I wrote an analysis of the AD-AS model, and I would appreciate any comments. Is there some mistake, something I left out? Is it deserving of a Nobel Prize [= hand me the check, please] , an Ignoble Prize [=tell me why, please] , or merely restating what has already been noted [= link, please]?
Here it is:
The problem, as stated by Keynesian. People want cash so badly that any new cash created by the Fed will just be hoarded away. And the problem with that is that nobody will buy what is being offered and nobody will invest in businesses, meaning they will have no money and will be forced to fire people.
This whole problem is certainly possible if there is just one giant company that makes only one thing. If nobody buys that one thing, you have to fire workers. Since there is only one company, nobody else will hire them, because there is nobody else to do the hiring.
Looking at things in terms of aggregates is only an accurate model for one company making one product. That's exactly what the model is doing. It's saying let's look at everything being made as if it was made by one company, the Aggregate Supplier, making one product, which the Aggregate Demander no longer wants.
But once we break up the model into something that correspond to reality, where there are many companies, each competing with each other for available resources, and that if one company makes more of product A that means another has to make less of product B, the whole situation changes. If, when looking at the numbers, you find that Aggregate Demand is down, you can then ask yourself, down for which particular products? Surely the answer will never be, down for every last thing offered for sale in the market. Even in the worst of recessions, some companies make money.
There will certainly be a demand for some things. The problem is that they cannot increase production because the unprofitable companies were, until now, competing with the productive ones for resources, the most obvious example being workers who were working for the unprofitable companies instead of the profitable ones. This also explains the hoarding. To the extent that people are not spending, it's because they wanted to spend on the good stuff, but not enough of it is being made.
Once we grasp that this is the correct picture of things, the the solution is immediate. Do nothing. As a result, the unprofitable companies will have to let go of the resources and labor they have been taking, and they will be transferred to the profitable ones.
Note that this is a two step process. First, the unprofitable business has to let go of its workers. Only then can they find employment with the profitable companies. The first step is called a recession. Unhampered it will quickly lead to a recovery, which is the second step.
Now, instead of doing nothing, you can try to "end the recession". This would mean making every effort to keep the workers and resources attached to the unprofitable company, and this indeed can be done by artificial means, aka monetary and fiscal "stimulus" of the zombie companies. Basically, this is an elaborate mechanism for imposing slavery on the populace. They work not for themselves, but to keep alive an unprofitable company, since the money to support it has to come from them.
Research has shown that slavery has always failed as an economic system, and explained why [= reluctance on the part of the slaves to work]. Now maybe if you hide from them that they are slaves, they will keep on working enthusiastically. After all, those pyramids got built somehow, right? But it's certainly not the most productive way of running your economy.
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It's easy to refute an argument if you first misrepresent it. William Keizer
1. I think that the current structure of your article is rather jumbled. While it is passable, if I were reading this then I would start off by thinking that this was a critique of the liquidity trap, and it is in a way, but not a straightforward way. A better title would, in my opinion, be something like "what is the answer to a recession?". At the same time this also acts as a critique of AS-AD, but at the same time it isn't very thorough. So if sheer brevity is what you're going for then it works fairly well, but there's a lot more you could go into. It's also hard to call this the solution to "our" liquidity trap since it doesn't talk too much about the specifics of what's going on today, nor why we are in a liquidity trap and why things aren't getting better.
2. I think that you misinterpret what fiscal stimulus does. There is no guarantee that it will merely prop up the "bad" companies (although this is a possibility), instead it is just as likely to change the demand structure of current companies and divert production away from consumer demand. This is my basic critique of government stimulus: fiscal stimulus crowds out both private investment and increases and decreases private consumption as some of the prices of the goods they were buying rises. Now this could be counteracted by the multiplier effect, there's nothing inherently wrong with that, but the problem with this is that recessions are precisely when the multiplier is likely to be the lowest. Furthermore if taxes increase then this decreases the multiplier and leaves us with the "tax multiplier", which puts a massive amount of pressure on the production structure to reflect government demand, rather than private demand. So even if this does return spending back to normal, then what? Well a dramatic decrease in demand will cause the business cycle again, a slow decrease in demand will "increase" the period of the recession since real private output will be dramatically lower than it otherwise would be. Therefore the recession may well be lengthened by this action.
