Population Dynamics and Nonlinearities in Economic Systems
The limitations of neoclassical economics.
Published on: Mar 4, 2016
Transcripts - Population Dynamics and Nonlinearities in Economic Systems
Population Dynamics and Nonlinearities in Economic Systems
Edward Hugh Florence : February 2012
• What follows is highly eclectic
• What Jean Francois Lyotard called
grand narratives can seriously
damage your health (together with that of
those around you).
What Is Neoclassical Economics?
According to a widely accepted view the neoclassical approach
to economics rests on three basic assumptions, which may be
elaborated in a variety of ways according to the nuances the
exponent seeks to emphasise:
• People have rational preferences among outcomes that can
be identified and associated with a value.
• Individuals maximize utility and firms maximize profits.
• People act independently on the basis of full and relevant
God put macroeconomists on earth not to propose and test elegant theories
but to solve practical problems.
Macroeconomics is the modern descendent of two earlier lines of economic
research: business cycle theory and monetary theory. Its best known early
exponent was John Maynard Keynes, who attempted to derive a general
theory of the economy that described the whole in terms of aggregates and
their movements rather than building an overall picture starting from individual
microeconomic components and then working up on an additive basis.
In fact Keynes himself did not develop a workable and testable model from his
General Theory, and it was left to one of his early followers, John Hicks, to
develop a simplified, but more concrete “toy” model, the IS-LM framework.
Life then went quietly along its course until, in 1976, Robert Lucas published a
paper which effectively blew a hole straight through the midships of the
Keynesian economic consensus which had dominated macroeconomic
thinking since the days of the late 1940s when Paul Samuelson wrote his
And Macroeconomics II
Lucas’s highly influential paper effectively revolutionised modern economic
thinking. He criticised the earlier large-scale Keynesian models widely used in
forecasting and policy evaluation by arguing that economic models based on
observed empirical relationships between variables tend to be of limited value
given that the government policies which underpin them constantly change
and a relationship which holds under one policy regime may no longer do so
under another. In fact, Lucas’s argument could be turned against virtually any
model based on the evaluation of historical time series.
But this was not his objective. Lucas was focused on the role played by
expectations in the movement of large economic aggregates, and he argued
that generalisation about policy is difficult, since the impact of any given
policy is critically determined by how that policy alters the expectations of the
various economic agents involved.
Lucas formed part of what came to be known as the freshwater
(sometimes sweetwater) school of economists, composed primarily of
macroeconomists who, starting in the early 1970s, began to challenged the
prevailing Keynesian consensus in macroeconomic research. The key
element in their approach was the idea that macroeconomics had to be
dynamic, quantitative, and based on how individuals and institutions make
decisions under conditions of uncertainty. In other words, economic
systems needed to be modelled from the bottom up, and not from the top
down as the earlier Keynesian tradition had done.
There is no doubt that as a result of the work done by new
neoclassical theorists like Lucas the field of macroeconomics had all the
appearance of becoming increasingly rigorous, using ever more
sophistocated mathematical techniques, and was wedded ever more closely
to the basic tools of microeconomics. What was left in doubt from the start,
and remains without an answer today, was whether the all that extra rigour
and all the mathematical sophistication did not come at a price – a steady
loss of realism, and distanciation from day to day economic reality. We have
still yet to see testable models that enable us to predict, or foresee anything
interesting about real world economies, and this surely is where the
dividing line between science and “doxa” (or mere opinion) has to lie.
So while it was comparatively easy for proponents of the New Classicism like Lucas
and Thomas Sargent to ridicule early Keynesian work - “For policy, the central fact is
that Keynesian policy recommendations have no sounder basis, in a scientific sense,
than recommendations of non-Keynesian economists or, for that matter, non-
economists,” they said in one paper (1979) - they also had to recognise that their own
approach was not able to generate a model that would be worth taking to Washington:
“We consider the best currently existing equilibrium models as prototypes of better,
future models which will, we hope, prove of practical use in the formulation of policy.”
At the time they thought about a decade might be needed, but as it happens the world
is still waiting.
Keynesian economists responded to this critique by building more elaborate
models of their own based on the incorporation of microeconomic
foundations. Such approaches have often been termed the “New Neoclassical
Synthesis”. Like the neoclassical-Keynesian synthesis of an earlier generation, the
new synthesis attempts to merge the strengths of the competing approaches that
preceded it. From the new classical models they took the tools of dynamic stochastic
general equilibrium theory. Preferences, constraints, and optimization formed the
starting point, with the analysis being steadily built up from such microeconomic
Yet it still remains unclear just how useful all this has been. Gregory Mankiw
has summed the situation up as follows: “As a matter of science, there was
much success in this research (although, as a participant, I cannot claim to be
entirely objective).... but..... was this work also successful as a matter of
engineering? Did it help policymakers devise better policies to cope with the
business cycle? The judgment here must be less positive”.
Hence he concludes:
“There is also a less sanguine way to view the current the current state of play.
Perhaps what has occurred is not so much a synthesis as a truce between
intellectual combatants, followed by a face-saving retreat on both sides. Both new
classicals and new Keynesians can look to this new synthesis and claim a degree
of victory, while ignoring the more profound defeat that lies beneath the surface”.
Is This Obsession With Establishing Micro
Foundations Really Helping Us Get Empirically
“The Wheels Of Metaphysics Turn And Turn, But There
Appears To Be No Motion In The Drive Shaft” – Gilbert
Ryle (British Philosopher).
So we come to the real question I am trying to ask in this presentation. At
the end of the day I am not convinced of the usefulness of the kind of micro
foundations modern macroeconomists have been working with in the
context of the general objectives Keynes set himself for macroeconomics,
which was to improve our understanding of the factors that drive
movements in broad economic aggregates, with a lick and a promise about
being able to do something useful to counter the impact of deep recessions
and depressions. I am also not clear what relationship the day to day grind
of applied macro analysis has with the models built by theoretical
macroeconomists using these aforementioned foundations.
From the standpoint of science, the greater rigor that the new classicals
offered has much appeal. But from the standpoint of engineering, the cost
of this added rigor seems too much to bear.
“If economists could manage to get themselves thought of as humble,
competent people on a level with dentists, that would be splendid.”
