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Posts Tagged ‘Austrian economics’

Every Model is Wrong

July 8, 2014 52 comments

We have been discussing Austrians and their relationship to “mainstream” economics here lately and that topic raises a lot of issues.  I want to go into some of those issues in depth but I want to address them in a very broad way that isn’t really about Austrian economics.  I want to address some deep philosophical questions surrounding the nature of models and their role in economics and the mindset of many people in various “heterodox” schools including Austrians but also Marxists, post-Keynesians and so on.

Models

In general, models serve one or both of two purposes.  They can be explanatory and exploratory.  By the former I mean that a model can be used to explain some concept that the creator has in mind in a (relatively) simple way to someone who does not necessarily fully see or understand it to begin with.  By the latter I mean that it can be used to explore a question which the creator of the model does not know the answer to.  Now clearly, a model which is originally exploratory, typically becomes an explanatory tool once it has answered the questions it is designed to answer and the function of explanation works in essentially the same way in the mind of the “student,” which is to say that it walks them through a series of logical steps which take them from a set of premises that they already “knew” to a set of conclusions which they previously did not know.  So every model is in some sense explanatory and exploratory, the distinction is in the mind of the beholder.

But the important thing to consider is the mindset of the person developing/working with the model.  Are they designing the model in order to explore some questions that they don’t know or to explain some concept that (they at least think) they know?  In my view, either one is fine.  Probably, the best models are created for the purpose of explaining a concept that is already, at least partially, understood by their creators.  However, what I think is imperative is that, when developing and working with a model, the modeler remain at all times an explorer.  By this I mean that he must be open to the possibility that the model will reveal something he had not previously understood.

This is the line between a scientist and a rhetorician.  It is also analogous to the (easier to understand) process of observation.  If a rhetorician thinks that an increase in X leads to an increase in Y, their goal is to convince you of that and they select data that reinforces their argument and try to ignore, downplay or obfuscate information that contradicts it.  (For an example of this turn on any cable news network at any time.)  If a scientist thinks that an increase in X leads to an increase in Y, they go through a careful process of gathering and analyzing data that can either confirm or refute that hypothesis and if the data refutes it, they acknowledge that outcome.

In modeling, we have a similar situation.  You can try to make a model that shows that an increase in X leads to an increase in Y but if you get in there and suddenly discover that this is not the case in your model, do you say “surprisingly, the relationship between X and Y in this model is not that which I previously speculated,” or do you say “this model isn’t working” and tweak it to get what you want or throw it out all together?  (For the record, it’s not necessarily bad to tweak it but you should notice that you have to do that because something didn’t work exactly the way you thought and this should increase your understanding.) Read more…

Further Reflections on Austrian Economics

July 4, 2014 22 comments

Oddly enough, the appearance of Major Freedom in the comments section of my last post has got me wondering if I have got Austrians all wrong.  I used to see that guy comment on other blogs and always completely miss the point and go on and on about stuff that made no sense.  Some people would always agree with him and they would go down some “Austrian” rabbit hole and everyone else, including me, learned to just skip those long blocks of text.  But since I felt obliged to respond, at least initially, on my own blog I had to go through the ordeal of trying to make counter-arguments to arguments that barely grazed the issues I had tried to address in the first place and it was very frustrating.  And then I started wondering: is this the type of person who has shaped my view of Austrian economics?

The short answer is no but the long answer, I think, is kind of nuanced.  The short answer is that a lot of it comes from Mises.org and people talking on TV like Peter Schiff.  And yes, I have read some Hayek and some Rothbard and some stuff like that.  I though Hayek had some interesting ideas.  I though Rothbard was mind-numbing.  I don’t really know what Mises thought, I just know what they say about what he thought on the afore-mentioned Mises.org.  So it’s not just Major Freedom and company.  Although, I am sure that to a lot of people, that is they account for the vast majority of their run-ins with so-called “Austrians.”  And I think, ironically, that this accounts for much of the severe disdain most “mainstream” economists have for all things “Austrian.”

So I think I have dug one layer deeper than most because I am a libertarian and so I have quite a bit of exposure to somewhat more serious, less troll-like “Austrians.”  But commenter John S. points out (and I have heard from some others) that there are really two schools of Austrian.  The Auburn/Mises.org school which is essentially what I am complaining about and the more reasonable GMU school, and apparently they don’t get along very well.  So I can’t help but wonder if I am being unfair to the latter.  I am trying to look into it a little.

I watched this debate between Caplan and Boettke which I remembered watching years ago and finding interesting.  Essentially, Caplan represents my view perfectly in every respect.  And the Boettke comes out and, as far as I can tell, doesn’t really disagree with anything Caplan says.  I get the impression that they both agree on practically everything except what to call each other.  Boettke thinks Caplan is an Austrian and Caplan thinks Boettke is neoclassical and while Caplan makes points about methodology, Boettke talks about the history of economics and who said what when and a bunch of stuff that I don’t really know about but to me is not that important.  I care about the methodology.  And that is what the people in the Mises.org camp are always griping about.  However, from what I can discern, Boettke seems pretty reasonable to me (though I do think “radical uncertainty,” or whatever, is not a useful concept).

So my position is essentially this.  Speaking solely in terms of micro, the basic, neoclassical, consumer choice model (and the model of markets which is built on it) is good and the arguments I have heard from so-called Austrians against it are all dumb.  Now what I wonder is: Do Boettke and the GMU “Austrians” agree with me that this is a perfectly good model or do they agree with the Mises.org guys that it is all garbage, and on a side note, do they agree that diminishing marginal utility is a logical necessity or, for that matter, that it is important in any way?

I get the feeling that they aren’t completely comfortable with this model because Caplan also wrote this which makes many of the same points I tried to make, along with some others which are also excellent, and he knows the GMU guys pretty well I think.  On a related note, maybe I should have been talking about “indifference” instead of continuous quantities.  Indifference doesn’t drive people to action.  Fine, but people act until they reach a state of marginal indifference.  That’s actually pretty much the central tenet of neoclassical economics.  But I digress.  Also, I probably need to learn a bit from him about how to get along with Austrians better.

But if the answer is that they agree with me about this model, then I am left wondering what is the difference between us.  If they say “nothing, you’re an Austrian” then I am unsatisfied and I would say “no you are mainstream” and we would be having what I consider a pointless argument (very similar to the debate above).  There are still some issues regarding the degree to which our analysis should be driven by preexisting normative beliefs.  Maybe I will say more on that later but for the most part, in my mind, if you drop all the criticisms of mainstream economics (at least the core of micro) and just say “we want to look into the role of the entrepreneur more” or whatever, then I have no problem but then why make a point of differentiating yourself from the mainstream so much?

At any rate, though I am genuinely interested in answering these questions, I think they are all dodging the real issue which is those blasted Mises.org people.  It may be the case that the GMU Austrians are not that nuts but they aren’t the ones on TV or blowing up the comment sections of every econ blog.  And if you go to any kind of libertarian gathering and try to talk to somebody who fancies themselves a part-time Austrian economist (which will be half the people there), chances are they will be suffering from a lot of confusion brought on by the popularity of Mises.org-type thinking in those circles.  So to me that is the issue that must be dealt with.  It would be nice if the GMU types could draw people away from that but they don’t seem to be very successful at this.  I don’t know what the answer is.  I just know that it’s a problem.  And admitting you have a problem is the first step toward recovery.

Categories: Micro Tags:

More on Diminishing Marginal Utility (or: This is Why Austrian Economics Drives Me Crazy)

July 2, 2014 41 comments

For those who are new to this blog, I am a pretty staunch libertarian, free-market kind of guy.  So naturally, there was a point in my life when I gravitated toward Austrian economics.  But the thing that really drove me away was when I realized what they believe about utility, especially “diminishing marginal utility.”  There are quite a few things that I think Austrians are wrong about (hyperinflation and Cantillon effects for instance) but the utility thing was special because it is a case where the confusion is plainly obvious if you really understand the mainstream model of consumer choice.

Of course, I figured I would just explain this to them and we would all live happily ever after.  Needless to say, that never seems to work.  But at this point it has become sort of my white whale: convincing an Austrian–just one Austrian–that diminishing marginal utility is nonsense.  Then recently I stumbled upon this paper by an Austrian, on Mises.0rg, in which an Austrian explains exactly what I have been trying, in vain, to explain.  So, what the hell, might as well give it one more try.

Here is a rough outline of the debate.

1.  Austrians claim that utility is inherently ordinal and that cardinal utility is nonsense.

Mainstream economists agree (at least officially) and have a model in which utility is purely ordinal but Austrians don’t realize it because it doesn’t look ordinal to them.

From my first year graduate text:

Toward the end of the nineteenth century, perhaps initially from introspection, the concept of utility as a cardinal measure of some inner level of satisfaction was discarded.  More importantly, though, economists, particularly Pareto, became aware that no refutable implications of cardinality were derivable that were not also derivable from the concept of utility as a strictly ordinal index of preferences.  As we shall see presently, all of the known implications of the utility maximization hypothesis are derivable from the assumption that consumers are merely able to rank all commodity bundles, without regard to the intensity of satisfaction gained by consuming a particular commodity bundle . . .

. . . To say that utility is an ordinal concept is therefore to say that the utility function is arbitrary up to any monotonic (i.e., monotonically increasing) transformation.

2.  Austrians don’t seem to believe in assuming things that can’t be proven to be necessarily true logically.

To this end they selectively reject whatever hypotheses mainstream economists arrive at because they all require some set of assumptions.

3. The one thing that Austrians feel comfortable claiming that they can prove logically without any assumptions whatsoever (except that people act) is the “law of diminishing marginal utility.”

In order to arrive at this conclusion logically, they construct a framework with “means” and “ends” and postulate that a person will always use a good (means) for the highest valued use (end) first and therefore, as they get more of the good, the value of the marginal use falls and thus you get diminishing marginal utility.  However, this is not a conclusion which logically must be true.  It is, rather, the result of an assumption which Austrians don’t notice that they are making.  McCulloch is somewhat unusual among Austrians in that he realizes this and pointed it out in 1977.  This is why the paper caught my attention.  Now that we know an Austrian said it, can we all agree that this is the case?

