13 May 2014
It has happened often in physics that a single phenomenon is explained, or a single puzzle resolved, by two theories that seem at first sight to be completely divergent but are later shown to be equivalent. Examples that spring to mind are Heisenberg's matrix mechanics and Schrodinger's wave mechanics or the quantum electrodynamic theories of Tomonaga, Schwinger and Feynman. In macroeconomics, the second half of the 20th century was dominated by the dispute between Keynesianism and monetarism, especially their divergent explanations of recessions, a dispute that continues to this day. This paper demonstrates that the conflict hinges on a simple dimensional misinterpretation of one of the variables in the quantity theory of money. At their heart, the two theories are equivalent.
Read the entire paper: The mathematical equivalence of Keynesianism and monetarism
09 May 2014
Primitive tribes must be the most equal of societies. Few of us, though, aspire to that kind of equality.
The thought occurred on reading about (note, not reading) Thomas Piketty's Capital in the 21st century that seems set to be the best-selling economics text of recent times. Piketty, who has in some quarters been hailed as a latter-day Marx, notes that income inequality in the US remained stable from 1910 to 1920, rose from 1920 to 1929, fell steeply after the Great Crash of October 1929 until the end of the war, remained stable until around 1980, and then rose steadily again, until in 2007 it rose above the level of 1928. A graph can be seen on Piketty's web site. To set right what he sees as a dire situation, possibly to prevent a capture of western governments by its poverty-stricken masses, Piketty suggests a general wealth tax and a top income tax rate of 80%.
Piketty seems to think that greater equality is something much to be desired. To test this I searched on the net for inequality measures for the Soviet Union to compare with the US. And I found some interesting figures in a paper Income Distribution in the USSR in the 1980s by Michael V. Alexeev and Clifford G. Gaddy. For the US some comparable figures can be found on the Federal Reserve Bank of St Louis web site.
The table below compares the two:
Readers may recall that the only revolution that happened was in the USSR, not in the US.
Poring over English factory inspector reports in the sixties and seventies of the 19th century Marx reached the conclusion that the overthrow of capitalism was imminent. If nothing else, Marx's prognostications should serve as a warning that one must not use short-term data to jump to eternal conclusions. In the graph the current trend of rising inequality dates from around 1980. Is there any other variable that could explain this as well as the shifts in inequality mentioned earlier: stable from 1910 to 1920, a rise from 1920 to 1929, a fall thereafter until 1945, stable until 1980, and a rise thereafter?
It is illuminating to look at the following graph of US long term interest rates.
It is taken from The real rate of interest from 1800-1990: A study of the US and UK by Jeremy J. Siegel. The graph of inequality on Piketty's site and the interest rate graph here follow a similar trajectory. The period from 1910 to 1920 is a period of rising rates and stable inequality. Thereafter the interest rate falls and inequality grows. Similarly the period from 1980 is a period of rising inequality, and interest rates begin to fall from around that date. The Depression years were an exception. So were the war years but then that was a period of wage and price controls.
One cannot help but feel that low interest rates help push up asset prices and thus boost those who earn a substantial part of their income from financial assets. Now it so happens that the people who complain about rising inequality, Paul Krugman to take one example, are also the ones clamouring loudest for keeping interest rates low. Talk about the law of unintended consequences.
02 May 2014
A mathematical equation that correctly describes a physical relationship between quantities is dimensionally homogeneous. However, the converse is not true. An equation that is dimensionally homogeneous does not imply the existence of a physical relationship between the quantities in that equation. The dimensions of the velocity of money are generally taken to be t-1. In what follows we examine this assumption and show that it is physically impossible. We then show what the correct dimensions of velocity are and arrive at the surprising inference that at their core Keynesianism and monetarism amount to the same thing.
02 April 2014
The velocity of money has a way of frustrating the best-laid plans of central banks. For instance, when the Fed wants to squeeze the growth of money it often finds that velocity increases sharply, so that the same amount of money does much more work than before, thus rendering the constriction of money ineffective. Similarly, when the Fed wants to expand the amount of money, it often finds that the velocity of money falls sharply.
The unpredictability of money velocity was a key factor in hastening the demise of monetarism in the eighties. Economics, the textbook by Paul Samuelson and William Nordhaus, said in the 2005 edition: "As the velocity of money became increasingly unstable, the Federal Reserve gradually stopped using it as a guide for monetary policy... Indeed, in 1999, the minutes of the Federal Open Market Committee contain not a single mention of the term 'velocity' to describe the state of the economy or to explain the reasons for the committee's short-run policy actions."
Economists since Milton Friedman have sought to relate velocity to a number of factors and have been unsuccessful. The graph below will therefore come as an utter surprise to many. It plots the velocity of money against Moody's Seasoned AAA Corporate Bond Yield. For the entire period of five decades, 1960 to 2011 it shows that velocity runs a course exactly parallel to corporate bond yield. No one can be more surprised than I am. The velocity of money graph occurs in my book "The General Theory of Money" published in May 2012 but until now I had never thought of connecting it with interest rates if only because all the papers I had read never spoke of any relation between the two.
