One week after Paul Krugman announced that “terrifying signs” of our “mutilated economy” were revealed in a report by Federal Reserve economists at last week’s IMF conference on financial crises, he was back on safer ground — Europe. In addition to his New York Times Op-Ed (“The Money Trap”), on Friday he posted “Europe’s Remarkable Achievement” in his blog, showing how, based on industrial production, Europe’s recovery from six years of recession is now falling behind the pace of its recovery from the Great Depression (here).
Meanwhile, Janet Yellen, the President’s nominee to head the Federal Reserve Board, was delighting Wall Street with her testimony at her confirmation hearing (here), but raising concerns from some Republican senators discouraged by slow growth and fearful that her pledge to continue aggressive monetary expansion will create another disastrous bubble (here). Thus, we see some Republicans, perhaps for different reasons, lining up behind Krugman’s assessment of the situation, as discussed in Part 1 of this post (here). Interestingly: “Members of both parties questioned whether the Fed’s policies had mostly benefited the wealthy, while doing little to improve life for most Americans” (Binyamin Appelbaum, in the second article). Of course, the agenda of their party is only making matters worse — but these are rare signs of economic realism from at least some members of the party that is trying to dismantle social security, hold back the minimum wage, and reduce unemployment insurance, food stamps, and other safety net programs.
The report that piqued Krugman’s anxieties — “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy” (herein “the FED study,” here) — can be seen in a slightly different light this week. As discussed in Part 1, the authors did not share Krugman’s sense that they were delivering terrifying news, and in fact avoided the appearance of delivering any news at all, concluding:
Thus, in an uncertain world, a policymaker’s choice of policy will depend not only on the extent to which he or she believes a demand shock is likely to affect potential GDP and employment, but also on his or her view of the risks associated with actively trying to offset these adverse supply-side developments through accommodative monetary policy. (p. 4)
It now appears the authors of the report anticipated that their new boss would likely be Janet Yellen, and expected the stance Yellen would take at her confirmation hearing: They appeared to be laying the groundwork for a continuation of Ben Bernanke’s policies.
In the process , though, they did need to discuss the economy, and we have learned much from their discussion. They were unwilling to predict the future, but their discussion confirmed the existence of a bias toward overoptimistic expectations built into “supply-side” approaches to modeling: Thus, despite a 7% decline in the size of the economy since 2008, the charts in Figure 4.3 project continuing GDP growth through 2014 (upper right panel), and a continuing decline of unemployment (lower left panel):
Of course, when you are recovering from rock bottom (2008-2010), and you have a new president armed with a stimulus package designed to keep the economy out of depression, such trends are inevitable — there is nowhere to go but up. But that makes it relatively easy for neoclassical ideology to mask reality: Whatever growth of income (GDP) has materialized since 2010 is due to a robust stock market and the continuing growth of the top 1% income share; and that growth has been so substantial that it masks the severe decline in the bottom 99% share of incomes and a decline of over 10% in median income. What makes the 7% decline in total GDP since 2008 so terrifying is that, with the economy’s total income declining this significantly, despite the huge success of the very wealthy, the bottom 99% income has suffered an even worse decline.
But the 7% figure is soft, and total GDP decline could actually be worse. Much of the variation among forecasters, the Fed report revealed, can be traced to variations in the definition and projection of potential GDP, and to the exclusion of the aggregate demand factor from supply-side models. Although some concept of “potential” GDP may be required for supply-side forecasting, the concept is too subjective to produce meaningful results in situations of growing stagnation. Demand-side forecasting, however, would proceed on an entirely different basis and, as the Fed report’s anecdotal observations regarding declining demand suggest, would likely produce lower forecasts of GDP. Demand reflects income, and the continuing redistribution of income from the bottom 99% to the top 1% has reduced the aggregate “propensity to spend.”
The discussion of long-term unemployment was the most instructive, so let’s return to that discussion where we left off in part 1:
Figure 2.8 from the Fed study shows that long-term unemployment jumped from about .8% of the labor force to in 2007 to over 4% in 2010, a time when total official unemployment rose to over 10%:
The Fed study’s argument is that the failure of long-term unemployment to fall back to pre-recession levels by now reflects “hysteresis” — an increased level of structural unemployment and a higher base or “natural” level of unemployment. That argument shifts the blame for the 7% decline from stagnation to unemployment, obviating the need to explain why the economy is stagnating, and rescuing the neoclassical faith in automatic full recovery to the “natural” level of unemployment: I.e., the economy hasn’t gotten smaller, it’s just gotten less efficient in allocating labor resources.
