By 4 November 2009, the US monetary base had increased by 142% over the previous two years to about 2 trillion dollars. These unprecedented and large open market operations conducted by the Fed stirred up the usual suspects, including a number of hapless Austrians and others, who were screaming that hyperinflation was on the way. A good example of such dire predictions can be found here:
Marc Faber with Peter Schiff – Hyperinflation in the United States a 100% Certainty, Glenn Beck, 28th May, 2009.
Other pro-free market bloggers boldly proclaimed that the UK or the US was the new Zimbabwe, with equally ridiculous and contemptibly stupid rhetoric.
Now we are in the first month of 2011, and there is no sign of any hyperinflation. In the UK and US, 2010 was a year of disinflation, not accelerating inflation.
Moreover, despite the initial QE in 2009, there was massive disinflation or outright deflation in the US or UK in that year. Various Austrian and other free marketeer predictions of hyperinflation were, and still are, wrong. Why?
The simple fact is that inflation of the base money supply by x% does not necessarily cause price inflation of x% (and to believe so relies on the flawed quantity theory of money which I have criticised elsewhere on this blog). Nor does a large increase in base money necessarily mean a large increase in the CPI, particularly in an economy with high unemployment and low growth. Predictions of hyperinflation in the current economic conditions are absurd. There is no reason why all the base money created by QE will be injected into the economy by banks when business confidence is low, credit demand is limited, and banks themselves are wary of lending.
The key to all this is the Post Keynesian insight that the broad money stock is essentially endogenous (for the classic study, see Moore 1988), a view which is also held by the monetary circuit theorists, was supported by Wicksell and Schumpeter (Howells 2006: 53), and can be traced back to the 19th-century Banking school (Wray 1998: 32–33).
Before we discuss endogenous money, however, we need to distinguish properly between (1) the base money supply and (2) broad money stock.
I have done this in the section below, and take the US as an example:
(1) High-powered money (= monetary base, base money, M0)Now we can review the facts above. If it is to cause inflation, QE-created money has to be injected into the economy by debt and then spent into an economy to inflate the prices of commodities. But private credit/debt is precisely what collapsed in the UK and US in late 2008 and 2009: we are in a debt deflationary environment with deleveraging, where the private-debt-derived part of aggregate demand has fallen or even gone negative, just as the Post Keynesian economist Steve Keen has shown in numerous posts on his Debtdeflation blog (Steve Keen, “What Bernanke doesn’t understand about deflation,” Debtdeflation.com, August 29, 2010).
Base money is currency in circulation and bank reserves (both required and excess reserves).
This means that the monetary base includes all cash and coins, even vault cash at banks, as well as deposits that banks hold at the Fed (which are reserves). Reserves come in two forms: (1) required reserves and (2) excess reserves. The latter are balances held at the Fed in excess of required (or minimum) reserves. It was excess reserves that soared after quantitative easing began in 2009, when in March the Federal Reserve announced it would purchase $300 billion of US government debt over 6 months. Banks sold bonds and then mortgage backed securities (MBOs) to the Fed.
Now no one denies that the central bank has the power to increase the base money supply by open market operations, and to control the interest rate.
But we need to look carefully at what is meant by the expression “printing money.” This expression has two meanings:
(1) expansion of the central bank’s balance sheet and the base money supply (M0), and
(2) central bank financing of government deficits (= monetizing deficits).
In sense (1), one can refer to the Fed’s QE as “printing money.” But the money created is reserves, and the process involved is actually better described as an asset swap: the banks swap their bonds for reserves. Furthermore, since required reserves and excess reserves are merely held at the Fed, they are not injected into the economy, nor are they used to buy goods or services. Money in the form of reserves merely held at the Fed is not inherently inflationary, despite the nonsense from many economic commentators over the last few years. Reserves must be turned into private debt and spent into the economy to enter the broad money stock before becoming inflationary.
(2) Broad money (M1, M2, M3)
Broad money is different from base money, and can be measured by M1, M2, or the now discontinued measure M3.
M1 is the most liquid form of money. M1 includes:
(1) currency in circulation outside bank vaults (and also excluding bank reserves),
(2) checking/transactions accounts (or demand deposits) and other checkable accounts, and
(3) travelers checks.
M1 excludes vault cash and bank reserves at the central bank. All M1 money can be spent quickly or relatively quickly, and is not locked up in time deposits. The key is that M1 does not include bank reserves. This is very important. Reserves, a major part of the monetary base, are not included in M1, or in any other measure of broad money. This is why, when base money supply soared in 2009, M1 did not increase by the same amount. Thus, when Austrians complain that QE caused massive inflation of the money supply, they refer to the monetary base, not to the broad money stock M1. But, as we have seen, inflation of M0 does not necessarily increase M1, unless the money is injected into it via private debt.
