Beating the Iron Law of Public Choice – a reply to Peter Boettke

Studying Public Choice theory can be very depressing for would-be reformers as they learn about what we could call the Iron Law of Public Choice.

The students of Public Choice theory will learn from Bill Niskanen that bureaucrats has an informational advantage that they will use to maximizes budgets. They will learn that interest groups will lobby to increase government subsidies and special favours. Gordon Tulluck teaches us that groups will engage in wasteful rent-seeking. Mancur Olson will tell us that well-organized groups will highjack the political process. Voters will be rationally ignorant or even as Bryan Caplan claims rationally irrational.

Put all that together and you get the Iron Law of Public Choice – no matter how much would-be reformers try they will be up against a wall of resistance. Reforms are doomed to end in tears and reformers are doomed to end depressed and disappointed.

Peter Boettke’s defense of defeatism

In a recent blog post Peter Boettke complains about “the inability of people to incorporate into their thinking with respect to public policy some elementary principles of public choice.”

The problem according to Pete is that we (the reformers) assume that policy makers are benevolent dictators that without resistance will just implement reform proposals. Said in another way Pete argues that to evaluate reform proposals we need to analysis whether it is realistic the vote maximizing politicians, the ignorant voters and the budget maximizing bureaucrats will go along with reform proposals.

Pete uses Market Monetarists and particularly Scott Sumner’s proposal for “A Market-Driven Nominal GDP Targeting Regime” as an example. He basically accuses Scott of being involved in some kind of social engineering as Scott in his recent NGDP Targeting paper argues:

“No previous monetary regime, no matter how “foolproof,” has lasted forever. Voters and policymakers always have the last word. However, before beginning to address public choice concerns, it is necessary to think about what sort of monetary regime is capable of producing the best results, at least in principle. Only then will it be possible to work on the much more difficult question of how to make the proposal politically feasible.”

So Scott is suggesting – for the sake of the argument – to ignore the Iron Law of Public Choice, while Pete is arguing that you should never ignore Public Choice theory.

Beating the Iron Law with ideas

I must say that I think Pete’s criticism of Scott (and the rest of Market Monetarist crowd) misses the point in what Market Monetarists are indeed saying.

First of all, the suggestion for a rule-based monetary policy in the form of NGDP targeting exactly takes Public Choice considerations into account as being in stark contrast to a discretionary monetary policy. In that sense NGDP Targeting should be seen as essentially being a Monetary Constitution in exactly same way as for example a gold standard.

In fact I find it somewhat odd that Peter Boettke is always so eager to argue that NGDP targeting will fail because it as a rule will be manipulated – or in my wording would be crushed by the Iron Law of Public Choice. However, I have never heard Pete argue in the same forceful fashion against the gold standard. That is not to say that Pete has argued that the gold standard cannot be manipulated. Pete has certainly made that point, but why is it he is so eager to exactly to show that a “market driven” NGDP targeting regime would fail?

When it comes to comparing NGDP targeting with other regimes of central banking (and even free banking) what are the arguments that NGDP targeting should be more likely to fail because of the Iron Law of Public Choice than other regimes? After all should we criticize Larry White and George Selgin for ignoring Public Choice theory when they have advocated Free Banking? After all even the arguably most successful Free Banking regime the Scottish Free Banking experience before 1844 in the end “failed” – as central banking in the became the name of the game across Britain – including Scotland. Public Choice theory could certainly add to understanding why Free Banking died in Scotland, but that mean that Larry and George are wrong arguing in favour Free Banking? I don’t think so.

So yes, Scott is choosing to ignore the Iron Law of Public Choice, but so is Austrians (some of them) when they are arguing for a gold standard and so is George Selgin when he is advocate Free Banking. As Scott rightly says no monetary regime is “foolproof”. They can all be “attacked” by policy makers and bureaucrats. Any regime can be high-jacked and messed up.

Furthermore, Pete seems to fail to realize that Scott’s proposal is to let the market determine monetary conditions based on an NGDP futures set-up. Gone would be the discretion of policy makers. This is exactly taking into account Public Choice lessons for monetary policy rather than the opposite.

My second point is the Pete’s view is ignoring the importance of ideas in defeating the Iron Law of Public Choice. Let me illustrate this with a quote from Hayek. This Hayek in an interview with Reason Magazine from February 1975 on the prospects of defeating inflation:

“What I expect is that inflation will drive all the Western countries into a planned economy via price controls. Nobody will dare to stop inflation in an ordinary manner because as things are at present, to discontinue inflation will inevitably cause extensive unemployment. So assuming inflation stops it will quickly be resumed. People will find they can’t live with constantly rising prices and will try to control it by price controls and that of course is the end of the market system and the end of the free political order. So I think it will be via the attempt to regress the effects of a continued inflation that the free market and free institutions will disappear. It may still take ten years, but it doesn’t matter much for me because in ten years I hope I shall be dead.”

Here Hayek is basically making a Public Choice argument – the West is doomed. There will not be the political backing for the necessary measures to defeat inflation and instead will be on a Road to Serfdom. Interestingly enough this is nearly a Marxist argument. Capitalism will be defeated by the Iron Law of Public Choice. There is no way around it.

However, today we know that Hayek was wrong. Inflation was defeated. Price controls are not widespread in Western economies. Instead we have since the end of 1980s seen the collapse of Communism and free market capitalism – in more or less perfect forms – has spread across the globe. And during the Great Moderation we have had an unprecedented period of monetary stability around the world and you have to go to Sudan or Venezuela to find the kind of out of control inflation and price controls that Hayek so feared.

Something happened that beat the Iron Law of Public Choice. The strictest defeatist form of Public Choice theory was hence proven wrong. So why was that?

I will suggest ideas played a key role. In the extreme version ideas always trumps the Iron Law of Public Choice. This is in fact what Ludwig von Mises seemed to argue in Human Action:

“What determines the course of a nation’s economic policies is always the economic ideas held by public opinion. No government whether democratic or dictatorial can free itself from the sway of the generally accepted ideology.”

Hence, according to Mises ideas are more important than anything else. I disagree on that view, but I on the other clearly think that ideas – especially good and sound ideas – can beat the Iron Law of Public Choice. Reforms are possible. Otherwise Hayek would have been proven right, but he was not. Inflation was defeated and we saw widespread market reforms across the globe in 1980s and 1990s.

I believe that NGDP targeting is an idea that can change the way monetary policy is conducted and break the Iron Law of Public Choice and bring us closer to the ideal of a Monetary Constitution that both Peter Boettke and I share.

PS Don Boudreaux also comments on Pete’s blog post.

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Related blog posts:

Boettke and Smith on why we are wasting our time
Boettke’s important Political Economy questions for Market Monetarists
Is Market Monetarism just market socialism?

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Update: Pete has this comment on Scoop.it on my post:

“Very thoughtful reply to my CP post. I too believe in the power of ideas, but I also believe that any time we assume away public choice issues we are in effect being intellectually lazy.  I think a robust approach to institutional design would explore not only the incentive compatibility of the proposal, but an incentive compatible strategy for its implementation.  Absent that, and we aren’t thinking hard enough.  I have been as guilty as anyone else in this regard, so I am not going to point fingers.  But I’d like us to think harder and clearer about these issues.”

