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Thomas Tooke: An Introduction

Posted by Alex M Thomas on 15th June 2013

Thomas Tooke (1774-1858) made important contributions to monetary history, theory and policy. His monetary economics has been viewed in a favourable light by economists such as Ricardo and Marx. Moreover, Tooke’s conception of the rate of interest as a variable determined independently (of the profit rate) bears significant similarities with Keynes’s idea of the rate of interest as a ‘monetary phenomenon’. This post presents Tooke’s monetary theory in brief through his role in the debates between the Currency School (to which Ricardo belonged) and the Banking School (Tooke being the prominent member) in the early 1840s. The reference for this post is mainly the recent research carried out by Matthew Smith.

During Tooke’s time, the dominant view was that the rate of interest is governed by the rate of profit (on capital employed in production) implying that the former is determined by ‘real’ forces. In Smith, it is the competition of capital and for Ricardo, it is the wage rate and production conditions taken together. Tooke argued that the rate of interest is determined by institutional factors in the financial market and is independent of the rate of profit. In his later writings, he stated that it is the rate of interest which regulates the rate of profit with the former entering as a component in the costs of production of commodities.

The Currency School maintained that prices can be controlled by adjusting the quantity of money, as espoused by the quantity theory of money. That is, by altering the bank notes in circulation, it was believed that fluctuations in nominal income could be suppressed. This assumes that there are no time lags and that the velocity of circulation is constant. Tooke contested this policy and stressed the role for a discretionary monetary policy flexible enough to deal with different economic situations. The central principles of the Banking School are as follows: (i) the quantity of money in circulation is endogenously determined by the level of nominal income; (ii) ‘the rate of interest has no systematic influence on the inducement to spend’; and (iii) the rate of interest, being a component of commodity prices, exerts a ‘positive causal influence on the price level’ (Smith 1996: xliv-xlv). Such principles imply that the velocity of circulation is, in fact, a summary measure of the institutional setting of the financial market which can change when activity levels and prices vary.

Tooke’s contributions place a greater responsibility on the central banks. The principles of the Banking School imply that the interest policy of the monetary authorities can have lasting impact on real variables (such as income and employment) by influencing prices and the rate of profit. There is no long-run neutrality of money – monetary variables impact real variables. Moreover, attempts to control the quantity of money solely based on the rate of interest need not be successful since it is endogenously determined. Finally, the causation runs from prices to the quantity of money and not vice versa.

REFERENCE

SMITH, M. (1996), ‘Introduction’, in Variorum of the First and Second Editions of Thomas Tooke’s Considerations on the State of the Currency (1826), edited in collaboration with P. D. GROENEWEGEN, Reprints of Economic Classics, Series 2, Number 8, Sydney, Centre for the History of Economic Thought, The University of Sydney, pp. vi–xlvi.

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Posted in Classical Political Economy, Economic Thought, Economics, History of Economic Thought, Inflation, Macroeconomics, Monetary Economics | 1 Comment »

James Steuart, Strange(r) Economists and the Indian Economy

Posted by Alex M Thomas on 26th September 2011

 

Inflation has been portrayed as the biggest challenge faced by Indian policy makers and its Central Bank, Reserve Bank of India, in recent times. The Chief Economic Advisor to the Government of India and Professor of Economics at Cornell University, Kaushik Basu, recently presented his professional views on inflation – understanding and management, at the First Gautam Mathur Lecture on 18 May 2011. This is currently available for download as a working paper at the Ministry of Finance website. Various excerpts from this paper have made its way in some English newspapers and TV media. I will comment on this paper at length on a later date. Reading Basu’s paper makes me wonder whether monetary economists or other policy makers know what India is, who Indians are and what Indians actually do. In more abstract terms, do economists know the structure of the Indian economy? Do they know what motivates Indians? Is it primarily region, class, caste, religion, gender, education, self-interest, compassion, sympathy, fame, status? Although, to be fair to Kaushik Basu, he asks the RBI not to experiment and not to put up a façade of knowledge (which he frequently does). Without having a clear understanding of, what the 18th century economist James Steuart calls, “the spirit of a people”, it is impossible to formulate effective policies. Moreover, the focus on employment generation has completely given way to inflation stabilisation, using sophisticated econometric techniques. Therefore, this blog post revisits James Steuart’s views on how “the spirit of a people” influences economic engineering. In the Indian context, the consequences of monetary intervention might not be those which are depicted in conventional models of inflation.

