March 13, 2016

It’s the price mechanism, stupid!

Comment on Bradford DeLong on ‘Ordoliberalismus and Ordovolkismus’

Blog-Reference and Blog-Reference on Mar 14

You present three propositions about output, deficit spending, and the Keynesian multiplier and then sum up: “That is the simple arithmetic of expansionary fiscal policy in a liquidity trap.”

The fact of the matter is that the multiplier arithmetic is flawed since Keynes. Therefore, the rest of your argument falls flat.

To cut the meticulous formal derivation short (2015; 2014; 2012), the most elementary version of the correct employment equation for the economy as whole is given here.

From this equation follows:
(i) An increase of the expenditure ratio rhoE leads to higher employment L (the letter rho stands for ratio). An expenditure ratio rhoE>1 indicates credit expansion, a ratio rhoE<1 indicates credit contraction/debt repayment of the household sector.
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment.

The complete employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and import/export. From employment L one comes to output O by multiplying both sides with productivity R. The employment/output equation contains only measurable variables and is testable.

Item (i) and (ii) is familiar since Keynes. What is missing in the Keynesian employment multiplier, though, is the ratio rhoF as defined in (iii). This variable embodies the price mechanism. It works such that overall employment increases if the average wage rate W increases relative to average price P and productivity R.

The employment equation says that an increase of investment expenditure or deficit spending, i.e. rhoE>1, increases employment. The multiplier, though, is different from Keynes’s flawed multiplier. The crucial difference consists in rhoF.

The correct employment equation reproduces the familiar Keynesian mechanisms. What is more important: it shows that the price mechanism, i.e. the relationship of wage rate, price, and productivity rhoF, can be used to increase employment/output. Thus, there is, to begin with, no need of increasing private/public debt or of pushing investment. The crucial point is that the price mechanism does not work as standard economics claims, in other words, standard price theory is provable false.

Hence, the real problem is not at all that 'Ordoliberalismus and Ordovolkismus' do not understand the logic of deficit spending but that both Keynesians and Walrasians have no idea of how the price mechanism in the monetary economy works.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL