Cowen, Murphy, and Hayek

Tyler Cowen challenges Bob Murphy and ABCT on the grounds of what he considers to be an embarassing co-movement of investment, capital maintenance, and consumption during the boom. Murphy had originally claimed that investment and consumption can move together because capital maintenance is neglected.

A few obvious questions emerge from this explanation from Murphy. The first one that comes to my mind is also mentioned by Cowen - why would monetary expansion encourage investment but not capital maintenance? Wouldn't those same low interest rates that encouraged malinvestments also encourage capital maintenance? It seems to be an awfully convenient thing for Murphy to grab for.

But the whole discussion also reminded me of something that Hayek said in Prices and Production (lecture 2) that has bothered me since I first read it. It solves the co-movement problem without resorting to Murphy's capital maintenance explanation. The problem is, I'm not sure why we should believe this "solution". Hayek writes:

"The raison d'etre of this way of organizing production is, of course, that by lengthening the production process we are able to obtain a greater quantity of consumer' goods out of a given quantity of original means of production. It is not necessary for my present purpose to enter at any length into an explanation of this increase of productivity by roundabout methods of production."

So Hayek says that you don't even need to resort to the neglect of capital maintenance. Investment and consumption move together because the lengthening of the capital structure makes investment more productive.

I wish he had explained it more because I see absolutely no reason to think this is true. He's not talking about technological progress that happens to elongate the capital structure. He's simply talking about increased roundaboutness itself. Why does that - in and of itself - make things more efficient? Does anybody believe this?

This line always bothered me for precisely the reason that I think Murphy's explanation bothers Cowen - it seems like a very convenient solution to the problem that is also conveniently short on details, citations, or empirical support. Take this assumption away and (it seems to me) you still have a theory of the business cycle that makes some sense (unsustainable changes in the capital structure - malinvestments that might need to be liquidated later on), but one that seems less binding theoretically (why can't we just grow into these malinvestments - clearly some roundabout production is necessary, and regular growth rates should allow us to eventually make use of investments that, just a few years ago, where malinvestments) and less convincing empirically (Tyler's co-movement problem reemerges).

UPDATE: Peter Boettke has thoughts here.

Prices and Production, Lecture 2, Post 1

It's been a pretty busy week or two with the NSF application, so I haven't gotten a chance to jump into Lecture 2 of Prices and Production as easily as I was able to review Lecture 1. On top of that, readers know that this lecture can be pretty confusing at points. Talking through some of these difficulties with Jonathan and EdP has helped me understand the chapter better, which is great - that's what these reading groups are for. I have a collection of thoughts I want to share, though, in at least two posts.

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1. W.C. Mitchell: First, I want to reiterate a point I made earlier about Hayek's treatment of W.C. Mitchell (p. 225), which I think was a little much. Hayek writes "I cannot agree that Professor Wesley Mitchell is justified when he states that he considers it no part of his task "to determine how the fact of cyclical oscillations in economic activity can be reconciled with the general theory of equilibrium, or how that theory can be reconciled with the facts." On the contrary, it is my conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of a tendency toward equilibrium.". The statement is a little vague on the part of both Hayek and Mitchell. I'm not sure exactly what Mitchell means by "how that theory can be reconciled by the facts" (I'm not very familiar with him). Is he talking about working up a new theory that better fits the facts? If that's the case, then I think that's perfectly legitimate. If he means that he has no obligation to seek out a correspondence between fact and theory, then I don't agree with that. It's also unclear what "tendency toward equilibrium" Hayek is referring to, but I'm wary of the claim that we are forced to build on the equilibrium theory we've always had. Many other economists besides Mitchell were concerned about the correspondence between what he observed and the existing equilibrium theory. The two that I know best are Joan Robinson at Cambridge and Edward Chamberlin at Harvard. Both independently developed theories of monopolistic competition in 1933 precisely because of the perceived inadequacies of the "foundations" they had received in explaining the facts. Hayek sees his project as taking a foundation and moving forward with it. That's fine, but I can certainly sympathize with people who have less reverence for former foundations.

