World Economics Journal and Economic Thought

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The Emergence of Profit and Interest in the Monetary Circuit

7 February, 2012 - 12:39

Efficient progress of the monetary theory of production (MTP) is hampered by an unsatisfactory account of how profit and interest emerge in the monetary circuit. As matter of fact, this question puzzled already the classics. It seems evident that it cannot be answered by applying the usual tools. The present paper’s purpose is to overcome the deadlock. This is done by setting the circulation approach on general structural axiomatic foundations.

Richard Cantillon’s Early Monetary Views?

7 February, 2012 - 12:31

The monetary theories in Philip Cantillon’s The Analysis of Trade (1759) differ in important respects from those found in Richard Cantillon’s much more famous Essai sur la nature de Commerce en général (1759). Contrary to the received opinion that the Analysis was a poor translation of the Essai, it is argued in this paper that many of these differences are due to the fact that Philip based his book on an earlier draft of his cousin’s great work. Comparisons between the two texts allow us to assess, for the first time, how Richard Cantillon’s developed his ideas on the quantity theory of money, the price-specie-flow mechanism and the determination of the interest rate.

The Determination of Profits

23 January, 2012 - 21:49

We join the recent chorus of interest concerning the determination of money profits. The Godley and Lavoie, 2007, framework is used. Two regimes are distinguished. Under ‘private banking’, ‘bank profits’ and ‘entrepreneurial profits’ sum to zero. Only government can support aggregate profits. Specifically, we show that the institution of the long-term bond is sufficient to deliver the result. Aggregate profits are part of the solution of a difference equation in central bank funding of economic activity. It can grow or shrink, cause or be effected by capital gains on long-term government bonds. The context of the exercise is a set of ideas thrown up during the recent financial-real crises emanating in the US of A. The dilemma is to distinguish profits generated in the financial circulation from profits earned on the production of goods and services. The consensus is that there is need to recapture the distinction between banks supporting production and inventory accumulation and long-term investments backed by financial institutions through money market funds. The latter are uninsured and some scholars, endorsing the intervention of the Federal Reserve to back real investments, have opined that the long-term government bond might be the monetary instrument of the future.

External Fragility or Deindustrialization: What is the Main Threat to Latin American Countries in the 2010s?

17 January, 2012 - 16:04

This paper analyzes the challenges posed by current capital inflows to Latin America. Several countries in the region experienced boom-and-bust cycles in the past, all of them associated with capital inflows. Based on these experiences, some analysts have recently begun to warn about the threats related to current flows of capital to the region. Although this is a valid concern, we believe that the main threat to Latin America lies not so much on the possibility of crises in some future, but on the effect of capital inflows on the real exchange rate (RER).

More concretely, our concern is that capital inflows may lead to excessive RER appreciation, which could damage the profitability of manufacturing activities, reduce employment and ultimately hurt the development prospects of the region.

The paper is organized as follows. After this introduction, we analyze the external context that most Latin American countries are facing today and argue why it is likely to persist in the foreseeable future. In section 3, we review the evolution of RERs in Latin America during the last two decades and suggest that current levels are overvalued. In section 4, we show that the appreciation of RERs have resulted in competitiveness loss in manufacture activities. We also show some evidence suggesting that the loss of competiveness is affecting the performance of manufacture and services activities. Finally, in section 5, we discuss a proposal for the conduct of macroeconomic policy to avoid excessive RER appreciation and its negative effects on employment and output in tradable activities.

Pension Liabilities: Fear Tactics and Serious Policy

17 January, 2012 - 15:58

In the last few years there has been a major push by many conservatives to cutback or eliminate defined benefit pensions in the public sector in the United States. This push comes after a 30-year period in which defined benefit pension coverage in the private sector plummeted from 50 percent to less than 20 percent. A major part of this push has been the use of accounting methods that hugely exaggerate pension liabilities, making them appear unaffordable.

The key issue is the rate at which pensions payouts in future decades are discounted. It is standard practice among pension fund managers to discount their liabilities (future payouts) by the expected return on the assets held by the pension fund. In the current environment, most pensions use a 7.5-8.0 percent nominal rate of return for discounting their future liabilities. This implies a cumulative unfunded liability for state and local pension funds of around $1 trillion. This amount is less than 0.3 percent of future income over the next three decades. Liabilities of this size will not impose an excessive burden in aggregate. (There are many governmental units where the unfunded liability is considerably larger relative to the size of the economy. In these cases, unfunded pension liabilities may be a substantial burden in coming decades.)

