Tuesday, July 31, 2012

Something to add to my reading list

I was just perusing Steve Horwitz's JEBO article again, which I hadn't read since I got the special issue from Peter Boettke in a little Coordination Problem contest. I was reading it before more in the context of my own interest in James Buchanan's constitutional work than in the context of the rules vs. discretion debate, so I hadn't really taken notice before of this article from 1936 by Henry Simons on the same question (it's called "Rules vs. Authorities in Monetary Policy").

The discussion does go back quite a ways!

I have a lot on my plate... probably won't be high on my reading list. But I thought you all might be interested in it.

Horwitz on Monetary Rules

Steve distinguishes between constitutional and policy rules here.

I agree with what he has to say. If we could have a constitutionally bound Fed that would obviously be considerably more predictable than a policy rule.

Steve suggests I don't understand the distinction, which I don't think is quite right. The discussion just wasn't about that distinction initially. And Kydland and Prescott (which I raised in my post) don't get into that distinction (UPDATE: I don't think they do at least... I'd probably have to go back and check to be sure). Don suggested that Wapshott advocates discretion and that "management of the economy" is the same as "discretion". That seems wrong to me no matter how you cut it. We are talking about rules, not discretion. If we want to get into the discussion of constitutional vs. policy rules, then I'd agree with Steve that most of what you see macroeconomists talk about today is policy rules, not constitutional rules. But that's a somewhat different issue than the rules vs. discretion point.

Steve also says this: "It is this last point that makes people sympathetic to Friedman unwilling to call that a “rule” in the same sense – it ultimately doesn’t constrain the central bank because it still has the discretion to change the rule.

Put differently, a policy-guiding rule is adopted by the central bank;  a policy-constraining rule is imposed on the central bank.  Their purposes are very different."

This is true, but whipping it out as a criticism of me is a little silly. Constitutional or legal impositions on the central bank (which we do have to some extent, by the way, in the Federal Reserve Act) are "discretionary" in this sense. After all Congress or the various actors involved in the various mechanisms for constitutional amendment have "discretion" over the constitutional rules!

Does that mean at its heart a constitutional rule is discretionary?

No, of course not. And neither is a policy rule.

There is a lot that's appealing to me about a constitutional rule, but part of what makes me hesitate is that we're still learning a lot about the economy and I'd worry that a bad constitutional rule might get locked in in a way that a bad policy rule might not. I'm not saying discretion should dictate monetary policy. We all agree that that's wrong. But consider this wild hypothetical: after thirty years of a monetary policy rule we have a once-in-a-lifetime shock and a fundamental rethinking of the ideal policy rule (say, we're considering whether NGDP level targeting is actually better than a Taylor rule). It seems to me that having the Fed switch to this new policy rule for many decades to come is not a bad thing. That sort of improvement might be stymied by a constitutional rule.

Or it might not be, I don't know.

But that's why I hestitate to go all-in for a constitutional rule. Not because I advocate discretion but because I genuinely think the trade-off between the costs of a bad rule on the one hand and the costs of the somehwat weaker assurance of a policy rule on the other is in fact a real trade-off.

If you want to read more about constitutional rules, I recommend Steves JEBO article here, or just do a search for "monetary constitution" at the Cato Journal - they've produced a lot of interesting stuff on the issue.

UPDATE: So the thirty year reference to the Taylor rule is a little odd I know because of the date Taylor published! This adds an implicit/explicit wrinkle to the constitutional/policy wrinkle of the rule/discretion debate. That's too many wrinkles for me, so I'll just let that whole discussion slide for now.

DeLong on Friedman in 2006

This is one of those pieces of writing I had trouble excerpting, so you get it all. Two things I would disagree with. First, the claim that Keynes underestimated monetary policy is exaggerated. Second I disagree with all but the first sentence of the paragraph about Keynes and technocracy. On the first point, I have some details in my RAE article and on the second point I have details in a paper I have yet to write (damn you unidirectional time!).

But this really ought to be a reflection on Friedman, not Keynes, so you don't need to worry about the details on those right now anyway. Here's Brad DeLong:

"Friedman Completed Keynes

The most famous and influential American economist of the past century died in November. Milton Friedman was not the most famous and influential economist in the world -- that honor belongs to John Maynard Keynes. But Milton Friedman ran a close second.

From one perspective, Milton Friedman was the star pupil of, successor to, and completer of Keynes’s work. Keynes, in his General Theory of Employment, Interest and Money , set out the framework that nearly all macroeconomists use today. That framework is based on spending and demand, the determinants of the components of spending, the liquidity-preference theory of short-run interest rates, and the requirement that government make strategic but powerful interventions in the economy to keep it on an even keel and avoid extremes of depression and manic excess. As Friedman said, “We are all Keynesians now.”

But Keynes’s theory was incomplete: his was a theory of employment, interest, and money. It was not a theory of prices. To Keynes’s framework, Friedman added a theory of prices and inflation, based on the idea of the natural rate of unemployment and the limits of government policy in stabilizing the economy around its long-run growth trend – limits beyond which intervention would trigger uncontrollable and destructive inflation.

Moreover, Friedman corrected Keynes’s framework in one very important respect. The experience of the Great Depression led Keynes and his more orthodox successors to greatly underestimate the role and influence of monetary policy. Friedman, in a 30-year campaign starting with his and Anna J. Schwartz’s A Monetary History of the United States , restored the balance. As Friedman also said, “and none of us are Keynesian.”

From another perspective, Friedman was the arch-opponent and enemy of Keynes and his successors. Friedman and Keynes both agreed that successful macroeconomic management was necessary - that the private economy on its own might well be subject to unbearable instability ­and that strategic, powerful, but limited economic intervention by the government was necessary to maintain stability. But, while for Keynes, the key was to keep the sum of government spending and private investment stable, for Friedman the key was to keep the money supply -- the amount of purchasing power in readily spendable form in the hands of businesses and households-- stable.

A relatively minor, technical difference in means, you might say. A difference of opinion that rested on different judgments about how the world works, which could (and ultimately was) resolved by empirical research, you might say. And you would be half right. For this difference in means, tactics, and empirical judgments rested on top of deep gulf in Keynes’s and Friedman’s moral philosophy.

Keynes saw himself as the enemy of laissez-faire and an advocate of public management. Clever government officials of goodwill, he thought, could design economic institutions that would be superior to the market -- or could at least tweak the market with taxes, subsidies, and regulations to produce superior outcomes. It was simply not the case, Keynes argued, that the private incentives of those active in the marketplace were aligned with the public good. Technocracy was Keynes’s faith: skilled experts designing and fine-tuning institutions out of the goodness of their hearts to make possible general prosperity -- as Keynes, indeed, did at Bretton Woods where the World Bank and IMF were created.

Friedman disagreed vociferously. In his view, it usually was the case that private market interests were aligned with the public good: episodes of important and significant market failure were the exception, rather than the rule, and laissez-faire was a good first approximation. Moreover, Friedman believed that even when private interests were not aligned with public interests, that government could not be relied on to fix the problem.

Government failures, Friedman argued, were greater and more terrible than market failures. Governments were corrupt. Governments were inept. The kinds of people who staffed governments were the kinds of people who liked ordering others around.

At the same time, Friedman believed that even when the market equilibrium was not the utilitarian social-welfare optimum, and even when government could be used to improve matters from a utilitarian point of view, there was still an additional value in letting human freedom have the widest berth possible. There was, Friedman believed, something intrinsically bad about government commanding and ordering people about -- even if the government did know what it was doing.

I do not know whether Keynes or Friedman was more right in their deep orientation. But I do think that the tension between their two views has been a very valuable driving force for human progress over the past hundred years."

Answering Jonathan's point

Jonathan (who said from the beginning that Chidem's argument was suprising to him too) made a reasonable point on initial post on Chidem:

"I think any defense is going to have to be by pointing at something implicit in Krugman's logic, not something explicit in what he's written. Krugman claims to be a "part oner" of The General Theory, instead of a "Chapter 12er," which pretty much means he accepts the premise that there can be a general glut (a scarcity of money) but that he rejects Keynes' own logic for why these exists. Then he turns around and uses IS/LM, which model's Keynes' logic.

But, Krugman advocates targeting a high inflation figure to boost "inflation expectations," which I think implies that entrepreneurs are uncertain about the state of long-term income prospects. It's not regime uncertainty, but it is a kind of self-feeding endogenous uncertainty that rises during periods of depression

I didn't expect it would be hard at all to find explicit statements to this effect, but I could see where Jonathan was coming from. It was ultimately an empirical question. Either he got explicit about uncertainty or there was a clear implicit argument to make.

