Sunday, August 4, 2013

The problem with ABCT is not that it abstracts from reality

In my forthcoming discussion of ABCT (actually I'm careful to say Hayek's business cycle theory because there are a lot of ABCTs), the editor unfortunately cut out a parenthetical prod I had in there. After discussing Sraffa's criticism of Hayek on the natural rate, as well as Robert Murphy's discussion of that I conceded the technical point to Murphy and Hayek (and Conrad and Lachmann), but then suggested that it's not a real problem for ABCT and that at most it obligates Austrians to be careful not to talk too casually about natural rates. I wrapped that up by saying "(few besides the odd Sraffian or Post-Keynesian are bound to call them out on it anyway)".

Well, a Sraffian/Post Keynesian has called them out on it recently and my reaction is again - meh. LK discussed the problems around talking about the natural rate along with several other points yesterday, which Jonathan Catalan ably responded to. I think Jonathan is right - LK is nitpicking about the fact that an abstract model is an abstraction but none of them seem to cut to the heart of ABCT. Nobody thinks, I hope, that ABCT or any economic model perfectly replicates the way that the economy actually works. They're all simple stories.

Wicksellian natural rates, loanable funds theory, equilibrium, full employment assumptions (of course in Profits, Interest, and Investment Hayek drops the full employment assumption, which shows you how important that is to the results), and flexible prices all come in for criticism from LK. And who can argue with the criticisms? But where does that really get us?

If prices are inflexible it may dull the unsustainable boom and the bust and may make us less sanguine about full recovery. So? Does it eliminate the Austrian business cycle? Not that I can tell.

On loanable funds, it's absolutely not a complete interest rate theory but is it a contentless theory of interest rates? Of course not. Holding liquidity preference constant demand for loanable funds is definitely going to move interest rates! It's still an operable factor in that market so the Austrian concerns still hold. Now could we say "this will make us less sure that the absence of central bank intervention is going to make everything OK" as a result of our mistrust of pure loanable funds theory? Definitely. But that hardly makes the theory "unsound" (LK's words) except in a very trivial sense.

Models are descriptions of mechanisms, not full blown replicas of economies. Does ABCT highlight a mechanism worth talking about? Yes, I think. And the scant empirical research shows that the length of the capital structure does seem to be pro-cyclical which also suggests the Austrians are highlighting an important mechanism.

A much more reasonable avenue for criticizing Austrian theory is not in nitpicking the modeling assumptions. The model does it's job fine - it illustrates an interesting mechanism. That's it's only job. We should instead be criticizing Austrian theory on the basis of how it does explaining the major causes of crises. The recent crisis doesn't seem to have anything to do with the unsustainability of an elongated capital structure. It seems to have everything to do with an asset bubble that lead to a demand shock. We could just say that ABCT isn't going to explain every crisis and that's fine, but that's one mark against ABCT and it matters a lot more than the criticisms LK raises. We could also point out the relationship between interest rates and estimates of the natural rate (for example, Laubach and Williams's estimates), and then we'd see that the looseness/tightness of monetary policy doesn't really follow patterns you would expect if ABCT were intelligible. There are lots of other, much stronger, critiques along these lines.

In total, they suggest to me that ABCT probably isn't the best way forward (although Austrian capital theory comes out better). But it's a very different sort of argument from LKs.

I personally don't understand this mentality that nit-picks at modeling assumptions. In LKs defense he doesn't usually do it to too great an extent. But it's the sort of stuff you see from Keen, Syll, and Pilkington among the Post Keynesians and Boettke on the Austrian side (surely others but he comes to mind most prominently). It's a strong heterodox tradition but I personally think it's rather weak and misses the point of models. I am looking for a good idea of how the world works, and then I'm looking to go out and see if the world actually works something like that. If a model succeeds in communicating that mechanism to me, it's done its job just fine. Models that claim more for themselves need to be more careful on foundational assumptions, of course.

20 comments:

  1. The issue here, as I pointed out to Catalan, not with models per se: it's with *bad* economic models, which are largely inapplicable and irrelevant to reality.

    All versions of the ABCT are flawed and largely irrelevant to reality, and that means that they are fundamentally false theories, if you're defining "theory" as a "justified description of reality", that is.

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    1. The problem is that you don't really present a case that the abstractions are damning.

      You point out that there are problems with the Wicksellian natural rate or with a full employment starting point. That's fine, we're all with you so far. Then you jump from that to the model being "unsound".

