Economics for Democratic Socialism Drexel University Spring Quarter

Economics for Democratic Socialism Drexel University Spring Quarter 2009

Revision of Outline • I told you this class is an experiment! • This week: – I still need to talk about classes and their relevance to 2008 -9 – I wanted to begin to understand the crisis of 2008, first with Keynesian and neoclassical economics, then Marxist, and starting with unemployment – Instead, I think it best to start with the monetary system. – New reading assignment: – http: //faculty. lebow. drexel. edu/mccainr/top/prin/txt/mo ney/Ch 18 To. C. html

Twenty-First Century • Democratic Socialists have learned a great deal from the twentieth century, and done some good, but have not created a classless society. The way to this objective seems, if anything, less clear rather than more. • Let us think a little more carefully about “classless society. ”

Classes • In Marxist analysis, different classes have different relations to the means of production. – Thus, for example, a farmer who works his own land is not a member of the working class. • American economist Thorstein Veblen distinguished the leisure class from the working class. – For Veblen, the independent farmer would be a member of the working class, not the leisure class • I’ll use both -- but Marxist by default.

Class Societies • In ancient societies, the major classes are the payers and recipients of tribute. – The early (Ummayad) Islamic Caliphate provides a very refined instance of this. – The Arab conquerors built new cities (Basra, Kufa, Cairo, e. g. ) where Arab soldiers lived on salaries derived from tribute. – Other classes -- merchants and rural landowners -existed and paid tribute to the ruling class. • In Feudalism, the main classes were landlords and peasants.

Classes in the 19 th Century • The Classical Political Economists (about 1776 -1880) observed that their society was divided into three classes: landlords, the (wealthy capitalist) middle class, and the laborers. This was still true in Marx’ time. • Nevertheless, it is specific to a period of transition from feudalism to capitalism. • Essentially, a worker didn’t own anything he (or she) couldn’t wear or eat. There were no old age pensions. • The “condition of the working class” has changed over the last century, though. • Are we “all capitalists now? ”

Classes over the Life Cycle • To define a social class in 2009, we need to think in terms of the life cycle. • Franco Modigliani, antifascist resistor and Nobel Laureate macro-economist, brought the life cycle perspective into economics. • If you have to work for a wage or salary for most of your life to survive and get a pension, you are a member of the working class. • (Modigliani was a free-market Franco Modigliani liberal. ) 1918 -2003

On the other hand … • Clearly, the working class in 2009 is better off economically than it was in the 19 th century -- even the poorest, if they are regularly employed. • The working class also has some political influence (particularly in Europe. ) • It can no longer be said that they “have nothing to lose but their chains. ”

Other Classes 1. Those who own wealth enough to operate a business, so that they have to work, but not for wages or a salary, are not part of the working class. They are what a Marxist would call petit bourgeois. Some may be no better off than workers, and there can be a lot of mobility from this class in both directions. 2. Those who inherit wealth enough to live without working, the trust fund class, approximate Veblen’s leisure class. 3. Those with wealth enough to control corporations (and buy congressmen) are the grand bourgeoisie -what I call the billionaire class.

Strata • The three groups have interests that are somewhat aligned, and may be thought of as different strata of the same capitalist class. • However, differences among them can be important, and their interests are not wholly aligned. • Interests of the grand bourgeoisie tend to be national and international, while those of the petit bourgeoisie tend to be local. • These conflicts are the major differences between the two parties in the USA.

Classless Societies • Can we even conceive of a classless society? • “Jeffersonian democracy” -- a society of freehold farmers -- would be classless. • But that is inconsistent with modern production. • In state socialism, everybody would (in principle) be a public employee. Thus, no class divisions. • In a system of worker cooperatives, as envisioned by Mill, everybody earns their income as a member of a worker cooperative. Thus, again, no classes.

State Socialism • While state socialism is in principle classless, it is unstable because it is hierarchical. • The technostructure of planners and managers becomes a group distinct from the workers, living off their surplus. (Galbraith, Djilas) • Whether or not this is a “new class, ” it sets the stage (as in the Soviet Union) for the return to capitalism, since they can extract the surplus more effectively as capitalist “oligarchs. ”

Nationalization • Many mid-twentieth century democratic socialists saw selective nationalization as a path to state-socialism. • As Busky points out, this, too, proved unstable - and was reversed by privatization, decisions taken by democratic governments with labor parties in the parliament. • Have the workers any stake in nationalization or state-socialism? No direct stake, anyway -although perhaps the technostructure do.

