Category Archives: Economics

Piketty’s Meat and Bones

I have yet to finish reading Capital in the Twenty-First Century. There are many reviews already out, many of them very much worth reading. Two critical reviews by Ryan Decker and Josh Hendrickson. There is also Paul Krugman’s, probably the most widely discussed review to date; Krugman makes some good points against Piketty, but also covers some of the book’s strengths.

The heuristic the book sells to the reader is r > g. That is, if the return on capital is greater than the rate of economic growth, inequality will increase. The concept, explained like that, is somewhat cryptic. It’s an easy heuristic for those who don’t want to get bogged down in the theoretical argument. The theoretical argument is actually not that complicated (theory makes up a very, very small minority of the book). Piketty makes it near the end of the sixth chapter of his book. His argument is that if the elasticity of substitution between capital and labor is > 1, the share of income accruing to capital will grow relative to that of labor.

You actually don’t have to buy the book to access the theory. In my opinion, the theory is not well communicated in the book. It’s available in the free technical appendix. Here is that appendix for chapter six (in case it doesn’t take you directly, the meat and bones starts on page 37),

Download the PDF file .

China: Future Migration Hotspot?

China is still a sending state, more migrants leave than come in. According to the World Bank, about 1.5 million people emigrated from China in 2012, on net. I am not sure how much of that includes emigration to Hong Kong and Macau. Still, compared to the United States, which received, on net, 5 million immigrants, China does not seem like a major attraction to migrants. But, will China always be a sending state, or will it soon begin to receive net immigration? Immigration is already an important facet of the Chinese economy, and there is reason to suspect that China, like Western Europe and the United States, will, down the road, become a receiving state.

Historically, China has always been a sending state. The World Bank measures net migration as the number of immigrants minus the number of emigrants. China has had a negative figure since 1962, which is when the data I have starts at. But, net emigration does not imply no immigration, and, as their economy continues to grow, with a growing demand for labor, immigrants have turned into vital means for growing productivity. While the amount of net emigration remains significant — although, the data includes emigration to Hong Kong and Macau (two important net recipients of Chinese migrants) —, the number has been steadily decreasing since the early 2000s: from 2.2 million immigrants, on net, to 1.5 million.

The country, however, is going through a structural change. It is going through a process similar to that of the U.S., between 1820–1910. Industrialization has brought with it one of the largest internal migrations in the world, as large amounts of people move between provinces. This includes movements from rural areas to the cities, and movement from poorer (typically, rural and agricultural) to wealthier regions. While there are not always known opportunities for higher paying jobs in the cities — migrants are often displaced by a falling demand for labor in the rural areas —, it is true that Chinese industry is a sponge, in need of a growing labor supply.

Domestic labor is not always enough, especially given China’s low population growth rate (0.5 percent, in 2012). If the demand for labor increases, and the labor supply is more-or-less stable, we should expect higher wages. According to the “neoclassical” theory of migration, where changes in relative wages cause migration between countries, we expect rising Chinese wages to attract migrants. This does not necessarily mean, though, that immigration will occur up until wage rates between countries are equalized — in fact, emigration to China may push wages up, inviting even more immigration.

If there are economies of scale, larger populations mean higher real wageMonopolistically Competitive Markets. As population grows, all else equal, so does output. This lowers the average cost and price, raising the real wage. Larger population also means a larger amount of firms, greater product diversity, and the accompanying welfare gains to the consumer. This result was formalized by Paul Krugman, in his work on trade theory.

Trade, or the movement of goods and capital, creates the same effect as an increase in population: an increase in the division-of-labor. But, if trade is restricted, or if bad policies elsewhere leads to low growth and high unemployment, the movement of labor may replace the movement of goods. Consider some of the “stylized facts” of sending states: history of low growth, extractive political institutions, and relatively low wages. Sending states each have a division-of-labor which is significantly isolated from the world’s. While China’s political climate may still be unattractive to many, the economic factors may grow in relevance. The country is surrounded by many others which are worse-off, and growing Chinese wage rates will become increasingly attractive.

Other factors, besides relative wages, that determines migration are “linkages.” Think of a linkage as a shared history. For example, many Indians migrated to the United Kingdom, because India is a former colony. Similarly, Spain attracts a disproportionate amount of South American migrants, because of their shared history. Countries with linkages are more likely to be involved in a migration pattern than countries without them, all else equal. China has shared histories with not only its neighbors (many of which, however, are also growing and/or prosperous), but also with populations one might at first suspect. The Chinese have invested heavily throughout Africa, and many Africans have migrated to do business in China. As African networks in China grow, this might attract larger flows in the future.

