Thinking through Chapter 3 of the General Theory

Bob Murphy is seeking some insights on Chapter 3 of the General Theory, and I thought I'd give it a shot. I haven't read the book carefully through for several years now, although certain chapters I've given multiple careful reads since. Chapter 3 is not one of them. It's worth noting - before jumping into this - that Keynes himself says that his exposition of the theory of effective demand at this stage, before introducing subsequent theory, "may not be fully intelligible".

Question 1: What is the unit of aggregate supply price and aggregate demand? In money?

As far as I can tell it's in money. The question, of course, is whether it's in current money or some constant value of money. For Keynes, money is not some numeraire. There is a reason for its value at any given point in time, and the value of money at any point in time, and the change in the value of money relative to expectations has consequences. So I would guess (and Keynes seems to give no reason not to suppose) that it is current money. He doesn't seem to make it explicit either way, but that's how I read it. Later in the chapter he talks about how the analysis of wage units can be done either in "money wages" or real wages.

Question 2: Is the aggregate supply price referring to the unit price, or the total proceeds?

This he does make explicit. The aggregate supply price is the total proceeds of the output associated with a given employment level, N. This is, of course, confusing. That's not a "price". But Keynes lays out his definition, and it is what it is. He says in the text that "the aggregate supply price of the output of a given amount of employment is the expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment." Murphy quotes this portion, and it's true it's not entirely clear from this sentence whether he's talking about total proceeds or unit price (i.e. - he could be refering to the unit price consistent with a total outpu that will make it with the while of the entrepreneurs). But the footnote to this sentence clarifies: "Not to be confused (vida infra) with the supply price of a unit of output in the ordinary sense of this term". This is still odd. We don't talk about the total proceeds of output much. However, I think it becomes clearer later, and it makes more sense when we think in terms of the quantity theory of money. The other clue is that the demand function - which equilibrates with supply and therefore must be measured in the same units for both variables - is clearly the entrepreneurial proceeds (not profits - which are proceeds minus factor costs). In the first paragraph he also calls the "proceeds" the "aggregate income (i.e. factor cost plus profit)". So I think it's quite definitely the total rather than unit proceeds.

Question 3: Related to this, are the functions Z=φ(N) and D=f(N) upward sloping? (And what is the Y axis here–money?) So Keynes is saying that in the general case, D starts above Z, but has a lower slope, so that when N is really low, D is above Z, but eventually they intersect as N increases?

Yes, I think so. This stands to reason. If Z and D are the total proceeds rather than unit price, then Z=φ(N)=pQs, and D=f(N)=pQd. We know that Qs is increasing in p and Qd is decreasing in p by the basic law of supply and demand, so at Z=D (or, equivalently, Qs = Qd) Z is steeper than D. Is that a unique equilibrium? We don't know. We take local equilibria and don't usually ask any more questions, unless circumstances or research interests compel us to ask questions. Multiple equilibria aren't relevant to the issue at hand, though.

The vertical axis, Z and D, is measured in money - presumably current money for the reasons I gave in response to the first question.

Consider the following data from a simple AD-AS graph which follows. After the AD-AS graph is the associated Z-D graph:

There's one major difference between my last graph here and the version that Keynes presents: my horizontal axis is in terms of the aggregate price level (i.e., the CPI) and Keynes's horizontal axis is in terms of N - employment.

Strange, isn't it? How did I get that on the horizontal axis? It's because we typically think of quantity as a function of price. So we talk about "quantity demanded" and "quantity supplied", but we never talk about "price demanded" or "price supplied". To get output (which we assume to be increasing with employment up to a level of diminishing returns at least) on the horizontal axis, all we need to do is sub Q for Qd and Qs in my data chart and sub pd and ps for p. You can see in this interchangability the origins of the Phillip's Curve*.

Question 4: Keynes says that when N is below the equilibrium point, then D is above Z, and so entrepreneurs have an incentive to hire more workers. But why? It sounds intuitive at first, but I’m not so sure it is. In particular, Keynes says that when N is such that D and Z intersect, the entrepreneurs profit has been maximized. But it seems to me the profit is zero at that point? (In a standard micro model, it’s fine for the producers to maximize profit at the point of zero-profit, because they’d earn negative profits at different levels of output. But that’s not what happens here. If N went below the intersection point, then wouldn’t aggregate profits go up?).

Entrepreneurs have an incentive to hire more workers for the same reason that they have an incentive to hire (i.e. - produce more output) when Q is below equilibrium in the supply and demand model: some entrepreneur is earning a marginal revenue that exceeds his marginal cost. What happens when N is below equilibrium? At that point Z, which is the minimum aggregate proceeds required to engage the employment of N units of labor, is lower than the expected proceeds of that labor. Profits are positive, as Bob notes. What do entrepreneurs do when they see positive profits? They enter the market. As Keynes writes "if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D". This is the basic market equilibrium of setting marginal revenue equal to marginal cost. Keynes does something you usually don't see, which is to present it in terms of the total proceeds from the market (i.e. price times quantity), because this is the relevant functional relationship in macroeconoimcs, where we look into the aggregate properties of human action.

Question 5: Later on, when discussing the implications of the classical view, where D=Z at all levels of N, Keynes says “the forces of competition between entrepreneurs may be expected to push [N] to this maximum value.” But why? If Z and D overlap each other for all N, and Keynes has earlier argued that at the intersection point, aggregate profits are maximized, then why would entrepreneurs have an incentive to move N one way or the other, if Say’s Law holds?

This part is confusing to me. If you read it all together, I'm not sure he's saying that the functions are identical - I think he's saying that for any given N, the D=f(N) curve shifts to be equal to Z=φ(N). Paying factors of production Z total proceeds creates the same amount of demand in the market, so demand increases in response. An increase in demand is a shift of the effective demand curve itself, not a shift along it. This seems to make the most sense to me after reading Keynes talk about demand "accomodating itself to the aggregate supply price", and "the proceeds D assume a value equal to aggregate supply price Z". That implies to me a change in demand, not an identical function.

If all values of N are admissable equilibrium, then Bob rightly asks on what basis would entrepreneurs move to a high value of N under Keynes's rendition of classical economics? We know entrepreneurs produce output until profits are driven to zero. What would require them to maximize N? If profits are zero, then income is made up of two components: factor costs of employment and what Keynes calls the "user cost". If we maximize the factor cost of employment (i.e., the wage bill) we have to minimize this "user cost". What is "user cost"? Keynes defines it as "the amounts which he [the entrepreneur] pays out to other entrepreneurs for what has has to purchase from them together with the sacrifice which he incurs by employing the equipment instead of leaving it idle" (emphasis mine).

People find private value in leaving things idle - in keeping capital or money ready at hand. This, more than anything else, is the point of the General Theory. The most valuable thing to keep idle, of course, is money. We only keep anything else idle because we think it may serve some purpose similar to what we turn to money for: either because we think it will store value, or because we think it can act as a medium of exchange.

Keynes argues that no classical economist really thought through the implications of leaving things idle. By ignoring it, they implicitly assumed that user cost would be minimized and that's what drives N up to the limits imposed on it by an inelastic supply curve and the marginal disutility of labor. Many classics touched on what would become known as "hydraulic Keynesianism". If you have a leak in the circular flow, your income level would go down. The mercantilists and Malthus got that far but were later pushed off the stage by classical economists who somewhat unfairly identified mercantilism with the protectionist ideas of kings and merchants. But this isn't really sufficient. This is what I've called the "whack-a-mole" theory of general gluts. Saying "demanding idle cash lowers income" doesn't do the trick because of the real balance effect. As the price level increases, the cash becomes more valuable and everything else becomes less valuable. As long as prices eventually adjust everything is fine. There's no reason for anything to change other than the price of money (i.e. the inverse of the price level). There's no reason for any relative price adjustments, in other words, and therefore no reason for a change in the employment rate.

