Archive for May, 2022

Hayek and the Lucas Critique

In March I wrote a blog post, “Robert Lucas and the Pretense of Science,” which was a draft proposal for a paper for a conference on Coordination Issues in Historical Perspectives to be held in September. My proposal having been accepted I’m going to post sections of the paper on the blog in hopes of getting some feedback as a write the paper. What follows is the first of several anticipated draft sections.

Just 31 years old, F. A. Hayek rose rapidly to stardom after giving four lectures at the London School of Economics at the invitation of his almost exact contemporary, and soon to be best friend, Lionel Robbins. Hayek had already published several important works, of which Hayek ([1928], 1984) laying out basic conceptualization of an intertemporal equilibrium almost simultaneously with the similar conceptualizations of two young Swedish economists, Gunnar Myrdal (1927) and Erik Lindahl [1929] 1939), was the most important.

Hayek’s (1931a) LSE lectures aimed to provide a policy-relevant version of a specific theoretical model of the business cycle that drew upon but was a just a particular instantiation of the general conceptualization developed in his 1928 contribution. Delivered less than two years after the start of the Great Depression, Hayek’s lectures gave a historical overview of the monetary theory of business-cycles, an account of how monetary disturbances cause real effects, and a skeptical discussion of how monetary policy might, or more likely might not, counteract or mitigate the downturn then underway. It was Hayek’s skepticism about countercyclical policy that helped make those lectures so compelling but also elicited such a hostile reaction during the unfolding crisis.

The extraordinary success of his lectures established Hayek’s reputation as a preeminent monetary theorist alongside established figures like Irving Fisher, A. C. Pigou, D. H. Robertson, R. G. Hawtrey, and of course J. M. Keynes. Hayek’s (1931b) critical review of Keynes’s just published Treatise on Money (1930), published soon after his LSE lectures, provoking a heated exchange with Keynes, himself, showed him to be a skilled debater and a powerful polemicist.

Hayek’s meteoric rise was, however, followed by a rapid fall from the briefly held pinnacle of his early career. Aside from the imperfections and weaknesses of his own theoretical framework (Glasner and Zimmerman 2021), his diagnosis of the causes of the Great Depression (Glasner and Batchelder [1994] 2021a, 2021b) and his policy advice (Glasner 2021) were theoretically misguided and inappropriate to the deflationary conditions underlying the Great Depression).

Nevertheless, Hayek’s conceptualization of intertemporal equilibrium provided insight into the role not only of prices, but also of price expectations, in accounting for cyclical fluctuations. In Hayek’s 1931 version of his cycle theory, the upturn results from bank-financed investment spending enabled by monetary expansion that fuels an economic boom characterized by increased total spending, output and employment. However, owing to resource constraints, misalignments between demand and supply, and drains of bank reserves, the optimistic expectations engendered by the boom are doomed to eventual disappointment, whereupon a downturn begins.

I need not engage here with the substance of Hayek’s cycle theory which I have criticized elsewhere (see references above). But I would like to consider his 1934 explanation, responding to Hansen and Tout (1933), of why a permanent monetary expansion would be impossible. Hansen and Tout disputed Hayek’s contention that monetary expansion would inevitably lead to a recession, because an unconstrained monetary authority would not be forced by a reserve drain to halt a monetary expansion, allowing a boom to continue indefinitely, permanently maintaining an excess of investment over saving.

Hayek (1934) responded as follows:

[A] constant rate of forced saving (i.e., investment in excess of voluntary saving) a rate of credit expansion which will enable the producers of intermediate products, during each successive unit of time, to compete successfully with the producers of consumers’ goods for constant additional quantities of the original factors of production. But as the competing demand from the producers of consumers’ goods rises (in terms of money) in consequence of, and in proportion to, the preceding increase of expenditure on the factors of production (income), an increase of credit which is to enable the producers of intermediate products to attract additional original factors, will have to be, not only absolutely but even relatively, greater than the last increase which is now reflected in the increased demand for consumers’ goods. Even in order to attract only as great a proportion of the original factors, i.e., in order merely to maintain the already existing capital, every new increase would have to be proportional to the last increase, i.e., credit would have to expand progressively at a constant rate. But in order to bring about constant additions to capital, it would have to do more: it would have to increase at a constantly increasing rate. The rate at which this rate of increase must increase would be dependent upon the time lag between the first expenditure of the additional money on the factors of production and the re-expenditure of the income so created on consumers’ goods. . . .

