It seems our Keynesian friend has decided to respond to my previous post critiquing his arguments against Austrian Business Cycle Theory. First, I appreciate his desire to respond directly and concisely (if incorrectly at times) to the arguments made. There should be more interactions like this in which ideas are challenged politely, so kudos to him. I’ve noticed his article is quite long, so I will target specific points of his for the sake of brevity. I wish to keep this debate crisp and productive, yet I fear it won’t be so short and simple.

Fiscal Stimulus?

To begin, he points out a supposed misstep in my argument that Keynesian fiscal stimulus goes to larger, more capital-intensive firms which doesn’t have quite the same affect on employment as is believed. He states,

this misses the after-effects and purpose of fiscal stimulus, which is increased aggregate demand. Increased aggregate demand is the purpose of fiscal stimulus, and this increased demand means more income for all businesses, not just the bigger ones. While the bigger ones might receive more at the start, and employment won’t immediately be boosted to a large extent, the effects are increased aggregate demand and increased income for all businesses and the utilization of idle resources.

If businesses are going to spend more money anyway, why use fiscal policy? Why not just use monetary policy? As I stated in my first post, fiscal policy is offset by monetary policy. But even besides that, if the point is to get more money in the hands of business who will create these positive externalities, why not accommodate them through bank lending? One might respond with the typical liquidity trap answer (which I addressed already), but that’s not what we’re talking about here. It’s simply about increasing aggregate demand, right? So allow me to answer why our Keynesian friend isn’t being a good little Keynesian like he thinks. As I said before, money is a normal good, in that when income rises the demand to hold cash rises. If larger firms receive more of the fiscal stimulus, that means those with larger incomes (smaller businesses have less obviously), are more likely to not utilize their cash in the way our Keynesian friend describes.

And, in fact, that’s something we witnessed after the great recession in which financial institutions and businesses (not just banks), sat on trillions of cash which did not circulate. There are several explanations for this, and in fact the very government policies like crowding out our Keynesian friend supports is often the reason! But on a more fundamental level, even Keynes doesn’t agree with him. Recall what we said about money being a normal good. Keynes was responsible for the concept of the marginal propensity to consume (MPC), in which a certain percentage of a marginal increase in income is spent on consumption, rather than being saved. The important thing is: the MPC is typically lower at higher incomes, so even Keynesian thinking isn’t very consistent here. Those with lower incomes should be receiving the extra stimulus if consumption is to rise to its potential. There are other points he misses like the money relation, but we’ll save that for another day.

Austrians typically agree with this very narrow point of MPC but word it differently saying something like “constrained by time preference, man will only exchange a present good against a future one if he anticipates thereby increasing his amount of future goods.” An increase in income will typically equal more money demanded, not spent. Monetary policy will therefore be more likely to enhance these externalities since it will better help marginal businesses who are in greater desire to spend, and in greater need of workers.

He makes a blunder here,

Another point he makes is that consumer demand, when artificially stimulated, is temporary. To know whether he is right or wrong, one must look at the actual “measure” of consumer demand, which, of course, can be measured. As you can see, output/income/spending for consumers is consistently increasing except during recessions, and that means demand is consistently increasing also. This demand doesn’t seem to be temporary, and it looks to be ever-increasing, so the arguments about companies deciding to not hire workers for short-term production don’t hold up.

First, my claim was not that consumer demand was temporary, but that businesses expected consumer demand to be temporary, hence why there is greater utilization of capital, and thus capital consumption towards the end of the boom. I would think a Keynesian would know the difference especially since expectations plays a big role in that mode of thinking. But more importantly, he says consumer spending is consistently increasing, except for recessions. But recessions are all we are talking about! No true follower of Keynes would say we need fiscal stimulus during a prosperous economy that’s at or near full employment, so why even mention anything other than during a recession?

Free Banking is Free?

Next our Keynesian friend shows a bit of a soft spot for a decentralized way to increase aggregate demand, but doesn’t fully endorse it for several reasons. I’ll try to put him at ease. He mentions Minsky’s Financial Instability Hypothesis (FIH) and Irving Fisher’s debt deflation. I’ll try to answer them both together:

Financial Instability Hypothesis:

Strong growth increases the profits of banks.

