ABCs of Business Cycle Theory, Part 2
A Synthesis of Hayek, Minsky, Friedman and Keynes, with Brad DeLong
Hear which insights DeLong draws from Friedman, Hayek and Keynes, and what he thinks the key difference is between modern and classical liberals:
Charlie Deist: Good morning everyone, and welcome to the Bob Zadek Show.
I’m Charlie Deist, Bob’s producer, once again filling in for Bob, who will be back next week to discuss the topic of morality and capitalism. Are the two compatible? Is a moral citizenry required for a capitalist system, or is it the inverse? Is capitalism the only system that does not require a moral citizenry?
I also want to wish our listeners a “seasonally-adjusted greetings.” The adjustment is both my filling in, and my special series here on the business cycle. When we talk about economics, we often refer to seasonally-adjusted statistics — business cycles fluctuate up and down, not only in these longer boom and bust cycles, but also throughout the year. Around Christmas time, consumers are running off to the store to buy the latest gadgets and gizmos, so we see a temporary spike in spending.
Last week I was joined by Robert Wenzel, who is a self-described Austrian economist. That does not mean that he is of Austrian nationality — it means he subscribes to the ideas of libertarian economists such as Friedrich Hayek, and Ludwig Von Mises. These were 20th-century economists who built a foundation for economics on a philosophical concept that is both simple and profound — that is, that humans are purposeful actors; we act with an intention to achieve certain aims, and use economic means as well as other means to achieve our desired ends.
The Austrian School is important today because everyday we see stories on the front pages of the newspapers about booms and busts, bubbles bursting, Bitcoin, etc.
Is Bitcoin a bubble? We might wonder whether humans are actually rational. Are they pursuing their ends in a way that will actually best achieve them, or are they, perhaps, less than perfectly rational?
These are the kinds of questions that economists debate, and this morning I’m privileged to have an economist with me. I’m joined by UC Berkeley economics professor Brad DeLong. Every so often, I need to ask a favor of Brad DeLong. He’s my old teacher and undergraduate advisor, from when I was something of an aspiring free market economist.
While preparing for last Sunday’s show on the hardcore libertarian Austrian theory of the business cycle it occurred to me that I don’t actually know what I’m talking about. I don’t have a PhD, or even a Master’s degree in economics, although thanks to Brad I was able to complete an undergraduate thesis on monetary policy. But it occurred to me, if I were in almost any other field, trying to diagnose a problem — something as complex and serious as the booms and busts in the economy, my musings here would be something akin to malpractice.
Brad DeLong is the chair of the political economy major at UC Berkeley. He was deputy assistant secretary at the U.S. Treasury, and is a visiting scholar at the San Francisco Federal Reserve Bank. He joins me by phone from Berkeley, where he also writes the popular blog, “Grasping Reality with Both Hands.” Now, that’s a metaphor, so if you’re driving keep both hands on the wheel.
I’m going to try to cram in close to a whole semester of economics with Professor DeLong, and hopefully he can help to explain in layman’s terms, his academic perspective on what’s really going on in the economy when we read about the Federal Reserve and interest rates, money supply, quantitative easing, and so on. Thanks for taking the time to talk with me.
Brad DeLong: It’s a great pleasure on my part to be virtually here. Thank you for asking me.
Charlie Deist: I want to start with a quote from a blog post that you wrote all the way back in 2004. This was when Alan Greenspan was still Federal Reserve Chairman, and it echos the message of my last guest, which was that the Federal Reserve negatively influence the economy — I don’t think there’s any question about that among economists. This was the end of a post from April 2004, where you were trying to figure out what was going on with monetary policy at the time.
“Alan Greenspan frightened away the Evil Depression Fairy in 2000–2002 by promising not that he would let the Evil Fairy marry his daughter but by promising high asset prices — unsustainably high asset prices — for a while. Whether this was a good trade or not depends on the relative values of the risks avoided and the risks accepted. And to evaluate this requires a model of some sort.”
So back in 2007, you were worried, just like our last guest, about the Federal Reserve inflating a bubble. What would you say is the Keynesian perspective, if you will, on the potential for the Federal Reserve to engage in this kind of pro-cyclical monetary policy — i.e., monetary policy that, rather than smoothing out the business cycles like it’s supposed to, actually can exacerbate them and make them worse?
Brad DeLong: Well, I would say that it’s not so much a Keynesian perspective as a Keynesian–Monetarist perspective. Or rather, since Keynesianism, Monetarism, and Austrianism are all very large and vague, unsettled creatures with very fuzzy borders, such that it’s not clear where the core is, let’s say John Maynard Keynes himself rather than the Keynesians, Milton Friedman himself rather than the monetarists, and Friedrich Von Hayek himself rather than the Austrians.
Here Keynes and Friedman would have been on the same side, approving of Greenspan’s policies. That is, Keynes thought the most important thing for monetary policy was to manipulate the economy so that the level of spending in the economy — the level at which the government plus private actors wanted to spend — was large enough to be able to put everyone to work, who wanted to work, at the prevailing wage level, without creating an excess of demand, over the amount that could be produced that would produce inflation. That, as he said, inflation is unjust in that it robs the saver of the returns that they’re expecting, and deflation is inexpedient. Perhaps deflation is worse in an impoverished world, but these are both evils to be shunned.
Milton Friedman was very much the same. That is, Milton Friedman thought that the right policy for the Federal Reserve to follow was for it to be constantly intervening in asset markets in order to keep the money supply from falling — even if private actors wanted to shrink their holdings of money — or keep the money supply from rising if private investors and private actors wanted to increase the supply of money. Also, Friedman thought that if there were to ever be sharp shifts in the velocity of money — sharp changes in how much people wanted to hold in terms of dollars in their bank account for every dollar they spent — the Federal Reserve should offset those too.
