The rich get substitution effects and the poor get income effects

*This post has been popular so imma top post it here.

It is pretty much understood that the basic orthodox labour market model is agnostic insofar as income and substitution effects are concerned. If for example real wages increase workers may choose to work less because they can consume more leisure with less hours of work or workers may work more hours because the opportunity cost of leisure has gone up. Which effects dominate workers’ incentives are not predetermined by the standard labour market model.

Implicitly, however, we can glean what mainstream economics tends to think are the incentives facing different classes (economic classes that is) of workers. In Mankiw’s recently ridiculed here, here, here and here article in the NYT, he argued the impact of a tax increase on the economic class of ‘workers’ at the top of remuneration scale was a decrease in the real wage which would be met by a substitution of more leisure for less work as the opportunity cost of leisure had been cheapened by the tax increase. Simply stated this class of workers would respond to a decline in their real wage with a union strike like reaction.

So far so good. I do not imagine it inconceivable that those workers with compensation packages that put them in the top 1% of income earners could choose to work less hours if they were faced with a wage cut with one important caveat. They would have to have the type of job which allowed them to control their hours of work and or have sufficient means to withdrawal from the labour market altogether aka independently wealthy. For example, an NHL hockey player cannot say to his coach I am playing one less game a year because of the increase in marginal tax rates; although he might try to make the team offset the tax increase with a higher salary. Thank god for salary caps.

However, when we turn to lower classes of workers we find that Mankiw argues that income effects dominate their incentives. In his introductory textbook he has the following to say about unemployment insurance:

So here Mankiw argues that workers respond according to income effects. Lowering unemployment insurance replacement rates would decrease unemployment because workers would have a greater income incentive to take a job.

What, therefore, accounts for the different reactions between these two classes of workers? Why that is will increased taxes on the rich (a decrease in the real wage) lead to a withdrawal from the labour market but a decrease in unemployment benefits (again a decrease in the real wage) increase the supply of labour. The answer of course is that most classes of workers are not independently wealthy and do not meaningfully control their hours of work. Workers have to work and outside of access to unemployment benefits they do not have the option of defecting from paid labour markets. Therefore whether income or substitution effects predominate is largely a function of class. Most classes of workers save for those at the very top respond to a decreased real wage either by seeking more hours of work through one of three ways: overtime, a second job or telling their teenager to go get a job and pay their own cell phone bill.

It is interesting that Karl Marx (well Smith too in some respects) were the first to recognize the differences between classes of workers what we once called proletarians and the bourgeoisie. But that is for another post.


Varieties of Capitalism: A Critique


The Varieties of Capitalism (VoC) has become the dominant approach in comparative political economy and enjoys wide application and attention in disciplines outside of political science and sociology. Indeed the VoC approach has enjoyed much attention in comparative industrial/employment relations (IR). This article undertakes a critical evaluation of the importation of the VoC paradigm into comparative IR. Inter alia, it is argued that the VoC approach, as it is presently configured, may have little to teach IR scholars because its basic theoretical concepts and methodological priors militate against accounting for change. This article begins with a summary of the routine problems researchers in comparative political economy and comparative IR have encountered when attempting to account for change within the constraints of the VoC paradigm. Here the focus is on the limitations imposed when privileging the national scale and the problems engendered by a heavy reliance on comparative statics methodology infused with the concepts of equilibrium and exogenous shocks. The article then goes beyond these routinely recognized limitations and argues that the importation of terminology from neoclassical economic theory, of which the original VoC statement makes foundational reference, further serves to constrain and add confusion to the comparative enterprise; namely, comparative advantage, Oliver Williamson’s neoclassical theory of the firm, the use of the distinction made between (im)perfect market competition in neoclassical economics and the fuzzy distinction made between firms, markets and networks.In the concluding section we argue that the VoC’s narrow focus on the firm and its coordination problems serve to legitimate IRs traditional narrow focus on labour management relations and the pride of place that HRM now enjoys in the remaining IR departments. Ultimately, however, the embrace of the VoC paradigm by comparative IR is a net negative normative move.

