Was Krugman right in 2002?

Yes, if you give his remarks a very charitable interpretation.  I am referring to the remarks discussed by Arnold Kling here and here, which have received a lot of attention recently.

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

As everyone knows by now the once kooky and discredited Austrian business cycle model has now become conventional wisdom.  Easy money creates bubbles, which inevitably cause depressions when they pop.  It’s Greenspan’s fault.  Paul and I are still not on board the Vienna express, but we are in an awkward position.  (Thank God I didn’t have a blog in 2002!)

Here’s what I think is a defensible view of what Paul might have meant. (Notice I use first names in the times I agree with him.)  The words are mine, not Paul’s:

“Business investment is tanking.  A sharp fall in overall investment can often lead to a depression.  The Fed should reduce interest rates to maintain adequate NGDP growth.  Because tech is so overbuilt, the lower interest rates may not be enough to bring business investment back to normal levels, instead other types of investment and consumer durables will have to pick up the slack.  We can expect the housing sector to expand if rates are cut sharply.  In the classical model we would then be moving along the investment PPF from less business investment to more housing investment, instead of moving far inside the PPF (as in the 1930s) with less overall investment as the economy tanks.  Let’s hope bankers lend money to people who are likely to repay their loans, so that the bankers do not lose hundreds of billions of dollars, and their jobs.  Monetary policy has no choice but to proceed on the assumption that we should stabilize the overall macroeconomy, and let the private sector decide where to allocate resources.  I am not asking the Fed to target housing, merely predicting it will expand if we have the appropriate level of AD.”

Would that statement have been defensible?  I think so, even today.  But if he wrote that poorly no one would read his blog.  Short, provocative, counter-intuitive statements are more fun, but can come back to bite you.

[PS, I hope no one will tell me that bankers didn’t lose money.  They did.]

Update:  Off topic, but since I am praising Paul Krugman, I don’t recall seeing a better post exposing the problem with the Republican Party than this.


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61 Responses to “Was Krugman right in 2002?”

  1. Gravatar of Wahler Wahler
    19. June 2009 at 09:00

    I don’t think Paul Krugman would ever “board the Vienna express.”

    It would be like a professional, and even, personal suicide of sorts for him.

    His whole career, outlook, politics is formed and driven by Keynesianism, and his commitment to Keynesianism.

    And his whole authority and reputation as an academic, professional economist, public intellectual, pundit, etc., is built upon Keynesianism.

    What’s the incentive? What’s in it for him to discredit decades of his professional life?

    Now I don’t believe necessarily that Krugman is consciously being disingenous, and that he will continue to be consciously disingenous no matter the strength of evidence against him. I imagine that there are powerful unconscious motives and biases at work, the same ones that afflict all of us.

  2. Gravatar of TGGP TGGP
    19. June 2009 at 09:22

    Off-topic, but I thought you might be interested in Casey Mulligan’s What Monetary Policy Cannot Do.

    On-topic: Other things Krugman wrote made it clear that (contra to Kling and Krugman’s defense) he really was advocating a policy rather than merely making a positive statement about economics.

  3. Gravatar of Current Current
    19. June 2009 at 09:38

    There are not really very many of us. I think it’s just that some other Austrian Economics sites linked to your blog. So, now you’re infected.

    Note that if there is excessively easy money the first place it is likely to go is where investment is needed anyway.

  4. Gravatar of Alex Alex
    19. June 2009 at 10:08

    Scott,

    Why do you insist on defending this guy? He has a popular blog (in case you didn´t notice much more popular than yours) and can defend himself alright without your help. You don´t need his approval and we don´t read your blog because we care to know what you think Krugman might have tried to say back in 2002. Stick to your original thoughts. Besides he is a smart ass with verbal diarrhea maybe this will help him shut his mouth or at least think twice before he writes/says something like that again.

    Alex.

  5. Gravatar of Lord Lord
    19. June 2009 at 11:30

    Only if they had ensured proper lending standards, it wouldn’t have been a bubble, but a sustainable rise.

  6. Gravatar of Nick Rowe Nick Rowe
    19. June 2009 at 13:33

    Scott:

    Yep. What is worrying is the possibility that sometimes the natural rate might be so low that it will be impossible to avoid a bubble in at least some asset prices.

    I was writing on a similar theme in February. Because it seems that Greenspan’s critics are confusing two different argument:

    1. Greenspan caused a bubbles by setting interest rates below the natural rate (implausible).

    2. Greenspan caused a bubble by setting interest rates low in an absolute sense. (more plausible).

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/02/what-if-both-greenspan-and-his-critics-were-right.html

  7. Gravatar of Jon Jon
    19. June 2009 at 16:39

    Nick, re #2. One such interpretation is that #2 arises from globalization. Namely there is a natural-rate but also a secondary factor such as interest-rate arbitrage.

    Thus your ‘absolute’ sense isn’t absolute at all but rather relative to a second parameter (interest-rate of other significant currencies).

    This was one of your options on your earlier list.

  8. Gravatar of ssumner ssumner
    19. June 2009 at 17:04

    Wahler, Yes, Krugman won’t become Austrian.

    TGGP, Mulligan’s argument is a bit odd. Milton Friedman believed that increases in the money supply cause inflation, he would never argue that the Fed would be unable to push up inflation with an expansionary monetary policy. I must have missed something there.

    Current, I know there are only a few Austrians, but most economists seem to have bought the Austrian story, or at least most that I talk to. Almost everyone I talk to asks me if the root cause of the problem was when Greenspan lowered rates to one percent.

    Alex, I try to be impartial. I evaluate views w/o regard to my personal view of the person expressing the view. BTW, I don’t think you need to worry about me getting Krugman’s “approval” I’ve been on his case pretty often in recent weeks.

    Lord, Bad lending standards caused the initial crisis, and then the Fed made it 10 times worse last fall.

    Nick, I agree with the first part, but don’t quite buy the second story, except perhaps in a sort of deterministic, ex post sense (but maybe that’s how you intended it.) What I mean is that ex ante there are always good options for the Fed, just set monetary policy at a level expected to produce 5% expected NGDP grwoth. Now in your hypothetical that probably would have, ex post, caused the housing bubble. My argument would be that even if it did pump up housing, ex ante you would have no reason to expect any major problems to flow from that fact. Bankers would not be expected to make hundreds of billion in loans will little prospect of being repaid. So what did happen? Bad luck. At least bad luck from the Fed’s point of view, as they must take private sector behavior as a given. (I won’t let bankers off the hook so easily.)
    So if you were saying given what they knew then, they sat in a room in 2002 and said “oh no, anything we do we’re screwed” then I wouldn’t agree. If you are saying had they had a crystal ball in the room, and no ability to influence private banker behavior, and they said “either way we’re screwed,” then I think you are right.

  9. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    19. June 2009 at 18:05

    I don’t understand the Spigot Theory at all. If interest rates are low, that is surely an incentive for some financial transactions, but not all. Everyday, as human agents, we confront incentives and disincentives. Actual human agents then act on them.The idea that human agents act mechanically means that there is no agency involved at all in the action. That view of human action is clearly useless in my view, but others seem to credit it.

    In the housing bubble, low interest rates will sensibly lead to the buying of houses for some time. However, as the price of houses go up, the low interest rate loses more and more of its value. Going forward, there will come a point when the purchase of a house, even at low interest rates, does not make sense given the vagaries of human life. We went way over that sensible limit in the bubble, and low interest rates can only explain a part of such buying. You need an incredibly BS narrative to overcome such prudence,which we had, and many people bought it. Not me. I sold my house, and I’m no genius.

    The Spigot Theory says that if you keep interest rates low ( leaving low to you theorists to define ), then a bubble will necessarily emerge. It is a purely mechanistic explanation. Even if you claim that this position has uses in explaining the economy, you still need to explain and defend the underlying assumptions and presuppositions that this view is based upon. In a certain sense, that’s what philosophical explanation is; namely, an exposition of the underlying presuppositions of a theory or explanation.

    Many economic theories and explanations seem to be based on Behaviorism, or, as in the case of Milton Friedman, Correlative Explanations put forward as Mechanistic Explanations. Since correlations can change, this type of view often leads to confirmation bias, where the theory or explanation keeps getting adjusted in ad hoc ways to explain natural anomalies involved in correlations involving human behavior.

    No doubt, there are technical adjustments that can mechanically work. However, they then still need to be correlated with human action.

    The only criticism that makes sense to me is that Greenspan could have raised interest rates to bust the bubble at some point. The Fed could lean against the wind. But, just as the Fed is a lender of last resort, it is a leaner of last resort, and will only do such a thing when the bubble is bigger than our faces.

    If requiring more of a down-payment as housing prices rose could have stopped the bubble, then low interest rates can’t cause the bubble. Here’s a paper giving my view of how this would work:

    “http://www.dallasfed.org/research/eclett/2009/el0904.html

    Economic Letter””Insights from the Federal Reserve Bank of Dallas

    Vol. 4, No. 4
    June 2009
    Federal Reserve Bank of Dallas

    Taming the Credit Cycle by Limiting High-Risk Lending
    by Jeffery W. Gunther”

    I hope that I made some sense.

  10. Gravatar of Nick Rowe Nick Rowe
    19. June 2009 at 18:21

    Jon: if two countries have integrated capital markets, then I would say they share a common natural rate. To say the same thing another way, if Japan, Germany, and China (say) want to lend to the US, then that lowers the US natural rate. (The mechanism is that loans to the US cause the real exchange rate of the US $ to appreciate, so the natural rate needs to be lower to offset this.)

    Scott: I was thinking more from the perspective of hindsight.

    But, perhaps we can now re-ask the same question with foresight: do we need another bubble (or risk another bubble) to get us out of this one?

  11. Gravatar of Jon Jon
    19. June 2009 at 19:31

    Nick:

    The time lags are different. The exchange-rate shifts import prices immediately but the normal inflation (and stimulus) process is “long and variable”. Your citation to an equilibrium condition is less than convincing.

  12. Gravatar of Current Current
    20. June 2009 at 04:04

    Nick Rowe is approximately correct. In the globalized economy the natural rate should will equalize across the world. But debts are denominated in money. So there will remain parts of interest rates charged that hedge against exchange rate changes. These may or may not be significant depending on the situation.

    I don’t understand this business of Greenspan and his critics being right. Absent:
    1) a huge change in the time-preference or
    2) saving behaviour that doesn’t depend on time-preference of the population (such as saving for an impending disaster like sending children to college).
    Absent those things the natural interest rate is always the most sustainable interest rate. Economic disturbances that happen due to changes in the natural rate can’t be avoided, nothing can stop them.

    Don, what on earth is this spigot theory? It sounds like a misunderstanding of Austrian theory.

    Now, back to silly defences of Greenspan. Does anyone think the real natural interest rate is ~0%?

  13. Gravatar of Joe Calhoun Joe Calhoun
    20. June 2009 at 08:03

    Although I tend to view the Austrian perspective as helpful, I don’t agree with the idea that interest rates were the necessary or sole driver of the housing bubble. Interest rates are but one factor in monetary policy.

