Archive for the 'Hayek' Category

Price Stickiness and Macroeconomics

Noah Smith has a classically snide rejoinder to Stephen Williamson’s outrage at Noah’s Bloomberg paean to price stickiness and to the classic Ball and Maniw article on the subject, an article that provoked an embarrassingly outraged response from Robert Lucas when published over 20 years ago. I don’t know if Lucas ever got over it, but evidently Williamson hasn’t.

Now to be fair, Lucas’s outrage, though misplaced, was understandable, at least if one understands that Lucas was so offended by the ironic tone in which Ball and Mankiw cast themselves as defenders of traditional macroeconomics – including both Keynesians and Monetarists – against the onslaught of “heretics” like Lucas, Sargent, Kydland and Prescott that he just stopped reading after the first few pages and then, in a fit of righteous indignation, wrote a diatribe attacking Ball and Mankiw as religious fanatics trying to halt the progress of science as if that was the real message of the paper – not, to say the least, a very sophisticated reading of what Ball and Mankiw wrote.

While I am not hostile to the idea of price stickiness — one of the most popular posts I have written being an attempt to provide a rationale for the stylized (though controversial) fact that wages are stickier than other input, and most output, prices — it does seem to me that there is something ad hoc and superficial about the idea of price stickiness and about many explanations, including those offered by Ball and Mankiw, for price stickiness. I think that the negative reactions that price stickiness elicits from a lot of economists — and not only from Lucas and Williamson — reflect a feeling that price stickiness is not well grounded in any economic theory.

Let me offer a slightly different criticism of price stickiness as a feature of macroeconomic models, which is simply that although price stickiness is a sufficient condition for inefficient macroeconomic fluctuations, it is not a necessary condition. It is entirely possible that even with highly flexible prices, there would still be inefficient macroeconomic fluctuations. And the reason why price flexibility, by itself, is no guarantee against macroeconomic contractions is that macroeconomic contractions are caused by disequilibrium prices, and disequilibrium prices can prevail regardless of how flexible prices are.

The usual argument is that if prices are free to adjust in response to market forces, they will adjust to balance supply and demand, and an equilibrium will be restored by the automatic adjustment of prices. That is what students are taught in Econ 1. And it is an important lesson, but it is also a “partial” lesson. It is partial, because it applies to a single market that is out of equilibrium. The implicit assumption in that exercise is that nothing else is changing, which means that all other markets — well, not quite all other markets, but I will ignore that nuance – are in equilibrium. That’s what I mean when I say (as I have done before) that just as macroeconomics needs microfoundations, microeconomics needs macrofoundations.

Now it’s pretty easy to show that in a single market with an upward-sloping supply curve and a downward-sloping demand curve, that a price-adjustment rule that raises price when there’s an excess demand and reduces price when there’s an excess supply will lead to an equilibrium market price. But that simple price-adjustment rule is hard to generalize when many markets — not just one — are in disequilibrium, because reducing disequilibrium in one market may actually exacerbate disequilibrium, or create a disequilibrium that wasn’t there before, in another market. Thus, even if there is an equilibrium price vector out there, which, if it were announced to all economic agents, would sustain a general equilibrium in all markets, there is no guarantee that following the standard price-adjustment rule of raising price in markets with an excess demand and reducing price in markets with an excess supply will ultimately lead to the equilibrium price vector. Even more disturbing, the standard price-adjustment rule may not, even under a tatonnement process in which no trading is allowed at disequilibrium prices, lead to the discovery of the equilibrium price vector. Of course, in the real world trading occurs routinely at disequilibrium prices, so that the “mechanical” forces tending an economy toward equilibrium are even weaker than the standard analysis of price-adjustment would suggest.

This doesn’t mean that an economy out of equilibrium has no stabilizing tendencies; it does mean that those stabilizing tendencies are not very well understood, and we have almost no formal theory with which to describe how such an adjustment process leading from disequilibrium to equilibrium actually works. We just assume that such a process exists. Franklin Fisher made this point 30 years ago in an important, but insufficiently appreciated, volume Disequilibrium Foundations of Equilibrium Economics. But the idea goes back even further: to Hayek’s important work on intertemporal equilibrium, especially his classic paper “Economics and Knowledge,” formalized by Hicks in the temporary-equilibrium model described in Value and Capital.

The key point made by Hayek in this context is that there can be an intertemporal equilibrium if and only if all agents formulate their individual plans on the basis of the same expectations of future prices. If their expectations for future prices are not the same, then any plans based on incorrect price expectations will have to be revised, or abandoned altogether, as price expectations are disappointed over time. For price adjustment to lead an economy back to equilibrium, the price adjustment must converge on an equilibrium price vector and on correct price expectations. But, as Hayek understood in 1937, and as Fisher explained in a dense treatise 30 years ago, we have no economic theory that explains how such a price vector, even if it exists, is arrived at, and even under a tannonement process, much less under decentralized price setting. Pinning the blame on this vague thing called price stickiness doesn’t address the deeper underlying theoretical issue.

Of course for Lucas et al. to scoff at price stickiness on these grounds is a bit rich, because Lucas and his followers seem entirely comfortable with assuming that the equilibrium price vector is rationally expected. Indeed, rational expectation of the equilibrium price vector is held up by Lucas as precisely the microfoundation that transformed the unruly field of macroeconomics into a real science.

The Verbally Challenged John Taylor Strikes Again

John Taylor, tireless self-promoter of “rules-based monetary policy” (whatever that means), inventor of the legendary Taylor Rule, and very likely the next Chairman of the Federal Reserve Board if a Republican is elected President of the United States in 2016, has a history of verbal faux pas, which I have been documenting not very conscientiously for almost three years now.

Just to review my list (for which I make no claim of exhaustiveness), Professor Taylor was awarded the Hayek Prize of the Manhattan Institute in 2012 for his book First Principles: Five Keys to Restoring America’s Prosperity. The winner of the prize (a cash award of $50,000) also delivers a public Hayek Lecture in New York City to a distinguished audience consisting of wealthy and powerful and well-connected New Yorkers, drawn from the city’s financial, business, political, journalistic, and academic elites. The day before delivering his public lecture, Professor Taylor published a teaser as an op-ed in that paragon of journalistic excellence the Wall Street Journal editorial page. (This is what I had to say when it was published.)

