Stock Taking on the Cambridge Capital Debate

With a new semester, comes a lot of driving for me (I teach at multiple locations for MOC) and that means I have time to listen to the podcasts of lectures that I haven’t had time for earlier. One of these was Roger Garrison’s excellent lecture on “Macroeconomics: The Boom and Bust Cycle.” The video and mp3 are found here.

During the question and answer period, a question came up on the Cambridge Capital Debate. The debate was started by neo-Ricardian economists like Joan Robinson and Piero Sraffa who argued that there was a mathematical flaw in the Austrian conception of capital. They argued that there could be “capital reswitching.” At a low interest rate, a producer would use method A, but as interest rates rise they would switch to method B—so far, so good. However, they argued that if the interest rate went even higher, then the producer would switch back to method A, hence “reswitching.”

The Austrians debated the neo-Ricardians’ points and this debate is called the “Cambridge Capital Debate.” Why Cambridge? Well, that is where Robinson taught and it was from there that the controversy was launched.

A few years ago, after the article by Cohen and Harcourt (2003) came out I did a little stock taking about the debate and found that there were few very answers to the modern Austrian responses. I have not published them, but kept them for a handy reference. After listening to the question posed to Garrison, I figure that a blog might make an excellent source to cite simply because this controversy has a tendency to come up without any regard for the state of the debate, especially if you are arguing with a Post-Keynesian.

So here are 10 issues that I think the “reswitchers” need to address before the debate can continue:

1. Yeager’s (1979) argument on “waiting” as a component in the production process;
2. Garrison’s (1979) species-reswitching parody;
3. Garrison’s (1979) and Robinson’s (1975) observation that the reswitching differences are very small;
4. Yeager’s (1979) and Garrison’s (1979) observation that there is really no reswitching occurring, but the problem only appears because when we are comparing two static states;
5. Yeager’s (1979) observation that there is no mechanism to “move” the interest rate independently and without a causal factor;
6. Lachmann’s (1978) observation that the debate consists more between the neo-Classicals and the neo-Ricardians, not the Austrians;
7. Lachmann’s (1978) insistence that the problem is with macroeconomic formalism that ignores microeconomic foundations;
8. Lachmann’s (1978) emphasis that there is no single rate of profit or return in the real world;
9. Lachmann’s (1978) observation that the neo-Ricardians do not adequately deal with expectations; and finally
10. Yeager (1979), Garrison (1979) and Lachmann’s (1978) observations that the problem really stems from the fact that the production function is presented as a relationship between physically defined capital inputs.

This last issue is of particular importance. Usually the neo-Ricardian will create an input/output table and shows how much steel, etc. is used in each stage of production. Then the neo-Ricardian assumes that any unit of steel is perfectly substitutable with any other unit of steel. This sort of analysis is not how an Austrian sees the Structure of Production. A ton of steel in an early stage of production is not necessarily substitutable with a ton of steel at a later stage of production. In fact, the same applies to labor and every other type of resource in the production process. Inputs and Capital, in particular, are not transferable homogeneous blobs. There are degrees of complementarity and substitutability that varies with each production process.

In order to bring back the debate, the neo-Ricardians need to respond to the Austrian replies to the reswitching debate. By simply reviewing the literature I have found 10 unanswered issues. I know that there are more. I know that this post is sort of odd, but here are the articles that I have referred to above. I hope that this might help anyone who is stuck in one of these too often recurring debates.

References:
Cohen, A. J. and G. C. Harcourt (2003). “Whatever Happened to the Cambridge Capital Theory Controversies”, Journal of Economic Perspectives. V. 17, N. 1, Winter: 199-214.

Garrison (1979) “Waiting in Vienna”, in Time, Uncertainty, and Disequilibrium, edited by Mario Rizzo.

Garrison (2001) Time and Money: The Macroeconomics of Capital Structure.

Lachmann (1978 [1973]) “Macro-Economic Thinking and the Market Economy”, Studies in Economics No. 6, Institute for Humane Studies.

Robinson (1975) “The Unimportance of Reswitching”, Quarterly Journal of Economics, 89(1), pp. 32-39.