In recent years there have been several well-publicized analyses arguing that public pensions should use either the interest rate on corporate bonds or the risk-free rate on long-term Treasury bonds as the discount rate for their liabilities. Using these lower discount rates would raise the unfunded liability of state and local pension funds to $3-$4 trillion, implying a much greater burden. Many political figures have seized on these calculations of higher unfunded liabilities to argue either for sharp cutbacks in pensions for workers in the public sector or for eliminating defined benefit pension plans altogether.

This paper addresses the issue of the proper discount rate to be used in pension fund accounting by constructing a series of simulations using data on stock and bond returns over the last 130 years. It contrasts two accounting rules for determining proper funding.

On the one hand, it uses a rule in which a pension discounts its future liabilities at the risk free rate. The alternative rule is one based on the expected return of the assets held by the fund. Under this alternative accounting rule the expected return in the stock marker varies inversely with the ratio of stock prices to trend earnings. When the ratio of stock prices to trend earnings is high then the projected return is low. This is both because the dividend yield will be lower than normal and also because the projection assumes that stock prices do not keep pace with the rate of growth of earnings so that price to earnings ratios revert to the long-term trend over a 10-year period. The opposite situation exists when the price to earnings ratio is below the long-term average.

The pension fund is assumed hold a mix of 60 percent equities and 40 percent bonds, which is similar to the mix of assets held by most funds. The pension fund is considered fully funded under either rule when it can pay all future benefits over the next three decades. Any shortfalls from full-funding must be made up over a 10-year period.

In the simulations constructed for this paper, the alternative funding rule implied a considerably smoother flow of funding than the rule that assumed a risk-free rate of return. As a result of the fact that it adjusted expected returns to current market conditions, there were fewer instances in which it was necessary to have additional funding beyond normal levels and the amount of additional funding was smaller.

The main reason for the difference is that the alternative funding rule would lead pensions to continue to accumulate during bubble markets like the 20s and 90s. The rule leads to a downward adjustment in expected returns. This implies that a higher level of assets would be needed to meet any schedule of benefit payouts. By contrast, using the risk free rate as a basis for assessing future liabilities would lead a pension to believe that it was overfunded in a period in which the stock market was in a bubble. When the bubble burst, the pension would be underfunded, necessitating a rise in contributions.

These simulations demonstrate the unambiguous superiority of using an alternative funding rule of the type described here. The assumption of a risk-free rate of return will leave pensions ill-prepared to deal with the fallout from the bursting of a stock bubble. Furthermore, because switching to a more stringent funding requirement requires a substantial build-up of reserves, which in turn requires higher contributions and implicitly higher taxes, the use of the risk-free guarantees the bad event that is hoped to be avoided by proper funding

Switching funding rules to one that discounts future liabilities using a risk-free rate of return would require a period of time of higher contributions to pensions and implicitly higher taxes. This switch would mean that we would see with certainty the bad event – higher taxes – that proper funding is intended to avoid. These simulations show that, with the range of stock movements we have seen over the last 130 years, there would have been few occasions where our funding rule would have created a need to raise taxes.

In short, if the goal is to ensure that full benefits can always be paid with a steady stream of funding, our funding rule is clearly superior to one that assumes a risk-free rate of return. Pension fund managers are therefore not being irresponsible in their current funding practices. In fact, if they moved to achieve full-funding using the risk-free rate of return they would be needlessly imposing an excessive tax burden on current taxpayers.

Richard Cantillon’s Early Monetary Views?

17 January, 2012 - 11:38

The monetary theories in Philip Cantillon’s The Analysis of Trade (1759) differ in important respects from those found in Richard Cantillon’s much more famous Essai sur la nature de Commerce en général (1759). Contrary to the received opinion that the Analysis was a poor translation of the Essai, it is argued in this paper that many of these differences are due to the fact that Philip based his book on an earlier draft of his cousin’s great work. Comparisons between the two texts allow us to assess, for the first time, how Richard Cantillon’s developed his ideas on the quantity theory of money, the price-specie-flow mechanism and the determination of the interest rate.

Mathematical Modelling and Ideology in the Economics Academy: competing explanations of the failings of the modern discipline?

