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.

Another “Austrian” Critique of Market Monetarism 3

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ShawnRitenour wrote a critique of Market Monetarism.   I responded to his criticism of our supposed failings of basic theory here.   I responded to his criticism of our view of the role of expectations here.   Here I will discuss Ritenour’s claim that Market Monetarists fail to understand the consequences of keeping nominal GDP on target.

Monetary inflation, therefore, will affect demands for certain goods first and then subsequent demands for different goods as the new money is spread through the economy. The step-by-step adjustment process during which the new money is absorbed necessarily results in real changes in relative prices and a real redistribution of wealth (Mises 1929, pp. 85-88; Mises 1938; Salerno 2010, pp. 202-03).

The market process by which an increase in the demand to hold money in the face of a fixed quantity of money leads to lower prices and wages and so an increase in the real quantity of money includes reduced money expenditures on goods and services.   Nominal GDP level targeting requires that instead the nominal quantity of money rise to match any increase in the demand to hold money.   Those particular people who choose to hold money reduce their expenditures on whatever goods, services, or financial assets they value less than the additional money balances. The newly-issued money is spent in some particular place or other.   This could easily impact relative prices and the allocation of resources. The effect is exactly what would happen if those choosing to hold more money had instead spent that money on whatever those issuing the money purchased.   The market economic system is especially good at making adjustments in the allocation of resources in response to just these sorts of changes in the composition of demand.

With a credit money system, those who choose to hold more money are choosing to accumulate a particular type of financial asset, and the banks (private or central) issue money by purchasing other financial assets–banks are financial intermediaries.    If the quantity of money rises with the demand to hold money, the effects are exactly as if those accumulating the additional money had instead accumulated whatever financial assets (loans or securities) purchased by the banks with the newly-issued money.    

The market process by which a reduction in consumption spending used to purchase financial assets results in lower market interest rates and more investment spending is reasonably well understood.   This shift in the relative demands for different types of goods results in an appropriate reallocation of resources.   Further, a shift in demand between different sorts of financial assets also results in adjustments in relative yields.   This may  result in some shift in the allocation of resources as well, but it is part of the normal operations of financial markets.   If investors sell one company’s bonds and purchase another company’s bonds, it is not neutral, but neither is it disruptive.

As for the change in the real distribution of income, it is correct that an unanticipated deflation of prices would have resulted in an unanticipated transfer of wealth from debtors to creditors .  Nominal GDP level targeting prevents this from occurring.   So, the unanticipated gain that all creditors, including those holding money, would have received under a constant money supply regime would not occur.   On the other hand, both the supply and demand for credit depend on the regime.    It is illegitimate to focus on just this one comparison.   In particular, nominal GDP targeting protects creditors from the impact of unanticipated inflation due to a decrease in the demand to hold money in the face of a constant quantity of money. 

When considering the trend growth rate of nominal GDP, the higher the growth rate, the higher the nominal interest rate that creditors receive from debtors.   Again, with a credit money system, that part of the money supply that bears interest, which is most of it, would pay a higher nominal interest rate due to a higher trend growth rate of nominal GDP.   Interestingly, the amount of money people hold in checkable accounts of various sorts will constantly grow exactly in proportion to what each person is holding.    For example, constant nominal GDP as suggested by Hayek or else the sort of “productivity norm” proposed by Selgin, would make holding hand-to-hand currency more attractive relative to checkable deposits.   The nominal interest rate paid on checkable deposits would be lower, though the real return on them would be approximately the same.

The problem with this common trope of Austrian economics repeated here by Ritenour is that it is really just simplistic “intellectual ammunition” trotted out in response to the helicopter drop thought experiment.   To take an even more unrealistic extreme, there is Hume’s thought experiment of every one’s money balance unexpectedly doubling overnight.    Is the creation of money perfectly neutral?   No, claim the Austrians and they are even willing to nitpick the helicopter chimera and Hume’s magic.   

I don’t think that money creation is neutral in the real world.   Exactly what it does depends on details of the monetary regime.   But where some Austrians go wrong is in claiming that these nonneutralities are especially disruptive.   In my view, any nonneutralities involved with money creation constrained by nominal GDP level targeting will not create any serious problems.

