Coordination Problem

Studies in Emergent Order

I'm happy to announce that the first volume of the new online journal Studies in Emergent Order is now available.  This journal was the outgrowth of a conference in the fall of 2007 sponsored by the Atlas Foundation's Fund for the Study of Spontaneous Orders that was organized by Gus DiZerega.   The papers in the first volume were from that conference. We had a second conference last month and those papers will be appearing in the journal sometime in 2009.  The papers in volume 1 come from both conferences.

The volume includes my own paper "Is the Family a Spontaneous Order?" which might be of interest to readers here.

Big thanks to Gus for all of his hard work on this.

The Financial Crisis of 2008: A View from Vienna, Virginia

I don't live in Vienna, VA, but it is the town next to us in Fairfax. But I cannot resist the irony of my approximate location.  In fact, a love the Vienna Inn (hot dogs and cheap beer) and I used to sponsor an Austrian graduate student meeting entitled "Friday's in Vienna" --- probably should bring that back!  But the location of "Vienna, Virginia" isn't meant to just hark back to the early days of the Austrian school from Menger to Mises, but also to signal the important Virginia School connection and the work of Buchanan and Tullock.  In short, it is not the Chicago price theory tradition applied to politics, but the Austrian market process tradition applied to politics and law that represents the unique intellectual blend that emerged out of GMU in the 1980s and since.  UVA and VPI had early versions of this mix in Dick Wagner and Randy Holcombe, but all the GMU students of my generation and beyond reflect this mix throughout their careers.  As I have tried to explain in my own instance, I see my position as analogous to Stiglitz's research agenda --- he worked within the Walrasian system, but tweaked two assumptions (asymmetric information and imperfect market structure) and then reworked the logic and reversed the results.  Similarly, for many exercises I want to work within the traditional social planning exercise but challenge the assumptions of omniscience and benevolence and rework the results.  I do give priority to the relaxing of the assumption of omniscience, and only relax the assumption of benevolence on the "third bite of the apple" -- but this is a methodological restriction done in the name of approximate value-freedom and in the hope of producing value-relevant research.

Anyway, this was the title of a talk I gave yesterday at the Atlas Economic Research Foundation.  My talk was divided into 4 sections.

Section I: From Market Correction to an Economy-Wide Crisis.  My argument was that what we are witnessing is the endogenous creation of a crisis as policy failures are compounding the problems.  Similar to how in the Katrina debackle the folly of man worsened the fury of nature, the policy path taken in the fall of 2008 has turned a market correction to previous government induced distortions into a potential system wide collapse (thank you very much Mr. Bush)

Section II: Some Historical Perspective: The Great Depression Revisited.  I argued that when you get to the big picture there are basically 3 explanations --- 2 of which put the blame on government.  First, we have the Austrian story of the boom-bust cycle generated by credit expansion in the 1920s.  Second, we have the Monetarist story of the monetary contraction in the 1930s. And finally, we have the Keynesian explanation of aggregate demand failure.  I argued that there is no reason that the Austrian and Monetarist explanations need to be at odds with one another as they pertain to two different time periods and both pinpoint government as the source of the problem.  I mentioned Mises/Hayek/Rothbard, but also Benjamin Anderson to support my claim about the credit expansion in the 1920s.  I mentioned Friedman and Schwartz to support my claim about the contraction in the 1930s. And I argued that the lesson we should learn from the 1930s is that the depth and length of the Great Depression cannot be attributed to monetary distortions (either credit expansion or monetary contraction) alone, but must be accompanied by a host of policy missteps that prevent markets from adjusting to changing circumstances.  Drawing on Robert Higgs, I highlighted how government policies in the 1930s and 1940s blocked market adjustment.  We had credit expansion followed by monetary contraction in concert with poor fiscal policy choices, the introduction of trade restrictions, and microeconomic regulations and restrictions.  Sort of perfect storm of government failure produced the Great Depression.  As I suggested, you do not cure a patient with bronchitus by shooting them in the chest, and Hoover and then FDR policies were not effective public policies, but instead a sawed off shot gun pointed directly at the chest of the economy --- with the predicted results.  We should learn from this, but we aren't!

Section 3: Some Theoretical Perspective.  I insisted that while there may be macroeconomic problems there are only microeconomic explanations and solutions to those problems.  I tried to weave a story that began with the demand that we explain the "cluster of errors" and thus put the critical explanation on monetary policy (money is 1/2 of all exchanges, if you screw with money you will screw with all exchanges).  However, as the exchange process works out in an economy, the microeconomics of relative price adjustments gets distorted when the accountability (high powered incentives) and calculability (valuation of assets) are muted by public policies.  It was my intent in this part of the talk to demonstrate how the Government Sponsored Entities, Community Reinvestment Act, etc. as well as the evolution of financial instruments such as mortgage backed securities were interconnected and weakened the accountability and calculabiltiy functions of the market economy.

