The Everyday Economist

I was asked and have accepted an invitation to join the group blogs at RGE Monitor. It will be a pleasure to blog alongside the likes of James Hamilton, Menzie Chinn, Charles Engel, Charles Goodhart, Jeff Frankel, and of course Nouriel Roubini and countless others. I would like to thank Nouriel Roubini publicly for the invitation and this opportunity. Also, fear not loyal readers, this will not impact my blogging here at The Everyday Economist as all entries will be cross-posted. Nevertheless, I would still like to encourage all of you to read the RGE Monitor group blogs as they feature many great economic minds.

It’s time for another edition of “Inflation? What Inflation?” Two stories from the WSJ today:

• U.K. Says Higher Rates Would Take Heavy Toll:
  

  New data showed the United Kingdom’s annual inflation rate jumped to 3.3% in May, and Bank of England Gov. Mervyn King set a two-year timeframe to nudge the rate to the central bank’s 2% target.

  [...]

  Data showed the annual rate of inflation rose to 3.3% in May — its highest level since 1992 — from 3% in April. Mr. King said the rate is expected to move above 4% in the second half of this year and remain “markedly above” the 2% target well into 2009.

  When the inflation rate is above 3%, the central bank governor is required to write a letter to the government explaining why prices are rising and what the bank intends to do about it.

• Fed Faces Dilemma as Costs Soar, Activity Slows:
  

  Data released by the Labor Department on Tuesday show companies are facing rising costs for an array of supplies, which may prompt them to increase prices on their products in the months ahead. The producer-price index rose 1.4% in May from the month before, partly reflecting a surge in crude-oil prices that pushed gasoline prices up 9.3%. Prices for other commodities also jumped.

  The index for core prices, which excludes energy and food, rose by a more muted 0.2% in May from the month before, but was up 3% from a year earlier, the biggest jump on a yearly basis since 1991.

It is time to restrain monetary growth on a global scale.

Bryan Caplan has issued a challenge:

Austrian economists often attack the mainstream for ignoring something they call “radical uncertainty,” “sheer ignorance,” or sometimes “Knightian uncertainty.” A common Austrian slogan is that “Neoclassical economists study only cases where people know that they don’t know; we study cases where people don’t know that they don’t know.”

All of this sounds plausible until you press the Austrian to do one of two things:

1. Explain his point using standard probability language. What probability does “don’t know that you don’t know” correspond to? Zero? But if people really assigned p=0 to an event, than the arrival of counter-evidence should make them think that they are delusional, not than a p=0 event has occured.

2. Give a good concrete example.

Austrians (as well as Post Keynesians), I believe, are correct to criticize neoclassical theory in this manner. Neoclassical theory assumes that there is a market of complete contingent contracts with an assigned probability for each anticipated state. This undoubtedly does not reflect reality as there exist states for which no contract is traded. As Keynes explained in “The General Theory of Employment” in the QJE in 1937:

But at any given time facts and expectations were assumed [by the classical economists] to be given in a definite and calculable form; and risks, of which, though admitted, not much notice was taken, were supposed to be capable of an exact actuarial computation. The calculus of probability, though mention of it was kept in the background, was supposed to be capable of reducing uncertainty to the same calculable status as that of certainty itself.

Actually, however, we have, as a rule, only the vaguest idea of any by the most direct consequences of our acts … Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of the classical economic theory.

By uncertain knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is merely probable … The sense in which I am using the term is that in which the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention are uncertain. About these matter there is no scientific basis on which to form any calculable probability whatever. [Emphasis added.]

The infamous beauty contest described in the General Theory is also a particularly useful analogy for stock market activity and speculation. Of course Keynes was overly pessimistic, in my view, of our ability to form meaningful expectations. Roger Koppl, for example, bridges the gap between Keynes and reality in Big Players and the Economic Theory of Expectations by discussing the emergence of planning horizons, in which each point in the future grows evermore uncertain and therefore the more distant the period, the more open-ended one’s expectations must become. Nevertheless, Keynes’ views on probability theory and economics is much more grounded in reality than the Arrow-Debreu markets for contingent claims.

