Are natural disasters economic disasters ?

Prof. Quiggin coincidentally we here in Chicago are regaled with the wondrous effects of terrible natural disasters.

I offer you a (dis)taste ….
http://www.chicagotribune.com/news/opinion/commentary/ct-chicago-katrina-financial-disaster-landrieu-new-orleans-mcqueary-emanuel-pers-20150813-column.html

”
Envy isn’t a rational response to the upcoming 10-year anniversary of Hurricane Katrina.

But with Aug. 29 fast approaching and New Orleans Mayor Mitch Landrieu making media rounds, including at the Tribune Editorial Board, I find myself wishing for a storm in Chicago — an unpredictable, haughty, devastating swirl of fury. A dramatic levee break. Geysers bursting through manhole covers. A sleeping city, forced onto the rooftops.

That’s what it took to hit the reset button in New Orleans. Chaos. Tragedy. Heartbreak.”
—- Kristen McQueary, Chicago Tribune

I wonder where stock-flow considerations come into this. Suppose the disaster knocks out significant productive capacity for a period of time, 6 months to a year. Then the flow of production that would have come from those assets is lost forever, unless we have in mind some subsequent period where some attempted catch-up takes place — which is unlikely to be achieved given capacity constraints even when the assets are back fully up and running. So even full restoration of the assets doesn’t capture all of the disaster costs. The usual approach to disaster costs is not great at capturing spillovers either, positive or negative. Katrina moved a lot of people to other parts of the south and southeast for substantial periods of time, and some areas did a better job of coping the displacement costs than others. But not counted in standard “costs of Katrina.”

TLDR: The economic loss doesn’t just arise from the cost of restoring the world’s capital stock, it also arises from the world’s capital stock being temporarily reduced.

That would be true if they had nothing else to do.

Which never happens, of course, because in a well-managed economy people aren’t left idle for want of will to enable them to do the tasks they could do.

I would add two points.

First, while one can understand the framing of the question in light of the ‘broken windows’ debate, I suggest that an ‘economic disaster’ should be narrowly defined as a disaster of economic systems as opposed to other kinds of disasters and shocks; to make the term useful. A natural disaster can be itself, in a separate category. The outcome of acts of war and civil violence can also be themselves; and depreciation. No need to confuse them all. An economic disaster should be a market failure that comes on suddenly and destroys value in a lasting way.

Meanwhile, the question of ‘when markets are working well’ is a huge one and sounds similar to ‘when political systems are working well’ – Kant’s quote that names the blog should be enough to sort out whether this is the common or uncommon condition. I am not a fan of government make-work, or destruction as a whole, but natural disasters, like the change of seasons, are part of the common condition of mankind. Blunting their impact and restoring afterwards should not be considered exception labor.

As for the positive impact of natural disasters, they can break stagnation and remove people from local maxima to seek new maxima. I’ll leave it at that, though there is definitely room to elaborate.

This is fine in the abstract, but there are a number of unexplored factors here:

1. Accidents happen, on all scales. They are part of life. So what’s the baseline? A flood as a routine, if annoying, part of life is different from a flood out of nowhere. A certain number of windows will be broken, and a certain capacity devoted to replacing them. That capacity will have some margin for fluctuations. So one extra is business as usual, two is no problem, ten is a nuisance, and so on up.

2. Following – opportunity cost is therefore never precisely calculable, and often may not be calculable at all.

3. Ditto for “cost of restoring assets to their pre-disaster condition”. Never possible. If my 1960’s built home is destroyed, I cannot buy another 1960s home. They don’t make them any more. Nor cathedrals, large red brick factories, seaside piers…..So the cost is, again, not calculable.

4. Insurance is about money, damage about real resources. To see this, think about scales: how would one insure, say, a disaster that destroyed the US? One could not. If the insurance money buys actual resources without strain, then those resources were idle beforehand. If there is strain (price rises, rationing, delays) then there is diversion of current capability.

So what does this abstract demonstration do for us?

Insurance was a big issue in the floods of 2011. These were 1 in 100 year floods and caused a great deal of damage. There was a great deal of controversy over insurance as some insurance policies didn’t include the flooding.

In my state insurance premiums in 2012 increased by 300-600% because after these floods many insurers mandated flood cover. This was because when people were flooded who didn’t have flood cover they complained and it was a great controversy that they were not covered for floods as the devil was in the details of the small print in their insurance.

A problem for insurers here is that fires and floods will increase with climate change.

Fires are actually important for a lot of plants to grow in the bush, and they clear out undergrowth that’s gotten too thick. The problem is the severity of the fires. The best way to reduce the severity of fires is to return to a more contemporary version of Indigenous fire management with controlled burning. There is evidence that many thousands of years ago before Indigenous fire management was practiced the Australian bush would have big uncontrolled high intensity fires; when Indigenous fire management was introduced Australia had fires which were smaller more contained and of lower intensity and the people made some pleasant grasslands by burning the trees and also used the fires to make plants like the yam daisy grow plentifully; but now with European settlement we have gone back to the big uncontrolled high intensity fires as there is no program of fire management and the government doesn’t budget enough money and resources and the department has no clear strategy and just burns the same 5-10% of land over and over.

With floods they are necessary for the health of waterways, as flooding clears out silt and branches and other things. More water sensitive urban design can help manage floods in built up areas to avoid damage to property and infrastructure.

There is probably some good reason for earthquakes too, for the health of the plate system or something or other, maybe to keep everything round.

The analysis is internally correct, but incomplete, as BenK hints. It leaves out the role of network effects and path dependence. A region could have evolved to a suboptimal economic state that is very expensive to escape.

