Monday, July 12, 2010

Is Deflation the Enemy, or Is It Inflation?

Like all Keynesian True Believers, Paul Krugman believes that the worst enemy of the economy is deflation. In his view, deflation causes unemployment and inflation reduces it, and he repeats that canard in this recent column.

Not surprisingly, Krugman claims that unless the Fed under Ben Bernanke engages in massive new money creation (and, of course, spending), the economy is doomed:
Today, Mr. Bernanke is the Fed’s chairman — and his 2002 speech reads like famous last words. We aren’t literally suffering deflation (yet). But inflation is far below the Fed’s preferred rate of 1.7 to 2 percent, and trending steadily lower; it’s a good bet that by some measures we’ll be seeing deflation by sometime next year. Meanwhile, we already have painfully slow growth, very high joblessness, and intractable financial problems. And what is the Fed’s response? It’s debating — with ponderous slowness — whether maybe, possibly, it should consider trying to do something about the situation, one of these days.

The Fed’s fecklessness is, to be sure, not unique. It has been astonishing and infuriating, as the economic crisis has unfolded, to watch America’s political class defining normalcy down. As recently as two years ago, anyone predicting the current state of affairs (not only is unemployment disastrously high, but most forecasts say that it will stay very high for years) would have been dismissed as a crazy alarmist. Now that the nightmare has become reality, however — and yes, it is a nightmare for millions of Americans — Washington seems to feel absolutely no sense of urgency. Are hopes being destroyed, small businesses being driven into bankruptcy, lives being blighted? Never mind, let’s talk about the evils of budget deficits.
In response, I will include material from Murray N. Rothbard's America's Great Depression, a recent article by Robert Higgs, and something I wrote for the Mises Institute two years ago. First, we look at what Rothbard has to say regarding deflation:
With the supply of money falling, and the demand for money increasing, generally falling prices are a consequent feature of most depressions. A general price fall, however, is caused by the secondary, rather than by the inherent, features of depressions. Almost all economists, even those who see that the depression adjustment process should be permitted to function unhampered, take a very gloomy view of the secondary deflation and price fall, and assert that they unnecessarily aggravate the severity of depressions. This view, however, is incorrect. These processes not only do not aggravate the depression, they have positively beneficial effects.

There is, for example, no warrant whatever for the common hostility toward "hoarding." There is no criterion, first of all, to define "hoarding"; the charge inevitably boils down to mean that A thinks that B is keeping more cash balances than A deems appropriate for B. Certainly there is no objective criterion to decide when an increase in cash balance becomes a "hoard." Second, we have seen that the demand for money increases as a result of certain needs and values of the people; in a depression, fears of business liquidation and expectations of price declines particularly spur this rise. By what standards can these valuations be called "illegitimate"? A general price fall is the way that an increase in the demand for money can be satisfied; for lower prices mean that the same total cash balances have greater effectiveness, greater "real" command over goods and services. In short, the desire for increased real cash balances has now been satisfied.

Furthermore, the demand for money will decline again as soon as the liquidation and adjustment processes are finished. For the completion of liquidation removes the uncertainties of impending bankruptcy and ends the borrowers' scramble for cash. A rapid unhampered fall in prices, both in general (adjusting to the changed money-relation), and particularly in goods of higher orders (adjusting to the malinvestments of the boom) will speedily end the realignment processes and remove expectations of further declines. Thus, the sooner the various adjustments, primary and secondary, are carried out, the sooner will the demand for money fall once again. This, of course, is just one part of the general economic "return to normal."
In other words, Rothbard says that deflation will help the adjustment process in which the economic fundamentals get back into balance. Given that Krugman operates on the theory that all assets are homogeneous, he is incapable of understanding anything else.

Prof. Higgs notes this about Keynesians and inflation and deflation:
With their great, simple faith in the efficacy of government spending as a macroeconomic balance wheel, vulgar Keynesians disregard malinvestment, past and future, and support government spending in excess of the government’s revenues, the difference being covered by borrowing. Of course, they favor central-bank actions to make such borrowing cheaper for the government. In fact, they chronically prefer “easy money” to more restrictive central-bank policies. As noted previously, they prefer easy money not only because it lowers the cost of financing the government’s deficit spending, but also because it induces individuals to borrow more money and spend it for consumption goods ― such increased consumption spending being viewed as always a good thing, notwithstanding the recent near-zero rate of saving by individuals in the United States. Reflecting on the vulgar Keynesian attitude toward Fed policy, I keep recalling a old country song whose refrain was: “older whiskey, faster horses, younger women, more money.”

Vulgar Keynesians do not spend much time worrying about potential inflation; on the contrary, they are obsessed with an irrational fear of even the slightest hint of deflation. If inflation should become an undeniable problem, we may count on them to support price controls, which, they are convinced on the basis of sketchy knowledge of such controls during World War II, can be made to work well.
In this article, I noted that the current crisis came about because of the Fed's reckless money creation, so it certainly is NOT possible that the Fed can SOLVE the problem with more inflation:
The central issue is that the Fed pushed a policy of inflation, with much of the new money going into the mortgage markets; there is no way to avoid the painful and terrible corrections that must follow such fiscal foolishness. (Now we finally see massive commodity-price increases, which have occurred because there is nowhere for the new money to go but directly into commodities and consumer goods.)