The two other measures of broad money are M2 and M3, and they include increasingly less liquid forms of money, such as time deposits, money market deposits, and savings deposits. Thus M2 is as follows:
M1 supply + money held in money market funds + savings accounts + small certificates of deposit (CDs).
M3 is simply M2 plus large CDs. The M3 measure was discontinued by the Federal Reserve in 2006, although Shadowstats.com maintains a useful estimate of M3.
One of the most important facts about M3 is that from 2009 to 2010, M3 actually contracted (see Ambrose Evans-Pritchard, “US money supply plunges at 1930s pace as Obama eyes fresh stimulus,” http://www.telegraph.co.uk, 26 May 2010), which can be seen on Shadowstats.com:
Although both M1 and M2 have increased since 2008, the percentage increase has been nothing like the 140% increase in base money.
In April 2008, M1 was about $1.4 trillion, and is now about $1.8 trillion. This is an increase of 28.57% since 2008. In November 2007, M2 was $7.41 trillion and has gone up to about $8.8 trillion in November 2010, which is an increase of 18.75%.
Moreover, if one looks at the historical growth rates of M1 and M2 over the past 50 years, one can easily observe that the percentage increases over the past few years are not unprecedented at all (see the longer term historical monetary charts at Shadowstats.com). Despite base money surging by 140%, M1 and M2 have not exploded. Nor has inflation.
What should be particularly damning for the hyperinflation hystericists is the recent contraction of M3, the broadest measure of money.
We must remember that, just as the creation of debt creates broad money, the repayment of debt destroys broad money (Wray 1990: 73). We therefore have an endogenous system that creates and destroys money, and expands and contracts the broad money stock.
In the current environment of private deleveraging, debt is being paid down, and there are powerful forces at play destroying broad money, which are probably reflected in the contraction of M3 (although higher capital asset ratios are also a reason). We can also note that, in the latter part of 2009 and early in 2010, M2 remained flat and even declined slightly at times, which may well have been caused by money destruction through private deleveraging.
When we say that the broad money stock is endogenous, it means that changes in M1 are essentially caused by internal factors like the amount of private debt issued by the banks and private demand for such debt (for the debate between accommodationists and structuralists on endogenous money, see Fontana 2003: 291–292 and Piegay 2003). Thus the broad money supply is determined by demand for bank credit, and the latter is itself caused by other economic variables, such as expectations, business confidence, the state of the economy, and other factors. This is in stark contrast to the neoclassical and monetarist view that the broad money supply is purely exogenous: that is to say, that the money supply is determined and controlled by central banks outside of the private sector. The myth that the broad money stock or its growth rate is under the direct control of the central bank was demonstrated as false during the disastrous experiment with monetarism in the early 1980s in the UK and US, particularly in Paul Volker’s failed monetarist experiment from 1979–1982. Volker tried to control the growth rate of M1, through targeting non-borrowed reserves, but this was a miserable failure, with the Fed badly missing its M1 targets (Wray 2003: 92). In October 1982, Volcker abandoned monetarism and returned to a discretionary interest rate policy, through the Federal funds rate (which had always been the main policy instrument before 1979). The Fed tried to target M2 growth rates for the rest of 1980s, but this was also a failure, and the monetarist fiction that the Fed controls broad money was officially abandoned in 1993.
In short, central banks do not directly control the broad money stock or its growth rate. Instead, the central bank controls the interest rate and supplies reserves, while broad money is created by the banks, which often obtain reserves afterwards (Howells 2006: 52).
Post Keynesian economists like Nicholas Kaldor, Basil J. Moore and Thomas I. Palley have defended and developed the endogenous money theory. In brief, the conventional textbook account of our monetary system relies on the money multiplier, a view that is false, as shown here by Bill Mitchell (Bill Mitchell, “Money multiplier and other myths,” April 21st, 2009).
With new private debt issued by banks constrained by falling demand, the idea that all the excess reserves created by quantitative easing would enter the economy and inflate M1 to a large extent, causing massive inflation, was ridiculous, even in 2009. With the net annual change in private debt falling in the US, internal deflationary forces are gripping the economy. Those deflationary forces have been reduced by deficit spending and Keynesian stimulus, which certainly prevented a global depression. But the stimulus packages in the UK and the US have been insufficient to stimulate the economy back into full employment. The US case is particularly dire: the most accurate government measure of unemployment in the US is U-6, and that stands at 17%. John Williams of Shadowstats.com thinks that even U-6 is not wholly reliable and produces his own estimate, which is now running at a shocking 22%. There is also a significant amount of excess capacity (idle capital) in the US and UK, so that if demand was to surge, what would happen is that capacity utilization rates would rise, rather than disastrous inflation.
