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Someone Out There Is a Flat-Earther, But Who Is It?

Published July 16, 2012 Uncategorized 32 Comments

Since Stephen Williamson posted his criticism of NGDP-targeting last week, a series of responses (here and here) and counter-responses have taken the discussion beyond the mere discussion of a criterion or rule for monetary policy, transforming it into a deep discussion of nothing less than alternative world-views. The catalyst for this shift in the nature of the discussion was Williamson’s use in his first post of the Hodrick-Prescott filter to detrend quarterly GDP data since 1947. Scott Sumner noted in his initial reply to Williamson that the Hodrick-Prescott filter necessarily interprets a downturn occurring at the end of the time series as a shift in, rather than a deviation from, the trend, thereby imposing a particular view of the nature of the recent downturn that might or might not be correct. In my comment on the initial Williamson-Sumner exchange, I noted Scott’s point, and added that an eminent time-series econometrician, Andrew Harvey, had warned about the possibility of spurious results from application of the HP filter, though he did not reject its use as necessarily inappropriate. Brad Delong and Tim Duy picked up on my warnings about the potential for HP filtering to result in spurious results with what seemed like blanket condemnations of the HP filter. This is when Paul Krugman joined the fray, warning that the HP filter could be used to show that the Great Depression reflected not a huge departure from the economy’s potential output and employment levels, but a shift in those levels.

[T]he methodology of using the HP filter basically assumes that such things don’t happen. Instead, any protracted slump gets interpreted as a decline in potential output! Here’s the chart I made way back in 1998 for the 1930s:

Yep: the HP filter “decided” that the US economy was back at potential by 1935. Why? Because it automatically interpreted the Great Depression as a sustained decline in potential, because by assumption the filter incorporated such slumps into its estimate of the economy’s potential. Strange to say, however, it turned out that there was in fact a huge amount of excess capacity in America, needing only an increase in demand to be put back into operation.

It seems totally obvious to me that people who are now using HP filters to argue that we’re already at full employment are making exactly the same mistake. They have in effect, without realizing it, assumed their answer — using a statistical technique that only works if prolonged slumps below potential GDP can’t happen.

As always, statistical techniques are only as good as the economic assumptions behind them. And in this case the assumptions are just wrong.

This attack by Krugman predictably elicited a response from Williamson. The response might have simply noted that applying the HP filter requires the investigator to make assumptions about the frequency of changes in the underlying trend, and that such assumptions ought in some sense to be reasonable. The particular assumption underlying Krugman’s figure was not necessarily reasonable — it didn’t smooth enough — and probably would not be accepted as such by those who like to use the HP filter. Williamson made this point, but he went beyond it, discussing how the HP filter is used within the larger theoretical paradigm known as modern real-business-cycle theory.

I won’t attempt to summarize Williamson’s discussion, but this is the point that I would like to focus on. Real-business cycle theory posits that observed fluctuations in economic time series, like real GDP and employment, can be understood as responses by economic agents to underlying changes in real underlying economic conditions, e.g., changes in labor productivity. Persistent changes in GDP must therefore reflect changes in the underlying real economic conditions, i.e., changes in the trend, while short-term fluctuations around the trend correspond to what we refer to as business cycles. The HP filter smoothes, but does not eliminate, fluctuations in the trend corresponding to persistent changes in the time series. When the time-series show persistent movements, as growth in GDP has shown since the middle of the last decade, even before 2008, real-business-cycle theory assumes that underlying real economic conditions are responsible for a downward change in the underlying trend. There may be transitory changes in the observed time series about the trend, but the trend itself is assumed to have changed. If the trend itself has changed, there is not necessarily any room for policy to make things any better than they are.

It is that view of the world that informs the following statement by Jeffrey Lacker, President of the Richmond Fed, quoted by Williamson:

Given what’s happened to this economy, I think we’re pretty close to maximum employment right now.

Williamson adds:

The “dual mandate” the Fed operates under includes language to the effect that the Fed should try to achieve maximum employment. Lacker says we’re there, and I’m inclined to agree with him.

