Consulting by RPM || Free Advice Blog

The Importance of Selection Effects

A neat puzzle from Alex Tabarrok, who is clearly in the top 50% of my ranking of MR bloggers:

During WWII, statistician Abraham Wald was asked to help the British decide where to add armor to their bombers. After analyzing the records, he recommended adding more armor to the places where there was no damage!

The RAF was initially confused. But just think about it and it makes sense. (Hint: Tabarrok’s title–which I copied above–is relevant.)

Murphy on Woods on Schiff

This is like Mozart grilling burgers, but anyway here is Tom Woods (bestselling PhD intellectual who went to Harvard) being an angry guy on the radio. He starts in with the completely over-the-top introduction around the 18:00 mark.

Real Working Economists Bask: Computing Actual and Potential GDP

OK, I know some actual, professional economists read this blog. It is your embarrassing pleasure that you have to hide from your friends, like how I listen to the early Madonna when I’m by myself in the car. (“Crazy for You” is just a great song.)

So here’s a little thought experiment, and I’d like you to please explain how actual economists who work in the CBO or whatever would handle it:

An economy is chugging along nicely at full employment, and price inflation is within the desired range. Real GDP is $1 trillion. Then geologists think they’ve discovered a humongous deposit of oil that will make Saudi Arabians feel like chumps. The problem is, the oil is buried pretty deep. So the oil industry in this country (not foreigners) spends $150 billion buying new drilling equipment and other necessary infrastructure. At the end of the year, the macroeconomists report that real GDP was $1.1 trillion. There was an extra $150 billion in output in the sectors producing the oil equipment, but that was only partially offset by a $50 billion drop in output elsewhere. The apparent discovery of the oil increased the productivity of the factors in the economy, which is what allowed potential GDP to go up 10% in a single year.

The next year, to their horror, the people in the oil industry realize that it wasn’t an oil deposit at all, but just some empty bottles that John Maynard Keynes had buried back in 1936. The entire drilling apparatus overnight becomes almost completely worthless, because it can’t be easily disassembled and shipped elsewhere.

So: Assuming no other technological discoveries or workers gaining skills, real output at best will drop back to $1 trillion in the new year, and will actually be less because some of the maintenance on other production processes would have been shunted into the oil industry the year before.

My question: How would macroeconomists in the CBO do their graphs? Would they go back and mark down the $1.1 trillion “real output” figure in the previous year, because that was obviously a mistake? Or would they say, “No, real output really was that high last year, and it just collapsed this year”?

(In case you’re curious, if the oil deposit had really existed, then oil would have flowed out and been sold [perhaps on the world market] and that’s partly what would have kept real output permanently higher, had there not been such a colossal mistake.)

Daniel Kuehn Falls Into My Gnome Trap Headfirst

I actually have to get a bunch of “real work” done before flying to Vienna this weekend, and I’ve yet to earn the luxury of blogging a full response to Karl Smith on this gnome business. But for now, let me just point out that Daniel Kuehn tried to jump in on the action, and broke a battle over Maynard’s head without realizing it.

Remember, the whole point of my post–if you don’t believe me, look at where I summarized its lesson here right after it ran–was that I thought I had come up with a clear-cut “supply side” scenario that the Keynesians would mistakenly diagnose in the same way that they are treating our current recession.

So in that light, look at what Daniel Kuehn ironically had to say, after mulling over Karl and my exchange:

So the gnome attack thought experiment has to do with the capital heterogeneity issue.

I’m not sure I entirely get Bob’s point here. If gnomes attack like this, how would Keynesians talk about it? They’d say it’s a sharp fall in the marginal efficiency of capital, wouldn’t they? Bob acts like Keynesians have no way of talking about specific capital that doesn’t work well, so they try to fit the square aggregate demand peg into the round hole in the observed data. That seems wrong to me.

Now – as I’ve pointed out previously – Keynesianism relies on heterogeneous capital…

Keynesians wave their hands at specific distortions of the capital structure, but they at least have a way of incorporating it into their models – namely the marginal efficiency of capital. There are lots of ways that the capital structure could be distorted. Gnome attacks. Zombie attacks (not as effective as gnomes). Ninja attacks (this would probably be even more effective than gnomes). Pirate attacks, etc. Of course if you really stretch your imagination you could also consider technological advance and obsolescence, political instability, interest rate distortion of the time structure, changes in regulations, wars, bottlenecks in energy supplies, and other problems messing up a heterogeneous capital structure too. It’s not clear to me why we would want to stake a business cycle theory on any single problem with the capital structure, particularly when we typically think entrepreneurs are more or less rational and profit maximizing. I prefer the more general Keynesian approach which explains how – given a particular marginal efficiency of capital – the economy can sit at an equilibrium below full employment.

