Such a metaphor for considering this trade-off is useful – but as Matt has noted in the past we should be very very cautious about overinterpreting this example when looking at real economic data. Hence why I got him to chat about that at the end.

The goal was to work out what capital is (and isn’t), to describe the difference between tangible and intangible capital, and to give a feeling for how we can add up quite different capital items.

Hopefully outlining what capital is will make the research discussed here and published here a bit more useful.

Keen for your thoughts

Hope it is an issue I can go more deeply on soon.

Being born in the old Soviet Union, and having talked to my parents about their experience with it, I thought it might be useful to share my views on the topic. 

What is the Parasite law?

The parasite law was Article 12 of the old Soviet constitution.  It reads as:

In the U.S.S.R. work is a duty and a matter of honour for every able-bodied citizen, in accordance with the principle: “He who does not work, neither shall he eat.”The principle applied in the U.S.S.R. is that of socialism : “From each according to his ability, to each according to his work.”

The parasite law was introduced in the 1936 Constitution with the moral precept that “he who does not work shall not eat,”. However, the “anti-parasite law” that is usually discussed took effect later in 1961. The law then established that all able-bodied adults who do not contribute to the collective work efforts, namely living a parasitic way of life, will be sent to exile in a specific region for a period of two to five years. 

It is not clear how often people were actually sent into exile as parasites as a result of “unearned income” from second-economy activities, but from my parents’ experience I can give the following tip. Even though the law got abolished (amalgamated) in 1976, the perception and the social norms around the law persisted until the end of the Soveit Union. Before writing this post, I called my mom and dad and consulted thoroughly on their work experience under the regime. My dad is 1939 born and mom 1959 born, so they have lived through and worked under different Soviet leaders.

My dad has confirmed that under Khrushev’s and partially Brezhnev’s regimes, it was indeed obligatory for single men and women to work. It was unusual and suspicious to see people walking on streets in the middle of the day (because everyone was supposed to be at work), so the police (militzia) would question them why they are not at work – if they did not have work, they would be taken to a factory and the factory owner would be told to give them a job. My mom confirmed that the idea of obligatory work (especially under Gorbachev – effectively when I was born), would still apply, but mainly to single men.  Furthermore, the expectation wasn’t as strict towards women with kids. 

My parents spoke very positively about past times and they haven’t felt that the restriction was affecting their happiness. 

What is it to do with MMT theory? 

The recent blog by MMT theorist Bill Mitchell points out how this same view underlies the job guarantee he sees as essential to MMT as a functional macroeconomic and political theory.

Let’s note down the first clear problem with such a guarantee.  By treating those who are “less productive” as parasite we can easily go down a road of eugenics and facism – a society, or a nation state, whose sole purpose is maximising output per person may see individuals it deems as without productive value worthless.  And totalitarian regimes (including the Soviet Union) have shown this.  Furthermore, regimes that are excessively free market – without a sufficient safety net – lead to the same issue.

To be fair, Mitchell doesn’t go down this road noting:

Marx clearly considered a progressive society would be one where all those who could work would contribute their efforts to advancing society, while creating surpluses, which would ensure that all those who could not work, would still enjoy a material prosperity in line with the nations’.

Each person should work if they can and contribute to the social product, which would then be distributed according to material need.

People who couldn’t work, would still have their material needs covered.

So instead the moral is from each according to their ability to each according to their need.  Standard Marxism.  Even so there is something that just doesn’t sit right with me.

Often you will hear that a “job guarantee is good for people by ensuring they have work”, where such options are good things. But it is a short step from giving someone the option of work to making it an “obligation” – which is exactly what Bill is pushing. When you are obliged to work for the greater good, when your ability determines that you need to sacrifice your time “for the state”, doesn’t it start to sound like slavery?  Furthermore, what is your incentive to work, how does this ensure that you get allocated to your comparative advantage?