But I think it can be shown . . . that . . . such a policy would . . . inevitably lead to a rapid and progressive rise in prices which, in addition to its other undesirable effects, would set up movements which would soon counteract, and finally more than offset, the “forced saving.” That it is impossible, either for a simple progressive increase of credit which only helps to maintain, and does not add to, the already existing “forced saving,” or for an increase in credit at an increasing rate, to continue for a considerable time without causing a rise in prices, results from the fact that in neither case have we reason to assume that the increase in the supply of consumers’ goods will keep pace with the increase in the flow of money coming on to the market for consumers’ goods. Insofar as, in the second case, the credit expansion leads to an ultimate increase in the output of consumers’ goods, this increase will lag considerably and increasingly (as the period of production increases) behind the increase in the demand for them. But whether the prices of consumers’ goods will rise faster or slower, all other prices, and particularly the prices of the original factors of production, will rise even faster. It is only a question of time when this general and progressive rise of prices becomes very rapid. My argument is not that such a development is inevitable once a policy of credit expansion is embarked upon, but that it has to be carried to that point if a certain result—a constant rate of forced saving, or maintenance without the help of voluntary saving of capital accumulated by forced saving—is to be achieved.

Friedman’s (1968) argument why monetary expansion could not permanently reduce unemployment below its “natural rate” closely mirrors (though he almost certainly never read) Hayek’s argument that monetary expansion could not permanently maintain a rate of investment spending above the rate of voluntary saving. Generalizing Friedman’s logic, Lucas (1976) transformed it into a critique of using econometric estimates of relationships like the Phillips Curve, the specific target of Friedman’s argument, as a basis for predicting the effects of policy changes, such estimates being conditional on implicit expectational assumptions which aren’t invariant to the policy changes derived from those estimates.

Restated differently, such econometric estimates are reduced forms that, without identifying restrictions, do not allow the estimated regression coefficients to be used to predict the effects of a policy change.

Only by specifying, and estimating, the deep structural relationships governing the response to a policy change could the effect of a potential policy change be predicted with some confidence that the prediction would not prove erroneous because of changes in the econometrically estimated relationships once agents altered their behavior in response to the policy change.

In his 1974 Nobel Lecture, Hayek offered a similar explanation of why an observed correlation between aggregate demand and employment provides no basis for predicting the effect of policies aimed at increasing aggregate demand and reducing unemployment if the likely changes in structural relationships caused by those policies are not taken into account.

[T]he very measures which the dominant “macro-economic” theory has recommended as a remedy for unemployment, namely the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection . . . money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour . . . into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained . . . The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing; not because . . . this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate.

Hayek’s point that an observed correlation between the rate of inflation (a proxy for aggregate demand) and unemployment cannot be relied on in making economic policy was articulated succinctly and abstractly by Lucas as follows:

In short, one can imagine situations in which empirical Phillips curves exhibit long lags and situations in which there are no lagged effects. In either case, the “long-run” output inflation relationship as calculated or simulated in the conventional way has no bearing on the actual consequences of pursing a policy of inflation.

[T]he ability . . . to forecast consequences of a change in policy rests crucially on the assumption that the parameters describing the new policy . . . are known by agents. Over periods for which this assumption is not approximately valid . . . empirical Phillips curves will appear subject to “parameter drift,” describable over the sample period, but unpredictable for all but the very near future.

The lesson inferred by both Hayek and Lucas was that Keynesian macroeconomic models of aggregate demand, inflation and employment can’t reliably guide economic policy and should be discarded in favor of models more securely grounded in the microeconomic theories of supply and demand that emerged from the Marginal Revolution of the 1870s and eventually becoming the neoclassical economic theory that describes the characteristics of an efficient, decentralized and self-regulating economic system. This was the microeconomic basis on which Hayek and Lucas believed macroeconomic theory ought to be based instead of the Keynesian system that they were criticizing. But that superficial similarity obscures the profound methodological and substantive differences between them.