Sir James Steuart (1713-1780) published An Inquiry into the Principles of Political Oeconomy in 1767 which was and has been overshadowed by Adam Smith’s Wealth of Nations published in 1776. Steuart acknowledged the importance of devising context-specific economic policies. However, we must realise that context-specific economic policy is not antithetical to general economic theories. In other words, proposing economic theories and models of a general nature is not inherently a problem; but, when applied blindly, they cause havoc, which is often supressed in very clever ways. Steuart writes:

“Every operation of government should be calculated for the good of the people. . .that in order to make a people happy, they must be governed according to the spirit which prevails among them” (p. 21).

An ignorance or lack of understanding of this “spirit” can have disastrous consequences. We see some of them in the worsening urban-rural inequality, falling of inflation-adjusted per capita incomes in interior villages [EPW, 2011], agricultural distress and forced migration [P Sainath, The Hindu, 2011]. One of reasons why such skewed policies are implemented is because of the rationale provided by “pure economic theory”, which Basu seems to praise for its scientific rigor and [semblance of] truth. To be clear, “pure economic theory” is something which Steuart was against because it assumed a certain “spirit” and claimed to be universal thereby neglecting important specificities and characteristics pertaining to individual economies.

For Steuart, “the spirit of a people is formed upon a set of received opinions relative to three objects; morals, government and manners: these once generally adopted by any society, confirmed by long and constant habit, and never called in question, form the basis of all laws, regulate the form of every government, and determine what is commonly called the customs of a country” (p. 22). That is, education, religion, region, caste, gender, etc would significantly affect the “spirit” of India. Also, important characteristics such as the percentage of Indians employed in agriculture, in unorganised manufacture, in self-employment, in rural areas, using informal sources of finance, who are socially poor (less than 100 rupees a day), who actually invest in stock markets, who read English newspapers and so on affect the outcomes of economic engineering. Not paying heed to these significant characteristics is the same as formulating an inappropriate policy. Let me highlight once instance. The RBI conducts Inflation Expectations Survey to estimate how the expectations of the Indian populace change over time and this result forms an input into monetary policy making. Despite this, the RBI did not survey any Indian living in rural areas; they seem to neglect and forget the fact that the main producers live in rural areas and their chief occupation is agriculture! This certainly deserves to be questioned. Policies should not be formulated “at any point which regards the political oeconomy of a nation, without accompanying the example with some supposition relative to the spirit of the people” (p. 23). If the “spirit of the people” is not taken into account, as the example above indicated, such policies could prove to be harmful. This also calls for greater dialogue between economists and other social analysts (sociologists, cultural theorists, political scientists, anthropologists, social workers, etc) when engineering nation-wide socio-economic policies. Hence, Steuart writes that “in every step the spirit of the people should be first examined” (p. 25).

Often, the attitudes of policy makers indicate how much their academic knowledge is irrelevant for practical economic and social problems. The reliance on “pure economic theory” is nothing but an intellectual looking, mathematically replete and made-difficult-to-understand version of free markets, because efficiency and rationality are our new gods! As Keynes writes in his preface to The General Theory, “the difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” Today, these “old ideas” are not only fashionable and ‘scientific’ (and often unsuited to India), but they are also communicated relentlessly to the new generations through schools and universities. In conclusion, it is scary to realise that India’s policy making is done by those who are “strangers” to the Indian realities. Steuart warns us that “when strangers are employed as statesmen, the disorder is still greater, unless there be extraordinary penetration, temper, and, above all, flexibility and discretion” (p. 27).

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Posted in Adam Smith, Agricultural sector, Classical Economics, Classical Political Economy, Economic Philosophy, Economics, Economics Education/Teaching, Employment, Government, History of Economic Thought, India, Inflation, Informal Sector, James Steuart, Keynes, Monetary Economics, Unemployment, Unorganised Sector, Urbanisation | 1 Comment »

(Mis)understanding Inflation

Posted by Alex M Thomas on 30th June 2011

 

The recurrent hikes in fuel prices over the last one year are a cause of concern. For, fuel is a basic commodity and it enters as an input directly or indirectly into the production of all commodities – agriculture, manufacturing and services. About a year back, an “expert” committee headed by Kirit S Parikh recommended a partial deregulation/liberalization of fuel prices. This has eased the financial burden of the government. In addition, economists have posited that deregulation will enable markets to become efficient (subsidies and taxes distort efficiency). In any case, the role of the government has been changing rapidly too – from that of a provider to that of an enabler (to quote our Chief Economic Advisor, Kaushik Basu).

