Eliezer Yudkowsky—founder of LessWrong and bestselling author on the dangers of runaway AI—recently posted a very long tweet detailing his views on investment bubbles (or what the Austrian economists call “economic booms”). Although I disagree strongly with Yudkowsky, I’m glad he made the post, because it exhibits how a very intelligent person can deduce his way into a fallacy, by ignoring the time element of production.
On this score, Yudkowsky is in good company, because (I claim) he made the same mistake as Nobel laureate Paul Krugman, back when he made a similar rhetorical move in his critique of the Austrian theory of the business cycle. In the wake of the 2008 crisis, I wrote a comprehensive response to Krugman (and also Tyler Cowen, who had raised similar objections) which was titled, “The Importance of Capital Theory,” but which many of my fans simply refer to as “the sushi article.”
In the present post, I’ll use Yudkowsky’s framing to showcase once again the importance of the capital structure when thinking about investment bubbles and the boom-bust cycle. I’ll try to keep my discussion in “plain English,” whereas my 2008 article is a bit more technical for readers who understand economics jargon.
Yudkowsy’s Critique of the Conventional View of Bubbles
The most compelling element of Yudkowsky’s analysis comes at the beginning, when he raises a seemingly logical problem with the conventional view of bubbles:
Hi, so, let’s talk about the general theory of investment bubbles. You may have heard that it’s painful, when a bubble pops, because investments got wasted on non-productive endeavors.
This is physical nonsense.
If the waste were what caused the pain, everyone would be sad *while* the bubble was inflating, and a bunch of labor & materials were being poured down the drain, unavailable for real production and real consumption. Once the bubble popped, and labor & materials *stopped* being wasted, you would expect the real economy to feel better and for consumption and happiness to go up.
The real waste — the loss of actual goods & services that get poured down the drain of bad investment — happens *before* the bubble pops. That waste is in fact a bad thing for the economy! But if that waste was the big bad phenomenon that produced the pain of bubbles, it would feel painful *while* the bubble was inflating; and after the bubble popped and the ongoing wastage ended, everyone would breathe a sigh of relief and increased real consumption.
Instead, what we see is that while the bubble is inflating, a bunch of people feel great. They’re consuming lots of goods and services. The economy as a whole seems to be doing fairly well!
Then, the bubble pops! Suddenly a lot of everyday people on the street, many of whom weren’t even connected to that sector of industry, are doing more poorly. They consume less. Some of them get fired and stay unemployed for a while. The economy feels sad.
You *cannot* account for this pain as a story of real goods and services that got wasted. The timing is all wrong. The waste was real! The waste was bad! And also, it is physical nonsense to imagine that the pain of the bubble popping is the pain of this waste. People were apparently having lots of fun while the waste was ongoing. That fun involved the consumption of real goods and real services, which were *not* being produced by the investment that wasn’t yet productive and later turns out to be just malinvestment.
Yudkowsky then goes on to give his own, superior explanation of why the boom feels good. (Specifically, he says that central banks inflate the money supply, which allows for more transactions to occur and mobilize previously idle resources, which had been immobilized because of rigid prices and wages that refused to fall in order to clear markets.) Ultimately, Yudkowsky ends up endorsing the Market Monetarist school’s proposal of Nominal Gross Domestic Product (NGDP) targeting, which was popularized by economist Scott Sumner.
The present post is not the place for my explanation and critique of NGDP targeting; interested readers can check out Chapter 15 of my book on money. Rather, I want to first unpack Yudkowsky’s argument above, in order to then highlight its glaring omission. Once I point out the hole in his analysis, the Austrian position on the boom-bust cycle should be obvious.
Explaining Yudkowsky
The essence of Yudkowsky’s block quotation above, is that the boom feels good while it’s happening, while everybody feels poor after the bubble pops, and that these undeniable facts are hard to reconcile with the conventional view that the real problem with a bubble is that it misallocates resources to the wrong projects.
Let’s work with a specific example (which is mine, not Yudkowsky’s). In the immediate wake of the financial crisis of 2008, many analysts said that too many resources had been devoted to home construction during the housing bubble, and that this overinvestment in residential real estate was the cause of the pain everybody felt in 2008. But Yudkowsky argues that this doesn’t make sense, according to physics (rather than finance). If too much wood, glass, and labor hours went into housing in 2004-2006, then that means too little wood, glass, and labor hours went into other sectors during those years. So why didn’t Americans in 2004-2006 chafe from a shortage of these other items? Why did the housing bubble feel prosperous when the boom was in full swing?
And then, Yudkowsky might continue, after the bubble popped, why weren’t Americans relieved? After all, the black hole of housing was no longer sucking valuable resources into residential real estate, and finally these inputs were freed to return to other sectors, where they were more urgently needed by the consumers. But of course, in reality, the popping off the housing bubble felt awful, and many Americans became fearful of their financial position.
