28 October 2011

The Laughter Curve

- the ability to laugh all the way to the Swiss Bank

The Laughter (Laffer) curve theoretically shows the relationship between government revenue raised by taxation and the taxation rate.

From the left, government tax revenues increase as the tax rate increases, but at a declining rate. It becomes more worthwhile hiring a accountant to avoid or evade paying tax. Beyond a certain point tax revenues fall as money pours into off-shore accounts. Capital flies out the country, reducing both investment and output, and inducing a further decline in tax revenues.  It falls to zero revenue at a 100% tax rate. There is some dispute over what this means. Has the individual moved to Switzerland, died, become street trader or is bartering?

One can reduce the number of tax cheats and fraudulent claims, by legalizing them.  It's not too difficult to imagine a country's tax system becoming unfairer (more regressive) and, at the same time, reducing the number of cheats (and vice versa).

The Curve was popular with Ronald Reagan who bent it to justify lower tax rates for high incomes in the US in the 1980s. From 1979 more than 40 countries cut their top rates of personal income tax.

This is what happened in the US:

and what motives the Wall Street protests. 


Now the problem with Greek austerity measures and structural reforms is all that money that has gone outside the country. Greek assets, including properties, will become even cheaper and capital will flow back in (hailed as a success) to buy them back up. Citizens, the poor, the ex-middle-classes, will be worse off (hailed a success. Well done Greece, more competitive, fly the flag, bright future etc). The result will be an increase in inequality and a re-vamped oligarchy energized by financial occupiers who would then slip away quietly. 

“To see what is in front of one’s nose needs a constant struggle.” (George Orwell). But injustice lingers with a rotting smell.

Back to the bunker

I forgot to mention the 27th October historic deal of day? Here why: ('of two minds': full post here via Zerohedge)

'EU Leaders Throw Europe a Plutonium Life Preserver
The euro system was doomed from inception for fundamental reasons; trying to conjure up "something for nothing" solutions will fail catastrophically, and soon.
As Europe flails helplessly in the waves of insolvency, its leadership has tossed it a life preserver. Too bad it's plutonium, and will take Europe straight to the bottom. Plutonium is of course one of the most toxic materials on the planet, and the "rescue" cooked up by the EU leadership is the financial equivalent of plutonium.
Stripped of propaganda .... "rescue" boils down to this: something for nothing .... in two ways:
1. The financial alchemist's favorite magic: leverage.....suddenly backstop 1 trillion euros of banking-sector losses, all with illusory money.
2. "Guarantees" to cover the first 20% of loan losses.... presented as the equivalent of 100% guarantees, because it is inconceivable that losses could exceed 20%. .... 80% of every bond is somehow "safer" because the first 20% will be paid by EU taxpayers.
..... "something for nothing" magic will turn lead into gold. Abracadabra....oh well, close; it's heavy, it's metallic--oops, it's plutonium.' (of two minds blog -Charles Hugh Smith)

Or a "haircut for the banks that will in reality just be a convoluted way to get citizens to pay get it without even realizing it" (Zerohedge). Compare the above deal with a 11-year-old boy's suggested solution to Greek debt crisis (here).

At least Archimedes knew what to do with leverages. He also invented another device for raising liquidity, but it seems the screw has a different meaning in Europe.

This is the point in the following video where G. Papandreou returns back from work.

'of two minds' goes on to describe the Euro model (add German taxpayers and workers don't win as well) as:

....... understanding the increasingly unstable dynamics of the EU is the post-colonial "plantation" model 

1. Low cost labor and low-value materials flow from the periphery (colonies) to the Empire (center), which then ships high-value, high-profit finished goods back to the colonies.
2. The colonies must buy the high-value finished goods on credit that is issued and controlled by the Imperial center.

....The euro cemented this co-dependency: ..... once the euro raised the cost of production in the periphery nations, then of course nobody could beat Germany's cost advantages. The euro actually lowered Germany's cost of production in terms of foreign exchange rates while raising the costs in periphery nations that were previously able to lower their cost of production via currency devaluations.

