Archive for July, 2012

George Selgin Asks a Question

I first met George Selgin almost 30 years ago at NYU where I was a visiting assistant professor in 1981, and he was a graduate student. I used to attend the weekly Austrian colloquium headed by Israel Kirzner, which included Mario Rizzo, Gerry O’Driscoll, and Larry White, and a group of very smart graduate students like George, Roger Koppl, Sandy Ikeda, Allanah Orrison, and others that I am not recalling. Ludwig Lachmann was also visiting NYU for part of the year, and meeting him was a wonderful experience, as he was very encouraging about an early draft of my paper “A Reinterpretation of Classical Monetary Theory,” which I was then struggling to get into publishable form. A few years later, while I was writing my book Free Banking and Monetary Reform, I found out (I can’t remember how, but perhaps through Anna Schwartz who was on George’s doctoral committee) that he was also writing a book on free banking based on his doctoral dissertation. His book, The Theory of Free Banking, came out before mine, and he kindly shared his manuscript with me as I was writing my book. Although we agreed on many things, our conceptions of free banking and our interpretations of monetary history and policy were often not in sync.

Despite these differences, I watched with admiration as George developed into a prolific economist with a long and impressive list of publications and accomplishments to his credit. I also admire his willingness to challenge his own beliefs and to revise his views about economic theory and policy when that seems to be called for, for example, recently observing in a post on the Free Banking blog that he no longer describes himself as an Austrian economist, and admires that Austrian bete noire, Milton Friedman, though he has hardly renounced his Hayekian leanings.

In one of his periodic postings (“A Question to Market Monetarists“) on the Free Banking blog, George recently discussed NGDP targeting, and raised a question to supporters of nominal GDP targeting, a challenging question to be sure, but a question not posed in a polemical spirit, but out of genuine curiosity. George begins by noting that his previous work in arguing for the price level to vary inversely with factor productivity bears a family resemblance to proposals for NGDP targeting, the difference being whether, in a benchmark case with no change in factor productivity and no change in factor supplies, the price level would be constant or would rise at some specified rate, presumably to overcome nominal rigidities. In NGDP targeting with an upward price trend (Scott Sumner’s proposal) or in NGDP targeting with a stationary price trend (George’s proposal), any productivity increase would correspond to price increases below the underlying price trend and productivity declines would correspond to price increases above underlying the price trend.

However, despite that resemblance, George is reluctant to endorse the Market Monetarist proposal for rapid monetary expansion to promote recovery. George gives three reasons for his skepticism about increasing the rate of monetary expansion to promote recovery, but my concern in this post is with his third, which is the most interesting from his point of view and the one that prompts the question that he poses. George suggests that given the 4.5-5.0% rate of growth in NGDP in the US since the economy hit bottom in the second quarter of 2009, it is not clear why, according to the Market Monetarists, the economy should not, by now, have returned to roughly its long-run real growth trend. (I note here a slight quibble with George’s 4.5-5.0% estimate of recent NGDP growth.  In my calculations, NGDP has grown at just 4.00% since the second quarter of 2009, and at 3.82% since the second quarter of 2010.)

Here’s how George characterizes the problem.

My third reason stems from pondering the sort of nominal rigidities that would have to be at play to keep an economy in a state of persistent monetary shortage, with consequent unemployment, for several years following a temporary collapse of the level of NGDP, and despite the return of the NGDP growth rate to something like its long-run trend.

Apart from some die-hard New Classical economists, and the odd Rothbardian, everyone appreciates the difficulty of achieving such downward absolute cuts in nominal wage rates as may be called for to restore employment following an absolute decline in NGDP. Most of us (myself included) will also readily agree that, if equilibrium money wage rates have been increasing at an annual rate of, say, 4 percent (as was approximately true of U.S. average earnings around 2006), then an unexpected decline in that growth rate to another still positive rate can also lead to unemployment. But you don’t have to be a die-hard New Classicist or Rothbardian to also suppose that, so long as equilibrium money wage rates are rising, as they presumably are whenever there is a robust rate of NGDP growth, wage demands should eventually “catch down” to reality, with employees reducing their wage demands, and employers offering smaller raises, until full employment is reestablished. The difficulty of achieving a reduction in the rate of wage increases ought, in short, to be considerably less than that of achieving absolute cuts.

U.S. NGDP was restored to its pre-crisis level over two years ago. Since then both its actual and its forecast growth rate have been hovering relatively steadily around 5 percent, or about two percentage points below the pre-crisis rate.The growth rate of U.S. average hourly (money) earnings has, on the other hand, declined persistently and substantially from its boom-era peak of around 4 percent, to a rate of just 1.5 percent.** At some point, surely, these adjustments should have sufficed to eliminate unemployment in so far as such unemployment might be attributed to a mere lack of spending. How can this be?

