December 1, 2015

The Fisher Effect — a specimen of scientific incompetence

Comment on ‘Once Upon a Time When Keynes Endorsed the Fisher Effect’

Blog-Reference

The Fisher Effect is ultimately the result of a design flaw of the monetary order/ institutions. As a rule, the monetary order is not consciously designed but the outcome of piecemeal institutional change in historical time. As we know from biological evolution, this leads regularly to suboptimal outcomes with regard to structure/functionality, which, however, become only visible in hindsight. The cecum is a case in point, but biology is full of weird and suboptimal constructions.

The Fisher Effect should not occur in a well-designed monetary order because it violates the principle of the neutrality of money. To see this clearly one has to change the methodological perspective.

Our analytical framework is given as elementary consumption economy.* The business sector consists of two firms, one produces the consumption good, the other produces money and credit and is called the central bank. The central bank stands here for the whole banking industry (for details see 2015, Sec. 7).

For simplicity, only the limiting case of a zero profit economy is considered. Then, in the consumption good producing firm this condition holds in the most elementary case

(1) Pc X=W Lc

Price Pc times quantity sold X equals wage rate W times labor input Lc. This reduces for the case of market clearing to

(2) Pc=W/Rc

The market clearing price is equal to unit wage costs W/Rc with Rc standing for the productivity in consumption good production.

For the central bank holds

(3) Jo OVD=Jd DEP+W Lb

that is, rate of interest Jo on the asset side (here current overdrafts) times overdrafts OVD equals rate of interest Jd on the liability side (here current deposits) times deposits DEP plus wage rate W times labor input in the banking industry Lb. Strictly speaking, OVD and DEP are the average stocks per period.

Both sides of the central bank's balance sheet are equal, that is current overdrafts OVD equals current deposits DEP. Current deposits are here identical with the quantity of money. For simplicity, the rate of interest on the liability side Jd is set to zero. This reduces (3) to

(4) Jo OVD=W Lb

All real variables (labor input, productivity, output etc) remain unchanged for the time being. The real side is frozen.

In the next period, the wage rate W in (1) and (4), which is here identical for simplicity, is doubled. As a consequence Pc in (2) doubles under the conditions of market clearing, zero profit, and no real changes.

When W doubles in (4) on the right hand side then either Jo or OVD must double on the left hand side. The correct solution is that the interest rate Jo remains constant and the asset side = current overdrafts = OVD is doubled. Because both sides of the central bank’s balance sheet are always equal the liability side = current deposits = DEP = quantity of money has also to be doubled.

In real terms, the situation remains unchanged for all agents. And this is as it should be according to the neutrality principle. In the historically given monetary order, however, neither the asset nor the the liability side of the consolidated balance sheet of the banking industry is properly adapted. Only for this reason the rate of interest, here Jo in (4), changes.

Therefore, in a well-designed monetary order the interest rate Jo is like a real variable that remains absolutely constant no matter what the rate of inflation or deflation is. It is, so to speak, the pole star of the economic firmament. The Fisher Effect is only an artifact, a historical accident, a freak phenomenon. In their analysis neither Fisher nor Keynes did ever rise above parochial realism.

This scientific incompetence is — not a matter of ‘once upon a time’ — but the defining characteristic of the representative economist.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL

* See graphic


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ICYMI (comment on Frank Restly of Dec 1 on Dec 2)

The zero profit economy is defined by the absence of profit and loss. And this is, as I clearly stated, a ‘limiting case’ to start with. The general case is discussed in my papers. Please help yourself on SSRN.

I have excluded profit/loss in my post about the Fisher Effect in order to avoid a discussion about profit theory which is defective since Adam Smith. See the post ‘Profit and the collective failure of economists’.

I am well aware that a risk free economy is different from a zero profit economy and that a central bank cannot set both price and quantity. But that is not the issue here. The issue is that the Fisher Effect is ultimately caused by a constructional flaw of the monetary order.

For the other defects see ‘Major Defects of the Market Economy


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ICYMI (comment on Frank Restly of Dec 2 on Dec3)

The representative economist does not understand basic methodological principles. “There can be no doubt whatsoever that a problem which has not yet been solved in all its aspects under its simplest conditions will be still more difficult to tackle if other, ‘more realistic’ assumptions are being made.” (Morgenstern, 1941, p. 373)

The zero profit condition is the simplest condition, therefore it is the correct starting point.

It is the very characteristic of the representative economist that he cannot rigorously focus on one line of argument and that he has the attention span of a goldfish.* In my posts you will not find the statement that ‘workers live forever, equipment does not wear out, and accidents and natural disasters do not happen.’

Could it be that you can neither read nor think but only waffle?

