vol. 11, no. 3 (January), 1998, pp. 48-51
Comment on J. W. Watson and Ida Walters
"The New Economics and the Death of Central Banking"
Liberty vol. 10, no. 6 (July), 1997
"Business Cycles Aren't What They Used to Be—and
Never Were." This article, penned by Gerald Sirkin a quarter of a century
ago (Lloyd's Bank Review, April 1972), recognizes the uniqueness
of each cyclical episode and the evolving ability of market participants
to learn and to cope. Sirkin, an unsung precursor of the now-fashionable
new classicism, draws conclusions similar to—though less sweeping than—those
drawn by Watson and Walters in their "New Economics and the Death Central
Banking" (Liberty, July, 1997). According to Sirkin, "It is time
for major re-examination and rewriting of business-cycle analysis.... The
eventual benefits will include redirecting our attention from the minor
problem of government as a stabilizer to the major problem of government
as a destabilizer, and the saving of the effort now expended on the hunt
for the lost business cycle."
Here the famous dictum of Lincoln holds true: You can't fool all the people all the time. Eventually, the masses come to understand the schemes of their rulers. Then the cleverly concocted plans of inflation collapse.... [I]nflationism is not a monetary policy that can be considered as an alternative to a sound money policy. It is at best a temporary makeshift. The main problem of an inflationary policy is how to stop it before the masses have seen through their rulers' artifices. It is a display of considerable naiveté to recommend openly a monetary system that can work only if its essential features are ignored by the public (from the epilogue to the 1953 edition of The Theory of Money and Credit).Lincoln, however, did not deter Mises from publishing the second and third editions of Human Action (1956 and 1966), complete with a full exposition of the Austrian theory of the business cycle. And Lucas, as interpreted by Watson and Walters, does not cause the Austrians to recant that theory today. The new classical conclusion that to anticipate monetary policy is to neutralize it must be rejected.
Central to Lucas's new classicism is the proposition that real variables, such as output and employment, are invariant with respect to nominal magnitudes, such as the money supply. With due allowances for nontrivial short-run variations, the idea was an integral part of old classicism as well. One of the more rhetorically effective recognitions of this "invariance proposition" takes the form of the parable of the cuckoo bird, as related in a letter from Nassau Senior to Lord Melbourne in 1852:
It is the old story of the children who made a wall across the valley to keep the cuckoo in. They raised the wall just over the level of the bird's usual flight, and when they found that [the cuckoo] just skimmed over the top, they thought that if they had laid only another row of stones it would have been kept in.Although Senior's immediate concern was about poor-relief legislation, his story applies equally well to monetary policy—where the nominal height of the wall is analogous to the nominal supply of money. The message is clear: People—even Cuckoos—can adapt to a changed environment. And what Senior lacked in rigor, he made up for in color.
While Lucas did claim the Nobel prize for his rational-expectations theorizing in the areas of money and business cycles, he can hardly claim that the fundamental insight was at all new. In fact, the newness consisted largely in the extremes to which Lucas and others were willing to push this old idea. In the limit (actually, beyond the limit), if expectations are sufficiently rational, then the central bank has no power—except the power to create chaos. Resources will be allocated during periods of monetary disturbances in the same way as during other periods. Distorted prices, wages, and interest rates will be de-distorted on the basis of the "information" that market participants allegedly have. Indeed, if market participants could be shown to actually have this requisite information, Lucas's brand of economics would constitute a "quantum advance."
Lucas and even Watson and Walters hedge their assumption about information with the terms "available information" and even "readily available information." But hedged or unhedged, the "invariance proposition" (monetary policy has no real effects) is either trivially true or demonstrably false. If market participants already have all the information that earlier writers (Smith, Mises, Hayek) thought was conveyed to them by the price system, then the powerlessness of the central bank follows trivially from the irrelevance (regarding information) of the price system. If, however, market participants are dependent to some extent on prices for their information, then distorted prices will convey misinformation, and the misinformation will result in misallocations. The period of (unperceived) misallocations is the boom; the eventual discovery of the misallocations precipitates the bust; and the subsequent reallocations constitute the recovery.
Any substantive claim about just how the economy works and just how policy might actually affect it must drive from our understanding of just what information is "available" to market participants. Lucas and his co-researchers have failed roundly in this regard. Rather than "trashing" or "gutting" or "utterly demolishing" all other business cycle theories, as Watson and Walters incautiously claim, the rational-expectations theorists are wholly dependent on insights from these other theories to keep their own theorizing from degenerating into arid mathematical exercises. Lucas's monetary misperception theory of the business cycle is based on a purely stipulative distinction between local information and global information. Local means "available immediately"; global means "available but only with a lag." If the "lagged information" remains unidentified with anything in the actual economy, then the theory cannot be applied; if the "lagged information" is identified with money-supply figures, then the application of the theory is empirically unsuccessful. In fact, it was the unexplained persistence of the real consequences of monetary stimulation (beyond the time that the relevant money-supply data were readily available) that caused this monetary misperception theory to give way to so-called real business cycle theory.
While Lucas respectfully acknowledges Hayek's writings on the price system as a communications network, he overlooks his critical distinction between "two kinds of knowledge"—the kind that is communicated by prices and hence is "available to market participants" and the kind that isn't. The "particular circumstances of time and place," known first-hand by one or a few market participants, is communicated to others through price signals. This entrepreneurial knowledge stands in contrast to theoretical knowledge, or knowledge about the structure of the economy. The price system itself does not tell market participants which theory (say, Austrianism, monetarism, or new classicism) is the correct theory. Watson and Walters' self-assured assessment notwithstanding, it does not tell even economists which theory is correct—hence the ongoing debates among proponents of the different schools of thought.
Market participants are ill-equipped, then, to compensate for policy-induced distortions in prices, wages, and interest rates. And if different market participants are attempting to compensate on the basis of the theory that each one believes to be correct, the collective effect of their compensatory actions could hardly be expected to nullify the policy-induced distortions. It is true, of course, that the more activist the monetary authority, the more worthwhile it is for at least some market participants to try to learn something about monetary theory. But different ones will learn different things. The marginal increase in theoretical knowledge possessed by entrepreneurs helps to make each cyclical episode different from the one before. In no case, however, will the level of knowledge be so complete as to preclude the possibility of further cyclical variation.
For some time now, new classicism has sustained itself on the basis of its "rhetoric of rationality." Dissenters are seemingly put in a position of arguing that market participants are irrational or, at least, a-rational. Bolstering this rhetoric is the notion that "being fooled," say, by a distorted rate of interest implies "being a fool." Lucas is portrayed as standing up for the common market participant and proclaiming him rational and no fool. But even a rational market participant can be fooled—as the full statement of Lincoln's dictum recognizes. Mises recognized it; Hayek recognized it; and Friedman recognized it. "The End of Central Banking" is nowhere in sight. Our politically attuned Federal Reserve will continue to exploit this power to fool into the foreseeable future. It would not be rational for Alan Greenspan to abdicate on the basis of new classical musings. To believe he might or to believe that new classicism might otherwise neutralize the central bank is truly to be a fool.
Roger W. Garrison