Anyone who believes that the Fed can pretend that heavily damaged mortgage securities are worth more than toilet paper and literally build a $200 billion loan portfolio upon them does not understand finance. Just because Ben Bernanke declares something to be "valuable" does not bestow value upon it.

The simple issue is not lack of liquidity. It is the fact that billions — make that trillions — of dollars were malinvested in markets where the increasing values could not be sustained. To pump near-worthless dollars into this mix does not solve anything; it only ensures that the coming day of reckoning will be even more unpleasant than it would have been otherwise.
So, if the Fed follows Krugman's demands, we can look forward to even more secondary contractions and more malinvestments. The "day of reckoning" won't arrive all at once; it will become a permanent part of our economic landscape.

40 comments:

AP Lerner said...

Once again, it becomes pretty clear that Prof. Anderson and Prof. Higgs do not understand how the monetary system works operationally. And if you don’t understand how the monetary works, how can you critique monetary or fiscal policy? I don’t know much about airplanes, so I leave the repair of my airplane to my airplane mechanic. There’s so many inconsistencies in this post I could go on for pages. But I’ll focus on one aspect that is particularly wrong, and should be obvious to anyone that puts a little thought into it:

“Of course, they favor central-bank actions to make such borrowing cheaper for the government”

Prof. Higss must not realize we are no longer on the gold standard. And since we live in an economy where the government is the monopoly issuer of a non convertible free floating currency, the government does not fund itself with borrowing. From an operational perspective, all borrowing does is change reserve balances in the banking system. That is it. End of story. Ask yourself this, in the 80’s when rates were high due to inflation, did the government scramble to find new sources of cheap funding? Did any bond auctions fail? Did Reagan take Volcker out back and beat him senseless for raising the fed funds rate? Or course not. Government spending creates the reserves needed to purchase government securities. End of story.

This is not Keynesian rhetoric, nor is it Austrian, or monetarism or any other label economist obsess about putting on people. This is the mechanics of a fiat monetary system. Spend a few years on a money market trading desk, or at the NY Fed trading desk, and this is pretty obvious. What is also obvious is the so called experts just do not get it, and their so called analysis does more harm than good.

Jonathan M. F. Catalán said...

Paying it through inflation doesn't mean it's not borrowing.

Craig said...

This is not Keynesian rhetoric, nor is it Austrian, or monetarism or any other label economist obsess about putting on people. This is the mechanics of a fiat monetary system.

Yes, and that's the problem; and you and your ilk seem perfectly sanguine with the damage that such a system creates. Curious.

jason h said...

You do know the U.S. gov't isn't actually issuing the currency.

Its called a Federal Reserve Note because the 'independent' Fed is creating the reserves. Although, maybe you are hinting that the Fed is not so independent.

Operationally speaking, the Fed creates a reserve in their account, then writes a check and purchases gov't bonds from say, Goldman Sachs, in the open market.

Ned Netterville said...

I posted my comment following your blog on this issue at the Mises.org website: Here: http://blog.mises.org/13237/paul-krugman-im-shocked-gets-it-wrong-on-deflation/

Anonymous said...

You should listen to what a wise man named Friedrich Hayek has said on deflation.

http://tinyurl.com/2dhcred
"I am the last to deny – or rather, I am today the last to deny – that, in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate. I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed. … I would no longer maintain, as I did in the early ‘30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognizable function whatever, and that there is no justification for supporting or permitting a process of deflation."


http://mises.org/journals/qjae/pdf/qjae6_4_3.pdf
In other lectures that same year, Hayek makes more interesting comments about his new attitude towards deflation (Hayek 1979). There he explicitly confesses that he has changed his opinion about it. A threatening deflation must be stopped because due to the disappointment of expectations, it tends to induce a “secondary deflation,” that “performs no steering function” (p. 15). Hayek states that were he responsible for monetary policy, he would prevent deflation by announcing that he would fight deflation with all means. This very announcement, he believes, would help to stave off a deflation. And he again shows his new inflationary bias by pointing out that “monetary policy must prevent wide fluctuations in the quantity of money or in the income stream”

Was Hayek a total buffoon too?

jason h said...

Isn't Hayek using the Austrian definition of inflation and deflation? The artificial increase and decrease in the money supply. Not the Keynesian definition of the general rise in fall of prices. Big difference.

Anonymous said...

"Isn't Hayek using the Austrian definition of inflation and deflation? "

Perhaps, but generally an decrease in the money supply is ultimately translated into a fall in the price level as well.

He says
"deflation of some short duration might break the rigidity of wages"

Here, he clearly implies a fall in the price level because that's the relevant factor in sticky wages.

Anonymous said...

"The artificial increase and decrease in the money supply."

