Sunday, December 11, 2011

Tyler Cowen makes a good point on ABCT (let's abstract from Hayek for a second)

Reviewing Wapshott's book, he writes:

"For all his brilliance, Hayek didn’t—at the critical time—have a good enough understanding of the dangers of deflation. He didn’t fully realize the extent of sticky wages and prices and, more deeply, he didn’t see that ongoing deflation would render the “calculation problem” of a market economy more difficult."

The "at the critical time" aside should do away with any need to argue about Hayek on NGDP targeting - a discussion that has never interested me all that much. The part I like is bolded.

A lot of Austrians seem to look at recessions like pressing the reset button on the economy. I've noted before in responses to Steve Horwitz (here and here) that this is exactly the opposite of how we ought to think about things. In the first link I write:

"Keynesians argue that the price distortion occurs in the bust, not the boom. Interest rates are too high, and the Austrians are embracing this distortion of the price mechanism as normal. When you hear Keynesians talk about stimulus, they don't usually talk about how it gives people jobs directly (although if you can do that on worthwhile projects like building roads and schools of course that's nice). When Brad DeLong talks about stimulus, for example, he always refers to its benefit as being the provision of high quality assets for which there is an excess demand. The point is to eliminate the price distortion in the interest rate, so that investors can once again engage in specialization and exchange."

This leads to some concerns about ABCT I've been hinting at a lot lately - concerns that I still don't feel I have adequately answered. I fully accept ABCT insofar as I accept that the capital structure changes with the interest rate. But from my perspective, the interest rate is "too high" during recessions so it seems to me that our biggest distortionary problem is in the bust. Austrians don't even seem to accept this possibility or address it. It's taken as an article of faith when things are "natural" and when they aren't.

If Austrians keep pretending people in the mainstream don't get specialization and exchange, or that they don't get profit and loss or that they don't get why we need to disaggregate (i.e. - if they take the Roberts/Papola approach), ABCT isn't going to get anywhere with the mainstream. The mainstream already gets all this, guys, and self-righteously re-explaining it to them is not going to get you anywhere.

The interest rate dynamics of malinvestment are also relatively straightforward. You're not going to have a hard time at all explaining that to the mainstream (and that's something that is probably genuinely new to a lot of them - this is your comparative advantage).

The place you're going to hit a roadblock is when you implicitly assume that recessions are periods where we work out the distortions of the growth years, when everyone else is assuming that the recession is the distortion.


  1. Curiously I was just writing a reply to your previous post on this...

    one thing that's curious that Ebeling doesn't speak to is why he thinks the production structure is consistent with time preferences in the slack economy. This is something I've been raising for a while. I don't think the idea that the structure of production responds to the interest rate should be all that controversial. As I try to point out over and over again, Keynes said it was - crediting Bohm-Bawerk - in chapter 16 of the GT. It's a fairly straightforward observation. But it seems it's precisely in a slack economy that the capital structure would be the most inconsistent with time preferences, and yet Ebeling's assumption here (and Garrison's too) is always for some reason that it is most inconsistent during periods of full employment. I still don't really have an answer to why someone would think that.

    None of us deny the possibility of a stable situation of full employment. We think that it's possible to have a capital structure that's consistent with the neutral interest rate and full employment at the same time.

    However, ABCT is all about the cause of crises. (It's much more concerned with their cause and prevention than with solutions to their aftermath). So, when we see a period of full employment and growth turn into a downturn we look to ABCT as a reason why. That causes us to doubt that the capital structure that existed up to that point was really consistent with the neutral interest rate.

    I would agree with you that if there is deflation during a recession then the capital structure is unlikely to be consistent with the neutral interest rate either. I think Ebeling would probably agree about that too if given a little more space to make a detailed argument. It seems to me though that if we have had ABCT then the capital structure during a recession is likely to be more consistent with the long run neutral interest rate than before hand, though we can't say for sure. In a recession the question becomes how can we get back to a reasonable capital structure. That's what you seem to be coming to in this post.

