Archive | August 2012

Things that are cool: Astrophysics

The sun is really big. Its really hard to get across the sheer incomprehensible bigness of these things, but sometimes you come across numbers that really brings it home:

Here is one: The sun creates light by converting mass into energy through fusion. Since the creation of the earth some 4.7bn years ago, the sun has converted roughly the total mass of the earth into energy. (6*10^24 Kilograms). This is a negligible proportion of the suns mass of 2*10^30kg.

Awesome.

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What really caused Stagflation. Part 1 of many.

In this post I propose to discuss the philips curve, which posits a relationship between unemployment and inflation. The first note about the philips curve, is that it is fundamentally an empirical relationship, rather than one which is explained fully by theory. Here is a rather nice graph of unemployment vs inflation:

So as we can see, the relationship held extremely well in the two decades leading up to the seventies, and then collapsed completely. The salient question is, why. In particular, if we would expect the Phillips curve to hold now, we would be saying that we *must* target higher inflation to lower unemployment.

The interpretation I am going to advance is simple: I propose that, in demand side recessions monetary stimulus is effective, and that the central banks of 1950-1970 engaged in monetary stimulus to lower unemployment, and raise inflation, and it works, and as unemployment fell they allowed to inflation to lax. Thus, I am really saying that the Philips curve is caused by effective central bank intervention, and fails when central bank intervention fails.

This simplistic expectation makes perfect sense to me, in a demand side recession, people stop buying stuff. Since prices clear markets, this only happens because the price level is wrong. Thus the central bank should step in to reset the price level, and this lowers unemployment. However, it is clear that it should be impossible for the central bank to lower unemployment below its structural limit, which is why the curve becomes very steep at some non zero level of unemployment.

At high unemployment, monetary stimulus (or fiscal) amounts to buying stuff that was created out of idle resources. Since production is increasing the amount of goods, in direct proportion to the amount of monetary stimulus, then there can be no inflation. (The price level is the ratio of supply of goods to the supply of money).

If this is the case, we might expect to be able to see it happen in real time: Our prediction is that inflation will only rise when unemployment reaches its natural rate:

If we look at the period 1950-1970, we see that is the case. Inflation rises only as unemployment reaches a natural rate of, say, four percent.

Now, we can see that the region 1970-1980 this was not the case. This is the case, because in that time, the problems the economy faced could not be lowered by central bank intervention. The archetypal example of this is an asteroid strike. Suppose that an asteroid wiped out half of the capital of the United states, but all people were successfully evacuated. So half the houses, half the factories, half the farmland etc. Is it not absurd to suppose that all the economy would need to reach full employment would be central bank intervention? Of course it is, we would need to build new houses, new factories, etc. Even when it came to basic resources we would have a problem, needing different types of mines, to extract the resources for building cities, rather than for doing lots of high value electronics manufacturing etc.

This is the very essence of a supply side problem, and they take time to solve. Now, the supply side problems of the US were not quite so typical. Would it surprise you to know that the 1970-1980 decade represented some of the strongest growth in US history? The economy added nearly twenty million new jobs despite the recession. In fact, this was the problem. The labour force was growing faster than capital could be formed to employ the new labour. Have a look at this:

Labour force participation grew by five percent. That is a huge change, representing millions and millions of jobs. This at a time when population growth was also strong, and the demographically large baby boomer generation was entering the workforce, led to an incredible rate of increase in the labour force:

So the labour force grew by 30 million from 80 to 110, a 35% increase in a decade. Is it any wonder that production could not keep up with demand? This is what really drove high inflation in the seventies, coupled with contraction in the world oil supply, and a few other assorted shocks. But really, this is what drove high inflation, we had ever more workers competing for a limited production which could not grow fast enough to keep up with rising demand.

Now you might think, looking a this graph, that labour force participation looks a lot like a straight line. But it is the percentage increase that is important, and subsequent decades increased a little less, starting from a much higher base. It is self evident that larger economies can handle an influx of a given size better than small economies.

It is self evident that the central bank can do little to control this type of supply side constraint. The economy was already building new capital at a high rate, and it was close to full employment, despite the high unemployment rate, as the labour force was simply expanding faster than jobs could be created. To put that in today’s terms, in the 1970’s the number of new jobs a month needed to increase by a quarter of a percent of the total number of jobs, every money, just to stand still. Adjusted for the size of the current labour force, that is 375,000 jobs a month just to stand still. These days we would kill for a number in the 300,000 range. And they needed that every month just to maintain the unemployment rate.

Anyway, to get bank on point: The central bank could not intervene effectively, because the economy was functioning perfectly. High inflation was a perfectly rational response to demand outstripping supply. Since the economy was at or near full employment, increases in the inflation rate did nothing to reduce unemployment. Thus the central bank was powerless to lower unemployment, and could control inflation only by inducing a recession. This left the central bank with a very unappetising choice. It could control inflation only by inducing a recession, and the only way to keep it down was to control the expansion of the labour force, which meant that unemployment remained elevated for most of the next decade. Fortunately, by 1970’s the growth in the labour force (as a percentage) was slowing drastically, alleviating the pressure, and by 1980 all was back to normal.

In summary: The central banks can fix nominal problems, it cannot fix real problems. We have no need to fear 1970’s style inflation due to monetary stimulus, as until the economy reaches full employment, extra monetary stimulus, (or increased velocity) will only lead to increased output, not inflation.

