Scott Sumner says this in response to a question from Tom about my model.
Tom, I don’t view fiscal policy as a partisan issue. The GOP loves tax cuts, for instance. Bush did a tax cut in 2008 for AD reasons.
What’s the intuition behind his result? Does he assume monetary policy is ineffective at boosting AD at the zero bound? Obviously it’s not ineffective, but I’m just trying to figure out where that result comes from.
First, I agree that “monetary policy” is effective at the zero bound. What I am actually trying to say is that monetary policy is required which cannot be carried out by what I assumed was the normal method of setting an interest rate and then creating whatever quantity of liquidity was required. So my main mistake was using the word “fiscal policy.” I shouldn’t have done that. I think of this as an explanation for why what most people call fiscal policy works, but it is a nominal explanation. So in that respect, I am really talking about monetary policy, just a different kind of monetary policy which may or may not be carried out in the form of government spending.
To see what I have in mind, think of the central government, the central bank, and the banking sector as one entity. The policy considered in the model was simply setting an interest rate and lending whatever funds are desired at that rate. But because those funds have to be paid back, and the interest rate is positive, the value of net monetary wealth (money minus debt) is decreasing over time. But in the face of that, the central authority is trying to create inflation. This means that they have to keep the money supply increasing. This means that they have to get people to borrow more and more relative to the value of their monetary wealth which means that they have to keep lowering the nominal (and real) interest rate.
So basically what I’m saying is that this creates a disconnect between expectations about future price levels and the price levels that can be sustained indefinitely through only lending by the CB. As long as there is slack in the interest rate, they can keep this going, but the longer it goes, the gap between the expected price level next period and what the price level would fall to if the money supply suddenly stopped growing on schedule.
Now the reason the money supply stops growing on schedule could be many things. It could be that they hit the lower bound and can’t induce enough lending. It could be that they mistakenly set rates too high. It could be that for some unexplained reason people decide to stop borrowing (which, of course must also be accompanied by one of the previous two explanations). But whatever the reason, if the money supply comes up a bit short, all hell could break loose.
This is for many reasons, some of which I have touched on in discussions about the significance of money being backed by debt. I will talk more about them in the future. But for now all I want to say is that they can be avoided if the money supply can be kept on track. The important thing is that once you are at the zero bound this can’t be done by simply inducing more borrowing in the usual way. You have to do something else to get the money out there. This could be government spending, funded by fresh money. For the record, I think that Sumner would say that this has a nominal and a fiscal component and it is the nominal component that I am interested in. But it could also be buying garbage debt for more than it is worth, or buying pretty much anything for that matter or, for that matter, buying absolutely nothing and just dumping money from helicopters.
This, of course, is the sort of the purest possible conception of “monetary policy.” But I will call it “unconventional monetary policy” (which, for the record, was also included in the heading of the section next to the words “fiscal policy” if I recall correctly). This allows me to draw the distinction which I think is important between “conventional monetary policy” which is carried out by expanding credit through borrowing and lending and “unconventional monetary policy” which is carried out by expanding the money supply in some other way which is not connected to any debt (or at least not a private debt).
For the record, there are other types of monetary policy which get a lot of discussion around the zero bound which are considered unconventional but which I see as further attempts to expand credit through borrowing. For instance, I see QE as an attempt to expand credit by pushing down longer-term interest rates. The MBS part of QE can be seen as either trying to push down risk premiums and expand credit or a kind of “unconventional” injection to banks in the form of a payment above what those debts are actually worth. Lowering the interest rate on reserves is essentially equivalent to lowering interest rates in my mind, it just means that you aren’t really at the ZLB.
Now I don’t think that I am saying anything very controversial about how monetary policy works at the ZLB. The thing I am saying which I think is controversial is that there is a natural tendency toward the ZLB in this system of inflation via credit expansion.
For the record, if the CB pays out all profits from interest payments in the form of a dividend, that also adds a source of additional slack. I think this will mitigate the issue but not fully fix it but I have to do some more work to be sure about that.
