Tuesday, 16 December 2014

The Russian crisis and the Eurozone: some economic context

Pretty dramatic things are happening with the Russian rouble. Its dollar value is as of yesterday just about half of what it was on average in 2013.

What does this mean for the eurozone? Over the course of the first decade of this century, oil revenues and the real appreciation of the rouble made the Russian economy much larger in euro terms than it had been, and it correspondingly became a more important export market for eurozone countries. The share of Russia in the eurozone's exports tripled between 1999 and 2008; while it has declined slightly since, 4.7% of eurozone exports went to Russia in 2013. Given that even the eurozone's anaemic growth since the financial crisis is entirely attributable to export growth, this is not insignificant.

Source: Eurostat, OECD, EIA, own calculations. Brent prices and export/import figures nominal

In the chart, I've tried to give some indications of possible impacts of the rouble's fall by recalculating 2013 figures on Russian and eurozone GDP at yesterday's exchange rate, and giving a rough extrapolative estimate of how much exports to Russia might fall as a result of the declining purchasing power of Russian consumers in euro terms.

This estimate suggests a fall in sales to Russia of 0.5% of eurozone GDP, which would be highly significant, especially to an economy growing as slowly as the eurozone's is.  However, there are potential compensating factors (and potential further dangers):

Potential compensating factors

  • Russia's demand for imports may prove inelastic (consumers may not scale back purchases proportionately to the rouble's fall).
  • The eurozone will be spending less on importing oil, improving its trade balance. If consumers and businesses spend and invest the money no longer going to oil, this will promote growth. 
Potential further dangers
  • In liquidity trap conditions, consumers and businesses may not spend and invest the savings from cheaper energy prices. Then falling energy prices would simply contribute to the severe risk of deflation in the eurozone.
  • There could potentially be serious consequences to the international financial system of Russian companies being unable to pay back dollar-denominated debt (see here for a relatively sanguine discussion of their payment prospects). Financial fragility means that relatively small events can have a big impact. 

Thursday, 6 November 2014

Why Mario Draghi's ECB colleagues just kneecapped his credibility: the politics of market tripwires

Something is afoot at the European Central Bank.  People at the very top of the institution--leaders of the central banks of the member nations, and members of the small Governing Council responsible for key decisions--have apparently co-ordinated to anonymously tell Reuters just how very much they dislike Draghi's leadership style.  He even looks at his mobile phones--all three of them--when they're trying to say important things to him! 

I think it likely that these public complaints had a very specific goal--and it wasn't to get Mario to put his screens away.  Instead, they are intended to weaken Draghi's influence over ECB policy and strengthen the influence of other members of the ECB Governing Council. To do this, it was necessary to weaken the credence markets give to Draghi's statements, and that the ECB insiders shaped their remarks accordingly--or so I argue in this post.

The politics of market tripwires

To understand the conflict between Draghi and his colleagues, one needs to bear in mind that it is playing out on the backdrop of the intense attention financial markets pay to the pronouncements of central bankers.  

Financial markets, as is well-known (read Keynes on this) are characterised by self-fulfilling prophecies. If market participants believe an asset will fall in value, they will convert prediction into fact by selling it and driving down the price. Market participants thus have an understandable terror of being the last to sense a shift in the collective prophecy (more prosaically known as "market expectations"), unable to sell before the price has fallen or buy before it has risen. 

Thus, investors are especially sensitive to what I'll call "market tripwires" -- events expected to cause a general shift in market expectations. When one of these tripwires is triggered, investors rush to react as quickly as possible, in some circumstances creating a panic. An example of a market tripwire familiar from the financial pages is the earnings forecasts of stock market firms--whether these are met, exceeded, or undershot can set off large shifts in prices. 

Sometimes, political actors create market tripwires in order to impose costs or constraints as a tool of influence. For example, the IMF's Michael Mussa accused Argentina's Finance Minister Domingo Cavallo of doing just this to pressure the IMF into extending more help as Argentina fought to stave off devaluation of the peso in the summer of 2001 (I assume the story is true, but don't know for certain; for present purposes it's enough that it could be true):
Through leaks to the local press, the Argentine government circulated the story that the Fund … would augment [a planned] disbursement with an addition of about $8 billion. Financial market reacted positively to this news, and the bank runs slowed. ...The suggested augmentation of Fund support was announced without consultations with the rest of the Argentine government. ... There were no prior consultations with the Fund, nor any prior indication of support from the Fund for a substantial augmentation of its lending. Indeed, Cavallo's tactic was to force the Fund to augment its lending by creating a fait accompli. Financial markets and Argentine citizens reacted favorably to the announcement of augmented Fund support. If they were disappointed that this support was not forthcoming, the Fund (and the international community more broadly) would be responsible for the consequences. [Mussa, Michael. 2002. Argentina and the Fund: From Triumph to Tragedy. Washington, DC: Institute for International Economics, p. 41-42]
In our terms, Cavallo tried to create a market tripwire.  He hoped to turn the IMF's failure to provide additional support into a signal for market panic, betting that the prospect of the panic would cause the IMF to agree to his demands.  

Draghi's tripwires

More than once, Draghi has used his status as the ECB's main spokesperson to do something very similar--make public announcements about policy, shifting market expectations, and implicitly (or explicitly, for all I know) inviting his ECB colleagues to contemplate the consequences of failing to carry out the policy.

A highly consequential example was Draghi's famous "whatever it takes" statement in July 2012, inserted into a prepared speech at the last minute.
Just as shocked were the ECB boss's aides and his colleagues on the bank's policymaking Governing Council, none of whom knew Draghi would make such a sweeping promise. "Nobody knew this was going to happen. Nobody," one senior ECB official said of the speech.
The tactic worked. Draghi's statement had a huge immediate impact in alleviating panic on sovereign bond markets, creating a market tripwire: failure to agree on an official lender-of-last-resort programme would reignite the panic, almost certainly in worse form.  The well-reported narratives of the ensuing hard bargaining that concluded with the announcement of OMT demonstrate that Draghi's statement was made well before he could be sure that he could get support for the sort of programme he wanted. 

This week's anonymous attacks were motivated by an effort to prevent Draghi from doing it again. This time, the issue on the table is not bond market panic, but the threat of deflation, brought on by weak growth prospects and the contraction of ECB lending as banks pay back earlier ECB loans without taking on new ones. To deal with this contraction would necessarily involve the buying Eurozone sovereign bonds (imprecisely known as Quantitative Easing, or QE), which German members of the ECB leadership oppose.

