The Truth About the Greek Loan Default

The events surrounding Greece's default is the culmination of everything wrong with the world order today:  An incorrect view of how modern currency works; a cultish adherence to debt repayment, a political order that puts the interests of international creditors ahead of ordinary workers, and a complete inability for the international power elite to admit they are wrong.

Of all the things that are wrong, I think the most perverse is the cultish attitude towards debt repayment.  Greece has no ability to pay back its debt.  For the last 5 years, it has agreed to almost every cut in government spending the E.U. and IMF have insisted on.  It has raised its retirement age by over a decade to 67.  It has continually increased taxes.  And yet, when none of these worked, the elite demanded more, more, and more.  Never considering that its time to declare bankruptcy and start over.

Despite 5 years of making things worse, The IMF, E.U. and World Bank continue to hold to their same old prescriptions: Cut government services to the poor, cut health care spending, raise taxes on labor, and cut taxes on capital.  That's right, you read that last part correctly.  As they insist on raising sales taxes - they call it VAT or Value-added-tax(the most regressive tax in modern democracies), they have insisted on Greece cutting corporate taxes.  The elite adhere to the idea of neoliberalism.  That if the country quits taxing capital and investment and moves taxes to a sales tax, at the same time they cut welfare then the country will prosper, tax revenues will go up, and the budget will be balanced.

Of course that idea has almost never worked.  (I can't think of a single instance where it did, but I'll say "almost" just in case there was one).  Despite this low success rate, the global elite keep trying to impose these policies on in-debt nations through the IMF, World Bank, and now... the European Central Bank.  Greece is only the latest causality.  It is shocking because its the first time the global elite have done this to an industrially advanced and well-developed country.  Their usual targets are 3rd world nations in Africa and Latin America.  Despite these neoliberal ideas hardly ever working, and not working in Greece for the last 5 years, they keep trying.  It is like a religion to them and they can't accept that it is failing.

Many people over simplify the problem by suggesting that Greece has "lived beyond its means" - I've seen that attitude in non-partisan business reports on the issue.  Thus trying to frame the whole thing as a morality play and those lazy-ass Greeks are getting what's coming to them.  This is a complete misunderstanding of currency and a reduction of a complex issue into willful ignorance.  They think that well if Greece is in debt, they just need to do what everyone else does: increase revenue and cut spending.

The problem is, if I do that, it affects very few people.  If a national government does that it affects a lot of people, raise unemployment, and put the entire country's economy into a tailspin... which results in lower, not higher revenue.  Also, if a person accumulates too much debt that they can't pay it, they can default.  A country cannot default without causing an entire economic shit-storm.  In addition, the E.U., IMF, and World Bank make it as hard as possible on countries that consider default by trying to cut all future financial ties.

Rather than default, the proper way for a nation to deal with a debt problem is to devalue its currency.  What this means is that their currency is worth less vs other currencies(like U.S. dollars vs Mexican Peso)  Either "naturally" by letting the currency exchanges happen naturally(this is what most countries do) or they do it explicitly if they have a "fixed exchange".  (Few countries have a "fixed exchange" where they declare something like they'll trade 7 lira for 1 American dollar or .01 oz of gold, but if they do and they have a debt\deficit issue, the can just decrease the exchange)

Unfortunately, Greece cannot do that.  Greece doesn't control their own currency the way other nations do.  They use the Euro.  Therefore, bankruptcy or accepting the terms of their new lender masters(IMF, World Bank, and E.U.) are their only options.  And since 5 years of being at their mercy hasn't resolved the issue, you can now understand why they chose default.  With 25% unemployment, a welfare state that has been gutted in 5 years, and taxes higher than ever, what choice did they have?

Well, that isn't completely true. They have another choice.  They can dump the Euro and go back to the Drachma.  All this strife never would've happened if they still used the Drachma.  Sure, they still may have suffered some economic consequences, but not to the degree that we have seen.  Even if one were to concede that Greek budget deficits were too high, the only consequence would've been the Drachma was worth less in the world.  That would've meant that all Greek's were poorer, sure (in other words... ALL citizens would've shared a small dip in wealth instead of just the poor not being able to find a job).  However it wouldn't have caused 25% unemployment for the next 5 years.  It also would've meant that Greece suddenly became an attractive place for a business to make goods for export.  If that had happened, instead of hearing lies about lazy-ass Greeks living beyond their means, we might instead be hearing about the Greek miracle of how Greece came out of the 2009 recession to become an industrial power house of Europe.

This could be the ultimate way out for Greece.  In fact, some insiders have noted that if the Greece government started giving out IOUs for its debts, and accepted them back for payment, the IOUs could become a defacto new currency.

For the sake of the people of Greece I sure hope they choose a route that does something like dumping the Euro.  Unfortunately, many people in Greece and its government don't realize the Euro is causing their trouble and want to keep it.  For those who may be inclined to agree, I have to ask, is 5 years of 25% unemployment worth the convenience of a single European currency?

Latest Grand Bargain is (mostly) a Grand Waste of Time

It's so frustrating to know how the economy works(MMT), and then watch a bunch of men who don't, try and improve the national economy. Here is a one line sentence explaining how to grow an economy.

People need to spend more money so that there will be the increased demand for new jobs and new business.

That's it.  But let's look at Obama's latest Grand Bargain proposal from a critical MMT perspective.  Obama's plan has 3 parts.

1. Simplify the corporate tax code
2. Try to coax companies to "repatriate" their foreign money holdings
3. Use the tax increase to fund infrastructure jobs.

