Quote of the Week...

...is from Roger Garrison’s Time and Money (2007):

In response to the question "What about expectations?", we get New Classical monetary misperception theory, real business cycle theory, and new Keynesian theory. This is the state of modern macroeconomics. While each of these theories include rigorous demonstrations that the assumptions about expectations are consistent with the theory itself, none are accompanied by persuasive reasons for believing that there is a connection between the theoretical construct and the actual performance of the economy over a sequence of booms and busts. Applicability has been sacrificed to rigor. The Keynesian spur has led us to this dead end.

Time and Money is one of several assigned books for my macroeconomics course this semester. The second chapter displays Garrison’s strong grasp of other modern macro theories and their unfortunate divergence from trying to model/explain the world as we know it. Having only read through chapter three, which begins to lay out the foundation of Austrian Business Cycle Theory (ABCT), I’ve already come across several discrepancies with modern monetary operations. In forthcoming posts, I hope to address these disagreements and outline a new theory that combines the positive features of Post-Keynesian monetary economics and Austrian capital theory.

 
Bibliography
Roger W. Garrison (2007-03-16). Time and Money (Routledge Foundations of the Market Economy) (Kindle Locations 801-806). Taylor & Francis. Kindle Edition.

Inequality Really Is Holding Back the Recovery

A couple weeks ago Nobel Laureate Joseph Stiglitz generated a heated debate among economists by claiming “Inequality Is Holding Back the Recovery.” Paul Krugman, another Nobel Laureate who is normally on Stiglitz’s side in these debates, actually took a somewhat opposing position:

First, Joe offers a version of the “underconsumption” hypothesis, basically that the rich spend too little of their income. This hypothesis has a long history — but it also has well-known theoretical and empirical problems.

It’s true that at any given point in time the rich have much higher savings rates than the poor. Since Milton Friedman, however, we’ve know that this fact is to an important degree a sort of statistical illusion. Consumer spending tends to reflect expected income over an extended period. If you take a sample of people with high incomes, you will disproportionally include people who are having an especially good year, and will therefore be saving a lot; correspondingly, a sample of people with low incomes will include many having a particularly bad year, and hence living off savings. So the cross-sectional evidence on saving doesn’t tell you that a sustained higher concentration of incomes at the top will lead to higher savings; it really tells you nothing at all about what will happen.

So you turn to the data. We all know that personal saving dropped as inequality rose; but maybe the rich were in effect having corporations save on their behalf. So look at overall private saving as a share of GDP:

The trend before the crisis was down, not up — and that surge with the crisis clearly wasn’t driven by a surge in inequality.

Not convinced by Krugman’s analysis, Arthur Shipman considers other potential reasons that gross saving might have fallen in response to rising inequality. As he wisely points out, the above trend is reminiscent of the change in inflation rates:
and even more so, the pattern of interest rates:
Still unsatisfied, Arthur concludes:

So are there a lot of explanations for why Krugman's graph goes up and down?

There must be.

While I won’t disagree with Arthur’s conclusion, I think a potentially satisfying explanation does exist if one disaggregates gross private saving.

Gross private saving = personal saving + wage accruals less disbursements + consumption of fixed capital (domestic business + households and institutions) + undistributed corporate profits with inventory valuation and capital consumption adjustments.

Using interactive data from the Bureau of Economic Analysis, Krugman’s chart can be recreated to depict each of the disaggregated measures as a percentage of GDP:

This chart makes it patently obvious that the sharp swings in gross private saving, as a percentage of GDP, are almost entirely due to changes in personal saving and undistributed corporate profits with inventory valuation and capital consumption adjustments.

Specifically focusing attention on the period from the mid-1980’s up to the recent crisis, the entire decline in gross private saving is basically due to declining personal saving. Can this observation be reconciled with rising inequality during the same time period?

In my view, the staggering fall in personal saving can not only be reconciled with rising inequality but also with declining inflation and interest rates. Rising income and wealth inequality starting in the 1980’s meant that many households could no longer maintain relative levels of consumption based solely on disposable income. Assuming this trend would not persist indefinitely, or maybe just unwilling to lower relative consumption, a proportion of households either drew upon previous savings or sought out loans (new debt) to temporarily raise consumption. As the upward trend in inequality persisted, more households elected to reduce savings or, having exhausted their savings, increase demand for debt.
Coincidently, inflation and interest rates were steadily declining during these years. Combined with numerous new debt subsidies and implicitly increasing federal backing, banks were all too eager to meet the rising demand for credit. This explosive expansion of credit is readily apparent in the following chart of household debt to GDP:

The concurrent drawing down of savings and growing stock of outstanding debt among households provides a very straightforward explanation for how inequality drove the observed decline in personal saving.

