Monday, April 4, 2011

Why is this so %$^&ing hard for some people???

If you don't agree with me and other Keynesians, fine. Macroeconomics is tricky, there's not nearly as much data as we'd like, and it's not like there's a "grand unified theory of macro" anyway - presumably lots of processes are operating, etc. etc. Fine.

Bob Roddis writes on Bob Murphy's blog: "I’m turning purple from holding my breath waiting for the very first Keynesian/Krugmanite/inflationist/spendthrift analyst who understands that the universal Austrian criticism of all their nefarious schemes is that they CRACK THE THERMOMETER of economic knowledge by disrupting and distorting the pricing process... The cure always remains the same: FIX THE THERMOMETER and allow it to work."

Why is it so hard to convince some Austrians that we don't need Austrian economics to tell us what we already know about market efficiency and the primacy of the price mechanism in resource allocation, growth, and prosperity. It is precisely the case of Keynesianism that we should "fix the thermometer and allow it to work". The Keynesian argument is essentially this:

(1.) Interest rates operate as a price in two markets - to simplify, we can call them the market for cash and the market for loanable funds.

(2.) This means that a particular interest rate may not clear both markets simultaneously. If you write it out, this isn't a disequilibrium - it is an equilibrium. To put it differently, arbitrage can't fix it.

(3.) Since we have a stable price that is not equal to the market equilibrium price, we have deadweight loss. It is misleading to think of this as a disequilibrium phenomenon: it is a stable equilibrium phenomenon and can be thought of as an "interest rate wedge" (like the more traditional "tax wedge").

This price distortion does what all price distortions do: it prevents entrepreneurs form effectively allocating resources.

Why, why, why do people like Bob Roddis (and many others) accuse us of ignoring what is in fact the central problem of Keynesian economics?

Brad DeLong points us to Keynes:

"Whilst... the enlargement of... government... in the task of adjusting... the propensitv to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it... as the only practicable... condition of the successful functioning of individual initiative...

[I]f effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him. The game of hazard which he plays is furnished with many zeros, so that the players as a whole will lose if they have the energy and hope to deal all the cards. Hitherto the increment of the world's wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough..."

One might also note:

"To put the point concretely, I see no reason to suppose that the existing system seriously misemploys the factors of production which are in use. There are, of course, errors of foresight; but these would not be avoided by centralising decisions. When 9,000,000 men are employed out of 10,000,000 willing and able to work, there is no evidence that the labour of these 9,000,000 men is misdirected. The complaint against the present system is not that these 9,000,000 men ought to be employed on different tasks, but that tasks should be available for the remaining 1,000,000 men. It is in determining the volume, not the direction, of actual employment that the existing system has broken down.

Thus I agree with Gesell that the result of filling in the gaps in the classical theory is not to dispose of the 'Manchester System', but to indicate the nature of the environment which the free play of economic forces requires if it is to realise the full potentialities of production. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government. Furthermore, the modern classical theory has itself called attention to various conditions in which the free play of economic forces may need to be curbed or guided. But there will still remain a wide field for the exercise of private initiative and responsibility. Within this field the traditional advantages of individualism will still hold good."

This is why many leftists complain that we are (and why Brad DeLong proudly wears the label of) "neo-liberals". "Neo-liberalism" as it is understood by the left has some less savory aspects to it as well, but the reason why this is hurled at prominent Keynesians is that the argument is one that is grounded in market economics.


  1. "It is precisely the case of Keynesianism that we should "fix the thermometer and allow it to work"."

    The point is that Austrians beg to differ. The Austrian POV is this: all you are doing is damaging to the thermometer. You can disagree with this perspective, but it really is an issue of where one is standing. That's why your argument here isn't terribly convincing.

    As for Keynes, well, we all know that there was no area of state control he would not condone - thus his love of the eugenics movement (to sort out the wheat from the chaff of the human "product").

  2. re: "The point is that Austrians beg to differ. The Austrian POV is this: all you are doing is damaging to the thermometer."

    Obviously, Gary. And the Keynesian point to the Austrians is "all you are doing is damaging to the thermometer".