The first plan is to simplify the corporate tax code in 2 steps.  First, it's going to eliminate several deductions and so-called "special interest" loop holes.  That will increase the amount of taxes the government collects.  The second step is to lower the tax rate to the point where the money gained by closing loopholes is roughly equivalent to what's lost by lowering the tax rate from 35% to 28%.  Overall this is "revenue" neutral.  Will this help the economy grow?  Hell no!  At best it might make the economy run more efficiently(always a good thing!), but it won't grow.   It won't grow because all they're doing is changing who pays what, and not the total amount taxed.  No growth.

The second part is to get companies with foreign money holdings to bring the money into the country.  Normally, there is, apparently, a tax on doing that.  Therefore, companies leave their earnings overseas.  This estimate says there are over a trillion dollars out there.  Obama's proposal is to try and get those companies to bring in the money by offering a one time, low tax, to do so.  From an MMT perspective this would be bad for the overall economy because it's taking money out of the economy.

The third and final part of the Obama plan is to start funding infrastructure and job training programs.  From an MMT perspective, increasing government spending will be good for the overall economy because it will increase demand for jobs and business.  Hooray!

The reason I call this plan a waste of time is because, the first part offsets itself and the good in the third part is offset by the harm of the second part.  Making these plans revenue neutral will never give the economy the boost it needs.  Infrastructure jobs that aren't offset with tax increases will.  Tax cuts that aren't offset by tax decreases will also do the trick.

If there is any redeeming part of the proposed 'grand bargain' is the possibility that money will be shifted from those who are letting it sit, to those who will spend it.  That's why I added the qualifier(mostly) into the title.  If that money is truly just sitting in a foreign bank, collecting low interest dust, then shifting the money to infrastructure and creating jobs for the unemployed will help some.  My guess is that only some of that money is "just sitting there", the rest is being reinvested into other enterprises and will only end up moving around who gets it.

The thing that Obama, along with the GOP that's already dismissed the whole thing, don't understand is that the government doesn't need that money to spend on infrastructure.  The government can't run out of money anymore than a stadium can run out of points on a scoreboard.  Therefore, we can grow this economy until unemployment is back to a non-embarrassing level.

Recognizing who\what Really Controls Interest Rates

Just in case there was any doubt about what really controls interest rates, the past couple of months should dispel any lingering doubts.  The Federal Reserve(The Fed) is without a doubt in full control of interest rates going up or down.

Back in spring, the Fed hinted that it was going to ease up on "Quantitative Easing" or QE3.  Quantitative easing, for those who don't know, is the Fed trying to flood the market with dollars by buying stocks and bonds(*True Story)  They call it Quantitative Easing to make themselves sound smarter than you(*Not a true story).

So guess what happened?  Interest rates have been steadily rising this summer.  Despite that, many people mistakenly believe that interest rates are determined by a "Free Market" or by "bond vigilantes".  The only time "the market" really gets involved is when they start trying to guess at what the Fed is going to do.  That was demonstrated last Wednesday.  The Fed said nothing, the market reacted as if that meant interest rates were going to go up.

The policy implications for this are immense.  I won't get into all of them on this little post.  But let's just start at the bottom.  The Fed sets interest rates.  That is a fact, one that cannot be denied.  Whether or not that is desirable is a different argument.  But, right now, the only thing standing between a 0% interest rate, or a 40% interest rate is a whole bunch of wealthy, well-connected bankers.

No amount of budget deficits or surpluses can change that fact.  Granted, the bankers may make their decisions based on federal budgets or the health of the economy.  But the decision is still in the hands of a small number of people, not "the market".

The Farce That is Sequestration

Brace yourselves, The effects of the so-called "Budget Sequestration" are about to hit.  The two parties aren't going to compromise so the automatic budget cuts are going to hit and hurt the economy.  The media will probably ultimately blame the two political parties for not coming together to fix something that EVERYONE knows is going to be bad for the economy.

The actual economic damage is compounded by the other deficit-reduction measures that have already slowed growth, including a 2 percent payroll tax increase. All told, economists expect the sequestration plus last month’s fiscal-cliff deal to slow the pace of GDP growth by 1.5 percentage points. That’s no small change for an economy growing about 2 percent a year, particularly one that appears to have lost steam in the fourth quarter of 2012.
<snip>
The reality is that they are equally at fault: Both sides accepted the across-the-board cuts if they couldn’t agree to more sensible ones.

I don't blame the two parties for this mess.  I blame bad economics.  John T. Harvey has a good write-up of why this is going to be bad and why it's all unnecessary in his article Suicide by Sequestration.

As suggested above, many others have already gone into detail on where cuts will hit and how bad it will be. But, the overwhelming majority of this has been written based on the assumption that we do, in fact, need to cut the debt and deficit, just not this way. I therefore want to do what I’ve done so many times before in this blog: explain why this is a false and terribly dangerous premise. ANY reductions in the deficit are a mistake, not just those forced by sequestration. Below, I attack a number of the fallacies on which these contrary opinions are based (many of these have appeared before in this column–I’ll keep repeating it until President Obama listens!):
<snip>
For God’s sake, we have so many difficult problems facing us today. Why add to that by shooting ourselves in the foot–no, the head–by purposely reducing economic activity even more? To see how well this brilliant economic-recovery strategy works, just look at Greece, Spain, and the UK. Better yet, look at the US in fourth quarter of 2012. That negative growth, correlated as it was with a big drop in government spending, is a precursor of things to come.

I highly recommend reading the rest.  John explains better than I could so I won't repeat his points.  Instead, I'll try to answer his question of Why do we keep trying to do this to ourselves?.

The economists that our leaders listen to keep telling them that budget deficits are always bad.  It's always bad to have debt for a household or business, so in theory, it should be bad for a national government.  It's a very powerful and emotionally convincing theory backed up by the metaphor of a household or business budget.  The people who keep pointing out that The Federal Budget is not Like Your Budget keep getting drowned out.