      The burden of proof if you're going to be criticizing models is to demonstrate that these departures from reality make the model itself useless. I know you think they're irrelevant. I'm not sure why except that you've argued that the models abstract from reality. Don't be surprised if everyone thinks you think the problem is the abstraction itself if that's all you're going to give us!

      Take loanable funds theory. I hope you'd agree that given a level of liquidity preference (and perhaps other interest rate determinants we might want to consider), demand for and supply of loanable funds is going to affect the market interest rate, right? This is in the first quadrant of PK horizontalist endogenous money models so you can't very well disown it. Everyone believes this. So, holding liquidity preference (and other stuff) constant any loanable funds theory-based model seems like it's still going to tell us something valuable. So why the bitching and moaning about loanable funds theory? I don't understand.

      If someone were to brazenly say that liquidity preference was wrong and draw conclusions from that declaration THAT'S when this becomes a real issue. If someone just chooses to focus on the consequences of changes in the supply and demand for loanable funds it hardly merits the criticisms you make.

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    2. As someone with a form of New Keynesian macro, perhaps you find my attack on loanable funds difficult to understand.

      Well, Keynes himself rejected loanable funds to the extent the interest rate is supposed to be a real phenomenon determined by saving decisions and time preference, so I am not quite sure why my focus on loanable funds would be that mystifying.

      Even if liquidity preference is constant, and increased saving occurs that flows to banks, that does not communicate any necessary data about future consumption at all. That is the whole point of Keynes:

      “An act of individual savings means – so to speak – a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption.” (Keynes 1936: 210).

      But that is precisely the assumption underlying ABCT: it requires that interest rates are communicating reliable information about time preference, and *unfettered* market interest rates are providing intertemporal coordination.

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    3. Umm, no. You don't need to explain this to me.

      Geez I was just expounding on this very passage recently on here. Loanable funds theory does not require the communication of necessary data about future consumption. Granted, if you're going to assume interest rates communicate that data you DO need a very strong loanable funds theory but the reverse is hardly true.

      Again, loanable funds theory is in the horizontalist endogenous money model.

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    4. LK writes,

      "But that is precisely the assumption underlying ABCT: it requires that interest rates are communicating reliable information about time preference, and *unfettered* market interest rates are providing intertemporal coordination."

      No, no it doesn't. In ABCT -- strictly speaking -- the interest rate isnt needed to communicate time preference. In fact, in ABCT the interest rate helps cause discoordination between savings and investment.

      (This isn't to say that many Austrians don't think that the rate of interest performs this function. I think they have a high likelihood of being wrong. But it doesn't impact the soundness of the ABCT model.)

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    5. No, this is getting ridiculous.

      Now Catalan is telling us that in Austrian theory the unfettered market rate allowed to match the (imaginary) natural rate doesn't coordinate real investment with real saving (i.e, provide intertemporal coordination)?

      That "in ABCT the interest rate helps cause discoordination between savings and investment" *when* the market rate falls below the natural rate isn't denied above in what I said.

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    6. "Now Catalan is telling us that in Austrian theory..."

      Austrian theory =/= ABCT. ABCT is ONE Austrian theory. And who's theory are you talking about? There are some Austrians who think interest coordinates savings and investment. There are other Austrians who think there are other forces at work (e.g. Hayek).

      "That "in ABCT the interest rate helps cause discoordination between savings and investment" *when* the market rate falls below the natural rate isn't denied above in what I said."

      It doesn't necessarily deny what you say, but you got my reasoning backwards. I'm saying that even if the theory that interest coordinates savings and investments is wrong, it doesn't mean that the usual transmission mechanism in ABCT is wrong. I believe that if the rate of interest falls, the quantity demanded for credit will rise. This doesn't imply that interest coordinates savings and investment; i.e. they are two separate arguments.

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    7. I think the quote LK mentions is more about the short term, and with recovery from recessions.

      In general if I keep £10 in my bank account then that enables the bank to lend out £10. Though perhaps only after a while, that's what Keynes was worried about.

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    8. Current,

      Keynes wanted to do away with the loanable funds theory altogether. It's not just that savings may sit idle in bank vaults for some time before it's lent out, but that the rate of interest wont reflect the supply of savings at all -- he basically wanted to do away with the supply of savings, demand for credit theory of interest.

      I agree with him. One issue with the pure time preference theory as it's usually explained is that it's a backwards-looking theory. You make a forward-looking theory, and I think you get more-or-less the same result as Keynes.

