The retreat of economic orthodoxy continues

The Global Financial Crisis should count as an important turning point in modern economic thinking. It has been followed in quick succession by the emergence of China as a competitor to the US economic supremacy, the Trump era jettisoning of orthodoxy, and recently the Covid 19 pandemic and its consequences. 

The list of orthodoxy upended by realism arising out of emergent exigencies continues to grow. Capital controls are no longer taboo, foreign exchange interventions are sometimes useful, macro-prudential policies to regulate credit markets have become acceptable, the acceptable limit for inflation has increased, trade protection measures to ensure level playing field are back in vogue, as is industrial policy to encourage domestic manufacturing, large fiscal deficits and steep rises in public debt to support large negative shocks are alright, rent controls are useful to address unaffordability of urban housing. See earlier posts here, here, here, and here. 

In each of these cases, when faced with similar problems in their own countries, the same set of reputed opinion makers and academicians in the west who excoriated developing countries in the nineties and noughties for pursuing such policies have now reversed their views. I think there is a polite word to describe such behaviour, hypocrisy. 

The latest addition is price controls to combat inflation. In a recent oped which has provoked strong reactions (see this, this and this), Isabelle Weber, an economics professor at University of Massachusetts, Amherst called for the re-introduction of price controls as an instrument against inflation. Weber's argument is that US corporate profit margins have risen to reach its highest level since the War, thereby contributing to inflation and also offering the space for "strategic price controls", like was done in the aftermath of the War to address market power of businesses. See this FRED graph.

She links to this Business Insider article which points out that "gains in US corporate profits over the past year (37%) has vastly outstripped both inflation (6.2%) and compensation increases (12%)". It also links to a recent Morgan Stanely research report. The article writes about the report's recommendations,

"Real wages currently still have to grow by 7.3% in excess of productivity growth to make up the gap," the report reads. "If this catch-up takes place over the next 5 years, unit profits will fall 33% from current levels… This would move the corporate profit share back to its 1990s average on a pre-tax basis, and leave it just marginally above on a post-tax basis." The team, led by chief US economist Ellen Zentner, argues that reducing the gap between profits and worker pay can serve as a "buffer" against higher wages driving prices higher... The chasm between compensation and productivity is a relatively new one, Morgan Stanley added. There was a "tight" relationship between the two in nearly every industry from 1950 to 2000. As businesses' revenues rose, worker pay generally climbed in lockstep. That link snapped in the 2000s, according to the bank. Workers' wages started to lag profit growth. Institutions that boosted worker power like unions and high minimum wages weakened. Corporations' owners and shareholders, meanwhile, benefitted from booming earnings and soaring stock values, Morgan Stanley said.

The gap between company profits and worker compensation in the past two decades is unprecedented and threatens the structure of the economy, the bank said. "This divergence between real compensation and real productivity had never before been seen in the recorded data," they said, adding the drop in worker pay "marks a break in the fundamental structure of the economy." Closing the gap wouldn't be a seamless transition, the bank added. Raising wages in today's tight labor market could put downward pressure on stocks in the near future. Still, strong corporate earnings and "ample liquidity" would cushion against a major selloff, the team said.

She points to the stark similarity with the World War II - increased household savings and attendant pent-up demand, supply chain disruptions, and inflation - which led to strict price controls, whose continuation to achieve post-war transition was advocated by some of the most distinguished US economists. 

Weber writes,

They argued that as long as bottlenecks made it impossible for supply to meet demand, price controls for important goods should be continued to prevent prices from shooting up. The tsar of wartime price controls, John Kenneth Galbraith, joined these calls. He explained “the role of price controls” would be “strategic”. “No more than the economist ever supposed will it stop inflation,” he added. “But it both establishes the base and gains the time for the measures that do.”... Today, there is once more a choice between tolerating the ongoing explosion of profits that drives up prices or tailored controls on carefully selected prices. Price controls would buy time to deal with bottlenecks that will continue as long as the pandemic prevails. Strategic price controls could also contribute to the monetary stability needed to mobilize public investments towards economic resilience, climate change mitigation and carbon-neutrality.

Adam Tooze (also here) links to a tweet thread and article by Eric Levitz, who has a very useful summary,

Price controls can produce negative, unintended consequences. But the same can be said of the orthodox approach to inflation management. That price controls *of any kind* are deemed absurd - and rate hikes, prudent - reflects custom more than reason... policymakers should pursue deflationary policies that are worthwhile on the merits. Medicare drug price-setting + rent control (paired with zoning reform and social housing) are two worthwhile price controls. 

Levitz also points to the recent successes in the US with rent controls,

As the Roosevelt Institute’s J.W. Mason has observed, several recent studies indicate that rent control is more effective at preserving affordability and neighborhood stability — and less detrimental to housing supply — than conventional economic wisdom holds... In New Jersey, Massachusetts, and California, the adoption of rent-control measures has successfully constrained rent increases for long-term tenants, thereby honoring the legitimate interest of such tenants in housing stability, while having no significant impact on new housing construction. Which makes sense. In most U.S. cities with extensive rent-control provisions, the constraint on new building is not excessively low rental prices but excessively restrictive zoning regulations.

As JW Mason points out, as on 2019, nearly 200 cities in the US have some type of rent control, mainly in New York, New Jersey, and California. 

Levitz also makes important points about the need to complement rent and price controls with other policies. Accordingly, rent control will have to be complemented with public housing investments and easing of land-use restrictions.

Noah Smith has a good article where he rejects price controls as response to the current inflationary episode. I am inclined to Weber and Levitz. In particular on the reflexive dismissal of price controls on the grounds that it does not conform to some theoretical models. Price controls have their use in certain markets, especially when its significant costs are more than off-set by the potential gains. And pharmaceuticals and housing are clearly two markets where the case for such regulation is strong. 

There may be a cyclical turn here. The twenties to the turn of seventies was the Keynesian era, whereas the next half-century was a return of the free market orthodoxy in the form of the neo-classical economics.   Paul Samuelson, Milton Friedman, Robert Lucas etc, with their mathematisation of economics led this neo-classical push, which now appears to have run out of steam. It's being replaced by a more realistic and empirical approach towards solving economic problems. The upending of economic orthodoxy should be seen in this backdrop. 

To the saltwater and freshwater schools, there may be a need to add a clearwater school of thinking, in so far as it is underpinned by empiricism and realism. 

It's most likely that many of the excesses that we seen in neo-classical economics and finance will be called out and reversed. The conventional wisdom on shareholder value maximisation, executive compensation, private equity, technological innovation and so on is most likely to be corrected. 

Needless to say, this reversal trend too will follow the same course. As this school of thinking gains ground, it will spawn its set of distortions and excesses. Once an ideological train is afoot, it creates narratives, and those narratives permeate thinking at all levels, taking down any opposition. It gathers an inexorable dynamic which invariably causes the pendulum to swing excessively in the other direction. The good from many of these realism-based policies will slowly be off-set by their bads. Clearwater will become muddier with time.

This dialectical process leads to a new anti-thesis and from it a new synthesis. But for now, the era of neo-classical American capitalism may be on the rear-view mirror.