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Response to Dr Horwitz’s thoughts

By Lorenzo

Dr Horwitz’s thoughtful and generous response to my original post is useful in clarifying what a serious Austrian school economist thinks and correcting some of my misapprehensions. It seems to have been a useful exercise, to provide reactions to Austrian commentary from someone much more familiar with mainstream economics. Even better, I now have something I can point to correct what Dr Horwitz rather nicely calls “consumer Austrians”.

Dr Horwitz has also provided useful links, such as Peter Lewin’s Capital in Disequilibrium. Though not always useful in the sense of being persuasive. I have never been comfortable with the Austrian framing of action in terms of plans by economic agents, in part because it smacks of responding to socialist touting of plans, a sort of high modernist hangover. Reading Peter Lewin’s book has crystallised the rest of my discomfort. Speaking as someone in business, the notion of a specific plan is not how one thinks of capital goods. It is about creating a capacity to produce that will (hopefully) pay its way across the flux of commercial circumstances. You do not have a definitive plan, you have an intent and associated estimations and you manage use of the capital goods as you go.

To invest in capital good(s) is to purchase capacity, capacity that typically expands production possibilities. Production possibilities that are not likely to be fully predictable, as some may only reveal themselves in use or once the capacity is there. One does notpurchase a production path (except in retrospect) for that is revealed over time. The hope is that the manifested production path is not, overall, below break even for the cost of the capital good. Having a plan, in the sense of pre-specified actions, is typically a way to retard performance through failing to respond quickly and effectively to new information and possibilities.

If the above is included in what is intended to be covered by the term ‘plan’, then it is highly misleading terminology and should be abandoned for something clearer.

Austeria
It remains of concern, the way folk who regard themselves as followers of the Austrian school are so frequently so arrogant and abusive (and, according to Dr Horwitz, often don’t understand the school of analysis they are so attached to). They are so, fairly clearly, because they believe they are possessors of “self-evident” truths about matters economic which follow from the inner logic of economic life. Since it is not a matter of competing empirical claims, but of intrinsic logic which has already laid bare by the Austrian school, they are left with only malice and stupidity to explain differences of economic opinion.

This embrace of a self-righteous “self-evident” rationalism is exacerbated by the moral commitments that the Austrian school comes with. Harold Demsetz’s rather grumpy response (pdf) to an attack by Walter Block on himself and Ronald Coase provides an nice example of economists discussing the positive economics and being subject to a moralising attack from an indignant Austrian.

So consumer Austrians (to use Steve Horwitz’s term) act like Eric Hoffer True Believers. No evidence or argument pierces their armour of self-righteous certitude. There is an Austrian form of political correctnes–political correctness as defined by Matt Ridleyof ought implying is–whereby economic phenomena are treated as if they are the way they ought to be for Austrian analysis to be correct and for Austrian normative preferences to be optimal policy. I vividly remember listening to a young Austrian economist tell his audience that “by definition” what government did could not be investment.

There is also a recurring failure to acknowledge that von Mises and Hayek got the 1930s Depression very seriously wrong (regarding appropriate policy response), as Hayek later admitted. With the result that their would-be acolytes are getting the Great Recession wrong, for essentially the same reasons. It is extremely poor advertising for the virtues of Austrian analysis if it attracts such unfortunate outlooks and behaviour.

On the other hand, as noted above, Dr Horwitz’s comments will be a useful rejoinder to such. (Who, as Dr Horwitz implies, much of my original comments were directed to.)

Of course, the “Austerians” (the Austrian supporters of austerity), as they [and other supporters of austerity] have come to be called, are not the only ones recycling past mistakes. If one reads either version of the paper (pdf) by Barry Eichengreen and Peter Temin, The Gold standard and the Great Depression, and replaces gold standard with inflation targeting, one gets an almost perfect description of the current failures of central banks and the mentality behind such; of the current mentality of the US Federal Reserve (the Fed), the European Central Bank (ECB), the Bank of England (BoE) and the Bank of Japan (BoJ). Particularly when the Eichengreen and Temin say (p.19 of the NBER paper):

policies were perverse because they were designed to preserve the gold standard, not employment.

Replace gold standard with inflation target and that is exactly what has been happening in our own time. Indeed, it was worse than that as the Fed and the Bank of France were not even “doing” the gold standard properly (pdf). Just as the ECB and the Fed are now not even doing inflation targeting properly. In all these cases, the central banks are and were being too restrictive. They acted and are acting, in effect, like conventional monopolists; underproviding their product in order to maximise return–the return being the “sound money” reputation of the officials involved and, after disaster unfolded, in refusing to change course, seeking protection from explicit or implicit responsibility for economic disaster.

Dangerous presumptions
Which brings me to my first specific disagreement with Dr Horwitz, his claim that:

Austrians emphasize inflation more because it has been and will be far more the real-world problem in a world of government central banks that have a strong incentive to err in the direction of inflation as a way to reduce the burden of government debt and raise revenue.  After all, historically, that’s where central banks came from:  governments created them when they could not raise revenue, especially for wars, through other means such as taxation or bond issues.  … in theory inflation and deflation are “equally” important phenomena, and my book argues that case, but in practice?  Not so much.

