resilience, not stability

Archive for the ‘Cronyism’ Category

Minsky and Hayek: Connections

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As Tyler Cowen argues, there are many similarities between Hayek’s and Minsky’s views on business cycles. Fundamentally, they both describe the “fundamental impossibility in maintaining orderly credit relations over time”.

Minsky saw Keynes’ theory as an ‘investment theory of the business cycle’ and his contribution as being a ‘financial theory of investment’. This financial theory was based on the credit/financing-focused endogenous theory of money of Joseph Schumpeter, whom Minsky studied under. Schumpeter’s views are best described in Chapter 3 (’Credit and Capital’) of his book ‘Theory of Economic Development’. The gist of this view is that “investment, and expenditures more generally, require financing, not saving” (Borio and Disyatat).

Schumpeter viewed the ability of banks to create money ex nihilo as the differentia specifica of capitalism. He saw bankers as ‘capitalists par excellence’ and viewed this ‘elastic’ nature of credit as an unambiguously positive phenomenon. Many people see Schumpeter’s view of money and banking as the antithesis of the Austrian view. But as Agnes Festre has highlighted, Hayek had a very similar view on the empirical reality of the credit process. Hayek however saw this elasticity of the monetary supply as a negative phenomenon. The similarity between Hayek and Minksy comes from the fact that Minsky also focused on the downside of an elastic monetary system in which overextension of credit was inevitably brought back to a halt by the violent snapback of the Minsky Moment.

Where Hayek and Minsky differed was that Minsky favoured a comprehensive stabilisation of the financial and monetary system through fiscal and monetary intervention after the Minsky moment. Hayek only supported the prevention of secondary deflationary spirals. Minsky supported aggressive and early monetary interventions (e.g. lender-of-last-resort programs) as well as fiscal stimulus. However, although Minsky supported stabilisation he was well aware of the damaging long-run consequences of stabilising the economic system. He understood that such a system would inevitably deteriorate into crony capitalism if fundamental reforms did not follow the stabilisation. Minsky supported a “policy strategy that emphasizes high consumption, constraints upon income inequality, and limitations upon permissible liability structures”. He also advocated “an industrial-organization strategy that limits the power of institutionalized giant firms”. Minsky was under no illusions that a stabilised capitalist economy could carry on with business as usual.

I disagree with Minsky on two fundamental points – I believe that a capitalist economy with sufficient low-level instability is resilient. Allow small failures of banks and financial players, tolerate small recessions and we can dramatically reduce the impact and probability of large-scale catastrophic recessions such as the 2008 financial crisis. A little bit of chaos is an essential ingredient in a resilient capitalist economy. I also believe that we must avoid stamping out the disturbance at its source and instead focus our efforts on mitigating the wider impact of the disturbance on the masses. In other words, bail out the masses with helicopter drops rather than bailing out the banks.

But although I disagree with Minsky his ideas are coherent. The same cannot be said for the current popular interpretation of Minsky which believes that so long as we deal with sufficient force when the Minsky moment arrives, capitalism can carry on as usual. As Minsky has argued in his book ‘John Maynard Keynes’, and as I have argued based on experiences in stabilising other complex adaptive systems such as rivers, forest fires and our brain, stabilised capitalism is an oxymoron.

What about Hayek’s views on credit elasticity? As I argued in an earlier post, “we live in a world where maturity transformation is no longer required to meet our investment needs. The evolution and malformation of the financial system means that Hayek’s analysis is more relevant now than it probably was during his own lifetime”. An elastic credit system is no longer beneficial to economic growth in the modern economy. This does not mean that we should ban the process of endogenous credit creation – it simply means that we must allow the maturity-transforming entities to collapse when they get in trouble1.

  1. Because we do not need an elastic, maturity-transforming financial system, we can firewall basic deposit banking from risky finance. This will enable us to allow the banks to fail when the next crisis hits us. The solution is not to ban casino banking but to suck the lifeblood out of it by constructing an alternative 100% reserve-like system. I have advocated that each resident should be given a deposit account with the central bank which can be backed by Treasuries, a ‘public option’ for basic deposit banking. John Cochrane has also argued for a similar system. In his words, “the Federal Reserve should continue to provide abundant reserves to banks, paying market interest. The Treasury could offer reserves to the rest of us—floating-rate, fixed-value, electronically-transferable debt. There is no reason that the Fed and Treasury should artificially starve the economy of completely safe, interest-paying cash”. ↩
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Written by Ashwin Parameswaran

August 23rd, 2013 at 4:56 pm

Radical Centrism: Uniting the Radical Left and the Radical Right

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Pragmatic Centrism Is Crony Capitalism

Neoliberal crony capitalism is driven by a grand coalition between the pragmatic centre-left and the pragmatic centre-right. Crony capitalist policies are always justified as the pragmatic solution. The range of policy options is narrowed down to a pragmatic compromise that maximises the rent that can be extracted by special interests. Instead of the government providing essential services such as healthcare and law and order, we get oligopolistic private healthcare and privatised prisons. Instead of a vibrant and competitive private sector with free entry and exit of firms we get heavily regulated and licensed industries, too-big-to-fail banks and corporate bailouts.

There’s no better example of this dynamic than the replacement of the public option in Obamacare by a ‘private option’. As Glenn Greenwald argues, “whatever one’s views on Obamacare were and are: the bill’s mandate that everyone purchase the products of the private health insurance industry, unaccompanied by any public alternative, was a huge gift to that industry.” Public support is garnered by presenting the private option as the pragmatic choice, the compromise option, the only option. To middle class families who fear losing their healthcare protection due to unemployment, the choice is framed as either the private option or nothing.

In a recent paper (h/t Chris Dillow), Pablo Torija asks the question ‘Do Politicians Serve the One Percent?’ and concludes that they do. This is not a surprising result but what is more interesting is his research on the difference between leftwing and rightwing governments which he summarises as follows: “In 2009 center-right parties maximized the happiness of the 100th-98th richest percentile and center-left parties the 100th-95th richest percentile. The situation has evolved from the seventies when politicians represented, approximately, the median voter”.

Nothing illustrates the irrelevance of democratic politics in the neo-liberal era more than the sight of a supposedly free-market right-wing government attempting to reinvent Fannie Mae/Freddie Mac in Britain. On the other side of the pond, we have a supposedly left-wing government which funnels increasing amounts of taxpayer money to crony capitalists in the name of public-private partnerships. Politics today is just internecine warfare between the various segments of the rentier class. As Pete Townshend once said, “Meet the new boss, same as the old boss”.

The Core Strategy of Pragmatic Crony Capitalism: Increase The Scope and Reduce the Scale of Government

Most critics of neoliberalism on the left point to the dramatic reduction in the scale of government activities since the 80s – the privatisation of state-run enterprises, the increased dependence upon private contractors for delivering public services etc. Most right-wing critics lament the increasing regulatory burden faced by businesses and individuals and the preferential treatment and bailouts doled out to the politically well-connected. Neither the left nor the right is wrong. But both of them only see one side of what is the core strategy of neoliberal crony capitalism – increase the scope and reduce the scale of government intervention. Where the government was the sole operator, such as prisons and healthcare, “pragmatic” privatisation leaves us with a mix of heavily regulated oligopolies and risk-free private contracting relationships. On the other hand, where the private sector was allowed to operate without much oversight the “pragmatic” reform involves the subordination of free enterprise to a “sensible” regulatory regime and public-private partnerships to direct capital to social causes. In other words, expand the scope of government to permeate as many economic activities as possible and contract the scale of government within its core activities.

Some of the worst manifestations of crony capitalism can be traced to this perverse pragmatism. The increased scope and reduced scale are the main reasons for the cosy revolving door between incumbent crony capitalists and the government. The left predictably blames it all on the market, the right blames government corruption, while the revolving door of “pragmatic” politicians and crony capitalists rob us blind.

Radical Centrism: Increase The Scale and Reduce The Scope of Government

The essence of a radical centrist approach is government provision of essential goods and services and a minimal-intervention, free enterprise environment for everything else. In most countries, this requires both a dramatic increase in the scale of government activities within its core domain as well as a dramatic reduction in the scope of government activities outside it. In criticising the shambolic privatisation of National Rail in the United Kingdom, Christian Wolmar argued that: “once you have government involvement, you might as well have government ownership”. This is an understatement. The essence of radical centrism is: ‘once you have government involvement, you must have government ownership’. Moving from publicly run systems “towards” free-enterprise systems or vice versa is never a good idea. The road between the public sector and the private sector is the zone of crony capitalist public-private partnerships. We need a narrowly defined ‘pure public option’ rather than the pragmatic crony capitalist ‘private option’.

The idea of radical centrism is not just driven by vague ideas of social justice or increased competition. It is driven by ideas and concepts that lie at the heart of complex system resilience. All complex adaptive systems that successfully balance the need to maintain robustness while at the same time generating novelty and innovation utilise a similar approach.

Barbell Approach: Conservative Core, Aggressive Periphery

Radical centrism follows what Nassim Taleb has called the ‘barbell approach’. Taleb also provides us with an excellent example of such a policy in his book ‘Antifragile’, “hedge funds need to be unregulated and banks nationalized.” The idea here is that you bring the essential utility-like component of banking into the public domain and leave the rest alone. It is critical that the common man must not be compelled to use oligopolistic rent-fuelled services for his essential needs. In the modern world, the ability to hold money and transact is an essential service. It is also critical that there is only a public option, not a public imperative. The private sector must be allowed to compete against the public option.