A job guarantee doesn’t ensure you get the job you want – it just ensures you are in a job.  The distinction is significant.  By forcing people to be in work, instead of giving people time to search (which is what most measured unemployment is outside of a recession), will that really put people into jobs where they are happier? Will it even really make the most productive jobs happen?  Finally, who wears the boots if you are obliged to work – does the employer get extra power over you, or does the state more strongly dictate what both of you can do?

Proponents of the Soviet/MMT left, pure free marketers, and the nationalistic right all share the view that someone’s value comes from their ability to produce.  Whether it be a view that all value is derived from labour or instead a more nuanced view that productive value stems from factors of production in general view is that our value comes from what we can produce.  Although theoretically the left and the right (of the above discussion) differ in terms of how that production is allocated, both sides agree that we have an obligation to produce as much as possible.

But this isn’t it.  There is a difference between these people and others who see “social value” embedded in factors of production and technology that should be shared without obligation.

A lot of my economist friends believe in a safety net that is provided without obligation – a minimum standard, a social dividend.  Then given that individuals should be incentivised to move into work, or invest in ideas or capital equipment, on the basis of what they can produce with it. 

The free marketers/strict capitalists overplay the incentive angle without thinking about the differences in power/opportunity – differences that can even destroy incentives to invest in skills and enforce hierarchies to make up for the lack of safety.  The Soviet/MMT/nationalists concentrate on their definitions of obligations and power without thinking about incentives or why production truly has value.  

Our modern society has looked past these naive definitions to give individuals choice, but to offer them a safety net when they fall – it is about maximising wellbeing, not making us machines that build as much stuff as possible.  Quite why people feel a romance for removing choice from others to ensure they are “productive” for the “nation” doesn’t make sense to me, and makes me uncomfortable about MMT – which I had previously thought had something to do with monetary policy.

But instead google tells us the exchange rate is 1.51, and so the New Zealand dollar appears approximately 23% undervalued.  But is that true?  Should global currencies adjust to set the price of Big Macs equal in every market on earth?  Let’s think about that a bit more below.

What is the Big Mac Index?

The Big Mac index is a light-hearted measure introduced by the Economist to underpin the “law of one price” and associated purchasing-power parity theory(PPP) of exchange rate determination. The PPP theory states that  the exchange rate is proportional to the ratio of price levels in the two countries in each country. 

At the current exchange rate a Big Mac in the United States would cost $8.62 NZD – compared to the reported $6.60 NZD it costs if it is purchased in New Zealand.  In this instance there appears to be the potential for arbitrage – a Kiwi could purchase a whole lot of Big Macs in New Zealand, ship them to the United States, and then sell them for a $2 profit.  

If Kiwi’s started to do that they would ultimately want NZD so they can buy goods and services here, so the US customers purchasing the product will demand more NZD in order to buy these cheap burgers.  Furthermore, as US customers will start buying from Kiwi’s instead of domestic Big Mac providers the demand for USD to buy these burgers will fall.  The increase in relative demand for NZD will then lead to an appreciation in the currency, which will reduce the incentive for Kiwi’s to export their Big Macs.  This incentive disappears once the price of Big Macs are the same.

This is the assumption behind the “undervaluation” in the Big Mac index.

How it fails and what that tells us

If Big Macs were perfectly tradable, with no transportation costs, and without any complication of competitive issues, then the Big Mac index would provide a clear measure of PPP.

But this isn’t the case.  Instead there is an observation that higher income countries tend to have higher prices – including for Big Macs.  This regularity is termed the Penn Effect, and thinking about the Big Mac index can give us a way to understand why this occurs in general.

A Big Mac cannot easily be transferred across borders, and even with the same inputs it needs to be constructed in the market using domestic labour.  This is a “non-tradable” component.  If wages for domestic workers are higher – say because of higher domestic productivity in general bidding up wages in all sectors – then this non-tradable component will cost more than in low wage countries.  Related to this is regulation – with taxes, minimum wages, and minimum employment standards all potential reasons why the burger might cost more in a given country.

Furthermore, the parts of the Big Mac that are traded may end up costing more in a country like New Zealand than other similar countries – as we are distant from the market and so there are potentially high transportation costs.

