Tuesday, December 1, 2015

Ecological (or Realist) Rationality in Economics

Those unfamiliar with ecological rationality may be surprised by the term ecological used in in a discussion of economic methodology and methods. For the last century, economic theory has been described increasing in terms of of systems linear equations. In order to be mathematically tractable, this framework assumes homogeneous agents whose preferences are only described in terms of prices and quantities. In this theoretical world, only one price, centrally computed by the Walrasian auctioneer, can exist simultaneously (Axtell 2005). All action is determined solely by preferences regarding price and quantity, couched in terms of utility maximization (Arrow and Hahn, 1971). Agents do not interact with one another directly, but rather, only indirectly through the prices and quantities proffered by the auctioneer. An agent’s decisions to interact with the auctioneer is always a consequence of their desire to maximize utility, a variable treated always as a cardinal measure. This is the core of neoclassical economic theory as it has come to be practiced professionally.

Not to buck the trend, macroeconomists have followed the same type of pattern. Over the last half century, macroeconomists have built models that employ either macrovariables, representative agents, or both (Hirschleifer. 1970; Kohn 1981; Lucas 1972). The move to DSGE simulations represents an extension of this equilibrium paradigm (Wagner 2011). The relaxation of some assumptions, such as the assumption of perfect information, still leaves economics with the same core. Agents in this paradigm are automatons driven by a singular desire to maximize a utility vector. The motives of these little resemble that of agents in the real world. To the extent that we are wrong, we would prefer not to associate with such avaricious, monotonously motivated agents.

The social world is far richer than the description provided by what has come to be accepted as the neoclassical paradigm. While a perfect model of reality would be redundant, the dominant paradigm lacks the fidelity necessary to be considered a simplified replication of a reality within an open system. Action of economic agents are not driven by solely by price and quantity vectors, although they do interact with prices and quantities. To the extent that they are, a subjective interpretation of price must be employed (Mises 1949). The world which economic agents inhabit is a subjective one. In this world, agents are not only imperfectly informed; they imperfectly perceive the world. They are certainly in no position to optimize (Chaitain, Doria, and da Costa 2011). Even when the world is defined in terms of prices and quantities, agent optimization according to the typical calculus is computationally intractable. In the least this is an insurmountable problem for the Walrasian auctioneer (Axtell 2005).

It is necessary, then, that economic theory not only drop its assumption of perfect information, but that economists altogether reevaluate the perceptual framework that modeled agents inherit. Theory must identify and employ only the elements most significant for the domain of study, but with the realization that agents interact with particular objects at a given place and time. An appropriate framework allows for the appearance of general contexts that represents the details of that contexts as general types. A ecological, or realist, framework of perception and rationality fulfills these requirements.

An ecological perspective can be described as containing heterogeneous and interacting agents. These agents inherently interact with the world in a manner consistent with Bayesian updating.

In the ecological view, thinking does not happen simply in the mind, but in interaction between the mind and its environment. This opens up a second more efficient way to solve the problem: to change the environment. The relevant part of the environment is the representation of the information, because the representation does part of the Bayesian computation [emphasis ours]. (Gigerenzer 2008, 17)
Agents offload computation onto objects and systems of objects that they perceive in the course of their existence. Agents do not optimize, they adopt patterns of behavior that tend to promote predicatable outcomes. One such family of decision-making rules is what Gigerenzer and Goldman term “Fast and Frugal” (1996). Fast and frugal rules allow the agent to make a decision based only on a single piece of information. (Are dark clouds forming to the immediate west? It is probably a good idea to wear a coat until they either subside or until a storm has come and gone. One does not need to check the weather report under such conditions.) Agents do not have the time to collect all available information when making decisions. In a world that is part of an open system and where variables of interest are not independent of one another, a fast and frugal rule actually outperforms regression analysis in predictive power (Gigerenzer 2008, 41). As agents grow accustomed to these rules, they become ingrained in habit and thereby reduce the computational work required by the agent.

Rules that guide agent action take a vast variety of forms. For example, an agent investor may only invest according to fundamental measures. Others may invest according to past data. Still others may copy the investment decisions of investors who consistently beat the market. An obvious consequence of action guided by these rules is agent interaction. Agents influence one another by influencing conditions of scarcity and by interacting with and copying one another directly. The first of these is accounted for, if only imperfectly, in the modern formulation of economic theory. The latter is non-existent in that realm. A convenient approach to framing this latter problem is in terms of an information cascade where the information transferred is a decision making rule (Earl, Peng, and Potts 2006). The rules that appear to promote an agent’s ends are copied by other agents (Hayek 1962; Bikhchandani, Hirshleifer, and Welch 1998).

Notice that this framework for decision-making fits nicely into a theory of expectations that does not assume the end it is supposed to prove. Consider the Lucas critique (1972). Lucas noted that any relationship among macrovariables will tend to disappear one it has been recognized. Proponents of rational expectation would argue that agents make predictions about the future using all available information and that agent predictions of the future are conveniently distributed around a median outcome that, absent information shocks, represents an accurate prediction (Muth 1961, Fama 1970). This model looks nothing like social reality. It suffers from the same problem that Gigerenzer identifies above concerning Bayesian computation. It has in its favor a modest degree of predictive power, but lacks the fidelity that is required for deeper understanding. The alternative contained within an ecological framework suggests that agents form rules that conform to their interpretation of reality. If agents expect that there will be a high degree of inflation, they will substitute assets in their portfolio in lieu of cash. They only need to know what sort of action to take given expectation of a particular circumstance. Those agents who tend to be better at predicting will tend to maintain larger stocks of wealth than those who predict poorly. As agents receive feedback concerning their actions, they will update if they believe they were following an inferior pattern of action. Over time, this allows strategies to be developed, tested, and either discarded or duplicated.

Roger Koppl describes this process in his theory of expectations. Borrowing from Schutz and Hayek, Koppl posits two types of expectations formed by agents: cognitive and acognitive (2002). Cognitive expectations represent conscious predictions of the world given some information. Conscious predictions, however, are limited in their scope inasmuch as they only affect agent action a single time. Agents also form habits over time that ideally promote their continued existence and prosperity. The old maxim, “early to bed, early to rise,” for example, encourages the formation of acognitive expectations with respect to ones bedtime and waketime. Those who follow must assume that action in concordance with the maxim promotes a state of affairs that is superior to a world where the agent lacks such a habit. Returning to the inflation example, agents may learn to immediately purchase assets – maybe real estate, stocks and commodities – whenever they hear a trusted source of information suggest that there will be inflation in the future. Any misallocations that occur in this process will be smoothed out over time by competing arbitrageurs in the long-run. This does not exclude the possibility of economic volatility in the meantime as relatively ignorant agents compete with one another, collectively discovering the true conditions of the market by a process of trial and error (Hayek 1942; [1968] 2002).

Over the last few decades, substantial progress has been made in understanding of human perception and that perception's interaction with the environment. Reliance on rational expectations by economists have prevented them from taking advantage of this progress. While rational expectations is useful in justifying econometric work which represents the bulk of applied research in the last half-century, there exists an opportunity to return to the mode of realist theorizing that dominated economics before World War II. Finally, I have not mentioned agent based modeling above. Econometric analysis was the workhorse of the most recent epoch of economic thought. I expect agent-based modeling to become the workhorse of economists working with pure analysis. Many of the components for this already exist (see Simon 1996; Hayek 1962; Crawford and Ostrom 1996; North and Denzau 1994; North 2005). It is only a matter of time before these methodologies are employed to create agent-based simulations across our field.