I very much apprecaite Pete’s kind words about my post and fundamentally think that we are moving towards common ground.

Update 2: Scott Sumner also comments on Pete’s post. Read also the comment section – George Selgin has some very insightful comments on the relationship between Free Banking and NGDP level targeting.

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Indian superstar economists, Egyptian (not so liberal!) dictators, the Great Deceleration and Taliban banking regulation – Some more unfocused musings

While the vacation is over for the Christensen family I have decided to continue with my unfocused musings. I am not sure how much I will do of this kind of thing in the future, but it means that I will write a bit more about other things than just monetary issues. My blog will still primarily be about money, but my readers seem to be happy that I venture into other areas as well from time to time. So that is what I will do.

Two elderly Indian economists and the most interesting debate in economics today

In recent weeks an very interesting war of words has been playing out between the two giants of Indian economic thinking – Jagdish Bhagwati and Amartya Sen. While I don’t really think that they two giants have been behaving themselves in a gentlemanly fashion the debate it is nonetheless an extremely interesting and the topic the are debate – how to increase the growth potential of the Indian economy – is highly relevant not only for India but also for other Emerging Markets that seem to have entered a “Great Deceleration” (see below).

While Bhagwati has been arguing in favour of a free market model Sen seems to want a more “Scandinavian” development model for India with bigger government involvement in the economy. I think my readers know that I tend to agree with Bhagwati here and in that regard I will also remind the readers that the high level of income AND the high level of equality in Scandinavia were created during a period where all of the Scandinavian countries had rather small public sectors. In fact until the mid-1960s the role of government in Scandinavia was more limited than even in the US at the same time.

Anyway, I would recommend to anybody interested in economic development to follow the Bhagwati-Sen debate.
Nupur Acharya has a good summery of the debate so and provides some useful links. See here.

By the way this is Bhagwati’s new book – co-authored with Arvind Panagariya.

Bhagwati

The Economics of Superstar Economists

Both Bhagwati and Sen are what we call Superstar economists. Other superstar economists are people like Tyler Cowen and Paul Krugman. Often these economists are also bloggers. I could also mention Nouriel Roubini as a superstar economist.

I have been thinking about this concept for a while  and have come to the conclusion that superstar economists is the real deal and are extremely important in today’s public debate about economics. They may or may not be academics, but the important feature is that they have an extremely high public profile and are very well-paid for sharing their views on everything – even on topics they do not necessarily have much real professional insight about (yes, Krugman comes to mind).

In 1981 Sherwin Rosen wrote an extremely interesting article on the topic of The Economic of Superstars. Rosen’s thesis is that superstars – whether in sports, cultural, media or the economics profession for that matter earn a disproportional high income relative to their skills. While, economists or actors with skills just moderately below the superstar level earn significantly less than the superstars.

I think this phenomenon is increasingly important in the economics profession. That is not to say that there has not been economic superstars before – Cassel and Keynes surely were superstars of their time and so was Milton Friedman, but I doubt that they were able to make the same kind of money that Paul Krugman is today.  What do you think?

The Great Deceleration – 50% structural, 50% monetary

The front page of The Economist rarely disappoints. This week is no exception. The front page headline (on the European edition) is “The Great Deceleration” and it is about the slowdown in the BRIC economies.

I think the headline is very suiting for a trend playing out in the global economy today – the fact that many or actually most Emerging Markets economies are loosing speed – decelerating. While the signs of continued recovery in the developed economies particularly the US and Japan are clear.

The Economist rightly asks the question whether the slowdown is temporary or more permanent. The answer from The Economist is that it is a bit of both. And I agree.

There is no doubt that particularly monetary tightening in China is an extremely important factor in the continued slowdown in Emerging Markets growth – and as I have argued before China’s role as monetary superpower is rather important.

However, it is also clear that many Emerging Markets are facing structural headwinds – such as negative demographics (China, Russia and most of the rest of Central and Eastern Europe), renewed “Regime Uncertainty” (Egypt, Turkey and partly South Africa) and old well-known structural problems (for example the protectionism of India and Brazil).  Maybe it would be an idea for policy makers in Emerging Markets to read Bhagwati and Panagariya’s new book or even better Hernando de Soto’s “The Mystery of Capital – Why Capitalism Triumphs in the West and Fails Everywhere Else”

Egypt – so much for “liberal dictators”

While vacationing I wrote a bit Hayek’s concept of the “liberal dictator” and how that relates to events in Egypt (see here and here). While I certainly think that the concept a liberal dictatorship is oxymoronic to say the least I do acknowledge that there are examples in history of dictators pursuing classical liberal economic reforms – Pinochet in Chile is probably the best known example – but in general I think the idea that a man in uniform ever are going to push through liberal reforms is pretty far-fetched. That is certainly also the impression one gets by following events in Egypt. Just see this from AFP:

With tensions already running high three weeks after the military ousted president Mohamed Morsi, General Abdel Fattah al-Sisi’s call for demonstrations raises the prospect of further deadly violence.

…Sisi made his unprecedented move in a speech broadcast live on state television.

“Next Friday, all honourable Egyptians must take to the street to give me a mandate and command to end terrorism and violence,” said the general, wearing dark sunglasses as he addressed a military graduation ceremony near Alexandria.

You can judge for yourself, but I am pretty skeptical that this is going to lead to anything good – and certainly not to (classical) liberal reforms.

Just take a look at this guy – is that the picture of a reformer? I think not.

Dictator

Banking regulation and the Taliban

Vince Cable undoubtedly is one of the most outspoken and colourful ministers in the UK government. This is what he earlier this week had to say in an interview with Finance Times about Bank of England and banking regulation:

“One of the anxieties in the business community is that the so called ‘capital Taliban’ in the Bank of England are imposing restrictions which at this delicate stage of recovery actually make it more difficult for companies to operate and expand.”

While one can certainly question Mr. Cable’s wording it is hard to disagree that the aggressive tightening of capital requirements by the Bank of England is hampering UK growth. Or rather if one looks at tighter capital requirements on banks then it is effectively an tax on production of “private” money. In that sense tighter capital requirements are counteracting the effects of the quantitative easing undertaken by the BoE. Said in another way – the tight capital requirements the more quantitative easing is needed to hit the BoE’s nominal targets.

That is not to say that there are not arguments for tighter capital requirements particularly if one fears that banks that get into trouble in the future “automatically” will be bailed out by the taxpayers and the system so to speak is prone to moral hazard. Hence, higher capital requirements in that since is a “second best” to a strict no-bailout regime.

However, the tightening of capital requirements clearly is badly timed given the stile very fragile recovery in the UK economy. Therefore, I think that the Bank of England – if it wants to go ahead with tightening capital requirements – should link this the performance of the UK economy. Hence, the BoE should pre-annonce that mandatory capital and liquidity ratios for UK banks and financial institutions in general will dependent on the level of nominal GDP. So as the economy recovers capital and liquidity ratios are gradually increased and if there is a new setback in economy capital and liquidity ratios will automatically be reduced. This would put banking regulation in sync with the broader monetary policy objectives in the UK.