A bimodal strategy of combining a conservative core with an aggressive periphery is common across complex adaptive systems in many different domains. It is true of the gene regulatory networks in our body which contains a conservative “kernel”. The same phenomenon has even been identified in technological systems such as the architecture of the Internet where a conservative kernel “represent(s) a stable basis on which diversity and complexity of higher-level processes can evolve”.

Stress, fragility and disorder in the periphery generates novelty and variation that enables the system to innovate and adapt to new environments. The stable core not only promotes robustness but paradoxically also promotes long-run innovation by by avoiding systemic collapse. Innovation is not opposed to robustness. In fact, the long-term ability of a system to innovate is dependent upon system robustness. But robustness does not imply stability, it simply means a stable core. The progressive agenda is consistent with creative destruction so long as we focus on a safety net, not a hammock.

Restore the ‘Invisible Foot’ of Competition

The neo-liberal era is often seen as the era of deregulation and market supremacy. But as many commentators have noticed, “”deregulation typically means reregulation under new rules that favor business interests.” As William Davies notes, “the guiding assumption of neoliberalism is not that markets work perfectly, but that private actors make better decisions than public ones”. And this is exactly what happened. Public sector employees were moved onto incentive-based contracts that relied on their “greed” and the invisible hand to elicit better outcomes. Public services were increasingly outsourced to private contractors who were theoretically incentivised to keep costs down and improve service delivery. Nationalised industries like telecom were replaced with heavily licensed private oligopolies. But there was a fatal flaw in these “reforms” which Allen Schick identifies as follows (emphasis mine):

one should not lose sight of the fact that these are not real markets and that they do not operate with real contracts. Rather, the contracts are between public entities—
the owner and the owned. The government has weak redress when its own organizations fail to perform, and it may be subject to as much capture in negotiating and enforcing its contracts as it was under pre-reform management. My own sense is that while some gain may come from mimicking markets, anything less than the real thing
denies government the full benefits of vigorous competition and economic redress

One difference between the “real thing” and the neoliberal version of the real thing is what the economist Joseph Berliner has called the ‘invisible foot’ of capitalism. Incumbent firms rarely undertake disruptive innovation unless compelled to do so by the force of dynamic competition from new entrants. The critical factor in this competitive dynamic is not the temptation of higher profits but the fear of failure and obsolescence. To sustain long-run innovation in the economy , the invisible foot needs to be “applied vigorously to the backsides of enterprises that would otherwise have been quite content to go on producing the same products in the same ways, and at a reasonable profit, if they could only be protected from the intrusion of competition.”

The other critical difference is just how vulnerable the half-way house solutions of neo-liberalism were to being gamed and abused by opportunistic private actors. The neo-liberal era saw a rise in incentive-based contracts across the private and public sector but without the invisible foot of the threat of failure. The predictable result was not only a stagnant economy but an increase in rent extraction as private actors gamed the positive incentives on offer. As an NHS surgeon quipped with respect to the current NHS reform project: “I think there’s a model there, but it’s whether it can be delivered and won’t be corrupted. I can see a very idealistic model, but by God, it’s vulnerable to people ripping it off”.

Most people view the failure of the Soviet model as being due to the inefficiency of the planned economy. But the problem that consumed the attention of Soviet leaders since the 1950s was the inability of the Soviet economy to innovate. Brezhnev once quipped that Soviet enterprises shied away from innovation “as the devil shies away from incense”. In his work on the on-the-ground reality of the Soviet economy, Joseph Berliner analysed the efforts of Soviet planners to counter this problem of insufficient innovation. The Soviets tried a number of positive incentive schemes (e.g. innovation “bonuses”) that we commonly associate with capitalist economies. But what it could not replicate was the threat of firm failure. Managers safe in the knowledge that competitive innovation would not cause their firm or their jobs to vanish were content to focus on low-risk process innovation and cost-reduction rather than higher-risk, disruptive innovation. In fact, the presence of bonuses that rewarded efficiency further reduced exploratory innovation as exploratory innovation required managers to undertake actions that often reduced short-term efficiency.

Unwittingly, the neoliberal era has replicated the Soviet system. Incumbent firms have no fear of failure and can game the positive incentives on offer to extract rents while at the same time shying away from any real disruptive innovation. We are living in a world where rentier capitalists game the half-baked schemes of privatisation and fleece the taxpayer and the perverse dynamics of safety for the classes and instability for the masses leaves us in the Great Stagnation.

Bailouts For People, Not Firms

Radical centrism involves a strengthening of the safety net for individuals combined with a dramatic increase in the competitive pressures exerted on incumbent firms. Today, we bail out banks because a banking collapse threatens the integrity of the financial system. We bail out incumbent firms because firm failure leaves the unemployed without even catastrophic health insurance. The principle of radical centrism aims to build a firewall that protects the common man from the worst impact of economic disturbances while simultaneously increasing the threat of failure at firm level. The presence of the ‘public option’ and a robust safety net is precisely what empowers us to allow incumbent firms to fail.

The safety net that protects individuals ensures robustness while the presence of a credible ‘invisible foot’ at the level of the firm boosts innovation. Moreover, as Taleb notes programs that bail out people are much less susceptible to being gamed and abused than programs that bail out limited liability firms. As I noted in an earlier post, “even uncertain tail-risk protection provided to corporates will eventually be gamed. The critical difference between individuals and corporates in this regard is the ability of stockholders and creditors to spread their bets across corporate entities and ensure that failure of any one bet has only a limited impact on the individual investors’ finances. In an individual’s case, the risk of failure is by definition concentrated and the uncertain nature of the transfer will ensure that moral hazard implications are minimal.”

The irony of the current policy debate is that policy interventions that prop up banks, asset prices and incumbent firms are viewed as the pragmatic option and policy interventions focused on households are viewed as radical and therefore beyond the pale of discussion. Preventing rent-seeking is a problem that both the left and the right should be concerned with. But both the radical left and the radical right need to realise the misguided nature of many of their disagreements. A robust safety net is as important to maintaining an innovative free enterprise economy as the dismantling of entry barriers and free enterprise are to reducing inequality.

Note: For a more rigorous treatment of the tradeoff between innovation and robustness in complex adaptive systems, see my essay ‘All Systems Need A Little Disorder’.

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Written by Ashwin Parameswaran

April 8th, 2013 at 2:54 pm

House Prices, The Wealth Effect And Crony Capitalism

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As I illustrated in a previous post, “a significant proportion of the balance sheet of wealthy Americans is made up of real assets – real estate, stock and business holdings”. Therefore “what wealthy Americans, businesses and banks share is a common interest in supporting asset prices (real and nominal), a lack of interest in seeking full employment unless it is a prerequisite for supporting asset prices, and an aversion to any policies that can trigger wage inflation”. The fact that our dominant macroeconomic policy doctrine depends upon the ‘wealth effect’ simply reflects the fact that our economy is driven by wealthy special interests.

The real question again is why there isn’t more mass opposition to such a blatantly regressive policy regime. In previous posts(1, 2), I have argued that crony capitalism achieves broad-based support by piggybacking upon broad-based programs aimed at the middle class. But they also achieve this support due to the absence of a safety net that breeds middle-class insecurity. This carrot-and-stick approach ensures middle-class support for the same stabilising policies that transfer wealth to the one percent. As the table below (taken from Edward Wolff’s paper) shows, the most significant asset holding of the middle class in the United States is their principal residence. The data is no different in the United Kingdom (table below from the ONS). Supporting house prices therefore is the sop that special interests need to provide to the middle class in order to ensure their support for the ‘wealth effect’-driven economy.

Household Wealth Distribution In The United States

Household Wealth Distribution In The United States

Household Wealth Distribution in the United Kingdom

Household Wealth Distribution in the United Kingdom

Although there are many instances of direct subsidies to middle-class households via cheaper mortgages (George Osborne’s latest policy being yet another example), these are dwarfed by the impact of the primary guiding principle of macroeconomic policy throughout the neo-liberal era – house prices must keep going up. Rising house prices don’t just act as a carrot to the home-owning middle classes. The fear of being left behind and being out priced by a rising market also acts as a stick to those who don’t own homes. Again, middle-class support for the crony capitalist plutocracy is driven by the stick as much as it is by the carrot. Those who “fear” that the latest housing scheme “risks driving up prices” should realise that the increase in house prices is not an unintended consequence but the primary aim of our crony capitalist policy regime.

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Written by Ashwin Parameswaran

March 28th, 2013 at 3:48 pm

Crony Capitalism Thrives In The Absence Of A Safety Net

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In his book ‘The Rise And Decline Of Nations’, Mancur Olson argued that over time stable democracies will experience a progressive increase in the power and influence of special interests and crony capitalists. Olson also identified the self-preserving nature of this phenomenon. Once rent-seeking has achieved sufficient scale, “distributional coalitions have the incentive and..the power to prevent changes that would deprive them of their enlarged share of the social output”. Olson’s diagnosis was accurate on both counts. Most developed economies are currently stuck within various stages of Olsonian demosclerosis.