Perhaps ironically, Keynes’ views on uncertainty are greatly complemented by the work of F.A. Hayek. Whereas Keynes explicitly laid out a vision of why things go wrong, Hayek countered (although not directly) by explaining how things could go right. Hayek’s work on economics and knowledge (here and here, for example) details how, even in the presence of uncertainty and dispersed knowledge, markets serve coordinate behavior and produce efficient outcomes. Similarly, Hayek’s writing on expectations detail how an individual’s views evolve over time and adjust in response to confirmation (or lack thereof) of expectations. Overall, the market provides signals through prices as well as through the profit and loss mechanism and therefore individuals are able to evaluate their expectations and evolve accordingly. Thus, Keynes provides the outline for the radical uncertainty that individuals face and Hayek explains how individuals are able to overcome and cope with said uncertainty. As I have stated previously, this is a much better description of reality than Arrow-Debreu contingent claims.

As to Bryan’s questions, in assigning probabilities (p = x, for example) for events that people don’t know that they don’t know, it is irrelevant what value x takes on as long as their expectations are proven grossly incorrect ex post or the probability of such an event precludes the existence of a contingent contract for that event. Had one posed a question on September 10, 2001 regarding the probability of a terrorist attack the following day the mean probability would undoubtedly not have been equal to 1 (it would likely have been less than 0.01) and I would venture to guess that it is even unlikely that one would have received a single response of 100%. Similarly, for Tyler Cowen’s example of the arrival of the Spaniards.

George Selgin’s Good Money.

Paul Krugman writes:

But as I said, this time around there’s no wage-price spiral in sight.

The inflation hawks point out that consumers are, for the first time in decades, telling pollsters that they expect a sharp rise in prices over the next year. Fair enough.

But where are the unions demanding 11-percent-a-year wage increases? (Where are the unions, period?) Consumers are worried about inflation, but you have to search far and wide to find workers demanding compensation in the form of higher wages, let alone employers willing to accept those demands. In fact, wage growth actually seems to be slowing, thanks to the weakness of the job market.

And since there isn’t a wage-price spiral, we don’t need higher interest rates to get inflation under control. When the surge in commodity prices levels off — and it will; the laws of supply and demand haven’t been repealed — inflation will subside on its own.

Krugman is right in pointing out that wages are not beginning (or in the midst of) an inflationary spiral. Krugman seems to blame the invisible presence of the unions. Their invisibility could be due to their declining power and/or the fact that inflation today is quite different than the 1970s, but not for reasons that Krugman emphasizes. In my view, it is not the case that invisibility of the labor unions is the cause of a different kind of inflation, but rather that a different kind of inflation is causing the invisibility of the unions.

During the 1970s, the inflation rate was rising at a much higher rate than is currently the case. Energy prices were high, but there were also a great deal of other prices on the rise as well. As Krugman points out:

In May 1981, the United Mine Workers signed a contract with coal mine operators locking in wage increases averaging 11 percent a year over the next three years. The union demanded such a large pay hike because it expected the double-digit inflation of the late 1970s to continue; the mine owners thought they could afford to meet the union’s demands because they expected big future increases in coal prices, which had risen 40 percent over the previous three years.

Where the current situation is different is that the rise in the price level is less diversified. Food and energy prices are leading the charge, while technology and globalization are putting downward pressure on other prices. The result is that despite the fact that prices of consumer staples are rising, the overall inflation rate remains low by historical standards. This may also explain Krugman’s claim that, “it feels like a recession to most people” even if it technically isn’t. When the economy is slowing and the prices of consumer staples are rising, it forces some belt-tightening.

What to do about the current situation, however, is somewhat more difficult. Krugman believes that there is too much risk involved in raising rates and precipitating further crisis in the financial markets. However, one must also bear in mind that the low rate policies in the wake of September 11 and afterward largely set the stage for the current credit crisis. In my view, thanks in large part to financial market innovation, inflation targeting has proven to be quite inept. In addition, targeting a rate of inflation and simultaneously ignoring the forces of globalization and productivity growth leads to an environment of easy money. The economy is (and has been) moving ever toward completely inside money of the variety described by Wicksell, which makes monetary policy and especially inflation targeting more difficult to conduct.

In any event, I am convinced that the Fed Funds rate is below the natural rate and leaving it there for some time will only lead to further asset price bubbles. If there are underlying problems in the financial market, we cannot ignore them by keeping rates low and hoping that they will go away.

I had my wisdom teeth removed this morning so blogging will likely be light. To tide you over, here is what I will be reading while on the couch:

• From Catastrophe to Chaos by J. Barkley Rosser
• Imperfect Knowledge Economics by Roman Frydman and Michael Goldberg
• Asset Bubbles and Their Consequences by Gerald O’Driscoll

I will also try to listen to the latest EconTalk podcast.