John Maynard Keynes
Following a division Keynes himself sought to identify with his dentist
analogy, Greg Mankiw talks of economists as being either scientists or
engineers. I think at the end of the day this dichotomy fails to satisfy our
needs, as it seems to be based on a very restrictive and even problematic
conception of what science actually is. In addition the idea that what
neoclassical economists are doing constitutes science simply due to the
logical and mathematical rigour of the reasoning process used seems
questionable, since surely good science is characterised by its parsimony
and realism when it comes to the kind of assumptions it makes (Occam’s
razor) and the empirical validity of the sort of rational expectations
assumptions which form the cornerstone of modern neoclassical theory
has never really been adequately established.
Meanwhile, many of those who belong to what Mankiw would call the
engineering branch of the macroeconomics, seem to find themselves
more than able to do reasonably useful macroeconomic analysis, analysis
which often gives results which have a more than a random degree of
predictive efficacy, and normally they achieve this outcome without
reference to any of those supposedly key “micro foundations”. On the
other hand those who build and work with such cumbersome apparatus
do not appear to be able to demonstrate a comparable track record.
As is evident, science is not only defined by analytical rigour, it is also
defined by the reproducibility of its experimental results (something
which is impossible for economics, since the world itself is the
laboratory), and the falsifyability of daring predictions advanced on the
basis of hypotheses formulated following the adoption of a set of
plausible initial assumptions. Actually the philosopher of science Karl
Popper never questioned the rigour of psychoanalytic or Marxian
methodologies, although he did consider them to be prototypical
examples of what he termed “pseudo science”. Interestingly, his colleague
Imre Lakatos considered neoclassical economics also to belong to this
latter group mainly due to the failure of realism in initial assumptions and
the absence of falsifiablity for its predictions.
The procedure of induction consists in accepting as true the simplest law that
can be reconciled with our experiences – Ludwig Wittgenstein
Put another way, if I am not doing “scientific” macroeconomics, I have at least
a certain degree of curiosity to find out exactly what it is I am doing. One
leading theoretical economist – Columbia’s Xavier Sala i Martin – recently
suggested that it was me – and not the neoclassics - who was practicing
astrology in claiming predictive power for simple models. Yet I could reply that I
save myself a lot time and effort by simply cutting out what seems to me to be
a lot of useless rigmarole. In particular, my simplified approach enables me to
get very close to the actual data, and make easily testable empirical hypotheses,
hypotheses which are often associated with straightforwardly falsifiable
Naturally, this is not to say that the task of building up useful models which can
adequately describe long term movements in macroeconomic aggregates is in
principle impossible, but merely to argue doing so with the current generation
of simplifying assumptions, and the mathematics available does not appear to
One comparison which could be made would be between machine and human
translation. Exact reproduction of meaning seems not to be possible using the
existing technology, but this does not mean it never will be. In the meantime
interpreters are not in any danger of losing their jobs.
Macroeconomics is all about identifying patterns which are to be found
in the economic system as a whole and studying the system properties
which are revealed by those patterns, which are often discrete and
distinushable from the properties and relationships of elements
observed at the micro level.
To give an example, the above chart, which was generated by my friend
and colleague Claus Vistesen , describes a simple model built to
illustrates relationships between external balances, export dependency
and population age. The model incorporates predictions which are
perfectly testable. We will return to relationships postulated here later in
Robert Solow In His Nobel Speech
“How to reconcile these two visions of the economy—one founded on Adam Smith’s
invisible hand and Alfred Marshall’s supply and demand curves, the other founded on
Keynes’s analysis of an economy suffering from insufficient aggregate demand—has
been a profound, nagging question since macroeconomics began as a separate field of
study”. – Gregory Mankiw
One of the areas of economic research which interests me most is growth
theory. Why do economies grow at a certain rate at one point in time, and
another rate later? Is there any underlying process here to be grasped, or is
everything simply the result of random stochastic shocks?
Robert Solow, the founder of modern neoclassical growth theory, produced
his seminal work on the subject as a result of similar preoccupations. As he
tells us in his Nobel acceptance speech, he really started to think seriously
about the issue by asking himself one simple question: Under what
conditions is an economy capable of steady growth at a constant rate? He
was worried by the conclusion he drew from the assumptions made by his
predecessors, assumptions that seemed to lead to the discomforting
conclusion that instability was so inherent that “the possibility of steady
growth would be a miraculous stroke of luck”.
This worry was what eventually lead him to formulate his now famous
theory which links growth in labour and capital with the impacts of
technological change. Solow tells us he was concerned about the
inherent instability which was associated with the earlier Harrod Domar
model, and in particular with the kind of instability associated with disequilibrium
behavior, implying that there was no guarantee that an economy which once
strays from an equilibrium growth trajectory would ever automatically find its way
back to any equilibrium growth path.
As he tells us, solving this problem really meant finding a way of integrating
short-run and long-run macroeconomics, of bringing together growth theory and
business-cycle theory. This very much takes us back to the kind of foundational
issues which so concerned Keynes, and lead him to lay the foundations for the
distinct discipline of macro economics.
Early Keynesians, such as Samuelson, Modigliani, and Tobin, thought they had
reconciled these visions in what is sometimes called the “neoclassical-Keynesian
synthesis.” These economists believed that the classical theory of Smith and
Marshall was right in the long run, but the invisible hand could become paralyzed
in the kind of short run described by Keynes.
This kind of solution did not satisfy Solow, and, as he informs us in his
Nobel speech, the problem of combining long-run and short-run macroeconomics ,
despite all best efforts, has still not been adequately solved. Not that, as he notes,
there have not been some ingenious attempts.
“One important tendency in contemporary macroeconomic theory evades
this problem in an elegant but (to me) ultimately implausible way. The idea is
to imagine that the economy is populated by a single immortal consumer, or
a number of identical immortal consumers. The immortality itself is not a
problem: each consumer could be replaced by a dynasty, each member of
which treats her successors as extensions of herself. But no short-
sightedness can be allowed. This consumer does not obey any simple short-
run saving function, nor even a stylized Modigliani life-cycle rule of thumb.
Instead she, or the dynasty, is supposed to solve an infinite-time utility-
maximization problem. That strikes me as far-fetched, but not so awful that
one would not want to know where the assumption leads”.
“The next step is harder to swallow in conjunction with the first. For this
consumer every firm is just a transparent instrumentality, an intermediary, a
device for carrying out intertemporal optimization subject only to
technological constraints and initial endowments. Thus any kind of market
failure is ruled out from the beginning, by assumption. There are no strategic
complementarities, no coordination failures, no prisoners' dilemmas”.
