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Another “Austrian” Critique of Market Monetarism: Part 2

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Shawn Ritenour critiqued Market Monetarism on the Mises.org blog.

I responded to what he sees as our theoretical shortcomings here.   He goes on to critique the Market Monetarist view of expectations:
For example, the market monetarists claim that it is expectations about future NGDP that solely determine present investment decisions and hence the direction of the economy. This claim fails to recognize that recessions are not merely the result of decreases in aggregate spending following a boom. They are the result of entrepreneurial error (Hulsmann 1998; Rothbard 2000, pp. 8-9). It is possible, for example, for entrepreneurs to reap profits even in an environment of declining total spending. What matters is not aggregate spending, but the spread between the price of products and the sum of the prices of the factors of production. If the total quantity of all spending in the social economy falls and overall prices fall, firms can still reap profits as long as they identify those projects at which the factors are underpriced relative to the future price of the product they can be used to produce. Market Monetarist do not claim “that it is expectations about future NGDP that solely determine present investment decisions and hence the direction of the economy. It is rather than we think that expectations about future NGDP are a very important influence on current spending decisions, which determine current NGDP. We believe that both investment and consumption decisions are influenced by expected NGDP, but we don’t claim that nothing else influences them.

Most Market Monetarists are skeptical that entrepreneurial errors in investment decisions lead to recession. They rather lead to losses for the particular entrepreneurs that made errors and are usually combined with profits for those entrepreneurs who made correct judgements. For example, an entrepreneur who continued committing resources to maintain the production of CD players loses money while the entrepreneur developing the ipod reaps great profits.

Ritenour argues that it is possible for entrepreneurs to reap profits despite reductions in nominal expenditure.   This is true, of course.   For example, it is possible for nominal expenditure to fall in aggregate, while nominal expenditure on some particular product rises.   However, expectations of reduced nominal expenditure in the future would still result in reduced expenditure now.

Ritenour has in mind a different scenario where firms invest today because they expect that resource prices will fall more than final product prices in the future.     In abstract, this is possible.   In practice, it would seem a bit difficult unless the shift in money supply or demand were permanent and the adjustment process swift.     While a firm spending now on relatively high priced capital goods would take a nominal loss after a general deflation of prices in the future, replacement costs of the capital goods and the real value of profits in terms of consumer goods would be the same.   However, if the deflation is temporary, wouldn’t the replacement costs be the same and the real profits permanently decreased?    Further, a firm using debt to finance investment in the face of an expected deflation of prices and wages is asking to have net worth stripped away by creditors, one way or another.

This sort of reasoning suggests that expectations of recession and deflation bring the recession and deflation right away.   If it is permanent, it causes whatever damage it will cause, and recovery, including real investment, can then begin in the context of lower prices and lower wages.    If the deflation is temporary, then expectations of the deflation move it to the present as before, though expectations of recovery and a return of  the price level to its previous value will also shift recovery nearer to the present.  

Ritenour accuses Market Monetarists of inconsistency:
Additionally, the form of expectations assumed is the source of a particular inconsistency in the market monetarist literature. This inconsistency, in turn, is also related to their failure to understand recessions as the result of a cluster of entrepreneurial error. Market monetarists assume that markets are efficient and forward looking. At the same time recessions are due to decreases in expected NGDP. If markets are efficient while forward looking, how can there be a cluster of entrepreneurial error? It seems that if market participants make efficient adjustments while looking forward, there should not be widespread mistakes made by entrepreneurs. If so, how can there be recession? Perhaps the response might be, as Christensen (2011, p. 5) implies, that although people have expectations that are indeed rational, they are not perfect. Even so, if market participants properly forecast that the Fed would not or could not continue to increase NGDP through 2008, why should there be a recession? If their forecast was correct, they should have acted accordingly and markets would clear, and at the very least there would not have been widespread persistent unemployment.
Market Monetarists, like most economists, don’t accept Rothbard’s assertion that recessions are about a “cluster of entrepreneurial errors.”   In my view, in a world of creative destruction, entrepreneurial error is rife.   Contemplation of the rate business failure and the number of workers that are laid off even when real output and employment are both growing strongly suggest that the market system is quite able to somehow manage massive entrepreneurial error, but also substantial variation in error without there being a recession.

How is that possible?   Here is one possibility.   In the context of growing aggregate spending on output, business failure results in lower supply, higher prices, and higher nominal and real profits.  This attracts more entry, allowing employment and production to recover, while reducing prices and profits return to their initial levels.    While real business cycles due to variation in entrepreneurial error would seem possible, it appears that the corrective process works quite well.

Market Monetarists believe that in fact expected expenditure on output influences current expenditure on output.   We also argue that a monetary regime that commits to return expenditure on output to a stable growth path as soon as possible will create expectations that will result in smaller decreases (or increases) of current spending on output relative to the target growth path than a regime where there is no such commitment.   Further, given any such deviation, the return to the target growth path will be more prompt.     A commitment to return nominal GDP to a target growth path will tend to keep spending on output on the target growth path.

Market Monetarists also believe that if prices and wages all adjusted more or less in proportion to the change in spending on output, real output and employment would not be much impacted by the change in spending on output.   However, Market Monetarists believe that in fact prices and wages are very sticky with respect to shifts in spending on output, not only in their levels but in their growth trajectories.

Market Monetarists don’t have any unusual explanation for sticky prices and wages.  Unlike new classical economists and apparently some Austrians, we are willing to accept the evidence we see rather than insist on theoretical arguments that markets must always clear.    My view is that the problem is one of coordination.   If there were a single firm making price and wage offers, it could more easily adjust to shifts in spending on output.   In the real world, the appropriate price and wage for each firm to set depends on what all the other firms will do.

I also recognize that this is true of spending on output.   How much it is appropriate (or possible) for any one firm or household to spend depends on how much other households and firms are currently spending.   But that doesn’t mean that expectations of future spending don’t directly impact spending now.   The Market Monetarist view isn’t that a commitment to keep nominal GDP on a target path is sufficient to keep nominal GDP on that path, it is just that it will do better than a monetary regime that makes no such commitment.

Of course, it is easy to find strong claims about rational expectations or efficient markets from Scott Sumner.    And perhaps the plain English meaning of those words would seem to require that prices and wages be perfectly flexible.   However, it is equally obvious that Sumner does not believe that wages are perfectly flexible.   Sumner’s use of those terms would imply that there is no contradiction in claiming that “markets” rationally and efficiently take into account that wages are in fact sticky.

On the other hand, I am a Market Monetarist and I am not at all comfortable with any strong statements about the efficiency of markets or rational expectations.   From my “Virginia School” perspective, the relevant question is what institutions, including what monetary regime, is the least bad approach for generating good results from markets that are inefficient from the standard of perfection and expectations that may be well short of “rational” by some objective standard.

In my view, the proper goal of a monetary regime is to provide a stable macroeconomic environment for microeconomic coordination.   This is in the context of constant change–creative destruction.   In my view, slow, steady growth in spending on output is the best (least bad) approach.   It isn’t perfect.  But a gold or silver standard, a fixed quantity or growth path of some measure of the quantity of money, or a stable price level or inflation rate are all worse.