Transcript: 390 With the ship sinking, G20 advocates drilling holes in the hull to let the water out

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Today on the podcast, Notes, the dynamics of expectations from John Maynard Keynes, markets, some politically incorrect environmentalism from Stewart Brand, and Steve Keen debunking a mainstay of orthodox microeconomics -- the marginal cost curve.

By way of Calculated Risk, we find

First, from the Financial Times: G20 drops support for fiscal stimulus

Finance ministers from the world’s leading economies ripped up their support for fiscal stimulus on Saturday ...

The communiqué of the meeting made it clear that the G20 no longer thinks that expansionary fiscal policy is sustainable or effective in fostering an economic recovery because investors are no longer confident about some countries’ public finances.

from the G20 communiqué:

The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances. Those countries with serious fiscal challenges need to accelerate the pace of consolidation.

And from Paul Krugman: Lost Decade, Here We Come

It’s basically incredible that this is happening with unemployment in the euro area still rising, and only slight labor market progress in the US.

...

The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound.

...

Utter folly posing as wisdom. Incredible.

The G20 has been reading from The Economist magazine/newspaper's most recent issue: "Fear Returns -- How to Avoid a Double Dip Recession." that confirms it. The Economist was encouraging us to avoid the onset of the last one, or the first part of this one, well into 2008.

The Economist cheerleads the sinking, with quote "America contemplates yet more fiscal stimulus and leaves the pain for later."

This "bring it on" bravado for the benefit of the real economy and governments is substantially absent in the Economist when it has to do with the financial sector. It's as if shrinking economies are going to find treasure in the mud.

Exports are going to save the economy, the Economist says, every economy. How is that going to work. Oh, Here. The forthcoming issue: Mars just phoned in with a massive order for MacMansions.

The Economist's slogan should be, "We didn't see it coming, We don't know hwere it's going, but we'll tell you what to think and besides our graphics are good.

Markets:

Stocks Down

Oil Down

Dollar Up (Is it oil down or dollar up?)

Bonds higher (don't forget the backdoor bailout of the banks means they can borrow from the Fed at zero, take it over to the treasury and lend, and collect the difference. This is a form of monetizing the debt, but paying for the privilege.)

The very weak jobs report was in line with Demand Side predictions. The second quarter was the peak of the federal stimulus, which provided the only positive noise in an otherwise deep and continuing recession. It should be observed that even with the federal stimulus, because of tightening at the state and local levels, the net contribution from government was slightly negative.

The help to states goes away in September and next January, although there is a probability that support for Medicaid will be continued. From the Demand Side point of view, there are only a few fibers holding us from another serious leg down. Perhaps it will not be as dramatic as the fall into the pit. But we're drilling below every other postwar recession now.

Another note from John Maynard Keynes on expectations. From Steve Keen's seminal article in 1995 entitled "Finance and economic breakdown: modeling Minsky's 'financial instability hypothesis.'

Keynes' (as in John Maynard's) explanation for the formation of expectations under uncertainty has three components:

• a presumption that 'the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto;"
• the belief that 'the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects;' and
• a reliance on mass sentiment: 'we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed."

As Keen points out, "the fundamental effect of shifts in expectations is to change the importance attributed to liquidity, thus shifting the apportionment of funds between assets embodying varying degrees of liquidity, with volatile consequences for the level and composition of investment."

Points one and two are the pillars of Rational Expectations theory and the efficient markets hypothesis favored by the Chicago School

According to Wikipedia:

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". Weak EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. Semi-strong EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. Strong EMH additionally claims that prices instantly reflect even hidden or "insider" information. There is evidence for and against the weak and semi-strong EMHs, while there is powerful evidence against strong EMH.

In other words, in 1936, Keynes identified the fallacy of expectations in conditions of fundamental uncertainty. In the 1980s, the fallacy was developed into a Nobel Prize winning theory.

The final component in Keynes triad, reliance on mass sentiment, is all the more powerful today. It did Stiglitz, Keen, Baker, Roubini, Krugman, Galbraith, et al, no good in terms of influence to be right in their analysis and predictions. As we saw, policy-makers are in thrall to the thousand-voiced financial sector, which dutifully amplifies the traditional sentiment to a frightening pitch. The fiscal tightening policy has no chance of success, even in producing the returns for the bond vigilantes themselves.


Now for something new. It seems like we've been saying the same thing for so long.

