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Keynes, Macroeconomics, and Traffic

Orlando Roncesvalles (oroncesval4@gmail.com)

Back in 1936, a smart aleck named Keynes (John Maynard, or just Maynard) cooked up something he called The General Theory of Employment, Interest, and Money. He thought of unemployment as something to be solved, possibly in the same way that Albert (surname Einstein) thought “relativity” was the mystery to get fixated on. The parallels stop pretty much there despite the historical fact that failed mathematicians sought to infuse physics into economics, a project that took a long time to be discredited (not until 2008 anyway, when the Great Financial Crisis finally put paid to the misconception that physics and economics can mix, the latter having the muddle-like consistency of dirty motor oil and the former the empirical clarity of replicable experiments).

The genius of Keynes was in his insistence that the short run mattered more than the long run (when we would of course all have died). In that short run, slack in an economy (or unemployment) could be dealt with by public works. This idea was nothing new — even the Roman emperors knew that public spectacles kept people employed (even entertained). Keynes came up with the idea that in the short run, aggregate supply (or output, later standardized into GDP or gross domestic product) would have to adjust to what he called aggregate demand, whose components included consumption, investment, and government expenditure. Textbooks would later call this equality between aggregate demand and supply as “goods equilibrium.”

But Keynes then married the idea of goods equilibrium with something we might today call “asset equilibrium”— a situation wherein people are content to hold the quantity or amount of money in their pockets.

Asset equilibrium meant that peoples’ “liquidity preference” was satisfied through the movements of the interest rate as the price of credit and the opportunity cost of holding money. Money demand was driven by GDP and the interest rate, while money supply was a policy variable in the hands of the central bank. The equality of money demand with supply would be at the market-determined interest rate. Recognizing such an equilibrium was a way of bringing in the workings of the money and banking system into a fuller explanation of the gyrations of the business cycle. After all, the money markets determined interest rates, and these rates in turn drove business investment, which of course is a component of aggregate demand in the goods market.

The essence of Keynesian thinking was and remains the workhorse of macroeconomics (that specialty within economics that concerns itself with the short run determination of GDP and interest rates).

After Maynard, everyone then had a field day. The business-cycle savants focused on the confidence-based elements of aggregate demand (consumption and investment); the politicians latched on because government spending was their domain and Keynesian economics provided cover for influence and corruption; and the bankers were very much in on the act of determining interest rates. Macroeconomics caught on as the thing to know before one can say anything about the national or global economy.

It turns out that the apparatus of macroeconomics can be tweaked to help us understand the relationship between GDP and traffic.

Recently, a noted legislator reiterated the idea that prosperity (a growing GDP) was behind our traffic woes. I interpret what the legislator said to mean that without the heaven of a business boom, we wouldn’t have the hell of traffic. We should sit back and no more challenge him and his ilk to take public transportation because of course he already knew the answer: We are prosperous, so that we should just grin and bear it!

A critical but opposite view has nonetheless come forward. It is the idea that traffic is a brake on prosperity. The more severe the traffic, the less the GDP.

So, which is it? Is it a positive correlation between GDP and traffic? Or a negative one?

Keynes would likely scoff at the seeming contradiction. The negative correlation is the working of goods equilibrium if we realize that the severity of traffic negatively impacts aggregate demand. Bad traffic keeps consumers from traveling to malls, and smart businesses would likewise invest less if traffic drags down sales projections. Bad traffic kills GDP.

The positive correlation is something else. As GDP grows, the more we want to acquire transportation assets, such as cars and motorcycles. But in the short run, there is only so much roadway for all, and traffic problems arise.

The two disparate relationships – goods equilibrium and “traffic equilibrium” – are synthesized in the macroeconomics apparatus. Smart students will see that the thought experiment is the same as that of the infamous IS-LM apparatus of macroeconomics, where IS represents goods equilibrium and LM represents assets equilibrium; we now simply replace assets equilibrium with traffic equilibrium. Traffic equilibrium, by itself, reflects the positive influence of GDP on the severity of traffic problems, though it also suggests that the less the traffic, the more that people will demand transportation assets (this is the analog to the idea that the lower the interest rate, the more we would prefer liquidity or hold money).

What does all this mean? Can we now have a “clean” sorting out of the two disparate influences – the one of GDP on traffic and the other of traffic on GDP?

The answer is this. As an economy grows so of course does GDP. If the traffic infrastructure is left “as is,” traffic problems worsen, and governmental neglect is the culprit. This is because the traffic infrastructure (like monetary policy) is in the hands of the economic authorities. The infrastructure is in fact a public good. Still, the hapless citizens aren’t exactly helpless. They can move closer to where they work or work closer to where they live. They can drive less and consume less, and coincidentally lessen their carbon footprint. As a modern Marie Antoinette might say, let the travelers have their air-conditioned “me time.” Except that the peasants don’t eat cake or have their James (the proper name for chauffeurs of Rolls or Benz automobiles). Apparently there is no free lunch, and traffic is here to stay. Embrace it.