Consider, for example, the wealthy suburbs of Washington, DC. They were built with cars in mind, and they’re now choked up and can’t accommodate their own population. Everybody knows this now and regrets this; nobody knew it in the 1970’s when it happened. And there is no way out of it. Denser development will only choke matters worse without greatly improved public transportation. Greatly improved public transportation is a waste of money in a car-centric area. These suburbs are locked in a suboptimal but very metastable state.

Let’s pretend that a hurricane hits Montgomery County and destroys all the physical infrastructure but not the jobs that generate the wealth. You now have a chance to rebuild from the ground floor up–and the resources to do so.

Which just goes to show that only oversimplified models can illustrate an economic principle. The real world is always more complex than the model.

Ebeneezer
“Let’s pretend that a hurricane hits Montgomery County and destroys all the physical infrastructure but not the jobs that generate the wealth. You now have a chance to rebuild from the ground floor up–and the resources to do so. ”

While this is true in theory, in practice it doesn’t work anything like that. Insurance money is allocated to rebuild what was destroyed, not what is wished for. There isn’t $50B made available in a lump sum, its thousands on individual distributions made to thousands of individuals and businesses – there’s no effective way to corral all of this money in to meaningful redevelopment in the manner you suggest – it might be nice, but in practice there isn’t any instance of this ever occurring on a widespread basis.

Even following Katrina, in which we know with 100% certainty there were home and businesses build below flood plan and destroyed, there were only a handful of areas that weren’t rebuilt more or less exactly the way they had been.

Perhaps an exceptionally strong government that could mandate building codes by fiat could pull off the renaissance you describe (and I’m not disputing it would be a good thing – I’ve been to montgomery county) – but as a practical matter its essentially impossible.

Trader Joe @ 17:
Quite so. I was trying to show that John Quiggen’s hypothesis contains more than his model; you are showing that mine does, too. Agreed.
What you say about NO after Katrina makes me smile. Tokyo had two chances for rational design from the ground floor up: the 1923 earthquake and the 1944-45 bombings. It took advantage of neither one, and a street map of Tokyo still looks like the intestines of a whale. (The subway system is great, but I don’t know when it was built.) OTOH, Japan and Germany both did a nice job replacing their capital stock with better capital stock after WWII.

Ben K,

“If fires are important for the plants, that essentially indicates that some plants have adapted to them and would not be as quick to adapt to their absence.”

For instance the Lodgepole Pinetree. Its pinecones often need high temperatures to open and release seeds, thus taking advantage of the cleared undergrowth and newly opened area.

Ebenezer Scrooge

“Consider, for example, the wealthy suburbs of Washington, DC. They were built with cars in mind, and they’re now choked up and can’t accommodate their own population. Everybody knows this now and regrets this; nobody knew it in the 1970’s when it happened. ”

Nobody in the 70’s? Like during the Carter “Put a Sweater on, Solar Panels on the White House” Presidency? Those 70’s? During those years, in California at least, lessons in sustainability and human impacts to communities and surrounding rural and undeveloped areas were part of the curriculum. Part of the problem is that other communities considered sustainability and eco-freindly policies to lead to Communism.

And that nobody could have predicted it, is very much of the ‘Nobody could have predicted’ meme that the Bush administration pushed post-9/11. The DFH’s managed to do so. Erasing that does not help.

The equilibrium assumptions are wrong. Suppose the destroyed input is a complementary good, like electricity (the generating station is destroyed). The electricity is priced at the intersection of marginal cost and marginal demand (or some regulated price based on average cost). However, the output lost — the opportunity cost — is much greater. For example, assume electricity priced at $100 (present value) is essential to produce output of $1,000 (present value) over the expected life of the generation station because without electricity the other factors of production are unusable although not destroyed. You can’t be saying that the entire $1,000 of expected output (the opportunity cost lost by the destruction of the generating station) would have been earned by the power company and nothing would have gone to the other factors of production. And thus the price of the inputs needed to rebuild the generating station (assuming competitive equilibrium) cannot equal the full discounted value of the opportunity cost. The fraction of the new output that will go to the power company as opposed to the owners of the other factors of production will depend on pricing for electricity (ideally the intersection of marginal cost and marginal revenue or regulatory average cost pricing), and the elasticity of supply for other factors of production.

.

“…coincidentally we here in Chicago are regaled with the wondrous effects of terrible natural disasters.”

Mrs. O’Leary’s cow just called. She wants to cancel her subscription to the Chicago Tribune.

“if the damage bill measures the cost of restoring assets to their pre-disaster condition, it is also equal to the opportunity cost of the disaster, namely the goods and services that would otherwise have been produced.”

In terms of valuation my reading is if you have insurance and are fully indemnified, the insurer will put you in the position you were before the disaster. The cost and therefore opportunity cost if that is the case must be zero. Otherwise, it must be the cost of restoration net of insurance.

However, if the opportunity cost of a choice is the value of the best alternative forgone. Since a disaster isn’t a choice, but just a random event that simply happens despite everyone not wanting it to, then you could say it has no opportunity cost. The concept just doesn’t apply.

On the other hand, if an action which was not taken could have mitigated damage from a disaster – for example a flood prevented by maintaining a levee. Then the disaster is a choice, and the net opportunity cost (or I suppose opportunity benefit) forgone is the cost of restoration less the minimum spend that could have avoided the destruction.

P O’Neill @ 3

This post, for those of us with an Irish connection and long memories, might bring to mind that time Richard Tol told the devastated citizens of Cork about how wonderful natural disaster was to generate economic activity (he actually trolled the public justified his argument by calling it Keynesianism).

Of course, this argument was all in pursuit of RTol’s peculiar take on climate change, but it provided some entertainment.

Ebenezer’s line of thought @15 can be extended. How does one cost Schumpeterian gales of creative destruction? Indeed, how can one tell a gale of creative destruction from a simple gale?

