Thursday, September 24, 2020

Relative Price Rigidity and Austrian Economics

The purpose of this post is to examine and provide a critique of Austrian price theory, and in particular the Austrian denial of relative price rigidity in the real world.

In the Austrian economist Ludwig Lachmann’s book Capital, Expectations, and the Market Process (Kansas City, 1977) there is a section where Lachmann reviews John Hicks’s book Capital and Growth (Oxford, 1965).

The significance of Hick’s discussion is described by Lachmann:
“Two other matters of great significance are dealt with in the first part of the book. As others have done before him, Professor Hicks finds it necessary to stress, in his chapter on Marshall’s method, that our world differs from that which Marshall took for granted in that we live in a world of prices ‘administered’ by manufacturers, ‘but in those days even manufactured goods usually passed along a chain of wholesalers and retailers, each of whom was likely to have some independent price-making opportunity.’ (55) Again, like others before him, our author attributes the cause of this change to the virtual disappearance of the wholesale merchant and his price-setting function after 1900. Formerly ‘the initiative would come from the wholesaler or shopkeeper, who would offer higher prices in order to get the goods which, even at the higher price, he could re-sell at a profit. Similarly, when demand fell, it would be the wholesaler who would offer a lower price. The manufacturer would have to accept that price if he could get no better.’ (56) Hence, while Marshall’s was a world of flexible prices, even though not of ‘perfect competition,’ ours is a ‘fixprice world’ with prices set on a ‘cost plus’ basis and wage rates as ultimate price determinants.

The analytical significance of this historical change lies, on the one hand, in the fact that the ‘Temporary Equilibrium Method’ which Hicks himself, following Lindahl, used in Value and Capital in 1939, has lost much of its validity. ‘The fundamental weakness of the Temporary Equilibrium method is the assumption, which it is obliged to make, that the market is in equilibrium—actual demand equals desired demand, actual supply equals desired supply—even in the very short period.’ (76) Hence we have to look for another method of dynamic analysis. To find it we must move nearer to Keynes and his successors who are here given credit for having understood, earlier than others, that a fixprice world requires a fixprice method of analysis.” (Lachmann 1977: 238–239).
Lachmann was well aware of the significance of fixprices, and discussed them in The Market as an Economic Process (Oxford, 1986), pp. 122–136.

Now, while Lachmann seems to have thought that the reduction in the role of wholesalers as compared with the 19th century was a major factor here, Post Keynesians would also point to other factors such as the role that relatively stable prices have in reducing business uncertainty and stabilising profits. But we can put these points aside for the time being.

Crucially, Lachmann said this:
“Those who glibly speak of ‘market clearing prices’ tend to forget that over wide areas of modern markets it is not with this purpose in mind that prices are set. They seem unaware of the important insights into the process of price formation, an Austrian responsibility, of which they deprive themselves by clinging to a level of abstraction so high that on it most of what matters in the real world vanishes from sight.” (Lachmann 1986: 134).
Lachmann even concluded that his own fellow Austrians had badly neglected the task of studying real-world price formation (Lachmann 1986: 130–131).

There is even an interesting anecdote about Lachmann from Bruce Caldwell:
“I first met Ludwig M. Lachmann on February 4, 1982 at the first spring semester meeting of the Colloquium in Austrian Economics at New York University. ….

During that first meeting I had an exchange with Mario Rizzo about the concept of market-clearing. I argued that though the speed of adjustment problem was an empirical issue, it was not something that could be tested as a general proposition. I drew the implication that one’s view of the rapidity of clearing was a matter of faith, nothing more than a metaphysical assumption, though obviously a crucial one. Lachmann nodded his head vigorously as I was finishing up, which pleased me immensely.” (Caldwell 1991: 140).
While that story does in fact seem to tacitly accept that there is an equilibrium structure of prices and wages that would clear all markets (something that can be doubted), the point of the story is well taken: the belief in the market’s tendency to any such state in rapid price adjustments is mostly “a metaphysical assumption.”

Lachmann was correct, and the ignorance of Austrians and advocates of Austrian economics on the issue of real-world prices continues to this day.

By the early 20th century, economists like Gardiner C. Means studied price setting by modern corporations in the United States in the 1920s and 1930s, and he concluded, after extensive empirical research, that prices of goods produced in many industrial corporations are set by a mark-up on cost of production (Downward 1999: 50), and simply are not flexible in the way required by Neoclassical theory. In other words, there is relative price rigidity that presents a severe problem for Neoclassical and Austrian theory.

(1) What is “Relative Price Rigidity”?
First of all, what do we mean by “relative price rigidity”?

It means this:
In the real world, there is a high degree of relative price rigidity, but relative to the models of Austrian or the most unrealistic versions of Neoclassical theory, where all or the vast majority of prices are assumed to be highly flexible, rapidly responsive to demand changes, and are flexible enough to cause a rapid and effective tendency towards market clearing in product markets.
Note well: this does not mean there is no flex-price sector (where prices are highly flexible) or no auction or auction-like markets.

This does not mean there are no goods whose production is inelastic and hence supply and demand have a greater role in determining prices.

Some goods like fresh produce, petrol, and seafood clearly have much more flexible prices than other goods, especially when goods are perishable.

In the retail sector, there is a higher degree of flexible prices, given retail sales. However, in the service sector and manufacturing sector, many prices are highly inflexible with respect to demand changes. Since both the service and manufacturing sectors together dominate most market economies, the use of widespread cost-based mark-up prices in these sectors are the fundamental cause of relative price inflexibility.

(2) Austrian Theory and Price Flexibility
Austrian economic theories absolutely require a high degree of price flexibility and nominal wage flexibility to be accurate models of the real world.

If the majority of real-world prices are relatively inflexible, not properly set by supply and demand dynamics, nor set to converge to market-clearing levels, Austrian economic theory encounters insuperable difficulties, for the following reasons:
(1) there is no strong, economy-wide tendency to Misesian “economic coordination” by which full use of resources is achieved as product markets and labour markets have a tendency towards clearing, so that unused resources offered for sale are eliminated.

(2) there can be no strong, effective, economy-wide tendency towards Mises’ shifting, dynamic “final states of rest” general equilibria in a modern economy (the “final state of rest” is Mises’ general equilibrium state).

(3) the idea of rapid and smooth recovery from recessions/depressions will not work, if there are widespread price and money wage rigidities, and firms adjust their output to demand changes, since adjustment will occur mainly via production output and employment changes, not via price and money wage adjustment.

(4) the whole Misesian argument against price controls collapses – at least in administered price markets – if a price control simply mimics an administered price already set by a private firm, allowing it a sufficient profit for the firm and allowing it continue to adjust its output to demand. If a firm’s total average costs change, government price controls can always be reviewed and changed, when necessary. There is no clear theoretical reason why such price controls could not work and be effective in those markets already subject to private capitalist administered prices, especially when production of the goods under price control is highly elastic, which, it turns out, many goods actually are in modern capitalist economies, except in primary sectors producing raw materials and agricultural products (Nell 1996: 108), and so on.

(5) Mises’s argument against socialist economic calculation is also rendered highly questionable if many firms already shun his flexible price mechanism.

Even if all consumer prices and prices for factor inputs were set by costs of production plus profit mark-up by a planning board, profit and loss could still be calculated by means of administered prices. If the production system had state-owned firms with unused excess capacity and stocks and inventories, they would simply adjust output quantity to the quantity demanded by consumers, as modern capitalist firms do.

Supply shocks in primary commodities and other crucial factor inputs could be dealt with through government buffer stocks, just as in fact Western capitalist nations did in the Golden Age of Capitalism and, to some degree, even to this day (e. g., think of the US Strategic Petroleum Reserve).
For these reasons, Austrian theories would be clearly inaccurate and highly flawed models of real-world economies, if we can show that relative price rigidity is a significant factor of reality.

(3) Responses to the Reality of Price Rigidity by Austrians
The standard response by libertarians and Austrians to evidence for price rigidity usually takes the following forms:
(1) libertarians deny that there is any evidence of relative price inflexibility;

(2) libertarians pretend that there is only minor relative price rigidity;

(3) libertarians will throw up all sorts of strawman misrepresentations of your arguments.
So, first of all, what is the empirical evidence of significant relative price rigidity?

(4) The Evidence for Relative Price Rigidity
We can lay out the evidence as follows:
(1) the evidence of stickiness in aggregate price movements in Consumer Price Indices (CPIs) and Producer Price Indices (PPIs), and the fact that price levels generally even rise in recessions;

(2) the quantitative data and quantitative studies of how frequently prices change;

(3) survey data and empirical investigation of firms and how and why they set prices, and how frequently.
First of all, it is well known that stickiness in aggregate price movements are observed in every modern Western capitalist economy.

Crucially, during most recessions since 1945 general price inflation continues even in the face of general negative demand shocks and we hardly ever see price deflation in a recession. That is, the general price level in recessions generally still rises, and generally recessions are just disinflationary (disinflation is a type of inflation, just inflation at a lower rate than in the previous year). In the United States since 1945, for example, virtually every recession has been inflationary: the only exceptions are 1949–1950, 1954–1955, and 2009.

For example, in the second quarter of 2020 American GDP collapsed by 32.9% in the face of the coronavirus pandemic and lockdowns. This kind of massive negative demand shock would require massive price deflation under Austrian theory, but instead the US economy has continued to experience price inflation, albeit at lower rates.

How can it be that when the economy suffers moderate to strong negative demand shocks in a recession, the general price level keeps rising if prices are highly flexible? The answer is that prices are not highly flexible in the way imagined by Austrian theory.

Now let’s move to the other quantitative data.

(5) Quantitative data on How Frequently Prices Change
Secondly, we have quantitative data and quantitative studies of how frequently prices change from various nations. Such research has been done for over 40 years and the results are very clear.

Moreover, central banks from various nations have recently made available their huge data sets on prices and price changes so that samples of quantitative data on price changes are very large. For example, a French study had a data set of more than 750,000 products tracked for price changes from 1994 to 2003 (this is Baudry et al. 2004 as described below), over a period of nearly 10 years.