Finally, competition against the Big Mac differs between countries.  In New Zealand Big Macs are generally seen as somewhat of an inferior good, and plenty of other options are available.  However, in some countries certain sections of demand (think Western visitors to South East Asia who desperately want a burger) may find a Big Mac is the only burger on offer – leading to higher prices due to market structure.

So what is the use?

There are three ways that the Big Mac index is still useful – even if it is imprecise.

1. Changes in the Big Mac index through time can be indicative of changes in under/over valuation.  The NZD was noted as overvalued in 2014 and has since become significantly undervalued.  With changes in relative productivity limited, NZ and US wages rising by similar amounts, and the terms of trade little different, this change suggests that either the NZD was overvalued in 2014 – or is undervalued now.
2. Persistent differences can bear a relationship with real income differences – a number of the countries that are very “undervalued” also have lower average wages, productivity, and GDP per capita than many high income countries. As a result, it isn’t that the currency is undervalued that drivers the difference in the index – but a difference in the relative productivity of the nation.  
3. It is a clear way of communicating the law of one price with an everyday product that is homogenous across the globe.

So while enjoying the light hearted discussion the Big Mac index – we need to remember there are good reasons why your burger might be much cheaper (or more expensive) than a burger overseas.  

In the discussion, the RBA outlined the cost side of this tool, namely “They can also encourage people to save more, rather than spend more, so they can be counter-productive from that perspective too.”

I would like to discuss this further as it is contrary to how we often talk about monetary policy, and fleshing it out helps to make some of the assumptions made clearer. 

How do negative interest rates work?

First of all, let’s shed some light on what are negative interest rates and how they work.

I have already discussed negative interest rates as policy here:

“The first solution to this problem is to try to set the interest rate to its appropriate negative neutral level. This isn’t the idea that savers pay lenders – as we aren’t really talking about their interest rate – but it is with regards to the cash rate. The cash rate sets the interest payment/fee for retail banks in their settlement cash accounts.”

By setting the cash rate lower and thereby pushing down interest rates in the economy, the central bank tries to boost demand in the economy – helping to lift both activity and inflation in a situation when both are below target/potential.  Specifically, as interest rates fall households and firm increase their expenditure/demand. This helps to moderate recessions, by cancelling out a drop in expenditure due to some underlying cause (uncertainty, animal spirits).

Assuming that a lower cash rate does lower interest rates, then the increase in expenditure is coming from consumers and firms spending more due to interest rates falling – hence if consumers and firms responded to the change in interest rates by initially saving more (spending less) this would fundamentally undermine the efficacy of the policy change.

Back to the Governor’s saving point…

As a result, it is worth spelling out the logic of how negative rates “…can also encourage people to save more…”.

A change in the interest rate has income and substitution effects – a lower interest rate incentivises spending now, as you receive less in the future from saving $1 (substitution effect). 

However, if you are a saver and have a “target amount” you want in the future, a lower interest rate might incentivise saving now – as you have to save more now to have that amount in the future.  Another way of saying this is that a lower interest rate reduces the lifetime income of a saver – and so that reduces their consumption now (and thereby increases their savings).

Normally we view the substitution effect as dominant in an aggregate economy, as the income effects cancel out between individual savers and borrowers (as the income effect will boost consumption now for a borrower).  However, the RBA may believe that – at a negative interest rate – the responses will be asymmetric. Borrowers will refuse to increase their consumption now, and saver will cut consumption strongly now in order to keep their “target” of future income.  As a result, aggregate savings could rise.

However, is there any evidence for this? And why does this channel only become relevant at a zero interest rate, surely the asymmetric responses of savers and borrowers could be seen as relevant at any interest rate – even very positive interest rates.  

Often we will look past the implications for savings because saving propensities are relatively invariant to the price (interest rate) while lending is responsive – and in turn determines demand.  Why would saving propensities suddenly become so much more responsive when the interest rate becomes zero?

Savers hoarding cash

It is also important to note that this mechanism is different from savers hoarding cash – which is a situation that changes significantly when interest rates near zero.  The savings argument above assumes that negative rates ARE passed through, and that household and firm behaviour is different – but there is an earlier question of whether a negative cash rate is passed on at all.

