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

Posted on January 27, 2011 by Henrik Jensen

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 mises.org, 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 mises.org 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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General Equilibrium Models are Not Utopian

Posted on January 26, 2011 by Henrik Jensen

Many are the times where use of general equilibrium methods is being met by harsh criticism. Mostly it happens when the associated model results concerning some policy reform do not provide politicians or voters with what they want or had expected. Sometimes it happens through more fundamentally-based reservations against the modeling strategy per se. Critics taking either point of departure support each other in envisaging general equilibrium models as fictional and idealized Utopian worlds. Hence, they are not to be taken seriously (and they are often claimed to be used merely to promote some free-market agenda).

As I see it, the critics often overlook (deliberately or not) that general equilibrium models are perfectly able of portraying strongly malfunctioning economies. Of course, they are fictional (as they are models), but they are definitely not Utopian. A recent example caught my attention today. In a World Bank publication, Economic Premise, Lúcio Vinhas de Souza writes on “An Initial Estimation of the Economic Effects of the Creation of the EurAsEC Customs Union on Its Members.” (pdf file). In the note, he attempts to provide an estimate of the GDP effects on the recent formation of a customs union within the Eurasian Economic Community (consisting of former Soviet states Belarus, Kazakhstan, Kyrgyzstan, the Russian Federation, and Tajikistan). He uses the GTAP model (which is available in the public domain), which is a computable general equilibrium model. The results are a nice example of how second-best analysis can provide answers, which I doubt any back-of-the-envelope/ Keynesian-cross analysis would adequately provide.

The result is that the harmonization of tariffs within this group of countries will reduce GDP for all in a range of experiments. The reason is that those countries that reduce tariffs (in particular Kazakhstan) are already trading “too much” under the existing conditions. The harmonization therefore exaggerates existing distortions. I am not a trade economist, so I cannot critically comment on the results as such, but I can guarantee that the model does not portray a Utopian world I would like to live in.

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The Fiscal Multiplier Wrestling Marathon

Posted on January 24, 2011 by Henrik Jensen

Welcome to the academic wrestling match of the recent years. In the left corner, Paul Krugman (with assistance from Bradford DeLong)! In the right corner, John Cochrane (with assistance from Eugene Fama)! They will fight over the size of the Fiscal Multiplier in a match where any trick may, can, and will be used. Both are heavyweights in the economics profession with one of them even with a Nobel Prize to his credit! This is a match not to miss.

Well, this is actually not funny at all. But one of the most important questions in macroeconomics, how effective is expansionary fiscal policy in a recession, have recently been subject to such heated debates among leading American economists that a tired sports analogy does not seem that much off the mark. Interestingly, the main contesters are not particularly known for their research in macroeconomics (but rather, trade theory and finance, respectively). But never mind about that – they are smarter than the average economists, so what they have to offer should be of interest.

Not only in the US, but in all other countries where the financial crisis has taken its recessionary tolls. In such a situation, knowing the size of the fiscal multiplier is actually quite important, if you as a responsible policymaker wants to counteract the immediate negative effects of the recession while still keeping an eye on a horizon where an aging population is looming (not in the dark as many wants to believe in my part of the world, but in the bright daylight).  Unfortunately, what could have been the time for modern macroeconomics to shine as providing relevant tools for policy advice, has been overshadowed by the (mud-) wrestling going on between very influential economists. Like it or not, in my part of the world nearly all advocates of fiscal stimulus refer to “Nobel Laureate Paul Krugman” as a backup for their arguments.

I definitely wouldn’t do that. His public arguments with John Cochrane are a bit embarrassing for the profession from an academic perspective, as they convey economists as frivolous and self-righteous persons who are only driven by a purely ideologically-based agenda. For what it’s worth, Krugman probably made the feud draw worldwide attention with his controversial New York Times Magazine article in September 2009, “How Did Economists Get It So Wrong?” There, he presented a caricature of macroeconomics as consisting of good, but naïve, guys (saltwater economists) and bad guys (freshwater economists), and he spiced it up with a lot of quite hateful outbursts against particular economists. It was a disturbing read, and everybody who hated macroeconomics loved it. The policy advice that came along with the article was essentially that since nobody got it right, there was nothing left to do than going back to Keynes. And apparently he meant going way back. John Cochrane wrote a response, “How did Paul Krugman get it so wrong?” trying his best to keep his composure in addressing all the attacks. Since then, the fight has been on.