[See pp. 251, 252 (you can thank Mises.org for copy/paste protecting the document….)]

McCulloch1

McCulloch2

 

Notice particularly the line: “Bilimovic argues as if these are valid deductions from a rank-ordering on W, but that is not the case unless we assume that the wants are unrelated.  So there you have it, an Austrian saying exactly what I have been trying to say.  But then, having said that, he goes on to assume that “unrelatedness” and continue to deduce the law of diminishing marginal utility based on that assumption.  This wouldn’t be that annoying if he didn’t then say this:

Note that the Austrian principle of diminishing marginal utility is a theorem, rather than an assumption as with Gossen, Jevons and Walras. [p. 255]

Okay, it’s a theorem, but it is only a theorem in the sense that it follows directly from the assumption of unrelatedness of uses.  In other words, in no way does it represent something that logically must be true.  It is just something that is true if the assumptions made to get to it are true.  And we know that that assumption need not be, and probably usually isn’t, true.  This doesn’t make the theorem meaningless but it does make it no different from all of the conclusions of the mainstream model which Austrians like to claim are useless….

And what’s more, the assumption made here is more restrictive than those typically made in the mainstream model of nonsatiation, substitution and quasi-convexity.  So, essentially there is no intellectual reason to cling to this means-ends framework and the notion of diminishing marginal utility.  Frankly, I don’t even understand what Austrians think the significance of diminishing marginal utility is.  If I had to guess, I would suspect that they might say that it implies downward sloping demand (and in some cases upward sloping supply) curves, and that is sort of true but the mainstream model does it much better.

It is diminishing marginal value that implies downward sloping demand.  Value, meaning the willingness to trade-off one good for another.  For this to be diminishing, you only need to have the ratio of the marginal utilities (the marginal rate of substitution) diminishing.  It is possible for this to be the case even if there is increasing marginal utility of both goods.  Now, it is true that diminishing marginal utility of all goods will give you diminishing marginal value, so in that sense, diminishing marginal value does imply downward sloping demand curves.  But you don’t need to go that far.  All it takes is quasi-concavity.  That is why the mainstream model assumes quasi-concavity and not diminishing marginal utility, because it is the smallest assumption required to get the type of refutable implications that the model gets.  So let’s review.

1. Diminishing marginal utility is an assumption.

2. It is more restrictive than the assumptions in the mainstream consumer choice model.

3. Therefore, the mainstream model is better.

This follows logically, therefore you can’t question it.  If you don’t see the logic, I will just dismiss you as someone who clearly doesn’t understand logic.  See what I did there?  But seriously, Austrians, this is an intervention.  I’m telling you this for your own good because I love you, I love the things that you love like free markets, property rights and individual liberty, and I want what’s best for you.  The mainstream model is just a better version of your model.  It’s that simple.  Let me put snarkyness aside for a moment and try to explain why.

1. Means/ends is pointless.

The means/ends framework adds nothing.  It only makes it easier to confuse yourself and others.  Economics is about choosing between scarce alternatives.  That means we need alternatives, and we need preferences over those alternatives.  That’s it.  If you are choosing quantities of two goods, all we need to know (by which I mean assume) are your preferences over different combinations of those goods.  It makes no difference why your preferences are what they are or what “ends” you are applying the goods too.

The only thing the means/ends framework accomplishes is to take the case where a consumer has preferences over combinations of the good and make it into a two-stage problem where the stages are essentially identical.  Instead of just saying “they have certain preferences over combinations of the good” you say “they have certain preferences over different ends and the goods can each be used for different ends in different ways.”  But the only thing that matters is their preferences over the different combinations of goods because that is the decision we are trying to model.  So you try to logically deduce what those preferences look like based on what you assumed about the preferences over “ends” and the connection between the ends and the means.  Then you claim that what you are saying about their preferences over combinations of goods is not an assumption, it follows from logical deduction.  But it only follows logically from the (possibly implicit) assumptions you made about their preferences over ends and the connection between ends and means.  You just buried the assumptions one stage deeper.  But this gives you nothing, it makes it needlessly complicated.  The only thing this accomplishes is it makes it easier for you to apply false reasoning in connecting the two levels by implicitly assuming something that is not necessarily true, deceiving yourself into thinking that it is necessarily true because you don’t notice that you are assuming it, and then believing that you have proven something which you haven’t.

So why not get rid of all of that nonsense and just say that people have preferences over different combinations of goods?  I think there are two possible Austrian answers to this.  One is that this is methodologically unacceptable because we are not allowed to make assumptions about people’s preferences that aren’t objectively and immutably true.  But the Austrian making this argument must not have been reading carefully because that is what you are doing anyway and the assumption you are making is more restrictive than the one I am making.  The other argument is that then we wouldn’t be able to sit around and talk about how ridiculous mainstream economics is because then our model would be exactly like theirs. (Okay, so maybe a little snarkyness.  A fish has gotta swim.)