Cooperative Socialism • In a cooperative socialist system, some of the cooperatives will be very large indeed -unavoidably -- and managers will be specialists. • However, as they are responsible to the people they manage, it is at least possible that the hierarchy will be much more limited. • Thus cooperative socialism remains a hope for a classless society.

Crises • This course is a small response to the economic crisis of 2008. • There are several terms that might be used to designate recent events: in addition to “crisis” we could say “recession, ” “depression, ” or “cyclical downturn. ” • These terms all have their built-in assumptions (presuppositions). • The most widely used framework for discussing these events is “Keynesian. ” • Keynes, in turn, borrowed some ideas from Malthus. • First, though, some preliminary ideas about money and other assets.

Assets and Liabilities • Keynesian and neoclassical economics tend to discuss economic activity in terms of flows, such as income and profits. • I want to begin instead by talking about the different players in a modern economy in terms of the assets and liabilities they hold. • Fair warning: I never had an accounting course and don’t know beans about accounting.

Sectors • For this discussion we will consider 4 main sectors, 3 with subsectors. – Private sector • Households • Nonbank Businesses –Public Sector • General Government • Social Production –Banking sector –Banks –Fed or Central Bank –Foreign

Social Production • The “social production” sector will not exist in a (pure) capitalist system. • It is a sector of commodity production -- that is, production of goods for sale -- within the public sector. • We assume that the receipts of the social production sector cover its costs. • Thus, for example, production of mass transportation as a public service is not social production, but a role of general government. • (But postal service since Nixon is social production. )

Covering Cost • In neoclassical economics, costs are opportunity costs. – That is, the cost of any product or service is the value of the other products or services that we have to give up to produce it. – In particular, in present conditions, investment has an opportunity cost. – The return of this opportunity cost is a net income to the proprietor of the business, called “accounting profit. ” – Thus, the return of the social opportunity cost is a net income to the public sector.

Mature Socialism • In a mature socialism, this return of the opportunity cost of investment in the social production sector would be a large proportion of the national product, perhaps as high as one-fourth to one-third. Some of this will be reinvested, but there will probably be a surplus. • This might be used to pay some of the costs of general government, reducing taxes -- perhaps to zero. • It might be paid as a social dividend. • But that would be pretty far in the future.

Assets and Liabilities 1 • Nonbank Businesses – Assets: productive capital goods, K – Liabilities: Debt, B, and equity, E. – K=E+B • General Government – Liabilities: Indebtedness, D – No Assets • Foreign – Net Assets, F

Assets and Liabilities 2 • Banks – Assets: • IOU’s , W • Reserves, Z (deposits in Federal Reserve) – Liabilities: • Deposits, U • Equity, V • Fed – Assets: government bonds – Liabilities: bank reserves, Z; currency

Assets and Liabilities 3 • Households – Assets: Household capital goods, H (mostly equity in owner-occupied houses). – Assets: part of E, B, and D, minus debt=household net financial assets denoted by A • Only households and the foreign sector are net asset holders. • Therefore P=A+F=E+B+D+U+V-W

Prudent and Legal Banking 1 • U+V=W+Z • Reserves, Z, must be sufficient to cover current withdrawals. • If people are not confident that a bank has sufficient reserves, they will all demand withdrawals -- making their belief a self-fulfilling prophesy. • This is a “run on the bank. ” • Both sound banking practice and regulations set lower limits on the ratio of Z to U.

A Run on A Bank

Another Bank Run

Depositor Risk • A run on the bank could destroy the wealth of the depositors. – There is government insurance for most deposits -FDIC – But only for recognized banks -- Enron and AIG suffered “runs. ” • A bank could suffer a run when it is quite profitable. • But bankruptcy of the bank also is a risk to the depositors.

Prudent and Legal Banking 2 • Because the risks of bank decisions fall largely on the depositors, it is recognized that banks must be regulated. • The ratio Z/U is universally regulated. • V/U is also increasingly regulated. • Suppose the reserve ratio, Z/U, is required to be at least 1/4. • If the bank can increase its reserves, Z, by one dollar it can increase its deposits (and loans) by 4 dollars. This is called the bank multiplier.