However, if variations in the value of money (presumably driven by the demand for money) can influence Keynes's "user cost" of capital - if leaving capital idle can earn a return - then there is no reason to expect a rebalancing. We have the raw ingredients for a theory of a stable underemployment equilibrium.

So Bob's fifth question is by far the toughest (I wrote most of this last night and then had to sleep on my response to the fifth question), but I think the clearest way to think about it is (1.) Keynes thinks the classics ignore user cost or the cost of not leaving things idle, (2.) the implication of this is entrepreneurial competition maximizing N, (3.) In Z-D terms, this means that increasing N provides the additional demand to employ that N, and the D schedule is driven up the Z schedule to the point where Z is inelastic.

That's my reaction - any thoughts? Later in the chapter Keynes provides a great synopsis of the General Theory, which I think helps clarify what is going on early in his discussion of the classics and "user cost". I haven't read Chapter 6 again, yet, but that also goes into more detail on user cost.

* This was actually an accident. In writing the post, I realized "that shouldn't be on the horizontal axis!" and had to think through why it came out that way. So it's a diversion, but an interesting diversion I thought. The point is in (1.) deriving a Z and D function where the D function isn't as steep at equilibrium as the Z function, and (2.) demonstrating why it follows necessarily from the definition of Z and D as the total proceeds of the output.

Assault of Thoughts - 6/30/2011

"Words ought to be a little wild, for they are the assault of thoughts on the unthinking" - JMK

I come home to over 1,000 posts on my blogroll... here are a few that caught my eye. What else deserves my attention?

- First - my connection to the outside world at the beach has been the Washington Post, so I did catch this article on Sweden's recovery, and this profile of Christine Lagarde, the new head of the IMF. As far as I can tell she's a good choice.

- As Simon Johnson points out, though, problems will persist so long as the international monetary system doesn'st solve the Triffin Dilemma.

- Krugman on monetary policy in a balance sheet recession.

- LK on the 1920-1921 depression. He hits some high points on why this particular downturn is different from, say, the current downturn. I've mentioned most of these points before. What LK does that I've refrained from doing is come out and say it's inconsistent with ABCT. I'm not sure I have the tools to go for that claim, but I certainly know it offers no clear evidence that fiscal policy doesn't work, and it seems to suggest that monetary policy is efficacious in downturns not characterized by debt-overhangs, deficient demand, or financial crises.

- Noahpinion discussing Brad DeLong and the political infeasibility of stimulus. I steeply discount the public choice theory credentials of people who suggest that Keynesianism is great for politicians (yes, this includes a lot of prominent public choice theorists).

- Tyler Cowen on British accents.

- This is a great post by Bryan Caplan on ability bias vs. signaling in the economics of education.

- In 1911 a piece of Mars slammed into Egypt. This sounds like it has Lovecraftian potential.

- Gary has several posts up on Jefferson at Pacific Crest Trail. This one is on Jefferson's views on Hamilton and debt. There are others - you can look at the blog. I've always found Jefferson's views on banking and debt hard to parse. Part of it is clearly that he doesn't understand the difference between public and private debt and he maintains old prejudices against public debt that were just beginning to fall to the wayside. But he also has more nuanced distinctions between politically connected private bankers who enrich themselves with their connections, and more independent public bankers. I'd love to learn more about exactly what he thought, but I'm not convinced it maps on to modern central banking as much as people like to think.

Another analogy...

Okay, let's try this: designer babies.  Let's say a gene therapy is developed that will allow parents to alter an embryo's genetic code, making the child immune to malarial infection.  This isn't a fix-it job, replacing problematic code with the normal genetic line-up you would find in nature in order to prevent something like Trisomy 21.  We're talking an inserted, man-made code that could be patented. 

Where would IP rights stand when this child has children, and they carry the anti-malarial GM code?  Would any offspring carrying it have to be destroyed?  Would new payments have to be made for future generations?  Perhaps an on/off switch inserted in the genetic code that would have to be booted up at a price for future generations to enjoy the benefit of protection from disease?  Or would the initial GM child simply have to be made sterile to prevent this problem ahead of time?

I doubt we would treat instances of GM human life like that.  The benefit of increased public health and welfare would keep the profit calculus from extending so far down.  

Heightening the stakes from the life of a plant to the life of a person perhaps highlights the question a little better, and puts us in a better position to step back again to GM crops... because despite a lack of depth in GM crops (compared to the dignity of human life), there is an awful lot of breadth present (billions of seeds produced, in legal limbo, or destroyed) that has real consequences for the livelihood of farmers and future food production.  

And to head off concerns already expressed by Gary... yes, I realize that farmers already have agreements with Monsanto.  I'm not trying to argue retroactively that a wrong has been committed.  The question is whether the way we're handling things now is unfair, unproductive, or stupid... and whether it makes sense to change how things are done.

Legal analogies for rights to self-replicating intellectual property

We finally got around to watching Food, Inc. last night, and while most of it wasn't new to us, it was definitely worth viewing.  I'd recommend it.  One of the subjects discussed was Monsanto's role in the genetically modified seed industry and the farmers that it has successfully driven to ruin.  Much as in the chicken industry, farmers who opt-in to business with Monsanto soon become trapped by restrictions and costs.  Because the genetic modifications of Monsanto seeds are patented, farmers are unable to save seeds from one season to the next, and must re-buy every year.  Most of this portion of Food, Inc. discusses the farmers and seed cleaners actively hunted down and sued by Monsanto lawyers.

The idea of farmers not being able to save their own grown seeds is ridiculous on the face of it, but after watching the documentary I was wondering what legal analogies might be drawn elsewhere in order to make some progress with more fair patent regulations.  The obvious analogue seems to be self-replicating nanotechnology.  Forget about existential threats like grey goo- the question of who should own later generations of these technologies is vexing enough by itself.  It's sensible enough to say that if Monsanto creates a genetic modification, they have some exercisable rights concerning its use.  But is it reasonable to tether farmers who fairly buy these products for generations on end?  A living seed (or even a self-perpetuating machine) is an inherently generative thing.  It doesn't make sense to create this sort of product and then pretend that it only has one shelf life.

...actually (maybe the reference to "shelf" led me here?) it just struck me that similar analogies could be drawn for ownership rights of e-resources in libraries.  As e-books become more mainstream and libraries purchase them for patron use, some publishers have threatened limited ownership rights, so that libraries would lose access to an e-book after so many check-outs (and I believe the proposed number is absurdly low... like two dozen check-outs or so) and have to repurchase it.  The argument of the publishers has been that e-books don't wear out like printed books, and it's unfair to publishers to sell away titles that won't ever deteriorate and need replacing.

At least in this case each individual check-out isn't construed as a reproduction of the publisher's intellectual property as in the above biotech/nanotech instances.  But similar questions apply.  And the basic one is this: when a fair purchase is made on a product for which proliferation of use is understood as inherent to the properties of the product (future generations for seeds or nanobots, future loans for a book), on what basis can the IP owner really claim the right to regulate later usage?

On the bright side, farmers and seed producers have recently sued Monsanto in an effort to avoid being punished when other peoples' Monsanto crops contaminate their own.  This hardly begins to approach proper recompense for these farmers, but keeping a multinational juggernaut from suing its victims into the ground is at least a start in the right direction.

Russ Roberts on Clinton and Keynes

He seems to intend this post to be entirely unironic. This is actually meant to be serious. No economist who's been teaching as many years as Russ has should write something like this. No student should write something like this.

This man is going on C-Span this weekend to talk to the public about Keynes, Hayek, and the recession. That's incredibly disheartening.

I am reading this

...if I am not in the waves, sipping some wine, or fishing

I am here

Two thoughtful posts on ABCT

First, LK talks about the differences between Hayek and Mises on business cycle theory.