So in both Friedman and Keynes’ view, the right strategy for the Federal Reserve was the Greenspan strategy of “act to try to keep inflation and unemployment as stable as possible, by doing whatever is necessary in terms of buying and selling assets, and pushing asset prices up and down.” It’s just that Friedman called it a neutral monetary policy, and Keynes feared that the Federal Reserve would not be able to do enough, and that you’d have to bring in other tools as well.
I think Keynes has won this one after 2007 to 2009, when the Federal Reserve did everything and it didn’t work. But they’re on one side agreeing with Greenspan.
Hayek, and I suppose also Hyman Minsky — who are on the other side — were saying back in the 1930s, the 1950s, the 1960s, that no, this is a very dangerous policy to pursue.
I is for Inflation Targeting
Although Austrians are suspicious of aggregate data, most will acknowledge that inflation is a useful indicator. Rapid inflation and deflation are both undesirable, so economists monitor price indexes — average prices of bundles of goods, such as the consumer price index (CPI) — to see whether the economy may be headed for recession, or if it is “overheating” due to excessive stimulus.
In recent decades, the Fed has tried to target inflation at around 2% annually. They can see whether they are on track by looking at past index data, or forecasting based on internal projections and the market’s expectation of inflation. The Treasury offers a bond — the Treasury Inflation-Protected Security, or TIPS — with an interest rate that pays out based on inflation. The spread, or difference between this rate and the non-inflation-protected rate gives a rough estimate of inflation expectations, which briefly became negative in 2008, and have averaged below 2% since the recession.
Many argue that the fall in inflation expectations starting in 2008 prolonged the recession. People had borrowed money on the assumption that the real interest rate (the nominal rate, minus inflation) would stay stable. When inflation fell, the real rate rose, debts became a greater burden, and mortgage holders who might have otherwise been on the edge of bankruptcy were now under water.
In theory, the Fed should be able to set long-term inflation expectations wherever it wants, as long as it can credibly commit to injecting enough money into the economy. Hitting an exact near-term inflation target is trickier, especially when markets are basing their expectations on the path of future interest rates, and that path becomes unclear.
JK is for John (Maynard) Keynes
Austrians focus on the long-term consequences of easy credit. John Maynard Keynes is famous for saying, “In the long run, we’re all dead.”
So far, the long run has been kinder to Keynes. While Hayek’s Austrian perspective enjoyed a brief moment of popularity, Keynes’ ideas sparked a revolution in macroeconomic thinking.
Russ Roberts contrasted the differing views of F.A. Hayek and J. M. Keynes in a rap video, “Fear the Boom and Bust.”
“So forget about saving, get it straight out of your head.
Like I said, in the long run, we’re all dead.”
— Keynes’ rapping alter ego
Keynes’ three biggest ideas are aggregate demand, animal spirits, and the paradox of thrift. Aggregate demand is characterized by the “circular flow” of money from consumers to producers, and back to consumers in the form of wages and returns on investment. Animal spirits are those psychological impulses that govern individual and collective economic decisions, including whether to spend now, or save for the future. The paradox of thrift identifies the problem when everyone suddenly decides to start saving at the same time. Since one man’s spending is another man’s income, the attempts to be thrifty are thwarted, because lower spending means people have less income to save.
While Austrians say that it is necessary to wait for deflation to bring markets back into equilibrium, Keynesians allege the government can restore spending to its original levels without much downside, except for higher taxes in the future, when the economy is healthy.
But while Keynes favored a greater role for government, he was also, like Hayek, a liberal — an enemy of authoritarianism and fascism. The Great Depression was unprecedented in terms of length and severity. There was no telling how bad things would have gotten before markets cleared, as the Austrian theory recommends. There was already discontent with the market system all around the world, and in some places, the threat of revolutionary socialism loomed large. Letting the bottom fall out could have made this unrest difficult to contain. Although his comment about the long-run may seem flippant, there is perhaps a sense in which wise interventions can give us the best of both worlds: a remedy for a desperate and exceptional short-term situation, and a long-term policy of stable prices.
Let’s turn to a a major short-term exception.
L is for Liquidity Trap
Long before the Fed lowered interest rates to zero in 2008, Keynesian economists speculated about a scenario called a liquidity trap, in which the Fed would lose its ability to ease, or “loosen” monetary policy through the usual means. This arises because of the way that the Federal Reserve injects liquidity (i.e., more readily spendable forms of cash), by swapping newly printed currency for short-term Treasury bonds that banks have on their balance sheets. This lowers the short-term interest rate until it reaches the Fed’s target that is believed to be sufficient to boost aggregate demand back in line with the economy’s full potential.
With more cash in their vaults, banks are usually more likely to lend. However, there is a lower bound to the interest rate — zero percent — beyond which banks will be indifferent between holding non-interest bearing bonds bonds and non-interest bearing cash. Further injections of money will simply sit on banks’ balance sheets, with no increase in lending/investment.
Paul Krugman warned about the liquidity trap back in 1999, and it would be less than 10 years before the Great Recession brought about the zero lower bound scenario. This “broke” the Fed’s main tool, and made it difficult for them to affect a loosening through the dual tools of 1) lowering interest rates and 2) injecting money into the economy.
In response to the liquidity trap, Keynesians often propose direct government spending as a way to get overall spending flowing again. Money paid out for public works programs, as tax rebates, etc., increases the amount of money in people’s wallets, inducing them to spend down their “real cash balances” until they are back in line with their preferred ratio. The period of low interest rates following a financial crisis is also the ideal time to borrow from a taxpayer perspective.
