Saturday, September 3, 2011

It's been a strange week for me on questions of substitutability

So Steve Horwitz especially has had several posts this week on capital and labor heterogeneity and specificity. What's been strange about it is that as a budding labor economist whose scant contributions to the field have mainly revolved around (1.) evaluating training programs that provide human capital to workers who aren't qualified to do certain jobs, (2.) understanding unemployment which cannot be remedied simply by lowering a reservation wage, and (3.) highly specialized labor markets, particularly for scientists and engineers, which can't turn on a dime, I was initially very receptive to Steve's posts. Indeed, as he was putting out these posts I've been writing about specialized engineering labor and how that specialization changes the response of the engineering labor market to increases in demand! My big quibble with Steve's post was that unless you assumed no substitutability it seems silly to deny that stimulus will have ripple effects: if 58% of ARRA-funded workers come from other jobs they will be largely replaced. Nobody has to abandon labor and capital heterogeneity to know this.

Anyway - because of all this I was predisposed to agree with Steve on labor and capital, but disagree on the implications for the stimulus (which he still left very vague). But as it happened, on Steve's blog an English PhD told me he knew what I thought and what economists thought about these things better than I do, a former central banker continued a long-standing habit of condescension towards me, and Steve mocked my question rather than answering it... so I don't feel like commenting on his new post on capital heterogeneity and the interwar period (another thing I'm very intereseted in) that is also quite thought-provoking.

But I did want to say something about capital specificity and Keynesianism.

One of the key insight of Keynes is that the act of saving is not just the other side of the coin of the act of investing. Money and debt allows for that connection to be severed. It's very hard to maintain that view and also think that capital is homogenous. Saving is about a demand for a prospective yield. Capital is about the execution of specific plan. If capital were not specific and were just a homogenous blog-like stream of benefits you would have a much easier time arguing that the act of saving and the act of investing are essentially the same act.

It's worth quoting extensively from Chapter 16 of the General Theory:

"An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.

If saving consisted not merely in abstaining from present consumption but in placing simultaneously a specific order for future consumption, the effect might indeed be different. For in that case the expectation of some future yield from investment would be improved, and the resources released from preparing for present consumption could be turned over to preparing for the future consumption. Not that they necessarily would be, even in this case, on a scale equal to the amount of resources released; since the desired interval of delay might require a method of production so inconveniently “roundabout” as to have an efficiency well below the current rate of interest, with the result that the favourable effect on employment of the forward order for consumption would eventuate not at once but at some subsequent date, so that the immediate effect of the saving would still be adverse to employment. In any case, however, an individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order. Thus, since the expectation of consumption is the only raison d'ĂȘtre of employment, there should be nothing paradoxical in the conclusion that a diminished propensity to consume has cet. par. a depressing effect on employment.

The trouble arises, therefore, because the act of saving implies, not a substitution for present consumption of some specific additional consumption which requires for its preparation just as much immediate economic activity as would have been required by present consumption equal in value to the sum saved, but a desire for “wealth” as such, that is for a potentiality of consuming an unspecified article at an unspecified time. The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.

It is of this fallacy that it is most difficult to disabuse men’s minds. It comes from believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield. Now, prospective yield wholly depends on the expectation of future effective demand in relation to future conditions of supply. If, therefore, an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment. Moreover, in order that an individual saver may attain his desired goal of the ownership of wealth, it is not necessary that a new capital-asset should be produced wherewith to satisfy him. The mere act of saving by one individual, being two-sided as we have shown above, forces some other individual to transfer to him some article of wealth old or new. Every act of saving involves a “forced” inevitable transfer of wealth to him who saves, though he in his turn may suffer from the saving of others. These transfers of wealth do not require the creation of new wealth — indeed, as we have seen, they may be actively inimical to it. The creation of new wealth wholly depends on the prospective yield of the new wealth reaching the standard set by the current rate of interest. The prospective yield of the marginal new investment is not increased by the fact that someone wishes to increase his wealth, since the prospective yield of the marginal new investment depends on the expectation of a demand for a specific article at a specific date.

