Sunday, November 15, 2009

Financial Deregulation and Origin of the Financial Crisis of 2008

Many neoliberals, New Classical economists and other defenders of free market economics argue that financial deregulation was not a fundamental cause of the crisis of 2008.

One recent aspect of the debate has been the assertion of Eugene Fama, who is from the University of Chicago and father of the “efficient market hypothesis,” that financial deregulation and international capital flows led to “a period of extraordinary growth” from the early 1980s in the developed world and some parts of the developing world.

Paul Krugman has demonstrated how utterly false this idea is in his New York Times blog.

Financial deregulation is not correlated with better or faster growth. In fact, in the wake of financial deregulation in the 1980s, average GDP growth rates in the Western world fell sharply, as compared with the extraordinary period of post-WWII prosperity now known as the Golden Age of capitalism (1945–1973). This period was the Bretton Woods era of Keynesianism, social democracy, and financial regulation.

Angus Maddison, Emeritus Professor at the Faculty of Economics at the University of Groningen, is widely recognized as a leading scholar on the history of rates of economic growth. In 1995, Maddison published a study called Monitoring the World Economy 1820–1992 (OECD Development Centre, Paris, 1995), the first authoritative study on the effects of globalization and neoliberalism on growth rates in the developing and developed world, as compared with the Bretton Woods era. He compared growth rates both in GDP and per capita GDP in seven major regions of the world from 1950 to 1973 with those in the early era of globalization (1974-1992). He found that there were significant declines in the average annual growth rates in six of the seven areas: in fact the average annual rate of growth of world GDP was only half of what it had been under Bretton Woods. That is, world economic growth was about 50% lower than in the Bretton Woods era.

The only region that showed an increase was East Asia, precisely the region dominated by the protectionist state-led model of industrialization, led by Japan, South Korea, Taiwan, and (from the early 1990s) China.

Maddison’s study was updated by the Centre for Economic Policy Research (CEPR) in 2001 in the Scorecard on Globalization 1980–2000: 20 Years of Diminished Progress (July 2001).

Since the full effects of the collapse of Bretton Woods were not really felt until after 1979, their updated version which studies economic growth rates from 1980 to 2000 gives us a much more accurate measure of the consequences of orthodox neoliberalism or globalization on the world economy. The era of globalization was a disaster for much of the Third World. In Latin America (where the adoption of neoliberalism was somewhat later than in the West), real capita GDP grew by 82 percent from 1960–1980. But from 1980–2000, per capita GDP grew by only 9 percent.

However, it is correct that global poverty has fallen over the last 20 years: but the overwhelming number of such people are in China and India, where governments largely reject the policy prescriptions of globalization/neoliberalism. In India and China, for instance, there are still capital controls that prevent “hot money” from flowing in and out and destabilizing the economy.

But the devastating proof of the failure of globalization is the fact that those countries that have followed the rules – in Africa, the Caribbean, Latin America, and the former Soviet Union – have seen growth rates collapse to a level lower than the Bretton Woods era, and in some areas poverty rates have got worse.

The era of globalisation between about 1980 and the early 2000s was characterized by extreme financial liberalization in comparison with the 1945–1980 period of tight and effective financial regulation.

One simply cannot deny that in comparison with the 1945-1980 period, the last 20 years have characterized by a major trend towards deregulation.

For instance, from about the 1930s to the 1980s, many countries had policies of financial regulation that included many of the following:
1. Interest rate ceilings
2. Liquidity ratio requirements
3. Higher bank reserve requirements
4. Capital Controls (that is, restrictions on capital account transactions)
5. Restrictions on market entry into the financial sector
6. Credit ceilings or restrictions on the directions of credit allocation
7. Separation of commercial from investment (“speculative”) banks
8. Government ownership or domination of the banks.
(Ito 2009: 431–433).
These were abolished as financial liberalization and capital account liberalization became widely adopted in the 1980s and 1990s.

In the case of the US, we can point to a number of important acts of financial deregulation that were the direct causes of the crisis:
(1) Repeal of the Glass-Steagall Act (1999)
In the US, the Glass-Steagall Act, initially created in the wake of the Stock Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities. This led to segregation of investment banks from commercial banks. Glass-Steagall was effectively repealed for many large financial institutions by the Gramm-Leach-Bliley Act in 1999.
Joseph Stigliz has argued that

“The most important consequence of the repeal of Glass-Steagall was indirect—it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns” (Stiglitz 2009).

Deposit insurance does make sense when it protects a commercial banking sector prevented from making highly speculative and risky investments.

(2) Hiding Liabilities on Off-Balance Sheet Accounting
Banks used off-balance sheet operations called special purpose entities (SPEs) or special purpose vehicles (SPVs) to take on toxic asset-backed securities. This allowed banks to escape even the weak regulation of Basel I and II. It is estimated that the top 4 U.S. depository banks put around $5.2 trillion into SIVs.

(3) Commodities Futures Modernization Act (CFMA), 2000
This exempted financial derivatives, including credit default swaps, from regulation.

(4) The SEC’s Voluntary Regulation Regime for Investment Banks, 2004-2008
The SEC's Consolidated Supervised Entity (CSE) regime was introduced in 2004. It allowed investment banks to engage in their own net capital requirements in accordance with the standards of the Basel Committee on Banking Supervision. It was voluntarily administered, and the result was that investment banks pushed borrowing ratios to as high as 40 to 1, as in the case of Merrill Lynch.
One major confirmation of the effectiveness of financial regulation is the state of Canada’s banking system. In 2008, the World Economic Forum ranked Canada's banking system as the soundest in the world. The US system was ranked at number 40, and Germany and Britain ranked 39 and 44. Canada’s banks required no direct government bailouts.

Some commentators blame Basel I and II as a major cause of the financial collapse.
But if Basel I and II led inevitably to asset bubbles and financial collapse, then why has this not occurred in Canada?