There have been a number of responses to George. Among them, Scott Sumner, Bill Woolsey and Lars Christensen. George, himself, offered a response to his own question, in terms of this graph plotting the time path of GDP versus the time path of nominal wages before and since the 2007-09 downturn.

Here’s George’s take on the graph:

Here one can clearly see how, while NGDP plummeted, hourly wages kept right on increasing, albeit at an ever declining rate. Allowing for compounding, this difference sufficed to create a gap between wage and NGDP levels far exceeding its pre-bust counterpart, and large enough to have been only slightly reduced by subsequent, reasonably robust NGDP growth, notwithstanding the slowed growth of wages.

The puzzle is, of course, why wages have kept on rising at all, despite high unemployment. Had they stopped increasing altogether at the onset of the NGDP crunch, wages and total spending might have recovered their old relative positions about two years ago. That, presumably, would have been too much to hope for. But if it is unreasonable to expect wage inflation to stop on a dime, is it not equally perplexing that it should lunge ahead like an ocean liner might, despite having its engines put to a full stop?

However, after some further tinkering, George decided that the appropriate scaling of the graph implied that the relationship between the two time paths was that displayed in the graph below.

As a result of that rescaling, George withdrew, or at least qualified, his earlier comment. So, it’s obviously getting complicated. But Marcus Nunes, a terrific blogger and an ingenious graph maker, properly observes that George’s argument should be unaffected by any rescaling of his graph. The important feature of the time path of nominal GDP is that it dipped sharply and then resumed its growth at a somewhat slower rate than before the dip while the time path of nominal wages has continued along its previous trend, with just a gentle flattening of the gradient, but without any dip as occurred in the NGDP time path.  The relative position of the two curves on the graph should not matter.

By coincidence George’s first post appeared the day before I published my post about W. H. Hutt on Say’s Law and the Keynesian multiplier in which I argued that money-wage adjustments — even very substantial money-wage adjustments — would not necessarily restore full employment. The notion that money-wage adjustments must restore full employment is a mistaken inference from a model in which trading occurs only at equilibrium prices.  But that is not the world that we inhabit. Trading takes place at prices that the parties agree on, whether or not those prices are equilibrium prices. The quantity adjustments envisaged by Keynes and also by Hutt in his brilliant interpretation of Say’s Law, can prevent price-and-wage adjustments, even very large price-and-wage adjustments, from restoring a full-employment equilibrium. Hutt thought otherwise, but made no effective argument to prove his case, relying simply on a presumption that market forces will always put everything right in the end. But he was clearly mistaken on that point, as no less an authority that F. A. Hayek, in his 1937 article, “Economics and Knowledge,” clearly understood. For sufficiently large shocks, there is no guarantee that wage-and-price adjustments on their own will restore full employment.

In a comment on Scott’s blog, I made the following observation.

[T]he point [George] raises about the behavior of wages is one that I have also been wondering about. I mentioned it in passing in a recent post on W. H. Hutt and Say’s Law and the Keynesian multiplier. I suggested the possibility that we have settled into something like a pessimistic expectations equilibrium with anemic growth and widespread unemployment that is only very slowly, if at all, trending downwards. To get out of such a pessimistic expectations equilibrium you would need either a drastic downward revision of expected wages or a drastic increase in inflationary expectations sufficient to cause a self-sustaining expansion in output and employment. Just because the level of wages currently seems about right relative to a full employment equilibrium doesn’t mean that level of wages needed to trigger an expansion would not need to be substantially lower than the current level in the transitional period to an optimistic-expectations equilibrium. This is only speculation on my part, but I think it is potentially consistent with the story about inflationary expectations causing the stock market to rise in the current economic climate.

George later replied on Scott’s blog as follows:

David Glasner suggests “the possibility that we have settled into something like a pessimistic expectations equilibrium with anemic growth and widespread unemployment…To get out of such a pessimistic expectations equilibrium you would need either a drastic downward revision of expected wages or a drastic increase in inflationary expectations.”

The rub, if you ask me, is that of reconciling “pessimistic expectations” with what appears, on the face of things, to be an overly optimistic positioning of expected wages.

