A Heisenberg-ish Pricing Uncertainty Theorem

Krugman pokes fun at Rand Paul endorsing Milton Friedman for FED chairman, since Friedman is neither alive nor an Austrian, though many conservatives don’t realize that. Then he rips into those who believe Hayek wasn’t a liquidationist:

I have, incidentally, seen attempts to claim that nobody believed this, or at any rate that Hayek never believed this, and that characterizing Hayek as a liquidationist is some kind of liberal libel. This is really a case of who are you gonna believe, me or your lying eyes. Let’s go to the text (pdf), p. 275:

And, if we pass from the moment of actual crisis to the situation in the following depression, it is still more difficult to see what lasting good effects can come from credit expansion. The thing which is needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production to the proportion between the demand for consumers’ goods and the demand for producers’ goods as determined by voluntary saving and spending. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes. (10) And so, at the end of our analysis, we arrive at results which only confirm the old truth that we may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come.

If that’s not liquidationism, I’ll eat my structure of production.

What Hayek is saying here assumes an economy that is not tightly interconnected. The problem is that (now) all economies are tightly interconnected.

An example where Hayek would be right would be something like a village that “invested” in building a giant temple, thinking that it would please their god and bring better harvests. But then the village realizes that while they were building the temple, no one was farming or doing much of anything else. In Hayek’s framework, they overinvested and underconsumed – and the solution is to get back to normal. But winter has just arrived, they have no crops, and a “Depression” is about to set in – most of them are going to die as a result. If they had been using beads as currency, an air drop of beads wouldn’t help them one bit – what they need is the outputs of production (crops) not “money”. And if a few people had some bags of rice stored up, an air drop of beads still wouldn’t help because it would just raise the price of the rice to match the demand. Again, the solution is to get the investment in farming back to where it needed to be in the first place – and that’s what Hayek is saying about depressions in our modern economy, too.

The problem with this thinking is that no one knows that the right price of anything is. We pay whatever price the buyer and seller find mutually tolerable, but there is always a range of prices that are mutually tolerable – and that range is highly dependent on an infinite number of other circumstances – well, that is, our perception of circumstances. In the case of many recessions and depressions, the cause is not objectively foreseen mal-investment – but rather “wise” investment that turns out to be “wrong” – like buying a house when all expectations are that the house will simply go up in value. But the mal-investment caused the price of the investment to rise, and when the price of an inflated good is finally realized to be inflated, it deflates. Importantly, this rise and fall is not separate from the “wise” and “wrong” judgements – they are one and the same thing. There’s no such thing as a mal-investment, except in hindsight – after it has fallen in price. Sure, you can make some predictions about something that will be a mal-investment, in advance – like, say, digging a million 6-foot holes in Death Valley. There is a very good chance that all that effort will yield no profit – only costs. But in every case there is still a chance that it will turn out to be a profitable venture – such as if you find a gold in those holes, or maybe an ancient meteor comprised primarily of diamond. Is that impossible? Not at all. Likely? Not in the least.

Thus, the view of Hayek, Austrians, Classical economists, etc, that economies recover “best” when left alone is wrong – and it really all comes down to the nature of price – and our ability to know a good price from a bad price. These philosophies all suppose that prices can be known, perhaps within tolerable ranges – and they believe that these known prices need to be “signaled” through the economy accurately – and as long as that happens efficiently, without distortion, economies will operate smoothly. Some go so far as to say that the boom-bust cycle is caused by the price distortions introduced by things like governments – and that a fully limited government that, say, merely fended off invaders and ran courts to enforce contracts (and that’s about it) would result in an economy that rendered everyone wealthy – at least, everyone willing to work. (You may laugh, but this really is what many Ron Paul supporters believe!)

And the core problem with their ideology is that prices are not known – and depression conditions are caused by (temporarily) increased uncertainty in prices (like a house that “goes down” in price 30% but regains that in 5-30 years). We all think we know why this or that costs however many dollars. The truth is that there is uncertainty at every stage of production, and that uncertainty builds with each stage. And in the end, every stage of production is beset with uncertainties so large and destructive and unpredictable (a hurricane can destroy the farms/refineries, or the trucks carrying the goods, or the consumers to buy them) that all prices are just a guess. The price of milk stays more or less consistent from day to day not because all the costs are known but because we don’t yet know what other risk factors (or realities) should be priced in. All we’re really doing is looking at the historical price and asking whether it should move up or down. Unfortunately, a bunch of people have fooled themselves into thinking that “past results” can be used to infer present-day (or future) prices accurately.

Another way of seeing how we set current prices is by “social convention.” Milk is $3 today because we all agree that’s about what it costs these days – ie, the “right price” is what we all agree it to be. Some will say that this is all wrong – that the “right price” is whatever price proves to be sustainable over time. But over what time period? Under what conditions? And under what supplier conditions? For instance, milk produced by a farmer with a high level of debt must be priced higher than a farmer with a low level of debt. Milk produced by a farmer whose government stole the land from natives will be cheaper than milk produced on land that was fairly acquired. Milk will be cheaper if no deadly germ mutations pop up, and no cattle-feed supply disruptions occur (from all causes – even random/weather causes). All of these kinds of factors can effect every stage of the supply chain, too – a grocer with more debt must sell the milk at a higher price. And then you have to start factoring negotiating strategies – how does a grocer know if the farmer is simply claiming his price is higher? How does a farmer know a grocer is being honest when the grocer says he can’t buy the milk if the farmer charges more than $2?

Again, the point is that price signals can only be as useful as Austrians need them to be in a world full of omniscient, honest, completely unselfish people. And we don’t live in that world.

(This is also why Austrians think Fiat Money is a bad thing. When it comes to our modern currency, they admit that the only thing giving it value is the faith of other people. They believe gold is different – that gold has value that stands outside people, and so gold is real money, while paper treasury notes are not. This is because they think that gold has a real, knowable price. The latest burst bubble in gold prices hasn’t been enough to make them question that assumption.)

(Food for thought: prices are a lot more like quantum mechanical particles – that is, probability waves – who take on a particular value [ie position] – only when forced to by an interaction. For prices, that’s a buy-sell transaction. For particles, that’s an interaction with some other particle.)


About stormculture

In pursuit of reality.
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