    What I find interesting is that few people consider the role of the falling value of the dollar in the housing bubble. I live in Miami and we get a lot of foreign buyers here so maybe I’m a little more attuned to it than others. At the peak we were getting a lot of Brazilians and Europeans buying condos. They were looking at the prices in terms of their home currencies and to them the prices looked reasonable and only slightly different than they were years before.

    The value of the dollar is not solely determined by the Federal Reserve. Obviously, they could target a value and achieve it but the role of the Treasury Department cannot be discounted. When you hire a series of Treasury Secretaries who all favor a cheaper dollar, in deed if not word, the world starts to notice a trend and act accordingly. Obviously, the federal budget has a role as well that is expressed through the actions of the Treasury.

    The Fed should have seen the falling value of the dollar as an indicator that policy was too loose in relation to Treasury policy and stabilized its value through monetary policy to offset the bad policies of the Treasury. If they had done that, even if they didn’t effect the change through a change in interest rates, the housing bubble would have been contained.

    I don’t think the Fed can operate monetary policy in a vacuum. They have to consider the actions of the Treasury and set monetary policy accordingly to maintain the purchasing power of the dollar. What worries me immensely right now is that the current Treasury Secretary is sending signals to the world that we want a weaker dollar. On one hand he tells the Chinese to be more “flexible” about the exchange rate of the Yuan (which is translated in China as wanting a stronger Yuan, i.e. a weaker dollar) and reassures them on the other hand that the US will protect their investment in US Treasuries. Obviously these statements are contradictory and in the confusion, the world takes the first statement as policy and the second as not credible.

    As for Krugman, I read the quotes at various blogs and blogged about it. I don’t think he was advocating a housing bubble but rather observing that the results of easing would be a shift of investment. That isn’t controversial but rather mundane and correct theory. I would not deny that monetary policy has the ability to initiate such a shift in investment preferences. I do however question the wisdom of such a policy as it distorts investment based on factors which are not and cannot be permanent. Basing long term investments on a set of temporary conditions would not seem to yield optimal results, as we’ve seen.

  14. Gravatar of Jon Jon
    20. June 2009 at 08:41

    Joe has got it right. The exchange-shift causes an instant realized changed in the price-level.

    Nick: in the Austrian sense, the natural-rate is an intrinsic individual time-preference. A country’s natural-rate cannot adjust as you propose.

  15. Gravatar of ssumner ssumner
    20. June 2009 at 09:43

    Don, You and I are really on the same wavelength. Did you see Tyler Cowen’s analogy where he discusses a banana subsidy? He assumes the banana subsidy caused people to build their roofs out of bananas. Then it rains hard and all the roofs collapse. Then people blame the government. Perhaps the banana subsidy contributed indirectly to the problem, but isn’t the main problem that people stupidly built their roofs out of bananas? The equivalent concept here is sub-prime lending, which reached pretty absurd levels regardless of interest rates.

    I also have a bias toward public policies that promote saving (to offset most of our public policies, whhich discourage saving.) So I like ideas such as minimum down payments for loans made by any federally insured banks.

    Nick, If it was hindsight, then I might agree with you. But it depends how deterministic you want to get. Are we allowed to “do over” the Fed’s interest rate decision of September 16, 2008? My view on blowing more bubbles has always been the following, whenever it comes up in discussion:

    Let’s not try to go back to the bubble days of 2006, let’s use monetary policy to get back to mid-2008, when housing was already deeply depressed, the rest of the economy was ok, and unemployment was in the mid-5s. I don’t think that’s an unreasonable way of thinking about the optimal monetary policy’s impact on the economy. And I don’t view mid-2008 as a bubble economy. Yes, housing was stronger than today, but I think we have now overshot the goal (on the downside.)

    Current, There is no way to know the equilibrium real rate, and the government shouldn’t even try to figure it out. Target NGDP and let the markets set rates. BTW, many economists think the equilibrium real rate is something like negative 5 or 6%. I think those estimates are meaningless, because they assume the economy is expected to stay weak. With appropriate monetary policy the economy would be expected to recover quickly, and thus the equilibrium real rate would rise sharply.

    Joe, Starting with your last point. I agree that Krugman wasn’t advocating a housing bubble, but he was advocating a monetary policy that he expected to produce a housing bubble—I don’t think there is any dispute about that. And I agree with him in a sense, although I don’t like the term ‘bubble’ because it means different things to different people. I will make 4 observations about monetary policy:

    1. Low rates were appropriate in 2002. If rates had been higher in 2002, then they would have been much lower in 2006. Why? Because if rates had been higher in 2002, the recession might have been a depression, leading to low rates in 2006.

    2. The housing boom was partly caused by weak business investment (which is the real reason rates were low in 2002, not the Fed as many assume), and partly by high savings rates in Asia. I have no idea the relative importance of these two factors in the early period. But once business investment recovered in 2006, then high Asian savings rates became relatively more important.

    3. Monetary policy was a bit too expansionary in 2004-06, but not because of the housing bubble, rather because NGDP was growing too fast. The housing bubble was a side effect.

    4. The housing bubble did not cause our current crisis, tight money in late 2008 did.

    Jon, Doesn’t the natural rate reflect both saving and investment schedules? How can it just reflect one side of the market?

  16. Gravatar of Lord Lord
    20. June 2009 at 10:21

    The presumption here is that rates were too low. In fact, they were too high, kept there by our ponzi financial system. Remember when Greenspan started raising rates, long rates fell. Bad lending was promising ridiculously high future returns which markets took at face value or ignored due to bad ratings and bad insurance. Bad lending increased leverage, reduced and eliminated qualification, promoted fraud and escalated asset prices. What started as a small problem was allowed to grow into a large problem (I would call $3T large) which was then compounded into an immense crisis when the Fed balked at covering those losses.

    If only good lending had been allowed, rates would have had to have fallen much further to the point where it wouldn’t have been worth investing here and lenders would have had to choose between losing money, lending elsewhere (probably also losing money), investing elsewhere (risking losing money), or consuming more (spending money). Would this have just created a recession anyway? It could have as trade adjusted to the new reality, but it wouldn’t have lead to a crisis of bad debt. Bad debt is bad enough, but when uncertainty exists as to how much, where, what, and who holds it, and how much punishment the Fed has in store, fear takes over.

  17. Gravatar of Lord Lord
    20. June 2009 at 10:34

    And it is not just about past losses, but also future losses due to breaking of the housing industry, breaking the consumption of asset price appreciation, and breaking of the financial sector’s means of revenue generation.

  18. Gravatar of Jon Jon
    20. June 2009 at 14:32

    “Doesn’t the natural rate reflect both saving and investment schedules? How can it just reflect one side of the market?”

    Sure, but the Fed has a different time preference and participates only on the supply side.

  19. Gravatar of Nick Rowe Nick Rowe
    20. June 2009 at 15:14

    Jon:

    “Nick: in the Austrian sense, the natural-rate is an intrinsic individual time-preference. A country’s natural-rate cannot adjust as you propose.”

    Does each individual have a unique natural rate? Or each street? town? region? country? Or is it the world?

    My answer would be that any group of people that share access to a common market for loanable funds share the same natural rate.

  20. Gravatar of Bill Woolsey Bill Woolsey
    20. June 2009 at 15:27

    Scott:

    An increase in the demand for housing isn’t a bubble in housing. A bubble is when people buy houses in expectation of price increass. And this generates the price increases.

    A bubble isn’t an increase in demand and a higher price. A bubble isn’t even when there is an increase in demand and a price hike, followed by an decrease in demand and a price drop. (At least that scenario gets the price change right–up then down.) A bubble is when the price rises because people believe that past price increases will continue into the future, they buy on that expectation, thus causing price increases, creating a self-fulfilling expectation. This is not sustainable and will evenutally “pop.”

    (I thought you believed this is meaningless unless we can figure out how to make money from shorting the bubble or else the Fed can figure out what is happening and can develop a policy response.)

    It would be possible for nominal income to be maintained despite a decrease in the demand for computer equipment by increases in the demands for many things. For expample, people could use more of their income to eat out at restaurants.

    More generally, consumption could increase. As you said, other sorts of investment could increase. And, yes, housing investment could increase.

    Investment demand shifts to the left. The natural interest rate falls. The quantity of investment demanded rises (perhaps more housing or capital goods besides computer equipment.) The decrease in the quantity of saving supplied is an increase in consumption. The new equilibrium has a lower natural interest rate and a lower amount saved and investment.

    This doesn’t necessarily require any more lending and borrowing. If the lower interest rate is associated with an increae in the demand for money, then the quantity of money should incease. And lending by the banking system matching monetary liabilities must increase. But other lending could shrink.

    For expample, firms could lend less and collect on old loans and use the funds to purchase captital goods other than computer equipment. More invetment funded out of retained earnings motivated because lower interest rates lower the opportunity cost of funds used for capital goods pruchased. Or, households could purchase fewer bonds and instead use income to go out to eat. Lower interest rates make refraining from eating a fancy restaurants to buy bonds less lucrative. Households could collect on old loans as they come due, and use the proceeds to buy a new car.

    I don’t count CDs as part of the money supply. So, banks could lend less and pay off CDs and those receiving the funds could purchase boats.

    However, Keynesians, like Krugman are always worried about how difficult it is to expand demand. The interest elasticity of consumption and investment is always assumed to be just about zero. And so, it is no surprise that he would claim that the only way the Fed could solve the problem is by creating a new bubble. That is, something destructive and unsustainable.

    What do I mean? Well, lower interest rates should increase the demand for housing, but that would be just a bit. Only if the resulting price increase caused people to expect future price increases, and so caused them to buy even more houses, causing higher prices and even more housing speculation and so even more dmeand, and higher prices. Yes.. that would create enough demand. In other words, something as bad as the tech bubble.

    Of course, the real answer is to have the government build bullet trains, provide health care to all, ect.

    I don’t think that “Austrian” interest rate theory is as undeveloped as the comments here suggest. I think that what is conventionally described as investment demand (expectations of the profitable use of capital goods,) counts as impacting “time preference.” The entrepreneurs are supplying present goods in exchange for future goods and so help determine the natural interest rate.. or something like that. It is like investment demand.

    Nominal income grew too fast in 2002. I don’t think that caused the misallocation of resources created by the housing bubble to any appreciable degree. Any misallocation caused by monetary disequilibrium 7 years ago should be long gon by now. And, I don’t think the drop in nominal income over the last year is a necessary consequence of the misallocation of resources.

  21. Gravatar of Bill Woolsey Bill Woolsey
    20. June 2009 at 15:35

    Lord:

    I think you are more or less correct. That is, the speculative bubble in housing raised interest rates from where they otherwise would be.

    Suppose, (like Scott has suggested) the price of housing was rising because a bunch of Chinese immigrants would going to come to the U.S. and use all the money they have saved up to buy houses here. Getting started now on building the houses would be a wise use of resources. And the funds needed to fund the housing speculation would bid of the interest rate on loanable funds. Well, there is an increase in investmnet demand. (Or, the entrepreneurs are demanding current goods, supplying more future goods.. willing to do so because they expect those future godos to be so valuable.)