In my last post, I put forth a model which leads to the crackpot conclusion that central banks, doing what they do, necessarily lead us into a “liquidity” trap unless there is some significant, and ever-increasing, leakage of money which is not backed by debt back into the economy (in other words “fiscal policy”). I didn’t say very much about fiscal policy, there is a lot of work left to do which I intend to be doing for a while. But at this point, just in case you are thinking that this theory is nutty, here are some graphs.
Quick history for the uninitiated. The U.S. went off the (international) gold standard in 1971. Then there was a decade of “stagflation” where inflation was high and, to put it (overly) simply, the Fed’s policy goals were not all that clear and people were still trying to figure out what was going on and what it meant in the long-run. Then Paul Volcker was appointed chair of the Fed and vowed to rein in inflation which he did. Since then, it has been supposed by many that the Fed has essentially been following a de facto inflation target. The following graphs go from August 1979 (when Volcker was appointed) until the present. We all know basically what output and the price level have done, so let’s cut to the chase.
Fed Funds Rate
Now total debt is a little tricky. Here is loans and leases in bank credit; all commercial banks, and the M2 money stock.
Notice that the ratio of M2 to total bank credit is about 1.74 in Nov. 1980 (this is as far back as the M2 series goes) and about 1.10 in Nov 2007. Obviously, we know what happened next, and bank credit fell bringing the ratio back down to about 1.47 currently. But of course, we also know what else happened….
I’ve been working on a macro model in which the quantity of money is endogenous and I want to post an early version of it here before I do any more complaining about other people not doing anything constructive. I am attaching it as a pdf because I couldn’t get the equations to work in wordpress. It is sort of a cross between a blog post and a working paper, lots of equations and boring math but with some very informal discussion here and there. Also, to put all the math in would have been very tedious, so I tried to put in as little as possible, so some steps are omitted. It should be possible to reconstruct what I did here from what I included but it would take some effort (and probably a mathematical computing package). I think it is possible to organize it in a simpler way but I am still working on that.
The thing you should take away from this is that monetary policy, as we are currently doing it (inflation targeting) works much the way we think it works but that I think it either leads, in a predictable way, into a “liquidity trap” and a deflationary recession in the long run or it requires ever-expanding “fiscal policy” to keep this from happening.
We have been discussing Austrians and their relationship to “mainstream” economics here lately and that topic raises a lot of issues. I want to go into some of those issues in depth but I want to address them in a very broad way that isn’t really about Austrian economics. I want to address some deep philosophical questions surrounding the nature of models and their role in economics and the mindset of many people in various “heterodox” schools including Austrians but also Marxists, post-Keynesians and so on.
In general, models serve one or both of two purposes. They can be explanatory and exploratory. By the former I mean that a model can be used to explain some concept that the creator has in mind in a (relatively) simple way to someone who does not necessarily fully see or understand it to begin with. By the latter I mean that it can be used to explore a question which the creator of the model does not know the answer to. Now clearly, a model which is originally exploratory, typically becomes an explanatory tool once it has answered the questions it is designed to answer and the function of explanation works in essentially the same way in the mind of the “student,” which is to say that it walks them through a series of logical steps which take them from a set of premises that they already “knew” to a set of conclusions which they previously did not know. So every model is in some sense explanatory and exploratory, the distinction is in the mind of the beholder.
But the important thing to consider is the mindset of the person developing/working with the model. Are they designing the model in order to explore some questions that they don’t know or to explain some concept that (they at least think) they know? In my view, either one is fine. Probably, the best models are created for the purpose of explaining a concept that is already, at least partially, understood by their creators. However, what I think is imperative is that, when developing and working with a model, the modeler remain at all times an explorer. By this I mean that he must be open to the possibility that the model will reveal something he had not previously understood.
This is the line between a scientist and a rhetorician. It is also analogous to the (easier to understand) process of observation. If a rhetorician thinks that an increase in X leads to an increase in Y, their goal is to convince you of that and they select data that reinforces their argument and try to ignore, downplay or obfuscate information that contradicts it. (For an example of this turn on any cable news network at any time.) If a scientist thinks that an increase in X leads to an increase in Y, they go through a careful process of gathering and analyzing data that can either confirm or refute that hypothesis and if the data refutes it, they acknowledge that outcome.
