Keynesianism is an ass

[Augustine2004]

Pilgrim called me an ass. Now he has an excellent chance to thoroughly demonstrate that I am.

Murray Rothbard reviewed (http://mises.org/journals/fm/apr07.pdf) Henry Hazlitt’s challenge to Keynesianism, The Failure of the “New Economics.” (http://www.mises.org/books/failureofneweconomics.pdf) He described the book as “vitally important and desperately needed” and “a detailed, thoroughgoing refutation of the General Theory.

The Keynesian Revolution did not succeed because the theory was obviously correct or supremely useful. Keynes apparently cleverly dressed up fallacies in “a wilderness of unclear writing and pretentious jargon” and “a bewildering morass of strange concepts.” Keynes’ followers “claimed to be the only ones able to understand the Master.” Old economists were cowed by those people, who were 35 or younger. And there was Keynes himself “an eminent, aristocratic Englishman–witty, charming, and thoroughly irresponsible.”

Two other factors boosted the revolution. The world was tilting towards statism. And Cambridge, Keynes’ home, previously taught a kind of economics that had important gaps, such as a theory of the business cycle.

Many Austrian school economists went over the Keynesian camp. Rothbard didn’t really explain why, but my guess is they were drawn to the state’s lure of material benefits. Another factor that Rothbard really didn’t cite, is that Mises’ Human Action (http://mises.org/Books/humanaction.pdf) wasn’t published until 1949. Hazlitt used principles from that book to demolish Keynesianism.

I’ve only just begun to study Hazlitt’s book (http://www.mises.org/books/failureofneweconomics.pdf).

[Augustine2004]

Hey Pilgrim, you got something to prove.

Keynes often used mathematical equations in his work. That’s a red flag. Now, to be sure, Man, Economy, and State by Rothbard does use equations. However, he made use of tables and diagrams far more often. I flipped through 885 pages of Human Action by Mises and failed to spot any equation. Both Rothbard and Mises use logic, all right, but there are indeed no constants in human action. Action taken by people or the choices that they make are essentially unpredictable. That leads to the conclusion that we can’t have equations in economics that are the counterparts of an equation in physics like F = ma where F is the force imparted to the free mass, m, and a is the mass’ acceleration. In some situations, like a rocket accelerating away from Earth, the mass varies with time, but its variation is known. Usually the mass is a constant, to the disappointment of many a miss who is vainly dieting.

[Sheepdog]

you expect Pilgrim to do more than toss bricks? to actually carry a substantive conversation? seriously?

[Augustine2004]

I guess I should not expect Pilgrim to be better than a brick tosser. Hey Pilgrim, you're a brick, nayah, nayah.

Moderator, it may be necessary for me to chain my posts now and then. Is that OK?


On page 50 (the book itself, not the PDF), Hazlitt wrote, “Keynes manages to insinuate the notion that the way people spend their incomes is essentially non-rational or irrational.” I’m not sure I agree with Hazlitt’s disapproval. If you ask a person why he choose to spend his money on a particular thing, he may give you reasons, but they may be not rational. Why those reasons and none other? He may not be able to answer. An economist would just have to take a person’s choice or action as granted, or assume it for the purpose of giving an example or analyzing a particular situation.

Hazlitt quotes Keynes, "But although the [Ricardian] doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners." (page 57) While economics is an useful science, you know already what I’m going to say, that people’s actions or choices are not perfectly predictable by any known means. I myself did predict in a way that we’re in for another Great Depression, but the timing and severity I didn’t know and still don’t know.

Mises did predict in a way the demise of the Soviet Union, but he didn’t know when and exactly how it would die. What effect did Ronald Reagan’s deal with the Saudis to keep oil prices low have on the Soviet Union?

Today the economy is manipulated by the government to benefit the ruler class. If you agree that the economy should be for the benefit of everyone, it follows that the government should refrain from manipulating the economy to benefit the ruling class. Is manipulation for the benefit of everyone still a good idea? No. The government must be able to forecast the consequences of any given manipulation. If the consequences do not benefit everyone, then don’t do the manipulation. The principle must be that no one should be made to suffer more than otherwise as a result of the manipulation. Do no harm. Because people’s choices or actions are not precisely predictable except rather broadly and in the short term usually, the government can’t do anything therefore with the economy. In any case, Austrian school economists have not found any case of putative manipulation that would benefit everyone. Take minimum wage legislation, for example. Analysis show that the people earning marginal wages are likely to lose their jobs. The people who do benefit are those who earn above-minimum wages. They have less competition, so can become lazy a bit, while they continue to earn cushy wages and enjoy greater job security.

What is left is laissez faire. If the government cannot do more except to take resources from the economy, what would be the point? How to spend those taken resources? Away with the USFG! The State governments! Also the local governments, but I would allow panarchy. Let those crazies choose their statist government, as long as it’s local, and everyone has some choice of governments–or none.

Another reason for laissez faire, is that generally speaking everyone knows his desires and situation in the world better than the government could. For the government to know what any given individual wants, he has to be allowed to act freely. To be sure, that means everyone has to allow everyone else his liberty.

Justice is necessary, because we will have evildoers. When they are caught, they must make their victims whole in so far as that is possible.

[Augustine2004]

I find it hard to believe anyone would take a guy seriously after he defines two terms in such a way that they must be identically the same, and afterwards go for pages like those terms are not really the same (pages 80-1). See page 95, in which saving is sinful, yet investment is a virtue.