2. You need more than just action.

Nothing follows logically from the single axiom that people act.  Their preferences matter.  Since we can’t observe preferences but only action, there is nothing we can say about those preferences that must be true a priori.  If you can’t say anything about those preferences that can’t possibly not be true, you can’t say anything about action period.  If you try, you will just end up assuming something without realizing it.  A careful and responsible approach to modeling action must be very explicit about what it assumes and try to cut those assumptions down to the smallest, simplest, most realistic and least restrictive assumptions possible for the model to “work” and tell you something interesting.  This is what the mainstream model has done and–I can’t stress this enough–our assumptions are less restrictive than yours!

3.  Continuous quantities!

First of all, discreet quantities are not more realistic.  Gasoline, flour, tap water, electricity, labor, cheese, ground beef, and a million other goods are actually measured in continuous quantities.  But more importantly, the consumption of any good properly understood, should be modeled as consumption per some unit of time.  So it’s not the number of cars you buy on a given day on the horizontal axis of the “cars” market, it is the average cars you use up in a year or something like that which is a rate and is inherently continuous.  But even more importantly, it makes everything so much easier and more sensical to use continuous quantities.  I sometimes wonder if you are purposely sabotaging yourselves by forcing yourselves to work with a model that is so unmanageable that no worthwhile conclusions can possibly be drawn from it.  It doesn’t have to be that way.

4.  It really is ordinal utility.

Just because we use a function to represent preferences doesn’t mean they are cardinal.  The numbers have no significance in the model beyond identifying which bundles are preferred to the one in question, which ones it is preferred to and which are neither (in which case the person is indifferent between them).  That is all the numbers mean.  You can plug in any function that preserves the rank ordering and you will get the same results.  This is something we are aware of and are careful about (at least some of us are).  Representing ordinal preferences this way allows us to apply a much higher degree of logic to the problem in much simpler ways than your framework.  This, is a benefit not a drawback.   Typically, we don’t even assign numbers or even a function we just say let there be some function which conforms to the minimum necessary assumptions mentioned above.  The fact that we put an actual function to it with numerical values in order to teach undergraduate students does not make the underlying model cardinal.

So there it is.  If you acquiesce on these points, you arrive at the standard mainstream model.  This has been an Austrian intervention.  Sure it’s one guy doing an intervention on a whole gang of people who all act as a mutual support group for each other, and yes, that does seem to run counter to the established rules for interventions.  So maybe it’s wishful thinking to expect it to be successful.  But that doesn’t mean I can’t waste my life trying.  Maybe if I can get through to one person, and then he can get through to one person, one day all of us true, old-school, ordinal-utility types will be able to band together and have an intervention with the Scott Sumners of the world when they say things like this (good grief!):

As an aside, I believe about 90% of all negative and positive utility in life occurs during dreams, as the feelings tend to be more intense than during waking hours.  (We forget most dreams.) It is only the bigotry of awake people (who control the printing presses) that privileges waking life.

 

Peter Schiff on Deflation

April 9, 2014 3 comments

A while back I sort of blasted Selgin for his position that deflation is not necessarily bad.  That was a bit unfair of me since he actually has a fairly nuanced and not totally unreasonable point.  If we had a monetary policy regime which caused deflation to not be bad (in other words, if we had one entirely different than the one we have) then it wouldn’t be bad.  But my reaction was sort of a knee-jerk response to a point of view that I run across often in libertarian circles that drives me nuts.

Here is the guy I was really arguing with.  So let me take out my frustration on him.  There is a lot that is wrong with this so I will try to knock off the really obvious but less important points first and work my way up to the big important stuff.  First of all, Schiff discusses an article on Bloomberg which he provides no link to.  IMO this represents a breach of blogging etiquette (there’s not a single link in the piece, it’s almost like he doesn’t expect the reader to question any of the bold empirical claims he is making).  Here is the link.

Postponing Consumption

Here is the argument.

 . . . there is now a nearly universal belief that deflation is an economic poison that works its mischief by convincing consumers to delay purchases. For example, in a scenario of 1% deflation, a consumer who wants a $1,000 refrigerator will postpone her purchase if she expects it will cost only $990 in a year. Presumably she will just make do with her old fridge, or simply refrain from buying perishable items for a year to lock in that $10 savings. If she expects the cost of the refrigerator to decline another 1% in the following year, the purchase will be again put off. If deflation persists indefinitely they argue that she will put off the purchase indefinitely, perhaps living exclusively on dried foods while waiting for refrigerator prices to hit zero.

That is a perfectly good debunking of a position that I don’t think anybody actually holds.  I dug out my intermediate macro text and I think I have identified what he is arguing with.  Here is Blanchard on the subject.

When inflation decreases in response to low output, there are two effects: (1) The real money stock increases, leading the LM curve to shift down, and (2) expected inflation decreases, leading the IS curve to shift to the left.  The result may be a further decrease in output.

