Steve Horwitz has an good offer for you – learn about the Great Depression for free

My friend professor Steve Horwitz has a very good offer for students. He is offering an eight-week long program on the Great Depression at the Learn Liberty Academy. 

Here is what Steve has to say at the Bleeding Heart Libertarians blog about the program:

Starting next month, I will be teaching an eight-week long program on the Great Depression for my friends at the Learn Liberty Academy, which is part of the Institute for Humane Studies‘ Learn Liberty project.  If friends or students you refer to the program register and mention your name as having referred them, you’ll get an Amazon gift card, and you’ll get another if they complete the full program.  So, faculty and student readers of BHL, please feel free to pass this info on to your students and friends and have folks sign up. It’s going to be a really great program!

Steve and I do certainly not agree on everything about the Great Depression, but Steve has done a lot of work on the Great Depression and is an extremely clever economist and monetary theorists so I strongly recommend to any student to check out Steve’s offer.

See more on the “Making Sense of the Great Depression” program here.

PS Now Steve send me some books!

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Scott Sumner: “It’s Complicated: The Great Depression in the US”

Yesterday I was surfing the internet for some information on events in 1937 – the year of the Recession in the Depression. While doing that I found a great lecture Scott Sumner did at Oxford Hayek Society in 2010.

Scott’s lecture basically is a wrap-up of his forthcoming book on the Great Depression. Scott tells me the book likely will be published later this year. I have had the pleasure and honor of reading a draft of the book. You all have have something to look forward to – it is a great book!

The thesis in Scott’s book is that the Great Depression in the US was a combination of two shocks. A negative demand shocks – excessive monetary tightening – and a series of negative supply shocks caused by Roosevelt’s New Deal policies particularly the National Industrial Recovery Act (NIRA) and the Wagner Act. His arguments are extremely convincing and I believe that you cannot understand the Great Depression without taking both these factors into account.

Scott does a great job showing that policy failure – both in the terms of monetary policy and labour market regulation – caused and prolonged the Great Depression. Hence, the Great Depression was not a result of an inherent instability of the capitalist system.

Unfortunately policy makers today seems to have learned little from history and as a result they are repeating many of the mistakes of the 1930s. Luckily we have not seen the same kind of mistakes on the supply side of the economy as in the 1930s, but in terms of monetary policy many policy makers seems to have learned very little.

I therefore hope that some of today’s policy makers would take a look at Scott’s lecture. You can watch it here.

Scott has kindly allowed me also to publish his PowerPoint presentation from the lecture. You can find the presentation here.

And for those who are interested in studying the disastrous labour market policies of the Rossevelt administration I strongly recommend the word of Richard Vedder and Lowell Gallaway – particularly their book “Out of Work”. Furthermore, I would recommend Steve Horwitz’s great work on President Hoover’s policy mistakes in the early years of the Great Depression.

The Austrian bust: HIGHER inflation and relative deflation

I have been thinking about an issue that puzzles me – it is about inflation in an Austrian School style bust.

Here is the story. If we think about a stylized Austrian school boom-bust then the story more or less is that easy money leads to an unsustainable boom that eventually – for some reason – will lead to a bust.

What people often fail to realize is that the Austrian business cycle theory basically is a supply side story.

Austrians will hate it, but you can tell much of the story within an AS/AD framework. The graph below is an illustration of this.

AS AD - AS shift rightwards

What happens is that the central bank cuts interest rates below the Wicksellian natural interest rate. Investors are tricked into thinking that it is the natural interest rates that has fallen and as a result investments are increased. Austrians will of course object by saying “it is not a overinvestment theory, but a malinvestment theory”. Yes, that is right, but that is not relevant for the question I want to look at here.

The boom happens not because of higher demand, but because of over (and mal) investment. The production capacity of the economy is hence expanded – the AS curve shifts to the right during the Austrian boom and production increases from Y1 to Y2. We ignore the demand effects – so we keep the AD unchanged – as the Austrians really are not paying much attention to this part of the story anyway (and yes, I am aware the there is relative demand story – private consumption vs investments).

Notice what happens with the price level initially. Prices drop from P1 to P2. Obviously that would not necessarily have to be the case if the AD curve also have shifted to the right as well (but that is not important for the story here). However, this pretty well illustrates the Austrian story that “headline” inflation will not necessarily increase during the boom. What happens – and we can obviously not realize that by just looking at AD and AS curves – is that we get what Austrians call relative inflation. Some prices rise, but the aggregate price level does not necessarily increase.

