24 Sep 2013

Things Don’t Look Good for Those Fixated on Aggregate Demand

Economics, Federal Reserve, Krugman, Market Monetarism, Scott Sumner 87 Comments

First let me relay Peter Klein’s take on the Fed’s non-taper announcement:

The above is a good summary of the Rothbardian view on our current situation.

Now, there have been some developments in just the last week or so that, in a just world, would cause severe angst in the psyches of those who have been blaming the Great Recession on inadequate demand.

First, there’s David Laidler’s surprising interview with Russ Roberts. Laidler is as old school monetarist as they come; he actually helped Friedman and Schwartz with their famous Monetary History that overturned the then-prevailing Keynesian explanation of the 1930s, and got economists thinking that the Fed committed a sin of omission. The omnipresent (on the Internet) von Pepe sent me the interview and drew my attention to the implications for poor Scott Sumner. Consider these excerpts:

Russ: And I would say especially if it originates in the financial sector. There’s some debate–you allude to it in your writing–about what I would call the ‘real side’ or the microeconomics side. And you point out that the Austrian view, the idea that both the 1929 collapse and the current mess did see a very rapid run-up on asset prices that suddenly collapsed; and that obviously caused some challenges for the financial sector.

Guest [David Laidler]: Yeah. I mean, that’s right. People keep calling these things ‘financial crises’. They are really asset market crises. And they happen on the margin between markets for financial assets and markets for real assets. Like real estate and factories and physical investment. I don’t think the monetarist story of the onset of the Great Depression by the way, or the monetarist story about the onset of this Great Recession, is quite plausible enough. I can’t find anything in the data in the 1920s or the data in the run-up to this event, that shows a degree of sort of conventional tightening of money growth that can account for the speed of the subsequent downturn. That really looks like, in both cases, an economy where something was going badly wrong in real asset markets, and it just needed a little bit of tap from the financial markets to set a downward spiral going. And, you’re right–the Austrians were the pioneers of this kind of analysis, in the 1920s even; and of course there are still Austrians around. And if I may sort of put in a plug for Cambridge, England, where John Maynard Keynes was, Keynes’s colleague, Sir Dennis Robertson was developing a parallel analysis to this in the 1920s. And he wrote a little textbook; and its 1928 edition has got a couple of paragraphs expressing his fears about what was likely to happen in the United States if that asset market boom kept on going. And this was before the Great Depression and before the stock market crash. In contrast, the representative of monetarism in the United States in the 1920s was probably Irving Fisher; and Irving Fisher didn’t see anything coming. He was just concentrating on the behavior of the price level and saying all is well, right down to October 1929. And indeed afterwards. So, I think we’ve got to give the Austrians and Dennis Robertson some credit. And I’d like to see our profession start taking that analysis a little bit more seriously. I mean the mainstream of our profession; because of course the people who have been propounding it are certainly professionals themselves. But they are in a minority.

And the part that excited von Pepe:

Russ: So, you think it’s much more than just a monetary phenomenon.

Guest: Yeah, I do. I never thought I would live to say this, but on this particular instance, I’m inclined to line up with the Austrians. I think they really have a point about this issue, about asset market distortions. After long periods of monetary stability.

Russ: This again puts you in a small group of economists who have learned something from the crisis. Most economists–I find it remarkable how many people have managed to keep their theological views unchanged by this experience.

Guest: Well you must remember that I’m retired, so I don’t have to worry about pleasing journal editors any more.

Russ: Yeah. Well, no comment. What would be your view on, going forward, would be the ideal monetary policy? Should we be doing something like the Taylor rule? Do you think anything positive about Scott Sumner’s approach and that of others who argue for nominal GDP targeting? Milton at one point–he changed sometimes, but he argued for a steady growth rate in the rate of money. Where do you think we are right now?

Guest: Let me back up. Let’s think about a state of affairs in which we are out of the aftermath of the recession. So, two or three years more down the path. I still am pretty happy with the inflation rate as the target of policy. I base this a lot on Canadian experience. We’ve been targeting the inflation rate since 1991; we’ve done it pretty successfully. We didn’t have a big asset market crisis here. We had not had a recession until 2008 since 1991. So inflation targeting worked pretty well for us. And it worked I think because it was a very explicit policy target agreed between the government and the Bank of Canada. It wasn’t an informal thing, as it was in the Fed. It was discussed continually. And as time passed, the targets were hit and it gained in credibility. So I would see no reason to go from that to a nominal GDP target. I don’t like nominal GDP as a target for policy, for the simple reason is: that’s a variable that’s measured with a lag and it’s subject to a lot of revision. And I don’t see how you can run forward-looking monetary policy targeting the behavior of a variable that you don’t get a good reading on for 18 months after it’s happened. With inflation targeting based on a Consumer Price Index, you get timely data and it’s not subject to revision. The indices are not perfect, but they are well understood by policy makers and the general public understands them as well. If I tell my wife the Bank of Canada is targeting nominal GDP, she’ll just look at me and wonder what on earth I’m talking about. If I tell her they are telling her they are targeting the rate at which the cost of living goes up, she understands that. And knowing that there is that target out there affects the behavior of ordinary consumers and producers, not just financial markets.

* * *

However, as exciting as it is to see Laidler throw Market Monetarism under the bus, what’s really got my attention is John Cochrane’s paper castigating the liquidity trap. At times like this, I wish I were a tenured college professor, because if Cochrane actually did what he claims to have done, this is absolutely devastating to both Krugman and Sumner. First Cochrane sets up the context:

New-Keynesian models produce some stunning predictions of what happens in a “liquidity trap” when interest rates are stuck at zero. They predict a deep recession. They predict that promises work: “forward guidance,” and commitments to keep interest rates low for long periods, with no current action, stimulate the current level of consumption. Fully-expected future inflation is a good thing. Growth is bad. Deliberate destruction of output, capital, and productivity raise GDP. Throw away the bulldozers, let them use shovels. Or, better, spoons. Hurricanes are good. Government spending, even if financed by current taxation, and even if completely wasted, of the digging ditches and filling them up type, can have huge output multipliers.

Even more puzzling, new-Keynesian models predict that all of this gets worse as prices become more flexible. Thus, although price stickiness is the central friction keeping the economy from achieving its optimal output, policies that reduce price stickiness would make matters worse.

In short, every law of economics seems to change sign at the zero bound. If gravity itself changed sign and we all started floating away, it would be no less surprising.

And of course, if you read the New York Times, people like me who have any doubts about all this are morons, evil, corrupt, and paid off by some vast right-wing conspiracy to transfer wealth from the poor to the secret conspiracy of hedge fund billionaires.

OK, now on to the devastation (if true):

So I spent some time looking at all this.

It’s true, the models do make these predictions. However, there is a crucial step along the way, where they choose one particular equilibrium. There is another equilibirum choice, where all of normal economics works again: no huge recession, no huge deflation, and policies work just as they ought to.

So Cochrane first shows that he knows how to reproduce Krugman’s (and Sumner’s, mind you) favored outcome: Cochrane can use a New Keynesian model to produce an economy in a perverse equilibrium in which big deficits help, and even the Fed just promising to be irresponsible in the future (without doing anything today) can help. Thus, you could use such a model to justify Bernanke’s rounds of QE and Obama’s stimulus package. People like Eugene Fama, John Cochrane, and little old me are shown to be complete fools. What’s even crazier, is that even though “sticky wages and prices” are the reason you get equilibrium unemployment in a New Keynesian model, Cochrane can reproduce Krugman’s claimed result that making prices and wages less sticky (though not perfectly flexible) will just deepen the slump.

