Hayek, Auto-poetic Social Order, and Critical Realism: Critical Realist Social Ontology as a Theoretical Tool Set for Economists

I have heard some say, “if you can’t measure it, it doesn’t exist.” At first look, the statement seems innocuous. If you cannot measure something, how do you know that it exists? Empirical-realism attempts to measure the world directly through the five senses. It requires some “objective” measurement. Not all causation can be measured. Some structures in society only evidence themselves through the imprint they leave behind. These imprints appear, to the careful observer, in the form of networks, norms, and other patterns of organization that cannot always receive neat, numerical measurement. The world does not fit well onto the Cartesian plane as Cartesian reasoning implies causality through correlation, not rules. A critical realist social ontology suggests causality from rules and structure. We must seek different forms of confirmation than are typically sought within modern economics if we seek evidence that our theory conforms to reality. By adopting this toolset in parallel to existing tools may also provide further improvement of equilibrium modeling and econometrics.

If we search for the subject of our study by constantly breaking down objects, both material and immaterial, into their constituent parts, where does the search stop? What is the source of the parameters that we estimate? We are measuring chance occurrences and assuming them guided by some force represented by the average. I don’t mean to pick on econometricians here. Their job of providing additional data to the study of history is indispensable! Theory cannot be limited by the domain of econometric testing. The desire of some individuals to engage in a more modern and, sadly, more mundane form of sorcery, is another issue entirely. Fitting a line or curve to past data is not the same thing as extrapolating an estimation. Attempting to predict the future by these methods assumes that underlying parameters are constant. More than likely, parameters don’t govern reality. Parameters measured ex post provide information – though the information provided is not exhaustive – about the processes of the underlying system of interest. As long as individuals using these methods do not undermine theory by arguing that their tool set is a substitute for it, this is not a problem. It is critical to the promotion of good economics that economists remain cognizant of something approaching a pure theory as a source of inspiration for modeling and to ensure that a theory misrepresents as little as possible the content it is used to present.

What we search for is not just the unseen, but the unrecorded. We are missing the information not captured by conventional models. “If you can’t measure it, it doesn’t exist!” But some entities are beyond the ability of humans to model. Our reality is remarkably consistent and can conform, in piecemeal form, to equilibrium theory. The reason for the piecemeal nature of equilibrium theory is that it is not suited to describe complexity. Twentieth and early twenty-first century empirical work has spoken wonders to what the equilibrium analysis was able to produce. However, new methods of data interpretation are available to economists, and economic theorizing must stay ahead of these changes. 

At its core, economic theory points the way to entities not yet easily, if at all, measurable. Theory posits laws that govern the objects that we observe. Modern theory gravitates toward theories whose laws govern human action through statistically observable relationships. Individuals make decisions according to the calculus of optimization. This does not leave much room for actual decision making. Equilibrium theory posits the world as a closed system and assumes that outside of that closed system, no laws exist that govern the order. Hand waving is the far less than perfect backfall to which most economists resort when this constraint becomes a problem. Thus, the dependence on exogenous shocks to initiate change within the economic system is perpetuated through a combination of equilibrium theorizing and narration. This is not a useless approach, just a limited one.

Thankfully, this problem does not hold true for the whole of economic theory. During the 1950s and early 1960s, Hayek developed a robust program into the study of complexity that he observed in society’s institutions. His development of this program also produced a challenge to modern economists. As he argued in “The Pretense of Knowledge”,

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word., since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed [emphasis author]."

At first look this is the classic critique that correlation does not imply causation. Upon further reading, we see that Hayek presents the problem from a novel light.

While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable.

