mercoledì 8 settembre 2010

Are average wages rising during the bust?

Stefan Karlsson on his blog claims that wage cuts would help speed up recovery and reduce unemployment, and that wages have been rising in the last years, despite the recession.

Data from Fed Fred, the datasets AHECONS, AHETPI, AHEMAN, e UNEMPLOY (average hourly earnings for construction, private sector and manufacturing, and total unemployed, respectively) show that the wages have really been on the rise.

However, there may be a large component of sample selection bias in the data.

People may have been fired in larger numbers among low-skilled workers than skilled ones, so that the average salary may have risen not because people are gaining more, but because the distribution of earnings has changed. This truncation in the data may cause an artifact.

Arguments in favor of my analysis:

  • It is usually the case that unemployment increases more among the poorer, or younger, workers. Maybe because of minimum wage laws, maybe because of the specific human capital embedded in skilled workers, which would hamper the company's productivity.
  • The effect has been stronger on construction workers, despite the crisis, than on average: but construction workers have also shrank in numbers much more than in other sectors, making the sample bias potentially more relevant.
  • Most of the increase has occurred when unemployment was rising, and the sample bias problem was thus stronger. Now the increase has settled.

However, the effect remains, so that real wages, instead of shrinking, are constant (or slightly rising: CPI growth is lower), and unemployment has become higher, and, what's worse from the worker's point of view, it lasts longer on average.

So, we are probably experiencing a little bit of Hooverian "don't cut wages" non-sense. But why? There shouldn't be strong unions in the US up to now, except in sectors such as steel or automotive. May it be that many workers have now, after the recession, lower than minimum wage productivity?

domenica 25 luglio 2010

ABCT and ratex again

I wrote a comment here:

Cowen's argument shows a part of ABCT that is not sufficiently explicit and as long as it won't be explicitly microfounded it won't convince many economists.

A similar argument was proposed by Lachmann against Mises in 1943. Mises answered that error clusters were an empirical generalization, i.e., he considered the criticism to be irrelevant (cfr Garrison in "Time and money") because the alternative was too unlikely.

However, this implies that the theoretical link between monetary expansion (in terms or M or MV or whatever, it's immaterial) and error clusters is not theoretically well founded, but only a likely empirical assumption.

Now, I find it more convincing to neglect ratex because they are unlikely instead of neglecting an obvious fact because it has not been shown to be apriori necessary, but the problem exists anyway.

Let's try an answer based on four elements:
  1. Mises's conception of money as a coordination device ("The nonneutrality of money")
  2. Carilli and Dempster's prisoner's dilemma model.
  3. O'Driscoll's focus on coordination problems
  4. Garrison's analysis of the role of moral hazard in booms.
The argument should run as follows:
  1. Monetary policy has redistributive effects
  2. The competitive market process under these externalities does not lead to efficient outcomes
  3. Malinvesting creates profit opportunities, because the individually rational strategy is to participate on the victor's side in the redistributive game
  4. Not malinvesting is a superior outcome, but it is a prisoner's dilemma and it is unlikely that it can be put in practise because competitive pressures will remove conservative entrepreneurs from the market during the boom
  5. No one in the market knows the right solution, but prices signal and incentivise malinvestments
  6. Avoiding herding behavior is a tragedy of the commons because no single entrepreneur contributes to systemic fragility, but every entrepreneur can profit out of it by malinvesting, and suffers losses if he wants to avoid malinvesting (under socialized costs, everybody pays other people's costs, but only adding to malinvestment it is possible to gain profits).
  7. As long as herding doesn't occur on a mass scale, malinvesting is safe, especially if central banks are active in avoiding recessions.
  8. The only strategy to avoid losses is to escape the capital intensive sectors because they will fail during the recession (if central banks are not effective in socializing costs through countercylical means), and escape labor-intensive sectors because resources will be bid toward the other sectors during the boom.
  9. Autarky is the only real solution, but it is so inefficient that inefficient boom/Bust cycles are a superior alternative also when great depressions are likely. It is better to play a vicious game than not to play at all. Avoiding the externality and cost socialization effects of activist monetary policy would largely remove the viciousness of the game, resulting in a first best solution.

sabato 24 luglio 2010

Cowen's "Risk and business cycle": a stocktaking.

Cowen's critique is the most thorough critical analysis of ABCT. Compared with Wagner's, Yeager's, Leijonhufvud's, Caplan's and Tullock's is probably the most interesting, and surely the most complete.

Here are his key points (there are other critiques, but I prefer these because they appear more relevant):

1. Why do consumption and investment comove during the boom and bust?
2. Why are interest rates so effective in causing malinvestment?
3. Why do entrepreneurs commit non-random, but biased, errors during the boom?
4. Why do central banks play a key role in miscoordination, whereas the market may be inherently unstable on its own terms?
5. Why does finance play no role in Austrian theorizing?

Point 1 requires a theory of overproduction, such as the one in Time and Money by Garrison. Machlup wrote something about capital consumption, and Hayek sometimes talked about the topic. Mises talked about overconsumption without defining the concept and justifying its possibility. I think the critique can be answered, but a convincing answer has not been found yet. Hayek went the wrong direction claiming that consumption falls during the boom through forced savings, but this is utterly incredible.

I don't get point 2. It appears that interest rate movements in neoclassical models do not have large effects... but this is due to the fact that money is useless in those models. However, the effectiveness of monetary policy in creating malinvestment relies on the potency of its transmission channels, and I don't know if a proper answer has been found to this objection.

Point 3 is about ratex. The standard Austrian answer is that ratex don't hold, but the only justification is Carilli and Dempter's prisoner dilemma argument. More can be done to analyse the issue: the result will surely focus on coordination problems (O'Driscoll's book is key), prisoner's dilemmas (Carilli & Dempster), and the role of money in coordination (Mises). Although I agree with this line of argument, Hayek's attempt to give a thorough microfoundation to the issue failed because of excessive complexity (he never wrote part two of The pure theory because of this).

I think that neoclassical economics don't get the foundation of the argument: a direct attack to Lucas's "signal extraction" view of money is required. Money is not (only) a signal, it is purchasing power: those who get it have higher spending power, and draw real resources away from others. This is an externality: externalities beget prisoner's dilemmas to be effectively counteracted, and this creates coordination problems. Translated into "neoclassical" words the argument may become more appealing.

Point 4 is based on a misperception of the Austrian literature: central banks are not required for intertemporal disequilibrium, they just enhance them. I don't know if banks can learn to avoid boom/bust cycles if left alone, but I'm sure that if they are shielded from the consequences of their own errors they will never learn, and cycles will be longer, deeper and more harmful.

Point 5 is a mystery. Except for sparse notes by Mises and Hayek on credit money, a book by Machlup whose focus was not business cycles, a paper by Antony Mueller (2001, QJAE), some notes by Chester Phillips and Strigl... I found no thorough analysis of finance in Austrian cycle theory. There is too much focus on money and not enough on credit: I'm convinced that financial accelerator models should be included in ABCT to make it a more complete theory. Cowen does something to solve this problem. Money is important in ABCT becasue it distorts the credit creation process, and monetary theory is important because it must explain how money affects market coordination through the credit market. Otherwise, ABCT would be a strand of monetarism. In my view, it is much closer to credit channel theories, such as Stiglitz, Bernanke, Geltler, Irving Fisher...

Despite, relative to other critics, Cowen has a fairly good understanding of ABCT, he sometimes wastes time on irrelevant arguments which make sense only within a homogeneous-goods theoretical framework. For instance, he says that entrepreneurs may react to an increase in loanable funds and interpret it as a fall in the demand for loans (i.e., a crisis). The underlying argument is that the fall in the demand for loans gives information about a fall in real returns and bad conditions. The problem is: who cares? I can make profits by increasing my investments, the world is too complex to interpret the result as either a variation of savings, of demand for loans, or an increase in fiduciary credit. The entrepreneur only knows that he can make an easy profit, or that competition will force him to act in that way. Cowen sometimes falls prey to macroeconomic habits of mind: the problem with macro is that it doesn't exist.

Interpretation of price signals to obtain information about the state of the economy is only possible in very simple frameworks (like those analyzed by Lucas, Stiglitz, Cowen) in which reality is so stylized that every signal can mean only one thing. In the real world entrepreneurs don't recreate the structure of the economy through monetary calculation, they only see if there are profits or losses in behaving in a certain way. Bayesian inference is not powerful when there are thousands of possible causes of the same effect.

A point in Cowen's arguments that strike me as absurd is when he claims that savings are stable during the business cycle. So, consumption is stable, savings are stable, GDP varies, but, national income identities assure us that GDP = Consumption + Savings + Taxes + Imports. Where's the variance in GDP? Probably Cowen is confusing personal savings and overall savings: I don't have data (I should check on Fred), but probably savings have the same variance of investments (very high), otherwise cycles could be only caused by large shifts in taxes and imports...