Second, Ryan Murphy has some really great thoughts up on ABCT and QEII. Everyone should read through it carefully. Ryan can correct me if I'm wrong, but I think Garrison offers this to us on pages 161-163. This section of my book is laced with outraged margin notes. The reason, as you might guess, is his neglect of the liquidity preference theory of interest in presenting the Keynesian argument, which allows him to easily refute it later on.

What is new that Ryan brings to the discussion, I think, is thinking about these dynamics in the context of QEII, IOR, and money demand.

Enjoy.

UPDATE: Ryan shares these thoughts over email - "Garrison had the supply curve moving rightwards because they were increasing savings at the expense of consumption (I, too, see no reason for this to screw things up). What I have is a leftward shift in the supply of loanable funds as consumers build up greater cash reserves. Or in the case of today, banks continually stockpiling money so they can earn more interest."

Peter Boettke on American Keynesianism

Peter Boettke has been interested in a topic that has also interested me: why and how was Keynesianism so successful in the United States. We've come to very different conclusions, some more thinking on his are here.

I think there are major blindspots to his approach, and one of the big one is a lot of problems with his take on what Keynesianism is exactly. Some of that is fleshed out in this interview that he also posted recently where he suggested that Keynesianism is outside of the "mainline" of economic thought that emphasizes the price mechanism, market efficiency, etc. If that's your starting point, then I can see why the history of American economic thought in the early twentieth century can be somewhat puzzling!

The understanding that has been stewing in my head for a while is that proto-Keynesianism economics has been American economics for quite a long time. It's been in both our popular and our academic understanding of economic science. One of the best examples of this is Jefferson himself in his letters to J.B. Say, and also to Madison. Benjamin Franklin and Irving Fisher both anticipated the liquidity preference theory of interest. What Grampp called the "liberal elements of English mercantilism" pervaded the economic thought of the colonial period and the early republic (this is covered well by Joseph Dorfman). Opening the West was all about lowering the marginal efficiency of capital (albeit not through the interest rate or fiscal policy) and Keynesian concerns about effective demand pervaded that effort. Bimetallists and populists of the late twentieth century all understood this too. Most of this tradition even managed to avoid the crudeness of "underconsumptionism" because it recognized that the real concern is investment demand, not consumption. America was fertile for Keynesianism long before modern progressivism and it would have done well here even if progressivism never came to pass, I think. This isn't to say that progressivism wasn't particularly consistent with Keynesianism - certainly it was. But I don't think it's the ultimate facilitator that Boettke seems to think it was. The roots go considerably deeper.

This is what living in a frontier society does. A frontier society has a strong disposition to embrace Smithian-Keynesian economics, which understands that the world is dynamic, that the division of labor is limited by the extent of the market, that we are neither pinned down to a production possibilities frontier (Smith) nor are we guaranteed to reach our full potential (Keynes).

Quick, uncited thought on the way Kuhn is used

I don't have any examples to point to, but for a while now I've meant to post on two tendencies to disparage certain concepts that people seem to have when talking about science that I think misunderstand Kuhn's attitude - one tendency touches directly on Kuhn, and the other somewhat more indirectly.

- The one that touches directly on Kuhn is disparaging references to "puzzle solving" scientists. This is what Kuhn thought the normal business of science amounted to - solving puzzles. You can think of puzzle-solving science as the normal hypothesize-test-falsify-rehypothesize iteration of the scientific method. Since Kuhn identified more totalizing paradigm shifts as the source of progress in science, people often scoff at puzzle-solving as missing the point, banal, boring, etc. I don't think that was Kuhn's perspective. First, puzzle-solving is the normal disposition of the scientist. Paradigm shifts don't come around all the time, after all! But more importantly, puzzle-solving facilitates paradigm shift by pushing the utility of a given body of theory to its limit. It doesn't require the same intuition and genius and ability to think outside the box that paradigm shift does, but I don't think he saw it in the diminutive way that people often talk about it.

- The second thing that people do touches more indirectly on Kuhnian themes, and that's the tendency to use "Potlemaic" or "phlogiston" as insults. In a way, this one bothers me more than the previous one. It's true that modern chemistry and cosmology are unambiguously considered progress from the Ptolemaic system or phlogiston chemistry to Kuhn. But part of his point was precisely that prior paradigms aren't wrong so much as immature. They only seem bizarre to us if we ignore the idea of a discontinuous shift in perspective. This passage from The Structure of Scientific Revolutions is especially good at illustrating the point with respect to Newton:

"Yet, though much of Newton’s work was directed to problems and embodied standards derived from the mechanico-corpuscular world view, the effect of the paradigm that resulted from his work was a further and partially destructive change in the problems and standards legitimate for science. Gravity, interpreted as an innate attraction between every pair of particles of matter, was an occult quality in the same sense as the scholastics’ “tendency to fall” had been. Therefore, while the standards of corpuscularism remained in effect, the search for a mechanical explanation of gravity was one of the most challenging problems for those who accepted the Principia as paradigm. Newton devoted much attention to it and so did many of his eighteenth-century successors. The only apparent option was to reject Newton’s theory for its failure to explain gravity, and that alternative, too, was widely adopted. Yet neither of these views ultimately triumphed. Unable either to practice science without the Principia or to make that work conform to the corpuscular standards of the seventeenth century, scientists gradually accepted the view that gravity was indeed innate. By the mid-eighteenth century that interpretation had been almost universally accepted, and the result was a genuine reversion (which is not the same as a retrogression) to a scholastic standard. Innate attractions and repulsions joined size, shape, position, and motion as physically irreducible primary properties of matter."

In another passage I can't put my fingers on right now, he talks about how Einstein then "reverted" back to pre-Newtonian physics by explaining the source of gravity rather than just taking it as an innate, given quality. Accusing Newton of retrogression for thinking of gravity as an innate quality is in a lot of ways like criticizing Keynes's citation of the mercantilists. If Keynes just said "you know - forget the nineteenth century, let's just take the mercantilists as is" there would be cause for concern I think. But seeing problems in a somewhat similar light to past paradigms itself is not a fault, because past paradigms are never really "wrong" so much as they are interpretatively immature. I don't think there's any chance of stopping people from using "Ptolemaic" or "phlogiston" as insults and I have even made use of "Ptolemaic" on occasion. That's OK as shorthand, so long as we understand the point I'm trying to make here. The idea of science as being "wrong" doesn't really make sense. Science is developmental. In the way that people call the Ptolemaic system "wrong" there's probably a lot now that we think that is "wrong". This isn't to say that the Ptolemaic system is "right" either of course! As Kuhn protested - he's not a relativist! Planets simply don't move the way Ptolemy said they moved. The point is that instead of thinking of the Ptolemaic system as a thumbs up or thumbs down idea we need to instead (or in addition?) think of it as a conceptual framework that we have simply transcended because we figured out a more useful conceptual framework.

In a lot of ways it's like why we think (well at least I think) Louis CK is funny when he talks about his kids. He's got a lot of jokes where the basic approach is to judge his kids by adult standards and highlight how miserably the fail. It's funny, but why is it funny? It's funny because kids aren't "stupid" per se - they're simply still developing. The standard he holds them to is instinctively off for us and we don't naturally judge children that way, so it's funny to think of them by that standard. Ptolemaic cosmologists and phlogiston chemists, of course, are not children - which is why we judge them so harshly. But it's still important to remember the developmental character of conceptual frameworks in science as well as the self-referentialism of these conceptual frameworks. Within the framework of the Ptolemaic system the world makes a lot more sense than the Ptolemaic system does from the perspective of the Copernican system. The Copernican system is progress but that does not mean that we fully understand the Ptolemaic system if we try to understand it from a more modern perspective. We miss something. That's really the whole point of Kuhn, after all - we miss something if we do that.

Some project updates

- This morning I submitted a shortish research note to the Cambridge Journal of Economics on the 1920-1921 depression.

