Did God overinvest in Land?

I had a short argument with Greg Ransom a couple of months back. Greg won. But actually, I wasn't really arguing with him. I was on his side to begin with, though it did help me clarify my views.

Question. "What is the economic difference between capital and land?"

If you answered: "People made capital and God made land", you are wrong.

Economists have known that answer is wrong since 1871, when we discovered that bygones are forever bygones, and switched to the forward-looking marginalist theory of value. In 1871 we stopped saying that the value of goods is determined by what they cost to produce in the past. Instead we said the value of goods is determined by their marginal utility in the present and expected future. (OK, there are two blades of the Marshallian scissors, demand and supply, but both blades are made of the same stuff (Mark Blaug?), because marginal costs are really opportunity costs, and are the foregone marginal utility of the other goods we could make with the same resources.)

It doesn't matter whether people or God made stuff in the past, and what it cost to produce it. The only things that matter are: the present; and present expectations about the future. If archaeologists discovered that Prince Edward Island was an artificial island, rather than a geological formation, it shouldn't matter at all for the allocation of resources going forward. (OK, some geologists would have extra work to do, to revise their theories.)

What is the economic difference between the existing stock of capital goods and the existing stock of land? Nothing really. Except we will, probably, be producing more capital goods in the future, and we won't, probably, be producing more land in the future.

But even that is not quite right. And not just because the Dutch invest in producing more land. The capital goods we are making today aren't always exactly the same as the capital goods we made in the past. Technology changes. I doubt that anyone today is building a computer exactly like the one I'm using now.

Antique furniture is really land, economically speaking. So is my Mazda MX6. They don't make them like that any more. If we lost the blueprints, and couldn't reproduce any of the existing capital goods in future, they would all become land.

The best we can say is that we can and will be producing capital goods that are a much closer substitute for some existing goods than others.

If there's a very elastic supply curve of newly-produced goods that have a high cross-elasticity of demand for some existing goods then we can think of those existing goods as capital. If there's a very inelastic supply curve of newly-produced goods that have only a low cross-elasticity of demand for some existing goods then we can think of those existing goods as land.

Where am I going with all this? Here's where I'm going:

Some people today say that the current/recent recession was caused by past overinvestment. Or malinvestment, for the more sophisticated version. Especially in houses.

And I'm saying there's something logically peculiar about any sort of theory like that, if you approach economics from a praxeological, forward-looking basis. Bygones are supposed to be bygones. It didn't ought to matter how we got to where we are today. All that ought to matter is where we are today, and where we expect to be tomorrow.

Suppose that geologists discovered that we all had false memories of the last decade. The houses that appeared in the US are in fact a very recent geological feature. They just sprung up out of the ground. There wasn't any overinvestment in houses at all. God did it. God overinvested in land. Did God make us poorer by doing that? Would the recession suddenly disappear, when people learned the news?

There is something logically peculiar about the Austrian theory of recessions, as being caused by past overinvestment. Sure, the natural rate of interest would be lower, and the future pattern of investment would be different, if a lot of houses suddenly sprang up out of the ground. But isn't the market supposed to be able to handle things like that?

It's not just the Austrians. It's the Keynesians too, at least those who say we are stuck in a liquidity trap and can't get out.

Suppose we all wake up tomorrow and learn that all the economic statistics published over the last few years are totally wrong. And that our personal memories are false too. We have all been brainwashed by the Martians into believing inflation has been low and real growth low. In fact, Nominal GDP has been humming along quite nicely. Is there any reason to expect that it couldn't continue to hum along quite nicely in future?

True, a few workers seem to have forgotten who their employers are. And a few employers seem to have forgotten who their workers are. But given a few months they could search and find each other again. Or, at least, find new partners.

And the US Fed would be surprised to find its balance sheet is far too large, and it would need to do a very big open market operation to sell a lot of the assets it holds. And commercial banks would be surprised to find their reserves at the Fed were far too large, and the rest of their balance sheets too small.

And a lot of people and banks would discover they seem to have made some past loans at ridiculously low nominal interest rates, so they immediately raise interest rates on new loans.

And firms find their capital stocks seem to be far too small, so they do a lot of investing to get them back up to normal. And households find they are crammed into houses that are smaller than they need be, because there are a lot of houses sitting empty, but they soon sort that one out. And are driving old cars, and wearing old underwear, and so start investing in a lot of new stuff.

But otherwise, the economy could hum along quite happily on the new equilibrium NGDP path.

Suppose we all wake up tomorrow morning and learn that our memories of driving on the right are false. Everybody drives on the left in Canada. We are puzzled to find our steering wheels on the wrong side, and the road signs in the wrong places, but everyone switches to the new equilibrium and drives on the left.

If a change in our memories can switch us to a new equilibrium, why can't an announcement of the new equilbrium, an NGDP target, do the same?

When did economists forget that bygones are supposed to be bygones? (Not that they are, of course, totally).

Comments

[White Rabbit]

Nick:

we'd end up in the old equilibrium.

the reason is that without economic history, banks would have to be conservative about their lending - I.e. their current behavior.

To break out of such a game theory scenario you need a BIG economic actor to move first or to threaten a credible move forward.

[Nick Rowe]

WR: Reckon central banks are big enough economic actors? They do control the money we buy and sell everything else with.

[Nick Rowe]

But yes, if the government and central bank *jointly* announced a new NGDP target, that would certainly help make it credible. (Unless they announced different targets, which would totally screw things up. Hmmmm. I wonder if that's what's been happening in the US?)

[Nick Rowe]

Hmmm. Chuck Norris could only be more credible if he threatened to use both his fists. Trouble is, it's costly for him to put his fiscal fist back in his pocket. Which both adds and subtracts to his credibility of threatening to use it. He doesn't want to use his fiscal fist, but if he does use it, he can't easily stop using it.

Maybe another post, bringing in the Fiscal Theory of the Price Level, NGDP targeting, and Chuck. Much later.

[Patrick]

Say you're in the K&E world; patient and impatient people, the impatient load-up on debt and then the 'oops' moment arrives ... If only they could forget the past! But they can't. Doesn't the recession comes about because they can't forget the past?

[Nick Rowe]

Patrick: I was afraid that someone would mention debt, which is an ipso facto violation of bygones are bygones.

Sure so the current distribution of wealth is influenced (not *determined*, except in a trivial accounting sense) by the distribution of past saving and dissaving. But:

1. Distribution effects have only second order aggregate effects.
2. The distribution of wealth that was seen as sustainable under the old expected NGDP level path should still be sustainable now, under that same path, especially since some dissolute lenders and borrowers have tightened up in the meantime.

Oh God, here come all the "Too Much Debt!" comments!

This is about Austrians and Keynesians. Not Kooers(?)

[Andy Harless]

Bygones are not merely bygones if bygones are a sunspot. (I have an image of Chuck Norris in the Peter Pan story beating up people who don't believe in Tinkerbell.)

[Nick Rowe]

Andy: agreed. (And ROFL). But if one suspot can get us into this mess, another sunspot can get us out.

To those who don't know what "sunspots" are in economics: the original sunspot theory (IIRC due to Jevons, who also invented "bygones are Bygones, and was one of the three 1871 revolutionaries) was that sunspots caused weather which caused harvests which caused the business cycle. It was a version of real business cycle (RBC) theory. The meaning of "sunspot theory" in modern economics is the exact opposite of what it originally meant. A sunspot is now a metaphor for something that everybody observes (and everybody knows everybody observes, etc., so sunspots are "common knowledge") that is also a totally irrelevant event intrinsically. But sunspots in a model of multiple equilibria can flip the economy from one equilibrium to another, simply because everyone thinks they do. Sunspots are just another metaphor for the confidence fairy.

[Andy Harless]

Can't it be the case that we're in a liquidity trap now and we were already in that liquidity trap five years ago but didn't realize it because we thought we had a lot of wealth that we didn't really have?

It seems to me the problem is not necessarily coordination failure but could be excessive patience (combined with excessive risk aversion). If everyone wants to shift their expenditures to the future at the same time, what can you do? You can cut the interest rate, but not if the nominal rate is already zero. You can issue a bunch of fake safe assets and make people believe they can shift expenditures into the future when they actually can't. Been there; done that. You can cut the price level low enough that people will expect it to be higher in the future. Only that one doesn't work if prices are sticky, of if you have a managed money supply and the central bank is committed to price stability. Or you can have the fiscal authorities behave impatiently to offset the patience of the private sector. That's the liquidity trap argument in a nutshell, and I don't see anything illogical about it. But people who make that argument have to realize that the problem existed before the housing boom.