Ritenour continues:

Credit expansion necessarily stimulates malinvestment by encouraging production processes that are too roundabout relative to social time preferences (Strigl 1934, pp. 120–33; Mises 1949, pp. 547–62; Garrison 2001; Rothbard 2004, pp. 994–1004; Hayek 2008, pp. 189–329; Huerta de Soto 2006, pp. 347–84; Salerno 2012). Without an increase in voluntary savings, longer production processes are not all able to be completed. This is the heart of the malinvestment problem.
The first statement is false on its face.   “Credit expansion?”   For example, suppose people reduce spending on consumer goods and purchase bonds.  This is an expansion in credit.    The price of bonds rise and the yields fall.   Firms respond to the lower cost of funds by selling additional bonds to fund production process that are more round about.    The quantity of credit has expanded.   The interest rate has fallen.   But there has been a change in “social time preference” (though I find that an awkward way to characterize an increase in saving supply.)   There has been an increase in voluntary saving and there is no reason to anticipate malinvestment.

Of course, Ritenour was being a bit sloppy, and by “credit expansion,” he had in mind an increase in the supply of credit generated by an increase in the quantity of money.    However, if the demand for money had not increased, then the resulting excess supply of money would result in greater expenditure on output, pushing nominal GDP above target.   Nominal GDP level targeting is inconsistent with “out of the blue” credit expansions.   As explained above, if the demand for money increased while consumption spending decreased, then the effect of the credit expansion is exactly as if the savers had purchased some other sort of financial assets directly.   They are reducing current consumption and saving by accumulating money balances.   By consuming less now, they free up resources to allow for more round about methods of production.    The purchases of securities by banks (including central banks) or the new bank loans provide funds to entrepreneurs to undertake these more capital-intensive projects.

Of course, if the increase in the demand for money occurs through households or firms spending fewer current receipts on other sorts of financial assets, then there is just a change in the composition of financial assets being held.   It is as if those accumulating the greater money balances had instead directly purchased the bonds that the banks purchased or made the loans the banks made.   Finally, it is possible to accumulate money balances by selling financial assets.   While this would not necessarily be “neutral,” it would have no obvious impact on the degree to which production is round about.    The result is the same as if those accumulating money balances had sold their assets and purchased the ones that the banks purchase.

Ritenour’s problem here is that he continues to pound the same square pegs into round holes.   He, like too many Austrians, remains fixated on the thought experiment where the quantity of money rises while the demand for money, the supply of saving, and the demand for investment are all held constant.   While the possibility of changes the demand for money and the supply of saving is recognized (and the demand for investment is balled up in there with the supply of saving in some way,) any such changes are assumed to already shift to a new equilibrium assuming a constant quantity of money.   Then the change in the quantity of money and matching credit expansion are assumed to occur from that equilibrium.

But that is an absurd approach.   What happens when the supply of saving and the demand for money both change and the quantity of money changes with the demand to hold money?   If it all happens at once, you can’t break it down and describe a disequilibrium adjustment process for only a single part.    Admittedly, Hayek tended to focus on booms that occurred due to an increase in the demand for investment, and a monetary regime that failed to raise interest rates enough to keep nominal spending stable.     However, to the degree that the higher interest rates generate an increased quantity of saving supplied, a “credit expansion” is appropriate.   Further, to the degree that higher interest rates on checkable deposits result in a greater demand for money, funding at least part of that added credit through additional money balances is also appropriate.   Naturally, those adjustments would be consistent with keeping the level of nominal GDP on target.

Ritenour then continues:

NGDP targeting advocates end up fostering the monetary illusion that scarcity can be overcome and prosperity can be achieved via monetary inflation.

Here he goes beyond error to offense.   Market Monetarists in no way propose to use monetary inflation to overcome scarcity.

On the contrary, Market Monetarists aim to keep spending on output growing at a slow stable rate.   We believe that this will have the consequence of reducing both the frequency and duration of periods where actual production remains below the maximum amount possible given the reality of scarcity.   Further, we believe that it will reduce both the frequency and duration of periods where spending growth exceeds expansions in the amount that can be produced consistent with scarcity.   I use the term “potential output” to refer to just that–the maximum that can be produced subject to the constraint of scarcity.

Why does Ritenour make what is an absurd charge?   It is because over 100 years ago, Mises was very interested in refuting claims that an expansionary monetary policy can (and should) be used to permanently reduce real interest rates.    Many of those making such proposals promised that this would not only mitigate the scarcity of capital,  but could go so far as abolish it.   And many considered its chief benefit to be to raise labor’s factor share in income at least somewhat, perhaps even to 100%.  