However, the Federal Reserve does have other instruments besides government spending at its disposal. It can promise to keep rates at zero for long periods of time, in what’s known as “forward guidance,” with the hopes that markets will adjust their expectations of future inflation.
Furthermore, the Federal Reserve is not limited to buying short-term bonds. It can buy other assets — such as the “troubled assets” purchased under TARP — that increase the money supply and raise inflation expectations. It can also sell its own currency and buy foreign currency on foreign exchange markets to cause depreciation. There is no historical case where a government tried and failed to produce inflation by printing money and buying things. Here, Austrians would argue that this is just forestalling an inevitable, necessary correction — re-inflating the bubble. However, if the Fed can target its purchases neutrally, the resulting inflation could ease the reallocation of resources from the mal-invested sectors to its new uses.
Perhaps it would have been easier for the Fed to credibly commit to a higher level of inflation in 2008 if it had been framing its policy in terms of money supply, and promising to buy as many assets as necessary to return the economy to its historical trend of 2% inflation.
This suggests that speaking about the “transition mechanism” of monetary policy in terms of money supply may be preferable to thinking in terms of interest rates. In a sense, the liquidity trap is only real to the extent that the Federal Reserve believes it is real, i.e., to the extent it thinks it controls interest rates alone, and thus has no way to signal its intention to ease its stance until it reaches a specific goal for inflation.
Charlie Deist: So there’s a lot to unpack here. We have four names: Keynes, Friedman, Hayek and now Minsky, who we’ll try to get to later. And each of them is telling a different story, and proposing a different remedy for this problem of the business cycle.
You used the word manipulation, and that seems to be where the Austrians would have the biggest disagreement with even the monetarists like Milton Friedman, who was one of the most famous libertarians — maybe the most famous libertarian. Yet in this one area, Friedman did favor a role for government manipulation of the money supply. This gets to the core of the technical debate in monetary policy, which is, what is the Fed actually doing on a day to day basis? How do they adjust, both through direct action and through the influence of expectations of the actors in the economy? Let’s summarize for listeners in layman’s terms how they influence the economy. Economists talk about a transmission mechanism. This is just the direction of causality from one action to the results that we see. Could you break down how the Federal Reserve actually achieves the smoothing of the business cycle, in either the Keynesian model, the Monetarist model, or whichever hybrid of the two you think makes the most sense?
Brad DeLong: Well, as early liberal John Stuart Mill put it back in 1829 — and I think he got it right and Keynes and Friedman would agree — that the economy is in balance, in a business cycle sense, if the supply and demand for money are equal. That is, if demand for money is greater than supply, then people are cutting back on their purchases because they want to hold more money than they can find. Then you have what they used to call in the colorful language of the early 19th century call a “general glut of commodities”: high unemployment, idle factories, cotton goods going begging as far as Kamchatka, in Thomas Malthus’ phrase. That’s a bad thing. And if the supply of money is greater than the demand, well that’s inflation, which is also a bad thing.
To keep the economy in balance, you need to match the supply and demand for money. But since the demand for money is somewhat erratic, the Federal Reserve or the Bank of England always have to be in there, buying and selling, pushing and shoving, increasing and decreasing the supply of money in order to keep there from being either unwanted inflation or unwanted deflation. That is just the way things are, if you are going to keep the economy stable.
Now this is a somewhat awkward position for Milton Friedman to be in because when you ask Uncle Milton about practically any other market, his response is, “The market will sort it out optimally. And even if the market wouldn’t sort it out optimally, building up any government bureaucracy to try to do better is doomed to failure.” Yet somehow, with respect to monetary policy, Uncle Milton goes very far towards saying that there are major institutional or cognitive human deficits in how the market for money works. So, we have to have this form of extremely soft, light-fingered central planning for the money supply — which he hoped could be done by a rule. That the Federal Reserve is going to say, “We’re going to let the money supply increase by one percent every quarter.” But it turned out that such rules don’t work very well. We need much more complicated rules — we need feedback rules, and even with the feedback rules, we have to deviate from them substantially on occasion.
So that is very much what Friedman and Keynes think is going on there. Minsky thinks that’s going on too, but Minsky also thinks that the same current of thought and institutions that lead to episodes of deflation and inflation in the private market — to financial over-speculation and so forth — that those are also going to affect the minds of policy makers. So, it’s just when asset prices are rising and people are enthusiastic and getting over-leveraged, then you’re going to find large political calls for deregulation of finance and for a reduction in regulatory requirements for collateral and down payments. And, conversely, just when the economy is in serious trouble and people are depressed, that’s when you’re going to have the Dodd-Frank bills imposed. That’s when you’re going to have governments demanding lot higher down payments. That’s when you’re going to have collateral requirements required by the Bank of International Settlements go through the roof.
Charlie Deist: So Minsky tells another story of the pro-cyclical policy where government, rather than smoothing out the business cycles, is tracking with either the people’s confidence of lack of confidence in the financial system. It’s a case where human irrationality and the lack of a sound technician at the board, so to speak, is leading to these wild fluctuations.
Brad DeLong: Well it’s a logical impossibility. Right? That, as William McChesney Martin — Fed Chair in the 1960s — said, “The purpose of the Federal Reserve is to take the punchbowl away just when the party gets going.” But just as the party gets going, that’s when absolutely nobody wants to take away the punch bowl.
Basically, Minsky had all kinds of hopes about how — because we would understand this cycle — we could transcend it, and moderate it, and deal with it. But those are basically unconvincing. If you take a Minsky point of view, we’re pretty much hosed, and all we can do is remember the historical parallels and analogies, and whimper and complain whenever this cycle gets going.