The answer is fairly simple: Canada, unlike many other Western countries, still has tight and effective banking regulation.

That the role of Basel I and II in the present crisis is exaggerated is suggested by the fact that
“Canadian banks were the first in the world to adopt risk-management approaches under the new international Basel II capital framework, which sets out rigorous requirements to ensure a bank holds adequate capital reserves appropriate to the risk it is exposed to through its lending and investment practices. Canada's banks offer haven in turbulent sea, Vancouver Sun, Saturday, September 27, 2008
Furthermore, neither investment banks nor hedge funds (essentially the shadow banking sector) were really subject to Basel rules, yet these were the sectors of the financial system where the crisis originated: thus it was the investment banks Bear Stearns and Lehman Brothers that first collapsed in 2008. Furthermore, even commercial banks could evade Basel by creating SIVs, which were not subject to Basel I and II capital regulations.

All in all, this crisis was clearly caused by a spectacular failure of regulation.

Bill Mitchell of Billy Blog, a neochartalist economist in the post Keynesian tradition, has proposed set of new financial regulations that command respect. He proposes the following:

– commercial banks should only lend directly to borrowers: all loans would have to be shown and kept on their balance sheets
– an end to third-party commission deals which might involve banks acting as “brokers” and on-selling loans or other financial assets for profit
– banks should not be allowed to accept any financial asset as collateral to support loans. The collateral should be the estimated value of the income stream on the asset for which the loan is being advanced
– banks should be banned from having “off-balance sheet” assets
– banks should be banned from trading in credit default insurance.

Billy Blog, Asset Bubbles and the Conduct of Banks, 2 October, 2009

These policies should be the starting point of any sensible response to the financial crisis of 2008.

Ito, H. 2009. “Financial Repression,” in K. A. Reinert, R. S. Rajan et al. (eds), Princeton Encyclopedia of the World Economy, Princeton University Press, Oxford and Princeton, N.J.

Wade, R., 2008, “Financial Regime Change?” New Left Review 53 (September-October),

Stiglitz, J. E., 2009, “Capitalist Fools,” Vanity Fair (January)

Weissman, R., 2009, “Reflections on Glass-Steagall and Maniacal Deregulation” (November 13),

Monday, August 17, 2009

Capital Controls, Financial Regulation and the Global Economic Crisis of 2008–2009

In 2008–2009, the world has seen the worst financial crisis since the Great Depression.

In 2002–2004, large amounts of money flowed into the US from East Asia and oil-producing countries at a time when the US Federal Reserve had an easy money policy of low interest rates.

The blogger Cynicus Economicus has argued that
This massive wall of money invested into consumer borrowing created a fundamental problem. In simple terms, the first tranche of money invested ought to find the cream of the investment opportunities. However, as more money enters the system, good opportunities become scarcer – but it must still ‘go’ somewhere. In such circumstances, the capital is allocated to ever riskier investments, which explains the rise in popularity of collateralised debt obligations (CDOs) and other, similar financial instruments. These practices were simply a method of burying bad investments, while creating an illusion of continued low risk … In such a situation, we can see the roots of the house-price boom in the US, UK, Spain and Ireland (among other places) – a classic asset-price bubble in which there was a massive increase in the supply of money and the money simply chased an asset-base that could not expand as fast as the supply of money. A boom in land and property prices was inevitable …
Thus Cynicus Economicus contends that the flood of money from the East to the West with insufficient investment opportunities to “soak up” the money was the underlying and real cause of the crisis. Furthermore, it is claimed that nobody can show how “any regime might have coped with the influx of money from the East” since the “the money coming from the East created a circumstance that was entirely novel in the West.” Thus “the money would have arrived in the economy, and bubbles would [have appeared].” (see note 1 below).

This thesis, I believe, is false. The situation was not novel, and there were clearly ways in which the West could have prevented the asset bubbles.

Was There No Way to Prevent Asset Bubbles in the West?
First, it is simply not true that the flood of money flowing into the West from 2000 to 2006 was unprecedented or novel. There is an obvious historical parallel: the petrodollars that started flooding into London and New York banks in 1973–1974 and 1979 after the “oil shock” price surge. In 1974, the Arab oil-producing countries had a current account surplus of $68 billion US, which they mostly invested in the West (in 2007 inflation-adjusted US dollars that would be the equivalent of $285 billion entering the US economy). In 1975, these countries had a surplus of US $92 billion, an even greater amount.

And yet the Western financial system was not destroyed by large destructive asset bubbles in these years. Why?

The reason is that we had effective financial regulation that still existed before the onslaught of deregulation in the 1980s and 1990s.

Secondly, controls on capital inflows were actually a regular part of capital controls in the Bretton Woods era and in some countries well into the 1980s (Goodman and Pauly 1993: 282).

The dangers of large destabilizing capital inflows into an economy are well known. They can result in:
(1) damaging appreciation of a nation’s exchange rate that harms its exports and trade;

(2) short-term capital or “hot money” that causes financial instability and rapid outflows due to irrational herd behaviour and in turn balance of payments crises, and

(3) asset price bubbles, if there are very large inflows (Magud and Reinhart 2007: 647).
There are effective ways to prevent all these things. For instance, in Europe, which experienced large petrodollar inflows in the 1970s,
“capital controls and domestic bank regulations … separated Eurocurrency markets from the corresponding national markets … [For instance, there were] controls on capital inflows designed to keep a strong currency from becoming stronger … [in the 1970s] the German authorities attempted to discourage capital inflows through a variety of means, including a 60% marginal reserve requirement on bank liabilities to foreigners and a 50% cash deposit ratio on foreign borrowing (Herring and Litan 1995: 33–34).
International financial centres at Paris and Frankfort remained heavily regulated until the 1980s (Jones 1996: 188). As late as the 1970s, both Switzerland and Germany imposed controls on capital inflows to prevent currency appreciation and too rapid an expansion of their domestic money supplies from foreign inflows (Quirk 1995: 9). Germany, in particular, did so during 1971–1975 and from 1977–1981, precisely the time when petrodollars were flooding into Europe through Eurodollar markets. It is no surprise that, despite the massive flood of money in the 1970s, there were no destructive asset bubbles in the West.