Now, economics is not ethics, judging acts as sinful or virtuous, though Austrian School economists often assume or discuss the free market, in which everyone follows the Maybury precepts. I.e., we won’t have the free market unless everyone follows the Maybury precepts. You don’t have to point out that in that sense today’s economy is far from being free.

Hazlitt sums up what he thinks Keynes is advocating: “The great virtue is Consumption, extravagance, improvidence. The great vice is Saving, thrift, "financial prudence." We are to be improvident. I doubt Keynes was a Christian or believed in miracles. Something has got to be off kilter in his theory. Would you be improvident on the grounds it would help everyone else? Including your kids? Bah, humbug. In the great housing bubble, were we not improvident? Are we not now suffering greatly? More suffering yet to come, I’m afraid.

[Augustine2004]

From page 133 of Hazlitt’s book:

It is this wilful blindness to the two-sidedness of every transaction—this concentration on the incentives to borrowing and obliviousness of those to lending, on the incentives of the buyer and not of the seller, of the Consumer and not of the Producer, this terrific to-do about the propensity to consume while the propensity to work is taken for granted or forgotten—it is this one-eyed vision that constitutes the Keynesian "revolution."I’d guess 80% of people hired to work as economists or maybe 90% are one-eyed people. Unfortunately most work for the government. Nobelist Paul Krugman, for one, is a columnist, but he does definitely work for the government, though not in an official capacity.

Ah, at last, the fabulous creature, the Multiplier, the Shmoo (http://en.wikipedia.org/wiki/Shmoo) of our times (page 135). If I understand Hazlitt right, Keynes thinks that government’s spending can act like a car’s supercharger (http://en.wikipedia.org/wiki/Superchargers) on the economy, except the government can create ‘money’ simply by pressing a button on a computer keyboard. The more inflation, the greater the prosperity. Wheeaaooo! Flattened like a pancake by the sheer acceleration. But many people were flattened in the current depression and many more will be.

I am amazed that someone like Keynes apparently does not understand why gold is so valuable. Furthermore, do 80% or so of professional “economists” really not understand? Or pretend that gold should not be regarded as valuable? (Page 155.)

[Augustine2004]

Hazlitt considers what Keynes wrote about risk, starting on page 165. I doubt Hazlitt handled the topic adequately. To be sure, Hazlitt may have much narrower definitions of risk in mind or considered rather specific situations. Nevertheless, his treatment seems to me at least misleading.

Every action has its own set of risks, without exceptions. Wits may put it this way: Life is a gamble. To be sure, by taking a new and different action, one may exchange one set of risks for another. Or, transform a present set of risks into another.

What cannot be done is to meaningfully reduce the level of risk, whatever that phrase may mean in the sense of an operational definition. It may be possible, but we shall never know for sure. To be sure, if one feels uncomfortable with one’s current set of risks, he may seek to transform that to one that he feels more comfortable with. Two or more actors may cooperate so as to transform their respective sets of risks. For example, insurance and futures trading.

By the same token, it’s not meaningful either say that the overall level of risk is thereby increased. Some people are thrill-seekers, but can we say that their lives are thereby more risky than the stay-at-home people? What about the risk of boredom? I do not see why we should value that any less than that of bungee jumping or parachuting, in view of our lack of knowledge about the future and inability to properly evaluate any particular risk.

In a related matter, you may have heard a lot of USFG chatter about systemic risk in the ‘free’ market.
http://www.lewrockwell.com/blog/lewrw/archives/025978.html
Anyone talking that up should be challenged to give an operational definition. I.e., is there a way to measure it? If so, what procedure should we follow? I’m sure you are going to get nothing substantive in whatever response there is.

Please, any criticism or questions?


...

On page 182, Hazlitt wrote, “The difference between gambling and speculation is clear: in gambling, the risks are arbitrarily invented or created; in speculation, the risks already exist, and somebody has to bear them.” It’s possible I fail to understand what is meant by arbitrarily invented or created risk. Anyway, I say that the gambler may have a different tolerance for risk in general than a given speculator. However, that’s a corollary of the truth that everyone has a different tolerance for risks than does everyone else.

Is there indeed a difference between gambling and speculation? The answer depends on the precise definitions of both terms. In general, however, I would say no.


...

I should have read on instead of immediately uploading my last post. Hazlitt wrote this: ‘The world would probably be richer rather than poorer if gambling casinos and race tracks did not exist at all.’
Wow, how could he make a statement like that? What about the risk of boredom, for one thing?

Anyway, pages 182-5 make it evident why politicians, including totalitarians and authoritarians, love Keynesianism. People who desire power can rationalize their taking it by quoting Keynes, especially those pages.

On page 191 Hazlitt seems to think that sometimes people don’t speculate. I wish there were a definition of speculation. As I’ve implied before, every time we choose some course of action and put that in effect, we are in some sense speculating. The guy that saves his money under his mattress is speculating as much as the guy that puts his money on pig-belly futures options.

No one can be considered a scientist who does not pay the requisite attention to necessary facts. On page 195 Hazlitt says that Keynes ignores real factors in the level of rates of interest. For that reason I say Keynes was no scientist.

[Augustine2004]

In an economy like the USA one in the decade after World War II, the following conclusion may apply:
‘So the process by which the Central Bank originally was able to lower interest rates, will now simply serve to raise them.’ The explanation on page 214 involves inflation.


Hazlitt espies another connection between Keynes and the Marxists.
Keynes was left with no real theory of interest. But on second thought it is clear that he was flirting with the oldest theory of all—the Exploitation Theory. This was once described by Irving Fisher as the persistent idea that "to take interest is, necessarily and always, to take an unfair advantage of the debtor. This notion is something more than the obviously true idea that the rate of interest, like any other price, may be exorbitant. The contention is that there ought to be no interest at all." After tracing the persistence of this notion through primitive societies, ancient Rome, and the Middle Ages, Fisher declared that, "Today the chief survival of the exploitation idea is among Marxian Socialists."13 But Fisher wrote this some years before Keynes attempted still another revival in "modern" guise. (Page 216.)

[Augustine2004]

On page 222, Hazlitt wrote, ‘Every manufacturer or seller knows that when by production or offer he increases the supply of a commodity he does not thereby raise its price . . .’ Surely Hazlitt meant the average price of commodities like what the manufacturer makes, that were sold in the past. Of course the manufacturer is free to set whatever price on his own manufactured goods he likes, but one knows that it would be foolish to set a price so high that prospective customers would think it ‘highway robbery.’

On page 225, Hazlitt wrote:
For if prices and wage-rates are fluid in both directions, the immediate response to a falling off in the desire to buy goods or to hire workers would be a lowering of prices or wage-rates to a point where people would cease to attempt to save more than before and would consent to make their usual purchases again. In any case, the reduced supply of money
offered would now be sufficient to buy the previous volume of goods and to employ the previous number of workers at the now lower prices and wages.I’m afraid some readers would think this is wrong. How could a diminished supply of money buy the same goods as before? That’s because sellers set their prices lower. The average height of prices is lower in conformance with the smaller size of the money supply.

As long as prices are free to move up or down, that is the reason why, as we add to our gold stock, it would still be able to buy any constellation of goods, no matter how big. Suppose that on the average there’s more gold per person than before. No problem! Prices will simply go up, without any dire economic consequences. On the other hand suppose we have less gold per person. Prices goes down, again no problem.


On pages 228-9 before Section 3, I think Hazlitt had the Federal Reserve System or some generalized central bank system in mind. The free-market banking system and the free-market money system don’t work like what Hazlitt describes. If someone wants, I can recommend books to read on the free-market systems.


Section 3 on page 229 may puzzle some readers. I suggest that they read Section 1.4 (page11?) of Man, Economy, and State by Murray Rothbard available in the Mises.org bookstore bookstore (http://www.mises.org/store/Man-Economy-and-State-with-Power-and-Market-The-Scholars-Edition-P177C0.aspx)

Of course if some readers are still puzzled, they will have to go to the beginning of Chapter 1 of M,E,S.
I would be glad to answer any reasonable question.

[Obsidian]

Austrians wrongly condemn the use of equations. Equations are only bad if they contain serious flaws.

In the case of Keynesian economics, the flaw is quite simple:

GDP = G + I + C + NX --- The GDP formula is itself the problem.

Obviously government expenditures (G) will always be more wasteful than consumer (C) expenditures. Therefore, our basic formula for calculating national wealth is erroneous!

One other flaw of Keynesian economics is that consumer spending (C) may be manipulated through national debt. The manipulated spending will be more wasteful than natural spending levels. Republicans frequently make this error. They use national debt to obtain money for tax cuts, and then they give the money to the consumers to spend, thinking they are creating wealth.

*Sigh*

[Augustine2004]

Obsidian, will you please give us an example of a equation that does not contain any serious flaw and is useful for something?

[Augustine2004]

he moderators were unhappy that I was chain-posting. The only thread I’m allowed to chain-post (blog) is the Augustine’s opinions http://www.theologyweb.com/campus/showthread.php?t=117929 thread. You readers have seen fit to simply lurk, so I have no choice but to complete my review in that thread.
Darn it Aug, you KNOW BETTER than to argue moderation in the thread

The continuing post is this: http://www.theologyweb.com/campus/showpost.php?p=2624735&postcount=396

[joel]

I decided to post here. I assume you are still free to dialogue here.

Are you reading Keynes' General Theory too, or just Hazlitt? I recently read the General Theory and Hazlitt's book side-by-side. My general impression is that Keynes was a poor writer and a poor thinker. I find it difficult to understand how anyone took Keynes for a serious economist.

Keynes offers the absurd ideas of the multiplier and the liquidity preference theory of interest. And then the rest of his reasoning is based on those ideas.

I think the point Obsidian made was valid, that it is useful to explain why a use of equations is wrong, as opposed to dismissing it with "equations are useless in economics" (though that may be the case).

For example, consider Keynes' use of algebra. He declares functional relationships that don't exist. For example, he defines O(N), the function of total output as a function of total employment of labor. Even ignoring the fact that total output and total employment of labor cannot be objectively quantified, there isn't a functional relationship. Given the same value of N, those workers could work on different projects, using different materials and different techniques. All of these choices affect output, and thus there is not a unique value of output for a given value of N. If x workers moved from project A to project B, then N stays the same, but total output may, as a result, increase or decrease.

In chapters 19, 20, 21 which are supposed to be his crowning achievement, he defines several functions (that aren't functions) like this. Then he does a bunch of differential calculus on them and derives equations relating their elasticities. But if there does not really exist a functional relationship--if O(N) is not a function in the real world--then you can't differentiate it. It's not a function (let alone a continuous, differentiable function), thus it does not have a slope or an elasticity.