Growth, however, does not always mean less emigration. The evidence shows that growth may actually lead to increasing emigration rates, below a certain threshold per capita income,

Emigration Flow to GDPPC

In early stages of development, other factors may dominate the marginal increase in relative wage. Since the poor are typically credit constrained, rising incomes will help them finance migration decisions. Networks in other countries may also attract large emigration flows. If early flows were restricted by asymmetric information, where potential migrants were simply unaware of the opportunity, growing networks in receiving states will correct this asymmetry and increase the flow of migration. Changes in relative income are important to consider, too. If early growth raises certain incomes disproportionately, the relative wage rates between countries for the non-affected income groups remain the same. Maybe this explains, in part, why China attracts high-skilled labor from South Korea and Japan, but exports low-skilled labor.

But, China’s GDPPC (GDP per capita) is just about at the threshold in the data. According to the World Bank, China’s 2012 GDPPC, in current U.S. dollars, was about $6,000. Net emigration has fallen since the early 2000s, and real wages in China continue to grow. Is China poised to become an important receiving state in the future? This will bring with it interesting problems. An immigration shock provokes hostility amongst a homogenous local population, leading to civil rights issues — issues the Chinese government will have to deal with. It will also have a significant effect on the global economy. The U.S. became a major industrial power in large part thanks to immigration. But, the U.S. started out with a relatively small population. China is already the largest country on Earth and there is still a growing demand for labor, despite the already large labor force. How will the Chinese government approach the “immigration problem?” How will this affect the United States and Western Europe? By 2070, or sooner, we might see large communities of American workers in Beijing!

Rules of Inequality

Two economists, Chris Dillow and Randall Holcombe, discuss income inequality and Joseph Stiglitz’ The Price of Inequality. For those who have not read the book, you can read my review. Dillow wonders why some libertarians — surely, not me! — do not oppose inequalities caused by rent-seeking. As if in direct response, Holcombe reviews Stiglitz’ book, showing how similar the liberal and libertarian positions on inequality can be. Both Holcombe and Dillow reference Stiglitz’ comment on the rules of the game. Stiglitz writes that inequality “is not the result of the laws of nature or the laws of economics. Rather, it is something that we create, by our policies, by what we do.” Those sentences can be hard to interpret. Stiglitz is not claiming that market forces will not create income inequalities. Rather, what he means is that the laws of nature and economics are not necessarily binding, and what is binding is our legal structure — we, as a democracy, can decide what the proper distribution of income should be. Put this way, Stiglitz’ argument is much more difficult for some libertarians to swallow.

What kind of distribution of income does economic theory predict? At its most basic, differences in income are caused by differences in marginal productivity. Your productivity is measured in how much value the marginal person in your profession produces, determined, in part, by the demand for final products. Medical services are worth more than grocery services, so a doctor will make more than a grocer. If you tried to explain the growth in income for management, especially in finance, in this fashion, you might make the claim that the productivity of management, at the margin, has increased. Managerial talent is in high demand.

Holcombe, Dillow, and Stiglitz discuss the role of rent-seeking in causing income inequality. When libertarians think about rent-seeking, they think about monopoly rents, in the sense of decreasing competition. A corporation, for example, might lobby government to introduce a law that hurts the firm’s competitors. Corporate subsidies is a clear example of rent-seeking. But, a broad definition of rent-seeking can also include opposition to restrictions on competition, which is not so obviously wrong. For instance, the NYSE might lobby government to lower the capital gains tax. Energy companies might spend money to pressure Congress to allow oil drilling in parts of Alaska. This kind of rent-seeking produces outcomes which are justifiable within a libertarian framework (and in general, too: there are many non-libertarians who think the capital gains tax should be zero). Yet, Stiglitz does not discriminate. He criticizes rent-seeking across the board.

