How does Steve Horwitz know that monetary and fiscal stimulus failed?

I don't know how he knows that, but if he knows that than he's a lot smarter than me (and pretty much every other economist out there). I had a thought early on in this crisis that isn't entirely uplifting but true nonetheless. I thought "well this is going to give me something to think and write about for the rest of my career". Apparently, that's off the table now, because as Steve Horwitz succinctly puts it:

"Let's look at the record of the last three years:

TARP = Failed.
QE1 = Failed.
QE2 = Failed.
Stimulus = Failed.
Non-existent budget cuts/debt ceiling increase = Failed, at least in S&P's eyes.

Each of these has involved more government activism and each has failed."

I think it's worth reminding people why it's so hard to know these things, despite Steve's own confidence and his disappointing assertion that those of us who are more circumspect about his claims are "religious fundamentalists", hypocrites, practitioners of "state idolatry", dogmatic and insane (in the Einsteinian, rather than the clinical sense, of course).

The problem

Fiscal and monetary policy are endogenous phenomena in human society, which basically means that causality runs both ways with these phenomena. We all think that fiscal and monetary policy affects the macroeconomy, but we also think the macroeconomic conditions and expectations about macroeconomic conditions affect fiscal and monetary policy. We know with a reasonable degree of certainty that the causal relationship running from the macroeconomy to policy is negative (as GDP goes down, policy becomes more expansionary, either through standard policy rules or automatic processes like decreasing tax revenue and automatically increasing social insurance outlays). The other causal relationship is the one where we disagree, and that we'd like to identify.

First, let's consider the case where fiscal and monetary policy has no net impact on the macroeconomy at all. If we simply regress GDP on some policy variable, what sort of outcome are we going to get in this case? We're going to observe a negative relationship between the two variables despite the fact that we know (by assumption) that policy has no effect. In other words, the endogeneity of fiscal and monetary policy implies that uncorrected empirical estimates of the impact will be biased downward.

You can observe this problem in the following graphic. Let's assume for a minute that stimulus actually has a positive impact on GDP, as the large majority of economists have come to agree on in the case of monetary policy and many have come to agree on in the case of fiscal policy. I have two thick black lines - the bottom one shows what the economy would have done in the absence of stimulus, the top one shows what the economy does with stimulus. We never observe either of these lines. What we observe is staggered point estimates of what actually happens:



So the only data we actually have is the red line. If you casually comment on the red line to understand what stimulus does, of course it looks like it doesn't work at all. This is what an unfortunate number of stimulus critics do. What you need to have for a valid empirical assessment of the stimulus is the two thick black lines. Since we can't observe GDP perfectly and instanteously, we could settle for the thin blue line and the thin red line - occasional observations of actual and counter-factual GDP. Unfortunately, we don't even have the thin blue line. We only have the thin red line.

If policy were not endogeneous this would not be that much of a problem. You'd still need to observe a lot of cases (you'd need a large sample), but you could pretty much compare situations with policy to situations without policy. The reason is that when these processes are not endogenous, the expected value of the counterfactual during periods of fiscal and monetary policy is the same as the observed data without periods of fiscal and monetary policy. The problem is, that's not the case here.

The solution (sort of)

The solution to getting an unbiased estimate of the impact of stimulus is to identify variation in policy that is exogenous to what's going on in the macroeconomy and then look at the association between that portion of the variation in policy and the behavior of the macroeconomy. (This is essentially the instrumental variable method that I talked about in this recent post - although macroeconomists are less likely to talk in terms of "instruments"). This is very hard to do. There are two very well known attempts at this, one by Christina and David Romer (on tax policy), and one by Robert Barro and Charles Redlick (on defense spending). I think both are admirable attempts at solving a very tough problem, but both have very large problems with them.

First and foremost, they are each looking at a large swath of the twentieth century, combining estimates for periods where we would typically expect multipliers to be high with where we would expect them to be low. That doesn't give a very useful estimate. As Jonathan Parker recently noted in an NBER working paper: "We do not have a good measure of the effects of fiscal policy in a recession because the methods that we use to estimate the effects of fiscal policy — both those using the observed outcomes following different policies in aggregate data and those studying counterfactuals in fitted model economies -- almost entirely ignore the state of the economy and estimate 'the' government multiplier, which is presumably a weighted average of the one we care about — the multiplier in a recession — and one we care less about — the multiplier in an expansion. Notable exceptions to this general claim suggest this difference is potentially large."

So although Romer and Romer, and Barro and Redlick presumably do a good job dealing with endogeneity, they can only solve it by neglecting the fact that the size of the multiplier itself is not constant over time. This is not easy stuff. What Steve Horwitz claims to know is really stumping a lot of people. One way to get a better handle of what's going on is to compare economies that are in different situations at different times. Ilzetzki, Mendoza, and Vegh do that here (long version here), and Chinn puts his spin on their findings (and a few similar studies) here.

An oft-proposed solution by skeptics

One thing that fiscal stimulus skeptics like to raise is the forecast of unemployment produced by Romer and Bernstein in January 2009. They note that unemployment has been worse than the forecast suggested would be the case without stimulus, so stimulus has hurt the economy. Steve Horwitz has made this sort of argument.

I have never understood the appeal of this argument at all. To make this argument you have to believe a couple things:

1. Forecasts of the future behavior of a complex system can be made with accuracy.
2. Forecasts by political appointees are reliable sources of counter-factuals for empirical analysis.

Both of these claims are so absurd I find it genuinely shocking that anyone that teaches economics would even make this argument - but they do. When Romer and Bernstein made their projections I was worried that Republican politicians would jump on it later and mistakenly use it in this way, but I didn't expect economists would.

