Category Archives: History

NGDP and the Recession

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One of the biggest reasons I don’t find much merit in the idea of NGDP targeting is that it’s not clear to me that changes in real GDP (RGDP) always follow changes in nominal GDP (NGDP). Likewise, I’m convinced that downward shocks to RGDP lead to downward shocks in the money supply, as opposed to vice versa. While I advocate a counter-cyclically elastic money supply, I don’t think that monetary stimulus can help avoid the correction of the real economy that results from fiduciary over-expansion. Scott Sumner’s recent post on what he would expect had the Federal Reserve begun targeting NGDP by mid-2008 only deepens my suspicions.

Sumner thinks that had the Fed been targeting NGDP in mid-2008, the financial crisis wouldn’t have happened. I find this claim very unconvincing. If we are to believe Gary Gorton, the financial crisis was mainly caused by a breakdown in wholesale credit channels, because the bulk of the collateral being used in these markets had become information sensitive. What this means is that the collateral began losing value, or trading below par, forcing investment banks, and other wholesale debtors, to increase the amount of collateral to maintain the same level of short-term borrowing. For Sumner to be right, NGDP targeting would have to, somehow, maintain the value of the collateral. The main asset acting as collateral, at the time, was the mortgage backed security (MBS), and related assets (i.e. the collateralized debt obligation [CDO]). The value of these assets were dependent on the nominal demand for housing.

Could NGDP targeting have maintained the demand for housing? The answer, in my opinion unambiguously, is ‘no.’ MBS’ are financial assets composed of mortgage debt, where the pooling of loans allows asset holders to spread the risk of loans with higher probabilities of default. Prior to the financial crisis, MBS’ were considered to be some of the safest, or relatively information insensitive, assets. Their safety, however, relied on the expectation that the default rate, on average, would be below a certain percentage. The default rate is a factor of various variables, such as homeowner income, the cost of the home, et cetera. But, during the boom, continuously rising prices effectively decreased the real cost of debt, since homeowners who couldn’t afford their mortgage could simply re-sell the house for a higher price than they bought it for — they would earn a profit! The rise in the home prices, in turn, was fed by continuous loan origination, but by 2005–06 loan originators were running out of people to loan money to.

There’s only so much room to lower lending standards. Thus, by 2005, the pace of loan origination starting to fall, and with it home prices began to plateau, then stagnate, and finally gradually fall. As home prices fell, the default rate increased. While it took roughly two years for it be obvious, the securitized assets based on these loans were also losing value — that is, the supply of safe assets shifted to the left (supply decreased). Financial firms which relied on MBS’ and CDO’s as collateral for short-term borrowing quickly saw the assets side of their balance sheet deteriorating, and this is what caused the financial crisis of 2007–09. There was a bank run. It didn’t look like a bank run, because it wasn’t ordinary depositors who were worried about banks making good of their deposit liabilities. Rather, it was wholesale depositors worried about being repaid, because it suddenly became obvious that banks simply didn’t have the assets to sell to access the liquidity to repay their debts.

The point is, for the financial crisis to have been avoided, it would have been necessary for the Fed to continue the housing boom. We normally think of Fed policy affecting asset prices more directly, but in this case the boom in asset prices was directly linked to the boom in home prices. Given the lack of a sufficient volume of new mortgage debtors, I don’t think it was possible to maintain the housing boom (not to mention it would have been undesirable).

We would have still seen the significant fall in real incomes (because of falling home prices and large household debt), and we would have still suffered from a dramatic fall in output. Wholesale credit markets would have still dried up, and banks’ would still be forced to deleverage. But, I agree with Sumner that the recession would probably have been milder had the Fed better accommodated the rise in the demand for money. This being said, I’m also sympathetic to a certain aspect of the Post Keynesian endogenous theory of money — well, actually, this is an aspect of mainstream banking theory, too (even if Post Keynesians think they’re the only ones who acknowledge it). The Fed can only accommodate the demand for money indirectly, by inducing banks to make loans. If the banking system is damaged and credit channels are dried up, then this channel becomes less effective. The same is true if uncertainty makes borrowing too costly, which is Richard Koo‘s major argument against monetary policy.

