Economists don’t understand economic growth

Peter Radford has contributed a couple of good articles to the WEA Review blog.  In Blind leading the blind he dissects the claim made by Dianne Coyle of the University of Manchester that “…microeconomics is both robust and often verifiable with real-world data.”  Obviously one can find “real-world” data to support practically any theory. Scientific verifiability requires searches for data that  a theory cannot explain. On this basis microeconomics is a seething swamp of inconsistency and assumptions wildly conflicting with observed reality.

In Can we move on? he explains:

Economics has become a small minded sub-discipline designed to produce analysis of small issues or problems that can be contained within the massive restrictions of the subject’s edifice. 

This is why, perhaps, none of its younger tyros attack big problems anymore. All of them apply their undoubted intelligence against microeconomic targets in the vain hope that accumulating answers at the micro level will somehow aggregate into macro changes.

They have all, in other words, been cowed by the absurdity of the micro-foundations zealotry of the older generation. Apparently they are unaware of the hollow nature of the micro adventure. I have always thought that the micro-foundations project was foolhardy. After all garbage-in is garbage-out. Bedside it represents a stubborn refusal to take on board some of the more modern and exciting insights of evolution, complexity, and chaos thinking. Not least amongst which is the idea that reality is multi-layered with phenomena emerging at one level without cause from the effects of other layers.

No empirical fact contradicts conventional economics more clearly than the fact of long term economic growth. Robert Solow published his ground breaking paper “A contribution to the theory of economic growth” in 1956. He demonstrated that increases in population and capital investment accounted for no more than 20 per cent of economic growth. The rest he attributed to “technological change” but since there was no room for such change under the standard microeconomic assumptions it was reclassified as the “Solow residual” and ignored for the next twenty five years.

Paul M Romer broke the logjam in 1986 with his article “Increasing Returns and Long-Run Growth” published in the Journal of Political Economy. He described his proposal as “endogenous growth theory” suggesting that technology developed in response to financial incentives.  This was a somewhat belated response to Joan Robinson’s comment: “In the Solow model technology drops like manna from heaven.”

Adam Smith laid the foundations of economic growth theory

Adam Smith was keenly interested in economic growth and development. In the first quote below Smith lays out two key factors: innovation; and specialization (the division of labour).

…from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.  I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations. (Smith WoN B1. I. 3)

In the second quote Smith makes the point that the possibilities of conditions favourable to such economic growth are created by extensive markets: growth is limited by the extent of the market

As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for. (Smith WoN B1. III. 1)

Neoclassical economists reject Adam Smith

While Adam Smith set out the basic facts about economic growth— scope of the market, returns to experience, innovation, and the division of labour—these are incompatible with the standard microeconomic assumptions.

  • The division of labour requires teamwork, but standard microeconomics assumes purely selfish behaviour. Imagine an Association Football team whose members never passed to each other, each hoping to score a goal. You have the neoclassical view of teamwork.
  • Innovation is hard work and requires a strong incentive; but under standard microeconomic assumptions all knowledge is instantly and costlessly transmitted, so there is no possibility of a commercial reward to innovation.
  • Returns to experience mean that every time a worker repeats a task he or she gets a little better at it. Under standard microeconomic assumptions the economy is in an equilibrium state, from which no further change is desirable.
  • Making the scope of the market the ultimate limit of firm growth rather than some mystical diseconomy of scale wrecks the whole basis of standard microeconomic competition theory.

Vandalizing Grandpa’s grave

It would be an unusual economics textbook indeed that did not offer tribute to Adam Smith as the “father of economics.” This will probably include a misleading reference to his book the Wealth of Nations. The insult may be extended by a quotation from a paper that no longer exits and that only Dugald Stewart claimed to have read.

Economists do themselves and their discipline no favour by pretending to honour Adam Smith while rejecting his most critical insights.

Uhlmann spins renewables

Chris Uhlmann has dropped a piece on the ABC web site describing the problems Australia may experience if it doesn’t slow down the move towards renewables.  This apparently triggered a number of complaints to the ABC.  Uhlmann clearly lacked the technical background to make an intelligent contribution, so spinning about renewables had to do.

Uhlmann positively gloated about the complaints:capture-uhlmann

My complaint about Uhlmann’s article is about the gobbledegook. If a journalist is going to write about technical issues they should at least get the words right.