Another part of the problem is that he seems to lose sight of cause and effect. For example: He divides all spending Y (and thus money income) into the categories consumption C and investment I, thus:

Y = I + C

is true by definition. If Y increases by a small amount ΔY, C and/or I must also change (by ΔC and ΔI), thus

ΔY = ΔI + ΔC

is also true by definition. Keynes then does some algebraic manipulation to get:

ΔY = (1/(1 - ΔC/ΔY))*ΔI

And defines k = (1/(1 - ΔC/ΔY)) as the "multiplier", thus ΔY = k * ΔI.
He takes this to be a functional relationship (Note that k hides a ΔY inside it; thus ΔY is on both sides of the equation, and thus this equation does not even define a proper algebraic function.), and thinks that we can then infer that an increment in investment will cause an increase in total income by k times that amount. Now, the equation is true--by definition. But Keynes' problem is that he (mis-)reads cause and effect into it.

The equation is true for any three quantities such that X = Y + Z. For example, suppose we have a bucket of marbles, some green G and some blue B. If M is the total number of marbles, then we have M = G + B, and we can do the same algebra as keynes to get

ΔM = k * ΔG,

with k = (1/(1 - ΔB/ΔM)) as the "multiplier". Supposing we add only green or blue marbles to the bucket, this equation is true, but we cannot safely conclude that all we have to do is add some green marbles to the bucket and then the total number of marbles will increase by more than that, as if additional blue marbles pop into existence by magic because some mysterious force holds k between 0 and 1.

Also if ever ΔC = ΔY, which is certainly possible, then the multiplier becomes infinite! (or rather, undefined. k will approach infinity in the limit.) Keynes' assertion of this cause and effect relationship also rules out the possibility of people deciding to consume less and invest more (or vice versa), so that ΔC = -ΔI, and Y stays the same. This, again would cause the multiplier to have a division by zero, and thus be undefined (though its limit would be zero).

Keynes was a hack. He overcomplicated some things and grossly over-simplified other things, and these errors led him to absurd conclusions.

[Augustine2004]

I didn't read the General Theory. I think Keynes wanted the kind of conclusions that supported big-government socialism or maybe rather fascism--like Nazi Germany's economic policy. The General Theory was created and shaped to obtain that kind of conclusions, and promoted to appeal to politicians and other socialists.

[joel]

I didn't read the General Theory. I think Keynes wanted the kind of conclusions that supported big-government socialism or maybe rather fascism--like Nazi Germany's economic policy. The General Theory was created and shaped to obtain that kind of conclusions, and promoted to appeal to politicians and other socialists.
Let's suppose you are correct. Then Keynesian ideas became mainstream because mainstream economists also desired justification for their previous love of big government?

But then why does the mainstream still hold onto Keynes' framework? Even Milton Friedman, who was for the most part a libertarian and apologist for small government, bought into this basic framework and made a case for small government from within the framework instead of refuting the framework itself. (For this reason, Friedman still couldn't reject monetary policy.) From what I understand, Friedman and some neoclasical "mainstream" economists argue for smaller government, but still hold onto ideas such as a consumption function and the multiplier, an aggregate demand function, liquidity preference theory of interest, the IS-LM model. But economists like Friedman have no reason such as you suggest for buying into this framework. So why do they? (After reading General Theory, I read this http://legacy.ncsu.edu/classes/ec348001/TextLinks.htm which I think gave me a better understanding of what "mainstream" economists think today. On the other hand most of the derivation of the models in this book consists of unsupported assertions, thus leaving me in the dark as to why they believe these things.)

Do you know of any debates between 'Austrian' and 'mainstream' economists (say, over something like the IS-LM model), that would help illuminate their point of departure? Or it would also be helpful if I had one or more 'mainstream' economists with whom I could dilalogue.

[Augustine2004]

Let's suppose you are correct. Then Keynesian ideas became mainstream because mainstream economists also desired justification for their previous love of big government?

But then why does the mainstream still hold onto Keynes' framework? Even Milton Friedman, who was for the most part a libertarian and apologist for small government, bought into this basic framework and made a case for small government from within the framework instead of refuting the framework itself. (For this reason, Friedman still couldn't reject monetary policy.) From what I understand, Friedman and some neoclasical "mainstream" economists argue for smaller government, but still hold onto ideas such as a consumption function and the multiplier, an aggregate demand function, liquidity preference theory of interest, the IS-LM model. But economists like Friedman have no reason such as you suggest for buying into this framework. So why do they? (After reading General Theory, I read this http://legacy.ncsu.edu/classes/ec348001/TextLinks.htm which I think gave me a better understanding of what "mainstream" economists think today. On the other hand most of the derivation of the models in this book consists of unsupported assertions, thus leaving me in the dark as to why they believe these things.)

Do you know of any debates between 'Austrian' and 'mainstream' economists (say, over something like the IS-LM model), that would help illuminate their point of departure? Or it would also be helpful if I had one or more 'mainstream' economists with whom I could dilalogue.Governments prefer Keynesists or economists that support big government. Austrian School economists have had to struggle against the government. Incidentally, did you hear about the TSA detaining a Ron Paul aide? Either that or they go over to the dark--and materially comfortable and safe--side.