I am not sure why George thinks there is a problem of reconciliation. As Hayek showed in his 1937 article, a sufficient condition for disequilibrium is that expectations be divergent. If expectations diverge, then the plans constructed on those plans cannot be mutually consistent, so that some, perhaps all, plans will not be executed, and some, possibly all, economic agents will regret some prior decisions that they took. Especially after a large shock, I see no reason to be surprised that expectations diverge or even that, as a group, workers are slower to change expectations than employers. I may have been somewhat imprecise in referring to a “pessimistic-expectations” equilibrium, because what I am thinking of is an inconsistency between the pessimism of entrepreneurs about future prices and the expectations of workers about wages, not a situation in which all agents are equally pessimistic. If everyone were equally pessimistic, economic activity might be at a low level, but we wouldn’t necessarily observe any disappointed buyers or sellers. But what qualifies as disappointment might not be so easy to interpret. But we likely would observe a reduction in output. So a true “pessimistic-expectations” equilibrium is a bit tricky to think about. But in practice, there seems nothing inherently surprising about workers’ expectations of future wages not adjusting downward as rapidly as employers’ expectations do. It may also be the case that it is the workers with relatively pessimistic expectations who are dropping out of the labor force, while those with more optimistic expectations continue to search for employment.

I don’t say that the slow recovery poses not difficult issues for advocates of monetary stimulus to address.  The situation today is not exactly the same as it was in 1932, but I don’t agree that it can be taken as axiomatic that a market economy will recover from a large shock on its own.  It certainly may recover, but it may not.  And there is no apodictically true demonstration in the whole corpus of economic or praxeological theory that such a recovery must necessarily occur.

Murdoch Tends to Corrupt

Allan Meltzer has had a long and distinguished career as an economist and scholar, making many notable contributions to monetary economics at both the theoretical and empirical levels, also writing valuable and highly regarded contributions to the history of economics and economic history, especially his 1989 book on Keynes and his recent monumental two-volume history of the Federal Reserve System. Meltzer has the added virtue of being a UCLA-trained economist, where as a student he began his long collaboration with his teacher Karl Brunner. So I take no pleasure in writing this post about what can only be described as an embarrassment, namely, the abysmal op-ed article (“What’s Wrong with the Federal Reserve?”) Meltzer wrote in today’s Wall Street Journal about the Fed and current monetary policy.

Meltzer immediately gets off to a bad start, from which he never recovers, with the following opening sentence.

By allowing its monetary policy to be influenced by elected politicians and market speculators, the Federal Reserve is putting its independence at risk.

Now you might have thought that a serious charge about the Fed’s conduct would require some supporting evidence that the Fed’s policy was being influenced by either politicians or speculators. Well, this is what seems to count as evidence for Professor Meltzer.

Consider the response to last week’s employment report for June—a meager 80,000 net new jobs created, and an unemployment rate stuck at 8.2%. Day traders and speculators immediately clamored for additional monetary easing. Even the president of the Federal Reserve Bank of Chicago joined in.

So the people that Professor Meltzer thinks are now controlling Fed policy are a bunch of day traders. This goes way past what even Ron Paul would say about who is controlling the Fed, i.e., international bankers (aka the Rothschilds). No, it’s a conspiracy of the day traders, apparently having co-opted the president of the Chicago Federal Reserve Bank. Talk about lowering the bar. But it gets worse. Let’s read on.

To his credit, Mr. Bernanke did not immediately agree. But he failed utterly to state the obvious: The country’s sluggish growth and stubbornly high unemployment rate was [sic] not caused by, nor could it [sic] be cured by, monetary policy.

OK, Professor Meltzer has discovered that the Fed is being controlled by a conspiracy of day traders working through the president of the Chicago Fed.  Except that Bernanke and the FOMC (except for that guy from Chicago) did not go along with the conspirators! What then is the evidence that Fed policy is controlled by the day traders? Apparently, the failure of Bernanke to make an abject admission of the Fed’s impotence.

Now what is Professor Meltzer’s evidence for the Fed’s impotence? Let him speak for himself:

Market interest rates on all maturities of government bonds are the lowest since the founding of the republic.

This is astonishing. Allan Meltzer is widely regarded as a founding fathers (along with Milton Friedman and Karl Brunner) of modern Moneterism, one of whose basic tenets is that nominal interest rates are primarily determined by inflation expectations. Thus, low interest rates, as Milton Friedman always pointed out, are symptomatic of tight monetary policy that keeps inflation, and inflation expectations, low, as they are now. But somehow Professor Meltzer has now concluded, like the Keynesians that Monetarists once disputed, that low interest rates are symptomatic of easy money. Meltzer later invokes Friedman’s authority to support the proposition that monetary policy is an unreliable instrument for stabilizing short-term fluctuations in the economy, causing one to wonder whether his memory lapses are random or selective.

Professor Meltzer’s memory of recent economic history is also dubious. Discussing the Fed’s adoption of QE2 in the fall of 2010, he writes:

Consider also how, in the summer of 2010, the Fed allowed itself to be spooked by cries about a double-dip recession and deflation. It added $600 billion to banks’ reserves by buying up federal Treasurys and mortgage-backed securities. Today, $500 billion of those reserves remain on bank balance sheets, and most of the rest of the dollars are held by foreign central banks. Not much help to the U.S. economy. By early autumn 2010, it had become clear that fears of a double-dip recession and deflation were just short-term hysteria.