But Olson also believed that there were limits to just how much of a nation’s GDP crony capitalists could extract before public anger or social instability would rein them in. Olson was almost certainly too optimistic in making this argument. In an earlier post I explained how crony capitalists can avoid these limits by piggybacking upon progressive programs that are meant to help the masses. As I concluded, “The masses become the shield for the very programs that enable a select few to extract significant rents out of the system. The same programs that are supposed to be part of the liberal social agenda like Fannie/Freddie become the weapons through which the cronyist corporate structure perpetuates itself, while the broad-based support for these programs makes them incredibly resilient and hard to reform once they have taken root”.

A common feature of most crony capitalist economies is the pervasive presence of subsidies targeted at the middle class. Progressives often view middle-class subsidies as the unavoidable price required to secure widespread support for the welfare state. But in reality middle-class subsidies act as the carrot that aligns the interests of the middle class with parasitic crony capitalism. However, along with the carrot comes a very hefty stick – the absence of a safety net. The absence of a safety net that protects individuals against catastrophic outcomes breeds middle-class insecurity. The fear of falling through the cracks causes the middle class to support the very rent-infested programs and corporate bailouts that sustain the plutocracy. In the absence of a safety net, the middle class seeks safety in the safety of the incumbent firm that employs them. I have often described the neo-liberal era as the era of “stability for the classes and instability for the masses”. But the two are not independent. It is precisely the fragility of the masses that provides stability to the classes.

Government provision of a safety net is not just a matter of social justice. It is in fact a critical component of a free enterprise economy. Just as those on the left of the political spectrum need to appreciate the insanity of supporting a system that ties the security of the masses to the security of its incumbent crony capitalists, those on the right of the political spectrum need to, as Reihan Salam argues, “embrace the idea of a social safety net as an important element of a free enterprise economy, not just as an unfortunate accommodation to political reality”. An employer-independent safety net promotes free enterprise by enabling us to dismantle the privatised welfare state that is the lifeblood of crony capitalism. Only if we construct a safety net for individuals can we dismantle the hammock that incumbent crony capitalists in our economy currently enjoy.

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Written by Ashwin Parameswaran

March 11th, 2013 at 3:06 pm

Posted in Cronyism

Creative Destruction and The Class Struggle

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In a perceptive post, Reihan Salam makes the point that private equity firms are simply an industrialised version of corporate America’s efficiency-seeking impulse. I’ve made a similar point in a previous post that the the excesses of private equity mirror the excesses of the economy during the neoliberal era. To right-wing commentators, neoliberalism signifies a much-needed transition towards a free-market economy. Left-wing commentators on the other hand lament the resultant supremacy of capital over labour and rising inequality. But as I have argued several times, the reality of the neoliberal transition is one where a combination of protected asset markets via the Greenspan Put, an ever-growing ‘License Raj’, regulations that exist primarily to protect incumbent corporates and persistent bailouts of banks and large corporates have given us a system best described as “stability for the classes and instability for the masses”.

The solution preferred by the left is to somehow recreate the golden age of the 50s and the 60s i.e. stability for all. Although this would be an environment of permanent innovative stagnation bereft of Schumpeterian creative destruction, you could argue that restoring social justice, reducing inequality and shoring up the bargaining position of the working class is more important than technological progress. In this post I will argue that this stability-seeking impetus is counterproductive and futile. A stable system where labour and capital are both protected from the dangers of failure inevitably breeds a fragile and disadvantaged working class.

The technology industry provides a great example of how disruptive competitive dynamics can give workers a relatively strong bargaining position. As Reihan notes, the workers fired by Steve Jobs in 1997 probably found employment elsewhere without much difficulty. Some of them probably started their own technology ventures. The relative bargaining power of the technology worker is boosted not just by the presence of a large number of new firms looking to hire but also by the option to simply start their own small venture instead of being employed. This vibrant ecosystem of competing opportunities and alternatives is a direct consequence of the disruptive churn that has characterised the sector over the last few decades. This “disorder” means that most individual firms and jobs are vulnerable at all times to elimination. Yet jobseekers as a whole are in a relatively strong position. Micro-fragility leads to macro-resilience.

In many sectors, there are legitimate economies of scale that prevent laid-off workers from self-organising into smaller firms. But in much of the economy, the digital and the physical, these economies of scale are rapidly diminishing. Yet these options are denied to large sections of the economy due to entry barriers from licensing requirements and regulatory hurdles that systematically disadvantage small, new firms. In some states, it is easier to form a technology start-up than it is to start a hair-braiding business. In fact, the increasingly stifling patent regime is driving Silicon Valley down the same dysfunctional path that the rest of the economy is on.

The idea that we can protect incumbent firms such as banks from failure and still preserve a vibrant environment for new entrants and competitors is folly. Just like a fire that burns down tall trees provides the opportunity for smaller trees to capture precious sunlight and thrive, new firms expand by taking advantage of the failure of large incumbents. But when the incumbent fails, there must be a sufficient diversity of small and new entrants who are in a position to take advantage. A long period of stabilisation does its greatest damage by stamping out this diversity and breeding a micro-stable, macro-fragile environment. Just as in ecosystems, “minor species provide a ‘‘reservoir of resilience’’ through their functional similarity to dominant species and their ability to increase in abundance and thus maintain function under ecosystem perturbation or stress”. This deterioration is not evident during the good times when the dominant species, however homogeneous, appear to be performing well. Stabilisation is therefore an almost irreversible path – once the system is sufficiently homogenous, avoiding systemic collapse requires us to put the incumbent fragile players on permanent life support.

As even Marxists such as David Harvey admit, Olsonian special-interest dynamics subvert and work against the interests of the class struggle:

the social forces engaged in shaping how the state–finance nexus works…differ somewhat from the class struggle between capital and labour typically privileged in Marxian theory….there are many issues, varying from tax, tariff, subsidy and both internal and external regulatory policies, where industrial capital and organised labour in specific geographical settings will be in alliance rather than opposition. This happened with the request for a bail-out for the US auto industry in 2008–9. Auto companies and unions sat side by side in the attempt to preserve jobs and save the companies from bankruptcy.

This fleeting and illusory stability that benefits the short-term interests of the currently employed workers in a firm leads to the ultimate loss of bargaining-power and reduced real wage growth in the long run for workers as a class. In the pursuit of stability, the labour class supports those very policies that are most harmful to it in the long run. A regime of Smithian efficiency-seeking i.e. the invisible hand, without Schumpeterian disruption i.e. the invisible foot inevitably leads to a system where capital dominates labour. Employed workers may achieve temporary stability via special-interest politics but the labour class as a whole will not. Creative destruction prevents the long-term buildup of capital interests by presenting a constant threat to the survival of the incumbent rent-earner. In the instability of the individual worker (driven by the instability of their firm’s prospects) lies the resilience of the worker class. Micro-fragility is the key to macro-resilience but this fragility must be felt by all economic agents, labour and capital alike.

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Written by Ashwin Parameswaran

July 5th, 2012 at 1:11 am

The Case Against Monetary Stimulus Via Asset Purchases

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Many economists and commentators blame the Federal Reserve for the increasingly tepid economic recovery in the United States. For example, Ryan Avent calls the Fed’s unwillingness to further ease monetary policy a “dereliction of duty” and Felix Salmon claims that “we have low bond yields because the Fed has failed to do its job”. Most people assume that the adoption of a higher inflation target (or an NGDP target) and conventional quantitative easing (QE) via government bond purchases will suffice. Milton Friedman, for example, had argued that government bond purchases with “high-powered money” would have dragged Japan out of its recession. But how exactly is more QE supposed to work in an environment when treasury bonds are trading at all-time low yields and banks are awash in excess reserves?

If we analyse monetary policy as a threat strategy, then how do we make sure that the threat is credible? According to Nick Rowe, “The Fed needs to communicate its target clearly. And it needs to threaten to do unlimited amounts of QE for an unlimited amount of time until its target is hit. If that threat is communicated clearly, and believed, the actual amount of QE needed will be negative.” In essence, this is a view that market expectations are sufficient to do the job.

Expectations are a large component of how monetary policy works but expectations only work when there is a clear and credible set of actions that serve as the bazooka(s) to enforce these expectations. In other words, what is it exactly that the central bank threatens to do if the market refuses to react sufficiently to its changed targets? It is easy to identify the nature of the threat when the target variable is simply a market price, e.g. an exchange rate vs another currency (such as the SNB’s enforcement of a minimum EURCHF exchange rate) or an exchange rate vs a commodity (such as the abandoning of the gold standard). But when the target variable is not a market price, the transmission mechanism is nowhere near as simple.

Scott Sumner would implement an NGDP targeting regime in the following manner:

First create an explicit NGDP target. Use level targeting, which means you promise to make up for under- or overshooting. If excess reserves are a problem, get rid of most of them with a penalty rate. Commit to doing QE until various asset prices show (in the view of Fed officials) that NGDP is expected to hit the announced target one or two years out. If necessary buy up all of Planet Earth.

