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Saturday, September 26, 2009

The Minsky Hour, or maybe just ten minutes

Plus Marc Faber and Steven Roach

Yes, we've been teasing too much, but there is too much to Minsky. We'll lead off with the insights of this obscure, but much less so today than last year, economist. A bit later we'll get more of Marc Faber and some Steven Roach on China.

First a discouraging word from Joseph Stiglitz, dropped in conversation at the Roosevelt Institute's Four Freedoms dinner recently. Stiglitz suggested to Lynn Parramore that still more than 60 percent of economists are holding on to the Chicago School mentality. Wow. When economics becomes not a science, but a religion.

But let's start out today with our minds clear and our focus simple.

And we go back to the algebra derived from Michal Kelecki's most simple assumption -- that workers consume all their income -- and see how Minsky develops it. Of course the assumption is not completely true, but it is not fatal to the analysis when it deviates the way, for example, the assumption of Neoclassical economics that all firms are price takers or the assumptions of rational expectations that market participants, indeed all economic actors, are imbued with economic omniscience.

Kalecki showed that when his assumption was allowed and in an economy with small government and little trade, investment equals profits, or profits equal investment.

By nothing more controversial than simple algebra, Minsky then demonstrated first that price is positively related to the wage rate and to the ratio of investment goods to consumption goods production, and negatively related to labor productivity. We went over that a couple of weeks ago, when we then digressed on the inappropriately prominent place the quantity theory of money has in the primitive orthodoxy that rules economics today.

But let's consider what Minsky's relationships mean. It's a no-brainer that prices vary in the opposite direction as productivity, because, productivity simply means producing more with the same labor. We at Demand Side recently demonstrated that productivity also goes up when the unemployment rate goes down. (I was so excited.) And since wages and unemployment also vary inversely, there is some amelioration of the labor cost impact on price, that is, on inflation. Put simply, prices do not rise in proportion to wages in periods of falling unemployment. This is, of course, opposite to the information derived from the famous Phillips Curve.

But the second part of this finding is very instructive. The algebra shows what we might also derive from common sense. As investment goods are emphasized over consumer goods, the price of consumer goods tends to rise, because, basically, workers in both sectors are bidding for the output of the consumer goods sector. So when the ratio favors investment goods more, demand for consumer goods is higher and output is lower.

But the implications are not all so common-sensical. The Kalecki demonstration that profits equal investment combines with this revelation that as new investment goes up, so do prices, to produce a condition in which higher prices, higher investment and higher profits coexist. Since investment also connects positively with output and income, we can expect these two -- output and income -- to be in the same virtuous soup.

This indeed was a somewhat surprising empirical finding of our research on economic performance by president. We found that in the postwar period employment is higher, unemployment lower, investment higher, corporate profits higher and GDP growth better when a Democrat is in the White House. It surprised us somewhat that with all the effort by Republicans to push companies into profitability, some would say at the expense of others, that is, the whole supply side idea, that they were not able to accomplish profits better than Democrats. The Kalecki-Minsky analysis demonstrates why it has to be. You can find it on pages 140 and following in Stabilizing an Unstable Economy.

Prices, Minsky says, carry profits, the raison d'etre for investment. In my micro courses we had fixed costs and variable costs and average costs. Prices were determined by marginal costs and where the marginal cost curve intersected the demand curve. This may be true, Minsky says, for price takers. But a whole great swath of the economy, by far its major part, is composed of firms which more or less set prices and vary output according to demand.

These firms operate on the basis of a set of nesting average cost curves, the highest of which includes capital asset validation cost, or profits in the normal use of the word. Such firms keep prices at the requisite level when demand falls by their market power, pricing power. Without this ability to constrain price movements, they may not be able to employ expensive and highly specialized capital assets and large-scale debt financing, Minsky observes.

We include that mention here not because we expect you to get it, the nesting average cost curves and so on, but just to let you know it is there in Minsky, as it is in the real world, and it informs what follows.

