I had a short argument with Greg Ransom a couple of months back. Greg won. But actually, I wasn't really arguing with him. I was on his side to begin with, though it did help me clarify my views.
Question. "What is the economic difference between capital and land?"
If you answered: "People made capital and God made land", you are wrong.
Economists have known that answer is wrong since 1871, when we discovered that bygones are forever bygones, and switched to the forward-looking marginalist theory of value. In 1871 we stopped saying that the value of goods is determined by what they cost to produce in the past. Instead we said the value of goods is determined by their marginal utility in the present and expected future. (OK, there are two blades of the Marshallian scissors, demand and supply, but both blades are made of the same stuff (Mark Blaug?), because marginal costs are really opportunity costs, and are the foregone marginal utility of the other goods we could make with the same resources.)
It doesn't matter whether people or God made stuff in the past, and what it cost to produce it. The only things that matter are: the present; and present expectations about the future. If archaeologists discovered that Prince Edward Island was an artificial island, rather than a geological formation, it shouldn't matter at all for the allocation of resources going forward. (OK, some geologists would have extra work to do, to revise their theories.)
What is the economic difference between the existing stock of capital goods and the existing stock of land? Nothing really. Except we will, probably, be producing more capital goods in the future, and we won't, probably, be producing more land in the future.
But even that is not quite right. And not just because the Dutch invest in producing more land. The capital goods we are making today aren't always exactly the same as the capital goods we made in the past. Technology changes. I doubt that anyone today is building a computer exactly like the one I'm using now.
Antique furniture is really land, economically speaking. So is my Mazda MX6. They don't make them like that any more. If we lost the blueprints, and couldn't reproduce any of the existing capital goods in future, they would all become land.
The best we can say is that we can and will be producing capital goods that are a much closer substitute for some existing goods than others.
If there's a very elastic supply curve of newly-produced goods that have a high cross-elasticity of demand for some existing goods then we can think of those existing goods as capital. If there's a very inelastic supply curve of newly-produced goods that have only a low cross-elasticity of demand for some existing goods then we can think of those existing goods as land.
Where am I going with all this? Here's where I'm going:
Some people today say that the current/recent recession was caused by past overinvestment. Or malinvestment, for the more sophisticated version. Especially in houses.
And I'm saying there's something logically peculiar about any sort of theory like that, if you approach economics from a praxeological, forward-looking basis. Bygones are supposed to be bygones. It didn't ought to matter how we got to where we are today. All that ought to matter is where we are today, and where we expect to be tomorrow.
Suppose that geologists discovered that we all had false memories of the last decade. The houses that appeared in the US are in fact a very recent geological feature. They just sprung up out of the ground. There wasn't any overinvestment in houses at all. God did it. God overinvested in land. Did God make us poorer by doing that? Would the recession suddenly disappear, when people learned the news?
There is something logically peculiar about the Austrian theory of recessions, as being caused by past overinvestment. Sure, the natural rate of interest would be lower, and the future pattern of investment would be different, if a lot of houses suddenly sprang up out of the ground. But isn't the market supposed to be able to handle things like that?
It's not just the Austrians. It's the Keynesians too, at least those who say we are stuck in a liquidity trap and can't get out.
Suppose we all wake up tomorrow and learn that all the economic statistics published over the last few years are totally wrong. And that our personal memories are false too. We have all been brainwashed by the Martians into believing inflation has been low and real growth low. In fact, Nominal GDP has been humming along quite nicely. Is there any reason to expect that it couldn't continue to hum along quite nicely in future?
True, a few workers seem to have forgotten who their employers are. And a few employers seem to have forgotten who their workers are. But given a few months they could search and find each other again. Or, at least, find new partners.
And the US Fed would be surprised to find its balance sheet is far too large, and it would need to do a very big open market operation to sell a lot of the assets it holds. And commercial banks would be surprised to find their reserves at the Fed were far too large, and the rest of their balance sheets too small.
And a lot of people and banks would discover they seem to have made some past loans at ridiculously low nominal interest rates, so they immediately raise interest rates on new loans.
And firms find their capital stocks seem to be far too small, so they do a lot of investing to get them back up to normal. And households find they are crammed into houses that are smaller than they need be, because there are a lot of houses sitting empty, but they soon sort that one out. And are driving old cars, and wearing old underwear, and so start investing in a lot of new stuff.
But otherwise, the economy could hum along quite happily on the new equilibrium NGDP path.
Suppose we all wake up tomorrow morning and learn that our memories of driving on the right are false. Everybody drives on the left in Canada. We are puzzled to find our steering wheels on the wrong side, and the road signs in the wrong places, but everyone switches to the new equilibrium and drives on the left.
If a change in our memories can switch us to a new equilibrium, why can't an announcement of the new equilbrium, an NGDP target, do the same?
When did economists forget that bygones are supposed to be bygones? (Not that they are, of course, totally).
Worthwhile Canadian Initiative 
Nick:
we’d end up in the old equilibrium.
the reason is that without economic history, banks would have to be conservative about their lending – I.e. their current behavior.
To break out of such a game theory scenario you need a BIG economic actor to move first or to threaten a credible move forward.
WR: Reckon central banks are big enough economic actors? They do control the money we buy and sell everything else with.