However, Cochrane then uses the same models and finds that there are different equilibria, where all the rules of Henry Hazlitt (my term, not his) apply:

The paper shows that all the magical policies are absent in this equilibrium: The multiplier is always negative, announcements about the far off future do no good, and deliberately making prices sticker doesn’t help.

These are not different models. These are not different policies or different expected policies. Interest rates follow exactly the same path in each case, zero from t until T=5, and following the natural rate thereafter. These are different equilibrium choices of the same model. Each choice is completely valid by the rules of new-Keynesian models. I don’t here challenge any of the assumptions, any of the model ingredients, any of the rules of the game for computation. Which outcome you choose is completely arbitrary.

The difference between the calamitous equilibrium and the mild local-to-frictionless equilibirum, in this model, is just expectational multiple equilibria (with an implicit Ricardian regime.) If people expect the inflation glide path, we get the benign equilibrium. If they expect inflation to be zero the minute the trap ends, we get the disaster.

I won’t quote him, but Cochrane goes on to say that if you’re trying to use empirical evidence to decide which equilibrium we’re currently in, then the Krugman story implies very large (price) deflation during the liquidity trap, whereas the “Treasury View” (aka classical economics aka full-employment economics aka “micro 101”) only works if we assume there have been impediments to the supply side since 2008. Hmm, can anybody think of any government policies that would hamper the economy since 2008?

* * *

And then, just to make sure we all agree that the interventionist New Keynesian approach “predicts” price deflation for times like ours, here’s Krugman commenting just yesterday nonchalantly on David Romer’s class notes:

I’ve mentioned David Romer’s nice formulation of modern applied macro — the way people actually think, as opposed to the intertemporal maximization with whipped cream that’s respectable. David now informs me that he has a set of publicly available class notes (pdf) that have been regularly updated, covering that ground even better — with an extensive section on the liquidity trap.

Romer’s notes still imply that a protracted liquidity trap should lead to accelerating deflation, which doesn’t seem to happen; I think most of us have turned to downward nominal wage rigidity as an explanation. In any case, this is more or less the state of the practical art, and I’m delighted to learn that he’s put it together.

Everyone catch the part I put in bold? The “state of the practical art”–you know, the approach that has blown the Austrians and austerians out of the water for its superior predictive ability–predicted accelerating deflation, according to Krugman. (NB, I think Cochrane’s NK model instead predicted an initially huge price deflation, which gradually shrinks as the liquidity trap continues. Not sure why there is a discrepancy, or maybe I’m misunderstanding.) But no worries, Krugman et al. just patched that up by turning to “downward nominal wage rigidity as an explanation.”

So, from now on, whenever any Keynesian guffaws at my inflation worries, I’m going to say, “I’m a scientist. In light of the new data, I realized that in 2009 I gave insufficient weight to the inertia in CPI, which I call the ‘ceiling friction coefficient.’ Other than that, my model came through with flying colors.”

87 Responses to “Things Don’t Look Good for Those Fixated on Aggregate Demand”

  1. Rick Hull says:

    While only tangentially related to Bob’s post, my feelings on “solving” economic problems via AD management:

    This modern idea of stimulating demand, for the sake of the “economy” (read: producers), reeks of putting the cart before the horse. An abundance of production is the result of a healthy economy, not the cause. You cannot return to a healthy state by stimulating demand for products that no one wants.

    Imagine a one-factory town that produces turds. People don’t want them at the price they are offered. Should we focus on the supply or the demand? What kind of tricks can we pull to make people demand turds?

    • Tel says:

      I heard the US and Canadian governments have been selling their GM shares, so maybe you should take notes on their strategy.

  2. Jonathan Finegold says:

    I was pretty astounded by Krugman’s wage rigidity hand-waving, too. It seems pretty “obvious” to me that the reason we didn’t see “accelerating deflation” is because, on average, most prices were actually increasing during the crisis — wage rigidity doesn’t imply an increase in the CPI.

  3. Daniel Kuehn says:

    This is fascinating. When Laidler changes his views as a result of the crisis he is lionized. When Krugman changes his views he is demonized for it. Hmmm…

    I wish I had the time to digest Cochrane’s paper too. Sumner has a post on it. I’m interested in hearing what Rowe, Wren-Lewis, and DeLong have to say (presumably some of them will get around to it soon).

    • Bob Murphy says:

      This is fascinating. When Laidler changes his views as a result of the crisis he is lionized. When Krugman changes his views he is demonized for it. Hmmm…

      Did I miss the Krugman post where he said, “I can’t believe I’m saying this, but the Austrians were right. I thought prices would drop at an accelerating rate, and they didn’t.” ?

      Daniel, the casual Krugman reader might not even realize he had changed his views on price movements in a liquidity trap, because Krugman so often says the Great Recession was a great showdown between two models (his and theirs), and Krugman’s model came through with “flying colors.”

      • Daniel Kuehn says:

        No the wage rigidity point. He learned there was something wrong with his model from the crisis. He reoriented his view of the world after seeing he was wrong. And he’s pointed out that he was wrong on this point – this wasn’t some new recent revelation.

        • Tel says:

          You have a link to where Krugman admits he was wrong… on something… on anything.

          You genius! Where did you find such a thing?

            • Matt Tanous says:

              He totally changed the model! Wage rigidity was never proposed by Keynesians as a factor, right? And, certainly, wages determining prices… that’s totally new. It’s not like that error has been floating around since Adam Smith and David Ricardo….

              • Daniel Kuehn says:

                Are you seriously extrapolating a comment on the role of marginal costs on prices into a full-fledged cost-of-production theory of value?!?

              • Tel says:

                Well well Krugman admitted he was wrong about something, there is still hope in the world.

                And, certainly, wages determining prices… that’s totally new.

                It seems a bit backwards when you look at the typical working class / middle class household and their nominal wages haven’t gone up by much, but the things they buy ( food, fuel, subway tickets, electricity, medicine, rent, etc ) have gone up significantly. Difficult to imagine how static wages are pushing up prices in this way.

                If the sticky wage theory was right then rigid wages might well slow down the rate at which prices fall… but that’s an explanation for an event that we never observed.

        • skylien says:

          Daniel,

          Is it really a change of his model, or not rather a change of input data that he estimated to be different? I mean Krugman always believed in wage rigidity so I don’t see how he changed his model significantly if at all.

          When Bob’s inflation bet didn’t turn out to be correct and he admitted to be wrong that he underestimated money demand, then it was also no change of the underlying model, right? It’s not like Bob thought money demand doesn’t play a role before that..

    • Bob Murphy says:

      DK wrote:

      I wish I had the time to digest Cochrane’s paper too. Sumner has a post on it. I’m interested in hearing what Rowe, Wren-Lewis, and DeLong…

      FWIW, I thought Scott almost didn’t even accurately reproduce what Cochrane’s point was, when he talked about it. But, at this point I am pretty critical of Scott so I’m probably biased. But for example Scott said something to the effect that it would be good if the Fed promised to keep interest rates low until NGDP was back on trend, when I thought Scott rejected the “awful” Woodfordian approach of thinking about monetary policy working through interest rates. Plus the whole “never reason from a price change” and “Milton taught us that low interest rates mean tight money” blah blah blah.

      Yeah I want to see Rowe and DeLong too.