In recent months, Draghi has clearly been trying to encourage the market to believe that this sovereign bond buying will happen, creating a market tripwire that he can use as leverage to make the program happen. Examples are:

  • Draghi's warning in his Jackson Hole speech--like "whatever it takes," inserted at the last minute beyond the control of the rest of the ECB leadership--that deflationary expectations were spreading and a promise that the ECB would "use all the available instruments" to try to fight them.
  • statement in early September that the ECB would try to expand its balance sheet to the levels of early 2012 (ie, reverse the contraction of its lending) 
Members of the ECB Council are perfectly aware of what this manipulation of market expectations is intended to accomplish.  According to one of Reuters' interviewees, the balance sheet statement,
"...created exactly the expectations we wanted to avoid," an ECB insider said. "Now everything we do is measured against the aim of increasing the balance sheet by a trillion (euros)... He created a rod for our own backs." 
You say that like it's a bad thing. Draghi wanted precisely that rod as a tool of policy influence. 

No, don't believe him

Of course, market tripwires only work as a tool of policy influence if markets believe the statements intended to set them. Cavallo would have gained no leverage over the IMF if the announcement of an impending expansion of support had not slowed bank runs. "Whatever it takes" would not have helped the passage of OMT without its calming effects on the markets.

So to disable the tripwire tactic, the German members of the ECB leadership Reuters' anonymous insiders set out to tell markets that Draghi is not to believed.  
"We specifically agreed at the meeting... not to put any numbers on the table," [said] one central banker. "Draghi's reference to the balance sheet of 2012 irritated a lot of colleagues. So he has had to backtrack a bit ... to compensate."
In other words, just because Draghi promises something, it's not necessarily going to happen. It is precisely Draghi's ECB opponents need to make this point, I believe, that explains why these complaints were made in public rather than in private. In July 2012, Draghi said:
Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
What his ECB colleagues are saying is: no, don't believe him. Wait to hear from us.

In particular, as becomes clear in the final paragraphs of the Reuters piece, don't believe Draghi if he hints that QE is coming. You can believe in QE if and when it is announced as an official policy. The insiders claim that without a consensus for QE in the ECB--and it's currently opposed by "at least seven and possibly as many as 10 of the 24 council members"--it can't happen because it's too politically divisive. (On this matter, one can only hope that the ECB majority will listen to Paul de Grauwe. A long as the ECB has unaccountable power, it should be used for good and not only for evil.) 

Kneecapping Draghi's credibility will make it harder for him to use his public announcements as a tool of unilateral policy-making, but it has costs, too. If the anonymous insiders succeed in turning Draghi into "the boy who cried QE," he will be unable to reassure the markets at moments when they need it most. For them that may be a feature rather than a bug of their strategy, but the rest of us should fear the dismantling of whatever capacity there is to contain the dangerous fickleness intrinsic to financial markets, and the destruction of whatever limited hope there is that deflation can be avoided without reversing austerity.

Wednesday, 22 October 2014

Governing by panic

Readers of this blog may be interested in my new paper, "Governing by Panic: The Politics of the Eurozone Crisis."  Here is the abstract:

The Eurozone’s reaction to the economic crisis beginning in late 2008 involved both efforts to mitigate the arbitrarily destructive effects of markets and vigorous pursuit of policies aimed at austerity and deflation. To explain this paradoxical outcome, this paper builds on Karl Polanyi’s account of how politics reached a similar deadlock in the 1930s. Polanyi argued that democratic impulses pushed for the protective response to malfunctioning markets. However, under the gold standard the prospect of currency panic afforded great political influence to bankers, who used it to push for austerity, deflationary policies, and the political marginalization of labor. Only with the achievement of this last would bankers and their political allies countenance surrendering the gold standard. The paper reconstructs Polanyi’s theory of “governing by panic” and uses it to explain the course of the Eurozone policy over three key episodes in the course of 2010-2012. The prospect of panic on sovereign debt markets served as a political weapon capable of limiting a protective response, wielded in this case by the European Central Bank (ECB). Committed to the neoliberal “Brussels-Frankfurt consensus,” the ECB used the threat of staying idle during panic episodes to push policies and institutional changes promoting austerity and deflation. Germany’s Ordoliberalism, and its weight in European affairs, contributed to the credibility of this threat. While in September 2012 the ECB did accept a lender-of-last-resort role for sovereign debt, it did so only after successfully promoting institutional changes that severely complicated any deviation from its preferred policies. 

Monday, 20 October 2014

When is a social democrat not a social democrat?

When he's Sigmar Gabriel, head of Germany's SPD and Minister for the Economy.  Here's Mr Gabriel in an interview with the Bild newspaper, defending the so-called "black null," the plan for a balanced budget:
Bild: There's a discussion in the SPD about whether or not new [government] debts ought to be incurred.  Is budget discipline social-democratic?   
Gabriel: Yes. Workers [Arbeitnehmer] want their taxes to be spent on social security, schools, or policy and not on interest payments to big banks for government debt. Only big banks earn money from high government debts. Government borrowing is antisocial.
There's a major problem with this argument: as Ambrose Evans-Pritchard noted, last week German government bond interest rates were "touching levels never seen before in any major European country in recorded history." In fact, correcting for inflation, Germany can literally borrow money interest-free:  August's inflation rate was 0.8% per year, and its ten-year bonds as of today yield 0.85%.  

Anyone who cannot find a way for the state productively to invest interest-free loans cannot be characterised as a social democrat (there's certainly plenty of low-hanging fruit).  For that matter, anyone who deliberately misleads workers about the costs of borrowing doesn't deserve the title either.  

Tuesday, 23 September 2014

Kalecki and the ECB

In 1943, Michael Kalecki gave what has recently become a very influential analysis of why it was that capitalists might object to Keynesian demand stimulus policies designed to ensure full employment. Such objections might seem puzzling, insofar as demand stimulus puts money in the hands of customers, selling to whom is how capitalists make their money. Kalecki argued that capitalists would indeed support stimulus to get out of recession for precisely this reason. However, they would object to using this policy to reach full employment (sacrificing profit as necessary), because