    Of course, in reality (I think,) the profits in housing were an illusion. And, once that was discovered, the natural interest rate dropped. (I don’t people were expecting a flood of immigration. Foolish investors were projecting past price increases into the future. But, the impact on the market is exactly like more realistic business plans.)

    If there had been no speculative bubble, then the natural interest rate would have been lower.

  22. Gravatar of TGGP TGGP
    20. June 2009 at 17:42

    The banana subsidy involved people putting large amounts of bananas on their roofs (made out of normal roofing materials) until the weight of the banans collapses the roofs. It is an “egg-shell” view of the market where a small intervention by the government is blamed for the ills of the market, whereas most people would consider it a failure on the part of the market.

  23. Gravatar of Bill Woolsey Bill Woolsey
    21. June 2009 at 03:54

    TGGP:

    Interesting take on the banana subsidy approach. “Who is to blame, government or market.” Is that it?

    My take is different. A banana subsidy should result in banana consumers purchasing and eating more bananas. Generally, this is “suboptimal” because the value of the other goods that must be sacrificed to produce the bananas are worth more than the bananas. But, because of the subsidy, this reality is masked and “too many” bananas are eaten.

    Now, on top of this, the banana consumers begin to store bananas. But the point of the story is that they do so in an inappropriate way. They put them up on their roofs, and put so many up there, that the roof collapses.

    If there were no subsidy, people would consume fewer bananas, and if they put any on the roof at all, it wouldn’t be so many as to collapse the roof.

    So, in a sense, the reason the roof collapses was the subsidy. However, in a more important sense, the reason the roof collapses is that people foolishly store more bananas on the roof than the roof will support.

    I don’t think the notion that the roofs are fragile is an important part of the story.

    In the case of the Austrian theory of the business cycle, to the degree than monetary expansion temporarily lowers interest rates, this may impact the allocation of resources away from current consumption and towards capital goods. This is suboptimal because people prefer the consumer now.

    But suppose entrepreneurs foolishing assume that the temporarily low interest rates are permanent and undertake investment projects that are only profitable if intereat rates remain low for a longer time than the monetary expansion results. When interest rates rise, then the suffer losses.

    In a sense, the temporarily low interest rate causes the entrepreneurs to make what will turn out to be unprofitable investments. But in a more important sense, the reason error was foolishly assuming that the temporarily low interest rates are more persistent.

  24. Gravatar of ssumner ssumner
    21. June 2009 at 04:31

    Lord, It’s not clear why you think this Ponzi scheme developed? Are you saying it was poor choices by investors, or poor regulations?

    Jon and Nick, I forgot the original context of this debate, but one small point. The interest parity condition equates nominal rates (adjusting for expected exchange rate changes.) Nevertheless, even if the dollar/yuan rate is fixed, China will have a lower real rate due to the Balassa Samuelson effect. This should cause savings to flow from the US to China, but the opposite is happening. (Although I am doing my part.

    Bill, I think NGDP grew too slow in 2002, but too fast in 2004-06.

    There are two main points you raise:

    1. One issue is the definition of bubbles. I agree that your definition is the one that makes the most sense, but what I meant to suggest is that people use the term loosely. Many people say any boom is a bubble. I don’t think oil futures showed any bubble-like behavior, but people still called last year’s oil run-up a bubble. So I thought Krugman might be using the term loosely, as simply a housing boom caused by low rates.

    2. You are right that a policy of NGDP targeting could simply cause lower saving and higher consumption to offset the crash in business investment. But my point was that that is not a likely outcome. If the economy remains near full employment, and interest rates fall, it is very likely that housing demand will rise. Alternatively it is very unlikely that housing demand with respect to the interest rate is perfectly inelastic. So if Krugman was simply making a forecast, it was a reasonable forecast.

    This is why I called it a “charitable interpretation.” It is only defensible if you assume Krugman was using terms loosely and making predictions, not policy recommendations.

    Bill, I am unclear as to why you doubt that people were expecting a flood of immigrants. We’d been having a flood of immigrants for years, why wouldn’t people expect that to continue? Of course the flood slowed down in 2007 when immigration enforcement was sharply tightened. BTW, 2007 is also when the sub-prime bubble burst. And it burst in working class neigborhoods in Arizona, Nevada and California. Guess who had been steadily boosting demand for housing in those neighborhoods. Having said that, I doubt immigration shifts could explain more than 20% of the housing shock.

    TGGP and Bill, I think you are both basically right. Tyler meant the example to indicate how a bad government policy could encourage behavior, and yet most people would still blame the behavior of foolish decisions.

  25. Gravatar of Jon Jon
    21. June 2009 at 08:32

    Nick: every individual has a natural rate, but the market is the aggregate. This contributes to why some people are poor and others are wealthy.

    I’m not sure I understand the Austrians well enough, but I do not believe that the ‘natural’ rate and the neutral rate are the same thing. The ‘natural’ rate as a concept is appealing to Austrians b.c. they were very early to the field of behavioral economics.

  26. Gravatar of Lord Lord
    21. June 2009 at 08:45

    There were certainly failures all around. Much of the fraud was implicit and indirect. Don’t ask, don’t tell. Bad lending, bad ratings, and bad insuring were market failures due to agency problems and bad incentives. It was investors allowing bad ratings and bad insurance on bad lending to substitute for judgment. It was everyone trusting (wink, wink, nod, nod) everyone else to do their job. It was the market depending on the Fed to save them from their folly. And finally, since to coin money and regulate the value thereof is a governmental function allowing unchecked fraud and then allowing the economy to collapse from it are regulatory and monetary failures.

  27. Gravatar of Bill Woolsey Bill Woolsey
    22. June 2009 at 02:57

    Scott:

    We have immigrants too. They typically live in rural trailer parks.

    But, perhaps in Boston dishwashers and gardeners own $200,000 homes. I know we are rather poor in South Carolina.

    I am sure that some kind of housing “boom” would be consistent with growing immigration. But trailer parks and apartment buildings seems more plausible to me. (If not shanty towns.)

    Now, the “subprime” phenomenon, which seems to be selling houses to people who can only afford them if they can make an adequate speculative profit on the house… perhaps recent immigrants were involved. Well, we know they were.

    But that isn’t building houses for immigrants to live in, excactly. It is lenders speculating on real estate with the “homeowner” serving as a frontman.

    There is also the phenomenon of renting rooms in single family homes to unrelated people. (So, a set of one room apartments with shared bathrooms and kitchen.)

    Perhaps regulations of trailer parks and restrictions on really small apartments make this a good black market work around. Still, I think it was about real estate speculators
    trying to fill up their vacant single family rentals.

    I get a no document loan and buy a second and third house. To cover the monthly payments, I rent out rooms to people. I am not really in the landlording business. I plan to sell the houses for a capital gain. (Because I have observed everyone else do it and make lots of money. In fact, I saw this informerical on TV about how average people just like me have become millionaires through this procedure. For just 19.99 get a CD that explains how.)

    My view, is that there was no notion of who would finally pay sky high prices for these single family homes and live in them. Your notion that people thought, correctly, no less, that subsistence farmers from central mexico would be buying them… well, I don’t think so.

    P.S. I entirely agree that a lower interest rate should be expected to result in increased demand for housing. And, further, that a re-evaluation of the profitability of additional fiber optic cable (downward) should result in lower interest rates. I just don’t think that ordinary supply and demand adjustments (lower demand, decrease in quantity supplied, increase in quantity demanded, new equilibrium) should be described as the Fed creating a new bubble.

  28. Gravatar of Current Current
    22. June 2009 at 03:13

    I should have been more careful about discussing natural rates around here. Let’s be clear….

    Each individual has time preference. This leads to a “rate of time preference” which is an individual phenomenon.

    The “Natural” rate of interest Garrison calls the “rate that reflects the underlying real factors”. It is the rate that would arise if money was not there causing system-wide effects. This is the rate that would appear in a barter economy.

    According to uncontroversial parts of Austrian theory the natural rate is determined entirely by the rates of time preference of the population. Productivity of capital does not come into the question in a systematic way. If capital is known to be more productive it yields a higher price. (If it is not known to be more productive the gain is an entrepreneurial one to those who do know, not interest). The output of the productivity of capital – consumer goods – these can change the rates of time preference in obvious ways.

    Now, what we were talking about at the start of this thread was 2002. Scott, in reply to me, says “many economists think the equilibrium real rate is something like negative 5 or 6%.” Which diverts discussion into the different topic of market interest rates now. That isn’t what I’m talking about. What I’m talking about is the natural rate over the period from 2002 to today.

    According to Garrison the neutral rate of interest is the rate that maintains the current GDP output. Maintains it regardless of the composition of that GDP. Exactly what this means though is a little hard to pin down.

    Now throughout the period from 2002 to the crisis do folks think that expansionary monetary policy was needed to prevent a fall in V? I don’t. So for most of that period an interest rate close to the natural rate of interest should have prevailed, even if not at the start of the period or towards the end. That rate must have a positive sign unless something very unusual is going on. So, it seems to me that the Fed were needlessly keeping interest rates too low. Does anyone think I’m wrong?

  29. Gravatar of Current Current
    22. June 2009 at 04:24

    Bob Murphy has commented on this:
    http://consultingbyrpm.com/blog/2009/06/austrians-our-victory-is-complete.html

  30. Gravatar of ssumner ssumner
    22. June 2009 at 05:49

    Lord, I am afraid that I couldn’t disagree more strongly with your view about fraud. First of all, I don’t think the sub-prime fiasco caused the current economic crisis—tight money did. But even if I am wrong, the sub-prime crisis was certainly not caused by fraud. Everyone knew that anyone who could fog a mirror was getting mortgages. It was a big joke back in 2006, even people who have no college education heard lots of stories of people buying houses who had no business getting mortgages. So if even the average person knew this, then certainly all the Wall Street firms that lost billions in mortgage bonds knew about the lax lending standards. There was some fraud (such as Madoff), but most of the “crimes” were committed in broad daylight, which means they weren’t fraud at all, they were simply bad judgments.
    I have heard that our leaders in Washington are having difficulty figuring out what sort of regulatory changes to make. That’s not surprising because they still don’t understand the nature of the problem. And when you don’t understand what caused the problem, it isn’t very likely you will come up with effective solutions.

    Bill, Where I live there are no $200,000 houses, indeed you can’t get an empty lot for that price. (I’m half joking here, in some of the lower income towns in Massachusetts they have houses in that price range, but not “metrowest suburbs”.)

    Unless I am mistaken there is massive demand for single family housing by immigrants in the Southwest, where the subprime bubble was concentrated (along with Florida.) I have read a number of articles suggesting that much of the demand for housing in inland California (i.e working class neighborhoods) came from foreign born residents, often from Mexico.

    There are probably millions of “subsistence farmers from central Mexico” living in single family homes that they own in the US right at this moment.