The problem, as discussed in detail in Part 1, is that this explanation is illogical and contrary to the evidence. First, there’s no rational basis for believing that structural allocation problems suddenly and irreversibly increased, at the time of the 2008 Crash, for the first time in modern history. Second, the more obvious explanation for the high level of long-term unemployment is a reduction in the number of available jobs relative to the total labor stock. We see evidence supporting that explanation everywhere today: Take, for example, jobs provided by big retail chains like WalMart, Lowes, Home Depot, and regional supermarket chains. As sales activity declines over time, such companies cut back employment to control costs. We have all, I believe, witnessed a reduction in the number of manned checkout lanes and a reduction of support personnel at major retail locations as their sales volumes flagged. Over time, with increasing stagnation, this constitutes permanent job loss.
Stagnation in the legal profession offers another example. Three years ago law school enrollment was high, and students ran up significant debt, only to discover that jobs for attorneys are far less available today than they expected. Yes, that is a kind of “structural” problem, but not one that would necessarily prevent them from being employed at all. They don’t need more education and training: Recent law school graduates could take other less demanding jobs anywhere, if enough jobs were available for both them and the work force that traditionally competes for them.
These examples demonstrate that an increase in the “normal” unemployment level (the amount of unemployment at optimal or “full” employment) is traceable to higher stagnation, not to greater structural problems. Proof of that point is provided by the chart of long-term unemployment provided by Paul Krugman:
Unlike the chart provided by the Fed study, this one goes back to 1950. Notice that after the recession following the Vietnam War and the beginning of the Reagan presidency in 1980, the so-called “normal” level of long-term unemployment (reached at the low points reached just before recessions) began to rise steadily. The number jumped substantially between the start of the recession of the early GW Bush presidency and the start of the Great Recession. Now, it appears, another increase is likely.
We know that ever since 1980 income inequality has been rising, and that total GDP has been declining. (For details, see my post “The Thirty-year Growth of Income Inequality” in the “Finding a New Macroeconomics” series, here). Thus, stagnation in the bottom 99% economy and an associated reduction in the number of available jobs relative to the total size of the labor force offers a necessary and complete explanation for the permanent increase after the Crash of 2008 in the “normal” level of long-term unemployment. Although it has been developing slowly, this is a textbook depression.
The Fed study itself provided further evidence of the gradual decline of available job opportunities relative to the stock of available labor:
This chart shows that the percent of employment from start-ups and young businesses fell from about 12% in the Reagan/GHW Bush years to 6% in 2011. This is further evidence of gradually increasing stagnation within the economy, and especially within the bottom 99% economy which includes the labor income from those jobs.
Belaboring the Boondoggle
A “boondoggle” is a time-wasting exercise. It is not a waste of time, however, to try to consider how close the authors of the Fed study, Messrs. Reifschneider, Wascher and Wilcox, may feel they have come to thinking they are wasting their time with supply-side modeling. Think about what they have told us:
In the wake of the financial crisis, real GDP in the United States fell 4¼ percent from its cyclical peak in the fourth quarter of 2007 to its trough in the second quarter of 2009, and the unemployment rate rose sharply, reaching 10 percent by late 2009. Moreover, the subsequent recovery in economic activity has been sluggish by historical standards, with real GDP in 2013 only modestly above its pre-recession peak and the unemployment rate still nearly 3 percentage points higher than it was through most of 2007. These features of the recession and recovery, coupled with observations by Reinhart and Rogoff (2010) and Cerra and Saxena (2008) that past financial crises tended to be followed by persistent shortfalls in real GDP, have led many to speculate that the financial crisis and ensuing recession have left a permanent imprint on the productive capacity of the U.S. economy. (p. 4)
They can see, in other words, that our economy has been declining, but they only know how to interpret a “permanent imprint on the productive capacity” of the United States in terms of financial crises, bubbles, and recoveries. Their neoclassical framework has not given them the tools to work it out any other way. They can sense, however, the un-explainable truth that something has gone terribly wrong, perhaps wrong enough to force a re-evaluation of their belief system:
In the United States, the collapse of a housing market bubble and the ensuing financial crisis led to the steepest drop in real GDP and the largest increase in the unemployment rate since the Great Depression. The fallout from these events on credit availability, balance sheets, and confidence continues to weigh on aggregate demand, restraining the pace of recovery in the housing market, firms’ willingness to hire and invest, and spending by consumers and state and local governments. In addition, these demand effects have probably diminished the productive capacity of the economy. (p. 2)
Paul Krugman’s reaction in “The Mutilated Economy” was swift:
[The authors] put a number to these effects, and it’s terrifying. They suggest that economic weakness has already reduced America’s economic potential by around 7 percent, which means that it makes us poorer to the tune of more than $1 trillion a year. And we’re not talking about just one year’s losses, we’re talking about long-term damage: $1 trillion a year for multiple years.