Certainly Austrian School people have criticized other economists such as Keynes and Paul Krugman. I think there were debates, but I can't recall one offhand.

[joel]

It may be useful to also discuss modern ideas derived from Keynesianism. I thought I could share some thoughts I had regarding what I learned about modern 'mainstream' macroeconomics from the McElroy text (that I linked to in my last post). But I don't want to be guilty of back-to-back posting, so if you are interested, you need to contribute with some discussion.

In this post, I'd like to discuss the modern interpretation of the "consumption function" and the multiplier. The analysis focuses entirely on the spending side of things (as opposed to production). Every dollar spent is received by someone else as income. Thus if you add up all the items of spending, it must equal total income Y. As before, if we divide all spending into consumption C and investment I, then

Y = C + I

Okay so far. Now what the 'mainstream' economists do is try to express C and I as mathematical functions of other quantities. They think of consumption as a function C(Y) of income, and investment as a function I(r) of the interest rate. Now there are various reasons to believe that C and I are not functions of these quantities. And conceiving of them in this way makes it seem as though they were independent, as if one could be increased independently of the other, as if there were not a tradeoff between them, such that you would have to reduce your spending on investment if you wanted to increase your immediate consumption. Y in the expression above is the income generated by the spending, but we seem to be ignoring the question of where people got the funds to spend in the first place, and that those funds are limited.

But even if we suppose that there exists such independent functions, we run into other problems. As a simplification they treat the function C(Y) as being (at least locally) linear

C(Y) = C0 + C1*Y

Thus we have

Y = C + I = (C0 + C1*Y) + I(r)

This brings us to the idea of the multiplier. Although Keynes seemed to think of the multiplier as something that is always mathematically true at every instant of time, it seems that the modern way to think of it is as an iterative phenomenon. Notice that there are two Y's in the above formula. The one on the left is the income generated by (and equal to) the spending on the right. The C1*Y implies, on the other hand, that a certain percentage of income previously received is consumed. It may be easier if we think of dividing up time into periods, where income Y2 (at time/period 2) is generated by spending out of income received in the previous time period Y1 (and perhaps out of cash saved--not spent--in even earlier time periods). Thus something like:

Y(t+1) = C0 + C1*Y(t) + I(r)

Where an equilibrium or 'steady state' (or 'evenly rotating economy') would require an unchanging income from period to period: Y(t+1) = Y(t).
For illustration, consider a numerical example. For simplicity, suppose C0=0, C1=0.9, I(r)=100, and thus

Y = 0.9 * 1000 + 100 = 1000

This describes the a steady state where people as a whole consume 90% of their income and invest 10%. Now let's suppose that the C and I above were only private spending and there wasn't any government spending. And then suppose the government comes along and taxes and spends 100. Now we are going to have:

Y2 = C(Y1 - T) + I(r) + G

where T is the tax and equals G, the government spending. Thus

Y2 = 0.9 * (1000 - 100) + 100 + 100 = 1010

Woah, starting from a steady state, the government taxed 100 and spent 100 and total income increased by 10! This is completely surprising and counterintuitive, because one would think that the tax must reduce private spending power by exactly 100. (What's more, income would have increased by even more if T=0, and the government still spends the same 100, running a deficit. In fact income, according to this model, would have increased by the full amount of the government's spending!) Instead of questioning this absurd result, the 'mainstream' economist considers this the "expansionary" power of government spending. McElroy, at least, does not stop to consider or explain where this extra 10 comes from. Let's see. In the steady state, Y was 1000, and C1 was 90% of that, so consumption was 900. But in period 2, consumption was decreased due to the tax:

C = 0.9 * (1000 - 100) = 810

Thus consumption decreased by only 90, less than the amount of the tax! But private spending power was reduced by 100. Something had to be reduced by the extra 10. McElroy never explains this. If reduction of consumption fell by only 90 and we assume that investment did not decrease, then if it didn't come into being by magic (or the government's printing presses), it could have come only from cash balances that people had saved up prior to the steady state and were not spending in the steady state. If people were spending all of their money every time period--which is possible--then the above result is outright contradictory, and thus the above formula has an obvious flaw. But why would people begin to consume their cash balances just because of the government's tax and spending. By what reason can we suppose this is necessarily true. Before considering this closer, let's get back to the multiplier. Y2 according to the above model was larger (1010). Now plug this in for the next time period, assuming the government continues its behavior of taxing and spending 100 each period:

Y3 = 0.9 * (1010 - 100) + 100 + 100 = 1019

Income got even bigger (but by a smaller increment). But then

Y4 = 0.9 * (1019 - 100) + 100 + 100 = 1027.10

And total income keeps getting bigger and bigger. According to this model, it will continue growing until Y(t+1) = Y(t). We can solve for this algebraically.

Y = C1*(Y-T) + I + G
solving for Y gives
Y = (1/(1-C1)) * (I + G - C1*T)

Thus (1/(1-C1)) is the multiplier. In this case, 1/(1 - 0.9) = 10. And
Y = 10 * (100 + 100 + 0.9*100) = 1100, thus we supposedly reach a new steady state where the income is 1100 each period. This is the magic of the multiplier. Algebraically, this is actually the same as Keynes' multiplier (as I described in an earlier post), because C1 is really ΔC/ΔY. It is merely interpereted differently here, as an iterative, instead of instantaneous, phenomenon.