But if we were to solve the supply side of the transport asset equation, we reduce the severity of traffic, and the GDP boom continues or strengthens.

How to improve the traffic infrastructure is then the key. It is the magic but elusive password. Our legislators are perhaps simply not up to the challenge. Boot them, but don’t use the Denver boot. It won’t work because they’re too self-important. They’ve so far set things up so that they don’t suffer the inconvenience of public transport. Instead, they tell the ordinary citizen that it’s his fault because he enjoys a prosperous economy. Nuts.

Bitcoin and bubble gum

Taleb is right, and Bitcoin is no bubble.

Maybe it’s gum.

A “bubble” becomes a bubble when you run out of nonbankrupt people calling it a bubble. ~ Nassim Taleb

The hard part is deciding when the bubble will pop.

So, when a rich guy tells you something is fundamentally great, he’s enticing you to do the bubble; but it’s not, until he shuts up. Think Buffett and Coke.

If the same guy tells you it’s a bubble, it isn’t, because he wants to slow you down so he can get in. When he shuts up, then it’s bubble time. This goes for seemingly staid banker types.

The rich guy then shuts up when he’s selling and laughing.

Sum-up: A bubble has two elements – a rising price, and an inevitable but unpredictable crash. It doesn’t mean that the smart money can’t get rich at others’ expense.

Disclaimer: I call Bitcoin a bubble. But then my opinion doesn’t count. After all, I’m just an economist, and Nassim Taleb says economists don’t know anything. He’s right.

Economics in disarray

Economics has problems. Because of Samuelson, it got a half-century case of physics envy. Then people read Schumpeter and McCloskey, and realized economics can’t predict a whit. Economics became useful (ex post) stories, a bit like archaeology or geology.

Then came The End of History (1989) and The Great Recession (2008), and weirdos still talk of evolving economics, but into what they can’t explain. Like Marx redux, they blame ‘capitalism’ or neoliberals, though they can’t go whole hog back to old-style apparatchik economics. Some think that the missing link is a co-equal infant science called psychology.

What to do? At one point, one way out was to study ‘institutions.’ But this seemed like hard work — too much scholarly pain for little gain. But gains there were if you read Coase or Ostrom, or (if you want Keynes to shudder) Hayek.

Perhaps that’s just the way it is. Economists are more like chickens with no heads but imaginarily pecking away at crumbs of intellectual progress. Some toil away at saving the world from falling over a cliff, much like Salinger’s Catcher in the Rye. That’s at least humanitarian if mostly unheralded.

Keynes did say that economists should be more like dentists. Dentists are good guys who help people prevent cavities and enable them to smile. The economist can then go home after a day’s work knowing the economy will still do its wayward thing but not die.

What next, after 2008? A book review

Mervyn King (The End of Alchemy, W. W. Norton, 2016) has a message. We are not safe. The economics profession has failed us. So have the economic policy makers of the US, Germany, China, and Europe. The banks still play a game that King calls ‘alchemy.’ Central banks won’t or can’t escape the infamous Keynesian liquidity trap. And we are prisoners facing dilemmas, macroeconomic policy is a paradox, sovereign debts are unbearable, and the world is full of ‘radical’ uncertainty.

In short, what we have today is pretty much a lull before the end of the world; 2008 was just the preview trailer. Alternatively, the world may not end but it will take a long while for robust economic growth to re-emerge, and there is very little that can be done about the matter. Either way, it’s a sobering conclusion.

Is the book worth reading? Yes, if only to get a handle on how central banks thought as they dealt with 2008 and its immediate aftermath. In addition, the curious but uninitiated reader gets introduced to the concepts of Prisoners’ Dilemma, the Keynesian Liquidity trap, liquidity transformation by banks, and the difference between risk and uncertainty.

King’s book also contains a longish but bureaucratic take on why 2008 happened. King gets to it on pp. 26-39 and pp. 317-328. Going by his view, as well as that of others in the fields of central banking and macroeconomics, the ‘conventional wisdom’ on 2008 might be summarized as follows.

It began with the fall of the Wall in 1989, also known as The End of History, that ushered in the Great Stability, an era of low inflation and robust economic growth all around. The main central banks finally imbibed the religion of the Quantity Theory in the 1990s and early 2000s, making themselves accountable to the public through pledges to abide by (low) inflation targets. King calls this period The Great Stability. (Never mind the hiccups of the 1997 Asian crisis or the bubble-crash of dotcoms in 1997-2001.)