But yes, if the government and central bank jointly announced a new NGDP target, that would certainly help make it credible. (Unless they announced different targets, which would totally screw things up. Hmmmm. I wonder if that’s what’s been happening in the US?)
Hmmm. Chuck Norris could only be more credible if he threatened to use both his fists. Trouble is, it’s costly for him to put his fiscal fist back in his pocket. Which both adds and subtracts to his credibility of threatening to use it. He doesn’t want to use his fiscal fist, but if he does use it, he can’t easily stop using it.
Maybe another post, bringing in the Fiscal Theory of the Price Level, NGDP targeting, and Chuck. Much later.
Say you’re in the K&E world; patient and impatient people, the impatient load-up on debt and then the ‘oops’ moment arrives … If only they could forget the past! But they can’t. Doesn’t the recession comes about because they can’t forget the past?
Patrick: I was afraid that someone would mention debt, which is an ipso facto violation of bygones are bygones.
Sure so the current distribution of wealth is influenced (not determined, except in a trivial accounting sense) by the distribution of past saving and dissaving. But:
1. Distribution effects have only second order aggregate effects.
2. The distribution of wealth that was seen as sustainable under the old expected NGDP level path should still be sustainable now, under that same path, especially since some dissolute lenders and borrowers have tightened up in the meantime.
Oh God, here come all the “Too Much Debt!” comments!
This is about Austrians and Keynesians. Not Kooers(?)
Bygones are not merely bygones if bygones are a sunspot. (I have an image of Chuck Norris in the Peter Pan story beating up people who don’t believe in Tinkerbell.)
Andy: agreed. (And ROFL). But if one suspot can get us into this mess, another sunspot can get us out.
To those who don’t know what “sunspots” are in economics: the original sunspot theory (IIRC due to Jevons, who also invented “bygones are Bygones, and was one of the three 1871 revolutionaries) was that sunspots caused weather which caused harvests which caused the business cycle. It was a version of real business cycle (RBC) theory. The meaning of “sunspot theory” in modern economics is the exact opposite of what it originally meant. A sunspot is now a metaphor for something that everybody observes (and everybody knows everybody observes, etc., so sunspots are “common knowledge”) that is also a totally irrelevant event intrinsically. But sunspots in a model of multiple equilibria can flip the economy from one equilibrium to another, simply because everyone thinks they do. Sunspots are just another metaphor for the confidence fairy.
Can’t it be the case that we’re in a liquidity trap now and we were already in that liquidity trap five years ago but didn’t realize it because we thought we had a lot of wealth that we didn’t really have?
It seems to me the problem is not necessarily coordination failure but could be excessive patience (combined with excessive risk aversion). If everyone wants to shift their expenditures to the future at the same time, what can you do? You can cut the interest rate, but not if the nominal rate is already zero. You can issue a bunch of fake safe assets and make people believe they can shift expenditures into the future when they actually can’t. Been there; done that. You can cut the price level low enough that people will expect it to be higher in the future. Only that one doesn’t work if prices are sticky, of if you have a managed money supply and the central bank is committed to price stability. Or you can have the fiscal authorities behave impatiently to offset the patience of the private sector. That’s the liquidity trap argument in a nutshell, and I don’t see anything illogical about it. But people who make that argument have to realize that the problem existed before the housing boom.
Andy: suppose the IS curve slopes down. But the IS shifts right if people have falsely overoptimistic beliefs relative to the rational expectations equilibrium time-path. So the natural rate (where the IS crosses LRAS) was above zero only because of those false beliefs. Then people learn the truth, and the IS shifts left, and the natural rate falls below zero. So we hit the ZLB. And the only other equilibrium above the ZLB either has much higher inflation, or a permanent fiscal policy shifting the IS right, until an exogenous shock (demographics, cars wearing out) shifts the IS right again.
OK. I think that is a logically coherent theory. It’s an ungodly mix of Austrians and Paul Krugman. I just don’t believe it’s true. I think the IS slopes up.
Another possibility is that there was an exogenous increase in risk aversion.
Or how about this for an ungodly mix, RBC and Keynesian: there was a breakdown in the technology for distributing risk, resulting in a higher cost of risk and a consequent decline in aggregate demand.
FWIW I don’t think my “phantom liquidity trap” argument is any more Austrian than Paul Krugman himself. Surely he wouldn’t have a problem with the idea that demand was being buttressed by false beliefs during the housing boom. And it’s entirely an aggregate argument, no differentiating between different types of capital or any of that other Austrian complication.
You’re right, the Austrian argument is but a place to begin. The first thing I saw this morning online was a graph of GDP ups and downs, I just sat and stared at it for a while.
I believe we can move ahead by creating more flexible interpretations, structures and vehicles for ownership itself. What does that mean in practical terms? What exists for us to buy needs to more closely match the resources we actually have at any given moment. When someone wants to build a restaurant for instance, that does not necessarily mean they wish to become a caretaker of a dilapidated old structure at the same time, or take on mortgage or rent that forces them to be open eight days a week in an environment that cannot support that much business.
A charter city might create grids of electrical and plumbing which people could rent both for residential and commercial use. The investment would come in the form of modular pieces that people could actually put together themselves to create what they want, pieces that can allow the individual to take full use of the production capacity of our current technological system. When people move on, they dissemble the parts and sell those still fully functioning to the next user. NGDP targets will not be like pushing on a string if people can grow from the place they are now, instead of having to jump over a huge chasm everytime and hoping they can make it to the other side.