We have just looked at what happens at the start of the adjustment process.  It is easy to describe a scenario in which things go from bad to worse over time.  The decrease in output from Y to Y” leads to a further decrease in inflation and, so, to a further decrease in expected inflation.  This leads to a further increase in the real interest rate, which further decreases output, and so on.  In other words, the initial recession can turn into a full-fledged depression, with output continuing to decline rather than returning to the natural level of output.  The stabilizing mechanism we described in earlier chapters simply breaks down.

Now I actually have a lot of issues with this theory.  For instance, it assumes irrational inflation expectations.  Also it assumes an exogenous change in output which causes inflation to fall.  I am actually inspired to explore these issues in a later post (this is not to say that economists are unaware of them).  But nowhere is it assumed that people, expecting prices to fall slightly, will decide to not consume at all.  There is a much more complex argument underlying this.  It involves a feedback loop between prices, inflation expectations and consumer demand which is certainly questionable.  But Schiff is not even scratching the surface of the actually questionable parts.  He is just seeing a result that he thinks is questionable (and is) and he is imagining that it is the result of a ridiculous formulation of the underlying consumer demand function (which it is not) and he is pointing out how ridiculous that demand function would be.  If this were what any economist had in mind, then he would have an excellent point.  However, I don’t think that is the case.

Sticky Wages (and “a change in demand is different from a change in quantity demanded”)

This is an area where I sort of agree with him.  The role of sticky wages tends to be exaggerated with a conspicuous lack of attention put on artificial (government) sources of stickiness like unions and minimum wage and price controls.  But he is going too far by claiming that these are the only source of price stickiness.  Certainly, at the very least, we can acknowledge that long-term contracts exist.  Plus there’s the whole debt thing that I’m always talking about (more on that later).  But what really betrays a failure to comprehend the sticky-wage argument is this.

However, inflation allows employers to do an end run around these obstacles. In an inflationary environment, rising prices compensate for falling sales. The added revenue allows employers to hold nominal wage costs steady, even when the raw amount of goods or services they sell declines.

This misses the point entirely.  He seems to be taking a decrease in the quantity sold for granted (reasoning from a quantity change?) and then treats the inflation as a completely independent phenomenon that just puts extra money in sellers’ pockets in spite of this decrease in order to allow them to keep wages high.

The actual argument behind sticky wages is not that the monetary authority has to cause inflation when the quantity of goods produced falls in order to keep wages from falling.  It is that they have to prevent prices from falling because wages can’t fall and that would cause the quantity of goods produced to fall.  This being due to the fact that employers could not continue to employ the efficient number of workers at the new, higher real wage.

So if we don’t start our reckoning by assuming that the thing we are trying to avoid happens exogenously (for no apparent reason), and instead we imagine that aggregate demand drops, perhaps due to unexpectedly tight monetary policy, we can make better sense of things.  In this case, demand for all goods would decrease.  This means that sellers would have to either reduce their prices or sell less or do both.  If all prices (including wages) were not sticky at all, they would simply lower their prices and wages until they were at the same quantity of sales and employment but at lower prices and wages.  But if they can’t lower wages, it will not be optimal for them to keep producing the same quantity at a lower price and the same wage.  This will cause them to cut back production (by laying off some workers) and lower prices until they are maximizing profits given the new lower demand and inefficiently high, sticky wages.

This, of course, can be avoided if the monetary authority avoids tightening, or in the case of aggregate demand (which is not the same as quantity) dropping for some other reason, by adopting a more accommodative policy to push it back up.  Is this a compelling argument for having a monetary authority manipulate the price level in the first place?  Maybe not, you decide.  But it is not a nonsensical argument and arguing with a distorted, straw-man version of it doesn’t get us anywhere.

And while we’re on the topic of Peter Schiff not really understanding what “demand” means, let’s deal with this:

Economists extrapolate this to conclude that deflation will destroy aggregate demand and force the economy into recession. Despite the absurdity of this argument (people actually tend to buy more when prices fall), . . .

There are two problems here.  One is that deflation doesn’t destroy aggregate demand, falling aggregate demand causes deflation.  I can forgive him for this because the textbook argument I cited above does actually give the impression that the causation goes both ways.  I think this is a problem with that exposition.  So I would be inclined to agree with his criticism if he didn’t blow it with the parenthetical statement.

This is econ 101 stuff.  The quantity demanded by a given consumer (or all consumers) is larger when price is lower and other things are constant.  This is different from a fall in demand!  Market prices are determined by supply and demand.  When demand falls, both price and quantity fall.  Aggregate supply and demand mean something a little different but the basic intuition is the same.  If your argument against the deflationary spiral is that “people buy more when prices fall” you are several layers of reasoning short of understanding the thing you are arguing with.

Debtors and Creditors

This is where it starts to get near and dear to my heart.  Schiff points out that inflation helps debtors but hurts creditors, giving the impression that it is simply a sterile transfer from one group to another with the implication that it goes on because the beneficiaries are more politically connected than those on the other side.