    It is quite clear there is a difference in opinion here, and that that is it. What's incredible to me is that over the course of this weekend from multiple angles I've been informed that I or my position is somehow ignorant of the price mechanism and market efficiency.

    To disagree with me on the impact of a policy is part of life - these disagreements will happen. To presume ignorance is unexcusable. I think Austrians are wrong on many points... I don't go around presuming they don't know how markets work because of that.

  3. I am sure an Austrian would counter that if you buy into Keynesianism that you are ignorant of the ultimate, self-correcting nature of the price mechanism.

  4. If you understand the interest rate as the ratio between future goods vs. present goods, then you'll notice its role in the economic system: it guides production between infinite alternatives and sorts the time structure of itself. Fiscal or monetary intervention does indeed damage the most important price in the economy (the interest rate) and the most important good (money).

    I would check the premise:

    "(1.) Interest rates operate as a price in two markets - to simplify, we can call them the market for cash and the market for loanable funds."

    The phenomenon of the interest rate can arise even in the absence of those two markets.

  5. ivanfoofoo -
    I think you are picking out exactly the right point of contention between Austrians and Keynesians.

    However, what I find surprising is this - why is it that I can say:

    "The Austrians are distorting the price mechanism by their proposals and risking depression and ruining markets by doing so, but I understand they know how markets and the price mechanism works, and the centrality of the price mechanism to economic calculation - they're just applying it incorrectly."

    But Austrians seem absolutely incapable of saying:

    "The Keynesians are distorting the price mechanism by their proposals and risking depression and ruining markets by doing so, but I understand they know how markets and the price mechanism works, and the centrality of the price mechanism to economic calculation - they're just applying it incorrectly."???

    Can you imagine how confused and dumbfounded Steve Horwitz, Peter Boettke, Bob Murphy, etc. would be if I repeatedly explained the price mechanism to them and insisted that they were wrong because they didn't really understand how it worked?

  6. Completely. I think Austrians focus a lot in the structure of production, that may explain their adherence to a sound one (defining sound as more equal to a pure free-market outcome). Keynesianism is all about market intervention, but not only as a paliative, but as the solution, because they think there exists a lot of market failures that should be fixed by continuous and eternal intervention (for instance, the idea of those two markets being operated by the interest rate, which may or may not clean both ones).

    Austrians see the interest rate as a consistent single information-bearing signal in the market that coordinates time (interest explained as a pure time-preference phenomenon).

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  8. Daniel,

    Your paradigms differ. This ought not to be shocking.

  9. Gary -
    It doesn't shock me in the slightest. Like I say, I'm not going around proseltyizing to Austrians on the price mechanism.

    What I am somewhat shocked by is that Austrians don't seem to note the paradigm difference, and instead like to think we just abandon the price mechanism.

    To keep your paradigm references, it would be like Newtonians - instead of simply recognizing that Einstein understands gravity in a fundamentally different way - accusing Einstein of not accepting the reality of gravity.

    That's more than a paradigm difference - that is an inexcusable presumption of ignorance in and failure to listen to the people you disagree with.

  10. I would guess that Austrians would counter with the same argument.

    Personally, I don't care.

    Keynesianism does not promote freedom; it promotes state sponsored paternalism. Whether it is right about "liquidity traps" or what have you is rather secondary to me.

    As for Austrian business cycle theory, it sort of seems trapped in a closed loop.

  11. "I would guess that Austrians would counter with the same argument."

    You keep saying this - what do you mean by this? What Keynesians are going around saying "gee, I don't think the Austrians know how the price mechanism works"? Where is the symmetry here?

    re: "Keynesianism does not promote freedom; it promotes state sponsored paternalism"

    If it did, I think a lot less economists in the liberal tradition would be Keynesians.

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  22. I really hate to do this, but I'm getting sick of this.

    This post is about economics. This post is about the way that the price mechanism is incorporated into Keynesian and Austrian economics, respectively, and the process of economic calculation in Keynesian theory.

    I'm sick of having it hijacked with poorly reasoned rants about whether Keynesianism inherently stands in opposition to the right to free speech.

    Anything else off topic is going to be deleted too.