Moreover, many Western economies have dysfunctional banks and excessive private debt. What is needed now is a thorough auditing of the financial institutions of the US, the UK and other Western countries. Non-performing loans and bad assets must be written off or restructured. Effective financial regulation needs to be re-introduced. Then radical Keynesian stimulus needs to be conducted to bring down unemployment.
In the absence of such policies, the most likely scenario for the West will be debt deflation and low growth for many years, possibly like Japan’s lost decade in the 1990s. Japan itself tried quantitative easing from 2001–2006, with the monetary base in Japan rising by 70%. The Bank of Japan increased the base money from about 65 trillion yen in 2001 to 110 trillion yen by 2006. But no hyperinflation ever resulted: in fact, deflation continued for some years after 2001 in Japan.
In fact, Japan offers the West some stark lessons. Japan suffered from a property bubble in the late 1980s and early 1990s (after ill-advised financial deregulation), and that bubble burst. Japan then endured the lost decade from 1992–2003. Though the causes of it are hotly debated, it seems clear that debt deflation, a zombie banking system infected by non-performing loans and bad assets, and an overvalued currency crippled the economy. The economy was on life support, and was saved by intermittent use of Keynesian stimulus, which, when done properly (as in the case of 1995 stimulus package), worked well (for the myth that Keynesianism did not work in Japan in the 1990s, see Posen 1998: 29–54 and R. Katz, “The Truth About Japanese Stimulus, Fiscal pump-priming can work to revive the economy,” January 16, 2009).
But the real lesson from Japan is that debt deflation and a zombie banking system must be fixed before an economy can function properly, and Japan did not really address the problem of bad bank assets until after 2002 with the Takenaka Plan.
One other important point should be stressed: Japan is an export-led growth economy. The yen was clearly overvalued for much of the 1990s (see Lok Sang Ho, “The Moral of Japan’s Lost Decade,” February 24, 2009). The low interest rate policy pursued by the Bank of Japan and its later turn to QE helped to cause depreciation of the yen through the carry trade, which allowed export competitiveness to be restored by the early 2000s. This was no doubt a factor in economic recovery that ended the lost decade. But QE in Japan did not stimulate domestic aggregate demand to a significant extent, nor did the broad money stock rise proportionally or significantly, just because the base money was inflated by QE. Instead, deflation continued until 2006.
It is possible that with austerity the US or UK might even slip into deflation again, although the demand for primary commodities from China and other developing nations which are factor inputs for the West will probably keep inflation mild to moderate.
Another factor ignored by those who predicted hyperinflation is that such a phenomenon generally requires a severe loss of confidence in a currency as a store of value, and this can be quite independent of the changes in the money supply (for an excellent account of hyperinflation and the Weimar episode, see Rob Parenteau, “The Hyperinflation Hyperventalists,” New Economic Perspectives Blog, March 22, 2010; and the Richebächer Letter, Number 417, June 2009, p. 4ff.). Often terrible crises are required to cause hyperinflation, such as ruinous wars, supply shocks, blockades or sanctions, civil war or internal collapse. In Weimar Germany, the classic instance of hyperinflation, there was
(1) a supply shock caused by WWI and the loss of productive capacity and output, made worse by the occupation of the Ruhr Valley in 1923;It is obvious that these factors do not apply to the US or the UK. There have been no savage supply shocks affecting production in America or Britain; instead, there is significant unused capacity in these countries. Although there has been significant depreciation of the pound sterling and the US dollar, that is simply not the same thing as a collapse of the currency. Nor are budget deficits in either country anything like Weimar Germany: in fiscal year 2010, the US budget deficit was 9.1% of GDP and is projected to fall to 7% of GDP in fiscal year 2011. In the UK, the budget deficit for 2010 was about 12% of GDP. Neither the US nor the UK is being invaded, and the wars in Iraq and Afghanistan are confined to those countries. In short, the factors that applied to Weimar Germany do not apply to the US or the UK.
(2) huge war reparations and budget deficits (in 1919, for example, the German budget deficit was perhaps as high as 50% of GDP); and
(3) exchange rate collapse.
In November 2010, the Fed announced a second round of quantitative easing (QE2), in which it would buy up to $900 billion of US Treasuries by quarter 3 of 2011. What are we to make of this? The first round of QE failed to stimulate aggregate demand and end high US involuntary unemployment, and I expect the second round will as well.
But the zero interest rate policy (ZIRP) in the US, of which QE is a part, will probably encourage more speculation in equities and commodities, and the US dollar carry trade. However, it is US dollars in the money markets which will be mainly used in these speculative and carry trade activities. Most of the new excess reserves created by QE2 will probably remain at the Fed, just as most of the base money created in QE1 has stayed at the Fed. We must remember that base money went from $800 billion in 2008 to about 2 trillion in early 2010, and has hovered around $2 trillion ever since. The $1.2 trillion created in QE1 has not entered the economy, but has been held by the banks as excess reserves.
