Lecture 2 - The Economics Network
Lecture 2 - The Economics Network
Economics for Democratic
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
– 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
– New reading assignment:
• 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
• 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
– 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.
• 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
Classes in the 19th 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
• Franco Modigliani, antifascist resistor
and Nobel Laureate macroeconomist, 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
On the other hand …
• Clearly, the working class in 2009 is
better off economically than it was in the
19th 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.”
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
3. Those with wealth enough to control corporations
(and buy congressmen) are the grand bourgeoisie -what I call the billionaire class.
• 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
• These conflicts are the major differences between the
two parties in the USA.
• 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.
• 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.”
• Many mid-twentieth century democratic
socialists saw selective nationalization as a path
• 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.
• 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
• This course is a small response to the economic crisis of
• 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
• 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
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.
• For this discussion
we will consider 4
main sectors, 3
– Private sector
–Fed or Central Bank
• The “social production” sector will not exist in a (pure)
• 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.)
• In neoclassical economics, costs are opportunity
– 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
– Thus, the return of the social opportunity cost is a
net income to the public sector.
• 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.
• General Government
– Liabilities: Indebtedness, D
– No Assets
– Net Assets, F
Assets and Liabilities 2
• IOU’s , W
• Reserves, Z (deposits in Federal Reserve)
• Deposits, U
• Equity, V
– Assets: government bonds
– Liabilities: bank reserves, Z; currency
Assets and Liabilities 3
– 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
• Only households and the foreign sector are net
• Therefore P=A+F=E+B+D+U+V-W
Prudent and Legal Banking 1
• Reserves, Z, must be sufficient to cover current
• 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
• A run on the bank could destroy the wealth of
– There is government insurance for most deposits -FDIC
– But only for recognized banks -- Enron and AIG
• A bank could suffer a run when it is quite
• But bankruptcy of the bank also is a risk to the
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 comprises those assets that serve as a medium of
• 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
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
• But U -- money -- in private hands is increased.
• 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”
– 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
– 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
• 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
• 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.
• 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
• The dot-com bust of 2001 stopped that.
• With E and B stagnant, either A must drop or D must
• Both happened.
• Taking house capital into account,
• 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
• Then the bust came -- and household assets dropped.
Boom and Bust
House price 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
• 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.
• born in "the Rookery", a
• son of Daniel Malthus, a
country gentleman and
avid disciple of JeanJacques Rousseau
• Best known for the work
on population, he also
wrote on “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
• The son of the Cambridge
economist and logician John
• Studied at Cambridge under A.C.
Pigou and Alfred Marshall.
• British civil service (India office)
• 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
• “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.
• “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.”
• 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
• 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
Consumption Function 1
• One of the simplest ways to express such a
relation of dependency is as a linear function:
• C = a + bY
• 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 + .9Y
• 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
• 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.
• In this simple example, the solution is
1 - 0.7
• The term 1 - 0.7 is called “the multiplier.”
• In a more realistic model, of course, it would be more
Here is the graphical
with the equality of
planned expenditure with
planned production -- the
Suppose instead that we
are at a level like 7000 -- a
planned production greater
than demand. Then
inventories build up.
Here a drop in
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
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.
• 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
• A change in
• For example, house construction is an
important part of investment.
U.S. Housing Starts
• Here is the longer view
Housing starts -- Annual
• The decline in investment played a key part
in the Great Depression.
Investment as a Proportion of GDP
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
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
• 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
To approximate employment, use the multiplier
Actually, the multiplier for deficit spending will
depend on the proportion of tax cuts and
with D=G-T, government spending minus tax
receipts. But we will ignore that complication.
Let N0 be the employment target
We can turn equation ii around:
Adjusting D to obtain the target
employment is called “fiscal policy.”
• 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.
To maintain target employment we have
two conventional methods.
“stimulates” the economy by lowering
may be limited by a “liquidity trap”
Certainly interest cannot go below zero
“stimulates” by government purchases of
goods and services or by tax cuts
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.
• 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.
• “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
• “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.
• 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).
• 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
with D=G-T+R-nR, where, again, G is government
purchases, T taxes, and nR 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
• 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.