Well, Market Monetarists have not argued that expansions in the quantity of money will permanently lower interest rates or that this would be a good thing because it would result in a larger capital stock or promote social justice by impacting the factor distribution of income.     Hardly anyone else makes these sorts of arguments either.   (Perhaps post-Keynesians or Modern Monetary theorists go there still.)

Market Monetarists have pointed out that it is possible for an increase in the quantity of money to be associated with increased nominal and real interest rates.   Admittedly, these are special scenarios associated with the introduction of a nominal GDP level targeting regime in the context of a previously existing shortage of money that has already pushed real output below the level consistent with scarcity.    More generally, Market Monetarists would like to see market forces determine all interest rates, and that those interest rates should be at levels that coordinate saving and investment at levels of  real output and income consistent with the constraint imposed by scarcity.    We argue that slow steady growth in spending on output is the least bad macroeconomic environment to maintain this sort of coordination.

Still, it is difficult to see how anyone who knows anything about the Market Monetarist approach could make the absurd accusation that we seek to use monetary inflation to overcome scarcity.   The best excuse, I guess, is again the effort to pound the square pegs into the round holes–repeating Mises’ arguments against his foes from more than 100 years ago.

Another “Austrian” Critique of Market Monetarism: Part 1

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Shawn Ritenour provides a critique of Market Monetarism on Mises.org.

He charges:
Market monetarist theory and policy is unsatisfactory primarily because Market monetarists use a faulty theoretical framework in analyzing economic activity, they misunderstand how expectations enter into economic decision making, and they do not recognize the actual consequences of the monetary policy necessary to stabilize NGDP expectations.
Is there any truth to these claims?   What about our “faulty theoretical framework?”

He writes:
Most relevant and troublesome for evaluating NGDP targeting is that there is no such thing as aggregate demand that equates with aggregate supply at a single price level.  In fact, the social economy is made up of a vast network of distinct markets that are integrated into a complex division of labor through the inter-temporal production structure and the use of a general medium of exchange. Productive activity, therefore, is the result of a vast number of decentralized decisions made by a multitude of different entrepreneurs at different places in the production structure.
Well, I certainly have no particular dispute with his broad description of the market economy.   I would add a bit more emphasis on creative destruction–innovation by entrepreneurs introducing new goods and services and new methods of producing existing goods and services.

So far, there is only one major difference.   In my view, there is something in a market economy that is usefully framed as “aggregate demand.”   And further, it can equal “aggregate supply” at a single “price level.” However, this framing of aggregate demand and supply is fully consistent with an understanding that a market order is a vast network of distinct markets.  (I might add, interrelated markets.)

He goes on to discuss capital:

Capital is not a blob of homogenous schmoo (Foss and Klein 2012, pp. 105-30), so investment is not a homogenous ‘I’ (Garrison 2001).
I certainly don’t think of capital as “homogenous schmoo,” and would even grant that investment is not a homogenous “I.”    Of course, the nominal volume of spending on newly produced capital goods is an actual flow of money expenditure.  It is a sum of the amount spent on a variety of different things.

But then, literally identical drill press machines can be used for a variety of purposes–continuing to produce some variety of automobile that no one is going to want or else producing washing machines in an insufficient quantity to meet an unanticipated demand.

That doesn’t make the role of the price of drill press machines in coordinating their supply and demand irrelevant.    Still, even if the price of drill press machines does coordinate the supply and demand for drill press machines, there is no guarantee that people will want to purchase all of the cars that some of the drill press machines were used to produce.   For example, some other entrepreneur may have innovated and introduced a new type of car that people like better.

Similarly, the heterogeneous nature of  capital goods doesn’t mean that interest rates cannot coordinate saving and investment.   However, even if saving and investment are coordinated, there is no guarantee that the particular capital goods being produced will help produce the products that people are most willing to buy.  Because of creative destruction, it is likely that there will nearly always be “malinvestment.”   Capital goods will be produced that in retrospect should not have been produced.  Instead, the resources would have been better used to produce something else.

Ritenour then states:

It is possible for people to decrease their demand for consumer and producer goods if they increase their demand to hold money. This would only lead to wastefully idle resources, however, if prices for these resources remained above market-clearing levels. This will not persist, of course, if prices are allowed to adjust (Hutt 1979, pp. 138-39).
Exactly, the first portion is exactly what aggregate demand is about.   It refers to a situation where the quantity of money or the demand to hold money shifts resulting in either a surplus of money or a shortage of money.