 

Unfocused vacation musings – part 4

It is still vacation time for the Christensen family. So far we have been extremely lucky with the weather in Skåne in Southern Sweden. There has also been time for a bit of blogging. So here are a bit more random and disorganised thoughts on money and the world in general – actually not too much on money. So consider this yet another attempt to throw a curveball.

Peter I of Serbia – a Hayekian liberal dictator?

My recent blog post on the connection between Hayek and Pinochet has made me think more of the issue of the possibility of what I generally would consider an oxymoronic idea – the “liberal dictator”.

Could we really imagine a situation where somebody gains power through a military coup and then start to reform the country during a period of dictatorship or isn’t it so that there is no such thing as a “benevolent dictator”? I would think – because I have studied Austrian economists like Hayek and Mises – that the idea of a benevolent dictator is foolish. Even the most liberal and would-be-reformist military dictators will sooner or later be corrupted by the situation. Or so I thought…

A couple of days ago I (again) started reading Christopher Clark’s book The Sleepwalkers about how Europe sleepwalked into war in 1914. The first chapter is among other things about pre-World War I Serbian history. Clark among other things writes about how Peter I of Serbia became King in 1903 after a very bloody military coup.

Peter was a very interesting person. Among other things he had translated John Stuart Mills’ “On Liberty” into Serbian when he was young and he seemed like a genuine reformer when he came to power. And sure enough – according to what I have read about him (and it is not a lot) he also moved to reform Serbia’s political and economic system. So maybe Peter’s rule was in fact a Hayekian style “liberal” dictatorship. Or rather during Peter’s rule Serbia moved towards constitutional monarchy and in that sense it is hard to talk about a dictatorship.

I have very little knowledge of Serbian history during this period, but when I read about it in The Sleepwalkers I clearly came to think about relevance for discussing Hayek’s concept of a “liberal dictatorship”. Again I am not making a value judgement. I am just saying that political scientists with interest in Hayek’s historical relevance might want to study Peter I’s rule.

Finally if any of my readers know Serbian history please enlighten me on Peter I. I would love to be hear that in fact Peter I turned out to be a horrible and tyrannical king who soon forgot about the liberalism of his youth. That would show that the idea of a liberal dictatorship indeed is oxymoronic.

I hate when Americans use the term “liberal”

Above I use the term “liberal” and I pretty well know what I mean by liberal and it is certainly not the same as when you generally hear Americans use that term. In US political lingo “liberal” means somebody who is in favour of big government and who is critical about the free market. In Europe it normally means exactly the opposite – somebody who are in favour of free markets.

I certainly consider myself a liberal – as did Hayek and Friedman. But when I speak to Americans I always make sure to say classical liberal. I refuse ever to call myself a conservative.

I find it extremely frustrating when I hear especially conservative pundits in the US talk about the “liberals” – these evil people who love big government and want to take away the guns from law-abiding US citizens. Could you please stop using that term? If you think people are socialists then use that term, but stop calling people who hates free markets “liberal”.

Yeah, I know it will make absolutely no difference what I think about this – after all Americans also call a sport where you hardly kick the ball “football”.  And no I don’t hate Americans…

By the way I equally hate when classical liberals like Milton, Hayek and Buchanan are called “conservatives”. Sure enough – there is such a thing as genuine conservatives, but these brilliant economists where not conservative. Something they all again and again stressed.

Dopingnomics?

Yesterday I was watching a great stage in the Tour de France. Danes generally love to watch bike racing and particularly the Tour de France and I am not exception. Kenyan-born Brit Chris Froome won the stage after a fantastic performance on the climb of Mont Ventoux.

Anybody who have followed professional cycling over the last decade or so knows about the major problems with doping in the sport so it was hardly surprise that the discussion of doping resurfaced yesterday and numerous commentators once again said that Froome’s fantastic performance had to be a result of doping.

I have no clue whether or not Froome is “clean” or not, but nerdy as I am I came to think that economics might help the cycling sport understand the doping problem.

So I have an idea for a working paper on “dopingnomics”. Now I just need to find somebody who will write it – or at least do the econometrics!

The riders in the Tour de France have climbed Mont Ventoux numerous time in Tour history so that makes for the perfect empirical test. As far as I know there are records of the time it has taken the winners of the stages to Mont Ventoux to climbed the mountain.

So why not estimate a regression for the time it have taken the stage winners to climb the Mont Ventoux? And then use the predicted “climb time” as a benchmark to which to compare with the actual time. That should give a pretty good indication of whether the winning rider on Mont Ventoux s is superhuman or not.

Here are some ideas for explanatory variable in the regression:

1)   Weather – was it sunny or rainy? Hot or cold?

2)   Number of kilometres on the stage prior to climbing the mountain

3)   Number of kilometres in the Tour prior to the Mont Ventoux stage

4)   Did the winner have a strong or a weak team?

5)   Tactics – what position did the winner of the stage have in the Tour? Was he a favourite or not?

6)   Technology – estimate the level of technology (basically the quality of the cycles) by looking at for example Total Factor Productivity in the US economy over time.

7)   Health and fitness of the general population – for example average living age or child mortality in for example France.

I am sure somebody interested in this topic could come up with more and better variables to use in the regression, but if you do the analysis we would have an “economic” measure of whether or not certain riders are super humans (doped) or not. That at least would be better than the present hearsay.

Why I still am (not) a Georgist

My good friend professor Peter Kurrild-Klitgaard likes to tease me with my (alleged) Georgist past (I tease him with something about privatized fire engines). Only a few days ago Pete did it again on Facebook – teased me with my Georgist past. I promised him to write a “response”. So here it is.

A Georgist of course is an admirer of the 19th century economist and social reformer Henry George. Henry George of course is famous for being a proponent of the so-called Single Tax – a tax on “land rents”.

Pete is right that when I was in my early twenties – so around two decades ago – I had some interest in Henry George’s work. In fact I have to admit that I still have a lot of sympathy for Henry George. In that sense I am still (if I ever were to begin with) a Georgist. However, my reason for my George sympathies is not his views on land taxation (which I find deeply flawed), but rather his view on free trade.

Henry George did not understand marginalism, which of course is the foundation of all modern microeconomic thinking and as a result his analysis “land rents” was rather foolish – in the same way as Ricardo and Marx failed in their thinking of wages, profits and rents.

However, I love Henry George’s thinking and his advocacy on free trade. Not because his arguments were particularly strong in an economic sense, but rather because of his genuine outrage over the negative social implications of protectionism. I must say this is exactly how I feel about the trade question. I never understood anybody who would try to make sense of protectionism (I was going to write something bad about Paul Krugman here), but I won’t). Frankly speaking it is not only idiotic in an economic sense I also find it deeply chauvinistic. I think Henry George felt exactly the same way. (For some reason he had the “wrong” view on immigration).