Clearly he and other Keynesians have gotten explicit about it, so we know the answer to this concern now.

It was actually because of Krugman's Japan paper that I didn't take his "Chapter 12er" thing in the same way I think a lot of more heterodox Keynesians did. I thought he meant it more in the way that someone like Roger Garrison might say something that sounds like he's rejecting the Lachmann/Lavoi/hermeneutics/radical subjectivism stuff (not that he's said such a thing - this is just an example of something that would be similar). It's not that Garrison is not a subjectivist or even that he thinks these guys are wrong. It's just that he thinks there are some more mechanical elements of Austrian theory he would like to stress. That's kind of the sense in which I read Krugman proclaiming himself as a Chapter 12er.

Keynesians on Uncertainty V

This comes from the relatively new Keynesian convert, Judge Posner, who nevertheless has really been able to nail Keynesian concerns in his writing on the crisis. Answering the question of why unemployment remains so high earlier this year, he writes:

"The uncertainty of the economic environment and the weakness of bank balance sheets caused banks to restrict lending (other than to the federal government and a handful of other reliable borrowers), so credit for consumer purchases became harder to get, and this further reduced consumption spending. The Federal Reserve flooded the banks with money, but the banks hoarded the money. With credit scarce and consumer spending down, companies reduced production and so laid off workers, which further reduced consumer spending, both directly by reducing incomes and indirectly by increasing uncertainty about the economic future. 

When the downward spiral stopped, and consumer spending revived, companies were reluctant to hire back the laid-off workers because of continued uncertainty about economic conditions arising in part from the deepending economic crisis in Europe and slowing economic growth in countries like China, India, and Brazil."


Now, this is five (count 'em - one, two, three, four - then this) unambiguous examples of the importance of uncertainty to Keynesian views of the crisis.

This was not out of the blue. When I disputed Chidem's claim a week and a half ago that Keynesian ignored uncertainty (and I was not the only person to say it was a very strange and uninformed post from her), Bob Murphy - after furnishing a quote that didn't really speak to the question - challenged me to find one example of Krugman citing uncertainty as a problem that needs to be addressed. I've found two from Krugman, two from DeLong, and one from Posner now and yet things are oddly silent from Bob (to be fair to him - and I definitely want to be fair to him - I know Bob's been very busy with writing and teaching lately). But it's still worth asking: does this cut it or should we continue this series?

Steve Horwitz got in on criticizing me too. A couple years back Steve was very supportive of me as a young scholar - something I really appreciated. For some reason now I get this:

"Ah yes, argumentum ad Keuhnum:

1. Austrian claims Keynesian says X
2. Austrian says X is wrong
3. DK says "I don't know of any Keynesian who believes X"
4. Austrian points to textual evidence of X
5. DK insists that's not what the Keynesian meant
6. Austrian does facepalm, wastes a bunch of time arguing about it and eventually realizes it's pointless, and goes back to working on something more productive

Why the facepalms? So far Bob has offered one quote showing a Keynesian who didn't accept a very particular version of an uncertainty argument. I've offered five examples of Keynesians highlighting uncertainty as a major contributing factor for the recession. Does Steve think better of this comment now too, or do I need to keep going?

Contrary to some peoples' beliefs, I see exactly zero benefit in bullshitting my readers or making stuff up - and that goes for my comments on other blogs too. I'm an open book, guys, and I see no point in obfuscating on plain truths.

My sincere claim is that uncertainty about the future is the critical driver of Keynesian theory. I am certainly not the first to say this, and it's in plain English in the General Theory. That's of course not the only thing going on. There are other non-expectations/uncertainty-related shocks to demand that really do matter, like the financial crisis and potentially some policy decisions as well. But those shocks generate uncertainty and changes in liquidity preference and subjective assessments of profit opportunities that depress demand further. This is not crazy stuff I'm proposing.

Remembering Milton Friedman

He would have been 100 today. One of my favorite Friedman vignettes is his exchange with General Westmoreland in a discussion of the draft. This account is from David Henderson's Friedman's paper on the economists who helped end the draft:

"In his testimony before the commission, Mr. Westmoreland said he did not want to command an army of mercenaries. Mr. Friedman interrupted, "General, would you rather command an army of slaves?" Mr. Westmoreland replied, "I don't like to hear our patriotic draftees referred to as slaves." Mr. Friedman then retorted, "I don't like to hear our patriotic volunteers referred to as mercenaries. If they are mercenaries, then I, sir, am a mercenary professor, and you, sir, are a mercenary general; we are served by mercenary physicians, we use a mercenary lawyer, and we get our meat from a mercenary butcher.""

He was fighting against what Kenneth Boulding called "the manpower concept".

Friedman was one of the greatest economists of the twentieth century, and Paul Krugman (in the essay where he referred to him as "a great economist and a great man") reminds us why:

"Keynesianism was a great reformation of economic thought. It was followed, inevitably, by a counter-reformation. A number of economists played important roles in the great revival of classical economics between 1950 and 2000, but none was as influential as Milton Friedman. If Keynes was Luther, Friedman was Ignatius of Loyola, founder of the Jesuits. And like the Jesuits, Friedman’s followers have acted as a sort of disciplined army of the faithful, spearheading a broad, but incomplete, rollback of Keynesian heresy. By the century’s end, classical economics had regained much though by no means all of its former dominion, and Friedman deserves much of the credit.

I don’t want to push the religious analogy too far. Economic theory at least aspires to be science, not theology; it is concerned with earth, not heaven. Keynesian theory initially prevailed because it did a far better job than classical orthodoxy of making sense of the world around us, and Friedman’s critique of Keynes became so influential largely because he correctly identified Keynesianism’s weak points."

Monday, July 30, 2012

Rules, discretion, and management of the economy

I've seen odd claims about "rules vs. discretion" a couple places now, so I thought I might comment on this. First, on a facebook, a relatively well known economist that everyone here would know recently equated "discretionary policy" and Keynesian policy in reference to Kydland and Prescott (1977). Then just yesterday Don Boudreaux acted as if Nicholas Wapshott, in suggesting that Milton Friedman would have advocated greater steps to "manage the economy" (Wapshott's words), was saying that Friedman would have supported discretionary policy. Don's response was that Friedman was an enemy of discretion and preferred policy rules.

Don, I think, is trying to pull the wool over his readers eyes here. The consensus for a long time now has been that policy rules are superior to policy discretion. All the major Keynesian voices Don usually complains about, and those who he would associate with Nicholas Wapshott, support policy rules - not discretion. Paul Krugman has specifically cited a Taylor rule to govern monetary policy, and has worked out a Mankiw rule answer in the past as well. Brad DeLong has come out in favor of an NGDP level target, although he's made points in the past grounded in the Taylor rule. And then of course there's Mankiw who is presumably pro-Mankiw rule and John Taylor who is presumably pro Taylor rule.

In short, Keynesian policy is rules-based policy. People might just cite the need for stimulus right now, because the shortfall is so egregious. But when you ask Keynesians what is required, a rule of one form or another is invoked.

Now there are important discussions going on about what rule is best, and level rules of any sort (NGDP level, price level, etc.) have important properties that rate-based rules don't have, particularly when we get knocked off trend so severely. It's important to have these discussions. But nobody is advocating discretionary policy.

To be honest, I doubt anyone ever did support discretionary policy. It's true, before Barro-Gordon and Kydland and Prescott the rules people followed were probably more ad hoc. It was probably more of the form "estimate the output gap with this proceedure and then fill the output gap". And since economic science and engineering get better over time, there are very real ways in which our rules are better than those old ad hoc rules. But I doubt anyone ever really advocated discretionary policy in the way that it's sometimes presented. The thing is, nobody had a reason to talk about "rules vs. discretion" until the rational expectations revolution made "rules vs. discretion" a thing. And then to make their case, they labeled the old guys "discretionary" and the new guys "rule based".

And that case was an important case to make, and the rhetoric used was effective for making it.

But I doubt there was ever a such a really stark divide on the question. People were always more or less rule based they had just never thought about the issue in those terms before.

Sunday, July 29, 2012

"Heterodox" and mainstream, honey and vinegar

One more thought on the Nick Rowe post on heterodoxy and mainstream.

As you all know, I consider myself a mainstream economist - but I also find a lot of the self-styled heterodox people interesting. Part of this is that I find intellectual history interesting, but I also think there are genuinely neat ideas out there. I don't think I'm unusual on that point.