In modeling, we have a similar situation. You can try to make a model that shows that an increase in X leads to an increase in Y but if you get in there and suddenly discover that this is not the case in your model, do you say “surprisingly, the relationship between X and Y in this model is not that which I previously speculated,” or do you say “this model isn’t working” and tweak it to get what you want or throw it out all together? (For the record, it’s not necessarily bad to tweak it but you should notice that you have to do that because something didn’t work exactly the way you thought and this should increase your understanding.) Read more…
Oddly enough, the appearance of Major Freedom in the comments section of my last post has got me wondering if I have got Austrians all wrong. I used to see that guy comment on other blogs and always completely miss the point and go on and on about stuff that made no sense. Some people would always agree with him and they would go down some “Austrian” rabbit hole and everyone else, including me, learned to just skip those long blocks of text. But since I felt obliged to respond, at least initially, on my own blog I had to go through the ordeal of trying to make counter-arguments to arguments that barely grazed the issues I had tried to address in the first place and it was very frustrating. And then I started wondering: is this the type of person who has shaped my view of Austrian economics?
The short answer is no but the long answer, I think, is kind of nuanced. The short answer is that a lot of it comes from Mises.org and people talking on TV like Peter Schiff. And yes, I have read some Hayek and some Rothbard and some stuff like that. I though Hayek had some interesting ideas. I though Rothbard was mind-numbing. I don’t really know what Mises thought, I just know what they say about what he thought on the afore-mentioned Mises.org. So it’s not just Major Freedom and company. Although, I am sure that to a lot of people, that is they account for the vast majority of their run-ins with so-called “Austrians.” And I think, ironically, that this accounts for much of the severe disdain most “mainstream” economists have for all things “Austrian.”
So I think I have dug one layer deeper than most because I am a libertarian and so I have quite a bit of exposure to somewhat more serious, less troll-like “Austrians.” But commenter John S. points out (and I have heard from some others) that there are really two schools of Austrian. The Auburn/Mises.org school which is essentially what I am complaining about and the more reasonable GMU school, and apparently they don’t get along very well. So I can’t help but wonder if I am being unfair to the latter. I am trying to look into it a little.
I watched this debate between Caplan and Boettke which I remembered watching years ago and finding interesting. Essentially, Caplan represents my view perfectly in every respect. And the Boettke comes out and, as far as I can tell, doesn’t really disagree with anything Caplan says. I get the impression that they both agree on practically everything except what to call each other. Boettke thinks Caplan is an Austrian and Caplan thinks Boettke is neoclassical and while Caplan makes points about methodology, Boettke talks about the history of economics and who said what when and a bunch of stuff that I don’t really know about but to me is not that important. I care about the methodology. And that is what the people in the Mises.org camp are always griping about. However, from what I can discern, Boettke seems pretty reasonable to me (though I do think “radical uncertainty,” or whatever, is not a useful concept).
So my position is essentially this. Speaking solely in terms of micro, the basic, neoclassical, consumer choice model (and the model of markets which is built on it) is good and the arguments I have heard from so-called Austrians against it are all dumb. Now what I wonder is: Do Boettke and the GMU “Austrians” agree with me that this is a perfectly good model or do they agree with the Mises.org guys that it is all garbage, and on a side note, do they agree that diminishing marginal utility is a logical necessity or, for that matter, that it is important in any way?
I get the feeling that they aren’t completely comfortable with this model because Caplan also wrote this which makes many of the same points I tried to make, along with some others which are also excellent, and he knows the GMU guys pretty well I think. On a related note, maybe I should have been talking about “indifference” instead of continuous quantities. Indifference doesn’t drive people to action. Fine, but people act until they reach a state of marginal indifference. That’s actually pretty much the central tenet of neoclassical economics. But I digress. Also, I probably need to learn a bit from him about how to get along with Austrians better.