Wind versus fossil fuel

Uhlmann uttered two howlers:

  • he described wind turbines as “asynchronous” and fossil fuel powered generators as “synchronous”.
  • he referred to fossil fuel powered generators intended to complement wind power as “base load”.

Take the second first: base load power stations are typically very large (500Mw each unit), take a long while (hours) to start and stop, and don’t react well to sudden load changes.  They are what renewables are intended to replace.  If a cold or even warm base load generator had been on Adelaide’s doorstep when the storm hit the lights would still have gone out.

Power systems need peaking plant to cope with sudden changes in load.  The ideal peaking plant is hydro.  It starts within seconds and is itself renewable.  Batteries are the coming alternative, but at the moment too expensive for widespread use.  The least worst alternative is open cycle gas turbines.  These are basically aero engines coupled to a generator in capacities up to 80 Mw.  Like hydro, they start in seconds.

Because wind and solar can’t be on line all the time, a system needs some intermediate level plant.  This can be hydro or gas fired steam cycle.  South Australia has such a plant; unfortunately it was on the wrong end of the broken transmission lines.

Synchronous and asynchronous

The vast majority of power system electrical generators are synchronous. This means that the rotor turns at a constant speed to keep the output frequency aligned with the rest of the power system. This applies to wind turbines as well as the rest.

In normal power system operation a limited number of generators run on governors. These generators pick up or drop load to keep the main frequency constant.  The rest are set to constant power in line with the National Electricity Market.  Wind turbines are currently operates at maximum output, but this is an operating decision.

The frequency acts as an emergency signal. If it rises suddenly, this indicates that a major load or transmission link has dropped out. All generators, whether part of the frequency control or not, will cut their output.  If they didn’t, they would risk damage from over-speed operation.  If the frequency drops suddenly it indicates that a major generating unit has disconnected. This should trigger load shedding to bring the load back within generating capacity.

Wind turbines and frequency control

The ghost of reality in Uhlmann’s mind seems to be that, as long as wind turbines are operated at capacity, they can’t be part of the frequency control.

Operating wind turbines at capacity is essentially a political decision. Obviously in slight winds the output will be below the nameplate, but as the winds rise generated output will reach the name plate. If the winds get stronger still and nothing was done about it the generator or gearbox would fail from overload.

For that reason the turbines protect themselves in high winds by partly feathering their blades. This keeps the power collected from the wind within the generator capacity. There is no physical reason whatever that the output limit could not be set below the nameplate.  This would allow turbines, or more likely, complete wind farms, to be part of the frequency control as long as the wind was blowing.

Implementing such a system would require a little networking and possibly a slight modification to the control software. It raises no technical issues whatever.

Stop the spin

Uhlmann’s spin is clearly intended to support the Prime Minister’s attempt to gain political advantage from the South Australian power failure. He claims that integrating large scale renewable sources into the power grid involves novel problems.

He hints that these problems are currently without viable, proven solutions. He is wrong.

Dissecting the superannuation rort

Australia’s superannuation system is a scam. The tax concessions that drive it are supposed to limit the demand on the old age pension. They cost almost three times as much as they save. Most people believe that the superannuation tax concessions are intended to help them build a retirement nest egg.  Instead they support a bloated funds management industry.

How did we get here?

In the 1960s and 1970s most professional employees, and blue collar employees in government enterprises like the railways and electricity supply industry, benefited from superannuation plans, often non-contributory. These plans were typically “defined benefit”, promising the members a life pension if they completed a minimum period of service. A few major private corporations also offered superannuation to blue collar as well as white collar staff.

The rest of the population had to rely on private savings and the old age pension to support their retirement. The age pension was subject to a means test based on income over a low threshold. Initially there was 100 per cent clawback: for each dollar of extra income, the pension was reduced by a dollar. By 1980 this had been replaced by a tapered system, where a dollar of extra income reduced the pension by 33 cents.

Australia elected a Labor government under Bob Hawke in 1983.  Hawke had been Secretary of the Australian Council of Trade Unions and considered the limited access most workers enjoyed to superannuation a major issue. His government was also committed to promoting employment and limiting the inflation rate. Conventional economists considered that this was impossible, since as soon as unemployment fell below NAIRU inflation would take off.  Milton Friedman had said so.