M is for Monetary History of the United States (and Minsky Moment)
Milton Friedman and Anna Schwartz’s magnum opus, A Monetary History of the United States, 1867–1960, showed a clear relationship between 100 years of business cycles and the money supply. This was a triumph of empiricism — measurement of broad aggregates like money supply, prices, and output — but also of a generally free-market approach to monetary policy.
Milton Friedman departed from the Austrians in arguing for a role for the Federal Reserve in stabilizing measures of money supply, which can fluctuate based on events in the private sector — unrelated to government money printing. We saw in the last post how fractional reserve banking can lead to large swings in the money supply, especially in the event of a bank run. There is a growing body of research into the psychology behind bubbles. While rationality may be typical for certain kinds of consumer behavior, crowds often have major blind spots when it comes to the macroeconomy, the exception of irrationality may be closer to the rule.
It’s been said that nothing makes someone crazier than seeing everyone around him getting rich.
Hyman Minsky observed that rising asset prices often result in speculation with borrowed money, until speculators can no longer service their debt with the cash being generated by their investments. This leads to the “Minsky Moment” — the crash period of the cycle, when loans are called in, borrowers default, and asset prices crash. This may dovetail with the Austrian theory, where easy credit is said to drive the speculation, but Minsky identified as a Keynesian, and the underlying psychological phenomena of overoptimism and shortsightedness do not require government intervention to take hold.
Should Economists be more like Philosophers or Dentists?
Charlie Deist: Tell us Hayek’s story — how Hayek relates to Minsky, and how it might echo it in some ways, or vice versa.
Brad DeLong: With Hayek, it’s in some sense very apocalyptic. It’s that everything would be fine if the market were just working well. It’s that you do not have a sudden large increase in the demand for money — the kind of thing that produces a depression — unless you had a large previous episode in which too much money has been created; in which the economy has somehow found itself with lots of liquid assets, which do not correspond to any fundamental values, either because the government has previously been printing a lot of money and generates an episode of inflation, or because the banking system has gone absolutely haywire, and private agents are facing bad incentives. Banks have extended many, many, too many loans thinking that they’ll reap fortunes if there are no bankruptcies for as long as they’re president of Bank of X. And if there should be bankruptcies, well, they’ll probably have moved on to another job by now.
So it’s a combination of fecklessness on the part of politicians who print extra money to spend or to lower taxes and so produce inflation, plus a principle–agent failure in the banking system, in which bankers make loans that are really lousy business in the long run because, hey — the long run might not come until they’ve moved on to another job.
That creates the inflation, and only after the inflationary boom comes is there ever a chance of being a large recessionary crash. So, for Hayek it becomes somewhat of a moral answer: that you have to keep the government a kind of moral, budget-balancing government, and you have to keep the bankers from grabbing us by the pumbs. And if we can have moral bankers and a moral government, somehow, then everything will be fine.
Charlie Deist: That’s an interesting interpretation — I want to pause on this question of market failure versus government failure. It’s a mixed story that you’re telling, where on the one hand there are the politicians and their short-sightedness — their money printing. On the other hand, there’s what economists call a “market failure,” which is where private actors supposedly acting in their own best interest, either short-term or long-term, make loans that will not bear the fruit necessary to pay back those loans. So we end up with people, not only borrowing, but leveraging or borrowing with the money that they’re making initially off asset price increases. They inflate this bubble, and get overly optimistic about the proceeds from this investment initially, so they’re doubling up, until we reach what’s called the “Minsky moment,” where everyone suddenly looks around and realizes that the punch bowl has been taken away, or that these investments are clearly not sound. And then we get a sudden crash.
Hayek said that this would not happen if government was not inflating a bubble, but Minsky considered himself a Keynesian, I believe, and argued that this would happen in the absence of that fecklessness on the part of the politicians. There is something inherent in human nature about being overly optimistic in these boom times.
And how do the Austrians solve that? They might say, “Well, we should go to a gold standard so that banks have to back up their deposits with some sort of hard money, precious metals and the like, and that will limit the loans.” Or they argue that in a free market banking system, agents would, on the whole, make more rational decisions. But this is an open question. Maybe it’s an empirical question. Maybe it’s a philosophical question. But you think that the preponderance of evidence is, empirically, on the side of people like Keynes and Minsky, who would still give some role for a wise and benevolent leader at the helm of the Federal Reserve, who could make corrections.
I think I remember a Keynes quote, and I don’t remember the exact quote — this might have been your email signature for a time — but it stuck in my mind, and it was something to the effect of, “We should hope that one day, economists will be as useful as dentists.” It’s “economists as technicians” rather than economists as “worldly philosophers.” People like John Stuart Mill seem to be more in the model of philosophers, but they also had economic theories, and these two things do seem to dovetail. What do you think is the proper role for economists, and are they more like dentists or they more like philosophers?
Brad DeLong: Well, we’re not terribly good as philosophers. As far as philosophers are concerned, we’re either third-rank libertarians or third-rank utilitarians. Or we used to have — I don’t know what you want to call it — third-rank Hegelians, talking about the necessity of freedom and the nurturing of humanity’s species-being, or identity as a species in one way or another. We’re not terribly good at any of those, and I think we’re better when we try to be technicians. Unfortunately, we’re lousy technicians.
Now let’s take this kind of question for example: Keynes, Friedman, Hayek and Minsky are all extremely smart and are all trying extremely hard, and indeed their positions bleed into each other. When Hayek stops talking about government engaging in deficit spending as the [sole] source of the boom that produces the bubble, and then slides over into banks that are improperly regulated for individuals who really do not understand that, say, the fact that Bitcoin has gone from $1,000 to $16,000 this year, does not mean that Bitcoin is likely to rise in the future — then, all of a sudden, Hayek starts moving over into Minsky. And when Keynes talks about how a boom leads to an increase in capital investments, that then reduces the rate of profit that can be earned on new investments, he starts sliding in the direction of Hayek.