  • Full employment raises worker bargaining power and undermines shop-floor discipline.
  • Deficit spending involves allocating money to people who haven't "earned" that money (for backup for the scare quotes see here), challenging "the fundamentals of capitalist ethics [which] require that 'You shall earn your bread in sweat'--unless you happen to have private means." 
  • For reasons explained here, without deficit spending, investment is crucial to maintaining full employment. Governments who shake business confidence therefore provoke unemployment.   "This gives to the capitalists a powerful indirect control over Government policy," which, Kalecki argues, they very much wish to preserve. Thus, "The social function of the doctrine of 'sound finance' [balanced budgets] is to make the level of employment dependent on the 'state of confidence'." 
It's really rather remarkable the extent to which these three motivations have found echoes in the Eurocrat and German establishments' reaction to the Eurozone crisis. 
  • Calls for structural reform and especially competitiveness are directed primarily at reducing worker bargaining power.
  • Moralised discourse about "earning" is deeply entwined with the export-led model that justifies the competitiveness emphasis.
  • Some officials have voiced the idea that the "state of confidence" should determine policy quite directly (obviating Kalecki's functionalism.)
One might think that recent events--the end of growth, the fall of inflation to just .4%, the increasingly manifest limitations of ECB string-pushing--might be enough to change some minds. Perhaps--but not at the ECB.  Here's an updated picture of the European demand situation (for background see here).
Source: Eurostat, chain-linked prices with 2005 reference year; these figures show a small amount of growth in Q2 2014 , so they're more optimistic than the headline real figure of zero growth. Investment is "gross capital formation."
One could look at this and note that the economy has replaced only 2/3s of its lost growth, government consumption has dramatically failed to keep pace with even this anaemic growth, that household consumption is lower than it was five years ago, and conclude that it's no surprise that investment has fallen. What market would investment seek to tap? Even remarkable growth in the trade surplus can't compensate for missing domestic demand--stimulating the latter would seem the obvious policy.

But Mario Draghi has a different take. As Kalecki would have expected of a capitalist, but perhaps not a public servant, it's the state of business confidence that's key.  Here's Draghi speaking to a committee of the European Parliament yesterday.
the success of our measures critically depends on a number of factors outside of the realm of monetary policy. Courageous structural reforms and improvements in the competitiveness of the corporate sector are key to improving business environment. This would foster the urgently needed investment and create greater demand for credit. Structural reforms thus crucially complement the ECB’s accommodative monetary policy stance and further empower the effective transmission of monetary policy. As I have indicated now at several occasions, no monetary – and also no fiscal – stimulus can ever have a meaningful effect without such structural reforms. The crisis will only be over when full confidence returns in the real economy and in particular in the capacity and willingness of firms to take risks, to invest, and to create jobs. This depends on a variety of factors, including our monetary policy but also, and even most importantly, the implementation of structural reforms, upholding the credibility of the fiscal framework, and the strengthening of euro area governance.
Draghi clearly does not believe in Keynesian arguments. Consider the italicised words in the passage above. The idea that monetary stimulus won't work without structural reform is at least coherent--the idea is that there will be no demand for cheap loans without confidence in the business environment. But a fiscal stimulus does not depend on confidence in the same way--the government just spends the money.

As if further evidence were needed, when pressed about whether countries with a better fiscal balance should spend more expansively, all Draghi would say is that the country-specific policy recommendations agreed by the European Council in July ought to be followed. For Germany, the relevant recommendations actually endorse rapid movement toward a budget surplus.  

In sum, the evidence that the supposed change of tone of Draghi's Jackson Hole speech was not serious mounts.

Thursday, 11 September 2014

Export orientation, supply-side thinking, and the theodicy of markets

This blog has argued (hardly uniquely) that the focus of the German and Eurocrat policymaking establishment on exports and competitiveness is destructive for the Eurozone's economy. Today, I want to argue that there's an intellectual feedback loop between highlighting export-led growth and the belief that individual, company, or country merit determines economic success. This is very much work in progress, and I'd particularly welcome feedback.
Early in July, Angela Merkel's party, the CDU, held its "Economy Day." The head of the party's economic council began with an excerpt from the Treasury of Teutonic Stereotypes a pronouncement. "Economic success is no gift;" he said, "rather, it must be earned every day through hard work."
I have a name for this kind of thinking: the "theodicy of markets."  
In the study of religion, theodicy refers to the problem of reconciling the existence of evil with the presence of a god both omnipotent and benevolent (here's a moving example).  But Max Weber used the term more generally, to refer to a doctrine that explains and justifies good and bad fortune. He wrote:

The fortunate is seldom satisfied with the fact of being fortunate. Beyond this, he needs to know that he has a right to his good fortune. He wants to be convinced that he ‘deserves’ it, and above all, that he deserves it in comparison with others.
A theodicy, in Weber's sense, explains why people deserve what they get. A theodicy of markets argues that those who flourish in a market economy deserve to do so. The sentiment expressed above is an example: economic success is no gift--it's deserved, because it results from hard work.

Weber's argument--made in the context of religion--is that intellectuals work hard on their theodicies trying to make them logically coherent. The intellectual difficulties they confront drive the development of doctrine and thereby influence action.

In this light, it's worth investigating the intellectual challenges facing the theodicy of markets.
Mapping desert (or merit) onto market outcomes is at best a dicey business, because it implicitly involves endorsing the fairness of the multitude of bargaining situations determining relative prices. (Germany, for instance, is an exporter of luxury cars, demand for which probably has something to do with increased economic inequality in the countries beyond its borders.) To refer to "productivity" as justifying success is just to rename the problem, since productivity is measured with respect to output prices.

More generally, at a very high level of abstraction, success in any endeavour is a joint product of merit (skill and effort) and circumstances. To maintain a claim that success is deserved, prediction of and adaptation to circumstances can be defined as part of the relevant success-generating effort. However, this move requires a very particular conception of circumstances: they must be amenable to prediction and, hence, fairly resistant to change, including change through the vagaries of deliberate human action.  An actor's success under a given set of circumstances would otherwise have to be ascribed in part to some other actor's decision not to change those circumstances, downgrading the importance of desert.  

Now in talking about the concrete issue of economic success such a conception of circumstances is, of course, quite absurd. The circumstances under which economic success is pursued can and do change due to deliberate action. Even Mr Lauk, who told us economic success is no gift, concedes in another context that sanctions on Russia will damage the German economy. So prior economic success was, in part, a "gift" of good relations with Russia (not to mention the purchasing power gifted to Russian consumers by high oil prices).

So how does one maintain a theodicy of markets in the face of the manifest role of manipulable circumstances?  Consider this remarkable July 2014 statement from Andreas Dombret, a member of the board of the Bundesbank:
[The] strong influence of international trade [on Germany's recovery] worried some observers. Many felt that Germany's reliance on exports was risky, as it exposed Germany to the ups and downs of the global economy. ... 
I have doubts that turning away from global markets would strengthen the German economy. Facing global competition ensures that German companies keep up with technological progress and retain their high productivity. This might come at the price of higher volatility, but to me this seems like a price worth paying.
The first thing to note is how very, very weak this is as a piece of economic argumentation.  To claim that policy of supporting domestic demand is equivalent to a policy of insulating firms from international competition is absurd--indeed, one of the arguments sometimes made against demand stimulus is that its effectiveness is limited when consumers prefer foreign to domestic products. 