Disagreements bring on exchange of ideas which can help a science evolve, but what is going on here on this serious topic is ludicrous. No policymaker gets any sensible advice, but they can pick the economist that suits their ideology to back up any policy. Cochrane essentially advocates a zero multiplier based on the Ricardian equivalence theorem, and Krugman essentially advocates a Keynesian multiplier through a figure of a Keynesian cross. So evidently, Krugman is indeed going all the way back to simple Keynes as we have learned it in undergraduate courses: Static graphical arguments, which may not be the best ones when dealing with an intrinsically dynamic issue. Cochrane is at least up front when he makes his points, as he cites modern macroeconomic literature and even acknowledges that some models can produce very large multipliers (in that direction, I would recommend Michael Woodford: “Simple Analytics of the Government Expenditure Multiplier” American Economic Journal: Macroeconomics, 2011).

Even though I actually side mostly with Krugman and Delong in terms of policy advice, I would never cite any of them in this situation. Their writings appear as resulting from a local (i.e., U.S.-based) spitting contest and not from sound academics. Therefore, when it comes to presenting clear academic arguments for one’s positions Cochrane is a clear winner of the match. Helped immensely by Krugman’s peculiar insistence on dumbing down his own position beyond comprehension. But picking a winner is not a remedy against the irreparable damage to macroeconomics caused by this marathon match. Even in academic wars there are no winners.

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“Dr. Doom” or “Mr. Lucky”?

Posted on January 19, 2011 by Henrik Jensen

A colleague of mine recently directed my attention to this interesting article from the January 9 edition of the Boston Globe: “That guy who called the big one? Don’t listen to him.” In the article, journalist Joe Keohane describes the now well-known 2006 prophecies made by Nouriel Roubini of New York University about an upcoming major financial crisis (he is described as, at that time, a “somewhat obscure economist“, which is extremely inaccurate I should say!). Due to his precise forecast about the crisis, which indeed began the year after, and took on an unprecedented world-wide scale in 2008, Roubini became a man to be taken really seriously. He apparently outsmarted the majority of economists who did not see the crisis coming. And he even gained a nickname for his capability of predicting this recession: “Dr. Doom”.

However, as the article goes, even though “Dr. Doom” predicted the big crisis, several of his subsequent predictions were not spot-on. As Keohane writes:

“For a prophet, he’s wrong an awful lot of the time. In October 2008, he predicted that hundreds of hedge funds were on the verge of failure and that the government would have to close the markets for a week or two in the coming days to cope with the shock. That didn’t happen. In January 2009, he predicted that oil prices would stay below $40 for all of 2009, arguing that car companies should rev up production of gas-guzzling SUVs. By the end of the year, oil was a hair under $80, Hummer was on its way out, and automakers were tripping over themselves to develop electric cars. In March 2009, he predicted the S&P 500 would fall below 600 that year. It closed at over 1,115, up 23.5 percent year over year, the biggest single year gain since 2003.”

Well, it is perhaps a bit cheap to dwell on some mistakes, which appear minor to the success in predicting the major event? But there is apparently a pattern here. Jerker Denrell of Stanford Graduate School of Business and Christina Fang of New York University has a new paper out in Management Science, vol. 56 (2010), “Predicting the Next Big Thing: Success as a Signal of Poor Judgment“. In this study they present a theoretical model of forecasting which imply that being able to successfully predict an “extreme event” (think “Dr. Doom” and the financial crisis), is consistent with having an intrinsically poor forecasting ability. They furthermore present evidence to support the model’s predictions. For example, using data on Wall Street forecasters they find that forecasters getting the “big events” right are among the poorest on average. A quote from their paper explains this nicely:

“The explanation is that because extreme outcomes are very rare, managers who take into account all the available information are less likely to make such extreme predictions, whereas those who rely on heuristics and intuition are more likely to make extreme predictions. As such, if the outcome was in fact extreme, an individual who predicts accurately an extreme event is likely to be someone who relies on intuition, rather than someone who takes into account all available information. She is likely to be someone who raves about any new idea or product.”