Stewart Brand is a long-time environmetalist. We excerpt aggressively from a TED lecture called four environmental heresies, bringing you a couple of them: nuclear power is environmentally friendly, genetically engineered crops are a moral imperitive, and geoengineering will have to be tried to reverse the environmental degradation of the Anthropocene, the geological successor to the Holocene.

STEWART BRAND


How broken is orthodox economics?

Last week we watched in horror as Steve Keen dismembered the standard curves used to describe prices in classical market curriculum. The curves? Fixed costs. Variable costs. The combination produces marginal cost -- the cost of producing one additional unit. Price set at the point where marginal costs equal morginal revenue.

Nice on paper. A feature of every textbook. Not accurate. Keen says, in part,

What “state of the art” means in economics, sadly, is applying a textbook model that is empirically and theoretically false to a real industry. Only by luck will it actually have the intended impact.

...

Neoclassical economists draw their “average cost curve” by combining two other hypothetical curves: one for fixed costs that don’t depend on the level of output (machines in a factory, or the cost of prospecting), and the other for variable costs that do depend on the output level ( labour, raw materials, energy, fuel).

Average fixed cost necessarily falls as output rises—a constant cost level is divided by an increasing output. For variable costs, economists make two assumptions:

• that the cost of inputs remains constant: inputs like labour and raw materials (of a set quality) are assumed to be readily available at a set price, regardless of how many units the firm purchases; and
• that the productivity of these inputs falls as output rises. Economists call this assumption “the Law of Diminishing Marginal Productivity“. Since each worker costs the same amount, but produces a lesser amount than the one before, the marginal cost of production rises.

Average cost per unit falls as the decline in “average fixed costs” dominates, but then rises as “marginal costs” increase. The average cost of production is therefore U-shaped.

It’s a simple, intuitively appealing model that is believed by all neoclassical economists. And it’s also empirically false. Over 150 academic studies of manufacturing firms have found that most firms have cost structures that look nothing like these drawings.

The most recent such research—Asking About Prices, by Alan Blinder, a past Vice-President of the American Economic Association—found that 89% of firms reported either constant or falling marginal costs (Blinder (1998)), while previous studies had put the figure as high as 95% (Eiteman and Guthrie (1952)).

It appears that the “Law” of Diminishing Marginal Productivity doesn’t apply in the real world. The reason is simple, and best illustrated with a farming example where the fixed input is land and the variable input is fertiliser.

Economists imagine that a farmer with a 100 hectare farm and 1 bag of fertilizer would spread the entire bag of fertilizer over the entire farm—using all of both his fixed and variable inputs.

But what a farmer does instead is leave most of the land unfertilized, and spread the bag at the recommended ratio per hectare—since this gives him the highest productivity. As each new bag of fertilizer is added, more land is fertilized, and so on, so that productivity remains constant right out to the 100 hectare limit.

A similar story applies for factories: they are designed by engineers so that they reach maximum efficiency at very close to maximum capacity. When a factory is first commissioned, it will have oodles of spare capacity—since it is built with the expectation that demand will grow over time. Therefore unit costs will fall as output rises because the factory becomes more efficient—not less, as economists fantasise.

Economists cling to the counter-factual fantasy they teach in their textbooks because without that fantasy, their model of a perfectly competitive market falls apart. As Blinder noted:

“The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost.” (Alan Blinder, Asking About Prices, p. 102)

...

Blinder’s “discovery” of this phenomenon casts an interesting light on the nature of scholarship in neoclassical economics. He undertook the research to provide a “microfoundation” for his position as a “New Keynesian” macroeconomist, where that particular Neoclassical sub-school explains unemployment (and other real world macro-phenomena) by the proposition that prices are “sticky”, and therefore don’t instantly adjust to eliminate involuntary unemployment as unreconstructed Neoclassical theory argues should happen (the rival “New Classical” school argues instead that prices do in fact adjust rapidly, and that all unemployment is voluntary—including that which occurred during the Great Depression).

But though he expected to find a reason for prices not to behave as the textbook said they should—to rapidly bring all markets into equilibrium—he was obviously surprised by what he found. His summary of findings included statements like the following (in addition to the “overwhelmingly bad news” comment above; I’ve added the emphases below):

“in a fair number of cases—and this was the big surprise—we found that the ‘fixed’ versus ‘variable’ distinction was just not a natural one for the firm to make.” (p. 101)

“Firms report having very high fixed costs-roughly 40 percent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks.” (p. 105)

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See much more at Keen's Debtwatch site, link online