Reswitching, relative prices and linearity

Ok so only 1000 people in the world understand this and only 10 care about it: economics for the most part has long since given up its empirical pretensions when it comes to its ontological assumptions.  Still I suspect the heterodox world will be interested in this forthcoming publication by Anwar Shaikh antiseptically titled, The Empirical Linearity of Sraffa’s Critical Output‐Capital Ratios.  Here is the conclusion:

Even though Marx initially develops his analysis in Volumes I‐II under the assumption that prices are proportional to labor values, he is adamant that the two must be systematically different. In his famous (and incomplete) transformation procedure in Volume III, he derives prices of production as linear functions whose deviations from values increased with the rate of profit. The first two components of the Sraffian decomposition can be therefore viewed as the vertically integrated equivalent of Marx’s procedure. The data clearly support Marx’s general hypothesis that prices of production deviate smoothly and near‐linearly from values.

Sraffa’s elegant and elliptical text suggests that prices of production are likely to exhibit more complex patterns. He specifically cites the potentially complex behavior of individual sectoral output/capital ratios as being the source of complicated price movements. But at an empirical level, individual output capital ratios turn out to be virtually linear functions of the rate of profit, so that individual prices of production and the aggregate wage‐profit curve are near‐linear.

Such findings clearly support the structural price theories of Ricardo and Marx. While they do not completely exclude reswitching, they certainly relegate it to a secondary role. This does not mean that they rehabilitate neoclassical economics. First of all, the structural determination of relative prices in equation (1.4) is a far cry from the neoclassical theory of marginal cost pricing. Secondly, the difference between classical and neoclassical theories of profit is most evident precisely when prices are equal to labor values. This is the condition under which profit is exactly equal to the surplus value created in production. Even if we further posit an infinite number of co‐existing techniques, timeless technical change, and a host of other non‐classical assumptions, then equality of standard prices and values is also the condition under which an aggregate pseudo (surrogate) production function obtains, in the sense that frontier techniques corresponding to lower rates of profit will have higher (constant) capital‐labor ratios5. But correlation is not causation: both profit‐as‐surplus value and the profit‐rate‐as scarcity‐price coexist in this abstract space because their real theoretical differences lie elsewhere (6).

Effecient Market Hypothesis: 40 Years of Confusion

I just finished reading a commentary by Bernard Guerrien and Ozgur Gun entitled Efficient Market Hypothesis: What are we talking about? . Inter alia the authors do an efficient job (as in 12 pages) not at demolishing the efficient markets hypothesis but rather the central confusion created by Fama’s inclusion of the term of efficiency into what had prior to the 70s been a discussion not about whether or not financial markets could be fairly described as efficient but rather about whether they could be fairly described as a “fair game.”

The distinction is incredibly important because something can be fair but not efficient and vice-a-versa. If we define “efficiency” to mean the quickest possible method to arrive at a decision between two strategies to achieve the same goal then the strategy chosen and the attainment of the goal has nothing to do with the efficiency or fairness of the process used to arrive at the decision. A coin toss would be both a fair and efficient process. A mother saying to her child “we will do X” is equally efficient but not fair.

Economics of course has a peculiar and convoluted definition of efficiency which is directly related to the the confusion introduced by Fama by maintaining that financial markets were not only a fair game but an efficient process. As the authors show, Fama conflated the fairness of the market (price formation displaying a random walk, i.e., unpredictable), with the proposition that a spot market price reflects the “true” valuation of say a publicly traded equity on an exchange on any given day, minute or second.

It is easy to imagine that an equity’s price reflects its “real” value and imagine that that price was arrived at through a contrived and unfair process (insider information). Fama conflated all these issues and that is why when queried in 2010 he responded that EMH was right because everyone got burned; that is, it is a fair game because nobody can beat the market. But as Bernard Guerrien and Ozgur Gun remark:

Now, it is not harmless to replace “beat the market” by “market efficiency”. For economists “efficiency” has a precise meaning: Pareto optimality. That is, a propriety of resources’ allocation which has little to do with stock markets and speculation. On the contrary, there is a close relation between Pareto optimality and general competitive equilibrium (through the two Welfare Theorems); it seems then natural to put forward this particular “model of equilibrium” – as it is suggested by Fama himself at the beginning of his 1970’s paper. With, as a result, even more confusion.

