February 7, 2015

Who rides the debt tiger cannot dismount

Comment on Lars Syll on 'The Hayekization of modern society'


Wolfgang Streeck gives a summary of the development of private/public debt, tax revenues/public spending, and employment in the major economies over the last 50+ years and then turns to the actual transition from expansion to the consolidation of public debt. This is the empirical part and it deserves the highest praise.

The part of interpretation consists of second-guessing the agents' motives, aims, constraints, and means of coercion, that is, of psychology and sociology. We learn what we knew already, viz. that the relationship between borrower and lender is asymmetric in good times and turns nasty when the economy underperforms. The game can only go on for another round as long as creditworthiness is maintained. All this is pretty obvious.

However, the psychological/sociological/political account, which is plausible, masks the lack of an underlying economic theory. We know from Adam Smith that it is one thing the individual agents think and want and do; and quite another thing how the economy behaves.

The bridge from the small picture to the big picture is established by theoretical economics. And, to make a long analysis (2014b; 2012b; 2012a; 2014a) short, the correct theoretical approach yields this testable formula (Wikimedia AXEC36)
It says roughly: unemployment goes down when the economy grows (=I=investment up), when the (average) expenditure ratio ρE increases, and when the (average) factor cost ratio ρF increases, and up in the opposite case. The definitions of the ratios are given here.

An expenditure ratio ρE>1 says that private/public debt increases. That means that the transition from credit expansion to consolidation, i.e. to ρE=1, increases unemployment (if the rest of the variables is kept constant). Worse, if overall credit is redeemed, i.e. ρE<1, the economy breaks down. As the Chinese proverb says 'Who rides a tiger cannot dismount.'

What can be done to counter, or at least postpone, this outcome? The formula says that the (average) factor cost ratio ρF should increase. The ratio is defined as W/PR. That is, under the condition of price stability the (average) wage rate W should rise faster than productivity R. Since the factor cost ratio is formally connected to the profit ratio this means in other words, that the (average) profit ratio (not absolute profit for the economy as a whole) should be lowered.

Note well, that wage-cutting — the classical economists' cure-all recipe — worsens the situation (all other variables in the formula are kept constant). That throughout history economists have been a hazard to their fellow citizens is publicly known at least since Napoleon: “Late in life, moreover, he [Napoleon] claimed that he had always believed that if an empire were made of granite the ideas of economists if listened to, would suffice to reduce it to dust.” (Viner, 1963, p. 1)

In theoretical economics, a Paradigm Shift is overdue.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2012a). General Formal Foundations of the Virtuous Deficit-Profit Symmetry and the Vicious Debt Deflation. SSRN Working Paper Series, 2115185: 1–30. URL
Kakarot-Handtke, E. (2012b). Keynes’s Employment Function and the Gratuitous Phillips Curve Disaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2014a). Mathematical Proof of the Breakdown of Capitalism. SSRN Working Paper Series, 2375578: 1–21. URL
Kakarot-Handtke, E. (2014b). The Three Fatal Mistakes of Yesterday's Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Viner, J. (1963). The Economist in History. American Economic Review, 53(2): 1–22. URL