Wednesday, July 24, 2013

Response to Andy K on Deflation

I am currently in a debate/discussion on inflation vs deflation.  My initial post is here be sure to read the comments, and the link to his response to my comments can be found in the comment section.  Here is my response to his blog post:

I'd like to point out that Woods and Herbener directly claim that when economists are talking about deflation they are talking about price decreases.  Not cuts in the money supply.  Hence, I addressed this argument.  I'd like to further point out that Andy is doing the same thing.  He is pointing out the benefits of price decline due to increased productivity.  Of course this is good for the economy.  Milton Friedman's theory allows for this.  If we increase a targeted money supply each year by say 3%, and if we have a year of high growth, this will cause mild price declines due to increased productivity.  This is why I claim that Milton Friedman and other economists are not afraid of mild deflation or price declines.

Like I said before and explained in my previous post they disfavor cuts in the money supply.  One argument the Austrians utilize is to ALWAYS refer to the price decline due to added production in the late 19th century.  That is not what I am talking about when I am talking about investment.  I am talking about 2% decrease in the money supply each year.  Maybe I did not make that clear.

To claim that fiat money and stable dollars is an oxymoron is truly confusing.  I commend you for not being a believer in gold standards, but rather a fan of competing currencies.  I as well believe we should allow competing currencies.  And just to point out Milton Friedman was not in the favor of the federal reserve.  All of his theorizing is given that it exists.

But if we had these competing currencies, would people not swarm to the company that is providing stable money, as Hayek points out in his paper "A Free Market Monetary System"?  He even says the most desired dollar could possibly be fiat as long as it is stable.  If it is not stable people will leave the dollar.  Even Herbener points this out in the video.  If deflation is all you make it out to be why would people be dumping this deflated dollar?  It is because you did not address the consequences of cutting the money supply, but rather you address the benefits of falling prices due to increased productivity.

Friedman wrote the book on monetary history of the United States, so if you want to see how he speaks about the 20's through the depression I suggest that you read his work.  But in summation, what he says is that the crash of 1929 is a normal bust caused by the federal reserve.  You would agree with that.  What he goes on to say is that the severity of it is caused by a 33% decrease in the money supply over the next 3-4 years.  Is a third of the banks closing good for the economy? No.  So what Friedman argues is that we should have had less of a boom in the 20's by proper monetary policy which would have not caused as large as a bust in the 30's.

You wrote very eloquently on the benefits of price decline caused by increased productivity and are obviously very knowledgeable on the subject.  But the reason why mainstream economists don't adopt Austrian theory is because it is incomplete.  There HAS to be consequences to cuts in the money supply.  If deflationary policies were as much of the bees knees as Austrians point out, 1, people would adopt the Austrian Theory, and 2, we would constantly be using deflationary policies and the economy would be perfect all the time.


I'd like to add a few things here:

1) My example about the 100 million dollar investment seems to have validity due to the fact that Herbener's solution to this problem that deflation creates is to abandon the currency that is deflating.  We obviously cannot do that in America.  Hence, deflation will cause real problems.

2) During the twenties Andy pointed out the dollar was still stable.  This is not entirely true.  The main thing to take home is that the fed was newly enacted and for the most part clueless.  They thought they could just use quantitative easing and make everyone millionaires.  This is why the crash happened.  Milton Friedman was against quantitative easing.

3) Andy points out that economists are regularly arguing that any slow down in the money supply will be disastrous.  These are Keynesians who do believe that is true during an economic crisis that we have right now.  However, I still hold to my claim that even Keynesians are not afraid of mild deflation during normal economic times.  Deflation is built into their model in order to steer other economic factors.  Obviously I disagree with that, but I do not believe they think it will be a catastrophe if they advocate it at certian times.

4) Milton Friedman, points out in an interview that during the economic crisis of the 70s two of the things we needed to do is cut spending and start slowing down the money supply (along with other things)

Tuesday, July 23, 2013

The Notion of Utility

In a blog post a while back I briefly discussed the notion of utility.  The Austrian's view of utility can be summed up by a quote I provided in that post (to view the initial blog click here).  Here is the first half of the quote again for a reference.
"Finally these valuations are entirely subjective in two ways: Jones's utility or satisfaction from wearing a pair Oakley's cannot be compared quantifiably to his satisfaction from wearing a pair of Ray-Bans.  Even by his own inspection."
As I mentioned in the previous post, Austrian economists make this claim very often.  One thing I have never seen them do though is argue against von Neumann and Morgenstern who wrote in 1944 that we can make such interpersonal measurements.  Furthermore, to do so, it takes no more than a simple thought experiment which Austrians should love.

