New EconStories Video--Deck the Halls with Macro Follies

Our friends at EconStories have produced another hit: "Deck the Halls with Macro Follies."  Enjoy!

Which Economists Show Support for Obama's Plan?

Today there was an article by Derek Kravitz on the AP which was entitled as "Economists Show Support for Obama Job-Growth Plan".  Now which economists are those?  Well, he quotes Mark Zandi of Moody's Analytics, Allen Sinai, chief economist of Decision Economics, Susan Wachter, a finance professor at the University of Pennsylvania's Wharton School, Michael Mandel, chief economic strategist for the Progressive Policy Institute, Paul Ashworth, chief U.S. economist at Capital Economics and Menzie Chinn, an economist at the University of Wisconsin.  (Personally, I have only heard of Zandi before and I think he usually has it wrong.)  Amazingly they say that more stimulus is what is needed.  Well, maybe not Mandel.  (Kravitz is not very clear on this point.)  And Ashworth says that people might just save it instead of running out and spend, spend, spending it.  (How horrible!)  However, as we see by the article's title, the whole point is to show how much economists love Obama's plan.  In fact, Chinn says that the plan doesn't go far enough.

Here's the commonality: they are all locked into the formula GDP = C + I + G + (X-M).  In other words, the size of the economy is equal to Consumption + Government Spending + Investment + Net Exports.  Of these components, they rightly see that consumption is by far the largest. 

The only problem with this approach of looking at the macroeconomy is that it is completely wrong. 

GDP is defined as the summation of all final goods and services in an economy over a certain period of time, usually a quarter or a year.  Only final goods and services are counted because we do not want to double count.  In other words, when we make a table, we don't want to count the table when we chop down the tree, and count it again when we turn it into boards, and again when we construct the table and then again when it goes to the wholesalers, and so on.  It's one table and we only want to count the one table once.  Fine.  That makes perfect sense; however most economic activity does not take place at the final stages of production.  That's the "Do you want fries with that?" stage.  Most people and most economic activity are not there. 

So what is a better approach?  The Austrian Approach is, by far, better.

We need to disaggregate the Capital Structure--The Structure of Production.  Only by viewing the economy as a process of production can we get an idea of how the economy works, and more importantly, how it grows.

The economy does not grow because people simply "demand" stuff.  Think about it.  Do you demand more than your parents, or grandparents, or people who lived 1,000 years ago?  Are we rich in the US because we simply want things more than those who came before us?  Ridiculous!  So, if it isn't demand that has caused us to be wealthy, then it must be that other thing that economists talk about--supply.

Yes, it is supply that allows us to be wealthy.  Now, let's pause as before and think about this point too.  Could it possibly be that more stuff is what allows us to have more stuff?  Duh!  Yes of course it is.  Supply has always been the limiting factor, not demand.  Thus, we need to focus our attention on production. 

In order to get out of these economic doldrums, we need to produce more.  It is only through production that we will be able to grow.  So how do we grow when starting from a depressed economy?  We need to let the costs of production fall.  We need to stop propping up prices and let them fall.  As input prices (yes, this includes wages) fall, profitability will rise.  As profitability rises, there will be more economic activity from both existing companies and new rivals.

The bottom line is that the business sector needs to cut its costs.  We could let input prices fall (commodity prices are still fairly high); we could let nominal wage rates fall; and we could reduce the costs of keeping up with rules and regulations.  Additionally, imagine how much productive energy would be released if we simply abolished the corporate income tax.  All those wasted hours converted into productive activity.  A zero corporate income tax would attract capital from all over the world to the US.  The first country to do this will be the big winner and then other countries will have to do the same to remain competitive.  Instead of implementing Frank-Dodd and ObamaCare, we should repeal these and even more regulatory burdens.  What a boon to business and the economy!  Production will grow and with it, the economy. 

And remember, consumption, jobs and prosperity are a consequence of production, they are not the reason for it.

Keynes vs. Hayek Round Two Video

The long awaited sequel to the Keynes vs. Hayek rap is out.
Enjoy.



