ABC’s of Business Cycle Theory

Part 2 — A Keynesian Critique, with Brad DeLong

Bob Zadek
Bob Zadek
Dec 9, 2017 · 37 min read

Beyond Keynes vs. Hayek

Historical memory can be skewed by the impulse to tell a good story. Keynes and Hayek offered different stories about the business cycle. Keynes took the position that capitalism needed to be saved from itself, while Hayek said that government intervention itself was responsible for the boom and bust cycle in the first place.

Keynes versus Hayek — sworn enemies, duking it out in “the fight of the century” — makes a great story (and an even better music video), but in reality, the men agreed on many substantial points. For example, both were liberals who warned the dangers of totalitarianism and understood competitive markets to be vastly superior to the central planning of a socialist state. Furthermore, both agreed that inflation was unjust to the extent that it robbed savers.

Bruce Caldwell speculates that the main disagreements between Hayek and Keynes were driven more by the differences in the personalities than their understanding of the underlying dynamics of the business cycle. Hayek’s worldview — “dark, sobering, sober” — led him to pessimism about our ability to improve outcomes through technocratic tweaks. Keynes — progressive, optimistic, and a more than a tad grandiose — thought it was within humanity’s grasp to reshape institutions to our advantage.

Without downplaying the differences between the Austrian and Keynesian schools, we want to avoid setting up a false choice. Austrians try to explain how bubbles build and lead to a disequilibrium, while Keynesians emphasize the frictions like sticky wages that slow down or prevent the Austrian “recalculation” story from running its course.

The following interview was conducted in the spirit of intellectual charity — a spirit that Keynes and Hayek rarely achieved in their dialogue. Brad DeLong is a a neo-Keynesian critic of many self-identified Austrian economists, yet he admits that Hayek in particular among the Austrians was a deep thinker, who can teach us a great deal about the social science side of macroeconomics.

Economics is made up of abstractions of reality, but economies are made up of real people whose lives are thrown out of balance by business cycles. Even the strictest Austrian would presumably be in favor of a policy that could bring us out a recession faster and with no downside. And even the most profligate Keynesian would not call for ever-expanding stimulus spending if he thought would saddle future generations with unpayable debt while merely postponing an inevitable crash.

This part of the series attempts to synthesize insights from Friedman, Hayek, and Keynes, and explain the biggest difference between modern liberals in the mold of Keynes and classical liberals who follow Hayek.

Dr. Hayek’s Strange Vision

Three months before Keynes’ death in 1946, he wrote a letter to Hayek signaling how far the two men had come towards agreeing with each other on the dangers of excessive stimulus spending.

Hayek had warned that some of Keynes’ followers might be abusing his ideas to grow government beyond reasonable limits. Keynesianism was becoming a cover for fiscal irresponsibility — even during good times. Keynes dismissed the concern, saying that if such a dangerous misinterpretation ever took hold in the mainstream, he could bring his acolytes into line with the wave of a hand.

Years earlier, the professors had been worlds apart, trading insulting reviews of each others’ main treatises on the subject. Keynes, writing about Hayek’s Prices and Production, went as far as to say:

“The book, as it stands, seems to me to be one of the most frightful muddles I have ever read, with scarcely a sound proposition in it beginning with page 45, and yet it remains a book of some interest, which is likely to leave its mark on the mind of the reader. It is an extraordinary example of how, starting with a mistake, a remorseless can end up in bedlam. Yet Dr. Hayek has seen a vision, and though when he woke up he has made nonsense of his story by giving the wrong names to the objects which occur in it, his Khubla Khan is not without inspiration and must set the reader thinking with germs of an idea in his head.”

Little has changed in 100 years. What seems as clear as day to the proponents of Hayek’s Austrian School seems like nonsense to the Keynesians, and vice versa. The debate fizzled out as World War II and other more pressing issues came to the fore, so the record was never set straight. However, it is often forgotten that Keynes acknowledged the shortcomings of his model, and changed his mind — taking a turn towards fiscal conservatism after the war. Today’s “neo-Keynesians” must be careful not to advocate what Keynes himself rejected.

The Austrians diagnosed a clear problem and began to develop a solution, although the Austrians like Hayek never formalized their models like the Keynesians did. Now, their ideas are being brought back into dialogue with the more mainstream schools of thought, which have independently confirmed parts of the Austrian story.

TRANSCRIPT

Bringing Keynes and Hayek Back into Dialogue

Charlie Deist: I’m joined by UC Berkeley economics professor Brad DeLong.

While preparing for last Sunday’s show on the 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 graduate degree in economics, and if I were trying to diagnose a problem in almost any other field — something as complex 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, “.”

