Tuesday, November 03, 2009

The Buffer Theory of Austrian Economics

About a month ago, Steve Sailer had a post that directed me (along with other readers) to this article by Paul Krugman.

In the article, Krugman tried to refute hangover theory with the question:

And now as then, the whole notion falls apart when you ask why, say, a housing boom — which requires shifting resources into housing — doesn’t produce the same kind of unemployment as a housing bust that shifts resources out of housing.

At first this seems a weird question, as Scott comments

Seriously, Paul basically just asked “Why doesn’t hiring people create the same unemployment that firing does?”

But on second thought, the question does bring up a profound issue within Austrian *"hangover") theory:

Why does the period of malinvestment create so much false prosperity, and why cannot the jobs created during false prosperty be continued or similar jobs created during the bust, in order to obviate the recession? What allows bad investements to make the economy seem so profitable?

As Henry Canaday asks on Sailer's blog in the comments:

I think what Krugman is asking is why, supposing the housing bubble created real but sometimes economically wasteful jobs, cannot fiscal stimulus also create real, even if sometimes economically wasteful, jobs?

To understand this issue, one has, I think, to understand the concept of a savings buffer. This is what might at other times be thought of as hoarding, etc.

What it comes down to is this: in Austrian theory, production can either be put into consumption or savings. Consumption in this case means that the resources are put to a use that satisfies an immediate or personal need. Savings means that that which is produced is not consumed in such a manner. Generally, savings by one person can be put into another's consumption, with the debtor obligated to eventually return resources to the creditor in excess of what he has borrowed. However, net savings, that is, that which is saved and not consumed by others, provides the basis of investment.

Investment is the use of resources to create structures which can satisfy needs in the future. From an Austrian standpoint, investment is a subset of savings, because the goods are being used to increase future production, even if in some sense they are consumed. To give an example: using copper to produce wiring to electrify a television set is consumption. Using it to produce wire that is used in the building of a factory to produce TVs is investment. Another term used is good order; a good of the first order is consumed, a good of the second order is used to produce a good of the first order, a good of the third order is used to produce a good of the second order, etc. In this case, the TV would be a good of the first order, and the wire in the factory a good of the second order. If the wire was used in the manufacture of a construction vehicle used to build the factory, it would be a good of the third order, etc.

It is often said that investment equals savings, and in the long run, that is largely correct; that which is not consumed eventually gets put to use.

But there is a lag time. Steel is stored, both as ingots or as beams or other forms. Wood boards are kept in warehouses rather than being turned into finished products such as chairs. People have educations that they are not currently applying, etc. These things provide what can be thought of as a buffer. This buffer is similar to inventory in a warehouse, and serves much the same purpose. What is saved in the buffer can be later taken out for use in investment, or for consumption.

So to recap, production during a given period of time can be consumed, invested, or saved in the buffer.

It should be noted that the buffer is dynamic; many things are not stored in the buffer long-term; rather, new things are added while old thigns are taken away; much as a store that is increasing inventory still uses its inventory; it is just being replaced faster than it is being used.

What purposes does the buffer serve? Is it not just idling there purposelessly? Ought we not to reduce the size of the buffer and put all of those resources to use, as in Lean manufacturing?

Well, for the first thing, the buffer serves the purpose of buffering. At any given time, the amount of savings and the amount of investment may not match up exactly. This is particularly acute if you realize that savings and investment, while they are mediated by fungible cash, are not themselves fungible, at least not entirely so (Note: in the linked Sailer piece, I state that resources are fungible. That was stated poorly; my point was that resource use is interconnected and that using resources one place can reduce resource use in lots of unrelated sectors of the economy; I was not saying that resources or goods were completely interchangeable). Corn meal cannot be magically converted into iron, or an education, or wood. There are times when more of something is produced than is needed, and times when more is needed than is being produced. The buffer helps to smooth these things out; very few people want to have to buy or make everything exactly when they need it; it would be like going to the supermarket every day to get the food for that day, and to be dependent on whatever gets picked at the orchard / slaughtered at the slaughterhouse, etc. on that particular day.

In practice, we have some level of resources held in reserve to allow us to coordinate resource use over time rather than simply moment-to-moment or day-to-day. The surplus grows over time, causing prices to fall, which reduces the amount produced and increases the amount consumed or invested, or it shrinks, causing the prices to rise, increasing production and decreasing consumption and investment. The fact that there is a surplus allows this process to occur smoothly, rather than investment and consumption dropping every time there is a glitch in production (this would throw any long-term planning into chaos; no one could build or invest anything based on any plan, because they would have no idea what resources and how much would be available from day-to-day).

According to Austrian theory, the cause of the boom bust cycle is distortions in economic coordination caused by monetary expansion. Low interest rates and increased money supply cause people to assume that there are more savings than there are and that more resources are available to invest than are actually available. The explosion of investments is the boom, but because theese investments are not sustainable with the actual resources available, there is eventually a bust. (It should be pointed out that the inaccurate resource picture can also lead to increased consumption, which likewise reduces the resources available to complete the malinvestments).

But why the boom? Why are so many jobs created and why is there so much apparent prosperity during the boom?

The answer is simple: all of the apparent prosperity is caused by the consumption of the buffer.

But again, one might ask, isn't this a good thing? What about Lean? Doesn't that work and make things more efficient? Aren't we just bringing idle resources to use?

The problem, again, is that Lean requires intense coordination of a sort that is not possible in a non-centrally coordinated economy, and it is unlikely that the overall economy can be planned in this manner. Moreover, Lean is generally used for production of specific goods that have a predictable production pathway. It is not as useful when producing large heterogenous masses of goods or investing in new technology whose direction is difficult to predict.

Moreover, Lean requires a correct estimate of what is available in the future. A boom caused by monetary expansion is not an example of consciously shrinking the buffer in order to be more efficient; the buffer shrinks because people do not realize that they are consuming more than they are producing; they are overestimating what is being saved, and assumethat the buffer is not shrinking.

The bust occurs when some of the essential resources in the buffer run out, or become too hard to get cheaply. For a time, continued monetary manipulation can keep the economy apparently growing, because people are dipping further into the buffer, altering consumption and investment to use alternate resources of which there is still a surplus, or redirecting resources from producing things are still plentiful to the things that are in short supply.

Eventually, though, the buffer runs out. At this point, the bust must come, and the more depleted the buffer is, the more severe the bust is, because there is less time and there are fewer resources to ease the process of readjusting the economy.

That is why the jobs produced in the boom cannot be recreated in the bust. The resource buffer which funds the salaries that these jobs pay and the materials and whatnot that are required to do these jobs no longer exists. Therefore, any unnecessary or inefficient, unproductive, make-work jobs produced to help the bust will do nothing but take resources away from productive jobs done by productive workers.

This also explains the increase in savings and decrease in investment that you get during the bust; with a depleted buffer, investment cannot be greater than savings, and because perfect coordination of savings and investment is impossible, there is going to be a tendency for savings to exceed investment, thus increasing the buffer, until the buffer is large and diverse enough that it can make up for termporary savings deficits again.

So in short, the concept of the buffer explains why the boom period can have apparent prosperity, as well as why this same process cannot be used ameliorate the bust. This also explains why savings goes up during the bust, and does so much better than the Krugmanian idea that the savings causes the bust.

That is all.

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