Actually, Chairman Bernanke only signaled in late August and early September 2010 that the Fed would engage in renewed quantitative easing, thereby producing an immediate market response. The renewed purchases did not begin until the autumn. What became clear in the autumn was not that recession and deflation fears were just short-term hysteria, but that quantitative easing prevented the slide into recession that had been anticipated by a sharp dive in the stock market in August 2010.

Meltzer asserts that the cause of the weak recovery is uncertainty about future tax rates, health-care costs, and the regulatory burden. One would expect that, as an accomplished empirical economist, Professor Meltzer would attempt to back up his assertion with evidence. But he apparently regards it as too self-evident a proposition to require any empirical support.

Professor Meltzer again displays a shockingly cavalier attitude toward empirical evidence with the following assertion:

Evidence is growing that many think higher inflation is in our future. One sign is the premium that investors pay to hold index-linked Treasury bonds that protect against inflation.

These claims about inflation expectations are not backed up by data of any kind, even though they are readily available. The only problem is that the data don’t support Meltzer’s claims.  Breakeven TIPS spreads have edged up slightly in the last couple of weeks as fears of an imminent financial crisis in Europe have eased, but even at the 10-year time horizon the breakeven rate is barely above 2%, which is less than inflation expectations have been for most of the nearly four years since the onset of the financial crisis in 2008. And according to the estimates of inflation expectations by the Cleveland Fed, 10-year inflation expectations in June were at an all-time low, about 1.2%.

Although there is much more to criticize about this piece, it would be churlish to continue further. But I cannot help wonder why Professor Meltzer is so heedless of his reputation that he would allow his name to be attached to a piece of work so far below not just his own formerly high standards, but even below a standard of minimal competence. My only conjecture is that Rupert Murdoch is somehow responsible. Perhaps Murdoch has cast a demonic spell on Professor Meltzer. That seems as good an explanation as any.

Williamson v. Sumner

Stephen Williamson weighed in on nominal GDP targeting in a blog post on Monday. Scott Sumner and Marcus Nunes have already responded, and Williamson has already responded to Scott, so I will just offer a few semi-random comments about Williamson’s post, the responses and counter-response.

Let’s start with Williamson’s first post. He interprets Fed policy, since the Volcker era, as an implementation of the Taylor rule:

The Taylor rule takes as given the operating procedure of the Fed, under which the FOMC determines a target for the overnight federal funds rate, and the job of the New York Fed people who manage the System Open Market Account (SOMA) is to hit that target. The Taylor rule, if the FOMC follows it, simply dictates how the fed funds rate target should be set every six weeks, given new information.

So, from the mid-1980s until 2008, everything seemed to be going swimmingly. Just as the inflation targeters envisioned, inflation was not only low, but we had a Great Moderation in the United States. Ben Bernanke, who had long been a supporter of inflation targeting, became Fed Chair in 2006, and I think it was widely anticipated that he would push for inflation targeting with the US Congress.

Thus, under the Taylor rule, as implemented, ever more systematically, by the FOMC, the federal funds rate (FFR) was set with a view to achieving an implicit inflation target, presumably in the neighborhood of 2%. However, as a result of the Little Depression beginning in 2008, Scott Sumner et al. have proposed targeting NGDP instead of inflation. Williamson has problems with NGDP targeting that I will come back to, but he makes a positive case for inflation targeting in terms of Friedman’s optimal-supply-of-money rule, under which the nominal rate of interest is held at zero via a rate of inflation that is the negative of the real interest rate (i.e., deflation whenever the real rate of interest is positive). Back to Williamson:

The Friedman rule . . . dictates that monetary policy be conducted so that the nominal interest rate is always zero. Of course we know that no central bank does that, and we have good reasons to think that there are other frictions in the economy which imply that we should depart from the Friedman rule. However, the lesson from the Friedman rule argument is that the nominal interest rate reflects a distortion and that, once we take account of other frictions, we should arrive at an optimal policy rule that will imply that the nominal interest rate should be smooth. One of the frictions some macroeconomists like to think about is price stickiness. In New Keynesian models, price stickiness leads to relative price distortions that monetary policy can correct.

If monetary policy is about managing price distortions, what does that have to do with targeting some nominal quantity? Any model I know about, if subjected to a NGDP targeting rule, would yield a suboptimal allocation of resources.