My question for Steve

Should be obvious by now: How exactly do you know what you claim to know? Can you let me in on the secret? I'm sure I'd blow my professors away this fall if I could nail down a fiscal multiplier estimate so conclusively. And I don't want to be an ideologue. I don't want to be a dogmatist. I don't want to be insane. I've never practiced idolatry toward the state - never - and I never want to. If I appear to be an ideologue or a dogmatist to you, it's because I'm ignorant, not because I'm an ideologue. Help me get past my ignorance because if there is conclusive evidence I'm wrong that you know, I want to know that too! I don't want to be unwittingly wrong!

A word on Don Boudreaux, marginalism, and reductio ad absurdum

Reductio ad absurdum has very narrow uses in economics, in my opinion. It is very good for ruling things in, but very bad at ruling things out. I want to share a good example and a bad example from this blog and from Don Boudreaux.

For example, in this recent post Jonathan responds to me about "sustainable" levels of economic activity (we're discussing Garrison's PPF): "I don't think you can push consumption to an "unsustainable" level. Consumption is what decides the degree of capital intensiveness. I think investment is the specific part of expenditure which may be unsustainable."

I then respond to him with a reductio ad absurdum of sorts. I ask him to consider a situation where 100% of income goes to consumption. Is this sustainable? Of course its not sustainable. You cannot sustain 100% consumption at current production, so this is clearly "unsustainable". Consumption certainly has sustainable and unsustainable levels given productive technology and preferences, just like investment does. I used the reductio ad absurdum to provide a stark example of why you couldn't rule that out.

Don Boudreaux regularly does something very different. He uses reductio ad absurdums almost exclusively to rule things out. I'll reproduce an "open letter" he had on his blog in full:

"Dear Mr. or Ms. FedupwithHayek:

You write: “You [Don Bx] wrong[ly] assume workers don’t want more job security. They do. They don’t appreciate trade lowering that security.”

I disagree, at least with the implication that the value to workers of greater job security exceeds the costs of supplying such security. Consider:

Nothing prevents a firm – say, Acme, Inc., a hypothetical chain of hair-styling salons – from offering the following sort of deal to consumers: “Acme will cut your hair, but only on condition that you agree to buy at least six haircuts each year from Acme for the next 25 years.” If Acme gets enough customers to buy haircuts on this condition, then it can offer more job security to its stylists, receptionists, and other employees than can Acme’s competitors who do not condition the sale of haircuts on customers’ willingness to sign such contracts.

Obviously, consumers won’t buy haircuts from Acme on these terms unless Acme makes these terms worthwhile to consumers – say, by offering haircuts at much lower prices.

But to operate profitably while charging much lower prices, Acme would have to find enough employees who value job security so highly that they’re willing to work for wages far below what they would earn by working elsewhere.

Because I see no such successful attempts by firms to cater to the alleged demand that workers have for greater job security, I conclude that workers in general are not willing to pay the cost of securing more job security. In short, the value to workers of greater job security is less than is the value to them of higher wages today.

Securely yours,
Donald J. Boudreaux"

The emailer is talking about - and Don starts to talk about - trade-offs. On the margin, there is a trade-off between income and security. Both income and job security cost employers money so they can't provide increases in both at the same time. You have to trade it off on the margin. A marginal increase in security for a marginal decrease in pay, etc.

But then Don abandons this marginal thinking and reaches for the extreme. One extreme way to guarantee job security is to demand complete customer loyalty. Then you can be assured of consumer demand, which means you can guarantee labor demand. This is an absurdity, clearly. It's a very extreme example. This is what economists call a "corner solution".

When you first learn constrained optimization you're always taught to check the "corner solutions" first, to see if any extreme option solves the optimization problem. When you rule those out, though, you don't say "well I guess there's no solution" - you then solve for an interior solution. You find the point at which the marginal cost is the same as the marginal benefit and you're at a trade-off point that satisfies all preferences of everyone involved. There is a some optimization point and there is some trade-off that workers will make for more job security. It will be a marginal trade-off. Excessive strategies for guaranteeing job security such as the one that Don offers are not in the cards because the employer and the consumer has to make these trade-offs as well. Wage rates, benefits packages, prices, hours, etc. change all the time to respond to these changes in preferences. Don should have agreed with the commenter that there may be demand for job security (makes good sense in this economy) and he should have laid out the concept of marginalism and constrained optimization and assured the commenter that market exchange will adjust to these changes in preferences. Instead, he sees some sort of threat, he grabs for his old stand-by - the reductio ad absurdum - he completely drops marginalism in the process, and because of this poor analysis he makes very bad claims like "Because I see no such successful attempts by firms to cater to the alleged demand that workers have for greater job security, I conclude that workers in general are not willing to pay the cost of securing more job security."

The scariest thing is, Don also recently shared with us that he's teaching a graduate level microeconomics course. All economists should think on the margin. It is perhaps the single most important hallmark of "thinking like an economist". Reductio ad absurdums are almost always used to obscure marginal thinking. Reductio ad absurdums are - not exclusively, but often - very, very, very bad economics. When you are tempted to use one think like an economist about what it is you're using. You're referencing a corner solution. Think about when it is appropriate to reference corner solutions and when it isn't before you go too much further. If a corner solution doesn't seem to make sense, don't assume there's no solution - look for an interior solution. If any students of Don's in the micro class read this, I'm curious how this stuff gets taught in practice. Does he resort to reductio ad absurdums a lot in class? Feel free to leave a comment.

Robots, Robin Hanson, Nick Rowe, and Socialism

OK, if you all insist I'll break my New Year's resolution one more time since I already have today.