Friedman’s hopes that you could make good Federal Reserve policy not automatic, but close to automatic, has pretty much been dashed, and that’s a big victory for Keynes. Keynes’ belief that you could have wise technocrats running the government does not look so hot, and that’s a victory for Minsky. And Hayek’s belief that, in some sense, the bubble is the cause of the depression and that if you avoid the boom in the bubble, you manage to avoid the depression, that really doesn’t look so good these days. Largely, because the two biggest depressions we’ve had in the past century — the 1930s and then the past decade — are far, far greater in magnitude than the previous bubble to which Hayek wants to blame them on. But I was much more of a monetarist 15 years ago than I am now. I thought Friedman looked much better than Keynes, and Minsky worse. Reality has a way of teaching you lessons.
Charlie Deist: Yes, and this is a nuanced perspective. We’re not calling names, or it’s not those bad guy Austrians or those good guy Keynesians. It’s a much more complicated picture with a lot of different shades and overlap between the theories. That’s what I’ve always appreciated about your blog and your writing is that it does seem like an earnest attempt — and even if we might disagree on some philosophical issues, there does seem to be this good faith effort to actually get to the truth.
N is for the Natural Rate Hypothesis
19th-century Swedish economist Knut Wicksell developed a theory of an underlying “natural” interest rate, at which the economy will have neither inflation nor deflation. Most central banks today are implicitly targeting this rate to achieve the goal of price stability.
The natural interest rate is not to be confused with the federal funds rate. First, while the Federal funds rate is the shortest-term interest rate possible, the natural interest rate is the medium to long-term rate that lenders and borrowers consider when making their decisions. The natural rate is also a “real” interest rate, meaning it must be adjusted for inflation. If you earn 4% per year, but prices rise 2%, it’s as if your money grew at a rate of 4–2%=2%. It is also not directly observable, but can be inferred from other measurements.
If the central bank can truly estimate the natural rate, and set it such that prices remain stable, it will have achieved an Austrian objective, using interventionist means.
O is for Output Gap
Keynesians characterize the economy as operating either at, above, or below its “potential output.” In a recession, there is said to be an “output gap” based on all of the slack resources and idle workers, which could be put to use if people weren’t hoarding cash and other safe, short-term assets.
Austrians believe that this output gap is an illusion. Those resources and workers cannot be put back to work until an entrepreneurial “discovery process” finds new patterns of specialization and trade for them to engage in. If the boom was in construction, it will take time to re-train construction workers to fit the new industry. Cranes and cement mixers may not have immediate uses at all, and may simply need to be written off as bad assets.
A commenter on DeLong’s blog writes:
“The Austrians probably have a point about the time that it takes to shift resources from one sector to another. If we had another million health care professionals, they’d pretty much be employed now. Even before health care reform, there were shortages of workers.”
DeLong has written why this explanation does not seem to hold up:
We have 2 trillion of losses in mortgages: we have to write down the value of the housing stock we have built over the past seven years, and presumably we will be building $200 billion less of housing per year over each of the next ten years relative to what we would have done otherwise, which means that we have to reduce construction employment below trend by 2 million workers for a long time to come. If it takes us six months of job search and recombination of enterprises to find new job-firm matches for each of these workers, the consequences of this act of overinvestment should be to raise the unemployment rate by 0.6% for a year.
But it now looks as though this recession is going to raise unemployment by an average of 4% for 3 years — 20 times as great as the overinvestment-and-sectoral-shift Hayekian story says.
The story [the Austrians] point to of overinvestment in construction and sectoral shifts is part of the story, but only 5% of the story.
An Austrian rejoinder might note that construction is only the tip of the iceberg — the most visibly malinvested part of the structure of production. The rest of the economy, however, may also have been distorted towards unsustainable long-term projects in more subtle ways. Modelling the structure of production remains a fruitful area for research by Austrians.
Praxeology: The Study of Human Action
Charlie Deist: We have a caller on the line, so I want to hear from them and see if we can maybe bring this conversation back to some fundamentals.
Michael, let’s hear your question.
Michael: Hi Charlie. Thanks for a fascinating show. I was going to bring up some fundamentals. When you talk about the Austrian school, a fundamental aspect of it is praxiology, and I was wondering how praxeology fits into the discussion?
Brad DeLong: Praxeology, at least as I understand it, at one level it is sheer and total genius. I was reading a piece last night by three left-wing economists at VoxEu.com — Sam Bowles, Rajiv Sethi, and I’m blanking on the name of the third author. [It] said that Hayek’s decisive and positive contribution to economics was in fact his rejection of Walrasian static, and also general equilibrium theory, as developed by Arrow and Debreu, [along] with the idea that the justification for the market is that it produces the best equilibrium. Because there’s never an equilibrium. Because all human action is a discovery and interaction process, in which people have different plans that are extraordinarily often inconsistent. And it’s the right way to analyze economics, and indeed all social life, is to look at how agents behaving in a disequilibrium situation, learn and react and adapt to each other.
Friedrich A Hayek (1899-1992), well ahead of his time, viewed the market economy as an information processing system…voxeu.org
Michael: I think the first step in criticizing praxeology is defining it. So why not just tell the listeners what it consists of.
Charlie Deist: Sure. Thanks, Michael.
Brad DeLong: As I’m saying, that’s my view of what praxiology is.