Interest on Reserves

Small negative rates on reserves or deposits held at the central bank are not unusual. But banks can and will pass on this cost to their deposit-holders in the form of negative deposit rates and given the absence of any better liquid and nominally safe investment options, most bank customers will pay this safety premium. For example, when the SNB charged negative rates on offshore deposits denominated in Swiss Franc in the mid-1970s, the move did very little to stem the inflow into the currency.

Significant negative rates are easily evaded as people possess the option to hold cash in the form of bank notes. As SNB Vice-Chairman Jean-Pierre Danthine notes:

With strongly negative interest rates, theory joins practice and seems to lead to a policy of holding onto bank notes (cash) rather than accounts, which destabilises the system.

Quantitative Easing: Government Bonds

Conventional QE can be deconstructed into two components: an exchange of money for treasury-bills and an exchange of treasury-bills for treasury-bonds. The first component has no impact on the market risk position of the T-bill holder for whom deposits and T-bills are synonymous in a zero-rates environment. But it is also irrelevant from the perspective of the banking system unless the rate paid on reserves is significantly negative (which can be evaded by holding bank notes as discussed above).

The second component obviously impacts the market risk position of the economy as a whole. It is widely assumed that by purchasing government bonds, the central bank reduces the duration risk exposure of the market as a whole thus freeing up risk capacity. But for most holders of government bonds (especially pension funds and insurers), duration is not a risk but a hedge. A nominal dollar receivable in 20 years is not always riskier than a nominal dollar receivable today – for those who hold the bond as a hedge for a liability of a nominal dollar payable in 20 years, the dollar receivable today is in fact the riskier holding. More generally the negative beta nature of government bonds means that the central bank increases the risk exposure of the economy when it buys them.

Apart from the market risk impact of QE, we need to examine whether it has any impact on the liquidity position of the private economy. In this respect, neither the first or the second step has any impact for a simple reason – the assets being bought i.e. govt bonds are already safe collateral both in the shadow banking system as well as with the central bank itself. Therefore, any owner of government bonds can freely borrow cash against it. The liquidity preference argument is redundant in differentiating between deposits and an asset that qualifies as safe collateral. Broad money supply is therefore unaffected when such an asset is purchased.

If conventional QE were the only tool in the arsenal, announcing higher targets or NGDP targets achieves very little. The Bank of England and the Federal Reserve could buy up the entire outstanding stock of govt bonds and the impact on inflation or economic growth would be negligible in the current environment.

Credit Easing and More: Private Sector Assets

Many proponents of NGDP targeting would assert that limiting the arsenal of the central bank to simply treasury bonds is inappropriate and that the central bank must be able to purchase private sector assets (bonds, equities) or as Scott Sumner exhorts above “If necessary buy up all of Planet Earth”. There is no denying the fact that by buying up all of Planet Earth, any central bank can create inflation. But when the assets bought are already liquid and market conditions are not distressed, buying of private assets creates inflation only by increasing the price and reducing the yield of those assets i.e. a wealth transfer from the central bank to the chosen asset-holders. As with quantitative easing through government bond purchases, the inability to enforce adequate penalties on reserves nullifies any potential “hot potato” effect.

Bernanke himself has noted that the liquidity facility interventions during the 2008-2009 crisis and QE1 were focused on reducing private market credit spreads and improving the functioning of private credit markets at a time when the market for many private sector assets was under significant stress and liquidity premiums were high. The current situation is not even remotely comparable – yields on private credit instruments are at relatively elevated levels compared to historical median spreads but the difference in absolute terms is only about 50 bps on investment-grade credit (see table below) as compared to much higher levels (at least 300-40 bps on investment grade) during the 2008-2009 crisis.

US Historical Credit Spreads
Source: Robeco

A quantitative easing program focused on purchasing private sector assets is essentially a fiscal program in monetary disguise and is not even remotely neutral in its impact on income distribution and economic activity. Even if the central bank buys a broad index of bonds or equities, such a program is by definition a transfer of wealth towards asset-holders and regressive in nature (financial assets are largely held by the rich). The very act of making private sector assets “safe” is a transfer of wealth from the taxpayer to some of the richest people in our society. The explicit nature of the central banks’ stabilisation commitment means that the rent extracted from the commitment increases over time as more and more economic actors align their portfolios to hold the stabilised and protected assets.

Such a program is also biased towards incumbent firms and against new firms. The assumption that an increase in the price of incumbent firms’ stock/bond price will flow through to lending and investment in new businesses is unjustified due to the significantly more uncertain nature of new business lending/investment. This trend has been exacerbated since the crisis and the bond market is increasingly biased towards the largest, most liquid issuers. Even more damaging, any long-term macroeconomic stabilisation program that commits to purchasing and supporting macro-risky assets will incentivise economic actors to take on macro risk and shed idiosyncratic risk. Idiosyncratic risk-taking is the lifeblood of innovation in any economy.

In other words, QE is not sufficient to hit any desired inflation/NGDP target unless it is expanded to include private sector assets. If it is expanded to include private sector assets, it will exacerbate the descent into an unequal, crony capitalist, financialised and innovatively stagnant economy that started during the Greenspan/Bernanke put era.

Removing the zero-bound

One way of getting around the zero-bound on interest rates is to simply abolish or tax bank note holdings as Willem Buiter has recommended many times:

The existence of bank notes or currency, which is an irredeemable ‘liability’ of the central bank – bearer bonds with a zero nominal interest rate – sets a lower bound (probably at something just below 0%) on central banks’ official policy rates.
The obvious solutions are: (1) abolishing currency completely and moving to E-money on which negative interest rates can be paid as easily as zero or positive rates; (2) taxing holdings of bank notes (a solution first proposed by Gesell (1916) and also advocated by Irving Fisher (1933)) or (3) ending the fixed exchange rate between currency and central bank reserves (which, like all deposits, can carry negative nominal interest rates as easily as positive nominal interest rates, a solution due to Eisler (1932)).

I’ve advocated many times on this blog that monetary-fiscal hybrid policies such as money-financed helicopter drops to individuals should be established as the primary tool of macroeconomic stabilisation. In this manner, inflation/NGDP targets can be achieved in a close-to-neutral manner that minimises rent extraction. My preference for fiscal-monetary helicopter drops over negative interest-rates is primarily driven by financial stability considerations. There is ample evidence that even low interest rates contribute to financial instability.

There’s a deep hypocrisy at the heart of the macro-stabilised era. Every policy of stabilisation is implemented in a manner that only a select few (typically corporate entities) can access with an implicit assumption that the impact will trickle-down to the rest of the economy. Central-banking since the Great Moderation has suffered from an unwarranted focus on asset prices driven by an implicit assumption that changes in asset prices are the best way to influence the macroeconomy. Instead doctrines such as the Greenspan Put have exacerbated inequality and cronyism and promoted asset price inflation over wage inflation. The single biggest misconception about the macro policy debate is the notion that monetary policy is neutral or more consistent with a free market and fiscal policy is somehow socialist and interventionist. A program of simple fiscal transfers to individuals can be more neutral than any monetary policy instrument and realigns macroeconomic stabilisation away from the classes and towards the masses.

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Written by Ashwin Parameswaran

June 4th, 2012 at 2:36 pm

The Great Recession, Business Investment and Crony Capitalism

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Paul Krugman points out that since 1985, business investment has been purely a demand story i.e. “a depressed economy led to low business investment” and vice versa. As he explains “The Great Recession, in particular, was led by housing and consumption, with business investment clearly responding rather than leading”. But this does not imply that low business investment does not have a causal role to play in the conditions that led to the Great Recession, or that increased business investment does not have a role to play in the recovery.

As Steve Roth notes, business investment has been anaemic throughout the neo-liberal era. JW Mason reminds us that the neo-liberal transition also coincided with a dramatically increased financialisation of the real economy. Throughout my series of posts on crony capitalism, I have argued that the structural and cyclical problems of the developed world are inextricably intertwined. The anaemic trend in business investment is the reason why the developed world has been in a ‘great stagnation’ for so long. This ‘investment deficit’ manifests itself as the ‘corporate savings glut’ and an increasingly financialised economy. The cause of the investment deficit is an increasingly financialised, cronyist, demosclerotic system where incumbent corporates do not face competitive pressure to engage in risky exploratory investment.

Business investments can typically either operate upon the scale of operations (e.g. capacity,product mix) or they can change the fundamental character of operations (e.g. changes in process, product). Investments in scaling up operations are most easily influenced by monetary policy initiatives which reduce interest rates and raise asset prices or direct fiscal policy initiatives which operate via the multiplier effect. Investments in process innovation require the presence of price competition within the industry. Investments in exploratory product innovation require not only competition amongst incumbent firms but competition from a constant and robust stream of new entrants into the industry.

In an economy where new entrants are stymied by an ever-growing ‘License Raj’ that costs the US economy an estimated $100 billion per year, a web of regulations that exist primarily to protect incumbent large corporates and a dysfunctional patent regime, it is not surprising that exploratory business investment has fallen so dramatically. A less cronyist and more dynamically competitive economy without the implicit asset-price protection of the Greenpan/Bernanke put will have lesser profits in aggregate but more investment. Incumbents need to be compelled to take on risky ventures by the threat of extinction and obsolescence. Increased investments in risky exploratory ventures will not only drag the economy out of the ‘Great Stagnation’ but it will result in a reduced share of GDP flowing to corporate profits and an increased proportion of GDP flowing towards wages. In turn, this enables the economy to achieve a sustainable state of full employment and even a higher level of sustainable consumption without households having to resort to increased leverage as they had to during the Great Moderation.