Nick, what matters is that there are expectational cascades or snowballs which systematically created inter-related expectations of interconnected future exchange ratios which cannot be sustained — expected economic exchanges at expected exchange ratios cannot take place at future points (the reality of what economists call “scarcity”). Fractional reserve banking, leverage, non-transparency, time, optimism, price regulations & controls, changing liquidity, and fraud can amplify these cascades — and hide them temporarily from view to actors in the system.
At the extremes, if expectations are massively systematically out of whack, some “goods” will actually completely lose their status as economic goods which are economized — they will have no positive sum economic place in the system of economic relations.
“Magically” overnight a capital good or input resource will become a Commodore 64, whose only economic significance is the costs of taking it to the dump.
If I had time, I’d give you a nice metaphorical expectations story starting Chuck Norris illustrating what happens to elements in the expectational system out at the longer time dimensions that find themselves like Wile E. Coyote off the edge of the cliff with no were to go but crashing straight down.
Re-coordinating a systematically and massively discoordinated inter-connected system of expectational relations across the dimension of time is not like a series of small localized adaptive readjustments. All sorts of elements will in mass lose there significance in the system of relations — some will no longer have an possible use (e.g. like a Commodore 64 in today’s world).
Well, this is alot already for a comment on a blog post.
Nick, try this thought experiment.
Overnight we wake up in the morning and 1/2 of the machines and workers are producing goods which were produced and consumed in 1979 at 1979 prices (and financed at 1979 interest rates, etc.), and the other 1/2 of the economy is producing goods which are consumed in 2011 at 2011 prices — an example of a massive discoordination of the relations between production processes and input to production, etc.
So — what to do with the machines designed to make 1979 goods and workers trained to do 1979 jobs?
Well, this problem won’t be solved with any pushing of buttons (ala Krugman’s teenage Asimov dream of ‘doing social science’), and price and asset and money supply juggling by the Federal Reserve won’t provide a push button solution either (although it might somehow help at the far margins — although who will know this and how they will know this is unclear).
“There is something logically peculiar about the Austrian theory of recessions, as being caused by past overinvestment. Sure, the natural rate of interest would be lower, and the future pattern of investment would be different, if a lot of houses suddenly sprang up out of the ground. But isn’t the market supposed to be able to handle things like that?”
I dunno. That’s what people say, but the evidence is debatable. Oscar Wilde said that a cynic is someone who knows the price of everything and the value of nothing. (I first heard that saying with economist instead of cynic.) Markets determine prices. Do people really confuse price with value?
To be sure, we can say that for a particular trade, the price of something is at least as great as its momentary value to the seller and at least as small as its momentary value to the buyer. That is something. But generalizing from that is dicey.
Over time, we might expect that prices tend to something that we can call values. But that is a convenient fiction. It is not just, as Keynes pointed out, that in the long run we are all dead. We know more about complex adaptive systems these days. There may well be no long run. Not that the system may cease to exist, but that the system as we know it may cease to exist.
“Economists have known that answer is wrong since 1871, when we discovered that bygones are forever bygones, and switched to the forward-looking marginalist theory of value. In 1871 we stopped saying that the value of goods is determined by what they cost to produce in the past. Instead we said the value of goods is determined by their marginal utility in the present and expected future.”
The future isn’t what it used to be (Yogi Berra?), but neither is the past. In a gambling game, if a player tries to maximize his immediate payoff, then if the bet is favorable, he will bet everything that he can. That is a road to ruin. If he instead tries to minimize his chances of going broke (while still betting), he will, as Bernoulli discovered many years ago, maximize his expected return on investment of his stake over time. How much he bets depends in part on how much he has. And how much he has depends on the past.
Turning to markets, it seems to me that how much a market participant has is not in general a datum that the market takes into account, except to the extent that the participant does so himself. If the market is dominated by those with a less prudential viewpoint, who are more concerned with immediate or short term reward, instead of expected return over time, then those market participants are likely to outbid the more prudential participant. Do we then say that the price is right and the prudential value is wrong?
Or suppose that, in addition to those who are trying to maximize short term returns, some market participants have deep pockets, so that their prudential value is in line with those of the short term crew. In that case prices are consonant with prudential values, but the prudential values of the rich. Do we really want to say that the value of something for society as a whole is determined by the rich?
After the long prologue, let me add that if we are trying to talk sensibly about bubbles and busts, we have to distinguish values from prices. 🙂 If the price is always right, what can we say?
Nick,
Your post touches many interesting ideas. I’m not sure which ones you care about most. In response to your “peculiarity of considering the past” point, I think that economists are really trying to answer two questions.
(1) What went wrong? [How did we drive into this ditch?]
(2) What do we do now? [How do we get out?]
I think you’re saying that we may need to analyze the past to answer (1), but we should not care about it if we just want to answer (2). I agree. However, the malinvestment and liquidity trap concepts are not just applicable to the past. These concepts are also applicable to “what recovery will require.”
