miércoles, 8 de enero de 2014

Some Fallacies of some "Heterodox" Economists: Post-Keynesians


In the Wikipedia world, almost every theory and major school of economics has, in order to bring balance to the discussion, its "criticism section" or something like that. The Austrian school has a long "criticism" section, other examples are Neo-classical school, New classicals, Monetarism (a very short one, given by austrians), Marxian school, Supply-side, that scapegoat the left love to use called "Neoliberlism" and even Keynesian economics has one! However Post-keynesians doesn't (New keynesians are another exception). So in order to "bring balance to the Force" I will show the fallacies of two main pilars of post-keynesianism: Its "price and inflation theory" and one of its "business cycle theories".

Why "Post"? And why "keynesians"?

There are three main schools of keynesianism: 1) Neo-keynesianism 2) New-keynesianism and 3) Post-keynesianism1) Is the so called "Neoclassical Synthesis" which tried to "mix" neo-classical microeconomics and keynesian macroeconomics. 2) Is the response of keynesians after the collapse of keynesianism in the stagflation of the 70s. 3) Is the most radical, and less numerous, of the three. They are "post" because they think they are the ones who better followed Keynes' original "revolutionary" ideas expressed in The General Theory, they came after (post) Keynes. They allegedly neither made any "synthesis" with other's (neo-classical) ideas like 1), nor any "adjustment" like 2). Despite the fact that they don't make any "synthesis" with neo-classicals, some of them have no problems with marxists ideas. This guys claim to be the "true heirs" of Keynes (Beaud and Dostaler, 1997:85). This is the "we have interpreted Keynes better than you" school of keynesianism. They went to the extreme to call "bastard keynesianism" to Neo-keynesian school.  They actually have a "guide" to recognize a "good" post-keynesian (Norman, 2008).

The leading spokesmen of the American branch of post-keynesianism, Paul Davidson, actually wrote about those economists who are usually classified as post-keynesians but, according to him, are not post-keynesians. For Davidson, some economists are a kind of "heretics" of post-keynesiansim (Davidson, 2003-2004: "Thus Sraffa and his followers (who now call themselves Neo Ricardians) can not be Post Keynesians — even though some have used (and still use) that appellation... [K]alecki’s monetary analysis is so different from Keynes’s General Theory that Kalecki can not be classified as a Post Keynesian... In reality Minsky was, and always wanted to be, a mainstream Keynesian").

As a consequence of that and as any school of thought, post-keynesians are also divided in opinions. It looks like there is division even in the alleged "pure" interpretation of Keynes. There are two main branches of post-keynesianism: 1) Neo-ricardians and 2) Post-keynesian Monetary Economics (Tiryaki and Tiryaki, 2007). My critique here is to 2), but if you want to see the fallacies of 1) see here, here, here (Spanish) and here (Spanish).

Price and inflation "theory"

"Administered prices"

"Administered prices" argument started with Gardiner Means in the 30s (Means, 1935a y 1935b, 1939) and "developed" it years later. According to Means, firms can manipulate prices practically at will; it does not matter whether or not demand had changed. Thus he was defying supply and demand analysis. This "theory" says that firms can administer prices putting some inflexible element in their movement; they can make prices more downward-sticky than in a competitive market. And it also implied that firms with "market power" can be more upward-aggressive than competitive ones by administrating prices (Kamerschen and Park, 1999). 