Charles Kindleberger in the classic Manias, Panics, and Crashes: A History of Financial Crises (5th edn, John Wiley and Sons, 2005) shows that financial crises are a perennial characteristic of unregulated financial systems: from 1725 to 1929 destructive bubbles have occurred roughly every eight and half years in the West. But they largely disappeared in the Bretton Woods era (1945–1973).

Capital account liberalization and deregulation of financial markets started in the 1970s and intensified in the 1980s and 1990s. The results have been predictable: a massive rise in financial crises and destructive asset price inflation.

Quite simply, an important real cause of the crisis and the asset bubbles was capital account and financial liberalization. It is utterly false to say that real estate and stock market bubbles are inevitable.

Note 1
The views of Cynicus Economicus are presented in these articles:
“Five minutes to midnight,” Trade and Forfaiting Review 12.5 (23 March, 2009)

“Underlying Economic Crisis Caused Financial Crisis,”

Calvo, G. A., Leiderman, L. and C. M. Reinhart, 1994, “The Capital Inflows Problem: Concepts and Issues,” Contemporary Economic Policy 12 (1994), 54–66.

Goodman, J. and L. Pauly, 1993, “The Obsolescence of Capital Controls? Economic Management in an Age of Global Markets,” in J. A. Frieden and D. A. Lake, International Political Economy: Perspectives on Global Power and Wealth, St. Martin's Press, New York, 1991. 280–298.

Herring R. J. and R. E. Litan, 1995, Financial Regulation in the Global Economy, Brookings Institution, Washington, D.C.

Jones, G., 1996, The Evolution of International Business: An Introduction, Routledge, London and New York.

Magud, N. and C. M. Reinhart, 2007, “Capital Controls: An Evaluation,” in S. Edwards (ed.), 2007, Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences, University of Chicago Press, Chicago and London. 645–674.

Quirk, P. J., Evans, O., Gajdeczka, P. et al., 1995, Capital Account Convertibility: Review of Experience and Implications for IMF Policies, International Monetary Fund, Washington, DC.

Rajan, R. S., and I. Noy, 2008, “Capital Controls” in K. A. Reinert, R. S. Rajan et al. (eds), The Princeton Encyclopedia of the World Economy, Princeton University Press, Princeton, 2009. 152–156.

Appendix 1: Capital Controls in the West

You can see here when capital controls were abolished in most Western countries. It is clear that throughout the 1970s Western countries were protected from damaging capital inflows.

UK – 1979, capital controls abolished.

Japan – 1980, capital controls abolished.

Germany – 1958, abolition of control on capital outflows; severe restrictions on inflows until 1969, then again from 1971–1975 and 1977–1981; final abolition of remaining controls in 1981.

Australia – 1983.

New Zealand – 1984.

Netherlands – 1986.

France – 1989, remaining controls abolished.

Tuesday, August 4, 2009

Deflation, the Business Cycle and Depression: Is There a Link?

In a recent post on the blog of Cynicus Economicus, there is an interesting discussion on deflation:
Deflation is a decrease in average prices throughout an economy. It is often accompanied by cuts in nominal wages. It is very important to emphasise this definition of deflation: by using the word “deflation” in this article, I am not talking about a decline in the prices of only one or two goods in an economy. Nobody, for instance, denies that specific price deflation in computers (caused by industry producing increasingly cheaper and better computers) is a good thing. But, when average prices across an economy fall in a significant way, you have general deflation, and this is a very different phenomenon from decreases in the prices of a few consumer goods that do not drag down the average price level.

With the exception of Japan in the 1990s, sustained and general price deflation is not something we in the West have seen since the 1930s.

The depressions of 1921–1922 and 1929–1933 were accompanied by severe deflation, and so were depressions in the classical gold standard era.

After World War II, deflationary busts were no longer a feature of the business cycle. The reason this happened was that the business cycles of the post World War II era have been fundamentally different from those before the 1930s. In essence, the gold standard era had its own distinctive business cycle. Before 1931/1933, the West was on gold standards of various types. The UK, for instance, was on the gold standard between 1819–1914 and a gold exchange standard from 1925–1931. The US had a de facto gold standard from 1834.

The age of the classical gold standard, when many other countries adopted the system, was roughly from the 1870s/1880s until 1914.

The gold standard era had its own particular type of business cycle. In that era, contractions in the economy (busts) were usually shortly preceded by the collapse of speculative bubbles and accompanied by general deflation. That is to say, as output collapsed and the economy contracted, deflation was a concomitant feature of the contraction.

I. Does Deflation Cause Depression?
It is certainly the case the price deflation was not in general the cause of gold standard depressions. There are few economists who seriously argue that general price deflation is a single, overarching and actual cause of contractions in the business cycle. Rather, price deflation was a regular characteristic (or symptom) of a contraction in the business cycle. As an economy contracted, at the same time it experienced deflation. The actual causes of recessions and depressions are varied and different from deflation, although deflation could in theory make a depression worse.

Since depressions and recessions in the gold standard era were nearly always deflationary, this is where the link between deflation and depression originates.

But the question whether sustained deflation during a contraction in the business cycle exacerbates depressions (rather than causes them) is, of course, a completely different question, and the volume of evidence suggests that deflation does indeed make depressions or recessions worse.

II. Has Deflation Accompanied a Growth in Output?
Yes, without a doubt. In the 19th century, there was a period of sustained deflation that lasted from 1873 to 1896. The period, however, was not one of continuous economic contraction: there were internal periods of economic growth and contraction (expansions and depressions). The entire period from 1873–1896 was not a “depression” in the accepted sense, but a period where prices showed a general trend towards deflation. The conventional explanation for this prolonged price deflation is that in this period there was an inadequate expansion in the money supply: money demand outstripped supply (money being tied to gold in this era).