And since my “vacation posts” very much have been about books and book recommendation here is another book recommendation. Take a look at Henry George’s fantastic defence of free trade “Protection and Free Trade” from 1886.

So what I really wanted to say is that I still am a Georgist when it comes to defending free trade. To me it is pretty much an emotional issue and simply can’t understand how anybody who calls himself an economist would ever defend any form of protectionism.

PS I will get out of this ranting phase and I will return to regular monetary blogging…

 

 

A Hayekian coup in Egypt?

(Warning: This has nothing to do with monetary policy issues)

For some time there has raged a very interesting – but for Hayek fans an unpleasant  – debate in the blogosphere about Hayek’s views of Chilean dictator Augosto Pinicohet. It all started with a blog post around a year ago by Corey Robin – a left-leaning long-time critique of conservative and libertarian thinkers – in which he claimed that “Friedrich von Hayek was a warm supporter of Augusto Pinochet’s bloody regime.” 

I must say that when I first read Corey’s post I thought he made a strong case. For a long time admirer of Hayek as myself that was not nice. Since then I have followed the debate about Corey’s claims on and off over the past year without having followed it very closely and without having made up my mind on all the issues involved in this debate.

Corey has been attacked by a number of libertarian scholars among them Kevin Vallier. Kevin’s latest post – Hayek and Pinochet, A Discussion Deferred For Now – on the issue was recently posted on the excellent Bleeding Heart Libertarians blog. Pete Boettke also has a very good discussion of related issues here.

Numerous scholars have been involved in this debate, but unfortunately I don’t think that anybody have written anything to sum up the debate – and I am certainly not going to do that. In fact I don’t really has a view on who is right and who is wrong on this topic. However, the debate is highly relevant for recent developments in Egypt and that is what is want I really want to touch on in this post.

Did general al-Sisi read Hayek’s “Law, Legislation and Liberty”‘?

I had just read another blog post by Corey Robin on the Hayek-Pinochet connection when the military coup in Egypt happened. That made me think what Hayek would have thought of that coup.

In his post Corey quotes Hayek:

As long-term institutions, I am totally against dictatorships. But a dictatorship may be a necessary system for a transitional period. At times it is necessary for a country to have, for a time, some form or other of dictatorial power. As you will understand, it is possible for a dictator to govern in a liberal way. And it is also possible for a democracy to govern with a total lack of liberalism. Personally, I prefer a liberal dictator to democratic government lacking in liberalism. My personal impression…is that in Chile…we will witness a transition from a dictatorial government to a liberal government….during this transition it may be necessary to maintain certain dictatorial powers.

Corey further claims the following about Hayek’s views:

He had his secretary send a draft of what eventually became chapter 17—“A Model Constitution”—of the third volume of Law, Legislation and Liberty. That chapter includes a section on “Emergency Powers,” which defends temporary dictatorships when “the long-run preservation” of a free society is threatened. “Long run” is an elastic phrase, and by free society Hayek doesn’t mean liberal democracy. He has something more particular and peculiar in mind: “that the coercive powers of government are restricted to the enforcement of universal rules of just conduct, and cannot be used for the achievement of particular purposes.” That last phrase is doing a lot of the work here: Hayek believed, for example, that the effort to secure a specific distribution of wealth constituted the pursuit of a particular purpose. So the threats to a free society might not simply come from international or civil war.

This discussion to me smells of the same kind of argument, which is being made in Egypt these days by anti-Muslim Brotherhood forces – among them some liberals (in the broadest possible sense). They have been arguing that while Morsi was democratically elected his regime turned anti-democratic and therefore it was in the interest of the people and freedom that the military deposed of him and the Muslim Brotherhood. Some would probably argue that the coup was necessary to save democracy in Egypt.

I don’t have a view on this, but tell me what to think please!

I should stress that I don’t have any particular view – at least not a qualified view – on what Hayek’s views on Pinochet was and I certainly do not have any idea about what he would have thought of the coup in Egypt. However, I do think that the fundamental philosophical discussion about the “rights” of the military to depose a democratically elected government is highly important particularly for what is going on in Egypt these days.

And yes, 90% of what I write on this blog is about monetary issues, but I am still on vacation so I am a bit philosophical here so I would hope that somebody will pick up the challenge and tell me what Hayek would have thought of the coup in Egypt. That is really what I want to know. And again I am not making any judgement on either the Hayek-Pinochet connection debate or the present situation in Egypt.

I am just asking questions. Maybe somebody much better schooled in Hayek’s philosophical work will help me.

PS let me know if you think it is interesting that I from time to time move into other areas of economics and politics than monetary matters. I promise I will not do it a lot, but on the other hand I might start doing it a little more frequent if my readers like it.

PPS In terms of political philosophy I do not and have never considered myself a Hayekian. In fact if any Austrian economist has influenced me on these issues it is – believe it or not – Murray Rothbard. Rothbard’s The Ethics of Liberty made a lot bigger impression on me than Hayek’s Law, Legislation and Liberty ever did, but I am certainly not a Rothbardian either.

PPPS Farant, McPhail and Berger’s 2011 paper on “Preventing the “Abuses” of Democracy: Hayek, the Military “Usurper” and Transitional Dictatorship in Chile”? is a must-read paper.

Update: Somebody sent me this quote from the Wall Street Journal:

“Egyptians would be lucky if their new ruling generals turn out to be in the mold of Chile’s Augusto Pinochet, who took power amid chaos but hired free-market reformers and midwifed a transition to democracy. If General Sisi merely tries to restore the old Mubarak order, he will eventually suffer Mr. Morsi’s fate.”

China – my fear is a ”secondary deflation”

China has certainly moved to the very top of the agenda in the financial markets this week and a lot of what is playing out in the Chinese markets is eerily similar to what happened in the US and European markets in 2008.

As in 2008 there is a lot of focus on a bubble being deflated both among commentators and among central bankers. This in my view could lead to very unfortunate policy conclusions. I am particularly afraid that the People Bank of China’s fear of reflating the bubble will lead it to take too long to ease monetary policy – as clearly was the case in the US and Europe in 2008.

China – an “ideal” Hayekian boom-bust?

Market Monetarists are in general very sceptical about the Austrian story of the Great Recession and sceptical about a bubble explanation for the crisis. That, however, do not mean that Market Monetarists outright denies that there can be bubbles. In fact I certainly think that there was many examples of “bubbles” in 2008. However, the real reason for the bust was not overly easy monetary policy, but rather that monetary policy became insanely tight both in the US and the euro zone in 2008.

But how do that compare to the Chinese situation today? I have earlier argued that I don’t believe that easy monetary policy on its own it enough to create a major bubble. We need something more – and that is the existence of moral hazard or rather the implicit or explicit socialization of the cost of risk taking. One can certainty argue that Too-Big-To-Fail has been and still is a major problem in the Western world, but that is even more the case in China, where the banking sector remains under tight government control and where the banks are mostly government owned. Furthermore, the investment decisions in many industries remain under strict government control.