So far so good. I know Austrian economists would say that I told the story in the “wrong way”, but I guess they will agree on the main points – Austrian Business Cycle Theory is mostly about the supply side of the economy and that the aggregate price level will not necessarily have to increase during the boom phase.

Now we turn to the bust phase…

At some point investors realise that they have made a mistake – the natural interest rate has not really dropped. Therefore, what they thought were good and profitable investments are not really that great. So as a result investors cut back investments – after the “bubble” have bursted a large part of the production capacity in the economy is worthless. This is a negative supply shock! The AS shift back leftwards.

AS AD - AS shift leftwards

What is the result of this? Well, it is simple – the price level increases from P2 to P1. We get higher inflation. This might seem counterintuitive to most people – that the bust leads to higher rather lower inflation – but remember this is due fact that the Austrian boom-bust cycle primarily is a supply side story.

‘Benign’ inflation should be welcomed

And this brings me to what I really wanted to say. An increase inflation should be welcomed if it reflects a rational and undistorted reaction to investors realising that they have made a mistake. That is exactly what happens in an Austrian style bust. We might get relative deflation/disinflation, but the aggregate price level increases due to the negative supply shock.

Therefore, when Austrians often argue that the bust should be allowed to play out without any interference from the government or the central bank then that logically mean that they should welcome an increase in inflation in the bust phase of the business cycle. That obvious is not that same saying that monetary policy should be eased in the bust phase, but inflation should nonetheless be allowed to increase as we get “benign” inflation.

However, in my view that would mean that it would be wrong from an Austrian perspective for the central bank to tighten monetary policy in response to rise in (supply) inflation during the bust. Those Austrian economists who favour NGDP level targeting – like Anthony Evans and Steve Horwitz – would likely agree, but what about the “internet Austrian”? And what about Bob Murphy or Joe Salerno?

Obviously the story I have told above is a caricature of the Austrian Business Cycle theory, but I think there is a relevant discussion here that need to be addressed. Is the aggregate price level likely to rise in the bust phase as natural consequence of market forces being allowed to run it cause?

The reason that I think this debate is important is that some Austrians spend a lot of time arguing that the deflationary tendencies that we see for example in Europe at the moment are a natural and necessary bursting and deflating of a bubble. However, IF we indeed were in the bust phase of a Austrian style business cycle then we would not be seeing deflationary tendencies. We would in fact be seeing the opposite – we would see HIGHER inflation, but at the same time relative deflation.

Obviously this is not what we are seeing in the US and Europe today – inflation in both the US and the euro zone is well-below what it was during the “boom years”. That mean that we are not in the bust phase of an Austrian style boom-bust. There might very well have been a boom-bust initially (I believe that was the case in some European countries for example), but we have long ago moved to another phase – and that is what Hayek termed secondary deflation – a downturn in the economy caused by an monetary contraction.

PS Take a look at what happened in the US in 2007-8. Overall inflation did in fact increase as the economy was slowing, while we at the same time had relative deflation in the form of falling property prices. However, starting in the Autumn of 2008 we clearly saw across the board deflationary tendencies – here it is pretty clear that we entered a secondary deflationary phase caused by a monetary contraction. This is consistent with an Austrian interpretation of the Great Recession, but it is not a story I have heard many (any??) Austrians tell. And of course it is not necessarily the story I would tell – even though I think there is a lot of truth in it.

PPS The graphs above could indicate that both production and prices shifts back to the initial starting point during the bust. That obviously would not have to be the case as I here have ignored the shift in the AD curve and as any Austrian would note the AS/AD framework is not telling us anything about relative prices.

