C + I + G + NX = Grossly Deceptive Partitioning

When I discuss the effect of monetary stimulus on aggregate demand with other economists, I notice that they often want an explanation couched in terms of the major components of GDP.  I find this very frustrating, as this approach does more to conceal than illuminate.  Suppose you were policy czar in a liquidity trap (such as right now), and you were asked to increase nominal GDP by 3-fold (i.e. 200%) in the next five years.  If you were given a choice of only one tool, which would it be–monetary or fiscal policy?  Any economist with an ounce of common sense would take monetary policy.  OK, so how would you explain its effect in terms of the 4 components of GDP?

One might object that this isn’t a fair question, such a rapid increase in GDP can only occur through inflation, and in that case the classical model applies–money (and velocity) determines the price level in the long run.  OK, so lets go as far from the classical model as possible.  You are at the lowest level of output (relative to trend) in American history, i.e. March 1933.  What policy tool do you choose?  FDR used both monetary and fiscal policy, although initially it was monetary policy that had the greatest effect.

So let’s look at FDR’s most effective stimulus–dollar devaluation.  How does one explain its effect using the famous four components of GDP?  One might have expected a sharp increase in the NX component, as a lower dollar boosted exports and discouraged imports.  Output did soar after the dollar was devalued, but it wasn’t because of a rise in NX, rather it was despite a sharp fall in NX.  Imports rose much faster than exports, as the “income effect” outweighed the “terms of trade effect.”

There are many ways that one could model the transmission mechanism between dollar devaluation and rising output.  The devaluation certainly raised future expected prices.  This probably reduced real interest rates, which is a very new Keynesian way of looking at things.  But it also directly impacted commodity prices in two ways, the obvious PPP effect, but also the fact that even in a closed economy that was expected to eventually return to a gold-dollar peg, a higher nominal price of gold will increase the expected future price of commodities, and thus their current price as well.  Furthermore, the resulting inflation will reduce the “debt-deflation” problem that was plaguing the economy.

In my view the most important transmission mechanism was real wages, which fell very sharply in the first four months of dollar devaluation.  One piece of evidence that real wages were important shows up in July 1933, when a policy of sharply higher wages (the NIRA) aborted a promising recovery in monthly industrial production after only 4 months.

Of course this is just one example, but it is also one of the few monetary shocks that we can identify with any confidence.  Now let’s look at another well-identified shock, the biggest year-over-year fall in the monetary base in modern American history, 1920-21.  The sharp fall in the base caused the sharpest 12 month deflation in modern American history between 1920-21.  And it also caused the sharpest one year increase in real wages in modern American history between 1920-21.  And real output plummeted.   What does the C+I+G+NX approach add to this story?  Nothing.  Of course investment usually falls more sharply than consumption in a depression, but that would be true almost regardless of what caused the depression.

Between October 1929 and October 1930 the same thing happened again, to a lesser extent.  The monetary base fell significantly, the price level fell, and real wages rose sharply.  Higher real wages made it less profitable to produce all sorts of goods–both consumption goods and investment goods.  Economists often flounder around seeking the mysterious cause of the drop in AD after late 1929.  Did consumers suddenly stop spending?  Or did a change in animal spirits hold back investment?  The answer is much simpler, as with any decline in nominal spending either the monetary base declined, base velocity declined, or both.  In 1930 it was both.  The various components of GDP will respond in different ways to the lower nominal spending under different conditions, but they don’t add any explanatory value.

Macroeconomics should be about aggregates, not components of spending.  Yes, changes occurring in the various components of GDP can impact interest rates, and thus velocity.  And if monetary policy is inept (i.e. doesn’t offset changes in velocity) that can impact nominal spending, but it certainly isn’t the most illuminating way of looking at the issue.  It’s like trying to explain changes in the overall price level by modelling changes in the nominal price of each good—theoretically possible, but a waste of time.


