Thursday, January 20, 2011

Blog 4: Preliminary Observations on Capital-Based or Austrian Macroeconomics

I am currently in the process of learning about capital-based or Austrian Macroeconomics, so these comments are reflective of what I have learned so far, what questions remain unresolved in my mind, and what I anticipate to read in further study.  I like to learn by getting a basic idea of a topic and then trying to guess where this is all going before reading everything.  I also try to sniff out possible problems that I see with what I have read again before reading ahead for all the ‘answers.’  Consequently, this blog is a collection of these guesses of mine based on a very preliminary understanding of the theory and also is reflective of what I am currently playing around with in my mind.  As such, I really haven’t edited this blog; you are reading thoughts that just poured out of my mind! 

The Austrian theory was a popular and growing view in the early 1930s that attempted to explain the cause of economic depressions.  From this causal theory, it offered up the solution to depressions, namely, laissez-faire economics.  Simply put, the Austrian view is completely opposite of what you will find in a stand undergraduate textbook.  This is because the typical textbook is written from a Keynesian perspective when it comes to depressions and recessions—meaning fiscal and monetary stimulus.  In other words, the typical textbook response is to get the government spending on projects, typically through deficit spending programs, and to get the central bank to lower interest rates through quantitative easing.  The Austrian view recommends the complete opposite—no government fiscal expansion, budget cuts (yes budget cuts and a policy of shrinking government), no central bank interest rate manipulations, no propping up of prices, and no business bailouts.  

Right off the bat, one can see the political ramifications stemming from this debate—the Keynesians wanting big government and a central bank versus the Austrians that want no government and no central bank.  So I suppose part of the reason why some people—myself included—favor one model over the other has to do with political perspectives.  For me, the Austrian view is attractive because it certainly appears to me to be more consistent with individual liberty than the Keynesian model.  However, there is much more to this debate than simply political preference.  This is, after all, a debate over economic models.

The Austrian model seems to address four different areas and how they are all interconnected.  These four areas are as follows:  The Loanable Funds Market, Production Possibility Frontiers, Stages of Production (or the Hayekian Triangle), and stage-specific labor markets.  I will now give a quick overview of what these four different areas address.

The Loanable Funds Market seems to be at the core of the Austrian model because it zeros in on the interest rate manipulation question.  My suspicion is that this Loanable Funds Market model is the competing model to the Keynesian Liquidity Preference model. 

In standard textbook treatments, the nominal interest rate is found based on the intersection of the real demand for money curve and the real supply of money curve.  This then morphs into the LM or Liquidity Money curve by changing real income (and holding everything else constant) and seeing that the real money demand curve shifts to the right and interest rates rise.  Consequently, the LM curve is an upward sloping curve, with real income on the horizontal axis and nominal interest on the vertical axis.  The equation for this is M/P = Y*L(i) where M stands for nominal money, P stands for the price level, M/P is the real money supply, Y stands for real income, and L(i) is the interest rate liquidity component.  Y*L(i), stands for the real money demand.  Specifically, it is Y times this "L function of i" term [think of basic algebra where you often deal with y = f(x); here the f(x) functional term becomes L(i).]  

The Loanable Funds Market model, on the other hand, has the interest rate on the vertical axis, and both Saving and Investment on the horizontal axis.  It looks identical to a supply curve and demand curve from any Economics 101 course!  The supply curve, meaning the supply of loanable funds is all based on savings from the public.  This makes sense; I save some of my money and so I can lend it out—I can ‘supply’ it to the loanable funds market.  The demand for loanable funds is based on business investment decisions—obviously, a lower interest rate will encourage businesses to invest more in capital projects (meaning, new machines, factories, raw materials, retail inventories, etc.)  In the loanable funds framework, the intersection of the supply and demand curves determines savings, investment, and the interest rate.

The second part of the Austrian analysis draws out a production possibility frontier.  The idea seems to be that the economy has a given amount of resources, (I think they mean factors of production such as land, machines, equipment, ‘capital goods,’ labor and so on) and that a trade-off exists between the production of consumption goods and the production of investment goods (i.e., future consumption goods).  The idea seems to be something like this:  I have 50 hours of labor and 20 machine hours available in my economy.  If I allocate all hours to producing (current) consumption goods, then I will be able to invest nothing in new machines, new tools etc.  This will compromise the future productive capacity of the economy because as the current machines and equipment wear out, there will be no new machines to replace the old ones.  Hence, the economy is a gigantic ‘trade off’ system between current consumption and investment—where investment sets the stage for the creation of new machines (that become available in the future) and hence future production of consumption goods.  This approach, of course, is very different from the textbook Keynesian Cross approach, which looks at consumption and investment as additive expenditure functions.  In the Keynesian world, we go Y = C + I or real income (Y) equals consumption expenditure (C) plus investment expenditure (I).  [This is a very similified version of the GDP equation; a more detailed version would look like this:  Y = C + I + G + X - E*IM; G stands for Government spending, X stands for exports, E stands for the real exchange rate, IM stands for imports.  The term E*IM exists because they are trying to solve the apples and oranges problem in this equation, that is, some of this is measured in terms of domestic goods (apples) and some of this is measured in terms of foreign goods (oranges).]  In the Austrian world, we have a tradeoff, more consumption today means less investment today.  More investment today means less consumption today--but it also means more consumption in the future (because investment today implies that the economy will have more machines, factories, tools, mines etc. in the future and so will be able to produce more consumer goods in the future). 