And that

As I noted earlier, there are very strong theoretical and historical reasons to do so as an empirical matter.  Central banks were born in the crucible of inflation  it is their raison detre.  They do make systematic errors in that direction because virtually every incentive they face is to do so… Yes, deflation can cause real problems and can’t be ignored (I’ve taken heat from other Austrians for paying too much attention to deflation), but Austrians are living in the real world more than Lorenzo by recognizing the historical fact that central banks are almost always inflators, not deflators.  Their mistakes are not random;  they are in fact systematic because the incentives are there to make one type of error and not the other.

Actually, central banks were born in debt management. This could be, but was not always, inflationary during wartime. Under some circumstances there is an inflationary incentive, but since the history of central banks dates back to the late C17th (central banking dates back to the founding of the Sveriges Riksbank in 1664, and the founding of the Bank of England in 1694), we can see this is not always the case. (The Bank of England, in particular, presided over long periods of stable, or at least non-inflationary, prices.) We should have no presumption about the direction of central bank failure; indeed, it is precisely such a presumption which during the 1930s did and is now doing its destructive bit to help central banks avoid accountability for their grotesque refusal to take responsibility for ensuring that there is sufficient money, and associated expectations, to keep the level of transactions on a stable path.

It is also revealing that Horwitz finds himself criticised from fellow Austrians for taking deflation “too” seriously. Presumably, taking unexpected disinflation seriously would be even more problematic, yet it clearly had much to do with current problems.

Regarding Dr Horwitz’s question:

But that does not exclude the possibility that the 20s involved an inflationary boom that produced the original downturn in August of 1929 (which precedes the stock market crash of course). … Austrians are interested (though not exclusively) in explaining why the turning point happens in the first place.  The typical Austrian business cycle story is sufficient, but not necessary, cause of a bust.  But saying that other factors were in play, such as in the Great Depression, does not, by itself, exclude the possibility that the origins (though not depth and length) of the bust are to be found in prior inflationary boom.  Let’s go look and find out!

As Dr Horwitz implies, the 1929 Crash is not very interesting. No more so than the 1987 Crash, which was of comparable size but without associated economic disaster. Said economic disaster having almost nothing to do with the 1929 Crash and everything with the (massively deflationary) policies of central banks. (On the matter of timing of the downturn, I would give some weight to the actions of the Bank of France [pdf], rather than just the Fed’s.) Hence the importance of not having a presumption about the direction of central bank failure. The two great central-bank-induced failures of the last 100 years have both come from central banks being far too restrictive, far too concerned about monetary value credibility. The damage from these two episodes have vastly exceeded the harm from periods of inflationary bias. Particularly when one adds in the effects of deflationary policies in Italy after World War One and the “strong money” policies in interwar Britain during the 1920s.

Giving too much credit
As he suggested, Dr Horwitz’s essay on Say’s Law from an Austrian perspective is well worth reading. Alas, I had the normal reaction I do when reading Austrian analysis; I am nodding along with the comments on information and markets as discovery mechanisms (particularly obvious when your business really does not have any identical product to compare prices with) and then we come to the analysis of the business cycle and I find myself suddenly very underwhelmed. (Especially with the apparent implication that inflationary central banks are required for the business cycle to occur.)

Yes, we have this clear picture presented and then one asks, but what is the evidence for this? It is a nice story, but why should we treat it as other than, at best, one way economies can run into difficulties? Australian experience over the last two decades makes the Austrian business cycle analysis much less plausible. The Reserve Bank of Australia (RBA) has been running a policy mildly more inflationary than the Fed, ECB and BoE, and significantly so than the BoJ, yet has avoided the recessions that have bedeviled all the aforementioned economies.

The Austrian business cycle story is both a production cycle and an asset price story. The asset market I am most familiar with, the housing market, simply does not conform to the postulated pattern. This is very obvious in recent US economic history, where different housing markets have had very different patterns under the same monetary policy. (Which is one of the reasons I do not accept Dr Horwitz’s analysis of [pdf] the Great Recession, or his suggested policy response.)

When one examines the operation of housing markets, it is very clear that it is supply constraints that are by far the most important driver in (housing land) prices. That the bidding up of prices due to supply constraints then encourages further such bidding because of housing land’s apparent revealed excellence as a store of value.

Why could this not be a more general pattern–that the boom runs into supply constraints that leads to overshooting of factor and asset prices? A result of the response of output to demand being “lumpy” due to capital and production processes being heterogeneous resulting in uneven expansions of capacity. Prices then fall as orders bottlekneck, creating a negative income expectations and wealth shock which leads to an increased demand for money which, if not compensated for by an increased supply of money, leads to a transactions crash (i.e. a “bust”/recession/depression); in a monetary exchange economy, recessions being always and everywhere a monetary phenomena.

A pattern that is entirely “natural” and is not based on some weird blindness of entrepreneurs to government policy whereby they get repeatedly fooled by government manipulation of interest rates (the Austrian story) and engage in remarkably overconfidentindefinite projection of interest rates. (As Peter Lewin notes, there is no particular reason to think that entrepreneurs will not “see through” the inflationary nature of such policies.)

