The Good Old Chicago School: RIP

Paul Krugman has recently had a lot of good posts on monetary policy, and also on the messages that are being sent from the bond market (if only we’d pay attention.)  Even where I disagree with him (as on fiscal stimulus) I concede that he has much better arguments than his opponents.  In this post he criticizes University of Chicago economist Raghu Rajan for advocating higher interest rates:

Rajan’s argument boils down to two assertions:

1. Raising rates a bit wouldn’t significantly deter investment.

2. “Unnaturally low” interest rates are distorting asset prices.

The first thing to say about these two assertions is that they are essentially contradictory. If the difference between current rates and the rates Rajan wants is trivial “” just a wafer thin mint “” how can that same difference be leading to a major distortion in financial markets? Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators? And actually, don’t asset prices themselves matter for real investment?

It might be worth noting, in this context, that just because the interest rate on safe bonds is near zero, that doesn’t mean that people making risky investments can borrow at near-zero rates.

Beyond all that, what does Rajan mean by “unnaturally low” rates? What makes them unnatural?

My take on the current economic situation is quite simple, and I would have thought corresponds to standard economics. Right now, we clearly don’t have enough demand to make full use of the economy’s productive capacity. This means that the real interest rate is too high. And so the “natural” thing is for the real rate to fall. Yes, that would mean a negative real rate. So?

And then here he (and Brad DeLong and Richard Serlin) point out that recent conservative arguments echo arguments that conservatives were making in the 1930s:

The attitude on display from quite a few economists bears a distinct resemblance to Depression-era liquidationism, as described in Brad DeLong’s excellent but somehow never published book on the economic history of the 20th century:

I have been making similar arguments in this blog.  Krugman’s observation reminded me of Milton Friedman and Anna Schwartz’s Monetary History of the US.  Friedman and Schwartz fought a battle on two fronts; against liberals who said monetary policy was ineffective in a depression, and against right-wingers who said it was effective in boosting nominal demand, but that this would be an undesirable outcome.  The conservatives saw the Depression as a sort of hangover—painful but necessary.  Friedman and Schwartz were particularly critical of the Austrian view that the roots of the Depression lay in easy money policies during the 1920s (policies that they correctly noted weren’t particularly easy.)

Unfortunately, Milton Friedman died in 2006 and Anna Schwartz has recently gone over to the dark side (as I showed in this post.)  If Friedman were alive, I am pretty sure that he would disagree with Rajan’s view that low interest rates lead to high asset prices.   Here is Friedman in 1998:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

No kidding!   Without Friedman, there doesn’t seem to be anyone left to make the argument that low interest rates are actually a sign of tight money.  

Although Friedman is best known for his advocacy of targeting the money supply, he was even more strongly attached to the idea of market efficiency.  In the 1990s he endorsed Robert Hetzel’s proposal to have the Fed target inflation expectations in the TIPS market.  Now if only we could find an economist who is willing to carry on the tradition of Milton Friedman.  Low interest rates are a sign of tight money, and we need to target inflation forecasts, not interest rates.  Who will resurrect the old Chicago School?

PS.  I hope Brad DeLong gets that book published.  I know how it feels to have a book weighing down on one’s shoulders for 15 years.


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40 Responses to “The Good Old Chicago School: RIP”

  1. Gravatar of Thorfinn Thorfinn
    14. June 2010 at 12:56

    Cochrane could have filled this role. Here is is in an essay (wrongly derided as “Treasury view”):

    In sum, there is a plausible diagnosis and a logically consistent argument under which fiscal stimulus could help: We are experiencing a strong portfolio, precautionary, and technical demand for government debt, along with a credit crunch… However, this demand can be satisfied in far greater quantity, much more quickly, much more reversibly, and without the danger of a fiscal collapse and inflation down the road, if the Fed and Treasury were simply to expand their operations of issuing treasury debt and money in exchange for high-quality private debt and especially new securitized debt.

  2. Gravatar of John Hall John Hall
    14. June 2010 at 13:20

    You can’t get to the original Friedman article from your link. Here it is:
    http://www.hoover.org/publications/digest/3531496.html

  3. Gravatar of Greg Ransom Greg Ransom
    14. June 2010 at 14:52

    Kugman’s bewilderment exposes the bankrupt economics of a man who “models” the structure of capital as “K”:

    “If the difference between current rates and the rates Rajan wants is trivial “” just a wafer thin mint “” how can that same difference be leading to a major distortion in financial markets?”

    In fact, contra-Krugman, capital DOES have a time structure, which is shaped by the rate of interest.

    This is at the CENTER of the logic of choice in a production goods using economy — but this key element is MISSING from Krugman’s mental universe. Hence his bewilderment.

    Production processes that take more time will typically not be adopted unless they yield a greater return than those that take less time, and even small changes in rate of interest will change the whole structure of interconnected production process, because their returns change depending on the rate of interest and time required for production.

    “K” is a stand in representing a bullet hole through the brain of the modern economist.

  4. Gravatar of Alejandro Alejandro
    14. June 2010 at 14:52

    Scott,

    It is not Friedman 1998, it´s from the AEA 1967 Presidential Address reproduced by the AER in 1968. Some more quotes from the same speech:

    “To state the general conclusion still differently, the monetary authority controls nominal quantities-directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity-an exchange rate, the price level, the nominal level of national income, the quantity of money by one or another definition-or to peg the rate of change in a nominal quantity-the rate of inflation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money.”