Historically (see Gorton’s Misunderstanding Financial Crises), to avoid the problem of moribund banks, there has been some process of balance sheet strengthening. For example, prior to the Federal Reserve, clearinghouses would pool member banks’ assets and issue their own currencies, almost as a temporary bailout. Following the financial crisis, the Federal Reserve bought large quantities of MBS’, but I’m not sure how effective this tactic actually was. It seemed to have a greater impact only years after the brunt of the damage had already happened.

Thus, my main concern with NGDP targeting is that the theory papers over concerns of resource misallocation. Typically, when we think of misallocation we think of too large of a housing sector, or too many construction workers, but there was also a massive misallocation of financial capital. Even if the Fed were targeting NGDP, the likelihood that the assets people had invested in at the time were going to see a large drop in value would be enough to cause a shock to RGDP, and therefore a shock to NGDP. It was out of the Fed’s control. I do think that accommodating the rise in demand for money would have eased the transition, but I don’t think this is a panacea. Also, I think there’s merit in the broad “regime uncertainty” story. I don’t believe our government suddenly became more interventionist than it was before, but I’m of the opinion that a lot of the transaction costs that make structural adjustments more difficult went, in a sense, unseen during the boom — fiduciary overexpansion made transaction costs less expensive. This is one reason why I find the “evidence” against fiscal austerity superficial and unconvincing. NGDP targeting is only a little bit less unconvincing than the case for fiscal stimulus. I prefer a Hayekian, microfounded explanation of the business cycle.

What’s So General about the General Theory?

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Bruce Bartlett considers the title of John M. Keynes’ magnum opus, The General Theory of Employment, Interest, and Money, an “unfortunate error.” According to Bartlett, Keynes’ core insight is the liquidity trap, which he defines as a situation where both inflation and interest rates are low, making bonds and money close substitutes. Thus, Keynes’ economics are mostly applicable only when an economy is in a liquidity trap. I think Bartlett has it mostly wrong. The liquidity trap only plays a small role in The General Theory, and the book’s major contribution — at least, as intended by Keynes — is its business cycle theory.

If you’re wondering what the liquidity trap is, I give an overview of the development of the theory in a June 2010 Mises Daily, “Krugman contra Hayek.” Most of my overview is based on a paper by Mauro Boianovsky, “The IS-LM Model and the Liquidity Trap Concept: from Hicks to Krugman.” A modern interpretation of the liquidity trap theory is provided by Paul Krugman, in his 1998 paper on Japan. Krugman’s definition is a bit more general: when conventional monetary policy no longer stimulates, otherwise known as the zero lower bound (ZLB).

How big of a role does the liquidity trap play in The General Theory? In Keynes’ 1936 book, the liquidity trap is mentioned, in passing, in chapter 15,

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest.

— p. 207.

Keynes suggested, with healthy skepticism, that the early 1930s may be an example of a liquidity trap, but that these cases are indeed very rare. It certainly is not the centerpiece of Keynes’ theoretical exposition. In fact, the liquidity trap is probably better identified with John R. Hicks (who later repudiated much of his work from “Mr. Keynes and the Classics“), who also introduced the IS/LM diagram taught in intermediate macroeconomics. In any case, none of the theories that Keynes developed in his book were specific to the liquidity trap, nor require the liquidity trap as a precondition for their validity.

Keynes’ main argument, in my opinion, consists of an integration of R.F. Kahn’s multiplier with the macroeconomic framework Keynes began to develop in his A Treatise on Money (and volume II). The main purpose of The General Theory is to explain how an underemployment equilibrium may arise, and Keynes’ theory is that cyclical fluctuations are caused by increases in the stock of savings which cannot be met with greater investment. The theory is similar to monetary disequilibrium, but rather than an increase in the demand for money and sticky prices, the shock in aggregate demand is caused by a sudden reversal of entrepreneurs’ expectations (more on the differences between the two theories here).

The most well known term associated with Keynes is “animal spirits,” but at first he actually frames his theory as a secular outcome of economic growth. As an economy becomes more productive and incomes grow, the propensity to save tends to grow at a faster rate than the marginal propensity to consume. In other words, the proportion of saving to consumption increases over time. A tenet of the Keynes–Kahn multiplier is that present investment is directly derived, by and large, from present consumption. As consumption falls, the scope of investment falls, and vice versa. It follows that at some point savings is bound to increase beyond the point it can be profitably invested, causing an aggregate demand shock. Drawing on “animal spirits” helps with the application of this theory, since recurring waves of optimism and pessimism can cause the sudden changes in expectations that leads to a shortage of investment. But, “animal spirits” is not a central component of the “general theory.”

In the course of explaining his theory, and its many components, Keynes offered two main challenges to what he termed Classical economics. The first, early on, is that wages aren’t sticky, rather they may not be able to fall in real terms, at all. He posited that since labor makes up a significant portion of the costs of production, a nominal reduction in wages will lead to a proprotional nominal reduction in the price of output, leaving real wages the same. By doing this, he circumvented the typical explanation for mass unemployment: the artificial rigidities created by interventionism. Second, he engaged the believe that savings and investment is well equilibrated by the rate of interest. He argued that the interest rate is not only determined by time preference, but also by liquidity preference — interest on non-cash assets have to include a premium to make up for their relative illiquidity. If a high liquidity preference increases the rate of interest well beyond its equilibrium, or natural, level, there will be some discoordination between savings and investment, leading to or aggravating a demand shock.

What’s the general theory, then? All of this is explained within the context of a novel macroeconomic framework. Keynes was advancing a theory of the coordination of several macroeconomic aggregates: investment, savings, consumption, interest, et cetera. He argued that capitalist economies are prone to demand shocks — not under special circumstances, but generally. And, actually, referring to Keynes’ theory as a business cycle theory may be somewhat misleading, because the business cycle theory is really only secondary to the macro framework Keynes was attempting to construct. That is, demand shortages are only a part of the broader theory of Keynes’ vision of how economies work on aggregate: investment, and therefore employment, is determined by the expected demand for final output. Keynes relegated supply-side considerations to the back burner.

Maybe by “core insight” Bartlett means the key concept that economists took from Keynes. But, even then, I think he’s wrong. The key, and in my opinion erroneous, belief is that present demand for consumers’ goods output determines the scope of present investment, especially without considering supply side qualifiers that would radically change the implications of Keynes’ general theory. It’s this idea that informs the opinion that consumption drives the economy (and that to restore aggregate demand we must stimulate consumption). It’s this relationship which is one of the most important facets of Keynes’ general theory of macroeconomic coordination.

Also, briefly, I’m not sure just how skeptical of monetary policy Keynes was. I recommend two papers on the topic: D. Moggridge and S. Howson, “Keynes on Monetary Policy;” and E. Dickens, “Keynes’s Theory of Monetary Policy.” Also, Hicks discussed some differences on monetary policy between Keynes and Ralph Hawtrey, in his book Economic Perspectives.

The Error of Latin American Market Reform

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Left Behind (Edwards)In the story of Latin American economic reform, then, one variable more than any other plays a crucial role. It is not inflation, wages, or economic growth; it is not privatization or the extent of openness and globalization; it is not even foreign debt. The key variable is the exchange rate, or the value of the local currency — the peso, the bolivar, the quetzal, the real, or the córdoba — in relation to the United States dollar. Repeated mistakes in exchange-rate policy will be singled out as the most important cause behind the region’s economic travails, the waning support for modernizing reforms, and the eventual revival of populism during the twenty-first century.

— Sebastian Edwards, Left Behind: Latin America and the False Promise of Populism (Chicago: University of Chicago Press, 2010), p. 142.

The problem that Edwards brings to our attention is the seeming inability for a fixed exchange rate regime to coexist in a country with independent monetary policy. In a floating exchange rate regime, a fall in the value of a currency will also manifest itself in the exchange rate — the currency becomes cheaper relative to others. If the price of local currency is fixed, however, internal inflation will cause it to become overvalued relative to foreign currencies. This discourages export-oriented growth.

But, the currency and debt crises that struck Latin America in the mid- and late 1990s was more than just a price fixing problem. Latin American assets (except for debt denominated in foreign currency) also required currency exchange to take place, and so the artificially overvalued local currency should also impact capital flows (or, at least, the kind of assets held). But, inflationary environments tend to correlate with — and/or cause, I think — asset price booms, so holding these assets becomes attractive. Most Latin American countries were running large trade deficits, meaning they have capital account surpluses. In my opinion fixed exchange rates in an inflationary environment is part of the problem, but not the whole story.

Stupidest Man Alive

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I apologize to Brad DeLong for taking the name of his “award,” but it’s for a good cause,

Harvard Professor and author Niall Ferguson says John Maynard Keynes’ economic philosophy was flawed and he didn’t care about future generations because he was gay and didn’t have children.

— Tom Kostigen.

Edit 1: Actually, DeLong has already commented on this, tracing the claim to Gertrud Himmelfarb.

Edit 2: Nial Ferguson apologizes. I don’t doubt his sincerity, but what possible cost-benefit analysis could have led him to make those remarks when he did?

Washington Consensus: Forced or Homegrown?

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Left Behind (Edwards)I have argued elsewhere that the Washington institutions — the U.S. Treasury, the World Bank, and the International Monetary Fund — had little to do with the specifics of these reforms. It is true that to participate in the Brady debt forgiveness program the Latin American countries had to show some commitment to modernizing their economies. However, there was no detailed list of reforms that had to be implemented. Clearly, the actual policies were not imposed or forced upon the Latin American governments. The reform programs were largely homegrown and were Latin America’s own response to more than a decade of crisis; they were developed by a group of foreign-trained economists who have been labeled “technopols.” In fact, the Washington institutions were skeptical — and in some cases openly opposed — to some of the most daring reform proposals. To be sure, as time passed, and more and more countries adopted these policies, Washington began to support the effort.

— Sebastian Edwards, Left Behind: Latin America and the False Promise of Populism (Chicago: University of Chicago Press, 2010), pp. 64–65.

The story Edwards tells is that the failure of the Washington Consensus wasn’t a failure of “Neoliberalism,” but a failure of local governments to implement at truly “Neoliberal” agenda.

Frames of Reference

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Pete Boettke writes on Keynesianism and how it changed the “language” of economics, arguing that this was a turn for the worst. Ryan Murphy argues that this can’t be true, since the evidence suggests that differences in language plays only a minor role in changing the way we think. In defense of Boettke, I think Murphy is is taking his criticism too far and Boettke’s use of the word “language” too literally.

Much of post-war economics was very different to the economics of the interwar years. This is one of the themes in Kim Kyun’s Equilibrium Business Cycle Theory in Historical Perspective. According to Kyun, interwar econometricians sacrificed much of the richness of interwar (business cycle) theory in exchange for more formal, but much more simple models which they could use to test against data. These models suffered from very similar problems that modern econometric models do, and so it can be argued that the decades following the Second World War represent, to one extent or another, theoretical stagnation. Some of this was reversed thanks to Robert Lucas, but not completely.

I think Murphy is right in that it’s always possible to use any language to describe your ideas. For example, RBC and DSGE models can be re-written to include things that Austrians are concerned about (this is actually a research program I’d like to explore, once I know the tools well enough). In fact, in ways much of this work has already been accomplished. In other words, models or a “language” don’t necessarily constrain the economist to a relatively limited number of research paths.

Nevertheless, it’s also true that existing models emphasize some concepts more than others. When learning these models, students will be exposed to these areas. They won’t be as exposed to the areas left unstudied. Someone looking to modify the existing models with different emphases, therefore, has to be exposed to these different emphases in other ways. This oftentimes happens, but I’m not so sure that it happens to everyone (and often, when it does happen, it goes either ignored or it becomes something of a paradigm shift — e.g. the microfoundations revolution). Those that don’t receive exposure to, or develop on their own, ideas not focused on in existing models will have a stronger impetus to continue research in the areas she knows best, which is why economists like Boettke argue that certain programs are left understudied.

So, while “language” might not make it any harder to think about one thing than another language, the concepts that a set of models looks at are the concepts that students of these models will get to know. This certainly does affect the beliefs and ideas that economists will hold. This isn’t true only of the mainstream. It’s something I’ve noticed within Austrian circles, as well, which is why I spend so much time arguing that we should opt for open-mind approaches as much as possible. There are ideas that aren’t emphasized in much of the (older) Austrian literature, so you have to go elsewhere to find them.

With regard to Boettke, my only complaint is that I think he has the culprit wrong. Keynesianism is relevant to the extent that it was the dominant school of thought during the immediate post-war era. But, there are different ways to think about Keynesianism. Kyun argues that it was the formalization and econometric drive of post-war economics which reduced the richness of theory. Keynes was actually skeptical of this program. Many of Keynes’ followers also went down different paths, many of them towards research programs that are now relatively obscure (e.g. Hicks’ later work, Minsky, et cetera), but thick and dynamic. More recently, Keynes has been re-interpreted (e.g. Shackle, Leijonhufvud, and Steele) in “Austrian” terms, with an emphasis on coordination. This is analogous, I think, to what Murphy has in mind.

Nevertheless, I do think there is something to the belief that there exists in economics “modes of thinking,” determined by the emphases of the models that economics students learn. This is why schools that close themselves off tend to focus too little on the very things their models speak little of, and why larger, more open schools tend to have a more versatile, richer tradition. It’s also a very good reason why Austrians should consider themselves only as compliments to the rest of the Neoclassical tradition — not just because of what we can teach them, but because of what they can teach us.

The Hicksian Revolution

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I’m reading required segments of George A. Akerlof’s and Robert J. Shiller’s Animal Spirits for a Keynes–Hayek seminar held, here, in San Diego, over this weekend. They write the following,

Within a year of the publication of Keynes’ General Theory, John R. Hicks published a quantitative interpretation of Keynes that emphasized a rigid multiplier and the interaction of its effects with interest rates. Hicks’ version soon superseded Keynes’ original as the authoritative embodiment of Keynesian theory. Keynes was ruminating, discursive, disjoint, impenetrable, but nevertheless provocative and amusing; Hicks was orderly, efficient, and logically complete. Hicks’ version won the day. He is not as famous as Keynes, for he is often viewed as a mere interpreter of Keynes’ genius. But in terms of the history of thought, the “Keynesian revolution” was just as much a “Hicksian revolution.”

— George A. Akerlof and Robert J. Shiller, Animal Spirits (Princeton: Princeton University Press, 2009), p. 14.

Not to mention, in many ways Hicks’ work was original, or at least based on previous theoretical research of his.

I’ve been thinking about how much Keynes contributed to the economist of the post-war, and I’m beginning to convince myself that the answer is “not much.” Many of the ideas in The General Theory are so far out there that they were bound to be rejected by the brunt of the profession. A lot of the overarching ideas were already out there, including Keynes’ earlier work. Maybe The General Theory‘s role in the history of thought was as an impetus. But, what seems most influential about Keynes is this widely held belief that he is the “father of macroeconomics,” despite the fact that Keynes’ direct influence on economics is probably overstated.