Some Research Questions To Think About

|Peter Boettke|

Here are some questions that were buried in the comments section.  These seem to be some important questions to answer.  Earlier in that same comment, the question of co-movement was raised, and Garrison's discussion on this was invoked, but I was unclear whether Garrison's response to the co-movement challenge was considered successful or not. So perhaps that can be thrown into the mix as well.

During this past term in my Theory of the Market Process I course, I often discussed Cowen's Risk and Business Cycles book, but I also do not find the rational expectations criticism as serious a problem as many others do due to timing issues, a slightly different understanding of the meaning of rational expectations and efficient markets (one that is looser, but also more accepted --- see Fox's The Myth of the Rational Market for a discussion of errors canceling out at any point in time versus canceling out over time), and the fact that obviously we are staring at a situation where systemic errors were in fact made by economic actors (who I don't believe just one day woke up and were crazy rather than 'rational').  Perhaps I am not thinking hard enough about the criticisms of the Mises-Hayek theory.   What I honestly believe to be the case, though I could be completely wrong, is that most critics focus on the easiest and best written explanation (Rothbard's America's Great Depression), where the theory is stripped down to its essential parts and presented in the most general way to explain the "cluster of errors", and then they infer that many of the questions that arise in thinking about the theory in a more subtle way have never been addressed by Mises, by Hayek, by O'Driscoll, by Garrison, by White, by Selgin, or by Horwitz (and others).

Anyway, here are the questions:

1. Does the stock of money or the flow of monetary services (the product of the stock of money and its velocity) matter for intertemporal discoordination?

2. Does discoordination arise because of a systematic and persistent failure of entrepreneurs or is it really necessary? The 1943 Mises paper which is being discussed said "maybe entrepreneurs may stop being deluded by inflation in the future, so far it has not been the case" (said more clearly: in Mises's - and Hayek's - ABCT there is no compelling answer against the ratex critique).

3. Does the boom really helps growth (does real forced saving outweighs, at least in the first stages of the boom capital consumpion)? If not, why booms tend to occur in periods of high productivity growth?

4. What happens in an open economy? Can fixed or floating exchange rate eliminate international intertemporal discoordination? Does expansion in one country creates malinvestment in others? How much trade deficit is related to ABCT and how much to real profitability?

5. What's the role of financial markets, for instance consumer credit, non-monetary means of exchange (M2, MZM), insurance (or hedging) against entrepreneurial errors?

6. What is the role of risk in all these developments?

7. If monetary injections make capital goods more expensive, why investment doesn't fall (instead of rising) due to higher input costs? (this I think it's an argument used by Keynes in his General Theory, but doesn't make much sense).

8. Is a crisis at the end necessary or can the long term consequences of miscoordination take the form of a less flamboyant secular stagnation?

Comments

[Greg Ransom]

If you compare Hayek's various works on this, Rothbard really doesn't capture all of the essentials of the story, not as Hayek understands them.

E.g. Hayek explains how production goods and resources at the margin go from being economic goods to being non-economic goods at the turn of the boom / bust.

I don't think I've ever seen anyone even hint that they are aware of this part of Hayek.

But is seems clear that Hayek's "critics" aren't addressing Hayek's work or Garrison's work -- they are attacking Rothbard and pretending that they are engaging Hayek and Garrison.

Whether they even engage Rothbard is also questionable.

Pete writes:

"What I honestly believe to be the case .. is that most critics focus on the easiest and best written explanation (Rothbard's America's Great Depression), where the theory is stripped down to its essential parts and presented in the most general way to explain the "cluster of errors""

[Doc Merlin]

"8. Is a crisis at the end necessary or can the long term consequences of miscoordination take the form of a less flamboyant secular stagnation?"

I think short term crisis is preferable to bending the growth curve downward, even if it were possible to do so.

[Pietro M.]

Thanks for the post!

I think that the theory of capital consumption (capital undermaintainance, as Hayek would have preferred to call it) is a good explanation of comovements.