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24 Responses to “C + I + G + NX = Grossly Deceptive Partitioning”

  1. Gravatar of Phil P Phil P
    25. February 2009 at 09:48

    Scott, what I think you’re saying is that changes in the money supply will effect the economy one way or another so it doesn’t matter how, at least in terms of components of spending, it’s only the quantitative relation between money and output that matters. The problem I have is that while there may be empirically a strong relation between money and output, it’s not an absolutely tight one. One reason for that is no doubt that the structure of the economy is always changing. Take your 1929 example. I recall Robert Gordon once wrote a paper analyzing the relation between money and output for the interwar period and found a large unexplained residual for 1930. Some economists think the stock market crash had a significant effect in explaining the sharpness of the initial downturn. Christina Romer thought it effected consumer confidence and hence spending on consumer durables. I think that to understand the relation between money and output you have to analyze the monetary transmission mechanism, which works differently at different times because of those structural differences.

  2. Gravatar of Jon Jon
    25. February 2009 at 15:14

    I think you are right that the traditional C+I+G+NX analysis is meaningless, BUT “C” in real-terms DOES have an important effect on the fractions of real vs. inflationary growth.

    In particular if you target a nominal growth-rate, you are not controlling the balance of growth and inflation. The later could be very negative and the former very positive. Its dubious that such a scenario would be desirable even if the net was a nominal GDP growth rate of 5%.

    If you consider the problem in terms of malinvestment, a clear cause of ‘recessions’ emerges: society is under a Malthusian pressure we must invest to counteract population growth, we must invest to have a rising standard of living, and we must invest to stem depreciation.

    When an economy goes through a long period of misallocation (such as the housing construction boom), necessary investment is neglected. Down the line, the production possibilities frontier has shrunk with respect to where it ought to have been based on rising population & living standard expectations.
    The pie on average is smaller and therefore if some people retain their old living standards, others must not. Unemployment results.

    Perhaps this sounds perverse: surely then production declines… repeat, repeat, but in our modern economy, labor contributes very little to production relative to capital. So it is the shrunken capital pool which is now divided among the smaller work-force which allows them to retain their productivity per-worker.

  3. Gravatar of ssumner ssumner
    25. February 2009 at 17:10

    Phil, Not quite sure if I understand the M and Y link. I had always thought that Keynesians tend to see a M to i to investment to AD to real output to inflation mechanism. I sort of agree with Friedman that M affects nominal GDP much more directly than the Keynesians assume (although I’d use a Ratex model), and the way it gets divided between real output and prices depends on the slope of the SRAS, whether the change was expected (i.e. shifts in SRAS) etc. I should add that although I revere Friedman, I do differ on some issues relating to policy lags, expectations, and the reliability of monetary aggregates, which will come out in future posts.

    The Great Depression is my main interest, and I have published papers arguing that, contrary to Romer, the 1929 stock crash was caused by (expectations of) the Depression, not vice versa. I think people like Gordon didn’t find an explanation because they didn’t know where to look. Under an international gold standard the gold/monetary base ratio is the only exogenous policy tool. This ratio (at the world level) suddenly began rising sharply after October 1929. The 9.62% increase over the following 12 months was highly deflationary, as it meant central banks were hoarding massive amounts of gold. That’s why stocks crashed, they correctly saw that the major central banks had blundered into a highly contractionary monetary policy stance. M1 and M2 are not always particularly informative.

    Jon, The Fed doesn’t control the long run real growth rate, so you’ll get roughly 2% long run inflation under a 5% nominal GDP rule. As you point out, the inflation rate could be somewhat variable under NGDP targeting. But I agree with the Austrians that investment instability comes more from nominal GDP instability, than from inflation instability. (At least I think that’s what the Austrians believe, I anticipate being taken apart in later posts by people who note (correctly) that I don’t know much Austrian economics. But at least my view here is favorable to the Austrians.)

  4. Gravatar of Jon Jon
    25. February 2009 at 20:26

    “But I agree with the Austrians that investment instability comes more from nominal GDP instability, than from inflation instability. (At least I think that’s what the Austrians believe, I anticipate being taken apart in later posts by people who note (correctly) that I don’t know much Austrian economics. But at least my view here is favorable to the Austrians.)”

    I happen to be sympathetic to the Austrians, but I’m not sure I trace the Austrian connection in your claim about nominal GDP instability; although I agree that the Austrian perspective is not concerned with “inflation instability”. Can you elaborate?

  5. Gravatar of Bill Woolsey Bill Woolsey
    26. February 2009 at 04:06

    Jon:

    Selgin and White argue that growing nominal income leads to malinvestment. Sumner confuses this with nominal income instability, I think, because it is a more plausible source of the problem. Well, that is my view.