In the Austrian analysis, the answer to (1) (the “thing that went wrong”) is a cluster of malinvestments. These investments were made in the past in response to price controls which were in place at that time [specifically, a control on the interest rate]. The Austrian answer to (2) is to let prices adjust now. This is necessary to avoid making malinvestments now. Otherwise, the production structures we build may be more malinvestments [which will be revealed as bad ideas in the future].
We can probably express this in money terms as well. There were big cash flows in the past [the investment purchases] which were made in anticipation of certain cash flows in the future. The people who made those purchaes were wrong. Some of their anticipated cash flows will not happen. To recover, we will need to develop new estimates for future cash flows. This estimation happens when capital goods prices adjust. New correct estimates are necessary before producers can invest [which will involve new big cash flows] now.
In the Keynesian analysis, the “thing that went wrong” was a cluster of liquidity seeking. Since money is the most liquid asset, these seekers started to save money. The effect of many people saving pushed us into a “liquidity trap,” where everyone is saving and knows that everyone else is saving. The Keynesian answer to (2) is to “let them eat liquidity.” We can either drop money from the sky until people have enough money. Or the government can spend money and issue more bonds [which are considered “liquid enough”]. Once people stop seeking liquidity, things will be “good.”
Your land-capital distinction is interesting. I don’t think that’s how most Austrians [at least Rothbardians] think of it.
Note well that part of the Hayek story is changing asset values, changing optimism, changing risk & uncertainty assessments, and changing asset liquidity — shadow money sharply declines and credit becomes tight and the demand for money increases.
This chain of events is set off when “crisis” sets in an production plans cannot be fulfilled at prices expected and when long term production goods, e.g. houses, prove to be radically over valued. (OK, I’ve radically condensed everything, oh well.)
Here’s an analogy.
The U.S. Forest Service puts out all forest fires before they spread — accumulated fuel of dead wood and brush builds and builds — now finally when one forest fire goes critical and runs away, and that fuel which was allowed to accumulate is touched, causing a super-temperature inferno even destroying the forest as no ordinary fire in the history of the forest ever produced, what do you blame?
Do you blame the accumulated fuel — or the forest service which stopped the normal process of nature from keeping a super-temperature fuel load to accumulate in the forest?
Not a perfect analogy, but enough of one to open eyes and imagination a bit.
It’s also possible (if the Y-axis is a real interest rate, not a nominal one) that the IS curve is non-monotonic, and the peak may still be too low to be consistent with 2% inflation. This doesn’t seem too implausible to me as a description of the world we are currently living in. Intuitively, it seems to me that there is a coordination failure going on, but it also seems that, before that coordination failure took place, we were struggling to maintain full employment at a positive interest rate despite having a lot of phantom wealth that induced people to behave as if they were less patient than they really are.
“Suppose we all wake up tomorrow and learn that all the economic statistics published over the last few years are totally wrong. And that our personal memories are false too. We have all been brainwashed by the Martians into believing inflation has been low and real growth low. In fact, Nominal GDP has been humming along quite nicely. Is there any reason to expect that it couldn’t continue to hum along quite nicely in future?
“True, a few workers seem to have forgotten who their employers are. And a few employers seem to have forgotten who their workers are. . . .
“And the US Fed would be surprised to find its balance sheet is far too large, and it would need to do a very big open market operation to sell a lot of the assets it holds. And commercial banks would be surprised to find their reserves at the Fed were far too large, and the rest of their balance sheets too small.
“And a lot of people and banks would discover they seem to have made some past loans at ridiculously low nominal interest rates, . . .
“And firms find their capital stocks seem to be far too small, . . . . And households find they are crammed into houses that are smaller than they need be, because there are a lot of houses sitting empty, . . . . And are driving old cars, and wearing old underwear, . . . .
“But otherwise, the economy could hum along quite happily on the new equilibrium NGDP path. . . .”
OK, Tinkerbell. 😉
“If a change in our memories can switch us to a new equilibrium, why can’t an announcement of the new equilbrium, an NGDP target, do the same?”
But you are positing not only a loss of memory, so that bygones are bygones, you are positing that people ignore present evidence. If only a change in memories could switch us to a new equilibrium, we are dummies. If, as you and DeLong have pointed out and as John Stuart Mill and perhaps Benjamin Franklin would have pointed out, the main problem is a shortage of the medium of exchange, how will erasing memories change that? (As always, I appreciate your stories, but, as is sometimes the case, I have trouble making sense of them. {sigh})
Bygones are not bygones and debt is not a bad explanation. Not on a moral level, but on a storage one. Debt creates storage and moves monetary obligations forward through time.
Step with me into my little differential-equation analysis, would please Nick? I promise to be gentle with the math.
Ok, comfortably inside? Have a seat, and lets begin.
A circuit or flow system with a storage element can be modelled as a first-order differential equation. The output is the sum of both the input and the change of the input, plus a few constants here and there which I will neglect for now. Now in a system which stores income in the form of debt and savings you get investment leading consumption and savings lagging consumption (the order doesn’t really matter). In this system you cannot change goods consumed and money spent instantaneously. If you could it would mean that you would have an infinite amount of goods and money. Since this isn’t true, you get a damped response. The income function looks like a wave.
So savings and investment will as storage elements will cause a divergence from the equilibrium business cycle after a shock. This is the transitory response. Those who care about the “long run” are talking about the forced response where the transitory response has ended. Of course if the forced response itself changes you will constantly have a business cycle.