When I first saw this post by Russ Roberts about an Econtalk with Robin Hanson about "technological singularities" I was very interested in it and almost posted on it. I've heard Robin Hanson lecture on this before. The timing is always speculative, but the logic of the argument - particularly when you look across the length of human history - is persuasive.

I was tempted to write a very quick post in response, simply noting that if the technological singularity Hanson describes here ever happens it would probably be sufficient to turn me from a market Keynesian to a socialist.

I decided the admission would haunt me for the rest of my blogging career so I didn't post it, but what the hell.

I post it now because of this post by Nick Rowe fleshing out the implications of the technological singularity in more detail, and this post by Karl Smith. "Overproductionism" inevitably leads people to socialism for good ethical reasons - if providing for demand can be easily achieved without contracting for the services of a large portion of the population, you're going to have extreme inequality and suffering not as a result of differential compensation from differential marginal products, but simply because the labor content of output is negligble. The problem with this line of reasoning has always been that our demand always outpaces technological unemployment (this is why concerns about underconsumption are much more defensible than concerns about overproduction). If there is a paradigm shifting technological singularity that makes the overproductionist fallacy no longer fallacious, then we're going to have to rethink a lot about the way society was organized.

Yes, this is very Marxist. What of it?

The point is, though, it's all predicated on the assumption that everything we know to be true about the economy is no longer true as a result of this sort of Hansonian "technological singularity". That assumes the singularity even happens, and it assumes it happens in the asymptotic, extreme way that it's being discussed by Hanson, Rowe, and Smith.

I think it would be a good thing, if we could manage the transition. Whether it's likely to even happen is a different story. I'm personally inclined to bet against Marx and crude overproductionism, but time will tell.

I think about these issues a lot... I think about the social implications (e.g. - "this would make me a socialist") less thoroughly than I think about the intellectual history of these overproductionist ideas. So thoughts on my thoughts on the social implications would be appreciated.

Technological Unemployment at The Onion

An opinion piece at The Onion notes the human touch that no machine can replace...

No Machine Can Do My Job As Resentfully As I Can

In today's increasingly mechanized world, where the bottom line so often takes precedence over human considerations, the working man never knows how long it will be before he is replaced by a machine. It's no secret that some in management at Gillian's Fish Products, where I work, feel that automation would improve productivity and quality control. But what they don't understand is that they will lose something far more valuable if employees are let go: the resentful human touch.

No mere machine can replace the embittered alienation of the flesh-and-blood worker. Sure, machines may be able to gut whitefish in the blink of an eye. But would they be able, as I am, to despise and bemoan their miserable lot? To seethe with the unbearable knowledge that this will be their sole livelihood until the day they die? To identify with the glassy, sightless eye of every fish as their sharp blades spill the innards out? ...

Conversation with John Papola at EconLog

I've been involved in an extended conversation with John Papola, the creator of the "Keynes vs. Hayek" video, in a blog post by David Henderson.

The post starts off by talking about one of Papola's remarks on behavioral economics. My initial concern was that he's conflating questions of cognitive bias with questions of socialist calculation unnecessarily. We can "solve" cognitive bias problems in ways that governments are doomed to failure in addressing calculation problems (for example - on savings decisions its plausible to think we can start to over come "status quo bias" but still recognize we can't centrally plan individual savings levels). That, however, quickly turned into a discussion of Keynesianism. My comments were rushed during lunch breaks and early in the morning so I hope I've done it justice - he comes at me with a lot of questions, so I'm sure I dropped some of them. But I think its instructive because he's peddling a lot of the fallacies about Keynesianism that I talk about on here - that Keynesians actually want to plan economic decisions, concerns about heterogeneity in depression, confusion of the savings identity with a behavioral law (which is done by assuming we're at full employment), talking about Keynesianism as if investment doesn't matter and consumption is paramount, etc. etc. Anyway - I try to succinctly address all of that because it all crops up.

If you (1.) live under a rock, or (2.) just want to see it again, this is Papola's video:

Some thoughts on Keynes

To borrow and slightly modify from Lee "[I like Keynesian economics,] and I get tired of defending it". Lee suggested he doesn't like Keynesian economics, and gets tired of defending it against others who don't like it, but don't understand what Lee considers to be the decent elements of the Keynesian framework. His thoughts on that are here.

He's addressing an earlier post by Russ Roberts, who I feel is one of the most frustrating to deal with on this issue. He proceeds as if all the dumb claims of what's been called "vulgar Keynesianism" are actually what Keynesians think. Consumption is better than investment. Saving is bad. The solution is always for the government to spend more. Governments know enough to plan economies. Heterogeneity doesn't matter. He doesn't skirt the edges of these things - this is Keynesianism for him. The result is, well, some bad analysis. His Keynes vs. Hayek rap is full of vulgar Keynesianism too, of course. If it were being shown to high school kids that never even heard of Keynes before, I guess it might be a useful educational tool. But in any college class it distorts more than it teaches.

I haven't read Russ's newest post yet, but he has a long one on his reflections on Keynes here. I probably won't read it. I already glossed over it and I'm not encouraged - "where does the money come from?" (as if there were some fixed quantity of money), "savings is bad" (as if he had never heard of liquidity preference that drives a wedge between savings and investment). I can't take time to read it now, but I welcome anyone's thoughts on Russ's post.

I have posts delving into my thoughts on some misconceptions of Keynes here, here, here, here, here, and here, and probably in a few other places as well.