So the question is, if you happen to think those neat ideas are the most important ideas (I don't know if I'd personally go that far), how do you - as a self-styled heterodox economist - promote them?

You probably shouldn't do it by insulting mainstream economists and claiming they don't understand things or that they're ideologues.

You're probably better off saying "Hey look - I know you don't usually think of the time structure of production in your models, and that's fine because you're talking about other stuff. But we all know that in actuality some production processes take longer than others, right? Well if you think about it, lower interest rates should encourage longer production processes, all else equal. On top of that - if you have most producers operating with a particular length production process, when the interest rate is reduced a disproportionate share of new loans are going to go to new investors (obviously), and because of what we noted earlier those new investors are going to have longer production processes than the existing population of producers. That's kind of a neat little dynamic, isn't it?"

Say that to a mainstream economist. Or better yet - write it up formally.

That whole paragraph would be quite amenable to any mainstream economist. I've personally thought it was a "neat little dynamic" ever since I first heard about it, and I always enjoy reading new research on it (particularly empirical research).

Unfortunately this is usually not what we get. What we get is Austrians haranguing mainstream economists for (1.) not understanding that capital is heterogeneous, or (2.) not understanding that the interest rate coordinates intertemporal decisions. There are two problems here. First, neither is true. Second, both claims make mainstream economists think that the Austrian has a very weak grasp of economics. In a lot of cases that may well be true.

That's not to say one can't do critiques. Just know that if you're critiquing mainstream science you are by definition taking issue with the consensus of a lot of very smart people.

That makes me nervous. I can't personally think of any element of economic science where I think every mainstream consensus (because it's true - sometimes there are a couple mainstream answers) is wrong. I think it should make most people nervous.

But trying to dismantle the mainstream is a very different proposition from suggesting a neat idea to the mainstream that maybe doesn't get as much consideration as it deserves. There's a lot out there to think about. Lots of interesting things have been missed.

So why not present it that way? Why not use honey instead of vinegar?

I didn't have the best study habits as an undergraduate...

...it wasn't that I wasn't interested in school. Actually the problem was I was interested in school and would just read things I was interested in, regardless of whether it was part of the class or not. I've since develped better study habits.

But that last post about Nick Rowe's suggestion to "read a textbook" reminded me of a time that I actually did read a textbook straight through, like you'd read a book, rather than chapter by chapter throughout a semester. It was my freshman year at William and Mary, and I kind of coasted through my intro to microeconomics class but then became a little worried about the final exam. I don't know if it was the study guide or maybe a worse grade on a midterm than I wanted or what, but I had realized I hadn't really read much of anything for the class that semester - I just went off of what was in the lectures. So two days before the final I sat down and read the Stiglitz microeconomics textbook we were assigned cover to cover.

Aside from doing well on the final, it really gave me an appreciation for the sense in which textbooks are a coherent whole. A lot of students think about textbooks as collections of problems, along with some commentary. They don't appreciate the fact that they really are books. I think in grad school you get more of an appreciation of this - and an understanding of how an author's view of the world can really shape a textbook and give it a certain character. Ask a grad student what they think about a given textbook. In most cases, they'll have a very strong opinion about it and back it up with detailed arguments.

Read a textbook

Nick Rowe suggests heterodox critics of mainstream economics do it here.

I think there are still a lot of people out there who have that still offer bad critiques of mainstream economics, but hopefully there's a marginal improvement. One of the nice things about actually reading textbooks is that you really understand what the difference between models and reality means for economists. There are always all kinds of notations about the nature and limits of simplification, and when the evidence does and doesn't corroborate the model. A lot of critiques of the mainstream work off of the presumption that the distinction between models and reality is ignored, and that can easily be remedied by reading a textbook.

There are more technical questions that can be resolved too, though. I used to get comments about utility theory and ordinal vs. cardinal preferences from the Austrians all the time. I don't hear that as much anymore, and I like to think it's because of the time I got fed up and walked through what Varian says about ordinal preference relations being represented by cardinal utility functions which have no particular psychological interpretation attached to them. When you actually see mainstream texts saying that you realize what B.S. places like the Mises Institute have been putting out about these issues.

It's not ultimately a solution, but it's a great start.

Fighting on opposite sides of a war makes for strange letters between friends...

Keynes to Wittgenstein in 1915 (who was fighting for Austria-Hungary):

"I hope you have been safely taken prisoner by now"

They apparently had to exchange letters through a post office in Switzerland.

Keynes, concerned with employment in local industries - an anecdote

I'm practically finished with my paper on Keynes's Newton activities (some lesser known activities... a lot of people know about his purchase of much of Newton's library in 1936 and the posthumous presentation of "Newton, the Man" in 1946, but he was fairly active in 1942 and 1943 on a few things too - I'm writing about that).

The last bit of the paper is about the gift of another portion of Newton's library from a historic preservation society, which he advised. The books were in bad shape and he suggested having them repaired at a particular local company. I found what he chose to highlight in his discussion of them interesting:

"J.P. Gray & Son of Green Street are the right experts for that, and they are not sorry in these times to have repair work, which uses up less scarce material than the new bindings, whilst enabling them to keep together a nucleus staff, almost the only one now remaining, of our oldest local industries." (July 14th, 1943)

First it's just great that he takes the time to highlight these things about his recommended bookbinder - the maintenance of the workforce and the local tradition. But it was also nice to read because this doesn't seem like the sort of thing you'd mention about a local shop unless you wandered in and talked to them about how things were going.

Alas - local consumption will not make it into my paper. But I thought at least Evan would be interested in this (as a former archive employee).

Saturday, July 28, 2012

Jonathan on Friedman on Positivism

These are all good thoughts from Jonathan Catalan:

"Unfortunately,  don't own the actual book and I can't access the complete article online, so I'm stuck reading only the first and last thirds of the article. But, this is enough to get the gist of Friedman's argument, which I actually find somewhat persuasive in some regards.  He argues that all theories necessarily abstract from some aspect of reality, and I think he's mostly correct.  However, like I write in my reaction to Caldwell's article on Post Keynesian methodology before, I don't think the preference for predictive over explanatory hypotheses is well grounded; rather, I think economics should seek to explain phenomena.  Sometimes these explanations, which establish laws of causality, can be useful for making general, relatively short-term predictions, but this isn't the main purpose of economic science.  Finally, it also seems to me that Friedman underrates the benefits of studying the same phenomenon from different angles — i.e. different models which abstract from different realities; this is readily apparent in the classical monetarist explanation for business cycles: a scarcity of money (as opposed to this being a secondary consequence or even unimportant)."

Friday, July 27, 2012

Sometimes I feel like Gene Callahan is the only libertarian that gets it

Here. (Calm down - I said "sometimes").

...choose to read that parenthetical how you wish.

How is Gavin Kennedy not on my blog roll?!?!?!?!

Every once in a while I realize there are blogs I actually read regularly, like, and (in this case) agree with regulalry but which somehow are not on my Google Reader.

I just realized Gavin's blog, Adam Smith's Lost Legacy, is one of those.

If you are in the same situation, add it to yours. And as always, tell me about any other blogs I should be following.

Generalizing my last post a little, or, "how liberals should talk to libertarians"

Allow me to generalize my last post with a little advice (take it or leave it) for those of you who, like me, find yourself "to the left of the right" (I say it that way because I find myself feeling more left some days than others). This is inspired by the fact that I agree completely with Gavin on the differences between Smith and neoclassical general equilibrium but would still say forcefully that Smith believed in a generalized invisible hand, guiding private interest toward public good.


So here it goes: Libertarians are simply wrong when it comes to many economic questions that society faces (they're also often wrong on economics as a scientific matter, but that's a different conversation entirely).

In addition to be wrong, libertarians also have a tendency to claim the power of markets as their own solution to the problem at hand. It is their solution, that's true. But just because they're wrong and you know they're wrong and they claim markets as their own doesn't mean you are obligated to downplay the value of markets.

There are lots of ways in which free markets can be a disappointment. Market power privileges the wealthy few, externalities simply give us the wrong solution in lots of cases, and asymmetric information burdens the disadvantaged. The fact that markets exist in a social context of reproducing families also means that disadvantages that are transmitted intergenerationally can be exacerbated by markets.

All of this is true.

But you can say forcefully that this is all true without denying that as a general principle, markets channel private self-interest into a public benefit and that therefore we need market economies to guarantee human flourishing.

