But that doesn’t mean I would want him in charge of managing a money supply, creating real wealth, or even to run a lemonade stand on my front lawn.
I’ve been gone for two days, and this thread is still going strong. Outstanding. Well done, everyone. Well done. Kudos to
Sam Stone
Hellestal
Ruminator
for continuing to contribute. You’ve earned your pay. Please take the rest of the evening off.
Ruminator…what are your thoughts on reforming the current fiat money supply and fractional-reserve banking system of the US, if you don’t want to go back to the gold standard? Just curious.
First, the construction industry is not the same as the home reno industry. This guy specifically told me that the one thing that was keeping them alive was that new home construction was doing relatively well and they do both new construction and renovations.
It’s possible that the renovation sub-industry demand could look like a sharp ‘V’ overlaying the gentler curve of the overall industry.
According to the Calgary Sun, new home starts are up 33% this year. I think there is inverse relationship between housing starts and home reno spending. When housing is too expensive, more people tend to renovate instead of buy new. So if starts are way up, I wouldn’t be surprised to find reno spending down (it could also be up, of course). Add in the expiration of the tax credit, and it might add up to a problem.
It’s also possible that the contractor was exaggerating or biased by not being able to see the bigger picture. Maybe the problem is more acute in the subset of businesses he personally knows.
We have discussed the fiscal stimulus in detail before but still let me address some of the issues that have been raised:
Lags in fiscal policy:
This is a relevant criticism of a discretionary stimulus for a minor recession. It’s quite possible that by the time the stimulus money reaches the economy it’s already in good shape. Clearly that is not a concern this time round. The US economy will be well below full employment in 2010,2011 and probably 2012. Even if it takes a year or two for the stimulus money to reach the economy it will still be useful.
The longer time frame also makes it likely that the stimulus spending is efficient. You don’t have to throw the money willy-nilly; you can plan the spending so that it actually creates something of value. It makes it more likely that the spending ends up utilizing unemployed resources. For example many quants who have lost their jobs on Wall Street have a high-level science and engineering background. Over a period of time many of them could be absorbed back into scientific research. Federally funded research is a pretty good way of absorbing these people and have them do something useful instead of sitting on their butts.
Debt burden created by the stimulus:
Not really that important. For one thing the US government can borrow at a very low rate of interest now because private sector investment is so low. In a way this as a market signal that the government should borrow more. Secondly the 1 trillion dollars of stimulus spending is simply not that big relative to the overall fiscal picture. The recession itself has a far bigger impact on the current deficit and in the long run Medicare cost increases are vastly more important for the deficit.
Distortions created by the stimulus:
First of all only a small part of a fiscal stimulus targets specific industries. This Wiki articlehas a detailed list of the spending proposals in the stimulus proposal. Looking through it most of it seems eminently sensible. Money for Medicaid. Help to school districts to avoid layoffs. Money for bridge and highway construction. And so on. A lot of it simply compensates for crippling declines in state-level spending.
Distortions are likely if a lot of money is concentrated in a relatively small area or industry. The political process tends to do the opposite: spread out the money across the country and across the different departments of the government. What percentage of the stimulus is likely to create serious distortions in the economy. 5%? 10%? Most of the distortionary stuff probably comes from the targetted tax cuts and Keynesians would be perfectly happy to replace that with spending. If for poltical reasons it has to be tax cuts, a broadbased cut in ,say, payroll taxes would be preferable.
I don’t think the issue of microeconomic distortions is completely irrelevant. Understanding them better could help us design a better stimulus. Since Austrians in particular are very concerned about this issue it could be an interesting part of their research agenda The trouble is that they rarely if ever do any kind of serious empirical work. My experience is they will talk about the issue in very general terms but rarely do the kind of detailed analysis which is likely to persuade the rest of the profession that the problem is important. If anyone knows of any counter-examples where they have looked at a particular stimulus initiative and analysed its impact in detail I would be happy to read it.
No, it isn’t. The framework continues to be just fine, thank you.
What’s more, a focus on M*V isn’t even a necessary part of the framework.
I didn’t intend for it to serve as a distraction. I started with it only because there are legitimate technical reasons to favor it, but everything I’ve said stands if we would choose against NGDP and instead target a stable long-term price level: a low steady inflation rate where the Fed overcompensates for missing its target so that 1) there is no danger of deflation, and 2) general price levels are very reliable and predictable out to the horizon. Nothing in the underlying structure here changes if you make that switch.
The value of any money, fiat or not, is determined by supply and demand. The supply of fiat money is arbitrary, an abstraction like sports scoring. Demand for money is not arbitrary. Demand for cash reserves is determined by people’s individual preferences for facilitating transactions, or for cash savings, or to hide moolah from the IRS, etc. Demand is based on our preferences and is thus subject to human cognitive biases.
Given this market interplay between abstract supply and psychologically determined demand, the real value of money is determined: how many goods and services each dollar can purchase. This real value of a dollar can even be given a sort of denomination: dollars can be measured in Economies. One 2009 US dollar was worth approximately 0.000,000,000,000,702 2009-US-Economies. That was the real value of one nominal dollar a year ago. We can do the supply and demand curves and the whole bit.
The initial supply of fiat money is an abstraction–but after it has been created, it is subjected to market forces (abstract supply meets people’s demand) and thereby its real value becomes known.