In his teaser, Professor Taylor invoked Hayek’s Road to Serfdom and his Constitution of Liberty to explain the importance of the rule of law and its relationship to personal freedom. Certainly Hayek had a great deal to say and a lot of wisdom to impart on the subjects of the rule of law and personal freedom, but Professor Taylor, though the winner of the Hayek Prize, was obviously not interested enough to read Hayek’s chapter on monetary policy in The Constitution of Liberty; if he had he could not possibly have made the following assertions.

Stripped of all technicalities, this means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge. . . .

Rules for monetary policy do not mean that the central bank does not change the instruments of policy (interest rates or the money supply) in response to events, or provide loans in the case of a bank run. Rather they mean that they take such actions in a predictable manner.

But guess what. Hayek took a view rather different from Taylor’s in The Constitution of Liberty:

[T]he case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals. The argument against discretion in monetary policy rests on the view that monetary policy and its effects should be as predictable as possible. The validity of the argument depends, therefore, on whether we can devise an automatic mechanism which will make the effective supply of money change in a more predictable and less disturbing manner than will any discretionary measures likely to be adopted. The answer is not certain.

Now that was bad enough – quoting Hayek as an authority for a position that Hayek explicitly declined to take in the very source invoked by Professor Taylor. But that was just Professor Taylor’s teaser. Perhaps it got a bit garbled in the teasing process. So I went to the Manhattan Institute website and watched the video of the entire Hayek Lecture delivered by Professor Taylor. But things got even worse in the lecture – much worse. I mean disastrously worse. (This is what I had to say after watching the video.)

Taylor, while of course praising Hayek at length, simply displayed an appalling ignorance of Hayek’s writings and an inability to comprehend, or a carelessness so egregious that he was unable to properly read, the title — yes, the title! — of a pamphlet written by Hayek in the 1970s, when inflation was reaching the double digits in the US and much of Europe. The pamphlet, entitled Full Employment at any Price?, was an argument that the pursuit of full employment as an absolute goal, with no concern for price stability, would inevitably lead to accelerating inflation. The title was chosen to convey the idea that the pursuit of full employment was not without costs and that a temporary gain in employment at the cost of higher inflation might well not be worth it. Professor Taylor, however, could not even read the title correctly, construing the title as prescriptive, and — astonishingly — presuming that Hayek was advocating the exact policy that the pamphlet was written to confute.

Perhaps Professor Taylor was led to this mind-boggling misinterpretation by a letter from Milton Friedman, cited by Taylor, complaining about Hayek’s criticism in the pamphlet in question of Friedman’s dumb 3-perceent rule, to which criticism Friedman responded in his letter to Hayek. But Professor Taylor, unable to understand what Hayek and Friedman were arguing about, bewilderingly assumed that Friedman was criticizing Hayek’s advocacy of increasing the rate of inflation to whatever level was needed to ensure full employment, culminating in this ridiculous piece of misplaced condescension.

Well, once again, Milton Friedman, his compatriot in his cause — and it’s good to have compatriots by the way, very good to have friends in his cause. He wrote in another letter to Hayek – Hoover Archives – “I hate to see you come out, as you do here, for what I believe to be one of the most fundamental violations of the rule of law that we have, namely, discretionary activities of central bankers.”

So, hopefully, that was enough to get everybody back on track. Actually, this episode – I certainly, obviously, don’t mean to suggest, as some people might, that Hayek changed his message, which, of course, he was consistent on everywhere else.

And all of this wisdom was delivered by Professor Taylor in his Hayek Lecture upon being awarded the Hayek Prize. Well done, Professor Taylor, well done.

Then last July, in another Wall Street Journal op-ed, Professor Taylor replied to Alan Blinder’s criticism of a bill introduced by House Republicans to require the Fed to use the Taylor Rule as its method for determining what its target would be for the Federal Funds rate. The title of the op-ed was “John Taylor’s reply to Alan Blinder,” and the subtitle was “The Fed’s ad hoc departures from rule-based monetary policy has [sic!] hurt the economy.” When I pointed out the grammatical error, and wondered whether the mistake was attributable to Professor Taylor or stellar editorial writers employed by the Wall Street Journal editorial page, David Henderson, a frequent contributor to the Journal, wrote a comment to assure me that it was certainly not Professor Taylor’s mistake. I took Henderson’s word for it. (Just for the record, the mistake is still there, you can look it up.)

But now there’s this. In today’s New York Times, there is an article about how, in an earlier era, criticism of the Fed came mainly from Democrats complaining about money being too tight and interests rates too high, while now criticism comes mainly from Republicans complaining that money is too easy and interest rates too low. At the end of the article we find this statement from Professor Taylor:

Practical experience and empirical studies show that checklist-free medical care is wrought with dangers just as rules-free monetary policy is,” Mr. Taylor wrote in a recent defense of his proposal.

There he goes again. Here are five definitions of “wrought” from the online Merriam-Webster dictionary:

1:  worked into shape by artistry or effort <carefully wrought essays>

2:  elaborately embellished :  ornamented

3:  processed for use :  manufactured <wrought silk>

4:  beaten into shape by tools :  hammered —used of metals

5:  deeply stirred :  excited —often used with up <gets easily wrought up over nothing>

Obviously, what Professor Taylor meant to say is that medical care is “fraught” (rhymes with “wrought”) with dangers, but some people just can’t be bothered with pesky little details like that, any more than winners of the Hayek Prize can be bothered with actually reading the works of Hayek to which they refer in their Hayek Lecture. Let’s just hope that if Professor Taylor’s ambition to become Fed Chairman is realized, he’ll be a little bit more attentive to, say, the position of decimal points than he is to the placement of question marks and to the difference in meaning between words that sound almost alike.

PS I see that the Manhattan Institute has chosen James Grant as the winner of the 2015 Hayek Prize for his book America’s Forgotten Depression. I’m sure that 2015 Hayek Lecture will be far more finely wrought grammatically and stylistically than the 2012 Hayek Lecture, but, judging from book for which the prize was awarded, I am not overly optimistic that it will make a great deal more sense than the 2012 Hayek Lecture, but that is not a very high bar to clear.

Did David Hume Discover the Vertical Phillips Curve?