I really don’t understand this. Williamson is apparently defending current Fed practice (i.e., targeting a rate of inflation) by presenting it as a practical implementation of Friedman’s proposal to set the nominal interest rate at zero. But setting the nominal interest rate at zero is analogous to inflation targeting only if the real rate of interest doesn’t change. Friedman’s rule implies that the rate of deflation changes by as much as the real rate of interest changes. Or does Williamson believe that the real rate of interest never changes? Those of us now calling for monetary stimulus believe that we are stuck in a trap of widespread entrepreneurial pessimism, reflected in very low nominal and negative real interest rates. To get out of such a self-reinforcing network of pessimistic expectations, the economy needs a jolt of inflationary shock therapy like the one administered by FDR in 1933 when he devalued the dollar by 40%.

As I said a moment ago, even apart from Friedman’s optimality argument for a zero nominal interest rate, Williamson thinks that NGDP targeting is a bad idea, but the reasons that he offers for thinking it a bad idea strike me as a bit odd. Consider this one. The Fed would never adopt NGDP targeting, because it would be inconsistent with the Fed’s own past practice. I kid you not; that’s just what he said:

It will be a cold day in hell when the Fed adopts NGDP targeting. Just as the Fed likes the Taylor rule, as it confirms the Fed’s belief in the wisdom of its own actions, the Fed will not buy into a policy rule that makes its previous actions look stupid.

So is Williamson saying that the Fed will not adopt any policy that is inconsistent with its actions in, say, the Great Depression? That will surely do a lot to enhance the Fed’s institutional credibility, about which Williamson is so solicitous.

Then Williamson makes another curious argument based on a comparison of Hodrick-Prescott-filtered NGDP and RGDP data from 1947 to 2011. Williamson plotted the two series on the accompanying graph. Observing that while NGDP was less variable than RDGP in the 1970s, the two series tracked each other closely in the Great-Moderation period (1983-2007), Williamson suggests that, inasmuch as the 1970s are now considered to have been a period of bad monetary policy, low variability of NGDP does not seem to matter that much.

Marcus Nunes, I think properly, concludes that Williamson’s graph is wrong, because Williamson ignores the fact that there was a rising trend of NGDP growth during the 1970s, while during the Great Moderation, NGDP growth was stationary. Marcus corrects Williamson’s error with two graphs of his own (which I attach), showing that the shift to NGDP targeting was associated with diminished volatility in RGDP during the Great Moderation.

Furthermore, Scott Sumner questions whether the application of the Hodrick-Prescott filter to the entire 1947-2011 period was appropriate, given the collapse of NGDP after 2008, thereby distorting estimates of the trend.

There may be further issues associated with the appropriateness of the Hodrick-Prescott filter, issues which I am certainly not competent to assess, but I will just quote from Andrew Harvey’s article on filters for Business Cycles and Depressions: An Encyclopedia, to which I referred recently in my post about Anna Schwartz. Here is what Harvey said about the HP filter.

Thus for quarterly data, applying the [Hodrick-Prescott] filter to a random walk is likely to create a spurious cycle with a period of about seven or eight years which could easily be identified as a business cycle . . . Of course, the application of the Hodrick-Prescott filter yields quite sensible results in some cases, but everything depends on the properties of the series in question.

Williamson then wonders, if stabilizing NGDP is such a good idea, why not stabilize raw NGDP rather than seasonally adjusted NGDP, as just about all advocates of NGDP targeting implicitly or explicitly recommend? In a comment on Williamson’s blog, Nick Rowe raised the following point:

The seasonality question is interesting. We could push it further. Should we want the same level of NGDP on weekends as during the week? What about nighttime?

But then I think the same question could be asked for inflation targeting, or price level path targeting, because there is a seasonal pattern to CPI too. And (my guess is) the CPI is higher on weekends. Not sure if the CPI is lower or higher at night.

In a subsequent comment, Nick made the following, quite telling, observation:

Actually, thinking about seasonality is a regular repeated shock reminds me of something Lucas once said about rational expectations equilibria. I don’t remember his precise words, but it was something to the effect that we should be very wary of assuming the economy will hit the RE equilibrium after a shock that is genuinely new, but if the shock is regular and repeated agents will have figured out the RE equilibrium. Seasonality, and day of the week effects, will be presumably like that.

So, I think the point about eliminating seasonal fluctuations has been pretty much laid to rest. But perhaps Williamson will try to resurrect it (see below).

In his reply to Scott, Williamson reiterates his long-held position that the Fed is powerless to affect the economy except by altering the interest rate, now 0.25%, paid to banks on their reserves held at the Fed. Since the Fed could do no more than cut the rate to zero, and a negative interest rate would be deemed an illegal tax, Williamson sees no scope for monetary policy to be effective. Lars Chritensen, however, points out that the Fed could aim at a lower foreign exchange value of the dollar and conduct its monetary policy via unsterilized sales of dollars in the foreign-exchange markets in support of an explicit price level or NGDP target.