I will leave readers to go and read the paper to fill in the gaps. What however I found really interesting is the account the authors gave as to why such a central confusion could become the dominant account of financial markets. The conclusion they come to is:

Only ideology – strong a priori beliefs – and circumstances can explain Fama’s decision to term the “old” Bachelier-Samuelson no-free-lunch theory “efficient market hypothesis”. In 1970, Fama was professor at the University of Chicago, where the “new classical macroeconomy” was elaborated on the postulate that an economy is always – thanks to “rational expectations” – in competitive equilibrium. Efficient resource allocations (that is, Pareto optimality) results from this postulate – at least if “market failures” are excluded. Contrary to the old “monetarist” (Friedman) tradition, external shocks – even those provoked by government’ discretionary actions – are not supposed to generate inefficiencies. Agents can be (temporary) fooled, but they always realize their optimal plan. Markets became a sort of deus ex machina which instantaneously (re)allocates resources in an efficient way12. In a nutshell, they are “efficient”. That is a postulate, an a priori belief, not a (testable) result.

This is a very interesting and concise commentary and is worth readers’ time. So go read the paper.

Mankiw was right, incentives do matter

It turns out that Greg Mankiw perhaps was *mostly* right: incentives do matter. To understand to what extent and how far my dear readers you will have to do three things.

First you will have to read Mankiws original article here. Then you will have to watch this 10 minute long animated lecture here (h/t Marc Lee) and then you will have to read Iglika’s post over at the Progressive economics blog. I know that is about 30 minutes of your time dear reader but I promise you will be rewarded for doing your homework and be equipped to make a difference.

My take away from the three homework assignments is this. If we combine Iglika’s post with Marc’s video link and reflect back on Mankiw’s now infamous article in the NYT we are left with one of three conclusions.

A) Mankiw is wrong.

B) The type of intellectual work he does is akin to basic mechanical manipulation of say moving a mountain of manure from spot X to spot Y.

C) A & B are correct if, and only if, Mankiw does not generalize from what he does for work to what real professionals do for work.

Take away is that both incentives and the type of work being done matter.

Stiglitz: Capitalism is Characterized by Big Bubbles and more

Stiglitz is one of the few (liberal) economists who is not suffering from a massive bought of cognitive dissonance owing to the GFC. This hour long interview with Joseph Stiglitz is well worth watching. Don’t have an hour? Then watch the first fifteen minutes.

Is there a housing bubble in the works?

Scotiabank hints at housing bubble

“Canadian house prices are rich no matter how one looks at it,” Scotia economists Derek Holt and Karen Cordes said in a report titled Is There a Canadian Housing Bubble? Of the many ways of gauging the health of a real estate market, affordability is one of the least useful because any measure that essentially compares income with mortgage payments is dependent on interest rates, Holt said Tuesday. Rates are at record lows at the moment, as the Bank of Canada’s benchmark rate sits at 0.25 per cent. Comparing current and past prices is more useful, the report says, and under that metric, Canadian housing prices are in eye-opening territory. The U.S. S&P/Case Shiller index rose 100 per cent between 2000 and its peak in mid-2006. The Canadian equivalent is up 86 per cent during the past decade. Looking at real estate on a price-to-rent perspective also suggests speculative activity, as the ratio of housing prices to how much the spaces could bring in rental income has more than doubled since 1981.

Selected Central Government Debt Ratios: An image begs a thousand questions

When discussing with my undergrad students why I thought Japan Inc. was bust I trotted out the graph below.  However, this morning while looking at the graph several questions came to mind.

1) From 1998 – 2008 what was average real interest rate in Japan and how does that compare to the ten years previous to 1998?

2) What has been the average level of inflation in Japan since 1998?  Again how does that compare to the 10 years previous to 1998?

I already know the answer to those questions but I would have not arrived there by any HAT (highly accepted theory).