  4. Daniel Kuehn says:

    There’s also a question of what these predictions assume about the monetary stance. We know Krugman’s NK model with a liquidity trap has the opportunity for the Fed to create inflation not through interest rates but through expectations. Is the simple Romer version he describes suggesting accelerating deflation in the absence of monetary policy? It would seem to have to because the idea of a Fed that can’t create inflation at all sounds odd and counter to everything we know about what NKs say monetary policy can achieve in liquidity traps. If the accelerating deflation outcome is before taking monetary policy into account then of course that’s another clear explanation of why we haven’t had accelerating deflation.

    I don’t know though, and I don’t know how Cochrane works with this.

    • Jonathan Finegold says:

      That’s what I thought, but I feel that if that was a possible explanation Krugman would have used it — because it’s much stronger than his wage rigidity argument. But, in his model inflation expectations need to be high over a period of future time, and if we argue that this was the case then the argument for fiscal stimulus falls apart (and, we know this wasn’t the case).

      • Daniel Kuehn says:

        Well the accelerating deflation is just a Friedman-Phelps argument as I understand it, with the output gap operating on expectations. But if something else is operating on expectations, that seems like a very reasonable explanation.

  5. Lord Keynes says:

    “And you point out that the Austrian view, the idea that both the 1929 collapse and the current mess did see a very rapid run-up on asset prices that suddenly collapsed; and that obviously caused some challenges for the financial sector.

    Only in the a bizarre world would anyway think this is a unique “Austrian” view. Irving Fisher (by 1933) and other heterodox Keynesians, and Old American Institutionalists like J. K. Galbraith have always stressed the 1920s asset bubble and the resulting financial crises and debt deflation.

    And, you’re right–the Austrians were the pioneers of this kind of analysis, in the 1920s even; etc.

    Where is the evidence that Austrians in the1920s were warning of the economic effects of an asset bubble collapse such as banking collapses and debt deflation? On the contrary, what they were doing is peddling their worthless business cycle theory; talking of largely imaginary distortions in the real capital structure and alleged lengthening of the structure of production, and calling for liquidationism — deflationary depression as a *solution* to crisis.

    It was only years later that Hayek realised that “secondary deflation” is a real and disastrous phenomenon.

    • Bob Roddis says:

      Banking crises and “debt deflation” are implicit, self evident AND OBVIOUS from the ABCT. If you borrow a bunch of money for unsustainable projects and you do this by foolishly relying upon the PRICE DISTORTIONS caused by the increase in credit, you probably are not going to be able to pay back your loans. Further, the price of the factors of your project will most likely collapse back to unadulterated levels but the amount still owing on yours loan will stay the same absent renegotiation or bankruptcy.

      That is the analysis your dishonest Keynesian brain cannot/will not process because it would be death of your Keynesian Hoax. And the Minsky-ite explanation (and all other explanations) completely avoid the cause of the boom, which was artificial funny money or FRB credit expansion resulting in artificial, adulterated and unsustainable prices.

      http://www.youtube.com/watch?v=Yb3-P7f2aLM

      (The nonsense about “secondary deflation” might be a concern where all the parties remain oblivious about what has actually happened (thanks in great part to “progressive” obfuscators) and the Nazis are about to take over.)

      • Lord Keynes says:

        “If you borrow a bunch of money for unsustainable projects and you do this by foolishly relying upon the PRICE DISTORTIONS caused by the increase in credit etc.

        Completely worthless analysis relying on non-existent, fantasy world assumptions like a tendency to general equilibrium, near perfect flexible prices, the mythical Wicksellian natural rate of interest, and ignorance of the widespread existence of administered fixprices.

        “Banking crises and “debt deflation” are implicit, self evident AND OBVIOUS from the ABCT.”

        Mises and Hayek were contemptibly ignorant of
        debt deflation.

        That is proven by their absurd belief that flexible wages and prices were the solution to economic crisis of 1929-1933..

        • Bob Roddis says:

          That is proven by their absurd belief that flexible wages and prices were the solution to economic crisis of 1929-1933..

          Take a deep breath, LK and put on your missing thinking cap.

          “Liquidation” suggests a failure of “Flexible prices” as a solution to a Keynesian/funny money induced crisis, doesn’t it? Hmmm?

        • Mike M says:

          “Completely worthless analysis relying on non-existent, fantasy world assumptions…”

          And yet, in the REAL world, that’s how things work. Unlike the academic safe room that folks like yourself never glimpse outside of let alone leave.

          • Tel says:

            Take a look at how government-backed student loans have pumped up prices in the tertiary education sector.

        • Matt Tanous says:

          “ignorance of the widespread existence of administered fixprices”

          You have yet to show how anything really changes if you clear the market by reducing production instead of lowering the price…

          “Mises and Hayek were contemptibly ignorant of
          debt deflation.”

          Or perhaps they didn’t hold the absurd belief that this would do what you think it will – spiral out of control somehow.

          “That is proven by their absurd belief that flexible wages and prices were the solution to economic crisis of 1929-1933..”

          I forgot, right. FDR’s fascism got us out of that fix. Just need to throw some folks in jail for charging less than the minimum price set by the large corporations, and that will fix everything!

    • skylien says:

      Yep, and your “solution” is to keep the booms and bubbles going, no matter the cost, right? Or why do you think the FED raised rates 2004-2006? Would it have been better not to do it?

      What you call peddling their worthless business cycle theory is exactly a general warning of asset bubbles by pumping them up with policy mandated lower interest rates (what Bernanke calls the “wealth effect”); Or doing it to keep some arbitrary price index level stable which according to Fisher would eliminate the business cycle.

      Mises argued systematically against that position in his essay “MONETARY STABILIZATION AND CYCLICAL POLICY” from 1928 in which he specifically critiques Fisher. Who was right Fisher or Mises?

      Of course you can still argue that Mises was merely right for the wrong reasons, but he certainly at least got the important thing right which is that the business cycle was not eliminated!

    • Daniel Kuehn says:

      LK: “Only in the a bizarre world would anyway think this is a unique “Austrian” view. ”

      EXACTLY.

      And in fact I’m not even sure how this is an “Austrian” view (except insofar as Austrians are like any other economists). Monetary policy ought to distort an entire structure of relative prices – not a certain type of asset.

      • Bob Roddis says:

        Dk and LK are beyond dishonest. Everyone learned in 4th grade that the 1920 stock bubble was caused by LAISSEZ FAIRE CAPITALISM, as opposed to the government/crony capitalist subsidized and regulated funny money banking regime that induced the creation of false, misleading and unsustainable prices.

        • Bob Roddis says:

          That should have been “1920s stock bubble”.

      • Bob Roddis says:

        The entire phony Keynesian spiel is based upon ignoring and obscuring the distinctions between the market on the one hand and statist interventions. The depression is always blamed on the market. The price distortions of bubbles are blamed on “the free market”.

        LK engages in this all of the time, with the most egregious being his “various types of laissez faire” nonsense or “there never was a period of Rothbardian laissez faire”.

        That is also what DK was doing in his suck-up to that scoundrel DeLong, trying to use intimidation to scare off those who might differentiate between the market and statist intervention:

        I do despise, of course, this impulse in the second paragraph to equate being pro-free enterprise with being anti-state. That’s a category error that saturates almost all libertarian writing. But I get his meaning on Hayek
        [But there is no meaning because of the category error:
        To characterize Hayek (or, indeed, earlier libertarians like Bastiat and John Stuart Mill) as a “lukewarm” supporter of market because he understands that markets require the right amount of public-sector support is to be a clown–and shame on Boettke, Moss, Wible, and two anonymous referees for not reasoning with him on this.

        http://delong.typepad.com/sdj/2013/09/peter-boettke-laurence-moss-david-tuerck-james-wible-and-two-anonymous-referees-have-a-huge-amount-to-apologize-for.html#comment-6a00e551f080038834019aff58b33d970c

        BTW, Mr. Laidler noted the intimidation: Guest: Well you must remember that I’m retired, so I don’t have to worry about pleasing journal editors any more.