We can even play with the abstract numbers on fiat dollar bills. We could pass a law tomorrow stating that all prices are immediately to be cut in half. All contracts are to be halved in value. All wages are to be paid 50 cents on the dollar. Every dollar in the economy is to be replaced by a newly issued 50 cents. The value of all debt is to be cut in the same way. The result? We would have instantaneous, overnight deflation. Prices of everything would drop nearly in half.
There’d be only half as many dollars chasing around goods and services in the same economy, and so the real value of the nominal dollar would double from 0.000,000,000,000,702 2009-US-Economies to 0.000,000,000,001,404 2009-US-Economies. (This is essentially what Mexico did with its peso in 1993, except at a 1000-1 scale. Jargonistically this is a change in quantity demanded rather than a change in demand, with elasticity of money demand truly damn near constant.)
There would be no intense economic damage here. Why? Because the abstract supply would be cut in half immediately and would be matched by perfectly corresponding cuts in every single factor that affects our demand for money. Everything would shift at once in a perfectly synchronized way and so our psychological perception of the system would basically not change. Our nominal biases would have no chance to take effect. Of course, we would still have some costs because of, say, vending machine coin recalibration and reprinting menus and old people not understand the revaluation and the like. But you could still implement that kind of deflation without worrying about damaging the underlying economy, because the demand for dollars would remain unphased. With everything moving together, there would be no wage stickiness gunking things up.
As I’ve spent nearly all of this thread explaining, this is not what happens when prices drop because of a shift in preferences to hold more cash (a change in money demand). Deflation that is caused by a change in people’s preferences to hold more cash reserves does not provide any information at all about our relative preferences between different goods and services. Instead, it destroys that information. I’ve gone through this process in some detail.
I will say, to close, that this is not some bit of idle whimsy on my part. It is a matter of overwhelming statistical rigor. This is not a matter of opinion or debate. There are many topics in economics that are not settled, and may never be settled. This is not one of them.
Your math is technically correct but motivationally incorrect.
Ok, let’s continue to explore this money abstraction and what it means…
We have 360 longitude lines marking off the globe. The longitude lines are a pure human invention – a mathematical abstraction of vertical subdivisions over a “real” Earth surface. Since it is our abstraction, we can choose to increase the longitude lines to 400 or 500 or 1000. We can make the nominal values anything we want. We could even put in a policy that we will “inflate” the longitude lines from 360 to 1000 at a constant rate over 10 years. Now, if we do that, have we increased the actual speed of ships crossing the ocean? Have we increased the actual velocity of airplanes crossing the skies? Have we made any real, actual progress in transportation technology? If not, why not? Or to ask a similar question… if we increase the # of longitude lines, have we increased the surface area of real land to build houses on and grow food? If not, why not?
I know you already know the obvious answer and I’m not insulting your intelligence. What I’m really asking is how you would best articulate in precise words how to debunk such a question about “actual” speed. (The challenge in explanation is similar to asking a native 50-year old American who has spoken English all his life to define the words “the” or “at.” It’s quite difficult even though he already “knows” what those simple words mean and has used them a million times. Unless one is a linguist or lexicographer, it’s very hard to create a definition for “the” or “at” that isn’t circular.)
We can then proceed from you particular debunking of the “false progress” of speed above and see if we can transfer any insights into how we can use money abstractions and perceive the M*V or NGDP measurements. Yes, I suspect you will see ZERO connection but let’s just take this one step at a time.
It’s quite bizarre that you keep insisting on this notion of “holding cash reserves.” You make it sound like it’s the only plausible reason the brain can fathom. Yesterday, I was willing to buy an iPhone for $500. Today, I realize the iPhone has too many problems with antenna reception so I decide not to buy. You keep reframing situations like that as a “desire to hoard cash.” Maybe my brain simply doesn’t want the phone anymore? If my irrational lust for cash was so impossibly paralyzing, I wouldn’t have even considered researching the iPhone as a potential purchase in the first place!
Whether it’s me choosing not to spend $500 for a suboptimal phone or a business/bank not to spend $1 million on a new factory does not mean we are all stupidly paralyzed into holding cash. We can’t eat the cash for nutrition. It’s too cumbersome to glue as wallpaper and the paper it’s printed on is terribly inefficient as a fuel for fireplaces.
I once heard a story of how the Klu Klux Klan was mocked because some kids learned the group’s code words and secret handshakes from a Superman radio show. The Klan members then saw the kids running around the neighborhood shouting KKK words and felt like idiots. Apparently, this partly led to the KKK’s decline.
I’d like to see teenagers use the same tactic with “liquidity trap” and “hoarding cash.” Imagine a teen daughter begging her father for a car. The father thinks about the cost of the car $5000 + the higher insurance premiums + gas + her immature habits to possibly leading to a DUI or tragic car accident. He says “no” to the car. The teen daughter than gabs to all her friends: “My dad won’t let me have a car! It’s a fucking LIQUIDITY TRAP!!!”
Let us frame every “no” as “hoarding cash” and “liquidity traps.” The levity alone should bring us closer to world peace.
The problem with the gold standard is that it still subject to the whims of the government.