Here is a sample of the quantitative data on price rigidity:
(1) Means, G. C. 1936. “Notes on Inflexible Prices,” American Economic Review 26 (Supplement): 23–35.

(2) Carlton, Dennis W. 1986. “The Rigidity of Prices,” The American Economic Review 76.4: 637–658.
This paper presents an analysis of price rigidity in America, and finds that for “many transactions, prices remain rigid for periods exceeding one year” (Carlton 1986: 637) and it “is not unusual in some industries for prices to individual buyers to remain unchanged for several years” (Carlton 1986: 638).

(3) Cecchetti, Stephen G. 1986. “The Frequency of Price Adjustment: A Study of the Newsstand Prices of Magazines,” Journal of Econometrics 31: 255–274.
This is a study of price rigidity in the prices of magazines.

(4) Kashyap, Anil K. 1995. “Sticky Prices: New Evidence from Retail Catalogs,” Quarterly Journal of Economics 110: 245–274.

(5) Bils, Mark and Peter J. Klenow. 2004. “Some Evidence on the Importance of Sticky Prices,” Journal of Political Economy 112.5: 947–985.
This paper shows a higher degree of price flexibility but only by including mere temporary price cuts (as in retail sales). Their method is disputed by Nakamura and Steinsson (2008) who point out temporary sales not affecting long-run prices of a good are abnormal and make prices appear more flexible than they really are.

(6) Baudry, Laurent, Le Bihan, Hervé, Sevestre, Patrick, and Sylvie Tarrieu. 2004. “Price Rigidity. Evidence from the French CPI Micro-Data,” ECB, Working paper series No. 384 https://ideas.repec.org/p/ecb/ecbwps/2004384.html
This paper uses a large dataset of prices from the non-farm business sector of the French economy. More than 750,000 products were tracked for price changes (that is, the time duration between two price changes of a product) from July 1994 to February 2003 (Baudry et al. 2004: 5). This study finds significant rigidity of consumer prices. The weighted average duration of prices was 8 months, but the authors calculate that extension of the data to include the whole French CPI would yield a weighted average duration of price change higher than 8 months (Baudry et al. 2004: 5–6). The study found that service prices are especially sticky: they typically last for a year (Baudry et al. 2004: 6).

(7) Dhyne, Emmanuel, Álvarez, Luis J., Le Bihan, Hervé, Veronese, Giovanni et al. 2006. “Price Changes in the Euro Area and the United States: Some Facts from Individual Consumer Price Data,” The Journal of Economic Perspectives 20.2: 171–192.
This paper analyses large quantitative price data sets from numerous European nations, including Austria, Belgium, Finland, France, Germany, Italy, Luxembourg, the Netherlands, Portugal, and Spain. The major finding is that in the Euro area that average duration of price changes is 13 months (Dhyne et al. 2006: 176). The sectors that have the most price rigidity are services, non-energy industrial goods, and even processed food (Dhyne et al. 2006: 189). In particular, the services sector (the largest sector in most nations today) shows very strong downwards price rigidity: on average, only 2 price changes out of 10 are downwards in the services sector (Dhyne et al. 2006: 181). On average throughout various sectors, just 4 price changes out of 10 are decreases in prices (Dhyne et al. 2006: 180), which shows that there is a bias towards price rises in modern capitalist economies.

(8) Sabbatini, Roberto, Álvarez, Luis J., Dhyne, Emmanuel et al. 2007. “What Quantitative Micro Data Reveal about Price Setting Behavior,” in S. Fabiani, C. Suzanne Loupias, F. M. Monteiro Martins and Roberto Sabbatini (eds.), Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York.

(9) Nakamura, Emi and Jón Steinsson. 2008. “Five Facts about Prices: A Reevaluation of Menu Cost Models,” The Quarterly Journal of Economics 123.4: 1415–1464.
This paper shows that without mere temporary price cuts (as in retail sales where prices revert to the normal, higher level after a sale) average US prices change infrequently: only about every 7–11 months.

(10) Klenow, Peter J. and Benjamin A. Malin. 2011. “Microeconomic Evidence on Price-Setting,” in Benjamin M. Friedman and Michael Woodford (eds.), Handbook of Monetary Economics Volume 3A. North Holland, Amsterdam and London. 231–284.
This chapter provides a table on p. 239 (Table 4) that summarises quantitative data from 19 nations on price rigidity. The data mostly comes from service and industrial sectors (and sometimes in addition also other sectors). For most nations, prices change “on average” at least once a year (Klenow and Malin 2011: 242). If merely short-lived prices (such as mere temporary price discounts) are excluded, prices change closer to once a year (Klenow and Malin 2011: 232).

(11) Nakamura, Emi and Jón Steinsson. 2013. “Price Rigidity: Microeconomic Evidence and Macroeconomic Implications,” Annual Review of Economics 5: 133–163.

(12) Kehoe, Patrick and Virgiliu Midrigan. 2015. “Prices are Sticky after All,” Journal of Monetary Economics 75: 35–53.
This paper responds to Bils and Klenow (2004) who looked at US consumer prices. Kehoe and Midrigan show that Neoclassical apologists cannot appeal to temporary sales or temporary price discounts in US consumer goods to justify the idea of high price flexibility, because after such temporary price changes the nominal price usually just reverts back to pre-existing nominal price, and one also needs to take account of producer prices. Kehoe and Midrigan find that, without temporary sales, prices change about once a year.
In many nations, prices change on average once a year (e.g., Carlton 1986: 637; Klenow and Malin 2011: 242, 232; Kehoe and Midrigan 2015). Of especial interest is the recent finding that in the Euro area that average duration of price changes is 13 months (Dhyne et al. 2006: 176).

In view of this evidence, a libertarian cannot refute the evidence for relative price rigidity by simply looking at random prices and finding price changes. As we can see, quantitative studies have already been done of large data sets of prices by Neoclassical economists and the overwhelming finding is a world of relative price rigidity, that is, relative to the price models of Neoclassical economics.

(6) Survey Data and Empirical Investigation of Firms
Surveys of and face-to-face interviews of price administrators, managers and CEOs of firms also reveal a great deal about price setting and price rigidity.

Here are some of the most important studies:
(1) Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.
This early important paper by R. L. Hall and Charles J. Hitch from research in the 1930s concluded that UK businessmen did not generally estimate the elasticity of the demand curves for their products or equate marginal revenue with marginal cost, but instead set prices by means of “full cost pricing” (Lee 1998: 90), which we would now call cost-based mark-up pricing. They also concluded businesses found that frequent price changes were unpopular with customers, that often price reductions would not induce significant additional market sales, and that they feared price wars (Lee 1998: 91).

(2) Andrews, P. W. S. 1949. “A Reconsideration of the Theory of the Individual Business,” Oxford Economic Papers n.s. 1.1: 54–89.

Andrews, P. W. S. 1949. Manufacturing Business. Macmillan, London.

Andrews, P.W.S. 1964. On Competition in Economic Theory. Macmillan, London.
Andrews noted the existence of excess capacity in many firms and how cost-based mark-up prices were normal even in markets where competition exists, or that is, “irrespective of the degree of competition which the firm has to meet” (Andrews 1949: 58–59). When firms wish to increase market share, it will often be by means of superior quality and reputation, rather than price cuts (Downward 1999: 50).

(3) Bhaskar, V., Machin, Stephen and Gavin C. Reid. 1993. “Price and Quantity Adjustment over the Business Cycle: Evidence from Survey Data,” Oxford Economic Papers n.s. 45.2: 257–268.
This paper reports data from a questionnaire posed to managers of 73 small UK firms in 1985. It shows quantity adjustments “are overwhelmingly more important than price adjustments over the business cycle” (Bhaskar 1993: 257) and “[m]ost firms do not increase prices in booms or reduce them in recessions, and when they do, managers suggest that these are relatively unimportant” (Bhaskar 1993: 266).

(4) Blinder, A. S. et al. (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.
This book reports a well-sampled survey of 200 US businesses. It was found that a typical good in the US is repriced roughly once a year, and prices are most sticky in the service sector, but the least sticky in wholesale and retail trade (Blinder et al. 1998: 105). Over 50% of firms said that they would not increase their prices when demand increased (Downward and Lee 2001: 476). Blinder et al. (1998: 200–201) also found that 56.8% of the firms they surveyed said that the idea that prices and price changes depend mainly on costs of production ranked as “very important” (38.8%) or moderately important (18%).

(5) Downward, Paul. 1999. Pricing Theory in Post-Keynesian Economics: A Realist Approach. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.
This book reports a survey conducted by P. Downward involving 283 UK manufacturing enterprises (Downward 1999: 150–151). When asked whether the firm set its prices for its products by means of a mark-up on average costs, 63.7% of firms said either “very often” (29.9%) or “often” (33.8%). When asked whether the firm sets prices to create price stability on the market, 65.5% of firms said “very often” (17.3%) or “often” (48.2%) (Downward 1999: 160).

(6) Hall, S., Walsh, M. and A. Yates. 2000. “Are UK Companies’ Prices Sticky?,” Oxford Economic Papers 52.3: 425–446.
This paper reports the results of a survey of 654 UK companies in 1995. When asked what happens when there is strong demand and this cannot be met from inventories or stocks, only 12% of firms said they would increase the price of their goods (Hall, Walsh, and Yates 2000: 442).

(7) Amirault, D., Kwan, C. and G. Wilkinson. 2004. “A Survey of the Price-Setting Behaviour of Canadian Companies,” Bank of Canada Review 2004/2005: 29–40.
http://www.bankofcanada.ca/2006/09/publications/research/working-paper-2006-35/
This paper examines price setting in a survey of 170 private, unregulated, non-primary sector Canadian firms. An impressive 67.1% of firms surveyed attributed price inflexibility to “cost-based pricing,” that is, to mark-up pricing (Amirault, Kwan, and Wilkinson 2004: 21).