Rising income and employment makes leverage more serviceable.

Lending criteria considered prudent in the past are relaxed.

An increase in the supply of credit increases the leverage of the banking system.

Credit boom drives economic growth and asset prices.

Rising debt-to-GDP ratio increases the risk for an economy if there is an external shock.

Small increases in bad debt can make the system unstable.

Debt Deflation:

Debt bubble bursting leads to debt liquidation.

Distress selling and a contraction of the deposit currency happens (slowing velocity of circulation).

Price level falls and purchasing power rises.

Fall in output, employment, and profits.

Losses, bankruptcies, and unemployment rise.

Confidence falls and pessimism rises.

Money is hoarded more and velocity of circulation is slowed further.

For the FIH, why shouldn’t lending standards fall when income and wealth rise? If my income goes up, and I am able to acquire more capital, why shouldn’t my ability to borrow be enhanced by my ability to provide quality collateral in return? Also, banks in a free banking system are not able to increase the supply of credit/money willy nilly, because competitive note issue in a clearinghouse system prevents the over-issue of bank-specific notes. When net clearings are applied, this will cause the bank that issued the most credit, given their market-determined reserve ratio, to lose reserves which put them in a financial constraint. Without a central bank or an FDIC to bail them out, banks must be more prudent.

But let’s assume the worst, for argument’s sake. Let’s assume there is a debt problem and bankruptcy issue in the financial and banking system. Barring a hyperinflationary scenario, there would be banks with strong balance sheets, banks with weak balance sheets, and some in between. Many marginal banks may be squeezed for liquidity, and it seems without a lender of last resort or a government institution to provide funding, the banking system and thus people’s wealth will be severely damaged. But hold on, isn’t the role of a central bank to make emergency loans to banks in need? Why couldn’t profit-seeking banks with stronger balance sheets do that? A bank that is financially sound could make a high-interest rate loan to a bank that is being squeezed at a higher market rate, by postponing redemption of it’s reserves to customers in exchange for a higher interest rate paid later on. This “option clause” rate would be exercised until lending at the higher short-term rates fell below it so that option clauses were no longer necessary for banks to obtain liquidity.

This would allow customers with strong banks to yield a higher income not far in the future, and would allow otherwise solvent banks to not falter due to a liquidity shortage. This lending by stronger banks at higher rates would continue until market rates. This has historically worked fine.

Next, the point about debt deflation completely misses the point and makes me question if our Keynesian friend has read any of the source material on free banking. To be clear, there’s a distinction between demand side deflation (which is not good), and supply side deflation (which is good). The former is what free banking protects against. George Selgin gives a good explanation here,

Monetary equilibrium is a situation where the supply of money equals the demand, given a particular constellation of prices. The supply of money includes both the monetary base and various forms of credit. In monetary equilibrium, the monetary system is doing the most it can to facilitate beneficial trades. An excess supply of money induces people to make some trades that market participants will later judge not to have been beneficial. A deficient supply of money hinders people from making some beneficial trades. Under free banking (so the argument goes), the profit motive guides banks toward monetary equilibrium. The way it has done so in historical cases of free banking is through the clearing system. The clearing system is where the supply and demand for credit meet. If a bank, or other credit-issuing institution, has issued a greater supply of credit than people are willing to hold, it experiences losses of reserves. Losses of reserves lead to monetary losses, because liquidating assets may involve selling them at a loss. On the other hand, if a bank or other credit-issuing institution is issuing less credit than people are willing to hold, it is missing an opportunity to make a profit. Other banks, if sufficiently alert, will seek to fill the gap and capture the profits for themselves.

We would both agree, then, that deflation coming from the demand side (hoarding) can cause macroeconomic distortions, and free banking is quite effective against this. But there’s nothing wrong about a price level falling due to increases in productivity. This actually increases incomes as prices fall and nominal wages remain the same or rise slightly, enabling individuals’ ability to pay down debt while employment and output do not fall because the falling prices are industry-specific and expected, not general (at least typically). Note that former Federal Reserve chairman Ben Bernanke, who wrote “Deflation: Making Sure ‘It’ Doesn’t Happen Here” echoes our sentiment,

Conceivably, deflation could also be caused by a sudden, large expansion in aggregate supply arising, for example, from rapid gains in productivity and broadly declining costs. I don’t know of any unambiguous example of a supply-side deflation, although China in recent years is a possible case. Note that a supply-side deflation would be associated with an economic

boom rather than a recession.

