Arnold Kling  

An Alternative to Hydraulic Macro

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Mainstream macroeconomics is "hydraulic." There is something called "aggregate demand" which you adjust by pumping in fiscal and monetary expansion.

I wish to reject this whole concept of macroeconomics. Instead, I want to get economists to think about unemployment in terms of the economic calculation problem.

[Before reading the rest of this post, you may wish to read something from about five years ago by Robert Solow (my dissertation adviser), dug up by Mark Thoma. In what you will see below, I take Solow's emphasis on "heterogeneity" a lot farther than Solow had in mind.]

In an article called "The Problem of Economic Calculation in a Planned Economy," Bruno Leoni wrote,


Moreover, the comparison between costs and results, which often occurs instantaneously for consumers, may turn out to be disadvantageous for enterprises, as it is almost always out of phase in time for the producers. As a rule, they have to first pay the cost of production, and later cash the income from goods that have been sold, possibly at prices that are different and less profitable than those known at the time when the costs were paid.

The "socialist calculation debate," to which Leoni was contributing, concerns the mistakes that a planner is likely to make in the absence of the information provided by markets. However, the paragraph quoted above shows that markets do not insulate the economy from planning mistakes. Entrepreneurs can make mistakes. Builders can construct houses and shopping malls that turn out to be unwanted. Individuals can obtain educational degrees that turn out to be in fields for which there is insufficient demand. Workers can develop experience in firms and industries that subsequently fail, leaving the workers with skills that have greatly diminished market value.

The Austrians emphasized planning errors, but to me they seemed focused on only the errors that entrepreneurs make in choosing the capital intensity of production in response to interest rates that are manipulated by the central bank. To me, all sorts of other errors are possible and ought to be allowed for in the theory.

Fischer Black had exactly the story of planning errors that I talked about, but he grafted onto it the theory of the Capital Asset Pricing Model, which says that people diversify away all idiosyncratic risk. Thus, everyone either does well together or does poorly together. Some people (think of government workers) choose "low-beta" assets, and so their economic circumstances change relatively little over the cycle, while others (think of people who buy stock index funds on margin) choose "high-beta" assets and get tossed around in whatever economic storms that blow in.

I don't think that the CAPM is even a decent approximation for the distribution of risk. That is, I think people take a lot of idiosyncratic risk, particularly in terms of their human capital, which is for most people their biggest asset.

I think that in the last 18 months, an unusually high number of people have had their plans go awry. They wish they had made different choices in terms of their education and occupations. Digging out from these mistakes is going to take a long time. A lot of recalculation needs to get done, and the problem is really daunting.

I don't think that fiscal and monetary policy solve this calculation problem. At best, they substitute the errors of fumbling central planner for the errors of fumbling individuals.


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COMMENTS (6 to date)
fundamentalist writes:

Nice post! Thanks!

The single most important change that mainstream macro needs to make is to get over their hydraulic model of the economy.

"The Austrians emphasized planning errors, but to me they seemed focused on only the errors that entrepreneurs make in choosing the capital intensity of production in response to interest rates that are manipulated by the central bank."

That's because the Austrian theory of cycles is a monetary theory. Normal errors would tend to cancel each other out and leave just random clusters of errors that are relatively small and irregular. The ABCT was intended to explain large, regular depressions, like the Great D and the current one, not the smaller ones brought on by wars, weather and natural entrepreneurial error.

darjen writes:

From what I understand, Austrian theory and the "socialist calculation debate" doesn't claim that individuals are free from errors.

What they do claim is that central planning greatly compounds these errors. Individuals can adjust their plans much more quickly than government. Therefore, scarce resources get re-allocated efficiently, while government continues to waste resources on failed plans.

Bill Woolsey writes:

You need to think about Say's Law, scarcity, and opportunity cost.

It is impossible for the value of the products of all firms to be less than their opportunity cost, unless people want more leisure. (I have noted that you always want to get back to the notion that unemployment in recessions is about taking vacatiosn from work.)

If heterogeneity has been the problem over the last 18 months, where are the sectors of the economy with rising prices, rising profits, and rising output?

Philo writes:

“I think that in the last 18 months, an unusually high number of people have had their plans go awry. They wish they had made different choices in terms of their education and occupations. Digging out from these mistakes is going to take a long time. A lot of recalculation needs to get done, and the problem is really daunting.”

The questionable phrase here is “an unusually high number.” It is easy, in hindsight, to point out specific mistakes. But mistakes happen all the time; it is always true that many people are “digging out.” Where is the *evidence* that recent mistake-making has been unusually intense? All I can see is the fact that we are in a depression, together with Arnold’s (dubious) Austrian-type theory about the cause of depressions.

An alternative view is that recent mistake-making has been at the normal level, which is usually accommodated by the economy without a depression. So what caused the depression? The Fed’s failure to “pump in enough liquidity” to maintain (nominal) AD.

Philo writes:

Of course, once we're in a depression many more earlier decisions will look like mistakes, because the depression was not expected. But Arnold's hyper-Austrian account works only if these decisions *would have been mistakes even absent Fed malfeasance*.

Shayne Cook writes:

To Bill Woolsley:

If heterogeneity has been the problem over the last 18 months, where are the sectors of the economy with rising prices, rising profits, and rising output?

Heterogeneity is not a problem, it is a dominant characteristic - particularly of a non-centrally planned economy where heterogeneity in economic activity is allowed to a greater extent. The "problem" of the last 18 months is one of how to return to a heterogeneity of activity and capital flows, post housing bubble. The "problem" of the preceding 5 years was that the housing bubble homogenized an inordinate amount of economic activity and capital flow toward housing "investment".

To answer your question, I would suggest looking toward energy and the commodities (gold, copper, steel, etc.). While economic activity is currently depressed, as economic actors re-evaluate the recent over-investment in housing, the assumption is that both energy and raw materials will be required to facilitate the return to heterogeneous economic activity, or the next homogeneous over-investment (bubble) to emerge.

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