Sometimes I think big disasters trigger government spending that would otherwise simply not happen. I don’t think this spending should be seen as having an opportunity cost, because the spending would never have happened without the disaster, and would not be spent on anything else but what the disaster damaged; but this spending increases the total economy.

A good example from the disaster I am most recently familiar with (the tsunami in north east Japan) is the sea wall; this is not built with private resources, and once it’s built it never gets rebuilt until a tsunami destroys it. It is not productive, in the sense that the only time it “produces” anything is when it works to prevent loss. But the tsunami tore up the sea wall so it needs major reconstruction work. The government will spend money on this, money that it would otherwise never have devoted to construction of any kind. This isn’t a diversion of productive resources from somewhere else to repair a random wall, like some kind of keynesian hole-digging-and-filling thing. It’s an increase in the total economic activity of the area.

People in some parts of the north east of Japan speak of a reconstruction bubble precisely because of this extra government spending.

I agree with Salem at 4 that the lost production has to be counted.

Perhaps more controversially, by destroying obsolete capital equipment and requiring its replacement by new kit, it might be possible in some cases (in which there are big distortions in other markets, particularly for long-term financing) that a natural disaster or war could move an economy out of a local equilibrium onto a better long-term growth path. I’ve seen this occasionally advanced as an explanation for German industrial performance but it has always seemed desperately unconvincing to me.

I find myself interested in the reverse question though – “Are economic disasters like natural disasters?”. Something like the closure of the UK coal industry in the 1980s, while necessary and correct from more or less every economic point of view, had large adverse consequences not at all unlike those of a natural disaster or war, and I wonder if there’s some similarly easy way of estimating those.

“Whether or not it was an economic disaster (leaving aside the humanitarian consequences), both in the short and long term and generally regardless of scale, depends where you’re standing. (Admittedly this might not be an economic answer)”

This is a bit like the Lisbon Earthquake of 1755. The philosophical reaction was a good example of Hannah Arrendt’s idea that many people then did not understand the difference of an evil beyond vice and a goodness beyond virtue. This is as the philosopher’s said it couldn’t be due to God’s judgement, since the Alfama was not damaged so much (this is the steep hilly part with old houses in poor condition); but actually the Earthquake significantly affected Portugal’s colonialism and empire making, but the philosopher’s didn’t give Imperialism any thought in reaching their conclusion as they thought it wasn’t a vice so it didn’t count as evil.

So some number of people in other countries suffered less from Portuguese imperialism after the Lisbon earthquake.

This is not to say that I think the earthquake was God’s judgment on imperialism, for who knows the mind of God. But just to point out that the philosophers left imperialism completely out of their reasoning about whether the earthquake was God’s judgement or not.

faustus’ (33) comment about government spending which would otherwise not occur not having an opportunity cost is problematic. The idea that taxes don’t cost anyone anything… is just as bad as the idea that insurance somehow makes the world whole.

Ultimately the question is whether disasters destroy something that was bad to begin with but couldn’t for reason of apathy or special interests be destroyed, or whether they destroy something at least on the balance good. If good, then there is no gain from the disaster, no matter how much effort goes into restoration or how well insured.

As an aside, having lived in Montgomery County Maryland, it isn’t the first place I would slate for total destruction.

Consider: “Every change to the world that is part of a pareto-optimizing improvement should be allowed to occur, because even if there are losers after the exchange, there are other changes we could make that would ultimately leave everyone no-worse off than if we started (and some better off).”

That’s famously wrong as moral logic, even though a bit of superficial sense: the basic flaw/deception is to say “could” when we might be thinking about “would”. (But the compensating changes that would help any losers somehow might not actually happen; funny that.)

As a matter of logic – not the truth of falsity of the broad question – why should we blithely accept the same “could”/”would” substitution here? Instead, we should be alert and suspicious of a word choice which, in other contexts, has been shown to be dangerously fallacious.

And it matters: what you have actually proven (or not) undergoes huge change if you were to talk about “goods and services that _would_ otherwise be produced”. If your argument is so very sensitive to this choice (and I think it is) from where do we get confidence that it’s right choice?

“Code of Gilgamesh”? What the hell am I on about? Hammurabi ffs.

It is a sort of crazy millenarianism to suppose that if you raze something to the ground something better will come out of it. Like self-decapitation to cure a headache. In fact it is much easier to destroy than to rebuild. What good ever came out of the destruction of the library of Alexandria or the Parthenon, for example? Yet this is the kind of cargo-cult thinking behind some of the business and foreign policy decisions of today — under the rubric/slogan of “creative destruction”.

Maybe that’s what it originally meant.

It seems to me that disaster and reclamation is always negative-sum.

In most cases (in the modern industrial countries), though, the resources used for repair (especially labor) were not fully utilized before. In those cases, I think you get substantial redistribution from capital to labor–and in some cases, negative-sum redistribution from capital to labor is assumed to be welfare-enhancing.

I’m not certain where the assumption I’m missing is.

Agree with both John Q. and Meredith. I like Mantel but wish she were more aware, somehow, of the differences between 19th c. measurement and the classical kind. James Scott seems to make the same (as I see it) mistake, conflating the social control involved in statistics and big data with that involved in defining weights and measures and enforcing the keeping of accounts. Good sources on this are probably, still, I.B. Cohen and Theodore Porter.

dquared @35
I think you are on to something.

I have in the past made a little argument about how regulation, can end up reducing pollution and improving productivity without increasing cost.

Imagine a highly competitive industry in which new technology has been developed which at the cost of upfront investment will reduce pollution, improve productivity and via recycling and/or increased resource efficiency actually reduce operating costs.

But there is a first mover problem, because of the competitiveness of the industry. Nobody wants to be the first to try out the new technology, which may cost more than is apparent or have hidden pitfalls. Then of course there is the knowledge that if you are successful, others will follow and the benefits will quickly disappear as price falls follow. So nobody makes the jump unless regulation pushes them.