    I believe that your “classical” view of saving and investment is a bit faulty. The allocation of resources between the production of consumer goods and capital goods, and its implications for future production is important–as is the allocation of resources between export industries, import industries, and capital goods industries.

    Malthusian pressure? Most output is due to capital?

    Why would a shift back of production possilities lead to less employment?

    The point is not to maintain sufficient investment for somehting or other. The point is to avoid distorting the market allocation of resources between current consumption and saving, investment, and the production of consumer goods in the future.

    Sumner’s view (which I agree) is that reallocations of all sorts do better in the context of an environment of growing total expediture. And that the maintenance of that environment is entirely a matter of an adequate quantity of money. Generally, it must grow, but it must fluctuate to accomodate changes in velocity/changes in the demand to hold money.

    No one is claiming that the allocation of resources is irrelevant. For example, we included the category “toys” separate from other consumer goods in the C+I+G+NX equation, no one would say that everything would be fine if all spedning was on toys and we had no food or clothing, much less an absence of drill press machines.

    The market system and profit and loss signals shift resources to produce what people want most. The “austrian” arument is that an expansionary monetary policy distorts this resulting in excessinve production of capital goods for a time, but that this must be reversed, with production returning to consumer goods.

    Perhaps, but there are any number of things that would require a shift from the production of capital goods to consumer goods. And, further, many shifts in the allocation of resources between types of consumer goods or types of capital goods. It happens every day.

    Perhaps you already understand all of this. Still, when you explain these things, it might help if you mentioned them in passing.

  6. Gravatar of ssumner ssumner
    26. February 2009 at 16:27

    Jon, I’ll defer to Bill on the Austrian question, since he knows the subject better than I do. If I interpret Bill correctly, when I read that people like Selgin and White thought constant NGDP was best, I assumed that was because he thought unstable NGDP was bad. I made that inference because it is a very Ratex way of thinking, indeed it is also the way Friedman thought about nominal shocks. It looks like I was wrong–Selgin and White think that even steady growth in NGDP creates all sorts of investment distortions. It’s been a while since I have read Selgin’s paper, and obviously need to reread it. I recall liking his arguments for NGDP, but I am not convinced that steady moderate growth in NGDP is destabilizing. I think Selgin and I both agree, however, that NGDP growth was too fast in 2004-06.

  7. Gravatar of Jon Jon
    26. February 2009 at 21:12

    “Sumner’s view (which I agree) is that reallocations of all sorts do better in the context of an environment of growing total expediture. And that the maintenance of that environment is entirely a matter of an adequate quantity of money.”

    The first is true from a balance-sheet prospective, but some concern is due the pattern of errors that can emerge when nominal growth distorts profit-loss calculation due to inflation. This is the same sort of idea as interest-rate distortions causing patterns of error–which I believe is the Austrian connection you’re making if I understand you right.

  8. Gravatar of Greg Ransom Greg Ransom
    27. February 2009 at 21:23

    Bill Woolsey has the “Austrians” wrong on the relative price / real resources sources of the artificial boom set up to the inevitable bust.

    The Hayekian view is that expansionary monetary policy and/or mistaken perceptions of bankers and entrepreneurs results in a misdirection of investment into longer-term projects which otherwise don’t make economic sense — and inevitably will not be completed. This is why interest rates and credit and money matter — relative prices are implicated throughout the time structure of production, a deeply significant fact ignored my most economists.

    [Think of all the capital and labor that went into time consuming projects in the housing and construction and real estate and mortgage businesses ...]

    There’s actually a important category of the microeconomics of resource use choice involved here, completely ignored by almost all other economists, see Hayek’s _The Pure Theory of Capital_.

    The issue really isn’t one of “capital goods” vs. “consumption goods”, this trade-off is implicated, but it doesn’t drive the story. The time structure of non-permanent productive resources drives the story.

    Bill wrote:

    “The “austrian” arument is that an expansionary monetary policy distorts this resulting in excessinve production of capital goods for a time, but that this must be reversed, with production returning to consumer goods.”

  9. Gravatar of Bill Woolsey Bill Woolsey
    28. February 2009 at 04:02

    Ranson:

    Follow through and complete the analysis. Why cannot these projects be completed? It is because of inadequate resources. Why are resouces inadequate? Becaues they are needed for something else. What else? Consumer goods.