[Nick Rowe]

Andy: suppose the IS curve slopes down. But the IS shifts right if people have falsely overoptimistic beliefs relative to the rational expectations equilibrium time-path. So the natural rate (where the IS crosses LRAS) was above zero only because of those false beliefs. Then people learn the truth, and the IS shifts left, and the natural rate falls below zero. So we hit the ZLB. And the only other equilibrium above the ZLB either has much higher inflation, or a permanent fiscal policy shifting the IS right, until an exogenous shock (demographics, cars wearing out) shifts the IS right again.

OK. I think that is a logically coherent theory. It's an ungodly mix of Austrians and Paul Krugman. I just don't believe it's true. I think the IS slopes up.

[Andy Harless]

Another possibility is that there was an exogenous increase in risk aversion.

Or how about this for an ungodly mix, RBC and Keynesian: there was a breakdown in the technology for distributing risk, resulting in a higher cost of risk and a consequent decline in aggregate demand.

FWIW I don't think my "phantom liquidity trap" argument is any more Austrian than Paul Krugman himself. Surely he wouldn't have a problem with the idea that demand was being buttressed by false beliefs during the housing boom. And it's entirely an aggregate argument, no differentiating between different types of capital or any of that other Austrian complication.

[Becky Hargrove]

You're right, the Austrian argument is but a place to begin. The first thing I saw this morning online was a graph of GDP ups and downs, I just sat and stared at it for a while.

I believe we can move ahead by creating more flexible interpretations, structures and vehicles for ownership itself. What does that mean in practical terms? What exists for us to buy needs to more closely match the resources we actually have at any given moment. When someone wants to build a restaurant for instance, that does not necessarily mean they wish to become a caretaker of a dilapidated old structure at the same time, or take on mortgage or rent that forces them to be open eight days a week in an environment that cannot support that much business.

A charter city might create grids of electrical and plumbing which people could rent both for residential and commercial use. The investment would come in the form of modular pieces that people could actually put together themselves to create what they want, pieces that can allow the individual to take full use of the production capacity of our current technological system. When people move on, they dissemble the parts and sell those still fully functioning to the next user. NGDP targets will not be like pushing on a string if people can grow from the place they are now, instead of having to jump over a huge chasm everytime and hoping they can make it to the other side.

[Greg Ransom]

Nick, what matters is that there are expectational cascades or snowballs which systematically created inter-related expectations of interconnected future exchange ratios which cannot be sustained -- expected economic exchanges at expected exchange ratios cannot take place at future points (the reality of what economists call "scarcity"). Fractional reserve banking, leverage, non-transparency, time, optimism, price regulations & controls, changing liquidity, and fraud can amplify these cascades -- and hide them temporarily from view to actors in the system.

At the extremes, if expectations are massively systematically out of whack, some "goods" will actually completely lose their status as economic goods which are economized -- they will have no positive sum economic place in the system of economic relations.

"Magically" overnight a capital good or input resource will become a Commodore 64, whose only economic significance is the costs of taking it to the dump.

If I had time, I'd give you a nice metaphorical expectations story starting Chuck Norris illustrating what happens to elements in the expectational system out at the longer time dimensions that find themselves like Wile E. Coyote off the edge of the cliff with no were to go but crashing straight down.

Re-coordinating a _systematically_ and massively discoordinated inter-connected system of expectational relations across the dimension of time is not like a series of small localized adaptive readjustments. All sorts of elements will in mass lose there significance in the system of relations -- some will no longer have an possible use (e.g. like a Commodore 64 in today's world).

Well, this is alot already for a comment on a blog post.

[Greg Ransom]

Nick, try this thought experiment.

Overnight we wake up in the morning and 1/2 of the machines and workers are producing goods which were produced and consumed in 1979 at 1979 prices (and financed at 1979 interest rates, etc.), and the other 1/2 of the economy is producing goods which are consumed in 2011 at 2011 prices -- an example of a massive discoordination of the relations between production processes and input to production, etc.

So -- what to do with the machines designed to make 1979 goods and workers trained to do 1979 jobs?

Well, this problem won't be solved with any pushing of buttons (ala Krugman's teenage Asimov dream of 'doing social science'), and price and asset and money supply juggling by the Federal Reserve won't provide a push button solution either (although it might somehow help at the far margins -- although who will know this and how they will know this is unclear).

[Min]

"There is something logically peculiar about the Austrian theory of recessions, as being caused by past overinvestment. Sure, the natural rate of interest would be lower, and the future pattern of investment would be different, if a lot of houses suddenly sprang up out of the ground. But isn't the market supposed to be able to handle things like that?"

I dunno. That's what people say, but the evidence is debatable. Oscar Wilde said that a cynic is someone who knows the price of everything and the value of nothing. (I first heard that saying with economist instead of cynic.) Markets determine prices. Do people really confuse price with value?

To be sure, we can say that for a particular trade, the price of something is at least as great as its momentary value to the seller and at least as small as its momentary value to the buyer. That is something. But generalizing from that is dicey.

Over time, we might expect that prices tend to something that we can call values. But that is a convenient fiction. It is not just, as Keynes pointed out, that in the long run we are all dead. We know more about complex adaptive systems these days. There may well be no long run. Not that the system may cease to exist, but that the system as we know it may cease to exist.

"Economists have known that answer is wrong since 1871, when we discovered that bygones are forever bygones, and switched to the forward-looking marginalist theory of value. In 1871 we stopped saying that the value of goods is determined by what they cost to produce in the past. Instead we said the value of goods is determined by their marginal utility in the present and expected future."

The future isn't what it used to be (Yogi Berra?), but neither is the past. In a gambling game, if a player tries to maximize his immediate payoff, then if the bet is favorable, he will bet everything that he can. That is a road to ruin. If he instead tries to minimize his chances of going broke (while still betting), he will, as Bernoulli discovered many years ago, maximize his expected return on investment of his stake over time. How much he bets depends in part on how much he has. And how much he has depends on the past.

Turning to markets, it seems to me that how much a market participant has is not in general a datum that the market takes into account, except to the extent that the participant does so himself. If the market is dominated by those with a less prudential viewpoint, who are more concerned with immediate or short term reward, instead of expected return over time, then those market participants are likely to outbid the more prudential participant. Do we then say that the price is right and the prudential value is wrong?

Or suppose that, in addition to those who are trying to maximize short term returns, some market participants have deep pockets, so that their prudential value is in line with those of the short term crew. In that case prices are consonant with prudential values, but the prudential values of the rich. Do we really want to say that the value of something for society as a whole is determined by the rich?

[Min]

After the long prologue, let me add that if we are trying to talk sensibly about bubbles and busts, we have to distinguish values from prices. :) If the price is always right, what can we say?

[marris]

Nick,

Your post touches many interesting ideas. I'm not sure which ones you care about most. In response to your "peculiarity of considering the past" point, I think that economists are really trying to answer _two_ questions.

(1) What went wrong? [How did we drive into this ditch?]

(2) What do we do now? [How do we get out?]

I think you're saying that we may need to analyze the past to answer (1), but we should not care about it if we just want to answer (2). I agree. However, the malinvestment and liquidity trap concepts are not just applicable to the past. These concepts are also applicable to "what recovery will require."

In the Austrian analysis, the answer to (1) (the "thing that went wrong") is a cluster of malinvestments. These investments were made in the past in response to price controls which were in place at that time [specifically, a control on the interest rate]. The Austrian answer to (2) is to let prices adjust now. This is necessary to avoid making malinvestments now. Otherwise, the production structures we build may be more malinvestments [which will be revealed as bad ideas in the future].

We can probably express this in money terms as well. There were big cash flows in the past [the investment purchases] which were made in anticipation of certain cash flows in the future. The people who made those purchaes were wrong. Some of their anticipated cash flows will not happen. To recover, we will need to develop new estimates for future cash flows. This estimation happens when capital goods prices adjust. New correct estimates are necessary before producers can invest [which will involve new big cash flows] now.

In the Keynesian analysis, the "thing that went wrong" was a cluster of liquidity seeking. Since money is the most liquid asset, these seekers started to save money. The effect of many people saving pushed us into a "liquidity trap," where everyone is saving and knows that everyone else is saving. The Keynesian answer to (2) is to "let them eat liquidity." We can either drop money from the sky until people have enough money. Or the government can spend money and issue more bonds [which are considered "liquid enough"]. Once people stop seeking liquidity, things will be "good."

Your land-capital distinction is interesting. I don't think that's how most Austrians [at least Rothbardians] think of it.

[Greg Ransom]

Note well that part of the Hayek story is changing asset values, changing optimism, changing risk & uncertainty assessments, and changing asset liquidity -- shadow money sharply declines and credit becomes tight and the demand for money increases.