There may be cases where a disaster works in this fashion in overcoming a threshhold barrier. (To make this practical, think of a infrastructure investments becoming feasable when massive disasters clear a pathway that never could have been acchieved by political means in normal times. Perhaps JQ could think about Darwin – the city not the man – in this light.)

Maybe the habit of thinking at the margin, that normal economic method method favours, makes one a bit blind to a possible solution surface which is not always smooth and monoclinal.

@57 ZM Point taken.

Sebastian H. @50

“creative destruction” is actually almost the opposite idea. The idea is that the competitor is better enough than the original that it replaces it. The destruction comes AFTER the creation.

Yes, in fact the name was a poor choice of words. It should be called destructive creation which is more accurate. To make it concrete, you didn’t need to get rid of horses first in order to make space for cars.

How about breaking your hand, and then hoping that after the doctor fixes it you will be able to play the piano?

Trader Joe @17:

“Perhaps an exceptionally strong government that could mandate building codes by fiat could pull off the renaissance you describe (and I’m not disputing it would be a good thing – I’ve been to montgomery county) – but as a practical matter its essentially impossible.”

I don’t think this is so unusual, or at least it didn’t use to be. Until a century or so ago, large urban fires was a major disaster in Norwegian cities and towns, which had mostly wooden buildings. And after a fire, the government often mandated that the cities and towns should be rebuild with masonry and bricks, the so-called “murtvang”. They had building codes in the Roman Empire, and probably long before, it’s not a new invention.

I’m not aware of any such massive re-planning or re-zoning post a natural-disaster.

I presume that we are all aware that it may be necessary to massively re-plan the developed world, to avoid a collapse of civilization in anthropomorphic natural disasters. More than one commenters has argued the WWII American mobilization model as an approach to structuring this response to climate change. In a sense, this would be “pre” natural disaster, but would only happen, given human nature’s ambivalent response to leadership, in a fortuitous response to some dramatic natural disaster, universally interpreted as foreshadowing the greater catastrophe.

One of the false notions embedded by the likes of Hazlitt and Hayek and Friedman in “market economy” cant is the idea that market price is enough to coordinate the economy, that the only necessary adaptive response is local. This is prescribing for the economy the nervous system of a slime mold. Our petri dish is not expanding; this shouldn’t be so hard to understand, but the denial may hide not stupidity, so much as an impulse toward cannibalism.

“One of the false notions embedded by the likes of Hazlitt and Hayek and Friedman in “market economy” cant is the idea that market price is enough to coordinate the economy, that the only necessary adaptive response is local.”

For what it’s worth, Hayek did not claim that prices are the only thing necessary for coordinating the economy. He did in fact claim the opposite. Critical Review’s “Hayek, the good the bad and the ugly” has details — I might post some if I have the time.

This claim seems to have beed manufactured by J. Stiglitz –while absorbed in the process of blowing his own horn– and then repeated by economists who couldn’t be bothered to check.

@70 TM

Exactly.

There’s a very early Superman story in which, after seeing a poor community be rebuilt with government help after a natural disaster, our hero deliberately destroys another one to achieve that end. Like, just straight up busts everyone’s houses. I don’t remember if he evacuates them first.

I think it comes before the one in which, after overhearing a high school football coach plotting to secretly replace a player with an adult, Superman decides the best course of action would be to forcibly replace someone on the other team (drugging a guy who happens to resemble him, saying he’ll thank him later). Presumably this was meant to teach the coach a stronger lesson than would have been learned if, say, the coach’s scheme had become a Clark Kent scoop. (How Clark Kent discovers it, who knows.)

Basically, early Superman prioritized throwing his weight around, but always under the guise of do-goodery. I wonder if this notion that natural disasters make us better off are similarly a means of exercising our more perverse fantasies.

Michael Lewis, in his book “The Money Culture” (written1989?) hypothesizes the destruction of Tokyo by massive earthquake in 1993. In his story, the Japanese call in all their loans to pay for the rebuilding, and the US spirals into recession.

@John Q.

It’s a fair one sentence summary of Hayek on this issue to say that “Prices are an essential mechanism for the market’s tendency for coordination.” It would also be fair to say that for Hayek, prices greatly reduce the amount of information that the economic agents need to have to act intelligently in the market.

It’s not a fair summary to say that Hayek thought that prices are the only knowledge that agents need in order to reach that coordination. He says so explicitly in “Economics and Knowledge:”

“It has become customary among economists to stress only the need of knowledge of prices, apparently because – as a consequence of the confusions between objective and subjective data – the complete knowledge of the objective facts was taken for granted. In recent times even the knowledge of current prices has been taken so much for granted that the only connection in which the question of knowledge has been regarded as problematic has been the anticipation of future prices. But, as I have already indicated at the beginning, price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge as I see it. ”

For Hayek, the institutional framework (e.g. competition) is also crucial for both coordination and for spurring knowledge discovery — again, it’s not just prices that do the work.

The greater point here is that representing Hayek as claiming that “prices are sufficient statitstics” misses the Hayek that does not actually fit into the premature formalizations of current economic theory. There is no serious theory of disequilibrium available today, but disequilibrium is the best setting for Hayek’s ideas about the role of prices and competition in market coordination.

“The fact that Hayek presented his views in more and less nuanced forms is scarcely as sufficient basis for your original claim of a relatively recent fabrication by Stiglitz.”

Once you introduce nuance into “prices are the only thing necessary to reach coordination” you’ve basically rejected that claim. Nobody is denying that for Hayek prices are an extremely important element for market coordination.

What would be the role of trial-and-error –a market mechanism which Hayek considered extremely important –if everything you needed to know is reflected in prices?

The representation of Hayek as claiming that “prices are sufficient statistics” is a hack job. This is not going to be changed by relying on (some) abstracts and on superficial quote selection, while ignoring the wider context of Hayek’s work.

