Austrian Business Cycle Theory: Dinosaur Economics

Just a very quick note so as to weigh in on a debate which, frankly, I don’t really want to weigh in on. It relates to the Austrian Business Cycle Theory (hereafter: ABCT) and its relationship to the natural rate of interest. The natural rate of interest was discredited by Piero Sraffa in the 1920s when he pointed out that there were actually multiple own rates of interest depending on which commodity you took as a numeraire. There have been many Austrian responses to try and iron this out — almost all of them imagine a range of financial market contracts, throw in some implicit “rational expectations” assumptions about how such contracts are priced and then claim that they can reconstruct the ABCT from here.

I don’t think that this is the case, I think that the assumptions they use to make the financial contracts produce the interest rate they wish to produce — because, let us have no doubt, this is a theory that at some base emotional level the Austrians want to be true — contradict other assumptions made elsewhere in Austrian theory; such as the assumption of Knightian uncertainty.

However, even leaving this aside we know that the ABCT will not work because, whatever way you cut it, it rests on the idea of a rate of interest that will bring the economy to full employment equilibrium. The manner in which the theory “works” is that the money rate of interest — i.e. that charged by banks — either falls above or below this full employment equilibrium rate, thus causing either inflationary or deflationary forces to generate. This view, however, is disproved by the Cambridge Capital Controversies which showed that such a rate of interest — which the Austrians take over from Knut Wicksell — cannot exist.

Here I will quote Peter Kriesler summarising the argument made by Colin Rogers in his extensive book on monetary theory, Money, Interest and Capital:

Wicksellian monetary theory relies crucially on the concept of the natural rate of interest which has logical flaws which are now recognized as having been exposed by the Cambridge capital controversies. The natural rate of interest was derived from the interaction of forces within the real sector, and determined the equilibrium monetary rate of interest. The natural rate of interest is derived from Wicksell’s capital theory on the assumption that all forms of capital must earn a uniform rate of return. The natural rate is the price which determines the equilibrium of savings and investment. By applying the results of the Cambridge critique of neoclassical capital theory to Wicksell’s concept of the natural rate of interest, Rogers is able to show that it has no rigorous theoretical foundation. Since, for Wicksell, it is the natural rate which determines the market (or monetary) rate of interest, this leaves Wicksell’s monetary theory also without foundation. (Pp52)

It also leaves the ABCT without foundation as this theory relies on the notion of an interest rate — call it the “natural rate” or the “equilibrium rate” or whatever else you want — that, as Kriesler says, “determines the equilibrium of savings and investment”. But this notion does not stand up to the results of the Cambridge Capital Controversies.

And just to wrap this all up I will quote Austrian economist Robert Garrison on the origins of the ABCT and how it relies crucially on Wicksell’s ideas on monetary theory that I have laid out above:

Grounded in the economic theory set out in Carl Menger’s Principles of Economics and built on the vision of a capital-using production process developed in Eugen von Böhm-Bawerk’s Capital and Interest, the Austrian theory of the business cycle remains sufficiently distinct to justify its national identification. But even in its earliest rendition in Mises’s Theory of Money and Credit and in subsequent exposition and extension in F. A. Hayek’s Prices and Production, the theory incorporated important elements from Swedish and British economics. Knut Wicksell’s Interest and Prices, which showed how prices respond to a discrepancy between the bank rate and the real rate of interest, provided the basis for the Austrian account of the misallocation of Financial capital during the boom. The market process that eventually reveals the intertemporal misallocation and turns boom into bust resembles an analogous process described by the British Currency School, in which international misallocations induced by credit expansion are subsequently eliminated by changes in the terms of trade and hence in specie flow. (My emphasis)

Put a fork in it. The ABCT has been a dead duck for years. Which leads one to wonder why Hayek received the faux-Nobel for it — which he received, ironically enough, joined with Gunnar Myrdal, Wicksell’s student who overturned the Wicksellian monetary theory!

Borrowing from Science: Philip Mirowski on Contemporary Neoliberalism

The historian of thought Philip Mirowski has published a very interesting piece entitled The Thirteen Commandments of Neoliberalism. The first and most important point to comment on is the following:

It is noteworthy that [Mont Pelerin Society] members began to explore the portrayal of the market as an evolutionary phenomenon long before biology displaced physics as the premier science in the modern world-picture.  If the market was just an elaborate information processor, so too was the gene in its ecological niche. Poor, unwitting animals turn out to maximize everything under the sun just like neoclassical economic agents, and cognitive science “neuroeconomics” models treat neurons as market participants. “Biopower” is deployed to render nature and our bodies more responsive to market signals. Because of this early commitment, neoliberalism was able to make appreciable inroads into such areas as “evolutionary psychology,” network sociology, ecology, animal ethology, linguistics, cybernetics, and even science studies. Neoliberalism has therefore expanded to become a comprehensive worldview, and has not been just a doctrine solely confined to economists.

