Archive for the 'selgin' Category

Two Problems with Austrian Business-Cycle Theory

Even though he has written that he no longer considers himself an Austrian economist, George Selgin remains sympathetic to the Austrian theory of business cycles, and, in accord with the Austrian theory, still views recessions and depressions as more or less inevitable outcomes of distortions originating in the preceding, credit-induced, expansions. In a recent post, George argues that the 2002-06 housing bubble conforms to the Austrian pattern in which a central-bank lending rate held below the “appropriate,” or “natural” rate causes a real misallocation of resources reflecting the overvaluation of long-lived capital assets (like houses) induced by the low-interest rate policy. For Selgin, it was the Fed’s distortion of real interest rates from around 2003 to 2005 that induced a housing bubble even though the rate of increase in nominal GDP during the housing bubble was only slightly higher than the 5% rate of increase in nominal GDP during most of the Great Moderation.

Consequently, responses by Marcus Nunes, Bill Woolsey and Scott Sumner to Selgin, questioning whether he used an appropriate benchmark against which to gauge nominal GDP growth in the 2003 to 2006 period, don’t seem to me to address the core of Selgin’s argument. Selgin is arguing that the real distortion caused by the low-interest-rate policy of the Fed was more damaging to the economy than one would gather simply by looking at a supposedly excessive rate of nominal GDP growth, which means that the rate of growth of nominal GDP in that time period does not provide all the relevant information about the effects of monetary policy.

So to counter Selgin’s argument – which is to say, the central argument of Austrian Business-Cycle Theory – one has to take a step back and ask why a price bubble, or a distortion of interest rates, caused by central-bank policy should have any macroeconomic significance. In any conceivable real-world economy, entrepreneurial error is a fact of life. Malinvestments occur all the time; resources are, as a consequence, constantly being reallocated when new information makes clear that some resources were misallocated owing to mistaken expectations. To be sure, the rate of interest is a comprehensive price potentially affecting how all resources are allocated. But that doesn’t mean that a temporary disequilibrium in the rate of interest would trigger a major economy-wide breakdown, causing the growth of real output and income to fall substantially below their historical trend, perhaps even falling sharply in absolute terms.

The Austrian explanation for this system-wide breakdown is that the price bubble or the interest-rate misallocation leads to the adoption of investments projects and of production processes that “unsustainable.” The classic Austrian formulation is that the interest-rate distortion causes excessively roundabout production processes to be undertaken. For a time, these investment projects and production processes can be sustained by way of credit expansion that shifts resources from consumption to investment, what is sometimes called “forced saving.” At a certain point, the credit expansion must cease, and at that point, the unsustainability of the incomplete investment projects or even the completed, but excessively roundabout, production processes becomes clear, and the investments and production processes are abandoned. The capital embodied in those investment projects and production processes is revealed to have been worthless, and all or most of the cooperating factors of production, especially workers, are rendered unemployable in their former occupations.

Although it is not without merit, that story is far from compelling. There are two basic problems with it. First, the notion of unsustainability is itself unsustainable, or at the very least greatly exaggerated and misleading. Why must the credit expansion that produced the interest-rate distortion or the price bubble come to an end? Well, if one goes back to the original sources for the Austrian theory, namely Mises’s 1912 book The Theory of Money and Credit and Hayek’s 1929 book Monetary Theory and the Trade Cycle, one finds that the effective cause of the contraction of credit is not a physical constraint on the availability of resources with which to complete the investments and support lengthened production processes, but the willingness of the central bank to tolerate a decline in its gold holdings. It is quite a stretch to equate the demand of the central bank for a certain level of gold reserves with a barrier that renders the completion of investment projects and the operation of lengthened production processes impossible, which is how Austrian writers, fond of telling stories about what happens when someone tries to build a house without having the materials required for its completion, try to explain what “unsustainability” means.