Alexander Field has illustrated how even the growth of the Golden Age of the 50s and the 60s was built upon the foundations of Pre-WW2 innovation. If this thesis is correct, the ‘Great Stagnation’ was inevitable and in fact understates how long ago the innovation deficit started. The Great Moderation far from being the cure was simply a palliative that postponed the inevitable end-point of the evolution of the macroeconomy through successive cycles of Minskyian stabilisation. As I noted in a previous post:

The neoliberal transition unshackled the invisible hand (the carrot of the profit motive) without ensuring that all key sectors of the economy were equally subject to the invisible foot (the stick of failure and losses and new firm entry)….“Order for all” became “order for the classes and disorder for the masses”….In this increasingly financialised economy, the increased market-sensitivity combined with the macro-stabilisation commitment encourages low-risk process innovation and discourages uncertain and exploratory product innovation. This tilt towards exploitation/cost-reduction without exploration kept inflation in check but it also implied a prolonged period of sub-par wage growth and a constant inability to maintain full employment unless the consumer or the government levered up. For the neo-liberal revolution to sustain a ‘corporate welfare state’ in a democratic system, the absence of wage growth necessitated an increase in household leverage for consumption growth to be maintained. 

When commentators such as James Livingston claim that tax cuts for businesses will not solve our problems and that we need a redistribution of income away from profits towards wages to trigger increased aggregate demand via aggregate consumption, I agree with them. But I disagree with the conclusion that the secular decline in business investment is inevitable, acceptable and unrelated to the current cyclical downturn. The fact that business investment during the Great Moderation only increased when consumption demand went up is a symptom of the corporatist nature of the economy. When the household sector has reached a state of peak debt and the financial system has reached its point of peak elasticity, simply running increased fiscal deficits without permitting the corporatist superstructure to collapse simply takes us to the end-state that Minsky himself envisioned: an economy that attempts to achieve full employment will yo-yo uncontrollably between a state of debt-deflation and high,variable inflation – somewhat similar to a broken shower that only runs either too hot or too cold. The only way in which the corporatist status quo can postpone collapse is to abandon the goal of full employment which is exactly the path that the developed world has taken.  This only substitutes an economic fragility with a deeper social fragility.

Stability for all is synonymous with an environment of permanent innovative stagnation. The Schumpeterian solution is to transform the system into one of instability for all. Micro-fragility is the key to macro-resilience but this fragility must be felt by all economic agents, labour and capital alike. In order to end the stagnation and achieve sustainable full employment, we need to allow incumbent banks and financialised corporations to collapse and dismantle the barriers to entry of new firms that pervade the economy. The risk of a deflationary contraction from allowing such a collapse be prevented in a simple and effective manner with a system of direct transfers to individuals as Steve Waldman has outlined. This solution also reverses the flow of rents that have exacerbated inequality over the past few decades.

Note: I went through a much longer version of the same argument with an emphasis on the relationship between employment and technology adapted to US economic history in a previous post. The above logic explains my disagreements with conventional Keynesian theory and my affinity with Post-Keynesian theory. Minsky viewed his theory as a  ‘investment theory of the cycle and a financial theory of investment’ and my views are simply a neo-Schumpeterian take on the same underlying framework.

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Written by Ashwin Parameswaran

December 7th, 2011 at 5:44 pm

Posted in Cronyism,Resilience

Rent-Seeking, The Progressive Agenda and Cash Transfers

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In my posts on the subject of cronyism and rent-seeking, I have drawn heavily on the work of Mancur Olson. My views are also influenced by my experiences of cronyism in India and comparing it to the Olsonian competitive sclerosis that afflicts most developed economies today. Although there are significant differences between cronyism in the developing and developed world, there is also a very significant common ground. In some respects, the rent-extraction apparatus in the developed world is just a more sophisticated version of the open corruption and looting that is common in many developing economies. This post explores some of this common ground.

Mancur Olson predicted the inexorable rise of rent seeking in a stable economy. But he also thought that once rent-seeking activities extracted too high a proportion of a nation’s GDP, the normal course of democracy and public anger may rein them in. Small rent seekers can fly under the radar but big rent-seekers are ultimately cut back to size. But is this necessarily true? Although there is some truth to this assertion, Olson was likely too optimistic about the existence of such limits. This post tries to provide an argument as to why this is not necessarily the case. After all, it can easily be argued that rents extracted by banks already swallow up a significant proportion of GDP. And there is no shortage of corrupt public programs that swallow up significant proportions of the public budget in the developing world. In a nutshell, my argument is that rent-extraction can avoid these limits by aligning itself to the progressive agenda – the very programs that purport to help the masses become the source of rents for the classes.

A transparent example of this phenomenon is the experience of the Mahatma Gandhi National Rural Employment Guarantee – a public program that guarantees 100 days of work for unskilled rural labourers in India. In a little more than half a decade since inception, it accounts for 3% of public spending and economists estimate that anywhere from a quarter to two-thirds of the expenditure does not reach those whom it is intended to help. So how does a program such as this not only survive but thrive? The answer is simple – despite the corruption, the scheme does disburse significant benefits to a large rural electorate. When faced with the choice of either tolerating a corrupt program or cancelling the program, the rural poor clearly prefer the status quo.

A rather more sophisticated example of this phenomenon is the endless black hole of losses that are Freddie Mac and Fannie Mae – $175 billion and counting. The press focuses on the comparatively small bonus payments to Freddie and Fannie executives but ignores their much larger role in the back door bailout of the banking sector. Again the reason why this goes relatively uncriticised is simple – despite the significant contribution made by Fannie and Freddie to the rents extracted by the “1%”, their operations also put money into the pockets of a vast cross-section of homeowners. Simply shutting them down would almost certainly constitute an act of political suicide.

Source (h/t to David Ruccio)

The masses become the shield for the very programs that enable a select few to extract significant rents out of the system. The same programs that are supposed to be part of the liberal social agenda like Fannie/Freddie become the weapons through which the cronyist corporate structure perpetuates itself, while the broad-based support for these programs makes them incredibly resilient and hard to reform once they have taken root.

Those who cherish the progressive agenda tend to argue that better implementation and regulation can solve the problem of rent extraction. But there is another option – complex programs with egalitarian aims should be replaced with direct cash transfers wherever feasible. This case has been argued persuasively in a recent book as an effective way to help the poor in developing countries and is already being implemented in India. There is no reason why the same approach cannot be implemented in the developed world either.

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Written by Ashwin Parameswaran

November 7th, 2011 at 2:25 am

Innovation, Stagnation and Unemployment

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All economists assert that wants are unlimited. From this follows the view that technological unemployment is impossible in the long run. Yet there are a growing number of commentators (such as Brian Arthur) who insist that increased productivity from automation and improvements in artificial intelligence has a part to play in the current unemployment crisis. At the same time, a growing chorus laments the absence of innovation – Tyler Cowen’s thesis that the recent past has been a ‘Great Stagnation’ is compelling.

But don’t the two assertions contradict each other? Can we have an increase in technological unemployment as well as an innovation deficit? Is the concept of technological unemployment itself valid? Is there anything about the current phase of labour-displacing technological innovation that is different from the past 150 years? To answer these questions, we need a deeper understanding of the dynamics of innovation in a capitalist economy i.e. how exactly has innovation and productivity growth proceeded in a manner consistent with full employment in the past? In the process, I also hope to connect the long-run structural dynamic with the Minskyian business cycle dynamic. It is common to view the structural dynamic of technological change as a sort of ‘deus ex machine’ – if not independent, certainly as a phenomenon that is unconnected with the business cycle. I hope to convince some of you that our choices regarding business cycle stabilisation have a direct bearing on the structural dynamic of innovation. I have touched upon many of these topics in a scattered fashion in previous posts but this post is an attempt to present many of these thoughts in a coherent fashion with all my assumptions explicitly laid out in relation to established macroeconomic theory.


Imperfectly competitive markets are the norm in most modern economies. In instances where economies of scale or network effects dominate, a market may even be oligopolistic or monopolistic (e.g. Google, Microsoft) This assumption is of course nothing new to conventional macroeconomic theory. Where my analysis differs is in viewing the imperfectly competitive process as one that is permanently in disequilibrium. Rents or “abnormal” profits are a persistent feature of the economy at the level of the firm and are not competed away even in the long run. The primary objective of incumbent rent-earners is to build a moat around their existing rents whereas the primary objective of competition from new entrants is not to drive rents down to zero, but to displace the incumbent rent-earner. It is not the absence of rents but the continuous threat to the survival of the incumbent rent-earner that defines a truly vibrant capitalist economy i.e. each niche must be continually contested by new entrants. This does not imply, even if the market for labour is perfectly competitive, that an abnormal share of GDP goes to “capital”. Most new entrants fail and suffer economic losses in their bid to capture economic rents and even a dominant incumbent may lose a significant proportion of past earned rents in futile attempts to defend its competitive position before its eventual demise.