A worst case scenario that is a possibility is that the US zero interest rate policy could fuel speculation in energy and commodities (particularly ones that are important factor inputs), which, combined with demand from emerging economies, might cause double digit inflation.
But, even with QE2, the idea that hyperinflation is on the way remains absurd: it is nonsense from people who are, moreover, clueless about how the modern monetary system actually functions.
Steve Keen, “The Roving Cavaliers of Credit,” Debtdeflation.com, January 31, 2009.
This is a classic essay from Steve Keen on endogenous money in the context of 2008 financial crisis.
Bill Mitchell, “Quantitative Easing 101,” March 13th, 2009.
Bill Mitchell analyses quantitative easing, refuting some myths about it and showing its limitations.
Bill Mitchell, “Zimbabwe for Hyperventilators 101,” July 29th, 2009.
Another excellent post from Bill Mitchell on hyperinflation in Zimbabwe.
Bill Mitchell, “Building bank reserves will not expand credit,” December 13th, 2009.
Without appropriate demand for debt from the private sector, increasing bank reserves does not cause equal, or even significant, expansion of credit.
NOTE: US DOLLAR COLLAPSE?
Another prediction that was widely heard last July (2010) was that the US dollar would collapse in 6 months. The date for this “prediction” is rapidly approaching, and I expect it will be as embarrassingly wrong as the prediction that hyperinflation was 100% certain. A look at the trade-weighted US dollar index shows that the dollar’s value is in fact higher than the nadir it reached in 2008. Some are now expecting a US dollar rally in 2011.
Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267.
Fontana, G. 2003. “Post Keynesian Approaches to Endogenous Money: A Time Framework Explanation,” Review of Political Economy 15.3: 291–314.
Howells, P. 2006. “The Endogeneity of Money: Empirical Evidence,” in P. Arestis and M. Sawyer (eds), A Handbook of Alternative Monetary Economics, Edward Elgar, Cheltenham, UK and Northampton, Mass. 52–68.
Kaldor, N. 1982. The Scourge of Monetarism, Oxford University Press, Oxford and New York.
Moore, B. J. 1988. Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge University Press, Cambridge and New York.
Palley, T. I., 2002, “Endogenous Money: What It is and Why It Matters,” Metroeconomica 53: 152–180.
Piegay, P. 2003. “Post Keynesian Controversies on Endogenous Money: An Alternative Interpretation,” in L.-P. Rochon and S. Rossi (eds), Modern Theories of Money: The Nature and Role of Money in Capitalist Economies, Edward Elgar Publishing, Cheltenham, UK and Northampton, Mass. 246–264.
Posen, A. S. 1998. Restoring Japan’s Economic Growth, Institute for International Economics, Washington, D.C.
Rochon, L.-P. 2003, “On Money and Endogenous Money: Post Keynesian and Circulation Theories,” in L.-P. Rochon and S. Rossi (eds), Modern Theories of Money: The Nature and Role of Money in Capitalist Economies, Edward Elgar Publishing. 155–172.
Targetti, F, and A.P. Thirlwall (eds), 1989. The Essential Kaldor, Duckworth, London.
Wray, L. R., 1990, Money and Credit in Capitalist Economies: The Endogenous Money Approach, E. Elgar, Aldershot, Hants, England and Brookfield, Vt., USA.
Wray, L. R., 1998, Understanding Modern Money: The Key to Full Employment and Price Stability, Edward Elgar, Cheltenham.
Wray, L. R. 2003, “Monetary Policy: An Institutionalist Analysis,” in Marc R. Tool and Paul Dale Bush (eds), Institutional Analysis and Economic Policy, Kluwer Academic Publishers, Norwell, Mass. 85–114.
Thanks for this excellent piece. I am also checking out Steve Keen's blog and thanks for linking to it.ReplyDelete
Why exactly is debt deflation a problem, if you could elaborate on that? Is it a bad thing if banks start recalling loans, especially when the crisis involved many bad loans made by banks in the first place? That's where a layman like me gets a little confused.
Why exactly is debt deflation a problem, if you could elaborate on that?ReplyDelete
Of course, deflation itself is not always associated with recession or depression.
But, under certain circumstances, debt deflation, after the collapse of a huge asset bubble in an economy saturated with excessive private debt, is the fundamental cause of depressions. In economies where aggregate demand has been pumped up by private debt, deleveraging and the fall in debt causes recession, and, without intervention, will lead to a vicious debt deflationary spiral – especially if the financial system is allowed to collapse.
