Marc Lavoie’s Eight ‘Macroeconomic
Paradoxes’: Emergent Properties of Aggregating from the Level of the Individual
or Small Groups to the Real World (Totally Overlooked by Representative-Agent DSGE
Modelling and other Micro-founded Approaches to Macroeconomics)
The following comes from
Chapter 1 of the 2015 second edition of Marc Lavoie’s fairly excellent textbook
of post-Keynesian economics, Post-Keynesian
Economics: New Foundations, called “Essentials of heterodox and post-Keynesian
economics”, in which Lavoie discusses the philosophy and methodology of the
post-Keynesian school as separate from other schools (though he does see many
connections between heterodox schools of economics as opposed to the orthodox
schools), and explores the reasons for the dominance of the neoclassical school.
In this section, he expounds the eight key ‘macroeconomic paradoxes’ discovered
by the post-Keynesian school; these show the crucial insights that can be
yielded from a holistic and social-class-based, ‘complex systems’ analysis[1]
of the economy (practised by classical economics/classical
political economy (Smith, Ricardo, Mill, Marx)) as opposed to the neoclassical
individualistic and atomistic, anti-complexity, equilibrium-obsessed approach
of the neoclassical school (beginning with Léon
Walras and Arthur Stanley Jevons, massively advanced by Paul Samuelson in the
early 1950s).
Paradox of thrift (Keynes, 1936): “Higher
savings rates lead to reduced output.”
Marc Lavoie [18]: “Keynes’
paradox of thrift says that an increase in the propensity to save will lead to
reduced output. With households being over-indebted, the paradox of thrift acts
against the recovery, as households desperately try to restore their past
levels of wealth by saving a larger proportion of their revenues. A quick check
confirms that the notion of the paradox of thrift has now disappeared from most
principles of economics textbooks. The Global Financial Crisis illustrated the
lack of awareness of this paradox, as several new classical [neoclassical]
economists seemed to endorse Hayek’s view that purchasing additional
consumption goods would increase unemployment (Robinson, 1973, p. 94). Luckily,
some decision-makers understood the paradox of thrift: Mark Carney (2008, p.2),
former Governor of the Bank of Canada and now Governor of the Bank of England,
referred to it in a speech made during the financial crisis, when he pointed
out that it would be ‘individually rational for people to want to save more’ in
uncertain times, although if all individuals do so, then ‘it becomes
collectively irrational’.
Paradox of costs (Kalecki, 1969; Rowthorn,
1981): “Higher real wages lead to higher profit rates.”
Marc Lavoie [18-19]: “The
paradox of costs, in its static version, says that a decrease in real wages
will not raise the profits of firms and will instead lead to a fall in the rate
of employment. This was explained by Kalecki (1969, p. 26) in a Polish paper
first written in 1939, where he concluded that ‘one of the main features of the
capitalist system is the fact that what is to the advantage of a single
entrepreneur does not necessarily benefit all entrepreneurs as a class’. Its
dynamic version has been proposed by Robert Rowthorn (1981). It says that rising
real wages (relative to productivity) can generate higher profit rates. This
flies in the face of a microeconomic analysis that would demonstrate that lower
profit margins generate lower profit rates. But if higher real wages generate
higher aggregate consumption, higher sales, higher rates of capacity
utilization and hence higher investment expenditures, profit rates will be
driven up. This of course is nothing else than a variant of Marx’s problem of
the realization of profit, underlined for instance by Amit Bhaduri (1986). In
the midst of a crisis, it is important to resist calls to reduce labour costs
in an effort to improve the profitability of individual firms. While this will
be profitable to the firms that achieve the greatest real wages reductions, the
overall effect will be detrimental to the overall economy, and most certainly
to the overall world economy.”
Paradox of public deficits (Kalecki, 1971): “Government
deficits raise private profits.”