There, I didn’t even bring out a Laplace Transformation.
Nick,
In my comment above, I mentioned that economists are trying to answer two questions: (1) how did we get here, and (2) what should we do now? Austrians and Keynesians use different concepts to answer both questions. But as long as those concepts are being applied to (2), the analysis is “forward looking.”
I think I understand your God-land concern. But if God had created the world as it now stands, we would not be asking (1). We’d know that they’d “started” this way. We’d only ask (2): How can we improve our situation?
In the recreation experiment, what would happen to the economy depends on whether our preferences and knowledge are recreated in their present state. If yes, then the answer is: exactly what’s happening now. If no, then the answer is: something else. Maybe something better, maybe something worse. It depends on the extent to which the current structure of production is tuned to satisfy those preferences, and to the extent that it is not, how quickly we can coordinate to make it so.
For example, an Austrian would say that if we all had a preference for big houses when we appeared, then the unemployed construction workers would quickly find work. Keynesians would say that if we all appeared, did not know that we were in a liquidity trap, and could avoid falling into one, then the economy would quickly recover.
Not sure about this, but I think everyone is basically doing the “same” analysis. Everyone thinks about what the economy will look like when it recovers, and then tries to figure out why we’re not there yet. The various theories just focus on different reasons why we’re not there.
For example, when the economy recovers, construction workers who are currently unemployed will be doing X. So why aren’t they doing X now? It could be that the workers don’t have the skills to do X yet. Or it could be that X is currently not demanded [Keynesians like to focus on this!]. Or it could be that the factors of production that they need to do X are currently being used elsewhere. Or those factors are sitting idle, but the entrepreneur who will hire them to do X has not yet thought of doing X.
brilliant post. and one that doesn’t mention the stickiness of nominal debt as a key cause of our problems.
A quick add: your designations of (passive)land and (active)capital are more vital than perhaps you imagine. It may well be possible to create economic scenarios in which more active frameworks are designated, that all participants understand and work within, in terms of the ways ownership might be approached.
Nick writes:
“Or malinvestment, for the more sophisticated version. Especially in houses. … if you approach economics from a praxeological, forward-looking basis. Bygones are supposed to be bygones.”
Hmm. What a curious set of statements. When I think of Praxeology, I of course think of Mises. Then we have you mentioning “malinvestment” which is a reference to the Austrian view. So, is this a veiled claim that the austrians are illogical from their own epistemology? In that vein, it is of course the Austrians who brought marginalist ideas to explain capital. So yours is a rather clever and veiled dig, if so.
The whole malinvestment theory is one of the most misunderstood concepts in Economics. That misunderstanding stems from not understanding where the theory came from–not understanding its assumptions. The austrian business cycle theory arises from the legal constraints imposed by Bank Charter Act of 1844 and equivalent regimes that were in vogue in the late 1800s and early 1900s. Here is how Mises introduces the theory:
The point here is that if the banks curtail the expansion of the money supply, then a crisis erupts. Sound familiar? Its should; he’s talking about an unrequited demand for money. This is (now) very mainstream stuff. He goes on to explain why (in his day) this is inevitable (this is where most people lose the proper thread of the argument):
He is explaining here that the crisis comes about because the legal regime requires inflationary excursions to be netted out. The part everyone forgets is that this inevitably will lead to a crisis in Mises’s model because the supply of uncovered notes is restricted (by law) and therefore the inflation rate is set by law. Therefore, it is necessarily the case that the banking system will eventually reach an impasse that demands they induce a disinflation.
The ABC theory, as far as it goes, explains how the interest-rate channel induces an acceleration in inflation. In particular, it explains how ‘too fast’ money expansion lowers the market rate of interest below the natural rate which produces inflation which acts to equalize the market-rate to the natural rate of interest. Why does inflation accelerate? The theory explains that the operative mechanism is that the lower market rate changes the structure of production (increases investment demand) but that change is artificial: i.e., people’s time preference for consuming in the present does not decrease–as would be the natural implication of the a decline in the real natural rate of interest. So, “Malinvestment” is an explanation for why the interest-rate channel gives you more investment demand and not-less consumption; and therefore, people both consume and investment demand increases, and inflation accelerates accordingly. The ABC is an explanation for why the IS curve is not vertical.
It is a very much secondary point that once equilibrium is again established, you will not recover those capital intensive factors of production which were sustained by the transitory depression of the market-rate below the natural-rate, and therefore that this boom-bust cycle damages the capital stock because some unsustainable investments cannot be liquidated. This secondary point stands as a reason to oppose the boom-bust pattern even if the recessionary interludes are minor.
Well if we look at the .com bubble, it provides some idea of what is going on, IMO. In an ideal situation the economy will perfectly allocate resources to best ability, producing what is needed just in time. That of course is impossible in the real world, so there is always going to be waste in one form or another. During the boom of the late-’90s, which I remember, there was tons of capital (labour) being poured into tech in all forms. People started pursuing derivatives of ideas — many woefully impractical — and some huge malinvestments such as plumbing fiber backbone more than would ever be needed on certain stretches by multiples. There was “real” (i.e. plausibly productive) economic growth behind .com, but there were too many players at the table with only a finite pot. It was a surety many of them would come up empty. When that happens — the market awakes to the fact that the actual market is smaller and there will be more certainty of the losers — an immediate drop is inevitable and with it mass layoffs. There isn’t usually much to keep labour productive because this happens too quickly and we get recessions. Further there is immediate destruction: a tour of scrapyards after the .com bust produced inefficient auctions and productive work/code being tossed in the dumpster. I cannot see how that can be considered “growth”: the engineer who devoted 5 years coding a masterpiece that’s erased is probably going to wish deep down she did something else.