The Equation of Exchange and the Metaphysics of Commerce

"The Balance of trade is the metaphysics of commerce, which few understand and which serves no other purpose than to disturb the imagination" - Thomas Fitzsimmons, 1785

*****

What would you all think if I wrote "By definition Y=C+I+G, so if you increase G you increase Y". You probably wouldn't take me very seriously. Even when I make a case for fiscal policy, it's never that case. Freshmen learn what's wrong with that argument. Would it improve things at all if instead I said "By definition Y=C+I+G, so if you increase G holding everything else constant you increase Y"? This version is at least logically coherent, but would your opinion of me change all that much? Probably not. Let me put it this way - I should hope you would still think I was talking nonsense. It's true that Y=C+I+G; that is trivially true. But when you change government spending, you can't expect other things in the equation to stay the same. So the first, unqualified statement that I made is logically wrong because nothing constrains C and I to stay the same, allowing me to conclude that we can increase G ad infinitum to achieve permanent growth. The second version of my statement was logically sound, but meaningless and demonstrative of a very poor understanding of economics. The lack of understanding is evident not in my manipulation of the equation itself, but in my understanding of the meaning and use of the equation.

Unfortunately, Don Boudreaux recently made precisely the same mistake with another famous economic law, the equation of exchange, MV=PQ. Don writes:

"In today’s Wall Street Journal, U.S Treasury Secretary Timothy Geithner, Singapore Finance Minister Tharman Shanmugaratnam, and Australia Treasurer Wayne Swan worry aloud that, in emerging economies, “rapid growth” increases “the risk of domestic inflation.” Baloney. Inflation is the result of too much money chasing too few goods. So by increasing the flow of goods (and services) produced in an economy, rapid growth decreases the risk of domestic inflation. That the finance ministers of three major world governments do not understand this fundamental fact is appalling." (emphasis is mine)

Don is quite wrong here, and the various finance ministers he cites are correct*. The key to understanding how to think about the quantity theory is that it's simply a balancing of the books. Alone, it tells you nothing about the causal relationship between any of these variables. I want to emphasize that because a lot of people from all sides of the aisle treat it like it's a causal law (Exhibit A being the regular testimony in the banking committee of the politician that every libertarian wants to pretend isn't just another politician).

Don is discussing the role that rapid growth (and increase in Q) plays in inflation. Taking the naive view of the equation of exchange, he reasons that since P = MV/Q, when Q increases P (the general price level) must decrease. He doesn't even say "holding everything else constant", and so his claim is logically wrong. But even if he had said "holding everything else constant", that just begs the question - why would you ever claim to hold everything else constant? Don certainly wouldn't let me get away with "holding everything else constant" in the national income identity. So how does Q grow in Don's example? Well for the answer to that question we have to turn to some method of determining output - Q. For this, of course, economists traditionally turn to supply and demand. Profit maximizers and utility maximizers come together in a market and set their respective marginal benefits and marginal costs equal to each other and come to agreement on a Q and a P**. So that gives us two of the four variables in the quantity theory - not bad. How does Q and P change in a supply and demand model? Well, the supply schedule can shift, the demand schedule can shift, or both can shift simultaneously. These supply and demand curves, unlike the equation of exchange, are actual behavioral claims made by economists. If you have a given set of preferences, and you have certain rational and informational prerequisites, and you face a particular suite of prices you will purchase Q goods for P dollars each in the market. This is claimed to be causal and it does describe behavioral relationships. It is not an accounting identity like MV=PQ or Y=C+I+G. So what happens if demand for goods and services increases? We would expect to see Q and P both increase. What happens if the supply schedule shifts to the right? We would expect to see Q increase and P decrease.

Now, to make another trivially true statement, we can say that if M and V are held fixed, these supply and demand dynamics will be reflected in observed values. On this point alone - even at this "trivially true"/"ceteris paribus" stage in the game, and after adding one supply curve and one demand curve to give some actual behavioral traction to our equation of exchange, Don is clearly wrong. Output growth can occur for at least two reasons - a supply shift (i.e. - increased productivity) or a demand shift, and a shift in demand will cause prices to increase at the same time that quantity increases***.

But presumably we aren't satisfied with a "trivially true" refuation of Don's point. When supply or demand shift, things happen to M and V too. When demand for goods and services increases, more transactions occur and people increase the rate at which they spend a given stock of money. In other words, the velocity of money, V, increases. Another way of saying this is that the desire to hold on to cash decreases if your demand for goods and services increases and your income stays the same. That cash did not circulate before, and now it is put into circulation. This is a standard impact of an increase in demand, and its inverse is why Keynesians associate low demand with an increase in the desire to hold cash or other liquid, idle assets. So if we have demand-lead growth, we would expect V to go up as well (which is another reason why when Q goes up in the equation of exchange you can't simply assume P goes down - that increase in Q may be a part of a process that simultaneously increases V).

What happens with the money stock? Well, of course that depends on how you define money. If you're thinking in terms of a very narrow definition of money, you can safely assume that that stays fixed and the explanation provided above of P, Q, and V gives you what you need. I don't know too much about this end of the theory, but clearly there are definitions of M with varying breadth. Nominal credit creation in response to an increase in demand can also be said to increase the money supply, and would also create inflationary pressure. Would you have nominal credit creation in response to a productivity (i.e. - supply schedule) increase? I don't really see why you would expect that. People need less exchange media to conduct the same amount of commerce, so it's probably less sensitive to supply-lead growth. Then again, if the aggregate demand schedule is highly elastic, maybe you would need more. These are the kinds of issues you have to think through - the equation of exchange doesn't provide you the answer to any of these relationships.

So be careful when you use these. Don't get caught saying "when we print more money it creates inflation" or "when output grows, it lowers prices". These are abuses of the quantity theory.

*George Selgin has some comments in the comment section of this post that are worth reviewing. I think Selgin is basically right and understands precisely what I'm saying here. Unfortunately he was clearly indulging Don's misunderstanding of the issue when he was taking issue with my comments, and trying to paper over a pretty egregious Cafe Hayek post.