Lavoie [19]: “The paradox of
public deficits can be directly attributed to Kalecki (1971). He showed that
higher government deficits play a role similar to that of higher net exports on
corporate profits. Higher public deficits lead to higher corporate profits,
just like higher public deficits lead to higher GDP and employment following the
teaching of Keynes. While mainstream authors used to argue about the
crowding-out effects of government activity, based on Ricardo-equivalence
effects or rising real interest rates, several governments have engaged in expansionary
fiscal policies in 2009 so as to sustain aggregate demand and corporate profits
despite the financial crisis. When things go really wrong, neoclassical
theories are thrown out of the window, being replaced by more pragmatic and
realistic theories. It must be admitted, however, that pragmatism did not occur
for long, as governments quickly called for fiscal consolidation programmes,
especially in Europe.”
Paradox of (private-sector)
debt (Fisher,
1933; Steindl, 1952): “Efforts to de-leverage might lead to higher leverage
ratios.”
Lavoie [19-20]: “This
paradox is also based on the concept of effective demand, and it was put
forward by Joseph Steindl (1952, ch. 9), who was a follower of Kalecki. From a
strictly microeconomic point of view, one would be led to believe that it is
always possible for economic agents to reduce their debt or leverage ratio by
simply deciding to do so. While this may be true for households, it may be
quite difficult for firms and financial institutions taken as a group. To
reduce the weight of indebtedness, firms may decide to cut their investment
expenditures and hence the amounts they borrow. However, if all companies are
pursuing this scheme, cutting back on borrowing and investment may not put
matters right, for the slowdown in capital accumulation reduces the overall
profitability of businesses and hence the accumulation of retained earnings. In
the end, the actual leverage ratio may rise, moving in a direction that is the
opposite of what is intended by the entrepreneurs. This is what Steindl (1952,
p. 119) and Jan Toporowski (2005, p. 236) call ‘enforced indebtedness’. The
paradox of debt may also apply to governments: as they reduce government
expenditures and pursue other austerity measures to reduce public debt, the
government debt to GDP ratio may rise instead.
Something
quite similar may happen to banks and other financial institutions as they try
to reduce their leverage ratios. This is linked to Irving Fisher’s
debt-deflation effect. As banks sell some of their assets, in an effort to
reduce leverage or recover liquidity, such forced sales bring down the price of
these assets, which are now sold at a loss, thus reducing the banks’ own funds,
so that the leverage ratio is rising instead of falling. Other efforts to
reduce the amount of loans may put borrowers in financial distress, as is
observed in times of credit crunch, so that again individual attempts to reduce
the leverage ratio (or to increase the capital to asset ratio) may indeed lead
to the opposite macroeconomic effect. This can be associated with what we would
call the paradox of banking refusal. When the economy is slowing down or is
entering a recession, it may be rational for each individual bank to take
protection measures against loan losses by rationing credit and refusing to
grant new loans. But, as is recognised by the Governor of the Bank of England,
if all banks do the same, ‘their actions will exacerbate the downturn and
increase their eventual losses’ (Carney, 2008, p.2).”
Paradox of tranquillity (Minsky, 1975): “Stability
is destabilizing.”
Lavoie [20]: “Also closely
tied to the financial system is the paradox of tranquillity. This is an
expression that I coined nearly 30 years ago (Lavoie, 1986a, p. 7), when
studying the works of Minsky. According to Minsky, a stable growing economy is
a contradiction in terms. A fast-growing free-market economy will necessarily
transform itself into a speculative booming economy. In a world of uncertainty,
without full information about the fundamentals, a string of successful years
diminishes perceived risk and uncertainty. People tend to forget the
difficulties encountered in the past: turning points, falling asset prices,
credit crunches and recessions. As time goes on, memories fade and economic
agents dare to take on higher levels of risk. Or else, as time goes on, the
risk level as computed by engineering models of finance, such as the very
popular value at risk model, appears to get smaller because the last recession
is just one remote observation among a series of more recent successful years.
