Recent Acquisitions

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1.  Steven M. Sheffrin, Rational Expectations (New York: Cambridge University Press, 1996): this should be a good, comprehensive introduction to rational expectations.

2.  Susan Howson, Lionel Robbins (New York: Cambridge University Press, 2011):  It is a little confusing, because the actual book is ~1,000 pages long, but Amazon.com says it’s 346.  So, I hope I did not buy some sort of abridged edition (and, if it is, I will probably return it) — it is especially confusing because Amazon.com offers a 79% discount.

3.  Steve Keen, Debunking Economics  (London: Zed Books, 2011): I figure that the first real post-Keynesian book I read ought to be what seems like one written for the layman.  If Keen’s book offers more, then all for the better.

Pigou on Keynes

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Daniel Kuehn recommends Keynes’ reply to Hayek’s review of The Pure Theory of Money.  Daniel is certainly right that the review is worth reading, but here is an interesting aside on the tactics employed by Keynes to defend his book.  This is Pigou’s observation,

The author’s answer was, not to rebut the criticisms, but to attack with violence another book, which the critic had himself written…!  Body-line bowling!  The method of the duello!

—  Lawrence H. White, The Clash of Economic Ideas (New York: Cambridge University Press, 2012), p. 91.

Hayek made roughly the same observation in his rejoinder.  It strikes me that Keynes’ decision to enroll the help of Sraffa, who was just as dirty in his own attack on Hayek, was more of a strategy that involved undermining the authority of his opponent, rather than defending the merit of his own ideas.

Congreso Austriaco, Madrid

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If you are within distance of Madrid in and around 20 June, I suggest seeing if you can attend the Austrian Conference at the Universidad Rey Juan Carlos on that day (I believe).  I will be giving a twenty minute presentation (in Spanish), titled “Regulating the Radically Unknown: Why Banking Regulations Fail.”  It is a bit strong, but Austrians like it strong.

Misleading Titles

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The May 21 edition of the Christian Science Monitor arrived yesterday, and the cover story title runs, “When Prison Doors Swing Open: A Record Number of Inmates are Being Released From State Prisons.  Is Society Ready for the New Surge?”  Directly below are two images, side-by-side, one of a big, scary Mexican guy (serving for second-degree murder) and the other of some graffiti.  On the opposite page, there is another big, scary Mexican guy, but this time with an array of tattoos on his face (even an anarchy symbol! — maybe he read some Murray Rothbard while in prison, or is he more of a David Friedman guy?).

Despite all these scary insinuations, the fact is that most prisoners are non-violent offenders.  This is both because of a rise in the imprisonment rate of non-violent offenders and because of a fall in the rate of violent crimes.  And, when state governments decide to start letting people out early, it does not select eligible prisoners at random.  Usually, the decision of early release revolves around the nature of the crime and total time served (in relation to length of sentence).

Maybe the substance of the article is less biased, but the editors seem like they are definitely trying to sell an idea that does not accurately reflect the truth. (I remember reading something recently that said that the average person only reads the first few paragraphs of an article.)

Supply-Side Limits

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Brad DeLong quotes some studies on the lack of effect of tax cuts on production.  I think the conclusions are largely indisputable and it makes me wonder how much money we would have saved had pro-market economists not made bad arguments. (Now, this does not mean I support high taxes!)

It is intuitive, even for a free marketeer.

Imagine an economy in a recession with depressed and stagnate investment.  We have large amounts of idle resources that could be used towards production if certain costs were lower (a free-marketeer might recognize these costs as originating from “regime uncertainty,” for instance).  Assume that at least some of these costs are independent of taxes (instead, they are associated with things like regulations and pricing chaos).  A reduction in taxes on entrepreneurs, or an increase in income that can be re-invested, will not induce an increase in investment, because there are still high “artificial” costs associated with productive investments.  All this also means that the government can tax idle income without adverse effects on production, since that income is not being used towards production, anyways.

[Edit: Of course, one can make the argument that if it were not for all these other factors holding back production, then tax cuts would actually be useful.]

Even during healthy economic activity, the discouraging effect on production that taxes have has been overstated.  To discourage production, the value of saving income or consuming income (and the associated taxes) must be higher than using income towards taxed productive activities.  Saved income may be used by others towards production, as well.

