Wednesday, October 1, 2014

Philip Pilkington on the Natural Rate of Interest

In a great Levy Institute working paper here:
Philip Pilkington, “Endogenous Money and the Natural Rate of Interest,” Levy Institute Working Paper No. 817, September 2014.
More background here.

The paper looks at endogenous money theory and the deficient and flawed way this was been incorporated into the “New Consensus Macroeconomics” (mainstream neoclassical theory), through the use of the natural rate of interest.

Tuesday, September 30, 2014

A Brief Outline of Mises’ ABCT

A quick summary following on from the last post of Mises’ Austrian business cycle theory (ABCT) in its successive stages, but with the version in Human Action included:
(1) a fall in the bank rate below the unique Wicksellian natural rate induces unsustainable, roundabout capital projects (Mises 2009 [1953]: 355, 360–361; Mises 2006 [1978]: 107–108). By the time of Human Action Mises replaces the unique Wicksellian natural rate with the single originary interest rate (apparently on capital goods) (Mises 2008: 547–548), but the two concepts are functional equivalents;

(2) but the new investment increases wages/aggregate income and non-labour factor prices (Mises 2008: 550), and so consumption increases in early and middle stages of the boom, and the prices of consumer goods rise (Mises 2008: 550). This increase in consumption is made more intense by the falling money rate of interest discouraging saving;

(3) the rising consumption also encourages consumer goods industries to expand production (Mises 2008: 558), further increasing demand for factor inputs.

(4) but, according to Mises (2009 [1953]: 362–363), as scarce factor inputs are bid away by the new firms engaged in more roundabout capital projects, raising the price of factor inputs, then the mature firms producing consumer goods in the last stages of production see their total quantity of output of consumer goods fall, even as inflation in consumer goods’ prices increases, and investment continues to increase. Presumably this is the point where investment and real consumption move in opposite directions.

(5) if the banks were to continue to expand the money supply indefinitely, the result will be hyperinflationary collapse of the currency, but normally banks end the process well before this (Mises 2008: 559). The boom reaches its end point when banks raise the money rate on loans, then investment falls. The capital projects that were unsustainable are folded up and liquidated, and this drives the bust (Mises 2008: 560–561; Mises 2006 [1978]: 115). The bust sees further falls in consumption and rises in saving, and liquidation of capital until bank rate and natural rate coincide and intertemporal coordination of saving and investment begins again, and investment rises.
An interesting question: did Hayek agree with point (4), that at some stage of the boom investment will continue to rise as real consumption falls?

Yet another question is: why does the law of demand (apparently) mysteriously stop working in the boom? Why doesn’t the relative degree of wage and price flexibility assumed in the theory (which, admittedly, is not perfect, but still reasonably strong) cause the Wicksellian natural rate to adjust and actually fall to the bank rate, as rising prices for consumer goods cause falls in the quantity demanded of consumer goods? Why don’t the rising prices of factor inputs cause falls in the quantity demanded of factors, so that investment is dampened?

If I am not mistaken, John Hicks (1967) wondered the same thing, and other neoclassical economists, citing Hicks, bring up the same objection (Vasséi 2010). Vasséi (2010: 213) points out that Mises (2008: 550) assumes no significant lag between the additional consumption through rising wages and the rise in the prices of consumer goods. So a serious time lag and “sticky” consumer goods’ prices cannot account for the lack of a tendency to market clearing.

Hayek’s answer, at least with respect to his version of the ABCT, was that disequilibrium in relevant product markets is not corrected because of the continuous “inflow of new money” into the system “at a given point and at a constant percentage rate” (Hayek 1969: 279). This doesn’t seem entirely convincing to me. It seems like the law of demand is asserted as a universally true law, but conveniently pushed aside when it contradicts the theory.

This also illustrates how the Austrians see market economies as incredibly feeble, fragile, unstable systems, which are thrown out of balance even by fundamental institutions of capitalism like fractional reserve banking and indeed any excessive credit money creation by private sector agents.

Under Austrian theory, capitalism isn’t some powerful Atlas, but is transformed into some hapless, puny weakling, liable to stumble and fall over at any time.

Further Reading
“Daniel Kuehn on the Austrian Business Cycle Theory,” December 5, 2013.

“John Hicks on Hayek’s Business Cycle Theory,” July 18, 2014.

“A Candid Admission from Hayek?,” Sunday, July 20, 2014.

Hayek, F. A. von. 1969. “Three Elucidations of the Ricardo Effect,” Journal of Political Economy 77.2: 274–285.

Hicks, J. R. 1967. “The Hayek Story,” in J. R. Hicks, Critical Essays in Monetary Theory. Clarendon Press, Oxford. 203–215.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Vasséi, Arash Molavi. 2010. “Ludwig von Mises’s Business Cycle Theory: Static Tools for Dynamic Analysis,” in Harald Hagemann, Tamotsu Nishizawa, Yukihiro Ikeda (eds.). Austrian Economics in Transition: From Carl Menger to Friedrich Hayek. Palgrave Macmillan, Basingstoke. 196–217.