For his part, Krugman has been fighting his belief system for a long time, at least since the Crash of 2008. In “How Did Economists Get It So Wrong” (September 2, 2009, here), he bared his soul:
It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.
Last year, everything came apart.
I hope the gentlemen from the Federal Reserve Board would forgive me for saying so, but they remind me of Karl Marx. Beyond all others, in my view (so far), Marx over-complicated the value/wealth system that classical economists so strenuously developed for over a century, a system that would prove spectacularly useless in coping with real dollars-and-cents income and wealth data. In the end, the proud Marx ended up advising the proletariat, in my words: “If you want to save yourselves, overthrow the monarch.” Similarly, these gentlemen from the Fed, with their Beveridge and Phillips curves and dazzling array of sophisticated econometric models, have demonstrated, to a fault, the “over-dismalization” of economics. We can no longer see the forest for the trees.
And that’s not anti-intellectualism talking. I have something none of them do — an entire career’s worth of experience in utility rate regulation, learning among other things to appreciate the macroeconomic significance of the cost of capital. So let’s get down to basics: It’s time to overthrow the reigning ideology.
The Inequality Factor
I’ll do this first in words, then provide the proof. Keynes viewed the economy as if there was a constant distribution of wealth and incomes. He understood the obvious, that distribution is controlled by taxation, but beyond that did not give it much thought. He had bigger fish to fry — or so he thought. But his fish turned out to be much smaller.
At any given distribution of wealth and income, economic conditions behave according to Keynesian demand theory. When demand for current consumption (the propensity to consume) wanes, economic activity declines. Such a decline does not automatically correct itself, he showed, because spending toward future consumption (investment) depends on expectations of future demand. This was his brilliant insight. But even he could not escape the “equilibrium” genie that kept urging him to believe that there would always be recovery from a slump. (The word “equilibrium” appears 83 times in his General Theory.) What’s more, his prescription for recovery, pumping more money into the economy to get it going again, was subject to a reasonable objection raised by Fredrich Hayek and the “Austrian School” — that could cause inflation.
It could indeed. For Keynes’s approach to work, his policies had to stimulate actual, real (here I mean “tangible,” not “constant dollar”) increases in output. Otherwise, all that additional money, if placed in the hands of people who would spend it on current consumption (consumers) would just tend to bid up prices on the lower, pre-existing supply of goods and services.
But neither Keynes nor the Austrians were correct, certainly not in today’s financial economies, for a reason neither side in “the great debate” suspected — the prevalence of economic rent. “Economic rent” in its broadest sense is money collected by someone (e.g., a hedge fund manager) without making any contribution to real wealth. If economic rent is skimmed out of the active economy and redistributed up, that effectively counters any stimulus Keynesian policy might provide, by nullifying the increase in consumer demand expected by Keynes’s “full employment” model (which had been another brilliant insight in Keynes’s dynamic model). Likewise, however, it nullifies any inflationary pressure additional consumer demand might produce.
Thus, the one factor studiously ignored by modern mainstream economics — the distribution of income and wealth — turns out to be the controlling factor in how an economy functions, and its impact is huge. Let’s look at the facts:
Thomas Piketty and Emmanuel Saez, who have a vast database of income distribution in the United States and around the world, have been tracking changes in the allocation of new income, that is income growth, in the U.S. economy, as summarized in my recent post on “Inequality and the National Debt” (here). The top 1%’s share of total income increased from 8.9% in 1979 to 22.5% in 2012. Importantly, the rate of income concentration has increased exponentially: The top 1% share of new income — i.e., income growth — increased from 11% in 1960-1969 to 43% in 1992-2000, 65% in 2002-2007, and 95% in the 2009-2012 recovery period, peaking at 121% (i.e., 100% going to only a fraction of the top 1%) in 2010. Thus, nearly all growth is now going to the top 1%, most of it high within the top 1%, and the rate of income inequality growth appears to have nearly maxed out.
This, of course, has implications for monetary policy ignored by the Fed study, by Janet Yellen, and by everyone else advocating the “full speed ahead” monetary policy (here). Pumping more money into the economy means that all or nearly all of it will just end up, fairly quickly, in the incomes of the very rich: Those senators, Republicans and Democrats alike, who worry that current monetary policy only benefits the rich (here), are absolutely right. No wonder Wall Street is so happy with Yellen!
