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?

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.
   

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.

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".

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.

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”.

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)