In my previous post about Nick Rowe and Milton Friedman, I pointed out to Nick Rowe that Friedman (and Phelps) did not discover the argument that the long-run Phillips Curve, defined so that every rate of inflation is correctly expected, is vertical. The argument I suggested can be traced back at least to Hume. My claim on Hume’s behalf was based on my vague recollection that Hume distinguished between the effect of a high price level and a rising price level, a high price level having no effect on output and employment, while a rising price level increases output and employment.

Scott Sumner offered the following comment, leaving it as an exercise for the reader to figure out what he meant by “didn’t quite get there.”:

As you know Friedman is one of the few areas where we disagree. Here I’ll just address one point, the expectations augmented Phillips Curve. Although I love Hume, he didn’t quite get there, although he did discuss the simple Phillips Curve.

I wrote the following response to Scott referring to the quote that I was thinking of without quoting it verbatim (because I couldn’t remember where to find it):

There is a wonderful quote by Hume about how low prices or high prices are irrelevant to total output, profits and employment, but that unexpected increases in prices are a stimulus to profits, output, and employment. I’ll look for it, and post it.

Nick Rowe then obligingly provided the quotation I was thinking of (but not all of it):

Here, to my mind, is the “money quote” (pun not originally intended) from David Hume’s “Of Money”:

“From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches.”

The first sentence is fine. But the second sentence is very clearly a problem.

Was it Friedman who said “we have only advanced one derivative since Hume”?

OK, so let’s see the whole relevant quotation from Hume’s essay “Of Money.”

Accordingly we find, that, in every kingdom, into which money begins to flow in greater abundance than formerly, everything takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skilful, and even the farmer follows his plough with greater alacrity and attention. This is not easily to be accounted for, if we consider only the influence which a greater abundance of coin has in the kingdom itself, by heightening the price of Commodities, and obliging everyone to pay a greater number of these little yellow or white pieces for everything he purchases. And as to foreign trade, it appears, that great plenty of money is rather disadvantageous, by raising the price of every kind of labour.

To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry. When any quantity of money is imported into a nation, it is not at first dispersed into many hands; but is confined to the coffers of a few persons, who immediately seek to employ it to advantage. Here are a set of manufacturers or merchants, we shall suppose, who have received returns of gold and silver for goods which they sent to CADIZ. They are thereby enabled to employ more workmen than formerly, who never dream of demanding higher wages, but are glad of employment from such good paymasters. If workmen become scarce, the manufacturer gives higher wages, but at first requires an encrease of labour; and this is willingly submitted to by the artisan, who can now eat and drink better, to compensate his additional toil and fatigue.

He carries his money to market, where he, finds everything at the same price as formerly, but returns with greater quantity and of better kinds, for the use of his family. The farmer and gardener, finding, that all their commodities are taken off, apply themselves with alacrity to the raising more; and at the same time can afford to take better and more cloths from their tradesmen, whose price is the same as formerly, and their industry only whetted by so much new gain. It is easy to trace the money in its progress through the whole commonwealth; where we shall find, that it must first quicken the diligence of every individual, before it encrease the price of labour. And that the specie may encrease to a considerable pitch, before it have this latter effect, appears, amongst other instances, from the frequent operations of the FRENCH king on the money; where it was always found, that the augmenting of the numerary value did not produce a proportional rise of the prices, at least for some time. In the last year of LOUIS XIV, money was raised three-sevenths, but prices augmented only one. Corn in FRANCE is now sold at the same price, or for the same number of livres, it was in 1683; though silver was then at 30 livres the mark, and is now at 50. Not to mention the great addition of gold and silver, which may have come into that kingdom since the former period.

From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. This will be easily accounted for, if we consider, that the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are encreasing. The workman has not the same employment from the manufacturer and merchant; though he pays the same price for everything in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen.

So Hume understands that once-and-for-all increases in the stock of money and in the price level are neutral, and also that in the transition from one price level to another, there will be a transitory effect on output and employment. However, when he says that the good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means, he keeps alive a spirit of industry in the nation, he seems to be suggesting that the long-run Phillips Curve is actually positively sloped, thus confirming Milton Friedman (and Nick Rowe and Scott Sumner) in saying that Hume was off by one derivative.

While I think that is a fair reading of Hume, it is not the only one, because Hume really was thinking in terms of price levels, not rates of inflation. The idea that a good magistrate would keep the stock of money increasing could not have meant that the rate of inflation would indefinitely continue at a particular rate, only that the temporary increase in the price level would be extended a while longer. So I don’t think that Hume would ever have imagined that there could be a steady predicted rate of inflation lasting for an indefinite period of time. If he could have imagined a steady rate of inflation, I think he would have understood the simple argument that, once expected, the steady rate of inflation would not permanently increase output and employment.

At any rate, even if Hume did not explicitly anticipate Friedman’s argument for a vertical long-run Phillips Curve, certainly there many economists before Friedman who did. I will quote just one example from a source (Hayek’s Constitution of Liberty) that predates Friedman by about eight years. There is every reason to think that Friedman was familiar with the source, Hayek having been Friedman’s colleague at the University of Chicago between 1950 and 1962. The following excerpt is from p. 331 of the 1960 edition.

Inflation at first merely produces conditions in which more people make profits and in which profits are generally larger than usual. Almost everything succeeds, there are hardly any failures. The fact that profits again and again prove to be greater than had been expected and that an unusual number of ventures turn out to be successful produces a general atmosphere favorable to risk-taking. Even those who would have been driven out of business without the windfalls caused by the unexpected general rise in prices are able to hold on and to keep their employees in the expectation that they will soon share in the general prosperity. This situation will last, however, only until people begin to expect prices to continue to rise at the same rate. Once they begin to count on prices being so many per cent higher in so many months’ time, they will bid up the prices of the factors of production which determine the costs to a level corresponding to the future prices they expect. If prices then rise no more than had been expected, profits will return to normal, and the proportion of those making a profit also will fall; and since, during the period of exceptionally large profits, many have held on who would otherwise have been forced to change the direction of their efforts, a higher proportion than usual will suffer losses.

The stimulating effect of inflation will thus operate only so long as it has not been foreseen; as soon as it comes to be foreseen, only its continuation at an increased rate will maintain the same degree of prosperity. If in such a situation price rose less than expected, the effect would be the same as that of unforeseen deflation. Even if they rose only as much as was generally expected, this would no longer provide the expectational stimulus but would lay bare the whole backlog of adjustments that had been postponed while the temporary stimulus lasted. In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected.

