Jan. 29, 2006
The central bank's continuing obsession with interest rate rises is a consequence of their dogmatic attachment to a theory associated with the concept of the NAIRU, the non accelerating inflation rate of unemployment which argues that any attempt to lower inflation below the natural rate or the NAIRU rate will generate expectations of accelerating inflation in the future.

The origins of this theory go back to Milton Friedman's paper presented at the American Economic Association's annual meeting in 1968. Friedman borrowing the concept of the natural rate from the Swedish economist Knut Wicksell who as early as the end of the nineteeenth and the beginning of the twentieth century had argued for the existence of the natural rate of interest below which one would get inflation argued that in the long run any rate of inflation was compatible with the natural rate of unemployment.(See the discussion of Wicksell`s doctrine in David Laidler`s excellent work, Fabricating the Keynesian Revolution:Studies in the inter-war Literature on Money, the Cycle and Unemployment,Cambridge university Press, 1999 pp.27-34)

(For a thorough discussion of the history of the concept and an alternative approach which I call the natural rate of inflation see Harold Chorney, "Restoring Full Employment:The natural rate of inflation versus the natural rate of unemployment", a paper presented to the Adelphi University Conference on Social Policy as if People Matter, Garden City , New York available on line at www.adelphi.edu/peoplematter/schedule2.php or simply google Harold Chorney and click on the Adelphi entry)

Friedman argued that whatever short run trade offs that might exist with the Phillips curve would be eliminated in the long run when workers realised the illusory benefits of wage increases in an inflationary environment. In other words money illusion would disappear. Because workers initially overestimated the value of their wage they sacrificed leisure time for work and ended up working for lower real wages than they would truly accept if there were no money illusion.

Once money illusion disappeared they would refuse to work for these lower real wages and would demand ever accelerating wage increases to compensate for inflation.Hence, in order to keep the unemployment rate below the natural rate the cost would be accelerating inflation.

This doctrine which is based on a number of heroic assumptions also ignores the fact that when the central bank preempts inflation by diagnosing inflationary expectations it almost always guarantees an accelerating rate of unemployment and a serious recession as a consequence.

In fact, what Friedman and his followers at our central banks have done is re-invent Marx's concept of the reserve army of the unemployed whose role it is to keep inflation low at the cost of unnecessary high unemployment, greater poverty and greater homelessness . (See the excellent discussion of the NAIRU in Dean Baker, The Nairu:Is it a real constraint? , in Dean Baker, Gerald Epstein and Robert Pollin, Globalization and Progressive Economic Policy ,Cambridge university press, 1998 pp369-388. See also Robert Eisner's comment on Baker in Baker et al, pp.388-390.)

An actual econometric study of the NAIRU for 17 OECD countries by Baker and one by Eisner for the US shows that there is little evidence for the existence of the NAIRU as a real as opposed to theoretical constraint. What is real of course, however, is the behaviour of the central banks and their attachment to the concept.

Baker's study analyses data from 1950 to 1995 and Eisner from 1956 to 1995. Both of them do so on a quarterly basis.When Eisner analysed the data on an assymetrical basis separating observations above the NAIRU rate from those below the rate he found that the NAIRU hypothesis was not confirmed."The sums of past inflation co-efficients summed to less than unity,and/or for low unemployment the sums of unemployment co-efficients were close to zero; for regressions with the consumer price index they were even slightly positive. This indicated...that at worst, unemployment below the hypothesized NAIRU would generate a slightly higher equilibrium but not accelerating inflation, and that it might even lower inflation."( P.389 in Baker et al) Eisner goes on to suggest that optimal unemployment rates for the US from the point of view of low inflation and low unemployment are in the 4-5 % range. Only below 4 % does inflation appear to be a significant threat. My view of the Canadian case is that we could achieve unemployment as low as 4.5 to 5 % before having any sort of threat of rapidly rising inflation. This a great deal lower unemployment than what David Dodge and the Bank of Canada are working with when they trigger their increased interest rates.

Unemployment bottomed out at 6.4 % and in fact had only dipped below 7 % when Dodge began increasing the rates.

Its time to drop the NAIRU and get up to date on the virtuous circle of low unemployment and low inflation.A single percentage point reduction in the unemployment rate generates over 100,000 additional jobs for the economy and considerably more GDP.