How powerful is this theory?  It's so powerful it drowns out common sense.  Let's take a different situation.  Let's say someone at the pet store tells you your fish tank should have no more than 3 snails for every 5 fish.  But your fish tank has 4 snails and 5 fish.  So you take away one snail.  But you notice that a week later your fish starting looking sickly and the water gets dirty.  You add back a snail and everything starts slowly recovering.  When you tell this to the pet store owner, he assures you "no no, you gotta take that snail away.  Your tank will get 'too clean'.  The 3 snails will eventually learn to clean more.".  So you go home and take the snail away again, but sure enough your tank gets dirty and the fish sickly.  How many times would you keep trying to take a snail away before you conclude that the pet store owner doesn't know what the hell he's talking about?  Well, if you're a congressman, at least more than 5 years!

We have experienced nearly 5 years of a trillion plus dollar budget deficit.  The entire time our economy has been slowly recovering.  The only times it has faltered is when congress has another budget or debt ceiling fight to cut the budget.  How long can this go one until more people start realizing that the economy is recovering and falters when we prematurely try to balance the budget?  If we were scientists and observed this many countervailing examples of our theory, we'd throw it out in a heartbeat.

But, we don't throw out the theory that "Budget Deficits are always bad".  Why?  Because the metaphor of the federal budget being like a household budget is just too strong.  We'll just keep telling ourselves that we "cut the 'wrong' things".  Apparently, they'll never conclude that it's the cutting itself that is 'wrong'.

A Gold Standard? How About a Labor standard?

For several decades the U.S. dollar was on some type of gold or silver standard.  Doing so anchored the dollar's value to something of value.  But why has it always been anchored to gold or some other precious metal?  Is there any reason why it has to be gold or precious metals?  It seems fairly arbitrary.   Maybe it's because it's rare and valuable?  In reality it though, the dollar - or any currency - could be tied to almost anything.  It could be precious metals, agricultural goods, or even consumer goods.  So why not set the value of the dollar to unskilled labor?  I think you'll find that we have all the advantages of price stability that gold provides, but also eliminate and reduce several other social problems.

Before describing how to implement a dollar that's on a "Labor Standard", let's review how governments maintained a gold standard.  First, they would have a reserve of gold.  Then they would declare that every so many dollars could be exchanged for so many ounces of gold.  For instance, 8 dollars for an ounce of gold.  At that point, the government must then constantly buy and sell gold to maintain it's value.

For instance, if the market determines that an ounce of gold is worth more than 8 dollars, people are going to trade in their dollars for gold.  This will remove dollars from circulation and add gold to the market.  As that happens, the supply of gold on the market will increase and thus it's value will decrease.  The opposite happens to the dollar.  As dollars are traded in, less will be in circulation which means the remaining dollars are worth more.  These two trends will continue until the 8 dollars for an ounce of gold is achieved.

If an ounce of gold is worth less than 8 dollars then the government must buy gold until it's value is back to 8 dollars.  As the government buys more gold it's value goes up.  At the same time, the market is flooded with dollars which makes the value of dollars go down.  The government must continue to buy gold until the value of a dollar is back to 8 dollars for an ounce of gold.

The thing to take away is that to maintain the value of it's currency in a gold standard, the government sets the price first.  Then, once it's price is set, it let's the quantity of gold it buys and sells float according to the open market.  It's important to understand how this is different from most government spending.  Most government spending first sets how much it's going to buy (say number of cars for the FBI) it then let's the market determine how much it's going to pay(whatever the market price for a black SUV is).

Instead of anchoring the value of the dollar to the price of gold, Modern Monetary Theory(MMT) economists propose that we set the value of the dollar to the price of unskilled labor.  For sake of argument, let's say 8$ an hour for 1 hour of labor.  Just like in a gold standard where the government makes a permanent market offer of 8$ for an ounce of gold, in a labor standard the government would make a permanent job offer of 8$ for one hour of work.

With the dollar set to the labor standard, the government would set how much it's willing to pay any American citizen for an hour of work.  The open market would then set how much labor would accept the job offer.  If 3 million people are unemployed and are willing to work for 8$ an hour, then the government would hire 3 million people and find work for them to do.  If the private economy improves, and offers people more money to work for private firms, the amount of workers hired will go down.  If the economy declines, the number of people hired will go up as the private sector lays people off.  Inflation and budgets are automatically controlled as people move between government 8$ pay and private sector pay.

Doing this would provide the same advantage that a gold standard has which provides long-term price stability.  Deflation would always hit a floor, because as the labor market slacks, the government would pump money into the economy as it hires all the freshly laid off laborers.  Inflation could only get out of control in one unlikely scenario:  The private sector hires virtually all the labor on the market and still demands more.  I call this scenario unlikely because it's never been achieved in the united states with only the exception of World War II.  Even in that case, it required the government to spend massive amounts of money by buying items at the market rate.

In addition to long-term price stability, a labor standard provides the added benefit of giving work to people who are unemployed.  Another way that a labor standard is superior is that instead of unemployed people being idle, they can provide a benefit to society in whatever form the government desires such as in-class teacher assistants, librarian assistants, visiting the elderly and infirm, being part of a neighborhood watch, cleaning up streets, litter, and graffiti, etc.

Another thing that makes the labor standard superior to a gold standard is that labor cannot be stored.  Unlike gold, for every hour that a worker isn't working, value is lost that can never be regained.  So why would we "fully employ" gold that always maintains intrinsic value, but let labor stay idle?  If the private sector leaves labor idle, any value the public sector can get out of it can only benefit society overall.