Thursday, November 5, 2015

Hummel Corrects the Dominant View of Banking Crises in U.S. History

Over at EconLog, David Henderson has posted on Jeff Hummel's commentary concerning the inefficacy of macroeconomic policy aimed at curtailing business cycles. I encourage you to take a look. Hummel also notes that banking crisis of the pre-modern era (before 1913) were not as damaging as many historians believe. (see also Selgin, Lastrapes, and White) Some historians have misinterpreted the data as they confuse bank suspensions that occur during panics with bank failures:

Bank Failures
Bank panics, even when accompanied by numerous suspensions (or what Friedman and Schwartz prefer to call “restrictions on cash payments” to distinguish them from government suspensions of redeemability), do not always result in a major number of bank failures.
For instance, Calomiris and Gorton report the failure of only six national banks out of a total of 6412 during the Panic of 1907, or less than 0.1 percent. Of course the Panic of 1907 was concentrated among state banks and trust companies. Unfortunately, as far as I can tell, there are no good time series on the failures of state banks for the period prior to the creation of the Federal Reserve. Yet there were over 12,000 state banks at the outset of the Panic of 1907. One very fragmentary and incomplete estimate of total bank suspensions (rather than failures) in Historical Statistics (1975), including both state and national banks, puts the number during that panic at 153. Even if all suspensions had resulted in failures, which of course did not happen, we still have a failure rate of 0.7 percent for all commercial banks.
Confusion of bank suspensions with bank failures can even infect serious scholarly work. For example, in Michael D. Bordo and David C. Wheelock (1998), charts meant to show bank failures are instead clearly depicting statistics on the annual number of bank suspensions. Similarly, periods of numerous bank failures do not always coincide with bank panics, as the S&L crisis dramatically illustrates. So it is crucial to distinguish between periods of panics and failures, although specifying the latter requires judgment calls. For the monthly number of national bank failures prior to the Fed’s creation, I have depended heavily on Comptroller of the Currency (1915), v. 2, Table 35, pp. 66-103.

The dominant historical narrative tends to follow the stale formula of:
1. Market Fails
2. Government Intervenes
3. Social Welfare Improves
I know this story from somewhere...


Tuesday, October 6, 2015

Equilibration without Scalar Utility: Formal Non-equilibrium Modeling (Sneak Peak)

This is what equilibration looks like when agents coordinate action without agents who consider the MRS as derived from scalar utility. The lower boundary represent the price that is represented by the ratio of desired reserve levels for each of the two goods in the model. Non-equilibrium modeling provides equilibrium results. I hope to have the paper up by the weekend.


Thursday, August 27, 2015

Austrian Cycle Theory: More Than a Theory of Inflation Driven Boom and Bust

Yesterday, David Henderson asked me "can you look at the stock price drops of the last week and say with much confidence that they are strongly confirming of ABCT?" I responded that we cannot know for certain. The more I thought about it, the more I thought that this is not the right question to be asking.

Austrian business cycle theory is an extension of price theory. As long as expectations are convergent, we can expect prices to tend toward an array that reflect underlying scarcities and demands. If expectations are not convergent, then we can expect increased volatility. As humans, we gain much of our knowledge by observation of others. This leads to a tendency for expectations to be subject to herding (Koppl and Yeager 1996). The more uncertain the future, the more likely expectations will be disparate. For at least as long as disagreeing agents remain solvent, this volatility will persist. Discoordination persists as relative prices fail to reflect  underlying economic reality. 

We can be certain that the mechanics of Austrian cycle theory are always in operation. 

The effect of discoordination of relative prices is always in force. Entrepreneurs and firms in the market are often able to withstand the volatility. This does not change that these agents are interacting with distorted prices. Movements in relative prices always affect the production structure. Sometimes price distortions do not greatly impact system stability. Sometimes they generate numerous insolvencies. In the current crisis, Austrian cycle theory seems to hold in China as myriad distortions have left the market in disarray. 

Confusion arises from the Austrian emphasis on inflation and inflation's relationship to the natural rate. Murphy argues that "the Federal Reserve was setting us up for another crash." How was it setting us up for another crash? Murphy points to the Fed's increased balance sheet as evidence that it has set the economy on course for a slump. He provides the traditional argument that the interest rate has been pushed below the natural rate.
However, what happens if interest rates fall not because of a genuine increase in saving by the public, but rather because central banks flood the financial sector with newly created money? According to the Austrians, this typical remedy merely sets off an unsustainable boom. Entrepreneurs still get the green light to start longer term investment projects, but the economy lacks the real savings necessary to bring them to fruition.
This version of the story is not as powerful as most Austrians think. Firms can substitute toward cheaper inputs as prices rise. Consumers can substitute away from goods that have become to expensive. Projects can be completed, but they may be completed at a loss. If losses accumulate, credit markets may seize for as long as their is a perception of high risk and/or a rate of expected deflation. The structure of production may lengthen, but discoordination occurs on more than one dimension. The story presented by Murphy is incomplete.

The core of Austrian cycle theory is not overconsumption or overproduction. Garrison's presentation with its use of the Hayekian triangle and emphasis on interest rates, demonstrate this version of Austrian cycle theory (edit 926 EST). The theory is more general than this. All relative price distortions lead to overproduction of some goods and under production of others. Inflation tends to make overproduction more common, as reflected by Garrison's movement off of the production possibilities frontier. Central bank policy contributes to this, especially when changes in the money stock are substantial and central bank action is unpredictable. 

This logic applies to more than central banks. All state intervention into the economy tends to be distortionary. The greater the magnitude of the intervention. the less sensitive is the structure of production to the actual needs of consumers. Unlike private agents, the state is not especially responsive to profit and loss as its funds derive from a different revenue stream: taxes. When relative prices are perpetually distorted by interventions and policy uncertainty, profit and loss becomes less effective in promoting expectations that reflect the underlying economic reality.

Thinking about prices and coordination:
Hayek - Socialist Calculation I, II, and III 
Hayek - Economics and Knowledge 
Hayek - The Use of Knowledge in Society 
Mises - Economic Calculation in the Socialist Commonwealth

 

Wednesday, August 26, 2015

Re: David Henderson: A Defense of Austrian Business Cycle Theory

At EconLog David Henderson is asking:
Question for Bob Murphy and other proponents of the Austrian Business Cycle Theory: is there any evidence conceivable that, if you believed it, would convince you that your theory is wrong?
This was in response to Robert Murphy who David quotes:
As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.
The logic that is implied by Murphy's statement, that Austrians have been warning about this for years, does not imply that they are right about the current problem. Saying "we were right" does not make it so. Murphy's story has not inspired David's confidence. Perhaps I can inspire some confidence.

The core of Austrian Business Cycle Theory proposes that changes in the money stock, whether due to gold discoveries (when that mattered) or credit expansion, alter relative prices. This leads to overproduction in some sectors and under production in others. As long as these distortions remain small, the economy will probably not be greatly destabilized. If the array of relative prices, which reflects consumer demands and existing and expected supplies, are continually pushed away from an array that actually reflects these factors, instability grows more likely and business fluctuations may increase in size or number.

Expectations may help offset the distortion; they may not. We are accustomed to thinking of expectations in macroeconomics as expectations about the price level. As long as velocity remains relatively stable, agents may form expectations that often approximate future changes in the price level. This is not the object of significance in the Austrian story. It may have features that coincide with price level movements. The argument stresses that movements in and the formation of expectations about a price level are not the prime cause of fluctuations, although high levels of expected deflation can be responsible for dysfunctional credit markets, as they were during the Great Depression. Typical monetarist analysis, despite all of its success and usefulness (i.e., the cash balance interpretation of depression) does not account for the story concerning relative prices.

We can expect that, in the short run, relative prices will be distorted and that this distortion increases as the size of the injection increases. We cannot expect a full and immediate adjustment of prices as knowledge exists only in dispersed bits. Those bits of knowledge are born from varying interpretations that have contributed to and been formed in part by the agent's interpretive (cognitive) structure. Distortion derived from interpretation increases as agents face greater uncertainty (edit 1826 EST) (Koppl 2002). We've been living in an atmosphere of elevated uncertainty for a decade.

Tuesday, August 25, 2015

Realist Theory and Complex Methods: The Path Toward Integration

In its purest form, economic theory describes its domain of study as it actually exists. Reality is not comprised of homogeneous agents who choose quantities of goods according to the mariginal unit of utility gained per dollar spent. If only life were so simple! In the real world, agents have no option but to make choices that confront scarcity of time and resources. These choices are often aided by some standard or algorithm. In some cases, choices appear to be random. Despite this, order in society is apparent enough to suggest to the observer with even a slight inclination toward introspection that the persons around her act with ends in mind; that there must be some process by which society organizes itself toward the ends of its agents.

James Buchanan identifies much of this order in the form of rules that govern human action and interaction. Douglas North took this a step further, arguing that the rules and order that appear in society first arise in a mind or minds. The rules of the mind come to impact the rules of the game and their structure. This may happen simply through duplication of the rule governed action by others, or may rely on a complex, iterative processes of instantiation. Herbert Simon showed us that humans are ecologically rational, using the information present in their surroundings to guide their actions. This is a process of necessity for humans to function in a world that is best described as an open system and where one's own computational power is limited both by physical and structural constraints of the mind. Hayek (1952; 1960; 2014) delved further into the nature of rules, perception, interpretation, and action, providing a general language that made many readers confuse his economics for something approaching philosophy.