Given the flimsy argument, maybe Dombret's statement is better understood as motivated reasoning emerging from an emotional commitment to the theodicy of markets. In particular, it resolves the problem of reconciling merit with the role of circumstances by
  1. Partitioning circumstances under which economic success is pursued into the mutable (domestic demand) and the immutable ("the ups and downs of the global economy").  
  2. Asserting that altering the mutable circumstances would undermine the promotion of merit ("productivity") and should thus be avoided.

One implication of [1] is that there ought to be a strong "elective affinity" between a commitment to the theodicy of markets and support for an export-led demand model. Export performance is the true test of economic merit, precisely because exports are directed into a "global economy" imagined as impermeable to policy manipulation. 

Imagined is the right word here, because of course "the ups and downs of the global economy" are strongly affected by policy decisions in individual nation-states. Or course, this problem could be avoided if every nation-state would accept the self-denying ordinance to ensure the triumph of merit by avoiding demand stimulus. Here's Bundesbank head Jens Weidmann throwing cold water on the idea that external circumstances should be changed in an interview with Le Monde (German, French) last month:
In general I am sceptically inclined to the idea that one can demand a contribution from others to one's own sustainable growth... Growth must instead come through one's own efforts. It is the responsibility not of the governments of neighbouring countries nor of the European Central Bank, but rather of each government to create a domestic environment that supports business innovation and employment.
And here he is in Spain in July:
At the time [of founding the Euro and agreeing the deficit-limiting Maastricht criteria], it was assumed that by constraining governments' ability to fiscally stimulate demand - and by shifting monetary policy to the European level - governments would have no choice but to implement structural reforms, improve their supply side, and strengthen their potential for sustainable growth.
Note the use of the word "sustainable" in both contexts, which seems to me to be another tactic of displacement, analogous to the rejection of demand stimulus, an implicit assertion that the market generates morally appropriate outcomes, at least in the long run (when, of course, we're all dead).

To sum up, then: to sustain the idea that "economic success is no gift" requires some substantial mental gymnastics with deeply destructive consequences for economic policy; in particular, it promotes an unrealistic reliance on export demand. I'd be very curious to hear from readers whether they found this convincing and/or of interest.

Wednesday, 10 September 2014

Draghi and fiscal demand stimulus: he's not serious

Mario Draghi's speech in Jackson Hole last month has been widely seen (one more auf Deutsch) as a bellwether, particularly for his discussion of the importance of increased demand to ward off deflation and create growth.

In plain language, Draghi seemed to many to be saying: austerity plus structural reform is not going to work; Germany needs to spend more and stop raising a fuss about budget deficits elsewhere in the Eurozone. 

I would have parsed the words of the speech differently, but in any event a better way of judging how serious Draghi is about promoting fiscal demand stimulus is to look at how he acts. And I think the evidence of the succeeding weeks strongly suggests that bringing fiscal stimulus to pass is low on his list of priorities. 

We have some information on how the ECB leadership has acted when it wants to promote particular fiscal or other policies on the part of Eurozone national governments.

  • It makes maximum use of its bargaining leverage, conditioning its monetary actions on government policy.
  • Rather than viewing the Eurozone's governing treaties as a given, it advocates changes--as Draghi did when pushing the fiscal compact or more recently in his call for more centralized control over structural reform. 
But we don't observe anything like a parallel assertiveness in pushing for fiscal stimulus at Draghi's recent press conference or anywhere else. A counterfactual Draghi pushing stimulus with similar forcefulness would have
  • Tried to exert leverage over German policy, for instance by throwing his weight behind the application of external mandates and financial penalties to reduce the German trade surplus (which would require stimulus of German domestic demand). After all, this is part of the legal framework of the Eurozone, for other parts of which Draghi isn't in the least hesitant to advocate. He might even have hinted that monetary policy measures known to annoy Germany would be needed if these rules were not followed.
  • Stated that should budgetary rules not give sufficient flexibility to stimulate demand, they ought to be changed.
Instead of this, what did we observe? (From last week's press conference.)
  • Draghi declined the opportunity offered by a questioner to address the need for expansive policy in Germany and other countries with low budget deficits.
  • He stated "the Stability and Growth Pact [setting out budget-balance rules] is our anchor of confidence ... [and its] rules should not be broken," and went on to say that "... discussions on flexibility should not be viewed or should not be such that they would undermine the essence of the Stability and Growth Pact." 
Draghi's example of how one might use the flexibility of the SGP is also indicative of how distant he is from serious demand-stimulus advocacy:
Within the Stability and Growth Pact, one could do things that are growth-friendly and also would contribute to budget consolidation, and I gave an example of a balanced budget tax cut. Reducing taxes that are especially distortionary, where the short-term multipliers could be higher, and cutting expenditure in the most unproductive parts, so mostly, actually not mostly, entirely, current government expenditure.
Since tax cuts put money in the hands of people already known not to be spending or investing enough, they're ineffective stimulus policy, even more so when offset by spending cuts. And how does Draghi support the idea that this sort of policy might be good for "business confidence and private investment ... [even] in the short-term," in the words of his Jackson Hole speech? Who's that hiding in footnote 15? Yes, it's Alberto Alesina (more).

Draghi did announce sweeping new monetary policies measures last week. But it don't mean a thing if you just push that string. People who think Draghi is on the side of the demand-stimulus promoting angels now (including Krugman) are misreading the situation badly. The ECB went to war for austerity and structural reform--it could do the same for stimulus, but it isn't. 

Friday, 15 August 2014

The Bundesbank is not demanding an increase in German demand

Yesterday's very bad news that growth has stopped in the the Eurozone reflects the lack of a realistic demand model: the ECB and much of the Eurocrat establishment see the key to growth as holding down worker wages in order to stimulate exports, but
  • exports are and will remain too small to be an engine of growth for the Eurozone, especially because
  • this strategy suppresses domestic demand, raising the amount of growth impulse needed.
So where is the demand going to come from?  As the Eurozone's largest economy, Germany has a huge influence on aggregate demand. That it has practised a policy of wage restriction makes recovery much harder throughout the currency block.

On this backdrop, it's worth evaluating the Bundesbank's recent intervention in the discussion on wages in Germany. To foreshadow my conclusions:

  • there is little evidence that the Bundesbank has embraced a demand-led growth model for Germany or the Eurozone
  • the Bundesbank's intervention focused on collectively bargained wages, but it's raising wages set outside collective bargaining that is the key issue

Emergence of the debate

In a meeting with union leaders and economists in July, the Bundesbank chief economist Jens Ulbrich told them (more background) that the time for wage restraint was over.  This was already creating something of a stir before Bundesbank chief Jens Weidmann (previously discussed) said a 3% raise for workers would be justified by a 1% increase in productivity and the ECB's 2% inflation goal (much higher than actual inflation in Germany).  