Of course, there are much better arguments against taxation.

Horwitz on Free Banking

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In lieu of a post of my own — for half of the day my attention is set entirely on international womens’ movements, abortion rights, and (unrelated to the last two) the economics of crime and the justice system —, here are two follow-up links on the topic of free banking,

  1. Horwitz, “Krugman’s Misleading Interpretation of US Banking History;”
  2. Horwitz, “Competitive Currencies, Legal Restrictions, and the Origins of the Fed: Some Evidence From the Panic of 1907” (gated version).

The real history is probably a bit more contested than Horwitz’ posts leads us to believe (Hickson & Turner [2002] and Ng [1988] come to mind; there are also various dissenting theoretical and statistical studies on competition and financial stability).  But, knowing that the United States has never truly had a free banking system, it is fair to criticize the essentially unsubstantiated a priori approach many economists have taken to regulation: if there have been mass failures it is because of the lack of sufficient or adequate regulation.  Finally, I think Horwitz is also right to point out the difference between mass failure and isolated failure, where the latter is the product of bad entrepreneurship.

Fiduciary Cycles

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Blogger “Lord Keynes” criticizes the use of the term “funny money” as being purposefully loaded.  I agree, but I suggested separating Austrians between those who believe that fractional reserve banking is fraud and those who do not.  It strikes me that the size of the latter group is growing, and the former dwindling (at the very least, more and more people are simply switching to supporting “free banking,” whether it be with fractional or full reserves).1  In response, LK writes the argument I would have least expected him to use.  Paraphrased,

  • Why would a fractional reserve free banking system not lead to recurring industrial cycles;
  • According to LK, the “whole point” of Mises’ and Hayek’s work in the area was to show how fiduciary expansion leads to business cycles;
  • In fact, how do promissory notes, bills of exchange, and checks not cause industrial cycles.

My purpose here is not to inflame another debate between full reservists and fractional reservists, but just to defend the White/Selgin (also referred to W/S here) model of free banking against LK’s claims.  In fact, “defend” might be the wrong term, since what this really boils down to is an illustration of just how poorly LK understands both the Austrian theory of industrial fluctuations and the theory of free banking.

Allow me to begin at the middle: Mises’ and Hayek’s theory of severe intertemporal discoordination.  Their ideas have to be understood in proper context and it also has to be accepted that they made mistakes — mistakes that do not invalidate the broad argument, but rather imperfections.  The theory of intertemporal discoordination (which I have discussed at length elsewhere: 6 Jan. 2011, 26 July 2011, and 12 August 2011) can be summed up as arguing that growth in the supply of money will lead to the creation of malinvestment throughout the structure of production, if this growth takes place in the “arteries” (my own term) that channel savings from one person to another — as long as the growth is over and above the supply of “real savings.”  Understanding this is crucial: what both Mises and Hayek were discussing is a distortion in the pricing process that makes capital goods seem more abundant and available than they actually are.

The basic idea behind malinvestment and the business cycle seems to be lost on a lot of people, and not just non-Austrians.  We are not talking about a lack of consumer demand for the final product, because consumer output prices will adjust to reflect their marginal valuation.  We are talking about the inability to complete investments, because the quantity demanded of capital goods outstrips the supply.  When these “artificial savings” are no longer available, entrepreneurs can no longer afford to bid away capital goods which have risen in price as a result of the monetary expansion.  This is why Austrians refer to the idea of investment over and beyond the stock of real savings.

In Hayek’s early writing (I have in mind his 1933 [1929] article “Monetary Theory and the Trade Cycle;” specifically, chapter four), he does actually believe that fractional reserve banking leads to recurrent business cycles.  He thought that industrial fluctuations were an unfortunate side effect of a more efficient use of savings. Hayek’s beliefs with regards to the debate, I think, mature between 1929 and the 1970s (i.e. “Choice in Currency” [1976] and “The Denationalization of Money” [1976]).  I think the Hayek of 1929 is correct to argue that the Austrian theory is an endogenous one, but I do not think he realizes what factors cause this recurring endogenous problem to be possible. That is, there are important institutional characteristics — one obvious one being the Federal Reserve — that makes endogenous business cycles possible.  This is why, in later life, Hayek opted to argue that the banking system should be reformed, by means of full privatization and deregulation.