  2. Speaking for myself I don't believe in the "purging" idea. I don't think there is any reason to believe that price deflation will target malinvestmented projects only. I think it affects all businesses and projects.

    Now the question become "what happens to interest rates during a recession" that's a very complicated question really. What often happens is the interest rates on very safe and liquid assets become very low and interest rates on less safe assets rise. As Keynesians have often observed (though they're not alone in that).

    We could at this point discuss the liquidity trap. As I've said before I'm rather suspicious of that idea. It seems to me to concentrate too try to portray bank balances as too similar to bonds. And it seems to me to ignore other sorts of investment. (For example, I find it implausible that the UK is in the "zero lower bound" when I've been investing my own capital in bonds with a duration of 1 year or 2 years since the crisis. I have never got less than 3% interest).

    Anyway, going back to the "safe assets" idea. I'm not really sure this is the problem. Part of the issue here is the difference between supply and demand. Do we have an inflexible or declining supply of safe assets? Well, the 2008 crisis involved a major banking crisis so in that case there was. It's worth noting though that most cycles aren't like that. I think in general the banks can supply vast amounts of current account balances and short-term bonds. I don't think in general they need the state to step in to create more base.

    Of course the situation from 2008 to today is quite different. Without government intervention many large US banks would have gone bankrupt, the monetary base would have undoubtedly shrank drastically. The Fed successfully headed off that course. But the state of banks and banking doesn't seem to have improved all that much, they are still very fragile. I think that now there is a good argument that in 2008 what should have happened is that the bankrupt banks should have been taken through liquidation quickly. I think in the long run the suggestion of having "living wills" for banks (from Roubini & Mihm) is a good one for the future.

    While we're talking about "overinvestment" something I've been trying to figure out is if the *Keynesian* theory of crises is also an overinvestment theory. It seems to me that in Minsky's hands it's at least an overproduction theory. As I see it during the last stages of the boom (which he sees as endogenously generated by financial markets) there is over-production for both consumption and investment.

  3. I guess that I really cannot absolve myself of injecting that bit on price on that last bit, now can I?

  4. The thing is that most probably price distortions of the interest rate occur during the boom as well as the bust. But that does not imply that the bust cannot be perceived as a period of “recovery”. I think that for a Keynesian there is a need to consider a possibility that the boom period is propelled by the initial distortion, however during the boom it might be seen as beneficial, i.e. raising the welfare.
    What most probably occurs during the bust – and we might see it as a problem – is the overshooting effect in the loanable funds market. You could make a good case that the effect is needlessly high and thus induces a distortion. But that does not mean that in the intervention-free conditions the interest rate does not converge to its “natural” rate. In fact, this is a process of recovery, even if burdened with some costs. Actually, if those costs did not exist, the optimal strategy would be to induce one boom after another, because during a boom social welfare is ceteris paribus higher, and in case of the bust the economy would simply return to its pre-boom conditions.
    There is however a problem when you want to ease the effects of the overshooting. If the economy operated previously in the conditions of artificially lowered interest rate, you face the problem of determining how high the “natural” rate is. An Austrian’s argument would run as follows: only an intervention-free market process can discover its new “natural” interest rate. But I don’t believe that he would claim that the above process is not associated with any costs.
    The most important thing is, and Austrians clearly state so, that if the initial interest rate distortion did not occur, there would be no boom, and consequently no bust. That means that there would be no need to bear the costs of the bust. And here is when Austrian and Keynesian optics are at biggest odds: what Keynesians see as a problem, Austrians see as an effect. Naturally, the advised policies will be at odds as well.

  5. Daniel, it just comes down to interest rate mechanics. We think the boom is the distortion because of Wicksell's work on credit markets and interest rates. I wrote a nice 10-12 pg paper on the technical workings of ABCT - did you ever read it?