Weidmann's intervention raised something of a ruckus. Employers were not amused and even a man who had called for a German government far to the left of the one now in power wrung his hands about strengthening labour's bargaining position. From a different perspective, Francesco Saraceno hailed this as a big, positive change:
The call for wage increases in Germany signals, and it was about time, that even conservative German institutions are beginning to realize the obvious: there will be no rebalancing, and therefore no robust recovery, unless German domestic demand recovers. This means a fiscal expansion, as well as private expenditure recovery. Unsurprisingly, the Buba rules out the former, but it is nice to see that at least the latter has become an objective. Faster wage growth may not make a huge difference in quantitative terms, but it still marks an important change of attitude. This is a huge step away from the low-wage-high-productivity-export-led model that the Bundesbank and the German government have been preaching (and imposing to their partners).
A shift to promotion of German domestic demand would indeed be a welcome development (Dieter Wermuth makes a good case for it), but Weidmann's statement does not reflect such a shift.

The Bundesbank has not converted to a demand-stimulus model

Crucial context for understanding Weidmann's statement comes from his recent speech in Spain
In any case, deliberately weakening the competitiveness of Germany's export sector would harm, rather than benefit, the stressed countries' economies. We should bear in mind that German exports contain imported intermediate inputs from other euro-area countries amounting to 9 % of the overall added value. 
If Germany were to accept the economic advice to excessively boost its wages in order to stimulate domestic demand, it would harm employment in Germany and, as a consequence, the economic situation in the entire euro area as simulation results show. 
Despite this, it is clear that against the background of Germany's strong cyclical position and the tight labour market, wages will rise faster than in the rest of the euro area. We expect effective wages to rise more than 3 % this year and next year.
Note, first, the explicit rejection of the idea that German wage policy should be based on stimulus of domestic demand--a point he repeated almost word for word in the interview that set off the kerfluffle.

Note, second, the report of the 3% number as a prediction, rather than a goal. (In fact, Weidmann denied that the Bundesbank was making a suggestion about wage levels, something missed in a lot of the coverage.) If Weidmann really wanted to promote German demand to help the Eurozone, he could have pushed for a number above the trends. German Keynsian economist Peter Bofinger, for instance, called last year for a 5% increase in wages to promote Eurozone rebalancing.

This year's collectively bargained wage round is producing raises of just over 3% (though weighted ad personam, not ad valorem, apparently). So Weidmann's statement was hardly designed to move the trend.

So if increasing demand wasn't Weidmann's target, what was? There seems every reason to accept his own justification--namely, that he was trying to ensure that wage negotiations were based on inflation expectations in line with monetary policy, just as the Bundesbank did in the past. It's simply that this time the issue is inflation expectations are too low, rather than too high.  There's no sign that this is based on an underlying economic model in which demand is crucial.

Collectively bargained wages are not the key issue

Germany is famous for its highly co-ordinated wage setting mechanisms.  However, only half of German workers are covered by coordinated wage bargaining arrangements.  Furthermore, although collectively bargained wages in Germany lagged productivity before the crisis, they've done some catching up since (see chart).
Source: productivity from Eurostat, converted by me from GDP deflator to HICP deflator, whole-economy hourly compensation from OECD, bargained wages from Statistisches Bundesamt

The chart reveals that it's clearly the non-unionised workers that have been dragging German wage levels down. And Weidmann in fact has argued against recent measures to introduce a minimum wage in Germany. It's clear that he continues to view wages primarily as determinants of costs rather than determinants of demand.  

In sum, for all that we should welcome the Bundesbank's willingness to countenance wage rises, it's still a long way from backing the sort of demand-led policy that could turn the Eurozone's economic crisis around.  

Thursday, 7 August 2014

Draghi's duplicity on the relative importance of structural reform and demand for investment

Mario Draghi once again cited the importance of structural reform at yesterday's ECB press conference, suggesting weaknesses in structural reform (his examples had to do with the ease of opening businesses) explained weak investment.
...one of the components of the low GDP figure for Italy is the significantly low level of private investment, while one would observe a rebound in private consumption. As far as private investment is concerned, one observes a very low figure, especially low figure of private investment. This isn’t unique in the euro area. The levels of private investment for the euro area as a whole is low, and certainly much lower than it is in other parts of the world, like in the United States. 
Then we ask ourselves why this is so. Now, certainly it’s not the cost of capital, because interest rates, nominal and real interest rates, have been low. And in some parts of the euro area they are negative, and have been negative for quite a long time.
So the answers are: one has to do with expected demand. But the second answer has to do with the reforms, uncertainty, the general uncertainty the lack of structural reforms produces a very powerful factor that discourages investment. 
There are stories of investors who would like to create, to build plants and equipment and create jobs, but it takes them months to get an authorisation to do so. There are stories of young people who tried to open their business, and it takes 8 to 9 months before they can do so. That has nothing to do with monetary policy. 
So it’s mostly the lack of structural reforms. I keep on saying the same thing, really – reforms in the labour market, in the product markets, in the competition, in the judiciary and so on and so forth. These would be the reforms which actually have and have shown to have a short-term benefit.
Ok, so here's a very simple test of that claim. If low investment mostly has to do with the lack of structural reform, rather than demand, we ought to see no significant variation in investment levels during periods of high versus low demand.  

Source: Eurostat, defining investment loosely as gross capital formation
To say low post-crisis investment is explained "mostly [by] the lack of structural reforms," is, not to put too fine a point on it, to lie. That arranging investment is harder than it should be is bad. But it's blatantly obvious that these difficulties were compatible with much higher levels of investment in the recent past.

Monday, 28 July 2014

Competitiveness, unit labour costs, and the class struggle

It's hard to spend much time reading about the Eurozone crisis without coming across the term "unit labour costs" (ULC).  There's a common narrative (see this post) that says that the Eurozone peripheral countries let their ULCs get out of control before the crisis, losing competitiveness, and now they have to get those costs back down.  For instance, here's Mario Draghi earlier this year:
...most of the stressed euro area countries have made remarkable progress in gaining competitiveness. Over the past five years, the cumulative unit labour cost differential vis-à-vis the euro area have fallen by more than 20 percentage points in Ireland, around 15 percentage points in Greece and Spain, and almost 10 percentage points in Portugal. This was accompanied by substantial improvements in the export dynamics of these countries.
This narrative is illustrated with charts like this one:

However, there's somewhat more to this than meets the eye. Unit labour costs are a unitless ratio--the share of labour compensation (including non-wage costs) in total value added in the economy, also known as GDP.  What's compared on this chart is actually something known as nominal unit labour costs (NULC; all this is explained in this paper, which I wasn't sure I believed at first, but I've checked against the official definition from Eurostat, confirmed that the calculation is done as I describe below, and that the numbers the ECB reports as unit labour costs are these same ones) that are meant to have a monetary significance.  Here's the formula for calculating nominal unit labour costs, with some algebra done
NULC = (labour compensation/GDP) * price index * correction for self-employment 
For simplicity's sake, let's ignore the last term, and call the first term "labour's portion," meaning the portion of value-added that goes to labour, rather than profits. So the formula becomes
NULC = labour's portion * price index
In the presence of inflation, all a rising NULC means labour's portion is not falling as fast as inflation is rising.  It does not necessarily mean that wage gains are outstripping inflation, productivity, or anything like that.  The chart below is based on exactly the same underlying data as the first chart (including the same correction for self-employment), but without the effects of inflation.
Source; I assumed no change from 1999-2000 in Greece due to missing data.
Note how different this chart looks from the previous one! In the run-up to the crisis, there was absolutely no general redistribution to employees in the PIIGS. As of 2007, in fact, in all of them save Ireland, employees were getting a smaller portion of value-added than in 2000. Wage restriction in Spain was almost identical to that in Germany.  (The spike in Ireland in 2008-2009 is largely due to the rapid fall in GDP, with compensation growth falling more slowly; I take it that GDP is generally a weird number for Ireland due to domiciling issues, so that might have something to do with it as well.)

So, the differences in NULC reflect to some extent slower redistribution of value-added away from employees in Portugal, Italy, Ireland, and Greece than in Germany, but mostly national differences in inflation. And at a first glance, it's hard to make the case that these national differences in inflation themselves stem from excessive worker bargaining power outside of Germany. I'm still a neophyte in working with these figures, but this seems to me to be a problem for the position often taken by political scientists that NULC outcomes reflect institutional differences across the Eurozone.  For instance, Peter Hall claims that "industrial relations institutions promote the co-ordinated wage bargaining that can be used to hold down labour costs."  

In any event, the NULC these days has become the de facto operationalisation of "competitiveness" for the ECB and dominant elite Eurozone opinion. On this definition, "become more competitive" translates into "labour should be receiving a smaller portion of value-added." Promotion of competitiveness has become class struggle (or distributional struggle, if you prefer) by another name. Promotion of competitiveness so defined is also identical to suppression of domestic demand, worsening the problem of the Eurozone's missing demand model

Thursday, 24 July 2014

Europe's missing demand model

I. Keynes - the very quick version

Keynes had lots of important insights, but I think the most crucial one is underplayed in my field of comparative political economy. The crucial insight is this: in a capitalist economy, workers can't afford to buy everything they make. Since to be profitable, the price of a good must equal its cost plus a mark-up, and wages are costs, aggregate wages must be less than the aggregate price of goods offered for sale. Thus, the only way for everything to be bought would be if the people drawing profits spent all of them (in addition to wage-earners spending all their wages). But they don't. Let's call this the "underconsumption problem."

The rest of his theory can be viewed as an answer to the question of how, then, can everything be bought? How can the underconsumption problem be solved? Keynes emphasised (a quick version of his key points is here) above all that some people draw wages for investment projects that do not lead to immediate sales, which they can then use to purchase consumer goods (or services). Thus, how easy it is to keep people employed to make stuff for immediate sale depends on how much investment is going on.

Investment depends on the mood of investors, which, Keynes convincingly argued, can vary wildly for no particularly good reason. If investment is too low to keep people employed, we should do something about it. Central banks, for instance, can lower interest rates, making borrowing cheaper and hopefully prompting more investment. However, interest rates are subject to the "zero lower bound"--central banks can't pay people to borrow money. When even interest-free lending doesn't prompt enough investment to keep people employed, monetary policy is "pushing on a string."

If investment isn't doing the job, then to buy up all the consumer goods on offer and keep people employed there needs to be some other source of spending, or demand, in particular spending in excess of income (spending just your income means you buy only as much as you sell, and thus you can't help make up for the fact that people in general don't want to buy everything they sell). This is why Keynesians advocate government "deficit spending" as a form of "demand stimulus." But consumers, not just government, can spend in excess of income via borrowing. Colin Crouch made a seminal contribution by coining the term "privatized Keynesianism" to refer to a systematic effort to get consumers to play this role.

For the individual country, another option is (net) exports. However, it's not possible for every country to export more than it imports.

II. Does the Eurozone have a demand model?

Different nation-states have found very different solutions to the underconsumption problem, or what you might call different demand models. Demand models seem to be quite enduring (see Monica Prasad's recent book and this article from Fred Block; also Peter Hall and David Soskice who have supplemented their initially exclusively supply-side Varieties of Capitalism approach with more attention to demand-side factors.)

However, Germany is promoting its famously (or notoriously) export-focused demand model for the Eurozone as a whole. I've made the following excellent chart to help us consider how that's working out.  (Data from here; I'm using the term investment slightly imprecisely to refer to gross capital formation.) Below the line we can see elements of the GDP--which are just the Keynesian sources of demand described above.

Some conclusions:

  • Five years from the onset of the crisis, the Eurozone has recovered only a bit more than half its lost GDP.
  • This is despite a staggering tripling in the trade surplus.
  • Export growth slowed dramatically in 2013.
  • There is no sign that export growth is feeding through to investment or household consumption.

So the answer is no--Europe does not have a sustainable demand model. All the sources of demand other than exports are stagnant or falling, and exports cannot be relied upon to replace them.

Weidmann's deceit on Spanish export growth

Bundesbank Chief Jens Weidmann gave a speech in Madrid on Monday.  He followed Draghi in putting lipstick on the PIIGS, or the S anyway:
Thanks to improved competitiveness, Spanish exports have risen by 8 % over the past 12 months. Since the cyclical trough in 2009, exports have even risen by more than 50 %, with intermediate goods showing particularly strong growth.
Hmm.  When I look at ECB stats here, I get only a 36.1% rise in Spanish exports since 2009.  I presume heads are already rolling in Weidmann's office.

But the stats do show 8.1% growth in exports over the past 12 months. So maybe I was wrong about slowing Spanish export growth?  No, actually Weidmann's doing a spectacular job of lying with statistics.  Look at this chart:

As you can see, the 8.1% figure stems from a big drop-off in Q1 2013. There's no acceleration against the recent trend--if anything the opposite.  Weidmann's cherry-picking to make his case look good. Even with this help, the case that there's a significant "competitiveness" component to export growth is hard to make:
  • Export growth was much faster in 2009-2010, before the competitiveness improvements Weidmann's touting--presumably because Spanish companies had rapidly to find ways to export things Spaniards couldn't afford any more.
  • If the economy were becoming generally more competitive, imports should be capturing a smaller share of domestic demand. In fact, their share has risen continuously since 2009 and reached what was at least a 10-year high in 2013. 