    There was some speculation, but I think much of the demand for subprime mortgages was from people who actually planned to live in the houses. I would add that when people speculate, they expect prices to be higher in the future. And the most likely reason for that to occur would be rapid population growth. Much of the speculation was in places like Phoenix and Vegas, where population growth was very fast, but has now slowed sharply. So there were real factors to explain both the speculation, and the subsequent crash. To repeat, I don’t think immigration shocks explain more that a modest part of the problem, but I do think it is a factor. Other housing booms also were correlated with immigration. Spain had very high rates of immigration, and also had a housing bubble. Places like Cleveland, with low population growth, did not have much of a housing bubble.

    I do agree with your opposition to the word bubble for this phenomenon, and again I was being charitable in assuming Krugman meant “boom.” But maybe he really did mean bubble, in that case I would disagree with him.

    Current, You said:

    “According to uncontroversial parts of Austrian theory the natural rate is determined entirely by the rates of time preference of the population.”

    Capital theory is not my area, but I thought Irving Fisher showed capital productivity does matter. Is this really uncontroversial? Are you simply making the argument about time preference at the margin?

    If Garrison is talking about NGDP (and I assume he is) then I totally agree. The neutral rate of interest is the rate that keeps NGDP stable. (My only quibble would be that I prefer 5% NGDP growth to 0% growth, but that is a minor point.)

    BTW, I hope any Austrians that favor a gold stand realize that under a gold standard NGDP is not stable, it rises over time.

    I think they kept interest rates low in 2002 precisely to offset a fall in velocity. Had they not done so, we might have had a Great Depression in 2002. Don’t believe me? Then explain why we had a Great Depression after 1929, but one could not have occurred after the 2000 stock bubble burst. Isn’t the only reason we avoided a second depression because Greenspan was more expansionary than the Fed had been in 1930?

  31. Gravatar of Current Current
    22. June 2009 at 07:38

    First, on capital theory….

    Scott: “Capital theory is not my area, but I thought Irving Fisher showed capital productivity does matter. Is this really uncontroversial? Are you simply making the argument about time preference at the margin?”

    Well, I didn’t think it was controversial. Perhaps I’m wrong, perhaps it is.

    This is what Rothbard said about the subject in his introduction to a book by Fetter:
    “Fetter approached the problem this way: If every factor earns a rent, and if therefore every capital good earns a rent, what is the source of the extra return for interest (or “long-run normal profit,” as it is sometimes called)? In short, if a machine is expected to earn an income, a rent, of $10,000 a year for the next ten years, why does not the market bid up the selling price of the machine to $100,000? Why is the current market price considerably less than $100,000, so that in fact a firm that invests in the machine earns an interest return over the ten-year period? The various proponents of productivity theory answer that the machine is “productive” and therefore should be expected to earn a return for its owner. But Fetter replied that this is really beside the point. The undoubted productivity of the machine is precisely the reason it will earn its $10,000 annual rent; however, there is still no answer to the question why the market price of the machine at present is not bid high enough to equal the sum of expected future rents. Why is there a net return to the investor?

    Fetter demonstrated that the explanation can only be found by separating the concept of marginal productivity from that of interest. Marginal productivity explains the height of a factor’s rental price, but another principle is needed to explain why and on what basis these rents are discounted to get the present capitalized value of the factor: whether that factor be land, or a capital good, or the price of a slave. That principle is “time-preference”: the social rate at which people prefer present goods to future goods in the vast interconnected time market (present ! future goods market) that pervades the entire economy.”

    I think that what Rothbard says is essentially correct. I have never heard of a good argument against it.

  32. Gravatar of Bill Woolsey Bill Woolsey
    22. June 2009 at 08:04

    Current:

    That capital goods are productive is not an adequate explanation of interest. However, the exact level of the interest rate almost certainly depends on how productive capital goods are expected to be.

    If the question is, “why is there this phenomenon of interest” then the productivity of capital goods is neither necessary or sufficient to explain it.

    If the question is, “why is the interest rate exactly at a certain level rather than higher or lower?” and, more importantly, “why does the interest rate change from one level to another?,” then expecations about the productivity of capital goods are important. This is both the physical productivity (on the margin,) as well as the value productivity.

    Just about all econmists (including me,) is interested in what determines the level of interest rates and why they might change.

    Just about no one is interested in determining the fundamental cause of the existence of the phenomenon on interest.

    More importantly, if you confuse the question of why there is interest, and then assume that only changes in intertermporal preference can cause changes in the interest rate, you will make terrible errors in analysis.

    In particular, if you are assuming that the natural interest rate is unchanging because of some argument about why interest exists, you are making a serious error.

    Where is the margin where intertemporal preferences apply?

  33. Gravatar of Greg Ransom Greg Ransom
    22. June 2009 at 08:37

    “kooky and discredited”

    Note well. Hayek’s work was never discredited by actual, you know, informed argument — it was slandered by the demonstrably ignorant and uninformed (Keynes, Krugman, etc.).

    And it was viewed as “kooky” by “non-kooky” economists who have given us one fashionable and then abandoned wave of scientistic “modeling” as “economic science” after another — people who demonstrably had no idea how science was done. And lets start by naming names — Paul Samuelson and Milton Friedman, for starters.

    As least Samuelson finally acknowledge that his image of how “economic science” would work as a complete bust.

    Friedman would never allow himself to acknowledge the self-evident failure of his own image of “economic science”.

  34. Gravatar of Jon Jon
    22. June 2009 at 08:37

    Current, great citation. Rothbard goes on to clearly state a point I made to Nick:

    Each individual has a personal time-preference schedule, a schedule relating his choice of present and future goods to his stock of available present goods. As his stock of present goods increases, the marginal value of future goods rises, and his rate of time-preference tends to fall. These individual schedules interact on the time market to set, at any given time, a social rate of time-preference. This rate, in turn, constitutes the interest rate on the market, and it is this interest rate that is used to convert (or “discount”) all future values into present values, whether the future good happens to be a bond (a claim to future money) or more specifically the expected future rentals from land or capital.

    Thus, Fetter was the first economist to explain interest rates solely by time-preference. Every factor of production earns its rent in accordance with its marginal product, and every future rental return is discounted, or “capitalized,” to get its present value in accordance with the overall social rate of time-preference. This means that a firm that buys a machine will only pay the present value of expected future rental incomes, discounted by the social rate of time-preference; and that when a capitalist hires a worker or rents land, he will pay now, not the factor’s full marginal product, but the expected future marginal product discounted by the social rate of time-preference

  35. Gravatar of Current Current
    22. June 2009 at 08:38

    Bill Woolsey: “In particular, if you are assuming that the natural interest rate is unchanging because of some argument about why interest exists, you are making a serious error.

    Where is the margin where intertemporal preferences apply?”

    I’m not saying that the natural interest rate is unchanging. I’m saying that it’s related to the time-preferences of the population. Related in quite a complicated way because of the distribution of assets and liabilities.

    As I expect you know this is a long-term argument. I’m not arguing about short-term fluctuations in the rate. (Which are of-course these days Fed induced).

    Bill Woolsey: “However, the exact level of the interest rate almost certainly depends on how productive capital goods are expected to be.”

    But how? Not at all directly.

    Suppose due to random meddling by space aliens a set of capital goods become twice as productive overnight. Since we aren’t talking about entrepreneurship here suppose everyone knows about it. How would this affect the natural rate of interest?

    In my view it wouldn’t affect anything. The price of the capital would increase by an amount similar to x2 the following day.

    Changes to the interest rate would then depend on who owns the capital and the nature of the consumer goods that the capital produces after roundabout production. The affected groups change their behaviour because what happens changes their intertemporal preferences.

  36. Gravatar of Current Current
    22. June 2009 at 08:57

    Scott: “If Garrison is talking about NGDP (and I assume he is) then I totally agree. The neutral rate of interest is the rate that keeps NGDP stable. (My only quibble would be that I prefer 5% NGDP growth to 0% growth, but that is a minor point.)”

    This is getting a little off the point, but anyway. Garrison doesn’t really like the idea of a “neutral rate of interest” in the current Central banking system. See http://mises.org/journals/qjae/pdf/qjae9_4_6.pdf

    Garrison broadly agrees with stability of MV though.

    Scott: “BTW, I hope any Austrians that favor a gold stand realize that under a gold standard NGDP is not stable, it rises over time.”

    I think that precisely what it does is an open question. Some Austrian economists think that the reverse is true. Demand for money holdings may increase in a recession. It doesn’t increase in normal times though.

    It’s a complicated question though because technology can change a lot of things. I’m not sure it can be settled either way.

    Scott: “I think they kept interest rates low in 2002 precisely to offset a fall in velocity. Had they not done so, we might have had a Great Depression in 2002. Don’t believe me? Then explain why we had a Great Depression after 1929, but one could not have occurred after the 2000 stock bubble burst. Isn’t the only reason we avoided a second depression because Greenspan was more expansionary than the Fed had been in 1930?”

    Perhaps the Fed did correctly keep interest rates low in 2002. I don’t know very much about 2002 though so I don’t really have a strong opinion on that. However, I’m not sure that excuses the Fed keeping them low for years afterwards.

  37. Gravatar of Current Current
    22. June 2009 at 09:15

    Speaking of expectations. Someone asked me about how expectations work in ABCT in another post here. Who was it? I can’t remember. I’ll reply of-list.

  38. Gravatar of Lord Lord
    22. June 2009 at 12:47

    I would agree with you that tight money is the principal problem, though I lean in the direction it is tight because of lost faith in the ability to repay it, by both borrower and lender, but that is the reason it is all the more important for the Fed to change those expectations.

    I have to say I have no better word than fraud for making loans that cannot be repaid other than through escalating asset prices. One can call it speculation, but there is no reason for the pretense of lending on speculation other than to mislead the ultimate lender into thinking the loan is safe and will be repaid. The entire prospect was oriented to disguise and hide risk and the fact that this was speculation from them. How much will you lend me to bet on black? I will offer a great interest rate but if it is red, sorry, you will be out of it. Even if prices escalate, even if there are some reasons to expect them to escalate, no one has any right to expect them to escalate forever and ever. Housing speculation was driving prices only I would not say it was only or even primarily borrowers speculating. It was as much lenders (intermediaries) speculating against each other. Home prices tripled or quadrupled in the most bubblicious areas. It was apparent there was not and would never be enough income to repay these loans. Even increased immigration increasing incomes comes up short when there are only so many families you can crowd into a home.

  39. Gravatar of david glasner david glasner
    22. June 2009 at 19:02

    Here are a random observations on this very interesting thread.

    Scott, you are mistaken to identify every theory that makes use of the concept of the natural rate of interest with Austrian business cycle theory. There are many theories in which the natural rate plays a significant role (e.g., Wicksell (who invented the term), Keynes in the Treatise and Hawtrey just to name three) that were clearly not Austrian. For that matter Henry Thornton and a number of currency school theorists in the nineteenth century were implicitly reasoning in terms of a natural rate model. On all of this see Leijonhufvud’s wonderful Wicksell Connection paper. So the idea that you have to buy into Austrian theory to accept the idea that the Fed fueled a bubble by keeping interest rates below the market level is not at all correct.