- A draft of the engineering paper is in the hands of my co-author now and should continue to progress. The presentation of the paper went OK on Monday. I'm usually my toughest critic on presentations and I personally thought it was rough, but I got good feedback. Verbalizing ideas can be harder than writing them, I think.

- I have one project I'm actually writing for right now - developing the idea in this blog post into something. As always, we'll see how that goes. Sometimes these things don't make it past a detailed outline. But with a lot of the engineering paper out of the way of my early mornings now, perhaps I can make some progress.


Anyone working on anything interesting?

Roberts and Jarboe on Technological Progress

Russ Roberts has a good WSJ article up about what has been called "technological unemployment". I think he's reading a lot into a line by Obama, but whatever - it's a hook for a good review of the argument against Ludditism.

While Russ's piece is good, I also liked this somewhat critical assessment from Kenan Jarboe on where Russ falls short:

"I agree with everything he said about the power of productivity (while I disagree with his political potshot at the President). But, when it came to tying technology to job creation, here is the best Roberts could do: "Somehow, new jobs get created to replace the old ones."

If we can't explain the "somehow", we will lose the policy debates.

Roberts more detailed explanation given was this: "Fifty years ago, the computer industry was tiny. It was able to expand because we no longer had to have so many workers connecting telephone calls." In other words, the computer industry grew because all those unemployed telephone operators (unemployed because of advances in computer technology) could all get jobs building the computers that replaced them.

Wrong. This is the fallacy of supply creating demand. Creative destruction is the process of new industries drawing resources from old industries. Freed-up labor doesn't magically create new jobs. Free-up labor fills new jobs that are created by new opportunities. It is the new opportunities part that keeps growth going -- not simply the higher productivity part. Higher productivity allows those workers greater output - thereby allowing labor to switch to other activities while maintaining the same or greater levels of production. But if it was simply greater output of the same old stuff, the system would grind to a halt with excess labor. This is the fear that has arise over the centuries.

Turns out these fears have not been realized -- because of innovation. Innovation creates new demand as well as increases productivity. The new demand for new products absorbs the labor freed up by productivity gains in a virtuous cycle - each side reinforcing the other."

I'm not sure Russ would even disagree with these points - but they're good points to make nevertheless. Innovation and technological development increases return on investment and investment demand. This raises the marginal efficiency of capital and prevents us from falling below full employment.

The Onion on Temporal Autarky

Well... sort of.

For those of you who don't know what I mean by "temporal autarky", see some of my previous posts on the idea here.

Words I never expected to read from Bill Gross

Wow (HT Krugman):

"Both parties, in fact, are moving to anti-Keynesian policy orientations, which deny additional stimulus and make rather awkward and unsubstantiated claims that if you balance the budget, "they will come." It is envisioned that corporations or investors will somehow overnight be attracted to the revived competitiveness of the U.S. labor market: Politicians feel that fiscal conservatism equates to job growth. It's difficult to believe, however, that an American-based corporation, with profits as its primary focus, can somehow be wooed back to American soil with a feeble and historically unjustified assurance that Social Security will be now secure or that medical care inflation will disinflate. Admittedly, those are long-term requirements for a stable and healthy economy, but fiscal balance alone will not likely produce 20 million jobs over the next decade. The move towards it, in fact, if implemented too quickly, could stultify economic growth. Fed Chairman Bernanke has said as much, suggesting the urgency of a congressional medium-term plan to reduce the deficit but that immediate cuts are self-defeating if they were to undercut the still-fragile economy."

Clearly he hasn't gotten around to reading Steve Horwitz's post yet.

This is even more impressive than Richard Posner. The more I look into the Posner move to Keynesianism, the less surprised I am by it. You almost get the sense that if Posner ever took up thinking seriously about macroeconomics, he was bound to have an affinity for Keynes. This is more surprising, though.

What's interesting is that Gross seemed to be betting directly against this recently, which really makes me wonder what he's been thinking through in the last couple months.

Seriously - how can you guys not love Brad DeLong

This is pretty funny.

Number 10 is the reaction I repeatedly try to invoke when I write posts like this. Or this. Or this.

Basically the world would be a better place if people read more Jefferson.

The solution to DeLong's #10 is, of course, to recognize the world for what it is, recognize what is laudable, and don't be dogmatic about abstract concepts and norms that we make up.

The sabbath is made for man - man is not made for the sabbath.

A question for Brits or them that know em'

I'm writing a short piece to submit to a British publication and I was wondering - do the British even use the term "libertarian"? What ought I to call libertarianism?

This particular venue likes to make reference to "neoliberalism" a lot. Would that be considered the equivalent, or would neoliberalism be broader than libertarianism (i.e. - also including the internationalist/establishment center-left)? I refuse to use "classical liberal" as a synonym for reasons I've stated here before.

Thanks.

An unimpressive blog post from a guy that I normally consider to be quite impressive

I don't feel like elaborating on this right now. I don't think I need to - you all know me. I've got two comments in the comment thread which I think should be interesting to see answered.

Bob Murphy on me

He has an extended criticism here. I'll sum up my position in this way: Krugman persuades successfully, he does not prove successfully. Proof is hard in macroeconomics. Unlike Bob, who in prior posts directly challenged me, Krugman obviously never mentions me. I'm going to make this distinction between plausible persuasion and successful proof more strenuously to a guy that specifically engages me. But since he seems to want me to call Krugman out, I'm happy to say that he hasn't really "proven" anything - there are lots of stories that are consistent with the evidence he provides. But he is definitely persuasive.

On the one hand, we should know very clearly the difference between these two things. Epistemological quibbles can really lead scientists astray. Scientists are in the business of rigorous persuasion. Mathematicians and logicians are in the business of proof. Now - with that understanding that proof is hard, a little casualness with words like "prove" and "falsify" is fine, I think - so long as we know what is meant. Epistemologists don't own these words, after all. My concern with some a priorists among economists is that not only do they use the language of "proof" and "falsification" - they also seem to think it should be used and understood in the same way that logician or mathematician uses or understands it.

Anyway - that's all a digression, but it's a digression that frames the issue. Ultimately, if you mention me by name in a post of course I'm going to engage you directly. I'm also in the business of persuasion - I'm happy to clarify that Krugman should know that when he says "prove" he means "persuade" or "justify". But I think he makes a good persuasive case, so of course I'm not going to spend scarce blogging time addressing it - even though Bob is right and I've never denied he's right on this point. I'd rather address people who (1.) don't make a persuasive case, and (2.) go further by mistaking their attempted persuasion as an attempted proof, and (3.) actually mention me by name.

On all this Krugman Hubub

There have been some interesting posts, particularly Bryan Caplan's on intellectual Turing tests, but I think there are a few fundamental misunderstandings of Krugman's claim that liberals know the opposition better.

1. There is no such thing as a "libertarian theory of economics". Libertarianism, like liberalism or conservatism, is a political position - an ideology even. It's not an economic theory. People are making a fuss over the fact that Krugman isn't making distinctions between conservatism and libertarianism and infering that he doesn't even know what libertarianism is. This is an absurd claim - of course he knows what libertarianism is - but it's also irrelevant. That's all politics. He is contrasting liberals with conservatives but he specifically mentions being able to describe the views of "saltwater economists", "a Keynesian economic argument", etc. etc. And of course, he specifically has in mind mainstream Keynesian vs. mainstream non-Keynesian (the so called "saltwater" vs. "freshwater"). In that face-off I think Krugman may actually have a point. Exhibit A is Casey Mulligan, Exhibit B is John Taylor. Smart guys by all means, but they have been a little disappointing through the crisis. A good example of what Krugman is getting at is when Krugman has to walk Taylor through his own Taylor Rule and explain why some economists have a slightly different view of what makes sense for the Taylor Rule even if it's not the "original Taylor Rule".