I personally find it frustrating that liberals like Joe Stiglitz - who is not an enemy of markets - criticizes markets as short-hand for criticizing what is really a libertarian view of the role that markets play in the broader constellation of social institutions. Because that's really where the difference is: not a disagreement over the value of markets, but over the value of other institutions (in most cases, government).

This way of talking about markets that a lot of liberals have forfeits the whole discussion to libertarians, who are implicitly treating governments and markets as opposites. We shouldn't forfeit that point. That's the whole discussion.

Liberals are pretty consistently supportive of markets and government. If you are actually not a fan of markets then you're really a part of the illiberal left - you're getting into socialist territory - and that's a whole different can of worms. But most Americans on the left are liberals and they are in the liberal tradition of free markets and free government.

Some of them need to start acting like it, and not forfeit the whole debate to the libertarians.

A comment from Gavin Kennedy

Gavin Kennedy writes in the comment thread of this post:

The fact is that Smith's specific (only) reference in Wealth Of Nations referred to some, but not all merchants, from their concerns for the "security" of the capital is sent abroad in the "foreign trade of consumption", preferred to invest in in "domestic industry" (mentioned four times by Smith, twice in the relevant sentence in para 9). This had the "unintended" consequence that it added to domestic "revenue and employment" arithmetically: the whole is the sum of its parts. Smith considered this public benefit. He didn't say anything beyond this. It said similar consequences applied in "many other" situations, without specifying them.
To suggest that this is a general unintended consequence of self-interested actions, leading to "Pareto Optima", "General Equilibrium", as many modern economists do, or that even "selfish" motives lead likewise, is an absurd attribution to Adam Smith. He details again and again how the "self-interested" actions of "merchants and manufacturers" lead to higher prices, less competition, and lower domestic employment in such self-interested" policies as tariffs, protections, prohibitions, monopolists, colonial preferences, the one-sided Combination Acts, the Settlement Acts, Wages set by the magistrate allies of employers, established religions, Primogeniture, Entails, chartered Trading Companies, directly act the general interest, Yet, daily - nay hourly - modern economists are reported, or media sources, continue to pour out nonsense about the existence of an invisible hand in, variously, the market, price systems, supply and demand, and so on.
That lay-people come to believe that in such a fictitious "invisible hand" - let alone that credible figures from our ranks of economists also believe it - though cracks are appearing in the former monolithic consensus sparked of by Paul Samuelson from 1948 - is a disappointing. I look forward to your own recantation of your apparent belied in the fiction of Adam Smith's so-called invisible hand.

Exactly right. I think Gavin is reading me far too strongly. This is the point I was trying to make in my post. You cannot equate Walrasian or Arrow-Debreu equilibrium or any claim about the Pareto optimality of markets with the invisible hand. It is because he equated those things that I was criticizing the linked article. They're not the same thing. It is important to know the general equilibrium properties of competitive markets Arrow-Debreu and all that isn't rubbish. But of course we all know that that's just a model of the real world, it's not the real world itself. And the properties of the Arrow-Debreu system were not what Smith was talking about.

Gavin might have been concerned about my response to bpabbot's comment, where I say that it's a more general point of Smith's than just the specific case of merchants who (to quote Smith) direct their "industry in such a manner as its produce may be of the greatest value". I stand by that. There will be no recantation from me on that. He does generalize this in his discussion of the butcher, the brewer, and the baker, which make the exact same point. Like the merchants directing their industry in the direction that is most beneficial to them, these tradesmen in seeking their own gain do well by others. Smith also cites Mandeville on these points. What is wrong with saying that this is general claim of Smith's?

Look, you can note that the emergence of public good from self-interested action is a general conclusions of Smith's without tying Smith to Pareto optimality or some Panglossian view of markets.

What's most amazing to me is that Gavin could read my post that way, even though I say pretty clearly in the post that: "I don't see how you can read Smith as implying some optimal general equilibrium."

I thought I was being fairly transparent about all this!

Generally Gavin's view of Smith is one that I find more convincing than the way you hear most libertarians talk about him, and this comment of his is no exception.

Atrocious comment watch...

I don't usually read comment sections of articles online... they're even worse than blog comment sections.

But a facebook friend was particularly critical of the invisible hand article I linked to earlier, so I took a look at a few of them. This one was like nails on a chalk board:

"The only "invisible hand" operating in economics is greed. The notion that there is an Invisible Hand which, if left to its own devices, will make our economic system All Just Work is on a par with 19th century beliefs in the ether and phlogiston. Are ate totally imaginary creations, invented because nobody knew what was really going on.

There is nothing about uncontrolled greed that ensures it will result in desirable economic result."

1. So, no, the invisible hand is not what happens to actions motivated by "greed". I personally don't think of my desire to put food in my belly, a roof over my head, and a small nest egg aside so my kids can go to college one day as "greedy".

2. Phlogiston was a 17th century theory that was thoroughly debunke by the 18th century. It was already derisive to reference it by the 19th century.

3. It's spelled "aether" not "ether". "Ether" is very real.

4. "Aether" actually survived as a theory into the early 20th century. Not long into the 20th century, of course, but a few years. That's 0-2 on your 19th century claim.

5. The sentence "totally imaginary creations, invented because nobody knew what was really going on" really bothers me. Isn't that what all scientific theories are? Good scientific theories are imaginary creations that are better at explaining things than our last imaginary creation.

6. Expanding on that point, it also bugs me when people mock phlogiston or aether. These were examples of good scientific explanation in their time. Same with Ptolemaic astronomy. When people use these as buzz-words for an unscientific view of things, it gives me the impression they don't really understand how science works. Of course our political climate is such that one can't reference creationism as an example of an unscientific view of things. Which is strange, because creationism never makes any claims to be a scientific explanation. It's pretty transparently intended to be a revelation, not a scientific answer. Anyway, we're getting far afield... don't knock phlogiston. You work with the evidence and the theory you've got.

7. His last sentence is obnoxious too. It's not "uncontrolled greed". The whole point is greed is controlled by other peoples' greed (again, if you insist on calling it "greed"... I prefer "self-interest".

Inaction is a pretty sad version of federalist experimentation

Normally I'm not too impressed with what Reason.com puts out. It often deals with horse-race kinds of politics, and doesn't discuss economics as often or nearly as well as other libertarian sites I follow. So I was eager to read their post on opportunities for federalism in Obamacare this morning, by Peter Suderman.

Unfortunately, it left a lot to be desired and is really a depressing look at what "federalism" means for them.

Federalism and the decentralization of decision making is a critical component of American political economy because it (1.) makes the whole system more robust to bad decisions by policymakers by not putting everyone in the same boat, (2.) encourages good decision making among policymakers because they have to deal with people voting with their feet and wallets, (3.) allows policymakers to learn from the experimentation of others, and (4.) allows policymakers to tailor what they do to the unique needs of their own constituencies. There are probably more benefits you could come up with for the decentralization of power (including simply the democratic principle that the power is closer to the people, which could be slotted under 4) but these are some big ones.

Suderman's view of federalism and Obamacare, though, is that states now have the ability to opt out of Medicaid expansion and he argues that if they opt not to create their own exchanges (something they always had the freedom to do), it looks like HHS may not be in a position to set up a federal alternative and the IRS may not be in a position to provide low income subsidies in that state.

In other words, for Suderman federalism = the opportunity for inaction.

That is very sad in my view. Federalism is really about different people trying out different things and learning from their mistakes and from each other. It's about the strength available through institutional diversity.

There is a word states simply rejecting a federal decision, but the word Suderman is looking for isn't "federalism" - it's "nullification". Those are two very different things.

I've presented a rough sketch of my ideal health reform on here before, but it's worth mentioning it again. Forget the mandate. The problem is a lack of insurance by those who would like to have it, so provide sufficient low-income or even middle income subsidies. That's how you address people's inability to get insurance when they want it - not by mandating them into insurance companies' revenue streams. Many people are going to have trouble getting insurance, so require states to develop either a public option or a private exchange, giving wide latitude for how these would be implemented. The public option is important. Exchanges rely on the current private insurance system that is resulting in double the prices for the same care. Introducing public options to compete with that can only improve the cost problem. States face relatively hard budget constraints. If they mess up and create a real albatross of a public option, they'll pay for that. Public options will also help push out new approaches to the payment system (i.e. - moving beyond fee for service) in a way that exchanges couldn't.

If some day in the future this federalized system converges on a real solution to health care, maybe we can apply it nationally. Federalism is not static.