The full article can be found here

How Can a Political Scientist get this and many (freshwater) economists do not

O.k. I wrote this years ago. Maybe 2003, maybe 2005:

And while NKs accept the basic logic of the rational expectations augmented Philips curve (that is, that the NAIRU is semi-fixed in the long run) monetary and fiscal policy can nonetheless be deployed in the short- run so long as the cause of the deterioration in effective demand is not caused by adverse supply shocks such as an unemployment rate below the NAIRU, insufficient capacity or medium to long-run supply constraints.  This essentially amounts to a hawkish policy stance against inflation and support for less than full employment.[1]  Or alternatively stated, outside of a liquidity trap, NKs are almost indistinguishable in terms of macroeconomic policy from their new classical cousins.

[1] As we shall see below Shapiro and Stiglitz (1984) make the argument that unemployment (above its frictional level) is functional to aggregate efficiency.

The Rebel Letter to Mankiw and some thoughts on education in economics

Yesterday I noted that 10 percent of Mankiw’s students walked out of his class to protest what they, rightly believed, to be a heavily biased introduction to economics.  I think the students are right.  Introductory courses are meant to introduce students to the discipline– both its orthodox core and its dissenting periphery.  Krugman has been consistently bemoaning the “dark age of economics” on his daily blog.  What is interesting is that I suspect Krugman is likely as guilty as Mankiw for the thin gruel that gets passed off as intellectual pluralism in the discipline of economics.  RatEx + sticky prices is hardly a different intellectual paradigm: it is a tweak.  Keen hits on some the ontological problems here.

I empathize with these students because like them when I took my intro to economics I was left asking myself if I could continue on studying a subject in which certain truths were baked in from the get go.  Here are a couple:

1) Minimum wages are bad because they decrease the level if employment and thus hurt low skilled workers.

2) Unions are bad because they similarly decrease employment via the premium on union wages.

3) Rent control is bad because it lowers rent and thus decreases private investment in housing leading to a shortage of housing.

In the end I simply quit the discipline and chose political science instead and then took as many credits as I could in the history of economic thought and directed readings with heterodox economists as I could shoe horn into my three degrees. In the end I pieced together a decent education in heterodox economics.  Although I wish I could have found an economics department where I could have been exposed to the best of heterodox thought along side the best of orthodox thought: Rowe, Steadman, Shaikh, Waldman, Mitchell, Dumenil, Lebowitz, Bowles, Fine, Hodgson, Lawson, Mirowski etc.

It is sad state of affairs that Intro to economics is not really and introduction to economic thought but rather an introduction to neoclassical economics.  The equivalent would be an introduction to political science where only rational choice theory was taught.  Political science is already a fairly conservative discipline and I recoil when I think about how much more conservative it would be if rational choice was the only intellectual paradigm I was seriously exposed to and if that paradigm dominated 85 95% of all hiring in the discipline.

From Mankiw’s perspective, and perhaps Krugman’s, I suspect the fact that 10 percent of the students self-identified as having heterodox instincts and declared their reluctance to continue on in economics as a feature and not a bug of the standard intro econ curriculum.

What a shame.  Below is the Rebel letter to Darth Vader Mankiw.

Dear Professor Mankiw—

Today, we are walking out of your class, Economics 10, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society.

As Harvard undergraduates, we enrolled in Economics 10 hoping to gain a broad and introductory foundation of economic theory that would assist us in our various intellectual pursuits and diverse disciplines, which range from Economics, to Government, to Environmental Sciences and Public Policy, and beyond. Instead, we found a course that espouses a specific—and limited—view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today.

A legitimate academic study of economics must include a critical discussion of both the benefits and flaws of different economic simplifying models. As your class does not include primary sources and rarely features articles from academic journals, we have very little access to alternative approaches to economics. There is no justification for presenting Adam Smith’s economic theories as more fundamental or basic than, for example, Keynesian theory.

