Thoughts on Capital-Based Macroeconomics

Thursday, January 03, 2013 by John P. Cochran

Part I.

In 1979 the Cato Institute published a collection of Hayek’s post-Nobel-laureate contributions to Austrian monetary theory, policy, and macroeconomics titled, Unemployment and Monetary Policy: Government as Generator of the Business Cycle. The monograph made more available to an American audience material originally published by The Institute of Economic Affairs in London in 1975, including the foreword by Gerald P. O’Driscolland “A Note on Capital Theory” by Sudha R. Shenoy. This volume has been one of my favorites and has been a source I have used frequently during nearly 30 years of commentary on Hayek’s business cycle theory. It is good to see others highlight passages from the work as was done most recently in the "Quotation of the Day" posted by Don Boudreaux on November 12, 2012 at Café Hayek. Much of the content or similar content is available in New Studies in Philosophy, Economics and the History of Ideas. For those who prefer an audio rendition of many of Hayek’s arguments during this same period of time my mentor,Fred R. Glahe, has made an audio of Hayek’s lecture given at the Department of Economics of the University of Colorado on April 28th, 1975 available at the Mises Institute web site. The question and answer period with CU-Boulder faculty is quite interesting, especially in the context of the then-emerging stagflation and the breakdown of the Keynesian synthesis that occurred along with and because of the development of the Phelps-Freidman natural unemployment rate theory.
Bourdeaux’s quote of the day (p. 40):

The conquest of opinion by Keynesian economics is due mainly to the fact that its argument conformed to the age-old belief of the businessman that his prosperity depended on consumer demand. This plausible but erroneous conclusion was derived from his individual experience in business, namely, that general prosperity could be maintained by keeping general demand high. Economic theory had been rejecting this conclusion for generations, but it was suddenly made respectable by Keynes. And since the 1930s it has been embraced as obvious good sense by a whole generation of economists brought up on the teaching of his school. Thus for a quarter of a century we have systematically employed all available methods of increasing money expenditure, which in the short run creates additional employment but at the same time leads to a misdirection of labor that must ultimately result in extensive unemployment.

Boudreaux’s commentary:

It is useful to add to this Austrian insightBob Higgs’s important theory of regime uncertainty. (For a longer treatment, see here. [For an update see here and here]) Nothing in economic theory argues against the possibility of a relatively rapid restoration of employment – employment of labor and other resources rapidly channeled into whatArnold Kling describes as patterns of sustainable specialization and trade. In contrast, demand-management policies, such as those favored by Keynesians, effectively aim to channel unemployed workers and other resources back into the employments that have proven to be unsustainable.

He continues:

The freer the market, the more rapid such restoration will be. But frantic post-boom government meddling into the economy — meddling both real and monetary, and both actual and plausibly threatened – dampens not only the ability but also the willingness of entrepreneurs and investors to experiment with creating sustainable patterns of specialization and trade. The faux-sensible “government must do something” [link added] attitude itself prolongs, and perhaps even deepens, the economic problem that that “doing something” is imagined to solve.

Besides this critique of Keynesianism, whether of the"bastard"form or of the actual economics of Keynes, which is highlighted by Boudreaux, the short monograph (slightly more than 50 pages), the writings make several important extensions, revisions, and updates to Hayek’s analysis from the 1930s and 1940s that are relevant today including, but not limited to:
1. Hayek provides a very explicit analysis of the causes of unemployment. Unemployment, properly understood, is a microeconomic phenomenon. The cause of unemployment is a misdirection of production that leads to “existence of discrepancies between the distribution of the demand among the different goods and services and the allocation of labor and other resources among the production of those outputs” (Hayek 1979, 25). Thus for Hayek, as for Mises, economic explanations of unemployment should be tied toSay’s lawproperly understood (See"Why Your Grandfather's Economics Was Better than Yours: On the Catastrophic Disappearance of Say's Law"by Steven Kates.) As such, and as emphasized by Bourdeaux, demand management policies will be ultimately ineffective in generating sustained recovery. Hayek explains (p. 41), “The places where the misplaced workers … can find lasting employment can only be discovered by letting the market freely operate.”
2. Hayek broadened his causes of misdirections of production to include the not only classic Austrian business cycle related malinvestments but also any misdirection from Cantillion effects (See Thornton’s "Cantillon on the Cause of the Business Cycle"). The allocation of resources and the valuation of assets (bubbles) are temporarily shaped by the non-neutrality of monetary changes. Misdirections will always occur following any monetary shock and the misdirections will depend on where and how new money spending enters the spending or income stream. In addition Hayek extended the causes of misdirections of production to include fiscal policy induced manipulations of the spending stream. As a consequence he cautioned that while active policy, whether monetary or fiscal policy, might temporally appear to succeed, such policies could make an “eventual breakdown even worse” (p. 3). This caution held, even for an economy already in recession. A Keynesian policy, even if initially stimulative, results in misdirections of production and is not sustainable. Active policy ultimately "creates more unemployment [emphasis original] than the amount it was originally designed to prevent” (p. 11). This point is reinforced in a new working paper by Adrian Ravier,"Dynamic Monetary Theory and the Phillips Curve with a Positive Slope." Ravier argues, "the long-term effect of monetary policy is never neutral. While it is true after a boom-bust cycle the economy returns to the natural rate of unemployment, the crucial point is that the ‘natural rate’ at the end of the cycle is quite different from the one evident at the start. This requires an ‘Austrian’ Phillips Curve with a positive slope.”
3. Further, like Higgs, Hayek recognizes (p. 42), “We must certainly expect recovery to come from a revival of investment.” He then cautions that return to sustainable growth and high employment is not likely if the wrong policies are adopted, “Neither subsidization of investment nor artificially low interest rates is likely to achieve this position. And least of all is the desirable (i.e. stable) form of investment to be brought about by stimulating consumer demand.”

