Horwitz and DeLong on policy in our depression

Steve Horwitz has an interesting discussion at the Adam Smith Institute on policy in this depression and specifically why "Krugman is wrong". If you are not familiar with Austrian macroeconomics it's an excellent summary. But of course, he also critiques the Keynesian response, and these portions are less strong in my view. I have two nit-picky concerns that nevertheless get to more fundamental issues - one that I'll address and one that I'll let Brad DeLong's recent post address.

Nit #1: "Stimulus failed"

Steve spends a lot of time talking about the failure of the stimulus package - not just the failure to get us out of the depression (many of us said at the time it wasn't up to that task), but the failure to do any good at all. I'm most troubled that he used the Romer-Bernstein graph to make the point. There are two reasons to show it:

1. To argue that forecasters in December 2008 did not get it right, or
2. To defend forecasters in December 2008 as presenting a viable counterfactual.

It's hard to say exactly where Steve falls because he doesn't frame it like I just did, but in the talk he seems to support the first option, and yet he also presents it as being bad news for stimulus. This seems like an extremely misleading thing to do. If you accept the first option, the only answer an economist really has any business providing on what it says for the stimulus is "we can't know exactly without a counter-factual, but we can rely on past evidence - but this graph that I am showing you understates the positive impact of the stimulus because of the poor forecast".

I could be misreading him and he could be arguing just for #2, but I don't think he's doing that. I think #1 is far more defensible myself. The problem is that Steve seems to want to have his cake and eat it too: he wants the premise from #1 but the conclusions from #2. It's not just him of course. You see this a lot. I don't understand it. Steve understands the problems around inference from non-experimental data, so why does he promote the graph as demonstrating the failure of the stimulus?

This has bigger consequences, and this is why this nit is important. In a world where "are you better off than you were four years ago" is perceived as a sensible question for evaluating a candidate, people who understand counterfactuals and inference from non-experimental data (like Steve Horwitz) ought to be clarifying this sort of thing to the public, not confusing them on what this graph means.

Nit #2: Krugman and people like him don't understand that interest rates coordinate intertemporal choice

I was surprised the first time I heard him say this, but then he revisited it several times. Does anyone honestly believe Krugman and people who agree with Krugman don't understand that the interest rate is a price signal?

A lot of people think this is what the argument is over - the market process. I disagree strongly. If you want a good example of a Keynesian understanding the interest rate as a price signal and raising other quite different concerns, I suggest you read Brad DeLong's Platonic dialogue today. The Hayek/Mises stuff is subtext until Sokrates jumps in farther down, but if you're at all familiar with the Austrian argument you should see it much earlier. This is a critical point in the exchange, from the perspective of the discussion with the Austrians (yes I know this critical "point" is like half the dialogue):

"Hypatia: A second worry is that because of tight fiscal-loose money the real rate of interest is not doing its job of signaling the true optimal first-best shadow price of intertemporal choices. It is making the price of investment too low.

Glaukon: Thus a tight fiscal-loose money economy would seem to be one that invests too much and that weights the composition of its investment too heavily toward long duration assets.

Hypatia: Yes. The price at which savers lend and at which investors borrow and choose investment projects is false. False prices produce transfer rectangles--in this case, a transfer from savers to investors--as well as excess purchases of the investment goods whose market price is less than their social resource cost.

...

Glaukon: But can you elucidate to me the harm from purchasing investment goods whose private purchase is profitable just because the interest rate is below the first-best optimal intertemporal tradeoff shadow price?

Hypatia: I don't think I understand: price is below shadow cost; purchases are too high; Harberger triangle; deadweight loss.

Glaukon: Let me see if I can say where I am having my problem: I understand pollution externalities--we undertake too much polluting activity because we do not factor the harm of pollution into the market price and so there is a deadweight loss Harberger triangle composed of the harm rectangle imposed on society as a whole offset by the triangle that is the benefit to private polluters minus the private cost.

Sokrates: That is completely correct, Glaukon.

Glaukon: But in the case of over-easy monetary policy I do not see this. I the benefit triangle to investors--they get to make investments that are privately profitable. I see the transfer rectangle. But where is the harm, exactly?

Tiresias: I believe that the harm must somehow arise out of the fact that consumers are non-Ricardian.

Klio: Non-Ricardian?

Tiresias: Yes, if consumers are Ricardian, then if taxes are too high they simply borrow to pay their extra taxes. Consumption and investment stay what they would be at first-best fiscal policy. There is no aggregate demand shortfall for easy money to correct."

My paraphrase of Brad's response to the Austrians is that yes, ultra-expansionary monetary policy, if we were to adopt it, would move us below the natural rate, and that will throw investment and consumption off balance and produce elongated capital structures like you're worried about. But it's critical to recognize that that is a cost associated with government spending that is below trend in a non-Ricardian world and of credit market problems. Loosening monetary policy is the best alternative to the fiscal and credit market problem. Another way of putting it is the old saying that "it takes a lot of Harberger triangles to fill an Okun's gap".

Yesterday he presented a somewhat different argument, which I am more amenable to: that we are actually above the natural rate right now, which is why the Wicksellian perspective calls for monetary expansion. There is no false signal being sent. In fact, if I were to put my Hayekian hat on I would be worrying that firms are getting the wrong signals to invest too little and to have production processes that are too short because we are above the natural rate.

How to square Brad's post yesterday with his post today? I'm assuming the monetary policies he's discussing today are genuinely "ultra-loose" in the sense that White meant it - below the natural rate - in order to compensate for the failure of fiscal policy makers.

So there are two responses to the Austrians:

1. You're right but those are costs that we incur because we're in second-best territory. If your argument is that first-best is better than second-best we agree. But these Harberger triangles still don't outweight the Okun gap.

2. You are right about the response of entrepreneurs to the interest rate but wrong that we are below the natural rate right now: all signs suggest we are above it.

Both are appropriate, but I think #1 is unnecessarily deferential to the Austrian assumptions about the natural rate.

Anyway, one thing is clear: Brad DeLong understands that interest rates are signals that coordinate intertemporal decisions.