About ratex, there is an abstract discussion of the topic in ch. 2 of Time and Money. It says (in my interpretation) that in new classical economics ratex is a consistency condition (if agents are omniscient they can't systematically fail in making forecasts), but inside the Austrian framework it is selfcontradictory to assume ratex as agents lack a perfect grasp of the working of the whole economy. However, the problem is not justifying errors per se, but errors biased toward malinvestment*.

I don't think the probem is Rothbard's fault. Mises admitted in his 1943 response to Lachmann that his theory rested on an empirical generalization (entrepreneurs do commit systematic mistakes), and not on a theoretically microfounded justification.

Carilli and Dempster's paper on the prisoner dilemma comes closer to a solution: somehow money socializes costs and rational agents flock toward a socially inefficient equilibrium. The neoclassical framework of the paper is a good methodological fiction to prove that even under those conditions ratex may fail.

There is also a Garrison's paper about it**: I love that guy, although not literally.

A couple of comments on the issues I raised:

Issue #1 is a basic point of disagreement between Alabama AE and Virginia AE (my terms). I think velocity matters, but a study of injection effects should take into account money and money substitutes, their velocity of circulation, the role of securitization in bank and shadow banks... ex ante, I'd bet that the existence of an easy relation between the Mx's (or the Mx*Vx's) and intertemporal coordination is not to be expected: there are neutral and non-neutral movements in the Mx and the Vx and there may be no simple criterion to distinguish the two.

Issue #7 is not an issue at all, but most people (like Keynes, who charged Mises of logical contradiction on this topic) find it confusing.

* This is (one of) Cowen's arguments in his book. For him, entrepreneurs may forecast increased volatility and immediately downscale investments instead of causing a boom. I consider it unlikely (like ratex), but I can't write a full argument against it up to now (also because in certain conditions it may happen, like during a stagflation).

** "Since a "monetization risk," unlike a default risk, is born by holders and non-holders alike, there is no monetization-risk premium—separate from the economywide inflation premium—built into the nominal yield on Treasury securities. The very potential for debt monetization is what breaks the link between fiscal irresponsibility and some corresponding risk premium." (The roaring '20s and the bullish '90s). It comes as no surprise if rational agents under these conditions take into account monetary subsidies on risk taking and inefficiently act accordingly.

[Niko]

@Ransom:
Rothbard in AGD:
"Wasteful projects, as we have said, must either be abandoned or used as best they can be."
When a project is abandoned, it has no price so it becomes an non-economic good. Where is Rothbard not capturing all the essentials of the story?

Again in AGD:
"As for idle capital goods, these may have been totally and hopelessly malinvested in a previous boom (or at some other time) and hopelessly lost to profitable production for a long time or forever. A credit expansion may appear to render submarginal capital profitable once more, but this too will be malinvestment, and the now greater error will be exposed when this boom is over."
He also point in a footnote to Hayek and Prices and Production.

[Pietro M.]

"E.g. Hayek explains how production goods and resources at the margin go from being economic goods to being non-economic goods at the turn of the boom / bust. I don't think I've ever seen anyone even hint that they are aware of this part of Hayek."

Do you refer to the creation of submarginal capital during the boom, which remains hidden as long as credit is loose and makes Keynesian scream "insufficient aggregate demand!" during the bust? :-)

There are at least three people in the world aware of this :-D (many others, I'd bet). You, me (I wrote a short article in italian 2 years ago about "submarginal capital and unused capacity") and Prof. Huerta de Soto.

Pag 465 of the PDF of "M,BC&EC" cites Prices and Production: "Whatever engineers may tell us about the supposed immense unused capacity of the existing productive machinery, there is in fact no possibility of increasing production
to such an extent. ... The existence of unused capacity is, therefore, by no means a proof that there exists an excess of capital and that consumption is insufficient"

The existence of submarginal capital also helps explaining away the comovement problem. It doesn't square well in the triangle-based theory of the production process, as it requires fixed capital.

[Peter G. Klein]

"Does discoordination arise because of a systematic and persistent failure of entrepreneurs or is it really necessary? The 1943 Mises paper which is being discussed said "maybe entrepreneurs may stop being deluded by inflation in the future, so far it has not been the case" (said more clearly: in Mises's - and Hayek's - ABCT there is no compelling answer against the ratex critique)."