While it is true that inflation (by which I mean more than expected inflation) helps debtors and hurts creditors, this does not make the net effect neutral.  This is because people in aggregate are net debtors vis-à-vis the banking system.  So it is possible for us to all go broke together.  This is where my crackpot theories diverge from both the Schiff/Rothbard crackpot theories and from the “mainstream” (crackpot) theories.  So going into that in detail here would take us far afield but if you’re interested click here, here and here.

The Zero Inflation Boundary

Schiff gives the impression that, until this Bloomberg article, economists were only worried about negative inflation and that they only advocated low, positive levels of inflation because this provides a buffer against accidentally falling into deflation but that so long as this is avoided, there is no problem.  I don’t think this is an accurate characterization of the stance of most mainstream economists.

There are two separate issues here.  One is the question of the appropriate long-run policy regime.  This is where Schiff probably got this idea.  Most macro models have some version of money neutrality in the long run.  Often, this takes the form of superneutrality which means that the monetary authority can grow the money supply (and therefore the price level) at any rate they want without affecting the real economy in the long run. 

This leaves policy-makers (assuming they control the money supply) with the issue of selecting a long-run growth path for money and prices.  A natural argument, if you believe in sticky prices/wages, is then to say that a positive but moderate inflation target might be best because it allows for some cyclical fluctuation around the target without triggering the sticky-wage problem.  This, admittedly, is a lot like Schiff’s characterization of the mainstream position.  But this is not really the issue that most economists are concerned about when they warn about inflation being too low.

It is one thing to argue that the monetary authority could follow a zero-inflation long-run policy path and it would be no better or worse than a 2% inflation or 10% or -2% inflation path.  It is something else entirely when the monetary authority sets a 2% inflation target and then produces 1/2%.  It’s not that there is something magic about crossing the zero-lower-bound on inflation.  The problem is when inflation runs below expectations.

When people make long-term financial decisions, they do so with some expectation about future prices.  For instance, if you invest in producing a good, you have to predict the price of that good in the future.  If the price turns out to be lower than you thought, your calculations will be wrong.  There is not some eternal magic number that the price must be and the central bank has to make it hit that price or else cause a lot of problems.  It’s just that they have to not screw up peoples’ calculations by causing them to expect a certain price level and then causing a different level to occur.

This is particularly problematic when it goes on for an extended period of time without any attempt at filling in the gap.  The bigger that gap gets the bigger the difference between the actual price level and the level people were expecting when they initiated long-term financial positions in the past.  Plus if they go on like this for a while without changing their target, it starts to become unclear what to expect from them in the future.

This is mostly important for decisions involving nominal debt because, as I like to go on and on about, debt contracts are long-lived and nominally denominated so your obligation in nominal terms does not fluctuate with the nominal value of other things like your labor or your house or the output of your business.  And remember, aggregately, we are net debtors so when the price level grows more slowly than we were expecting, this causes a systematic weakening of the financial position of the economy as a whole.

This is my special way of characterizing the issue at the heart of the inflation question.  There are different ways of characterizing these issues and different models for trying to understand them but almost all of them rely in an essential way on the role of inflation expectations.  Peter Schiff is not even scratching the surface of these issues.

 

P.S. This is the most unimportant point and I originally put it at the beginning but it is probably also the most inflammatory and I figured some people might not make it past it to the more important stuff so I cut it out and stuck it here at the end.

 

Definition of “Inflation.”

This is a common sticking point for Rothbardians (which is what I am now using to refer to a particular popular sect often known as “Austrians” on the advice of commenter John S).  Economists almost universally use this word to refer to the change in the aggregate price level.  Rothbardians commonly assert that this is the “wrong” definition in the sense that it was not the original definition.  This is a completely pointless debate.

Usually this argument is brought up for one of two reasons.  One is to generally discredit mainstream economists and imply that they don’t know what they are talking about because they don’t even use the “right” definitions of words.  The other is to weasel out of hyperinflation predictions by saying “well, okay, prices haven’t really risen that much but that’s not the actual definition of inflation…”

I am no expert on the evolution of this term and I don’t care about it enough to research it but just for fun here is my educated guess of how things went down.  Originally inflation meant what the Rothbardians say it means because at that time, that was the most useful definition for thinking about the economy.  Eventually the state of economics evolved in such a way that someone had to give a name to the rate of change in the aggregate price level and they called it the “inflation rate” because they figured prices tended to be positively correlated (perhaps proportional) to the size of the money supply, other things being equal.  As the science continued to evolve, economists found themselves being very interested in the rate of change of prices and not so much in the money supply, except to the extent that it affected prices.

To see why this is reasonable consider the following thought experiment.  You need to make some investment/consumption decisions.  Maybe this is buying a house, or investing in the stock market or taking a new job or whatever, it doesn’t matter what it is.  An angel comes down from heaven and offers to do you one of two favors.  He will either tell you what the size of the money base will be in ten years (and not the price level) or he will tell you what the price level (somehow defined) will be and not the size of the money base.  Which would you prefer?

Before 2008, you probably could have at least argued that the choice was trivial because you could extrapolate pretty easily from one to the other but that notion should be dead now.  Of course, Rothbardians realize that what really matters is prices, their arguments are always actually about the price level.  They never say “we’re going to have hyperinflation of the money supply and you should be really worried about that even though prices will never rise more than 2% per year.”  When they make their inflation arguments, they are always talking about the price level.  It is only when those predictions don’t come true that they step into their time machine and act like the original argument that took place two years ago was really a hundred years ago and “inflation” didn’t really mean what you thought it meant.  And by the way, they weren’t really making a prediction because Austrians don’t make predictions so if you thought they were, you must have been confused.

When economists say “inflation” they are talking about changes in the price level.  All economists realize that this is what other economists mean.  If you want to use it in a different way, and be clear that this is what you are doing, because it allows you to say something interesting, I have no problem with that but if you are just ridiculing someone for using a word to mean what most people commonly accept it to mean, you are wasting everyone’s time.

Why Austrian Economics is Devastating to Libertarians

March 9, 2014 56 comments

Since it’s the weekend, I’m going to take a break from my attempts to reinvent (essentially) the existing macroeconomic paradigm from the ground up using debt (and collateral) as the backing for money and do something much easier–bash Austrians.  This is from a recent post on The Money Illusion.

I constantly hear conservatives complain that elderly savers can’t earn positive interest rates because of the Fed’s “easy money” policy.  Is there any time limit on how long you will make this argument, before throwing in the towel and admitting rates are low because of the slowest NGDP growth since Herbert Hoover was President?  Or is your model of the economy one where decades of excessively easy money leads to very low inflation and NGDP growth?

In other words, is there some sort of model of monetary policy and nominal interest rates that you have in your mind, or do you see easy money everywhere and tight money nowhere?  What would tight money look like?  What sort of nominal interest rates would it produce?

If you have spent any time at all reading econ blogs you should know exactly what answer you will get to this without bothering to check the comments section.  But in this case, you don’t have to wade too deep into the 266 (and counting) responses before you get it.  On the second comment Old Reliable, Major_Freedom, supplies it for us.  (I bet when people see “Free Radical” they expect me to be like that guy but it’s partly tongue-in-cheek!) Read more…

Austrians on Deflation

January 30, 2014 1 comment

A commenter on an older post about hyperinflation says the following:

“deflation is not the end of the world, and there are different kinds of deflation, too.”

Then he posts links to a bunch of Austrian posts about inflation and deflation. They are highly confused and I want to go through them point by point. First though, let me say that I agree there are different types of deflation. This is what I have been trying to say all along. If money were an organic and decentralized phenomenon, then there would most likely be steady mild (price) deflation at most times. This is altogether different from what happens when we have a central bank regime which encourages a highly leveraged society and then tightens monetary policy (or fails to loosen it sufficiently to keep the leveraging going). I’m not confusing these two, Austrians are confusing them. When they say “deflation is not the end of the world” they (seemingly) are talking about the first kind. But they say this in contexts which have nothing to do with that type of regime.  They don’t see the difference.  Deflation in a highly leveraged economy is the end of the world.  Read more…

More on Hyperinflation

January 14, 2014 Leave a comment

There is a piece on Mises.org that sums up the confusion among Austrians and conservative more generally about hyperinflation.   For those of you who don’t know me I am a libertarian and don’t like the idea of a central bank but I think this hyperinflation stuff is seriously misguided and bad for the liberty movement.  There is a lot deal with here.

First, the article clearly states what the author means by hyperinflation.

Hyperinflation leads to the complete breakdown in the demand for a currency, which means simply that no one wishes to hold it. Everyone wants to get rid of that kind of money as fast as possible. Prices, denominated in the hyper-inflated currency, suddenly and dramatically go through the roof.

This is important to point out because there is a standard sequence that these arguments usually follow in which the hyperinflation side changes their definition in the middle, talking about what a dollar bought a hundred years ago and claiming that we have actually had hyperinflation all this time (look at the comments to see what I mean).  But steady single-digit inflation over decades is clearly not what they have in mind when they talk about hyperinflation so let us get that out of the way up front.

Now I will concede that if the Federal Reserve secretly wanted to create a hyperinflation, it is possible that they could.  But the argument here seems to be that they will do so accidentally because they “do not understand the true nature of money and banking.”  The narrative put forth begins when foreigners suddenly decide they don’t want to hold dollars any more.  I don’t think this is likely to happen in the near future but it is possible so let’s take that as a starting point and evaluate the hyperinflation case.  I will take it one step at a time.

Is it possible that the Fed could prevent a hyperinflation?

Simply put, the answer is yes.  The Fed inflated the money supply in the first place by buying financial assets (mainly government debt).  They can take money out simply by doing the opposite.  There is no reason to believe that they could not reign in inflation in this way if it were running higher than they wanted.

Would the Fed accidentally create a hyperinflation?

The author doesn’t even argue that it would be impossible for the Fed to prevent a hyperinflation.  Rather, he argues that they would mistakenly compound the inflation because of their commitment to low interest rates.

Committed to a low interest rate policy, our monetary authorities will dismiss the only legitimate option to printing more money — allowing interest rates to rise.