    Arbitrage equalizes observable market interest rates. Arbitrage can’t equalize unobservable natural rates. An area in which the local natural rate is below the international market rate will experience a below average rate of growth and conversely for areas with local natural rates above the international market rate.

    The idea of a natural rate is a huge simplification and abstraction, and is at least as problematic as the price level which is one of the principal betes noires of Austrian theory. If it has any meaning the natural rate must refer to the entire term structure of interest rates, not to the federal funds rate which is the only rate over which the Fed has direct control under normal circumstances. There is a huge logical gap between the proposition that the Fed can affect a short-term interest rate and the proposition that it can shift the entire term structure. And it is the latter proposition upon which most natural rate theories (with the notable exception of Hawtrey’s) depend.

    The notion that real interest rates are determined only by time preference and not by productivity is a crude fallacy latched onto by Austrians like Rothbard (but not Hayek!) who are pathologically immune to understanding the simple indifference curve diagrams deployed by Fisher to show that the equilibrium interest rate corresponds to a point of tangency between an indifference curve representing time preference (marginal rates of substitution between current and future consumption) and productivity production possibilities frontier between current and future output of consumption goods.

    However there is a parallel and presumably equivalent analysis that could be articulated in terms of the stock of capital. Corresponding to each rate of time preference there is an implied value of the current capital stock. Given the current value of the capital stock, and the cost of producing new capital there will be a corresponding amount of investment in new capital that it is profitable to build. Thus shifts in time preference imply shifts in the value of existing capital and corresponding adjustments in the stock of capital over time that result in a steady state equilibrium in which the rate of time preference equals the marginal productivity of capital. So there is a stock-flow model of capital investment implicitly associated with the fisherian equilibrium between time preference and productivity.

    If the ability of the Fed to affect the entire term structure of interest rates is minimal as I believe, then we have to look elsewhere for explanations for bubbles. What seems most plausible to me is the huge accumulation of monetary reserves by a few countries with persistent export surpluses like China and the oil exporting countries. That was the savings glut identified by Bernanke and Greenspan after the dot com bubble burst. And even as the Fed was raising the Fed funds rates after 2004, the rest of the term structure actually went in the opposite direction. The behavior of these countries was analogous to the behavior of the French after they stabilized their currency in the late 1920s and began accumulating gold like crazy, but the immediate effect was less disastrous because they were not forcing deflation on the world economy. However, the accumulation of reserves by those countries was also destabilizing though I am still trying to work out the linkages in my own mind. But despite the analogy that one can draw between China in 2002-08 and France in 1926-31, I am not at all sure that China was as critical to the story as France. And in both cases, the Fed could have kept the bottom from falling out from under the markets.

  40. Gravatar of Current Current
    23. June 2009 at 03:02

    An interesting post by David Glasner. Most of which I agree with except for a few points.

    As David says it is not only Austrians that use the concept of a natural rate of interest.

    David: “The idea of a natural rate is a huge simplification and abstraction, and is at least as problematic as the price level which is one of the principal betes noires of Austrian theory.”

    There are good reasons though for the differing treatment. Mises often talks about changes in the price of goods as being “from the good side” or “from the money side”. In the Theory of Money and Credit he agrees that an index of the price level can be found over the period of a few years.

    There are two reasons the price level is a bete noire for Austrians. Firstly, other economists often treat it as an accurate variable. People take quite seriously the idea of deflating the GDP figures from the 50s to the present day. Has anyone read about how the price level was calculated even in the 1960s. I have a book that discusses it. In the UK the price level for 1958 had been calculated by 1960. This price level depended on a basket that hadn’t been changed in years and wasn’t changed for years afterwards.

    The second problem is that mainstream economists often treat the CPI and PPI and other measures as though they are representative. These average price levels are not necessarily informative to any particular person or business. A businessman who wishes to act like an agent in a New Classical model cannot use the producer price index, he must calculate his own price index.

    Other sorts of economist don’t treat the natural rate in the same way. Nobody thinks that they can separate out the natural rate of interest for the last fifty or so years and present a table of it. Also, few who talk about the natural rate of interest make the mistake of thinking that it applies similarly to every agent.

    David: “here is a huge logical gap between the proposition that the Fed can affect a short-term interest rate and the proposition that it can shift the entire term structure. And it is the latter proposition upon which most natural rate theories (with the notable exception of Hawtrey’s) depend.”

    Yes, the Fed can only affect the short-term interest rates, where that short term is perhaps a few years. This was shown quite clearly in the 70s. However, that is all that is really needed for ABCT.

    I agree with you that there is a set of interest rates not just one. I agree with you also that many treatments ignore this.

    David: “The notion that real interest rates are determined only by time preference and not by productivity is a crude fallacy latched onto by Austrians like Rothbard (but not Hayek!) who are pathologically immune to understanding the simple indifference curve diagrams deployed by Fisher to show that the equilibrium interest rate corresponds to a point of tangency between an indifference curve representing time preference (marginal rates of substitution between current and future consumption) and productivity production possibilities frontier between current and future output of consumption goods.”

    It’s not that we don’t understand it, we just think that it’s wrong. I will discuss why and Hayek’s view below.

    David: “However there is a parallel and presumably equivalent analysis that could be articulated in terms of the stock of capital. Corresponding to each rate of time preference there is an implied value of the current capital stock. Given the current value of the capital stock, and the cost of producing new capital there will be a corresponding amount of investment in new capital that it is profitable to build. Thus shifts in time preference imply shifts in the value of existing capital and corresponding adjustments in the stock of capital over time that result in a steady state equilibrium in which the rate of time preference equals the marginal productivity of capital. So there is a stock-flow model of capital investment implicitly associated with the fisherian equilibrium between time preference and productivity.”

    I agree with that except for the last couple of sentences.

    Roger Garrison once said that the problem here is that not all rates are rates of interest. That is the error the Fisherian side make.

    Changes to productivity affect the price of the capital stock. They don’t affect the rate of interest. If capital becomes more productive it becomes worth more, the interest rate is not directly affected. It may be affected indirectly by a change in time preference that other changes bring about.

    I’ll show you want I means by some examples. We want to discuss exogenous change here so I’ll invoke space aliens for that job.

    Suppose we go to the city in China where buttons are produced. Aliens go into one of the button factories at night. They improve the machines for making buttons so that they produce twice as many per hour. What is the result of this? Well, since the Aliens have implemented the change in every button factory each of those businesses are on the same footing. The increased productivity will cause the price of buttons to be bid down. Button factory owners will only gain because buttons are close substitutes for other products such as laces. So, the price the button factories (or button machines) will increase due to that. It may also fall if the button making capacity is now higher than demand. Since this is likely an overall fall would be expected. None of this directly changes the interest rate. The interest rate may change though due to changes in the time preference of the population. If buyers of large quantities of buttons know they can buy them cheaply they may spend more now knowing that the button problem is smaller. This is the competing capital situation.

    Suppose instead that we go to the US. Here the aliens talk to many engineers in businesses that design silicon chips. To each they give a different secret that enables better products to be made. Each engineer works for a company making chips for a different market. When they go to work each is able to make a better product. They are able to charge more for their job and their employers are able to change more for the products. Since each are competing in different markets against goods that are not close substitutes the situation is not the same as it was for the button makers. In this case the capital value of the knowledge the engineers hold, or the businesses they work for is likely to increase. Even the value of the machines they use may increase since they have been made more productive buy improvements elsewhere. This is the complementary capital situation. In this case most of the income from the improvements is likely to come to those who own the factors I mention. The consumer will benefit through competition with substitutable goods, as before. In this case it is unclear how the overall time preference situation will change. It may be that those who now own these new streams of income have different time-preference to the rest of the population.

    The view I’ve outlines above is, as I understand it, the same as Hayek’s.

    Notice that in either of the examples I give above I could use a change in any sort of productivity. The productivity of capital, labour or land. None are special.

    So, to conclude, productivity has no simple relationship with the interest rate. When there is a change in productivity there is a change in the subjective valuation of some items. There is a consequent change in objective prices that occurs in the presence of competition. That provokes a change in the prices of capital. It also produces a changes in the expect prices of future goods. And changes in expected future incomes. These two factors then affect time-preference and saving/dis-saving decisions. Exactly which way this happens is probably impossible to predict except in very special situations.

  41. Gravatar of ssumner ssumner
    23. June 2009 at 05:57

    Current, The machine owner earns a return on their time, as well as a return for risk taking, so there is no mystery to explain. But part of the return is rent on the machine.

    Bill, I agree and would emphasize the role of behavior at the margin, which Current seems to gloss over. Changes in capital stock size and/or productivity certainly do change the interest rate, and hence time preference at the margin. Maybe I misunderstood his argument.

    Greg, I meant “kooky” in a good way, like when I call myself a monetary crank. Seriously, the reputation I am talking about comes from the perception that people like Rothbard opposed expansionary policies in the early stages of the Depression. Is that perception right? Did he say expansionary policies were unwise? I was not taking a position on the question of whether the perception was deserved.

    Jon, The mistake here seems analogous to arguing that only supply determine price, not demand, because in a competitive market price always equals MC at the margin. Yes, but when demand shifts you move to a new point on the MC curve. The same for shifts in the capital sector, which move you to a new point on the time preference curve.

    Current#2, New investment makes the expected future supply of goods rise, which changes time preference at the margin.

    Current#3, You got me in trouble with Roger. I repeated your claim that Garrison supported NGDP targeting on Bob Murphy’s blog, and Roger denied the claim.

    Regarding gold, Austrians need to look at the evidence. The stock of gold grows massively over time. It is many, many times larger than 200 years ago. Unless gold velocity drops at an incredible rate, NGDP will certainly grow under a gold standard, and in fact did grow massively during historical gold standards. So the Austrians (if they believe what you say) are wrong on both theoretical and empirical grounds.

    I didn’t say the 2002 policy excused later Fed behavior, indeed I specifically said many times that Fed policy was a bit too loose in 2004-06.

    Lord, One point I keep emphasizing is the the villains were the victims. The same people that made what you call fraudulent loans, bought those loans in massive quantities and kept them on their own books. I don’t know why people keep trying to make up some story that the big banks knew these were bad loans and passed them on to others. Why do people think the big banks are in so much trouble if they weren’t the victims of the subprime fiasco? It makes no sense. And it’s not true. But it makes a nice Hollywood story I suppose, we are all taught that big Wall Street firms are evil. No they aren’t evil, they were just stupid in this case. And they shot themselves in the foot.

    David, I should have read your comment first, as it is a much better reply to Current than mine. On the question of Austrians and bubbles, you may be right about the views of others, but isn’t there this distinction:

    I view most other monetary economists as arguing that too much money will lead to an inflationary boom, as rising AD pushing the economy against capacity and prices rise. But there is not necessarily any bubble. The Austrians seem to focus on the sectoral problems, that the boom will be concentrated in one sector—creating a bubble. Is this right? As you know, I don’t buy the Austrian model of the economy, but I don’t know any other contemporary school of thought that makes this argument. But then I have to admit that I don’t follow post-keynesians, and perhaps they make a similar argument.