This was certainly not the first time that Hayek made the same argument. See his Studies in Philosophy Politics and Economics, p. 295-96 for a 1958 version of the argument. Is there any part of Friedman’s argument in his 1968 essay (“The Role of Monetary Policy“) not contained in the quote from Hayek? Nor is there anything to indicate that Hayek thought he was making an argument that was not already familiar. The logic is so obvious that it is actually pointless to look for someone who “discovered” it. If Friedman somehow gets credit for making the discovery, it is simply because he was the one who made the argument at just the moment when the rest of the profession happened to be paying attention.

Hayek, Free Banking and Tax Payments

Among the many interesting comments on my previous post about free banking was one by Philippe which provoked an extended (and perhaps still ongoing) exchange between Philippe and George Selgin. Referring to this assertion of mine,

if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies

Philippe made the following comment:

In “The Denationalization of Money” Hayek argued that you should be able to pay taxes with privately-issued currencies. However, this would in effect turn those ‘private currencies into’ de facto state currencies, or forms of government ‘fiat money’. For some reason Hayek chose to ignore this massive contradiction in his argument. Essentially, what he was actually arguing was that private corporations should be granted special state powers, i.e. the power to issue money backed by the state’s legal powers of taxation.

I thought that this was a very insightful observation by Philippe, though its significance for me may be somewhat different from its significance for Philippe. In my criticisms of Hayek’s free-banking position – I call it a free-banking position even though free banking may be a misnomer inasmuch as Hayek advocated banks’ creating new currency units not just allowing banks freedom to create a complete menu of liabilities denominated in existing currency units – my argument was that newly created currency units would be worthless unless the banks made them convertible into some outside asset not under their control. Or in Nick Rowe’s helpful terminology, Hayek advocated free-alpha-banking, while conventional free bankers advocate free-beta-banking. The reasoning behind my argument is that the value of a pure medium of exchange depends entirely on its expected value in exchange, so if a currency unit is not defined in terms of a commodity providing a real, valuable, service apart from being used as money, people will eventually realize that its value must go to zero. Any positive value that it may temporarily have is just a bubble, and, like every bubble, it will burst.

However, unlike the private issuer of a currency unit, a sovereign issuer can impart a real value to a fiat currency by making the currency acceptable for discharging tax liabilities, creating a real demand for the currency distinct from its use as a medium of exchange. Using this argument, I have suggested that bitcoins are a bubble, though it is possible that are some techie reasons that I don’t understand why bitcoins could provide real services that would allow them retain a positive value. At any rate, the point made by Philippe — that if governments were to accept newly created private currency units in payment of taxes – they could retain their value just as fiat currencies issued by governments do – is a point that had escaped me in my criticisms of Hayek. So, well done, Philippe.

However, Philippe seems to carry this valid point a bit too far, accusing Hayek of a massive contradiction in arguing that private corporations be granted special state powers. The problem with that argument is that it begs the question what is special about money that confers the sole power to issue money to the state. I actually once wrote a paper trying to answer that question (once again relying on an argument that I heard from Earl Thompson) published in a volume called Money and the Nation State. I summarized the argument in chapter 2 of Free Banking and Monetary Reform.

The short answer is that currency debasement may be necessary as a means of emergency taxation when a sovereign is faced with a hostile military force threatening its survival. To profitably debase a currency, you have to be the monopoly supplier. Ergo, sovereigns that monopolize the mint or the supply of currency have a better chance of surviving than sovereigns that don’t. Hayek was a staunch anti-communist, cold warrior, so the defense argument, at least on some level, would have appealed to him. But otherwise, it’s not clear to me why Hayek could not have said that, apart from certain national-defense functions, there really are no government services that may not be provided by private enterprise. After all, we do allow various services that were once exclusively provided by the government to be provided by private enterprise. I don’t say that this is always a good thing, but it doesn’t seem to me inherently unreasonable to believe that the burden of proof is on the one claiming that the state has an exclusive right to discharge a particular service, not on the one who questions that such an exclusive right exists.

Having said that, I will also say that it also seems perfectly reasonable for a government to say that a tax obligation that it legitimately imposes – I freely admit that I am now begging the question where this legitimate power comes from, but only libertarian fanatics dispute that power – can only be discharged in terms of a currency unit that the government itself specifies. And implicitly or explicitly, George Selgin and other free bankers — i.e., free-beta-bankers — seem to be perfectly OK with the government specifying the currency unit in terms of which tax obligations may be discharged. In other words, the government may impose a tax obligation on me that is specified in dollar terms. To discharge it, I have no choice but to pay the government the requisite number of dollars, either delivering the government’s own currency or delivering a private (beta-bank) money denominated in dollar terms.

The peculiarity in Hayek’s argument is that he was proposing that governments impose a tax liability in, say, dollar terms, and then accept payment in some other currency unit without specifying any method by which an obligation specified in dollars would be discharged in terms of another currency unit. Any creditor is free to specify at the time an obligation is created the terms on which the debt will be discharged (subject of course to legal tender laws, but for purposes of this discussion I am ignoring legal tender laws which are not the same as tax acceptance). The government is not just any creditor, but there doesn’t seem to me to be any compelling reason why a government should not be entitled to say we have created this obligation in terms of dollars and it must be discharged in terms of dollars. And, if I am right in asserting that acceptability in payment of taxes is a necessary condition for an inconvertible fiat money to retain value, there does seem to be something funny about Hayek’s argument for the creation of private fiat moneys, even if it is not a flat-out contradiction as Philippe claims.

What is funny is the degree to which the viability of a Hayekian private fiat currency is dependent on its being accepted by the state as payment for taxes. Moreover, Hayek’s argument was that there would be a discovery process in which many competing currencies would vie for acceptance with the market eventually choosing one or a few currency units as somehow being the most desirable. Hayek thought that the currency unit with the most stable value would eventually capture the largest market share. There are lots of problems with the argument, especially that it ignores the network effects that tend to produce an entrenched monopoly, and the extreme path dependence of such outcomes, but on a practical level, it seems almost unimaginable that a government would, or could, allow any number of distinct competing currency units to be simultaneously acceptable in payment of taxes.