But still no reason is given to believe that people necessarily behave in this way. Also it has all the same failings as Keynes'. For example, C1 could be 1 (that is, a change in income could coincide with a change in consumption by the same amount). But as C1 approaches 1, Y goes to infinity! Something is wrong here.

Also consider that Y, being total spending, must be equal to the sum of all the prices paid for everything purchased:

Y = p1 + p2 + p3 + ...

The only way Y could increase is for either more goods to be produced and purchaced or for the prices of the purchases to increase, or both. But government taxing and spending does not magically produce more goods to be purchased--that takes production, which takes time and scarce resources. Thus if it does cause an increase in Y (which there is reason to suspect), it can happen only by increasing purchase prices overall. But this is the same thing as a fall in the purchasing power of money (i.e., inflation). So this means that the increase in Y is offset by a fall in the value of that money, and thus the real value of Y is unchanged or even reduced.

Furthermore, if the purchasing power of money falls but the money supply remains the same (as we are assuming here), this means that the real value of the total cash holdings of everyone is shrinking. But this can happen only if the demand for money (i.e., the demand for cash holdings) has fallen. If it hasn't then there will be a shortage of money, in which case people will reduce their purchases and increase their sales in order to try to gain more money. This behavior will tend to drive prices downward, counteracting the above supposed increase in Y. There is no reason to believe that additional government taxing and spending will decrease the demand for money, let alone decreasing it simultaneously and by the exact amount predicted by this mathematical model. In fact, the uncertainty generated by the government increasing its taxing, spending, etc., may be likely to cause people to want to increase rather than decrease their cash balances.

In order to get around this last problem, the 'mainstream' economist proposes a brand new theory of interest, throwing out all the advancements in the study of interest over the past 200 years. This new theory of interest is severely flawed. Though I should leave that for another post, assuming anyone is interested in continuing the discussion.

[Augustine2004]

In a free market, a shortage of money would never develop. If perchance the people saved more money than usual, or somehow the gold mines output less gold so that grams of gold per capita decreased, the economy can easily adjust the prices so that each gram of gold would have greater purchasing power, i.e., it can buy more goods or services than before.

What could be meant by consumption being a linear function of total income? That can be true only if it is good every time. It's got to be at least partially a function of time. People used to not save money--well, not much. Now, suddenly they've got saving religion! Hallelah, a saved dollar saves!

The choices that people and the actions that they take, as I've said more than once, are not predictable. Hence, the function of time must not be knowable.

Modern theory, phooey. Keynes, phooey.

[joel]

In a free market, a shortage of money would never develop. If perchance the people saved more money than usual, or somehow the gold mines output less gold so that grams of gold per capita decreased, the economy can easily adjust the prices so that each gram of gold would have greater purchasing power, i.e., it can buy more goods or services than before.

Yes, although couldn't we also say that actually there is always a small shortage or surplus of money because we are in a constantly changing economy? Certainly at final prices and in the evenly rotating economy there is no surplus or shortage of money, but we are never quite there, always moving toward a moving target. This is what makes entrepreneurial profit and loss possible. In mainstream terminology this would be called the "short run." Suppose we start out with no shortage or surplus, but then the demand for money quickly increases (or decreases). Prices don't adjust everywhere instantly or at the same time (or to the same degree). Mises called this a cash-induced change to the money relation. Redistribution effects will occur in the process of prices across the economy adjusting. In this "short term", before prices have finished adjusting, people will have smaller cash balances than they want, no? But any shortage or surplus is always tending toward zero.



What could be meant by consumption being a linear function of total income? That can be true only if it is good every time. It's got to be at least partially a function of time.
If you suppose that consumption C(Y) is a differentiable function of Y, then you can treat it as being locally linear via a first-order Taylor expansion (http://en.wikipedia.org/wiki/Taylor_series). For example, suppose Y =1000, C=900. Then we would say that C(1000) = 900. Suppose also that we can know the slope C'(1000) of the function C at Y=1000. Let's say the slope is 0.8. Then C(Y) is approximately

C(Y) = 1000 + 0.8 * (Y-1000)
or
C(Y) = 200 + 0.8 * Y, (Thus C0=200, and C1=0.8)

at least in the neighborhood around Y=1000. Of course the problem is that we don't know that there is a functional relationship between C and Y at any point in time, let alone that it is continuous and differentiable. Even if there were such a function, we couldn't measure C0 and C1 because they would constantly be changing. We would have no way of knowing whether a change over time was a movement along the function or if the function itself changed or both. So yes, like you say, you would need to know it as a function of time too:
C(Y, t). But then what does the function even mean when you vary Y but hold t constant? Are we then speaking of counterfactuals?--What would consumption be (have been) at time t if Y were other that it actually is (was) in the real world. One can argue that there is no such thing as a true counterfactual--especially when talking about beings with free will.



The choices that people and the actions that they take, as I've said more than once, are not predictable. Hence, the function of time must not be knowable.
True. The amount people consume depends on changing personal preferences and fact of what actually gets produced in what proportions and offered at what prices. There is never a single, definite, level of consumption determined by a given level of income.

So much for the consumption function and the multiplier. Perhaps the next thing to discuss is investment and interest. What do you think about the 'mainstream' idea that the total amount of investment I is a function I(r) of the rate of interest? For example, "Given expectations about returns on fixed investment, every level of interest rate [r] will generate a certain level of planned fixed investment and other interest-sensitive spending" (http://en.wikipedia.org/wiki/Islm If one looks at that page, one will see that the
Y=C(Y-T) + I(r) + G that we have been considering defines the IS curve in the IS-LM model).