Finally, the last thing that makes a labor standard superior is that it eliminates most unemployment and all the social ills that accompany unemployment.  Any unemployed workers that the private sector doesn't want, the government would hire if they are ready, willing, and able to work.

Of course, this diary is just using an alternate description of the Job Guarantee.  For more information on how that works, please see my diary: Job Guarantee:  Zero Unemployment Without Causing Inflation.  (I encourage you to read it before attacking the program.  Especially if you're going to use the tired, "zOMG! Socialism!" attack)  When talking about the Job Guarantee, most people get caught up in the social safety net aspect.  However, for those who worry about inflation, currency devaluation, etc, I wanted to write this alternative way of thinking about the same thing.  The dominant economic thought believes that inflation and unemployment must be balanced, but as I've tried to show here, Modern Monetary Theory shows that price stability can be achieved through full employment.

General Theory Study Guide: Chapter 3, Section I

This Chapter introduces the Keynesian concept of "effective demand".  He does so in the most confusing way possible.  I'll try to simplify as much as I can.

In section I, all Keynes does in this section is define "effective demand".  Here's the theory from Keynes's own words.

The amount of employment... depends on the amount of the proceeds which the entrepreneurs expect to receive from the corresponding output.  For Entrepreneurs will endeavor to fix the amount of employment at the level which they expect to maximize the excess of the proceeds over the factor cost.

In other words, Employers will guess what the most profitable level of employment will be, and that is how many people will be hired.  If entrepreneurs don't believe hiring more people will be profitable, they won't hire them.  The point where the cost of employment meets the expected increase in revenue is the point of "effective demand".

Keynes contrasts this with the classical theory(The belief that supply creates it's own demand).  For that belief to be true, any increase in the number of employed people must mean that the cost of hiring will always be less than or equal to the expected profits .  If that were the case, then entrepreneur's would constantly be hiring people until there was no one left and employment really would be determined by the Marginal Disutility of Labor.

Obviously, Keynes doesn't believe the above paragraph is true.  He will lay out his explanation and theory of why in Chapter 3, section II.

Hopefully, my non-math and non-statistical explanation of his definition of "effective demand" will help you understand Keynes's math heavy explanation in Section I.

All that Bunk About Deficits and Skyrocketing Interest Rates

It is astounding how long experts can keep repeating the conventional wisdom in the face of -what SHOULD be - overwhelming reality.  The way things work today, the Federal Reserve sets the interest rate.  Additionally, inflation is determined primarily by aggregate demand.  We have nearly 5 years of data backing this stuff up.  Yet, the conventional wisdom marches on.

The federal reserve very plainly sets the (short-term) interest rate.  That is what they do.  It's called an Open Market Operation. When they want interests to go down they buy U.S. bonds.  That puts cash in the system and lowers interest rates.  When the Fed wants interest rates to go up, they sell their stock of U.S. bonds and remove cash from the system.  In this way the federal reserve sets the interest rate on U.S. bonds which then in turn influence other interest rates(like mortgages and car loans).  This isn't a secret.  They explain it on their website.

Despite this, we have deficit terrorists running around telling us that we need to cut social security and gut medicare right now! This very instant!  Because if we don't, interest rates will spike.  We'll have to start paying 150 bazillian% (Note:  not a real number) on the federal debt and our mortgages.  Pete Peterson, the stereotypical deficit terrorist, states the conventional wisdom very plainly.

I see two potential crises in the future: a near-term financial crisis rooted in declining investor confidence that leads to sharp rises in interest rates and forces sudden, draconian changes in the federal budget; and a longer-term economic crisis that would result from diverting more and more of our national resources to servicing debt instead of investing in areas that are essential to long-term growth. These crises are made all the more likely by the fact that growing debts aren’t just an American problem. Projections show that, by 2035, the world’s advanced economies could face debts approaching 200% of their GDP. With countries competing for scarce capital, interest rates are almost sure to rise steeply.
(emphasis added)

We are now on fiscal year 5 of approx trillion-dollar budget deficits.  I'm still waiting on those mythical bond vigilantes to spike our interest rates.

With that in mind, I found two news stories that are oh-so interesting.  The first is that Mortgage rates hit a new record low last week.  So much for worrying about skyrocketing interest rates...  But what about U.S. bonds?   Maybe those are skyrocketing?  They are still insanely low.  On top of that, there was a bond auction this week where, for every 1$ in U.S. treasuries being sold, 3.16$ was bidding to buy them.  That is a record high amount of bids.  So despite low interest rates and high budget deficits, bond holders are not only sticking with U.S. bonds, but are flocking towards them in record numbers.

In both cases, it is because the federal reserve is purposely keeping the interest rates low.  They always keep it low when they want it low and always keep it high when they want it high.  At this point, I expect someone who is well-versed in the conventional wisdom to grab his or her hair and shout, "Fed keeping interest rates low?  zOMG!  Hyperinflation!  Weimer!  Printing Press!", and then their head explodes(Note:  I cannot be held liable for exploding heads).  All I have to say is that I am still waiting on that hyperinflation.

The small, but growing community of Modern Monetary Theory(MMT) economists can explain this phenomenon better than conventional economists.  They understand how Modern money works.  How Inflation an interest rates are really set.  Unfortunately, the conventional wisdom doesn't want to hear it.  Instead, we continue to have both presidential nominees talk about budget deficits without anyone asking to explain the supposed problem.

General Theory Study Guide: Chapter 2, Sections VI and VII

In Section VI, Keynes gives "Classical Economics" a final blow.  He starts to build his case that Money has an effect on the way an economy works.  The thought that the principles of a barter economy can be applied to a monetized economy was strong.  In fact, it is still strongly believed by Austrian Economics that barter is a useful model for monetized economies.