Much of rent-seeking is “reactionary,” in that it responds to legislated laws which override marginal productivity. That rent-seeking can return income distributions to how they would be in the free market is an important point, because it is what differentiates the argument Stiglitz is making from the less controversial argument that Holcombe endorses. Few liberals, apart from some libertarians, support an income distribution based on marginal productivity alone. A liberal polity may agree — as has been the case so far — to redistribute some fraction of income or wealth to its worst off, because there are other concerns that override the justice of marginal productivity theory. Government can also change the income distribution through regulation. Businesses lobby to lower taxes and regulatory costs. To those who see these taxes and regulations as necessary, businesses who fight them are seeking additional rents. Stiglitz’ complaint against rent-seeking is not an implicit endorsement of an income distribution based on marginal productivity.

This brings me to something Dillow quotes,

And that this inequality is not inevitable.  It is not, as Rich said yesterday, like the weather, something that just happens to us. It is not the result of the laws of nature or the laws of economics. Rather, it is something that we create, by our policies, by what we do.

— Stiglitz, “The People Who Break the Rules Have Raked in Huge Profits and Wealth and It’s Sickening Our Politics.”

At the end of the day, the rules of the game which are binding are those which are legislated. Distributions caused by differences in marginal productivity can be changed. Inequality is not like the rain, something out of our control. No, we can decide, as a society, what the proper distribution of income ought to be. We will tax some and give to others. We will regulate industry, increase the workers’ bargaining power. There exists a gamut of tools a liberal society can employ to redistribute income, each with its costs and benefits. At least, that’s Stiglitz’ message.

Something else to consider is how little inequality rent-seeking may cause. “Crony capitalism’s” role in inequality is easy to exaggerate. Our GDP is ~$15.6 trillion. How much is spent on lobbying? One source puts the 2011 figure, which is a maximum in their data, at $3.5 billion. How much does the U.S. spend on corporate welfare? I’m not sure what year this figure is for, but Aljazeera cites $110 billion. Putting both of them together, and assuming the figures for 2013 are similar enough: .7 percent of GDP. We can assume that the estimate is below the true number. But, the amount of income directly redistributed through rent-seeking is still relatively small. Further, much of that income is distributed to the employees of those firms, not just management — rent-seeking does not always distribute between income groups.

There are other theories that may have more explanatory power. How much inequality does inheritance explain? Think about that question in the context of low growth and high rates of return on capital. More importantly, how much do productivity differences explain? If it explains 90+ percent of the income distribution, then the progressive and libertarian views on inequality do not match very much at all.

Holcombe writes, “there is a substantial consensus that government is the cause of many of the problems people perceive.” He is saying the same thing as Dillow, “It is just silly for libertarians to pretend that inequalities are fair.” Both are assuming that opposition to rent-seeking creates a large common ground between libertarians and progressives. But, the types of collusion some progressives, such as Stiglitz, want to include are more than what most libertarians, and many non-libertarians, would be willing to concede. And, ultimately, rent-seeking may not explain very much inequality at all. There may be more important causes of inequality, where the question of justice is more ambiguous. The common ground between libertarians and progressives is much smaller than the battlefield.

ABCT and the Price Level

I remember my monetary theory professor using an aggregate demand/supply graph to illustrate supply-side theories of the business cycle, where a supply shock shifts the supply curve to the left. All else equal, a negative supply shock will lead to an increase in the price level — the same amount of money chasing less goods. This is how some people interpret Austrian business cycle theory (ABCT): there is a negative supply-side shock to the capital stock. It follows that the price level for capital goods rises. But, the evidence suggests the exact opposite, falling prices in the capital (intermediate) goods sector. That interpretation is wrong. ABCT is a demand-side theory, and it predicts just what the evidence shows, a falling price level for capital goods.

I also discuss what predictions ABCT makes regarding the general price level. The simple answer: none. This is why the ABCT cannot explain the depth of a recession on its own. I make my case in the second part of the post.

If you think that Hayek’s theory is about a supply-shock, read “The Maintenance of Capital.” The article presents a theory of the value of the heterogeneous capital stock. It’s related to Hayek’s business cycle research, in that it clearly frames the issue in the context of aggregate demand. Note his discussion of “capital consumption.” Capital consumption is not the same thing as a supply-side shock to the capital stock. Remember, the value of the capital stock is imputed (derived) from the final product. A rise in the price of an input is caused by an increase in demand for that input’s output. A fall in the demand for the final product, leads to a fall in the value of those inputs — capital consumption. This is important to keep in mind, because this is one of the basic parts to ABCT.