        • Lord Keynes says:

          “The entire phony Keynesian spiel is based upon ignoring and obscuring the distinctions between the market on the one hand and statist interventions.”

          No, roddis, your worldview is derived from an absurd and incompetent inability to understand the real market, e.g., where endogenous money expansion and credit money and FR banking are the norm.

          In fact, if you really think “funny money” is to blame for most problems in market systems, you have demonstrated that capitalism is flawed and that you are profoundly anti-capitalist. Your only option is to effectively call for coercive attacks on private enterprise and private contract — as Rothbard did — to restrict private money creation and FR banking contracts.

          “LK engages in this all of the time, with the most egregious being his “various types of laissez faire” nonsense or “there never was a period of Rothbardian laissez faire”.

          Can you name even one period of genuine Rothbardian laissez faire? Do tell.

          If not, my statement is correct.

          • Richie says:

            Lord Eugenics building more strawmen. Impressive.

          • Bob Roddis says:

            FRB is a credit transaction masquerading as near-barter. There is nothing wrong with a credit transaction if all of the parties are aware of the terms. We’ve been over this so many times before.

            http://factsandotherstubbornthings.blogspot.com/2012/07/bob-roddis-makes-bad-argument.html?showComment=1342711388945#c3957944063574219509

            • Lord Keynes says:

              “There is nothing wrong with a credit transaction if all of the parties are aware of the terms. “

              You do not even understand your Austrian theory.

              It would not matter if all people understood the legal nature of FR banking (that is a separate issue), since credit money would still — theoretically speaking, even though ABCT is rubbish — drive a monetary rate below the fantasy natural rate of interest inducing an alleged Austrian business cycle.

              Every time you open your mouth you demonstrate more and more how you’re ignorant of basic Austrian concepts.

              • Major_Freedom says:

                “It would not matter if all people understood the legal nature of FR banking”

                On the contrary, for the lack of knowledge of who exactly owns the dollars in existence, is precisely the reason why fracitonal reserve banking leads to calculation errors.

                Just because you don’t understand any of this, it doesn’t mean it “doesn’t matter.”

              • Major_Freedom says:

                “theoretically speaking, even though ABCT is rubbish”

                You haven’t shown that, and you don’t understand it.

          • Bob Roddis says:

            The fact that there has never been a period of “pure” Rothbardian laissez faire does not hinder an examination of whether a particular past situation reflects laissez faire or intervention. Application of basic English common law concepts of private property, assault and contract make the examination quite simple.

            You are again trying to make obscure what is uncomplicated, as I endlessly note.

            • Lord Keynes says:

              “The fact that there has never been a period of “pure” Rothbardian laissez faire does not hinder an examination of whether a particular past situation reflects laissez faire or intervention.”

              lol. So now you can distinguish past situations to see whether they reflect “laissez faire or intervention”?

              With no pure “laissez faire”, that entails that such systems must reflect “various types of laissez faire” — which simply reinforces the idea you quote above.

              • Major_Freedom says:

                “So now you can distinguish past situations to see whether they reflect “laissez faire or intervention”?”

                That’s always been possible. We have records of government violations of property rights, specifically in the field of money.

              • Major_Freedom says:

                “With no pure “laissez faire”, that entails that such systems must reflect “various types of laissez faire”

                It also “reflects various types” of socialist violation of property rights and the concomitant distortions to economic calculation.

                It is that coercive aspect which is the cause.

          • Mike M says:

            Monopolized fiat currency with legal tender law enforcement is the foundation of capitalism and without it capitalism is flawed? That is a stretch even our you LK

            • Bala says:

              What do you mean when you say that’s a stretch? Did you not learn that black is white? Do you really mean that no one ever taught you that? Do you still believe that black is not white? Your ignorance is astounding!!!!!!!

            • Lord Keynes says:

              That is not what I said, Mike M.

              Your straw man bespeaks dishonesty or stupidity.

              • Mike M says:

                LK you in fact created the straw man. Your posts excel at such activity. Your argument bespeaks intellectual dishonesty.

                Bala, Your correct, my bad, LOL. I forgot that that up is down, good is bad, the old insanity is the new sanity. I endeavor to do better yet remain sane.

          • Razer says:

            Or how about you name this service.commodity/product that has this ‘fix price’ you speak about so we can look to see if, in fat, this price has remained fixed throughout time. If it hasn’t you’ve been debunked, right? Please tell the pro-eugenics mastermind you so clearly worship didn’t build his “theory” on this stuff.

      • Matt Tanous says:

        “Monetary policy ought to distort an entire structure of relative prices – not a certain type of asset.”

        If you distort an entire structure, you will inevitably end up with a beam or two that’s longer than all the rest – i.e. one or more assets where that distortion is most visible in the form of rapidly rising prices that don’t really make sense.

    • Jonathan Finegold says:

      Secondary deflation = non-neutral money policy (i.e. monetary disequilibrium).

      “Primary deflation” = liquidation of debt as a result of malinvestment. It has always been part of the theory.

      • Lord Keynes says:

        Except you cannot separate the two things out and Hayek’s attempt to do so just illustrates the absurdity of his position.

        Any severe deflation induces both debt deflationary collapse and liquidation of bad debt.

        And there is still not a shred of evidence Hayek ever properly considered debt deflation.

        • Jonathan Finegold says:

          Yes, we can separate them — I just did. That both happen concurrently doesn’t mean that they have different causes, and we can therefore separate them.

        • Major_Freedom says:

          “And there is still not a shred of evidence Hayek ever properly considered debt deflation.”

          He properly considered it, he just didn’t have the same theory of it as you do.

    • Major_Freedom says:

      “Only in the a bizarre world would anyway think this is a unique “Austrian” view. Irving Fisher (by 1933) and other heterodox Keynesians, and Old American Institutionalists like J. K. Galbraith have always stressed the 1920s asset bubble and the resulting financial crises and debt deflation.”

      Who said it was “uniquely Austrian”? He just said it was the Austrian view, which is true.

      “Where is the evidence that Austrians in the1920s were warning of the economic effects of an asset bubble collapse such as banking collapses and debt deflation?”

      Mises: In the summer of 1929, Mises refused an important job at the Kreditanstalt Bank because, as he told his fiancé, “A great crash is coming, and I don’t want my name in any way connected with it.” (Margit von Mises My Years with Ludwig von Mises , Arlington House, 1976, p. 31).

      Hayek: Writing for the Austrian Institute of Economic Research Report, February 1929, Hayek successfully predicted that “the boom will collapse within the next few months.”

      They thought the market would crash because of the unsustainable asset bubble. Debt is an asset. It is included. It doesn’t have to be explicitly mentioned, any more than equity has to be explicitly mentioned. The theory is that “higher order goods” are affected.

      • Lor d Keynes says:

        (1) ““Where is the evidence that Austrians in the1920s were warning of the economic effects of an asset bubble collapse such as banking collapses and debt deflation?”

        Mises: In the summer of 1929, Mises refused an important job at the Kreditanstalt Bank because etc.

        That does not constitute evidence that Austrians were warning of the US asset bubble collapse causing banking collapses and debt deflation and a global depression at all.

