Monthly Archives: August 2015

The Kaldor-Verdoorn Effect

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Brian Romanchuk has a nice post on how the case for productivity is something which is overstated by economists. There’s less discussion in the econoblogosphere on this. Here I’ll add a few things with a slightly different perspective.

Sometime in the historic past, nations’ economies started diverging. Some nations’ fortunes rose while others lagged behind. Nations which became rich saw high rises in productivity. It’s easy to then conclude that productivity is the raison d’être for the success or failure of nations. In fact this is what Greg Mankiw says in his textbook Principles Of Macroeconomics, 7th Edition, page 13:

The differences in living standards around the world are staggering …

What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living standards is attributable to differences in countries’ productivity—that is the amount of goods and services produced by each unit of labor input. In nations where workers can produce a large quantity of goods and services per hour, more people enjoy a high standard of living; in nations where workers are less productive, most people endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth of its average income.

The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance … some commentators have claimed that increased competition from Japan and other countries explained the slow growth in U.S. incomes during the 1970s and 1980s. Yet the real villain was not competition from abroad but flagging productivity growth in the United States.

[bold in original, italics mine]

So although it cannot be denied that rich nations have seen rise in productivity, the above story entirely misses the reverse causality – i.e., from production to productivity. And because of that, it entirely misses the cause of success and failure of nations.

Nicholas Kaldor rediscovered the relation between rise in output and rise in productivity (which can be attributed to Petrus Johannes Verdoorn) in 1966 and interpreted the causality right: from rate of growth of production to the rate of growth of productivity. The main reason given was “learning by doing”.

This still leaves open the question about what determines production itself. Unlike the supply-side models of neoclassical theory, Kaldorians tell a story about a demand-led growth and the balance of payments constraint being the most important determinant of economic growth. Some nations had the fortune of growing fast earlier in history and in this process of cumulative causation became more competitive in the process. This not only increased their fortunes but immiserated other nations. This is because poor nations would get stuck with a balance of payments constraint and this would affect their competitiveness. Competitiveness can either be price-competitiveness or non-price competitiveness. Price competitiveness depends on pricing goods and services in international markets. This in turn depends on productivity. So nations which got an early lead in history saw rise in production and hence productivity via the Kaldor-Verdoorn process and also gained in price-competitiveness.

There is a feedback effect here. Do you see it? That’s circular and cumulative causation. The effect can be better understood by writing a model such as as done by Mark Setterfield in his chapter titled Endogenous Growth: A Kaldorian Approach in the book The Oxford Handbook Of Post-Keynesian Economics, Volume 1, Theory And Origins. 

Usually the story is told with price-competitiveness. I am unaware of any model which also includes non-price competitiveness in the story.

Anyway, to conclude, cheering for productivity is not going to help the world economy. The solution is to increase production: productivity will rise when production rises. The standard story as told in Mankiw’s textbook is erroneous.

Click Bait Monetary Economics

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Some economic commentators, in trying to point out the importance of government deficits and debt, go for the overkill.

Exhibit:

Sorry for picking Steve Roth, who is generally a nice person. But this is counterproductive. If you see the comments below, a commentator who claims to be a trained accountant also agrees with Steve Roth. The bait involves saying that this argument is “technically right”. It can be technically right for several reasons but outright misleading and commentators should stop doing this. So it could be true because the act of bank loan making itself creates an asset and liability equally, so there is no increase in net assets of either households or the private sector as a whole by just one transaction. But this is not just the argument. The argument seems to be that it doesn’t increase household net worth at all even if another transaction is involved, such as a house purchase because a firm sells the house not a household and in national accounts firms are distinct from households. So much click baiting.

In this post, I show how a household’s net worth rises on sale of a house. Let’s assume that I (Household 2) am a sole proprietor of a house building firm (Firm P) and hence the ownership of the firm is not publicly traded in a stock exchange. Suppose I sell a house worth $1mn to you (Household 1). The house is sold from my firm’s inventory of houses and becomes a sale. You buy this after taking a loan from Bank A.

Now, we need some good national accounting. A good way is to just pick up Wynne Godley’s stock-flow consistent models in which he values inventories at current cost of production. See Godley and Lavoie’s book Monetary Economics, Edition 1, page 29.

Let’s suppose the current cost of production is $400,000.

