The Real Economy

After a period of some 30 years between 1945 and 1975 Keynesianism as macroeconomic policy unravelled rapidly under slumpflation. Now the alternative, Monetarism, in spite of denials by the head of the Federal Reserve in the USA, has, after another 30 years began to unravel under similar circustances to slumpflation.

The form of the current crisis was predicted in 1976 ¹ in an analysis undertaken by Hector McNeill on the failure of Keynesianism stating that a similar end could face the then advancing policy option of Monetarism.

KM policy weaknesses

Another shorter paper published in 1981 ² summarised the main weaknesses of Keynesian and Monetarist approaches referred to as KM policies. Both create policy-induced cycles because KM policy variables affect target variables only in an indirect manner.

Macroeconomic policy needs to support the objectives of a diverse economic constituency ...

Thus under demand stimulation or suppression the government has no immediate means to prevent overshoots in the direction of price inflation or in the degree to which demand is suppressed. This problem is well known and has been described as a policy string being able to pull the economy in either direction but that you can't push on a string.

The diverse constituency

Attention was drawn to the effects of the divesified policy constituency in the United Kingdom.

Policy outcome perversity

Thus the vast array of specific conditions facing companies and individuals in the economy, the policy constituency, is bound to result in any particular policy move having widely differing outcomes. There exist distinctions between “the general good” as defined by policy objectives and a range of perverse policy impacts which might be called the “sub-group bad”. These perverse effects can vary from corporate failure, increased unemployment and mortgage holders losing their houses at one end of the policy spectrum to price inflation undermining real incomes and profits at the other end, and much in between. Thus the direct impact of policy across the policy constituency is highly differentiated and ranges from serious negative consequences to something equivalent to neutrality as well as direct benefits; it isn’t at all, all easy going.

Shifting sands

McNeill pointed out that considerable cross-currents influence the effectiveness of KM policies because such macroeconomic management is run as a supplemental overlay to several parallel processes all of which influence the economy including:

laws and regulations on accounts and taxation of all kinds
annual budgets
warfare
changes in key exchange rates
any legislation with economic and financial implications initiated by Parliament
any legislation with economic and financial implications initiated by the European Commission
undertakings made within international forums such as the General Agreement on Tariffs and Trade
bi-lateral development & trade agreements.

These impact the outcome of macroeconomic policies. In addition the unpredictability associated with the "pushing on a string analogy" which applies to KM policies in isolation is exacerbated by considerable additional unpredictability in outcomes relating to:

policy instruments operating only indirectly on demand
the policy constituency being very diverse
the shifting of position of priority target indices
the existence of many significant economic cross-currents emanating from other domestic and increasingly foreign spheres

KM policies lack predictability and threaten welfare in an uncertain world

McNeill concluded that it was evident that KM policies did (do) not provide a robust form of management capable of providing the requisite levels of predictability in a world where trading relationships are becoming more complex and in some cases, such as the European Union, regulated. In the case of critical natural resources such as energy KM policies are ill-equipped to manage the economic impacts from significant price rises. This has important implications for the welfare of the people of Britain now and in the future.

Decoupling of indices disorientates policy priorities

Although aggregate demand is considered to be the “governor” of the economy, at any particular time in the policy cycle different indicators will rise to dominate the current attention of policy makers. Thus unemployment might become something of concern, or attention might be deflected by rising inflation. On the other hand declining investment might be tied to interest rates having been set at too high a level.

Independence of interest rate setting has little traction when indices diverge, in fact policy outcomes can become arbitrary and, in some cases, perversely discriminatory against some economic units...this is a serious constitutional issue.

Things can get out of hand when several indicators rear up as issues for attention. Thus our experience with slumpflation is a good example of a combination of everything going “the wrong way”, that is falling demand, employment and output with rising inflation."

The current state of affairs

Recently, McNeill stated that the same type of division of indices is occurring today with banks being severely constrained in their ability to lend resulting from imperfect information concerning risk, even at low interest rates. This state of affairs has arisen following falls in porfolio component performanc caused by failures in cash flows dependent upon several key, largely USA-based, indices. In this case the indices were ratings of mortgage holders (ability to pay), the percentage of asset value guaranteeing loans advanced, general inflation, interest rates, current and asset price futures and exchange rates. The overall risks are higher for foreign holders because indices can move "the wrong way" with respect to inflation, exchange rates, interest rates and asset prices. Since the negative movements tend to move together the impact on the foreign held values of such "derivatives" can be disastrous. On top of this the mutiplier effect intensifies interest rate rise pressures creating a demand for higher rates of mortgage payments forcing defaults on already stretched mortgage holders leading to rising requests for repossession. In terms of collateral for failed loans, many such assets are falling in value causing net losses on the associated loan cycles. The outcome is a declining value of portfolios and therefore of the ratings (share values) of those who hold them.

From confusion to positive traction

In a recent tutorial ⁴ McNeill expresses the opinion that, as in the 1970s, economic policy decision-makers now, through their inability to identify policies which demonstrate a high degree of outcome certainty, or ability to avoid possible perverse side effects, only help contribute to confusion and an undermining in market confidence. Their propensity to discuss options in a somewhat hapless fashion by referring to different indices only serves to confuse the public and, in many cases, businessmen.

In the 1981 paper ² McNeill makes a significant criticism in his consideration that the overall KM policy environment weakness arises from what he calls a "lack of traction"; this has a specific meaning. Thus it is stated that, "...current policy instruments do not gain enough traction over the decisions of companies and individuals within an economy to shift activities towards a mutually acknowledged beneficial state.