The wisdom of those great economists who have come before us serves as foundation for a new framing of economics. This starts with a reconstruction of the agent along the lines suggested by the economists above mentioned, as well as researchers in the adjacent disciplines which include philosophy, sociology, cognitive science, computational and computer science. Carl Menger dreamed of building a robust economic system that integrated essential innovation in formal knowledge of mind, human action that flows from the mind, and the society that arises as a result of human action. In some ways, Mises (1949) fulfilled this dream in human action. However, unaddressed problems concerning epistemology made his contribution fodder for those who do not appreciate the implications of his argument. Hayek corrected much of this with his work from the Abuse of Reason project. It is no coincidence that he is highly cited by those who study the emergence of institutions.

Many recognize that Hayek's work in this domain is valuable, but I have yet to see a substantial integration of his ideas with the core of economic theory. Many researchers in institutional economics have picked up the torch that he passed. Elinor Ostrom credits Hayek (1937, 1945) for her understanding of the emergence of social institutions that help to govern the commons. A similar appreciation is true for North and Denzau, as well as more recent work from Boettke, Coyne, and Leeson. The latter of these note that Hayek "was among the first to emphasize these aspects of spontaneously emergent institutions (333)." Koppl (2002) advises us to consider the internal state of the economic agent with reference to his perception of the external world. He argues that agents form expectations according to types that they have constructed or borrowed from others. (When I approach a cashier, I do not necessarily expect to make a friend, but I can be nearly certain that he will facilitate my purchase.) Agents have mental maps - private ontologies - which are comprised of a mixture of anonymous and personal typifications and rules that are believed to govern the existence and interactions of objects represented by these typifications.

The work of all of these mentioned have helped move economics toward the cusp of a change that has been building throughout the last half-century. Their work is part of a line realist theories that trace their lineage back to early economists like David Hume and Adam Smith who were not afraid to recognize, and even awed at, the complexities inherent in social interaction. These contributions represent a more scientific rendition classical political economy. This is synonomous with Wagner's "entangled political economy."  Their work is integral to the resuscitation and development of a paradigm of realism to underlie the work of economists.

Not long after the Samuelsonian turn in economics, theorists on the margins of the discipline - and some like Arrow who was certainly not on the margin - began to employ a new set of tools. These tools are part of the complexity paradigm. Researchers within this practice investigate emergent processes and the objects and structures that the processes generate. Of primary concern for economic theorists are agent based models. Some popular models include Shelling's (1971) segregation model, Axelrod's (1997) conflict model, and Gode and Sunder's (1993) zero-intelligence trader model. Theoretical contributions are arising from this line of inquiry. Gode and Sunder show that the process of coordination is an outcome of simple rules governing the buying and selling of goods. Axtell (2005) demonstrates that exchange is a process of social compuation! These theorists have created a number of innovation that other economic theorists can integrate into their own practice and understanding.

Now to bring these treasures together into a cohesive framework. A robust economic theory must explicitly identify its objects of concern, relationships between objects, and processes that govern these. Emphasis on rule-based perception and coordination is critical for understanding the core of social processes. Perception is at the foundation of agent action. Agent-based modeling provides a method to which a methodologically robust rendition of economic theory can be applied. Integration of these will provide us models that not only explain and demonstrate economic theory. The same platform also allows us to produce models whose predictions take economic process into account.

Wednesday, June 3, 2015

Hayek's "Degrees of Explanation": Moving Away from the Apodictic Certainty Derived from the "Axiom" of Human Action

In "Degrees of Explanation", Hayek defends a system of analysis that approaches knowledge in a deductive manner. His proposed methodology is unique in that it is not Misesian, though it bares some similarities. Core knowledge need not be "apriori" in the sense that Mises employs the term. As Kant claimed in his Critique of Pure Reason, apriori claims must be established in empirical observation. Since they are core claims within an argument or, more generally, within a system, we must be especially confident about these claims.

Mises begins his analysis with a single fact. Humans act. Of course he does more than this. In contextualizing his analysis, Mises argues that,
Complex phenomena in the production of which various causal chains are interlaced cannot test and theory. Such phenomena, on the contrary, become intelligible only through an interpretation in terms of theories previously developed from other sources. In the case of natural phenomena the interpretation of an event must not be at variance  with the theories satisfactorily verified by experiments. (31)
This is true for the study of society as well.
Praxeology is a theoretical and systemic, not a historical, science. Its scope is human action as such, irrespective of all environmental, accidental, and individual circumstances of the concrete acts. Its cognition is purely formal and general without reference to the material content and the particular features of the actual case. It aims at knowledge valid for all instances in which the conditions exactly correspond to those implied in its assumptions and inferences. (32)
So far, we see nothing unreasonable. Research in one field should be consistent with, or at least take account of research in other fields. Mises then goes on to make more extreme statements.
Its statements  and propositions are not derived from experience. They are, like those of logical and mathematics, a priori. They are not subject to verification or falsification on the grounds of experience and facts. They are both logically and temporally antecedent to any comprehension of historical facts. (32)
A consistent reading of Mises suggests that these arguments are necessary as an analytical starting point. The trouble is that he does not frame them as such. In attempting to defend the scientific nature of social analysis, which includes economic analysis, Mises makes an argument that is stronger than the facts themselves merit. The facts that we employ are, as far as agents with finite knowledge can know, more true or less true. The facts support analysis of social order must be well-supported by prior research. The task of a good theorist is to identify those facts that are implied by the facts that one takes as given. This should lead to new areas of research that can either support or invalidate the extrapolation. This isn't what Mises is saying, though I wish it was.

Not too far later (39), Mises makes the claim that is perhaps the most problematic for his treatise:
Action and reason are congeneric and homogeneous; they may even be called two different aspects of the same thing. That reason has the power to make clear through pure ratiocination the essential features of action is a consequence of the fact that action is an offshoot of reason. The theorems attained by correct praxeological reasoning are not only perfectly certain and incontestable, like the correct mathematical theorems. They refer, moreover, with the full rigidity of their apodictic certainty and incontestability to the reality of action [emphasis mine] as it appears in life and history. Praxeology conveys exact and precise knowledge of real things.
Two problems arise here.

1) Mises does not explicitly direct interpretation away from social atomism. Perhaps all action is the result of reason, but we must ask, "Whose reason?" Must action and reason be coterminous? Can the reason of one man or many lead to action in someone not directly connected to them? What is the range of action, local or non-local, that results from reason exercised at some time t. The reason of humankind echoes throughout society in its institutions. These are established through a combination of reason and blind groping, through the process of trial and error. Without the use of reason, an agent might take action in the same way that wolves learn the social norms of a wolf pack. Perhaps this fits Mises's definition of reason as applied with a means/ends framework, but I doubt that Mises would apply it in this manner as he argues that "animals are unconditionally driven by the impulse to rpeserve their own lives and by the impulse of proliferation (19)." The relationship between reason and action is more complex than Mises admits here; I suspect that this is the result of Mises's ideological emphasis and the collectives zeitgeist that was in the air of academic conversation at the time.

2) Mises claims that "the theorems attained by correct praxeological reasoning" are "perfectly certain and incontestible." Mises is playing a logical trick here. His statement is true to the extent that conclusion arise from "correct praxological reasoning". But in what situation can I confirm that I have engaged in "correct" analysis? Every theory must always have a disclaimer attached to it that says, "we consider fact A implied by our theory true as long as facts B, C, D, etc... hold as true." We don't live in a world with perfect knowledge, but if we did, we would be apodictically certain. Just as this statement about apodictic certainty is a tautology - useful as it may be - so is Mises claim, but he does not explicitly identify it as a tautology. And his defense of economics that follows is a defense contingent on the truth of the facts upon which praxeology relies. A more honest approach admits that we cannot know that the claims of economists are true with apodictic certainty, even if they apply the system that Mises uses. The best that one can say is that he or she employs a system that makes full use of available, time-tested knowledge (even this claim may be too much due to the asymmetries of interpretation).