This is an enormously important point. Many Post-Keynesians and other aspiring “new economic thinkers” have fooled themselves into believing that all economics has to do is mimic the scientific method more accurately than the neoclassical economists have done to produce results. The problem, however, is that this method itself has become infested with ideas that originated in economics. Nor is this a new phenomenon; Herbert Spencer’s “Social Darwinist” ideas predated the evolutionary theories of Charles Darwin (theories I have no doubt was inspired by the laissez-faire theories popular at that time) and these theories themselves soon got caught up in the eugenics movements of the 19th, 20th and 21st centuries.

The problem has always been the same: social sciences require legitimacy and for that they turn to the authority of the hard sciences; while the hard sciences, being by nature atomistic and largely unable to create meaningful narratives, require structures in which to contextualise their operation for which they often turn to the social sciences. In reality, of course, such authority is completely arbitrary and “Science” in this regard is merely the modern zealot’s stand in for “Religion”. The narratives generated too are fairly arbitrary; usually being subject to whatever metaphorical grid is fashionable at the time (energy physics; computer science; evolutionary genetics etc.). What we have is a two-tiered academic culture in which both tiers lean on one another and rely on one another for their continued existence — and authority.

This two-way street is the prime determinate of the generation of meaning in our contemporary secular societies. It governs the way most people think; it inhabits the language they use; it dictates the metaphors — largely dead metaphors — that they deploy; and it even governs the morality which they believe to guide their actions. As I have written elsewhere: to penetrate it is largely to understand the Zeitgeist.

What Mirowski is pointing to is, as I have pointed out elsewhere before, part of a far broader cultural shift that goes right back to the beginning of the Enlightenment itself when a certain discourse — that of Enlightenment — sought to squash and silence its critics; many of whom had provided the basis on which Enlightenment stood. Neoclassical economics is only a particular manifestation of this tendency — a tendency that has long grown sick and decrepit — but what Mirowski calls “Neoliberalism” is almost certainly a more general strain. That is why, as Mirowski says, Neoliberalism feeds on new changes in the various sciences, rapidly pumping and dumping scientific metaphors to suit its purposes.

This ties in with another important point Mirowski makes: namely, that what he refers to as Neoliberalism affects how people view themselves. Before I engage with this I should clean up Mirowski’s statement somewhat in order to make it more accurate. What this discourse does is not so much change the way people in general conceive of themselves, rather it changes the way elites conceptualise both themselves and other people. This is an important distinction because what Mirowski calls Neoliberalism is a highly artificial construct that is rejected by the majority of the population as vulgar, reductive and offensive. It really is only the cultural elites — from politicians to scientists — that fall for this stuff, as it gives them the power they innately desire.

I have two minor bones to pick with Mirowski on this. First of all, he seems to think that the labour theory of value was somehow more homely than the “human capital” theory that Neoliberalism soon became enamored with. He writes:

Neoliberalism thoroughly revises what it means to be a human person. Classical liberalism identified “labor” as the critical original human infusion that both created and justified private property. Foucault correctly identifies the concept of “human capital” as the signal neoliberal departure that undermines centuries of political thought that parlayed humanism into stories of natural rights. Not only does neoliberalism deconstruct any special status for human labor, but it lays waste to older distinctions between production and consumption rooted in the labor theory of value, and reduces the human being to an arbitrary bundle of “investments,” skill sets, temporary alliances (family, sex, race), and fungible body parts. “Government of the self ” becomes the taproot of all social order, even though the identity of the self evanesces under the pressure of continual prosthetic tinkering; this is one possible way to understand the concept of “biopower.” Under this regime, the individual displays no necessary continuity from one “decision” to the next. The manager of You becomes the new ghost in the machine.

Here I totally disagree with Mirowski. What he is referring to as “Neoliberalism” is simply the latest incarnation of the Enlightenment project. The labour theory of value was just another earlier manifestation of this same project. The only reason the metaphor has changed is that people in modern post-industrial societies no longer resemble labourers. Frankly, this is probably a positive development. Whatever one thinks of the Dilbert character at the office terminal, it is surely better than the coal-blackened industrial labourer who dies at 36.

My second minor bone to pick with Mirowski is that he has — and this is not characteristic of his work generally — missed the key source in this regard. It is not Michel Foucault, as he seems to think, but rather the American cultural historian Christopher Lasch. In his seminal book The Minimal Self — one that was largely overshadowed by the success of the inferior The Culture of Narcissism — Lasch examines how the elites’ view of itself today is largely shaped through psychological categories. It is these that become sort of quasi-ethical precepts for how one should live one’s life. Thus it is probably in the language of contemporary evolutionary psychology and its popular manifestations in workplace and family counseling that we should try and catch where what Mirowski calls “Neoliberalism” tries most directly to shape the Self.

All in all, however, Mirwoski’s piece is well worth a read and it is certainly headed in the right direction. Too many heterodox economists think that all we need to do is increase the proximity between hard science mumbo-jumbo and social science mumbo-jumbo in order to produce a solid analytical structure with which to organise our societies. Nothing could be further from the truth and it is to Mirowski’s great credit that he appears to realise this.

When Clowns Run the Circus: Economic Institutions and Intelligence Services

Adam Curtis has a new blog post out today which is as fantastic as usual. This one deals with intelligence services and how they are generally run by weirdos and idiots. This is something I’ve long been aware of personally — having been earlier exposed to the psychological pseudo-science lying behind the CIA’s infamous MKUltra program.