To study this period, we can take England as an example. From 1873–1896, England experienced price deflation, but had a number of business cycles you can see here:
1873–1879, depression
1879–1883, expansion
1883–1886, depression
1886–1890, expansion
1890–1894, depression.
Thus there were three economic contractions (genuine downturns in the business cycle, with slumping production, unemployment etc) in this period, but there were two periods of expansion: during these booms output increased despite general deflation, and overall the period saw increased output. So it must be admitted that the idea that deflation only occurs during depressions or recessions is a myth.

Cynicus Economicus argues that
It is worth noting that, if wages were to remain static in monetary unit terms during a period of steady deflation, the recipient of the wages would find the purchasing power of their wage increasing.
This is correct. In the period from 1873–1896, nominal wages did not fall significantly or as fast as prices. This meant that real wages actually rose and living standards rose as well.

However, it should be noted that, apart from the period 1873–1896, expansions in the gold standard era tended to be inflationary. For example, the sustained boom that began in 1898 in most countries and that continued until 1913 was inflationary.

But Cynicus Economicus goes on to argue that
if wages were to remain static in monetary unit terms during a period of steady deflation, … the person would, in real terms, see an increase in their wealth. Even if the person’s wage were to decrease in a period of deflation provided that the decrease is less than the rate of deflation, they would still be seeing an increase in their wealth. Why such an outcome might be viewed as problematic is entirely unclear.
The fatal flaw in this argument is that it fails to take account of the effects of large amounts of debt (or other fixed contracts like leases) during unexpected deflationary periods. If nominal wages remain constant but prices of goods fall (and hence sales earnings), eventually this will cause profits to fall if companies have debt to service or rent to pay.

III. Debt Deflation: It Creates Deeper and Longer Recessions
Cynicus Economicus argues that
That depression might create deflation is not to say that the deflation is itself problematic. When looking at the deflation scare, it is a genuine puzzle that the scare has been allowed to gain so much traction. There is simply no evidence that a deflation would take the economy deeper into depression.
It is correct that deflation is not generally the initial cause of recessions. It could even be said that, under certain circumstances, deflation itself is not problematic.

But under a combination of certain factors, deflation will be catastrophic.

When there is a depression or recession, and deflation occurs, there are reasons why deflation can cause deeper economic contractions. The crucial point is that, if there is a very high level of debt before a recession begins, then deflation can have devastating effects.

Quite simply, Cynicus Economicus does not address the issue of profit and wage deflation, loss of consumer income, and the effects of continuing deflation.

It is the interaction of factors caused by deflation in a recession that can lead to a self-reinforcing downward spiral of prices, profits and wages.

The crucial factor is that the deflation continues. If prices fall, eventually profits fall as well, and employers must cut wages or reduce employment.
Because of wage “stickiness,” businesses will often be forced to reduce employment, rather than reduce wages. Debtors will suffer when they become unemployed and have no income.

Recessions can cause deflationary pressures. When demand falls and consumption falls sharply, first inflation falls through distress selling. If demand and consumption do not recover (or indeed become worse), this cost cutting caused by businesses reducing excess inventory will result in actual deflation. During this process unemployment rises and there will be downward pressure on wages. If there are steep cuts in wages, then incomes are reduced: this is the real cause of debt deflation: unemployment and cuts to wages.

There is both empirical and theoretical evidence that large amounts of debt in an environment of unanticipated wage and price deflation has disastrous effects on economic activity (Zarnowitz 1992: 156; Caskey and Fazzari 1987).

The economist Hyman Minsky (1892; 1986) has studied in detail how such debt deflationary spirals occur in the context of financial crises.

Debt contracts are set in nominal terms. As debtors see their incomes falling (or are laid off), some will eventually be unable to service debt, not only because their nominal wages have fallen, but also because they pay back debt with money of greater value.

Thus debt defaults and bankruptcies increase, money supply contracts, and there are further falls in demand. Debt deflation is a problem for businesses as well. As profits decline, business themselves are subject to much the same problem as individuals. Their debts become a much greater burden. This causes additional falls in output as business go bankrupt. The economy enters a vicious cycle.

The classic example of a deflationary spiral was 1929–1933. Moreover, if a government lowers interest rates in an attempt to stimulate the economy but cannot reduce it any further (because it will approach zero or become negative), then there is also a danger of entering a liquidity trap, if banks do not lend money, and hold excess reserves which they refuse to lend for investment.

This is the recipe for a Great Depression.

IV. Wage Stickiness: An Old Problem
According to Classical economics, downward wage flexibility was supposed to prevent an economy from ever falling into a deflationary spiral and collapse. But nominal wages, like loans or leases, can be fixed by contracts that do not take account of future deflation. As is well known, wage levels in practice tend to respond slowly to economic shocks, and they simply cannot be adjusted instantaneously: wages are “sticky” (Arnold 2008: 167).

But when deflation occurs and nominal wages are not adjusted downward, then profit margins fall (Kumar et al. 2003: 8). Businesses are faced with lower profits. In the face of wage stickiness, the first response tends to be job losses rather than wage cuts. But higher unemployment simply causes further collapses in demand. Once again a vicious circle has developed.

The problem of wage stickiness is a well known one in modern economics. People in general object to having their nominal wages cut. Even managers often dislike across-the-board pay cuts. Recent studies suggest that employers avoid pay cuts because they diminish workers’ morale, and then falling morale reduces productivity (Bewley 1999).

Wage stickiness, then, is a problem that happens even in free market economies. The economic theory that drastic cuts in wages will be able to cure depressions quickly (a feature of neoclassical economics and the Austrian school) is simply a fantasy that takes no account of the empirical evidence from the real world.