The tendency Solow is referring to is that best represented by the work of
Nobel Laureate Edward Prescott, as exemplified most notably in his 1982
paper with Finn Kydland “Time to Build And Aggregate Fluctuations”.
Solow was not convinced, and draws the conclusion that “historical time
series do not provide a critical experiment”. We will return to this point.
No one could be against time-series econometrics. When we need
estimates of parameters, for prediction or policy analysis, there is no
good alternative to the specification and estimation of a model. To
leave it at that, however, to believe as many American economists do
that empirical economics begins and ends with time series analysis, is
to ignore a lot of valuable information that can not be put into so
convenient a form.
Skepticism is always in order, of course. Insiders are sometimes the
slaves of silly ideas. But we are not so well off for evidence that we can
afford to ignore everything but time series of prices and quantities.
Growth theory was invented to provide a systematic way to talk about
and to compare equilibrium paths for the economy.
It will not do simply to superimpose your favorite model of the business cycle on
an equilibrium growth path. That might do for very small deviations, more in the
nature of minor slightly autocorrelated "errors." But if one looks at substantial
more-than-quarterly departures from equilibrium growth, as suggested for instance
by the history of the large European economies since 1979, it is impossible to
believe that the equilibrium growth path itself is unaffected by the short- to
So a simultaneous analysis of trend and fluctuations really does involve an
integration of long-run and short-run, or equilibrium and disequilibrium.
The most interesting case to consider is one where real wage and rate of
interest are stuck at levels that lead to excess supply of labor and goods
(saving greater than investment ex ante).
The economy may eventually return to an equilibrium path, perhaps because
"prices are flexible in the long run" as we keep telling ourselves. If and when
it does, it will not return to the continuation of the equilibrium path it was on
before it slipped off. The new equilibrium path will depend on the amount of
capital accumulation that has taken place during the period of disequilibrium,
and probably also on the amount of unemployment, especially long-term
unemployment, that has been experienced. Even the level of technology may
be different, if technological change is endogenous rather than arbitrary.
The main result of Malinvaud's analysis is a clarification of the condition
under which a "Keynesian" steady state is possible, and when it is locally
stable, i. e. when it will be approached by an economy disturbed from a
nearby equilibrium path. The unstable case is just as interesting, because it
suggests the possibility of small causes having big results. All these stability
arguments have to be tentative because the interest rate and real wage are
assumed to be fixed while quantities move. That is not an adequate reason
to dismiss the results in a purist spirit; but obviously the research program is
My own inclination - it is just an inclination - is to try a slightly different
slant…. The obvious alternative to a model with sticky prices is a model with
imperfectly competitive price-setting firms. Then, of course, one can no
longer speak in any simple way of excess supply of goods. But we can find
something just as interesting; the possibility of many coexisting equilibrium
paths, some of which are unambiguously better than others.
In my 1956 paper there was already a brief indication of the
way neutral technological progress could be incorporated into a
model of equilibrium growth. It was a necessary addition
because otherwise the only steady states of the model would
have constant income per person and that could hardly be a
valid picture of industrial capitalism. Technological progress,
very broadly defined to include improvements in the human
factor, was necessary to allow long-run growth in real wages
and the standard of living. Since an aggregate production
function was already part of the model, it was natural to think of
estimating it from long-run time series for a real economy. That
plus a few standard parameters - like saving rate and
population growth - would make the model operational.
At one point in his paper Solow does examine whether the model could be
applied to a case where population movement was endogenous rather than
exogenous. His conclusion was that it could, but the explanation he offers
is indeed interesting:
“Instead of treating the relative rate of population increase as a constant, we
can more classically make it an endogenous variable of the system.
Suppose, for example, that for very low levels of income per head or the real
wage population tends to decrease; for higher levels of income it begins to
increase; and that for still higher levels of income the rate of population
growth levels off and starts to decline”.
What Solow postulates here is a kind of U shaped function, part of which
roughly corresponds to what we could call the "Malthusian era" when
population levels fluctuated as real wages (or income per head fluctuated),
and part of which offers a first approximation to the modern growth era, in
the sense that fertility (and hence population levels) tends to decline as
income rises. But between these two fertility "regimes" there would seem to
be a clear break, since what has not been observed (anywhere) is that as
incomes fall back subsequent to the transition from one regime to another
then fertility rises. Normally we find (in post Malthusian population
environments) that as living standards fall, even in the longer run fertility
also itself tends to fall.
Looking At The Limitations?
To try to illustrate some of the difficulties which arise when researchers
employ a theory of economic decision making and optimization based
on the rational expectations hypothesis when attempting to account for
long term movements in aggregate macroeconomic phenomena I will
offer three examples derived from:
• Currency Theory
• Current Account Imbalances
• Growth Theory
“If It Doesn’t Work, Throw It Away” - American Pragmatist.
Equilibrium Currency Theory
Perhaps one of the first people to think seriously about the problem of
monetary and fiscal policy would work in an economy in which capital
flowed freely in and out in response to differences in interest rates was
Robert Mundell, back in the 1960s.
Mundell came to the conclusion that everything depended on what that
country did about its exchange rate. If, for example, a country insisted on
maintaining the value of its currency in terms of other nations' monies
constant, monetary policy would become entirely impotent. Only by letting
the exchange rate float would monetary policy regain its effectiveness.
This lead him later to broaden this initial insight by proposing what has
become widely known as the concept of the "impossible trinity" – free
capital movement, a managed exchange rate, and an effective monetary
policy (Mundell, 1968). The trinity is impossible because a country can pick
two (and only two) of the three. A country can fix its exchange rate without
emasculating its central bank, but only by maintaining controls on capital
flows; or it can leave capital movement free but retain monetary autonomy,
but only by letting the exchange rate fluctuate; or it can choose to leave
capital free and stabilize the currency, but only by abandoning its ability to
control the movement of interest rates to fight inflation or recession.
Key to the impossible trinity idea was the assumption that if there was free
capital movement, and a floating exchange rate, macroeconomic stability in
a small open economy could be ensured by the application of an adequate
monetary policy. Many of the contemporary critics of the common Euro
currency tend to work on this assumption – namely if the economies on
Europe’s periphery had their own (floating) currency, and an appropriate
monetary policy, then all would be for the best in the best of all possible
Would that life were so simple!
