The natural rate of economic ignorance

Having taught modern policy just this week, about inflation targeting and the natural rate of interest, and again while doing it wondering whether such gross stupidity can still persist when it has caused nothing but grief, it was nice to see this in The Australian today, by David Uren, that all is still wrong with the world and economics remains stuck in the same rut it’s been in for thirty years. This is from his article, Stubbornly low inflation tests even RBA’s patience:

When Philip Lowe took up the governorship of the Reserve Bank of Australia a year ago, financial markets were betting he would be cutting rates within six months. Today they are betting he’ll be raising them by May next year.

After Tuesday’s RBA board meeting, Lowe said there would be no change in rates, as he has after every meeting since his first as governor in October last year. . . .

It is as if the economy were stuck in first gear, and the Reserve Bank keeping its foot to the floor is neither making it go any faster nor lifting inflation. Central banking the world over is in ferment as top officials wrestle with the risks created by a decade of ultra-low rates and with their failure to generate the modest inflation required by their formal targets.

The inflation targeting framework that has governed the world of central banking for the past two decades, and that seemed to work so well at taming runaway inflation, is now struggling to deal with price rises chronically undershooting the mandated goals.

The Reserve Bank has been pursuing a target of keeping inflation between 2 per cent and 3 per cent since the early 1990s. The underlying rate of inflation (which strips out volatile movements such as petrol price jumps) has been below 2 per cent since the beginning of last year and the RBA’s projections suggest it doesn’t ­expect a ­return to the desired 2.5 per cent until the middle of the next decade. The same is true the world over, and it is leading central bankers to question whether their explanation of the economy and their impact on it is correct.

In a speech last week, US Federal ­Reserve chairwoman Janet Yellen pondered whether there was a “risk that our framework for understanding inflation dynamics could be misspecified in some fundamental way”. A week earlier, Bank of England governor Mark Carney had claimed globalisation was responsible for weak inflation but said he was not ready to ditch his bank’s inflation target.

The Bank for International Settlements, which is a kind of central bank to the world’s central banks, warns that the inflation targeting framework is fostering a dangerous build-up of risk. Head of its monetary and economic ­department Claudio Borio says central banks must “feel like they have stepped through a mirror”. Having spent their lives struggling to bring inflation down, they now toil to push it up. Where once they feared wage increases, now they urge them on.

Borio challenges the intellectual underpinnings of central banking. For the past century it has been assumed that there is a “natural” (or “neutral”) rate of ­interest that balances the needs of savers and investors. If a central bank sets its policy interest rate below this natural rate, it will ­encourage people to run down their savings and lift spending, pushing inflation higher. If the policy rate is higher than the natural rate, people will save more of their income to take advantage of the higher rates, spending less, and inflation will fall.

The theory runs that while central banks set the short-term rate of interest, long-term bond rates trend ­towards the “natural rate”. But this natural rate of interest is an economists’ hypothesis — it can’t be seen or measured, except by economists’ models. Borio calls it an “abstract, unobservable, model-dependent concept”.

Low interest rates are one of economic theory’s worst ideas ever, a notion once universally understood by all and now understood by none. Economic theory will have to relearn the lessons of the nineteenth century. It is quite quite astonishing to see these errors compound and the undoing of this mess won’t be pleasant. So to the article’s end:

The RBA slashed its cash rate from 4.75 per cent to 1.5 per cent between late 2011 and late last year, triggering a house price boom that pushed up household debts by an average of almost 7 per cent a year.

This week the International Monetary Fund said household debts much above 60 per cent of GDP were a threat to growth and financial stability. The RBA’s measure of the household balance sheet shows debts have soared from 120 per cent of GDP to 137 per cent since 2011, putting them among the highest in the world.

Lowe worries that a small shock could turn into a much lar­ger downturn as households seek to repair their balance sheets. The danger is that debts are already so high that any rise in rates would crunch household spending, while rates are still low enough to make further borrowing attractive. With no path forward, the Reserve Bank is stuck where it is.

As for the theory that explains it all, you could go to Keynes, not The General Theory where he abandoned it all, but to his very orthodox 1930 Treatise on Money where he discussed the natural rate of interest in just the way it had been discussed since the end of the nineteenth century. Or you could go to the last two chapters of my Free Market Economics, whether editions one, two or three, since it is the same message in each.

