Can someone explain why measures of the broader money stock increase at a greater rate than the monetary base during recent recessions?
Friday, February 28, 2014
Tuesday, February 25, 2014
In Prices and Production Hayek writes,
Firstly, that money acts upon prices and production only if the general price level changes, and therefore, that prices and production are always unaffected by money - that they are at their ‘natural’ level, - if the price level remains stable. (7)
Macroeconomic aggregates do not act upon one another. Equations that describe macroeconomic activity provide this illusion. I.e., if the money stock increase by x%, GDP will grow by y%. Trends like these might exist in macroeconomic data, but this by no means suggests a fundamental relationship. An increase in the money stock, for example, acts directly on prices of particular goods. Consider simple, endogenous changes in the money stock that might occur in a boom without a central bank. Say that new credit is created in response to an increase in demand for loanable funds. The new money will be used to by particular goods whose prices will rise due to an increase in investment. This will translate to an increase in the price level over time, but there is no force acting directly on the price level. Most economists understand this, but our models suggest that the macro-aggregates do act upon one another, so this is worth explicitly stating.
Friday, February 21, 2014
There are three shortcomings of the Hayekian triangle I wish to bring to light.
1) Empirically, prices in all stages of production tend to move together.
2) Related to critique 1, the Hayekian triangle assumes an economy at full employment equilibrium.
3) The Hayekian triangle is an incoherent representation of the macroeconomy.
In his book, Risk and Business Cycles, Tyler Cowen considers points 1) and 2)
Positive comovement [in prices of goods at both the early and latter stages of production] poses a dilemma for theories of the business cycle which start with the assumption of full employment. Comovement requires that all, or nearly all sectors of the economy expand at once, as we usually find in the data. (30)
This poses a problem for Hayek’s analysis where resources are moving from the latter stages to the earlier stages of production. This process is depicted below (Prices and Production, 44, 52).
Notice that the triangle gained two rows. This gain comes at the loss of the length of the already existent rows. That is, investment increases at the expense of consumption in the early stages of the boom. Hayek’s model is a static one where the economy starts at a full-employment equilibrium. In the case of credit expansion it is pushed from this equlibrium. Consumption does not reduce to compensate for the lengthening of production and there is even an increase in consumption as wages rise. Consumers compete with producers for resources in an unsustainable boom that is inevitably followed by a bust. Hayek’s model describes an aspect of reality, but how significant is that aspect? Is artificial expansion of credit necessary for this scenario?
The model assumes that the economy is at the edge of the PPF, that it is at a full-employment equilibrium. A more likely scenario is that the economy is constantly oscillating between the edge of the PPF and the origin. Of course, an economy with well-functioning markets likely operates in greater proximity to the PPF than the origin. Central bank intervention will distort this natural fluctuation, though it is unclear in what ways and to what extent. The state of the economy is always in flux, so the same intervention will not always lead to the same results. The assumption of full employment equilibrium obscures the interaction between natural fluctuations and central bank intervention, and thus the model overemphasizes a unique case. This might be corrected by expanding the model to include different levels of employment.
As a model of the macroeconomy the triangle is represents a snapshot at a given point in time. In this interpretation, the triangle is an aggregation which describes the macro economy in a misleading manner. We might represent an individual good in Hayekian form, and trace out changes in different stages with only minor distortion, but when used to represent the entire economy the triangle must implicitly assume price levels similar to those for which he critiques his peers. In his critique of Hawtrey’s discussion of the price level Hayek writes,
But the main concern of this type of theory is avowed, with certain suppositions ‘tendencies, which affect all prices equally, or at any rate, impartially, at the same time in the same direction.’ And it is only after the alleged causal relation between changes in the quantity of money and average prices has thus been established that effects on relative prices are considered. (5)
But Hayek refers to the price ratios between the stages of production. In referring to the macro economy, he must be referring to the ratio of price levels between the stages (assuming that stages can be neatly represented at this level of analysis). Hayek did not to apply this critique to his own theory.