The reason that these organisations fill up with freaks so quickly is because there is no real oversight. Curtis quotes from a history of spying by Philip Knightley The Second Oldest Profession:

The whole organisation [MI5] was riddled with nepotism — dim, dreary people of utter unmemorability; sub-men who were doubled up with other sub-men to create an illusion of strength and only doubled the weakness; others made memorable only by poisonous, corrupt malevolence or crass, mulish stupidity; the whole run by a chain of command remarkable for its feebleness. The entire service was decrepit and incompetent.

What happens in organisations with no-strings-attached funding and no real oversight is that incompetent but politically ruthless people tend to rise to the top. They then solidify their position by populating the lower-ranks with Yes Men and allies. Those at the top then impose their bizarre and otherworldly ideas on the organisation and all sorts of weird stuff starts to happen.

The economics profession, while not quite as desperate, is somewhat similar. The reason it is not quite as desperate is that economic institutions — from central banks to the IMF to think-tanks — are largely answerable to open institutions, while intelligence services are not. There are some checks and balances keeping such institutions in the tow of practical administration. Nevertheless, however, economic institutions are populated by head-in-the-clouds incompetents who lack almost any ability to see the world for what it is.

This is what accounts for the complete disconnect people often notice between these institutions and the real world. Unlike in other institutions — such as the court system — the people in economic institutions have been trained to purely think in abstractions and their jobs allow them to take an enormous distance from everyday matters. Reading the statements that come out of these institutions is often rather comical — not to mention concerning — but it is for structural reasons that this is the case. And when you meet many of the people that work in these institutions you quickly notice that they talk about abstract ideas as if they were real entities.

This is not to say that there are no good people in these institutions. But they are usually marginalised or find themselves more suited to practical matters (like managing open market operations or something of the sort). They almost never rise up the ranks to call the shots about the general direction of the institution. This is because their colleagues generally dislike them to some extent and find their pragmatism and lack of toleration of airy-fairy abstract nonsense irritating and personally insulting.

Such is also the case, as Curtis points out, in intelligence services. He gives the example of Percy Sillitoe who was brought in by the radical Labour government after the Second World War to clean up the mess that was MI5 Sillitoe, who told his wife that he was “working in a madhouse”, was a former police chief who dealt with gang violence in Glasgow. He was a careful and realistic man — and the people working at MI5 hated him because, presumably, he burst the phantasmatic insulated bubble that they lived within. Curtis writes:

All the insiders hated him, and they ridiculed him by speaking in Latin (which he didn’t understand) in front of him. Plus they deliberately gave him the wrong papers when he went to see the Prime Minister.

Today, in light of Edward Snowden’s revelations, intelligence services are under intense scrutiny. Some of the worst excesses are likely to be cleared up but we should never expect a leopard to change its spots. Likewise, after the 2008 financial crisis, some of the worst excesses of the economic institutions were reigned in. But again, to hope that a leopard can change its spots is perhaps to hope too much. With no real, hardline oversight forcing these institutions to engage properly with the real world the clowns will continue to run the circus.

Mises and Freud: Another Heroic Misreading

You know that I want your loving
But my logic tells me that it ain’t never gonna happen
And then my defenses say I didn’t want it anyway
But you know sometimes I’m a liar

— Violent Femmes, ‘Promise‘

Ugh… why do I find myself criticising Mises’ garbage philosophy so much over the past few weeks? I do not know — I seem to not be engaged in “purposive action” — but whatever the reason I hope I can get this out of my system soon.

Some time ago the blogger Lord Keynes pointed out that Mises included in his Human Action a discussion of psychoanalysis. At the time Lord Keynes did a bit of a hatchet job and proclaimed that Mises was guilty simply by association with a discipline that everyone knows is a pseudoscience. (How does everyone know this? Because Popper said so, I guess… despite the fact that he used his “falsifiability” criteria to dismiss psychoanalysis and this criteria quickly showed itself to be lacking in many ways, as now almost everyone beyond a few Popperian extremists acknowledge).

Anyway, I didn’t actually get a chance to look up what Mises was talking about at the time but the more I thought about it the less it made sense. How could the theorist of conscious, rational, purposive human action ever get to grips with the idea that many, if not most of our actions are unconscious, irrational and purposive only insofar as we are the slave to our drives? Well, now I’ve looked into it and the answer is clear: he came to terms with it by misunderstanding it and engaging in sophistical reasoning.

Here is the relevant paragraph from page 12 of Human Action:

Whether an action stems from clear deliberation, or from forgotten memories and suppressed desires which from submerged regions, as it were, direct the will, does not influence the nature of the action. The murderer whom a subconscious urge (the Id) drives toward his crime and the neurotic whose aberrant behavior seems to be simply meaningless to an untrained observer both act; they like anybody else are aiming at certain ends. It is the merit of psychoanalysis that it has demonstrated that even the behavior of neurotics and psychopaths is meaningful, that they too act and aim at ends, although we who consider ourselves normal and sane call the reasoning determining their choice of ends nonsensical and the means they choose for the attainment of these ends contrary to purpose.

