Tuesday, April 8, 2014

Rule-Based Macroeconomics: A Possible Avenue for Non-Equilibrium Theorizing

If you have been reading my blog recently, you know that I have not written kindly about the integration of rational expectations and the efficient markets hypothesis into Austrian economics. This might seem strange to any readers who believe that markets work. I sympathize with that perspective, but I believe it is inappropriate to assume this. As I have noted about some modern Austrian macroeconomic models, reliance on RE and EMH assumes disequilibrium out of existence unless it is caused by an exogenous shock. RE and EMH may approximate market outcomes 99% of the time, or even 99.9% of the time, but the remainder, (1 – p), needs to be understood, especially if its source is endogenous.  Imagine if I have a 1/100 or 1/1000 chance of being struck by lightning every time I step outside. The variance of outcome in the case I am struck is high. According to a quick Google search, there is a 10% chance that I die, and some spectrum of other outcomes. I am not interested in the median result – say, I spend one week in the hospital – if 1 in 10 times I end up dead. Furthermore, in a world of fat tailed probability distributions, which seem to better describe the world of finance than Gaussian distributions, I may not want to optimize expected value if I am not sure how fat the tails are. In other words, I may know that my map of possible outcomes does not cover the entirety of possible outcomes, but I am unsure to what extent it is lacking. This is what George Shackle and Israel Kirzner refer to as surprise: outcomes that one is absolutely ignorant of. If it so happens that the possible outcomes I am missing from my probability distribution have much higher expected losses than any outcome within my probability distribution, I may want to consider not optimizing in a way suggested by RE. 

None of this is to say that RE and EMH are not useful. They provide a teleological compass for fruitful economic analysis. In many cases, however, median outcomes do not matter. In these cases, RE and EMH are better described as an Achilles heel of economic analysis.

What is needed is an economic framework that allows for emergent processes, a non-equilibrium framework. We do not know what the economy will look like in ten years – even absent exogenous shocks – neither should agents in our models. (If you disagree, extend the time frame to 100 years.) 

What is needed is not that Austrian economics “catch-up” to the modern equilibrium paradigm, “but an effort to create the contemporary analytics that might have been created had Austrian macro theorizing continued to evolve since 1940 with the same robustness that it exhibited before 1940 (Wagner, 98).” 

What is needed is a macroeconomics that foregoes determinism associated with RE and EMH and concentrates on rules that guide decision-making and human action. Individuals do not approach “truth” directly. They integrate information according to heuristics, and then act to achieve their ends according to their interpretation of information. 

Those who endeavor to develop this research program must model in terms of heterogeneous agents whose actions are determined according to rule sets. The outcomes of interactions between agents acting according to rule sets and the transformation of rule sets over time may shed light on market processes in a way that equilibrium theorizing cannot.

Monday, April 7, 2014

Latest Revision of "Good as Gold?"

I have posted my latest revision of "Good as Gold?" This was a dramatic overhaul as I combined this paper with another that concerns the monometallism and price instability. An excerpt from the conclusion:

The danger of deflation was augmented by the centralization of gold reserves in the previous half century. In 1914, most of the world’s monetary gold was stored at a small number of central banks. By 1922, “the world market in gold was practically coterminous with the monetary demand of one great country” as nearly half of the world’s monetary gold resided at the Federal Reserve (Hawtrey 1947, 97). Consolidation made prices even more sensitive to changes in the demand and supply of gold. When coordination of independent central banks from the Bank of England ceased, the price of gold became unhinged, swinging wildly between 1914 and 1920 and again between 1929 and 1932. 
This problem was inherent in the system. It was not a defect of the gold standard per se. It was a defect of management under a system of fixed exchange rates. Deflation must follow an unbacked expansion of the money stock by the central bank if larger players like the Bank of England and the Federal Reserve refuse to keep reserve ratios suppressed. Under a system of floating exchange rates, on the other hand, the economy probably would have adjusted to a higher price level and “the subsequent collapse would almost surely not have occurred (Friedman 1961, 68).” Of course, depression also could have been avoided by a return to the gold standard at devalued parities, but such an option was politically unpalatable. In light of political constraints, the economic instability associated with the latter decades of the gold standard was not a glitch, but rather the logical end of an international, monometallic legal tender regime.