Yeager (1979) “Capital Paradoxes and the Concept of Waiting”, in Time, Uncertainty, and Disequilibrium, ed by Mario Rizzo.

Paul A. Samuelson (1915-2009)

Paul A. Samuelson passed away on Sunday, December 13, 2009. Along side Milton Friedman, John Maynard Keynes and Irving Fisher, he was one of the most significant influences on modern, mainstream economics. His influence is even felt at Mount Olive College. His textbook placed Macroeconomics before Microeconomics, and as a result, our MOC principles of economics classes are ECO 211 Macroeconomics and ECO 212 Microeconomics.

As an Austrian Economist, I think that his popularization of Keynes's theories led the economics profession down the wrong path, that his mathematization of theory was overreaching and in error, that his separating Macroeconomics from Microeconomics is unjustifiable (and Microeconomics should come first), and that his insistence of the superiority Soviet Union's economy over the U.S.'s was just plain wrong. However, he was a brilliant economist and he deserves his due. The official Press Release from MIT is here and an obituary from Robert Higgs is here.

Humpty Dumpty Health Care

“And all the King’s Horses and all the King’s men couldn’t put Humpty together again.”

This children’s nursery rhyme makes a fitting warning. Sometimes, after a sequence of events, there is no going back. Such is the situation with the passage of governmental health care. When the government passes the so-called “public option,” there will be no going back. Why? In economics, we say that we have fallen into a transitional gains trap. A transitional gains trap is one in which it would be better if we had entirely avoided it, but once we are in the trap, there are so many vested interests, there is no escape.

When governmental health care becomes available, new incentives will be created and economic actors (consumers, suppliers, politicians, bureaucrats, special interest groups, etc.) will respond to them. Let’s take a look at each group in turn.

Consumers

Consumers are always comparing benefits and costs at the margin, and we usually don’t even know that we are doing it. When we go to a store was look for deals and specials and decide whether the purchase is “worth it.” By making this appraisement, we are not only signaling our wants and desires, we are also placing a limit on how much of which items we are willing to purchase for these prices. Suppliers react to this information and search for the least cost methods to provide these items and thereby make money.

In a world, where there is a third-party payer, these checks-and-balances disappear. The consumer is no longer constrained by the amount of purchasing power available to himself. He is no longer “writing the check.” Someone else is paying. So the discernment over price, quality and quantity vanishes. The result is a dramatic overconsumption of health care and skyrocketing prices. Once someone else is paying the bill, a resistance to even the idea of paying for these services yourself builds until no one can even remember what it was like to not have a third-party payer. This group is now stuck in the trap.

Suppliers
Suppliers are constantly striving to earn profits. They do so by raising their revenues and by cutting their costs. Raising a company’s revenue is not the easiest thing to do. A company can certainly raise prices, but the consequence to this choice is the reaction made by customers. They will make fewer purchases as the price goes up. There is a limit to the height of prices before revenues diminish. Economists call this relationship “the price elasticity of demand.”

The alternative choice that companies can make is to cut costs. The cutting of costs is a difficult and sometimes painful process. It may require the purchasing of machines that displace workers. Trying to increase internal efficiencies and cutting internal costs requires tenacious dedication and penny pinching. The virtue that comes from this is that resources are seldom wasted. When waste does occur, there is an incentive to correct it and raise profit levels.

When the government enters into the picture, they are not subject to market conditions. Companies are allowed charge “cost-plus-mark-up.” We see this approach in many highly regulated sectors of the economy like water and electric utilities. Under a single payer system, companies that supply medical care will always be able to cover their costs. The incentive to vigilantly cut waste evaporates. In fact, the reverse occurs. There is now an incentive to pad one’s costs. The result is that the financial burden of the health care market multiplies. The companies like not having to compete and hold down costs. They are now stuck in the trap.

