Pretending or Maintaining Ignorance
One key reason that risky social policy experiments are attempted is due to an “appeal to ignorance.”
The con artist who comes up with a given self-serving social policy then claims that we must accept the new social policy because you cannot tell if it works until you try it. An example is “healthcare-for-all” where the lawmaker then controls the health insurance markets (or they end up controlling him).
The famous quip by a notable politician (paraphrased) …
“You have to pass the bill, before you can find out what is in the bill”
… gets right at the heart of this matter.
Postivism = “anything goes”
The error is called Positivism, and it means that, whatever you write down as a law could work as good as anything else could, if you enforce it hard enough. It is fuel for the aphorism of “giving people democracy, good and hard.”
But in lawmaking, positivism doesn’t just claim that “the pen is mightier than the sword,” it claims that the pen is mightier than reality. It is, truly, “unhinged law.”
Recently, we’ve gone through social policy experiments completely unhinged from reality, and the officials all relied on the appeal to ignorance and said we must comply, to see if it works out.
But proper theory tells you what works even before you try it out. Proper theory also tells you what is bound to fail after being tried out. But the problem with having a proper theory is that power-lusters don’t like it — because they can no longer appeal to ignorance while concocting their social policy schemes.
Austrian Business Cycle Theory
Before the Great Depression, F.A. Hayek correctly “called it” (explained business cycles and depressions) with an essay called Monetary Theory and the Trade Cycle. But, because the theory doesn’t allow for big and expensive social policy experiments, it was largely ignored.
J.M. Keynes created a theory that put government money to use, and it was heralded.
But only Hayek’s theory is the correct one. Hayek’s theory is even misunderstood by top economists, such as Tyler Cowen, who recently spoke about Hayek on Macro Musings, with David Beckworth.
If disciplined professionals like Tyler Cowen cannot even get it right, then we’ve got problems. Mr. Cowen incorrectly says that Hayek’s theory can’t explain simultaneous growth in consumption and investment. Let’s check that …
If the base of the orange triangle represents stages of production, and the height of the right side represents the total of “current-period” consumer spending, you can ask what happens if people save more. The increased supply of savings drops the price of loaned money (the interest rate; depicted by the slope of the hypotenuse).
It makes producers confident that they can invest more into a longer process of production that is aimed at greater “future-period” consumption, even if “current-day” consumption is down (because people saved more).
The consumers had the same idea when they saved more: That they are merely postponing consumption so that they can consume even more, later on.
Because producers and consumers have the same inter-temporal preference, no recession occurs, and some consumption is just “pushed” into the future more than it had been before consumers ramped up their savings.
The blue part at bottom left only came into existence when the price of loaned money fell, and it is a restructuring of capital. Because producers believe that people started saving more, that means that they believe that those consumers, in the future, will be rich — and able to buy the extra product produced by the longer production process.
Easy Money
But what if an injection of easy money, not savings, is what it is that dropped the interest rate on loans?:
Addendum: the blue triangle at bottom-left refers to the crooked green shape.
Notice how the production process lengthens regardless of the cause of lower interest rates, but that, under easy money, consumers and producers have opposite time preferences (consumers will even spend more than usual if money is too easy to get).
By the time that producers get to that last stage of the new and longer production period, consumers have spent all their cash, and cannot financially support those final stages of production with their consumption habits.
Producers then frantically try to borrow in a frenzy, but because savings never increased in the first place, that frenzy just raises interest rates and causes a recession.
But notice how it is that, in this second chart, both investment and consumption go up — contrary to what Tyler Cowen claimed. Also, if there is any slack in the system (any idle resources; anywhere), then Hayek’s theory is perfectly compatible with simultaneous increases in both consumption and investment.
Stock Market Crash of 1929
The Crash of 1929 is not entirely explained by “money injections” as it is by hopes of unearned advantage that led people to buy stocks on margin — where you borrow up to 90% of the stock price, paying 10 cents on the dollar, because everybody and their brother is under the illusion that stock prices cannot stop rising.
More “peer-to-peer” lending occurs when everyone has high-hopes to make gain.
People were lured into believing that they could extract unearned advantage, mostly through Public Utility Holding Companies whose holdings (the public utilities, themselves) had government-protected monopoly status. This means that Hayek’s triangle got more wide than would be commensurate with the consumption change.
This effect, where production got lengthened more than consumption got dropped, leading to inter-temporal mis-allocation of resources, can be seen in a graph of the difference of the index of producers’ goods versus the index of consumption of non-durable goods:
The difference of (producers’ goods index) - (consumer transient goods index) went from -8.2 in Nov 1927 to +6.9 in May 1929, indicating that production and consumption had decoupled. Just look at how much of the capital structure that had to be liquidated/repurposed by 1933 (the index difference exceeded -40).
Austrian Business Cycle Theory is the correct economic theory, but it doesn’t lend itself to social policy experimentation so — as if punished for its success in showing us all the best way forward — it is largely ignored.
Further Reading
Hayekian Trade Cycle Theory: A Reappraisal. 1986. ( link )
Hayekian Triangles and Beyond. 1994. ( link )
Hayek on the Business Cycle. 2008. ( link )
The Relevance of Hayek’s Triangle Today. 2018. ( link )
My own theory is that increased monetary velocity drives inflation, which sends a subtle signal to consumers that they must raise themselves up the ownership ladder before their lagging income makes it impossible to do so. Because the signal is subtle and generalized, purchases are not targeted to accurately beat the inflationary trend and a habit of promiscuous buying at interest ensues.
I don't think we can understand economic trends without a reasonable grasp of the psychological mechanisms that shape choice architecture. The above is one pattern, and a broader one than may initially be obvious.