Archives: February 2009

The eternal quest to fix prices

If there is one single belief that unites most political thinking throughout the history of mankind it is that prices for goods and services cannot simply reflect supply and demand but should be manipulated to  achieve more grandiose goals. Although mankind has gone through numerous cycles of fixing prices, discovering the unintended consequences, and reluctantly abandoning these policies, the temptation for each generation to improve upon  something as  “crude” as supply and demand remains too much of a temptation. The Ludwig von Mises Institute has resuscitated a book that documents this seemingly never ending quest to distort the price mechanism.

Centralized planning regularly appears in every generation, and is just as readily discarded after several years of fruitless experimentation, only to rise again on a subsequent occasion. Grandiose plans for regulating investment, wages, prices, and production are usually unveiled with great fanfare and high hopes. As reality forces its way in, however, the plans are modified in the initial stages, then modified a little more, then drastically altered, then finally allowed to vanish quietly and unmourned. Human nature being what it is, every other decade or so the same old plans are dusted off, perhaps given a new name, and the process is begun anew.

It is not an exageration to state that generating arguments why the laws of supplies and demand require enlightened assistance by philosophers, economists, and politicians  has always been in high demand by such diverse  institutions as kingdoms, labor unions and central bankers.  Realizing how widespread this mindset has been thoughout history may provide some  stoic relief to those who are frightened by contemporary developments. Robert L. Schuettinger &  Eamonn F. Butler’s Forty Centuries of Wage and Price Controls: How Not to Fight Inflation is available here.

Neo-liberalism’s dead end street blues

The legal scholar Frank van Dun has written an insightful essay in Libertarian Papers about the unfortunate identification of liberalism with utilitarian-pragmatic policy making. His analysis is helpful for explaining why some liberal ideas became popular and others remained ignored.  Van Dun touches upon the heart of the matter when he writes that politicians like

Margaret Thatcher in the U.K. and Ronald Reagan in the U.S.A., adopted the free-market rhetoric to gain power on the promise of renewed economic growth.

In the late 1970s the effects of the post-war interventionist policies had become unpopular with so many people that selective use of classical-liberal rhetoric could actually benefit a person running for power. This is not to say that  these politicians did not actually believe in these ideas, but that some liberal modification of the prevailing social democratic orthodoxy  had simply become necessary  in order to prevent modern western countries joining the third world in terms of productivity and welfare.

Selling policy illusions to the government proved a lucrative business for the neo-liberals. Chastened by the experience of stagflation, governments and the interests that thrived on their support were willing to try new ways of maintaining their positions and achieving their objectives that were supposedly more effective and more efficient than the failed Keynesian policies….From the point of view of the ruling politicians, the neo-liberals were excellent team players, always ready to make the existing system more efficient, never eager to question its raison d’être or its self-assigned legal privileges and immunities.

The new neo-liberal opinion makers and the orthodox establishment remained united in their teleological interpretation of “the economy” as a tool to achieve specific policy outcomes.  The objective of a depoliticized society that is at the heart of classical liberalism was ignored in favor of specific public policy proposals to stimulate “growth.” It should not be surprising, then, that the pendulum of history would be swinging back to the older ideas  again when the monetarist orthodoxy would be deemed inadequate to explain and address contemporary economic events.

In every dead end street there is a point where one can only go from left to right and back and then right again, and so on and on. It is hardly helpful to call this the inevitable swing of the pendulum of history. It is going round in circles. The obvious solution is to recognize that the street is a dead end street and to abandon the illusions one had when entering it. Until the utilitarian-pragmatic cult loses its grip on education, the media, and the economics profession in particular, politics, but little else, will continue to thrive on the illusion that it can control the uncontrollable. Not equipped with the divine attribute of prescience, no government can predict, let alone determine, how over time multitudes of other people will react to its policies, exploit the opportunities they create and learn to avoid their burdens.