As a representation of the macro economy, the triangle also errs in predicting the nature of new investments. Consider Hawtrey’s critique of Hayek’s stages.
It is quite likely that the additional investment will be predominantly in the earlier stages, but it is not necessarily so. It might happen that the next most remunerative openings for investment are mainly or exclusively among the later stages. There is no necessary connection between the margin of investment and the stages, and the introduction of the stages into the exposition of the extension of investment serves no useful purpose. (243)
There may be a tendency for increased investment in the
later earlier stages, but that tendency ought not
preclude a broadening of the triangle’s base. Hawtrey also argues that there is
a continual deepening of the capital structure during booms and depressions.
Expansion may augment this deepening but it can also broaden the capital
structure during the boom period if there are unrealized gains in the later
stages that result from the lowering of the interest rate.
Unlike the problem first discussed, I am not sure that these last two can be easily corrected. In terms of macroeconomic analysis, we are left with a triangle whose usefulness is exceeded by its obscurantism.
Tuesday, February 18, 2014
Some of the most powerful tools of modern macro lack micro-foundations. Given the sort of micro-foundations that have been attempted to this point in time, I don’t mind that my research employs aggregate demand (AD) as equivalent to the money stock (M) times velocity (V). In other words, the quantity theory as an accounting identity is a useful tool for macroeconomic analysis. For those not familiar, see this simple AD-AS graph.
(Graph from here.)
Output measured in nominal terms is P*y. The quantity equation states that P*y = MV. (This is an accounting identity that provides macroeconomics with its own macro-foundations.) We can replace AD with MV as a result of the accounting identity known as the quantity equation. This presents an intuitive framework for understanding fluctuations in aggregate demand. If M rises (falls), then AD rises (falls). Likewise for velocity which is the inverse of portfolio demand for money – think of portfolio demand (1/V) as cash reserves as opposed to transactions demand (output, y) which is money spent on goods and services.
We know that, for example, in depressions M and V tend to move together. The broader stock of money contracts and velocity falls (demand for money rises). So the quantity theory guides us to consider the composition of and changes in the money stock. We can ask, why the money stock fell during the Great Depression and find that waves of bank failures in the United States led to a monetary contraction. We find that these failures were due to a combination of a fragile unit-banking system which disallowed large banks from operating branch banks and tight monetary policy from the Federal Reserve. The latter was due to a dedication to maintaining high level of gold reserves, which was part of a general increase in demand for gold by central banks. The quantity theory tells us that these factors surely pushed down gold denominated prices and played a significant role in the international crisis.
Research that employs the quantity theory has been fruitful and I assume that it will continue to be so.
While useful, reliance on economic aggregates also obscure analysis. These aggregates do not act on one another directly, but emerge through individual interactions. Causation is not always obvious and requires careful intepretation. Note that I can rewrite the quantity equation four ways:
M = P*y/V
V = P*y/M
P = M*V/y
y = M*V/P
One may dig deeper into causation and define each variable by a set of parameters. Say we define M as a function of output and the interest rate, M(y, i) and y as a function of capital, labor, and technology, y(K, AL). This entails greater specificity and a nice model that we can test econometrically. This may provide us with new information, but we are left operating within a framework that conveys a teleological myth that says, “given starting point A, the economy will move to point B.” Good economists work around this problem, but can we have a branch of macroeconomics that embraces the problem itself?
Richard Wagner thinks so. He observes the problem discussed above,
Equilibrium-centered macro theory can, of course, give an account of interdependence among economic activities. Indeed, such an account is perhaps the prime virtue of this theoretical framework. What it cannot do, however, is give an account of turbulence that arises through inconsistencies among plans because no action is presumed to take place until all plans are mutually consistent. All plans are pre-reconciled within the equilibrium framework, just as the actions of the members of a parade are pre-reconciled. The alternative to the equilibrium framework is to treat the ecology of plans as an emergent process where macro-level objects supervene on micro-level interaction. Any relation among macro-level variables is thus intermediated through interaction among entities at the micro level. (“The Macro Economy as an Emergent Ecology of Plans”, 438)
The economy is itself defined by turbulence and this turbulence cannot be consistently observed via macroeconomic aggregates, though it does generate the macroeconomic data. To posit the macroeconomy as a formula with an optimal solution ignores the competition and conflict that occur at the micro level.
