A couple of things

First Bob says

My answer to Karl (starting at the 44:00 mark) involved the Austrians’ sophisticated view of the economy’s capital structure. A cruder Keynesian model, which involves aggregates such as K and L, can’t grasp the Austrian diagnosis of the typical boom-bust cycle, and consequently yields disastrous policy advice — such as massive deficit spending to prop up “aggregate demand.”

I think crude Keynesianism does just look at basic aggregates. I believe it was Bob Solow who said that if God had intended there to be more than two factors of production he would made it easier to draw three dimensional graphs.

So it was asked. So it has been delivered.


Indeed we don’t have to stop at three anymore


More generally we can use GAMS (General Algebraic Modeling System) to model as many markets as we want. How many you want? We can have 50,000 markets. Its only a matter of time before we can do millions of markets.

The computer scientists tell us impossible to build a complete model of the entire economy including every possible market, that will solve faster than the actual economy will solve, so there will always be a level of abstraction. But, we certainly don’t have to settle for K and L.

The thing is we still don’t get the effects that Bob is talking about. No Gnomes, even in 500 dimensions.

To illustrate what’s wrong with the typical Keynesian view of the economy, in the debate I told the spectators to imagine that one night, mischievous gnomes decided to rearrange all of the capital goods and skilled laborers in the country. The next morning, brain surgeons who were supposed to report to a hospital in Albuquerque would wake up in Miami. Factory owners in Trenton would open their doors and see that their assembly lines were gone, replaced by defecating cows. Farmers in Iowa, for their part, would be baffled to see drill presses and computer servers sitting in their empty fields.

Suppose the Keynesian statisticians in this absurd thought experiment could make perfectly accurate measurements of their standard variables. What would they say? In the first place, they would be horrified to report that “real GDP” — the flow of newly created goods and services — suffered the worst collapse in world history. The annualized rate of real output in one day would have fallen perhaps 99 percent. Factories would be idle, and workers would be wandering the streets in a daze. Official unemployment statistics would be 90 percent or higher in the days immediately following the gnomes’ evil prank.

The government and the public would demand that the elite economists explain this calamity. The Keynesians would check the various aggregates and consult their models. Was it a “supply-side” disturbance? It wouldn’t appear to be so: the total stock of capital goods was the same as it had been the week before, and the same would be true of the supplies of various types of labor. It wasn’t as if the economy had been struck by an earthquake or a plague; the same “productive capacity” was still there. Furthermore, there wasn’t any negative “technology shock,” as far as the Keynesians could ascertain. The recipes for turning inputs into outputs would all still work, just as they did the week before.[1]

This is why the discussion of Co-movement is so crucial. If there were gnomes moving stuff around then we should see stuff moved around. But, we don’t.

We can look at market after market and it seems like there is some effect which is hitting everything to a greater or lesser degree. For example. Health care is an example of a sector that just keeps adding jobs.

As a New Keynesian I would say this is in large part because consumer foot very little of the health care bill. The government foots nearly half and third-party insurers who are contractually obligated to pay foot most of the rest.

Nonetheless, even in this market – a market that everyone thinks will keep expanding – look what happed to construction.

FRED Graph

The top line is private construction spending on health care, the bottom is public construction spending on health care. Can you see how in late 2008 private health care expenditures falls.

Can we also see how public health care spending did not fall until late 2009.

What’s our gnome explanation for this. Who moved the private bulldozes in the fall of 2008 from the hospital parking lots and why did they wait until 2009 to move to move only a couple of bulldozer from the VA hospital?

In my world Lehman Brother moved the bulldozes. Lehman created a sharp rise in liquidity demand that had even hospitals hording cash. No one thought the market for sick people was drying up. They though the market for cash was drying up and so they pulled back on spending.

We can go through private spending series after private spending series. We can look at very short lived items like hot food. We can look at long lived items like industrial machinery. They all move the same. Indeed, lets look at those two

FRED Graph

They rise together. They peak at roughly the same time, they fall together, and they recover together.

Capital goods are more sensitive to the financial crises than is hot food but nonetheless they move in rough tandem. This is what tells me that Aggregate Demand is a general effect. Its something that hits everything to a greater or lesser extent.

If we are looking for a gnome effect, we really want to see some sector of the economy that is moving out of sync. We want to see some place which should have been getting lots of resources but wasn’t.

We then want to see resources being transferred into that area as people realize what went wrong. Its hard to find what that thing is.