Sure, one day the government decrees that 1 oz gold = $X but next month, the government just issues another arbitrary decree that it’s worth $X-Y.
I don’t see the government allowing regular public tours of Ft Knox to allow the citizens to continuously audit the amount of gold it says it has.
Another issue is that gold standard is more workable if all the other countries switched to it as well.
Lastly, the government can confiscate it and/or declare its possession illegal if it becomes “too inconvenient” for the govt to maintain its obligations to the standard.
I don’t have a problem with the theoretical benefits of fiat money if it was properly managed. If its quantity was computed without bias based on population growth or discovery of new energy sources, that should provide enough stability and would better reflect “real” economic activity. That unemotional cold calculation scenario however is just theoretical pie-in-the-sky. Today’s actual application of fiat money results in manipulation to “solve” unemployment and “fix” the economy.
I believe tomorrow’s currency reform will start from the bottom up and not from the top down. As citizens’ confidence in their countries’ currencies diminish, new private currencies will develop. I’m not exactly sure on the particular form it will take. Maybe it will be tokens of digital credit from private companies. Technology could also fuel an explosion in cashless transactions because smarter exchange systems can be set up to facilitate fine-grained barter for products and services. Today’s ebay and craigslist is too crude for that type of scenario. History may repeat itself as countries governments clamp down on the fragmented private digital money and re-consolidate them into new issues of govt digital money. The cycle then repeats.
Okay. since the previous discussion seems to be winding down (and amicably at that), let’s go ahead and talk about Austrian Business Cycle Theory. I’ve been doing some more thinking about it in the past few days, and I’d like to get everyone’s take on where exactly this theory is wrong. Don’t get me wrong - I don’t think it’s perfectly correct. The first problem it had was that it failed to explain the length of the Great Depression. The second problem it has was that Hayek himself seemed a bit stumped as to what the ‘right’ policy is in an Austrian economic system. But I think there may be parts of it that, if not fully correct, have at least some insight to share about how recessions start, if not how to fix them.
Let me summarize Austrian Business Cycle Theory. Hellestal, if you see any mistakes in my description, feel free to correct them.
Let’s consider an economy with a fixed money supply (not a fixed aggregate (i.e. gold standard), but a constant MV). What happens to that economy over the years?
The first thing to consider is that business investment varies in time required to recoup investment, the amount of capital needed to create profit, and the risk of failure.
And how does business find capital to invest in this closed world? From savings - either personal or from other businesses. And because businesses borrow money against other people’s savings, a relationship develops between savings, investment, and interest rates.
Let’s say the demand is high for short-term capital (say, to replenish inventories, hire workers to start a new assembly line, whatever). When this demand forms, people start lending money. If the demand for production goes up, interest rates begin to rise. This acts as a signal to savers that they should save more money (they’re earning more on their savings). It also acts as a signal to the market that long-term investment is now more expensive. So long term investments cut back, easing the strain on the money supply.
Now what happens if the short-term capital requirements drop? Let’s say there’s overproduction, inventories are high, and businesses cut back on short-term spending while their inventories fall. This reduces the demand for capital, driving down the interest rate. That acts as a signal to longer-term investors, and they start borrowing money for longer term investments again.
In this model, interest rates act as the information transfer mechanism that encourages or discourages private savings and changes the mix of investment in the economy between short term production and long-term investment. Interest rates also act as a check on GDP growth. If the economy starts to overheat, the demand for capital drives up interest rates which makes business investment more expensive, and which causes consumers to switch to more savings, lowering demand. The economy cools off again.
Now, in the Hayekian view, here’s one of the things that happen when central banks get involved: In the case of a bubble, the economy heats up. Businesses look healthy, and there is high demand for capital. So interest rates start to tick up, and the central banks goes, “Whoa! That’s not a good thing. Here we have a healthy economy, with tons of demand for money. Let’s provide it, and keep this hot economy going.” So the fed starts injecting money into the economy to keep interest rates down. But targeting the interest rate at a low level means that savers do not benefit, so savings don’t go up. The low cost of credit encourages even more borrowing. Long-term projects keep ramping up, even though there’s already high demand for capital in the short-term economy.
This is exactly what happened in the 1990’s. Alan Greenspan held interest rates low because he had convinced himself that the internet and computer revolutions had permanently increased productivity, and therefore the growth was real and the money supply was holding back a real expansion, and not a speculative bubble. So he willingly held interest rates low to keep the party going.
Now, Hayek says that the problem with all this is that this demand in the end translates into a need for real things - you need more people, you need more raw materials, you need more of everything. But the money supply is now disconnected from that reality. So what happens is that companies start bidding up the price of everything in competition with each other, and you start getting inflation. But more to the point, there actually isn’t enough to go around. So something has to give. Eventually, interest rates are forced up because of inflation, and the first thing that happens is that those uncompleted long-term projects become non-viable. So you wind up with half-finished condos in California, abandoned oil drilling projects, internet companies that fail before they have a chance to find a revenue stream, etc.
And because the cheap money caused savings to remain low, people are overleveraged. Asset prices come down, and people go into a savings mode to repair their finances. Consumer demand drops, which causes the recession to deepen, etc.