2. The time structure of demand: When I first read Keynes's account of Bohm-Bawerk's views on roundabout production (well, when I read it for the second time I suppose, because I didn't see as much significance in it when I read it the first time), it sounded really odd to me. I had by that point learned ABCT through Garrisonesque emphasis on the structure of production. Keynes, on the other hand, talked about roundaboutness in terms of the time structure of demand (demands that are less immediate support more roundabout production). That sounded weird, although the conclusions essentially worked out the same. What's interesting is that that's largely how Hayek approaches the question, at least in his discussion on page 226: "What I have here in mind are not changes in the methods of produciton made possible by the progress of technical knowledge, but the increase in output made possible by a transition to more capitalistic method of production, or, what is the same thing, by organizing production so that, at any given moment, the available resources are employed for the satisfaction of the needs of a future more distant than before." I think a lot of modern renditions of ABCT move away from this question of the time structure of demand, although many of these still note that facet of the theory (Garrison, page 48).

3. Assumed productivity of roundaboutness: Hayek asserts but does not explain why more roundabout methods of production are more productive. He writes "It is not necessary for my present purpose to enter at length into an explanation of this increase of productivity by roundabout methods of production. It is enough to state that within practical limits we may increase the output of consumers' goods from a given quantity of original means of production indefinitely, provided we are willing to wait long enough for the product" (pg. 227). I wish he had taken the time to demonstrate the point. Abstracting away from actual improvements in technology (as Hayek does and which I agree is appropriate to do), the primary impact that time will have on productivity is through interest costs and inventory costs. Indeed, these are the determinants of the relative productivity of a given "roundaboutness" when Keynes discusses Bohm-Bawerk (and I imagine these are the relevant factors in Bohm-Bawerk too). But there is no presumption that more roundabout methods are more productive. Does anyone know what Hayek is referring to here? Clearly, we may also get into his reasons for claiming this in future lectures.

4. Income, expenditures, and capital: I want to clarify for fellow readers that the numbers in Hayeks figures represent expenditures, not income. This is an issue that took some hashing out in this post on Jonathan's blog. Figure 2 is the clearest. The level of income in the economy (i.e. - GDP) is 40 here. The level of total expenditures is 120 (80 on intermediate goods, 40 on final goods). The savings rate, as far as I can tell, is 0%. Figure 3 is more confusing. Income is 30 in this figure because 10 is saved. Total expenditure is still 120 (90 on intermediate goods, 30 on final goods). What is confusing is that Hayek is still not including capital as a factor of production. So capital investment - which we normally think of as "final output", and income from capital - which we normally think of as part of income, isn't included at all! I'm hoping in subsequent lectures these will be brought in, but right now its a little confusing. We've just removed a portion of income because it's not counted as income to an "original factor of production", and we've removed a portion of output because it's not "consumer output" (although at another point - p. 236 - he says that capital is intermediate goods... so at that point it is included in the model, but it's still not a factor of production earning income!), so an important portion of economic output and income (i.e. - capital and capital's income) just evaporates from the model. On page 231 he writes "interest is then received by the owners of the original means of production with wages and rent", but then he completely neglects this point later when he has the original means of production earn 30 instead of 30 + interest. I'm guessing when capital is explicitly introduced later (as he promises) this will all get cleared up. But it's off to a muddy start.

5. Unused resources: Hayek acknowledges that the question of why some resources lay idle is something that needs to be explained (pg. 224). This is good, but he also insists that we should not start there. He writes "it is not true that the existence of unused resources is a necessary condition for an increase of output, nor are we entitled to take such a situation as a starting point for theoretical analysis". This is kind of an odd approach in my mind, particularly with his original point that we have to start from a foundation of theoretical equilibrium. Why should we expect unused, idle resources to emerge from a system that is assumed from the outset to be stable? Aside from frictions and disturbances, we generally wouldn't. So you can see where Hayek's business cycle theory is heading from the very beginning - by virtue of how he chooses to conduct his analysis, it's going to be some external force such as government that is going to be required to disturb the system, by virtue of how he sets up the problem. Hayek says the starting point has to be the full employment of resource (p. 224). Why? He gives no reason at all and it's not clear to me why we should assume that idle resources emerges from full employment of resources and theorize it as such. Hayek suggests we theorize such that full employment is normal and then explain why idle resources can happen. The alternative, of course, is to theorize such that full employment or idle resources are natural. What's especially strange about this point is that Austrians have always critiqued Friedman for his version of positivism, which rejects the need for realistic assumptions... and yet Hayek is here engaging in what I think can fairly be called "unrealistic assumptions" (Garrison did this too and it was one of my biggest complaints about him - for details, see this post).