But if the answer is that they agree with me about this model, then I am left wondering what is the difference between us. If they say “nothing, you’re an Austrian” then I am unsatisfied and I would say “no you are mainstream” and we would be having what I consider a pointless argument (very similar to the debate above). There are still some issues regarding the degree to which our analysis should be driven by preexisting normative beliefs. Maybe I will say more on that later but for the most part, in my mind, if you drop all the criticisms of mainstream economics (at least the core of micro) and just say “we want to look into the role of the entrepreneur more” or whatever, then I have no problem but then why make a point of differentiating yourself from the mainstream so much?
At any rate, though I am genuinely interested in answering these questions, I think they are all dodging the real issue which is those blasted Mises.org people. It may be the case that the GMU Austrians are not that nuts but they aren’t the ones on TV or blowing up the comment sections of every econ blog. And if you go to any kind of libertarian gathering and try to talk to somebody who fancies themselves a part-time Austrian economist (which will be half the people there), chances are they will be suffering from a lot of confusion brought on by the popularity of Mises.org-type thinking in those circles. So to me that is the issue that must be dealt with. It would be nice if the GMU types could draw people away from that but they don’t seem to be very successful at this. I don’t know what the answer is. I just know that it’s a problem. And admitting you have a problem is the first step toward recovery.
For those who are new to this blog, I am a pretty staunch libertarian, free-market kind of guy. So naturally, there was a point in my life when I gravitated toward Austrian economics. But the thing that really drove me away was when I realized what they believe about utility, especially “diminishing marginal utility.” There are quite a few things that I think Austrians are wrong about (hyperinflation and Cantillon effects for instance) but the utility thing was special because it is a case where the confusion is plainly obvious if you really understand the mainstream model of consumer choice.
Of course, I figured I would just explain this to them and we would all live happily ever after. Needless to say, that never seems to work. But at this point it has become sort of my white whale: convincing an Austrian–just one Austrian–that diminishing marginal utility is nonsense. Then recently I stumbled upon this paper by an Austrian, on Mises.0rg, in which an Austrian explains exactly what I have been trying, in vain, to explain. So, what the hell, might as well give it one more try.
Here is a rough outline of the debate.
1. Austrians claim that utility is inherently ordinal and that cardinal utility is nonsense.
Mainstream economists agree (at least officially) and have a model in which utility is purely ordinal but Austrians don’t realize it because it doesn’t look ordinal to them.
From my first year graduate text:
Toward the end of the nineteenth century, perhaps initially from introspection, the concept of utility as a cardinal measure of some inner level of satisfaction was discarded. More importantly, though, economists, particularly Pareto, became aware that no refutable implications of cardinality were derivable that were not also derivable from the concept of utility as a strictly ordinal index of preferences. As we shall see presently, all of the known implications of the utility maximization hypothesis are derivable from the assumption that consumers are merely able to rank all commodity bundles, without regard to the intensity of satisfaction gained by consuming a particular commodity bundle . . .
. . . To say that utility is an ordinal concept is therefore to say that the utility function is arbitrary up to any monotonic (i.e., monotonically increasing) transformation.
2. Austrians don’t seem to believe in assuming things that can’t be proven to be necessarily true logically.
To this end they selectively reject whatever hypotheses mainstream economists arrive at because they all require some set of assumptions.
3. The one thing that Austrians feel comfortable claiming that they can prove logically without any assumptions whatsoever (except that people act) is the “law of diminishing marginal utility.”
In order to arrive at this conclusion logically, they construct a framework with “means” and “ends” and postulate that a person will always use a good (means) for the highest valued use (end) first and therefore, as they get more of the good, the value of the marginal use falls and thus you get diminishing marginal utility. However, this is not a conclusion which logically must be true. It is, rather, the result of an assumption which Austrians don’t notice that they are making. McCulloch is somewhat unusual among Austrians in that he realizes this and pointed it out in 1977. This is why the paper caught my attention. Now that we know an Austrian said it, can we all agree that this is the case?