The fix for this is that once interest rates come back down, and people recover enough money through saving, investment starts up again. But first, all the bad investments have to be cleared away. Capital has to be freed up from the non-viable long-term business plans. Business that only survived in an environment of artificially low capital costs and overstimulated demand have to be allowed to fail so that the people and resources tied up in them can be released and used by more viable business. Reality has to be allowed to assert itself.
That’s no doubt a gross oversimplification of the model, but that’s the gist of what the Austrians thought caused recessions. Now, it doesn’t have to be limited to government action - a speculative bubble or a tulip mania can cause the same problem. But without a central bank holding interest rates low, these types of recessions should be short and not too damaging as they self-correct fairly quickly.
So one way major recessions can happen is when the fed acts to lower interest rates to accomodate a heated economy. The other way is the opposite. Interest rates rise at the tail-end of a upswing, and the economy starts to go into recovery mode. Investment slows down, people start being laid off, unemployment starts to rise. Now the central bank has an incentive to lower interest rates to keep the party going. So it lowers them, the economy struggles along, and starts to go down again. So the fed lowers interest rates again, hoping to ride out the natural business cycle while avoiding a recession. But since the economy isn’t clearing out the malinvestments that caused it to get sick in the first place, this doesn’t happen. Maybe you get a period of low growth with lowering interest rates, with the real economy getting sicker and sicker. Eventually, the fed runs out of bullets because the interest rate hits zero. Then the house of cards comes crashing down.
I think that’s a reasonably accurate description of the Austrian model. Hayek’s ‘fix’ for this is not a gold standard - it’s to change the central bank’s policies to target a constant money supply (as opposed to targeting a constant or slowly growing consumer price index, or targeting interest rates). But I don’t think he had a good answer for how to really do that.
If Hayek is right, then fiscal stimulus is a bad idea in anything other than a crisis situation, because it’s just another way to keep the economy going without correcting the underlying fundamental imbalances that are causing the problems in the first place. Bailing out long-term investors is also a bad idea, because of the moral hazard and because it doesn’t clear the resources out from those investments which are no longer profitable. The economy just goes into a long period of low growth propped up by various interventions until the cost of those interventions gets too high, then things go really, really bad.
Comments? Anyone want to point out where the model goes wrong?
Work Note: I don’t have any more time after today. I’ve got a seminar next week that I have to finish organizing, followed by a nice long vacation. I’m not going to go back to the hotel after a day of wandering in the sun and start posting here. Just won’t happen. (There’s some gaps of time between, but there will probably be other work I need to finish.) If people indicate that they still have questions later, I’ll bump the thread in late August.
So. Cartography.
The lines of latitude and longitude are an abstraction, totally arbitrary. But once it’s been implemented, the mathematics becomes consistent within that arbitrary system. Distance between two points on the globe, say New York and London, is a real fact. The arbitrary system will give a constant, consistent way to measure that fact. The math is always the same after the abstraction is decided.
And if we change the abstraction in an arbitrary way? Make lines of longitude/latitude twice as far apart? Then the math changes, the calculations all alter. But the real distance between New York and London is the same. It is the reality of the distance between our two cities that gives us the relationship between the two arbitrary systems. We can get the conversion factor by comparing how the two different arbitrary units measure the same real distance.
Now here’s the important part.
With real world navigation, we’re talking about a system that we should implement and then not alter. Once the abstraction of longitude and latitude is created, the math is always the same within the system. That’s convenient for our minds. So the best way to avoid human error is to fix it and then not fiddle with it. Our price system, in contrast, is not like that. Our price system can’t be held fixed. Even with a perfectly constant money supply–or better, especially with a perfectly constant money supply–our price system will fluctuate. The mathematics of navigating our globe of prices is not determined by the abstraction of money supply alone. It’s determined by the interaction between abstract supply and human demand. Human demand is naturally variable, and so the latitude and longitude of prices are always in a state of flux.
We are already impossibly removed from an ideal of perfect stability in measurement. It can’t be done. And I need to emphasize here: A change in money demand need have nothing to do with changes in our relative preferences for goods and services. I can like all the same things, in exactly the same proportions, and yet still have a change in my desire to hold cash reserves. This change in money demand would in turn change the price level. We have to navigate the globe of markets when the price lines of latitude and longitude are constantly, unceasingly, always shifting from where they previously were.
It’s like being in a boat with a computer navigation system that is constantly altering the parameters of longitude and latitude. This particular computer can’t be replaced. We have to deal with it, and adjust our mental maps and our calculations to keep up with the constantly shifting lines.
And to say it again, these longitudes of price can shift even with a completely stable money supply. All it takes is a change in our demand for cash reserves. I say again: We can have the exact same relative preferences for any goods and services we decide to buy, and yet shifts in money demand could still change the price level. How? We might want the same goods and services, but next week instead of day. We might be holding more cash not because we like different things, but only because we want to enjoy the exact same things at a slightly different time. That would still result in a change of money demand.
And this change in money demand will affect the price level. It’s like the boat navigation computer that nudges those lines of latitude and longitude. We have to mentally adjust and recalculate.
Navigating in a boat like this would be hellish if the computer really got ornery. This is like a large inflation rate. The map in our heads becomes out of synch with the changing cartographic lines from the computer (prices from the markets) so quickly that we have to spend vast amounts of time and effort updating our notions of the distance, double- and triple-checking our calculations to be sure we’re on course. But if the computer’s changes are small? We’d have an easier time getting to our destination. When price changes are small, we have a good intuitive sense of where things stand even if we’re a little off. We’ll reach our destination without much hassle.
