July 14, 2016

There is no thrift paradox, or, How economists fell over their own feet

Comment on Richard Koo on ‘Paradox of thrift was the norm before industrial revolution’

Blog-Reference

Richard Koo’s paper about macroeconomic development* is descriptively accurate and historically rich in detail. It is far above the low level of familiar orthodox and heterodox economics. What is lacking, though, is a sound theoretical foundation. This cannot be otherwise because economics as a whole lacks sound foundations. More precisely, both current microfoundations and macrofoundations are false.

Koo puts it thus: “Macroeconomics is still a very young science compared to such disciplines as physics and chemistry. It started when Keynes began taking about the concept of aggregate demand in the 1930s, only 85 years ago. As a very young science, it has achieved only limited coverage of the broad range of economic phenomena and remains prone to fads and influences.”

Reality is actually far worse. Keynes based macroeconomics on logically and conceptually defective foundations and neither Post Keynesians nor New Keynesians nor Anti-Keynesians have realized Keynes’s foundational blunder in 80 years (2014).

Keynes defined the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

This two-liner is defective because Keynes never came to grips with profit: “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al., 2010, p. 12)

Let this sink in, Keynes had NO idea of the fundamental concepts of economics, viz. profit and income. Because profit is ill-defined the whole theoretical superstructure of macroeconomics is false, in particular ALL I=S/IS-LM models (2011; 2013).

Koo starts his analysis as follows: “One person’s expenditure is another person’s income. It is this unalterable linkage between the expenditures and incomes of millions of thinking households and businesses that makes the study of the economy both interesting and unique.”

Note that Koo’s first sentence is identical with Keynes’s. For every economist this proposition is pure common sense ― a mere accounting identity. As a matter of fact, it is provable false and this explodes the whole of macro. Economists do not grasp the elementary mathematics of accounting (2012) and this goes a long way to explain why economics has never risen above the proto-scientific level.

To get out of failed economic theory requires nothing less than a full-blown paradigm shift from accustomed microfoundations and Keynes’s flawed macrofoundations to entirely new macrofoundations.**

Ultimately, the paradox of thrift has its roots in the confusion about saving of the household sector, retained profit (falsely termed ‘saving’ of the business sector), profit and distributed profit. The correct profit equation reads: Qm = Yd+I-Sm (2014, p. 8, eq. (18)). Legend Qm: monetary profit, Yd: distributed profit, Sm: monetary saving, I: investment expenditure. The interaction of I and Sm underlies Koo’s description of economic expansion and balance sheet recession. What is entirely missing in Koo’s description is the interaction of Qm and Yd.

The profit equation gets a bit longer when import/export and government is included.

Roughly speaking, there are TWO self-reinforcing feedback loops:
(i) Household sector saving Sm up -- profit Qm down -- investment I down because of reduced self-financing out of retained profit -- profit Qm down -- and so on (with wages, prices, and employment down)
(ii) Household sector saving Sm down or dissaving up -- profit Qm up -- investment I up because of increased self-financing out of retained profit -- profit Qm up -- and so on (with wages, prices, and employment up)

The confusion is, again in rough terms, this: (a) saving of the ‘workers’ is bad because it drags down the economy, (b) ‘saving’ out of profit (= retained profit) is good because it is normally put to use for business expansion = investment. In this case, bankers/financiers/ lenders are not needed at all or less so. There are less restrictions to expansion from the monetary side.

What the Classicals had in mind when they lauded ‘saving’ and ‘frugality’ was in fact retained profit and reinvestment in contradistinction to profit distribution and spending on consumption. What Keynes had in mind was saving of the household sector. The cross-talk about saving and investment goes on until this day: “The truth is, most persons, not excepting professional economists, are satisfied with very hazy notions.” (Fisher, quoted in Mirowski, 1995, p. 86)

What economic history will some day find out is that the kick-off event of the Industrial Revolution has been a happy combination of DISSAVING of the household sector and credit creation of the emerging banking sector on an ever increasing scale and self-financing out of profits which freed business from lenders and the economy as a whole from the clampdown of a fixed quantity of money. Credit creation that translates directly into an increase of the wage bill (with wage increase = productivity increase) helps to enable a perfectly inflation-free growth. Money out of nothing is a GOOD thing IF DONE PROPERLY.

Bottom line: saving Sm and investment I develop INDEPENDENTLY. There is NO such thing as an interest mechanism which equalizes I and S. It is neither true that saving ‘causes’ investment as the Classicals claimed nor that investment determines saving via the multiplier as Keynes claimed. The perpetual difference between investment I and saving Sm is the main determinant of profit Qm. BOTH, the Classicals and Keynes got the profit theory wrong. Nothing worse can happen to an economist.***

Koo’s approach is a clear improvement with regard to the credit mechanism but shares the fundamental conceptual error which is embodied in this simple proposition: Income = value of output.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2011). Squaring the Investment Cycle. SSRN Working Paper Series, 1911796: 1–25. URL
Kakarot-Handtke, E. (2012). The Common Error of Common Sense: An Essential Rectification of the Accounting Approach. SSRN Working Paper Series, 2124415: 1–23. URL
Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. London, Basingstoke: Macmillan.
Mirowski, P. (1995). More Heat than Light. Cambridge: Cambridge University Press.
Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL

* real-world economics review issue #75
** For more details see ‘The other half plus the hitherto missing true foundations of macroeconomics
*** See also ‘I=S: Mark of the Incompetent’.