In "Degrees of Explanation", Hayek engages a softer claim.
It is, no doubt, desirable that in working out such deductive systems the conclusions should be tested against the facts at every step. We can never exclude the possibility that even the best accredit law may cease to hold under conditions for which it has not yet been tested. But while this possibility always exists, its likelihood in the case of well-confirmed hypothesis is so small that we often disregard it in practice. The conclusions which we can draw from a combination of well-established hypotheses will therefore by valuable though we may not be in a position to test them.
Later in the same paper, he claims,
We shall here have to proceed in our deductions, not from the hypothetical or unknown to the known and observable, but - as used to be thought to be the normal procedure - from the familiar to the unknown.
There is no need to claim that we have apodictic certainty of any kind. Our analysis is a certain as the facts that represent the core claims that support the analysis. In this sense, theory represents facts and arrangements of facts that we are most certain about, assuming that deductions were correctly carried out.

In this spirit, Hayek writes in "Economics and Knowledge",
My criticism of the recent tendencies to make economic theory more and more formal is not that they have gone too far but that they have not yet been carried far enough to complete the isolation of this branch of logic and to restore to its rightful place the investigation of causal processes [emphasis mine] , using formal economic theory as a tool in the same way as mathematics.
Hayek points the way toward forming a more perfect praxeological system. If we are to take Popper seriously, we must accept that we will never have such a perfect system. Theory represents knowledge in most general and most perfect form that we can expect. It is from this light that Daniel Klein's revised iteration of Peter Boettke's claim that "The best reading of Mises is a Hayekian one and the best reading of Hayek is a Misesian one" holds (2012, 30):
I might concur with Peter Boettke that the most charitable reading of Mises is a Hayekian one. The most charitable reading of Hayek, however, is not a Misesian one (32).

Tuesday, June 2, 2015

My Review of Nigel Dodd's "Social Life of Money" is up at EH.net

Read it here.

Brief summary of review: In ideologically charged fashion, Dodd pulls together diverse perspectives concerning money role in society. The author eschews theories of money that stress price theory and Say's identity in favor or analyses that consider the social and political roles of money.

Monday, April 6, 2015

How the Credit Cycle Forms the Basis of the Business Cycle

Within the world that we have constructed, agents and objects take on discrete states.  Agents do not experience the world continuously, but rather, in chunks. For example, when an agent purchases some quantity of a good, very often that good can only be sold in whole units. For example, an agent must purchase some discrete number of computers as defined by an integer. Wholesalers must hold some quantity of goods on hand. Agents and firms must constantly adjust their output to avoid shortages or relieve surpluses of goods and services.

Sometimes economic data changes so quickly that suppliers are unable to avoid loss. Particularly troublesome is a scenario where total demand for goods collapses. This is the bust that comprises the latter part of the boom-bust cycle. After a period of relative prosperity, firms may find themselves holding excess stocks of goods that they can only discard if they lower prices. By lowering prices, the marginal revenue earned by the firm falls. In  extreme cases, the firm finds itself subject to an accounting loss. This is a signal to the firm that it has overproduced and must therefore slow production. By slowing production, the firm will also need to cut expenditures on inputs. This is equivalent to a decrease in demand for intermediate goods produced by firms higher in the supply chain. This reduction in expenditures also includes a reduction of the quantity of labor hired by the firm. 

The bust represents a cluster of errors by entrepreneurs and firms. A large proportion of market participants find that they have erred in their expectation of the future and face subsequent losses. These losses accumulate such that total demand for goods and services – i.e., aggregate demand – falls across the economy. Losses extend beyond only those agents who had taken large risks. Prices and output plummet as agents seek to acquire money to repay debts and increase the security of their positions. The process continues until agents regain confidence in the market, however, the timing of the rebound is far from certain.

What is the nature of the business cycle and why does it occur? The first of these questions can be answered succinctly:

A business cycle is a cyclical fluctuation in the aggregate economic activity of a nation, or a cyclical change in the rate of economic growth.” Business cycles involve coherent changes in output quantities and prices of consumer goods and capital goods, input costs, employment and wage rates, profits, productivity, investment, total and per capita income, the quantity of money, volume of credit and interest rates. (Wood 1997)

The business cycle represents a recurring pattern of a increases and decreases in the value of goods and services produced across all markets, The cause of the business cycle is not exactly obvious. Many economists have attempted to explain the causes of these fluctuations, but few have adequately explained a substantial number of features of the cycle. The most salient explanation of which I am aware comes from Ralph Hawtrey. Hawtrey describes the elements that comprise aggregate demand:

. . . The consumers’ outlay is the whole effective demand for everything that is produced, whether commodities or services. The trader who buys to sell again is merely an intermediary passing on a portion of this demand to one of his neighbours. The cyclical alternations in effective demand must therefore be alternations in the consumers’ outlay. (Hawtrey 1919, 52)

Consumer outlays fluctuate concurrently with production as incomes of both laborers and capital owners are dependent upon total productivity. In a world where money was super-neutral or in a world where capital could somehow trade costlessly for other capital, the business cycle would not exist as a recurring phenomena. But this is not the world that we live in. Exchange occurs indirectly. Agents sell their goods and labor for money in order purchase goods and services from other agents. This would not be a problem except that there occur periods where either the stock of money, demand for money, or both, fluctuate. Fluctuations in the money stock and income are dominated by changes in total volume of credit extended. In a world with a static monetary base, changes in the volume of credit extended are driven primarily by changes in expectation of the value of goods and services produced. An investor who purchases a bond must expect that the borrower can repay his loan and the interest it accumulates. When businesses borrow, the money soon ends up in the hands of the laboring class.

It may be pointed out that the consumers’ outlay is increased as soon as producers begin to borrow. The producers and their employees have more to spend while the orders are still uncompleted. (Hawtrey 1919, 55)

A increase in consumer income translates to an increase in aggregate demand assuming that agents spend at least a portion of this increase. In industries where the new money is spent to purchase goods that otherwise would not have been purchased, prices will tend to increase and so too will production in the short-run relative to prices given the same scenario absent credit expansion. The reverse is also true. A contraction of total credit expanded promotes a fall in incomes.

The business cycle arises when the expectations of a substantial number of investors and entrepreneurs are upset, meaning that at the time of initial investment these agents expected incomes to be higher than turned out. If enough borrowers are unable to repay their loans, bank who suffer these defaults must begin to slow their rate of credit expansion so as to allow there reserve ratios to recover. An increase in the reserve ratio is equivalent to a decrease in the broader money stock. This contraction leads to a fall in incomes which worsens the problem. With less credit available, firms must begin to rely more on savings for repayment of debt. This further contracts the money stock. Firms whose managers sense that the business outlook has turned for the near future also begin to increase their balances of cash and reduce their reliance on borrowing, both of which lead to reductions in the total stock of credit, and therefore, money. (Hawtrey 1919, 14). As agents sense that the economy is in a state of consolidation, many begin to form expectations of price deflation. Demand falls in the short-run and the fall in prices accelerates. Only after banks have increased reserve ratios to a level that pleases managers, and ultimately depositors, may banks interrupt this fall in prices by expanding credit on net. They must wait to expand credit, however, until businesses feel safe to expand production.

This story of credit expansion and contraction gives the theorist a starting point from which to build an understanding of the business cycle. Credit seems the primary driver, but what drives credit? It is expectation by financiers that will be an increase in production that drives the expansion of credit. The process of credit creation creates a natural oscillation in productivity, and therefore, oscillating expectations concerning productivity. Credit is not the only driver of expectations. Innovation brings new products and increases the efficiency of production. The expansion of production made possible by new technology certainly affects the expectations of financiers and bankers and of producers. New technology raises opportunity for economic profit and therefore serves to attract the funds of perceptive financiers. Not only must entrepreneurs sense profit opportunities, but financiers must be apt to perceive that the entrepreneur is correct. (It is worthwhile to consider how they accomplish this. Consider that as a rule of thumb, successful venture capitalists, which are one class of financiers, are sure to bet on a person, which includes that person’s network, vision, and creativity, not simply an idea.) Thus Schumpeter is to some extent correct when he claims:

We agree with him [Hawtrey], first, in recognizing that the fundamental cause, whilst in its nature independent of the machinery of money and credit, could not without it produce the particular kind of effect it does. (86)

He is incorrect in claiming:

Booms and consequently depressions are not the work of banks: their cause is a non-monetary one and entrepreneurs’ demand is the initiating cause even of so much of the cycle as can be said to be added by the act of banks. (86)

I have shown that there exists a natural fluctuation in credit driven by errors in expectations of entrepreneurs and financiers, the effects of those errors on the position and expectations of banks, and therefore, on the available stock of money and demand for a portion of that stock. The high level of expected profits that emerges from knowledge of an innovation attracts more capital into the market than would otherwise exist. As long as the expectation of economic profit exists, the innovation will increase total credit extended in the market. If expectations of creditors are on average correct, this expansion of technology is responsible for a long-run increase in the volume of production and its real value to consumers. It is possible that a sector centered around a new innovation will attract a large portion of available credit during an expansion, but this would only serve to increase the amplitude of cycles where financiers overinvested in the sector of innovation.