    In a barter society, the interest rate is a manifestation of time preference - and there truly will be no general interest rate, only specific interest rates per person. In barter, there is no "price" for wheat; only specific bargains and transactions.

    When money emerges through barter, the same process that happens with wheat and iron happens to the interest rate - people arbitrage until it finds an equilibrium rate. This equilibrium represents the price at which people will sell time.

    I do not believe Keynes can be fully correct in a LP theory because interest payments still accrue in barter. There may be some validity in a fractional reserve environment, though.

  6. I think Black Lion's comment is good, and I agree with him.

    He mentions something interesting:
    "Actually, if those costs did not exist, the optimal strategy would be to induce one boom after another, because during a boom social welfare is ceteris paribus higher, and in case of the bust the economy would simply return to its pre-boom conditions."

    Recently we discussed the reasons Mises gave to separate his theory from other "overinvestment" theories. The reason Mises wanted to do this was because of some ideas from Schumpeter. When Schumpeter read "The Theory of Money and Credit" he reasoned that Mises was right about forced saving, but he saw forced saving as beneficial in the long run. That is, a credit induced boom can cut the real price of labour at the expense of present labourers, but to the *benefit* of future generations who are aided by the greater capital accumulated. I think the comments Mises wrote in Human Action are specifically targeted at debunking this idea. More clearly though p.106-108 of "The Causes of Economic Crises" are about tackling that view.

  7. Daniel,

    I think your post overlooks the fact that both in the boom and the bust Austrians think that it is interventionist policies that cause the distortions. Without intervention (Austrians believe) free-market processes would lead to optimal outcomes both in minimizing the depth and frequency of the busts and providing the fastest recovery when they do occur.

    Even in a recession where it is obvious that resources (such as labor) are being un-utilized most Austrians believe that artificially lowering the rate of interest below the market clearing rate will still cause malinvestments that will lay the seeds for future busts.

    This sounds counter-intuitive but there are good theoretical reasons for this view.

    Austrians believe that one of the main causes of the bust is the need to abandon those projects which (it becomes clear) will never be profitable. The reason for unused resources in a bust then is not deficient AD but rather that the capital and price structure (plus general disorientation) left over from the preceding artificial boom needs to adjust.

    This will cause a temporary decline in investment demand. The demand for labor will shift to the left and the supply of labor will move along the supply curve - leading to a decrease in employment levels.

    Austrians would tend to see the supply curve for labor as being unduly flattened by by supply-side factors like UI and minimum wage laws causing employment levels to be lower than they otherwise would be. They also see the labor supply as itself having been distorted by the requirements of the boom years in the same way as the capital structure was and likewise causing structural issues.

    Without intervention Austrians believe that these would be short-term effects and soon the demand for labor would pick up again. Attempts to "fast-track" a solution via artificially inflating AD will simply prolong the life of the old mal-investments and allow new ones to develop in parallel.

    One other note: This is a bit controversial in Austrian circles but some Austrians (those whop support free banking and worry about "secondary deflations") would expect that IRs would tend to be low or even zero during busts, and may even support CB action to expand the money supply and lower interest rates on the basis that this is what would happen in a free market with free banks.

  8. liquidationist, Mattheus, and others -
    I'm very well aware of what Austrians think of the source of recessions. What I'm saying is that ABCT is still of value to a mainstream that considers this to be quite wrong.

    A lot of Austrians make so much hype of the "end the Fed" stuff that they rarely even consider how their views on the capital structure might be integrated into a mainstream theory. That strikes me as a real waste.

    But trust me - this: "I think your post overlooks the fact that both in the boom and the bust Austrians think that it is interventionist policies that cause the distortions." is not lost on me. I just think it's wrong, and I think Austrians spend too much time defending this and too little time talking about their capital theory.

    Mattheus I think I did read it but feel free to send/link again.