Friday, April 4, 2014

The Comparative Advantage of Austrian Economics: Away from Positivism and Into Historical Time

Since the Great Depression, Austrian economics has moved more in the direction of equilibrium theorizing than it had been previously (I have discussed these issues before, so I will spare you). Austrian economists have, to a far lesser extent, embraced germs of uncertainty inherent in Austrian methodology. Some exception include Ludwig Lachmann, Mario Rizzo,and Gerald O'Driscoll. And of course, Hayek, with "The Use of Knowledge in Society" and numerous other works brings to light the complexity of markets and society in general. Despite this, what is lacking is a systematic way to speak about complexity and uncertainty within economics.

Economics has been locked squarely in the positivist paradigm for over a half-century. Adherence to logical time - that is, a paradigm where the end-state of the economy is determined by its starting point and the parameters and assumptions of the model - under assumptions of efficiency robs Austrian economics precisely of what distinguishes the discipline from competing schools of thought: strict adherence to methodological individualism. The integration of Austrian macroeconomics within modern perspective steeped in assumptions of long-run efficiency has resulted in an approach that ignores market process. As modern macroeconomics is engrossed in positivist methodology, it need not concern itself with microfoundations for modeling. The purpose of these models is prediction, not understanding of process (Friedman 1954).[1] Theories are tested by evaluation of their predictive power using econometric models. It should be no surprise, then, that when positivist theories adopt microfoundations, those microfoundations are not substantive and exist only to fulfill a shallow requirement.[2] The functionality of the models remain largely undisturbed. As long as time is logical, outcomes are predetermined by assumptions and parameters. Making a model more complex by adding new parameters does not alter the assumption that for every input, there is a single output.

Peter Boettke and Kyle O’Donnell state the problem without apology. “Pure economic theory, especially equilibrium analysis, is incapable of shedding light on the process by which the subjective knowledge held by individuals is sufficiently adjusted so as to bring about intertemporal plan coordination (2013, 309).” An economics that considers market process must take into account the nature of decision making within a context of imperfect information. Some actors have access to newer, more accurate information than others. Some are better at interpreting the information to make predictions about the future. Others simply copy the actions of those whom they consider smarter than themselves. Under such conditions, a single input might be capable of multiple outputs. To simplify the problem by assuming rational expectations narrows the decision-making set to whatever set of probabilities a model defines as rational. This assumes away the problem of gathering and interpreting information. The approach is both limiting and unnecessary absent a positivist standard (Rector 1991, 219).

To amend the problem requires nothing less than a paradigm shift. As Ralph Rector notes:
From a positivist perspective, interpretive-type data appear irrelevant because they cannot be formalized as testable for quantitative predictions. In contrast to this view, interpretive economists believe that our understanding of important social phenomena has been hindered by the positivist standard of relevancy. (1991, 220)
The new economic framework should not concern itself with scarcity of resources and their single, optimal allocation which has been the emphasis of positivist economics. Agents act in historical time where their actions and the effects of those actions are irreversible. It emphasizes scarcity of knowledge. It must ask, “what are the principles of choice that allow the continual growth of knowledge (Potts 2000, 114)?” This author might add also, “what are the principles that allow the continual growth in the employment of knowledge toward desired ends by a multitude of agents?”

To confront this question, we must consider what constraints limit gathering, interpretation, and creation of new information. While some individuals might be privy to high level interpretation of statistics, most individuals do not have access to such knowledge and most data in the real world does not lend itself to such interpretations. Even if all actors did have access to these methods and all data corresponded to them, it is impossible ex ante for them to know to what degree the model of choice applies to the data in question. A more reasonable scenario is one where individuals rely on heuristics to make economic decisions. From this view, rationality and efficiency lack a clear standard outside duplicability of the action in question. No other standard need be posited and none need act as a teleological compass to guide the construction and results of a model. Such a paradigm does not seek to predict. It seeks to understand and model complexity within the economy and society.

[1] “The ultimate goal of a positive science is the development of a ‘theory’ or, ‘hypothesis’ that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed.”
[2] Acknowledging the reach of the positivistic paradigm also clarifies the tension existent in Muth (1961) as he claims that his theory does not “state that predictions of entrepreneurs are perfect or that their expectations are all the same (317).”