And now I return to deflation. Always and forever.
A touch of inflation can be okay. With just a touch of inflation, we tend to make navigation errors that send us just a bit further out from shore than we were expecting. With deflation, people consistently run aground.
And maybe your brain still wants the phone and not something else.
You didn’t buy the phone. Okay. And did you burn 500 dollars of cash when you made that decision? Did you immediately leave the unused cash on a street somewhere and walk away? Or did you hold on to the money by deciding that there was something else that you might rather buy with those 500 smackaroos in the future?
It’s obviously not a random guess on my part when I say you held on to the cash. Naturally, you already realize that you just shifted your preferences to cash reserves, “hoarding cash”. Deciding against a present purchase, in favor of future consumption, is (as you appear to know) an increase in demand for cash. Now here’s the funny part: Unless you bought something else with that money, you didn’t provide the present-day markets much information about your relative preferences between goods and services. The only thing that is certain is that you didn’t buy anything.
By making a purchase, you would’ve made a choice among available possibilities. Your relative preferences would have been discovered. By not making a purchase, you deprived the market of that particular bit of information. But your relative preferences might not have changed. As far as the market is concerned, you might still want the exact same things. You could want that very same model iPhone. Maybe you just want to go shopping for it next week instead of this weekend. This is why holding money instead of spending it tells us very little about your relative preferences between goods and services.
Obviously you still want to buy something. You’re not going to burn the $500. You intend some sort of consumption. But you hoarded the cash, and the markets don’t yet know what that something is. What should they make for you? The same thing? A different thing? Who knows? You haven’t provided the needed information.
Your demand for something hasn’t disappeared. It’s just been put off into a time frame where nobody yet knows about it. Maybe not even you.
If you’re on your lonesome with this decision against purchasing, then there’s no harm done. But I’m talking money here, which means aggregate measurements. And if there is some exogenous shock that causes everyone, simultaneously, to cut back on present purchases in order to consume something in the future, then an overwhelming amount of information about relative preferences is lost overnight.
The general price level drops. The specter of deflation starts creeping in.
If all prices everywhere were to drop simultaneously, everything moving perfectly together at once, this would be no huge problem, because relative preferences between present goods and services would be almost fully preserved. Mexico can revalue the peso. There would be a touch of damage–gramps would be troubled by the strange new numbers–but most people would work out it okay. But that’s not what happens in the typical deflationary situation. Some prices are sticky and resist changing in sync with the others.
The information about relative preferences between goods in the economy is lost, gone, destroyed, obliterated. It’s lost in the noise of sticky wages.
There is no actual need for a change of relative preferences. It just looks like a change of preferences, because some prices drop quickly and others don’t. Eventually, the economy will get so fucking terrible that even skilled workers will be forced to take wage cuts. But how long would that take? Real wages of those who were lucky enough to still be employed rose for three years straight during the Great Depression.
This. Is. A. Distortion. It doesn’t just affect gramps, like a peso revaluation. It blinds nearly everyone, like a terrible fog that has descended on the globe of prices, with our navigation system suffering a bias that hides from us how close we actually are to the rocky shore. Relative prices are changing, but not just because our relative preferences are changing. Now obviously, there is going to be some change in relative preferences during a recession. But how much of the relative change in prices can be attributed to recession, and how much to sticky wages? Who the hell knows? The information is gone, gone, gone. And soon enough, the economy is gone, too. Producers just can’t decipher the garbled information.
The smidge of deflation is overwhelmingly more damaging than the smidge of inflation because downward stickiness is overwhelmingly stronger than upward stickiness.
This is partly our inherent psychological loss-aversion, combined with money illusion, which causes an unwillingness to accept nominal wage cuts even if real wages would be steady. This partly a self-reinforcing cycle: an increase in money demand causes a drop in prices, which makes money worth more, which causes an increase in money demand, etc. This is partly because of the inevitable increase in real interest rates, at the zero lower bound, given every additional point of expected deflation; at 0% nominal interest and 5% deflation, real interest is 5%. Who would borrow money at such unfavorable terms? Who would take the risk in lending, when they could make their money back just by holding on to their cash?
It’s as if longitude at London were sticky, with longitude at New York fluid–the computer says the two cities are getting further apart. But they’re not. The real distance can be exactly the same (people’s relative preferences between two different goods can be exactly the same), and yet because of the sticky distorted system, all the ships are now navigating a course that leads them straight to disaster.
This is the problem our economy is suffering right bloody now. And this problem can be prevented.
We have printing presses. We do not need to have dropping prices. The right monetary policy, given this horrible deflationary situation, means compensating strongly in the other direction. Doing that would clear the fog of deflation, and would also push the lines of market longitude back in sync with stable long-term expectations, that which coincides best with our own mostly inflexible mental maps.
The essence of the Austrian theory is how an artificial monetary stimulus distorts the structure of production. Let’s say there are two sectors in the economy: the consumption sector and the capital goods sector. There is a balance between the two sectors based on its natural rate of interest. Now the government intervenes and artificially lowers the rate of interest. This changes the balance and resources shift to the capital sector. These are malinvesments produced by the government policy. Eventually the policy reverses and artificial monetary stimulus ends. The malinvestments are exposed as fundamentally unsound and resources shift back to the consumption sector till balance is restored.