Let me point out before I summarize the von Neumann and Morgenstern argument that they acknowledge the fact that this is a controversial topic.  Also, if you want to read their full argument, and I highly suggest you do so, it is in Theory of Games and Economic Behavior in the section entitled The notion of Utility.  Hence the title of this blog post.

The first thing they point out in the section is that in the past there have been certain phenomena that were considered non-measureable up to a certain point in time.  E.G. sensations of light, heat, muscular activity etc.
"All this [utility] is strongly reminiscent of the conditions existent at the beginning of the theory of heat: that too was based on the intuitively clear concept of one body feeling warmer than another, yet there was no immediate way to express significantly by how much, or how many times, or in what sense.
This comparison with heat also shows how little one can forecast a priori  what the ultimate shape of such a theory will be.  The above crude indications do not disclose at all what, as we now know, subsequently happened.  It turned out that heat permits quantitative description not by one number but by two: the quantity of heat and temperature."
They go one further and argue that
"The historical development of the theory of heat indicates that one must be extremely careful in making any negative assertions about any concept with the claim to finality.  Even if utilities look very unnumerical today, the history of experience in the theory of heat may repeat itself, and nobody can foretell with what ramifications and variations"

As you can see, they are laying down the groundwork for numerical utilities in these arguments.  Who is to say at one point we will not have developed a certain device that measures the dopamine that is produced when we consider consuming certain goods in order to help us satisfy our wants more accurately.  Such a device would allow us to measure utility to an exact number.  If such a device were discovered, would the Austrians  reevaluate their views on this matter or would they dig in their heels while keeping their antiquated theories that have been refuted or improved?  How they would react to such findings is speculation, but I digress.

The next thing von Neumann and Morgenstern do is demonstrate how to gain information on the degree to which I might prefer one good to another by doing a thought experiment.  Let me point out that utility is just a word economists picked to discuss the topic at hand.  Clearly we do get some satisfaction out of consuming goods and utility is just the word given to such satisfaction to use in conversation.  I personally like to think of it as a "payoff" of sorts.

Consider an individual with the choice of three goods, call them A, B and C.  Without loss of generality assume this individual, Mary, prefers B to A, A to C, and B to C.  Next consider Mary having two options on how she might receive these goods.  She can either choose A automatically, or choose the option of getting either B or C with 50-50 odds between the two of them.  She will get one of them with 100% certainty.  If she chooses A over the bundle this tells her some information of how much she prefers A to C and B to A.  Now since B and C are both compared to A, she can induce a comparison between B and C.  This thought experiment gives us a way to determine "distances" between the utilities one receives from the three goods.  Since we have distances, we can enumerate them.

Morgenstern and von Neumann actually go one step further and show numerical measures can be used more directly if we consider all probabilities.  I am not going to go into that now.  I do plan on addressing it at a different time.  However, I think this thought experiment Morgenstern and von Neumann introduce is rather convincing allows us to consider how we can derive "distances" between utilities which Austrians continuously claim is not possible.

Friday, July 19, 2013

Neo-Classical Economics

As of late I have been getting into many debates with adherents of Austrian Economics about how economists should do economics.  One thing I have found to be in common with all these debates is that Austrians don't fully understand how neo-classicals actually do economics.  They tend to think the neo-classical sits at a computer with data and tries to empirically find economic principles from this data.  This could not be further from the truth.  I have written a few economics papers and there is a standard way to go about writing them.

Step one of writing a paper is deciding what you are interested in.  I personally am interested in education, environmental economics, game theory, agriculture and others.  Step two is to come up with a theory involving your area of interest.  This is no easy step.  The theoretical portion of the paper is THE most important part of the paper.  If the theory is wrong then the rest of the paper means nothing.  Up to here, neo-classicals and Austrians agree.  Theory is the most important part of economics.  That being said, I can understand the Austrians grief with mathematical economics.  A lot of mathematics is replacing theory.  This is not good for economics.  This does not mean that mathematics does not belong in economics, or have uses in economics, however.