Next post we will discuss Milton Freidmann’s explanation for why the philip’s curve broke down, and why I don’t find it as convincing as the explanation given out above.

Funded and Unfunded Entitlements

There is a lot of talk in the political/economic sphere about the problem of unfunded entitlements. The ever excellent interfluidity offers a compelling perspective on price stability and the elderly. In that vein I wish to offer a different perspective on saving, and to do that, I will consider the following statement:

“In any closed economic system, there is no difference between a funded and unfunded entitlement”.

It seems intuitively obvious that an unfunded entitlement will impose a monetary burden on future generations, after all, they will be the tax payers who are paying it. However, such an intuition fundamentally misunderstands the role of saving in an economy. In particular, it is the division of current production among consumers that is the principle goal of all social security programs.

Consider a stylised model where generation A works, and when they retire their jobs will be taken over by generation B, but total production remains stable. In the case of an unfunded retirement, generation B, directly funds the retirement of A, by giving half of their consumption claims’, and hence half of their production, to A. In the case of a funded entitlement, generation A saves half of their consumption claims, however, the remaining half is still sufficient to buy all of the production while they are working. They are saving their claims, not their actual production. In a flexible economy, the amount of money in circulation (i.e. not saved) is always sufficient to buy all of the goods. When generation A retires, they liquidate their savings and attempt to buy B. However, this is simply increasing the number of consumption claims, without affecting the total production (which, by assumption, is stable). Thus, assuming their saving was sufficient, generation A still ends up consuming half of the production, and generation B is in an identical position.

Of course, the real world is not so simple. In particular, saving often means investing in assets which will increase the total production. Holding the total production steady is a very poor approximation to the real world. On the other hand, it does make clear that it is consumption that is important. The elderly will consume a fraction of our resources, regardless of whether their entitlement is funded or unfunded. I’m not sure if this means we can all be blasé about unfunded entitlements, or if we should be worried about the inflationary potential of the baby boomer generation liquidating their assets. My main point is that it doesn’t matter how we fund it, we are going to be giving a certain fraction of our production to caring for the elderly as our demographic changes, and the reality is that very little production can be stored up for later. Healthcare, for example, cannot be saved. Even semi durables like cards cannot be saved, as pensioners are unlikely to want 1970’s vintage cars as part of their share of consumption.

Let us refocus the debate where it matters: Maximising production, and sharing out claims on that production fairly.

Rising Inequality in the Developed World

In this post I will consider the follow theses:

(1) That rising inequality is a secular trend, driven by the economic forces of globalisation, and is largely unrelated to tax rates.

(2) That the stagnation of the median wage is due to the integration of unskilled labour in the BRICs and other countries, and is likely to continue for some time.

To my mind, points one and two above are really the same point. Let us consider a few graphs, firstly, that inequality, as measured by the gini coefficient, is rising,

Gini_mkt

although most of that rise was pre the bursting of the dotcom bubble, to my mind, the key point is that even highly progressive countries like sweden are experiencing similar movements. Conversely world inequality is down

world gini coefficient from 1970 to 2006

(I got these images from google images, I have not sourced the data myself, but they look a lot like I expect).

To my mind, the big story in rising inequality is this:

 

 

 

which shows the declining labour share of employees in the manufacturing industry, this comes from a BLS report. I think this graph makes clear where the productivity gains since 1990 have gone in manufacturing, into rising commodity costs, but that, in itself, is not an answer. It is a personal dictum that one should remember that an economy is all people. Paying more for commodities largely means paying more to miners, and basic heavy industries, which are located in the BRIC’s. This makes sense, labour is cheaper there, we have moved unskilled, semi-skilled, and low-skilled labour offshore, and this is hurting those parts of our labour market. What we should expect to see then, is that the wages of brazilian miners are rising rapidly to converge with the wages of labour in the developed world. And we do see this, although data is not so easy to come by, http://laborsta.ilo.org tells us that the wages of brazilian miners and basic metal manufacture doubled between 1994 and 2002.

The integration of more workers into global labour markets, is driving the decrease in global inequality, but it is also reducing the bargaining power and wages of manufacturing employees in developed countries, which has led to stagnant wages. In contrast, the wages of the skilled classes are increasing, if you are a manager, or a technical specialist, your are now in more demand than ever, as your are needed in more countries than ever. It will take time for countries like brazil to develop law schools, universities, and business schools to rival those in developed countries, and until they do we will have a shortage of professionals on the world stage, and their wages will rise. Therefore, I predict that inequality in developed economies will cease rising, at the same time that world inequality stops falling. This will also be the end of wage stagnation in manufacturing in the developed world.

I have not talked much here about the owners of capital. It is a fact, that for those who build companies, larger markets mean larger markets. Google has brought its search function to three billion consumers. IBM has made more microchips than there are people on the planet. Those who built these companies have profited immensely from expanding trade. Rising profits for the 0.01% is not surprising. Nevertheless, I am not too worried. It is harder than one imagines to stay on top. Most companies eventually go bankrupt, and take a lot of their founders wealth with them. Finally, wealth is a lot like insurance, whereas it is inequality of consumption that should worry us.

A final, political, note. It seems to me that the world is changing, and rising inequality will be here to stay until factor price inequality is complete, that it will be maintained until higher education is developed throughout the world, whence it will fall. This, to me, represents a cogent reason why conservative minded persons should support a more progressive tax system in the medium term.