Economic theory reaching the bottom of the barrel

Excerpts from a comment on Keynesian economics. Everything about this annoys me and is demonstrably wrong. The full comment is found at the end of this post

1) “Keynes’ mistake was not in his solution to a savings glut, since there is nothing wrong with the notion of using public works to absorb a savings glut

2) “the distortions created by excessive government intervention are likely to do far more damage than they solve over time

3) “neither Keynesian nor neoclassical synthesis are used by mainstream economists today

4) “both were well and truly discredited by the new classical revolution sparked by the Lucas critique, Friedman, Schwartz and others”

5) “unfortunately, new classical economics failed to explain the real world which enabled new Keynesian economics to emerge.”

6) “there are also a few very dopey economists who go the other way and persist with discredited ideas from the right, such as the Austrian school.”

So my comment on this comment.

1) A “savings glut” is a misinterpretation of the effect on business confidence after a financial crisis. That everyone goes into a shell for a few months is hardly surprising, whose effects are compounded by a reluctance of those with money to lend to others since no one really knows who is and is not solvent.

2) I absolutely do go along with the concern about governments misdirecting resources but the qualifier at the end, “over time”, makes me very suspicious. The damage caused by the distortions are immediate although it may take a while before the effects of misdirected production begin to show up, and here we are talking about even 3-4 years.

3) If I was told that the phrase “aggregate demand” had been purged from economic theory I might just be willing to go along with the idea that Keynes is dead and gone. But once you recognise that the Keynesian innovation was “aggregate demand”, the notion that Keynesian economics is dead is absolute nonsense. Until that goes, macro will only cause harm and almost never do a single thing right, other than by chance.

4) “New classical” economics is so absurd that it never fails to astonish me that it ever gathered a following, other than it pretended to be the refutation of Keynesian theory. This is what it really is. Keynes set up a strawman version of classical theory in The General Theory which he said was based on the supposedly classical assumption that there could never be involuntary unemployment. No actual pre-Keynesian classical economist believed any such thing, but New Classicals actually do. They have attempted to refute Keynesian theory by actually promoting Keynes’s strawman as the real thing!

5) New Classical theory gave up all pretence of being able to understand an actual recession after the GFC. Since it said no such things could occur – that all unemployment was voluntary! – they had nothing in their kit bag to explain the situation or to devise policies to deal with a set of circumstances they argued could never actually occur.

6) Not an Austrian myself – “JSM Classical” – but you can get a lot more sense in Mises than from just about anyone since he actually incorporates the role of entrepreneurs in how economies work, as do all other Austrians. They discuss markets and relative price adjustments. They see an active role for competition. I have my differences, but most of Austrian theory is as sound as you can find in the modern world.

Economic theory is at such a low level of insight that it fills me with a kind of despair, since as it is currently structured, it is part of the process helping to push the freest and most prosperous civilisation in history over the cliff.

As for the comment in full, here it is in all its irrelevance.

Keynes believed there was a diminishing return to capital and so there was a risk of a savings glut and hence lower consumption. His prescription was for public works spending to absorb this savings glut and and so maintain production. Keynes never suggested redistribution of either wealth or income which is what your anecdote implies. Indeed, Keynes was very much opposed to governments running cyclical deficits on recurrent expenditure, which is why he suggested that any temporary increase in spending to address a savings glut should be managed through public works.

The common misunderstanding of Keynesian economics stems largely from the fact that John Hicks wrote a book to interpret the General Theory in terms of neoclassical economics. As a result, the view of Keynesian economics shared by most people today is of Hicks’ neoclassical synthesis rather than Keynesian.

Keynes’ mistake was not in his solution to a savings glut, since there is nothing wrong with the notion of using public works to absorb a savings glut. The problem is that such savings gluts are exceedingly rare and transient at best which means that they will almost inevitably be over before any government can respond. In fact, the distortions created by excessive government intervention are likely to do far more damage than they solve over time.

Of course, neither Keynesian nor neoclassical synthesis are used by mainstream economists today. Both were well and truly discredited by the new classical revolution sparked by the Lucas critique, Friedman, Schwartz and others.

Unfortunately, new classical economics failed to explain the real world which enabled new Keynesian economics to emerge. This new Keynesian economics had little foundation in economic theory and so the two branches merged to give us the new neoclassical synthesis which is the mainstream of modern economics.

Whilst there may be much in the new neoclassical synthesis that is wrong, there is nothing in the theory which supports the redistribution of ether wealth or income. What this means, is that many economists may believe in redistribution but the economics itself does not support this, at least as far as the mainstream is concerned.

Naturally there remain a number of heterodox economists out there who support outlandish ideologies, such as a few Marxists, Sraffians and New Keynsians etc. There are also a few very dopey economists who go the other way and persist with discredited ideas from the right, such as the Austrian school. However, orthodox economics, and this includes Keynes, new classical and the latest new neoclassical synthesis does not support redistribution.

