached housing valuations. Why haven’t we included rent?

When you stop to think about it, that’s not doable. There’s data on average rents. But unlike shares, rental property comes with ongoing expenses such as rates, insurance and maintenance, which can be huge when you have to replace a roof or something.

Also, most landlords – except those who have owned a rental for many years – pay mortgage interest. In fact, many landlords find that expenses including interest total more than rent, and they make ongoing losses. And the tendency for that to happen will increase when mortgage interest rises. Their investments make sense only when they sell the property at a profit.

Taking all this into account, there’s no way to come up with representative numbers for net rental income. On average they will probably be positive, but how big?

All we can say is that the graph shows total returns on New Zealand shares since the end of 1979 are twice as big as house price increases. Shares look a better bet to me.

Okay, you might say, but the graph also shows that shares are much more volatile, adding to risk.

True, most landlords take on a different sort of risk, by borrowing to invest – something that few share investors do.

Borrowing ups the ante. If the investment goes well, you get gains on the bank’s money as well as your own. But what if you’re forced to sell – perhaps because you lose your job – when house prices are down? If your mortgage is bigger than the proceeds of your sale, you can end up with no investment and owing the bank. It happens.

Even if you sell the property at a gain, does it more than cover your losses over the years because of interest and expenses?

The added risk from borrowing can certainly make rental property a bigger worry than shares.

And there are other ways that shares are less risky:

• If you also own your home, your investments are in a different market.

• It’s much easier to spread your risk by owning many different shares than many different properties.

• It’s also much easier to invest offshore, which also spreads risk.

• You can easily drip-feed money into shares, removing the risk that you invest the lot at the top of a cycle.

• If you need some money, you can sell any portion of your share investments. Even if you own several rental properties, you can cash them in only in big lumps.

On top of all that, investing in a wide range of shares or a share fund – the best way to do it – is much less hassle than a rental property. You’re not going to get the 2am phone call from the tenants saying the washing machine has flooded the house, or the news that your tenants have used the house as a P lab.

Then there are the disputes. In 2016, 16,600 landlords and 2300 tenants made complaints to the Tenancy Tribunal, and many more were resolved in mediation. You don’t get that with shares.

Our graph also shows:

• Sometimes the New Zealand and international share markets (MSCI World Accumulated Index) move roughly together, but sometimes they are quite different. New Zealand had the 1980s boom and bust, and world markets had the turn-of-the-century tech bubble bursting. It’s wise to have some of your share investments in local shares and some offshore.

• You write of my “mantra” that nearly always a share market will gain over a 10-year period. In the graph that’s generally true, but with some exceptions. If you invest just before a crash – in the local market in 1987, or the world market in 2000 – you are barely ahead a decade later, although things come right quite soon after.

You can get around this problem by drip-feeding money into shares over time, as happens automatically with KiwiSaver. Then only a small proportion of your money will “fail” the 10-year test.

NZ Herald

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