Care in presenting an unbiased perspective on economics is particularly important for an introductory course of 700 students that nominally provides a sound foundation for further study in economics. Many Harvard students do not have the ability to opt out of Economics 10. This class is required for Economics and Environmental Science and Public Policy concentrators, while Social Studies concentrators must take an introductory economics course—and the only other eligible class, Professor Steven Margolin’s class Critical Perspectives on Economics, is only offered every other year (and not this year). Many other students simply desire an analytic understanding of economics as part of a quality liberal arts education. Furthermore, Economics 10 makes it difficult for subsequent economics courses to teach effectively as it offers only one heavily skewed perspective rather than a solid grounding on which other courses can expand. Students should not be expected to avoid this class—or the whole discipline of economics—as a method of expressing discontent.

Harvard graduates play major roles in the financial institutions and in shaping public policy around the world. If Harvard fails to equip its students with a broad and critical understanding of economics, their actions are likely to harm the global financial system. The last five years of economic turmoil have been proof enough of this.

We are walking out today to join a Boston-wide march protesting the corporatization of higher education as part of the global Occupy movement. Since the biased nature of Economics 10 contributes to and symbolizes the increasing economic inequality in America, we are walking out of your class today both to protest your inadequate discussion of basic economic theory and to lend our support to a movement that is changing American discourse on economic injustice. Professor Mankiw, we ask that you take our concerns and our walk-out seriously.


Concerned students of Economics 10

Krugman clarifies: modern Keynesians are no planners.

I do think it’s useful to read Keynes. But Greg is right: modern Keynesianism is to be understood through the views of modern Keynesians, not by hunting through the original works for hidden meanings.

And modern Keynesians are emphatically not advocates of central planning…

Uncontroversial and totally right as long as we do not go Austrian and include price setting as central planning. Indeed some version of this is what libertarian critiques of central banking amount to.

Just who are Paul Krugman’s people? And a side dish of MMT

I know Paul thought he was just being relaxed. Moses knows we all have a right to relax de temps en temps but it is a really remarkable slippage. In his latest post he writes:

So: I basically think of asset prices in a Tobin-type stock equilibrium framework (pdf). People make portfolio choices, allocating their wealth among bonds, stocks, etc.. Asset prices – including the famous “q” – rise and fall to match these portfolio choices to the actual asset supplies (emphasis added).

I have never been able to get past the basic misrepresentations of reality that are hard wired into (liberal: both reform and conservative) economists heads. How can a social science do such a violent abstraction? People in general do not allocate their assets into portfolios. I imagine Paul does, as I imagine some retires who do not have retirement plans but nonetheless who have saved must. But these are fleetingly small group of asset allocators. The vast majority of asset allocation is done by a special class of people who work in the FIRE sector for large institutions which in turn attempt to maximize (beat/achieve the average) by any and all means necessary. If there is a mismatch between assets demanded and assets supplied it has nothing much to do with people.

Now none of this really has much to do with Krugman’s post. But it is still incredibly annoying.

At the end of his post Krugman drops this bomb:

Update: Also, if you think that US interest rates are being held down by the fact that in some sense the Treasury hasn’t had to go to the market lately, since the Fed is buying debt — although the Fed isn’t actually buying it direct from Treasury — consider the case of Greeece (sic). Greece isn’t going to the market at all these days, since it’s getting all its funding from the bailout package. That hasn’t stopped the 10-year interest rate on its outstanding debt from reflecting investors’ perception of its underlying solvency:

This is just weird. Paul himself has noted that you just can’t compare Greece to the US–EVER–period. The Greeks do not have currency sovereignty. For all intents and purposes Greece is a province of the EMU. California can go broke the US can’t. Now politically the US federal government can be forced to go marked to market and normally they are but they do not have to as it is a self imposed constraint. That is not to say that there are not consequences to refusing to abide by this solemn constraint it is just to say the US ain’t Greece no matter how many e’s you put in it.