Thus, our Keynesian friend confuses supply side deflation with demand side deflation, an elementary mistake. He also links to several posts about the historical problems with free banking. I could do the typical Austrian dance of referencing Larry White, Kevin Dowd, or George Selgin on the merits and faults of old free banking that would put those links into question, but if we’re talking about free banking in terms of the free competitive issue of bank liabilities, branch banking, free capital flows, etc. then it wasn’t the true free banking we desire. It had many good qualities and some faults, but it would take a huge effort to sift through the details to figure out whose argument is sounder, and I don’t want to drag readers through the mud here. Here is Selgin, again, on what I mean.

Then there’s this mess,

Secondly, there are problems that come with competing currencies, like networking effects (desirability of a commodity based on amount of others using it, making it hard for superior alternative currencies to overtake current ones), purchasing power stability is only one factor in choosing currencies (costs of switching, degree of acceptability are others), and the danger of forgeries when no switch happens (like it did in Somalia).

Did advertising die? Is signaling no longer a thing? Steve Horwitz clears something up,

before deposit insurance, banks could, and did, use a whole variety of ways of signaling their soundness, particularly by advertising their balance sheets and boards of directors. It’s true that the FDIC stamp is such a signal, but to say it’s “low cost” requires asking “in comparison to what?” The costs of deposit insurance are large when we include the ways it encourages risk. Advertising and other methods for banks to provide similar, if not better, signals, are cheaper, all costs included. Plus, we know from history that they were largely effective when other regulatory interventions did not needlessly increase the risk of contagion.

Heterogeneous Capital and Dead Debates

It’s slightly disturbing how our Keynesian friend sidesteps several of my specific points made in reference to his problems with ABCT, in order to make one overarching statement that the concept of Austrian capital theory and “roundaboutness” is wrong. He speaks of the infamous “Cambridge Capital Controversy”, and even links to an Austrian’s essay who critiques the Hayekian triangle (though the link doesn’t allow it to be downloaded so I don’t know why it was even linked at all since no one can see it). He also makes mention of Paul Samuelson’s comment on how the attack on the Neoclassical position is also a potent attack on Austrian capital theory. But let’s hear out Robert Murphy,

But does this mean that the conclusions of Austrian capital and interest theory are incorrect? Not at all! What Samuelson has done is simply invent a fictitious world in which there are only two ways of producing a particular good… More generally, the basic Austrian vision of the effects of saving can be summed up like so: If individuals are willing to sacrifice consumption goods (on the margin) now, this allows the creation of more tools, machines, factories, etc. than would have existed otherwise. This in turn renders labor more productive, so that after the new capital goods are produced and have been integrated into the economy, average output (and hence consumption) is higher than it would have been without the increased saving. Böhm-Bawerk felt that this story was accurate, because at any given time there are more technically efficient but very time-consuming processes “on the shelf” that are unprofitable at the market rate of interest, but would become profitable at lower rates. Does Samuelson’s model cast doubt upon this? That is, does Samuelson feel that in the real world—as opposed to the one with only two techniques of production—the “simple tale” as told by Böhm-Bawerk and others is wrong? No, actually he doesn’t. After showing how his hypothetical technology would allow for a drop in the interest rate to cause a lower capital stock and lower steady-state consumption, Samuelson says: Whether it is empirically rare for this to happen is not an easy question to answer. My suspicion is that a modern mixed economy has so many alternative techniques that it can, so to speak, use time usefully, but will run out of new equally profitable uses and is likely to operate on a curve of “diminishing returns”…

To be upfront, the reswitching argument isn’t a great refutation and here is why,

In conclusion, the possibility of technique reswitching underscores the great danger of basing economic propositions on purely physical facts, rather than subjective value judgments. To the extent that much of Böhm-Bawerk’s analysis rested on such an approach, it is therefore suspect. Nonetheless, the basic conclusions of Austrian capital and interest theory survive Samuelson’s critiques, largely because Samuelson misunderstood what the claims were.