Okay, read again that first sentence that I have highlighted in red. As anyone who has even a cursory knowledge of psychoanalysis or even psychology can see it is complete and utter nonsense. An action that purely stems from clear deliberation and a lack of unconscious motivation (whether such an action actually exists we will leave in the air) is entirely different in nature from an action that results from unconscious influences. Why? Because the former is intentional and fits nicely with our ego while the latter is wholly unintentional and is usually repressed, pushed to the side and covered up.

Let me take a personal example from the other day. I was talking with a friend of mine online who said that he thought I was being overly hostile toward certain groups online. I said that I didn’t really care what they thought, that I had to tolerate such nonsense in real life too often and that in such real life circumstances I was generally amicable. The only problem was that I wrote “amenable” rather than “amicable”; a classic Freudian slip. I quickly corrected myself and then laughed that I had made a Freudian slip (most people not interested in psychoanalysis would have corrected themselves and just ignored the slip — i.e. they would have engaged in “direct repression” rather than a “working through”).

Obviously there was a lot of truth contained in my slip and it could be divined by reading what I had written carefully. I was unconsciously annoyed that due to social etiquette I often have to tolerate people talking absolute rubbish in real life without pointing out their errors. Because this annoys me at an unconscious level my unconscious mind deems my conscious actions to be “amenable” while my conscious mind happily tried to pass these same actions off as “amicable”. Obviously the former unconscious judgement is a negative evaluation of these personality traits while the latter conscious judgement is a positive evaluation of the same traits.

What this example shows is that from a psychoanalytical point-of-view the mind is torn in two and often simultaneously thinks (perhaps “thinks” is the wrong word) along two or more contradictory lines at once.  The psychoanalytical image is of a battle between two forces each vying for power over the individual: one is the conscious, socialised ego-personality; the other is the unconscious, unsocialised id-personality. Clearly then, the actions of each part of the personality cannot be considered, as Mises says, of the same “nature”. They are inherently in contradiction with one another. That is precisely the Freudian problem!

This is where the rest of Mises’ example breaks down entirely. There is not one “true” motivation guiding the individual; but a multitude of different, conflicting motivations all at war with one another. Our ego tries to keep the id at bay while the id tries to get us to engage in behaviors that offend the ego. Such a view of the world is not simply at odds with Mises’ idea that there are singular determinants of “human action”; no, such a view of the world completely demolishes Mises’ conception, a conception it would consider merely a manifestation of rationalisation designed to engage in repression and hide from consciousness that there are “other forces” at work and that these forces conflict with conscious intentions.

Mises wanted to have it both ways. He wanted to integrate the idea of unconscious motivations because at other times he could use his crude understanding of psychoanalysis to criticise whole classes of political opponents as being mentally defective (something someone who actually understood these ideas would never do), but when it came to fundamentals he didn’t want to recognise what such ideas actually entail. If anyone was mentally defective it was Mises himself. Here we have a classic case of a second-rate thinker who, being vaguely aware that he is producing only recycled half-digested dross, compensates for his shabby ideas with crass self-assertion and other forms of flashy chicanery. Mises thought that he had created a new synthesis of thought with his Human Action but all he had really left behind was a testament to his lack of ability to understand the ideas he engaged with — from Kant to Freud and there are likely many others.

Joan Robinson and the Labor Theory of Value

Here’s an interesting thought from Geoff Harcourt on Joan Robinson’s relationship with the Marxist economist (and possible Soviet infiltrator) Maurice Dobb which also goes into what she thought about the labour theory of value (excuse the Americanised spelling in the title, but you must fish for hits on Google…). I think I should comment on it because I really dislike the labour theory of value for the same reasons as Robinson and I think Harcourt and King (the interviewer) are being immensely unfair here:

She thought [Dobb] was schizophrenic. She could never understand him. Here he was, this great Communist, Marxist, out of office hours, teaching Marshall in office hours. And I think Maurice thought that she was an upper-class bourgeois liberal with pinkish overtones who wouldn’t go the whole hog. And also, I think, he was offended by her rather philistine, very British, attitude to the philosophical problems of the labor theory of value, whereas he argued that the labor theory of value was the base on which you should erect Marxism, in his essay on “The Need for A Theory of Value” in Political Economy and Capitalism (Dobb 1937: Chapter I). And of course he recognized — I know you [the interviewer: John King] don’t agree with me on this, but it’s what I think — that the labor theory of value was really an explanation of the origin of profits in the capitalist mode of production, and as a byproduct of that you have to explain why the prices of production don’t coincide with underlying labor values. And I think Maurice always thought of it like that, and I think Sraffa did as well, whereas to Joan it was always gobbledegook. She said, “It’s great metaphysics for stirring the workers up, but it’s not a theory. You don’t need it.” She said, “I don’t need the labor theory of value to explain why the chaps who’ve got the finance can push around the chaps who haven’t.” And it was that sort of English philistine contempt for European philosophy, I think, which rather annoyed Maurice. But this is conjecture. Joan did say to me that he was schizophrenic in his intellectual thought.

I include the biographical detail merely because I find it a part of the interesting tapestry that was the left-wing in Britain in the post-war years. But what I really want to focus on a few points.