**You could of course raise some market process objections to this story, but the basic supply and demand relationship has been experimentally verified (by other George Mason professors, in fact), so whatever non-auctioneer market process is going on is clearly giving us about the same results, which should not be surprising to anyone.

***In the article that Don discusses, the authors mainly point to demand-lead growth in emerging economies as the inflation risk for emerging economies only. They specifically cite demand for exports, growing domestic demand, and rising commodity prices (which have been demand-driven, not supply-driven).

*****

Quantity theory links:

- I started a thread on this issue in Jonathan's forum here.

- This recent post by Brad DeLong doesn't explicitly mention the quantity theory, but he does bring up the problems with a Monetarist approach to the crisis. His critique is based on the interpretation of Monetarism as a misuse of the quantity theory... or at least a misuse given the very special circumstances we're going through now.

- Stephen Williamson replies to Mark Thoma and writes: "This is why I'm not an old-fashioned quantity theorist. What has to be going on here is a large increase in the world demand for US currency during the financial crisis. All the more reason to be worried about inflation, as the crisis-driven demand [for US currency] goes away." I'm not sure if Williamson is saying that "old-fashioned quantity theorists" misuse the equation of exchange, but this doesn't seem quite right as a critique of the quantity theory itself. If there is an increase in world demand for US currency that you expect to be temporary, then that's the same as saying there is a decrease in V that you expect to be temporary. If you expect it to be temporary, then you'd expect an increase in V in the future. If, following the processes I outlined above, you think that increase in V is going to be paired with an increase in demand and thus P and Q, then Williamson's worry about inflation in the future is perfectly justified and perfectly consistent with the quantity theory. It's simply not on the top of my list of things to worry about right now. When we actually see that inflation, it means we're probably out of the slump.

- Bill Mitchell, of the Modern Monetary Theory school, has a weekly quiz. The second question of a recent quiz is on the quantity theory. Mitchell sets up a straw man of what quantity theorists believe (essentially attributing Don Boudreaux-type views to them), and then credits Keynes with fixing all that. This is a little much - many users of the quantity theory long before Keynes used the quantity theory without making these mistakes, and Keynes certainly embraced the quantity theory - and he used it correctly and to great effect. So Mitchell's analysis here is correct - but his history is a little self-serving.

- Jonathan reposts some thoughts by Richard Ebeling on Hayek and the quantity theory here.

- And of course, a lot of this emerges from our discussion of Hayek's Prices and Production. You'll find my post on the first lecture, in which I deal with some of these questions, here. I think Hayek does much the same thing that Mitchell does with his treatment - he provides a reasonably accurate analysis of the quantity theory, but a fairly self-serving history of the idea. He also has a weird "this isn't important and in fact it's misleading" reaction to it by the end.

- Keynes has a suberb discussion of the use and misuse of the quantity theory in the Tract on Monetary Reform (it actually is the same discussion where he says "in the long run we're all dead"). I'll hopefully get a chance to quote it at length this weekend, but if I don't please look it up yourselves

Surprise! I agree!

It's always surprising to see areas where Austrians or libertarians pronounce that there is some sort of disagreement where there really isn't. It makes me wonder (1.) how much of the rift is caused by misconceptions, and (2.) what am I asserting about Austrians or libertarians that they actually agree with me on?

Two things bring this to mind - first, Jerry O'Driscoll responded to a point on Coordination Problem about demand deficiencies and the impact on the labor market. O'Driscoll responds (quite politely), "There is more to unemployment than a "labor demand deficit." I have a post at ThinkMarkets on the issue." The post he's refering to is very good - I read it several days ago when he first posted it. It's on labor heterogeneity and you can read it here. It's unclear, I suppose, whether he thought that I was saying demand deficiency was all there was to the labor problem. I never said it was all there was to it, so I don't see why someone would assume that that's what I thought. It's the major issue right now, though. Anyway - I know this is minor, but it was surreal to be pointed towards labor heterogeneity by a guy like O'Driscoll. I've been well aware of the issue of labor heterogeneity and the kinds of things that it leads to for quite a while - it's important in a lot of the New Keynesian literature and it was something that I had written on for school long before I even heard of the Austrian school. This is pretty common-ground stuff. This was a more ambiguous case, but it just makes me wonder if O'Driscoll realizes he's preaching to the choir. Hopefully he realizes that and is just sharing a new post of his (God knows I self-promote).

Even stranger was at ThinkMarkets where Mario Rizzo wrote:

"According to an article in the September 6th issue of the New York Times, more and more “experts” are now saying that the government should not try to prop up the housing market but should let prices adjust to their correct levels as rapidly as possible.

Well, you read that here as early as November, 2008 and then again in March 2009. It is part of the continuing myopic harping on aggregate demand which ignores all of the relative price adjustments that a post-bubble economy must experience. The Keynesian habit of ignoring the causes of depressions and dealing only with the analytically-secondary phenomena of aggregate expenditure is or should be unacceptable among intelligent economists.

I repeat what I said in 2008: Let the housing market collapse — fast."

Can someone clarify to me in what universe an aggregate demand or Keynesian perspective thinks that relative price adjustment shouldn't occur or is unimportant? The whole idea is that even when relative prices adjust naturally - as they should - aggregate equilibria can still be below full employment. Keynesianism assumes and expects the adjustment of relative prices - there is a call for price level stabilization, but explicitly and implicitly you don't touch or distort relative prices. I'm not even sure how distortion of relative prices even makes sense from a Keynesian position - it's not simply that Keynesians have never raised an argument against microeconomic efficiency, it's that there's nothing in their macroeconomic inefficiency story that would justify doing anything about relative prices.