Theoretical analysis, however, demonstrate the fallacies of this "theory". As Shapiro (1974: 14, 138-39, 141, 146, 150-51, 170, 261-62) explains:
"[I]n reality it is not so much the "market" per se that establishes prices but rather it is the firm which sets them at all times. It is the firm that sets prices initially, and it is the firm that later adjusts prices (and quantities) in response to the market feedback of surplus or shortage. Even more significant, it is the firm, in its efforts to maximize profits (or minimize losses), that makes the price and quantity adjustments required to avoid disequilibria (p. xxii) (surpluses, shortages), and thereby creates the market's tendency toward stability of output and prices."
And here is the core of the problem: 
"Furthermore, despite the fact that the firm (i.e., its management) is responsible for personally setting the prices of its products, ultimately it is the market that determines prices, through the demand-and-supply mechanism... Whatever price the firm initially sets on its product, it must do so with its fingers crossed, because only its eventual confrontation with market demand will determine whether its best-laid plans are successful or not—that is, whether it will be able to sell out its Qs at the original asking P... [T]he firm faces the prime task of determining the selling price and the quantity of production that will enable it to realize the desired profit rate—a task made all the more difficult because of the uncertainty of consumers' demand and the competitive environment. Hence, the firm is incapable of knowing in advance exactly what the market-clearing price will be."
To confront the ignorance about consumer's desires, firms have the planned sales period:
"The planned sales period (PSP) is that period of time by the end of which the firm expects to sell out the quantity supplied to the market. The PSP will vary from product to product, firm to firm, and season to season. Since no firm has an exact pre-knowledge as to precisely how long it will take to sell out its supply—let alone whether it will be able to realize its price and profit expectations—it can only make a best estimate as to the desired length of the sales period and the rate of sales progress. It can then compare the actual rate of sales with the planned, desired rate, and gauge its sales progress accordingly."
Firms adjust prices and quantities to achieve what consumers want. Firms adjust themselves to market conditions, they do not adjust market conditions.
"For any given quantity supplied by the firm, the problem becomes one of setting the right price—the price that will clear the market within the planned sales period (PSP). Otherwise, if it sets the P too high or too low, the result will be either a surplus or a shortage, respectively. Similarly, for any given price at which the firm wants to sell, the problem becomes one of gauging the right quantity to produce in order to clear the market. Otherwise, if it produces too much or too little, it will end up facing a surplus or shortage, respectively."
What post-keynesians see as "administering the price" is actually the way in which firms adjust themselves to market conditions and consumer desires:
"[F]or convenience, we will hereafter refer to a surplus or a shortage as a disequilibrium type of outcome. A "disequilibrium" simply means that, for the time being, the firm has failed to achieve its market-clearing or equilibrium objective within its PSP... it should be obvious that the firm's adjustments to market disequilibria can involve changes in its selling price (P) and/or quantity-supplied (Qs). Altogether, the firm can make three possible adjustments: (1) change its selling P, or (2) change its Qs, or (3) make a combination of changes in both P and Qs. Thus, in response to disequilibrium, the firm might institute a cut (or increase) in P, or a reduction (or increase) in Qs, or some combination of changes in both P and Qs."
This is what post-keynesians fail to see due to their superficial way to see reality: 
"It is market demand that ultimately determines prices. True, in practice it is the firm that establishes the selling prices and determines how much to supply the market. But in the final analysis, this is about all the firm can do; in all cases it ultimately has to reckon with the market. It is market demand that ultimately ratifies or vetoes the firm's price and quantity decisions. Will the firm set P too high or too low? Will its Qs be too high or too low? Or will there be market-clearing? Only the market can tell."
Now the fallaciousness of "administered prices" is evident:
"[N]o real-world firm really has the "power" to suspend the law of demand and supply—that is, to avoid ending up with a surplus for overpricing its product, or to avoid less-than-maximum profits by underpricing its product and realizing a shortage. Sooner or later, after trial-and-error searching for the market-clearing price, every real-world firm finds itself eventually having to "take" the market price that actually clears its supply. Thus real-world firms are "price-takers" no less than firms in pure competition, the only difference being this: PC firms "take" their P from the market right from the start (they have perfect knowledge!), whereas real firms "take" their P only after trial-and-error search in the market. Irony of ironies: real firms are, in an ultimate sense, price-takers, too!... To be sure, in the real world every firm is free to sell or not to sell at the going market price. For example, it is free to withhold some of its product if it believes this will cause a shortage and a rise in market price. But this "power" to withhold supply can in no way force the buyer to pay that higher price. The buyer is always free not to buy if he thinks the price is too high. The only "power" possessed by any firm is the right to post its selling price—merely to ask for whatever price it wants—that's all! In no way can it compel any buyer to pay that price."
The fact that 1) firms set the price but cannot determine price and 2) they have to make a trial and error process was already known long before Means' misinterpretation. For example in 1912 (Mises, 1912: 162-65). And after that, a lot of economists and authors have demonstrated administered price's numerous fallacies: See Rothbard (1959, 1962: 661-71), Hazlitt (1960: 88-90), Haberler (1960: 42-45), Poirot (1971), Howard (1966), Shostak (2002), Greaves (1973: 66-68), Greaves (1975: 37-53) and Fleming (1951: 74-83, 99-106, 180-85). My own opinion here and here.