First of all the notion that people who dislike the labour theory of value (hereafter: “LTV”) are “philistines” who don’t understand continental philosophy. This is an accusation often thrown around by Marxists who believe in the LTV. It is one that permeates the whole of the interview with both Harcourt and King talking as if Robinson didn’t have the intellectual sophistication to understand the LTV. It is an absolutely odious criticism for two reasons. First of all, because numerous continental philosophers have criticised Marx’s materialist philosophical views on which the LTV is based as being inconsistent with the tradition he was following — and have done so fairly consistently throughout the 20th century.

Secondly, and tied to this, the most powerful criticism of the LTV is precisely from a continental philosophical viewpoint. Marx borrowed his arguments from Hegel but largely misunderstood him — as was often pointed out to him by his friend and hand-picked heir to Hegel Bruno Bauer. For Hegel and for most other actual continental philosophy materialism makes no sense at all because you cannot assume that there exists an “out there” independent of what is in your head. This leads to many conclusions, such as that value is entirely relative — as I have argued before from the viewpoint of contemporary continental philosophy — and cannot be measured in terms of physical human exertion which is completely arbitrary.

It is the Marxists who have a poor understanding of continental philosophy, not their opponents. Their version of continental philosophy is handed down to them, frankly, by a second-rate Hegelian who always refused to recognise the contradictions of deploying Hegelian/Idealist thought to a naive materialism. You can see this in the way Marxists banish such debates by turning the term “Idealism” into a pejorative among themselves and never engaging with genuinely Idealist critiques beyond deploying their crudely constructed pejorative. If you’re dubbed an “Idealist” you’re below debate in Marxist circles; such is enough to disqualify you. Why? Because Marx said so; that’s why.

The other point I want to deal with is more so economics than it is philosophy. Harcourt says that “the labor theory of value was really an explanation of the origin of profits in the capitalist mode of production, and as a byproduct of that you have to explain why the prices of production don’t coincide with underlying labor values.” He also says this as if Robinson didn’t “get” it at some level. I think she “got” it perfectly well but she recognised it for what it is: a moral judgment and not an economic judgment.

Such a statement is, as Robinson would always point out with such statements, circular. It gets its result from its assumptions and then hides its assumptions behind its result. Yes, the LTV “explains” profits in a capitalist economy perfectly well if we take the a priori view that the capitalist is simply a leech and that all value should by rights belong to the worker. Let’s put that same statement another way: the LTV “explains” profits in a capitalist economy if one is a Marxist socialist or communist.

It does no such thing, however, if one does not subscribe to such a viewpoint. If I, for example, believe that capitalists actually perform a useful social function then the LTV “explains” nothing about profits because it assumes that all value comes from workers and none from capitalists. So, really the political judgment is already “baked in” to the theory, making the theory not a theory at all but an ideology. That is what Robinson always recognised and what she always insisted upon. At no point in the discussion do Harcourt and King, who both seem to be LTV believers, actually lay out why Robinson was wrong; instead they talk among themselves like members of a church about why their deceased friend always failed to see the light and find salvation.

Addendum: Before someone points out to me the popularity of Marxism among certain 20th century continental philosophers let me just anticipate this. It is true that certain very prominent continental philosophers such as Levi-Strauss, Sartre and Merleau-Ponty were indeed Marxist in their politics. However, this was because Marxism was fashionable in certain groups at the time and their politics never really gelled with their philosophies — apart from the case of Sartre who actually altered (and I would say: debased) his philosophy later in life to try to line it up with Marxist ideas. All of this didn’t last long and what today is scorned by Marxists as “postmodernism” eventually cleared out the last remaining vestiges of Marxism among continental philosophy. Where it appeared after this it was usually just faddish rhetoric or political posturing.

Routledge’s Karma: Free Stuff Alert!

Karma. The idea is that you do something wonderful and it will cancel out the awful deeds you do at some other point in time (okay, I’m taking liberty with my definition and giving a rather Catholic-tinged exposition but I’m not the first Westerner to do so). Routledge, it would seem, are balancing their karma almost perfectly these days having provided a load of free papers on and by one of the worst economists of the 20th century and one of the best. That is, Friedrich von Hayek and Joan Robinson respectively.

I’m only kidding, of course (well, sort of). But kudos to Routledge for doing this. And kudos to Louis-Phillipe Rochon — one of the included authors — for bringing this to my attention.

Misuse of Data Part Deux: Redux

Okay, so there’s been a bit of a misunderstanding regarding my previous post on Catalán’s misuse of data. Some of this is likely squirming but some may be due to my own presentation. So, let’s run through this in order to be crystal clear.

Catalán’s original argument was that the PPI index measuring the price of capital equipment could be used to show that said prices of capital equipment are flexible enough to respond to flows of profits. This, according to Catalán, would then show that fixed-price theory when applied to capital goods was “highly debatable” — his words.

My point was that the measures that Catalán had used were really just proxies for inflation. I went on to say that if he had deflated his measures by the CPI then he would have seen far smaller changes in the price of capital equipment (whether this has anything to do with fix versus flexi-price we will consider shortly). Catalán and his friend then said that it was stupid deflating one price index by another price index. But is it?