Let’s call an economy “neutral” when the allocation is optimal (don’t worry about frictions and imperfections). Picture an economy as a production possibilities frontier (PPF), with capital goods on one axis and consumer goods on the other. The PPF represents potential mixtures of output, given some given amount of resources. Not all points on the PPF are equally valuable. The neutral economy produces where the opportunity cost is lowest, which is a specific point on the PPF. Essentially, ABCT predicts that an excess supply of money will cause an economy to become non-neutral, by producing on some other point along (or inside) the PPF. This is shown in the graphic below, where the PPF is on the right — consumer goods on the y-axis and capital (or producer) goods on the x-axis. There are two marked places on the PPF; the uppermost circle is the original mix of output, and the lower circle is the new mix of output.

Output Combinations and the Hayekian Triangle

(Don’t worry about the Hayekian triangle on the left panel.)

Forget about central banks and interest rates, and focus on an excess supply of money. Hayek and Mises believed excess supplies of money to be non-neutral. Specifically, they thought excess supplies of money changed the prices of capital goods relative to those of consumer goods. The stylized process by which this happens is that new money is introduced through the loanable funds market, as banks extend loans. That borrowed money is used to buy certain inputs, raising the price of those inputs, and thus the profitability of producing them. The economy moves towards producing somewhere lower on our PPF curve, above (the second point on the curve). This means less consumer good output, since more resources are being used to manufacture intermediate (capital) goods. But, the level of consumption remains the same, so as the supply of consumers’ good falls, their price increases. This sets off a process of reversion, where the structure of production has to re-adapt to society’s time preference (intertemporal equilibrium).

Where is the shock to the capital stock? As amount of current inputs going into the production of future inputs increases, it changes the nature of capital. If the value of capital is imputed from the final product, and the final product capital is being used for changes, then the value of the capital stock will change. The excess supply of money, by raising the price of inputs, creates “false” profits. To keep it simple, “false” profits are non-neutral. These profits will make the new structure of production seem of high value. But, the reversion process corrects this, and there is a change in the pattern of demand. The investment during the boom is “malinvestment,” and the capital stock loses much of its value (it’s consumed), by virtue of the fact that the “false” demand for its output collapses.

Note that the prediction is a fall in the value of the capital stock. The physical stock of capital remains the same. The prices of capital goods, however, collapse. The type of inputs produced by the boom-time structure of production are not as useful as they first seemed. The range of productive uses narrows, and if the capital is highly specific it might become completely useless (Hayek makes this point explicitly in Prices and Production, and references the debate on idle resources).

To put the same point differently, imagine a supply/demand graph. The price of a capital good is decided at the margin at which the supply and demand curves meet. ABCT predicts that the demand curve will shift to the right during the boom, and then to the left during the process of reversion. Thus, the bust coincides with a falling price level for capital goods. The supply-side shock, just to be able to compare and contrast, predicts that the bust coincides with a leftward shift of the supply curve, or an increase in the price level for capital goods. The intuition behind that process is that as the amount of a type of capital decreases, the least valuable end that last input is useful towards increases in value (since there is less capital, there are less ends that can be satisfied — and, optimally, the most valued ends are satisfied first). This is not what ABCT predicts. Rather, ABCT says that, during the bust, the least valued end will decrease in value, because, as it turns out, what producers thought were highly valued ends were just distorted profit signals, caused by an excess supply of money.

The theory fits the empirical evidence, at least in this respect,

PPI Intermediate Materials 2001-2012

What about the general price level (consumers’ + producers’ goods)? ABCT is somewhat indeterminate in this regard, because capital consumption occurs while the price of consumers’ goods increases. It’s also ambiguous whether the excess supply of money will end through a rise in the price level, or through some kind of aggregate reflux mechanism. What brings about the primary effects of the ABCT are not changes in the money stock, but changes in relative prices. To explain a decline in the general price level, Austrians usually employ another theory, typically referred to as “secondary deflation.” Because this is no longer really within the scope of the ABCT, Austrians are somewhat vague on this point. But, I think this point is worth discussing, because it shows that ABCT most likely cannot explain a major business cycle on its own.

