Small Logical Steps

Somewhat short of time, but a thought occurred to me and I wanted to lay out this curious little argument, even if it's a bit facetious and doesn't mean very much.

If you:

a) believe in rational expectations - that consumers will always act in their own self-interest,

b) believe in a classical free market economy - that the aggregation of individuals' self-interested decisions creates the optimum allocation of resources, and

c) believe that government is imposing a large burden on the economy, and believe that a substantial reduction in taxation and spending would provide major economic benefits, then

d) there is something seriously and fundamentally wrong with our democracy, and it is failing to represent the views of the people.

Think about it. If everyone acts in their rational self-interest, this produces the optimal economic outcome, and the optimal economic outcome involves a smaller state, then democracy must be failing to provide the people's desperate wish of a drastically smaller government.

Of course, the people who hold these views aren't really upset at our democracy for failing to represent the interests of the people. They aren't calling for direct democracy; it's interesting, in fact, that the calls for greater democracy are coming from the leftist Occupy movement, which rejects free markets, let alone rational expectations. What irritates neoliberals is the failure of democratic institution to propagate their own - patently correct - views.

I'm not blaming them for this. I get quite angry when government policy deviates from my views of how things should be. But it does bear thinking about, because the majority of people aren't voting for the Super Neoliberal Party. The closest thing we have is the Tories, many of whom are far too preoccupied with being tough on immigration, crime and the moral decline of society for most economists' tastes (though it is arguably this message that strikes the best chord with the wider electorate).

So, either consumers are irrational, free markets aren't best anyway, or the state isn't too big. Otherwise we need more direct democracy.

Just a thought.

Where's the Deflation?

I think it’s time to throw my fedora into the ring regarding the inflation debate. One of the most interesting things about the economic crisis has been the conspicuous absence of deflation. With large output gaps pretty much everywhere, even today, it’s strange that inflation remains around or above target in most advanced economies (ignoring for a moment the internal devaluation taking place in countries like Ireland and Spain). One would expect that, with large excess capacity, prices would fall. Britain is the starkest example of this not being the case; consumer price inflation is still running at 3% year-on-year, having peaked at over 5% in 2011. There are a few different explanations for this phenomenon.

One is that output gaps simply aren’t as large as we think they are. Perhaps the financial crisis seriously damaged potential GDP. There has been quite a lot of focus on hysteresis effects recently – the effect of a reduction in GDP on potential GDP. Estimates of maximum capacity have been revised significantly down pretty much across the board, including in the US and UK. Certainly, if the economy was running at above capacity before the crisis, and potential GDP has been almost flat since then, the output gap might be a lot smaller than estimated, and so might not be exerting nearly as much downward pressure on prices as previously assumed.

This has disturbing implications, because it implies that the high unemployment and low growth that we see today have become permanent structural problems within the economy rather than being symptoms of a reversible shortfall in demand. Rising rates of long-term unemployment and falling labour-force participation support this conclusion. The structural hypothesis basically surmises that unemployment is high not because employers are unwilling to hire, but because they can’t find workers with the right skills and experience.

Fortunately, it is unlikely that our structural problems are quite this bad. For one thing, the economy might not have been running too far above capacity prior to the crisis. After all, inflation was fairly close to target in 2006 and 2007. So, even if there has been low growth in potential GDP over the past few years, there’s still likely to be a sizeable output gap, at least in the UK, where actual GDP is still 4% below its pre-crash peak. Further, there is some evidence suggesting that the woes of the economy are more to do with demand than structural problems. Employment hasn’t fallen only in specific declining industries – every sector has seen significantly reduced payrolls. Moreover, this chart suggests that most UK employers would be able to find workers with the right skills, if only they were actually looking to hire at all. Ultimately the buck stops with the demand side; any structural issues are actually being created and reinforced by a persistent lack of demand. This means that, while structural problems are an issue, fiscal and monetary stimulus would help remedy the problem, by increasing actual GDP and preventing the structural problems from getting worse.

Meanwhile, if there is a large output gap, then something else must be to blame for high inflation. Some economists, notably Paul Krugman, have attributed the lack of deflation to sticky prices, specifically the downward nominal rigidity of wages. It’s not especially counterintuitive a concept; most people understand, if they think about it, that it is very difficult to cut people’s wages in nominal terms. If people aren’t getting wage rises (and so losing out in real terms), that’s one thing. But an actual wage cut has different implications and employers are very reluctant to reduce wages. The upshot of this is that wages haven’t fallen despite high unemployment; in fact, most people’s wages have remained completely flat, with small rises for some earners, leading to an overall rise in wages. This chart from Krugman illustrates this trend nicely. Rising nominal wages exert upward pressure on prices, and so deflation is prevented and inflation remains stubbornly high.

This story is convincing and sticky wages have, in my view, contributed to high inflation. But there’s something deeper at work here, too. The current crisis has been compared to the Great Depression ad infinitum over the last five years. Interestingly, one initial response to the Depression in America was to prevent wage cuts in what was arguably a much more flexible labour market than today’s. This, it was hoped, would prevent prices from falling and so stop the debt deflation spiral which was ravaging America’s economy. But it didn’t work. Wholesale prices, especially, continued to tank and the result was the worst depression in modern history.