Noah Smith wrote a splendid post today about Williamson’s post in which he gave the following description of Ned Prescott’s strategy for modeling real business cycles:

  1. Chose how big of a “business cycle” he wanted to model. [By an appropriate parameter choice in the HP filter]
  2. Built a model of business cycles that produced fluctuations of about the size he chose in step A, and
  3. Claimed to have explained the business cycle.

The reason that this is not an entirely circular exercise is that although “the amount of smoothing in the HP filter is a free parameter . . . , if you choose it too big or too small, people will be skeptical. After all, we have other measures of recessions, like the NBER recessions.”

The situation described by Williamson and Smith (who, I should note, is not really a fan of real-business-cycle theory) reminds me of the situation at the time of Galileo, when Galileo was trying to explain to people why they should disregard their common-sense notion that the earth is stationary and flat, and that the sun revolves around the earth. In his famous book, The Structure of Scientific Revolutions, Thomas Kuhn called the clash between Galileo and scientific establishment of his time a clash of paradigms and of world views. Kuhn made the controversial claim that, based on the available evidence at the time, the received Ptolomeic paradigm was empirically better supported the than revolutionary Copernican-Galilean paradigm. Nevertheless, the Copernican-Galilean world view fairly quickly won out, producing a paradigm shift even before Newton provided more powerful evidence than Galileo for the heliocentric paradigm. Each paradigm could still interpret evidence apparently in conflict with its predictions by reinterpreting the evidence. Evidence was interpreted not in some purely objective, neutral way – there is no Olympian perspective from which facts can be objectively determined — but from the perspective of the paradigm that either side was trying to uphold.

Similarly today we are watching a clash between two competing paradigms of business cycles. The received paradigm of business cycles holds that persistent deviations of observed real GDP growth and employment from long-run stable trends are problematic and call for policy responses to eliminate or reduce those deviations. Real-business-cycle theorists reject that understanding of business cycles. If there are persistent deviations of observed real GDP and employment from their long-run trends, it is the trends that must have changed. This difference in world views has, on occasion, been described, misleadingly in my view, as a conflict between Keynesian economics and common sense, and in a post that I wrote almost a year ago, I cited Galileo to show that our common-sense notions are not always infallible.

There is a strong temptation to dismiss real-business-cycle theory simply on the grounds that it seems to fly in the face of our common-sense view that in recessions and depressions, people who would like to work can’t find employment. I think that real-business cycle theory should be dismissed, but to do so will require better reasons than a conflict with our common sense. Remember it was the flat-earthers who were upholding common sense against Galileo. We need more sophisticated arguments than appeals to common sense to dispose of annoying modern real-business-cycle theory.

An Unforeseen Effect of Global Warming?

Published July 13, 2012 Uncategorized 15 Comments

Is the unusually hot summer that we are sweltering through causing a sudden outbreak of nonsense to be written by moderately illustrious economists this week? It all seems to have started with Allan Meltzer, coming from the hard right in Tuesday’s Wall Street Journal, whose outburst provoked this response from me. Then, hard on Meltzer’s heels, there was Martin Feldstein, coming from the moderate right, with this bit of ill-informed pomposity. Marcus Nunes provided a brief, but well-targeted, response to Feldstein’s pontification.

Now, today, we have Jeffrey Sachs, coming from the center-left, in the Financial Times, posing as the voice of reason, rising above the obsolete debates between the irrelevant ideologies inherited from the 1920s and 1930s.

The two sides of the debate live in timeless and increasingly irrelevant ideologies. The prescriptions of free market economics peddled by the Republicans – slash taxes and spending, end financial and environmental regulations – are throwbacks to the 1920s. Today’s free market ideologues are uninfluenced by the lessons of recent history, such as the financial crisis of 2008 or the devastating climate shocks hitting the world with ever-greater frequency and threatening far more than the economy. Their single impulse is the libertarianism of the rich: the liberty to enjoy one’s wealth no matter what the consequences for the economy or society.

The other side is also wide of the mark. In Paul Krugman’s telling, we are in the 1930s.  We are in a depression, even though the collapse of output and rise of unemployment in the Great Depression was incomparably larger and different in character from today’s economic stagnation.

