Bookblogging: What next for macroeconomics ?

It’s been slow going, but I’ve finally finished the draft chapter of my book-in-progress that looks forward to a new research program for macroeconomics, an absurdly ambitious task, but one that needs to be tackled. Of course, what I’ve written isn’t fundamentally new – it’s a distillation of points that Old Keynesians, post-Keynesians and some behavioral economists have been putting forward for a while. But I hope I’ve got some positive contribution to make. More than ever, comments are much appreciated.

Update In response to comments, mostly at Crooked Timber, I’ve fairly substantially revised the section on “avoiding stagflation”. While I don’t back away from the points I made previously, I took for granted some things that I’d mentioned in other places in the book. The result made for a fairly unbalanced treatment with an excessive focus on the role of labor militancy. I’ve now tried to put this into proper context. I don’t expect that will satisfy everybody, but this is closer to what I meant to say all along.End update

What next ?

The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so – and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually work. Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed. Animal Spirits, Akerlof and Shiller

It was reading this passage in Animal Spirits, and posting about its implications for macroeconomics in the Crooked Timber blog, that led to the writing of this book. A commenter suggest that this, and some earlier posts, would make a good book, Brad DeLong of UC Berkeley picked the idea up and the result is before you.

Animal Spirits was mostly written before, or in the early stages of, the Global Financial Crisis, but the Crisis has made its central point more important than ever. For many years economists have worked like the anecdotal drunk who searches for his dropped keys under a lamppost because the light is better there. In the future, and particularly in macroeconomics, economists need to start looking where the keys are, and try to build tools that will improve the chances of success.

This does not mean abandoning all the work of the past thirty years and returning to old-style Keynesianism. But it does mean starting from the traditional Keynesian perspective that a general macroeconomic theory must encompass the reality of booms and slumps, and, particularly of sustained periods of high unemployment that cannot be treated as marginal and temporary deviations from general equilibrium. We must model a world where people display multiple and substantial violations of the rationality assumptions of microeconomic theory and where markets depend not only on prices, preferences and profits but on complicated and poorly understood phenomena like trust and perceived fairness.

First, the program needs more realistic microfoundations. As Akerlof and Shiller observe, we need to look at how people actually behave, and how this behavior contributes to the performance of the economy as a whole.

Second, we need to reconsider the concept of equilibrium. The whole point of Keynes “General Theory” was that the market-clearing equilibrium analysed by the classical economists, and central to DSGE models, was not the only possible equilibrium. An economy can settle for long periods in a low-output, high-unemployment state that may not meet the neoclassical definition of equilibrium, but does match the original concept, borrowed from physics of a state in which the system tends to remain and to which it tends to return. More importantly, perhaps, we need a theory which encompasses crises, and rapid jumps between one kind of equilibrium and another. Ideally this will combine ‘old Keynesian’ analysis of economic imbalances with a Minsky-style focus on financial instability.

Between these two levels, we need to consider the fact that the economy is not a simple machine for aggregating consumer preferences, and allocating resources accordingly. The economy is embedded in a complex social structure, and there is a continuous interaction between the economic system and society as a whole. Phenomena like ‘trust’ and ‘confidence’ are primarily social, but they affect, and are affected by the performance of the economic system.

Finally, now that Keynesian macroeconomic policy has re-emerged as a practical tool, we need to reconsider the real and perceived failures of the past, and in particular the emergence of stagflation in the 1960s. If the revival of Keynesian policy is to be sustained, it must provide not only an emergency response to the present crisis but a set of tools that can deliver sustained non-inflationary growth.


Better microfoundations ?

It is now generally accepted that people are not, and cannot be, the infinitely foresightful, unbounded rational utility maximizers described by the axioms of dynamic stochastic general equilibrium theory. On the contrary, economic behavior, even that of highly sophisticated actors like the ‘rocket scientists’ who design financial instruments for investment banks, is inevitably driven by a partial view of the world, with heuristics and unconsidered assumptions inevitably playing a crucial role. For finite beings in a world of boundless possibilities, nothing else is possible.

The problem for a new macroeconomics is not so much a failure of economists to understand this point as an embarrassment of riches. Several decades of research in behavioral economics, non-expected utility decision theory and other fields have demonstrated, to anyone willing to look, a wide variety of ways in which real economic behavior differs from the neoclassical ideal. The problem is to focus on behavioral foundations that are most relevant to the problems of macroeconomics.

An obvious place to start is with attitudes to risk and uncertainty. Keynes himself wrote extensively in this topic, and was highly sceptical of the ideas that led to the emergence of the now-dominant expected utility theory (the first formal exposition, von Neumann and Morgenstern’s classic Theory of Games and Economic Behavior was published in 1994 only two years before Keynes’ death. The starting point for expected utility was the idea that people can, and should, reason about uncertainty on the basis of their perceived probability of relevant events such as an increase in interest rates or a slump in exports.

“By `uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty…The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence…About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (J.M. Keynes, 1937)

Post-Keynesian economists like Davidson and Shackle argued, that this fundamental uncertainty was central to Keynes’ thought and that it had been ignored as part of the development of the Keynesian-neoclassical synthesis. But, as with so many ‘heterodox’ schools of economic thought, the post-Keynesians were much stronger on critique than on the development of a coherent and usable alternative. Shackle in particular ended up denying that we can know anything about probability, even in such simple cases as the toss of a coin, a nihilistic view that was never likely to convince many.

Davidson took the critique in more productive directions and did some valuable work on the way in which attitudes to uncertainty affect individuals demand to hold money, which play a crucial role in Keynes theory of the ‘liquidity trap’, a situation where even at interest rates of zero, investors and households would prefer to save rather than invest.

Mainstream Keynesians, such as James Tobin, had also developed the idea that liquidity preference could be seen as a reflection of risk attitudes. Tobin’s analysis, was developed using the standard financial portfolio analysis based on the idea that the investment involves trading off mean returns against measures of riskiness such as the variance, which depend on the assumption that we can always formulate sensible probabilities for events. Although Tobin himself was always highly critical of the irrational behavior of financial markets, his analysis was easily restated in terms of expected utility theory and absorbed into models based on the efficient financial markets hypothesis.