Now we need another concept: own funds at book value from the 2008 SNA, Paragraph 13.71d-e:

d. Book values reported by enterprises with macrolevel adjustments by the statistical compiler. For untraded equity, information on “own funds at book value” can be collected from enterprises, then adjusted with ratios based on suitable price indicators, such as prices of listed shares to book value in the same economy with similar operations. Alternately, assets that enterprises carry at cost (such as land, plant, equipment, and inventories) can be revalued to current period prices using suitable asset price indices.

e. Own funds at book value. This method for valuing equity uses the value of the enterprise recorded in the books of the direct investment enterprise, as the sum of (i) paid-up capital (excluding any shares on issue that the enterprise holds in itself and including share premium accounts); (ii) all types of reserves identified as equity in the enterprise’s balance sheet (including investment grants when accounting guidelines consider them company reserves); (iii) cumulated reinvested earnings; and (iv) holding gains or losses included in own funds in the accounts, whether as revaluation reserves or profits or losses. The more frequent the revaluation of assets and liabilities, the closer the approximation to market values. Data that are not revalued for several years may be a poor reflection of market values.

The accounting entries are simple (I am considering increases/decreases here, so “= +” is understood as an increase in the thing on its left.)

For Household 1:

Assets

Liabilities and Net Worth

House = +$1mn

Bank Loan = +$1mn
Net Worth = +$0

For Bank A:

Assets

Liabilities and Net Worth

Loan to Household 1 = +$1mn

Deposits of Firm P = +$1mn
Net Worth = +$0

For Firm P:

Assets

Liabilities and Net Worth

Deposits = +$1mn
Inventories = −$0.4mn

Own Funds = +$0.6mn
Net Worth = +$0

For Household 2:

Assets

Liabilities and Net Worth

Own Funds at Firm P = +$0.6mn

Net Worth = +$0.6mn

So, my (Household 2’s) net worth has risen by $600,000 by selling you (Household 1) a house.

I have in this example, intentionally chosen a privately owned firm to score a point. If the firm had been publicly owned, the house sale would have increase the firm’s net worth and my (Household 2’s) net worth would increase when the firm’s net worth reflects in the share price (which is not immediate). But I just had to show one example. It’s not just academic – many firms are family owned.

Steve Roth’s claim are similar to claim made by Neochartalists who claim that the private sector can only save if the government runs deficits and so on. All counterproductive.

The case for fiscal expansion can be made quite strongly, but not by these click bait claims.

Economists Can Be So Wrong

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Oh boy! Krugman could not have been more wrong about Macroeconomics than what he said recently in his blog The Conscience Of A Liberal for The New York Times. In a blog post, Competitiveness And Class Warfare, he concludes:

International competition is a mostly bogus notion; …

In a sense it is not surprising. Paul Krugman has done enough to push free trade. With that position, one is forced to take a position that competitiveness doesn’t matter (or that free trade will lead to a convergence between successful and unsuccessful nations).

The notion that balance of payments does not matter is as old as Monetarism. If it is understood that competitiveness does matter and that for a nation it hurts domestic producers and hence one needs some sort of protectionist measures goes against the notion of free trade. For neoclassical economists other than Paul Krugman, competitiveness does matter but in a different sense. They would argue that it there is divergence in performance of nations because of “loose fiscal policy” or “fiscal profligacy” and so on and that once the government balances its budget and behaves the way as per a standard textbook model, there’ll be convergence in performance because market mechanisms will do the trick. But Krugman is different. During the crisis, he has understood that fiscal policy is important and that it is not impotent as claimed by his colleagues.

There are of course other factors at play in the examples Krugman provides. Japanese producers are highly competitive but at the same time, the government of Japan didn’t expand domestic demand by fiscal expansion and so the performance of the economy of Japan has suffered. But that doesn’t mean that the competitiveness of Japanese producers doesn’t matter. Had they been less competitive, Japanese exports would have been lower than otherwise and Japan would have imported more because foreign producers would beat them at their home. Moreover, a weaker current account balance of payments would have led to a bigger government deficit and the Japanese government would have (incorrectly) tightened fiscal policy in response, with the result that both balance of payments and fiscal policy would have reduced domestic demand and hence output.

So while there are other factors affecting economic performance, none of it ever means that competitiveness doesn’t matter.

Cambridge economists were clear on this. Here’s Wynne Godley in a 1993 article Time, Increasing Returns And Institutions In Macroeconomics, in S. Biasco, A. Roncaglia and M. Salvati (eds.), Market and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini, (New York: St. Martins Press), page 79:

… In the long period it will be the success or failure of  corporations, with or without active help from governments, to compete in world markets which will govern the rise and fall of nations.

In trying to defend the importance of fiscal policy, some economists such as Paul Krugman become forceful in their views about the way the world works and underplay the importance of matters such as international competitiveness. They seem to falsely believe that this strategy would work for them because accepting the importance of competitiveness would give enough chance for their opponents to argue against worldwide fiscal expansion.  It is a sad and counterproductive strategy.