David R. Henderson  

Priceless Macro, Part One

Deficits ad Absurdum... The Case for McMedicine...

At a Carnegie-Rochester conference I attended over 30 years ago, when I was an assistant professor at the University of Rochester B-school, Arnold Harberger criticized a pile of economists' papers on Latin American development. One of his criticisms still stands out in my memory: the papers, he said, were "priceless." That is, they left out price theory or contradicted it. Much of macroeconomics is that way, especially the crude Keynesian macro that Paul Krugman is pushing.

An article that points that out beautifully is Robert Murphy's "Does 'Depression Economics' Change the Rules?" Krugman's answer is yes. Murphy's answer is no. In making the "no" case, Murphy brings in standard price theory. He points out that Krugman and fellow Keynesian Mark Thoma assume that when the government spends more on building some project, it will use resources that are otherwise idle. That assumption if false. Murphy writes:

Within the broad category of "labor" we find a similar situation, once we actually contemplate doing this project for real. If the city of Houston wants to build a new bridge, is it really the case that every last person even remotely involved with the project, will come from the ranks of the unemployed who are within commuting distance of the Houston bridge site? Surely the project will draw on engineers, construction foremen, and other skilled workers, who were still gainfully employed even amidst the recession, and who therefore will not be able to work on as many private-sector projects as they otherwise would have.
What is particularly ironic in this discussion of idle resources is that it is the pro-stimulus Keynesians who ought to be very fastidious in their recommendations for government spending projects. After all, if the whole point is to draw down resources that have been thrown out of work, then care should be taken to tailor the stimulus package for the resources in question. Is it really the case, for example, that bridges and roads require labor and other inputs in the same proportions as housing construction and finance? Does the construction of a new sewer system require the services of investment bankers and roof layers in such combinations that local government spending can perfectly offset the bursting of the housing bubble?

A little price theory, realizing, for example, that not all workers are perfect substitutes, would have gone a long way here.

Murphy also addresses why the resources are idle in the first place, pointing out the overexpansion in certain sectors of the economy. Although Murphy blames Greenspan, Jeff Hummel and I have said why we think that's unjustified. But you can unbundle Murphy's package. None of Murphy's points depend on whether the idle resources are due to Greenspan's monetary policy. What we know is that three sectors that need to shrink are housing, autos, and financial services. And guess what sectors the government is subsidizing.

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COMMENTS (14 to date)
Greg Ransom writes:

Either way -- China or the Fed -- it's still Hayek: Hayek explains both kinds of generators of the trade cycle in his _Monetary Theory and the Trade Cycle_.

And note well that Hayek includes housing as among non-permanent production resources discussed in his account of the micro of the trade cycle (see _The Pure Theory of Capital_).

You write:

"Murphy also addresses why the resources are idle in the first place, pointing out the overexpansion in certain sectors of the economy. Although Murphy blames Greenspan, Jeff Hummel and I have said why we think that's unjustified."

Carl The EconGuy writes:

So if three sectors were bubbled (housing, financial services, autos), and they collapsed because *perceived* (i.e., financial, not real) wealth took a nosedive, we have several logical problems to solve.

One, the theoretical one -- why is aggregate demand dependent on perceived and not real wealth? Keynesian theory will not help here at all.

Two, if price theory tells ud (I think correctly) that we need to reallocate resources to other sectors, where are the relative price signals coming from? Where is the effective demand for the goods/services that should be expanded in a new, more stable full employment equilibrium?

Three, if we are expanding effective demand through govt outlays, what does the financing of that do to private sector and export demand (C and I and X-M)? Ricardian theory, which has been pretty well validated empirically (see Kormendi's work, evaluated in a good survey article in JEL back in the 90s, also his and Protopadakis' recent expansion of that), suggests that deficit financing works just like taxation, i.e., it will displace some non-government demand.

These three questiond are the classical dilemmas for macro theory -- exactly the ones that Keynes wrestled with, and no one quite has resolved to out common satisfaction yet. Keynes resolved the last two by saying that even though the real wealth of the private sector was, in principle, sufficient to get us back to full employment after a heavy disturbance, the price mechanism could become incapacitated from signaling fast enough exactly which markets would need to expand. This is the Clower-Leijonhufvud theory of effective demand failure, using the generalized purchasing power of money as evidence of lack of specificity in the demand changes that should tell private sector producers where to go next. Keynes' solution was to ensure that government expenditure would provide that specificity, and thus would create employment.

Note that this is all consistent with the corridor theory that you expanded on in an earlier post. This is why Keynes said, in the end, that if you have a complete effective demand failure, i.e., lack of specific markets where the relative price signals should emerge but don't due to consumers not yet giving those signals clearly, it ultimately does not matter if you put people to digging holes. Give them income, and they will spend on the basic things, and that should get you going again.

But this is all in a deep, deep depression, way down at the bottom. We're not there yet, and hopefully we'll never get there this time around. So let's not reach for heavy Keynesianism yet. Our current mess could very well work its way out on its own, with a hard blip of a year or two -- but I doubt we're in for a decade or more of over 20% unemployment.