Nor do we avoid this conclusion by arguing that what the owner of wealth desires is not a given prospective yield but the best available prospective yield, so that an increased desire to own wealth reduces the prospective yield with which the producers of new investment have to be content. For this overlooks the fact that there is always an alternative to the ownership of real capital-assets, namely the ownership of money and debts; so that the prospective yield with which the producers of new investment have to be content cannot fall below the standard set by the current rate of interest. And the current rate of interest depends, as we have seen, not on the strength of the desire to hold wealth, but on the strengths of the desires to hold it in liquid and in illiquid forms respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other. If the reader still finds himself perplexed, let him ask himself why, the quantity of money being unchanged, a fresh act of saving should diminish the sum which it is desired to keep in liquid form at the existing rate of interest.

Certain deeper perplexities, which may arise when we try to probe still further into the whys and wherefores, will be considered in the next chapter.

It is much preferable to speak of capital as having a yield over the course of its life in excess of its original cost, than as being productive. For the only reason why an asset offers a prospect of yielding during its life services having an aggregate value greater than its initial supply price is because it is scarce; and it is kept scarce because of the competition of the rate of interest on money. If capital becomes less scarce, the excess yield will diminish, without its having become less productive — at least in the physical sense."

Think about how hard this passage would be to write with an understanding of capital as a homogenous blob. There are blobs in there: the prospective yields that people demand. They just want a yield. It doesn't matter if it comes from owning capital in a mining firm, a manufacturing firm, or a barber shop - it doesn't even have to come from capital. People just want a yield, and that's understandable why that would be a blob. Savers are not entrepreneurs.

But that is precisely the problem. If capital were also just a homogenous good producer and prospective yield producer, this would be much easier. Savers could be satisfied with the guarantee of a homogenous prospective yield. With that guarantee they could more easily signal that they want some future blob of consumption, which would justify bringing forth that homogenous capital in the first place. The fact that saving and investing are separate acts would not pose too much of a problem if capital were homogenous. It poses a problem, according to Keynes, precisely because (1.) capital is heterogenous, and (2.) demand for prospective yields by savers largely isn't.

This is the key line: "The prospective yield of the marginal new investment is not increased by the fact that someone wishes to increase his wealth, since the prospective yield of the marginal new investment depends on the expectation of a demand for a specific article at a specific date."

Savers can save without specificity on their future demand. They can refrain from current consumption without placing an order for any specific future consumption. Investors can't invest without specificity.

So why do the commenters on Steve's blog (and apparently Steve himself) have this idea that Keynesians think capital is homogenous. There are several commenters for whom the reason appears to simply be ignorance. But this isn't true of all of them. For most I think the problem is models with "K" or "I" in it. This is a hang-up that they need to get over. A few points on that:

1. Models aren't reality. This may conflict with your methodology, but that doesn't mean you can pretend that they are real. Models are abstractions from reality that provide insights into specific mechanisms that we think are important in a less abstract reality. Of course the abstraction you make in modeling may be non-trivial, which is why we test models to make sure they still hold up. But models aren't reality - so don't freak out when you see a "K" or an "I" in models.

2. Models are so damn useful that lots of people use precisely the models you criticize us for using. Flip through Hayek. Flip through Garrison. I can't speak for Mises but I'm sure there are others. Tell me how many "K"s, "I"s, and references to "investment" or "capital" you see. You see a lot. Why? Because the abstraction is useful. That's very different from making an argument with a variable "K" that depends on homogeneity.

3. Finally, you need to differentiate between aggregation and homogenization. Saying "I'm talking about the schedule of the marginal efficiency of capital given a particular demand" is the aggregation of all heterogeneous capital on a single metric that all that capital shares. To point out that they share this quality and can therefore be aggregated is very different from saying that they all produce the same thing.


  1. One other point I was just reminded of - a commenter on Steve's new post wrote "Austrian capital theory coupled with a thorough-going subjectivist perspective is exactly why Austrian economics is directly relevant to analyzing how an economy really functions"

    I had to laugh at that, not because I disagree that Austrian economics is relevant - but because subjectivism is another area where Austrians will insist to you that you are not a subjectivist even if you are one and have always been taught a subjective theory of value and how wrong any other theory of value is.