Here is the original first video:

Austrian Economics Forum Spring 2011 #4--Austrian B-Cycle

***I know that it has been some time since the last Austrian Economics Forum update.  The reason is that I missed a session.  I heard that it was nice.  Everyone went outside and sat on the grass and discussed economic theory.  The lesson is, of course, never to miss an AEF meeting!***

This session's discussion centered on two readings: Richard E. Wagner, "Austrian Cycle Theory: Saving the Wheat while Discarding the Chaff" The Review of Austrian Economics, 12(1), 65-80, 1999; and Walter Block, "Yes, We Have No Chaff: A Reply to Wagner's 'Austrian Cycle Theory: Saving the Wheat While Discarding the Chaff'" The Quarterly Journal of Austrian Economics, 4(1), 63-73, 2001.

I was rather disappointed by both of these articles. 

The first thing that caught my attention was the very condescending tone of the Wagner article.  He refers several times to the "canonical" version of the Austrian Business Cycle Theory (ABCT).  It is as if he thinks that there is no independent thought among Austrians, that there is no debate, and that if one doesn't hold to the "cannon" then they are out of the Austrian club.  How ridiculous!  It's insulting and demeaning.

There are two major criticisms that Wagner puts forward in opposition to the ABCT.  They have both been argued and reargued for decades.  Wagner is apparently unaware of these debates or he simply has chosen to ignore them.

The first criticism can actually be traced to Gottfried Haberler.  Haberler wrote a summary of the different theories of the business cycle for the League of Nations.  This work was then converted into the book Prosperity and Depression (1937).  Joe Salerno presented a paper at the 2011 Austrian Scholars Conference on Haberler's portrayal of the ABCT.  Salerno makes the point that Haberler mistakes the malinvestment theory for one of an inefficient use of resources.

Here is Haberler's story.  The Central Bank expands credit and pushes down interest rates.  As a result, entrepreneurs are misled into investing in the earlier stages of production.

So far the story is right, but it is missing an important element.  Haberler's story is that we start with the Structure of Production at point A.  When the new, (lower) interest rates emerge, we slide out to point B.  When the market recognizes the mistake, we slide to back to point A.  Thus Haberler and those who have followed his characterization of the ABCT have dismissed the ABCT as an inadequate theory.  If this were all that the ABCT was, then I would also dismiss it as a simple theory of a misallocation of resources and the resetting of them.

The ABCT is not simply a theory that sloshes capital goods from late stages of production to earlier stages and back again.  What Haberler is missing is the bi-directional signal of the interest rate.  The ABCT is a theory that contains both malinvestment at the higher stages of production and overconsumption!  The modern, Garrisonian version looks like this:

Here we see what John Cochran calls "The Dueling Structure of Pro- duction."  (See QJAE 4(3), p. 19, 2001.)  When the interest rate falls it sends a signal not only to investors and entrepreneurs to invest more.  It also tells consumers that the return on savings has fallen.  As a result, income saved falls and income consumed rises.  Thus, the structure of production is split and torn apart in two directions.  For the mainstream macroeconomist, he sees C (consumption) and I (investment) increasing together, which is solid GDP growth.  Unfortunately, this information is misleading.  The modern macroeconomist is misled due to the overaggregation of his statistics.

The invested capital also has various degrees of specificity and substitutability.  As a result, the conversion of the malinvestment into sustainable capital structures can be long and difficult.  It is that conversion process that is the recession.

The second objection that Wanger raises against the ABCT centers on expectations.  There is an old objection to the ABCT that says, "if people knew the ABCT, then when they look at the actions of the Central Bank, they could adjust and avoid the Boom and the Bust."  This logic is built upon Haberler's mischaracterization of the ABCT.  The ABCT is not about sectoral shifts in resources.  It is about soldifying liquid capital into specific production methods and then breaking them up as the malinvestments are revealed.  Furthermore, the Austrians model money as being non-neutral and so even if an entrepreneur had the knowledge of what has happening, the Cantillon effects are unavoidable.