Monetary policy fails because it inevitably results in ABCT. I don't buy that the stimulus would disproportionately affect the "bad" companies over the "good" companies because the whole flaw with AS-AD is that it looks at aggregates, not at specifics. The government can't specifically step in and "fix" the bad industries, it can only realistically target the whole economy, if for no other reason than the multiplier effect. Therefore it's more likely to be good and bad companies producing bad things than bad companies being propped up for their current production.
3. "This also explains the hoarding. To the extent that people are not spending, it's because they wanted to spend on the good stuff, but not enough of it is being made."
I find this extremely dubious. If this were the case then demand for the good stuff would just increase and production of the good stuff would increase regardless of what the government did. The whole point of a recession is that a fall in demand in some sectors is not immediately made back up by an increase in demand in other sectors. A much simpler description is the basic narrative that people are uncertain about the future and afraid of losing their jobs. That's the narrative that Rothbard explicitly told, and I think that Mises believed exactly the same time (otherwise I don't see why he believed that wages would have to fall)
I want to ask you a few questions about what you wrote, Neo, but aliens are currently in the process of abducting me. Look for my reply later. I need the econ practice; it's been too long.
Neo,
Indeed I should have omitted the subtitle, "What is the Austrian solution to our current liquidity trap." That was the question someone asked that I responded to. But when thinking about this question, it occured to me that the whole AS-AD model is inadequate to describe an economy that has many producers and many products. And that is the point that I was asking about.
So let's put aside govt actions and proposed solutions to recessions and liquidity traps. I am wondering about the description of the problem using the AS-AD model. So here's what I'd like your opinion on, please.
1. Is the critcism correct that the AS-AD model simplifies into one product from one producer, but the moment one recognizes that there are many producers of many products, then the description "lack of aggregate demand" it totally inadequate? That the correct description of the situation is "some companies suffering from lack of demand, others are making money, and still others would make [even more] money if they were able to draw resources from somewhere"? And the reason this is true is that in a large economy, surely there are companies of the second and third type, even during a recession.
2. If 1. is true, does it not immediately follow that it is mad to take action to support unprofitable companies, who by definition [of unprofitable] are making things nobody wants? And that the problem will solve itself, as the unprofitable companies will reduce production, and the third group mentioned in 1, the ones that are dying for more and cheaper resources, will pick up the unprofitable company's workers and resources and increase production? And surely the increased production will also lower prices, allowing for more sales, meaning taking care of the hoarding?
3. Maybe I shouldn't go into this, because I would like to focus on the two previous points. So after due emphasis that this isn't my main focus I'll toss this in parenthetically:
About your final paragraph. Production of the good stuff would be hampered by the govt propping up the bad stuff. And demand for the good stuff would be hampered for the same reason. The pie is finite. Whatever slice the govt diverts to the bad stuff means less of the pie for everyone else, is the basic problem with govt action.
Now you may argue that the govt may accidentally divert from the bad company to the good comapny also. But that would have happened anyway. So the net difference the govt makes is in the opposite direction.
I'm not sure where people being afraid of losing their jobs fits in. If they have jobs, they are presumably working for a profitable company, or else they'd be laid off. So it's perfectly fine if they sit tight.
Wages having to fall is a solution to chronic unemployment, when people get fired from the bad companies and can't find work in the good companies. If the particular reason for their failure to find new jobs is the law restricts them from accepting a lower wage, then the solution is to take care of that bottleneck by allowing wages to fall.
1. Generally I'm in agreement here, however, the one thing that I disagree on is that I think that even though it's a radically oversimplified vision of the economy, that doesn't mean that there isn't a grain of truth in there. AS-AD can explain certain events such as inflation, hoarding, and increases in productivity, but it's a mistake to take that particular model too seriously since it's super simplistic. If people are/have hoarded money and prices haven't adjusted then demand is effectively too low compared to what consumers really demand. Once prices adjust, and in the Keynesian model AD moves to the right and we retain the old equilibrium condition. However, in the mean time there is a lack of demand in that some firms will either be unduly running at a loss or unemployment/unemployed resources where everyone would be better off if prices had simply adjusted.