Also austrian school economist Machlup (1946, 1947, 1952, 1967) refuted the attempts of some economists to defy "marginalist" analysis by simply "asking" entrepreneurs how firms set the price:
"The marginal cost that guides the producer is the addition to his total cost which he expects would be caused by added production. An outside observer, if he had expert knowledge of the production techniques and full insight into the cost situation of the producing firm, might arrive at a different, "objective" figure of the firm's marginal cost; but what the observer thinks is not necessarily the same as what the producer thinks. The producer's actual decision is based on what he himself thinks; it is based on "subjective" cost expectations... one must not assume that all producers "really" know their cost in the sense in which an efficiency expert would determine it; several of them may lack the interest or experience; they may not find it worth their while to dig too deeply into the mysteries of their business. (After all, we know that there are good business men and bad, and that the majority is somewhere between good and bad.) But this does not invalidate the proposition that the producer is guided by marginal cost. The same thing is true with regard to price expectations and sales expectations. It is the "demand as seen by the seller" from which his revenue expectations stem. The increase in demand which is relevant in the analysis of the firm need not be "the real thing"; it may precede an "actual" increase in demand, lag behind it, or be entirely imaginary. The business man does what he does on the basis of what he thinks, regardless of whether you agree with him or not. Marginal analysis of the firm should not be understood to imply anything but subjective estimates, guesses and hunches."
The fact that entrepreneurs answer with their "rule of thumb" to set the price, does not refute subjective marginal analysis at all: 
"On the basis of marginal analysis of the firm and the industry, we should expect for most industries that price in the long run would not deviate too much from average cost, yet that the firm would attempt to get better prices when it could safely get them and would not refrain from cutting prices when it believed that this would increase its profits or reduce its losses. Now let us compare with this the findings of one of the empirical re-search undertakings which shook the researchers' confidence in the marginal principle and convinced them that business men followed the "full-cost principle" of pricing regardless of profit maximization… Do these findings support the theory of the average-cost principle of pricing? I submit that they give little or no support to it. The margins above aver-age cost are different from firm to firm and, within firms, from period to period and from product to product. These differences and variations strongly suggest that the firms consult other data besides or instead of their average costs. And, as a matter of fact, the reported findings include some that indicate what other considerations were pertinent to the price determinations by the questioned business men… In any event, there is little or nothing in the findings of this inquiry that would indicate that the business men observed an average-cost rule of pricing when such observance was inconsistent with the maximum-profit principle. On the other hand, there is plenty of evidence in the findings that the business men paid much attention to demand elasticities - which to the economist is equivalent to marginal revenue considerations."
The fact that entrepreneurs don't even know what "marginal principle" is, does not refute marginalism either:
"The business man who equates marginal net revenue productivity and marginal factor cost when he decides how many to employ need not engage in higher mathematics, geometry, or clairvoyance. Ordinarily he would not even consult with his accountant or efficiency expert in order to arrive at his decision; he would not make any tests or formal calculations; he would simply rely on his sense or his "feel" of the situation. There is nothing very exact about this sort of estimate. On the basis of hundreds of previous experiences of a similar nature the business man would "just know," in a vague and rough way, whether or not it would pay him to hire more men. The subjectivity of his judgments is obvious. Just as different drivers may reach different conclusions about the advisability of passing another car under given "objective" conditions, different business men will have different "hunches" in a given situation."
And here is the essence of Machlup's explanation, it's about change:
"This is not to deny that a goodly portion of all business behavior may be non-rational, thoughtless, blindly repetitive, deliberately traditional, or motivated by extra-economic objectives… One may presume that producing larger production volumes, paying higher wage rates, or charging lower product prices than would be compatible with a maximum of money profits may involve for the business man a gain in social prestige or a certain measure of inner satisfaction. It is not impossible that considerations of this sort substantially weaken the forces believed to be at work on the basis of a strictly pecuniary marginal calculus… Instead of giving a complete explanation of the "determination" of output, prices, and employment by the firm, marginal analysis really intends to explain the effects which certain changes in conditions may have upon the actions of the firm. What kind of changes may cause the firm to raise prices? to increase output? to reduce employment? What conditions may influence the firm to continue with the same prices, out-put, employment, in the face of actual or anticipated changes? Economic theory, static as well as dynamic, is essentially a theory of adjustment to change. The concept of equilibrium is a tool in this theory of change; the marginal calculus is its dominating principle… If a firm were to regard a certain price change as a desirable step for the time being, but feared that a later reversal might be difficult or costly, it would weigh this anticipated future cost or loss against the short-run benefit. Anticipations of this sort, complementary or competing with one another, are not exceptions to marginal analysis but are part and parcel of it."
Machlup (1967) explains one of the fallacies involved in the "behavioral studies" is this one: 
"To confuse the firm as a theoretical construct with the firm as an empirical concept, that is, to confuse a heuristic fiction with a real organization like General Motors or Atlantic & Pacific, is to commit the "fallacy of misplaced concreteness." This fallacy consists in using theoretic symbols as though they had a direct, observable, concrete meaning."
 As Connell (2007) explains:
"A key problem for Machlup, as for Mises (1981) and Hayek (1945), was adaptation to unanticipated change. In "Marginal Analysis and Empirical Research" Machlup (1946) argued that the purpose of assuming profit maximization is not to predict everything a firm does, but instead to predict how it will react to changes in its environment, especially with respect to demand or costs. Far from the neoclassical mainstream, Machlup's unconventional version of marginalism produces a process story appropriate for analyzing exogenous changes and adjustments to those changes made by a representative ideal type who prefers more profit to less, knows of the exogenous change, and knows how to adapt more or less profitably to that change (Langlois and Koppl 1991, p. 96). Machlup's subjectivist marginalism can be described in terms of a four-step adjustment model in which steps 1 (initial equilibrium) and 4 (final equilibrium) are methodological devices in a mental experiment designed to analyze causal connections between a disturbing change (step 2) and an adjusting change (step 3)."
Finally Crossan (2005) explain us: 
"Lester (1946) and Hall and Hitch (1939) demonstrate a flawed understanding of the economist’s position with regard to profit maximization and the marginalist debate. Lester argues that the over-simplification of a business into two simple variables (i.e. marginal revenue and marginal costs) makes the theory useless.  Indeed, the argument that other factors would have an influence on the decisions made about price, output, employment and all other supply side (MC) and demand side (MR) variables does not falsify the marginalist approach. Economists have always accepted that other factors may influence the actions of individuals who control firms, and there is no reason why all possible factors could not be included in a model of the firm. It is possible to construct a model of any firm and expand this to include the utility function of the owners (this would give you all the information on costs, profits and the satisfaction (utility) of the owner of the firm in question). However, a model of a firm and not a theory of the firm would have been constructed. The marginalist approach is an abstraction of reality, and as long as profit maximization is a goal, ceteris paribus, for the majority of firms, then the theory is valid. Machlup writes “The purpose of the analysis of the firm is not to explain all actions of each and every firm in existence; we are satisfied if we can explain certain strong tendencies in representative sectors of business” (Machlup, 1947; p149) As long as the average businessman/manger of a firm is attempting to maximize profits then this is adequate support for profit maximization as a general rule of firm behaviour. Economics is not a natural science where laws can be proved or disproved in absolute terms, rather it is a social science. The best any social scientist can hope for is that they can predict the average or normal behaviour of a large majority of people. Therefore Lester’s attacks on the theoretical underpinning of the marginalist approach are unfounded."
The basic fallacy of post-keynesian price "theory" is that it is a theory of price setting, not of price determination. They only see firms setting the price, buy they ignore completely how prices are ultimately determined. They are just superficial, they cannot see beyond what their eyes see. They ignore the other necessary part for the actual emergence of price in the daily exchange life: the willingness to buy from part of consumer, which in the last instance is the ultimate factor. This superficiality is what makes their price theory groundless and fallacious.

Not even all Cambridge economists did support the fallacies of “full-cost” pricing (Hall and Hitch’s version) as demonstrated by Marcuzzo and Sanfilippo (2007).  

From the empirical point of view (which is the main basis for "administered prices"), George Stigler made a very good refutation in 1962 (Stigler, 1962). Before that, in the 40s, Stigler refuted Lester fallacious empirical attacks on "marginalism" on the issue of minimum wage (Stigler, 1947). But we had to wait until the 70s to see the war burst between him and Means. Stigler and Kindahl (1970, 1973) refuted empirically "administered prices". They roughly said that that the data used by Means was simply wrong. Means's reply (Means, 1972) only demonstrated the problems his theory had and how arbitrarily defined it was.  