(8) Fabiani, Silvia, Gattulli, Angela, and Roberto Sabbatini. 2004. “The Pricing Behaviour of Italian Firms: New Survey Evidence on Price Stickiness,” ECB Working Paper Series No. 333 http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp333.pdf
This paper reports a survey in 2003 of 333 industrial and service firms in Italy (Fabiani et al. 2004: 8). It was found that about 60% of firms review prices once a year, and around 50% only actually change prices once a year too (Fabiani et al. 2004: 21).

(9) Kwapil, Claudia, Baumgartner, Josef and Johann Scharler. 2005. “Price-Setting Behavior of Austrian Firms,” ECB Working Paper Series no. 464 http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp464.pdf
This paper reports a 2004 survey of 873 Austrian firms mainly in the manufacturing sector. The firms were asked how often they changed prices on average in a given year:
No change: 22.1%;
Once a year: 54.2%;
2 to 3 times a year: 13.9% (Kwapil, Baumgartner and Scharler 2005: 18).
Moreover, 63% of firms said they would leave their prices unchanged in response to a large positive demand shock, and 52% would leave prices unchanged in response to a large negative demand shock (Kwapil, Baumgartner and Scharler 2005: 33). In the face of small demand shocks (either positive or negative), 82% of firms simply leave prices unchanged (Kwapil, Baumgartner and Scharler 2005: 33).

(10) Parker, Miles. 2017. “Price-Setting Behaviour in New Zealand,” New Zealand Economic Papers 51.3: 217–236.
An earlier version is online here:
Parker, Miles. 2014. “Price-Setting Behaviour in New Zealand”
https://cama.crawford.anu.edu.au/amw2013/doc/Parker,Miles.pdf
This paper reports a survey of 5,300 firms selected as a representative sample of all sectors of the New Zealand economy (Parker 2017: 217). It was found that the average firm reviews prices twice a year but changes its prices only once a year (Parker 2017: 229). When asked whether temporary price reductions were important, 44% of firms said “not at all,” and 17% said “a little important” (Parker 2014: 17). Parker also finds that mark-up prices account for about 54% of business prices.

(11) Apel, Mikael, Friberg, Richard and Kerstin Hallsten. 2005. “Microfoundations of Macroeconomic Price Adjustment: Survey Evidence from Swedish Firms,” Journal of Money, Credit and Banking 37.2: 313–338.
This paper reports results from a survey of about 600 private-sector firms in Sweden. When asked to report how often prices were changed, the weighted results were that 40.3% of firms change prices once per year, and 27.1% adjust their prices less than once a year (Apel et al. 2005: 318).

(12) Aucremanne, Luc and Martine Druant. 2005. “Price-Setting Behaviour in Belgium. What can be learned from an ad hoc Survey?,” ECB Working Paper Series No. 448.
This paper report the results of a survey of 1,979 firms in the industrial, construction, trade and services sectors, in a sample that should represent about 60% of Belgian GDP. It was found that 55% of firms changed prices once a year, 18% less often, and 27% more than once a year (Aucremanne and Druant 2005: 31).

(13) Martins, Fernando. 2007. “How Portuguese Firms set their Prices,” in S. Fabiani, C. Suzanne Loupias, F. M. Monteiro Martins and Roberto Sabbatini (eds.), Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York. 152–164.
This chapter reports a 2004 survey by the Banco de Portugal of 1,370 Portuguese firms, mainly from manufacturing. The survey found that 75% of firms generally changed their prices but once a year (Martins 2005: 24).

(14) Langbraaten, Nina, Nordbø, Einar W. and Fredrik Wulfsberg. 2008. “Price-setting Behaviour of Norwegian Firms – Results of a Survey,” Norges Bank Economic Bulletin 79.2: 13–34.
This reports a well-sampled survey of 725 firms throughout many sectors of the Norwegian economy: nearly 50% of firms said that they only changed their product price once a year, and about 23% of firms said that they changed the price twice a year (Langbraaten et al. 2008: 18).

(15) Levy, Daniel. 2007. “Price Rigidity and Flexibility: New Empirical Evidence,” Managerial and Decision Economics 28.7: 639–647.
This review article summarises 14 empirical studies of price rigidity in a special issue of Managerial and Decision Economics.

(16) Keeney, Mary, Lawless, Martina, and Alan Murphy. 2010. “How Do Firms Set Prices? Survey Evidence from Ireland,” Central Bank of Ireland, Research Technical Papers, no 7/RT/10.
This paper reports a survey of 1,000 Irish firms. When firms were asked how likely it was that they would adjust prices downwards in response to a negative demand shock, 66.5% of firms said that negative demand shocks were of little or no relevance to pricing decisions.

(17) Fabiani, S., M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias, F. Martins, T. Mathä, R. Sabbatini, H. Stahl and A. Stokman. 2006. “What Firms’ Surveys tell us about Price-Setting Behavior in the Euro Area,” International Journal of Central Banking 2.3: 3–47.

Fabiani, Silvia, Suzanne Loupias, Claire, Monteiro Martins, Fernando Manuel and Roberto Sabbatini. 2007. Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York.
The wide-ranging survey of Fabiani et al. (2006) and (2007) on prices in the Eurozone from many central bank studies finds that the average for mark-up pricing throughout the Eurozone is 54%, a majority of firm prices. In industrial goods markets in Germany, the largest economy in Europe, a strikingly high 73% of firms have administered prices (Fabiani et al. 2006: 18, Table 4).

(18) Govindarajan, V. and R. Anthony. 1986. “How Firms use Cost Data in Price Decisions,” Management Accounting 65: 30–34.

Shim, Eunsup, and Ephraim Sudit. 1995. “How Manufacturers Price Products,” Management Accounting 76.8: 37–39.
Govindarajan and Anthony (1986) conducted a survey in which over 500 US industrial companies answered a questionnaire on how they set prices. They found that 85% of companies surveyed used full cost pricing (Govindarajan and Anthony 1986: 31). Shim and Sudit (1995: 37) conducted a survey in 1993 of US industrial companies, and found that 69.5% used full cost pricing.
This evidence of surveys and face-to-face interviews of business people has been going on since the 1930s, and it consistently finds that cost-based mark-up prices (sometimes called “full cost prices,” “normal cost prices,” or “cost-plus prices,” or “administered prices”) are a plurality, or even a majority, of prices in modern Western nations and even in Third World nations (where evidence exists).

Mark-up prices are set by businesses through their cost accounting conventions in an ex ante manner before transactions take place, on the basis of
(1) total average unit costs plus (2) a profit mark-up, at a given, estimated, projected or target quantity of output or level of sales (from which of course the ex post or actual quantity of output produced or sold in a given time period might differ).
Empirical evidence shows us that mark-up prices are generally inflexible with respect to demand, but tend to change – though it is by no means a necessary or universal process – when total average unit costs change or when the business wants to change its profit mark-up. Importantly, cost-based mark-up prices are not set with the primary purpose of clearing markets nor creating a tendency towards supply and demand equilibrium in product markets.

One typical Austrian response to all this data is pretend it doesn’t exist! A second response is to focus on some studies like Blinder et al.’s Asking about Prices (1998) and claim that because they have what looks like small sample sizes (Blinder’s research looked at about 200 US businesses, for example), somehow the research is invalid. But this is all desperate dishonest apologetics. Blinder’s sample was carefully selected to be generally representative of large swatches of the goods in US GDP, and one cannot simple dismiss it because it was a small sample. Worse still for Austrians, there are dozens of survey studies from over twenty-one nations on how businesses set prices and they all come to the same conclusion: that cost-based mark-up prices exist and are often a majority of prices. For example, Parker (2017: 217) examined an impressive 5,300 firms selected as a representative sample of all sectors of the New Zealand economy. One cannot simply dismiss this evidence.

In fact, to reject this vast body of evidence that extends back to the 1930s as being false or inaccurate would require Austrians to believe in some vast conspiracy theory, which is obviously absurd.

Finally, let us run through some other strawman responses by Austrian charlatans:
(1) Austrians will misrepresent the Post Keynesian argument and pretend their Post Keynesian opponent has said that “prices never change at all, or most prices never change.”
This is an obvious and dishonest lie. This is not what Post Keynesians say. Of course, cost-based mark-up prices do change over time, either upwards or downwards. But what was said is that relative to Neoclassical and Austrian models, most prices have a high degree of inflexibility, and are not set with the primary purpose of clearing markets and creating a tendency towards supply and demand equilibrium in product markets. Showing that prices do in fact change over time does not refute the critique above in any manner.

(2) Austrians will say Post Keynesians have said there is no flex-price sector where prices are highly flexible.
Once again, this is an obvious lie. There is a flexprice sector in all nations, where prices are highly flexible, for example, in auction-like markets, but the extent and significance of this flexprice sector are grossly exaggerated.

(3) Austrians will say their Post Keynesian opponent has said there are no sales in retail stores done temporarily to clear certain stock.
This is a straw man. Retail sales obviously occur, but their existence does not refute the massive evidence of relative price rigidity, relative to the models of Neoclassical and Austrian theory. Furthermore, the extent of sales is much less significant in the service sector and the sector that produces intermediate goods and factor inputs.
None of these arguments deployed by libertarians and Austrians are anything but dishonest misrepresentations of the Post Keynesians argument offered to them.

In short, the accusation of Ludwig Lachmann that his fellow Austrians had failed to understand real-world prices was entirely correct, and remains correct to this day, and the quotation in question deserves to be repeated:
“Those who glibly speak of ‘market clearing prices’ tend to forget that over wide areas of modern markets it is not with this purpose in mind that prices are set. They seem unaware of the important insights into the process of price formation, an Austrian responsibility, of which they deprive themselves by clinging to a level of abstraction so high that on it most of what matters in the real world vanishes from sight.” (Lachmann 1986: 134).
BIBLIOGRAPHY
Bils, Mark and Peter J. Klenow. 2004. “Some Evidence on the Importance of Sticky Prices,” Journal of Political Economy 112.5: 947–985.

Caldwell, Bruce J. 1991. “Ludwig M. Lachmann: A Reminiscence,” Critical Review 5.1: 139–144.