One extraordinary example of deflation making a depression worse was the depression of 1873–1879. In this time, in industrial economies like Germany, deflation was accompanied by falls in profits and cuts to nominal wages in industry that reduced real wages and living standards (Kitchen 1978: 159). This was the longest economic depression in recent history: it consisted of 65 months of economic contraction with deflation (Glasner and Cooley 1997: 148, 734).

V. The Solution to Wage Stickiness: Fiat Money!
Since people find it difficult to accept cuts in nominal wages, even if the real wages remain the same or actually rise during deflation, a practical solution is the use of fiat money: the central bank fights deflation with an expansion of the money supply.

If fiscal policy is used to inject the new fiat money into the economy, this will cause inflation and end the vicious circle. Putting people back to work raises output and stimulates demand. Employers find that they no longer have to face the problem of wage cuts as real wages will adjust through the value of money slightly decreasing through later inflation.

Thus fiat money and reflation (and of course fiscal policy) are pragmatic solutions to deflationary spirals and depressions.

VI. Money Does not Rise in Value During Disinflation (High to Low Inflation)
Cynicus Economicus argues that
A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.
The specific effect of debt-deflation Cynicus Economicus is talking about here is when money rises in value through deflation. That is, if you pay back loans in money of higher value later (when it can purchase more), you are experiencing a specific aspect of debt deflation.

But, in the example Cynicus Economicus gives, the real issue is that the debtor is paying a higher real interest rate.

You can calculate the effect of higher real interest rates in this example:
In 2000, a business takes out a loan for five years at a 15% interest rate when inflation is 10% and the bank thinks it will stay at around 10% for some years. The real interest rate in 2000 is 5%. But inflation falls to 5% by 2003. The real interest rate has risen to 10%.

NIR = nominal interest rate
I = inflation rate
RIR = real interest rate.

2000 15% 10% 5%
2001 15% 10% 5%
2002 15% 9% 6%
2003 15% 5% 10%
2004 15% 5% 10%
But this effect is different from paying the money back when it is of greater value through deflation.

We can quote this explanation from Wikipedia:
Deflation is a sustained decrease in the general price level resulting in a sustained increase in the real value of money and other monetary items. Money and other monetary items are worth more all the time during deflation as opposed to being worth less all the time during inflation. Deflation is negative inflation. Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but at a slower rate resulting in a continued, but lower rate of real value destruction in money and other monetary items. A lowering of inflation is not deflation but disinflation. Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency – money - and other monetary items are worth more all the time. Deflation causes an increase in the real value of money and other monetary items. Inflation destroys real value in money. Disinflation destroys real value in money more slowly. Deflation creates real value in money.
The debt deflation effect I have talked about earlier is when you pay back your loan in money of greater value owing to deflation. (But of course paying higher real interest rates is also a part of the problem under deflation and, to this extent, the two situations are similar.)

But, even under disinflation (the move from higher inflation to lower inflation), the value of money is still falling, because it is only the rate of inflation that has changed. You are paying back your loan at a higher real interest rate, and are not subject to the specific debt deflationary effect mentioned earlier. That effect requires that the value of money has fallen through actual deflation.

VII. Does a Move from High Inflation to Low Inflation Cause Debt Deflation and Depression?
Of course not. In a booming economy, when there is a fall in the rate of inflation, this will not have the same effects as long-term, severe deflation in a recession where there is a large amount of debt.

A change in the inflation rate from 3.5% to 2% over one year and then stable inflation at 2% in a booming economy with low debt and high employment will not be a serious problem.

Disinflation is not actual deflation. Average prices are not falling.

The crucial factors that would cause a serious debt deflation and exacerbate a recession would be as follows:
(1) High debt levels before deflation
(2) A recession (for example, caused in part by the collapse of a bubble)
(3) Significant falls in demand and distress selling
(4) Nominal wages at too high a level
(5) Long-term, unexpected and severe deflation in goods produced in an economy
(6) Significant falls in profits, difficulty in servicing debt
(7) High unemployment, business failures, cuts to wages
(8) Further collapses in demand
(9) Then back to (6), (7) etc above.
This is a deflationary spiral. This is similar to what happened in the Great Depression.

A fall from high inflation to low inflation and then stable inflation in an essentially healthy economy does not have the same effect.


Arnold, R. A., 2008. Economics (9th edn), Cengage Learning.

Atkeson, A. and P. J. Kehoe. 2004. “Deflation and Depression: Is There an Empirical Link?” American Economic Review 94.2 (Papers and Proceedings of the One Hundred Sixteenth Annual Meeting of the American Economic Association San Diego, CA, January 3–5, 2004). 99–103.

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Caskey, J. and S. Fazzari, 1987. “Aggregate Demand Contractions with Nominal Debt Commitments,” Economic Inquiry 25: 583–597.

Eichengreen, B. J. 2002. Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, Oxford University Press, New York.

Farrell, C. 2004. Deflation: What Happens When Prices Fall, HarperBusiness, New York.

Glasner, D. and T. F. Cooley (eds). 1997. Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York.

Kitchen, M. 1978. The Political Economy of Germany, 1815–1914, Croom Helm, London.

Kumar, M. S. et al. 2003. Deflation: Determinants, Risks, and Policy Options, International Monetary Fund, Washington, D.C.

Minsky, H.P. 1982. Can “It” Happen Again? M.E. Sharpe, Armonk, NY.

Minsky, H.P. 1986. Stabilizing an Unstable Economy, Yale University Press, New Haven.

Smith, G. W. 2006. “The Spectre of Deflation: a Review of the Empirical Evidence,” Canadian Journal of Economics 39.4: 1041–1072.

Zarnowitz, V. 1992. Business Cycles: Theory, History, Indicators, and Forecasting, University of Chicago Press, Chicago.

Tuesday, July 28, 2009

The Myth of the Labour Theory of Value

The labour theory of value has its origins in Classical economics, and was held, in various forms, by Adam Smith and David Ricardo. Later it was taken up by Karl Marx and is still a part of modern Marxist economics.