The RBA has managed, since 1991, to keep the Australian economy from sliding into recession precisely because it has tightened monetary policy when things are running “hot” and loosened them when they are running “cold”. A business cycle pattern which has little or nothing to do with credit inflation, and which has effectively been managed into mildness by an active central bank running a mildly more inflationary policy than other major Western countries, really is not a good place from which to find the Austrian analysis of business cycles plausible.

Note, I am not saying the above is the only way a boom-bust cycle could occur (any appropriate demand or supply shock which led to an increased demand for money not matched by increased supply could have the same effect), I am merely pointing out that it is an entirely plausible way such a cycle could occur where the basic fluctuation is “natural” to the economic system, particularly in an economy with technological innovation.  One that is much more plausible than the Austrian “stupid entrepreneurs” and “it takes an inflationary central bank” theory of the business cycle.

If we reject the Hayekian notion of uncertainty as simply being dispersal of knowledge (which market prices can fully deal with, if allowed to) and accept the Knight-Keynes-Schumpeter approach that uncertainty represents the reality that some knowledge is simply missing (starting with there being no information from the future), then there are further grounds to accept some natural economic instability; even more so with technological innovation (pdf).  But even in more technologically stable markets, the inability to know when turning points will occur (no information from the future)–such as the inability to know when the self-fueling apparent revelation of housing land as a superior store of value will collapse–creates overshooting and price collapses.

I am also curious why, on the Austrian story, wouldn’t people be really fooled when interest rates are near-zero? “Great, I can invest all I want at almost no time cost!” In reality, to entrepreneurs, interest rates are only a cost whose likely future path has to be considered; the income expectations arising out of the current commercial circumstances also matter. That this is so is particularly clear in present circumstances, when the monetary base in the US and Japan is very high, interest rates are very low, yet folk are not investing all that much precisely because their income expectations are so poor. (In Australia, the monetary base is much lower, interest rates are higher, and investment and economic activity is doing rather better, thank you very much, because income expectations are much stronger.) That, in monetary matters, quantities do not speak for themselves is something Austrian analysis should be comfortable with; that prices also do not speak for themselves, perhaps not quite so much.

As noted above, particularly due to my knowledge of the heterogeneity of housing markets, I did not find Dr Horwitz’s analysis (pdf) of the Great Recession and appropriate policy response plausible. It seemed to be a case of “there is a standard Austrian story to be told and it is going to be told yet again, damnit”. I much prefer Clark Johnson’s analysis (pdf).

But Dr Horwitz’s analysis is a nicely clear statement of the Austrian business cycle theory, and associated concepts. The Austrian story assumes even flow in access to resources (i.e. no fluctuating capacity constraints), no macro-shifts in consumer time preferences and appears to gloss over the role of risk and uncertainty (and shifts in level and framing of same) in time preferences. Accepting the reality of all of them would, of course, undermine blaming the business cycle on inflating central banks.

I was particularly unimpressed with the following:

That the capital goods industries expanded during booms and contracted during busts was an empirical observation that demanded explanation in any theory of the cycle

This struck me as an unremarkable, even trivial, observation.  Of course production of capital goods expand disproportionately in booms and contract disproportionately in busts, capital goods have much longer transaction horizons than consumer goods. Their value is fundamentally based on expectations about their role as a continuing source of income. So they will be far more sensitive to shifts in expectations than consumer goods. All the above observation tells us is that capital goods, as assets, have expectations-based value and that there is a business cycle (i.e. commercial activity, and the expectations derived therefrom, goes up and down).

As for the housing and financial market problems that led to the Global Financial Crisis, the destruction of prudence, and the unstable effects of innovation (these being magnified by the destruction of prudence encouraging perverse innovation), were much more important than monetary policy in causing problems in finance markets. The “micro” features of finance and housing markets were more important than the macro effects of monetary policy. Where monetary policy really mattered was in the aftermath, with the failure to respond to the increased demand for money.

Dr Horwitz also re-runs the standard Austrian attack on treating capital as an aggregate:

Because capital is, for the Austrians, always embodied in specific goods, it cannot be treated as an undifferentiated mass. Entrepreneurs purchase inputs or build machines that are designed for specific purposes. They cannot be costlessly redeployed to an infinite number of other uses the way the homogenous conception of capital might suggest.

Well, yes, up to a point. For aggregation is necessary for action over any scale; a corporation aggregates, a state aggregates. Yes, nuances are lost but this does not disqualify such abstraction. A capital-rich society is very different from a capital-poor one. One where labour income depends on the labour/land ratio is very different from one where it depends on the capital/labour ratio. And there are useful things to say about such differences.

Only congenial complexity
While I agree with Dr Horwitz that markets are generally superior allocation mechanisms, the optimum private/public border can be a complex question. The-market-as-superior-allocation-mechanism can slide very easily into an unfortunately simplistic market fundamentalism. I take Dr Horwitz’s point about Austrian rejection of standard equilibrium analysis, but there is in Austrian economics a deep confidence in the coordinating function of markets, particularly prices, that easily becomes dangerously dismissive of the possibility and, in the circumstances of now and the 1930s, the reality of coordination being restricted to very sub-optimal outcomes by, in the context of sticky wages and prices, income expectations continuing to be repressed due to money and associated expectations being underprovided. That, as Dr Horwitz notes, prices can be in error does not, of itself, undermine this confidence–that is just part of markets-as-discovery processes. The issue is more if errors in prices are systematic or not (and, if so, why).