Those differences will be considered in future posts.

References

Friedman, M. 1968. “The Role of Monetary Policy.” American Economic Review 58(1):1-17.

Glasner, D. 2021. “Hayek, Deflation, Gold and Nihilism.” Ch. 16 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Batchelder, R. W. [1994] 2021. “Debt, Deflation, the Gold Standard and the Great Depression.” Ch. 13 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Batchelder, R. W. 2021. “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?” Ch. 14 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Zimmerman, P. 2021.  “The Sraffa-Hayek Debate on the Natural Rate of Interest.” Ch. 15 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Hansen, A. and Tout, H. 1933. “Annual Survey of Business Cycle Theory: Investment and Saving in Business Cycle Theory,” Econometrica 1(2): 119-47.

Hayek, F. A. [1928] 1984. “Intertemporal Price Equilibrium and Movements in the Value of Money.” In R. McCloughry (Ed.), Money, Capital and Fluctuations: Early Essays (pp. 171–215). Routledge.

Hayek, F. A. 1931a. Prices and Produciton. London: Macmillan.

Hayek, F. A. 1931b. “Reflections on the Pure Theory of Money of Mr. Keynes.” Economica 33:270-95.

Hayek, F. A. 1934. “Capital and Industrial Fluctuations.” Econometrica 2(2): 152-67.

Keynes, J. M. 1930. A Treatise on Money. 2 vols. London: Macmillan.

Lindahl. E. [1929] 1939. “The Place of Capital in the Theory of Price.” In E. Lindahl, Studies in the Theory of Money and Capital. George, Allen & Unwin.

Lucas, R. E. [1976] 1985. “Econometric Policy Evaluation: A Critique.” In R. E. Lucas, Studies in Business-Cycle Theory. Cambridge: MIT Press.

Myrdal, G. 1927. Prisbildningsproblemet och Foranderligheten (Price Formation and the Change Factor). Almqvist & Wicksell.

Summer 2008 Redux?

Nearly 14 years ago, in the summer of 2008, as a recession that started late in 2007 was rapidly deepening and unemployment rapidly rising, the Fed, mainly concerned about rising headline inflation fueled by record-breaking oil prices, kept its Fed Funds target at the 2% level set in May (slightly reduced from the 2.25% target set in March), lest inflation expectations become unanchored.

Let’s look at what happened after the Fed Funds target was reduced to 2.25% in March 2008. The price of crude oil (West Texas Intermediate) rose by nearly 50% between March and July, causing CPI inflation (year over year) between March and August to increase from 4% to 5.5%, even as unemployment rose from 5.1% in March to 5.8% in July. The PCE index, closely watched by the Fed as more indicative of underlying inflation than the CPI, showed inflation rising even faster than did the CPI.

Not only did the Fed refuse to counter rising unemployment and declining income and output by reducing its Fed Funds target, it made clear that reducing inflation was a more urgent goal than countering economic contraction and rising unemployment. An unchanged Fed Funds target while income and employment are falling, in effect, tightens monetary policy, a point underscored by the Fed as it emphasized its intent, despite the uptick in inflation caused by rising oil prices, to keep inflation expectations anchored.

The passive tightening of monetary policy associated with an unchanged Federal Funds target while income and employment were falling and the price of oil was rising led to a nearly 15% decline in the price of between mid-July and the end of August, and to a concurrent 10% increase in the dollar exchange rate against the euro, a deflationary trend also refelcted in an increase in the unemployment rate to 6.1% in August.