[Augustine2004]

I think that given enough data points that are reliable and cover a given t,Y area reasonably well, we can fit a nonlinear C(Y,t) to the data. No need for a Taylor expansion. The problem is to get the reliable data timely. In practice, the data is collected in weeks or even months. Even at that, the data may not be reliable anyway.

But, suppose we do have a C(Y, t) to play with anyway. What general conclusions be made from that? We really can’t assume it is really continuous and differentiable. There may be steep slopes that are effectively discontinuous, but that the data, as discrete as it is, does not show. We certainly can’t assume that the function applies to all time intervals anyway.

As for the relationship between the total amount of investments and the interest rate(s), there is no such thing as the interest rate. Every time the mix of different interest rates may differ from any other time. One could create an index, but it depends on how the index is created. It would have to be consistently applied to the data. How can that be, when the mix of interest-bearing instruments may vary from time to time. Even so, the amount-rate relationship may vary from time to time.

[joel]

As for the relationship between the total amount of investments and the interest rate(s), there is no such thing as the interest rate.

I think that seals its fate right there. And I think there are other problems besides. For the sake of argument, let's suppose that there were just "the interest rate." Take that quote:

"Given expectations about returns on fixed investment, every level of interest rate [r] will generate a certain level of planned fixed investment and other interest-sensitive spending"

They are taking returns on fixed investment as given, and varying the interest rate on business loans, as if those two things were independent of each other. In reality, however, those two things tend toward each other. If returns on capital goods are expected to be greater than the interest rate, then people will refrain from lending and directly invest in order to capture the greater expected return. This will drive the interest rate up and the return on those capital goods down (because it will drive the price of them up and the price of their product down). Likewise if the expected return on capital goods falls below that of the interest rate on loans, then people will choose to lend their money at interest instead of investing directly in capital goods. This will drive the interest rate down and the return on the capital goods up, until expected returns are equal. So the premise of the quoted statement is erroneous.

The assumption of the IS curve and the multiplier is that consumption will iteratively adjust until savings and investment balance at whatever the interest rate may be. But how can this be? The formula Y2=C(Y1-T) + I(r) + G does not include savings anywhere--at least not in the sense that they mean it. Savings is defined as Y1-T-C. But this doesn't appear anywhere. There is no mention in the formula of any tradeoff between consumption and saving. In fact, we might point out that lending money is an alternative to consumption spending. The higher the interest rate, the higher the opportunity cost of consuming vs lending (it also makes it more expensive to borrow to consume). But the 'consumption function' does not take this into account. Perhaps it should be C(Y, t, r). And likewise investment (here restricted to mean only the purchase of capital goods) surely depends on the funds available to invest, which are limited by things like past income and consumption. But no mention of this is made in the function I(r) which varies only with the rate of interest.

Specifically, the 'mainstream' economist says that the relationship between the quantity of investment and the interest rate on loans is an inverse one. If the interest rate increases, then the volume of investment will decrease.
But is this really true? Note that if we take into account an inverse relationship also between consumption and the interest rate (as described above), this would seem to further support the idea that a high interest rate is bad because it drives down both consuming and investing, thus driving down total income Y! But if the rate of interest increases, this must also mean that the expected return on capital goods is tending to increase too, because the two are always tending toward each other, as explained above. Thus we should expect an increase in motivation to invest in capital goods.

The 'mainstream' economist also ignores time preference here. Both the expected return from capital goods and the interest rate on loans are part of the larger category of the 'time market'--the exchange between present goods and future goods. If the demand for present goods (in exchange for future goods) increases while the supply schedule remains the same, then the rate of return (on both 'investment' and loans) will increase, and the volume of lending/investing will also increase. Likewise if the government were to impose a maximum rate of return below that which would occur on the unhampered market, then investment would decrease, and there would be a shortage of investment. Thus it is not necessarily the case that there is an inverse relationship between investing and the rate of interest.

But if this relationship does not necessarily hold, then their whole theory breaks down. The IS-LM model is a theory of the interest rate. It says, for example, that if government spending increases, then the IS curve shifts to the right. Consumption drops by less than the amount of the tax (if any) and this is compensated by a rise in the interest rate causing investment to decrease by just the amount needed to supposedly compensate for the given demand for money, based on a liquidity-preference theory of interest. And so we see that according to this model, interest must be determined exactly by demand. The interest rate needs to adjust to the point that balances demand for consumption and the demand for money and the demand for investment (and government 'demand'). This is supposedly the point where the IS and LM curves cross. But this completely leaves out the obvious cause for the rate of interest: the supply and demand for present goods (as exchanged against future goods). It ignores a couple hundred years of advancement on the understanding of interest.

And ather thing that doesn't make sense to me: Before the increase of government spending, we assume we are in a state of equilibrium. In particular, the supply of funds for loans must equal the demand for loans. Then the interest rate increases in order to equilibrate demand. But the higher rate of interest makes the supply of loans increase (as indicated by the LM curve)--people become more eager to loan money--and the demand for loans to decrease--people become less eager to borrow. But surely this means that there is now a surplus of lendable funds! People want to lend more than people are willing to borrow. We cannot possibly be at a new equilibrium.