Having surrendered that mechanism to access the deep credit markets of the center, then they had no choice but to buy the high-margin finished goods from Germany, as nobody else could make the same goods for the low German price.

These booming high-profit German exports of finished goods to the European periphery generated vast surpluses of capital that were then loaned to the periphery to enable their further purchases of German goods

It's the classic mercantilist-consumer co-dependency on a gigantic scale, with low-cost credit fueling both increased consumption and production. ....... let's ask: how many German goods would have been imported by the EU periphery if those nations had been forced to pay cash for everything from the start? Precious little is the answer; the cash--in the form of actual surpluses available to spend on imports--would have run out immediately after the euro was launched.

In other words, the debt orgy enabled not just carefree consumption, it also enabled vast German exports to the Eurozone. Now we start seeing how the once-mutually beneficial co-dependency has become toxic: now that the periphery's debtors have become debt-serfs, German exports to the periphery are contracting.

When it all implodes, German exports to the periphery will be a shadow of their past glory, and the surpluses which enabled the leveraged orgy of credit will dwindle

Sovereign currencies are the only mechanism for discounting differences in credit worthiness and production costs. The euro was established as the currency equivalent of gold, holding the same value in every member country. But the mercantilist/quasi-colonial model requires credit to flow from the center to the periphery, and that is precisely what has happened in the EU.

In the colonial model, the colonists are indebted and poor. The net value of their labor flows to the Imperial center as interest payments, and the banks at the center set the cost of money and the terms--naturally.  (Full post at: of two minds blog -Charles Hugh Smith)

Germans are also ripped off, since their working poor will either produce trade surpluses or being made unemployed, and then there is eventual tax bill for the entire Euro mess.

"Prime Minister Papandreou said 'let's hope a new and better dawn emerges".  Dusk is more likely, as without economic growth, darkness descends on those unable to pay their lighting bills.  Greeks (for those who can find work) will be working for the good of WHAT country/institution/organisation at or near subsistence levels. It is hoped that the Greek sovereign debt will be reduce to 120% by the year 2020. The structural reforms is supposedly an ambitious plan, making the Greek economy more competitive and sending out the right signals.  So, students can relax. Don't rush your exams as you won't be needed until 2020.  An ambitious deal with the right incentives and signals, indeed.


Its now Oxi day. The day celebrates the Greek rejection of the ultimatum made by Mussolini on October 28, 1940 to be occupied or be invaded. The invasion led to a defeat of Mussolini's army. Swedish band Sabaton (excuse the metallic blood) shows the mythical status. Merkels' remarks, on the eve of this celebration, about refusing to accept the Euro deal would end the peace in Europe was unfortunate timing (Merkel wants 'permanent' supervision of Greece, warns of war).

18 October 2011

On the Brink

The previous post concerned economic agents and economic models  Lets zoom in a little closer.

Here is a blog-post (translated and appearing in the Greek left Review blog) that describes the life of a 37-year-old woman in Athens in these days of crisis. Many in Greece are trapped in similar circumstances. I am posting it, as it is also a story that is not so unfamiliar to other parts of the world.

“I have worked since I was 16 and I have lived in Athens since I was 24. I remember that many times I had to struggle in order to survive with two jobs, but never have I stayed unemployed for too long. During the past eight years there were times when things were tight and difficult and other times when things were more or less ok. But not even in the most difficult period of my life, as a University student, did I find myself in the position I am today. For thirteen years I struggled, I fought, I stood on my feet. But now I can’t take it anymore. I’m giving up."