Rothbard provides an entire section (pp. 14–19) to explaining secondary deflation in America’s Great Depression. He employs a very strict quantity theorist definition of inflation/deflation: an increase/decrease in the money supply (although, I’m not sure this is consistent with some of the causes of deflation he discusses). Some of the causes he gives assume a gold standard, relevant then, but not now. Still, I think they can be generalized. He cites an outflow of gold (or, more broadly, let’s call it capital), forcing banks to contract their balance sheets. He also cites debt liquidation, where credit simply cannot be repaid. Finally, a third force is the increase in the demand for money. The deflationary process is, strictly speaking, separate from the process described by ABCT; related to it, but not directly. Rothbard considers the deflationary process beneficial. In the preface to “Monetary Theory and the Trade Cycle,” Hayek also distinguishes deflation from the process described by ABCT, but writes that “an indefinite continuation of that deflation would do inestimable harm.”

There are multiple margins to judge deflation on. Rothbard’s point, which is valid, is that what matters are relative prices, not general prices, so that deflation doesn’t necessarily cut into profits — especially if capital good prices fall faster than consumer good prices (which is empirically true). I will come back to this shortly. Other channels through which deflation may not be beneficial include those akin to Fisher’s theory of debt deflation. A New Keynesian model will also tell you that a non-inflationary environment forgoes the benefit of inflation to reduce the demand for money, if we are in a liquidity trap, where interest-bearing assets and money are equally attractive, because of low interest rates. I’m not going to comment on the validity of these theories. They are nevertheless worth considering, and I will say why that is below.

Debt deflation and liquidity traps aside, knowing why Rothbard is somewhat wrong is important. Note a claim he makes on the height of unemployment caused by an Austrian business cycle,

Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary.

America’s Great Depression, p. 14.

This is, by the way, the exact claim Paul Krugman makes in his criticism of ABCT, what he calls the “hangover theory.” The initial boom period requires substantial capital readjustment, as well, but during this period the unemployment rate is relatively low — either around its “natural” level (~4–5 percent), or below. I think the critique is not as strong as some make it out to be, because the bust is a sudden change in relative demand, with significant capital consumption. During the boom, there is competing demand for consumer and capital goods, so one sector doesn’t necessarily suddenly become unprofitable. The shift in the allocation of labor is much less painful during the boom. Still, Krugman (and Rothbard) have a point: ABCT cannot explain the depth of unemployment very well.1 You need an additional story, and the scapegoat many Austrians like is government, bad supply-side policy and regime uncertainty. But, blaming government is not always right.2

Explaining the direction the general price level moves in is relevant to explaining the depth of unemployment. Putting debt deflation and liquidity traps aside, deflation is good if it’s neutral. If the demand for money increases and deflation is non-neutral, the unemployment rate and the output gap will grow. Assume the money stock at time t is M1, but the demand for money at time t+1 calls for a stock equal to M2. If the supply of money doesn’t increase, there will be a demand shortage. There will be people who want to increase their cash balances by selling non-money assets, including labor and goods/services. But, there isn’t enough money to meet their demand for it. If deflation is neutral, a falling price level will cause a falling demand for money. If deflation is not neutral, the demand for money remains the same there is a shortage of money, and therefore of demand, and trade that would have taken place does not — output falls. Deflation can be non-neutral if some key prices don’t fall to clear the market, including the price of labor and, perhaps, other capital goods that are heavily complimentary to labor. This is monetary (dis)equilibrium theory. You need this theory to explain the depth of the recession.3

Austrian business cycle theory does not offer us ideas on the direction the general price level takes during a bust. Empirically, deflation is the norm. ABCT cannot explain this deflation, except through use of alternative theories. Further, while the ABCT explains the boom and the direct causes of the bust, it cannot explain other elements of the bust that are caused by confounding factors. But, ABCT definitely does not predict an increase in the price level of capital goods, which is what would happen in a supply-side shock. Rather, it predicts declining capital good prices, which fits the evidence.



1. I discussed a similar criticism in an August 2011 article, “Rethinking Depression Economics.” I think that much of my insight is valuable, but, at the time, I had not considered the role of monetary equilibrium to the extent I should have.

2. Bad supply-side policy can explain a lot of unemployment. The high unemployment of the Great Depression is explained in large part by bad supply-side policy. Alternative theories should be seen as complimentary. Look at the difference in unemployment between Spain and the United States, both of which have similar output gaps. Spain is an example of bad supply-side policy. The U.S., however, is an example of bad demand-side policy. As the unemployment rate falls, the output gap remaining equal, supply-side theories of unemployment have less explanatory power.

