Keynesian and Classical economics,the expurgated version

What is the dispute between Keynesian economics and Classical economics.
Quite a lot really.

Most people think Keynesianism means using fiscal stimulus when the economy slows down.
WRONG!!
Don't believe me then read the General Theory  yourself.

Keynesianism is using fiscal policy when there is a liquidity trap. What you ask is a liquidity trap?

It is circumstances when monetary policy doesn't work. In the 1930s it was deflation. now it is zero bound interest rates. I would also add when monetary policy is impotent such as in Australia's case during the GFC. the RBA eased rates BUT banks found it hard to get any funding, even with a Government guarantee, to lend money out.

The big trick is to ensure as the temporary stimulus runs out that fiscal policy doesn't become too strict and ruin any recovery such as the US in 1937 or Japan in the 90s.

In 'normal' times' monetary policy is the preferred policy instrument. Fiscal policy is only used to the extent automatic stabilisers kick in.( i.e. no large deficits).
Thus we see it is counter-cyclical.

Classical economics, on the other hand, emphasises always having a balanced budget no matter what the business cycle. As the budget begins to get into deficit because unemployment rises and tax receipts fall The Government cuts spending and/or raises taxes to attempt to maintain a balanced budget.
Thus it is pro-cyclical. In bad times it exacerbates a slowdown and creates a recession. you can even promote a depression like Ireland or Estonia.

In good times Keynesianism means much stricter fiscal policy that classical economics. See here for example.  This means a larger budget surplus the stronger the economy.
Classical economics on the other hand means greater stimulation to the economy. This is because the government will either spend more money or cut taxes as more revenue comes in because of the stronger economy.

Now you ask what should be happening right now?


I think Jonathon Portes and Richard Koo both have a good take on that.

This means Australia has done an extremely good job since we got hit with the GFC. The stimulus was large enough to avert a recession and as the stimulus has finished the detraction from GDP has not been too large to offset the recovery.

Music interlude part 2

I can do it now so enjoy. more later

MYEFO & the MRRT

MYEFO was released on Monday.

The Government has foolishly locked itself into producing a budget surplus. ( Economists would regard a surplus of less than 1% of GDP as a balanced budget.)

Having said this I am glad it has used accounting tricks, smokes and mirrors etc both in the budget and in MYEFO. You really do not need to detract more than just over 3/4 of a percentage point from GDP at present.

Think for a moment if the Government produced a fearful budget that detracted say 2 pecentage points from annual growth. the RBA for one would be nervous having to reduce interest rates to well below 3% to compensate.

At present our bonds are being bought up big time by overseas buyers , particularly central banks, because we have a sound economy and our rates are, naturally, higher than elsewhere. This is outweighing the fall in commodity prices thus the exchange rate hasn't fallen like it has in the past. This has a contractionary effect on our economy.

It  appears the MRRT brought in no money in the first quarter it started. Given the fall in commodity prices this is not surprising. Afterall it is a tax on super-profits. No super-profits then no revenue.

Will it produce revenue? It will if the Chinese economy starts growing at its normal levels again.  It appears to have bottomed at present so this may eventuate.

Postscript.

I forgot about one of the major if not the major point for the budget. Whereas real GDP growth is above trend. Nominal GDP growth is below trend at present. Hence the low tax as a % of GDP levels we have seen post GFC. They have been  21.8% , 20.3%, 20.1% and 21.1%.

You have to go back to the first two years of the previous government to see such low levels. If only Wayne Swan had the tax levels of Peter Costello he would be rolling in surpluses.


In regards to the MRRT it appears most State governments think all mining companies wil have to pay the MRRT and so have the royalties claimed against liabilities however only a very small number will.

wow.

Knowing your subject again

Oh dear Simon Cowan is at it again. ( see previous article).

He conflates headline deficits with structural deficits. ( Hint if the public sector is detracting from growth you can be pretty sure the structural deficit is not deteriorating. This current budget is detracting a bit more than 3/4 of a percentage point from GDP growth. On the other hand quite a few of Costello's budget surpluses added to GDP growth!)

Please read this and then this.
Now remember as Austerity was imposed the headline deficit figure increased as a % of GDP.

Why you ask? 

The IMF  ( Oliver Blanchard and Daniel Leigh actually) recently examined public debt and paying it off etc.

Look in particular at the UK in the 1920s. This quote tells you a lot.

"the United Kingdom (1918) had the worst growth performance, with negative growth and a considerable increase in its debt burden." 