Why are figures about export growth so important that Weidmann and Draghi feel compelled to be deceptive about them?  The reason is that they want to make the case that their preferred policy of austerity plus structural reform (which involves holding down wages) is a reasonable model of growth. For this to be so, exports must be able to drive growth. Consider what their policies do to the other sources of demand:
  • Government final consumption - restricted by austerity 
  • Household final consumption - restricted by austerity and structural reform
  • Investment (Gross capital formation) - so far held down by anaemic growth prospects 

This leaves just the trade surplus as a possible source of growth. For this reason, if advocates of austerity and structural reform want to be optimistic about the future, they have to trumpet--and sometimes exaggerate--export performance.  Stay tuned for another post about the weaknesses of this demand model.

PS: The Spanish export growth numbers are a bit different than in my previous post, presumably due to some combination of the facts that these are real rather than nominal figures and quarterly rather than annual ones, but that doesn't change the big picture.

Thursday, 10 July 2014

Why Draghi put lipstick on the PIIGS

In London yesterday, Draghi made a speech in which he advocated more centralised control over "structural reform" (liberalizing labour and other markets) for members of the Eurozone.  

In making the case that structural reform would be a good idea, Draghi implicitly relied on the badly misguided idea that it's feasible to generalise the German model of wage suppression and export-led growth. And to make this case, he said something demonstrably misleading:
[W]e have seen the improvement that has taken place when governments implemented reform. The change in current account positions in stressed countries ranges from an almost 11 percentage point correction of GDP in Spain to a 16 percentage point improvement in GDP in Greece [clearly since 2008-DW], only part of which is explained by lower imports in the context of a recession.
So, "current account positions" is exports minus imports (trade balance) plus some other stuff not very important for these countries. Draghi is claiming that trade balance in the "stressed countries" (presumably the PIIGS minus Italy) is improving not just because imports are sinking because people are too poor to afford them, but also because exports are increasing. This is supposed to substantiate the idea that export-led growth is a reasonable model.

It's not, and a closer look at the two countries Draghi cited proves it.  (Data for the claims below come from here and you can find my calculations here.)

For Greece, Draghi's claim is not even true. Greek exports are still below what they were in 2008, even in nominal terms.  Greece's trade balance in 2008 was -14.5% of GDP; if there had been no fall-off in imports it would been -20% of GDP instead of the -2.6% it actually was in 2013. (It's a tiny bit less misleading if you were to start in 2009 instead of 2008, but even over this period the rise in exports was less than a third of the fall in imports).

For Spain, what Draghi said was true. The rise in Spanish exports over this period was more than double the fall in imports. But the idea that this is a promising sign of a shift to a new sustainable model is laughable.
  • Over the last five years, increased exports have replaced only 40% of Spain's loss of domestic demand
  • Since 2008, Spain's exports have increased in nominal value at 4.91% per year. At this rate, even assuming domestic demand stops falling, Spain can expect to have replaced its lost domestic demand half way through 2020. 
  • Most of the gains in Spanish exports were actually in 2010-2011. More recently exports have been growing at 4% a year -- fast enough to replace lost domestic demand in the first quarter of 2022.  
Even in the better case for him, Draghi is touting as vindication trends that amount to a recipe for not just a lost decade, but a lost 12-14 years (even in nominal terms).  Impressive.

Friday, 4 July 2014

Commons, Hale, Polanyi, and, naturally, Piketty

I. Commons and Hale: Capitalism is a bargaining power economy in which coercion is omnipresent

The great institutional economist John R. Commons specified (see pages 65-69) that to understand any apparently bilateral transaction one must actually look at five parties:
  1. the buyer
  2. the seller 
  3. the buyer's next best option
  4. the seller's next best option
  5. the state, which shapes what the parties are allowed to do, what they are allowed to agree to, and whether and how agreements will be enforced.  
This is the minimal information one needs to understand bargaining power in the individual transaction, and thus the determinants of prices and wages.

One consequence of this, especially clearly set out by Robert Hale, is that it's not useful to think about market economies as eliminating coercion by enabling people to engage in voluntary transactions. As soon as you realise parties to transactions have to choose between available options what counts as "voluntary" becomes entirely a matter of taste.  "Your money or your life," "Accept my wage offer or starve," "Accept my wage offer or live on the dole," "Accept my wage offer or the one 10% lower at an easier job," "Buy this candy bar for £1.10 or walk to the next shop and buy an identical one for £1.05" are all choices. I've arranged them in rough order of how much subjective sense of coercion we might feel, from most to least, but there's no point at which you can draw a line and say: here's where the coercion starts. 

II. Polanyi: The meaninglessness of self-sufficiency in the net of bargained prices

Now, dear, patient reader, please consider the following passage from the sacred writ Polanyi's The Great Transformation:
Liberal economy gave a false direction to our ideals. It seemed to approximate the fulfillment of intrinsically utopian expectations. No society is possible in which power and compulsion are absent, nor a world in which force has no function. It was an illusion to assume a society shaped by man’s will and wish alone. Yet this was the result of a market view of society which equated economics with contractual relationships, and contractual relations with freedom. ... Vision was limited by the market which “fragmentated” life into the producers’ sector that ended when his product reached the market, and the sector of the consumer for whom all goods sprang from the market. The one derived his income “freely” from the market, the other spent it “freely” there. Society as a whole remained invisible. The power of the state was of no account, since the less its power, the smoother the market mechanism would function. Neither voters, nor owners, neither producers, nor consumers could be held responsible for such brutal restrictions of freedom as were involved in the occurrence of unemployment and destitution. Any decent individual could imagine himself free from all responsibility for acts of compulsion on the part of a state which he, personally, rejected; or for economic suffering in society from which he, personally, had not benefited. He was “paying his way,” was “in nobody’s debt,” and was unentangled in the evil of power and economic value. His lack of responsibility for them seemed so evident that he denied their reality in the name of his freedom.  
But power and economic value are a paradigm of social reality. They do not spring from human volition; noncooperation is impossible in regard to them.

(2001 ed., p. 266-267)
How are we to make sense of Polanyi's implication, that "every decent individual" is entangled in power and economic value? The idea of capitalism as a bargaining power economy helps quite a bit.  In such an economy, each bargain struck or contemplated involves a balancing of threats and opportunities that are part of a vast interconnected net of bargaining contexts. For example:

  • A consumer who has paid a low price for one good may be better able to pay a higher price for another, allowing that seller to capture a higher share of the consumer surplus.  
  • An employer paying high wages may be able to bargain harder with suppliers, by making them aware of the tight margins these wages imply. 