In that sense one can argue that China over the past 4-5 years have had the “ideal” environment – easing money and massive moral hazard problems – for creating a bubble. The result has most likely also been the creation of a bubble. I have no clue have big this bubble is, but I feel pretty certain that the Chinese government run banking system has created serious misallocation of capital and labour in the last 4-5 years. In that sense we have probably been through a Hayekian boom-bust in the Chinese economy.

Fear the secondary deflation rather than a new bubble

The Chinese authorities have been extremely focused on how to deflate what they consider to be a bubble and as a result Chinese monetary and credit policies have been tightened significantly since early 2010 when the PBoC the first time in the post-crisis recovery tightened reserve requirements.

Hence, since 2010 the PBoC has basically tried to “deflate the bubble” by tightening monetary conditions and as a result the Chinese economy has slowed dramatically.

The PBoC obviously has been right to tighten monetary policy, but I have for some time though that the PBoC was overdoing it (see for example my post on “dangerous bubble fears” from last year) and in that regard it is important to remind ourselves of Hayek’s advice on conduct of monetary policy in the “bust” phase of the business cycle.

When Hayek formulated his version of the Austrian business cycle theory in Prices and Production from 1931 he stressed that the monetary authority should let the bubble deflate with out any intervention. However, he later came to regret that he in the 1930s had not been more clear about the risk of what he called the “secondary deflation”. The secondary deflation is a “shock” that can follow the necessary correction of the “bubble” and send the economy into depression.

If we formulate this in Market Monetarist lingo we can say that the central bank should allow nominal GDP to fall back to the targeted level if there has been a “bubble” (NGDP has accelerated above the targeted level). This will ensure an orderly correction in the economy, but if the central bank allows NGDP to drop significantly below the “targeted” level then that will could trigger financial distress and banking crisis. This unfortunately seem to be exactly what we have seen some signs of in the Chinese markets lately.

The graph below shows two alternative hypothetical scenarios. The red line is what I call the “perfect landing” where the NGDP level is brought back on trend gradually and orderly, while the green line is the disorderly collapse in NGDP – the secondary deflation. The PBoC obviously should avoid the later scenario. This is what the ECB and fed failed to do in 2008.

boombust

Reasons why the PBoC might fail

I must admit that my fears of monetary policy failure in China have increased a lot this week, but luckily a secondary deflation can still be avoided if the PBoC moves swiftly to ease monetary conditions. However, I see a number of reasons why the PBoC might fail to do this.

First, there is no doubt that the PBoC is preoccupied with the risk of reflating the bubble rather than with avoiding secondary deflation. This I believe is the key reason why the PBoC has allowed things to get out of hand of the past weeks.

Second, significant monetary easing will necessitate that the PBoC should allow the renminbi to weaken. There might, however, be a number of reasons why the PBoC will be very reluctant to allow that. The primary reason would probably be that the Chinese do not want to be accused of engineering a “competitive deflation”. In that regard it should be noted that it would be catastrophic if the international community – particularly the Americans – opposed renminbi devaluation in a situation where the crisis escalates.

Third, the PBoC might feel uncomfortable with using certain instruments at its disposal for monetary easing. One thing is cut banks’ reserve requirements another thing is to conduct to do outright quantitative easing. We know from other central bank how there is a strong “mental” resentment to do QE.

I strongly hope that the PBoC will avoid remarking the ECB and fed’s mistakes of 2008, but the events of the past week certainly makes me nervous. Monetary policy failure can still be avoid it – how things develop from here on it up to the PBoC to decide.

Spain’s quasi-depression – an Austrian ‘bust’ or a monetary contraction? Or both?

A couple of days ago I wrote a post on the behavior of prices in the ‘bust’ phase of an Austrian style business cycle. My argument was that the Austrian business cycle story basically is a supply side story and that in the bust there is a negative supply shock. As a consequence one should expect inflation to increase during the ‘bust’ phase.

My post was not really about what have happened during the Great Recession, but it is obvious that the discussion could be relevant for understanding the present crisis.

Overall I don’t think that the present crisis can be explained by an Austrian style business cycle theory, but I nonetheless think that we can learn something relevant from Austrian Business Cycle Theory (ABCT) that will deepen our understanding of the crisis.

Unlike Austrians Market Monetarists generally do not stress what happened prior to the crisis. I do, however, think that we prior to the crisis saw a significant misallocation of resources in some countries. I myself in the run up to the crisis – back in 2006/7 – pointed to the risk of boom-bust in for example Iceland and Baltic States. Furthermore, in hindsight one could certainly also argue that we saw a similar misallocation in some Southern European countries. This misallocation in my view was caused by a combination of overly easy monetary conditions and significant moral hazard problems.

This discussion has inspired me to have a look Spain in the light of my discussion of ABCT.

My starting point is to decompose Spanish inflation into a supply and a demand component. I have used the crude method - the Quasi-Real Price Index – that I inspired by David Eagle developed in a number of posts back in 2011. I will not go into details with the method here, but you can read more here.

This is my decomposition of Spanish inflation.

Spain inflation QRPI

The story prior to the crisis is pretty clear. Both demand and supply inflation is fairly stable and there are no real sign of strongly accelerating demand inflation. However, the picture that emerges in the “bust-years” is very different.

As the graph shows supply inflation spiked as the crisis played out and has remained elevated ever since and we are now seeing supply inflation around 5%. However, at the same time demand inflation has collapsed and we basically have had demand deflation since the outbreak of the crisis.

I would stress that my crude method of decomposing inflation assumes that the aggregate supply curve is vertical. That obviously is not the case and that likely lead to an overestimation of the supply side inflation. That said, I feel pretty confident that the overall story is correct.

Hence, the Spanish story in my view provides some support for an Austrian-inspired interpretation of the crisis in the Spanish economy. As the crisis in Spain started to unfold the Spanish economy was hit by a large negative supply shock, which caused supply inflation to spike. There is clearly an Austrian style argument to be made here. Investors realised that they had  made a mistake and therefore economic resources had to reallocated from unprofitable sectors (for example the construction sector) to other sector. With price and wage rigidities this is a supply shock.

A negative supply shock will not in itself cause a depression 

However, this is not the whole story. A purely Austrian interpretation of the crisis misses the main problem in the Spanish economy today – the collapse in aggregate demand. Despite the sharp increase in Spanish supply inflation headline inflation (measured with the GDP deflator) has collapsed! That can only happen if demand inflation drops more than supply inflation increases. This is exactly what have happened in Spain. In fact we have a situation where we have high suppply inflation AND demand deflation.

What have happened is that the Spanish economy has moved from the ‘bust’ phase to what Hayek called ‘secondary deflation’. The ‘secondary deflation’ is the post-bust phase where a negative demand shock causes the economy to go into depression and a general deflationary state. This is a massively negative monetary shock and this is the real cause of the prolonged crisis.

The ‘secondary deflation’ is not a natural consequence of an Austrian style boom-bust, but rather a consequence of a monetary contraction. In that sense the secondary deflation is more monetarist in nature than Austrian.

