After tormenting Tyler Cowen, Daniel Davies decides that post-Austrian Tyler and post-Keynesian Daniel are really long-lost brothers:
Crooked Timber: Dumb it up, Tyler! : ...Both Tyler and myself are quite a long way outside the mainstream of neoclassical economics. He's basically an Austrian, I'm a Post-Keynesian. And in fact, Tyler's particular brand of "New" Austrianism is very close to Post-Keynesianism indeed. Specifically, he rejects the key Austrian premise that recessions and malinvestments are always caused by gaps between the "natural" and "money" rates of interest opening up (as a result of Big Bad Government, natch), encouraging investors to make mistakes about the time-preferences of consumers and invest in production technologies with the wrong returns period. Tyler takes from rational expectations macroeconomics the idea that it doesn't make sense to assume that policy-makers can systematically fool the rest of the economy, and from modern portfolio theory and financial economics, the idea that one of the real determinants of investment is the equity risk premium (a concept I discussed here). It's a "Risk-based Business Cycle" theory in which the business cycle is driven in an Austrian manner by cycles of malinvestment and liquidation, but these cycles do not have a monetary origin. To cut a long story short, his model of the business cycle is one which is more or less entirely driven by animal spirits on the part of entrepreneurs. That's why he thinks that all these monetary factors are irrelevant...
But there's a mysterious gap in the logic here that I can't wrap my head around. John Maynard Keynes believed that the business cycle arose because of irrational "animal spirits" on the part of entrepreneurs. He didn't believe that monetary forces were irrelevant.
Suppose that for some reason investment spending is depressed--either your entrepreneurs have woken up with a big headache after five years drinking much too much usquebaugh, taken a look at all the capital equipment they have bought, and moaned and promised never to buy another machine tool again, or your entrepreneurs have simply suffered an attack of the vapors and are lying prone on the floor. If this deficient investment problem comes on suddenly and is of short duration, there is little a central bank can do. But if you can foresee this coming (as, say, the NASDAQ starts to collapse from the start of 2000) or if this is of long duration (hint, hint), the fact that the investment slump is of non-monetary origin does not mean that it must have a non-monetary cure.
Think of it: to say that an economy has too much capital--that entrepreneurs do not expect additional investment to earn its keep--is a statement that depends on the current structure of interest rates. Lower interest rates, and all of a sudden a bunch of investment projects that appeared unviable will acquire a pulse. Lower them far enough and convince people that they will be kept low long enough, and a great deal of stimulated investment is possible.
"But," a post-Austrian (though I hope not a post-Keynesian!) might say, "You can't keep the money rate of interest below the natural rate of interest indefinitely. Sooner or later it has to snap back--and when it does you have just magnified the 'liquidation' problem!" The proper answer to that is, "Sez who?" If at your new lower money interest rate ex-ante saving is equal to ex-ante investment, your new, lower money interest rate is now the natural rate, isn't it? (Yes, I know this paragraph is incomprehensible to anyone who has not read Wicksell in the original Swedish.)
But I agree there is a problem with boosting investment if ex-ante saving is less than ex-ante investment. But even if you don't want to (or can't) boost investment spending to push the economy back to full employment, there is no reason why an investment slump must be accompanied by high unemployment and depression. You can expand employment, production, and demand in lots of other ways. You can lower the value of your currency (through monetary policy) and so increase exports. You can boost the liquidity of the household sector (through monetary policy) and (if you believe in direct effects from liquidity to spending not mediated through interest rates) so boost consumption spending. You could even--even in this neoliberal age--raise government spending, and construct parks, zoos, trails, ports, bridges, highways, medical research establishments, circuses, museums, railways, pyramids, mausoleums, hanging gardens, colossi, statues, lighthouses, and (if you don't have a first amendment hanging around) temples in which people can cry "Great is Diana of the Ephesians!"
The point that Tyler makes that central banks have limited powers is a good one. The way I put it, central banks have an easy time pushing short-term rates to where they want them to be (as long as where they want them to be is above zero) but the interest rate that matters for investment spending is not the short-term nominal safe interest rate central banks control, but the long-term real risky interest rate--and central banks face the zero-bound problem in trying to make the nominal rate they control into the real rate, face a credibility problem in trying to make the short rate they control into the long rate, and have next to no bloody influence at all over the risk premium. Plus they need lots of advance warning about collapses in investment spending: their tools have powerful effects, but only with long lags.
But Tyler overstates the point: because central banks cannot do everything does not mean they cannot do a lot.