Downward, Paul. 1999. Pricing Theory in Post-Keynesian Economics: A Realist Approach. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Hicks, John Richard. 1965. Capital and Growth. Oxford University Press, Oxford.

Lachmann, Ludwig M. 1966. “Sir John Hicks on Capital and Growth,” South African Journal of Economics 34: 113–123.

Lachmann, Ludwig M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy (ed. Walter E. Grinder). Sheed Andrews and McMeel, Kansas City.

Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford.

Nell, Edward J. 1996. Making Sense of a Changing Economy: Technology, Markets, and Morals. Routledge, London and New York.

Monday, April 27, 2020

Response to Academic Agent on Modern Monetary Theory (MMT) Part 2

Academic Agent had a livestream here criticising my blog post that was a critique of his original video against MMT:



This stream is a train wreck. Academic Agent and his Austrian-school libertarians struggle to even accurately grasp Modern Monetary Theory (MMT).

I will not correct all the errors and misrepresentations here, or bother to correct every strawman argument.

But, first of all, let us just provide a knockout blow to Academic Agent and his minions. Throughout the earlier part of this stream, Academic Agent cannot understand how in a fiat money world, taxes and bonds do not, technically speaking, finance government spending. It appears that Academic Agent cannot imagine a state of affairs where a central bank directly monetised part of a government budget deficit, without concomitant bond issues, even though this has happened on numerous occasions since the abolition of the gold standard, as in Japan, Germany and New Zealand in the 1930s, America in World War II, and in post-1945 “tap systems” at central banks.

Under the historical “tap system” of issuing government bonds after the abolition of the Gold Standard after WWII, a number of Western countries (like Australia) for many years actually had their central banks purchase government bonds directly when such bonds were not all bought by private bondholders.

The system is explained by MMT economist Bill Mitchell at his blog:
“[around 1981] the Australian Office of Financial Management was set up as a special part of the Federal Treasury to manage federal debt. Previously, bond issues were made using the “tap system”, whereby the government would announce some volume of debt it wanted to issue at a particular rate and then sell whatever was demanded at that yield. Occasionally, given other rates of return in the financial markets the issue would not be fully subscribed – meaning some of the Government’s net spending would be covered in an accounting sense by central bank buying treasury bills (government lending to itself!). The neo-liberals hated this system and regarded it providing no fiscal discipline on government. They knew that by linking deficits $-for-$ with private debt they could more easily mount the debt hysteria and maximize their pressure on government to cut deficits and withdraw from the market.”
Bill Mitchell, “D for Debt Bomb; D for Drivel,” Bill Mitchell - Modern Monetary Theory, July 13, 2009.
That is to say, Australia once had a “tap system” of direct purchases of Treasury bonds by the national central bank when the private sector did not wish to buy all bonds at some issue of government debt, which means, in layman’s terms, on various occasions the Australian central bank was just “printing money” to fund part of the government’s budget deficit. Did Australia collapse into hyperinflation when this happened? Did the Australian dollar totally collapse? No.

Even the US Federal Reserve originally had the power to directly buy US government debt, and this was done in 1942 (during WWII) and some other years after WWII as well.

Most recently, in Britain as hit by the coronavirus pandemic, the Bank of England has increased the “Ways and Means facility” (a kind of government overdraft with the central bank) that can allow the British Treasury to finance spending without direct and immediate bond issuing. This would effectively be short-term “printing money” to finance UK government spending and allow the British Treasury to temporarily bypass the bond market:
Yves Smith and Richard Murphy, “At long last the Government can Borrow straight from the Bank of England – As Modern Monetary Theory has always suggested it should,” Nakedcapitalism.com, March 24, 2020.

Chris Giles and Philip Georgiadis, “Bank of England to directly Finance UK Government’s Extra Spending, Financial Times, April 9 2020.”

Larry Elliott, “Bank of England to Finance UK Government Covid-19 Crisis Spending,” The Guardian, 9 April 2020.
While at the moment, the British government says it will later this year borrow any money spent now unbacked by private bond issues, this is effectively a type of short-term MMT in action right now! How does Academic Agent explain all this if MMT is impossible?

Now let us go on to address the following major points:

(1) Quantitative Easing (QE)
Post Keynesians and MMT advocates do not advocate QE as a major policy tool.

The primary tool is fiscal policy. In a serious recession/depression, Keynesian deficit stimulus in the form of new, or improved, public infrastructure, public utilities, R&D and social spending is the primary method to get people back to work, and stimulate private investment and employment growth.

Money would be paid directly to any unemployed people hired by the state or to any business from which the state buys resources, and hence money would be spent into the economy as newly-hired workers and businesses spend money.

(2) The Purpose of Taxes in MMT
According to MMT, taxes function to:
(1) regulate aggregate demand;
(2) free up real resources for the government to purchase when there is a high level of economic activity, or for people to whom government pays money (that is, state employees, or welfare recipients)
(3) dampen inflation at times of inflationary pressures
(4) address moral issues like gross inequality of wealth, and prevent a plutocratic system where highly wealthy people have so much money they can control democracy and governments.
MMT does not advocate the abolition of taxes because they still have an important role to play.

(3) Relative Price Rigidity
First of all, Academic Agent persistently commits a comical strawman argument when he is confronted with the reality of relative price rigidity: Academic Agent pretends this means that no prices ever change, or that all prices are rigid for long periods of time.

This is a pathetic and pathologically dishonest tactic. Academic Agent, at this point, is simply forced to use this tactic, probably because he cannot think of a plausible response to the widespread reality of relative price rigidity.

This strawman leads Academic Agent to his risible attempt to refute me by citing price data from 1972 (which, in point of fact, was a period of strong supply-side inflation!). Merely showing that prices change does not refute anything I said about relative price rigidity, because “relative price rigidity” doesn’t mean that no prices ever change. Of course, cost-based mark-up prices do change, but often because unit costs rise or businesses demand higher profits.

Moreover, what does widespread “relative price rigidity” actually mean?

It means this:
In the real world, there is a high degree of relative price rigidity, but relative to the models of Austrian or Neoclassical theory, where prices are assumed to be highly flexible, rapidly responsive to demand changes, and are flexible enough to cause a rapid and effective tendency towards market clearing in product markets.
Note well: this does not mean there is no flex-price sector (where prices are highly flexible) or no auction or auction-like markets.

This does not mean there are no goods whose production is inelastic and hence supply and demand have a greater role in determining prices.

For example, on world markets for many years oil prices were set by the cartel OPEC. But in recent decades, OPEC’s power has weakened and prices are much more influenced by production decisions by “swing producers”. Thus oil prices are much more flexible than cost-based mark-up prices used in industrial manufacturing and the service sector.

Some goods like fresh produce, petrol, and seafood clearly have much more flexible prices than other goods, especially when goods are perishable.

In the retail sector, there is a higher degree of flexible prices, given retail sales. However, in the service sector and manufacturing sector, many prices are highly inflexible with respect to demand changes. Since both the service and manufacturing sectors together dominate most market economies, the use of widespread cost-based mark-up prices in these sectors are the fundamental cause of relative price inflexibility.

So the fundamental point here is that the size and prevalence of flex-price markets are grossly exaggerated.

Academic Agent’s fellow Austrian called “Radical Liberation” in this stream also commits gross strawman arguments. “Radical Liberation” claims that I asserted or showed that there is only “a little bit of [price] stickiness.” This is utterly false.

“Radical Liberation” also claims I assert that I think prices need to change instantly to changes in demand. This is also false. In Austrian theory or more dogmatic Neoclassical models, prices must change relatively quickly and rapidly to achieve an effective tendency to supply and demand equilibrium in product markets, not instantly.

In the real world, there is a very high degree of relative price rigidity, and this has been admitted for decades even in mainstream Neoclassical research literature. For example, here is some literature on the empirical evidence for relative price rigidity:
Means, G. 1935. “Industrial Prices and their Relative Inflexibility,” Senate Document 13, 74th Congress, lst Session, US Government Printing Office, Washington, DC.

Means, G. C. 1936. “Notes on Inflexible Prices,” American Economic Review 26 (Supplement): 23–35.

Means, G. C. 1939–1940. “Big Business, Administered Prices, and the Problem of Full Employment,” Journal of Marketing 4: 370–381.

Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.

Stigler, G. J. and J. K. Kindahl. 1970. The Behavior of Industrial Prices. New York.

Means, G. C. 1972. “The Administered Price Thesis Reconfirmed,” American Economic Review 62: 292–306.

Beals, R. 1975. “Concentrated Industries, Administered Prices and Inflation: A Survey of Empirical Research,” Council on Wage and Price Stability, Washington.

Carlton, Dennis W. 1986. “The Rigidity of Prices,” The American Economic Review 76.4: 637–658.
This paper presents an analysis of price rigidity in America, and finds that for “many transactions, prices remain rigid for periods exceeding one year” (Carlton 1986: 637) and it “is not unusual in some industries for prices to individual buyers to remain unchanged for several years” (Carlton 1986: 638).

Cecchetti, Stephen G. 1986. “The Frequency of Price Adjustment: A Study of the Newsstand Prices of Magazines,” Journal of Econometrics 31: 255–274.
This is a study of price rigidity in the prices of magazines.

Bils, M. 1987. “The Cyclical Behaviour of Marginal Cost and Price,” American Economic Review 77: 838–855.

Bhaskar, V., Machin, Stephen and Gavin C. Reid. 1993. “Price and Quantity Adjustment over the Business Cycle: Evidence from Survey Data,” Oxford Economic Papers n.s. 45.2: 257–268.
This paper reports data from a questionnaire posed to managers of 73 small UK firms in 1985. It shows quantity adjustments “are overwhelmingly more important than price adjustments over the business cycle” (Bhaskar 1993: 257) and “[m]ost firms do not increase prices in booms or reduce them in recessions, and when they do, managers suggest that these are relatively unimportant” (Bhaskar 1993: 266).

Kashyap, Anil K. 1995. “Sticky Prices: New Evidence from Retail Catalogs,” Quarterly Journal of Economics 110: 245–274.