His pars construens is much worse than the critical part, however. He tries to build an efficient investment frontier along which the economy moves due to monetary policy, and higher growth is traded off with higher instability. In my opinion, it is the INEFFICIENCY of risk taking during booms that is the key aspect of business cycle theory, the economy trades off risk for nothing. Real growth just hides the unsustainability of malinvestment and misintermediation by soothing the inflationary impact of unsustainable policies. Booms during periods of technological progress last longer and are more dangerous.

Cowen's arguments are a good starting point to:
  1. Translate ABCT in comprehensible terms
  2. Add a financial dimension to ABCT
  3. Highlighting the critical points of ABCT
  4. Comparing ABCT with present-day theorizing
  5. Focusing on the role of risk
Although I haven't like the pars construens, I recognize that the pars destruens and the issues which are discussed are very important. Austrians' reaction to Cowen's book has not been constructive.

PS I forgot to mention that using Carilli and Dempster's paper to claim that Cowen is wrong implies a temporal error: that paper came four years later than Cowen's book. I'm a terrible philologist.

martedì 6 luglio 2010

Costs of deflation

I posted it as a comment to the previous thread.

Which are the sources of the costs of deflation?

1. Floor on interest rates
2. Destruction of credit
3. Price rigidities
4. Coordination problems

Let's see them in detail.

1. Floor on interest rates

The minimum nominal interest rate is 0%. It doesn't make any sense to pay less, because holding money is better than lending and losing it, although Mises said the contrary in Human Action.

If prices are stable, the minimum real rate is 0%. If prices are rising, the minimum real rate is higher than zero, so that by cutting nominal rates you can manage to have negative real rates, as we have now in Europe, especially Eastern Europe.

However, if prices fall, there is a minimum floor on the real rate, for instance 10%, equal to the deflation rate. This means that no credit contract between lenders and borrowers at less than 10% (real) can be made. This is equivalent to a floor on a price, and causes excess demand (people save, but no one invests) because it is non-market clearing price.

The appropriate theory here is that of price caps and floors, such as Mises's theory of interventionism, although it has nothing to do with interventionism strictu sensu.

It is wrong to argue that this cannot happen because an increase in consumer spending and a reduction in investment would reduce deflation. This process is by itself a recession.

2. Destruction of credit

Asset deflation (not price deflation) causes a reduction of asset values and nominal wealth, which may cause a reduction in lending. For instance, if I need a collateral to assure my lenders that I'm creditworthy (as in credit channel models of asymmetric information) the reduction in collateral value creates problems to me. However, this is at least partially compensated by the fact that also assets to buy are cheaper, so I can invest with less money, and production yields higher returns which foster higher investments.

A more serious trouble is that the banking crisis yields a destruction in bank credit, and the financial crisis yields deleveraging, i.e., a destruction of nonbank credit. In this case, the opposite effect of credit creation occurs: firms suffer a dearth in purchasing power and have no resources to invest. This phenomonenon was described by Strigl in "Capital and production" in 1934. The crisis destroys bank and nonbank credit, not banknotes, so this shift causes a reduction in the firms' purchasing power.

3. Price rigidities

Of course, price rigidities play a role. Normally a short-run role, but it depends on the structure of markets. For instance, if there are more unions, especially with coercive power, there are more rigidities. The same is true if the market is heavily regulated. In this case, unemployment can last forevere and an underemployment equilibrium can arise, as in Southern Italy, or East Germany, or the US during Hoover and Roosevelt.

4. Coordination problems

The banking panic is, well, a panic. The panic destroys habits and information, it makes market coordination more difficult, disrupting normal relations. The apex of the crisis is a moment of disorientation for the whole market, which can last (under normal conditions) several months. Because all price relations need to be rethought, and because relative prices need to change, the fact that also absolute prices change adds to the problem, especially if price rigidities cause relative price distortions by keeping some markets from clearing.

Besides, deflation may foster political problems, which we may call, following Robert Higgs, "Regime uncertainty".

lunedì 5 luglio 2010

Deflation, no pros, but almost inevitable.

I wrote a comment on this post by Prof. Rizzo.

I just add a note: when I say "normal market response" I don't mean it is good because it is natural, but that it is inevitable.

There are a couple of differences in the Austrian and Monetary Equilibrium frameworks I have to check, I'm reading Yeager now, before forming my own informed opinion. Here's the comment:

Prof. Rizzo:

“While some distortion may be introduced by anti-deflationary monetary policy, this pales in comparison with the catastrophe of outright, significant and prolonged deflation.”

I’m worried of entering a heated and verbose discussion, given the risk of appearing a troll, but I disagree. I’m also worried because my contribution is verbose, too.

1. I consider the extension of the financial system (monetary multipliers included) to be a mainly endogenous phenomenon, given external constraints like the supply of gold or the monetary policy function of the Fed. If the boom causes the financial and banking system to overshoot, the recession needs to check and counteract this overexpansion. This has been called deleveraging: from a monetary point of view, however, it is deflation. It is endogenous to the business cycle, thus it is a normal market response, although painful.

2. The fear of deflation appears to be mainly based on a single event: the Great Depression. The 1873 depression hardly existed in real terms (I downloaded some paper on the subject on JSTOR, but I haven’t read them thoroughly yet), or the 1920 recession, which was severe but short-lived (I don’t know much about XIX recessions). I base my analysis on Cole and Ohanian’s papers: a historical unicum calls for a specific explanation, i.e., an exception to general models.

Given (1), I’d consider impossible for an economic system whose “normal” monetary multiplier is ten, which however during the boom overshooted to twenty, to do without deflation. I generalize this: the same is true for financial leverage and many others risk indicators, it is true for both banks and shadow-banks, because it is a credit problem and not a money problem. This secondary depression is likely to have a greater real effect than the mere liquidation of malinvestment, as said by Strigl in “Capital and production”, and by Hayek. But it is a short-lived phenomenon, the Great Depression excluded.

So, what can be done to avoid deflation? Monetary equilibrium analysis assumes that the problem is an excess demand for money, but the problem at the peak of a long boom is an excess of almost everything: risks, leverage, mismatches, malinvestment, malintermediation… M1 is too high with respect to M0, M2 is too high with respect to M1: the recession brings normalcy to these aggregates.

Friedman and Schwartz had a similar opinion: in “Monetary history of the US” they argued that the Fed, by guaranteeing liquidity to the national banks, succeeded in increasing the efficiency of gold use, albeit at the cost of increasing the fragility of the whole financial edifice. If something has risen too much, it needs to fall.

So, I reach point (2). I’m convinced that the Great Depression has been a historical unicum: Cole and Ohanian convincingly argued that it was caused by Hoover’s and Roosevelt’s policies of cartelization, sindacalization, nominal wage preservation, etc. This was also Phillips, McManus and Nelson’s thesis (one of them, better) in “Banking the the business cycle” and the beef of the argument against Hoover in Rothbard’s “America’s Great Depression”.

Shall we fear deflation on the basis of the experience of the Great Depression? It depends on which interpretation of its severity and length is correct. I don’t consider it a relevant proof of the dangers of deflation: its persistence had other causes.

Hayek was thus doubly right: in saying that the deflation is painful and in saying that resource mobility is key for a quick recovery: if the latter holds, however, the fear of the former can be greatly relaxed.

mercoledì 19 maggio 2010

Economic data pro and con.

Commenting on these questions posed by Prof. Rizzo on TM I've shown the world I suffer multiple personality disorder. Here's the evidence.

I’m on two minds on the issue because although I recognize that empirical evidence and operational definitions are important, problems in these endeavors are not specific to Austrian economics, as they should be recognized as problems by almost everyone: I know, for instance, of no econometric evidence of monetary non-neutrality (cfr King & Plosser), although I believe that money is always non-neutral.

Anyway, my being on two minds has begotten to contrasting comments.

Comment #1

ABCT has not been proposed as a model so it can’t be directly compared with the data. Only highly aggregate fully specified DSGE models can, and I wouldn’t bet that this comparison with the data is better than playing curve fitting.

However, to look for evidence, I would first look at financial data (there is always plenty of financial data: the credit channel literature is full with econometrics) to check the prociclicality of all financial fragility proxies: financial leverage, maturity mismatch and risk taking. This is the credit creation (and destruction) process at work and it can take millions of different forms (pure bank credit or shadow banking, for instance).

However, credit must be linked to money in order to have ABCT, otherwise it’s Minsky, not Mises. So I would check for the effect of interest rates and monetary aggregates on the financial intermediation proxies. This I think has already been done in the credit channel literature, which I haven’t checked.

Then I would check the structure of production. Unfortunately, I know of only a few papers investigating something similar: Mike Montgomery has shown that capital complementarity explains the lags in the economy’s response to shocks, Mulligan, Wainhouse and Keeler have found something else but I don’t remember the details. It was all about correlations having the expected behavior.

However, it appears that not much evidence is needed to prove that interest-rate sensitive markets are more prone to crises than others, which is all that is required by ABCT: this is a well recognized stylized fact.