Money • Money comprises those assets that serve as a medium of exchange. • In a modern economy that is currency and deposits. • Deposits do serve as a medium of exchange. If you pay for something with a check or debit card, you are transferring part of your deposit to the seller. • (Since the seller may be a customer of a different bank, the Fed cancels this out by transferring reserves -- bank deposits in the Fed -- from the buyer’s bank to the seller’s bank. )

Banks Create Money • We will ignore currency for simplicity. • Suppose a bank lends me money to build a new room on my house. The bank – Creates a deposit in my name, a liability, and – Accepts my IOU -- a deposit. • U and W are increased in U+V=W+Z • The increases in U and W offset in P=E+B+D+U+V-W • But U -- money -- in private hands is increased.

Credit Card • A credit card is not money, because it is not an asset. It is a line of credit. • Suppose you pay with a credit card. • This increases W, and the bank creates a deposit in the name of the seller a libility, U, to pay the seller immediately. • This loan, too, creates money.

Monetary Policy 1 • Suppose the Fed wants to “stimulate” increased production. – They buy bonds. – When the sellers deposit their checks, this increases bank deposits in the Fed -- that is, reserves, Z. – Thus banks can create more money, U, by some multiple of Z – This increases U/P

Monetary Policy 2 • The Fed wants to “stimulate” increased production. – U/P is increased. – People have “liquidity preferences” that connect U/P with the interest rate. – Higher U/P means lower interest. – Lower interest leads to higher investment, which leads to increased production.

Monetary Policy 3: Catch 22 • Here is one possible glitch: • Recall, V/U, the ratio of equity to deposits, is also regulated, since low V/U means a high risk of bankruptcy. • Thus, if the bank has sustained losses reducing V/U, it may not be willing to create money (by lending it) because that would reduce V/U even lower. • That was a big problem in late 2008. • That was why the government bought in -- providing new equity to raise V/U.

Why Did Greenspan Think …? • Recall P=E+B+D+U+V-W • Now, suppose D, government indebtedness, is negative and dropping. • People pay their taxes by transferring bank deposits, U, to the government. Suppose the government lets them remain as bank deposits. • U/P is reduced • Interest rates rise • Investment falls • Production decreases • And that just keeps on, year after year.

Capital Glut • Again recall P=A+F=E+B+D+U+V-W • Suppose U+V-W and U/P are about constant. • According to Bernanke’s discussion of the capital glut, F increased in the 1990’s and 2000’s. In the 1990’s, D was about steady, but E increased so that equality was maintained. • The dot-com bust of 2001 stopped that. • With E and B stagnant, either A must drop or D must increase. • Both happened.

Housing Bubble • Taking house capital into account, – H+A+F=H+K+D+Z • Households shifted their assets from A to H, borrowing against rising house equity. Thus household total assets did not (seem to) decline. • This generated the housing bubble, so that actually a considerable part of the household asset H was an illusion. • Then the bust came -- and household assets dropped.

Boom and Bust

After the Bust • Consumers discover that their total assets, H+A, are less than they had supposed. • We would expect that they would attempt to rebuild them. • With H stagnant, that means A must increase, – Leading to an increase in saving, • Leading to a paradox of saving – Leading to a recession » Leading to an increase in unemployment • But to fill in those details we need a different approach.

Malthus • 1766 -1834 • born in "the Rookery", a family estate • son of Daniel Malthus, a country gentleman and avid disciple of Jean. Jacques Rousseau • Best known for the work on population, he also wrote on “General Gluts. ”

General Gluts • “It has been thought by some very able writers, that … commodities always being exchanged for commodities, one half will furnish a market for the other half, and … a general excess is impossible. • “This doctrine …appears to me to be utterly unfounded …. • “But it appears to me … that the employment of capital [often will] find a limit, long before there is any real difficulty in procuring the means of subsistence; and that both capital and population may be at the same time, and for a period of considerable length, redundant, compared with the effectual demand for produce. ”

And Landlords … • “There must be a considerable class of persons who have both the will and power to consume more material wealth than they produce, or the mercantile classes could not continue profitably to produce so much more than they consume. In this class the landlords no doubt stand pre-eminent, …”

John Maynard Keynes • 1883 -1946 • The son of the Cambridge economist and logician John Neville Keynes • Studied at Cambridge under A. C. Pigou and Alfred Marshall. • British civil service (India office) 1906 -09 • Then returned to Cambridge • Editor, the Economic Journal, 1911 • Treasury office, 1914 -18