In the case of Spain the monetary contraction is a direct consequence of Spain’s euro membership. If a country has a freely floating exchange rate then a negative supply shock – the bust – will cause the country’s currency to depreciate. However, due to Spain’s membership this obviously is not possible. The lack of depreciation of Spain’s currency de facto is monetary tightening (process that plays out is basically David Hume’s Price-Specie-flow story).

In fact the monetary tightening in Spain has been massive and has caused demand inflation to drop from around 4% to today more than 5% (demand) deflation!

This obviously is the real cause of the continued crisis in the Spanish economy. So while my decomposition of Spanish inflation seems to indicate that there has been an ‘Austrian story’ in the sense that there Spain has gone through of re-allocation (the negative supply shock) the dominant story is the collapse in aggregate demand caused by a monetary contraction.

The counterfactual story – and why a Austrian style bust is not recessionary

The discussion above in my view illustrates a clear problem with the Austrian story of the business cycle. I my view Austrians often fail to explain why a reallocation of economic resources will have to lead to a recession. Yes, it is clear that we will get a temporary downturn in real GDP in the bust phase, but there is nothing in ABCT that explains that that will turn into a depression-like situation as is the case in Spain.

What would for example have happened if Spain had had its own currency and an independent monetary policy regime where the central bank had targeted nominal GDP – for example along a 6% NGDP growth path.

Lets say that the entire initial Spanish downturn had been cause by a bubble bursting (it was not), but also that the central bank had been targeting a 6% NGDP growth path. Hence, as the bubble bursts real GDP growth decelerates sharply. However, as the central bank is keeping NGDP growth at 6% inflation will – temporary – increase. Most of the rise in inflation will be caused by an increase in supply inflation (but demand inflation will not drop). This is temporary and inflation will drop back once the re-allocation process has come to an end. Hence, there will not be a deflationary shock.

Therefore, the drop in real GDP growth is a necessary adjustment to a bubble bursting. However, the drop will likely be rather short-lived as aggregate demand (NGDP) is kept “on track” due to the NGDP target and hence “facilitate” a smooth re-allocation of resources in the Spanish economy.

This in my view clearly illustrates why we cannot use Austrian Business Cycle Theory to explain why the crisis in the Spanish economy is as deep as it is. Clever Austrians like Roger Garrison and Steve Horwitz will of course agree that ABCT is not a theory of depression. You need a monetary contraction to create a depression. This is Steve Horwitz on ABCT:

Both critics and adherents of the ABCT misunderstand it if they think it is some sort of comprehensive theory of the boom, breaking point, and length/depth of the bust.  It isn’t.  As Roger Garrison has long insisted, the theory by itself is a theory of the unsustainable boom.  It is a theory that explains why driving the market rate of interest below the natural rate through expansionary monetary policy produces a boom that contains endogenous processes that will cause that boom to turn to a bust.  Again, it’s a theory of the unsustainable boom.

ABCT tells us nothing about exactly when the boom will break and the precise factors that will cause it.  The theory claims that eventually costs will rise in such a way that make it clear that the longer-term production processes falsely induced by the boom will not be profitable, leading to their abandonment.  But it says nothing about which projects will be undertaken in which markets and which costs (other than perhaps the loan rate) will rise, and it tells us nothing about the timing of those events.  We know it has to happen, but the where and when are unique, not typical, features of business cycles.

… The ABCT is not a theory of the causes of the length and depth of recessions/depressions, but a theory of the unsustainable boom.

…The ABCT cannot explain the entirety of the Great Depression.  It simply can’t.  And adherents of theory who make the claim that it can are not doing the theory any favors.  What ABCT can explain (at least potentially, if the data support it) is why there was a recession at all in 1929.  It argues that it was the result of an unsustainable boom initiated by an excess supply of money at some point in the 1920s.  Yes, the bigger the boom, cet. par., the worse the bust, but even that doesn’t tell us much.  Once the turning point is reached, there’s not a lot that ABCT can say other than to let the healing process unfold unimpeded.

I think Steve’s description of ABCT is completely correct and in the same way as Steve doesn’t believe that ABCT can explain the entire Great Depression I would argue that ABCT cannot explain the Spanish crisis – or the euro crisis for that matter. Yes, there undoubtedly is some truth to the fact that overly easy monetary policy from the ECB contributed  to creating a unsustainable boom in the Spanish economy (and other European economies). However, ABCT cannot explain why we still five years into the crisis are trapped in a deflationary crisis in the Spanish economy. The depressionary state of the Spanish economy – at this stage – is nearly fully a consequence of a sharp monetary contraction. The bust has clearly long ago run its natural cause and what is keeping the Spanish economy from recovering is not a necessary re-allocation of economic resources, but very tight monetary conditions in Spain.

Conclusion: ABCT provide important insights, but will not help us now 

So to me the conclusion is pretty clear – Austrian Business Cycle theory do indeed provide some interesting and important insights to the boom-bust process. However, ABCT only explains a very limited part of the crisis in the Spanish economy and the euro zone for that matter. Had monetary policy been kept on track as the re-allocation process started the adjustment process in the Spanish economy would likely have been fairly painless and swift.

Unfortunately that has not been the case and monetary policy has caused the Spanish economy to enter a ‘secondary deflation’ and clever Austrians know that that is not a result of a bust, but rather a result of a monetary disequilibrium resulting from a excessive demand for money relative to the supply of money. There is no reason to worry about about reflating a bubble. The bubble has been deflated long ago.

PS The purpose of this post has been to discuss ABCT in the light of the crisis in Spain. However, the purpose has not been to tell the full story of Spain’s economic problems. Hence, it is clear that Spain struggles with serious structural problems such as extremely damaging firing-and-hiring rules. This structural problem significantly contribute to deepen and prolong the crisis, but it has not been the cause of the crisis.

Mario Rizzo on Austrian Business Cycle Theory

Mario Rizzo has an excellent post on Austrian Business Cycle Theory (ABCT). I think Mario do a good job explaining what ABCT is and what it is not.

At the centre of Mario’s discussion is that monetary policy is not neutral, but that the important think is not inflation, but rather “relative inflation”. Here is Mario:

The Austrian theory rests, not on a catalyzing effect of core inflation or headline inflation, but on changes inrelative prices that cause resources to be allocated in ultimately unsustainable ways. The Great Depression was not preceded by much inflation because productivity improvements allowed for increases in bank credit without increasing (by much) the price level. Hayek said repeatedly that the price level aggregate can hide the distortions basic to the cycle.

This point is especially important in the early stages of recovery when there is so much unused capacity and previous investment pessimism that expansions in bank credit (not meaning base money) may be returning to sustainable levels and inflation in the usual sense is unlikely. Nevertheless, as the recovery proceeds, there is a danger that maintenance of low interest rates by the central bank for long periods can induce a distorted character of investment, even as the total amount of investment measured throughout the economy has not recovered.

The policy-relevant point is that if the central bank decides not to allow interest rates to rise until aggregate investment has recovered to boom levels, it will have waited too long. The character of the investment will be distorted. Malinvestments will set in – even without inflation.