Upper and lower turning points cannot be predicted. I would guess that ABCT should predict several years of boom and several months of recessions in standard conditions: that’s what usually happen. There are lots of complicating factors, however: the Japanese ZIRP and Hoover can make things last much longer. I don’t know of anyone capable of predicting turning points, however.

For what concerns the links between monetary, financial and productive data (the third ones are quite scant, because only Austrians are interested in them, while the others are plentiful), data can only show correlations, not causality. So none of these data amounts to corroboration or refutation for any theory.

In few words, Austrians can free ride on the credit channel and look for patterns there. I normally don’t read econometrics papers (it’s deadly boring) and I’ve only seen a few of them, but there are hundreds.

Comment #2

I doubt that the notion of intertemporal disequilibrium can ever be operationalized: it’s not a matter of aggregates but of structures, and structures imply knowledge problems.

Also the notion of monetary non-neutrality has no operational content. All economists can do is to play vector autoregressions and hope noone notices that they prove nothing. The King/Plosser explanation of observed correlations between money and output is as good as any other. There is no empirical evidence that money is non-neutral or neutral, otherwise real business cyclers and new keynesians would have ended their squirmishes decades ago. The problem is empirically undecidable.

While the latter is a problem for all schools of thoughts, the former is a problem only for Austrian economics because others disregard structure. So, let’s disregard money too and all problems are solved. :-)

Efficiency is another notion I don’t know how to apply to reality: it is a property of fully specified models of artifical economies, not something which can be predicated of reality. When I see something, I can never now whether it could have been better without knowing all the alternatives and all the brute data.

Another example is the natural rate of interest: no one knows it. It’s a theoretical construct with no empirical counterpart. This is a problem both with Austrian and New-Keynesian economics. More than a problem, however, I would say it’s an epistemic property of markets.

Another example is taken from my terrible introductory macro textbook (Blanchard), which wanted me to believe that the 1980-1983 recession falsified the rational expectation theory of stagflations. It falsified nothing, as usual with economic data: newclassicals resorted to the makeshift of distinguishing between credible and non-credible disinflationary attempts and saved their theory. It is a blunder to consider ratex a falsifiable hypothesis.

Before concluding, I would add that new keynesian models have been criticized for excessive plasticity: any contrarian data was rationalized by changing some detail in the model. This is what I call “curve fitting theorizing”, which of course it is an oximoron. David Romer had some issue with this in his textbook, too.

Data collection reveals problems, but offers no solutions. Theories which are so rigid in predictions to yield falsifiable results are usually very poor theories. DSGE models are, on the contrary, very rich theories from this point of view. So rich that they can predict everything, by properly specifying the details.

One problem I’ve had is that the Greenspan era has lasted for so long: ABCT without chinese savers and technological innovation would have predicted a crunch in the ’90s, not 20 years of inflationary booms with some minor slowdowns. This is how data can improve theorizing, by showing expectations requiring second thoughts and additions.

Economic theory is not a theory in the sense of natural sciences, but it is like a language. Languages enable understanding, but are never falsified: they are enriched by interaction with new problems.

The distinction between theory (a mere inquiry into logical structure with limited predicted power) and history (the understanding of complexity) will sooner or later become necessary also among the “mainstream”.

lunedì 10 maggio 2010

Capital theory

I discovered today this debate on Coordination Problem regarding capital theory. Don't miss my wondrous comments, of course, but it is a much better idea to ponder prof. Koppl's.

The fact that general equilibrium models which includes even a moderate amount of complexity can have absurdly complex dynamics is, in my opinion, the tombstone of positive economics: general equilibrium theory yields no positive restrictions on the empirical predictions of economic models. This is not a problem of Austrian economics only to the extent that the problem had been already recognized decades ago, as it is the rationale for Mises's distinction between theory (although an emasculated notion of theory indeed) and history (a realm in which we can cast only limited restrictions). Now everybody is clearly stuck in the same mud.

Strangely enough, many Mises's followers are convinced that economic theory can yield relative positive predictions, on purely apriori grounds, but this is not Mises's message: it's wishful thinking. Theory is the logical analysis of the structural properties of economic concepts, it can yield nothing regarding the real world unless it is coupled with some a posteriori proposition regarding the real world. Sometimes these additional hypotheses are so obvious that a priori theory can yield relevant results, but as a rule this is not true.

However, given that it is likely that a deep bath in the ocean of capital theory yields limited and difficult to evaluate insights, and Hayek's late '30s and early '40s writings are the definite proof of the untractable complexity of the subject, what shall we learn out of capital theory, except that we all are too ignorant to grasp it?

Well, I think that the core of capital theory as applied in the Austrian theory of business cycles is the notion of structural unsustainability: the economy may reach an unsatisfactory state from which it can move only by experiencing a recession.

This insight is typical of Austrian economics, and possibly also of Postkeynesian economics. It is remarkably neglected, on the other hand, both by Neoclassical and by Neokeynesian theorists.

I thus need to ask two questions, and divide macroeconomic theories in four classes depending on the answer to the two questions.
  1. Is the economy capable of reaching dead ends, i.e., structurally unsustainable states which make a subsequent recession necessary?
  2. Can government policies solve the problem or make it less severe, or, on the contrary, is the government a relevant factor in making things worse?
From these two questions we derive four different macroeconomic Schools.
  • If the answers are "structural problems don't exist" and "governments shouldn't do anything", it's Neoclassical macroeconomics.
  • If the answers are "structural problems don't exist" and "governments can improve upon the results of the market", it's Neokeynesian macroeconomics.
  • If the answers are "structural problems exist" and "governments can improve upon the results of the market" it's Postkeynesian macroeconomics.
  • If the answers are "structural problems exist" and "governments shouldn't do anything", it's Austrian macroeconomics.
The proper domain for Austrian macroeconomics is thus the notion of structurally unsustainable market dynamics driven by policy-induced market miscoordination. All the theories with this logical structure are to be considered a variant of the more standard Austrian theory of business cycles.

Policy-induced miscoordination is usually due to monetary factors, but it need not be so in general: most likely, however, money is the only factor which has sufficient scope to cause market-wide distortions.

Capital-structure problems are the usual notion of structural unsustainability in Austrian theory, but it need not be so: the financial structure is likely to be capable of the very same dynamics that Austrian economists traditionally impute to capital malinvestment.

Thus spoke Pietro M. (it's my research agenda for the next three or four centuries, depending on my spare time)

lunedì 3 maggio 2010

Anarchy in rubbish collection

Very interesting post on a blog I didn't know of since a couple of days ago (I love the subtitle). There's a comment of mine which is quite abstract but I hope interesting. It's an application of Austrian institutionalism, let's say, a theory I don't know much about (I've always focused on the business cycle). Let's see it as Menger's theory of money: first came private money, then government seized it. First come social rules, than government power seizes it. To believe in the creation of money and rules by government fiat is constructivism. However, the comment was a little difference: it was about the "natural history of the growth of power", very jouvenelian.

"Very nice post.

Starting from a situation of no formal institution and no informal rules of conduct, which might be called anomy, there are instances in which the latter form much earlier than the former.

The economic organization of the POW camp saw cigarettes becoming the foundation of a price system quite naturally. Nigerian scavengers show the same pattern, as examples I've heard about of self-generated rules, regulations and entire legal systems (maybe the Law Merchants).

But freedom is a public good: it benefits everyone, but none in particular. Wait some time and a hierarchical structure will form, and the libertarian scavengers will become citizens of the Free Republic of the Wasteland, and a political elite will form and rule the rest of society.

Just a matter of time. In the West, it took centuries... but power has private benefits and public costs, and thus it is a public evil, whereas liberty is a public good. No doubt about which of the two will win in the long run: we are living in a tragedy of the commons and have no clue about how to solve it, mass democracy have only made things worse because there has never been so much concentration of power and loss of social capital.

It's not wealth, in conclusion, that begets power: it's time. Soon after the establishment of the Free Republic of the Wasteland, the libertarian scavengers will lose all of their social capital and will become incapable of cooperating without the loving care of their political elite, just like Tocqueville's Americans could do everything by themselves, and present-day Americans need a loan from a chinese peasant."

giovedì 22 aprile 2010

Another ABCT debate

For those who want to investigate ABCT in detail, there is plenty of material to ponder in the recent debates on Coordination Problem. Of course, this is no substitute for a detailed study of the literature, but, however, without knowledge of this literature most of the debate is fairly incomprehensible.

Many aggregate-demand analysts tend to think that a recession can be made less severe, or altogether avoided, by increasing the money supply in order to offset, or more than offset, a fall in velocity.

The objection that has been raised by many, me included, in the comments of the linked post is that malinvested firms are the most likely to ask for an extension of credit, so that prima facie most of the easing of credit (money) constraints will be used to postpone the liquidation of malinvestment and the consequent recovery.

The criticism has not been answered. In the comments, I refer to a work by Peek & Rosengren on the behavior of Japanese banks during the lost decade. I also have to cite a casual remark by Hayek in "The formation of capital" about the dangers of relational banking throwing good money after bad.