It had a substantial primary surplus over the period which inhibited economic growth.However public debt rose BECAUSE growth was so low!

Let me outsource to John Quiggin the maths behind debt rising or falling.

"This is pretty much arithmetic, since public debt (at end of) this year is the sum of public debt (at end of)last year and (an appropriate measure of) this year’s deficit.

If public debt is growing faster than nominal GDP, then public debt/GDP ratio will rise. Note that, since debt is a stock and GDP is a flow, it isn’t strictly correct to refer to debt as a “share” of GDP."

I hope Simon understands now.

The US economy and such

The US economy has not recovered quickly or strongly since the GFC.

A number of Keynesian critics say this shows that fiscal stimuli doesn't work.

However the net fiscal stimulus was not large. ( Their NBER paper is a must read as this is the expurgated version.)

Herein lies the irony. Private sector employment has been quite good. It is public sector employment that has held the recovery back. It is extremely ironic that if public sector employment grew at levels we saw when George Bush Jr was in power then unemployment would be falling to 7%. If public sector employment was similar to that when Ronald Reagan was in power then unemployment would be falling to 6%.

In either case the Fed would be increasing rates not indulging in QE!

We see here that simply allowing the private sector to grow is not good enough. Libertarians must be tearing their hair out seeing their ideological cubby hole being demolished.

One of the major inhibitors this time round has been the housing sector. It was in a bubble and thus not able to be a prime mover to boost economic growth.The distressing gap has been large for some time.

I will leave it to you to guess what would happen to that gap if unemployment was approaching 6% rather that only just getting under 8%.

In the Presidential election we see a current President who in reality has been much more austere than any Republican and of course unsuccessful.

We have a challenger whose economic plan doesn't add up and seems to have ignored why both Reagan and Bush blew their budgets. Indeed the Romney team have supported the totally discredited  theory of austerity policies promoting economic growth. ( gosh it is working well in Europe.)

Then we have the possiblity of a fiscal cliff which would lope a cool 5% of GDP. This would bring on another recession.

I am glad I live in Australia where economic policy has been quite good and successful.

CRA and the GFC

There are people out there who believe the CRA caused the GFC reading the Sub-prime crisis.

Randall Kroszner , (a person thought too conservative to be a Fed governor by silly Democrat Senators) gives both a good description of what the CRA is/was and looks at one of the many studies into by either the Fed or each of the Regional Feds.

This paper blows that CRA caused the GFC argument apart.

I now quote Richard Green who is far more knowledgeable than I.
" If CRA encouraged subprime lending, one should see a discontinuity at the thresholds, but there is none.

These are originations for 2-28 subprime loans.  Under CRA, lenders received credit for originating and funding loans in census tracts whose median incomes were below 80 percent of area median income.  If the CRA was inducing lending, we should see a jump in lending to the left of the 80 percent cut-off--there isn't (either visually or econometrically).  They find the same result when looking at pricing and default.  "

Finally  The RBA's Luci Ellis looks at the causes of the GFC in part of this speech.

All in all people who support the theory the CRA caused the GFC have no evidence and like old time communists are letting their  ideology overule the facts of the situation.

Know your subject continued

At Catallaxy Sinclair Davidson here  and here makes a fool of himself.

First of all he really doesn't know how much of the CPI increase is due to the ETS.

Let us see what the CBA economics department say.

"The ABS has noted that it is not able to quantify the impact of carbon pricing.  But one back‑of‑the‑envelope calculation is to compare the contribution from higher utilities prices with the average or “normal” contribution.  Over the past two years higher utilities prices contributed an average 0.27ppts to QIII CPI growth.  The contribution in QIII 2012 was 0.48ppts.  The gap of 0.2ppts should represent the bulk of the carbon tax impact on consumer prices.  This outcome suggests that the price impact will fall short of earlier Treasury modelling work that put the CPI contribution in 2012/13 at 0.7ppts.

 QIII CPI growth.  The contribution in QIII 2012 was 0.48ppts.  The gap of 0.2ppts should represent the bulk of the carbon tax impact on consumer prices.  This outcome suggests that the price impact will fall short of earlier Treasury modelling work that put the CPI contribution in 2012/13 at 0.7ppts."

Well that is vastly different to what Davidson is alleging.

He then goers on to say this:

"15.3 percent increase in electricity prices? In one quarter? What did Treasury modelling say about that? Oh, yes:

The carbon price leads to an average increase in household electricity prices of 10 per cent over the first five years of the scheme."