Steve Horwitz’s “Introduction to US Monetary Policy”

Steve Horwitz is out with an new paper – “An Introduction to US Monetary Policy”. I haven’t read the paper yet, but I am sure it is very good. Steve always writes interesting and insightful stuff about monetary policy issues. I hope to find time to read it in the coming days, but until I have more to say about that paper you should have a look. Here is the abstract:

This study examines the history and operation of the Federal Reserve System (“the Fed”). It explores the Fed’s origins in American economic history and emphasizes the political compromises that produced it. It seeks to provide an accessible explanation of how the Fed attempts to change the money supply and of the structural challenges it faces as it attempts to get the money supply correct. The paper uses the framework thereby developed to examine recent monetary policy, including quantitative easing. Inflation and deflation result when the Fed creates too much or too little money, and the study discusses the causes and costs of both in detail. The paper concludes with an examination of alternatives to central banking, including the gold standard and a system of competition in money production known as free banking

The last brick – RIP James M. Buchanan

Nobel Prize winning economist and founding father of the Public Choice school James M. Buchanan has died at age 93. His friends and students have already offered many kind words in his memory. Here I quote two of my friends professors Steve Horwtiz and Peter Kurrild-Klitgaard.

Here is Pete:

James M. Buchanan, RIP. If making a difference is what matters, he was one of the five most influential thinkers of the last 50 years. Sharp as a knife into his 90s and always the scholar.

And Steve:

There is much that one can say about him (Buchanan), not the least of which is that he was still intellectually sharp and active into his 90s. In short: he changed the face of economics and politics and advanced the cause of liberty as much as anyone in the second half of the 20th century…

…No one who wishes to talk responsibly about politics can be ignorant of public choice theory. No one should ever invoke the language of market failure (including externalities) without having digested his work on government failure. And people who run around talking about the constitution better be able to understand something of constitutional political economy.

Beyond all of that, he was a role model of the old school scholar: widely read and properly skeptical of turning economics into an engineering discipline. He was, at bottom, a humanist and a liberal in the oldest and best senses of the terms. And best of all: he was utterly unimpressed by degrees from fancy schools.

Buchanan produced an enormous amount of scholarly works including numerous books in his long life. Best known is probably The Calculus of Consent which he co-authored with Gordon Tullock. However, the works that had the biggest influence on my own thinking undoubtedly was “What should economists do?” and “Cost and Choice”.

Even though Buchanan primarily was a constitutional economist and a Public Choice theorist he also contributed to monetary thinking. His so-called brick standard was particularly intriguing. Here is Pete Boettke and Daniel Smith on Buchanan and the brick standard:

James Buchanan, sought to bring his extensive work on rule-making to bear in envisioning a monetary regime that could operate within a contemporary democratic setting. From the start, Buchanan (1999[1962]) eschewed the ‘presuppositions of Harvey road’ that held that economic policy would be crafted and implemented by a group of benevolent and enlightened elites. Buchanan set out to make the case for a monetary regime using comparative institutional analysis that compared monetary regimes in real, not ideal settings.

Buchanan (1999[1962]) believed that it was not so much the specific type of monetary regime adopted, but the set of rules that defined that regime. Buchanan argued that the brick standard, a labor standard, or a manager confined by well-defined rules, would all put a stop to the government growth let loose by the fiscal profligacy encouraged by the wide scale acceptance of Keynesian ideas in the political realm (see Buchanan and Wagner (2000[1977]). The brick standard, as defined by Buchanan, would be a monetary regime that allowed anyone to go to the mint with a standard building brick of a specified quality and exchange it for the monetary unit, and vice versa. As the general price level fluctuated, market forces would cause automatic adjustments as people would exchange money for bricks when the price level rose above the equilibrium level, and bricks for money when the price level fell below the equilibrium level. Under this regime, market actors, guided by profits and losses would be the mechanism that achieved price predictability, not a government-entity entrusted with the goal of achieving it. In addition, a brick standard would, most likely, divorce domestic monetary policy from international balance of payment and exchange rate policies due to the fact that a brick standard would be unsuitable for those purposes.

For Buchanan (1999[1962], 417), it came down to a toss-up between a brick type standard and a limited manager. What mattered most for monetary predictability was that the rules that set up the monetary regime must be of the ‘constitutional’ variety. In other words, the rules must be set to be ‘relatively absolute absolutes’ in order to protect them from tampering.