A couple of days back, our esteemed Deputy Chairman of the Planning Commission Montek Singh Ahluwalia told the media that the recent hikes in fuel prices was a strategic move. According to him, the hike in prices of petroleum products would help ease inflation in the long run as it would suck money from the system. This post examines this statement by trying to understand the mechanism of inflation.

INFLATION

Inflation, as we know, refers to a continuous increase in the price level over a period. To make sense of this seemingly simple statement, we must have a clear understanding of the two concepts based on which we understand inflation. It is on the basis of this understanding that policy decisions are made both by the RBI as well as the Central Government to control inflation. The two concepts are:

(1)   Time: the price rise has to be continuous over a certain period.

(2)   Index number: inflation is studied by making use of these special averages

Time

How much time must elapse before we can characterise the price increase in an economy as inflationary? In theory, economists solve this problem of having to fix the time period by introducing the distinction between short-run and long-run. However, this distinction does not solve the problem, but only adds to the complexity. What do we understand by short-run? Does it refer to one week, one month, 6 months or one year? Interestingly, there is no fixed answer to this. The distinction between short-run and long-run shows how creative economists are, although its utility is questionable. Short-run refers to the time during which the variables under consideration do not have adequate time to adjust or settle (at their equilibrium positions). Whereas, long-run refers to a period (point?) when all the adjustments are over and all the variables have settled. How convenient! The long-run will remain a mirage.

Given these unsettled issues, how does our Deputy Chairman of the Planning Commissions confidently maintain that fuel price hikes will ease inflationary pressures? This statement is meaningless because the long-run is a fictitious concept. Such statements indicate the misplaced confidence economists possess as well as the poverty of economic theory.

Index numbers

Price level is what we examine in theory when trying to understand inflation. In applied work, we trace changes in indices such as WPI and CPI (which is a proxy for the general price level in an economy) in computing inflation. The construction of a good index number is a difficult task. Selection of relevant variables, choice of base year, the kind of index number to use – Paasche, Laspeyre or Fisher – are some of the issues which have to be tackled. A detailed discussion of index number will feature as a blog post in the future.

Ahluwalia, one of our economic planners, maintains that fuel price hikes will ease inflation in the long run. The explanation he provides for this occurring is both logically and factually incorrect. He said that fuel price hikes “suck excess money out of the system.” Firstly, this statement is based on a particular view or understanding of inflation, namely the neoclassical one. Inflation is seen by this group as a result of excess money in the economy. In the words of economics textbooks, which do an excellent job at indoctrination, inflation occurs when too much money chases too few goods. It is this factually incorrect view which dominates academia as well as the policy arena. In fact, it is this view which is widely communicated in the media as well. Several economists have questioned this notion but with limited success. For, if inflation is not a monetary phenomenon, how will the central banks survive? In any case, this view is not a correct representation of reality because manufactured products and services are not priced on the basis of demand (unlike agricultural prices which are largely demand-determined). [See Who prices the Products? and On Prices/Values] If the prices increase from non-monetary factors, such as production conditions, expensive labour, from a higher profit margin, corruption or rise in fuel prices, how will removal of money reduce inflation? In fact, how does one arrive at a benchmark for computing ‘excess” money? Fuel price hikes, on the other hand, will threaten the livelihood of both the poor consumers and poor producers.

What does our planner mean when he talks of the “system”? A closed economy? An open one? Will the money not still be circulating in the economy even after the fuel price rise? Without clarifying the above mentioned issues, the statement made by the Deputy Chairman of the Planning Commission holds no ground, however scientific it might sound! Such statements only reinforce the arrogance of economists and the poverty of economics!

