July 30, 2015

How to save the economy from storytelling economists

Comment on Simon Wren-Lewis on ‘The F story about the Great Inflation’


There are political economics and theoretical economics. In political economics, it suffices to tell a good story, in theoretical economics scientific standards are observed. Because economists since Adam Smith pursued these two hares with varying intensity consistency eventually got out of sight. More precisely, economists failed to develop a theory about how the market economy works that satisfies the criteria of material and formal consistency.

The Phillips Curve debate is a case in point. Originally, Phillips presented an astounding empirical relation between the rate of unemployment and the rate of change in the wage rate. After a little conceptual shell gaming, it was about unemployment and inflation. And after some additional wish-wash about expectations, the ending of the story was that there is no way to escape natural unemployment.

This conclusion lacks a sound theoretical foundation. To make a long argument short, the most elementary version of the correct Employment Law is given on Wikimedia AXEC62a:

From this equation follows inter alia:
(i) An increase in the expenditure ratio ρE leads to higher employment. An expenditure ratio ρE>1 indicates credit expansion, a ratio ρE<1 indicates credit contraction/debt repayment.
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment. This implies that a higher average wage rate W leads to higher employment. This explains the original Phillips Curve but is contrary to conventional wisdom. It is, though, easy to prove that conventional wisdom is a mere Fallacy of Composition (2015).
(iv) A price increase lowers the factor cost ratio and is conducive to lower employment. This explains stagflation.
(v) The complete Employment Law is a bit longer and contains in addition profit distribution, public deficit spending, and the trade balance with the rest of the world. All variables are measurable, the structural Employment Law is testable.

Point (i) and (ii) are old Keynesian stuff. Let us focus here alone on the factor cost ratio as defined in (iii). This variable formally represents the price mechanism which, however, does not work as Orthodoxy imagines. As a matter of fact, overall employment increases if the average wage rate W increases relative to average price P and productivity R. This gives one the lever to improve the employment situation all over the world and to fend off deflation without rising debt and without artificial capacity growth.

According to pre-Keynesian Orthodoxy, the price mechanism as embodied in ρF should spontaneously establish full employment. More precisely, a falling average wage rate should restore full employment. The consistent structural Employment Law says that the opposite is true.

The overlooked irony of the original Phillips Curve is that it clearly shows a positive correlation between average wage rate and employment that should have cast doubt on the familiar supply-demand-equilibrium story.

The core of the employment problem is that the price mechanism does not work as orthodox economics says and this has nothing to do with wage or price stickiness but with the fact that theoretical economics never could really emancipate itself from political economics and thus arrive at a consistent theory of how the monetary economy works.

Egmont Kakarot-Handtke

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

Related 'The end of storytelling' and 'Storytelling and facts'.