Milton Friedman summarised Keynes as follows

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Central banks ignore modern macroeconomics

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Why is Austrian business cycle theory held to such a high-bar?

I find it surprising that so many concentrate on rational expectations when discussing Austrian business cycle theory (ABCT). Is Austrian business cycle theory the only modern business cycle theory that must reach such a high bar?

Many modern business cycle theories build on information costs and learning and explain that people make forecasting errors because of noisy information, and repeated monetary shocks keeping up this confusion.

A good general explanation of misperceptions theories of business cycle is in Alchian and Allen (1967), which Murray Rothbard called a brilliant textbook. The business cycle is not based on money illusion or on systematic mistakes.

People take time to acquire the necessary information to interpret what has shocked the economy and what these changes mean for them. Additional shocks complicate this learning so there are more errors and confusion continues to affect market choices. Learning is neither instantaneous nor is the requisite information free to collate. People must make do with the incomplete knowledge they have and make choices about market signals that might be spurious or be meaningful signs of change.

Mises, Hayek, and Rothbard all noted in the collection edited by Garrison, for example, that a one-shot monetary shock would be soon uncovered by entrepreneurs, the malinvestments quickly reversed, and the boom would bust. Monetary shock after monetary shock require repeated entrepreneurial revisions and it will take a long time for entrepreneurs to catch up. This is also in Alchian and Allen.

Rothbard (MES pp. 1002-1005) discusses one-time versus repeated and increasingly large in size monetary shocks as the basis for booms and the reasons for the on-going deception of entrepreneurs. The shocks must increase in size to keep injecting more unanticipated noise into monetary and entrepreneurial calculations.

ABCT proposes a more complicated signal extraction problem than in say the Lucas-Phelps islands model. Dispersed and slowly unfolding information must be produced as each new monetary shock ripples its own unique way across the economy, passing through different hands each time. Only slowly does the requisite knowledge about the relative prices effects of each new monetary shock emerge as the result of market interactions and become open to entrepreneurial discovery.

What is perhaps dismissed too easily by Rothbard (but not Mises) is that under a gold standard, increases in the output of gold mining can be well forecasted by entrepreneurs. Rothbard’s best ground is when he notes that "the credit expansion tampered with all their [entrepreneurs’] moorings." A stop-go monetary policy is by definition unpredictable. Gold output fluctuations are irregular but usually small. A unique contribution of ABCT is that the longer the boom, the deeper the bust.

Groundhog Day for economic forecasters – The Grumpy Economist

via The Grumpy Economist: Groundhog Day.

Wrong from the start – Joseph Stiglitz

A man of his times, back in 1996, smoking Joe Stiglitz used to be an admirer of the Japanese banking system because of its long-range thinking and lending

Cooperative behaviour between firms and their banks was also evident in the operations of capital markets.

In Japan each firm had a long-standing relationship with a single bank, and that bank played a large role in the affairs of the firm.

Japanese banks, unlike American banks, are allowed to own shares in the firms to which they lend, and when their client firms are in trouble, they step in. (The fact that the bank owns shares in the firm means that there is a greater coincidence of interest than there would be if the bank were simply a creditor; see Stiglitz 1985.)

This pattern of active involvement between lenders and borrowers is seen in other countries of East Asia and was actively encouraged by governments.

That  praise of the Japanese banking system in 1996 did not stop him criticising the Japanese Zombie banks in 2009. Shame, Stiglitz, shame.

Note: A zombie bank is a bank with an economic net worth of less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support.

The ultimate resource

simons population

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Does fiscal policy cause inflation?

Milton Friedman on the onset of the Great Depression from the standpoint of 1930s macroeconomics

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Comparing US state GDPs to entire countries

USMap2013

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Doing bad when trying to do good: the cost of employment protection laws

Chart 2. A chilling effect

A policy designed to protect workers from unemployment, over time, will increase the duration of unemployment spells through a chilling effect on job creation. Employment protection laws are a tax on job creation. With fewer vacancies posted, the unemployed will take longer to find jobs.

Robert Lucas explained his support for U.S. monetary policy in 2008 as follows

  • There are many ways to stimulate spending, but monetary policy was the most helpful counter-recession action because it was fast and flexible.
  • There is no other way that so much cash could have been put into the system as fast, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.
  • There is no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These were important virtues.

Murray Rothbard on John Keynes

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Keynesian macroeconomics as a form of juvenile real business cycle theory (RBC)

Keynesian macroeconomics postulated that the economy slips into recessions for all sorts of reasons such as shifts and turns in the animal spirits and a loss of consumer confidence leading to a fall in autonomous investment and autonomous consumption. A collapse in autonomous investment and autonomous consumption is the Keynesian explanation for the great depression.

Both Keynesian macroeconomics and real business cycle theories, at least at the outset couldn’t explain why there were recessions. Both attributed to them to causes they were yet to explain. Keynesian macroeconomics  could not explain what drove the waves of optimism and pessimism that  either sharply increased or reduced investment.

Real business cycle theorists attributed recessions and booms to productivity drops in productivity surges, which initially were not explained in themselves. This theory sees productivity shocks as the cause of economic fluctuations. For example, if productivity falls, current returns to working and investing decline, so workers and firms choose to work and invest less and take more leisure. Real business-cycle theory views a recession as the optimal response by households and firms to a shift in productivity.