    So Friedman believed the FED could use NGDP in principle as a target.

    So what did Master Yoda I mean Friedman suggest?

    “The first requiremrent is that the monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy…”

    So drop the Taylor Rule.

    “Of the three guides listed, the price level is clearly the most important in its own right. Other things the same, it would be much the best of the alternatives-as so many distinguished economists have urged in the past. But other things are not the same. The link between the policy actions of the monetary authority and the price level, while unquestionably present, is more indirect than the link between the policy actions of the authority and any of the several monetary totals. Moreover, monetary action takes a longer time to affect the price level than to affect the monetary totals and both the time lag and the magnitude of effect vary with circumstances. As a result, we cannot predict at all accurately just what effect a particular monetary action will have on the price level and, equally important, just when it will have that effect. Attempting to control directly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false stops and starts.

    Drop P (level) targeting since it is hard to determine the link between instruments and outcome in the short run. I guess the same would apply to NGPD targeting.

    “Accordingly, I believe that a monetary total is the best currently available immediate guide or criterion for monetary policy-and I believe that it matters much less which particular total is chosen than that one be chosen.”

    But what about NGDP futures as you suggest? Do you think Friedman would have agreed?

    Maybe this helps to answer the question

    “A second requirement for monetary policy is that the monetary authority avoid sharp swings in policy. In the past, monetary authorities have on occasion moved in the wrong direction-as in the episode of the Great Contraction that I have stressed. More frequently, they have moved in the right direction, albeit often too late, but have erred by moving too far. Too late and too much has been the general practice.”

    “The reason for the propensity to overreact seems clear: the failure of monetary authorities to allow for the delay between their actions and the subsequent effects on the economy. They tend to determine their actions by today’s conditions-but their actions will affect the economy only six or nine or twelve or fifteen months later. Hence they feel impelled to step on the brake, or the accelerator, as the case may be, too hard.”

    Should we get a ouija board just to be sure?

    Alejandro

    PS: Changed my nick from Alex to Alejandro since there are too many Alex´s posting here.

  5. Gravatar of Greg Ransom Greg Ransom
    14. June 2010 at 14:53

    Except that De Long presents a completely fraudulent account of the work of Hayek and others.

    “The attitude on display from quite a few economists bears a distinct resemblance to Depression-era liquidationism, as described in Brad DeLong’s excellent but somehow never published book on the economic history of the 20th century”

  6. Gravatar of Alejandro Alejandro
    14. June 2010 at 15:02

    Scott,

    I correct myself. You are right, the quote is from 1998, but it is basically the same as a paragraph from the article I quoted from 1968.

    Alejandro.

  7. Gravatar of Greg Ransom Greg Ransom
    14. June 2010 at 15:02

    Once again, Scott, you are muddling disputes about empirical facts and disputes about theory.

    Hayek post-1960 repeatedly said he had the money story in the USA in the 1930s WRONG. Hayek explicitly said that Fed policy in the 1930s made the monetary contraction far worse, and Hayek said he advocated counter-deflationary measures in such conditions, CONSISTENT WITH HIS THEORY.

    You’ve gotten this right before, why are you telling the misrepresenting the story now?

    Scott writes:

    “Friedman and Schwartz fought a battle on two fronts; against liberals who said monetary policy was ineffective in a depression, and against right-wingers who said it was effective in boosting nominal demand, but that this would be an undesirable outcome. The conservatives saw the Depression as a sort of hangover””painful but necessary. Friedman and Schwartz were particularly critical of the Austrian view that the roots of the Depression lay in easy money policies during the 1920s (policies that they correctly noted weren’t particularly easy.)”

    And a BIG problem for Americans is to remember that Hayek and Keynes in the early 1930s had their focus on Britain, it was the British situation they knew and cared about.

    Hard for an American to wrap his head around, I know.

  8. Gravatar of Greg Ransom Greg Ransom
    14. June 2010 at 15:04

    Note well.

    As early as Feb. 1932 Hayek was endorsing the validity of some of Keynes’ ideas for counter-cyclic “interventions” — and he repeated these endorsements throughout his life.

    Economists like Krugman willfully falsify the record for their own political purposes — and it needs to be said.

  9. Gravatar of david david
    14. June 2010 at 15:41

    Scott’s statement of Friedman’s view on Austrian theorydoes seem correct, though.

  10. Gravatar of jsalvatier jsalvatier
    14. June 2010 at 15:51

    I think the second chart here is great http://www.economist.com/blogs/freeexchange/2010/06/monetary_policy_3

  11. Gravatar of Greg Ransom Greg Ransom
    14. June 2010 at 16:34

    I’ve found no evidence that Friedman was competent in Hayek’s economics — beyond the picture of the price system as a signaling information system which Friedman borrowed from Hayek for the opening chapter of his _Free to Choose_.

    We know that Friedman taught Hayek’s essay “The Use of Knowledge in Society” to his grad students.

    And we can guess that Friedman heard some “pop” Hayek on such things as inflation at Mont Pelerin Society meetings or from the popular media.

    But I’ve seen no evidence that Friedman understood Hayek’s economics at any non-superficial level — and much evidence that Friedman failed to “get it” at a very basic level.

  12. Gravatar of scott sumner scott sumner
    15. June 2010 at 05:55

    Thorfinn, I don’t agree with Cochrane’s fiscal view of the price level, and I don’t think Friedman would either. He sees cash and Treasury debt as close substitutes, whereas Friedman and I don’t. But his proposal is better than nothing.