I do not mean to be overly critical of Hayek, for whom I always have had the greatest admiration, but he had an unfortunate tendency to get carried away with certain utopian ideas and proposals, for example his idea of separating the law-making power from the governing function of parliaments into two distinct bodies, going so far as to propose a method for selecting members of the law-making body under which people at the age of 35 would each year elect a number of their contemporaries to serve a 15-year term in the law-making body, the law-making body being composed entirely of people between the ages of 35 and 50. He presents the idea in volume 3 of Law, Legislation and Liberty, a wonderful book of great philosophical depth and erudition. But it is amazing that Hayek felt that such an idea could ever be implemented. I don’t like to think so, but it occurs to me that his toleration for certain dictators might have had something to do with his imagining that they could be persuaded to implement his ideas for political and constitutional reform. His Denationalization of Money was a similar flight of fancy, based on some profound insights, but used as the basis for practical proposals that were fantastically unrealistic.

 

Ludwig von Mises Explains (and Solves) Market Failure

Last week Major Freedom, a relentless and indefatigable web-Austrian troll – and with a name like that, I predict a bright future for him as a professional wrestler should he ever tire of internet trolling — who regularly occupies Scott Sumner’s blog, responded to a passing reference by Scott to F. A. Hayek’s support for NGDP targeting with an outraged rant against Hayek, calling Hayek a social democrat, a description of Hayek that for some reason brought to my mind Saul Steinberg’s famous New Yorker cover showing what the world looks like from 9th Avenue in Manhattan.

saul_steinberg_newyorker

Hayek was not a libertarian by the way. He was a social democrat. If you read his works closely, you’ll realize he was politically leftist very soon after his earlier economics works. Hayek was actually an economist for only a short period of time. He soon became disenchanted with free market economics, and delved into sociology where his works were all heavily influenced by leftist politics. He was an ardent critic of government, but not because he was anti-government, but because the present day governments were not his ideal.

Hayek favored central banks preventing NGDP from falling yes, but he was a contradictory writer. It is dishonest to only focus on the one side of the contradiction that supports your own ideology. If you were honest, you would make it a point that Hayek also favored monetary denationalization, of competitive free market currencies. He wrote a book on that for crying out loud. His contradictions are “Hayekian.” NGDP targeting is merely the Dr. Jekyll to his Mr. Hyde.

Then responding to the incredulity of another commenter at his calling Hayek a social democrat, the Major let loose this barrage:

From [Hans-Hermann] Hoppe:

According to Hayek, government is “necessary” to fulfill the following tasks: not merely for “law enforcement” and “defense against external enemies” but “in an advanced society government ought to use its power of raising funds by taxation to provide a number of services which for various reasons cannot be provided, or cannot be provided adequately, by the market.” (Because at all times an infinite number of goods and services exist that the market does not provide, Hayek hands government a blank check.)

Among these goods and services are:

“…protection against violence, epidemics, or such natural forces as floods and avalanches, but also many of the amenities which make life in modern cities tolerable, most roads … the provision of standards of measure, and of many kinds of information ranging from land registers, maps and statistics to the certification of the quality of some goods or services offered in the market.”

Additional government functions include “the assurance of a certain minimum income for everyone”; government should “distribute its expenditure over time in such a manner that it will step in when private investment flags”; it should finance schools and research as well as enforce “building regulations, pure food laws, the certification of certain professions, the restrictions on the sale of certain dangerous goods (such as arms, explosives, poisons and drugs), as well as some safety and health regulations for the processes of production; and the provision of such public institutions as theaters, sports grounds, etc.”; and it should make use of the power of “eminent domain” to enhance the “public good.”

Moreover, it generally holds that “there is some reason to believe that with the increase in general wealth and of the density of population, the share of all needs that can be satisfied only by collective action will continue to grow.”

Further, government should implement an extensive system of compulsory insurance (“coercion intended to forestall greater coercion”), public, subsidized housing is a possible government task, and likewise “city planning” and “zoning” are considered appropriate government functions — provided that “the sum of the gains exceed the sum of the losses.” And lastly, “the provision of amenities of or opportunities for recreation, or the preservation of natural beauty or of historical sites or scientific interest … Natural parks, nature-reservations, etc.” are legitimate government tasks.

In addition, Hayek insists we recognize that it is irrelevant how big government is or if and how fast it grows. What alone is important is that government actions fulfill certain formal requirements. “It is the character rather than the volume of government activity that is important.” Taxes as such and the absolute height of taxation are not a problem for Hayek. Taxes — and likewise compulsory military service — lose their character as coercive measures,

“…if they are at least predictable and are enforced irrespective of how the individual would otherwise employ his energies; this deprives them largely of the evil nature of coercion. If the known necessity of paying a certain amount of taxes becomes the basis of all my plans, if a period of military service is a foreseeable part of my career, then I can follow a general plan of life of my own making and am as independent of the will of another person as men have learned to be in society.”

But please, it must be a proportional tax and general military service!

The disgust felt by the Major for the crypto-statist Hayek is palpable, reminiscent of Ayn Rand’s pathological abhorrence of Hayek for tolerating welfare-statism. Ah, but Ludwig von Mises, there is a man after the Major’s very own heart.

In distinct contrast, how refreshingly clear — and very different — is Mises! For him, the definition of liberalism can be condensed into a single term: private property. The state, for Mises, is legalized force, and its only function is to defend life and property by beating antisocial elements into submission. As for the rest, government is “the employment of armed men, of policemen, gendarmes, soldiers, prison guards, and hangmen. The essential feature of government is the enforcement of its decrees by beating, killing, and imprisonment. Those who are asking for more government interference are asking ultimately for more compulsion and less freedom.”

Moreover (and this is for those who have not read much of Mises but invariably pipe up, “but even Mises is not an anarchist”), certainly the younger Mises allows for unlimited secession, down to the level of the individual, if one comes to the conclusion that government is not doing what it is supposed to do: to protect life and property.

Well, the remark about Hayek’s support for — perhaps acquiescence in would be a better description — conscription (see the Constitution of Liberty) reminded me that in Human Action no less – for the uninitiated that’s Mises’s magnum opus, a 900+ page treatise on economics and praxeology — Mises himself weighed in on the issue of military conscription.