After the theoretical part is done, step three is to do literature review.  Often times in this part of your paper you will be able to find whether your theory is on target or needs to be adjusted.  Furthermore, during the literature review you see how other economists have addressed this problem.  This part of writing a paper is important as well because here is where you decide whether past economists have made mistakes in their theory or their model and can find areas to improve upon.

Next is to gather data.  This is where neo-classicals and Austrians disagree.  Austrians think that gathering and testing data is fruitless.  They have various arguments why they think it is fruitless, but these arguments are lacking.  I will address why I think they are lacking in a different post.  Gathering data can make or break your paper.  If you cannot find proper data then your paper is meaningless.  The data obviously has to be relevant, have many observations, be recent, and it must be "clean".

After you have found and cleaned your data, it is time to make your empirical model.  Many times this is a regression.  If you have ever written a proper econometrics paper you will understand a lot of effort goes into this.  This part of your paper takes around 20-30 pages of tests to make sure your estimates are not over or under estimated.  After creating your model you can now run the tests and see whether your theory has merit or not.  Then finally, the last step of writing your paper is to point out the flaws in your own paper and model.  No model is ever perfect and can always be improved upon.  This is one of the most important parts that will lead further researchers in the right direction.

Here is an example from a paper I wrote as an undergraduate.  In the movie Food Inc. (which I highly recommend) they talk about how the price of beef goes up with the price of corn and fuel.  This is bad because cows are supposed to be grass fed and it is healthier to eat local where the cows are not grown as fast and as unhealthily as possible.  I decided to test this.  What I found is that the price of corn and fuel, while it did slightly effect the price of beef it was not statistically significant.  I.E., the price of corn and fuel do not significantly affect price changes in beef.

In conclusion, I hope this sheds some light on how neo-classicals do economics.  It is not this radical data worship that Austrians can make it out to be.  Neo-classicals believe theory always comes first.  I personally think running a regression to see if your theory holds is not very radical.  As Rothbard points out, Austrians play mind games holding things constant in their head to try and extract economic principles is the same thing as a regression except regression can test how significant the economic principles are after you have played this mind game.

Wednesday, July 10, 2013

Inflation vs. Deflation

Inflation or deflation, which is better?  The answer can vary depending on who you ask.  Consider the question from the position of a worker as an importer or exporter.  If we have inflation, our dollar is weaker compared to other currencies so exporters will be able to sell more while importers will be able to buy less.  From this perspective it is easy to see that each profession, whether an importer or an exporter, will view inflation differently.  The same can be said for deflation.  In addition to the importer/exporter scenario the same principle holds when considering this question from the position of a borrower vs. a lender.

Let me first point out that no economist would argue that mild deflation or inflation is troubling.

Now let's consider some of the things Austrians say about deflation.  They claim it is not something to be feared and it is as silly to fear deflation as it is to think wars are good for the economy.  In a video with Tom Woods and Jeff Herbener they approach the discussion in a very frustrating way.  Tom Woods begins by saying that there are various definitions of deflation and when most economist are talking about deflation they are not referring to a drop in a money supply but rather a decrease in prices.  They go on to talk about the implications of falling prices (you can watch the video here).  One of the implications they falsely represent is that people will delay making purchases indefinitely because of the falling prices.  They laugh at the prospect of people waiting to buy coffee 10 days later because it will be five cents cheaper.  I want to address some of these arguments because they are not handled properly.

First of all, when other economists talk about deflation as a negative for the economy, they are speaking in terms of deflationary policies being implemented by the Federal Reserve.  They are not arguing that an increase in production that causes deflation is bad for the economy.  What is meant by Federal Reserve deflationary policies is exactly what Tom Woods says most economists are not referring to, which is a decrease in the money supply.  So right off the bat this video is misleading the viewer.

The next question you should be asking yourself is, why are deflationary policies unfavorable?  Consider a drastic decrease in the supply of money, say 20% (during the great depression the money supply dropped 33% over three years).  The problem is not that prices will fall eventually, the problem is that inflation/deflation takes around 9-15 months before the economy will start to feel these effects.  With this being considered, within the minimum of 9 months we would have only 80% of the the previous money supply while prices have yet to drop.  This has various implications, but clearly with less money to go around there will be less investment by businesses, less consumption by the consumer, less lending by banks etc.  The economy will slow down because of this.