The problem is that none of this explains the boom or bust during a real-world business cycle. In the boom both the consumption sector and capital sector are expanding and the overall unemployment falls. Why does this happen? Why aren’t resources shifting from one sector to the other so that the consumption sector contracts?
Similarly during the boom why are both sectors contracting. Shouldn’t resources be shifting from the capital sector to the consumption sector. There may be a transition period but does that really explain the sharp spike in unemployment during a recession? And why are jobs lost in the consumption sector as well? Shouldn’t that be expanding now that artificial interest rate policy which boosted the capital sector is over. And if the transition period of shifting resources from the capital sector to the consumption sector causes so much unemployment how come you don’t get unemployment in the reverse transition from the consumption sector to the capital sector during the boom.
One big problem of the Austrian theory is that they don’t really analyze the financial sector where most of the action takes place with irrational exuberance and risk taking during the boom and a downward spiral and collapse during the bust. Minsky’s financial cycle theory does a much better job of this and has come back into fashion in the last couple of years.
There are plenty of other problems with the Austrian business cycle theory. Tyler Cowen wrote an entire chapter critiquing the theory in his book Risk and Business Cycles. Caplan also has a section with some trenchant criticisms in his well-known essayon Austrian economics.
Here is a nice articleby Gordon Tullock (pdf file). He addresses in greater detail the same problem that I wrote about in my previous post.
Tullock’s article reminds me that there are plenty of prominent academic economists who are pro-market: Chicago School, public choice, some of the NIE guys and AFAIK the vast majority don’t support the Austrian business cycle theory. Doesn’t necessarily mean they are right of course but clearly there are many economists with broadly similar politics who just don’t find the Austrian theory convincing.
A correction: In the third para of my last post it should be “Similarly during the bust why are both sectors contracting?”
The problem with fixing the money supply is that it’s hard to do. It’s easy enough to fix the size of the cash itself, but velocity is a hard thing to nail. It moves around. It responds to Keyne’s ‘animal spirits’. Irrational exuberance causes velocity to shift upwards, increasing supply. Fear causes it to contract. So how do you measure it, anticipate it, and correct for it?
Early in his career, Hayek suggested targeting wholesale prices. Later, he thought the consumer price index would be a reasonable measure, but he never explained his shift in opinion. And that seems flawed anyway - If you target consumer prices, you’re going to keep inflation and interest rates in check, which destroys the signals Hayek said we needed.
Joseph Schumpeter didn’t think there was a fix. He thought that we’d get wealthy, and government would wind up doing more and more because we have more and more excess capital to give to government, until government grows to the size where it chokes off real innovation and growth and replaces it with rigid rules and bureaucracy. Each round of the business cycle would result in new layers of regulation piled on top of us and increases in the size of government.
After looking at the new financial reform bill, I’m not sure he’s wrong.
Lantern: I’ll go off and read Bullock’s essay. But my first thought as to why the economy hasn’t behaved as the Austrians predicted is simply because the money supply is not stable. Even without fed action, manias and bubbles can drive up MV. And for most of the modern economic era we’ve had banks doing exactly what Hayek said they should not do - attempt to manage the business cycle by manipulating money.
But also, I suspect the devil is in the details, as it is for other economic models. These kinds of models all look good and sound intuitive and right when they are reduced down to simple thought experiments. But I’m not sure the real behavior of the economy is anywhere close to these models in a world where we have central banks behaving differently in different countries, floating exchange rates, the ability of capital to flow freely around the world through multiple regulatory regimes, and all the rest of the complexity that the real world brings. I believe this also applies to pure Keynesian theory, and that’s why the fiscal stimulus doesn’t appear to have operated as advertised. There’s just too much in a modern economy you can’t model and understand.
Well yes, which is why you need to figure out the testable implications of your models and then actually test them against the data. IMO the “pre-analytic vision” of Austrian economics is interesting and original; especially Hayek’s idea of market prices as a discovery mechanism which has had a significant influence on mainstream economics. But after a certain point you have to convert your vision into concrete models. Here the Austrians have fallen short because their methodology discourages explicit modeling and empirical testing.
Sure. When I started this thread, one of the things I was interested in was whether modern math and technology can provide techniques to begin to quantitatively model this stuff. There has been a lot of work done in complexity theory and computational economics which might be able to play a role here.
I subscribe to this notion. You see it arising in virtual worlds online.
But I would argue that is exactly what happened with the gold standard in historical times. Governments didn’t need to do anything. They didn’t need to start printing paper with numbers on it and declare anything.
The gold standard has always arisen naturally of its own accord, much like your digital credit example. Occassionally it was wampum or seashells or something like that, where societies were disconnected from the Western World and didn’t have access to gold (or another precious, scarce resource).
I would argue that if the government did nothing, the gold standard or something similar would arise, much like your hypothesis in P5. Prices of goods would be reflected in grams of gold or ounces of gold like they were in historical times. I don’t want to return to those days, since they imposed huge transaction costs on the economy. But it’s worth pointing out that the government doesn’t really need to do anything here. It could choose to do nothing.