It is a process like this:
(1) High debt levels and asset bubble before deflation
(2) collapse of asset bubble
(3) A recession (for example, caused in part by the collapse of a bubble)
(4) Significant falls in aggregate demand and distress selling of assets (e.g., houses)
(6) Long-term, unexpected and severe deflation in goods produced in an economy
(7) Significant falls in profits, business failures, difficulty in servicing debt
(8) Higher unemployment, more business failures, cuts to wages and deflation
(9) Further collapses in demand
(10) Then back to (7), (8), (9) etc above.
I recommend Irving Fisher’s classic study:
Fisher, I. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.
Fisher’s insights have been developed by Post Keynesian economists, the most important of whom was Hyman Minsky:
Minsky, H.P. 1982. Can “It” Happen Again?, M.E. Sharpe, Armonk, NY.
Minsky, H.P. 1986. Stabilizing an Unstable Economy, Yale University Press, New Haven.
Ah, I see, it's a spiral. But is it a never ending spiral? Is there a ground till which it can touch?ReplyDelete
I am reading Irving Fisher's study at http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf, and it explains how price deflation can cause debt deflation and debt deflation can cause price deflation, and how a business cycle is not just one cycle but various cycles and various factors acting together, independently or not. Very revealing.
He says the natural end to a depression comes after nearly universal bankruptcy and unemployment - situation difficult to fathom since I have never heard of it happen in practice. It contradicts the conventional wisdom I acquired from reading Joseph Schumpeter's idea of creative destruction, who says that failure is a necessary part of business (UK just had several newspapers shut doors, even as nine others compete aggressively with even more circulation). Where Fisher says that it is cruel to allow almost endless bankruptcies to go on until things get better, can one also not consider that bankruptcies keep happening in times of boom and that they are necessary for further flowering of business?
If endless failure, loss, and bankruptcy has allowed better investment and better quality products to end consumers in the history of business, why can't that apply to depressions?
And when debt becomes more expensive due to deflation, does that not take care of moral hazard and adverse selection problems?
Especially when bad loans were being made due to, as Fisher says, lure of big gains and reckless promotions?
But is it a never ending spiral? Is there a ground till which it can touch?ReplyDelete
Of course. History shows the worst depressions end in mass unemployment (20-30%) and a 25% to 30% collapse in GDP. Horrific.
Where Fisher says that it is cruel to allow almost endless bankruptcies to go on until things get better, can one also not consider that bankruptcies keep happening in times of boom and that they are necessary for further flowering of business?
Bankruptcies in normal times are not a problem. Mass bankruptcies during a depression are mostly unnecessary, and a ridiculous destruction of otherwise productive capital.
He says the natural end to a depression comes after nearly universal bankruptcy and unemployment - situation difficult to fathom since I have never heard of it happen in practice.
Try looking at Australia’s depression in the 1890s. It is a very good example of what Fisher is talking about.
Fisher’s actual words, by the way:
“Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”
The words “after almost universal bankruptcy” are of course a piece of rhetoric, perhaps a bit over the top. Can you not see that?
What he means is: after “a very large and devastating number of bankruptcies.”
He is completely correct, too.
Especially when bad loans were being made due to, as Fisher says, lure of big gains and reckless promotions?
Non-performing loans and bad assets can be cleared without causing a depression (e.g., by asset management companies buying bad mortgages or assets, and also by writing off and restructuring debt). To stop poor lending practises in the first place you need effective financial regulation. We had such a system before the 1980s. Then the neoliberals and New Classicals dismantled it, and set up their own severely flawed system of regulation.
Some information on Australia's 1890s depression:ReplyDelete
Australia had no central bank and a “free” banking system in the 19th century.
How did that system end? There was a massive property and stock market bubble in the 1880s which collapsed in 1890/91. The depression that followed went on for years and was probably worse than Australia’s Great Depression in the 1930s.
Unfortunately, there was no “evil” central bank or regulated banks to blame for this. It was entirely a free market failure.
The depression lasted from 1892-1894, but involuntary unemployment and stagnation continued until 1899.
Real GDP fell by around 10% in 1892, and 7% in 1893. There was sustained deflation of more than 20% from 1891 to 1897 in retail prices.
Charles R. Hickson and John D. Turner, 2002, “Free Banking Gone Awry: The Australian
Banking Crisis of 1893,” Financial History Review 9: 147–167.
I feel guilty for making this cheap argument, since even I myself don't believe it much, but could the unemployment in Australia have been caused by the wages being higher than the marginal product of unemployed workers? The Wiki article mentions powerful trade unions in Australia, and...well, I don't need to go further.ReplyDelete
It's been the opinion of one or two economists that America's Great Depression was partly aggravated by labour unions refusing to allow wages to fall below marginal product, thus forcing businesses to hire fewer people. It's not a very convincing argument, but I wonder what you think about it.