This chain of events is set off when "crisis" sets in an production plans cannot be fulfilled at prices expected and when long term production goods, e.g. houses, prove to be radically over valued. (OK, I've _radically_ condensed everything, oh well.)

Here's an analogy.

The U.S. Forest Service puts out all forest fires before they spread -- accumulated fuel of dead wood and brush builds and builds -- now finally when one forest fire goes critical and runs away, and that fuel which was allowed to accumulate is touched, causing a super-temperature inferno even destroying the forest as no ordinary fire in the history of the forest ever produced, what do you blame?

Do you blame the accumulated fuel -- or the forest service which stopped the normal process of nature from keeping a super-temperature fuel load to accumulate in the forest?

Not a perfect analogy, but enough of one to open eyes and imagination a bit.

[Andy Harless]

It's also possible (if the Y-axis is a real interest rate, not a nominal one) that the IS curve is non-monotonic, and the peak may still be too low to be consistent with 2% inflation. This doesn't seem too implausible to me as a description of the world we are currently living in. Intuitively, it seems to me that there is a coordination failure going on, but it also seems that, before that coordination failure took place, we were struggling to maintain full employment at a positive interest rate despite having a lot of phantom wealth that induced people to behave as if they were less patient than they really are.

[Min]

"Suppose we all wake up tomorrow and learn that all the economic statistics published over the last few years are totally wrong. And that our personal memories are false too. We have all been brainwashed by the Martians into believing inflation has been low and real growth low. In fact, Nominal GDP has been humming along quite nicely. Is there any reason to expect that it couldn't continue to hum along quite nicely in future?

"True, a few workers seem to have forgotten who their employers are. And a few employers seem to have forgotten who their workers are. . . .

"And the US Fed would be surprised to find its balance sheet is far too large, and it would need to do a very big open market operation to sell a lot of the assets it holds. And commercial banks would be surprised to find their reserves at the Fed were far too large, and the rest of their balance sheets too small.

"And a lot of people and banks would discover they seem to have made some past loans at ridiculously low nominal interest rates, . . .

"And firms find their capital stocks seem to be far too small, . . . . And households find they are crammed into houses that are smaller than they need be, because there are a lot of houses sitting empty, . . . . And are driving old cars, and wearing old underwear, . . . .

"But otherwise, the economy could hum along quite happily on the new equilibrium NGDP path. . . ."

OK, Tinkerbell. ;)

"If a change in our memories can switch us to a new equilibrium, why can't an announcement of the new equilbrium, an NGDP target, do the same?"

But you are positing not only a loss of memory, so that bygones are bygones, you are positing that people ignore present evidence. If only a change in memories could switch us to a new equilibrium, we are dummies. If, as you and DeLong have pointed out and as John Stuart Mill and perhaps Benjamin Franklin would have pointed out, the main problem is a shortage of the medium of exchange, how will erasing memories change that? (As always, I appreciate your stories, but, as is sometimes the case, I have trouble making sense of them. {sigh})

[Determinant]

Bygones are not bygones and debt is not a bad explanation. Not on a moral level, but on a storage one. Debt creates storage and moves monetary obligations forward through time.

Step with me into my little differential-equation analysis, would please Nick? I promise to be gentle with the math.

Ok, comfortably inside? Have a seat, and lets begin.

A circuit or flow system with a storage element can be modelled as a first-order differential equation. The output is the sum of both the input and the change of the input, plus a few constants here and there which I will neglect for now. Now in a system which stores income in the form of debt and savings you get investment leading consumption and savings lagging consumption (the order doesn't really matter). In this system you cannot change goods consumed and money spent instantaneously. If you could it would mean that you would have an infinite amount of goods and money. Since this isn't true, you get a damped response. The income function looks like a wave.

So savings and investment will as storage elements will cause a divergence from the equilibrium business cycle after a shock. This is the transitory response. Those who care about the "long run" are talking about the forced response where the transitory response has ended. Of course if the forced response itself changes you will constantly have a business cycle.

There, I didn't even bring out a Laplace Transformation.

[marris]

Nick,

In my comment above, I mentioned that economists are trying to answer two questions: (1) how did we get here, and (2) what should we do now? Austrians and Keynesians use different concepts to answer both questions. But as long as those concepts are being applied to (2), the analysis is "forward looking."

I *think* I understand your God-land concern. But if God had created the world as it now stands, we would not be asking (1). We'd know that they'd "started" this way. We'd only ask (2): How can we improve our situation?

In the recreation experiment, what would happen to the economy depends on whether our preferences and knowledge are recreated in their present state. If yes, then the answer is: exactly what's happening now. If no, then the answer is: something else. Maybe something better, maybe something worse. It depends on the extent to which the current structure of production is tuned to satisfy those preferences, and to the extent that it is _not_, how quickly we can coordinate to make it so.

For example, an Austrian would say that if we all had a preference for big houses when we appeared, then the unemployed construction workers would quickly find work. Keynesians would say that if we all appeared, did not know that we were in a liquidity trap, and could avoid falling into one, then the economy would quickly recover.

Not sure about this, but I think everyone is basically doing the "same" analysis. Everyone thinks about what the economy will look like _when it recovers_, and then tries to figure out why we're not there yet. The various theories just focus on different reasons why we're not there.

For example, when the economy recovers, construction workers who are currently unemployed will be doing X. So why aren't they doing X now? It could be that the workers don't have the skills to do X yet. Or it could be that X is currently not demanded [Keynesians like to focus on this!]. Or it could be that the factors of production that they need to do X are currently being used elsewhere. Or those factors are sitting idle, but the entrepreneur who will hire them to do X has not yet thought of doing X.

[adjacent / q]

brilliant post. and one that doesn't mention the stickiness of nominal debt as a key cause of our problems.

[Becky Hargrove]

A quick add: your designations of (passive)land and (active)capital are more vital than perhaps you imagine. It may well be possible to create economic scenarios in which more active frameworks are designated, that all participants understand and work within, in terms of the ways ownership might be approached.

[Jon]

Nick writes:
"Or malinvestment, for the more sophisticated version. Especially in houses. ... if you approach economics from a praxeological, forward-looking basis. Bygones are supposed to be bygones."

Hmm. What a curious set of statements. When I think of Praxeology, I of course think of Mises. Then we have you mentioning "malinvestment" which is a reference to the Austrian view. So, is this a veiled claim that the austrians are illogical from their own epistemology? In that vein, it is of course the Austrians who brought marginalist ideas to explain capital. So yours is a rather clever and veiled dig, if so.

The whole malinvestment theory is one of the most misunderstood concepts in Economics. That misunderstanding stems from not understanding where the theory came from--not understanding its assumptions. The austrian business cycle theory arises from the legal constraints imposed by Bank Charter Act of 1844 and equivalent regimes that were in vogue in the late 1800s and early 1900s. Here is how Mises introduces the theory:

It is apparently true after all to say that restriction of loans is the cause of economic crises, or at least their immediate impulse; that if the banks would only go on reducing the rate of interest on loans they could continue to postpone the collapse of the market. ... Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs

The point here is that if the banks curtail the expansion of the money supply, then a crisis erupts. Sound familiar? Its should; he's talking about an unrequited demand for money. This is (now) very mainstream stuff. He goes on to explain why (in his day) this is inevitable (this is where most people lose the proper thread of the argument):

While people were untiring in calling Peel's act the unfortunate legislative product of a mistaken theory... yet one legislature after another took steps to limit the issue of uncovered banknotes. ... any limitation of the circulation of notes, whether they are backed by money or not, must prove injurious, since it prevents the exercise of the chief function of the note issue, the contrivance of an adjustment between the stock money and the demand for money.

He is explaining here that the crisis comes about because the legal regime requires inflationary excursions to be netted out. The part everyone forgets is that this inevitably will lead to a crisis in Mises's model because the supply of uncovered notes is restricted (by law) and therefore the inflation rate is set by law. Therefore, it is necessarily the case that the banking system will eventually reach an impasse that demands they induce a disinflation.

The ABC theory, as far as it goes, explains how the interest-rate channel induces an acceleration in inflation. In particular, it explains how 'too fast' money expansion lowers the market rate of interest below the natural rate which produces inflation which acts to equalize the market-rate to the natural rate of interest. Why does inflation accelerate? The theory explains that the operative mechanism is that the lower market rate changes the structure of production (increases investment demand) but that change is artificial: i.e., people's time preference for consuming in the present does not decrease--as would be the natural implication of the a decline in the real natural rate of interest. So, "Malinvestment" is an explanation for why the interest-rate channel gives you more investment demand and not-less consumption; and therefore, people both consume and investment demand increases, and inflation accelerates accordingly. The ABC is an explanation for why the IS curve is not vertical.