The labour theory of value has been abandoned by modern mainstream (neoclassical) economics, and was rejected as long ago as the 1870s by early marginalist and neoclassical economists (Blaug 1982: 595; Dooley 2005: 212). The theory is also rejected by the Austrian school, an offshoot of neoclassical economics.

I will show below that the labour theory of value is invalid.

First, What is Value?

From a philosophical perspective, value is the worth of something, however that is judged. Philosophers distinguish between extrinsic (= instrumental) and intrinsic value (Iannone 2001: 539). The extrinsic value of something is its worth for the sake of something else, in the sense that it is valued because it will obtain, or allow you to achieve, some other thing or goal. The intrinsic value of something is its worth for its own sake. Yet another concept is intermediate value, which is when something has a combination of both extrinsic and intrinsic value. These concepts, however, are not what economists mean when they talk about value.

In economics, three concepts are important in the definition of value:
(1) utility,
(2) use value, and
(3) exchange value.

Utility is a concept from modern neoclassical economics. Utility is the satisfaction or pleasure derived by an economic agent (a person or a firm) from consuming a good (Rutherford 1995: 428). Utility is the measure of value. This stems from a subjective valuation of the worth of the good by an economic agent (Keen 1999: 1212). Thus the value placed on any good can, and often does, vary from person to person. Two people can derive completely different utilities from a good that costs them the same price.

By contrast, the concept of use value has a specific definition in Marxist economics.
In Marxist thought, use value is the objective usefulness of a good and depends on the way in which the good is used by the buyer.

Exchange value is the power that something has in obtaining other goods in exchange, and the term is used in both neoclassical economics and Marxism.

In modern economics, value is normally exchange value, that is, something has an economic value when it is traded or bought as a commodity in a market. The exchange value (or economic value) is related to the eventual price of the commodity, although the price can also be affected by supply and demand.

The utility of the good (and the individual subjective valuation of that good) can directly influence the price, particularly when aesthetic judgements are involved.

In modern microeconomic analysis, price theory is the study of how prices are determined in individual markets. There are two main factors affecting the price of a good: the demand side and the supply side. The demand side is essentially consumer behaviour involving individuals maximizing utility. The number of individuals who place a subjective value on a particular good can cause demand, and along with supply, this influences the price of the good.
(If there is no interference in the markets by governments, monopolies or oligopolies, the interaction of these factors across the economy produces equilibrium prices, where the price is a true reflection of the value, according to neoclassical theory).

Thus price has also a relational component: the price of a good can be influenced by its scarcity relative to demand.

This can be summed up in the following way:

In neoclassical economics this utility is ultimately subjectively determined by the buyer of a good, and not objectively by the intrinsic characteristics of the good. Thus, neoclassical economists often talk about the marginal utility of a product, i.e., how its utility fluctuates according to consumption patterns.

Modern economics thus has a utility theory of value, which is a subjective theory of the values of commodities.

The essence of this theory can be explained in this way:

Human beings are the ultimate source of economic value …. Human “consciousness” is the key to value, in that our awareness of the linkage between an object and its ability to satisfy a need is what gives goods value (Horwitz 2003: 266).

If something is subjective, then it is an internal, introspective process in a human mind. Fundamentally, it is a matter of personal preference, desire or taste, which is not necessarily shared by other people. The subjective value of a good, by definition, lacks an underlying objective cause or validity: it is arbitrary. In other words, the subjective value of something does not have an underlying objective source. If we say that economic value is subjective, then the economic value of a good exists only as a mental state in a human mind, and this subjective judgement about its value is arbitrary and cannot, by definition, be caused by other objective factors like labour.

The labour theory of value, of course, is an objective theory of value: it holds that the source of value is in fact something objective: the human labour that has created a good or gone into bringing it to market for exchange.

Does Value really Come from Amount of Labour?

The labour theory of value is a type of objective value theory. In the Classical versions of the theory, it is held that the value of a good comes from, or is based on, the amount of labour spent producing that good. That is to say, exchange values of goods are determined by the labour time (often measured in hours) that is directly or indirectly required to produce them.

As Adam Smith argued:

If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.

Adam Smith, The Wealth of Nations: Books I–III (Penguin Classics, 1982), Book 3, Chapter 6, p. 150.

First, it should be observed that no amount of labour will confer value on a product by itself. An often cited instance of this is if I dig a hole and fill it up for hours on end: no value will be created. Clearly, another factor is needed to create value.

Yet the Classical labour theory of value says that the real only cause of value is labour, and that this can be measured by labour hours.

A simple example shows this can’t be correct. Consider this situation:

(1) One man in the south of France in a obscure region not famous for wine spends 100 hours of labour planting a vineyard, harvesting the grapes and making 50 bottles of wine.

(2) One man in France in Bordeaux spends 100 hours of labour planting a vineyard, harvesting the grapes and making 50 bottles of wine.

For the sake of argument, let us assume that the soil conditions happen to be the same, and that both men are equally expert and conditions are similar in the two regions and they have produced wine of the same quality. The first man sells all his 50 bottles of wine for $50 ($1 each). But the second man sells his 50 bottles of wine for $500 ($10 each), because his wine is produced in Bordeaux and is valued at a higher price than the wine produced by the first man, even though the latter’s wine is of the same quality.

Yet, according to the labour theory of value, they have both put in precisely the same amount of labour, so the price should be the same.

But clearly they are not. The value of the wine has a fundamental subjective cause: people value wine from Bordeaux more highly than wine from other regions.

Consider this second situation:

(1) One man spends 200 hours digging in a mine and finds a diamond and sells it for $1000.
(2) Another man spends 1 hour digging and finds a diamond which he sells for $1000.

Although they receive exactly the same price, they have put in completely different amounts of labour. If the labour theory of value were correct, than the first man would be paid 200 times more for his diamond than the second.

But again the underlying labour time has no effect on the value of the diamond which is determined by subjective values (e.g., people desiring diamonds for beauty and people needing diamonds for industrial purposes).