It really is time to bring monetary policy at the central bank up to date and discard old discredited theories that have cost us unnecessary unemployment, poverty and homelessness.
Posted by Haroldchorneypolecon@me.com at 2:46 PM 0 comments




The British national debt 1690 to 1910
Over the years that I have researched the question of the national debt and its impact upon an economy I have always been astonished at how boldly politicians, journalists and others ignore the lessons of historical experience.

For example, during the great depression of the 1930s one of the principal barriers to the relaunching of the British and North American economies was the obsession in balancing the budget despite the hardship that this act imposed and despite the negative consequences for the economy and the unemployed.In my writings I have drawn upon historical statistics to show that debt to GDP ratios were much higher than the levels reached in recent years and yet despite this the economies recovered and prosperity was restored and the debt ratio eventually dropped.

This was brought about through rapid economic growth and a sharp decline in the rates of unemployment. The notion that economic growth, wealth creation and prosperity are not incompatible with high debt to GDP ratios is crystal clear from the British case. The economic historian James Macdonald in his excellent work A free nation deep in debt makes exactly this point on pages 354-355.

He displays a chart which runs debt as a percentage of the GDP for Great Britain from 1690 to 1910. The ratio begins at 0% in 1690 runs higher and higher in a lurching manner until it peaks at about 300 % of the GDP in the late 1820s and then consistently declines with several brief upticks until it closes at around 20 % in 1910.As Macdonald states the debt was never lower than 100 % of the GDP for the century between 1760 and 1860 and averaged above 150 % from 1780 to 1845. "simplistic notions that national power and national debt are mutually incompatible are disproved by this single historical fact." (p.355)

For it was during this period that Britain became the leading industrial power in the West.Similarly in the twentieth century the British debt to GDP ratio rose to above 200 % and despite this Britain remained an important industrial power with a very high standard of living.
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A theory of inflation
Throughout the history of monetary theory the subject of inflation and the role of the money stock has loomed large. One can go back to Copernicus and discover rudiments of the quantity theory of money .

The doctrine that there was a direct relationship between money stock, its speed of circulation and prices at which goods and services sold in the economy is a very old doctrine. The problem with it and the problem that writers and financial market actors had with the doctrine from John Law in the 18th century to Keynes in the twentieth century was that it developed into a dogma that aserted that any increase in money stock automatically led to price rise or inflation. The original classical statement of the theory that MV=PT argued that since both velocity was so stable so as to be a constant and T (transactions a proxy for output) was because of Say's law and Walras's law also a constant at full employment. Hence there was a direct relationship between money and prices.

The problem was, as Keynes and others pointed out, Say's law that supply always created its own demand was false and Walras's invisible auctioneer who cleared temporary gluts through the process of tâtonnement was not always operational and velocity also varied in unpredictable ways. The consequence then of moving from a barter economy to a money economy was therefore that money was not neutral, could be held for its own sake, markets would not always clear and thus the direct relationship between changes in the money stock and inflation did not always hold.

Instead it is more insightful to consider that money is a vector in the economy that operates along side other vectors to influence economic activity. Sometimes its force acts largely upon output other times largely upon prices but often affects both output and prices. Since the economy is measured by P*O increases in the money stock can act largely to increase O but also to affect P somewhat. But as the supply of unemployed factors drops, more of the impulses can affect prices.The neoclassicals argue that when this occurs in an accelerating fashion you have reached the point just beyond the NAIRU rate.But my argument is that they have set this rate far too high.

Hence , it is possible to have simultaneously both some unemployment and some price rise without experiencing accelerating inflation or inflationary expectations.In fact, some of this price rise is a necessary lubricant for the operation of the economy and the forward investment planning of the private sector. It ought not to be misdiagnosed as accelerating inflation.

The real economy,as opposed to the black box economy that the quantity theory operates with, is composed of many industries and sectors. In some, strong trade unions and powerful oligopolies dominate. In others, there are many very small firms and entrepreneurs and little opportunity for price rise until full capacity is reached. In the more oligopolized unionized industries the inflationary process can begin at much lower rates of capacity utilization.

Hence, to get the overall picture we have to aggregate all the industries and sectors with the appropriate weights given to each in order to see whether or not we are likely to experience price rises that can be called inflationary. We can think of the money stock as a wave of water that washes across the variegated economy , in some place simply lubricating investments and activity in other places facilitating inflationary price rise. Supply bottlenecks, wage push, profit push and elasticity of demand as well as the decisions to save and the decisions to invest will affect the overall outcome.

