Model worker

While I remember, I want to jot down a couple of points about the two macroeconomic models I have found to be of the most practical use in looking at policy and performance in emerging economies: the full Keynesian domestic economy model, which brings in flexible prices and depends on particular view of how firms are likely to respond to changes set off by a change in demand; and the Keynesian open economy model in the short run, which is for economies in which international trade is significant component. It assesses the likely impact and effectiveness of monetary and fiscal policies—the two main levers of policy control—when the exchange rate of a country’s currency is kept artificially fixed against the currencies of the outside world and when it is allowed to float. These models are best "applied" separately, even to the same economy, in order to simplify the analysis of the expected lines of causation.

ISLMAS(K)AD. In contrast to the situation when we are looking at the knock-on effects of demand changes on the goods and financial markets of the domestic economy only, the introduction of the possibility of changes in the price level produces two new effects for policymakers to consider. In the first, [and in addition to the feedback loops set off between the goods and money markets through changes in interest rates and national income,] a price change caused by a rise in demand in the goods market, reflecting perhaps a fiscal expansion, erodes the real money supply, altering the equilibrium conditions in the money market—that is, its shifts the LM curve down, wiping out some or all of the gain in output from the original change in demand. The second is the effect of a change in the price level on the labour market, understood as working in a particular way. The key features of this model, which give rise to its distinctive results, are the assumptions of flexible prices in combination with "sticky wages"—that is, when nominal wages take time to adjust to changes in the price level, either up or down. Assuming that there is spare capacity in the economy, a boost in government spending or a cut is taxes will push up demand for goods and services, but it will also push up price growth. If the nominal wage fails to adjust upwards to compensate for inflation, the real wage falls, inducing a rise in labour demand (ie firms find it profitable to employ more staff) and a fall off in labour supply (people want on average to work less). This divergence of labour demand and supply temporarily boosts the level of employment and so, as conditioned by a definite level of technological development, economic output and income. At the same time, it reduces the level of involuntary unemployment. In modern economies, at least until the great economic crisis of 2007-09, this was the direction of price movements that interested economists, as it matched, for a time, the broad empirical trends of the economies in which they found themselves. However, I think I'm right in saying that Keynes emphasised the "downward stickiness" of wages, as, writing in the 1930s on the events of the Great Depression, what interested him was, understandably, the impact of deflation, which he identified as a trigger of the intractable and socially damaging problem of high and enduring unemployment. This was because institutional and legal factors prevented money wages from adjusting to a fall in prices by falling themselves, as predicted in classical economic theory. In turn, this tended to boost the real wage and so induce a fall in labour demand from firms and a rise in labour supply, at once reducing both employment and output, and amplifying "involuntary" unemployment.

Because the model sets out systematically the relationships between a large number of variables, it is a helpful framework for looking at a wide range of phenomena relevant to assessing the health and stability of economies, from demand-pull inflation and hyperinflation, overheating, soft and hard landings, to the co-ordination of policy with economic recoveries and slumps.

ISLMBOP. In an open economy, which incorporates the impact of inward and outward/net currency flows on the financial and goods markets, fiscal policy is powerful when the country’s currency is set at a specific rate, whereas monetary policy is relatively ineffective. If the authorities allow their currency to find its own level, however, without interfering by buying or selling on the currency market, then the reverse is true: the impact on monetary policy in enhanced and that of fiscal policy weakened. The reason for this is that

Looking both ways

Question: How does a closed economy adjust to shocks from the outside or to economic policy changes in the short run? Why is using the ISLM a more sophisticated and useful approach than looking at the real and financial sectors separately?