The Hawke government resolved this issue by negotiating a wage freeze accompanied by a universal superannuation scheme. Instead of a pay rise employers would pay the equivalent into a superannuation account for each worker. Since the cash wage would not go up it would not drive inflation.

In June 1986 the Conciliation and Arbitration Commission set the universal minimum contribution at 3 per cent.

In 1990 Australia, along with much of the English speaking world, experienced a severe recession brought on by high interest rates; the rates had been raised in response to a perceived increase in inflation. In 1991 Prime Minister Hawke, under pressure from his ambitious Treasurer Paul Keating, announced that Australia was adopting free trade as a policy and as a first step, support for the textile, clothing and footwear industries was withdrawn.

The Fitzgerald report

Adopting free trade and forcing the textile, clothing and footwear industries off shore was supposed to launch a flood of innovation and trigger the formation of exciting new industries. It didn’t. Instead the Australian trade deficit grew to historically monstrous proportions.

The government, now led by Paul Keating, sought advice from Dr Vince Fitzgerald, Executive President of the ACIL consulting group. Dr Fitzgerald handed over his report in June 1993.

Fitzgerald correctly observed that the growing balance of payments deficit reflected an inadequate level of investment in exporting and import-competing industries. He then interpreted Australia’s problem as one of insufficient saving.  He managed to rely on two major economists’ errors. He implicitly adopted the quantity theory of money, ignoring credit creation by banks.  He explicitly espoused “hydraulic Keynesianism”, asserting that increasing savings would necessarily increase investment.

Since Australian policy was firmly in the hands of neoliberals, locally known as “economic rationalists”, the flaws in Fitzgerald’s reasoning were ignored and the government accepted his diagnosis.

The Labor government moved the superannuation system from the conciliation and arbitration system to a universal system.  The rate of contributions was set to rise from 1992 until it reached 9 per cent. Fitzgerald made several recommendations aimed at ensuring that the integrity of the superannuation system as a pension supplement was preserved.  He predicted that by 2011 the superannuation system would start reducing the relative cost of the age pension.

The Costello — Morrison two-step

In 1996 the Liberal (conservative) Party won the elections of that year and John Howard became Prime Minister with Peter Costello as his treasurer.  Australia was about to enter an economic boom as demand in China for construction materials soared. The iron ore price rose from under $20 to over $100 per tonne while quantities trebled.

Mining company profits soared, as did those of the many firms involved in mining services. In spite of relatively lax enforcement, tax revenue also soared.  The Howard government was not particularly interested in major infrastructure investments and so decided to dissipate the surplus.  A major tax cut favouring the rich might have upset the electorate, so successive Costello budgets attacked the integrity of the tax system. The rich could avoid lots of tax, while the headline rates remained the same.

Costello’s made major changes to the capital gains tax and to the superannuation system. The capital gains tax changes launched a bubble in the housing market that is simultaneously preventing young people from buying their first home while draining the revenue of several billion dollars per year.  The changes to the superannuation system turned into an unlimited tax shelter for those on high incomes.

The Howard government was defeated in the 2006 election and replaced by a Labor administration. The incoming government was confronted with the Global Financial Crisis, which it handled successfully. It did not undertake serious reform of the capital gains tax or superannuation systems.

In 2013 the Labor administration was replaced by a Liberal administration with Tony Abbott as Prime Minister and Joe Hockey as Treasurer. Abbott and Hockey proved to be unreconstructed class warriors, wholly out of touch with the Australian people. The pair did considerable public harm in a mean way but popular opposition blocked their major policy changes. An internal Liberal party coup displaced Abbott and Hockey in 2015 and installed Malcolm Turnbull as Prime Minister and Scott Morrison as Treasurer.

Morrison is just as much a class warrior at Hockey, but less blatant about it most of the time.  He shares the right wing obsession with cutting tax rates on companies and high incomes.  He also repeats baseless claims about Australia’s budget deficit to justify his attack on age pensioners and other social service recipients.

Morrison has walked away from Fitzgerald and the “need” to boost savings by encouraging superannuation. He now proposes to reduce the age pension to a meagre safety net, forcing the majority of the population to rely on superannuation to support their retirement. He has made a token gesture to equity by restricting the more outrageous tax avoidance loopholes provided by the superannuation system.