Politicians

Economics differs from other fields such as political science when it comes to the basic assumption about the motivation of individuals. Political scientists traditionally ask about “the good, “the just” or “equity” and then assume that the actor in their scenario pursues these goals. The economist assumes that individuals are rationally self-interested. They set their own goals and pursue them in the way that maximizes benefits and minimizes costs. The economist applies this outlook to politicians. We suppose that politicians are no different than the rest of us and pursue their own personal goals. Chief among these goals is the goal of staying in power. I do not think that this is an unreasonable assumption to make about politicians.

The politician stays in power by getting people to vote for him or, at least, by voting against the other guy. If a governmental take over of health care occurs, the politicians in favor of the system will campaign on the platform of expanded the benefits to all who vote for him. At the same time, he will demonize his rival by stating that his opponent will “take away your health care.” The implication of this campaign is that only those who are in favor of a governmentally run system are compassionate and just, while those who are against it want to see people dying in the street. Thus, the political class will have an incentive to maintain and expand the system—even those who were initially opposed to it.

Bureaucrats
A large bureaucracy will be needed to run governmental health care. Those employed by the government obviously have an interest in perpetuating the system, but the incentives are much worse. Bureaucrats are paid by the seriousness of the problem. The larger the problem they are tasked to solve, the more money and resources they command. That translates into nicer offices, more lavish conference locations, etc. They even have a disincentive to actually solve the problem. We see this occurring in the public school system. Failing businesses are liquidated and resources are transferred to more efficient users. In contrast, failing schools get larger budgets and more resources to “fix the problem.”

On a departmental level, we know that budgets are assigned by “need.” “Need” in a bureaucracy is determined by how much it spent the previous year. Thus, there is a strong incentive to spend all of the money in the budget as rapidly as possible so as to increase the future budget. As a result, health care costs spiral and service declines. The bureaucrats are strongly entrenched in the trap.

Special Interest Groups
There is currently an army of special interest groups on Capitol Hill and there is nothing that indicates that the situation will change with the passage of governmental health care. In fact with more power and more money flowing through Washington, we should expect to see an increase in lobbying efforts. We should not be surprised to see lobbying efforts to expand Program X and efforts to include Group A and efforts to cut the out of pocket expenses for Group B. New special interest groups will spring up. And why not? When it is easier to gain by the majority vote of 535 people than by any other means, people will follow the path of least resistance and lobby 535 people. These special interest groups will raise money for those politicians that support them. They will increase the costs to the system. They will actively help perpetuate the trap.

After Humpty Dumpty Falls

The transitional gaps trap is a nasty place to be. There is no easy way out. Once we are in it, the combination of these groups, acting in their own self-interest—basically responding to the incentives before them, diminishes the whole. Unfortunately, the direct cost of getting out of the trap is higher and so we will sink further and further into the trap until the entire system implodes.

It is for these reasons that we must fight as hard as we can to stay out of the trap, because once Humpty Dumpty falls, no one will be able to put him back together again.

The True Meaning of Thanksgiving

This month I was going to write about why Thanksgiving is one of my favorite holidays. Why? It's simple. It is because Thanksgiving represents the triumph of Capitalism over Socialism.

Beating me to the punch this year, is my former Hillsdale College economics professor, Richard Ebeling. He now teaches at Northwood University in Michigan and here is his post.

Enjoy!

The Proper Role of Macroeconomists

Last week Mount Olive College hosted a lecture by an economist from the Federal Reserve District Bank of Charlotte. While he presented several interesting facts, his explanation of why the economy was in a recession was unimpressive. He said that it was as if the economy was riding on a bicycle and it was hit by a car. Since the car has sped away the only thing left to do was attend to the victim. There is no sense leaving that poor guy on the side of the road, because he could die if nothing was done.

Maybe I am reading too much into a single analogy, but I think that this story is very telling about the sort of theory that he is operating under. That is, there is no theory. Where did the car come from? Why did it hit us? Are there other cars? Will they also hit us? Macroeconomists call events such as these “Real Stochastic Shocks.” In other words, these mainstream macroeconomists are saying, “We really have no idea when these shocks will happen or how big they will be. These shocks could be anything: a change in the oil market (think early 1970s), the popping of the dot.com bubble, the bursting of the real estate market bubble, etc. It’s rarely the same thing twice and we really can’t prepare for it. It’s just a part of the world we live in. It’s sort of like a car hitting you from out of the blue. One thing is certain, the shock wasn’t caused by anything that The Fed did or any policy that Congress and the President have been following. They have no culpability in the existence of the business cycle and thank goodness that they are there with the tools to save us from ourselves.”

