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This paper briefly addresses the key shortcoming in the world of macro modeling, but its main purpose is to recount, from a history-of-thought perspective, the reasoning behind the heart and soul of macroeconomic theory, which rests largely on the insights that have evolved on the impact of hoarded savings, the distinction between nominal credit and real credit, and full-employment restoration problems after a contractionary shock.
A secondary purpose of the paper is to note but not explore deeply that our most recent recession was not a product of a decline in aggregate demand caused by traditional Keynesian factors, but rather was instigated by a purely micro factor internal to the commercial banking system.
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And it did. And, lest we forget, Keynes ardently believed that his research project was highly pro-capitalist, not anti-capitalist. Rather, he believed that the broadly-free aspects of a market economy will remain robust, providing.
Within a Keynesian mindset, subcomponents of the economy were perceived as independent microeconomic variables that could not set in motion systemic forces capable of overturning the entire apple cart. As long as the total of all investment, consumption, etc.
Those who employed the sophisticated computer models commissioned by Wall Street were afflicted by the common illusion that the word quantitative ensures objectivity and hence somehow also infallibility Byers, , pp. Non-quantitative analytical warnings had always existed in the sidestreams of economics see, e. It is also noteworthy that more than a century ago a non-economist, one of the fathers of sociology, fully appreciated the vulnerability of a modern market economy, whose complex, interconnected web of exchange can come unhinged if a few key specialized threads are cut.
The apprehension of Dostoevsky and Byers is shared by Professor Caballero:. A perfect example of that to which Prof. Stephen LeRoy of U.
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Incidentally, the bubble comments of Prof. Eugene Fama to the New Yorker are instructive. He noted that it is easy to ascribe bubble behavior to a previously-favored asset whose price has just suffered a dramatic decline. The most recent scenario of model-induced blindness had enormous social costs. To wit, the unexpected lack of a high rate of foreclosure on subprime mortgages in the s—due to the unprecedented ease of serial refinancing at successively easier terms 4 Edmiston, , p.
Treasury, a supposition that turned out to be correct, despite explicit, early-on and repeated public denials by key Congressional promulgators of the subprime program.
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Incidentally, the massive issue of unregulated derivatives was not the root cause of the financial crisis. The seminal source of the meltdown was the plethora of State-encouraged subprime mortgages, period. The undercapitalized derivatives that followed to either hedge or bet against subprime securities 6 were merely fruit of the poisoned tree. This entire process, which began with the Community Reinvestment Act of , has been traced in a comprehensive, highly interdisciplinary fashion in my book-length examination of the meltdown forthcoming.
The bottom line for our purposes here, in brief, is that not until did many in the financial community finally come to realize that the triple-A ratings of subprime securities ere unjustified.
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This sale was an attempt to capture these gains in order to apply them toward rebuilding their equity-capital reserves. However, the resultant massive simultaneous selling by all banks presented the spectre of the fallacy-of-composition dilemma, 8 which ignited a meltdown of their non -subprime assets, thereby evaporating the hope of equity-reserve restoration. Consequently, banks were forced to curtail lending until more equity reserves could be accumulated a protracted task , which contributed to the extended wimpiness of the recovery following the huge contraction that had been brought-on by the financial crisis.
This episode inflicted serious damage on the credibility of the entire body of knowledge known as macroeconomic theory. Since the first two of these are tied to the concept of demand, this is where we shall begin. Although it was John Maynard Keynes who gave us the pivotally-important concept of aggregate demand with its fungible components of spending by households, firms, government, and foreigners —a concept which became the bedrock of macro reasoning—it was Adam Smith who fathered the notion of effective demand.
In short, said Smith, firms will produce within their capacities whatever people want and can afford to buy , but firms will not produce that which people cannot afford and hence cannot buy. Smith did not, however, address the consequences of a situation in which people indicate, by suddenly withholding some of their spending power, that they simply no longer wish to continue purchasing at the same rate, usually due to a particular set of anxiety-laden circumstances that have arisen.
In a nation with a balanced budget and a closed economy thereby precluding leakages from either a fiscal surplus or a trade imbalance , aggregate demand will be sufficient to prevent cutbacks in production only if no one hoards cash.
In this framework I am defining savings in the Keynesian sense, as all abstention: All disposable income that is not spent by its recipients Keynes, , pp. Most savings are fertile because they are redirected to others through the credit system. The savings that are not made available for lending are sterile because they are being hoarded, either by those who earned the dollars or, more likely, by banks who elect not to lend them in modern terms: to hold them at the Fed in their accounts of excess cash reserves.