So what exactly does Rizzo have in mind here? I had no idea, so I asked. He came around to saying "I am simply saying that if you concentrate exclusively on aggregate demand you would look at the decline of housing prices as bringing about a negative wealth effect and thus (further) decline in demand." This, of course is a very different claim. Yes, I would agree - if you plug your ears and close your eyes and pretend microeconomics doesn't exist at all (i.e. - "concentrate exclusively on aggregate demand"), then you will end up saying some dumb things. Who does that, though???

Keynesian macroeconomics assumes an underlying microeconomic foundation. You can't simply erase that microeconomic foundation and call it "Keynesianism". Neoclassical microeconomics is the microeconomic assumption of Keynesian macroeconomics. You'll see all kinds of frictions and asymmetries and fun things like that introduced, but none of that roams outside of neoclassical microeconomics.

It just gets a little silly to single out Keynesians on a post where the simple point is "housing prices need to deflate" - I point that has been made repeatedly across different economic schools of thought. As I said to Rizzo, I've always interpreted the home price shibboleth as being pushed by politicians who are concerned about the homeowner vote. Odd stuff.

As with most misunderstandings like this, it's a human fallacy rather than a fallacy that any single group is prone to. I'm sure I do it too - are there any areas that I comment on where Austrians/libertarians think "Surprise! I agree!"? Is there any area where I regularly make strange, needless conflict?

UPDATE: Joe Stiglitz, Keynesian grand poo-bah, certainly doesn't find aggregate demand thinking to be an impediment to basic points about relative price adjustment.

Also - I coined a term for this in a prior blog post: the "presumption of ideological orthogonality", or the idea that "because I think X, and their group disagrees with my group, they must think not-X". It's a bad assumption to make.

Damn it Cthulu movie promoters!

OK, so previously I've linked to this pretty cool Youtube video alleging to be an H.P. Lovecraft interview by the WPA. It brings Lovecraft and the New Deal together, it's the only video I've ever seen of the guy, and it's also probably a fake to promote the movie. I simply jumped on it and assumed it was real - I've always thought it would be neat to check out WPA records for more info, but since I never did much besides link it in blog posts I never made that effort or thought much more about it.

Bah! Egg on my face now. Most serious of all problems, of course, is that there was no WPA until 1935!

Based on my reading of what Lovecraft had to say about the New Deal the sentiments expressed here, as well as the regional affinities, the Oswald Spengleresque views on civilization, the talk about religion, etc. are all pretty faithful to what he might have said. Unfortunately, that doesn't quite cut it.

Oh well. No harm done I suppose. I still feel pretty dumb.

This is a list of WPA interviews in Rhode Island, where Lovecraft was from. This is a list of WPA interviews in Massachusetts, which was usually the setting of Lovecraft's stories.

Kling on Austerity and 1945-47

He writes it up here.

This post could be submitted to Webster's as an example under the word "strawman argument".

I'm in the comment section. Anyone who knows what I think about 1920-21 can guess what I have to say about 1945-47.

A great post on the stimulus/austerity debate

A really good summary (HT: Joe Cordes).

The argument:

1. Austerity is stupid
2. Stimulus is dangerous
3. Lying is optimal
4. Economic choices are not scalar

The first point I hope speaks for itself. The second point is obvious too. I think a fifth point ("depression is really dangerous") would better round out the choice set we're facing right now. It's a "lesser of two evils" situation. The third point is interesting but not surprising to economists. The fourth point is very important for those interested in infantilizing the debate. Cafe Hayek is one site that loves to engage in "reductio ad absurdum" arguments, and I've recently discovered Wayne Anderson's penchant for that sort of thinking too. It's a really dumb way to approach these questions, and we need to keep that in mind. Generally speaking, reductio ad absurdum is a bad strategy to use when talking about economics.

This is the essential point of the post:

"I think there are lots of things government can and should do that would be fantastic. A “jobs bill”, however, or “stimulus” in the abstract, are not among them. If we do smart things, we will do well. If we do stupid things, or if we hope for markets to figure things out while nothing much gets done, the world will unravel beneath us. We have intellectual work to do that goes beyond choosing a deficit level."

Chumming the waters for confused devotees of Bastiat

This should produce quite a few confused blog posts. My bet is Cafe Hayek will be first.

This is actually a tough article to parse in terms of its economics. It only discusses flows, not stocks, until the last paragraph where it discusses economic damages (which presumably include stocks as well). But it also gets into employment. Employment is tricky because you have to consider the counterfactual: where would these people be employed otherwise? Just because the clean-up creates X jobs doesn't mean that the economy adds X jobs. There's nothing inaccurate about the statement, but it's just something to keep in mind. Since there's a lot of excess labor, the impact probably will be positive for the entire economy. The statements about GDP, though, are unambiguous. Some production will be displaced by the clean-up, but that is already taken into account in GDP forecasts (otherwise it wouldn't be a GDP forecast!). This is also why people are wrong when they criticize forecasts of the impact of the stimulus on GDP as not considering the "seen and unseen". It does. Multiplier estimates are produced by comparing to a counterfactual, and therefore already nets out the production that is displaced by stimulus. The estimate may be inaccurate, but it does incorporate concerns about what has been called "the seen and the unseen".

For a review of why I think a lot of people are going to get confused about this WSJ article, see my recent post on Bastiat.