Neoclassical economics, as it has come to be accepted among most modern economists, functions well when the world is “smooth, continuous, and twice differentiable,” to steal a phrase from Richard Wagner. To state it more clearly, causation is assumed to be consistent, continuous, and linear or log-linear. In these models, process comes to be represented – inappropriately as a means for deep theorizing – by parameters. But what use is a parameter if it is constantly fluctuating? While some have brilliantly addressed the problem by using models with fat tails and other more nuanced implements, the underlying process remains masked if we do not take off our econometrician hats. It is a mistaken method. When outcomes are generated by complex process, causation ceases to be identifiable by equilibrium analysis. Simultaneous events are subject to interdependency that prevents causation of the individual pieces of a system from being uniquely represented. Causation must be observed from a systems level. To observe features of the market system that are not currently measurable, we must investigate process in the system through the use of types.

Austrian economists would do well to be aware of, if not adopt to a greater or lesser extent, a critical realist social ontology. Fleetwood references 5 types of deep structures: structures, mechanisms, rules, powers, relations. These concepts have close relation to institutions consistently emphasized by Austrian economists. But they also include something that is not emphasized as greatly. Internal rule sets have not played a prominent role in Austrian economics in the way that it does in social ontology. The application of internal rule sets expands the scope of investigation to include not only formal and informal institutions, but the orientation of expectations through the employment of mental structures shared in common within particular networks. This provides a decent enough of a model for free individuals in the system to form coalescent plans over time.

Now we are ready to consider briefly some deep structures and their relation to Austrian analysis. The most fundamental aspect of society, I believe, are rules. These include both external rules that set bounds on allowable behavior and internal rules that guide decision-making. Informal norms arise through the interaction of rule sets within a population. Economic agents set out each period (I do not mean period in the homogeneous sense but as a period where there is planning followed by action) to accomplish some activity. It may be to buy a good or to do something as mundane as taking a nap. The ability of an agent to accomplish any activity requires that the agents internal and external rule sets allow for the special space necessary in the social system for actors to form expectation and attempt to make that expectation a reality. We see demonstrated that the other terms fall out of the analysis. Structures, mechanisms, powers, and relations all owe their existence to the interaction of rule sets. Fleetwood argues that “Owing to the existence of a set of deep structures in the form of social rules of conduct [emphasis author], a high degree of compatibility of actions and consequences is ensured, where incompatibility appears [emphasis mine] to be the more likely outcome.” Rules tie together deep structures that bring are responsible for order in society.

Norms, a type of informal rule, arise in order to tie together each individual’s internal rule set. Individual rules are allowed to interact. Rules develop that contain the information made available by a tortuous struggle of trial and error. Especially innovative rules that guide internal and external organizations tend to be adopted while failing rules lack the ability to survive absent a strong incentive for distortion. This is not to suggest that we suffer no loss from failing to adopt rule sets that may generally improve welfare. At least in a free society, if the benefits of a form of organization can be recognized by just one entrepreneur, that entrepreneur has the opportunity to also make the new organization a realization. Continuation of a bad rule set typically requires that the rule is not that costly to those practicing it or that the mode of conduct supported by a rule or rules be implemented through force. The latter case is associated with myriad complications that arise by limiting the span of human behavior in a way that prevents the information generated by that behavior from even coming into existence! That is, the more ways human behavior is restricted by force, the less adaptive the system becomes. Having expressed my point, I leave it to the reader to decide to what extent this approach is compatible with economics: Austrian and otherwise. I am certain that CR perspective will be a dominant method for the creation and discovery of the theory of auto-poetic orders.

* This post is originally for an informal reading group.

**I am currently investigating the CR literature, so my own ignorance may be obvious those more knowledgeable. If you find that I have incorrectly represented any concept, please let me know in the comments.

Brittney Wheeler at Thoughts on Liberty Need to be Familiar Scholarly Work by Libertarians

Last week I critiqued Brittney Wheeler in her attack on the Federal Reserve Transparency Act. To sum, I find two problems with her argument. 1) She should be more intimately familiar with both literature supporting Fed independence and literature that is written and read by libertarian academics. She may not realize it, but academic libertarians have a substantial and credible literature to draw from. To grow the school of thought, not any argument will do. 2) She fails to outline exactly what policies should be implemented by the Fed. Transparency or a lack thereof, means little without a plan for policy. I suggested that a better position is to eliminate implement transparency and initiate a rule. The Fed would be relegated to acting as a computer and market actors would be able to form accurate expectations about the availability of future liquidity.