Consider an economy in which there has been a very poor harvest of apples and said apples have risen in price by 45%. Now consider that this same economy has a general increase in prices of 10% due to as yet unknown reasons. Do we then attribute the whole 45% of the rise in prices of apples to the poor harvest? Of course not. Some of it must have been due to the general rise in prices. Provided that we assume that apples only make up a very small part of the general price index a good proxy measure for how much of the price rise in apples was due to the poor harvest can be gotten by deflating the apple price by the general price index.

Again, what Catalán was seeing in his graph was largely the general drift of inflation; not some particular price increase for capital equipment. This is where the big question comes in: does the existence of inflation disprove the idea of fix-price markets for capital equipment? Well, sure if you understand that fix-price markets mean “markets where prices don’t fluctuate and inflation doesn’t exist”. We will give Catalán the benefit of the doubt in that he didn’t make this amazingly stupid mistake.

No, a graph that basically shows the effects of inflation says nothing about whether markets are fix-price or flexi-price. Nothing. Nada. Zip. And that is why it was glaringly obvious to me that Catalán had misused the data from the moment I cast eyes on his graphs. I thought this would be straightened out fairly quickly by simply pointing out that his graphs were proxy measures for general inflation and had nothing to do with whether or not there existed fixed or flexi-price markets for capital goods. But alas, mistakes made die hard.

Let’s go one further: even if Catalán had deflated his graphs would it have told him anything about whether the markets were fix-price? Of course not. Unless we interpreted the far smaller changes in the price of capital equipment that would result from said deflation as proof that fix-price markets don’t exist. But again this would entail interpreting fix-price markets to mean “markets in which prices don’t fluctuate”. Again, we will give Catalán the benefit of the doubt in that this is not what he meant.

Update: I just noticed a comment on the previous post from Catalán’s friend that might be worth responding to in this post directly. Dkuehn wrote:

[Your argument regarding deflating the price of capital equipment by the CPI is] like deflating the Dow by the NYSE and concluding that financial markets are largely placid.

Is this really a fit analogy? I have already laid out a theoretical argument (the apple argument above) why this is not necessarily the case. But one would wonder if dkuehn would make the same case if, say, market analysts used a measure for inflation-adjusted oil prices or any number of other inflation-adjusted measures. After all, these are just price indices being deflated by other price indices (which probably contain the original price indices as a component). Remember, oil price measures are themselves price indices and according to dkuehn:

Thinking about real and nominal differences in price level changes is interesting, but you don’t get there by adjusting one price index by another price index!

He then goes on to talking about how we should instead adjust a single price by the price index to get an “interesting” result. But what is a “single price”? Is he talking about going to the supermarket and looking at the price on a single television and then deflating this? After all, the manner in which television prices are compiled in the CPI is by aggregating many prices and then weighting them; that is, compiling them into an index and then putting this into the broader index. It is not clear what “interesting” results such ultra-micro level price deflating would produce — but then I suspect that dkuehn got confused as to what the words “price index” mean.

The deeper you dig into bad data usage the more profound the misunderstandings revealed become.

Animism and Monetarist Thinking: The Inflation in the US in the 1970s

In some tribes studied by anthropologists it was found that members believed that animals and objects, rather than human beings, were responsible for pregnancies. Pregnant women were asked by other members of the tribe what object or animal they had seen immediately before discovering that they were pregnant. That object or animal — say, a large rock or a monkey — would then be considered to be the father of the unborn child.

Such is a rather humorous example of what is called “animistic” or “magical” thinking. At root, it is based on spurious correlation — the belief that just because two things coincide, in this case the discovery of the pregnancy and the sighting of an object or animal, that one must have caused the other. We see such spurious correlations together with magical thinking in certain economic tribes today too.

In my last post pointing out how an Austrian blogger had grossly misused data the debate in the comments section eventually turned to the idea that inflation was a monetary phenomenon. I anticipated this was going to happen (Austrians are remarkably predictable because their theories are so simplistic that a computer program could very nearly follow and anticipate their reasoning) and so I crunched some of the numbers on inflation in advance.

First I should establish that it is true that inflation is generally accompanied by a rise in the money supply. But this is as true as the fact that the pregnant tribeswoman sees a large rock just before she discovers her pregnancy. The fact is that money does not “do” anything — just as large rocks do not impregnate women. Money is a passive medium and saying that it “causes” inflation is simply animistic or magical thinking.

The money supply expands and contracts as inflation rises and falls. This was well-known by the economist that the Austrians claim to follow: Knut Wicksell. Wicksell realised that bank credit was flexible and that money was passively “pulled” from the banking system as prices rose. He understood this because he had read and comprehended the views put forward by the great pioneer of modern monetary theory, Thomas Tooke.

The Austrians, however, together with their monetarist cousins came to forget this and today they will make animistic claims about money as some sort of active agent driving economic activity. To others this appears bizarre and amusing. Practical economists working day-to-day know that in order to understand why inflation occurs — and what drives the expansion of the passive medium known as “money” — we must study what the causes price rises. These are usually events or institutions that have all-too-human aims and goals.

It might be illuminating then to turn to the inflation of the 1970s in the US to illustrate this point. All the data used in what follows is from FRED.