ISLM: internal macroeconomic adjustment in the short run

An alarming slowdown in economic growth gnaws away at business confidence, so that increasing numbers of firms lose faith in their ability to hit next year's sales targets, leading them to hold off on investments that would otherwise have gone ahead, depressing economic growth still further. Or instability in the financial markets sees more investors cashing in financial holdings so as to avoid the chance of a fall in their value. It is the macroeconomic implications of scenarios like these that the forbiddingly named ISLM framework helps us to analyse systematically. By selecting the most relevant economic indicators and sketching the expected relationships between them, this framework helps us to trace through the rest of the economy the knock-on effects of destabilising economic developments, such as the ones above, and to work out the kinds of results that we might expect from policy responses to them. The most important variables include the rates of growth of government spending, household consumption, private investment expenditure, and the national output of goods and services. Important, too, are changes in tax rates, money holdings and interest rates. Over a longer period, changes in the price level would be included on this list. When looking at imbalances in the goods and the money markets taken separately or together, the crucial difference is that, in the second case, there are feedback loops between them, going in both directions. The key link by which imbalances in the real economy are transmitted to the financial sector is between the economic activity (or output) and money demand. Imbalances originating in the money market affect the production of goods and services by way of changes in short-term interest rates. And just as we conventionally show the main relationship as between output (Y) and the price level (P) in graphical form when looking at aggregate demand (“PY space”), so it is useful to illustrate the two-way links between the goods and money markets as a relationship between output and short-term interest rates (“IY space”), because these, as I have said, are the main channels through which changes in one market are transmitted to the other. Thus, the IS schedule (the letters stand for “investment” and “savings”) is simply a graphical summary of all possible combinations of interest rates and national output in which goods demand and supply just balance. It incorporates much the same information as in the PY or aggregate demand diagram—since aggregate demand is affected by changes in both the goods and the money markets—but is examined from a different angle so as to bring out the interlinks between the domestic economy’s component markets. As lower interest rates encourage borrowing by firms and households for investment and consumer purchases—and thus also higher levels of economic output—the IS curve is negatively sloped: as interest rates rise, investment, and so economic output, falls. Likewise, the LM schedule (standing for “liquidity preference”, or money demand, and “money”, or money supply) represents all the combinations of interest rates and output in which money supply and demand are in balance. In contrast with the IS line, the LM schedule is positively sloped: as output rises, it takes higher interest rates at every level to equate money demand with a (nominal) money supply that is centrally fixed. Movement along the curve can be read as showing that higher money demand is associated with increased rates of growth in national income—that is, to facilitate the rise in the number of transactions—but that higher rates of interest are required to maintain balance with the fixed money supply. The point of crossover of the two schedules thus represents the unique rates of interest and output growth needed to keep both markets in balance at the same time.

By goods alone: IS

One way to proceed is to contrast the results to be expected following the combined and separate adjustment to developments that upset balance in either market. In the real domestic economy, the kinds of changes that could affect the level of demand for goods and services include alterations in the pace of growth of private investment, household disposable income or government spending. It would also include changes in tax or savings rates, or in the responsiveness of private investment to changes in interest rates. (Reforms of public spending or of the rates of taxation—fiscal policy—are the main policy instruments used by the government to influence activity in the real sector.) Changes in the first set of factors would affect the position of the IS curve, shifting it up or down, boosting or sapping demand for goods and services—and thus the growth rate of national output—at all interest rates. Changes in the second set would tilt the IS curve so that it becomes flatter or steeper. A flatter IS curve implies that only small changes in interest rates are needed to induce a relatively large increase in investment demand. A steeper curve means that even large changes in the interest rate are able to induce only a small change in desired investment. (The slope of the IS curve might be said to reflect the level of development or friendliness of the business environment.) In the short run, changes in domestic spending mean that some combination of firms, households and the government together plan to buy more or fewer goods and services than are currently being supplied. Such a change tells domestic producers whether to make more or fewer products. In this relatively simple model of the domestic economy, firms are assumed to be able to respond unproblematically to imbalances in the goods market by adjusting production for the inputs they need: they supply just as much or as little as is desired.