That's a narrow definition. Why does it need to be "artificial?" The money supply can fall by itself with or without government intervention, which has happened in every recession.

http://i.imgur.com/0EvYM.gif

Jonathan M. F. Catalán said...

Anonymous,

I think most Austrians agree that price deflation brought about by a fall in the supply of moneys is harmful, because it ultimately causes "capital disequilibrium".

Please see: http://www.economicthought.net/2010/07/consistency-and-deflation/

Anonymous said...

"I think most Austrians agree that price deflation brought about by a fall in the supply of moneys is harmful"

I wouldn't say most. At least the most vocals ones on the internet are usually for deflation. As far as I can tell William L. Anderson isn't one of those people that see deflation as a danger. But anyway, preventing deflation implies using expansionary monetary policy, although I get that ideally Austrians wouldn't want a central banks around in the first place. But as a practical matter, you shouldn't be encouraging deflation, which happens naturally in every modern recession.

Also in that paper I posted from mises, the author seems to be criticizing Hayek for wanting to prevent deflation so there hardly seems to be a consensus among Austrians about the deflation issue.

Jonathan M. F. Catalán said...

Anon,

I think you are confusing Hayek's position. Hayek didn't regard price deflation as dangerous. He saw monetary deflation, or a decrease in the supply of money, as dangerous (which can also cause price deflation, because there is of course less money in circulation).

On the other hand, Hayek saw price deflation as a result of an increase in productivity as a good thing (as do all Austrian economists).

I agree that there isn't really consensus, although I think both Mises and Hayek saw falls in the volume of money as harmful. But, both Hayek and Mises would agree that a fall in the supply of money was a consequence of the previous boom (as the rate of defaults increase).

In any case, I am writing an article on exactly this topic.

Anonymous said...

"On the other hand, Hayek saw price deflation as a result of an increase in productivity as a good thing (as do all Austrian economists)."

I don't think anyone would disagree with that, Keynesian or Austrian. I think this is a moot point though because we're talking about deflation in the context of a recession, which I think by the most part, any fall in the price level would be related to deflation in the money supply right now. I hardly think an increase in productivity is what's causing the crux deflationary pressure right now.

"although I think both Mises and Hayek saw falls in the volume of money as harmful."

I think Hayek saw it that way too (although it seems he didn't believe that back in the great depression era), which is why I posted those quotes, but from what I'm reading this blog, William Anderson would disagree that deflation is bad right now.

Anonymous said...

Catalán, okay I read your blog post more carefully. I think I understand your point of view more clearly. So we both agree that a fall in the money supply doesn't do the economy any good. In the article Anderson linked written by himself though, he does say that the fall in the in the money supply is not catastrophic to the economy and disagrees with Milton Friedman with that point. So he disagrees with what Hayek, you, and I think to that extent.

Anyway, here's what comes right before the first Hayek quote I posted.

------
“The second situation in which it is true that an increase of employment requires an increase in aggregate demand,” Hayek (1974, p. 5) now maintains, “is found in the later stages of a depression when, in consequence of the appearance of extensive unemployment, the economy frequently is subjected to a cumulative process of contraction of secondary deflation, which may go on for a very long time.” He concludes:


"I am the last to deny – or rather, I am today the last to deny – that, in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate. I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed. … I would no longer maintain, as I did in the early ‘30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognizable function whatever, and that there is no justification for supporting or permitting a process of deflation."

----

I think this describes the Great Depression, Japan's Lost Decade, and our current recession in the US perfectly. The mechanism to increase aggregate demand (in order to increase employment) is through monetary stimulus. In the second paragraph, Hayek says "deliberate attempts to maintain the money stream, are appropriate." He's implying to target nominal GDP through monetary expansion. Although Krugman says to target an inflation rate, I don't think the concept behind what Krugman is saying is that different from what Hayek suggests. (targeting NGDP)

William L. Anderson said...

Deflation CAN be disastrous IF the government insists upon keeping failing enterprises alive, as was the case in Japan. During a period of deflation, the malinvested capital and resources should be liquidated or changed to other uses that would be profitable.

Certainly the short-term effects of deflation are very painful. Owners of capital and factors of production are going to have to take reductions in pay, and people don't like that. In fact, Hayek would have been agreeing with Keynes in saying that prices for factors (including and especially wages) are "sticky downward."

I don't disagree with that assessment; I DO disagree with the Keynesian notion that in order to adjust REAL prices of factors downward, government should inflate.

With inflation, one gets the "good effects" first, but the bad effects kick in later, and what happens is the distortion of the relationships of the factors. Keynesians operate on the assumption that factors are homogeneous, so inflation always will put things back into balance, in that view.

Deflation, however, gives us the "bad effects" first, and there is the public outcry for government to "stop the pain." That is the theme of most of Krugman's columns and blog posts these days. His view is that only the "short run" matters, reflecting Keynes' view that "In the long run, we all are dead."