I think that, in most cases, the unique difference between a liquidationist and an anti-liquidationist are their political beliefs.ReplyDelete
Besides that, I see that (apart from the Austrians) nobody cares about such things as the "structure of production" and the "lengthening of production". This is what they mean when they say they want a "sound recovery".
Besides that, I see that (apart from the Austrians) nobody cares about such things as the "structure of production" and the "lengthening of production".ReplyDelete
Austrian business cycle theory (ABCT) is flawed.
There is no convincing reason to think ABCT explains the business cycle.
but could the unemployment in Australia have been caused by the wages being higher than the marginal product of unemployed workers?ReplyDelete
Not likely. The power of unions in that period was weak, not strong; and the state responded with violence and repression to the strikes, smashing the labour movement:
Rodney Maddock and Ian W. McLean, Australian economy in the long run, CUP Archive, 1987, p. 249
Wages were high by international standards because of labour scarcity, not union power.
More, real wages fell in the 1890s - the labour unrest by unions were a response to their falling wages.
There seems to be an Austrian, neoclassical or free market bent to your comments.
Moreover, real wages fell ...
Yes yes, I can not deny that I was ingrained with biases when I was young. You see, I was only 14 when I read Henry Hazlitt's Economics In One Lesson. Only 14! It was also in my teenage years that I read books by Thomas Sowell. I thought all economists were free marketers, and I thought all academic debate was only between within the scope of that. Many economics books for non-economics specialists had that bent.ReplyDelete
(I started feeling something was wrong when I first read Sowell say, "I know people who are blind or retarded who nevertheless have jobs. So you can imagine how much sympathy I have for able-bodied men who are begging on the streets.")
I try to come out of it, and I try to disregard what may have already been put into my mind and start over. These days, I try to see what other schools think. One has to hear firsthand what other groups think, because each group has many strawmen about what the other group thinks.
I regard myself as a layman in economics, being mostly an enthusiast of finance (CAPM, Black-Scholes,.etc), and I leave it to those actually learned in economics to teach me. Blogs like these are an excellent learning opportunity.
Hi. I'm constantly arguing with Austrians (libertarians) online but there is little in the way of criticism. I was just wondering if you could explain why free markets are not self correcting. Austrian claim they are. How are they wrong? Also, why are free markets destabilizing in the first place? Thanks in advance and thank you for this wonderful blog.ReplyDelete
I was just wondering if you could explain why free markets are not self correcting.ReplyDelete
Well, the neoclassicals think markets will tend to equilibrium and full employment, with their neo-Walrasian fables. But their theory is quite different from Austrian economics.
The Austrians reject the neoclassical concept of equilibrium, but then sneak it in through the backdoor in the form of their concept of plan/pattern co-ordination.
On why they are wrong, try reading this:
The fundamental uncertainty we face about the future renders their ideas about pattern co-ordination absurd.
A longer answer would stress that Say's law is also a complete myth:
Moreover, unregulated financial markets in capitalist economies are inherently unstable, as argued by Hyman Minsky.
So, to answer you question, free markets are not self-correcting, because of
(1) ontological uncertainty
(2) Say's law does not work, and
(3) financial markets are unstable.
To the anonymous poster, I would simply point out that there is no such thing as a guarantee of self-correction. Nobody can predict the future. Moreover, self-correcting in what sense? Edmund Burke, a politician, once said there is no such thing as a high price of wheat or a low price of wheat, there is just the price of wheat. Whether you like it or not is irrelevant; but the price of wheat being the price of wheat is just the reality of the situation.ReplyDelete
Now, this is more of metaphysics than economics, but utilitarian calculus is just impossible. A policy decision always has tradeoffs, and there is no way for anybody to argue that after a given course of action, everybody as a whole will be better off. We don't even know what the consequences will be, and they could be dangerous.
All in all, the burden of proof does not lie upon "free markets" or those who propose to do nothing. The burden of proof lies upon those who propose to do something, and their task is going to be harder than those who propose to do nothing. (That's not to say doing nothing is the best option, but who in this world knows?)
It amuses me that believers in the Austrian Apocalypse (hyperinflation) tend to dismiss other people's versions of doomsday, like the global warming apocalypse, as Chicken Little stuff. "No, we want the Apocalypse to support our beliefs, dammit! not those other guys' crazy notions!"ReplyDelete
"So, to answer you question, free markets are not self-correcting, because ofReplyDelete
(1) ontological uncertainty
(2) Say's law does not work, and
(3) financial markets are unstable."
I was always expecting something like this from Lord Keynes, thanks for the summary!