Our Keynesian friend makes this mistake too,

Hayek’s argument, viewing ‘capital goods’ as materials which only retain their physical identity through a process of fabrication into consumable form, overlooks the grip that durability has in constraining the business man’s choice of productive methods. The span of the nine-year business cycle, to which his theory was meant to apply, is not long enough for a wholesale discarding of existing equipment during the latter half of its upward phase, say two or three years.

Hayek makes clear in his book Individualism and Economic Order that it is the subjective nature of market participants that matters. The reswitching debate doesn’t get any attention in the economics field for good reason… it’s not very important. Austrian Business Cycle Theory has issues, but this isn’t really one of them, and economists like Steve Keen (who was mentioned) have their own critics to worry about. Furthermore, I don’t think our Keynesian friend was paying attention to our earlier point about comovement in ABCT. He uses this quote,

One problem is asymmetry. During a boom when the structure of production is lengthened, the industries of goods of higher orders expand while the industries of goods of lower orders contract, and labor is bid from the latter to the former. During a depression, the reverse takes place. Why are these two processes not symmetrical in their effect? Why is the expansion of industries with higher goods and contraction of industries with lower goods associated with general prosperity and full employment, but the opposite is associated with general depression and unemployment?

He must have missed my point,

Our Keynesian friend doesn’t seem to be aware of one of the most basic tenets of ABCT, and that is the multi-stage capital structure and it’s many heterogeneous resources. He has a very “hydraulic” understanding of the theory in which consumption and investment must be at odds because he cannot visualize the economy as anything other than a simple two-stage economy, rather than a time-oriented production structure that is equally affected by the time-discount effect and the sound version of derived demand.

He’s clearly read the “basic-bitch” Austrian version of the business cycle, but any reading of Salerno, Garrison, or De Soto will show it’s not as simple as a trade off between consumption and investment. He may want to stop arguing with internet-Austrians on Instagram and read the source material if he is going to critique it (or at least read a non-Austrian who understands the models).

Liquidy Preference Preferred

There is some wasted space in this section with arbitrary quotes questioning the validity of the loanable funds theory (none of which are particularly good), but our Keynesian friend attempts to show how Hazlitt misinterprets the idea of liquidity preference,

However, Hazlitt and my critic don’t take into account that there are three sources of demand for liquidity money, and we can look at all of them with the law of demand– as demand increases, price increases (in this case the price of borrowing money)– in our minds.

He mentions 3 aspects of the demand for money: transaction, precautionary, and speculative. But let’s stop him right there: these are totally ambiguous motivations for demanding money, and cannot be objectively separated from one another. Here is Rothbard,

The first error in this concept is the arbitrary separation of

the demand for money into two separate parts: a “transactions

demand,” supposedly determined by the size of social income,

and a “speculative demand,” determined by the rate of interest.

We have seen that all sorts of influences impinge themselves on

the demand for money. But they are only influences working

through the value scales of individuals. And there is only one final

demand for money, because each individual has only one value

scale. There is no way by which we can split the demand up into

two parts and speak of them as independent entities. Furthermore, there are far more than two influences on demand. In the

final analysis, the demand for money, like all utilities, cannot be

reduced to simple determinants; it is the outcome of free, independent decisions on individual value scales. There is, therefore, no “transaction demand” uniquely determined by the size

of income.

His point about liquidity preference doesn’t pass the sniff test. By looking at interest rates, we can see that money velocity almost always falls at the beginning of a recession, regardless of whether interest rates are high.

1) How do you disambiguate the velocity of money, which is the inverse of the demand for money, into the three margins and 2) explain the lack of consistency in the relationship between interest rates and the demand for money. I propose our Keynesian friend consider 3 other margins, which are more concise and less ambiguous. Again, here’s Rothbard,

People, therefore, allocate their money among consumption,

investment, and hoarding. The proportion between consumption

and investment reflects individual time preferences. Consumption

reflects desires for present goods, and investment reflects

desires for future goods. An increase in the demand-for-money

schedule does not affect the rate of interest if the proportion

between consumption and investment (i.e., time preference)

remains the same. The rate of interest, we must reiterate, is determined by time preferences, which also determine the proportions of consumption and investment. To think of the rate of interest as “inducing” more or less saving or hoarding is to misunderstand the problem completely.