Keynes starts off section IV by quoting John Stuart Mill and Alfred Marshall.  This is to demonstrate the current thought which is that "supply creates it's own demand" as presumed by Mill.  The Marshall quote goes to show that the belief really is that if a person abstains from spending his income, it somehow automatically triggers a corresponding investment by himself or others.  Keynes claims this is incorrect because the two are using a false analogy between the world in which we live(a monetized economy) and a Robinson Crusoe economy of pure barter.

Keynes makes  a couple guesses as to why people have made this mistake.  The first is the strong case of Says law.  He agrees with the premise that the "income"(things it gets) of an entire community is exactly equal to it's "output"(things it makes).  This concept is confused with a (what Keynes calls a "similar-looking") proposition: "the costs of output are always covered in the aggregate by the sale-proceeds resulting from demand".  So what does that mean?  I found someone who explained it simply:

That is, I do not decide how many ipods will be made this year, but I do decide whether I want to buy one. Apple has to guess whether or not I will buy.

His other guess as to why people make this mistake is that those who believe Say's laws are basing it on individuals.  If an individual "saves" he is richer.  If every individual in the community "saves" then shouldn't the whole community be richer?  Keynes doesn't think so since.  This is his first hint at his fallacy of composition argument.

The two most important concepts from this section are:

1. Money matters.  It changes the way an economy works.  Money is not a "thing veneer" over a pure barter economy.

2.  The "classicals" are "fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption."

This leads Keynes to declare that many theories of "the classicals" need to be re-examined.

Section VII

Section VII is a summary of the rest of the chapter.  Keynes summarizes the 3 biggest ideas of the classical economists(seen below) that he believes are flat out wrong.  The following ideas must all be true, or all not true.

1. The real wage is equal to the marginal disutility of the existing employment;
2. There is no such thing as strictly involuntary unemployment;
3. supply creates its own demand

General Theory Study Guide: Chapter 2, Sections III, IV and V

In these sections, Keynes finishes demolishing the classical understanding of unemployment that he started in section II.  By the end of section V, his theory of employment should start(START!) coming into focus.  If by the end of section V, you don't understand his argument of why there is involuntary unemployment in a money economy, I would reread sections II through V over and over until you do before moving on.

Section III

Section III starts off by repeating that workers have no mechanism to lower their own REAL wages across the economy.  This is such an important point, Keynes can be forgiven if he repeats it a couple (or even a hundred) times.  Workers can only cut their dollar-wages, but that doesn't necessarily lower their REAL wage. Understanding this is critical to Keynesian economics.  From Section III

In other words, the struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour-groups, and not its average amount per unit of employment, which depends, as we shall see, on a different set of forces. The effect of combination on the part of a group of workers is to protect their relative real wage. The general level of real wages depends on the other forces of the economic system.

I cannot over stress the criticality of understanding this.  Keynes is pointing out that because people make their deals in money-terms and not REAL-wage terms, there is no way for workers to increase the general level of employment by accepting wage cuts.  Even if workers start a cycle of slashing their wage demands, all that will happen is either the price of what they're making is slashed or their wages will be redistributed to other groups.  If all workers lower their dollar-wage, it redistributes wages to capital or land in the form of interest and rent.

More detail on how and why this is will be explained later and throughout the book.  For now, just understand that Keynes rejects the notion of obstinate workers as an explanation for involuntary unemployment.

Keynes also points out now why it is actually logical(remember how the Classicals thought it illogical) for workers to resist reduction in dollar-pay, but not resist loss of REAL wages from a sudden increase in the cost of living.  A rise in cost-of-living affects all industries equally and happen so often that resisting them is impractical.  Of course, Keynes, being thorough, does point out that there are exceptions when things go to the extreme(i.e. A very high increase in cost of living).

Section IV
Section IV is where Keynes takes up the task of defining involuntary unemployment.  He makes some obvious caveats about his definition and existing definitions first(you shouldn't have a problem with theses).  Then he gets to his definition.  It is a complicated definition:

Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment

Fortunately, if you have a hard time deciphering this "an alternative definition, which amounts to the same thing, will be given in the next chapter".  What he's saying here is if the cost of living rises, but dollar-wages stay about the same, and more people are working after the rise than before the rise, then there was some involuntary unemployment.

Keynes in this section then reiterates that his problem with "the classicals" isn't their reasoning, it is their assumptions.  They have assumed, whether they realize it or not, that "Full Employment" already exists.

Section V
In this section Keynes comes puts and explicitly states that he does believe a reduction in REAL wages will in fact increase employment(assuming land and capital remains even).  He is not disputing this.  Only thing he is disputing is the ability for workers to cut their REAL wages.  At the end of the section he states, "The theory of wages in relation to employment... cannot be fully elucidated, however, until Chapter 19 and its Appendix have been reached."

Happy B-day to 2 Misunderstood Men: Adam Smith & J.M. Keynes

It is a fun fact that both the "founder" of economics, Adam Smith, and "founder" of macro economics, John Maynard Keynes, share the same birthday.  It is a not so fun fact that both men and their theories are so misunderstood by, not just the general public, but by other economists as well.  I realize I'm a day late on wishing them a happy birthday, but I'd like to give them both a belated present:  Clearing up some common misconceptions of their work.