This emphasis on disequilibrium points to the fact that the “optimum” state for a dynamically competitive capitalist economy is one of constant competitive discomfort and disorder. This perspective leads to a dramatically different policy emphasis from conventional theory which universally focuses on increasing positive incentives to economic players and relying on the invisible hand to guide the economy to a better equilibrium. Both Schumpeter and Marx understood the importance of this competitive discomfort for the constant innovative dynamism of a capitalist economy – my point is simply that a universal discomfort of capital is also important to maintain the distributive justice in a capitalist economy. in fact it is the only way to do so without sacrificing the innovative dynamism of the economy.

Competition in monopolistically competitive markets manifests itself through two distinct forms of innovation: exploitation and exploration. Exploitation usually takes the form of what James Utterback identified as process innovation with an emphasis on “real or potential cost reduction, improved product quality, and wider availability, and movement towards more highly integrated and continuous production processes.” As Utterback noted, such innovation is almost always driven by the incumbent firms. Exploitation is an act of optimisation under a known distribution i.e. it falls under the domain of homo economicus. In the language of fitness landscapes, exploitative process innovation is best viewed as competition around a local peak. On the other hand, exploratory product innovation (analogous to what Utterback identified as product innovation) occurs under conditions of significant irreducible uncertainty. Exploration is aimed at finding a significantly higher peak on the fitness landscape and as Utterback noted, is almost always driven by new entrants (For a more detailed explanation of incumbent preference for exploitation and organisational rigidity, see my earlier post).

An Investment Theory of the Business Cycle

Soon after publishing the ‘General Theory’, Keynes summarised his thesis as follows: “given the psychology of the public, the level of output and employment as a whole depends on the amount of investment. I put it in this way, not because this is the only factor on which aggregate output depends, but because it is usual in a complex system to regard as the causa causans that factor which is most prone to sudden and wide fluctuation.” In Keynes‘ view, the investment decision was undertaken in a condition of irreducible uncertainty, “influenced by our views of the future about which we know so little”. Just how critical the level of investment is in maintaining full employment is highlighted by GLS Shackle in his interpretation of Keynes’ theory: “In a money-using society which wishes to save some of the income it receives in payment for its productive efforts, it is not possible for the whole (daily or annual) product to be sold unless some of it is sold to investors and not to consumers. Investors are people who put their money on time-to-come. But they do not have to be investors. They can instead be liquidity-preferrers; they can sweep up their chips from the table and withdraw. If they do, they will give no employment to those who (in face of society’s propensity to save) can only be employed in making investment goods, things whose stream of usefulness will only come out over the years to come.”

If we accept this thesis, then it is no surprise that the post–2008 recovery has been quite so anaemic. Investment spending has remained low throughout the developed world, nowhere more so than in the United Kingdom. What makes this low level of investment even more surprising is the strength of the rebound in corporate profits and balance sheets – corporate leverage in the United States is as low as it has been for two decades and the proportion of cash in total assets as high as it has been for almost half a century. Specifically, the United States has also experienced an unusual increase in labour productivity during the recession which has exacerbated the disconnect between the recovery in GDP and employment. Some of these unusual patterns have been with us for a much longer time than the 2008 financial crisis. For example, the disconnect between GDP and employment in the United States has been obvious since atleast 1990, and the 2003 recession too saw an unusual rise in labour productivity. The labour market has been slack for at least a decade. It is hard to differ from Paul Krugman’s intuition that the character of post–1980 business cycles has changed. Europe and Japan are not immune from these “structural” patterns either – the ‘corporate savings glut’ has been a problem in the United Kingdom since atleast 2002, and Post-Keynesian economists have been pointing out the relationship between ‘capital accumulation’ and unemployment for a while, even attributing the persistently high unemployment in Europe to a lack of investment. Japan’s condition for the last decade is better described as a ‘corporate savings trap’ rather than a ‘liquidity trap’. Even in Greece, that poster child for fiscal profligacy, the recession is accompanied by a collapse in private sector investment.

A Theory of Business Investment

Business investments can typically either operate upon the scale of operations (e.g. capacity,product mix) or they can change the fundamental character of operations (e.g. changes in process, product). The degree of irreducible uncertainty in capacity and product mix decisions has reduced dramatically in the last half-century. The ability of firms to react quickly and effectively to changes in market conditions has improved dramatically with improvements in production processes and information technology – Zara being a well-researched example. Investments that change the very nature of business operations are what we typically identify as innovations. However, not all innovation decisions are subject to irreducible uncertainty either. In a seminal article, James March distinguished between “the exploration of new possibilities and the exploitation of old certainties. Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” Exploratory innovation operates under conditions of irreducible uncertainty whereas exploitation is an act of optimisation under a known distribution.

Investments in scaling up operations are most easily influenced by monetary policy initiatives which reduce interest rates and raise asset prices or direct fiscal policy initiatives which operate via the multiplier effect. In recent times, especially in the United States and United Kingdom, the reduction in rates has also directly facilitated the levering up of the consumer balance sheet and a reduction in the interest servicing burden of past consumer debt taken on. The resulting boost to consumer spending and demand also stimulates businesses to invest in expanding capacity. Exploitative innovation requires the presence of price competition within the industry i.e. monopolies or oligopolies have little incentive to make their operations more efficient beyond the price point where demand for their product is essentially inelastic. This sounds like an exceptional case but is in fact very common in critical industries such as finance and healthcare. Exploratory innovation requires not only competition amongst incumbent firms but competition from a constant and robust stream of new entrants into the industry. I outlined the rationale for this in a previous post:

Let us assume a scenario where the entry of new firms has slowed to a trickle, the sector is dominated by a few dominant incumbents and the S-curve of growth is about to enter its maturity/decline phase. To trigger off a new S-curve of growth, the incumbents need to explore. However, almost by definition, the odds that any given act of exploration will be successful is small. Moreover, the positive payoff from any exploratory search almost certainly lies far in the future. For an improbable shot at moving from a position of comfort to one of dominance in the distant future, an incumbent firm needs to divert resources from optimising and efficiency-increasing initiatives that will deliver predictable profits in the near future. Of course if a significant proportion of its competitors adopt an exploratory strategy, even an incumbent firm will be forced to follow suit for fear of loss of market share. But this critical mass of exploratory incumbents never comes about. In essence, the state where almost all incumbents are content to focus their energies on exploitation is a Nash equilibrium.
On the other hand, the incentives of any new entrant are almost entirely skewed in favour of exploratory strategies. Even an improbable shot at glory is enough to outweigh the minor consequences of failure. It cannot be emphasised enough that this argument does not depend upon the irrationality of the entrant. The same incremental payoff that represents a minor improvement for the incumbent is a life-changing event for the entrepreneur. When there exists a critical mass of exploratory new entrants, the dominant incumbents are compelled to follow suit and the Nash equilibrium of the industry shifts towards the appropriate mix of exploitation and exploration.

A Theory of Employment

My fundamental assertion is that a constant and high level of uncertain, exploratory investment is required to maintain a sustainable and resilient state of full employment. And as I mentioned earlier, exploratory investment driven by product innovation requires a constant threat from new entrants.

Long-run increases in aggregate demand require product innovation. As Rick Szostak notes:

While in the short run government spending and investment have a role to play, in the long run it is per capita consumption that must rise in order for increases in per capita output to be sustained…..the reason that we consume many times more than our great-grandparents is not to be found for the most part in our consumption of greater quantities of the same items which they purchased…The bulk of the increase in consumption expenditures, however, has gone towards goods and services those not-too-distant forebears had never heard of, or could not dream of affording….Would we as a society of consumers/workers have striven as hard to achieve our present incomes if our consumption bundle had only deepened rather than widened? Hardly. It should be clear to all that the tremendous increase in per capita consumption in the past century would not have been possible if not for the introduction of a wide range of different products. Consumers do not consume a composite good X. Rather, they consume a variety of goods, and at some point run into a steeply declining marginal utility from each. As writers as diverse as Galbraith and Marshall have noted, if declining marginal utility exists with respect to each good it holds over the whole basket of goods as well…..The simple fact is that, in the absence of the creation of new goods, aggregate demand can be highly inelastic, and thus falling prices will have little effect on output.

Therefore, when cost-cutting and process optimisation in an industry enables a product to be sold at a lower cost, the economy may not be able to reorganise back to full employment with simply an increased demand for that particular product. In the early stages of a product when demand is sufficiently elastic, process innovation can increase employment. But as the product ages, process improvements have a steadily negative effect on employment.

Eventually, a successful reorganisation back to full employment entails creating demand for new products. If such new products were simply an addition to the set of products that we consumed, disruption would be minimal. But almost any significant new product that arises from exploratory investment also destroys an old product. The tablet cannibalises the netbook, the smartphone cannibalises the camera etc. This of course is the destruction in Schumpeter’s creative destruction. It is precisely because of this cannibalistic nature of exploratory innovation that established incumbents rarely engage in it, unless compelled to do so by the force of new entrants. Burton Klein put it well: “ firms involved in such competition must compare two risks: the risk of being unsuccessful when promoting a discovery or bringing about an innovation versus the risk of having a market stolen away by a competitor: the greater the risk that a firm’s rivals take, the greater must be the risks to which must subject itself for its own survival.” Even when new firms enter a market at a healthy pace, it is rare that incumbent firms are successful at bringing about disruptive exploratory changes. When the pace of dynamic competition is slow, incumbents can choose to simply maintain slack and wait for any promising new technology to emerge which it can buy up rather than risking investment in some uncertain new technology.