Posted by DeLong at July 30, 2003 10:40 PM | TrackBack
Excellent points! It puts paid to the notion that Greenspan 'created' the bubble by causing to the drop in the equity risk premium the late 1990s. However, Greenspan CAN be blamed for not acting more quickly after Dec 1999, when the inverted yield curve clearly told him the party was over and he should start easing aggressively. He was a full year too late in starting to ease, and did not cut far enough, fast enough in 2002-03.
Posted by: Peter vM on July 31, 2003 12:39 AM>>>>>>
Think of it: to say that an economy has too much capital--that entrepreneurs do not expect additional investment to earn its keep--is a statement that depends on the current structure of interest rates. Lower interest rates, and all of a sudden a bunch of investment projects that appeared unviable will acquire a pulse. Lower them far enough and convince people that they will be kept low long enough, and a great deal of stimulated investment is possible.
<<<<<<
What happens when additional investment is not made not because of interest rates, but because operating costs (wages) make a zero-interest-rate investment uncompetitive with an equivalent investment made elsewhere?
The zero-interest Japanese have been complaining about China "exporting deflation", apparently for just this reason.
Here's the money quote from a very interesting article:
"Since February 2001, the economy has lost 2.6 million jobs, 90% of them in manufacturing. I don't know when the hemorrhaging of manufacturing jobs will stop, but it may not be soon."
http://www.thestreet.com/pf/comment/spincycle/10099717.html
Posted by: Michael Robinson on July 31, 2003 03:52 AMPeter -
"Greenspan CAN be blamed for not acting more quickly after Dec 1999, when the inverted yield curve clearly told him the party was over and he should start easing aggressively."
Presumably the massive steepening we've seen in the past few weeks means Greenspan should hurry up and get tightening before the party gets out of hand?
Hope all is well with you.
Think of it: to say that an economy has too much capital--that entrepreneurs do not expect additional investment to earn its keep--is a statement that depends on the current structure of interest rates. Lower interest rates, and all of a sudden a bunch of investment projects that appeared unviable will acquire a pulse. Lower them far enough and convince people that they will be kept low long enough, and a great deal of stimulated investment is possible.
Hold on a second, (Ritual disclaimer: I'm but a lowly undergrad who has taken some micro, macro, trade theory and monetary economics but not that much.) I know you are right that the interest rate affects whether entrepreneurs are willing to invest (in the sense you mean investing) because it alters the opportunity cost of doing so. However, what of a situation where they are unwilling to invest because they already have too much capital and can't use it at full capacity without seriously hurting the prices they can charge? In this case, wouldn't interest rates be irrelevent? (I.e. any capital investment must go unused or drive down revenue by increasing supply beyond equilibrium and therefore necessitate the lowering of price or accumulation of inventory)?
Posted by: Lorenzo on July 31, 2003 08:23 AMLorenzo, it is also possible for some capital investment to be a total loss to the point where it can be ignored, because technology and demand are always changing and different capital investments serve different purposes (it's not a commodity).
Let's consider for example what happens when SARS decimates the population. So now there is roughly 1 worker to operate the equipment that before was operated by 10. So it is probably correct that there are many items which you don't want more of... office buildings, vehicles and their related means of production are good examples of what will not be needed I think. So those type of things that last a long time and are useful a long time can be used without making more while the surviving workers are retrained and shifted more to consumption items. A lower interest rate will accomplish this stimulation of consumption. But at the same time, there will be new things invented and so these new things will be demanded both as consumption and as productivity enhancers, and the low interest rates will also allow the SARS survivors to invest more in these new technologies even as much of the old capital investments sit around collecting dust.
"What happens when additional investment is not made not because of interest rates, but because operating costs (wages) make a zero-interest-rate investment uncompetitive with an equivalent investment made elsewhere?"
This ignores interest rate parity. Any overseas investment by Japan must generate superior cash flows AFTER CONVERTING YUAN BACK INTO YEN at future dates. The forward price of the yen is extremely expensive compared to US dollars (and the $-pegged Chinese yuan) due to the interest rate differential. There is no free lunch to be had by Japan investing overseas. The high overseas returns are regularly taken away by the capital market, via hedging costs and/or yen appreciation over time. Similarly, low Chinese wages reflect low productivity (and to the extent that they don't, wages will eventually rise).
peter vm:
"Similarly, low Chinese wages reflect low productivity (and to the extent that they don't, wages will eventually rise)."
Actually, low Chinese wages reflect a surplus labor force approximately equivalent to all G8 workers combined. As Chinese workers have little to no pricing power for their labor, they are more than willing to accept PPP compensation (and the concomitant standard of living) that would be unacceptable to workers in developed countries for work of equivalent quality and productivity.
Consider the downward pressure on U.S. IT wages attributed to H1-B workers. That's a very small tip of a very large iceberg.
Posted by: Michael Robinson on August 1, 2003 03:31 AM