Now if we think of the economy as a collection of various short-term projects, in which resources are applied and then, after a slight lag, yield their ultimate products, then Yudkowsky’s analysis would be correct. In other words, if the entire GDP consisted of things like hot dog sales from street vendors, haircuts, massages, and live musical performances, then Yudkowsky’s analysis would be valid. But in reality, the economy consists of long-term projects, where resources must be deployed to various lines that might not yield their final output for several years. The complex capital structure of the economy gives rise to the possibility of capital consumption during the bubble years, which explains why an economic boom can feel good even though it is characterized by malinvestment.
Two Quick Examples
To quickly demonstrate that something must be wrong with Yudkowsky’s analysis, we can apply it to a Ponzi scheme. Imagine Yudkowsky saying to Madoff’s investors:
“You feel poorer now that you realize he lied to you, and from your comments, I gather that you think the problem occurred back when he took your money under false pretenses. But that is physical nonsense. If Madoff misinvesting your money was the problem, then you should have felt poor years ago. Now that you’ve received new information and have stopped writing him checks, you have stopped the bleeding and should have a higher standard of living.”
I trust the reader can see that the above (fake) quotation attributed to Yudkowsky, although possessing a certain glibness, is obviously balderdash. I won’t even spell out why, because it will be more relevant to jump to a physical example involving agriculture.
To that end, suppose a farmer becomes convinced that with a new fertilizer and irrigation techniques, he can harvest the same amount of crops on half of his existing acreage. So he only plants on his (most arable) half, and converts the rest of his land into a golf course and swimming pool. Because he only maintains half of the farmland that he tended in prior years, the farmer has more leisure on this cycle—which he uses to work on his slice and do cannonballs in the deep end.
Alas, when it’s time for the harvest, the farmer realizes to his horror that the yield per acre is only 10 percent higher than it had been in previous years—not anywhere close to the doubling he had expected. Consequently he and his family must brace for a much lower standard of living for a year, while he rips up the golf course and pool and brings the full land back into cultivation. Yet even here, the damage has been done; it will take several cycles to fully return to the original harvest.
Now suppose Yudkowsky said to this farmer: “Sure, your family is hurting right now, just after you realized your harvest was 45 percent lower than last year’s. But the problem didn’t occur months ago, when you installed the swimming pool and the golf course. If that’s when the problem occurred, then why didn’t you feel miserable when you were teeing up on the 7th hole, or going down the water slide? Clearly, there must be some systemic problem now that is causing your family’s suffering, that has nothing to do with the previous malinvestments that you may have made.”
Mises’ Master Builder Analogy
The best analogy I have seen for the Austrian theory of the business cycle comes from the inventor of the theory, Ludwig von Mises himself. Mises stressed that the problem of the boom isn’t overinvestment, but rather malinvestment. Interest rates indicate the relative amount of savings available for investment opportunities. When the banks (often led by the central bank) expand credit “gratuitously” and push down interest rates even though households haven’t saved more out of income, it effectively gives a green light to entrepreneurs to invest resources in longer-term projects than can be justified. The households aren’t willing to wait for these longer projects to yield their fruits, and so eventually a crisis occurs.
To illustrate his theory, Mises likens the economy to the construction of a house. If the master builder is given an inventory of the available bricks, windows, lumber, etc., and then draws up a blueprint, it’s critical that he has the correct information about his supplies. If the builder erroneously believes he has 15,000 bricks, when in reality he only has 10,000, that necessarily means his blueprints cannot be completed. At some point—and the sooner he realizes his mistake, the better—the master builder will announce to everyone on the work site, “Stop!” At that point, the master builder will revise the blueprints, in light of the true brick count. Some extravagant flourishes, like a separate guesthouse, might be abandoned, while others—like a shed—might be retained, albeit now using only wood, rather than brick.
Mises argued that this is analogous to what happens with the entire economy when the boom collapses. Unemployment spikes as entrepreneurs need to stop and reevaluate the situation, in light of more accurate guidance on the relative supplies of various inputs. Some projects were entirely creatures of the boom, and simply go under. Other projects are sustainable, but only after scaling back their original vision. But clearly, the mistakes were made during the boom, and those mistakes are the source of the present angst.
Conclusion
Eliezer Yudkowsky is a clever thinker who should be applauded for challenging the conventional narrative on the popping of investment bubbles. However, in his initial essay he overlooked the role of capital consumption, and how it can allow for (a) malinvested resources during the boom while (b) everybody’s flow of “real consumption” also increases during the boom. I gave two quick examples here (namely, Bernie Madoff’s Ponzi victims, and a hypothetical farmer with unrealistic hopes), and in my 2008 response to Krugman I gave a detailed story with actual numbers.
Although targeting level NGDP growth might be a sensible policy for the Federal Reserve, given that it must exist, I still believe that the Fed’s very existence fuels asset bubbles and recessions. If Yudkowsky really wants to promote sustainable and stable economic growth, he should examine the case for ending the Fed.