But you know this, I’m sure. I saw it first-hand and the reason for recessions is obvious from the trenches.
When it comes to land, well, land is productive because we have an idea of “highest and best use” to produce the most earnings by owning it. The way I look at land value is the residual of the expected future capital expenditures compared to revenues and slap on some risk measures to get a spread above risk-free. That is, I can say I want to build a house and rent it out for 100 years. It costs me X to build the house and I get Y annual rent. Based on financing and risk the business case works only by paying below a certain amount for the land: land is the dependent variable. I don’t think it’s any more complicated than that.
Economists have known that answer is wrong since 1871, when we discovered that bygones are forever bygones, and switched to the forward-looking marginalist theory of value. In 1871 we stopped saying that the value of goods is determined by what they cost to produce in the past. Instead we said the value of goods is determined by their marginal utility in the present and expected future.
The Minskyan argument is that that present and expected future utility may have little to do with anyone’s need for the actual good, but merely with the belief that all others will keep believing for a while, during which time I can make a buck. Until, well, people stop believing. There’s a Ponziness of beliefs as well as capital that comes undone. And undoing beliefs is another word for uncertainty which will inevitably involve an analysis of the past. An NGDP path which is beyond what people truly believe will only work via the inflation channel, i.e. by favouring debtors over creditors, which, if debt is the problem and if not overdone, might lead to more certainty in the future.
Trouble is also that macro economics only has one instrument – money. And, depending on the analysis of what is keeping back confidence, investors (supply side) or consumers (demand side), and who is to lame for the current predicament, the only question is: whom do we give it to? But maybe, just maybe, money is not the only thing troubling us. And no, I’m not making an argument that central bankers should take over the role as confidence whisperers, which is what I see the ‘expectations management’ school as trying to do. There is something laughably ‘mystical’ and ‘omnipotent’ about the idea. Rather, I think economists should be a tad more modest about what it is they can or cannot achieve. All of them… Apply money wherever it can work, declare how you think it will work (mechanics) and why you think it’s right (morals), and then shut up.
NGDP targeting is possible using either monetary or fiscal policy, or both, as the engine.
Market Monetarists know what they mean by it (NGDP targeting using monetary policy), but they should qualify it accordingly and regularly.
Otherwise, they’re assuming the effectiveness/superiority of one idea over another (more QE rather than fiscal) in arguing the case for a second, separate idea (NGDP targeting) that depends in execution on the effectiveness of the first. Both cases must be argued in turn.
Just a reminder.
(Or, does the market monetarist position on NGDP extend to fiscal use? Brad Delong has his own version that includes fiscal, behind monetary policy. I assume the MM position is that it won’t be required. But does it actually exclude it? What is the position?)
JKH,
I wouldn’t want to exclude the use of fiscal policy from MM. British governments from 1976-1985 had monetary aggregate targets and used both fiscal policy (PSBR targets and funding changes) and monetary policy (interest rate targets) to pursue these monetary aggregate targets. I would want to call such a regime monetarist (especially under Thatcher where the monetary aggregates assumed high importance) and equally I would want to call a government that targeted NGDP* MM even if it used fiscal as well as monetary means.
* Arguably, from 1979 to 1990 the UK government had implicit NGDP targets and NGDP was indeed kept between about 7% and 11% from 1981-1990.
Determinant: “Bygones are not bygones and debt is not a bad explanation. Not on a moral level, but on a storage one. Debt creates storage and moves monetary obligations forward through time.”
Even if you wipe out human memory, the economic system has its own kind of memory. 🙂
“I” is me, by the way.
Brad Delong continues to bend NGDP targeting toward fiscal policy:
http://delong.typepad.com/sdj/2011/10/delong-smackdown-watch-nominal-gdp-targeting-through-unconventional-monetary-policy-and-through-fiscal-policy-edition.html
Prof. Steve Keen of the University of Western sydney explains why. I’ve been following his course on behavioural finance which has been posted to YouTube here: http://www.youtube.com/watch?v=KWUG1n1jEJI
You can watch a summary he made at Oxford recently here: http://www.youtube.com/watch?v=YoaUTpr2SNo&feature=mfu_in_order&list=UL
I cannot seem to get away from this post, for I want to revisit the idea of malinvestment. One person’s malinvestment is another person’s current economic reality. It really depends on where a person resides in terms of income, and multi-tiered cities and towns of the future could do a better job of reflecting income disparities. While different incomes may at first seem to imply rich places and poor places that does not have to be the case at all. Each town could come to resemble a snowflake in that first the inhabitants would agree upon certain levels of infrastructure, simpler residential and building requirements, and then proceed from there to pursue similar intellectual challenges that would create the town’s snowflake pattern.