Any modern theory of inflation must also take into account internet technology, just in time production, globalization and free trade all of which act as anti-inflationary forces. The problem with our central banks is that they appear to be taking decisions based on a much more restrictive theory of the inflationary process. One that places excessive weight on inflationary expectations and a narrow conception of the quantity theory.
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On exports, economic growth and monetary and fiscal policy
Nov. 30, 2005

The current strategy of Canada and most G7 countries appears to focus on trade as the engine of growth of the domestic economy.

This can be analysed by using the conventional Keynesian and neo-classical macro-economic equation of
C+ I + G-T + X-M = GDP. where C is consumption, I is investment, G is government expenditures, T is tax revenures and X is exports and M imports. Currently the Government of Canada is running a budgetary surplus. This means that G-T is negative.

To offset this the Government is counting on exports X to exceed M imports and for investment I to be larger because they believe that a surplus guarantees low interest rates because they believe in the theory of loanable funds. Lower rates means higher I investment and therefore the combination of higher I and a booming export industry translates into faster economic growth and lower unemployment.

But what if the Bank of Canada does not co-operate and raises interest rates?

Look what happens. A rate rise leads to less investment, that is I declines and higher rates mean a stronger Canadian dollar. A stronger Canadian dollar in the absence of offsetting gains in productivity through increased use of technology or lower wages means less competitive exports and the gap between X and M diminishing. All of this adds up to slower growth and not as big a rise in the GDP.

Now if the surplus is used to retire outstanding debt the return of funds to bondholders may offset some of the pressure of rate rise but it also complicates the problem of translating these returned savings no longer in asset form but in cash form into investments. At the same time taxes which exceed spending subtracts purchasing power from the economy. So the strategy of putting too many eggs into the export led growth strategy without at the same time ensuring a supportive fiscal and monetary policy could backfire. That is why the tax cuts and the new program expenditures are so important. More on this in future blogs.
Posted by Haroldchorneypolecon@me.com at 1:57 PM 0 comments Email ThisBlogThis!Share to TwitterShare to FacebookShare to Google Buzz


The German economic dilemma
Nov. 23, 2005

The recently formed grand coalition between the SDP and Mrs.Merkel's Christian Democrats faces a major dilemma. The Merkel Conservatives would like to impose neo-con style reforms of the labour market practices and the welfare state in Germany.

Most of these are wisely resisted by the SDP. But the SDP has agreed to significant tax increases. Tax increases when the unemployment rate is above 11% are not a smart idea. Coupled with the dogmatic monetarism and tight money policies of the European central bank the result is likely to be higher not lower unemployment.

The European central bank needs a major overhaul and rethink of its strict monetary targeting. The rigid anti-deficit rule that prevails in the European Union also needs to be reformed. Its not possible to fight dangerously high unemployment with both the fiscal and the monetary hand tied behind your back.I wonder how long it will be before either the Christian Democrats or their SDP partners wake up to this reality?

Labour market clearing strategies that rely upon the neo-Keynesian doctrine of rigidities explaining why general equilibrium does not always hold sometimes are useful. But this time in Germany they are too close to the classical laissez-faire economic doctrine of the 1930s that insisted despite enormous evidence to the contrary that unemployment was due to rigidities rather than inadequate aggregate demand.

The European central bank and the resistance to using budget deficits to stimulate are the true culprits. Lets hope the political leadership in Germany comes to realize this soon.
Posted by Haroldchorneypolecon@me.com at 1:47 PM 0 comments Email ThisBlogThis!Share to TwitterShare to FacebookShare to Google Buzz


On deficit finance and President George Bush
Nov.19,2005

Two years ago I wrote an op ed in The Globe and Mail Canada's leading newspaper that defended President George Bush's policy of running a deficit to stimulate the American economy through a combination of tax cuts and increased spending in certain areas.

This was a very politically incorrect thing to do and offended some of my friends on the left who resented Bush because of his foreign policies and in particular the War in Iraq. But as I pointed out in the op ed one did not have to agree with Bush on his foreign policy or even aspects of his domestic policy to appreciate the willingness of the Bush administration to make use of appropriate deficits to stimulate the economy. As I said at the time it would have been far more preferable for the President to cut the taxes of the poor far more than the taxes of the rich.