Blinder, A. S. et al. (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.
This book reports a well-sampled survey of 200 US businesses. It was found that a typical good in the US is repriced roughly once a year, and prices are most sticky in the service sector, but the least sticky in wholesale and retail trade (Blinder et al. 1998: 105). Over 50% of firms said that they would not increase their prices when demand increased (Downward and Lee 2001: 476).

Downward, Paul. 1999. Pricing Theory in Post-Keynesian Economics: A Realist Approach. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.
This book reports a survey conducted by P. Downward involving 283 UK manufacturing enterprises (Downward 1999: 150–151). When asked whether the firm set its prices for its products by means of a mark-up on average costs, 63.7% of firms said either “very often” (29.9%) or “often” (33.8%). When asked whether the firm sets prices to create price stability on the market, 65.5% of firms said “very often” (17.3%) or “often” (48.2%) (Downward 1999: 160).

Hall, S., Walsh, M. and A. Yates. 2000. “Are UK Companies’ Prices Sticky?,” Oxford Economic Papers 52.3: 425–446.
This paper reports the results of a survey of 654 UK companies in 1995. When asked what happens when there is strong demand and this cannot be met from inventories or stocks, only 12% of firms said they would increase the price of their goods (Hall, Walsh, and Yates 2000: 442).

Bils, Mark and Peter J. Klenow. 2004. “Some Evidence on the Importance of Sticky Prices,” Journal of Political Economy 112.5: 947–985.
This paper shows a higher degree of price flexibility but only by including mere temporary price cuts (as in retail sales). Their method is disputed by Nakamura and Steinsson (2008) who point out temporary sales not affecting long-run prices of a good are abnormal and make prices appear more flexible than they really are.

Amirault, D., Kwan, C. and G. Wilkinson. 2004. “A Survey of the Price-Setting Behaviour of Canadian Companies,” Bank of Canada Review 2004/2005: 29–40.
http://www.bankofcanada.ca/2006/09/publications/research/working-paper-2006-35/
This paper examines price setting in a survey of 170 private, unregulated, non-primary sector Canadian firms. An impressive 67.1% of firms surveyed attributed price inflexibility to “cost-based pricing,” that is, to mark-up pricing (Amirault, Kwan, and Wilkinson 2004: 21).

Fabiani, Silvia, Gattulli, Angela, and Roberto Sabbatini. 2004. “The Pricing Behaviour of Italian Firms: New Survey Evidence on Price Stickiness,” ECB Working Paper Series No. 333
http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp333.pdf
This paper reports a survey in 2003 of 333 industrial and service firms in Italy (Fabiani et al. 2004: 8). It was found that about 60% of firms review prices once a year, and around 50% only actually change prices once a year too (Fabiani et al. 2004: 21).

Kwapil, Claudia, Baumgartner, Josef and Johann Scharler. 2005. “Price-Setting Behavior of Austrian Firms,” ECB Working Paper Series no. 464
http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp464.pdf
This paper reports a 2004 survey of 873 Austrian firms mainly in the manufacturing sectors. The firms were asked how often they changed prices on average in a given year: No change: 22.1%; Once a year: 54.2%; 2 to 3 times a year: 13.9% (Kwapil, Baumgartner and Scharler 2005: 18). Moreover, 63% of firms said they would leave their prices unchanged in response to a large positive demand shock, and 52% would leave prices unchanged in response to a large negative demand shock (Kwapil, Baumgartner and Scharler 2005: 33). In the face of small demand shocks (either positive or negative), 82% of firms simply leave prices unchanged (Kwapil, Baumgartner and Scharler 2005: 33).

Parker, Miles. 2017. “Price-Setting Behaviour in New Zealand,” New Zealand Economic Papers 51.3: 217–236.
An earlier version is online here:
Parker, Miles. 2014. “Price-Setting Behaviour in New Zealand”
https://cama.crawford.anu.edu.au/amw2013/doc/Parker,Miles.pdf
This paper reports a survey of 5,300 firms selected as a representative sample of all sectors of the New Zealand economy (Parker 2017: 217). It was found that the average firm reviews prices twice a year but changes its prices only once a year (Parker 2017: 229). When asked whether temporary price reductions were important, 44% of firms said “not at all,” and 17% said “a little important” (Parker 2014: 17).

Apel, Mikael, Friberg, Richard and Kerstin Hallsten. 2005. “Microfoundations of Macroeconomic Price Adjustment: Survey Evidence from Swedish Firms,” Journal of Money, Credit and Banking 37.2: 313–338.
This paper reports results from a survey of about 600 private-sector firms in Sweden. When asked to report how often prices were changed, the weighted results were that 40.3% of firms change prices once per year, and 27.1% adjust their prices less than once a year (Apel et al. 2005: 318).

Aucremanne, Luc and Martine Druant. 2005. “Price-Setting Behaviour in Belgium. What can be learned from an ad hoc Survey?,” ECB Working Paper Series No. 448.
This paper report the results of a survey of 1,979 firms in the industrial, construction, trade and services sectors, in a sample that should represent about 60% of Belgian GDP. It was found that 55% of firms changed prices once a year, 18% less often, and 27% more than once a year (Aucremanne and Druant 2005: 31).

Martins, Fernando. 2007. “How Portuguese Firms set their Prices,” in S. Fabiani, C. Suzanne Loupias, F. M. Monteiro Martins and Roberto Sabbatini (eds.), Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York. 152–164.
This chapter reports a 2004 survey by the Banco de Portugal of 1,370 Portuguese firms, mainly from manufacturing. The survey found that 75% of firms generally changed their prices but once a year (Martins 2005: 24).

Nakamura, Emi and Jón Steinsson. 2008. “Five Facts about Prices: A Reevaluation of Menu Cost Models,” The Quarterly Journal of Economics 123.4: 1415–1464.
This paper shows that without mere temporary price cuts (as in retail sales where prices revert to the normal, higher level after a sale) average prices change infrequently: only about every 7–11 months.

Langbraaten, Nina, Nordbø, Einar W. and Fredrik Wulfsberg. 2008. “Price-setting Behaviour of Norwegian Firms – Results of a Survey,” Norges Bank Economic Bulletin 79.2: 13–34.
This reports a well-sampled survey of 725 firms throughout many sectors of the Norwegian economy: nearly 50% of firms said that they only changed their product price once a year, and about 23% of firms said that they changed the price twice a year (Langbraaten et al. 2008: 18).

Levy, Daniel. 2007. “Price Rigidity and Flexibility: New Empirical Evidence,” Managerial and Decision Economics 28.7: 639–647.
This review article summarises 14 empirical studies of price rigidity in a special issue of Managerial and Decision Economics.

Keeney, Mary, Lawless, Martina, and Alan Murphy. 2010. “How Do Firms Set Prices? Survey Evidence from Ireland,” Central Bank of Ireland, Research Technical Papers, no 7/RT/10.
This paper reports a survey of 1000 Irish firms. When firms were asked how likely it was that they would adjust prices downwards in response to a negative demand shock, 66.5% of firms said that negative demand shocks were of little or no relevance to pricing decisions.

Klenow, Peter J. and Benjamin A. Malin. 2011. “Microeconomic Evidence on Price-Setting,” in Benjamin M. Friedman and Michael Woodford (eds.), Handbook of Monetary Economics Volume 3A. North Holland, Amsterdam and London. 231–284.
This chapter provides a table on p. 239 (Table 4) that lists surveys and studies from 19 nations on price rigidity. The data mostly comes from service and industrial sectors (and sometimes in addition also other sectors). For most nations, prices change “on average” at least once a year (Klenow and Malin 2011: 242). If merely short-lived prices (such as mere temporary price discounts) are excluded, prices change closer to once a year (Klenow and Malin 2011: 232).

Nakamura, Emi and Jón Steinsson. 2013. “Price Rigidity: Microeconomic Evidence and Macroeconomic Implications,” Annual Review of Economics 5: 133–163.

Kehoe, Patrick and Virgiliu Midrigan. 2015. “Prices are Sticky after All,” Journal of Monetary Economics 75: 35–53.
The reality of relative price rigidity is why even Monetarists and other more realistic Neoclassicals are forced to take account of short-run price and money wage stickiness in their models, and why many advocate activist monetary policies in a recession or depression.

Yet another crucial piece of evidence of relative price rigidity is that during most recessions since 1945 general price inflation continues even in the contraction of demand and we hardly ever see price deflation in a recession. The general price level in recessions still rises, and generally recessions are just disinflationary (lower rates of infation). In the United States since 1945, for example, virtually every recession has been inflationary: the only exceptions are 1949–1950, 1954–1955, and 2009.

Secondly, Academic Agent’s claim that Austrian theory is only looking at the prices of a good across a whole economy is a bizarre and blatant falsehood.

While Austrian price theory and the Austrian Theory of the Firm are of course not predicting what all firms do, they nevertheless must predict what the majority of firms do, or the average firm does, because otherwise they would be empirically false.

Murray Rothbard says the following about price determination:
“Private business prices its goods and services to ‘clear the market,’ so that supply equals demand, and there are neither shortages nor goods going unsold.” (Rothbard 2006a: 259).
If Rothbard isn’t talking about the average real-world firm here, or the majority of real-world individual firms, then what the hell is he even talking about?

During this pandemic crisis, some good prices have risen where production is inelastic (such as in fresh fruit and vegetables) or where supply-side issues have happened, but, as I stated, in many cases large supermarkets and retailers have maintained the prices of goods like toilet paper, tissues and hand sanitiser, even when shelves are empty.

More flexible prices on eBay or marginal small shops are obviously not representative of all prices, since only small quantities of the products in question are sold at the margins at these places.

The large supermarkets and retailers are where the vast majority of sales happen, and it was not “evil” government that is forcing them to maintain prices: the producers and retailers are largely choosing themselves to maintain prices, since this is their normal behaviour anyway with respect to many goods and services when demand changes: if demand increases, often production is simply ramped up and prices remain unchanged.

(4) Cantillon Effects
Academic Agent fails to understand my critique of the Cantillon Effect. My position is not Cantillon effects never happen at all.