2. And then there are the Austrians. I just don't think he has them in mind here. It's simply not a rival school in any meaningful sense. I think it's interesting and I think it's worth talking to you guys, but not everything Krugman posts is a challenge to you. I think he mostly has other people in mind. So what about the Austrians? Krugman has definitely botched the theory in the past, and most other Keynesians couldn't explain it either. But when you look at guys like Don Boudreaux, Russ Roberts, John Papola, and even better Austrians than them it's pretty clear they do no better. They are probably more broadly familiar with Keynesianism than vice versa. I would agree with that. But there's still considerable ignorance on both sides. I think this has a different origin on each side. Most Keynesians generally ignore the Austrian school, which is the source of their ignorance. Most Austrians actually hold a distorted understanding of Keynesianism, and many (not all) attribute very bizarre ideas to Keynesians (like that they think the government can plan the economy, etc.). So this is a mess all around IMO, but ultimately I think not even what Krugman had in mind.

3. Caplan's Turing test idea is interesting. I think I'd do decently well posing as someone else. I think calling out someone who is posing is much more difficult. After all, there are really bad Austrian expositors of Austrianism and really bad Keynesian expositors of Keynesianism out there. A great idea, nevertheless.

4. As I said in the comments of David Henderson's post, I think it's inevitable that each side is overconfident, and there are a few good reasons to expect that.

5. This is also one of those questions where not only is it hard to find an answer to, but there might not be an answer to the question. Who belongs on either side, for one thing? And the distribution of knowledge is going to look really weird it's not like you're going to have two clean normal distributions with a clear winner, on average. You're going to have people like Bruce Caldwell and Barkley Rosser perform great, and you're going to have a huge group of people that do poorly. Ultimately this sort of test will be driven by the shape of the tails of the distribution, not by any center of gravity of knowledge. So what does that really tell us.

6. There's also a lot of disagreement! I don't agree with all the post-Keynesians. Are they "with me"? I would rule out a lot of Austrian explanations of Keynesianism as being absurd, but clearly they hold those views for a reason and they're going to challenge that. This is sort of where the Turing test comes in, of course, but even within a school of thought there are differences. If I talk like a Rothbardian, what will a Hayekian think? If someone talks like a Hicksian what will a New Keynesian think?

7. Finally, I think monetary disequilibrium theorists on both sides of the aisle will do comparatively well at Bryan's test.

Daniel Kuehn: Subverter of Positivism!

I suppose...

Ryan Murphy posts this: "That seems like the important question in the most recent spat between Daniel Kuehn and Robert Murphy. Kuehn’s Keynesianism and RPM’s [no relation] Austrianism sound an awful lot like what Karl Popper would call a metaphysical doctrine. That is, if your theory doesn’t tell us that it is impossible to observe something in the empirical world, the “theory” is nothing more than an arbitrary way of categorizing whatever you see. RPM’s acceptance of such a label is defensible in the sense that many Austrians have acknowledged this and hand-wave the issue away because economics allows us “understanding.” Kuehn’s statement is quite a bit more subversive since it is far afield from the positivism of mainstream macro."

I think it's very important to distinguish between the way scientists talk about what they do and some buttoned-up epistemology you learned somewhere. Yes, positivism talk is all over the place. I talk like this too on occasion. Economists who talk in terms of "identification" implicitly have a sort of falsification in mind, after all, and all empirical economists (which is what I do for a living) are constantly obsessed with identification problems.

That's all well and good. But let's not confuse that positivist sentimentality and lingo with the epistemological logic that also bears the same name.

To quote Rorty, "We can tell you about justification but we can't tell you about truth - there's nothing to be said about it. We know how we justify beliefs, we know that the adjective "true" is the word that we apply to the beliefs that we've justified. We know that a belief can be true without being justified. That's about all we know about truth. Justification is relative to an audience and to a range of truth candidates. Truth isn't relative to anything. Just because it isn't relative to anything there's not much to say about it. Truth with a capital "t" is sort of like God - there's not much you can say about God - that's why theologians talk about "ineffability". Contemporary pragmatists tend to say the word true is indefinable, but none the worse for that. We know how to use it. We don't have to define it."

I ultimately think talk about proof is just a shorthand way of saying we're impressed by the evidence in its favor and we can't think of an obvious rival candidate to explain our observations. If we can formulate our theories in a way that is more precise and puts our theories to a more apparently stringent test, that's a good thing. We ought to keep on using the language of falsifiability because it's awfully useful language to use and awfully profitable to approximate. But as Marshall said, nature's action is complex. The hope for genuine falsifiability is a pipe dream. I think it's far better to have a clear, formal, meaningful theory that is specific enough to be interesting and to be persuasive when confronted with the evidence. Testing those sorts of theories rigorously enough is going to get us incredible useful understandings of the world. We can talk like positivists - that's fine. We can even operate on the mistaken impression that we are positivists. You might even catch me saying I'm a positivist as shorthand for the scientific method that I ascribe to. But ultimately, I think a lot of this epistemology is just word-games and not all that useful. What do we "know"? What an absurd question! Forget what we "know" and spend time constructing persuasive explanations for what we experience.

More to the bookshelf...

I went to the used bookstore after work today and picked up two books: Thomas Kuhn's The Copernican Revolution, and a collection of J.A. Hobson's essays (Hobson was an underconsumption theorist from the late 19th and early 20th centuries).

From Baltimore, I got six volumes of Sir Arthur Conan Doyle that belonged to my great-grandfather.

I also got several histories of Maryland including:
Rivers of the Eastern Shore
The Amiable Baltimoreans
Baltimore in the Eighties and Nineties [1880s and 1890s]


A nice hardback copy of The Complete Writings of Ralph Waldo Emerson (so now I can jettison my crumbling copy of a lot of his stuff that I picked up at some point)


Kon Tiki - one of my favorite books. I also have a crumbling paperback and now I can replace it with a nice hardback.


A three volume history of World War I, published in 1919


A biography of Oliver Wendell Holmes, Jr.

And a 1923 edition of The Legend of Sleepy Hollow, another favorite.

I also got three maps of the Maryland interstate highway system from 1951.

The books associated with the constitutional convention that I hoped to get to weren't in the boxes that I went through. I did, however, get a chance to look through a lot of old photos of my grandparents' families from the 30s, 40s, and 50s. I also got to mess around with an old Kodak camera made in 1917. Between that, talking a lot with them, and eating at their favorite sandwich shop it was a good Saturday.

I think it's time to grab some books I don't make much use of from the shelf and donate them to the public library book sale... circle of life and all that...

"A great, albeit flawed, economist"

A good summation of Hayek by DeLong. That's actually just a small part of the post, but I liked it a lot. I hate this "clash of the titans"/"fight of the century" mentality that some people have. It's absurdly juvenile. If you can't recognize quality economics in both Keynes and Hayek - if you have to dismiss either of them as being some kind of threat to Western civilization - you're really out of your depths and should probably just keep your thoughts to yourself.

That's all.

The Consistent Keynesian Story

Brad DeLong highlights a particular portion of Krugman's piece on Keynes:

"What did Keynes really intend to be the key message of the General Theory?... [I]t’s surely not the most important thing.... What matters is what we make of Keynes, not what he really meant.
I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability.... Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law, about the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed....

So who’s right about how to read the General Theory? Keynes himself weighed in, in his 1937 QJE article, and in effect declared himself a Chapter12er. But so what? Keynes was a great man, but only a man, and our goal now is not to be faithful to his original intentions, but rather to enlist his help in dealing with the world as best we can..."

A lot of people claim that there's this massive contrast between the early Keynes and the late Keynes. I think that's vastly overblown. Yes, there are a few ideas that the late Keynes provides us that the early Keynes hadn't thought of yet. But as early as the early 1920s you could see the germ of all the later arguments - all of them. And nothing was especially contradictory, so much as immature.