Yellen testified: “At this point I do not see risks to financial stability.” But she, like her predecessor Bernanke, is not thinking about, and is likely unaware of, the distributional consequences of Fed policies. The Fed is “expanding its holdings of Treasury securities and mortgage-backed securities by $85 billion a month to drive down borrowing costs for businesses and consumers,” Applebaum reports. That’s about $1 trillion per year, the amount by which Krugman tells us the Fed study shows the aggregate economy has been shrinking. Coincidence? No, because all or nearly all of that additional income collected at the top (think economic rent) is simply converted into idle savings. In short: The $1 trillion/year of extra money infused into the economy is converted into idle savings, not additional income.
Most economic rent collected at the top in recent years has indeed been converted into idle savings. A reasonable estimate of the increase since 1980 in the wealth (net worth) of the top 1% of wealth holders, in current dollars, is $22-25 trillion. My analysis of Census Bureau net worth data shows top 1% net worth increasing by about $3 trillion in the four years we have been discussing, from 2008 to 2012. (See my chart of U.S. national debt, GDP, and top 1% net worth in “Inequality and the National Debt,” here). Thus, from 2008-2012 the net worth of the top 1% has increased on average about $750 billion per year, implying about a $1 trillion per year growth in top 1% pre-tax income. This is consistent with the Fed study’s findings, because the rate of decrease in total GDP (income) should roughly match the rate at which that income is transferred to the top 1% and sequestered from the active economy.
As I also explained there, an increase in top 1% net worth of this magnitude could not have been possible without the contribution of our involuntary fiscal policy as well. The national debt, which now totals more than $17 trillion, financed the lion’s share of this increase in top 1% net worth, with the balance ($5-8 trillion) extracted from the incomes and savings of the bottom 99%.
These facts, in proper perspective, explain the vast inequality we see today and its anomalous consequences. We now have a framework, if not all of the exact details, for understanding how — at a time when unemployment, poverty and homelessness are peaking, home ownership and owner-occupied housing are flagging, state and local governments are slashing budgets, health care and higher education are in crisis, and the federal government cannot balance its budget despite major belt-tightening because its revenues have continued to flag — we can be treated to headlines like this one: “Warhol painting could fetch $80 M; sale follows auction record of $142 M for Francis Bacon work” (The Washington Post, Entertainment, November 13, 2013, here):
In just six minutes, bids shot up to $142.4 million for a Francis Bacon triptych, making it the most expensive work of art ever sold at auction. World auction records also were set for 10 artists.
More feverish bidding is expected Wednesday night when a provocative double-panel painting by Andy Warhol comes up at Sotheby’s. “Silver Car Crash (Double Disaster)” is expected to fetch as much as $80 million, which would set a record for the pop artist.
“The demand for seminal works by historical important artists is truly unquestionable and we will keep witnessing new records being broken,” said Michael Frahm, a contemporary art adviser and partner at the London-based Frahm Ltd. “This is the ultimate trophy hunting.”
The atmosphere at the standing-room-only sale of postwar and contemporary art was electric as a handful of collectors vied for Bacon’s 1967 “Three Studies of Lucian Freud.” Bidding rapidly soared above the nearly $120 million paid for Edvard Munch’s “The Scream” at a Sotheby’s sale in 2012, replacing the iconic work as the most expensive artwork sold at auction.
Such prices underscore the fact that such works of art no longer have any meaningful “intrinsic” value; they are simply are one of many places economic rent can go to hide.
Economic rent was right at the top of the list of factors commanding the attention of the early classical economists — Adam Smith, T.R. Malthus, Jean-Baptiste Say, and David Ricardo. That was the era of “scientific” economics, and that factor has long been forgotten by economic science. The key to understanding what has gone wrong with economics is an appreciation of the degree to which ideology and mythology have corrupted “scientific” economics and destroyed the effective administration of public policy. In a previous post (Is Economics a Science? Really? here), I discussed how Karl Marx in 1873 bemoaned the death of “scientific” economics in Europe after 1848.
The three biggest threats to wealthy interests were posed by J. M. Keynes, Karl Marx, and Henry George. Among the three, Keynes posed the least problem, for his focus on full employment did not directly threaten wealth accumulation. The mission of wealthy interests regarding Keynesianism was to minimize government involvement in the economy, its control of monopolies, and other limitations on profits.