I want to address the coffee argument because this is an egregious oversimplification of deflation.  First and foremost, no decent economist will ever tell you people will wait to buy coffee ten days because of falling prices nor will they say that people will postpone buying a computer because the prices will fall.  This is a straw man argument.  What needs to be considered when thinking about the economic effects of deflation is whether a businessman wanting to invest $100 million into his company would wait a few months if prices are projected to fall?  Any rational business man would consider waiting because if they were to take out a $100 million loan and prices are falling by 2% each year for 30 years how much extra would they have to pay back?  My investment will have be able to generate more profit than what I am paying back in interest to the bank in addition to having to pay back the amount the dollar has deflated.  This scenario doesn't seem quite so laughable now does it?  A business man with thinking like an economist will not think it is laughable either.

Woods and Herbener do address this issue at around the 7 minute mark but the manner in which they address it is improperly handled.  In America we cannot simply switch money, which is Herbener's solution to this problem.  He claims that in times of mild deflation, historically, this did not happen but I addressed this in argument in previous paragraphs.

What might the monetarist say?

In Milton Friedman's view, he would want a slight increase in a targeted money supply.  He usually argued somewhere between 3-5% with 3% being his best recommendation.  This itself, according to Friedman, would keep inflation or deflation mild.  This is what good economists argue for.  A stable money supply leads to a stable economy.  He argued this because of the evidence Herbener points out.  During the times of great expansion there were small increases in the gold supply.  Friedman wanted to emulate this with the Federal Reserve if our economy is to operate with a Federal Reserve.

The next time you hear an Austrian argue that it is silly to fear deflation you can argue that no economist fears mild deflation.

Monday, July 8, 2013

Discovery and Mathematics

When most people think of mathematics, they usually think of algebra, geometry, calculus, differential equations, and that is pretty much it.  While there is nothing wrong with this analysis, the truth of the matter is, those subjects are on the bottom of the totem pole of mathematics.  Topology, for example, is the study of topological spaces.  Topological spaces could be anything from the real number line to the 11 dimensional shape of our universe that some theoretical physicists claim it to be.  In general, mathematics is the study of patterns.  This allows us to do remarkable things, and one example is to "see the unseen".

If we consider the history of black holes, Einstein did not believe they existed because they were too "mathematical" and couldn't arrive at their existence intuitively.  There were other physicists who disagreed with him.  Clearly Einstein was wrong here, but how was the debate settled?  Black holes have such a large gravitational pull that we cannot see them.  They do not even let light escape.  So without being able to actually physically observe them, how can we conclude that Einstein was wrong?  Well, that is where math comes in.  The laws of conservation can tell us many things but one is if we put 10 gallons of water through a hose and only get 9 gallons on the other side we know there must be a hole somewhere in the hose.  This is how physicists and mathematicians can "see" black holes.  If we observe 10 particles going through a selected area and only 3 emerge on the other side we know there must be a hole somewhere in that area.  I am a bit of a nerd so things like this are amazing to me.  We can look at a piece of paper with symbols and numbers and literally see a black hole in those symbols and numbers.  (it turns out the equations of general relativity hold true under the extreme conditions of black holes and hence, they are the strongest evidence that Einstein's theory is true)

What does any of this have to do with a blog dedicated to economics?  I am working to demonstrate the powerful tool of mathematics and its limitless ability to discover patterns in the world.  It is because of the powerful nature of mathematics to discover patterns in the world that it really irks me when certain economists act as if it is "silly" to use mathematics in economics.  Some economists even argue that those who use mathematics in economics are not doing "real economics".  Mathematical economics is relatively young and advancements to the methods are being improved constantly.  There have been 6 (correct me if I am wrong) mathematicians to win the Nobel Prize in economics for game theory.  These methods are being applied to various areas of economics, especially oligopolies, with very good results.

This isn't to say all we need is mathematics, far from it.  Good theory is always the most important part of an economic paper.  All I am arguing is that mathematics can be a useful tool to complement the theoretical portion of economics.

It took mathematics to prove one of the greatest physicists was wrong about his disbelief in black holes. Will those who denounce mathematical economics come around if there is a truly significant advancement in economics achieved mathematically?