Stocks, Flows, and Bastiat

Jonathan Catalan defends Austrians on Bastiat in the comment section here. I want to clarify my concern with how Bastiat is handled. I think most people familiar with him (Austrian, libertarian, or "mainstream") understand and agree with Bastiat. It's a fairly obvious and unremarkable point he makes, after all. I think a lot of the problems come in when people try to apply him. Here are a few basic problems that I see crop up over and over again, even with professional economists:

1. Gross vs. Net benefits: Lot's of gross benefits can result from a crisis, but Bastiat's point is simply that there is never any net benefit to destruction. Jonathan insists that Austrians know the difference between gross and net. I agree - of course they do. The problem isn't in understanding the concept - the problem usually comes in inappropriately applying the concept when you're trying to catch someone in committing a fallacy. Russ Roberts recently put up a post that didn't exactly criticize articles remarking on the "green jobs" created by the oil spill. He didn't criticize those articles because they hadn't even been written yet! He was anticipating them and asked people to "keep him posted" on any such fallacious articles. Roberts, like a lot of Bastiat fans, was just itching to play "gotcha". Here's the problem with that - there are gross benefits to the spill and the creation of green jobs and the invigoration of the environmental management industry are two of them. Russ can't call foul on an article that simply points out a gross benefit unless it suggests there is no greater gross cost. And I think I'm safe in saying that no article on the spill is going to suggest there isn't a greater gross cost to the spill. If they don't say it explicitly, it is clearly implicit. Do Russ and do others understand the difference between gross and net. Without a doubt they do! But understanding something and applying your understanding with fidelity in a given situation are two entirely different things.

2. Stocks and Flows: Economists care deeply about the distinction between a stock variable and a flow variable: a given, existing quantity of something and a new addition of that something. We often talk about "flows" - namely, GDP. Every year, the American economy produces several trillion dollars worth of stuff. That's GDP and that's a flow. But a lot of that stuff is durable. I just moved into a new apartment and spent yesterday carrying lots of very heavy furniture, none of which was produced this year. So that is an existing stock of "wealth" that remained from a previous flow of "production". Sorry to belabor the point, but it's important for readers unfamiliar with the distinction. So economists talk a lot about "flows" (you never hear annual wealth stock statistics, but you hear annual GDP, consumption, and investment statistics all the time). So how does this relate to Bastiat? Well, when destruction occurs - when there is a war or a flood or an earthquake - usually what gets destroyed is stock. Buildings, cars, etc. The gross negative that contributes to the inevitable net negative largely falls on stock. Now, human action changes in response to massive destruction like that - production (a flow) can shoot through the roof to replace the destroyed stock. As we produce more and more we bring in more labor and capital. This is how destruction can actually lead to a period of sharp growth and low unemployment. None of this contradicts Bastiat because there is still a net loss. But if the gross loss falls on stock and the net loss falls on flows and flows are important to you (say, if you care about something like employment - which I do), it's fine to comment on the impact that destruction has on flows.

The modern canonical example of the broken window fallacy for Bastiat aficionados is Paul Krugman's claim that 9-11 would increase investment. Krugman was absolutely right. Investment is a flow variable, and a lot of destroyed capital did need to be replaced after the attack. In the article where Krugman wrote this he went to great lengths to explain that there certainly was a broader tragedy - he wasn't denying that - but that this was one (gross) economic product of the attack. Krugman wasn't misunderstanding the broken window fallacy - his critics were. (A caveat, of course, is that if enough capital gets destroyed it can impede growth and growth can actually be lower... but whether this is the case in any given crisis is ultimately an empirical, rather than a theoretical question).

Wilhelm Ropke, a German economist who is highly regarded by the Austrians, made very similar points about the differential effect of destruction on stocks and flows in his book Crises and Cycles. I quote the relevant section and provide brief comments here. Ropke gets it. A lot of modern libertarians and Austrians don't, I fear. And it's not because they don't understand basic concepts - it's because they are so obsessed with playing "gotcha" with people they're convinced they have to embarrass and disprove that they don't take the time to think through these issues carefully, the way Ropke does. Wayne William Anderson has a blog dedicated to arguing against Krugman for God's sake! That's the kind of climate that many of these sorts of people operate in. With that kind of attitude you're going to take simple concepts like gross and net and stock and flow and confuse them instead of applying them accurately.

A New Fallacy

I'm coining a new fallacy in discussions of economics and politics: the Central Government Fallacy. Committed by those who forget that we live in a federal republic, and in so doing make fallacious claims about policy. People are very prone to committing the Central Government Fallacy when talking about macroeconomic policy.

How significant is the Central Government Fallacy for today's public discourse? Very significant. If you're one of those people that thinks the United States is engaging in Keynesian macroeconomic policy, then you haven't been paying attention.

There's been a lot of talk about Keynesianism lately - and that's good. And there are a lot of policymakers that have been taking Keynes seriously lately - and that's also good. But if you think we've been practicing Keynesianism, you're quite simply wrong. How would I characterize our policy response to the economic crisis? Tepid monetarism. That works tolerably well in most circumstances, but not when nominal interest rates are at record lows, inflation is low, and demand is weak.

Past Fallacious Fallacies on F&OST

This morning, I described the "aggregation fallacy" as a "fallacious fallacy" - something that a lot of people wrongly point to as a fallacy. I think I'll try to highlight a couple more of these cases over the next couple weeks, mostly from economics.

In the meantime, since we've gotten a lot more readers lately, I wanted to highlight two past posts on fallacies on this blog that I thought were both pretty fun.

The first is a post by Evan on a fallacy that he enjoyed coining: the fallacy of gravity as a mechanism of consciousness. As Evan suggests, it probably already has a name, but it's more fun to give it a new name that enables you to reference Wile E. Coyote. The post is very good.

I also have one on the fallacy of teleological thinking when we talk about evolution and the environment.