This modern macroeconomic story is a blending of the Real Business Cycle and the New Keynesian theories. Unfortunately, neither one of these theories is that; they are not theories! Theories are explanations of how the pieces fit together. The fundamental question of what caused the business cycle is, “Is the cause either a random or a non-random occurrence?” If there is a pattern that can be detected, then the causes of the business cycle are not random. Economics is about finding the patterns in human society.

Fortunately there is a pattern that business cycles follow, but it is not one that the politicians and Fed bureaucrats would like to acknowledge. The pattern is this: the central bank of the US (The Fed) artificially lowers interest rates below the rate that a free market would produce. Whenever the price of something is below its equilibrium price a shortage is created. Normally, a capital shortage would be the result, but since the Fed has the power to create money out of a black hole of nothingness, it is able to “paper over the shortage.” Thus, individuals are reducing their savings (lower interest rates encourage consumption spending) and there is an increase in investment spending. This phase is the artificial boom. The problem is that there simply aren’t enough resources to go around. There is a crisis that manifests itself as either a credit crunch or a real resource crunch. The recession is a liquidation process that is a painful but necessary process to clear out all of the built up malinvestments that were launched during the artificial boom. (I have made an analogy where I assigned my students a big paper that is due tomorrow morning at 8am. They then get hyped up on caffeine (boom) and crash (bust) the next morning.)

The bottom line is this: the economy was not hit by a car. It was not some random event that just happens to us. It was not some unavoidable occurrence that happens in a free market economy. No, the blame is to be placed squarely on the shoulders of the central bank and the rest of the Federal Government. They created the bubble. They say that Wall Street was drunk with greed. Fine, but it was the Fed that was supplying the alcohol. Greed is checked by fear—the fear that you’ll lose your shirt. With the bailouts, that fear has dissipated and it will be worse next time.

The culpability of the Fed also means that their “doing more of the same but larger” measures are not only not going to help the economy, but it is making a bad situation worse. The government is claiming that there is a lack of Aggregate Demand in the economy; that there is not enough spending, but we are spending ourselves into a huge hole. The national debt is nearly $12 trillion. The whole US GDP is only $14 trillion! The average credit card debt is around $10,000. How much more deficit spending can we handle? All of this debt is being supported by a massive increase in newly created dollars. The high wire act that the Fed is claiming to be able to pull off is that as the economy improves, they will be able to pull that money back into the big black pit of nothingness before we see prices skyrocket.

The good economist walks a tough road during a recession. He is blamed for the problem and when asked for advice, the good economist basically tells the policy setters to stop what they are doing and don’t do it again. It is a policy of non-interference, and it is a terrible policy for a central bank and government to take, however it is better than its alternatives. It should be remembered that the hardship endured under a non-interference policy does not stem from the policy itself, but from the fact that the economy is in a recession caused by prior economic interventions. When malinvestments are built up during previous expansionary monetary policies, recessions are the necessary consequence. Going to the dentist due to a cavity is not a pleasant experience, but it is a necessary one for the overall health of the individual. Recessions are terrible economic events, but are necessary for the overall health of the economy.

The best means to transform malinvestments into viable economic activities is by increasing savings. This means that one of the government’s most effective policies is to cut taxes on savers. Those who are savers are usually labeled as “the rich.” Unfortunately, the prescriptions of “get government out of the market” or a “tax cut for the rich” tend not to be politically popular. Regardless, it is the duty of the economist to present the truth. The economist cannot state that the government should do nothing. Such a policy was tested in the early 1930s and failed. The modern economist needs to present the case that the government caused the recession and only by removing the government from the equation can the economy truly recover.

Distress Index

The Foundation for Economic Education has asked me to put together a Distress Index. So I quickly threw together five variables to create the index.