Aside from encouraging credit expansion, innovations that increase efficiency tend also to devalue capital whose role the innovation has displaced. What was the fate of the horse and buggy after Henry Ford began production of the model-T? Was it not appropriate that the mass production of telephones and computers contributed to the waning of the telegram? This capital lost most of its value as agents in society no longer demanded them. This devaluation of capital can hardly be blamed for a tendency toward depression for the whole economy. Neither overinvestment in new innovation or devaluation of obscelescent capital are necessary or sufficient to generate the cycle in its most essential form.


There a number of other models that describe the business cycle, some of them ad hoc. These include, in no particular order, Lucas’s Island Model, New Keynesian theories of market imperfections, Real Business Cycle Theory, and the Austrian Business Cycle. Of special note are modern monetarist theories concerning fluctuations in the money stock and money demand as they are closely related to the creit cycle. I have posted on these before, including in this short summary. For more on the Austrian Business Cycle see here and here.

Wednesday, April 1, 2015

The Emergence of the Clearinghouse

We continue our journey through the evolution of banking with the rise of the clearinghouse association. First, let’s review the evolution of economic development thus far. Imagine a world of scarcity where we have instantiated agents. These agents own property and take action according to their preferences. As agents interact, direct (barter) exchange arises. Each agent trades some good or goods that he owns for some other good or goods that he or she values more than the item or bundle given up. In each exchange, agents pays only as much for a good or goods as they are willing. Sometimes, a good desired by an agent can only be acquired by multiple exchanges. Imagine that agent A owns an apple, agent B owns an orange, and agent C owns an avocado. Agent A is willing to trade her apple for an avocado, but agent C will only trade her avocado for an orange. It just so happens that Agent B would like to trade his orange for an apple. Agent A, sensing an opportunity to attain her desired end, trades her apple for agent B’s orange. Then she trades the orange for an avocado. This is indirect exchange. Over time, some types of commodities, say oats, come into use for indirect exchange. The commodity used for indirect exchange comes to gain value for its use in indirect exchange. This value is its exchange value.

Eventually, one or several of these moneys comes to dominate markets of indirect exchange. Money has developed whose price tends to reflect its supply and demand. One interesting feature of a commodity money is that its quantity is, in the long run, dependent on its supply and demand. If money becomes dearer due to an increase in demand for it, its price will rise and thereby increase the quantity of money supplied. A fall in demand will allow the quantity supplied in a given time period to fall. Thus, the quantity of money stock is self-regulated with respect to changes in demand.

Commodity moneys are costly for agents carry. If the commodity money is not standardized, it may be difficult to measure. If it is heavy, like gold or silver, it may be costly, or even dangerous, to carry on one’s person. Owing, at least in part, to these reasons, agents find that they benefit from leaving their money entrusted to a third party at a secure location. The agent will likely receive a deposit slip in exchange which can be used as money. Thus we have the emergence of fiduciary currency. Eventually, the agent or firm entrusted with the gold realize that they might profit from lending out some portion of the existing deposits. This allows the latent media to earn a return. This return allows the agent or firm to pay interest on deposits. The cost of holding gold is no longer borne by the agent who owns the commodity. Fractional-reserve banking is born.

Any bank in operation chooses to keep on hand some commodities whose value is equal to a portion of its reserves. This is needed in the case that some depositors want to immediately withdraw their currency from the bank. If too many depositors attempt to withdraw from the bank simultaneously, the bank may risk being unable to make a repayment. Absent any institution designed to aid the bank in such a crisis, the bank will have to borrow from another bank in order to stave off hysteria. Of course, if no other bank is willing to lend to the bank, it will have to close until it can acquire the funds. This option is a last resort as it will certainly attract the attention of risk-averse depositors. Bankers realize that they have incentive to minimize the occurrence of this scenario as a wave of collapses may have repercussions for the entire economy. It so happens that a clearinghouse association is an organization in prime position to provide stability during a run. 

A clearinghouse is the location at which multiple banks may hold some of their reserves and keep their records. By holding their reserves and records at a common location, banks can clear debits and credits between one another and use the reserves on hand to pay remaining debts between one another. The clearinghouse is also a nexus for information concerning the creditworthiness of borrowers, thus serving a role in risk mitigation. The clearinghouse might also mitigate risk by producing temporary currency during a crisis. The clearinghouse has plenty of reserves on hand. During a crisis the clearinghouse, ostensibly drawing from these reserves, can lend out emergency currency. This emergency currency allows banks that consider themselves to be at risk and that the clearinghouse deems to be only illiquid - not insolvent - to build up their reserves without depleting the supply of available credit. Since credit is employed predominantly for business, a net decrease in available credit typically diminishes the level of future production, and consequently, real income. Likewise, a collapse in the credit markets leads to a collapse in production until the collapse reverses (assuming it reverses). A wave of banking failures, like the one that occurred during the Great Depression, can turn an economic recession into a depression. For the sake of self-preservation, the clearinghouse has incentive to prevent such an extreme crisis.


Given the risk of a credit crisis, the clearinghouse also takes on a proactive role in regulating the positions of its member banks. If may, at random or on the suspicion of a bank’s malhealth, withdraw a large amount of funds from a member bank in order to test its capacity to handle adverse clearings. This serves to discourage excessive risk taking by member banks and represents yet another means of promoting the stability within the system. 

Having mechanisms that promote stability does not suggest that the system is itself perfect. Every system has bugs. There will always be some banks that take on excessive risk. There will always be failures. Irresponsible banks must fail or else they corrupt the whole system. The significance of the clearinghouse system is not that it prevents any instability, but that it places bounds on that instability. Regulation and stability are themselves properties of the system as entrepreneurs earn profit by finding ways to mitigate risk.

Monday, March 30, 2015

Central Banking: The Basics

1. Credit Fluctuations and Financial Crisis

Last post, we discussed the role of fluctuations in total credit extended to the value of production and also to the total money stock. When credit is expanded, this is typically indicative of an increase in the value of production. This can occur either through an increase in production itself, an increase in prices, or an increase in demand for cash balances which may lead to an increase in demand for credit assuming that prices do not immediately adjust to accommodate the change in demand for money. The relation between credit and money implies a relationship between aggregate demand and credit. When the volume of credit extended increases on net, this is equivalent to an increase in the money stock, and therefore an increase in aggregate demand (MV). Thus, changes in the credit stock, absent a change in demand for money, shifts the aggregate demand curve in the same direction. After a period where credit has been misallocated, something only discovered ex post, there must follow a contraction as the value of collateral adjusts to reflect underlying demands of the economy. While this process works to reallocated resources to their most highly value use, the fall in credit also precipitates a fall in income. Falling incomes encourages agents and firms to take a more conservative stance financially until they expect that the crisis is nearing an end. This tendency creates aggregate oscillations known as the business cycle. We will discuss the business cycle in later posts. For now it is sufficient that we recognize that the phenomenon exists.

When these oscillations in the volume of available money and credit grow extreme, banks that might otherwise be economically sustainable risk default. The same holds true for other businesses. In the worst case, these fluctuations may create a wave of insolvencies that turn a minor crisis into a financial pandemic. Nominal fluctuations begin to affect the structure of the real economy. This is what occurred in the recent crisis. Many large financial firms were holding bundles of AAA rated mortgage backed securities. The AAA rating hid from non-critical observers the risk contained in these securities. Before the crisis in 2007 and 2008, banks held these securities were able to acquire very high levels of leverage. The ratio of debt to cash on hand grew to dangerously high levels. When the value of these assets collapsed, leverage levels increased as many of these firms were on the brink of collapse. Assets that had served as money – mortgage backed securities – fell in price. This was equivalent to a drop in the broader money stock as it necessitated a contraction of credit in order for the system to stay solvent. In order to avoid collapse, the Federal Reserve provided the market with liquidity by buying up “toxic” assets, i.e., the overvalued mortgage backed securities. Ignoring the politics that were at issue, we observe that the Federal Reserve was, in an unorthodox manner, serving the role of lender of last resort.