There are problems in deciding which prices are relevant. Means used BLS sellers’ reported prices while Stigler and Kindahl used buyer’s transaction prices. It was obvious that the later was better to know the responses to economic conditions. Theory's own bad definitions make very difficult to achieve a non-arbitrary consensus on what prices we must use. The other problem (related to the first one) was the bad and vague definition of administered prices, "susceptible to reinterpretation as the characteristics of the sample changed." (Perlman and McCann, 1993). This was an embarrassing defeat for "heterodox" economics; they lost with one of the most neo-classical of all neo-classicals: George Stigler. "Means thesis was supported by poor empirical research and an ill-defined methodology." (Perlman and McCann, 1993).

Actually there is no *conclusive* empirical evidence about "administered prices" at all. Even an important post-keynesian, like Malcolm Sawyer, had to admit that fact. In the first line on the chapter about the "evidence" of administered prices he said: "There is a considerable amount of conflicting and mainly American evidence on the ‘administered price’ controversy." (Sawyer, 1981: 104). Since "conflicting" means "opposite" or "contradictory", then he is clearly saying: There is evidence saying *Yes*, and there is also evidence saying *No*. That means: is not conclusive evidence. Sawyer, at least, was honest enough to admit it. After that, he himself had also to tell us some of its difficulties and problems: 1) "Results reported by one author often display considerable differences between time periods, indicating that results are sensitive to the time period examined." 2) "There are problems of identifying periods of rising demand and periods of falling demand." 3) "Investigators often cover a relatively small number of prices and conflicting results may reflect differences in sample selection or data availability." 4) "There are difficulties of allocating industries into those with market-dominated prices and those with administered prices, and differences in results may reflect differences in the allocation of industries between the two groups." 5) "There are difficulties of construction of price indices, well-illustrated by the study of Stigler and Kindahl (1970)." 6) "Finally, there has been considerable confusion and disagreement over what the ‘administered price’ thesis was." And besides all that "Much of this evidence is further discussed by Lustgarten (1975b), who concludes that the administered price thesis has many interpretations and that the evidence is generally not in accord with his interpretation of the thesis." (italics are mine)

Kamerschen and Park (1999) also acknowledge the problems: 
"[T]he hypothesis remains confusing and controversial. The confusion has arisen largely because of inadequacies of the empirical research. The controversies are mostly because of methodological rather than theoretical differences. However, the main difficulty in resolving the controversies is the lack of cogent theory explaining why and how firms with different market structure show different pricing behaviours. Statistical research that is not based on the convincing theory is seldom persuasive." (italics are mine). 
Actually, the definition was not even precise enough: 
"Although the administered-price thesis started with Means' statistical findings, they were interpreted so differently as to cause much controversy. In the process of controversy, especially between Means and Stigler and Kindahl (1970), the definition of the administered price often changed, which affected the new formation of theories." (italics are mine).
Means did not even offered an explanation of why "administered prices" exist, as a consequence of that his definition was "conceptually unclear" and "not operationally revealing". In the 60s and 70s, Means' theory was popular again but there still was no explanation: 
"Means did not offer any theoretical rationale for how some firms having market power could ignore the market situations to administer their prices, and did not provide any clear explanation as to how the prices administered by those firms are related to inflation.". 
And his lack of explanation provoked the subsequent problems and convenient changes of definitions, for the data to fit them: 
"Means' operational definition of the administered price changed from the infrequency of industrial price adjustments to low amplitude, and finally to perversity of behaviour (or countercyclical) over the business cycle. This definitional change caused confusion and controversy in empirical research."
If all that was not enough, here are the three problems raised on the debate: "the (i) measurement of prices (ii) classification of market- and administration-dominated prices, and (iii) definition of turning dates over the general business cycles." (italics are mine). Kamerschen and Park (1999) are very clear when they say this about the debate between Means and Stigler and Kindhal: "The two contradictory inferences from the same sample of price changes illustrated dramatically the methodological problems involved in testing the administered-price hypothesis." (italics and bold mine).  

Is this non-mainstream? No. They were and, to some extent, are part of the mainstream. Jacques Rueff (1956: 13-16) made a very good description of the situation for Mises:
"Such an attitude on the part of Mises sets him apart from other economists. Most of his colleagues take the social structure as a fact that cannot be changed in any respect by the will of men. The Marxists explain it as a revelation of history. The non-Marxists look upon it as the inevitable product of a technical evolution which has given rise to a capitalism of large units, and to monopolies, car­tels, and trusts. Marxists and non-Marxists alike ascribe to our modern economies a rigidity which makes them almost completely immune to the price mechanism. For both groups any doctrine basing the establishment and main­tenance of economic equilibria on price movements is false, fruit­less, and outdated. According to them, it is the task of the economist to discover the proper processes that guarantee economic order without resorting to spontaneous regulation. The sum total of these processes constitutes the new science of economics, which is re­quired by the actual state of the world in which we live. It is true—nor does Mises deny it—that our contemporary econ­omy is more rigid than that which existed before employers’ associations and labor unions had regimented a large part of the forces of production. The essential thing, however, is that the present inelasticity of our societies is far more the result of their institutional character than it is of the nature of the techniques applied. It is institutions established by men and wanted by them that immobilize prices, salaries, and rates of interest. It is the same insti­tutions that lend their protection, without which the oligopolies or monopolies in their quasi-totality could never exist." (italics and bold are mine)
As we see, the old and nowadays attitude of this "heterodox" economists has been part of the mainstream, and austrians like Mises were just the opposite.