Monday, March 24, 2014

A Short Note on Rationality, Information Constraints and Business Cycles

According to the efficient markets hypothesis, “security prices at any time ‘fully reflect’ all available information (Fama, 1970; 383).” This is a description of EMH in its strong form, which according to Fama, “is probably best viewed as a benchmark against which deviations from market efficiency (interpreted in its strictest sense) can be judged.” I find EMH troubling, not because it is wrong per se, at least not in an impure sense, but because finding and interpreting information is tricky business. EMH is a specific standard that the world fails to live up to because of constraints on the transmission and interpretation of information.

If the strong form of the EMH accurately describes reality, or at least approximates it, we would expect few, if any, financial bubbles. Yet bubbles are a recurring feature of reality. Jason Potts notes that “asset bubbles are an endemic feature of market capitalism and as old as open societies with property rights over financial assets (2004, 17).” Bubbles are common and are likely endogenous. Prices are not always moving toward their long run equilibrium. In other words, the strong form of EMH does not hold in the short run, and the long-run effects of information may never fully reveal itself. The reason for this is intimately tied to the nature of information transmission and interpretation. Not all investors receive information simultaneously, nor do they interpret information homogeneously.Information does not interpret itself.

Let me posit, for the sake of elaboration, that there is some deep fundamental truth that ultimately guides, or at least should guide for the sake of efficiency, investment decisions. Some investors might actually be privy to this truth, although even if they are, I am skeptical about whether or not they actually know that they are privy. If this sort of investor does exist, or perhaps many investors act in this manner but only on limited margins, their decisions may not guide the market immediately toward a posited equilibrium.


Most investors are probably not privy to the truth. For example, there is an investment industry built upon technical analysis. (Thanks to Gene Callahan for turning me on to this idea in a recent article.) There are individuals who make trades simply because their novice neighbor suggested an investment he or she has had success with in recent months. There are also investors who simply copy other investors who they believe, rightly or wrongly, are smarter than themselves. All of these groups use special rules to guide their investment decisions, and none of these rules directly approach the truth that, according to EMH, guides the market – at least in the long run. I posit further that the majority of traders fall within this category. What does this mean for EMH? In the long run, markets might approximate the truth, but in the short run, extreme deviations can occur even if all individuals are optimizing. Business cycles, then, can occur endogenously.


Individuals optimize according to the information they have. They optimize according to their interpretation of information. The information they receive might be direct, that is, it is as close an approximation of the truth as is possible to attain, or it might be an inference from second and third order effects of fundamental changes in the economy – i.e., this is how I would categorize technical traders. If I am correct, then modern macroeconomics has missed the mark in more fully clarifying our understanding of markets. Heterogeneity of actors, of rule sets, and of institutions must be considered in order to more fully understand the market process. Models that employ representative individuals and/or that posit that macroeconomic variables actually act upon one another miss this mark. They banish disorder and disequilibrium from analysis except in cases of exogenous shocks. Even then, disorder is soon subsumed by movement toward a new, predetermined equilibrium. Even if useful, a myth to be sure.

Saturday, March 22, 2014

Roundaboutness of Production?: Explaining Austrian Business Cycle Theory with Present Value

What is “roundaboutness” of production? What is a production period? These words are thrown around in Austrian circles, but as Inigo Montoya would say, “I do not think it means what you think it means.” An illustration with present values will make this more clear.

First, a decription of the cycle from Ludwig von Mises in the Theory of Money and Credit

So long as the rate of interest on loans coincides with the natural rate, it will not pay him [the entrepreneur]; to enter upon a longer period of production would involve a loss. On the other hand, a reduction of the rate of interest on loans must necessarily lead to a lengthening of the average period of production. It is true that fresh capital can be employed in production only if new roundabout processes are started. But ever new roundabout process of production that is started must be more roundabout than those already started; new round about processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns. It is only all the short roundabout processes of production have been appropriated that capital is employed in the longer ones. (360-61)