Money alone: LM

In the financial sector, three factors are typically cited as capable of igniting disturbances. In each case, any imbalance in the money market triggers changes in interest rates, which ensure that a new equilibrium level, higher or lower than the initial one, is achieved. The first factor is a change in the pace of growth of economic activity. For example, a splurge in consumer spending—say, in the run up to Christmas, or ahead of a rise in value-added tax (VAT)—boosts aggregate demand and hence the rate of growth of national income, simultaneously pushing up the demand for money to carry out these additional buys. The LM curve shifts up and left. A second important destabilising factor would be any trend towards holding more private wealth as money. Such a rise in "liquidity preference"—say, in response to high volatility in bond markets, as in my opening paragraph—would likewise shift the LM curve leftwards and up, also by setting off by unbalancing rise in monetary demand. A third important factor that can produce money market imbalance is a change in the growth of the real money supply. In the short run, when prices are fixed, this is identical with the growth or contraction of the nominal money stock, which is controlled by the central authorities as a tool of (monetary) policy to influence other economic indicators, such as the short-term interest rate, or, over the longer term, the pace of growth of the general price level. Typically, it does this by buying or selling government securities (bonds and bills), which increases or decreases amount of cash in the financial sector, pushing interest rates down or up. The excess money supply linked to faster growth in the stock of money in the economy disturbs equilibrium in the money market, triggering a shift in the LM curve, this time rightwards and down, so that money market balance is restored: a reduction in the interest rate induces a switch from less attractive interest-bearing bonds to cash, so that money demand rises to the point where it just offsets the increase in the money supply, restoring money market balance.

Both together: ISLM

Probably the clearest example of the distinct result of the interaction of the goods and money markets can be seen by working through the knock-on effects of a change in demand. From such a change, the main conclusion is that impact of the multiplier, whether positive or negative, is dampened by the interaction with the financial sector, because of the two-way feedback loops between the goods and money markets.

Causes. A rise in demand could be the result either of putting more money into the circular flow of income or of withdrawing less from it. In a closed economy, this might result, for instance, from an increase in government spending, or a tax cut (which would leave households with a larger slice of their income to divide between spending and saving, in this way, assuming that the ratio between them stays the same, boosting consumption demand). Such measures featured heavily in the many "fiscal stimulus packages" that have been implemented by governments around the world since 2008 in an attempt to counter the impact of a sharp drop in foreign demand set off by the global economic crisis. A boost to domestic demand might also stem from an improvement in business or consumer confidence, lifting investment and consumption demand, perhaps because the outlook for economic growth has substantially brightened, or because the latest figures show employment growing more briskly than expected.

Mechanism. An increase in spending and/or confidence boosts aggregate demand, though the rise in output is larger than the original impetus because, along the way, the original sum becomes someone’s income and they, in turn, spend a proportion of it, creating additional goods demand. In the short run, however, with prices relatively rigid, the rise in demand induces only an increase in economic output and the IS curve shifts right: output is higher at all interest rates. But that's not the end of it because the expansion of economic activity shows up in the money market as an increase in demand for money, which is needed to cope with the increased number of transactions. With wealth split, for analytical purposes, between money and bonds, saying that there is an excess of demand for money is the same as saying that there is an excess supply of bonds. With bond offerings exceeding planned new bond purchases, bond prices fall and the yield on bonds moves in the opposite direction—ie the interest rate rises. (Another way or seeing it is that interest rates rise because, in the case of bond-financed government spending, government borrowing bids up the cost of borrowing by creating additional demand for the supply of loanable funds.) This restores balance in the money market by choking off the increase in money demand to equate it to the nominal money supply, which is fixed by the central monetary authorities. At the same time, some business projects are rendered unattractive by the rise in interest rates. This discourages some private investment demand ("crowding out"), reducing aggregate spending and shifting the IS curve somewhat back left. Thus the conclusion is that the full impact of the multiplier on national output is dampened by the feedback loop in the financial sector. This also works the other way, so that the same mechanism will ameliorate the impact on the real economy of a drop in demand. The result contrasts not only with the outcome expected in the goods market taken in isolation, where the impact on the multiplier unfolds fully, but also, looking ahead, with the expected outcome of macroeconomic adjustment over the longer term, once the effect of the inclusion of the domestic labour market is taken into account where fully flexible wages and prices ensure that a boost to government spending produces no increase in output or employment at all (at least, with the classical or monetarist versions of the supply curve). Instead, all of the adjustment takes place in the form of faster price growth and the complete crowding out of private investment. From the point of view of disturbances originating in the financial sector, such as a loosening of monetary policy to try to “jump start” the economy to offset an economic slowdown, or a change in the pattern of distributing assets between money and other forms of wealth, in the first case would see the LM curve shift right, reducing interest rates and pushing up investment demand, which in turn pushes the curve back in the direction it came from.