I may add that (3) is a consequence of (1). Also, as far as I'm concerned, Kirzner tries to defend the free market with his theory of "entrepreneurial discovery" (I think it's not really a discovery, but more like a creation), so the free market's stability heavily relies on the *correct* decisions made by the entrepreneurs, and that may not be a very sound reason. But as Prateek Sanjay said:
"All in all, the burden of proof does not lie upon "free markets" or those who propose to do nothing. The burden of proof lies upon those who propose to do something, and their task is going to be harder than those who propose to do nothing."
In other words, how can we know that the interventions will have better outcomes? I think that in order to solve that, we need some kind of objective parameter, and there isn't.
"All in all, the burden of proof does not lie upon "free markets" or those who propose to do nothing.ReplyDelete
This is a non sequitur. If you're assuming here that the Austrian idea of pattern/plan co-ordination is true, then you're just begging the question too.
Well-designed interventions reduce uncertainty.
Here is a perfect example.
Take the financial crisis of 2008: government interventions that prevented the collapse of the financial system and a depression reduced uncertainty.
What was the financial crises? A crisis of confidence in the banks and the presence of extreme uncertainty, in that banks doubted the solvency of other banks. That is why they stopped lending to each other, and the interbank lending markets froze up in late 2008.
The interventions restored confidence and liquidity, and interbank lending resumed.
Keynesian government interventions, by and large, serve to reduce uncertainty too, say, by preventing debt deflation, severe economic contraction, and mass unemployment.
In other words, how can we know that the interventions will have better outcomes?
By using either:
(1) inductive arguments in support of Keynesian/interventionist policies (if you think induction can be defended rationally), or
(2) the Popperian hypothetico-deductive method, with falsification (not verification) of Keynesian hypotheses by empirical evidence.
My philosophical defense of government intervention can be found here:
The Austrians believe in epistemological uncertainty, not ontological uncertainty (as in Post Keynesian economics).
The Austrians think there is some kind of market process analogous to evolution by natural selection that produces pattern/plan co-ordination in the free market (their version of the neoclassical concept of “equilibrium”).
But in the face of ontological uncertainty and subjective expectations that argument just doesn’t work.
As I understand, you are speaking of the unknown unknowns?ReplyDelete
It's sort of similar to what is explained in finance, under "Variance At Risk". Some people were once asked to make a statement saying "I am 95% certain the value of X will be between L1 and L2." In the experiment, the 5% margin of error came up 45% of the time. They were wrong half the time about what they were completely sure about, because there were some things they did not know they knew. Some things they knew they knew, some things they knew they did not know, and some things not even that. It's not possible to calculate probabilities.
And because there are unknown unknowns, we all just work by casuitry and taking reckless leaps. Sure, I buy that fully. But that can backfire in the direction of the technocrats, right? Even they don't know what they don't know.
A businessman only loses his own wallet. The technocrats could cause great damage to thousands of households from an unknown factor suddenly coming in.
The interventions of today's crises may not cause problems now. Or the next year. Or in ten years. But if they cause another kind of severe problem in 20 years? Current technocrats do not pay the price for it.
eg. One economist pointed out that guarantee of bank deposits by government in the 1930s led to huge losses by banks covered by taxpayers in the 1960s, because of gradually rising bad lending practices.
The interventions of today's crises may not cause problems now. Or the next year. Or in ten years. But if they cause another kind of severe problem in 20 years? Current technocrats do not pay the price for it.ReplyDelete
You are saying that you cannot do anything now for fear that there might possibly be some bad, unforseen problem in 20 or 30 years time??
If this argument were remotely serious, it would cause all people (in private or public decision making) to stop doing ANYTHING whatsoever, for fear of possible unforseen consequences. No private investment would be possible or any private business activity at all, under such an argument. And even doing nothing would have "possible unforseen consequences" too, so that would not really help.
For god's sake, you might as well make that this argument against leaving your own home ever agin, for fear that walking down to the local shop might cause "possible but unforseen consequences" 20 or 30 years from now.
This is a ridiculous piece of sophistry.
I have recently seen this excellent post from L. Randall Wray on the New Economic Perspectives blog:ReplyDelete
Private decision making is different from public decision making, is it not?ReplyDelete
The former concerns costs of mistakes to be borne by just the decision-maker and his affiliates. The latter concerns a cost to be borne by everybody but the decision-maker.
My own parents have been running a small business for a decade, and they have been trying to raise funds from venture capital to expand it. The principle of conservatism is always at work, where we overestimate future costs and underestimate future sales in our projections shown to them. The investors do not commit any capital for more than six months to two years, and then they see whether we achieved any milestone, and then they see whether they will invest more or not at all. These investments keep coming in small amounts. That's because everything beyond the short term is uncertain, but what is certain is that there will be costs. So yes, private businesses are wary about what may happen in even five or ten years, which is why they don't commit to that period, but a smaller one.