Miss Wheeler responded and displayed that she does not seem to understand that by writing a blog called Thoughts on Liberty, she is representing the libertarian brand. I listed off the sources that she should be familiar with if she wants to represent this brand. Furthermore, I outlined a type of argument that she, as a brand bearer, should be making. I don’t think she picked up my point as she didn’t mention anything that I suggested that she read. Instead, she digs her heels in further.

Finally, I have been criticized for using academic research published by the Fed.  However, the same people who reject the Fed’s research could be said to have an ideological bias, but that doesn’t warrant the dismissal of their research.  I see no reason why both are not equally credible. Unless the critics can demonstrate a particular issue with the methodology used in the research, I will stand by its validity. However, if the research I originally cited isn’t enough to convince you of the pitfalls of allowing more congressional influence over monetary policy, here is another academic paper that explains how greater independence helps minimize political pressures and points to the supporting body of research, such asCukierman [sic] (1992) , Fischer (1995) , and Maloney, Pickering, and Hadri (2003). In fact, when the IGM Panel of Economic experts was surveyed regarding a similar bill, 70% disagreed with the idea that this type of audit  would improve the Fed’s legitimacy without hurting its decision making.

Comments like this make me think that Thoughts on Liberty should just be called, Thoughts. Sourcing her argument is an improvement, but falls short of the mark. Again, if you adopt the libertarian brand, which Miss Wheeler and the other blogger at Thoughts on Liberty have done, you need to do a good job of representing the school of thought. If you disagree, that is okay, but you need to demonstrate that you are familiar with these ideas. Again, I invite the girls at Thoughts on Liberty to take a look at my citations from last post. As libertarians, I’m sure they will find the literature appealing. I hope that any libertarian interested in economics spend time sifting through the sources I use throughout my posts.

A Wacky Attack on the Federal Reserve Transparency Act at Thoughts on Liberty

Over at Thoughts on Liberty, Brittney Wheeler has made some poorly founded claims about Federal Reserve policy and oversight. Usually when I read some bit of foolishness promoted by the ToL crowd regarding liberty, I ignore it because they are arguing about social issues. This recent bit is too much for me sit back and let the authors at ToL continue to spout their ignorance. In this case, Brittney Wheeler needs to spend more time reading about the Federal Reserve, public choice economics, and monetary policy in order to formulate a useful opinion about the Fed. I find the lack of expertise and standards at ToL appalling, given that they are writing for such a broad audience. As usual, the author is bordering on charlatanism in this recent post.

Wheeler has chosen a poor time to defend a lack of transparency at the Fed. Recently, Carmen Segarra exposed officials at the Fed for specially favoring Goldman Sachs. According to USA Today,

In one session on tape, as the examining team was discussing tactics for probing a Goldman deal one of them characterized as "legal but shady," this timidity was on full display.

"I think we don't want to discourage Goldman from disclosing these types of things in the future," said one male participant who remained unidentified in the transcript, "and therefore maybe you know some comment that says don't mistake our inquisitiveness, and our desire to understand more about the marketplace in general, as a criticism of you as a firm necessarily. Like I don't want to, I don't want to hit them on the bat with the head [sic], and they say screw it, we're not gonna disclose it again, we don't need to."

Officials at the Fed were concerned with not offending a bank that they were bailing out. Think about the insanity of this. A large financial firm acts irresponsibly in the market. Not only did the U.S. government socialize the losses, they did not want to offend those responsible for this disaster. Instead of ensuring discipline within the market, they give a poorly behaved firm special treatment! When the Federal Reserve severs the decisions of a firm from the profits and losses that result from those decisions, they destroy market discipline and deal harm to the process by which markets provide information of scarcity and wants to consumers and producers. It is clear that officials are in no position to regulate the financial industry. Wheeler fails to consider this recent fiasco in her post.

