Ebeling on the virtues of Austrian and the fallacies of Keynesian Macroeconomics

Dr. Richard Ebeling posted a piece on the Cobden Centre website on 10th January contrasting Austrian with Keynesian economics. 

On the one hand Ebeling criticises the widely accepted `Keynesian´ approach to macro economics on the grounds that it deals with aggregate quantities (average prices, average wages); quantities that "have no real existence", using an approach that overlooks all the individual prices and wages of specific products and skills. On the other hand he praises the 'Austrian' way of looking at macro economics (as expounded by von Mise, Hayek, Rothbard and others) for its refusal to consider such aggregates, and its insistence that the economy will adjust itself far better if left alone than when tampered with by ill-informed government intervention.

I think it is ridiculous to view these two approaches to macroeconomics as though they are in conflict; as though one must be `wrong´if the other is `right´.

Of course there is an average wage and an average price level. They do not exist, but they are determinable quantities.  Keynesian theory does not interfere with the prices of individual items nor the wages of particular operatives, any more than the Austrian theory does; they are of course left to market forces, by both theories. If the average price level rises (or is raised) a few percent relative to appropriate wages, individual productions will become profitable one after the other in the same general(#) way on the Keynesian theory as with the Austrian theory.

The Austrian theory does not require aggregates because it is not going to advocate any government interference. It is simply going to watch while the business cycle works its way through the economy, bankrupting firms and depriving families, until entrepreneurs once again find that there are too few skilled workers, and start to hire `foreigners´. It explains, but does not intervene. 

Non-intervention is better than bad intervention, and that is the virtue of the Austrian school. But is it better than good intervention? I think not, and that is the weakness of the Austrian school. I think that it is morally impossible to sit back and watch capitalism at work. I mean impossible for a moral conscience. It is too easy for the wealthy to exploit the poor, the clever to cheat the foolish. And I think western civilisation has come to the same conclusion over the last thousand years, instituting taxes and charities, encouraged by a predominantly Christian view of heaven and hell.

But if that is the weakness of the Austrian School, what of its strengths? And do governments effect more harm that good? 

It is undoubtedly a weakness of democracies that they find it hard to raise sufficient revenue in taxes. Who, for example, campaigns for votes by offering to raise taxes? (Only in Scandinavia where, one suspects, it is for predominantly climatic reasons.) So, I suggest that the fact that governments seem to get it wrong more often than right, may not be solely down to their (governmental) stupidity. As for the newspapers and the voters, that is another matter, and I suspect that ignorance plays a considerable part.  I like to think that, since 1936 when Keynes published his General Theory, governments have, occasionally, mitigated the severity of the business cycle on the populations in their care, by providing relief, or work on infrastructural projects. 

However, tinkering with bank rate has its limitations, and I am not yet convinced of the benefits of quantitive easing, except benefits for the bankers, for I am skeptical of the extent of trickle-down.

(#  I realize that the order in which businesses become profitable one after the other will be slightly different when the price rise is general (as it might be if government intervenes) compared with the diverse price rises that pure market forces can devise. The Keynesian result will not be identical to the Austrian result.)

Shostak on The Importance of Theory

Shostak on 'The Importance of Theory'.

In “Fed confused about what drives inflation?”, Dr. Frank Shostak writes:

“The purpose of a theory is to enable to ascertain the definition of a phenomenon that is subject to investigation.
    The correct definition attempts to identify the essence of the phenomenon i.e. the key parts that drives the phenomenon.
    For instance, the definition of human action is not that people are engaged in all sorts of activities, but that they are engaged in purposeful activities – it is purpose that gives rise to an action.
    So when Tarullo states that Fed policy makers do not know the causes that drive inflation he basically says that Fed policy makers have not as yet established the correct definition of inflation.
    Is it then valid to be practical, as suggested by Tarullo, to focus only on the data to understand what inflation is all about? If Fed policy makers respond to changes in price indices without establishing what drives these changes this runs the risk of making things much worse.”

My literal translation (into English).

The reason for propounding a theory is to make possible the definition of the phenomenon under investigation. A correct definition identifies the essence of the phenomenon, i.e. the forces that drive the phenomenon. For instance, the correct definition of “human action” indicates that activities are purposeful, not merely varied; for it is the purpose that gives rise to the action.

So, when Tarullo states that policy makers at the Federal Reserve do not know the causes that drive inflation, that is tantamount to saying that they have the wrong definition of inflation. Is it then valid to focus only on the data (as a means of understanding the ‘meaning’ of inflation)?  To react to change in the Consumer Price Index without understanding what is causing those changes could make matters worse. 

My Comment

I do not think the reason for propounding a theory is the one given, and I disagree with Shostak’s definition of “definition”, and (in addition) his definition of “human action”. But this nonsense is not germane, and perhaps can be safely ignored. I agree with Shostak that the Federal Reserve should try to understand the cause (or causes) of any current inflation. 

It may be that inflation indicates that something is changing; the volume of money, or of goods. An intelligent Government would try to identify what exactly is changing, and adjust for that. They should not merely obliterate the signal. There is a parallel in healthcare. Pain is a signal of something going wrong. An analgesic like paracetamol obliterates the signal but does nothing to identify precisely what is going wrong, and nothing to rectify the problem.