But there's no point in celebrating a federalism that simply amounts to vetoing Obamacare. You don't like Obamacare - I get it. I don't like big parts of it either. But just not doing Obamacare isn't particularly enticing either, and it isn't particularly federalist.

Did you know that Smith's invisible hand and Arrow-Debreu General Equilibrium were the same thing?

Neither did I!

This guy really mangles Smith and confuses a lot of the claims of neoclassical economics (HT - Peter Boettke). It's assertions like this (by a non-economist, I should add) that feed Boettke's (in my view, wrong) criticisms of mainstream economics.

I don't see how you can read Smith as implying some optimal general equilibrium. Smith argues that by pursuing private interests, economic agents promote general welfare. This is obviously true whether a "perfect" Arrow-Debreu general equilibrium holds or not. Identifying the two with each other is a mistake. The contribution of Arrow-Debreu was to rigorously demonstrate the general equilibrium outcomes of a certain type of model of the market that is (rightly) widely in use. Any departure from that optimum ought not to be confused with a non-existence of the invisible hand forces that Smith referred to.

Confusing Smith's claim with Arrow-Debreu's claim leads to inappropriate conclusions that because we've departed from a neoclassical optimum it means that the market "doesn't work" or has "failed". That, I think, is the wrong way of looking at it.

Thursday, July 26, 2012

Fed funds rate, the discount rate, and 1920-21

Brad DeLong points out that the two rates are not the same...

...and you don't hear much about the discount rate these days because that's not a particularly important policy lever.

But that is not how it's always been. As I point out in my RAE article, this was not true very early on. In his Congressional testimony following the 1920-21 depression, Benjamin Strong discussed how banks would borrow from the Fed, and not from each other, to meet any shortfall in their reserves. Marvin Goodfriend, in his 2003 review of Meltzer's history of the Federal Reserve, describes the experience of using the discount rate during this episode as "traumatic" for the Fed, due to the unexpected potency of that particular policy lever. That experience would lead them, in the mid-1920s, to begin relying primarily on open market operations for implementing monetary policy - which, of course, they still do today. Open market operations work on the federal funds rate indirectly, replacing the earlier policy of expanding or contracting the money supply through changes in the discount rate.

This is part of the reason why I don't like it when people try to evaluate the value of a central bank on the basis of some of its behavior in the early years. Such an approach to evaluating institutions completely ignores the role of learning and adaptation.

A question for you Brits

OK, how do you refer to Robert Strutt, fourth Baron Rayleigh?

Can you, after first mentioning him in a piece of writing, susbequently refer to him as "Strutt", or should you subsequently refer to him as "Lord Rayleigh". I've seen it both. Is there a reason to choose one over the other or is it just important to keep it consistent?

And (less important for the purposes of my writing) why isn't he just called "Lord Strutt"?

One more point on poverty...

...I kind of alluded to it, but it's worth making this explicit: the racial incidence of poverty alone leads me to steeply discount Bryan's behavioral list as the driving factor, and it leads me to place a lot more emphasis on social and institutional determinants (in which I include all the intergenerational constraints I discussed earlier).

Notice that we don't usually think about poverty in the way that Bryan does. Why is China experiencing such phenomenal growth now? Why is South Korea doing so well and North Korea doing so poorly. Is there a behavioral difference? Are North Koreans more irrational than South Koreans?

Of course not.

It's a social and institutional difference.

You can see the same social forces at work in the emergence of the South out of poverty in the middle of the last century.

If poverty weren't such a geographically distinct phenomenon, this might be harder to carry over to discussions about poverty in the U.S.. But poverty is geographically distinct - it's not smoothly distributed geographically.

New Acquisition

The Elgar Companion to Post-Keynesian Economics

Sitting in a free book pile in the econ department. It's the first edition, and a second edition is out so it's older, but it's still a nice one to have - and hard copy!

This will be useful, I think, for my Macro Political Economy class this fall.

Caplan on the poor

I had started a response to Caplan's recent posts on the poor (starting here), taking issue with his view and some things expressed by Matt Yglesias (who makes a lot of similarly bad inferences about unemployment because he's stuck in partial equilibrium thinking about what happens in the labor market after a wealth shock). I dropped it after a little while, but now that Bryan has put more out I want to say at least a little.

Caplan's has been arguing that you can't really balme destructive practices on poverty (thus sympathizing with poor people who engage in those practices) if the practices themselves would help lead people out of poverty. For example, drug use can't be blamed on poverty because a poor person would have an interest in not doing something that would help them emerge from poverty. He suggests looking for a common cause like low IQ, low patience, or irrationality. Like so many of Caplan's arguments, this is fine to a point. If we're specifically thinking about poor people one need only look at the homeless - the extreme poor - to see the role that IQ and mental health can play in driving both poverty and substance abuse. Clearly  it's going to play some kind of role further up the income distribution too. Just like signalling as an explanation for some of the returns to education, I don't think anyone disputes this.

But it's a thin reed to build an entire view of poverty around.

One point I want to particularly emphasize is intergenerational and institutional constraints. Children aren't naturally industrious, interested in building human capital, or even aware of the costs and benefits of doing so. A lot of early human capital investment occurs because parents insist on it, and good habits are developed over time. Sometimes, of course, a parent may want to invest more in their child but are unable to provide it or are unable to move to a neighborhood or school district where it is provided. This might be because of social constraints on the parent (both public and private), but perhaps it's because the parent is just plain no good at being a parent.

The point is, by the time a child has the opportunity to remedy an underinvestment like that, it's probably too late for them to fix all of it. At the very least, obstacles to the pursuit of success by young people is highly unequal across the income distribution. For upper middle class youth, you practically have to work at failing. A lot of youth in the upper middle class don't even contemplate what other paths they could take until they're already enrolled in college, and while I'm by no means a "college for all" type, that's still more or less a ticket to a decent life in America, if you want it. Lower income youth don't automatically get shoved through this sequence - either because their parents don't care or are irrational (more of a Bryan Caplan argument), or because they are unable to. This predisposes them to be in the same position as their parents.

Of course you can still better yourselves. We're dealing with a distribution here, and people move both up and down that distribution regardless of the path their parents set them on. But they don't make those decisions on an equal footing or as a blank slate. And if groups of people in this position are segregated, the problem is enhanced by the fact that youth can't rely on a wider social support network when their parents fail them.

These problems, of course, reproduce themselves. These children then have children in the same position that are instilled with the same human and social capital and the same limited family resources to draw on.

One of the most critical behavioral characteristics, of the ones that Bryan lists, is probably low patience - high discount rates. Certainly over time the people who climb out of poverty are going to be the ones with particularly low discount rates and those who fall in (or stay in) poverty are going to be those with particularly high discount rates.

I have no idea how much of a person's discount rate is heritable and how much is environmental. Certainly it's going to be a mix, but I don't know what that mix is.

But the point is, even if it's 100% heritable, intergenerational transmission of human, social, and financial capital combined with segregation is going to add an additional burden on anyone unlucky enough to be born into such a circumstance.

And "luck" is th right word. No child has any control over being in such a circumstance.

So Bryan is I think making both an obvious and a wrong point. Obviously factors drive both the actions of the poor and poverty itself, and it can be spurious to attribute all of the poor's actions on poverty itself. But simply noting that there is some spurious corelation is not sufficient for Bryan to dispute the status of the poor as victims.

A lot of my views on poverty and inequality come from especially from Charles Tilly's book Durable Inequality and also Deirdre Royster's Race and the Invisible Hand. I often side with economic against sociological arguments for social phenomena, but this is one area where I think socioogists provide some very convincing arguments that beat out a lot of what the economists have to say.

Wednesday, July 25, 2012

Noah Smith: Proponent of pragmatic ontology

Very nice to see.

He writes:

"3. Ontology. Ontology is the philosophy of what existence means. My ontology is basically what I think of as "pragmatist"...we believe things because it's useful to believe them. If you disbelieve in the existence of a wall, you're going to stub your toe and it's going to be unpleasant. Or maybe not...try disbelieving in the wall and let me know the result. I'll be over here with a beer, getting your experiment on video. That's basically my philosophy of what "existence" means. One result of this outlook is that I think of "detectability" (or "observability") is the same thing as "existence"...if you can't in some way, however indirectly, stub your toe on something, it might as well not exist. I don't know if that's what other people mean when they say "pragmatism", but see Point 1 about language."

After that he gets into epistemology. I think those thoughts are essentially pragmatist and could be improved by becoming explicitly pragmatist. As Richard Rorty noted, the label "truth" is a compliment paid to sentences that pay their way (i.e. - that are useful). The discussion of epistemology is still good, of course.