Hoards, therefore, were not classified as part of total savings by Mill, because they are being withdrawn from the financial recycling process.
Keynes added a further twist: He mischaracterized all boosts in saving as highly apt to be hoarded, a supposition that enabled his paradox of thrift, namely, a recession brought on by a decline in aggregate demand caused by a rise in hoarded savings.
So in Keynes every additional dollar saved became a likely source of leakage un matched by additional injections of investment Ahiakpor, , pp. As Keynes put it,.
Global capital flows, for simplicity, are assumed here to be zero. On this point, Keynes scores highly; however, we will soon learn that Mill and several others of his era were well aware of the harmful macroeconomic consequences of a rise in hoarding.
Therefore, the eminent Prof. S38; italics added.
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Unintended investment, I u , is defined as any accumulation of unwanted inventories—excess to the needs of firms—whose rueful existence is due to production based on overly-optimistic projections of sales, described by J. In other words, the absence of hoarding ensures the absence of unintended investment manifested as an unwanted stock of unsold goods. In short, the real-world macroeconomic scourge—namely, a rise in hoarding i.
Yet he provided no rationale for his zero-hoarding condition:. By attacking it, Keynes instigated a reassessment that ultimately propelled the pedagogical importance of its implications Formaini, , p. Consequently, Keynes asserted wrongly that the later classicals taught that all output will be sold; that is, no inventories will disappointedly appear to cause firms to unplug machines and lay off workers.
See, for example, Laidler, , p. Keynes mistakenly ascribed to the successors of Smith and Say an elevation of the likelihood of the zero-hoarding condition from usual to always, an elevation that Keynes saw as unjustified and misleading. In his eyes, it was a convenient assumption that enabled them not to have to confront and account for recessionary unemployment, and he therefore severely criticized his predecessors and contemporaries without warrant , creating an infamous red herring in the history of economic thought.
In short, Keynes was motivated by his baseless belief that an absence of hoarding was a basic datum among a broad swath of classical and early neoclassical economists.
So to recap: Say continued the Smithian tradition, adding that people produce only so that they can either consume, or personally invest, or lend their savings to facilitate capital acquisitions by others.
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This interpretation is endorsed in Leijonhufvud , p. But they did affirm that it held ex ante. And the potential difference between the two was the key to explaining the good or ill of macroeconomic events. In addition, banks had originally planned to lend all their deposits beyond their internally-established level of cash reserves. Consequently, aggregate demand and aggregate supply, ex ante , were necessarily equal. But the best laid spending plans of mice and men will be revised downward in response to new, worrisome information, causing end-state aggregate demand to shrink due to unplanned hoarding either by individuals or banks.
A fear-motivated growth in excess reserves is the big danger, as occurred during the mid s Friedman and Schwartz, , pp.
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In such cases the equality between AD and AS that existed ex ante will falter ex post , spurring production cutbacks reductions in aggregate supply until the new, contracted AS is again equal to AD, but to an AD lessened by the appearance of hoarding, yielding, thereby, a new, inferior macroequilibrium that is characterized by lower national income and higher unemployment.
If an economy begins at full employment it will remain there only if, first, no discombobulating liquidity crisis arises due to an exogenous or endogenous shock, and if, second, most firms have correctly anticipated the types of goods and services that customers want, enabling a frictionless meshing of production and consumption. Serious coordination errors, said Mill and his numerous contemporaries, will effect a recession, but in such cases the downturn is not from a shortfall in total demand; rather, these lay-offs occurred because output was ill-suited to the otherwise sufficient volume of demand.
See the quotes from various classical writers in Kates, , pp.
See the quotes from both men in Kates, , pp. My admiration of the son is based on his assessment of the former of the two threats to macro stability, namely, the dilemma of a liquidity crisis, on which he was indeed brilliant. Mill, in Leijonhufvud, , p.
In the recession scenario, however, all plans are altered in response to some unanticipated, desultory event unspecified in Mill that incites trepidation, making people become abnormally cash-hungry, causing the demand for goods and capital, across the board, to fall far below the supplies that are sitting on the shelves, the input payments for which have already been disbursed to those who are now clinging to part of same Beard, , pp.