Charlie Deist: Praxeology being, most simply, the study of human action. Mises, in his book “Human Action” defines — I don’t know if he originated the word — but basically it’s “how do humans act?” It’s not necessarily what should they desire, but given that humans have certain ends, and that they use certain means, what can we say?
Whereas the typical classical economic approach to studying markets doesn’t necessarily begin with these assumptions about human action — these axioms that can be laid out just by going inward and thinking about the structure of the mind. It starts more with what [DeLong] is talking about: this Walrasian idea of an equilibrium (Leon Walras, not to be confused with the marine mammal, was the guy who basically invented supply and demand curves).
You have supply, where people will be induced to produce more of a good if there’s a higher price, and then demand, people will demand more if it’s a lower price. That gives you an upward-sloping supply curve and a downward-sloping demand curve, and where those meet, you have an equilibrium price and quantity. That’s what the market will produce. But, in praxeology, can we use supply and demand curves or do we need a completely different model?
Brad DeLong: Well, we can use supply and demand gingerly, because they do have very stringent underlying assumptions that most of the discovery that is the core of the market process have already been accomplished. I think that view, that rejection of Walrasian general equilibrium as a road that may well mislead us — that’s going to miss most of what is going on — is the very good part of praxeology.
The bad part of praxeology is simply when one tries to reduce what is, after all, an empirical study of how markets behave, to a set of logical consequences of looking inward and trying to assess one’s own motives. Even what I see as the Hayekian side of praxeology moves us towards creating a reified theoretical superstructure that then has little to do with how markets actually operate in the world. So I think the internal, psychological side of praxeology kind of leads away from the world, into another, different, abstract theoretical structure.
That’s why I would prefer to say Hayek rather than the Austrians, because I think Hayek has by far the better of the arguments here. I find Hayek’s viewpoint, which is focused on the market as discovery process, much more congenial to how I think than saying that we will take another step back from empirical reality, and try to derive laws of thought and human action from introspection.
If the psychologists tell us anything, it’s that we’re pretty bad at introspection. We vastly overestimate how smart we are — even how much of the world we see around us — and that can lead us wrong.
Charlie Deist: We should be more humble with regard to what we can know, and I think that the Austrian school tends to emphasize this in one area — mainly with respect to what government can know about the economy and thus what it can manipulate, so it’s very skeptical of the sort of technocratic economist-as-dentist paradigm. But you’re offering, with the same logic, a counterpoint which is that when we try to build our foundations for economics on this logical deduction, based on the logical structure of the human mind, that can also take us in a direction where we might have the overconfident in our models.
Brad DeLong: Did you receive the gorilla basketball video?
Charlie Deist: I believe so, but describe it for our listeners.
Brad DeLong: It was a psychologist’s experiment. They take the students to the professor to be experimented on and they set them in front of a TV screen and they say, “A basketball team is going to come out, and they’re going to practice, and they’re gonna pass the ball to each other, and your job is to count how many times they pass the ball to each other. And we’re trying to assess how smart people are, and how well they can deal with rapid information, so you’re trying to count accurately. And of course, we’ll judge you as if you get it wrong, et cetera, et cetera.”
And so then the basketball team comes out and they begin passing. And after about a minute, a person in a gorilla suit walks into the field of view from the left, slowly, and in the middle of the field of view, he beats his chest, and then walks off to the right, and then the video ends and people report how many times the ball was passed.
And then the experimenter asks, “Was there anything else about the video that struck you as remarkable?” And recorders of the people, they know, and then they say, “Did you notice the gorilla? The person in the gorilla suit?” And two-thirds of the people say no. That always struck me as a statement, not just about how focused humans are on whatever they’re focused on, but also how much we overestimate how aware of what’s going on in the world around us we can possibly be.
You can get the same experience by going to magic shows, by the way, in terms of just how unaware the people they are conducting their tricks on are — how unable to follow everything that’s going on. Especially, if you’re Penn and Teller and you have three different levels of misdirection there.
Charlie Deist: It’s a fascinating example of how we can have these huge blind spots, and it’s another good lesson about the humility that we should bring to any academic or philosophical enterprise. So thank you, Michael ,for your question, and I believe we have another caller on the line.
Real Wealth or Another Bubble?
Let’s hear from John.
John: I have a question for the professor. I assume that housing values and stock values represent much of the wealth in America and those values have fluctuated widely in the last ten years from high to low, now to very high. Has our society gotten wealthier or is this purely a monetary phenomenon? I’ll take the answer off the air.
Brad DeLong: Has our society gotten wealthier? Well, I would say yes and no. I would say the best way to look at it right now is that high stock and housing prices more reflect a low expected private rate of return on investment so that companies that have earnings right now, plus some that don’t like Amazon, plus houses that are built and are providing satisfaction to human beings, have a relatively high price relative to currently produced goods and services because there’s little opportunity to build new buildings and take new machines and use them to create enterprises that will be equally profitable. So that in one sense, it reflects not that we’re rich now, so much as though we’re not expected to become that much richer, faster in the future.
And you can go down to Silicon Valley and find Google’s Chief Economist Hal Varian, and he’ll say that what’s really going on is we’re becoming more prosperous at an amazing rate. Look at how much people like their cell phones, look at access to information and communication. It’s just that these particular sources of human well-being are not ones that are really being created and transferred by the market process. That is, that rather than selling what it produces, which is information, Google is running off of the fumes created by selling your eyeballs to advertisers, and the value it earns by selling your eyeballs to advertisers is much, much less than the value you receive from the access to information that Google gives you.