Mike Moffat responds to both my previous post and Peter Klein’s challenge:

Does anyone ever ask what the optimal corporate income tax rate or optimal sales tax rate is? Of course not. Why should emission taxes be held to a different level of scrutiny?

I would argue that many quibble about a variety of optimal tax rates, but I digress. In any event, I have explicitly stated (in the linked post above) that if we want to have the debate regarding what we should tax, it could certainly prove fruitful. However, that is not the ground upon which the Pigou Club is arguing. The Pigou Club largely takes for granted that taxes are warranted in order to promote an efficient outcome when externalities are present. There arguments are fundamentally based upon arguments for greater efficiency, whereas income tax rates and sales tax rates are not justified by the same presupposition. I am simply arguing that there is little reason to believe that such taxes pass the efficiency test, which is the primary justification used by Frank, Mankiw, and others.

Peter Klein says it best:

Mike’s response, based on more detailed comments here, is interesting, but to my mind misses the main point. Pigouvian taxes aren’t perfect, Mike says, but neither are income taxes or excise taxes or any other taxes. Fine, I say, but the relevant comparison isn’t between Pigouvian taxes and other taxes, but between Pigouvian taxes and alternative institutions for dealing with externalities such as cap-and-trade, common-law tort remedies, etc.

David Beckworth writes:

…why not tax noisy leaf blowers (noise pollution) or billboards along the highway (sight pollution) or rancorous, smelly, ugly people (noise, sight, and smell pollution)? Conversely, should we subsidize quiet neighbors, firms that do not advertise on highway billboards, and beautiful, well-kept people?

Now I am not advocating we tax or subsidize the above items. However, this list does illustrate the fact that society does choose to correct only certain externalities. So what is the decision criteria used in this process? Presumably it involves equating some margins; I am just not sure which one they are though.

Mark Thoma also chimes in as well.

The Pigou Club is out in full force this week in the form of Robert Frank’s Economic View column in the New York Times. He writes:

The production and consumption of many other goods, however, generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others. As before, market forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers.

The upshot is that gasoline consumption is inefficiently high. Suppose that pollution costs are $2 for the last gallon consumed, but that its $4 price at the pump is just enough to cover its direct production costs. Reducing production and consumption by a gallon would then cause consumers to lose fuel that they value at $4, which would be exactly offset by the $4 in reduced production costs. The $2 in reduced pollution costs would thus be a net gain for society.

The “efficiency” of the gas tax, which seems to be the highlight of Frank’s piece is a suspect concept. The idea of an efficient tax to correct for a market failure such as an externality is based on Pigouvian welfare economics, which sees the tax as Pareto-improving. Yet, even members of the Pigou Club do not argue on behalf of Pareto efficiency (whether they are aware of it or not), but rather the Hicks-Kaldor criteria under which those who benefit gain enough to fully compensate those who lose, even if the compensation never takes place.

The problem inherent in any such analysis is the view of societal benefit and societal loss that is assumed to be easily calculated and dealt with through Pigouvian taxation. The ability to identify the social cost of a particular action is extremely difficult as each individual has his or her own subjective valuation. The problem is communicating each of these preferences in aggregate form to some central authority. This is a distinct problem in terms of both Hayekian knowledge and a neoclassical framework (Arrow’s Impossibility Theorem). In the absence of this ability, setting the tax rate is extremely difficult.

What’s more, the idea of externalities as a market failure misunderstands the role of the market and what is meant by efficiency. Markets are not efficient in the sense that they produce the optimal outcome of some economist, environmentalist, or other casual observer who wishes for a certain outcome. Markets are efficient because they serve to allocate resources to those who value them the most.

I would welcome a debate about what we should be taxing. I do believe that it would make sense to tax the things that we want less of. However, the Pigou Club is making the argument on the grounds of efficiency, which misunderstands both the term and the process through which the tax rate would be determined.

The work of Keynes can be separated into two categories, the general theory and the applied theory.  Unfortunately, much of what survives as Keynesianism in today’s lexicon is the applied theory, which essentially consists of the government serving as the facilitator of increased demand during a recession or a depression.  I must confess that I myself frequently fail to distinguish between each theory when discussing what I believe to be the failures of Keynesian aggregate demand management.  Nevertheless, Keynes’ general theory was an important, but Keynes’ most profound ideas are not the ones that are emphasized in economics today.