Dr Horwitz tells us that Austrian analysis has moved on, but the Mises/Hayek position in the 1930s was clearly that price adjustments could and should do the job of bringing back full employment: this was clearly false given the realities of modern economies. Moreover, taking any position categorically on which is worse, inflation or unemployment, is vile nonsense. It entirely depends on what the economic situation is at the time. Now, as in the 1930s, unemployment was and is much the worse problem.

Accompanying the deep confidence in coordination by market prices is an exaggerated belief in the necessity of untarnished monetary calculation for economic functioning. This feeds into the inflation obsession, though it shouldn’t as deflation disrupts monetary calculation every bit as much as inflation and deflation’s effect on the willingness to transact is generally more negative–folk being less willing to spend money rising in value than money falling in value; particularly if falling money income is making existing debt and other obligations more onerous. But this exaggerated belief also led Mises and Hayek to wildly overstate the rate of operation of calculation difficulties in a centrally planned state. Not only is the human capacity to “muddle through” greater than they supposed (such as Leninist central planners using Western newspaper prices and mail-order catalogues in the planning process), but other calculation criteria can be used (however less satisfactory for handling complexity). Our hominid ancestors managed to engage in successful productive activity (of a limited scale, but of a life-or-death nature) for millions of years before anyone got around to inventing money.

The Austrian School predilection for Just So stories reaches deep into the heart of Austrian economics, notably Menger and Mises‘ approach to the origins and value of money, as usefully set out by Bob Murphy, with its nonsense history of human societies starting with barter (“this piece of meat for those two yams” spot trades, which is not remotely how foraging groups operate) and spontaneously converging media of exchange. (But that is the subject of a forthcoming post, a companion piece to my Easy Guide to Monetary Policy, so I will leave the matter for now.)

Mark Lewin, in his Capital in Disequilibrium, gives us another such Just So story:

For example, we share categories for measuring space—distance (miles and kilometers), area (acres of land), and volume (gallons of gasoline)—and weight (pounds of sugar), figuring accounts, classifying occupations, driving on the roads, walking along pathways, and innumerable other conventions, customs, habits, and the like, which make our actions predictable to others. These institutionalized categories and modes of behavior (which we may designate as institutions broadly understood) are the cumulative unintended results of individual actions and they represent a real convergence of expectations. Starting out from a position of many different standards or modes of behavior that converge to one or a few implies that individuals come to expect certain kinds of behavior, with a degree of confidence related to degree of conformity of the particular standard.

This is nonsense history, as James C. Scott’s Seeing Like A State sets out very nicely. The development of standardised units of measurement did not arise spontaneously, but was a process imposed on social diversity by states that homogenise and rationalise so they can “see” and so tax and control (building on a pattern going back to the origins of the state). Austrian analysis is so impressed with spontaneous order, it falsely projects it onto patterns of historical evolution.

Still sceptical
Nicholas Wapshot’s Keynes/Hayek: the Clash that Defined Modern Economics is an enlightening book, but it reinforces the view that I came to after reading David Glasner’s posts explaining the prescience of Gustav Cassel and R. G. Hawtrey (discussed in more detail here [pdf]); that, admitting their real contributions, much damage was also done to the development of economics by the brilliance of Keynes and Hayek, for both were significantly wrong. Hayek was wrong on the business cycle, appropriate responses to a severe downturn (particularly his obsession about inflationary dangers–there are worse things than mild inflation; it was not inflationary policies that helped bring Mussolini and Hitler to power but deflationary ones) and the nature of uncertainty. Keynes encouraged a false downplaying of monetary policies and overestimated the likely efficacy of fiscal stimulus and underestimated its likely costs. In particular, fiscal stimulus is a political mechanism and cannot be separated–particularly not as a general prescription–from the limitations of political mechanisms. (Perhaps because it is about Keynes and Hayek, Wapshot’s coverage of monetary history and policy is patchy; much better on the 1920s and the lead-up to Bretton Woods, when Keynes was focused on them, than later.)

Reading Wapshot and other writers on interwar economic history, it is also clear how much damage to Britain’s capacities, social cohesion and self-confidence was done by “strong money” policies; with disastrous results at home and internationally. Policy makers (though not Keynes) failed to note how the economy had changed in structure or replicate the commercially-grounded pragmatism of past policy.

A recurring theme in Wapshot’s book is the barrier to the persuasiveness of Austrian economics due to its very specific terminology. If Austrian economics is going to be persuasive, it needs to be accessible. If it uses public language with private meanings, then it will be misunderstood (even, apparently, by people who are self-declared adherents). It is all very well to say that, if you do the reading, you can understand what is really meant, but why should people bother to do that reading? And how much is it legitimate to complain about people reading words and terms in familiar ways?