    Bryan Caplan nailed this point in his debate with Peter Boettke when he mused that Austrians attached the adjective "radical" to "subjectivist" because they weren't getting any traction in distinguishing themselves on the subjectivism point (because almost every economist I'm aware of - certainly the entire mainstream - is subjectivist).

    A note to readers on future professional interaction: don't tell other people what they think. It's obnoxious. Others will tell you that they think values are subjective and capital is not a homogenous blob. Trust them when they say this and it'll make it much easier to get along with them (granted, for some people the goal may be NOT TO get along with them).

  2. Arguing that government action X will produce objectively more welfare versus the absence of it is departing from subjective theory of value.

    After all, if value is subjective, how can you possibly make utility calculus?

  3. Hi Daniel,

    Totally unrelated, but I was interested if you have ever read, "Where Keynes Went Wrong" by Hunter Lewis? I've just started it now and was curious to see if you thought it does a fair job of stating Keynes' views.

  4. Robert -
    Nope. In a nutshell, where does Keynes go wrong?

    Mattheus -
    You can't do utility calculus. You can keep talk of utility calculus in the theoretical realm and do all kinds of fancy stuff with it. That can be useful to do. Or you can guess at it as a society in the real world and do alright at guessing hopefully. This has benefits. But you can't actually do utility calculus in the real-world. We're not smart enough.

    I think you're being a little fast and loose with the word "objective" in your first sentence. I like ice cream. That is a subjective value. But it is an objective fact that I like ice cream. It's not an objective VALUE but the existence of the subjective value is an objective fact. I don't think it's quite the problem you're making it out to be.

  5. We cannot engage in interpersonal utility comparisons.

    To say that the state should tax people and do X with that money is implicitly accepting the premise that whatever is created is of higher value than whatever else could be done.

    You sit here writing blogs all day. This demonstrates a preference for writing blogs over any number of items you could, conceivably, be doing.

    But, whereas you are one person and can judge opportunity cost, we cannot make the comparison between peoples. If we truly stick to subjective theory of value, we must remain agnostic on ALL government policies, programs, and expenditures.

  6. I'm thinking of Robbins' position in the 1930s.

    Part III

  7. Well, I've just started the book but the main topic so far is Keynes view that "existing interest rates are too high" and his solution is to have the government print enough money until the prevailing interest rate is brought down to and maintained at 0%. He asserts money injected into the economy this way "is just as genuine as any other savings."

    He also seems to contradict himself and never define or explain what seem to be really important concepts. For example when he writes, "The rate of interest is not self-adjusting at a level best suited to the social advantage but constantly tends to rise too high" (p. 351) you would think he would clearly define what this social advantage is. What specific evidence there is to support the notion that the market rate of interest is "too high" and depriving the economy of the benefits that come from an artificially manipulated lower rate of interest and so forth.

    So basically on the one chapter of content I've read so far he quotes Keynes extensively and summarizes that his position is to reduce interest rates to 0% permanently to increase economic prosperity and the way to do this is to use the central bank to print as much money as possible, as this influx of new money is identical to genuine savings.

    Needless to say, the author (and myself) think this is quite wrong.

  8. Some sample pages from the book are available here:

  9. Mattheus -
    I said government would be guessing. These guesses aren't the same as a stab in the dark.

    We've been over the intersubjective comparisons before, Mattheus. I don't understand why people get hung up on this. Since we can't make intersubjective comparisons, that would make any market solution any more reasonable than a non-market solution. You may know what you like and don't like relative to your own standard of utility, but there is no guarantee at all that the market will generate the most utility.

    So what do we do?

    We say - we'll people all should be treated roughly equally. My inherent utility might be naturally 100 times your inherent utility from things. But we're not strict utilitarians - we don't think it follows from that that you should give me all your stuff because it would get more bang for the buck with me.

    In a sense I'm sympathetic. There's something intrinsically artificial about any discussion of utility, which is why it amazes me that some people think that micro is on more solid ground than macro (which doesn't rely as much on these fake constructs... until the microfoundations revolution, that is). I sympathize with the skepticism, but I disagree with the use of that skepticism as an argument against government.

    If we can't make interpersonal utility comparisons and follow the consequences of that, we can't endorse ANY institutional arrangement. The market is no guarantee of anything any more than the government is.