        Mises’s comments refer to one Austrian bank, not to the US asset bubble. And Mises says nothing about debt deflation.

        (2) “Hayek: Writing for the Austrian Institute of Economic Research Report, February 1929, Hayek successfully predicted that “the boom will collapse within the next few months.””

        Hayek said no such thing in that report of the Österreichische Konjunkturforschungsinstitut (Austrian Institute for Business Cycle Research).

        Here is the archive of the reports here:
        http://www.wifo.ac.at/bibliothek/archiv/MOBE_HTML/index.html

        Show me the quote.

        And here is what Hayek actually did say in the 26 October 1929 issue of the Monatsberichte, in contrast to your fantasy world quotation of him:

        However, at present there is no reason to expect a sudden crash of the New York stock exchange. However, it is not impossible that the end of the absolutely amazing price increases has arrived, and [that] the [price] level should slowly crumble. The credit possibilities/conditions are, at any rate, currently very great, and therefore it appears assured that an outright crisis-like destruction of the present high [sc. price] level should not be feared. At the moment, European funds are already being withdrawn in large amounts, so that the value of the [US] dollar is down.”
        Monatsberichte des österreichischen Institutes für Konjunkturforschung, 3. Jahrgang, Nr. 10 (26 October, 1929), p. 182.

        • Major_Freedom says:

          “That does not constitute evidence that Austrians were warning of the US asset bubble collapse”

          Yes, it actually does.

          “Mises’s comments refer to one Austrian bank, not to the US asset bubble.”

          No, he was speaking of the market, not a single bank. “Crash” is not a term used for single banks. Banks don’t crash, markets do. Banks go bankrupt.

          And you comimtted a no true scotsman. You never asked about the US specifically. You asked for an example of an Austrian predicting a crash. I gave an example of Mises doing what you claimed no Austrian did.

          He applied his theory to the asset markets (probably of Europe). The same theory can apply to any other market if Mises chose to do so. The phenomena of artificial low interest rates has the same effect in Europe as it does in the US.

          • Lord Keynes says:

            (1) Mises’s quote applies to an Austrian bank not the US. And Mises never used the debt deflation concept.

            (2) Where’s that Hayek quote, MF?

            You have the archive right there!

            Or more likely you’re feeling like the fool you are, because the quote does not exist.. Austrian cultists have been peddling a mythical quote for years.

            • Major_Freedom says:

              (1) Mises quote applies to the market, not the single bank. There are not “great crashes” for single banks.

              (2) I don’t speak German.

            • Major_Freedom says:

              In 1975, Hayek stated:

              “I was one of the only ones to predict what was going to happen. In early 1929, when I made this forecast, I was living in Europe which was then going through a period of depression. I said that there [would be] no hope of a recovery in Europe until interest rates fell, and interest rates would not fall until the American boom collapses, which I said was likely to happen within the next few months.”

              • Lord Keynes says:

                Hayek was making things up.

                Scholars have checked the Monatsberichte and there is no trace of any such prediction, just as Hansjörg Klausinger, 2010. “Hayek on Practical Business Cycle Research: A Note,” in H. Hagemann, T. Nishizawa, Y. Ikeda (eds.), Austrian Economics in Transition: From Carl Menger to Friedrich Hayek, Palgrave Macmillan, Basingstoke. 218–234 at p. 227 notes.

              • Richie says:

                More bullshit from Lord Eugenics.

            • Richie says:

              “Austrian cultists have been peddling a mythical quote for years.”

              Yeah, a bullshitter with the name LORD KEYNES calling Austrians cultists. Asshole.

              • Bob Murphy says:

                Richie,

                Good catch on “Lord Keynes” calling us cultists, but what if my mom delves into the comments? Let’s please refrain from naughty words.

              • Richie says:

                I apologize to you.

    • Major_Freedom says:

      “On the contrary, what they were doing is peddling their worthless business cycle theory; talking of largely imaginary distortions in the real capital structure and alleged lengthening of the structure of production, and calling for liquidationism — deflationary depression as a *solution* to crisis.”

      (1) You haven’t shown the theory to be “worthless.” You don’t even understand it.

      (2) The distortions are not imaginary, they are real.

      (3) Liquidation cures malinvestments caused by inflation.

      • Bob Roddis says:

        Gosh, MF. Isn’t that a bit harsh? I mean, LK writes such original, thoughtful (and new) stuff on his blog, like:

        It [is] well known that Wicksell’s unique “natural rate of interest” was taken over by Mises and Hayek in their early formulations of the Austrian business cycle theory. In essence, the classic Austrian business cycle theory borrowed the “real” natural rate idea from Wicksell that required an assumption of homogeneous capital: something that modern Austrians are at pains to deny, since they accept (as Post Keynesians do) that capital is heterogeneous.

        This is serious problem for Austrians. Austrians use a concept – the Wicksellian natural rate of interest – that is incompatible with their heterogeneous capital theory.

        http://socialdemocracy21stcentury.blogspot.com/2013/09/wicksells-natural-rate-and-homogenous.html

        Deep stuff, huh?

  6. DesolationJones says:

    >>Russ: So, you think it’s much more than just a monetary phenomenon.
    Guest: Yeah, I do. I never thought I would live to say this, but on this particular instance, I’m inclined to line up with the Austrians. I think they really have a point about this issue, about asset market distortions. After long periods of monetary stability.

    I don’t understand how Laidler’s views line up with Austrians. That whole paragraph seems to suggest the opposite. First he says it’s more than a monetary phenomenon, but Austrians basically think recessions are a monetary phenomenon. Then he says “after long periods of monetary stability”, but Austrians would say there was monetary instability while he thinks there was stability. I listened to the rest of the interview and he also says that a more rigorous QE3 was needed, that he endorses inflation targeting, and he attributes the light recession in Canada to a more tightly regulated mortgage market. He talks about the main problem being related to the real asset market as if unrelated to monetary policy. That’s completely contrary to Austrian views.

    It seems to me Laidler really doesn’t know much about Austrians only has a vague view about Austrians talking about booms in asset markets.

  7. Lord Keynes says:

    “Romer’s notes still imply that a protracted liquidity trap should lead to accelerating deflation, which doesn’t seem to happen; I think most of us have turned to downward nominal wage rigidity as an explanation. “

    (1) Keynes never accepted the idea of a liquidity trap as the existence of an infinitely elastic or a horizontal demand curve for money at some positive level of interest rates. The “liquidity trap” is aneoclassical deviation from Keynes’s theory and unnecessary.

    (2) as for why accelerating deflation did not happen, the answer is straightforward: monetary policy prevented the financial and banking sector from collapse, and fiscal policy stabilised AD and stopped and reversed severe downward pressure on flexprice markets.

    And in any case, prices in the real world are largely administered fixprices and their relative rigidity is an empirical fact.

    It is only grossly ignorant people who think the price system is some flexible system with convergence to market clearing prices.

    • Innocent says:

      Okay so sorry a few notes based on your comments and forgive me if they sound hopelessly ignorant.
      (2) as for why accelerating deflation did not happen, the answer is straightforward: monetary policy prevented the financial and banking sector from collapse, and fiscal policy stabilised AD and stopped and reversed severe downward pressure on flexprice markets.

      Okay, ummm, I really have never found a time in history when accelerating deflation has ever happened. Could you please point me to a reference in history so that I can better myself on this item. I have seen accelerating inflation, just not the reverse. So again, sorry for the ignorant question I am more than happy to be taught on this.

      Additionally, does not deflation typically have to do with one of several sets of economic truisms?