I do not think that the Austrian theory says anything unique about inflation – in the sense of increases in the aggregate price level – beyond the warning that aggregates of this sort can conceal the theoretically-relevant magnitudes for understanding business cycles.

I think this is a completely fair and accurate description of Austrian Business Cycle Theory (at least the Hayek-Garrison version of ABCT). That said, I do have serious problems with ABCT as a general business cycle theory. First of all while I don’t think the so-called Cantillon effect is completely irrelevant I don’t think it is very important empirically and the Cantillon effect seems to be based on the assumption that some agents have adaptive or static expectations and/or asymmetrical information (these assumptions are highly ad hoc in nature). Second, ABCT is also based on the assumption that credit markets are imperfect – that might or might not be the case in the real world, but Austrians often fail to state that clearly. I hope to follow up on these issues in a later post.

That said, unlike some other Market Monetarists I don’t think Austrian Business Cycle theory is irrelevant. Rather, I think that (variations of) ABCT will be helpful in understanding the “boom” in for example certain euro zone countries prior to 2008 – and it certainly helped me in my own research on for example Iceland and the Baltic States during the “boom years” of 2006-7. However, empirically I think that both the US and particularly in euro zone are in the secondary deflation phase of the business cycle (in the sense that NGDP has fallen well below the pre-crisis trend), which as Mario notes ABCT has little to say about. As a consequence I don’t think that monetary easing in at the present state of the cycle is likely to lead to a Austrian style boom with distortion of relative prices – at least not if monetary easing is conducted with-in a clear rule based set-up like NGDP level targeting.

In a sense one can say that my biggest problem with ABCT is not so much ABCT in itself, but rather that many Austrian economists today seems to believe that we are in necessary “bursting of the bubble”-phase of the cycle rather than in the secondary deflation phase.

Concluding, while I do not think that ABCT is a general theory of the business cycle and I would certainly also stress the “secondary deflation” part of the cycle much more than the “boom” phase of the cycle I nonetheless think that Mario’s description of Austrian Business Cycle Theory is excellent and I hope that Austrian and non-Austrians alike will read it.

—-

Suggested reading on ABCT:

Hayek’s Price and Production

Garrison’s Time and Money (I linked to a PDF of Garrison’s book, but do yourself a favour and buy a hardcopy)

See my earlier post on the Rothbardian version of ABCT and Steve Horwitz excellent reply to that post. Steve’s reply to me was very much in line with Mario’s views.

Was the Geyser crisis caused by a negative supply shock?

I am writing this while having a small break between meetings and interviews in Reykjavik. It has been a great day, but also a busy day in Iceland’s capital for me. Today’s meetings and talks have been educational for me and it had made me think about a lot of issues regarding the Icelandic economy. I always find that meetings “on the ground” educate me about the economies I am analyzing rather than just looking a the numbers.

I strongly believe that the Great Recession was caused by a monetary shock in both the US and in the euro zone. However, I don’t think that that (necessarily) was the case in Iceland. Rather some of the meetings today have made me think that the shock to the Icelandic economy in 2008 was a negative supply shock rather than a negative demand shock. Take a look at the graph below.

Iceland RGDP NGDP

It is pretty clear – Icelandic nominal GDP (NGDP) growth continued to growth strongly all through 2007 and 2008 and even spiked in the Autumn of 2008 (as the Icelandic krona collapsed). So if anything Icelandic monetary conditions easied rather than tightened through 2008 – contrary to what we saw in the US or the euro zone.

On the other hand real GDP (RGDP) growth started to slow already in 2007 and continued to slow sharply during 2008.

With NGDP growth accelerating and RGDP growth decelerating inflation increased through 2008. If one don’t know the story of the “Geyser crisis” these numbers would lead one to conclude that the Icelandic economy was hit by a negative supply shock rather than a negative demand shock.

This is interesting as it indicates that the Icelandic crisis was not necessarily caused by monetary policy failure – at least not in the monetarist sense of an excessive tightening of monetary conditions.

So how can we explain this supply shock? Normally we would think of a supply shock as a increase in for example oil prices. However, in the case of Iceland the shock has to be found in the financial sector and related sectors. From 2004-5 the financial sector as share of GDP grew strongly in Iceland and the general perception among investors was that Iceland had very strong comparative advantages in the production of financial services. However, as jitters started to emerge in the global financial markets in 2007 investors probably started to doubt how brilliant an idea it was that Iceland should be a “financial hub” and that led to a significant down-revision of growth expectations for the entire Icelandic economy. This was the negative supply shock.

This also means that there there was not a monetary “answer” to the Icelandic crisis. The only thing the central bank could do was to acknowledge the fact that investors had been too positive about the long-term growth potential of the Icelandic economy and try to keep nominal GDP growth on track.

That said, in the later part of 2008 we also saw a sharp monetary contraction and NGDP dropped sharply and the Icelandic central bank obviously could have counteracted that, but initially failed to do so. However, judging from the graph above the primary shock was a real shock rather than a nominal shock.

In the years following 2008 we have actually seen additional negative supply shocks. First of all the draconian capital controls put in place in response to the crisis has seriously increase “regime uncertainty” in Iceland which is certainly having an negative impact on investment growth. Furthermore, numerous policy issues regarding debt restructuring, taxation and the settlement of the so-called Icesave case are likely also adding to “regime uncertainty”. Second. the negative shock to the Icelandic economy has also meant that a large number of Icelanders was leaving the country to look for job opportunities in for example Norway. Hence, we have continued to see a negative supply shock to both K (capital) and L (labour) and that is clearly reducing the growth potential of the Icelandic economy.This in my view helps explain why Icelandic inflation has stayed elevated despite the sharp drop in growth.

Therefore, I think that it is reasonable to conclude that the (perceived) growth potential of the Icelandic economy is somewhat smaller today than was the case prior to the crisis. As a consequence it is much harder to argue that monetary easing necessarily is warranted in Iceland – contrary to for example in the euro zone where monetary easing clearly is warranted.

Concluding I believe that there was very serious policy mistakes made in Iceland in the run up to the collapse in 2008 and in the imitate aftermath. However, a lack of monetary easing did play a significantly smaller role in Iceland collapse than for example was the case in the US and the euro zone. In that sense the Icelandic crisis was more Hayekian than Hetzelian.

HT Mar

“Money neutrality” – normative rather than positive

When we study macroeconomic theory we are that we are taught about “money neutrality”. Normally money neutrality is seen as a certain feature of a given model. In traditional monetarist models monetary policy is said to be neutral in the long run, but not in the short run, while in Real Business Cycle (RBC) models money is (normally) said to be neutral in both the long and the short run. In that sense “money neutrality” can be said to be a positive (rather than as normative) concept, which mostly is dependent on the assumptions in the models about degree of price and wage rigidity.

As a positive concept money is said to be neutral when changes in the money supply only impacts nominal variables such as prices, nominal GDP, wages and the exchange rates, but has no real variables such are real GDP and employment. However, I would suggest a different interpretation of money neutrality and that is as a normative concept.

