June 7, 2015

The guessing game

Comment on David Glasner on ‘Repeat after Me: Inflation’s the Cure not the Disease’


Always when economists have been reminded that the actual economy does not work as economic theory says the Pavlovian answer since the classics has been: yes, it perhaps looks like a clear-cut refutation, but, just wait, in the long run, we will be vindicated. It is important to note that this is, to begin with, not a testable proposition because the long run is never properly specified.

This old short-run-long-run shell game has shifted entirely to the thin-air-discussion of the interdependency of expectations between agents and the central bank. What is the outcome of the guessing game? Remember the Morgenstern-Paradox and the train chase between Victoria Station and Dover where Holmes and Moriarty try to outguess each other?

What always makes a good story makes bad science.

“In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum, 1991, p. 30)

Economists have no true theory, in other words, they are clueless about how the actual economic system works (2014). It is therefore quite natural that they resort to a discussion about what could possibly happen in the never-ever-nowhere-land of the long run.

It should be common knowledge by now that all variants of Keynes-Wicksell-Hicks-Krugman models which underlay the discussion are methodologically defective.#1

Which brings us to the point at issue: could inflation be the cure against economic stagnation?

To make the argument short, the true employment theory (2015), which is absolutely free of behavioral guesses, is summarized in the simplified formula on Wikimedia AXEC62
The formula contains Keynes' employment theory as a special case, that is, if investment expenditures I or the expenditure ratio ρE increases then employment L increases. The generalization vis-à-vis Keynes consists of the factor cost ratio ρF. This configuration of wage rate, price, and productivity encapsulates the working of the price mechanism.

The implicit promise of conventional economics is that the price mechanism works smoothly such that the configuration of wage rate/price/productivity ultimately produces full employment — in the long run. This is wishful thinking.

The correct employment formula says:
• An increase in the wage rate W taken in isolation, i.e. ρF up, leads to higher employment. This is contrary to received economic wisdom (which rests on the Fallacy of Composition).
• A price increase, taken in isolation, i.e. ρF down, is conducive to lower employment.

Price inflation and wage inflation have opposite effects on employment. The net effect depends on the relative rates of change in the simple formula. The absolute rates are of no consequence if they are equal (with productivity constant, of course). Hyperinflation at full employment is therefore possible as a limiting case.

The formula is perfectly compatible with the observation of rising prices and increasing employment.

In sum: The net employment effect of inflation is positive if the rate of change of the wage rate W exceeds that of the price P; in the opposite case one gets stagnation, rising unemployment, or stagflation. Note that the simple employment formula is testable in principle.

What the agents subjectively think or expect about the relationship of the quantity of money, inflation, and employment is immaterial. The simple employment formula represents the objective structural properties of the economic system. When subjectivity and objectivity are at odds it is always subjectivity that has to give way.

Egmont Kakarot-Handtke

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). Essentials of Constructive Heterodoxy: Employment. SSRN Working Paper Series, 2576867: 1–11. URL
Stigum, B. P. (1991). Toward a Formal Science of Economics: The Axiomatic Method in Economics and Econometrics. Cambridge: MIT Press.

#1 See also on the Uneasy Money blog