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".
martedì 6 luglio 2010
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:
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.”
“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.
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)
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.
- Is the economy capable of reaching dead ends, i.e., structurally unsustainable states which make a subsequent recession necessary?
- 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?
- 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.
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.
"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.
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.
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.
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