Returning to the propositions derived from the insights of Kelecki. Minsky expanded these by introducing big government and trade and workers who save. Elegant and simple algebra yields some remarkable insights.

Note here and we'll explain more in a minute that Minsky's profit is not the same profit with which we are familiar, nor that which we measured in our comparisons of economic performance by president.

Nevertheless, when government and taxes and deficits are introduced, something remarkable appears. It can be shown that after-tax profits equal investment plus the government deficit. When there is no investment, profits equal the deficit. See the details on page 148.

What are the implications of this? One implication is certainly that the big business types who encouraged the tax cuts to promote business should not now be bellyaching about the deficits. They are supporting profits. Now let's look at exactly what profits they are supporting.

Minsky's profits he also terms the "surplus," and it is not only the return on capital we normally think of as profit, but all the returns which are not technologically determined costs of production. These include advertising and professional services, executive salaries and overhead costs, costs of financing and the aforementioned costs to validate capital assets.

Two things jump out at me. One is that the profit or surplus feeds the white collars and presumably the big salaries as opposed to the blue collars on the production side. The other is that price-taking firms are disciplined into being more lean and less top heavy. It appeals to me as justification for taxing incomes progressively.

But let's go back to the price takers versus the price makers. What happens when demand falls? In the case of price takers, demand is reflected by a price that runs back along the marginal cost curve. In the case of price makers, who set the price and prevent its falling by market power, something else happens.

If output drops below the first critical average cost curve, capital asset prices are no longer validated and investment in new capital assets stops -- with implications across the economy for incomes and output. If output drops below the second critical curve, fixed debt payments can no longer be supported, and the various financing instruments come under pressure. Of course, the overhead and executive costs are compressed to some extent, but these may be resistant. For example, firms may increase advertising in attempts to gin up demand.

And when overall demand affects many firms, the same kinds of financial instruments come under pressure and we walk into the kind of crisis we have today.

See that the deflation is resisted by such firms on their products, because they have individual pricing power, but that the drop in output affects incomes and investments and financial arrangements dramatically -- without affecting price.

So my take here is that we ought not to be too ecstatic that deflation is not spiraling. The cost-cutting and absence of investment and the pressure on the financial sector, all too evident in the current stagnation and apparent in declining payrolls may likely mean more bad jujus.

AND of course, business cash flow is being supported mightily by government deficits.

I hope this is semi-clear. It is new to us in this form, and it is a lot to digest. But here at the micro level, you can see what about modern capital-intensive corporate capitalism Minsky found so unstable.

Now, moving on.

Here is Marc Faber, continued from last week. He begins by taking some shots at Paul Krugman, which I purposely leave in here, though I may have to turn in my progressive economics club card. Faber says a kind word about the Austrian School as well. To that I reply with the anecdote in James K. Galbraith's piece we put up on the blog recently. When James K.'s father John Kenneth addressed a conference in Austria, two of the leading lights ... well, here it is verbatim.

...when the Vienna Economics Institute celebrated its centennial, many years ago, they invited, as their keynote speaker, my father [John Kenneth Galbraith]. The leading economists of the Austrian school—including von Hayek and von Haberler—returned for the occasion. And so my father took a moment to reflect on the economic triumphs of the Austrian Republic since the war, which, he said, “would not have been possible without the contribution of these men.” They nodded—briefly—until it dawned on them what he meant. They’d all left the country in the 1930s.

unquote from James K. Galbraith

Now, Marc Faber


Mark Faber

Now just a word from Steven Roach head of Morgan Stanley Asia, in support of our contention that the Chinese miracle may be a mirage unless they establish some sort of basis for homegrown demand, by which I mean social insurances for health care, old age and unemployment. Absent this, they may spend their dollars in pushing infrastructure and see the GDP number respond without establishing anything fundamental. The same sort of infrastructure spending in the U.S. would do great things, but because we have the basis for demand to respond rather than grab the loose dollars and stuff them under the mattress.

Steven Roach with Leslie Cohen of the BBC's Business Daily.


Steven Roach

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