It is a very much secondary point that once equilibrium is again established, you will not recover those capital intensive factors of production which were sustained by the transitory depression of the market-rate below the natural-rate, and therefore that this boom-bust cycle damages the capital stock because some unsustainable investments cannot be liquidated. This secondary point stands as a reason to oppose the boom-bust pattern even if the recessionary interludes are minor.

[jesse]

Well if we look at the .com bubble, it provides some idea of what is going on, IMO. In an ideal situation the economy will perfectly allocate resources to best ability, producing what is needed just in time. That of course is impossible in the real world, so there is always going to be waste in one form or another. During the boom of the late-'90s, which I remember, there was tons of capital (labour) being poured into tech in all forms. People started pursuing derivatives of ideas -- many woefully impractical -- and some huge malinvestments such as plumbing fiber backbone more than would ever be needed on certain stretches by multiples. There was "real" (i.e. plausibly productive) economic growth behind .com, but there were too many players at the table with only a finite pot. It was a surety many of them would come up empty. When that happens -- the market awakes to the fact that the actual market is smaller and there will be more certainty of the losers -- an immediate drop is inevitable and with it mass layoffs. There isn't usually much to keep labour productive because this happens too quickly and we get recessions. Further there is immediate destruction: a tour of scrapyards after the .com bust produced inefficient auctions and productive work/code being tossed in the dumpster. I cannot see how that can be considered "growth": the engineer who devoted 5 years coding a masterpiece that's erased is probably going to wish deep down she did something else.

But you know this, I'm sure. I saw it first-hand and the reason for recessions is obvious from the trenches.

When it comes to land, well, land is productive because we have an idea of "highest and best use" to produce the most earnings by owning it. The way I look at land value is the residual of the expected future capital expenditures compared to revenues and slap on some risk measures to get a spread above risk-free. That is, I can say I want to build a house and rent it out for 100 years. It costs me X to build the house and I get Y annual rent. Based on financing and risk the business case works only by paying below a certain amount for the land: land is the dependent variable. I don't think it's any more complicated than that.

[Oliver]

Economists have known that answer is wrong since 1871, when we discovered that bygones are forever bygones, and switched to the forward-looking marginalist theory of value. In 1871 we stopped saying that the value of goods is determined by what they cost to produce in the past. Instead we said the value of goods is determined by their marginal utility in the present and expected future.

The Minskyan argument is that that present and expected future utility may have little to do with anyone's need for the actual good, but merely with the belief that all others will keep believing for a while, during which time I can make a buck. Until, well, people stop believing. There's a Ponziness of beliefs as well as capital that comes undone. And undoing beliefs is another word for uncertainty which will inevitably involve an analysis of the past. An NGDP path which is beyond what people truly believe will only work via the inflation channel, i.e. by favouring debtors over creditors, which, if debt is the problem and if not overdone, might lead to more certainty in the future.

Trouble is also that macro economics only has one instrument - money. And, depending on the analysis of what is keeping back confidence, investors (supply side) or consumers (demand side), and who is to lame for the current predicament, the only question is: whom do we give it to? But maybe, just maybe, money is not the only thing troubling us. And no, I'm not making an argument that central bankers should take over the role as confidence whisperers, which is what I see the 'expectations management' school as trying to do. There is something laughably 'mystical' and 'omnipotent' about the idea. Rather, I think economists should be a tad more modest about what it is they can or cannot achieve. All of them... Apply money wherever it can work, declare how you think it will work (mechanics) and why you think it's right (morals), and then shut up.

[JKH]

NGDP targeting is possible using either monetary or fiscal policy, or both, as the engine.

Market Monetarists know what they mean by it (NGDP targeting using monetary policy), but they should qualify it accordingly and regularly.

Otherwise, they’re assuming the effectiveness/superiority of one idea over another (more QE rather than fiscal) in arguing the case for a second, separate idea (NGDP targeting) that depends in execution on the effectiveness of the first. Both cases must be argued in turn.

Just a reminder.

(Or, does the market monetarist position on NGDP extend to fiscal use? Brad Delong has his own version that includes fiscal, behind monetary policy. I assume the MM position is that it won't be required. But does it actually exclude it? What is the position?)

[I]

JKH,

I wouldn't want to exclude the use of fiscal policy from MM. British governments from 1976-1985 had monetary aggregate targets and used both fiscal policy (PSBR targets and funding changes) and monetary policy (interest rate targets) to pursue these monetary aggregate targets. I would want to call such a regime monetarist (especially under Thatcher where the monetary aggregates assumed high importance) and equally I would want to call a government that targeted NGDP* MM even if it used fiscal as well as monetary means.

* Arguably, from 1979 to 1990 the UK government had implicit NGDP targets and NGDP was indeed kept between about 7% and 11% from 1981-1990.

[Min]

Determinant: "Bygones are not bygones and debt is not a bad explanation. Not on a moral level, but on a storage one. Debt creates storage and moves monetary obligations forward through time."

Even if you wipe out human memory, the economic system has its own kind of memory. :)

[W. Peden]

"I" is me, by the way.

[JKH]

Brad Delong continues to bend NGDP targeting toward fiscal policy:

http://delong.typepad.com/sdj/2011/10/delong-smackdown-watch-nominal-gdp-targeting-through-unconventional-monetary-policy-and-through-fiscal-policy-edition.html

[Alex Plante]

Prof. Steve Keen of the University of Western sydney explains why. I've been following his course on behavioural finance which has been posted to YouTube here: http://www.youtube.com/watch?v=KWUG1n1jEJI
You can watch a summary he made at Oxford recently here: http://www.youtube.com/watch?v=YoaUTpr2SNo&feature=mfu_in_order&list=UL

[Becky Hargrove]

I cannot seem to get away from this post, for I want to revisit the idea of malinvestment. One person's malinvestment is another person's current economic reality. It really depends on where a person resides in terms of income, and multi-tiered cities and towns of the future could do a better job of reflecting income disparities. While different incomes may at first seem to imply rich places and poor places that does not have to be the case at all. Each town could come to resemble a snowflake in that first the inhabitants would agree upon certain levels of infrastructure, simpler residential and building requirements, and then proceed from there to pursue similar intellectual challenges that would create the town's snowflake pattern.

Whereas, the malinvestment of sticky markets keeps people on limited tracks that do not allow intellectual exploration. Sticky markets insist certain goods be provided within the same context of scale and cognitive perimeters. One will not find the (relatively) pure market forces of a dollar store in housing, health and education. But the paradox of the sticky market is that - as individuals, we end up with less of the kinds of housing, education and health services than we actually want.

So, in considering malinvestment, maybe it's not just about the 'next big thing' that matters but rather, the whole economic environment that multiple 'things' exist in.

[Darius]

"The only things that matter are: the present; and present expectations about the future."

I'm gonna weigh in to agree with the naysayers here. Bygones can only be bygones in non-hysteretic system, and that clearly excludes economies.

Suppose at time t0, everybody forgets about the distribution of debts and claims at times t-n..t-1, but retains knowledge of current and maybe also historical spot prices.

If everybody forgets the historical prices then the trajectory of those prices has been lost altogether, and the expectations of the market are useless anyway. At t+1 any individual agent's expectations might as well be randomly selected, and there's no telling how long it will take for the market to arrive at another equilibrium.

But even if everybody retains knowledge of historical prices and therefore price trajectory, the distribution of debts and claims is the only way to know what the *bias* of that trajectory was. There can't have been no bias, because then there would be no debts to forget. Only now nobody has any way of knowing whether their existing position included a hedge against pending claims, or leverage acquired by borrowing against some other good, or what. The whole edifice of arbitrage falls down and has to be rebuilt from scratch.

These sorts of situations are certainly recoverable, and I would even argue that they're a good thing in the sense that the "amnesiac" system is likely to be more resilient and more adaptive in the long run. But they're not exactly a "humming along".

Since acquiring the long-run benefits of amnesia without short-term disruption isn't a problem that you see solved very well in nature either, I'm disinclined to think that there's an easy solution. In general, "efficiency" and "local fitness" require access to information about the past. If information you want to "forget" is embedded in the structure of the system then you may not be able to "forget" it without completely decohering. But even if it's stored in a way that makes it selectively forgettable, the forgetting itself means at minimum that some of the system's efficiency is lost.

[Nick Rowe]

I can't do justice to all these comments. (I'm supposed to be doing something else now anyway).

A random thought:

A Newtonian physicist, solving the (say) 2-body problem, who knows the mass of the 2 bodies, and the gravitational constant, will need *two* snapshots taken at different times. On now, and one a few seconds back. Because the 2 bodies have momentum, so he needs to know their velocities today as well as their positions.