My original position is that in the face of widespread relative price rigidity, Cantillon effects are likely to be minor and marginal, and, on their own, cannot possibly be a serious objection to government spending based on increasing the money supply, because all private sector activity that also increases spending by increasing the money supply would also cause the same type of minor or marginal Cantillon effects.

At this point in the discussion, “Radical Liberation” falsely claims I asserted that prices need to change instantly to changes in demand. Again, this is wrong. For major Cantillon effects to happen, most prices must be highly flexible in response to demand, and change relatively quickly and rapidly.

Also, Academic Agent totally misses my point about the gross contradiction in his reasoning in relation to the orthodox Quantity Theory of Money and the existence of Cantillon effects at the same time, since Austrian economics requires the rejection of short and long-run money neutrality, but money neutrality is a fundamental assumption of the Quantity Theory of Money.

(5) The Quantity Theory of Money
Here it appears that Academic Agent refuses to defend the orthodox Quantity Theory of Money.

At least this is in line with the most important Austrian economists, who did not defend the orthodox Quantity Theory of Money either, but had serious criticisms.

However, changes in the general price level are a highly complex result of many factors, and not some simple function of money supply. Real factors also are an important factor in driving inflation.

If we dig deeper into the Austrian view of inflation, we can find some surprisingly sensible analysis.

Curiously, the Austrian economist Frank Shostak has a surprisingly sensible view on inflation:
“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.”
Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.
The statement that prices “are determined by real and monetary factors” is, essentially, empirically correct (although, from the Post Keynesian perspective, still needs qualification), but requires we reject the Monetarist superstition that “inflation is always everywhere a monetary phenomenon,” which Academic Agent appears to defend.

As I said, while a long-run, sustained price inflation does need a growing money supply to sustain it, the money supply is often not the causal factor in such price inflations, but the intermediary factor. Monetarists mistake the intermediary medium (money supply) for the only and fundamental driver of price inflation, when real factors underlie movements in prices.

To put this another way, in serious depressions, the falling money supply (when so much of the money supply is understood to be credit money) was not so much the cause of the collapse of economic activity, but the consequence of the collapse in economic activity as credit demand collapsed (though, of course, when banks failed and depositors lost their money savings, this affected economic activity too).

In fact, this is the whole point of the Post Keynesian insight into capitalism: the ability to increase production in an historically unprecedented way is achieved in modern capitalism not simply by superior technology and production methods, but also by an endogenous money supply: a banking and monetary system where capital investment can be financed by new credit money, not backed by prior “saved” money.

As Nicholas Kaldor said in “The Irrelevance of Equilibrium Economics” (Economic Journal 82 [1972]: 1237–1252):
“This is the real significance of the invention of paper money and of credit creation through the banking system. It provided the pre-condition of self-sustained growth. With a purely metallic currency, where the supply of money is given irrespective of the demand for credit, the ability of the system to expand in response to profit opportunities is far more narrowly confined.” (Kaldor 1972: 1250).
Money supply growth, then, is a necessary condition of not only long-run, sustained price inflation, but also a dynamic, highly-productive capitalist economy, because most money is credit money created by banks and, in earlier pre-1930s capitalist eras, by private sector agents who created bills of exchange, promissory notes, negotiable cheques, fractional reserve credit money (book money) and private bank notes.

In this sense, at a fundamental level, in a modern advanced capitalist economy, economic activity and demand for credit drives money supply growth, although in commodity money systems, exogenous growth in the money supply did happen via new gold discoveries, which could then cause demand-side inflation.

The more a modern capitalist economy has an endogenous money system, the more that the Quantity Theory fails to apply.

(6) Full Employment and William H. Hutt
Here Academic Agent appears to largely concede my critique is valid.

However, when Academic Agent (at 2.14.11) states that “the economy does not have the goal of full employment,” he appears to have forgotten the whole point of flexible money wages in Neoclassical and Austrian theory: a flexible money wage (and absence of other alleged harmful interventions) is supposed to cause a strong tendency towards the clearing of the labour market, which is just another way of saying that free markets are supposed to have a strong tendency towards elimination of involuntary unemployment and high levels of employment.

Moreover, Academic Agent makes the insane charge (from 2.17.29) that Post Keynesians wish to create something like Mises’ “Evenly Rotating Economy” (a fictitious general equilibrium state) when nothing is further from the truth: Post Keynesians totally reject general equilibrium analysis or the idea that a dynamic capitalist economy that faces uncertainty and constant change could ever have a tendency to general equilibrium, or could ever reach that state.

BIBLIOGRAPHY
Kaldor, N. 1972. “The Irrelevance of Equilibrium Economics,” Economic Journal 82: 1237–1252.

Rothbard, Murray N. 2006a. For a New Liberty: The Libertarian Manifesto (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

Friday, April 24, 2020

A Refutation of Academic Agent’s “Debunking Modern Monetary Theory (MMT)”

Academic Agent – a YouTube libertarian and unusually ignorant advocate of Austrian economics – tries to refute Modern Monetary Theory (MMT) in this video:



Let us run through this video and refute Academic Agent’s arguments point by point:

(1) Academic Agent fails to Refute the Three Core Principles of MMT
There are three fundamental principles in Modern Monetary Theory (MMT), as follows:
(1) Most sovereign governments today are the monopoly issuers of their own fiat currencies (since the gold standard has been abolished);

(2) Because of (1), the government is not revenue-constrained in the way it was under the gold standard, because it is the creator of its own fiat money;

(3) In a fiat money world, taxes and bond issues do not, technically speaking, finance government spending.
Even if Academic Agent thinks that a central bank creating money directly to fund a government budget deficit results in excessive inflation or hyperinflation (which is one of his arguments), he still has failed to refute these three core principles of MMT.

In fact, it is difficult to see how any sane libertarian would deny propositions (1) and (2), because these are their primary objections to fiat money!

(2) Emergence of Commodity Money in modern POW Camps or Prisons does not vindicate Menger’s Theory of the Origin of Money
Academic Agent notes (from 1.34 in the video) that commodity money has emerged in modern jails and thinks this confirms Menger’s theory of the origin of money.

In reality, this does no such thing. Ultimately, libertarians like Academic Agent rely on such things as the work of R. A. Radford (“The Economic Organization of a POW Camp,” Economica 12.48 [1945]: 189–201) that demonstrates the emergence of a cigarette money in a POW camp. But situations in which barter is observed in groups of human beings in modern times where some good emerges as a medium of exchange can hardly be regarded as confirming the barter-origin-of-money theory, because the people concerned in these cases were already perfectly familiar with money and a price system (Graeber 2011: 37; see also Ingham 2006: 264–265), and were not like ancient people who lacked a monetary system.

(3) Carl Menger’s Theory of the Origin of Money is False as a Universal Theory
Carl Menger’s theory of the origin of money is defended by Academic Agent against Chartalist theories, often used by advocates of MMT.

However, it is important to note that even if Chartalist theories of the origin of money are false, then this still does not refute the macroeconomic theories and policy recommendations of MMT applied to modern capitalist economies, since these things are, logically, two separate things.

However, there are good reasons for rejecting Carl Menger’s ideas as a universal theory of the origin of money.

Briefly, Menger imagines a pre-monetary world where people exchange goods for goods in spot transactions (barter). The famous problem of the double coincidence of wants is overcome as certain goods with a high degree of saleableness (that is, that are much more likely to sell than other goods) are desired to overcome the double coincidence of wants, and eventually the most saleable good (or goods) becomes the medium of exchange (Menger 1892: 249). This is taken to be a universal theory of how money emerges on markets by many modern Austrians and libertarians, although Menger’s own position was much less extreme than this.

If we read Menger’s classical article of 1892 in its English translation by C. A. Foley published in the Economic Journal, we find an interesting qualification that Menger makes to his theory:
It is not impossible for media of exchange, serving as they do the commonweal in the most emphatic sense of the word, to be instituted also by way of legislation, like other social institutions. But this is neither the only, nor the primary mode in which money has taken its origin.” (Menger 1892: 250).
That leaves open the possibility that money can be instituted by a modern government, but no doubt libertarian halfwits like Academic Agent are blissfully ignorant of this more reasonable opinion of Menger.

The trouble with Menger’s theory is that, while it is probably true that money in some historical circumstances can emerge from barter (especially in long distance trade), money can arise in other ways, and Menger’s theory is therefore flawed and cannot be considered a universal theory.

Historically speaking, money might arise in various ways, as follows:
(1) money can arise from so-called “ceremonial money” that was originally prized as a prestige good, or for magical power (and not as the most saleable good), and first used mainly for social reasons, but then used in wergild (compensation for murder) and other penalty systems, where penalties are calculated in terms of a common unit of account;

(2) money can arise as an abstract unit of account imposed from above by ancient government-temple institutions using weight units of metal from their economic planning systems.
We can review these points below.

First, in pre-monetary societies, we find that barter spot trading within that community is far less prevalent than is imagined in Austrian and Neoclassical economics. Sometimes money – in the true modern sense – does not even develop at all. Primitive societies can overcome the double coincidence of wants problem by a system of gift exchange and debt–credit exchanges, and many such societies without money can function quite well, and limit significant barter trade to trade between geographically distant regions and people.

In some such pre-monetary societies studied by modern anthropologists, there emerges what anthropologists call “non-commercial money” or “ceremonial money,” which is non-commercial in the sense that it is not used for everyday purchases of goods and services, or only rarely for such ordinary goods: thus it is non-commercial in the sense that it is not a universal medium of exchange. Such “primitive ceremonial monies” include shell money in the Americas or Papua New Guinea, cattle money in Africa, bead money, feather money, and so on. These were rarely used to buy everyday items in the societies that used them. Instead, they are employed in social relations like marriages and to settle disputes (Graeber 2011: 60).

Such “non-commercial money” (or “ceremonial money”) is most frequently used in social interactions, often formal social events such as marriage, wergild and bloodwealth payments (that is, compensation for murder), political relations (e.g., potlatch, moka), and fines and other compensations (compensation for adultery, or for things lost), and may only be rarely used, if at all, for everyday purchases or commercial transactions (Grierson 1977: 15–16).