If savers were to hoard cash instead of accepting negative deposit rates, then that would prevent banks from passing the lower cash rate in terms of borrowing rates.  Why?  Because their inability to cut deposit rates implies that they need to continue charging a higher lending rate to make the same margin.

As a result, hoarding does influence the pass-through of a negative cash rate (and the ability for negative interest rates to practically occur) but it is not related to the idea that saving will rise with negative rates.

Furthermore, with regards to cash hoarding negative rates haven’t been as problematic as was anticipated (at least in the short-term).

This paper from the ECB found no evidence that the negative interest rates incentivises households to hoard cash. While the other evidence shows the opposite relationship, where firms get penalized by cash hoarding, hence why they tend to lend out more.   

Overall, although the RBA piece makes some excellent points I think they oversell the weakness of negative interest rates as a monetary policy tool.

Wages are termed sticky when they don’t adjust to the optimal level driven by the changes in labour market conditions. The interaction between sticky wages and economic shocks helps to generate the business cycle, and also causes a lot of the most costly elements of an economic downturn – unemployment and losses in skills. 

As I have discussed in a previous post, prices as well as wages can be sticky. However, the focus here is on the inability for wages to change from a predetermined path – specifically the downward rigidity of money wages.

A strong reason why wages can be very sticky is unionisation.  Unions and employers both use size to generate a bargaining position to negotiate wages.  As part of this strategic negotiation, unions (at least in the Anglo-Saxon sense) tend to promote relatively sticky wages – and demand persistent increases in wages even when the economic cycle turns south.

But what does this have to do with wage inequality?

Note:  There are multiple models of unionisation and social assistance – Matty pointed out that the books “Varieties of Capitalism” and Chapter 13 of the Oxford handbook of the welfare state are a useful read for thinking about this.  The response of unions in Germany during the GFC and COVID show that the relationship between unions and stickiness is complex – and the assumption they are related is based on the experience of Anglo-American economies in the 1960-1980s.

So what does this have to do with wage inequality?

Biasi and Sarson (2020) provides an interesting link between flexible wages and the wage gender gap.

The authors find that the wage gap between women and men offered by flexible payment agreements is higher than under the collective bargaining agreement. 

Collective bargaining agreement introduces wage stickiness to the economy, as the union’s agreement usually includes a wage rise by a certain amount each year. 

However, these agreements don’t discriminate against employees based on their gender. And since these agreements are made prior to any downturn, wages continue to rise even though the revenue generated by each worker falls.  Such stickiness can then force employers hands, making them lay workers off rather than cutting wages.  Weakening union power to allow more flexible wages appears to help solve this issue. 

Note: Again this is a simplistic form of unionisation – by supporting job transition, or creating a cost for layoffs, unions might also prevent large swings in unemployment.  Ultimately what matters is the specific form of unionisation that is used – and for clarity we are assuming a form that ONLY makes wages more rigid.

However, even if there are issues of wage rigidity generating excess swings in unemployment the same unionization can also help narrow the gap in pay between similar workers due to collective agreements.  Collective agreements are often transparent and are based on objective criteria – specifically non-discriminatory criteria.  As a result, if a man and a woman are equally likely to get selected into a job (another area of potential discrimination) unionisation helps to ensure they will get paid the same.

In history this was not always the case – with unions and other institutions specifically including wage discrimination as a target on the basis of the “nuclear family-male breadwinner” view of the world. Modern unions are not expected to do this. However, the selection into a job issue remains important – as it is one of the main reasons why the wage gap exists, rather than due to differential payments for the same job.

The evidence seems to support this view of the wage gap and unionisation. In this study the authors note that the union wage gap (or mark-up) in the UK in the 1980s was approximately 10%. It was highest for women, part-timers, those who lived in the North, in high unemployment areas and worked in small plants.

As a result, although we normally view wage stickiness from unions as negative – as during a recession this can lead to more people out of work – such agreements can also help to achieve other social ends, namely closing the wage gap (reducing discrimination).

In the first few days back, I have heard a lot of people from around the building talking about how they prefer different work arrangements – and I’ve heard a lot of people say that they felt more work was being done away from the office.  And yet, teams appear to be making the choice to move back to the office.  Why is this the case?

Although it may be the case that the teams stated and real preferences differ, I suspect there is something else at play – strategic complementarity.  Once we understand this concept it can become clear why we can end up in a worse equilibrium with regards to our work arrangements even when given flexi-choice, and why explicitly promoting working from home could be a “win-win”.

My choice depends on your choice

To understand how strategic complementarity works it is useful to look at an individual’s choice regarding where to work in two scenarios: 

1. When everyone else is working from home,
2. When everyone else is working from office.

In scenario one, everyone else is working from home.  Because of this all meetings will be online (via Teams or Zoom), there will be no workplace gossip to miss out on, and no-one will look strangely at you if you fold clothes while you are in a meeting.  In this case there is a strong incentive to work from home.

In the second scenario, where everyone is working from the office, it becomes more difficult to work from home.  You get shut out of meetings, people catch up on each other’s lives without you joining in, and a decision to fold your washing during a meeting would go down poorly with your boss.  As a result, the incentive to work from home is much lower – and with the benefit of group chats and getting heard at meetings at work you have a strong incentive to also go to work.

Because you have a greater incentive to work from home when others do, and a greater incentive to work from the office when others do, these actions are strategic complements.  If someone decides to work from the office, it increases pressure for other people to work from the office – and if someone switches to work from home it increases the pressure to work from home.

This leads to multiple equilibria.  Namely, when the number of people choosing to work from home increases, the effectiveness of that type of arrangement works well and an additional person will have an incentive to work from home. Similarly, when the majority of people choose to work from the office increases, it functions well as well and an additional person has an incentive to work from the office. 

In a simplistic example, people in both cases choose to go with what the majority is doing, and we end up with two equilibria points – all work at home or all work in the office.

Is the equilibrium we choose the best (Pareto Optimal)?

The answer is not necessarily.  The equilibrium selected isn’t based on the underlying preference regarding working at home or the office – but instead is history dependent or based on what has happened in the past and what people expect others will do.

In our example above it sounded like the individual would like to work from home all things considered – but with a push to get back to normal and get in the office they know that their workmates will be in the office, as a result they also go to the office. As they are making their choice to go into the office based on the expectation that others will go to the office – and not because they actually prefer working in an office – this equilibrium is Pareto Inferior! 

So what is the takeaway here?  Just because historically, everyone chooses to be in the office, it doesn’t mean that we shouldn’t be open to better ways of working. If it is true that people are just as productive, and are happier, when working from home then that is something worth encouraging – but due to strategic complementarities it is not something that will organically occur if we simply state that flexi-work is allowed.

On the face of it this sounds pretty simple – if prices change often then there doesn’t seem to be much scope for them to be sticky.  But when we think about it a bit more this isn’t true – and thinking about why it isn’t true can give us useful insights into the macroeconomy.

Heterogeneous price behaviours

The recent interview by  Harvard economist Emi Nakamura on price dynamics, monetary policy, and this “scary moment in history”, inspired me to look at the issue of this post. 

P.S. I recommend reading the interview , as I am sure everyone will discover something new from it. 

Nakamura earned the John Bates Clark medal, awarded to the most promising economists under age 40. I’m a fan of Nakamura due to her clear way of articulating the economic ideas and concepts, without complexity and jargon. It’s a talent that I appreciate in economists.

Nakamura discusses how price behaviours are heterogeneous – namely that different sectors change their prices in different ways. For one sector , e.g. soft drinks companies constantly run sales on their products throughout the year, including tough periods suchs as the pandemic. However,  for certain sectors ,e,g, restaurants and shops, price changes don’t occur much frequently, especially not during the COVID-19 shock.

We want to understand the reasons why prices are so reluctant to adjust given the shock in the economy. 