Obviously, when governments place a floor on the prices of factors (and not just wages), deflation will have disastrous effects because the adjustments of the factors will be halted, and the result will be unemployment. I am arguing that government should NOT be placing structural barriers against the adjustment of the factors.

What we have to understand is that because of these structural barriers against adjustment, we have to bear a cost of problems in the economy, including unemployment. However, I can see that at least some people commenting here believe that such barriers constitute a "solution," not a problem. So be it.

AP Lerner said...

@ Jason H – yes, exactly. That is exactly how the monetary system operates. While monetary policy is conducted ‘independently’ from fiscal policy (the Fed does not tax and spend) it clearly is not an independent entity.

@ Jonathan M. F. Catalán – I’m not sure what you mean by saying “Paying it through inflation doesn't mean it's not borrowing”. My point was Higss and Anderson repeatedly insist the US government represents credit risk, and is on the verge of bankruptcy. This is not correct, and is a misunderstanding of how the US government funds itself. Yes, inflation is a risk, but that is different from credit risk. The US government is not a household, and is not a corporation.

@ Anon – “The mechanism to increase aggregate demand (in order to increase employment) is through monetary stimulus.”

Agreed. Except, against the zero bound, there is little room for additional monetary stimulus (which is why the money supply was falling). Higher deficits are needed to offset the shrinking money supply. I’m sure every person on this blog would agree lower taxes would help the situation, so even so called Austrians agree with this concept.

“What we have to understand is that because of these structural barriers against adjustment, we have to bear a cost of problems in the economy, including unemployment.”

I don’t think anyone denies this, including Krugman. The point here is the government, with its sudden rush to cut deficits and implement austerity are actually making the short term and long term problem worse. The simple reality is this is a balance sheet recession, credit is being destroyed by the billions every month and the only way out of this is to eliminate debt. The government can alleviate some of the pain by running bigger deficits, since bigger public deficits = higher private savings. Public deficits always equal net private savings (which is why the surpluses of the late 90’s caused the credit bubble, not Fed money printing, but that’s another topic for another day). Some folks (including Krugman) seem to forget there’s two ways to run deficits…and significant cuts in payroll taxes would do wonders right about now.

Tocano said...

@AP Lerner - I'm confused and legitimately curious. I've never heard that equation: Public deficit = private savings. How do you calculate that? Does that mean that every year since the like 1957, US private savings have increased? That seems counter to the observation that over the last 40 years, a larger and larger % of the US population is in ever larger debt.

What does explain that, (and seems to make sense to me) is that an intentionally inflationary monetary policy, and artificially low interest rates, incentivize borrowing (i.e. increases the time-preference demand for money), thereby creating the culture of debt we see.

So I'm having a hard time understanding how this is just simple arithmetic of negative money here means positive money there. I feel a variable (or 6) is missing.

Thought experiment: If this whole thing is just a balance sheet problem, then what would happen if the US govt borrowed the $6-7 trillion it owes foreign countries and private individuals from the Fed, then just had the Fed "erase" those balances and "forgive the debt"?

Anonymous said...

Anderson should start a Hayek-in-Wonderland blog seeing how wrong he thinks Hayek is. Make sure to include as many ad hominems as possible.

AP Lerner said...

Hi Tacano – all very good questions. I think many people on this blog, especially Prof. Anderson, will benefit from my answers.

When I refer to public deficits = net private savings, I am referring to a very simplified version of the accounting identity:

net household financial income = current account surplus + government deficit + Δbusiness non-financial assets

In simpler terms, public deficits = net private savings. There is not enough space to prove of this identity, but looking at this chart, it becomes pretty obvious.

http://images.creditwritedowns.com/2010/01/financial-sector-balances.png

Notice two things. 1) whenever deficits rise, so do private savings. Therefore, when deficits shrink, so does private savings. 2) the government ran surpluses in the late 90’s. Consequently, this drained savings and income from the private sector, distorting the credit markets, and creating a credit bubble (contrary to what Prof. Anderson believes, it was the surpluses of the late 90’s that created the credit bubble, not Fed money printing, but that’s another topic).

So, when you say “Does that mean that every year since the like 1957, US private savings have increased?” yes, that’s true, except during surplus years, like the late 90’s. Keep in mind, the private sector is made up of more than individuals…folks seem to forget about corporations, and there has been a corporate savings glut for some time now (Prof. Anderson will tell you the glut is because of the anti business Obama, but of course this is nonsense since it’s been going on for decades, as this chart shows)

http://www.newyorkfed.org/research/current_issues/ci13-4/chart3.html

Notice total savings stayed high despite personal savings going to zero.

So the overriding error in Prof. Anderson and Prof. Higgs logic (actually, it’s not logic, it’s partisan rhetoric and a silly disdain for Krugman when you get down to it) is this: both the private sector AND the public sector cannot de-lever at the same time. Impossible. So by arguing the US government should shrink the deficit, you are arguing the private sector should not de-lever, and the one thing I think we all can agree on is the private sector MUST de-lever.