So, the fact that it isn’t expected that future investments will be very profitable doesn’t mean that they won’t be very productive or very welfare-enhancing, but Hal is a minority point. The majority point is that we seem to have entered a world in which people are less optimistic about the future of economic growth than they were. That’s the thing that’s pushing up housing prices, and currently installed housing prices and current stock prices, because those companies have made their investment. And what it’s really saying is investments in the past were more valuable than the investments you make today, and that’s why they’re so high.
There’s a second sense in which high housing prices in greater San Francisco are a sign of our poverty. That is, in a better functioning world — in a world without my crazy NIMBY neighbors, there’d be no way that a house like mine — a mile south of the University, a mile north of the Rockridge BART — there’s no way that the neighborhood of Elmwood now would still be composed overwhelmingly of houses like mine rather than of triple-deckers like the small apartment buildings surrounding Harvard, or like the ten-story apartment buildings surrounding Columbia, or like the 25-story stuff surrounding NYU. But [given] the population of greater San Francisco, if San Francisco development in the land of Silicon Valley had followed the standard American pattern, we’d have seen its population grow from five million to ten million over the past 25 years. Instead, it’s only grown from five to 6.5 million due to NIMBY development restraints. And that means that the houses that exist are extremely valuable. But the reason they’re so valuable is because they’re so scarce. It’s a monopoly rent. And we’re poorer by the fact that we ought to have 3.5 million dwelling units in greater San Francisco that we do not have because we have seriously screwed up our land-use governance over the past 25 years. So.. all of this is a standard economist’s answer: on the one hand, on the other hand; yes and no.
Charlie Deist: Right. Another axiom that economists are fond of is that there are always trade-offs. One of the points that the Austrians maybe internalized, but maybe still have a ways to go in incorporating into their thinking is the idea that planning has to take place at some level. There’s no such thing as a purely neutral zoning policy, for example, and if we want to come up with the ideal regulations, well, maybe there is no such thing as an ideal regulation, because there will always be trade-offs. So economists have to be the wet blankets to inform people that they can’t have everything that they want.
P is for “Panic!”
Panic is the dark side of the “animal spirits” concept coined by Keynes. It’s the sudden uneasy feeling when everyone realizes they’ve been deluding themselves about some hope of future prosperity. The run-up is the manic period when, according to Charles Kindleberger, “New opportunities for profit are seized, and overdone.”
Kindleberger published a book called Manias, Panics and Crashes: A History of Financial Crises in 2000. There was a moment following the collapse of the dot-com boom when the economy appeared to be sliding into a deep recession.
Putting aside questions of the best tools to use, the Fed’s basic job is to keep markets from panicking — serving as a lender of last resort, but not being so easy with credit in bad times as to encourage excessive risk taking.
Frontiers for the Aspiring Austrian Economist
Charlie Deist: Sadly we’re coming close to the end of the hour.I’m speaking with professor Brad DeLong. He is at UC Berkeley, where he is the chair of the political economy department. He’s also a visiting scholar at the Federal Reserve Bank in San Francisco and served as deputy assistant secretary at the U.S. Treasury, so he’s an expert in the matters of monetary policy as well as economic history and a variety of other things.
I wish I could pick his brain all morning, but in these last ten minutes, I want to come back to what you were saying about Hal Varian and this world that we’re entering, where more of the value is coming from our smartphone technology, from information technology. On the one hand, this can give us an incredible amount of satisfaction. I’ve found blogs and Twitter and all these things to be a source of incredible education. But at the same time, they can also be… it’s a mixed bag. And in this new economic system, maybe there’s less emphasis on physical stuff and things.
But the Austrian business cycle theory places a big emphasis on these long-term capital malinvestments — these are the areas where we tend to see inflation having the greatest effect. We get inflation from the long-term areas because cheap credit encourages a sort of … Hayek talks about the structure about production, meaning certain investments take longer to materialize … and if we’re injecting money into credit markets first, then you will tend to incentivize people to develop longer-term things.
Is there any kind of application for that model in your mind to the current world that we live in? Most of these Austrians were writing well before the 1960s. Hayek and Mises were early 20th-century economists. Is there anyone doing work in your mind that brings these ideas into the 21st century? Or, what areas do you think would be most fruitful for someone who is interested in an Austrian approach to focus on, without getting to thick into the weeds?
Brad DeLong: Well, with respect to that of over-investment in the structure production, I think the Minskyist current is winning and is the most productive one to pursue now. That is, if you’ve made investments and if you did make them assuming long-term interest rates will be lower than they in fact are now, and if they are now unprofitable, that doesn’t mean we should shut them down. To say we should shut them down is the sunk cost fallacy, to which I think Hayek and Von Mises fell subject to, to a large degree. What it does mean is that our future investments should be focused on things that have short-term payoff.
Then the question is, “Well, if we shouldn’t shut down long-term investments that are now unprofitable because we’ve already made them (and we might as well get something out of them), why is the reaction to a period of prolonged sub-normal interest rates a depression?”
And the Minskyite answer is that it’s the financial system that messes up. That there’s no good way to quickly allocate the losses. The core of it is the fact that losses have not been allocated, and people wanting to commit new money are scared their new money will go to pay for old losses.
And that, I think, is a very fruitful line of investigation — that it’s not so much a hangover of excess buildings and excess machines, because we can always find uses for buildings and machines. It’s a hangover of bad assets — of bad debt that somebody is going to have to pay, or swallow and eat — and social disagreement over who has to eat them. So, I would say investigating the structure of bankruptcy and principal–agency finance, and how to quickly resolve situations in which debts go bad is the most fruitful thing to pursue.
If I can also give a commercial?
Charlie Deist: Absolutely.