[See pp. 251, 252 (you can thank Mises.org for copy/paste protecting the document....)]
Notice particularly the line: “Bilimovic argues as if these are valid deductions from a rank-ordering on W, but that is not the case unless we assume that the wants are unrelated. So there you have it, an Austrian saying exactly what I have been trying to say. But then, having said that, he goes on to assume that “unrelatedness” and continue to deduce the law of diminishing marginal utility based on that assumption. This wouldn’t be that annoying if he didn’t then say this:
Note that the Austrian principle of diminishing marginal utility is a theorem, rather than an assumption as with Gossen, Jevons and Walras. [p. 255]
Okay, it’s a theorem, but it is only a theorem in the sense that it follows directly from the assumption of unrelatedness of uses. In other words, in no way does it represent something that logically must be true. It is just something that is true if the assumptions made to get to it are true. And we know that that assumption need not be, and probably usually isn’t, true. This doesn’t make the theorem meaningless but it does make it no different from all of the conclusions of the mainstream model which Austrians like to claim are useless….
And what’s more, the assumption made here is more restrictive than those typically made in the mainstream model of nonsatiation, substitution and quasi-convexity. So, essentially there is no intellectual reason to cling to this means-ends framework and the notion of diminishing marginal utility. Frankly, I don’t even understand what Austrians think the significance of diminishing marginal utility is. If I had to guess, I would suspect that they might say that it implies downward sloping demand (and in some cases upward sloping supply) curves, and that is sort of true but the mainstream model does it much better.
It is diminishing marginal value that implies downward sloping demand. Value, meaning the willingness to trade-off one good for another. For this to be diminishing, you only need to have the ratio of the marginal utilities (the marginal rate of substitution) diminishing. It is possible for this to be the case even if there is increasing marginal utility of both goods. Now, it is true that diminishing marginal utility of all goods will give you diminishing marginal value, so in that sense, diminishing marginal value does imply downward sloping demand curves. But you don’t need to go that far. All it takes is quasi-concavity. That is why the mainstream model assumes quasi-concavity and not diminishing marginal utility, because it is the smallest assumption required to get the type of refutable implications that the model gets. So let’s review.
1. Diminishing marginal utility is an assumption.
2. It is more restrictive than the assumptions in the mainstream consumer choice model.
3. Therefore, the mainstream model is better.
This follows logically, therefore you can’t question it. If you don’t see the logic, I will just dismiss you as someone who clearly doesn’t understand logic. See what I did there? But seriously, Austrians, this is an intervention. I’m telling you this for your own good because I love you, I love the things that you love like free markets, property rights and individual liberty, and I want what’s best for you. The mainstream model is just a better version of your model. It’s that simple. Let me put snarkyness aside for a moment and try to explain why.
1. Means/ends is pointless.
The means/ends framework adds nothing. It only makes it easier to confuse yourself and others. Economics is about choosing between scarce alternatives. That means we need alternatives, and we need preferences over those alternatives. That’s it. If you are choosing quantities of two goods, all we need to know (by which I mean assume) are your preferences over different combinations of those goods. It makes no difference why your preferences are what they are or what “ends” you are applying the goods too.
The only thing the means/ends framework accomplishes is to take the case where a consumer has preferences over combinations of the good and make it into a two-stage problem where the stages are essentially identical. Instead of just saying “they have certain preferences over combinations of the good” you say “they have certain preferences over different ends and the goods can each be used for different ends in different ways.” But the only thing that matters is their preferences over the different combinations of goods because that is the decision we are trying to model. So you try to logically deduce what those preferences look like based on what you assumed about the preferences over “ends” and the connection between the ends and the means. Then you claim that what you are saying about their preferences over combinations of goods is not an assumption, it follows from logical deduction. But it only follows logically from the (possibly implicit) assumptions you made about their preferences over ends and the connection between ends and means. You just buried the assumptions one stage deeper. But this gives you nothing, it makes it needlessly complicated. The only thing this accomplishes is it makes it easier for you to apply false reasoning in connecting the two levels by implicitly assuming something that is not necessarily true, deceiving yourself into thinking that it is necessarily true because you don’t notice that you are assuming it, and then believing that you have proven something which you haven’t.