Let’s Take A Look At Some Examples
Columbian Peso New Zealand Dollar
Swiss Franc Japanese Yen
The four examples in the last slide are not chosen at random. They
provide clear, but not isolated examples of countries whose
currencies, although floating, have fluctuated in what might be
termed a counter intuitive fashion.
The first pair, Columbia and New Zealand, provide examples of the
case where, in a world which is awash in liquidity and permanently
being swept by what Nouriel Roubini evocatively terms a “wall of
money”, the application of conventional monetary policy (raising
interest rates to curb overheating domestic demand) proves
counterproductive, since it produces a “perverse” outcome –
namely that a self reinforcing process is induced whereby inbound
capital flows overheat domestic demand, and then the rising
interest rates which are applied as a “cooling mechanism” only
serve to attract an even stronger inward capital flow (due to the
interest rate differential and the continually rising currency) which
causes the central bank to raise interest rates even further, etc, etc,
Naturally such processes only go on for as long as they do, and
then end in tears.
The second pair offer examples of what are often termed “safe haven” or
“funding” currencies. This phenomenon arises in the context of mature
economies which suffer from congenitally weak (see below) domestic
demand which leads to either very low domestic inflation, or even
Under these circumstances the respective central banks are constrained
to maintain interest rates very near to what is termed the “zero bound” –
again the perpetuation of this situation as a lasting one is certainly not
contemplated under the standard neoclassical models. The assurance of
very low interest rates over extended periods of time turns the currencies
in question into funding currencies for what has become known as the
“carry trade”. This trade operates on the basis of the anticipated interest
rate differential between the funding country and the destination one
(Columbia, or New Zealand, for example).
As long as the global economy is in what is known as “risk on” mode, that
is to say the risk sentiment level is high, then the funding currencies trade
at values which are significantly below “economic fundamentals fair
value” due to the fact that investors borrow in the currency and then sell to
invest elsewhere. This mechanism drives the currency down.
However, when the global economy goes into “risk off” mode, and risk
sentiment falls to very low levels, as happened during the Global
Financial Crisis, this carry trade unwinds, and as investors buy the
funding currency in order to close their positions that currency gets
driven up to very high levels. This is precisely what has happened to both
the Japanese Yen and the Swiss Franc during the first decade of this
The consequences of this phenomenon for the domestic economies of
both countries have been important. While the Yen was at a low value,
Japanese exports drove the economy, and indeed such were the cost
advantages that Japanese companies even relocated back home.
Now, the situation is very different, since as the “Japanese disease” has
spread, zero bound interest rates have become the norm rather than the
exception in the developed world, with the consequence that both the Yen
and the Swiss Franc have lost their pride of place as funding currencies of
reference, while at the same time the “safe haven” status of the
respective currencies in times of financial turbulence such as that
associated with the current European Debt Crisis means that the currency
is driven up rather than down.
In fact, the ideal carry trade needs to be symmetric (to optimise
earnings), in the sense that as the destination currency gets driven up,
the funding one should ideally be forced down. This means that the
Euro is a much more desirable funding currency in the current
environment than the Swiss Franc is, while the USD is obviously
preferable to the Japanese Yen.
Naturally, the consequences of this situation have been little short of
disastrous for the Japanese economy, and the country has, for example,
totally lost out to Germany in the key Chinese market. Exports have not
returned to anything like their pre crisis levels, and the economy
constantly flirts with recession.
On the other hand the Swiss Franc has been under constant pressure
throughout the eurozone crisis, as the currencies safe haven status
has attracted EU citizens anxious to seek protection from any
possible knock on effects were Greece to exit the common currency.
The Swiss National Bank has pegged the currency to the Euro and
been directly and indirectly intervening in the market to maintain the
peg. However, such was the fear aroused by electoral stalemate in
Greece that the Swiss authorities admitted they were contemplating
inbound capital controls if the situation deteriorated.
Of course the hypothetical fragmentation of a large currency bloc is
hardly a normal situation, but it is interesting to note the way in
which the issue of capital controls has gradually shifted from one of
avoiding capital flight to one of avoiding “over abundance”.
Far From Finding A Stable Equilibrium Path,In General
Most Contemporary Currencies Are Either
Systematically “Undervalued”” or “Overvalued”. Very
Few Currencies Today Find What Used To Be Termed A
Basically if you want to understand currency
movements you need to understand the operation of the
economic system at a global level. Simple knowledge of
local conditions doesn’t necessarily help. You need to
start at the top and work down, not from the bottom and
work up. Or maybe you need to work from both ends
and find out where they meet and interact. Global
economics is “holistic”, and treats the global economy
as a system. Studying the properties of “small open
economies” in the abstract and building up from the
bottom offers a poor guide.
Global Financial Accelerator – Carsten Valgreen.
Perhaps the first to note this “perverse” raising interest rates, revaluing
currency stimulating credit growth circularity phenomenon was the
Danish economist Carsten Valgreen – and he termed the phenomenon
the “Global Financial Accelerator”.
The thought involved is the following: real economic decision makers
are increasingly isolated from local monetary conditions and more
exposed to global monetary conditions and credit extension willingness
(or, if you prefer, global risk sentiment).
As Valgreen says:
“Take an arbitrary example: A Polish household wants to buy a
second home in France. To do this they contact their local bank
(which happens to be the subsidiary of a Swedish based banking
corporation) in order to obtain mortgage finance. They then
chose to borrow the money in Swiss Francs and Yen. This action
is likely to have a large impact on the future income streams and
net asset value of this Polish household, and – hence – its future
behaviour in the real economy. However, as long as free capital
flows are maintained the Polish central bank has limited influence
on the transaction. None of it is in PolishZloty. And the credit
decision of the private banking corporation extending the
credit is taken based on a credit model maintained in Stockholm
“What will matter for the family is the future currency and rate
moves in Swiss Francs and Yen. And the price developments for
second homes in France. Andperhaps also the future credit
attitude of a Swedish based credit institution”
The point of Valgreen’s example is to show just how powerless national
monetary policy can actually become in small open economies in a world
of fluid cross border financial flows. He goes on to illustrate his point by
referring (in mid 2007, before the global financial crisis broke out) to two
countries which were later to gain a certain notoriety. As he points out,
neither the Icelandic nor the Latvian central bank would have been able,
using simple recourse to conventional monetary policy tools to control
the rate of credit extension in their countries, despite the fact that one
country had floating exchange rates while the other had a currency peg.