A surplus of money is matched by a shortage of goods and services, and that is what it means for aggregate demand to exceed aggregate supply.   A shortage of money is matched by a surplus of goods and services, and that it what it means for aggregate demand to be less than aggregate supply.   And finally, if the quantity of money is equal to the demand to hold money, there is no shortage or surplus of output.  Aggregate demand is equal to aggregate supply.

How does this relate to a “single” price level?    If the prices of both final goods and resources adjust, then the real quantity of money will adjust to match the demand, closing off any surplus or shortage of money.   The primary problem with Hutt’s account is the assumption that the problem is necessarily the price of the resource in surplus and that it is the fault of obstinate labor unions preventing the adjustment.  

While unions certainly could cause problems, if output prices fail to fall in the face of an excess demand for money, no amount of wage cutting will help reduce unemployment.    The problem isn’t with the relative price of some resource, the real wage in this instance, but rather with the price level and the real quantity of money.   Further, there have been many historical instances where unions are unimportant, weak, or even nonexistent, and reductions in spending on output have resulted in extensive reductions in both output and employment.

Market Monetarists (and nearly all mainstream economists these days,) recognize that decreases in prices and wages increase real money balances and expand aggregate demand and that this can bring the real volume of sales into balance with the productive capacity of the economy.

Something like this is behind what is called the “natural rate hypothesis.”    In the long run, aggregate supply is vertical at the level of output  that depends on the ability and willingness to produce goods and services.   Aggregate demand solely influences the price level, including the prices of productive resources like labor.

Market Monetarists insist that expanding the nominal quantity of money is a much better way to raise the real quantity of money and bring it into balance with the real demand to hold money, simultaneously raising nominal and real aggregate demand so that it matches potential output.

By the way, Market Monetarists, like just about everyone else, recognizes that while an excess demand (shortage) of money is matched by an excess supply (surplus) of output, that output is heterogeneous.   Each and every type of output has its own supply and demand, and the difference between each supply and demand, evaluated at the current market price, must be summed to find the net excess demand or supply of output.

If aggregate demand equals potential output, then the sum of the excess demands for all types of output is zero.   This implies that there can very well be surpluses of some goods or services, but that these surpluses are matched by shortages of other types of goods and services.

 In other words, it is almost exactly like what a naive interpretation of Say’s Law claims must be true at all times.  Supposedly, supply creates its own demand, and so while there may be a surplus, or glut, of some goods, this is because resources have been used to produce the wrong goods or services.   The markets for the goods that were not produced because of the misallocation of resources are in shortage.

That prices fall in markets with surpluses and rise in markets with shortages is exactly how market signals are created to shift resources to produce the most highly valued goods.   In my view, in a world of creative destruction, this is happening all the time.  The market order is a system of constant mutual adjustment to constant change.

Ritenour continues:

Instead of allowing markets to clear via price adjustments according to subjective preferences, market monetarists advocate that monetary authorities bring about market stability by increasing the money supply. Such inflation, however, will not necessarily equilibrate the specific demand for and supply of money on the part of the individuals who are experiencing the excess demand. If prices and wages are that sticky, there will need to be a significantly large increase in NGDP to maintain equilibrium.
Actually, Market Monetarists favor having monetary authorities adjust the quantity of money either up or down to keep it equal to the demand to hold money.  I find it odd that so many Austrians have this blind spot.   It is always a critique of “inflation” (an increase in the quantity of money,) rather than considering the opposite situation where a reduction in money demand leads to a surplus of money, a shortage of output, and so a higher price level to reduce the real quantity of money and lower real aggregate demand to match potential output.   Market Monetarists favor a reduction in the quantity of money in this situation.

The notion that an expansion in the quantity of money cannot accommodate an added demand to hold money because it fails  to reach the specific individuals who want to hold more money is absurd.    It ignores the fundamental proposition of monetary theory.

The individuals who want to hold more money actually do obtain it by spending less out of their current incomes or selling some asset they own.  Of course, those from whom they would have purchased the goods or those to whom they sold the assets now have less money.    As those people in turn restrict expenditures or sell assets, they rebuild their money holdings but the shortage shifts to still others.

The fundamental proposition of monetary theory is that the individual can adjust his or her actual money holdings to desired money holdings easily.   It is rather that if the total quantity of money is fixed, then the market as a whole must adjust its desired money holdings to the existing quantity.   For this adjustment to be consistent with economy-wide coordination, what must change is the price level, both of output and productive resources including labor.