      (1) innovation will cause a reduction in price needed to create a good, this then allows the production or distribution of said good to require less input, competition then forces prices down, creating a lower cost and ‘deflating’ the asset.

      (2) – Demand drops for a good, this can be for any number of reasons. It can be it is no longer a viable good in the market place ( cell phones without touch screens ) or a T.V. that is not a flat screen, etc and so on. It could be the price was high and the disposable income of various individuals can no longer purchase that good at the current price point due to a drop in aggregate demand. etc…

      (3) – The good was in a bubble stage. This happens with any number of assets, Tulips, Stocks, Houses, heck even currencies. This means there was an overly large amount of aggregate demand which overcomes the true price point of a good.

      Heck I would suggest that wages are not as sticky as Keynes led us to believe if we actually had a free market. I would suggest that under a regulated market they MUST be sticky ( I cannot hire someone for less than minimum wage for instance ) or if I am dealing with a ‘Union’ I have no choice but to have wages be sticky ( that is the point of a Union ) but we are now no longer in that day and age and a new paradigm needs must be explored. Most people I know that went through the recession and lost employment are at 80% currently of where they were before the drop. That is not even taking into account the inflation that has taken place driving wages even further down. Which if things all deflated then they would not have lost purchasing power, rather a new base line of economics would be established.

      Again, this is my own ignorant way of seeing all of this, I am more than happy to be corrected by something that adequately explains how an injection of stimulus actually does anything to help the little guy through the creation of ditch digger jobs that create no economic output benefit other than to create additional aggregate demand.

      • Lord Keynes says:

        “Okay, ummm, I really have never found a time in history when accelerating deflation has ever happened. “

        Then I suspect you failed economic history 101.
        Here are two instances of accelerating annual deflation rates:

        US Inflation Rates
        1929 0.00
        1930 -2.51
        1931 -8.80
        1932 -10.31

        1933 -5.12

        UK Inflation Rates
        1929 -0.89
        1930 -3.84
        1931 -6.95

        1932 -2.12
        1933 -2.22
        1934 0.00
        http://www.measuringworth.com/calculators/inflation/

        Good enough for you?

        Or perhaps you’re the sort of Austrian to whom empirical evidence never proves anything?

        • Innocent says:

          @Lord Keyens I am not an Austrian, I believe all schools of economic thought have something good to offer however, just as heretic ally believe all religions have good things they teach. I am attempting to understand your point of view by asking questions, because I am ignorant. I believe I admitted to ignorance, However these same cycles have occurred at other times have they not?

          1866 – 1878

          1920 – 1922

          and yes of course 1930 – 1933

          What I meant to ask, and forgive me for obviously phrasing it poorly is why these three years during the Depression matter and these other time periods do not.

          No I did not fail Econ 101, passed with straight A’s in point of fact in all my economic classes. However that is all in regurgitation rather than actual thought and understanding as I would hope you would know.

          Anyway, my point is this, I see that there was Deflation, my point is that Deflation was not accelerating, in all of these instances there was either a ‘blip’ or sustained period of deflation.

          So the problem is that your ‘proof’ that things got better because of the monetary policy and Government polices in the 1930’s is because they did, eventually, get better. Now I am not saying that Fed intervention and the New Deal did not work, but by the same token I do not believe that simply because you can point to intervention that you can claim success in monetary policies. Even with those policies in place we have had some of the most extreme downturns in USA history since the 1930’s as well as some horrible inflation times as in the 1970’s.

          I suppose what I am attempting to say is I did not see accelerating deflation occur in a bad way in the 1930’s, I would categorize it as a foolish regulatory environment via government and unions that shackled business. Now this is just an armchair analysis. Regardless of the environment an Economy will come back to life. During the last ‘crisis’ I honestly said come 4 years from that crisis it did not matter who was in the Presidents seat the economy will have recovered. I am actually shocked at how weak the economy still is, that rather than learn our lesson and unshackle actual production we have attempted to create aggregate demand, and since that did not work to satisfaction all I hear is ‘it wasn’t big enough’

          Well I claim that about anything. Well if we had simply given a BIG enough tax cut this never would have happened in the first place, or if Government had simply reacted with LARGER spending during the Iraq war this would not have occurred. It is a null hypothesis, completely unprovable and therefore ‘safe’ so long as I can give the weakest justification for it.

          Now again I am not saying your point of view is incorrect, heck, since things did improve then there may well be something to it.

          Lastly, and this is an important facet to what I am attempting to say. I do not view deflation as a bad thing. I know, again I am a heretic, and you can call me all kinds of names and they are most likely justified. Ignorant and stupid and I simply do not understand even with the knowledge that I do have. I would argue that I am fairly intelligent at least by analytical standards. And am fairly sought after in my field of work. This does not mean I understand economics nor do I claim to. I am attempting to better understand economics and what I am suggesting is that your belief in accelerating deflation has no real basis in anything other than a four year data point one of said years we were not accelerating in deflation.

          Basically on a time scale I do not see your point. Yes deflation accelerated, well it would have to if the price points were well above equilibrium now would they not? Intervention would actually prolong a drop causing a gradual acceleration until such time as the ‘bottom’ was hit and prices could stabilize.

          Again, ignorant here. But I work with VERY large sets of data and go through huge sums of trends and information. The very case you made by pointing this out does not in my mind show acceleration, but rather moving toward the bottom and then coming back.

          And why is there not a case to be made in the same way that a stable inflation rate is a good thing? Especially when everyone prices it into their equation anyway? Would that not mean we are just as subject to misreading the market place as not having one in the first place? Again ignorant so please feel free to explain, if you so care.

          • Innocent says:

            Oh and I know there is a case to be made that deflation during the late 19th Century was due to innovation whereas the issue in the 1930’s was a lack of ‘money’ I suppose you could say.

        • Matt Tanous says:

          “Here are two instances of accelerating annual deflation rates”

          Only two? Hell, if we only have to look at three years, then we can point to MILLIONS of cases of the opposite – accelerating inflation rates.

    • Jonathan Finegold says:

      Regarding (1), Keynes never formalized it, but the gist of Keynes’ description is the same: “…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.”

    • Major_Freedom says:

      (1) It not a “deviation” from Keynes’ theory. He wrote about it himself in The General Theory:

      “There is the possibility … 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. In this event the monetary authority would have lost effective control over the rate of interest.” – John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan &
      Co. Ltd. (1964), p. 207.

      (2) So we can all make predictions that are falsified, because we can always point to “new information” and “new actions” that have taken place which “explains” the falsification. Now you know why Murphy argues empiricism is bankrupt.

      • Lor d Keynes says:

        The selective Keynes quote in (1) demonstrates your dishonesty or sheer incompetence.

        On the very same page Keynes says that he knew no real world instance of it and it never becomes part of his theory or explanation of involuntary unemployment:

        “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. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.. (Keynes 2008 [1936]: 187).

        For Keynes the liquidity trap is purely hypothetical and imaginary unless any empirical evidence of such a thing ever emerged, but he said clearly no thing had been observed, and it was never used in his explanation of low investment or involuntary unemployment.

        • Major_Freedom says:

          How in the world is my contention that the liquidity trap was not a deviation from Keynes’ theory, by you posting the same quote that shows it is part of his theory?

          The fact that he said he has never SEEN such a thing in real life is completely irrelevant to my argument.

          My argument concerns theory only.

          YOU are being dishonest.