Brad DeLong: I had dinner last week in San Francisco with a guy named Jerry Taylor, who used to be a vice president at the Cato Institute, and he now has split off and has his own libertarian think tank called the Niskanen Center in Washington D.C., which has a lot of smart people doing a lot of interesting thinking. If you’re looking for a set of people thinking and arguing about libertarian ideas in the 21st Century, and want to put them on your Christmas list, I think the Niskanen Center ought to be first among your choices.
Charlie Deist: Those who listen to this show know that we often host guests from the Cato Institute — sometimes we’ll have a month where half our guests or more will come from Cato. Jerry Taylor, as Brad DeLong is mentioning, is someone who fits that mold, but he has come up with a new intellectual venture. This is the Niskanen Center, and they are producing ideas — would you characterize them as a moderate, centrist, technocratic Libertarian perspective or … what is their byline or subtitle?
Brad DeLong: Their byline is to explode the center and to kind of ask, “What does libertarian mean, not in the 19th, not in the 20th, but in the 21st century?”
Charlie Deist: I had also hoped to ask you — this is one of those questions that I could talk about for hours, and we’ll just have to keep it to a few minutes — but to your mind, what is the different between a liberal and a classical liberal, and do you identify as one or the other, or both?
Brad DeLong: The shortest way I’d put it is:
Suppose you’re locked in a cage and suppose there’s a key that someone outside the cage is holding. The classical liberal would say, “You’re free as long as there’s a key and there’s somebody you could buy it from.” A New Deal liberal would say, “Wait a minute, you’re only free if you have the money to buy the key from the person holding it.”
I would say I’d identify myself as a modern liberal — a New Deal liberal — for that reason, but I’d also say that New Deal liberals, traditionally, have an appalling disregard for the magnitude of government failure and for the damage caused to the economy by rent seeking.
If I find myself in a group of too many social democrats, I’ll actually start calling myself a neoliberal. And if I find myself in a group of too many liberals, I’ll start calling myself a social democrat.
Charlie Deist: So kind of a natural contrarian — I like that.
We’re gonna have to cut off my conversation here. If you are interested in following Brad DeLong’s work, you can find him at bradford-delong.com. He’s also on Twitter at @delong. And once again, I’m Charlie Deist, filling in for Bob, who will be back next week.
We’ve just spent the hour discussing the Austrian theory of the business cycle, in contrast with the Keynesian perspective, as well as the Friedmanite, the Minskyist, and there’s probably many other perspectives that we didn’t get to. This is an area that anyone who’s interested can get online and do their own homework, and form their own conclusions. We’ve been fortunate to have someone who has a nuanced perspective, and can treat this issue with the full intellectual weight it deserves. So stay tuned next week, Bob will be back. And you can always catch this episode and any others at bobzadek.com. Once again, thanks Brad for taking the time to talk with me.
Brad DeLong: You’re welcome. It’s been a great pleasure.
Q is for Quantity Theory of the Money
This Theory is fundamental. Its correspondence with fact is not open to question. — Lord Keynes, on the QTM
Economists have understood the fairly direct relationship between the quantity of money and the level of prices for centuries.
During the Great Depression, the stock of money fell by a full third. While there is some question whether this would have happened under a pure gold standard, this collapse in the banking system was certainly a factor in the length and severity of the downturn. There is some debate over what aspect of the collapse is most responsible for declining economic activity.
Milton Friedman, the chief proponent of monetarism, held that inflation (and deflation) are always and everywhere a monetary phenomenon. All that was needed to stave off the unnecessary deflation was a general injection of temporary liquidity by the Federal Reserve.
Ben Bernanke, however, wrote a paper in the 1980s in which he emphasized the specific relationships between banks and their borrowers — a form of institutional capital that makes up the “credit channel.” Bank closures disrupt the credit channel and constitute a supply shock to the economy, not a demand shock, like a fall in the supply of money. In this scenario, the Fed must take a more active role than Friedman recommended to shore up the banking system and preserve institutions that might otherwise fail.
R is for Reserves, Interest Paid on
In 2008, when the Federal Reserve engaged in TARP (Troubled Assets Relief Program), the result was a large injection of liquid assets — cash — in exchange for mortgage-backed securities whose values had crashed, with the assumption that these values would recover if they acted as a buyer of last resort. However, in order to prevent a major inflation from the new money entering the financial system, they also began paying 0.25% interest on banks’ cash reserves — essentially paying banks not to lend.
This has fundamentally changed the way that monetary policy is conducted. Jeffrey Rogers Hummel suggests that it heralds a shift towards a greater central planning role for the Federal Reserve, and away from the simple, discretionary rules that Milton Friedman advocated.
Economists continue to speculate on what Milton Friedman, perhaps the most respected economist since Keynes, would say about the present situation.
The final installment of this series will pick up with Friedman’s modern adherents: the market monetarists.
- Bradford-DeLong.com — DeLong’s semi-daily web journal.
- @Delong on Twitter
- ABCs of Austrian Business Cycle Theory with Robert Wenzel, Part 1
- Note to Self: Getting in Touch with My Inner Austrian: Toy Stochastic Processes Edition, November 26, 2017 — DeLong’s attempt to build a mathematical model for the Austrian theory.
- Getting in Touch with My Inner Austrian: A Still-Unwritten Paper, by Brad DeLong, April 03, 2008
- Manias, Panics and Crashes: A History of Financial Crises, by Charles Kindleberger, December 2000
- Ben Bernanke versus Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner, by Jeffrey Rogers Hummel, The Independent Review, Spring 2011
- Getting in Touch with My Inner Austrian: A Still-Unwritten Paper, by Brad DeLong
- Neel Kashkari, Pres. of the Minneapolis Fed: “My Take on Inflation”
- THINKING ABOUT THE LIQUIDITY TRAP, Paul Krugman, December 1999