  9. One problem I have with the view that the bust is the distortion is the lack of a robust explanation for its cause. A "demand shock" is such a weak theoretical basis for a bust ("supply shocks" are not much better but at least they're palpable). More than anything, they seem to require such a high degree of faith, as you can only produce them under very special conditions - simulations of things like "cascade failures" are what I have in mind. And these special conditions don't seem to be a part of the arguments by those in favor of the demand shock explanation.

    In any case, characterizing the cause of AD failure as the "housing shock" just pushes the question back further - what caused the housing shock? If you literally thought it was a shock caused by some random deficiency in demand, then I'd argue you're ignoring the basic feedback mechanisms that we learn in econ 101. If you think the housing shock was a bubble, at least in part caused by low interest rates, then I find it difficult to argue that the bust is the distortion. Isn't the popping of the bubble a correction? And if we believe in general equilibrium effects, then the bubble whose peak was the housing market will extend to the whole of the economy. And as such, the bust should be considered more of a correction than a distortion.

    Tell me where I'm going wrong here because I find it hard to view our current situation as the distortion. Are you saying that initially it may have been corrective but then it morphed into being distortionary? I find this defensible, but I've never gotten the impression that that's what you're arguing.

  10. Well, OK. In defense my post assumed that you understood the causes of the bust. I was rather trying to address your statement 'But from my perspective, the interest rate is "too high" during recessions '.

    But I guess I now see that your post was really an attempt not to discuss that point but rather to advise Austrians that maybe they could be accepted by the mainstream a bit more if only they would downplay the controversial free-market stuff a bit :)

  11. "I think Austrians spend too much time defending this and too little time talking about their capital theory"

    On this point, I guess that I can somewhat agree with you. However, I am rather curious about your comments regarding your opinion that Mises, "simply doesn’t want to be associated with Marxists."

    What gives?

  12. Sorry, I am of course talking about your comment on Murphy's blog (for the sake of continuity).

  13. re: "But I guess I now see that your post was really an attempt not to discuss that point but rather to advise Austrians that maybe they could be accepted by the mainstream a bit more if only they would downplay the controversial free-market stuff a bit :) "

    Downplaying free markets is NOT a good way to get more respect from mainstream economists!!!!

  14. This comment has been removed by the author.

  15. I think Daniel means ditching the political theory underpinning it and not the emphasis on free markets in general.

  16. I was joking in my comment. I also observe that Austrians can sometimes come across as sounding like stuck records. One needs to make an attempt to get away from the rhetoric and find the real common ground and real differences.

    I very much respect Daniel's attempt to do that in his blog.

  17. Certainly Austrian Capital theory isn't just about ABCT. Too much of it is an attempt to underpin ABCT rather than a separate exercise. That said, I think few of us are interested in using Austrian Capital theory to undermine ABCT.

    If you want to have a go be my guest ;)

  18. @ Current

    Actually, I don't think that the capital theory (I'm using "the" because I don't know any other CT) is a necessary requirement for the ABCT. You can write a DGE model without referring to the CT and still make it replicate the ABC.

    From this viewpoint I can appreciate Daniel's comments. You can integrate the CT into the mainstream economics and put it to good use, without forcing the mainstream to accept the ABCT.

  19. I generally try to interpret things in the way that doesn't make the writer sound like he has no idea what the hell he is talking about, but I'm having trouble with this:

    "Keynesians argue that the price distortion occurs in the bust, not the boom."

    You can look at the Case-Shiller real housing price index and conclude that it's the boom that's normal? You can look at a chart of commercial lending versus deviation from the original Taylor rule and conclude that it's during the recession where distorted behavior is occurring? You can look at European NGDP and conclude that everything is fine until the recession? You can look at international flows of gold during the 20's and conclude that there are no distortions here? I know you study your economic history well enough to be aware of all these facts. So, how? How do you look at them and see a normal, healthy economy?

  20. Daniel,

  21. t3nk3n -
    Asset bubbles and irrational exuberance in the financial markets are extremely important for understanding the causes of the bust. Certainly there's some misallocation associated with these.