    Current#4, I’ll let you debate this with David, but let me just say that it doesn’t seem to me that you agree with most of what he says, as you claim. You certainly disagree with the core ideas of Fisherian capital theory. And in that area I would have to agree with David, who knows much more about this than I do.

  42. Gravatar of Current Current
    23. June 2009 at 08:00

    Scott: “The machine owner earns a return on their time, as well as a return for risk taking, so there is no mystery to explain. But part of the return is rent on the machine.”

    Yes.

    Scott: “New investment makes the expected future supply of goods rise, which changes time preference at the margin.”

    Yes. But read what I said in the examples I gave above. It is not clear how this change will affect time preference.

    Scott: “Bill, I agree and would emphasize the role of behavior at the margin, which Current seems to gloss over. Changes in capital stock size and/or productivity certainly do change the interest rate, and hence time preference at the margin. Maybe I misunderstood his argument.”

    The problem is the order of causes. Changes in productivity can’t directly change the interest rate. The effect is through the paths I described in the last message.

    Scott: “You got me in trouble with Roger. I repeated your claim that Garrison supported NGDP targeting on Bob Murphy’s blog, and Roger denied the claim.”

    Supporting a stable MV or something similar doesn’t necessarily mean supporting NGDP targeting. Garrison calls the idea of a Fed set neutral rate of interest a “hall of mirrors” (or something similar) because each side is trying to reflect the views of the other. I think Garrison’s view is that only free banking can do the job. That said I may misunderstand him.

    Where is his post?

    Scott: “Regarding gold, Austrians need to look at the evidence. The stock of gold grows massively over time. It is many, many times larger than 200 years ago.”

    I agree with you about that.

    Scott: “Unless gold velocity drops at an incredible rate, NGDP will certainly grow under a gold standard, and in fact did grow massively during historical gold standards. So the Austrians (if they believe what you say) are wrong on both theoretical and empirical grounds.”

    Whether NGDP grew significantly under historic gold standards is a difficult question. Some economic historians think that during gold standards prices generally fell with productivity. I think that is the argument George Selgin makes. During the period of the international gold standard 1873-1896 Selgin says that “prices in most gold-standard countries fell at an average rate of about 2 percent a year” as productivity rose. It is very difficult to know for certain though because of the problems of the measuring price level I mentioned elsewhere.

    Changes in V will always cause MV to increase over time, but these happen only very slowly.

    I got this wrong earlier when I said “Some Austrian economists think that the reverse is true.” What I should have said is that some Austrians think that except for gradual changes in V the long term (and short term ones due to recessions) the trend in a commodity standard is for GDP to rise while NGDP stays relatively constant.

    Scott: “I didn’t say the 2002 policy excused later Fed behavior, indeed I specifically said many times that Fed policy was a bit too loose in 2004-06.”

    Ah right, OK. I haven’t read that many of your older posts as I should have done.

    Scott: “The Austrians seem to focus on the sectoral problems, that the boom will be concentrated in one sector””creating a bubble. Is this right?”

    No, not necessarily. The problem is the structure of production. The price of goods that pay for themselves only far in the future becomes artificially low. That may concentrate problems in one sector or it may not.

    Scott: “but let me just say that it doesn’t seem to me that you agree with most of what he says, as you claim. You certainly disagree with the core ideas of Fisherian capital theory.”

    Well, David isn’t throwing the idea of the natural rate of interest completely off the table though. He isn’t saying that it is irrelevant or that only the short run is relevant. He isn’t denying the existence of time preference.

  43. Gravatar of Current Current
    23. June 2009 at 10:31

    I think that the view others take about Capital theory could be more a difference of perspective.

    In Mises and Rothbard an individual has a particular set of preferences at a particular time. If the information they hold changes then those subjective preferences change.

    So, I may prefer in order A, B, C and then D. As a result I save £X. I save this to fund C which is a future good, D I cannot afford. I’m then informed that in the future consumer goods including C will fall in price. I may then prefer the same goods, but I anticipate that I’ll be easily able to afford C. This may result in me saving less £X – 10. It may also result in my buying D in the present.

    Some economists consider this to be productivity modifying the rate of time preference. Mises and Rothbard though consider time preference to be something an individual comes to after thinking about their present situation. When that situation changes the time preference can change too. I think this is the best way to look at it.

    Other economists though see the change as interacting with an existing set of preferences. So they see the expected fall in consumer goods prices as more-or-less directly leading to less saving. This is a reasonable way of looking at it.

  44. Gravatar of Lord Lord
    23. June 2009 at 11:12

    Don’t confuse the agents, the employees of these firms, with the firms themselves. No doubt they lost their jobs and some deferred compensation, but that was nothing compared to the money they took out of the system doing so. Finance operates under extreme discount rates, and are even higher for the individuals involved. So were the high salaries in finance due to their laughable brilliance or their employers incompetence? What market failure led to that? Yes, I am sure they all really, really, believed black would come up and keep coming up. It was just a case of bad luck. Heck, they didn’t even know red existed. Aw, shucks. Now that would be one for a movie script but no one would find it credible.

    Natural rates originated with Adam Smith though he didn’t go into how they were established or occurred.

  45. Gravatar of Bill Woolsey Bill Woolsey
    24. June 2009 at 03:08

    Current:

    I think Glasner is a bit cruel, but he basically has it.

    On the other hand, I think a supply of saving and demand for investment analysis is just as useful to see the insight.

    The claim that productivity changes can’t cause changes in interest rates directly is pointless. Changes in the market impact supply or demand and result in shortages or surpluses. This motivates changes in prices. Relative prices are always are the indirect effect of fundamental causes.

    Who cares if the impact of changes in the productivity of capital goods on the interest rate is “indirect” while the impact of changes in time preference is “direct?”

    The increase in productivty of capital goods makes it more attractive to postpone consumption to free up resources to produce the capital goods and so the future consumer goods. This provides more reources to compensate those consuming current income for reducing their consumption now. Of course, this compensation comes in the future. Anyway, there is a shortage. The interest rate is bid up to elicit a decreasion in current consumption, and increase in saving. At the new interest rate, time preference is still reflected, but it is different because the margin has shifted. And this came about because of the added productivity of the capital goods.

    In Rothbard’s story about future and present goods being exchanged, the productivity of capital goods is hidden in the supply of future goods by entrepreneurs. What they (or everyone) knows about how many future goods will be generated by the capital goods they are going to produce is included in the amount of present godos they demand in exchange.

    Further, you can see the “productivity of capital goods” showing up in credit markets. How much interest firms funding capital goods are willing to pay depends on the productivity of the capital goods they are going to finance.

    The supply of loanable funds by those saving does depend on their time preference. How much future consumption do they need to get them to sacrifice current consumption.

    What the exact level of the interest rate will be, and how it changes, is what is interesting.

    What would happen if no one cared when they consumed, or what would happen if we had no capital goods, is not terribly relevant to explaining the actual level of interst rates and how they change.

    Scott:

    Your “supply-side” only determination of prices was funny. In reality, Rothbard insists that all prices are determined solely on the demand side. It is marginal utility only. He recognizes, of course, that the production of goods changes marginal utility. But he rails against Marshall’s sissors.

    David:

    My understanding of all of this “demand only” price theory is about necessary and sufficient conditions to explain the phenomenon of relative price.

    If there is no production (no capital goods, for example,) there is no production involved, but there still can be relative prices based upon marginal utility. For intertemporal exchange, this involves time preference. (More or less.)

    So, we don’t need the productivity of capital goods to explain the existence of interest rates or any other relative price.

    It is not necessary.

    As for sufficent, if people were indifferent as to when there consumed (no time preference according to Mises,) then there would be no interest, no matter how productive capital goods would be.

    I think the Austrian way of looking at it is that if you don’t have to compensate people for waiting, then we will just produce the capital goods without there being any interest involved. (I think there is more to be said, of course.)

    Anyway, this shows productivity of capital goods is not sufficient to explain interest.

    But, if one goes from there and says that changes in the productivity of capital goods (or preceptions) have no impact on interest rates–it is crazy.

  46. Gravatar of ssumner ssumner
    24. June 2009 at 04:36

    Current, If you say you agree with my comments on capital, then I’ll just defer this issue, as i am not sure what we are debating.

    Roger’s denial came in a email to Bob that was passed on to me, but your analysis sounds similr to what I recall him saying, he thinks stable MV is desriable, but has little faith in a Fed targeting scheme. He prefers free banking. The hall of mirros stuff is interesting. It is what I have called the circularity problem in other posts. It is why I share Roger’s view that the market should set the money supply. My preferred scheme is NGDP futures targeting, where the Fe dhas no say ove rthe monetary base, they just set the NGDP target.

    I strongly disagree with you about NGDP under a gold standard. Most of my career has been spent studying the gold standard, and I can tell you that you are flat out wrong. Even during the late 1800s NGDP rose. It was slow growth because there was a temporary lull in gold discoveries. But when new gold was discovered (1890s) NGDP picked up strongly. By 1914 the US NGDP was many times higher than 100 year earlier. World NGDP also grew strongly measured in gold terms. There simply is no dispute about this, NGDP grows strongly over time under gold standards.

    Lord, I don’t agree that finance uses extreme discount rates, I plan a post someday about the myth that Wall Street has a short term perspective. And the view that bad guys got rich by making bad loans and then walking away before it crashed in 99% myth. There may have been few cases like that, but certainly not enough to explain the bubble. Most of the bad guys lost a lot of money.

    Bill, Yes, I agree with you and David.

  47. Gravatar of Current Current
    24. June 2009 at 06:02

    Bill Woolsey: “The claim that productivity changes can’t cause changes in interest rates directly is pointless. Changes in the market impact supply or demand and result in shortages or surpluses. This motivates changes in prices. Relative prices are always are the indirect effect of fundamental causes.”

    Yes, yes. We all agree with that. I’m not saying here that a change in productivity can’t affect interest rates. I’m saying that time-preference determines the interest rate. Changes or expectations of changes in future conditions may affect time-preference.

    Bill Woolsey: “Who cares if the impact of changes in the productivity of capital goods on the interest rate is “indirect” while the impact of changes in time preference is “direct?””

    David Glasner, Fisher, Scott and yourself are drawing a line between interest rates and productivity that is too direct.

    The “directness” matters because a theory will not be correct unless it acknowledges it.

    Bill Woolsey: “The increase in productivty of capital goods makes it more attractive to postpone consumption to free up resources to produce the capital goods and so the future consumer goods. This provides more reources to compensate those consuming current income for reducing their consumption now. Of course, this compensation comes in the future.”

    If that happens it is because of individual time-preference changes. In this sentence you are glossing over individual action.

    Suppose the productivity of capital goods owned by Jim increases. How do we get from there to the postponing of consumption by others to free up resources to produce capital goods?

    Bill Woolsey: “Anyway, there is a shortage. The interest rate is bid up to elicit a decreasion in current consumption, and increase in saving. At the new interest rate, time preference is still reflected, but it is different because the margin has shifted. And this came about because of the added productivity of the capital goods.”