Now Krugman is suggesting there's some divide in the General Theory itself!

I really don't think there's any reason to choose here.

Why can the economy operate below full employment? Because investment demand isn't guaranteed to adjust to full employment. Why doesn't investment demand always adjust? Because investment demand is limited by the interest rate which - rather than being determined in the loanable funds market - is determined entirely by the demand for money or liquidity. The low expectations that Krugman refers to from Chapter 12 lower the expected stream of benefits from an investment. When those expectations are reduced, the marginal efficiency of capital - the discount rate at which an investment breaks even - is also reduced. Financial panics that reduce expectations also increase money demand. So the MEC consistent with full employment is getting lower at the same time that the demand for money is getting higher, and there is no guarantee that the interest rate provides a level of investment that is consistent with full employment.

We have a new equilibrium. It is not a unique equilibrium. There are many, including many that are below full employment.

Chapter 12 and Book 1 don't conflict. You need Chapter 12 to explain why Book 1 says that we're not guaranteed to sit at full employment. And furthermore, you need a liquidity preference theory of the interest rate to understand any of this or to make sense of the behavior of interest rates and employment over the last two years.

A Good Keynesian Round-up of links

- Brad DeLong extensively comments on the Krugman post on liquidity preference I provided earlier.

- Paul Krugman shares five favorite books (HT-David Henderson), two by Keynes (the General Theory and Essays in Persuasion). I got Essays in Persuasion a couple months back and have read through a few of the essays. They're great reads, as is to be expected. One of the great things about this book is that they're largely essays which are (of course) trying to persuade policymakers to do certain things. So you really get a picture of Keynes's political savvy, his understanding of the constraints that politicians are dealing with, his insistence on the proper role of politicians in society, and a mature attention to the public choice issues that have been more formally theorized since that time.

- This is Krugman's lecture for the Keynes conference being held at Cambridge in honor of the 75th anniversary of the General Theory. It's a very good summary of the position of what you might call the "new old Keynesians" - not the "New Keynesians" that are essentially neo-Pigovians, but the old Hicksian, neoclassical synthesis Keynesians brought up to modern times - generally the perspective taken on this blog. Now I have a goal for myself, too: to be invited - as a distinguished Keynesian scholar - to present something at Cambridge for the 100th anniversary of the General Theory, 25 years from now. A good thing to shoot for, I think.

Vannevar Bush: Not a dumb or reactionary guy

Tomorrow I'm presenting what I have so far on the engineering paper at the Urban Institute. I was looking for a quote from Vannevar Bush's Science the Endless Frontier (1945) to express this fear of massive science and engineering labor shortages. I've always liked Bush, but since almost anyone that talks about this issue that's not an economist (particularly those advising government, as Bush did) gets worked up about labor shortages, I figured there was a good chance that Bush raised the idea.

No such luck (at least as far as I can find). I read through his chapter on workforce issues, and while I wouldn't phrase everything quite how he did he has a pretty even keel on this stuff. The only time he mentioned anything like supply inadequacy was fairly legitimate - he was talking about the impact of the draft (a genuine supply restriction) on the number of enginering graduates. Of course a few years later a lot of soldiers would go back to school on the GI Bill and get those engineering degrees.

Good links on liquidity preference

Daniel asks, Brad DeLong delivers, Krugman elaborates.

This is also a good post recently from Brad:

"From my perspective, the strange thing is that people kept trying to prove uniqueness and stability of general equilibrium. Simply look at:



and try to avoid the conclusion that to first order the U.S. economy can be in at least meta-stable equilibrium with an adult employment-to-population ratio of about 63% or with an adult employment-to-population ratio of 58.5%--and probably anywhere in between as well.

Proposing that economists pursue the research program of demonstrating that the economy has a unique stable equilibrium has thus always seemed to me to be like proposing that physicists pursue the research program of demonstrating the feathers fall unusually rapidly..."

Family Federalists

I'm in Baltimore today, looking through some of my great-grandfather's papers and books and becoming their caretaker. As many readers probably know, I have an ongoing research interest in him. He was the president of Maryland's Constitutional Convention of 1968. The Constitution ultimately failed amidst the turmoil of the King assassination and the expansive changes to the state government that were proposed.

I came across this statement by him at the beginning of the convention that I liked a lot. A strong federalist and reformist impulse motivated his work throughout the convention:

"And so, we, the citizens of what we proudly call the great free State of Maryland, have, along with our fellow citizens of other states, become cringing, favor-seeking vassals, fawning at the feet of Uncle Sam, grateful for the few crumbs of our own money tossed to us. But that great big, sprawling, bureaucratic colossus sitting astride the Potomac is too big, too far removed from the people, too impersonal to make more than uncertain, feeble, ineffective, and ofttimes inept attempts to solve these problems which ought to be solved by state and local governments.

The challenge is clear for us to see; it is written in large bold letters on the walls of this historic State House. We have almost complete freedom in drafting a constitution to submit to our people. So long as it provides for a republican form of government, so long as it does not transgress the rights and liberties of the individual citizens guaranteed and protected by the Constitution of the United States, we, the people of the State of Maryland, can have almost any kind of constitution we choose."

A very interesting paper

On the economics of superstars. I read this a while back and was just reminded of it in trying to figure out with a colleague why the graduate wage premium estimates I was getting for my engineering sample were consistently higher than the typical college (i.e. - undergraduate) wage premiums in the literature.

Now, if you're the sort of person that thinks simple math that doesn't always flesh out all the detail of the market process and is not as useful as extensive prose on abstract ideas, you might not like this paper. I'm personally very glad to have reacquainted myself with it, and I'm finding that it is facilitating the development of a useful understanding of the world as I observe it.

[sorry... still baffled by how some people approach economics... it is a really good paper]

Stossel and O'Reilly on Keynes

Here (the embed code isn't working... starts at 3:06)

Stossel actually looks sharp here compared to O'Reilly (only compared to O'Reilly, of course). He mentions the 1920-21 depression too. Granted, he messes up the history IMO. But even worse than that, he says there was no Fed in 1920. Hmmmm....

The Market Process and Blue Skies

Peter Boettke has an interesting, if unconvincing, discussion of the Austrian distinction in terms of thinking of the market as a process. He provides an excellent Mises passage: "The market is not a place, a thing, or a collective entity. The market is a process, actuated by the interplay of the actions of the various individuals cooperating under the division of labor".

I asked what he thinks other economists think the market is if not a process, and I'm still not quite sure what his answer to that is. I certainly view it as a process. I'm not even sure what a theoretically viable alternative answer would be!

The discussion takes two diversions that I think are unhelpful, but I suppose might shed light on what he means:

1. They discuss the sorts of issues economists look into
I would agree that Austrians talk about the market process itself a lot more than most mainstream economists. This is true. But I don't think you can draw the same conclusions from that many of the commenters try to draw. At work we evaluate a lot of federal programs. There are two major components to an evaluation: an impact analysis, and a process analysis. I mostly do the statistical work on the impact analysis. What actually happens at these federal programs is usually a black box to me (sometimes we empirically model the process itself, but usually not - we just get at it through interviews and focus groups). My job is just to use econometrics to produce a defensible estimate of the impact a program had. Now, the fact that this is what I spend a lot of my time working on that doesn't mean I don't understand there is a very complex process that is going on in these programs. It's just a scientific division of labor. I'm better at running the numbers. I've interviewed for the process studies on a couple of occasions and it was a good experience, but it wasn't really my strong suit. I'm the only junior staff in my center right now that knows how to implement a regression discontinuity design or do propensity score matching. It figures they assign me to do that stuff.

Evolution is fundamentally a genetic process. There are lots of biologists that aren't geneticists. It doesn't mean they don't accept or understand that evolution is a genetic process. Weather is fundamentally just classical mechanics - it's physics. Meteorologists aren't primarily Newtonian physicists, but this doesn't mean they don't understand the nature of that underlying process.