Hayek calls Mises’ version of the theory an exogenous one, but I think this is a mistake that originates from the lack of insight on the institutional characteristics of the banking system.  Mises recognized that the problem is one of cartelization and regulation.  Also, contra LK, Mises never opposed the issuance of fiduciary media.  In Human Action [1949], for instance, Mises calls fiduciary media an important tool, but highlights crucial limitations to a bank’s ability to extend credit (pp. 431–441).  The mechanism by which this occurs is actually roughly similar to that in the White/Selgin model: excess notes are spent and ultimately returned to the bank for redemption, threatening a bank’s stability.  Why do banks not seem to be affected by these supposed limits in most, if not all, modern banking systems?  Government intervention.

I am not saying Mises was a fractional reserve free banker, although I do not think Mises was a full reserve absolutist, either (however, Mises did argue in favor of full reserves in lieu of free banking, to constrain the capabilities of a cartelized and regulated banking system).  A pretty convincing and authoritative comparison between Mises and W/S is provided by Salerno’s May 2010 Mises Daily piece (although, his calling W/S free bankers part of a “Neo Banking School” seems to me a bit too broad).

Two main points that should be taken from what I have written so far,

  1. Austrian business cycles are caused by “artificial savings;”
  2. Neither Hayek, except very early on, nor Mises thought fractional reserve banking is the source of the problem — they thought it was fractional reserve banking by an institution which characteristics and abilities have been distorted by government intervention.

How does the White/Selgin model of fractional reserve banking fit in all of this?  In Selgin’s The Theory of Free Banking (a book that, like most economic treatises, needs to be read from cover to cover), two general means of reserve reduction are presented.  Quoting directly from my article “Prices and the Demand for Money,” these are,

  1. Over time, “inside money” — banknotes (money substitute) — will replace “outside money” — the original commodity money — as the predominate form of currency in circulation. As the demand for outside money falls and the demand for inside money rises, banks will be given the opportunity to shed unnecessary reserves of commodity money. In other words, the less bank clients demand outside money, the less outside money a bank actually has to hold;
  2. A rise in the demand to hold inside money will lead to a reduction in the volume of banknotes in circulation, in turn leading to a reduction of the volume of banknotes returning to issuing banks. This gives the issuing banks an opportunity to issue more fiduciary media. Inversely, when the demand for money falls, banks must reduce the quantity of banknotes issued (by, for example, having a loan repaid and not reissuing that money substitute).

The S/W model, therefore, assumes that none of these two phenomena will lead to a dramatic2 over-issue of fiduciary media.  This is because, in principle, the supply of money in circulation3 is stable.  In the case of (1) bank notes originally act as money-certificates, replacing outside money in circulation.  The act of turning some of those money-certificates into fiduciary media by selling part of a bank’s reserve stock of outside money does not change the fundamental fact that (1) alone maintains the supply of money stable.  The description for (2) above explains the mechanism, but I will reiterate: the idea is that money held (not spent) is no longer circulating, so it can be replaced by a new banknote (or equivalent unit of credit or what have you).  What (2) does, though, (and this is the most controversial part, I think, within Austrian circles) is distribute this held purchasing power to entrepreneurs, shifting spending to the non-consumer stages of production.  The W/S rationale is that holding money represents savings, because the individual holding money is deferring from present consumption.

This is my attempted reconciliation.  Mises, as I have already said, was not a fractional reserve free banker in the same vein as W/S, et. al.  He did not recognize any of the above two mechanisms.  Mises is clear, though, that individual banks which over-issue will risk their stability, because when over-issued fiduciary media return to banks for redemption, banks will find their reserves too scarce.  Again, this is the same mechanism present in the W/S model.  The important difference is that free bankers who prefer Mises’ theoretical exposition tend to think that fractional reserve lending will be minimized by “market forces” and free bankers of the W/S kind — such as myself — tend to think that reason (1) behind fractional reserves will exert the most pressure in reducing the size of reserves of outside money and (2) will cause subtle fluctuations in the stock of fiduciary media.  Whatever occurs, it is easy to see how free banking would not lead to recurrent industrial fluctuations, and any intertemporal discoordination that does occur will not be to the same degree as it occurs in cartelized/regulated banking system (with a government currency monopoly).