In time, some societies move to the next stage where a prescribed and traditional system of compensation payments are calculated in terms of “ceremonial money” as a common unit of account to simplify calculation of payments, which later spread to the wider community in economic transactions as a modern form of money (Grierson 1977: 29). So it is possible that in some societies money arises from its previous role in systems of legal compensation.

Secondly, we have evidence from ancient Babylonia and ancient Egypt that money arose there from an abstract money of account in the temple and palace institutions.

In ancient Mesopotamia, for example, an abstract money of account seems to have been developed in the temple and palace institutions. These temples and palaces were institutions with large internal centrally-planned economies, with complex weights and measurements for internal accounting of the products produced, received and distributed, and rent and interest owed. Many prices were set and administered in the money of account which developed from weight units. The two units of account were (1) the shekel of silver (which was equal to the monthly grain ration) and (2) barley (Hudson 2004).

Silver money of account spread to the private economy mostly as a means of reckoning debts to temples and palaces (Hudson 2004: 115). But many ordinary people could pay in commodities, and the administered pricing system in terms of silver/grain that was developed in the temples was to assist in calculation of payments in kind.

And it is likely precious metals were used as non-commercial money or ceremonial money in ancient societies before they became abstract units of account. Given their scarcity, it is unlikely that silver would have arisen as a unit of account and medium of exchange in, say, Mesopotamia from internal barter trade as the most saleable good precisely because there wasn’t enough of it.

Finally, the first metal coinage in ancient Lydia and Greece was an invention of the state, and the first Lydian coinage was struck in electrum (not gold or silver) and used to pay soldiers and mercenaries. This was most probably a high prestige object and perhaps even non-commercial money. At most, it was simply one of many goods used in conventional barter trades: there is no convincing evidence that it was the reigning medium of exchange (money) that had already emerged as the most saleable good in spot barter trades before it was adopted by the Lydian state.

Much more detailed analysis of the origins of money with scholarly citations can be found in these posts:
“Menger on the Origin of Money,” January 5, 2012.

“Menger’s Nuanced View on the Origin of Money,” November 6, 2012.

“George Selgin versus David Graeber on the Origin of Money,” March 30, 2016.

“Larry White on the Origins of Coined Money: A Critique,” August 26, 2017.

Reply to Selgin on the Origin of Electrum Coinage, Part 1, September 3, 2017.

The Majority View in Modern Scholarship on the Origin of Electrum Coinage: An Update, September 4, 2017.

“Reply to Selgin on the Origin of Electrum Coinage, Part 2,” September 5, 2017.

“The Origin of Money and Coinage in Western Civilisation: The Case of Ancient Greece,” April 5, 2013.
(4) Academic Agent fails to Understand Widespread Relative Price Rigidity
Academic Agent’s major argument against government spending and MMT-style deficit spending is Cantillon effects (from 9.42 in the video).

The Cantillon effect is the idea that price level changes caused by increases in the quantity of money depend on the way new money is injected into the economy and actually where it affects prices first. New money will then spread out altering the level of prices and structure of prices or relative prices (Blaug 1996: 21). Another way of saying this is that, although prices rise as the quantity of money increases, contrary to the naive quantity theory of money, prices do not rise proportionally, but in a complex manner that depends on who received the money and how they spent it.

Libertarians are fond of using this “Cantillon effect” argument against government spending where money supply rises: the argument is essentially that only those who first receive the new money will benefit from it, and all other people who latter receive the new money will suffer rapid and serious inflation.

But this argument is absolutely dependent on the false view that all or most prices in modern capitalist economies are highly flexible and rapidly responsive to changes in demand. This is utterly false, and the reality is that even mainstream Neoclassical economists recognise that modern capitalist economies have a high degree of relative price rigidity.

Most prices are cost-based mark-up prices, relatively inflexible with respect to demand, and the empirical evidence for this as given in the post below is overwhelming:
Mark-up Pricing in 21 Nations and the Eurozone: the Empirical Evidence .
So the idea that goods prices rapidly respond to demand increases is a falsehood. Cantillon effects are largely mythical precisely because of relative price rigidity, and to the extent there are marginal or minor Cantillon effects this would occur in response to any type of new spending in an economy, whether this was new foreign purchases of domestic goods or new spending from money creation by private capitalist fractional-reserve banks. Since minor Cantillon effects would also occur from privately-induced changes in the quantity of money, as well as from government-induced ones, it cannot be a serious objection on its own against government intervention raising the quantity of money unless it also invalidates all private causes of the expansion of the money supply, such as, for example, foreigners bringing in new money via large flows through a country’s capital account into financial markets, foreign direct investment, purchases of exports, or spending on tourism, etc.

To turn to the evidence for relative price rigidity, we can look at some data.

Blinder et al.’s Asking about Prices: A New Approach to Understanding Price Stickiness (New York, 1998) reported the results of one of their survey questions, asked of 200 firms selected to be representative of total US GDP, which was as follows:
“How often do the prices of your most important products change in a typical year?” (Blinder et al. 1998: 84).
The results were:
(1) less than 1 | 10.2%
(2) 1 | 39.2%
(3) 1.01 to 2 | 15.6%
(4) 2.01 to 4 | 12.9%
(5) 4.01 to 12 | 7.5%
(6) 12.01 to 52 | 4.3%
(7) 52.01 to 365 | 8.6%
(8) more than 365 | 1.6%.
(Blinder et al. 1998: 84).
It follows that 78% of US GDP consists of goods that are repriced quarterly or less. But of this fully 49.2% of firms reprice their goods only once a year or within a period over more than a year.

Blinder et al. (1998: 84) conclude that the US does have an auction-like market sector where prices are highly flexible, but it is very small indeed.

In fact, we have just seen massive relative price rigidity in response to increased demand in many goods prices during this pandemic crisis. Although of course some goods prices have risen where production is inelastic (such as in fresh fruit and vegetables) or where supply-side issues have happened, in many cases large supermarkets have maintained the prices of goods like toilet paper, tissues and hand sanitiser, even when shelves are empty.

Academic Agent is an idiot who denies the price rigidity in many goods right before his eyes.

As an aside, Academic Agent also commits a gross contradiction in his reasoning if he wants to defend the orthodox Quantity Theory of Money and the existence of Cantillon effects at the same time, since Austrian economics requires the rejection of short and long-run money neutrality, but money neutrality is a fundamental assumption of the Quantity Theory of Money (more on this in the next section).

For more refutation of the libertarian concept of Cantillon effects, see this post:
“Are Cantillon Effects an Argument Against Government Spending?, September 27, 2011.”
(5) The Quantity Theory of Money is Empirically Wrong
Academic Agent relies on the flawed Quantity Theory of Money as his explanation of inflation. Now nobody denies that demand-side inflation is real, nor that hyperinflations can happen. But the Quantity Theory of Money is much more than the claim that demand-side inflation occurs.

This section is, unfortunately, highly technical.

The Quantity Theory of Money is the theory that, when the money supply expands or contracts, this is the cause – when other variables are constant – of proportional or equal changes in the price level. The standard equation often used to express the Quantity Theory of Money is the Cambridge Cash Balance Equation.

The standard form of the Cambridge Cash Balance Equation as used today is usually given as follows:
M = kPY or
M = kd PY
where M = the quantity of money;
k or kd = the amount of money held as cash or money balances;
P = the general price level;
Y = real value of the volume of all transactions entering into the value of national income (that is, goods and services).
In the Cambridge approach, the variable k was held to be superior to Irving Fisher’s “velocity of circulation” concept V, because, unlike V, k is supposed to be empirically measurable.

The Quantity Theory of Money makes the following assumptions:
(1) the size of the money supply is exogenously determined by the central bank, and there is an independent money supply function;

(2) the assumption of long-run money neutrality;

(3) the direction of causation as assumed in the quantity theory equation is from left to right (that is, from the money supply to the price level). That is to say, an exogenously-determined money supply is the fundamental cause, or driver, of price level changes.
But these assumptions are wrong.

First, price inflation is a complex phenomenon, and there is no simple, monocausal explanation of price inflation, because one major factor is the high degree of relative price rigidity that happens in modern economies. An increase in the money supply does not necessarily cause corresponding increases in the general price level, either in the short run or long run, when so many prices do not automatically respond to increased demand. Thus assumption (2) above is simply false!

Secondly, the Quantity Theory of Money makes the false assumption of an exogenous, independent money supply under the direct control of the central bank. But in reality the modern money supply is endogenous.

What this means is that normally broad money creation is credit-driven. That is, most money is created by private banks in the form of demand deposits (denominated in the fiat currency of their nation) and its quantity is determined by the private demand for credit or demand deposits. This is the essence of endogenous money: in an endogenous money system, even the “monetary base” is normally endogenous too, given that the central bank must accommodate the banks’ demand for high-powered money to avoid financial crises and banking panics. Of course, the central bank does control the ability to create fiat money and is the monopoly issuer of its national fiat currency, but a lot of the money supply in any nation is actually credit money in the form of private-bank demand deposits, which is denominated in the national fiat currency.

A truly independent money supply function does not actually exist in an endogenous money world, because private-bank credit money comes into existence because it has been demanded (Rogers 1989: 244–245). So the broad money supply is not independent of money demand, but can be demand-led (Ingham 2004: 53). Thus assumption (1) above is false.

Thirdly, assumption (3) is also false. In an endogenous money system, the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases. Therefore the direction of causation generally runs:
(1) business demand for credit (to pay for goods and labour factor inputs, whose prices may have risen against previous production periods) + demand for demand deposits

(2) increases in broad money supply (driven by changes in the level of demand deposits)

(3) banks’ demand for more reserves (high-powered money) when they need to clear obligations.

(4) the central bank creates the needed reserves.
Changes in the general price level are a highly complex result of many factors, and not some simple function of money supply. Businesses will raise their prices for all sorts of reasons independently of a money supply expansion.

