The Importance of Capital Theory? Supply-side Economics With a Vengeance

From Brad DeLong’s weblog (where it came from Mark Toma), I was directed back to Paul Krugman’s NYT blog, where he comments on a 2008 blog post by Robert P. Murphy on the Austrian capital theory. I am not an expert on Austrian economics, so it is interesting to read a piece by one I guess is a prominent figure within that school. My guess is based on visiting the web-site, where one sees that Murphy is/or has been teaching at the Ludwig von Mises Institute, and I reckon they wouldn’t let him do that, if he wasn’t somewhat representative of the Austrian school. Also, on his own blog, he links to his Wikipedia bio, which in the Information Box categorizes him as belonging to the Austrian School and as opposing Paul Krugman (yes, these Wikipedia articles can be laughable).  (By the way, I have always believed that schools were for children, or when it came to “schools of thought” that they are for insecure people or religious people: They give you something to hang on to – a feeling of belonging. Actually, the site has a slight church-like flavor: every now and then writings of dead Austrians are read out loud on mp3 files.)

Another reason why it is interesting to read is the seemingly renewed interest in Austrian economics under and after the financial crisis. Just take the raise of a Peter Schiff who apparently predicted the crisis, and who has quite a following these days among those hating monetary policy and even the very existence of central banks. Also, there are intense, ideologically based, debates in the US on fiscal stimulus, inflation and the like (hence the above mentioned blog cross referencing). There, Murphy and Schiff play roles that merit attention (while this sort of attention seeking merits a smiley or an eye-rolling emoticon). In Europe, this revival is not so visible (in my eyes), but we – for better or worse – always tend to import most from the US at some point in time. So one might as well be prepared.

Murphy’s mission is to discredit Keynesian economics, and in particular Paul Krugman and his support of expansionary demand policies like the US fiscal stimulus. For this purpose, Murphy explains why the Austrian capital theory of business cycles is important, as it demonstrates the incoherency of the advices of Krugman (and anybody with a slight sympathy for demand-based stabilization policy). Murphy presents a simple, and admittedly entertaining, example of an Island Economy. On this island, people live in a steady state of perfect harmony and maintain life by eating sushi. This is accomplished by having one quarter of the population being fishermen, one quarter being rice farmers, one quarter being sushi manufactures, and one quarter spending time maintaining the fishermen’s boats and nets.

Onto this island Paul Krugman arrives on a motor boat. He convinces the population that they could be eating more sushi if they added his motorized boat to their fleet and spent more time fishing, farming and producing sushi. In turn, they must spend fewer resources on maintaining their boats and nets. The population follows Krugman’s advice and eats more sushi; so initially they are happy. But then the Austrian capital theory kicks in, as the boats and nets start to depreciate, and the fishermen bring in fewer fish. Sushi quality goes down, and Krugman reallocates workers from farming towards fishing to partially compensate for the drop in the volume of fish caught. This cannot prevent sushi production to go down, and the islanders begin to become unhappy. The story stops there with Krugman presumably being “saved by the Swedes”, and the islanders suffering a sushi recession as lot of resources now have to be devoted to bring the boats and nets back to pre-Krugman standards.

This is a nice story about resource allocation in a socialist command economy. What this model essentially says is that when you start out with THE efficient allocation, and then changes the allocation, then you get an inefficient outcome. That is not very deep. Moreover, and more important, I fail to see the demand implications of Krugman’s arrival to the Island. If I should try to give his role any economic interpretation, then he represents an inefficient supply shock: What causes the havoc in the economy is that resources are diverted away from investment and towards consumption. Clearly this increases consumption in the short run, but it is purely driven by supply forces. A price system is absent in the sushi command economy, but in a market economy a similar thing would happen if the relative price of investment to consumption is distorted upwards. Again, it would be caused by an inefficient supply shock. The sushi economy is a supply-side economy if there ever was one, so I cannot see how it in any way can be used to say anything meaningful about, e.g., fiscal stimulus. It is a complete mystery to me, so only if the island Murphy is thinking about is the one from the TV-Series LOST, then I understand. (For non-LOSTies: everything on that island is a mystery.)

To get a firmer grip on this story, and the capital theory, I therefore tried to dig up a more formal model by Murphy. I found one in a publication of his: “Dangers of the One-Good Model: Böhm-Bawerk’s Critique of the ‘Naïve Productivity Theory’ of Interest.” Journal of the History of Economic Thought, Vol. 27 (2005), pp. 375-382. The model is essentially a simplified version of the one-good Ramsey-Cass-Koopmans model with a constant supply of labor and capital (!). One punchline of this steady-state analysis is that one cannot, in a one-good model, formally analyze Austrian theories as they rely on different prices on capital and consumption goods. I think I could have guessed that without the math.

Another punchline is that because the real interest rate on financial capital equals the consumers’ rate of time preference, it is unrelated to the marginal product of physical capital. I could sort of have guessed the first part as well, since it is a well-known steady-state property of the Ramsey-Cass-Koopmans model that the real rate of interest equals the rate of time preference. The second part is problematic, however, because in the real Ramsey-Cass-Koopmans model, dynamics imply that the capital stock adjusts such that its marginal product is equal to the rate of time-preference in steady state. So they are not independent – they are equal. The independence of interest rates and marginal product of capital, which I understand is important in Austrian capital theory, only arises in Murphy’s model because he arbitrarily defines an interest rate on financial capital and, independent of that rate, fixates the stock of physical capital (and thus its marginal product). So it is independence by assumption. The definition of the real interest rate of financial capital does not appear in any budget constraint as financial capital actually does not appear in the model at all. If it did, I doubt that even the crudest model devices could decouple the marginal product of physical capital from the interest rate on financial capital. Perhaps the presence of a Socialist dictator instead of a market for capital?

As should be clear, reading this paper didn’t help in terms of formalizing the sushi model, but thinking about the Ramsey-Cass-Koopmans model convinced me that this is all supply-side economics. In a fully-fledged version of that model, in its basic one-good version, one could describe the sushi dynamics as resulting from an exogenously increase in the capital stock (the arrival of Krugman’s motorized boat). This would lead to an increase in consumption, followed by falling consumption and disinvestment towards to the steady state. But I do not believe that such a classical supply-side model is a good model of business cycles. The Austrian capital theory does not seem to provide a better alternative. Indeed, as noted by many, it predicts a negative co-movement between consumption and investment, which is not a predominant feature of business cycles. It is supply-side economics with a vengeance.

So on these matters, I so far agree with Krugman when he labels these thoughts as coming from “demand deniers”: He states the following about their refusal to accept that demand can play a role and their belief that demand management policies are necessarily the workings of the evil government (with the intellectual achievement in my interpretation being Keynes and Friedman, inter alia):

“It’s kind of shocking if you think about it. Here we have a huge, hard-won intellectual achievement, one that accounts very well for the world we actually see, and yet it’s being thrown away because it doesn’t go along with ideological preconceptions. Once that sort of thing starts, where does it stop? The next thing you know, the theory of evolution will get the same treatment. Oh, wait.”

I sincerely hope that all this stuff is just a fad, and one we eventually will not import to Europe.

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