Section 4: The Current Mess. So my explanation of the current mess turned on multiple policy failures.  Credit expansion under Greenspan, the breakdown of fiscal restraint which goes back much farther in our policy history, and perverse incentives caused by a variety of government actions which generated the housing bubble and have prevented the needed market adjustment.

And finally, Section 5: Why Have So Many Free Market Economists Failed to Stand Tall Throughout This Crisis?  I have four explanations:

(a) Monetarist fear of deflation and a Monetarist underestimation of the costs of inflation;
(b) Misunderstanding of the nature of economic theory and the argument for laissez faire that sees the defense of a free market as based on hyper rationality and perfect market conditions such that deviations from those conditions means irrationality and imperfect markets --- in contemporary economics this is the victory of behavioral economic explanations;
(c) Fear of a cummulative rot thesis and the problem of secondary depressions and the relationship to the too big to fail argument;

And, finally,

(d) The free market movement among economists was an illusion that many of our foundations and think-tanks believed in, but was never true.  The Washington Consensus was never "free market", it was just economists being economists (e.g., stating the obvious that incentives matter), but that policy recipe was always one of macroeconmic stabilization and microeconomic regulation.  So "we" have not had the victory of ideas and ways of thinking that we had thought since the Reagan and Thatcher era.  I also argued that there is a "preference falsification" issue going on.  If prominient economists can get away with labeling other economists as "right wing, wing nuts" there just aren't many in our profession who are willing to stand up to that, state clearly that they oppose the government policies, and don't care if they are called "right wing, wing-nuts" (or worse).  Better make some pro-active argument and talk about minimizing the costs of policy failures.

Anyway, I really enjoyed my time at Atlas, the questions that were raised and the discussion that followed.

(photo curtesy of Morgan Ashcom)

Don't Harp on TARP

Unless you're a corporatist.  Were's Luigi Villari when they need him?

Why hasn't the Left come out against this?  I seem to recall them saying something about the Military-Industrial Complex some decades ago.  Now all what they focus on is being green -- just like all the commercials I see and hear these days.

Addition:  Here he is:

COUNTS, GEORGE SYLVESTER (1889-1974). VILLARI, LUIGI (B. 1876). RORTY, MALCOLM CHURCHILL (1875-1936). BAKER, NEWTON DIEHL (1871-1937) Bolshevism, Fascism, and Capitalism
New Haven. Pub. by the Yale university press 1932. 1st Edition. No. of pages: 274. Description: 4 p. l. [3]-274 p. 21 cm. Subjects: Economic policy. Communism. Fascism. Capitalism. Near fine copy in the original gilt-blocked wine buckram cloth. Slightest suggestion only of dust-dulling to the spine bands and panel edges. Remains particularly well-preserved overall; tight. bright. clean and strong. Weight in Kg appr.: 1

Offered for EUR 56.00 = appr. US$ 88.42 by: MW Books - Book number: 52097

http://www.antiqbook.com/

And the Verdict is in...

President Bush can now officially be declared the worst president since World War II, if not the 20th century, if not ever. 

From a libertarian perspective, is there really anything he did right?  I'm not sure I can think of more than two or three.

At the risk of falling for the classic "King's Singer" example in comparative institutional analysis, it's getting harder to imagine Obama being any worse.  (Just as bad?  Maybe.)

The die-hard optimist in me has been sorely tested these last three months.

This Just In: Grad Students Occupy Building At The New School

From a Frederic Lee mass URPE email I just received:

As many of you may know, The New School Graduate Faculty building has been and will continue to be occupied autonomously by a large group of students since early yesterday evening. This is only the beginning, and we need you here - either to join us in occupation or to show your support!  

Why?

The original idea of the University in Exile, and the New School in general, was to be a safe-haven for academic freedom and scholarship free of oppressive political regimes, be they in Europe or America, and to be a center for critical engagement with important issues of our times. It was known for its deep thinkers, its innovative academics, and its committment to social and political justice as a bedrock of all other scholarship. The New School, under its current administration, is no longer able to fulfill that role of critical engagement and dissent. This continued betryal of our founding principles cannot be tolerated any longer, and the time has come to revive the University in Exile. This is a call for student action!

More here.