The significance of Technique

Technique: is here defined as the way in which humans apply technology and this involves a leanring process through which capabilities in the application of techniques, that is skill, advances to enhance the overall impacts of technology.

In real income terms people's experience and skills, beyond applying technology in the workplace, extend to other pursuits and the environment within which such real incomes-enhancing activities occur. Real incomes represent a space within which each person can exercise their individual freedom of expression, formulate ideas and shape their preferences on all aspects of life relevant to them. It is through the refining of technique that each of us learns what we can achieve and what is possible. Real incomes is not just a bare economic statistic but is holds within it, for each one, what can be secured from life itself. Just as the economic constituency needs to be served by economic policies which serve their will, so, as social communities, people are better served by governance capable of providing a resposiveness to their social preferences.

However, McNeill observed that a transition to this state of affairs should not be accompanied by the current assumptions that macroeconomic policy can continue to operate on the basis of the expensive luxury of monopoly interventions in markets (a subject expanded upon in another paper ⁵ ). He states that, "For any policy to gain the level of traction necessary to secure a direct control over a prime index (target variable), this prime index needs to be acknowledged as one which represents a common objective of the policy constituency, the economy and the electorate of the United Kingdom."

McNeill explains that traction can only be obtained, that is the target variable will only move in the direction desired and as far as approriate, if the economic participants acknowledge that an agreed "prime index" can be used to constitute a basis of economic activity objectives at the microeconomic level. Leading from this, the motivations of microeconomic decision-making would become coherent with agreed macroeconomic policy targets. This gives rise to a completely different approach to macroeconomic mangement in that rather than being dominated by government monopoly interventions made on the basis of imperfect information, outcomes would be determined by the rational decision-making of the diverse units of the economic constituency. McNeill also explains that it is important not to use multiple indices but rather a single prime index, he proposes real incomes, to measure GNP, corporate profits as well as incomes.

Determining real incomes not as simple as might be assumed

McNeill provides an explanation as to why real incomes are not what economists generally assume them to be but the very fact that real incomes are in reality a very complex domain within which individuals and companies can create their own values and worth causes real incomes to be the most suitable prime index for an economy, such as that of the United Kingdom, with diversity of economic units and interests all with changing preferences. This has important political and constitutional implications as set out in another paper ⁶.

A proactive policy for development

The last step in gaining traction, that is having macroencomic policy achieve what eveyone desires, is to get rid of the "overlay" nature of macreocomic policies acting in an interventionist monopoly fashion in different markets and, in particular, on the rental market for money by setting interest rates. To achieve this a real incomes policy, as an alternative to KM policies, is proposed as a basis to integrate the controlling policy variable into fiscal policy, corporate and personal accounts and taxation.

A real incomes fiscal policy

In 1981 in another paper McNeill proposed a macroeconomic approach called Price Performance Fiscal Policy ³ which measures outcomes of economic performance in real income terms. Companies who effectvely lower the rate of unit price increases over cost increases, and thereby enhance purchasing power (real incomes) end up paying lower taxes. On this basis they end up with higher real net profits. On the other hand those who increase price rises relative to cost rises pay higher taxes and a net reduction in per unit real profits simply because they are eroding purhasing power and real incomes and generating inflation.

Innovation through technology & technique

Price Performance Fiscal Policy can help stimulate innovation directed towards enhanced real incomes, international competition and national welfare...

The way the fiscal levy works provides a positive incentive for the seeking out and investing in technological innovation so as to lever the tax regime to create real financial resources helping companies and their workforces progress more rapidly down so-called learning/cost curves. The broad impact is a higher output and low unit prices for goods and services and therefore economic growth resulting from the enhancement in the level of purchasing power in the economy. This approach to fiscal policy is radically different from KM policies largely because of the significant difference between the nominal and real indices applied.

Supply side?

If readers suspect that this sounds like supply side economics then they are right. However, in other analysis McNeill explains what was (is) known as supply side was associated with Monetarism and therefore there was no sustainable traction. Indeed, he observes that supply side was moved from centre stage fairly soon following 1981 and it ended up being an appendage to Monetarism in an environment where the Keynesian multipliers persist. According to McNeill the priorities were, and are, inappropriate in an increasingly competitive world economy and this arose from the failure of KM policies to take into account the historic role, as well as the future potential, of technology and technique (see box above) in bringing relevance and traction back to macroeconomic policy. McNeill covers these aspects of KM technological ignorance in another paper ⁷.

¹"Inflation, Its Control through Price Performance Fiscal Policy," McNeill H.W., Rio de Janeiro, June 1976.

²"Notes on Real Incomes Policy - An outline", McNeill, H.W., December 1981, HPC, ISBN:907833-05-5/978-0-907833-05-5

³"Price Performance Fiscal Policy - A Real Incomes Approach",McNeill, H.W., August 1981, HPC, ISBN: 907833-00-4/978-0-907833-00-4

⁴"Is there a problem?", The Real Incomes Approach Tutorial Series, McNeill, H.W., February 2008, HPC, Real Incomes.

⁵"Price Fixing, Quotas and Restricted Markets - Free and constrained markets", McNeill, H.W., December, 1981, HPC, ISBN: 907833-15-4/978-0-907833-15-4

⁶"Moral Philosophy and Political Economy - Individual preferences and the economic motivations", McNeill, H.W., December, 1981, HPC, ISBN: 907833-20-8/978-0-907833-20-8

⁷"On the Problem of Technological Ignorance Amongst KM-Economists - Supply as demand", McNeill, H.W., December 1981, HPC, ISBN: 907833-10-9/978-0-907833-10-9