    The projects are not “completed?” What does cmpleted mean? The final end of production processes: consumer goods and services.

    The emphasis on the heterogenous nature of capital goods and when they finally generate consumer goods seems realistic to me realtive to imagining that all capital goods are homogenous. I think the emphasis that Austrians have put upon this is in response to the notion that a one shot inflationary episode would permaently augment the capital stock and so generate a sustainable increase in production and income. Austrians generally have argued that this could happen, but only if the tranfers generated by the inflation result in a different pattern of effective preferences. (Some savers end up wealthier and have more impact on the allocation of resources.) Otherwise, there may be more “capital” after an inflationary episode, but it is the wrong sort of capital. The financial losses on the things reflects the fact that they are less useful for generating consumer goods in the near future.

    Anyway, resources are shifted away from current consumption during the boom. And the recession involves shifting them back. The extra capital goods produced during the boom are pretty much useless and so wasted. But not all capital good production in the boom is waste.

    And, as I have explained before, monetarists and Keynesias are solely interested in what Hayek calls the secondary Depression.

    Reallocations of resoucres, including labor, and including a reversals of misallocation of resources is included in what most economists understand to be “full employment.” The unemployment of labor is called “structural” or “technological” unemployment. Traditional monetarists and Keynesias believe that reductions in total spending in the economy also lead to unemployment. And that is what is supposed to be remedied by monetary or fiscal policy. Using monetary or fiscal policy to try to prevent reallocations of resources is not the point.

    The notion that recessions are corrections of misallocations of resources seems to me to be mistaken. What is the impact of Americans purchasing their cars from Japan rather than Detroit. How exactly is this different from the shifts in relative prices and the allocation of resource that occur when misallocated resources move are corrected?

    Suppose the American car industry was built up to meet an increased demand for cars, but that people actually produced the additional cars from Japan? How is that different?

    Some of the resources..capital goods.. that were directed to domestic car production do not reach completion–cars. The resources are instead used for export goods, or, in the case of a net capital inflow, other sorts of capital goods. There is a loss of specific capital. Labor must be moved and there is structural unemployment. Loans to the domestic car industry may not be repaid.

    And, if that is too different, suppose poeple just decide that they want to consume more now. Puritan attitudes about saving give way to efforts to copy Paris Hilton. What happens?

    My view is that Mises was fixated on proving that reform efforts to abolish interest income were “impossible.” One set of implausible reforms is to lend whatever amount of newly created money as is necessary to abolish all interest income. Lend unlimited funds at zero. According to Mises, heroic efforts to carry out this policy would destroy civilization. Perhaps. I doubt, however, that recessions like the one we are having now have much to do with past money creation. Monetary regimes impact that allocation of resources in sustainable ways. A monetary regime aimed at zero interest income would have much of a sustainable impact, especially if it destroys civilization.) Errors in the operation of a regime may cause errors in the allocation of resources. But errors in the allocation of resources occur all the time for all sorts of reasons.

    I beleive that the regime we have, of 5% spending growth creates a different, sustainable allocation of resrouces than the one I prefer, 5% spending growth. And that is different again than the one that Selgin/White/Horwitz Austrians prefer of constant aggregate expendture. And that is different from a constant quantity of fiat money. Which is different from the 100% gold standard that the “Mises Insitute” crowd favors.

    Shifts between regimes are likely to cause unsustainable shifts in the allocation of resources. Errors in the operation of these regimes will also have that effect.

    In my view, the speculative bubble in residential housing was not closely related to either regime shifts or erros in regimes. I think it has more to do with fools, and people hoping to sell to greater fools.

  10. Gravatar of Bill Woolsey Bill Woolsey
    28. February 2009 at 04:13

    Ranson:

    Follow through and complete the analysis. Why cannot these projects be completed? It is because of inadequate resources. Why are resouces inadequate? Becaues they are needed for something else. What else? Consumer goods.

    The projects are not “completed?” What does cmpleted mean? The final end of production processes: consumer goods and services.