As for your thought experiment, a few critical errors. 1) the government and the central bank are both part of the public sector. So looking at them as two separate entities is not correct. 2) the US government does not have ‘creditor’s. All government securities do is impact reserve balances. But if you don’t believe this, I’ll run with your experiment for a moment. If the government ‘borrows’ from the Fed, then they spend the money in the private sector. This creates reserves in the banking system, which in turn is used to ‘loan’ the money to the government. The net impact – nothing. It’s a myth to believe the US government funds itself like a household or corporation. I can go further into this, but it’s based on the fact the US government is never revenue constrained since they are the monopoly issuer of a non-convertible currency with 100% of their ‘liabilities’ denominated in USD.

For some reason, the above logic, data, facts, and reality is lost on this blog, and, unfortunately, it is lost with policy makers. And we will all suffer the unnecessary consequences of unnecessary austerity

Anonymous said...

I would like to see Mr Anderson respond to AP Lerner's post.

Jonathan M. F. Catalán said...

Unfortunately, AP Lerner's post is very convoluted, unclear, ambiguous, and confusing, so I don't think anybody will be able to provide a proper rebuttal.

A comment, however. He writes, "2) the government ran surpluses in the late 90’s."

IIRC, this is untrue. Clinton only ran "surpluses" because he drew funds from other government programs in order to pay for present spending. In other words, he drew funds from reserves like social security (in fact, I think social security was the very fund he drew most of the necessary money from).

The result was an accounting illusion, where he could boast of surpluses, but in fact spending actually stilled outstripped revenue.

AP Lerner said...

@ Jonathan M. F. Catalán - convoluted and unclear? Do you not believe in statistics and data? And sorry, your comment on the 90's deficits is not accurate. It appears, you have a fundamental misunderstanding of how the monetary system operates. The government does not borrow or draw funds from itself. You continue to view the governments balance sheet like a corporation or a household, and as long as you continue to view the government this way, you won't be able to understand how the monetary system operates. Even if we assume your comment about the surpluses being an accounting illusion is true, what is not up for debate is the deficit shrunk during the late 90's. It shrunk massively and quickly as tax revenues increased rapidly, and when this happens, it draws savings and income from the private sector, distorting the credit markets.

I know it's unlikely I'll get a logical response, much like when I posted questions asking why bond rates keep falling. It's unfortunate.

Jonathan M. F. Catalán said...

AP Lerner,

The statistics are clear. What remains unclear is the legitimacy of how they were extrapolated (your "simple accounting identity").

In any case, you continue to bring up how government funds itself, but by doing so you completely miss my point. You said the Clinton administration ran surpluses. No, it did not, by any accounting method. It simply drew funds from social security in order to make it seem that it had run surpluses. But, spending was higher than tax revenue.

I am not commenting on how the government funds itself. I am commenting on the accounting tricks the Clinton administration did to make it seem as if they had run surpluses. They had not. They had run deficits.

AP Lerner said...

Ok, I'm not going to debate you that tax revenues were higher than expenditures in the 90's, even if data from heritage.org says so.

http://www.heritage.org/budgetchartbook/growth-federal-spending-revenue

And I thought Heritage was always 100% accurate? Ok, so maybe Heritage fell for the same accounting gimmick. But what can't be debated is tax revenues exploded in the 90's, and spending essentially flat lined:

http://www.heritage.org/budgetchartbook/federal-government-revenues

So is your point the deficit never shrunk in the 90's? Are you saying it got bigger? Even if you believe there was never a surplus, you do agree it shrunk, right? If you tell me the deficit got bigger, then I'll see your point. I'll disagree, but I'll be able to understand your logic. The direction of the deficit is very important.

Ok, if you believe it shrunk, then the math is pretty simple:

Public deficits = net private savings.

As public deficits go down, private savings go down. It's pretty basic accounting taught in econ 101. If you have research disproving this identity, please send it along. Logically, it should make sense. The reality is taxes were too high in the 90's, the deficit got too small (turned positive), and when this happens, private savings get too low, or in this case, turned negative, creating a credit bubble.

So my overriding point is this: cutting the deficit now, now, now, only prolongs the required de-leveraging of the private sector. It's simply math, reality, and common sense.

Tocano said...
This comment has been removed by the author.
Tocano said...

As I understand the Austrian viewpoint, the reason why it's not always easy to explain every abnormality in the market is because Austrians, unlike Keynesians like Paul Krugman, recognize that there are almost always more variables than are considered.

At one time, the idea higher taxes = higher tax revenue was considered a sound economic position. Then Laffer realizes that there's a variable that was overlooked that shows that after a certain point, higher taxes = lower tax revenue. But because of other variables that Laffer may not have considered (like patriotic nationalism during war), sometimes even that's wrong.

Those who know please correct me, but as I understand it, Austrians aren't saying "We know everything." They're saying, "You don't either." It seems they're accused of saying, "You can never know anything." But it seems to me that they are saying, "It's almost impossible to look at a correlated graph or statistic, and directly assume causation because of the sheer number of variables in play."