The Icelandic central bank could control the interest rate on Icelandic
kronur. But that did not matter much for households, non-financial
companies or banks borrowing funds in foreign currency. Neither does it
seem to matter too much today that the official currency of Croatia is the
Kuna, since the country has one of the most Euro-ised economies
outside the actual Euro Area. As Valgreen argues in the Icelandic case, as
long as the banks have a high credit rating and are perceived as sound
by the international markets, credit flows easily to them in a liquid global
environment. “Perversely”, he noted, “it even seems as if a stronger
currency stimulates the Icelandic economy in the short run, as consumer
spending reacts to increasing external buying power and as exports are
concentrated in price insensitive commodity sectors.
“In the world of economics and finance, revolutions
occur rarely and are often detected only in hindsight.
But what happened on February 19 2010 can safely be
called the end of an era in global finance. On that day,
the International Monetary Fund published a policy
note that reversed its long-held position on capital
controls. Taxes and other restrictions on capital
inflows, the IMF’s economists wrote, can be helpful,
and they constitute a “legitimate part” of
Capital Controls To Stop Inflows?
Another Theoretical Puzzle, Just Why Did Those Famous “Global
Economic Imbalances” Build Up?
As is well known, one
group of countries -
Japan, Germany and
China – were running
account surpluses in
the years prior to the
Global Financial Crisis.
Another group – who
we may call the debtor
countries, in particular
the UK, the US and
Spain – ran
One Hypothesis - Could Something As Simple As Median Population
Age Help Us To Understand?
Ours is an age of rapidly ageing
societies. What is so modern
about our current situation is not
the ageing itself, but its velocity,
its global extension, and the
differing rates even between
countries in the same group
(developed economies, emerging
markets, less developed
Leaving aside the cases of China
and Italy, many of the advanced
countries running surpluses had
notably higher median ages than
those running deficits. The former
group had median ages well over
40, while the latter group were
typically in the range 35 to 40. Is
there an association here?
.Median Age And The Imbalances
As mentioned previously, the current account appears to show a
non linear relationship with median population age, with the
later also being reflected in the level of export dependency
versus credit expansion involved in the attainment of economic
growth. This hypothesis has been explored by the young
Danish economist Claus Vistesen.
Steady State Growth?.
All theory depends on assumptions which are not quite true. That is what
makes it theory. The art of successful theorizing is to make the inevitable
simplifying assumptions in such a way that the final results are not very
sensitive.' A "crucial" assumption is one on which the conclusions do
depend sensitively, and it is important that crucial assumptions be
reasonably realistic. When the results of a theory seem to flow specifically
from a special crucial assumption, then if the assumption is dubious, the
results are suspect.
Robert Solow, A Contribution To the Theory of Economic Growth, 1956
Economic growth is an issue that has attracted economists’ attention ever
since the phenomenon became really evident following the onset of the
industrial revolution, but it was not until the middle of the last century,
under the impact of the great depression in the US that theoretical
economists really started to ask the question why continuous economic
growth could be expected.
Steady State Growth II.
Today we take it for granted that this is just the way things are, and after
each recession we expect a recovery almost automatically. But things
weren’t always this way, and for thousands of years before the industrial
revolution economies barely grew. So the idea that there should be growth
is not an entirely self evident one, and, indeed, growth theory itself grew
out of a historical episode where for more than a decade it seemed hard to
believe that growth would eventually come, just like manna from heaven.
The early attempts to systematise growth theory were born from an
environment where it seemed more plausible to speculate that capitalist
economies were doomed to permanent breakdown, or at least to the
possibility of one serious breakdown after another. Few were willing to
believe that financial and product markets provided a near permanent
correction mechanism, and theorists rather than wondering why there was
stability were more concerned with why there was so much instability.
Steady State Growth III.
As Solow himself says about the early growth models, “An expedition from
Mars arriving on Earth having read this literature would have expected to find only
the wreckage of a capitalism that had shaken itself to pieces long ago”.
However, despite the irregularities and evident vicissitudes of the business cycle.
Solow was convinced that sufficient evidence was available to support the idea that
some sort of stable long term growth path did in fact exist for developed economies,
and thus he sought to produce a model which could illustrate how this might be.
At this point it is worth emphasising that while there is at times ambiguity in Solow’s
own writing – he often talks about an equilibrium growth path, while allowing that
there may be more than one of these – he never in fact makes the assumption
made by many modern representatives of the neoclassical growth tradition that the
steady state growth path towards which a given economy will tend to
converge involves a relatively constant rate of growth. That is to say, he
leaves open the option that along the steady state, or balanced growth path
the rate of growth may vary, and may even do so in a systematic fashion.
That is the possibility I wish to explore here.
Steady State Growth IV.
As he tells us, his attention was attracted to the various kinds of growth
instability which seemed inherent in the earlier models.
Naturally, as a good neoclassic Solow needs to use the term equilibrium
(rather than balanced, or sustainable, or simply trend) growth path, “Growth
theory,” he says, “was invented to provide a systematic way to talk about and to
compare equilibrium paths for the economy”.
However once we strip out such standard neoclassical vocabulary, it is easy to
see that what really interested him was modelling why an economy which
deviated from its balanced path should generally correct back to either that path
or another similar one. Why, for example, once a given economy had strayed
from what had been its trend path should it not head for catastrophe, or simply
enter a period of terminal decline, or decadence. Argentina in the 20th century
(not the 21st) has often been thought of as the archetypal case for such decline,
since it moved from being a comparatively wealthy country to being a relatively
poor one, although it should be noted that the position is only relative: Argentina’s
economy still grew over the century. But why should this be an atypical, and not a
typical phenomenon? Why should economies grow over time, and do so in a
This then was Solow’s starting question, and as becomes evident once we
start to think about what is happening to developed economies post the
Global Financial Crisis, it was a good one.
According to standard growth theory, once the steady state growth rate is
achieved any external perturbation which sends the economy off its
growth path will only have a temporary (or transitional) impact before
assumed homeostatic mechanisms send it back on course. In more
conventional language, once the equilibrium growth rate is achieved, it
should be stable, absent external shocks, since regardless of the initial
value of key parameters like the capital-labour ratio, the system will
exhibit a tendency to develop toward a state of balanced growth.