Over the past thirty years, however, a huge body of research has shown that people do not always make choices in line with the requirements of expected utility, and a great many models of choice under uncertainty have been developed over the past thirty years to produce more realistic representation of behavior. Probably the most famous is the prospect theory of Kahneman and Tversky, put forward in 1979, which earned Kahneman a Nobel prize in economics and Tversky a rare posthumous mention.

My own academic career got its start with a paper published a couple of years later, giving a tweak to the idea of probability weighting by showing that the model worked better if low-probability extreme events (large gains and large losses) were overweighted, while events leading to intermediate outcomes were overweighted. Kahneman and Tversky incorporated this idea in a revised version of their original model, called cumulative prospect theory.

What specific features of a more general and realistic model of choice under uncertainty might contribute usefully to a renewal of Keynesian macroeconomics? There are at least two obvious examples. First, there is the problem of unknown unknowns, which is also, and not coincidentally, a critical problem for the efficient markets hypothesis. An obvious feature of economic crises is that people are forced to consider contingencies they might previously have disregarded, such as the possibility that their employer, or their bank might fail, or that currency might rapidly lose its value. When such a contingency suddenly enters the minds of many people, large macroeconomic shocks may result.

Second, as I’ve already mentioned, although people fail to consider some low-probability extreme contingencies, they tend (perhaps in compensation) to overweight those they do consider. It is this fact that keeps the sellers of lottery tickets and air crash insurance in business. In the macroeconomic context, a ‘normal’ situation in which people disregard or at least do not account for the risk of a serious recession may suddenly be replaced by a far more pessimistic outlook in which the same people place a high weight on the possibility of total economic collapse. Unsurprisingly, such a change in ‘animal spirits’ may represent a self-fulfilling prophecy. If a lot of people expect a recession and try to increase savings and reduce investment, these defensive actions may bring about the recession against which they are designed to guard.

Of course, awareness of this fact will do nothing to moderate the potential impact; if anything the reverse. People who are suddenly worried about a recession will not, if they are looking to their own well-being, keep spending in the hope that others will do likewise and thereby keep the economy afloat. Rather they will reason that others are likely to think as they do, and that a recession is even more probable than the objective evidence would suggest.

Keynes talked about such phenomena in terms of ‘animal spirits’. Such notions seemed hopelessly old-fashioned in the light of the development of rigorous models of choice under uncertainty based on the elegant axioms of expected utility theory, the apparent success of the theory in explaining a wide range of economic behavior and the dominance of the efficient markets hypothesis. But as the evidence against these models has mounted, the pendulum has swung. The idea of animal spirits has been revived in by George Akerlof and Robert Shiller in a recent book of the same name.

Akerlof and Shiller consider five deviations from the standard model of rational maximization (confidence/trust, fairness, corruption, money illusion and stories) and argue that some combination of these can be used to explain a range of economic outcomes inconsistent with the standard model. Their discussion makes a compelling case that macroeconomics needs new, and more realistic foundations.

If the prospects for a macroeconomic analysis based on alternatives to expected utility theory are so promising, why has so little work been done along these lines? In part, perhaps, this simply reflects the effects of specialisation. Decision theorists focus on individual choices, and when they seek economic applications, this leads them naturally to look at microeconomic problems (that’s certainly true in my own case).

But there is a more fundamental problem. Individuals who satisfy the conditions of expected utility theory display a property called ‘dynamic consistency’ which, as the name suggests is of fundamental importance in dynamic stochastic general equilibrium models. Dynamically consistent economic agents never change their view of the world in any fundamental way. They respond to new information by changing their subjective probabilities for particular events, but they never change their underlying prior beliefs and preferences about the world. That means, in particular, that they can fully anticipate how they will respond to any possible future situation, and would never wish to change their mind about this, or to ‘lock themselves in’ to a course of action they might be unwilling to carry through when the time comes.

Such consistency is admirable (at least in the eyes of decision theorists) and makes it much easier to obtain well-defined solutions for dynamic stochastic general equilibrium models. But it is far from realistic. It turns out, however, that the decisions predicted by such models always display dynamic inconsistency under certain circumstances. This problem has been the subject of considerable controversy on the rare occasions when economists have sought to introduce non-expected utility preferences into macroeconomic theory (as with the robust control theory of Hansen and Sargent.

From the neoclassical viewpoint that dominates modern macroeconomics, the absence of a coherent dynamic equilibrium concept seems like a fatal objection. But from a Keynesian perspective, and on the basis of real world experience, this is a positive, indeed necessary, feature of a sensible macroeconomic model. The fundamental macroeconomic problem is precisely that an economy that seems to be enjoying an equilibrium path of steady growth can suddenly crash or veer off into an unsustainable boom.


Aggregate models and equilibrium

If there is one thing that distinguished Keynes’ economic analysis from that of this predecessors it was the rejection of the idea of a unique full employment equilibrium to which a market economy will automatically return when it experiences a shock. Keynes argued that an economy could shift from a full-employment equilibrium to a persistent slump as the result of the interaction between objective macroeconomic variables and the subjective ‘animal spirits’ of investors and other decisionmakers. It is this perspective that has been lost in the absorption of New Keynesian macro into the DSGE framework.

The revival of notions like ‘animal spirits’ by leading economists such as Akerlof and Shiller offers the potential to revive these fundamental Keynesian insights. But this is not simply a matter of modifying the way we model individual behavior Phenomena like animal spirits, social trust and business confidence can’t be reduced to individual psychology. They arise from economic and social interactions between people.

It’s precisely for this reason that such social aspects of individual psychology are likely to be associated with multiple equilibria in the real economy. The aggregate level of trust and confidence in an economy cannot be derived by simply adding up individual values in the way in which DSGE models aggregate consumer preferences.