And again, the point is not salvaging some claims about Hayek’s lack of flaws. The point is that conceptual advances by Hayek, on issues like disequilibrium adjustment, where current economic theory has basically nothing to offer, are smothered by shallw interpretations of his work.

In The Use of Knowledge in Society, where Hayek is being intelligent and careful that a great many prices in industrial economies do not vary enough to carry the load of coordinating information he wants to attribute to them. He tries, rather feebly, to recover his position by waving his hands at the auxiliary conditions that attach to prices, but does not pursue that point at length — one suspects he doesn’t pursue it because he instinctively senses such elaboration would further undermine his argument. And, he also suggests without much elaboration that greater price flexibility, and therefore, variability would be a good thing (because it would allow price to carry the information load that otherwise must be managed by the horror of deliberate planning) — a policy imperative that has since become a centerpiece of neoliberalism.

In relation to neoclassical economics as an ideological myth, I think we are all familiar with where this went: Hayek was celebrated for the part he played in interpreting the “market” economy as a process of emergent self-organization arising from distributed competition — a genuine intellectual achievement — and the polar-opposition he proposed to distinguish capitalist market economies from socialist centrally planned economies became a centerpiece of cold-war propaganda, and, eventually, neoliberalism.

Shallow interpretation is part of the deal with the devil, which takes place, when your work is re-purposed as propaganda. My claim @ 67 about what Hayek contributed to ” ‘market’ economy cant” is an accurate summary of what he enthusiastically worked to achieve, in terms of propaganda.

Could mainstream economics benefit from engaging critically with Hayek the Scholar and Scientist? Could economics shed the heavy weight of neoliberalism? I don’t think these questions are so easily separated.

If a critical and intelligent person just reads the careful argument in The Use of Knowledge in Society, taking due note of the admissions Hayek makes, which I mentioned above, the takeaway would seem to be that “price” is most definitely not a sufficient statistic. That’s not what Hayek the Propagandist wants the reader to take away, mind. But, an interlocutor pursuing a more disinterested interest in the science of economics might well be led to interesting questions about the role of uncertainty.

Hayek recognizes that specialization implies exclusive local knowledge implies global ignorance. He proposes that price supplies the global deficit, conveying information in compact, digestible form from remote co-operators. From the text of The Use of Knowledge in Society alone, as I have said, I think it is pretty clear that Hayek realized that observable facts were against his hypothesis.

I have to struggle to restrain myself from my usual diatribe against the stupidity of neoclassical economics. Rejecting the hypothesis should have been the next step, if not by Hayek, then by his interlocutors in the academy — not singing paeans to capitalism. Rejecting the hypothesis isn’t the end of the research program; it is the path of a research program. Failing to reject the hypothesis when the facts are against the hypothesis is how economics has become a degenerative and sterile discipline. If a reasonable reader of Hayek accepts that the hypothesis of price as a sufficient statistic must be rejected, then the next step is to construct a better theoretical analysis, and derive better hypotheses, no?

I don’t mean to imply that no one has gone forward since 1947. Of course, a great deal of fine and penetrating work has been done. But, there’s a real sense in which the world is stuck with the economics of 1947, or otherwise Professor Quiggin wouldn’t be writing, Economics in Two Lessons, refuting a book of nonsense praising a market economy that did not exist then or now. I don’t think he would be framing his narrative around the idea that prices could be accurate signals of opportunity costs (allowing for externalities, which Hayek allowed for as well), if the rejection of Hayek’s hypothesis by observable facts had been thoroughly accepted and digested by the profession.

If economic theory cannot pick up Hayek’s genuine conceptual advances and run with them, to offer something where it seems to offer nothing, it is because it is stuck, not quite able to develop and apply an accurate and sophisticated functional analysis of price, knowledge and information in a money economy.

As JQ says, Hayek the Propagandist worked pretty hard in favor of this stuckness. Hayek and his allies in constructing propaganda touting a natural economy congenial to reactionary aims had plenty of help from Samuelson et alia, who were never quite willing to cannibalize their intellectual capital as good scientists must to get on.

If I express exasperation frequently on these threads, I honestly do not see what is holding anyone in economics back, at this late date, the Cold War over. Hayek’s hypothesis should have been rejected at the time and out-of-hand, as people looked around and saw a capitalist economy peopled by vast networked hierarchies engaged in detailed, engineering control of production processes, while merchandise was exchanged at stable, administered prices. There is not a lot of information in price, certainly not enough to do the kind of coordination Hayek imagined; what there is — and this should have been recognized universally — is a warranty. You’ve heard the dictum that the medium is the message? Well, the stability of price is the critical information conveyed in price: the manufacturer and merchant are distilling out a lot of variability, absorbing risk as well as noise, and the system of money and finance is facilitating that.

Hazlitt’s economic system on a knife-edge of opportunity cost such that a baker cannot buy a suit according to plan, because someone unexpectedly broke a window the night before is just crazy. No one in the world knows enough to be on such a precise knife-edge. The real-world is hedged about with insurance and slack. The baker will throw away some bread at the end of the day, because he regularly bakes too much, because the opportunity cost of losing an unanticipated sale, even occasionally, is greater than the certainty of regularly throwing away non purchased inventory. The baker will have insurance or reserves to pay for the window and will go ahead and buy the suit. The glazier will have enough capacity to respond to the emergency and replace the window without undue delay.

And, yes, the baker will bake according a recipe (rules!) and receive visits from the health inspector, who will require compliance with seemingly arbitrary requirements (regulation! more rules!). If the bakery is in the U.S., the baker will have to have refrigerators for his inventory of eggs; in Britain, perhaps not — because the two countries have differing schemes governing the production and distribution of eggs, schemes that emerged from conscious, deliberate design by technical experts, and not market iteration guided by price, and each achieves an acceptable level of efficiency and safety.