In Krugman’s simplified Keynesian worldview, there are no structural challenges, only shortfalls in aggregate demand. There is no public debt problem. There is no global competitiveness challenge, since “competitiveness” is a myth when applied to national economies. Fiscal multipliers are predictable, timeless, persistent, and large. All growth reversals can be solved through larger deficits. Politicians can be trusted to design short-term stimulus spending programmes of hundreds of billions of dollars. Tax cuts are about as good as increases in government spending, and short-term boosts in spending are about as good as long-term public investments.  Not one of these conclusions stands scrutiny.

Both Krugman and Brad Delong, not surprisingly, are miffed by Sachs’s attack on the Keynesian model as irrelevant to today’s problems. Krugman defends the IS-LM model as a good way of identifying the chief problems preventing the economy from recovering the ground lost since the 2008 downturn. Krugman believes that the key contribution of the IS-LM framework is to focus attention on the zero-lower bound problem. I agree that that is an important problem, and IS-LM identifies it, but I am not so sure that IS-LM is the best way to think about it. In my paper “The Fisher Effect under Deflationary Expectations,” I think that I showed that the simple Fisher equation may provide at least as much insight into the zero lower bound problem as the IS-LM model. And I have also complained, as Sachs does, that our thinking about what to do about our current difficulties should not be restricted to the Keynes-Hayek stereotypes in which economic debates are now so often framed.

But my point in this post is not to argue with Krugman, it is rather to agree with him that Sachs is way, way off base in his argument in today’s Financial Times. Does Sachs really think that a 4% annual rate of growth in nominal GDP since the end of the 2008 downturn is sufficient to support a recovery? Has there been any recovery since the Great Depression that has been associated with a rate of growth in nominal GDP of 4%? I don’t think so. If Sachs thinks that 4% nominal GDP growth is adequate, is he prepared to argue that macroeconomic policy should not aim at a faster rate of growth in nominal GDP? Actually I would be shocked if Sachs does think that 4% growth is adequate, but If he does, then he needs to explain why, rather than engage in the pretense of rising above an irrelevant debate between those who are in favor of policies skewed to favor the wealthy and those who simply want to increase the size of the federal deficit and don’t care about the size of the debt burden. And if he doesn’t think that 4% nominal GDP growth is adequate, then he needs to support policies that would raise nominal GDP growth. Those policies need not be Keynesian policies, but he can’t just ignore the question as he does in today’s very unhelpful contribution to the discussion of economic policy.

George Selgin Asks a Question

Published July 11, 2012 expectations , Keynes , monetary policy , monetary theory , selgin , W. H. Hutt 18 Comments

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

Published July 10, 2012 expectations , inflation , monetary policy 26 Comments

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

Published July 6, 2012 expectations , Fisher equation , Friedman , inflation , monetary policy 22 Comments

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

Published July 4, 2012 Alchian , expectations , Hayek , Keynes , monetary theory , W. H. Hutt 26 Comments

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.

Both Sraffa and Hayek Were Right and Wrong About the Natural Rate of Interest

Published June 28, 2012 expectations , Hayek , monetary theory 30 Comments

Last September, after Robert Murphy and Lord Keynes wrote about the Sraffa-Hayek debate of 1932 about the natural rate of interest, I wrote a post about that controversy in which I took an intermediate position defending Hayek against Sraffa’s charge that his use of the natural-rate concept was incoherent, while observing as well that the natural rate of interest in nominal terms is not unique, because any real intertemporal equilibrium is consistent with any choice of price level and any rate of inflation. The condition for a real intertemporal equilibrium with money is simply that the level and rate of change of prices be foreseen correctly.  In such an equilibrium, own rates could differ, but by no more than necessary to compensate for different real service flows and different costs of storage associated with different assets, inasmuch as the expected net real return from holding every asset must be equal in equilibrium. But while expected real returns from holding assets must be equal, that unique real return is consistent with any nominal return reflecting any arbitrary rate of price change.  It is not by choosing a particular nominal rate of interest — a rate that equals the natural rate — that the monetary authority brings about intertemporal equilibrium.  Rather, it is the consistency between whatever nominal interest rate the monetary authority has chosen and the expectations by economic agents of future prices that is the necessary and sufficient condition for intertemporal equilibrium. Any nominal interest rate can become the natural rate if it is supported by an equilibrium set of price expectations. Hayek almost, but not quite, understood this point. His incomplete understanding seems to have prevented him from responding effectively to Sraffa’s charge that his concept of a natural rate of interest was incoherent based on the potential existence of many different own rates of interest in a barter equilibrium.