Monetary policy should ensure money neutrality

Normally the discussion of money neutrality completely disregard the model assumptions about the monetary policy rule. However, in my view the assumption about the monetary policy rule is crucial to whether money is neutral or not.

Hayek already discussed this in classic book on business cycle theory Prices and Production in 1931 – I quote here from Greg Ransom’s excellent blog “Taking Hayek Serious”:

“In order to preserve, in a money economy, the tendencies towards a stage of equilibrium which are described by general economic theory, it would be necessary to secure the existence of all the conditions, which the theory of neutral money has to establish. It is however very probable that this is practically impossible. It will be necessary to take into account the fact that the existence of a generally used medium of exchange will always lead to the existence of long-term contracts in terms of this medium of exchange, which will have been concluded in the expectation of a certain future price level. It may further be necessary to take into account the fact that many other prices possess a considerable degree of rigidity and will be particularly difficult to reduce. All these ” frictions” which obstruct the smooth adaptation of the price system to changed conditions, which would be necessary if the money supply were to be kept neutral, are of course of the greatest importance for all practical problems of monetary policy. And it may be necessary to seek for a compromise between two aims which can be realized only alternatively: the greatest possible realization of the forces working toward a state of equilibrium, and the avoidance of excessive frictional resistance.  But it is important to realize fully that in this case the elimination of the active influence of money [on all relative prices, the time structure of production, and the relations between production, consumption, savings and investment], has ceased to be the only, or even a fully realizable, purpose of monetary policy. ”

The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly, all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.”

Hence according to Hayek monetary policy should ensure monetary neutrality, which is “a stage of equilibrium which are described by general economic theory”. In Prices and Production Hayek describes this in terms of a Walrasian general equilibrium. Therefore, the monetary policy should not distort relative prices and hence monetary policy should be conducted in a way to ensure that relative prices are as close as possible to what they would have been in a world with no money and no frictions – the Walrasian economy.

As I have discussed in a numerous posts before such a policy is NGDP level targeting. See for example herehere and here.

And this is why the RBC model worked fine during the Great Moderation

If we instead think of monetary policy as a normative concept then it so much more obvious why monetary policy suddenly has become so central in all macroeconomic discussions the last four years and why it did not seem to play any role during the Great Moderation.

Hence, during the Great Moderation US monetary policy was conducted as if the Federal Reserve had an NGDP level targeting. That – broadly speaking – ensured money neutrality and as a consequence the US economy resembled the Walrasian ideal. In this world real GDP would more or less move up and down with productivity shocks and other supply shocks and the prices level would move inversely to these shocks. This pretty much is the Real Business Cycle model. This model is a very useful model when the central bank gets it right, but the when the central bank fails the RBC is pretty useless.

Since 2008 monetary policy has no longer followed ensured nominal stability and as a result we have moved away from the Walrasian ideal and today the US economy therefore better can be described as something that resembles a traditional monetarist model, where money is no longer neutral. What have changed is not the structures of the US economy or the degree of rigidities in the US product and labour markets, but rather the fed’s conduct of monetary policy.

This also illustrates why the causality seemed to be running from prices and NGDP to money during the Great Moderation, but now the causality seem to have become (traditional) monetarist again and money supply data once again seems to be an useful indicator of future changes in NGDP and prices.

Maybe Scott should talk about Hayek instead of EMH

Every other month or so Scott Sumner writes a defence of the so-called Efficient Market Hypothesis. I have noticed that the commentators already react quite aggressively to Scott’s unwavering support of EMH and my own personal experience is that people – especially people who themselves are active in the financial markets – will strongly oppose the idea of efficient markets.

Why is that? Fundamentally I think that most people think of economics and financial markets based on their personal micro observations rather than based on economic logic. We all have met or heard of completely insane investors that far from can be described as being rational and if such people exists how can we talk about efficient markets? EMH is simply a very hard sell – whether or not it empirically is a good description of the world.

Even though Scott and I agree that EMH probably is the best description of today’s financial markets it might actually be an idea to stop talking about EHM and instead confront the anti-EHM crowd with an alternative. Such an alternative could be Hayek’s description of capitalist market system as the best aggregator of information known to man.

Recently I have been re-reading some of the key chapters in Hayek’s Individualism and Economic Order. The book is full is Hayekian classics such as The Use of Knowledge in Society and The Meaning of Competition and as well as some key chapters discussing calculation in socialist society. Contrary to neo-classical theory which is at the core of EMH Hayekian thinking is based on much less rigid assumptions (and is somewhat less stringent). At the core of Hayek’s thinking is that no social planner has the knowledge to allocate goods and resources in society. Preferences are individual and are changing constantly and so do natural conditions.

We do so to speak not know the “model” of the economy. Contrary to this EHM and rational expectations build on the explicit assumption that the model is known. Hayek on the other hand would strongly object to the notion that the model is known – least at all by policy makers.

Scott uses EHM to argue that since the markets are more or less efficient no central bank forecast will be able to consistently beat the forecast of the market and therefore central bank policy implementation should be build on the use of the market mechanism through NGDP futures.

This makes perfectly good sense, but hold on for a second. What if the “model” of the economy is known why should we bother using NGDP futures when a benevolent central bank could just solve an optimisation problem and solve the model and implement the policy that would ensure the highest level of societal welfare? First of all, there would be a problem which social welfare function to optimize, but lets assume that this (non-trivial!) problem is solved. Then second, would you really think that we could and should leave it to central bankers to define what model is the “right” of the economy (most central banks today rely on New Keynesian models which both Scott and I think make very little sense). Take Scott and me. 90% (I changed that from 99%) of our thinking about monetary issues is the same, but I could come up with a few areas where we do not agree on the theoretical issues and even if we agreed about the model of the economy we could still disagree about the empirical size of the parameters in the model.

This is of course why it is much better to leave it to the market to decide on the implementation of monetary policy through the direct and indirect use of prediction markets (such as macroeconomic forecasting, the implementation process and NGDP futures).

But what if I was in a room full of non-economists and I had to explain why this makes sense. Would I start by outlining a mathematical model and tell them that markets where efficient (most people have no clue what efficient mean – neither do most economists) or would I tell a Hayekian story about how central planning is impossible and markets is the best aggregator of information? I surely would go with the Hayekian story. It is simply much more acceptable to most people than the EHM and radex story – even though Scott and I full well know that it is basically the same story.

That said, it is therefore interesting that it is especially Scott’s Austrian oriented readers who so strongly object to Scott’s insistence that markets are efficient. They should really read Hayek because Hayek is exactly saying that the markets are significantly more efficient than any other form of allocation mechanisms. Yes, he is also saying some – in my view – weird things about mathematics, but overall Hayek thought that we could describe the economy as being efficient and that rational expectations would be a good approximation of the real world. Hayek’s classic description in “Price and Production” from 1933 of his business cycle theory is in fact very much an attempt (which fails in my view) to describe the business cycles within a fundamentally neo-classical set-up.

Scott’s conclusion is to “let a thousand models blossom” so instead of trying to figure out what really is the right model of the economy central bankers should use market information in the conduct and implementation of monetary policy. Would Hayek disagree? I think not…

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