Adam Smith was a compassionate person who cared greatly about morality, the well-being of humanity, and the poor.  Before publishing his famous economic Treatise, The Wealth of Nations, he published The Theory of Moral Sentiments.  A book that starts out with (bold emphasis mine)

How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortunes of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it... a matter of fact too obvious to require any instances to prove it

Smith was certainly no "let the poor fend for themselves or die" Ayn Rand disciple.  Despite this, the right wing in this country attempts to portray Smith as their mascot.  Even to the point of naming right-wing institutes after him.  So let's take a look at some of his views that would get him drummed right out of the republican party, tea party, and the general conservative movement.

Adam Smith recognized "the rich" taking advantage of the poor.  This excerpt is from From Book I, chapter 11 of the Wealth of Nations. (bold emphasis mine)

Rent, considered as the price paid for the use of land, is naturally the highest which the tenant can afford to pay in the actual circumstances of the land. In adjusting the terms of the lease, the landlord endeavours to leave him no greater share of the produce than what is sufficient to keep up the stock from which he furnishes the seed, pays the labour, and purchases and maintains the cattle and other instruments of husbandry, together with the ordinary profits of farming stock in the neighbourhood. This is evidently the smallest share with which the tenant can content himself, without being a loser, and the landlord seldom means to leave him any more.

In his day, Smith didn't use the term 'the rich' or the '1%' to describe wealthy people living off of the working class.  In his day they were called land lords and he didn't particularly care for them.  In this day and age he'd be accused of "envy" and "class warfare".  The excerpt above is just one of many that paints a negative view of landlords.

One last thing on Adam Smith.  If you were to claim Adam Smith's principles of taxation as your own, your right-wing friends and relatives would label you a socialist. It's really that first principle that would get smith labeled a socialist and thrown out of the tea party. From Book 5, Chapter 2, part 2. (bold emphasis mine)

1. The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state...
2. The tax which each individual is bound to pay, ought to be certain and not arbitrary...
3.  Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it...
4. Every tax ought to be so contrived, as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state...

I'm not saying Smith would be a liberal or a democrat if he were alive today.  But I am saying he'd be a lot closer to one than he would be to modern conservatives.

Now let's move on to Keynes.  John Maynard Keynes was a pro-capitalist, anti-communist British economist.  His biggest contribution to economics was a coherent theory showing that when it comes to analyzing a modern economy, money matters.  Up to that point, many thought that one could apply the principles of a barter economy to a monetary economy.

The common perception is that Keynes's big contribution to economics was that "demand creates its own supply" as opposed to "Say's law" which stated "supply creates its own demand".  If that was the only thrust of his argument, people wouldn't still be talking about him.  Economists had been making that argument since the time Say made his law.  It was the underlying theory behind his conclusion that made him famous.  Keynes arrived at his  "demand creates its own supply" conclusion based on his analysis of money and it's effect.  There was a reason his major book was called "The General Theory of Employment, Interest, and Money" not "The General Theory of Employment, Interest, and demand".  There was a reason that the prequel to "The General Theory" was called "A treatise on Money" and not "A Treatise on aggregate demand".  If you still don't believe me, read this excerpt from the Preface to "The General Theory".

When I began to write my Treatise on Money I was still moving along the traditional lines of regarding the influence of money as something so to speak separate from the general theory of supply and demand. When I finished it, I had made some progress towards pushing monetary theory back to becoming a theory of output as a whole.
[snip]
This book, on the other hand, has evolved into what is primarily a study of the forces which determine changes in the scale of output and employment as a whole; and, whilst it is found that money enters into the economic scheme in an essential and peculiar manner, technical monetary detail falls into the background. A monetary economy, we shall find, is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction.

There is something else about Keynes.  He shows that, because of money, the state must play a role in the economy to maintain full employment.  This has spawned two common misconceptions:  One is that conservatives demonize Keynes as the second-coming of Karl Marx.  The other is that in a recession, the government should spend money all willy-nilly until the recession is over.

For the first misconception, Keynes seemed ready for the attack.  In the last chapter of "The General Theory" he states several times he is no socialist and does not advocate it.

But beyond this, no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community.
[snip]
To put the point concretely, I see no reason to suppose that the existing system seriously misemploys the factors of production which are in use.  There are, of course, errors of foresight; but these would not be avoided by centralizing decisions.
[snip]
But there will still remain a wide field of the exercise of private initiative and responsibility.  Within this field the traditional advantages of individualism will still hold good.

Finally, if your only understanding of Keynes is, "use government stimulus to get out of recessions", you haven't fully understood him.  Keynes made clear that in a monetary economy, there is chronic under-consumption and under-utilization of resources.  Even during expansions there is a need for "social investment" (though not necessarily as much).  If the government can always guarantee full employment levels of spending, the private sector will respond by making their own investments and thereby cut the amount government needs to make.  There's much more to Keynes than just his conclusion of demand management.  But they'll have to wait as this post is too long already.  They'll have to wait until next year.

Types of Unemployment

Modern, mainstream economics universally recognizes three types of unemployment:  frictional, structural, and cyclical.  Some people add in seasonal unemployment to give us four types of unemployment.  These types of unemployment are pretty universal.  Not only on the net(see here, here, here, and here), but in N. Gregory Mankiw's Intro text book, Principles of Economics, as well.  Let's take a brief look at each kind.

Frictional Unemployment are workers who are literally "between jobs".  It is only the time lag it takes for a worker to leave one job and go to another(or become self-employed).  There might be some delay while a worker works on her resume` and goes through the interview process and possible wage negotiations.  Frictional unemployment is normal and healthy in any economy.  In fact, not having any, I speculate, would be inefficient and have a lot more unhappy workers who are stuck in their jobs.

Structural unemployment is the type of unemployment that comes up when the jobs employers are offering do match the skill or desire of those who are looking for work.  In a way, this could be considered long-term frictional while employees get new skills or employers adjust their requirements.  But I think that it is right to separate this kind of unemployment from frictional.  It's causes are different and therefore solutions would be different.