Here is a graph showing the CPI and its major components between 1970 and 1982:

The two major components of inflation in this era were rising unit labour costs — that is, rising wages relative to productivity — and rising oil prices. The former was due in large part to the strength of union-bargaining power which we shall break down in more detail below. The latter was due to the oil price spike initiated by OPEC in response to geopolitical events in the Middle-East.

Let us, however, zoom in to the first outbreak of inflation and see what the data tells us:

This is a very interesting graph because it tells us a pretty solid story about the beginning of the inflation in the US in the 1970s. As we can see, it is actually the inflation that takes off before the rise in unit labour costs. The inflation begins to pick up in the 3rd quarter of 1972 while unit labour costs only begin to rise in the 1st or 2nd quarter of 1973. Unit labour costs responded quickly to the inflation because many contracts were indexed to inflation measures similar to the CPI, but it is clear from the data that the inflation came first.

The reason for this was that spending on the Vietnam War had gotten out of control in the late-60s. In his last year as president Lyndon Johnson was running a budget deficit of somewhere between 3-4% of GDP (the numbers are very unreliable for this period) while unemployment was substantially below 4%. The reason for this was that because the Vietnam War was very unpopular the Johnson administration did not want to fund it out of tax receipts and instead opted for a “guns and butter” economy.

The result of this was that inflationary pressures began to build. These pressures were initially contained by a strong, fixed dollar. This lasted until the Bretton Woods system began to falter. As the fixed exchange-rate system fell apart between 1971 and 1973 the dollar lost over 20% of its value; meanwhile the US continued to run trade deficits. By 1972 the inflation could no longer be contained and prices began to rise. Nixon put in place wage and price controls in the 3rd quarter of 1971 but these began to gradually break down, unleashing the beginning of a wage-price spiral from the then heavily unionised workers. Finally, in the 4th quarter of 1973 OPEC initiated the first oil price shock and inflation reached a high of 12% in the 4th quarter of 1974 — pushed on, no doubt, by a continuing wage-price spiral. After this the situation got completely out-of-control and was exacerbated by another oil price shock in 1979.

That is basically the story of the 1970s inflation. As we can see all the actions undertaken were by people, not by animistic monetary forces. The politics of the Vietnam War played a large part; so too did OPEC and geopolitics in the Middle-East; and so too did the unions, although there is a case to make that they were reacting rather than acting. The money supply did increase in this period but this was due to increases in bank credit together with new money spent into the system by the government.

Saying that this inflation was a “monetary phenomenon” is a bit like saying that a bruise is the result of internal bleeding; while this may be somewhat accurate, it leaves the cause of said internal bleeding completely unanswered. And maybe that’s the point. Maybe the point is not to discover true causes but to blame imaginary ones that fit with preconceived notions. It is, after all, a lot easier to say that a large rock is the father rather than admit that your brother impregnated your wife.

On the Misuse of Data and Confirmation Bias

When I was doing my undergraduate in journalism I became interested in economic reporting and commentary. One of the things that struck me was the inability of respected opinion-makers to handle data; a disease that Dean Baker documents daily on his Beat the Press blog. Much to my surprise when I began to study economics I found that the situation was not much better among academics and working economists. Often whole debates would disintegrate on a basic data-point.

A good recent example of this is the case of Jonathan Finegold Catalán, an Austrian economist and Mises.org contributor. (The Austrians, I should add, are serial offenders in the misuse of data…). Catalán was debating the blogger Lord Keynes on a rather obscure point of the equally obscure Austrian Business Cycle Theory. Without getting into the weeds of what is a rather unproductive and interminable debate, Catalán provided the following graph to prove that the price of finished capital equipment fluctuated in line with supply and demand:

Looks good, right? Wrong. Catalán committed the cardinal sin of data usage: he forgot to inquire whether the measure was nominal or real. If it is nominal the price fluctuations can be explained by changes in inflation, while if it is real Catalán’s point that there is something resembling a free-market for capital equipment might stand up. Is this hard to check? Nope. If the measure doesn’t say “real” or “inflation-adjusted” then it is likely nominal. We can further check this by mapping the CPI next to the data-points being used. If they approximately match up then most of the price fluctuations are just an illusion built into the data.

Low and behold, the effects of inflation seem to be almost completely dominant! This should not be surprising at all to anyone familiar with the structure of the data produced by the Federal Reserve. Nor should it be surprising to someone who works with data often. (And I should say before the Austrians pile into the comments section: no, much of the inflation shown in the above time-series is not the result of demand-pull forces).

I would like to put such misuse of data down to poor education. And indeed, part of the blame lies there. There is, however, another reason for such misuse: confirmation bias. It is extremely pleasant when data fits nicely with our conception of the world; it gives us an ego-boost and reinforces our theories. But we must be extremely careful because oftentimes this desire to prove oneself right leads us astray. Better to deflate our egos and our figures at the same time then get caught up in errors.

It is for this reason that we should always let the data speak rather than our theories. It is the latter that should change in response to the former; not the other way around. The only way to get away from confirmation bias is to fully give oneself over to the data: the data is sacred; the theory is not. It seems to me unlikely, however, that certain types of economists can accomplish this; because, as I have argued elsewhere, their theories are not an attempt to understand the world but rather an active attempt to shape it in their phantasmatic image.