  23. Sorry, Prateek - your comment was fine I'm just deleting the whole thread.

  24. I would just note that in none of my above arguments did I insult an individual; I simply made the point that ideologies which concentrate power in the hands of government should not be surprised when the fruits of such are curtailments of liberty.

  25. No probs man. Your crib, your rules!

    By the way, when DeLong says, "you have presented us with two different supply-and-demand arguments, one saying that Treasury bond prices should be low and hence are about to collapse, and the other saying that Treasury bond prices should be high and are likely to stay more-or-less where they are for some time to come" - I found something eery.

    I have come to the exact same thought during idle moments, and then juggling around with it is like having one finger go in a forward circle and the other in a backward circle. It's incredible to see how smoothly a professional economist moves through such a contradiction.

  26. Where is the contradiction? :)

    It's not a contradiction so much as an indeterminance in this case. You have two markets - a market for cash or liquidity and a market for bonds or loanable funds. There is no obvious reason to expect that the same price/interest rate will clear both markets. Is that a contradiction? Not really. It's just a function of money as both a store of value (hence it's intertemporal exchange prospects) and as a medium of exchange (hence the demand for liquidity).

    The very nature of money forces two separate goods to trade at the same price. But you can imagine what would happen if this were imposed on other markets too. Think if for some institutional reason - because of the very nature of sandwiches and sodas, a sandwich had to trade at a price that is the inverse of the soda price. It's weird to think of that because goods aren't naturally like that, but would you call the resulting discoordination a "contradiction"? Not really. It would just be a natural, stable imbalance that would express itself either in the amount of sandwiches bought in sold, the amount of soda bought and sold, or both.

    The easiest way to think about it is basic overidentification in linear algebra. You have four equations (a supply relationship and a demand relationship for both goods) and only three unknowns (the quantity of loanable funds, the quantity of liquid assets, and the interest rate - which functions as the price for both). What does four equations and three unknowns give you? An over-determined system - and overdetermined systems have slack.

    That's all a depression is - slack.

  27. And here I thought a depression was the result of a misallocation of stuff in an economy and the working out of such.

  28. Just noticed there is only one picture on the blog now.

    I always wonder which one was which.

  29. All income is consumed or invested. Since investment is just deferred consumption, all income is consumed in the long run. In other words, the purpose of all production is consumption.

    In a monetary economy, for produced goods and services to be deployed to this end, it is necessary that aggregate nominal spending be sufficient at the prevailing price level.

    If aggregate nominal spending is insufficient, then some part of what has been produced will neither be consumed nor invested. This will defeat the purpose of production by preventing it from being consumed.

    I can't put it any simpler.

  30. My familiarity with Keynesian economics is practically nil. But let me check if I understand this right. Is the interest rate the only thing which is able to clear the market for cash (liquidity preference)? It's not obvious to me why the interest rate is THE opportunity cost of holding cash. I can see that in some circumstances my next best valued alternative would be the rate of interest. But at other times it may be the yield I would obtain from using that cash to purchase certain consumption goods. And if the price of those goods were to fall, then my opportunity cost of holding cash would eventually rise to the extent that I would be willing to part with it. And this could occur without the interest rate moving. I can also imagine various other scenarios in which the "boundary" opportunity cost of holding money would not be the interest rate and, moreover, that there would be mechanisms that move the cash market to clear - and that is separately from the bond market. Am I missing something obvious?

  31. you claim Austrians are wrong about a lot of things but I have never seen you explain what any of those things might be.

  32. idsds -
    Yes, I believe Tyler Cowen once made this point that there are multiple margins on which we can think about the opportunity cost of cash. It does seem to me, though, that it would have to be some sort of security, rather than a consumption good. When we talk about "demand for cash" or even "demand for money" what we're really talking about ultimately is a demand for liquidity, right? There interest rate is the most important cost to consider because you are strictly being compensated for parting with liquidity. The price of a consumption good, on the other hand, doesn't really have a liquidity premium associated with it because you permanently lose the liquidity of that cash.

    Anyway, I'd have to think about it more - I don't know.

    What you describe is essentially the real balances effect, which was a major counter-argument to Keynesianism in the early years. My understanding is that empirically the real balances effect was not considered to be substantial (although I don't know that literature).