    Spell that out as a set of individual actions and you will see the problem that I’m pointing to. See the examples of the button factory and the silicon chip designers I wrote above.

    Bill Woolsey: “In Rothbard’s story about future and present goods being exchanged, the productivity of capital goods is hidden in the supply of future goods by entrepreneurs. What they (or everyone) knows about how many future goods will be generated by the capital goods they are going to produce is included in the amount of present godos they demand in exchange.”

    Point me to the specific bit of Rothbard you are talking about.

    Bill Woolsey: “Further, you can see the “productivity of capital goods” showing up in credit markets. How much interest firms funding capital goods are willing to pay depends on the productivity of the capital goods they are going to finance.”

    Let’s take Rothbards examples from above:
    “If every factor earns a rent, and if therefore every capital good earns a rent, what is the source of the extra return for interest (or “long-run normal profit,” as it is sometimes called)? In short, if a machine is expected to earn an income, a rent, of $10,000 a year for the next ten years, why does not the market bid up the selling price of the machine to $100,000? Why is the current market price considerably less than $100,000, so that in fact a firm that invests in the machine earns an interest return over the ten-year period? The various proponents of productivity theory answer that the machine is “productive” and therefore should be expected to earn a return for its owner. But Fetter replied that this is really beside the point. The undoubted productivity of the machine is precisely the reason it will earn its $10,000 annual rent; however, there is still no answer to the question why the market price of the machine at present is not bid high enough to equal the sum of expected future rents. Why is there a net return to the investor?”

    Profit from entrepreneurship is involved here too, something Rothbard doesn’t mention here.

    In your example what drives this source of profit is really entrepreneurship. It happens when the vendor of machine Y sells it to some entrepreneur who buys it with credit. That entrepreneur gains because he or his business knows how to use the machine better than others. Or it is at least in expectation of that outcome that the entrepreneur buys the machine.

    These are artifacts of the entrepreneurs time-preference that are affected by his expected future profits. They then impact the interest rate through his borrowing behaviour.

    Bill Woolsey: “What the exact level of the interest rate will be, and how it changes, is what is interesting.”

    Yes. But my argument is that your productivity theory isn’t accurate. Increases in productivity don’t universally do what you claim they do.

    See what I’ve said above about competing and complementary capital.

    If you really want some punishment read Appendix V of “The Pure Theory of Capital” by Hayek.

  48. Gravatar of Current Current
    24. June 2009 at 08:05

    Scott: “If you say you agree with my comments on capital, then I’ll just defer this issue, as i am not sure what we are debating.”

    What I’m discussing here with Bill Woolsey and David Glasner is an esoteric point in capital theory. I don’t really agree with them or you. I think that it’s too simplistic to say that improvements in productivity drive the interest rate up or down or changes it at all.

    These things depend on the situation. Consider if there were an improvement in the productivity of sitting tenured professors. The professors decide to use that increase in productivity to spend more time gardening and writing interesting blogs.

    Now, consumers won’t directly benefit from that change. Surely, the benefits will filter down over years. That period though may be after current consumers are dead, or so far in the future that it will not affect their decisions.

    The “Ricardian Question” of who gets income must be answered in part before the effect on the interest rate can be understood. Then when individuals receive the income or act on the expectation of receiving it then those individuals time-preference rates will change. Then the interest rate changes.

    Scott: “I strongly disagree with you about NGDP under a gold standard. Most of my career has been spent studying the gold standard, and I can tell you that you are flat out wrong. Even during the late 1800s NGDP rose. It was slow growth because there was a temporary lull in gold discoveries. But when new gold was discovered (1890s) NGDP picked up strongly. By 1914 the US NGDP was many times higher than 100 year earlier. World NGDP also grew strongly measured in gold terms. There simply is no dispute about this, NGDP grows strongly over time under gold standards.”

    Yes, as I said in my previous reply to you I got this wrong.

    When I said “Some Austrian economists think that the reverse is true.” What I should have said is that some Austrians think that except for gradual changes in V the long term (and short term ones due to recessions) the trend in a commodity standard is for GDP to rise while NGDP stays relatively constant.

    That is GDP is the variable that changes significantly from year to year. The money stock rises due to gold discoveries too and the velocity changes due to changes in how trade is done (and in recessions). But these later two changes are not as large as GDP.

    So, overall you get something like the period of the International Gold Standard in this graph:
    http://commons.wikimedia.org/wiki/File:US_Historical_Inflation_Ancient.svg
    That is a falling price level.

    According to Selgin changes in banking practices that allowed less reserves to be used are of a similar importance to gold discoveries.

    Is that right, or do you still disagree?

  49. Gravatar of david glasner david glasner
    24. June 2009 at 16:50

    Here are a few responses to points raised since my posting a couple of days ago.

    Current: It seems to me that your arguments in favor of a purely time preference theory of interest a la Rothbard, Mises, and Fetter, involve either a confusion between movements of a curve and movements along a curve, between simultaneous determination of several variables with sequential determination (first explain why there is a positive interest rate, then explain why it settles down at any particular level), and incorrect inferences from examples in which the productivity of only a small portion of capital goods increases while the rest of the capital stock is unchanged. I fail to see the relevance of such conceptual experiments to the determination of interest rates. You also say that you do understand the basic Fisherian model describing the tangency of the marginal rate of substitution between present and future consumption on the one hand and the marginal rate of transformation of the output of present and future consumption on the other hand, but you think it is wrong. Maybe I missed it, but I don’t think that I have seen any refutation (or even an argument against) that proposition. The shapes of the relevant indifference curves are governed by individuals’ rates of time preference and the shape of the relevant production possibilities curves are governed by technological factors (in other words the productivity of capital). Changes in capital productivity alter the shapes of the production possibilities curves, so the new point of tangency between the relevant curves will generally reflect a change in the marginal rates of time preference and the marginal rates of transformation in production. While you are right that the value of capital will change in part because future income streams are discounted at a rate that differs from the discount rate used before the change, that is all perfectly well accounted for in the Fisherian model. If you think otherwise, then you indeed have not understood the Fisherian model. Your lengthy quotes from Fetter and Rothbard in that regard are simply beside the point. Rates of time preference, of capital productivity, and of interest can be determined simultaneously; they do not have to be determined sequentially. At the formal level, Hayek never took issue with the basic Fisherian model, and, as I recall, even Mises was at pains to limit the scope of his disagreement with Fisher. For Mises, I think the problem lay in an inability to appreciate the idea of simultaneous determination of multiple variable, so he attached priority to time preference and viewed productivity as subordinate to time preference. But that is just conjecture on my part. At any rate, Rothbard, as was often the case, was way out of the Mises-Hayek mainstream on this point.

    My view on the natural rate of interest is basically agnostic. It is useful as a heuristic for motivating a discussion of monetary policy, but I think its value is limited. Conventional natural rate models are problematic as well, because the implicit model of money and banking is inconsistent with a theory of bank behavior in which the supply of (inside) money by banks is determined by some sort of marginal revenue equal marginal cost equilibrium as opposed to a mechanical money multiplier analysis which is utterly without microeconomic foundation.

    Just to be controversial and perhaps slightly paradoxical, I would observe that the conventional analysis which tries to provide a partial equilibrium (and supposedly neo-classical) analysis of the determination of interest rates in terms of the supply of and demand for loanable funds is at best trivial and at worst misleading because the real factors underlying the determination of interest rates are more properly taken into account in the markets that determine the prices of capital assets which represent sums of the discounted expected future cash flows attached to those assets. Given expected future cash flows, the relevant interest rates must adjust to whatever level induces the public to hold willingly the existing stock of capital, which, of course, is fixed in the short run.

    Scott, the difference between the Austrian natural rate theory and other natural rate theories is that the Austrian theory is associated with a particular story about how the capital structure and the production process changes in the course of the cycle and the aftermath of an increase in the market rate that triggers the upper turning point of the cycle. All sorts of earlier natural rate theories were associated with a story about overtrading or speculation fueled by easy money that is consistent with a bubble, and although the Austrian theory is consistent with a bubble, the bubble is not essential or particularly prominent in the Mises and Hayek versions. The notion that a bubble is somehow only explicable in terms of the Austrian theory is just another instance of the annoying self-promotion and self-flattery of many contemporary Austrian acolytes.

    Bill Wolsey: I am sorry if I was cruel. But it was only to be kind.

  50. Gravatar of Bill Woolsey Bill Woolsey
    25. June 2009 at 04:07

    Jim’s capital goods are more productive. Given the amount he must pay for the capital goods, his profit from purchasing additional capital goods rises. To finance the additional capital goods, he borrows money. The resulting shortage of the market for loanable funds raises the interest rate.

    Or, Jim floats a new stock issue to fund the capital goods. Those buying the stock hire fewer workers. Demand for labor falls as does the wages paid. The production of their producst fall, and their prices rises. The difference between factor prices and product prices expands.

    What you are saying (and it is confused) is that if time preference remains unchanged, then the disount of factor prices and output must remain the same. People would bid up the prices of the resources until they are less than the value of the product by their time preference. One equilibrium condition.

    Well, that would be true if the interest rate elasticity of saving was infinite. But it isn’t.

    Anyway, failing to understand marginal analysis and the supply and demand is an error.

    Finally, higher time preference means higher interest rates. Lower time preference means lower interest rates.

    Now, the normal theory (and correct one) is increased productivity of capital goods raises interest rates. You are saying that it can only do so if it lowers time preference. That for some reason, on the margin, people become more impatient. I think that to claim that, we really don’t know what will happen to interest rates in this situation is bad econnomics. If, on the other hand, increased productivity of capital goods should usually result in higher time preference (more impatience) then I think you are packing too much into time preference.

    To some degree, this is a matter of using the words in different ways, but I think that a more careful analysis is important. You would need to break it down to get at the idea of preferences regarding the time path of future consumption.

    Interest rates are market prices. Like other market prices they depend on supply and demand. What people know about production will impact supply and/or demand. And that includes the productivity of capital goods.

  51. Gravatar of ssumner ssumner
    25. June 2009 at 05:08

    Current, I don’t understand your “professor” example at all. If professors use their extra time for leisure or blogging, then that is certainly a form of consumption. I don’t think any economists would dispute that.

    The graph that you claim shows falling prices under a gold standard, actually shows stable prices under the gold standard. Again, prices were stable and NGDP rose strongly, regardless of what Austrians claim.

    David, I agree with your view that the price of capital goods is often a more meaningful variable than the flows of loanable funds. Do you agree with those who say the whole US current account deficit picture looks much different from an asset perspective, where the US continues to be roughly balanced, despite cumulative CA deficits that suggest we should now be trillions in debt? (The so-called “dark matter” hypothesis.)

  52. Gravatar of Current Current
    25. June 2009 at 07:30

    Scott: “I don’t understand your “professor” example at all. If professors use their extra time for leisure or blogging, then that is certainly a form of consumption. I don’t think any economists would dispute that.”

    Yes. How has the increase in productivity changed the interest rate?

    Scott: “The graph that you claim shows falling prices under a gold standard, actually shows stable prices under the gold standard. Again, prices were stable and NGDP rose strongly, regardless of what Austrians claim.”

