Beware of Economic Textbooks

by Dan Lieberman, Alternative Insight

Protests by British university economic students, whose demonstrations have been backed by prominent academics, highlight the notion that economic education is dominated by theories that defy practical applications and applications that can not predict, prevent or ameliorate periodic crises. Students learn economics from unverified theories, many contradicting each other, which leads to a confused understanding of the discipline and complicates approaches to resolve problems. Adding to the dilemma is that textbooks in Middle Schools, High Schools and universities lack updates with recent knowledge and contain dubious propositions. It is time to examine several propositions that are prominent but seem dubious.

This examination, which is not absolute, is intended to arouse discussion and serve to gauge if the propositions should be restated or expunged from economic text books.

1. Laffer curve
2. Philips Curve
3. Disposable income
4. Keynes Multiplier
5. Okun unemployment
6. Money multiplier

Laffer Curve

The Laffer Curve graphs a hypothetical relationship between tax rates and tax revenue collected by a government. Is it a correct curve and is it important?

Arthur Laffer, one of President Reagan’s Economic Policy advisors, credits Ibn Khaldun, a 14th century philosopher, as being the originator of the curve. The Arab philosopher wrote:

“It should be known that at the beginning of the dynasty, taxation yields large revenue from small assessments. At the end of the dynasty, taxation yields small revenue from large assessments.”

The first observation is that if there is an optimal tax rate for tax revenue it depends on several dynamic factors — the state of the economy, the health of the financial markets, type of government spending, and the dependence of the system on subsidies and welfare. Certainly the tax rate for maximizing government revenue is different during a depression than in prosperous times.

Secondly, an economic system can be devised where close to 100% tax rates provide substantial tax revenue. Even if the government takes almost 100% in taxes, the federal spending can be arranged to reapportion payments to taxpayers and provide subsidies, in effect, creating an artificial re-distribution of income in a highly centralized system that allows free enterprise.

Contradictory studies, no accepted theoretical proof, and no proven applications indicate the Laffer curve has prompted exaggerated attention. A New Palgrave Dictionary of Economics report, summarized at, http://en.wikipedia.org/wiki/Laffer_curve describes the contradictions in studies.

…a comparison of academic studies yields a range of revenue maximizing rates that centers around 70%. Economist Paul Pecorino presented a model in 1995 that predicted the peak of the Laffer curve occurred at tax rates around 65%. A 1996 study by Y. Hsing of the United States economy between 1959 and 1991 placed the revenue-maximizing average federal tax rate between 32.67% and 35.21%.

The clincher is the historical record. Irrespective of the direction of tax rates, federal tax revenues after 1950 have monotonically increased, except for slight dips during recessions and large excursions during periods of severe economic decline. If there is an optimum tax rate for maximizing government revenue, the rate is masked by the continual rise in earnings and GDP.

Conclusion: The Laffer Curve has not had empirical support and is no proven guide for tax policy. The optimum tax depends upon the effects of government spending and the economic moment.

Philips Curve

The Philips curve has had several transitions from its original concept. Its inception started from a paper in 1958 titled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, which was published by William Phillips, a New Zealand born economist in the quarterly journal Economica. Phillips described an apparent inverse relationship between wage changes and unemployment in the British economy during a one hundred year period. Because wage and price inflation move together, Paul Samuelson and Robert Solow determined there must be a link between inflation and unemployment; when inflation was high, unemployment was low, and vice-versa.

Milton Friedman and others modified the concept by agreeing the Phillips Curve existed in a short run, but not in the long run, and concluded there was no trade-off between unemployment and inflation.

Historical data during the period from 1990-1999, which shows inflation and the unemployment rate decreasing together, refutes the Philips curve.

Federal Reserve Bank of San Francisco
http://www.frbsf.org/education/publications/doctor-econ/2008/march/phillips-curve-inflation

Attempts to explain the obvious refutation of the Philips curve during the Clinton presidency from 1991 to 1999 are meaningless – a theory that does not include all varying inputs and is incorrect for any part of the time (other periods have also contradicted the curve) is conjecture and not a theory.

An explanation for why inflation sometimes occurs when unemployment decreases may be more due to the euphoria in an expanding economy. As the economy looks bright, the bright start to borrow, which raises asset values and demand. If the money supply creates demand that swells beyond production capacity, then prices are sure to rise. And if the government continues to run deficits, which adds to the money supply, the pressure on prices increases. During the Clinton administration, the government ran surpluses, which lowered demand and maintained prices.