    Deflation and disinflation introduce their own problems too, of course.

  33. Anonymous -
    You need to be more specific. I haven't gone through the details of my view on Austrians for a while, so perhaps I should restate it.

    1. I think their views on the way changes in the interest rate change the capital structure are very important. Bohm-Bawerk's version of this was hinted at in the GT, and dismissed not as wrong or illogical, but simply as soemthing Keynes wasn't going to concern himself with at the time. I think it's logical as well, I think it's very interesting, and I think it definitely deserves more study, but

    2. I have a problem with their loanable funds theory of the interest rate just as I have a problem with anyone that has a loanable funds theory of the interest rate. They have a very interesting capital theory but do a poor job applying it to macroeconomics because they miss the fundamental point of macroeconomics.

    3. I don't think the action axiom with ordinal preferences gets you substantially different results from constrained optimization with cardinal preferences - and constrained optimization is easier to use and can do more. So while I don't think there's anything especially wrong with praxeology, I don't think all that much about it either, and I note that it can be hard to apply to more complicated questions.

    4. Economics is not strictly a logical science. Most Austrians don't even think it is, so there's really not that much notable about my rejection of this idea.

    What else did you have in mind? You need to be more specific.

    I have to say, I'm thinking less and less about Austrian economics these days.

  34. Daniel, I agree with you on point 3. But I don't get point 2. Do you think the Austrians have a loanable funds theory of the interest rate? I don't think so. The vast majority of Austrian have a pure time-preference view of the interest rate, and, even if it is displayed in the market for loanable funds, the interest rate can (and does) indeed exist in the absence of that market. In fact, that is one of its main distinctions of the Austrian school that sets it apart from other schools in economics. Could you please elaborate on that?

  35. Ya you said that before. What do you mean "in the absence of that market"?

    What is the demand for loanable funds if not the an intertemporal choice equilibrium at a certain time preference. How would you talk about time preference without a credit market of some sort? Or - put it this way - how would you move from a discount rate (which is time preference irrespective of a loanable funds market) to the interest rate without a loanable funds market?

    Time preference doesn't seem to me to be distinct to the Austrians, is it? You find this in mainstream textbooks, do you not?

  36. Yes, and time preference is not distinct to any school of economics, but other interpretations of the interest rate take other considerations apart from the time preference. Here is Rothbard on that issue:

    "It is important to realize that the interest rate is equal to the rate of price spread in the various stages. Too many writers consider the rate of interest as only the price of loans on the loan market. In reality, as we shall see further below, the rate of interest pervades all time markets, and the productive loan market is a strictly subsidiary time market of only derivative importance."

    And then he adds:

    "Although the loan market is a very conspicuous type of time transaction, it is by no means the only or even the dominant one. There is a much more subtle, but more important, type of transaction which permeates the entire production system, but which is not often recognized as a time transaction. This is the purchase of producers’ goods and services, which are transformed over a period of time, finally to emerge as consumers’ goods. When capitalists purchase the services of factors of
    production (or, as we shall later see, the factors themselves), they are purchasing a certain amount and value of net produce, discounted to the present value of that produce. For the land, labor, and capital services purchased are future goods, to be transformed into final form as present goods."

  37. So I guess what I'm wondering is this: where do you get the demand for loanable funds?

    You get it from an individuals' time preference in an intertemporal choice arrangement.

    So I agree with Rothbard on time preference, but I'm wondering why he's juxtaposing that with loanable funds.

    This insight from Rothbard is truly important: "In reality, as we shall see further below, the rate of interest pervades all time markets, and the productive loan market is a strictly subsidiary time market of only derivative importance"

    And is similar to what I write about here with respect to labor:

    Where is this cited from - I'd like to read the whole section.

    I think Rothbard is dumping on loanable funds too much - that is time preference theory of interest - but I think Rothbard is entirely right to point out that time preference is relevant for LOTS of other markets.

  38. This is cited from his treatise "Man, Economy and State", Chapter 6: Production: The Rate of Interest and Its Determination. A remarkable passage is in Section 7: The Myth of the Importance of the Producers’ Loan Market.

    You can see it here: .


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