As a result of last September’s post about Sraffa and Hayek, my colleague Paul Zimmerman and I wrote a paper about the Sraffa-Hayek debate and Keynes’s role in the debate and his later discussion of own rates in chapter 17 of the General Theory. I gave a talk about this paper at Brock University in St. Catherines, Ontario on Sunday at the annual meeting of the History of Economics Society. At some point in the near future, I hope the paper will be ready to circulate on the internet and to submit for publication. When it is I will provide a link to it on the blog. So it was an interesting coincidence that two days after the conference, the Sraffa-Hayek debate about the natural rate and about own rates was the subject of renewed interest in the blogosphere.

The latest round was started by Andrew Laiton who wrote about multiple own rates of interest. Laiton apparently thinks that there could be multiple real own rates, but seems to me to overlook the market forces that tend to equalize own rates, market forces wonderfully described by Keynes in chapter 17. Nick Rowe followed up with a post in which he seems to accept that real own rates could differ across commodities, but doesn’t think that that matters. All that matters is that the monetary authority choose a particular own rate and sets its nominal rate to match the chosen own rate. (Daniel Kuehn agrees with Nick here.)

Nick is right that there is no natural rate that can be defined apart from a particular choice of a nominal price path for at least one commodity over time. But in an economy with n commodities and t time periods, there are nt possible choices (actually many more possible choices if we take into account all possible baskets of commodities and all possible rates of price change). The job of the monetary authority is to pin down a path of nominal prices.  Given that nominal choice, the natural rate consistent with intertemporal equilibrium would find expression in a particular nominal term structure of interest rates consistent with the equilibrium price expectations of agents. Hayek himself proposed constant NGDP as a possible monetary rule. What Hayek failed to see is that it was the choice of a particular value or time path of nominal GDP that would determine a particular nominal value of the natural rate, not, as Hayek believed, that by choosing a nominal interest rate equal to the natural rate, the monetary authority would ensure that NGDP remained constant over time.

Justice Scalia Is Overruled by Judge Posner

Published June 28, 2012 Uncategorized 7 Comments

Justice Antonin Scalia’s over-the-top outburst in the form of an oral reading of his dissent in Arizona et al. v. United States elicited a stinging rebuke from Judge Richard Posner of the Court of Appeals for the Seventh Circuit. Judge Posner’s rebuke of Justice Scalia is properly receiving a lot of attention, but the attention has been focused chiefly on Judge Posner’s comments on the unseemly political character of Justice Scalia’s outburst. But Judge Posner’s comments on the substantive issues involved in illegal immigration are also worthy of note.

Illegal immigration is a polarizing political and social issue. Many people hate illegal immigrants. Others regard them as an indispensable part of the American labor force. There are 10 million to 11 million illegal immigrants (for rather obvious reasons no one knows the exact number), and illegal immigrants are thought to amount to about 5 percent of the total labor force. Because they tend to do jobs that few Americans want, and because their wages are below average, many (though by no means all) economists believe that the illegal immigrants actually increase the wages of Americans (including legal immigrants). The reason is that the existence of a large body of low-wage workers increases the demand for goods and services both by reducing the cost of production and by their own purchases as consumers, and increased demand for goods and services translates into increased demand for labor and hence higher wages. This is not a certainty but seems a good guess of the effect of illegal immigrants. Illegal immigrants do receive some social services, but fewer than citizens do. It is unclear whether they commit more crimes on average than citizens; they may commit fewer. Of course, some illegal immigrants are criminals, and the Obama administration has decided to focus the very limited resources of the federal immigration enforcement authorities on catching and deporting the criminals. Focusing on them and leaving the law-abiding (law-abiding except for the immigration law itself!) illegal immigrants seems a defensible policy. And certainly state and local law enforcement can assist the feds in apprehending illegal immigrants who commit crimes (being in this country without legal authorization is unlawful, but, with some exceptions, it is not criminal); nothing in the Arizona decision prevents that.