R.I.P. James M. Buchanan

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Update – other economists and scholars on James Buchanan:

Steve Horwitz

Daniel Kuehn

Eamonn Butler

Don Boudreaux (also from Don in 2005 and Don in WSJ)

Mark D. White

Grover Cleveland

Mario Rizzo

David Boaz

Robert Higgs

David Henderson

Alex Tabarrok

Randall Holcombe

Peter Boettke

Ryan Young

Bill Woolsey

Veronique de Rugy

Nick Gillespie

Arnold Kling

Brad DeLong

Christian Bjørnskov (in Danish)

Tyler Cowen (more from Tyler Cowen)

Lenore Ealy

Garett Jones

Charles Rowley

Edward Lopez

The Economist: Free Exchange

Buchanan

Guest post: Misunderstanding Say’s Law of Markets (Garrett Watson)

I have always wanted to promote the work of young scholars on this blog and have been grateful that a couple of gifted young economists have published guest posts on this blog. I want to continue that “tradition” and I am therefore happy that Garrett Watson – a student of Steve Horwitz at St. Lawrence University – has accepted my invitation to write a guest post for my blog.

Enjoy Garrett’s excellent discussion about the “Misunderstanding Say’s Law of Markets”. The post has previously been published on Tu Ne Cede Malis.

Understanding Say’s Law and the connection to monetary policy is key to understanding the present crisis. So enjoy Garrett’s guest post.

Lars Christensen

 

Guest post: Misunderstanding Say’s Law of Markets

- By Garrett Watson, St. Lawrence University

Few ideas in the history of economic thought have achieved a level of perplexity and criticism than Say’s Law. Perhaps one of the most misunderstood and elusive concepts of the Classical economics, Say’s Law of Markets, first postulated by John Baptiste Say in 1803, underwent considerable support and eventual decline after its assault by John Maynard Keynes in The General Theory. Many of the fundamental disagreements we observe in historical debates surrounding macroeconomics can be traced to different conceptions of how Say’s Law operates in the market economy and the scope used in the analysis. By grasping a thicker idea of Say’s Law, one is able to pinpoint where disagreements in both macroeconomic theory lie and judge whether they necessarily must be dichotomized.

Say’s Law is best known in the form Keynes postulated it in The General Theory: “supply creates its own demand” (Horwitz 83). Despite the apparent eloquence and simplicity contained in this definition, it obscures the genuine meaning of the concept. For example, one may interpret this maxim as meaning that whenever one supplies a good or service, it must be demanded – this is clearly untrue (83). Instead, Say’s Law can be interpreted as saying that the ability to produce generates their ability to purchase other products (84). One can only fully grasp Say’s Law when analyzing the nature of the division of labor in a market economy. Individuals specialize in producing a limited range of goods or services, and in return receive income that they use to buy goods and services from others. The income one receives from production is their source of demand. In other words, “all purchasers must first be producers, as only production can generate the power to purchase” (84).  This idea is intimately linked to the Smithian idea that the division of labor is limited by the extent of the market (89).

The result of this fascinating principle in the market economy is that (aggregate) supply will equal (aggregate) demand ex ante as demand is equally sourced by previous production (Sowell 40).  Another important point made by Say’s Law is that there exists a trade-off between investment and consumption (40). In contrast to the later Keynesian idea of falling investment leading to a fall in consumption and therefore aggregate demand, an increase in investment means falling consumption, and vice versa. This idea can be analogized to Robinson Crusoe abstaining from consumption to build a fishing net, increasing his investment and his long-term consumption of fish (42). Therefore, a higher savings rate pushes up investment and capital accumulation, increasing growth and output (as Smith eloquently argues) (40). In another stark contrast to Keynesian analysis, there is only a transactions demand for money, not a speculative nor a precautionary demand (40). The implications of this are that money cannot affect real variables; it is a veil that facilitates transactions only – money is neutral (Blaug 148). Finally, Say’s Law also shows that there cannot exist a “general glut”; an economy cannot generally overproduce (Sowell 41). Whilerelative over and under-production can occur, there is no limit to economic growth (41).

While it was uncontroversial among the Classical economists that there wasn’t a limit on economic growth, several economists took issue with the fundamental insights of Say’s Law (44). One of the most well-known criticisms was that of Thomas Malthus. Malthus was an early proponent of the “Paradox of Thrift” – an excessive amount of savings could generate an economy with less than full employment (43). One could describe the view of Malthus as fundamentally “under-consumptionist” (Anderson 7).  Unlike his contemporaries, Malthus did not view money as inherently neutral (Sowell 41). Other classical economists, such as Smith, argue that money “will not be allowed to lie idle”, effectively dismissing a precautionary motive for holding money and therefore monetary disturbances (38). This is where we see the inherent difference in perspective in the analyses of Smith and Malthus. Smith is focused on long-run conditions of money (its neutrality and importance of real fundamentals) versus the short-run disturbances money can generate in output (39).