I like this story. I always had the gut feeling that one could suspect that those few who got it right about the financial crisis perhaps were just lucky. I mean, if you keep rambling about the coming of some scenario, at some point you will be right. And the more potential scenarios you ramble about, the more of your wild guesses may turn into reality. That does not necessarily mean that you have outsmarted the others. As Denrell and Fang shows us, you may indeed be systematically less smarter than others.

So “Dr. Doom” was maybe just “Mr. Lucky”? Probably not “just”, as Roubini is a very clever economist with an outstanding academic track record. But Denrell and Fang’s study is interesting as it warns us to be cautious about hailing those successfully predicting wild and crazy events as prophets.

UPDATE, February 11, 2011: Morten has directed my attention towards the following disclaimer now appended to the Boston Globe article:

Correction: Because of a reporting error, this article misattributed a statement about SUV production to economist Nouriel Roubini, and implied that he made an incorrect forecast about the failure of hedge funds in late 2008. He did not offer any advice about SUVs, and his prediction that hundreds of hedge funds would fail was correct.

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The Inflation Fallacy and central banking debates in the US

Posted on January 18, 2011 by Henrik Jensen

Among my favorite contemporary academic economists is N. Gregory Mankiw. I have always found his academic writings very lucid and to the point. I was once again reminded of this today, when I stumbled over some debates about abolishing the Federal Reserve System. Opponents of central banking, mostly self-proclaimed followers of the “Austrian school”, view central banks as monopoly powers that undermine free markets and are inherently inflationary – implying a government-supported devaluation of the population’s wealth. In the United States, these opponents are having golden days, as they can blame the Fed for having not only caused the financial crisis, but also for engaging in irresponsible quantitative easing that will inflate the US economy to pieces.

Well, one of Mankiw’s principles in his successful undergraduate textbook Principles of Economics is that “Prices rise when the government prints too much money”, so it is not really disputed that creating too much money is inflationary. Think about Zimbabwe. (It is, however, open for debate whether it is true when nominal interest rates are at, or close to, zero, but leave that aside for now.) And sure, governments and central banks can and do make policy mistakes and may in many circumstances be tempted to be more inflationary than is good (think Zimbabwe again). This was realized by Kydland and Prescott in 1977, but the United States is hardly Zimbabwe when it comes to central banking. What are then the fears in the minds of those wanting to get rid of the Fed?

Ron Paul, republican congressman from Texas, has recently embarked on a crusade against the very existence of the Fed under the heading “Sound Money”. On the site RonPaul.com the concept is explained by alluding to a story akin to Milton Friedman’s helicopter drop of money. In the Ron Paul story, by contrast, it is “money elves” that overnight bring money to people. The story then goes along as usual, namely that as demand increases, prices go up. But the mechanisms at force in mainstream economic models suddenly stop short: Workers’ wages suffer from perfect and permanent nominal rigidities. So, the fable about the money elves ends by people facing lower real wages. So people are worse off, except those lucky few who are interconnected with the creators of the money elves (i.e., some evil companies and bad financial institutions who are friends with the Fed).

This is not how the usual Friedman helicopter-drop-of-money story ends. (Not even Carl Barks’ 1950 Donald Duck cartoon A Financial Fable ended on such a depressing note.) It ends by all prices in the economy eventually being increased proportionally by the increase in the money stock. And hence also the price on labor, i.e., wages. Nothing real has changed. The fable of the money elves suffers from “The Inflation Fallacy” described by Mankiw in his Principles book:

“If you ask the typical person why inflation is bad, he will tell you that the answer is obvious: Inflation robs him of the purchasing power of his hard-earned dollars (…)

Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus inflation does not in itself reduce people’s real purchasing power.”

Simple. Money is neutral in the long run. So an inconsistent story about money elves seems to be a weak case for drastic monetary reform. Of course, more detailed arguments are put forth by others, but they appear more like ideological arguments based on principles of individual freedom, completely free markets, anti-government intervention, inter alia. Not healthy economic theory.

But hey, some would ask, isn’t Mankiw just part of The System that helps suppressing the “right” economic theories like those of the Austrian School (discarded in 1998 by Paul Krugman as “being as worthy of serious study as the phlogiston theory of fire“)? Maybe so, but could it be that the little space such theories take up in standard textbooks is actually a sign of their failure of surviving the free market forces of economic thoughts?