How can one model the sort of competition that I underscored in yesterday’s post? How can one represent an economy that does not move directly from equilibrium to equilibrium? Or an economy without equilibrium in the strict sense? Recent attempts have drawn on string theory where there are different layers of interaction (Potts, 2000; Potts and Morrison, 2007). For their “micro meso macro” framework, Potts and Morrisson explain,
In mmm [micro meso macro], an economic system is conceptualized as being made of generic rules that allow carriers to perform operations (Dopfer and Potts, 2004). A rule and its population of carriers is a meso unit, the macroeconomic system is a complex system of connected meso units, and economic evolution is the process of change in meso units, either through novel generic rules being introduced into the economic system or through a change in the population of each meso rule. Evolutionary macroeconomics is the study of how the entire systems of meso are coordinated and how they change. Evolutionary mesoeconomics is concerned with the structure and population of each generic rule, and evolutionary microeconomics is the study of the individual processes of adoption by a carrier (such as an agent) of the rule. This framework is intended to capture the idea of economic evolution as a process of endogenous transformation of the economic order through the origination, adoption and retention of new economic ideas, or generic rules, that may variously manifest as behaviours, organizing rules or technologies. (Potts and Morrison, 309)
Micro meso macro is a convenient representative case of this new macroeconomics. It emphasizes connections between individuals, resources, firms, etc… and rules about those connections.
The task is far from complete. The challenge is to build and employ models that impart new understanding of market processes and the emergence of institutions. These will be models that include the messy details of individual interaction and of randomness. Within this framework, one can include optimization as one possible outcome without being constrained by its determinism and avoid "throwing the baby out with the bathwater."
Sunday, February 16, 2014
Roger Garrison’s Time and Money lays out explicitly the Austrian Business Cycle Theory with a focus on the impact of central bank intervention. His exposition is clear. In fact, so clear that it lays out a fundamental weakness in the theory. In the chapter title, “Sustainable and Unsustainable Growth”, Garrison argues booms funded by an increase in real savings don’t result in resource misallocation.
The market works. But just how the intertemporal markets work requires that we shift our attention to the intertemporal structure of production. The altered shape of the Hayekian triangle shows just how the additional investment funds are used. The rate of interest governs the intertemporal pattern of investment as well as the overall level. The lower interst rate, which is reflected in the more shallow slope of the triangle’s hypotenuse, favors relatively long-term investments. Resources are bid away from late stages of production, where demand is weak because of the currently low consumption, and into early stages, where demand is strong because of the lower rate of interest. That is, if the marginal increment of investment in early stages was just worthwhile, given the costs of borrowing, then additional increments will be seen as worthwhile, given the new, lower costs of borrowing. While many firms are simply reacting to the spread between their output prices and their input prices in the light of the reduced cost of borrowing, the general pattern of intertemporal restructuring is consistent with an anticipation of a strengthened future demand for consumption goods made possible by the increased saving. (64)
Garrison presents us with the beginning state, interest rates drop, and guides us to the end state, claiming that credit markets reallocate resources from the late stages of production to the earlier stages of production. Boom. There you have it. Interest rates coordinate production and markets adjust. But just how does this occur? This is a challenging question for Austrians who do not believe that business cycles can occur endogenously (not to suggest that this is the case for all Austrians).
The process of bidding away resources from the late stages of production does not occur smoothly. Let us imagine that the interest rate has dropped and new profit opportunities arise because there is a discrepancy between the rate of return for the new project and the rate of interest. Entrepreneurs will flock to the new opportunity. The more attractive the opportunity, the greater the number of entrepreneurs who will pursue the project. The entrepreneurs know that they are competing against other entrepreneurs and that not everyone can be successful in this endeavor. Likewise, banks provide credit to entrepreneurs that they believe will be successful. Again, the banks are aware that not every investment in this new opportunity will succeed, but they hope to do better than their competitors by allocating loans wisely and operating efficiently.