Besides, I cited the last three chapter of Hayek's "The pure theory of capital" because his criticism of Keynes's liquidity preference analysis is perfectly suitable to criticize also attempts to stimulate aggregate demand: a liquidity demand increase arising out of an unsustainable structure of production is not really a rise in liquidity preference, but banks (as in "Monetary theory and the trade cycle") have no means to distinguish between the two.

It is of course conceivable that an exogenous rise in money demand puts pressure on production because of short-run rigidities. It is impermissible to think that easing monetary and credit conditions when most of this increase in money demand is endogenous to the structure of production is a solution to the problem of malinvestment.

sabato 10 aprile 2010

ABCT debate

Following Krugman's and Cowen's criticism of Austrian Business Cycle Theory several days ago, Boettke has written a post on Coordination Problem and the debate in the comments is strongly suggested for the intermediate/advanced students of ABCT.

I cut and paste my comments because I'm quite proud of them.

The first was on the strange argument by which every change in the structure of production must yield unemployment because workers are laid off, so that the boom must increase unemployment. The argument is based on the confusion between structural changes which increases the demand for labor somewhere and structural changes that reduces the demand for labor somewhere else.

If demand increases in long-term capital goods, unemployment is reduced AND the structure of production is changed; if demand decreases in long-term capital goods, unemployment is increased AND the structure of production is changed. There is no reason to expect that ANY change in the structure of production need increase unemployment: there are structural changes involving a fall in job vacancies (increased employment) and structural changes involving a fall in job positions (increased unemployment).

Then I go astray and comment on a totally unrelated topic which has been raised by someone, I hope (otherwise I'm delusional). FRED is the Federal Reserve Economic Data database. Summary: there is no compelling reason at first sight to believe that long rates are not affected by monetary policy, at least looking at the rates. The regressions I ran are quite laughable but to me appears to prove the point. A more serious analysis should consider a vector autoregression specification, several control variables, and real interest rates. I don't have any experience in applied economics, also because it is so overvalued that I'm bored by it.

I don't understand the idea of the long-run rates untouched by monetary policy. Interest rates move in parallel, just look at FRED to be sure. Correlation between fed funds and 3-year interest rates is very strong (R-squared 0.87 with a RATE3Y=a+b*FEDFUND equation). This means that to know the present monetary policy and to know the present structure of commercial paper, t-bills and constant maturity treasuries rates is almost the same thing, from 1m to 5y. One can phone Bernanke and know the whole structure of the interest rates listed above by just asking for the Fed rates. So, either Bernanke looks at the interest rates and sets the target rate, or it affects interest rates at all maturities with his only policy instrument. The latter appears to be the correct explanation to me: a 1% cut in Fed funds is a 0.6% cut in 5y rates, i.e., a 3.3% compounded gift to 5y debtors. But maybe I'm missing some VAR specification and some data modeling...

My third comment was about many themes:

As a Garrisonmania suggestion, considering that the comovement issue (does consumption fall or rise with investments?) has been discussed by many, there is a 1993 (I guess) paper, available on his site, about overconsumption and forced savings in the theories of Mises and Hayek. Although that material is also in Time and money, that article for me is the starting point to assess most of Krugman's and Cowen's (and Woolsey's, Tullock's...) criticisms of ABCT. The standard version of ABCT with reduced consumption during the boom originated with Hayek and is so at odds with reality that although I believe ABCT is right I would never say that. :-) For what concerns praxeology, I quote Boettke: praxeology is not absurd, although less powerful than most think. However, although hyperrationalist interpretations of Mises are for bloggers, they are not the layman's fault: Rothbard and Hayek sometimes made the same mistake. The problem is that Mises is read in terms of Theory and the other 50% of his epistemology, History, is downplayed. Theory is a jackknife, not a miracle machine.

Then I decided it was time for overshooting and wrote a little treatise on ABCT. This comment is long, maybe too much, and probably difficult to follow.

First point: I never said that the boom/bust is a nominal phenomenon:

My point is that *real* GDP rises more than sustainably feasible, the fact that NGDP rises is true, too, but not central. The economy is overheating in real terms during the boom, producing beyond capacity: it's Y/P > PPF.

The second point is that overproduction beyond the PPF has nothing keynesian. A theory of a real resource crunch follows (the exogenous credit crunch due to inflationary fears was too common sense for me).

Real overproduction is not keynesian, it is misesian (in Hayek there is nothing like that): malinvestment and overconsumption are a movement beyond the sustainable production possibility frontier, not a free lunch of an economy working below it's potential due to market failures. Only movements within the PPF are keynesian (or MET, or credit channel).

I would describe the boom in three chronological steps, in which the first one lasts a money circulation period (one month?) and is separated for expository purposes only:

phase 1: money injected as credit causes an investment boom.
phase 2: money originally injected as credit circulates as wages and causes a consumption boom. (underlying hypothesis: C and I go beyond the sustainable PPF, otherwise phase 2 would cause a halt to investments).
phase 3: binding production constraints halt the simultaneous booms, prices may start rising, consumption and investment will no longer be able to comove, the boom ends independently on monetary policy (the delay between phase 3 and 2 is not due to monetary circulation, is due to the time structure of production: overproduction is possible, but not forever).

The third point regarded the comovement of investment and consumption.

1. It is true that price rigidities (MET) can push the economy below its PPF.
2. Not only price rigidities can do this: also credit deflation (as in Strigl, "Capital and consumption") and financial accelerators of various kinds. MET is a special case of a more general class of accelerators which make the recession harder than neoclassically ("movements along the PPF") necessary: all kinds of financial frictions can do the same job as price rigidities.
3. Even if the bust had no decelerators (the original Austrian "below PPF" accelerators are credit destructure and panic coordination problems), real expenditures in consumption should *fall* and not rise during the recession, because the recession is the discovery of the squandering of capital, i.e., it is an inward movement of the PPF. In reality, part of the recession is not a movement of the PPF, of course. There are frictions, and rigidities are one of them.

Another point was about the relation of credit and monetary disequilibrium. I haven't finished the study of this theory (is there a study which has an end?), however. I end up criticizing Hayek.

I'm not going to say that ABCT explains the severity of all the recessions, it is not true (as recognized by Mises 1931, C. Phillips 1937 and Rothbard 1963 for the Great Depression, when they pointed out the role wage rigidities). But the recession happens when productive unsustainability is revealed, it is a concept that can do without nominal frictions (which, however, exist).

As there is no exposition of ABCT which satisfies me on this point, the best being Garrison's - as usual - which is too aggregate, I make an example.

Let's assume that I've undermaintained old fixed capital for five years. I've moved workers toward the production of new fixed capital (which will require a lot of saving which will not be available on time and which adds to the consumption stream during the overconsumption phase), and toward the production of consumption goods. I can do this because fixed capital is durable, and as long as old and new fixed capital does not physically deteriorate, the boom can go on. When however the surge in the demand for saving arrives but demand for consumption remains strong, the recession begins. During the recession I have to reduce consumption, invest in the old and new fixed capital to save part of it, and scrap the unusable (for lack of complementary capital goods, i.e., savings) submarginal part of it.

This would be a problem also without frictions. Frictions only add severity and length to the readjustment. The countercyclicality of consumption which Krugman and Cowen criticize only exists in Hayek's writings, but not in Mises's or Strigl's or Garrison's. Hayek's theory of forces saving is the standard account of ABCT, but it is theoretically indefensible. Unfortunately, more sophisticated versions to my knowledge are way too complex. What really happens to the economy during overproduction and how real resources come to bind at the onset of the depression is at least to me still a mystery.

An interesting point I never analyzed in detail was why the crisis is sudden. I don't answer the problem because I need more careful thought on it.

Hayek said that it is impossible to consume now what will be available for consumption tomorrow, although it is always possible to save and invest now what is not consumed today: it's the time of production asymmetry. Frictions (among which price rigidities, I repeat, are only a part of the problem) add to the problem. I would consider, however, speed as a positive thing: it is better to have a 3 months crisis then a 5 years one, even for similar cumulative losses. The ideal would be a one week crisis: 100% unemployment for a week and then business as usual. This is impossible, however, because the capital structure need be fixed before reverting toward the sustainable path. Fixed capital is to be reshuffled, consumption need to change, workers need to be retrained and reallocated. I would allow several months for this, and for the panic and the ensuing coordination problems, even in the best case. This is a point I never considered, thanks.

There can be, however, a slow recession, which implies no readjustment of capital: Greenspan called it a soft landing. We saw them in 1921, in 192 and 1927, and in 1990 and 2000. Problems weren't solved, just postponed, but the bill turned out to be expensive. Can there be a slow recession, i.e., a slow building up of demand for capital because of capital undermaintenance during the boom which causes a slow reduction in employment, capital utilization, output, monetary multipliers and consumption which does not impede recovery? Can time be bought for readjustment?