There was some truth in Hayek’s musings. The baker really did not need a central plan directive from government regarding how many doughnuts to bake on the second Tuesday in July. But, his vision was too narrow and claimed too much. The problem was to sort out where and when it was useful to “centralize”, to identify what supervision in hierarchy was good for, why business enterprise used hierarchy so extensively, and so on. Someone should notice the doughnut franchise and think a thought that maybe a market or two has been displaced? For a reason? The extravagant claims of neoliberalism for willy nilly deregulation are based in no small part on the self-enforced ignorance of economists, regarding the uses of knowledge in society in hierarchy and the deliberate construction of technical systems by regulation and entrepreneurial innovation, ignorance traceable in part to Hayek the Propagandist.

Anyway, that’s enough of a rant from me, today.

Bruce Wilder @81
There are at least two things within the profession which economists must do, both as individuals and collectively, in order for the ‘science’ of economics to progress.

There are problems with economics theory, and there are problems with its institution.

Each economist must be prepared to write off his intellectual errors of the past. Since these errors are entwined into current theory, this cost, this intellectual sunk cost, is enormous. In particular, he, or she, must surrender his emotional attachment to his theoretical ‘darlings.’ It takes great intellectual courage to do this.

Any economist who seeks to publish on this issue must expect to be opposed by the economic establishment, to the degree of his deviation from the accepted dogma. We notice this is more and more the case today, when the ‘tournament of advancement’ in economics, (and in general all tournaments in academia,) has become increasingly competitive. One consequence is that the ‘criteria for success’ have become increasingly narrowly defined, arcane, and difficult to achieve. In a field of intellectual competition, the tournament favors the development of increasingly difficult and increasingly technical theorems based on an essentially fixed set of assumptions, over the intellectual and socially risky activity of questioning those assumptions, or developing novel theory incorporating other assumptions. Indeed, an economist may feel the tournament is so demanding that he cannot spare the needed effort to examine those assumptions, or for any research activity other than those which efficiently promote his position in the tournament.

In parallel with this, the demands of the tournament lead to increasing isolation of the economist and the institution of academic economics, from both the actual economy, as ever more esoteric theory increasingly diverges from reality, and alternative and possibly corrective sources of information in that economy. The range of sources for inputs of both data, but also theory, declines.

Now many economists may be aware of, and may have been addressing these problems. However, because of the pressures of intellectual conformity, they may not have shared these efforts with others. Thus, none of them may be aware of other economists who may also have been doing this. So those economists who have been addressing these issues may each think that they are alone, and so reluctant to produce their results.

Economics must address its foundations. And it must open itself up.

Oh, yes. Since financial ‘assets’ are not consumed, as real assets are, conventional economists seem not overly concerned with the increasing depletion of the earth’s limited supply of real, natural resources. You have to go outside of academic economics departments to find many people giving much attention to that little problem. One place the interested reader might start is: http://phys.org/news/2015-08-humanity-nature.html

The pointer is from the comments from this post at Angry Bear: http://angrybearblog.com/2015/08/we-need-to-be-kind-to-be-cruel.html

49: “It is a sort of crazy millenarianism to suppose that if you raze something to the ground something better will come out of it.”

I just came across this:

Just the other day, Chicago Tribune Editorial Board Member Kristin McQueary wrote. “I find myself wishing for a storm in Chicago — an unpredictable, haughty, devastating swirl of fury. A dramatic levee break. Geysers bursting through manhole covers. A sleeping city, forced onto the rooftops. That’s what it took to hit the reset button in New Orleans. Chaos. Tragedy. Heartbreak.”

Disaster capitalism at its best.
http://michaelklonsky.blogspot.com/2015/08/mcquearys-disaster-capitalism-fantasy.html

greg @ 80, 84

Let me try to restate from my own knowledge and perspective what you are saying.

The system of distribution and production must motivate itself reflexively, no? Money and finance are clever mechanisms for loose coupling of system that must allow for people to coordinate their activities. Like any mechanism, it operates with frictional losses from the limitations of its design and the potentially catastrophic losses from malpractice in its administration.

Economics since before Adam Smith has distinguished the real from the monetary, promising to allow its practitioners to penetrate the maya of money, as if money is not a mechanism, but only a veil of illusions obscuring the real. The philosopher David Hume argued for a concept that has come to be known as the neutrality of money. The great Irving Fisher popularized the notion that inflation is the difference between changes in nominal values and changes in indexed “real” values.

Distinguishing the “real” from the “nominal” (aka monetary) in these conventional and facile ways obscures the extent to which money as a very real mechanism becomes the locus of social problems, which can be solved by political or technocratic tweaking of the mechanisms of money and finance. Promoting a better understanding of money in the economy, therefore, becomes a means of progressive change.

One respect in which money is real is that money makes demand effective. People, with or without money, may have needs and desires, but those needs and desires become motivating data in the economy only when they have money with which translate those needs and desires into effective demand on the system of production and distribution. Conversely, on the supply side so to speak, people may have ambition, talent, ideas for a better world and productive potential, but only where money is available to finance appropriate organization and sunk-cost investments, can they realize some of their potential in production of goods and services that earn them claims on the production of the whole economy. Outside the money economy, people are hopeless and helpless, and it is not always clear how people outside the money economy can get themselves in.

Money (payments, credit, finance) provides the mechanism by which the system of production and distribution is motivated in the most extensive sense. Money is the fluid and conduit by which income and risk are distributed to motivate production and distribution.

Somehow, I think the idea that money transmits risk is the part that’s hardest to hold onto thru a chain of economic reasoning and argument, but it is the critical part for understanding how money works in the economy, for good and ill. Risk is conceptually difficult to manipulate logically in formal reasoning and difficult to observe and measure in the world, but it is familiar to all and practically pervasive. Risk rules the economy.