Returning to the disaggregated chart of saving as a percentage of GDP, the reasons behind the sharp rise during and after the recent crisis are also much clearer. On the household side, declining home values and rising unemployment clearly brought about a shift in personal saving. Having already amassed a large stock of debt, households were pressured to increase saving in order to meet the principal and interest payments coming due. Furthermore, recognition by many households that previous saving was insufficient for present retirement plans may have added to the rise in personal saving.

Switching to the corporate side, the change in undistributed corporate profits can also be disaggregated into its distinct parts:

The recent crisis saw an unparalleled fall and rise in undistributed corporate profits that returned the percentage to heights previously witnessed only briefly sixty years ago. It’s also worth noting that undistributed corporate profits had risen significantly following the bursting of the dot-com bubble. Contrary to Krugman’s claim, this suggests wealthy households were and are continuing to use corporations as a means of effective saving.  

By disaggregating the data for gross private savings, the drivers behind the large fluctuations and trends become increasingly apparent. This data is consistent with rising income and wealth inequality but requires reversing Stiglitz’s “underconsumption” hypothesis. Trying to maintain relative consumption levels, many households clearly chose to rely on previous savings or new debt as a means of temporarily boosting consumption. As inequality continues to rise, wealthy households are now electing to retain more of their savings within corporations. It doesn’t take a leap of faith to suggest this combination of factors depresses aggregate demand. Stiglitz is therefore correct in concluding:

Now we realize that we are paying a high price for our inequality and that alleviating it and promoting growth are intertwined, complementary goals. It will be up to all of us — our leaders included — to muster the courage and foresight to finally treat this beleaguering malady.

Probability Theory vs. Knightian Uncertainty: Is It Simply Semantics?

My Micro II course this semester is being taught by Bryan Caplan, who many readers may recognize as a frequent blogger over at EconLog. As an introduction to the course, the initial assigned readings included Caplan’s papers, “The Austrian Search for Realistic Foundations” and "Probability, Common Sense, and Realism: A Reply to Hülsmann and Block." The latter paper is a reply to Austrian criticisms of claims made in the former. Although the former paper’s focus on microeconomic discrepancies between Austrians and neoclassicals was personally intriguing (since I normally think along macro lines), the latter paper raises questions worth addressing.

Caplan’s reply can seemingly be divided into two distinct halves: the first half attempts “to spell out the philosophical side of [his] original thesis in greater depth” (p. 69) and the second half directly responds to the numerous critiques. Since Caplan is especially adept at undermining the validity of these critiques, the ensuing discussion will be directed solely at the first half of his paper.  

The paper begins by furthering discussion of probability as it relates to the Austrian-Neoclassical divide:

In Caplan (1999), my central counter to the full-blown Misesian rejection of quantifiable probability was a reductio ad absurdum. If we cannot quantify the probability of an “individual, unique, and nonrepeatable” (Mises 1966, p. 111) event, then we can never quantify probability at all, because strictly speaking, all events are “individual, unique, and nonrepeatable.” Naturally, though, this reductio is only persuasive if, ex ante, you acknowledge the absurdity of rejecting all real-world applications of probability theory.2 (p. 70)

Reading this passage for the first time I wondered, are the quantifiable probabilities being subjectively or objectively determined? Based on my previous readings of Mises’ and general perception about the debate, I presume Caplan is referencing subjective probabilities. However, as I understand the typical Austrian position, the trouble with subjective probabilities is not that they can’t be or aren’t formed. The issue is that, ex ante, it remains unclear and possibly unknowable how accurately those estimates will align with future observed outcomes. When predictions diverge from realistic probabilities, the chance of human action working against a desired end rises along with the likelihood of disequilibrium states.

Only a few pages later Caplan sufficiently answers this question while clarifying an important, yet often overlooked, distinction within neoclassical economics:

this conflates a fundamental tenet of neoclassicism—subjective-but-quantifiable probabilities—with a popular subsidiary neoclassical hypothesis—rational expectations (1997, p. 56). Rational expectations is a hypothesis linking subjective-but-quantifiable probabilities to objective frequencies. Empirical evidence of systematically mistaken beliefs (Caplan 2001a) counts only against rational expectations, not probability. (p. 73)

Personally I was caught a bit off guard by this neoclassical division since my subjective experiences suggest practically all neoclassical economists currently adhere to rational expectations. Whether this perception is due to my proclivity for macroeconomics or sampling bias remains an open question. Regardless, it was precisely this view about neoclassical (mainstream) economics that drove me away from the discipline in my undergraduate years and towards Lachmann’s radical uncertainty more recently.