Frankly, this betrays a total ignorance of the Fed’s stated policy goals.  They are not committed to low interest rates.  They are essentially committed to a certain inflation rate and they change interest rates to try to hit their inflation target.  They have been keeping rates low and doing quantitative easing because they are falling short of that target.  If inflation suddenly shot up, they would be thrilled to let rates rise.  This way of thinking opens up a big can of worms including such Scott Sumner classics as “never reason from a price change” and “low rates don’t mean easy money” but you don’t even have to start down that path before the hyperinflation argument falls apart on this count.

Inflationary recession?

This claim is very peculiar.

Only the noninflationary investment by the public in government bonds would prevent a rise in the price level, but such an action would trigger a recession.

Presumably, the investment in government bonds to which he is referring here would be due to the bonds the Fed would have to sell to soak up the excess liquidity which was driving the inflation.  But this would not cause a recession in an environment of hyperinflation.  It is true that if the Fed did this when inflation was not running above trend it would likely cause a recession.  To understand why this is (and why the hyperinflation argument is mistaken) see this post.  But the premise is that there is a bunch of new money flooding domestic markets driving prices up which we need to take out of the system to prevent a hyperinflation.  This produces a lot of slack for the Fed to contract the money supply without causing a recession.

Also this makes no sense.

Instead, the government will demand and the Fed will acquiesce in even further expansions to the money supply via direct purchases of these government bonds, formerly held by our overseas trading partners. This will produce even higher levels of inflation, of course.

Buying government bonds is normal expansionary monetary policy but he gives no reason whatsoever explaining why the Fed would do this in the midst of a sudden dramatic inflation, he just arbitrarily says that they would.  There is no logical connection here, he’s basically just saying “then the Fed will create some more inflation for no apparent reason.”

Feedback effects?

In addition to the strange response assumed by the Fed, the author imagines a lot of reinforcing feedback effects which layer more inflation on top of the original inflation but these also make no economic sense.  For instance:

State and local governments will also be under stress to increase the pay of their public safety workers or suffer strikes which would threaten social chaos. Not having the ability to increase taxes or print their own money, the federal government will be asked to step in and print more money to placate the police and firemen.

This is profoundly confused.  He starts by saying that the domestic economy is flooded with currency previously held by foreigners.  This extra money drives prices up.  Then he claims that people demand higher prices (wages are a price) and so the government has to print more money to pay them and that causes more inflation.  Here is another example.

 Goods will disappear from the market as producer revenue lags behind the increase in the cost of replacement resources.

There is no reason to think that producer revenue would lag behind the increase in the cost of replacement resources.  The extra money would cause increased demand for final goods and services which would increase their price.  This would increase the demand for intermediate goods and services and raise their prices but it is silly to think that it would somehow raise them so much that downstream buyers would not be able to afford them.  This is the kind of classic confusion that kids in introductory econ get into when they say “demand increases which increases price which decreases demand.”  There seems to be no concept of market equilibrium underlying this, it’s “reasoning from a price change” on steroids.

Similarly, it is arbitrary and incorrect to say that state and local governments would “not have the ability to raise taxes.”  If the price of everything doubles, property taxes double, income taxes double, they would automatically raise twice as much in taxes.  No need to print more money here.

An alternate story

The thing that is so frustrating about this hyperinflation myth is that most of the story would go from making no sense at all to making perfect sense if you just took out inflation and replaced it with deflation.  Think about it.

Either because of or in spite of Fed policy, demand for money suddenly increases and velocity and prices go down.

Workers in both government and the private sector refuse to alter their union contracts to reduce their compensation.

Companies are forced to lay off workers because they can’t pay them less.  Many can’t find work because of minimum wages, government mandated benefits etc. (“sticky wages” in Keynesian speak) and end up on the government dole.

State and local governments lose tax revenue but their government workers–and more importantly their debt–is just as expensive as ever so they have to be bailed out by the Federal government.

Workers who maintain work but at lower wages can’t pay their mortgages which are as expensive as ever so they have to be bailed out.

As people realize that prices are falling, they stop borrowing money which causes the money supply to contract further.

Eventually, the Federal government has to basically buy everything with newly printed money to keep the whole country from collapsing.  It is seen as the absolutely necessary, proper, patriotic, and ethical thing to do…..

The reason I think that Austrians can’t see this is that they are committed to arguing that inflation is bad and deflation is not.  A hundred years ago they made this argument against creating the Federal Reserve and they were right then.  But now that we have had the Federal Reserve for a century, things are different.  They are still trying to mash that old argument together with the current facts and what they end up with is totally incoherent.

But you don’t have to believe in hyperinflation to think the Federal Reserve is a bad idea.  The reason that deflation is dangerous is because of the Federal Reserve (here’s how, in case you missed it above).  We’ve got a fever and the only cure is more government.  We got the fever from the Federal Reserve.  But we (conservatives/libertarians) are in denial about having the fever.  The medicine is killing us slowly but if we stop taking it the disease will kill us quickly.  The first step is to admit we have a problem