As long as particular assumptions are implicitly taken for granted in a given social group, such as the business community, few members of that group are likely to consider the possibility that these assumptions might fail. Evidence against those assumptions will be ignored or explained away. So, for example, the spectacular examples of market irrationality and business corruption exhibited during the dotcom boom and bust did almost nothing to shake the faith of business and political leaders in the efficiency and stability of financial markets. This faith remained strong even as the evidence of fundamental problems grew through 2007 and early 2008. Then, in the space of a few months this confidence collapsed to be replaced by a panic in which even the most reputably financial institutions would not lend to each other, and instead threw themselves on the protection of the national governments they had previously dismissed as obsolete relics.

A realistic macroeconomics requires the incorporation of variables like trust and confidence in explanatory models. Fluctuations between ‘irrational exuberance’ and equally irrational ‘panics’ (this old term for a financial crisis is in many ways more useful than the technical language of ‘recessions’) give rise to bubbles and busts, which in turn drive much of the macroeconomic cycle. The insights of behavioral economics provide good reasons to expect such fluctuations, but they do not, at least as yet, admit the kind of rigorous derivation of aggregate values from individual preferences that is referred to in the standard demand for ‘microfoundations’.

Expressed in the language of systems theory, the traditional Keynesian approach treated macroeconomic behavior as an emergent property of the economic system, to be analysed in their own terms rather than being derived from supposedly more ‘fundamental’ microeconomic explanations. [1] In a world of boundedly rational economic decisionmakers, and, for that matter, boundedly rational economists, we need to simplify and the simplifications that are appropriate for doing macroeconomics may not be the same as those that are appropriate in microeconomics.

Obviously, it’s much easier to announce a new program for macroeconomics than to actually implement it. To give some more concreteness to the general proposals presented here, it’s worth thinking about some specific problems, such as bubbles and the ‘Minsky moments’ in which they burst.


Bubbles and Minsky moments

Macroeconomists working in the micro-economic foundations framework did not ignore bubbles. Far from it. Dozens of papers were written on the possibility or otherwise of self-sustaining bubbles in asset markets. But, characteristically, the central concern was to determine whether or not bubbles could arise in markets with market participants who were perfectly rational, or nearly so. This focus on microeconomic foundations diverted attention from the real issues.

There was a rather smaller policy oriented literature, concerned with the question of whether central banks should intervene to prevent the emergence of bubbles, or to burst them early, before they became too damaging. Most of this literature followed the lead of Alan Greenspan, who initially showed some sympathy for the idea of intervention, but eventually became the strongest advocate of the view that central banks should not second-guess markets. But even interventionist participants in the discussion took it for granted that an anti-bubble policy had to be implemented within a policy framework of inflation targeting using interest rates as the sole policy instrument. With these constraints, the conclusion that nothing could or should be done was largely inevitable.

A realistic theory of bubbles would start with the observation that every bubble has a story to explain why, in the words of …, ‘this time it’s different’. And, for particular assets and markets, sometimes it is different. Those who got in early with shares in Microsoft or Google, or with land in … in … multiplied their money many times over. And although the days of spectacular growth came to an end in each case, there was no bursting of the bubble ending in losses all around.

So a theory of bubbles designed to inform a policy of bubble-pricking must begin with an attempt to understand how ‘this time it’s different’ stories emerge and come to be believed and how to distinguish true, or at least plausible, stories from those that involve a collective abandonment of reality. The story-telling aspect of animal spirits discussed by Akerlof and Shiller is important here.

Given a better understanding of bubbles it may be possible to develop an analysis of the costs and benefits of pricking putative bubbles. Such a policy reduces the damage from spectacular busts such as the one we have just seen, but it would require a willingness on the part of central banks to explicitly over-ride the judgements of capital markets, rather than merely ‘leaning against the wind’ by raising interest rates.

An uncontrolled bubble must eventually burst, and the bursting of a bubble is a prime example of a ‘Minsky moment’, when euphoria suddenly turns to panic. In Minsky’s model there are three classes of financial enterprises – conservative ‘hedge’ financiers whose operations generate sufficient income to service their capital costs, speculative financiers who rely on rising asset prices to service debt and who drive the market further upwards, and ‘Ponzi financiers’ cover their costs in either the short term or the long term, but who can conceal their insolvency long enough to reap substantial gains. Ponzi operators fail from time to time, but, in periods of growth, these failures are seen as isolated events of no general significance. However, in the later stages of a bubble, when a large proportion of economic activity has been devoted to speculative finance, the failure of a Ponzi financier can bring about a sudden shift in sentiment, as investors fear that the associated corruption is widespread. The rush to withdraw extended credit brings about more failures, not only of Ponzi financiers but of the speculative finance firms that relied on continued growth.


Avoiding stagflation

Avoiding stagflation

The last Keynesian golden age ended in stagflation. The causes of this breakdown are many and complex, but they must be addressed if we are to avoid repeating them. In particular, it is important to avoid relying on easy excuses, such as the 1973 oil shock and to face the fact that the stagflationary breakdown reflected serious failures in the dominant version of Keynesian macro theories, and in the political and industrial strategies of the social democratic, left and labour movements. These failures were amplified by the expansion, from very small beginnings, of a global financial system that broke down the institutional framework of the Bretton Woods agreement.

The discovery of the Phillips Curve around 1960, and the general success of Keynesian macroeconomic policies in the postwar period produced increasing support for policies of fiscal expansion aimed at reducing already low levels of unemployment even further, and an acceptance of higher rates of inflation and sustained budget deficits as a reasonable price to pay. This intellectual atmosphere fitted in neatly with the political needs of the Johnson Administration in the US, which sought to implement both an expensive (but initially quite successful) set of welfare programs dubbed the War on Poverty and an actual, if undeclared, war in Vietnam, while avoiding the political opprobrium of raising taxes. There were similar developments in other countries as pressure to expand the welfare state ran into the first elements of resistance that would later become the Tax Revolt of the 1970s.

In the short run at least, expansionary fiscal policies resolved these problems, and an expansionary fiscal stance became accepted as the norm. This contrasted with the older Keynesian approach where expansionary policies used to stimulate the economy out of recessions and depressions were balanced by contractionary policies aimed at controlling overheated booms.