I've gathered that Austrians view economics as a social science that should be evaluated through observation and logical deduction (like anthropology). Thus, many accuse Austrian economics as not being "scientific" because they don't view empirical analysis as valid. However, in the hard/natural sciences, to really gather empirical data of the impact of certain changes to a system, you have to have two identical systems: one test and one control. Then, when you change a single variable, you can know that that variable was the cause of whatever difference in result. Because of the scale of macroeconomics, you CANNOT setup such a situation because you cannot have 2 identical systems and you cannot control every single variable. So, to me, it seems the very people that accuse Austrians of being non-scientific, often overlook the rigidity of hard science itself. You have to know and hopefully control EVERY variable in order to draw the correct conclusions about the impact of changing one of them.

Y = I + (X - M) + C + G

The aggregate demand seems to be one of the central equations of Keynesians. But what if they have overlooked a variable or two? What if it would be more accurate to say:

Y = I + (X - M) + (C - .5G) + .5G

because govt spending is half as efficient as direct consumer spending? Or where is the variable to distinguish between govt spending tax money vs spending debt or newly created money? It would seem pretty obvious that the TYPE of money has different impacts on the economy. It cannot possibly be just "The larger that Y is, the better things are."

Anonymous said...

If we don't know every variable, how can Austrians call Obama's stimulus a total failure and say it didn't do anything? Do they look at the unemployment rate and conclude it didn't do anything? Or do they just base it of their preconceived notion that government spending never does anything because that's what Austrian economics says? Seeing how empirical evidence is useless to them because there will always be unknown variables, it would have to be the later, right? So theoretically, if the unemployment rate went down to 3% after Obama's stimulus plan passed within a year, would Austrians claim that the stimulus only slowed down the recovery and the only thing it did was increase our debt burden? After all, you can't base anything off empirical evidence.

Tocano said...

@Anon - Firstly, I'd use Obama's own criteria as a measure of success or failure. He said that if we didn't pass the stimulus, we'd see unemployment up to 9%. But if we passed the stimulus, they claimed it would keep unemployment below 8% and turn it around. There's a good discussion to be had about how things would have happened without the stimulus, but with unemployment at over 10%, and us still in full recession, you could hardly say it fixed the economy or call it a success.

As I tried to state, the point isn't that you can't know anything, ever. The point is that you should be very careful to conclude anything based on any given statistic. Their view (and again, please someone deeper into the Austrian perspective than me correct or corroborate) as I understand it is that deductive reason and prolonged, careful observation (trying to assess all the variables) are the preferred way to understand the system and the impacts of given change. And focusing so much on mathematical models gives a false sense of understanding. Because the math can be correct, but missing variables that should be in the equation can still make the outcome wrong.

If, as you suggest, unemployment went down to 3% a year after the stimulus, then yes, you couldn't just conclude that the $700 billion was alone what caused it. Was there a massive expansion of credit? Negative Fed interest rates? Did the Treasury print $5 trillion new dollars and/or increase the debt by several trillions? Or from the opposite end, did it lower income taxes by 15% in every tax bracket or eliminate all business taxes? Did it get rid of the minimum wage? Or, apart from govt, did a newfound technology or energy suddenly create an entirely new industry with tons of untapped capacity? If any or all of these actions (or others) took place, then yes, it would be a gross mistake to conclude that the stimulus package is what generated the low unemployment. And in the Austrian view, correlation does not mean causation is taken seriously.

Anonymous said...

APLerner,

Would you be willing to go onto the forums at Mises.org and debate some Austrian's there? You'll probably meet your match and I'd like to see someone worthy challenge your assertions. I don't think the owner of this blog is going to be called out, which is disappointing. But someone there will happily fill in for him.

Inquisitor said...

"If we don't know every variable, how can Austrians call Obama's stimulus a total failure and say it didn't do anything? Do they look at the unemployment rate and conclude it didn't do anything?"


No, because they'd be doing the very thing they accuse mainstream "economists" of doing.

"Or do they just base it of their preconceived notion"

Read: grounded in actual economic theory as opposed to statistically -derived crap.

" that government spending never does anything because that's what Austrian economics says?"

Indeed. Via its theories, which you can either critique properly or of which you can make inane, irrelevant comments. Your pick.

"Seeing how empirical evidence is useless to them because there will always be unknown variables, it would have to be the later, right?"

You're learning. Now we can take away the "dunce" cap.

" So theoretically, if the unemployment rate went down to 3% after Obama's stimulus plan passed within a year, would Austrians claim that the stimulus only slowed down the recovery and the only thing it did was increase our debt burden? After all, you can't base anything off empirical evidence. "

If there is no theoretical argument for it, that is indeed true. Unless you have a parallel universe to experiment with, please offer an actual economic argument backing your religious superstitions on government spending somehow "stimulating" the economy. Thanks.

AP Lerner said...