Another error that I think that you are falling into, and something that I think that a lot of Austrians do, is the belief that the "good" firms are in no danger of running losses during recessions. Consumer spending during such periods are likely to be extremely volatile and risk premiums in interest rates are probably going to escalate pretty dramatically. For these reasons it is by no means entirely obvious who is "safe" or "unsafe", nor who is even really profitable. Furthermore firms at the margin who are running "thin" profit margins will run into especially severe problems. Firms that are running at losses also may or may not be able to restructure in such a way as to start running profits.
2. "does it not immediately follow that it is mad to take action to support unprofitable companies, who by definition [of unprofitable] are making things nobody wants?"
Well there's a few problems here. The first is that, as I indicated above, it may not always be only bad companies who are running losses in recessions, and this is greatly exacerbated if there is hoarding. This is also a point that I've stressed before, but it's incorrect to call malinvestments the production of "things nobody wants"
3. "And demand for the good stuff would be hampered for the same reason. The pie is finite. Whatever slice the govt diverts to the bad stuff means less of the pie for everyone else, is the basic problem with govt action."
This is less the case with government spending with a high multiplier and generally idle resources, but the problem with this in a recession is a low multiplier. Remember that the multiplier effect is production of what private citizens want, only the initial payment is the only part of this that is truly "government" spending.
"Now you may argue that the govt may accidentally divert from the bad company to the good company also. But that would have happened anyway. So the net difference the govt makes is in the opposite direction."
What do you mean by this?
"I'm not sure where people being afraid of losing their jobs fits in. If they have jobs, they are presumably working for a profitable company, or else they'd be laid off. So it's perfectly fine if they sit tight."
Firms running at a loss don't go out of business instantly, nor is it wholly obvious what companies will and will not go out of business, particularly if you are a normal worker without a great understanding of economic conditions.
"Wages having to fall is a solution to chronic unemployment, when people get fired from the bad companies and can't find work in the good companies. If the particular reason for their failure to find new jobs is the law restricts them from accepting a lower wage, then the solution is to take care of that bottleneck by allowing wages to fall."
But if payroll hasn't fallen for workers in general there is no reason that wages have to fall, workers could be immediately employed into other industries. Without deflation (in the sense of a fall in the purchasing power of money) wages could remain constant by and large since the problem is where the workers are, not how much they are being paid.
I have a few questions that I've found problematic with ABCT, I might post them here later.
Smiling Dave: I'm not sure where people being afraid of losing their jobs fits in. If they have jobs, they are presumably working for a profitable company, or else they'd be laid off. So it's perfectly fine if they sit tight.
Dave, how is the average employee to know what kind of straits his company is in? Maybe they could do the research, but I think that it's a pretty natural and prudent reaction of normal people to cut back on expenditures in the case of an economic downturn.
The Anarch is to the Anarchist what the Monarch is to the Monarchist. -Ernst Jünger
^
Pretty much how I feel on the matter.
Back to the drawing board.
Thanks, guys.
Well NAA, if you ever get returned by aliens then you might as well ask whatever you want to ask
Smiling Dave,
I agree with some of your arguments and some of Neodoxy's responses. They do illustrate good economic thinking.
But I am not sure what the original argument is that you are trying to refute.
It sounds that you start off by assuming there is such a thing as a valid "Aggregate Demand- Aggregate Supply theory" and that "hoarding" and multiplier effects exists and needs a formulaic explanation and it can be used to argue that there is a "liquidity trap" that should be handled differently but within their definitions.
What if the AD-AS argument is bogus to begin with?
What if there is no such thing as "hoarding" or "liquidity trap" What if the liquidity trap is just a manifestation of individual value scales?
All those terms require you to accept certain Keynesian arguments as sound. Why give them so much credit?
What if the fake boom caused regular Joe citizen to malinvest .The artificial "boom" causes people to have extra credit and sometimes extra cash laying around. The gossip from the neighbor tells him he can get a higher return on his savings by buying Beanie Babies, or Dotcom companies or investment real eastate or whatever. His value scale reference tells him to try this with some of his money.
For a while the neighbor is proven right. He profits.Word of mouth spreads and soon credit is used to "invest" in this new craze. It creates not only new jobs in this industry but those workers buy more shoes and pizzas. The eggheads do the math and claim proudly the GDP has grown.
Sometime or another the Ponzi zcheme gets to it's limit. Mainstream economists and Keynesians are of the illusiion that this "boom" is the real economy and should be maintained.