To buy, to sell, to consume, to produce is necessarily to introduce ripples into this interconnected net, expanding the choices of some, narrowing those of others, redistributing, minutely or massively, coercive capacities.  One pulls at the net's strings as soon as one chooses one purchase over another, helping to establish the current and prospective economic value of both.  Unemployment and destitution, as prospects or realities, shape wage and price bargains, sending out their own ripples. Any state with a remotely serious claim to a monopoly of legitimate violence is in the net as well, often constituting the resources bargained over (such as money and property), employing physical coercion against some to defend the property rights of others, everywhere affecting bargaining power.

Polanyi's suggesting that the language of self-reliance, "paying your way," being "in nobody's debt,"
obscures the "reality of society," the reality of the net--obscures how every individual in a market economy is causally implicated in all sorts of coercion that seem quite distant from her at first glance. Going a bit further, to ascribe moral status to paying your way is to implicitly to ascribe legitimacy to the price system that shapes your income and spending. If you thriftily make all your purchases at Wal-Mart so you can spend less than you earn, you're "paying your way," but you're doing so by taking advantage of, and contributing to, the company's enormous bargaining power in its dealings with suppliers and workers.

By the same reasoning, recognition of the net of bargaining power makes it extremely hard to give a sensible definition of a "meritocratic" income distribution. Some people believe that in a well-functioning market economy people are paid according to their marginal product and that this is what they deserve (although the second is not a logical implication of the first). But marginal product is defined as the addition to firm revenue achieved by hiring the person in question, and so again fundamentally depends on the price system. A moral defence of meritocracy along these lines would have to begin with a defence of the legitimacy of the prices shaped by the net of bargaining power (as Hale pointed out nearly a century ago). As an outstanding example of such a defence let me cite... well, actually, let me know if you ever see one; I haven't. Without such a defence, advocacy of meritocracy obscures the omnipresence of bargaining power just as the language of self-reliance does.

III. Piketty, meritocracy, and bargaining power

One of the most interesting criticisms of Piketty, to my mind, is that he ignores the processes that give rise to profits and the rate of return on capital. Here's an influential take from Deborah Boucoyannis, building on her outstanding reading of Adam Smith:
Where Smith emerges as more “radical” [than Piketty], ironically, is in his insistence that if we see high profits (a high r) it is sophistry, deception, and power that are to blame, not technology and trade increasing demand for capital. He may have said, faced with Piketty’s turn to taxation to fight inequality, that this treats the symptom, not the disease; that we should not be just treating inequality as pathological and inefficient, but high profits, too. As I argued also here, unless we start seeing high profits as a symptom of something wrong, any effort to limit them, either before or after taxes, will founder faced with the “insolent outrage of furious and disappointed monopolists.”
In other words, Smith is more radical than Piketty because he offers a critique of excessive bargaining power and an analysis of its origins. Galbraith also attacks at the same point, arguing for a reconfiguring of the bargaining power net:
If the heart of the problem is a rate of return on private assets that is too high, the better solution is to lower that rate of return. How? Raise minimum wages! That lowers the return on capital that relies on low-wage labor. Support unions! Tax corporate profits and personal capital gains, including dividends! Lower the interest rate actually required of businesses! Do this by creating new public and cooperative lenders to replace today’s zombie mega-banks. And if one is concerned about the monopoly rights granted by law and trade agreements to Big Pharma, Big Media, lawyers, doctors, and so forth, there is always the possibility (as Dean Baker reminds us) of introducing more competition.
What I'd like to suggest is that one reason Piketty ignores this issue is his ambivalent, but still real, affection for the meritocratic ideal. It's very easy to start making an argument about merit and immediately assuming the moral legitimacy of the price system that is merit's metric, and this is a trap into which Piketty falls.

The case is a little bit difficult to make, because Piketty really is very ambivalent. At some points Piketty comes off as an advocate of meritocracy who believes it crucial to democracy, and who fears that patterns of wealth accumulation will undermine it.
Our democratic societies rest on a meritocratic worldview, or at any rate a meritocratic hope, by which I mean a belief in a society in which inequality is based more on merit and effort than on kinship and rents. This belief and this hope play a very crucial role in modern society, for a simple reason: in a democracy, the professed equality of rights of all citizens contrasts sharply with the very real inequality of living conditions, and in order to overcome this contradiction it is vital to make sure that social inequalities derive from rational and universal principles rather than arbitrary contingencies. Inequalities must therefore be just and useful to all, at least in the realm of discourse and as far as possible in reality as well. (p. 422)
Piketty the engineer of meritocracy on rational and universal principles is on display in his proposal for a highly progressive income tax. On the basis of his own and others' research, Piketty concludes that there is an enormous gulf between what US top executives are paid and their contribution to productivity.  (He can be quite scathing on the misuse of "meritocratic extremism" as a mere cover story for vast divergences in pay unrelated to performance; p.417,487.) His diagnosis of the causes is that the top executives are winning this outrageous level of compensation from bargaining hard with "incestuous" corporate boards. And thus he proposes 80% marginal rates on high incomes, as this would reduce managers' incentive to push for high compensation, which would "drastically reduce remuneration [at the top] but without reducing the productivity of the US economy, so that pay would rise at lower levels."(p. 512).

I submit that the principle of meritocracy has really limited the scope of this argument. Piketty is only able to produce his critique of managerial pay in excess of productivity by accepting the field of prices that determines productivity. He finds such a disjuncture that he decides to look at what distorted meritocracy in this case and comes up with a bargaining situation that he hopes to re-engineer. But he never considers the possibility that the economy is bargaining situations all the way down, presumably because this would deprive him of a meaningful standard by which to measure productivity. That he assumes that pay denied managers would pass downwards, without offering any bargaining-power argument for this claim, is a striking illustration of the problem.

There's a second reason Piketty's proposals don't focus on tweaking the bargaining power net. Despite his analysis of excessive executive compensation, he doesn't seem to believe that such assessments are generally possible
[We need to] move beyond the futile debate about the moral hierarchy of wealth. Every fortune is partially justified yet potentially excessive. Outright theft is rare, as is absolute merit. (p.443) 
Broadly speaking, the central fact is that [wealth accumulation] often inextricably combines elements of true entrepreneurial labor (an absolutely indispensable force for economic development), pure luck (one happens at the right moment to buy a promising asset at a good price), and outright theft [not so rare, then?]. The arbitrariness of wealth accumulation is a much broader phenomenon than the arbitrariness of inheritance. (p. 446)
And this is why Piketty advocates his progressive global wealth tax. Forget about creating a fair economy; it can't be done. Just tax wealth, whatever its origins. Remarkably enough, both the attractions of meritocracy and its practical infeasibility turn out to give reasons to stay away from a restructuring of bargaining power--which is what a fairer capitalism would really need.

P.S. I've had Polanyi on the brain even more than usual thanks to a wonderful talk by and stimulating conversation with Peggy Somers this week--she and Fred Block have more on Polanyi's views on the "reality of society" in their great new book.