We’re 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 what’s going on when we read about the Federal Reserve, 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.


I is for Inflation Targeting

Although Austrians are suspicious of aggregate data, inflation is one aggregate indicator that cannot be ignored. Because both rapid inflation and deflation are undesirable, economists monitor measures such as the consumer price index (CPI) to see whether the economy may be headed for recession, or “overheating.”

In recent decades, the Fed has tried to target inflation at around 2% annually. They can forecast future inflation with internal projections or by checking the market’s expectations. The Treasury offers a TIPS bond — the Treasury Inflation-Protected Security — which pays interest based on recorded inflation during the period in which the bond matures. The “TIPS spread” is the difference between the interest rate on TIPS bonds and on non-inflation-protected T-Bonds, which gives a rough estimate of inflation expectations. The TIPS spread became negative in 2008, and has 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 remain stable. When inflation fell, the real rate rose. Debts accordingly became a greater burden, and mortgage holders who might have otherwise been on the edge of bankruptcy found themselves underwater.

In theory, the Fed should be able to set long-term inflation expectations wherever it wants by increasing the money supply and making it clear that the increase is permanent, not temporary. Hitting an exact near-term inflation target is more difficult, however. — especially when markets are basing their expectations on the path of future interest rates rather than the money supply. In times of uncertainty, when the “zero lower bound” is involved (see “L is for liquidity trap”), the path of monetary policy can become unclear.

The Return of the Evil Depression Fairy

Charlie Deist: I want to start with a quote from . This was when Alan Greenspan was still Chairman of the Federal Reserve, and it echos the message of my last guest, Bob Wenzel, that the Federal Reserve can 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.

You said:

“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.”

April 20, 2004

So back in 2007, you were worried about the Federal Reserve inflating a bubble. What is the Keynesian perspective on the potential for the Federal Reserve to engage in this kind of procyclical monetary policy — i.e., monetary policy that, rather than smoothing out the business cycles like it’s supposed to, actually exacerbates them and makes them worse?

Brad DeLong: 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 at which the government plus private actors wanted to spend was large enough 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. As Keynes 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’s 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, etc., that no, this is a very dangerous policy to pursue.

J & K 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 of academic opinion has been kinder to Keynes’ ideas. 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’ main ideas include 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 collective economic forecasts and spending 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 group’s 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 level without much downside, except for higher taxes in the future, when the economy is healthy (a reasonable trade-off if the policy works).

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.


Minsky Muddies the Waters

Charlie Deist: So there’s a lot to unpack here. We have four names: Keynes, Friedman, Hayek, and now Minsky. 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. 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: As early liberal John Stuart Mill put it back in 1829 — and I think he got it right, and Keynes and Friedman would agree — 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.” You have high unemployment, idle factories, and “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 is, 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 — that lead to financial over-speculation and so forth — 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.

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 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.


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 situation arises due to the way that the Federal Reserve injects liquidity (i.e., more readily spendable forms of cash) and the instrument — interest rates — it chooses to target.

In the modern era, central banks change the money supply through “open market operations” — buying and selling short-term Treasury bonds from the banking system. All else equal, banks prefer to hold as little cash in their vaults as possible compared with loans or bonds that pay some amount of interest. However, the fractional reserve system requires them to have a certain amount of cash in the Federal Reserve’s vaults at the end of the business day. Banks thus trade with one another in a highly liquid “open market” to ensure that they have sufficient federal funds. If not, they must borrow from other banks at the federal funds rate — a market rate that increases when cash is scarce or demand for money is high.

By swapping newly printed cash for Treasury bonds, the Fed increases “Base Money” and lowers the short-term federal funds rate until it reaches the target that is believed to be sufficient to boost aggregate demand back in line with the economy’s full potential.

Normally, with more cash in their vaults, banks are more likely to lend. However, there is a lower boundary to the federal funds rate — zero percent — beyond which banks will be indifferent between holding non-interest bearing bonds and non-interest bearing cash. Further injections of money will simply sit on banks’ balance sheets with no increase in lending/investment. At the zero-lower bound, no new loans are created and the “money multiplier” fails to kick into gear.

, citing Japan as the poster child for ineffective monetary policy. It would be less than 10 years before the Great Recession brought about the dreaded zero-lower-bound scenario in the United States.

In response to the liquidity trap, Keynesians often propose direct government stimulus as a way to get overall spending flowing again. When lowering interest rates is no longer an option, paying out cash for public works programs or as tax rebates is a fail proof way to increase the amount of money in people’s wallets and checking accounts. This should induce people to spend down their real cash balances (the percentage of wealth held as currency or currency substitutes) until they are back in line with their preferred ratio relative to less liquid assets.