A precise re-establishment of the old price-ratios between production goods and consumption goods is not possible, on the one hand because the intervention of the banks has brought about a redistribution of property, and on the other hand because the automatic recovery of the loan market involves certain of the phenomena of a crisis, which are signs of the loss of some of the capital invested in the excessively-lengthened roundabout processes of production. It is not practicable to transfer all the production goods from those uses that have proved unprofitable into other avenues of employment; a part of them cannot be withdrawn and must therefore either be left entirely unused or at least be used less economically. In either case there is a loss of value. Let us, for example, suppose that an artificial extension of bank credit is responsible for the establishment of an enterprise which only yields a net profit of 4 per cent. So long as the rate of interest on loans was 4 ½ per cent, the establishment of such a business could not be thought of; we may suppose that it has been made possible by a fall to a rate of 3 ½ per cent which has followed an extension of the issue of fiduciary media. Now let us assume the reaction to begin, in the way described above. The rate of interest on loans rises to 4 ½ per cent again. It will no longer be profitable to conduct this enterprise. Whatever may now occur, whether the business is stopped entirely or whether it is carried on after the entrepreneur has decided to make do with the smaller profits, in either case – not merely from the individual point of view, but also from that of the community - there has been a loss of value. (362)

This can be restated without the confusing language of the roundaboutness of production. It is a simple present value problem. There is a stream of payments that a firm must pay from the moment a certain process of production is begun to the time that the final product of sale is sold. (It will be simpler to imagine that only one firm is involved in this process) and revenue the the firm will receive in the final period. The “problem” can be formalized like this:

π = Profit
C = Cost
R = Revenue
i = period
n = final period
r =  nominal interest rate              0 < r < 1

For those of you not comfortable with math, don’t sweat. This says that the present value – meaning, the value of something when accounting for the interest rate – of the goods of final sale, minus the present value of the costs incurred by the firm over the course of production is equal to the firm’s profit. An increase in the period of production moves n, the period of final sale, away from the present by an additional period. Thus, the addition of a period, ceteris paribus, reduces the present value of profit by a factor of 1/(1 + r). In order for the addition of a period to be profitable, production must increase by a factor of at least (1 + r). That is, gains made from increasing production must exceed the gains a firm can receive by simply investing in an asset whose rate of return is the market rate.

If the rate of interest is depressed, either by a lowering of the reserve ratio or an artificial increase in the stock of base money, longer processes of production can be employed profitably as long as the rate remains depressed. Notice that this is because the payments received in the last period will be discounted at a lower rate. (Remember if r decreases, the present value of the final sale increases!)

If the interest rate increases some time between the start of production, period t = 0, and the final sale,  period t = n, then the company will receive smaller returns than expected, and therefore, smaller or even negative profits. The longer the interest rate remains depressed, the greater the impact will be on the structure of production and the greater the losses will be when the interest rate returns to the natural rate. The bust sets when a large portion of firms’ costs exceed their revenue. This inevitably impacts credit markets as firms revenues cannot cover their debts – a part of their costs – and so demand for money grows alongside a shrinking supply of fiduciary currency. The latter results from an decreased willingness of banks to lend.

Thursday, March 20, 2014

Delong on Conservative Economists Who Still Believe that Inflation is Driven by Increases in the Money Stock

Brad Delong on conservative economists and the Fed’s payment of interest on excess reserves:
And Larry White chimed in: “the Fed has sterilized those injections” that had taken “the monetary base and see[n] it double and triple…” by paying interest on reserves.
 On the videotape, Josh Bivens looks visibly flummoxed. I can see him thinking: “All of these guys are relatively orthodox quantity theory guys–they all expect a tripling of the monetary base to cause 200% inflation. And here they are, all saying that what you need to halt that 200% inflation is for the Fed to offer to pay 0.25%/year on reserves. Paying the banks $5 billion a year on their $2 trillion of reserves is enough to stop a 200% inflation in its tracks, and do so indefinitely. Do they really believe this?”
 Apparently they do…
If Brad Delong is correct in his cynicism, we should not see a noticeable change in inflation from an increase in the base of nearly 400% in the last 6 years if the rate paid was 0%. If he is right, the program is pointless and the Fed's payment of interest on excess reserves only complicates things.

[Late Add]

Note from my last post that Greenspan successfully handled crises by standard injections of liquidity and these proved successful. Bernanke steered away from this policy and suddenly long-run inflation is no longer a function of the money stock?

Monday, March 17, 2014

Where's the Inflation At?: A Review of and Thoughts on Hummel's "Ben Bernanke Versus Milton Friedman"

Leading into the recent crisis, and especially after the Federal Reserve responded with “quantitative easing” [QE], the press was a flurry in talks about inflation. Over 5 years after the first QE, commodity prices have not risen in proportion to the increase in the monetary base. The hyperinflation predicted by many has failed to materialize. Why is this so?