So why not get rid of all of that nonsense and just say that people have preferences over different combinations of goods? I think there are two possible Austrian answers to this. One is that this is methodologically unacceptable because we are not allowed to make assumptions about people’s preferences that aren’t objectively and immutably true. But the Austrian making this argument must not have been reading carefully because that is what you are doing anyway and the assumption you are making is more restrictive than the one I am making. The other argument is that then we wouldn’t be able to sit around and talk about how ridiculous mainstream economics is because then our model would be exactly like theirs. (Okay, so maybe a little snarkyness. A fish has gotta swim.)
2. You need more than just action.
Nothing follows logically from the single axiom that people act. Their preferences matter. Since we can’t observe preferences but only action, there is nothing we can say about those preferences that must be true a priori. If you can’t say anything about those preferences that can’t possibly not be true, you can’t say anything about action period. If you try, you will just end up assuming something without realizing it. A careful and responsible approach to modeling action must be very explicit about what it assumes and try to cut those assumptions down to the smallest, simplest, most realistic and least restrictive assumptions possible for the model to “work” and tell you something interesting. This is what the mainstream model has done and–I can’t stress this enough–our assumptions are less restrictive than yours!
3. Continuous quantities!
First of all, discreet quantities are not more realistic. Gasoline, flour, tap water, electricity, labor, cheese, ground beef, and a million other goods are actually measured in continuous quantities. But more importantly, the consumption of any good properly understood, should be modeled as consumption per some unit of time. So it’s not the number of cars you buy on a given day on the horizontal axis of the “cars” market, it is the average cars you use up in a year or something like that which is a rate and is inherently continuous. But even more importantly, it makes everything so much easier and more sensical to use continuous quantities. I sometimes wonder if you are purposely sabotaging yourselves by forcing yourselves to work with a model that is so unmanageable that no worthwhile conclusions can possibly be drawn from it. It doesn’t have to be that way.
4. It really is ordinal utility.
Just because we use a function to represent preferences doesn’t mean they are cardinal. The numbers have no significance in the model beyond identifying which bundles are preferred to the one in question, which ones it is preferred to and which are neither (in which case the person is indifferent between them). That is all the numbers mean. You can plug in any function that preserves the rank ordering and you will get the same results. This is something we are aware of and are careful about (at least some of us are). Representing ordinal preferences this way allows us to apply a much higher degree of logic to the problem in much simpler ways than your framework. This, is a benefit not a drawback. Typically, we don’t even assign numbers or even a function we just say let there be some function which conforms to the minimum necessary assumptions mentioned above. The fact that we put an actual function to it with numerical values in order to teach undergraduate students does not make the underlying model cardinal.
So there it is. If you acquiesce on these points, you arrive at the standard mainstream model. This has been an Austrian intervention. Sure it’s one guy doing an intervention on a whole gang of people who all act as a mutual support group for each other, and yes, that does seem to run counter to the established rules for interventions. So maybe it’s wishful thinking to expect it to be successful. But that doesn’t mean I can’t waste my life trying. Maybe if I can get through to one person, and then he can get through to one person, one day all of us true, old-school, ordinal-utility types will be able to band together and have an intervention with the Scott Sumners of the world when they say things like this (good grief!):
As an aside, I believe about 90% of all negative and positive utility in life occurs during dreams, as the feelings tend to be more intense than during waking hours. (We forget most dreams.) It is only the bigotry of awake people (who control the printing presses) that privileges waking life.
Frances Wooley has a post about all-you-can-eat sushi. It was meant to illustrate a broad, overarching truth about economics. That point is valid, but the discussion got a little sidetracked by the al-you-can-eat-sushi issue. Since this is the kind of thing I am actually trained in (as opposed to monetary economics which I am basically absorbing/making up as I go along), I figure I will interject myself. I tried to explain it in the comments but I need a bit more space to really knock it out of the park. Here it goes. Read more…