Money is half of every exchange; a change in money can therefore spill over into the other half of every exchange, real goods and services (Horwitz 92). In effect, “The Say’s Law transformation of production into demand is mediated by money” (92). This means that Say’s Law may not hold in conditions in which monetary disturbances occur. John Stuart Mill recognized this possibility and affirmed Walras’ Law: an excess of money demand translates to an excess supply of goods (Sowell 49). An excess money demand manifests itself by individuals attempting to increase their money balances by abstaining from consumption. This therefore generates an excess supply of goods, which some would argue can be self-correcting, given downward adjustment of prices (Blaug 149). Malthus (and later on, Keynes) argues that downward price and wage rigidities (which can be the result of game theoretic problems in firm competition, efficiency-wages, or fixed wage contracts) can short circuit this process, yielding a systematic disequilibrium below full employment (Sowell 65). In terms of the equation of exchange, instead of a fall in V (and therefore a rise in money demand) being matched by a fall in P, the fall in V generates a fall in Y. This point was taken into further consideration by later monetary equilibrium theorists, including Friedman, Yeager, and Hutt.The same analysis can be used to understand the effects of drastic changes in the money supply on short term output, as Milton Friedman and Anna Schwartz would demonstrate in the contraction of the money supply during the formative years of the Great Depression

When analyzing the large disagreements over Say’s Law, it becomes clear that they stem from a difference in scope: supporters of Say’s Law analyzed the macro economy in terms of long-run stability, while Malthus and others after him focused on short-run disequilibrium generated by monetary disturbances (Sowell 72). Smith and other classical economists, pushing back against mercantilist thought, emphasized that money was merely a ‘veil’ that does not affect economic fundamentals, and that quantities of money ultimately didn’t matter (72). The Malthusian grain of truth regarding disequilibrium caused by monetary disturbances in the short-run does not refute Say’s Law; it reveals the necessity of getting monetary fundamentals correct in order for Say’s Law to cohesively operate. It becomes increasingly clear that once we look at the disagreements through the lens of scope, the two conceptions of the role of money in a market economy need not necessarily be incompatible.

References

Anderson, William. “Say’s Law: Were (Are) the Critics Right?” Mises Institute1 (2001): 1-27. Mises Institute. Web. 19 Oct. 2012.

Blaug, Mark. “Say’s Law and Classical Monetary Theory.” Economic Theory in Retrospect. 4th ed. Cambridge: Cambridge University Press, 1985. 143-160. Print.

Horwitz, Steven. “Say’s Law of Markets: An Austrian Appreciation,” In Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Steven Kates, ed. Northampton, MA: Edward Elgar, 2003. 82-98. Print.

Sowell, Thomas. On Classical Economics. New Haven [Conn.]: Yale University Press, 2006. Print.

Sandy is BAD NEWS. The two graph version.

Let me just quote Steve Horwitz’s latest Facebook update:

“It’s a good thing I shaved my head this morning or else I’d be tearing out my peach fuzz with my fingernails thanks to the plethora of broken windows fallacies being bandied about in the media today. If you think Sandy is “good for the economy,” you are hereby remanded to my Econ 100 class (and ordered to read endless Bastiat) and I expect to see you cheering the next disaster that kills people because it boosts the demand for funeral homes and cemeteries.

Disasters, whether natural or social, DESTROY WEALTH AND MAKE US WORSE OFF. Period. End of sentence. There is NO “silver lining.” The economy would be BETTER OFF HAD SANDY NEVER HAPPENED. Got it?”
I got more hair than Steve, but he is spot on. It is unbearable to hear the stories about Sandy being good news for the US economy. Sandy is horrible news – for the the victims and for the US economy. Any other view is bordering idiotic.
Here is the two graph version of Sandy. Sandy is a negative supply shock and not a positive demand shock (that is what the journalists – and some keynesians – apparently fail to understand…). Sandy destroys production resources and disrupts production. That shifts the AS curve to the left (from AS to AS’) and reduces productions (from Y to Y’) and increases prices (from P to P’). That’s not good news. That is BAD NEWS.
But it could be worse! Imagine you have a inflation/price level targeting central bank that targets prices at P. Then it would tighten monetary policy and shift the AD curve to the left (to AD”) – maintaining prices at P and reducing production to Y”. This is what would have happened if Sandy had hit Europe. Yes, the ECB would have tightened monetary policy in reaction to Sandy – just remember what the ECB did in 2011 after the Japanese tsunami.
Update: I decided to add a picture to this post – this guy knew about the “Sandy fallacy”.