3. Hayek understood this. Apart from his comments on the negative effects of deflation, see “The Gold Problem” (published in Good Money, Part I) and “Monetary Nationalism and Monetary Stability.” I think he realized the power of Hawtreyian (?) explanations of the Great Depression, which focused on international gold flows and reserve hoarding by part of central banks. He wanted to synthesize these theories with his own.

What Makes Austrian Business Cycle Theory Attractive

Tyler Cowen links to a recent paper which explores credit expansion and financial crashes. Cowen comments that Austrian Business Cycle Theory (ABCT) needs more Minsky. I disagree. It reminds me of a passage that I had highlighted in Piketty’s Capital in the Twenty-First Century, on bubbles and self-fulfilling expectations. One thing that makes ABCT so attractive to me — one of the most attractive facets of Austrian economics, in general — is the emphasis on rule-following behavior. This requires interpreting Hayek’s 1930s work on industrial fluctuations through a 1940s Hayekian lens. One way to interpret the business cycle is to ask why certain rules work for some period of time, which we can call the “boom,” and why these rules suddenly create erroneous decisions during another period of time, the “bust.”

Piketty offers a conventional psychological theory of the self-fulling bubble,

[T]hese anticipated future prices themselves depend on the general enthusiasm for a given type of asset, which can give rise to so-called self-fulling beliefs: as long as one can hope to sell an asset for more than one paid for it, it may be individually rational to pay a good deal more than the fundamental value of that asset (especially since the fundamental value is itself uncertain), thus giving in to the general enthusiasm for that type of asset, even though it may be excessive. That is why speculative bubbles in real estate and stocks have existed as long as capital itself; they are consubstantial with history.

— p. 172.

The above is representative of a fairly common way of explaining bubbles and financial crises. Other explanations, such as Minsky’s might be more sophisticated, but they essentially grasp towards the same idea. I find their insight to be somewhat trivial, because they are vague theories that simplify agents’ behavior in financial markets to “they buy what they think everyone else will buy.” But, and this is an empirical question, I doubt that very many investors make their choices based on the expectation that an asset will continue to rise in value, despite that price diverging from “fundamentals.” Instead, what we see is investors justifying their decisions based on their reading of the “fundamentals” — i.e. the national housing market will not suffer a bust —, only to find out that their interpretation is wrong.

What ABCT does, once fully synthesized with Hayek’s later work on knowledge, institutions, and rule-following behavior, is embrace rational, informed decision-making in financial markets, and then explain how these rules can lead to welfare reducing outcomes if these rules are “distorted.” Hayek’s early model simplified all of these behavior-constraining rules to profits. Investors chase profits, because profits signal healthy, strong investment. Where assets grow in value is where there are profits. To investors, these increased revenue streams are the “fundamentals.” They invest in an asset because that business, or that market, is doing well. Any theory of the business cycle has to explain why these expectations, and the “fundamentals” (the heuristics) that guide them, are suddenly reversed — why do markets, which usually read the “fundamentals” so well, fail in bulk?

Minsky needs ABCT, not the other way around. The ABCT is, so far, the most complete demand-side theory of reversed expectations. I will refrain from claiming it’s the best, because so far maybe it hasn’t been compared to adequate alternatives. And, undoubtedly, ABCT is far from perfect, itself. You also need to take an empirical approach, because the lessons of ABCT have to be generalized — the narrow model is not perfectly applicable (as is the case with every theory). But, the point I want to make is that the credit-boom aspect is not what’s unique to ABCT. You can find that in Minsky. Other economists have made similar connections (e.g. Alan B. Taylor). What’s unique to ABCT is how it puts the story together by trying to explain investors’ behavior, and why this behavior turns out to be systemically suboptimal. It provides a sophisticated explanation, and I don’t think Minsky — or others who rely on psychological, rather than institutional, explanations — succeeds to the same degree.

Spain’s Cyclical Disorder

I like to read the comments people leave in articles in Spanish sports papers. I find them funny. There’s typically a decent mix of inter-team hate, intra-team hate, and general conspiracy theory. One can find a similar mix in the press of other countries, but not nearly to the same extent as in Spain. What these comments reveal — although there may be some sample bias — is an emerging culture of mistrust, caused in large part by ongoing depression in Spain and political corruption. Strong economies are built on trust, and this emerging culture in Spain can undermine forces of recovery in a country already handicapped by bad structural and counter-cyclical policy.