From the General Theory 1 • “From the time of Say and Ricardo the classical economists have taught that supply creates its own demand; meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product. • “Those who think in this way are deceived, nevertheless, by an optical illusion, … • “They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption …. ”

From the General Theory 2 • “Clearly we do not mean by ‘involuntary’ unemployment the mere existence of an unexhausted capacity to work. • “Nor should we regard as ‘involuntary’ unemployment the withdrawal of their labour by a body of workers because they do not choose to work for less than a certain real reward. • “Furthermore, it will be convenient to exclude ‘frictional’ unemployment from our definition of ‘involuntary’ unemployment. .

Still More From the General Theory • “Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = g(N), which can be called the Aggregate Supply Function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the relationship between D and N being written D = f(N), which can be called the Aggregate Demand Function. ”

Perhaps he means … Keynes didn’t draw diagrams, but this seems to be what he meant. We will find this version of aggregate supply and demand useful as we move on.

Keynes’ Discussion • “The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand. . this is the substance of the General Theory of Employment. . ” • “ ‘Supply creates its own Demand’ must mean that f(N) and g(N) are equal for all values of N, i. e. for all levels of output and employment; …” • “This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. ”

Expenditure • Keynes’ thinking (as usually interpreted) centered on the interaction of income and expenditure. • To develop an income-expenditure model, it makes sense first to analyze expenditure. Expenditure has just four components: • Consumption expenditure. • Investment expenditure. • Government expenditure. • Net Exports.

Consumption • The next step in understanding the vicious-circle relationship between income and expenditure is to look at the link from income to consumption. • We suppose that, if income increases by a dollar, consumption would increase by a fraction of a dollar. This fraction is the marginal propensity to consume. • Marginal Propensity to Consume -- abbreviation MPC • From one additional dollar of income (after taxes), the Marginal Propensity to Consume is the fraction of the dollar that is spent on consumption. (The rest is saved).

Consumption Function 1 • One of the simplest ways to express such a relation of dependency is as a linear function: • C = a + b. Y • where C is the consumption expenditure, (in billions of 1992 dollars, for example), Y the national income (in the same units) and a and b are constants. The constant b is the Marginal Propensity to Consume.

Consumption Function 2 • An example with specific numbers would be • C = 200 +. 9 Y • where a would be 200 billion dollars and b would be. 9. In this example, then, the Marginal Propensity to Consume is. 9. • Remember, this is only an illustrative example! to get a reliable approximation, we would need to use some statistical methods and some real numbers.

Equilibrium 1 • For a specific example, let I = 1000 (billion dollars), and assume the consumption function is • C = 500 + 0. 7*Y • with consumption and income, again, measured in billions of dollars. Taking equation 1 and substituting 1000 for I and zero for G and NX, we have • Y = C + 1000 • With two equations and two unknowns, we can solve for C and Y -- the equilibrium.

Equilibrium 2 • In this simple example, the solution is Y=1000+500+0. 7 Y • The term is called “the multiplier. ” • In a more realistic model, of course, it would be more complex

Diagram Here is the graphical version. Keynes identifies “equilibrium” with the equality of planned expenditure with planned production -- the 45° line.

Disequilibrium Suppose instead that we are at a level like 7000 -- a disequilibrium with planned production greater than demand. Then inventories build up.

Inventories

Multiplier Here a drop in planned consumption results in a decrease of production about 3 times as large -- a multiplier of 3. A big issue in February 2009 was: which policy changes have bigger multipliers?

Paradox of Thrift • Now suppose • people try to increase their saving • this leads to a decline in equilibrium income • their saving is no more than before • The reduction in income offsets the increase in intended saving. How do the two changes balance out? In this simple model, they cancel out exactly -- although people have tried to increase their saving, the result is a drop in equilibrium income and no change in saving. This is called The Paradox of Thrift.

Booms • We should point out that an increase in consumption would also have a multiplier effect. In our numerical example, an increase in autonomous consumption by 100 billion dollars would increase equilibrium production by 100*333. 33 = 333. 33 billion dollars. The multiplier works in both directions. US saving rate

Investment 1 • A change in investment will also cause a change in production in the same direction, with a multiplier.

Investment 2 • For example, house construction is an important part of investment.