It's not sophistry or posturing. Franklin Delanore Roosevelt of the United States was not a literate on finance, and without having known moral hazard and adverse selection, he approved guarantee of bank deposits. It led to $200 billion being used to bail out banks in the 1980s savings-and-loans crisis. Not to mention all the gradually increasing losses to be covered by government in the 1960s. Just because Roosevelt wasn't alive to see it does not mean he should not have considered he will cause such a huge loss to taxpayers from such an expensive guarantee.
You're changing the subject. Your original comment:ReplyDelete
The interventions of today's crises may not cause problems now. Or the next year. Or in ten years. But if they cause another kind of severe problem in 20 years? Current technocrats do not pay the price for it
Your argument appears to be that the possible bad and unforeseen consequences of an action in 10 or 20 years time is an argument against such action.
If so, that would apply to both private and public decisions.
E.g., a businessman may make a decision now and sell his business in 3 or 4 years and no longer be the owner of it, when the "possible bad and unforeseen consequences of his action" have effect 20 years later.
And what sort of morality blames people for the unforeseen and possible bad consequences of an action in 10 or 20 years time??
E.g., if I see a drowning man, and save that man, are you telling me am I morally to blame if that man commits murder 20 years after I rescue him??
Of course I am not. To believe so is utterly ridiculous.
So, too, a private or public decision made today that has an utterly unforeseen bad consequence 20 years from now is not the moral fault of the original decision maker, whether it is a private businessman or government planner. The most that can be done is to take action in future decisions, if at all possible, to prevent such unforeseen bad effects.
Private decision making is different from public decision making, is it not?
The differences are exaggerated. Public decision making has multiple mechanisms that make people accountable: courts, police, voters, newspapers, international legal principles and organizations, and private watchdogs.
The former concerns costs of mistakes to be borne by just the decision-maker and his affiliates.
Wrong. Bad decisions by private businesses can have bad effects on thousands or even millions of people. These are called “negative externalities.”
Witness the effects of liar’s loans, NINJA loans and reckless lending by banks on the property bubble in the US from 2001–2007. The huge bubble caused by this private activity caused a major financial crisis and recession, throwing millions out of work. And you say that “private decision making” only results in costs to “just the decision-maker and his affiliates”?
Franklin … Roosevelt of the United States was not a literate on finance, and without having known moral hazard and adverse selection, he approved guarantee of bank deposits. It led to $200 billion being used to bail out banks in the 1980s savings-and-loans crisis.ReplyDelete
Your knowledge of history is inaccurate. Roosevelt’s system of financial regulation was very effective. It was modified and attacked by New Classical and neoliberal ideologues after about 198o, and was made deeply dysfunctional.
The main legislative acts were as follows:
Depository Institutions Deregulation and
Monetary Control Act (1980)
Garn–St. Germain Depository Institutions Act (1982)
These were major contributors to the Savings and Loan crisis.
Further neoliberal acts that attacked Roosevelt’s system:
Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)
Financial Services Modernization Act of (1999), also called the Gramm-Leach-Bliley Act
Commodity Futures Modernization Act (2000).
The SEC’s Voluntary Regulation Regime for Investment Banks (2004)
I'll look these up, thanks.ReplyDelete
What exactly is this word "neoliberal"? I keep seeing columnist Alexander Cockburn using it. Indian magazines also use it as some broad all-encompassing word for everything they dislike.
I am sure there was once some specific concrete meaning of this word, but these days, it's like what George Orwell says - people want to use words instead of specific statements to avoid debate. Here in India, everything bad is neoliberal, so when a journalist calls something neoliberal (like government storage of food), it automatically becomes a bad thing, with no further elaboration needed.
What exactly is this word "neoliberal"?ReplyDelete
"Neoliberal" refers to the mainstream economic policies that were adopted by governments and international institutions (like the IMF, World Bank and World trade organization) after 1980.
In terms of macroeocnomic theory, it refers to the "new consensus macroeconomics" - what you find taught in university economics departments - that emerged from Milton Friedman's monetarism, the New Classical economics, and the "New Keynesian" economics. It is essentially a resugence of neo-Walrasian neoclassical theory. Its policy mix is often described as "globalization" or the "Washington consensus."
This displaced the neoclassical synthesis Keynesianism and (non-neoclassical) Post Keynesianism that was dominant from 1945 to about 1979.
Classical Keynesianism came in 2 forms.
I advocate the non-neoclassical, heterodox Post Keynesianism tradition.
Prateek, it's same in Europe here, neoliberal is always used pejoratively whenever it is publicly used, no politician ever wants to be called neoliberal. It's funny because "liberal" here means free marketers, but even they never call themselves "neoliberal", always just "liberal". And "keynesian" is pretty much neutral.ReplyDelete