On his statement on the goals of science, I would emphasize simply knowing about the world. Science provides benefits by giving us power over reality, it's true. But you don't need science to do that. And a lot of science is just done to gain a deeper understanding of the world, and if practical outcomes come out of it at some point it certainly can't be said to be a goal of science. So I'd put those more on par. I'm not sure this has anything to do with the "pleasure of scientists". A better understanding of the world is a goal in its own right. Certainly some discoveries are going to be unpleasant, after all!

I agree on point 6 - the discussion of scientific models. In economics especially we are dealing with multiple simultaneous processes. Models illustrate these processes. Of course in isolation such a picture is never complete, but that misses the point. It helps us understand the process of interest. If your model doesn't do that it's not of much use.

I agree with a lot of his point 7 - the techniques of science. On 7b (evidence), I would emphasize science as an explanatory endeavor rather than just a predictive endeavor. Too much focus on prediction in science has lead to the overemphasis of falsification that Noah (rightly) criticizes.

In his point 9, he shares several unhelpful views of science. I want to agree with and expand on his criticism of this one: " "Science does not always need evidence; sometimes, we can start from judgment and proceed by logic to a conclusion, and then accept that conclusion without checking it against evidence." This is like when the evil wizard tries to win by turning himself into a snake...it never works."

The reason why "this never works" is the frailty of the human mind. Logic is nice to keep you more or less coloring inside the lines. But we can't rely solely on logic in explaining a complex phenomenon like reality unless we know all of the fundamental, axiomatic forces dictating reality AND some initial value or state of reality. This is true of any science. Pure logic can only guide you in physics if you take into account all the fundamental forces and an initial value. No physicists knows this, of course. We have good guesses, and so we do make models like this that simulate the evolution of a universe like ours. But you can't recreate our universe or our solar system without perfect knowledge to logically build from. The same goes for economies or anything else. Our knowledge is always imperfect and so our simulations will always deviate from actual reality.

So the question is - how confident are you in your understanding of the laws of the universe and some initial value of the universe? Is it good enough to rely on logic alone? How would you know if it were? Nobody's knowledge is that good. Indeed nobody could have any sense of whether their knowledge was that good without appealing to evidence. So you always have to check how close your logic is to the actual data and then evaluate whether your logic really worked or not. This is the problem with the praxeological tendencies in the Austrian school.

I very much agree with his last point on judgement and theory in macroeconomics too.

H1-B Answers at Economix

Economix has a Q&A with Brookings researchers on the H1-B. This question specifically deals with work I've done:

Why can Intel not find suitable American-born STEM workers for their approximately 2,800 openings but Lowell and Salzman report that the American STEM graduates each year exceed the number of openings by a factor of 3?
John Gary, Boulder Colo.
The years of education demanded by the average American  job is growing, and the educational level of American workers has fallen behind to some extent.  However, there is disagreement about the existence of a shortage of science, technology, engineering and mathematics workers in the United States.

Some argue that the American educational system lacks rigor in these fields and that American students lack the interest or ability to pursue these occupations to the extent that our companies need them.  Others argue that we are in fact graduating enough students in STEM every year but that they are being diverted to work in other fields.  Meanwhile, American companies that report having trouble finding qualified workers among the existing work force are using the H-1B program to fill job openings."

The "Lowell and Salzman report" they're refering to is this one - I did research assistant work on it while at the Urban Institute. Lowell and Salzman are my two co-investigators on the Sloan Foundation grant that I was just awarded, and Lowell was the Georgetown professor that organized the conference I was at the other week.

We know that people do a lot of things with a STEM degree besides just STEM jobs, so I usually prefer not to do the straight ratio of graduates to openings. But it is a useful number to have on hand when you're dealing with people who act like this is a linear pipeline and we don't have enough graduates to meet demand on the other end.

A lot of the questions are about wages and immigrants taking American jobs. This doesn't interest me as much. Of course supply lowers wages. Of course some immigrants are complements to native labor while some are substitutes. But so what? I'm out of the workforce right now, more or less (I'm not sure what income from my grant makes me in terms of labor force status, but let's say I'm out because I'm not working full time anymore). When I get back in the labor force, I will also lower other people's wages. My labor will be a complement to some labor and a substitute for other labor.

So? Who cares?

These things about immigration don't really bother me.

What bothers me about the H1-B is that we are using policy to pick and choose what kind of workers we are importing, and we are favoring high skill workers. I don't see any reason why we should be doing that.

Several new research briefs on unemployment from the Urban Institute

- Racial and Ethnic Differences in the Receipt of Unemployment Benefits During the Great Recession, by Austin Nichols and Margaret Simms, finds that despite the fact that black unemployment is higher than for other groups, receipt of unemployment benefits is lower. In a lot of cases this is because of unemployment insurance program rules (more on this issue below).

- Disadvantaged Workers and the Unemployment Program, by Maria Enchautegui looks at how disadvantaged workers fare across states and find that differences in state programs drive a lot of the underutilization.

- Identifying those at Greater Risk of Long Term Unemployment, by Greg Acs and Michael Martinez-Schiferl, breaks down who is among the long-term unemployed.

In addition, Stephan Lindner and Austin Nichols look at how unemployment insurance modernization efforts have expanded program eligibility in a longer research report. The most important moderniztaion policy is the "alternative base period", which provides more flexibility in identifying base period wages that are used to determine program eligibility (helping low income workers qualify for the program they have been paying into). Lindner and Nichols estimate that universal adoption of the reforms that are already adopted in many states would increase eligibility from just over fifty percent of the unemployed to seventy percent of the unemployed.

I just started again at the Urban Institute this week after a hiatus since the winter, and I'm currently working on a brief in the same series as the three linked above. It will be on unemployment and joblessness (i.e. - unemployment or out of the labor force) among young black males, as compared to males in other age and race groups.

Murphy on WWII

Bob Murphy has an interesting article in The American Conservative on WWII and Keynesian policy. He discusses the recent paper on the subject by Steve Horwitz as well (here, and forthcoming in the Independent Review). I think there's a lot you can get out of both, but you have to be careful with what you try to derive from them.

Murphy and Horwitz provide important clarification of the trends in living standards during WWII. Any of you that weren't snotty little brats and actually took the time to talk to your grandparents about their experiences know that WWII was a tough time to live. People were frugal, goods were often rationed, and times were lean to support the war effort. Living standards, in other words, were low.

But there was one thing your grandparents probably never told you: that they or anyone they knew was involuntarily unemployed during the war.

This is a critical distinction. I think think the articles linked above do a great job exploring the contours of private consumption in the early forties. Horwitz is especially good at providing a lot of the primary source material that drives the point home. But when we're talking about macroeconomic policy, it's important to keep straight why private consumption was so low during this time. We made a decision to help free Europe from fascism, and we decided to shift our position on the classic guns vs. butter tradeoff.

The macroeconomic policy debate is about getting the economy to operate at its full potential. The use of that potential is a question for free consumers and free voters.

If the monetary decisions of the early Roosevelt administration weren't enough, WWII was a stunning demonstration of the validity of Keynes's insights, only five years after he wrote the General Theory. Nothing in Murphy or Horwitz should be read to have refute that point. But facts are facts, people, and the facts are that we used that full employment economy for ends other than private consumption in the early 1940s. If you want to argue about whether that was a good choice or not, you can have that discussion but that is not a macroeconomic discussion.

There's an extended discussion of these points in Bob's comment section for this post.

Tuesday, July 24, 2012

Can someone explain this comment from Peter Boettke for me???

In response to some great points from LK on the macroeconomic record of the third quarter of the 20th century, Peter writes: "It is called the economics of illusion ... Albert Hahn got this right years ago. Our current problems are not a decade old, but six decades old -- see Kotlikoff on intergenerational accounting, and Buchanan and Wagner on why this "fiscal child abuse" is the political legacy of Lord Keynes."

Can someone explain what Peter could possibly be thinking of? Looking at the actual course of public debt over the last six decades is helpful here:

The first thing to note is that the debt load of the post-Depression period has never, ever, ever been in a danger zone. We are getting into uncomfortable zone, and we were in an uncomfortable zone in WWII, but we have a sense of the debt limits of fiscally responsible states and we're not courting that at all.