If the quantity of money changes to match the increase in the demand to hold money, then those choosing to accumulate money holdings do so, but the effect is identical to what would have happened if they had chosen to purchase whatever is purchased with the newly- issued money.   For example, if people choose to reduce expenditures out of current income and accumulate funds in their checking accounts, and banks create new money and make loans to various businesses, then the effect is the same as if those accumulating the money had instead made those loans directly to those businesses.   Those accumulating money spend less on some goods, and the businesses spend more on other goods.   There is no change in nominal GDP.  

There is a reallocation of resources.  But there would have been a reallocation of resources anyway.   What an adjustment in the quantity of money allows is for this reallocation to occur  without everyone in the market having to adjust their money prices (including wages) to increase the real quantity of money to match the demand.  With an increase in the nominal quantity of money, those who need to expand production get a signal of increased nominal and real demand.   Those who need to contract get a signal of reduced nominal and real demand.

This is as opposed to everyone getting a signal of reduced nominal demand, which is nearly always taken as a signal of reduced real demand and so creates the mistaken response of all firms cutting production.   Only when the resulting surpluses of resources result in lower resource prices is the reality that all nominal opportunity costs have fallen (and real opportunity costs are the same) signalled to firms, so that they can expand both production and employment.  The reallocation occurs anyway, with the signal to shift the allocation of resources arriving as some firms see falling costs turn their losses into profits sooner than others.  

Anyway, since Market Monetarists favor a target growth path for NGDP,  the notion that “there will need to be a significantly large increase in NGDP to maintain equilibrium,” is beside the point.   All that Market Monetarists propose is that increases in the demand for money be accommodated by increases in the nominal quantity of money so that they require no change in NGDP.   We are not proposing to raise NGDP so that…I don’t know what.   No one ever adjusts their expenditure because they are short on money?    I am not sure that would be possible.  

As is so common, there is an implicit assumption that Market Monetarists are proposing to target real GDP or unemployment.   Or perhaps more realistically, old arguments against targeting real GDP or unemployment are being trotted out where they don’t apply.   Market Monetarists are not proposing to increase nominal GDP whatever amount is necessary to close the output gap (raise real output to potential output) or lower the unemployment rate to the natural unemployment rate.

Retinour makes the following claim:

Additionally, decreases in demand are always experienced in particular markets. When there is either a decrease in demand or a decrease in supply in the face of elastic demand, total expenditures will drop. Note however, that spending is the effect of the changes in the preferences of buyers and sellers, not the cause of the decrease in demand or supply. Salerno (2006) shows how this applies to the broad social economy. Market-clearing prices (and quantities) are determined on every market by the interaction of individuals’ value scales on which goods are valued in relation to one another and to money. It is only after market equilibrium prices and quantities and, therefore, the value of money, have already been determined that “spending”occurs.

I am not sure how much of this is all due to Salerno or even if Ritenour correctly expresses Salerno’s views.   (I haven’t read Salerno 2006.)   But the way Ritenour describes it, Salerno is promoting an absurdly Walrasian account of the economy.   First the equilibrium prices are determined, then everyone makes exchanges.   I take a more “market process” view of the market economic order.  

On the other hand, I don’t think people choose to spend a certain amount of money on some particular good independent of the price and quantity combination it represents.    From a micro perspective, the focus on spending comes from the budget constraint, keeping in mind that choosing to accumulate more money is a use of money income as well.

In later posts I will comment on Ritenour’s criticisms of the Market Monetarist view of expectations and the actual consequences of changes in the money supply necessary to keep NGDP growing at a  slow steady rate.

Austrian Business Cycle Theory 2

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Some advocates of the Austrian Business Cycle Theory trace the passage of new money through the economy. The new money enters the economy at a certain place, and those receiving it spend it. And so on. As the money passes through the economy, it distorts relative prices. Since relative prices provide signals and incentives to adjust production, the passage of the new money through the economy distorts production as well. These distortions of production are malinvestments.

If the point of this argument is that changes in the quantity of money are not likely to be neutral–to impact all prices in proportion–the argument has some value. However, excessive focus on the new money is an error. Suppose the new money has a different color. For example, all existing money is green, and the new money is red. Is it really correct that the distortions in the economy can be identified with the transactions undertaken with the red money and all of those transactions handled with green money reflect some kind of undistorted market?

In my view, such a position is so wrong as to be wrongheaded.