The original Austrian theory of the business cycle was thus a theory specific to the historical conditions associated with classical gold standard. Hawtrey, whose theory of the business cycle, depended on a transmission mechanism similar to, but much simpler than, the mechanism driving the Austrian theory, realized that there was nothing absolute about the gold standard constraint on monetary expansion. He therefore believed that the trade cycle could be ameliorated by cooperation among the central banks to avoid the sharp credit contractions imposed by central banks when they feared that their gold reserves were falling below levels that they felt comfortable with. Mises and Hayek in the 1920s (along with most French economists) greatly mistrusted such ideas about central bank cooperation and economizing the use of gold as a threat to monetary stability and sound money.

However, despite their antipathy to proposals for easing the constraints of the gold standard on individual central banks, Mises and Hayek never succeeded in explaining why a central-bank expansion necessarily had to be stopped. Rather than provide such an explanation they instead made a different argument, which was that the stimulative effect of a central-bank expansion would wear off once economic agents became aware of its effects and began to anticipate its continuation. This was a fine argument, anticipating the argument of Milton Friedman and Edward Phelps in the late 1960s by about 30 or 40 years. But that was an argument that the effects of central-bank expansion would tend to diminish over time as its effects were anticipated. It was not an argument that the expansion was unsustainable. Just because total income and employment are not permanently increased by the monetary expansion that induces an increase in investment and an elongation of the production process does not mean that the investments financed by, and the production processes undertaken as a result of, the monetary expansion must be abandoned. The monetary expansion may cause a permanent shift in the economy’s structure of production in the same way that tax on consumption, whose proceeds were used to finance investment projects that would otherwise not have been undertaken, might be carried on indefinitely. So the Austrian theory has never proven that forced saving induced by monetary expansion, in the absence of a gold-standard constraint, is necessarily unsustainable, inevitably being reversed because of physical constraints preventing the completion of the projects financed by the credit expansion. That’s the first problem.

The second problem is even more serious, and it goes straight to the argument that Selgin makes against Market Monetarists. The whole idea of unsustainability involves a paradox. The paradox is that unsustainability results from some physical constraint on the completion of investment projects or the viability of newly adopted production processes, because the consumer demand is driving up the costs of resources to levels making it unprofitable to complete the investment projects or operate new production processes.  But this argument presumes that all the incomplete investment projects and all the new production processes become unprofitable more or less simultaneously, leading to their rapid abandonment. But the consequence is that all the incomplete investment projects and all the newly adopted production processes are scuttled, producing massive unemployment and redundant resources. But why doesn’t that drop in resource prices restore the profitability of all the investment projects and production processes just abandoned?

It therefore seems that the Austrian vision is of a completely brittle economy in which price adjustments continue without inducing any substitutions to ease the resource bottlenecks. Demands and supplies are highly inelastic, and adjustments cannot be made until prices can no longer even cover variable costs. At that point prices collapse, implying that resource bottlenecks are eliminated overnight, without restoring profitability to any of the abandoned projects or processes.  Actually the most amazing thing about such a vision may be how closely it resembles the vision of an economy espoused by Hayek’s old nemesis Piero Sraffa in his late work The Production of Commodities by Means of Commodities, a vision based on fixed factor proportions in production, thus excluding the possibility of resource substitution in production in response to relative price changes.

A more realistic vision, it seems to me, would be for resource bottlenecks to induce substitution away from the relatively scarce resources allowing production processes to continue in operation even though the value of many fixed assets would have to be written down substantially. Those write downs would allow existing or new owners to maintain output as long as total demand is not curtailed as a result of a monetary policy that either deliberately seeks or inadvertently allows monetary contraction. Real distortions inherited from the past can be accommodated and adjusted to by a market economy as long as that economy is not required at the same time to undergo a contraction, in total spending. But once a sharp contraction in total spending does occur, a recovery may require a temporary boost in total spending above the long-term trend that would have sufficed under normal conditions.

George Selgin Asks a Question

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

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

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

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

Here’s how George characterizes the problem.

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

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

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

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

Here’s George’s take on the graph:

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

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

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

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

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

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

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

George later replied on Scott’s blog as follows:

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

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

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

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

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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