Fallacious Fallacies and the Great Recession

Aggregate Demand and the Great Recession
On April 17th, the chair of Obama's Council of Economic Advisors chairwoman (and W&M alum) Christina Romer set off a firestorm in the economics blogosphere with a relatively benign rendering of mainstream economics through the medium of a shout out to 1990s political culture. Namely, that: "it's the aggregate demand, stupid". Romer's case is that aggregate demand is driving unemployment as opposed to unemployment insurance. The Economist provides a general overview of the question, while a paper prepared for a Brookings panel and a San Francisco Fed paper provide some empirical structure to the debate.

Bloggers have lined up on either side. Menzie Chinn, Michael Derby (WSJ), Mark Thoma (here and here), and Brad DeLong take Romer's side. Arnold Kling and Megan McArdle are opposed to her position. Tyler Cowen and Bryan Caplan are also opposed, but their posts go down this strange rabbit hole of nominal wage rigidities, which is very unusual because (1.) Romer never mentions nominal wage rigidities, and (2.) nominal wage rigidities have exactly zero to do with aggregate demand deficiencies, although some economists are fond of referencing them.

Fallacious Fallacies
Some of the more interesting posts on the issue get into alleged fallacies committed by the pro-Romer aggregate demand crowd. I'm going to call these "fallacious fallacies", because they miss the mark by a fair margin, they threaten clear thinking, but you hear them a lot because human beings (particularly bloggers) love to play "gotcha". So I'm gonna call "gotcha" on the "gotcha" guys. The fallacious fallacy in question is the "aggregation fallacy". While most economists content themselves with the fact that aggregate demand is real and job search intensity (which is lowered by generous UI benefits) is real, and we have to arbitrate between their relative importance, some economists flatly reject the validity of aggregating anything. Robert Higgs recently listed the "aggregation fallacy" first in his list of six alleged fallacies. The argument is that by aggregating a variable like income into a variable like GDP, or an individual price into an aggregate like the CPI, complex processes at a lower level of aggregation are glossed over. This critique can come in several varieties, but it's disconcerting for me that it is ever expressed in the all-encompassing way that Higgs presents it. Peter Boettke recently brought this aggregation debate into Romer's aggregate demand debate. In his comment section, after some debate on the question, Peter writes that he is "unpersuaded that aggregate concepts do much of anything to improve our understanding of an economic system".

The problem, as I see it, with this common "fallacious fallacy" is that it takes a kernel of truth and explodes it completely out of proportion, to the detriment of clear thinking. Of course haphazard aggregative thinking can lead to erroneous conclusions. But we already have a name for that: the ecological fallacy. Ecological fallacies are committed when you infer things about individuals based on the behavior of aggregates. That's an entirely valid thing to look out for, and it's something that macroeconomists who do trade in aggregates obviously have to take special care to watch out for. But Boettke and others, by taking the risk of committing an ecological fallacy to the extreme, themselves are at grave risk of a fallacy of composition. I would argue that the rejection of the paradox of thrift, the rejection of the prospect of a "general glut", or the rejection of the possibility of a wage-price spiral are all such fallacies of composition. If I were to commit a "fallacious fallacy" of my own, I would say that Boettke and others are committing a "disaggregation fallacy" (but I won't, because I have no methodological hang-ups about micro-data, which I personally use far more often than macro data).

Why do these fallacies persist? I'm not quite sure. A couple weeks ago I would have attributed it to the insularity of the Austrian school. Like Darwin's finches, eccentricities around something as mundane as an aggregate serve a function in the Austrian school (it's an easy to understand whipping boy for Keynesianism that is accessible to new initiates) that would not have evolved outside of that niche but can persist in that particular insular environment. Since transitioning from a few less illuminating Austrian blogs to more illuminating Austrian blogs, though, I have a much harder time making this argument. Then what is it? Why do smart guys with good things to say like Peter Boettke insist on peddling "fallacious fallacies" like the "aggregation fallacy"? Why is it so hard to see that there are two very real fallacies - the ecological fallacy and the fallacy of composition - that do apply in certain instances, but that you can't simply assume apply in all instances? I'm not sure - any ideas? I can't imagine how these people justify the co-existence of psychology and sociology, or organic chemistry and biology.

Quick Conclusion on UI, AD, and the GR

I want to point out that the empirical work I link to above shows that extended UI benefits have marginally increased unemployment (by 0.4 percentage points). We obviously don't have the data or the identification strategy to get an especially rigorous estimate, but that one seems to hold water with the Fed and the NBER. This suggests that Romer is right that UI benefits aren't a huge component of the story. But it also suggests that the economists who argue that the aggregate demand impact of the UI program in particular is a net positive are wrong. The argument goes that if you give unemployed workers more spending power it boosts aggregate demand, which helps the economy. A negative net impact of UI extensions - even a small negative impact - suggestst that any AD effect is swamped by the incentive effects. In other words, tentative, preliminary empirical evidence suggests that we're getting to the point where UI extensions may be justifiable on a humanitarian basis, but are getting harder and harder to justify on a stimulus basis. That does not mean that UI is keeping us in quasi-depressionary conditions. That doesn't even mean we shouldn't extend UI. And it certainly doesn't mean what Jerry O'Driscoll seemed to be implying: that you can't simultaneously say that AD and UI are important determinants of the unemployment rate, but that AD is more important than UI right now (as opposed to, say, the late 1990s when UI might have been a more important factor). What it means is we need to be careful about how we justify UI extensions, and seriously consider cutting off the extensions.

This has been fun. Future "fallacious fallacies" I might tackle are the Broken Window Fallacy, the accounting-identity-as-behavioral-law fallacy and reductio ad absurdum. Each of these, like the "fallacy of aggregation" has a kernel of truth that is habitually blown way out of proportion by zealous "gotcha" bloggers.