Notes

1.  What this suggests is that the size of the population of well-read Austrians who really believe that fiduciary media is “funny money” is actually substantially low and dwindling.  Those who use it in the media are either: (a) part of the small group of Austrians who are full reserve absolutists or (b) using the term precisely because it holds a negative connotation.  An alternative reason could be that some of the people who use the term “funny money” are thinking specifically of fiduciary media created that would not have been created in an alternative free market banking system — in other words, it is a fuzzy term that has a nebulous meaning to encompass the entirety of the banking cartel.  I actually suspect that it this last reason that explains most of the usages of the term, with a little bit of (b) mixed in as well (every Austrian knows “funny money” is not an academic term, but their intentions are not academic).

2.  Remember, these theories are meant to be ideal types; they explain the workings of a system by abstracting from certain details.  In this case, the abstraction is disequilibrium.  This is why I write “dramatic over-issue,” since over-issuance (and under-issuance) will occur in a world characterized by disequilibrium and decentralized knowledge.  It is also conceivable that some banks might fail due to over-issuance — entrepreneurs can make mistakes.

3.  The idea of “in circulation” is key.  Mises 1998 (1949), “The only vehicle of credit expansion is circulation credit,” p. 431.

Advocates of Reason: 14 May 2012

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Man has only one tool to fight error: reason.

— Ludwig von Mises

1.  Joseph Salerno, “Klein versus Kirzner.”  This is such a great post; this is the kind of stuff I was looking forward to when the Bastiat Circle was first established.  Salerno comments on an exchange between Peter Klein — I think, as it stands, one of the foremost authorities on the theory of entrepreneurship (and it should be emphasized that Klein is returning the theory of entrepreneurship to its roots of disequilibrium and uncertainty; his is a true subjectivist theory of entrepreneurship) — and followers of Kirzner.  Kirzner defended his comparison of an entrepreneur with an arbitrageur, similar to the Walrasian auctioneer, as a metaphor.  Klein attacked this, arguing that a metaphor illustrates reality, and this is not what Kirzner’s entrepreneur does.  Salerno doesn’t say it explicitly, but I don’t think it would be too much of a stretch to interpret Klein as saying that Kirzner’s entrepreneur does adequately describe what a real world entrepreneur does.  For people interested in the topic, Klein is an economist you should be reading and following.  Together with Jeffrey Friedman’s continued elucidation on the theory of radical ignorance, we are coming towards a truly subjective theory of entrepreneurial decision making.

2.  Greg Ransom, “Recommended New Books with Hayekian Themes.”    A very good  list: I bought a good number of books on that list, even though I have yet to read them (fortunately, the semester ends on Wednesday, so I will have plenty of free time during the next three months).  One book, though, that I have looked closely at is Pete Boettke’s Living Economics.  Many people may have their problems with some of Boettke’s beliefs (in economics and politics), whether it is about his interpretation of the mainstream or something else, but nobody can deny that his sole purpose is discovering the truth.  He is also incredibly well read and he is able to put together a complex web of ideas and re-write them for the layman.  I have read only parts of the book, but what I have read manifests the best qualities of Boettke as an academic economist.  You may not agree with everything he writes in his new book, but I guarantee that you will walk away recognizing that it was a book well worth reading.

3.  What is the status of Brad DeLong’s own history of modern economics?   Looking through White’s The Clash of Economic Ideas, I realized that DeLong’s book would be a perfect contrast.  As one can imagine, I think DeLong is wrong on many things, but he is a great communicator, a great mind, and it seems to me that his book would be a great contrasting perspective to White’s.  Also, check out the list of DeLong’s unpublished book reviews.

4.  Everyone is talking about this Rajan piece, and I still have not gotten my copy of Foreign Affairs in the mail.  For what it’s worth, I tend to side with Rajan, but I also think that the “structural” argument can be overplayed (and I am not talking about Rajan specifically) — it can be turned into a theory that does not make any more sense than the exaggerated demand-side one.  I have in mind, out of other examples, the notion that labor and entrepreneurs cannot respond quickly enough to a shifting economy (as if the structural shifts are exogenous, and not a product of entrepreneurial and labor changes).

5.  David Kestenbaum interviews Ronald Coase.  The only public good Coase can think of on the spot is the military.  It is a sign that people ought to be more careful when that term is thrown around.

