The Everyday Economist

In Keynes’ General Theory, he explained that an equity market collapse could be blamed on either a weakening of confidence or of the state of credit — in modern parlance, these are referred to as “counter-party risk” and “liquidity risk” respectively. The importance of this observation, however, is given by Keynes subsequent assertion that “recovery requires the revival of both” (Keynes, 1936 [1973]: 158).

The point raised by Keynes is especially prescient given the current market turmoil. The realization that asset-backed securities were not worth what investors thought they were led to a collapse of both confidence and the state of credit. Financials were left wondering what the true size of their balance sheet was and therefore liquidity was in short supply, while simultaneously the increase in counter-party risk led these same institutions to be hesitant to lend. The result was a substantial increase in conventional measures of risk as reflected by the LIBOR-OIS spread and the TED spread as well as others. In an effort to ensure that both the collapse in confidence and of liquidity were reversed the Federal Reserve has taken drastic action. They have expanded the scope of the discount window through the Primary Dealer Credit Facility (PDCF) and have created the Term Auction Facility (TAF) to ensure that firms have the liquidity that they need. In addition, the federal funds rate was lowered precipitously to 2%. Thus, the major question is whether this has worked.

The conventional wisdom seems to be that the Federal Reserve has been moderately successful, but that they need to hold their course (i.e. not raise rates) to prevent a further exacerbation of the crisis. On the other hand, I have recently advocated a tightening of the federal funds rate in an attempt to stave off ever-growing inflationary pressures from a world awash in liquidity and therefore would like to submit the current data to closer analysis.

Currently the spread between the 3-month LIBOR (the London Interbank Offer Rate) and the Overnight Indexed Swap remains relatively high. Similarly, although the TED spread has gone down it remains elevated. In a recent paper by John Taylor and John Williams, they argue that these elevated risk spreads in the aftermath of the creation of the TAF suggests that it has not been successful. They may be correct, but I would like to float a different hypothesis. It is my view that the creation of the TAF and the subsequent creation of the PDCF have only satisfied one aspect of the recovery process, namely, an increase in liquidity. Whereas the programs increase the scope of the Federal Reserve’s role as lender of last resort thus ensuring that there is liquidity to be had, the programs have not succeeded in restoring confidence. In other words, the conventional measures of risk are reflecting counter-party risk, rather than liquidity risk. As the allusion to Keynes earlier highlights, it is not enough to start a recovery by merely providing liquidity; confidence must also be restored. Although the Fed had hoped that the creation of such programs would encourage firms to accept the same collateral, they have provided no such increase (or at least very little increase) in the state of confidence (as reflected in the still elevated conventional measures of risk).

If I am correct in my hypothesis, this would suggest that the rate cuts by the Federal Reserve have gone too far and have not contributed substantially to the increase in liquidity nor to the alleviation of the crisis. Under such circumstances, it would therefore prove prudent for the Federal Reserve to begin raising rates to stave off inflationary pressures rather than relying on others to do so. Unfortunately, my hypothesis also suggests that the crisis is here to stay for some time as the financials sort things out and until, ultimately, confidence is restored.

Gabriel Mihalache has criticized the views of myself and others on radical uncertainty as follows:

Some people wrongly interpreted Caplan’s point as being one about markets, so they jumped at a chance to criticize a set of complete, contingent markets, but a) this is not about markets, but rather about agents; and b) neoclassical economics can be done with incomplete markets or no markets at all!

Contingent claim markets are used in models of representative agents, so I am not sure where this criticism quite fits. The problem that I have with contingent claim markets and the use of representative agents in general equilibrium theory is far too expansive for a blog post. Similarly, I do not want to get bogged down with other elements of GE theory.

First, I would point out that the world is non-ergodic (to use a term of Doug North, Paul Davidson, and others). As the quote from Keynes in my previous post as well as the work of Schumpeter on creative destruction indicates that there is no probability distribution that exists for invention, innovation, etc. Similarly, as Doug North points out, economists treat uncertainty (as defined in the Knightian sense of the word) as though it is a rare case, when in fact, “it has been the underlying condition responsible for the evolving structure of human organization throughout history and pre-history” (Understanding the Process of Economic Change, Douglass C. North, p. 14).

Thus, ignoring the misuse of uncertainty in the general equilibrium framework, let’s use the classical example of risk and uncertainty from microeconomics. An actuarially fair insurance premium would be such that:

Premium = p*L

where p is the probability of the event and L is the loss. (We can expand this to include a risk premium, but it would not embolden our analysis). Of course, in reality, there are cases where both p and L are unknown. Suppose, for example, one wanted to purchase insurance against the risk of the price of a given commodity falling over an extended period of time. What is the likely price of that commodity 5 years hence? 3 years? 1 year? 3 months? What is the probability that the price will fall? As Keynes would say, “About these matter there is no scientific basis on which to form any calculable probability…”

I am in no way trying to argue that models or risk and uncertainty should be abandoned. They are clearly useful in cases in which the probabilities and potential losses are explicitly known. However, we would do well to recognize that the world is not ergodic and that always and everywhere modeling it as such is an impediment to our understanding of complex human interaction.

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.

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.

Axel Leijonhufvud is perhaps one of the most insightful and poignant economists of the twentieth century — not to mention the authority of John Maynard Keynes (ed. note — and what Keynes should have said?). He always seems to be a bit ahead of the curve in terms of mainstream macroeconomic thought. Thus, when he writes, I eagerly read. His latest piece over at VoxEU tackles inflation-targeting and central bank independence. Here is a sample:

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.

I have come around to this view in recent months (although I favor something more like this). I cannot, however, support his view on ridding ourselves of the idea of central bank independence. The prospects for efficient policy are bleak.

J.M. Keynes on inflation in The Economic Consequences of the Peace (p. 235-6):

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

HT: Robert Higgs