Let’s jump to P1.
There is a conceptual notion that I think you have backwards. That is not meant as an insult. The notion seems deceptively simple, and perhaps even pointlessly semantic, but I think it’s important.
The gold standard does not declare that gold is worth $X. It declares that the little green piece of paper with numbers on it is worth x ounces of gold. And is redeemable for same. The little green piece of paper could be called a dollar, a MauleMan, a ThingyMaBob, or anything else. 1 Ruminator unit = 0.02 ounces of gold, or something like that. It doesn’t really matter.
All it is, is a receipt that is redeemable for a certain weight of gold. You could just as easily scribble it down on a matchbook or the back of a bus ticket.
The receipt needs to be effortlessly and quickly redeemable for the weight of the resource on demand. Most people will not bother to do so, since it is far easier to carry decimal-based divisable pieces of paper around than nuggets or grains of gold (or seashells, or barrels of oil). It is also easier to transact virtually, as you note above.
Now let’s jump to P2 and P3.
As far government arbitrarily decreeing that the paper is now only worth 0.5*x of what it was worth before, or allowing tours of Ft Knox, I agree.
BUT THAT IS THE WHOLE POINT.
That sort of devaluation is a brazen attempt by the government to steal from the stored value and private property of its citizens. And that is indeed what FDR did back in the 1930’s…he arbitrarily changed the value of the green paper receipt, and when the public recoiled, he used the threat of force to seize their assets.
That’s the whole point, sir. The whole kit and caboodle.
That is what we as citizens need to monitor and defend against. There is no need to know how much is in Fort Knox or anywhere else…as long as we are freely able to switch back-and-forth between paper and gold, there is no need to know how much is there.
When it suddenly becomes less easy to do that, or when the government declares that the paper is no longer worth what it was before, is time for concern and action.
That is why gold and gold certificates started disappearing around the time of FDR’s actions. It wasn’t because there was anything wrong with using gold as a standard for the currency…it was because people didn’t trust the pieces of paper would be redeemable for gold. They hoarded the safe store of value that they had.
Politicians claimed that the actions of the citizenry were proof that we needed to go off the gold standard - when in fact the gold standard was doing exactly what it was supposed to do…act as a constraint on the government’s devaluation of the currency.
That’s the whole point. That’s what it is supposed to do.
Let’s look at the alternative. An un-elected body slowly devalues the currency over time, to the point where inflation has eroded 95+% of its value since we went off the gold standard. It whipsaws the economy through booms and busts, almost invariably due to poor monetary policy (often exacerbated by borrowing to fund wars) that result in overly loose money, followed by overly tight, etc. as Sam Stone has noted. No arguments there.
Is that better? How? I would argue it is much worse.
You have no control over that as a citizen. None at all, except through the tortuous, hugely disconnected path of electing 1 Representative every 2 years, a President every 4 years, and a Senator every 6 years. 3 dudes or dude-esses out of 539 people.
It seems that the essence of your argument against the gold standard is that it can be violated by the government in a brazen, unconstitutional fashion that requires force. Of course it can. That’s the whole point.
The government needs to get right in your face - right in your “Grill”, as the young folks today like to say - and make it plainly obvious that it is stealing from you and the savings that you have put aside for your children.
That would be unpleasant to be sure, but would be obvious to the voting populace.
I like constraints like that on my government.
I would argue the current method is just as bad, and gives us less control as citizens. It’s a slow, easily disguised drip-feed by unaccountable and unelected officials that unfortunately ends up in the same place…only worse, because too many people don’t even realize it is happening.
I guess my answer here, is the same logic that you use so many times in your posts against centralized planning.
Why does the government need to anticipate and correct for it, at all? How does trying to react against a natural movement in the economy need to become a necessary function of government? Why would you fiddle around with the currency to address such things?
The government can always borrow against either (1) its asset base or (2) the future revenue streams of tax receipts if it needs short term resources to serve a social need. And if it can’t, that’s a huge signal to the citizenry that something is rotten in the state of Denmark. Or perhaps more accurately, the District of Columbia.
I would argue that such borrowing could be necessary to address liquidity traps, or to fund wars, or for some other reason.
I don’t understand why manipulation of a fiat currency would be the primary option.
The problem with a money supply is that velocity can change. For instance, let’s talk about the gold standard. Now, I haven’t thought much about the gold standard other than to decide it was probably not a good idea, so maybe there’s some holes in my logic that you can point out.
Let’s say that we decide a dollar is worth .001 ounces of gold. So our total money is linked directly to the size of our gold reserves. But what happens if money stops moving? Now there’s a shortage of cash. It’s hard to get loans, which contracts business activity. This causes velocity to slow down even more. You get into a deflationary spiral which does all kinds of damage to investment and the information content of prices.
Specific to the gold standard is the problem that the amount of gold itself fluctuates. Advocates of the gold standard say that because gold is constantly mined, the gold supply will slowly increase, giving you a nice, slightly positive inflation rate, which is what most economists agree is a good thing (low but positive inflation, that is). But do you really want to tie your money supply to something as arbitrary as discovery rates for gold? Is it really that predictable? Also, gold is used for other things like electronics and jewelry. Gold used for these purposes is taken out of the money supply indefinitely - it really is like putting your money under a mattress. So the money supply would constantly be pulled and tugged by forces that have nothing to do with money.