The next thing to note is that for the first three deades of Peter's six decade period - when Keynesianism was actually guiding fiscal policy to a large extent - we had a declining debt burden. To Keynesians this isn't surprising, of course, because Keynesianism is all about responsible fiscal policy, maintaining leg room for action when it's necessary, extracting demand through smaller deficits when appropriate, etc.. And if things are going smoothly there's no reason to run up public debts anyway, so you'd expect the burden to decline.

Democracy in Deficit was published in 1977, at the very low point of this trend. What could they have possibly been thinking? After years and years of more or less responsible policy and growth Keynes is somehow leaving a legacy of fiscal irresponsibility? Generally speaking I would give a blanket endorsement of James Buchanan's work, but what he's done on Keynes is a notable exception. I encourage people to read the critical responses to Democracy in Deficit.

So how can one argue this?

After 1977 the story changes somewhat. Writ broadly, fiscal policy still seems to be under control of course. There were arguably geopolitical issues in the 80s that needed to be dealt with. I think one can say that the fiscal accomodation of the period was highly unnecessary, but there seems to be no reckless build-up here that is introducing problems now. Anyway, this has little to do with Keynes or Keynesianism. The debt problem - to the extent that there was one in the 1980s - was a very Classical effort to improve the productive capacity of the economy, coupled with a political unwillingness to make spending cuts. There's a lot to criticize there, but of course none of it has anything to do with Keynes - as Peter seems to suggest it does.

The spike in the debt in recent years is of course at least partially attributable to Keynesianism, but:

1. The Keynesian argument is that this is precisely the time to shoot any fiscal ammunition you've got, so there's a real challenge to the idea that this is even a problem.

2. No reasonable person thinks the deficits we've been running the past couple years have anything to do with our long-term debt problem. Let me rephrase that for emphasis: if you think the deficits of the past couple years are our long-term debt problem you either don't understand the federal budget or you're not a reasonable person, or both.

3. A lot of this is due to low tax receipts and has nothing to do with policy decisions anyway.

The real debt problem - to the extent we have one - is an entitlement problem, particularly a problem with Medicare. We probably need to do another fix of the tax system too - which seems daunting with the current Congress. But my point is, both of these can be done within the confines of what has become normative American post-war political economy. You don't need to wreck or abandon anything about post-war political economy to make the fix. But it's equally important to recognize that neither of these problems - entitlements or taxes - has anything at all to do with Keynesianism or Keynes's legacy.
So why do I see Peter arguing this in a variety of fora - often just accusing people he disagrees with of partaking in the "economics of illusion" without ever actually explaining himself? The logic, to me, seems circular:

Keynes is not one of those responsible "mainline" economists, ergo any irresponsibility among politicians (much of which is misdiagnosed, as I've noted, but we can leave that aside for a second) must have it's origin in Keynes's legacy because Keynes dominates post-war economics. But on what grounds are you calling Keynes an irresponsible, non-mainline economist?, I would ask Peter. It seems to me he is very much in the well grounded tradition of Smith, Mill, and the rest of the mainline? Well look at the impact he's had on the way we think about political economy in the post-war period!, I imagine Peter would respond (and he is welcome to correct me if I'm wrong).

The claims are circular. Keynes is non-mainline and therefore has lead us down this terrible path. How can you claim he's not mainline? Well he's lead us down this terrible path so clearly he's not mainline!


And it's tough to argue the point because anyone that thinks Keynes is an important figure is defined out of the mainline themselves.

I, for one, am getting a lot less out of Coordination Problem than I used to. Hopefully these things are cyclical.

Two Keynes links

1. John Gray asks "what would Keynes do?", HT my lovely wifey. There's lots of great discussion of his evolution since Bloomsbury, but this was the real meat of the article: "It's hard to imagine Keynes sharing such a simple-minded view. As he would surely recognise, the problem isn't just a deepening recession, however serious. We face a conjunction of three large events - the implosion of the debt-based finance-capitalism that developed over the past twenty years or so, a fracturing of the euro resulting from fatal faults in its design, and the ongoing shift of economic power from the west to the fast-developing countries of the east and south.

Interacting with each other, these crises have created a global crisis that old-fashioned Keynesian policies cannot deal with. Yet it's still Keynes from whom we have most to learn. Not Keynes the economic engineer, who is invoked by his disciples today. But Keynes the sceptic, who understood that markets are as prone to fits of madness as any other human institution and who tried to envisage a more intelligent variety of capitalism."

I think this is right and important to consider. We have an aggregate demand problem because of the financial crisis, the eurozone problems, and probably some more secular savings glut/transitional issues too. The demand problem has a clear government response. But we should not forget the causes of the demand problem, and we should not expect demand management to fix a broken banking system or currency union. We have no reason to expect that out of demand management. That requires other solutions.

2. LK contrasts the economic system of Marx and that of Keynes. The two - obviously - are like night and day. A Keynesian social order is non-sensical without private property, decentralized ownership and decision making, and free citizens. Marx and Communism even before Stalinism, was adamantly opposed to all of this. Marx had some interesthing things to say. I've particularly enjoyed reading his thoughts on Jean Baptiste Say and general gluts. In a lot of ways he did better than Malthus on all that. He's an interesting guy, but he was still a theorist of brutality. This idea that Marxism was sanitary before Lenin and Stalin came along to muddy it up is complete hogwash. The totalitarianism is all there in the original. It's not that it had to wait for Lenin and Stalin - it was always there, it's just easier to turn a blind eye to when it's on paper. This is not to condemn all socialism (although I think it's a foolish thing to get caught up in). Strictly identifying Marxism with socialism writ more broadly is a mistake that unfortunately a lot of Americans make.

Some liquidity trap thoughts

The one that will probably get the most press is this from Scott Sumner. I actually think Scott has more interesting things to say after his point about the liquidity trap, but I want to write about the liquidity trap. Scott says: "It’s beginning to look like Keynes was wrong about liquidity traps, at least when he argued that there’s a certain minimum nominal yield that government bond investors demand, and that long term rates can be reduced no further.  Wherever people draw a line, bond yields just seem to plunge right through, to one record low after another.  And we know from Japan that they can go even lower.  But what does this mean?"

Recall what Keynes wrote (p. 207):

"(2) There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest."

So Scott is right - this really does seem like a problem for this particular passage, at least. One interesting thing to note is that the last sentence Keynes has here seems right whether the first part of the paragraph holds true or not (in other words - the case for fiscal policy still stands just fine - a point that Krugman makes, and argues is independent of all those "Keynesian things").

The question, of course, is why is he wrong? I don't feel like I have guidance on that from Scott. Why would investors prefer a negative yield to a zero yield assuming both assets have negligible risk? This isn't a Keynesian question that deserves an answer - it's a basic rationality question that deserves an anwer. My first thought roamed into international economics (which makes me nervous beause I don't feel like I have a good intuition for it). If foreigners are buying a lot of Treasuries and there is some exchange rate risk involved, the yield on cash may not be zero. But that doesn't seem to work because the exchange rate risk is going to impact demand for Treasuries (which are denominated in dollars) as well. Perhaps transaction costs associated with working with bonds is lower for foreigners than cash? I don't know.

The only other thing I could think of is that building a cash reserve must be limited somehow, so while a zero yield would be preferable its not a viable option. Is this true? That would seem to explain it. If the reason why interest rates can transcend the lower bound of the liquidity trap is that the supply of cash is constrained, you would want policy that creates more cash: like public works that create jobs or more bond purchases. If you'd like people to get jobs before banks get cash to sit on, you might prefer the former. If you'd like banks to get cash to sit on before the jobs start flowing, you might prefer the latter.

I also wanted to point out that Barkley Rosser is talking about liquidity traps this morning, and he is particularly taking economists to task for allegely rejeting the idea of negative prices. Again, like the Sumner post, the discussion is interesting but it doesn't get at the real question that's bugging me: fine, I accept prices can be negative (although can't that just be thought of as a flip-flop of the role of buyer and seller? No matter). The real confusing question for me is how this price could be negative when the price of an otherwise equal product is zero? Barkley's example (brides who alternatively trade for dowries or bride prices) isn't relevant here because the brides aren't the same quality product. The whole problem with a liquidity trap is that cash and government bonds presumably are. Barkley's first commenter shares my concern for the real question here: "So what's the mechanism by which negative interest rate bonds come about?". He comes to the same conclusion about the limited supply of cash, and he is more amenable to the foreign flight to quality issue (I'm still not so sure... flying to quality is sensible, but why fly to American bonds rather than American cash??).

I feel too dumb to answer this, but I feel smart enough to confidently say that Scott and Barkley and no one else I've seen has answered it either.