Update: Yes PK is of course right even if the analogy is bad. The point of my post was that loose talk and poorly thought out analogies lead people to think un-rigorously. Specific type of people do asset allocation. California and Greece cand be compared because they are both wards of a larger monetary union. The point is crucial because the discourse on deficits is completely confused at this point and just down right wacky in the US.

Understanding Corporate Tax Cuts: embracing conventional wisdom and coming to radical conclusions

Warning this post contains scenes of graphic illustration, it is not intended for short attention spans or people who can not locate coordinates in two dimensional space.  Viewer patience is therefore highly advised.

The debate on corporate income taxes brings out a really nice teachable moment in that it provides an occasion to clarify the terrain of past present and likely future debates on macroeconomic policy.  In what follows I will hew closely to the standard story, but what I intend to show is that even within the terms of the conventional collective memory there is an important contradiction that helps clarify what the real debate over corporate cuts ought to be about.  Let me see if I can deliver.

The conventional account of history runs something like this.  By the 1970s and early 80s unions had become too strong, unemployment insurance and welfare programs too generous and together they produced highly distorting macroeconomic outcomes: high unemployment, high inflation and low output (referred to at the time as stagflation).  Let me just accept this account for argument sake because I think it represents the story in the back of the head of most policy makers and economists over forty.  Let us represent this conventional story by line A in the diagram below.  Notice the oscillating line around A.  That represents the economic cycle.  From the vantage point of policy makers and economists over forty  the problem with the Keynesians is that they were preoccupied with stabilizing those oscillations when they should have been preoccupied with moving the economy towards line B.  Line B represents an equilibrium in which both employment creation and output proceed in a balanced manner.

Point Y represents the bad equilibrium that Keynesians were unwittingly fixated.  In their drive to stabilize the macro economy via employment they gave short thrift to output and thus created an inflationary environment which produced increasing high levels of unemployment, low levels of output and high levels of inflation. In time policy makers and economists shifted their attention away from cyclical stabilisation to structural change .  That is, from attempting to smooth the oscillations around line A to moving the macroeconomic trajectory from line A to B.

Notice that point Y does not entail a lower level of employment but rather a higher level of output.  And this was what was so seductive about the supply side arguments of that time.  What they in fact said was that it was possible to maintain employment and increase output provided the appropriate structural reforms were undertaken.  Everybody and I mean everybody wanted lower inflation and higher employment.  And in the face of stagflation the punters got onside and away we went.

My argument is simply this.  After the largely successful attack on trade unions was accomplished, after the reform of both welfare and unemployment insurance programs were completed and within the context of free trade and capital mobility the real impact of he structural changes was to move the economy to line C point Z.  That is to say, even granting neoliberalism was not some radical attempt to reconfigure income and wealth distribution between economic classes the structural reforms were more successful than its antagonists imagined and thus instead of landing on trajectory B point Y we landed on trajectory C, point Z.

When therefore there is the call to cut corporate income taxes it explicitly assumes that the Canadian economy is still stuck on trajectory A point X.  But if in fact we are on trajectory C, point Z; we are thus in fact stuck at a bad equilibrium.  The move to further juice up output without a commitment to juice up employment is like the Keynesians of yore trying to smooth the oscillations around a bad equilibrium. But this time around it is employment which is lacking not output capacity.

What does this have to do with corporate tax cuts?  Corporate income tax cuts are suppose to be a stimulus to increase the output capacity of the Canadian economy over the medium to long term.  But if as is widely recognized output is not the problem but employment why are we even talking about supply side measures (i,e. corporate tax cuts)?

I think economists are still fighting the last war and not the war we are in.  And as any historian of war will tell you an army that does so will loose.

Update: this is not as radical an idea as it may appear: see this article in the business section of the Globe online.  The difference with Canada is that I think are debt growth is papering over the underlying bad equilibrium.

My Dad, Me and Paul Krugman

So I calls my pops this evening (well evening for me and afternoon for him) and we get to chatting about politics in general and specifically about economic policy. Being originally from the US and being a well read individual he routinely reads Paul’s op eds in the New York times.