2. The Central Bank and the Money Stock

The central bank’s primary means of policy implementation depends on its control of the money stock. This control provides it the ability to intervene within a market. There are 3 means by which a central bank typically intervenes.
a. Discount Rate 
The central bank lends money directly to other banks through the discount window. In the early days, this was the central bank’s primary means of intervention. It has come to play a smaller role in the modern environment. 
b. Open Market Operations 
This is a favorite tool of central banks. Open market operations is the general process in which central banks engage when they buy and sell debt on the open market. If the central bank purchases debt, it has increased the monetary base, usually with the expectation that this increase will promote credit creation. If the central bank sells, bonds, it diminishes the base money stock and, by so doing, discourages the creation of new credit. Most central bank policies imply an inflationary bias, so this latter case is less common. 
c. Reserve Requirements 
The central bank can influence the broader money stock by changing the proportion of commercial bank liabilities that are required to be held with the central bank. By increasing reserve requirements, the central bank contracts the total money stock. By decreasing reserve requirements, the central bank enables the expansion of the total money stock.
3. The Central Bank as the Lender of Last Resort

The lender of last resort role is probably the strongest justification for central bank management of the money stock. During a crisis, banks need liquidity. Under some banking regimes, private banks collectively established institutions that stabilized the banking system during crises (as we will see next post). The norm has been for governments to establish a central bank.

The central bank is responsible, not only for providing liquidity during a crisis, but also to manage the base money stock. This is of particular significance for the functioning of credit markets. If a bank or banks risks collapse, cannot acquire credit, and appears to be solvent, the central bank’s role is to provide temporary liquidity to the institution. This function provides stability to the system during periods of credit collapse.

a. Moral Hazard 
The lender of last resort role creates a problem of second-order: moral hazard. In a system where stability is provided privately, provision of liquidity is constrained by expectation of repayment. This expectation is formed by the creditor’s local knowledge of the bank receiving emergency funds. In the private system, this role is decentralized as major players within different banking systems (networks) play the role of lender of last resort. The implementation of a central bank degrades this local knowledge and distorts incentives. Banks with relatively high levels of risky assets might not receive credit under the private system. They are more likely to receive credit under a system of central banking as 1) politics plays a greater role in allocating credit and 2) private bankers and investors may form the expectation that the central bank will always provide them liquidity. This encourages private banks to extend more credit than they would otherwise.
4. Relative Prices and the Flow of Goods and Currency
a. Fixed Exchange Rates (Gold Flows) 
During the years of the gold standard, this role was fulfilled by adjusting the base money stock according to business conditions. This might lead to fluctuations in the reserve ratio as well as gold flows. Under this system, exchange rates could not adjust to bring international prices to parity. Instead, prices denominated in gold were brought into parity by arbitrageurs.

One part of this process is the price-specie-flow mechanism. Let us assume that the economy is in equilibrium. If the central bank increases the portion of the base money stock comprised of paper money absent a change in the gold stock, this will tend (though not always) to promote credit creation and increase prices within the nation. This leads to discrepancies between the prices of domestic goods and goods from abroad. The discrepancy in prices encourages gold to flow out of the country to other nations where prices are lower and goods are therefore cheaper. Domestic interest rates are also depressed, thus encouraging gold to leave the country. Likewise, a contraction of the paper money by the central bank will lead to a domestic deflation which encourages the flow of gold from foreign countries into the domestic economy.

In the long run, the price of any like goods tend to equalize. This gives rise to purchasing power parity. Traders can earn a profit by purchasing goods or claims to goods in a country where prices are relatively lower and selling them in countries where prices are relatively lower. This shifts demand away from the more expensive goods and toward the cheaper goods which diminishes the discrepancy in prices. This long-run tendency is the process on which the law of one price depends. Anywhere where there is a discrepancy in the price of goods represents a profit opportunity. Consequently, in a gold standard world, gold has only one international price, deviations from which are constrained (Samuelson 1980).
b. Floating Exchange Rates 
For the most part, central banks no longer hold gold. They hold currency and debt, both foreign and domestic, as the large share of their assets. The effects that operated under the gold standard still effect prices, but these changes tend to be swamped by swift changes in exchange rates. If a central bank increases the money stock, ceteris paribus, then we can expect that prices will tend to rise on average. The currency loses value. If the exchange rate of the currency adjusts before domestic prices, then there exists an arbitrage opportunity for investors who purchase these domestic goods and sell them abroad. Under the gold standard, fixed exchange rates led goods to flow into the country as prices rose. Relatively cheaper foreign goods would flow into the country engaged in inflation. With no fixed exchange rate, however, the flow of goods out of the country whose currency has devalued relative to other currencies is the consequence of inflation.

5. The Federal Funds Rate

In the United States, the Federal Reserve sets a target for the Federal Funds Rate. This is the rate at which banks lend to one another, often overnight. Since new money first comes into possession by banks that sell assets to the Fed, this rate is relatively responsive to changes in the money stock.

6. Types of U.S. Government Debt

The Federal Reserve usually expands money by buying government debt. This debt is divided into 3 categories
a. Treasury Bills 
This is comprised of debt that matures within one year. These represent the bulk of debt purchases by the Federal Reserve. 
b. Treasury Notes 
Treasury notes include debt that matures in 1 to 10 years. 
c. Treasury Bonds 
Treasury bonds mature in greater than 10 years.

Wednesday, March 25, 2015

Money and Credit: Origins, Instruments, and Dynamics

Banking

When money first arises, agents must find a way to economize on cash balances. Agents can hold on to commodities, but this is a risky practice. Commodity money may deteriorate or be lost or stolen. Theft was especially a problem for those making long trips through the countryside. Holding on to cash balances is costly. Early on, agents realize this. Those with enough wealth begin to keep their money with a trusted third party. Historically, when gold came into use as money, agents left their gold at a warehouse in exchange for a deposit slip. These deposit slips served a role as a medium of exchange. If the warehouse has multiple branches, the deposit slips might be exchanged at another branch, thus increasing the marketability of the slips by diminishing agents’ incentive to discount the them. These slips are part of a more general class of money known as fiduciary currency (the root of the word fiduciary comes from the Latin word for “faith”). These are promises to repay.
                
Eventually, the keepers of the warehouses realize that they can lend the money entrusted to them so long as depositors do not rush all at once to retrieve their commodity money. This is fractional reserve banking. Banks hold some portion of their reserves (the money lent to them) while lending the remainder. This allows cash to be employed when it would otherwise sit in reserve. For depositors, this diminishes the cost of holding cash balances. In a gold standard world, for example, instead of holding and exchanging in actual gold, agents can exchange deposit slips. Meanwhile, they earn interest on the money that they have temporarily relinquished to the bank. This creates a tendency for the total money stock, which in our example is the total gold plus the total amount of deposit slips to fluctuate due to changes in demand to hold currency. We measure the relative size of the total money supply by comparing the base money stock to the total amount of money in circulation.

MT= MB / r
               
Where:
MT = Total Money Stock (MB + Liquid Credit Instruments)
MB = Base Money
r = Reserve Ratio (Aggregate)

The logic here is straightforward. Collectively, banks form an aggregate reserve ratio. It is defined by the amount of currency they have on hand divided by their total liabilities. Monetary dynamics fall out of this identity. When banks extend credit on net, the reserve ratio drops. When banks contract credit on net, the ratio increases. When agents deposit currency on net, the ratio increases. When agents withdraw currency on net, the ratio falls (Hawtrey 1919).

We might also think of the reserve ratio as its inverse: the money multiplier. This represents the ratio of total currency to base currency. The ratio of currency to deposits plays an important role in this identity as it allows us to observe the effect of a change in currency or deposits on the money multiplier.
Mt = C + D
Mb = C + R
Mt/Mb = (C + D) / (C + R)
Mt/Mb = (C/D + 1) / (C/D + r)
Where:
Mt / Mb = Money Multiplier
C = Currency
D = Deposit 
*Other variables defined as above

Notice that the numerator is larger than the denominator as long as r < 1. This means that as C increases, the denominator grows at a faster rate than the numerator. The money multiplier falls under this scenario. Likewise, as the total stock of currency shrinks, the money multiplier grows. Similarly, as the amount of deposits increases, the denominator, C/D + r, falls at a faster rate than the numerator. The money multiplier increases. As deposits falls, the money multiplier falls.