    The emphasis on the heterogenous nature of capital goods and when they finally generate consumer goods seems realistic to me realtive to imagining that all capital goods are homogenous. I think the emphasis that Austrians have put upon this is in response to the notion that a one shot inflationary episode would permaently augment the capital stock and so generate a sustainable increase in production and income. Austrians generally have argued that this could happen, but only if the tranfers generated by the inflation result in a different pattern of effective preferences. (Some savers end up wealthier and have more impact on the allocation of resources.) Otherwise, there may be more “capital” after an inflationary episode, but it is the wrong sort of capital. The financial losses on the things reflects the fact that they are less useful for generating consumer goods in the near future.

    Anyway, resources are shifted away from current consumption during the boom. And the recession involves shifting them back. The extra capital goods produced during the boom are pretty much useless and so wasted. But not all capital good production in the boom is waste.

    And, as I have explained before, monetarists and Keynesias are solely interested in what Hayek calls the secondary Depression.

    Reallocations of resoucres, including labor, and including a reversals of misallocation of resources is included in what most economists understand to be “full employment.” The unemployment of labor then is called “structural” or “technological” unemployment. Traditional monetarists and Keynesias believe that reductions in total spending in the economy also lead to unemployment. And that is what is supposed to be remedied by monetary or fiscal policy. Using monetary or fiscal policy to try to prevent reallocations of resources is not the point.

    The notion that recessions are corrections of misallocations of resources seems to me to be mistaken. What is the impact of Americans purchasing their cars from Japan rather than Detroit. How exactly is this different from the shifts in relative prices and the allocation of resource that occur when misallocated resources are corrected?

    Suppose the American car industry was built up to meet an increased demand for cars, but that people actually purchased the additional cars from Japan? How is that different?

    Some of the resources..capital goods.. that were directed to domestic car production do not reach completion–cars. The resources must instead bed used for export goods, or, in the case of a net capital inflow, other sorts of capital goods. There is a loss of specific capital. Labor must be moved and there is structural unemployment. Loans to the domestic car industry may not be repaid.

    And, if that is too different, suppose poeple just decide that they want to consume more now. Puritan attitudes about saving give way to efforts to copy Paris Hilton. What happens?

    My view is that Mises was fixated on proving that reform efforts to abolish interest income were “impossible.” One set of implausible reforms is to lend whatever amount of newly created money as is necessary to abolish all interest income. Lend unlimited funds at zero. According to Mises, heroic efforts to carry out this policy would destroy civilization. Perhaps. I doubt, however, that recessions like the one we are having now have much to do with past money creation. Monetary regimes impact that allocation of resources in sustainable ways. A monetary regime aimed at zero interest income would have much of a sustainable impact, especially if it destroys civilization.) Errors in the operation of a regime may cause errors in the allocation of resources. But errors in the allocation of resources occur all the time for all sorts of reasons.

    I believe that the regime we have, of 5% spending growth creates a different, sustainable allocation of resrouces than the one I prefer, 3% spending growth. And that is different again than the one that Selgin/White/Horwitz Austrians prefer of constant aggregate expendture. And that is different from a constant quantity of fiat money. Which is different from the 100% gold standard that the “Mises Insitute” crowd favors.

    Shifts between regimes are likely to cause unsustainable shifts in the allocation of resources. Errors in the operation of these regimes will also have that effect.

    In my view, the speculative bubble in residential housing was not closely related to either regime shifts or erros in regimes. I think it has more to do with fools, and people hoping to sell to greater fools.

    I think the popping of that bubble resulted in a large increase in the demaand for money. And that a large increase in the quantity of money is in order to correct taht problem. Such a policy will not “correct” the misallocated resources or result in people buying up houses at a rate to use up current construction capacity. But it would prevent other sorts of consumption and investment from dropping at a rapid rate.

  11. Gravatar of ssumner ssumner
    28. February 2009 at 11:10

    Dear Jon and Greg, Again with the disclaimer that Austrian econ is not my strength, I wonder about a couple points:

    1. If there is over-investment during a boom, and resources later have to be redirected, does that need to cause mass unemployment? It seems to me that for two years we got away with redirecting resources from housing to areas like exports and services, with only a mild rise in unemployment. Then unemployment rose sharply in the second half of last year when nominal GDP started falling.

    2. Is the Austrian view consistent with rational expectations? I admit that after back-to-back manias (tech and housing) the efficient markets argument is difficult to make, but nonetheless I will make it in another post. But either way, I’d like your thoughts on whether the Austrian view is based on the premise that investors behave in a way that is not in their own interest during these excessive investment booms.