 

 

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Posted in Economics, India, Inflation, Macroeconomics, Michal Kalecki, Monetary Economics, Neoclassical Economics, Prices | 1 Comment »

Knut Wicksell: Some Aspects of his Work

Posted by Alex M Thomas on 21st March 2010

This post is different from the others because it deals with the contributions of a single economist. Knut Wicksell was a Swedish economist who made significant contributions to capital theory, monetary economics and fiscal policy. Despite being grouped under the neoclassical or the Austrian school because of his affinities to ‘marginal’ analyst, Wicksell was a socialist and a radical. He advocated policies which involved the government in a big way. And owing to his varied interests in poetry, mathematics, feminism, mathematics, politics, etc he became a Professor of Economics and Fiscal Law at Lund University only when he was fifty. A few of his well known students are Erik Lindahl, Gunnar Myrdal and Bertil Ohlin. They are considered to be part of Stockholm or Swedish school of economic thought.

In the passages below, only a few of his contributions will be elaborated. He has also made lasting contributions to the theory of interest, revitalised quantity theory of money, introduced mechanisms linking the real and monetary sector, etc.

Wicksell demonstrated that problems could arise if capital is treated just like other ‘factors of production’ – land and labour. Cambridge capital controversies dealt with many of these problems. “Knut Wicksell (1851–1926) himself casts doubt on the specification of the value of capital, along with the physical quantities of labour and land, as part of the data of the system. ‘Capital’ is but a set of heterogeneous capital goods. Therefore, unlike labour and land, which ‘are measured each in terms of its own technical unit . . . capital . . . is reckoned . . . as a sum of exchange value’ (Wicksell, 1901, 1934, p. 49). But capital goods are themselves produced commodities and, as such, their ‘costs of production include capital and interest’; thus, ‘to derive the value of capital goods from their own cost of production or reproduction’ would imply ‘arguing in a circle’ (ibid., p. 149).” [Segura and Braun 2004]

Like other contemporaries of his, Wicksell did not write about unemployment. This was because the existence of unemployment was considered to be a paradox, an anomaly for neoclassical economists. As they could not comprehend why resources (here, labour) would be left idle! The central problem in (neoclassical) economics was not to provide or create uses for factors, but only to allocate the factors among various uses. As Bo Sandelin, editor of Wicksell’s papers and the author of A History of Swedish Economic Thought writes in the introduction that “the fundamental question in economics was how to manage an economy with scarce resources.” Strange indeed!

Wicksell was a strong proponent of the marginal productivity theory of distribution. A corollary of this theory is the the sum of all the marginal products of the factors should be equal to the total product, known as the product exhaustion theorem. However Wicksell demonstrated that the operation of this theory depends on the returns to the scale. That is, only under constant returns to scale will the marginal products exactly add up to the total product. And that for both decreasing returns and increasing returns, the product will not be completely exhausted.

The Swedish school made another important contribution to economic theory. They introduced the categories of ex ante and ex post. These categories, we know are used widely today and were the result of the School’s dissatisfaction with the equilibrium analysis. Apart from these ways of thinking, Myrdal has provided us with the concept of circular and cumulative causation as well. These categories provide us with alternative modes of conceptualising or thinking about economic problems.

Relying solely on textbooks reduces our extent of reach. We often fail to come across interesting and heterodox economists. But, history of economic thought provides us with ample personalities to look into. Wicksell is one among them. Also, some of their categories provide us with alternatives, which remain unfinished. For instance, after going through some of the secondary and primary works on/by Wicksell, he appears exceedingly interesting and aware of the implications of certain simplifying assumptions. He pointed out the ‘necessity’ of the constant returns to scale assumption, which economics faithfully aligned with for a considerable period. This was challenged within the mainstream only with the entry of the endogenous growth theories, which emphasised increasing returns.

References

Pressman, Steven (2004), Fifty Great Economists, Routledge: India.

Groenewegen, P and Vaggi, G (2006), A Concise History of Economic Thought: From Mercantilism to Monetarism, Palgrave Macmillan.

De Marchi, N and Blaug, M (1991), Appraising Economic Theories: Studies in the Methodology of Scientific Research Programmes, Edward Elgar.

Segura, J and Braun, C (2004), An Eponymous Dictionary of Economics: A Guide to Laws and Theorems Named After Economists, Edward Elgar.

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Posted in Capital Theory, Economic Philosophy, Economic Thought, Economics, Gunnar Myrdal, History of Economic Thought, Monetary Economics, Neoclassical Economics | 2 Comments »