Thus we may chuckle at such amusing anecdotes, but this does not represent the problem and never did.

Bad advice from The Financial Times

Every time I think we are making progress on getting rid of Keynesian macro, I come across something like this from The Financial Times in the UK: Donald Trump’s trickle-down delusion on tax.

Today, debt is 77 per cent of GDP, productivity is flat and, not only have the major gains from female participation in the labour force been realised, but birth rates are lower, and the president is doing the best he can to limit immigration. Growth equals productivity plus demographics. Game over, unless something in that equation changes. . . .

But if you survey the economic landscape, it’s not like there isn’t plenty of money sloshing around. Dealmaking, asset values and corporate debt are at record highs. The money is there. The jobs are not.

I would argue that this is because there is not enough consumer demand. . . .

Sure, we can cut taxes. But it will not change the fact that we have a private sector market system that no longer serves the real economy. Business leaders who care about long-term growth and competitiveness need to think hard about how to fix that, and stop kidding themselves that a trickle-down tax plan is the answer.

They don’t want the US to cut business taxes but do want it to increase consumer demand! As dumb as FILL IN YOUR OWN and then some.

The productive horse must come before the spending cart

These are selected comments that followed Per Bylund’s article on the Mises website where he discussed More Spending does not Drive more Employment. I have emphasised those that supported Per’s argument. I will provide a bit of a commentary to see where things are going. I might add that the one and only text that carries all of this at an introductory level is my Free Market Economics now in its third edition.

A discussion on the use of our resource base in maintaining and building capital

Diane Merriam: Maintaining anything is still a cost, so it still needs a market.

Demand equals supply at a given price. Without the price mechanism demand can be infinite and supply zero.

There have been too many cases, when it’s only government involved, that haven’t been far off from that case … think the Bridge to Nowhere :). If maintenance of something *is* going to be done, there’s still a market for getting it done.

The only value available for investment is value that hasn’t been spent on current consumption.

It doesn’t matter how much how many people work, how hard, how much they invest, any of it. If what they produce isn’t what people want at the price it is offered for, it has *no* value. Value is assigned by the purchaser and, even then, only at the time of any specific exchange. You can’t simply put a price tag on something and say that is what it’s worth. If people won’t buy it at that price, then it’s *not* worth the price.

All business decisions are forward looking with no guarantee ever of a positive return

Q: What do you think: “…when business people see a profit opportunity. …” means?

DM: [Businesses] may *think* they see a market opportunity. But more often than not, when a new product or more of an old one actually gets to the market, they find they were wrong.

Q: You should have more faith in our private sector job creators.

DM: I don’t have faith that they will do any better than they already are. The FACT is that most new businesses and even large expansion of existing businesses FAIL. If they could reliably predict what will and won’t sell for how much, they would already be doing it. They can’t. Distortions of the market will make analysis even harder, resulting in even *higher* rates of failures than now.

Value added is what matters most

Q: But if there are people available to work, the business person will hire them and create MORE VALUE.

DM: Again, it doesn’t matter how many people are working. Unless what they produce is worth the price it’s offered at to the final buyers, *no* value was created.

There is *no* demand until *after* something is created. Every investment is a risk because of that very basic fact. And once something is created, there is still no guarantee that people will want to buy it, much less at more than the total cost of making it, or even enough more that a business wants to keep making it.

*Risk* is the defining characteristic of *any* investment. A consumer saying “I want something” means next to nothing economically. Even “I want something particular at less than this price at this specific moment given what else I could buy and also want” says nothing about what that consumer will want tomorrow or what they’re willing to pay for it tomorrow or that something new will not come out such that they don’t want any more of what they bought today afterwards.

Even then you’ve only scratched the surface of risk evaluation. As a business person, it’s not only guessing at what demand might be tomorrow or next year and at what price. What if the minimum wage goes up another 80 or 90%? What if the cost of this or that material needed to make what I produce goes up? If I want to invest my current available savings (or even what I can borrow) in product A, what will that do to my line of product B? What if inflation jumps back up again or interest rates go up? I see all this “new” money floating around and I know that is going to increase inflation and interest rates. By how much? How soon? For how long? I see a lot of cost increases coming down the road and I see that what I earn is going to be worth less than it is now. Can I risk even expanding current production? Can I afford to lose what it’s going to cost?

And even after all that analysis, most new businesses *still* fail.

All production is driven by entrepreneurs and not by those who might buy the product after it has been produced

Q: What about if consumers wave money in front of the noses of the job creatos and say “wakey wakey”

DM: The business owner would look at them and know that *they* are wakey wakey and have no idea what they’re talking about. Business owner looks at what they say they want, then how much they are willing to pay for it, then sees what the potential upside *and* downside is, then looks at costs and what they can afford to invest and what they can afford to lose if it doesn’t work out. By the time it’s all said and done, what people say quite often doesn’t work out in the real world.