Perhaps Miss Wheeler is living under a rock. This would explain why she ignores the recent revelation and argues for maintenance of Fed independence.

Why is the independence of the Federal Reserve important? Why shouldn’t Congress have a hand in monetary policy actions? The Fed was specifically designed to maintain as much independence from the political process as possible… and with good reason! Effective monetary policy must be concerned with long-run goals, not short-term political gain.Although the Fed ultimately does answer to Congress and the people in terms of its mandated goals, there is a difference between being accountable for achieving goals and actually allowing Congress to insert itself into the monetary policy making process.

But what is effective monetary policy? This is where Wheeler finds herself in the mud because she does not understand the topic about which she writes. Her statement also implies that she does not consider, or perhaps, lacks the facility to consider the dynamics and effects of political decision making.

Whether or not the Federal Reserve is independent, policy is decided on a political basis. In one case, firms receive special privileges according to the dictate of Fed officials. In the other case, those in the legislative branch sway policy in favor of interest groups. Of course, reality is a mixture of these cases, probably weighted more toward the first than the second at present. While the second case may be worse than the first – it is difficult to say for sure – robust political economy tells us that the actions of Fed officials today are not appropriately constrained so as to prevent both and provide an outcome better than the one that would likely result in the market. I expect that transparency will be a relatively effective constraint given a robust rules framework.

The appropriate policy decision, then, does not choose only between oversight or no oversight. Oversight is of little help without a robust framework to guide policy. Federal Reserve policy must be guided strictly by a well-defined and well-implemented rule in order to prevent the influence of special interests over monetary policy. Wheeler would be better off arguing that the Fed should be audited, but that any legislation that promotes an audit should also include a provision for a monetary rule. This would neuter the ability of Fed officials to grant special favors to firms and to politicians. And, in line with Hayek’s thesis in The Constitution of Liberty, this type of regime would make the consequences of one’s actions more predictable. As he writes early in the book,

This is possible only by the state’s protecting known private spheres of the individuals against interference by others and delimiting these private spheres, not by specific assignation, but by creating conditions under which the individual can determine his own sphere by relying on rules which tell him what the government will do in different types of situations.

If they want to do the world a favor, the authors at ToL should first read the thoughts of their forbearers and understand the deeper substance of the political debates in which they engage. (Wheeler did at least read one academic paper in building her argument.)  At the core of an argument for limited political intervention is a desire for good rules that constrain the behavior of agents both in the private and public spheres. Those rules require transparency in order to be effective. If independence is sacrificed by transparency as a consequence of the Federal Reserve Transparency Act, the independence lost is the sort of independence that allows Fed officials to treat banks like Goldman Sachs as above reproach. This is a type of independence that is not subject to rules. Instrument independence, the type on which Miss Wheeler focuses her post, can be facilitated by the inclusion of George Selgin's five suggestions to guide the form of Fed operations: “(1) abolish the primary dealer system, (2) limit or abolish repos, (3) abandon “Treasuries only,” (4) revive the Term Auction Facility, and (5) stop last-resort discount window lending (312).”

The text I cite from ToL contains an additional problem. Wheeler fails to defend her claim that independence is necessary and sufficient for the Fed to be effective. She needs to consider whether the Fed was effective at all. Instead, she buys into the typical rationale for a central bank,

The Federal Reserve System was created in 1913 with the goal of providing a more stable and flexible monetary and financial system at a time when banking panics were a common occurrence and caused a lot of economic distress.

Really? According to Selgin, Lastrapes, and White, the Fed has caused more volatility than it has helped prevent. Anyone who reads this blog knows that Fed officials engaged in disastrous policies alongside the insane Bank of France during the Great Depression. Even when we remove these years from the record, Selgin, Lastrapes, and White show that the Fed regime has performed about as well as pre-Fed arrangements. The pre-Roosevelt Fed was had a high degree of independence, but this did not stop the implementation of destructive policies that ushered in the Great Depression. I hope that Miss Wheeler can see how the stated purpose of the Federal Reserve differs from its actual consequences. Let's not be given to the nirvana fallacy. Miss Wheeler would also benefit from reading Timberlake to understand the central bank role of clearinghouse associations before the establishment of the Fed.