The problem with political  consequentialism is not that it does not necessarily lead to libertarian conclusions but that every single policy can be justified in a consequentialist framework, depending on the values of the public policy maker in question.  There are no consequences that “speak for themselves.” This does not mean that critics of political consequentialism agree on what should take its place. Natural rights philosophy does not offer better prospects. Attributing any kind of goal to society, whether it is maximization of a social welfare function or enforcement of natural rights, prevents careful thinking about human interaction.

Curing “rights talk” with more “rights talk”

John Gray reviews Dominic Raab’s The Assault on Liberty: What went Wrong with Rights and makes an important observation:

Ironically, while he astutely criticizes the rise of a legalistic culture of rights, Raab seems to believe we can extricate ourselves from our present predicament through another exercise in legalism. Yet when much of the British political class no longer cares about freedom and barely understands what it means, a Bill of Rights can hardly be expected to turn the tide. It was not law or rights that Churchill invoked when dismantling wartime infringements of freedom. It was civilization, which requires a measured restraint in the use of power on the part of our rulers without which bills of rights are not much more than scraps of paper.

Classical liberals should not be surprised about the current proliferation of rights. As soon as the term right is divorced from actual contract, the road is cleared for all other kinds of rights claims. The challenge is to overcome the incoherent thinking about rights as such.

Understanding business cycles

In his book Recessions and Depressions: Understanding Business Cycles, Todd A. Knoop points out that a Rational Expectations perspective does not necessarily require that all segments of society are rational or use all available information:

Those who are rational will take advantage of the profit opportunities created by those who are consistently making mistakes.

In other words, the failure of some individuals to act on the future effects of policies  will create profit opportunities for people who do anticipate such effects.  This is an important observation because it highlights how public policies can be rendered ineffective without having to assume that all people are forward-looking, rational individuals.

The book also contains a useful observation about the effect of random shocks on business cycles:

It might seem strange that random shocks to productivity can create business cycle swings. Shouldn’t every negative shock be quickly offset by some positive shock? The answer is, no. Economists and statisticians have long known that if you flip a coin 20 times, cyclical patterns will emerge. There will be series of heads that follow each other just as there will be series of tails. If productivity is a random variable, then it is not surprising that economies exhibit cyclical patterns. Persistent business cycles can come about as a result of the luck that is inherent in any random process.

The existence of business cycles as such in unregulated economies does not necessarily constitute “market failure.”  In its most simplistic form, such a view of market failure would be akin to saying that free markets fail because they are not immune to meteorite attacks.

But at the end of his chapter on Rational Expectations Knoop states that

rational expectations in an imperfectly competitive model of the economy can have much different implications….It is not necessarily rational expectations but the Rational Expectations model of perfectly flexible markets that generates what many economists consider to be implausible results.

Any model that assumes competitive markets will lead to implausible results if it is used to predict how individuals behave in an economy where government policies adversely affect the operation of markets. This does not invalidate models of perfect competition but highlights the need for models that reconcile the postulate of rationality with imperfect markets, provided such models do not claim to be actual descriptions of laissez-faire economics.

One troubling implication of Rational Expectations is that government can only influence real variables in the economy if its policies are secret and unpredictable.  Even if one does not agree with the strong postulates of Rational Expectations, public stabilization policies that assume that people will repeatedly ignore their future tax burden or neglect profit opportunities that are generated by these policies, do not even pass the test of common sense. Government can, of course, respond in turn by preventing markets to refect these new realities, but this can only produce  a perpetual cycle to disturb the operation of the price mechanism.

Knoop’s book on understanding business cycles is a useful introduction to the subject although his chapter on Real Business Cycles Models could benefit from a more balanced perspective. The conjecture that business cycles could be the most efficient response to  exogenous changes given the structure of the economy is an important insight and reconciles microeconomics and macroeconomics.  Although the New Keynesian economists also provide microfoundations for their views, it is sometimes hard to tell whether these views are refinements of classical economics or departures from it. If New Keynesian Economics is just a “hodge podge of reasons for this or that market failure” it runs the risk of being able to explain any kind of empirical observations.

New Keynesian Economics seems to be less confident about public policy recommendations. It will be interesting to observe what the fate of this school of economics will be if recent work on the microfoundations of political failure will be given more attention in macroeconomics.