Can Value be Subjective and at the Same Time be Created through Labour?

In a recent post called “Reforming Money - Fixed Fiat Currency,” the blogger Cynicus Economicus presents a rather different theory about value that involves labour:

In a fascinating article which I urge you to read, he presents a theory of a fixed fiat currency, but relates this to an underlying theory about labour.

Cynicus Economicus argues that

all economic activity is rooted in the value of labour. A commodity such as gold only has value once labour has dug it from the ground, and labour has moved it to the surface. Once it arrives at the surface it will be some form of labour that is utilised to move it to where it is next utilised …. At the heart of all economic activity is human labour, and economics is the process of exchange of value of labour between individuals, organisations and other economic units.

Unlike the classical labour theory of value, however, Cynicus Economicus does not believe that goods are valued by the quantity or amount of labour need to produce them (that is, number of hours worked).

He concedes that individuals subjectively value goods. Thus actual value of labour between individuals might be determined differently, and the underlying labour that is exchanged is valued in a subjective way:

The reality in any economy is that labour has variable value. I am simply saying that, if person A undertakes labour at value x on date 'y', then that value should be stored at value x. The rights and wrongs or how it might be valued is not the issue. Nevertheless, all value in economics commences with some kind of labour.

As we have seen, if something is subjective, then it does not have an underlying objective source: it is arbitrary. Either value is subjective or it is not.

To show this, we can look at some examples where labour allegedly causes the value of goods.

Example 1: Does a Diver’s Labour Cause Value in a Pearl?

According to Cynicus Economicus’ view, if a diver finds a pearl on a seabed, the pearl has value that has been created by the labour that brings it to the market where it is exchanged, even though the labour is valued subjectively in that market.

However, subjective value exists in the minds of human beings, as we have seen. The man dives for the pearl because he knows that pearls will have a value in exchange already. The value of the pearl is ultimately a subjective phenomenon, and can exist before the pearl is even possessed by the diver. If a diver sees a pearl on the seabed, he already has a subjective value in his mind attached to it.

Is the High Value of Antiques Caused by the Added Labour Value of Experts?

If a painting is examined by an expert and pronounced to be a genuine Vincent van Gogh, then is the expert who determines that the painting is genuine adding the value of his labour to the object, and thus making it of high value?

We have already seen that value is subjective. If I believe that a painting is by Vincent van Gogh, then I am willing to pay a high price for it before the expert examines it. The subjective value in my mind has simply been confirmed, not created, by the expert who examines it. It was my previous subjective belief that the painting is genuine, not the appraisal of the expert, that makes it of high value to me.

This is confirmed if you think of old books. If you go to a second hand book shop, and find a rare book from the 18th century, to many people its subjective value will be much higher than other books. No one needs to have the age confirmed by an expert: its age can be confirmed by physical examination of it. No expert opinion is required to “add value to it.”

A Point of Confusion: Factors of Production are different from Value

It seems to me that Cynicus Economicus has confused factors of production (or factor inputs) with value.

It is undoubtedly true that labour is a fundamental factor of production for many goods, most notably manufactured goods.

However, it is simply not true that it is the only factor of production: there are 4 recognized factors of production:

(1) natural resources, including land, raw materials, water, and energy.
(2) labour,
(3) capital goods, and
(4) entrepreneurship (O’Connor and C. Faille 2000: 63).

Factors of production are the inputs that are combined and used to transform things into goods and services. Labour is undoubtedly a major input, and capital goods and entrepreneurship also depend on human labour to a great extent.

But natural resources, factor (1) above, do not always depend on human labour. It is easily demonstrated that labour is not the only important input into production: for example, when farmers grow crops, there are fundamental natural inputs (soil, rain, sunlight) without which production could not occur.

Thus it is simply not true that “all value in economics commences with some kind of labour.” Without many natural resources, there could be no production.

In economic terms, value is subjective, and is measured individually by the utility a good provides to an economic agent. It is the demand for goods caused by the subjective desires of people that is the cause of value, not labour.

To have value in economic terms means to have a price/exchange value as a good traded in a given market. The economic value of a mushroom is already known to people as the price it trades on markets.

But the cause of that value is the subjective desire of consumers to have mushrooms, and is not created by labour. A man could pick a mushroom and then find that the price has collapsed to nothing, because demand for mushrooms has collapsed: despite his labour it will have zero economic value.

Thus labour is not even a sufficient condition for the mushroom to have value. The necessary condition is that the mushroom has subjective value for consumers who are willing to pay money for it or exchange other commodities for it. This subjective value is a mental state. The labour involved in moving a mushroom to a market does not create or give it economic value.

The picking of mushrooms and conveying them to a market is part of economic production and output. But natural resources have a major role in the production/output of the mushrooms as well.

The simple fact is that, if you subscribe to a subjective theory of value, then goods do not achieve value because of labour. Goods achieve value through the subjective valuation of them by individuals, and this can be influenced by supply and demand. This subjective valuation is a mental process, even in exchange value.

Labour is certainly required to turn input factors into output.

But, as has been pointed out by Arun Bose and Steve Keen, raw material inputs and labour work together to create output (or, in Marxist thought, the intrinsic value or essence of a commodity). Labour alone is not the essence of output (or value as conceived in Marxist theory): both labour and commodities (natural resources) are sources of output. No matter how much labour is expended on production, the production of goods is impossible without natural resources. Non-labour inputs have an indispensable role in production (Bose 1980; Keen 2001: 288–289).

Is Money merely a Store of Value of Labour?

Cynicus Economicus also argues that

within [a] system of exchange of value of labour, the underlying purpose of money is very clear. It should only act as a medium through which the value of labour might be accounted, and is always representative of a store of value of labour, with an underlying contract that it might, at some future point in time, be exchanged for the value of labour of others.