The normal progression for business that open simply on the basis of what people say they want is funds invested, attempts made, followed within a year or three by bankruptcy. It’s just not that simple.

“For every complex problem there is an answer that is clear, simple, and wrong.” – H. L. Mencken

Look at the three states, I think it is now, who tried to implement a single payer plan … until they got the dollar figures on what it was actually going to cost, and that was under best case scenarios. All three attempts just quietly went away.

Simply because some people say they want something doesn’t mean it’s the right or affordable thing to make.

Jobs are not created by spending

Phil Miller: “The jobs are created by spending”

Jobs are created by entrepreneurs who take risks to satisfy consumer wants. You can’t have spending unless you have entrepreneurs first taking risks and producing products. You’ve got the cart in front of the horse.

Q: “Value and wealth are created by entrepreneurs and indeed money if they borrow it.”

PM: Wealth must first be created before it can be borrowed. You can’t borrow something that doesn’t exist.

Understanding the meaning of wealth and wealth creation

DM: Wealth does not equal value. Wealth is nothing but a numerical accounting of the assumed value that a person or business has at their disposal to spend or invest. It’s one of those loose words, along with others like inflation and money, that make it easy to obfuscate economic understanding among the general populace (and even many economists).

Of course entrepreneurs can’t create money. Neither can governments or anyone else. First the value has to be created. *Then* that value can be traded, either directly (as in barter) or indirectly (using an generally accepted form of value storage called money).

You can throw trillions of pieces of paper around and not one job will ever be created. Without the intermediary steps of deferred consumption (savings) and risk taking entrepreneurs you have nothing.

Money, in the formal definition, must be an actual commodity that has value in and of itself. The best commodities to use are durable, have high value per volume, are easily divisible, and do not *need* to be consumed.

Paper currency, when it is a claim on actual money, makes it even easier to use as long as the receiving party trusts that the actual money is and will always be available upon demand. When that convertibility is taken away, a major trust support is lost. Even the value as an intermediary of exchange becomes subject to the whim of the printer. If the printer prints more, then prices have to go up. Which prices go up and by how much can be any mix of end user prices and/or investment vehicles and everything in between. More paper, in and of itself, does not and can not create value.

Production comes first and demand only later

Leopardpm: It is just pure crazy that their are still folks in the world that are so confused as to think that ‘spending’ precedes production or increases demand. All one has to do is reduce the economy down to 1 or 2 folks and see how things work – this strips away the myriad of confusing layers and distractions which seem to plague peoples minds.

These people completely lose their ability to think just because a fiat currency is introduced into the equation, as if it acts as some magical incentive to drive folks all ‘wakey wakey’ in their search for wealth.

It is simply a logical impossibility for spending to drive the economy, no matter what a study may conclude or a person may ‘feel’ should happen…

Entrepreneurs are a breed apart and do not need to be coddled to get them to produce

DM: Entrepreneurs do not need a *good* economic climate, but they do need one that at least makes profit possible. The worse the climate, the worse the returns and therefore the less the growth that investment will result in.

Leopardpm: Suppose you and another person are in a forest and he has an item you desire and you have nothing that he values to trade for it – can you simply ‘spend’ to obtain it, or do you need to produce something first in order to trade for it?

Even though way over-simplified, it still highlights the underlying, fundamental point: someone, somewhere, somehow must first produce something before it can be ‘spent’. Debt can alter the time frame (ie: you could trade a debt for the item, but that debt must either be repaid or any future ability to trade debt will be greatly devalued), but not the principle.

Why do you insist that I am creating a strawman here? This article is about creating employment through spending, and it follows that it also is referring to the greater thought of ‘Spending drives the economy’… my ‘strawman’ is both of these….

“Your claim that there is someone claiming that spending preceeds production is just childish.” You must not get out much – the idea that spending proceeds production and thus is the main driver in the economy is repeated throughout the media and economic circles: “Spending accounts for 70-80% of the economy (or economic growth)” etc… perhaps you are not understanding the concept, or maybe do not hear what is said by the news et al?

Structure of production

Bob Robert: Your failure is in not understanding the structure of production.

In order to be used to build final products, the “capital” machines must be produced. Production precedes consumption.

In order to be used to produce the machines, the “capital” factories must be produced. Production precedes consumption.

In order to be used to build the factories, the “capital” bricks, iron, flywheels, electrical generators, and on and on endlessly (see: I, Pencil) must be produced. Production precedes consumption.