However, the Federal Reserve does have other monetary policies at its disposal besides simply lowering the current interest rate. It can specify what interest rates will be in the future through what is known as forward guidance. A credible commitment to keeping interest rates low can lead to an increase in inflation expectations, which further lowers real interest rates. Furthermore, a central bank is not limited to buying short-term bonds. It can buy other assets — such as the “troubled assets” purchased under TARP (the Troubled Asset Relief Program) — which also 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.

Indeed, it has been noted that there is no historical case in which a government tried and failed to produce inflation by printing money and buying things.

Here, Austrians would argue that such policies are just forestalling an inevitable, necessary correction and inflating a new bubble. However, if the Fed can target its purchases neutrally, the resulting inflation could ease the reallocation of resources from the malinvested sectors to its new uses.

Learn more about Open Market Operations, the Fed’s main tool for injecting liquidity to boost demand.

M is for Minsky Moment

There is a growing body of research into the psychology behind bubbles. It’s been said that nothing makes someone crazier than seeing everyone around him getting rich. While rationality may be typical for certain kinds of consumer behavior, crowds often have major blind spots when it comes to the macroeconomy, and the “exception” of irrationality may be closer to the rule.

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 the underlying psychological phenomena of overoptimism and short-sightedness do not necessarily require government intervention to take hold. They could be the result of a market failure rooted in irrational crowd psychology.


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 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 principal–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 thumbs. If we can have moral bankers and a moral government, then somehow 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 up — 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, 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.

“We should hope that one day, economists will be as useful as dentists.”

— John Maynard Keynes

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 source of the boom that produces the bubble and then slides over into banks that are improperly regulated then all of a sudden he 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 — have 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 the bubble is in some sense the cause of the depression — and that if you avoid the boom in the bubble, you manage to avoid the depression — 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 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 — even though we might disagree on some philosophical issues — it does seem like a 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. The Federal funds rate is the shortest-term interest rate possible, while the natural interest rate is the medium to long-term rate that lenders and borrowers consider when making investment decisions.

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. However, Hayek and later Keynes were skeptical about the idea of a natural rate. Even if it did exist, they thought is could not be measured.

O is for Output Gap

Keynesians characterize the economy as operating either at, above, or below potential output. A recession breeds an output gap, due to 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 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 and project managers to fit into new industries. Cranes and cement mixers may not have immediate uses at all, and 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 replied with why he believes this explanation does not 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.”

May 2009

An Austrian rejoinder might note that construction is only the tip of the iceberg — i.e., 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. Modeling 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 — Michael, let’s hear your question.

Michael: Hi Charlie. Thanks for a fascinating show. When you talk about the Austrian school, a fundamental aspect of it is praxeology, 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 — 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 equilibrium, 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. He rejected this 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 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.

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 praxeology 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 else can we say [about the laws governing purposeful human action]?

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, 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 rejection of Walrasian general equilibrium as a road that may well mislead us and 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 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 is 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 a counterpoint with the same logic, 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 become overconfident in our models.

Brad DeLong: Did you ever see the gorilla basketball video?

Charlie Deist: Yes, 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 going to 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, etc., etc.”

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 dealing with 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.


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 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, one job for an effective central bank 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.


Real Wealth or Another Bubble?

Charlie Deist: Let’s hear from another caller, 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. In one sense, it reflects not that we’re rich now so much as that we’re not expected to become that much richer, faster in the future.

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. What it’s really saying is that 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 the neighborhood of Elmwood (a mile south of the University, a mile north of the Rockridge BART) 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.

Given the population of greater San Francisco, if 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. 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. 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 need to incorporate 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.

Frontiers for the Aspiring Austrian Economist

Charlie Deist: I want to come back to what you were saying about Hal Varian and this world where more of the value is coming from our smartphone and 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 it’s a mixed bag, and in this new economic system, maybe there’s less emphasis on physical stuff and things.

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 investments because cheap credit encourages a more roundabout production process. Hayek talks about the structure of 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 pursue?

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?”

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 . 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–agent 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, 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 ., 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: 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 difference 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 this:

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: A natural contrarian — I like that.

If you are interested in following Brad DeLong’s work, you can find him at . He’s also on Twitter at .

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 are probably many other perspectives that we didn’t get to. Anyone who’s interested in this area can get online, do their own homework, and form their own conclusions. We’ve been fortunate to hear from someone with nuanced perspective, and who can treat this issue with the full intellectual weight it deserves. Once again, thanks Brad for taking the time to talk with me.

Brad DeLong: You’re welcome. It’s been a great pleasure.


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