Finally, Wheeler fails to show the reader what effective monetary policy looks like. As I have shown in the final section of “Whither Gold?”, good policy is both predictable and makes the monetary base respond to changes in demand for base money. As long as we the Fed exists, its actions should be limited to facilitating changes in demand for base money and thus provide a nominal anchor much like the gold standard provided. For this rule to be executed successfully requires increased transparency at the Fed. In other words, we cannot be sure monetary policy is effective unless we know the rationale behind the implementation of those policies. In the case of a nominal income level target, the rationale comes from Say’s identity and the equation of exchange. If implemented as a policy rule within the framework of the Federal Reserve Transperency Act environment, there is a much greater probability that the rule will be implemented properly.

Summing up, implementation of a good rule is not possible without transparency - the type which the Federal Reserve Transparency Act promotes. Given the special treatment of Goldman Sachs in the recent crisis, it is critical that we implement both a good policy rule and framework for transparency. These cannot be treated separately. Wheeler should not be arguing that the Federal Reserve Transparency Act is going to hurt the efficacy of monetary policy. She should argue that transparency must include a rule so that market actors can form more accurate expectations.

Two Roads?: Endogeneity of Credit, Expectations, and Fed Activism

Like gold, credit is subject to laws of supply and demand. Since it doubles as money, its quantity can adjust to alleviate an excess demand for money assuming that expansion is not limited by elevated credit risk. We can expect credit markets to conform more closely to the classical model if policy uncertainty is reduced (Koppl 2002, 184-194).[1] A consistent rule like nominal income targeting would help limit some of this risk by stabilizing expectations about monetary policy. Not only does the base money supply become responsive to demand under a nominal income target regime; credit markets become more flexible too. In what follows, I will outline the operation of credit markets as would occur absent outside interference. I will also analyze the effects of central bank activism and of regulation of credit on the responsiveness of credit markets to demand for money.

The relationship of credit and an endogenous money stock has long been recognized (Thornton 1939; Wicksell 1936; Hawtrey 1919). The response of credit to an increased demand for money is not only an empirical observation. As Glasner aptly points out, “nominal balances [of banks] fluctuated with ‘the needs of trade.’ . . . The law of reflux, in fact, is equivalent to Say’s Identity (1985, 47).” Much like the response of the gold production to an increase in the price of gold, an increased demand for money is concomitant with a rise in demand for money-like substitutes. Financial intermediaries respond to this demand by lowering reserve ratios and expanding their balance sheets (Leijonhufvud 1979; Gorton and Pennacchi 1990; Selgin and White 1994; White 1999).

For clarification, we can imagine a scenario where credit creation helps overcome a shortfall in aggregate demand. Consider an economy that is at the bottom of an economic depression. Prices are still falling, but production and employment have finally begun to increase. Sensing a rise in optimism, entrepreneurs begin to attract investment into new projects.[2] During the depression, banks had to increase their reserve levels in order to maintain solvency. Now that the outlook has improved, banks that survived the spike in defaults begin to increase net investment. They provide the money necessary for entrepreneurs to employ inputs left idle by the depression. Once economic volatility subsides enough to allow the expectations of investors and entrepreneurs to converge to a great enough extent, the former will extend credit to the latter. As realistic plans for a new ordering of resources emerge, output begins to increase and relieve the shortfall in demand.