Whereas, the malinvestment of sticky markets keeps people on limited tracks that do not allow intellectual exploration. Sticky markets insist certain goods be provided within the same context of scale and cognitive perimeters. One will not find the (relatively) pure market forces of a dollar store in housing, health and education. But the paradox of the sticky market is that – as individuals, we end up with less of the kinds of housing, education and health services than we actually want.
So, in considering malinvestment, maybe it’s not just about the ‘next big thing’ that matters but rather, the whole economic environment that multiple ‘things’ exist in.
“The only things that matter are: the present; and present expectations about the future.”
I’m gonna weigh in to agree with the naysayers here. Bygones can only be bygones in non-hysteretic system, and that clearly excludes economies.
Suppose at time t0, everybody forgets about the distribution of debts and claims at times t-n..t-1, but retains knowledge of current and maybe also historical spot prices.
If everybody forgets the historical prices then the trajectory of those prices has been lost altogether, and the expectations of the market are useless anyway. At t+1 any individual agent’s expectations might as well be randomly selected, and there’s no telling how long it will take for the market to arrive at another equilibrium.
But even if everybody retains knowledge of historical prices and therefore price trajectory, the distribution of debts and claims is the only way to know what the bias of that trajectory was. There can’t have been no bias, because then there would be no debts to forget. Only now nobody has any way of knowing whether their existing position included a hedge against pending claims, or leverage acquired by borrowing against some other good, or what. The whole edifice of arbitrage falls down and has to be rebuilt from scratch.
These sorts of situations are certainly recoverable, and I would even argue that they’re a good thing in the sense that the “amnesiac” system is likely to be more resilient and more adaptive in the long run. But they’re not exactly a “humming along”.
Since acquiring the long-run benefits of amnesia without short-term disruption isn’t a problem that you see solved very well in nature either, I’m disinclined to think that there’s an easy solution. In general, “efficiency” and “local fitness” require access to information about the past. If information you want to “forget” is embedded in the structure of the system then you may not be able to “forget” it without completely decohering. But even if it’s stored in a way that makes it selectively forgettable, the forgetting itself means at minimum that some of the system’s efficiency is lost.
I can’t do justice to all these comments. (I’m supposed to be doing something else now anyway).
A random thought:
A Newtonian physicist, solving the (say) 2-body problem, who knows the mass of the 2 bodies, and the gravitational constant, will need two snapshots taken at different times. On now, and one a few seconds back. Because the 2 bodies have momentum, so he needs to know their velocities today as well as their positions.
An Arrow-Debreu economist, who knows the preferences and the technologies, only needs one snapshot of the current vector of endowments of stocks of capital/land. He can then solve the system going forward.
There is “momentum” in Newtonian physics. There is nothing akin to “momentum” in Arrow-Debreu GE theory. One snapshot is all we need.
The differential equations aren’t the same, Determinant.
Jon: “So, is this a veiled claim that the austrians are illogical from their own epistemology? In that vein, it is of course the Austrians who brought marginalist ideas to explain capital. So yours is a rather clever and veiled dig, if so.”
It wasn’t intended to be veiled.
I stole von Mises word praxeology because we are (nearly) all Miseans on this point, and his word best captured what I wanted to convey. We are all talking about the logic of human action.
But I wasn’t really saying that Austrians are peculiarly inconsistent. All economists (except for a few lost souls who never got past 1871) agree with the Austrians on the basic principle that bygones are bygones in micro theory. There’s nothing particularly Austrian about that. That imposes restrictions on how we explain recessions.
marris: “Not sure about this, but I think everyone is basically doing the “same” analysis. Everyone thinks about what the economy will look like when it recovers, and then tries to figure out why we’re not there yet. The various theories just focus on different reasons why we’re not there.”
Yep. And those “different reasons” should, if bygones are bygones, be restricted to facts about today, not facts about yesterday. (Yours, in your following paragraph, do focus on facts about today.)
The bygones are the anticipated expectations and plans that cannot be fulfilled …
Related point.
The malinvestment / time disequilibrium story is intertwined withe the monetary disequilibrium story, see Steven Horwitz’s Microfoundations and Macroecomics or Hayek’s works. Horwitz studies with Yeager, and many other Hayekians are big fans.
Greg: “The bygones are the anticipated expectations and plans that cannot be fulfilled …”
But somehow, it must be the reflection of the failure of those past plans and past expectations embodied in today’s reality that determines what happens today.
Horwitz is on my “ought to read” list. Sounds like a lot of convergence there. As you know, I’m a big Yeager fan, when it comes to monetary economics.
BTW, do you like/agree with my proposed capital/land distinction (the first half of this post)?
A random thought:
A Newtonian physicist, solving the (say) 2-body problem, who knows the mass of the 2 bodies, and the gravitational constant, will need two snapshots taken at different times. On now, and one a few seconds back. Because the 2 bodies have momentum, so he needs to know their velocities today as well as their positions.
An Arrow-Debreu economist, who knows the preferences and the technologies, only needs one snapshot of the current vector of endowments of stocks of capital/land. He can then solve the system going forward.
There is “momentum” in Newtonian physics. There is nothing akin to “momentum” in Arrow-Debreu GE theory. One snapshot is all we need.
The differential equations aren’t the same, Determinant.
Nick, savings cause consumption to lag income, and debt causes consumption to lead income. Any system with storage elements that cause the flow variable to both lead and lag the forced variable, which we very much have here, IS a second-order differential equation with the equivalent of momentum. It is the same as a resistor/inductor/capacitor circuit or a mass/damper/spring system.