An Arrow-Debreu economist, who knows the preferences and the technologies, only needs *one* snapshot of the current vector of endowments of stocks of capital/land. He can then solve the system going forward.

There is "momentum" in Newtonian physics. There is nothing akin to "momentum" in Arrow-Debreu GE theory. One snapshot is all we need.

The differential equations aren't the same, Determinant.

[Nick Rowe]

Jon: "So, is this a veiled claim that the austrians are illogical from their own epistemology? In that vein, it is of course the Austrians who brought marginalist ideas to explain capital. So yours is a rather clever and veiled dig, if so."

It wasn't intended to be veiled.

I stole von Mises word praxeology because we are (nearly) all Miseans on this point, and his word best captured what I wanted to convey. We are all talking about the logic of human action.

But I wasn't really saying that Austrians are *peculiarly* inconsistent. *All* economists (except for a few lost souls who never got past 1871) agree with the Austrians on the basic principle that bygones are bygones in micro theory. There's nothing *particularly* Austrian about that. That imposes restrictions on how we explain recessions.

[Nick Rowe]

marris: "Not sure about this, but I think everyone is basically doing the "same" analysis. Everyone thinks about what the economy will look like _when it recovers_, and then tries to figure out why we're not there yet. The various theories just focus on different reasons why we're not there."

Yep. And those "different reasons" should, if bygones are bygones, be restricted to facts about today, not facts about yesterday. (Yours, in your following paragraph, *do* focus on facts about today.)

[Greg Ransom]

The bygones are the anticipated expectations and plans that cannot be fulfilled ...

Related point.

The malinvestment / time disequilibrium story is intertwined withe the monetary disequilibrium story, see Steven Horwitz's _Microfoundations and Macroecomics_ or Hayek's works. Horwitz studies with Yeager, and many other Hayekians are big fans.

[Nick Rowe]

Greg: "The bygones are the anticipated expectations and plans that cannot be fulfilled ..."

But somehow, it must be the reflection of the failure of those past plans and past expectations embodied in today's reality that determines what happens today.

Horwitz is on my "ought to read" list. Sounds like a lot of convergence there. As you know, I'm a big Yeager fan, when it comes to monetary economics.

BTW, do you like/agree with my proposed capital/land distinction (the first half of this post)?

[Determinant]

A random thought:

A Newtonian physicist, solving the (say) 2-body problem, who knows the mass of the 2 bodies, and the gravitational constant, will need *two* snapshots taken at different times. On now, and one a few seconds back. Because the 2 bodies have momentum, so he needs to know their velocities today as well as their positions.

An Arrow-Debreu economist, who knows the preferences and the technologies, only needs *one* snapshot of the current vector of endowments of stocks of capital/land. He can then solve the system going forward.

There is "momentum" in Newtonian physics. There is nothing akin to "momentum" in Arrow-Debreu GE theory. One snapshot is all we need.

The differential equations aren't the same, Determinant.

Nick, savings cause consumption to lag income, and debt causes consumption to lead income. Any system with storage elements that cause the flow variable to both lead and lag the forced variable, which we very much have here, IS a second-order differential equation with the equivalent of momentum. It is the same as a resistor/inductor/capacitor circuit or a mass/damper/spring system.

In order to have a general solution you MUST have both f(0) and f'(0), you need the equivalent of position and velocity in order to obtain the complete solution y(transitory) and y(forced).

Laplace transformations make this easy but you must have complete initial conditions.

You are saying that Arrow-Debreu GE only posits a single-order differential equation, which can be solved with only one initial condition. But that is not the sort of economy we have with savings and investment, both leading and lagging storage elements. In a single order differential equation you can have a leading element or a lagging element but not both.

If you are in fact saying this then I content that your GE is not general enough. You have to have one more condition to solve the second-order differential introduced by both savings and investment.

Come to think of it, I have just said that savings and investment may or may not be equal. I accept that they exist in some quantity and proceed to solve from there, but need two initial conditions to do so. You may be able to simplify down to a first-order differential if you accept S=I. I believe that may be the most treacherous and misleading identity in the whole of economic history for that reason.

Still, with a first-order differential you can have Income or Consumption change instantaneously but not both.

[Nick Rowe]

Determinant: simplify. Forget investment. What's your consumption function?

Is it: C=a+bY(t-1)? Or C=a+bE(Y(t+1)) ?

[Jon]

Nick: bummer, I was hoping to discuss my revisionist presentation of ABCT. The first part of my post was a compliment; calling something veiled is not an insult!

[Bob Murphy]

Mr. Rowe, you are assuming a can opener, I think. You ask us to suppose that we all discover that we've been in a healthy economy the last few years. Then, you simply assert that this change in our mental states would restore full employment. Finally, you take this assertion as a reason to believe that targeting NGDP would have the same results.

Maybe you're right, maybe you're wrong, but you haven't really presented an independent argument. You've just said, "I think expectations are what's holding us back, nothing 'structural'" and put it into a cute thought experiment.

[Nick Rowe]

Jon: OK, maybe it was veiled! ;)

I just re-read your comment. Was that a *revisionist* presentation of ABCT? I still can't get a fully clear intuition of ABCT, despite numerous readings and people like you and Greg trying to explain it to me. But your presentation seemed roughly in line with what I thought it was supposed to be.

My version: Start in equilibrium. The central bank lowers the interest rate. People start building a house that's twice as big as before. They get it half-finished then run out of bricks. So they abandon it, because it doesn't have a roof on, so it's useless.

[Bob Murphy]

Nick Rowe wrote:

There is something logically peculiar about the Austrian theory of recessions, as being caused by past overinvestment.

It's not just the Austrians who make this mistake. About a week after the earthquake/tsunami in Japan, people were talking about how it was disrupting Japan's economy. I mean, just think of it--they were explaining the current state of the economy, by something that had happened in the past. (!) These Sraffians are everywhere.

[Nick Rowe]

Bob: Welcome! (And call me "Nick" please.)

Yep. This post doesn't really have any constructive argument that nothing is holding us (OK, I mean you, the U.S.) back from a normal equilibrium growth path. Though that is my belief. It is more of a challenge to others who say something *is* holding the US back. What is that "something"? And I am arguing that that "something" cannot simply be what happened in the past, because that would violate "bygones are bygones". It has to be something in the present. (Or perhaps the expected future?).

[Nick Rowe]

Bob: earthquake hits yesterday. The capital stock is lower today than it was last week. Therefore the level of output today is lower than it was last week.

The housing stocks in the US is higher today than it was x years ago. Therefore?

[Jon]

Nick: my revisionism is that such discussions about useless capital goods is some minor adjunct which while true is not meant to be presented as the cause of the recession. Mises states more than once that the recession arises from tight money.

The ABCT has to be read as a critique of the Currency School. Without that mooring, you cannot get a clear intuition from it. The point of the subsistance fund story (running out bricks as you called it) is that the capital structure theory implies that a reduction in the real-rate will create investment demand without a reduction in the MPC. Mises very explicitly explains that society does not in practice run out of bricks, what happens instead is that the price-level rises and that is the problem under a legal regime such as Peel's act.

So the short version is: Start in equilibrium. Banks accelerate their note issuance which lowers the real-rate in the market below the natural rate. Investment activity increases (This is explained by the Austrian Capital Structure Theory, although we don't identify it as such any more). That increase in activity is inflationary. The supply of money is capped by law by the gold-cover ratio. Therefore, the note issuance must stop and the new inflation-rate cannot be sustained. Tight money produces the bust.

This is why the 'bust' is an inevitable consequence of the boom. You can delay the boom for longer and longer by allowing more unbacked issuance but eventually whatever gold-cover ratio you set will bite, the price-level will collapse back to its legal limit and the bust will occur. This is why you have the austrian claim that the longer you let the boom go on (the higher the price-level rises), the harsher it will be when the gold cover ratio bites and forces the price-level to drop.

[Bob Murphy]

I don't know if I can call you "Nick"; weren't you born several decades before me? Excuse me, I mean, isn't your current age higher than mine? (I didn't want to offend Menger, Jevons, and Walras with my first formulation.)

Yes, I understand the overall thrust of your post, and it's a good one. I'm just pointing out that you were assuming your conclusion in the Martian example, and with my wise-aleck Japan tsunami comment, I'm giving a hint as to how the Austrians would respond.

But, since Yglesias asked a similar thing, I think I will try to write up an official Mises.org article on all this.

[Nick Rowe]

Jon: Aha!