Where does this market process focus get you, though? Not very far in my opinion. If that's an interesting question to them, that's great. I think there are other more fruitful things to look into, and you can get a lot of mileage answering the really interesting questions out of the parsimony of neoclassical models than you can out of the richness of a poetic prose treatment of discovery, surprise, etc. I have a lot of questions I find interesting and want to answer in my career (1.) why is there excess worker reallocation, and how does it vary over the business cycle? (2.) what role do worker flows play in price level adjustment?, (3.) what is the impact of the job creation tax credits that have been implemented?, (4.) how do scientists and engineers select into technical and managerial occupations?, (5.) why are African Americans so much worse of economically in the United States? (6.) what happened to the American economy between 1919 and 1922?, etc. etc. I don't see how process theorists like Mises or Kirzner can really help me with most of these problems. There could be some applications, but it doesn't seem like the best way to answer the questions that I find truly interesting. Not to mention the fact that market process theory doesn't have any insights into the intellectual history that interest me - the intellectual history of Keynesianism.

What I find scientifically interesting seems like an odd metric for whether I think the market is a process or not.

2. They discuss modeling
The other thing that came up in the comment thread was modeling. Akerlof completely oversimplifies things and never talks about alternatives therefore he doesn't see how complex the market is and that the market is actually a process, etc. etc.. You all have heard the claim before. I don't know why this is such a stumbling block for people. Human society is incredible complex and if we want to understand it scientifically we have to explore questions parsimoniously. Parsimony in exposition is not the same thing as an oversimplified understanding. Yes, models simplify things to highlight specific mechanisms operating in the economy. This is a feature, not a bug. People need to deal with it. We've known about government failure and market efficiency for centuries. This is the foundation of the discipline. Everyone knows this stuff. When Akerlof and Stiglitz were starting to write about information asymmetries that was a genuinely new insight and mechanism they were exploring. Constructing simple models to illustrate the process and understanding the role it plays was excellent science on their parts. It certainly had a higher marginal benefit than someone who spent their time telling us more about what we already know about government failure or market efficiency.

*****

I called this post "the market process and blue skies" because this post from Boettke reminded me of the debate that he had with Bryan Caplan a while back (part 1 is here). I don't always agree with Caplan, but I thought he did incredibly well in this debate - particularly in the debate portion (I was less impressed with the performance during the Q&A, but I imagine that's a lot harder to do). Anyway, one of the things Caplan says is that a lot of Austrian claims are of the "Hayek said the sky is blue" variety. There are lots of claims that Austrians make that basically everyone agrees with and has agreed with even before there was an Austrian school. But if Hayek said it at some point it somehow becomes owned by the Austrians. The market is a process, values are subjective, socialism doesn't work, etc. etc. Anway, it's good stuff.

Positive Externalities Part 1: The Subsidy Solution

In this post on public investments in science, Stravinsky asks how "the government internalizes benefits of funding basic research". I'm not sure saying that the government internalizes the benefits is the best way to phrase it. Remember when we say that costs or benefits are "internal" or "external", these reference internality or externality to the market transaction. You can think of public solutions to externalities as a way of finding another allocation process besides the market which internalizes some of the benefits that were previously external. From the perspective of the person enjoying the benefits or paying the costs, the benefits are always there, after all! The question is - are these people at the table making the allocation decision? In many market transactions they are not. The idea is that in a democratic polity or any other democratic social institution they have a chance to be, so there may be a plausible improvement.

Economists usually talk about three solutions to a positive externality: public subsidy, public provision, and the reassignment of property rights. [UPDATE: So as I'm thinking about it, there's an extremely important fourth solution that I'll go over too - in addition to public provision, there is of course direct public demand. We can think of this as a price response (subsidy), two quantity responses (supply and demand), and an institutional response (property rights allocation)]. I'm going to try to discuss each of these in turn, and I'll start with the subsidy, which is presented here:



Here you have the basic positive externality. Market transactions can be expected to converge towards the point where marginal benefit equals marginal cost (the far lower left yellow circle marks this equilibrium). That's where private net benefits are maximized. The problem is, if there are substantial externalized benefits, that's not where total (i.e. - private plus social) benefits are maximized. I've shaded the deadweight loss region of the graph in gray, and you can think of an externality like a tax imposed by the property rights regime. Now, there are some social benefits enjoyed, of course. I've shaded in green the social surplus and in red the private surplus.

One solution is to subsidize private purchasers of the good in question. I've marked this subsidy with the dashed line. We can think of it as a lump sum ("we'll give you $X to go towards Y") or you can think of it as a percentage ("we'll pay X% of the cost of Y"). Either way, it will shift the quantity demanded and the price charged out to a new equilibrium along the marginal cost curve (if demanders are being subsidized the situation has not changed for the suppliers, so we are still on the MC curve).

One argument against public solutions for externalities that I am always shocked so many smart people are impressed by is this banality that "the government doesn't know where the equilibrium is". Of course it doesn't. Has anyone said it does? I think drawing an optimal subsidy or tax to deal with an externality on paper has given people the false impression that those who support these public investments think the government knows where the marginal social benefit curve meets the marginal cost curve. I've never claimed that, and I cannot recall anyone else claiming that. So to avoid that confusion, I've drawn several potential new equilibria (also in yellow dots), none of which fall on the intersection of the marginal social benefit curve and the marginal cost curve! Four words you have never seen written on this blog are "the government is optimal", and you never will see those four words written.

So the government is not optimal. That is so obvious it doesn't need elaboration. The point is, though, any public solution to the left of the intersection of the marginal social benefit and marginal cost curve is an improvement on market allocation. Allocation is still efficient because we are still using the market to economize on decentralized knowledge about who can produce and use the good most efficiently (i.e. - we are still on the MC curve). And it's also closer to being welfare maximizing. This is an unambiguous improvement.

It becomes more ambiguous if we move to the right of the intersection of the marginal social benefit and marginal cost curves. Past that point marginal cost exceeds total marginal benefit, which means net social benefits are declining. I say this is "ambiguous" rather than bad, because the net social benefits at a point to the right of the intersection of the marginal social benefit and marginal cost curve may still be higher welfare than the market solution. But of course this is not the territory we want to be in. But if clear social benefits are modestly subsidized, there's no good reason to run away from this option. If we think about "robust political economies", both the market alone and the government alone clearly fail to pass the robustness test in the case of positive externalities. Both are incapable of fully dealing with the incompleteness and imperfection of human decision makers. This really shouldn't surprise economists. Anyone who clings to a corner solution should immediately raise red flags - the "economic way of thinking", as it's been called, alerts us to the fact that corner solutions are rarely sensible or robust. Experience shows us this as well. Societies that rely heavily on government allocation repeatedly fail, and societies without a robust government to meet social needs fail to emerge or develop into mixed economies over time (it only took a matter of years to move from the Articles to the Constitution).

Next I'll do public provision, and then I'll do the rearrangement of property rights. Not sure when exactly - I'm going to be out of town a lot of this weekend, and working on the engineering labor supply paper as well.

This is not rocket science (although they should be doing rocket science too)

Brad DeLong first points us to a cringe-worthy announcement by Biden that the government's going to show how tough it is by shutting down a desert tortoise website, which collects and disseminates data on the tortoise. This is the grip that the austerity narrative has - politicians are constantly focusing on "waste", which is (1.) next to useless when it actually makes sense to control government spending, and (2.) exactly the wrong thing to be talking about right now.

DeLong follows up with a point about public investment in science: "Providing scientific information as a public good is one of the core competencies of government. That was what the fracking Lewis and Clark expedition was for..."