Anyone who has taken a course in macroeconomics is probably familiar with the quantity equation.
MV = Py
Note that P = MV/y. An increase in the money stock, all else equal, leads to an increase in prices in the long run. But all else is not equal. Or so says Jeffrey Rogers Hummel in “Ben Bernanke Versus Milton Friedman: The Federal Reserve’s Emergence as the U.S.Economy’s Central Planner” Hummel writes that Bernanke believes that
a disruption of what he calls ‘the credit channel’ in effect will induce households and firms to hold more money rather than spend it on consumption and investment. True to his New Keynesian inclinations, what Bernanke is thus saying is that the failure of banks brings about a prolonged, negative velocity shock, although he never expresses this idea in such straightforward terms.
The collapse of major financial institutions may result in fear-induced cash holding – “a negative velocity shock.” This negative velocity shock is special in that it acts as a black hole for increases in the money stock. Someone beckons Keynes’s ghost.

“What was the norm during the previous chairmanship at the Federal Reserve?”, you ask. It was essentially that sudden changes in V should be stabilized by M (this is only approximately true, but you will see what I am getting at soon). Under Alan Greenspan, the Federal Reserve met negative shocks to V with increases in M. Hummel notes three instances:
  1.    .   Black Monday (1987)
  2.        The Y2K Scare (1999/2000)
  3.         9/11

During all of these crises, the Federal Reserve temporarily raised the rate of increase of the monetary base. (You won’t observe an increase in the chart in 1987 as the intervention employed purchases that were bought back within two weeks.) The sharp increases in liquidity stabilized the markets.

Ben Bernanke’s tenure reflected a different approach. From the start of his chairmanship, the rate of growth of the base money stock dropped steadily. Bernanke was aware that a potential crisis was on the horizon, though the size of its impact was unclear. Hummel quotes Bernanke,

As late as May 17, 2007, Bernanke was predicting that troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.’

The course he charted, however, did not involve an increase in the rate of growth of the base money stock. Instead, he redistributed credit and continued to let the rate of growth of the base money stock drop.

By summer of 2008, lending to banks through the Term Auction Facility ahd climbed to $150 billion, and discounts added another $18 billion. Other things being equal, this lending would have brought about a substantial bulge in the monetary base. But other things were not equal. For pari passu, Bernanke was pulling money out of the economy by selling Treasury securities. As a consequence, during the year ending in august 2008, the monetary base had increased less than $20 billion, a mere 2.24 percent, which was well below its average annual growth of 7.54 percent during Greenspan’s nineteen years in charge… Bernanke was not injecting liquidity, just redirecting it.

Even when Bernanke’s actually expanded the monetary base, the expansion was actually another rendition of credit reallocation. He accomplished this by initiating a policy of paying interest on reserves held at the Federal Reserve. The entirety of the QE1 expansion did nothing to increase market liquidity directly. Instead, the new credit remain latent, collecting interest at the Federal Reserve. Oddly enough, management of credit by Bernanke created a nearly perfectly elastic demand for money by banks, much like the problem that he believed caused the Great Depression. He created a liquidity trap!

Management was a hallmark not only of Bernanke’s chairmanship, but his philosophy. Hummel again quotes Bernanke,

‘What we do know is that the central bank of the world’s economically most important nation in 1929 was essentially leaderless and lacking expertise. This situation led to decisions, or nondecisions, which might well not have occurred under either better leadership or a more centralized institutional structure [emphasis Hummel’s].’

Hummel continues in his own words,

These are not the words of a sedate central banker reluctantly intervening in a crisis but rather of an activist regulator who views the economy as requiring expert, detailed management with constant, coordinated control. Still more recently at Princeton University, Bernanke explicitly called for improved ‘economic engineering’ and ‘economic management’ by the regulatory authorities.

One might find this indictment harsh, but it is difficult to deny that Bernanke’s policies have reflected such an attitude. What has resulted is an empowered Federal Reserve and several years of lackluster growth under Bernanke. The economy would likely have faired better if, upon the first signs of crisis, the Federal Reserve provided a one-time spike in the base money stock that did not become locked away behind its own doors. I expect that we would have seen some failures, but that the market would have steadied and recovered in a more a robust manner than we have experienced thus far.

Originally posted here.