6.  Paul Krugman, “Panics Happen.”  Contra Krugman, I think the common factors are two-fold: (a) unstable, regulated, and cartelized banking system (whether it is under a central bank or under some kind of national banking system), and (b) the inability for banks to issue notes when there is a sudden rise in the demand for money.  So, I don’t think it’s about containing panics as much as it is about being able to avoid panics altogether.  Will we have a panic today?  What’s the use of rushing a bank for cash when you have a debit/credit card?  In a follow up post, Krugman compares the costs to industrial output of various recessions.  None of this contradicts anything his opponents are claiming: generally, the post-WWII economy has been smoother because there has been a gradual lifting of the constraints on fiduciary over-expansion.

7.  I have been missing out.  As I have said a few times before, I spent much of the past week reading John Grisham’s A Time to Kill.  I am probably overreacting, since I do not usually read fiction (too much time spent reading textbooks and economics books/articles), but reading this book was extremely rewarding.  I also saw the film after reading most of the novel.  I originally saw the film sometime in late 2007 or early 2008, in Spanish (I was living in Spain, at the time), and only parts of it.  The movie has nothing on the book; in fact, there are so many subtle differences between the novel and movie.  Reading the book definitely “sort of” ruined the movie for me.

Quote of the Week

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Let us not forget that The General Theory runs in broad, aggregative terms and is therefore precluded from dealing, and is not designed to deal, with sectional unemployment, which is the result of faulty allocation of resources or of shifts in demand. It is meant to deal only with general, mass unemployment resulting from a deficiency in aggregate effective demand (deflation). Its author clearly assumed that the smaller problems would take care of themselves, if only aggregate effective demand was kept on an even keel or raised when necessary, for example when the wage and price level is pushed up.

— Gottfried Harberler, “The Place of the General Theory of Employment, Interest, and Money in the History of Economic Thought,” The Review of Economics and Statistics 28, 4 (1946), p. 194.

Hayek on Keynes

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Steve Horwitz paraphrases Hayek’s criticism of Keynes’ theory of money,

As Hayek points out in his review of the Treatise, what Keynes was doing in that book was trying to tell a Wicksellian story about investment, savings and the price level but without the Austrian (via Bohm-Bawerk) theory of capital on which Wicksell’s original argument rested. Specifically, Hayek (1995a, p.125) argues that Keynes’s treatment of the process by which current output is produced is flawed precisely because he views that process as “an integral whole in which only the prices paid at the beginning for the factors of production have any bearing on its profitableness.” In other words, Keynes does not recognize that production comes in stages and capital goods sit in specific places in that staged process, or, in Menger’s terms, that capital goods can occupy different orders in the structure of production.

— Steven Horwitz, “Contrasting Concepts of Capital: Yet Another Look at the Keynes-Hayek Debate,” The Journal of Private Enterprise 27, 1 (2011), p. 14

I think, though, that the best paper that explains the differences between Keynes’ and Hayek’s view of the pricing process will also explain why Hayek failed to persuade the profession.  That is, why students of Hayek — Hicks, Kaldor, Lerner, Shackle, et cetera — were never sold on Hayek’s work, and why in-and-around 1936 they all so quickly accepted Keynes’ conclusions.  Moreover, why did students like Hicks and Shackle accept some of Hayek’s capital theory, but only enough as to design a vastly different theoretical edifice?

I do not know how much of Austrian capital theory Keynes understood, although it is clear that he was read in much of Hayek’s contemporaneous work (e.g. “The Maintenance of Capital”).  This suggests some familiarity; Keynes was also in contact with economists who had attended Hayek’s 1931 lectures.  Indeed, I would think that Keynes was familiar with Prices and Production, because he essentially hired Sraffa as a hit-man to attack it.  What this suggests is that Hayek was not persuasive.  Knowing why Hayek failed, in my opinion, is an important part of knowing why capital theory is not present in any of Keynes’ work.

An answer might be found in the work of Knight, which Keynes approvingly cited (and Horwitz notes, but does not discuss or reference [Horwitz references it in-text as a "1932 article;" it is actually Knight's 1934 essay, "Capital, Time, and the Interest Rate"]).  Whether a decisive critique or not, Knight’s was relatively comprehensive, and it may explain why Keynes — and so much of the profession — never bought Hayekian capital theory.