Tuesday, September 21, 2010

Fear the Boom and Bust and Recession and Recovery and...

The first time I saw that rap video of Keynes vs Hayek I felt just like that desk clerk. “And who are you sir?” That’s when I decided to pick up “the road to serfdom” and look into this alternate perspective. You see, as a student of economics at the University of Washington there is no mention of an alternative to Keynes. And as I sat and listened to how borrowing money can be a good thing, I couldn’t help but wonder how we would pay it back in the future. Of course I never voiced my concerns of the limitations of Keynes theories, but they lingered. I think my tipping point was when I heard a professor make this claim: “the reason we are in a recession is because of too much government spending, now to get out of it we need to increase government spending.” Hmmmm, I’m not sure about this.

Alas, having grown up in the Keynesian school of thought, I can’t help but cringe at some of the points attempting to be made in this lecture. And after having heard the Austrian perspective I can now say that I truly have no economic home. Seeing as most of our group appears to be leaning much further right than myself, and having a background in Keynesian thought, I suppose I have a voluntary duty to put my head on the block again this week.

I suppose the first weakness in this argument that I should make is the most potent. The foundation of Austrian economics is that growth is derived from savings whereas Keynes argues that savings is a luxury good and comes as a trade-off to consumption. I have to say there is no winner here. Of course we know that with a zero percent savings rate there is no money for investors to borrow. This is obviously dampening to output as borrowing money for capital can increase productivity immediately and lead to real sustainable growth. One could argue that without investment, there would be no production at all. On the other hand, it should not be hard to imagine that a one-hundred percent savings rate leaves no money for consumption at all. Therefore, it must be true that there exists some maximizing level of savings between the two extremes. And for that reason, blanket statements such as increased savings equal increased production is clearly fallacious. Although true at some points, the same can be said about the opposite case.

I should also point out that the PPF demonstrated in the slides is fundamentally no different than a Keynesian cross. However, there is a huge error in interpretation within the model shown. We can definitely say that consumption and investment are trade-offs. However, the PPF described does not reflect full employment by any stretch of the imagination. To "consume" investment goods does not require the labor inputs that consumption goods do. Unfortunately, that realization unravels most of the argument made later.

Although there is much more to be said, I think I will just touch on one more subject, The Federal Reserve. The thrust of the Austrian argument is that monetary policy creates booms and busts. The zeitgeist that has been created is that the Fed somehow is inherently evil and manipulates some agenda so that artificial growth makes people feel good. In fact, the Federal Reserve was created to stabilize an already chaotic financial system (which faced 27 recessions before the Fed was created) and was made independent of the rest of the government for the purpose that it could not be used to manipulate the money supply in order to make politicians look good by artificial means. The Fed answers to the Congress, its members appointed by the President and its profits belong to the US treasury. It is required to testify to the Congress on its actions and that they fall in line with its legal responsibilities of trying to accomplish three noble goals, for the good of the people.

Those goals are sometimes impossible to achieve simultaneously, but to violate these goals is to face prosecution. The first goal is to attempt to maintain “full employment”, which does not mean that everyone in the country must work. It means that everyone trying to find a job has the opportunity to find one. It is not even 100% of workers working that is the target. It allows for the frictional unemployment created by leaving one job for another, which allows the economy to correct inefficiencies. So this goal is actually what is called “the natural rate of unemployment”. That is a good goal. It means that we don’t want people that are willing and able to work to be starving on the streets. That means that this goal reduces the amount of money that society would feel obligated to pay in welfare to rid itself of the guilt from being lucky while others starve by random chance.

The second goal is price stability. This goal is the most lenient, but still important. Changing prices affect price expectations and prices never change in unison. The chaos in prices would exasperate the problems, that is to say they are a negative feedback loop. Although it may be true that the market clearing adjustments create a better outcome on paper, the real impacts on people’s lives are much more devastating and impossible to quantify.

And finally, the Fed has a legal responsibility to attempt to maximize sustainable economic growth. That is why the Fed moves the money market in counter-cyclical motions, not continuous injections of “caffeine”.

The bottom line is that people respond to the incentives that they face. No economist I know would ever argue with that. To believe that requires a belief in people weighing their expected values from a trade, which is exactly what “Animal Spirits” are; the producer’s confidence in an investment being profitable versus the fear that it won’t and the consumer’s faith in having an income, as well as expectations of future prices. As those expectations change, the economy moves up or down, without any change in the money supply. All I am saying is let’s not be so quick to think we have it all figured out.

PS: Best line ever = "can we ruin the economy? YES WE CAN!"

1 comment: