Boudreaux’s Knowledge Problem

Don Boudreaux quotes from Lucien Albert Hahn’s book Economics of Illusion.  On this topic, I reviewed Hahn’s book Common Sense Economics, which was, in a sense, a follow-up to Economics of Illusion.  I also provide a brief history of Hahn’s intellectual journey and his contributions to economic science.  Boudreaux repeats something that many people who know of Hahn’s economics like to write, and which Hahn also said of himself: Hahn’s original beliefs closely mirrored those of Keynes, and his original treatise  preempted Keynes’ The General Theory.  I think that Keynes’ economics are probably fundamentally different to those of Hahn (at least, Hahn’s original paradigm).  The complexities of Keynes’ theories are far more advanced and intricate than Hahn’s, or at least substantially different.  What many people do not realize is that Keynes did not just sell a set of policy prescriptions; he caused a revolutionary shift in framework.

I have actually, to-date unsuccessfully, tried to come upon an English translation of Hahn’s original treatise, Volkswirtschaftliche Theorie des Bankkredits.  I was interested in actually comparing the ideas of Hahn and Keynes.  I have become skeptical of comparisons to Keynes, because I have come to realize that most people took away only a very superficial understanding of what Keynes was trying to get across.  I am not saying that Keynes was right; I believe the exact opposite.  I am saying that few people have taken away from Keynes the unified body of theory he presented in The General Theory, correct or incorrect.

I have gone on a bit of a tangent on L. Albert Hahn and John Maynard Keynes, and I originally did not intend to do so.  Instead, I wanted to comment on a minor point Boudreaux makes in his post that I think is wrong.  Boudreaux writes as follows,

In contrast, microeconomic maladjustments across both space and time – what Arnold Kling might call unsustainable patterns of specialization and trade – are not seen by anyone (save by careful economic theorists).

I admit that I am critiquing a tangential point, and probably reading too much into what Boudreaux writes.  Nevertheless, I think this is a good time to bring up the fact that no economist can “see” “unsustainable patterns of specialization and trade”, or malinvestment.  We can make a generalized assumption that malinvestment exists, or that conditions are present for the formation of malinvestment, but you cannot point out which exact investments are malinvestment and which are not.  To illustrate my point: you cannot call the entire housing sector beyond some theoretical point “malinvestment.”

Malinvestment is a microeconomic concept.  It has nothing to do with “patterns of specialization and trade.”  Hayek’s ideas here, as elucidated in Prices and Production, are quite clear.  Malinvestment is caused by a dearth of capital goods, and who exactly will be affected the most by this scarcity is a question of the unfolding pattern of coordination.  Thus, you cannot pinpoint where exactly malinvestment is occurring or predict where it will occur.  Those who are forced to liquidate are those who feel that the changing conditions of investment no longer favor their entrepreneurial adventure.  That is why economic recessions are so widespread; they affect all capital goods industries.

The over-investment in the housing sector was not a consequence only of credit expansion.  There was an over-concentration of malinvestment in the housing sector for other reasons, which are outlined in Jeffrey Friedman’s and Wladimir Kraus’ Engineering the Financial Crisis (reviewed by me here).  Capital minima regulations imposed upon banks by the Recourse Rule channeled investment into highly rated (AAA) mortgage-backed bonds, favoring housing loans over business loans.

Those who claim they can see malinvestment will be handicapped by the same “knowledge problem” as the person who claims he knows what is best for the economy.  On this basis, I challenge Boudreaux’s assertion that the careful economist can see malinvestment.  I agree with his overarching point, which is that an economist trained in the proper tradition might be able to recognize the opportunity for malinvestment; but, this claim is very different from the much stronger one that Boudraeux, perhaps unintentionally, put in his post.

All this being said, I agree with the conclusion he draws.  Keynesians and Monetarists mistake the fall in demand as the cause of the recession, where a fall in demand is a secondary consequence (Monetarists, more specifically, mistake a fall in the supply of money as the cause, where it is a secondary effect of malinvestment).

  • Mattheus von Guttenberg

    I disagree. I think it should be obvious that one can identify areas that have malinvestment before the fact. Peter Schiff and Ron Paul are two examples of Austrians who saw the housing sector as being the prime area for malinvestment. And further, I think their testimony shows to what extent it was malinvestment.

    • Jonathan Finegold Catalán

      They made educated guesses, because they saw the forming bubble in prices. I’m not saying you can’t make rough predictions, but this is very different from saying you know exactly where there is malinvestment. This is illustrated by the fact that not every investment in the housing sector, even after the beginning of credit expansion, was a malinvestment; many people completed their investments.

      That’s also why I brought up Friedman’s and Kraus’ book. There were more things operating behind the housing bubble that made it so obvious.

  • Silvano

    “Volkswirtschaftliche Theorie des Bankkredits” is worth reading, expecially the second edition that can be considered the most pre-keynesian work of Hahn. I like this author.

    Modeling a kind of pure credit economy he explains how generally loans create deposits and not vice versa (at least from a systemic perspective). In Hans view credit and capital formation are strictly linked, money is not neutral and an increase in purchasing power doesn’t transmit immediately to prices of consumers good. He adopts the idea of Schumpeter that capital goods are created through credit channel (and not thanks to an increase of savings) bringing to extreme consequences. Then he figures out the idea of a “perennial high conjuncture”. Even if it has a strong inflationary stance (partially amended in his third edition) is really worth reading. It helps to understand how many post Keynesians think. He offered to me (even when I disagree with him) interest insight and since I work in a bank I easily understood his way of thinking.

    Basically if you want to model an endogenous process of money and credit creation you can agree that – at least in nominal terms – loans create deposits*, repayments of loans (re)create reserves and deficits / surpluses in balance of payments destroy / create reserves, i.e. threaten / improve banks’ own liquidity**.

    *De Soto asserts that even a single bank can create its own deposit, but I think this is an excessive interpretation.

    **See also the paragraph “Liquidity preference of creditors” in Anachronism of Liquidity Preference (The Economics of Illusions) for a better understanding of the accumulation of excessive reserves.

    • Jonathan Finegold Catalán

      Did you read the book in English or in German? If the former, where did you find it?

      • Silvano

        I read it in Italian (I don’t know German). It has been (re?)published with a good intro in 1990. In English I found “The Economics of Illusion” and “Common Sense in Economics” (the latter I still have to read it). If you speak Spanish very well you can make an attempt. I don’t know if it has been translated in English. If you can’t find it you may look for “German Monetary Theory” (H.S. Ellis) to know something more about him.
        I’m looking also for other early essays wrote by Hahn and Schumpeter but (unless you speak German) they’re very very difficult to find.

        • Jonathan Finegold Catalán

          I don’t think Common Sense Economics is worth reading in any urgency, especially with the reading you’ve already done. It has a good discussion on the stock market, but apart from that there are better books out there.