From this point of view one has to deal with the often-raised problem of whether conscription and the levy of taxes mean a restriction of freedom. If the principles of the market economy were acknowledged by all people all over the world, there would not be any reason to wage war and the individual states could live in undisturbed peace. But as conditions are in our age, a free nation is continually threatened by the aggressive schemes of totalitarian autocracies. If it wants to preserve its freedom, it must be prepared to defend its independence. If the government of a free country forces every citizen to cooperate fully in its designs to repel the aggressors and every able-bodied man to join the armed forces, it does not impose upon the individual a duty that would step beyond the tasks the praxeological law dictates. In a world full of unswerving aggressors and enslavers, integral unconditional pacifism is tantamount to unconditional surrender to the most ruthless oppressors. He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government. The essential task of government is defense of the social system not only against domestic gangsters but also against external foes. He who in our age opposes armaments and conscription is, perhaps unbeknown to himself, an abettor of those aiming at the enslavement of all.

There it is. With characteristic understatement, Ludwig von Mises, a card-carrying member of the John Birch Society listed on the advisory board of the Society’s flagship publication American Opinion during the 1960s, calls anyone opposed to conscription an abettor of those aiming at the enslavement of all. But what I find interesting in Mises’s diatribe are the two sentences before the last one in the paragraph.

He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government.

Here Mises says that we have to defend ourselves to maintain our freedom, otherwise we will be enslaved. OK. And then he says that voluntary self-defense will not work. Why won’t it work? Because the market isn’t working. And what causes the market to fail? “Isolated attempts on the part of each individual to resist” will fail. In other words, defense is a public good. People will free ride on the efforts of others. But Mises has the solution. Impose a draft, and compel the able-bodied to defend the homeland and force everyone to pay taxes to finance the provision of the public good, which the unhampered free market is unable to do on its own. Of course, this is just one example of market failure, but Mises doesn’t actually explain why the provision of national defense is the only public good. But, analytically of course, there is no distinction between national defense and other public goods, which confer benefits on people irrespective of whether they have paid for the good. So Mises acknowledges that there is such a thing as a public good, and supports the use of government coercion to supply the public good, but without providing any criterion for which public goods may be provided by the government and which may not. If conscription can be justified to solve a certain kind of public-good problem, why is it unthinkable to rely on taxation to solve other kinds of public-good problems, whose existence Mises, apparently unbeknown to himself, has implicitly conceded?

With the logical rigor that his acolytes find so compelling, Mises concludes this particular diatribe with the following pronouncement:

Every step a government takes beyond the fulfillment of its essential functions of protecting the smooth operation of the market economy against aggression, whether on the part of domestic or foreign disturbers, is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.

Let’s think about that one. “Every step a government takes beyond the fulfillment of its essential function of protecting the smooth operation of the market economy against aggression . . . is a step forward on a road that leads into the totalitarian system where there is no freedom at all.” Pretty scary words, but how logically compelling is this apodictally certain praxeological law?

Well, I live in Montgomery County, Maryland, a short distance from US Route 29. When I visit Baltimore about 35 miles from my home, I often come back from Baltimore via Interstate 70 which starts at a park-and-ride station near Baltimore and continues for about 2153 miles to Cove Fort, Utah. I am happy to report that I have never once driven from Baltimore to Cove Fort. In fact the first exit off of Interstate 70 puts me on US Route 29. What’s more, even if I miss the exit for Route 29, as I have done occasionally, there are other exits further down the highway that allow me to get to Route 29; just because I drive the first four miles on Interstate 70 from Baltimore, it doesn’t necessarily follow that I will wind up in Cove Fort, Utah. So this particular example of the supposedly impeccable Misesian logic sure seems like a non-sequitur to me.

 

Aggregate Demand and Coordination Failures

Regular readers of this blog may have noticed that I have been writing less about monetary policy and more about theory and methodology than when I started blogging a little over three years ago. Now one reason for that is that I’ve already said what I want to say about policy, and, since I get bored easily, I look for new things to write about. Another reason is that, at least in the US, the economy seems to have reached a sustainable growth path that seems likely to continue for the near to intermediate term. I think that monetary policy could be doing more to promote recovery, and I wish that it would, but unfortunately, the policy is what it is, and it will continue more or less in the way that Janet Yellen has been saying it will. Falling oil prices, because of increasing US oil output, suggest that growth may speed up slightly even as inflation stays low, possibly even falling to one percent or less. At least in the short-term, the fall in inflation does not seem like a cause for concern. A third reason for writing less about monetary policy is that I have been giving a lot of thought to what it is that I dislike about the current state of macroeconomics, and as I have been thinking about it, I have been writing about it.

In thinking about what I think is wrong with modern macroeconomics, I have been coming back again and again, though usually without explicit attribution, to an idea that was impressed upon me as an undergrad and grad student by Axel Leijonhufvud: that the main concern of macroeconomics ought to be with failures of coordination. A Swede, trained in the tradition of the Wicksellian Stockholm School, Leijonhufvud immersed himself in the study of the economics of Keynes and Keynesian economics, while also mastering the Austrian literature, and becoming an admirer of Hayek, especially Hayek’s seminal 1937 paper, “Economics and Knowledge.”

In discussing Keynes, Leijonhufvud focused on two kinds of coordination failures.

First, there is a problem in the labor market. If there is unemployment because the real wage is too high, an individual worker can’t solve the problem by offering to accept a reduced nominal wage. Suppose the price of output is $1 a unit and the wage is $10 a day, but the real wage consistent with full employment is $9 a day, meaning that producers choose to produce less output than they would produce if the real wage were lower, thus hiring fewer workers than they would if the real wage were lower than it is. If an individual worker offers to accept a wage of $9 a day, but other workers continue to hold out for $10 a day, it’s not clear that an employer would want to hire the worker who offers to work for $9 a day. If employers are not hiring additional workers because they can’t cover the cost of the additional output produced with the incremental revenue generated by the added output, the willingness of one worker to work for $9 a day is not likely to make a difference to the employer’s output and hiring decisions. It is not obvious what sequence of transactions would result in an increase in output and employment when the real wage is above the equilibrium level. There are complex feedback effects from a change, so that the net effect of making those changes in a piecemeal fashion is unpredictable, even though there is a possible full-employment equilibrium with a real wage of $9 a day. If the problem is that real wages in general are too high for full employment, the willingness of an individual worker to accept a reduced wage from a single employer does not fix the problem.