Keynes’ applied theory has been the subject of a great deal of criticism and rightfully so.  However, his general theory has also been attacked (often by those who oppose his applied theory).  These attacks often fail to understand exactly what is important in Keynes’ general theory.  There is no doubt that reading Keynes’ General Theory is at times akin to gnawing on a two-dollar steak, but there are profound insights to be discovered.

It is clear from reading Keynes that he either misunderstood some of the classical economists or was not well read in their theory with respect to Say’s Law and monetary disturbances.  Nevertheless, this criticism is to some extent aesthetic, as Keynes was arguing as much against the classical economists as he was against the Marshallian market adjustment process. (It is in this argument against the Marshallian adjustment process that Keynes arrives at his great insight, which will be discussed later.)

First and foremost, Keynes’ theory is a monetary theory.  It begins with Keynes’ Treatise on Money and is extended through the General Theory.  This is often overlooked as Keynes’ applied theory emphasizes the impotency of monetary policy in correcting the shortfalls in aggregate demand that result in recessions.  Keynes monetary theory in the Treatise can be outlined as follows.  Each businessman has his own subjective expectations of future profitability and other business conditions.  If these expectations are pessimistic, businesses will invest less and therefore reduce the amount of securities that are issued.  This decrease in the supply of securities leads to excess demand and therefore raises the price of securities and therefore lowers the natural rate of interest.  As the market rate of interest begins to decline in accordance with the natural rate, bear speculators who were used to getting the higher rate of return begin to sell some of their ‘old’ securities and therefore the market rate is prevented from completely adjusting with the natural rate and the market ‘clears’ at a point of disequilibrium.  The result is an excess demand for money and a corresponding excess supply of commodities.

It is at this point that we must understand Keynes’ profound insight of The General Theory.  Keynes’ insight is that in the absence of perfect price flexibility, the adjustment process will come from output rather than the price level (which ran counter to the conventional wisdom of the Marshallian adjustment process).  The result is therefore a recession.

Unfortunately, the key insight of Keynes is often highlighted by modern macroeconomists as either the importance of insufficient demand or of sticky prices.  Each of these insights downplays the role of Keynes’ general theory and fails to differentiate Keynes from his classical counterparts.  The idea of sticky wages and prices is not something created or even truly advocated by Keynes (see the work of Leland Yeager or Clark Warburton for a detailed summary of the lineage of sticky prices).  Rather Keynes’ emphasis was on the fact that prices were not perfectly flexible and therefore a reduction of stickiness would not alleviate the problem.  (It is actually quite amusing that so-called “New Keynesians” adopted sticky prices in his name when in fact his theory was written in a time of rapidly falling wages and prices.)

The prevailing theory of business fluctuations (in the U.S.) was monetary disequilibrium theory, which held that when there is excess demand for money, there will be deflationary pressure which can only be eased by an increase in the money supply or a decrease in the price level.  However, the presence of sticky prices will prevent the necessary decline in the price level and output and employment will fall as a result.  In this scenario, the presence of sticky prices is to blame for the downturn.  However, in Chapter 19 of the General Theory, Keynes refutes this point, claiming that prices need not be sticky, but only lack infinite flexibility.  Further, Keynes points out that if the prices were allowed to change, it may exacerbate the problem by inducing a scenario of debt-deflation (Keynes does not use the term, but it fits his analysis).  So while the mainstream continues to adhere to this idea of sticky prices as a product of the work of Keynes, a reading of Chapter 19 suggests otherwise.

The work of Keynes is, of course, not without significant error.  His applied theory is clearly a source of frustration.  More importantly, however, is the abandonment of the Wicksell-foundation of the natural rate and market rate of interest in favor of the liquidity preference (a topic which would require another post altogether).  What’s more, it is not clear to me that Keynes’ general theory is all that general, but rather more specific to the time in which he was writing and specific periods of downturn.  Advocates of his theory may disagree with this analysis and point to the current credit crisis as an example that fits with the theory, but I am not convinced that this is the case (nor are the Austrians, of whom I am sympathetic).

This post should by no means be construed as an advocacy of Keynes’ general theory, but rather an emphasis on what he got right – something that is missing from much of the present day discussion.  Keynes’ work is best understood as a lineage of evolving ideas (an evolution, which regrettably did not remain wholly consistent with the Wicksell-foundations).  His General Theory is certainly a flawed work (this seems to fit, however, with Keynes’ famous quote, “I would rather be vaguely right than precisely wrong”), but his insights regarding output adjustments and disequilibrium should nevertheless be appreciated.