Finally, Lets Have a Serious Economic Conversation on the Underlying Theory

Tyler Cowen, as he is often capable of doing, raises questions about the fundamental theory underlying the so-called break down in markets that explains the current "crisis".

But since Tyler is a habitual contrarian (and this is a great skill to possess), he tends to underestimate the side that might have the answer and overestimate the side that has the critique.  This is good for discussion and it does force those who believe they have found the answer to work harder (always a good thing).  However, I would argue that the economic theory criticisms in this instance are misplaced and thus the exercise ultimately leads to a confusion among interested laymen when theory is employed to address questions of public policy relevance.  The simple reason, the socialist calculation argument has nothing to do with general equilibrium economics.

In fact, this has been a problem with Tyler's analysis of the financial crisis throughout.  Under conditions that would result in a general competitive equilibrium, the disturbances of monetary and credit expansion would be non-existent.  In fact in Tyler's Risk and Business Cycles book, which makes an outstanding contribution to the Austrian literature by demonstrating the sensitivity of traditional Austrian results to assumptions, makes this contribution by tweaking the assumptions in the model to such an extent that the Austrian type conclusions do  not make sense.  But of course they don't make sense if you assume rational expectations and perfect capital markets.  So from an "economic model" point of view, the sort of "cluster of errors" that result when distortions in a nominal variable (money) lead to distortions in the real variables (the pattern of exchange and production).  Such distortions do not occur in a world of rational expectations and perfect capital markets by definition.

But this is not new to the Austrians, Mises in fact wrote an article in Economica (1943) on "elastic expectations", and while he did talk about Lincoln's law (you can fool some of the people some of the time, you cannot fool all of the people all of the time) and thus was not ignorant of the basic intuition of money illusion, it didn't follow in Mises's framework that one must go the whole way to say people can never be fooled.

If one buys into Cowen's rendering of these issues, the Austrian presentation is just an earlier and immature presentation of the theory of the business cycle and when updated to be consistent with modern theory can no longer be sustained and rightfully should be discarded.  All that is left is non-economic explanations such as psychological delusion --- e.g., irrational expectations, herding behavior, and collective pessimism, etc.

The Austrian understanding of monetary theory and the market process represents an alternative to this view.  As I have tried to point out several times (unsuccessfully), the Austrians represent a unique position in economics because they begin with a full embracing of the heterodox problem situation, but through analysis result in more or less traditional conclusions about complex interconnections and social cooperation under the division of labor.  To most economic thinkers, the conclusions can ONLY follow if the orthodox assumptions hold. Deviations from those assumptions, result in deviations from the conclusions.

But Mises pointed out that the mechanical interpretation of the quantity theory was flawed, but he didn't accept the conclusions of monetary cranks and instead argued for a process oriented understanding of the quantity theory.  Similarly, Hayek rejected perfect competition, yet he didn't reject the important role that competitive market process plays in the discovery, communication, and use of knowledge.  And both Mises and Hayek did not make the socialist calculation argument based on equilibrium prices, it was in fact disequilibrium prices that are doing the job of enabling economic calculation and producing complex coordination of economic activity.  In fact, if you read the pages around 99-101 in Socialism closely, you can see Mises's arguing that the monetary price system does this with prices serving three unique functions --- an ex ante function, an ex post function, and a discovery function.  None of these functions matter if prices perfectly reflect opportunity costs and production is at the minimum point on the average cost curve at every point in time.  Nope, as Mises put it clearly, the problems with socialism are problems of dynamics, not statics.  As Hayek put it, the only economic problems society confronts are problems of change.  Advanced economics is about adaptations to changing conditions.

In the first issue of the Review of Austrian Economics that I edited, there was a paper by Leland Yeager entitled "Should Austrians Score General Equilibrium Theory?"  Yeager chided the Austrians for their abusive language toward the great contribution of General Equilibrium Theory to economic knowledge.  Yeager had a point and it is an important point.  But ultimately, his argument rests on economists understanding complex interconnections and interdependencies.  What happens to the price of copper in NY when a revolution in Chile takes place?  Or, how is it that the common woolen coat ends up on the back of the day laborer?  Or, who really does know how to make a pencil?

The real question is not whether or not this point about complex interconnectedness is a vital to economic understanding, but whether the formal model of general competitive equilibrium is the only way (let alone the best way) to maket his point.  If it was, then we would need to live by those assumptions and die by those assumptions.  But this is precisely the argument that the Austrians have challenged from day 1 and Menger's objections to Walras's presentation.  They might have been talking about something similar but they did so differently and the differences matter far beyond style of presentation.  Mises and Hayek were wrong in their assessment at times when they claimed that the differences were only differences in style not substance.