From the late 1960s onwards, rates of wage and price inflation rose steadily. Throughout society, the combination of (seemingly permanent) full employment and economic growth with inflationary pressure led to the abandonment of attitudes of restraint that had, until then, been engendered by memories of the Great Depression and fears of a new one. Business leaders ceased to be the sober, socially-minded, technocrats described in works like JK Galbraith’s New Industrial State and started on the path that would lead to the lionization of figures like ‘Chainsaw Al’ Dunlap and Jack Welch.

Financial markets shook off the memories of the Great Crash and became, once again, places where vast fortunes could be made from abstruse transactions. Most attention was focused on stock markets, which went through their first real boom since the 1920s. More significant in the long run was the (re)emergence of an uncontrolled global financial market. This began, with the creation of the ‘Eurodollar’ market, in which mostly European banks located outside the regulatory control of the US dealt in dollar-denominated securities, with liquidity provided by the shift of the US balance of payments from a century old pattern of surpluses to an almost equally durable string of deficits. in one of history’s ironies, the most important single player in the early years was Moscow’s Narodny Bank, which faced increasingly pressing needs for access to Western financial markets and an equally pressing imperative to avoid the control of US authorities.

But the most striking manifestation of the inflationary breakout took place in labour markets. There was an explosion of labour militancy, reflected in an upsurge in strikes and in wage demands that could not be met except through continuing inflation. Even without the militant push, low unemployment would have strengthened the bargaining power of unions and put upward pressure on wages. But the revolutionary utopianism of the 1960s, exemplified by the events of May 1968 in Paris, produced an atmosphere where any kind of restraint became impossible. Unions that sought to focus on realistic and sustainable demands were pushed aside by their own members.

By 1973, after the breakdown of the Bretton Woods system and a failed attempt by the Nixon Administration to halt inflation through a wage-price freeze, the era of Keynesian dominance was drawing to a close. The coup de grace came in October of that year when, in response to US support for Israel in the Yom Kippur war, the members of the Organization of Petroleum Exporting Countries first cut off oil supplies to the West, then raised prices fourfold.

The oil shock was a consequence, not a cause of the inflationary upsurge. Commodity prices were rising sharply across the board well before this event. However, the structure of the oil market, with a small group of oil companies (called the ‘Seven Sisters’) facing an increasingly well-organized OPEC meant that, when the price shift came, it took the form of a single dramatic leap. And, having been caused by stagflation, the oil shock amplified and entrenched it in the economic system, leading to decades of high unemployment and persistent inflation.

The stagflationary outbreak took a heavy toll on the Keynesian social-democratic welfare state and the organizations and ideas associated with it. In particular, the great wage push was disastrous for both for the unions and for the Keynesian/social democratic system. The seemingly-continuous strikes of the 1970s undermined popular support for unions and paved the way for a series of ever-more brutal assaults by governments and employers. Margaret Thatcher’s crushing victory over the National Coal Miners and Ronald Reagan’s equally successful action in firing striking air traffic controllers en masse brought an end to the idea that strikes represented a reliable route to improved wages and conditions, let alone to the collapse of the capitalist system. Particularly in the English-speaking world, union membership dropped rapidly as new laws made it easy for employers to keep unions out.

Keynesian economists were discredited and driven from positions of power by monetarist and new classical rivals. Only by making the massive theoretical and policy concessions involved in New Keynesianism were they able to regain a seat at the table.

Meanwhile, the financial sector, which had precipitated the crisis claimed victory, as did the economists who extolled its merits. Stagflation was seen as a demonstration that attempts to resist the logic of the market must ultimately fail. It took several decades to relearn the Keynesian lesson that an uncontrolled financial system will fail even more disastrously

The inflationary surge that began the late 1960s has some important lessons that must be learned if we are to avoid similar failures in the future. First, it is important to maintain a focus on keeping inflation rates low and stable as well as on maintaining full employment. Once inflation rates get signficantly above 3 per cent per year, the risk of embedding inflationary expectations, and the eventual cost of lowering those expectations, becomes greater. It is therefore important to maintain a commitment to low inflation and to adopting the policies necessary to contain and reduce inflation when some shock to the system produces a significant increase in the price level.

At a theoretical level, this does not involve huge modifications to the standard Keynesian view. The idea of a stable long-run trade-off between unemployment and inflation, represented by the Phillips curve, was a relatively late addition, and quickly abandoned. But the problem of how to deal with inflation remains largely unresolved.

In policy terms, inflation can’t be reduced unless macroeconomic policy acts to constrain excess demand and liquidity. So Keynesian policies must be used consistently throughout the cycle, to reduce excess demand in boom periods as well as stimulating demand during recessions.

This still leaves the problem of what to do if high inflation becomes established. A number of countries showed, in the 1980s and 1990s, that a co-operative approach could reduce inflation and unemployment simultaneously. In Australia, following a deep recession in the early 1980s, the newly elected Hawke Labor government reached an agreement with the trade unions referred to as ‘The Accord’. Under the Accord, unions agreed to reduce the rate of growth of wages in return for an increase in the social wage, most notably the introduction of a national system of health insurance, called Medicare.

At about the same time, and facing similar problems, unions and employer groups in the Netherlands negotiated the Wassenaar agreement. In this case, the trade-off for wage moderation was a reduction in working hours and the adoption of a range of measures designed to promote employment growth. The Wassenaar approach survived the stresses of the early 1990s and, according to the ILO was “a ground breaking agreement, setting the tone for later social pacts in many European countries.”

The co-operative approach that motivated these policies was ultimately swept away by the ever-growing power of the financial sector. But, if a Keynesian policy framework is to be successful, it must be revived. Hopefully, the memory of past disasters will promote a more cautious and co-operative approach in future.

[1] Unfortunately, discussion of these ideas tends to get bound up in more or less mystical claims and counterclaims about reductionism and holism. But nothing of that kind is intended here. In principle, without doubt, all social phenomena are determined by interactions between individual people, whose behavior is in turned determined by their genes and the environment in which they grew up. Genes are collections of DNA molecules which in turn are made up of atoms made up of subatomic particles behaving according to the laws of quantum physics. If we were the unboundedly rational individuals posited in the DGSE literature, , such we would presumably be doing quantum physical calculations whenever we made economic decisions.

86 thoughts on “Bookblogging: What next for macroeconomics ?

  1. @Joseph Clark

    And I thought Milton Friedman had been well and truly buried by recent events? I think the story of inflation is a bit more complicated that Uncle Milty believed.

  2. @Freelander
    Freelander you note
    “Unfortunately union leaders were relatively ignorant in the ’60s and ’70s and hence played a large role in creating inflation, and stagflation where their wage agreements were not fully accommodated by policy makers (which is not to say that policy makers should have accommodated them). A significant portion of the union movement was comprised of the ‘looney left’ who were intent on achieving the unachievable. ”

    This argument is often used as a scapegoat for the reasons for the stagflation in the early 1970s. It may be fine except for one point…increased union activity is a local event and the high inflation of the early 70s was clearly an international event which played out in many industrial nations, many of whom had no incidence of increased union activity or militancy.

    I think this is a red herring and sure I do acknowledge that unions may have argued for wage rises but they were chasing the dragon and were not the fundamental cause.

  3. @SJ
    SJ – I think what that author was saying (better than I can) is that the dependent variables (ie quintile income shares of a population or say a gini index) are bounded (I(0) but the explanatory variables (eg inflation rate) are not bounded -(I(1) – so why do we need to examine the dependent variables for a unit root? I think the suggestion is one can incorporate non linear relationships between distributional variables and eg macro variables even though the estimating equations are linear.

  4. @Alice

    I am not sure that every country had exactly the same inflation experience until they all experienced the oil shocks. I would have to look at the data. However, with fixed exchange rates there would have been inflation passed on from country to country. With the US being a larger proportion of world trade back then, their inflation would have been transmitted to others.

    Also, measuring militancy is not so easy. A lack of strikes is not necessarily evidence of a lack of union militancy. Strikes can be evidence of a degree of militancy on both sides. Also, contrary to the perfect competition model, I think businesses can have periods where they also start hiking their prices. After all, businesses don’t really know what price to charge. They can hike up their prices and see what happens. And if they are all doing it, where is the competition to keep their prices down? Businesses will ultimately be limited by pushing their prices too far ahead of the pack. But the capacity of businesses to set their prices means that there is a battle between labour and capital for income share. A battle that has been comprehensively lost by labour over the last thirty years. Although the reasons for labour lossing this battle are more complicated than the reduction in unionism and militancy.

  5. @Freelander
    No – not every country Freelander experienced high inflation in the early 1970s Freelander (I didnt say every country…) but quite a lot of industrial nations were affected in a relatively short space of time in the early 1970s. Rather than ascribe it to an increase in union activity, which, as I mentioned before is a local event and it is highly improbable that increased union activity erupted simultaneously in all those countries affected and in fact it certainly didnt.

    Thats not to say increased union activity wasnt a subsequent event that added to the effect – people facing inflationary price rises will seek higher wages and unions will express that desire and act on it…but arguing that unions were the cause of the 1970s inflation is rather like using a tail to wag a dog IMHO.

    You make a very important point Freelander

    “With the US being a larger proportion of world trade back then, their inflation would have been transmitted to others.”


    So what I am suggesting is we need to do is to go back and focus more closely on what was happening in the US economy and the lead in to that period as an explanation for the high inflation of the 1970s which was clearly an international event.

    Which brings me back to my suggestion that the entry of the US into the war in Vietnam at a time when their economy was already close to or at full employment needs further investigation.
    This is, according to Keynesian theory, the expression of a situation where demand is overstimulated (inappropriately) leading to demand pull inflation – there is evidence that manufacturing wage growth in the US started markedly more quickly from about 1964-65. Manufacturing wages suggest the use of metals. The use of metals is increased by war.

    Added to that was the fact that Nixon escalated war expenditures sometime around the late 1960s or early 1970s (I havent got the details at hand). Add an oil shock to what may have been good old fashioned mismanagement of Keynesian theory (governments are far from perfect) and she goes up like a powder keg.

    Yet to me, to suggest the 1970s inflation was a failure of Keynesian policy is a very odd thing now, and was an odd call then….but I suspect there were rising young turks from a different school who took their opportunity to add their contributions. However, did they attempt to extinguish just a little too much of the prior thesis? You know the advance of knowledge etc ….thesis.. antithesis… synthesis.

    (? like now).

  6. @Freelander
    Freelander – lets just extend on this even a little further …lets assume the rising young turks of the “new school” in the 1970s managed to successfully caste doubt on Keynesian theories even if their criticisms were not quite correct and managed to influence governments to think along the lines of their theories and to focus less on the use of Keynesian theory and to a greater extent on Monetarist theories (keeping it simple – yes, acknowledged there are many other theoretical offshoots since) and fell victim to a view that unions were to blame for the crisis, and labour productivity was crucial to recovery etc etc, leading to a concerted joint effort by both capital and governments to constrict unions….

    As you said.. “Businesses will ultimately be limited by pushing their prices too far ahead of the pack. But the capacity of businesses to set their prices means that there is a battle between labour and capital for income share. A battle that has been comprehensively lost by labour over the last thirty years. Although the reasons for labour lossing this battle are more complicated than the reduction in unionism and militancy.”

    I suggest both capital and governments, since that crisis, rightly or wrongly united to an extent, againts unions and union activity, to ensure that labour lost in this battle (two groups against one?)….but now we have a situation where inequality has risen since that time, underemployment has risen since that time quite substantially since that time, the use of shorter labour contracts has risen since that time, there is greater insecurity in the workforce and at every full employment level NAIRU is higher.

    It has been suggested that this higher level of NAIRU is acceptable due to factors outside a governments control such as globalisation or technological change. This I do not accept. As the level of unemployment is a policy benchmark setting by which we judge the economic performance of a government, so is the level of NAIRU. The rise in income inequality has also been recently quite strongly linked to loss of union membership over time in studies.

    I believe this de-emphasis on the rights of labour through policies designed to constrain union activity (and even dismantle them entirely) has been a policy choice of governments on the promise of theories based on trickle down, which are more accommodating to capital, and at some later date subsequent to gains made by capital, supposedly to labour also. I do not think governments have acted deliberately for benefits to flow to capital against labour, but I suggest that they were swayed to believe in economic theories that did not ultimately carry the level of “flow through benefits” they purportedly embedded, leaving labour somewhat inequitably out of pocket and the level of inequality higher, with the beneficiaries being the uppermost (top) decile of income earners where, of course, we expect the creme de la creme of capital to reside.

    Rising inequality is a bit like a balloon in an artery that will weaken the vessel over time.

    But in the end its the voters who decide…as an example – JH made every valiant attempt to convince people that the world was / would be rosier and they would be better off with workchoices….. unfortunately the reality stripped him of his government, despite unions having been kneecapped well before workchoices.

  7. Freelander

    While Friedman did over-simplify the relationship, there is a fairly compelling link between money growth and price inflation, be that in goods or asset prices. A central bank which accommodates high inflation will almost certainly feed that inflation. Of course on the other side of the ledger tight policy has been proven to reduce inflation, albeit at a pretty high short-term cost.

  8. @sdfc
    “While Friedman did over-simplify the relationship”.
    Agree. It was an oversimplification and the oversimplification is expressed thus in the capitalised words “inflation is ALWAYS and EVERYWHERE a monetary phenomenon.”

  9. @Alice

    Sorry, Alice but I have been overseas so my capacity for causing trouble has been marginalised!

    The problem with broad economic theory is that individual countries, with their unique institutional and social cultures could easily rubbish a broadly painted theory. Germany, for instance, had unions who were prepared to accept stagnant wages during the noughties in order for German industry to be more productive today. This is not repeated in the unions of, say, France or the UK or USA. However, France has a strongly concept of social solidarity than the UK and USA so the “socially minded” technocrat can become a leader in a French company while it is doubtful that the same type of leader will lead a similar US or UK based company. It could also explain the lack of entrepreneurialism in the French economy.

  10. @SeanG
    Sean G – dont tell fibs. The last I noted you were kicked out permanently. You must have grovelled appropriately. Its a good thing your capacity for causing trouble has been marginalised. There are positive externalities in curbing you Sean G.

    But, if you are trying to suggest the usual “militant unions caused the inflation of the 1970s’ that wont work.

    Now, if you are trying to suggest that France lacks entrepreneurialism as a result of its greater degree of “social solidarity” –

    What actual evidence do you want to put on the table for that Sean??

    Please do take into account the level of immigration.

  11. @Alice

    I was kicked out permanently? I have to check that but shocking as this is to you… I have been overseas so haven’t been able to regularly update myself on happenings in this blog.

    I wasn’t actually suggesting the usual, Alice. Re-read my post because you would notice that I started by looking at Germany where the unions were prepared to have stagnant wages in order to improve German competitiveness.

    And the problem in France has been noted by many others including Nicolas Sarkozy in his semi-biographical/manifesto-of-a-book “Testimony” which he is now trying to arrest with pro-business policies specifically designed to boost the number of new companies being created in France.

  12. @SeanG
    Then Sean, you better start grovelling appropriately now…(o’seas my eye!)…!! LOL this is funny. You know I never realied conservatives were such good fibbers…but it goes with the territory does it? Hmmm..”we create our own universe and you lesser mortals just tag along??”

  13. Sean..

    strange as it sounds but you have to have the heart of a socialist to actually feel sorry for people like you when they get kicked out.

    Its really not so bad – you should try it some time.

  14. A lot of comments note that if you look at individual countries or periods, then broad economic policy prescriptions/theories have to be modified – for example that French companies are not run like UK ones, or that social policies/attitudes in Holland lead to fifferent outcomes. But isn’t this pointing to a greater difficulty – that these theories cannot specify a domain of applicability, either in time or space. If Friedman had said “inflation is mostly a monetary problem in industrialised societies since the late 50’s, except where…” I doubt he would have got a Nobel Prize (but he would have been much closer to the truth).

    Reductionism works well where there is some underlying unit/force you can reduce to. If there is not, you end up going in circles if you persist in trying to use this approach. An example of something you cannot reduce is language – it seems to be a product of the interaction of at least 5 networks (sound/grammar/linguistic context/personal context/social context) operating simultaneously, with no one network in any sense more “basic”. Social interactions, including economic ones, are probably at least this irreducibly complex. Can we mathematically model this?

    On my limited reading of his work, Keynes eventually took the approach of looking for useful but partial and contingent truths. Since I share his evident dislike of applying mental straitjackets to complex problems, I would like to see this aspect of Keynesian economics revived.

  15. @Peter T

    Agree Peter – particularly your last para. We shoudl beware those who think they have the one solution of all seasons. It always seemed to me that Friedman thought he had a monopoly on the problem of inflation..

    JQ – I really am feeling a bit sorry for Sean G. Maybe he should he make a little apology? (but I cant help laughing about it just the same…pretending he was overseas and didnt see his ejection! No proof it was pretense of course…LOL)

  16. As far as militant unions causing the stagflation that ended the Keynesian consensus era, I think that is scapegoating the unions. Granger causation studies found that inflation causes strikes, not the other way round. This is rather an interesting finding, because if inflation expectations are shared between unions and managers then higher inflation would lead to higher wages without the expense to both parties of a strike. It clearly has to do with heterogenous inflationary expectations.

    Prof Quiggin suggests that incomes policy can be used to painlessly reduce inflation if it gets out of hand. This is only the case if it is used in a co-ordinated fashion with monetary policy. Most countries in the 70s tried to reduce inflation with price and income controls alone, but failed miserably.

    The Accord was always promising 4% inflation just around the corner in the government’s budget papers. This target was only hit once due to the 1982 recession and the effect of Medicare on the CPI; for most of the rest of the Accord era inflation was in the 7%-10% bracket, due to monetary policy with an implicit target in that range. The Accord was, however, spectaculalry successful in reducing real wages – something that was not its objective begin with.

    If incomes policy is used in a co-ordinated fashion with monetary policy, it can reduce the costs of disinflation. This is tricky, as the monetary authority must take great care in setting interest rates to take into account inflationary expectations, not just respond to the
    (temporarily supressed) ex-post inflation rate. Given that goverments typically use incomes policy as a substitute for sound monetary policy, not a complement to it, anouncing an incomes policy may actually increase medium term inflationary expectations (although central bank independence may help here).

  17. @Tim Peterson
    Thank you Tim
    “Granger causation studies found that inflation causes strikes, not the other way round.”
    I agree…Im really a bit past the political “militant unions caused inflation in the 1970s” line. Ive now heard it a number of times here. I have a lovely graph here that clearly shows wages desperately trying to play catch up to inflation but failing, rather than the other way around in the 1970s. It is pretty evident the inflation wave rolled in before hand.

  18. @Tim Peterson

    Inflation will cause strikes because union attempts to keep ahead of inflation and productivity by wage claims will not be accommodated by policy makers hence businesses will not be able to accommodate their demands either with the result that unions strike. The unwillingness to accommodate results in stagflation.

    Is there research showing that inflation granger causes wage inflation (in excess of increases in labour productivity) but not the other way around?

  19. Alice,

    It is interesting to note that unions were universally blamed at the time for the first bout of stagflation in 1970/71. This, combined with the power-mongering of Fed chairman Arthur Burns, persuaded Nixon to impose wage/price controls while cranking up fiscal and monetary policy to generate a boom to get him re-elected in 1972. Similar measures were undertaken by Ted Heath in the UK.


    If both parties expect non-accomodation of wage/price increases by policy makers, then there is no point having a strike over wage increases – unions realize that they would loose the strike and don’t bother with it.

    In the 70s, policy makers generally did accomodate wage increases; they believed that wage push was an exogenous, sociological phenomena that couldn’t be addressed with the tools of demand management (ie more scapegoating of unions).

    I don’t know about wage/price granger causation off-hand. I would imagine that there is bidirectional causation going on there, at least partly because wages are sensitive to the output gap.

  20. Freelander,

    I have thought a bit more about the inflation/strike thing, and concluded that because unions are democratic, what matters is the inflationary expectaions of the membership, which would likely be less acurate that the leadership (in big unions that are economically sophisticated).

    Does anyone know if any unions hire economists to advise them on such matters?

    Regarding the granger causation, to prove that inflation is wage push based you need to show that the causation from wages to prices isn’t caused by the output gap.

  21. @Tim Peterson
    Tim – the output gap is too indirect a measure for this, too too vague (and assumes models work as modelled)…. wages asks for more money when prices rise when inflation rolls around when they need it – members put pressure on union bosses – maybe they see other industries rising maybe they dont…how about charting the growth in wages, compared to the inflation rate itself (use a few different kinds if you want to)….whats wrong with that?…you can see what is happening visually. I dont know of any unions that hired economists…not to say it didnt or doesnt happen.

  22. Alice,

    Nixon was prepared to do practically anything to get re-elected (eg Watergate). He appointed Arthur Burns (a highly respected academic economist and expert on business cycles) to the Fed with the express condition that he do whatever was necessary to win 1972. Burns had one condition: that Nixon impose a wage/price freeze. Burns loosened monetary policy and Nixon cut taxes; in combination with the wage/price controlls this produced a reasonably strong boom in 1972, enough to get Tricky Dicky back in power. The inflation rate bounced back as soon as the controls lapsed.

  23. Alice,

    The unemployment rate would be better for assessing causation between wages and prices.
    That or a similar variable should be used, since demand pull inflation effects the economy mostly first through wages (and commodity prices) and then through into retail prices, ie most wage inflation is demand pull (when it isn’t an attempt to catch up with past inflation).

  24. @Tim Peterson

    Back in those days there wasn’t too much democracy in unions. I don’t think unemployment is really that good for modelling causation because the unemployed can become quickly detached from the labour force and, back then, powerful unions are not to worried about the well-being of non-members.

    I would like to note that I am not anti-union and believe that strikes can be a good and justified weapon that has been outrageously restricted by the last twenty years of ‘reforms’.

  25. As for Tricky Dicky, I think he was no worse when it came to naughty behaviour than Kennedy, perhaps Johnston and certainly Reagan. He was more likely brought down by the extreme right (the future mainstream) in the Republican party than investigative journalism. The extreme right were not happy with détente. Détente was not good for arms business and Reagan soon put and end to that nonsense much to the delight of his wealthy backers. As Eisenhower noted in his farewell speech – the industrial-military complex.

  26. @Tim Peterson
    Tim – what would be ideal is to separate any initial commodity price effect where particular commodities are subject to an OS price shock which we then import from any wage effect here ie how much of it is imported is always a good question especially after our two biggest inflation problems (1970s and 1950s) appeared to be imported from US activities.

  27. Freelander,

    According to Layard you can account for the detatchment effets by seperating unemployment into short term and long term (with the latter having a much smaller effect on wages).

    Johnson was way up there in terms of naughty behaviour (blackmailing senators/congresmen and lining how own pockets) but I have not heard anything bad about JFK except for frequent and compulsive sexual indiscretions.


    Yes: you really need to trace all the forces behind inflation in a Granger causation setting to figure out what was going on. The 1950s inflation imported to Australia due to the Korean war deserves attention for the following reason: inflation fell from 20%+ to low single digits without a severe recession – attaining the best ‘sacrifice ratio’ of unemployment/inflation reduction in Australian history. The UK achieved similarly good performance after a huge blip in inflation due to an end to wage/price controls and rationing in the early 50s.

    The peak in inflation here in the early 80s had a large home grown component, appart from the effects on the second oil shock; the ‘crawling peg’ system was similar enough to a float of the exchange rate to prevent demand pull inflation from being imported from the USA.

  28. Freelander: an interesting comment regarding Nixon. The right of the Republican party wouldn’t have liked wage/price controls, universal government subsidised health insurance or the guaranteed minimum income either (the latter two being Nixon policies that never got past congress). Maybe they also disliked normalization of relations with China at that stage. But I thought ‘deep throat’ was an FBI man.

    As far as detente goes, I just don’t see it as practical after the Soviet invasion of Afganistan, the deployment of SS-20 nuclear missiles in central Europe, and general growth in the Soviet conventional arsenal through to 70s. Jimmy Carter started out trying to extend detente, but by about 1979 had concluded that Breshnev was too hardline to meaningfully negotiate with.