Beneath the gloss of prosperity were gathering problems. Banks were raising their leverage in the hunt for profit. Prices in stock and real estate markets outpaced inflation of everyday goods, and central banks felt that paper wealth was not a worrisome thing (after all, one cannot eat stocks or houses), and the US Fed actually thought it would boost consumer spending. Some countries pushed their luck with foreign borrowings, notably Greece, Italy, Ireland, Portugal, and Argentina.

The failure of Lehman Brothers in September 2008 is considered the trigger of the crisis. It was, with hindsight, the outcome of the unexpected fall of real estate prices in the summer of 2007 and associated mortgage defaults in the US. The failure exposed the extreme leverage in the US financial system, and with banks unwilling to recognize their paper losses in the derivatives market for sub-prime mortgages, a run for liquidity, called The Great Panic, ensued. The panic was arrested only by official rescues. Consequently, in 2008-2009, the financial crisis affected real economies, with world trade falling and global GDP decelerating into The Great Recession.

King, as do other observers such as Edwin Truman, believes that underlying macroeconomic imbalances were also to blame. The extreme example often cited was the ‘savings glut’ in China that fueled ‘overconsumption’ in the US. Supposedly, the excess saving in China was intermediated by the banking systems of both countries. The theory is that without such imbalances, there would have been no resources that could fuel the asset price inflation in the US and in other countries.

So far so good. King then ends up suggesting that the re-capitalization of major banks since 2008 is a good thing but probably not enough.

As to the book’s shortcomings, they are:

King seemingly ignores the work of Charles Kindleberger (Manias, Panics, and Crashes, 2005) where Kindleberger had formulated an economic model of financial crises, based on the work of Hyman Minsky. King does mention Minsky but in a somewhat negative light.

King nonetheless cites (on p. 34), with some tongue in cheek, two ‘laws’ on financial crises, which he attributes to Dornbusch. One is that ‘an unsustainable position can continue for far longer than you would believe possible.’ The other is: ‘When an unsustainable position ends it happens faster than you could imagine.’ It is of course almost vintage Minsky.

And yet, to date, the economics profession’s best ever model of financial crises still seems to be the Kindleberger-Minsky model. That model cannot be used to make precise predictions, but it does give the best explanation, ex post, of how a financial crisis plays out. The major central banks had been using, in 2008, something called DSGE (‘dynamic stochastic general equilibrium’) macro models. These models were not at all designed to incorporate Keynes’ deus ex machina of ‘animal spirits,’ except as ‘shocks’ external to the structure of DSGE models, which meant that the central banks had essentially no inkling of the crisis before it hit. The IMF insiders called it ‘group think.’

If we could ask Kindleberger or Minsky today on their views on 2008, most likely they would say that it fits their model that sees a financial crisis in three parts — mania, panic, crash. The story is not much different from King’s, except that Minsky would give greater emphasis on the trigger of 2008 as one rooted in overconfidence, what Greenspan had called ‘irrational exuberance.’ That there had to be other villains is a given. In 2008, they included the toxification of bank balance sheets (with inexplicable financial derivatives) that was an outcome of a ‘deregulation’ tilt that allowed subprime debts to be brazenly sold by lenders as ‘almost prime.’ Since King doesn’t like the fractional reserve nature of modern banking, he gives more emphasis to the alchemy-like leveraging that modern banks practice. In effect, King would not disagree with Minsky that it was a kind of Ponzi game that allowed banks to trap themselves into a corner that would eventually ‘blow up.’

This comparison of models means that King’s main proposal — his view that central banks should act like a ‘pawnbroker for all seasons’ — to narrow monetary base creation to ‘safe’ banks, while widening the securitization of other lending by bank-like institutions, is just another way of allowing excessive exuberance to be seen as a can to be kicked down the (future) road of ‘fundamental uncertainty.’ In short, since King has set up the medium and long term as a problem of fundamental uncertainty, there isn’t much that central banks or governments can do to tame business cycles. That is not different from Minsky and his ‘moments.’ There is an inexorable underlying tension between free capital markets and macroeconomic management by governments and central banks, something Robert Shiller and others had more or less also observed (see Shiller and Akerlof’s Animal Spirits, 2009).

King does not quite succeed in explaining the arcana of modern economics in the areas of: (a) how Keynes was co-opted into the ‘neoclassical synthesis’ (King merely says that Keynes was at odds with ‘neoclassical economics,’ a basic lesson from an introductory economics class); (b) the ‘paradox of policy,’ where he asserts that the short-run need to overcome the liquidity trap is inconsistent with the need in the long run to let the private sector decide how to correct ‘structural imbalances’ in the economy; and (c) how ‘fixed’ exchange rates and differences in saving rates across countries lead to ‘imbalances’ that in the long run need to be addressed.