Yet Daniel is leaving out a biggie in terms of what Keynesians think can push down the marginal efficiency of capital: a drop in expected future demand for a business’ products. That’s the mechanism through which “animal spirits” can lead to a slump, after all.

In any event, how does a Keynesian propose to fix a drop in the marginal efficiency of capital? It would depend on why the marginal efficiency dropped, wouldn’t it? If the Keynesians knew it had fallen because of a supply shock, then (hopefully) they’d sit back and let nature take its course. In contrast, if it fell because of a drop in demand, then they would recommend monetary or fiscal stimulus.

Incidentally, I hope Daniel’s point isn’t that the Keynesians could look at video footage of the gnomes moving stuff around, and then declare, “Whoa, supply shock! Nobody touch the fed funds rate!” Obviously it’s cheating to know what the actual cause is.

Rather, my point is that the standard Keynesian diagnostics would react to a gnome attack the same way they’d react to a balance-sheet driven drop in AD. Daniel Kuehn’s post confirms my claim.

A Qualified Defense of Don Boudreaux

I don’t know Don Boudreaux personally, and to be honest I wonder why he writes so many letters to the editor. But I want to give a qualified defense of him, because lately our friendly neighborhood Keynesians have been calling foul (e.g. here and here).

I’m not defending the tone of Boudreaux’s stuff; of course we could all stand to be a little more forgiving to the people with whom we disagree. What I want to clarify is where we nutty, strawmen’ing free-market guys could possibly get the idea, that Keynesians think it’s ultimately consumer demand that drives a recession and then a recovery.

I’ll tell you where: Paul Krugman.

For example, it was a Krugman column that forced me to write my own piece called, “Consumers Don’t Cause Recessions.” Now, was I being unfair to Keynesians with that title? Here’s what Krugman wrote:

The long-feared capitulation of American consumers has arrived….

To appreciate the significance of these numbers, you need to know that American consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even for a single quarter was in 1991, and there hasn’t been a decline this steep since 1980, when the economy was suffering from a severe recession combined with double-digit inflation.
…
So this looks like the beginning of a very big change in consumer behavior. And it couldn’t have come at a worse time.
…
Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine’s plea: “Grant me chastity and continence, but not yet.” For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.
…
For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It’s true that Ben Bernanke hasn’t yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it’s hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.

The capitulation of the American consumer, then, is coming at a particularly bad time. But it’s no use whining. What we need is a policy response.

The ongoing efforts to bail out the financial system, even if they work, won’t do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we’ve seen, Americans were overextended even before banks started cutting them off.

No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

Perhaps we free-market guys can be forgiven for thinking that Krugman was here saying that the federal government needed to step in and spend, because consumers no longer could. I confess that even after being scolded by Daniel Kuehn and Karl Smith, it still looks to me that Krugman is saying that. But it’s my anti-Keynesian bias no doubt.

I have an even better illustration of exactly the kind of thing Boudreaux was attacking. In November 2008, George Will faced off against Paul Krugman on a Sunday talk show. Will said that the problem with the economy in the 1930s was low business investment, caused by FDR’s constant assaults on property rights. (I’m paraphrasing; I couldn’t get video.)

Krugman came back and said something like, “It’s pretty easy to explain why businesses weren’t investing in the 1930s: there was weak demand for their products. Why would you invest in a bigger factory if you were already operating below capacity?”

I’ve tried to find the video of this, because (as I say) it was literally the exchange between the free-market guy and the Keynesian, that Daniel Kuehn says is a fantasy of our imagination. There are plenty of blogs referring to it, but YouTube pulled the video. Unfortunately no one is summarizing the part of the exchange that interests us here, but this post comes close when it quotes Krugman as saying: “There was a collapse of the financial system which was not restored for a long time. There was a deep slump in consumer demand and therefore no investment demand so we were stuck in this trap.” (Note that there is video at that link, but I can’t get it to play for some reason.)

Assuming that’s an accurate quotation, do y’all see the work that the word “therefore” is doing in the above? This is exactly the mindset Boudreaux was attacking, and which Kuehn, Smith, and presumably other Keynesians are denying is their position.

Also, although it’s clouded by many other issues, Krugman’s “what a lazy idiot!” reaction to Barro reaffirms Boudreaux’s point, when Krugman writes:

You can see right away that [investment is] strongly affected by the business cycle: investment is high when demand is strong and firms see a good reason to expand capacity. So the best thing we could do to spur business investment would be to get a recovery going by whatever means necessary, including fiscal stimulus.

The true irony in all this, is that when Krugman smacked down George Will–by matter-of-factly pointing out that it wasn’t regime uncertainty, but rather weak consumer demand, that explained lackluster investment in the 1930s–Krugman’s colleagues and fans didn’t recoil in horror, wondering why Krugman had uttered such heresy. No, they high-fived him and said he “schooled” George Will (I seem to recall a lot of “pwn”s being tossed around too at the time).