Unspent Margin: Cash Balances, Money on Account, and Substituting for Available Credit Lines

Agents respond to the incentives of this relatively flexible system. We assume that agents economize on cash balances. That is, they decide to hold cash for several reasons. Agents receive income in discrete units, so they must build up reserves in preparation for periods where income has yet to be received. Agents also hold currency or deposit balances in order to hedge for risk. Last, agents deposit their currency in discrete quantities. (This was more important before the development of direct deposit and electronic quasi-monies.) Agents may economize on cash balances by leaving their money on deposit to collect interest. They may also choose to allot some wealth to long-term investments where it collects more interest than an ordinary demand deposit account. They may also choose to substitute an available credit line for balances of cash or deposits. By doing this, an agent may collect a higher yield from long-term investments while still having ample liquidity to deal with fluctuations in their own demand for money.

The unspent margin serves as analytical proxy for demand for money. First we must identify the unspent margin. “The unspent margin is equal to all the cash, whether in circulation or in the banks, plus the net interest bearing assets of the banks (Hawtrey 1919).” The unspent margin represents portfolio demand for money. In a world where credit influences the money stock, a net increase in loans by the banks will first have the effect of increasing the unspent margin. When credit is expanded without being exchanged for goods, the credit represents an increase in the money stock with an offsetting expenditure. Demand for money increases (velocity falls) as a result. A contraction of credit represent a fall in demand for money. Demand for money falls as agents relinquish cash to the bank and the bank fails to offset the decrease in liabilities. In either case, prices must adjust to in order to facilitate the exchange despite a change in the money stock.

It is from this pattern that Hawtrey made an observation concerning the relation between incomes and changes in credit.

Apart from this shuffling of debts, all the credit created is created for the purposes of being paid away in the form of profits, wages, salaries, interest, rents – in fact, to provide the incomes of all who contribute, by their services or their property, to the process of production, production being taken in the widest sense to include whatever produces value. It is for the expenses of production, in this wide sense, that people borrow, and it is of these payments that the expenses of production consist. So we reach the conclusion that an acceleration or retardation of the creation of credit means an equal increase or decrease in people’s incomes.


In the world that we have constructed thus far, exchange only occurs when both agents expect to profit. This implies an expectation of the lender that the borrower has or will earn the means to repay the loan at a later date. The borrower will typically produce goods or provide services in order to raise the income required for repayment. In a world of voluntary exchange, then, incomes rise and fall with increases and decreases of the credit stock as this reflects changes in the expected value of production.

Monday, March 23, 2015

The Nature and Role of the Interest Rate

What is Interest?

When an agent owns wealth, whether in the form of a commodity or currency, he or she may decide to temporarily relinquish control of his or her asset in exchange for a return whose value is dependent upon the length of time for which the asset is relinquished. The value of the return divided by the original investment – the value of that which was lent – represents the rate of return. The rate of return implies a time period over which investment occurs. Typically this period is one year. If the rate of return is 10%, an agent who invests $100 or an asset worth $100 in year one receives a value of $110 in year two. The rate of return in this sense is a rate of return for an individual investment. We might weight the returns from an agent’s investments to calculate an average rate of return for an individual agent or we might attempt to calculate the rate of return for the market as a whole. The latter of these is known as the market rate of return.
                
When working with the rate of return, either for analysis of the past or estimations of the future, we use the equation for present-value. In its simplest form, we compound over one year (period):

PV = FV/(1 + r)

Where:
PV = Present Value
FV = Future Value
r = Interest Rate

We can use this equation to estimate the rate of return for any investment, monetary or otherwise. Alchian and Allen (1983, 108) show us that we might calculate the rate of return using physical assets. This is known as an own rate of interest. (For a discussion of own rates see this post from David Glasner). Imagine that we have 3 pound of grapes. That one pound of grapes might be sold immediately or they might be processed for a year and sold as a bottle of wine. Let us assume that, aside from time, this process is costless. In this case, the present value of the grapes is equal to the price they would sell for on the market. The future value is equal to the price that a bottle of wine is expected to fetch one year from the present. If the bottle of wine is expected to sell for $1.10 and the three pounds of grapes is expected to sell for $1.00, then we again have a case where the expected rate of return is 10%:

1 + re = $1.10/$1.00
1 + re = 1.1
re = .1

This calculation can also be performed ex post in order to compare the actual return to the return on another investment.

Recall that agents achieve profit by transforming the present state of the world into one that they prefer more greatly. Interest helps to expand this definition of profit. We can now imagine not only a transformation of the present state, but so also the exchange of expected states in the future. If an agent comes to realize a return that is less the market rate of return, she may choose to invest in assets whose returns she expects to at least match the market rate of return. This exercise in arbitrage is what drives the market toward an equilibrium state so long as expectations are convergent; that is, so long as agents’ expectations about the present state of reality and its future unfolding tend to cohere with one another. This is not an unreasonable assumption as those who fail to predict the future state of the market will tend to be out-competed by those who do. In the short run, extreme, even systematically destabilizing outcomes may occur. We should beware against ignoring context and process by turning belief in market efficiency into a tautology. (For more on expectations, see Koppl 2002; Koppl and Butos 1993)

The rate of interest emerges as a result of agents’ time-preferences. Given one’s context, an agent reflects time preference in his or her decisions to refrain from consumption or not. If an agent refrains from consumption and invests his or her wealth for a period of time, that agent increases the availability of loanable funds. Assuming normal conditions – i.e., the future is expected to look mostly like today – a typical agent demonstrates positive time preference. He prefers having goods in the present to having the same goods in the future. Absent other influences, this results in a positive rate of interest. It is possible that markets might arrive at a negative rate of interest, but this categorically cannot be the result of an inversion of time-preference where agents prefer a state in the future to an otherwise identical state in the present. This positive time preference leads agents to invest so long as they receive a positive rate of interest.

The other, secondary determinate of the interest rate is the productive sector. If agents are lending their wealth to other agents with expectation of a certain rate of return, then agents who are borrowing expect either to earn higher rate of return. If this expectation is incorrect, the borrower will incur a loss, and in the worst case, default. For now we deal with the first case. Time preference is reflected by the supply of loanable funds, investment opportunities determine the demand for loanable funds. If an increasing number of agents expect that rate of return in the market will be greater than the interest rate, the demand for loanable funds will increase (See Figure 1). The rate will tend to rise until agents, in aggregate, no longer expect a rate of return higher than the interest rate. Likewise, the interest rate will fall if agents, in aggregate, expect that the rate of return will be less than the market rate of interest. (This analysis may be further complicated by differing expectations for a variety of time horizons. For simplicity, I leave this case out.)

























Figure 1

Natural Rate of Interest

The interest rate plays a significant role in coordinating investment across time. Of particular concern in the natural rate. Wicksell explains,

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital. ([1898] 1936, 102)

The natural rate of interest is the rate of interest that would exist absent nominal factor such as fluctuations in the money stock or fluctuations in demand for money. The nominal rate of interest is thought to fluctuate within proximity of the natural rate and is ultimately bounded by the natural rate. In the long run, the natural rate constrains the viability of particular investments, although in the short-run profits might be made from investments that are unsustainable. If a tendency arises for unsustainable investment projects to receive funds, this will eventually be checked by liquidity constraints. A rising interest rate thus reveals this problem and forces funds to be allocated away from those projects.

Real and Nominal Rates

Interest rates are observed in nominal form. This means that the observed rate of interest can, and typically does, deviate from the natural rate, defined in terms of a real rate. In equilibrium, meaning all exchanges have been made and under conditions where perception and expectations cohere with objective reality, the observed rate is equal to the sum of the real rate and the inflation rate. This is known as the Fisher Equation

i = r + π

                Where:
                                i = Nominal (Observed) Interest Rate
                                r = Real Interest Rate
                                π = Inflation Rate


Through a process of trial and error, agent action factors the average rate of inflation into the money rate of interest. Within this construct, the money rate of interest converges with the natural rate of interest.