There is another disconcerting implication of all of this. On page 202 of the General Theory, Keynes points out that "...if the general view as to what is a safe level of r is unchanged, every fall in r reduces the market rate relatively to the "safe" rate and therefore inreases the risk of illiquidity; and, in the second place, every fall in r reduces the current earnings from illiquidity, which are available as a sort of insurance premium to offset the risk of loss on capital account, by an amount equal to the difference between the squares of the old rate of interest and the new. For example, if the rate of interest on a long-term debt is 4 per cent., it is preferable to sacrifice liquidity unless on a balance of probabilities it is feared that the long-term rate of interest may rise faster than by 4 per cent. of itself per annum, i.e. by an amount greater than 0.16 per cent. per annum. If, however, the rate of interest is already as low as 2 per cent., the running yield will only offset a rise in it of as little as 0.04 per cent. per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level. Unless reasons are believed to exist why future experience will be very different from past experience, a long-term rate of interest of (say) 2 per cent. leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear."

We usually hear the "more to fear than to hope" logic as we approach the zero lower bound, right? But these calculations squaring the interest rate are symmetric.

What does it say about expectations for the future path of interest rates if interest rates are currently negative?

This sort of thinking explodes quickly. Part of me wants to paraphrase Herbert Stein and say that path is not sustainable, so it won't be sustained. There must be something driving this other than expectations of future interest rate paths, because that answer is the explosive answer. Another part of me thinks that even if the explosive solution doesn't come about, the fact that investors aren't afraid of a negative yield says something real about their expectations of future yields.


I minor pet peeve on the workings of the internet - no need to comment on this in the comment section - why in the world are there more Austrian links in the reference list of the Wikipedia entry on liquidity traps than Keynesian links? It's really a shame that people who try to learn about economics from the internet get a such a distorted sense of the field, simply because old Mises Institute blog posts are so accessible relative to the actual economics literature.

Monday, July 23, 2012

Jonathan on Keynesian Uncertainty

Jonathan makes some excellent point on Keynesianism, the Austrian school, and uncertainty here. I don't know why some people feel this need to make things up about the other side to make them appear completely naive to less knowledgeable readers. It's not a way to raise the discussion to a higher level.

I think the best and most obvious way to put it is that uncertainty and expectations have been a critical part of both the Keynesian and Austrian visions. Uncertainty has probably been more central to Keynesians longer. It's the core of Keynes - and he contributed, along with Frank Knight, our most sophisticated understanding of uncertainty, as opposed to risk*. Both of these men wrote a lot about how uncertainty was critical for understanding the role of the entrepreneur in the economy. This concern for uncertainty continued implicitly and explicitly through other Keynesians. I think you saw uncertainty enter the Austrian discussion somewhat later with Lachmann, Kirzner, Higgs, and Rothbard (I'm happy to be corrected - I just never hear people citing earlier work on Austrian uncertainty the way they cite Keynes).

As Jonathan points out, concern with expectations has been there from the beginning for both. I think I've noted before that in this sense New Keynesianism is really coming back to the Keynesian core by emphasizing things that the "Old Keynesianism" that came from Hicks and Samuelson glossed over. Part of this is just modeling sophistication. Hicks made a tremendous contribution. We can't expect him to formalize everything in the General Theory. Uncertainty, of course, is notoriously hard to model for reasons that Jeff Friedman outlined in a recent Critical Review article. I disagree with Friedman on the point of whether economists who work with search and risk models ignore these points. I don't think they do at all. But he's right on the modeling difficulties.

So that's a lay of the land on uncertainty and expectations I think. You would be safe to steeply discount anyone who says this isn't central to the way Keynesians think. You also ought to steeply discount anyone who says that of Austrians.

That's not very salacious blogging, I know. "We both think X but we may emphasize somewhat different things about it" is a lot less exciting than "they don't pay attention to X and that's why they're awful". It's less interesting blogging to some people, but it is... you know... accurate.

Jonathan notes:

"Whether or not these economists are talking about uncertainty in their blogs and op-eds is irrelevant, because uncertainty is implicit in their models.  Consider, for instance, Paul Krugman’s work on Japan (“It’s Baaack,” Brookings Papers on Economic Activity 1998, 2 [1998]): expectations, and thus uncertainty, is a major factor behind the advocacy for high inflation targeting.  That they target different causal factors doesn’t make it any less of a use of uncertainty."

I agree with this. A lot of the understanding of uncertainty is implicit. Uncertainty is a big part of why financial crises reduce demand. It's not just an income effect (although the income effect matters too!). Sometimes both of these are subsumed and people just observe that financial crises cause large demand shocks. So I think Jonathan is right that even if we don't see this stuff in blog posts, that doesn't mean it's not there. But as the last four Keynesian Uncertainty posts of mine pointed out - it's in the blog posts, spelled out very clearly! I'm also glad he linked to Krugman's Japan paper, because despite any claims by Krugman to the contrary, he's not just a hydraulic, circular flow Keynesian - and the Japan paper proves that. It discusses uncertainty and long-run expectations on a more sophisticated level than you'll see most Post-Keynesians discussing the issue, certainly.

Jonathan ends with this, and I am intrigued to hear more: "So, when discussing on what causes the differences in policy advocacy between Austrians and the rest, the real answer ought to target the decades (almost a century now) of divergence in understanding of the market process."

Maybe. I'm not quite convinced that's the real difference. I keep hearing that Austrians have a sophisticated understanding of the "market process" that nobody else shares but I've never in my life heard an Austrian say something about the market process that isn't agreed to by most economists (including, of course, Keynesians). Sometimes Austrians may like to provide verbal expositions and they think that the modeling of others is unsophisticated. Sometimes the feeling is mutual, even. Different styles emphasize different things. But I have yet to come across an explanation of the market process or exchange relations from an Austrian that goes beyond emphasizing something I might not talk about as much and actually clashes with my view of thing.

So I'm doubtful. This stuff often veers into that "I'll tell you your position, which I will then proceed disagree with" territory that really bugs me.

I think the differences are a lot less exciting than that. First, we emphasize different processes. Austrians talk a lot about the impact of macro phenomena on the capital structure - an issue Keynesians often ignore in the name of parsimony. Keynesians discuss why liquidity preference implies that the economy is demand-constrained, and that the interest rate is not just the price of loanable funds. Divergences between the interest rate implied by a clearing loanable funds market and one satisfying demand for liquidity can generate swings in economic activity. Austrians often ignore these issues, less in the name of parsimony (because there is less formal modeling among Austrians), and more as a result of the way they think about credit markets. There's nothing "anti-Keynesian" about talking about the capital structure (in fact Keynes agrees with Bohm-Bawerk's capital theory in the General Theory, he just says it's inconsequential for the macroeconomy). Likewise there's nothing "anti-Austrian" about talking about liquidity preference (see Bob Murphy). They just ended up talking about different things.

I think the directions they each took Wicksell is key to understanding the difference between Austrians and Keynesians. You will hear internet Austrians say that Keynes didn't understand Wicksell. Ignore them. They are barking up the wrong tree and probably doing it because they have a chip on their shoulder about Keynesians. Hayek added Cantillon and Ricardo and Bohm-Bawerk to Wicksell and came up with a theory that emphasized certain processes. Keynes added Jevons and Marshall and Malthus to Wicksell and came up with a theory that emphasized certain process. Which Wicksell would have preferred isn't knowable because the man was dead by then. I'd bet he would have liked both.

The point is, pretending that the difference between Austrians and Keynesians as being (1.) political (e.g. - Keynesians are statists and Austrians are the ones that appreciate liberty), (2.) a differential appreciation of something that both demonstrably have an appreciation for (e.g. uncertainty), (3.) a somewhat different way of talking about something we all agree on (e.g., the market process) is all wrong.

The difference, really, is that human economic and social behavior is tremendously complex and there are a lot of processes at work. No one can talk about all of them. Austrians and Keynesians talk about slightly different processes (with at least one common antecedent: Wicksell). There are two questions: (1.) does their theory make sense (in most versions of Austrian and Keynesian economics I think the answer is more or less "yes"), and (2.) is their theory empirically important (I tend to think the Keynesian answer wins out on this one)?

* - This is another example of "making things up" that people do. Some people will only cite Knight on this development and act like Keynesians are clueless or don't understand the role of entrepreneurship and profits. Why? They published their most substantial contributions in the same year. They're both famous books and most people cite them together. The only reasons are genuine ignorance (which is easily corrected) or pettiness (which is less easily corrected).