"I’ve been unemployed for ten months. Knowing that I was going to lose my job, I started searching for a new one from as early as the Easter of 2010. By now I’ve send 155 CVs but I only got two replies back, both saying that they didn’t need employees. For the first time in my life I’m facing an eviction order by the end of this month. The landlord says that I have no dignity and that I live on her expense, forgetting the eight years that I have been meeting my obligations regularly or even the improvements I ‘ve made to her house on my own expenses. Still, she’s right. She’s no charity – she wants her money. The movers ask for 1200 euros to take my stuff back to my mother’s city or 150 per month in order to store them in a container. I cannot afford either of the twoscenarios. I will probably have to throw away my household of ten years. The tax service is demanding 300 euro as an emergency levy with a 3% interest for every month I don’t pay. Another emergency tax is expected with the next electricity bill and that’s going to be 420 €. I have to pay 640€ every two months for social security, although the company I worked for explicitly told me that they have no job to offer and that even if they did, they would pay a monthly salary of no more than 420 euro. In short: the city in which I have lived for the past 13 years is spitting me off to the margins like if I’m some kind of trash. For the first time in my life, I have no place to stay and no one to hold on to. Any stock of patience and courage I had has now vanished”.

(From the blog Typos Nykhterinos extract from Greece on the brink of social explosion)

The Inequality of Economic Theories Part 2

Where to next?  The Lost Map and the Territory

The model that has dominated macroeconomics, DSGE (dynamic stochastic general equilibrium model), has been suffering some heavy criticism. Economics has some very powerful tools. By all means, attack what they build and how they used it but don't throw away the tool box.

John Kay (The Map is Not the Territory: An Essay on the State of Economics) writes:

'Lucas has called structures like these ‘analogue economies’, because they are, in a sense, complete economic systems. They loosely resemble the world, but a world so pared down that everything about them is either known, or can be made up. Such models are akin to Tolkien’s Middle Earth, or a computer game like Grand Theft Auto'
I don't have a problem with this. I have a problem when the only game on the shelf for policy makers to play with is 'Grand Theft Auto'. Politics in Europe decides what can or cannot placed be on the shelf.

'Economists have tried to do something that even physicists have failed to do - unify the micro and macro cosmos' (Hitch Hiker's Guide to Macroeconomics). This is not as an argument to throw away science, Newtonian Physics or a Theory of Relativity. We retain our the models because of their usefulness, but in Economics we also have to ask useful for who and for what purpose?

Rational expectations was a powerful breakthrough. Its interesting to know both when and where they do or do not apply, and what happens in these situations. One may build a complex/algorithm or computer model that describes a baby's movements; it does not imply that a baby crawls around with a laptop in his hand. There might be reason to dismiss the model if it predicts that the baby should be bouncing with joy, when in fact it needs toilet training. On there other hand, such a model error might be flashing lights to tell you its time to change the baby.

So is the efficient market hypothesis a bad model because it not describing the financial markets, or is it good one as it can tell you there is something wrong with the markets (eg imperfect information, uncertainty or moral hazard) that need dealing with? The point being it is a tool not an ideology to believe in.

What people think they “know” and cannot know and how far they can see into the future is not constant. (also see Paul Davidson: The State of Economics).  The world of 2007 is different from that of 2011. Such variables should not be treated as constants. The various families of ARCH models in various ways recognise this.  It is neither 'animal spirits' or perfect information rationality, but something that varies between.

One problem, or decision to deal with, in macroeconomic modeling is the focus; the degree or over what we abstract. It determines the story that is to be told. This was one of the initial points of Macroeconomics.

For instance, the case against DSGE models blindly adopting the equivalence property could be made not because it is essentially wrong, but because it buries essential economic information.  Ricardian equivalence is often used in a particular way to tell one type of story: a government carrying out austerity measures to reduce government deficits will result in people recognising (rational expectations) the policy to mean lower taxes or higher spending in the future. They feel worse off today, but as they realise that they will be richer tomorrow, they will increase spending.

This has not happened and something is very wrong. (and even at this level as Krugman argues Ricardian Equivalence does not imply this outcome).  There might be a different story. Reducing deficits (and austerity measures) may be someones pain today and someone's else gain tomorrow.

In a similar way, I don't have a problem with real wages per se in models.  Given a shock that results in the price level and wages going up by 10% and 25%, we may well conclude that there is an increase living standards. This might miss an important story. To say that everyone is better off is to assume the effects on everyone are symmetrical, there are no redistribution effect and that there are no change in relative prices.  If the relative price of what the poor consume rises faster than that of the rich, and the numbers of poor have increased, then there is a completely different story to tell.  The problem of non-asymmetric shocks happens within an economy as well as the EuroZone - not just geographically but amongst agents themselves.

Politicians, however, can't seem to separate reality from fantasy, can't understand them and cut and paste them into their own versions of Middle Earth: the 'Euro's one ring to rule them all'.  The blindness, or deliberate refusal to turn away from such a world, leads them to select and finance only models that produce the desired answer. Politicians then use maps that have nothing to do with the territory they supposedly represent.  Or, as  the New York Times puts it, 'Austerity a political ideology masquerading as an economic policy' ('Britain’s Self-Inflicted Misery').  Europe is a particular tragedy, as a new road map is issued every two months.

Some random wonkish thoughts and a little cutting and pasting:

One neglected political business cycle theory, at the time of Keynes is from Michał Kalecki with a 1933 essay and important 1939 work "Essays in the Theory of Economic Fluctuations".  He put forward the argument that political decision processes of Oligarchic or Imperfectly Competitive system would not allow the persistence of full employment.

During the war he work with other Polish escapees for the British War time Government and eventually moved to the US in 1946. McCarthy's witch hunts of his close contacts and friends convinced him to move back to Poland and live behind the Iron curtain where his influence dwindle.

Kalecki towards the end of life 'made the sad but true observation that the story of his life could be compressed into a series of resignations in protest-against tyranny, prejudice, and oppression' (George Feiwel).

Whereas Keynes argued that governments could impose their plans on the economy to control the business cycle, Kalecki argued the reverse. The market structure would restrict any management of the economy and the business cycles would impose itself on governments.

It is of interest because it is built on the oligarchies, cartels and Monopolies and is about inequality.

Let me describe a story it can tell:

1) There are two groups in the global economy. Those who need to work earn wages and salaries and those who can just live off profits.
2) One group is defined as those working but cannot save significantly more than what they need to service debts. (eg Debt-Serfdom Is Now The New American Norm)
3) The other group can save and accumulate funds to invest or manage large portfolios that are highly mobile, moving with ease from one part of the world to another.

Now lets do a different type of Creative accounting.  To be provocative, I will use different labels than Kalecki:

Total Profits + (Total Wages - Debts) = Workers Consumption + (Corporate profits + Creditors)
                                                               Consumption + actual Investment
As most workers can't save or are enslaved to there debts we have:
(Total Wages - Debts) = Workers Consumption  
And canceling this from both this sides, gives:
 Total Profits = (Corporate profits + Creditors) Consumption + actual Investment

This is his famous profits equation, which simply says that profits are equal to the sum of investment and capitalist’s consumption.  Now ask a cause and effect question.

a) Does corporate owners’s consumption and investment determine profits or
b) Profits determine corporate owners’ consumption and investment?

Kalecki would argue the answer depends on who can decide. Corporate owners can choose to consume less now and invest for high expected returns in the future. Higher or lower than expected profits leads to an adjustment in their decisions. Here we could introduce all sorts of things (Kareken and Wallace model?). My second quote from Tom Sargent, rational expectations is "helpful in predicting the crisis, not the timing of the crisis because there are random variables, but in terms of predicting the measures that increase the probability of a crisis, and that’s the Kareken and Wallace model." So from above a) is the prime cause and b) the revision: profit rates leads to corrections

If corporate owners’s consume more, then one would image that they have less funds at the end of the period. This consumption, however, would also feeds backs in each other's profits. In a way,  Kalecki views them as masters of their fate. .... http://en.wikipedia.org/wiki/Micha%C5%82_Kalecki#Theoretical_contributions

It is interesting as it can leads use to model, income distribution, inequality and the economy being at inefficient allocations of wealth and income. We could of course look at other alternative models that might be better. Isn't that the point of Econometrics? Or is it just to make sure the data fits our favorite model? 