    Bill, I agree with you that it is a mistake to see recessions as simply a reallocation of capital (although some of that may occur.)

    What is the “second depression”? Is that what I think of as a regular depression? And if so is the drop in consumption during an investment boom the first depression? BTW, I thought consumption rose during booms, and it was leisure time that got pinched?

  12. Gravatar of Jon Jon
    1. March 2009 at 00:02

    “But either way, I’d like your thoughts on whether the Austrian view is based on the premise that investors behave in a way that is not in their own interest during these excessive investment booms.”

    The irrationality of the actors is that they cannot separate the true ‘time-preference’ from the ‘distorted-interest-rate’; however, the actors may otherwise be rational.

    Given this, the claim is that credit expansion is not felt as a uniform distortion of the price-level or as uniform stimulus. Rather, certain activities are more interest-rate sensitive. This produces a distortion wherein capital-intensive processes are overproduced (and compete resources away from capital-insensitive processes). This is an inefficient allocation of resources vis-a-vis the natural state. Consequently, the ‘real surplus’ declines ceteris paribus (inflation), which continues to magnify the interest-rate distortion. Eventually bankers panic (in a modern sense because of their inflation targets or in the classical sense because of gold-cover-ratios) and withdrawal the supply of credit.

  13. Gravatar of ssumner ssumner
    1. March 2009 at 17:59

    Thanks Jon, It seems to me that the business cycle transmission mechanism is so complex, that we might never figure it out. Indeed we might come up with a reasonable solution (say NGDP targeting) without knowing exactly why that solution works. On a slightly different topic I recall Bennett McCallum once writing that there were at least 10 different theories of wage and price stickiness, each with subtly different implications. And that’s just within new Keynesianism. The business cycle might be partly due to wage stickiness, partly to price stickiness, partly to distortions in the credit markets emphasized by the Austrians, partly due to the new Classical idea of confusing real and nominal shocks, etc. I am a pragmatist, and am mainly focused on what sort of monetary policy seems to work. I feel that when we have made clear policy errors, in almost every case a smoother path of NGDP would have been better in retrospect.

  14. Gravatar of Greg Ransom Greg Ransom
    1. March 2009 at 18:29

    Kevin Hoover compares “Austrian” and “New Classical” versions of expectations in his 1990 _The New Classical Macroeconomics_.

    And here’s Garrison on “rational expectation”, pointing out that Lucas credits Hayek for inspiring his work in this direction (a topic also covered by Hoover):

    http://www.auburn.edu/~garriro/a1interview.htm

    “How do you view the rational-expectations revolution? Did it make a significant and meaningful contribution? Did it owe any debt to the Austrians?

    The most significant positive effect of the rational-expectations revolution has been to require macroeconomic theorists to make explicit their assumptions about expectations. Before the revolution, all too many theoretical results hinged on some critical but unstated assumption of systematic expectational error. Sometimes simply articulating an assumption, for instance, that workers take the cost of living to be constant when in fact it is steadily increasing, reveals its implausibility. But if the word rational is stipulated to mean consistent with—or, at least, not systematically inconsistent with—the underlying structure of the economy, then the rationality of expectations does not guarantee or even imply plausibility. How do agents know—or behave as if they know—the structure of the economy? Adam Smith has taught us that markets can work despite the fact that agents have little or no appreciation of theoretical economics. All I’m suggesting here is that replacing know-nothing agents with know-it-all agents is not always an improvement. We need to theorize in terms of know-all-they-can-plausibly-know agents.
    The rational-expectations revolution does owe a debt to the Austrians. Lucas makes regular payments on that debt by acknowledging Hayek’s early contributions in the area of economics and knowledge. But the clearest antecedent is in the 1953 addendum to The Theory of Money and Credit (1912), where Mises captures the kernel of truth in the rational-expectations hypothesis in his critical analysis of inflationary finance. Mises offered his own insightful treatment of expectations as an application of Lincoln’s Law: “You can’t fool all of the people all of the time.”

    How would you classify the Austrian approach to expectations? If it is neither rational nor adaptive, then how is it best classified?