Williamson defends his comments about stabilizing seasonal fluctuations as follows:

My point in looking at seasonally adjusted nominal GDP was to point out that fluctuations in nominal GDP can’t be intrinsically bad. I think we all recognize that seasonal variation in NGDP is something that policy need not be doing anything to eliminate. So how do we know that we want to eliminate this variation at business cycle frequencies? In contrast to what Sumner states, it is widely recognized that some of the business cycle variability in RGDP we observe is in fact not suboptimal. Most of what we spend our time discussing (or fighting about) is the nature and quantitative significance of the suboptimalities. Sumner seems to think (like old-fashioned quantity theorists), that there is a sufficient statistic for subomptimality – in this case NGDP. I don’t see it.

So, apparently, Williamson does accept the comment from Nick Rowe (quoted above) on his first post. He now suggests that Scott Sumner and other NGDP targeters are too quick to assume that observed business-cycle fluctuations are non-optimal, because some business-cycle fluctuations may actually be no less optimal than the sort of responses to seasonal fluctuations that are general conceded to be unproblematic. The difference, of course, is that seasonal fluctuations are generally predictable and predicted, which is not the case for business-cycle fluctuations. Why, then, is there any theoretical presumption that unpredictable business-cycle fluctuations that falsify widely held expectations result in optimal responses? The rational for counter-cyclical policy is to minimize incorrect expectations that lead to inefficient search (unemployment) and speculative withholding of resources from their most valuable uses. The first-best policy for doing this, as I explained in the last chapter of my book Free Banking and Monetary Reform, would be to stabilize a comprehensive index of wage rates.  Practical considerations may dictate choosing a less esoteric policy target than stabilizing a wage index, say, stablizing the growth path of NGDP.

I think I’ve said more than enough for one post, so I’ll pass on Williamson’s further comments of the Friedman rule and why he chooses to call himself a Monetarist.

PS Yesterday was the first anniversary of this blog. Happy birthday and many happy returns to all my readers.

W. H. Hutt on Say’s Law and the Keynesian Multiplier

In a post a few months ago, I referred to W. H. Hutt as an “unjustly underrated” and “all but forgotten economist” and “as an admirable human being,” who wrote an important book in 1939, The Theory of Idle Resources, seeking to counter Keynes’s theory of involuntary unemployment. In responding to a comment on a more recent post, I pointed out that Armen Alchian relied on one of Hutt’s explanations for unemployment to provide a microeconomic basis for Keynes’s rather convoluted definition of involuntary unemployment, so that Hutt unintentionally provided support for the very Keynesian theory that he was tried to disprove. In this post, I want to explore Hutt’s very important and valuable book ARehabilitation of Say’s Law, even though, following Alchian, I would interpret what Hutt wrote in a way that is at least potentially supportive of Keynes, while also showing that Hutt’s understanding of Say’s Law allows us to view Says Law and the Keynesian multiplier as two (almost?) identical ways of describing the same phenomenon.

But before I discuss Hutt’s understanding of Say’s Law, a few words about why I think Hutt was an admirable human being are in order. Born in 1899 into a working class English family (his father was a printer), Hutt attended the London School of Economics in the early 1920s, coming under the influence of Edwin Cannan, whose writings Hutt often referred to. After gaining his bachelor’s degree, Hutt, though working full-time, continued taking courses at LSE, even publishing several articles before taking a position at the University of Capetown in 1930, despite having no advanced degree in economics. Hutt remained in South Africa until the late 1960s or early 1970s, becoming an outspoken critic of legal discrimination against non-whites and later of the apartheid regime instituted in 1948. In his book, The Economics of the Colour Bar, Hutt traced the racial policies of the South African regime not just to white racism, but to the interest of white labor unions in excluding competition by non-whites. Hutt’s hostility to labor unions for their exclusionary and protectionist policies was evident in much of his work, beginning at least with his Theory of Collective Bargaining, his Strike-Threat System, and his many critiques of Keynesian economics. However, he was opposed not to labor unions as such, just to the legal recognition of the right of some workers to coerce others into a collusive agreement to withhold their services unless their joint demand for a stipulated money wage was acceded to by employers, a right that in most other contexts would be both legally and morally unacceptable. Whether or not Hutt took his moral opposition to collective bargaining to extremes, he certainly was not motivated by any venal motives. Certainly his public opposition to apartheid, inviting retribution by the South African regime, was totally disinterested, and his opposition to collective bargaining was no less sincere, even If less widely admired, than his opposition to apartheid, and no more motivated by any expectation of personal gain.