The Inequality of Economic Theories Part 1

Inequality and Inefficiency

The monetary base of economies has changed.  Global capital, which can refinance, is running circles around governments who cannot refinance themselves. (re: East India Company v's the 'absolute monarch', Louis XVI).

As the 2011 Nobel economics prize winner Tom Sargent comments, greedy bankers figure out odds, what’s their interests and increased the risks and probability of a crisis. That’s rational expectations.

Protesters are against greedy bankers, who they know can out figure the odds, their interests, run rings around the governments and increased the risks of the crisis.  Protesters' "we know what you are doing" is also rational expectations. The '1%, by the 1%, for the 1%' (Joseph E. Stiglitz in Vanity Fair) is the argument.  Global Protests are against a system that makes people study and work hard to produce low or zero returns. They protest against the inefficiency and a cycle, or downward spiral, of inequality.

Protesters have new social networking tools and technology that makes it both easier and more effective to organise change. (see 'Occupy' is a response to economic permafrost'). 'Horizontalism becomes endemic-techn makes it easy: it kills vertical hierarchies spontaneously'.

In the meantime governments are suffering coordination failure, or worse from illusions: RT@NickMalkoutzis 'thanks for the behind the scenes footage from the Eurogroup meeting'

Lets suppose a model where global capital has rational expectations, Governments suffer from coordination failure, political meltdown and protesters have rational expectations.  It makes an explosive model.

The current economic and political systems is tied by a Gordian Knot. In Greece both protesters and analysts agree that the system is inefficient, but who cuts the knot?

Inequality, and the squeeze on the middles classes, has struck hard at the 'advance' economics. Economic growth has moved eastwards. The room at the top has filled up, only few enter and leave it, and the door is firmly shut.  The inequality that it leaves outside kill opportunities, leaving an economy becomes increasingly inefficient (relative to its potential).

There are two double think theories on inequality that need to canceled themselves out:

1)   Lowering 'low' incomes increases productivity and competitiveness. Cheaper wages, leads to more exports (provided everyone doesn't do the same policy - who buys?), greater growth and the economy is prosperous (for your country, children, your children's children, religion or whatever). 'Be poor or we won't give a job' argument.  Great in a perfectly competitive model (homogeneous agents: everyone is equal, wealth does not restrict market entry, equal access, etc) but not in an oligarchic or monopolistic reality.

2)   The opposite argument if you are rich: increasing 'high' incomes increases productivity, as it rewards those for being the most productive in the economy. An 'I deserve to be rich; you deserve to be poor' argument from the 19th Century 'marginal-productivity economic theory. To make sure that the 'powerful' remain powerful, they then monopolise educational, resources and all pathways to power. Thus, financial managers of the crisis are rewarded for their contributions to society.  Austerity measures, falling output, poverty, destruction of human capital, whole sale destruction of communities are somehow necessary to keep up these wonderful contributions to society. Contrast this very few rewards received by 100,000s of contributions, ideas, pioneers, social enterprises and creative users on the internet.  Unsurprisingly cyber space wants also to also occupy physical space. To what extent was Microsoft's Encarta v's Wikipedia an uneven competition between private entrepreneur property and social entrepreneur property?

Inequality is inefficient:
1)  it restricts opportunity and deprives access to untapped resources. Practices result in dumping (human) resources to maintain or protect inequalities.
2) it reproduces itself, through monopoly power and preferential tax treatment for special interests and loop holes. Financial capital is highly mobile, but restricts the mobility of human capital via opportunities, uneven development, labeling, standardization, product discrimination into race, rationality, gender, age,fashion, etc.
3) it breaks up social and community action do deal with, for example, environment, health, education problems and to coordinate responses to financials crisis. It generates mistrust; a 'tragedy of the commons' 
4) misallocates resources, (buying power is uneven and supply is restricted), benefits are privatised and costs are socialise such as pollution or bank bailout. The most talented young people go into professions that are not actually productive - be it armies of lawyers, bureaucratic or finance - for the economy

As I write, a twitter: @INETeconomics "Market outcomes need to be modified to create a more even #distribution of incomes" Nobel laureate Michael Spence http://t.co/U2zUNdFK. Such is the speed of change.