I don't think there's any evidence of a massive market failure yet. Thus, hold your Keynesian horses for a while yet.

Bob Murphy writes:

Thanks for the link! My favorite line from your post:

"But you can unbundle Murphy's package."

After that, I don't need to argue about Greenspan anymore.

MattYoung writes:

Carl The EconGuy, great comments worth thinking about.

mk writes:

Whew! Thank you for posting this! Between this post, the recent EconTalk chats with Boettke and the Keynesian guy, I finally feel like we're beginning to shed light (for laymen like me) on the different macroeconomic stories that are underlying everyone's different prescriptions.

I would frankly love to see a debate between some Keynesians and some Austrians, not so much about *what* we should do, but about *why* we should do it.

What we know is that three sectors that need to shrink are housing, autos, and financial services. And guess what sectors the government is subsidizing.

Well, the government could legitimately subsidize failing industries to allow a soft landing. Whether that's better than a robust non-sectorally-targeted system of unemployment insurance and job retraining, I don't know.

Stimulus opponents would probably get farther if they advocated specifically for thickening the generalized safety net, rather than merely arguing against bailouts which seem to have the ring of "compassion" about them.

Of course stimulus opponents may disagree with strengthening the social safety net. But given politics' demand for compassion, stimulus opponents may not have a choice, and advocating for the thickened safety net may be their best option anyway.

Greg Ransom writes:

Friedrich Hayek explains the micro of this in several books and articles. Over the pay grade of Paul Krugman and Brad DeLong, but I'm guessing you could handle it.

Carl writes:

"One, the theoretical one -- why is aggregate demand dependent on perceived and not real wealth? Keynesian theory will not help here at all."

Greg Ransom writes:

Note well that both Hayek and Friedman supported social safety nets with market-friendly characteristics. Friedman was especially creative and out front in this area. Incredibly dishonest leftist have told the public that Hayek and Friedman didn't do this, buy those dishonest leftist economists know that they are lying to the public. I won't name names here.

MK writes:

"Stimulus opponents would probably get farther if they advocated specifically for thickening the generalized safety net, rather than merely arguing against bailouts which seem to have the ring of "compassion" about them."

Bob Knaus writes:

I've stated this elsewhere but I suppose it bears repeating.

The first phase for any construction project is the financial analysis. You have to figure out how much it will cost, what the payback is, and whether it's really worth doing. Seems to me this would be an ideal way to employ out-of-work financial sector people.

A really great outcome would be that they decide most of the projects are not worth doing, by which time a year will have passed and their skills will be back in demand by the private sector. And, it will save us a whole bunch of money in useless construction projects.

megapolisomancy writes:

Speaking of prices, in the recent past you wrote:

"Some Austrian School economists, following in the monetary tradition of Ludwig Mises and Murray Rothbard, utterly reject Selgin's short-run goal. They contend that there is no need for the money stock to compensate for any shifts in money demand, whether arising from velocity shocks or output growth. All such shifts, in their view, can easily be accommodated by price adjustments."

I think that your reservations about Murphy's view of Greenspan and the Fed could benefit from a carefully argued case why price adjustments will not be able to accommodate such shifts. One reason why the case for free markets meets a lot of skepticism from most people is because of sustained rising prices despite greater productivity. This does not make sense to them, and neither does it to some Austrian libertarians.

Bill Woolsey writes:

Perhaps housing, autos, and finance needs to shrink. While I can imagine that some of the financial services have negative value, I am
sure that the houses and the cars are both valuable. What that means to say that they should
shrink is that the resources currently deployed there would be better deployed elsewhere.
But that means there should be shortages
elsewhere. Not enough of these other goods where
the resources would be better used are being produced because the resources were being used to produce too many cars and houses.

In an absence of monetary disequilibrium (that is,
if the demnad for money remains equal to the supply,) then if people are spending less on
houses, autos and finance, they must be spending
more on something else. For every buyer there is a seller. What happens to the money?

Of course, because of specific skills and capital goods, this process is gradual and quite painful. There are losses in the shrinking indutries. There is structural unemployment.

If people wanted to buy roads and bridges, then, there would be a shift of resources, including labor, to roads and bridges. This would not immediately sweep up all the unemployed financiers, car workers, and home construction workers into bridge construction.

Those most suited for road and bridge employment go to it. That creates vacancies from where they came or would have gone. Those are filled with the next most suitable workers, and so on.

So, where are consumers showing that they want the resources deployed? It looks like nowhere.

If people are spending less on some things and buying nothing, but rather accumulating money balances, then, there is no signal that other goods and services should be produced.

If that is the situation, these other goods (cars and houses) are not really being overproduced at all. The resources have no alternative uses. They have no cost.

But, of course, the "solution" to a situation where the people demand more money is for the supply of money to rise to meet the demand. The market system will generate this through lower prices (and incomes) and a higher real supply of money. As the real supply of money rises, some may lend that money out, lowering interest rates and stimulating investment spending. Or else, the added real wealth will result in more consumption.

This is all standard.

Where is this in Murphy's story?