In “Economics and Knowledge,” Hayek developed a theory of equilibrium incorporating the role of expectations. In a division-of-labor where each agent relies in large part on others, an equilibrium occurs when the expectations of these agents coincide. For example, you, generally speaking, would only continue to work if you were certain that you would receive a paycheck at the end of the week. Businesspeople have certain expectations of the demand for their product, and of profitability. In the real world, expectations are often wrong — businesses fail, stock markets crash, et cetera. In equilibrium expectations are in harmony, so that everyone’s plans coincide.

The term “coordination” is essentially synonymous with “equilibrium.” For disparate expectations to jive, plans must be coordinated. When plans don’t coincide, there’s discoordination. Coordination differs from equilibrium, however, in that it has a more ambiguous definition. It might be useful to think about it as a spectrum. Plans may not be perfectly coordinated, but people’s actions are not always total failures. In fact, most of the time, things work out. When you take your car to the mechanic, he’s there; your paycheck arrives on time; your landlord expects and gets his rent by the monthly deadline; et cetera. We can also think about an economy having a certain degree of order, where equilibrium is maximum order. The better coordinated plans are, the higher the degree of order.

The concept of order can be applied to business cycle theory. Expectations have played a central role in business cycle research since the 1930s. Most firms do not expect a sharp decline in demand. Those that do typically mistime their preparation. A clear example is the 2007–09 financial crisis. Investment banks’ plans did not work out when a significant fraction of their assets dropped in value. The small businesses which went bankrupt had their expectations reverse. In mid-2006, few people thought that they had a large probability of losing their jobs in 2008–09. The business cycle is a period of discoordination — a loss of order.

Spain’s recession, following a housing bubble, has been particularly bad. Indeed, it feels more like a depression. Spain’s unemployment rate is over 26 percent. Much like during the Great Depression, a large fraction of unemployment is the result of bad policy. The IMF estimates Spain’s average outgap gap for 2013 at –4.338, which is comparable to that of the United States. Yet, the U.S.’ unemployment rate is “only” at 6.7 percent. Bad supply-side policy, in conjunction with bad demand-side policy, has made a disaster of an already bad situation. Spain’s structural problems, of course, have existed for a long time, but they were partly hidden by the boom of the early and mid-2000s. Schneider (2011) estimates that the value of production in Spain’s informal (extralegal) sector has been greater than one fifth of Spain’s GDP since ~1994, falling to 19.3 percent of GDP in 2007 — but, no doubt larger after the crash (although, in part because of a decline in GDP). Large extralegal sectors are typically a sign of bad supply-side policy.

Problems in Iberia go beyond bad policy. Spain’s democracy is more fragile than some people realize. The country has passed a few tests for robustness — such as the (quasi-abortive) February 1981 coup —, and high growth during the late 1990s and for much of the 2000s seemed promising. Indeed, many in Spain were looking forward to the day that the country would replace Canada in the G8! But, the country’s economic woes have been joined with corruption issues in government — and the problem crosses party lines: bribery, illegal payments, money laundering, et cetera. Further, regional banks funded local programs, and the relationship between these banks’ balance sheets, their health, and the political support they receive is unclear. These scandals have made it hard for Spaniards to trust their governments, whether national or local. The range of this distrust has spread to the royal family — especially after legitimate corruption charges against some of its members — and elsewhere.

The extent of distrust can be seen in Spain’s changing football (soccer) culture. Referees are always criticized. It’s hard to find an article on a big Premier League game without reading one manager’s criticism of the referee’s handling of a game. There are constant complaints against refereeing in all sports. But, in Spain, it’s especially bad, because complaints have given way to conspiracy theories. There is this notion that the governing body in Spain, RFEF, implicitly or explicitly supports a status quo that favors Barcelona and Real Madrid, the two highest earning football teams in Spain. The theories go as far as to claim that referees make their calls to purposefully help the the two “big teams” (los grandes). And, of course, between the two big teams fans accuse the other club of corruption. Even players have made these accusations — Cristiano Ronaldo and Sergio Ramos, players for Real Madrid, made comments to this effect after last weekend’s match against Barcelona.