In the General Theory, launching an attack on what he carelessly called “classical economics,” Keynes devoted special attention to the doctrine he described as Say’s Law, a doctrine that had been extensively and inconclusively debated in the nineteenth century after Say formulated what he had called the Law of the Markets in his Treatise on Political Economy in 1803. The exact meaning of the Law of the Markets was never entirely clear, so that, in arguing about Say’s Law, one can never be quite sure that one knows what one is talking about. At any rate, Keynes paraphrased Say’s Law in the following way: supply creates its own demand. In other words, “if you make it, they will buy it, or at least buy something else, because the capacity to demand is derived from the capacity to supply.”

Here is Keynes at p. 18 of the General Theory:

From the time of Say and Ricardo the classical economists have taught that supply creates its own demand; — meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product.

In J. S. Mill’s Principles of Political Economy the doctrine is expressly set forth:

What constitutes the means of payment for commodities. Each person’s means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because every one would have twice as much to offer in exchange.

Then, again at p. 26, Keynes restates Say’s Law in his own terminology:

In the previous chapter we have given a definition of full employment in terms of the behavior of labour. An alternative, though equivalent, criterion is that at which we have now arrived, namely, a situation in which aggregate employment is inelastic in response to an increase in effective demand for its output. Thus Say’s Law, that the aggregate demand price of output as a whole is equal ot its aggregate supply price for all volumes of output [“could we suddenly double the productive powers of the country . . . we should . . . double the purchasing power”], is equivalent the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.

Keynes restated the same point in terms of his doctrine that macroeconomic equilibrium, the condition for which being that savings equal investment, could occur at a level of output and income corresponding to less than full employment. How could this happen? Keynes believed that if the amount that households desired to save at the full employment level of income were greater than the amount that businesses would invest at that income level, expenditure and income would decline until desired (and actual) savings equaled investment. If Say’s Law held, then whatever households chose not to spend would get transformed into investment by business, but Keynes denied that there was any mechanism by which this transformation would occur. Keynes proposed his theory of liquidity preference to explain why savings by households would not necessarily find their way into increased investment by businesses, liquidity preference preventing the rate of interest from adjusting to induce as much investment as required to generate the full-employment level of output and income.

Now the challenge for Keynes was to explain why, if there is less than full employment, wages would not fall to induce businesses to hire the unemployed workers. From Keynes’s point of view it wasn’t enough to assert that wages are sticky, because a classical believer in Say’s Law could have given that answer just as well.  If you prevent prices from adjusting, the result will be a disequilibrium.  From Keynes’s standpoint, positing price or wage inflexibility was not an acceptable explanation for unemployment.  So Keynes had to argue that, even if wages were perfectly flexible, falling wages would not induce an increase in employment. That was the point of Keynes’s definition of involuntary unemployment as a situation in which an increased price level, but not a fall in money wages, would increase employment. It was in chapter 19 of the General Theory that Keynes provided his explanation for why falling money wages would not induce an increase in output and employment.

Hutt’s insight was to interpret Say’s Law differently from the way in which most previous writers, including Keynes, had interpreted it, by focusing on “supply failures” rather than “demand failures” as the cause of total output and income falling short of the full-employment level. Every failure of supply, in other words every failure to achieve market equilibrium, means that the total effective supply in that market is less than it would have been had the market cleared. So a failure of supply (a failure to reach the maximum output of a particular product or service, given the outputs of all other products and services) implies a restriction of demand, because all the factors engaged in producing the product whose effective supply is less than its market-clearing level are generating less demand for other products than if they were producing the market-clearing level of output for that product. Similarly, if workers don’t accept employment at market-clearing wages, their failure to supply involves a failure to demand other products. Thus, failures to supply can be cumulative, because any failure of supply induces corresponding failures of demand, which, unless there are further pricing adjustments to clear other affected markets, trigger further failures of demand. And clearly the price adjustments required to clear any given market will be greater when other markets are not clearing than when those other markets are clearing.

So, with this interpretation, Hutt was able to deploy Say’s Law in a way that sheds important light on the cumulative processes of contraction and expansion characterizing business-cycle downturns and recoveries. In his modesty, Hutt disclaimed originality in using Say’s Law as a key to understanding those cumulative processes, citing various isolated statements by older economists (in particular a remark of the Cambridge economist Frederick Lavington in his 1921 book The Trade Cycle: “The inactivity of all is the cause of the inactivity of each”) that vaguely suggest, but don’t spell out, the process that Hutt describes in meticulous detail. If Hutt’s analysis was anticipated in any important way, it was by Clower and Leijonhufvud in their paper “Say’s Principle, What it Means and Doesn’t Mean,” (reprinted here and here), which introduced a somewhat artificial distinction between Say’s Law, as Keynes conceived of it, and Say’s Principle, which is closer to how Hutt thought about it.  But to Clower and Leijonhufvud, Say’s Principle was an essential part of the explanation of the Keynesian multiplier.  The connection between them is simple, effective supply is identical to effective demand because every purchase is also a sale.  A cumulative process can be viewed as either a supply-side process (Say’s Law) or a demand-side process (the Keynesian multiplier), but they are really just two sides of the same coin.