While the initial point of entry into the economy is important, after that, changes in prices impact the patterns of demands–the way that “old” money is spent. It is the various direct and indirect effects of changes in demand that are relevant.

Suppose households refrain from spending $10 billion on restaurant meals and instead purchase bonds. The bonds are sold by firms who use the proceeds to purchase $10 billion of drill presses.

The central bank creates $5 billion of new(red) money and lends it to the firms to purchase drill presses. The increase in the supply of loans immediately results in a surplus of loans. The central bank, and the bond buyers compete to find borrowers, resulting in a lower market interest rate. The central bank lends newly created money into existence at a lower interest rate. The prices of the bonds the households buy are higher, and the yields lower.

Because of the lower interest rate, firms can profitably use more drill presses. The demand for drill presses rises. It would be possible that households would continue to refrain from purchasing restaurant meals and continue to purchase $10 billion worth of bonds. When added to the $5 billion lent by the central bank, that will be a total of $15 billion spent on drill presses. In that scenario, $10 billion of old (green) money is spent on drill presses like before, and $5 billion of additional new (red) money is spent on drill presses as well.

However, the lower interest rate that households receive from bonds reduces their incentive to buy them. Suppose they purchase $2 billion fewer bonds and instead purchase restaurant meals. The households spend $2 billion additional old (or green) money on restaurant meals. They spend only $8 billion of old (green) money on bonds, which is received by firms to purchase drill presses. So the firms spend $2 billion less old (green) money on drill presses. Of course, the central bank is lending $5 billion new (red) money to firms to purchase drill presses. So the firms spend $8 billion old (green) money on drill presses. They spend $5 billion new (red) money on drill presses, for a total expenditure on drill presses of $13 billion. The increase in expenditure on drill press machines is $3 billion.

Clearly, $2 billion of the $5 billion of new (red) money is spent on drill presses that would have been purchased even if the central bank hadn’t lent anything. Of course, they would have been purchased with old (green) money. At most, $3 billion of the new (red) money is used to purchase drill presses that are only purchased because of the central bank’s loans.

However, even this is not necessarily true. Suppose there are several established firms that regularly purchase drill presses. They buy $10 billion worth. The central bank, lends those firms $5 billion. Every drill press that is purchased with the new (red) money would have been purchased even if the central bank had done nothing. The firms sell only $5 billion of bonds to fund the other $5 billion of drill presses. The households who would have purchased the other $5 billion of bonds must either purchase restaurant meals or else lend to someone else. Since they are willing to accept lower interest rates, some new, start-up firms enter the industry and sell $3 billion worth of bonds and purchase $3 billion worth of drill presses. The additional drill presses are all purchased with old (green) money.

So, in this scenario, the central bank creates $ 5 billion in new (red) money. All of it is spent on drill presses that would have been purchased anyway. However, the distortion of interest rates does have an effect. While $5 billion of old (green) money continues to be spent on drill presses exactly as it would have been spent, $2 billion of old (green) money is spent on additional restaurant meals, and $3 billion of old (green) money is spend on additional drill presses. In this scenario, all of the increase in demand created by the central bank involves the expenditure of old (green) money.

While in this scenario, more of the increase in demand was on drill presses ($3 billion) and less on restaurant meals ($2 billion,) it would be possible that the situation is reversed. Suppose the demand for restaurant meals and the supply of bonds is very interest elastic. On the other hand, the demand for drill presses by the start-up firms is not very interest elastic. It would be possible that all of the $5 billion of new (red) money is lent to firms that would have purchased drill presses anyway. They sell $5 billion of bonds and still purchase the other $5 billion of drill presses with old (green) money coming from the households. And the households use $3 billion of old (green) money to purchase restaurant meals that they would not have bought if they had instead been using that income to purchase bonds. And they purchase $2 billion of bonds using old (green) money from the startups, who are purchasing $2 billion of drill presses using that old (green) money.

The new (red) money was spent on drill press machines, but the distortion in demand involves entirely the pattern of expenditure of old (green) money. And the greatest distortion is in a segment of the economy, restaurant meals, different from where the red money is spent.

I am not arguing that only in these special cases where none of the new (red) money is spent on the particular goods that represent the malinvestmen does tracing the new money become pointless. I think the most plausible scenario for the drill presses would be that some new money is spent on drill presses that are only profitable because of the lower interest rate. And some old money would be spent on those particular drill presses too. My point, however, is that the color of the money is irrelevant.