Dr. Shostak is angry about inflation because it robs value from those with positive bank balances. But there will (presumably) be others who like inflation because it gives value to those with negative balances, and those who create the money. 

But let us get back to the "importance of definition". Dr. Shostak writes:

"However, if we accept that inflation is about rises in money supply and not a rise in prices then all ........ can be easily explained.  It is not the symptoms of a disease but rather the disease itself that causes the physical damage. Likewise it is not a general rise in prices but rises in money supply that inflicts the physical damage on wealth generators."

Once again  I disagree. I believe that the money supply should increase as and when necessary, for example, when there is an increase in goods. 

But there is a quite different, and much more subtle argument in favour of a controlled low level (2%p.a.) of inflation. Is the Keynesian position not generally accepted that, for psychological reasons, an economy is more stable and more easily controlled when there is a constant low level of inflation? Do we throw out the "General Theory" and 8 decades of largely successful government for the sake of simple mathematics? I do not think the case is made, yet.  

Maybe we could agree that, as a type of covert taxation, inflation is a bit underhand. 

Exchange Rates and Balance of Payments

Translation and Comment on:
BALANCE OF PAYMENTS AND THE EXCHANGE RATE

“Summary and conclusion (as posted by FRANK SHOSTAK  on Cobden Centre 13 MARCH 2017)

"Contrary to a popular belief, the state of the balance of payments has nothing to do with the determination of exchange rates. The key factor behind the rate of exchange determination is the relative purchasing power of various monies. The trade balance statistics could be however useful in ascertaining the diversion of foreigners’ real wealth from the rest of the world to the US given that the US dollar is the most popular money created out of thin air by the US central bank and the US banking system. As long as the floating exchange rate regime is allowed to function the more severe damage is inflicted onto the process of real wealth generation. One way out of this mess is the introduction of a gold standard.”

Let me try to understand what is being said in the above quotation.  I shall simplify by dropping the first 5 words, as they declare themselves to be irrelevant.  I shall next suggest that the “state of the balance” is “the balance”.  Perhaps “the determination of exchange rates” can be understood to mean “determining exchange rates”. For “monies” I shall write “currencies”.  For his “... rate of exchange determination” perhaps we could try “The key factor determining the exchange rate between two currencies is their relative purchasing power.”   So it seems that Shostak is suggesting:

The balance of payments has nothing to do with determining exchange rates. The key factor determining the exchange rate between two currencies is their relative purchasing power.

I disagree with both statements. I think the Trade Balance is a major factor determining exchange rates (ER), while not the only factor. And I think the link between exchange rates and relative purchasing power is so close as to make it hard to decide which "causes" which. (Does sunset cause the onset of night or vice versa?)

I believe the exchange rate US$:Yen is determined by a number of factors all round the world among which I would include: the desire of the Japanese to acquire dollars, and their desire to sell goods to the USA, and reciprocally the need in the USA for yen, and their need to sell goods to Japan; plus a host of smaller influences like tourism and trade flows with third countries. But there are two other big influence that need to be recognized: capital flows, and reserves. If Japan has a positive trade-balance with the States they will have dollars to: [1] sell, or [2] to invest, or [3] to keep in reserve. If Japan sells their dollars for Yen the exchange rate will be affected (the dollar will devalue). But Japan may be content to keep the dollars as “quasi-gold”, or they may invest in the USA to gain interest.  (Of course, the States may reciprocally hold Yen or invest in Japan.)

The Balance of Trade used to be the main ‘determiner’ of the exchange rate, but now there is (apparently) far more money shooting round the world looking for ‘interest’, than looking for ‘goods’. Many countries maintain a trade imbalance for many years, because capital flows and interest rates are not taken into account.

Suppose a basket of mixed goods costs 550 Yen in Japan and 5 US$ in the United States. However, the current ‘exchange rate’ in the money markets is 111 Yen:US$. The “real exchange rate”  (RER) is calculated by correcting the ratio of the basket-prices by the ratio of the currency-prices to produce a dimentionless number. In theory, with perfect markets and large baskets, the “real exchange rate” is 1.0 ; in our example 550/5 x 1/111 = 0.991. It can be imagined that if the basket contained tuna the ratio of the prices (Japan:USA) might be 650/5, and our view of the “real exchange rate” would be distorted by the Japanese love of tuna. We need a large basket.

RER(Japan:USA)= 650/5 x 1/111 = 1.171.

Likewise, if interest rates were higher in the USA than in Japan the desire to hold US$ could distort the “real exchange rate” the other way. In time, and with perfect markets, the RER should relax towards 1.0

RER(Japan:USA)= 550/5 x 1/121 = 0.909

In short: I think Shostak underrates the role of trade-balance in determining exchange-rates; it remains funtamental, though it is by no means the only factor. For me, the value of his article is that it has forced me to go elsewhere to understand the matter.  I suspect it has only won a place on the Cobden Centre website because of the miraculously irrelevant mention of gold.