Austrian economics concerns itself with issues of importance that interest me–some of them greatly–and it does so from a moral perspective I have considerable sympathy for. Yet I continue to find myself unpersuaded that I should expend much time and effort exploring Austrian economics further. Especially given the way so many self-proclaimed followers of Austrian economics are exactly, and perniciously, repeating the role of Austrian school commentary in the 1930s; burbling on about entirely imaginary (in the then and now circumstances) inflationary dangers, so banging the drum for disastrous monetary policies. I fear Bryan Caplan is basically correct (though, despite my comments above, I would give the economic calculation critique of socialism more credit than he does); what Austrian economics has to say about economics that is of value, mainstream economics either has or can incorporate and what it has to say that is not such is either not very useful or simply wrong.

[Cross-posted at Critical Thinking Applied.]

23 Comments

  1. kvd
    Posted June 28, 2012 at 9:59 am | Permalink

    Getting link fatigue here Lorenzo, but thank you for another interesting post.

    On a sort of related matter – interest rates, cost of capital and such – isn’t it reassuring to know that economists can rely upon real-world data feedback to both test and perfect their understanding as to how markets operate?

  2. Posted June 28, 2012 at 3:52 pm | Permalink

    kvd@1 Thanks, both for the thanks and the great link; grist to the mill for a post I have been working on.

  3. Mel
    Posted June 28, 2012 at 4:14 pm | Permalink

    Lorenzo:

    “Of course, the “Austerians” (the Austrian supporters of austerity) …”

    While “Austerian” may be a play on the term “Austrian”, it is a term used to denote advocacy for cutting government spending as treatment for an economic slump. This is how wiki defines the term and this is clearly the way it is used by most economic bloggers.

  4. kvd
    Posted June 28, 2012 at 5:04 pm | Permalink

    If it uses public language with private meanings, then it will be misunderstood [....]. It is all very well to say that, if you do the reading, you can understand what is really meant, but why should people bother to do that reading?

    Which gives me the tentative confidence to ask: what exactly does any economist mean by “the business cycle”?

  5. kvd
    Posted June 28, 2012 at 5:18 pm | Permalink

    Lorenzo, that is a serious question btw – from a person used to applying it to individual businesses, but not economy-wide.

  6. Posted June 28, 2012 at 6:48 pm | Permalink

    M@3 Perhaps, but in the part of the blogosphere i inhabit, I took it to have particular reference to Austrian commentary, so “clearly” is perhaps putting it too strongly. If the set of persons referred to is larger, then OK, it refers to other folk as well.

    kvd@3 ‘The business cycle’ refers to the boom-and-bust tendency in economies; the tendency to significant economy-wide fluctuations in the level of commercial activity. ‘Cycle’ is a bit misleading, since there is no set regularity in the fluctuations. One of the signs that a bust is coming is folk start talking as if the business cycle has been vanquished.

  7. JC
    Posted June 28, 2012 at 9:09 pm | Permalink

    Couple of comments on your piece.

    I don’t think you offer enough credence to the Austrian school for really understanding the importance (and highlighting it) of capital structure. Capital in aggregation has it’s place when looking at say a macro setting or what generally a firm is allocating towards capital expenditure. However firms don’t allocate in the aggregate. They allocate project specific. The Austrian school also offers the best reasons why nearly everything in our world should be left to the market.

    There’s one reason why it fails on the monetary side and that’s because economies aren’t set up to take hits through wages or the prices of goods and services. If we could it would work well, but we don’t have those sorts of economies where people readily understand they have to take nominal wage cuts. I also think the banking system is far too leveraged to allow for unchecked deflationary tendencies, However that’s not a fundamental flaw but more the fact that we’ve moved away from that sort of world.

    it would be nice to know that money was in fact a store of value that could not be trifled with. But we don’t have that sort of system.

    Like you I think the argument Scott Sumner makes about targeting NGDP is the way we ought to be heading. However I don’t quite see that as the optimum solution. It’s the best long term band aid we have in an economic system which is sub-optimal. It’s a mixed economy and a mixed economy by definition is sub-optimal.

    By the way most hedge fund people ascribe to the Austrian school and pound for pound they have a far better understanding of finance and how markets work than academic economists.

    Lastly you seem to be sneering at those consumer Austrians, as you called them I think. But what exactly is wrong with relatively lay people attempting to learn something new.? Would you think it’s better we have a bunch of religiously motivated people pushing for freer markets or people reading Marx and religiously pushing that abomination?

    The RBA has managed, since 1991, to keep the Australian economy from sliding into recession precisely because it has tightened monetary policy when things are running “hot” and loosened them when they are running “cold”.

    Or perhaps because the Hawke/Keating/Howard reforms really did pay off and there was a series positive supply shocks rolling through the economy and later on possibly the sheer luck that we had the stuff in the ground to sell at the most appropriate time.

    Again I agree with Scott’s argument for NGDP targeting however I disagree with his diagnosis of the Australian economy having been a NGDP targeting success story for the past 20 years.

    Supply side matters. even Scott recognizes this as he believes the US has experienced a supply shock as a result of the Odumbo administration.

    The RBA response during the crisis was actually pretty ordinary for a host of reasons and think that the only reason we got out well was because of the enormous turn in the terms of trade. In other words government really matters. Bad government matters more than good government, as we’re finding out now.