Thus, it is incorrect to attribute decreasing unemployment to increasing inflation and vice-versa; it is the optimistic market and uncontrolled money supply expansion that causes the inflation. Actually, as the industrial base and employment expand, costs should decrease – economies of scale grow and fixed costs become a lesser cost of each production item, at least until the marginal revenue for each new worker starts to decrease.

A tight labor market often leads to higher wages and statistics indicate an accompanying inflation. The chart below shows that for thirty years, the Consumer Price Index (CPI) has kept wages constant with inflation. This does not mean that elevated wages have accelerated inflation; it means that managers refuse to lower their profit margins maintaining them consistent with costs, even though absolute profits may rise rapidly.

Disposable income

Disposable income is defined in text-books as total personal income minus total personal current taxes.

Is this true?

Are not all taxes transferred back to the economy and able to provide income to others? Individuals may have their disposable income reduced by taxes, but does not the disposable income of the entire population remain the same?

As a simple example, let us have the tax revenue used to support government workers. In effect, disposable income has been transferred from the private sector to the public sector, but remains the same. The civil service workers also pay taxes and their taxes may support wages in a defense industry. Continue through continuous quick cycles of pay-as-you-go-taxation and government spending and we find that disposable income for the entire population is always equal to income. The regeneration of taxes and income follows the geometric series shown below, where t is the tax rate.

(1-t) + (t- t2) + (t2-t3) + …(tn-1-tn) = (1-t) (1 + t + t2 + t3 +…tn) = (1-t) /1-t = 1

Keynes GDP multiplier

I am surprised at the trust given to the Keynesian Multiplier. From my perspective it detracts from the economist’s efforts and places him in an awkward position. The explanation of the Keynesian “multiplier” from https://wiki.ubc.ca/Keynesian_Multiplier is as follows:

The intuition comes from the fact that the marginal propensity to consume (MPC) is positive. MPC is the money people spend when they get an extra dollar of income. When MPC = 0.8, for example, when people gets an extra dollar of income, they spend 80 cents of it. So the Keynesian multiplier works as follow, assuming for simplicity, MPC = 0.8. Then when the government increases expenditure by 1 dollar on a good produced by agent A, this dollar becomes A’s income. As MPC = 0.8, A will spend 80 cents of this extra income on something is wants to consume. Suppose A spends the 80 cents on a good produced by B, then B would have an extra income of 80 cents. B would then spend 0.8 of this 80 cents, ie, 64 cents, on something else. This 64 cents becomes someone else’s income, and this someone will spend 0.8 of it. The process repeats itself. The GDP added to the economy is the sum of all the spending, 1 + 0.8 + 0.64 + 0.512 + … which has a larger effect than the 1 dollar that the government originally spent. In other words, the government spending is “multiplied”. Mathematically, the sum 1 + 0.8 + 0.64 + … is a geometric series. When you sum them up, it takes the form 1/1-MPC. For MPC = 0.8, the effect of the government spending is multiplied 5 times.

Very good, except for two consideration, (1) the exact multiplier value (5 in this instance) requires an infinite number of transactions, which will take an infinite number of years, and (2) spending on goods (not services, which is not in the multiplier) does not generate more spending; the spending goes to the entrepreneur and generates new investment. Government deficit spending only adds to the money supply, to either purchase unsold goods, purchase new goods, provide profit or, if entering the market when production capacity has been reached, stimulate an increase in prices. During the last years of deficit spending the GDP has risen slowly and profits have risen greatly.

If taken at face value, The Keynesian Multiplier hits a theoretical inconsistency; when MPC = 1, the multiplier becomes infinite, and the era of abundance has been reached. Actually a MPC = 1 signifies that if the total of the original investment is spent and continues to be totally spent, then, after an infinite number of spendings of the initial investment, the total contribution to GDP during the infinite period will total infinity.

The contribution of exogenous investment to an economy in any one year depends upon the number of business cycles from the investment, which is a function of the velocity of money. If the MPC is < 1, then in each succeeding business cycle the contribution to GDP will continually decline until it becomes nil. Rather than being a “multiplier,” the formula is actually a “divider.” If there is only one business cycle in the first year then the contribution to GDP cannot exceed the deficit spending, the “multiplier” cannot be more than one and the contribution to GDP cannot be more than the exogenous investment during that year and succeeding years.

Okuns Law

Former Federal Reserve Chairman, Ben Bernanke has summarized Okun’s Law:

Okun noted that, because of ongoing increases in the size of the labor force and in the level of productivity, real GDP growth close to the rate of growth of its potential is normally required, just to hold the unemployment rate steady. To reduce the unemployment rate, therefore, the economy must grow at a pace above its potential.

More specifically, according to [the] currently accepted versions of Okun’s law, to achieve a 1 percentage point decline in the unemployment rate in the course of a year, real GDP must grow approximately 2 percentage points faster than the rate of growth of potential GDP over that period. So, for illustration, if the potential rate of GDP growth is 2%, Okun’s law says that GDP must grow at about a 4% rate for one year to achieve a 1 percentage point reduction in the rate of unemployment.

Here we are faced with vague expressions – real GDP growth, GDP potential growth, unemployment. How are they defined, especially unemployment? Is teen age unemployment the same as that of experienced workers? Does the gain in the former contribute as much to GDP as a gain in the latter?

Edward S. Knotek, a vice president at the Federal Reserve Bank of Cleveland, has examined Okun’s law. His Kansas City Federal Reserve Bank publication, How useful is Okun’s law? is available at http://www.kc.frb.org/publicat/econrev/pdf/4q07knotek.pdf

First among these is that Okun’s law is not a tight relationship. There have been many exceptions to Okun’s law, or instances where growth slow downs have not coincided with rising unemployment. This is true when looking over both long and short time periods. This is a reminder that Okun’s law-contrary to connotations of the word “law”-is only a rule of thumb, not a structural feature of the economy.

This article has also documented that Okun’s law has not been a stable relationship over time. Part of this variation is related to the state o fthe business cycle: The relationship between output and unemployment is different in recessions and expansions, and recent expansions have been longer than average. Additionally, the data suggest that a weakening of the contemporaneous relationship between output and unemployment has coincided with a stronger relationship between past output growt hand current unemployment. This finding favors versions of Okun’s law that are less restrictive in the timing of this dynamic relationship. These findings have practical applications. For instance, forecasting the unemployment rate via Okun’s law is much improved by taking into account its changing nature. These forecasts can be improved even more by allowing for a dynamic relationship between unemployment and output growth.

Despite some rationalizations that approve use of Okun’s law, Knotek’s review does not give Okun’s law a strong validation; mainly saying that under some conditions Okun’s law may apply.

What bothers me is how is GDP defined? If it is defined as the total sale of goods and services, then the law faces problems – service revenue, which can pass funds from one service to many others without creating new funds, is able to contribute to rapid GDP growth without unemployment growth by having service personnel work more hours or charge more for their labors, or service revenue can grow slowly while employment grows quickly when added employment of service workers consists mainly of low paying jobs.

If GDP is defined only for the goods industries, then it depends on more than employment – include the balance of payments, private borrowing and government deficits.

All Okun’s law says is if employment increases, the GDP will also increase and vice versa.

Money Multiplier

Text books explain the money multiplier by describing how Fractional Reserve Banking works.

Banks are required to keep a certain percentage of deposits as reserves, presently a 10% amount for deposits more than $103.6 million. Because each loan becomes a deposit, which is subjected to the 10% reserve requirement, the entire banking system deposits grows with each loan and, unless limited by other rules, the banking system can potentially lend ten times its initial deposits.

The text book description for the money multiplier is not entirely accurate, the mistake being that deposits do not govern loans; loans determine deposits. Realizing the public’s gap between truth and belief, the Bank of England, has published a report that clarifies the issue. The complete report, which is partially summarized below, can be read at:

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves – that is, interest rates. In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks.

Banks first decide how much to lend depending on the profitable lending opportunities available to them – which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England. Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.

This description of money creation contrasts with the notion that banks can only lend out pre-existing money. Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out. A related misconception is that banks can lend out their reserves. Reserves can only be lent between banks, since consumers do not have access to reserves accounts at the Bank of England.

Time to re-evaluate accepted economic concepts and correct text book explanations of these topics.