And of course increased civilian spending is usually better than increased military spending. Nevertheless because the Democrats and their ideological allies in Canada had become so dogmatically fiscally conservative it was a welcome breath of fresh air that this compassionate conservative Republican appeared to understand that sometimes deficts were an appropriate policy.

What have been the results? Unemployment has dropped significantly in the US in the past two years and economic growth continues to surprise analysts. Furthermore despite the trade deficit and the public sector deficit the US dollar continues to be a strong currency.

Maybe its time that people re-evaluated their approach to deficits and rediscovered the wisdom of Keynes. Public sector deficits that are targeted on investments in infrastructure, tax cuts for the poor and middle classes and social investments are an excellent response to a business cycle downturn.

Rather than crowding out private investment they crowd it in by changing pessimistic expectations to more optimistic ones among investors and by injecting much needed aggregate demand to combat the downturn in the cycle.

What is extraordinary is that the fiscal conservatives are now located among liberals, social democrats and in the US centrist Democrats, while conservative Republicans appear at least in part to be Keynesians, even if only military Keynesians.

The next deep business cycle downturn will pose some serious challenges to the fiscally orthodox.
Posted by Haroldchorneypolecon@me.com at 1:42 PM 0 comments Email ThisBlogThis!Share to TwitterShare to FacebookShare to Google Buzz



Keynes versus monetarists 2
Some additional distinctions : Keynes&monetarists

Keynes' theory of investment depends upon what he calls the marginal efficiency of capital. He defines the mec as follows: that rate of discount from a future stream of earnings that equates the current supply price of capital. All of this takes place under conditions of uncertainty.

For Keynes uncertainty is not strictly reducible to a quantitative calculable probability.(See His Treatise on Probability and Ana Carabelli's interpretation of it.) Because of these factors investment is unstable and strongly affected by the bank rate. Should the bank rate rise this will eliminate investment projects that have a lower rate of return. Obviously it is increasingly difficult to assess risk the further into the future one goes. In addition the stock market is highly risky because of the tendency toward speculative selling of shares and the tendency to operate on short term time horizons . Inherent values matter less than whether one can sell at a higher price than one has bought. Accurate judgement in the market is premised upon being able to judge the likely judgments of others about value and price. Therefore the markets are an unstable source of investment in capital projects.

The monetarists do not seem to have a unified theory of the investment process. Like Friedman's theory of inflation money in - prices out, what I and others call a black box theory they seem to argue that investment happens more or less naturally because the animal spirits are strong(Keynes' phrase) or the entrepreneurial knights of creative destruction(Schumpeter) or the waves of technological innovation bring it about. They also argue that statist intervention is antithetical to investment. Some of them, but not Friedman also argue that deficits raise interest rates and thereby crowd out investment. Keynesians would say au contraire deficits in recessions crowd in investnment.

The classical quanity theory equation was MV=PT and then MV=PO where M was money stock, V velocity, P prices, T transactions and O output. Since V was regarded as highly stable and predictable and T and O fixed at the full employment level by Say's law then there was held to be a direct relationship between M and P.

Keynes used the Cambridge variant of the equation M= 1/k (PO) where k is the demand for money balances or the tendency to hold money rather than to part with it. He also elaborated the equation by distinguishing between money stocks, M1, M2 and M3 where M1 was income deposits, M2 business deposits and M3 savings deposits the precursors to his transactions demand, precautionary demand and speculative demand for money. Then P= V1(M-M2-M3)/O where M = M1+M2+M3 .(See his Treatise vol.1 The pure Theory of money p.150London: Macmillan, 1930 and Tract, CW)

Friedman alters the classical model by writing it in Keynesian form as the demand for equities, financial assets, real capital assets, and cash. Md = P.f(y,w;R*m,R*b,R*e;u) where Md = the demand for money and P is the price index,y income of a single wealth holder, w fraction of wealth in non human form ; R*m expected nominal return on money; R*b expected nominal rate of return on securities; R*e expected nominal rate of return on phsyical assets, u all other variables that affect the utility attached to the services of money. (See his Quantity Theory of Money in the new Palgrave Money edited by John Eatwell, M.Milgate and P.Newman, eds.London: Macmillan, 1989.p.13)

Key Words: "Keynes"; "monetarists"; "Milton Friedman"; "quantity theory"; and from previous entry
"Say's law" ;involuntary unemployment" "labour market clearing"