While the initial point of entry is important, after that, there is no point in looking at what happens to the new money. And, everyone who understands this and is using language about what happens to the new money, stop! It is rather the new patterns of demand that might have various secondary and tertiary effects.

Because of the influence of the Austrian theory on free market oriented laymen, there is a significant group of people who are liable to get confused. And further, they will pontificate about what the Austrian theory means to still other people in a confused fashion. So let’s avoid the confusion.

More Austrian Cycle Theory

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I believe that the monetary disequilibrium and the public finance versions of the Austrian Business Cycle Theory hold simultaneously. To the degree the inflation process involves excess supplies of money and money is being lent into existence, the market rate is pushed below the natural interest rate and the demands for more interest elastic goods expand relative to the demands of less interest elastic goods. However, this results in larger or smaller shortages of these goods. This might impact the composition of output, but the entire process only lasts as long as there is an excess supply of money. Once prices adjust enough so that the real quantity of money equals the real demand for money, and they are growing together, there is no more impact on the composition of demand and so no tendency to impact the composition of output.

Simultaneously, the rather slender base of the inflation tax and the inflation rate throws off a revenue. If this revenue can and is directed into a subsidy for the provision of credit, the result is a decrease in the natural interest rate and a new equilibrium allocation of resources as long as the inflation process continues. Basically, to the degree the people pay the inflation tax by reducing their demands for goods whose demands happen to be relatively interest inelastic, then resources are shifted by the impact of the subsidy to the production of those goods that are relatively interest elastic. Fewer restaurant meals and more houses, drill presses and dams seems plausible. Since restaurant meals are clearly consumer goods, this can be described as “forced saving.”

If the inflationary process is stopped, then there is a decrease in the demand for goods whose demands are relatively interest elastic and an increase in demand for whatever those paying the inflation tax had sacrificed. Given the interaction of the tax and subsidy scheme, that should be increased demand for goods whose demands are relatively interest inelastic. The result would be similar to any other situation where the demand for some goods fall and the demand for other goods rise–structural unemployment, losses on specific capital goods, and a need to construct more appropriate capital goods. This is very different from the correction of a monetary disequilibrium where higher prices and market interest rates cause the shortages of goods with relatively high interest elasticity to shrink faster than the shortages of those goods with demands that are less interest elastic.

My view is that nearly all Austrian economists, including the greats like Mises and Hayek, but also my fellow “free bankers,” like Selgin, White, Garrison, and Horwitz, confound these two processes. The monetary disequilibrium is given an implausible persistence by confounding it with the public finance effect. The “correction” from the monetary disequilibrium is confounded with the quite different “correction” that results when there is a decrease in the rate of the inflation tax.

I would like to pretend that these differences are purely technical, but I must confess that they are policy driven. Many years ago, I was a strong advocate of the Greenfield/Yeager scheme of free banking. They called it the Black-Fama-Hall payments system. The system generates a stable price level. Those versions of the Austrian theory that claim that a stable price level in the face of rising productivity leads to malinvestment are a challenge to the desirability of the Greenfield/Yeager scheme of free banking.

I still favor free banking in the context of a 3 percent growth path for aggregate cash expenditures. The reason for the 3 percent growth rate is that the productive capacity of U.S. economy has grown about 3 percent in the past, so the scheme should result in a stable price level on average. While the scheme results in price inflation or deflation when the productive capacity of the economy deviates and returns to trend, it would seem that it would be subject to the same “Austrian” critique. Price stability on average in the face of growing productivity must lead to malinvestment.

No. It doesn’t.

While I don’t believe the terminology of “inflation tax” applies very well to a free banking system with a stable price level, the effect exists. Growing productivity raises real income. Growing real income raises real money demand. If the price level is stable, increasing real money balances requires growing nominal balances. The way those using money increase their nominal balances is by holding nominal expenditures less than nominal incomes. That means that real expenditures are held below real incomes. This frees up resources to produce something. The newly issued nominal balances are lent out and used by the borrowers to purchase goods and services. And that is what the resources are used to produce.

This is the “public finance” argument but the money creation is limited to the growth in the real demand to hold money. What is important is that this is not disequilibrium. Any impact on the allocation of resources can persist as long as these monetary institutions persist.