3) Why are we even talking about programs cuts in Canada before it is clear that the world economy and the US economy has started a robust recovery? And why especially when Canada is way below the advanced capitalist curve (in terms of debt to GDP)?

Click for larger image

We do not do spin…We don’t lose our focus: Carney the rain maker

Listening to Mark Carney talk tough is like watching Stephane Dion pound his fists on the table.  Well ok a little more credible than that.  Being a former GS man you know he knows people who know people.  Some of which I should think are quite unpleasant characters.  Problem is there is not really a robust connection between the value of the Canadian dollar and inflation or deflation.  Currency traders probably know this…at least more than they have some version of the standard (and empirically dubious) model in their head.  So when Carney says “we take our inflation target seriously.”   Currency traders likely shrug and say: “we are banking on it.”

Mr. Carney said he has a range of tools and he can use to dampen the blow of the currency’s rise, and signaled that any investor who thinks he’s shy to use them is making a mistake.

“Markets should take seriously our determination to set policy to achieve the inflation target,” Mr. Carney said. “Markets sometimes lose their focus. We don’t lose our focus.”

Carney’s problem (well actually the manufacturing sector’s problem) is that the BOC does not care about the level of activity in exports. It only cares about their target.  Full stop.  So unless deflation increases in some way that can be definitively linked to the appreciation of the CAD–which is doubtful–the BOC is not going to do anything.

Ontario Minimum Wage: Classic Arguments Against

I am not going to wade into the debate on whether the scheduled rather modest minimum wage increases in Ontario are a good thing.  I will, however, with pleasure reproduce this comment by a compassionate petty-proprietor over at the Star:

I have a business that has paid our employees $10.50 an hour to care for children with special needs. Three years ago that wage was good (until they graduated from college) but now its going to be minimum wage? What am I supposed to do, pay more to my employees so I don’t lose them or pay more and I end up making as much as my employees? People take the risk to start businesses to have a shot at the bigger things in life. I have a solid business, but the gov’t is screwing it up – spending my money to get themselves re-elected.

Classic, just a classic.

Brad Delong is Wrong

It would appear that Brad Delong is the only prominent independent “liberal” economist (that is not on the Obama bank role) that is willing to shill for the Geithner-Obama cash for trash program.  All the liberal Nobel (in memorial) Laureates have lined up against the plan not to mention Robert Reich and Jeff, Mea Maxima Culpa, Sachs.

Apparently the fact that Geithner has never won a multi-million dollar bonus is sufficient proof for Delong that little Timmy is no tool of Wall Street.  Well neither has Obama, but both men are surely acting as though they are the tools of Wall Street (click the Reich and Sachs links above).  Indeed, it is the overwhelming opinion that it is not just the Obama administration but that much of the senate and congress is also under regulatory capture by Wall Street:

Brad is quoted in the FT as saying:

“We have to ask ourselves: Do we want to revive our economy, or do we want to punish the bankers?” says Mr DeLong. “I don’t agree that we can do both.”

Sure you can Brad it is called nationalization.  And if you and much of the congress and senate were not so captivated by your ideology (and their self-interest) the banks would have been nationalized, the bankers and their shareholders wiped-out and thereby punished, and the tax-payers’ would eventually have some nice banks on their collective balance sheets which they could later sell back to the investment community.

When the most simple, most elegant and most effective policy is not being pursued it begs the question of why not?

And only three answers seem plausible: it is vested interests, ideology, or both.

And finally an Economist hits it right on the head

Robert Waldmann over at Angry Bear hits the ball right out of the park with “Price Revelation” is Mysticism. The post covers so much ground with implications so counter to the grain (too bad he does not take them beyond CDs) that it is quite simply elegant. His clarifications in the comments section are equally valuable. Much of financial engineering has been based on the idea that markets always get the prices right but that it is possible to beat the markets. That is, simultaneously clinging to the hard version of the efficient markets hypothesis and not.

At some point we will have to open up the debate on the difference between price formation and price selection. Neoclassicals have made a living off collapsing the two.