There is more detail at the FEE webpage (and a better picture too).

Methodology:
The idea was to keep the index simple, so that no more than a handful of statistics are used, and it was also important that those statistics be relatively uncontroversial. So we relied solely on numbers provided by the Federal Government.

Included Statistics:

Unemployment: Clearly, no “misery” index would be very relevant without considering unemployment. This is pretty self evident.

Consumer Price Index: Like the original “misery” index, we included inflation, even though we are actually in a deflationary period at the moment.

Gross Domestic Product: GDP is the market value of all final goods and services in a particular geographic area over a period of time. It is the most widely recognized measure of the "health" of economy.

Total Capacity Utilization (TCU): This is a measure of the utilization of the all available capital goods. We use the inverse of this number, since higher utilization is generally a good thing. So for instance, if TCU is at 70 percent, we would add 30 percent to our index as a measure of the idle capacity.

Household Financial Obligations as a percent of Disposable Personal Income (HFO/DPI): This measure is intended to gauge the ability of individuals to participate in the consumer economy.

It is important to emphasize that no statistic will ever fully articulate what is happening in the real economy. The real economy is made up of living, breathing, planning, acting individuals. Statistics are simply an abstraction and, as such, imperfect. Nevertheless, we feel this index has substantial value for two reasons.

First, it gives us a tool to help interpret what the media and government are telling us about the economy. Second, we hope it will give voice to the taxpayer and the frustrating conditions he or she is enduring these days. We hope the index will keep pressure on policy makers and opinion leaders to make decisions that improve the economy rather than distressing it further.

After a cursory historical analysis on the index, we can see that the results were pretty impressive. The chart below shows the Distress Index since 1967 with economic recession periods highlighted. There seems to be at least a superficial correlation between the index breaking 45.0 and the economy falling into recession. (Note we have not tested the strength of this correlation). In most cases the index appears to lead the recession’s beginning and end, which would seem to indicate that the index is actually useful in telling us where we are headed, not just where we’ve been.

THE CURRENT DISTRESS INDEX IS 61.0.

Unemployment: 9.7%

CPI: -1.5%

Real GDP: 3.897% (as a % change y-t-y × -1)

TCU: 30.4% (100% - TCU = an Idleness Index)

HFO/DPI: 18.5%

Please feel free to comment and improve this index.

Covering Insurance

A podcast with FEE on this topic is found here.

If you have a television or have listened to talk radio you cannot help but notice the large controversy surrounding the role of government in our health care system. Recently I heard one talk radio caller make the following comment: “I can see that doctors and nurses provide a service, but what does an insurance company add?” The implication was that since insurance companies are not adding anything “real,” they are simply parasitical and could be easily replaced with a government agency.

Today there is a general lack of understanding when it comes to insurance. The word “insurance” has been misused for decades. We have Social Security Insurance, Unemployment Insurance, Medicare Insurance, but none of these programs are actually insurance programs. Many people look at insurance as a Club Membership Discount Card. The thinking is “Once I get the card, I will get health care for less or even for free!” However, this is not what insurance is.

Insurance is about the mitigation and elimination of risk.

It begins with the idea of class risk. Class risk means that we know the statistical probability of an event happening to an individual in a group but we don’t know who in particular it will happen to. So we could know that a certain percentage of MOC students will get into a car accident or get cancer or have their house burn down, but we couldn’t point to someone and say that it would happen to a particular person.

If an individual can influence the probability of the event, then they change their risk class. So if you are a careless driver, then you are a higher risk. And this is why we do not pay insurance claims to arsonists who burn down their own houses.

Insurance is when we all put a small amount of money into a common pot. The winner of the pot is the one who suffers the tragedy. So the guy who gets into a car accident is the winner and gets to pull the money out of the pot. The guy who gets cancer is the winner and the winner is also the guy whose house burns down. The losers are those who are fine. They are not in car accidents nor have any other tragedy befall them. The money the “losers” put into the pot goes to the “winners.” The risk of not being able to pay for the catastrophic event is reduced or eliminated because of the existence of this pool of money.