6. The role of the entrepreneur: On page 236, I think there's an interesting discussion of the role of the entrepreneur, "whether the structure of production remains the same depends entirely upon whether entrepreneurs find it profitable to reinvest the usual proportion of the return from the sale of the product of their respective stages of production in turning out intermediate goods of the same sort. Whether this is profitable, again, depends upon the prices obtained for the product of this particular stage of production on the one hand and on the prices paid for the original means of production and for the intermediate products taken from the preceding stage of production on the other." So again, the terminology is a little confused... profit is the difference between costs and revenue (so far so good), which means that it is a portion of the value added at successive stages of production. This would suggest that the entrepreneur is included in the "original factors of production". That's fine - it's a special type of labor, specifically it is labor that organizes the structure of production. What is still confusing, of course, is this reinvestment question. So now income from capital seems to be included in the original means of production (because it's the entrepreneur's profit). But since capital right now is still just intermediate goods (see p. 236) it's completely removed from the income figure (which, by 239, declines from 40 to 30). What you need is to bring capital and capital's income explicitly into the model. Garrison does this - Hayek may do this in the future.

7. Aggregates: I just want to note that this lecture is chock full of aggregates. One of the frustrating things to me about complaints from Austrians about using aggregates (aside from the fact that the complaint is simply misguided) is that they regularly use aggregates in their own work. Anyway, you should note the use of aggregates when you read and then maybe reevaluate how damaging aggregates really are and how sincere Hayek's later critique of Keynes on this front really was.

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OK - I should have another post on the capital structure itself as I finish the lecture. So far, this has been a very confusing presentation. I think there are much better modern renditions of ABCT than this (I would say the same for Keynes, btw - he has some great insights in the General Theory, but his exposition of the mechanics of the theory itself are not as good or clear as later revisions). Obviously I'd point readers to Garrison because I'm the most familiar with him - but aside from that I think he is widely recognized as being one of the best expositors of ABCT. His approach is not without problems, but I think it's tighter than Prices and Production so far. However - we are still near the beginning!

Paul Samuelson on Hayek and "Prices and Production"

From "A few remembrances of Friedrich von Hayek (1899–1992)," Journal of Economic Behavior & Organization 69, pp. 1–4. This selection on Prices and Production is quite harsh, but Samuelson has better things to say about other work that Hayek had done later in the article. Nevertheless, that other work is not the subject of our reading group!:

"Rise and Fall of 1931 Prices and Production

There were good historical reasons for fading memories of Hayek within the mainstream last half of the twentieth century economist fraternity. In 1931, Hayek’s Prices and Production had enjoyed an ultra-short Byronic success. In retrospect hindsight tells us that its mumbo-jumbo about the period of production grossly misdiagnosed the macroeconomics of the 1927–1931 (and the 1931–2007) historical scene.

When a centrist like me says this about an extremist like Hayek, readers have a right to reserve judgment. More weighty was the later opinion to the same effect of the conservative Lionel Robbins. It was Robbins who had brought Hayek out of Austria to the LSE. It was Robbins who wrote a 1934 Hayekian book entitled The Great Depression. Not so very long after 1934, Robbins repudiated his own early take, saying in effect, I must have been a bit loony at the time.
Aside from the substance of Hayek’s (1931) text, part of his short-lived popularity came from the fact that many in England, annoyed by Maynard Keynes’s unorthodox testimonies before the 1930 Macmillan Committee, hoped that Hayek would be the White Knight to slay the Black Dragon.

Productivity and reputation of Keynes itself fluctuated in Kondratief waves. His 1930 two-volume Treatise on Money posterity judged to have been an anti-climatic flop. But the deeper the drop into the 1929–1935 Great Depression, the more rapidly came the recognition of Keynes as top dog in the twentieth century. (In 1932 as a 16-year-old freshman, I asked my Chicago tutor, Eugene Staley: “Who is the world’s greatest economist?” He answered, “John Maynard Keynes.” For once I never became tempted to question the authority of my many great teachers.)

Gentle Charles Darwin had Thomas Huxley to be his bulldog for evolution. Sraffa (1932) must have been editor Keynes’s bulldog to annihilate Prices and Production, and its author. I never much admired Sraffa’s methodological contentions in that debate but at least his item did have the merit of introducing for the first time Sraffa’s novel concept of “the own rate of interest” in terms of corn or rye or caviar.