In order to have a general solution you MUST have both f(0) and f'(0), you need the equivalent of position and velocity in order to obtain the complete solution y(transitory) and y(forced).
Laplace transformations make this easy but you must have complete initial conditions.
You are saying that Arrow-Debreu GE only posits a single-order differential equation, which can be solved with only one initial condition. But that is not the sort of economy we have with savings and investment, both leading and lagging storage elements. In a single order differential equation you can have a leading element or a lagging element but not both.
If you are in fact saying this then I content that your GE is not general enough. You have to have one more condition to solve the second-order differential introduced by both savings and investment.
Come to think of it, I have just said that savings and investment may or may not be equal. I accept that they exist in some quantity and proceed to solve from there, but need two initial conditions to do so. You may be able to simplify down to a first-order differential if you accept S=I. I believe that may be the most treacherous and misleading identity in the whole of economic history for that reason.
Still, with a first-order differential you can have Income or Consumption change instantaneously but not both.
Determinant: simplify. Forget investment. What’s your consumption function?
Is it: C=a+bY(t-1)? Or C=a+bE(Y(t+1)) ?
Nick: bummer, I was hoping to discuss my revisionist presentation of ABCT. The first part of my post was a compliment; calling something veiled is not an insult!
Mr. Rowe, you are assuming a can opener, I think. You ask us to suppose that we all discover that we’ve been in a healthy economy the last few years. Then, you simply assert that this change in our mental states would restore full employment. Finally, you take this assertion as a reason to believe that targeting NGDP would have the same results.
Maybe you’re right, maybe you’re wrong, but you haven’t really presented an independent argument. You’ve just said, “I think expectations are what’s holding us back, nothing ‘structural'” and put it into a cute thought experiment.
Jon: OK, maybe it was veiled! 😉
I just re-read your comment. Was that a revisionist presentation of ABCT? I still can’t get a fully clear intuition of ABCT, despite numerous readings and people like you and Greg trying to explain it to me. But your presentation seemed roughly in line with what I thought it was supposed to be.
My version: Start in equilibrium. The central bank lowers the interest rate. People start building a house that’s twice as big as before. They get it half-finished then run out of bricks. So they abandon it, because it doesn’t have a roof on, so it’s useless.
Nick Rowe wrote:
There is something logically peculiar about the Austrian theory of recessions, as being caused by past overinvestment.
It’s not just the Austrians who make this mistake. About a week after the earthquake/tsunami in Japan, people were talking about how it was disrupting Japan’s economy. I mean, just think of it–they were explaining the current state of the economy, by something that had happened in the past. (!) These Sraffians are everywhere.
Bob: Welcome! (And call me “Nick” please.)
Yep. This post doesn’t really have any constructive argument that nothing is holding us (OK, I mean you, the U.S.) back from a normal equilibrium growth path. Though that is my belief. It is more of a challenge to others who say something is holding the US back. What is that “something”? And I am arguing that that “something” cannot simply be what happened in the past, because that would violate “bygones are bygones”. It has to be something in the present. (Or perhaps the expected future?).
Bob: earthquake hits yesterday. The capital stock is lower today than it was last week. Therefore the level of output today is lower than it was last week.
The housing stocks in the US is higher today than it was x years ago. Therefore?
Nick: my revisionism is that such discussions about useless capital goods is some minor adjunct which while true is not meant to be presented as the cause of the recession. Mises states more than once that the recession arises from tight money.
The ABCT has to be read as a critique of the Currency School. Without that mooring, you cannot get a clear intuition from it. The point of the subsistance fund story (running out bricks as you called it) is that the capital structure theory implies that a reduction in the real-rate will create investment demand without a reduction in the MPC. Mises very explicitly explains that society does not in practice run out of bricks, what happens instead is that the price-level rises and that is the problem under a legal regime such as Peel’s act.
So the short version is: Start in equilibrium. Banks accelerate their note issuance which lowers the real-rate in the market below the natural rate. Investment activity increases (This is explained by the Austrian Capital Structure Theory, although we don’t identify it as such any more). That increase in activity is inflationary. The supply of money is capped by law by the gold-cover ratio. Therefore, the note issuance must stop and the new inflation-rate cannot be sustained. Tight money produces the bust.
This is why the ‘bust’ is an inevitable consequence of the boom. You can delay the boom for longer and longer by allowing more unbacked issuance but eventually whatever gold-cover ratio you set will bite, the price-level will collapse back to its legal limit and the bust will occur. This is why you have the austrian claim that the longer you let the boom go on (the higher the price-level rises), the harsher it will be when the gold cover ratio bites and forces the price-level to drop.
I don’t know if I can call you “Nick”; weren’t you born several decades before me? Excuse me, I mean, isn’t your current age higher than mine? (I didn’t want to offend Menger, Jevons, and Walras with my first formulation.)
Yes, I understand the overall thrust of your post, and it’s a good one. I’m just pointing out that you were assuming your conclusion in the Martian example, and with my wise-aleck Japan tsunami comment, I’m giving a hint as to how the Austrians would respond.
But, since Yglesias asked a similar thing, I think I will try to write up an official Mises.org article on all this.