With the passage of time, entrepreneurs either reap rewards for their success or losses for their failure. The rise of the interest rate from increased demand for loanable funds and the fall in the rate of return on the new projects from the increase in entrepreneurial activity make this scenario unavoidable. There will be failure and it will occur under conditions where all actors are profit maximizing. If there was significant interest in the sector where the new investment opportunity arose, there may also be significant levels of failure, especially if the sector is highly competitive. We can expect that, alongside bankruptcies, prices in the sector will fall and credit will tighten due to debt-deflation. That is, bankruptcies will decrease the amount of funds available in the sector. Eventually, these assets will be bought by successful firms or new entrepreneurs at lower prices.
Thus, we have the formation of a business cycle without central bank intervention. This is not to suggest that central bank intervention in credit markets cannot encourage bubbles to be larger and more numerous, only that this should be the starting point of a business cycle theory. As Joseph Schumpeter argued in “The Explanation of the Business Cycle”,
…is it not imperative to develop for the purposes of fundamental explanation an analysis independent of the occurrence of impulses from without – an analysis of the way in which new things come to be done in industrial life, and old methods come to be eliminated together with those firms who cannot rise above them? (297)
It is imperative that we have an endogenous theory of the cycle as our starting point. This is a story where low interest rates induced from increased savings encourages a boom and subsequent bust. Garrison’s model does not allow for this. It suggests that markets transition smoothly from one state to the next as long as changes in the interest rate are produced endogenously.
That is, the change in the underlying economic realities imply an altered growth path; the market process translates the technological advance into the new preferred growth path; and there is nothing in the nature of this market process that turns the process against itself. (60)
Nothing to turn the process against itself? Nothing except the entrepreneur. Nothing except competition and failure. Markets fail. That is the beauty of markets.
Thursday, February 13, 2014
New Keynesians are a variant of old monetarism. They are grappling with the same macroeconomic questions. Why does the economy experience extended periods of disequilibria? One New Keynesian answer, for example, is sticky nominal price and real wages. Despite a newly proposed answers, the question itself is not a Keynesian question. This brings me to the problem that Simon Wren-Lewis at Mostly Macro presents.
When it comes to macroeconomic policy, and keeping to the different language idea, the only significant division I see is between the mainstream macro practiced by most economists, including those in most central banks, and anti-Keynesians. By anti-Keynesian I mean those who deny the potential for aggregate demand to influence output and unemployment in the short term.  Why do I use the term anti-Keynesian rather than, say, New Classical? Partly because New Keynesian economics essentially just augments New Classical macroeconomics with sticky prices. But also because as far as I can see what holds anti-Keynesians together isn’t some coherent and realistic view of the world, but instead a dislike of what taking aggregate demand seriously implies.
He mentions another division, that of mainstream and heterodox, but this division appears to be swallowed by this [Mainstream] Keynesian/Anti-Keynesian divide that Simon posits.
Generalizations are troublesome. This one is especially troublesome because it obscures the origins of the arguments that New Keynesians grapple with. It also suggests that Wren-Lewis either ignores or misinterprets the history of economic thought. If New Keynesians have abandoned the Old Keynesian position on fiscal policy (it might be more accurate to say that they let the issue fade into the background), then they are, as Leland Yeager points out in “New Keynesians and Old Monetarists”, actually Old Monetarists. Two cases in intellectual history will suffice to make the point.