In the standard competitive model, there is a perfect market for every commodity in which every transactor is assumed to be able to buy and sell as much as he wants. But the standard competitive model has very little to say about the process by which those equilibrium prices are arrived at. And a typical worker is never faced with that kind of choice posited in the competitive model: an impersonal uniform wage at which he can decide how many hours a day or week or year he wants to work at that uniform wage. Under those circumstances, Keynes argued that the willingness of some workers to accept wage cuts in order to gain employment would not significantly increase employment, and might actually have destabilizing side-effects. Keynes tried to make this argument in the framework of an equilibrium model, though the nature of the argument, as Don Patinkin among others observed, was really better suited to a disequilibrium framework. Unfortunately, Keynes’s argument was subsequently dumbed down to a simple assertion that wages and prices are sticky (especially downward).

Second, there is an intertemporal problem, because the interest rate may be stuck at a rate too high to allow enough current investment to generate the full-employment level of spending given the current level of the money wage. In this scenario, unemployment isn’t caused by a real wage that is too high, so trying to fix it by wage adjustment would be a mistake. Since the source of the problem is the rate of interest, the way to fix the problem would be to reduce the rate of interest. But depending on the circumstances, there may be a coordination failure: bear speculators, expecting the rate of interest to rise when it falls to abnormally low levels, prevent the rate of interest from falling enough to induce enough investment to support full employment. Keynes put too much weight on bear speculators as the source of the intertemporal problem; Hawtrey’s notion of a credit deadlock would actually have been a better way to go, and nowadays, when people speak about a Keynesian liquidity trap, what they really have in mind is something closer to Hawtreyan credit deadlock than to the Keynesian liquidity trap.

Keynes surely deserves credit for identifying and explaining two possible sources of coordination failures, failures affecting the macroeconomy, because interest rates and wages, though they actually come in many different shapes and sizes, affect all markets and are true macroeconomic variables. But Keynes’s analysis of those coordination failures was far from being fully satisfactory, which is not surprising; a theoretical pioneer rarely provides a fully satisfactory analysis, leaving lots of work for successors.

But I think that Keynes’s theoretical paradigm actually did lead macroeconomics in the wrong direction, in the direction of a highly aggregated model with a single output, a bond, a medium of exchange, and a labor market, with no explicit characterization of the production technology. (I.e., is there one factor or two, and if two how is the price of the second factor determined? See, here, here, here, and here my discussion of Earl Thompson’s “A Reformulation of Macroeconomic Theory,” which I hope at some point to revisit and continue.)

Why was it the wrong direction? Because, the Keynesian model (both Keynes’s own version and the Hicksian IS-LM version of his model) ruled out the sort of coordination problems that might arise in a multi-product, multi-factor, intertemporal model in which total output depends in a meaningful way on the meshing of the interdependent plans, independently formulated by decentralized decision-makers, contingent on possibly inconsistent expectations of the future. In the over-simplified and over-aggregated Keynesian model, the essence of the coordination problem has been assumed away, leaving only a residue of the actual problem to be addressed by the model. The focus of the model is on aggregate expenditure, income, and output flows, with no attention paid to the truly daunting task of achieving sufficient coordination among the independent decision makers to allow total output and income to closely approximate the maximum sustainable output and income that the system could generate in a perfectly coordinated state, aka full intertemporal equilibrium.

This way of thinking about macroeconomics led to the merging of macroeconomics with neoclassical growth theory and to the routine and unthinking incorporation of aggregate production functions in macroeconomic models, a practice that is strictly justified only in a single-output, two-factor model in which the value of capital is independent of the rate of interest, so that the havoc-producing effects of reswitching and capital-reversal can be avoided. Eventually, these models were taken over by modern real-business-cycle theorists, who dogmatically rule out any consideration of coordination problems, while attributing all observed output and employment fluctuations to random productivity shocks. If one thinks of macroeconomics as an attempt to understand coordination failures, the RBC explanation of output and employment fluctuations is totally backwards; productivity fluctuations, like fluctuations in output and employment, are the not the results of unexplained random disturbances, they are the symptoms of coordination failures. That’s it, eureka! Solve the problem by assuming that it does not exist.

If you are thinking that this seems like an Austrian critique of the Keynesian model or the Keynesian approach, you are right; it is an Austrian critique. But it has nothing to do with stereotypical Austrian policy negativism; it is a critique of the oversimplified structure of the Keynesian model, which foreshadowed the reduction ad absurdum or modern real-business-cycle theory, which has nearly banished the idea of coordination failures from modern macroeconomics. The critique is not about the lack of a roundabout capital structure; it is about the narrow scope for inconsistencies in production and consumption plans.

I think that Leijonhufvud almost 40 years ago was getting at this point when he wrote the following paragraph near toward end of his book on Keynes.

The unclear mix of statics and dynamics [in the General Theory] would seem to be main reason for later muddles. One cannot assume that what went wrong was simply that Keynes slipped up here and there in his adaptation of standard tools, and that consequently, if we go back and tinker a little more with the Marshallian toolbox his purposes will be realized. What is required, I believe, is a systematic investigation from the standpoint of the information problems stressed in this study, of what elements of the static theory of resource allocation can without further ado be utilized in the analysis of dynamic and historical systems. This, of course, would be merely a first step: the gap yawns very wide between the systematic and rigorous modern analysis of the stability of simple, “featureless,” pure exchange systems and Keynes’ inspired sketch of the income-constrained process in a monetary exchange-cum production system. But even for such a first step, the prescription cannot be to “go back to Keynes.” If one must retrace some step of past developments in order to get on the right track – and that is probably advisable – my own preference is to go back to Hayek. Hayek’s Gestalt-conception of what happens during business cycles, it has been generally agreed, was much less sound that Keynes’. As an unhappy consequence, his far superior work on the fundamentals of the problem has not received the attention it deserves. (pp. 401-02)

I don’t think that we actually need to go back to Hayek, though “Economics and Knowledge” should certainly be read by every macroeconomist, but we do need to get a clearer understanding of the potential for breakdowns in economic activity to be caused by inconsistent expectations, especially when expectations are themselves mutually dependent and reinforcing. Because expectations are mutually interdependent, they are highly susceptible to network effects. Network effects produce tipping points, tipping points can lead to catastrophic outcomes. Just wanted to share that with you. Have a nice day.