Of course, due to the quandary created by the fallacy-of-composition issue McEachern, , p. Say, saw the macroeconomy as Smith had seen it, namely, as a network of production and trade within which money was useful only as an exchange instrument; that is, since it was universally accepted, it enabled the acquisition of goods and services without barter. Money was not contemplated as an anxiety ameliorant. So unwanted inventory accumulations in Say result only from an inability or unwillingness of the profit system—due primarily to governmental malpractice of some sort—to induce labor and capital to shift from areas of surplus to areas of relative scarcity.
The possibility that aggregate demand could decline, ex post, due to a change in plans not originating in a public-policy failure was never considered by Say. Yet to his credit he assumed, contrary to the rest of the classicals, that relatively frictionless ex-post amendatory reactions by firms to their ex ante mistakes in forecasting demand should be the presumptive norm, thereby precluding the attribution of recession to some type of purely market-based rigidity that supposedly suppresses, necessarily on a grand scale, the reallocations of capital and labor from overstocked sectors to ultra-high demand yet relatively undeserved areas, shifts that are needed to minimize the accumulation of unwanted inventories in the former and shortages in the latter.
As a comparative foil to the reasoning put forth by Boettke and Sautet, it is worthwhile to note that, for those whose livelihoods are earned as federal legislators, the fear of bankruptcy is highly mitigated by their heavy investment in financially-invulnerable political capital instead of business capital.
This fact, when combined with the very high reelection rate of Congressional incumbents, creates a moral hazard on Capitol Hill that inhibits even the concession of errors, much less their correction.
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Harmful public policies, therefore, are difficult to modify. Hence the quest by firms to expand their horizons is ceaseless; moreover, it shifts into high gear whenever a disconcerting. It is impossible to have a perfectly seamless adjustment to ex post conditions that have diverged substantially from ex ante expectations, because capital is not homogeneous. Since much of capital is customized, i.
This is the soft-putty vs. See the evidence in Machovec, , pp. Since the classicals originated the concept of creative destruction, they certainly understood that capitalism generates perpetual apprehensiveness, precisely because its dynamics are inherently disruptive.
And not only intellectuals. Fortunately, men and women have displayed amazing resilience and flexibility in remaking themselves career-wise, and in finding ingenious ways to retrofit their capital and thereby extend its ability to serve human wants.
This state of affairs, however, does not merit labeling a market economy as unacceptably deficient. Too often, added Hume, we unjustifiably flagellate ourselves by measuring our performance against a humanly-unattainable exemplar Hume, , pp.
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Yet dismal, exceptional cases do materialize, and some have been extensive enough to have had deleterious macroeconomic consequences. Most recently, for example, the United States was faced for several years with a massive glut of malinvested residential-housing capital that had been diverted, for politically-expedient motives, from other, more socially-salutary alternatives, by State incentives during the subprime mortgage experiment of — Sowell, , pp.
These vacant homes and empty condominium units had virtually no other uses, especially in cities with zoning laws.
But if no one intends to throw their future earnings into the ocean, then, argued Mill in support of Say , the aggregate demand for consumer goods and capital goods—a demand that was planned in year t-1 for year t— cannot be less than the target aggregate supply, the source for providing demanders with their desired incomes, the production of which was organized in year t-1 for execution in year t.
But something untoward might happen in the meantime to make many people unwilling, for an extended period, either to purchase and invest at the same level as previously intended, or, in the case of banks, unwilling to relend, to the same degree, the savings that have been lent to them by their depositors, savings which, in anxious times, are likely to be rising.
In such a case, said Mill , p.
When hoarding arises, wrote Marshall in , it ushers in a contagion that spells macroeconomic hell:. In any event, even if Keynes had interpreted the classicals correctly, he would have objected to the adjective occasional, replacing it, at a minimum, with regular, and more likely with the adjectival phrase nearly perennial. Although Marshall incorporated the classical understanding of the antisocial consequences of a rise in hoarding, he did not speculate as to how to solve the who-goes-first problem of speeding up the restarting of production, and hence of beginning the restoration of aggregate demand by resuming the payrolls of the laid-off workers who are rehired during the initial, kick-off round of recovery—the signaling and multiplier effects from which presumably will inject a dose of anti-pessimism serum that will encourage other firms to do likewise.
Tackling this issue fell to his illustrious student, whose novel recipe of State pump-priming served to energize the adjective that is housed within the term political economy.