I stopped calling my dad for awhile because the cell phone long distance rates were high and we always wasted 30 minutes on Krugman. To be honest Krugman pisses me off more than he pisses me on (if that makes any sense) and the notion that I should spend 60 cents a minute talking about the man every time I called my dad is untenable (18$!!). And there was no way out of it because my dad also subscribes to the New York Review of our Friends Books. Incidentally, and on that last point, for a couple of Christmases my dad bought me a subscription to the NYRB in which I was to be grateful for a constant drip of Paul’s POV. When I finally got a job one of the first things I told my dad is please do not buy me another sub to the NYRB I have departmental funds and can buy a sub. I did not.

Nonetheless because of Paul’s gig with the NYT I am constantly preparing for another go around, at 60 cents a minute, on the greatness and weakness of Paul Krugman. Don’t get me wrong Paul seems cool enough and he would have fit right in around the family dinner table with his toxic brand of optimism and cynically naive take on the world.

Tonight was interesting in the above regards. I called my dad and inevitably the conversation turned to Krugman. Actually I initiated it and I think it started with the mild preface WINTHFHISGOWTFDBPK. I thought it was a harsh but fair opening position to take. My dad demanded WITFHRUTA? I responded how long can he lean on the same saw: they won’t listen to me, they won’t hire me, I have no voice, I am peripheral to the conversation. To which I continued if he would just ask the question why.

Then my pops responds but he has and it is a disgrace. It is a though he thinks that people in positions of power are just suckers or slaves to conventional wisdom.

Like a …you fill in the simile. Precisely I says. It is like a conversation with an old school Marxist who rebuffs every question about a query over the dis-juncture between the revolutionary interests of the working class and their actual choices with a demure to false conciousness.

My dad responds it is like PK thinks there is no material reason for the elites to think as they do, they are merely sheep being herded by conventional wisdom.

Then the conversation then broke into some esoteric conversation over fallacies of composition and rationality at the level of the individual owner of capital and the consequences of deriving policy there from. Which is PK’s point. Save for the incredibly obvious point that what the individual capitalist now knows (those that count in national accounts) is that the state will, when necessary, rob from the relatively poor to backstop the rich so they really do not have to care about aggregation errors.

My dad is a smart guy!

Krugman looses it and losses it bad: Maybe economics is a morality play

Krugman is precisely what is wrong with American progressives. He thinks after spending a life watching while nobody left of him was left standing; that after mission accomplished, he would be benighted. The reality is that he has been rendered superfluous. The War is over kid and you were used like a peon.

Like Stiglitz, Paul reminds of a good reform liberal who, after coming back from the crusades, realizes that the war he thought he was fighting was not the war he was actually fighting. That hit home for Stiglitz circa his tour at the world bank. Old Joe has never really recovered. Something opened his eyes at the world bank and suddenly almost all the little tightly written mechanical equations he ever employed seemed to evaporate into thin air.

Earth to planet Paul there is a reason Larry gets the plumbs. Hint: and it is not because he is a better economist than you. Larry understands something your naiveté never will. Economic laws are made by Humans (for Larry men) the rest is commentary. Larry does not speak truth to power so much as he cloisters it in shiny white garb serving up technocratic, but nonetheless, ideological resources ready to hand for power. If Larry gets annoyed sometimes maybe it is not because of principle, maybe it is because he thinks the powers he serves are too deft to their own interests. And that really was the conceit of Keynes.

You behave as you believe: public policy is for the betterment of human kind. Here is what is going to happen Paul; 8-10 years from now you will be proven right and nobody will care. Whatever the configuration of economic and political forces at that time will be they will not give one shit about your sage like prevision.

In short, you will be equally as superfluous as you are now. Here is a clue Paul. Keynes, your hero, was in a very interesting milieu with socialists and communists to his ascendant left and self serving, myopic, reactionary forces to his right. Keynes could under these conditions position himself in the centre: You can’t. Your left flank has long since been burnt.

