The Wizards of Oz
For months I have been arguing that if only the Fed had pumped enough money into the economy to keep expected NGDP growth at around 5%, then we would be back where we were in mid-2008. As you may recall, in mid-2008 we had already had nearly 2 years of orderly contraction of the housing industry. Because growth in other sectors took up the slack, unemployment remained in the mid-5% range, only slightly above the normal rate. So we weren’t doing that bad. Then the Fed adopted a highly contractionary monetary policy (see Hetzel’s discussion of what they did wrong) and NGDP starting falling fast. And now we have 9.4% unemployment, and a mind-bogglingly large fiscal deficit as the government futilely tries to stop the recession with deficit spending.
Little did I know that there was a country that followed a policy similar to the one I advocated. No, not Britain, which was a model cited by Krugman in recent post. Britain has done a bit better than the eurozone, but they are still doing poorly in an absolute sense. No, I’m thinking of a much more successful country.
Imagine a continental-sized country populated by English-speaking people, with a highly diversified economy of manufacturing, services, mining, and agriculture. Imagine a country full of recent immigrants from all over the world. Imagine a country that typically runs “unsustainable” current account deficits of about 5% of GDP, year after year, decade after decade. Imagine a democratic political system and a free market economy where the government’s share of GDP is about the same as in the US. In fact, a country as similar to the US as you are likely to find anywhere in the world.
And while we are channeling John Lennon;
Imagine there’s no business cycle,
It’s easy if you try . . .
A commenter named Lorenzo sent me some data from the Australian Bureau of Statistics. He said that since 1992 the year over year NGDP growth rate has never fallen below 4%. If I am not mistaken, the most recent figures (ending March 2009) show 4.4% NGDP growth. Given that Australia relies heavily on commodity exports, and given that commodity prices collapsed late last year, it is no surprise that Australia has not completely escaped fallout from the worldwide slump. Unemployment edged up to 5.8% in June (wouldn’t we love to have that rate) and real growth has slowed. But the current view is that they will fall just short of a technical recession, getting by with a modest slowdown. Not bad for the worst worldwide economic crisis since the 1930s.
Yes, I know that Australia is called “the lucky country.” But ask yourself this; if it was just luck how did they also sail through the 2001-02 recession almost unscathed? My answer is that they kept NGDP growing at a fairly steady rate in 2001 and 2002.
Sometimes when I debate Austrian commenters they tell me that if we merely tried to paper over our problems by printing enough money to keep NGDP growing about 5% per year, then we would just create an even bigger bubble and a bigger future collapse. If so, by now the Aussies must be due for a Great Depression. But somehow I think they’ll continue to do better than us.
Earlier I said Australia is very similar to the US. The main difference is that the wizards who run monetary policy in Australia don’t listen to Puritans who insist we must suffer high unemployment for our sins. They are a pragmatic lot; the sort of people who realize that if you borrowed too much and spent too much the solution is not to force millions of workers to take long “involuntary vacations” but rather to buckle down and work even harder.
PS. In early 1991 I had the good fortune to teach in a university named after a convicted felon on the Gold Coast of Australia. Imagine Florida but with a better climate, less crime, lower prices, prettier scenery, nicer people and casino gambling. Lucky country? Yeah I’d say so. Then I traveled all over the country. I stayed with a very nice rancher near Goondawindi, and later drove by myself from Darwin to Perth. More than 3000 miles and in places the connecting “highway” was one lane (not each way, one lane total.) Once I found myself 50 miles off the highway in the desert of northwest Australia and bouncing over boulders on a dry creek bed in my rented Toyota 2 wheel drive minivan. I suddenly realized “this is really stupid” and headed back to the highway. So I have a lot of fondness for Australia. I was able to visit all the states except South Australia and Tasmania. In April 1991 I presented a paper on forward-looking monetary policy at RMIT in Melbourne. Australia hasn’t had another recession since 1991. Coincidence? I don’t believe in coincidences. (Unless they are being used to disprove the EMH.)
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8. August 2009 at 15:29
I’m glad I found your blog. Its’ very interesting so far.
I’m curious about this unconventional monetary policy. Is the perspective essentially that the hoarding of money (increased savings, but banks not lending) represents an increased demand for money and hence the need for monetary expansion in some proportion?
8. August 2009 at 16:00
Thanks for the plug! (Both individually and nationally: though I make the March quarter to March quarter growth in GDP expenditure at current prices to be 5.0%.)
Australia aka Oz, as you would know, went through a major series of economic reforms from 1983 onwards, much debated. It is a commonplace of Australia has a “Benthamite” political culture, the country where Chartism (of a form) won. A lot of that pragmatism came out in financial de-regulation. Yes, de-regulate (because regulation is not working) but keep strong prudential regulations (because that just seems sensible). Very pragmatic. Monetary policy seems to have been similarly based on informed pragmatism.
8. August 2009 at 16:20
Mike, I have several proposals including a nominal GDP target path, negative interest rates on excess reserves, etc. The basic idea is to supply more money when money demand rises, but some of the details are novel. The following web site was set up by a commenter to provide a broad overview of the ideas in this blog:
http://target-the-forecast.com/
You can also go back through some of the early posts from February, such as the one below, and get a good overview of my ideas:
http://blogsandwikis.bentley.edu/themoneyillusion/?p=249
Lorenzo, Thanks. I found a lot of time series but wasn’t able to find the rates of change you mentioned. I thought one page mentioned NGDP rose 4.4%, but perhaps I had the wrong data. In any case, 5% is even better, so I’m glad you cleared that up. Is there a particular page or table I should look for that has the 12 month NGDP growth rates going back to 1991? I couldn’t find it.
8. August 2009 at 16:32
The US is currently suffering the triumph of ideology over common sense. In 2001, when it became apparent that ideology has won the day, pragmatism was discredited, and “science” was rapidly being made illegal, I _almost_ moved to New Zealand.
My chief reasoning was that it was a lot like Australia, but they didn’t have giant poisonous spiders and ultra-deadly snakes.
8. August 2009 at 17:31
Scott, did the central bank in Australia inject more reserves into their financial system than Bernanke did in the fall of 2008? If not, then the case of Australia is consistent with my theory too, namely that Bernanke hurt the economy by cutting interest rates so low and expanding the Fed’s balance sheet so much.
To put it in other words, if you don’t see Australia’s central bank doing anything crazy in 2001-2 or now, then the fact that their NGDP is growing decently, doesn’t prove you’re right. That would be like saying a parent should target 98.6 thermometer readings when raising a kid.
8. August 2009 at 18:55
Bob, Australia did not begin the crisis in the same spot as the US… Thus, they never needed to resort to direct easing instead of interest rate cuts. This was Australia’s August 08 central bank statement:
http://www.rba.gov.au/PublicationsAndResearch/StatementsOnMonetaryPolicy/statement_on_monetary_0808.html
Note that in spite of a 3 month annualized inflation of ~4%, they reversed a trend of credit tightening. They did hold stable, but indicated a shift toward more easing. Then in September 3 (before the crisis) they began lowering, and accelerated it as events moved forward. They dropped fully 4.25% since last september.
http://www.rba.gov.au/Statistics/cashrate_target.html
If the US had 4% to 4.5% annualized inflation (regardless of expectations of weak growth, which the Australian CB cites as reducing _expected_ future inflation), I rather strongly suspect that the anti-inflationistas on the Fed Open Market Committee would have been up in arms… and that, from their perspective, a 5.5% unemployment rate would have not even been worth a second thought. After all, the Fed is already winding down it’s credit facilities and we’re at 9.5% official unemployment and 3% nominal expected growth in the final quarter (which doesn’t compensate for a year of declines).
Can you explain how the Australia story supports your argument that Bernanke’s Fed should have done even less than it did?
8. August 2009 at 18:56
My apologies, I meant 3% annualized nominal growth in the third quarter…
8. August 2009 at 20:11
This is Krugman spin — it’s a libel on Hayekian macroeconomics which falls out of a brain dead Keynesian / Philips curve understanding of boom-bust theory, and it has nothing to do with Hayek’s work. It’s intellectual incompetence served up as an “insult”.
Best to put Krugman’s deeply dishonest cheap shots back in the dumper where they belong.
Scott wrote:
“the wizards who run monetary policy in Australia don’t listen to Puritans who insist we must suffer high unemployment for our sins”
8. August 2009 at 21:25
It is nice to see some recognition of the role of monetary policy in Australia’s recent economic performance. The Australian government tries to tell everyone who will listen that the relatively not so bad performance of the economy since the financial crisis has been due to fiscal stimulus, rather than the consequences of a floating exchange rate and monetary policy.
I have the impression that our Reserve Bank might pay more attention to inflationary expections than the Fed, but I am not in a good position to make that judgement. (I would be interested in other views on this.)
It seems to me that Australia would now be in a better position if the government had relied more heavily on monetary policy. The (dubious) argument that monetary policy doesn’t work when interest rates fall to zero has not been relevant in Australia because interest rates remain very much in positive territory.
The future prospects of the Australian economy are being marred by an unnecessary increase in public debt to fund poor quality public investments as a consequence of the stimulus package. It is cold comfort that the Australian economy is not alone in that respect.
8. August 2009 at 21:38
Scott: By the way, I’m glad you enjoyed your visit to Australia. It seems to me to be most appropriate that you, as a monetary economist, should have taught at Bond university.
8. August 2009 at 22:37
This is really a shockingly incendiary remark. Its the same code Krugman uses for his strawman rendition of the Austrian Business Cycle.
Before which you also say:
I thought we were at the point of agreeing that the Austrian argument is particularly about 1) how a suppression of the interest rate below the natural-rate effects different industries differently and 2) how that disparate impact induces a loss in CPI above and beyond that which the coincident quantity changes would imply and 3) the consequence of committing to a certain time-path for the price index.
Double emphasis on the last point.
Don’t pick fights you don’t need. I find your direct argument perfectly sensible on its own terms: an NGDP target is not a commitment to a specific time-path for the price-index.
I’m still a little suspicious though that it depends on inflation expectations nonetheless being anchored. And although I can sort of see that working out if people’s expectations of real growth are anchored, there is a leap-of-faith required.
9. August 2009 at 03:29
Presumably, Australia would do even better with a free banking system, which is what most Austrians advocate.
9. August 2009 at 04:37
Statsguy, I also like New Zealand. The Puritan streak in America didn’t start in 2001, and it is still going on.
Bob, That’s great if you also agree that 5% NGDP is desirable, and the dispute is merely over how to get there. I agree that with a better monetary policy the base would have risen far less. Indeed the rise in the base reflects hoarding, which reflects a failure of monetary policy. So we aren’t far apart.
My comment was directed against all the commenters who keep saying things like “the recession isn’t the problem, it’s the solution.” When a family has spent too much, I don’t see going on an extended vacation as the solution.
(see end of this comment as well.)
statsguy#2, You said:
“Bob, Australia did not begin the crisis in the same spot as the US… Thus, they never needed to resort to direct easing instead of interest rate cuts. This was Australia’s August 08 central bank statement:”
It is important to remember that the US also did not enter the crisis with zero interest rates. They were 2% all though August and September and early October, and didn’t even get to 0.25% until mid-December. So the US did not need to rely on QE in the early stages of the crisis, indeed I suspect if they had moved aggressively and staked out an explicit price level target then they never would have had to rely on QE.
You said:
“If the US had 4% to 4.5% annualized inflation (regardless of expectations of weak growth, which the Australian CB cites as reducing _expected_ future inflation), I rather strongly suspect that the anti-inflationistas on the Fed Open Market Committee would have been up in arms… and that, from their perspective, a 5.5% unemployment rate would have not even been worth a second thought.”
I’d go even further. You don’t need to suspect, because the inflation rate was fairly high in mid-2008 in the US (because of oil prices and other commodities.) And Hetzel’s article provides a lot of evidence that Fed officials were concerned about inflation, and that this was the reason they failed to act in August and September.
Greg: Hayek favored NGDP targeting, so I obviously wasn’t referring to him. Rather I was referring to commenters who call themselves Austrian and keep insisting that the recession isn’t the problem it’s the solution.
(see also end of comment.)
Winton, Thanks for the background info on Rudd’s fiscal policy. Do you or anyone else know how big Australia’s fiscal deficit is as a share of GDP? I suspect it is currently much lower than in the US, so I doubt fiscal expansion has much to do with Australia’s relatively good performance.
I agree with you that the fiscal stimulus package was probably a mistake, but if you stand back and look at Australia relative to other countries, I still think your future is relatively bright.
Jon#2: You said:
“This is really a shockingly incendiary remark. Its the same code Krugman uses for his strawman rendition of the Austrian Business Cycle.”
Here’s what I consider shockingly incendiary remarks–all those who comment here and insist the recession isn’t the problem it is the solution. As I said to Greg and Bob I wasn’t referring to those Austrians like Hayek who favor NGDP targeting, or something like Selgin’s productivity norm.
You said:
“Don’t pick fights you don’t need. I find your direct argument perfectly sensible on its own terms: an NGDP target is not a commitment to a specific time-path for the price-index.
I’m still a little suspicious though that it depends on inflation expectations nonetheless being anchored. And although I can sort of see that working out if people’s expectations of real growth are anchored, there is a leap-of-faith required.”
I would point to my recent post on abolishing inflation. Since there is no “true” rate of inflation, NGDP growth can serve exactly the same role. It essentially anchors expected income growth over time. And that keeps nominal interest rates at reasonable levels and prevents an inflation shock from something like oil from working its way into the core inflation rate via higher wage gains.
Bill, I can’t tell if your joking, probably because I am still reeling from the Austrian reaction.
Bob, Greg, Jon, when one is criticized by three different people for the same offense, there must be some validity to the criticisms. So apologies to you all for unfairly attacking “Austrian economics” when I had a much more specific target in mind. There was no need for me to even mention the term “Austrian.”
9. August 2009 at 04:56
Ransom:
Hayek isn’t the only Austrian. Sadly, the 100% gold reserve banking, in praise of deflation, version of Austrian economics is pretty common.
Scott:
Read Hetzel again. It is the real bills advocates of the credit cycle who claim that recessions are needed to clear out the consequences of the excessive speculation caused by failure to follow their lending rules.
I will grant, however, that some self-described Austrians make very similar arguments.
9. August 2009 at 05:19
Scott:
The Austrian argument basically is that trying to use monetary policy to reverse the mild recession from late 2007 to mid-2008 would be a mistake. The reallocation of resources from housing needed to something else needed to occur. This is going to involve structural unemployment and slow real growth (perhaps negative growth) as adjustments are made.
We agree with that view. I can get picky as to what degree I think that the excessive investment in housing was caused by excessively low interest rates 7 or 8 years ago, but I don’t think monetary policy should be used to avoid reallocations of resources. I am convinced that the housing was always malinvestment. I think you grant that it is malinvestment in retrospect. Some parts of the economy should shrink, other parts grow more quickly. Making that adjustment is going to result in temporarily slower growth (maybe negative) and higher unemployment of labor.
As I always say, it isn’t much different than the shift of car production from Detroit to other parts of the U.S. and the world.
The difference between you, me and just about all the Austrians is that you favor 5% nominal income growth and believe that staying on that growth path would allow all the needed adjustments in resource allocation and would not cause any future problems regarding malinvestments. The 2% trend inflation isn’t a problem.
I favor 3% nominal income growth. I think getting back to that growth path would allow a rapid recovery in income and employment, allow the continued reallocation of resources, cause to future problems with malinvestment, and move us to a new noninflationary environment. (I don’t think the 2% trend inflation would result in problems with malinvestment either.)
Selgin, Ransom, and Hayek’s ghost (I guess) favor stablized nominal income. They certainly agree that the drops were a bad thing. And they wouldn’t want any more drops. And maybe, just maybe, they would favor getting it back to its previous peak, but they insist that the only way to avoid future malinvestments is to move to a deflationary price trend.
Also, I don’t know that it is best to describe their view is nominal income targetting. I grant that is is very similar. But it is more like the view that the quantity of money should adjust to changes in the demand given a price level that is changing at a rate reflecting productivity growth. This means that excess supplies or demands of money that would cause changes in nominal income are avoided. But it isn’t exactly “targettting” nominal income. It is support for monetary institutions that result in the quantity of money adusting to the demand to hold it at a price level that is generally falling with the rate of productivity increase (though a suppose rising if productivity decreases.)
9. August 2009 at 05:40
Bill Stepp,
“Presumably, Australia would do even better with a free banking system, which is what most Austrians advocate.”
The US had a free banking system for quite some time during the “Wildcat Banking” era. You might want to look that up and realize that large numbers of banks fail entirely on their own, given the incentives for almost every actor in the economy to create credit and investment bubbles.
9. August 2009 at 06:14
Bill:
“I don’t think monetary policy should be used to avoid reallocations of resources”
It seems like the crux of the argument comes down to an _empirical_ question of whether reallocation of resources (to productive ends) and resumption of a normal growth path occurs faster via rapid debt-deflation/liquidationism (rolling waves of default) or under a stable NGDP regime in which lower “real” growth is accompanied by higher inflation (even if we don’t care about measuring this).
(I am not arguing that anything Bill says is wrong, just trying to isolate the empirical question of debate.)
I will note one thing about the Austrians – when they spoke about capital reallocation, they were mostly speaking about physical capital. One of the chief problems we currently face is reallocation of bad _human capital_ investments, including an overinvestment in rent-seeking industries that desperately need some additional regulation (e.g. banking). Empirically, we do know that the best way to reallocate human capital is to keep people employed in productive areas(even if it’s not doing what they were initially trained to do).
Also, I echo Mike Sandifer on lessons of history regarding free banking. Disastrous.
9. August 2009 at 06:36
Sandifer:
You need to read Selgin, White, and Dowd on “free banking.”
The free banking era in the U.S. was called “free banking” because there were standard rules for entry into the banking industry. Before that time, and in states that never adopted “free banking,” it took an act of the state legislature to set up a bank. Whether “free” or not, banks issued redeemable paper money.
So, rather than lobbying (bribing) enough members of the state legistlature to set up a bank, anyone meeting simple requirements was “free” to organize a bank. “Free” banking.
“Free banking” invovled a detailed regulatory scheme. Those founding a “free bank” had to put up a capital investment, but then banknotes had to be backed 100% by approved bonds. The bonds were deposited at the state treasury and, in return, standardized banknotes (that did state the name of the issuing bank and were redeemable in gold or silver coin at that bank) were issued. There was nothing special about the gold redeemable banknotes. It was the special bond collateral and the ability of anyone meeting simple requirements to organized that bank that made it special.
General obligation bonds of the particular state were always appropriate backing, but sometimes revenue bonds for important (politically important) road or canal projects would be acceptable.
If a bank failed, and the bonds were good, then the state currency office redeemed the banknotes of the failed bank by selling off the bonds. If the bonds were bad, because the canal or road project failed or else a political change resulted in an explicit default on state debt, then pretty much all the banks would fail and their banknotes could not be redeemed.
Generally, the free banking rules involved unit banking. Some states, without free banking, had statewide branch banking. With the end of the Bank of the United States, there were no banks with nationwide branching.
While banknotes of free banks that had not failed were redeemable in the particular town where the bank was located, and so traded at par, there was no effective clearing system for most of the country, and so banknotes of sound banks, currently redeeming notes, traded at a discount depending on the distance from the issuing bank.
To the degree people actually obtained them at the location of the issuing bank, it is pretty clear that any discount far away shows that the cost of carrying specie was worse. But, I suppose the organizers of the bank might have “spent” (or really sold them) at a point distant from their bank.
However, even during the “free banking era” there was a clearing systyem set up in New England, which kept the banknotes issued by may banks trading at par over a broad area.
Anyway, “free banking” as described by Stepp includes permitting bank branching (rather than enforcing unit banking,) making notes (and deposits) obligations on the general credit of banks rather than having special collateral requirements for banknotes and not deposits, and not having special fractional reserve requirements for either, but especially not different ones.
While “free bankers” generally have little use for the particular regulatory scheme of the “free banking system,” there is no promise that banks won’t fail under free banking.
If I had to summarize the maco view of the free bankers, it would be that particular regulations of banking in the U.S. interacted with the gold standard to create extra instability in the U.S. Without those banking regulations, the macroeconomic performance would have been better. The regulations that made up “free banking” were similar too, and perhaps no better than the ones that made up the national banking system, which is the key target of the criticism.
9. August 2009 at 09:09
Scott,
No need to respond to this, but just to clarify: I’m getting a little lost in all the back-and-forth, but you never offended me or anything. I understand what you mean about Austrians saying the recession is the solution; I agree with them. 🙂
Here’s what I’m saying: You are pointing to Australia as an example of a country doing it right. Australia never let its NGDP rate fall below a certain level, and that’s exactly what you think the Fed should do here, and wow! Australia is doing great.
So in response, I pointed out that Australia hasn’t done the kind of “insane” monetary injections that Bernanke did in fall/winter of 2008–the ones you consider too timid. So it’s a bit weird for you to cite the efficacy of incredible injections of base, by pointing to a country that did it less than we’ve done it here.
It would be like Krugman citing the effectiveness of propping up aggregate demand, and pointing to Australia as a success story. You’d say, “What are you talking about, Paul, their deficit as a % of GDP is lower than ours?” And he’d say, “Right, because their commitment to propping up aggregate demand has kept investment high, so their output gap never got that out of hand in the first place.”
Do you at least see the analogy? Maybe you’re right, but I’m saying your argument in this blog post could just as well “prove” that Krugman is right to focus on fiscal policy.
9. August 2009 at 10:28
Canada, like Australia, has an inflation-targeting central bank and flexible exchange rates. Lots of other similarities too, both politically and economically. But Canada has had falling GDP since mid-2008. http://www.statcan.gc.ca/daily-quotidien/090731/dq090731a-eng.htm
Two differences might explain this:
1. Australia has traditionally had a higher interest rates than Canada (nobody knows why, but it just seems as if Australia, and even more New Zealand, has a higher natural rate). http://www.rba.gov.au/Statistics/cashrate_target.html
http://www.bankofcanada.ca/en/graphs/a1-table.html
Even though Canada and Australia have cut their overnight rates by roughly the same amounts, Australia is at 3% while Canada is at 0.25%. Maybe people expect that the Reserve Bank of Australia can and will loosen monetary policy if needed without needing to resort to “unorthodox” measures, while the Bank of Canada cannot?
(1a. RBA targets 2%-3% inflation, while BoC targets 2% inflation, so that only explains 0.50% difference.)
2. Canada has much closer trading links with the US.
But I am not satisfied with those 2 explanations. The Bank of Canada cut its overnight rate target more quickly than did the RBA.
9. August 2009 at 11:47
I think Bob Murphy has a good point. Although Australia never dipped below 4% NGDP, they have also not done the extreme measures the U.S. has. I think the critical difference is an explicit inflation target. Although Australia has multiple monetary objectives (growth, employment and inflation), they have stuck to just inflation since 1993. This has the effect of solidly anchoring inflation expectations and curtailing any debt-deflation cycles. Credibility and expectations seem so wishy washy at first, but I am beginning to see how powerful they can be.
Australia dose not, to my knowledge, pay interest on excess reserves. I view government bonds, currency and reserves as living on a spectrum of money-ness, where individuals choose which one to use based on ease of exchange and interest earned. Since there is a tiny difference in the U.S. between interest earned on reserves and currency, currency dominates the choice. Australia is not in this situation and is thus not forced to do the kinds of crazy stuff we are.
Finally, “Australian Economics” and “Austrian Economics” are only 2 letters apart. I don’t believe in coincidences either. 🙂
9. August 2009 at 11:50
It should read “Since there is a tiny difference in the U.S. between interest earned on reserves and bonds, reserves dominate the choice.”
9. August 2009 at 13:11
Scott for some background:
http://www.slate.com/id/9593
Which includes this gem from Krugman:
Now who doesn’t understand supply and demand :). The flaw in his thinking of course is the price-level which is part-and-parcel to the whole Austrian argument.
9. August 2009 at 13:33
Bill, You said,
“The Austrian argument basically is that trying to use monetary policy to reverse the mild recession from late 2007 to mid-2008 would be a mistake. The reallocation of resources from housing needed to something else needed to occur. This is going to involve structural unemployment and slow real growth (perhaps negative growth) as adjustments are made.
We agree with that view.”
It depends what they mean. If Austrians are saying they agree with Bernanke’s decision to sharply cut interest rates in late 2007 and 2008, and that all they would oppose is even greater stimulus than what was actually done, then I agree. But I am pretty sure that a lot of Austrians even disagreed with his cuts in that early part of the recession. In that case I don’t agree, as if he hadn’t done so NGDP would have been falling early in 2008, not late in 2008.
I agree with the rest of your comment.
Mike, I’m not expert on free banking, but I think the big problem was actually our branch banking restrictions. Canada had nationwide branching and its banks have always been pretty stable. Even so, I think we need some sort of centralized monetary policy, so I don’t go as far as some libertarians.
Statsguy, Those are good points about physical and human capital. I lot of bad things flow from unemployment.
Bill, I agree with you on the regulatory environment. Although the US is often viewed as a free market economy, in some ways Canada had freer markets.
Bob, You said;
“No need to respond to this, but just to clarify: I’m getting a little lost in all the back-and-forth, but you never offended me or anything. I understand what you mean about Austrians saying the recession is the solution; I agree with them.”
Does that mean it’s OK for me to start insulting Austrians again? At least I’ve never mentioned that Hitler was born in Austria. Oops, I just did it. 🙂
Seriously, I see your point but I think you misinterpret what I am saying about Bernanke. Yes, I’m say monetary policy should have been more expansionary, but no, I’m not saying he should have pumped even more money into the economy. In my view if they had not paid interest on reserves, and if they’d adopted an explicit NGDP or even price level target, the Fed could have hit its objective in September and October with less than $100 billion injected, not the $800 billion actually injected. It wasn’t so much that they were doing too little, but rather they were doing ineffective and counterproductive things.
Having said that I understand why people may have the opposite view of what I am saying. I don’t always spell this out, and sometimes out of laziness take shortcuts in saying they didn’t inject enough money. But what I really mean is that they needed both a more expansionary and a smarter policy.
azmyth,
I do see your point (and please read my response to Bob above.) And I agree that anchoring expectations is the key, and that at first it seems counterintuitive that such a small issue could matter so much. But it’s kind of like a currency band. The very fact that speculators know the central bank will eventually move the exchange rate back into the band, makes speculators reluctant to move the exchange rate very far outside the band–unless there is a loss of credibility.
BTW, paying interest on reserves is only a problem when you are struggling to get out of a liquidity trap. Some countries have done it quite effectively when rates weren’t stuck at the zero bound. So even if the Aussie central bank did so, it might work better than in the US.
You said,
“Finally, “Australian Economics” and “Austrian Economics” are only 2 letters apart. I don’t believe in coincidences either.”
I noticed that too, but I couldn’t think of any clever joke to relate the two.
Perhaps my most “Austrian view” is my NGDP futures targeting scheme, which would have the free market determine both the quantity of money and the interest rate that they think is most likely to hit the NGDP target. If I kept focusing on that idea, and lowered the NGDP growth rate to 2% or 3%, I might get a more sympathetic treatment from many Austrian commenters. But I suppose the real world debate keeps pushing me off course. NGDP futures are just not an option right now.
9. August 2009 at 14:31
Scott, my response to your post can be found here:
http://www.institutional-economics.com/index.php/section/the_wizards_of_oz_behind_the_curtain/
9. August 2009 at 15:49
Nick, You said:
“1. Australia has traditionally had a higher interest rates than Canada (nobody knows why, but it just seems as if Australia, and even more New Zealand, has a higher natural rate).”
I’m surprised no one seems to know why. I had trouble finding NGDP growth rates, but I eventually did find data for 1974-2003. Just eyeballing the data it looks to me as if between 1974 and 1998 NGDP growth rates in Australia were nearly 2% higher than Canada. Nominal interest rates are highly correlated with NGDP growth rates. On the other hand during the late 1990s and early 2000s the gap narrowed, and I don’t have recent data. So if NGDP growth rates have converged, then that might create a puzzle. But I suspect that even today investors expect a bit faster NGDP growth in Australia than in Canada. I suppose the other obvious possibility is that investors fear AUS$ depreciation due to their large CA deficits.
Does anyone have average NGDP growth rates for the two countries over the past 15 years?
You said:
“(1a. RBA targets 2%-3% inflation, while BoC targets 2% inflation, so that only explains 0.50% difference.)”
I suppose inflation may be more relevant than NGDP growth for an open economy. But I would also like to see actual inflation rates, as targets aren’t always credible.
(Just between you and me, are the Aussies as trustworthy as Canadians? They seem a bit more fun-loving to me, which might correlate with overshooting the inflation target at times.)
You said:
“2. Canada has much closer trading links with the US.
But I am not satisfied with those 2 explanations. The Bank of Canada cut its overnight rate target more quickly than did the RBA.”
I think the close trading links could be a problem for Canada. On the other hands East Asian output really plunged last winter, and Australia does a lot of trade there. As you know, I don’t put much weight on interest rate cuts as a sign of policy easing, and regard really low rates as more an indication of a loss of credibility. When a central bank is doing a good job, it doesn’t look like it is doing much of anything at all. Sort of like if a fiscal authority stabilized the business cycle with ultra-effective fiscal fine tuning, you wouldn’t see much change in the budget deficit, as the automatic stabilizers are the biggest part of the swings in the deficit.
I don’t have any definite answers, but I think you are asking the right questions.
Jon, I am probably dense, but I don’t see a problem with Krugman’s argument. Obviously he is assuming some sort of overall macro equilibrium, say inflation targeting or NGDP targeting. And then he says that if people want to spend more money in one area they spend less in another. But in that case why is there any unemployment? I think the Austrians would say it is the frictional problem of moving workers from one sector to another. Krugman and I don’t think that is a serious enough problem to cause a major recession. But maybe I don’t see the problem you are noticing.
9. August 2009 at 16:18
Scott: You asked about the size of Australia’s fiscal deficit as a percentage of GDP. The estimates of fiscal balance from the budget (in May) are as follows: 07-08, +1.9%; 08-09, -2.7%; 09-10, -4.5%; 10-11, -4.6%. The component attributable to increased spending would be much smaller. You are right that these estimates are a lot lower than current fiscal deficits in the U.S.
Several comments have been made about the possible effects of explicit inflation targets in anchoring inflation expectations in Australia. Comments made by Glenn Stevens, Governor of the Reserve Bank in a seminar paper (in March last year) might be of some interest in that context. He seems to me to be trying to shape expectations about the Bank’s ‘reaction function’:
“The objective is to achieve an average rate of CPI inflation of between 2 and 3 per cent. The ‘on average’ specification is used precisely because the CPI is sometimes affected over short periods by factors that will not be there in a year or two’s time, when the effects of any monetary policy changes will still be coming through. For policy to chase those short term fluctuations would risk making the economy less, rather than more, stable. So we need to look ahead to where the CPI is likely to be in future, as well as where it is now. For that purpose, we employ analytical devices to help us detect what the ongoing trend in inflation is likely to be, and this is where the underlying measures are useful. They are not, themselves, the target variable. But a policy that targets future CPI inflation, using underlying inflation as an analytical tool and/or as a predictor of the headline CPI, would probably look very similar to one that was targeting underlying inflation per se. So, in this sense, if one is trying to assess what economists would call the Bank’s ‘reaction function’ using particular price series, underlying measures would probably be more helpful than the headline rate” (Paper available at: http://www.rba.gov.au/Speeches/2008/sp_gov_140308.html
I wonder if there is much difference in practice between targeting “underlying” inflation and targeting the markets expectation of inflation.
10. August 2009 at 04:05
I calculated the growth rates in expenditure GDP at current prices from downloading the xls spreadsheet. It is a little laborious but not so bad with judicious use of block copying summing and growth equations.
10. August 2009 at 04:08
The webpage to download from is here
http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/5206.0Mar%202009?OpenDocument
10. August 2009 at 05:01
Stephen, Thanks for the comment. Here are some thoughts.
1. The higher average NGDP growth in Australia does help explain why NGDP growth today is higher than most other countries, but it doesn’t explain why the slowdown (change in NGDP growth rate) has been much less than in other developed countries.
2. A slightly higher average inflation rate could be viewed as a negative, but it could also be a positive, as one is less likely to bump up against the zero rate bound.
3. The inflation band rather than a single number might also be a hidden advantage, if the central bank uses it as “cover” to quietly focus on NGDP, not inflation.
Because you are closer to the scene, I don’t doubt that you see some flaws in policy that I miss, but I still think they have stumbled upon a pretty effective countercyclical policy, even if partly by luck.
Winton,
You said:
I wonder if there is much difference in practice between targeting “underlying” inflation and targeting the markets expectation of inflation.
That’s a good point. In practice the transitory parts of the CPI are pretty hard to forecast more than a few months out, so the two may be quite similar, as you say.
You said:
“Scott: You asked about the size of Australia’s fiscal deficit as a percentage of GDP. The estimates of fiscal balance from the budget (in May) are as follows: 07-08, +1.9%; 08-09, -2.7%; 09-10, -4.5%; 10-11, -4.6%. The component attributable to increased spending would be much smaller. You are right that these estimates are a lot lower than current fiscal deficits in the U.S.”
Thanks. In fairness, a Keynesian might say the full employment deficit in Australia is a much larger share of the total, as the recession is much milder. But even so, I’d guess both countries would end up with FE deficits having risen just a few percentage points. Even worse for the Keynesians, I’m told that Australia has relied heavily on mailing out checks, and relatively less on actual government output. But this is the type of fiscal stimulus that Paul Krugman says has been ineffective in the US. Put it all together and there is not a shred of evidence that the superior performance of Australia is due to fiscal stimulus. I am convinced it is monetary. Monetary policy is what determines the long run NGDP growth track, not fiscal policy. And markets have confidence that Australia’s NGDP will keep growing.
Lorenzo, Thanks, I’ll take a look.
10. August 2009 at 07:56
Scott asks:
I don’t think that the frictional effects are the only element of the ABC analysis. Indeed, they strike me as relatively minor adjunct to the Austrian theory of capital allocation. So, I agree that too much emphasis is placed upon them. The error Krugman makes relates to the price of goods. Even if consumers transfer their spending that doesn’t mean that real-production of consumption goods increases by as much. It may well be that price of consumption goods is much higher.
“may well be”–the Austrian story is in fact particularly about this. The ABC narrative is that holding the interest-rate below the natural-rate induces a sectoral boom in investment goods and then an inflation which causes the prices of consumer goods to rise do the relative allocation of resources that results–as a side note, the Capital theory here is discussing a mechanism of a CB inducing CPI for reasons other than quantity alone, i.e., that CB intervention alters the velocity of money as well. For whatever reason the CB eventually loses its nerve (historically this would be because of the gold-cover ratio, but in a modern economy it is the price-level target). At this point they withdrawal their stimulus. Unemployment follows because money has become scarce relative to the current price-level which persists until the structural adjustment completes.
I don’t think unrecoverable value plays a big role in this narrative. Its a secondary effect at best.
11. August 2009 at 03:16
Scott, Jon,
There are several versions of the Austrian Business Cycle Theory. As Jon describes the central bank may lose their nerve. However, it is important to understand that ABCT still applies if they don’t. When the production process is lengthened without corresponding saving the fund of circulating capital produced for the immediate future decreases, there is no getting away from this. That will be reflected in higher consumer goods prices.
There are two distinct sorts of capital misallocation. Firstly, when market interest rates are suppressed below the natural rate this leads to long-term investments. These can’t be sustained and they become unprofitable later. Secondly there are loses from the expected returns from the lower interest rate. Thirdly, there are the loses from the “secondary recession” caused by fall in AD.
Loses from misallocation are important, firstly because they may be large and secondly because of the disturbances they cause.
Krugman is wrong because he is mistaking flows of money for those of goods. The GDP equation is an accounting tautology.
David Gordon wrote a good commentary on Krugman’s article:
http://mises.org/story/3579 . On the section you mention he wrote:
“Did you spot the fallacy? When the investment boom collapses, people may shift spending to consumer goods. It doesn’t at all follow, though, that a boom in consumption goods will result. A consumption boom, one presumes, means an increase in the quantity of consumer’s goods; and no reason has been advanced to expect such an increase. All we have been given is that spending on consumer goods has increased. This may well simply increase the prices of these goods rather than expand production.”
11. August 2009 at 06:05
Jon, In the process you describe the price level changes. I am sure that Krugman would agree that if the Fed did nothing the price level would change. Krugman is a Keynesian, so he obviously believes that investment instability can create problems if not offset by the central bank. But I inferred he was assuming the Fed was targeting the price level. In that case if there is more demand for investment goods, the price of investment goods rises and the price of consumption goods falls (as more demand for investment goods implies less demand for consumption goods.)
Current; You said;
“These can’t be sustained and they become unprofitable later.”
Are you referring to accounting profits or economic profits? Remember that the cost of building these projects is a sunk cost, so only if firms cannot even cover the marginal cost of operation, will they choose to shut down.
Austrians like to point to a few houses that were recently torn down in California. But that is a drop in the bucket. Most new houses get utilized.
I don’t see how the David Gordon quotation addresses Krugman’s point. But then I’m not 100% sure I know what Krugman’s point was. I generally don’t find these sorts of vague discussions useful. Unless an economist talks in terms of RGDP, NGDP, the price level, relative price changes, sectoral shifts in output, etc, I have trouble following the argument.
Here are the key issues:
1. What causes NGDP to change?
2. Are recessions caused by unexpected shifts in NGDP, or other “real” factors?
Anything else is a meaningless diversion. I believe the Austrians are arguing that recessions can be caused by real shocks, even if NGDP growth is stable. But I can’t be sure because they don’t use the same language that I use. If Austrians think that a stable NGDP would prevent most recessions, then we basically agree, but just use different language. If they think we’d get recessions even with stable NGDP growth, then I disagree with the Austrian view.
11. August 2009 at 07:41
Current:
The U.S. lowers tariffs and quotas on foreign goods.
Americans import more goods and services. The demand for U.S. import competing goods fall. Jobs are lost to foreign competition.
But what do the foreigners do with the money they are earning from their exports? They buy U.S. goods, or there is a net capital flow into the U.S., lowering interest rates in the U.S. and expanding the demand for interest sensitive consumer goods or else capital goods.
And so, while demand falls in import competing industries and production and employment in those areas fall, demand rises in export industries and interest senstive industries, and employment and output expands in those industries.
Can you spot the fallacy? The added demand in export and import competing industries should cause a boom there, but maybe prices rise and output doesn’t!
Everything about the “Austrian” theory of the business cycle applies to any sectoral shift in the economy. This is the bread and butter of analyzing the impact of international trade. Ecnomists deal with this all the time in the context of “trade destroys jobs.”
11. August 2009 at 08:27
Scott: “Are you referring to accounting profits or economic profits? Remember that the cost of building these projects is a sunk cost, so only if firms cannot even cover the marginal cost of operation, will they choose to shut down.”
You are right about sunk cost. My point is that both the sorts of profit you mentioned are diminished.
Just because a marginal cost of operation is met doesn’t mean that an asset is properly utilized. Consider an enormous electronics factory.
A factory like this can be run with very little demand. The marginal costs can still be met with only a part of it being used. However this is not optimal use of the asset. The entrepreneur has unused space and equipment in the factory, this is misallocated. As a result there is an economic loss and an accounting loss. Though they may not necessarily be proportional.
Scott: “Austrians like to point to a few houses that were recently torn down in California. But that is a drop in the bucket. Most new houses get utilized.”
Yes. However, a house isn’t so different from the factory I mention above. In the case of a person buying a house there isn’t a profit involved. However the person making the purchase decides on the basis of a future plan. As the person’s expected future income increases so they spend more on luxuries. They don’t intend to commit to financing luxuries if they can’t afford it. This may happen though if they are mistaken about their future income. A large house may be such a luxury.
Scott: “I don’t see how the David Gordon quotation addresses Krugman’s point. But then I’m not 100% sure I know what Krugman’s point was. I generally don’t find these sorts of vague discussions useful. Unless an economist talks in terms of RGDP, NGDP, the price level, relative price changes, sectoral shifts in output, etc, I have trouble following the argument.”
I’ll attempt to explain.
Krugman wrote:
“As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income. Every sale is also a purchase, and vice-versa. So if people decide to spend less on investment goods, doesn’t that mean that they must be deciding to spend more on consumption goods implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?”
Krugman has used this argument against Austrian economics before. Take the GDP equation.
NGDP = Consumption spending + Investment spending + Government spending
Each of these is a money aggregate. They don’t represent a real amount of goods. Krugman’s point is that every economic agent must spend on one of those classes of goods. Certainly that is true.
But, there will be real losses in changes between different employment. Some human skills will not be useful, so some of the the time and money spent acquiring them may be wasted. Similarly capital equipment moved from one employment to another may not be well suited to it’s new use.
David Gordon: “Did you spot the fallacy? When the investment boom collapses, people may shift spending to consumer goods. It doesn’t at all follow, though, that a boom in consumption goods will result. A consumption boom, one presumes, means an increase in the quantity of consumer’s goods; and no reason has been advanced to expect such an increase. All we have been given is that spending on consumer goods has increased. This may well simply increase the prices of these goods rather than expand production.”
Gordon’s point is that the consumption goods sector may not be ready. For growth in the sales of consumption goods to occur there must be capacity in that sector. The materials must be on hand. Otherwise the result will be a small rise in real output and a large rise in prices. (The same is true of a swift change towards production goods, but as I’ve mentioned before that is very unlikely to occur).
Scott: “1. What causes NGDP to change?”
Changes in the demand to hold money. Changes in demand and supply for goods that constitute a part of GDP.
Scott: “2. Are recessions caused by unexpected shifts in NGDP, or other “real” factors?”
Both.
Scott: “Anything else is a meaningless diversion. I believe the Austrians are arguing that recessions can be caused by real shocks, even if NGDP growth is stable. But I can’t be sure because they don’t use the same language that I use. If Austrians think that a stable NGDP would prevent most recessions, then we basically agree, but just use different language. If they think we’d get recessions even with stable NGDP growth, then I disagree with the Austrian view.”
Your view of policy is at odds with the Austrian economists. What is at odds is your call for NGDP+5% rather than just NGDP without an increment. Without adding an increment we are talking about “monetary equilibrium”. Which is what Hayek wanted and similar to what Mises suggested in his early work.
Adding an increment involves long-run price inflation, that creates Cantillon effects (I understand you don’t believe in those) and accounting errors. It also involves creating more money than is demanded which reduces the market rate of interest below the natural rate. Both of these we see as causing instability in the longer-term.
However, since you only recommend a small increment on NGDP your policy position isn’t so different.
Bill,
I think you’ve told me before that you have read quite a lot of Mises and Rothbard. I think you know what I’m going to write.
You are correct that the argument is the same as that associated with the disturbances caused by reducing tariffs. However, doing that has long-term advantages despite it’s short-term problems.
What though is the benefit of artificially creating such short-term problems?
US tariffs average 3%. Instead of a steady 3% the percentage could be picked by rolling a dice every five or so years.
I could go on and mention the stages of the structure of production, but I think you probably know about that.
11. August 2009 at 12:50
[…] August 11, 2009 by kevindick The two economists that have most informed my view of the current macroeconomy are Arnold Kling and Scott Sumner. In both cases, their models and explanations make sense to me. They use solid reasoning and evidence; I don’t feel I’m getting a lot of hand waving. Unfortunately, at first glance, their views seem mutually exclusive. Kling believes business cycles are the result of many planning errors by individual agents (for example, this recent post and this follow up). Sumner believes business cycles are the result of contractionary monetary policy by the central bank (for example, this recent post and this one). […]
11. August 2009 at 17:14
Scott:
If that’s the case, he did a bad making his argument. Obviously if you assume the CB is successful, then you’ve begged the question.
Minor correction to your remarks: the Austrian argument is that supply and demand of investment goods rises as the interest-rate is suppressed. Whether the price of those goods rises or falls is not discussed, but it is claimed that the price of consumption goods rises because factors of production are bid away at the peak. Thus CPI would accelerate. Once this occurs, nominal-rates would otherwise begin to rise (excepting continued pumping), the real-rate would be restored to the natural level, and thus the neutrality of money would take hold and the dislocation of resources would unwind at the new, higher price-level. In practice, monetary policy is backward looking. So the CB overshoots, pumping continues past the point when CPI accelerates. So the CB tightens money late. Their subsequent intention is only to stabilize the price-level but again policy is backward looking and they overshoot. Which means in practice the policy usually partially restores prices to their old trend-line and in the process inflation results.
Thus it is a purely hypothetical notion that the CB might act perfectly by choosing to not restore the price-level. This was always Mises’s position. He doubted that the CB would ever act perfectly. Thus the ABC was a ‘truth’ in practice.
The CB would have no more success precisely stabilizing NGDP. It would instead roll around the target. Thus, I while I think an Austrian could accept that a ‘stable’ NGDP would be free of the ABC, he would reject the notion that your NGDP gyrations would be any more free of a cyclic unemployment effect.
Frankly you’d be crazy to make such a claim. I’ll concede that NGDP targets offer other advantages but an end to recessions? NO.
Current: I don’t think malinvestment losses are meaningful to the Austrian theory at all. To understand why you need to look at the history of the ABCT. Did it arise deus ex machina? No. It arose from the Austrian’s capital structure theory which related changes in ‘i’ to changes in sectoral activity. Nothing in that theory discusses losses due to structural shifts. The structural/frictional effects of the business cycle is an add-on. i.e., oh by the way churning the resource allocation in the economy has efficiency costs. That is it. It doesn’t fall out of any sort of analysis.
Scott+Current: ABCT arose as a challenge to the real-bills doctrine among other theories of the place and time which suggested credit expansion was harmless. The narrative serves then to discredit those notions and explain how they are part-and-parcel of boom/bust patterns in the economy. The narrative does not really describe an alternative policy. It merely focuses attention on the real problem: banking dynamics have real effects (in the short-term).
Surprisingly this argument is still of modern relevance. People seem to have an inability to associate ‘recessions’ as consequences of imperfect policy execution.
I continue to believe that the ‘day of reckoning’ given by classical Austrian writings depends on the notion that the price-level must be restored to trend eventually. In this way, you can avoid recessions by drifting further and further from your trend-line but once you decide to go back pain will come–sharp and fast or slow and drawn out.
11. August 2009 at 19:29
I meant to add a few more comments, but I’m very excited to see your QT post, but it will take a bit to digest and read that one. Yikes, do you get anything done besides writing posts and responding to comments :)?
I think its worthwhile to ask: what is the intellectual contribution of the ABCT?
1)
The Quantity Theory doesn’t really explain anything. Sure, ceteris paribus, an increase in M causes inflation and nothing else, but so? This “insight” was useful in the 70s to help people realize that pushing ‘M’ COULD be really destructive.
The real question is why doesn’t credit expansion create real benefits. There seem to be continual battles over ‘free coinage’–unrestricted credit expansion. A priori its certainly plausible to wonder whether a monetary expansion wouldn’t create real growth–its a possibility under the equation of exchange! The Austrian theory provides the answer by explaining how an expansion that lowers the real interest-rate below the natural-rate (which is to say an expansion in excess of supply/demand variance) necessarily eventually results in inflation.
**Austrian Theory Explains the Long-Run Neutrality of Money**
2)
Milton Friedman’s long and variable lags are clear in the Austrian frame-work. The lag occurs because the inflation depends upon bidding away resources from one sector to the subsidized sector.
3) The pattern of sectoral differences during the boom/bust is explained
12. August 2009 at 07:04
Jon,
You are mostly right about the Austrian Theory of Business cycles. However, you have Austrian Capital Theory wrong.
Jon: “I don’t think malinvestment losses are meaningful to the Austrian theory at all. To understand why you need to look at the history of the ABCT. Did it arise deus ex machina? No. It arose from the Austrian’s capital structure theory which related changes in ‘i’ to changes in sectoral activity. Nothing in that theory discusses losses due to structural shifts. The structural/frictional effects of the business cycle is an add-on. i.e., oh by the way churning the resource allocation in the economy has efficiency costs. That is it. It doesn’t fall out of any sort of analysis.”
Malinvestment losses are certainly are “meaningful to the Austrian theory”. They have been a part of it from Mises first explanation of the theory until today.
Also, you are confusing too different issues here. On the one hand we have the costs of “churning the resource allocation”. That is the costs of moving resources from one use to another. This isn’t malinvestment, but it is a source of waste.
Malinvestment is the investment of goods in processes of production that are not sustainable. Malinvestment happens during the boom, it is revealed by the bust.
For example, in my previous job I designed custom parts for mobile phones. I used tools and software to do that. I worked for a components supplier who sold those parts to mobile phone OEM companies. Those companies then got ODM manufacturers to make them into phones. They were sold to mobile carriers who then sold subscriptions to the consumer. From my job to the end product this process took years.
This entire process depends upon expectations of the final product. These may simply be wrong, in that case we have the normal sort of misallocation that comes about from entrepreneurial error. However, this also may be wrong because of the effect on relative prices of changes in the money supply or the market interest rate.
12. August 2009 at 07:04
Current, Your attack on Krugman only makes sense if there is some sort of supply shock. He is implicitly holding NGDP constant. So if you want to say that when people switch over to consumption goods and the prices rise because it takes time to make new capacity, you are basically making a supply side argument. You are saying that even if NGDP was constant, prices might rise and hence RGDP might fall. That is all true. But Krugman would say that in the real world the problem isn’t falling RGDP and rising prices, it is when both prices and RGDP fall at the same time. And that is caused by demand shocks. And the Austrian mechanism doesn’t explain those. Of course Austrians also have a monetary model that explains why NGDP might fall, but unless I am mistaken that’s not what makes Austrian economics distinctive.
I still don’t quite follow the accounting cost issue. The problem is not profits or losses (economic or accounting), it is misallocation of resources. Even if resources are misallocated, it is not obvious to me why that would cause much unemployment. It seems to be a “frictional” problem, which most economists (including me) think plays little role in business cycles.
Jon, You said.
“Frankly you’d be crazy to make such a claim. I’ll concede that NGDP targets offer other advantages but an end to recessions? NO.”
I do think a forward-looking NGDP target, level targeting, could prevent severe recessions like 1921, 1930, 1937, 1981, 2008. It might even prevent most milder recessions. I see us doing about as well as Australia since 1991.
I agree with you that Krugman expressed his idea poorly, but if you recall that he is a Keynesian, he obviously wasn’t arguing that an attempt to invest more could not cause a business cycle, as that’s exactly what Keynesians think does cause business cycles. Instead, I think he was arguing that you need Keynesian assumption, not Austrian assumptions, to get that result. I’ll leave it at that, because I find both Keynesian and Austrian discussions needlessly confusing. I still think it boils down to what causes NGDP fluctuations (bad monetary policy) and what causes RGDP to change when NGDP is stable (changes in MTRs, oil shocks, crop failures, minimum wage increases, etc.)
You said:
“I continue to believe that the ‘day of reckoning’ given by classical Austrian writings depends on the notion that the price-level must be restored to trend eventually. In this way, you can avoid recessions by drifting further and further from your trend-line but once you decide to go back pain will come-sharp and fast or slow and drawn out.”
Earlier I argued that Keynesian economics was a gold standard model. This suggests that Austrian was as well. Neither finding would be surprising, because in those days (before fiat money) the price level did have to return to
trend.
Jon#2, 1. Don’t almost all modern business cycle models imply money is neutral in the long run?
2. The long and variable lags is exactly what I don’t like about monetarism. A couple months back I did a post criticizing “mystical” lags.
3. Again, all business cycle models that I am familiar with imply that the investment share of GDP is very procyclical.
Thanks for the comment on my productivity. I go on vacation next week for a while, so my productivity may soon dry up.
12. August 2009 at 07:53
Scott,
I mostly agree with what you have written. The ABCT is a description of how an unsustainable boom occurs and how it ends in a bust. Once that bust is underway the problems are quite different, the secondary recession comes into play. In this period Austrian economists talk about monetary equilibrium like you do. That is something that isn’t particularly specific to them, though they were some of the first proponents of it.
The problem with discussing the boom is that there is no concept of the “subsistence fund” in mainstream economics. In Austrian economics the subsistence fund is, roughly speaking, the set of non-permanent capital goods. Over time these are used to make final consumer goods. The supply shock comes from here. The structure of production is not consistent with demand.
The problem isn’t “overinvestment” as Krugman describes in his article. Overinvestment isn’t really a threat because if some private party “overinvests” they must save to do so. They must sacrifice present goods for future goods. If they get it wrong that is entrepreneurial error.
12. August 2009 at 20:40
Yes but the Austrian mechanism describes HOW money can have short-term effects and be neutral in the long-run. Namely the short-run effects arise from interest-rate differential and that the formation of inflation eventually nulls that. For a hundred year old theory; I think that’s a contribution.
So then we agree that it would good if the Austrian approach explained them. Which it does good.
I don’t agree. Capital is essentially nonexistent in the Keynesian model. Most other models lack a sectoral distinctions or do not link them to ‘i’.
My annoyance is that the roots of ABCT are from the late 1800s. There are pretty clear refinements with Mises and Hayek but this barely gets us into the 1930s. I’d like to think we have advanced since then. There are some useful ideas, and then there is rubbish. People can point out the rubbish–liquidation costs for instance, but they get far too uppity. Mises deserved a lot more respect than he got–so I’m testy about this but please, we shouldn’t be combing the pages of the GT for insight just as we shouldn’t be combing the ToMC.
13. August 2009 at 00:23
Jon,
How do you do quotes like that on this forum?
13. August 2009 at 05:43
Current: use the html style blockquote tag
13. August 2009 at 06:30
Thanks for the info Current. My interest is primarily the monetary part of the cycle. I’m not too concerned with supply side issues.
Jon, I think other theories of money neutrality have generally assumed that prices are sticky in the short run and flexible in the long run. I like that much better than the interest rate view, because interest rates are a very poor indicator of the stance of monetary policy.
I don’t like the Austrian view of lags anymore than the monetarist view. They both assume that markets aren’t efficient.
On you third point, all the Keynesian and monetarist theories I’ve ever seen imply investment is highly procyclical. Keynes thought changes in investment due to animal spirits drove business cycles. There is also the accelerationist hypothesis. Friedman argued that investment was procyclical because of the permanent income theory. I know less about RBC theories, but I think they also imply procyclical investment
I don’t know as much about Austrian theory as you do, but so far no one has been able to package Austrian ideas in a way that makes them appealing to mainstream economists. At the same time, I have been unable to package my ideas in a way that makes them appealing to mainstream economists. So who am I to throw stones?
13. August 2009 at 16:20
Scott: “They both assume that markets aren’t efficient.”
No, not really.
We assume that participants in the market for loanable funds can’t tell what disturbance in the interest rate are caused by injection of newly created money and which aren’t. We assume that it isn’t always (though it is sometimes) possible for a supplier to tell if an increase in demand for their good is caused by a relative effect or by an increase in the money supply. Lastly, we assume that no economic agent can discern the structure of production in a quantitative way.
However, if people *could* see those changes we would expect no cycle.
14. August 2009 at 04:19
Current; You said;
“We assume that participants in the market for loanable funds can’t tell what disturbance in the interest rate are caused by injection of newly created money and which aren’t.”
Well then Austrians can’t blame the Fed for setting rates at low levels in 2003, because they have no way of knowing that the low rates were caused by the Fed. I agree, but Austrians don’t seem to agree with you.
14. August 2009 at 06:01
*I* do not assume this at all–again this is part of the liquidation add-on for which I find no evidence of having been a a part of the capital structure theory. Indeed what I find is Mises saying that he cannot get this piece to fit in the underlying theory.
I think the investments during the boom are perfectly profitable and not loss making. The participants need not be fooled to rationally respond to the signal. Its the people who forgo the investment boom that get shafted.
14. August 2009 at 07:21
Scott: “Well then Austrians can’t blame the Fed for setting rates at low levels in 2003, because they have no way of knowing that the low rates were caused by the Fed. I agree, but Austrians don’t seem to agree with you.”
This comes back to this problem about the EMH. Mises said that economists can’t predict when crashes will occur. They can only point out what policies are likely to cause crashes. Mises wasn’t very consistent on this point since he occasionally expressed opinions. I think Hayek was the same.
Bill Woolsey and I had this disagreement with Barkley Rosser and Greg Ransom in May. See:
http://austrianeconomists.typepad.com/weblog/2009/05/despite-the-enormity-of-recent-events-the-principles-of-economics-are-largely-unchanged.html
The basic question here is “Can economists know better than the market about the implications of economic theory”?
In my opinion this question is a difficult one.
Is “The Theory of Money and Credit” common knowledge which is already worked into the market price of stocks? Are the implications of posts on TheMoneyIllusion already discounted in the currency market?
I don’t have a good answer to this myself.
Jon: “*I* do not assume this at all-again this is part of the liquidation add-on for which I find no evidence of having been a a part of the capital structure theory. Indeed what I find is Mises saying that he cannot get this piece to fit in the underlying theory.
I think the investments during the boom are perfectly profitable and not loss making. The participants need not be fooled to rationally respond to the signal. Its the people who forgo the investment boom that get shafted.”
I don’t really understand you. I think that you are proposing a variant of ABCT. But I can’t really understand it well from a few posts here.
Surely if the people who forgo investment are the ones who lose we must ask “why did they lose”? What was hidden to them?
17. August 2009 at 00:05
Jon, I am coming at this several days later, so I forget the point of you insisting the investments could be profitable. I get the impression that some Austrian theories imply investors are irrational during the bubble phase, but some Austrians deny this.
Current; You said;
“This comes back to this problem about the EMH. Mises said that economists can’t predict when crashes will occur. They can only point out what policies are likely to cause crashes. Mises wasn’t very consistent on this point since he occasionally expressed opinions. I think Hayek was the same.”
What I said was worse than not predicting the time of the crash, if it’s hard to interpret interest rates (and you’re right it is hard) then it’s even hard to know when policy is off course. This is where I keep coming back to NGDP growth, which is what I think is the best indicator of whether Fed policy is off course. By that indicator it was the 2004-06 period that was too expansionary. Yes rates were low in 2002 and early 2003, but that reflected economic weakness.
You asked:
“Are the implications of posts on TheMoneyIllusion already discounted in the currency market?”
People are going to think this weird, but I’d argue yes. The reason is becasue I take my marching orders from the market. I only think inflation is likely to stay low because the TIPS spreads say so. I only think monetary policy can be effective in a liquidity trap because the markets say so (as they responded strongly to modest easing in December and March.) So I think the ideas in this blog are priced into the markets.
17. August 2009 at 03:45
Scott: “What I said was worse than not predicting the time of the crash, if it’s hard to interpret interest rates (and you’re right it is hard) then it’s even hard to know when policy is off course. This is where I keep coming back to NGDP growth, which is what I think is the best indicator of whether Fed policy is off course. By that indicator it was the 2004-06 period that was too expansionary. Yes rates were low in 2002 and early 2003, but that reflected economic weakness.”
I see your point. I’m not pro prediction-making from interest rates.
Scott: “People are going to think this weird, but I’d argue yes. The reason is becasue I take my marching orders from the market. I only think inflation is likely to stay low because the TIPS spreads say so. I only think monetary policy can be effective in a liquidity trap because the markets say so (as they responded strongly to modest easing in December and March.) So I think the ideas in this blog are priced into the markets.”
What I mean is “are the implications of your theories discounted”? Surely that’s a different thing than saying that your predictions come from the market.
Let me put it this way. There are some economic theories that say that market prices cannot be used as you believe they can in monetary policy. There is yours that say that they can. Has the market looked at those rival theories and incorporated it’s view of which is correct in market prices of securities?
The problem I’m pointing at here is that there is a vast amount of publically available knowledge that is really very obscure.
19. August 2009 at 02:48
Current, If I understand you right, you are asking if my theories are priced in, not just my predictions. I’d still say yes, indeed one of my two examples was a sort of theory. It is a theory to say monetary policy can still be effective at zero rates. Lots of Keynesians disagree. But I think the market agrees with me.
19. August 2009 at 03:28
That’s an interesting point of view.
The problem I’m intending to highlight here is that obscure theories may have a great amount of effect on future business. This is one reason why the EMH seems a little odd to me.
For example, when the first papers came out describing optical-fibre would the implications of them be marked into the price of businesses offering competing communications media? I think the answer to that is probably no.
23. August 2009 at 08:28
I don’t think that the EMH is a statement about individuals. So I don’t really understand this question. I’m sure some liquidation losses occur; it just isn’t obvious that there is aggregate net loss after account for the proceeding years of ‘boom’.
The basis of Austrian Capital theory comes from Menger (first, robust marginal pricing theory), Böhm-Bawerk, Wieser, and Schumpeter (detailed study of cycles as the result of disturbances from Walrasian equilibrium). Many people read Mises without having read those that proceeded him.
His statements are deductions from a greater body of theory… theory which does not really have tools to conclude that liquidation losses are at the heart of business cycles.
23. August 2009 at 13:43
As I understand the EMH it’s about the great difficulty of beating the market. What I mean is, you write:
My question is: if this is the case why do others know something that those who forgo investment don’t? Scotts, point is appropriate here. Austrian economists give reason why people don’t know that unsustainable booms are going on and therefore can’t plan around them. What’s your reason for making the split you describe where those who forgo investing lose. What do you mean by forgoing investment anyway? Do you mean hold cash for the entire cycle or do you mean holding bonds or interest bearing savings accounts?
I know that Mises does not precisely follow Menger, Bohm-Bawerk and Wieser. But I don’t see how this makes him wrong. What is it that doesn’t follow?
23. August 2009 at 21:35
Individuals lose. Society (as an aggregate) does not. Which is why a passive strategy, such as index investing, wins. You follow society, you win.
People interpret information differently. A competitive economic system is an optimization engine. The dynamics of how it performs optimization is not relevant if you accept the EMH. The EMH is a statement that the economic system optimizes.
Consequently, even though there are individuals who act differently from the consensus, society still comes out ahead.
I’m not saying Mises is wrong. I’m saying that certain claims of his follow from the greater body of “Austrian” work. Other claims, particularly the liquidation cost theory–whether or not they are true or otherwise supported–do not rest upon those same immediate foundations. Certain people are wont to pull at this one leg of commentary in Human Action and then declare victory against the Austrian theory generally. This is wrong, and it mistakes the periphery for the core.
The liquidation theory is a narrative. It is not a deduction from a broader theory per se except in as it incorporates the prior Austrian (capital) theory of how money exerts short-term real effects as the beginning of that narrative.
23. August 2009 at 23:02
Current, You said;
“For example, when the first papers came out describing optical-fibre would the implications of them be marked into the price of businesses offering competing communications media? I think the answer to that is probably no.”
If not, then there was a great investment opportunity awaiting you. Sell the fiber optics competitors short.
Jon, Don’t forget to identify who you are quoting.
24. August 2009 at 04:02
Exactly. The situation I described was historical. However, from time-to-time such situations do occur. When they do occur engineers who are very involved in the industry are in a good position to make money by speculating on them and sometimes do that.
Specialist knowledge may be “public” or “private”. But there are parts of “public domain” knowledge that require so much specialist interpretation that they aren’t really public in the normal sense.
24. August 2009 at 07:42
Jon,
I find your post confusing. I don’t understand what you’re trying to say.
What situation are you talking about here? Investment? If so how does that relate to our discussion about business cycles?
If you are talking about business cycles then I don’t understand you. If “society (as an aggregate) does not” lose then obviously there will be no recession.
Fair enough, I agree. What I was criticizing above wasn’t so much the EMH’s conclusions but more how they are arrived at.
Yes, I’d agree with you there.
All economic theories are “narratives” to some extent. ABCT is only similar in that regard to other theories. That theory integrates Mises’ theory of money with Austrian Capital theory. But Mises theory of money is derived from marginalist principles.
I agree that Mises mistakes don’t necessarily reflect on Menger or Bohm-Bawerk.
24. August 2009 at 20:21
Current says:
I’m saying that the EMH allows me to say ‘individuals lose’ while also saying ‘society wins’. Therefore, I can agree that there are liquidation loses without agreeing that society’s overall liquidation losses exceed society’s overall excess return during the boom.
So when you say I need to explain “why do others know something that those who forgo investment don’t?”. The premise of the EMH is that this is irrelevant. The question is whether people are systematically ‘fooled’. The EMH premise is that they are not.
Current states:
Well sure. But there is a pattern of reasoning: start with what’s agreed upon and then deduce new principles. The broader work of Austrian capital structure theory falls into this category.
Latter developments in ABCT, particularly what I have called the liquidation narrative, are merely assertions. Its not a conclusion from a broader model.
The capital structure theory allows me to deduce that an expansion of money that depresses the interest-rate leads to a sectoral shift (that eventually inducts an inflation which restores the interest-rate rate and reverses the sectoral shift). i.e., money has real effects in the short-run. This is really an amazing contribution when you realize that it occurred in the late 1800s. What’s critical here is my claim of deduction.
The liquidation theory is just an assertion. Austrian capital structure theory itself offers nothing that would explain a persistent pattern of error. Mises furnishes none himself either… partially this reflects his distaste for econometrics. This isn’t to say the liquidation theory is wrong, only that it less substantiated than other claims such as the sectoral shift just discussed.
25. August 2009 at 00:35
Remember that misallocation does not occur during the bust, it occurs during the boom. How then are there “excess returns” during the boom?
Also, how can there fail to be an overall loss due to liquidation? What liquidation means is that assets must be moved to another purpose. Obviously that purpose must be less useful to society or they would already have been used for that purpose in the first place.
At the end of this bit you say “The EMH premise is that people are not systematically fooled”. But above you have said that you think those who forego investing are systematically fooled.
There are a few things in Rothbard and Mises that are assertions. The idea that whatever size the recession is afterwards is necessary. Also, I think the idea of “purging” deflation.
However liquidation is most certainly part of the theory. Read Roger Garrison he is much more explicit about this.
If the capital triangle is expanded into the kinked shape Roger Garrison describes in his slides then losses are inevitable. Not only losses to individuals but also losses to wider society.
http://www.auburn.edu/~garriro/cbm.ppt
Austrian capital structure theory does explain a persistent pattern of errors. Errors occur because production structure is not visible and observable. It is hard to distinguish a sustainable production structure from an unsustainable one.
If you think Mises went wrong with liquidation perhaps you could explain which specific bits you think are wrong.
26. August 2009 at 20:26
Current:
You continue to confuse groups of people with society as a whole. Your argument then relies on a false dichotomy. Some people groups maybe be systematically fooled into making mistakes–some people are just bad investors, but that is the same as concluding that on the balance society is fooled.
This leads to the crux of EMH critique of the liquidation theory. Yes, changes in the interest-rate may fool some of the people… it may even fool all of the people for a time, but it cannot repeatedly fool all of the people.
Current writes:
No, the capital structure only explains why different industries are more or less interest-rate sensitive. Again, this is a big contribution in 1888. I don’t want to demean it, but its only a component of the argument. The people is that if there is a real-divergence in the interest-rate, monetary policy has real-effects even if the effects are null in the long-term. It took nearly 100 years for mainstream economics to rediscover this point.
So… what’s the evidence for the claim that society, on the net significantly mistakes an unsustainable production process–particularly evidence that excludes other theories? Its the dominance of the effect that’s in question.
27. August 2009 at 00:59
So, those who don’t invest when the expansion begins are just bad investors? I suppose that’s reasonable.
In some cases you are right. But, as Mises wrote, the task is to explain the causes of those business cycles that do occur.
No it doesn’t. Certainly capital structure does explain why different industries are more of less interest rate sensitive. But, there is much more to it than that.
It shows that only if the interest rate is determined by the market for savings and investment will the capital structure be sustainable. Monetary expansion will produce an unsustainable capital structure.
What is your argument against that? It is quite clearly explained in Hayek and Mises.
I assume you mean “point” rather than “people”. If so, then, I agree. Of course it’s very unlikely that the effects will be null in the long term.
I agree with you that this is the main problem. Regarding other theories I think that the problem is that the other theories don’t really make sense.
27. August 2009 at 02:24
Current, I agree that insiders occasionally have information that is helpful. I thought you were referring to something that almost anyone could go out and ascertain. But it is because all these insiders have information, and trade on it, that prices gradually get nudged to their appropriate level. Does it work perfectly? Far from it. But well enough that it is awfully hard to outpredict the market, even if you have a bit of inside information.
27. August 2009 at 16:42
Current:
I realized that I haven’t been clear. I agree that distribution of production is not sustainable–indeed, money is neutral in the long-run.
The question is whether this liquidation entails a social cost that outways the returns earned during the boom. This is the sticking point with the EMH.
28. August 2009 at 01:19
Yes. I mostly agree with what you’ve said, that is the normal situation that EMH discusses. Note that a “bit of inside information” may be useful on average. Because we are theorizing that the well known information is already accounted for in the price. However, I’ll come on to this.
My point though was a little different. In the thread where we were arguing about Hayek you explained why you want to know about the policy prescriptions of earlier economists. To you it is a way of breaking through the problems of interpreting their work in the context of the time.
The study of these sorts of problems of interpretation is called “hermeneutics”. I don’t know a whole lot about it. Despite what some post-modernist claim it doesn’t necessarily lead to a perspective of radical scepticism.
I do know a few of the basics of this though. When we read something, or hear something we must interpret it in accordance with what we know. The meaning of the words in the language we speak, for example. When we read an argument it is difficult to understand it without knowing both sides of the argument. The way some people explain it is to compare it to an object in the physical world. To see it we must place it in front of a background that provides a comparison. A black object can’t be seen on a black canvas, and nor can a chameleon be seen in it’s natural habitat.
Any particular fact or piece of information about the world may infer something for the market price of a company. However, a background is necessary to interpret the fact. This is where the problem with public and private information comes in. It may be, for example, that a fact is well known to all market participants, but only a few of them know how to interpret that fact. Books about making money from the stock market often claim that this is the situation. Anthony Bolton says in his book that only a person who is familiar with the markets is in a position to use facts about them properly.
What I’m arguing here is that the conclusion of the EMH may be correct. But I think the logic behind it is suspect.
28. August 2009 at 04:45
The boom which ABCT concerns itself with isn’t the result of normal growth. It’s the eventual result of cheap credit created by central bank actions. There are no real overall returns earnt from this boom. It is purely destructive.
Misallocation occurs during the boom, it is revealed by the bust. Have a look at the Garrison slide show I linked to above. Garrison is more clear on this than most of the earlier books on Austrian economics.
28. August 2009 at 16:01
Current: You cannot just so cavalierly make those statements. Here is a narrative that would be consistent with the EMH but closer to your claim:
The economy is in a equilibrium state. From the EMH, we assume that the distribution of goods is optimal. A depression of the real-rate then leads to a boom in the capital-goods industry. This is, by nature, a mis-allocation of resources which eventually leads to rising inflation and the long-run neutrality of money. Money does have long-run effects, therefore we can believe this portion of the story to be true on that account.
Once this occurs the resource mis-allocation unwinds. There are some costs to doing so; however, business cycles are a persistent phenomena. Therefore, under the EMH, we can assume that participants in this boom will earn an excess return that covers the liquidation costs.
Because the reallocation of goods is suboptimal, during the progress of the boom real productivity falls. Therefore RGDP is falling. This not apparent in NGDP because inflation is increasing.
These losses are borne instead by holders of fixed-income assets (including the central bank) who experience an unexpected rate of inflation and a decline in the notional value of their assets–i.e., they face an unexpected inflation tax that funds the payoffs of those who participate in the boom.
The recession arises from the productivity shock.
28. August 2009 at 16:03
I meant money does not have long-run effects…
29. August 2009 at 20:18
Current, You said;
“What I’m arguing here is that the conclusion of the EMH may be correct. But I think the logic behind it is suspect.”
I am sympathetic to this point. I don’t see any way the EMH could work perfectly, otherwise no one would have an incentive to collect the information needed to make it work. So it must be an approximation of reality, at best. I also liked your comments about hermeneutics. Because I am self-taught (auto-didact?) there are big gaps in my knowledge, indeed I only had a fuzzy idea of what that word meant, as I generally infer meaning from context. I just picked up a smattering of philosophy here and there. I have read a bit of post-modernism, but not enough to talk about it intelligently.
30. August 2009 at 05:01
I’m self-taught about these things too.
I agree that the EMH can’t work perfectly. I mostly agree with what you’ve written in your reply.
Markets agglomerate information. Each agent acts on their own local information though in it’s local context with their own knowledge about background. I think the important thing is that this process is more efficient than centralised processes. So, a good argument for it would be something like Hayek’s price-signalling argument in the socialist calculation debate.
Greg Ransom has mentioned on his blog that there is some work going on to make a theory that works this way. It will probably end up something like the EMH, but with some different conclusions.
Barkley Rosser has pointed out that the EMH conclusion may not be true if the background of all agents is the same. This is rather like Mike Sproul’s criticism of my comments in the other thread. He says that the newspapers don’t print the assets of central banks because everyone believes the Quantity Theory. Similarly, Nassem Taleb says that everyone believed that Gaussian coppola functions modelled risk. I think that the specific criticisms these three make are all wrong. However, I think that there is a theoretical possibility that these sort of background knowledge problems may apply.
2. September 2009 at 15:26
Current, Those are reasonable ways of looking at things. But I share your skepticism about all agents having the same views, I see quite a diversity of views out there, which I think is healthy.
26. September 2009 at 07:38
You are so right. I’ve been saying the same thing for 15 years. The two primary fears about money creation, i.e. the federal debt is unsustainable and large deficits cause inflation, simply are not supported by history.
See: http://rodgermmitchell.wordpress.com/2009/09/07/introduction/ and http://rodgermmitchell.wordpress.com/
Rodger Malcolm Mitchell
27. September 2009 at 10:48
Thanks Rodger, I am more worried about debts than you are, but I agree that policy right now is too contractionary.
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