What had happened, of course, was deflationary pressure not from wages but from elsewhere. Reduced demand and the consequent fall in production in every industrial economy meant a collapse in commodity prices and this was a deflationary shock which policy was unable to offset. The million-dollar question, of course, is this – what’s changed since then?

One of the major differences is in monetary policy. In the early years of the Great Depression, America was on the Gold Standard and so didn’t have control over the money supply. This meant that they could do very little to discourage hoarding, because money was effectively guaranteed to maintain its value. Thus deflation became self-reinforcing, as people hoarded cash because it would be worth more following expected further deflation in the future. By contrast, the modern response to the depression and to the threat of deflation was massive monetary stimulus. Reduced interest rates and quantitative easing have meant that there has been an increase in the money supply that has offset reduced monetary velocity. You can debate endlessly the influence – or lack of it – that central banks have when interest rates are at the zero lower bound, but it seems likely that monetary policy at least contributed significantly to staving off deflation.

The other difference between today and the 1930s is globalisation. The world economy is increasingly integrated and there are a lot more industrial economies. In the Great Depression, steel prices collapsed because almost all of the demand for steel came from industry in America and Europe. Prices didn’t recover until industry did. In the modern crisis, commodity prices did drop, as the financial crash reverberated around world markets. But then something strange happened. Even though output was still severely depressed in the developed world, especially in Europe, commodity prices began to increase again. It wasn’t because of any isolated incident. Floods in Asia, the Libyan Civil War and so on may have disrupted the production of particular commodities, raising their prices. But the trend was present across the board, from corn to oil to copper, and the main reason for this is that demand is now global. Demand for these commodities might have fallen in the developed world, but it has increased massively in fast-growing China, India and Brazil. Countries like the USA and especially the UK, which buy large amounts of commodities from abroad, are particularly vulnerable to imported inflation from global market price increases. This is an important factor in considering why deflation has failed to materialise. Demand is rising in other places, and that’s having an effect on prices here in a way that it wasn’t during the Great Depression.

In the 1970s, ‘stagflation’ was a structural issue. Growth was low because potential GDP growth was low and the economy was running above full employment. Today this phenomenon occurs for different reasons. Large output gaps and low growth should and are be causing deflationary pressure, but this is being offset by commodity price rises as a result of increased emerging-market demand. And that’s an important part of the story, which sticky-wage-emphasising Keynesians too often fail to account for.

When Is Overinvestment Not Malinvestment?

This week’s edition of The Economist has a special report on the Chinese economy. It makes some interesting points, many of which I agree with. Its particular focus is de-emphasising the role of exports and China’s trade surplus, which is now below 3% of GDP and falling. Instead, the report identifies the main engine of Chinese growth as investment, which runs at over 45% of GDP – far larger than other East Asian economies like South Korea and Japan during their boom years. Unsurprisingly, this enormous rate of investment has led many to conclude that Chinese growth is unsustainable, fuelled by an inflating investment bubble which is inevitably doomed to burst.

The Economist’s report seeks to characterise the nature of this bubble by marking a distinction between overinvestment – investment which exceeds savings to an unstable extent – and malinvestment – inefficient and unproductive investments, of which the ‘ghost city’ of Kangbashi is one example. It is easy to argue that Chinese investment, largely provided by state-owned enterprises and financed by banks at artificially low rates, is inefficient. However, whether the Chinese are investing too much is another issue altogether.

The Economist concludes that, with the savings rate even higher than investment at 51% of GDP, charges of overinvestment cannot be levelled at China. But the distinction between overinvestment and malinvestment seems to imply there can be overinvestment without malinvestment - efficient, productive investment being a bad thing.

This is a little bit strange. Surely ‘too much’ investment would be too much purely because it was inefficient? An excess of investment over saving is not always a bad thing. Obviously, excess of investment over savings would ordinarily cause a rise in the interest rate, so that the excess disappears. However, the interest rate may be sticky, either for generic reasons or because the Chinese government caps the return payable on bank deposits. It would then not adjust to correct the imbalance. What then happens is that the increased investment causes GDP and incomes to rise; as people see their incomes rise, their propensity to save increases, and balance is achieved through an increase in saving.

An interesting counterpoint to this theory is that, as the Chinese get richer, it is expected that consumption will become a greater proportion of GDP. In this case, what is occurring is that, though savings rates fall, the balance is achieved by a greater fall in investment as the economy adjusts to a model more dependent on domestic consumption.

The effect of an increase in GDP restoring the investment-saving equilibruium would obviously not occur if the investment did not serve to increase GDP – i.e. the investment was wasteful and inefficient. The Economist article refers to the East Asian financial crisis of the 1990s as an example of overinvestment. However, here, foreign finance clearly served solely to inflate asset price bubbles rather than for any real economic gain. This implies that some of the investment was unproductive, and that the real problem was malinvestment. A similar story is visible in the Spanish economy of the 2000s.

It is clear that market liberalisation would lead to reduced malinvestment in China. It is also evident that, as the economy inevitably shifts towards a model more dependent on domestic consumption, rates of both savings and investment will fall. However, this will probably represent a fall in the productive rate of investment combined with less malinvestment; it won’t be because there are productive investments to be made, but making them would be unsustainable.