17 January, 2012 - 10:43

The widespread and long-lived failings of academic economics are due to an overreliance on largely inappropriate formalistic methods of analysis. This is an assessment  I have long maintained. Many heterodox economists, however, appear to hold instead that the central problem is a form of political-economic ideology. Specifically, it is widely contended in heterodox circles that the discipline goes astray just because many economists are committed to a portrayal of the market economy as a (overly) smoothly or efficiently functioning system or some such, a portrayal that, whether sincerely held or otherwise, is inconsistent with the workings of social reality. Here I critically examine the contention that a form of political-economic ideology of this sort is the primary problem and assess its explanatory power. I conclude that the contention does not fare very well. I do not, though, deny that ideology of some sort has a major impact on the output of the modern economics academy. However it is of a different nature to any form typically attributed to the mainstream, and works in somewhat indirect and complex ways. Having raised the question of the impact of ideology I take the opportunity to explore its play in the economics academy more generally.

Brain Physiology, Egoistic and Empathic Motivation, and Brain Plasticity: Toward a More Human Economics

13 January, 2012 - 15:42

The brain physiology research of leading evolutionary neuroscientist, Paul MacLean, has important implications for human economic motivation. Gerald Cory in his research has admirably utilized MacLean’s findings and has persuasively explained that humans have two dominant motivations: 1) ego or self-interest and 2) empathy or other-interest, which our brains attempt to balance. This view is clearly important and at odds with mainstream economics in which self-interest is the dominant motivation. The MacLean-Cory view, also known as Dual Motive Theory (DMT), represents a serious challenge to mainstream economics and has begun to attract considerable interest. However, the DMT leaves something to be desired. While understanding the promise of the perspective deriving from brain physiology, some scholars have expressed dissatisfaction with how the three level modular brain model has been used to explain economic behavior. Accordingly, the purpose of this paper is to integrate DMT with the concept of brain plasticity.

Brain plasticity refers to the ability of the brain to change structurally and functionally as a result of input from the environment. Some of this plasticity is no doubt genetically determined but some brain change is a product of individual effort and represents the individual’s investment in intangible capital (standard human capital, social capital, personal capital, and so on). In this revised view, the balance that individuals, groups, and societies strike between ego and empathy orientation is to a great extent determined by these intangible investments, not simply by brain physiology. In other words, it is the plastic aspect of the brain that determines how the capacity associated with brain physiology gets expressed.

An Evolutionary Efficiency Alternative To The Notion Of Pareto Efficiency

13 January, 2012 - 10:42

The paper argues that the notion of Pareto efficiency builds on two normative assumptions: the more general consequentialist norm of any efficiency criterion, and the strong no-harm principle of the prohibition of any redistribution during the economic process that hurts at least one person. These normative concerns lead to a constrained and static notion of efficiency in mainstream economics, ignoring dynamic efficiency gains from more equal allocations of resources. The paper argues that a weak no-harm principle instead provides an endogenous efficiency criterion which shifts attention away from equilibrium analysis in hypothetically perfect markets towards an evolutionary analysis of efficiency in real-world, non-equilibrium markets. Moreover, such an evolutionary notion of efficiency would be less normative than the Paretian concept.

On the Limits of Rational Choice Theory

13 January, 2012 - 10:41

The value of rational choice theory for the social sciences has long been contested. It is argued here that, in the debate over its role, it is necessary to distinguish between claims that people maximise manifest payoffs, and claims that people maximise their utility. The former version has been falsified. The latter is unfalsifiable, because utility cannot be observed. In principle, utility maximisation can be adapted to fit any form of behaviour, including the behaviour of non-human organisms. Allegedly ‘inconsistent’ behaviour is also impossible to establish without qualification. This utility-maximising version of rational choice theory has the character of a universal ‘explanation’ that can be made to ‘fit’ any set of events. This is a sign of weakness rather than strength. In its excessive quest for generality, utility-maximising rational choice theory fails to focus on the historically and geographically specific features of socio-economic systems. As long as such theory is confined to ahistorical generalities, then it will remain highly limited in dealing with the real world. We have to move on and consider the real social and psychological determinants of human behaviour.