The third part of the model, which looks at stages of production, is also known as the Hayekian Triangle because it is a product of Professor Hayek’s thinking and because it looks like a right triangle.  This part of the story is completely new to me.  The gist of it is that production of final consumer goods goes through a number of stages of production.  It kind of reminds me of the ‘value chain’ material that is usually attributed to Michael Porter.  Central bank credit manipulations are modeled by changes in the shape of this Hayekian Triangle.

The last part of this model is stage-specific labor markets.  What they mean by stage-specific is a specific stage in the production process.  In other words, an early stage of production, such as mining, will have one labor market.  A later stage of production, such as selling cars at the retail level, will have a separate labor market.  The model allows for the equilibrium wage in these separate labor markets to be different.  Pictorially, each labor market has its own labor supply curve and labor demand curve and hence its own unique equilibrium wage rate.

At this point, I will admit that I do not completely understand all the rest of how this model works (all the internal dynamics) with regard to central banking credit expansion.  But I do understand the very general gist of it.  I will explain the gist of it and then have a discussion of some of my questions, concerns, etc.

The general gist of the model is that central bank credit expansion—quantitative easing—causes the loanable funds market to go into disequilibrium.  This disequilibrium sets in motion a number of changes in the production possibility frontier graph (basically the economy in the ‘boom’ stage is pushed into a theoretically impossible situation between consumption and investment).  Also, the Hayekian triangle graph gets all distorted in shape, and the stage-specific labor markets have a number of changes (it sounds like the wage rates get distorted and overbid).  In other words, the problem originates in this loanable funds market and then causes adverse changes in the three other areas in the model.

The loanable funds model goes into disequilibrium when the central bank creates additional credit, the so called ‘print money up out of thin air’ problem.  This causes the supply of loanable funds curve to shift to the right.  The interest rate then is found at the intersection of this new supply curve of loanable funds and the original demand curve for loanable funds.  The problem stems from the fact that the public is still functioning along the ORIGINAL supply of funds curve.  The public, seeing the lower interest rate, moves down and to the left along the original supply curve—private sector savings actually fall.  But, investment (borrowing by firms) booms as firms take advantage of the lower interest rates (they move down their demand curve to the right.)  The gap between the supply of savings and the demand for savings (demand for savings is the demand by firms to borrow funds for investment projects) is satisfied by this newly created money.  This seems to be the root of the Austrian theory of economic depression.

For me, part of the thinking process is to figure out why firms will go along with this.  Don’t firms learn from experience that such artificial credit expansions lead to a boom followed by a bust?  I have a few temporary hypotheses to account for this.  First, I suspect that some entrepreneurs do not know about economic history and so see the lower interest rates that are produced by the bank credit expansion, and borrow because the money is cheap.  They do not anticipate that their borrowing is setting up a boom-bust cycle.  Projects that once looked unprofitable now appear to be very profitable and so they jump for it.  This stems from the net present value calculation being done to determine whether a project should be done or not.  Lower interest rates will certainly make the net present value number appear better.  Maybe also there is some sort of optimism bias in entrepreneurial decision-making.  These entrepreneurs may certainly know about the boom-bust set up but convince themselves that the losers will be ‘somebody’ else.  They assume that the problems of the bust will affect other firms, not their own firm.  If every entrepreneur were to think this way, then everyone would favor taking out new loans at the cheaper interest rate engineered by the credit expansion.  I also think that maybe the use of metrics to judge management leads managers to take out these loans.  If a mutual fund manager invests when stock prices are rising, then his quarterly figures look better and he might get a bigger raise.  So maybe the short term compensation considerations of a manager will drive him or her to borrow this money in order to invest.  The reason I have for this last hypothesis goes something like this.  Part of the Austrian model is based on the idea that credit expansion leads to misinformation being sent into the market—the below free market interest rate [the actual observed interest rate is below the rate that would exist in a free market--where the term free market implies that no central bank exists].  The observed interest rate is faulty and leads to bad decision-making on the part of businesses.  I noticed, from my own experience, how the use of student evaluations of teachers leads directly to bad decision-making on the part of teachers.  Specifically, the use of student evaluations of teachers directly punishes teachers for being demanding and rewards them for being fun and entertaining.  So by forcing teachers to maximize their student evaluation numbers, teachers actually make decisions that tend to be contrary to the actual objectives of education.   Demanding courses, lots of reading, lots of studying, lots of homework etc. all tend to disappear in order to satisfy the 'customer' student.  Consequently, I am thinking that maybe the interest rate manipulation problem in the loanable funds market is exactly the same as the problem of manipulation of student evaluation scores in higher education.   Both are based on managing behavior (i.e., the behavior of the teacher or the behavior of the business firm) by some sort of metric (student evaluation number or the interest rate) and both seem to place short-term considerations ahead of longer-term objectives.  (Goodbye long term objective of critical thinking or goodbye to a sustainable economy.)

One thing that bothers me about this loanable-funds framework is that of what exactly is this interest rate being determined?  Is it a short-term rate or a long-term rate?  My impression is that this is a short-term rate.  Why then are long term investment decisions being made on a short-term rate?  Or does the entire structure of interest rates change in addition to the short-term rate?

I think that is enough for now!  I’ll post any more comments in a later blog.


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