When the correction comes and the bubble bursts and things return to where they belong, they bemoan this needed loss and blames it on all sorts of "animal spirits" or greed or price gouging or other strange names. We don't have to name it or give it a formula, we know it is a correction.
People and companies in the "fad" industries go bankrupt and lose their jobs. But not only them, the shoe salesman, pizza shops and millions of other vendors shrink or die. It is a correction. Credit dries up and people have less "mad money" to waste on frivilous projects. It has nothing to do with liquidity trap or "hoarding" except in mainstream economists eyes.
Sure everybody now sees these malinvestments for what they were and does a quick re evaluation of their priorities. The out of work ones might only spend on food and shelter. The employed ones might immediately decide to stop frivolous investing. They might pay off debt, they might imrove their education, they might not run up a credit card but pay cash.They might buy a new machine for the factory or service the old machine instead of buying a new company or hiring 100 new employees. Thousands of different choices but certainly not the same as during the boom. Some millions buy gold.Yes some of them might decide to start a rainy day fund by saving- which is not the same as hoarding. (depending on each persons value scale)
NONE of this can be callede hoarding. Hoarding is a derogatory term usede by Keynesians to vilify savers and succesfull businessmen that do not blow their profits immediately.
Even keeping money under the mattress or in a low yield CD or savings account is "investing" according to that person's value scale. And ALL of these are good for the economy.
"Cash will just be hoarded away" is a misguided mainstream thought. Even money sitting in a lowly savings account releases more credit back to another entrepeneur to improve capital goods. Even money hidden under the mattress shrinks the money supply and increases the value of the currency and counteracts inflation. No need to deride these people (yes we all agree the government should not bail out, but that has nothing to do with the fact that we or rather I, dispute the Keynesian calculations in the AD-AS argument.)
So I see no need to think of alternatives to handling the liquidity trap if I dispute that such a thing exists.
Albert,
I don't disagree with anything you said.
I'll explain what was going on in the Smiling Dave brain factory. While thinking about a question someone asked on reddit, about how Austrians would deal with a liquidity trap, I got sidetracked into exploring another idea, the AS-AD model. I had previously written about something else entirely the following homely parable:
Imagine trying to model marriage with a simplified universe of Robinson Crusoe alone on island. It doesn’t work like that. Marriage requires two people minimum. You can’t model marriage with just one person.
Forgetting completely about the original question, it just popped into my mind that maybe an AS-AD model is making the same mistake. Maybe it, too, is essentaily pretending there is one producer creating one product and selling to one consumer, and maybe such a model is as flawed as modeling a marriage with only one person.
If we assume only one of everything, the Keynesian story is inevitable. Less consumption means the one company in existence has to cut down on production and fire people, who have nowhere to go.
But if you have tens of thousands of producers, surely many of them would be making money hand over fist, and are only hindered from making even more because they are being outbid for resources by the unproductive companies. So that all you need do is not interfere, and let nature take its course. The companies losing money will cut down on production, lay off workers, and those workers will be picked up by the productive ones, who are dying to get their hands on them, but until now were blocked by the fact that the losing comapnies hired them.
OK, so where do we stand now? Basically, that last paragraph is what [I think] Mises wrote would happen. I've seen others quoting Hayek as saying the workers laid off would go into working for companies that produced higher order goods, not consumer goods, a variation on the last paragraph. It has the advantage of being able to promise those jobs would be there waiting, because the very fact that consumers are not spending now means they are interested in buying later on in the future instead of now [surely they do not intend to hoard forever], which is a need that will be met by putting more resources into higher order goods.
Now the question becomes, am I sure that is what will happen? Am I sure there will be enough good companies to pick up the slack? Can I prove they will be there in sufficient quantity, these employment opportunities? At this humble stage of my knowledge of AE, I have to answer no.
But something has been accomplished. Because we have to ask ourselves, on whom is the burden of proof? Answer: On Keynes. He claimed to have a sure fire proof that a rich economy will lead to hoarding which will lead to unemployment and other idle resources, and that such a thing is inevitable, over and over, until the economy is "poor enough" once again.
Well, here we have shown a hole in his proof. His proof assumes, for all intents and purposes, one producer of one product. Once we allow many producers of many products, the events he outlines as happening are no longer sure to happen.