Block centers his criticism of the Wagner article on this particular point.  The best argument he makes is that, "those who shift resources from the lower to the higher orders of production [will do so] in response to a lowering of the loan rate of interest, even if they know this emanates from Fed machinations, not a change in time preference, and thus [it] can only be temporary."  While the argument is correct, Block does not hammer the point. 

In my opinion the best explanation on why entrepreneurs must expand with lower credit, even if they know that it will lead to a boom / bust cycle, is found in Carrilli and Dempster, "Expectations in Austrian Business Cycle Theory: An Application of the Prisoner's Dilemma," The Review of Austrian Economics, 14(4), 2001.  They set the problem up as a prisoner's dilemma in which the global solution may look like no one should borrow the new credit and invest, but the local solution is that they must.  With money being injected sequentially into the economy and injected at specific points, the non-neutral Cantillon effects show that those who get (and use) the new money first are the big winners.  Those who get the money last (or choose not to use it) lose.

In Defense of Economists

It’s that time of the year, Christmastime. This is the time of year when people say that the spirit of Christmas should center on giving and not on receiving. Two of the top Classic Christmas cartoons are “A Charlie Brown Christmas” and “How the Grinch Stole Christmas.” They both have the same moral. Materialism is bad. They say that we should stop focusing on the stuff and look to the deeper, true meaning of Christmas.

It is at this point that economists get scorned. Many, too many, think that economics (and by default economists) is all about (and only about) stuff, and consuming stuff in particular. Economists have pointed out that many firms don’t break even until the first day after Thanksgiving. It is the day when many firms climb out of the red and into the black, hence “Black Friday.” The implication is that if we didn’t have Christmas and all the buying of (needless?) stuff that goes along with it, then many of our businesses would never see an annual profit. Furthermore, Keynesian economists have defined the size of the economy, GDP, in a way that emphasizes consumption. The formula for GDP is consumption spending + investment spending + government spending + spending on net exports. Of these factors, consumer spending is the largest and if that dips, then so does our measurement of GDP. Therefore, too many people conclude that we should spend, spend, spend, and economists are accused of being the chief cheerleaders for this. While there are some economists that in fact cheer on consumption for consumption’s sake, Austrian economists do not.

To an Austrian economist, economics is a value-free (or value-neutral) science. The Austrian economist should not care if the economy is rapidly expanding, slowly growing or even contracting. His job is to study the economy and try to figure out how it works. If someone asks the Austrian economist, “Will this policy enhance or diminish future growth,” the answer is not the economist injecting his own values into the debate. This is what Mises and Kirzner mean by economics being a “Wertfreiheit” or value-neutral science. As an individual, the economist can step out of his role as a value-neutral scientist and suggest goals such as economic growth or unemployment reduction. However as an economist, as a scientist, it really should not matter if a person or a society consumes at a high rate or saves at a high rate. So it is rather silly to assume that all economists are cheerleaders for materialism and ever expanding rates of consumption.

To an Austrian economist, economic growth does not mean that there has to be more stuff. Austrian economics has long taught that value is subjective and cannot be compared between individuals. Thus, an economy may be better off if it takes fewer resources and less time to make the same amount of stuff. This is certainly true for individuals. We call that free time, or leisure hours. If you got the same pay for working fewer hours, would you consider yourself better off? Now imagine that for the entire economy. We are clearly better off, but not consuming more stuff.

That being said, as an Austrian economist and as a thinking individual, I prefer higher rates of future economic growth. Although to an Austrian economist, expanding future economic growth does NOT mean expanding our rates of consumption today. In fact, it means exactly the opposite. For the economy to grow in the future, it will need capital. In order for capital to be freed up for more roundabout production methods, more resources must be invested instead of consumed. In other words, that means there must be an increase in savings, not consumption.

These new methods of production are more complex and more roundabout, but are used because they either cut down on the amount of resources needed, cut down on the amount of work hours needed, or both. This process frees us up to do more or allows us enjoy leisure time. It is a major benefit of growing economy. It allows us to take time off and enjoy the Christmas holiday. Without a market economy, our holiday might not be as cheery or bright.

So have yourself a very merry Christmas, and think about the benefits that a market economy provides. I know I will.