@ anon – I have posted on mises.org, and found it to be a waste of time. When the lead post on your website is the ‘Anti Education Effects of Public Schools’, it’s pretty clear it is not an economics blog. It’s a political blog, like this one, pushing an ideology. The Keynesian blogs are no different; ideologically driven nonsense. Personally, I’m a data wonk. Unfortunately, the folks at mises.org, like Prof. Anderson, have formed an ideology and data mine to support their view, whereas I look at data first then form an opinion.

The reality is there’s only a handful of macro blogs (Big Picture, Calc Risk, Credit WriteDowns) that offer thoughtful, data supported, and factually driven analysis. So called Austrian blogs live in a world where paranoia and constant whining about the government cloud the bigger picture and thoughtful analysis. Hayek (and Keynse) would be embarresed by what folks are claiming to be analysis in their name. And most so called Austrians do not understand the monetary system in the slightest way, and continue to base their ‘analysis’ (hard to call something like ‘Social Security is nothing but a Ponzi scheme, Krugman is a crook’ analysis, which is why I quoted it) as if we are still on the gold standard. If you do not understand how the monetary system works, then how can you comment on inflation and solvency?

“You'll probably meet your match and I'd like to see someone worthy challenge your assertions”

This is an interesting comment. Implicitly, you are saying the owner of this blog and he’s supporters (like Jonathan M. F. Catalán) have not credibly countered the argument and data I have presented. I take this as a very high compliment. Thank you.

Greg said...

At first I considered you just a crackpot, spouting nonsense and trolling around. I still don't agree with much of what you say, but I give you credit that you called out the owner of the blog to challenge his idea and stuck around, while he's a no-show. And you backed up some of the thing you've claimed with data, which is refreshing.

So I think you're at least entitled to the debate you're obviously wanting, otherwise you would have split by now.

Mises.org not an econ site? Nonsense. Best economic site I've found on the web.

If you really want to get your ideas across and show up us dumb AS'ers, then hop on over there because the Prof. that owns this site doesn't feel compelled to take you on. I'd like to see it too.

Anonymous said...

@ AP Lerner: I thought that Keynesians believed in running budget surpluses in times of economic booms, and deficits in downturns? Is the government supposed to run deficits at all times, then?

Greg said...

AP Lerner,

Since Prof. Anderson has decided to not take you on and refute your ideas, and since you won't head over to Mises.org for an honest debate, looks like I'll have to stand in for the Prof. on and issue or two. You claim that he's wrong by characterizing SS as a Ponzi scheme. I also consider it a Ponzi scheme.

What is your disagreement with this assessment?

AP Lerner said...

“I thought that Keynesians believed in running budget surpluses in times of economic booms, and deficits in downturns? Is the government supposed to run deficits at all times, then?”

The short answerer is yes, the government should always run a deficit. External balances complicate the equation a bit, but since the US economy and its trade partners are structured in a way that the US runs an external balance, to have positive private sector balances, the government should run a deficit. Now, this does not mean the government can just keep running massive deficits and growth will go to the moon. Inflation is the check on deficits. Take a look at this chart, and look at what happens to private balances when public balances shrink.

http://images.creditwritedowns.com/2010/01/financial-sector-balances.png

I fundamentally disagree with the Keynesian view the government should run a surplus during economic booms. We are no longer on the gold standard, and if Keynes were alive today, I think he would rethink that view as well. So when you look at this chart, and accept the view that private and net public balances must = 0, it becomes pretty clear what austerity will do to the economy when the private sector is demanding huge surpluses to de-lever. Both the US government and the private sector CANNOT de-lever at the same time.

@ Greg – the Ponzi comparison is inaccurate because it is a misunderstanding of how the US government funds itself. The US government, as a monopoly issuer of a non-convertible, free floating currency, is NEVER revenue constrained. I addressed this under the post where Prof. Anderson tried to compare Krugman to Maddoff. It was a post back in June. Then, I was posting as anonymous. I was the first poster on that thread, and it was that post when I realized just how incorrect Prof. Anderson’s understanding of the monetary system really was, and how most folks still have a gold standard mentality. I got flamed in that thread because the view was completely out of line with how most ‘Austrians’ believe the government funds itself. This discussion spilled over to the thread on why bond rates continue to fall despite massive borrowing and massive printing, a phenomenon that nobody on this blog could explain. I was the first poster there as well. And again Prof. Anderson and any other person he quoted or brought into the debate could not come up with logical responses. Unfortunately, I was still posting as anonymous in that thread, but I’m sure you can figure out which responses are mine. I can circle back on this thread if any of my posts there are unclear. I’m sure I could throw some charts and graphs up as well that make it a little clearer.

Tocano said...

@AP Lerner: "Take a look at this chart, and look at what happens to private balances when public balances shrink."

It appears that, once again, you may be overlooking that "correlation does not equal causation". I could see how in a recession, the demand for money increases, so people save more in preparation for the worst or for the possibility that the recession could last a long time. At the same time, for at least the last 60 years (timeframe of your chart), govt response to recessions have been larger, bigger deficits. Thus both increase. As the recession fades, people have more confidence in spending, and the govt has less rationalization to continue high deficits, so both come down. Two correlated actions with completely independent motivations based on the relative health of the current state of the economy.