It appears that it is up to others to try to make better sense of what King wants to recommend as a way out of the economic doldrums post-2008. Perhaps this explains why the book blurbs on the outside back cover hint of mystery amid faint praise from the usual suspects.

Will Bitcoin crash and resurrect?

NOT BITCOIN but better.

One use of Bitcoin is for anonymous transactions, i.e., as a substitute for ordinary cash or bank notes.

The problem is that the currently available bitcoins fluctuate in value. The ideal is a bitcoin that is stable for at least a certain determinate or even indefinite time against a major currency, such as the US dollar. In short, we want or need an alternative bitcoin that is like a dollar banknote. We imagine this alternative works better than keeping banknotes under the mattress or in a safe deposit box, because it avoids thievery and the transaction costs of going to the safe deposit box.

It can be done. The easiest is for the US Fed to do it. It would allow anyone to buy something we might call the official bitcoin dollar in exchange for a guarantee that bitcoin dollars are exchangeable into US banknotes. If this works, it will be because it would reduce the costs now paid by the central bank for printing currency and going after counterfeits. In this scenario, the blockchain ensures that counterfeit official bitcoins cannot exist.

Another way is for a major private bank to ‘create’ its bitcoin dollar. Imagine that Chase does it, and calls it the Chase bitcoin dollar. All it is is a special debit card account where Chase guarantees to make the Chase bitcoin dollar exchangeable for cash. The guarantee is in effect a promise that Chase will honor Chase bitcoin dollar liabilities ahead of its any other liabilities. To ensure such a guarantee, Chase would enter into a ‘currency board’ arrangement with the US Fed by maintaining Fed fund balances in a separate special account solely for the purpose of redeeming Chase bitcoin dollars. In short, the fractional nature of the private banking system will not apply to bitcoin dollars.

The blockchain also allows Chase to ensure that no other entity can create Chase bitcoin dollars. The ‘supply’ of Chase bitcoin dollars will always be the same as the demand for such dollars.

Any other private bank would be allowed to participate in a ‘branded’ bitcoin currency. I can imagine HSBC issuing special debit cards for HSBC bitcoin dollars, HSBC bitcoin euros, or HSBC bitcoin yen. They may be allowed to compete through enhancements on convenience of use, allowing for fee-free global transfers, or even the payment of interest.

One important enhancement would be US consumer protections against fraud now being given to users of credit cards. Any merchant declining to honor a bitcoin debit card would be presumed to be up to no good.

The similarity with bank notes will have to be carried to an extreme that meets certain anonymity and privacy standards. The issuer of a bitcoin dollar will have to honor the bearer of the account provided that said bearer satisfies identity requirements.

At the same time, the use of such accounts will have to be protected by bank secrecy rules, but subject to money-laundering limits. For example, bitcoin dollar transactions in a particular account cannot exceed $10,000 per day, and a bank cannot allow a depositor more than one bitcoin dollar account. A maximum-balance limit of, say, $100,000 per account, could be imposed, in parallel with limits now applied under existing deposit insurance schemes.
Central banks could also impose limits on how many bitcoin dollar accounts an individual can have. To protect banks from money-laundering, bitcoin dollar accounts would not be available to corporations.

Will the advent of such official or private bitcoin dollars kill the existing bitcoins? It could, especially if bitcoins continue to be more attractive as speculation vehicles than as means of payment.

But bitcoin exchanges could create ‘hybrid’ bitcoins whose ‘mining’ or supply-side arrangements are fully transparent, and whose value could be stabilized in some fashion desired by the bitcoin holder. In short, there could be different bitcoins for different purposes. Caveat emptor and ‘know your customer’ rules would still be needed. However, such bitcoins would remain without guarantees similar to deposit insurance, and they may still be vehicles for speculation.

My best guess: Bitcoins will evolve, i.e., the fittest will survive. The Dutch tulip variety will become extinct. As of now, they’re pretty much as primitive as Dutch tulips.

EC 11. Special HW on the stock market

Imagine that your grandparent willed you P1 million. You have decided to invest this inheritance in the Philippine stock market, specifically in only one company.

Your homework assignment is to choose that one company, and report at how much you acquired the stock (any price at which it traded in the PSE will do) in an email, and to give a short explanation for your choice.

A second part of this assignment is to report at the end of the semester how your investment did, and to give a brief explanation of how or why the outcome came about. Try to answer the following questions, based on your readings and your experience in this imaginary experiment: Are stock market investors who win just lucky? To what extent do diligence and smarts matter?

The first part is due by Friday, February 5, 2016. The second part is due on March 20.