 Inflation or "administered-inflation"

The whole theory is fundamentally based on the cost-push fallacy (Humphrey, 1998) which means that inflation (deflation) is caused by nonmonetary, supply-oriented influences that affect the unit cost and profit markup components of prices of goods. This fallacy is neither new nor original. Keynes himself supported it (Humphrey, 1977). Humphrey (1998) traces back the fallacious and old origins of this to 1) James Steuart in 1767, 2) antibullionist writers of 1797-1821, 3) Banking School's leader Thomas Tooke, and others. It is as old as it is wrong. It is old because it has 200 years old, and it is wrong because classical economists and marginalists (David Ricardo, John Wheatley, Henry Thornton, Knut Wicksell, Irving Fisher, Gustav Cassel) refuted it completely again and again since the early 1800s. 

Actually, from the very beginning with Steuart in 1767, this led to another "modern" fallacy of post-keynesians: the reversed causation of money and prices (Humphrey, 1998: "Having denied that money drives, or governs, prices, he argued that causation runs in the opposite direction from prices to (velocity-augmented) money."). After that, the same argument is continued with the antibullionists (Humphrey, 1998: "[T]hey highlighted cost-push influences directly affecting the individual prices of specific commodities, notably grains and other staple foodstuffs that constituted the principal component of workers budgets. These food-price increases then passed through into money wages to raise the price of all goods produced by labor.").

Bullionist writers, like Ricardo, completely refuted the logical fallacies involved in their reasoning:

1) Confusing relative with absolute prices: "[I]n the absence of inflationary monetary growth… With total spending (and full-capacity aggregate output) fixed, a rise in the relative price of food requiring workers to spend more on that commodity would leave them with less to spend on other goods whose prices would accordingly fall. If so, then the rise in food’s price would be offset by compensating falls in other relative prices, leaving general prices unchanged." (Humphrey, 1998).

Antibullionists tried to defend themselves with two new errors denying that monetary growth caused inflation: 1) the real bills doctrine ("money can never be excessive if issued against the security of sound, short-term commercial bills drawn to finance real goods in the process of production and distribution") and 2) a positive interest rate assures no excessive issue of credit ("since nobody would borrow, at any positive rate of interest, money not needed, banks could never force an excess issue on the market."). David Ricardo and Henry Thornton, once again destroyed them:

2) The fallacious Real bills doctrine: because "[I]t links the nominal money stock to the nominal volume of bills, a variable that moves in step with prices and so the money stock itself. By linking the variables, it renders both indeterminate. Far from preventing overissue, it ensures that any random jump in prices will, by raising the nominal value of goods-in-process and so the nominal volume of bills presented as collateral for loans, cause further increases in borrowing, lending, the money stock, spending, and prices ad infinitum in a self-perpetuating inflationary spiral." (Humphrey, 1998)

3) The "reflux mechanism", overclocks the crucial point: "Loan demands, and hence new money advanced to accommodate them, depend not upon the loan rate of interest per se but rather on the difference between that rate and the expected rate of profit on the use of the borrowed funds. When the expected profit rate exceeds the loan rate (as occurred to an extraordinary degree during the Napoleonic wars), borrowing becomes profitable. Such profitability renders loan demands insatiable. With the Bank accommodating these loan demands with fresh issues of notes and deposits—money that spills over into the commodity market in the form of excess demand for goods—prices rise without limit. And with rising prices elevating the nominal value of goods and therefore the nominal volume of bills that represent them, those bills pass the real bills test and are accepted as collateral for additional loans." (Humphrey, 1998)

All those fallacies were the basis for the modern, and faulty, "monetary theory" of post-keynesians (and others): Endogenous (demand-determined) money (Humphrey, 1988). Some of today's post-keynesians, though not all of them, accept one (fallacious) variant of endogenous money called Modern Monetary Theory (MMT).  They also reject (wrongly, of course) the money multiplier.

After that, in the great debate between Banking and Currency School, it was Thomas Tooke (Banking School) who restated the already refuted arguments: "Arguing that falling rates meant lower costs of doing business, he reasoned that these cost reductions would be passed on to buyers in the form of lower prices. The result would be price deflation even if the money stock per unit of output remained unchanged… Conversely, Tooke noted that rising interest rates inflate prices by boosting business costs. And they do so independently of the behavior of money." (Humphrey, 1998). And now was the turn of Knut Wicksell to kill again the inflationary beast:

4) Monetary assumptions:
"Tooke had simply failed to perceive that monetary contraction—namely, shrinkage in the stock of velocity-augmented money per unit of output—and not interest rate reduction per se is the true cause of deflation. For without such contraction, aggregate monetary expenditure MV on the nation’s full-capacity output of goods and services O would remain unchanged. In such circumstances, interest rate reductions would exhaust themselves in lowering relative, not absolute, prices. The prices of capital-intensive goods—goods in which interest expense forms a relatively large share of total cost—would fall, to be sure. But such falls, by reducing the amount spent on those goods so that more could be spent on non-capital intensive goods, would produce a compensating rise in the prices of the latter. The prices of capital-intensive goods would fall relative to the prices of noncapital-intensive goods. There would be a change in the structure, but not the overall level, of prices. Absolute or general prices would remain unchanged…" (Humphrey, 1998. See also Humphrey, 1977)

Wicksell even gave another three additional reasons why Tooke analysis was false. Despite the amazing refutation and failure of these theories, some authors, like Galbraith (post-keynesian), rehabilitated it in the XX Century. But Wicksell did not limit himself to Tooke, he also combated another cost-pushers. Again he demonstrated the confusion between relative and absolute prices: "The proposition that prices of commodities depend on their costs of production and rise and fall with them, has a meaning only in connection with relative prices" he said.