I believe that the secondary deflation is at least in part unavoidable. It adds to the pain, but there are no painkillers available. Friedman and Schwartz said that the expansion in the '20s made the banking system more vulnerable to shocks. There is no boom without an overextension of monetary multipliers, financial leverage, risk... and there is no recession without a painful return to normalcy. If banks need to deleverage, also some good investments will be starved, if banks are forced not to deleverage by nominal expansion, the inherent fragility of their position at the onset of the boom remains (and moral hazard adds to the problem). It is a pity that the financial structure has never played a key role in ABCT... and it is largely compatible.

Back to Krugman's argument that the shift from capital-goods to consumer-goods industries should involve no unemployment because it is a shift in relative and not in absolute demand... with applications to Japan.

The argument assumes, however, that production with capital goods (roundabout) and production with hand-to-mouth technologies are equally productive. The lack of saving stops the production process. There is no boom in consumption because there is a tug-of-war between consumption and demand for credit. No one can produce without capital, and if consumption weren't curtailed, there would be no funding available for the restructuring of production.

I will make an easier example. Krugman (Brookings, 1998) said that devaluation may have helped the Japanese economy by fostering net exports. By fostering carry trade, however, devaluation would just siphon domestic savings out of the country. With which funds were Japanese going to restructure their economy, if investing in T-bills was better than investing in Mitsubishi bonds?

Finally, submarginal capital! What is it? What does constitute it?

I agree with Barkley Rosser in that overproduction is intuitively and theoretically a more complex object than the basic (and indefensible) Hayekian story of forced saving and reduced consumption.

As far as I know, what happens to the economy when there is overproduction has never been analyzed in details. Garrison talks of triangles pulled at both ends, but it's a metaphor, not a theory. He also talks of money illusion by part of workers, which can cause overproduction. Hayek and Machlup occasionally talk about undermaintenance of capital, increased exploitation of capital goods, shifts from long-term to short-term production at the top of the boom (Ricardo effect). However, to my knowledge this is a work in progress, not a full-blown theory.

However, don’t lose time with my comments. O’Driscoll, Woolsey, Koppl and many others have given life to a wonderful thread.

mercoledì 31 marzo 2010

Rational irrationality

The comments of this post from Coordination Problem are interesting, especially - as usual - O'Driscoll's. The topic is Bryan Caplan's theory of rational irrationality. There is also a comment of mine, but O'Driscoll's comments make it outdated. I think I will think about the issue during the holidays.

Just a small summary of Caplan's argument (I bet my language is different: I've never studied public choice seriously, I'm Austrian, and I read the book "The myth of the rational voter" more than one year ago).
  1. If I believe that gravity doesn't exist and I jump off a bridge, I die. That's the cost of being irrational, which is particularly strong in real "private" life.
  2. Where's this feedback mechanism in politics? Each single voter has a 0.0000001% probability of being relevant at the margin at the elections. The benefits of informed and rational choices are public, the costs are private: reasonableness is a public good. Rationality is systematically underproduced, because rational politics from the point of view of the voters is a tragedy of the common.
The argument is a priori correct and a posteriori touches a very important fact I consider beyond dispute: people which are clever in their private lives become much dumber when it comes to politics, and I have never noticed the opposite. Besides, the theory also explains the success of Keynesian ideas.

The objections raised in the comments are:
  1. Organized political groups are competitive and will invest in "rationalizing" the voters.
  2. Economists don't invest in laymen's education: when they did it, voters were more rational.
These are great issues. Unfortunately I don't know much public choice, but I think I have something to say about it. Next week.

Is money a present or future good?

This morning I read "credit creation or financial intermediation?" by Cochran, Call and Glahe (QJAE).

The paper precisely hits one point of disagreement in the monetary disequilibrium vs injection effects debate, which divides the orthodox Austrian camp (Mises, Hayek, Rothbard,...) and a new brand of Austrian-monetarist synthesis whose most important proponent is Horwitz (Microfoundations for microeconomics), and is at the root of the works of Warburton, Yeager, Selgin, White, and Sechrest.

The two theories appear to differ on many aspects, some of them of purely ideological and noneconomical nature, and some of theoretical interest: is free banking feasible?, is money a present or future good? are injection effects or price rigidities responsible for monetary non-neutrality? is the law of reflux a feasible way to enable a proper use of voluntary saving?

Today I want to talk about the issue of presentness, because I consider both camps to be wrong (which means that the only right explanation is to be found in this blog, and this adds to the unlikeliness of its reliability):
  • Cochran says that there is no cost in money holding, in terms of foregone consumption, because money can be used without any delay: money is a present good.
  • Horwitz says that money holding is saving, because it is not consumption.
  • I say that money holding is neither of the two.
When a bank receives 1$ of deposit and decides to lend a fraction 0 < X < 1 of it, it is immobilizing X$ worth of real resources (assuming constant prices) for an investment project. The moneyholder, however, doesn't lose the availability of his spending power, so that it has not yet decided whether he will consume or not. The bank is right in lending the deposit if the consumer won't exercise his option of using his money to buy consumers' goods before the investment is liquidated. The bank is wrong if the option is exercised before final liquidation, because it will have to ask for credit to pay for something that was not intended as credit. If all the banks at once immobilize more money than money holders are willing to consider as real saving, the banks will run out of liquidity and a crisis will ensue. This is not a liquidity crisis: it is a real crisis, because it is the command over real resources that is not available, not liquidity per se, at least if money doesn't depreciate (i.e., if a firm and a consumer want the same commodity, this is real scarcity, it is not a monetary problem). Of course, the banks can reduce the real value of their monetary liabilities in order to avoid running out of liquidity by printing more money. This is exactly what happens under central banking. However, without a public safety net I don't believe that this behaviour would be feasible, other than in the shortest run: there are limitations to monetary devaluation in that outside money cannot be printed, as it is commodity money.

This is not an analysis of the business cycle, becasue, to say the least:
  • a distinction between real and nominal movements should be done: if prices were perfectly flexible, market coordination were instantaneous, and monetary movements had no distributive effects... money would only be a nominal issue, of no interest for economics (this is unlikely, of course),
  • not all banking crises result in inflation, so that an analysis of deflationary crises is necessary (there is no mystery here: credit and monetary aggregates are countercyclical, so not all crises result in devaluation, a stop in the credit creation process suffices to create a crisis when the underlying market structure is unsustainable, and its reversal adds to it).
I believe that some of the deposits are to be considered as saving, and that fractional reserve banking is stable to the extent that it can distinguish, at a systemic level, between money intended as saving and money intended as consumption.

The error in the monetary equilibrium analysis is to confuse a tautology (money holding is saving now, as there is no consumption) with the real economic issue (in order to avoid problems, money holding will have to be saving from now to the end of the underlying investment).

At this point, a question must be raised about how banks can distinguish between real saving (in the economically relevant sense, i.e., over an horizong linked to the time structure of production, which in monetary equilibrium analysis is never considered) and merely instantaneously foregone consumption. I know of no reliable answer to this question, maybe because, in the literature I know, both "presentists" and "futurists" don't see the problem in these terms.

sabato 13 marzo 2010


Uh, this morning I've understood another small element of the edifice of economic theory.

Here's my comment (on this post by Prof. Rizzo) which shows the intuition:

Moral hazard is not only relevant because of deposit insurance: it is relevant whenever costs are socialized.

If I invest too much now, together with everybody else, in a private-costs world I would expect high interest rates in the future, when there will be a scramble for credit, i.e., investment that raises the demand for capital, as Hayek put it.

When there is the central bank following a countercyclical monetary policy, during the scramble for capital, normally, interest rates don't rise in the short run, and probably also in the long run (the policy intervention will be at least as persistent as the crisis, i.e., the scramble for credit).

Counterfactually, an interest rate that in a private-costs world would have risen to 7-8% at the onset of the crisis, becomes a 0% interest rate because of the central bank. This may be imply great cost socialization… as the counterfactual market interest rate is not observable, however, it is difficult to evaluate if the phenomeon is relevant.

When costs are socialized, the market system is uncapable of retrieving and spreading correct information and forcing correct incentives. All the coordination process goes astray.

Competitive market agents will take moral hazard into account and “optimize” taking the cost socialization technology into account, i.e., they won’t “optimize” to find a “social optimum”, whatever it means.

Systemic risk cannot be avoided because noone has private incentives to avoid it. Only monetary authorities can stop socializing risks, but countercyclical policies work on the opposite principle.

Ebeling on Mises

This post by Ebeling on Coordination Problem is very interesting and well worth reading.

Mises's epistemology was characterized by a dichotomy: Theory and History. The epistemic properties of the two realms of social inquiry were opposite. I think that it is better to use a Husserlian terminology and call them "research of essence" and "research of existence": the former, Theory, is about logical relations among concepts, the latter, History, is about all the complications which arise when it comes to apply Theory to the real world.