Yikes.
 First of all he is comparing a Treasury forecast based on CONSTANT prices with the CPI which must be in current prices.
Secondly he is comparing the whole increase in electricity prices to Treasury's forecast which is based on the impact of the ETS.

Thus neither he nor any commenter has a clue of what they are talking about.

This man is an academic!

Somewhat on topic Ricardian Ambivalence has a great post on the CPI , measuring inflation and what the CPI means.

Know your Subject

If you write on a subject you would expect the writer to have some knowledge of the subject he is pontificating on.

Sometimes this doesn't happen. Take Simon Cowan's piece at the CIS blog.

There are a lot of unfortunate errors.
Keynesian policy involves boosting spending ONLY when monetary policy doesn't work or is impaired. ( It is commonly called a liquidity trap.) The spending is a one-off as well usually on infrastructure.

It also involves a balanced budget or surplus ( sometimes substantially so) in economic good times.

Running an alleged 45 deficits in 50 years since WW2 might be a lot of things but Keynesian economics it most certainly isn't.

A few other things but in no particular order.

He seems to think you must have a budget surplus to reduce debt. He should examine the UK between the wars as the IMF did. Its debt increased despite budget surpluses. Why you ask. Lack of growth!!


Japan's lost decade came about from premature austerity.see Adam Posen .

Europe's problem's were exacerbated by austerity as we have seen previously.

Both Spain and Ireland had either a superior fiscal policy or a similar fiscal policy to Australia coming into the GFC.
Italy had a primary surplus.

Not good Simon. Not what I would expect from the CIS.


Paul Fritjers on both Club Troppo and Core Economics wrote about China at some time overturning the USA as the world super-power.
He linked to a paper on the USA/USSR rivalry.

When asked why he didn't review when the USA superseded the UK as the World Super -power he said the war of independence wasn't a great look or words to that effect.

Only problem he was out by at least 180 years.
He didn't even understand about the line about both countries arguing about battleships.
Yipes most people have the Washington Treaty as when the changeover was confirmed.

And he is an academic. Moreover he stops comments when this is pointed out so he combines a thin skin with inaccuracy.

Back to basics

two great posts on basic economic topics.

Macroblog has a great article on employment surveys, the unemployment rate, the participation rate etc.

This article is fantastic in examining cyclically adjusted deficits and the problems of measuring them.

European blues

Europe  is currently in what the Yanks would say is a funk.

The problem is that monetary policy can't really get a lot lower and there is one exchange rate for all nations in the Euro area.

Therefore when European nations bring in contractionary fiscal policies then one can only expect the economies to contract and that is what has occurred. They have reduced their cyclical adjusted fiscal deficits quite significantly. See here .

As we saw yesterday the IMF has offered a mea culpa. They were wrong and the policies they advocated have made the situation worse.

To reduce debt you must have growth and classical economics in bad times makes economies worse not better and hence debt ratios worse not better.

We have known this since at least 2010

When will people learn?

Another stake in the heart of Classical economics

The OECD and the IMF have recently released some papers that give great pause for thought.

The OECD has looked at micro-economic reform whereas the IMF has looked at macroeconomic policies.

the OECD has come to the view the best thing to do is just to get on and do the reforms HOWEVER there is a big proviso.The state of the economy can affect the short run impact of such programs.
For instance if the economy is in the doldrums then large scale labour market reforms will reduce employment not increase it. Lowering benefits may well increase one's incentive to get a job but if no jobs are available then less money is spent
Reducing job protection will make it easier to get rid of excess staff but a bad economy will mean not many hires.

The best thing to do when the economy is in the doldrums, like Europe, is to start with is reforming the product markets. As the economy improves then one should get 'stuck' into the labour market.

The IMF  has found out that in times of a liquidity trap (my words not theirs but essentially when monetary policy doesn't work) the multiplier is larger, quite larger. See Paul Krugman  for a reasonably good exposition on why this is so.

Classical economics tells us one should always have a balanced budget no matter what the state of the business cycle. In other words it is pro-cyclical.
Keynesian economics , on the other hand, believes in counter cyclical economics when there is a liquidity crisis.

The IMF has again found empirical support for Keynes as it did when it examined whether fiscal consolidation was expansionary and again none for classical econmics indeed quite the opposite.

This simply continues the story we have seen around the world since the GFC. Any countries that adopted classical economic policies either endured a large scale recession or a depression. This didn't happen when a country attempted Keynesian policies.


In ending it is highly ironic that some but all countries now in trouble didn't attempt Keynesian policies in good times i.e. a budget surplus indeed a substantial surplus sometimes.