Evidently pleased with the deflationary impact of its passive tightening of monetary policy, the Fed viewed the falling price of oil and the appreciation of the dollar as an implicit endorsement by the markets, notwithstanding a deepening recession in a financially fragile economy, of its hard line on inflation. With major financial institutions weakened by the aftereffects of bad and sometimes fraudulent investments made in the expectation of rising home prices that then began falling, many debtors (both households and businesses) had neither sufficient cash flow nor sufficient credit to meet their debt obligations. Perhaps emboldened by the perceived market endorsement of its hard line on inflation, When the Lehman Brothers investment bank, heavily invested in subprime mortgages, was on the verge of collapse in the second week of September, the Fed, perhaps emboldened by the perceived approval of its anti-inflation hard line by the markets, refused to provide, or arrange for, emergency financing to enable Lehman to meet obligations coming due, triggering a financial panic stoked by fears that other institutions were at risk, causing an almost immediate freeze up of credit facilities in financial centers in the US and around the world. The rest is history.

Why bring up this history now? I do so, because I see troubling parallels between what happened in 2008 and what is happening now, parallels that make me concerned that a too narrow focus on preventing inflation expectations from being unanchored could lead to unpleasant and unnecessary consequences.

First, in 2008, the WTI price of oil rose by nearly 50% between March and July, while in 2021-22 the WTI oil price rose by over 75% between December 2021 and April 2022. Both episodes of rising oil prices clearly depressed real GDP growth. Second, in both 2008 and 2021-22, the rising oil price caused actual, and, very likely, expected rates of inflation to rise. Third, in 2008, the dollar appreciated from $1.59/euro on July 15 to $1.39/euro on September 12, while, in 2022, the dollar has appreciated from $1.14/euro on February 11 to $1.05/euro on April 29.

In 2008, an inflationary burst, fed in part by rapidly rising oil prices, led to a passive tightening of monetary policy, manifested in dollar appreciation in forex markets, plunging an economy, burdened with a fragile financial system carrying overvalued assets, and already in recession, into a financial crisis. This time, even steeper increases in oil prices, having fueled an initial burst of inflation during the recovery from a pandemic/supply-side recession, were later reinforced by further negative supply shocks stemming from Russia’s invasion of Ukraine. The complex effects of both negative supply-shocks and excess aggregate demand have caused monetary policy to shift from ease to restraint, once again manifested in dollar appreciation in foreign-exchange markets.

In September 2008, the Fed, focused narrowly on inflation, was oblivious to the looming financial crisis as deflationary forces, amplified by the passive monetary tightening of the preceding two months, were gathering. This time, although monetary tightening to reign in excess aggregate demand is undoubtedly appropriate, signs of ebbing inflationary pressure are multiplying, and many forecasters are predicting that inflation will subside to 4% or less by year’s end. Modest further tightening to reduce aggregate demand to a level consistent with a 2% inflation rate might be appropriate, but the watchword for policymakers now should be caution.

While there is little reason to think that the US economy and financial system are now in as precarious a state as they were in the summer of 2008, a decision to raise the target Fed Funds rate by more than 50 basis points as a demonstration of the Fed’s resolve to hold the line on inflation would certainly be ill-advised, and an increase of more than 25 basis points would now be imprudent.

The preliminary report on first-quarter 2022 GDP, presented a mixed picture of the economy. A small drop in real GDP seems like an artefact of technical factors, and an upward revision seems likely with no evidence yet of declining employment or slack in the labor market. While noiminal GDP growth declined substantially in the first quarter from the double-digit growth rate in 2021, it is above the rate consistent with the 2% inflation rate that remains the Fed’s policy target. However, given the continuing risks of further negative supply-side shocks while the war in Ukraine continues, the Fed should not allow the nominal growth rate of GDP to fall below the 5% rate that ought to remain the short-term target under current conditions.

If the Fed is committed to a policy target of 2% average inflation over a suitably long time horizon, the rate of nominal GDP growth need not fall below 5% before normal peacetime economic conditions have been restored. Until a return to normalcy, avoiding the risk of reducing nominal GDP growth below a 5% rate should have priority over quickly reducing inflation to the targeted long-run average rate. To do otherwise would increase the risk that inadvertent policy mistakes in an uncertain economic environment might cause sufficient financial distress to tip the economy into recession and even another financial crisis. Better safe than sorry.


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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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