The hyperrationalist interpretation of Mises, which I think was due both to Rothbard (in which constructivism and apriorism play important ideological functions) and Hayek (for instance, when he said that Mises's "Socialism" was a great and influential work, but too rationalistic), is not compatible with what Mises writes, with or without the additional important insights which Prof. Ebeling has added with his post (which I'm looking forward to reading in the referenced books by the Liberty Fund).

Without History, what remains of Mises is a delusional hyperrationalist who thinks to be able to derive propositions about the real world out of purely logical constructs. This interpretation is not consistent with Mises's writings, in which the dichotomy between Theory and History hides all the uncertainty of the real world in the latter camp. Mises claimed explicitly that the apriori may have had an evolutional origin, that all theories are incomplete and subject to radical changes, that all the rational constructs are based on more or less arbitrarily chosen "ultimate givens". Where's the hyperrational? To have clear ideas and to state them clearly cannot be a symptom of hyperrationalism.

Let's make an example: socialism is impossible because there cannot be monetary calculations AND monetary calculations are necessary for coordinating a complex economy. The last hypothesis is not apriori: it is an empirical generalization of very vast applicability.

There are cases in which empirical hypotheses, which are logically necessary to apply Theory to History (essence does not beget existence, Saint Anselm notwithstanding), are not as clearcut. While it can be claimed that reality is complex, production takes time, capital is heterogeneous and information is scarce without fear of being falsified on a posteriori grounds, it cannot be said with the same level of certainty that the structure of production is sustainable or not, if a boom is fundamentally sound or will be turned into a bust, whether economic agents are conned into believing, or acting as if, something is true when it is not...

Relevance is never a priori concept: it is an a posteriori judgement about the relative importance of several conceivable causal factors in the interpretation of a specific historical event.

giovedì 11 marzo 2010

My reading skills fail me

I was asking a question to Prof. O'Driscoll on this Prof. Boettke's post on the public choice dangers of monetary policy (post and comments strongly suggested). Then I realized that I didn't understand its comment, as I thought he was saying that the Fed has sterilized monetary interventions in Fall 2008 (instead of BEFORE Fall 2008).

However, this is a 15m work on Fed FRED data, and I post it as a summary.

Fed Policies in Fall 2008.

Target interest rates: in Fall 2008 it fell from 2 to 0. This is expansionary.

Monetary base: in Fall 2008 it came from 850 to 1700b$. This is expansionary, too. Quantitative easing implies that monetization is not sterilized, otherwise is a portfolio rebalance (buy toxic waste, sell t-bills). The Fed would have run out of good collateral.

Extra facilities like TAF, TALF, MMIFF, AMLF, CPFF, created from Summer 2008 to Fall 2008, created reserves. I'm quite sure about that regarding TAF (and the already existing, in Fall 2008, PDCF), the others are a little bit to complicated for me. The already existing TSLF was not a monetary facility, but a credit transformation facility.

One element remains out of sync with the other policies: interest payments on deposits at the Fed, started in mid Oct 2008.

However, this rate fell to zero (dot something) after two months of existence, so I wouldn't consider it relevant at the margin: it's a 0.0025 * M0 gift for the banks, i.e., less than 5b$/y.

If return rates were not (risk adjusted) zero elsewhere in the economy, the substitution effect would have been quite nil. If they were zero elsewhere in the economy (like in New Keynesian ZIRP models with negative real natural rates), this is what has to be explained.

Besides, the CPI started falling before interest payments on reserve (July 2007), and deflation accelerated in September 2008, before interest on reserves. Inflation turned back in early 2009, so the eventual effect of this policy on the CPI was very short lived, if existent.

Interest on reserves is somehow a mystery, and I can only explain it as fear of inflation, but with 0.25% interest paid, I think it's also practically irrelevant.

Why did they do it? The standard answer is "to enlarge the Fed balance sheet without losing high quality collateral, i.e. t-bills", but why did they feared this? Just expand M0 as if there is no tomorrow. Japan already did it, and with zero effect (it makes the public debt marginally less expensive and it helps overvaluing toxic waste).

martedì 2 marzo 2010

Little fragments that do not add up to a monetary theory

I'm amassing material on several issues in Austrian business cycle theory which do not seem to me well founded from a theoretical perspective. I hope noone has noticed these problems yet, so that when I solve them I will get in the Olympus together with Mises, but I often find papers which have treated some part of the problem and give important hints (not necessarily a satisfactory treatment) of the very same problems I was investigating.

One of these problems is how (in detail) money influences real activity. Objections that can be found in the literature are: small interest rate movements cannot explain much variation in investment decisions, the risk-free rate is dwarfed by risk premia, money is effective only in the short run and thus cannot affect long-term investment, rational entrepreneurs will make random (unbiased) errors and not biased errors favoring long-term with respect to short-term investment. Then, there are debates on whether the money stock (M) or the money flow (MV) set the stage for the boom-bust cycle, whether only M1 is relevant or also Mx, with x = 2, 3, ZM, whether price rigidities or injections effects are relevant, whether money is to be considered an information-carrying signal or (also) a means of exchange (in the former case, the Lucasian framework, monetary economics would be a mere subset of statistical estimation theory), whether rules are really preferable to discretion and which kind of rules (NGDP, M0, M1, M2 targets...) is preferable.

At the moment, I'm just collecting pieces. I've no full-fledged monetary theory in my head, and I only have a mass of papers on a shelf over my bed, which is somehow dangerous for my safety (and I hope this will incentivize me to read them as soon as possible).

Prof. Boettke has recently written a post on his blog regarding his public choice doubts about the policy of stabilizing the flow of monetary services (MV), also known as nominal GDP. I too have doubts, although nothing I can write anything of interest upon: I just started reading about monetary disequilibrium, and although I'm not convinced by this theory, I don't think I'm already grasping enough details. However, I will try to sketch an argument in favour of freezing the monetary base. I will divide the argument in steps.

1. A decentralized market system can work provided that the price system conveys correct information and gives correct incentives. The price system is endogenous to the market process, meaning that entrepreneurs improve upon the price system and the latter helps the former. Errors cannot be ruled out, but absent systematic distortions, it can be argued that entrepreneurs will act so as to push the economy as close as possible to some optimal equilibrium. For this point to be relevant, it is not necessary that the market system really reaches some optimal status, or even gets close to it, but only that monetary interventions cannot improve upon its behavior. It's a relative and not an absolute comparison.

2. Monetary policy has redistributive effects: it socializes part of the costs of investing and taking on risks. This implies that there are systematic externalities within the market process imposed upon by central bank policies. In these conditions, entrepreneurs are led astray and the price system is distorted. This is an induced market failure: it is not that the market process fails because there is something wrong with it (this could be contracted away, because any market failure is a profit opportunity, although its exploitation may be hampered by transaction costs), but the result of explitic policies imposed upon the market.

3. The key point here is that cost socialization devices shouldn't be used, otherwise entrepreneurs, instead of moving toward some sort of optimal equilibrium, move to a suboptimal one. Somehow, and in this somehow I should put something from a theoretical point of view, the market process and entepreneurship cannot be trusted upon to internalize monetary externalities (which are, despite their name, real externalities, not pecuniary ones). Here I give two examples of market distortion: the baseline (neoclassical) view of markets is that market agents optimize some utility function subject to constraints, and externalities hampers this process, which loses its optimality properties. A more realistic (austrian) view of markets is that markets are also made of contracts, institutions, bargaining, market/firm choices; externalities will lead all this complex entrepreneurial process astray, for instance by incentivizing insufficient screening in credit transactions. It money is the tailor which sews together the market process, whatever happens to money is something that is at least in part beyond the scope of entrepreneurship: coordination is bound to fail, and if monetary policies are systematic, failure will be systematic as well.

4. Any rule which eliminates or minimizes these redistributive effects will enable the market process to behave properly. If the rule is credible (although I think this hypothesis to be wholly unrealistic), which rule is followed matters much less than the fact that entrepreneurs no longer have any "externality producing" technology to exploit. This is a point that runs counter to both orthodox Austrian economics and monetary disequilibrium theory (although I only have a cursory understanding of the former).

5. In conventional Austrian economics, it is injection effects (increases in the money supply that are spent in credit markets) which start the business cycle. This process requires the cooperation of the banking system, which however will also pay the cost for these errors. Here's the point: if the monetary rule is followed, the banking system will be forced to internalize this cost, and will be less compelled to expand credit. The US banking system in the XIX century didn't need a central bank to cause a mess, but it can be argued that its weakness was due to limitations to branch banking, institutional uncertainty (silverites, greenbacks...), the forced use of securities as outside money (instead of plain gold, or, as I'm advocating, a fixed amount of base money), and moral hazard caused by banking holidays and specie conversion suspensions. Banking instability was not the rule in the world before central banks, so I guess there must be some specific US factor behind the misery of its monetary performance, both before and after the creation of the Fed.

6. In monetary disequilibrium theory, either in the aggregate Yeager's version or in the more Austrian Horwitz's version, it is monetary expansion in excess of money demand that starts the problem. This calls for some stabilization of MV, in which V is somehow taken as the inverse of money demand. The transmission mechanism relies on price rigidity: however, I believe that price rigidities, among all the frictions which create monetary non-neutrality, is unlikely to be the most important. Financial frictions, credit injection effects, moral hazard in the demand and supply of credit are likely to be much more relevant, although I can't justify this convinction in detail. The market being a complex system, it is unlikely that only one friction is relevant in causing monetary non-neutrality, and it must be noted that boom and bust policies are never a matter of mere money, but always involve credit, so that the secret of non-neutrality must lie in the relation between money and credit, and not in money per se (monetary disequilibrium, at least in the pre-Horwitz version, appears to be so aggregate that even the distinction between consumption and saving is irrelevant for its analysis of business downturns).

7. The "distorted market process" view is more robust because it does not rely on a single transmission mechanism. Whatever causes coordination problems by incentivizing excessive risk taking, capital consumption, overconsumption and malinvestment will more or less have the very same effect. Freezing the monetary base will eliminate the cost socialization technology that leads the market process astray. Thus, entrepreneurs will be forced to take into account the risk that their behavior will cause instability and, these costs being privatized, there will be an optimal risk-return choice. Externalities are likely to be the key building block in explaining monetary non-neutrality: tragedies of the commons that cannot be corrected by entrepreneurs, and impinge upon their ability to coordinate, may explain why injection effects are biased (without externalities, I have trouble imagining a tragedy of the commons in monetary matters). If Mises, answering in 1943 to Lachmann, said that the entrepreneurial cluster of error was not an apriori principle but an empirical generalization, systematic externalities created by monetary (and sometimes non-monetary) factors may give a robust microfoundation to this often criticized aspect of Austrian business cycle theory.

8. In the short run (at least a couple of years), this policy will be wildy contractionary because the banking system will be forced to step back, no longer being able to rely on the Fed's monetary safety net. Almost all of the risk-related aspects of the financial structure will be affected: there will be less maturity mismatch (monetary multipliers included), less financial leverage, less opacity and complexity, less reliance on originate-to-distribute business models, less currency carry trade, less short term foreign-currency borrowing... the enormous costs of this process are surely a very good reason to look for alternatives. But I see no alternatives that eliminate the root cause of the problem without having these adverse effects in the short run. Deleveraging is necessary to return to normalcy.

9. With respect to free banking, as described by Selgin and White, there is one major difference. Shifts in the currency/deposit mix will keep on having a destabilizing impact on the banking system: reserves turned circulating media will cause credit and monetary contraction, and banks will not be able to respond by printing banknotes convertible in outside money. Not being able to solve the problem by printing banknotes (offset by reduced deposits), banks will need to keep relatively high reserves in order to minimize the impact of these changes. With reserves in the range of 20%, it is likely that even large shifts in the demand of banknotes against deposits will have a minor impact. This war chest may not be required in free banking (with freedom of note issuance), but I don't see how it can be avoided in the system I'm advocating, which is surely easier to implement than an overall banking reform. I have no particular reasons not to eliminate this source of disturbance by also introducing freedom of note issuance.

10. My policy will not be able to eliminate all injection effects (banks may continue to issue money primarily through loans), price-stickiness effects (banks are constrained in their capacity of accomodating changes in the demand for money, because they need high reserve ratios to accomodate the risk of deposit/note shifts), and financial friction effects (there will always be moral hazard and adverse selection issues to take care of throughout the financial sector). The point is that there would no longer be an externality producing technology to shift eventual costs to third parties: so the entrepreneurial process itself is not hampered, and may be able to take into account and optimally adjust to all these factors.

11. The only remaining limitation, thus, is what limits entrepreneurship: transaction costs in credit markets and in monetary transactions (I think the former to be more relevant). Absent the cost socialization technology created by the central bank, all benefits and costs are private, or at least can be made private by entrepreneurial experimentation with the market structure. Only problems that are impossible to solve because they are too complex, because of too high transaction costs, or because they require too much information, will remain. But without systematic moral hazard agents have at least the incentive to avoid problems they cannot solve.

12 Finally, the monetary base is easy to check, and, thus, public choice concerns, to the extent that the rule is respected, are relatively low: there is nothing to estimate, like the neutral rate of interest and nothing to distinguish, like good (productivity driven) and bad (money side) deflation. Of course, there will be no political will to adopt this policy, which given the amount of confusion I have on these issues, may not be a bad thing.

mercoledì 24 febbraio 2010

The doomsday cycle

This VoxEU article shares many similarities to my previous posts. It doesn't mean I've been copied (I think no one has read any post yet), but that it is very interesting.

Financial regulation and monetary policy - (3)

While safety nets are probably much more harmful than useful, as they create the illusion of stability and incentize instability-creating risk taking in the long run, the case for or against regulations is probably more complicated.

A distinction could be made between actions which add to risk without adding to efficiency, which could be regulated with no opportunity costs in terms of foregone output; and actions which add to risk but also add to efficiency. In the latter case, regulations will impact both bad entrepreneurial decisions induced by moral hazard and good ones which result in a better allocation of productive resources: distinguishing between the two is necessary to minimize the output loss due to the quest for higher stability, but involves a knowledge problem, as market information about risks and returns are distorted, by assumption, and regulators cannot use them as guidelines.

Prudential regulations avoiding the former type of market actions are good for the economy, whereas prudential regulations of the latter type will be difficult to evaluate, and probably harmful for growth and efficiency. Public choice problems could be added to the bill, but I would like to highlight another potential problem which is more seldom taken into account: the very same "market failure" which induces entrepreneurs to make bad decisions will also induce entrepreneurs to circumvent regulations hampering his ability to exploit these profit opportunities.

If we consider the probably most relevant case (relevance is a concept that cannot be derived a priori but it is always relevant in the assessment of real market phenomena), i.e., "market failures" induced by safety nets, which we may dub "policy market failures", we have some sort of a schizophrenic policy.

Let's call "Ben" the source of policy moral hazard and "Dolly" the regulator (in the US, there are scores of regulators, and Dolly being the cloned sheep, I guess the name is quite apt). Ben induces policy moral hazard and entrepreneurs start behaving as masochistic morons; Dolly sees that there is something wrong with the process and starts regulating what entrepreneurs can do in order to limit their stupid behavior. Ben, however, will keep on inducing masochism on the market process by socializing risks and credit costs, and so entrepreneurs will have to forego profits in order to obey Dolly: the most likely result is that they will try to circumvent, and sometimes maybe corrupt, Dolly.

Ben increases the enforcement costs of Dolly's diktats. It undermines the effectiveness of her attempts and increases the real costs of turning entrepreuneurs away from dangerous activities. This doesn't mean that regulations are never useful, but that regulatory policies imposed upon a decentralized system which is subject to perverse incentives is likely to be terribly complicated, expensive and inefficient. All sorts of tricks, from off-balance sheet accounting to off-shore corporate chartering.

The usefulness of exogenous regulations without policy moral hazard would be probably quite limited, and, besides, the entrepreneurial process is quite likely to be able to internalize many possible sources of "market failure". This implies that regulations may be mostly a solution (and quite often an additional problem) to a problem created by policymakers: if the political process were rational and efficient, it is likely that no such policies would exist.

However, it is so evident that policies often tend to be counterproductive, and that their inefficiency is quite never considered sufficient reason to avoid them, that it comes as no surprise that the best strategy is not often the chosen one. Even if it were intellectually evident that interventionist monetary policies are always counterproductive and that regulations wouldn't be necessary without them (I think these two statements are too strong, but not too much), it would be extremely unlikely that governments avoided the abuse of a policy instrument capable of reducing the cost of their debt, please voters by causing booms, postpone the redde rationem of economic restructuring when an unsustainable boom comes to its end, fund their activities, and give privileges to lobbies.

We have an aut aut. Either we have free markets that, because of policy moral hazard, will be rather dysfunctional and unstable, or we have a constrained market system, possibly with an evergrowing web of regulations imposed upon it, which will cause inefficiency in terms of foregone output and growth. We could solve the problem, or at least reduce it very much, by restablishing entrepreneurial responsibility by removing countercyclical policies, and this would likely reduce the usefulness of external regulations (endogeneous, i.e., entrepreneurial, regulations is led astray by policy moral hazard and thus cannot be trusted upon in these conditions); or we can keep on having the present system, but it is unlikely to be beneficial to society as a whole, other than politicians and lobbyists.

I think there must be some sort of a universal tendency in politics to hamper the working of decentralized institutions in order to substitute political subordination to market coordination. Cost socialization is the weapon of choice to convince everybody to evolve power toward the ruling elite in order to avoid the dysfunctionalities of a market process turned tragedy of the commons.

sabato 20 febbraio 2010

Financial regulation and monetary policy - (2)

Proven that decentralized decision making (e.g., the market process) can be lead astray by policies socializing costs and risks, because entrepreneurs will start exploiting the fake profit opportunities created by policy safety nets, and the entrepreneurial process of internalizing external costs is hampered by the possibility of exploiting the safety net, we are left with the option of regulating at least the most absurd aspects of market risk taking, for instance 30:1 financial leverage or 120 months/ 3 months maturity mismatch (mortgages vs abcp).