Part II.

Recently in the Wall Street Journal, Mary Anastasia O’Grady’s in “Ben Bernanke: Currency Manipulator” argues, “Latin America is rightly worried about the Federal Reserve's monetary policy.”
Relative to U. S. monetary policy, O’Grady points out,

From September 2008 through the end of 2011, Mr. Bernanke's Fed created $1.8 trillion in new money. But Fed policy makers were only warming up. In September they announced that they will engage in a third round of quantitative easing — that is, more money creation, ostensibly to spur growth and thus bring down unemployment — at a rate of $40 billion per month with no deadline.
With so many dollars sloshing around in US banks and with a fed-funds rate set near zero, investors have found it hard to earn a decent return. The scavenger hunt for yield has sent dollars rushing into emerging markets where, as they are converted into local currency, they put upward pressure on the exchange rate.

O’Grady then provides analysis consistent with an Austrian, or capital-based macro insights without explicit reference.

The sustainability issue [see Roger Garrison’s “Natural Rates of Interest and Sustainable Growth”]is troubling. As Bank of England Governor Mervyn King noted in a speech last week: “When the factors leading to a downturn are long-lasting, only continual injections of [monetary] stimulus will suffice to sustain the level of real activity. Obviously, this cannot continue indefinitely.”
In a perfect world, the end of the dollar flows — or a downturn in soaring commodity prices when investor expectations begin to shift — would simply mean an economic slowdown. But booms are almost always accompanied by credit expansions, and Brazil's is no different. Since 2004, bank credit has grown to 167% of gross domestic product from 97%.
What happens when a leveraged economy, living on accommodative monetary policy, suddenly finds the spigot turned off? Ask Americans who were on the receiving end of Fed tightening in 2007.

Andreas Hoffman in "Zero-Interest Rate Policy and Unintended Consequences in Emerging Markets"provides arguments and evidence of how the current loose polices adopted by major central banks including Bernanke’s Fed and the European Central Bank have adversely affected countries on the periphery. From the abstract:

In response to the subprime crisis and Great Recession central banks in advanced economies have cut interest rates towards zero and increased monetary accommodation to step-up domestic growth. In this paper I attempt to describe the unintended consequences of the low interest rate policies in emerging markets.I argue based on the Mises-Hayek business cycle theory that the current low interest rate policy in advanced economies may have planted the seeds for new bubbles and gave rise to interventionist cycles in emerging markets. I show that capital flows to high-yielding emerging markets translate into monetary expansion in emerging markets. In the face of buoyant capital inflows fear of floating forces emerging markets to follow the interest rate policy of advanced economies. The monetary expansion triggers mal-investment and over-borrowing [emphasis mine]. To stem against arising inflationary pressure and kill-off speculative capital inflows empirical evidence suggests that emerging market governments increasingly repress financial markets. International financial markets disintegrate. I conclude that the monetary policy of the large advanced economies is incompatible with financial integration and globalization.

Austrian economists should continue to develop this extension of Austrian business cycle theory.

Part III.

In a recent Circle Bastiat post, “Fiscal Stimulus or Fiscal Depressant?” Joseph Salerno provides a summary of recent research on Keynesian multipliers that provides some support of Austrian arguments.
Of special interest may be an IMF Working Paper entitled "How Big (Small?) Are Fiscal Multipliers?" by Ethan Ilzet, Enrique G. Mendoza, and Carlos A. Vegh. Summarizing some of the results from a study, Salerno reports:

Last and most important for the US economy, the study sorts the sample into “country-episodes” where the total central government debt to GDP ratio has exceeded 60 percent for more than three consecutive years. This is the case for the US from 2007 to the present. For the high-debt country-episodes the impact fiscal multiplier is close to zero and the long-run multiplier is -2.30. This means that $1.00 of additional government spending has no effect on impact but in the long run destroys $2.30 of total output in the economy.