[Augustine2004]

I think that seals its fate right there. And I think there are other problems besides. For the sake of argument, let's suppose that there were just "the interest rate." Take that quote:

"Given expectations about returns on fixed investment, every level of interest rate [r] will generate a certain level of planned fixed investment and other interest-sensitive spending"

They are taking returns on fixed investment as given, and varying the interest rate on business loans, as if those two things were independent of each other. In reality, however, those two things tend toward each other. If returns on capital goods are expected to be greater than the interest rate, then people will refrain from lending and directly invest in order to capture the greater expected return. This will drive the interest rate up and the return on those capital goods down (because it will drive the price of them up and the price of their product down). Likewise if the expected return on capital goods falls below that of the interest rate on loans, then people will choose to lend their money at interest instead of investing directly in capital goods. This will drive the interest rate down and the return on the capital goods up, until expected returns are equal. So the premise of the quoted statement is erroneous.Not only that, but government 'investment' is like a joker. Who could forecast its amount and where it would be invested?


Specifically, the 'mainstream' economist says that the relationship between the quantity of investment and the interest rate on loans is an inverse one. If the interest rate increases, then the volume of investment will decrease.
But is this really true? Note that if we take into account an inverse relationship also between consumption and the interest rate (as described above), this would seem to further support the idea that a high interest rate is bad because it drives down both consuming and investing, thus driving down total income Y! But if the rate of interest increases, this must also mean that the expected return on capital goods is tending to increase too, because the two are always tending toward each other, as explained above. Thus we should expect an increase in motivation to invest in capital goods.I recall reading somewhere that as the economy expands, the interest rates tend to rise. However, the volume of loans and other investments may expand also, because business seems to be so good.


The 'mainstream' economist also ignores time preference here. Both the expected return from capital goods and the interest rate on loans are part of the larger category of the 'time market'--the exchange between present goods and future goods. If the demand for present goods (in exchange for future goods) increases while the supply schedule remains the same, then the rate of return (on both 'investment' and loans) will increase, and the volume of lending/investing will also increase. Likewise if the government were to impose a maximum rate of return below that which would occur on the unhampered market, then investment would decrease, and there would be a shortage of investment. Thus it is not necessarily the case that there is an inverse relationship between investing and the rate of interest.It may be better to put what you said about the volume first, not last, in the quoted passage above.


But if this relationship does not necessarily hold, then their whole theory breaks down. The IS-LM model is a theory of the interest rate. It says, for example, that if government spending increases, then the IS curve shifts to the right. Consumption drops by less than the amount of the tax (if any) and this is compensated by a rise in the interest rate causing investment to decrease by just the amount needed to supposedly compensate for the given demand for money, based on a liquidity-preference theory of interest. And so we see that according to this model, interest must be determined exactly by demand. The interest rate needs to adjust to the point that balances demand for consumption and the demand for money and the demand for investment (and government 'demand'). This is supposedly the point where the IS and LM curves cross. But this completely leaves out the obvious cause for the rate of interest: the supply and demand for present goods (as exchanged against future goods). It ignores a couple hundred years of advancement on the understanding of interest.if the government will really do more good than bad, I would be all for letting the government manage our resources--all of it.


And ather thing that doesn't make sense to me: Before the increase of government spending, we assume we are in a state of equilibrium. In particular, the supply of funds for loans must equal the demand for loans. Then the interest rate increases in order to equilibrate demand. But the higher rate of interest makes the supply of loans increase (as indicated by the LM curve)--people become more eager to loan money--and the demand for loans to decrease--people become less eager to borrow. But surely this means that there is now a surplus of lendable funds! People want to lend more than people are willing to borrow. We cannot possibly be at a new equilibrium.Would the people really be more eagar to lend their money, especially when the Fed drives short-term interest rates so low?

[joel]

if the government will really do more good than bad, I would be all for letting the government manage our resources--all of it.

How do you reconcile this with Mises' argument that economic calculation is impossible under socialism? --that even if the government agents are perfectly virtuous and wise and do their best to do more good than bad, socialist control of the means of production would result in capital consumption and the disintegration of the social order, because economic calculation would be impossible.



Would the people really be more eagar to lend their money, especially when the Fed drives short-term interest rates so low?

I was specifically referring to the case of an increase in interest rates.

[Augustine2004]

How do you reconcile this with Mises' argument that economic calculation is impossible under socialism? --that even if the government agents are perfectly virtuous and wise and do their best to do more good than bad, socialist control of the means of production would result in capital consumption and the disintegration of the social order, because economic calculation would be impossible.I was being sarcastic.

I was specifically referring to the case of an increase in interest rates.OK, but the tendency of the Fed is to drive down interest rates. Only when it feels the need to moderate inflation (think Paul Volcker) does it deign to raise interest rates.

Suppose the economy came low to a point where it had no capital, but the people finally shucked off the government.

At first we would have Y = C + S, C being consumption and S being savings.

S eventually becomes in part investment S = S1 + I + Int, I being investment in capital goods and Int being investment in interest-paying instruments. The return from I is not instant, of course. It could take years for part of our savings to finally return to Y. Let that be R. Let Rint be the interest paid by the instruments.

Y = C + S, still, even though there’s plenty of capital. Y would have grown, though:

Ynew = W + R + Rint + other, other being gifts and inheritances (we have to take care not to double-count) and W being salary or wages.

It’s getting too complicated for me.