Anyway, having the government build roads and bridges meanas that there is no need for deflation. And yes, you still get the structural unemployment and losses in the shrinking sectors, just like you would if consumers and investors chose what they wanted to spend on.

The downside to this approach is that maybe the roads and bridges are not all that valuable to people, and, of course, more national debt in the long run.

Charlie writes:

It's funny that Murphy mentions Friedman as he is another nobelist that would side with Krugman in this debate. In practice, Friedman might support unconventional monetary policy over fiscal stimulus, but in principle he has the same model of how the world works.

Greg Ransom writes:

The whole point of a trade cycle is that money is deeply implicated in the massive discoordination of the economy across time and sectors -- monetary disequilibrium is "built in" so to speak.

Massive intertemporal discoordination means massive mis-evaluation of values across times and between sectors. One thing that happens is that people spend less because suddenly stuff is less valuable -- often near monies are less valuable. So the massive discoordination of the intertemporal structure of the economy literally makes it happen that some people have less money than they had before.

Economists make the mistake of thinking that "money" is a given "stock" that circulates and flows as if it were exactly like a given quantity of water. It ain't. This is a "macro" picture possible only for folks who have really are incapable of thinking (micro) economically because of their "macro" training in terms of non-economically related aggregates.

"In an absence of monetary disequilibrium (that is, if the demnad for money remains equal to the supply,) then if people are spending less on
houses, autos and finance, they must be spending
more on something else. For every buyer there is a seller. What happens to the money?"

Maniel writes:

Could it be that most folks have too much debt, that they either can't or won't take on more, and that they are either servicing their debts or starting to save? The chain of events that triggered the decline in housing prices - defaults, foreclosures, over-supply, more declines, more defaults, etc - has obviously decreased demand in that sector. However, could the more general decline be the result of people no longer having as much discretionary money (either cash or credit lines)? If so, it is not surprising that aggregate demand is down.

Of course, public debt, which must also be serviced (eventually), has also grown dramatically. Could it be that the solution will not be found at the bottom of an even deeper debt hole, the product of bailouts and a "newer deal?"

Bill Woolsey writes:

When one person pays off their debts, the person they pay receives the money. What does that person do with it?

If people save, they accumulate assets. Generally, they buy assets. Who sells these assets? What do they do with the money.

In the absense of monetary disequilibrium, Says
law applies in the simple form. Supply of
goods and services creates a matching demand.
Surpluses must be balanced by shortages.

Two extra elements of monetary disequilibrium theory-- if production fallls, and income falls, this plausibly reduces the demand for money. If the quantity of money doesn't drop, the result is excess money and added expenditure.

If there is a shortage of something other than money, those who cannot purchase whatever it is they wanted to buy at current prices are now left with excess money balances. What do they do with them? Do the hold them? Then there is monetary
disequilibrium. Do they use them to buy something else? Then not.

These ideas come from Yeager.

As for Ranson, the field of "money and banking" is all about the relationship between various sorts of money. In my view, the zero-interest bearing currency, into which all the various bank liabilies are redeemable, is the key. Everything else has a nominal yeild and a supply and demand determined quantity.

However, any of it that is used as the medium of exchange has the characteristic that it can be demanded by receiving it in payment and not spending it. There is no market were people have to go and get it.

Those "near monies" that must be purchased with money have ordinary markets as well as yeilds and the private ones have supply and demand determined quantities.

Money is intergral to an economy. We buy goods for money and sell goods for money. Relative prices and the composition of supply and demand are changing all the time. Resources are shifiting. That includes labor. Unemployment is part of life.

If Chinese saving leads to a trade cycle, then how is this anything more than the view that "trade cycles" are just shifts in the pattern of demand? How is overshooting anything more that cobwebbing?

No one denies creative destruction and structural unemployment. Few accept that any change in the money supply creates reversing shifts in resource allocation. I think most would accept (I know I do) that this is an effect of monetary policy mistakes. But why isn't this just lost in the wash of creative destruction? Supplies and demands are changing all the time.

Some Austrians have don't analyiss on the assumption that the price level adjusts so that the real supply of money equals the real demand for money, and so, the resource shifts are all that happens. New classical macreconomics and real business cycle theory is pretty explicit abou this too.

Anyway, old monetarists seemed a bit fixated on finding the holy grail of a combination of assets that are more or less money, the demand for which doesn't change--or maybe grows at a constant rate. M2 seemed to work. If the quantity of M2 can be manipulated by controling the monetary base, then monetary disequilbrium can be avoided.

Keynesians have constantly searched for discovering scenarios where monetary disequilibrium cannot possibly be corrected by an increase in the real quantity of money--either the easy way of increasing the nominal quantitiy of money, or the hard way, of a deflation raising the real supply of money.

To just assume taht the needed deflation as occured and that it works, so that everything is sectoral shifts is always going to result in looks of puzzlement from people who don't believe that the needed delation has occured, worry about the disruptions of the deflation, and even about whether it would work.

The notion that Macroeconomists have never heard of structural unemployment is crazy. It is just that it isn't the problem they are worrying about.

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