The analysis of incentives in economics is all about the contingent distribution of risk. In preaching their religion, economists acting as civic priests, simplify this into the economics of virtue: rewarding the good proportionally for their good works. That is, of course, nothing but bull excretions. High theory, in the form of general equilibrium theory, posits that for an economic system coordinated by market price to work efficiently, distributed decision-makers would need to be fully insured, so that neither undue risk-aversion nor reckless risk-taking distorted their choices.

In the real world, as Rich Puchalsky observes, the rich and powerful may find it desirable (from their own perspective) to keep a large part of the world desperate, sub-dividing the desperate masses into a class of obedient servants, and using a second sub-class of the truly hopeless and helpless pour encourager les autres. This weakens the society as a whole and must entail some loss of effectiveness or efficiency. Economists, who delineate this dynamic clearly, may find fewer opportunities to secure tenure at institutions funded and controlled by the rich and powerful. Even leaving such cynicism aside, reasoning about risk or investigating risk empirically and objectively are very difficult intellectual problems, on which policy economics and macro-economics have run aground.

I’ve been struggling in my fumbling, bumbling way to come to my own terms with Professor Quiggin’s frame: accepting the idea that market price represents the economic system’s more or less accurate estimate of opportunity cost: where we acknowledge that price incorporates a dampening of noise and risk, a sufficient statistic to use Alex K’s term. It does seem to me that reactionaries, like Hazlitt, Hayek and Friedman, are hiding the pea, by selectively obscuring the implications of risk and how the economic system manages risk with money.

Hi Bruce. Thanks for your long and thoughtful response to my comments at 80 and 84. I’m going to eventually address the issues you raise of risk and John Quiggan’s original concern for opportunity cost in separate comments. Here I’m going to deal with the difference between the ‘monetary’ and the ‘real.’

You wrote: Bruce Wilder @ 89:

“……..
Distinguishing the “real” from the “nominal” (aka monetary) in these conventional and facile ways obscures the extent to which money as a very real mechanism becomes the locus of social problems, which can be solved by political or technocratic tweaking of the mechanisms of money and finance. Promoting a better understanding of money in the economy, therefore, becomes a means of progressive change.

Yes, money is a very real mechanism that has become the locus of social problems. But I think this fact has been obscured not by economics distinguishing between the real and the nominal/monetary, but by the failure of economics to distinguish between the real and the monetary. By mistakenly asserting that money, of itself, has value, is ‘real,’ money becomes an ‘asset.’

Now to an individual, money is an asset. To an individual, if you have more money, you have more assets. Money is ‘real.’ But you have more assets not because money has value for what it is, but because it can be exchanged for something else, a good or service, which has a real value. Money has value, to the individual, because it is a token of demand. The individual’s demand on the real goods and services produced by an economy is proportional to how much money he has. (Money can also be exchanged for what are actually just other varieties of money, like bonds, which serves to confuse the issue.)

But the quantity of money, of itself, makes no difference to an entire economy. A society’s demand on the real goods and services produced by its economy has nothing to do with how much money it has in circulation. A society’s demand on goods and services is just how much real goods and services that economy has and produces, no matter what the supply of money. If you increase its money supply, an economy is no richer. If you decrease its money supply, an economy is no poorer. It is a failure of composition. More money may make an individual richer. But it does not make an economy richer. When you add money to an economy, you’re not adding anything ‘real.’ This is the idea of the neutrality of money. Changes in the quantity of money only change the nominal variables in the economy. In fact, I think it can be argued that the neutrality of money is only possible if money has no intrinsic value, but only value as a token of demand. I’ll have to think about this. Anyway.

So if money is not an asset per se to an economy, of what use is money to that economy?

Money efficiently allocates demand throughout an economy. (Efficiently here should in no way be thought of as implying optimally. Indeed, since unrestrained, money tends to concentrate, and as can be shown tends to concentrate in the consuming sector rather than the producing sector, the resulting distribution of demand may be destructive to the economy. So here efficiently merely means rapidly and with low costs.) Money is a token of demand, which is exchanged for real goods and services in the economy. So the distribution of money in an economy is the distribution of (potential) demand in that economy. In an economy, the money flows in the opposite direction to the goods and services. So if you change the flows and distribution of money in an economy, you change the flows and distributions of real goods and services in that economy. In this sense, money is very real, and it is not neutral. The allocation of resources in an economy determines how and if that economy grows, and the allocation of resources is governed by the distribution of money, that is, the distribution of demand.

I think this is sort of like the difference between plane and spherical geometry. In the small, money looks and acts like an asset. But as you scale up to the entire economy money acts less and less like an asset, until it isn’t an asset at all. Right now that’s just a picture I’m looking at. Not quite sure what to actually make of it.

Get to the other two comments tomorrow. Sorry. Yawn.

OK john. Won’t argue because I think you’re right about that point. It is very difficult for an economy to expand on a fixed money supply. It seems to me, (and this is more of an impression, actually kind of a memory as I thought about this so long ago, and don’t have time here to rework my thinking,) in a static economy, the average monetary profit for business is zero. Other things being equal. With a fixed money supply, in an expanding economy, with increasing numbers of of businesses, it would be negative. If we throw in credit and interest, in an expanding economy it would be more negative. Worse, any profits would be concentrated in the financial sector, and losses concentrated in the real producing sector. This is assuming a fixed wage bill for the economy.

The only possible real profit, which would be required for real growth, would be through price deflation.

Because of this, I favor a moderate sustained expansion of the money supply of about three or four percent above the rate of real growth. ie Moderate inflation. BUT. Fiscal or possibly helicopter money, not through QE or the banking system at all. QE just gives the financial sector leverage over the real sector, and the only way the money supply can be increased in the real economy, and so encourage real growth, is through the financial sector buying up real assets. Not good. (BTW does this resemble anything happening in the real world?)