There is, in general, an emerging culture that sees corruption and scandal everywhere. Bonds of trust are disintegrating. This can have dire long-term consequences. Trust, in some sense, is an institution; or, it’s a value manifested in certain institutions. Businessmen spend a lot of time and money establishing a relationship of trust with their clients. They offer warranties, they make sure to always leave their customer satisfied (hoping for the relationship to be repeated over time), et cetera. When there is no trust, the economy suffers. The transaction costs to some exchanges can become too high, and trades which would have led to gains for all parties involved simply don’t take place. To put the role of trust into perspective, recall the 2011 paper by Nunn and Wantchekon, finding evidence that slavery created a culture of mistrust, holding development in sub-Saharan Africa back. This is happening in Spain. While political corruption is hard to compare to slavery, the emerging culture in Spain may have dire economic (and political) consequences for years to come.

Mistrust might make political reform more difficult. Note how untrustworthy Ukrainian protestors have been of the “reformed” Ukrainian government. The same is true of Spain, although in different areas and to a different degree. Governments with fragile relationships with their people are going to have a hard time passing structural reforms that may not produce immediate results. Mistrust also makes a situation ripe for regime uncertainty. Uncertainty over the political climate makes business more difficult and less attractive, especially if this business requires large investments. Mistrust can spill over into the private sector in other ways around. Large businesses — which tend to be villainized when it’s the worst off who suffer the most — can lose demand for their product, even if their product confers to the consumer the highest satisfaction relative to other choices. Mistrust can even hurt relationships between small businesses, and even between small time vendors and their customers.

The effects of the business cycle, especially if these effects are made worse by bad policy and political corruption, can influence an economy for many years thereafter. They can make recovery more difficult. When a people lose faith in their institutions of governance, this mistrust tends to spread to other sectors of life, including business. It itself is corrupting, because it changes the institutions which guide economic processes. It limits trade, and when trade is limited we lose out on gains from trade. Countries like Spain (and Greece) are undergoing this transformation, and if this process isn’t reversed, the consequences can become more dire than they already are.

“Narrow” Self-Interest

Jacob Levy, at Bleeding Heart Libertarians, digs up a comment on Hayek and public choice theory, made by Jeremy Shearmur. Shearmur makes what I believe is a mistake in his interpretation of how economists use the term “self-interest,”

Buchanan argued, steadily, that we should treat people as self-interested. But it is clear that this does not work: there seems every reason to believe that people go into politics for a variety of motives, and no special reason to believe that they are motivated by narrow self-interest.

Notice the adjective that he tacks on to self-interest: “narrow.” But, why should we interpret self-interest, as used by economists, to mean the narrow kind and not the broad kind? Most economists, whether implicitly or explicitly, mean “broad,” not “narrow,” self-interest.

How do individuals choose between alternatives? The subjective theory of value that underlies most of modern economic theory assumes that people attach values to various ends, and that they will choose between ends based on these values and their budget constraint. Suppose, for example, that some representative agent holds strong moral beliefs that call for donating half of her income to charity. In other words, because of her moral beliefs, she attaches what we can assume to be a high value on the end of donating half of her income to charity. And, if she donates that money to charity, we can assume that that end was valued higher than all other alternative ends.

Notice how the concept of “narrow” self-interest is difficult to even define. Assume that it’s about money. If economists really believed in “narrow” self-interest they would have to make the case that it was irrational for that representative agent to donate half of her income, because the alternative of not donating any fraction of her income seems like the superior choice. If y is her post-donation income, 2y > y. But, then they would have to deal with the paradox that the end attached to the act of donating half of one’s income is ranked higher than all other alternative ends, including keeping her full income for herself. But, there is no paradox, because economists know — and assume — that individuals will choose based on a set of subjective preferences.

What leads people to interpret the economist’s use of self-interest as having a “narrow” definition is probably the way economists design their models. People tend to interpret these models too literally. Economists use narrow concepts in order to simplify the model. The model itself is only an imperfect tool to understand the much more complex real world. If we included everything that might influence how an individual values alternative ends we would have a very intractable model and it would not be very useful as a tool, despite being more “realistic.” (See how little insight “more realistic” methods have gained us. See how some of the deepest insights in economics have come from extremely simple models.) So, instead we assume they base their decisions on the amount of money alternative ends return, or some other proxy. That’s the thing: when modeling, economists use proxies to simplify the problem.

This speaks to the recent controversy over how physicists interpret economic problems. I feel that many people missed Chris House’s point. People outside the discipline, who learn the methods for their own specialization, oftentimes misinterpret why economists do things the way they do. This model is unrealistic. This model is missing this or that. They assume that economists are ignorant of some fundamental insight. The fact is, however, that this is simply not the case. They miss the point of why economists model the way they do.