    Getting back to the RBA..I believe they have made a fundamental mistake in deciding the direction of monetary policy over the past couple of years. They could have chosen to take a looser course in which case we would have experienced higher inflation or tighter policy and lower inflation. In other words unlike Scott, I think the RBA has been on a inflation target over the past few years. A low one.

    It’s decimated our non-mining industries through currency over-valuation and much higher than necessary interest rates. It was a terrible choice because there is nothing they could have done would have slowed the mining sector. They could have raised interest 1000 basis points and it would not have mattered as mining is a China story. We’re now paying for the bad RBA policies of the past few years and by the looks of the recent PMI will get worse.

  8. kvd
    Posted June 29, 2012 at 5:44 am | Permalink

    JC@7 with your background, see the link @1 re LIBOR manipulation. I am wondering if you would have a comment on that?

  9. Tim Quilty
    Posted June 29, 2012 at 11:20 am | Permalink

    Just thinking that if the general economy made more use of bonuses in payment systems (modeled for example on the finance industry) you would have a move toward flexible wages and prices in economic downturns.

  10. JC
    Posted June 29, 2012 at 11:38 am | Permalink

    KVD

    I really don’t think much about it. It appears to me that the banks screwed up and some acted underhanded in setting LIBOR, but I also think that the fines and the drama that goes with it is way over the top.

    In any event LIBOR is basically the price at which banks say they will lend to prime borrowers. In other words it’s a private decision what they decide goes into the making up the rate. So why is it suddenly so important to look at the reasons that went to making the rate for the day?

    In any event there are choices for borrowers in terms of what they can use as an anchor. If LIBOR becomes discredited people will move to another index.

    Look, I think there is far to much over the top zealousness on the part of the political establishment to go after firms these days. That’s all well and good. However , I think we’re getting to the point now where banks are frightened of their own shadows and that creates a few problems. It chills their decisions to lend and freezes innovation in that sector. that’s not good.

    Banks are vital to our economic system We’re highly leveraged and leverage has suited us well in the recent past by helping economic growth. Sure that creates problems such as ups and downs in the economy, but overall it’s been positive to be able to buy a home through a loan or a firm get a loan etc. I think the zealousness of going after the banks is over the top these days.

    Lastly where are the injured parties in all this? The fines raised are astronomical in size. The major US banks for instance were fined $25 billion over mortgage misdeeds. It doesn’t appear to me that the injured parties are getting the loot. The bulk of the money is going to the Feds and the states.

    Fine, hit the banks. Punish them. However when they’re not lending, we all know why that is.

  11. Mel
    Posted June 29, 2012 at 12:23 pm | Permalink

    L@6:

    I don’t think so, Lorenzo.

    Even on blogs I assume you follow, the meaning of Austerian is as I have explained, see here for example.

    I think Krugman is the major popularizer of the term and, once again, he only ever uses it in the way I have explained.

  12. kvd
    Posted June 29, 2012 at 12:33 pm | Permalink

    JC@10 thanks. Those are fair comments. But I’d just refer you back to your earlier long response to Lorenzo’s post where you say “The Austrian school also offers the best reasons why nearly everything in our world should be left to the market” and call me naive, I suppose, but that leads me to say that the very basis for “the markets” operating in any sort of predictable fashion is basic trust in the system.

    It just seems to me that where you have such basic manipulation of this sort of ‘ground rule’ then it costs all of us – right down the line – because in making our individual business decisions we have to build in not only a normal risk premium, but also a ‘theft’ premium. I mean, I accept that burgulars are great for the home security system companies, but in terms of day to day operations they are simply a group of people who refuse to play by the rules, and basically freeload off others who operate within normal bounds. Same with the Somali pirates; god knows how much they add to shipping and insurance costs.

    The naivety comes from believing everybody should play by the rules, but I’m not saying that – I’m simply saying that the sort of activity undertaken to tweak libor is coming from the very centre of our economies, and costing each and everyone of us. I share your cynicism regarding fines as reparations – because here we go round the loop again, whereby the banks will simply build into their cost structures a loading for fines.

    It just makes a mockery of the whole process when you see that during the crisis when the whole inter-bank lending process froze solid, these particular pirates were still gaming the system to their advantage. If you remove ‘trust’ as a basic business factor, then we are running close to anarchy, and that makes most any form of economic analysis pure speculation; naive if you like.

  13. JC
    Posted June 29, 2012 at 1:06 pm | Permalink

    KVD

    I have no real issue with the regulators unearthing bad practices at the banks. However why does most of the money raised as fines these days end up going into government coffers rather than the supposed injured parties? This seems to be happening more and more these days.

    I’m seriously uncomfortable with that. This sort of thing seems like gangster capitalism to me.

    A few of the banks seem to be the culprits. Not all of them.

    Finally I don’t really understand why this has taken on so much status. I was in the markets for 25 years or so. I always thought LIbor was a manipulated, or rather a self serving rate to the banks and not hugely reliable. Funny how things sudden become important.

  14. kvd
    Posted June 29, 2012 at 1:21 pm | Permalink

    JC, regarding fines, I expect the levying of a fine is far simpler administratively than sorting out exactly who the losers are (that would be you, me, all of us) and making direct recompense. Speaking of recompense, and going back in time to that cardboard box ‘coalition’ it always seemed to me that the fines for Pratt et al should have started AFTER the recompense to the customers who were dudded. The thing is, the elevated/manipulated libor rate (just like the cost of the boxes) was simply passed down the line by the next in line, so a fine really is the only practical penalty.