In his peroration, Justice Scalia says that “Arizona bears the brunt of the country’s illegal immigration problem. Its citizens feel themselves under siege by large numbers of illegal immigrant who invade their property, strain their social services, and even place their lives in jeopardy.” Arizona bears the brunt? Arizona is only one of the states that border Mexico, and if it succeeds in excluding illegal immigrants, these other states will bear the brunt, so it is unclear what the net gain to society would have been from Arizona’s efforts, now partially invalidated by the Supreme Court. But the suggestion that illegal immigrants in Arizona are invading Americans’ property, straining their social services, and even placing their lives in jeopardy is sufficiently inflammatory to call for a citation to some reputable source of such hyperbole. Justice Scalia cites nothing to support it.

As of last year there were estimated to be 360,000 illegal immigrants in Arizona, which is less than 6 percent of the Arizona population—below the estimated average illegal immigrant population of the United States. (So much for Arizona’s bearing the brunt of illegal immigration.) Maybe Arizona’s illegal immigrants are more violent, less respectful of property, worse spongers off social services, and otherwise more obnoxious than the illegal immigrants in other states, but one would like to see some evidence of that.

PS I notice that one blogger points out that Judge Posner’s arithmetic is off.  If the total number of illegal immigrants is 10-11 million, then illegal immigrants are approximately 3% of the US population, so that Arizona has a significantly higher ratio of illegal immigrants to its population than does the US as a whole.  Still, if the number of illegal immigrants in Arizona were equal to only 3% of Arizona’s population, there would be about 200,000 illegal immigrants in Arizona.  That Arizona may have an extra 160,000 illegal immigrants compared to the national average is not quite the same as “bear[ing] the brunt of the illegal immigration problem.”

The Bank for International Settlements Falls into a Hayekian Trap

Published June 27, 2012 Great Depression , Hayek , monetary policy 9 Comments

On April 9, 1975, F. A. Hayek, having recently received the Nobel Prize in economics, was invited to give a talk to a group of distinguished economists at the American Enterprise Institute in Washington DC. He was introduced by his old friend and colleague from Vienna, Gottfried Haberler. During his talk, Hayek pointed out that although a downturn can be triggered by microeconomic factors causing a lack of correspondence between the distribution of demand across products and industries and the distribution of labor across products and industries.

These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due ot some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, somewhat misleadingly, we call an equilibrium structure, and second, that labor is reallocated according to these new prices.

Lacking such price readjustment and resource reallocation, the original unemployment may then spread by means of the mechanism I have discussed before, the “secondary contraction,” as I used to call it. In this way, unemployment may eventually become general.

In the subsequent discussion, Haberler asked Hayek to elaborate on the concept of a “secondary contraction,” and the appropriate policy response to such a phenomenon. Haberler asked:

I was very glad you said that you find some justification in the view that depressions are aggravated by a cumulative spiral and that there is such a thing as a secondary deflation. Don’t you think that it is possible to do something about that aggravation without recreating the fundamental maladjustments which, in your opinion, caused the depression.

Hayek replied:

I hope I implied this. The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose.

Later in the discussion, Haberler again pressed Hayek on his position regarding a downward deflationary spiral such as occurred in the 1930s. Hayek responded to Haberler as follows:

You ask whether I have changed my opinion about combatting secondary deflation. I do not have to change my theoretical views. As I explained before, I have always thought that deflation had no economic function; but I did once believe, and no longer do, that it was desirable because it could break the growing rigidity of wage rates. Even at that time I regarded this view as a political consideration; I did not think that deflation improved the adjustment mechanism of the market.

In a terrific commentary on the recent annual report of the Bank for International Settlements, Ryan Avent disposes of the arguments offered by the BIS for tightening current monetary policies.

I was especially struck by the following passage, quoted by Avent, from the report.

Although central banks in many advanced economies may have no choice but to keep monetary policy relatively accommodative for now, they should use every opportunity to raise the pressure for deleveraging, balance sheet repair and structural adjustment by other means.

Here, in another, slightly less ferocious, guise, is the deflationary argument that Hayek himself disavowed nearly 40 years ago:  that secondary deflation could be used to “break the growing rigidity of wage rates,” or in updated BIS terminology could “raise the pressure for deleveraging, balance sheet repair and structural adjustment.”

Plus ca change, plus c’est la meme chose.