Sorry my dear comrade you are now the indefensible poll-bearer of the left. So please stop Kvetching and pony-up.

Apostle Paul writes:

The point is that it would have been much better if the Depression had been ended with massive spending on useful things, on roads and railroads and schools and parks. But the political consensus for spending on a sufficient scale never materialized; we needed Hitler and Hirohito instead.

Gee Paul and why might that be? Why might capitalists prefer fascism and war to useful things? The answer to that question is where the morality play of economics leaves-off and objective political economy begins.

Macro Models, Reality and Policy

Testimony of David Colander Submitted to the Congress of the United States, House Science and Technology Committee for the Hearing: “The Risks of Financial Modeling: VaR and the Economic Meltdown.”
September 10, 2009

Some non-economists have blamed the financial heart attack on economist’s highly technical models. In my view the problem is not the models; the problem is the way economic models are used. All too often models are used in lieu of educated common sense, when in fact models should be used as an aid to educated common sense. When models replace common sense, they are a hindrance rather than a help.

Modeling the Economy as a Complex System

Using models within economics or within any other social science, is especially treacherous. That’s because social science involves a higher degree of complexity than the natural sciences. The reason why social science is so complex is that the basic unit in social science, which economists call agents, are strategic, whereas the basic unit of the natural sciences are not. Economics can be thought of the physics with strategic atoms, who keep trying to foil any efforts to understand them and bring them under control. Strategic agents complicate modeling enormously; they make it impossible to have a perfect model since they increase the number of calculations one would have to make in order to solve the model beyond the calculations the fastest computer one can hypothesize could process in a finite amount of time…..

This recognition that the economy is complex is not a new discovery. Earlier economists, such as John Stuart Mill, recognized the economy’s complexity and were very modest in their claims about the usefulness of their models. They carefully presented their models as aids to a broader informed common sense. They built this modesty into their policy advice and told policy makers that the most we can expect from models is half-truths. To make sure that they did not claim too much for their scientific models, they divided the field of economics into two branches—one a scientific branch, which worked on formal models, and the other political economy, which was the branch of economics that addressed policy. Political economy was seen as an art which did not have the backing of science, but instead relied on the insights from models developed in the scientific branch supplemented by educated common sense to guide policy prescriptions.

In the early 1900s that two-part division broke down, and economists became a bit less modest in their claims for models, and more aggressive in their application of models directly to policy questions. The two branches were merged, and the result was a tragedy for both the science of economics and for the applied policy branch of economics.

It was a tragedy for the science of economics because it led economists away from developing a wide variety of models that would creatively explore the extraordinarily difficult questions that the complexity of the economy raised, questions for which new analytic and computational technology opened up new avenues of investigation.[1] Instead, the economics profession spent much of its time dotting i’s and crossing t’s on what was called a Walrasian general equilibrium model which was more analytically tractable. As opposed to viewing the supply/demand model and its macroeconomic counterpart, the Walrasian general equilibrium model, as interesting models relevant for a few limited phenomena, but at best a stepping stone for a formal understanding of the economy, it enshrined both models, and acted as if it explained everything. Complexities were just assumed away not because it made sense to assume them away, but for tractability reasons. The result was a set of models that would not even pass a perfunctory common sense smell test being studied ad nauseam.

Initially macroeconomics stayed separate from this broader unitary approach, and relied on a set of rough and ready models that had little scientific foundation. But in the 1980s, macroeconomics and finance fell into this “single model” approach. As that happened it caused economists to lose sight of the larger lesson that complexity conveys —that models in a complex system can be expected to continually break down. This adoption by macroeconomists of a single-model approach is one of the reasons why the economics profession failed to warn society about the financial crisis, and some parts of the profession assured society that such a crisis could not happen. Because they focused on that single model, economists simply did not study and plan for the inevitable breakdown of systems that one would expect in a complex system, because they had become so enamored with their model that they forgot to use it with common sense judgment.Italics added to original.