Combating structural unemployment seems to be the one issue that unites liberals and conservatives in the United States.  Reducing structural unemployment seems relatively simple.  If workers don't have the skills they need, then they need training or education.  Job training appears to be the only "jobs" program conservatives are willing to fund.

Cyclical unemployment is of course unemployment related to downturns in the economy.  Classic Keynesian economists will say it's from a lack of demand in the economy.  Monetarists or neoliberals like Mankiw will call it a downturn out of sync with the "natural rate of unemployment".  Austrians will deny that such a thing exists(claiming it's a type of structural unemployment created by bad policy) .  Unlike structural unemployment, conservatives are usually less willing to do anything about this.  Although not always, since the Bush tax prebates in 2001 that sent money to people is a Keynesian solution to driving up demand.  It might not be considered an orthodox approach, but it accepts the Keynesian precepts of driving up demand via government.

Finally, we come to seasonal unemployment.  There are some jobs that are only demand for part of the year.  For instance, retail stores hire extra people before Christmas.  Another example are farm workers who are only needed during the planting season and harvest time.  These are jobs that naturally don't exist year round.  When the demand for those jobs end, workers are left unemployed.  I understand why some people don't consider this a type of unemployment.  Some might just call this frictional since, presumably the workers will find other seasonal jobs once laid off.  I can understand that reasoning of both sides.  Seasonal employees will likely have more than 1 job, but seasonal unemployment poses unique problems from the other types so it makes sense to track them separately.

So that's the three (or four) different types of unemployment.  Not a lot of controversy for the most part.  The only part up for debate between the different economic schools is the existence of cyclical unemployment, and how best to understand it.

General Theory Study Guide, Preface and Book 1, Chapter 1

After reading of the Preface and Introduction(Book 1, Chapter 1) of The General Theory I find four things worth mentioning.  The first is why he wrote the book and the urgency with which he writes it.  The second is who he wrote the book for and why.  The thrd is the books relationship to his earlier writing, "A Treatise on Money".  The last thing I'll discuss is Keynes preview of the book and the significance of his title.

In the preface, Keynes lists his reasons for writing the book.  His goal was to deconstruct current economic theory, refute it, and reconstruct a new theory. He wrote the book during the Great Depression.  A time when unemployment was persistently high and didn't seem to be going down.  Most mainstream economists of the time were offering either conflicting or ineffective advice. Keynes noted that the longer the recession went on, the less the public was listening because the traditional advice(let the markets clear!) wasn't working.  Therefore there was an urgency to get things figured to end the Great Depression.

Keynes also made clear that he was writing this book for his fellow economists.  Apparently, he felt that they needed to be convinced before he had any hope of convincing the general public of his new ideas.  Since Keynes work was directed towards his fellow economists, Keynes really lays down the gauntlet.  He declares his book is going to attack current economic theory by refuting some of it's most basic assumptions.  He also warns that his disagreement isn't because he doesn't understand the mainstream economics of the time, but because he believes that mainstream economics is wrong.  As evidence he offers that he once "held with conviction for many years the theories which I now attack, and I am not , I think, ignorant of their strong points".

In the preface, Keynes mentioned something I found interesting about his earlier work, "A Treatise on Money".  His treatise was not only critiqued by his most-famous-rival Hayek, but his contemporaries piled on.  Keynes makes a bold claim in his preface.  He states that any legitimate criticism of his Treatise wasn't the result of him getting too far away from mainstream economics, but because he hadn't gotten far away enough.  If you don't think that's bold, imagine this:  You have an argument with someone.  The other person clearly loses.  The next day that person comes back and states, "I figured out why I lost our debate,  it was because I underestimated how wrong you are".

The last thing that I learned was from the introduction.  In the introduction, Keynes explains why the book is called "The General Theory".  Having never read the introduction before, I assumed that it was called "The General Theory" because he was laying a high level theory explaining the  economy.  Instead, Keynes had a subtler, more important meaning in mind for the title.

The title of the book, according to Keyne's introduction is that most of economics is based on a certain condition:  That the economy is in perfect equilibrium(everyone and thing is employed at what it is most efficient at).  Keynes says his book is an economic theory for when the economy isn't in equilibrium.  And, based on his intro, I believe that he believes the economy is almost never in that state.  From Keynes:

The characteristics of the special case assumed by the classical theory happen not to be those of the economic society which we actually live.

I specifically call this out because I've read economists that have claimed that Keynes was only writing for the Great Depression and his theory, conclusions, and recommendations didn't apply otherwise(see here, and here).  But his introduction leads me to believe that he was writing for almost every occasion.  He doesn't say 'currently' aren't living in.  He says flat-out, we don't "actually live" in the world assumed by classical economists.  I think this is the most significant thing I read as it refutes many people who suggest that Keynes didn't mean for his analysis to apply to non-depressions.

I didn't mention this in the intro, but be sure to read the footnote in Book 1, Chapter 1.  Keynes defines what he means by "The Classical School".  Apparently, he means any economist who can trace their work and theories back to David Ricardo.

For just a Preface and an Introduction, this was some pretty intense reading.  I have a feeling the rest of the book is going to be like this so I'd better settle in for a long ride.

Reading The General Theory

As much as I've talked about economics on this blog, I've never actually read Keynes's entire Magnum Opus, "The General Theory of Employment, Interest, and Money".  Sure, I've read parts of it here and there, but never all the way through as written.  Normally, I'd feel ridiculous about talking about a subject without reading one of the most famous books on the subject.  But apparently, most "real" economists haven't done so either and some even actively advocate against reading it.