In other words, first we decide on our demand for money. Does it increase or decrease? Then we decide what proportion of that increase or decrease comes from consumption or investment. If less is spent on consumption when our demand for money rises, then interest rates (and our time preferences) fall. The opposite is also true. If, however, the demand for money rises, and it’s an equal split between consumption and investment then interest rates are not affected at all. The demand for money, therefore, is time-preference neutral, and by extension, interest rate neutral. While it most often does influence interest rates, it does not inherently do so.

Friedman and Garrison

Garrison claims that a credit-induced boom would be weakly reflected in the output aggregate, and instead booms represent helpful growth and busts represent an “extramarket force” presumably bad central bank actions leading to malinvestments that eventually lead into busts. The capital restructuring that causes the recovery after would be the boom. Thus, an Austrian bust-boom cycle. The problem with Garrison’s explanation is the assumption that credit-induced booms wouldn’t be the booms shown in the plucking model. An increase in consumption, even if “taken” from investment by force rather than time-preferences, would have the effect of boosting output.

I’ve said this before but our Keynesian friend is not a very good writer, at least in our exchanges. He often dances around a point and never lays it out sequentially. It’s hard to follow what he’s getting at half the time. So I don’t quite know what his issue is here. That being said, I’ll make an attempt to clarify.

In this part, what I’m saying is simple. The lack of proportionality in the boom and the bust in ABCT can be seen by first looking at Hayek’s secondary deflation. This is essentially simplified monetary disequilibrium. This occurs when a fall in asset prices, capital values, incomes, and employment has already commenced after the boom peaks How does one disambiguate this using Friedman’s model? That’s the first point.

The second point is also a challenge. During the boom, there is malinvestment and genuine growth that bad investments are “piled on top of”. Meaning, not all investments are liquidated and seen as unprofitable during the bust. Some businesses that provide quality goods will survive the recession, and may even thrive. Some firms that were making huge profits during the boom may go bankrupt and leave workers unemployed since they specific skills that are no longer useful during recession. What proportion of the total boom was due to this malinvestment, and how much to sound economic growth? If you cannot measure either of these points above, then of course it’s unlikely that Friedman’s model is going to confirm any symmetry in ABCT.

Which Natural Rate of Interest?

Our Keynesian friend says,

Wicksell suggests for theoretical reasons that the interest rates must be the same on all capital during equilibrium, and this condition for equilibrium is a uniform marginal efficiency of capital. To define this equilibrium, however, capital must be treated as mobile and homogenous. This is so it may move between sectors to equalize the rate of interest/profit, which can be fulfilled using the definition of value capital as capital, but not using a definition of capital defined in technical or quantitative terms. You also need to assume a tendency to general equilibrium, which is a debated economic concept (but alas that is for another article).

I’m not sure why he keeps thinking we are Neoclassicals adhering to Wicksell’s inconsistent view on the matter. It has more to do with Mises’ interpretation. So instead of getting bogged down on the very abstract natural rate, here is a link for our Keynesian friend to look at. It’s important because it’s a debate between two well-read Austrians who argue on the validity of the natural rate of interest: one in favor and one against (Note: It’s not the exchange involving the deleted profile, it’s the one below that). I ask our Keynesian friend to read the exchange and respond, if he chooses to, with who he thinks won the exchange and why.

there are other sources of recessions, and the ABCT does not preclude that other inefficient fluctuations (caused by frictions like output gaps, sticky prices, various externalities, etc.) exist.

I’m not sure I ever denied this (#2 in the link).

Conclusion

Our Keynesian friend comes to some strange conclusions, but makes some interesting criticisms of Austrian economics, several of which should not be ignored. That being said, I find Keynes to be a master manipulator. While he has some value, he is a perverter of market principles. Young and impressionable enthusiasts would be wise to avoid him.