Practical application

Under what circumstances might such a model be of practical use? A practical use of such a model would be when the international context is either a small or negligible factor for the economy in question, or the international trading environment is stable. This would include countries with economies characterised by a relatively low level of trade of integration with international financial markets. In countries in which the capital or debt markets are underdeveloped, the feedback loop between goods and financial markets is inhibited and the financial sector is an ineffective medium for transmitting official interest rate policy.

The path of despair

Hegel argues somewhere that an awareness of the inadequacy of our conceptions is what propels us towards self-criticism, making intellectual progress—which, for him, is the same as progress per se—possible. He calls this "the path of despair". Amid the current fad for shallow self-help books and studies of the "economics of happiness", it might be worth remembering that happiness is not the main goal of progress, freedom is. From the vantage point of enhanced freedom, people might be in a better position to hammer out whatever happiness is for them.

After the Iraq war, it became clear to me that, whatever the mainstream of Western left is, I'm not really a part of it, either in terms of philosophical outlook or political inclination. However, I do still consider myself a Marxist of sorts—in the sense that most of my political "starting points" come out of that tradition—and I still think that progress should be possible in extending the areas of popular political an economic control. I think of this as "socialism", although I don't suppose it really matters what its called. Is there an economics possible that raises living standards for most people on the planet and gives them greater control over their own lives? This has been our Holy Grail for some time, of course, but is still probably the most important question facing the left in this generation. There can’t be any socialism unless we get a plausible answer on this. But it is a huge task. To get anywhere would require a large number of like-minded, flexible-thinking, knowledgeable and talented people working closely together over many years. After Iraq, however, and the apparent retreat of many into the safety of the broad political dogmas that existed beforehand—most obviously, an oddly reactionary brand of "anti-imperialism"—it doesn’t seem as though the conditions are in place for the "ruthless criticism of all that exists". This would be only the starting point for such a programme, which would also have to turn its sceptical gaze in multiple directions, towards itself as much as to the outside world. Perhaps one reasons that this doesn’t happen very readily is that, for many, the left is something like a family, and, at the social-psychological level, not many family members want to risk becoming an outcast by speaking out of turn.

Right at the beginning of The Phenomenology of Spirit, Hegel says this:“The more the ordinary mind takes the opposition between true and false to be fixed, the more is it accustomed to expect either agreement or contradiction with a given philosophical system, and only to see reason for the one or the other in any explanatory statement concerning such a system. It does not conceive the diversity of philosophical systems as the progressive evolution of truth; rather, it sees only contradiction in that variety. The bud disappears when the blossom breaks through, and we might say that the former is refuted by the latter; in the same way when the fruit comes, the blossom may be explained to be a false form of the plant's existence, for the fruit appears as its true nature in place of the blossom. These stages are not merely differentiated; they supplant one another as being incompatible with one another. But the ceaseless activity of their own inherent nature makes them at the same time moments of an organic unity, where they not merely do not contradict one another, but where one is as necessary as the other; and this equal necessity of all moments constitutes alone and thereby the life of the whole. But contradiction as between philosophical systems is not wont to be conceived in this way; on the other hand, the mind perceiving the contradiction does not commonly know how to relieve it or keep it free from its one-sidedness, and to recognize in what seems conflicting and inherently antagonistic the presence of mutually necessary moments.”