Nick Rowe on Money and Coordination Failures

Via Brad Delong, I have been reading a month-old post by Nick Rowe in which Nick argues that every coordination failure is attributable to an excess demand for money. I think money is very important, but I am afraid that Nick goes a bit overboard in attempting to attribute every failure of macroeconomic coordination to a monetary source, where “monetary” means an excess demand for money. So let me try to see where I think Nick has gotten off track, or perhaps where I have gotten off track.

His post is quite a long one – over 3000 words, all his own – so I won’t try to summarize it, but the main message is that what characterizes money economies – economies in which there is a single asset that serves as the medium of exchange – is that money is involved in almost every transaction. And when a coordination failure occurs in such an economy, there being lots of unsold good and unemployed workers, the proper way to think about what is happening is that it is hard to buy money. Another way of saying that it is hard to buy money is that there is an excess demand for money.

Nick tries to frame his discussion in terms of Walras’s Law. Walras’s Law is a property of a general-equilibrium system in which there are n goods (and services). Some of these goods are produced and sold in the current period; others exist either as gifts of nature (e.g., land and other privately owned natural resources), as legacies of past production). Walras’s Law tells us that in a competitive system in which all transactors can trade at competitive prices, it must be the case that planned sales and purchases (including asset accumulation) for each individual and for all individuals collectively must cancel out. The value of my planned purchases must equal the value of my planned sales. This is a direct implication of the assumption that prices for each good are uniform for all individuals, and the assumption that goods and services may be transferred between individuals only via market transactions (no theft or robbery). Walras’s Law holds even if there is no equilibrium, but only in the notional sense that value of planned purchases and planned sales would exactly cancel each other out. In general-equilibrium models, no trading is allowed except at the equilibrium price vector.

Walras’ Law says that if you have a $1 billion excess supply of newly-produced goods, you must have a $1 billion excess demand for something else. And that something else could be anything. It could be money, or it could be bonds, or it could be land, or it could be safe assets, or it could be….anything other than newly-produced goods. The excess demand that offsets that excess supply for newly-produced goods could pop up anywhere. Daniel Kuehn called this the “Whack-a-mole theory of business cycles”.

If Walras’ Law were right, recessions could be caused by an excess demand for unobtanium, which has zero supply, but a big demand, and the government stupidly passed a law setting a finite maximum price per kilogram for something that doesn’t even exist, thereby causing a recession and mass unemployment.

People might want to buy $1 billion of unobtanium per year, but that does not cause an excess supply of newly-produced goods. It does not cause an excess supply of anything. Because they cannot buy $1 billion of unobtanium. That excess demand for unobtanium does not affect anything anywhere in the economy. Yes, if 1 billion kgs of unobtanium were discovered, and offered for sale at $1 per kg, that would affect things. But it is the supply of unobtanium that would affect things, not the elimination of the excess demand. If instead you eliminated the excess demand by convincing people that unobtanium wasn’t worth buying, absolutely nothing would change.

An excess demand for unobtanium has absolutely zero effect on the economy. And that is true regardless of the properties of unobtanium. In particular, it makes absolutely no difference whether unobtanium is or is not a close substitute for money.

What is true for unobtanium is also true for any good for which there is excess demand. Except money. If you want to buy 10 bonds, or 10 acres of land, or 10 safe assets, but can only buy 6, because only 6 are offered for sale, those extra 4 bonds might as well be unobtanium. You want to buy 4 extra bonds, but you can’t, so you don’t. Just like you want to buy unobtanium, but you can’t, so you don’t. You can’t do anything so you don’t do anything.

Walras’ Law is wrong. Walras’ Law only works in an economy with one centralised market where all goods can be traded against each other at once. If the Walrasian auctioneer announced a finite price for unobtanium, there would be an excess demand for unobtanium and an excess supply of other goods. People would offer to sell $1 billion of some other goods to finance their offers to buy $1 billion of unobtanium. The only way the auctioneer could clear the market would be by refusing to accept offers to buy unobtanium. But in a monetary exchange economy the market for unobtanium would be a market where unobtanium trades for money. There would be an excess demand for unobtanium, matched by an equal excess supply of money, in that particular market. No other market would be affected, if people knew they could not in fact buy any unobtanium for money, even if they want to.

Now this is a really embarrassing admission to make – and right after making another embarrassing admission in my previous post – I need to stop this – but I have no idea what Nick is saying here. There is no general-equilibrium system in which there is any notional trading taking place for a non-existent good, so I have no clue what this is all about. However, even though I can’t follow Nick’s reasoning, I totally agree with him that Walras’s Law is wrong. But the reason that it’s wrong is not that it implies that recessions could be caused by an excess demand for a non-existent good; the reason is that, in the only context in which a general-equilibrium model could be relevant for macroeconomics, i.e., an incomplete-markets model (aka the Radner model) in which individual agents are forming plans based on their expectations of future prices, prices that will only be observed in future periods, Walras’s Law cannot be true unless all agents have identical and correct expectations of all future prices.

Thus, the condition for macroeconomic coordination is that all agents have correct expectations of all currently unobservable future prices. When they have correct expectations, Walras’s Law is satisfied, and all is well with the world. When they don’t, Walras’s Law does not hold. When Walras’s Law doesn’t hold, things get messy; people default on their obligations, businesses go bankrupt, workers lose their jobs.

Nick thinks it’s all about money. Money is certainly one way in which things can get messed up. The government can cause inflation, and then stop it, as happened in 1920-21 and in 1981-82. People who expected inflation to continue, and made plans based on those expectations,were very likely unable to execute their plans when inflation stopped. But there are other reasons than incorrect inflation expectations that can cause people to have incorrect expectations of future prices.

Actually, Nick admits that coordination failures can be caused by factors other than an excess demand for money, but for some reason he seems to think that every coordination failure must be associated with an excess demand for money. But that is not so. I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is go great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Nick invokes Hayek’s paper (“The Use of Knowledge in Society“) to explain how markets work to coordinate the decentralized plans of individual agents. Nick assumes that Hayek failed to mention money in that paper because money is so pervasive a feature of a real-world economy, that Hayek simply took its existence for granted. That’s certainly an important paper, but the more important paper in this context is Hayek’s earlier paper (“Economics and Knowledge“) in which he explained the conditions for intertemporal equilibrium in which individual plans are coordinated, and why there is simply no market mechanism to ensure that intertemporal equilibrium is achieved. Money is not mentioned in that paper either.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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