    But I don't think we should confuse bubble psychology with an elongation of the capital structure.

    People often make these strange claims that Keynes doesn't explain the cause of the bust. It's nonsense - he talks at length about precisely the sort of things you list. Bubble psychology is crucial. But I think if you look at the last several instances - the housing bust, the tech bust, the S&L bust, etc. - it has a lot more to do with bubble psychology in top of a healthy economy than any sort of ABCT dynamic.

    Mattheus - thanks

  22. Black Lion,

    Arguments about relative prices can be used as a substitute for a more complex argument about capital structure. I don't find those arguments very clear though. Daniel is certainly right that a form of capital theory could make it's way into mainstream economics.

  23. "But I don't think we should confuse bubble psychology with an elongation of the capital structure."

    Here's a question then.... In your variant of Austrian Capital theory is it possible to have a rate of interest below the neutral rate. If it is then is that damaging?

  24. So when I think of ABCT I don't think "oh that's such a sham". Certainly one could imagine an interest rate below a neutral rate, and I'm not interested in revising everything that everyone's always said that will do to the capital structure.

    Whether it's damaging, of course, depends on why the rate is so low to begin with. Certainly it might make sense to err on the side of being too low at times - if, for example, the potential damage from malinvestments is less significant than the potential damage from not keeping rates low enough.

    But that's all entirely an empirical question.

    And empirics is exactly why I think ABCT is so important. Andrew Young and several other recent papers have done a lot of good work looking at shifts in the capital structure in the data. It can't just be ignored. I'm just not sure it has the full business cycle implications that are often attributed to it (for the reasons I've been musing on here).

  25. From the political point of view I can't help noticing that Daniel's theory is very clever. On the one hand during a boom the capital structure is consistent with interest rates, so no action is necessary and the central bank can do what it likes. Then the markets cause a bust through their fits of irrational exuberance - which of course means the markets need much regulation. Then when there is a bust we have the twin threat of unemployment and of a distorted capital structure causing lower growth in the future. Naturally this doubles the argument for Keynesian stimulus ;)

    Anyway, back to economics.... I agree that ABCT could do with more empirical research. Though I think doing that research will be very difficult.

    But, the problem with Capital theory is that it points towards the interest rate, as we have discussed. Minsky and Mises both provide possible causes for the business cycle. As you point out Minsky's is in some ways an expansion of Keynes'.

    I think it's useful at this point to discuss the relationship between these ideas. Now, being a Keynesian you are fond of Keynes and Minsky's view and wish to absolve Central Bankers of blame. But, once the capital <-> interest rate link is established that becomes more difficult. What I think Minsky is saying is that irrational factors influence the broad interest rate. If you think carefully about the productivity theory of interest (or the productivity plus time-preference theory) then it becomes clear that it's really expected productivity that matters. So, psychology plays a role. If an entrepreneur perceives that the future is full of opportunities then he will invest heavily in new projects, that will cause incomes elsewhere to rise. If short-term incomes are used to value capital stocks then the value of that capital will rise. But, that sort of explanation is very like what ABCT says about money. In ABCT the issue is much simpler, Central banks inject money and it spreads. Or to put matters differently, central banks control short-term interest rates and heavily influence short-term price-inflation rates. Those two aggregates are what links the present and future in monetary calculation.

    That makes it clear what Minsky's supporters are really saying. They're saying that entrepreneurs can somehow see through the influence of central banks, but can't see through the influence of other entrepreneurs. That is, if demand for their products rise because the central bank pushes creates money beyond the demand for it then entrepreneurs can somehow tell that their extra money profits won't result in the same real profits, and that the extra demand will be short-lived. But, on the other hand, if the same sort of thing happens for psychological reasons that are endogenous to the market then somehow entrepreneurs can't the same sort of thing. I can't see how this can be.

    I can see that an economist could agree with Minsky and Mises, and that an economist could agree with just Mises. But, I don't see how it's possible to just agree with Minsky.


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