We need exploratory investment because this expansion of the economy into its ‘adjacent possible’ does not derive its thrust from the consumer but from the entrepreneur. In other words, new wants are not demanded by the consumers but are instead created by entrepreneurs such as Steve Jobs. In the absence of dynamic competition from new entrants, wants remain limited.

In essence, this framework incorporates technological innovation into a distinctly “Chapter 12” Keynesian view of the business cycle. Although my views are far removed from macroeconomic orthodoxy, they are not quite so radical that they have no precedents whatsoever. My views can be seen as a simple extension of Burton Klein’s seminal work outlined in his books ‘Dynamic Economics’ and ‘Prices, wages, and business cycles: a dynamic theory’. But the closest parallels to this explanation can be found in Rick Szostak’s book ‘Technological innovation and the Great Depression’. Szostak uses an almost identical rationale to explain unemployment during the Great Depression, “how an abundance of labor-saving production technology coupled with a virtual absence of new product innovation could affect consumption, investment and the functioning of the labor market in such a way that a large and sustained contraction in employment would result.”

As I have hinted at in a previous post, this is not a conventional “structural” explanation of unemployment. Szostak explains the difference: “An alternative technological argument would be that the skills required of the workforce changed more rapidly in the interwar period than did the skills possessed by the workforce. Thus, there were enough jobs to go around; workers simply were not suited to them, and a painful decade of adjustment was required…I argue that in fact there simply were not enough jobs of any kind available.” In other words, this is a partly technological explanation for the shortfall in aggregate demand.

The Invisible Foot and New Firm Entry

The concept of the “Invisible Foot” was introduced by Joseph Berliner as a counterpoint to Adam Smith’s “Invisible Hand” to explain why innovation was so hard in the centrally planned Soviet economy:

Adam Smith taught us to think of competition as an “invisible hand” that guides production into the socially desirable channels….But if Adam Smith had taken as his point of departure not the coordinating mechanism but the innovation mechanism of capitalism, he may well have designated competition not as an invisible hand but as an invisible foot. For the effect of competition is not only to motivate profit-seeking entrepreneurs to seek yet more profit but to jolt conservative enterprises into the adoption of new technology and the search for improved processes and products. From the point of view of the static efficiency of resource allocation, the evil of monopoly is that it prevents resources from flowing into those lines of production in which their social value would be greatest. But from the point of view of innovation, the evil of monopoly is that it enables producers to enjoy high rates of profit without having to undertake the exacting and risky activities associated with technological change. A world of monopolies, socialist or capitalist, would be a world with very little technological change.” 

For disruptive innovation to persist, the invisible foot needs to be “applied vigorously to the backsides of enterprises that would otherwise have been quite content to go on producing the same products in the same ways, and at a reasonable profit, if they could only be protected from the intrusion of competition”Burton Klein’s great contribution along with Gunnar Eliasson was to highlight the critical importance of entry of new firms in maintaining the efficacy of the invisible foot. Klein believed that

the degree of risk taking is determined by the robustness of dynamic competition, which mainly depends on the rate of entry of new firms. If entry into an industry is fairly steady, the game is likely to have the flavour of a highly competitive sport. When some firms in an industry concentrate on making significant advances that will bear fruit within several years, others must be concerned with making their long-run profits as large as possible, if they hope to survive. But after entry has been closed for a number of years, a tightly organised oligopoly will probably emerge in which firms will endeavour to make their environments highly predictable in order to make their environments highly predictable in order to make their short-run profits as large as possible….Because of new entries, a relatively concentrated industry can remain highly dynamic. But, when entry is absent for some years, and expectations are premised on the future absence of entry, a relatively concentrated industry is likely to evolve into a tight oligopoly. In particular, when entry is long absent, managers are likely to be more and more narrowly selected; and they will probably engage in such parallel behaviour with respect to products and prices that it might seem that the entire industry is commanded by a single general!

This argument does not depend on incumbent firms leaving money on the table – on the contrary, they may redouble their attempts at cost reduction via process innovation in times of deficient demand. Rick Szostak documents how “despite the availability of a massive amount of inexpensive labour, process innovation would continue in the 1930s. Output per man-hour in manufacturing rose by 25% in the 1930s…..national output was higher in 1939 than in 1929, while employment was over two million less.”

Macroeconomic Policy and Exploratory Product Innovation

Monetary policy has been the preferred cure for insufficient aggregate demand throughout and since the Great Moderation. The argument goes that lower real rates, inflation and higher asset prices will increase investment via Tobin’s Q and increase consumption via the wealth effect and reduction in rewards to savings, all bound together in the virtuous cycle of the multiplier. If monetary policy is insufficient, fiscal policy may be deployed with a focus on either directly increasing aggregate demand or providing businesses with supply-side incentives such as tax cuts.

There is a common underlying theme to all of the above policy options – they focus on the question “how do we make businesses want to invest?” i.e. on positively incentivising incumbent business and startups and trusting that the invisible hand will do the rest. In the context of exploratory investments, the appropriate question is instead “how do we make businesses have to invest?” i.e. on compelling incumbent firms to invest in speculative projects in order to defend their rents or lose out to new entrants if they fail to do so. But the problem isn’t just that these policies are ineffectual. Many of the policies that focus on positive incentives weaken the competitive discomfort from the invisible foot by helping to entrench the competitive position of incumbent corporates and reducing their incentive to engage in exploratory investment. It is in this context that interventions such as central bank purchase of assets and fiscal stimulus measures that dole out contracts to the favoured do permanent harm to the economy.

The division that matters from the perspective of maintaining the appropriate level of exploratory investment and product innovation is not monetary vs fiscal but the division between existing assets and economic interests and new firms/entrepreneurs. Almost all monetary policy initiatives focus on purchasing existing assets from incumbent firms or reducing real rates for incumbent banks and their clients. A significant proportion of fiscal policy does the same. The implicit assumption is, as Nick Rowe notes, that there is “high substitutability between old and new investment projects, so the previous owners of the old investment projects will go looking for new ones with their new cash”. This assumption does not hold in the case of exploratory investments – asset-holders will likely chase after a replacement asset but this asset will likely be an existing investment project, not a new one. The result of the intervention will be an increase in prices of such assets but it will not feed into any “real” new investment activity. In other words, the Tobin’s q effect is negligible for exploratory investments in the short run and in fact negative in the long run as the accumulated effect of rents derived from monetary and fiscal intervention reduces the need for incumbent firms to engage in such speculative investment.

A Brief History of the Post-WW2 United States Macroeconomy

In this section, I’m going to use the above framework to make sense of the evolution of the macroeconomy in the United States after WW2. The framework is relevant for post–70s Europe and Japan as well which is why the ‘investment deficit problem’ afflicts almost the entire developed world today. But the details differ quite significantly especially with regards to the distributional choices made in different countries.

The Golden Age

The 50s and the 60s are best characterised as a period of “order for all” characterised by as Bill Lazonick put it, “oligopolistic competition, career employment with one company, and regulated financial markets”. The ‘Golden Age’ delivered prosperity for a few reasons:

  • As Minsky noted, the financial sector had only just begun the process of adapting to and circumventing regulations designed to constrain and control it. As a result, the Fed had as much control over credit creation and bank policies as it would ever have.
  • The pace of both product and process innovation had slowed down significantly in the real economy, especially in manufacturing. Much of the productivity growth came from product innovations that had already been made prior to WW2. As Alexander Field explains (on the slowdown in manufacturing TFP): “Through marketing and planned obsolescence, the disruptive force of technological change – what Joseph Schumpeter called creative destruction – had largely been domesticated, at least for a time. Whereas large corporations had funded research leading to a large number of important innovations during the 1930s, many critics now argued that these behemoths had become obstacles to transformative innovation, too concerned about the prospect of devaluing rent-yielding income streams from existing technologies. Disruptions to the rank order of the largest U.S. industrial corporations during this quarter century were remarkably few. And the overall rate of TFP growth within manufacturing fell by more than a percentage point compared with the 1930s and more than 3.5 percentage points compared with the 1920s.”
  • Apart from the fact that the economy had to catch up to earlier product innovation, the dominant position of the US in the global economy post WW2 limited the impact from foreign competition.

It was this peculiar confluence of factors that enabled a system of “order and stability for all” without triggering a complete collapse in productivity or financial instability – a system where both labour and capital were equally strong and protected and shared in the rents available to all.


The 70s are best described as the time when this ordered, stabilised system could not be sustained any longer.

  • By the late 60s, the financial sector had adapted to the regulatory environment. Innovations such as Fed Funds market and the Eurodollar market gradually came into being such that by the late 60s, credit creation and bank lending were increasingly difficult for the Fed to control. Reserves were no longer a binding constraint on bank operations.
  • The absence of real competition either on the basis of price or from new entrants meant that both process and product innovation were low just like during the Golden Age but the difference was that there were no more low-hanging fruit to pick from past product innovations. Therefore, a secular slowdown in productivity took hold.
  • The rest of world had caught up and foreign competition began to intensify.