However, as we have seen, once you recognise that the value is subjective and not determined by labour, and that there are other inputs which go into the production of commodities, there is no reason why money should be defined simply in this way or only have this function.


Blaug. M. 1982. “Labour theory of value,” in D. Greenwald (ed.), Encyclopedia of Economics, McGraw-Hill, New York. 595–597.

Bose, A. 1980. Marx on Exploitation and Inequality: An Essay in Marxian Analytical Economics, Oxford University Press, Delhi.

Dooley, P. C. 2005. The Labour Theory of Value, Routledge, Abingdon, Oxon.

Horwitz, S. 2003. “The Austrian Marginalists: Menger, Bohm-Bawerk, and Wieser,” in W. J. Samuels, J. E. Biddle, J. B. Davis (eds.), A Companion to the History of Economic Thought, Blackwell Publishing, Oxford, UK and Malden, MA.

Iannone, A. P. 2001. “Value,” in A. P. Iannone, Dictionary of World Philosophy, Routledge, London and New York. 539–540.

Keen, S. 1999. “Use-value and exchange-value,” in P. A. O’Hara (ed.). Encyclopedia of Political Economy, Volume 2: L–Z, Routledge, London. 1212–1213.

Keen, S. 2001. Debunking Economics: The Naked Emperor of the Social Sciences, Zed Books, New York.

O’Connor, D. E. and C. Faille. 2000. Basic Economic Principles: A Guide for Students, Greenwood Press, Westport, Conn.

Robinson, J. 2006 [1962]. Economic Philosophy, AldineTransaction, New Brunswick, N.J. and London.

Rutherford, D. 1955. “Utility,” in Routledge Dictionary of Economics, Routledge, London and New York. 428.

Friday, July 24, 2009

New Zealand and “Think Big”: Did it Ruin the Economy?

In a recent conversation with a friend, I was presented with the argument that New Zealand’s high ranking by per capita GDP collapsed in the late 20th century because of socialism and industrial policy.

Curious about this claim, I did some research.

Throughout the Bretton Woods era, New Zealand’s GDP ranking was very high: higher than the OECD average, although there was a clear downward trend as other larger economies with greater potential for growth overtook New Zealand.

But the fundamental fact is that New Zealand’s economy was mainly based on commodity exports until the mid-1970s, not manufacturing exports. New Zealand had a protected domestic manufacturing sector, but full employment during the post-WWII era.

But from the 1950s to 1966, New Zealand had growth of about 2.2% a year in per capita GDP.

This was partly caused from 1951 when New Zealand’s GDP was boosted by an extraordinary boom in wool exports caused by the Korean War. It is obvious that export earnings would fall as this boom ended, and that this would affect GDP. Thus growth was lowered from 1966 onwards when the price of wool fell.

When there was a fall in the price of commodities in the mid-1970s and oil shocks, New Zealand’s ranking by per capita GDP also fell significantly.

However, although per capita GDP fell, it remained at roughly the OECD average, as you can see in the table in this article by Brian Easton (the author of In Stormy Seas: The Post-War New Zealand Economy University of Otago Press, 1997):

Brian Easton, Output Since the War: New Zealand’s GDP Performance

The Conservative government of Robert Muldoon (1975–1984) implemented an industrial policy called “Think Big” after 1981 (Brooking 2004: 146) in response to the oil shocks.

Yet the first significant fall in New Zealand’s ranking by per capita GDP had already occurred:

significant declines [in New Zealand’s per capita GDP] occur only in the 1966 to 1969 period, … 1976 to 1978, … and 1986 to 1992 …. [The] first decline was due to the collapse of the world price of crossbred wools in late 1966 ... the second decline [was due] to this source too … If so the total decline from the wool price shock was about 20 percent, and was largely over by the mid 1970s. An alternative view is the second fall was the result of the oil price shock of late 1974. Whichever explanation is correct, the first two falls can be unequivocally attributed to external shocks over which New Zealand had little influence … .Brian Easton, Output Since the War: New Zealand’s GDP Performance,

Thus it is simply not possible to blame “Think Big” for the fall in GDP of the 1970s. Moreover, after Robert Muldoon’s “Think Big” was launched, per capita GDP actually increased slightly during its implementation, and there was no dramatic collapse.

The fact is that the really significant collapse in New Zealand’s per capita GDP occurred in the neoliberal era, under the onslaught of Rogernomics (the equivalent of Thatcherism) after the election of free market Labour government in 1984. In 1984, per capita GDP in New Zealand was at the same level as the OECD average. Then after 1984 it went into free fall:
The other big fall occurred in the late 1980s and early 1990s. There was no significant external shock ... Rather, a faulty [sc. neoliberal] macroeconomic policy … ignored the health of the tradable sector which is at the centre of the growth process … It seems likely that had there been no [sc. neoliberal] reforms – or to be more precise, had the reforms been akin to those implemented in Australia: more practical and less ideological – New Zealand would still be at the OECD average.” Brian Easton, Output Since the War: New Zealand’s GDP Performance,
 Thus New Zealand’s per capita GDP collapsed from 100% of the OECD average in 1984 to just 83% of the OECD average by 1999, before the election of the Labour government of Helen Clark that rejected some of the more extreme neoliberal policies. Growth in per capita GDP has resumed since 1999 and is now 86% of the average.

The conclusion is clear: a major collapse in New Zealand’s per capita GDP happened under neoliberalism when it fell well below the average.

External shocks to the New Zealand economy in the late 1960s and 1970s did cause the first major collapse in per capita GDP, but this happened well before the industrial policy of Robert Muldoon.

Bassett, M. 1998. The State in New Zealand, 1840–1984: Socialism Without Doctrines? Auckland University Press, Auckland.
Brooking, T. 2004. The History of New Zealand, Harcourt Education, Oxford.

Tuesday, July 7, 2009

Opening Post

This blog is a commentary on the current economic crisis and the prospects for Social Democracy in the 21st century. I am not an economist, but someone with a life-long interest in economics and social democracy.