In a recent post, I presented an argument between Ralph Hawtrey and John Maynard Keynes where Keynes questioned the efficacy of monetary policy in regard to high unemployment. This was an ongoing debate between Hawtrey and Keynes. It did not only appear at the Macmillan Commission. Hawtrey dedicated “Public Expenditures and Trade Depression” (1933) to confronting this issue. In response to Keynes proposition that monetary policy can be impotent, Hawtrey wrote
But to a great extent their [the central bank’s] purchases of securities will result merely in the investment market paying off advances, so that the desired increase in the banks' assets is offset. If the banks persist in buying securities beyond the point at which the indebtedness of the investment market has been reduced to a minimum, the result will be a disproportionate rise in the prices of gilt-edged securities. There will thus be very great pressure upon the banks to find additional borrowers, and, in view of what I have said above as to the intermittent and partial character of the pessimism which seems to dominate markets, I should contend that there is good reason to expect that the borrowers would be forthcoming
Hawtrey accepted that the markets do not immediately adjust to aggregate demand shocks and argued that, given an institutional arrangement where central banks influence the money stock, an expansion via open-market purchases is sufficient to offset negative aggregate demand shocks due to a credit contraction. He also doubted the efficacy of fiscal policy. He was not a New Keynesian.
And consider also Herbert J. Davenport, who Yeager quotes in the above-mentioned piece.
Goods and services exchange for each other through the intermediary of money, for which an excess demand may sometimes develop. ‘The halfway house become a house of stopping.’ The problem is ‘withdrawal of a large part of the money supply at the existing level of prices; it is a change in the entire demand schedule of goods.’ (290) [internal quote from Davidson]
Yeager continues on the same page,
Supplies of bank account money and bank credit typically shrink at the stage of downturn into depression. A scramble for base money both by banks’ customers and by banks trying to fortify their imperiled reserves enters into Davenport’s story.
In this presentation, a negative aggregate demand shock initiated by a credit contraction occurs endogenously! Davenport accepts that economies do not immediately re-equilibrate after a demand shock. According to Yeager, Davenport wrote this in 1913, so he can hardly be considered a
New Keynesian. No, this was the status-quo of pre-Keynesian arguments concerning the business cycle. Most theories from the time period implicitly
concerned themselves with upward sloping short run aggregate demand supply curves, though they did not point this out explicitly. Note that this was also the case with Hawtrey's earlier work, Good
Trade and Bad, which was written in 1913.
The short-run aggregate supply curve was not purely a discovery by Keynes, so can we stop deluding ourselves and just admit that, except for the New Classicals, “we’re all monetarists now”?
HT David Glasner for his follow-upon the Wren Lewis post and Nick Rowe for his suggestion that "'Monetarist' vs 'anti-Monetarist' would work as well.”
I think that it works better.
Wednesday, February 12, 2014
Hayek quoted Cassel to support his argument. He wrote that "Professor Gustav Cassel states his apprehension there with a clarity which leaves nothing to be desired. He writes:"
Planned Economy will always tend to develop into Dictatorship . . . [because] experience has shown that representative bodies are unable to fulfill all the multitudinous functions connected with economic leadership without becoming more and more involved in the struggle between competing interests with the consequence of a moral decay ending in party - if not individual - corruption. The parliamentary system can be saved only by wise and deliberate restrictions of the function of parliament. Economic dictatorship is much more dangerous than people believe. Once authoritative control has been established, it will not alwyas be possible to limit it to the economic domain. ("Freedom and the Economic System", Socialism and War, 192)
Hayek quotes from "From Protectionism through Planned Economy to Dictatorship", written in 1934. A keyword search in Individualism and Economic Order reveal only a passing reference about Cassel's work on interest. Elsewhere, Hayek references Cassel in regard to monetary theory and the business cycle, but I find no obvious alliance in the socialist calculation debate.
One modern Austrian, Jesús Huerta de Soto, derides Cassel for his comments about the viability of socialism, but the socialism that Cassel referred to was a poor representation of the system. In theorizing about a socialist economy, he wrote "Our socialist economy must thus essentially be based on the free exchange of personal services and means of satisfying personal wants." (133) He goes on to say that the economy needs money and that workers do not receive equal wages. Later in the book he refers to the entrepreneur and the lack of appreciation for him by socialists, as I mentioned in the previous post. There is a semantic problem here. Cassel's use of the word "socialism" is a loose one. If, as de Soto suggests, Cassel’s work was foundational for later proponents of planning, they were not reading his work very closely. For now, this snapshot of intellectual history remains murky.