5) Hidden monetary assumptions: "Monometallist cost-pushers, Wicksell argued, simply fail to understand that it is only through accommodative money growth (or restrictive growth in the case of deflation) that relative price changes can be translated into overall price level changes. In such cases, it is precisely the monetary accommodation (or restriction) itself rather than cost-push that changes the price level. Cost-pushers accordingly are wrong in holding that monetary accommodation merely validates price changes produced by other means. Accommodation (or the lack thereof), not cost-push, is the one absolutely necessary and sufficient condition for price changes to occur. In overlooking this point, monometallists erred in attributing the post–1873 price deflation entirely to cost-reducing productivity shocks. It was not the shocks that produced deflation. On the contrary, prices fell because the money stock failed to grow as fast as real output." (Humphrey, 1998).

And finally we are in the XX Century and like a fallacious phoenix, cost-push inflation fallacy rebirthed again with Laurence Laughlin. He actually described "three types" of cost-push mechanisms, one of them was the administered prices (fun isn’t it!). His adversary this time was Irving Fisher, who found 4 errors. The first one is the failure to distinguish between changes in relative and absolute prices (yes, again the same mistake!). "In Fisher’s own words, cost-pushers "have seriously sought the explanation of a general change in price levels in the individual price changes of various commodities considered separately. Much of their reasoning goes no farther than to explain one price in terms of other prices"" (Humphrey, 1998).

6) A change in one place is compensated in another place: The second one was that "anything that affects the price level must do so through changes in the stock of money, its circulation velocity, or the physical volume of trade. If these magnitudes remain constant, the price level cannot change. There is no reason to believe that changes in the specific wages of unionized labor or the prices of monopoly products will affect these macroeconomic variables. Therefore, if "trade unions seek to raise prices of labor while trusts raise prices of commodities," the general price level "cannot change"… True, the individual prices of union labor and monopoly products might rise. But these changes in particular "parts of the price level may occur only at the expense of opposite changes in other parts" (Humphrey, 1998).

7) Ad hoc explanations: "Cost-pushers typically "pick out some particular cases with which they happen to be familiar and drag them before the public." A crop failure renders corn dear, a firm raises its price, a union demands higher wages—"and immediately someone hails the event as a representative cause of the high cost of living"… Fisher termed this practice "the error of selecting special cases." He argued that because such alleged causes of inflation occur only sporadically, are short-lived, and affect only a limited range of commodities, they could not explain a sustained rise in the level of all prices. As he expressed it, "special causes working on selected commodities" would not "be general enough to explain the concerted behavior of . . . changes in the general scale or level of prices" (p. 16). Only excessive monetary growth could account for sustained inflation." (Humphrey, 1998).

8) The worst consequences: "Finally, Fisher opposed cost-push inflation theories because they lead to what are now called price and wage controls, or incomes policies. Such "vicious remedies" he wrote, "are not only futile, but harmful"… Unfortunately, since incomes policies per se cannot permanently reduce inflation if money growth remains excessive, the inevitable result is that "disappointment follows their application.""

The post-keynesian Nicholas Kaldor (a former hayekian) was a perfect example of all this fallacious thinking (Humphrey, 1988). With their faulty "theory" of prices, money and inflation, post-keynesians are just repeating the old and refuted "arguments" of Banking School.

Business Cycle

A lot of them endorse the Keynes-Fisher-Minsky theory of Debt-deflation. It roughly says that in an environment in which there is a lot of debt (i. e. a lot of people and firms indebted), a fall in prices (deflation) will increase the real value of nominal debt (nominal debt remains the same while prices drop = real debt raises). This clearly diminishes the net worth position of indebted agents (debtors). Indebted firms will react by trying to obtain capital through the dismissal of workers or decreasing investment for example and as the relation lender-borrower is in conflict, the access to new or more credit becomes very difficult. You need 1) indebted agents in nominal terms (contract) and  2) a fall in prices. Those two conditions been fulfilled, they will unleash the debt-deflation chaos.  Minsky extended Fisher's insight to deflation in asset markets (selling assets, reduces its prices damaging over-leveraged agents. That impulses further asset selling reducing spending on consumption/investment). Bernanke's version says that debt-deflation implies massive bankruptcies, destroying credit intermediation process. The "theory", however, has serious problems:  

1) Not a business cycle theory: This is not even a business cycle theory! At best it only describes a particular situation that can happen during a business cycle, it is an incomplete business cycle theory (as Mario Rizzo noted in this comment). Debt-deflation is just a special case of a more general process: malinvestment liquidation (Mulligan, Lirely and Coffee, 2010). So even if debt-deflation is not present or prevented, there still are malinvestments after a credit-driven boom. Even if we avoid a "chaotic" debt-deflation after a credit-induced boom, we still have to restructure the structure of production. 

2) Easy money, the cause: Even if 1) is not true, we still have problems. The first and necessary condition for debt-deflation to operate is over-indebted agents. But what is the cause of over-indebtedness? It is credit expansion! As Fisher (1933) clearly stated: "Easy money is the great cause of overborrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money." Mises noted that any theory (whether it is monetary or non-monetary) presupposes previous credit expansion which feeds the boom (Mises, 1949: 551-52: "In fact, every nonmonetary trade-cycle doctrine tacitly assumes—or ought logically to assume—that credit expansion is an attendant phenomenon of the boom."). Also Röpke (1936: 119) clearly explains: 
"We may conclude, then, that the last American boom is a striking example of how the disequilibrating effects of variations in the volume of credit may possibly be greatly aggravated by peculiarities in the qualitative composition of the stream. But it must, of course, not be overlooked that this can only be an additional factor of instability and presupposes that an inflatory credit expansion is already going on. Without this, misdirections of credit can hardly give rise to a general economic disequilibrium. The same must be said about Irving Fisher's "debt-deflation" theory of cycles which implies that it is overindebtedness incurred during the boom which starts the crisis. Overindebtedness could not occur without an inflationary expansion of credit, or, to be more explicit, it is only another word for it, since expansion of credit means, on the reverse side, expansion of debits, i.e., a growing volume of indebtedness."
Then, it is inflation and credit expansion precisely what created de debt deflationary problem (over-indebtedness) in the first place, but its advocates surely would recommend inflation and credit expansion to prevent the fall in prices that will unleash the debt-deflationary chaos. In doing so they are not only contradicting themselves, but they are trying to extinguish fire with more gasoline. The only way to prevent debt-deflation is to stop credit expansion (easy money). 