    The Austrian treatment of expectations is guided by considerations about what kind of knowledge market participants can plausibly have. Hayek often makes use of the distinction between two kinds of knowledge. Theoretical knowledge, or knowledge of the structure of the economy, is contrasted with entrepreneurial knowledge, or the knowledge of the particular circumstances of time and place. Economists have some of the first kind of knowledge but not much of the second; market participants have some of the second kind of knowledge but not much of the first. There is a certain formal parallel, here, with the two kinds of knowledge (global and local) in typical island parables as told by New Classicists. The difference between the two constructions reflects a more general contrast between Austrian real-worldliness and New Classical other-worldliness.
    Beyond the constraint imposed by considerations of plausibility, the Austrians, starting with Menger, have tried to give free play to expectation so as not be second-guessing the entrepreneur. There are, however, some implicit assumptions underlying it all that some market participants have greater entrepreneurial foresight than others, that the market systematically rewards superior entrepreneurship, and that reality eventually asserts itself.
    It’s worth pointing out that the Hayekian distinction between theoretical and entrepreneurial knowledge helps identify the limits of both rational planning and rational expectations. Trying to push beyond the limits reflects erroneous views about who can plausibly have what kind of knowledge: Advocates of rational planning believe that planners or their economists can have as much—if not more—of the second kind of knowledge as can market participants. Proponents of the more extreme versions of rational expectations assume that market participants have, or behave as if they have, as much of the first kind of knowledge as do economists.”

  15. Gravatar of Jon Jon
    1. March 2009 at 20:46

    Scott:

    “Thanks Jon, It seems to me that the business cycle transmission mechanism is so complex, that we might never figure it out. Indeed we might come up with a reasonable solution (say NGDP targeting) without knowing exactly why that solution works.”

    I think this is just so, and in particular, that not all recessions are the result of the same processes. Austrians and Keynesians alike are arrogant in presuming that the same narrative links cycle to cycle.

    In that sense, a monetary policy rule that is agnostic to the cause could be just the right line. Still what about the Taylor Rule?

    BTW, if you haven’t, I do recommend some of Taylor’s recent work on this crisis. He makes a pretty convincing case that there never was a liquidity crisis per-se.

    http://www.stanford.edu/~johntayl/

  16. Gravatar of ssumner ssumner
    2. March 2009 at 16:41

    Greg and Jon, Both good posts. Greg, I understand the point Garrison was making, but I guess I still go back to the idea that one shouldn’t assume that people are making errors in a particular direction. Thus if there is a monetary shock, I agree that financial markets won’t always correctly understand its implication, but I also don’t think that one should assume they consistently over or underestimate its impact. That’s really all I am saying–and I think it is all the Ratex hypothesis implies. I’ll have a couple posts in a week or two that give practical examples of what I mean.

    Thanks for the article Jon. I had read it and liked much of it. My only problem is that I still think policy needs to be more forward-looking. And I think October 2008 was a perfect example of a backward-looking central bank falling behind the curve.

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    [...] These ideas were addressed from a slightly different perspective in this very early post, which appears to be Marcus Nunes’ [...]

  22. Gravatar of TheMoneyIllusion » Spending on cars and houses doesn’t matter TheMoneyIllusion » Spending on cars and houses doesn’t matter
    27. April 2012 at 05:49

    [...] new GDP figures offer a reminder that one can’t analyze movements in GDP by looking at components of GDP.  We saw huge increases in spending on cars (pushing consumer durables up by 15.3%) and houses (up [...]

  23. Gravatar of Scott Sumner on Smithianism « Modeled Behavior Scott Sumner on Smithianism « Modeled Behavior
    1. May 2012 at 08:32

    [...] writes The new GDP figures offer a reminder that one can’t analyze movements in GDPby looking at components of GDP.  We saw huge increases in spending on cars (pushing consumer durables up by 15.3%) and houses (up [...]

  24. Gravatar of “Regime Uncertainty” or “Monetary Policy Misjudgments”? | Historinhas “Regime Uncertainty” or “Monetary Policy Misjudgments”? | Historinhas
    6. September 2013 at 14:11

    [...] knows the dictum: “don´t reason from a price change”. Less known is the one that says: “don´t reason from a GDP component change”. And that´s the ‘error’ Higgis makes. The chart shows Nominal Net Private Investment and [...]

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