          • Major_Freedom says:

            Missed a word:

            “How in the world is my contention that the liquidity trap was not a deviation from Keynes’ theory, [challenged/refuted/etc] by you posting the same quote that shows it is part of his theory?”

  8. Martin says:

    Russ’ interview with Laidler was pretty awesome. I especially liked the passage that followed the one quoted here – there is, it seems, quite a bit to quote from the interview:

    “Well, my take on that has always been, is that abstracting from the monetary and financial system is all very well for many problems, but not for the problems of the macroeconomy. And you’ve seen a lot of people trying to put monetary and financial factors back into this kind of model of the market economy, not realizing that it’s already in those models. A tacit assumption that the monetary and financial systems are functioning all very well, thank you. So they are trying to put the monetary and financial system into the same model twice, with different assumptions about the way it works. And it comes out as a bit of a mess. And I think that’s where we’ve been.”

    Laidler’s point here also complements a point made by Samuelson, namely that for microeconomics you need a stable macroeconomic environment. Call it macroeconomic foundations of microeconomics if you will. This was Samuelson’s interpretation of Keynes anyway and what I believe created the neoclassical synthesis. Now note here that Samuelson in this does not differ from Marshall or Mises and other Austrians. The sole differences is how to achieve this stable background. Marshall wanted to stabilize the monetary unit, and Mises, well I will not get into that, but let’s say that he favored a monetary policy bound by rules. And Samuelson’s view was that government’s job was to maintain aggregate demand. All three argued that – for the lack of a better word – microeconomics is contingent on macroeconomics.

    Laidler says here – that’s how I interpret him anyway – that the state of the art has got it exactly backward. First it is assumed that all the ingredients necessary are present for coordination, and then it is assumed that something is wrong with those very same ingredients. I think that that is a valuable point to make, and before that I did not realize how little the state of the art actually shares with what went before it. Some questions and problems have simply been struck from the agenda. Rowe’s recent posts also helped in this. What is it about these Canadians?

    • thinkingotherthings says:

      I think Laidler is incorrect in his characterization of how current macro models are attempting to incorporate finance. In addition to the quote you posted, he continues by noting that the current trend in macro-financial modeling is to assume that there are frictions caused by the financial system, which, as he remarks, is indeed quite bizarre given that the point of financial institutions is to reduce frictions, and that if there were no frictions before finance was introduced explicitly then smooth-functioning financial infrastructure is already assumed implicitly.

      But this characterization is not accurate based on the papers I’ve looked at. It’s not that the models introduce financial institutions that create frictions, but rather they introduce natural frictions in the allocation process that exist without financial markets, and that then creates a role for financial institutions to reduce those frictions. Which makes much more sense.

      • Martin says:

        But it is not about the financial institutions creating frictions. The allocation process is basic microeconomics, and basic microeconomics depends on a particular macroeconomic environment, hence why Keynes talked about a “General Theory”.

        It does not make any sense whatsoever to say that there is an allocation process, and then that there are frictions which are inconsistent with the allocation process existing as modeled.

        Let me give you an example. If I remember my undergrad class in banking correctly, then one reason why there are financial intermediaries is because they have economies of scale and scope. It’s much easier to analyze one loan if the same equipment can be used to analyze another loan, and if you’ve analyzed one loan you are better at analyzing another loan. This is one reason, but there are many.

        Now the translation of this reasoning to economese, is approximately as follows: draw a downward sloping marginal cost curve which approaches the abscissa asymptotically in (P,Q)-space. The curve of course begs the question, why not one firm instead of many? Do we not observe many financial intermediaries instead of one? Well, if there was no competition you would not be able to draw that curve as we just did. In any case, it would probably lie a great deal higher.

        Similarly as we cannot draw the curve without competition, we cannot draw the curve without having some idea where P is going to be tomorrow. We cannot draw the curve without having some idea of what the relationship is going to be between P and Q tomorrow. One depends on monetary policy, one depends on the capital structure, which in turn depends on relative prices – P again, two at least this time – or the expectation of in any case, which in turn depends on monetary policy.

        See what I am getting at? If you argue in terms of frictions you cannot just argue in terms of frictions on top of a allocation process. The frictions change the allocation process. How, I do not know. If I or anyone else did, then there would be no problem. You could write it out as any other maximization problem.

        Once you can write a friction down in terms of relative prices, then you are doing micro and you are using micro. If micro depends on macroeconomic foundations, then discussing macroeconomic phenomena in terms of relative prices is to assume the problem away to discuss it.

        • thinkingotherthings says:

          Your example left me confused and I think it is flawed in several respects. However, I’d prefer not to focus on that but instead address the general points you raise as best I understand them.

          But it is not about the financial institutions creating frictions.

          Right. To clarify my above post, Laidler seems to be under the impression that modelers were bringing in financial institutions as a source of friction. My claim is that he was wrong about this – modelers introduce frictions through other assumptions and thereby create a valuable role for financial institutions to play in reducing those frictions.

          The allocation process is basic microeconomics, and basic microeconomics depends on a particular macroeconomic environment

          We might be on the same page here, but I would point out that the outcome of microeconomic resource allocation depends on the macro environment. Microeconomic theory, however, does not. Put another way, parameter values may vary with the macro environment, but the models derived from theory themselves are robust.

          It does not make any sense whatsoever to say that there is an allocation process, and then that there are frictions which are inconsistent with the allocation process existing as modeled.

          The frictions are incorporated precisely to affect the allocation process. For instance, you can incorporate search costs associated with individual lenders and borrowers finding each other. Or you can assume that individual lenders cannot adequately assess the credit risk of borrowers, and so demand high collateral or interest rates in order to lend. Then you introduce financial institutions in these models to reduce these fractions (because they reduce the costs of credit flow and are better able to assess credit risk).

          If you argue in terms of frictions you cannot just argue in terms of frictions on top of a allocation process. The frictions change the allocation process.

          Right. The frictions aren’t so much thrown on top of the allocation process as embedded within it, thus creating a socially valuable role for financial institutions to play by lessening the social costs of these frictions.

          If micro depends on macroeconomic foundations, then discussing macroeconomic phenomena in terms of relative prices is to assume the problem away to discuss it.

          As I noted above, I dispute the idea that microeconomic theory rests on macro foundations.

          • Martin says:

            “We might be on the same page here, but I would point out that the outcome of microeconomic resource allocation depends on the macro environment. Microeconomic theory, however, does not. Put another way, parameter values may vary with the macro environment, but the models derived from theory themselves are robust.”

            I think we found our problem right here. You mistake the theory of value for the whole. If we are in equilibrium, then a change in one parameter can bring us into another equilibrium with a different allocation. So much is true.

            The problem with the theory of value used here however is that it does not tell us how the first equilibrium is arrived at, nor does it tell us why the other equilibrium is arrived at after a change in one of the parameters.

            To assume these problems away, you need to assume that the parameters are stable. Otherwise feedback mechanisms such as profit-and-loss, will not work very well, if at all. How else are people to compare apples and oranges if there is no point of comparison? You cannot add apples to oranges, nor can you subtract oranges from apples. You need a medium of account for that, and a medium of account is not a medium of account if it is not stable.

            For the record lest we get into word games. Economic theory is always true, the question always is however whether it applies. It is logic after all. Most of what you call microeconomic theory, and what’s in the book by the same name, is premised on the assumption that the parameters are stable, and that in particular the medium of account is stable.

            Now you could argue that if two gentlemen are haggling over wine and cloth, that the medium of account is irrelevant, and that therefore microeconomic theory is not premised on its stability. First I would argue that that is wrong, but second we were talking about state of the art models of the market economy with microeconomic foundations. And these foundations do depend on the premise that the medium of account is stable.