3) The real source of instability is not the financial system: Instability comes from fractional reserve and central bank, rather than financial system per se. What makes the financial system unstable is the expansion of (unbacked) credit, not speculators (Bagus, 2007: "Since ongoing booms are only possible if there is ongoing credit expansion, asset price booms can serve as a good indicator for credit expansion… To end asset price booms and busts, one has to eliminate their cause -- credit expansion. To do this, a sound monetary system must be installed."). As Shostak (2007) explains: 
"In a free market, then, if a particular bank engages in an unbacked expansion of credit this bank runs the risk of being "caught." Consequently, the threat of bankruptcy is likely to deter banks from pursuing the expansion of unbacked credit. We can thus conclude that there is no inherent tendency in the capitalistic economy to generate unbacked credit that destabilizes the economy. For post-Keynesians such as Minsky, what matters is the particular institutional setup of the economy. They argue that Minsky's Financial Instability Hypothesis (FIH) is only applicable to a modern capitalist economy. In short, the FIH is not a general theory as such but is institutionally specific… Contrary to Minsky and the other post-Keynesians, it is the existence of the central bank that makes the present capitalistic framework unstable and susceptible to financial turmoil. It is not the expansion of credit as such that leads to an economic bust but the expansion of credit "out of thin air,"… We thus conclude that Minsky's Financial Instability Hypothesis doesn't prove that the capitalistic system is inherently unstable. The instability that Minsky has identified has nothing to do with capitalism, per se, but rather with the institution (the central bank) that prevents the efficient functioning of capitalism."
Finally we can see the empirical evidence showing that asset bubbles "are not random, or endogenous to financial markets, but connected to specific government policies designed to stimulate the economy…" (see Bordo and Landon-Lane, 2013a and 2013b).

4) Fallacy of composition: It is true that massive bankruptcies that can result from over-indebted people in the context of falling prices are deplorable from the point of view of individual entrepreneur, owner and capitalist that suffers it and that individual firms will be out of business. However it is wrong to extend that conclusion to all firms or that a great number of firms will be abandoned without producing, thus bringing a fall in production. From the aggregate (social) point of view, it is not important who control the existing firms and resources, because they are intact and they do not disappear (Hülsmann, 2008b: 67-68; Bagus, 2006). 

Even if we have mass bankruptcies, we don’t have a problem in the aggregate. That's because the existing owners are replaced by new owners. Let's assume we have all the firms and business that conforms the entire structure of production and all of them didn't anticipate the contraction of money supply and as consequence of that they all go bankruptcy; even in this situation plants can still be operated at the lower price level (what matters for firms is not price level, but the margin between the price of the product and costs). But why did they go bankrupt? Because they had contract-debt. With the fall in prices, firms will be incapable of serving debt. After that happens, there are 2 options: 1) renegotiate debt: reduce the size of debt because prices and incomes have fallen, this is how debts are reduced in a context of falling prices and 2) bankruptcy: the creditor wants the full amount of debt and don't want to renegotiate, then the creditor takes over the firm. The creditor knows he will never get back the full amount of money lent, but at least he has the firm. And he can operate the company in a new profitable way at the lower price level. Even in a context of massive full-scale bankruptcies, all we have is a massive change in the composition of owners of firms, production can still be carried out. An entire "class" of (indebted) entrepreneurs and business men are just replaced by other people; firms and plants are still there and can still be operated profitably at the lower price level. Even in this case of completely unanticipated deflation and debt deflation situation, there are no macroeconomic problems. All that happens in this situation is a great change in composition of entrepreneurial class, a lot of them go bankrupt and are out of business, but other individuals replace them; firms and the productive apparatus has not disappeared. For the other people who are not entrepreneur or owner, the situation would not be a disaster. For employees for example the situation would not be a serious problem, whether they work for mister Burns or mister Scorpio (Hülsmann, 2008a: 26-27; Bagus 2003, 2006). 

Besides it must be emphasized that the people who replace the bankrupt owners are precisely the people that are less indebted at the moment when prices sank. They anticipated better the future than the over-indebted people whose business is in bankruptcy. Only the obvious fact that these people acquire the firms, demonstrate that these people anticipated better the future and did not go in too much debt.

But wouldn't it take too long to settle all legal problems of bankruptcies thus impairing production? No. There is no theoretical reason for that to happen and empirical evidence demonstrate that it can be done efficiently. 

5) It can't even explain the Great Depression: Ohanian and Cole (2001) compared the increase in private debt burden due to deflation in two depressions, 1920-22 and 1929-31, and they found no evidence that debt-deflation explains the depth (fall in output) of the later. In 1920-22 the increase in private debt burden was bigger and there was no Great Depression: "The most striking feature of these data is that the debt burden channel rises more in 1921-22 than in 1929-31. The more rapid 1920s deflation increased the debt burden by 0.29 between 1920-22, compared to 0.20 between 1929-31. This higher debt burden increase, however, is associated with a much smaller decrease in output... We conclude from these data that the debt-deflation story does not explain why the Great Depression was worse than the 1921-22 Depression." (italics are original and mine). In the discussion section, Mark Gertler tries to defend his explanation through an unconvincing change in dates, and even there we see an enormous increase in debt burden in early 20s that didn't cause serious problems (relative to those of the Great Depression). 