So let me give a modified version. Start in equilibrium. then the central bank cuts the interest rate. Investment increases, money supply expands, inflation increases. This is unsustainable, because it's all going to accelerate. So eventually the central bank (one way or another, gold standard or no) has to raise interest rates at least back to and maybe above the natural rate (which may not be the same as the old natural rate) which ends the boom (and maybe causes a recession if the central bank has to raise the market rate above the natural rate to turn inflation around).

Starts to sound much more like me. Sounds much more Friedmanite.

Bob: Aarrrr! You're just a lad! It would be good to see your response. Must look up the Yglesias post.

[Determinant]

Nick wrote:

Is it: C=a+bY(t-1)? Or C=a+bE(Y(t+1)) ?

It could be either. I had in my head just plain C, a number, any number, just like a resistor in a Resistor/Inductor/Capacitor circuit (that is a filter).

My systems prof would say that C=a+bY(t-1) is causal and therefore stable. In a casual system y(0) = 0 for t <=0 and anything else for t>0, so C=a+b(0) and C=a and varies thereafter.

In the case of C=a+bE(Y(t+1)), at t=0 you are getting C=a+bE(Y(I)) which is a look-ahead system. This is not a casual system and in look-ahead systems are generally assumed to be unstable in nature. They can have unbounded output for bounded input. Guessing is like that.

My model your function is akin to a potentiometer, the dial you adjust your dining room light with. If the dial looks back it is causal and stable, if it looks forward, you are on your own.

But either way, in the presence of two storage elements and a second-order flow circuit, if you adjust C you will get a significant "ringing" due to the transitory response.

[Greg Ransom]

Nick, the Wicksell/Hayek distinction is between permanent resources which can be used an infinite number of times in sequence (land) and non-permanent resources which are can be used only a finite number of times, i.e. are used up, (capital goods or production goods).

The deal is that in economizing across time, we have to take into consideration relative multi-good input and output tradeoffs where non-permanent resources are concerned. How often do we use that antique furniture and that Mazda MX6, how much money do we sink into the upkeep, safe condition, and maintenance of the furniture and car?

We have to make economizing choices and choices at the margin in our affairs concerning non-permanent goods, whose trade-offs implicate the value or output we get from them, and these choices have a clear time dimension that can be shorter or longer, e.g. we can burn the antique furniture for a winter fire or we can crash the car for kicks, or we can use these only as tools for important production activities, tell your own stories using furniture or a car.

It's late and I'm tired and I'll sleep on the question of hooking this all up to elasticities of demand and substitutabilities, which seem relevant.

[Greg Ransom]

The idea is if overnight your Mazda MX6 became indestructible and never again required repairs and would last forever and ever, it would become land and would no longer figure in our economic choices over time in the same what that capital goods / non-permanent production goods are economized over at the margins of input, time and output.

[Min]

Determinant: "Come to think of it, I have just said that savings and investment may or may not be equal. I accept that they exist in some quantity and proceed to solve from there, but need two initial conditions to do so. You may be able to simplify down to a first-order differential if you accept S=I. I believe that may be the most treacherous and misleading identity in the whole of economic history for that reason."

Is it an identity? After all, we have this identity (sic!):

(G – T) = (S – I) – (X – M)

If S = I is an identity that should really be written

G – T = M - X

No?

[Jon]

Yes. That is it, and so we have Hayek promoting something like NGDP targeting. Now my story isn't the one you usually hear because...

1) One of Hayek's big ideas was the local nature of information. Hayek is a definitely an Austrian, and a consequence of knowledge of time and place could be something like Klings PSST. So its right to say that's an Austrian story, but it isn't the story that whose pedigree goes back to Menger and Böhm-Bawerk. In other words, there are two stories, both Austrian, but if you muddle them together, nothing makes sense.

2) Mises does talk about the inefficiency of liquidating capital during the boom, but its more like, "oh yeah there are some other reasons this is bad for society". The concept itself is an observation; it isn't derived from theory.

3) Mises (and Rothbard) were virulently anti-socialist. Most of all they hated inflation because they viewed it as a form of tyranny. That meant first that they didn't do much to clarify the argument for people. Second, also as a result of this Mises favored a gold standard. This seems mighty strange in light of the story I just presented.

Except the Mises's gold standard is rather different: the CB has unlimited authority to print notes 100% backed by gold--i.e., by buying and warehousing gold bullion. That seems strange, but he proposes that the CB buy gold only at par (and the Government is obliged to sell it to the CB at par). If the price of market gold is above par, the government subsidizes the transaction from the general fund. It seems me that what this system means is that rather than the gold-miners setting the supply of money, what you have instead is that the CB sets the money supply (using a 0% inflation target) and the government _subsidizes_ mining to ensure that gold production keeps pace with the growth in money demand. I find this complicated contraption as proof that Mises really did understand what you called Freidmanite story, but he was also politically anti-socialist and linked that up with the gold-standard because he didn't want so-called socialist budget deficits funded to be funded by the CB. This scheme makes the government pay directly for inflationary excursions which is an interesting way of creating incentives.

[reason]

Nick,
I don't understand this:

"Yep. This post doesn't really have any constructive argument that nothing is holding us (OK, I mean you, the U.S.) back from a normal equilibrium growth path. Though that is my belief. It is more of a challenge to others who say something *is* holding the US back. What is that "something"? And I am arguing that that "something" cannot simply be what happened in the past, because that would violate "bygones are bygones". It has to be something in the present. (Or perhaps the expected future?)."

The past is in the household sectors balance sheets. The present is unemployed resources. This combination has changed the perception (and reality) of risk for lenders and investors alike. Unless someone insures that risk, the economy cannot grow because (risk free) interest rates have already fallen as low as they can. If you insist on ignoring balance sheets (and the implied risk factor built into them) - of course you cannot understand it.

[reason]

Greg Ransom
"Nick, the Wicksell/Hayek distinction is between permanent resources which can be used an infinite number of times in sequence (land) and non-permanent resources which are can be used only a finite number of times, i.e. are used up, (capital goods or production goods)."

- sorry I don't understand that distinction - surely that is a difference of degree not kind. Land still comes with maintenance costs. True it doesn't become obsolete, and can't be wholly replaced - but surely that is just an extra cost.

[Pdt]

Isn't there an assumption here that the stock of money equals the stock of real things? I can't see that it does. Money is a representation - a picture - possibly of a real thing (or possibly not). The economy is people creating real things and turning some of them into money, but it is also people turning money into money, or money into real things (or, in the case of derivatives, turning money into money into money....). One can build up a lot of pictures that are believed to represent real things, until more than usual are found to be false - then it's suddenly a game of musical chairs with several chairs short. So the past matters, as people cling to (past) hopes and dreams, hold on to old "pictures" hoping that one day they will again equal real things, create more pictures along old lines and so on. In short, any human system will have enormous momentum, as various forms of memory are intrinsic to their functioning - not just overt individual memeories, but the memories embodied in things, organisations, habits...

[reason]

P.S. I really like Jesse's post - I think he has it pretty right.

But just so everybody here knows where I stand - I think Greenspan booms were a response to another imbalance, not the cause of the imbalance. The US Trade deficit is hot trail that we should be concentrated on. Why could the US only maintain full employment via a series of irrational asset price bubbles? Because the US dollar was set so low, that there were hardly any other productive investments available (so you end up with gold rush type snowballs). After all, even if low interest rates encourage investment - investors will still try and seek out the most promising investments. Why did they choose to gamble, rather than looking for safe easy picking investment, that might now have been made affordable by low interest rates?

P.S. It seems to me that Austrian's should ask themselves whether the undeniable fact of consumer credit, doesn't complicate their story about the lengthening of the investment horizon with low interest rates. It seems to me, it wasn't a factor in Hayek's time.

[reason]

oops
... because the US dollar was set so HIGH ....

[reason]

And Nick - I think the distinction between land and capital is that capital is mobile (sometimes admitedly that mobility is very expensive). Land has a fixed position and that position is CRITICAL to its value.

[Nick Rowe]

Jon: you are making an awful lot of sense. ABCT is a mixture of Friedman + Arnold Kling's PSST originally told in an institutional setting where any change in the money supply and price level had ultimately be reversed (though a similar story can be told outside that setting). Plus, the vague I-S=delta(M) idea is basically the Laidler/Yeager one I sketched out in my Wicksell and the Hot Potato post. It is all coming much clearer now, after 35 years of puzzling this over. Well done!

Greg: I think of farmland vs oil deposits. And hammers vs whisky. The first of each pair can be used forever, if treated carefully. The second is used up when consumed. I would say that's an important distinction, but cuts across the land/capital distinction.

reason. Hmm. Mobility is also important, but some God-given resources are mobile. Oil and gas can be moved. Water too.