10 October 2011

Zeno's Political Impossibility Paradox

...... and Reality

You might have noticed that the meetings, crisis, meetings, crisis .. are occurring at shorter intervals. There is a wise old Greek who might help us to understand this and why everyone is being pushed to and off their limits.

There is also the Box Bunny's carrot (less stick) version. The IMF  latest report recommends that countries should reverse their austerity measures. In very damning graphical detail, section 1.1 (Divergent Recoveries, but a Synchronized Slowdown?) shows the Euro as a very sub-optimal monetary union.

We could ask why Greece is not included in the recommendation to reverse austerity measures.  A Zeno swapping arrangement might have helped to explain -  but the following may serve better.

It's useful to remember above image when reading about "moral hazard" - it is after all about the control and exploitation of information.


A comment on a Nobel economics prize winner

Macroeconomics and Reality 2.0 – when will it be released?

Thomas Sargent and Christopher Sims won the Nobel economics prize on Monday. Many are speaking about their work on the impact of expectations on policy. I shall take a different line.

When Chistopher Sims published "Macroeconomics and reality" (Econometrica 1980) a revolution was instigated in macroeconometrics. C. Sims argued that existing macroeconomic models were strangled by "incredible overidentifying restrictions". Models were so prejudiced by the underlying assumptions and pet theories that were in vogue that hypothesis testing, policy analysis and forecasting were virtually rendered meaningless.  As Macroeconometric models failed to predict and handle the subsequent events of the 2008 global crisis, we might like to ask the same question today.

Learning, knowing or worrying about something affects the outcome (here enters Sargent and also the Alice-in-Wonderland Cheshire Cat) but, until Sargent's work on rational expectations, it was very difficult to build into macroeconometric models. Macroeconomics models were static representations of a complex dynamic reality. C. Sims provided a philosophy, co-developed a toolbox and opened the way to a new horizon of possibilities.

Back in 1980 C. Sims proposed freeing macroeconometric models from its cage by allow 'history' (past values of variables) to determined the shape of models and hopefully, if not visible, allow the causal nature and underlying structure of macroeconomic reality to feed into the models. The result was a revolution and an attempt to shift to move models away from classical statistical models.

He introduced a theoretical approach based on Vector AutoRegressions and Baynesian methods to allowing the data to speak to the structure of models (variables' past values could be switched on or off by he data) and/or the possibility of beliefs and theories to be imprinted on to the model without imprisoning it.  His subsequent contribution to the work on the econometrics package RATS (later CATS!) provided the tools for others join the revolution.

The possibilities seemed endless – that was also the problem.

Subsequent work by others, who were also to receive Nobel prizes, gave clues: Granger causality time series (testing if y is more related to x's past than x to y's past - or crudely - which comes first, the fire or fire engine?); Cointegration analysis (suppose a drunk is walking randomly around with his dog. Both are non-stationary. Both pull and tug with each other. Individual movements make no sense but there is a relationship), Error correction. Learning models, etc.  New tools seemed to be appearing all the time.

What went wrong?

Referring back to previous post: (How can blindness and Deafness be explained?), perhaps this gives an answer:
'I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way... The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether.' 
Robert Solow, United States Congress hearings (July, 2010) investigating why macroeconomists failed to foresee the 2008 Financial crisis
The pioneering work of the 1980s opened up a new terrain. The same neoclassical building was built on it. Only a Walrasian auctioneer or single consistent rational super entity can occupy its premises.

The award to Christopher Sims comes at a good time.