  29. @Tim Peterson

    He was an FBI man and a Republican but he wasn’t the only one trying to ‘leak’ to the press. Someone else (higher up and also a Republican) tried to leak to the NYTimes but the reporters he tried to leak to were just about to change jobs and couldn’t be bothered. If you know journalists many of them are quite lazy, and quite a few are not beyond expecting their ‘sources’ to write their stories for them.

    The Soviet invasion of Afghanistan is a bit more complicated than usually portrayed. The government in Afghanistan was a communist government and the Soviets were ‘invited’ in and did so with reluctance and over the objections of the Soviet generals. The government that invited them had suffered a coup by one of the ‘communists’ who had also murdered many of his opponents and that’s why they were ‘invited’.

    Reluctantly, they were trying to improve the situation. The reaction first from Thatcher and then in a big way from the CIA under the blessing of Reagan was to fund, arm and train every crazy from the Islamic world to go to Afghanistan to fight the ‘invaders’. The CIA called the list of crazies ‘the database’ which has an interesting translation into Arabic. First Thatcher then the CIA gave them surface to air missiles which were decisive in downing helicopters. Of course, the battering the Soviets took there and the increase in their arms expenditure to try to keep up with Reagan’s expenditure crashed the Soviet economy, and the Soviet’s unwillingness to kill the numbers of people necessary to retain control resulted in the break up. China remained willing to do what was necessary in 1989 and, hence, still has a ‘communist’ government today.

    Of course, the American created a rod for their backs. One of the crazies on the database was bin Laden and when Gulf War I happened he was not too happy. He had made an offer to the Saudis to lead his crazies against Saddam, but the Saudis turned him down when the Americans and all offered their help. When the Americans set up bases in Saudi Arabia and female GIs, were to his mind, dressing sacrilegiously in what to him was a sacred country, he told the Americans, his former benefactors, that either they remove their bases from Saudi Arabia or he would be at war with them. Of course, they did no such thing. One of the reasons they don’t broadcast what al Qaida have to say, is because this is what they said and say. Contrary to the Bush-Cheney story, the activities of the bin Laden part of al Qaida were not motivated by a hatred of American ‘mom and Apple pie’.

    When the Americans invaded Afghanistan why do you think there was there so much munitions to blow up? Where do you think it all came from?

    As for the Soviets, the SS-20s and so on, missing from the story is the provocation for the Soviets to do these things. Constantly in the US, the research funded by the ‘military-industrial complex’ as Eisenhower named them, would exaggerate the Soviet threat to get expenditure on new weapons. Outrageous claims about what the Soviets were going to have built in the next five years were constantly made by ‘researchers’ to justify new expenditures. These predictions about what the Soviets would do never were realised. The Soviets were always massively behind the Americans, although given MAD how massively behind didn’t really matter.

    The MIRVs and MARVs were an example. The ‘research’ claims about these were in, for example, Scientific American in the ‘70s. The claim in this case was that the Soviets were going to follow the Americans in MIRVing and MARVing their ICBMs, which would tip the balance in the Soviets’ favour. This never happened to anywhere near the extent predicted and the ‘researchers’ own numbers at the time of the predictions demonstrated that the Soviets would be mad to do so because if they had, because their ICBMs were less accurate, they would have massively reduced the effectiveness of their first strike capability.

    Recent events have been quite worrying. Having done nothing to stop Russia from ending up where it has, in a new totalitarian regime, the US under Bush was busy trying to provoke them by bringing former Soviet satellites into NATO, which should have dissolved with the collapse of ‘communism’, and by threatening to put a ‘missile defence shield’ on the Russian boarder to defend against non-existent Iranian missiles. The US military industrial complex needs a cold war to justify weapons expenditure. Unfortunately, weapons expenditure may ultimately result in the collapse of the US as it did to the USSR.

    The whole Cuba thing is discussed in a some what unbalanced way. The Americans almost started WWIII because the Russians had put missiles in Cuba, with plenty of provocation, but they had for some time had nuclear missiles in Turkey which is a lot closer. The deal struck (but not in the headlines) was that the Russians would take their missiles out of Cuba and the Americans would take theirs out of Turkey.

    The Russians don’t trust the US with good reason. When the Berlin wall was at risk of falling, the US made an agreement with Gorbachev that if the Soviets let it happen and let the Eastern block fall, the US would not use the opportunity to roll NATO eastward and include any of the other countries in NATO. That promise didn’t last long.

    But back to Woodward and Bernstein, don’t you find it interesting that Woodward has such good contacts in the Republican party? Also, some have claimed that inconsistencies in the “All the President’s Men” point to ‘Deep Throat’ having been a composite of more than one source because, one source like Mark Felt, could not have supplied him with all the information sourced to ‘Deep Throat’.

    And further, given that the upper echelons of the government agencies are their at the President’s pleasure, and the ‘special prosecutor’ was chosen by the Attorney General, who was also there at his pleasure, and the Congress could be sufficiently partisan to stop things regardless of moral rights or wrongs, don’t you find it interesting that the whole thing wasn’t ‘dead in the womb’?

    When they swept Nixon away there was no one left in the Republican party but the loonies you have today. But these loonies are not bad for (the arms) business.

  30. Freelander,

    SS-20s seemed to be specifically designed to threaten western Europe without triggering an intercontinental nuclear response from the USA, and thus MAD. They were countered by the USA using pershing and cruise missiles. The Soviets were not behind NATO in conventional troop strength, tanks, and artillery in Europe. They also had more nuclear attack submarines than America, Britain and France put together – which seemed very threatening at the time but was later revealed by spying on the USSR to be primararily about defending their missile subs and not conducting a WW2 style anti convoy campaign.

    You are right about US involvement in the Soviet Afgan war coming home to roost since 9/11; pity the Afgans didn’t show more gratitude!

    Fascinating info about the additional leaks to the press at the time of Watergate.

  31. The way I see it is that George Reisman has made major strides in macro-economics, and the rest of the profession hasn’t caught up to him yet.

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