    As to your last point, taking you at your word, I’d simply ask was there any thing taken as a reliable base indicator upon which you operated? But I think the ‘so much status’ you mention goes to my comment re ‘trust’.

  15. kvd
    Posted June 29, 2012 at 1:53 pm | Permalink

    JC, just an addendum if you don’t mind. re the ‘fines’ I guess you can think of them as a penalty upon the shareholders of said banks – who must have gained via higher/maintained dividends or share price. The ones missing out in the penalty stakes are the executives; officers who either initiated these manipulations, or once aware, did nothing. I don’t see why white collar crime attracts any less penalty than that attached to an armed robbery of your local servo.

    Madoff was a reasonable response; more of the same – however many knights of the realm were involved.

  16. Posted June 29, 2012 at 1:56 pm | Permalink

    Good Grief!

    4350 words in this post (breaking the record set by SL) & it would seem that a few people have actually read it right through.

    Congratulations on the nice round figure of 4350. Quite a pleasant number to read!

  17. Posted June 29, 2012 at 2:54 pm | Permalink

    M@11 Regarding the comment you linked to, at that time, the Austrian school led by Hayek was the New Big Thing in Anglo economics competing with Keynes so, no, I did not read it as more general. My mistake clearly, but new usages can have that problem. Anyway, I have already put in a correction.

    JC@7 On capital structure, we can agree to disagree on the value of the Austrian analysis (they have a point, just not as much of one as they think).

    As for reasons to leave things to the market, Deidre McCloskey puts the reasons which are rather more powerful than theory. Of course, relying on the empirics and working theory out interactively from that leads to less absolutist conclusions on these matters and I realise being comfortable with the messiness of a complex reality is not to the taste of those who prefer their politics simpler (aka more “pure”).

    On policy advocacy, I am with Scott Summer–advocate what has a realistic chance of being implemented. Yes, there is are good reasons to be sceptical about central banking–and one of my beefs to the Austrians is precisely they give such critiques a bad name by being so one note about it. But, in a sticky prices, central banking world what the central bank does matters. Worse is not better, as the 1930s starkly proved.

    Yes, the increased supply side flexibility of the Oz economy is a good thing and makes the RBA’s job easier. But much of the key changes occurred before the 1991 recession, the “recession we had to have”, so the shift in the RBA’s policy matters in explaining why Australia has had such a mild business cycle for 19 years.

    I agree that the RBA is not actually doing NGDP targeting, but it is doing as close as you can to that with an inflation targeting policy. And I am sure various criticisms of the RBA’s performance can be made; it is just so vastly better than that of the BoJ, BoE, Fed and ECB that some appreciation is in order.

    I would not, however, blame the RBA for the exchange rate, as a range of other things have been going on. If you are targeting a domestic variable, you are pretty well stuck with whatever the exchange rate does.

  18. kvd
    Posted June 29, 2012 at 4:50 pm | Permalink

    Just a couple of further thoughts on this LIBOR business. I was going to post this, as some sort of rueful commentary:
    _______________
    A football analogy – based on the Euro 2012 final:

    1. Lorenzo begins his pre-match summary with “Assuming a level playing field…”
    2. Italy completely ignores the offside rule, having bribed both linesmen
    3. Spain reverses its goalmouth – net to fore – and plays all men forward
    4. Ladbrokes takes bets on the inevitable penalty shootout – having reached an ‘understanding’ with both sides – several weeks previously.
    5. FIFA express ‘shock and dismay’ upon being informed of this at their post-competition Barbados conference and immediately fine the match referee for wearing his sponsor’s armband upside down..

    And English fans overwhelm a Jersey-based website offering cheap tickets for Euro 2013.
    _______________

    - but then I read this, which to save those tl;dr impatient people, I would just summarise with this quote:

    And while some financial players are now trying to atone for this by turning to other benchmarks, such as the OIS, these are unlikely to replace Libor soon. After all, an estimated $350 trillion of derivatives contracts have already been written using Libor as a reference point, and about 90 per cent of US commercial and mortgage loans are thought to be linked to the index, too.

    Please note the continuing theme of basic trust in the system. Which has now been lost.

  19. JC
    Posted June 29, 2012 at 8:15 pm | Permalink

    KVD

    LIBOR is basically similar to published mortgage rates. You don’t give a toss how or why those rates were set. All you’re interested in is the cheapest rate.

    If people benchmark of off LIBOR then tough titties, that’s really their problem. In any event you don’t need to use LIBOR to benchmark because you can you treasuries or something like a short term swap rate which are market based rates, not what someone says they will lend to a prime borrower for 90 days.

    In other words getting stuck into the banks is a beat up for the most part.

    And no white collar crime is not the same as a bunch of thugs threatening violence to take money. Violence is whole different category of crime.

    The system is broadly trustworthy, it’s just that people are very hyper about what happened in the GFC and the regulators and governments have an easy target with the banks. Everyone hates them because they’ve talked themselves into hating them.

