Monday, 16 January 2017

Simon Wren-Lewis’s odd criticisms of the Pigou effect.

The Pigou effect is the fact that in a perfectly functioning free market, and given some sort of shock which causes a recession, wages and prices will fall, which increases the REAL VALUE of money, base money in particular. That increases the value of private sector liquid assets,  will induce the private sector to spend more, which cures the recession.

Incidentally, not only does the real value of the stock of base money rise: so too does the real value of government debt. But as Warren Mosler (founder of Modern Monetary Theory) pointed out, government debt can be seen simply as a term account at a bank called “government”. That is, government debt is almost indistinguishable from base money (a point also made by Martin Wolf). Base money and government debt are both assets as viewed by the private sector.

The reason the Pigou effect does not work very well in the real world is Keynes’s famous “sticky downwards” point: that is, given deficient demand for labour, the price of labour DOES NOT FALL very much and for the simple reason that if it does you tend to get strikes, riots and so on. The year long coal miners’ strike in the UK in 1926 nicely illustrated that.

The Pigou effect might seem arcane, give that it does not work too well in the real world, but it’s actually quite important. Reason is thus. It is generally accepted in economics that free markets product an optimum outcome, or tend to maximise GDP, unless market failure can be demonstrated. E.g. it is normally accepted that governments should not interfere with the market in apples unless for example it can be shown that apple growers have set up a cartel and artificially raised the price of apples, in which case government intervention is justified. That is, government should punish the cartel ring-leaders and restore something like a genuine free market in apples.

Something similar applies to the Pigou effect: that is, since the Pigou effect works in a hypothetical and ideal free market, it is a guide to what sort of policies will maximise GDP in the real world, and more on that below.

Wren-Lewis takes issue with the Pigou effect in an article entitled “Why the Pigou Effect does not get you out of a liquidity trap”. His first salvo against the Pigou effect is thus.

“The Pigou effect is when the authorities keep the current stock of money constant, and falling prices mean that its real value increases. The idea is that at some point people feel sufficiently wealthier that they spend more, which adds to demand. For this to work, we have to assume that the nominal stock of money will remain unchanged, unaffected by falling prices. Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary. Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow.”

As you’ll see, there is not much difference between my definition of the Pigou effect and Wren-Lewis’s. The only slight difference is that he says (first half of the above quote) that the nominal stock of money has to stay CONSTANT. Actually the Pigou effect would still work (or not) given a small annual increase or contraction of the nominal stock of money.

Indeed, the latter point is more than just a theoretical point: in an economy on the gold standard, a fall in prices would equal an increase in the real value of gold, which would induce gold miners to dig up more gold. So in that scenario, the Pigou effect would increase BOTH the nominal stock of money and real value of each unit of that money.

But to repeat, the latter point is a minor one, so I won’t dwell on it any further.

 Wren-Lewis then says (second half of the above quote):

“Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary. Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow.”

Eh? Why “might” I agree that the fall in prices is “temporary”? I’m baffled.

In common with others who accept the Pigou effect would work in a perfectly flexible free market (I assume), it strikes me the Pigou effect works as follows.

1. Assume demand is deficient. 2. Prices fall and the real value of the stock of base money rises. 3. Given a larger stock of money in real terms, people tend to spend more (as the empirical evidence confirms).  4. The most reasonable and simple assumption is that the real value of the stock of money continues to increase until the additional demand brings the fall in wages and prices to a halt, and that point equals an equilibrium which is maintained until some sort of new shock knocks the economy off equilibrium again.

So where does Wren-Lewis get his “higher prices tomorrow” from? Following straight on from the above quote, he continues:

“But we have already established that in that case you do not need a Pigou effect, because higher inflation tomorrow at the ZLB will mean lower real interest rates, and you get the demand stimulus the good old real interest rate route. Furthermore, if people understand that prices will rise, they are not really wealthier in an intertemporal sense, because their extra real money balances will be inflated away. If you like, they save their extra real money balances today to pay for future inflation taxes.”

Well the fact that one does not “need” a particular solution to a problem does not prove that solution doesn’t work. Taking your foot off the accelerator in a car will slow the car down because it requires energy to make the engine revolve at a speed faster than ticking over speed, and that energy can only come from taking kinetic energy from the car as a whole: i.e. slowing it down. However, the fact that one does not “need” that method of slowing the car down because one can always use the brakes does not prove that taking you foot off the accelerator won’t slow the car down, (my dear Watson).

Then in the second half of the latter quote, Wren-Lewis invokes Ricardianism: that’s (roughly speaking) the idea that peoples’ income rises, they do not spend their increased income because their income is determined just by what they perceive their life-time earings to be. Put another way, Ricardianism claims that households ignore what are possibly temporary increases or falls in income and instead go in for a large amount of “lifetime income smoothing”.

Now the only people who seriously believe that are people with PhDs in economics. I.e. anyone with a grain of common sense knows that when people come by windfall increases in income (e.g. when they win a lottery) they spend a significant amount of that windfall. Indeed the empirical evidence supports that.

Or as the Nobel laureate economist Joseph Stiglitz put it, “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense”. Or as the Cambridge economist Ha Joon Chang put it “Unfortunately a lot of my academic colleagues not only do not work on the real world, but are not even interested in the real world.”

Towards the end of his article, Wren-Lewis says, “We can sum this up rather neatly, as Willem Buiter did with the aid of lots of maths, by saying that what matters is the terminal stock of money, not its current value. The government can only make people feel wealthier by printing money if people believe that the increase in its real value is permanent.”

Well the first flaw there is that Buiter (like Wren-Lewis) assumes the validity of Ricardian equivalence, which everyone (apart from economics PhDs) knows is largely nonsense.

Next, Wren-Lewis says (to repeat), “The government can only make people feel wealthier by printing money if people believe that the increase in its real value is permanent.”

Well sure! And in the simple Pigou effect scenario set out above where a shock requires an increase in the real value of the stock of money, that increase IS PERMANENT – unless and until some new shock comes along.


Buiter and Wren-Lewis do not succeed in denting the Pigou effect, far as I can see. And there is another very simple point that supports the Pigou effect, as follows.

The purpose of economic activity is to produce what people want. So if there is insufficient economic activity, i.e. not enough of “what people want” is being produced, then the solution would seem to be to give people more of what they need to purchase what they want, i.e. MONEY!!!! That is, a good solution to a recession is tax cuts and increases in social security payments.

And given that when it comes to what people want, they normally express a desire for having about a third of their income come to them in the form of public spending, any cure for a recession should include some of the new money being used to increase in public spending.

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