Although Caplan is trying to disprove the existence of radical (Knightian) uncertainty, specifying his neoclassical position garnered my full attention. Extending his original argument against uncertainty and in favor probability theory, Caplan appeals to our common sense:

The basic principles of probability are simply self-evident. It is self-evident that one holds beliefs with some degree of certainty.3 It is self-evident that the degree of belief must vary from impossible to certain. (p. 70-71)

Denying the truth in these self-evident claims would be foolish, yet I still fail to see how these statements lead to the conclusion that “Knightian uncertainty is incoherent.” (p. 75) Strangely enough, a similar appeal to common sense may help show why the two concepts are not mutually exclusive.

As I understand it, Knightian (radical) uncertainty refers to the actual experience of outcomes that were previously unforeseeable. Caplan doesn’t appear to disregard this possibility, but instead claims this is effectively the same as having “a perceived probability of 0.” (p. 73) This appears to relegate the disagreement to one of mere semantics, but a little introspection suggests otherwise. Have you ever heard someone state the following?

“That possibility never crossed my mind.”
“I had not considered that possibility.”
“If I had known that was possible...”

Assuming your answer is yes, it is self-evident that one believes possibilities exist that were previously unconsidered. It is also self-evident that some events seem unpredictable. Therefore it is equally self-evident that true uncertainty exists.

Contrary to Caplan’s conclusion, Knightian uncertainty and “the basics of probability theory are self-evident and, rightly understood, are highly intuitive.” (p. 75) The seemingly semantic differences in effective behavior appear to be borne out by subjective experience. Ultimately these infrequent instances, though providing a sharp critique of rational expectations, fail to either contradict or materially add to probability theory. I’m therefore resigned to agree with Caplan that “any attempt to deny probability theory inevitably winds up presupposing it.” (p. 75)



Note: Within this debate about probability theory versus Knightian uncertainty, Caplan also argues that “Mises is correct to point out that beliefs about the efficacy of action are implicit in action. But he at best misspeaks when he characterizes this necessary feature of action as knowledge of “causality.” Instead, the necessary belief component of action is weaker; we don’t need to know—or even believe we know—any exceptionless causal laws. We merely require beliefs about conditional probabilities. (p. 72) This leads Caplan to conclude that “probability theory deserves to take the place of causality as a fundamental implication of the action axiom.” (p. 75)
This view raises a much deeper philosophical question about human action. Unfortunately that conversation will be postponed to a later date. In the meantime, here are a couple questions to ponder...

Are beliefs about conditional probabilities and/or knowledge of “causality” actually necessary for action? Or, would an individual without those characteristics still act, but in an unforeseeable manner?

 
 

Quote of the Week...

...is from “The Economics of Exchange Rates and the Dollarization Debate: The Case against Extremes” by Thomas I. Palley:

Historically, the onus of defending the exchange rate has fallen on the country with a weakening exchange rate. This requires the country to sell foreign exchange reserves to protect the exchange rate. Such a system is fundamentally flawed, because countries have limited reserves, and the market knows it. This gives speculators an incentive to try and "break the bank" by shorting the weak currency, and they have a good shot at success given the scale of low-cost leverage that financial markets can muster. Recognizing this, the onus of exchange- rate intervention needs to be reversed so that the country with strong currency (the central bank with an appreciating exchange rate) is responsible for preventing appreciation, rather than the country with weak currency being responsible for preventing depreciation (Palley 2003). Because the bank with strong currency has unlimited amounts of its own currency for sale, it can never be beaten by the market. Consequently, once this rule of intervention is credibly adopted, speculators will back off, making the target exchange rate viable. Such a procedure recognizes and addresses the fundamental asymmetry between defending weak and strong currencies. (2003: p. 78-79) (emphasis added)

This quote and paper by Palley ties in nicely with an earlier post this week on “The Impossible Trinity or The Permanent Floor: Adding Modern Money to Mundell-Fleming.” Weak global economic growth and high unemployment continues to permit experimentation in monetary policy. While many economists have yet to fully comprehend the change to a floating fiat currency, even fewer appear to completely recognize the transformation currently taking place. Although this paper helped fulfill a current homework assignment, it’s also part of a broader literature review that will hopefully lead to my first publishable paper. My goal is to further establish these ideas in unison with the “Permanent Floor” in order to present recommendations for a more comprehensive global monetary framework. Wish me luck!

Teaching Austrians Endogenous Money

Last semester a couple PhD students in the economics program at George Mason started a Capital Theory Reading group. While the initial bi-weekly meetings were focused on Austrian Business Cycle Theory (ABCT), the discussion has more recently expanded beyond capital theory and into monetary theory. As the proponent of Post-Keynesian monetary economics among a group of Austrians, the conversation occasionally stalls when I try to explain the implications of endogenous money. The other students are, however, open to learning about endogenous money and we have collectively decided to make that subject the central theme of our next meeting.

This post (bleg) is a request for guidance in selecting the best and most appropriate readings to teach endogenous money to Austrians that are largely unfamiliar with the theory. What academic papers or book chapters would you recommend?

Thanks in advance for your help.