    There is a big price spike during the civil war when the US went to fiat money. For almost every year after that though there is a fall in the price level until WWI this is the international gold standard period. Do you think that this works out to be a stable price level?

    Bill: “Interest rates are market prices. Like other market prices they depend on supply and demand. What people know about production will impact supply and/or demand. And that includes the productivity of capital goods.”

    Yes. I agree entirely.

    Bill: “You are saying that it can only do so if it lowers time preference. That for some reason, on the margin, people become more impatient. I think that to claim that, we really don’t know what will happen to interest rates in this situation is bad econnomics. If, on the other hand, increased productivity of capital goods should usually result in higher time preference (more impatience) then I think you are packing too much into time preference.”

    Time-preference is not quite the same thing as “impatience”.

    Hayek writes in the “Pure Theory of Capital” p.419:
    “A person is ‘impatient’ according to his [Fisher’s] terminology if, being assured of equal present and future incomes, he prefers some addition to his present income, even if only a very large one to any permanent addition to his future income, even if only to a very small one. That means that the term ‘impatience’ actually implies what it conveys in popular language, i.e. that a person is anxious to anticipate his future income in order to increase his present income beyond the level at which it can be permanently kept.”

    We are talking about time-preference, not impatience in this sense.

    What I’m saying is that marginal decisions should be understood from the point of view of the individual. The possibility of an increased stream of future income will change how an individual behaves. In my view that changes the time-preference of an individual.

    You could say that their time-preference stays the same but their expectation of future income changes. I suppose that’s reasonable too. You can’t say that a change in productivity somewhere causes this unless you can say that it will increase their future income.

    Now, back to Jim…

    Bill: “Jim’s capital goods are more productive. Given the amount he must pay for the capital goods, his profit from purchasing additional capital goods rises. To finance the additional capital goods, he borrows money. The resulting shortage of the market for loanable funds raises the interest rate.

    Or, Jim floats a new stock issue to fund the capital goods. Those buying the stock hire fewer workers. Demand for labor falls as does the wages paid. The production of their producst fall, and their prices rises. The difference between factor prices and product prices expands.”

    What happens when Jim has got his entrepreneurial plan in place depends upon Jim and his time-preference. He may be so rich already that he doesn’t bother to do anything at all.

    Probably Jim will do exactly what you say.

    I’ll write a more careful explanation for yourself and David Glasner in a couple of days. I need to read about this again.

  53. Gravatar of Bill Woolsey Bill Woolsey
    26. June 2009 at 05:38

    Enhanced productivity of captial goods isn’t the same thing as increased productivity.

    In “austrian” terms, there is an increase in the return from waiting. Technology changes in such a way that waiting increases output more than before. Round about methods are even more productive than before.

    It is possible to conceive of technoglogical improvements that are capital saving. Fewer resources are needed to produce a particular capital good. Less waiting is needed.

    My understanding is that changes in expected time path of income do impact interest rates, but rather due to changes in saving. While I supposed additional productivity of captial goods do impact future output and income, and so the amount people want to save, This is a change in their intertemporal budget constraint, not their preferences.

    To me, “time preference” has to to with–preferences.

    The market interest rate and future income impact that differnet consumption combinations possible made possible by saving.

    The producitivity of capital goods impacts the interterporal production possibilities. How many additional consumer goods can be obtained in the future by sacrificing the production of consumer goods now, and instead producing capital goods.

    While it is interesting to break down the market between consumption possibliities due to the interest rate and income on the one hand, and production possisiblities on the other hand, the actual market process of supply and demand don’t necessarily split up so neatly.

    In particular the market for loanable funds doesn’t divide up with the “demand side” being driving solely by the productivtiy of captial goods and the supply side by time preference.

    Anyway, Rothbard does the same thing with relative prices of consumer goods. They all depend solely on marginal utility. (More or less the ratios of the price reflect the ratios of marginal utilities. Of course, the profitibility of the goods, and so the relative prices and marginal costs impact production, and this, in turn impacts the level of marginal utility.

    All of this “pure time preference” theory of interest is just the same thing.

    It is pointless. In relality, the dispersed knowledge about how resources can be used to produce different goods, including the possiblity of getting future output by producing capital goods rather than current consumer goods plays a key role in the determination of relative prices, just like preferences.

    The only thing that requires a bit of care is making sure not to identify “supply” with the production possibilities and “demand” with the preferences. Market supply is generated from other market prices, which involve demand as well as supply.

  54. Gravatar of ssumner ssumner
    26. June 2009 at 06:12

    Current, Yes prices rose with the fiat money of the Civil war, but the fall afterward did not reflect the gold standard, as we weren’t on the gold standard. We returned to gold in 1879. By 1914 prices had showed virtually no change from 1879.

    Indeed the US price level in 1933 was essentially the same as in the late 1700s. There is no up or down trend under commodity money. During the Civil War prices rose, but they fell back afterward. The long run trend is flat.

    The professor analogy makes no sense if you are trying to explain interest rates in the market. The actions of individuals don’t affect prices in any competitive market. If all workers got more productive, and did more gardening, it would affect interest rates.

  55. Gravatar of david glasner david glasner
    26. June 2009 at 06:43

    Scott, I am not well informed about debates over how to measure the current accounts deficit. From the little that I’ve seen, the dark-matter hypothesis sounds reasonable to me, but I couldn’t go beyond that very superficial impression.

  56. Gravatar of Current Current
    26. June 2009 at 07:18

    Scott: “Yes prices rose with the fiat money of the Civil war, but the fall afterward did not reflect the gold standard, as we weren’t on the gold standard. We returned to gold in 1879. By 1914 prices had showed virtually no change from 1879.”

    Well, if that really is the case then George Selgin is wrong and so am I. Have you published your research on this anywhere?

    Scott: “The professor analogy makes no sense if you are trying to explain interest rates in the market. The actions of individuals don’t affect prices in any competitive market. If all workers got more productive, and did more gardening, it would affect interest rates.”

    It wasn’t intended to be an analogy but rather an example. Productivity does not increase evenly across all sectors of the economy. It increases in particular industries and places at particular times.

    Anyway, I’ll write a reply to David and Bill explaining this more carefully.

  57. Gravatar of ssumner ssumner
    27. June 2009 at 09:59

    Current, I haven’t done the research myself, but relied on other studies showing a stable long run price level under the gold standard. I do agree that if there are no gold discoveries (1879-96), prices will trend down. And perhaps things are different today. If the annual percentage increase in gold stocks is now less than real growth, we might get a bit of long run deflation. My point is that Austrians can’t be confident in their price level predictions under gold.

  58. Gravatar of Current Current
    29. June 2009 at 09:28

    Scott: “My point is that Austrians can’t be confident in their price level predictions under gold.”

    Fair enough, I agree with you there.

  59. Gravatar of Current Current
    3. July 2009 at 06:13

    I’ve thought about this and read about it. In this dispute we have advocates of “pure time preference”(PTP) and advocates of “time preference and productivity” (TP&P). As far as I can see none of you deny that time-preference is present so those are reasonable names.

    To clear up this issue I think it’s necessary to talk about the definition of time-preference. I think we are using different meanings. When discussing this we need to talk about means rather than ends. Goods and services are only useful when they can together serve the end. So if the end is to cook a bowl of soup then the vegetables and stock are useless with the pan. Similarly if the end is to go to college a flat near the campus is useless without enrolling in a course.

    The definition David Glasner and Bill Woolsey are using means something like “impatience”. In this view time-preference explains why a person prefers a higher income in period 1 rather than the same rise in income in period 2. The baseline situation being a steady income of the same amount per period.

    To Mises, Hayek and other Austrian economists time-preference is something different. The baseline I mentioned needs explaining. A person who has a steady income could save his money from period 1 and plan to spend it in later periods. Even if there were no savings market he could often do this by hoarding durable consumer goods. Except for rare misers nobody does this. So, the Misean view is that all spending demonstrates time-preference. Even a person who spends the same per period is demonstrating time-preference, Mises discusses this on p.483 of Human Action. Perhaps this difference of thinking is part of the reason why we disagree.

    The cause of a productivity change also changes incomes. On the supply side of the savings-investments market there are two relevant changes. Firstly, demand for capital may raise the interest rate. Bill discusses what happens when a new innovation improves expectations of productivity. Secondly, people may expect a higher real income in the future. As I said earlier on the saving side what the TP&P advocates say really refers to expectations of future consumption.

    The first situation -increased demand for capital- is related to profit. From the point of view of PTP advocates those who hold liquid assets at the time when they are in demand benefit. That though is a transient phenomenon and therefore a profit. It seems to me though that this is a matter of taste and definitions. Austrians talk about entrepreneurship (even accidental entrepreneurship) earning transient incomes which are profits. Under another sort of framework though this income could be made part of the natural rate of interest.

    Regarding individual behaviour….

    Above I gave the example of professors and the examples of buttons factories and electronics companies. My point in those examples is that the change in income distribution associated with productivity change is relevant. Various factors have different savings behaviours and time-preferences. A friend of mine spends all of his (small) income each week. He saves nothing and quite frequently he’s broke before he gets paid. Even if his real income were to rise slightly he would not likely change his behaviour. A large change would be necessary for him to consider it worth his while saving.

    The argument about general increases in productivity misses the point. An even increase in productivity across all parts of the economy never happens in practice. Productivity improvements happen unevenly across various industries. Even within companies they are very uneven. This was the point I was making when I gave the example of tenured professors above. Hayek realised this after writing his “Pure Theory of Capital” and mentioned the problem in an added appendix, Appendix V which I referred to above. His theory in that book (and I think lots of other theories) refer to an “evenly progressing economy”.

    Regarding Bill’s criticisms of Rothbard….
    What you are criticizing is Rothbard’s ERE models. There he separated things out that in the real world are not so separate. He would agree with you that “dispersed knowledge about how resources can be used to produce different goods, including the possibility of getting future output by producing capital goods rather than current consumer goods plays a key role in the determination of relative prices, just like preferences.” I think there is a lot to criticize in Rothbard’s ERE models in Man, Economy and State. But I don’t think that really changes much in what we were discussing.

  60. Gravatar of ssumner ssumner
    3. July 2009 at 12:17

    Current, Thanks, but we are getting so deep into Austrian capital theory that I’ll have to plead ignorance and move on. The only time I feel confident here is when we connect it up with business cycle theory applied to real world cases. Perhaps some of these ideas can be applied to later posts.

  61. Gravatar of Current Current
    6. July 2009 at 01:19

    Fair enough.

    I think I can summarize though what I was saying more concisely.

    Austrian definitions of these things were moulded by arguments with Marxists. Marxists identified surplus as a social ill.

    Austrians took surplus and split it into two parts. Firstly, there is “originary” or “natural” interest, which is payment for waiting. Secondly, there is profit which is always associated with disequilibrium.

    Later economists made a different sort of split. If you look at them both though they don’t say anything radically different. They just say things in different ways.

    The main difference is that the productivity view is less “individualist”.

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