Ultimately, the real objection to the gold standard that I think has merit is that it’s a false hope. You think that by ending fiat money you take away the power of the government to screw with the money supply. But I have no hope that that’s the case. After all, the government passes ‘good government’ laws all the time, and then completely ignores them. Campaign Finance Reform, 8 million balanced budget amendments, pay as you go rules, anti-lobbying rules, etc. They’re always ignored, delayed, or worked around whenever the government feels the need to do so. I have no doubt that when the first financial crisis hits, government will just abandon the gold standard again anyway, like it did in 1934. Or, it will come up with some way to jigger the gold standard, like issuing gold certificates borrowed against future discovery or some damn thing.
But ultimately, the biggest argument for a fiat currency is that prices can be kept stable, or at least ultimately controlled in some kind of predictable fashion. Most economists agree that deflation is a really bad thing, and under a gold standard there’d be no way of stopping that from happening under the right conditions. Also, I think you’d see more attempts at currency manipulation by speculators, you’d find dishonest governments over-stating their gold reserves, yada yada.
I don’t even think it’s true that a gold standard would avoid recessions - one of the problems for the Austrian theory is that there were plenty of recessions before there were central banks and fiat money. About the only thing a gold standard would prevent is an inflationary spiral from governments printing money willy-nilly. No one wants to be the next Weimar Republic or Argentina. But I’m not sure that’s a real risk for the U.S. - too many other nations are pegged to the U.S. dollar, and the U.S. is too invested in keeping the value and stability of the dollar up.
In fact, I’ve been thinking that floating exchange rates and worldwide currency trading are perhap the best control mechanism we have to ensure that fiat money doesn’t get out of hand. If a country is completely cut off from trade, then maybe it can put off the day of reckoning by constantly inflating the money supply. But in a global economy with floating exchange rates, there’s a marketplace for world currencies. Screw around with your money supply, and it shows up in the exchange rate. If you finance debt by selling Treasury Bills to foreigners, you’ll find your interest rates being driven up by the need to clear your auctions. So the real world asserts itself on you. Now, if people advocated a single world fiat currency, that would be a very bad idea.
I’ve been one of the people who early on feared that all the QE going on would result in inflation in the future. I’m not so sure any more. I think it increases the risk of that, but it also decreases the risk of deflation, which would be worse. Clearly the price of gold indicates that people are hedging against inflation, but I’m not sure how much of that is simply reflective of the fear and uncertainty that’s affecting all markets, rather than a specific inflation hedge.
Am I confident that government will manage the money supply correctly? Not a chance. I think there is plenty of evidence that it hasn’t done so. But I don’t have a great solution other than regulatory reform. Perhaps the money supply could be linked to the price of a collection of commodities, or the consumer price index, or some other way of measuring the ‘real’ need for the money supply. There have been plenty of different proposals for improving the way the fed makes its decisions.
Unfortunately, that ship just sailed. The new financial reform bill has new oversight rules for the Fed, but they are vague and rely on a council of smart people to make up the rules as they go along, as I understand it. That just makes the problem worse and injects politics into the process.
I was just exploring if extra numbers produces actual progress in velocity or increases land surface area. Btw, the overlaying of prices on shifting real world preferences as if prices are analogous to a coordinate system is not correct.
I’d like to see the mathematical equation that models invariant preference ratios for non-cash while the preference for cash changes. Seems very challenging given the fact that the world is changing every second and preferences change every second.
Ah, Keynes reborn.
The focus on cash/money is wrongheaded. It’s a flawed model.
It’s better to unify (generalize) cash/money as simply another tool (among many) for delayed consumption.
When we do that, we’ll see there are almost unlimited forms delayed consumption: every wine bottle stored in a kitchen pantry, any clothes that don’t unravel and tear in a single day, any car that doesn’t self-destruct after one trip.
Once we generalize money is a non-special case, we see that adding more of it purely in nominal terms is wrongheaded. Using your logic of money as a special case of spending fails to explain why money does not make it down to the unemployed in Detroit Michigan.
Not buying something does provide information to the market.
Again, sticky wages is overrated. I said previously that workers can get fired. Also, if employers are paying sticky wages, then it’s a good chance they are bleeding cash. Their weakening balance sheet also informs the market. The bank will withdraw their discretionary line of credit. A potential investor may turn away. Or the company becomes a juicier target of a buyout by a bigger company. The management at the bigger company may have less reservations about laying off all those redundant sticky wage people.
Also, stick wage people are not seeing their “real wage” increase like you believe. That’s a misleading assessment. The “real world” that’s providing goods & services has also changed. Yes, nominal prices are lower but there are additional negative market effects not noticed because of over emphasis on price: less quantity of that product, less options and choice of that product. So, a loaf of bread costs less, but there’s less choice of bread. To say that “real wages” have increased in light of all the other non-price attributes changing is misleading.
I can certainly see that analysis of money in the way you have done can lead to thinking that’s how it works.
When you come back in August, we can explore David Ricardo’s island of coconuts and fish. We can overlay that island with fiat money and see if recessions can be prevented. We then proceed to dismantle M*V and NGDP.