[W. Peden]

Also, can't an area be flooded to dry out another area? I.e. the creation of dams involve the sacrifice of some land for other land and these are sometimes on a vast scale. That's not quite "mobility", but it's close for many purposes.

[Bob Murphy]

Nick, as an orthodox priest of the Misesian/Rothbardian tradition, let me say that I view Jon's remarks as heretical. So, you are obviously free to consider them on their merits, but I'm just saying I don't at all agree with how he is saying "this is what Mises was really saying" etc.

(Jon, forgive me for just dropping that claim and leaving, but I don't have time to wade through it right now. But e.g. when you say Mises says that the bust is caused by tight money, I think that's very misleading if you're trying to build bridges with a target-NGDPer person. I know what you are talking about, but I think the linking of the central bank to the onset of the recession is entirely different in both camps.)

[Nick Rowe]

And dams themselves are normally understood as capital, but can't be moved.

[reason]

Nick,
I agree dams, roads, railways etc (i.e. infrastracture) are another category entirely. And so are non-renewable resources (which unlike land get used up). So does our attempt to reduce all long lasting stuff to one single "capital" category make sense?

[reason]

P.S. A a bit of a greenie and someone with some sympathy for the Georgian (i.e. Henry George) view of things - I think you may see where I'm heading to.

[Nick Rowe]

reason: the Henry George aspects to this question did cross my mind. Suppose we implemented a Henry George tax on land. Then we discovered that Prince Edward Island was in fact capital, not land. Would we suddenly scrap the tax on farmland in PEI? There is no economic difference between putting a tax on land and putting a tax on all land and existing capital, and promising never to repeat this in future on capital built after today.

[reason]

"There is no economic difference between putting a tax on land and putting a tax on all land and existing capital, and promising never to repeat this in future on capital built after today."

Hard to imagine that surviving legal challenge. And of course the point of Henry George is that the value depends on location (and externalitites associated both with infrastructure and other buildings, people and firms). The value of a machine is no so dependent on externalities.

[reason]

And Nick,
saying that PEI is capital doesn't affect MY definition of land as being location.

[Greg Ransom]

Let's stick with Popper policy that "words don't matter" here, we are interested in concepts to help us with different kinds of economic problems. We don't want to be arguing over mere words,

"Greg: I think of farmland vs oil deposits. And hammers vs whisky. The first of each pair can be used forever, if treated carefully. The second is used up when consumed. I would say that's an important distinction, but cuts across the land/capital distinction."

[reason]

Greg,
I'm sure you want to say something here - but what exactly escapes me.

[Greg Ransom]

reason -- I don't find you to be either particularly sincere or particularly interested in carefully reading what I write. So don't be surprise if I don't engage your "arguments".

[Greg Ransom]

Nick, if we wanted to argue over words, we could re-write this as:

"I would say that's an important distinction, but cuts across _my_ land/capital distinction."

Wicksell points out that many improvements of land become permanent features of the land, so the economics of "improvability" differs depending on what are improving, i.e. we can also improve petroleum, but it remains for all purposes I can think of a production good which is used up.

[Greg Ransom]

As Menger and Ricardo and many others make clear, words used in economics are technical terms whose meanings derive from economic functions in the logic of choice and calculation. We do with with all sorts of words. We are looking to identify economics useful concepts to help us with particular problems.

The economics problems and causal consequences of coordinating alternative uses of non-permanent resources is different than that for permanent resources.

The economic use of non-permanent resources takes us beyond a "manna from heaven" economy.

Permanent resources for the most part do not.

[Greg Ransom]

We want to think about the coordination of non-permanent production plans and resources across time because this is where productive economization takes place ...

Across the boom and bust this coordination across time is demonstratively out of whack -- a systematically selective set of non-permanent plans and resources loose their former economic relevance and former value position in the system of relations across time.

So a second reason we want to focus on the coordination of non-permanent resources used for shorter or longer production plans is to understand the character of discoordination when plans and resources are systematically discoordinated across time, with prices directly implicated across time are dramatically altered and when processes taking more or less time are dramatically shifted (e.g. the boom and bust in the extremely long production process of "providing housing to a family" represented by rocketing and then crashing home prices.)

I'll stop there.

[reason]

Greg Ransom,
don't take my banter for unseriousness. But to be honest, I find your expression amounts often to what seems to me deliberate obfuscation. I must say I admire Nick for trying to deal with it and create a little clarity.

[reason]

Greg,
and forgive my scepticism, but I find that making excessively definitive distinctions where there is in reality a whole range of subtle variations is one of the biggest sources of error in thinking.

[Jon]

Bob, I once took an entire class on the philosophy of causation in my early years as an undergrad. Let me weasel from the start and say: well that depends on your meaning of cause.

Mises supported the idea of a stable price level, so very plainly he does not put the animus of his argue directly on the act of tightening. He instead strikes at the earlier sin qua non: had there been no loosening, there would be no inflation and therefore no tight money thereafter.

You need to keep the mechanics of his model and his policy argument separate.

Second, I do view my presentation here as revisionist. It's easy to misunderstand Mises if you don't consider the preoccupations of the early 1900s. Mises is writing to a technical audience where you have on one hand peels act and machinations to stifle boom-bust patterns by controlling the issuance of notes and you have the real bills doctrine, which states that unlimited discounting of CP will never lead to a bust.

The big Austrian point is that any expansion of credit that will lower the market rate below the natural rate will induce an inflation and therefore a bust no matter the quality of the assets acquired by the banks.

[reason]

Greg,
I wish you people would find another example than housing. I think this sentence

"(e.g. the boom and bust in the extremely long production process of "providing housing to a family" represented by rocketing and then crashing home prices.)"

is completely wrong headed. First of all it is not "home prices" that rocketed and crashed - it is land prices. Secondly the production proceess of providing housing to a family is not extremely long. Producing pharmaceuticals or refining petroleum - now they are extremely long production processes.

[Greg Ransom]

Sorry, "reason", you have this wrong.

Intentionally?

[Nick Rowe]

Jon: so Mises was arguing the real bills doctrine was false, and that there could be an excess supply of money, even if the CB followed the real bills guidelines? Hmm. Mises is going up in my estimation.

[Greg Ransom]

A house is an extremely long period production good.

[Greg Ransom]

Here's a short period production good -- a sand castle.

Here's another -- a temporary stick and branch shelter in the forest built for emergency

Think about how additional time consuming production goods and processes are required to extend the productive time of the productive goods closer to direct consumption they can help create.

[Bob Murphy]

Nick wrote:

so Mises was arguing the real bills doctrine was false, and that there could be an excess supply of money, even if the CB followed the real bills guidelines?

Oh, for sure. Have you read The Theory of Money & Credit?

[Greg Ransom]

In thinking of output of a house as a long time production good with a long time choice horizon also think of the long time period inputs to that production good -- timber grown for years, then harvested using equipment which which took time to manufacture, using equipment which took time to design and manufacture.

If people don't want years of housing and just want a big fire, they could immediately burn down the forest at get that output, and not waste time building heavy lumbering equipment, machines to build heavy lumbering equipment, or waiting for the forest to mature, or building the house and maintaining it over decades and centuries.

[rp1]

"Suppose that geologists discovered that we all had false memories of the last decade. The houses that appeared in the US are in fact a very recent geological feature. They just sprung up out of the ground. There wasn't any overinvestment in houses at all. God did it. God overinvested in land. Did God make us poorer by doing that? Would the recession suddenly disappear, when people learned the news?"

The problem is the debt taken on to build those houses. People borrowed a lot of money to pay extremely high prices. That is, they dedicated years of future income to a house, probably under the belief that prices rise forever, and it turned out to be a very bad investment. The prices fell, many people lost their jobs and their houses, and most people are still paying for it. Annul the debt and you will end the recession, at the cost of moral hazard. But if you ignore the role of debt, you are never going to see the problem.

It's worth examining why people would ever take such extreme risks. Obviously they judged the alternative (not buying a house, sitting it out) to be an even greater risk. And maybe it was. In Canada housing never crashed and is rocketing higher and higher. We have surpassed the US on many metrics such as debt to income and price to rent. Anyone who sat this out for any reason is basically obliterated. It literally does not matter what kind of job or education you have if you're under 35. Maybe it will correct, but maybe it won't. Inflation is transferring mountains of wealth from savers to debtors, adding more and more cement to that gain or loss. For people on the losing side, it is a bitter pill to swallow, but the majority is happy.