In recent years, the Federal Reserve, under the chairmanship of Ben Bernanke, has failed to lead the economy into a robust recovery. Instead, the Bernanke Fed has taken on unprecedented roles as a financial regulator and credit allocator (Hummel 2012). Furthermore, the payment of interest on excess reserves has served to incentivize the persistence of low market rates of interest. Increased uncertainty is evidenced increased demand for liquidity as near zero returns on U.S. treasury bills and an elevated spread between these and treasury bonds reflect (U.S. Treasury). Due in part to policy uncertainty and in part to perverse incentives from risk free returns, creditors are more risk averse than usual. Since the start of the crisis in 2008, there has been drop in both the level and rate of growth of bank credit at all commercial banks (see FRED). This is true even as the recession ended 5 years ago. Given an increase in Fed activism under Bernanke, banks were better off lending only to the highest quality borrowers, investing in treasury bills, or leaving excess reserves on account at the Federal Reserve to collect interest.[3]

This pattern of policy activism has increased uncertainty.[4] Every time the officials at the Federal Reserve adopt an unexpected policy, market actors must recoordinate their actions to match these new circumstances. If these actors begin to expect numerous changes in policy within a certain time period but are unsure of what those policies will be, they will limit risky activity and the length of investment. In the case of banks, intermediaries will refuse to offer loans to borrowers to whom they would otherwise lend. As banking activity slows due to uncertainty, credit markets are less able to relieve an excess demand for money. Anemic economic growth results.

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[1] Roger Koppl argues, “Fed activism did induce instability in money demand. The Fed should not abandon money supply targets, but should pursue them according to a fixed rule.”

[2] This story is consistent with the “stylized facts” of the business cycle. SeeSnowden and Vane (2005).

[3] During the crisis, inflation hedging waned as liquidity preference increased (Gurnayaka, Sack, and Wright 2010, 89).

[4] Ironically, Bernanke cited the importance of a “clear and credible commitments about future policy actions [author’s emphasis].” Cited in Espinosa (2012).

Brief Thoughts on the Gold Standard as a Rule-Based Regime

I'm making what I hope are some final changes to "Wither Gold", a paper where I integrate gold flows and monetary policy decision rules into Austrian analysis. It has struck me that the gold standard is actually just a complex rule-based regime. These rules were not altogether unambiguous.

Identifying Federal Reserve policy as a violation of the “rules of the game” reveals a weakness of the gold standard. Not only was there no mechanism of enforcement for these “rules”. The “rules of the game” were an implicit agreement between authorities of different national central banks. The precise rules governing central bank management of the gold standard were not always clear. When the Federal Reserve System contracted the monetary base under the leadership of New York Federal Reserve governor Benjamin Strong in 1920, domestic prudence demanded that the Federal Reserve raise interest rates and reserve levels. At one point, Strong defended the systems role in maintaining stability.[1] Strong may have felt justified by the ends of this policy, but the means was dangerous. 

The Federal Reserve tended to follow the “Real Bills Doctrine” at the time, but its implementation was imperfect (Timberlake 2007). Again in 1927, a political battle between Strong and Miller as Strong wanted to help stabilize the European monetary situation and Miller was concerned about an expectant increase in speculation due to inflation (Wueschner 1999, 136-38). At times, Miller even waivered concerning his own policy (Wueschner 1999, 149). Collective decision-making over the monetary base, absent an explicit rule, yields most often a compromised outcome.[2] Absent a clear rule to guide policy, it is hard to imagine the implosion of the gold standard as anything but inevitable. It is also hard to imagine that investors and entrepreneurs felt confident about expectations regarding policy.

The next draft should be up soon.

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[1] Benjamin Strong wrote to Montagu Norman at the Bank of England that without the Federal Reserve “bankers would now be insisting that borrower pay their loans, and, were this to force sacrifice sales of inventories at present quoted prices, we would have a long list of insolvencies, closing mills, unemployment etc.” quoted in Wueschner (1999, 18n89)

[2] Wueschner draws attention to this in reviewing the Federal Reserve’s deflationary policy in 1920:

The outcome, Strong later wrote to Norman, was not at all what he would have recommended, “nor indeed, confidentially, did [it] meet the advice of my associates in the Bank.” It amounted to a “compromise between differing views of our own with differing views in the Federal Reserve Board and finally, radically diferent views held by the officers of the Treasury.”