Pete, I don't think this argument bites very hard. The cluster of errors that constitutes the bust is an ex post phenomenon. Expectations, whether "rational" or deluded, occur (obviously) ex ante. Entrepreneurs can be fully rational in the Lucas sense, e.g., knowing that interest rates are below their natural levels, that some projects undertaken at these artificially low rates cannot be completed, that some entrepreneurs will not survive the shakeout, and so on without knowing exactly *when* the turning point will come. The inability to forecast exactly what the monetary authorities will do, exactly when the bubble will burst, exactly which projects are unsustainable, etc. does not constitute "irrationality" or delusion or systematic error.

[Current]

"E.g. Hayek explains how production goods and resources at the margin go from being economic goods to being non-economic goods at the turn of the boom / bust. I don't think I've ever seen anyone even hint that they are aware of this part of Hayek."

Hayek's changes between "capital-intensive" and "labour-intensive" methods of production during the downturn worry me.

When the economy changes in this way that will cause a change in the demand for money. We can't really tell which way. That will be added on top of other changes in the demand for money for the reasons normally discussed.

[Greg Ransom]

Hayek's has an _account_ of how the trade cycle turns things into economic goods, and then turns them into non-economic goods. The account matters.

The account provides a mechanism which is essential to the causal explanation.

Rothbard differs from Hayek substantially when it come to thinking about production goods, and when it comes to doing the economic of production goods.

I'd submit that this stuff matters.

Niko writes:

But I will grant that it is a long time since I've gone through the details of Rothbard.

"Wasteful projects, as we have said, must either be abandoned or used as best they can be."

When a project is abandoned, it has no price so it becomes an non-economic good. Where is Rothbard not capturing all the essentials of the story?"

[Greg Ransom]

What Peter Klein said.

[Greg Ransom]

What would be an example of this?

"E.g. Hayek explains how production goods and resources at the margin go from being economic goods to being non-economic goods at the turn of the boom / bust."

Think of a rare element used only in a single a highly capital intensive process with an extremely long production time, with an output that becomes potentially economically viable only with the expectations and capital costs existing during the boom.

When the boom crashes to bust, that rare element turns from an economic good to an non-economic goods.

[Matt Stiles]

I may be oversimplifying matters, but I find it useful to differentiate between rational expectations and rational action. All action is inherently rational, otherwise it wouldn't be taken. Yet ratex requires omniscience - an impossibility. Thus, someone may act rationally based on a set of false information and fail. eg. home prices always rise.

It seems that many have an insatiable desire to eliminate this failure from the face of the earth. But it is the attempts to eliminate failure that, in part, give rise to popular delusion and systematically irrational expectations. Whether humans are susceptible to irrational expectations for some other endogenous cause, I'm not sure. Bob Prechter has his own theories hereto.

[Roger Koppl]

Pete,

You wonder whether there is a "compelling answer against the ratex critique" for ABCT. If I'm right about BRACE and BRICE and the future of macro, then I don't think ratex is that big an issue. If you have heterogeneous, boundedly rational agents creating an ecology of expectations as in Arthur's El Farol model (aka the minority game), then you won't have strict ratex. Arthur and others found a "market psychology" in their artificial stock market, which had an ecology of expectations. ABCT might be improved by explicitly bringing in such an ecology.

I also think your list of issues omitted the state of confidence, which is important. As you know, my Big Players theory is precisely a theory of the state of confidence. I would note also, BTW, that it is "falsifiable" because it has "empirical content" *and* my co-authors and I have subjected it to a series tests that it has so far passed.

I think the state of confidence will be a nontrivial part of mainstream macro for at least a decade and probably more. We clearly lost confidence in Fall 2008 and I don't think the next generation of macro models will ignore that fact. This point is clearly linked to my earlier point as 1) a shock to an Arthurian ecology of expectations can generate cascades if agents are borrowing knowledge from each other, and 2) you can't really have a psychological state of confidence in a ratex model. I know some folks would say ratex models of self fulfilling prophecies *are* models of the state of confidence, which is why I stuck on the qualifier "psychological." I think that's where we're headed. As I say in my BRACE draft, ratex models of self-fulfilling prophecies don't get you enough market volatility. I discuss a paper of Farmer that tries to get around that. As far as I can tell, however, Farmer's model depends on inappropriate and artificial models of labor market infirmities. Basically, I don't think his lemons model of the labor market reflects the relevant facts on the ground.