And, if you can get past the fancy language and the romantic metaphor, I think it’s the same with, say, Hayek, or neo-liberalism, or whatever is the left's current demonic totem. We should be asking: What in these outlooks is useful? What can be usefully absorbed? What remains after an all-out criticism to be absorbed? That is, there has to be an appreciation and a firm grasp of Hayek and of neo-liberalism, of their strong points and achievements, as well as their weaknesses and faults, before they can be superseded. The same applies to all previous intellectual and practical efforts towards developing a socialist economics, including the holy-of-holies, Capital. From the point of view of empirical investigation, it means distinguishing capitalist propaganda from results. For example, where have their development efforts or their standard macroeconomic policies been successful, and why? And where have they been unsuccessful? Do they have any tools that we can reuse? Despite the colossal scale of the current financial-economic crisis, I personally haven’t yet seen anyone coming close to grasping the nettle. Certainly not the so-called "hard" left, whose ham-fisted/ hare-brained attempts to oppose the injustices of capitalism somehow always reek of injustice themselves, appear not to have picked up any tips from the disasters of the 20th century and, somehow, intimate the preparation of something worse than run-of-the-mill late liberal/social-democratic capitalism. (Sometimes—who could have conceived it?—even the imperialists appear to be more progressive.) But also, if a bit more depressingly, not even intelligent Marxists such as Robert Brenner (to judge by his organisation's website), who otherwise looks pretty much correct, so far as I can see, about the causes of the current crisis being found in the monetary response to the problem of long-term decline in profitability in the advanced capitalist states.

Movement without change

Neo-classical growth theory is an attempt to explain the conditions in which dynamically stable, or equilibrium growth, may be achieved. A key feature of the method of analysis used in neo-classical economic theory is the application of marginal techniques to the demand side (explaining commodity prices in terms of variations in marginal utility to consumers, for example) as well as the supply side (factor returns explained by their marginal products), rather than just to the supply side, as with classical theory.

Very broadly, the picture of the growth process envisioned in neo-classical theory is as follows. The level of savings in the current period is conditioned by the level of income from the previous period of production. This determines the size of funds available for current investment, all current savings being absorbed for this purpose. Investment may be used either to equip new workers with the same level of capital as all other workers, in this way maintaining the capital-labour ratio (capital widening), or to increase the level of capital per worker, in this way increasing the capital-output ratio (capital deepening). Capital widening can increase the absolute level of output produced, but not the rate of growth of output per worker. Capital deepening can increase productivity in the short run, but market mechanisms will adjust the relative prices of capital and labour in such as way as to encourage firms to economise of one or the other, bringing the capital-labour ratio to its long-run average—that is, the one consistent with dynamically stable, equilibrium growth—so that, without technological progress, only capital widening can occur.

In the long run, therefore, for a given level of technology, an economy will tend to grow at a rate determined by the growth rate of the population (the causes of which lay outside the field of enquiry of the model), because, assuming full employment of all factors of production, all other variables with potential to influence the level or rate of growth of economic output will adjust. To put this in another way, in the long run, only technological progress can permanently increase the rate of growth of output and income per head, because it increases the average product of labour for any given capital-labour ratio, raising also the capital-output ratio. Counter intuitively, the rate of saving has no effect on the long-run rate of growth of the economy.

To reach these conclusions, the neo-classicists make a number of simplifying assumptions; some of the most important ones are as follows.