In order to be used to build all those things, the “capital” of individual laborers must be produced. Production precedes consumption.

It’s called “structure of production”, and it is something which both Marx and Keynes ignored utterly.

Summing up

Noah: ” the entrepreneur will employ people before demand is known — in fact, even before demand can be known”

Exactly. Well phrased.

” capital replaces labor (by making it more productive) ”

Which is represented by the “good” form of wealth inequality, since the return on output logically returns to the capital that is increasingly invested in greater proportion than to the labor that is reduced. Both the rich and poor get richer in real terms, but the return on investment/capital (that is replacing labor to increase output) means the rich get richer at a faster pace than the poor get richer.

What’s the problem, if this system is actually allowed to work (which it increasingly is not) under limited credit expansion? Unlimited credit expansion means ONLY the rich get richer, at least in nominal terms.

“the Keynesian avalanche”

What a wonderful phrase! This is very good article in the realm of those that show production/supply is primary over consumption/demand (rather than the other way around, as the the Keynesian avalanche led many to believe.

Perhaps too scattered as all such conversations are but an interesting and quite high level discussion.

Crony capitalism in action

A Keynesian stimulus is nothing other than a way for our elites to reward each other with other people’s money. This is a story that ought to lay bare what you need to know about public sector spending where the pretence is made that the stimulus is to help those at the bottom of the income pile. Here is the reality: Most Americans Still Worse Off Than Before Recession, Fed Finds.

Newly released income and wealth data from the Federal Reserve Board’s triennial Survey of Consumer Finances show that America’s richest families enjoyed gains in income and net worth over the last decade. Not part of the top 10 percent? Then your income probably fell. The data show that families ranked in the highest percentile saw an income gain of $16,300 from 2007 to 2016. Those below are still making less money.

A government has very poor judgement on what is value adding for a community but is absolutely perfect in being able to reward their friends.

RMIT is the George Mason of the South

It was certainly never intended that way but the School of Economics, Finance and Marketing at RMIT has become one of the great free market universities of the world. This has been posted at Instapundit just today following the post you see below on The Blockchain Economy:

INTERNET 4.0: Chris Berg (Australia’s free speech champion), Sinclair Davidson (of Catallaxy Files fame), and Jason Potts have put together The Blockchain Economy: A beginner’s guide to institutional cryptoeconomics. If they’re right, regulators and taxmen have a lot to fear.

And allow me to add myself into this equation. I presented my paper on Tuesday on “Classical Economic Theory Explained” which discussed the many many many things wrong with Keynesian macro – that is, all of modern macro – that the classics got right. And while the number of people who get this is quite small at the moment it is not quite zero and the numbers are growing. Therefore, let me refer you to this paper by Per Bylund More Spending Does Not Drive More Employment in which the following passage may be found:

Economists prior to the Keynesian avalanche, which contemporary Say’s Law scholar Steve Kates argues was all about dismissing the organic view of the market economy, had the same understanding of the economy as Mises. What drives the economy is not demand or spending, but entrepreneurship and production.

Indeed, JS Mill famously notes that “Demand for commodities is not demand for labour” in his fourth fundamental proposition on capital. While this statement is subject to much debate and most modern economists cannot make sense of it, it is in effect very straight-forward if one recognizes the role of entrepreneurs.

And if you want to want to read about Mill’s Fourth Proposition, you can go here. This was its first defence in more than a century but as said by Leslie Stephen in 1876, “it is the best test of a sound economist”.

Capitalism and ignorance

From Three wild speculations from amateur quantitative macrohistory but there is nothing wild about the diagram other than how ignorant most people are about what it shows.

In How big a deal was the Industrial Revolution?, I looked for measures (or proxy measures) of human well-being / empowerment for which we have “decent” scholarly estimates of the global average going back thousands of years. For reasons elaborated at some length in the full report, I ended up going with:

Physical health, as measured by life expectancy at birth.

Economic well-being, as measured by GDP per capita (PPP) and percent of people living in extreme poverty.

Energy capture, in kilocalories per person per day.

Technological empowerment, as measured by war-making capacity.

Political freedom to live the kind of life one wants to live, as measured by percent of people living in a democracy.

Two million years of “human” history where the only tools were made of stone, and then a bronze age, iron age, industrial revolution and now us.

We now have morons [who call themselves “progressives”!] trying to take us back in time to just where I don’t know, perhaps 1890, maybe 1920, but certainly to a time of greater poverty and fewer chances in life. The diagram is only for us because most of those trying to kill off our carbon-based energy sources would be too thick to understand any of it since the basis for their entire ideological view of the world is a hatred for the capitalist system that has transformed the human race.