So if you have followed me this far, you may be asking yourself, did Hutt really rehabilitate Say’s Law, as he claimed to have done? And if so, did he refute Keynes, as he also claimed to have done? My answer to the first question is a qualified yes. And my answer to the second question is a qualified no. I will not try to justify my qualification to my answer to the first question, except to note that the qualification depends on the assumptions made about how money is supplied in the relevant model of the economy. In a model in which money is endogenously supplied by private banks, Say’s Law holds; in a model in which the supply of money is fixed exogenously, Say’s Law does not hold. For more on this, see my paper, “A Reinterpretation of Classical Monetary Theory,” or my book Free Banking and Monetary Reform (pp. 62-66).

But if Hutt was right about Say’s Law, how can Keynes be right that cutting money wages is not a good way (but in Hutt’s view the best way) to cure a depression that is itself caused by the mispricing of assets and factors of production? The answer is that, for all the care Hutt exercised in working out his analysis, he was careless in making explicit his assumptions about the expectations of workers about future wages (i.e., the wages at which they would be able to gain employment). The key point is that if workers expect to be able to find employment at higher wages than they will in fact be offered, the aggregate supply curve of labor will intersect the aggregate demand curve for labor at a wage rate that is higher, and a quantity that is lower, than would be the case in an equilibrium in which workers’ expectations about future wages were correct. From the point of view of Hutt, there is a supply failure because the aggregate supply of labor is less than the hypothetical equilibrium supply under correct wage expectations. But there is no restriction on market pricing, just incorrect expectations of future wages. Expectations need not be rigid, but in a cumulative process, wage expectations may not adjust as fast as wages are falling. Though Keynes, himself, did not discuss the possibility explicitly, it is also possible that there could be multiple equilibria corresponding to different sets of expectations (e.g., optimistic or pessimistic). If the economy settles into a pessimistic equilibrium, unemployment could stabilize at levels that are permanently higher than those that would have prevailed under an optimistic set of expectations. Perhaps we are now stuck in (or approaching) such a pessimistic equilibrium.

Be that as it may, Hutt simply assumes that allowing all prices to be determined freely in unfettered markets must result in the quick restoration of a full-employment equilibrium. This is a reasonable position to take, but there is no way of proving it logically. Proofs that free-market adjustment leads to an equilibrium are based on some sort of tatonnement or recontracting process in which trading does not occur at disequilibrium prices. In the real world, there is no restriction on trading at disequilibrium process, so there is no logical argument that shows that the Say’s Law dynamic described by Hutt cannot go on indefinitely without reaching equilibrium. F. A. Hayek, himself, explained this point in his classic 1937 paper “Economics and Knowledge.”

In the light of our analysis of the meaning of a state of equilibrium it should be easy to say what is the real content of the assertion that a tendency toward equilibrium exists. It can hardly mean anything but that, under certain conditions, the knowledge and intentions of the different members of society are supposed to come more and more into agreement or, to put the same thing in less general and less exact but more concrete terms, that the expectations of the people and particularly of the entrepreneurs will become more and more correct. In this form the assertion of the existence of a tendency toward equilibrium is clearly an empirical proposition, that is, an assertion about what happens in the real world which ought, at least in principle, to be capable of verification. And it gives our somewhat abstract statement a rather plausible common-sense meaning. The only trouble is that we are still pretty much in the dark about (a) the conditionsunder which this tendency is supposed to exist and (b) the nature of the process by which individual knowledge is changed.

In the usual presentations of equilibrium analysis it is generally made to appear as if these questions of how the equilibrium comes about were solved. But, if we look closer, it soon becomes evident that these apparent demonstrations amount to no more than the apparent proof of what is already assumed[11] . The device generally adopted for this purpose is the assumption of a perfect market where every event becomes known instantaneously to every member. It is necessary to remember here that the perfect market which is required to satisfy the assumptions of equilibrium analysis must not be confined to the particular markets of all the individual commodities; the whole economic system must be assumed to be one perfect market in which everybody knows everything. The assumption of a perfect market, then, means nothing less than that all the members of the community even if they are not supposed to be strictly omniscient, are at least supposed to know automatically all that is relevant for their decisions. It seems that that skeleton in our cupboard, the “economic man,” whom we have exorcised with prayer and fasting, has returned through the back door in the form of a quasi-omniscient individual.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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