The longer an economy is in a tranquil state of growth, the less likely it is to
remain in such a state. As Minsky himself says, ‘each state nurtures forces that
lead to its own destruction’ (Minsky, 1975, p. 128). In three words, the
paradox of tranquillity says that ‘stability is destabilizing’ (Minsky, 1982,
p. 26). Applied to a monetary economy, this implies that a string of successful
financial operations will induce banks to indulge in ever riskier financial
structures.
What Minsky
was claiming 30 years ago seems quite prescient today: ‘Over a period in which
the economy does well, views about acceptable debt structure change. In the
deal-making that goes on between banks, investment bankers, and businessmen,
the acceptable amount of debt to use in financing various types of activity and
positions increases (Minsky, 1977, p. 24). The cushion for safety – the
difference between the additiona revenues expected from some new activity and
the financial commitments required by this activity – gets reduced through
time. For Minsky, instability and the rising fragility of the financial system
are inherent features of an unregulated capitalist economy. Part of this
destabilizing stability is tied to financial institutions, which will be
introduced or expanded when things go well (ibid.). This view of the financial
system is reminiscent of that of John Kenneth Galbraith, who, in his various
books, most notably A Short History of
Financial Euphoria (1990), has argued that speculative euphoria in market
capitalism was an inevitable outcome, as speculators and bankers ride the wave
by using leverage and believe they become rich because they are smart.”
Paradox of liquidity (Dow, 1987; Nesvetailova,
2007): “New ways to create liquidity end up transforming liquid assets into
illiquid ones.”
Lavoie [20-21]: “The paradox
of tranquillity is certainly at the heart of the Global Financial 0Crisis. But
no less important for the subprime crisis is the paradox of liquidity. In
modern finance theories of the neoclassical type, most assuredly the
efficient-market hypothesis, liquidity is of little concern. It is assumed that
well-informed market participants always manage to arrive at a transaction
price reflecting the correct fundamental value of an asset. What is at issue is
only the expected return and the estimated risk of the asset. By contrast,
liquidity is a crucial element of post-Keynesian economics (Davidson, 2009).
Investors should always be concerned about the impossibility of cashing in
their assets. There must be some market-maker who guarantees to purchase assets
if the market suddenly goes one way. These market-makers are dealers, with
access to lines of credit issued by banks, or the banks themselves, with access
to central bank liquidity.
The paradox of
liquidity can be seen from two angles. First there is the obvious fact, also
linked to Fisher’s debt-deflation proposition, that the attempt of economic
agents to become more liquid transforms previously liquid assets into
not-so-liquid assets. The frenzy to get rid of assets drives down the price of
these assets and may transform the markets for these assets into one-way
markets, with no purchaser, leading to a total freeze, as occurred in some
markets during the Global Financial Crisis. As Sheila Dow (1987, p. 85) says, ‘attempts
to increase the stock of liquid assets only succeed in reducing it; this is a
paradox of liquidity on a par with Keynes’ paradox of saving’. But there is a
second paradox of liquidity, tied to innovations in the financial system that
we just mentioned. Financial innovations seem to increase liquidity when they
are really diminishing it. This second paradox was already pointed out by
Minsky, but it has recently been underlined in a book. Anastasia Nesvetailova
(2007, p. 78) claims that ‘to Minsky and his followers, therefore, every
institutional innovation that leads to both new ways to finance business and
new substitutes for cash assets, decreases
the volume of liquidity available to redeem the debts incurred’. Thus, she
continues, ‘in the process of financial expansion the financial system,
contrary to appearances, becomes progressively
illiquid’. The financial system gets ever more layered, with everybody
thinking that they can easily access means of payment, but with virtually
nobody holding safe assets without capital-loss risk.”
Paradox of risk (Wojnilower, 1980): “The
availability of individual risk cover leads to more risk overall.”