    What we can do with a theoretical interpersonal utility comparison is explain behavior pretty well - people act on the margin. Should we be more careful about interpreting welfare analysis? Sure. But that goes for all uses of welfare analysis. You can't pick and choose. If we declare welfare analysis unworthy, then a communist has an equal leg to stand on as a libertarian at least in utilitarian terms.

    The other option is to decide that we as a society think that everyone has an inherent right to maximizing their own utility. That's a political decision rather than a scientific decision, but it's a political decision that makes neoclassical intersubjective utility comparison reasonable to talk about.

    I'm not sure how much sense that made, but I really do think Austrians should take a hint as to why nobody else follows them down this intersubjective comparison path (while still being subjectivists).


    - As a scientific question, marginal behavior on the basis of an individual's utility seems to be right, and the conclusions derived don't change when you (1.) simplify by assuming well behaved utility functions, or (2.) assume a common standard for utility measurement.

    - As a scientific matter, welfare analysis of either government or markets or anything else is less tenable because while marginal utility is set equal between the marginal buyer and seller, that is only set equal in money-terms, and of course the utility of money varies between given buyers and sellers too!

    - As a political matter, it seems very reasonable to assume intersubjective marginal utility.

    - As an engineering problem, it therefore seems reasonable to do some welfare analysis.

  10. Mattheus,

    You have to remember that Keynes adopted the Freudian notion that people are essentially herd animals (Freud has a famous called "The Herd Instinct" on this very point - Keynes picked his Freudian ideas up from the Bloomsbury group and various hangers on), so almost all of them get their preferences from some initiator. So in Keynes' way of viewing things you might as well make that initiator the wise types that come out of Cambridge.

  11. Daniel,

    You wrote "then a communist has an equal leg to stand on as a libertarian at least in utilitarian terms"

    Watching your debate with Mattheus I was kind of afraid you're slip into that hole.

    The Austrian position is that voluntary trade is u-enhancing for both parties (cardinal, not ordinal), while involuntary can be u-reducing for one or even both (cf min wage) parties.

    So voluntary exchange is always Pareto enhancing, involuntary we don't know.

    Therefore we can't choose between, say, Mao and Pol Pot, but what we can say is that voluntary exchange always beats non-voluntary exchange.

  12. Sorry, last sentence should read "voluntary exchange weakly dominates non-voluntary exchange."

  13. Peter - assuming the exchange is voluntary, yes. When people typically argue a case for government they're not Pol Pot boosters. They're arguing for intervention in a situation where the exchange is involuntary in some sense (externality), which is precisely when that claim that you and I both agree on about voluntary markets doesn't hold.

    Now - that's Pareto optimal. Mattheus wasn't referencing Pareto optimality - he said "Arguing that government action X will produce objectively more welfare versus the absence of it" and my point to him was that we can't make the "more welfare" claim for markets either if utility can't be compared intersubjectively.

  14. Aside from the frightening elasticity of the externality argument (eg we're not anti-gay, we're just correcting for harmful moral externalities), I think most labor regulation actually isn't justified by externalities. Minimum wage, discrimination, environmental (OSHA) are, I believe, justified as correcting for asymmetric bargaining leverage.

    Taking the min wage, a liberal might say that too-cheap wages are unconscionable, thus it's actually a good thing if regulation makes some bargains go unmade -- no man should have to work for pennies. An Austrian would say that any voluntary bargain is u-enhancing for both parties, so the key isn't the regulator's (or voters') sense of fairness, rather the key is the absolute # of bargains. Fewer bargains implies lower welfare for the would-be-bargainers.

    So I think the liberal has a dilemma comparing the u-impact of outlawing low-wage labor (which is what min wage does) vs raising the wage of the still-employed. The Austrian sees no trade-off, simply asking whether or not bargains have been frustrated. If so, it's presumed bad policy for those frustrated (typically the lowest skilled).

  15. "Therefore we can't choose between, say, Mao and Pol Pot, but what we can say is that voluntary exchange always beats non-voluntary exchange."

    Well, the other thing Peter missed is that the real assumption is that in voluntary exchange both parties will *believe* ex ante that the exchange will turn out to be utility enhancing. That certainly does not mean they are correct about this! As Mises liked to say, "Tis many a slip twixt cup and lip."


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