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Towards a rational macroeconomic policy post-Covid-19
Part 1


Hector McNeill1
SEEL



This site has explained a range of shortcomings with "conventional" economic policies including Keynesianism, Monetarism and supply side economics (KMS policies). First of all they all are founded on the proposition that the Aggregate Demand Model (ADM) provides the foundation for managing the economy. These presumptions have failed spectacularly several times with Covid-19 occasioning yet another failure albeit arising from a different cause but highlighting, non-the-less, the weakneses of KMS policies.

The other common factor that characterises KMS policies is that they create winners, losers and some who remain in a neutral policy impact state. With time, the plight of the lower income segments becomes worse. This macroeconomic approach has precipitated major financial crises in 1929, 1970s, 2008 and now 2020.

It was the lamentable lack of the effective Keynesian and monetarist policy instruments to solve slumpflation in the 1970s, that prompted the development of the Real Incomes Approach. This approach which offers a foundation for a more rational macroeconomic management of our affairs post-Covid-19.

This article is Part 1 of an explaination of the justification and logic behind this development in order explain why it is a more resilient alternative as a general economi theory with practical effectiveness.

The Production, Accessibility & Consumption Model (PACM)

The PAC Model of the economy was developed as a result of an analysis of how economies operate. It was identified in 1975-1976 to explain the financial crisis in the late 1970s which was caused by the international petroleum price rising rapidly, giving rise to slumpflation that combined high inflation with high unemployment. ADM logic had assumed this was not possible since up until that time low unemployment had been associated with high inflation as depicted in what is known as the Philips curve (see right). However, the PAC Model, as a general model, was able to explain the "new situation". As a general model it can be used to analyse any economic situation and all of the crises (1929, 1970s, 2008 and 2020). To explain the PAC model elements of production, accessbility and consumption I have highlighted these elements in red in the passges that follow.

The initial recent slide in the performance of the global economy was not a lack of demand but rather a lack of supply. Since many economic units survive and earn their income from servicing supplies from China such companies have had significant problems and some have already failed. So the governor of economic activity in this case was not a gap in Aggregate demand but rather a gap in Aggregate production. This gap transmitted an impact in the form of essential products from China not being accessible locally in the market where they are normally consumed, that is, the effective supply was not there. As a result, even although in the short run consumers were able to afford to purchase the products if accessible, the lack of supply resulted in low or no consumption. Other aspects of accessibility are access to information concerning products and accessible unit prices. As Covid-19 bites, self-isolation and the lack of income resulting from lack of gainful employment, the cash flow of consumers could be compromised leading to a fall in their purchasing power and as a result the what were accepted as normal affordable prices might move beyond the state of accessible unit prices leading to a fall in consumption.

With Covid-19 impacts now affecting Western economies the purchasing power of many people who are self-isolating and out of work has fallen because the normal prices of rent, mortgages, food and utilities are beyond their ability to pay on a sustained basis over even a few weeks because of lack of nominal income and savings. The generalise low income levels and inability to save creating a lack of resilience within the population to tide them over difficult periods and that affects a lerge proportion of constituents in "developed" and "high income" countries, is related to a prolonged adherence of policy makers to the Aggregate Demand Model approach as will be explained in Part 2 of this article.

Slumpflation

In the 1970s-1980s, neither Keynesianism nor Monetarism could resolve slumpflation without imposing yet more severe prejudice on the constituency. This was because of a blind faith in assertions of "leading" economists such as Milton Friedman concerning the central role of centrally imposed interest rates in stemming inflation. Indeed, this "solution" in the UK, under the Conservative government of Margaret Thatcher led to high centrally imposed interest rates leading to the rises in premiums being beyond the ability to pay of around 2 million families who lost their homes. The policy in fact created these sub prime mortages from a portfolio of sound mortgage agreements by imposing an enormous hike in interest rates. These were beyond what could have been expected at the time these agreements were drawn up.

Slumpflation was caused by disruption in the circustances of production caused by one major input, petroleum, undergoing very high rates of unit price increase. So inaccessibility was not lack of producion but rather the inability of some production units to be able to afford this input in the light of the purchasing power of their consumers. Here you can see we are dealing with a real income or purchasing power problem as has now arisen under Covid-19. In the late 1970s through mid-1980s many companies further down the supply chain also failed and unemployment rose yet further as a result of a deficit in their real incomes or purchasing power linked to the high prices of the upstream production that depended upon petroleum inputs. The inaccessiblity of these unit prices is a repeat of the real incomes problem further down the chain in a similar way to that now observed under Covid-19 as people lose jobs as a result of self-isolation.

I initiated work on the Real Incomes approach in 1975 after I had attempted to apply the policy instruments of Keynesianima and monetarism to identify a solution to slumpflation. I discovered to my amazement that this was not possible without inflicting severe arbitrary prejudice on constituents which I found to be unacceptable. I therefore sat down to analyse this state of affairs to try and identify a more acceptable solution. The basic form of the Real Incomes approach took about one year to complete by 1976. At around this time other economists, including Robert Mundel, were developing what came to be know as "supply side economics". When I read what supply side economics was, I was surprised to find it is a fiscal scheme based on reductions of marginal taxation rates but whose operation was wholly-based on the same presumptions of the Aggregate Demand Model logic used by Keynesianism and monetarism. As far as I could make out, there were very few supply side elements.