Further, if instead of price stability, the institution generates a trend of price inflation (for example, 5 percent cash expenditure growth and 2 percent trend inflation rate,) then the public finance argument applies here as well. Those using money would have to reduce their real expenditures to maintain real balances in the face of inflation. The resources that would have been available to those holding money of stable value (or appreciating money) go to those borrowing. This allocation of resources can persist as long as these monetary institutions persist.

So what about the monetary disequilibrium effect? If we imagine that monetary institutions generated a mild deflation with productivity growth, and then they change to price stability, in the absence of somewhat implausible instant adjustment to a rational expectations equilibrium, there should be the disequilibrium effect–real surpluses of money, a matching increase in the real supply of credit, and lower market interest rate, and a distortion of the pattern of demands creating larger and smaller shortages. The same would be true if the shift was from the deflationary environment to the mildly inflationary environment to an even larger degree. Or there would be a similar impact if the change was from a stable price level to mild inflation.

However, the mild inflation of the Great Moderation did not develop from a baseline of mild deflation. On the contrary, it developed from a large disinflation from the Great Inflation of the seventies. The thought experiments that might apply to shifts in monetary regimes from mild deflation to price stability to mild inflation have little direct application to the economic history of the later twentieth and early twenty-first centuries.

The notion that the mild trend inflation during the Great Moderation involved persistent surpluses of money is absurd. To the degree that the mild inflation tax generated a subsidy that impacted the allocation of resources to the production of additional housing or any other capital good, there was nothing to prevent this from persisting forever. (One of the possible costs of shifting to my preferred regime of cash expenditure growth consistent with a stable price level regime is a need to reallocate resources.)

Will the Austrians soon make “Schweizerwitze” about an increasingly backward country?

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What is happening now around the Bundeshaus, can foresee bad for the upcoming election year. “You do not deal with a Federal Council,” said Johann Schneider-Ammann this week.

Our Minister of Economic Affairs obviously never mentally left the Emmental. He can not understand that the Swiss Trade Union Confederation, which has been unsuccessful in recent years, does not want to lose this battle for the accompanying measures. Where clever negotiation would have been necessary, we are now faced with a shambles, because the time of the “Lords of Bern” is over.

We have dealt badly in Germany and have not made any point in Brussels for many years. The EU is not weakening, as our Augurs have always suspected, but Switzerland is losing weight. This senses Schneider-Ammann’s party colleague, Foreign Minister Cassis, several times. His position in Brussels is simply hopeless.

Professor Carl Baudenbacher, our former President of the EFTA Court, warned against this situation for years, but our political BBB elite did not want to listen to these experienced and bright lawyers.

The FDP has two bad cards in his hand. In this situation, party leader Petra Gössi said: “I do not want to become a Federal Councilor.” Is that all?

She could have talked about the challenge that comes to us from Vienna. There, the Austrian Chancellor Sebastian Kurz wins international weighting. In short, who has a good connection to the Eastern European EU countries, Viktor Orban at the top, can play this card in Brussels, where you get past him less and less.

Through his ambassador in Brussels, he let Switzerland know via “Swiss Month” that we should finally move. Have we perhaps become the little brother of Austria and will soon be making “Swiss jokes” about an increasingly backward country, which used to know only the joke about the Austrians?

It does not look much better for the CVP. Party President Gerhard Pfister, who is what one calls “an honest skin”, faces the difficult task of accompanying his Federal Councilor, Doris Leuthard, out of office without harm.

Doris Leuthard is weakened in the Bundesrat, she can no longer play the tip of the scales as before. She has dossiers that she would rather deliver today than tomorrow.

The “big change”, the environmental policy, is an adventure costing the citizens billions, which has so far brought little results. Leuthard let billions sink in the sandbox of the environmentally friendly energy politicians. No serious person believes that this could lead to a good ending. Doris Leuthard is looking for an escape route.

The progressive transport policies of its predecessors should have resolutely continued; there is little to see. The streets are more clogged than ever. The congestion costs amount to two billion francs a year alone. Doris Leuthard did not speed us up, but wants to even comprehensively introduce Tempo 80. This is reminiscent of Gottfried Keller and “The People of Seldwyla”.

The neglected rail traffic needs new billions nobody wants to make available.

Our air traffic policy, above all at the “Hub plus” at Zurich Airport, is to give the German Lufthansa Group free flight for its expansion plans. Switzerland pays the expenses and covers the environmental, health and noise risks, while the Germans are spared.

Doris Leuthard, the best saleswoman in the Bundesrat for many years, is really in front of a pile of shit. I will deal with the other Federal Councilors and their parties shortly.