So the sort of gross substitutability and stability questions that Tyler discusses ARE important questions inside of the equilbrium model.  And Fisher's challenge is real --- what faith can we have in the general equlibrium conclusions unless we understand the disequilbrium processes that produce the equilibrium results.  Fisher's book (and Presidential Address to the Econometric Society) is huge.  But the answer is not in the formal theorizing that he engaged in.   The Davidson critique of gross substitutability is an important critique of the formal model and the orthodox problem situation. But again, the conclusion that market order is not sustainable doesn't follow.  In both instances, the "solution" is to be found in the literary economics of the Austrian school.  The "appreciative theory" of the entrepreneurial market process outdistanaces the "formal theory" of equilibrium economics and its critique by heterodox economists.

Heterodox problem situation, but orthodox conclusions about social cooperation under the division of labor.  Lets assess the Austrians on their own terms.

Can Regulators Enforce Their Own Rules?

Bernard Madoff's alleged $50 billion fraud is another interesting example of the limits of governments to enforce their own rules. As this opinion piece in today’s Wall Street Journal argues, in spite of the huge increase in the SEC’s budget since the fall of Enron (from $377m to $900m) and its army of staff devoted to enforcement, they didn’t notice that perhaps the most successful hedge funds manager was a fraud (when many people in the industry suspected as much).

In the current times, there is little hope that governments will take notice of their own failures, and draw the right conclusions. SEC failures give credence to Peter Boettke’s project on anarchy. Anarchy as a Research Program should be high on the Austrian agenda. The more rules governments must enforce, the less they will be able to do so adequately. Instead, one should rely on the incentives people have to successfully enforce the arrangements they themselves establish or on the reputation of others to enforce those arrangements. As the WSJ puts it:

The fact is that the only people who seem to have taken concrete action to protect investors from Mr. Madoff are private research shops like Aksia LLC. Its analysts did the real work of figuring out that Mr. Madoff's claimed investment strategy couldn't be happening at the volumes he claimed to be trading. Likewise, it was the short sellers who first blew the whistle on Enron, while the SEC was clueless and the firm's auditors were asleep.

The SEC not only aims at stopping activities that are generally legitimate and desirable, but when there are cases of actual fraud, the SEC can’t stop them. The SEC is another agency that should be abolished. Again, one can only agree with the WSJ and prepare for more useless public spending:

There's a lesson here for investors and Congress. Instead of shoveling more money and power to the regulators who already had plenty of both, let's take care not to overregulate the people who actually warned about Mr. Madoff's miracle returns. Law enforcement is useful in punishing wrongdoers after the fact, which will deter some crooks. But expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff.

The Market Is An Ecological System

I posted this over on our Economic Way of Thinking blog. 

I often hear somebody complain "Why are there so many different cereals in the grocery isle?  We don't need all that!"

My response:

True.  In fact, we don't need any cereal.  And do we really need all the different birds above our heads, too.  Who needs that variety of trees we see in parks and woods?  Who needs all the different grasses, flowers, weeds?  And so on.

Dan Mitchell on Why Keynesian Fiscal Stimulus is Bad Public Policy

I went to graduate school with this guy.  Good job Dan!  I think we should, as a matter of educational purpose, have a lot more of these sort of videos available on you tube.

Partial Credit Cassandra?

I just happen to come across this entry of mine from just about a year ago.  Can I get some partial credit in Pete's Cassandra poll?

One worry is that even in this world, a monetary inflation that did not show up as significant price inflation due to a productivity increase that offset the upward pressure on prices would go unnoticed as the price level remains the official gauge of inflation. 

Another worry is that we'll see more sector-specific "booms" thanks to unwarranted credit expansion, possibly due to a regulatory intervention that distorts interest rates and the risk-return trade-offs in those sectors.  The S&L crisis might fit this story in some ways and so might the housing bubble. 

However, the bigger problem at the moment is the moral hazard issue the Fed has created via the housing market.  Jerry O'Driscoll has a nice piece in the November Freeman that makes the argument that the "Greenspan doctrine," whereby monetary policy makers cannot detect asset bubbles but can detect their collapse and should offset their fallout, led mortgage lenders to believe that their actions were risk-free because the Fed would inject funds to bail them out.  Well guess what we're seeing right now?  Having created this precedent, what is to stop other sectors from figuring their losses will get bailed out as well?  The result of this might well be both serious micro distortion directly and inflation more generally.  Both the gold standard and free banking would be unable to create this moral hazard problem.