Similarly, when Robert Barro tries to suggest that long-run policy certainty is necessary for a rebound in business investment, Krugman’s fans love it that the Great One smacked around the moronic Barro for not realizing that investment is pro-cyclical because of consumer demand. I mean duh, what could be more obvious than that? These RBC guys are so freakin’ dumb! (Not to mention evil.)

Then, when Don Boudreaux complains that Keynesians think total aggregate demand is ultimately driven by changes in consumer spending…the Keynesians can’t believe such a lazy liar would attribute such simplistic ideas to them.

So in conclusion, yes, Boudreaux was condescending in his post. But he’s not inventing a strawman. If Keynesians actually don’t believe that businesses invest less during a recession because of low final demand for their products, then you should tell one of your leading lights to stop blogging this and saying it on TV.

More MMT Wisdom on How Debt Works

Somebody in the comments a while back sent me this Mike Norman piece, in which he argues that the federal government paid off the national debt 4 times already…this year!

The phony debt crisis facing the United States is kept alive by this one, stupid, soundbite: “How are we gonna pay it back?”

The subtext, of course, is that the U.S. is deeply in debt to the tune of $14.5 trillion and there is no way we can ever pay it back. Indeed, even some great “minds” (NOT) like Jim Rogers have publicly said that the U.S. will never be able to pay back its debts.

Well guess what…not only can we “pay it back,” but we’ve already paid it back four times over–THIS YEAR!!

That’s right…the total amount of redemptions (public debt paid back) so far this fiscal year amounts to $58.8 TRILLION! That’s trillion with a “T.”

I am not making this up. Please see for yourself that number right off the Treasury’s Daily Statement.

[Norman links to a Treasury document.–RPM]

So we “paid back” nearly $59 trillion in the past 11 months without a hitch. The yield on 10-year Treasuries is below 2%. How did that happen? Simple…the Fed debits securities accounts and credits reserve accounts by whatever number it needs to. It’s paid back by mere accounting entries. That’s it. End of story. No digging up gold out of the ground, no mortgaging our future and best of all, no grandchildren involved. Please send to your Congressional representative.

If I had more time, I would call up the Treasury to verify this for sure. Barring that, let me say I am 99% confident that Norman here is making a ridiculous error. I think the Treasury document–which claims that there have been some $58.8 trillion in “total redemptions” in debt this fiscal year so far–is referring to the fact that the debt rolls over.

The fact that you can roll over maturing debt doesn’t prove that you never have to pay it off. Firms in the private sector roll over debt too–they “pay back” lots of their debt in a given year, even if their total indebtedness increases over the course of the year.

Maybe Krugman Isn’t Taking Sumner to the Prom After All

This is like watching Sam and Diane on the old Cheers. One day it’s Krugman, Sumner, and Milton Friedman versus the world, the next it’s this (HT2 a reader whose email I just lost):

Nor does focusing on nominal GDP instead of M2 or whatever really bridge the gap. The point about M2-based monetarism was that it was supposed to give the Fed a target it could clearly control — although in a liquidity trap it turns out that even that isn’t true. Whatever else it is, and whatever virtues it may have, nominal GDP isn’t that kind of target.

My broader take on this is that the quasi-monetarists are trying too hard to find a deep essence when what’s really needed is just a model. Let’s tell a story about what economic players do, and see what it says about policy options. That’s all it takes.

At least with Rothbardians, Scott knows where he stands: We’ve said from Day One that he’s nuts.

Left- and Right-Wing Anarchists Agree: Gene Callahan Can’t Read

[UPDATE: Gene emailed Graeber, explained things the way Gene was looking at them, and Graeber said, “OK he misread your post.” Yet all I did was claim that Gene said fiat money preceded commodity money; that is the title of Gene’s post, after all. I’ll let Gene decide if it’s appropriate to reproduce his full email exchange with Graeber in the comments.]

From Graeber’s latest response to me (on naked capitalism):

Last week, Robert F. [sic] Murphy published a piece on the webpage of the Von Mises Institute responding to some points I made in a recent interview on Naked Capitalism, where I mentioned that the standard economic accounts of the emergence of money from barter appears to be wildly wrong. Since this contradicted a position taken by one of the gods of the Austrian pantheon, the 19th century economist Carl Menger, Murphy apparently felt honor-bound to respond.

In a way, Murphy’s essay barely merits response. In the interview I’m simply referring to arguments made in my book, ‘Debt: The First 5000 Years’. In his response, Murphy didn’t even consult the book; in fact he later admitted he was responding at least in part not even to the interview but to an inaccurate summary of my position someone had made in another blog!

That “inaccurate summary” is this.