Papers about money, regime uncertainty and efficient religions

I have the best wife in the world and she has been extremely understanding about my odd idea to start blogging, but there is one thing she is not too happy about and that is that I tend to leave printed copies of working papers scatted around our house. I must admit that I hate reading working papers on our iPad. I want the paper version, but I also read quite a few working papers and print out even more papers. So that creates quite a paper trail in our house…

But some of the working papers also end up in my bag. The content of my bag today might inspire some of my readers:

“Monetary Policy and Japan’s Liquidity Trap” by Lars E. O. Svensson and “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rate” by Bennett T. McCallum.

These two papers I printed out when I was writting my recent post on Czech monetary policy. It is obvious that the Czech central bank is struggling with how to ease monetary policy when interest rates are close to zero. We can only hope that the Czech central bankers read papers like this – then they would be in no doubt how to get out of the deflationary trap. Frankly speaking I didn’t read the papers this week as I have read both papers a number of times before, but I still think that both papers are extremely important and I would hope central bankers around the world would study Svensson’s and McCallum’s work.

“Regime Uncertainty – Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” – by Robert Higgs.

My regular readers will know that I believe that the key problem in both the US and the European economies is overly tight monetary policy. However, that does not change the fact that I am extremely fascinated by Robert Higgs’ concept “Regime Uncertainty”. Higgs’ idea is that uncertainty about the regulatory framework in the economy will impact investment activity and therefore reduce growth. While I think that we primarily have a demand problem in the US and Europe I also think that regime uncertainty is a highly relevant concept. Unlike for example Steve Horwitz I don’t think that regime uncertainty can explain the slow recovery in the US economy. As I see it regime uncertainty as defined by Higgs is a supply side phenomena. Therefore, we should expect a high level of regime uncertainty to lower real GDP growth AND increase inflation. That is certainly not what we have in the US or in the euro zone today. However, there are certainly countries in the world where I would say regime uncertainty play a dominant role in the present economic situation and where tight monetary policy is not the key story. My two favourite examples of this are South Africa and Hungary. I would also point to regime uncertainty as being extremely important in countries like Venezuela and Argentina – and obviously in Iran. The last three countries are also very clear examples of a supply side collapse combined with extremely easy monetary policy.

Furthermore, we should remember that tight monetary policy in itself can lead to regime uncertainty. Just think about Greece. Extremely tight monetary conditions have lead to a economic collapse that have given rise to populist and extremist political forces and the outlook for economic policy in Greece is extremely uncertain. Or remember the 1930s where tight monetary conditions led to increased protectionism and generally interventionist policies around the world – for example the horrible National Industrial Recovery Act (NIRA) in the US.

I have read Higg’s paper before, but hope to re-read it in the coming week (when I will be traveling a lot) as I plan to write something about the economic situation in Hungary from the perspective of regime uncertain. I have written a bit about that topic before.

“World Hyperinflations” by Steve Hanke and Nicholas Krus.

I have written about this paper before and I have now come around to read the paper. It is excellent and gives a very good overview of historical hyperinflations. There is a strong connection to Higgs’ concept of regime uncertainty. It is probably not a coincidence that the countries in the world where inflation is getting out of control are also countries with extreme regime uncertainty – again just think about Argentina, Venezuela and Iran.

“Morality and Monopoly: The Constitutional political economy of religious rules” by Gary Anderson and Robert Tollison.

This blog is about monetary policy issues and that is what I spend my time writing about, but I do certainly have other interests. There is no doubt that I am an economic imperialist and I do think that economics can explain most social phenomena – including religion. My recent trip to Provo, Utah inspired me to think about religion again or more specifically I got intrigued how the Church of Jesus Chris Latter day Saints (LDS) – the Mormons – has become so extremely successful. When I say successful I mean how the LDS have grown from being a couple of hundreds members back in the 1840s to having millions of practicing members today – including potentially the next US president. My hypothesis is that religion can be an extremely efficient mechanism by which to solve collective goods problems. In Anderson’s and Tollison’s paper they have a similar discussion.