Money Wages and Money Illusion

Published June 27, 2012 Alchian , Earl Thompson , expectations , monetary theory 6 Comments

A couple of weeks ago, in the first of three posts about Armen Alchian’s discussion of the microeconomic underpinnings for Keynesian involuntary unemployment, I quoted the following passage from a footnote in Alchian’s classic paper, “Information Costs, Pricing, and Resource Unemployment.”

[C]onsider the following question: Why would a cut in money wages provoke a different response than if the price level rose relative to wages – when both would amount to the same change in relative prices, but differ only in the money price level? Almost everyone thought Keynes presumed a money wage illusion. However, an answer more respectful of Keynes is available. The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen. A cut only in one’s present job is revealed. The money versus real wage distinction is not the relevant comparison; the wage in the present job versus the wage in all other jobs is the relevant comparison. This rationalizes Keynes’ definition of involuntary unemployment in terms of price-level changes. If wages were cut everywhere else, and if employees knew it, they would not choose unemployment – but they would if they believed wages were cut just in their current job. When one employer cuts wages, this does not signify cuts elsewhere. His employees rightly think wages are not reduced elsewhere. On the other hand, with a rise in the price level, employees have less reason to think their current real wages are lower than they are elsewhere. So they do not immediately refuse a lower real wage induced by a higher price level, whereas they would refuse an equal money wage cut in their present job. It is the revelation of information about prospects elsewhere that makes the difference.

Saturos made the following comment on that post:

“The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen.”

But that is money illusion. If my money wage rises by less than inflation, that says nothing about whether other money wages have risen by less than inflation. There is no explanation for a separate behavioral response to a cut in one’s observed real wage through nominal wages or prices – unless workers are observing their nominal wages instead of their real wages, i.e. money illusion.

I gave only a cursory response to Saturos’s comment, though I did come back to it in the third of my series of posts on Alchian’s discussion of Keynesian unemployment. But my focus was primarily on Alchian’s discussion of the validity of the inflation-induced-wage-lag hypothesis, a hypothesis disputed by Alchian and attributed by him to Keynes. I discussed my own reservations about Alchian’s position on the wage lag in that post, but here I want to go back and discuss Saturos’s objection directly. My claim is that there is a difference between the assumption that workers observe only nominal, not real, wages, in the process of making decisions about whether to accept or reject wage offers and the assumption of money illusion.

Here is how to think about the difference. In any period, some workers are searching for employment, and presumably they (or at least some of them) can search more efficiently (i.e., collect more wage offers) while unemployed than employed.  In obtaining wage offers, workers can only observe a nominal wage offer for their services; they can’t observe a real wage, because it is too costly and time-consuming for any individual to collect observations for all the goods and services that enter into a reasonably comprehensive price index, and then compute a price level from those price observations. However, based on experience and other sources of information, workers, like other economic agents, form expectations about what prices they will observe (i.e., the prices that will clear markets). In any period, workers’ wage expectations are determined, in part, by their expectations of movements in the general price level. The higher the expected rate of inflation, the higher the expected wage. The absence of money illusion means that workers change their expectations of wage offers (given expectations about changes in real wages) in line with their expectations of inflation. However, within any period, workers’ expectations are fixed. (Actually, the period can be defined as the length of time during which expectations are held fixed.) This is simply the temporary-equilibrium construct introduced by Hicks in Value and Capital and again in Capital and Growth.

With expectations fixed during a given period, workers, observing wage offers, either accept or reject those offers by comparing a given nominal nominal wage offer with the nominal reservation wage settled upon at the beginning of the period, a reservation wage conditional on the expectation of inflation for that period formed at the beginning of the period. Thus, the distinction made by Alchian between the information conveyed by a nominal-wage cut at a constant price level versus the information conveyed by a constant money wage at an unexpectedly high price level is perfectly valid, and entails no money illusion. The only assumption is that, over some finite period of time, inflation or price-level expectations are held constant instead of being revised continuously and instantaneously. Another way of saying this is that the actual rate of inflation does not always equal the expected rate of inflation. But to repeat, there is no assumption of money illusion. I am pretty sure that I heard Earl Thompson explain this in his graduate macrotheory class at UCLA around 1972-73, but I had to work through the argument again for myself before remembering that I had heard it all from Earl about 40 years earlier.

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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