Lavoie [21-22]: “The paradox
of liquidity can be extended to a paradox of risk. Financial innovations
designed to reduce risk at the microeconomic level, by spreading it over a
larger number of financial institutions – as is the case with securitization,
collaterized debt obligations, credit default swaps, equity default swaps,
interest rate swaps, and the whole gamut of financial futures and financial
derivatives – end up creating a larger amount of macroeconomic or systemic
risk. For instance, it is now widely believed that the extensive use of
mathematical models to quantify risk, yielding the illusion of precise and
objective assessments, encouraged banks and other financial institutions to
pursue more risky strategies and to use more leverage. Famous US regulators
such as Alan Greenspan –the former Federal Reserve Chairman – and Tim Geithner –the
former President of the New York Fed and former US Secretary of Treasury – both
claimed as late as 2006 that credit derivatives were a stabilizing factor in
the financial system, as they reduced the concentration of individual exposure
to risk, spreading credit risk to those best able to handle it. Even left-wing
economist such as Michel Anglietta (1996) argued that securitization would have
beneficial effects on the economy. Each microeconomic agent believes that he or
she is now covered against risk; but the risk is still there, in the form of counterparty
risk. Indeed, even if the counterparty seems to be safe, the counterparty’s
counterparty may not be, and its failure may well spill over. The illusion of
liquidity induces agents to take even more risky decisions. Thus risk-reducing
microeconomic financial innovations end up producing a more risky macroeconomic
environment. Derivatives were likened to the contingent markets of the general
equilibrium model à la Arrow-Debreu. But we do not
live in such a world. It is completely imaginary. We live in a world of
fundamental uncertainty à la Keynes and Knight.
Derivative
financial products do not stabilize the economy. While they are a tool of risk
management, ‘derivative markets actually increase the credit risks’, since ‘at
the first whiff of crisis or instability, the first thing to evaporate is the
liquidity’ that these tools are supposed to provide (McKenzie, 2011, p. 212).
Thus, ultimately, as summed up long ago by another Minsky follower, Albert M.
Wojnilower (1980, p. 309), the ‘supposed immunity to financial risk always
turns out to be illusory, and the risks and costs of shattering the illusion
may be considerable’. Wojnilower was particularly perceptive about this since,
as far back as 1984, he predicted the bailout of AIG from its CDS sales:
“The recent
entry of major insurance companies into the business of insuring banks and bond
investors against loan defaults represents another effort to stretch the safety
net. Now, it can be presumed, the authorities will have to intervene to
interdict a cascading of defaults only if to save the insurance industry.”
(Wojnilower, 1985, p. 356)”
Paradox of profit-led demand
(Blecker,
1989): “Generalized wage restrictions lead to a slowdown in growth even when
all economies seem to be profit-led.”
Lavoie [22]: “While a
country taken in isolation may succeed in raising its net exports and its
economic activity by imposing reductions for nominal and real wage, thus
gaining a competitive advantage, this scheme will be unsuccessful if all other
countries do the same. As will be discussed in Chapters 6 and 7, when only
domestic demand is taken into consideration, thus omitting demand arising from
abroad, all countries benefit from an increase in real wages (or in the wage
share), mainly because of their positive impact on consumption expenditures. Because
Planet Earth is a closed economy, the exports of one country are necessarily
the imports of another country, and hence globally net exports are nil. Even
though all countries may individually benefit from a change in income distribution
towards profits, if other countries do not follow suit, such a change will have
detrimental effects on the economic activity of the world economy if all
countries pursue wage restrictions.”
[1] Steve
Keen, loosely identified with the post-Keynesian tradition though influenced
most by Sraffa, Schumpeter, Marx and Minsky (only the last of whom is regarded
as a member of the post-Keynesian tradition (one of the most important)), makes
a cogent case for the adoption of mathematical complexity theory and nonlinear
dynamics in economics in his magnum opus, Debunking
Economics. Keen’s best argument is the success of his own dynamic model – a
mathematization of Minsky’s model of financial instability – in predicting the
Global Financial Crisis. Recently, I have noticed Keen engaging in Twitter with
another pioneer of nonlinear dynamics in social science, the ‘cliodynamicist’
historian, Peter Turchin, who has a grand theory of historical cycles in empires
called the ‘Structural-Demographic Theory’.
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