I'm not saying these are the only inputs or effects in play, but to assume that just because a chart has two data points that seem to match up, doesn't mean that one causes the other. A chart that shows a direct correlation between crop growth and malaria cases doesn't mean that growing crops cause malaria (or vice versa). The truth is that both are triggered (one directly and one indirectly) by rainfall, a variable not in the graph.

That's the gist of what I think Austrians say: Too many economists look at a trend, chart, graph, or other statistic and because they can find a correlation between 2 elements (out of thousands) of the entire economy, they draw conclusions about impacts, cause and effect, and, finally, actions. Some even do this by looking at individual markets, extrapolate to the whole economy and base their theories and recommendations on that. I'm not saying it's ALWAYS wrong and NEVER right, but that is a very dangerous way to create policy recommendations.

"The US government, as a monopoly issuer of a non-convertible, free floating currency, is NEVER revenue constrained"

This is true. There is nothing that stops the US federal government from issuing ANY amount of currency. However, I think the contention is that there are negative effects (even perhaps beyond just inflation) of doing so that make issuing currency (or debt) a bad idea. And because of this ability, it incentivizes politicians to create whatever programs and spend whatever money because they believe that they can simply print their way through it.

"The government and the central bank are both part of the public sector"

I don't think they are. The central bank (The Federal Reserve) is SUPPOSEDLY a coalition of private banks. Now, I'll admit, it's a pretty fuzzy line between where private stops and public begins (and I think that's intentional), and from those that defend the Fed, it appears that many seem to declare is as being private sometimes and public at others, depending on the point they're trying to make at the moment. For example, those of us calling for a full and detailed audit of the Fed are rebutted by claims that the Fed is a private organization and thus the entitled to privacy (or something like that).

Tocano said...

@AP Lerner: "From an operational perspective, all borrowing does is change reserve balances in the banking system. That is it. End of story."

This is from one of your first comments, but I think my issue with this statement is not that it is "operationally" incorrect, but that it implies that there are NO effects of borrowing; that borrowing has no impact or at least that as long as that borrowing isn't outrageous and all at once, the effects are all positive. Is that what you're saying? Cause, to me, that would clear up a lot about your perspective.

XYZABC said...

@Prof. Higgs “Of course, they favor central-bank actions to make such borrowing cheaper for the government.”

@AP Lerner "From an operational perspective, all borrowing does is change reserve balances in the banking system. That is it. End of story."

Borrowing from who? Treasury sells government bonds to private persons on the open market. Fed can then buy those bonds and exchange them with money that never existed before. This increases the money supply which, ceteres paribus, lowers interest rates.

This Fed buying of government bonds is called Open Market Operations. Do you disagree with the above statement? If so, why?

@AP Lerner "Ask yourself this, in the 80’s when rates were high due to inflation, did the government scramble to find new sources of cheap funding? Did any bond auctions fail? Did Reagan take Volcker out back and beat him senseless for raising the fed funds rate? Or course not."

Fed can lower interest rates, through Open Market Operations, thus lowering the cost of borrowing for the government. This is Money and Banking 101.

But you disagree? That you mentioned Volcker, who did indeed raised interest rates in the early 1980s, did not necessarily raise the cost of borrowing.

Here is why. Bond yields are stated in nominal interest rate terms. Even with a high interest rate, let's say at 15%, the inflation rate can be at 13%, equaling a real interest rate of 2%. Inflation would give the borrower a discount from the nominal rate.

For borrowers, the real interest rate is all that counts. Even if the real interest rate was indeed 15%, Volcker's rate increase would only been temporary.

@AP Lerner "This is not Keynesian rhetoric, nor is it Austrian, or monetarism or any other label economist obsess about putting on people. This is the mechanics of a fiat monetary system."

I do not think you even understand the basic mechanics of of the Federal Reserve system, or if you do, your views would be highly unorthodox compared to a Keynesian or Monetarist.

AP Lerner said...

@ Tacano and XYZABC – many of your comments/questions have been addressed in my numerous other comments, particularly the posts by Prof. Anderson on bond rates, and where he compares Krugman to Maddoff. I will just add that nowhere have I said endless borrowing would not have negative consequences. In the framework I have been discussing, deficit spending is highly inflationary when done in excess of the private sectors demands for savings. I would also point this framework is not 'unorhadox' when you recognize the US is no longer on the gold standard, and has a non convertable currency

Right on time, Krugman posts on his blog today a much more eloquent comment on what I have been discussing here, only with fancier charts and said much, much clearer than I. I suggests taking a look at this post, which even Prof. Anderson mostly agrees with.

http://krugman.blogs.nytimes.com/2010/07/17/more-on-deficit-limits/

I would also suggest reading this piece by Paul McCulley, who is much more qualified to speak on this topic than I, or Krugman.

http://www.creditwritedowns.com/2010/07/paul-mcculley-does-modern-monetary-theory.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+creditwritedowns+%28Credit+Writedowns%29&utm_content=Google+Reader

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