Cwik Interview on Mises.Org

In yet another shamless promotion of myself, my interview by the Mises Institute has been posted to their web site.  I think they have done a nice job.

They started with some easy questions, but then there were some that I had to do some thinking about. 

The link is here:  http://blog.mises.org/14889/faculty-spotlight-interview-paul-cwik/

I hope you enjoy it.

Hayek vs. Keynes Rap Sequel Preview

Earlier this year a rap video between Hayek and Keynes called "Fear the Boom and Bust" was posted on YouTube.  It was wildly successful.  You can find it here. With all good things, a sequel is in the works.  Here is a sneak peak of a live duel between Hayek and Keynes.

Austrian Economics Reading Group Session 6 Spring 2010

The last two readings were Murray Rothbard’s “The Austrian Theory of Money” and O’Driscoll and Shenoy’s “Inflation, Recession, and Stagflation.”

Rothbard’s article touches upon several issues: Non-Neutral Money, Mises’ Regression Theorem, the absence of money in an ERE, future issues to explore, and the definition of money.

The non-neutrality of money is one of the most important contributions that the Austrian School has made to the field of Macroeconomics. Unfortunately, it has almost been universally ignored by the mainstream. It is easier to define neutral money and then compare non-neutral money to it. Neutral money is the idea of money having no real effects when it is injected into the economy. The neutral money theorists usually assume a magical helicopter that doubles the money supply over night. People wake up to see that they all have more money, but since everybody has double, nothing real is affected. All that happens is a doubling of prices. Non-neutral money states that such a story is not only wrong, but dangerously misleading. Money is, instead, injected into the economy at specific points and then spreads out from those injection points. The people with the new money are able to enter into the market at current prices and use the new money to bid resources away from their alternative resources. In a stepwise, sequential fashion, prices rise but not in a uniform manner. Those that get the new money first benefit and those who see prices rise, but do not have the new money lose real wealth. In other words, there is a real wealth transfer from those who get the new money last to those who get the new money first.

Mises’ Regression Theorem is the solution to what was called “The Austrian Circle.” When looking to apply marginal utility theory to money, it is noticed that people hold money, not because they use it as a good, but because it is the medium of exchange. In other words, they hold on to it because of its exchange value. Money is held because it has preexisting purchasing power. As Rothbard asks, “if the demand for, and hence the utility of, money depends on its preexisting price or purchasing power, how then can that price be explained by the demand?”

The solution is what is called The Regression Theorem. Mises argued in The Theory of Money and Credit that we need to go back to the point where this commodity money has not yet money. On the day before it was money, it had use value. Then on the next day it had both use value and exchange value. Thus there is no discontinuity as exchange value grows.

Rothbard also pointed out that in a world of perfect knowledge, there is no need for money. Some of the future issues that Rothbard suggests exploring are (1) How to return to gold; (2) free banking vs. 100% reserves; and (3) how should we really measure the money supply. It was on this last point that Rothbard’s America’s Great Depression received its most significant criticism. Obviously, this is a topic for further discussion.

The second essay presents the standard Austrian Business Cycle Theory (ABCT). While this was written in the mid-1970s, it presents the core in a comprehensive manner. Nevertheless, when considering the different areas of Austrian Economics, it is clear that the ABCT has been tremendously improved upon. There are really three levels of exposition of the ABCT today. The first is the basic story placed in the context of artificial boom leading to bust. I have done this here. Then there is the undergraduate level that is found in Roger Garrison’s Time and Money. Then there are the graduate-level articles written in the journals like The Quarterly Journal of Austrian Economics and The Review of Austrian Economics.

Overall, the NCSU Austrian Forum was good. I look forward to next semester’s line up. I am hoping that there will be more students to attend the sessions, but for me the benefit is from forcing myself to read.

Unfortunately we did not cover the text completely, but you are welcome to comment on the remaining articles in this forum.

Hayek vs. Keynes: "Fear the Boom and Bust"

This is a very nicely done video that, while entertaining, covers the key differences between the Austrian and Keynesian business cycle theories.

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.