Reasons why prices don’t change:

1. Menu Costs:  A menu cost is the catch-all term for all the different reasons why prices may stay fixed even when there is an incentive to change them.  In other words, there is some cost of adjustment and this is termed a menu cost (eg a product with a RRP written on it or a menu that has prices on it will both have a cost associated with changing the packaging).
2. Reputation element(cost) of increasing the prices: If activity picked up for a temporary reason there would be more customers trying to buy the product. The natural way of dealing with the excess demand for the firm would be to increase the prices. However, this may burn long-term bridges – existing clients may feel taken advantage of, hurting sales in the long-term.  As a result, firms may keep prices fixed so maintain goodwill.
3. Strategic elements: The interdependency between peoples choices can strongly influence how prices are set:
   1. These strategic complementarities between their prices mean that when faced by a shock firms may limit how much they want to change their price.  
   2. Furthermore, in so far as there is a first-mover disadvantage due to the above reputation costs this can be even more of a concern. 
   3. Finally, the game between firms can lead to tacit collusion which can strengthen or breakdown during the economic cycle. Let’s take an airline company as an example. 

We can think about all three in terms of an example.  Airlines normally compete in a form of oligopoly. The pricing is relatively non-fixed due to the use of online platforms. They compete with each other, so that they constantly change the prices to get a sudden gain in the market and to generate a brand and goodwill with customers. 

However, the airlines recognise that this is a repeated game – and if they can work together on certain routes they can both earn a greater profit.  As a result,  they also have an incentive for tacit collusion – they do not announce collusion, but start setting prices with reference to each other in a way that boosts their profits.

In these situations the price of some goods, services, and factors of production may adjust while other don’t.  That misallocation of prices then leads to a loss of efficiency and resources.  This is not the end of the story though – these small misallocations can lead to larger macroeconomic costs, and once it propagates through the value chain the final decline in economic activity can be much larger than the small initial misallocations would suggest.

Flexible prices can still be rigid

These stories also help us recognise something else – price rigidity isn’t necessarily about the price not changing or being unable to change.  It is about whether the specific price adjusts towards the “optimal” level quickly.  This is why stickiness is a bit of a misleading work.

This can help explain why price stickiness is seen as key to Keynesianism, but the event that Keynes was explaining involved a sharp decline in nominal prices and wages – even though these prices fell the adjustment suffered from coordination failures and over a complex emergent macroeconomy this led to a significant drop in output.

Price stickiness of the form I am thinking about here was first discussed in The General Theory of Employment, Interest and Money, by John Maynard Keynes – but it relates to the debate between Ricardo and Malthus on the possibility of a general glut in the face of market pricing. 

According to the Keynesian school, prices and wages are rigid as they don’t react to the shock in a way that would clear all product and factor markets (the optimal allocation of prices).

For instance, the price for Chanel bags go up every year by a certain amount. Even though prices are changing this is still an example of the price stickiness – as the change in the price is not occurring to clear the current market for Chanel bags.  Many other drivers could be behind this, in my view it is fear of competitors’ entrance and the need to keep prices at a level buyers think is “fair” that restrains Chanel from a massive increase in prices in response to a temporary lift in demand.  They have a reputation for increasing prices a certain amount each year, and any deviation of that strategy would have reputational consequences. 

As a result, a study showing that firms often change their prices does not imply that price stickiness – and the misallocation this leads to – is not an issue.  Instead it just tells us about the mechanisms that may cause the misallocation – if prices are constantly changing it is probably not menu costs that drive this misallocation, but instead the strategic interaction between firms or the timelines associated with their sales and production.

This can even imply that prices that are “more flexible” in terms of having fewer menu costs can actually create even more harmful misallocations due to these intertemporal and strategic concerns. As a result, policies that make it such that prices can move doesn’t imply that the markets will clear.

What this does tell us is that national economies are complicated – and a more sophisticated understanding of price setting behaviour shows us that the complex emergent nature of macroeconomic phenomena are hard to describe with our normal microeconomic tools.  This is why macroeconomics takes the form it does – and why we need to be careful with the way we argue from aggregate values such as “goods and service prices” and “average wages”.