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Dead economists can’t analyze the present

Posted on January 16, 2011 by Henrik Jensen

Of course they can’t. Yet, many pick up some dead economist and speculate what he or she would have thought about some current economic incident or policy. For example, even though a whole industry is still devoted to try figuring out what Keynes actually meant when he wrote The General Theory three quarters of a century ago, many discuss Keynes’ “advice” for policy in the present times of economic slump. While interesting from the perspective of the History of Economic Thought, it sometimes seem as a lot of wasted intellectual resources. Never mind about what Keynes would or would not have thought. Read him and learn, but don’t bestow him with conclusions he could never draw.

Likewise, never mind what Milton Friedman would have thought about the massive quantitative easing policies that many central banks have adopted recently. Nevertheless, Paul Krugman has just argued that Friedman would have favored it, based on Brad DeLong’s “proof”, which again is based on a quote from a 2000 interview where Friedman advocates that Japan should adopt a more expansive monetary policy. Well, Friedman died in 2006, so we cannot really know what he would have said about today’s issues. And honestly, does it matter that much?

Probably only to those who like to be associated with some camp, or particular school of thought. They can then either seek comfort in such speculations, or use them to ridicule followers of another camp. I, however, have never favored the insistence of such associations: It can only lead to potential inconsistencies, which then lead to wasted time on trying to explain why you on this and that point did not say or mean exactly what the founder(s) of this particular school said, or is believed to have said today. It just gets to speculative to me. And as an academic, I don’t care much for speculations, but care much more for rigorous analyses.

Speaking of potential inconsistencies: When Krugman makes his point, he writes the following about Friedman:

“His criticism of the Fed during the Depression was that it didn’t do enough to prevent a fall in M2 — that is, that it didn’t print enough money.”

I.e., Friedman thought a monetary contraction could be, and was shown to be, harmful. This made him suggest that the Fed should aim at stabilizing a broad money aggregate. In 2007, Krugman had the following to say about Friedman:

“Japan in the Nineties offered a fresh opportunity to test the views of Friedman and Keynes regarding the effectiveness of monetary policy in depression conditions. And the results clearly supported Keynes’s pessimism rather than Friedman’s optimism.”

So, four years ago it seemed as if Krugman did not think Friedman’s views on monetary expansion in a depression (characterized by zero nominal interest rates like the present) had much merit. A conclusion based on what actually happened in Japan. But today he argues that that Friedman would favor an expansion based on what Friedman said in 2000 about Japan. Does it make sense? I mean, would Friedman not have learned from the Japanese experience? Would he believe that the current crisis was caused by too restrictive monetary policy (which seems to be a prerequisite for making the Great Depression analogy valid)? I am not sure Krugman would seriously argue that Friedman would think so today. Does it matter much? Why not just explain your own thoughts? (I am aware that Krugman is not trying to make an economic point per se, but a more political one; that, however, does not make speculation about late people’s thoughts anymore relevant.)

Until the time machine is invented, let dead economists rest in peace, and let us learn from their writings. We shouldn’t use them as a starting points for guessing games.

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Krugman on Friedman in 2007

Posted on January 15, 2011 by Henrik Jensen

I recently stumbled over Paul Krugman’s 2007 article “Who was Milton Friedman?” from the New York Review of Books. In his otherwise very appreciative and balanced biography (not according to all), Krugman writes the following when commenting on Friedman the-free-market-advocate-rather-than-academic-economist:

“What’s odd about Friedman’s absolutism on the virtues of markets and the vices of government is that in his work as an economist’s economist he was actually a model of restraint. As I pointed out earlier, he made great contributions to economic theory by emphasizing the role of individual rationality—but unlike some of his colleagues, he knew where to stop. Why didn’t he exhibit the same restraint in his role as a public intellectual?

The answer, I suspect, is that he got caught up in an essentially political role. Milton Friedman the great economist could and did acknowledge ambiguity. But Milton Friedman the great champion of free markets was expected to preach the true faith, not give voice to doubts. And he ended up playing the role his followers expected. As a result, over time the refreshing iconoclasm of his early career hardened into a rigid defense of what had become the new orthodoxy.”

I couldn’t help thinking that these more or less same words some day in the future may be written by another great economist, writing about the economist who first came up with these words.

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