At least Prescott and other real business cycle theorists accepted that they must eventually unpack productivity drops and name causes that can be explored further and perhaps found persuasive or perhaps wanting.

Keynesian macroeconomics was quite happy to live with the waves of optimism and pessimism of the animal spirits that drove investors to push the economy into recessions. In his General Theory of Employment Interest and Money) Keynes puts it this way,

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

A far better explanation of the animal spirits is there is a productivity drop in one sector of the economy that leads that sector to reduce its demand for inputs supplied by the rest of the economy. This reduction in demand spreads across the economy. The slowdown in the economy is attributed to this  reduction in demand, rather than the forces behind it,  which is a fall in productivity in one sector of the economy.

Long and Plosser in 1983  wrote a famous article where they were able to generate business cycles in an economy  with rational expectations, complete current information, stable preferences,  no technical change,  no long-lived commodities, no frictions and adjustments cost,  no government, no money  and no serial dependence in the stochastic elements of the environment.

In response to a productivity disturbance in one sector this economy,  consumers will smooth a change in their consumption possibilities and production possibilities over a number of  quarters  by saving  and dissaving and varying the amount of time they devote to work and leisure and they will invest more or less in light of the changing situation.

This  consumption smoothing  is enough to generate a slowdown in the economy from changes in one sector. Laid-off workers in the sector subject to a disturbance will take time to find jobs in other sectors of the economy and  will be unemployed in this interim period of job search. Other workers who were previously employed in the sector subject to the productivity decline might wait for prospects to improve in that sector rather than search for a job in another occupation or location.

As research progressed, real business cycles were  viewed as recurrent fluctuations in an economy’s incomes, products, and factor inputs—especially labour—due to changes in technology, tax rates and government spending, tastes, government regulation, terms of trade, and energy prices. In his Nobel lecture Ed Prescott explained that:

We learned that business cycle fluctuations are the optimal response to real shocks.

The cost of a bad shock cannot be avoided, and policies that attempt to do so will be counterproductive, particularly if they reduce production efficiency.

During the 1981 and current oil crises, I was pleased that policies were not instituted that adversely affected the economy by reducing production efficiency. This is in sharp contrast to the oil crisis in 1974 when, rather than letting the economy respond optimally to a bad shock so as to minimize its cost, policies were instituted that adversely affected production efficiency and depressed the economy much more than it would otherwise have been.

By the time Keynesian macroeconomics papered over the flaws mighty exposed by the 1970s stagflation, it rebranded itself New Keynesian macroeconomics. This is no more than becoming monetarist macroeconomists without having to admit all of your previous criticisms of Friedman were wrong.

At bottom, Keynesian macroeconomics makes an unjustified assumption that technological progress unfolds at a relatively smooth rate, and changes in government regulation, terms of trade, and energy prices were not important sources of economic fluctuations. As for tax rates and government spending, Keynesian macroeconomists saw these is a solution to recessions rather than their cause.

In time, real business cycles theory and Schumpeterian theories of business cycles will merge. new inventions and processes that are, by the nature of research and development, stochastically discovered. Part of this randomness in discovery will be that the emergence from time to time of great interventions –  general purpose technologies -that result in economy wide changes and a wave of secondary inventions and the retraining of the workforce and reallocation of many workers into new sectors of the economy. These great inventions can be anything from electricity to information and computer technology and the Internet

Every time the Fed tightens the money supply, interest rates rise (or fall); every time the Fed expands the money supply, interest rates rise (or fall).

The problem is that… there are several causal factors operating on interest rates and in different directions.

If the Fed expands the money supply, it does so by generating more bank reserves and thereby expanding the supply of bank credit and bank deposits. The expansion of credit necessarily means an increased supply in the credit market and hence a lowering of the price of credit, or the rate of interest. On the other hand, if the Fed restricts the supply of credit and the growth of the money supply, this means that the supply in the credit market declines, and this should mean a rise in interest rates.

And this is precisely what happens in the first decade or two of chronic inflation. Fed expansion lowers interest rates; Fed tightening raises them.

But after this period, the public and the market begin to catch on to what is happening. They begin to realize that inflation is chronic because of the systemic expansion of the money supply.

When they realize this fact of life, they will also realize that inflation wipes out the creditor for the benefit of the debtor. As creditors begin to catch on, they place an inflation premium on the interest rate, and debtors will be willing to pay it.

Hence, in the long run anything which fuels the expectations of inflation will raise inflation premiums on interest rates; and anything which dampens those expectations will lower those premiums. Therefore, a Fed tightening will now tend to dampen inflationary expectations and lower interest rates; a Fed expansion will whip up those expectations again and raise them.

There are two, opposite causal chains at work. And so Fed expansion or contraction can either raise or lower interest rates, depending on which causal chain is stronger.

Which will be stronger? There is no way to know for sure. Will In the early decades of inflation, there is no inflation premium; in the later decades, such as we are now in, there is. The relative strength and reaction times depend on the subjective expectations of the public, and these cannot be forecast with certainty

Murray Rothbard

Did “Cash for Clunkers” work?

via Managerial Econ: Did “Cash for Clunkers” work?.

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