Economics and Research Assessment Systems

13 January, 2012 - 10:37

This paper seeks to analyse the effects on Economics of Research Assessment Systems, such as the Research Assessment Exercise (or RAE) which was carried out in the UK between 1986 and 2008. The paper begins by pointing out that, in the 2008 RAE, economics turned out to be the research area which was accorded the highest valuation of any subject in the UK, even though economists were then under attack for failing to predict the global financial crash which had occurred a few months earlier. One aim of the paper is to explain this economics anomaly in research assessment. The paper goes on to point out a key difference between economics and the natural sciences. Most areas of the natural sciences are dominated for most of the time by a single, generally accepted, paradigm, whereas there are always in economics different schools of thought which have different and highly conflicting paradigms. Given this situation, it is argued that the effect of research assessment systems in economics is to strengthen the majority school in the subject (whatever that is), and weaken the minority schools. This conclusion is supported by empirical data collected by Frederic Lee for the UK. It is then shown that the greater the dominance of the majority school, the higher the overall valuation of the subject is likely to be, and this is used to explain the anomaly noted earlier. It is argued that research in economics flourishes better in a situation in which there are a number of different schools treated equally, than in one in which a single school dominates. The conclusion is that research assessment systems have a negative effect on research in economics and give misleading results. Instead of such systems, an attempt should be made to encourage pluralism in the subject.

What Kind of Theory to Guide Reform and Restructuring? A focus on theoretical approach

13 January, 2012 - 10:35

The economic crisis has exposed shortcomings in standard economic theory and provided an impetus for new economic thinking. But the theoretical debate in the wake of the crisis has been unduly constrained by the terms of the mainstream approach to economic theory. Like any approach, it is characterised by a way of framing reality, giving meaning to terms and setting criteria for good argument. It also determines how any economic theory is understood, whether from the history of economic thought or from the contemporary literature. But there are other approaches to economics which would open up the field to a much wider range of possibilities for new economic thinking. Addressing the challenge that any reader bases her understanding on her own approach, the purpose of this paper is to attempt to explain what it means to consider different approaches. This is done by discussing two features of the financial crisis which pose particular problems for economic theory. These are the role of changing market sentiment in driving asset prices on the one hand and the breakdown of trust relationships in banking on the other (the moral hazard issue). We will see how these are addressed by mainstream theory and by alternative approaches. First, market sentiment is discussed within the mainstream rational-optimising framework, where risk is quantifiable, and compared with the Keynesian approach based on the general uncertainty of knowledge, where reason, evidence and sentiment are integrated. The moral hazard issue is then discussed in its mainstream form in terms of rational opportunism and in its institutionalist form in terms of the foundation of social relations (including relations between institutions) in trust. It is shown that different ways of approaching theorising in each case imply different policy measures. It is argued further that a deductive mathematical approach to analysis of market sentiment and trust is unduly limiting, and that a more pluralist approach would more fully address the issues.

Diagnosis of Financial Crisis by High Moment Deviations and Changing Transition Probability

11 January, 2012 - 15:40

High moments and transition probability provide new tools for diagnosing a financial crisis. Both calm and turbulent markets can be explained by the birth-death process for up-down price movements driven by identical agents.

The master equation approach in statistical mechanics and social dynamics derives the time-varying probability distribution for population dynamics. We calculate the transition probability from stock market indexes from open economic systems that is different from a Gaussian distribution from equilibrium physics in conservative systems. Market instability can be observed from dramatically increasing 3rd to 5th moments before and during the crisis and the changing shape of transition probability. Positive and negative feedback trading behavior can be revealed by the upper and lower curves in transition probability. There is a clear link between liberalization policy and market nonlinearity. The crisis condition for market breakdown can be found from the solution of the nonlinear birth-death process. Numerical estimation of a market turning point is close to the historical event of the U.S. 2008 financial crisis. The representative agent model of random walk and geometric Brownian motion in macro and finance theory does not provide any clue on the condition of a financial crisis. The sub-prime crisis in the U.S. indicates the limitation of a diversification strategy based on a mean-variance analysis. Historical lessons in recurrent financial crises demand a more general framework with endogenous instability and economic complexity, such as nonlinear interactions, non-stationary dynamics, and social interaction. Our general framework greatly extends the scope of equilibrium models in finance, which is a special case of a calm market in our nonlinear model. We obtain a unified picture of economic complexity with endogenous instability and market resilience (JEL G01, E32, C58)