Naturally the key here is the idea of homeostasis, better known in an
economic context by its euphemism “the hidden hand”. If there is not
some sort of automatic regulatory mechanism then there is no good
reason why the system should not randomly veer off its path, never to
return. However, as we will see when we come to think about population
dynamics, it is not clear that any such overarching homeostatic
mechanism actually exists in the longer run. It could thus be the case that
the modern economic system is only locally stable since it incorporates
components which are inherently unstable in the longer run.
The fundamental distinctive feature of Solow’s model is his
assumption is that growth is exogenously determined – in other
words, it is determined outside of the model – in this case by rates of
saving and rates of population growth which take place in an
environment characterised by a series of more or less random
This is the leading “plausible” assumption Solow made when setting
up his model. The basic idea is that the rate of growth of any economy
in the longer run is effectively determined by the rates of growth of the
labour and capital inputs which are themselves assumed to grow at a
given relatively constant rate. Solow considered both population
growth rates and savings rates to be behavioural variables which in
mature economies vary from one country to another according to
national characteristics. Thus along balanced paths growth rates vary
from one country to another according to the values associated with
these behavioural parameters, but in the case of a given country, once
attained the steady state growth rate doesn’t fluctuate significantly.
Of course, it is important to understand that we are talking about models
here, and simplifying assumptions which are made in building them. At the
end of his path breaking paper Solow did consider other cases where rates
of both population growth and saving might vary, and we will return to this
Steady State Growth VI.
Solow’s basic workhorse model can be formalised in the following way:
Y = f(K,L)
Where Y is national output (or GDP), K is capital, and L is the labour force.
Really the idea conforms to our most basic intuitions, in the sense that
economies grow as the capital base expands and employment grows.
Naturally, these intuitions also tell us that something is missing, otherwise, for
example, the old soviet-style economies where emphasis was placed on
increasing capital investment and putting growing numbers of people to work
(including for example the female labour force) would have had the best
growth performance of all, which manifestly they didn’t.
The missing ingredient was evidently productivity, which is simply a relational
variable which describes how the two basic ingredients are combined. Rather
like a good cocktail, the outcome depends not only on the raw materials
applied, but the shaker used, and who does the shaking.
“A balanced growth path in the neoclassical growth model is defined as a
situation in which all quantities grow at constant exponential rates (possibly zero)
For the sake of modelling simplicity an additional assumption is often
made that the function has a specific form, namely that the parameter
coefficiants add up to 1. This function is known to economists as a Cobb–
In the above version of the function Y represents total economic output, A
represents multifactor productivity (often generalized as technology), K is
capital and L is labour. The Cobb Douglas assumption is a kind of stability
ensuring one. As Solow says:
“The basic conclusion of this analysis is that, when production takes place
under the usual neoclassical conditions of variable proportions and
constant returns to scale, no simple opposition between natural and
warranted rates of growth is possible. There may not be- in fact in the case
of the Cobb-Douglas function there never can be – any knife edge. The
system can adjust to any given rate of growth of the labour force, and
eventually approach a state of steady proportional expansion.
If, to take a different case production functions exhibit non-constant
returns to scale in all factors, then the very existence of a balanced
growth equilibrium path requires the production function to be a Cobb-
Douglas one. Or as Charles Jones says:
“The use of the word “balance” is suggestive in another way. In
particular, consider the familiar phrase “balanced growth path” and ask
what it is that is balanced along such a path. What must be ‘balanced’ to
get a steady state with positive and constant factor shares? The answer
is the growth rates of the two effective inputs, BtKt and AtLt. If one
effective input grows faster, a trend is induced in the factor shares unless
the production function is Cobb-Douglas.”
Essentially it is this coefficient summing-to-one condition which
guarantees the balance, otherwise growth in the model would
either shoot down to zero or up exponentially towards infinity
following an increase or decrease in one of the effective inputs.
Steady State Growth VII
Now while the question of having the long run growth rate determined
outside the model by national saving and population growth rates leaves
us with a feeling of frustration over the scope of the Solow model, the
external shock role given to technology seems to confound even our
most basic intuitions about growth, since it is evidently the case that the
function of a part of the labour and capital put to work inside the model is
to generate just this techological change. In just the same way as more
resources devoted to investment could be thought to generate
employment and growth in the longer term, so more resources devoted
to R&D would seem to do likewise. Always assuming of course the
proviso – and this is a big proviso – that such investment and such
research is “warranted” and profitable. This issue of the role of human
capital in generating productivity/technology did in fact give rise in the
first place to a whole generation of neoclassical growth models, and later
to a wave of “new growth theory”.
The intent of this new wave of theory is perhaps best expressed in a recent
paper by two of the movements best known exponents, Paul Romer and
“The very narrow focus of the neoclassical growth model sets the baseline
against which progress in growth theory can be judged. Writing in 1961,
Kaldor was already intent on making technological progress an endogenous
part of a more complete model of growth.......Growth theorists working today
have not only completed this extension but also brought into their models the
other endogenous state variables excluded from consideration
by the initial neoclassical setup. Ideas, institutions, population, and human
capital are now at the center of growth theory. Physical capital has been
pushed to the periphery”.
For thousands of years, growth in both population and per capita
GDP has accelerated, rising fromvirtually zero to the relatively rapid
rates observed in the last century.
Jones & Romer document this argument with the above chart, which shows
population and per capita GDP for “the West”—an amalgam of the United
States and twelve western European countries for which Maddison (2008)
reports data going back 2,000 years.
Plotted on a linear scale, the by-now-familiar “hockey stick” pattern would
be highlighted, where both population and per capita GDP appear
essentially flat for nearly two thousand years and then rise very sharply in
the last two centuries. We’ve chosen to plot these two series on a
logarithmic scale instead to emphasize the point that the rates of growth
— the slopes of the two series—have themselves been rising over time.
More people lead to more ideas. For most of human history,more
ideasmade it possible for the world to supportmore people. In a dynamic
version of themodel used to explain Fact 1, this simple feedback loop
generates growth rates that increase over time.
Of course, it is biologically impossible for the population growth rate to
become infinitein finite time. At some point, human fertility can’t keep up.
This leads to a second way to close the model. One can relax the
assumption that population adjusts instantaneously to drive income down
to subsistence and replace it with an economic model of fertility. At low
rates of growth and low levels of income, desired fertility may be able to
keep up with new ideas, so per capita income remains close to the
subsistence level and population growth accelerates. Eventually, though,
fertility and population growth level out. Growth in per capita income then
accelerates until it reaches modern rates.