If religion is an mechanism to solve collective goods problems then the most successful religions – at least those which compete in an unregulated and competitive market for religions – will be those religions that solve these collective goods problems in the most efficient way. My rather uneducated view is that the LDS has been so successful because it has been able to solve collective goods problems in a relatively efficient way. Just think about when the Mormons came to Utah in the late 1840s. At that time there was effectively no government in Utah – it was essentially an anarchic society. Government is an mechanism to solve collective goods problems, but with no government you have to solve these problems in another way. Religion provides such mechanism and I believe that this is what the LDS did when the pioneers arrived in Utah.

So if I was going to write a book about LDS from an economic perspective I think I would have to call it “LDS – the efficient religion”. But hey I am not going to do that because I don’t really know much about religion and especially not about Mormonism. Maybe it is good that we are in the midst of the Great Recession – otherwise I might write about the economics and religion or why I prefer to drive with taxi drivers who don’t wear seat belts.

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Update: David Friedman has kindly reminded me of Larry Iannaccone’s work on economics of religion. I am well aware of Larry’s work and he is undoubtedly the greatest authority on the economics of religion and he is president of the Association for the Study of Religion, Economics and Culture. Larry’s paper “Introduction to the Economics of Religion” is an excellent introduction to the topic.

The counterfactual US inflation history – the case of NGDP targeting

Opponents of NGDP level targeting often accuse Market Monetarists of being “inflationists” and of being in favour of reflating bubbles. Nothing could be further from the truth – in fact we are strong proponents of sound money and nominal stability. I will try to illustrate that with a simple thought experiment.

Imagine that that the Federal Reserve had a strict NGDP level targeting regime in place for the past 20 years with NGDP growing 5% year in and year out. What would inflation then have been?

This kind of counterfactual history excise is obviously not easy to conduct, but I will try nonetheless. Lets start out with a definition:

(1) NGDP=P*RGDP

where NGDP is nominal GDP, RGDP is real GDP and P is the price level. It follows from (1) that:

(1)’ P=NGDP/RGDP

In our counterfactual calculation we will assume the NGDP would have grown 5% year-in and year-out over the last 20 years. Instead of using actual RGDP growth we RGDP growth we will use data for potential RGDP as calculated Congressional Budget Office (CBO) – as the this is closer to the path RGDP growth would have followed under NGDP targeting than the actual growth of RGDP.

As potential RGDP has not been constant in the US over paste 20 years the counterfactual inflation rate would have varied inversely with potential RGDP growth under a 5% NGDP targeting rule. As potential RGDP growth accelerates – as during the tech revolution during the 1990s – inflation would ease. This is obviously contrary to inflation targeting – where the central bank would ease monetary policy in response to higher potential RGDP growth. This is exactly what happened in the US during the 1990s.

The graph below shows the “counterfactual inflation rate” (what inflation would have been under strict NGDP targeting) and the actual inflation rate (GDP deflator).

The graph fairly clearly shows that actual US inflation during the Great Moderation (from 1992 to 2007 in the graph) pretty much followed an NGDP targeting ideal. Hence, inflation declined during the 1990s during the tech driven boost to US productivity growth. From around 2000 to 2007 inflation inched up as productivity growth slowed.

Hence, during the Great Moderation monetary policy nearly followed an NGDP targeting rule – but not totally.

At two points in time actual inflation became significantly higher than it would have been under a strict NGDP targeting rule – in 1999-2001 and 2004-2007.

This of course coincides with the two “bubbles” in the US economy over the past 20 years – the tech bubble in the late 1990s and the property bubble in the years just prior to the onset of the Great Recession in 2008.

Market Monetarists disagree among each other about the extent of bubbles particularly in 2004-2007. Scott Sumner and Marcus Nunes have stressed that there was no economy wide bubble, while David Beckworth argues that too easy monetary policy created a bubble in the years just prior to 2008. My own position probably has been somewhere in-between these two views. However, my counterfactual inflation history indicates that the Beckworth view is the right one. This view also plays a central role in the new Market Monetarist book “Boom and Bust Banking: The Causes and Cures of the Great Recession”, which David has edited. Free Banking theorists like George Selgin, Larry White and Steve Horwitz have a similar view.