6) A political problem: deflation does not present economic problems when it is correctly understood and prices are free to move as market determines. But it does present political problems. The business men and entrepreneurs don't like to be replaced by other people. If we have a massive fall in prices, then a lot of them will fall. So we have an incentive from indebted owners and entrepreneurs to collude and to make lobby to avoid at all cost this scenario. So all the "captains of industry" have a tremendous incentive to pray for government intervention to avoid the "disastrous" deflation, after all they are the best, they must remain in place! Who will run the country if they are not there? Deflation destroys economic establishment, as Hülsmann says. So we can see how conservative John M. Keynes’ monetary thought was. Deflation is not an economic problem, but a political problem. For more, listen here.  

As we see, post-keynesians, other keynesians and mainstream economists, fail to understand correctly deflation. 

Note: Mulligan thinks we can reconcile Minsky and Mises (Mulligan, Lirely and Coffee, 2010).  

Is this theory non-mainstream? No. Mainstream is (Korinek and Mendoza, 2013; Shiller, 2011; Reinhart and Sbrancia, 2011 and Krugman) and has been (Bernanke, 1983; Kiyotaki and Moore, 1997; Bernanke and Gertler, 1990)  very interested in this theory. This is not a unique feature of post-keynesians at all, but it might be possible that they have developed this "theory" much more than mainstream.


The core of this "heterodox" branch of economics called post-keynesianism is neither new nor original. It is just a resurrection of old and refuted economic fallacies. The failure of Keynes' system is taken to the ultimate and failed consequences by these economists. They are the modern face of mercantilism, Banking School and institutionalism/historicism. Some of them even found a good ally in some theoretical (and refuted) elements of marxism. 

In economics, old fallacies die hard. Post-keynesian's main problem is not to be old, but to be old and fallacious. Far from being an alternative paradigm to the problematic mainstream neo-classical economics, postkeynesians want to replace the unreal assumptions of the former with their own unreal assumptions. They want us to return to old economic fallacies, they want us to return to flat earth theories. And in that sense, they are the true heirs of Keynes.


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7 comentarios:

  1. On administered prices:
    I think a way to clarify it is to say that Austrians talk about prices("Historical relations of exchange") and P-K's talk about prices ("proposed relations of exchange"). i.e. if you go to a supermaket you may see a 2€ etiquette. That's a proposed price. When you end up paying it you get the price. This is set as per usual price theory. The offered price is set in any way the entrepreneur wants it. However, not any offered price she wants will end up becoming a true price.

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  2. " It is true that massive bankruptcies that can result from over-indebted people in the context of falling prices are deplorable from the point of view of individual entrepreneur, owner and capitalist that suffers it and that individual firms will be out of business. However it is wrong to extend that conclusion to all firms or that a great number of firms will be abandoned without producing, thus bringing a fall in production. From the aggregate (social) point of view, it is not important who control the existing firms and resources, because they are intact and they do not disappear (Hülsmann, 2008b: 67-68; Bagus, 2006). "

    Agregate demand disappears. You see as businesses are sold and people sell their houses at distressed prices the debt is nominal and stays that way. That means that debt gets bigger in real terms as people's incomes and asset prices fall. The winners are owners of financial assets, money government bonds etc. debt slavery is effectivly created this way. You can say that aggregate demand doesn't fall because purchasing power is only transfered from debtors to creditors, in reality this is not true in debt deflation economy. This post is a lot of wishful thinking.

    1. “That means that debt gets bigger in real terms as people's incomes and asset prices fall.”

      Right. And, as I said, that situation can be managed with a) renegotiation: lowering the nominal value of debt (nominal debt falls as all prices fall) or b) bankruptcy: non-indebted people take over firms. In option a) you can still pay debt as you were doing before deflation and in b) your debt is cancelled with an asset owned by a guy who was not over-indebted at the moment of deflation. In no case there is some kind of “debt slavery”.

      “debt slavery is effectivly created this way”

      Actually, “debt slavery” is created this way:

      "At the beginning of the twentieth century, most firms and industrial corporations were financed out of their revenues, and banks and other financial intermediaries played only a subordinate role. Today, the picture has been reversed, and the most fundamental reason for this reversal is paper money. Paper money has caused an unprecedented increase of debt on all levels: government, corporate, and individual. It has financed the growth of the state on all levels, federal, state, and local. It thus has become the technical foundation for the totalitarian menace of our days." (Hülsmann, 2008a: 21)

      A deflationary spiral wipes out debt. There is no more debt left after the whole process, only equity. Nobody trust each other, nobody give credit anymore.

      It is not “aggregate demand” what remains unchanged, but the level of activity. It is not true that economic activity *must* decline with deflation. However there has been a change in composition of owners.

      Actually those who don’t want deflation are the big multi millionaire debtors. The big “captains of industry”, big corporations, governments, etc. And as long as deflation increases interest rates, the value of assets falls. It is *inflation* what works in favor of government and its closest business crony allies, they enrich themselves at expense of all citizens.

  3. Podrías refutar este post? http://socialdemocracy21stcentury.blogspot.com.ar/p/there-is-mountain-of-empirical-evidence.html
    Se menciona más evidencia que la de Means y casi no hay estudios que contradigan los de mark up prices :/

  4. Este comentario ha sido eliminado por un administrador del blog.