The acceleration of population growth and per capita growth are striking
bits of time series evidence that support the feedback between
population and ideas. There is no comparable cross sectional evidence
at the level of individual nations because economic integration lets
countries of widely varying sizes draw from a shared pool of ideas. Until
India reformed its trade and investment laws, workers in tiny Hong Kong
may have had access to more ideas than workers in much of India.
Looking forward, virtually all demographic projections call for the number
of humans on earth to reach a maximum in this century, which may lead
to a slowing of growth in technology. Many forces could offset this
change. The effective number of people with whom each individual can
share ideas could grow through more intense integration. The total
number of people living in cities will continue to grow long after total
population has begun its decline. Barring some drastic political setback,
the trade and communication links between all these cities will also grow
tighter still. Rising levels of human capital per capita could make the
average individual better at discovering and sharing ideas. If new
institutions change incentives, the fraction of the available human capital
that is devoted to producing and sharing ideas could go up fast enough
to offset the decline in the total.
These forces have been operating in much of the OECD during the
last half century and there is much room for each to have big effects
as policies and levels of human capital in places like China and
India come to resemble those in the OECD. For all these reasons, it
is quite possible that growth at the technological frontier could
continue for the foreseeable future and who knows, might even
increase yet again in this century compared to the last.
Nevertheless, this century will mark a fundamental phase shift in the
growth process. Growth in the stock of ideas will likely no longer be
supported by growth in the total number of humans.
The textbook explanation for the rapid catch-up growth that we see
in Japan, South Korea, and China is transition dynamics in a
neoclassical growth model. A significant problem with this
explanation, of course, is that it is based on a closed-economy
setting where capital cannot flow across countries to equate
marginal products. But international capital flows seem important in
practice;................ The fact that rates of catch-up growth have been
rising over time is difficult to understand in a pure neoclassical
framework but is a natural occurrence in a world of ideas, where the
technology frontier is relevant to what can be achieved.
Steady State Growth VIII
Now this presentation is about growth, and how to think about it, not how
to model it, so essentially I am going to skirt all these issues, and come
to a piece of work by Gregory Mankiw, David Romer and David Weil,
“Taking Solow Seriously” (1992), which has the merit of being perhaps
the most influential paper on neoclassical growth theory after Solow’s
As they point out, growth in the Solow model is exogenous, because
rates of growth of capital and rates of growth of labour depend on
national savings habits and population movements, respectively. Since
both of these are determined outside the model, and vary between
countries, then different countries will exhibit differing growth paths.
These are then Solow’s “plausible” assumptions.
Steady State Growth VI
But, as they say, this very simplicity of set-up enables us to derive a couple of
very basic predictions which flow from it, and test them. These are, the higher the
rate of saving the richer the country, and the higher the rate of population growth
Steady State = Constant?
Now maybe this is a good point to address one of the possible confusions
which arises from Solow’s work, and that is whether or not the concept
“steady state growth” necessarily implies constant trend growth. Despite
the fact that Solow himself uses the term “relatively constant” from time to
time, it is quite clear that it doesn’t, and that Solow himself didn’t think that
To go no further, if economic growth rates are associated to some extent
with population growth rates and these latter are by no means constant for
any given country, then clearly the so called steady growth rate is
something of a moveable feast. And if in addition, these movements in
population growth rates are associated with shifting population age group
proportions then, assuming Modigliani’s life cycle model of saving and
borrowing, then save rates will be similarly affected.
Nonetheless, this has not stopped many working economists assuming that
steady state means something like constant.
One reason why people have fallen into this apparent trap has been
the recent history of the US economy. Using data taken from Angus
Maddison , the US economist Charles Jones estimated that the
growth rate of the US economy between 1950 to 1994 was an annual
1.95 percent, which was slightly higher than the rate he derived for
1870 to 1929, which was 1.75 percent. However even these highly
aggregated numbers conceal a considerable degree of variance,
since the growth rate registered in the 1950’s and 1960’s - 2.20
percent - was considerably higher than that found during the Solow
productivity slowdown of the 1970s and 80s, which was a "mere"
1.74 percent. Nonetheless, if we look at a chart for the 10 year
moving average for US growth from the mid 1950s, well, the result
does show relative stability and constancy.
Thus the the existence of such apparent stability in U.S. growth rates
over such long periods of time has given considerable support to the
"common sense" and conventionally accepted view that the U.S.
economy is, and has been, running at close to what is considered to
be some sort of long-run steady-state (or balanced growth) path. GDP
growth is, of course, always volatile, but when you strip out some of
the volatility the smoothness of the US path really is quite remarkable
– especially when compared, as we will see, with that of many other
countries - making it hardly surprising that many US economists
have found the idea of relatively constant steady state growth a fairly
One distinction which may help get address the problem is the one
Jones himself makes between a constant and a balanced growth path.
Along both such paths, growth rates remain constant over an
extended period of time, but in the former case constant growth is
simply the (coincidental) by-product of a process which is effectively
driven by series of transition dynamics while in the latter what is
involved is stable and self correcting since what we have is a steady
A balanced growth path is normally defined as a situation in which all
variables grow at constant geometric rates (possibly zero). (Jones,
So we might like to consider one further possibility at this point. Could
it be that the "as a matter of empirical fact" transition dynamics
associated with the various factors of production in the United States
have worked in some strange way to precisely offset one another, and
in so doing leave the growth rate of output per worker fairly constant?
A One Off Demographic Transition?
Now, as we have already noted, it is a key postulate of neo-classical
growth theory that each economy has its own long run steady state
One of the consequences of making this sort of initial assumption
(albeit as a purely hypothetical and theoretical one) is not in fact that
hard to see, since the steady state assumption would seem to imply
that as the demographic transition which produced those earlier
"transitional dynamics" is left steadily behind (the demographic
transition remember is associated with large fluctuations in levels
and growth rates of population) then a steady growth rate in the
labour force (achieved in part via institutional efficiencies in the
labour market) and a supply of savings regulated by effective
monetary and interest rate policy, should mean that any given
economy would have its own given balanced growth rate,
irrespective of key population variables like fertility rates and life
This neo-classical long run steady state growth rate needs, of
course, to be understood as a theoretical postulate, a sort of ideal
limit case, but nevertheless the concept continues to orient and
inform a good deal of conventional economic thinking about
It also informs the way most people conceptualise and approach the
present global economic crisis, since underlying one rescue and
stimulus package after another is the idea that there is a long term
trend growth rate out there somewhere, just waiting to be
Just A Heuristic?