The immediate cost of any policy favouring one group over another is moral hazard. People in Canada will continue to buy more and more houses until the policies are changed. Then we are likely to get a really big bust. But timing is everything. In China these policies were continued for 20+ years. Rich families own hundreds of empty apartments. Speculators can and do get incredibly rich. College graduates with professional salaries are packed 6 to a room and can not find wives or settle down. Vancouver is looking more and more like this. I think I will leave Canada before it turns into China.

[Determinant]

Determinant: "Come to think of it, I have just said that savings and investment may or may not be equal. I accept that they exist in some quantity and proceed to solve from there, but need two initial conditions to do so. You may be able to simplify down to a first-order differential if you accept S=I. I believe that may be the most treacherous and misleading identity in the whole of economic history for that reason."

Is it an identity? After all, we have this identity (sic!):

(G – T) = (S – I) – (X – M)

If S = I is an identity that should really be written

G – T = M - X

No?

It can be used as an identity in economics and frequently is, though as I said it really shouldn't be. It's much more interesting and realistic to assume that S and I diverge somewhat and see what the response of the system is. When you do that you will change the "resonant frequency" of the system.

My argument is to let S and I be, don't force them to be equal and don't use concepts that rely on S=I. See what the system does when they diverge. We call that a small-signal model.

When economists argue about the short run and long run, I read that as the transitory response of a system and the forced response of the system. Both are valid but they have different causes. The transitory response is based on the interaction of S, C and I and the income flow through them. The forced, long-term response is based on production and consumption, S and I disappear as direct factors.

[Nick Rowe]

Bob: I read both the Theory of Money and Credit, and Human Action. But *ages* ago, when I was but a lad. Yes, I *should* re-read TMC, but there's a 100 other things I should read too.

[Min]

Nick Rowe: "Determinant: simplify. Forget investment. What's your consumption function?

"Is it: C=a+bY(t-1)? Or C=a+bE(Y(t+1)) ?"

Determinant: "In the case of C=a+bE(Y(t+1)), at t=0 you are getting C=a+bE(Y(I)) which is a look-ahead system. This is not a casual system and in look-ahead systems are generally assumed to be unstable in nature."

May add my two cents worth? :)

In C = a + b * E(Y(t+1)), I assume that E() stands for expected. (I hope that we are not talking about mathematical expectation, though.) Since E(Y(t+1)) is not an observable (as I gather from these discussions ;)), then, in operational terms, what is the difference between that equation and C = a ?

I do not mean to suggest that expectations, in some non-mathematical sense, do not matter. But in order not to treat them as sources of error, don't we need some kind of theory of expectations? If we have such a theory, then C = a + b * E(Y(t+1)) can be expanded to include more terms. C = a + b * Y(t-1), since Y(t-1) is observable, does not need to be expanded.

Consider a man dropping from a hovering helicopter. If that is all we know, we can predict that he will land directly below where he is now, with some degree of error. If we also know that he is wearing a parachute, he has some control, and our error is greater. If we also know that he is a sky diver with a sky diving parachute, we know that he has even greater control, and our error is even greater. We may also suppose that he expects to land somewhere, which may not be directly below where he is now. But without a clue about his expectations, all we can say is that our error is large. However, suppose that we know that he is in competition, and has a landing target. Then, no matter where he is (within limits), we can predict where he will land, with a smaller error.

I do not think that the question is one of causality, but of what we know and observe. To be sure, human expectations are affected by memory. But if you wipe out human memory, and we know nothing else about those expectations, the expectation term becomes part of the error. Now, if everybody forgot that we have had high unemployment for years, and forgot that house prices used to be higher, and forgot that credit card rates used to be lower, and forgot how high the debt and deficit used to be, and forgot stock market histories, and forgot that we had a financial crisis and forgot that we bailed out Wall Street, etc., etc., that mass forgetting would probably help the economy. But people are still out of work, and still in debt, and still facing foreclosure, and so on. There is still systemic memory, encoded in present facts.

I do not know enough to judge Determinant's circuit model. But I do not think that the existence of an equilibrium invalidates it. Nor do I think, if we are in a sub-optimal equilibrium, that mass forgetting is enough to get us out. We still need to get money into circulation, no?

[Greg Ransom]

Here's another very short term production good: a Jack-O-Lantern.

The longest part of the production process is manufacturing of all the inputs into the equipment used on the farm where the pumpkins are raised. The shortest part of the production planning and production streams going into the output of the enjoyment of the Jack-O-Lantern is the part of that time consuming process when the thing actually sits on the porch.

[Determinant]

Exactly, Min.

S and I, as components that have time-forward and time-previous contracts, encode that systemic memory.

When you say "get more money into circulation" it is exactly what you should do. That is a positive input that will force the system to respond and transit to a different forced input state faster.

Even better if we can increase I and reduce S. In a second-order differential as a control system, I is the second-order term and S is the direct term. A system that has higher I and lower S is underdamped, it will have a faster response time to a new forced input. A system with higher S than I is overdamped and will be much slower in coming to a new state.

For expectations, what you are doing is predicting what C(t+1) will be based on C(t). Which is OK and will work but it has a significant chance of error. When I say there is a causality problem, I mean a system cannot directly read and process Y(t+1).

Reading the past? Easy.

Inter-temporal contracts are, like anything, great under certain circumstances but you have to be prepared for when you have suboptimal conditions.

[Patrick]

Determinant: lots of very clever people have thought about really hard about this stuff. There is more to economic modelling than A-D. Off the top of my head as a rank amateur: try googling Barkley Rosser, also computation economics.

If you want to follow the advice of Sun Tzu:

http://cowles.econ.yale.edu/P/cm/m17/

It's hard slogging to read closely (Bagehot is a Harlequin in comparison), but at least it's not Hayek.

[Jon]

Jon: so Mises was arguing the real bills doctrine was false, and that there could be an excess supply of money, even if the CB followed the real bills guidelines? Hmm. Mises is going up in my estimation.

Yes, he definitely did that, but before you esteem him too highly in public, I'll warn you that his handling of says law is quite muddled. This I think is the real weakness of my revisionist presentation. He understood that the money supply needed to be elastic, and he understood that tight _credit_ induced the bust but connecting the two with a clear analysis that says law was wrong--that he has never had.

No the only clear explanation he gives for why production will fall below potential is Wicksell's view that a rise in the market-rate retards investment activity. Its the interest-rate channel only. I don't think Mises believed recessions could happen in a non-credit economy. This is how the story eventually degenerates into liquidation inefficiencies.

Hayek on the other hand got over this hurdle.

[reason]

Greg Ransom
"Think about how additional time consuming production goods and processes are required to extend the productive time of the productive goods closer to direct consumption they can help create."

So it seems you define production as consumption. You just speak a foreign language. So , if I want a very long term production process I should create children. Is the birth rate negatively correlated with the real interest rate?

[reason]

Greg,
I guess I sort of agree that in a sense consumer durables are productive capacity (although - apart from houses - not in the normal national accounting sense). But from the point of view of dividing the world into producers and consumers, this is irrelevant to a producer. His interest ends when he sells it. Stories about running out of builders materials then are beside the point. And the house doesn't in any sense become unsustainable - it keeps giving shelter. (Particularly in the case of housing because most of the adjustments are made in land prices). There is any real "unsustainability" issue - only a financial one (which potentially has a financial solution). Why do you want to insist on a real solution to a financial problem?

[reason]

P.S.
By the way, I'm of the belief that the excess building of houses - while real - was relatively minor and in normal circumstances would have already been corrected. The major problem was the excess price paid for the land they were built on and the debt taken on for that land. So real resource misallocation - small - asset price bubble - major.

[reason]

P.P.S.
I'm a total heretic in that I think the idea of single stable economic equilibrium is an irrelevant myth. So worrying about deviations from this are also pointless. If there was a shortage of investment leading to deflationary conditions, then investing in better houses is not stupid thing to do (people always want better houses). But the land price bubble was destructive of the financial health of the household sector. Land price bubbles need to be better understood, and we need better policies (particularly on the supply side) to counter them.

[J.V. Dubois]

Nick: "There is something logically peculiar about the Austrian theory of recessions, as being caused by past overinvestment. Sure, the natural rate of interest would be lower, and the future pattern of investment would be different, if a lot of houses suddenly sprang up out of the ground. But isn't the market supposed to be able to handle things like that"

I am no Austrian myself, but as I understand the key point for the theory is malnourishment of particular phases of production process (capital formation). So I think that according to the Austrian story, even if we would see houses sprang up from the ground, the problem with depreciation of capital in some stages of the production would remain. That means that even if you wake up with total amnesia and somehow get to work (maybe you have the address of your employer in your phone), you would find that your production tools are damaged and you would have to wait for them to be replenished. Presumably, waiting for this as one of the unemployed. So that is only a different way of saying the usual structural story.