The ideas of Marx and George, however, were more threatening to extreme wealth, as they waged a direct assault on excessive inequality. Marx found no solution short of political revolution, however, and his threat could be, and was, nullified by the intellectual and real-world defeat of communism. George, however, was especially threatening: Like Marx, he sought to correct the growth of poverty and inequality that accompanied progress, but like Keynes, he sought to harmonize scientific economics with market capitalism. That was his mission, and its success could potentially dismantle runaway plutocracy at its roots, leaving the “free market” system intact. George located the problem in the treatment of economic rent, and the solution in taxation.
The eminent Georgist Mason Gaffney, who turned 90 in October of 2013, has been the leading critic of “neoclassical” economics from the Georgist perspective. But, more than that, he is one of the few modern economists to pinpoint the downfall of American economics in the invention and rise of neoclassicism. Gaffney traces the defeat of Georgist economics, popular at the turn of the 20th Century, to the attack on rent theory by one of its neoclassicism’s original American founders, John Bates Clark. Here is how he sums up the relevant economic history and its consequences:
Having taken shape in the 1880-1890s, Neo-Classical Economics (henceforth NCE) remained remarkably static. Major texts by Alfred Marshall, E.R.A. Seligman and Richard T. Ely, written in the 1890s, went through many reprints each over a period of 40 years with few if any changes. * * *
Not until 1936 was there another major “revolution,” and that was hived off into a separate compartment, macro-economics, and contained there so that it did not disturb basic tenets of NCE. Compartmentalization, we shall see in several instances, is the common NCE defense against discordant data and reasoning. After that came another 40 years of Paul Samuelson’s “neoclassical synthesis”. J.B. Clark’s treatment of rent, dating originally from his obvious efforts to refute Henry George (see below), “has been followed by an admiring Paul Samuelson in all of the many editions of his Economics” (Dewey, 1987: 430).
* * * “To date, capital theory in the Clark tradition has provided the basis for virtually all work on wealth and income” (Dewey, 1987: 429; cf. Tobin, 1985). Later writers have added fretworks, curlicues and arabesques beyond counting, and achieved more isolation from history and from the ground under their feet, than in [Simon] Patten’s dreams, but all without disturbing the basic strategy arrived at by 1899, tailored to lead to arguments against Henry George.
To most modern readers, probably George seems too minor a figure to have warranted such an extreme reaction. The impression is a measure of the neo-classicals’ success: it is what they sought to make of him. It took a generation, but by 1930 they had succeeded in reducing him in the public mind. In the process of succeeding, however, they emasculated the discipline, impoverished economic thought, muddled the minds of countless students, rationalized free-riding by landowners, took dignity from labor, rationalized chronic unemployment, hobbled us with today’s counterproductive tax tangle, marginalized the obvious alternative system of public finance, shattered our sense of community, subverted a rising economic democracy for the benefit of rent-takers, and led us into becoming an increasingly nasty and dangerously divided plutocracy. (The Corruption of Economics, 1994, pp. 28-31)
Although I cannot vouch for the accuracy of Gaffney’s conspiratorial attributions, I can endorse the list he offers of the impacts of neoclassical thinking. I would add only that, as a theorist, John Bates Clark was worse than Gaffney implies. His disorganized Essentials of Economic Theory was proudly presented without any notes or references. Consider that its opening words were these:
The creation and use of wealth are everywhere governed by natural laws, and these, as discovered and stated, constitute the science of Economics.
That, of course, is nonsense. The incidence of depression and the accumulation of economic rent and wealth are the result of human laws and institutions, not natural laws. With this, however, Clark creates an impression that any amount of inequality is the unavoidable consequence of normal economic activity. Borrowing randomly from classical discussions without material contribution, Clark created a playground in which a neo-classical game could be played scarcely honoring any laws at all. I’ve seen nothing else quite like it.
Whether Clark is ultimately blamed for what has since transpired is beside the point. What we now call “neoclassical” economics, analysis shows, would more properly be called “preclassical” economics, if for no other reason than that it missed the one factor that is the driving force of inequality in unfettered market economies, economic rent.
With data on income and wealth distribution available, economics is now poised to destroy the neoclassical dogma that “emasculated the discipline” once and for all, because the dynamic impacts of redistribution are so profound as to eradicate all neoclassical myths, from full employment “equilibrium” to efficient markets and natural growth. The self-destructiveness of modern capitalism in extremis is now becoming fully apparent.
The next steps will be to regain the sense that economic policy should favor society, not a small handful of “winners.” There is still time.
JMH — 11/17/13 (ARC edits, 12/11/13)