So Let’s Take Solow At His Word
It was in some sense with this kind of issue in mind that Mankiw,
Romer and Weil wrote what has since become a highly influential
paper - A Contribution To the Empirics of Economic Growth - since
they clearly felt the need to try to put neo classical theory onto a
somewhat more stable footing. In their paper the authors outline what
they see as the core of the Solow thesis using following words:
This paper takes Robert Solow seriously. In his classic 1956 article
Solow proposed that we begin the study of economic growth by
assuming a standard neoclassical production function with
decreasing returns to capital. Taking the rates of saving and
population growth as exogenous, he showed that these two variables
determine the steady-state level of income per capita. Because saving
and population growth rates vary across countries, different countries
reach different steady states. Solow's model gives simple testable
predictions about how these variables influence the steady-state level
of income. The higher the rate of saving, the richer the country. The
higher the rate of population growth, the poorer the country.
Are The Assumptions Plausible?
The first thing to notice about the argument is that the Solow
model clearly predicts two pretty straightforward and neatly linear
relations: more population-less growth, and more saving-more
Now, we are immediately presented with an important difficulty
here since, as we will see below, there is now a considerable and
accumulating body of empirical evidence which seems to suggest
that among "mature" developed economies, those who have the
fastest rates of population growth are also those who experience
the highest rates of per capita income growth (the United States is
the most obvious example) but as we will see this is also the case
of France and the United Kingdom.
Growth Function That Looks Like An
In those countries where population momentum has slowed, even
to the point where their populations may now decline (Italy, Japan,
Germany, for example) do not seem able to achieve their former
high rates of economic growth, and, even worse, seem to be losing
ground in per capita income terms with those economies whose
populations continue to grow reasonably rapidly.
Now I do not seek here to explore this question in all its intricate
detail, I simply wish to make one clear and central point, and that
is that the relations involved between population growth and per
capita income growth do not seem to be simple linear ones, and
arguably it is this property which has thrown many previous
researchers off track since in running growth correlations they
have normally tended to treat them as if they were.
.Running Out Of Energy?
Pre Capita Income In Higher Population
.Versus Per Capita Income Growth In The Slow
Population Growth Group
High Median Age
And Lower Median Age.
Whoops, More Steady State Growth?
Either Steady State Growth Exists, Or It
As Bernanke and Gurkaynak say in their paper on neoclassical
growth, there are two and only two possibilities here: either the long-
run growth rate is the same for all countries (that is, g(i) = g for all i),
as maintained (following Solow) by MRW, or it isn't.
Even more to the point, "explaining" growth by assuming that growth
rates differ exogenously (or for factors which lie outside the model)
across countries is not particularly helpful, especially since such
changes in the growth rate seem to be systematic and not incidental.
Once it is allowed that long-run growth rates not only differ across
countries, but that growth processes in individual countries often do
not exhibit properties which are normally associated with a balanced
growth path ( that all variables do not grow at constant geometric
rates, for example) then we are naturally pushed to consider
explanations for these differences, and towards a fresh approach in
What Might Population Ageing Have to Do With All This?
As far as we are able to understand the issue at this point,
population ageing will have major economic impacts and these
can be categorised under four main headings:
i) ageing will affect the size of the working age population, and with
this the level of trend economic growth in one country after another
ii) ageing will affect patterns of national saving and borrowing, and
with these the directions and magnitudes of global capital flows
iii) through the saving and borrowing path the process can influence
values of key assets like housing and equities
iv) through changes in the dependency ratio, ageing will influence
pressure on global sovereign debt, producing significant changes in
ranking as between developed and emerging economies.
Life Cycle Hypothesis
There is a generally accepted wisdom in academic work known
as the “life cycle hypothesis” (Modigliani). This suggests that the
population’s financial behaviour changes depending on age. In
terms of adult life, those in their twenties and early thirties tend
to be net borrowers as they are relatively low earners at the same
time as they look to buy housing, expensive durables and fund
their burgeoning families. At some point around middle-age this
group then tends to move from being net borrowers to net
investors as they move into their economic prime and
accumulate financial assets to hopefully fund their retirement. As
they approach retirement this group then start to shed the
financial assets they’ve been accumulating to fund their
Different Rates Of Ageing
• The pace of aging varies greatly across countries and regions,
• Most pronounced and rapid in those countries that for decades have
had fertility rates below replacement levels - Japan, German speaking
countries, Southern and Eastern Europe.
• The median age of populations in Europe as a whole will most likely
increase from around 38 today to 49 in 2050 (with significant
differences between countries), and at this point it will be over 20
years above the estimated median age in Africa (which will be the
• Spain - with half its population older than 55 by 2050 – is expected to
become the oldest country in the world, followed closely by Italy and
Austria, where the median age is projected to be 54.
Causes Of Population Ageing - Second
This process of rapid ageing is due to the combined impact of two
1) Declining fertility
Spain Total Fertility Rate
2) Steadily Rising Life Expectancy
Spain Male Life Expectancy
(years, from birth)
Many Societies – Like The Italian One Have
Had Stationary Populations Ex-immigration
But The Population Pyramid Has Been Shifting, And Will Continue To Do So
Before The Crisis Immigration Drove The Italian
Population And The Workforce Upwards
The Same Thing Happened In Spain
But Then The Housing Bust
Sent Everything Into Reverse Gear
Latvia Has Similar Problems
Population has been
falling, due to low birth
rates and outward
But now the economic
crash, and the absence of
strong recovery, is
accelerating the process
as young people leave in
search of work.
1/. You can do meaningful applied, predictive and testable macroeconomics
without reference to the theoretical rigmarole associated with mainstream
2/. Economies are complex systems, characterised by the presence of
widespread feedback mechanisms and should be treated as such.
3/ Far from the ideal type entities generated by applying the model of classical
physics to economics, economies are path dependent entities where the
outcome depends very sensitively on initial conditions
4/ For this very reason forecasting future conditions is extraordinarily difficult,
since they very often depend on what happens tomorrow, and the day after.
5/ Population projections are fairly easy to offer based on plausible
assumptions about future trajectories for fertility and life expectancy, but in a
world where the main mover of population numbers in the developed
countries is international migration it becomes a very difficult and sensitive
process. I defy anyone to tell me what Spain’s population will be in 2020!
Thank You For Your Attention
Eppur si muove!