Investment 3 • Here is the longer view

Investment 4 • The decline in investment played a key part in the Great Depression.

Fiscal Policy • Government spending can “stimulate” aggregate demand.

More From the General Theory • “If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment …”

Coordination Failure

Synthesis • Again recall P=A+F=E+B+D+U+V-W • Suppose U+V-W and U/P are about constant. • We have A+F=E+B+D

Employment 1 • • To approximate employment, use the multiplier concept. i. N D Actually, the multiplier for deficit spending will depend on the proportion of tax cuts and infrastructure projects. i. N G with D=G-T, government spending minus tax receipts. But we will ignore that complication.

Employment 2 • § § • Let N 0 be the employment target We can turn equation ii around: D Adjusting D to obtain the target employment is called “fiscal policy. ”

Classical View • The classical view is that such government policy will never be necessary (except, perhaps, on a temporary basis). • Adjustment of the interest rate and the real (purchasing power) wage will bring the demand for labor into equality with the supply. • Lewis’ socialist view (and his ideas generally) are quite classical in this sense. • Unfortunately, the facts do not seem to agree.

Employment 3 • To maintain target employment we have two conventional methods. 1. § § § 2. § Monetary policy “stimulates” the economy by lowering interest rates may be limited by a “liquidity trap” Certainly interest cannot go below zero Fiscal policy “stimulates” by government purchases of goods and services or by tax cuts

Employment 4 • § § • • Suppose that, year after year, Then D must grow year after year. To maintain A+F=E+B+D, A or F or both must continue to increase every year. This may be inconsistent. What if people don’t want to hold increased assets -- that is, they want to spend them instead? Higher interest rates might persuade them -otherwise, inflation may result.

Iceland 1 • Consider, for example, Iceland. – In Nov. 2007, unemployment was less than 1%, inflation was a problem. – Icelandic banks were making loads of money borrowing and lending abroad. – They also had a housing bubble. – The Crown (Icelandic currency) was depreciating. – They raised the interest rate to 13. 75 to restrain inflation and slow the depreciation.

Iceland 2 • “The nation's celebrated rags-to-riches story began in the Nineties when free market reforms, fish quota cash and a stock market based on stable pension funds allowed Icelandic entrepreneurs to go out and sweep up international credit. ” • “But, as a result of the international banking crisis, the billionaires who own everything from West Ham United football club to the Somerfield supermarket chain, Hamleys toy shops and the House of Fraser, are in trouble and the country is drowning in debt. ” – -- Huffington Post, Oct 6. 2008.

Iceland 3 • Their banking system collapsed in October, 2008. Three of four banks in the country were nationalized. • But no-one would buy Icelandic bonds. • They sought aid from the IMF. • Interest rates went up to 18% in October, and would have been higher had they not gotten an IMF loan. • They are now 17%. • Unemployment more than tripled as production declined by about 10% (projected).

Exception? • Yes. Iceland is a small country, and its experience has been extreme. But there has been concern that Britain and Italy could experience similar collapses of demand for their government bonds, and while the United States is not close to that situation -– “It can’t happen here” are dangerous words!

Socialist Alternative 1 • Suppose instead that there is a social production sector. Its only asset is its productive capital R. It has no liabilities. Investment in expansion of the social production sector comes from reinvestment of earnings and/or tax receipts. • The formula for employment becomes N D+ R with D=G-T+ R-n. R, where, again, G is government purchases, T taxes, and n. R the net income of the social production sector available for re-investment.

Socialist Alternative 2 • Instead of expanding the government deficit in a crisis, the socialist system could expand the sector of socialist production, “stimulating” the economy by increasing R. • According to Keynes, K (investment) is largely determined by business expectations, which cannot be rational, but can be modified by experience. • Success in “stimulating” the economy could prove to be the kind of experience that would lead to business optimism and increases in K. • Then R would be cut back, and instead government could expand socialism by buying corporate shares, as Lewis suggested.

Conclusion • Keynesian economics is our best guide to the consequences of an economic crisis and the government policies that may ameliorate them, in the short run. • However, as conservatives warn, continued Keynesian policy may lead to further and worse crises. • A mixed socialist system would have at least one more “degree of freedom” to stabilize the capitalist economy. • This requires a sector of social commodity production, and its expansion decisions must be independent of the state of business expectations.