For my money more to the point was Richard Kahn’s simple oral 1932 statement:

"If Hayek believes that the spending of newly printed currency on employment and consumption will worsen our current terrible depression, then Hayek is a nut."

Alas, one fatal error eclipses a few elementary true truths á la Mises and Hayek: Easy money now often does entail tighter money later which will come as a surprise to uncompleted projects and new contingent contemplated investment projects. Hayek himself, naively, diagnosed the fall of his 1931 opus as due to the fact that his period-of-production mutterings there did not do full justice to the not-yet-completed Austrian theory of capital (Menger, Böhm et al.). Therefore, heroically but hopelessly, he wasted years on a task that he was grossly under-equipped to handle. Hayek’s (1941) The Pure Theory of Capital was not stillborn. But it was a pebble thrown into the pool of economic science that seemingly left nary a ripple."

I share this to (1.) note the thoughts of a giant in modern economic thought on the subject of our studies, and (2.) to demonstrate that I'm not the harshest critic of Hayek out there!

Richard Kahn, by the way, is credited with shoving Keynes towards thinking more about employment than he had previously in the years between the Treatise on Money and the General Theory.

Lecture 1: Theories of the Influence of Money on Prices

Hayek uses the first lecture in Prices and Production to lay out what he sees as the developmental trajectory of monetary theory, as well as an introduction to the advances he proposes to make in subsequent lectures. He identifies four stages of theory, the last of which is said to be in its infancy in 1931, when Hayek wrote the lectures.

The first stage is more or less what most people know of as the quantity theory of money. Hayek has two primary critiques of this approach: it is analytically problematic, and even if it weren't problematic it is practically useless. I think Hayek errs on both of these points (which is not to say that I disagree with him that monetary theory could be developed beyond the quantity theory). First, Hayek suggests that "none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of a knowledge of the decisions of individuals that the main propositions of non-monetary theory are based". In this sense, Hayek sees a divorce between monetary theory and what we would know as microeconomics. He continues, "if, therefore, monetary theory still attempts to establish causal relations between aggregates or general averages, this means that monetary theory lags behind the development of economics in general. In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena".

Towards the end of his discussion of the first stage, Hayek writes that "you are all sufficiently familiar with this type of theory to supply these [examples] for yourselves and to correct any exaggerations which I may have committed", and so I'll take him up on this and correct some exaggerations. What Hayek appears to miss here is that the quantity theory is useful not as a behavioral law or a statement of causal relations, but simply as a statement of accounting. If you take all the prices charged in an economy and add them up, and then take all the instances that a particular piece of money in the economy was spent and add all those up, the two sums have to be equal to each other. This is a definitional constraint on the system. Think of it as analogous to the "conservation of energy" in physics. On its own, the conservation of energy doesn't tell you anything about cause and effect, and it doesn't tell you about the dynamics of a particular system. Its power is in parameterizing the system so that when action does occur as the effect of some other cause, that action is forced to conform to the conservation of energy, and so the conservation of energy is a useful principle in understanding how cause and effect play out in physical systems. The same is true of the quantity theory of money. Hayek fundamentally misunderstands the very purpose of these theories if he thinks they imply some sort of causal relationship.

The second thing that Hayek critiques about this first stage is his claim that anything that the quantity theory can tell us is relatively useless. He writes "for none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of the knowledge of individuals that the main proposition of non-monetary economic theory are based". This seems odd. The various problems associated with inflation and deflation are very well understood, and were most definitely understood when Hayek wrote these lectures. Fisher had not yet written his famous article on debt-deflation theory, but I don't think anyone has claimed that these ideas were especially original to Fisher. Keynes wrote extensively on the differential impact of inflation and deflation in 1923, and I know Hayek read that book. Debt-deflation, the differential impact of deflation on quits and layoffs, the differential impact on the distribution of wealth and the implications for demand, etc., can't be investigated by asking "what does the price do in this particular market - how do relative prices change?". These things can only be investigated by asking "what happens to the general price level?". So on both counts, I think Hayek is quite misguided in his critique of the "first stage" of monetary theory, although he's certainly right that there is more to be said.