1. Output is of a single homogeneous commodity. The level of output depends on the quantities of inputs of labour and capital, and is subject to constant returns to scale (ie by doubling the quantity of inputs of capital and labour, output is exactly doubled).
2. The supply of labour—which is also homogeneous in character—grows at a constant rate. This is the most important “exogenously determined” variable, the one to which the other variables, conditioning one-other within the confines of the model, must adjust. There is always full employment of labour, such that any extra contribution to productive capacity from this source translates exactly into actual contributions to output.
3. The rate of saving is constant. Whatever the level of income from the previous production period, in each new period, the same proportion of income is saved and the same proportion consumed. The current level of saving is determined by the level of income achieved in the previous period—that is, it is explained by processes at work within the model.
4. All current savings are employed as current investment in capital. This is so because interest rates on the capital market adjust to equate the two; if there is an excess of savings, interest rates will fall, raising the relative profitability and thus attractiveness of investment.
5. Capital does not to depreciate, but the “capital-deepening” process is subject to diminishing returns; that is, as the average capital per worker increases, the increase in output for each new unit of capital added to the production process is less than the last (ie the capital-output ratio begins to decline). The explanation for this for neo-classical economists lies in the low substitutability of labour and capital inputs.
6. The rates of reward to production factors are not constant; on the contrary, the movement of relative prices is the mechanism of adjustment by which a steady-state growth path is achieved.
   
   

Mr Ricardo's political arithmetic

The question of why economies grow has been central to economics since its emergence from the Enlightenment as a discipline in its own right. On this, I shall take an approach that will allow me to look at the question from different angles, bit by bit. The best place to start, it seems to me, is with a little foray into the history of economic thought.

All the classical economic theories were theories of growth—that is, they were designed to show that freedom for economic actors and free trade were essential for improving the prospects for the growth of national wealth. Later, with the "marginalist revolution" of the 1870s, mainstream economists shifted their focus to the analysis of the static problem of resource allocation. In the 1950s they began to apply marginalist tools to the problem of the growth of whole economies over the long term. More recently, this approach to growth theory has itself come under fire.

Of the classical growth theories, that of David Ricardo is perhaps the easiest to expound in a small space. As is usual in classical economics, Ricardo looks at the growth process through supply-side glasses to explain the development of productive capacity; this he assumes will be the same as actual output because market mechanisms assure full utilisation.

Ricardo's model is of a mainly agricultural economy in which production is the outcome of the combination of three factors: land, labour and capital. At any point in time, land is fixed in quantity but variable in quality; the labour supply is fixed; and the stock of circulating capital, or wage fund, is also fixed (it is envisioned as a stock of corn).

In any one period of production, the owners of capital hire the owners of labour to work on the land. Capitalists deploy labour in such a way as to equalise the marginal product of labour. The wage rate of workers is determined by the size of the wage fund, divided by the number of workers (the labour force); capitalists will hire workers as long as the marginal rate of labour is higher than the wage rate, the difference between the two accruing to the capitalist as profit; the income of landowners, in the form of rent, is determined by the difference between the average and the marginal products of labour multiplied by the number of workers on a farm.

This is the static part of the model. The model is set in motion by the behaviour of the economic groups with regard to their income. Workers consume all their wages to reproduce themselves, so that they are fit for labour in the next production period. Capitalists tend to save their profits, adding it to the volume of circulating capital, the wage fund—which is the source of economic growth. Landlords spend all of their income on "unproductive consumption".

However, in Ricardo's model—and in contrast with the model of Adam Smith—growth is not without inherent limits. This depends crucially on the role played by the expansion of the population, which is stimulated as a growing wage fund boosts the wage rate, raising it above subsistence level. As production on existing farms intensifies and also moves outwards to less fertile land, rents increase, which is useless from the perspective of economic growth; worse, the marginal product of labour falls and, with it, profitability, eventually bringing the growth of the wage fund—and thus the growth of national income—to a halt. This is known as the stationary state.

Although Ricardo’s model retains a certain self-contained elegance, it cannot be reconciled to the growth process as it has subsequently happened. This is for three main reasons.

• Population growth has often been "exogenously" determined, and the envisaged close relationship between the income and population growth has not obtained.
• There has been steady progress in the development of agricultural technology, some of it induced by the pressures of population growth.
• The emphasis on the role in growth played by circulating capital ignores the contribution to growth from the employment of fixed capital—particularly in industry, but even in agriculture—through improvements in productivity.