The monetary aggregate used in the graph is what I have called Corrected Money Supply in my book. A brief explanation is in order. Assume that you receive a salary of $1000 at the start of every month into your demand deposit. During the course of the month you spend 95% of this and save 5%. So the demand deposit would start at $1000 and run down to $50. However, you choose to keep a little extra in your demand deposit to allow for exigencies, say $500, roughly the value of your demand deposit at the middle of the month. If you add all the funds in all demand deposits in the economy there would thus be a certain amount of money that is never spent. Corrected Money Supply is M1 reduced by this money that is not a medium of exchange but is held purely with a precautionary motive.
One economist who came close to identifying the relation between money velocity and interest rates was John Tatom. In a 1983 paper called "Was the 1982 velocity decline unusual?" published by the Federal Reserve Bank of St Louis he observed that during numerous recessions after 1947 the velocity of money fell. He was, however, puzzled by the fact that in the 1970 and 1973-75 recessions the velocity rose. After some analysis he concluded: "Explanations that focus on declining interest rates also do not match up well with the recent pattern of velocity declines. In the first quarter of 1982, corporate Aaa bond yields averaged 15.01 percent and had risen from 14,62 percent one quarter earlier or 14.92 percent two quarters earlier. During the remaining quarters of 1982, the bond yield declined to 14.51 percent, 13.75 percent and 11.88 percent.9 The pattern in the second half of 1982 is consistent with a decline in velocity. What remains unexplained, however, is the largest decline in velocity, which occurred in the first quarter."
If Tatom had had the right monetary aggregate he would have reached different conclusions. He would also have realised that if money velocity falls during most recessions it is because usually interest rates fall during recessions.
The mechanism relating a rise in interest rate to a rise in velocity (or as it has been sometimes called, the case of the missing money), is quite simple. But for economists who have been brought up to view money in a particular way it is very difficult to grasp.
17 December 2013
On 31 July 2013 the Bureau of Economic Analysis of the USA released the initial results of the 14th comprehensive revision of the National Income and Product Accounts.
Many of the revisions were marginal. For example, the average annual GDP growth rate for 1929-2012 was 3.3 per cent, which was just 0.1 percentage point higher than in previous published estimates. Similarly, the average annual increase in the price index for gross domestic purchases for the period 1929-2012 was lowered from 3 per cent to 2.9 percent.
However, the estimates for personal income, disposable personal income and personal saving have undergone huge revisions. These revisions are mainly the result of using an "accrual approach for measuring defined benefit pension plans".
Under the new system, the sum of employers' actual and imputed contributions is the accrual-basis measure of the compensation income that employees receive from their participation in defined benefit pension plans. According to the BEA, "accrual accounting is preferred over cash accounting for compiling national accounts because it aligns production with the incomes earned from that production and records both in the same period; cash accounting, on the other hand, reflects incomes when paid, regardless of when they were earned". If you don't understand this, don't worry.
The Figure below shows the estimates for personal saving in June 2013 and then again in December 2013 for the period from 2001 to 2013. The new estimates are higher than the older estimates for 2001 to 2007, lower for 2008, and higher again from 2009 onwards. For October 2001, the new estimate is nearly 200% higher than the old one. For November 2001 it is nearly 100% higher. For April 2005 it is again nearly 100% higher.
When a mere accounting change results in such gargantuan revisions it is of course necessary to take a closer look.
On juxtaposing the old and new estimates for personal saving with the S&P 500 for the same period, as in the figure below, some patterns emerge. It is only during 2008 that the old estimates are higher than the new estimates. This also happens to be a period when the S&P 500 was falling. What this suggests is that much of the change is the result of the stocks being held by pension funds. It is true that in 2001 and 2002 when the S&P 500 was falling the new estimates were higher than the old ones, but again this can be explained by the fact that pension funds also held mortgage and mortgage-related bonds that were rising during the period.
During periods when the S&P 500 or the real estate market was rising rapidly employers needed to make little or no contribution to defined benefit pension funds. The rising value of the funds' assets accounted for the employers's "imputed contribution". The BEA's error is of course in adding the rise in value of DB pension fund assets to employees' income, disposable income, and personal saving, although the increase in no way adds to employees' current income and of course it adds nothing to employees' disposable income because they never get to lay their hands on it. What the BEA likes to call higher personal income is contributed neither by production during the period nor by employers but is simply a reflection of higher markets. After 2008 one could say without much exaggeration that it is a direct result of QE.
The BEA justifies its new definition of personal income by saying it is consistent with business accounting. But a commonplace of business accounting is that the difference between the recorded value of available-for-sale securities and their fair market value is added to the equity section (or comprehensive income) of the balance sheet, and not to the current year's net income. The latter is of course what the BEA's change in accounting policy amounts to.
Whatever the faults of the old cash-accounting method it related sensibly to reality unlike the new accrual method.