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    9. Jonathan,

      I don't agree.

      I think Daniel's post above describes most aspects of the loanable-funds argument well. The other is the nature of bank accounts. A balance in a bank account is a loan to the bank, a savings accounts with a notice period or a bond is another type of loan to a bank. When people move assets from bank accounts to other forms and vice-versa that certainly affects the rates of interest, and when central banks do the same thing it does too as we all know. But, behind that there is still the loanable-funds market which also has an effect. What's going on in the broad loanable-funds market affects the amount of OMOs needed for the central bank to achieve a particular target.

      We really need to talk about several interest rates on different things to deal with all this properly.

      I don't understand your backwards-looking/forward-looking distinction.

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  2. This is slightly unrelated. I've read your draft and found it very useful for someone with non-Austrian background. Anyway, when you mentioned inflexible prices, I've wondered - isn't some sort of nominal rigidity crucial for ABCT too? It's the real interest rate that matters for investment decisions, and if prices were perfectly flexible, I would expect that monetary expansion would just raise expected inflation and nominal interest rates (due to Fisher effect) and leave real rates unchanged. In other words, there must be some other source of money non-neutrality in addition to time structure of capital.

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    1. Yes. The Cantillon Effect requires that prices don't change immediately when the supply of money changes. So nominal stickiness of some sort is beede to make the theory work.

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  3. "After discussing Sraffa's criticism of Hayek on the natural rate, as well as Robert Murphy's discussion of that I conceded the technical point to Murphy and Hayek (and Conrad and Lachmann)"

    Have you read Gene Callahan's discussion of this? I think he's right.

    http://gene-callahan.blogspot.ie/2013/02/sraffa-and-own-rates.html

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  4. The recent crisis doesn't seem to have anything to do with the unsustainability of an elongated capital structure. It seems to have everything to do with an asset bubble that lead to a demand shock.

    I agree. The problem starts with funny money distorting real prices all to solve a problem that does not exist. That is the BASIC Austrian concept. This can play out in a multiplicity of ways. DK showed this in his paper on the 1920 depression.

    ABCT is simply one form of the effects of miscalculation.

    http://www.economicthought.net/blog/?p=594#comment-608991024

    Asset bubbles and associated unpayable private debt are another. Funny money generally causes everyone to think that society is richer than it really is. It generally leads to an overestimation of the potential future “demand” for one’s products. This is not a failure of “the market” and it certainly does not indicate that the solution is more funny money, government spending and distorted prices. "Nominal" prices caused by bureaucratic "solutions" are the problem, not the solution. Get rid of them.

    Anticipating LK on “uncertainty”, life is uncertain. Purposefully distorting prices makes it much more uncertain.

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  5. "And the scant empirical research shows that the length of the capital structure does seem to be pro-cyclical which also suggests the Austrians are highlighting an important mechanism."

    Hey Daniel, I've been wondering about this. How is the "length of capital structure" defined and measured in empirical research?

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  6. "And the scant empirical research shows that the length of the capital structure does seem to be pro-cyclical which also suggests the Austrians are highlighting an important mechanism."

    Hey Daniel, I've been wondering about this. How is the "length of capital structure" defined and measured in empirical research?

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    1. I bet you could find data for different production processes that are boom sensitive and find the number of stages that inputs have to go through before getting to the final product (then you can compare non-boom to boom).

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    2. But, after Böhm-Bawerk a lot of Austrians started getting away from the "average period of production" framework, and Mises, in Human Action, worries about creating too objective a theory by focusing on lengthening, rather than also on widening (or deepening). I think what Austrians have to do is model an explicit theory and then test it themselves. If, say, Daniel tests one of our models and finds it to be flawed, a lot of Austrians (like me) will say, "Hey, that's not my theory!" We then lose credibility.

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  7. So private debt went up by approximately $15 trillion from 2000 to 2008, but money wasn't loose.

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  8. "I think Jonathan is right - LK is nitpicking about the fact that an abstract model is an abstraction but none of them seem to cut to the heart of ABCT. Nobody thinks, I hope, that ABCT or any economic model perfectly replicates the way that the economy actually works. They're all simple stories."

    I would agree with you that all models (particularly when it comes to the issue of behaviour) are in some way or another, unrealistic, as people don't always act the same way at all times. However, I suppose that there could be "closer approximations to the truth" than other accounts, or to use one word: versimilitude. The following book review makes a similar point.

    http://www.amazon.com/review/R38D9RW0M0BR1F

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