[Niko]

@Ransom:
"Think of a rare element used only in a single a highly capital intensive process with an extremely long production time, with an output that becomes potentially economically viable only with the expectations and capital costs existing during the boom."

But that thing has to be really really big and important to cause big problems. In the end this element can be placed in the big shock theories, like end of technological progress, some kind of "we have no place to invest in" or "the world doesn't like what we have to offer."

This has no place, anywhere, in ABCT. In order to cause a recession/depression, this "rare element used only in a single a highly capital intensive process ..." has to be very very expensive and also has some really big investor behind it, a huge one, with a big market share, that is willing to commit such and amount of capital and resources for profits 100 years later. Are we talking about green technology?

So, when are we getting to ABCT?

[Peter Boettke]

Peter,

Just to clarify, these are not my questions, they are Pietro M's questions from the comments section.

I happen to agree with you about your point about ex ante and ex post.

Pete

[Jake McCloskey]

The bigger question in my mind is: where is the evidence? Low interest rates early in the decade could just have easily been caused by insufficient monetary stimulus as too much.

[Peter G. Klein]

Oh, right, thanks. I lost track of who was saying what.

Then again, we always agree. :)

[Jim Rose]

I find it surprising that so many concentrate on rational expectations when discussing Austrian business cycle theory (ABCT). Is Austrian business cycle theory the only modern business cycle theory that must reach such a high bar?

Many modern business cycle theories build on information costs and learning and explain that people make forecasting errors because of noisy information, and repeated monetary shocks keeping up this confusion.

A good general explanation of misperceptions theories of business cycle is in Alchian and Allen (1967), which Rothbard called a brilliant textbook. The business cycle is not based on money illusion or on systematic mistakes.

People take time to acquire the necessary information to interpret what has shocked the economy and what these changes mean for them. Additional shocks complicate this learning so there are more errors and confusion continues to affect market choices. Learning is neither instantaneous nor is the requisite information free to collate.

People must make do with the incomplete knowledge they have and make choices about market signals that might be spurious or be meaningful signs of change.

Mises, Hayek, and Rothbard all noted in the collection edited by Garrison, for example, that a one-shot monetary shock would be soon uncovered by entrepreneurs, the malinvestments quickly reversed, and the boom would bust. Monetary shock after monetary shock require repeated entrepreneurial revisions and it will take a long time for entrepreneurs to catch up. This is also in Alchian and Allen.

Rothbard (MES pp. 1002-1005) discusses one-time versus repeated and increasingly large in size monetary shocks as the basis for booms and the reasons for the ongoing deception of entrepreneurs. The shocks must increase in size to keep injecting more unanticipated noise into monetary and entrepreneurial calculations.

ABCT proposes a more complicated signal extraction problem than in say the Lucas-Phelps islands model. Dispersed and slowly unfolding information must be produced as each new monetary shock ripples its own unique way across the economy, passing through different hands each time. Only slowly does the requisite knowledge about the relative prices effects of each new monetary shock emerge as the result of market interactions and become open to entrepreneurial discovery.

What is perhaps dismissed too easily by Rothbard (but not Mises) is that under a gold standard, increases in the output of gold mining can be well forecasted by entrepreneurs. Rothbard's best ground is when he notes that "the credit expansion tampered with all their [entrepreneurs'] moorings." A stop-go monetary policy is by definition unpredictable. Gold output fluctuations are irregular but usually small.

A unique contribution of ABCT is the longer the boom, the deeper the bust. The lower interest rates delays sectoral reallocations by keeping afloat many firms that must close or shrink.

[Jerry O'Driscoll]

Jim Rose brings up a number of important issues. I agree with the relevance of Alchian and Allen. Price searching behavior undergirds how they analyze markets. Monetary shocks add to price uncertainty.

It is not an issue of a one shock, but repeated shocks. The Fed shocks financial markets every day. That is on top of all other, "normal" shocks. Kirznerian entrepreneurs must be hyper-alert.