Salerno concludes:

Of course, the very concept of a fiscal multiplier is completely rejected by Austrian economists and it has been subject to detailed and devastating critiques in the works of Henry Hazlitt, William Hutt, and Murray Rothbard. But the dawning realization among mainstream economists that government spending, at least in some circumstances, may actually destroy income and depress economic activity is a long overdue and highly welcome development.

This is extremely relevant as our politicians prepare to discuss policies to deal with the current policy induced budget deficit and expanding government debt. The actual problem is not the deficit, nor the debt, but the size of government relative to the economy. As I have tried to emphasize — based on work by Gwartney, Holcombe, and Lawson, "The Scope of Government and the Wealth of Nations."and by Vedder and Gallaway,"Government Size and Economic Growth" — in early 2009, when much of the current expansion in the size of government was being implemented, “Even if the current stimulus and budget proposal have short-term benefits in terms of measured GDP, the results will be temporary. And, by these estimates, they would come at a significant long-run cost to the economy.”
Garret Jones at EconLog in his post “ Which hurts more in the short run, tax hikes or spending cuts?” highlights two other studies that do not neatly fit the textbook Keynesianism that was the engine behind the bad fiscal policy beginning in 2008 under Bush and raised to unrealistic extremes by the Obama administration in early 2009.
The first work is a 2011 IMF working paper, “ Expansionary Austerity: New International Evidence” by Guajardo, Leigh, and Pescatori. The graph Jones highlights from the work (see below) bears careful examination in light of the real danger that higher taxes will be a major tool in the current administration's plan to reduce the deficit. Higher taxes, notwithstanding the standard textbook Keynesian analysis, are significantly more contractionary, both short run and long run, when compared to spending reductions of similar magnitude. The second paper, written by two New Keynesians, Blanchard and Perotti, provides evidence about the impact of spending and tax shocks that should be relevant to Austrians. From the abstract, “One result has a distinctly nonstandard flavor: both increases in taxes and increases in government spending have a strong negative effect on investment spending.” From the conclusion, “the response of investment, which decreases in response to both increases in taxes and increases in spending, is hard to reconcile with the Keynesian approach [emphasis mine].”
The chart from Guajardo et al (p. 25) clearly indicates that spending cuts have relatively minor short run impacts, especially relative to tax increases of similar size, on private consumption and real gdp. If correct, the graph perhaps provides indirect evidence supporting a Rothbardian policy to aid recovery. While like Hayek, cited above, Rothbard in America’s Great Depression (p. 21) argues that the “(t)he most important canon of sound government policy in a depression, then, is to keep from interfering in the adjustment process”, he (p. 22) also recommends:

There is one thing the government can do positively, however: it can drastically lower its relative role in the economy, slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment. Reducing its tax-spending level will automatically shift the societal saving-investment–consumption ratio in favor of saving and investment, thus greatly lowering the time required for returning to a prosperous economy. Reducing taxes that bear most heavily on savings and investment will further lower social time preferences. Furthermore, depression is a time of economic strain. Any reduction of taxes, or of any regulations interfering with the free market, will stimulate healthy economic activity; any increase in taxes or other intervention will depress the economy further. [notes eliminated]

Assuming an economy’s response to a tax cut is similar in magnitude, but opposite in direction, to a tax increase, even if reducing government has, as indicated by the figure, a short run contractionary effect, the effect would be small and overwhelmed by the impact of the simultaneous tax reduction. In the longer run the impact of the government spending reductions on output and consumptions are non-existent or small in the graph. The impact of the tax cuts on consumption and output would be positive and significant. If the results on spending reported above by Salerno are more representative of the economy and would also be valid not only for a spending increase but for spending decreases, a $1.00 reduction in government spending would have no effect on impact but in the long run would lead to an additional $2.30 of total output in the economy. In either case the spending and tax cuts should expand the economy in the long run in ways likely to be sustainable. The result is even more likely when coupled with the conclusion from Blanchard and Perotti that both the tax and spending cuts should contribute to increased investment.
In the current economic environment; a slow recovery from a depressed economy, large government deficits and debt, and a size of the national government relative to the economy, 22-25 percent, clearly above a level consistent with adequate economic growth, Rothbard’s recommendation is a win-win policy. But as important, in the long run the Austrian policy would move the economy a la Gwartney et al to higher sustainable growth path, a path with a good chance of actually providing sufficient prosperity to not just reduce deficits, but pay down or ultimately eliminate the debt burden.

John P. Cochran is emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research. He is also a senior scholar for the Mises Institute and serves on the editorial board of the Quarterly Journal of Austrian Economics. Send him mail. See John P. Cochran's article archives.