    John, Thanks, I fixed it.

    Greg, You said;

    “Production processes that take more time will typically not be adopted unless they yield a greater return than those that take less time, and even small changes in rate of interest will change the whole structure of interconnected production process, because their returns change depending on the rate of interest and time required for production.”

    If so then Krugman’s right and Rajan’s wrong. Krugman is arguing that higher rates would affect investment.

    Thanks Alejandro, It’s good to read those golden oldies. Late in his life he endorsed futures targeting.

    Greg, I think DeLong was criticizing Hayek of the early 1930s, not of the 1960s.

    Greg, You said;

    “As early as Feb. 1932 Hayek was endorsing the validity of some of Keynes’ ideas for counter-cyclic “interventions” “” and he repeated these endorsements throughout his life.”

    By then it was much too late, the damage from tight money had mostly been done. And fiscal stimulus had little to offer.

    David. Thanks.

    jsalvatier. Yes, that is a great graph.

    Greg, Wouldn’t they have conversed when they were both at Chicago?

  13. Gravatar of Doc Merlin Doc Merlin
    15. June 2010 at 06:47

    ‘Low interest rates are a sign of tight money, and we need to target inflation forecasts, not interest rates’

    You cannot point to the price level of debt and say money is tight or loose.

  14. Gravatar of Greg Ransom Greg Ransom
    15. June 2010 at 07:55

    Scott, this was close to the first thing Hayek published in an English publication.

    Hayek was a theorist, he wasn’t a politician and wasn’t a policy wonk, and he’d just moved to England. Hayek wasn’t offing policy advice, Hayek was doing science and trying to get the theory right, that was his interest and his agenda.

    You are condemning Hayek on false grounds and blaming him for events he had nothing to do with.

    You mistake Hayek for the sort of political hacks that populate the economic departments today.

    “Greg, You said;

    “As early as Feb. 1932 Hayek was endorsing the validity of some of Keynes’ ideas for counter-cyclic “interventions” “” and he repeated these endorsements throughout his life.”

    By then it was much too late, the damage from tight money had mostly been done. And fiscal stimulus had little to offer.”

  15. Gravatar of Greg Ransom Greg Ransom
    15. June 2010 at 08:00

    Hayek and Friedman didn’t talk that much while together at Chicago, and there isn’t much evidence that they ever talked economics. They were in different departments, working on very different topics.

    The only exception is that Friedman presented his paper on how to do economic science in Hayek’s faculty seminar on the philosophy of science. In Hayek’s judgment that work has done more damage to economic science than any other single work, excepting only Keynes’ “General Theory”.

    And Friedman’s remarks on Hayek’s explanatory strategy in economics shows that Friedman had no understanding whatever of Hayek’s approach to economic science.

    “Greg, Wouldn’t they have conversed when they were both at Chicago?”

  16. Gravatar of Greg Ransom Greg Ransom
    15. June 2010 at 08:15

    I’m talking about the structure of different streams of production, you and Krugman are talking about “aggregate investment”.

    This is Krugman:

    >>1. Raising rates a bit wouldn’t significantly deter investment.

    2. “Unnaturally low” interest rates are distorting asset prices.

    The first thing to say about these two assertions is that they are essentially contradictory.<<

    If different rates of interest alters the structure of production and relative prices of processes taking differential lengths of time, then "aggregate investment" can be the same quantity, and AT THE SAME TIME asset prices can be distorted.

    This is relative price / capital theory 101 — and it the BIG NEWS here is that Krugman can't even conceive of its existence.

    Adjustments across time and between production processes are at the HEART of the market adjustment process — and this heart of the system is lost on Krugman. Why? Because it is eliminated from "economics" by the fiat of assumption, in order to produce elegant, tractable "Keynesian" models, which apply to no world that exists anywhere.

    "Greg, You said;

    “Production processes that take more time will typically not be adopted unless they yield a greater return than those that take less time, and even small changes in rate of interest will change the whole structure of interconnected production process, because their returns change depending on the rate of interest and time required for production.”

    If so then Krugman’s right and Rajan’s wrong. Krugman is arguing that higher rates would affect investment."

  17. Gravatar of david glasner david glasner
    15. June 2010 at 10:43

    Scott,

    I agree with your point originally made by Friedman that you can’t infer the policy stance of the monetary authorities just by looking at the interest rate that they are setting. It’s the old identification problem. The stance depends on the relationship between the observed central bank rate and the unobserved “natural rate” (to use a terminology that I am increasingly uncomfortable with). But for the protection of the unwary, I think that you should from time to time add the qualification that a central bank seeking to loosen its policy stance will always REDUCE its rate and a central bank seeking to tighten its stance will always RAISE its rate. What would your reaction be if Bernanke announced tomorrow that he was going to raise the Fed Funds rate to say 2.5 percent?

    Greg, I sympathize with your desire to shield Hayek from unfair criticism, but unfortunately you really can’t absolve him from all blame for bad policy advice during the 1930s. First of all, in those days, everyone was giving policy advice on the basis of limited knowledge of the facts, so the fact that Hayek obviously had limited knowledge of the facts can’t excuse his really bad advice which was not to try to stop deflation and not to go off the gold standard. It just doesn’t get much worse than that and it is what it is. Second, Lionel Robbins published his book The Great Depression 1934 (which he later disavowed), and it was a deflationist tract written very much under Hayek’s influence. Do you think that Robbins (who was Hayek’s colleague and best friend in those days) would have published a policy book in Hayek’s area of expertise that Hayek disagreed with?

    Moreover, Hayek and Mises were very outspoken in criticizing Benjamin Strong for cutting interest rates in 1927, warning that it would only delay not avoid an eventual downturn. Are you saying that whenever they got it right, they should get credit, but whenever they got it wrong it was just because they weren’t fully informed?

    Finally, on Krugman. First of all, he is arguing with Rahgu Rajan who is operating in a simple neoclassical model. Why would you expect Krugman to criticize him from an Austrian perspective. He is simply saying that in terms of his own theoretical position, Rajan is arguing incoherently. As for the substance of your criticism, while Austrians certainly believe that the interest rate affects the composition of investment, I don’t think that Austrians would deny that the interest rate also governs the quantity of investment. If voluntary savings increase because of a reduced rate of time preference, the reduced interest rate must not only affect the composition of investment it must also induce an increased aggregate level of investment to match the increased amount of voluntary savings. So even if Krugman overlooked the effect of interest on the composition of investment, it doesn’t mean that he was wrong about the quantity of investment.

  18. Gravatar of Greg Ransom Greg Ransom
    15. June 2010 at 21:26

    David writes,

    “you really can’t absolve him from all blame for bad policy advice during the 1930s.”

    Can you give me some citation of this advice?

    Is it some remark Hayek made in the 2nd edition of _Prices and Production_ written in 1935?

    Or what?

    Davis writes:

    “First of all, in those days, everyone was giving policy advice on the basis of limited knowledge of the facts, so the fact that Hayek obviously had limited knowledge of the facts can’t excuse his really bad advice which was not to try to stop deflation and not to go off the gold standard.”

    I’m interested in getting the history right. I’m not much interested in anything else.

    In the 1930s Hayek must have been working more than 10-12 hours a day, given his editing, teaching load, reading load, and theoretical output. And I don’t see any evidence that any of this time was spent following the empirical situation in America. Hayek thru his life is often clueless about what is happening on the ground (people who knew him have told me this, I’m curious about your own experience with Hayek.) He spent his time post-1929 on his theory and reading, and he lived in Britain and cared about the British political economic situation. In the early 1930s Hayek’s knowledge of the American case was far more severely limited than, say, an American statistical macroeconomist working at the NBER.

    Everyone seems to believe something close to the idea that Hayek secretly wrote Robbins 1934 book. But he didn’t write it.

    Has anyone done the scholarship to establish exactly what Hayek’s relationship was to the content of the particulars of Robbins text?

    Robbins was a leading figure deeply engaged in British financial policy and politics. Hayek was not involved in that at all. It would be deeply revisionary — requiring facts — to argue that Robbins was not an independent figure with complete authority and confidence in his own judgment when it came to policy and theory.

    Until we have better scholarship, we are going on guesswork here, not facts.

    David writes,

    “Lionel Robbins published his book The Great Depression 1934 (which he later disavowed), and it was a deflationist tract written very much under Hayek’s influence. Do you think that Robbins (who was Hayek’s colleague and best friend in those days) would have published a policy book in Hayek’s area of expertise that Hayek disagreed with?”

    David writes,

    “Hayek and Mises were very outspoken in criticizing Benjamin Strong for cutting interest rates in 1927, warning that it would only delay not avoid an eventual downturn.”

    At this time Hayek was doing empirical monetary and trade cycle work and was publishing empirical monetary and trade cycle work. After 1930 Hayek did none of this work.

    David writes,

    “Are you saying that whenever they got it right, they should get credit, but whenever they got it wrong it was just because they weren’t fully informed?”

    No, I’m not saying that.

    But its just an historical fact that between 1923 and 1929 Hayek did a lot of empirical work on money and trade cycle data, and after 1930 he did none.

    And not just Hayek, but the whole profession learned a lot from Friedman & Schwartz’ _Monetary History_.

    And it’s simply part of the historical record that Hayek says he didn’t know what was happening in America in the 1930s.

  19. Gravatar of Greg Ransom Greg Ransom
    15. June 2010 at 21:34

    No, Krugman is attacking Hayek by name, and linking him to Rajan.

    Did you read his blog post?

    It’s pretty clear that Krugman is ignorantly assuming a simple neoclassical model in his attacks on Hayek’s economics as well, and he’s done this repeatedly, even when corrected by other economists.

    Krugman can’t think outside this contrary-to-reality box — and you can’t talk with any intelligence about Hayek unless you can.

    David writes,

    “First of all, he is arguing with Rahgu Rajan who is operating in a simple neoclassical model.”

  20. Gravatar of Greg Ransom Greg Ransom
    16. June 2010 at 06:02

    David and Scott,

    What we need to do is stay in the realm of facts.

    1. Hayek and Hayek’s work had NO influence on economic policy in any country in the world in the 1930s.

    2. Hayek didn’t do ANY work in the realm of either empirical study or policy recommendations in the 1930s.

    3. Hayek’s economics — give the ACTUAL FACTS of the time — imply counter-deflationary monetary actions.

    4. The measures David claims Hayek recommended in the early 1930s (please provide the passages) are NOT implied by his monetary / trade cycle work — they are POLITICAL measure to address a political problem.

    Here’s why this matters. Economists such as De Long and Krugman want pass off a FALSE account of these facts order to smear and discredit Hayek’s THEORETICAL work on grounds that have NOTHING to do with his work, and that is EXACTLY what Krugman does in his blog post, and that is what Scott has repeatedly also does with his references to Friedman’s attacks on “Austrian” economics in his _Monetary History_.

    If we care about actual getting the science right we need to chop away all of the unhelpful bogus history that provides a brick wall blocking actual thinking.

  21. Gravatar of scott sumner scott sumner
    16. June 2010 at 06:03

    Doc Merlin, I would prefer we target the price of goods, not the price of debt.

    Greg, You said;

    You are condemning Hayek on false grounds and blaming him for events he had nothing to do with.”

    Not only did I not condemn Hayek in my post, I didn’t mention his name. What I said was in response to a point you raised. I actually like Hayek as an economist, and have no interest in condemning him. This post attacks recent trends in Chicago macro, not Hayek.

    Greg, I just don’t understand your criticism of Krugman. He never denied that the structure of investment could change as well. Your criticism applies to Rajan, not Krugman. Rajan’s the one who says interest rates don’t affect investment.

    David, You said;

    “I agree with your point originally made by Friedman that you can’t infer the policy stance of the monetary authorities just by looking at the interest rate that they are setting. It’s the old identification problem. The stance depends on the relationship between the observed central bank rate and the unobserved “natural rate” (to use a terminology that I am increasingly uncomfortable with). But for the protection of the unwary, I think that you should from time to time add the qualification that a central bank seeking to loosen its policy stance will always REDUCE its rate and a central bank seeking to tighten its stance will always RAISE its rate.”

    I’m not sure I agree with this, at least if monetary policy is defined broadly to include other instruments. (Other than short term rates.) Thus if a country devalues, as we did in 1933, monetary policy becomes far more expansionary even if interest rates don’t change at all. As I recall there was almost no change in rates in 1933. If Bernanke announced a much higher inflation target tomorrow, that would be a more expansionary policy even if accompanied by a tiny increase in the fed funds rate.

    I think it would be more correct to say that central banks often use short term rate changes as a signal of policy intentions. In that case I agree with you. But short term rates can’t be the only policy tool, or else the price level becomes indeterminate. If you change other policy instruments (like inflation targets) then interest rates can move perversely.

    But you raise a good question, and I might want to think a bit more about this and do a post sometime.

    I appreciate the info on Hayek. It is very interesting that he criticized Strong’s easy money policy of 1927.

    Greg, Krugman’s criticism of Rajan on interest rates and investment is very different from his criticism of Hayek. He never said Hayek denied that interest rates could affect investment. Indeed I think Hayek would also disagree with Rajan.

  22. Gravatar of scott sumner scott sumner
    16. June 2010 at 06:06

    Greg, Hayek and I both favor NGDP targeting. Why would I want to smear his theoretical work?

  23. Gravatar of Greg Ransom Greg Ransom
    16. June 2010 at 09:21

    Are we talking about the money total of investment, or the structural distribution of investment” These are VERY different things.

    Changing interest rates changes the structural distribution of investments. This could distort asset prices.

    And this does not require a change in the total aggregate size of investment.

    Krugman seemed to deny this, Rajan seemed to suggest this.

    The big point is that economists are not clear about this — and the the very significant reason that they have chosen mathematical ease and tractability over applicability to the problem at hand.

    Economics studies a coordination problem. If by modeling fiat you eliminate the central coordination problem, your results won’t helpful or valid.

    Scott writes,

    “I just don’t understand your criticism of Krugman. He never denied that the structure of investment could change as well. Your criticism applies to Rajan, not Krugman. Rajan’s the one who says interest rates don’t affect investment.”

  24. Gravatar of Greg Ransom Greg Ransom
    16. June 2010 at 09:24

    Here’s Krugman, characterizing Rajan:

    “1. Raising rates a bit wouldn’t significantly deter investment.

    2. “Unnaturally low” interest rates are distorting asset prices.”

    #2 simply says that changing interest rates changes the structural distribution of investments, which could distort asset prices.

    And as I said, this is not incompatible with #1, i.e. it does not require a change in the total aggregate size of investment.

    This is Rajan’s position, which Krugman denies.

    Right?

  25. Gravatar of Greg Ransom Greg Ransom
    16. June 2010 at 09:28

    Scott, I don’t get it. In earlier posts this you plainly stated the topic here in Friedman and Schwartz was the supposed pro-deflation views of Hayek and the Austrians:

    “Krugman’s observation reminded me of Milton Friedman and Anna Schwartz’s Monetary History of the US. Friedman and Schwartz fought a battle on two fronts; against liberals who said monetary policy was ineffective in a depression, and against right-wingers who said it was effective in boosting nominal demand, but that this would be an undesirable outcome. The conservatives saw the Depression as a sort of hangover””painful but necessary. Friedman and Schwartz were particularly critical of the Austrian view that the roots of the Depression lay in easy money policies during the 1920s (policies that they correctly noted weren’t particularly easy.)

    Unfortunately, Milton Friedman died in 2006 and Anna Schwartz has recently gone over to the dark side (as I showed in this post.)”

    And De Long and Krugman always link this stuff up to Hayek.

    You write:

    “And then here he (and Brad DeLong and Richard Serlin) point out that recent conservative arguments echo arguments that conservatives were making in the 1930s:

    The attitude on display from quite a few economists bears a distinct resemblance to Depression-era liquidationism, as described in Brad DeLong’s excellent but somehow never published book on the economic history of the 20th century:”

  26. Gravatar of david glasner david glasner
    16. June 2010 at 10:32

    Greg, You are right I did not look at Krugman’s post before I commented on your comment. Now that I looked at his post criticizing Rajan, I see that he did not mention Hayek. He went after Hayek in a different post. I think that Krugman is being unfair to Hayek, but the quotation from Hayek that he includes could reasonably be read as a moderate avowal of liquidationism. A Rothbardian could read it and feel that Hayek was on his side. It could also be read more charitably, as you and I would, but it is not a statement that I am particularly happy with. In later years, Hayek was much more emphatic in support of measures to prevent a downward spiral than he was in the passage Krugman quoted.

    At any rate, Krugman is correct in pointing out that if one believes that the interest rate is powerful enough to distort asset prices, then it would be inconsistent to deny that it is powerful enough to affect aggregate spending on investment. You are correct that conceptually the volume of investment is not the same as its composition. But why would you think that in any plausible set of circumstances, the effect of the interest rate would be felt on just one of those, but not the other?

  27. Gravatar of Greg Ransom Greg Ransom
    16. June 2010 at 10:49

    Right, Krugman went after Hayek in the 3rd Krugman post Scott linked to above.

    http://krugman.blogs.nytimes.com/2010/06/14/antipathy-to-low-rates/

    Note that if we allow into our mental universe the fact that there is a time structure to investment, we think of things very differently. We can be a Sumner/Hayek believers in anti-deflationary NGDP targeting and against _aggregate_ “liquidationism” of the perverse kind, and we can acknowledge that in the post artificial boom phase there will be malinvestments that are “liquidated” (e.g. Scott Sumner’s point about over investment in housing during the last boom).

    This is NOT Krugman / De Long “liquidationism” — but you have to view the world as it is, and not in terms of a one capital goods model, or “K” or “aggregate investment” or simple “GDP” to see the causal process that actually functions in the world.

    But Krugman and De Long intentionally use this ambiguous and misleading notion to smear rival scientific programs — they play with brass knuckles and dozens of top academic economists say so.

  28. Gravatar of Greg Ransom Greg Ransom
    16. June 2010 at 10:55

    It takes careful thinking to distinguish between post artificial boom malinvestment “liquidation” and perverse secondary depression monetary deflation caused “liquidation” — and it takes careful thinking to think about the role of money, interest and government spending in interacting with the changing structure of relative prices and the time structure of production processes.

    Models premised on “K”, a one capital good and one representative agent world, homogeneous “GDP”, homogeneous “aggregate demand”, etc. block the mind from validly engaging the causal process of the market involving the coordination of all this stuff.

    Which side of the wall does Scott stand on here? It’s not clear.

    I wrote:

    “Note that if we allow into our mental universe the fact that there is a time structure to investment, we think of things very differently. We can be a Sumner/Hayek believers in anti-deflationary NGDP targeting and against _aggregate_ “liquidationism” of the perverse kind, and we can acknowledge that in the post artificial boom phase there will be malinvestments that are “liquidated” (e.g. Scott Sumner’s point about over investment in housing during the last boom).

    This is NOT Krugman / De Long “liquidationism” “” but you have to view the world as it is, and not in terms of a one capital goods model, or “K” or “aggregate investment” or simple “GDP” to see the causal process that actually functions in the world.

    But Krugman and De Long intentionally use this ambiguous and misleading notion to smear rival scientific programs “” they play with brass knuckles and dozens of top academic economists say so.”

  29. Gravatar of Greg Ransom Greg Ransom
    16. June 2010 at 16:01

    He also endorsed free banking and competitive money …

    “in the 1990s [Friedman] endorsed Robert Hetzel’s proposal to have the Fed target inflation expectations in the TIPS market.

  30. Gravatar of scott sumner scott sumner
    17. June 2010 at 06:23

    Greg, I completely disagree with your interpretation of Rajan. He isn’t saying that higher rates would increase some types of investment and decrease other types, leaving total investment unchanged. He is saying it would affect asset prices, but not real investment quantities. And that is very implausible, as Krugman says.

    There is nothing inaccurate in the views of Friedman on the Austrians. His remarks are completely accurate.

    If I link to someone, that doesn’t imply I agree with everything he wrote, rather only the parts I quoted (If I indicate approval) I certainly agree with you that DeLong can be unfair at times when criticizing those he disagrees with (Like me!)

    Greg, You said;

    “It takes careful thinking to distinguish between post artificial boom malinvestment “liquidation” and perverse secondary depression monetary deflation caused “liquidation” “” and it takes careful thinking to think about the role of money, interest and government spending in interacting with the changing structure of relative prices and the time structure of production processes.”

    This has been the whole point of my blog from day one. But for some reason my argument is viewed as being novel. Almost no one regards it as an Austrian argument. I don’t doubt that there are some Austrians who agree with me, but the general perception out there is that my argument is most definitely not Austrian. And some Austrian economists strongly disagree with me.

    I’d guess that most Austrians don’t believe that the current crisis was caused by excessively tight money.

    I don’t use capital in my business cycle models, I just focus on aggregate output.

  31. Gravatar of John Papola John Papola
    17. June 2010 at 08:35

    I’ll try and hop in…

    “I’d guess that most Austrians don’t believe that the current crisis was caused by excessively tight money.”

    Correct. Austrians would say that blaming the tight money is akin to blaming a flu on the fever instead of the virus. The tight money that turned the boom to bust is looked at as the “upper turning point” in Austrian theory and it is viewed as inevitable after a period of excessively easy money. The reason is capital structure and the coordination of the production structure to provide for the composition of demands and time preferences.

    So in the boom, we are tricked into over-investment in longer-term lines capital projects, calculating that the future demand will create profits in excess of the interest on loans to build capacity for providing the goods. MGM sees skyrocketing demand in Vegas and plans a massive, multi-year “CityCenter” project.

    But the excess money creation drive real demand to hit supply constraints and then flips real demand into nominal inflation. There aren’t enough workers to build all these houses while also building all the other stuff that is being demanded. There aren’t enough commodities to go around either in the short run. Inflation sets in. Input prices rise. MGM’s plans start to become unprofitable along with everyone else who was tricked by artificially low rates. They turn back to the credit markets to role over their financing and keep their projects on track, but that increased demand pushes up rates and renders many of these projects unprofitable. If the central bank continues to “accomidate” the “needs of trade” with more money creation, inflation accelerates even more. Seeing that, they allow rates to rise and thus the boom turns to bust.

    So Austrians view the tight money at the upper turning point as a product of the prior boom.

    So what’s all that “capital” talk? Because MGM’s unfinished “CityCenter”, the new fleet of capital equipment and years of construction experience are devalued. They aren’t just part of some blob “capital stock” that can be swiftly reallocated to other uses. GM factories don’t become windmill factories overnight and construction workers don’t become doctors or nurses either. This is why the “overinvestment” is MALinvestment. The actual composition of demand matters for the value of the composition of supply. There is no “aggregate demand” bidding in a market for “aggregate supply”. Those curves neither exist nor meaningfully cross.

    I don’t use capital in my business cycle models, I just focus on aggregate output.

    Austrians see “macroeconomics” as a coordination problem where “macroeconomic” issues have microeconomic causes and microeconomic cures.

    Given the above, Austrians would say that this represents a problem for your business cycle model. Show me the GDP widgets people buy and the process by which they bid for them with GDP suppliers.

    Love the blog, Scott. I think you’d benefit by carving out some time to dig into the Austrian macro story enough to feel that you understand it. There’s a really neat rap video out there to help 😉

  32. Gravatar of John Papola John Papola
    17. June 2010 at 08:49

    All that said. The post-bust “tight money” is where Austrians get into arguments with one another.

    Selgin and Horwitz point to avoiding “secondary deflation” through NGDP stabilizing monetary expansion as the right thing to do and see the interest on reserves and nominal shock of 2008 as the Fed repeating 1930s mistakes. White/Selgin/Horwitz appear to be Sumner+Capital Theory, more or less. Hayek, from what I understand, falls into this category as well.

    The other side is the Rothbard school. Joe Salerno and the 100% reserves side say (I think) that there is no reason believe that the central bank’s increase in the money supply to meet money demand will actually get the people who are actually increasing their demand. They see NGDP stabilization as suffering from too much aggregation and central planning knowledge problems and will be just as likely to cause relative price distortions that are as unsustainable as money creation at any other time. So they say, if people want to hold more money, great. Let prices fall as they have in all the recessions prior to the 1930 which recovered just fine thank you very much.

    I don’t know which side I find more compelling yet. The former is compatible with Friedman on the post-bust prescription. The latter is incompatible. The former sees “fractional reserves” as having been sustainable in the past (Scotland, Canada). The latter sees that kind of banking as unstable (the whole borrow short and lend long deal), illegitimate and surviving only with the help of governments and central banks to prop them up and bail them out. I’m sympathetic to this last point.

    Who knows. I hope I didn’t misrepresent anyone or state the obvious.

  33. Gravatar of Greg Ransom Greg Ransom
    17. June 2010 at 22:57

    No, Scott, like an Austrian you’ve said the original problem was a malinvestment artificial boom in housing, which had to end in an inevitable bust.

    And in a fashion similar to Hayek, Horwitz, Glasner, Selgin and other “Austrians” in the Hayek tradition, you’ve said that deflation caused disequilibrium has turned a small bust into a major recession.

    The main academic Austrians are compatible with your arguments, as you’ve said many times.

    But for some reason, you don’t read them, and you read “Austrians” with little or no foot in academic economics, some of them mere fake name blog commenters. And you call what these guys write “the Austrian position” and what Hayek, Horwitz, Selgin and others write, the non-Austrian position.

    Scott writes,

    “This has been the whole point of my blog from day one. But for some reason my argument is viewed as being novel. Almost no one regards it as an Austrian argument. I don’t doubt that there are some Austrians who agree with me, but the general perception out there is that my argument is most definitely not Austrian. And some Austrian economists strongly disagree with me.

    I’d guess that most Austrians don’t believe that the current crisis was caused by excessively tight money.”

    Scott writes,

    “I don’t use capital in my business cycle models, I just focus on aggregate output.”

    This is self evident. This is why you don’t get Hayek — and this lackmof understandingnismwhat allows you to presume Hayek was wrong, when you actually haven’t engaged the arguments ofmthe rival conception.

    Friedman’s negative appraisals are equally superficial.

  34. Gravatar of Greg Ransom Greg Ransom
    17. June 2010 at 23:05

    You again fail to demarcate between what people believe empirically to the the case in the recent episode and what they believe theoretically about causal processes.

    Those who agree with you on the theory and understanding of causal processes can have different judgements about the empirical facts of the last few years. what makes someone a Hayekian or not is theory, people with the same theory can judge the facts differently.

    Scott writes,

    “This has been the whole point of my blog from day one. But for some reason my argument is viewed as being novel. Almost no one regards it as an Austrian argument. I don’t doubt that there are some Austrians who agree with me, but the general perception out there is that my argument is most definitely not Austrian. And some Austrian economists strongly disagree with me.

    I’d guess that most Austrians don’t believe that the current crisis was caused by excessively tight money.”

  35. Gravatar of david glasner david glasner
    18. June 2010 at 06:21

    Scott, you wrote:

    “if a country devalues, as we did in 1933, monetary policy becomes far more expansionary even if interest rates don’t change at all. As I recall there was almost no change in rates in 1933. If Bernanke announced a much higher inflation target tomorrow, that would be a more expansionary policy even if accompanied by a tiny increase in the fed funds rate.”

    I probably was a bit too categorical in my statement earlier that an increase (decrease) in the monetary authorities’ target interest rate always tightens (loosens) policy. You are right that the monetary authorities can do more than one thing at a time, so that the net effect could go in the opposite direction. But with a ceteris paribus qualification or with an appropriately defined partial derivative, I think that it is still correct to say that when the Fed raises the Fed funds rate it is loosening and when it raises the Fed funds rate it is tightening. By what mechanism the change in bank rate (to adopt the old British terminology) gets translated into tightening or loosening is indeed a very puzzling (and still unsolved to my satisfaction at least) theoretical problem. As a history of thought problem, it is indeed curious how Friedman cut the ground out from beneath his own feet by pointing out that low interest rates more often than not correspond to tight money and high interest rates to easy money. That was the beginning of the end for the quantity theory of money (at least in its Monetarist version).

  36. Gravatar of scott sumner scott sumner
    18. June 2010 at 11:54

    John Papola, Yes, that’s a very good summary of the various types of Austrian economics. In the real world I think most Austrians are more sympathetic to the Rothbard view, but I think the best Austrians (and I) prefer the other view. I think conservatives (who may know nothing of Austrian econ) lean toward the Rothbard view and don’t agree with the need to use monetary stimulus to keep NGDP from falling.

    Greg, I’d say 90% of the conservatives I read on the internet oppose more monetary stimulus. And I’d say 90% of them are not Austrians. They are conservative Keynesians, they are Chicago school, they are all over the map. But they oppose monetary stimulus.

    At the SEA meeting in late November 2008 there was a big panel with a lot of libertarian/Austrian types, and they all seemed to oppose more monetary stimulus. I report what I see.

    Greg#2: You said;

    “You again fail to demarcate between what people believe empirically to the the case in the recent episode and what they believe theoretically about causal processes”

    I’d argue just the opposite. I argue that my fellow right-wingers with whom I share many similar views on monetary economics oppose monetary stimulus while I support it. I get more support from liberals who don’t share my theoretical construct.

    David, I agree with what you say here about ceteris paribus, but am puzzled at how it undercuts Friedman. I thought Friedman was famous for arguing that overnight nominal interest rates are not a reliable indicator of the stance of monetary policy. His whole theory emphasized looking at a wide range of assets. And of course the monetary aggregates.

  37. Gravatar of Greg Ransom Greg Ransom
    18. June 2010 at 12:06

    I wrote,

    “You again fail to demarcate between what people believe empirically to the the case in the recent episode and what they believe theoretically about causal processes”

    Here I think you are just changing the topic. I don’t see how this engages the problem I point to arguments about the empirical and theoretical episode of the 20’s and 30’s:

    “I’d argue just the opposite. I argue that my fellow right-wingers with whom I share many similar views on monetary economics oppose monetary stimulus while I support it. I get more support from liberals who don’t share my theoretical construct.”

  38. Gravatar of ssumner ssumner
    19. June 2010 at 08:02

    Greg, It is you who is changing the topic. I responded to a comment you made that referred to “recent episodes” and then you complain that I am not dealing with the 1920s and 1930s. Which is it you want?

    Sure, I agree that in the early 1930s some of the policy views could be considered at variance with the theoretical construct, and I’ve always conceded that. It doesn’t affect anything I wrote.

  39. Gravatar of John Papola John Papola
    19. June 2010 at 20:30

    Scott,

    Why should NGDP grow at all? If I understand this correctly, and I probably don’t, the premise behind expanding the money supply to meet money demand and maintain NGDP is to prevent a nominally fixed debt-deflation death spiral.

    It seems as though the problems emerge from a confusion by entrepreneurs about the whether falling demand for their goods is a real change or a nominal one. Is that right?

    I don’t think I fully get it. Why should NGDP be stable? It seems somewhat arbitrary. And if it should be stable, why should it grow? And either way, I don’t think I understand the mechanisms for controlling NGDP.

    There doesn’t seem to be much of a market process or allocation of resources in this NGDP world. That’s what trips me up and rings my “too much aggregation” bell. But it is very interesting.

    Do you have any good primer posts for an honest enthusiast like myself?

  40. Gravatar of Scott Sumner Scott Sumner
    20. June 2010 at 04:58

    John, Here are a couple posts you might want to check out:

    https://www.themoneyillusion.com/?p=592

    https://www.themoneyillusion.com/?p=3059

    It talks about NGDP targeting form my perspective, and also from an Austrian perspective.

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