Any time there is a serious economic downturn, mainstream economics drops in popular and intellectual esteem, even though mainstream economics generally does not pretend to have abolished the business cycle while it explains why reliable, systematic prediction of future economic conditions is impossible.
However, serious economic downturns are almost invariably the result of bad policy, and economists and economics will be berated for failing to give successful advice. (Indeed, one view is that serious downturns can be manifestations of market predictions of bad policy.)
This loss of esteem is generally unfair about microeconomics. In the words of former head of the Department of Prime Minister and Cabinet, Dr Michael Keating, microeconomics is successful at “producing robust predictions of general tendency”. It is rather less unfair about macroeconomics, which has failed to achieve even a common analytical language.
Of course, some folk can be correct in predicting some particular event or trend, but it will generally not be continually the same folk. Outlier predictors are, of course, a statistical possibility—consider having a large number of people predicting heads or tails: some folk will continue to get it right though fewer and fewer as more throws are made, but that is a result of that a particular sequence will occur and, with enough varied predictors, some people will pick that sequence; it is not that they have some insight into “heads or tails”.
That said, economics also creates rods for its own back, and it does so by some poor naming of major ideas. Typically, such names misleadingly over-claim and either provoke hostile responses from the unsympathetic or encourage poor thinking or both.
Information and expectations
Consider ‘rational expectations‘: it should really be labelled consistent expectations since the fundamental notion is that expectations of agents in the model of the economy should be consistent with the model. That is, you should not base any economic model on the mere presumption that the modeller has significantly and persistently better insight into the operation of the economy than the (other) agents in the economy. It is fundamentally a principle of analytical humility but, unless one can provide reasons why the modeller would have—in a systematic and continuing way—better information than people for whom a great deal is at stake, it is a sensible analytical principle.
The principle is a formal expression of the reality that people react to information about the economy: which includes (implicit or explicit) models of the economy. But labelling the principle ‘rational expectations’ is misleading and invites misreading as putting some very high value on the “quality” of expectations rather than their common cross-agent limitations. (Yes, the notion is that agents are rational in their use of information but rationality is a general economic principle: the principle involved here is specifically about analytical consistency in application of information.)
Then there is ‘the efficient market hypothesis (EMH)’: which should be labelled the informed market hypothesis, since the notion is that prices will reflect information available to agents. The problem with terming it the efficient market hypothesis is that it then looks like a principle of market perfection, which it is not. (There is a strong version[, a semi-strong] and a weak version: I am talking here of the weak version.) The weak version does imply that open markets will the best way of pricing assets, but that does not entail that markets are perfect: merely there is no systematically better mechanism for pricing assets. It does not even imply that information is transferred instantaneously.
Nor does EMH imply that asset price bubbles are impossible: on the contrary, it is precisely because we cannot predict new information that we cannot predict turning points, so asset price bubbles become possible (since if we could reliably and systematically predict turning points, prices would not rise to a level for people to be caught by them when the bubble bursts) while expectations of capital gain both motivate agents and are part of the information feeding into prices. Asset bubbles are clear enough in hindsight, when we have the information about how they ended: specific information not available to the participants in the bubble (hence there are always folk denying that any bubble exists: and if income on said assets rises to “catch up with” the expected capital gains, they will be correct).
If EMH was labelled the ‘informed market hypothesis’ it would be less misleadingly named and less of an affront to folk not enamoured of markets. (And yes, EMH is about the efficiency implications of use of information but, again efficiency—or its lack—is a general feature of economic mechanisms; EMH is specifically about markets and information.)
Putting consistent expectations and informed markets together—the alert reader will have noticed that they both enjoin the analyst to take information flows seriously and not presume one is a privileged observer—suggests that considerable scepticism about regulation is appropriate. (Particularly discretionary regulation, where the approval of officials is required.) As there is no reason to think regulators will be systematically better informed than economic agents in general. (Noting that regulation is based on some implicit or explicit model of behaviour.) Indeed, there is good reason to think that discretionary regulation will make markets more chaotic, rather than less, by narrowing the use of information and generating perverse incentives: an expectation that has considerable empirical support (pdf), particularly in the experience of command economies.
There is a large debate about central banking in particular around the discretionary/rule/open markets possibilities (central bankers should have discretion; they should operate according to some policy rule; they should be abolished). Hence Swedish economist Lars Svensson’s suggestion to target the forecast; so policy action and market information work together.
Note: I am using “layperson friendly” characterisations of both “rational expectations” and EMH: for much more sophisticated discussion of both and critiques thereof, see Stephen Williamson’s review essay(pdf) on John Quiggin’s Zombie Economics.
Another case of poor labelling is the Austrian economics concept of ‘malinvestment‘. What is or is not a good investment significantly depends on larger economic conditions. What is a great idea in New York may be a really dumb one in Port-au-Prince. The notion of malinvestment is that unwarranted monetary expansion misleads folk about the future path of economic activity. As conditions change, investments based on such unwarranted expectations are “exposed” and need to be liquidated to free resources to go to more valuable uses.
But the label implies (in compete contradiction of Austrian value subjectivism) that being a malinvestment is an intrinsic quality of an investment. If so, the level of economic activity becomes irrelevant to the level of malinvestment. So, you can happily advocate any amount of restrictive “adjustment” because the level of “bad investments” wasting resources is set.
Conversely, if you understand that what is or is not a good investment significantly depends on economic conditions, then driving down income expectations does not “release” resources, it increases (potentially considerably) what becomes a non-returning investment and what level of burden they are. (After all, the original idea is that investments are created based on misleading expectations about future economic activity.) This process can be conveyed graphically:
… the debt-to-equity ratio for U.S. small businesses soared above 100% in 2008, where it has persisted to the present. That level is significant in that it indicates that external lenders (banks) currently have a greater financial interest in the small businesses to which they’ve lent money than do the actual owners of the small businesses.
Consequently, lending institutions are carrying over half the financial risk associated with the operation of U.S. small businesses.
Barry Eichengreen makes the point well in his essay on the problems of a gold standard:
Society, in its wisdom, has concluded that inflicting intense pain upon innocent bystanders through a long period of high unemployment is not the best way of discouraging irrational exuberance in financial markets. Nor is precipitating a depression the most expeditious way of cleansing bank and corporate balance sheets. Better is to stabilize the level of economic activity and encourage the strong expansion of the economy. This enables banks and firms to grow out from under their bad debts. In this way, the mistaken investments of the past eventually become inconsequential.
Restrictive adjustment insisting on prior liquidation of “malinvestments” is a “cure” which is, in fact, more of the disease (by increasing the level and burden of non-returning investments). Thus does poor analytical terminology lead to bad policy thinking.
As an historical aside, the Austrian business cycle story does not make much sense for the 1920s boom and 1930s bust, as David Glasner explains nicely. Yes, the central banks, especially the Fed, got it wrong but it was their restrictive monetary policies that did the real damage, though Ben Bernanke’s words to Milton Friedman in his 2002 speech:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.
now ring very hollow.
What is money for?
The mislabelling which does the most damage to general economic thinking is using ‘real’ prices and ‘real’ wages when what is meant is prices and wages in terms of goods and services. This terminology does analytical damage by attempting to abstract away from money while preserving the fundamental attributes (and so reasons to use, and effects of) money.
In actual economies, there are only two sorts of prices: money prices and barter prices (i.e. prices in terms of goods and services). Money can come in various forms: commodity money (gold, silver, rum, cowrie shells, cigarettes, tins of mackerel), commodity standard money (commodity money with paper notes added and/or paper notes backed by some commodity or commodities: as in, most famously, the gold standard) and fiat money (paper/plastic notes with the commodity standard taken away: now extended to include electronic entries).
Whatever its form, we use money because it massively reduces transaction costs. Prices and obligations can be dealt with by a single medium of account across all transactions. We have a single unit of account to record prices and obligations in and a single medium of account to make offers and set and pay obligations. This hugely reduces search and information costs. So much so, that people continue to use money even in times of ludicrous hyperinflation.
The cognitive burden in trying to price things in terms of goods and services is large: far too much so in a complex economy with a wide variety of goods and services (a result of the interaction between there being very little production-for-self and expanding technological capacities). While, even in hyperinflation, the search costs involved in finding useful chains of barter are too high for it to become a general mechanism.
So, we use money for good reasons: it serves extremely useful functions. Using the concept of ‘real’ prices abstracts away from “actual” money while continuing to invoke its functions. This is not analytically helpful, for we then make money what it is not—immediately, transparently “neutral” about prices in terms of goods and services. Cognitive simplification means precisely that and is a genuine economic function. It takes time to register shifts in the barter price(s) of money (what it buys in terms of goods, services and assets). Which means that shifts in spending have effects on output, until people adjust for any general change in what money buys (in terms of goods, services and assets).
Such abstracting away also takes from money what it is—a contractual constraint. Contracts are set in money terms: it is what our obligations are typically set in. So, of course wages will be “sticky” downwards because people will resist being paid less of what their existing obligations are set in. (They will also resist any unilateral changing of contracts by the other party, since this undermines the very notion of a contract and their own “standing” as a contracting party.)
In other words, money matters in the economy and it matters for good reasons. By using ‘real’ prices and ‘real’ wages we create statistical artefacts that encourage us to incorrectly discount the actual economic functions of money, creating a misleading “shadow” of still-using-the-functions-of-money “real” prices and wages between the economic realities of (money) spending and (goods and services) output. Basic economic functions of money are turned into “money illusion” (rather than cognitive simplification, information lags and contractual constraints), creating misleading expectations about economic behaviour.
By instead using the term ‘barter prices’ (prices in terms of goods and services) we keep the actual functions of money analytically “front and centre” rather than ontologically discounting money prices by implying they are not as “real” as our misleadingly labelled statistical construct. By abandoning the language of “real” prices, our language conforms to the economic reality that there is not “nominal” and “real” spending, there is (money) spending and (goods and services) output.
Looking at things in this way, we can more clearly see that inflation is a (positive and continuing) gap between spending and output. Goods and services inflation is (positive and continuing) gap between spending (on goods and services) and output (of goods and services) while asset price inflation is the (positive and continuing) gap between spending on, and the level of, assets. Conversely, deflation is a (negative and continuing) gap between spending and goods and services output/level of assets. Inflation and deflation are neither “tack-ons” to the “real” economy nor “ring-fenced” “money illusion” phenomena: they are consequences of basic economic phenomena and influence behaviour—primarily, through their effects on use of money and thus the form and level of transactions. So expectations about money and spending matter.
Abandoning the notion of “real prices” would also allow us to see price indices more clearly for what they are: measures of shifts in the scarcity of money in circulation compared to “stuff” (goods, services and assets). Price indices are inevitably “works in progress” (though technology can dramatically improve them). If we have some notion of “real prices” which somehow have to be discovered by having the “right” basket and making the “right” adjustments this leads to angsting about (ultimately insoluble) problems of shifts in technology (what is the price of a PC in 1930 dollars? Infinite, because there weren’t any, so no amount of money could buy one). If we instead accept that they are only money prices and barter prices, only spending and output, then price indices are still useful as measures of the changing scarcity of money in circulation compared to stuff. While trying to estimate changes in standards of living over time would be more clearly about indices of consumption, about measuring consumed output, which can lead to some striking results (pdf):
These experiments provide evidence that an hour’s work today will buy about 350,000 times as much illumination as could be bought in early Babylonia.
(I recommend Nordhaus’s paper: he has a very droll sense of humour.) We can also see more clearly that measuring changes in the scarcity of money compared to stuff and measuring changes in consumed output are not, in fact, the same function. Hence the latter is better measured in a continuing constraint, such as time (even though that changes too in that we are no longer sun-up-to-sun-down societies), or a continuing requirement, such as energy.
If we can measure output, and spending, even roughly, then we can get estimates of things we want to know without being diverted by the chimera of “real” prices, for there is no Platonic “shadow land” of “real” prices to be discovered in between spending and output which is nevertheless (in true Platonic style) somehow more “real” that what we actually observe: there are just prices in terms of money and (barter) prices in terms of goods and services.
Thus, the barter value of a wage (‘barter wage’ for short) is what a given wage can purchase in terms of the goods and services. If the barter price(s) of money falls, then barter wages fall. If the barter price(s) of money rises, then barter wages rise. But a wage is also a cost, so then the good-and-services cost of labour rises.
So it is perfectly possible to tell the “real wages” story but in a way which uses the same language for money and wages without playing the silly and misleading game of “abstracting from” money while continuing to invoke the functions that money performs. Similarly, we can talk of spending GDP (money spent on productive transactions) and output GDP (GDP deflated by the changes in the barter price[s] of money) without then misleading language of “nominal” and “real”, as if money is some epiphenomenon diverting us from some Platonic “real” economy that is more “real” that all that using-money-things people do.
Using this language also discourages the irritating (and false) usage that interest rates are “the price of money”. Interest rates are the price of credit (or, if you like, the opportunity cost of holding money across more than one time period: the opportunity cost of money within a single time period is its barter prices[s]—what you can get for it in goods and services). Interest rates cannot be the “price of money” since they include expectations of changes in the future barter prices(s) of money. (And if you are wondering when money becomes capital, it does when anything produced by people becomes capital: when it is used for productive purposes over more than one time period.)
It is all very well to say what specific terms “really” mean, but terms are not transparently neutral between us and the world. The terms themselves have connotations and implications that matter, as they encourage or discourage patterns of thinking. Coined poorly, they can also get in the way of communicating with, let alone persuading, others. Labelling, like money, matters, and economics (whether mainstream or Austrian) does itself no favours with its mis-labellings.
[Cross-posted at Skepticlawyer.]