So, I started reading "The General Theory" and very quickly learned new things and other things that I wanted to find more information about.  That's when I discovered there are no free, online study guides for The General Theory that are pro-
Keyensreality (the one I found was written by a very hostile austrian enthusiast).  So, I've decided to start one.  What qualifies me to do this?  Absolutely nothing but a curious intellect and a blog.  But, the way I figure it, until a more qualified person offers the same thing , I've got a monopoly on this niche.

So, what I'm going to do is read a selection.  Then I'll blog about what I read.  In the title, I'll put what section I'm talking about.  I'll point out things that I think are correct, things that I think are wrong, things I found insightful or interesting, and things that I found difficult to understand.  I'll then try to justify why and put in the correct information or summary.  I expect that I may occasionally change my mind or find new information and will have to update a post.  If it's a small change I'll edit the post.  If it's a big change I might just rewrite it and note that the older section is deprecated.

I'll also be creating a new page, The General Theory Study Guide, that puts the readings in order so that future readers can easily find the different sections.  I have no idea how long this will take, but it won't be finished unless I start it.  Hopefully, somebody will eventually find this helpful.  For those who are curious, this is the edition I'll be reading on the eBook reader device of my choosing.

Economic History Debunked: Economics Before Adam Smith

There was a rich history of economists long before there was an Adam Smith.  They didn't necessarily call themselves "economists" or use even the older term "political economy", but what they were studying was the "dismal" science known as economics.  Despite this, "Smith is widely cited as the father of modern economics and capitalism and is still among the most influential thinkers in the field of economics today" according to many.

Like so many other western sciences, economics has roots in the Greek philosophers of ancient times.  Plato stumbled onto a variation of the advantages of the division of labor.  One of Plato's greatest students, Aristotle, also touched on the subject of economics.  Just read book I of "Politics" Chapters 8(VIII) through 11(XI).  It is available online.  In it he discusses the "art of acquisition".  He touches on subjects that modern economists would refer to as "the nature of money", the concept of a monopoly, and markets.

Skipping ahead a few centuries... we come to Spanish Scholasticism at the University of Salamanca.  Scholasticism is a term usually used to describe a type of learning by medieval monks and scholars.   The University of Salamanca in Spain was founded by a group of scholastic scholars.  Austrian economist Joseph Schumpter did a lot of research to uncover much of the work done on economic thought at the University.

Similarly the Spanish Scholastic Diego de Covarrubias y Leiva (1512–1577) a distinguished expert on Roman law and a theologian at the University of Salamanca, wrote that the "value of an article" depends "on the estimation of men, even if that estimation be foolish." Wheat is more expensive in the Indies than in Spain "because men esteem it more highly, though the nature of the wheat is the same in both places." The just price should be considered not at all with reference to its original or labor cost but only with reference to the common market value where the good is sold, a value, Covarrubias pointed out, that will fall when buyers are few and goods are abundant and that will rise under opposite conditions

Schumpter gives a lot of credit to the late medievalearly Renaissance scholars at the school for making advances in economics that were later credited to Austrian economists that came 300+ years later.  Pretty good head start if you ask me.

To read more about these religious scholars struggle with "Just Price" you can read an excerpts from the book, "Modern Catholic Social Documents and Political Economy".  This link to Google Books should allow you read the whole excerpt "Scholastic Just Price" that starts on the bottom of page 63.  To sum up the excerpt, there was a great debate of whether the "Just Price" of a product was the market price, or the "cost to produce" price.    It is an interesting discussion because what they were discovering without realizing it, I think, was what came to be known as "economic rent".

The next group to talk about is probably the mercantilists.  For those who do talk about mercantilism, I think the conventional wisdom gets it right.  Mercantilism isn't so much a complete economic theory as much as it's a collection of disparate ideas of how to make the ruler of a nation state rich and rival rulers poor.  I won't rehash what others have said better:

Mercantilism was a reaction against the economic problems of earlier times when states were too weak to guide their economies and when every town or principality levied its own tariffs on goods passing through its borders.
The modern age brought the rise of powerful nation states (Holland, France, Spain and England) and was marked by almost constant warfare. Money (bullion) was needed to support ever-expanding armies and navies. Mercantilist concepts developed from this need.
Underlying this theory was the belief that wealth was finite. If one nation hoped to grow richer, it had to do so at the expense of some other nation.

Mercantilism drove economic and foreign policy during Renaissance Europe.  The reason I mention it is because it's existence was what our next group was rejecting:  The Physiocrats.  This group came on the scene in the mid 1700s - just a couple decades before Adam Smith published his Treatise.  They started and were based entirely within France.  There physical location is important.  The french economy was under severe distress at the time.  It makes sense that a group would be formed to understand why and come up with ideas of how to fix it.  While this group didn't come up with supply & demand concepts, they are sometimes still cited for things that they did come up with.  Some things that Smith also discovered and some things that he missed.  There is too much to put in this post, but they were a significant school of economic thought before Adam Smith(It is unclear to me how much Smith was affected by the french physiocrats). After the Physiocrats, finally came Adam Smith's treatise on the Wealth of Nations.

Here is one more worthy historical note.  My above analysis is extremely Anglo/European centric.  I've completely left out of my above are any non-western thinker.  There were several non-western thinkers that touched on economics that are worth exploring from the middle east, India, China, and probably others that I haven't found yet.  It's a shame our natural bias seems to leave out non-European thinkers from the official history.

As you can see he was most certainly not the first economics writer.  I'm not sure why he, historically, gets the credit for being the first.  Maybe because his book was the most complete and accurate tome written at the time.  A worthwhile accomplish no doubt, but not sure why he seems to get credit for "founding" economics.