  20. JC
    Posted June 29, 2012 at 8:29 pm | Permalink

    JC@7 On capital structure, we can agree to disagree on the value of the Austrian analysis (they have a point, just not as much of one as they think).

    Yes we can disagree, that’s fine, but I continue to maintain that the Austrians have capital theory down pat. No other theories come close. They also were able to offer an better understanding of the way interest rates are derived which melds in the their capital theory.

    As for reasons to leave things to the market, Deidre McCloskey puts the reasons which are rather more powerful than theory.

    Like what exactly?

    Of course, relying on the empirics and working theory out interactively from that leads to less absolutist conclusions on these matters and I realise being comfortable with the messiness of a complex reality is not to the taste of those who prefer their politics simpler (aka more “pure”).

    I don’t think importance lies in purity. What’s important is who appears to be right.

    On policy advocacy, I am with Scott Summer–advocate what has a realistic chance of being implemented. Yes, there is are good reasons to be sceptical about central banking–and one of my beefs to the Austrians is precisely they give such critiques a bad name by being so one note about it. But, in a sticky prices, central banking world what the central bank does matters. Worse is not better, as the 1930s starkly proved.

    I agree. It’s perhaps the best method to manage monetary policy and I also agree with Scott about Milton Friedman loss. Yes, the cemeteries are filled with people who thought they were indispensable, but Milt’s death was a huge loss to the right as he did keep the intellectual framework within a decent set of boundaries. If Milt was around he would have calmed things down on the right.

    Yes, the increased supply side flexibility of the Oz economy is a good thing and makes the RBA’s job easier. But much of the key changes occurred before the 1991 recession, the “recession we had to have”, so the shift in the RBA’s policy matters in explaining why Australia has had such a mild business cycle for 19 years.

    The RBA is basically on an inflation target. I forget the ceiling.. is it 3%?.. so it’s really no different to say to what the ECB has been running although the ECB is of course 2%. I don’t know how one could say the RBA has been targeting NGP when it’s not on an NGDP target.

    I agree that the RBA is not actually doing NGDP targeting, but it is doing as close as you can to that with an inflation targeting policy.

    I don’t think so. I think they have mostly lucked out and we’ve had really good terms of trade of the better part of a decade that has helped disguise things.

    And I am sure various criticisms of the RBA’s performance can be made; it is just so vastly better than that of the BoJ, BoE, Fed and ECB that some appreciation is in order.

    it would be interesting to see how they’ve done if we were able to splice out the terms of trade performance.

    I would not, however, blame the RBA for the exchange rate, as a range of other things have been going on. If you are targeting a domestic variable, you are pretty well stuck with whatever the exchange rate does.

    I wouldn’t blame them entirely either and they also have a ceiling on the inflation rate. However the fact remains that we could have allowed a higher inflation rate and possibly not experienced difficult times in the non-mining sectors as we have.

    (hope it’s okay, not time to proof read)

  21. Posted June 29, 2012 at 10:09 pm | Permalink

    JC@20 It reads fine.

    On McCloskey, follow the link.

    The RBA is basically on an inflation target. I forget the ceiling.. is it 3%?.. so it’s really no different to say to what the ECB has been running although the ECB is of course 2%. I don’t know how one could say the RBA has been targeting NGP when it’s not on an NGDP target.

    The RBA has a 2-3% average over the business cycle target. That is not what the ECB or strict inflation targeting central banks have been doing, as I discuss in my Easy Guide.

    it would be interesting to see how they’ve done if we were able to splice out the terms of trade performance.

    But the terms of trade only improved dramatically in the last few years, we avoided recession even when our terms of trade were in long term decline.

    On whether the RBA should have been more lenient on inflation, don’t know one way or another and have no strong view on the matter.

  22. JC
    Posted June 29, 2012 at 11:00 pm | Permalink

    T

    he RBA has a 2-3% average over the business cycle target. That is not what the ECB or strict inflation targeting central banks have been doing, as I discuss in my Easy Guide.

    Oh really, okay. So Scott’s right then it’s pretty close to a NGDP target. Fair enough. I thought they were all pretty strict.

    But the terms of trade only improved dramatically in the last few years, we avoided recession even when our terms of trade were in long term decline.

    Technically. However dropping from a decent clip to 1% annualized or sub feels recessed.

    On whether the RBA should have been more lenient on inflation, don’t know one way or another and have no strong view on the matter.

    That’s been my big bug bear about the RBA. They could have raised rates to the stratosphere and it wouldn’t have impacted demand in the mining sector one iota as it was always a China story. Other than wages and those sorts of costs, which I accept are material most of mining is done in US dollars. The only thing that’s here is the hole in the ground. However monetary policy does impact the rest of the economy, so running a higher inflation rate would have been a better strategy in my mind. They’ve basically helped in hollowing it out when it wasn’t necessary. I can understand their concerns in terms of the impact of wage demands in the current FWA (symmetrical) environment which is why it’s critical the incoming liberal government thinks about liberalizing labor markets again and figure ways of weakening the unions by removing their special privileges.

  23. Posted June 30, 2012 at 3:28 am | Permalink

    JC@22

    from a decent clip to 1% annualized or sub feels recessed

    Hence my comment about the business cycle being “managed into mildness”, not abolished.

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