Supply side

It is important to clarify what I mean by supply side. Supply side involves the processes and decisions that determine the economic and financial productivity of a production unit. This requires business rules to guide management decision analysis on resources allocation to improve the quality of output, preferably at declining unit costs and, when possible, setting unit output prices at more competitive and even lower levels. The result of this sequence should be that companies, their workforce and consumers all benfitting from rising real incomes and purchasing power. Naturally by aggregating economic unit growth in real incomes one ends up with a real growth at both sector and macroeconomic levels. I did not set out to create a real incomes policy or even a supply side solution. However it was simply as a result of my analysis that these elements emerged as essential elements for any successful economic policy orientation. It came as a surprise after such intensive work and tracing the transparency of this analysis to find that these elements were largely absent from the existing macroeconomic models and policies. So what emerged from this work was that it is imperative to focus on:
  • real incomes
  • the specification of supply side decision analysis rules - business rules
  • the design of policy instruments to help companies achieve this type of mutually beneficial growth
So the first significant difference between what became the Real Incomes approach and KMS policies is that is is founded on microeconomic principles, it is essentially bottom up in nature. It can only succeed if the business rules enable companies in any operational state to make use of the policy instruments to maximise their real incomes. Therefore the decision-making is all on the supply side and in the hands of management and workforces. The other significant difference between Real Incomes approach and KMS policies is that the supply side decisions are not limited to margins and price setting but consist of a combination of technical, economic and financial decisions.
Learning, technologies, techniques, innovation and growth

KMS policies on the other hand provide no such supply side orientation but consist of top down market interventions through government revenue-seeking and taxation, public expenditure and centralised fixing of interest rates, varying money volumes that are in fact loans, as well as government loans where revenues do not cover outlays. The reason such policies create winners, losers and those who remain in a neutral policy impact state is that sectors, companies, individuals and families all have very different objectives, capabilities, cash flows, social and economic interactions and prospects. Applying centralised monolithic market interventions are bound to create differential outcomes. KMS policies are not designed to adapt to the conditions of each economic unit. This is why most KMS policies do not possess effective traction because they end up not supporting the interests of most segments of the economy.

Inflation

An important detail, at the time, was the need to drive inflation out of the economy. It is self-evident that much of the inflation can be traced to the massive rise in petroleum input prices. So the inflation had nothing to do with "demand" but rather production and supply conditions where costs could not be controlled easily. The only way to get rid of inflation was through steps to improve productivity by substituting petroleum or making use of petroleum in a more effective and efficient manner. Without this, inflation would rage on at the mercy of the internatonal price of petroleum. So we see here a general but important principle that in reality what governed inflation was the levels of productivity and the pricing decisions of economic units, linked to the purchasing power of consumers. Note that if the consumer disposable income purchasing power was not high enough there would be no consumption. So the ability to reduce unit prices through the combination of technical, economic and financial analysis and allocations could help raise consumption. Note, once again, production decisions on unit prices increase consumption (KMS "demand") while reducing inflation. So with an decrease in inflation demand increases. It is important to note that this demonstrates a false logic in the KMS-ADM approach that associates rising demand (consumption) with inflation. As explained, it is not demand that stimulates inflation it is the supply and pricing decisions of economic units.

This is why a coherent policy needs to be related to business rules which can be used by economic units to maximise their real incomes while reducing inflation. Policy wise this signifies that to support the general interests of the diverse constituency it is important under such circumstances to encourge economic units to set unit prices according to the purchasing power of their consumers so as to penetrate the market. This has the effect of gaining in scale of operation and intensification of learning and accumulating tacit knowledge (know how) which in turn leads to marginal reductions in costs associated with rises in productivity. This, of course, fans out into a range of corporate decisions relating to technology and techniques, innovation and the importance of a significant need to assist economic units to be successful in simultaneously raising the corporate real income and value of executive, owner, shareholder and workforce real incomes while sustaining a market penetration.

To the degree that such a production-based policy results in enhanced real incomes of all associated with an economic unit, it is not much of an intellectual challenge to realise that such an operational structure generates its own levels of consumption by taking care to set prices at accessible levels for consumers, many of whom are employed by economic operating under the same conditions.

The rise of financialization

Milton Freidman and others were so wedded to the Aggregate Demand Model and, in his case, the Quantity Theory of Money that he convinced many decision-makers, governments and leaders, that to lower inflation it was necessary to raise interest rates to lower demand. But as explained, in the 1970s, demand was not the problem, the problem was the conditions of production. Needless to say the monetarist solution applied under Reagan and Thatcher resulted in rising unemployment and business closures, thousands of US family farmers and householders losing their properties to banks and the same in the UK with over 2,000,000 losing their homes, all in the name of the absurd notion of "trickle down economics" manifested in "Reaganomics" or the first application of supply side economics. This "medicine" was applied on the basis of the mantra that, "There is no alternative" constituted an immense injustice and completely unjustified abuse of constituents.This was the result of providing too much credence to unproven economic theories to attempt to solve a unique set of economic circustances.

The value of money



The Quantity Theory of Money



Alternative funding



Quantitative easing



Central banks



Constitutional economics

The more important abuse arose from the failure of governments to apply principles of constitutional economics involving procedures of transparent public choice. But, in the UK, the government seemed to operate on the assumption that constituents would never understand the issues. Only a small select number of their advisers would have been schooled in ADM-KMS economics so they would be able to make rational choices on behalf of the nation. The solution was to impose the policy as an act of decisive and strong governance.


1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.