The second stage Hayek identifies is the attempt by Locke, Montanari, Cantillon, and others to trace the path through which an increase in the money supply affects prices. The modern equivalent is something like the "monetary transmission mechanism", which has been so central to Ben Bernanke's own research (back when he did research!). He has a few other things on his plate right now, but even now this transmission mechanism problem has played a substantial role in how he has handled his tenure as Fed chairman relative to Greenspan. I was very interested in this section of Hayek's lecture to see some vague allusions to a long-run vs. short-run Phillip's Curve relationship: "Hume, however, makes it clear that, in his opinion, "it is only in this interval or intermediate situation, between the acquisition of money and the rise of prices, that the increasing quantity of gold and silver is favourable to industry".

The third stage of the development of monetary theory was the link between money and the interest rate. Hayek attributes this insight to many people, including Malthus, Mill, Bentham, etc. - but of course it is found in its most developed form in the hands of Knut Wicksell. Hayek muses that "by a curious irony of fate, Wicksell has become famous, not for his real improvements on the old doctrine, but for... his attempt to establish a rigid connection between the rate of interest and the changes in the general price level." This was interesting to read because I know Wicksell best for his "natural rate of interest" and loanable funds market theory of interest work, and not for whatever this other point is that Hayek is refering to. Clearly, the discipline has recognized in Wicksell as important exactly what Hayek recognized as important in 1931. That's encouraging! In 1931, Hayek felt that Wicksell was being acknowledged for the wrong thing, but now in 2010 we all acknowledge Wicksell for the work that Hayek thought was important.

I have another critique of Hayek here - I think he is far too hard on Wicksell when it comes to equilibrium and the price level. Hayek writes "according to Wicksell, the equilibrium rate of interest was a rate which simultaneously restricted the demand for real capital to the amount of savings available and secured stability of the price level" - taking issue with this position, Hayek counters that "the banks could either keep the demand for real capital within the limits set by the supply of savings, or keep the price level steady; but they cannot perform both functions at once. Except in a society in which there were no additions to the supply of savings, i.e., a stationary society, to keep the money rate of interest at the level of the equilibrium rate would mean that in times of expansion of production the price level would fall." Hayek's analysis here is right, of course, but I think his critique of Wicksell is misguided. Wicksell provides us with a loanable funds market equilibrium, right? The equilibrium position assumes a given demand for and supply of loanable funds. Of course if there is an "expansion of production the price level will fall", as Hayek says - but the whole point is if there is an expansion of production there will be a shift in the demand for loanable funds and there will be a new loanable funds market equilibrium. Imagine if you were describing a market for food and you noted that where supply and demand met you had an equilibrium price where the real price level would be stable. Hayek here is saying "well that doesn't make sense because if you make more bread the price level will fall!". Certainly it will, but that's because the supply curve has shifted. So, just as I would not take his critique of the quantity theory very seriously, I would not take his critique of Wicksell very seriously. There are ways to complicate and add to the loanable funds market, but there's nothing fundamentally wrong with it.

The fourth stage of the development of monetary theory is of course Hayek's turf: the impact of changes in the quantity of money on relative prices, particularly prices of the same good over time. I can't argue with the fact that this is one avenue to develop. I've never accused this version of ABCT of being illogical. Hayek is a little vague on why exactly this is such an important culmination of prior monetary theory. It appears to me to be an interesting side-issue to look into, not a conclusion towards which monetary work was naturally heading. But of course, my bias in this regard is probably obvious. If you asked a group of people reasonably well educated in the history of economic thought "which early twentieth century economist earned his fame for his work bringing monetary economics into mainstream economic theory", the answer would not be Hayek. The answer, in all likelihood, would be Keynes. This is not to say that Keynes invalidates Hayek's work. This was, at it's core, both of their projects. They both sought to make monetary theory relevant for the broader world of economic theory. My feeling is that Hayek took this project down a detour. It is an interesting detour and probably an accurate detour, but a much less significant path than the path that Keynes took. This seems to be the assessment of Hayek and Keynes's peers and descendants as well. Money is important because it is the medium through which demand is translated into effective demand, and the quantity of circulating medium substantially influences the efficacy of demand in stimulating production. I don't want to make this a post about Keynes, but the similarity between their missions was absolutely unmistakable in reading this first lecture.

I guess my lingering question is "why is this the fourth stage, other than because Hayek is writing about it and he wants to put it in the context of earlier stages?" Any answers? Why should I care more about relative prices than about the impact of money on effective demand?

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Other discussions of Hayek's first lecture tied into our reading group (graciously organized by Jonathan Catalan) can be found here, here, and here. Please let me know if I've missed one.