What it clear is that Morrison proposes to feed still more government revenue to the financial services industry. He will pretend that this will save the government money by reducing the ongoing cost of the pension, but this is simply not true.

Superannuation by the numbers

Getting precise numbers is difficult, but assembling numbers that illustrate the scale of the problem is not.

  • Income support for seniors cost the Federal budget about $44 billion in 2015-16.
  • Superannuation tax concessions cost the Federal budget about $31 billion in the same year.
  • The Age Pension is means tested, meaning that not all Australian seniors can claim all or part of it.  The means test saved the Federal budget about $11 billion in 2015-16.
  • The total value of superannuation balances is around $2,000 billion as at mid-2016.
  • The fees charged by financial companies to manage these superannuation funds range from 0.7% to 2.9% of the balance, totalling around $28 billion.

The numbers don’t lie.  Assessing seniors’ independent assets and income saves the budget $11 billion.  Concessions aimed at encouraging the assembly of such assets cost $31 billion. Managing the assembled funds of actual and potential seniors holding those assets cost $28 billion, over 90 per cent of the value of the tax concessions.

Simultaneously abolishing the age pension means test and all the superannuation tax concessions would save the budget $20 billion a year. Seniors would enjoy a guaranteed minimum income.  Since the pension counts as taxable income, independently wealthy seniors would return up to 48 per cent of their pension as income tax. This would further improve the budget “bottom line”.

What is absolutely clear is that government superannuation policy is driven by its need to pander to the financial services industry. The adequacy or otherwise of the retirement income system is treated as a secondary issue of no great interest .

European Union – or jail of nations?

One of the first responses to the Brexit vote came from Jean-Claude Juncker, President of the European Commission. He said “The United Kingdom will have to accept being regarded as a third country, which won’t be handled with kid gloves. If the British leave Europe, people will have to face the consequences — we will have to, just as they will. It’s not a threat but our relations will no longer be what they are today.”

European Union or European jail?

As Joseph Stiglitz pointed out, Juncker in a couple of sentences confirmed the worst hyperbole of the Leave campaigners. The European Union is not an organisation that countries want to belong to because of the benefits of membership.  It is a place that countries fear to leave because of the punishments that will follow such attempts.

Britain, as a semi-detached member of the EU, enjoyed economic benefits and relatively little interference. The benefits flowed to a relatively small part of the UK population. The neoliberal governance of Britain ensured that the majority of the population saw few benefits and suffered many problems.  It suited successive British governments to blame the problems caused by their own policies on the EU.  In reality EU policies did very little direct harm to ordinary British people.

The people of Greece were not so lucky.  The brutal punishment of Greece continues, not because Greece tried to leave the EU, but just because its government questioned EU policies. Greece is suffering a rapidly shrinking economy, intolerable unemployment, and a collapsing social welfare system.

But the experts say…

The British cabinet minister and Leave campaigner Michael Gove said “people in this country have had enough of experts”.  Given his position and career this statement conveyed extraordinary chutzpah.  It still struck a chord with the electorate.

Marija Bartl explains that the Leave vote was not a rejection of experts in toto.  It was a rejection of the advice that has seen the majority of the British population suffer over thirty-five years of declining incomes and increased insecurity.

As Nicholas Barrett noted, “When Michael Gove said, “The British people are sick of experts,” he was right. But can anybody tell me the last time a prevailing culture of anti-intellectualism has lead to anything other than bigotry?”

However, this interpretation misunderstands and banalises the challenge that ‘ordinary people’ are making. Ordinary voters may be grappling towards a far more sophisticated epistemic claim than commentators assume. They are not challenging knowledge, or expertise, per se. They are trying to challenge that knowledge, which stands behind – and justifies – the way we do things now, the current socio-economic order or status quo that has predominantly been of little or no benefit to them.

The EU suffers a dramatic democratic deficit. Power is concentrated in a  small bureaucracy in Brussels. The Council of Ministers and the European Parliament have little real power to control or direct this bureaucracy.

The EU bureaucracy is in thrall to neoliberalism in its meanest, nastiest form. It resists democracy precisely because it knows that no informed electorate would support its policies.  They are experts, but experts at suppressing, not promoting, the common good.

Brexit may or may not make Britain better off. It will relieve the British people of the moral guilt by association. As the EU punishes its weaker members the British will no longer be complicit.


How to be effective in the real world in spite of economics

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