As Burton Klein noted, “competition provides a deterrent to wage and price increases because firms that allow wages to increase more rapidly than productivity face penalties in the form of reduced profits and reduced employment”. In the absence of adequate competition, demand is inelastic and there is little pressure to reduce costs. As the level of price/cost competition reduces, more and more unemployment is required to keep inflation under control. Even worse, as Klein noted, it only takes the absence of competition in a few key sectors for the disease to afflict the entire economy. Controlling overall inflation in the macroeconomy when a few key sectors are sheltered from competitive discomfort requires monetary action that will extract a disproportionate amount of pain from the remainder of the economy. Stagflation is the inevitable consequence in a stabilised economy suffering from progressive competitive sclerosis.

The “Solution”

By the late 70s, the pressures and conflicts of the system of “order for all” meant that change was inevitable. The result was what is commonly known as the neoliberal revolution. There are many different interpretations of this transition. To right-wing commentators, neoliberalism signified a much-needed transition towards a free-market economy. Most left-wing commentators lament the resultant supremacy of capital over labour and rising inequality. For some, the neoliberal era started with Paul Volcker having the courage to inflict the required pain to break the back of inflationary forces and continued with central banks learning the lessons of the past which gave us the Great Moderation.

All these explanations are relevant but in my opinion, they are simply a subset of a larger and simpler explanation. The prior economic regime was a system where both the invisible hand and the invisible foot were shackled – firms were protected but their profit motive was also shackled by the protection provided to labour. The neoliberal transition unshackled the invisible hand (the carrot of the profit motive) without ensuring that all key sectors of the economy were equally subject to the invisible foot (the stick of failure and losses and new firm entry). Instead of tackling the root problem of progressive competitive and democratic sclerosis and cronyism, the neoliberal era provided a stop-gap solution. “Order for all” became “order for the classes and disorder for the masses”. As many commentators have noted, the reality of neoliberalism is not consistent with the theory of classical liberalism. Minsky captured the hypocrisy well: “Conservatives call for the freeing of markets even as their corporate clients lobby for legislation that would institutionalize and legitimize their market power; businessmen and bankers recoil in horror at the prospect of easing entry into their various domains even as technological changes and institutional evolution make the traditional demarcations of types of business obsolete. In truth, corporate America pays lip service to free enterprise and extols the tenets of Adam Smith, while striving to sustain and legitimize the very thing that Smith abhorred – state-mandated market power.”

The critical component of this doctrine is the emphasis on macroeconomic and financial sector stabilisation implemented primarily through monetary policy focused on the banking and asset price channels of policy transmission:
Any significant fall in asset prices (especially equity prices) has been met with a strong stimulus from the Fed i.e. the ‘Greenspan Put’. In his plea for increased quantitative easing via purchase of agency MBS, Joe Gagnon captured the logic of this policy: ““This avalanche of money would surely push up stock prices, push down bond yields, support real estate prices, and push up the value of foreign currencies. All of these financial developments would stimulate US economic activity.” In other words, prop up asset prices and the real economy will mend itself.
Similarly, Fed and Treasury policy has ensured that none of the large banks can fail. In particular, bank creditors have been shielded from any losses. The argument is that allowing banks to fail will cripple the flow of credit to the real economy and result in a deflationary collapse that cannot be offset by conventional monetary policy alone. This is the logic for why banks were allowed access to a panoply of Federal Reserve liquidity facilities at the height of the crisis. In other words, prop up the banks and the real economy will mend itself.

In this increasingly financialised economy, “the increased market-sensitivity combined with the macro-stabilisation commitment encourages low-risk process innovation and discourages uncertain and exploratory product innovation.” This tilt towards exploitation/cost-reduction without exploration kept inflation in check but it also implied a prolonged period of sub-par wage growth and a constant inability to maintain full employment unless the consumer or the government levered up. For the neo-liberal revolution to sustain a ‘corporate welfare state’ in a democratic system, the absence of wage growth necessitated an increase in household leverage for consumption growth to be maintained. The monetary policy doctrine of the Great Moderation exacerbated the problem of competitive sclerosis and the investment deficit but it also provided the palliative medicine that postponed the day of reckoning. The unshackling of the financial sector was a necessary condition for this cure to work its way through the economy for as long as it did.

It is this focus on the carrot of higher profits that also triggered the widespread adoption of high-powered incentives such as stock options and bonuses to align manager and stockholder incentives. When the risk of being displaced by innovative new entrants is low, high-powered managerial incentives help to tilt the focus of the firm towards a focus on process innovation and cost reduction, optimisation of leverage etc. From the stockholders and the managers’ perspective, the focus on short-term profits is a feature, not a bug.

The Dénouement

So long as unemployment and consumption could be propped up by increasing leverage from the consumer and/or the state, the long-run shortage in exploratory product innovation and the stagnation in wages could be swept under the rug and economic growth could be maintained. But there is every sign that the household sector has reached a state of peak debt and the financial system has reached its point of peak elasticity. The policy that worked so well during the Great Moderation is now simply focused on preventing the collapse of the cronyist and financialised economy. The system has become so fragile that Minsky’s vision is more correct than ever – an economy at full employment will yo-yo uncontrollably between a state of debt-deflation and high,variable inflation. Instead the goal of full employment seems to have been abandoned in order to postpone the inevitable collapse. This only substitutes an economic fragility with a deeper social fragility.

The aim of full employment is made even harder with the acceleration of process innovation due to advances in artificial intelligence and computerisation. Process innovation gives us technological unemployment while at the same time the absence of exploratory product innovation leaves us stuck in the Great Stagnation.


The solution preferred by the left is to somehow recreate the golden age of the 50s and the 60s i.e. order for all. Apart from the impossibility of retrieving the docile financial system of that age (which Minsky understood), the solution of micro-stability for all is an environment of permanent innovative stagnation. The Schumpeterian solution is to transform the system into one of disorder for all, masses and classes alike. Micro-fragility is the key to macro-resilience but this fragility must be felt by all economic agents, labour and capital alike. In order to end the stagnation and achieve sustainable full employment, we need to allow incumbent banks and financialised corporations to collapse and dismantle the barriers to entry of new firms that pervade the economy (e.g. occupational licensing, the patent system). But this does not imply that the macroeconomy should suffer from a deflationary contraction. Deflation can be prevented in a simple and effective manner with a system of direct transfers to individuals as Steve Waldman has outlined. This solution reverses the flow of rents that have exacerbated inequality over the past few decades, as well as tackling the cronyism and demosclerosis that is crippling innovation and preventing full employment.

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Written by Ashwin Parameswaran

November 2nd, 2011 at 7:29 pm

The Influence of Special Interests and Rentiers on Monetary and Fiscal Policy

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Triggered by Robert Kuttner’s column in the American Prospect, the explanation du jour of our current economic malaise blames the ‘rentier class’ i.e. owners of financial assets – the thesis being that wealthy Americans do not want any more inflationary policies to be enacted and may even prefer deflation instead. Paul Krugman argues that wealthy Americans do not want inflation because financial securities are overwhelmingly held by the richest 10% of the population. But what matters for the incentives of rich households is what proportion of their balance sheet is made up of nominal financial securities. And Edward Wolff’s paper shows us that a significant proportion of the balance sheet of wealthy Americans is made up of real assets – real estate, stock and business holdings.

Similarly, a return to deflation will result in a fall in demand for products and services sold by businesses and a deterioration in bank balance sheets with increased and disruptive bankruptcies. As Brad DeLong noted, no one benefits from a deflationary collapse in the economy. A much better explanation is offered by Matthew Yglesias when he observes that “the Fed has hardly been indifferent to the potential for monetary expansion. It’s just that the goal of monetary expansion has been to do just enough to stabilize financial asset prices without going far enough to produce catch-up growth in the labor market.” What wealthy Americans, businesses and banks share is a common interest in supporting asset prices (real and nominal), a lack of interest in seeking full employment unless it is a prerequisite for supporting asset prices, and an aversion to any policies that can trigger wage inflation.

This bias towards asset price inflation doesn’t just impact the amount of stimulus. It has an influence on the type of stimulus that is preferred in this class conflict. The goal of asset price inflation without wage inflation is best achieved by an exclusive reliance on monetary policy – as I discussed in a previous post, a combination of “liquidity” facilities to prevent a collapse in shadow money supply and open market operations/QE to reduce real rates across the risk-free curve. Given the anaemic state of household balance sheets and insensitivity of corporate investment to interest rates due to a cronyist corporate sector, lower rates will not trigger sufficient real economic activity to trigger wage inflation but they will support real asset prices. Even within the ambit of fiscal policy, supply-side incentives for businesses are preferred. Given a less than competitive corporate sector, these will feed through to business profits more than they will feed through to wage inflation and employment.

Some of you may have noticed the distinctly Marxist tone of this debate – an emphasis on class conflict that rarely permeates economic discussion in mainstream circles. This is not a coincidence – as I observed in an earlier post, the dynamics of a crony capitalist economy resemble a zero-sum Marxian class struggle. Rather than expanding the size of the economic pie, economic agents focus their energies on trying to capture a larger slice of a static, stagnant output.

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Written by Ashwin Parameswaran

June 13th, 2011 at 4:58 am