To sum, the interest rate is emerges as the result of positive time preference. Individuals value present goods over future goods. The interest rate tells us by how much agents, on average, these agents prefer the future to the present. A secondary factor of influence over the interest rate is the rate of return on investments in the market. If opportunities for profitable investment, in terms of dollar value, are expected to exceed the rate of return, this pushes the rate of interest upward. Likewise, if there is a general expectation that the value of investment opportunities are shrinking, this will push down the rate of interest. In the long run, the interest rate will tend to reflect the real return on capital. Nominal factors such as changes in demand for money and changes in the available money stock tend to produce short-run deviations away from the natural rate. These fluctuations tend to be limited by liquidity restraints and are mitigated by a short-run rise in the interest rate. In the long run, inflation will be factored into the observed rate such that observed rate of interest is equal to the sum real rate and the nominal rate of interest. Finally, the reader should be aware that this analysis occurs within a static framework and ignores complications that arise due to destabilizing events such as herding, distortions from Big Players, political, economic, and/or natural disasters, etc... These additional sorts of details require a careful study of history and the use of simulation to further our understanding.

Tuesday, March 3, 2015

Say's Principle and Macroeconomic Analysis

In his 1936 treatise, Keynes formulated Say’s Law as proposing that “supply creates its own demand.” It is not clear exactly what Keynes meant by this. The statement implies an assumption of equilibrium where all excess demands are zero. That is, if supply creates its own demand, then quantity demanded of a good and the quantity supplied must be equal.  This is at worst a misrepresentation of Say’s Identity and at best an incoherent statement that appeared in one of the most popular economics treatises in history.

What is Say’s Law and why does it matter? In A Treatise on Political Economy, Say argues
A man who applies his labour to the investing of objects with value by the creation of utility of some sort, can not expect such a value to be appreciated and paid for, unless where other men have the means of purchasing it. Now, of what means do these consist? Of other values of other products, likewise the fruits of industry, capital, and land. Which leads us to a conclusion that may at first sight appear paradoxical, namely, that it is production which opens a demand for products.
Ultimately, goods must pay for goods. If an agent wishes to purchase a product, he or she must either exchange another good directly for the desired good or else acquire by exchange money to purchase the item. Confusion arises when money must be integrated into the framework. Unfortunately, Say does not do a good job of explaining the significance of money within this schema.

Thus, to say that sales are dull owing to the scarcity of money, is to mistake the means for the cause; an error that proceeds from the circumstance, that almost all produce is in the first instance exchanged for money, before it is ultimately converted into other produce: and the commodity, which recurs so repeatedly in use, appears to vulgar apprehensions the most important of commodities, and the end object of all transactions, whereas it is only the medium. Sales cannot be said to be dull because money is scarce, but because other products are so. Should the increase of traffic require more money to facilitate it, the want is easily supplied, and is a strong indication of prosperity – a proof that a great abundance off values has been created, which it is wished to exchange for other values.

Say’s description implies that he understands that there can be an excess demand for money that raises money's price. That increase in price will encourage an increase in the available money stock. Having brushed off the problem of insufficient demand by relying on an invisible-hand process, Say give a less than satisfactory supply-side argument for explaining general gluts.

It is because the production of some commodities has declined, that other commodities are superabundant. To use a more hackneyed phrase, people have bought less, because they have made less profit; and they made less profit for one or two causes; either they have found difficulties in the employment of their productive means, or these means have themselves been deficient.

Say describes here a misallocation of resources that only adjustment of price, and subsequently, of the capital structure can fix. It is possible however, that the processes that coordinate market activity might be interrupted by extreme swings in demand for money. It is this problem for which Leijonhufvud and Clower’s extension of Say’s Law as “Say’s Principle” (they refer to it as SP) provides a clear explanation.

Leijonhufvud and Clower describe Say’s Principle first in terms of individual agents. The core of their claim goes that “the net value of an individual’s planned trades is identically zero.” Individual agents make decisions concerning the allocation of their money. An agent may decide to spend all available money on goods and hold no cash on hand or he may decide to withhold some amount of money for safe-keeping. In the latter case, the agent has a positive portfolio demand for money. Algebraically, the authors represent this elementary budget constraint in a system of exchange where such a constraint is implied by secure property rights:

               Pxdx + pydy + dm– sm,0 = 0

In order for an individual's plans to be coherent, planned expenditures plus planned holdings of money (portfolio demand) must equal the stock of money available to the agent. The authors explain further in terms of common interpretations,

‘No one plans to supply anything of value without also planning some use for the proceeds from the sale, which may include simply planning to hold money until a later decision is made to purchase other commodities.’ This statement is correct and sensible.”

‘Confronted with given prices, each transactor must plan to supply commodities of sufficient value to finance all his planned net demands.’ This statement is also correct.

If you have not intuited this by now, Say’s Principle is simply an observation of agent action given a budget constraint.

When money is not included as the “mth commodity”, it is possible that excess supplies of goods can exist. However, when money is included we find that all excess supplies are equally offset by excess demands for goods. This is of special significance if one is to understand macroeconomic fluctuations. Distortionary representations of Say’s Principle connect the identity to an equilibrium assumption. This seems to be what Keynes was implying. Say’s Principle does not imply equilibrium absent a process to correct expectations. SP is an observation. Movement toward equilibrium requires some minimum threshold of convergent expectations amongst the population of agents as well as some combination of flexible prices and an endogenous money stock.

Money is different from all other goods in that it comprises one side of every monetary exchange. For this reason, we may separate economic goods into two categories for the sake of analysis. There is 1) money and then there are 2) all other goods. The value of goods in the second category are enumerated in a given currency unit. An excess supply of any good occurs when agents plan, in aggregate, to purchase less of the commodity than is available at a given price. This leads, by definition, to an excess demand for the “mth” good, money, meaning that at given the current constellation of prices, agents demand more money than is available. This will tend to push the price of money – the amount of goods that money exchanges for – upward and, conversely, the prices of commodities downward. This does not mean that the price of all commodities will necessarily fall, but that there will be deflationary pressure as the real stock of money (M/P) is others unable to facilitate exchange of goods until either prices have fallen or the nominal money stock (just M) rises. Until the problem is corrected, there will be a fall in output and employment of both labor.

We can illustrate Say’s principle with graphs of the money stock and of aggregate supply and demand. Those of you reading last week should recognize these graphs.



This represents an economy where agents have elected to increase the nominal value of their dollar holdings. Before prices adjust to reflect this change, there will be 1) and excess demand for money and 2) an excess supply of goods. Not enough money exists to facilitate exchange until prices drop. Eventually, prices must drop in order to clear available inventories. If the general fall in prices takes an extended period of time to occur, then there will be a depression: an extended fall in real output. This comes with an increase in unemployment and a fall in living standards for those agents not prepared for the depression.
   
Two solutions to this problem have been discussed. Either prices can fall to alleviate growing inventories or the money stock can increase. This has policy implications. 1) A central bank can attempt to alleviate, either in whole or in part, fluctuations in demand for money. The most popular formulation of this proposal is that the central bank should attempt to stabilize MV by adjusting M to offset changes in V. Leijonhufvud and Clower note some historical skepticism about this approach:

. . . Its use raises other issues. To whom is ‘the engine of inflation’ to be entrusted? What limits to that party’s discretionary use of the throttle would it be advisable to impose? . . . Reliance on the automatic solution, in this [classical] view, is argued to be the lesser of two evils.

Perhaps a better solution to this problem is to enact policies that enable the money stock to automatically fluctuate according to changes in demand for it. This might include the removal, or at least minimization, of barriers to liquidity that discourage asset owners from converting those assets into cash (i.e., the capital gains tax and legal restrictions applied to particular classes of assets). Another significant element in promoting a robust economy is the facilitation of expectation formation in regard to public policy. Government agencies are “Big Players” whose plans and actions are considered by agents in the formation of their own expectations (Koppl 2002). If “Big Players” act unpredictably, agents will be less able to coordinate. If these “Big Players” are unable to accommodate this need due to the nature of the political process, then there may be a case for a shrinking of the scope of influence for these government agencies. Of course, this is not to deny that it is possible that changes in government structure might also accommodate this need, but this is even more difficult of a task to accomplish.

I leave you with Say’s perspective concerning this problem.


. . . Wherever , by reason of the blunders of the nation or its government, production is stationary, or does not keep pace with consumption, the demand gradually declines, the value of the product is less than the charges of its production; no productive exertion is properly rewarded; profits and wages decrease; the employment of capital becomes less advantageous and more hazardous; it is consumed piecemeal, not through extravagance, but through necessity, and because the sources of profit are dried up. The laboring classes experience a want of work; families before in tolerable circumstances, are more cramped and confined; and those before in difficulties are left altogether destitute. Depopulation, misery, and returning barbarism, occupy the place of abundance and happiness.