            • thinkingotherthings says:

              You mistake the theory of value for the whole.

              I have no idea what you mean by this.

              The problem with the theory of value used here however is that it does not tell us how the first equilibrium is arrived at, nor does it tell us why the other equilibrium is arrived at after a change in one of the parameters.

              Standard microeconomic theory absolutely *does* tell us how equilibria – both starting and subsequent in response to shocks or parameter changes – are arrived at using a framework of utilitiy-maximizing agents and profit-maximizing firms.

              To assume these problems away, you need to assume that the parameters are stable. Otherwise feedback mechanisms such as profit-and-loss, will not work very well, if at all. How else are people to compare apples and oranges if there is no point of comparison? You cannot add apples to oranges, nor can you subtract oranges from apples. You need a medium of account for that, and a medium of account is not a medium of account if it is not stable.

              You seem to be equating parameter stability with money supply stability. That is not how the term “parameter” is typically used in the academic literature.

              If your point is simply that profit-and-loss accounting relies on having a stable medium of account, then sure, I agree. You seem to now be suggesting that this claim is equivalent to your previous claim: that microeconomic theory depends on macroeconomic foundations. I don’t think they are equivalent, and still dispute the latter claim although I have no problem with the former.

              Also, I can’t tell if you are implying this or not, but to be clear: “Financial friction” does not mean “unstable medium of account”.

              • Martin says:

                1. One definition is, “The theory of value is that part of economics that seeks to explain the pattern of relative prices in an economy and the resulting allocation of
                resources” (Cf. Kohn 2004, 2: Value and Exchange).

                Now to make clear that I am not making up things here, see also Debreu’s monograph “The Theory of Value” which is subtitled “an Axiomatic Analysis of Economic Equilibrium”.

                2. There is a difference between people doing what they do because they believe and expect to be better off after, and profit maximizing and utility maximizing, if by those you mean to reformulate those as a maximization problem with constraints. In the case of the latter you already assume equilibrium.

                That was after all the whole point of the exercise, we assume equilibrium and reformulate it as a maximization problem so we can derive operationally meaningful theorems which can be refuted by the evidence.

                What profit maximization and utility maximization do not do, is to explain why the equilibrium is attained or how a new equilibrium is attained. It does explain, given the assumption of equilibrium, why prices are as they are, and why prices change as they do.

                3. Now the stability of the medium of account is an example of a parameter that needs to be stable if you want profit and loss to work. This however is only a necessary condition, it is not sufficient. What other conditions are necessary is difficult to say

                4. Given however that you agree with that the value of the medium account needs to be stable for profit and loss to work, I do not see why you say that microeconomics does not rest on macroeconomic foundations? Surely money is macro.

                5. I do not equate financial friction with the medium of account. It’s the easiest example on which there is, I hope, no disagreement that it can be a cause for instability.

                6. IF financial frictions are also cause for trouble, in the same way as the medium of account is, then you cannot model it as if it is not a cause for trouble.

                If it for example affects how reliable profit and loss is as a guide to actors outside of equilibrium, then you cannot model it as if it is a reliable guide to action and assume equilibrium and explain the relative prices in equilibrium as the result of those financial frictions. For there is no reason to suspect that maximization is a good description there of what is going on. If it affects profit and loss, then it affects how appropriate maximization is as a description.

  9. Wonks Anonymous says:

    I don’t think you can lump Sumner in with Krugman as a target for Cochrane. Sumner has never believed in the counter-intuitive upside down world of “liquidity trap economics” where negative supply shocks are a good thing a la the “paradox of toil”. Sumner has always viewed Casey Mulligan’s take to be perfectly compatible with his, just with different emphases.

    • Bob Murphy says:

      Wonks Anonymous, I agree that Cochrane much more specifically has Krugman in his sights than Sumner, but one of the “crazy” liquidity trap things Cochrane talks about is the possibility of “forward guidance” helping things. And Cochrane says that in his normal equilibrium, where the standard rules of economics apply, the Fed doesn’t help anything by promising to have looser monetary policy in the future. The latter is what Scott’s all about, so if it falls, so does his worldview.

  10. joe says:

    That video is horrific. The guy makes huge logically leaps. Monetary policy is responsible for *all* the growth in the economy because Bernanke is continuing QE? No. He’s continuing QE to offset the fiscal headwinds created by a GOP controlled Congress.

    • Richie says:

      Fail. The GOP controls the house, the Dems control the Senate. Idiot.

    • Razer says:

      facepalm.

  11. thinkingotherthings says:

    1. One definition is, “The theory of value is that part of economics that seeks to explain the pattern of relative prices in an economy and the resulting allocation of
    resources” (Cf. Kohn 2004, 2: Value and Exchange).

    Now to make clear that I am not making up things here, see also Debreu’s monograph “The Theory of Value” which is subtitled “an Axiomatic Analysis of Economic Equilibrium”.

    I know what the theory of value is. What confused me is what you meant by “the whole” and why you thought I was mistaking it for the theory of value.

    2. There is a difference between people doing what they do because they believe and expect to be better off after, and profit maximizing and utility maximizing, if by those you mean to reformulate those as a maximization problem with constraints.

    The only difference is how the assumptions are formulated: verbally or mathematically. Utility maximizing agents and profit maximizing firms do what they do because they believe and expect to be made better off by doing so.

    What profit maximization and utility maximization do not do, is to explain why the equilibrium is attained or how a new equilibrium is attained.

    This is just wrong. Check EconLit or JSTOR or NBER or SSRN for any papers on microeconomic dynamic general equilibrium models and you will see how equilibria are derived, and how prices are expressed as functions of variables and parameters, all under the assumption that agents and firms act in their own self interest.

    4. Given however that you agree with that the value of the medium account needs to be stable for profit and loss to work, I do not see why you say that microeconomics does not rest on macroeconomic foundations? Surely money is macro.

    Microeconomic theory still holds in barter economy or with a growing money supply. You can still use the microeconomic framework to explain and predict how people will act given that they have scarce means to achieve specific ends. Microeconomic theory does not break down in the presence of an unstable medium of account even though profit and loss become less reliable indicators of resource allocation efficiency.

    5. I do not equate financial friction with the medium of account. It’s the easiest example on which there is, I hope, no disagreement that it can be a cause for instability.

    We agree that an unstable money supply can cause instability. We disagree if you think that this is equivalent to saying that microeconomic theory breaks down, i.e. that agents acting in their self interest no longer respond to incentives when determining how to allocate scarce resources to achieve given ends.

    6. IF financial frictions are also cause for trouble, in the same way as the medium of account is, then you cannot model it as if it is not a cause for trouble.

    If it for example affects how reliable profit and loss is as a guide to actors outside of equilibrium, then you cannot model it as if it is a reliable guide to action and assume equilibrium and explain the relative prices in equilibrium as the result of those financial frictions. For there is no reason to suspect that maximization is a good description there of what is going on. If it affects profit and loss, then it affects how appropriate maximization is as a description.

    What do you mean by “cause trouble”? If you mean that financial frictions give rise to costs, then yes that is precisely why they are included in models. If by “cause trouble” you mean that financial frictions invalidate profit-and-loss accounting as a guide to efficient resource allocation, then no, you are misunderstanding what financial frictions are. They are real costs associated with an imperfect world. Financial frictions affect profit of course, as do all other real costs. But they do not reduce the signaling value of profits. They make the models more realistic.

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