Hence, if anything monetary policy would have been tighter in the late 1990s and and from 2004-2008 than actually was the case if the fed had indeed had a strict NGDP targeting rule. This in my view is an illustration that NGDP seriously reduces the risk of bubbles.

The Great Recession – the fed’s failure to keep NGDP on track 

According to the CBO’s numbers potential RGDP growth started to slow in 2007 and had the fed had a strict NGDP targeting rule at the time then inflation should have been allowed to increase above 3.5%. Even though I am somewhat skeptical about CBO’s estimate for potential RGDP growth it is clear that the fed would have allowed inflation to increase in 2007-2008. Instead the fed effective gave up 20 years of quasi NGDP targeting and as a result the US economy entered the biggest crisis after the Great Depression. The graph clearly illustrates how tight monetary conditions became in 2008 compared to what would have been the case if the fed had not discontinued the defacto NGDP targeting regime.

So yes, Market Monetarists argue that monetary policy in the US became far too tight in 2008 and that significant monetary easing still is warranted (actual inflation is way below the counterfactual rate of inflation), but Market Monetarists – if we had been blogging during the two “bubble episodes” – would also have favoured tighter rather than easier monetary policy during these episodes.

So NGDP targeting is not a recipe for inflation, but rather an cure against bubbles. Therefore, NGDP targeting should be endorsed by anybody who favours sound money and nominal stability and despise monetary induced boom-bust cycles.

Related posts:

Boom, bust and bubbles
NGDP level targeting – the true Free Market alternative (we try again)
NGDP level targeting – the true Free Market alternative

Steve, George and Bryan debate Austrian economics and empirics

I am a huge fan of Cato-Unbound.org. Here you find good insightful and intellectual debates amount classical liberal, libertarian and conservative scholars on a number of topics. The quality of the pieces on Cato Unbound is always very high. That is also the case for the latest “debate”. As always there is a “Lead Essay” and a number of “Response Essays”. This time the topic is “Theory and Practice in the Austrian School”.

The lead essay is written by Steve Hortwiz and the response essays are by George Selgin and Bryan Caplan.

Fundamentally Steve’s claim is that Austrian method – praxeology – is not as strict anti-empirical as it is often said to be. In his essay “The Empirics of Austrian Economics” Steve makes an heroic attempt to argue that there is no real conflict between praxeology and empirical studies. Everybody who know me would know that I have greatest respect for Steve and I think he is a very open-minded Austrian. However, sometimes Steve’s attempt to defend Austrian economics goes too far. Fundamentally Steve is making up a version of Austrian economics, which never really existed – or rather the Austrian economics that Steve describes is not really Austrian economics, but rather it is how Steve would like to think Austrian economics should be. And I certainly admit I that I prefer Hortwizian economics to Misesian-Rothbardian economics and Steve certainly knows (much!) better than me what “Austrian economics” really is. However, his essay did not convince me that Austrians are as methodologically open-minded as he claims. Neither has he convinced Bryan Caplan and George Selgin.

Both Bryan and George are well-known friendly critics of Austrian Economics. My own feelings about Austrian economics are similar to those of Bryan and George. To me the world of economics would be very empty without Austrian economics. The contributions to economics by Mises, Hayek and Kirzner etc. can certainly not be overestimated. But I also share the view of particular Bryan who rightly notes that it is too bad that Austrians tend to marginalize themselves and the contributions of Austrian economics by their eagerness to not speak in language of mainstream economics. It is hard not from time to time to feel that Austrian economics is a cult. That is sad because it means that far to many economics students around the world are never introduced to Austrian economics (if you are one of them get a copy of Human Action and start reading NOW!).

Furthermore, I share George’s view that empirical research can be useful in understanding what is important and what is not important. Empirical research is also useful in figuring out the magnitude of a certain economic problem. We can deduct from praxeology that an increase in minimum wages will increase unemployment, but praxeology is not telling us anything about how large that the increase in unemployment will be if minimum wages are increased by X dollars. Both Mises and Rothbard were negative about this kind of empirical analysis – Steve tries to argue that that is not the case, but George shows that his arguments for this is rather weak.

Anyway, the three gentlemen have much better arguments than I have on these issues so read their pieces yourself:

Steve Horwitz: “The Empirics of Austrian Economics”

Bryan Caplan: “Horwitz, Economy and Empirics”

George Selgin: “How Austrian Is It?”

Update – follow-ups:

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