Often general price inflation is a cost-push phenomenon, in which
(1) workers or unions demand higher wages and businesses agree to these increases and/or

(2) prices of other factor inputs rise, and then businesses will need to obtain higher levels of credit from banks.
While a long-run, sustained price inflation does need a growing money supply to sustain it, the money supply is often not the causal factor in such price inflations, but the intermediary factor. Often, it is business and corporate use of cost-based mark-up prices and their pricing decisions, based on the need for more profit or changes in unit costs, which drive price inflations.

So inflation might be driven by demand for higher wages or supply-side factors. Hence broad money supply growth rates rise in an endogenous money world which generally accommodates the demand for credit, but this rise precedes further price increases because businesses will generally raise mark-up prices to maintain profit margins at a later time, given that most firms engage in time-dependent reviews and changes of their prices at regular intervals. In extreme situations, a wage–price spiral might break out: this involves the same process as above but in a vicious circle.

In short, with (1) the Quantity Theory of Money being a false theory and (2) the real world having a high degree of relative price rigidity, virtually all libertarian objections to MMT based on inevitable and rapid inflation fall apart.

Of course, this does not mean demand-side inflation never happens nor that hyperinflation never happens, but then MMT does not advocate causing excess demand-side inflation or hyperinflation.

A full refutation of the Quantity Theory of Money, with citations, is here:
“Why is the Quantity Theory of Money Wrong and can Anything be Salvaged from it?,” September 15, 2014
For some other links against the Quantity Theory, see here:
“Inflation is NOT Always and Everywhere a Monetary Phenomenon,” August 4, 2014

“So-Called ‘Long-Run’ Monetarist Correlations and Non-Ergodicity,” August 7, 2014.

“What is a ‘Long-Run Trend’?,” August 5, 2014.
(6) Academic Agent relies on a Strawman Argument from William H. Hutt
Academic Agent cites the work of William H. Hutt, who is one of the most ignorant and stupid critics of Keynesianism ever produced by libertarianism.

Hutt’s criticism of Keynes and Keynesian concepts are often ridiculous strawman misrepresentations.

To take one example, the concept of “full employment” was never meant to include normal frictional and seasonal unemployment as a problem to be ended. “Full employment” does not mean a 0% unemployment rate, and never did.

This is completely absurd. Rather, frictional and seasonal unemployment are of course always going to happen, and “full employment” actually means persistent involuntary unemployment. In a modern capitalist economy, “full employment” has often been estimated as somewhat below a 4% unemployment rate.

Academic Agent’s entire attack on “full employment,” based on Hutt, is a ludicrous parody, and not to be taken seriously.

All in all, Academic Agent fails to refute MMT, and reveals the profound flaws in Austrian economics.

BIBLIOGRAPHY
Blaug, M. 1996. Economic Theory in Retrospect (5th edn), Cambridge University Press, Cambridge.

Blinder, A. S., Canetti, E. R. D., Lebow, D. E. and J. B. Rudd (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.

Graeber, David. 2011. Debt: The First 5,000 Years. Melville House, Brooklyn, N.Y.

Grierson, P. 1977. The Origins of Money. Athlone Press and University of London, London.

Hudson, M. 2004. “The Archaeology of Money: Debt Versus Barter Theories of Money’s Origins,” in L. R. Wray (ed.), Credit and State Theories of Money: the Contributions of A. Mitchell Innes. Edward Elgar, Cheltenham. 99–127.

Ingham, G. 2006. “Further Reflections on the Ontology of Money: Responses to Lapavitsas and Dodd,” Economy and Society 35.2: 259–278.

Menger, C. 1892. “On the Origin of Money,” Economic Journal 2: 238–255.

Rogers, Colin. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

Monday, February 10, 2020

Academic Agent on Excess Capacity

The libertarian “Academic Agent” examines the concept of excess capacity here:



First, Academic Agent is utterly wrong to claim that Austrian theory is only looking at the “price of a good across a whole economy,” and that my analysis of how real-world individual firms behave is somehow irrelevant to Austrian theory.

Austrian economics has a “Theory of the Firm,” just like Neoclassical economics, and Austrian theory says the average firm should be engaged in flexible pricing of its products, in order to clear markets and equate supply with demand.

Academic Agent’s claim that “Austrian theory…. as regards price responsivity to supply and demand does not predict the behaviour of individual firms” (at 5:33–5:36 in the video) is a bizarre and blatant falsehood. While Austrian price theory and the Austrian Theory of the Firm are of course not predicting what all firms do, they nevertheless must predict what the majority of firms do, or the average firm does, because otherwise they would be empirically false.

Austrian theory makes both prescriptive and descriptive claims about how most firms, or the average form, should be behaving.

Consider these statements by Austrian economists:
(1) “Private business prices its goods and services to ‘clear the market,’ so that supply equals demand, and there are neither shortages nor goods going unsold.” (Rothbard 2006a: 259).

(2) “… selling prices will tend toward the market-clearing level, and need not hit the mark every time the firm sets it price. Despite the firms’ lack of perfect knowledge of [demand] and [supply] conditions, they are motivated to seek market-clearing outcomes and avoid disequilibrium outcomes.

For one thing, there is the economic incentive to maximize profits. As we have seen, surplus and shortage outcomes cause the firm less profit than otherwise under the given demand and supply conditions. Thus, in the case of a surplus, the firm will have to slash its [price] below the planned level, whereas in the case of a shortage the firm has missed an opportunity for greater profits by setting its [price] too low or producing less than the market was ready to absorb.

On the other side of this coin is the fact that, of the three possible market outcomes—market-clearing, surplus, or shortage—only market-clearing outcomes validate the firm’s expectations and strengthen its confidence in its ability to judge market conditions.
In contrast, surpluses and shortages are truly disappointments—sources of regret and diminished confidence.” (Shapiro 1985: 208).
If Rothbard and Shapiro aren’t talking about the average real-world firm here, or the majority of real-world individual firms, then what the hell are they even talking about?

Furthermore, Austrian economics requires that the majority of individual real-world firms are engaging in flexible pricing to clear markets, because otherwise there would be no real-world tendency to market clearing, and towards shifting “final state of rest” equilibrium states (for Mises’ general equilibrium concept, see here).

Secondly, Academic Agent’s claim that equilibrium “does not take into account what is happening in the inventories of individual firms or at the producer-good level” is a bizarre statement.

Here is what Austrian economics has to say about inventories or buffer stocks:
(1) “Competitive prices are the outcome of a complete adjustment of the sellers to the demand of the consumers. Under the competitive price the whole supply available is sold, and the specific factors of production are employed to the extent permitted by the prices of the nonspecific complementary factors. No part of a supply available is permanently withheld from the market, and the marginal unit of specific factors of production employed does not yield any net proceed. The whole economic process is conducted for the benefit of the consumers.” (Mises 2008: 354).

(2) “We know from ‘microeconomic’ analysis that if there is a ‘surplus’ of something on the market, if something cannot be sold, the only reason is that its price is somehow being kept too high. The way to cure a surplus or unemployment of anything, is to lower the asking price, whether it be wage rates for labor, prices of machinery or plant, or of the inventory of a retailer.” (Rothbard 2006b: 44).

(3) “There is no reason why prices cannot fall low enough, in a free market, to clear the market and sell all the goods available. If businessmen choose to keep prices up, they are simply speculating on an imminent rise in market prices; they are, in short, voluntarily investing in inventory. If they wish to sell their ‘surplus’ stock, they need only cut their prices low enough to sell all of their product. But won’t they then suffer losses? Of course, but now the discussion has shifted to a different plane.” (Rothbard 2008: 56).
As we see, Austrian economics makes specific claims about buffer stocks and inventories, and they are contemptibly wrong. In real-world capitalism, firms set their mark-up price based on average unit costs of production, and then normally adjust production to match demand, while keeping inventories and significant unused capacity at factories and plants available to meet increases in demand. When demand falls, businesses fire workers and cut production.

It is absurd to say, as Austrians do, that firms aim to sell their whole supply, or that businesses only have inventory or stocks because they are “speculating on an imminent rise in market prices.”

Thirdly, the final devastating problem with this video is that, in the last few minutes, it unintentionally and rather comically sets out to refute me, but ends up confirming and vindicating my main points in Academic Agent’s points about his imaginary firm “Baker Bros.”

In essence, Academic Agent admits that his imaginary firm would cut production and employment (and hence change his variable capital and labour) to match production output to expected demand, and would not bother to cut prices to clear his supply every production cycle.

But this now raises the following issues:
(1) if the majority of real-world firms normally use relatively-inflexible cost-based mark-up prices and vary production to meet demand and shun highly flexible money prices to clear markets, then

(2) how can real-world capitalism have a strong tendency to market clearing (that is, equilibration of supply and demand by flexible prices) and a tendency to general equilibrium? (or, in Austrian terminology, Mises’ “final state of rest”).
Without a real-world tendency to market clearing and full employment general equilibrium, Austrian economics collapses: this is true because Mises’ idea of economic coordination and his idea of a real-world tendency to shifting “final state of rest” general equilibrium states are absolutely dependent on a flexible system of money wages and prices.

Libertarians like Academic Agent have no answers to these questions, and have nothing but evasions, lies and sophistry to offer in response to such critiques.

Further Reading
“Vulgar Austrians do not Understand Austrian Price Theory (Updated),” July 10, 2014.

“Price, Average Total Cost, Average Variable Cost and Marginal Cost,” November 28, 2013.

“Mises on Marginal Cost: A Critique,” December 3, 2013.

“Reality Refutes Mises on Costs and Prices,” December 9, 2013.

“Administered Prices Discredit the Austrian Economic Theories of Mises,” December 10, 2013.

BIBLIOGRAPHY
Mises, Ludwig von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Mises Institute, Auburn, Ala.

Rothbard, Murray N. 2006a. For a New Liberty: The Libertarian Manifesto (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

Rothbard, Murray N. 2006b. Making Economic Sense (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

Rothbard, Murray N. 2008. America’s Great Depression (5th edn.). Ludwig von Mises Institute, Auburn, Ala.

Shapiro, Milton M. 1985. Foundations of the Market Price System. University Press of America, Inc. Lanham, MD and London.