Back to the foundation of the republic our founding fathers knew what "provide for the general welfare" meant even if modern libertarians want to scrap that bit of the Constitution, and they knew - Jefferson especially, but others as well - that it included public investments in science. Scientific research is a positive externality - it provides lots of benefits that can't be internalized into market transactions. So, while the market does invest in necessary science, it underinvests in it. Certain science requires public investment for a healthy, vibrant society. That includes studying endangered species, which don't have much market value, and exploring and colonizing new worlds - which may have market value far into the future, but not now. It includes making large investments which may pose collective action problems for private actors. Government is one of many emergent social institutions that the human species has developed to get things done. One of the things a healthy state institution does is invest in science - although as Eisenhower warned we need to guard against militarized science and promote public investments in science for purposes of peace and the expansion of our understanding of the world.

Two new Big Think videos with Neil deGrass Tyson, both touching on the economics of science

In this one, on competition in science, he talks about public spending on science. He also notes some differences between the production of art and the production of science that could be interesting for those of you who are into the intellectual property rights issue. At the end he touches on what economists would call "intensive vs. extensive growth", and notes that innovation and science is necessary for extensive growth. Barry Eichengreen - in his book on the post-war European economy - stressed that the reason for the economic slow-down in Europe after their initial post-war growth miracles was that they did not have institutions that could foster extensive growth and innovation in the way that the U.S. did.



In this one he talks about science funding as stimulus. I of course agree with him, but I would make distintions between long-run and short-run growth here. He's talking about long-run growth and of course that's not the only thing we need to be thinking about right now. Science funding didn't do badly in ARRA but it was ridiculously lop-sided. The National Institutes of Health got a lot of the research funding, continuing a trend in NIH funding started by the Bush administration. I think a greater emphasis on NSF funding would have made more sense.



Also - Tyson has something in common with Keynes. They're both huge Newton fans.

Robust Political Economy

I recently watched a video of Mark Pennington discussing "robust political economy" and thought it was very good. Arnold Kling is promoting it as well, which inspires me to share it here. The robustness of political economy that Pennington discusses is robustness to human error, frailty, ignorance, etc.

I highly recommend the talk, but I also want to highlight something that bothers me about it. This is essentially an argument for a constitutionally limited republic, and it also makes a good case for a constitutionally limited federal republic, in particular. Pennington goes a little off the reservation in acting as if he has produced a case for libertarianism, however, as if libertarianism and constitutionally limited federal republicanism are coterminous.

You see this with public choice theory a lot as well, where the economics and political science gets mixed in with a particular ideological prerogative. I think that's unfortunate. This is great political theory all around. In fact, he's highlighting exactly why I support a constitutionally limited government as well as why I make a big deal on here about federalism, and Pennington highlights these classic elements of liberal political economy by drawing attention to perhaps their most important feature: their robustness. I think Pennington pushes away people who agree with him on robust political economy but not on the libertarianism, and I think libertarians who listen to this risk thinking this elaboration of good political theory is somehow a justification of libertarianism.

I would also caution listeners to take what he says about "market failure" arguments with a grain of salt. He makes good points about robust political economy but I think he presents a somewhat distorted picture of market failure to facilitate a juxtaposition he wants to make (a juxtaposition which I think is entirely unnecessary and comes across as forced).

UPDATE: Arnold Kling highlights this conclusion which I endorse: "Societies benefit from continual experimentation. Since no one knows enough to design a perfect system, more experimentation is better.". Again, I'd highlight here the important difference between classical liberal robust political economy and modern libertarianism. One of the primary reasons for my unease at libertarianism is the threat that it poses to continual social experimentation. "There are a couple things we could try" is not a phrase you'll hear a libertarian say very often.

Labor's share of national income

I'm not sure if there's some common underlying motivation, but both David Frum and Stephen Gordon posted recently on a famous "stylized fact" of macroeconomics - the relatively constant share of national income going to labor. Frum's is here and Gordon's is here. Labor's share of national income has been falling for the last couple decades, which is a trend that a lot of people have been speculating on. One of the better known treatments has been this IMF study (cited by Gordon) which attempts to identify the source of the decline for several different groups of countries.

I've worked a little on this issue with Wayne Vroman (recent recipient of an award from NASI!). One of the things we looked at was the change in the components of what's put into "labor share". There's wage and salary, total compensation (which is wage and salary plus benefits), and some portion of proprietor's income (usually set at something like two-thirds). Not unsurprisingly, the major source of decline has been in wages and salary. Non-salary compensation (i.e. - health and retirement benefits) have gone up over the last several decades, so that the total labor share has declined, but not as much as wages and salaries. Wayne and I are specifically looking at the implications for the unemployment insurance program, which is paid for with payroll taxes. As wages and salaries go down (while other benefits go up) the tax base for unemployment insurance is shrinking, even as the importance of a job for supporting retirement and health insurance is growing. In other words - losing a job is getting more costly at the same time that insurance against losing your job is getting harder to finance.

Right now we just have a lot of data, literature, and outlining that I've collected on the trends and their implications for unemployment insurance. We're hoping to write something up this summer on it.

If the gold standard is too fiat for you...

...you might be a Ron Paul supporter (or Ron Paul himself).

Auri sacra fames strikes again.

Question for readers on graduate school wage premiums

Has anyone ever heard of an estimate of a graduate school wage premium (i.e. - over undergrad)? I'm calculating wage premiums for engineering graduate school grads relative to undergrads, and then using Goldin and Katz's (2008) basic supply and demand approach I'm trying to work elasticities of substitution out of that. I'm getting somewhat lower grad school premiums than they got undergrad premiums. It all looks fine - that sounds plausible to me - but it would be even better if someone actually produced these grad school premiums before and mine are comparable. I'm not even sure I'll include the elasticities in the paper - I've got plenty of micro-data, but I'm not working off of many years. The relationship is surprisingly strong, but when a kid with a crayon and a penchant for connect-the-dots can do just as well with a print out of my data, I'm a little loathe to call it an "estimated elasticity of substitution".

If I could verify the magnitude of the wage premium with other literature, though, that would be great.

Let's round this out with a third one on misconceptions of Keynes

Actually this will just be a series of links for you all to follow, because I have a few things to do.

Recently, Don Boudreaux put forward this idea that Keynes was a utopian (this was somewhat before he put forth the idea that he was a dystopian... confusing, I know - but try to keep up). I noted the source of his confusion on this matter - his understanding of the marginal efficiency of capital, which he seems to think is just the cost of capital (if MEC goes to zero and MEC is the cost of capital then we do have post-scarcity on our hands... the problem is, MEC isn't the cost of capital). I responded to Don in this post.

That's all been on F&OST before. What I wanted to bring your attention to was a post by Robert Thorpe on the Cobden Centre blog on the whole exchange. I have not gotten the chance to read it yet - I am guessing Keynes (and I) don't come out well, but the author was perfectly polite when he shared the link, so I hope I'm passing on something enriching.

This issue also came up again with George Selgin on Cafe Hayek in the comment section. The whole exchange starts here with my response to Don, and Selgin jumps in quickly. Selgin is frustrating. He's a smart guy and definitely worth interacting with in the blogosphere. But he's very dismissive and when he slips into his dismissive mood I lose the ability to make heads or tails of his argument. When he's done making the argument, he's done making the argument and you won't get much more out of him. Everything I've said in this series of exchanges is trying to impress upon Don and trying to get Don and Selgin to tell me why they think Keynes is saying capital would be "free". Selgin writes, for example "But he is saying in effect that capital will become a free good, like air or water." Does he say this, George? Where? Later on he talks about an excess supply of capital (and other goods) and an excess demand for liquidity. Sure, George. We all know this. Excess supply doesn't give you free capital, though. That's hardly an answer. So where are you getting that capital is free? I'm still not sure.

*****

OK - I should have been writing this morning, but now that I've fulfilled my stereotype three times over I suppose I can be more productive for the rest of the day staying home to work on the chapter.