What about the multiplier effect, and the propensity to consume, and the liquidity trap, and all the other stuff? Even if we grant it all for the sake of argument as being true, it is all besides the point. All that stuff is justification for assuming hoarding, or for assuming great unemployment from small hoards. But even if we grant that, the flaw we pointed out above remains.
Note that all this stays the same whether we assume malinvestments, or animal spirits, or whatever. In other words, it is an attempt to hoist the Keynesian framework on its own petard, granting all its assumptions but one. We merely do not grant that the economy has one producer, and his proof crumbles to dust.
Note also that the discussion is not about his proposed solutions. We are addressing something prior to that, his argument that rich countries will get poor, inevitably, if left alone.
There is one thing that is still not clear to me. I have elaborated on Mises reply to the hoarding problem elsewhere. I'm still trying to figure out how his reply fits in with the ideas here.
TL;DR version of what Mises wrote. A hoarder is basically doing two things. First, he is working for free, which benefits the economy. Second, he is decreasing the money supply, which is neutral to the economy, [merely shifting prices here and there, but otherwise not doing anything]. Those rich people who used to light their cigars with hundred dollar bills thought they were merely showing off. In reality they were also giving us free gifts by the very act of burning that cash.
Whew, that was a long one. Thanks to anyone who got to here.
I guess the idea here is an elaboration of what Mises wrote, that reduction of money supply does no harm.
OK S Dave I get it,
I agree with you if you want to talk to mainstream economists and refute their claims in their own language your point is certainly well taken. They believe in this "equilibrium" and "evenly rotating economy" so they can "aggregate" everybody together and do statistical analysis on the whole economy as a single unit. Us Austrians believe in human action and we know that there will be as many variations as there are humans. That is why we can predict what will happen, but not if it will happen to any particular company or person.
In their own language then, here are a few other things that bother me in their formulas.
They equate everything to "THE HOLY GDP" a nebulous number that can be manipulated and reconfigured to please the reigning politicians.
In their formula for Agregate Demand they include government spending as if it is a legitimate contributor to "the economy" or GDP as they like to measure it.
That is why they so easily conclude that if producers and sellers slow their production the GDPor "economy" will slow unless the government increases their spending. That is the faulty conclusions you will get if you allow their definitions and formulas to stand.
Because of the broken window fallacy we know that the government has no money, that it has to plunder the "economy" to get its money before it can "spend" it on infrastructure, or stimulus or "saving" this sector or that.
If we were to write a formula for "the economic value" we would take all production and the prices of all products and services and then from it we would SUBTRACT government spending and taxes. In our formula it would be clear that the more the government spends, the weaker the economy gets.. no matter what spirit or boogyman you care to name it after.
Henry Hazlitt wrote a whole book full of further examples
I think that this is an important thing to note, but at the same time it's a non-answer:
"What if there is no such thing as "hoarding" or "liquidity trap" What if the liquidity trap is just a manifestation of individual value scales?"
There is nothing wrong with this per se, but it doesn't disprove the negative repercussions or existence of anything above. What constitutes, or doesn't constitute "hoarding" for instance, is ultimately very subjective, but this doesn't mean that the concept has no importance. The question here is of a mass change in value scales, and therefore the behavior of economic actors, and how that affects a changing, uncertain, and imperfect economy. Furthermore in your examples you overlooked the very case that we were talking about: plain savings caused by the very conditions of the recession. The fact that this is caused by changes in value scales don't change these conditions since value scales are exactly what cause the conditions in the first place. Regardless of whether you're saying that it's positive or negative, hoarding is still a phenomenon that is theoretically possible. Replace it with "mass savings" or "happy goodness savings", and the affects should still be the same.
Furthermore the problem that I have with the basic theorem that an increase in plain savings will merely cause an increase in capital is just that this, while occurring very rapidly, alongside great uncertainty and resource reallocation, it may well result in shortfalls in demand in general, enough demand to buy back the entire product at "full employment", which will cause a rise in unemployment. Price flexibility is always key, in inflationary and deflationary situations, but also in mass reallocation. Because there are frictions on these fronts and on the matter of reallocation of resources, there will always be shortfalls as a result of business cycles and especially rapid changes in consumer demand
OK Neo,
I have to concentrate a bit before answering you. I mostly agree but will give a better thought out reply tomorrow.