Update: Catalán has responded in the comments section saying that I have misrepresented his argument. He says that his point “doesn’t have anything to do whether the prices of capital goods have to do with supply and demand”. Let’s be very clear here so that we avoid confusion. He wrote:

I’m not saying that prices aren’t “administered,” because all prices, to some extent or another, are set by the firm (the real world isn’t perfectly competitive, where everyone is necessarily a price taker). I am saying that the idea that producers’ good prices aren’t flexible enough to change with flows of profit is wrong.

Now to me that does have to do with whether the price of capital goods has to do with supply and demand. What Catalán is arguing is that the price of capital equipment fluctuates with the change in the flow of profits (that is, the demand for the goods and services being produced by said capital equipment).

I do not, however, wish to argue semantics because I have no desire to handle the slippery fish that is Austrian capital theory. So, let us just say for the sake of argument that I have misrepresented his argument. Well, we are quite clear then that if he is saying anything at all it is that “producers’ good prices” are “flexible enough to change with flows of profit”. If this is the case then we would expect there to be some correlation between the change in the price of capital equipment and the flow of profits. Do we see such a correlation? Nope. See for yourself:

That graph is a bit pesky to read. I had to graph the two variables on different axes because the fluctuation of profits is so much greater than the fluctuation of the price of capital equipment. Nevertheless, if you can take the time to read it properly you will see that there is no correlation. Indeed, in some periods such as 1974-75 and 1979-1980 there is a strong negative correlation. (There is, however, some correlation in the late-1940s, but in order to say that there is a relationship between these two variables we would need a longer term correlation; this graph is, as can clearly be seen, all over the place).

Whatever way you cut it, Catalán’s argument doesn’t add up. What he was really seeing when he was looking at the price of capital equipment was inflation plain and simple. And inflation has nothing to do with the flow of profits in a capitalist economy as can be seen clearly above.

Why Kant’s and Mises’ Studies of Man Were Based on a Logical Contradiction

While I do not really want to deal with the Austrians on this blog — let alone Mises who, together with Rothbard, was the most muddled and mediocre of the school — nevertheless I think it might be worthwhile making a general point about Mises’ book Human Action. As discussed previously on this blog Mises’ goal was essentially to form an a priori basis with which to delineate all of human behavior.

I have already in my last post on the topic outlined why this is a doomed project. Here I would like to raise a more fundamental logical inconsistency in Mises’ project — a logical inconsistency that can be traced back to Kant himself who, of course, was Mises’ inspiration for his praxeology. First let us allow Mises himself to get a word in on what he is trying to do. The following is from page 38 of his Human Action:

The real thing which is the subject matter of praxeology, human action, stems from the same source as human reasoning. Action and reason are congeneric and homogeneous; they may even be called two different aspects of the same thing. That reason has the power to make clear through pure ratiocination the essential features of action is a consequence of the fact that action is an offshoot of reason. The theorems attained by correct praxeological reasoning are not only perfectly certain and incontestable, like the correct mathematical theorems.

The idea, as we can see, is to deduce certain constants that take place in human behavior. However, Mises was treading on ground which Kant himself had stumbled near the end of the 18th century. I refer, of course, to his lectures on anthropology. As Michel Foucault pointed out in his famous introduction to his French translation there was a logical contradiction in Kant’s approach. Here is Foucault on the inconsistency

Thus the relation between the given and the a priori takes on, in the Anthropology, an inverted structure with respect to that which has been employed in the Critique. The a priori in the order of knowledge, becomes, in the order of concrete existence, an originary that is not chronologically primary, but which, as soon as it appears in the succession of figures of the synthesis, reveals itself as already there; on the other hand, what is given is lightened, in the reflection on concrete existence, by soft lights that give the depth of the already operated.

What Foucault is saying is that in Kant’s original system the a priori is thought to be something that exists outside of time and space; it is, then, something infinite. Yet, in his anthropology Kant says that we can study men as objects. But this is contradictory because if we understand that men carry around with them certain infinite and timeless truths inside their heads and then we try to study them as objects in their finite existence (i.e. in real historical time) then we are committing a fallacy insofar as we are merely examining superficial untruths without seeing the infinite truths lying behind them.

To put it another way: if we rest our philosophy on an Absolute Subject and claim that such an Absolute Subject inhabits all men, then studying these men as objects in finite time doesn’t make any sense. Either the truth of man lies in a priori principles that are non-empirical, or the truth of man lies in his empirical, finite existence. Kant wants to have it both ways. But he cannot.

The same criticism, of course, applies to Mises. As the blogger Lord Keynes has pointed out elsewhere Mises slips in empirical observations into his analysis and then tries to cover up what he has done. The reason he has to do this is because of what we have just laid out above: you cannot study human behavior seriously and assign it truth-value and at the same time hold that there are a prioris that lie within the Absolute Subject. You can only have one or the other; you cannot have your cake and eat it.

Kant made this mistake toward the end of his life, but in doing so he did not necessarily undermine his earlier work. His slip up could simply be seen as a mistake and thrown out as such. Mises, on the other hand, constructs his entire theory around this contradiction, making all of it completely incoherent.