By the way, that science is the art of abstraction from irrelevant detail is known since J. S. Mill “Since, therefore, it is vain to hope that truth can be arrived at, either in Political Economy or in any other department of the social science, while we look at the facts in the concrete, clothed in all the complexity with which nature has surrounded them, and endeavour to elicit a general law by a process of induction from a comparison of details; there remains no other method than the à priori one, or that of ‘abstract speculation’.” (1874, V.55)

References
Mill, J. S. (1874). Essays on Some Unsettled Questions of Political Economy. On the Definition of Political Economy; and on the Method of Investigation Proper To It. Library of Economics and Liberty. URL
Morgenstern, O. (1941). Professor Hicks on Value and Capital. Journal of Political Economy, 49(3): 361–393. URL

* See ‘One entirely sufficient reason for the shutdown of economics


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ICYMI (comment on David Glasner of Dec 2 on Dec 4)

It seems, that not only Frank Restly can neither read nor think.

In eq. (3) of my post of Dec 1 the rate of interest Jd on the central bank's liability side explicitly appears and is subsequently set to zero in order to focus the argument. The rate of interest on financial assets is discussed in my papers on multiple occasions (please help yourself on SSRN).

It should be known by now that it is rather silly to argue that a lot of phenomena are missing in an extremely simplified example and thereby to distract from the point at issue.

Note that the introduction of the rate Jd does not change the essential point of my argument. Every serious student can verify this by following the References.

The urgently required New Thinking in economics does not consist in the exegesis of obsolete authors (‘some defunct economist’ in Keynes’s apt terminology) and in playing old academic games. As Peirce nicely put it on a similar occasion: “[The pragmatist] is none of those overcultivated Oxford dons — I hope their day is over — whom any discovery that brought quietus to a vexed question would inevitably vex because it would end the fun of arguing around it and about it and over it.” (1931, 5.520)

References
Peirce, C. S. (1931). Collected Papers of Charles Sanders Peirce, volume I. Cambridge, MA: Harvard University Press. URL


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ICYMI (comment on Frank Restly of Dec 3 on Dec 4)

You ask: “Then what exactly do you mean by a zero loss economy?”

I mean exactly that profit/loss is set to zero and thereby taken out of the picture for the time being in order to streamline the argument. This means that I deal with profit/loss on another occasion* and by no stretch of a feeble imagination that it escaped my notice that profit/loss occur in the real world.

What I have shown, indeed, is that the profit theory is false since Adam Smith. If you intend to educate yourself have a look at my website.**

Did you ever realize that the original Walrasian model (ni bénéfice ni perte) and the original Keynesian model are zero profit economies? [ni bénéfice ni perte = no profit no loss]

In the general case, overall profit of the business sector as a whole is positive according to the Profit Law Qm=Yd+I-Sm and in this case all your objections go up in smoke. The essential point of my post of Dec 1, though, remains unaffected.

* See for a start ‘Profit and the collective failure of economists
** ‘Profit is the key


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ICYMI (comment on David Glasner of Dec 5 on Dec 7)

Let us agree that the Fisher effect is about (i) the difference between nominal and real interest rates and (ii) that there are many real interest rates because there are many types of real assets.

Here is the Wikipedia definition of the Fisher effect: “...the Fisher effect is the proposition by Irving Fisher that the real interest rate is independent of monetary measures, specifically the nominal interest rate and the expected inflation rate. The term "nominal interest rate" refers to the actual interest rate giving the amount by which a number of dollars or other unit of currency owed by a borrower to a lender grows over time; the term "real interest rate" refers to the amount by which the purchasing power of those dollars grows over time — that is, the real interest rate is the nominal interest rate adjusted for the effect of inflation on the purchasing power of the loan proceeds.

The relation between the nominal and real rates is given by the Fisher equation, which states ... that the real interest rate equals the nominal interest rate minus the expected inflation rate.”

In my example the lender rate, the borrower rate and the price of the consumption good appears. What I have shown is that in a well-designed monetary order the rate of interest is constant, no matter what the rate of inflation/deflation is. This means that the concept of expected inflation falls flat and with it the distinction between nominal and real interest rate. Therefore, the Fisher equation as a whole falls flat.

Your answer of Dec 3 is that my example is irrelevant because the expected future price has no effect. False. My example is relevant because it shows that the Fisher equation describes a freak phenomenon that appears because of a flaw in the monetary order.

Now, if there is something fundamentally wrong with the Fisher equation there is no need to go further and to look deeper into the concept of own rates of various real assets.

What seems to be pretty obvious is that neither Fisher nor Keynes got the fundamental economic relationship right. This refers to interest rate/inflation, interest/profit, and profit/income. So there is no need for a lengthy elaboration of the finer points of their confusion.

I agree, let things stay where they stay at the moment. It is certainly much more rewarding to go beyond refuted concepts and authors.

Egmont Kakarot-Handtke