However, there are several problems with this approach.

First of all, regulations will both limit the entrepreneurial capacity of exploiting fake profit opportunities, thus increasing efficiency and lowering instability (moral hazard involves excessive risk taking, so limiting its effects involves increasing stability), and of exploiting real profit opportunities, thus hampering efficiency and growth.

Secondly, regulations will create an awful lot of public choice problems, which, considering that politics is rarely even close to be rational and efficient, will be usually beneficial to those in power and to organized pressure groups, but more rarely beneficial to society as a whole: I consider a matter of fact that few or no policies can be explained by assuming rational and benevolent politicians. In the field of monetary policies, given that the Fed in one century of existence has caused the Great Depression, the Great Inflation and now the Great Delevaring, I hold my tenet to be even more evident.

Thirdly, regulators can only use market-data conditional on other policies and regulations: risk prices distorted by moral hazard are all that a regulator can use to constrain risk-taking. As every market agent, policymakers included, cannot know more about the global state of the economy than prices tell them, distorted prices are a problem for the entrepreneur (which may be induced in error) and the regulator alike. It shall not be expected that the information destroyed by monetary policy interventions is available to regulators (and entrepreneurs): regulators are as blind as any other market participants when the price system is systematically distorted. This cost of hampering the market process will never be countervailed by regulations.

The first bottom line is that eliminating the source of moral hazard will enable the market process to work more stably and efficiently, and that no real alternative exists when the use of the market process is necessary to find and exploit information and to coordinate complex production plans. The intellectual division of labor enabled by the price system is effective as long as entrepreneurs foot their own bills. That's not what has been happening in financial markets, at least since Greenspan started his policy of systematic bailing out of those markets, if not in 1987, at least in 1990.

The second bottom line is that a systematic network of cost-socializing institutions and policies will hamper the market process and will result in squandering of resources and unproductive instability (this has nothing to do, contrary to Cowen's theory in "risk and business cycles", with choosing a point on the risk-return efficient frontier: moral hazard will enable additional risk taking even if it is not balanced by higher growth, so I'm talking of something completely different).

Bottom lines are, however, generally too clear cut. In Mises's terms, theory is accurate, often simple, and of universal validity, but history doesn't share these properties, and economic policies, like economic history and entrepreneurship, requires judgement and is never only a matter of pure theory. Thus, in the real world there are fuzzier cases than "the pure unhampered market process with no non-internalized relevant externalities" and "economic policies which systematically fail because of the knowledge problem", and, the causes of economic phenomena being never visible, the problem of causal imputation is never a theoretical problem, and often an untractable problem (in plain english: you can know that A causes C and that B causes C, but when you observe C, it's usually very difficult to say how much of the effect is due to A and how much to B).

What happens when markets have some element of inherent instability, other than that resulting from monetary policies and other sources of coordination failures among market participants? Can safety nets be justified? And can regulations be justified?

And, given that some safety net exists, is there a "second best" theory of optimal regulations that enable to smooth at least some of the problems created by moral hazard (or similar problems) which is not bound to failure because of some sort of a knowledge problem?

For what concerns the former objection, I would say that the existence of some tendency to instability inherent in the market process does not imply that market agents shall be shielded from the results of their own actions by safety nets. Unruly children are not made less unruly by overprotective parents: on the contrary, the more they smash their head against the floor, the less they will be likely to do stupid things. More seriously, to counteract the effects of some potential inherent instability by removing the private costs of bad decision making adds to the problem: it eliminates the only force that can internalize the potential sources of inefficiency, by removing the symptoms of the disease.

This is not, however, an argument against regulations limiting the possibilities of action of market participants, but only against safety nets: unruly children which are impeded to do stupid things may really cause less harm to themselves.


venerdì 19 febbraio 2010

Financial regulation and monetary policy - (1)

A week ago or so I wrote a comment on Thinkmarkets about regulations. The comment, as usual, was too long not to be boring and too short to be clear. As on my blog I don't mind being boring, I'll try at least to be clearer.

This was the original O'Driscoll's post, this my comment and this is an interesting paper by O'Driscoll regarding market-based regulations, which probably helps understanding the post and the following flame about bananas (banana is a technical term: check this comment). What I'm going to say can be partly found in this conference paper, although that paper focuses on a slightly different issue.

Financial regulation is a technical issue and as all technical issues is... ridden with technicalities. However, behind the intricacies of real markets and real attempts to steer and constrain them, there are a few theoretical principles of wide applicability which can be analyzed abstracting from the details. This is a result of the dicothomy between theory and history stressed by Mises.

This first post is largely introductory, and somewhat obvious, at least for those who have been exposed to some Austrian economics.

Decentralized decision making

The first point to notice is that on average a market works because profits and losses make bad decision making costly. This is not an obvious point: profits and losses depend on prices and prices shall depend on some underlying economic reality in order to make market coordination meaningful. For instance, in a lake subject to a tragedy of the commons, the price of using the lake is zero, the price of replenishing the lake with fishes is zero, and thus no one ever replenishes the lake and everybody fishes as long as the other costs of fishing (i.e., the fishing rod) are lower than the price of fishes.

In this case market coordination is not a free lunch and some redefinition of the structure of the game is required in order to make decentralized decisionmaking efficient: this process of restructuring the market is a form of entrepreneurship and constraints on entrepreneurship (i.e., transaction costs) stand in the way of this process of internalizing costs and benefits. The alternative to entrepreneurship is policy regulation, which however raises some important problems.

To summarize: the market process does not always work on autopilot (i.e., private optimality is not necessarily social optimality), but some assumptions are required for its smooth working, for instance the absence of relevant externalities not internalized by the entrepreneurial process. This process of "internalization" is part of the market process itself (at least as understood by Austrian economists), and it is one of the most important aspect of the market process.

Policy-induced "market failures"

The second point to notice, tightly related to the previous one, is that there are policies which create tragedies of the commons (or, more in general, "market failures": a term which is quite strange because it means "failure of the assumptions of standard neoclassical economics", which is tantamount to consider the existence of air friction as a failure of the universe instead of elementary mechanics).

Examples abound. For instance, if the cost of deposit insurance were not risk-weighted, or if risk weights do not adequately reflect true market risks (and how could they? Bureaucrats are not omniscient, and cannot recour to the market process without distorting it too much to learn from it), there will be profit opportunities which will not be exploited and false profit opportunities that will be created. Underpriced risks are a form of moral hazard, and will induce inefficient risk taking.

It is more seldom explicitly recognized that also monetary policy has a moral hazard effect, even without bailouts, recapitalizations, deposit insurance, monetization of private assets, credit guarantees by governments and government agencies (such as Fannie and Freddie)... the reason is that monetary injections have distributional effects: what I could have bought with my old money will be bought by someone else with his new money. The result is that when something is bought with new money, the costs are shared by everyone has to face (counterfactually) higher prices. For instance, if the entrepreneur who gets a loan from the bank makes the price of machinery rise, it will harm all other entrepreneurs.

Under these conditions, I'm rather surprised things work

At this point, a question must be asked: how can anyone think that the market process can ever work under widespread, systematic and long-term monetary policies which create this cost socialization problem? If entrepreneurs can buy and sell goods by shifting part of the costs on other entrepreneurs, on final money-holders, or on other market agents (for instance, bond-holders receiving lower returns, tax-payers which have to refinance banks, etcetera), how can this decentralized market process lead to socially beneficial results?

The standard answer, of course, is to regulate. However, there are several problems with this approach.


lunedì 15 febbraio 2010

Hello world

This blog is supposed to be my notepad about Economics. I'm not an economist and so you shouldn't expect this to be a professional blog. Besides, even if I were an economist, I couldn't write anything that could be used to pass an exam, because I'm mostly interested in Austrian Economics.

I'm going to link blog posts, newspaper articles and academic papers I like, and occasionally write a comment. I'm mostly interested in macroeconomic issues and so most of the posts will be related to the financial crisis and other not-so-funny topics.

Comments are free (although this blog will be so boring that I don't expect any), but I'm not interested in flames, and easily bored by prolixity: I prefer suggestions and analyses on the economics literature. That's also the reason I'm not going to post what I don't like: I prefer to be constructive.

Probably the greatest problem with Austrian Economics today is that it is the most famous economic theory on the blogosphere, which is not something to be proud of, considering the low average quality of web discussions. I'm interested in the wheat and not in the chaff, and I hope to be able to distinguish them.

I created this blog because I often comment on other blogs, but as I most often write when I have a doubt or when I disagree, I fear to appear overly critical. Besides, not to write too much I often write too manicheist comments. I hope blog posts will improve upon my comments.

I hope this blog will be more original than the title of my first post.