Also, the example of deflation you raise reinforces my claim about the nature of money: That its value is not intrinsic, but derived from its use as a token of demand.
During a deflationary period, the ‘real’ value of say, a dollar, increases, not because what that dollar is made of somehow becomes more valuable, but because that dollar can demand more of society’s goods and services. Good for the individual with a dollar, but does society have a greater demand on its goods and services because its money is nominally more valuable? No. With real growth, and in the absence of monetary growth, society’s money is more valuable because the society produces more goods and services. Recognizing that money is demand, and just demand, makes that causation obvious.

Which bring us back to the issue I was addressing in my previous comment: The distribution of money, the distribution of demand, between the real producing sector and the financial manipulative sector.

So changes, or the absence of changes, in the quantity of money do have an effect on growth. But I think that changes in the distribution of money have a greater affect on growth. Speaking of deflationary periods, the money supply underwent enormous contraction at the onset of the Great Depression. But whose share of the money supply contracted the most? And so what was the consequent redistribution of demand?
(Actually, this is a little muddier than it first appears. Oh, well.)

Bruce Wilder

You speak of “assets”. There are no real assets. Something — some object, organization, resource — becomes an asset, when money tells a sufficiently plausible story about it. All assets are fictions told in the language and narrative traditions of money.

Well, yeah. Much of the ‘value’ of ‘assets’ in positional and relative. But real things are what they are, and they have a real value exactly because of what they are, and because people are what they are. A gallon of water is water is a gallon of water. An apple has X amount of calories and a certain nutrient value, a gallon of gasoline so many BTU’s in potential energy. These things and their real value are real, constant and independent of any price and the implied value their situation in an economy might place on them. And it is these things, with their real value, which form the foundation of the rest of the economy, a pyramid of successive layers of exploitation, each level of the one below, of increasing subjectivity and decreasing substance as you proceed upward from the ground, as ‘value’ becomes increasingly dependent, not only on the conditions and requirements of the things of greater substance below, but the demands and wishes of the objects of lesser substance above.

So when I try to develop the idea of ‘value,’ to reinforce my illusion of control, I sort of start with a continuum, things or real and substantive ‘value’ and one end, and things of completely derived and evanescent value, like money, on the other. But it is the activity of the evanescent things , like money, which controls the activity of the real objects in the economy. Rather like the mind controls the body, and I mean that rather closely. And similarly, if the mind fails to meet the needs of the body…

Of course, if people were rocks, made of silicon, the value they would assign things, and the economy of those things, would be different. ;-)

BW I’m not sure money is the sort of thing that has a quantity.

This kind of reminds me of the question: “What is the height of the atmosphere?” We are definitely dealing with something fuzzy.

@95

greg @ 98:

Re: quantity

In some ways, money is like the score in a basketball game. Would officials ever have to call a basketball game, because they ran out of numbers to put on the scoreboard?

Re: Wealth and usury

Piles of money, untied to production or immediate exchange, only have one potential function in the economy: insurance. I won’t lay out the dynamic in detail, because I think you already understand it: the rich get richer as the poor get poorer, and every disturbance to the economy that increases systemic financial risks and general precarity increases the profitability of the rich lending money to the poor. Removing all mutual insurance and social insurance as competitors becomes a policy priority.

Re: Money in the organization of production and investment

Price, at least with regard to most manufactured goods and most services, is not a mechanism of allocation. At best it is a signal with the noise stripped away, an output of complex mechanisms for engineering a production cost that can be predictably controlled in conditions of pervasive uncertainty.

In a profound philosophical sense, money and finance is not (mis)reporting precise point estimates of opportunity costs, that might be biased relative to their “real” values. Money and finance are papering over a reality that is too complex and uncertain for any kind of estimate.

Quite incidentally, money and finance often do report arbitrary, stylized numbers, as when financial accountants, say, use straight-line depreciation or when government statisticians report an index number for inflation, based on an arbitrary market basket. And, those stylized numbers actually do help people to estimate more ambiguous, amorphous values. Information theory might explain why those practices work better than trying harder to estimate the actual target, why Acme Company doesn’t report the actual wear-and-tear on its invested capital, or the Labor Department might leave econo bloggers to tease out, say, “core inflation” or to sort out the differing implications of month-to-month and year-over-year changes.

Whatever the insights of information theory, the ontology does not justify believing that a more solid real world lies behind the shadows presented in dramatic fashion on a financial stage. I am not saying that we don’t need to constantly work for better score-keeping, or to correct errors or bias in the score-keeping. I am saying that there’s no absolute truth much beyond the score-keeping, at least no truth that looks anything like the score, or is anywhere as easy to digest and make use of, as the score.

This is where Professor Quiggin’s leading with the correspondence between price and opportunity cost makes me a bit squeamish, in ways I cannot fully articulate. It is why I decry the careless way people declare that we live in a market economy, and why I think myths of a market economy — the legacy of propaganda like Hazlitt’s — are so dangerous.

The economy of production is an economy organized around imperfect control of production processes, in which people are engaged in a struggle against chance and the limits of their own knowledge. Price isn’t controlling these systems; these systems are controlling price. Money enables these systems and their more or less loosely coupled coordination. Government regulation is rarely concerned with “market” price; it is usually about containing degeneration of the production system, so that planes don’t crash and lettuce doesn’t poison thousands of people.

The dangers are particularly acute, I think, in financial regulation reform, where economists, with competitive markets on the brain, prescribe unworkable and irrelevant constraints on a system already swollen into a monster: macro-prudential regulation, say, or living wills for TBTF institutions, or increased capital requirements for big banks, while ignoring or glossing over issues like the integrity of loan issuance procedures or strategic coordination within suprafirms, such as the universal banks.