Suppose that you and your friends have no insurance and there is no social safety net. As a result, you are exposed to risk. If something happens, you are fully liable for the full cost of whatever that has befallen you. Suppose that you are most worried about broken bones. You and your friends are a fairly safe group and the class risk for this group is that one person in the group will break a bone over the course of the year. We don’t know who will break their bone this year but we can predict that it will be one person. So if you and your friends come together and each put a small amount into a fund, then the winner, the person who breaks a bone, gets to pull the money out of the pot to pay the doctor. The small amount that each person puts in is the premium.

Now suppose that another group, a bunch of rugby and lacrosse players, want to join your insurance club. They are of a much higher risk class. They are much more likely to break more bones than anyone in your group.

If they are able to join and pay the same amount as you and your friends, then they will be subsidized by the “losers” of the club. The rugby players will pull money out of the pot at a much faster rate than before. So either the rate they pay will have to go up (because they are in a different risk class), or everyone’s rates will go up (thus transferring more wealth from the losers to the winners), or once the money in the fund is used up, that’s it, and no one can pull money from the pot.

We have moved away from using insurance according to the first choice. Instead, we have been raising rates across the board or have started to ration health care. A few years ago, Massachusetts created a law that requires all people to have medical insurance. Today 95% of the state’s population is covered. The result is that health care gets overused and healthcare gets rationed. The average wait time in the top 15 metro markets for a specialist is 20.5 days. However in Boston it is 49.6 days. (The next highest is Philadelphia with 27.0 days.) This result is even more surprising when it is discovered that Massachusetts has the highest number of doctors per capita in the nation. Rationing means longer waiting times. The waiting times in Canada and the U.K. have become ridiculous.

We have come to look at medical insurance as a discount card or entitlement. It is not surprising that people will use more health care services if they are not directly paying for it. If the funds come from a third-party payer, then why not run that extra test just to be sure or go to the emergency room and see the most expensive doctor? If someone else is footing the bill, then why should I be concerned with how much it costs? And if I do care, can I even find out?

If we decouple insurance from the idea of a free give away or entitlement and return to the idea of risk mitigation, the health care landscape would change for the better. Individuals would be able to buy insurance according to their own needs. If I am worried about broken bones and car accidents but not sickle-cell anemia, then I could get an insurance plan that covers me the way I desire.

Regular doctors visits are not something that insurance should cover because there is no risk to mitigate. As a result the responsibility of buying health services is placed back on to the customer. Consumers are better with spending their money than any bureaucracy. There is no grocery store insurance or clothing insurance and we see that these prices are competitive. And there is a diversity in the markets. On one end of the spectrum there are stores such as Whole Foods and Nordstrom and on the other there are Food Lion and Walmart. And just because you occasionally shop at Nordstrom doesn’t mean you can’t pick up some socks from Walmart.

Today if one has a preexisting condition, he cannot get insurance. Or if he can, it is extremely expensive. Why? It is because we do not have a free market in health care. There is blanket coverage in policies that are organized through employers. (Using employees of a firm doesn’t even make any sense normally. Why would a single firm’s employees all belong to the same risk class for broken bones, etc.? Yet they are all under the same plan!)

Imagine a person who has won the fight against breast cancer. It’s true that the risk of cancer returning is higher than the risk to another person (thus a higher premium for cancer insurance), but why shouldn’t this safety conscious person be able to buy health insurance for broken bones at the same rate as those in your club? Obviously we live in a very skewed system.

A truly free market for health care would have a great diversity in options for all. With consumers spending their own dollars, costs would come down just as they are in the relatively free markets of cosmetic and lasik surgeries.

Insurance companies in a truly free market reduce and eliminate risk; the risk that you will be unable to cover the costs of a medical event. The losers are those that pay in and nothing happens to them. And while the insurance winners are those are able to collect from the pool of funds, in a truly free market for health insurance we are the winners with falling costs and increasing quality. If we turn away from the market and adopt a system that is controlled by bureaucrats and politicians we will all be losers.

A podcast with FEE is found here.